Federal Income Tax Outline (Tax 1)


Federal Income Tax Outline (Tax 1)

 

Federal Income Tax Supplements for Law School

 

  1. Introduction to Federal Income Taxation
    1. A Glimpse Backward

      1. The nation had few taxes in its early history. From 1791 to 1802 (tax was abolished), the United States government was supported by internal taxes on distilled spirits, carriages, refined sugar, tobacco and snuff, property sold at auction, corporate bonds, and slaves. The high cost of the War of 1812 brought about the nation’s first sales taxes on gold, silverware, jewelry, and watches. In 1817, however, Congress did away with all internal taxes, relying on tariffs on imported goods to provide sufficient funds for running the government.

      2. In 1862, in order to support the Civil War effort, Congress enacted the nation’s first income tax law. It was a forerunner of our modern income tax in that it was based on the principles of graduated, or progressive, taxation and of withholding income at the source. During the Civil War, a person earning from $600 to $10,000 per year paid tax at the rate of 3%. Those with incomes of more than $10,000 paid taxes at a higher rate. Additional sales and excise taxes were added, and an “inheritance” tax also made its debut. In 1866, internal revenue collections reached their highest point in the nation’s 90-year history—more than $310 million, an amount not reached again until 1911.

        1. The Act of 1862 established the office of Commissioner of Internal Revenue. The Commissioner was given the power to assess, levy, and collect taxes, and the right to enforce the tax laws through seizure of property and income and through prosecution. The powers and authority remain very much the same today.

      3. In 1868, Congress again focused its taxation efforts on tobacco and distilled spirits and eliminated the income tax in 1872. It had a short-lived revival in 1894 and 1895. In the latter year, the U.S. Supreme Court decided that the income tax was unconstitutional because it was not apportioned among the states in conformity with the Constitution.

      4. In 1913, the 16th Amendment to the Constitution made the income tax a permanent fixture in the U.S. tax system. The amendment gave Congress legal authority to tax income and resulted in a revenue law that taxed incomes of both individuals and corporations. In fiscal year 1918, annual internal revenue collections for the first time passed the billion-dollar mark, rising to $5.4 billion by 1920. With the advent of World War II, employment increased, as did tax collections—to $7.3 billion. The withholding tax on wages was introduced in 1943 and was instrumental in increasing the number of taxpayers to 60 million and tax collections to $43 billion by 1945.

      5. Prior to 1874, U.S. statutes were not codified. That is, they were not set forth in one comprehensive subject matter title, but were instead contained in the various acts passed by Congress. Codifications of statutes (including tax statutes) undertaken in 1873 resulted in the Revised Statutes of the United States, approved June 22, 1874, effective for the laws in force as of December 1, 1873 (title 35 of which was the internal revenue title). Another codification was undertaken in 1878. In 1919, a committee of the U.S. House of Representatives began a project to recodify U.S. statutes which eventually resulted in a new code in 1926 (including tax statutes).
      6. The tax statutes were re-codified by an Act of Congress on February 10, 1939 as the “Internal Revenue Code” (later known as the “Internal Revenue Code of 1939”). The 1939 Code was published as volume 51, Part I, of the United States Statutes at Large and as title 26 of the United States Code. Subsequent permanent tax laws enacted by the United States Congress updated and amended the 1939 Code.
      7. On August 16, 1954, in connection with a general overhaul of the Internal Revenue Service, the IRC was greatly reorganized by Congress and expanded. To prevent confusion with the 1939 Code, the new version was thereafter referred to as the Internal Revenue Code of 1954 and the prior version as the Internal Revenue Code of 1939. The lettering and numbering of subtitles, sections, etc., was completely changed. For example, section 22 of the 1939 Code (defining gross income) was roughly analogous to section 61 of the 1954 Code. The 1954 Code replaced the 1939 Code as title 26 of the United States Code.
      8. On Oct. 22, 1986, President Reagan signed into law the Tax Reform Act of 1986, one of the most far-reaching reforms of the United States tax system since the adoption of the income tax. The top tax rate on individual income was lowered from 50% to 28%, the lowest it had been since 1916.

    2. The Income Tax and the United States Constitution
      1. Article 1, Section 8: Constitution of the United States confers on Congress the “power to lay and collect taxes, duties, imposts and excises…”
      2. 16th Amendment: The 16th Amendment took effect in 1913 and gave Congress the power to impose income taxes.
      3. Apportionment Among the States
        1. Article I, Section 2, clause 3 and Section 9, clause 4 require that “direct” taxes be apportioned among the several states in accordance with their respective populations
          1. Direct tax v. Indirect tax
            1. A direct tax is demanded from the very person intended to pay it while an indirect tax is paid primarily by a person who can shift the burden of the tax to someone else or who at least is under no legal compulsion to pay the tax
        2. The Rule of Apportionment says that after Congress has established a sum to be raised by direct taxation, the sum must be divided among the states in proportion to their respective populations
        3. In Pollock v. Farmers’ Loan and Trust, the Supreme Court invalidated an income tax statute that included as income rents from real estate because they felt that the intention of the drafters of the Constitution was to prevent the imposition of tax burdens on accumulations of property, except in accordance with the rule of apportionment
      4. Uniformity Among the States
        1. Article 1, Section 8, clause 1 reads: “all duties, imposts, and excises shall be uniform throughout the United States”
          1. By uniform, it is well settled that the Constitution requires only geographic uniformity
        2. Whenever some manner or mode of taxation is used somewhere in the US, the same manner or mode must be used everywhere throughout the US
        3. Notwithstanding the Constitutional fiat of uniformity, in the practical application of the income tax laws some lack of uniformity creeps in, even in the geographical sense, because there are always uncertainties in the interpretation of statutes
      5. Due Process
        1. It has been long settled that Congress may impose an income tax measured by the income of a prior year or by income of the year of the enactment before the enactment date
        2. If questions can be raised about retrospective taxation, the 5th Amendment seems the likely weapon, but the Supreme Court has held that it “is not a limitation upon the taxing power conferred upon Congress by the Constitution”
          1. Although the 5th Amendment may not limit the taxing power, it can vitiate a statute that, while masquerading as a tax, in reality amounts to confiscation
      6. Self-Incrimination
        1. It is well settled that requiring a taxpayer to file an income tax return does not violate the 5th Amendment privilege against self-incrimination; rather, the proper place to raise the objection is in the return itself
    3. Sources of Federal Income Tax Law
      1. Internal Revenue Code of 1986 (IRC): Title 26 of the United States Code (USC) is the primary source of authority for the federal tax law.
      2. Treasury Regulations: Regulations are drafted by the United States Treasury Department under authority from Congress.
        1. Legislative: The regulations are drafted to cover specific provisions of the IRC. They carry the force of law unless they are drafted so broadly as to fall outside of their specific mandates.
        2. Interpretative: Some regulations are interpretative. These are issued under general authority granted by Congress, and are given a strong presumption of correctness by the courts. Regulations can be held invalid.
      3. Revenue Rulings and Procedures: Rulings and procedures are written by IRS attorneys and are not official pronouncements. They respond to a limited factual setting, accordingly, their scope is limited. Essentially, “an indication that you’re going to get hassled if you go through with the transaction.”
      4. Rulings and Determination Letters: Letters of ruling or determination are written for taxpayers’ inquiries sent to the IRS national office or a district director. These are issued only if a clear determination can be made from the IRC, a treasury regulation, or court decision. These letters cannot be cited as authority, but guide in determining the IRS position with regard to an issue.
      5. Judicial Opinions: Tax controversies are heard by the United States Supreme Court, US Court of Appeals, US District Court and the United States Claim Court. In addition, the United States Tax Court is specifically set aside for tax issues.
    4. Income Tax Terminology
      1. Tax Computation
    5. The Big Picture
      1. Gross Income (§61) (all income from whatever sources derived-except for statutorily excluded)
        1. Less: Certain Deductions (i.e.Business Expense (§61)
      2. =Adjusted Gross Income
        1. Less: Personal Exemptions
        2. Less: Standard or Itemized Deductions
      3. = Taxable Income
        1. Multiplied by Tax Rate (from tables in §1)
      4. =Tax Due on Taxable Income
        1. Less: Credits
      5. = Tax Due/Refund
        1. Filing Categories and Rate –§1
          1. Progressive: Proportional tax rate.
          2. Marginal: Rate at which the last dollar is taxed at the top tax rate to which the taxpayer is exposed.
          3. Effective: Average tax rate applied to every dollar.
    6. Tax Ethics
      1. A taxpayer has a responsibility to file an accurate tax return, and a lawyer may advise a client to take a particular return position only if it has a “realistic possibility of success on the merits if litigated.” Certain civil and criminal penalties attach to an inaccurate tax return.
    7. The Road Ahead
      1. Relevant Questions to Consider in Working Tax Problems
        1. What is gross income?
        2. Who pays tax on it?
        3. What deductions are allowed on that gross income?
          1. Above the line” deductions are subtracted from gross income and are available to all taxpayers whether they choose to itemize or not
            1. Common deductions: Contributions to IRA, non-employee trade or business expenses, employee expenses paid by the taxpayer under a reimbursement arrangement with her employer, losses from the sale or exchange of property, expense related to the production of rents or royalties, employer contributions to the taxpayer’s pension or profit-sharing plan, contributions to qualified retirement savings plans, alimony payments made by the taxpayer, employment-related moving expenses that were not reimbursed by the taxpayer, qualified contributions to medical savings accounts, and interest paid on qualifying education loans.
          2. Below the line” deductions are subtracted from adjusted gross income to arrive at taxable income. These include the standard deductions, regular itemized deductions, and miscellaneous itemized deductions. The TP may choose either the standard below-the-line deduction or itemized deductions, but not both.
            1. Common itemized deductions: Interest paid §163, taxes paid to state and local governments §164, charitable contributions §170, business and investment losses §165, personal casualty losses, medical expense §213, moving expenses, education §222
            2. Common miscellaneous itemized deductions: §67 Unreimbursed employee expenses, expenses related to generating investment income, and tax preparation fees. The key fact to remember about these deductions is this: only that amount of miscellaneous itemized deductions, added together, which exceeds 2% of AGI may be deducted from AGI. The 2% floor does not apply to pass through entities such as partnerships.
        4. For what year is an item income or deductible?
        5. What is the character of various items?
        6. Is a gain or loss to be immediately recognized?
        7. What is the taxpayer’s tax liability?
        8. Are any credits available?
        9. Have any mistakes been made and what would happen in the event that one was?

 

 

————————————————–GROSS INCOME———————————————————-

 

  1. Identification of Income Subject to Taxation
    1. Gross Income Definition – §61: “Gross income means all income from whatever source derived.” Broad interpretation. Compensation for services, rents, royalties, interest and dividends is explicitly included. §71-87 mention additional items included in gross income. However, this list is not considered exhaustive. There are also numerous exclusions such as interest on state and municipal bonds.
    2. Receipt of Financial Benefit
      1. Realization and Recognition: A gain or loss is said to be “realized” when there has been some change in circumstances such that a gain or loss might be taken into account for tax purposes. Realization requires the accrual or receipt of cash, property, or services, or change in the form or nature of an investment. A realized gain is then said to be “recognized” when the change in circumstances is such that the gain or loss is actually taken into account. Therefore, a realization of gain does not necessarily bring forth immediate gain recognition.
        1. Pure Income: Tax immediately.
        2. Capital Investment: Tax when owner pulls the realization trigger.
          1. Example: A taxpayer owns stock for which she paid $100 and the stock goes up in value to $150. There is no realized gain even though there has been an increase in the taxpayer’s wealth. Gain is realized when the shares are sold for $150 or exchanged for other property worth $150.
      2. Found Money – Treasure-trove is specifically included as gross income. Cesarini v. United States (ND Ohio, 1969) In 1957, Mr. and Mrs. Cesarini purchased a used piano for $15. In 1964, they found $4,467 in old currency hidden inside. The Cesarinis exchanged the old currency for new, and reported the total amount on their tax return for 1964. They were forced to pay tax on the money totaling $836.51, which they subsequently asked to be refunded on the ground that found money is not ordinary income under IRC and that even if it were income, it should have been declared in 1957, and thus recovery is barred by the three-year statute of limitations. Plaintiffs also argued that if the money was treated as income, plaintiffs should receive capital gains treatment rather than being charged with ordinary income. Holding: Found money is ordinary income.
        1. Rationale:
          1. No Exception: §61 specifically provides that “all income from whatever source derived” is to be included as income unless it falls under one of the IRC exceptions. Found money is not one of those exceptions.
          2. Income When Found: Revenue Ruling 61, 1953-1 CB 17, specifically provides that “the finder of treasure trove is in receipt of taxable income…for the taxable year in which it is reduced to undisputed possession.” Because this money was not found until 1964, it is not income for 1957. Ohio law (if no federal regulation then look to Ohio law)
          3. Not a Gift: Found money does not fit within definition of a gift.
          4. Not a Capital Gain: This money is not entitled to capital gains treatment since found money is to be included as ordinary income in the year in which the taxpayer gains control over it.
        2. Analysis: “Income from all sources is taxed unless the taxpayer can point to an express exemption.” The statement gives §61 of the I.R.C. a broad interpretation, and appropriate reading as the statute’s language suggests. Court noted that the Treasury Regulation was on point on this issue: “Treasure trove, to the extent of its value in the United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession. Case is an overview of the variety of interpretive materials-legislative, judicial, and administrative-used to decipher the meaning of the code. The court’s use of Ohio law to determine when the Cesarini’s became liable for the tax, serves as an example of the extent to which underlying state law rights and obligations can play a significant role in the federal income tax scheme.
      3. Payments to 3rd Parties(Discharge of Debt- §61(a)(12))– The discharge by a third part of an obligation owed by the taxpayer is an economic benefit to the taxpayer, and is includable in gross income.Old Colony Trust Co. v. Commissioner (1929) American Woolen Company’s board of directors voted to pay the income taxes due on the salaries of the main company’s officers. Woolen’s president, William Wood’s taxes for 1919 and 1920 where $1,032,349.15, which Woolen paid in full. The Commissioner argued that this amount was additional compensation to Wood, which must be included in Wood’s taxable income. Holding: Employer’s payment of income taxes assessed against the employee does constitute additional income to the employee. The employee does not even need to directly receive the money to realize the economic benefit. It is enough that the transaction has increased the wealth of the employee.
        1. Rationale:
          1. Tax Payment As Compensation: The employer’s payment of the tax was in consideration of the services rendered by the employee. Even though the payment was voluntary, it was not a gift. Presumably, the employee accepted this payment of his tax liability in lieu of some other form of compensation.
          2. Tax Payment As Income Benefit: Discharge of an obligation of the taxpayer by a third party is nevertheless a benefit (income) to the taxpayer.
          3. Irrelevance of Payment Form: The form of payment makes no difference. It is therefore immaterial that the taxes were paid directly to the government.
          4. Problem with Holding: If there is a tax on the tax paid and the company pays that tax, is there not a never ending cycle? Court: The treasury did not try to collect again on the 2nd payment by the company
      4. Compensation for Services: §61(a)(1) Consideration transferred for the performance of a service whether in the form of salary, fees, commissions, fringe benefits and whether in the form of cash, property or other services.
        1. Examples: are a lessee paying the lessor’s mortgage and a corporation paying an officer’s fines.
        2. Timing: The taxable year in which a taxpayer will include an amount of compensation income will depend on the taxpayer’s method of accounting, and if restricted property is involved, the rules of §83
      5. Court Awards – §104
        1. Personal Physical Injury: Damages received as compensation for a physical personal injury are excluded from gross income. This rule applies even though a portion of the payments represents compensation for earnings lost because of the injury.
        2. Business Recoveries: To decide whether a business damage recovery is excludible, one must determine “in lieu of what were the damages paid.” Thus, if a damage award is compensation for lost profit, the award is income. Where the award is for damage of an asset, the recovery is applied against the basis of the asset damaged, reducing the basis of the asset. If the award exceeds the basis of the asset involved, the excess is taxable gain and the basis of the asset thereafter is zero.
        3. Punitive Damages: Punitive damages are generally taxable as ordinary income.
          1. Punitive damage awards are taxable as gross income (unless from personal injury)Commissioner v. Glenshaw Glass Co. (1955) Plaintiff won a settlement from Hartford-Empire Company of $800,000, approximately $325,000 of which represented punitive damages for fraud and antitrust violations. Plaintiff did not report this portion of the settlement as income, and the Commissioner assessed a deficiency. Holding: Gross income includes all amounts recovered as a result of lawsuit.
            1. Rationale:
              1. Broad Definition of Income: Income is broadly defined as “…gains or profits and income derived from any source whatsoever.” The Court has consistently interpreted this provision broadly to give Congress “the full measure of its taxing power.” The money received is a windfall gain and increase in wealth to the recipient, and is not specifically exempted from income by any provision of the IRC.
              2. TEST: Gross income is an “accession to wealth, clearly realized, and over which the taxpayer has complete dominion.” Any increment in net worth is presumed to be income, unless it is specifically exluded. The test is purposefully broad in order to fulfill what the Court deems to be Congress’ intent-to exert the full measure of its constitutional taxing power.
          2. Awards as Income: Money recovered that represents lost profits is clearly taxable as the profits would have been, had they been earned. By the same logic, the punitive damages are an increase in wealth from the same source and should be treated likewise, absent clear congressional intent to exempt them from income. Today, punitive damages are not taxed when related to personal injury. Compensatory damages which replace lost profits or the amount the plaintiff would have received had the competitor not violated the law. So such awards should be taxed just like profits.
      6. Non-cash Receipts: Noncash receipts may be income even if the benefit is the form of property or service. §61(a)(3)
        1. Example: Travel credits converted into cash in a personal travel account established by an employer constitute gross income to the employee) Charley v. Commissioner(9th Circuit, 1996) Citing Glenshaw Glass, the tax court found that Dr. Charley (P) was wealthier after the transaction. There was a taxable event. However, the court is not going to decide whether frequent flyer miles constitute gross income. Two ways the court can analyze: 1) The travel credits that were converted to cash can be characterized as additional compensation equal to the difference between the first-class rate and the coach rate. 2) If it is assumed that the frequent flyer miles were not given to Dr. Charley, then the transaction can be viewed as dealing in property, expressly taxable under §61(a)(3). The gain from the disposition of property is equal to the difference between “amount realized” and the property’s adjusted basis. The (P) received the miles at no cost, he had a zero basis in them. He then exchanged the miles for ash, resulting in a gain also equal to the difference between the first-class rate and the rate for flying coach
      7. Additional:
        1. Gross income from business §61(a)(2)
        2. Gains derived from dealings in property §61(a)(3)
        3. Investment Income §61(a)(4-7)
        4. Alimony §61(a)(8), §71
        5. Discharge of Indebtedness §61(a)(12)
        6. Prizes and Awards §74
        7. Helpful Payments §82,85,86
      8. Miscellaneous:
        1. Illegal Gains: Money or property that the taxpayer obtains through illegal activities is includable in his gross income because, as a practical matter, the criminal derives readily realizable economic value from it. The fact that the money really belongs to another is immaterial.
        2. Unemployment Benefits: Unemployment benefits that are payable to the individuals pursuant to a federal or state program are fully taxable.
        3. Rebates, Discounts and Cents-Off Coupons: Not income. There is no financial benefit, but a reduction of an expense. Coupons serve as a price adjustment during the purchase transaction.
        4. Frequent Flier Miles: Could possibly be taxable income, depending upon situation. The difference between frequent fliers miles and rebates is gray.
      9. Antique Piano Hypothetical: Would the results to the taxpayers in the Cesarini case be different, if instead of discovering $4,467 in old currency in the piano, they discovered that the piano, a Steinway, was the first Steinway piano ever built and it is worth $500K?No gross income unless sold. Change in perception of value does not trigger a tax event. Recognition v. Realization. Mere appreciation in value happens all of the time, until you convert it to cash it is not income.
      10. Watch Lottery Hypothetical: Winner attends the opening of a new department store. All persons attending are given free raffle tickets for a digital watch worth $200. Disregarding any possible application of §74, must Winner include anything within gross income when she wins the watch in the raffle?Result: Is it detached or disinterested on the part of the donor? Does it meet the test for gift? No, it seems like advertising, not just a generous gift, therefore watch is income. See Commissioner v. Duberstein (Chapter 3)Example: Celebrity swag bag-IRS taxes it because it was not given solely out of affection.
      11. Employee Car Hypothetical Employee has worked for Employer’s incorporated business for several years at a salary of $40K per year. Another company is attempting to hire Employee but Employer persuades Employee to agree to stay for at least two more years by giving Employee 2% of the company’s stock, which is worth $20K, and by buying Employee’s spouse a new car worth $15K. How much income does employee realize from these transactions?Result: Employee realizes$35,000 from employer’s perks. The car is part of the employee’s compensation and is attributed to his income, even though it is utilized by his wife. NOTE: Vested stock is different (will learn later) NOTE: Employee does not receive the car in the problem. The spouse gets the car. In Old Colony the fact that the employee received the benefit from the employer by them paying off the tax liability is the same as giving the spouse the car. Therefore, the employee gets the benefit from not having to buy the spouse the car…. indirect payment to the employee, therefore the GI of the property=fair market value of the property($15K) and so the employee realizes the $15K of the car as GI. Therefore $20K +$15K+$40= $75 is taxable
      12. Kickback Hypothetical: Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals
        1. Does Adjuster have gross income? Yes
        2. Even if the arrangement violates local law? Yes
      13. Rent Hypothetical Owner agrees to rent Tenant her lake house for the summer for $4K.
        1. How much income does Owner realize is she agrees to charge only $1K if Tenant makes $3K worth of improvements to the house? $4K of rent income
        2. Is there a difference in result to Owner in (i), above, if Tenant effects exactly the same improvements but does all the labor himself and incurs a total cost of only $500? No, still receives a $3K in improvement value.
        3. Are there any tax consequences to Tenant in part (ii) above? Yes, benefit was received by the tenant by only having to pay $500 instead of $3K, therefore net income of $2.5K or gross income of $3K with a $500 deductible.
      14. Frequent Flyer Miles Hypothetical Flyer receives frequent flyer mileage credits in the following situations. Does Flyer have gross income?
        1. Flyer receives the mileage credits as a part of a purchase of ticket for a personal trip. The credits are assignable. No, miles part of price of the ticket, nothing to do with business context (similar to cents off coupons.)
        2. Flyer receives credits from Employer for business flights Flyer takes for Employer. The credits are assignable. Business flights for the employer, since assignable they have value (fair market value)
        3. Flyer receives the credits under the circumstances of (ii) above, but they are nonassignable. If non-assignable, do they have value? Not GI, can’t do anything with them, must be used for business.
        4. Same as (c), above, except Flyer uses the nonassignable Employer provided credits to take a trip. No authority on point; however if used for personal trip, likely to be classified as GI, since using for personal benefit unless find a employer/employee exclusion.
    3. Income without Receipt of Cash or Property §61 and Reg. 1.61-2(a)(1),-2(d)(1)
      1. Personal Imputed Income – The rental value of a building used by the owner does not constitute income within the meaning of the 16th Amendment. Helvering v. Independent Life Insurance Co. (1934)Plaintiff owned an office building and used a portion of the building for its own offices. The IRS took the position that the rental value of that space should be considered income by plaintiff. Holding: The taxpayer does not have to declare as income the fair market value of a building that he owns and occupies.
        1. Rationale: There was no actual benefit realized because the company there was not otherwise required to pay rent. However, even benefits that are not tangible can lead to taxable income if the benefit results in a financial gain for the taxpayer. (SeeDean v. Commissioner)Key: Look to see if benefit was realized.
          1. If a statute lays taxes on the part of the building occupied by the owner or upon the rental value of that space, it is not allowed because that would be a direct tax requiring apportionment.
        2. Additional Comment – “Imputed Income”: Imputed income is created when a taxpayer works for or uses his property for his own benefit. “The value of one’s own services or goods that are used to benefit oneself.” If a taxpayer lives in his own house, he is theoretically paying himself rental income. Likewise, a homemaker receives imputed income for domestic services rendered in the home. Or if an attorney represents himself in a case. While Congress is generally recognized to have the power to tax imputed income under the IRC, it has never attempted to do so. Such a tax would be an impossible administrative burden. In addition, most people do not think of imputed income as income, and this idea would meet severe political resistance.
      2. Barter Income – Revenue Ruling 79-24 (1979): The IRS held that services exchanged by a lawyer and a housepainter are taxable income to each individual to the extent of the market value of the services. The IRS also held that the value of a work of art exchanged by an artist for rent on an apartment is taxable income to both the landlord and the artist. Rationale: If let the system go then have the whole country running everything through barter club and the “Why should I pay taxes if nobody else is” which leads to a complete undermining of the tax system
        1. Fair Market Value – §1.61-2(d)(1): If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income.
        2. Barter Analysis:
          1. Is the barter a pure barter of services or a transactional barter of services?
          2. What is the relationship between the parties to the barter?
          3. Does the flow of goods and services suggest a flow of income between the parties?
          4. If yes, then analysis alerts parties that such barter is probably income.
      3. Use of Corporate Property – The fair market value of residential property that is provded by an employer is to be included in gross income, even if the employer is the taxpayer’s wholly-owned corporation. Dean v. Commissioner (3rd Circuit, 1951) Plaintiffs, the Deans, were sole shareholders of a personal holding company. The corporation’s assets included a home that Mrs. Dean owned and contributed to the corporation in exchange for stock. Plaintiffs occupied the home as their residence, and Mrs. Dean expended a great deal of her personal funds in the upkeep and beautification of the property. IRS held that the fair rental value of the residence should be included in plaintiffs’ gross income. Holding: Free use of corporate property by its sole shareholders as their personal residence does constitute gross income to them.
        1. Rationale – Fair Market Value: It was the taxpayer’s legal obligation to provide a family home. If it was done by occupying property that was held in the name of the corporation of which the taxpayer had control, the fair market value of that occupancy was income to him.
      4. Vegetable Garden Hypothetical: Vegy grows vegetables in her garden. Does Vegy have gross income when
        1. Vegy harvests her crops? No income.
        2. Vegy and her family consume $100 worth of vegetables? No income.
        3. Vegy sells her vegetables for $100? Income.
        4. Vegy exchanges $100 worth of vegetables with Charlie for $100 worth of tuna that Charlie caught? Income.
      5. Extrapolation Hypothetical: Vegy agrees with Grocer to sell her vegetables in Grocer’s market which previously did not have a vegetable section. Grocer pays $50 per month to landlord for the portion of the market used by Vegy but Grocer does not charge Vegy any rent. Vegy keeps all proceeds from her sales. Initially, it would seem that the Grocer’s $50 rent cost would be income for Vegy. However, the bar examiners felt otherwise seven years ago. This is because Grocer could’ve anticipated that the presence of vegetables in the market will bring in more total customers to the entire store. By Grocer giving a portion of the store to Vegy, Grocer must think that it’s going to bring in more than $50 a month to him. Hence, it would be seen as Grocer’s expense not Vegy’s expense. Vegy also loses the deduction for rent. Now Vegy must pay tax on all of her proceeds from sales and won’t get the rental deduction. Furthermore, to tax Vegy for the $50 rent would serve to tax the landlord and Vegy for the same $50.
      6. Barter System Hypothetical: Doctor needs to have his income tax return prepared. Lawyer would like a general physical check up. Doctor would normally charge $200 for the physical and Lawyer would normally charge $200 for the income tax return preparation.
        1. What tax consequences to each if they simply swap services without any money changing hands? Each one has income in the value received
        2. Does Lawyer realize any income when she fills out her own tax return? No
      7. In the NEWSPerson blew the whistle of some wrongdoing in the labor department and received $75K for pain and suffering. Is it taxable? Defendant said that the Congressional amendment in 1996 was unconstitutional(prohibit the exclusion of emotional distress damages (as opposed to physical injuries) from gross income calculations. The District court ruled that it was constitutional and therefore taxable. HOWEVER, the circuit court of appeals ruled that Congressional change in the tax statute in 1996 was unconstitutional The panel examined the original intent of the framers of the 16th Amendment to determine the definition of “incomes” within the language of the amendment. The panel explained that it sought to examine materials from the time period near 1913, when the amendment was ratified. According to the panel, an attorney general opinion and Treasury Department ruling from 1918 “strongly suggest that the term ‘incomes’ as used in the 16th Amendment does not extend to monies received solely in compensation for a personal injury and unrelated to lost wages or earnings.” “In sum, every indication is that damages received solely in compensation for a personal injury are not income within the meaning of that term in the 16th Amendment,” the panel concluded.

 

————————————————–EXCLUSIONS FROM GROSS INCOME PART I ——————————————–

  1. General: Exclusions are construed narrowly, an item must fit within the exact parameters of an exclusion statute in order to be excluded from gross income)
    1. Excluded:
      1. Loan Repayment: §61(a)(4) A lender receives no income from a loan repayment. This is merely a change in the form of property from that of a receivable to cash. However, interest received on the loan is income.
      2. Loan Borrowing: Receiving a loan does not produce income since liabilities have increased along with assets, leaving net worth the same as before.
      3. Capital Recovery: A taxpayer’s income from the sale or exchange of property is his or her profit on the transaction, not the total amount received. A taxpayer is entitled to receive his or her capital investment in the property tax free, although the timing of this recovery is a matter for legislative determination.
      4. Imputed Income: Value of services on performs for oneself or one’s family and the value of any property used that one owns are imputed income.
      5. Death Benefits §101
      6. Gifts §102
      7. Compensation for Personal Injury or Sickness §104
      8. Discharge of Indebtedness Income §108
      9. Qualified Scholarships §117
      10. Exclusion for Gain on Principal Residence §121
      11. Employment Related
        1. Meals and Lodging §119
        2. Statutory Fringe Benefits §132
        3. Insurance Premiums and Payments §79, §105, §106
        4. Educational Assistance §129
        5. Adoption Expenses §137
      12. Child Support §71

 

  1. GIFTS AND INHERENTANCES (Chapter 3)
    1. Rules of Inclusion and Exclusion §102(a) and (b) first sentence
      1. In General: Certain items are includible or partially includible in gross income (§71 – 90-Includible), and certain items are excludible or partially excludible in gross income (§101-136-Excludible). Example: §71 Alimony is includible. Example: §109 Improvements by lessee on lessor’s property is excludible.
      2. Rules of Inclusion – §102(a) and (b): Gross income includes any financial benefit received that is:
        1. Not a mere return of capital.
        2. Not accompanied by a contemporaneously acknowledged obligation to repay.
        3. Not excluded by a specific statutory provision.
        4. Not within the concept of a tax-free fringe benefit.
    2. Gifts Defined
      1. Gifts In General§102: Gifts are excluded from gross income, but not the income from such a gift, or where the gift is income from property §102(b):. The gift must stem from a “detached and disinterested generosity” §102(a) and must not be business-related. The determination of whether a gift has been made is essentially a factual question that must be decided by the trier of fact based on his knowledge of the “mainsprings of human conduct.” It is a question of the donor’s intent.
        1. Basis §1015: Receipt of property by gift or inheritance must determine the basis he or she has in the property
          1. Property received as gift: The recipient of property by gift takes the donor’s basis in the gift, plus a portion of any gift tax paid on the transfer. However, if at the time of the gift the FMV of the property was less than its basis, for purposes of determining loss on subsequent sale or disposition, the donee takes the FMV of the gift on the date of the gift §1015(a)
      2. Gifts DefinedA gift is a transfer made with detached and disinterested generosity motivated by affection, respect, charity or similar feeling.Commissioner v. Duberstein (1960) Plaintiff referred customers to Berman, which proved to be profitable to Berman. Although plaintiff did not expect payment, Berman gave him a Cadillac. Berman then deducted the price of the car as a business expense. Plaintiff did not include the Cadillac as income. This case was joined with Commissioner v. Stanton. Plaintiff was the controller of a church. When he resigned, the church’s board voted him a “gratuity” of $20,000. Plaintiff had no enforceable right or claim for the payment. Plaintiff did not include the $20,000 in his income. Holding: The plaintiffs’ receivables were not given with “a detached and disinterested generosity” (no obligation or consideration) so as to constitute gifts.
        1. Rationale:
          1. Compensation: Where payment is in return for services rendered, it is irrelevant that the donor derives no benefit from it. The payment is not a gift – it is income. Here, plaintiffs rendered services.
          2. Lack of Duty is Irrelevant: The mere absence of a legal or moral duty to make such a payment, or the lack of economic incentive to do so, does not in itself show a gift.
          3. Donor’s Intent: Whether a transfer amounts to a gift depends upon consideration of all facts surrounding the transfer. The tier-of-fact should given discretion in determining the donor’s intent. A gift exists if it “proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses.” The primary motive of the donor is determinative, and this definition is narrowly applied by the courts to restrict many would-be “gifts.”
        2. Additional Comment:
          1. Trier of Fact:
            1. A jury: the judgment must stand unless it is found that reasonable men could not differ on the issue.
            2. A judge: then the appellate court must find the judgment “clearly erroneous”
          2. Act of Congress:Congress did act on part of the issue. Section 102(c): requires any transfer from an employer to employee to be included in gross income.
          3. Problem with Holding: Leaves the court with the problem of determining the dominant intent of the donor.(TEST) Deciding a person’s or a group of people’s intent is a subjective thing, and leads to disparate judgments
      3. Tips: Tips and gratuities are income to the recipient.
        1. Las Vegas Hypothetical: At the Heads Eye Casino in Vegas, Lucky Louie gives the maitre d’ a $50 tip to assure a good table, and gives the croupier a $50 toke after a good night with the cubes. Does either the maitre d’ of the croupier have gross income?Maitre d’: YES: services were given in exchange for $ Croupier: YES: service worker has to report tips (big issue)-produce income amounts. However, only taxed on part of it.
      4. Employee Gifts: IRC § 102(c) states that an employee “shall … not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.”
        1. Limited exceptions:
          1. IRC § 132(e)Retirement Gifts allows traditional retirement gifts to be treated as de minimus fringe benefits.
          2. IRC § 74(c)Employee Achievement Awards (Excludes)
            1. IRC §274(j): Limited to items of tangible personal property (the value of which is subject to certain limitations) receive in recognition of length of service or safety achievement
          3. IRC § 10(b)Employee Death Payment: allows $5,000 exclusion for payments made by employers on account of an employee’s death. Amount received must not represent benefits that the employee would have enjoyed had he lived (i.e. retirement benefits, pension plans).
          4. IRC § 274(b)(1)Business Gifts: limits the deductible amount of business (non-employee) gifts to $25per donee per year. However, there is no limit on deductibility by employer of employee business gifts since employee must report the gift as income per IRC § 102 (c).
        2. Bargain Purchases: Whether a taxpayer’s purchase of property for a bargain price is a gift or income depends on the motive of the seller and all of the surrounding circumstances.Example: An automobile dealer allows certain employees to purchase cars at below market price as an employment benefit. The bargain element is income to the employee.
        3. Employer and Son Hypothetical: Employer gives all of her employees, except her Son, a black and white television set at Christmas, worth $100. She gives Son, who also is an employee, a color television set, worth $500. Does Son have gross income?
          1. Two ways to argue:
            1. Gross income= dominant motivation is to reward the employee with a better television
              1. Gift= dominant motivation is to give son a great gift
          2. Pg. 946-bottom left column(tax book)
        4. Church Hypothetical: The congregation for whom Reverend serves as a minister gives her a check for $5,000 on her retirement. Does Reverend have gross income? NO:Long line of cases decided that the reverend/congregation relationship was very special and was therefore not a normal employer/employee relationship and were therefore excludable from gross income. $5K from congregation probably not GI, intent is gift, no duty to give her $ for retirement
        5. Retirement Gift Hypothetical: Retiree receives a $5,000 trip on his retirement. To pay for the cost of the trip, Employer contributed $2,000, and fellow employees of Retiree contributed $3,000. Does Retiree have gross income?
          1. Can you determine the intent for all the individual contributions?
            1. Argue that all they have is an employee-employee relationship which is not tainted by Section 102(c)
          2. Some of it is an employer transfer ($2K), therefore would not be excludable under Duberstein or Section 102(c).
            1. Therefore answer at least $2K is gross income, while the rest is a gift.
          3. NOTE: In actual case, court divided up the group of people into seven groups and decided the dominant intent of each group.
    3. Income Tax Meaning of Inheritance
      1. Inheritance In General – IRC §102(a): Gross income does not include property received by devise, bequest, or inheritance. However, the exclusion does not apply to the income from any property received as a bequest, devise or inheritance, nor where such bequest, devise or inheritance is of income from property. Note that the exclusion applies to an heir who receives a portion of the decedent’s estate by reason of a settlement in contest over the decedent’s will.
          1. Basis §1015
            1. Property received by inheritance §1014: The recipient of property through inheritance takes as his or her basis in the property the FMV of the property on the date of the decedent’s death or the alternate valuation date if that date was elected by the estate administrator for valuation purposes.
      2. Will Contest – Property received by an heir from settlement of a will contest is still an inheritanceLyeth v. Hoey (US Supreme Court, 1938) The IRS treated the amount received by Lyeth (P) from a settlement of the contest of his grandmother’s will as income rather than an excludable inheritance, and required him to pay taxes on it. Lyeth sued for a refund Holding: Money received in compromise of rights under a will contest is not to be characterized as taxable income.
        1. Rationale:
          1. Acquisition by Compromise: Plaintiff obtained the money because of his standing as an heir and his claim in that capacity. If he had obtained the money by a judgment, it would have been exempt. The distinction between acquisition by judgment and acquisition by compromise in lieu of judgment is too formal to be sound because it ignores the hiership underlying the compromise. Furthermore, courts prefer settlements.
          2. Estate Taxes: Estate taxes will be applied regardless of the will contest. Congress has not shown any intention to tax that property again as income when it is distributed to heirs.
        2. Additional Comments: Similar to Duberstein because the Court declines to place limitations on the exclusions found in 102(a) that are not clearly required by the statute. Not going to define gift and not going to define inheritance. Congress has had since 1913 to define and limit these terms if it chose.
      3. Compensation for Past Services –Money earned by providing services is income and not an inheritance even when paid through a willWolder v. Commissioner (US Court of Appeals, 2nd Circuit, 1974) Defendant, an attorney, contracted with a client to provide lifetime legal services in exchange for a provision in her will to leave him securities. When the client died, defendant received $15,845 and 750 shares of common stock. Defendant did not report this sum as income, and the IRS assessed a tax deficiency. Holding: When a bequest is made to satisfy a contractual obligation, it does constitute taxable income.
        1. RationaleParties’ Intent: Whether a payment is a gift or compensation depends on the intent of the parties. Substance over form. In this case, “a transfer in the form of a bequest was the method that the parties chose to compensate Mr. Wolder for his legal services, and that transfer is therefore subject to taxation, whatever its label by federal or by local law may be.” There is no question that the parties contracted for services and that the provision of Boyce’s will was in satisfaction of that contract. Cites Commissioner v. Duberstein saying that the U.S.S.C. held the true test was whether it was a bona fide gift and not a form of compensation and to look at the intent of the donor. Applying that test it is clear that the intent was to pay for the legal services. In terms of the NY state code, matters of federal tax code cannot be determined by NY state law.
      4. Additional Comment – Plaintiff relied onUS v. Merriam(US Supreme Court, 1923): Testator made cash bequests to his executors “in lieu of all compensation.” Supreme Court allowed the exclusion from income as a gift, stating that the executors were under no obligation to perform specific services but merely to make a good faith effort to be executors
      5. Inheritance Hypotheticals: Consider whether it is likely that IRC § 102 applies in the following circumstances:
        1. Father leaves daughter $20,000 in his will. Yes.
        2. Father dies intestate and daughter receives $20,000 worth of real estate as his heir. Yes.
        3. Father leaves several family members out of his will and daughter and others attack will. As a result of a settlement of the controversy daughter receives $20,000. Yes.
        4. Father leaves daughter $20,000 in his will stating that the amount is in appreciation of daughter’s long and devoted service to him. Yes.
        5. Father leaves daughter $20,000 pursuant to a written agreement under which daughter agreed to care for father in his declining years. No.
        6. Same agreement as in (e), above, except that father died intestate and daughter successfully enforced her $20,000 claim under the agreement against the estate. No.
        7. Same as (f), above, except that daughter settles her $20,000 claim for a $10,000 payment. No.
        8. Father appointed daughter executrix of his estate and father’s will provided daughter was to receive $20,000 for services as executrix. No.
        9. Father appointed daughter executrix of his estate and made a $20,000 bequest to her in lieu of all compensation or commissions to which she would otherwise be entitled as executrix. No.Statutes provided percentage amounts to the executrix and the lawyer also gets a percentage as well-therefore the system is set up so that the executrix will get something even if the will is silent.(however the decedent can change that)
          1. If daughter was not in the will but would get the entire estate, when would it be advantageous for her to decline the $20,000 commission and do the work for free?
            1. If she declines the commission then it stays in the estate and comes to her as the heir and it is not taxed. If she takes the commission then it will be taxed as gross income.
            2. What if the estate was subject to estate tax?
              1. Then the $20,000 seen as a deductible for the maintenance of the estate with a 45% estate tax, because then she would only get taxed 35%.
      6. Commitmentphobe Hypothetical: Boyfriend who has a “mental problem” with marriage agrees with Taxpayer that he will leave her “everything” at his death in return for her staying with him without marriage. She does, he doesn’t, she sues his estate on a theory of quantum meruit and settles her claim. Is her settlement excludable under§102? Is it a strict contract claim? No indication
      7. Future Holding Hypothetical: If the Wolder case arose today, would §102(c) apply to resolve the issue?NO, because §102(c) applies to employer/employee relationship. The attorney/client is not viewed as an employer/employee relationship. They are considered agent relationship because the employer cannot dictate all the terms in the events because the lawyer is bound to do the best work for the employer.

 

  1. EMPLOYEE BENEFITS
    1. Fringe Benefits (§132 (no j(2) +(5), (m) and (n), §61(a)(1), §79, §83, §112, §125)
      1. Fringe Benefits In General – IRC § 61(a)(1): IRC includes in gross income “compensation for services” which may be property or cash, direct or indirect. However, some fringe benefits are excluded from gross income. Any fringe benefit not excluded by IRC is includible under IRC §61 and §83 at the excess of the fair market value of the benefit over any amount paid for the benefit. Fringe benefits must be non-discriminatory, as under IRC § 132(j), and extend to family members, as under IRC § 132(h).
      2. No-Additional-Cost ServicesIRC § 132(b): Employees may exclude a no-additional-cost service a service provided to the employee by the employer that is regularly offered for sale to customers where the employer incurs no substantial additional cost (and forgoes no revenue) in providing the service.
        1. Requirements for exclusion:
          1. IRC § 132(b)(1): The services are offered for sale to customers in the same line of business of the employer for which the employee is working.Example: Airline offers free standby flights for its employees.
          2. IRC § 132(b)(2): The employer incurs no substantial additional cost (including foregone revenue) in providing the service to the employee.
            1. Example:Airline tickets will not be included in gross income if the employee is flying standby, however if the employee is required or has the ability to book the tickets in advance means that the airline lost the opportunity to sell the tickets to a paying customer.
          3. IRC § 132(j)(2): The services must be provided in a nondiscriminatory basis such that the upper echelon employee’s do not receive services unavailable to lower echelon employees. If service is offered discriminatory, i.e. 60% discount to officers and only 40% to other employees, officer does not even get to exclude 40%. Employees cannot dissect services which discriminate.
        2. Reciprocal Agreements: IRC §132(i)Services provided to an employee of another employerTreats a service provided to an employee of another employer as a no-additional cost service fringe benefit is that service is provided. Requirements: 1) pursuant to a written agreement between the employers 2) neither employer incurs substantial additional costs in providing the service, 3) and the service provided by the other employer is the same type of service offered by the employee’s employer in the same line of business in which the employee works.
      3. Qualified Employee DiscountsIRC § 132(c): The value of discounts on services or property (except real or investment property) provided to the public by the employer, purchased from employer by employee may be excludible.
        1. Requirements for exclusion:
          1. In the same line of business.
          2. Nondiscriminatorily awarded.
        2. IRC § 132(c)(1)(B): (Services) The maximum discount on services does not exceed 20% of the price at which the service is offered to customers. Legislative history has shown that the purchase of insurance polices to be a service.
        3. IRC § 132(c)(1)(A): The maximum discount on property does not exceed the gross profit percentage of the price at which the service is offered to customers. The gross profit percentage = [aggregate sales price – cost] / aggregate sales price. Essentially, discount cannot drop below the markup that customers pay. Example: A bookstore pays $500,000 during one year for books and sells them for one million. [1,000,000 – 500,000] / 1,000,000 = 50%. So, an employee may buy a $10 book for $5 and exclude the $5 discount from tax.
      4. Working Condition FringesIRC § 132(d): Employee not taxed on employer-provided item if the employee would have been entitled to deduct the item as a business expense, or depreciation deduction under §§ 162 and 167, if she had paid for it herself.Example: Use of company car for business purposes, business periodicals, bodyguards, free or subsidized parking.
        1. Exclusion is not applicable to spouse of employee. Example: Not applicable to spouse who takes a business trip with an employee spouse.
        2. Can be discriminatory.
      5. De Minimus FringesIRC §132(e): Property or services are excludable if the value is so small as to make accounting for it unreasonable or administratively impractical.
        1. Eating facilities – Operation by an employer of any eating facility for employees is de minimis fringe if:
          1. Such facility is located on or near the business premises of the employer, and
          2. Revenue derived from such facility normally equals or exceeds the direct operating costs of such facility.
        2. Examples: Use of copying machine, company picnics, supper money, coffee and donuts, small holiday gifts and baseball tickets (not box seats).
        3. Can be discriminatory.
        4. Reg. 1.132-6 (d)(2)(B) Overtime: The meals, meal money or local transportation fare is provided to an employee because overtime work necessitates an extension of the employee’s normal work schedule. This condition does not fail to be satisfied merely because the overtime is foreseeable.
      6. Qualified Transportation Fringe –“Qualified Parking” includes parking provided to an employee on or near the business premises of the employer IRC §132(f): The following transportation fringe benefits are excludible:
        1. IRC §132(f)(5)(B): Transportation in a commuter highway vehicle if in connection with travel between employee residence and job.
        2. IRC §132(f)(5)(A): Any transit pass, token, farecard, voucher or similar item for mass transit.
        3. IRC §132(f)(5)(C): Qualified parking provided to employee on or near business premises or from where commutes by commuter highway vehicle.
        4. Limitations: $100 per month for commuter vehicle and transit pass. $175 per month for qualified parking.
      7. Qualified Moving Expense ReimbursementIRC §132(g): To the extent that the employee would have been entitled to a moving expense deduction if she had paid for moving expenses herself, she will have no tax if the employer pays or reimburses her moving expenses.
      8. Spouse and Dependent ChildrenIRC §132(h)(2): Use by spouse or dependant child shall be treated as use by employee.
      9. Athletic FacilitiesIRC §132(j)(4): Value of any on-premises athletic facility provided by employer is excludible if it is operated by the employer and is used mostly by employees.
      10. The Statutory Exclusion of Other Fringe Benefits: §132 indicates that if another Code section provides an exclusion for a type of benefit, Section 132 is generally inapplicable to that type of benefit; an ad hoc provision prevails over the general rules of Section 132. Some other sections excluding fringe benefits from gross income are:
        1. IRC §79– excludes group term life insurance premiums for up to $50K coverage
        2. IRC §112excludes compensation received by military personnel for service in a combat zone and compensation for periods during which the person is hospitalized as a result of wounds, disease, or injury incurred while serving in a combat zone
        3. IRC §129 excludes amounts paid by an employer for “dependent care assistance” up to a maximum annual amount of $5K
        4. IRC §137 excludes employer payments of qualified adoption expenses
        5. IRC §134 excludes some additional military benefits
      11. Fringe Benefit Hypotheticals: Consider whether or to what extent the fringe benefits listed below may be excluded from gross income and, where possible, support your conclusions with statutory authority:
        1. Employee of a national hotel chain stays in one of the chain’s hotels in another town rent-free while on vacation. The hotel has several empty rooms.ExcludedNo additional cost involved. Fringe is excludible underIRC § 132 (a) (1).
        2. Same as (a), above, except that the desk clerk bounces a paying guest so employee can stay rent-free. . See Reg. §1.132-2(a)(2) and (5) Not Excluded:(Declining a customer in place of an employee counts automatically as “substantial additional cost”).
        3. Same as (a), above, except that the employee pays the bill and receives a cash rebate from the chain. see Reg. §1.132-2(a)(3) Maybe – similar toIRC § 132 (f) (3).
        4. Same as (a), above, except that the employee’s spouse and dependant children traveling without the employee use the room on their vacationExcluded IRC §132 (h)extends the benefit to family and nothing requires the employee to be there, ergo it is not taxable to the employee.
        5. Same as (a), above, except that employee stays in the hotel of a rival chain under a written reciprocal agreement under which employees pay 50% of the normal rent.ExcludedThe 50% is a red herring. It is still no-cost to the employer. The mere fact that the employee has to pay 50% doesn’t cause us to abandon it from inclusion under no-cost.
        6. Same as (a), above, except that employee is an officer in the hotel chain and rent-free use is provided only to officers of the chain and all other employees pay 60% of the normal rent. Not ExcludedIRC § 132(j)says that these benefits must be paid in a non-discriminatory fashion. Benefit cannot discriminate just highly paid employees.
        7. Hotel chain is owned by a conglomerate that also owns a shipping line. The facts are the same as in (a), above, except that the employee works for the shipping line. No. The benefit must be in the same line of business according toIRC § 132 (b) (1).
        8. Employee attends a business convention in another town. Employer picks up employee’s costs.Working condition fringe underIRC § 132 (d).
        9. Employer has a bar and provides the employees with happy hour cocktails at the end of each week’s work.De minimus fringe under Section132(a)(4) However, is weekly too frequent, because the section states “occasional cocktail parties”
        10. Employer gives employee a case of scotch each Christmas. SeeReg. §§ 1.132-6(e)(1)Not Excluded The case of scotch would not be a low value holiday gift under Section 132(a)(4)
        11. Employee is an officer of corporation that pays employee’s parking fees at a lot one block from the corporate headquarters. Nonofficers pay their own parking fees. Assume there is no post-2001 inflation. Excluded, if it takes one of the three forms under Section 132(a)(5) Qualified Transportation Fringe: 1) commuter highway vehicle 2) transit pass 3) qualified parking
        12. Employer provides employee with $110 worth of vouchers for commuting on a public mass transit system during the year. Assume there is no post-2001 inflation. . Excluded ($105) Not Excluded ($5-gross income) Note: For parking it is now $205 a year.
          1. NOTE:It will be noted in the statutes whether there is inflation for the number or not.
        13. Employer puts in a gym at the business facilities for the use of employees and their families.IRC §132(j)(4) covers on-premises gyms.
    2. Exclusions for Meals and Lodging (§107, §119(a)(d) Reg. 1.119-1)
      1. Meals and Lodging In General – IRC § 119 (a):Meals and lodging provided by the employer to employee, spouse and dependents are excludible from gross income if all the requirements are satisfied:
        1. Employer Convenience (Both): It is for the convenience of employer. The employer has a “substantial noncompensatory business reason” for supplying the meals and lodging
        2. On Business Premises(Both): Meals and lodging are on business premises of employer. “On the business premises” means that a significant part of business must be performed at that location. Example (p. 101 #2 – Jack B. Lindeman, 1973): Planner was required to live in house adjacent to motel. Planner worked at motel and was on-call 24 hours a day. House is considered “on business premises and lodging was excludible.
        3. Condition of Employment (Lodging): The lodging must be required as a condition of employment. Usualy showing that the employee is on call for the business of the employer
      2. Employee as Employer Lodging – The fact that a taxpayer is a shareholder in a closely held corporation does not alone disqualify him from excluding lodging benefits furnished for the convenience of the corporation.Herbert G. Hatt (Tax Court of the United States, 1969) Plaintiff became general manager and president of funeral home. Plaintiff moved into apartment located in the funeral home building. Plaintiff answered business calls in the apartment and, as was customary in the area, met with customers during nonbusiness hours. Commissioner assessed a tax deficiency against plaintiff. Holding: Value of employer-furnished lodging may be excluded from gross income where the taxpayer controls the employer corporation.
        1. Rationale:
          1. Housing Exclusion – IRC § 119: IRC grants an exclusion from gross income for the value of employer-furnished lodging if three conditions are met:
            1. The lodging is on the business premises of the employer.
            2. The employee is required to accept such lodging as a condition of his employment.
            3. The lodging is furnished for the convenience of the employer.
          2. Control of Conditions is Irrelevant: Although plaintiff’s position enabled him to determine the “convenience” of the employer and the “conditions” of his own employment, this alone does not disqualify plaintiff from taking the exclusions. The court adopted an objective test focusing on the benefit to the employer, looking at substance over form; after all the policy behind the exclusion is to benefit employers.Here, plaintiff is allowed to take the § 119 exclusion, since a showing was made that it was customary and necessary in that area that the manager of a funeral home reside on the premises to perform his duties. Although the ambulance drivers could take night calls, they were not authorized to carry on funeral business, especially financial aspects.
            1. NOTE: Holding hinges on the nature of the business as a corporation. Had this been a sole proprietorship, Hatt (P) would have lost the exclusion because a person cannot be his own employee.
        2. Additional Comments – Commissioner v. Anderson (US Court of Appeals, 6th Circuit, 1966): Deduction was where a motel manager was “on call” at an employer-owned residence two blocks from the motel. Residence was considered determined not to be on the business’s premises. Mere ownership of property by employer does not satisfy “on business premises” requirement.
      3. Family Residence Hypothetical: Employer provides employee, spouse and child a residence on employer’s business premises, having a rental value of $5,000 per year, but charging the employee only $2,000.
        1. What result if the nature of the employee’s work does not require employee to live on the premises as a condition of employment?Income of $3,000 to employee.
        2. What result if employer and employee simply agreed to a clause in the employment contract requiring employee to live in the residence?It has to be a condition of employment or, as in Hatt, it has to be of the convenience of the employer. Look at nature of circumstances
        3. What result if employee’s work and contract require employee to live on the premises and employer furnishes employee and family $3,000 worth of groceries during the year?Groceries can’t be excluded, even if they can be turned into meals.
        4. What result if employer transferred the residence to employee in fee simple in the year that employee accepted the position and commenced work?Does the value of the residence constitute excluded lodging?No.
      4. Patrolman Hypothetical: State highway patrolman is required to be on duty from 8am to 5pm. At noon he eats lunch at various privately owned restaurants which are adjacent to the state highway. At the end of each month the state reimburses him for his luncheon expenses. Are such case reimbursements included in his gross income?Commissioner v. Kowalski (US Supreme Court, 1977) determined that such meals are technically on the premises.

 

——————————————————–PROPERTY GAIN-————————————————————

  1. GAIN FROM DEALING IN PROPERTY
    1. Factors in the Determination of Gain (Sections 1001(a), (b) first sentence, (c); 1011(a) 1012 (cost basis)
      1. Gain In General: Five Step Approach: 1) Identify a realization event 2) computing realized gain or loss 3) determining the amount of recognized gain or loss 4) determining the character of any recognized gain or loss 5) determining the basis of property received in the transaction.
      2. Realization Event: §1001 Occurs when a taxpayer exchanges property, receiving some materially different item, (one that bestows on a taxpayer a different legal interest than what she or he had before.
      3. Realized Gain or Loss: §1001(a): measured by the difference between the amount realized (fair market value of property received in transaction) and the adjusted basis (value of transferred property including appreciation and depreciation). Therefore, in order to determine the return on capital, the basis in property must be determined.
        1. Example: The taxpayer owns stock with a basis of $5. He sells the stock for $8, realizes $8 on the sale, and thereby has a gain of $3 on the sale of the stock.
        2. Example: Purchased book for $15. The purchase transaction (acquisition) is not a gross income tax event at that time. End of the semester going to engage in an arm’s length transaction whereby the book is sold in Jan 07 for $35. Is the sale a tax event? Yes. Now what is the Glenshaw Glass amount(i.e. What is the accession to wealth that is now clearly realized)? One’s wealth has been increased by $20 (not $35 because have to minus the investment cost of $15) and therefore is the gross income in the form of gain.
          1. Look further…do you really buy a law school book for $15? Therefore, the question is was the book purchased for fair market value? NOTE: Fair market value is defined as “the price at which the item changes hands in an arms length transaction between two parties that know everything about the transaction.” Not going to look into the motive of the parties. When the book was purchased for $15 that was the fair market value at the time. When the book was sold for $35 that was the fair market value at the time.
          2. What year is this transaction going to be taxed in?
            1. Probably 2007, the year the transaction took place §1001(c)…HOWEVER the tax can be deferred in certain circumstances (i.e. payments into a retirement program
      4. Amount Realized: §1001(b) A taxpayer’s amount realized on the sale or other disposition of property is equal to the sum of the cash and fair market value of property or services received, plus the amount of liabilities assumed by the other part to the transaction (i.e. mortgage)
      5. Character: The character of the gain or loss recognized as capital or ordinary will depend on the nature of the asset in the hands of the transferor.
      6. Adjusted Basis: Equal to its initial basis adjusted upward for improvements and downward for capital recovery (depreciation) deductions- see below for further detail.
      7. Formula:
        1. Gain =Amount realized(AR) over adjusted basis (AB) for determining gain (Section 1001(a))
          1. AR= amount of money received and the fair market value of property (other than money) received on the disposition.
        2. Loss = Excess of AB for loss-AR (Section 1001(a))
          1. Considered a deduction
    2. Determination of Basis
      1. Cost as Basis Sections 109; 1011(a), 1012, 1016(a)(1); 1019 Regulations: Sections 1.61-2(d)(2)(i); 1.1012-1(a)
        1. Purchases (Cost Basis)– IRC § 1012: Generally, the basis of property is the cost of such property to the taxpayer. (If a taxpayer performs services and receives property in payment, the amount the taxpayer includes in gross income as payment will constitute the basis of the property.)
        2. Cost as Basis – The cost basis of property received in a taxable exchange is its fair market value of the property received in the exchangePhiladelphia Park Amusement Co. v. US (Court of Claims of US, 1954) In 1889, the Philadelphia Park Amusement Co. (P) was granted a 50-year franchise to operate a passenger railway. In 1934, in exchange for a ten-year extension on the franchise, the (P) deeded over to the city a bridge it had built at a cost of $381,000. The (P) eventually abandoned the franchise and later asserted depreciation deductions and a loss upon abandonment. The (P) sought to use the cost of the bridge as its cost basis in the franchise. Holding: Basis of the property (i.e. the franchise extension) is the value of the property received in a taxable exchange.
          1. Rationale:
            1. Transfer of Assets as Basis: A transfer of assets is a taxable event unless exempted by statute. The taxpayer is taxed on the difference between the adjusted basis of the property given in exchange and the fair market value of the property received in exchange. Just because there is an equal exchange does not mean there is no tax (i.e. artist-attorney barter income). Thus, the taxpayer’s basis in the new property is its fair market value on the date of transfer. When the transfer is at arm-length, and the new asset can’t be valued, the value of the new asset is deemed to be equal to the value of the old. Therefore, the Park’s basis in the ten-year franchise extension is equal to the fair market value of the bridge in 1934.
            2. Depreciation: However, if the fair market value of the new asset (franchise) cannot be readily determined, the basis is the value of the asset (bridge) given up in an arm’s length transaction. Thus, plaintiff can take a loss on the undepreciated value of the franchise at the date of abandonment.
            3. Recording of Exchange: The fact that plaintiff did not properly record the exchange does not prevent it from being a taxable event.
        3. Additional Inclusions to Basis:
          1. Expenses of Acquisition: Attorney’s and broker’s fees and the like spent in acquiring property are added to the cost basis.
        4. Additional Exclusions to Basis:
          1. Tenant Improvements – IRC § 1019: Basis will not be increased by capital improvements made by a tenant or lessee, unless owner realizes a financial benefit from such improvements when the property is sold.
        5. Property Resale Hypothetical: Owner purchases some land for $10,000 and later sells it for $16,000.
          1. Determine the amount of owner’s gain on the sale. $6,000 Gain.
          2. What difference in result in (i), above, if owner purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option? $1K option, then $9K paid, still paid $10K and sold for $16K. Therefore the AR = $16K and the AB = $10K ($1K + $9K) so $16K-$10K= $6K (Gain)No difference NOTE: Not going to take into account the option as a completed transaction but as a step to the purchase of the land in the event it is exercised for that purchase.
          3. What result to owner in (ii), above, if rather than ever actually acquiring the land, owner sold the option to investor for $1,500?$500 gain.
          4. What difference in result in (i), above, if Owner purchased the land by making a $2K cash payment from Owner’s funds and an $8K payment by borrowing $8K from the bank in a recourse mortgage (on which Owner is personally liable)? (2)Would it make any difference if the mortgage was a nonrecourse liability (on which only the land was security for the obligation)?
            1. Raised purchase price by engaging in a borrowing transaction producing $8K. AR=$16K and AB=$10K(Do not take into account where the $ came from IF there is an offsetting obligation in the form of a binding transaction to pay it back) therefore $16K-$10K= $6K(Gain)
            2. For tax purposes it does not matter if it is recourse or nonrecourse.
          5. What difference in result in (i), above, if owner purchased the land sold for $10,000, spent $2,000 in clearing the land prior to its sale, and sold it for $18,000?$6,000 gain.
          6. What difference in result in (i), above, if owner had previously rented the land to lessee for five years for $1,000 per year cash rental and permitted the lessee to expend $2,000 clearing the property? Assume that, although owner properly reported the cash rental payments as gross income, the $2,000 expenditures were properly excluded under IRC § 109. If improvements are made to property and not in lieu of rent, then owner doesn’t need to report as income. AR = $16K, AB = $10K, therefore $16K-$10K= $6K(Gain). NOTE: Exclusions Sections to defer the $2K from the year that get the property back with increased value to the year when the property is sold. §109 “Gross income does not include income (other than rent) derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee.” ( POLICY: When the land comes back to the lessor with the increased value, there is no actual cash for the lessor to pay the increased tax that would be attached to the increased value. ) And § 1019 whichsays that the adjusted basis shall not be increased or diminished on account of income derived by the lessor in respect of such property and excludable from gross income under §109
          7. What difference in result in (i), above, if when the land had a value of $10,000, owner a real estate salesperson, received it from employer as a bonus for putting together a major real estate development, and owner’s income tax was increased $3,000 by reason of the receipt of the land?The amount realized is still $16,000. $10,000 is the basis. The basis of money is always its face value. AR = $16K, AB = $10K, therefore $16K-$10K= $6K(gain) ; $3K of income tax not included to adjust basis since it was actually an income event in the form of property and was already taxed. The acquisition was a tax income event therefore the basis needed the $10K or it would be taxed again. Section 1012 basis even though nothing was paid.
          8. What difference if owner is a salesperson in an art gallery and owner purchases a $10,000 painting from the art gallery, but is required to pay only $9,000 for it (instead of $10,000) because owner is allowed a 10% employee discount which is excluded from gross income under IRC § 132 (a) (2), and the owner later sells the painting for $16,000?The gain would be $6,000 and the basis is $10,000. AR = $16K, AB = $10K, therefore $16K-$10K = $6K(gain)
            1. §132(a)(1) excludes employee benefit as GI. If you only use basis of $9K would actually act as a deferral until the sale of the painting when the income would be taxed as part of the gain. Need the cost concept of $10K to realize the purpose of §132(a)(1), so you treat basis as if discount does not exist and = value of product w/o discount.
      2. Property Acquisition by Gift ( §1015(a), §1015(d)(1)(A), (4) and (6) )
        1. Gift Basis In General – IRC § 1015: Property acquired as a gift generally retains the same basis as it had in the hands of the donor, a case of transferred basis. However, if such basis is greater than the fair market value of the property at the time of the gift, then solely for purposes of determining loss, the basis is such fair market value of the property on the date of the gift.
          1. Example: Whether one spends $250 on a case of scotch, receives the same case as a gift or receives one as a de minimus fringe benefit, basis is still $250. Although gifts and fringe benefits are generally not taxable, tax cognizance is taken of both situations, so basis is still carried over from the gifts and benefits.
          2. Depreciated Property Hypothetical: Property cost $2,000. It declines in value to $1,000 and is given to donee.
            1. Donee sells property at $2,500 – $500 gain.
            2. Donee sells at $500 – $500 loss because basis was greater than fair market value so refer to fair market value to determine gain.
            3. Donee sells at $1,500 – neither gain (not above the $2K basis) nor loss (not below the FMV)
        2. Donee Assumes Donor’s Basis Rationale– The Constitution does not prevent Congress from treating as taxable income to the recipient of a gift the increase in value of the gift while it is owned by the donor. Taft v. Bowers (US Supreme Court, 1929)A donnee of stock sought to recover income taxes paid on the amount the stock appreciated while in the hands of the donor. Father gave his daughter shares that were more valuable than when he had acquired them. When she sold them she argued that only the appreciation of the shares during her ownership is taxable. Holding: Donee assumes the donor’s basis in property acquired by gift.
          1. Rationale – Basis is Donor’s Basis: A donor is exempt from income taxation if he makes a gift of property. Thus, if plaintiff’s position were sustained, the amount of increase in value during the period the property was held by the donor would go untaxed. Donee must pay tax on total appreciation.
        3. Contingent Transfer Not a Gift – A transfer which should be classified as a gift under the gift tax law is not necessarily to be treated as a gift, income-tax-wiseFarid-Es-Sultaneh v. Commissioner (US Court of Appeals, 2nd Circuit, 1947) A taxpayer sought to have her basis in corporate stock determined by the value of the shares when she acquired them, because she claimed the stock was acquired by purchase, in exchange for the release of marital rights. Holding: Plaintiff did not receive stock as gift.
          1. Rationale – Not Gift: No absolute gift was made since the transfer initially was contingent upon the death of the donor before marriage. When the event did not occur, the transfer was still made, but in consideration for plaintiff in giving up other rights. Case is pre-IRC § 1041.
        4. Analysis of Property Disposition: Is disposition quid pro quo or gratuitous?
          1. Quid Pro Quo (Farid-Es-Sultaneh v. Commissioner)
            1. What is the amount realized in the exchange?
            2. Subtract basis of whatever property was transferred in exchange.
            3. Remainder will be gain or loss realized.
          2. Gratuitous(Taft v. Bowers)
            1. What is the donor’s basis under §1015?
            2. Is fair market value less than the donor’s basis? Use fair market value for loss calculation purposes.
            3. Subtract (a) and (b) from amount realized when donee later sells gift property.
        5. Property Transfer Hypothetical : Donor gave donee property under circumstances that required no payment of gift tax. What gain or loss to donee on the subsequent sale of property if
          1. the property had cost donor $20,000, had a $30,000 fair market value at the time of the gift, and donee sold it for:
            1. $35,000. AR $35K-AB $20K=$15K GainDonee gets the cost basis of the DonorSection 1015(a)
            2. $15,000. $5,000 loss. AB $20-AR$15K= $5K LossSection 1015(a):For the basis of loss take the fair market value
            3. $24,000. No gain or loss. AR $25K-AB $20K=$5K Gain
          2. The property had cost Donor $30K, had a $20K fair market value at the time of the gift, and Donee sold it for:
            1. $35,000 AR $35K-AB $30K= ($5K Gain)§1001(c) and §102applies to donee (not donor)
            2. $15,000 AB $20K-AR $15K= $5K Loss§1015(a) allows the basis to be FMV-not going to let the donee get the loss from the donor.Donor (AB $30K)——–Gift (FMV $20K)———-Sell ($15K)
            3. $24,000 AR $24 –AB $30K = $0 GainDonee has not recovered the full basis($30K) of Donor, therefore no gain. AR $20 –AR $24K = $0 LossConversely the FMV has increased from the time of gift and therefore there is no loss during the time of donee’s possession
        6. Father had some land that he had purchased for $100K (Original Basis= AB 100) but which had increased in value to $200K (FMV). He transferred it to Daughter for $100K in case in a transaction properly identified as in part a gift and in part a sale. Assume no gift tax was paid on the transfer.
          1. What gain to Father and what basis to Daughter under Reg. §§ 1.1001-1(e) and 1.1015-4(a)(1)?
            1. Father: AR $100K – AB $100K = Gain of $0
              1. If Father had sold it there would have been a gain of $100K
              2. Now, there is a $100K gain (unrealized). There should there be a preservation of that gain, and when the donee sells the property she will realize the $100K gain and it will be taxed. Example of shifting of gain.
            2. Daughter: AB $100K
          2. Suppose the transaction were viewed as a sale of one-half of the land for full consideration and an outright gift of the other one half. How would this affect Father’s gain and Daughter’s basis? Is it a more realistic view than that of the Regulations? Cf. §§170(e)(2) and 1011(b), relating to bargain sales to charities.
            1. Step 1: Pretend you have two severed transactions (gave ½ on Monday and sold the other half on Tuesday):
              1. Monday
                1. Father: No gain
                2. Daughter: AB $50K (remaining half)
              2. Tuesday
                1. Father: AR $100K –AB $50K= $50K Gain Going to subdivide the property
                2. Daughter: AB $100K
            2. Step 2: Now reunite the transactions:
              1. Daughter: AB $150K (1/2 sale +1/2 gift)
      3. Property Acquired Between Spouses or Incident to Divorce § 1041
        1. In General – IRC § 1041: Gain or loss will not be recognized on a transfer of property from an individual to a spouse, or to a former spouse provided that the transfer is merely incident to the divorce.(Same basis it had immediately prior to the transfer) Generally, within six years of divorce. Transferred basis applies even with a loss in value, unlike a gift that realigns basis to match fair market value.
        2. Property Transfer Hypothetical: Andre purchased some land ten years ago for $4,000 cash. The property appreciated to $7,000 at which time Andre sold it to his wife Steffi for $7,000 cash, its fair market value.
          1. What are the income tax consequences to Andre?No tax implications
          2. What is Steffi’s basis in the property?$4,000 basis is transferred to Steffi
          3. What gain to Steffi is she immediately resells the property? $7K-$4K=$3K (gain)
          4. What results in (a)-(c), above, if the property had declined in value to $3K and Andre sold it to Steffi for $3K? No difference.
          5. What results (gains, losses, and bases) to Andre and Steffi if Steffi transfers other property with a basis of $5K and value of $7K (rather than cash) to Andre in return for his property? Steffi’s basis will be the land’s basis. Andre’s basis in his new property will be $5,000.
      4. Property Acquired From a Decedent ( §1014(a),(b)(1) and (6), (e) )
        1. In General – IRC §1014: A stepped-up in basis for property passing by way of inheritance is permitted. Generally, the basis of the property becomes its fair market value at the time of the decedent’s death. Value appreciation while still in donor’s hands is not involved in the donee’s income tax calculations. However, appreciation is still subject to estate tax.
        2. Anti-Stuffing Statute – IRC §1041(e): Prevents transferring to somebody in anticipation of their death, so that the deceased then transfers back to original property holder with a stepped-up basis in order to evade taxes. Transfer must be at least one year from his death. If not then when the transfer back to the original property holder occurs the basis in the property returns to its original basis in the hands of the original property holder.
          1. Problem: In the current year, Giver holds two blocks of identical stock, both worth $1M. Giver purchased the first block years ago for $50K and the second block more recently for $950K. Giver plans to make an inter vivos gift of one block and retain the second until death. Which block of stock should Giver transfer inter vivos and why?The second block. Because that way when the Giver dies the $50K block would have a stepped up basis to something closer to $1M and the gain would be decreased
    3. Amount Realized ( §1001(b) )
      1. Amount Realized In General: The amount realized equals the amount of cash received, plus fair market value of any property or services received or obligation satisfied, plus the amount of any liabilities assumed by the other party to the transaction (mortgage)
      2. Money’s Worth Received is the Amount Realized – When a taxpayer disposes of property in exchange for services, there is an “amount realized” equal to the fair market value of the servicesInternational Freighting Corp. v. Commissioner (US Court of Appeals, 2nd Circuit, 1943) After an company gave to certain employees bonuses consisting of corporate stock that had appreciated in the hands of the company, the government sought to tax the company for a gain equal to the amount the stock had appreciated. Holding: A corporation may realize a taxable gain when it pays stock bonuses to employees.
        1. Rationale:
          1. Compensation Not Gift: The shares given in this case were not a gift by plaintiff, but were compensation for services actually rendered. Therefore, delivery of the shares constituted a disposition for a valid consideration. The consideration received by plaintiff for the $8,000 appreciation of the stock was the work performed by the workers earning the stock bonuses.
          2. IRC § 1001 (b): “The amount realized” is the sum of “any money received plus the fair market value of property received.” However, in circumstances such as these it has been held that “money’s worth” is received and that such a receipt comes within the confines of the section. If there had been no formal bonus plan and plaintiff had simply paid the shares to selected employees as additional compensation, there would surely have been a taxable again.
      3. Mortgage: The amount of a mortgage assumed by the purchaser, or to which the property is subject at the date of the property’s sale, is treated as part of the seller’s proceeds. There is no relevance in taxes for a property’s fair market value.
      4. Cancellation of Indebtedness – A taxpayer who sells property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the amount realized on the sale.Crane v. Commissioner (US Supreme Court, 1947) The owner of an apartment building, having a fair market value equal to the mortgage on the building, sold the building for $3000, subject to the mortgage, and reported a taxable gain of $1250 under the theory that the “property” she acquired and transferred was merely her equity in the apartment building. Holding: Basis is equal to the net value of the property and the unassumed mortgage.
        1. Rationale:
          1. Seller’s Benefit: A mortgagor not personally liable on the debt who sells the property subject to a mortgage and for other consideration realizes a benefit equal to the amount of the mortgage as well as the additional consideration received.
          2. Property Definition: Property is the physical thing that is the subject of ownership, or the sum of the owner’s rights to control and dispose of the property. Court stresses the need to include the mortgage in order for the definition of property to be the same for acquisition, depreciation or deposition. Had the defendant’s basis been zero, then she could not have taken depreciation.
        2. Dissent – Justice Jackson: Defendant was never personally liable for the debt and hence was relieved of no debt upon sale of the property.
      5. Mortgage Balance Exceeds Value of Property Sold – When a party transfers property encumbered by a nonrecourse mortgage with an unpaid balance that exceeds the fair market value of the property, the transferor has realized an amount equal to the unpaid mortgage balance Commissioner v. Tufts (US Supreme Court, 1983) A partnership reported a loss on the sale of property encumbered by a nonrecourse mortgage equal to the excess of the balance on the mortgage over the fair market value of the property, an amount of $55,740 Holding: Crane rule regarding non-recourse mortgages applies even where the mortgage exceeds the value of the property disposed of.
        1. Rationale:
          1. Crane Decision: The Crane decision requires the amount of a non-recourse liability to be included in the property’s basis and the amount realized on its disposition. This is based on the assumption that the mortgage will be paid in full and represents an obligation to pay.
          2. Non-recourse Mortgage: Absence of personal liability on a mortgage does not relieve the borrower of his obligation to repay, but only limits the mortgagee’s remedies on default. The seller’s amount realized will include the full amount of debt and the seller will compute realized gain in the ordinary fashion.
          3. Recourse Mortgage: The buyer would not assume it because it would place his other assets in risk
      6. Inter vivos Gift Hypothetical Gainer acquired an apartment in a condominium complex by inter vivos gift from Relative. Both used it only as a residence. It had been purchased by Relative for $200K cash and was given to Gainer when it was worth $300K. Relative paid a $60K gift tax on the transfer. Gainer later sells the apartment to Shelterer.
        1. What gain or loss to Gainer on his sale to Shelterer for $320K?
          1. First Step: AB$200K (AB at time of gift). Is there income tax effect because of the gift tax? Yes, 1015(d)(6)- the increase in basis provided by this subsection with respect to any gift for the gift tax paid under chapter 12 shall be an amount (not in excess of the amount of tax so paid) which bears the same ratio to the amount of tax so paid as— (i)the net appreciation in value of the gift, bears to (ii)the amount of the gift.
          2. Second Step: $300 generated $60K tax. At the time of the gift had AB $200K meaning that $100K was unrealized at the time of the gift. Therefore Congress will allow to take a portion of the gift tax that represents the gift tax on the unrealized portion and use that as a tax gift basis. (Figure it out 1/3 not realized and 1/3 of $60K is $20K so $20K will be added to the AB $200 so AB$200 +$20K=AB$220K for gain or loss
          3. Therefore: AR$320K-AB$220K=$100K Gain
      7. Gifted Property Encumbered by Gift Taxes –
        1. Net Gift”: When a donee pays gift taxes as a condition of receiving a gift. Since donee agrees to pay something for the transferred property, the amount paid by the donee reduces the amount of the donor’s gift. If these taxes exceed the donor’s basis in the gifted property, the donor realizes a taxable income.
        2. Rationale:
          1. Donor Pays Gift Taxes: When a gift is made, the gift tax liability falls on the donor. This is as much a legal obligation as is a donor’s income tax or a mortgage. When the donee agrees to pay the gift tax, the donor receives an immediate economic benefit of that amount. Gift basis was $50,000. Donor received $60,000 in gift taxes. Donor had $10,000 taxable gain.
          2. Legislative Intent: Congress has structured gift taxes to encourage transfer. Some exception may be forthcoming to exclude conditional gifts or net gifts from income taxation. However, this is a legislative function. The Court is bound by the definition of IRC § 61, which provides that gross income is income “from whatever source derived.”

 

—————————————-LIFE INSURANCE AND ANNUITIES———————————————

 

  1. Annuities and Life Insurance Proceeds
    1. Life Insurance §101(a)(c)(d)(g) Regulations: Sections 1.101-1(a)(1), (b)(1), -4(a)(1)(i), (b)(1), (c)
      1. Life Insurance In General –
        1. We have an owner, the insured and a beneficiary.  The insured died and the beneficiary receives the proceeds, §101 says no tax.  What about the estate tax on the owner of the policy?  As long as the person who died does not own the policy there is no estate tax.  Who can be an owner?  Irrevocable life insurance trust-set up just to hold the policies as owner.  At death the trust will terminate and all the proceeds (tax free) will go to the beneficiaries with no increase in the insured taxable estate-have to make sure there is no interest remaining with the insured
      2. IRC §101: Certain Death Benefits
        1. § 101(a): Proceeds of lifeinsurance contracts payable by reason of death
          1. (1): General Rule:Except as otherwise provided in paragraph (2), subsection (d), and subsection (f), gross income does not include amounts received (whether in a single sum or otherwise) under a lifeinsurance contract, if such amounts are paid byreason of the death of the insured.
          2. EXCEPTIONS:
            1. Interest Only Payments: §101(c) The beneficiary only draws on the interest from the insurer (100%taxable). At the end of the term, the original amount is given to beneficiary (100%not taxable)
            2. Installment Payments: § 101(d) If the benefits are paid in installments rather than in a lump sum.
              1. Example: $100K at $250/month($3K/yr) for life. Life expectancy is 50 yrs. Will receive $150K ($50K more than entitled) Therefore will exclude $2K from and include $1K in gross income each year (Look at tables for life expectancy)
              2. Hypothetical:When Matt’s Aunt Harriet passed away, he learned that he was the beneficiary under a $50K life insurance policy that she had purchased. Under the terms of the policy, the proceeds will be paid out in five annual installments of $12K. He must include $2K of each $12K payment in his gross income each year.
            3. Cash Surrender Value: If the insured elects to take the cash surrender value of the policy, that value might exceed his basis. In that case, he would have taxable income on the excess because it was not paid by reason of his death.
              1. Exception: Certain Accelerated Death Benefits – IRC §101(g):Terminally or chronically ill persons in need of funds often seek to cash in their life insurance policies or to draw on the proceeds before death. In this situation, certain amounts received under a life insurance contract of an insured who is terminally or chronically ill will be considered “paid by reasons of death of the insured,” and thus, excluded from gross income. Usually requires certification by physician of no longer than 24 months. NOTE: No ceiling on amounts paid to terminally ill, but chronically ill are limited to $175/day§101(g)(3)(D)or costs of qualified long-term care§101(g)(3)(A)(i)both can be reduced by reimbursements from medical insurance proceeds §101(g)(3)(A)(i)
                1. Policy: Not going to treat the person who is dying differently than the beneficiary of the life insurance policy who would receive the benefits tax free. Do not want people destitute because of their medical bills (i.e. AIDS patients)
            4. Transfer– IRC §101(a)(2): If the insurance contract is transferred for valuable consideration, the exclusion no longer appliesunless the transfer is to (i) transferee who acquired the policy with a transferred basis §101(a)(2)(A) (ii) the insured, (iii) her partner, (iv) her partnership or (v) a corporation in which she is a shareholder or an officer. § 101(a)(2)(B)NOTE: Only taxed on the excess of the original investment NOTE: Don’t need to actually use the transfer basis, just that the basis was established from looking at the transferor’s
      3. Policy Categories
        1. Whole Life (aka endowment policy, straight life policy): Savings feature that builds up value as years progress. Provides protection for the entire life of the insured. Usually requires an annual premium.
        2. Group Life (aka term life policy): Pure insurance. Provides protection for a specific term, usually a year
      4. Problems:
        1. Insured died in the current year owning a policy of insurance that would pay beneficiary $100,000 but under which several alternatives were available to beneficiary.
          1. What result if beneficiary simply accepts the $100,000 in cash?No income, under IRC § 101 (a).
          2. What result in (a), above, if beneficiary instead leaves all the proceeds with the company and they pay her $10,000 interest in the current year?Interest is taxable.
          3. What result if insured’s daughter is beneficiary of the policy and in accordance with an option that she elects, the company pays her $12,000 in the current year? Assume that such payments will be made annually for her life and that she has a 25 year life expectancy.$12K x 25 = $300K gross payout. $200K is taxable. $100K – $12K payment is excluded.
          4. What result in (c), above, if insured’s daughter lives beyond her 25 year life expectancy and receives $12,000 in the 26th year?Under IRC § 72, the 26th payment of $12,000 is all taxed.
        2. Jock agreed to play football for Pro Corporation. Pro, fearful that Jock might not survive, acquired a $1million insurance policy on Jock’s life. If Jock dies during the term of the policy and the proceeds of the policy are paid to Pro, what different consequences will Pro incur under the following alternatives?
          1. With Jock’s consent Pro took out and paid $20K for a two year term policy on Jock’s life. §101(a)(1) allows for theexclusion of the $1 mil from being taxed.
          2. Jock owned a paid-up two year term $1mill. Policy on his life which he sold to Pro for $20K, Pro being named beneficiary of the policy. $1mil – $20K (paid for policy)=$980K taxable
          3. Same as (b), above, except that Jock was a shareholder of Pro Corporation. Full $1mil is not taxable. §101(a)(2)(B)
        3. Insured purchases a single premium $100K life insurance policy on her life for a cost of $40K. Consider the income tax consequences to Insured and the purchaser of the policy in each of the following alternative situations:
          1. Insured sells the policy to her Child for its $60K fair market value and, on Insured’s death, the $100K of proceeds are paid to Child. $100K-$60K (paid for policy)= $40K taxable for Child$60K-$40K= $20K taxable for Insured §1012 (Basis of Property)
            1. NOTE: If gave as gift, then there is no transfer of value issue and the proceeds/benefits are not taxable.
            2. NOTE: If half gift/sale: Change price to $50K. Therefore, AR$50K and AB$40K= $10K gain. Insured dies so the $100K goes to child. Are there any exceptions? Yes, because § 1015 enabled to establish a basis for the child ($50K)and therefore §101(a)(2)(A) applies as that basis was established by looking at the transferor.(Similar to transfer of basis under § 1041)
          2. Insured sells the policy to her Spouse for its $60K fair market value and, on Insured’s death, the $100K of proceeds are paid to Spouse. Insured: §1041(Transfers of property between spouses or incident to divorce) Not taxable for Insured Spouse: §1041(b)(2) states that the basis of the transferee in the property shall be the adjusted basis of the transferor. Therefore, under §101(a)(2)(A) it is excluded because the transferee basis was determined by reference to the basis of the transferor (carryover) as mandated by §1041(b)(2) Not taxable for Spouse
          3. Insured is certified by her physician as terminally ill and she sells the policy for its $80K fair market value to Viatical Settlement Provider who collects the $100K of proceeds on Insured’s death. IRC § 101 (g)(2)(a) “If any portion of the death benefit under a life insurance contract on the life of an insured described in paragraph (1) is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance contract by reason of the death of such insured.” Therefore Non-taxable for InsuredHowever, there is no exception for the company,therefore $100K -$80k-subsequent premiums (§101(a)(2) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee”)=taxable income for Company
    2. Annuities
      1. Introduction: An annuity contract is one in which the taxpayer invests a fixed sum, which is later paid back, with interest, in installments for a set period or for life. That part of each annuity payment that represents the taxpayer’s investment in the policy is exempt as a return of capital. The interest portion, however, is income and therefore taxable under IRC § 72.
      2. Annuity Categories
        1. Single Life Annuity: Fixed payments to one annuitant for his life.
        2. Self and Survivor Annuity: Payments to one person for life and then to another for life.
        3. Joint and Survivor Annuity: Payments to two persons and then to survivor of the two.
        4. Refund Feature: An annuity guarantees a minimum payment if the annuitant dies early.
        5. Fixed Term Annuity: Annuity pays for fixed term rather than life. If annuitant dies early, payments go to beneficiary.
        6. Variable Annuity: Payment varies based on performance of investments.
      3. IRC § 72: Annuities; certain proceeds of endowment and life insurance contracts IRC recognizes that each annuity is made of income and a return on capital. A portion of each payment is excluded as a return of capital and not taxed (ratio of the investment in the contract to the expected return under the contract) The amount of payment in excess of the portion (excluded amount) is included in gross income.
        1. § 72(a)Annuities: except as otherwise provided, gross income includes any amt received as an annuity, endowment or life insurance contract
        2. § 72(b)Exclusion Ratio: Calculating the return of capital portion is done by determining the exclusion ratio, “the cost of the annuity divided by the expected return. The expected return is calculated by either a fixed contract or by reference to the life expectancy of the investor (determined from the actuarial tables pg. 926/927)”. The amount excluded from each payment is the product of the exclusion ratio and the payment. The amount of each payment that exceeds this return-of-capital portion is then taxed as net income. Note that certain employee pension plans that work quite similarly to annuities are treated differently. Example: Mr. A pays $60,000 for an annuity for life at $500 per year. Mr. A’s life expectancy is 20 years, so he hopes to have a return of $100,000. Ratio is 60/100. 60% ($300 of each $500) payment is excluded from tax.
          1. IRC provides that if annuitant lives beyond his life expectancy and recovers investment in contract, full amount of any subsequent payments are gross income. If annuitant dies before recovering investment in contract, the estate gets a deduction §72(b)(3)(B) of the rest of the investment on deceased’s last income tax return.
          2. §72(b)(3)(C) Net operating loss deductions provided For purposes of section 172, a deduction allowed under this paragraph shall be treated as if it were attributable to a trade or business of the taxpayer. Allowed 2 years back and 20 years forward. Necessary if there is no continuation of payments after death.
        3. § 72(c)(1) defines “investment in the contract” as the amount initially paid
        4. § 72(c)(3) defines “expected return” as the total amount received over the life of the contract
      4. Problem:
        1. In the current year, T purchases a single life annuity with no refund feature for $48K. Under the contract T is to receive $3K per year for life. T has a 24-year life expectancy.
          1. To what extent, if at all, is T taxable on the $3K received in the first year? $3000 X $48000/$72000= $2000 non taxable, therefore $1000 is taxable.
          2. If the law remains the same and T is still alive, how will T be taxed on the $3K received in the thirtieth year of the annuity payments? It will be treated as full income§ 72(b)(2)
          3. If T dies after nine years of payments will T or T’s estate be allowed an income tax deduction? How much? Yes, $2000(nontaxable) X 9(years)= $18000 $48000-$18000= $30000 will be allowed for deduction.§72(b)(3)(A)(ii) NOTE: Make sure to include the payment in the year of the deceased if received.
          4. To what extent are T and T’s spouse taxable on the $3K received in the current year if at a cost of $76,500 they purchase a joint and survivorship annuity to pay $3K per year as long as either lives and they have a joint life expectancy of 34 years? Look at page 929

 

——————————————————-DISCHARGE OF INDEBTEDNESS————————————————-

  1. Discharge of Indebtedness
    1. Cancellation Of Debt In GeneralIRC § 61 (a) (12): A debtor whose debt is discharged or canceled at less than the full principal amount has taxable income to the extent of the difference between the full principal amount of the debt and the amount paid in satisfaction of the debt.
      1. Example: An individual borrows $100, issuing a promissory note in the amount of $100. She later settles the debt for $90. She has $10 of realized income from cancellation of indebtedness.
    2. Forgiven Debt is Income – If a corporation purchases and retires any bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is a gain or income for the taxable yearUS v. Kirby Lumber (US Supreme Court, 1931After a company had purchased, for less than par value, bonds which it had issued at par value, the government sought to tax the difference as gross income COURT: If a corporation purchase and retires any bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase prices is a gain or income for the taxable year. When Kirby issued bonds, it essentially took out a loan. The company received and used funds, but realized no income because there was a legal obligation to repay the bondholders. When Kirby then purchased the bonds for less than face value, they essentially paid off a loan for less than the loan amount. IRC § 61 (a) (12) expressly provides for this type of situation.
      1. Exceptions to Inclusion of this type of income:
        1. Discharge occurs in bankruptcy
        2. Discharge occurs while the taxpayer is insolvent, but only to the extent of the insolvency
        3. Discharge is qualified farm debt
        4. Debt relates to business property
        5. Debt arises out of purchase directly from the creditor
        6. Discharge is a gift under § 102
    3. Debt Hypothetical: Poor borrowed $10,000 from Rich several years ago. What tax consequences to Poor if Poor pays off the so far undiminished debt with:
      1. A settlement of $7,000 cash? $3,000 income.
      2. A painting with a basis and fair market value of $8,000? $2,000 income.
      3. A painting with a value of $8,000 and a basis of $5,000? $5,000 income to Poor. $3,000 in appreciation of property and $2,000 in debt forgiveness.
      4. Services, in the form of remodeling Rich’s office, which are worth $10,000? No income. §61(a)(12)
      5. Services that are worth $8,000? $2,000 income.

 

—————————————————————-DAMAGES———————————————————————-

  1. Damages and Related Receipts
    1. Damages In General
      1. Business Recoveries In General: To decide whether a business recovery is excludible, one must determine “in lieu of what were the damages paid.” Thus, if a damage award is compensation for lost profit, the award is income. Where the award is for damage to an asset, the recovery is applied against the basis of the asset damaged, reducing the basis of the asset. If the award exceeds the basis of theasset involved, the excess is taxable gain§61(a)(3) and the basis of the asset thereafter is zero.
        1. Recovery of Goodwill is Nontaxable…Except: Compensation for the loss of plaintiff asset (good will) in excess of its cost is gross income Raytheon Production Corporation v. Commissioner (US Court of Appeals, 1st Circuit, 1944) A government sought to tax as gross income damages a company received in settlement of an antitrust suit settlement. Holding: Damages which represent a reimbursement for lost profits are income. Question: In lieu of what are the damages awarded? Generally compensation for the destruction of goodwill(asset) is not taxable as it is a recovery representing a return of capital. However, goodwill, like any asset has a cost to the owner. If the recovery is in excess of its cost of establishing goodwill, then the company essentially realizes a gain made over its basis in the goodwill and compensation for the loss of goodwill in excess of its cost is gross income. Moral: IRS wants to collect every penny it can!
          1. Commissioner v. Glenshaw Glass (US Supreme Court, 1955): Recovery of lost profits and punitive damages are income.
        2. Other Sections that Deal with Inclusion of Damages/Settlements
          1. §71 Alimony
          2. §80 Restoration of value of certain securities
          3. §111 Recovery of tax benefit items
          4. §1341 Computation of Tax
          5. §1351 Treatment of recoveries of foreign expropriation losses.
      2. Includible or Excludible Hypothetical:Plaintiff brought a suit and unless otherwise indicated successfully recovered. Discuss the tax consequences in the following alternative solutions:
        1. Plaintiff’s suit was based on a recovery of an $8,000 loan made to debtor. Plaintiff recovered $8,500 cash, $8,000 for the loan plus $500 of interest. $500 of $8,500 is taxable as income. The $8K is the repayment of the loan and is not a tax event.
        2. What result to Debtor under the facts of (a) above, if instead Debtor transferred some land worth $8,500 with a basis of $2K to Plaintiff to satisfy the obligation? AR$ 8500 – AB$2000= $6500 gain What is Plaintiff’s basis in the land? $8500 (as if Plaintiff bought the land for $8500)
        3. Plaintiff’s suit was based on a breach of a business contract and plaintiff recovered $8,000 for lost profits and also recovered $16,000 of punitive damages. All taxable income, as under Glenshaw Glass.
        4. Plaintiff’s suit was based on a claim of injury to the goodwill of plaintiff’s business arising from a breach of a business contract. Plaintiff had a $4,000 basis for the goodwill. The goodwill was worth $10,000 at the time of the breach of contract. (Similar to Raytheon)
          1. What result to plaintiff if the suit is settled for $10,000 in a situation where the goodwill is totally destroyed? $6,000 would be taxable.
          2. What result if plaintiff recovers $4,000 because the goodwill was partially destroyed and was worth $6,000 after the breach of contract? No taxability because recovery did not exceed the basis. $4K (basis) – $4K (received) = 0 goodwill (asset) AB $4K- $4K(received)= 0 basis
          3. What result if plaintiff recovers only $3,000 because the goodwill was worth $7,000 after the breach of contract? No taxability because recovery did not exceed the basis. $4K (basis)- $3K received)= $1K goodwill (asset) AB $4K- $3K(received)= $1K basis.
    2. Damages and Other Recoveries for Personal Injuries Sections §104(a); 105(a)-(c) and (e); 106(a)Reg. 1.104-1(a), (c), (d), 1.105-1(a); 1.106-1
      1. Compensation for Injuries or Sickness IRC § 104:
        1. Excludes recoveries for physical or mental injuries, limited to the following five categories:
          1. Workman’s Compensation: IRC§104(a)(1) Provided that injury was job-related.
          2. Damages for Personal Injuries or Sickness:§104(a)(2) Damages received as compensation for a physical personal injury, either by judgment or settlement, are excluded from gross income. This rule applies even though a portion of the payments represents compensation for earnings lost because of the injury. “Personal injury” includes any physical tort or tort-type claim.
            1. Limitations: Recent amendments to the Code now limit this exclusion to physical injuries or physical sickness (injury, medical malpractice). Damages for nonphysical injuries [e.g. wrongful death, alienation of affections, defamation, libel, slander, and employment related discrimination (i.e. Commissioner v. Schleier (US Supreme Court, 1995))] are no longer included.
            2. Emotional Distress: Depends on the circumstances. If recovered for emotional distress incurred on account of physical injury then excludable. However, emotional distress itself is not a physical injury, regardless of whether there are physical symptoms and any recoveries are included.
            3. Punitive Damages: If recovered for a physical personal injury suit, then they are included in gross income. Exception: If awarded for a wrongful death action under state law in effect on Sep. 12 1995 and punitive damages are the only wrongful death recovery.
          3. Benefits under Health and Accident Insurance Policies: §104(a)(3) Excludes from gross income amounts received under accident and health insurance policies for personal injuries or sickness. Applies to all amounts received from non-employer funded policies. Limited: to the proceeds of policies paid for by the individual and should be compared with the treatment of certain employee health and accident benefits under §105
          4. Disability Pensions: §104(a)(4) Excludes disability pensions of members of the armed forces and certain other governmental units.
          5. Disability Income: §104(a)(5) Excludes disability income attributable to injuries incurred as a result of terrorist or military activity.
        2. Proper Allocation: Taxpayer’s complaint is the best evidence for determining a proper allocation of a settlement between excludable claims for physical injury and excludable claims fro compensatory damages and claims for punitive damages
          1. Express Allocation: Tax Court will generally follow and express allocation if the agreement is entered in an adversarial context at arm’s length. However it is not necessarily determinative if other facts(various claims, strength of claims, which party drafted the language, was it tax motivated) indicate that the payment was intended to be something else. Example: A party might want to allocate the money to things that are not taxable and stay away from allocating to punitive damages.
      2. Receipts from Health and Accident Insurance IRC §105
        1. Premiums Paid by Taxpayer – IRC §104:If individual paid all premiums for the insurance, all payments received are excludible – even multiple recoveries.
        2. Premiums Paid by Employer – IRC §105:If employer paid the insurance premiums, the premium payments are excludiblefrom the employee’s income [IRC §106(a)], but amounts paid to the employee under the policy are includible, except for:
          1. Reimbursements by Employer- §105(b): If an employer directly or indirectly reimburses an employee for expenses of medical care(§213(d)) for the employee or the employee’s spouse or dependents (§152) the amount received is excluded from gross income
          2. Payments Unrelated to Absence from Work: IRC §105(c) This subsection provides that, if an employee receives payments through health or accident insurance provided by an employer without tax cost to the employee for loss of a member or function of the body or for disfigurement of the employee or the employee’s spouse or dependent, and if the amount is computed only with regard to the nature of the injury and not to the period the employee is absent from work, the amount is excludedfrom gross income
          3. Compensation for the permanent loss or loss of use of a member or function of the body.
        3. Contributions by Employer to Accident and Health Plans In General: §106(a)Except as otherwise provided, gross income of an employee does not include employer-provided coverage under an accident or health plan
          1. Qualified Account – IRC §106(d) Qualified amounts contributed by the employer to an eligible employee’s “medical savings account” are also excludible.
        4. Revenue Ruling 79-313:Taxpayer sustained permanent personal injuries by X. Brought action against X. X carried liability insurance with M. M proposed a settlement of suit which Taxpayer accepted. M agreed to make 50 payments to taxpayer for “personal injury, pain and suffering, disability, and loss of bodily function”. Payments will increase by 5% over the amount of the preceding annual payment. Taxpayer cannot accelerate the payment or increase or decrease the amount of the annual payments specified. Under the agreement, M is not required to set aside specific assets to secure any part of its obligation to the taxpayer. The taxpayer’s rights against M are no greater than those of M’s general creditors. M’s obligations to the taxpayer result solely from the settlement out of court of the legal action that the taxpayer instituted against X who was insured by M. All payment received by the taxpayer in this case, pursuant to the settlement agreement, are excludable from the gross income of the taxpayer under §104(a)(2)
      3. Problems
        1. Plaintiff brought suit and successfully recovered in the following situations. Discuss the tax consequences to Plaintiff.
          1. P, a professional gymnast, lost the use of her leg after a psychotic fan assaulted her with a tire iron. P was awarded damages of $100K. No gross income
          2. $50K of the recovery in (a) above, is specifically allocated as compensation for scheduled performances P failed to make as a result of the injured leg. Loss profit 104(a)(2), so would be completely included as income
          3. The jury also awards P $200K in punitive damages. Punitive damages are not excludible, so she would have to include the full amount as gross income
          4. The jury also awards P damages of $200K to compensate for P’s suicidal tendencies resulting from the loss of the use of her leg. If attached to the physical injury which is covered by 104(a)(2), it will be excluded from gross income
          5. P in a separate suit recovered $100K of damages from a fan that mercilessly taunted P about her unnaturally high, squeaky voice, causing P extreme anxiety and stress. Emotional damage that stands alone and is not attached to a physical injury is generally not excludible. However could exclude amount under 213(d) medical expenses.
          6. P recovered $200K in a suit of sexual harassment against her former coach. Any recovery on the sexual harassment would constitute income for tax purposes, unless she is able to prove that a portion is compensation for physical injuries under Code § 104.
          7. P dies as a result of the leg injury, and P’s parents recover $1M of punitive damages awarded in a wrongful death action under long-standing state statute. Subsection 104(c) provides a narrow exception to the rule of inclusion for punitive damages in a wrongful death action where state law provides the only damages that may be awarded are punitive damages.
        2. Injured and Spouse were injured in an automobile accident. Their total medical expenses incurred were $2500.
          1. In the year of the accident they properly deducted $1500 of the expenses on their joint income tax return and filed suit against Wrongdoer. In the succeeding year, they settled their claim against Wrongdoer for $2500. What income tax consequences on receipt of the $2500 settlement? They can only exclude $1000 because they would be double dipping if they were allowed to exclude the full settlement. They already had a deduction in the previous year and are simply recovering the same amount.
          2. In the succeeding year Spouse was ill but, fortunately, they carried medical insurance and additionally Spouse had insurance benefits under a policy provided by Employer. Spouse’s medical expenses totaled $4K and they received $3K of benefits under their policy and $2K of benefits under Employer’s policy. To what extent are the benefits included in their gross income? $3,000 from employee paid policy is not income. $2,000 from employer paid policy is taxed unless a reimbursement. 2,000/5,000 x 4,000 = 1,600. $400 of employer policy is taxable.
          3. Under the facts of (b), may Injured and Spouse deduct the medical expenses? See §213(a). They can only deduct expenses paid during the taxable year not compensated for by insurance or otherwise.
      4. Limitations on ExclusionIRC §105(b): Restricts exclusions under IRC §104 by disallowing any exclusion for deductions relating to medical expenses, as under IRC §123, for the prior tax year. No double dipping. Taxpayer can’t take a deduction in one year and then seek an exclusion for the same amount the following year.
        1. Example: In 1982, taxpayer deducts $500 for a medical bill. In 1983, taxpayer gets a $500 reimbursement. Taxpayer can’t exclude $500 reimbursement in 1983 under IRC § 104.
        2. Example: In 1982, taxpayer pays $500 medical bill. Taxpayer receives reimbursement in 1982. IRC § 105 doesn’t apply but taxpayer can’t deduct $500 in 1982.
      5. US v. Burke (US Supreme Court, 1992): Taxpayer recovers for sex discrimination. For tax purposes, it is necessary to determine whether recovery was contractual, or for personal injuries where IRC § 104. Holding: There must exist pain and suffering to be categorized as a personal injury. Recovery is taxable. Professor Brown disagrees. Brown thinks that it is clear that sex discrimination is a personal injury.
      6. Horton v. Commissioner (US Court of Appeals, 6th Circuit, 1993): Taxpayer received $1.5 million in punitive damages in slander case. Holding: Punitive damages are not excludible because there was no physical injury.
      7. Future Payments for Personal Injury – Revenue Ruling 79-313 (1979) Taxpayer sustained permanent injuries after being struck by an automobile, for which he accepted a settlement from the driver’s insurer. Insurer agreed to pay taxpayer 50 consecutive annual payments, which would increase each year by 5% over the amount paid in the preceding year. The settlement agreement provided that insurer was not required to set aside specific assets to secure the obligation. Holding: 50 consecutive payments are excludible from the taxpayer’s taxable income.
        1. Rationale – Annual Payments Excluded: All payments received pursuant to a settlement agreement for personal injuries are excludible from taxable income. If the taxpayer had received a lump sum payment, all future income generated from the settlement proceeds would be taxable. The form of the recovery appears to control.
      8. Medical Hypothetical: Spouse was ill but, fortunately, they carried medical insurance and additionally spouse had insurance benefits under a policy provided by employer. Spouse’s medical expenses totaled $4,000 and they received $3,000 of benefits under their policy and $2,000 of benefits under the employer’s policy. To what extent are the benefits included in their gross income?$4,000 in medical expenses. $5,000 in benefits. $3,000 from employee paid policy is not income. $2,000 from employer paid policy is taxed unless a reimbursement. 2,000/5,000 x 4,000 = 1,600. $400 of employer policy is taxable.

 

—————————————————SEPARATION AND DIVORCE———————————————-

  1. Separation and Divorce §71, (omit (c)(2) and (3), §251(a) and (b), 7701(a)(17) Reg. 1.71-1T(a) and (b) (omit Q 6,7,11 and 12)
    1. Alimony and Separate Maintenance Payments
      1. Direct Payments: Payments between spouses in connection with marital dissolution are treated consistently between both parties. That which is taxable to the one spouse is deductible by the other. Conversely, a nontaxable receipt by one spouse is not deductible by the other.
        1. Requirements for Alimony – IRC § 71(b): Lists various requirements that must be met in order for payments to qualify as deductible alimony. These include:
          1. IRC § 71(b)(1)(A): The payment is received by, or on behalf of, a spouse under a divorce or separation instrument. (1) divorced, 2) legally separated by decree 3) married but payments are directed by a written separation agreement 4) married but payments are directed under a support decree. Exception:Does not apply if married and filed a joint return.
          2. IRC § 71(b)(1)(B): The instrument does not designate the payment as a nonalimony payment.
            1. Parties can designate among themselves in the divorce/separation agreement who will pay alimony tax by labeling any portion of the payment as non-alimony. Permits the parties to elect to treat otherwise qualified payments as outside the scope of §71 and §251
          3. IRC § 71(b)(1)(C): In the case of a decree of legal separation or divorce, the parties are not members of the same household at the time of payment. See IRC § 71(b)(2)(A)
          4. IRC § 71(b)(1)(D): There is no liability to make any payment in cash or property after the death of the payee spouse.
          5. IRC § 71(c): The payment is not for child support, and the payment must be in cash.
        2. Divorce Hypothetical: Determine whether the following payments are accorded “alimony or separate maintenance” status and therefore are includible in the recipient’s gross income under IRC § 71 (a) and deductible by the payor under IRC § 215 (a). Unless otherwise stated, Andy and Fergie are divorced and payments are called for by the divorce decree.
          1. The divorce decree directs Andy to make payments of $10,000 per year to Fergie for her life or until she remarries. Andy makes a $10,000 cash payment to Fergie in the current year. Treated as alimony. Alimony is in cash and pursuant to divorce decree.
          2. Same as (1), above, except that Andy, finding himself short on cash during the year, transfers his $10,000 promissory note to Fergie. Not alimony. Not in cash but promissory note.
          3. Same as (2), above, except that instead of transferring his promissory note to Fergie, Andy transfers a piece of artwork, having a market value of $10,000. Not alimony. Not in cash but artwork. In this case §1041 applies as it is a transfer between spouses and allows for it to be nontaxable as there is no gain since it is incident to the divorce
          4. Same as (1), above, except that in addition the decree provides that the payments are nondeductible by Andy and are excludible from Fergie’s gross income. Not alimony. Taxpayer cannot opt out of IRC.
          5. Would it make any difference in (4) above, if you learned that Andy anticipated that he would have little or no taxable income in the immediate future, making the §215 deduction practically worthless to him, and as a consequence of this agreed to the “nondeductibility” provision in order to enable Fergie to avoid the imposition of federal income taxes on the payments? No, because there is no motive inquiry.
          6. What result in (1), above, if the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years? Not alimony. Alimony must be limited by death of recipient. IRC § 71(b)(1)(D)
          7. Same as (5), above, except that under local law Andy is not required to make any post-death payments. Alimony. Local law cures defect in (5).
          8. Same as (1), above, except the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years or her life, whichever ends sooner. Additionally, the decree requires Andy to pay $15,000 cash each year to Fergie or her estate for a period of ten years. Andy makes a $25,000 cash payment to Fergie in the year. $10,000 is alimony. $15,000 is not alimony.
          9. Same as (1), above, except that at the time of the payment, Andy and Fergie are living in the same house. Not alimony. IRC requires divorced individuals are not in the same household. IRC § 71(b)(1)(C)
          10. Same as (1), above, except that Andy and Fergie are not divorced or legally separated and the payments are made pursuant to a written separation agreement instead of a divorce decree. Alimony. Payments are made pursuant to a separation agreement.
        3. NOTE: For the deductions and inclusion in gross income there is not a requirement that the payor have income for the deduction. This is of interest when negotiating settlements
      2. Indirect Payments
        1. Indirect Payments In General: The nature of the payments (rights and interests of the parties) determine whether an indirect payment is considered alimony.Indirect payment must be irrevocably and economically benefiting spouse on whose behalf payments are made.
        2. If payments are merely to maintain property owned by the payor spouse that is simply used by the payee spouse, they do not qualify as indirect alimony payments.
          1. Include: 1) premium payments on life insurance 2) mortgage payments on real property where the underlying property is owned by the payor spouse. However, if payments are made in satisfaction of a legal obligation exclusively that of the payee spouse and are applicable with respect to property in which the payor spouse has no legal interest, such indirect payments qualify as deductible alimony.
        3. I.T. 4001: Life insurance premiums may qualify as indirect payments provided that the policy is irrevocably signed so that the payee ex-spouse owns it and the policy must irrevocably designate payee as beneficiary.
        4. Life Insurance Hypothetical: Husband pays premiums for life insurance policy (for divorce purposes) assigned to his former wife and with respect to which she is the irrevocable beneficiary. This is includible in the wife’s income and deductible by husband.
        5. Life Insurance Hypothetical: Husband pays premiums on a life insurance policy (also for divorce purposes) not assigned to wife, but where she is only a contingent beneficiary. This payment is neither deductible nor includible.
        6. Alternative Payments Hypothetical: Tom and Nicole are divorced. Pursuant to their written separation agreement incorporated in the divorce decree, Ted is required to make the following alternative payments that satisfy the IRC § 71 (b) requirements. Discuss the tax consequences to both Tom and Nicole:
          1. Rental payments of $1,000 per month to Nicole’s landlord. This is indirect alimony. Payment receives alimony treatment.
          2. Mortgage payments of $1K per month on their family home which is transferred outright to Nicole in the divorce proceedings. Payment receives alimony treatment.
          3. Mortgage payments of $1,000 per month as well as real estate taxes and upkeep expenses on the house where Nicole is living which is owned by Tom. Not indirect payment. Tom can’t deduct because he owns the beneficiary.
        7. Brad and Jen Hypothetical: Brad agrees to pay Jen $15,000 a year in alimony until the death of either or the remarriage of Jen. The alimony satisfies the IRC § 71 (b) requirements. After 3 years, Jen is concerned about Brad’s life expectancy and they agree to reduce the alimony amount to $10,000 a year if Brad provides Jen $100,000 of life insurance on his life.
          1. What are the tax consequences to Brad and Jen if Brad purchases a single premium $100,000 policy on his life for $60,000 and he transfers it to Jen? It is indirect alimony on the $60K
          2. What result in (1), above, if Brad instead pays Jen $60,000 cash and she purchases the policy for $60,000? Brad can deductbecause it is in cash. Assuming that there is an instrument then it does get shifted.
          3. What result if Brad buys an ordinary policy on his life for $5K transfers it to Jen, and agrees to transfer $5K cash to her each year so she can pay the annual premiums on the policy? No shift on first $5K (look at (1)). The $5/yr would be shifted.
          4. Same as (3) above, except that Brad pays the $5K annual premiums directly to the insurance company. Indirect payment, as long as pursuant to instrument and all other requirements are met it is a cash benefit for the spouse and it is shifted.
          5. Same as (4) above, except that instead of transferring the policy to Jen, Brad retains ownership of the policy but irrevocably names Jen as its beneficiary. No shift, because he retains property rights.
    2. Property Settlements
      1. Property Settlements – IRC § 1041: Payments that fail to meet IRC § 71 criteria to qualify as alimony are either property settlements or child support. In either case, they have neutral tax consequences. That is,the payor spouse gets no deduction, and the payee spouse is not assessed taxable income. Property transfer must happen within six years after the end of marriage or provide for the transfer as incident to divorce in the written instrument.
      2. Gain Recognized by Transferor – OverruledUS v. Davis (US Supreme Court, 1962) a husband was taxable on the gain in his separate property, measured by the difference between the property’s fair market value and its adjusted basis, when the property was transferred to his wife in satisfaction of her dower rights and she takes the basis when she receives the property. In contrast if in a community property state and divorced viewed as simply retaining their pre-existing property interest, even where each individual community asset was not divided equally.
        1. Additional Comment – Davis Reversed – IRC § 1041: IRC § 1041 reversed the Davis holding with regard to property transfers incident to divorce, making such a nonrecognition event in all states. Prior to IRC § 1041 created problems in community property states since the property was owned by both spouses.
      3. Michael and Lisa Marie Hypothetical: Michael and Lisa Marie’s divorce decree becomes final on January 1 of year one. Discuss the tax consequences of the following transactions to both Michael and Lisa Marie:
        1. Pursuant to their divorce decree, Michael transfers to Lisa Marie in March of year one a parcel of unimproved land he purchased 10 years ago. The land has a basis of $100K and a fair market value of $500K. Lisa Marie sells the land in April of year one for $600K. His basis of $100K transfers under §1041(b) to her so that when she sells it for a gain of $500K. Taxed on the gain of $400K when Michael owned it and then the gain of $100K when she owned it.
        2. Same as (i) above, except that the land is transferred to satisfy a debt that Michael owes Lisa Marie. The land has a basis of $500K and a fair market value of $400K at the time of the transfer. Lisa Marie sells the land for $350K. Does not matter. Transfer between spouses. §1041(b) covers it as long as incident to the divorce (within a year)
        3. What result if pursuant to the divorce decree, Michael transfers the land in (i) above, to Lisa Marie in march of year four. §1041 A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce and the transfer occurs not more than 6 years after the date on which the marriage ceases.”
        4. Same as (iii) above, except that the transfer is required by a written instrument incident to the divorce decree.
        5. Same as (iii) above, except the transfer is made in March of year seven. If after the 6 years then the presumption that the transfer was not made pursuant to the divorce can be rebutted. §1041 A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce and the transfer occurs not more than 6 years after the date on which the marriage ceases.”
    3. Other Tax Aspects of Divorce
      1. Child Support: IRC § 71(b)(1)(B) Unlike alimony, payments made to an ex-spouse for child support are not entitled to a deduction nor is the payment taxed to the payee.
        1. If the divorce decree or agreement specifies that payments are to be made both for alimony and for child support, but the payments subsequently made fall short of fulfilling these obligations, the payments will be allocated first to child support and then to alimony.
        2. Contingent Alimony – IRC § 71(c)(2): Any amount of payments pursuant to a divorce agreement that is reduced upon the happening of a contingency related to the child (i.e. the child marries or becomes emancipated) shall be deemed child support no matter how the instrument describes the payment. Example: Assume the divorce or separation instrument requires payor spouse to pay $12K each year for the life of the payee support and for the support of their child. When the child reaches majority, marries or dies, the annual sum is to be reduced to $8K. Of the total $12K paid, $4K would be deemed fixed for child support and $8K would be for alimony or separate maintenance.
          1. At a time which can clearly be associated with a contingency of a kind specified in subparagraph (A)(see above)
        3. Child Support Hypothetical: Sean and Madonna enter into a written support agreement that is incorporated into their divorce decree at the time of their divorce. They have one child who is in Madonna’s custody. Discuss the tax consequences in the following situations:
          1. The agreement requires Sean to pay Madonna $10,000 per year and it provides that $4,000 of the $10,000 is for the support of their child. $6,000 is alimony. $4,000 is child support.
          2. The agreement requires Sean to pay Madonna $10,000 per year, but when their child reaches age twenty-one, dies or marries prior to reaching twenty-one, the amount is to be reduced to $6,000 per year. $6,000 is alimony. $4,000 is child support.
          3. The agreement requires Sean and Madonna $10,000 per year but that the payments will be reduced $8,000 per year on January 1, 1998, and to $6,000 per year on January 1, 2002. Sean and Madonna have two children: Daughter (born June 17, 1980), and son (born March 5, 1983). $6,000 is alimony. $4,000 is child support. Reg. §1.71-1T(c)
          4. What result in (i) above, if Sean pays Madonna only $5,000 of the $10,000 obligation in the current year? $4,000 for child support and $1,000 for alimony§71(c)(3) Special rule where payment is less than amount specified in instrument
        4. Relating payment to reduction through contingency
          1. A payment which would otherwise be treated as alimony or separate maintenance payments will be presumed to be reduced in two situations:
            1. Payments are to be reduced not more than 6 months before or after the date the child is to attain the age of 18,21, or local age of majority.
              1. Rebutted if the reduction is a complete stop of alimony during the 6th post separation year or upon the expiration of a 72-month period..
            2. Payments are to be reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24, inclusive.
          2. Can be rebutted by showing that at the time which the payments are to be reduced was determined independently of any contingencies relating to the children of the payor.
      2. Alimony Payments Made by a Third Party
        1. IRC §215; 682. See §§ 72; 1041.
        2. Trusts – IRC § 682 (a): As a general rule, trust income is taxable to the grantor where it is used for the support of any beneficiary whom the trustor is legally obligated to support. However, under IRC § 682 (a), a trust set up by a spouse, the income of which is paid to a divorced or separated spouse, is effective to shift the tax burden from the grantor to the beneficiary. Payee is taxed on trust payments.
      3. Divorce: If the parties are divorce or legally separated and the decrees are later declared invalid in the same jurisdiction, the IRS views the parties as still married. Payments made thereafter absent a written separation agreement are not taxable to payee nor deductible to payor.

 

———————————EXCLUSIONS FROM GROSS INCOME PART II—————————————-

  1. Other Exclusions from Gross Income
    1. Gain from the Sale of a Principal Residence §121(omit (d)(4) and (5), (e) Reg. Section 1.121-1(a), (b)(1), (2) and (4) Example 1, (c)(1), (d),-2(a)(1)-(4) Example 2, -3(b), (c)(1)(4) Example 1, (d)(1)-(3) Example 1, (e)(1) an d(2), (f), (g)(1)-(2) Example 1
      1. In General – IRC § 121: Taxpayer is generally able to exclude up to $250,000 §121(b)(1) ($500,000 if married filing a joint return§121(b)(2)) of gain realized on the sale or exchange of a principal residence. No more frequently than once every two years and has to have occupied it as a principal residence for at least two of the five yearsprior to the sale or exchange.
      2. Residence Sale Hypothetical: Determine the amount of the gain that taxpayers (a married couple filing a joint return) must include in gross income in the follow situations:
        1. Taxpayers sold their principal residence for $600,000. They had purchased the residence several years ago for $200,000 and lived in it over those years. $400,000 gain. Each spouse has ability to exclude $250,000. Therefore the $400K is excluded.
        2. Taxpayers in (a), above, purchased another principal residence for $600,000 and sold it 2 ½ years later for $1 million. Exclusion revived every two years. $400,000 is excluded.
        3. What result in (b), above, if the second sale occurred 1 ½ years later? §121(b)(3)(A) applies and it would not qualify for the exclusion. $400,000 gain realized.
        4. What result in (b), above, if Taxpayers had sold their first residence and were granted nonrecognition under former Section 1034 (the rollover provision) and, as a result, their basis in the second residence was $200,000? They are rolling their $200,000 basis forward, so here, they would have to pay tax on the remainder of the exclusions, which would be $300,000 ($800,000 gain – $500,000 exclusion).
        5. What result in (a), above if the residence was Taxpayers’ summer home which they used 3 months of the year? Would not be excluded because it is not their principal residence.
        6. What result if Taxpayer who met the ownership and use requirements is a single taxpayer who sold a principal residence for $400,000 and it had an adjusted basis of $190,000 after Taxpayer validly took $10,000 of post-1997 depreciation deductions on the residence which served as an office in Taxpayer’s home? Under §1016 every $1 of depreciation decreases the basis by a $1. Therefore under §121(D)(6) the $10K is gross income and cannot be excluded because it was deferred by the deduction and is now recaptured when the residence is sold.
      3. Residence Sale Hypothetical #2: Single Taxpayer purchased a principal residence for $500,000 and after using it for one year, Single sold the residence for $600,000 because Single’s employer transferred Single to a new job location.
        1. How much gain must Single include in gross income? §121(c)(1)(B)(i)(I or II)(how long property has been owned as principal residence or period after the date of the most recent sale-USE THE SHORTER) divided by (how long supposed to live in residence)X $250(maximum allowable exclusion)=$125K gain
        2. What result in (a), above, if Single sold the residence for $700,000? $75K
      4. Residence Sale Hypothetical #3: Taxpayer has owned and lived in Taxpayer’s principal residence for 10 years, the last year with Taxpayer’s Spouse after they married. Spouses decide to sell the residence which has a $100,000 basis for $500,000.
        1. If the Spouses file a joint return do they have any gross income? They do meet the ownership requirement however (only one needs to meet this), the spouse does not satisfy the use (both need to meet this requirement) Since they don’t meet the eligibility for that joint return look at§121(b)(2)(B) Other joint returns Q1: Does T have two years ownership and use?T satisfies the 2 yr ownership and the use, therefore eligible for the $250,000 exclusion. Spouse (looking at last sentence-“each spouse shall be treated as owning the property during the period that either spouse owned the property”, therefore eligible for the 2 yr ownership but does not meet the use, therefore not eligible for any exclusion so….$400,000-$250,000=$150,000 Gain
        2. What result if the Spouses had lived together for two years in Taxpayer’s residence prior to their marriage and sold the residence after one year of marriage for $500,000?
        3. What result in (a), above, after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Spouse lived in the residence while Taxpayer moved out and, one year later, they sold the residence for $500,000? Each owns ½ of the house at time of sale. Not married and are not going to file joint returns so the $500,000 is not going to be allowed. T is selling ½ (only allowed to take exclusion on that) $250,000 allowed because meets the requirements. Spouse has used it for more than 2 years, however only had 1 year of ownership. Look at §121(D)(3)(A) Property transferred to individual from spouse or former spouse-can tack ownership so the spouse will qualify for the $250,000. (Remember §1041-transfer must be incident to the divorce-if you fall out of §1041 you fall out of the tacking provision)
        4. What result in (a), above, if after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Taxpayer continued to occupy the residence while Spouse moved out, and, one year later, they sold the residence for $500,000? Q1: Does T have two years ownership and use? Yes, Q2: Does Spouse have two years ownership and use? YES§121(D)(3)(B) Property used by former spouse pursuant to divorce decree.
      5. Residence Sale Hypothetical #4: Estate planner sold a remainder interest in Planner’s principal residence of $300,000(its fair market value) to Planner’s Son. Planner’s basis in the remainder interest was $125,000. Does Planner have any gross income? §121(D)(8) Sales Remainder Interest However the son is a related party see§121(D)(8)(B) Related Parties and then cross reference to §267(b) for a definition as a related party. Therefore $300,000-$125,000= $175,000 gross income because the son is a related party and does not apply for the exclusion.
      6. Notes:§1001(c) Except as otherwise provided in this subtitle (which is §121), the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized.
    2. Earned Income Abroad
      1. Earned Income Abroad – IRC § 911: Income earned abroad is allowed special income treatment and is excluded. Taxpayer must be a bonafide resident of foreign country or countries for uninterrupted period that includes the entire tax year or taxpayer must be a resident of a foreign country for 330 consecutive days per year. Countries in which travel is restricted (i.e. Cuba, Iraq) are excluded. Income must be from a foreign source and attributable to the taxpayer’s performance or services. The exclusion is limited to $70,000.
    3. Federal Taxes and State Activities
      1. Tax Exempt Interest
        1. Interest on Obligations of State and Local Governments – IRC § 103: The interest on obligations of state and local governments generally is exempt from federal income tax. This tax break allows these governments to borrow money at a reduced rate, since the exclusion of interest will add to the investor’s rate of return, particularly an investor in a higher tax bracket. In effect, this is a subsidy from the federal to the state and local governments. The reason behind this exclusion is to encourage investment in state and municipal bonds. Also, it is constitutionally questionable whether taxing these obligations would be an improper infringement on state and local government.
          1. Limitations: Generally, public activity bonds issued for traditional government activities such as roads, schools, etc, will be available without limit. However, “private activity” bonds will be subject to limitations as to specific uses as well as amounts, unless private activity bond is a “qualified bond”, an “artbitrage bond,” or one which is in “registered form.” “Private activity” bonds will be limited to the greater of $50 per resident or $150 million dollars per state.
          2. Policy: Allows government to access the credit market at a lower interest rate.

 

——————————————-ASSIGNMENT OF INCOME—————————————————-

  1. Assignment of Income §1(a)-(e), (h), §6013(a) See §1(g), §63, §66, §73
    1. Introduction: Generally an item of income is taxed to the person who earned it or who owns the producing property. However, the progressive tax rates encourage attempts to divide income among family members or other entities, and in so doing reduce the earner’s total tax liability. In the income tax area there are both statutory and judge-made restraints on the “assignment of income,” and these provisions may be mandatory or elective. This deals with assignment of income to other individuals.
    2. Identification of the Proper Taxpayer
      1. IRC §1 distinguishes who must file:
        1. Married individuals filing joint returns/surviving spouses
        2. Heads of households
        3. Unmarried individuals
        4. Married individuals filing separate returns
        5. Estates/trusts
      2. Generally an item of income is taxed to the person who earned it or who owns the producing property. However, the progressive tax rates encourage attempts to divide income among family members or other entities, and in so doing reduce the earner’s total tax liability. In the income tax area there are both statutory and judge-made restraints on the “assignment of income,” and these provisions may be mandatory or elective.
        1. Mandatory restraint – i.e. IRC § 73(provides that a dependent child’s income is taxable to her and not to her parents)
          1. However, see§6201(c) where a parent can be liable for the child’s tax on income included in gross income under §73
        2. Elective – income-splitting provisions available to married couples (which were passed in response to the inequities that arose from community property states permitting married couples to split their income regardless of who earned it).
      3. Congress has enacted a number of rules to prevent assignment of income:
        1. Kiddie” Tax§1(g)Children under age 14 are taxed at their parents’ rate for all unearned income.  For example, if X, a child under 14 receives property from her parents that produces passive, unearned income her parents have successfully transferred the income.  But, X will be taxed at her parent’s income tax rate.
        2. Trusts – People used to shift money to trusts to avoid higher tax rates.  In 1986, Congress essentially eliminated the ability to do this by changing income tax levels on trusts.  Now, if the trust earns $7500 income, it is taxed at the 39.6% rate; $5500 taxed at 36% rate; $3500 taxed at 31% rate.
        3. §482 Reallocation of income and deductions-under broad statutory authority granted in this statute, the IRS may reallocate among related entities items of gross income, deduction, and credit if necessary to prevent the evasion of tax or clearly to reflect income. Gives the IRS a powerful tool to combat the misallocation of tax items.
    3. Income From Services
      1. Anticipatory Contracts – If a taxpayer who performs services attempts to direct the compensation to another person by private agreement, the taxpayer (not the transferee) will be required to include the amount in gross income. Lucas v. Earl (1930) Earl entered into a contract with his wife in which they agreed that any income either of them earned would be owned by them as joint tenants. Earl claims that due to this contract, he can only taxed on ½ of his income. The commissioner held that defendant should be taxed on the whole of his income.Holding: A contract does not allow an earner of income to prevent his salary from vesting for tax purposes.Rationale IRC § 61 (a): taxes the net income of every individual “derived from salaries, wages or compensation for personal services.” The statute does not seek to tax only income beneficially received, but also that which is actually earned. One cannot by agreement attribute fruits to a different tree from that on which they grew.
        1. Additional Comment – Refuse Compensation: It is possible to decline income as long as it is done before it is completely earned. This would serve as a disclaimer rather than an assignment.
      2. Anticipatory Assignments – A taxpayer who makes an unqualified refusal to accept compensation, without a direction of its disposition, does not realize taxable income. Commissioner v. Giannini (US Court of Appeals, 9th Circuit, 1942) Defendant was president of Bancitaly Corporation. From 1919 to 1925, he received no compensation. In June 1927, the board of directors approved a plan whereby defendant would receive 5% of the corporation’s gross profits each year in lieu of salary, with a minimum of $100,000 per year. Taxpayer informed corporation that he would not accept such a payment (value of $400,000) and suggested that corporation should do something “worthwhile with the money.” Corporation donated the money to the University of California. Commissioner stated defendant realized the income even though it was eventually donated to the University of California. Holding: When a taxpayer, by anticipatory assignment, makes a gift of the interest or compensation that he is entitled to receive at a future date in return for his present services, he thereby realizes taxable income. However, here there was no income.
        1. Rationale: Anticipatory Assignments: When a taxpayer makes an anticipatory assignment of compensation that he is to receive at a future date in return for his present services, he nevertheless receives income. It is as if he had received the compensation and then directly paid it to the donee. The courts have consistently held that income is realized by the assignor who owns or controls the disposition of amounts owed him.
        2. Instant Case Differs: Defendant neither received the money nor directed its disposition. He made an unqualified refusal to accept the money and only suggested that it be used for some worthwhile purpose. The corporation could have kept the money, and all arrangements for its disposition were handled by the corporation. This was a valid disclaimer.
        3. No Fraud: There is no evidence that this transaction was a fraud intended to save defendant and his wife income taxes.
      3. Revenue Ruling 66-167: Taxpayer elected not to receive compensation for services as executor of his deceased wife’s estate. The main consideration was whether the waiver involved would at least primarily constitute evidence of an intent to render a gratuitous service. The taxpayer was determined not to be in receipt of taxable income of the amounts he would otherwise have received as fees and commissions. It is not always desirable for executor to disclaim fee since it denies the estate a deduction that may be more valuable.
      4. Revenue Ruling 74-581: The IRS allowed law school professors to assign their income from legal clinics and services to their law school and successfully shift their income. The following are some of the factors which are considered in determining whether personal services can be assigned: (1) Would the taxpayer normally be expected to receive the income? (2) What was the relationship between the assigning parties? (3) Who bore the risk of loss? (4) Did the assignor of the income receive something in return close to fair market value? Faculty did not have the right to keep this income anyway because they operated as agents of the law school.
    4. Income from Property
      1. In General: Income derived from property is taxable to the one who owns the property. The income cannot be split off from the property that produced it and shifted to another.
      2. Transfer or Assignment of Property: When a right to receive income has matured before the taxpayer assigns the property producing it, the income will be taxable to the assignor at the time that the property is transferred to the assignee. Any income earned after the date of the transfer to the donee will be taxable to the donee.
      3. Critical Factors: There are two critical factors to income shifting:
        1. Timing: When was the transfer? How close was the transfer date to when the income would have been ripe. Was the taxpayer on the verge of receipt?
        2. Property: What was transferred? Property rights and interests are required, not mere income.
      4. Application:
        1. Interest Coupons – An assignment of the right to receive income from property is an economic benefit to the owner of the property, and is income realized and taxable to the owner of the propertyHelvering v. Horst (US Supreme Court, 1940)Defendant owned bonds with detachable interest coupons. Defendant delivered the coupons to his son as a gift. When the coupons matured, defendant’s son cashed them. Holding: Donor should be taxed for bond interest when he gives the interest coupons to another before maturity. Rationale – Holder of coupon has two rights, one to demand and receive at maturity the principal amount and the other is the right to receive interim interest payments. Does not have to receive the income directly to realize it. Right to Income: Income is realized by the assignor when he diverts the payment that he could have received to the donee. Plaintiff retains right to capital that generates the income of the coupons. Essentially, taxpayer retains the tree and gives the fruit to another. Mr. Horst precluded any possibility of collecting the interest payments when he gave the coupons to his son. But this disposition of his right to receive income is, nonetheless, enjoyment of the income, no different than had he used the coupons to purchase goods, pay debts or donated them to charity.
      5. When Taxpayer Has Only an Income Interest: If the taxpayer has only an income interest, he can transfer taxability of future income by transferring the interest
      6. Coupon Bond Hypothetical: Father owns a registered corporate coupon bond that he purchased several years ago for $8K. It has a $10K face amount and is to be paid off in 2010. The current fair market value of the bond is $9K. The bond pays 8% interest, semi-annually April and October 1. What tax consequences to Father and Daughter in the following alternative situations?
        1. On April 2 of the current year, Father assigns Daughter all the interest coupons. F will be taxed on the value of the interest coupons. D will have no taxable income from the interest coupons.
        2. On April 2 of the current year, Father gives Daughter the bond with the right to all the interest coupons. Daughter is taxed and Father is not because father essentially gave away the “tree”
        3. On April 2 of the current year, Father gives Daughter a one-half interest in the bond and the right to all the interest coupons. Both are taxed at half because F only gave away part of the tree
        4. Father owns an income interest in a trust that owns the bonds and on April 2, Father gives Daughter his income interest (the right to the succeeding interest coupons) to Daughter. D is entitled to income during her life from a trust established by her father.  F can transfer portions of the life estate to his children, so each of them would receive a portion of the income to which he was otherwise entitled during his life. F’s children become the owners of their respective portions of the present interest in the trust, and income paid to them had to be included in their gross income, not F’s.  
        5. On December 31, Father gives Daughter the bond with the right to all the interest coupons. As far as I can tell, there are no limitations as to when the change can occur. Either the father will still have taxable income even though he essentially gave away the “tree” or because he did give away the “tree”, D will be taxed
        6. On April 2, Father sells Daughter the right to the two succeeding interest coupons for $600, their fair market value at the time of the sale. If a right to future income is sold or exchanged for its present value, there is no gratuitous assignment.  The transferor must include the proceeds of the sale or exchange in his gross income.  The transferee takes a cost basis in the right to future income.  The transferee must include in his gross income in the later year the difference between the amount she receives and the amount she paid. 
        7. On April 2 of the current year, Father sells the bond and directs that the $9K sale price be paid to Daughter. F would have to pay taxes on the $9K price because a sale by one person cannot be transformed for tax purposes into a sale by another using the latter as a conduit through which to pass title.
        8. Prior to April 2, Father negotiates the above sale and on April 2 he transfers the bond to Daughter, who transfers the bond to buyer, who then pays Daughter the $9K price. F would have to pay taxes on the $9K price because a sale by one person cannot be transformed for tax purposes into a sale by another using the latter as a conduit through which to pass title. However, the court would look at how far into the sale F was and how much work he had done before determining who had to pay taxes on the $9K
      7. Anticipatory Assignment Hypothetical: In the financial page of the SF Chronicle, it was reported: “Playboy Enterprises declared a semiannual dividend of six cents a share Tuesday, but the company said its president Hugh Hefner, decided to give his back. A spokesman said his dividend would’ve totaled more than $380K as he holds more than six million of the total shares in the company. ‘It was a gesture of faith in the company,’ said the spokesman.”
        1. How will the Commissioner treat Mr. Heffner’s gesture? What additional facts do you want to know? Mr. Heffner’s gesture will still likely be taxable even though he chose to divert his share back to the company

 

Income Producing Entities

Trusts

  1. In General: Trust income is taxed to the grantor who created the trust, the trust itself, or the beneficiary of the trust. Since income from property is normally taxed to the owner, a threshold issue is whether the grantor has sufficient control over the trust to be considered its owner.
  2. Income Taxable to the Grantor: (Sections 671 – 678)
    1. Power to revoke or alter the trust
    2. Corliss v. Bowers
      1. P transferred an income-raising fun to trust to pay income to his wife, but P reserved the power to revoke in whole or part the trust.
        1. §676: If the grantor or other non-adverse party (nonbeneficiary) has the power to revoke the trust after its inception and revest all or part of the corpus in the grantor, he may be taxed for trust income.
          1. §674: Income taxable to Grantor If the parties above have control over
            1. Who gets the corpus or income
            2. When it will be available
    3. Power to use trust income to discharge grantor’s legal obligations
    4. Morrill v. United States
      1. Morrill established trusts for his children to mature at age 21; also provided that trustee had the discretion to use the trust income to pay for kids college education.
        1. The amounts used to pay tuition/room were used to satisfy legal obligations of P and therefore taxable as income under §677
      2. Rule: Trust income that is used to satisfy a legal obligation of the grantor, is in effect, distributed to him and is therefore taxable to him (Reg 1.677(a)-1(d))
        1. Irregardless of whether obligations are by contract or by law
          1. Includes premiums on the grantor’s life insurance or aid in supporting dependents
            1. Spouse included
    5. Helvering v. Clifford
      1. Clifford put securities in trust for wife, however had power to sell or exchange any of the stock, exercise the voting power of the trust stock, invest income at his discretion, etc.
        1. Held: He retained ownership of trust property because he retained unfettered control over it.
    6. Reversionary Interest/ Current Law under §673
      1. A grantor will be taxed on the income of the trust if he has a reversionary interest with a value greater than 5% of the value of the trust
    7. Problems
      1. Grantor who is a lawyer creates a trust for the benefit of her adult Son with income to Son for life, remainder to Sons children. Who is taxed on the income paid to Son in the following circumstances?
        1. Grantor transfers the trust accounts receivable for services which have never been included in her gross income. The clients pay the fees represented by the receivables in the succeeding year. (Son?)
        2. Grantor owns a building subject to long term lease. She transfers the right to future rentals under the lease to the trust. (Grantor)
        3. Same as (2) above except that she transfers the building along with the right to the rentals at a time when no rent has accrued. (Son)
        4. Same as (3) above except that six months’ rent has accrued on the lease at the time of Grantor’s transfer. (Grantor 6 months; Son the following)
        5. Same as 3 above, except the Grantor retains the right to revoke the trust at anytime. (Grantor)
        6. Same as above, except that Grantor holds liberal powers to change the income beneficiary of the trust from Son to anyone other than Grantor. (Grantor)
        7. Same as above, except that at Son’s death, the property reverts to Grantor if Grantor is living. The value of the reversionary interests exceed 5% of the value of the trust corpus. (Grantor)
        8. Same as (7) above except Son is a 19 year old minor. (Grantor)
        9. Same as 8 above, except that the trust instrument provides that the corpus shall revert to Grantor only if Son dies prior to reaching 21 years of age. (Son)
        10. Same as (3) above except the Grantor may direct the sale of the trust corpus to any person including herself at any price she wishes. (Grantor)
        11. Same as 3 above, except that Son is a minor and the income from the trust while Son is a student is used to pay Sons tuition at a private high school Son attends. (Grantor income for tuition)
        12. Same as 3 above, except that under the terms of the trust, Husband may require the trustee to pay the income from the trust to him in any year. (Husband)

NEED TO FINISH PP 872-77; income with respect to decedents

 

————————————————DEDUCTIONS————————————————————-

 

  1. Deductions
    1. In General: Expenses incurred during a taxpayer’s tax year that may be subtracted, in whole or in part, from the taxpayer’s gross income or from his adjusted gross income in order to compute the taxpayer’s taxable income.
      1. Types:
        1. Above-the-line: Class of deductions available to all individual taxpayers whether they choose to use the standard deduction or to itemize their other deductions. Subtracted from gross income
          1. Examples: IRA, Non-employee trade or business expenses, Employee expenses paid by the taxpayer under a reimbursement arrangement with her employer, Losses from the sale or exchange of property, Expenses related to the production of rents or royalties, employer contributions to the taxpayer’s pension or profit-sharing plan, Contributions to qualified retirement savings plan, Alimony payments made by the taxpayer, Employment-related moving expenses that were not reimbursed by the taxpayer’s employer; Qualified Contributions to Medical Savings Account, and Interest paid on qualifying education loans§62
        2. Below-the-line: Either the standard deductions or the taxpayer’s itemized deductions. Can use either but not both.
          1. Examples: Interest paid (home mortgage interest, as well as investment interest paid), Taxes paid to state and local governments, and on real property, Charitable contributions(limited to a maximum of 50% of AGI for certain charities, and 30% for others), Business and investment losses, to the extent that they were not reimbursed by insurance, Personal casualty losses in excess of $100 (but only to the extent that they exceed 10% of AGI), Medical expenses(but only to the extent that they exceed 7.5% of AGI), Moving Expenses
        3. Miscellaneous itemized deductions: Include unreimbursed employee expenses, expenses related to generating investment income, and tax preparation fees. Only that amount of miscellaneous itemized deductions, added together, which exceeds 2% of AGI may be deducted from AGI (does not apply to pass through entities such as partnerships.
      2. Limits: §274, §465

 

 

———————————————-BUSINESS DEDUCTIONS—————————————————————-

  1. Business Deductions §1, §63
    1. Introduction
      1. IRC § 151 – § 250: Since there is no constitutional right to a deduction, in order to claim a deduction, taxpayers must find a specific code section that specifically allows the deduction. Two motivations dictate the federal income tax use of deductions and credits: (i) to tax only net income, and (ii) to encourage certain activities or investments.
      2. Hierarchy of Deductions
        1. Expenses deductible in context of trade or business-look at Schedule C on the IRS website
        2. Expenses incurred in connection with a profit-seeking activity.
        3. Deductions to individuals or corporations without regard to whether they have a business, income or profit connection.
        4. Deductions to individuals only.
      3. Capital Investment v. Expense:
        1. Main Difference:
          1. Timing: An expense deduction gives the taxpayer a benefit for the year the expense was made. Capitalization requires the taxpayer to wait until he disposes of the asset in order to realize the tax benefit (an increase in basis)
        2. What they do:
          1. Capital Investment: acquires, replaces, alters, rehabilitates or improves.Generally, large financial outlays. Capital improvements are a charge against income that it helps to earn over the expected useful life of the property. Repairs to a building which appreciably extends its useful life is capital. A few new shingles are an expense.
          2. Business Expenses: repair (keep property in current condition and do not add value to value or appreciably prolong the property’s life),maintain, preserve and restore.Generally, small financial outlays.
    2. Business Deductions In General – IRC § 162, Reg. 1.162-1(a): All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business” are deductible.” Four issues frequently arise in this context: (i)What kinds of expenditures are properly classified as expenses? (ii) Was the expense “ordinary and necessary”? (iii) Was the expenditure a current expense or a capital outlay? and (iv) Was the expense for business or personal reasons?
      1. Ordinary and Necessary”
        1. In General: “Ordinary and necessary” means that the expenses are common or accepted in the particular business or profession and that they relate to producing the current year’s income.
          1. Example: Reasonable salaries, office rentals, office supplies, and traveling expenses are all deductible when incurred for business purposes.
        2. What are “Ordinary and Necessary” Expenses?
          1. Not one that is habitual but rather expenses that are common in the taxpayer’s particular industry or businessWelch v. Helvering (1933) The owner of a grain purchasing business sought to deduct from his income payments he made and there were directed to the creditors of a grain company for which he had served as secretary and which had all its debts legally discharged in bankruptcy. COURT: The norms of a particular business or community make the inquiry into whether the expense is common to the industry an objective one. There is no bright-line-rule. Life itself must supply the answer. Reputation is akin to a capital asset, much like goodwill. The money spent in acquiring it is not an ordinary expense in the operation of a business. Ordinary and necessary business expenses are defined according to the normal means of conduct and forms of speech in the business world. Paying another’s debts does not fall within this definition. By the usage of trade, paying debts without legal obligation is extraordinary, even if done for the purpose of strengthening one’s own credit. This is not the normal method of dealing with this type of business situation (i.e. not ordinary expense of doing business).
            1. Note: The Commissoner’s ruling carries with it a presumption of correctness, and Mr. Welch has the burden of proving otherwise.
            2. Note: For Payment of Debt to Be Deductible: Direct Business Purpose Required: A taxpayer’s payment of another’s expenses or debts is not deductible unless the purpose of making the payment is to directly further or promote his own business.
          2. Does not mean that expenses must be habitual or normal in the sense that the same taxpayer will have to make them often. Midland Empire Packing Co. (U.S.Tax Court 1950) pg. 319 The expense is ordinary “because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack.”It is enough that the situation is unique in the life of the taxpayer affected, but not in the life of the group or community which he is apart. Protecting a business building from the seepage of oil caused by a nearby factory would seem to be the normal thing to do. However, the outcome of this case may have been different if the water had been a significant burden that needed to be dealt with, in order for the basement to be used for its originally intended purpose. It could have then been determined the concrete lining was a foreseeable part of the process of completing Midland’s initial investment and therefore needed to be capitalized.
        3. Problem:
          1. Taxpayer is a businessman, local politician who is also an officer-director of a savings and loan association of which he was a founder. When, partially due to his mismanagement, the savings and loan began to go under, he voluntarily donated nearly one half a million dollars to help bail it out. Is the payment deductible under §162? See Elmer v. Conti(1972) TP’s expenditure was proximately related to his business activities and was made to preserve and protect his business reputation in order to enable him to continue to carry on such activities. Consequently, he is entitled to a deduction in that amount under section 162(a).
          2. Employee incurred ordinary and necessary expenses ona business trip for which she was entitled to reimbursement upon filing a voucher. However, Employee did not file a voucher and was not reimbursed but, instead, deducted her costs on her income tax return. Is Employee entitled to a §162 deduction? See Heidt v. Commissioner (7th Cir. 1959) She voluntarily gave up reimbursement from her employer to which she was entitled by promulgation of an alleged oral rule which applied only to herself, the expenses did not constitute ‘ordinary and necessary expenses of carrying on any trade or business’ and hence were not deductible since taxpayer could not convert the employer’s right to a deduction into a right of his own.
      2. Expenses §162(a) and §263(a) Reg. Sections 1.162-4; 1.263(a)-2, -4(a) through (c)(1), (d)(1), (e)(1)(i), (2), (3), (4)(i), -5(a), (b)(1)
        1. Rules:
          1. §162(a):Deduct expenses paid or incurred during the taxable year in carrying on any trade or business: reasonable allowance for salaries, traveling expenses, and rent(as along as taxpayer has not taken or is not taking or in which he has no equity)
          2. §263(a): Capital Expenditures provides that deductions may not be taken for amounts “paid out for new buildings or for permanent improvements or betterments made to increase the value of any property.” Some of the criteria distinguishing capitalizations from expenses are: (see Midland Empire Packing)
            1. Whether the expenditure prolongs the life of the property?
            2. Whether the improvements will endure and beyond the taxable year?
            3. Whether the expenditure adds to the value of the property?
            4. Whether the expenditure was part of an overall improvement or only a replacement of minor or recurring items?
            5. Whether there is a change of alteration in use or function?
        2. Capital Expenditures:
          1. Does not require separate and distinct additional asset: The fact that an expenditure does not create or enhance a separate and distinct additional asset does not alone preclude the expenditure from being treated as a non-deductible capital expense. INDOPCO, Inc. v. Commissioner(1992): Costs of arranging friendly corporate takeover, which would result in long-term benefit to corporation, are not deductible. The question of whether an expenditure is an ordinary and necessary expense deductible under §162, or whether it is in the nature of a non-deductible capital expense, often turns on the particular facts of the case. While it is sufficient if it creates or enhances a separate asset, that is not necessary. The scope of the regulations are narrow. “The IRS and Treasury Department have initially defined the exclusive scope of the significant future benefit test through the specific categories of intangible assets for which capitalization is required in the proposed regulations.” Pg. 334
          2. One Year Benefit Limit: Realization of benefits beyond the year is undeniably important in determining whether the expense will be held deductible under §162, or whether capitalization is required. INDOPCO, Inc. v. Commissioner(1992) In this case Indopco realized benefit well beyond the tax year in question, including access to Unilever’s resources and its transformation to a wholly-owned subsidiary, which lessened the company’s administrative costs.
          3. Examples:
            1. Expenditure of money to install a drainage system that would protect neighbor’s property from the flow of water from the landMt. Morris Drive-In Theater (US Tax Court, 1955): Theater installed a drainage system because water runoff was damaging their neighbor’s land. Holding: Nondeductible capital expenditure because this improvement would protect the theater from further liability.
            2. Equipment depreciation allocable to construction of capital facilities. Commissioner v. Idaho Power Co. (1974)
            3. Cooperatives’ required purchases of stock in Bank of Cooperatives United States v. Mississippi Chemical Corp. (1972)
            4. Additional premiums paid by bank to federal insurers Commissioner v. Lincoln Savings & Loan Assn (1971)
            5. Legal, accounting, and appraisal expenses incurred in purchasing minority stock interest Woodward v. Commissioner (1970)
            6. Consulting, legal and other professional fees incurred by acquiring firm in minority stock appraisal proceedingsUnited States v. Hilton Hotels Corp. (1970)
            7. Payment by parent company to cover subsidiary’s operating deficit Interstate Transit Lines v. Commissioner (1943)
            8. Expenses incurred by shareholder in helping executives of company acquire stock Deputy v. Du Pong(1940)
            9. Brokerage commissions Helvering v. Woodmill(1938)
            10. Payments of former employer’s debts Welch v. Helvering(1933)
            11. Soil remediation expenses related to purchased property United Dairy Farmers Inc. v. United States(6th Cir. 2001)
            12. Accounting fees related to corporate reorganization United Dairy Farmers Inc. v. United States(6th Cir. 2001)
            13. Engineering Studies United Dairy Farmers Inc. v. United States(6th Cir. 2001)
            14. Expenses after “final decision” in corporate acquisitionWells Fargo & Co. v. Commissioner (8th Cir. 2000)
            15. Costs related to making auto loans Lychuk v. Commissioner(2001)
        3. Expense Deductions:
          1. What is a Repair? An expenditure made for the purpose of restoring property to a sound state, or for keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor appreciably prolong its life.Midland Empire Packing Co.(U.S.Tax Court 1950)Plaintiff has been using its basement for curing meat and storing hides for 25 years when oil from a nearby refinery started to seep into the basement, creating a hazard. A concrete lining installed on the floor and walls solved the problem. Plaintiff deducted the expense of the oil proofing as an ordinary and necessary business expense. COURT: A structural change to a building which does not add to the life or usefulness of the building, and is the normal manner of dealing with a specific situation, can be deducted as a business expense. While it is fact that expenditures for replacements, alterations, improvements, or additions connotes substitution, which prolong the life of property, increase its value, or make it adaptable to a different use, the expenditure in this case did not add to the value or prolong the expected life of the property beyond what it was before the event occurred.
          2. Examples:
            1. Legal expenses incurred in defending against securities fraud chargesCommissioner v. Tellier
            2. Legal expenses incurred in disputing adverse postal designationCommissioner v. Heininger (1943)
            3. Salaries paid to corporate officers related to corporate acquisition Wells Fargo & Co. v. Commissioner (8th Cir. 2000)
            4. Legal fees related to the investigatory stage of the corporate acquisitionWells Fargo & Co. v. Commissioner (8th Cir. 2000)
            5. Costs for marketing, researching, and originating loans PNC Bancorp, Inc. v. Commissioner(3rd Cir. 2000)
            6. Expenses made resisting hostile takeover-preserve the status quo A.E.Stanley Manfuacturing Co. v. Commissioner(7th Cir. 1997)
            7. Extensive maintenance on towboats Ingram Industries v. Commissioner(2000)
        4. Alternative Theories:
          1. For Loss: A taxpayer has the choice of a deduction of loss or a deduction for any repair to restore the property.
            1. In order to deduct for losses, it must be realized, an identifiable event that justifies a current accounting. A decline in value caused by wear and tear will not give rise.
        5. Landlord Hypothetical: Landlord incurs the following expenses during the current year on a ten-unit apartment complex. Is each expenditure a currently deductible repair or a capital expenditure?
          1. $350 for painting three rooms of one of the apartments. Deductible
          2. $1,500 for replacing the roof over an apartment. The roof had suffered termite damage. Deductible (Trying to put the roof back to its useable state over one apartment.. NOTE: If replacing the whole roof because of wear and tear would probably be capital expenditure. Shows the two poles between which to measure repair or capital expenditure)
          3. $500 for patching the entire asphalt parking lot area. Deductible, just patching, not a replacement.
          4. $750 for adding a carport to an apartment. Expenditure, wasn’t there before, adding value.
          5. $100 for advertising for a tenant to occupy an empty apartment. Expenditure
      3. Carrying on” Business §162(a) §195 §262 Regulations §1.195-1(a).
        1. General Ideas:
          1. First job” expenses are generally not deductible under§162, but see Compensation to 3rd Parties below. The expense must be incurred during the time the taxpayer is actually engaged in carrying on a trade or business.
            1. Going Concern: A taxpayer is carrying on trade or business from the date that it is a going concern, i.e, has regular activity in the areas in which the business is organized.
            2. Pre-opening expenses§195: expenses incurred prior to opening must be capitalized. Expenses that would have been deductible if the taxpayer had been engaged in a trade or business may be amortized over a period of 60 months beginning with the month of opening.
        2. Searching for Business:
          1. Travel expenses and legal fees spent in searching for a business to purchase cannot be deducted under§162(a) Morton Frank v. Commissoner (US Tax Court, 1953)Plaintiff and his wife spent about one year traveling around the country in an attempt to locate a newspaper or radio station to buy and operate. They deducted their travel and other related expenses. Holding: The Franks were not engaged in any trade or business at the time the expenses were incurred. The trips were preparatory to entering into a business. They could possibly have been deducted under §195 which requires that the expenses meet the requirements under §162 (ordinary and necessary) and must have actually started a business
          2. NOTE: The plaintiff could have rolled these costs and made it a part of a business which he could have bought.
        3. Transactional Stage:
          1. Def: Where preliminary investigation had led to the decision to purchase specific business but further investigation still continues
          2. Amounts paid to complete the transaction (appraisals, transactional documents, regulatory approval, advice on tax consequences) generally must be capitalized.
          3. If abandon during this stage then the deduction claimed should be for a loss on a transaction entered into for profit §165(c)(2)
        4. Start-Up Expenditures– IRC § 195:allows taxpayers to amortize “start-up” costs over five years. If taxpayer elects not amortize start up expenditures, they are to be capitalized and treated as nondeductible expenditures. Start-up costs are definedas1) amounts incurred in investigating the creation or acquisition of an active trade or business 2) creating an active trade or business; or 3) activities engaged in for profit, before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. (Anything that would be deductible in a trade or business.)
          1. If the business is completely disposed of prior to the completion of the amortization period, any start-up expenditures not previously deducted may be deducted to the extent provided in §165
          2. Examples of expenses that cannot be amortized and must be capitalized:
            1. Appraisal of a target company or its business or assets
            2. Analysis of target company’s books and records
            3. Drafting acquisition agreements
            4. Drafting documents for submission to regulatory agencies
          3. Under §§ 163 (interest), 164 (taxes), and 174 (research expenses) do not constitute start-up expenditures. As such, these expenses need not be amortized but instead may be deducted currently to the extent allowable under the respective sections.
        5. New Employment: Pre-employment expenses are rarely deductible. Look at §162 and §212
          1. Exception: Services rendered to one who was to become an employee of a third party prior to the commencement of his employment, but payment for the services is contingent on becoming employed
            1. Examples: Employment agencies (have to get hired)
              1. Hundley (Tax Court, 1967): Baseball player hires his father as his agent. Father’s fee is contingent on the player getting a professional baseball contract. Father gets a percentage only after player signs contract. Holding: Employment seeking services that are contingent upon employment that are not incurred until employment is secured are deductible.
          2. Issues:
            1. Whether a prospective employee is in a trade or business
            2. Whether new employment prevents one from continuing to be considered as carrying on one’s former trade
            3. Whether lack of employment ends a trade altogether(not usually unless prolonged length of time)
        6. Expansion Expenditures: Ordinary and necessary expenditures incurred in the expansion of an existing business are currently deductible under§162
        7. Problems:
          1. Determine the deductibility under §162 and §195 of expenses incurred in the following situations.
            1. Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation. Not Deductible (Look at §195– would be handled under the Morton Frank)
            2. The facts are the same as in (a), above, except that Tycoon, rather than having been a doctor, was a successfully developer of residential and shopping center properties.Would be deductible unless attributable to specific properties.
            3. The facts are the same as in (b), above, except that Tycoon, desiring to diversity her investments, incurs expenses in investigating the possibility of purchasing a professional sports team. Not an extension and are not§162deductions but could possibly be§195deductions.
            4. The facts are the same as in (c), above, and Tycoon purchases a sports team. However, after two years Tycoon’s fortunes turn sour and she sells the team at a loss. What happens to the deferred investigation expenses?§195would allow it be accelerated it and take it as a§195loss
          2. Law student’s Spouse completed secretarial school just prior to student entering law school. Consider whether Spouse’s employment agency fees are deductible in the following circumstances
            1. Agency is unsuccessful in finding Spouse a job. No, first job, not deductible under§162and§195is not applicable to employees and their expenses.
            2. Agency is successful in finding Spouse a job. No, still first job
            3. Same as (b), above, except the Agency’s fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse has begun working. It is the Hundley case, where the expenses are not paid until actually in the job.
            4. Same as (a) and (b), above, except that Spouse previously worked as a secretary in Old Town and seeks employment in New Town where student attends law school. Generally okay, because same job in different employment. Being an employee is a trade or business-§162would probably apply but have to look at exceptions (gap in time of employment-too long it would be a first job again)
            5. Same as (d), above, except that Agency is successful in finding Spouse a job in New Town as a bank teller(different job).It would depend on whether it is a new job/different employment. If she hired them to find her a bank teller job, then first job and no deduction. If she hired them to find her a secretary job and they found her the bank teller job then it might be deductible.
    3. Specific Business Deduction (Question: What is the employer’s deduction?)
      1. Reasonable” Salaries §162(a)(1) §162(m) 280G Reg. Section 1.162-7, -8, -9
        1. What is Reasonable?
          1. Executives salary is “reasonable” if its proportional to investor’s profitsExacto Spring Corp. v. Commissioner (7th Cir. 1999) pg. 344 (Judge Posner)The I.R.S. challenged a closey-held corporation’s CEO’s salary as so excessive as not to be deductible as “reasonable” salary. COURT: Rejected seven factor test of the tax court. Looked at the facts that the CEO was indispensable as its chief salesman and researcher, is a rare specialist, is qualified, contributed to the corporation. The IRS says that the salary reduces the shareholder’s return but disallowing the deduction would reduce it more. “Independent Investor Test”- executive’s salary is presumed reasonable if he generates correspondingly high returns for investors
            1. NOTE:Not any better than the Seven Factor Test-does not address situations out of the disguised dividend situation and therefore does not provide guidance in the entire “reasonable” field.
            2. Seven Factor Test-still law in most jurisdictions:
              1. Rendered services type and extent
              2. Scarcity of qualified employees
              3. Employee’s qualifications and prior earnings
              4. Employees contribution to the business
              5. Employer’s net earnings
              6. Comparable employee’s prevailing compensation
              7. Employer’s business peculiar characteristics
            3. NOTE: Prof. doesn’t think the independent investor test is any better or more predictable than the seven-factor test previously used. Says it does not provide general guidance for the calculation of reasonable compensation. What happens to corporations in loss positions that are nonetheless paying shareholder/employees large amounts of compensation? What it does is show how difficult it is to come up with a generic approach in these types of highly varied, fact-specific circumstances.
            4. NOTE: this test has not achieved wide acceptance outside the Seventh Circuit
          2. Not reasonable if not made pursuant to an arm’s length free bargain- Harold’s Club v. Commissioner (9th Cir. 1965)The proprietors of a gaming establishment sought to pay a fixed percentage salaries, ranging from $350,000 to $560,00 paid to the establishment’s manager, father of the proprietors, from 1952 to 1956. COURT: Smith’s salary was unreasonable, above 15% of the club’s profits, and therefore an invalid business expense for tax purposes. Compensation is ordinarily allowed as a deduction even though it may be greater than the amount ordinarily paid, if the formula that calculates what is paid was made pursuant to a “free bargain” between the employer and the individual. The Tax Court concluded that here the agreement was not the result of a free bargain, due to Smith’s position and dominance as the father of the owners of the club. Even though Smith was valuable to the business that only shows that he had unlimited dominance over his employers.Prof. points out that the formula here is likely what Posner was trying to advance in Exacto. Says the court could’ve found a free bargain here, but it doesn’t underscore theory that IRS and Treasury Regulations would allow the formula to result in “unreasonable” compensation being paid as long as that formula is the result of a free bargain
          3. Not reasonable if trying to hide dividends in the salaries or like payments.
        2. Problem: Employee is the majority shareholder (248 of 250 outstanding shares) and president of Corporation. Shortly after Corporation was incorporated, its Directors adopted a resolution establishing a contingent compensation contract for Employee. The plan provided for Corporation to pay Employee a nominal salary plus an annual bonus based on a percentage of Corporation’s net income. In the early years of the plan, payments to Employee averaged $50,000 annually. In recent years, Corporation’s profits have increased substantially and, as a consequence, Employee has received payments averaging more than $200,000 a year.
          1. What are Corporation’s possible alternative tax treatments for the payments? Suggestion that as majority shareholder makes it close to Harold (no free bargain). Not sure how much of it would be unreasonable. $50,000 would not be unreasonable since it was allowed in the past.
          2. What factors should be considered in determining the proper tax treatment for the payments? Even though the Seventh Circuit advocates the independent investor test, most jurisdictions still use the seven-factor test. See above for exact factors.
          3. The problem assumes Employee always owend 248 of the Corporation’s 250 shares. Might it be important to learn that the compensation contract was made at a time when Employee held only 10 out of the 250 outstanding shares? I think the court might take it into consideration with regard to “free bargain”
        3. Shareholder-Employees: Corporations frequently attempt to deduct as business expenses large salaries paid to executives who are also shareholders of the corporation. The IRS tries to get these salaries classified as nondeductible dividends. Salary payments which have no real relationship to the value of the services rendered are therefore not deductible as ordinary business expenses.
          1. Additional Comment – Unreasonable Compensation: A salary based on a percentage of income or profits is deductible even if unreasonable if it is found that a “free bargain” was entered into in setting the compensation amount
        4. $1 Million Ceiling: IRC §162(m) on the amount of compensation(cash or anything else) a publicly held corporation may deduct in year as renumeration for services by a covered employee (CEO, and one of the next four highest compensated officers in the corporation)
          1. Excluded: Compensation paid on commission, compensation paid solely on account of attainment of performance goals(approved by shareholders), amounts that are excluded form the recipient’s gross income (payments to IRA, health, etc.) If less than $1million, doesn’t automatically mean reasonable.
          2. NOTE:Because of exclusions this regulation doesn’t have “much teeth”
        5. Golden Parachute” PaymentsIRC § 280(G): Section restricts deductions for substantial bonuses paid to corporate executives contingent (contract formed within one year of change of ownership §280(G)(b)(2)(A)(i) )on the change in control of the company and the aggregate present value §280(G)(d)(4) of all such payments §280(G)(d)(3) must equal or exceed three times the disqualified individual’s base amount. §280(G)(b)(2)(A)(ii)
          1. NOTE:Does have potential teeth but is limited because there are certain opportunities to get out of it. He thinks these provisions are here to show that Congress will respond to perceived public policy issues.
        6. Reasons why some expenses are NOT deductible:
          1. Compensation disguised as dividend: expenses labeled as such may not really be expenses, but disguised payment such as gifts & dividends and mixed use expenses;
          2. Timing: some expenses are business related but must be capitalized & aren’t currently deductible;
          3. Public Policy: some expenses, even if business related, shouldn’t be deductible because they violate public policy (fines, penalties, bribes, kickbacks);
          4. Because Congress says so: some expenses aren’t deductible because Congress decided, for political reasons, not to make them deductible. (non-tax policy prohibition) Depart from HS
      2. Travel “Away from Home” §162(a)(2), §162(a) second to last sentence, §274(n)(1) See Sections §162(h), §274(c)(h)(m)(1) and (3) Regs. Section 1.162-2 (omit 2(c)).
        1. In General –Under §262Personal expenses (commuting to work, sleeping and eating) are not allowed as deductions except in special circumstances. Example: IRC 162(a)(2)allows the deduction of expenses for traveling, meals, and lodging while “away from home” and “in pursuit of a trade or business. Prof. says this is the polar opposite of IRC §262 that says no allowance for personal, family, or living expenses, i.e., commuting to work, sleeping, eating
          1. Deduction limited by §274: Amount, mode of transportation, etc.
          2. Deduction limited by §262: No deduction allowed for personal, living or family expenses.
        2. Policy: To offset the costs associated with maintaining a permanent residence and temporary residence while on the road.
        3. What is the scope of “Home”?
          1. Def: One’s home for tax purposes is the city in which one carries on his principal trade or business. When a taxpayer leaves the city on a business trip for a short time(overnight) he is entitled to deduct traveling expenses. But if he stays away for many months, the IRS may argue that he has shifted his tax home and that he is no longer “away from home” within the meaning of the IRC. If the taxpayer chooses to in a city other than the one where he works the deduction is not allowed either.
          2. Overnight” Rule: IRS insists that “away from home” means away overnight or long enough for sleep/rest.
          3. Without a Home: Living expenses paid by a single taxpayer who has no home and is continuously employed on the road may not be deducted in computing net income under §162Rosenspan v. US (2nd Cir., 1971) Plaintiff was a traveling jewelry salesman. Plaintiff was on the road almost all the time and did not maintain a home anywhere, although he received mail and registered for voting purposes at his brother’s home in Brooklyn. Plaintiff deducted the meal and lodging expenses incurred on his trips. HOLDING: There is nothing to indicate that the statute was meant to address the situation where a business traveler has no home. The Supreme Court says that Three Requirements of Deduction: (i) the expense must be reasonable and necessary, (ii) the expense must be incurred “while away from home and (iii) the expense must be incurred in pursuit of a business.” Plaintiff satisfies the first and third, but not the second. Cannot read the words “away from home” out of the statute. There must be some duplication of expenses in producing income in order for deduction to further the deduction policy.
          4. Multiple HomesA taxpayer can only have one home for purposes of deducting travel expense under§162(a)(2)Andrews v. Commissioner (2nd Cir. 1991) Plaintiff operated a swimming pool construction company in New England. Plaintiff also owned two race horse breeding farms and resided in Florida in the winter months, training horses and running horse operations. Plaintiff began to spend so much time in Florida that he eventually bought a condominium in Florida. In 1984, plaintiff worked in Florida for six months and worked in Massachusetts for six months.HOLDING: Taxpayer may claim as a deduction his duplicative living expenses caused by having two businesses that require him to spend a substantial amount of time in each of two widely separate places. Rationale: The purpose of this deduction is to mitigate the burden on a taxpayer who, because of the exigencies of his trade or business, must maintain two places of abode and thereby incur additional living expenses. A taxpayer’s home, for purposes of IRC § 162, is the area or vicinity of his principal place of business. The court however does not determine which home is the “tax home” but suggests looking at the length of time spent at each.
        4. Limit on Time Away from Home: “Temporary” v. “Indefinite” Rule: Taxpayer is entitled to deduct his transportation, food and lodging if a job assignment at a distant location is temporary, but not if the assignment is of indefinite duration. Generally, if a taxpayer is temporarily working away from his tax home for one year or less, it is presumed that such work is “away from home.” If the work lasts between one or two years, taxpayer must show that the work was temporary in nature. And, if the work lasts over two years, it is presumed to be indefinite and not “away from home.”
        5. Two or more locations of business:If the taxpayer is engaged in business at two or more separate locations, the “tax home” for purposes of this deduction is located at the principal place of business during the taxable year. Travel between the different locations is deductible, but meals and lodging are deductible only when the taxpayer is at a location which is not “home” (i.e. not the principal location).
        6. Commuting:§280
          1. Commuting Expenses: Generally expenses incurred in traveling between the taxpayer’s residence and his place of work are not deductible as business expenses. Example: An employee takes a cab from his home to his office. The expense is not deductible as it is a commuting expense
            1. EXCEPTIONS:
              1. Travel between business locations:costs of going between one business location and another business location generally are deductible. However, if the taxpayer carries work related materials (e.g. tools) with him, only those extra costs incurred to transport those materials (e.g. trailer rental) are deductible.
                1. .
              2. Can Deduct Transportation from “Home Office” to Place of Business §280A(c)(1)(A) Taxpayer may deduct expenses for the business use of the portion of the taxpayer’s personal residence that is exclusively used on: 1) a regular basis as the principal place of business for any trade or business of the taxpayer, or 2) as a place regularly meeting with patients, clients, or customers.
                1. Limitation on Deduction: Not in excess of the gross income of the business minus the sum of the nonbusiness deductions plus business deductions not related to the use of the property.
                2. Limitationon Employees:Only deductible if the exclusive and regular use of the portion of the residence is for the convenience of the employer.
              3. Travel from residence to location outside metro area. Taxpayer can deduct daily transportation expenses incurred in going between the taxpayer’s residence and temporary work location outside the metropolitan area where the taxpayer lives and normally works.
                1. Example: An employee flies from Chicago to New York on business. The airfare is deductible
              4. Travel from residence to a temporary work location, IF there are more than one regular work locationin the same trade or business are deductible regardless of distance.
                1. Example: An employee takes a cab from his office to the office of a client. The cab fare is deductible.
          2. Pursuit of a Trade or Business”: Expenses must have been incurred primarily in furtherance of business rather than personal objectives.
            1. Flowers: Attorney lived in Jackson, Mississippi, and got new job in Mobile, Alabama. Holding: It is the taxpayer’s personal choice to maintain his residence in a state other than his state of employment, and therefore is denied a deduction for commuting from home to work.
          3. Business and Pleasure Trips: When a trip is incurred for these dual reasons, the expenses are deductible if the primary purpose of the trip was business. However, the expenses must be allocated between business and pleasure.
            1. Problem with mixed trip/part trip part pleasure. Transportation expenses (airfare, cab-how to get from here to there). If you go two days on business and three days on holiday, then none of the airfare is deductible. If you go three days on business and two days on holiday, then 100% of the airfare is deductible. Have to decide what the primary purpose of the trip is. All or nothing regulation.
          4. Commuting Hypothetical:
            1. Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch in various restaurants in City.
              1. May Commuter deduct his costs of transportation and/or meals? NO
              2. Same as previous, but Commuter is an attorney and often must travel between his office and the City Court House to file papers, try cases, etc. May Commuter deduct all or any of his costs of transportation and meals? YES for transportation, NO for meals (unless conducting business over meals)
              3. Commuter resides and works in City, but occasionally must fly to Other City on business for his employer. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or a part of his costs? YES, Transportation, NO for Meal because it is§162personal meal (even if traveling away from home in accordance with §162(a)(2)still under the “Overnight Rule” to qualify for deduction.) Would be allowed if had clients. Because he left town in morning and returned in the early evening, was not away long enough to require sleep or rest no deduction for meals
            2. Taxpayer lives with her husband and children in city and works there.
              1. If her employer sends her to Metro on business for two days and one night each week and if Taxpayer is not reimbursed for her expenses, what may she deduct? See §274(n)(1) Transportation is allowable, lodging is appropriate for business time and is allowable. Meals allowed because she is required to stay over. BUT, IRC §270(n) limits her to 50% on meals.
              2. Same as (i), above, except that she works three days and spends two nights each week in Metro and maintains an apartment there. Spending more of her time in Metro and under Andrews have to determine which one is the “tax home”. Since most of contacts are in City that would probably be qualified as her “tax home” and Metro would be qualified for the deductions. Still under argument about which “tax home”
              3. Taxpayer and Husband own a home in City and Husband works there. Taxpayer works in metro, maintaining an apartment there, and travels to City each weekend to visit her husband and family. What may she deduct? NOTHING
            3. Burly is a professional football player for the City Stompers. He and his wife own a home in Metro where they reside during the 7 month “off season.”
              1. If Burly’s only source of income is his salary from the Stomper, may Burly deduct any of his City living expenses which he incurs during the football season? NO. He chose to live in a city other than where his work was located. (Look at Flowers case)
              2. Would there be any difference in result in (i) above, if during the 7-month “off season” Burly worked as an insurance salesman in Metro? POSSIBLY, (Look at Andrews case)-Use a multi factor test: where does he spend most of his time? What are the relative amounts of income for the different sites? What are the contacts with the different locations? (don’t forget the 50% deduction on meals)
            4. Temporary works for Employer in City were Temporary and his family live.
              1. Employer has trouble in Branch City office in another state. She asks Temporary to supervise the Branch city office for nine months. Temporary’s family stays in City and he rents an apartment in Branch City. Are Temporary’s expenses in Branch City deductible? Yes, all transportation and lodging and 50% of meals.
              2. What result in (i), above, if the time period is expected to be nine months, but after eight months it is extended to fifteen months? See Rev. Rul 93-86, 1993-2 C.B. 71 No longer temporary because over the one year mark. (However, can salvage the deductions if it was projected as temporary for 8 months and then after the 8 months it was no longer going to be temporary and no longer available for deductions.)
              3. What result in (i), above, if Temporary and his family had lived in a furnished apartment in City and he and family gave the apartment up and moved to Branch City where they lived in a furnished apartment for the nine months? Depends.No duplication of deductions (against the policy of allowing deductions), if believe it depends on the duplication then NO, not allowed for deductions. However, if you only require being away from original location then duplication is irrelevant and deduction would be allowed.
            5. Traveler flies from her personal and tax home in New York to a business meeting in Florida on Monday. The meeting ends late Wednesday and she flies home on Friday afternoon after two days in the sunshine.
              1. To what extent are Traveler’s transportation, meals and lodging deductible? Reg. §1.162-2(a) and (b) Lodging (100% deductible days related to business, 0% deductible days not related to business) Meals: 50% of meals related to business Transportation: Have to look at purpose: Mixed purpose, have to look at days (in this case more business than fun) so can deduct 100%.
              2. May Traveler deduct any of her spouse’s expenses if he joins her on the trip. See §274(m)(3) No, not unless employee and can deduct on their own terms.
              3. What result in (i) above, if Traveler stays in Florida until Sunday afternoon? Larger proportion of the trip for pleasure therefore 0% deduction on transportation. Lodging and Meals stay the same.
              4. What result in (i), above if Traveler takes a cruise ship leaving Florida on Wednesday night and arriving in New York on Friday? See §274(m)(1). No extra days involved in trip, so still primarily business, but look to see about luxury water travel and there is a $ limitation (Twice the government per diem) (pg. 257-TC)
              5. What result in (i), above, if Traveler’s trip is to Mexico City rather than Florida? See §274(c) Within the one week allowable time period to be the exception to the non allowable deductions and therefore the deductions would be allowable. (if more than one week look at the next paragraph for deduction if business is more than 75% of the trip)
              6. What result in (v) above, if Traveler went to Mexico City on Thursday and conducted business on Thursday, Friday, Monday and Tuesday, and returned to New York on the succeeding Friday night? See §1.274-4(d)(2)(v) If conducting business and need layover time (days between meetings) then allowed as business days. Therefore 6 days are business days so 2/3 of transportation is allowed.(Going between 25%-50% of primary business where a portion is going to be lost)
              7. What result in (v) above if Traveler’s trip to Mexico City is to attend a business convention? See §274(h). Treat like US trip if can meet the requirements of the section.
    4. Miscellaneous Business Deductions§162(a), §274(a)(d)(e)(k)(l)(n) Reg. 1.162-20(a)(2); 1.274-2(a)(1), (c), (d)
      1. Introduction: All ordinary and necessary business expenses are deductible whether specifically mentioned in the statute or not. These expenses when combined with other miscellaneous itemized deductions become deductible only if they exceed 2% of the taxpayer’s adjusted gross income. Not deductible if in your “area”. Start with the idea that some of these can be directly business expenses and are eligble. Some can become eligible if away from home. Look at circumstances of the act. Prior to 1962, the Cohan rule that the IRS should make an approximation to the best of its ability when a taxpayer claims business expenses but cannot prove those expenses was often applied. Congress enacted §274 in 1962 in an attempt to stifle deductions in the absence of proof.With respect to substantiation of deductions not within the scope of §274, the Cohan rule still applies (pg. 390-391)
        1. Entertainment in General §274(a)(1)No deduction is allowedfor any item with respect to an activity that constitutes amusement, entertainment or recreation unless§274(A)allows the deduction if the taxpayer establishes that the item was directly related to the conduct of the taxpayer’s trade or business. Also, if the item immediately precedes or follows a substantial business discussion, it is sufficient if it is “associated with” the business or the taxpayer (SCREEN BEFORE GETTING TO FURTHER REDUCTIONS)
          1. Business Meals and Entertainment: §274(n)The deductions for business meals and entertainment (and the cost of the facilities) are limited to 50% of such expenses. In addition, the meal and entertainment must be directly related to the conduct of the taxpayer’s active trade or business.
            1. In order to deduct 50% of the cost of a meal, the taxpayer or his employee must be present at the meal (k)(1)(B) and the meal must not be lavish(k)(1)(A)
            2. Spouses: Can deduct spouse’s expenses if they are closely connected to the business activity.
          2. Facilities: No deduction is allowed for the cost of entertainment facilities §274(a)(1)(B) (e.g. yachts, hunting lodges, or social, athletic, or sporting clubs). Likewise, dues paid to any clubs organized for business, pleasure, recreation or other social purposes cannot be deducted.Nevertheless entertainment activities related to the use of such facilities remain 50 percent deductible if the rules for deduction of entertainment activity expenditures are satisfied.
            1. Example: A taxpayer takes a client skiing, staying several nights in taxpayer’s ski home. 50 percent of expenses for lift tickets, ski rentals, and meals are likely deductible as an entertainment activity. However the costs related to the home even if used exclusively for business entertainment are disallowed under §274(a)(1)(B).
          3. Entertainment Tickets: §IRC §274(l)(1)(A) & (n)(1):Generally the deductible costs of certain entertainment events are limited to 50 percent of the face amount of the ticket
            1. Exception:§274(l)1)(B)Charitable sports eventsIF, 1) organized for the primary purpose of benefiting an organization §501(c)(3) and tax exempt §501(a) 2) all net proceeds go to organization 3) uses mostly volunteer workers for the event
          4. Business Gifts:§274(b)
          5. IMPORTANT: Recordkeeping:§274(d): Section requires that the taxpayer keep adequate records or corroborative evidence supporting his entertainment expense claims
        2. Summer Homes – IRC § 280A: Section allows limited deductions for homes that are rented out part-time. If a dwelling is used as a personal home for over 14 days or 10% of the days it was rented, it is subject to this section, and expenses must be prorated between rental time and personal time (which is not deductible).
        3. Uniforms: Expenses of acquiring and maintaining uniforms used for work are deductible as ordinary and necessary business expenses if (i) the uniform is specifically required as a condition of employment, and (ii) the uniform is not adaptable to continued usage in the place of regular clothing.
        4. Advertising: Generally, advertising expenses of a business are deductible in the year incurred even though the effect may last for several years.
          1. Signs: A billboard or sign which will last several years is a capital asset and must be depreciated over several years.
          2. Lobbying Expenses: No direct or indirect political contributions can be deducted except by individuals.
        5. Dues: Dues paid to organizations related to one’s business, such as bar association dues or union dues, are deductible.
        6. Child-Care Expenses: A taxpayer can claim a credit for up to 30% of the costs caring for a dependent under age 15 and the costs of household services, if the costs are incurred so that the taxpayer can be employed. The credit cannot exceed $2,400 for one individual and $4,800 for two or more individuals. Also, the expense cannot exceed the earned income of the lower earning spouse (unless a student).
        7. Expenses for Tax Advice – IRC §212(3): Section allows a deduction for expenses in determining, collecting or refunding taxes. This covers return preparation, tax litigation and tax planning services.
        8. Business Deductions Hypotheticals:
          1. Employee spends $100 taking three business clients to lunch at a local restaurant to discuss a particular business matter. The $100 cost includes $5 in tax and $15 for a trip. They each have two martinis before lunch.
            1. To what extent are Employee’s expenses deductible? Look at §162, then to §274(a) need the meal to be directly related to business or specific business being done or associated with business being done. In this case going to pass the directly related to business test. Next, §274(k)-lavish or extravagant? Probably not, Next, §274(n) cutback, so the $100 including tax and tip gets cut to $50. §274(d) is there substantiation (get a receipt)-look at regulations for allowable recordkeeping. At the end $50 deduction
            2. To what extent are the meals deductible if the lunch is merely to touch base with the clients? No deduction allowed. Not directly related
            3. What result if employee merely sends the three clients to lunch without going herself but picks up their $75 tab? Fail §274(k) requirement that the employer attend.
            4. What result if in addition employee incurs a $15 cab fare to transport the clients to lunch? Allowed
            5. What result if employer reimburses employee for the $100 tab? Employee is allowed to deduct the $50 but is receiving the $100 back. The ultimate taxpayer the employer will be subject to §274(e)(4), (k)(2), (n)(2) where the employee is under a reimbursement program, not going to apply limitations to employee but to the employer so the employee will have zero net effect, while the employer will incur the $100 cost and get the $50 deduction.
        9. Broadway Tickets Hypothetical: Businessperson who is in New York on business meets with two clients and afterward takes them to a Broadway production of The Producers. To what extent is the $600 cost of their tickets deductible if the marked price on the tickets is $100 each, but businessperson buys them from the hotel concierge for $200 each? §274(l) Only allows for face value $300 and then 50% of that so total allowed for deduction $150. (Note, what about service fees? Not deductible since not the “face value”)
        10. Airline Pilot Hypothetical: Airline Pilot incurs the following expenses in the current year:
          1. $250 for the cost of a new uniform. Deductible. “Special purpose clothing”
            1. Example:modeling-high cost clothes-would not wear outside the workplace, therefore allowed as deduction.
          2. $30 for dry cleaning the uniform. Deductible.-Maintenance
          3. $100 in newspaper ads to acquire a new job as a property manager in his spare time. NotDeductible.-Change in job field.
          4. $200 in union dues. Deductible. §162(e)(3)Even if discretionary-look to see if helpful
          5. $50 in political contributions to his local legislator who he hopes will push legislation beneficial to airline pilots. NotDeductible. §162(e) limit on political lobbying
          6. $500 in fees to a local gym to keep in physical shape for flying. NotDeductible. Too remote from the actual requirements of the job.
          7. What is the total of Pilot’s deductible §162 expenses? $480
    5. NON-Deductible Business Expenses
      1. Lobbying Expenses: §162(e) No deduction is allowed for amounts paid or incurred in connection with: influencing legislation; participation in or opposition to the political campaign for any candidate for public office; attempts to influence the general public with respect to elections, legislative matters, or referendums; or direct communications with a covered executive branch official in an attempt to influence such official.
        1. Limits: Not applicable to business related costs incurred in: influencing legislation at the local level; in-house lobbying expenses if such expenses do not exceed $2K in an year, and lobbying expenses incurred by professional lobbyists directed on behalf of another person.
      2. Illegal bribes and kickbacks. IRC §162(c)
      3. Fine and penalties paid to the government. IRC §162(f)
      4. Two-thirds of treble damage payments in criminal anti-trust proceeding. IRC §162(g)
      5. Any business expenses incurred by illegal drug dealers. IRC §280E
    6. Business Losses -§165 Reg. §1.165-1, 1.165-7, 1.165-8
      1. General Info: If a transaction or event produces a “loss” §1.165-1, the threshold question whether the loss may deductible must always be answered on the basis of §165. Losses of property used in a business or profit-seeking activity are deductible whether or not they are due to casualty or theft §165(c)(1)-(2)
        1. §165(c)(1), §280(B)Section permits an individual to deduct any loss “incurred in a trade or business.”-Gives Authorization (parallel §162)-liberal
        2. §165(c)(2): losses incurred in any transaction entered into for profit, though not connected with a trade or business(parallel §212)-liberal
      2. Realization Requirement: The loss must be realized (i.e. evidenced by a closed and completed transaction, or fixed by an identifiable event). Mere decline in the value of property is not enough. However, not every closed transaction that results in financial disadvantage qualifies as a loss.
        1. Example: Deduction is allowed for loss sustained on demolition of building used in trade or business or held for rent production. However, if the building was purchased with demolition in mind, the cost of the building would be treated as part of the land cost, and no loss would be allowed and amounts described above shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located§280B
      3. Amount of Deduction: The amount of loss deductible is the difference between the value of the property immediately preceding the loss and the value of the property immediately afterwards. §1.165-7(a)(2)(i) and (b)(1) The difference in value claimed as a loss cannot exceed the adjusted basis of the property §165(7) and is reduced by any insurance or other compensation received as a result of the loss.
        1. Example: You owned a duplex used as rental property that cost you $40,000, of which $35,000 was allocated to the building and $5,000 to the land. You added an improvement to the duplex that cost $10,000. In February last year, the duplex was damaged by fire. Up to that time, you had been allowed depreciation of $23,000. You sold some salvaged material for $1,300 and collected $19,700 from your insurance company. You deducted a casualty loss of $1,000 on your income tax return for last year. You spent $19,000 of the insurance proceeds for restoration of the duplex, which was completed this year. You must use the duplex’s adjusted basis after the restoration to determine depreciation for the rest of the property’s recovery period. Figure the adjusted basis of the duplex as follows:
Original cost of duplex $35,000
Addition to duplex 10,000
Total cost of duplex $45,000
Minus: Depreciation 23,000
Adjusted basis before casualty $22,000
Minus: Insurance proceeds $19,700
Deducted casualty loss 1,000
Salvage proceeds 1,300 22,000
Adjusted basis after casualty $-0-
Add: Cost of restoring duplex 19,000
Adjusted basis after restoration $19,000
NOTE: Land still has original basis of $5K.

 

      1. Example: D buys a Chris Craft which he operates for hire at a resort, but the boat, which is not insured is demolished in a storm. His loss is a casualty loss:
        1. Total Destruction(pg. 398) §165(b)Boat is destroyed AB=$6K FMV Pre- $10K FMV Post-$0 Amount of Loss $10K however cannot exceed the adjusted basis and therefore only $6K is allowed(which ever is less between the AB or the Amt of Loss) Function of a loss deduction is when an event has happened and will allow to recover the tax cost which will make the tax account whole. Can’t deal with negative basis in tax. If abandoned then would be the difference of the AB and the amount realized ($6K).
        2. Partial Destruction: Reg §1.165-7(b)(1)Boat damaged: FMV before $10K and after storm $7K limited by AB$6K in the property. Still going to use lesser of two figures. Difference would be that there is a difference of $3k which is the lesser of the two. When it is not totally destroyed have to recognize that the AB has to be different therefore, $6K-$3K(amount deducted by loss and recovered partial basis) and therefore the AB will now be $3K to carry forward.
        3. Insurance: To the extent that the loss is compensated by insurance D’s deductible loss is reduced, if the insurance recovery exceeds D’s AB in the boat he has a casualty gain§1001(a)
      2. Example: AB $6K and totally destroyed when FMV of $4K and no insurance. $4K loss in economic terms or $6K basis-usually the lesser value is taken but under the rule in the reg when there is total destruction and the FMV is less then the reg allows the $6K deduction. Rationale: Economic loss is $4K in economic value but the asset is totally destroyed and if don’t give full basis deduction there will be no other opportunity to recover the $6K basis. Otherwise would have a AB of $2K and no asset…how silly. If receive $4K in insurance then the $6K loss would be offset by how much insurance was received so actual loss would be $2K. Now AB $6K with a loss deduction of $2K on the tax return and received $4K and returns to you $4K of the $6K basis and have received the total amount.
      3. Problem: Taxpayer has an automobile used exclusively in his business that was purchased for $40K and, as a result of depreciation deductions (§1016), has an adjusted basis of $22K. When the automobile was worth $30K, it was totally destroyed in an accident and TP received $15K of insurance proceeds.
        1. What is TP’s deductible loss under §165? FORMULA:Determine your adjusted basis in the property before the casualty or theft and determine the decrease in fair market value (FMV) of the property as a result of the casualty or theft. From the smaller of the amounts determined above, subtract any insurance or other reimbursement received or expected to be received. Therefore Economic loss $30K AB=$22K Loss=lesser of the two $22K reduced by the insurance $15K with a loss deduction of $7K
        2. What result above if the automobile had not been totally destroyed but was worth $10K after the accident? FMV pre $30K FMV(post) $10K the economic loss is $20K and the AB is $22K. going to take the $20K which is less and then take away the insurance $15K so with a loss of $5K $10K – $15K = ($5K) Gain – may be deferred until later time §1001(a)
        3. What is TP’s adjusted basis in the automobile in b if TP incurs $17K repairing the automobile? $7K + $17K = $24K
  1. The Carryover and Carryback Devices §172
    1. Net operating losses: Under a §172(a) and (b)(1), a net operating loss suffered in any year can be carried back to the previous two taxable years. Enables the tax payer to file an amended return for the prior year reducing its income for that year by the loss carryback which produces a refund. Can apply to individuals as well as corporations, although salaried employees cannot have an operating loss and the interaction of the net operating loss rules with the regime of personal deductions can be quite complex.
      1. A NOL is generated when a corporation’s allowable deductions for a tax year exceed its gross income.
      2. When an NOL is carried over, it is referred to as a net operating loss deduction (NOLD) in the year it is used.
      3. A corporation must first carryback an NOL 2 years, starting with the earliest of the 2 years. If the NOL exceeds taxable income for the carryback years, the excess is carried forward for 20 years (or less if it is used up before the end of 20 years).
      4. A corporation may elect to forego the carryback period and instead, only carry the NOL forward for 20 years. The election must be made on a timely–filed tax return, including extension, for the year the NOL was created
      5. Example: If produce $20,000 of revenue and in connection with that activity, incur $14,000 in wages, $5,000 in utilities, $8,000 in depreciation on equipment $3,000 of interest, $2000 for travel and entertainment.= $32000 totally allowable deductions. Allocate that to the business and we have produced a situation where there is $12,000 allowable deduction in excess of income. What are the consequences of this situation? If can’t use the deductions this year than can take it back 2 years and forward 20 years. Under §172 Take it back to the earliest of the years, if it can be used, use as much as can be used and then keep going until the 20 years runs out. Can recalculate with the carry back and get a refund from the previous year, which gives you money to offset the cash that you lost because the recent operations and still have enough to bring to the next previous year. Depending on projected financing might decide to carry forward as it would be more valuable. Have to do it sequentially. Have to keep an amount in suspension and keep account of it as each year goes by. Departing from the pure accounting formula. Very valuable deduction.

 

————————————————-DEPRECIATION———————————————————————

  1. Depreciation IRC §§167(a), (c); 168(a), (b), (c), (e)(1) and (2), (f)(1) and (5), (g)(1), (2), and (7), (i)(1); 1016(a)(2). See §§62(a)(1) and (4); 168(d); 263(a); 263A. Regulations §§1.162-4; 1.167(a)-1(a), -10; 1.167(b)-0(a), -1(a), -2(a)
    1. Depreciation: is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time. In the tax sense, depreciation is the deduction available during the current tax year for that portion of the cost of a capital asset chargeable to that tax year in accordance with a schedule giving effect to the estimate useful life of that asset.
      1. To Determine: Need the useful life of the asset, the salvage value of the asset, and the method for allocating the cost of the asset (less the salvage value of the asset) over its useful life.
    2. Introduction: For federal income tax purposes IRC §§ 167 and 168 treat depreciation as if it were an operating expense by allowing an annual deduction for exhaustion and wear and tear (including predictable obsolescence) of property.
      1. Only expenses can be deducted, not a capital investment. Since we cannot take cognizance of a capital investment, we take a stream of deductions for that investment and treat this series of deductions as an operating expense.
        1. Limits:IRC§ 167(a) §168(a)authorizes a deduction by permitting a depreciation deduction a “reasonable allowance for the exhaustion, wear and tear” of assets(i) used in a trade or business or (ii) held for the production of income. (Only property that will be consumed, or will wear out, or will become obsolete, or will otherwise become useless to the taxpayer can qualify for the deduction. Also, intangible assets (e.g. copyright) may be depreciated unless their useful life is indefinite)Exception: Not applicable to inventory or property held for sale to customers.
      2. Rules:
        1. §167: Depreciation intangible assets
        2. §168: Depreciation ontangible business or investment property
      3. Problem: T buys machine for $8K so it is AB. For eight years T purchases each year $12K worth of supplies. Each year he makes 200 pairs of shoes and sells them for $100 a piece. There is a cost revenue of $20K with deduction of $12 and a profit figure of $8K. Therefore after 8 years he THINKS he has made $64K At the end of the 8th year going to get rid of the machine. Therefore we are going to get an AR –AB. Let’s say going to get nothing for it so the result would be AR 0-AB$8K and would be able to have a zero at the end ($8K profit -$8K loss). Not right so…….going to take the $8K of the machine and spread it over the 8 years so it can be realized each year. Totally artificial, and doesn’t cost a thing, no cash outlay for depreciation. How did you buy the machine? $800cash and $7200 bank(look at crane case). No reference on how we get it (could be gift, inheritance, etc.) so “Cost” =AB. Salvage value conceptually is the “estimated” view at the present time of the junk value of the machine at the time you wish to sell it down the road(subject to audit) Look at authorization to allow the deduction §167. Going to distinguish in terms of “USE”. Land or inventory is not allowed to be depreciated. He doesn’t care about salvage value because it is always treated as $0 in §168. Two additional variables that you are working with are the Useful life/time period and method/conventions. Will have situation where you are going to use something for 10yrs and the useful life only says 7yrs and the method allows to take larger deductions in the beginning years and smaller deductions in the later years, provides incentive to buy another one sooner.
    3. Non-Accelerated Cost Recovery System (ACRS) Computation: Depreciation is computed by taking the cost of the asset (less salvage value) and allocating it over the useful life of the asset by an accepted depreciation method. Purpose: To recover basis in assets before the disposition of the asset. Can do depreciation write offs while the property value goes up. Purely a cost recovery mechanism
      1. Useful Life: The asset depreciation range (ADR) system, under IRC §168 (c), (e)(1), is a list of broad classes of assets with estimated useful lives, published by the IRS. A taxpayer may elect a useful life within 20% of these guidelines, and the IRS will not challenge it. If the taxpayer chooses a useful life outside this range, she has the burden of showing the reasonableness of her estimation..
        1. Land: Land is not depreciable since it has an unlimited useful life. Therefore, when a taxpayer purchases land and buildings he must allocate the purchase price between the buildings (which may be depreciated) and the land.
    4. Methods: Any “reasonable” method for allocating the cost of the wasting asset over its useful life is acceptable, but may not result in a faster write-off than that allowed by the “double-declining balance method.” IRC § 167 outlines the numerous limitations and rules with respect to depreciation methods, with particular attention given to the rules governing the different declining-balance methods. The most common depreciation methods are discussed below.
      1. Straight-Line Method: To compute yearly depreciation, the cost of the property, less salvage value, is divided by the useful life of the property. Suppose that a taxpayer purchases a machine for $10,500 that has a useful life of five years and a salvage value of $500. Each year she could claim depreciation of $2,000 [ ($10,500 – $500)/5 ]. There exists a point at which the straight-line method becomes more desirable than an accelerated method. Taxpayer can change to that method at that time. Congress Intent: encourages investment in capital equipment and the economy benefits.
        1. Must be used for nonresidential real property and residential rental property i.e. apartment buildings
      2. Declining-Balance Method: Each year’s depreciation is computed by subtracting from the property’s basis the amount already written off, and applying a constant rate to the remaining basis. The rate should not be more than twice the rate used in the straight-line method above, and the salvage value is not deducted, but is equal to what remains at the end of the useful life. For example, if a taxpayer purchases a machine for $10,500 with a useful life of five years, she would compute depreciation under the double-declining balance method (200% the straight-line rate) as follows:

Year Rate Year’s Depreciation Remaining Basis

$10,500

1 200% $4,200 $6,300

2 200% $2,520 $3,780

3 200% $1,512 $2,268

4 200% $907 $1,361

5 remainder $544 $817

(salvage)

    1. Relationship of Depreciation to Basis:Under IRC §1016(a)(2), when a taxpayer claims depreciation on property, the basis must also be reduced by that amount. However, since depreciation is viewed as a continuing expense each year, basis is reduced even if the taxpayer claims no depreciation deduction. Thus the cost or other basis for depreciable property may be likened to a limited supply of deductions from which the taxpayer may draw in accordance with various methods until the supply is used up. If the supply is to be tapped over a period of several years, there must be a device for keeping track of the supply. Basis is the device, although of course it serves other purposes as well. As deductions are claimed, downward basis adjustments effect a shrinkage of the supply, and “adjusted” basis reflects the remaining amount that can be claimed as deductions.
      1. Determined in accordance with the method that has been adopted by the taxpayer.(If no claimed than the straight line method will apply §1016(a)(2)
    2. Accelerated Cost Recovery System (ACRS): §168 Old ACRS rules in IRC § 168 apply to all tangible depreciable property used in a trade or business or held for the production of income and placed in service after 1980 and before 1987. Current ACRS (MACRS) rules apply to assets placed on service after 1986.
      1. Shorter Lives for Personal Property: Instead of a system that is based on complicated guideline lives, the old ACRS provided for shorter lives for assets placed in service after 1986. The current lives are typically older. ACRS provides an option for taxpayers who wish to depreciate assets over a slower method and/or over a longer life.
      2. General Info: It is mandatory, applicable to most tangible depreciable property.§168(a). Otherwise use §167
        1. ACRS accelerates the taxpayer’s depreciation deductions in three ways: §168(b)(c)(e).
          1. It uses recovery periods that are substantially shorter than the actual useful lives of the property.
          2. It allows the use of accelerated depreciation methods.
          3. It assumes that the salvage value of the property is zero, permitting deductions of the entire cost of the property.  §168(b)(4))
        2. Deductions are determined by:
          1. Applicable Depreciation Method
          2. Applicable Recovery Period §168(c), (e)
          3. Applicable Convention §168(d)
      3. Limitation: Intangible property and property depreciated under a unit-of-production method . Under both the old and current ACRS, limits are placed on the deductions for cars and home computers used for business. Unless the business use of any car or home computer is more than 50% of its total use, only straight-line (not ACRS) depreciation can be used. Variables to be tinkered with: Decreased salvage values ($0) so you don’t have to take into account the salvage value, encourages front loading, also shorten the useful life. Writing off more of it in the earlier years and none in the later years, Choice of methods
      4. Current ACRS Classes of Property: §168(c),(e) There are now six different classes of property under the ACRS. Each of these classes reference old ADR lives and include the following personal property: Three-year (i.e. special tools and racehorses), five-year (i.e. automobiles, computers, copiers, semiconductor manufacturing equipment, typewriters), seven-year (office furniture, fixtures and equipment, agricultural single purpose buildings), ten-year (petroleum refining assets), fifteen-year (sewage treatment and telephone distribution plants) and twenty-year (i.e. municipal sewers). A taxpayer can elect to use longer lives for the assets.
        1. Current Methods Applied:
          1. 200% Declining Balance: Method prescribed for three-year, five-year, seven-year and ten-year personal property, switching to the straight line method for the year when that method yields a greater depreciation allowance.
          2. 150% Declining Balance: Method prescribed for fifteen-year and twenty-year personal property, switching to the straight line method for the year when that method yields a greater depreciation allowance.
          3. Straight Line Method: Can elect to use the straight-line method to postpone deductions. In addition, a half-year convention is used for the year the property is placed in service or sold. Accordingly, only a half-year’s deduction is allowed in the year that property is purchased or sold. Used for Residential rental property and nonresidential real property
          4. Real Property: The recovery period for real estate is 27.5 years for residential property and 39 years for other property. (NOTE: Residential rental and non residential real use the straight line method)
          5. Recapture: Present IRC § 1250, applicable to buildings, allows recapture of only the difference between accelerated and straight-line depreciation as ordinary income. ACRS leaves this unchanged for residential real property and for nonresidential real property if straight-line depreciation was used. However, if requires the entire amount of prior depreciation to be recaptured as ordinary income if accelerated depreciation was used for nonresidential real property
        2. Excluded:
          1. Land: Land is not depreciable since it has an unlimited useful life. Therefore, when a taxpayer purchases land and buildings he must allocate the purchase price between the buildings (which may be depreciated) and the land.
          2. Leaseholds: The person who suffers due to a decrease in the value of property is entitled to claim the depreciation. This is generally the lessor, but there are exceptions, as when a lessee constructs a building on leased land (then the lessee may claim depreciation). For example, if a lessee is required to maintain property and return it to the lessor at the same value, the lessee would be entitled to deduct depreciation.
        3. Conventions: §168(d)The ACRS system also adopts certain “conventions,” administrative rules of convenience that, for depreciation purposes, treats property as having been placed in service using the date on which the property is placed in service rather than the date on which it is acquired to determine when the depreciation deductions begin.
          1. If the asset is not “real property” a half year convention applies so the asset is deemed to have been placed in service on the date this halfway through the year §168(d)(1) and (4)(A)
        4. Anti-churning Rules: §168(f)(5) Current ACRS also provides a series of anti-churning rules that are designed to prevent taxpayers from bringing within current ACRS rules property they or “related persons” used before the current ACRS rules applied.
          1. For purposes of this rule, “related persons” include family members of the taxpayer and entities such as corporations, partnerships and trusts in which the taxpayer has an interest.
          2. Apply IF and ONLY IF, the current ACRS rules allow the taxpayer a more rapid write-off in the first year the property is placed in service than depreciation allowed for that year by the rules under which the property was being depreciated by the related person.
            1. Example: If in the current year a taxpayer acquires property from a “related person” who owned or used the property and who acquired it after 1980 but prior to 1987, (so that old ACRS applied), the taxpayer cannot use current ACRS but must use old ACRS if in the first year of use current ACRS would allow a more generous depreciation rather than old ACRS.
        5. Expensing: IRC §179allows taxpayers to expense up to $25,000 per year of the cost of personal property. In addition, the $25,000 limitation is reduced dollar for dollar for the cost of IRC §179 property placed in service during the tax year in excess of $200,000.
    3. Depletion – IRC § 179: Section allows owners of a wasting asset (e.g. oil, gas, minerals, gravel, timber) to deduct a reasonable allowance for its use or exploitation. A “wasting asset” is any deposit that is consumed by use or exploitation. There are two methods of deducting depletion.
      1. Cost Method: The cost of the wasting asset is divided by the estimated number of units recoverable, to obtain a cost per unit. This figure is the deduction that may be claimed for each unit that is extracted. For example, if the total cost of drilling an oil well was $30 million and it is estimated that five million barrels of oil will be recovered from the well, the owner could claim $6 depletion for each barrel of oil that is ultimately recovered
      2. Percentage Method: §613A fixed percentage of gross income may be deducted. Congress sets the percentage figure, which ranges from 5% (for gravel deposits) to 22% (for gas and oil). This method has the advantage of continued life, in contrast with cost depletion, which runs out when the cost of the asset is fully recovered.
        1. Limitations: Note that in no circumstances may this deduction exceed 50% of the net income. The large oil companies are now precluded from using the percentage depletion. Only the independents with no retail outlets or independents producing up to 1,000 barrels per day may use percentage depletion.
      3. Intangible Drilling Costs: §613A(b) The taxpayer has the option of either deducting intangible drilling costs or capitalizing them and then claiming depletion on their costs. The most advantageous method would be to deduct the costs and then use the percentage depletion method, which is a percentage of gross income, not of cost.

 

————————————–RESTRICTIONS ON DEDUCTIONS————————————————

  1. Restrictions on Deductions §183, §274, §280A, §465, §469
    1. Introduction
      1. That which Congress giveth, Congress may also take away.
        1. In general, the “give” provisions are IRC §§ 161 through 198, which prescribe deductions for individuals and corporations, and in IRC §§ 211 through 222, authorizing additional deductions for individuals.
        2. Most of the “take” provisions are in IRC §§ 261 through 280H, specifying nondeductible items and carving out some no-nos in the affirmative rules.
          1. IRC §274 is a broad disallowance provision that constitutes an important instance of congressional finger crossing. IRC §274 strongly assets itself with respect to the §162 deductions, imposing numerous limitations on various ordinary and necessary business expenses. In general, it is a congressional attempt to call a halt to businesspersons living too high on the hog at government expense.
      2. Many of the statutory restrictions are aimed at tax shelters.
        1. Tax Shelter: Tax shelter is a situation in which the taxpayer generates deductions in excess of income from one activity and uses that excess to reduce income from another unrelated activity. However, some deductions are not allowed to spill over into other activities.
          1. Example: A successful investor who has high-bracket income generated by services, or by dividends or interest on investments, may become a gentleman farmer in an enjoyable rural area. In the absence of statutory limitations, if the farm activity generates deductions in excess of income, the taxpayer can use excess deductions from the farm to reduce taxable income (and correspondingly the tax on the income) from other sources.
        2. Congress has attacked shelters in two fashions: substantively, by limiting deductions and, procedurally, with special penalties and registration requirements.
          1. The substantive provisions are of two difference types:
            1. Disallowance: Congress limits the use of artificial losses by disallowing or partially disallowing the deductions from an activity.
            2. Postponement: Congress can also limit the current deduction of losses or the assertion of credits by postponing them, or disallowing their utilization in the current year but permitting them to be carried over to be used in future years.
          2. The procedural assault is one in which Congress penalizes one who promotes or participates in the promotion of tax shelters by making false or fraudulent representations concerning the tax benefits from the shelter or gross overvaluation of involved assets.§6700(a)(2)(A)
      3. Question Approach:
        1. Look first to §183, then go to §465, can’t get the deduction in excess of your amount of risk, then go to §469 and then §172
    2. Deductions Limited to Amount at Risk §465(a),(b),(d),(e)(1) (#2 Hurdle)
      1. Amount at Risk §465
        1. At Risk” LimitationIRC §465(a): Section limits the current deduction of operating losses from certain investments to the amount which the taxpayer has “at risk” in the investment. Provision applies only to individuals and closely held C corporations (50% or more of the stock is owned by no more than five people). Need to have the possibility of losing $.
        2. Definition of “at Risk”: The term means the amount of the taxpayer’s investment in the property, but not counting purchase-money loans for which the taxpayer has no personal liability.
        3. Activities Covered – IRC §465(c)(3): Section provides that the “at risk rules” apply to “each activity engaged in by the taxpayer in carrying on a trade or business or for the production of income.” Beginning in 1987, taxpayers are no longer at risk with respect to real estate if they obtain non-recourse financing from someone other than a third-party financial institution. Deductions are allowed when the lenders are qualified (i.e. government lending).
          1. Qualified Non-Recourse Financing is treated as an amount at risk under §465(b)(6) if it meets the following criteria:
            1. Borrowing with respect to the activity of holding of real estate
            2. Borrowing satisfies
              1. Qualified person
                1. IRC § 49(a(1)(d)(iv) – A person who is engaged in the business of lending who is not:
                2. A related person,
                  1. If related à commercially reasonable and substantial terms as unrelated person
                3. The seller of the property, or
                4. Receives a fee
              2. From the Government
              3. No person is personally liable
              4. Not a convertible debt
        4. Definition of Operating Loss: “Losses” are the excess of deductions from the activity over income from the activity during the year.
        5. Recapture Rule: Where there is a negative amount at risk, then a taxpayer is required to recapture the negative amount as gross income in the current year under IRC §465(e)
          1. Where the T/P takes negative amount in to GI, the T/P takes a deduction in that amount in immediate succeeding tax year
        6. Timing of Loss: If taxpayer deducts a loss in one year, the amount at risk is reduced the next year by that amount. Disallowed losses can be carried forward until taxpayer increases the amount at risk.
    3. Deductions Not Allowed When:
      1. Activities Not Engaged in for Profit IRC § 183 (a)-(d) (Screen) (#1)
        1. Hobby Losses:A taxpayer may only deduct the losses of a profit-seeking activity. An activity is presumed to be for profit-seeking purposes if for at least three of the last five taxable years (unless hobby is in horses that means two out of seven years), the activity brought the taxpayer a net profit. §183(d) Otherwise, the facts and circumstances are explored to ascertain the taxpayer’s intent. Factors considered are (i) research, (ii) past experience, (iii) time devoted and (iv) money devoted to activity. If it is found that the losses were sustained in a nonprofit-seeking activity (i.e. a hobby), the taxpayer may deduct only interest, taxes, and other costs not to exceed the income produced from the investment
        2. First attempt by Congress to limit the deductions
      2. Passive Activity Limitations (#3) IRC §§469(a), (b), (c)(1), (2), and (7), (d), (e)(1), (f), (g), (h)(1) and (2), (i)(1)-(3)(A) and (6), (j)(1), (l)(1). Regulations §§1.469-4(a), (c), (e) and (f)(1), -5T(a), (b)(2)(ii), (iii), (c), (d).
        1. In General§469: Limits deductions of passive activities losses and the usage of passive activity credits to income from such activities .
        2. Definition of an “Activity”: The legislative history of IRC §469 provides some guidance as to what constitutes an activity:
          1. It indicates that an activity consists of undertakings that are an “integrated and interrelated economic unit, conducted in coordination with or in reliance upon each other, and constituting an appropriate unit for the measurement of gain or loss.” It also states that what constitutes a separate activity is a determination to be made in a realistic economic sense considering all of the facts and circumstances.
            1. The regulations adopt an “appropriate economic unit” test to determine whether one or more trade or business activities or one or more rental activities are to be grouped as a single activity for purposes of §469. Factors given greatest weight in determining an appropriate economic unit include:
              1. Similarities and differences in types of businesses
              2. Extent of common control and ownership
              3. Geographic location of different units
              4. Interdependencies among the activities
            2. Once a taxpayer has grouped activities, no regrouping is allowed unless the original grouping was clearly inappropriate or there is a material change in facts and circumstances making the original grouping clearly inappropriate, in which case a taxpayer must regroup activities.
          2. Identifying an activity is important for several reasons. If two undertaking are merely parts of a single activity, the taxpayer need establish material participation only with respect to the overall activity to avoid passive classification. If however, they are separate activities, the taxpayer must establish material participation separately for each. Another reason every activity must be identified is because, at the time of the sale of an activity, prior disallowed losses generated from that activity become currently deductible.
        3. Definition of a Passive Activity A passive activity is one where the taxpayer does not “materially participate” in the conduct of the trade or business.
          1. Material participation is one who is involved in the operations on a regular, continuous and substantial basis, and the activity is the taxpayer’s principal businessIRC§ 469(h) & 1.469-5T (Note: If spouse participates it is attributed to the taxpayer)
            1. 500 or more hours per year
            2. Does all the work of activity
            3. >100 hours but no one else worked more than that
            4. It is a significant participation activity and aggregate amount of all significant participation act is >500 hours
            5. Materially participated for 5 out of the last 10 years
          2. Agent or Representative: Activities of one’s own agent are not attributed to a taxpayer in establishing material participation
          3. Legal Services: Providing legal services to a business as an independent contractor is not materially participating.
          4. Management functions: Passive if merely formal and nominal participation, does not allow for independent discretion and judgment. Can have an active intermittent role
          5. Special rules determine whether an entity is materially participating in an activity. A closely held C corporation or a personal service corporation is treated as materially participating in an activity if one or more shareholders holding more than 50 percent of the value of outstanding stock of the corporation materially participate in the activity.
          6. An estate or trust is treated as materially participating in an activity if an executor or other fiduciary, in one’s capacity as such, materially participates in the activity.
          7. Rental activity is generally passive, even if a taxpayer materially participates in the activity
            1. However, rental real property trade or business of a taxpayer other than a closely held C corporation is treated as active if more that ½ of the personal services performed by the taxpayer in all trades or business are performed in real property trades or business in which the taxpayer materially participates in §469©(7)(A)
          8. All limited partnership interests are passive investments. Limited partnership (formed to bring associates and assets together and divide the profits)-it in itself is a business- looks like a shareholder in public-look at hours, and participation In addition, property held for rent is defined to be passive. All of the taxpayer’s passive activities are combined and tested for net passive income or loss. Passive loss can be carried forward indefinitely.
        4. Passive Activity Losses and Credits: A net amount of income or loss is computed for the taxable year with respect to each passive activity. Then all such income and losses are combined. The limitation applies to the extent that losses from all passive activities exceed income from such activities for the year, or that credits from such activities exceed tax liability for the year attributable to such activities §469(a)(1) and (d) Doesn’t matter if loss or gain-overall results are then calculated…the passive activity losses are only allowable against passive activity gains If there is net income then that is subject to tax…it is like a balancing act. The net is the passive activity loss- if you still have an overall loss it is not allowed this year, but continues to the next year in the passive activity corral-carrying separate accounts. Does this corralling look familiar? Yes, because it is applicable in capital gains/losses
          1. Passive Activity Losses” are the excess of losses from all passive activities over the income from such activities during a taxable year;
          2. Passive Activity Credits” are the excess of credits from all passive activities over the tax liability for the year attributable to such activities §469(d)
            1. However, the disallowed losses and credits are sometimes only postponed, not totally disallowed, because the loss deductions and credits disallowed by this limitation are carried forward and treated as losses and credits form passive activities in succeeding years §469(b)
          3. Determining Income or Loss: In determining income or loss from a passive activity, portfolio income of the activity is excluded. §469(e)(1) Portfolio income includes interest, dividends, annuities and royalties not derived from ordinary trade or business. Also included in portfolio income are gains and losses not derived in the ordinary course of a trade or business from the disposition of property that produces such interest, dividend, annuities, and royalties and from the disposition of property that is held for investment, eve if it is not productive of current income.
            1. However, any gain or loss from the sale of an interest in a passive activity is deemed not to be part of portfolio income or loss §469(e)(1)(A)
          4. Credits from Passive Activities: §469(d)(2)(A)Credits may reduce tax liability in a year only to the extent that there is net income and tax liability from all of the taxpayer’s passive activities for the year. Thus, if there is a net loss from all passive activities, there is no tax generated and no credits are allowed. In a year when there is net income form all passive activities in the amount of tax liability allocable to those activities equals the difference between 1) the tax liability for all income and 2) the tax liability for all income excluding passive activity income. Look at §27(b), 28, 29, 38 for credits.
        5. Taxpayer Subject to the Limitations: The passive loss rules apply to individuals , estates and trusts, closely held C corporations, and personal service corporations. Conduit entities such as partnerships and S corporations are not subject to the passive loss rules. However, the shareholders and partners are subject to the rules.
        6. Exceptions to Disallowance: IRC§469 provides a blank disallowance of excess losses and credits from the current year, but there are two exceptions to this rule.
          1. Closely Held C Corporations: §496(e)(2) A closely held C corporation that is not a personal service corporation is allowed to offset passive activity losses and credits against active taxable income other than portfolio income
          2. Rental Exception: §469(i)(1) Individuals that actively participate(pg. 528)in real estate rental activities can deduct up to $25,000 net passive losses attributable to such activities. However, the $25,000 amount is phased out for taxpayers with adjusted gross incomes between $100,000 and $150,000.
        7. Release of Suspended Losses and Credits: Losses and credits disallowed in any year are carried forward to be used against net income or taxes from passive activities in subsequent years.§469(b) Two special rules come into play here when a taxpayer either converts a former passive activity to an active one or sells the taxpayer’s entire interest in a passive activity.
          1. Treatment of Former Passive Activities: A person can be passive with respect to an activity one year and then become active the next year. In such a case, previously suspended losses or credits remain suspended and continue to be treated as passive activity losses §469(f)(1)(C); however, previously suspended losses can continue to be applied against net income (other than portfolio income) from the former passive (now active) activity and previously suspended credits can be offset against newly arising tax liability of the former passive activity.§469(f)(1)(A) and (B) Policy: to avoid discouraging taxpayers from materially participating in activities.
            1. Also applies: When a taxpayer ceases to be a closely held C corporation or personal services corporation.
          2. Dispositions of Entire Interests in Passive Activities: When a taxpayer disposes of his entire estate in a passive activity (or former passive activity) and all gain or loss realized on the disposition is recognized, any previously suspended losses from the activity are generally allowable as deductions against income.(See §469(g)(1)(C) for reductions.
            1. They are allowed in the following order:
              1. First, against income or gain from the passive activity for the taxable year of disposition
              2. Second, against net income or gain for the same year from all other passive activities
              3. The remainder, against any other income or gain for that year
            2. Policy: At the time of the disposition the actual economic gain or loss can be accurately computed.
            3. Type of disposition: is a sale to a third party at arm’s length transaction thus for a price equal to FMV.
            4. If a taxpayer sells an entire interest in an activity by way of an installment sale, suspended losses are released each year in which payments are made in the same ratio that gain reported in the year bears to the total gain on the sale.
            5. A gift does not release suspended losses. However, if a taxpayer disposes of an interest in a passive activity by gift, the basis of the interest is increased by passive activity losses allocable to it.
            6. If interest in an activity is transferred by reason of death, suspended losses are deductible on the final return of the decedent. However, such losses are deductible only to the extent that they exceed the step up in the basis of the property allowable under IRC §1014.
            7. In contrast to the sanctioned utilization of suspended losses upon a taxable disposition of an entire interest in a passive activity, suspended credits remain suspended

 

—————————————-CAPTIAL GAINS AND LOSSES————————————————-

  1. Capital Gains and Losses
    1. Introduction
      1. Current Capital Treatment: The Revenue Reconciliation Act of 1990 raised the upper rate on ordinary income to 31% and retained the 28% ceiling rate on capital gains. As a consequence, taxpayers must characterize gains and losses as capital or ordinary. The small upper difference in tax rates will make this distinction somewhat irrelevant for many transactions. However, the capital loss rules will give taxpayers an incentive to characterize losses as ordinary rather than capital. In addition, the capital gain rules will still be important in recovery-of-basis situations. Listed below are some of the reasons that capital gains have been given favorable treatment in the past.
      2. Bunching of Income: When they are taxed all at once, gains realized in one year that have accrued over a period of years subject the taxpayer to unfairly high tax rates under the graduated income tax rate structure.
      3. Inflation: In a period of inflation, capital gains are not real income to the extent that they merely reflect the rise in general prices.
      4. Lock-In Effect: Subjecting capital gains are not real income to refrain from selling appreciated assets. This “lock-in” effect reduces liquidity and impairs the mobility of capital.
      5. Investment Deterrent: Taxation of capital gains tends to deter investors’ willingness to bear the risks of investment. Without giving a tax benefit to the investor, society must pay the high price for high-risk activities. This tends to slow the mobility of capital.
      6. Interest Rates: When interest rates fluctuate, a portion of capital gain reflects a change in the rates at which income is capitalized, rather than reflecting true income.
    2. General Info:
      1. Capital Gain: An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on income taxes.
      2. Capital Loss: An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on income taxes
    3. Mechanics of Capital Gains IRC §§1(c), (h) (omit (h)(2), (5)(B), (6), (8), (9), (10), (11)) and (i); 1222. See Sections 1(a)-(e); 1201(a); 1202(a)-(e); 1221(a)(1)-(4).
      1. In General: To determine the net capital gains and losses, the taxpayer must determine whether he has “realized” gain or loss from the “sale or exchange” of a “capital asset.” Then it must be determined whether the gain or loss realized must be “recognized.” The gain or loss is then computed by subtracting the adjusted basis from the amount realized. The adjusted basis is the property’s basis (acquisition cost) plus other capitalized expenditures (i.e. amounts not deductible as current expenses), less depreciation and other receipts chargeable to the capital account. The amount realized from the sale of a capital asset is the sum of money received on sale plus the fair market value of property received (if any).
        1. Three factors to consider:
          1. Does this transaction involve a capital asset? §1221
          2. Has this capital asset been subject to of a “sale or exchange”?
          3. Has this capital asset been held for a long enough period of time?
      2. Non-Corporate Taxpayers: §1222(11) provide preferential tax treatment for “net capital gain”. Taxes most net capital gain at 15%, with a fixed ceiling rate of 28%. §1222 (1) Short Term Capital Gain, §1222(2) Short-Term Capital Loss §1222(3) Long Term Capital Gain, §1222(4) Long Term Capital Loss.To arrive at the tax on capital transactions, the individual taxpayer follows these steps
        1. Segregate Long-Term and Short-Term Transactions: Capital assets that a taxpayer sells or exchanges before he has held them for more than one year are treated differently than “long-term” capital assets.
        2. Net the Amounts – IRC § 1222: After the transactions are segregated by term, the short-term capital gains and losses are netted to reach a net short-term capital gains or losses. The same is done with the long-term transactions to arrive at a net long-term capital gain or loss. The tax treatment depends on the amounts and classifications of the net long-term and net short-term amounts.
          1. Short Term Capital Gain minus Short Term Capital Loss=Net Short Term Capital Gain or Loss §1222(5) or (6)
          2. Long Term Capital Gain minus Long Term Capital Loss= Net Long Term Capital Gain or Loss §1222 (7) or (8)
          3. Results:
            1. Net Short-Term Capital Gain Exceeds Net Long-Term Capital Loss: Where this occurs, the excess short-term amount is treated as ordinary income. Ordinary income is not subject to capital gains ceiling.
            2. Net Long-Term Capital Gain Exceeds Net Short-Term Capital Loss: The excess long-term capital gain is included in gross income. Long term gain is subject to capital gains ceiling. For example, suppose a taxpayer has taxable income of $15,000 and capital gains and losses as follows:
              1. Long-term capital gain $5,000
              2. Long-term capital loss $1,000
              3. Short-term capital gain $2,000
              4. Short-term capital loss $3,500
              5. Netting the amounts would give the taxpayer a net long-term capital gain of $4,000 and a net short-term capital loss of $1,500. The excess of net long-term capital gain is therefore $2,500. This total is added to ordinary income to arrive at a gross income of $17,500.
              6. Some type of preferential treatment is provided to the “net capital gain” which is defined by §1222(11) as the excess of net long-term capital gain over net short-term capital loss. All assets making up net capital gain must have been held more than one year §1222(3)(7)(11)
            3. Both Short-Term and Long-Term Gains: If both net amounts show gains, the combined amount is included in gross income. Capital gains are subject to capital gains rate ceiling.
            4. Net Short-Term Capital Loss Exceeds Net Long-Term Capital Gain: IRC § 1211 (b) allows up to $3,000 of the excess net short-term capital loss to be deducted against ordinary income. The excess must be carried over to future years.
            5. Net Long-Term Capital Loss Exceeds Net Short-Term Capital Gain: IRC § 1211 (b) allows up to $3,000 of the excess net long-term capital loss to be deducted against ordinary income. The excess must be carried over to future years.
            6. Both Short-Term and Long-Term Losses: If both netted amounts show losses, the short-term loss is used first against the $3,000 ceiling. Excess amounts are carried over to future years.
          4. Example: (see page. 681)
        3. Difference in Rate Treatment: Long-term capital gains receive only a minor favorable rate treatment and short-term capital gains receive no favorable rate treatment.
          1. 28 percent: Imposed on several types of net capital gains §1(h)(1)(E)
            1. Collectibles: art work, antiques, gems, coins, stamps and alcoholic beverages
          2. 25 percent: Imposed on “unrecaptured §1250 gain” to the extent that such gain makes up net capital gain §1(h)(1)(D), (6)
          3. 15 percent: Imposed on the gain on most long term capital assets included in net capital gain (other than gains from collectibles, unrecaptured §1250 gain, and §1202 gain. §1(h)(3)-(7)
          4. 10-15 percent: §1(a)-(e) If there is inadequate ordinary income to fill in the tax table under the 25 percent table.
          5. 5 percent: See page 683
          6. Example: See page. 683
        4. §1202: Incentive to encourage noncorporate taxpayers to invest in start up companies. Provision allows a noncorporate taxpayer an exclusion of generally 50% of the gain on “qualified small business stock” held for more than 5 years.
      3. Corporate Taxpayers: Corporations determine their net capital gains and losses the same way as non-corporate taxpayers.
        1. Net Capital Gains: Corporations do not receive preferential treatment on capital gains. Capital gains are treated at same rate as ordinary income. Gets a special rate §1(h)
          1. Net capital gain is the gate keeper definition from §1222 as modified by §1(H)(11) : NLTCG – NSTCL=net capital gain…implies that there are long term gains only (no benefit for short term gains)
        2. Net Capital Losses: IRC § 1211 (a) allows corporations to deduct capital losses only to offset capital gains. The amount that is not used to offset capital gains may be carried back three years and forward five years and offset against those years’ capital gains. Limitation on the deduction §1211 and the carryover in §1212 Can use against capital gains. Limited to a maximum of $3K, corporations have none. Penalty because can only take into the rest of the income in the amount of $3K
          1. In the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.

          2. Other taxpayers
            In the case of a taxpayer other than a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) the
            lower of –

            1. $3,000 ($1,500 in the case of a married individual filing a separate return), or

            2. the excess of such losses over such gains

          3. Can choose when incur gain or loss (realization-tax event), which makes Congress suspicious that you might choose to incur the loss at a time when it would be able to allow to pay less taxes…Could sell something and get a $50K loss to offset $50K salary. So Congress has the same suspicions as in §469 and tax shelters….so there is the limitation of $3K to offset outside income.

    4. The Mechanics of Capital Losses IRC §§1211(b); 1212(b)(1), (2)(A)(i); 1222(10). See Sections 165(c) and (f); 1211(a); 1212(a); 1221(a)(1)-(4); 1222.
      1. Noncorporate Taxpayers: In the case of a noncorporate taxpayer, capital losses in excess of capital gains can be deducted from capital gains without limit however in regards to being deducted from ordinary income, only to a limited extent. Any capital loss balance remaining is carried forward into succeeding taxable years, retaining its original character as either long-term or short-term capital loss. This carryover loss is applied against capital gains (and to a limited extent against ordinary income) in each succeeding year until fully utilized. Look to §165(c) to determine whether a loss is deductible.
      2. The Section1211(b)Limitation: The starting point for the treatment of ca[ital losses is IRC §1211(b), which provides, essentially, that capital losses are deductible only to the extent of capital gains plus, if such losses exceed such gains, an amount of ordinary income not to exceed the lower of $3K ($1500 in the case of a married individual filing separately) or the excess of such losses over such gains. See page 688 for an example
      3. The Section 1212(b) Carryover: (Allows the excess capital loss not allowed past the $3K to carry over nand tells which loss to apply to ordinary income first) The carryover statute for noncorporate taxpayers, §1212(b), provides that capital losses not utilized in the year incurred retain their original character in succeeding years and are carried over into subsequent taxable years. The “if” clause at the beginning of §1212(b)(1) makes the carryover provisions dependent upon the taxpayer having a “net capital loss,” which is defined in §1222(10) as “the excess of losses from the sales or exchanges of capital assets over the sum allowed in §1211.” If the sum allowed under §1211(b) does not exceed $3K of excess losses over gains, there is no “net capital loss,” no carryover, and no need or permission to use §1212(b). See page 690 for example
        1. However, if for any year capital losses exceed capital gains by more than $3K, §1212(b) applies and questions arise both as to the amount and the character of any carryovers. The secret of interpreting §1212(b) and of answering the questions of what to do with the excess capital loss and which net loss (short or long term) is first consumed against ordinary income is found in §1212(b)(2) and thus one must make the §1212(b)(2) computation first, before computing carryover losses under §1212(b)(1)

 

    1. Netting: The following rules apply to the netting of capital gains and losses:
      1. Short-term capital losses including carryovers are combined with short-term capital gains. Any net short-term capital loss is used to reduce long-term capital gains in the following order: 28% sale gain, unrecaptured § 1250 gain (25%), and adjusted net capital gain (20%).
      2. Gains and losses are netted within the three long-term capital gain groups to determine a net capital gain or loss for each group. There can be no net loss in the 25% group, which is limited to gain to the extent of straight-line depreciation
      3. A net loss from the 28% group (including long-term capital loss carryovers) is used to reduce gain in the 25% group, and then any net loss balance is carried to the 20% group
      4. A net loss from the 20% group is used to reduce gain from the 28% group and any remaining net loss is carried to the 25% group.
    2. Corporations: The major difference in the treatment of capital losses of corporations and individuals is that §1211(b), authorizing noncorporate taxpayers a limited deduction in excess capital losses from ordinary income, is neither applicable nor duplicated for corporations. In the case of a corporation, §1211(a) provides that losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.
  1. Computations

    1. The Alternative Minimum Tax
      1. The AMT was introduced by the Tax Reform Act of 1969,and became operative in 1970. It was originally intended to target very high incomes which were subject to many exemptions under the mainstream tax code of the time.
      2. In essence, the intention of the AMT is to set a minimum tax rate of about 27% on the highest earning tax payers so that they can not use loop holes or other tax reduction strategies to entirely avoid paying a substantial amount of income tax. The AMT affects taxpayers who have what are known as “tax preference items.” These include (among others):

        1. Long term capital gains

        2. Accelerated depreciation

        3. Percentage depletion, and

        4. Certain tax-exempt income which are all considered to have favorable tax treatment and could trigger the alternative minimum tax.

      3. In addition to the normal tax code calculations, the AMT system uses a different set of rules for determining taxable income and allowable deductions, and uses a simple 26/28%rate calculation to determine the “Tentative Minimum Tax” (TMT). The TMT is compared to the income tax amount calculated for the taxpayer.
        1. If the regular income tax amount is greater than the TMT, no special action is required.
        2. If the TMT is greater than the tax calculated using the regular rules, the difference between the TMT and the regular tax is added to the regular tax amount, so the taxpayer pays the full amount of the TMT (although some of that tax is considered regular tax and some is considered AMT).
      4. The portion of the tax which is considered AMT may be available in later years as a “Minimum Tax Credit”, reducing the regular income tax due in later years, but only to the taxpayer’s TMT level in those later years.

      5. Essentially, this is a way to require us to take our regular taxable income and add back elements that originally Congress thought we shouldn’t have gotten, but didn’t want to change the Code, and now thinks will better reflect our income.

 

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