John Demeter Federal Income Taxation Rosenberg Fall 2004
I. GROSS INCOME
A. IRC § 61 - Gross income is all your income
B. Receiving a financial benefit is gross income
1. Finding money is receiving a financial benefit, and thus gross income
(Cesarini) - Money found in the piano is gross income
2. If you steal money, you must pay taxes on it.
(Charley) - Downgrading tickets from 1st class to coach & taking $ makes this gross income
3. If you receive a financial benefit from yourself, you have not gross income
- If you own land and build your own house, you do not have to report gross income.
C. Income without receiving cash or property
1. If you receive services in lieu of $, you must pay taxes on the fair value of the services received
e.g. Barter exchange of services - I will paint your house if you do my taxes
(Old Colony Trust) - Company paid executive’s taxes for him. This is gross income which executive must report
2. IRC § 109 - Tenant improvements are not considered gross income, and are taxed upon the sale of your property
D. IRC § 102 - Gifts and Inheritance are not gross income
1. A gift is determined by the donor’s intent.
a. If the donor gives from a detached, disinterested generosity, then it is a gift
b. If the donor anticipates getting something in return it is not a gift
NOTE: It is up to the trier of fact to determine this
2. Gifts to Employees
a. Gifts to employees are not excluded if given in return for services rendered
- Must be detached, disinterested generosity on behalf of the employer to be a true “gift”
2. A bequest, inheritance or devise is also excluded from gross income
a. This goes for a contested inheritance or breach of contract award as well.
(Wolder) - Clever attorney tried to circumvent taxes by doing services for free & taking a gift under the will. This
was treated as compensation.
E. Employee Benefits
1. IRC § 132 - Fringe benefits are excluded from gross income
a. Things that would be deductible if you were self employed are excluded for gross income
- flying to a business meeting & renting a car
b. No additional cost services
- Service must be “in the line of business”
- Service must be available for sale to the public
e.g. stewardess gets free seat on a flight - fringe benefit - not gross income
Law partner uses company jet for personal use - non-fringe benefit - taxable
2. IRC § 119 - Meals and lodgings for the convenience of the employer are excluded from gross income
a. The lodgings must be on the premises of the business
b. You can furnish the employee with meals, not groceries
NOTE: IRC § 107 - Allows a congregation to provide minister/priest with a home or rental allowance
3. Lots of other employee benefits which are tax-free
- Life insurance
- Health insurances
- Some retirement benefits
F. Release from Indebtedness
1. If a creditor cancels your indebtedness, must be treated as gross income.
LOGIC: It is as if the creditor gave you the $, and then you used it to pay off the debt.
EXAMPLE: Borrow $10K from bank. Bank says “just pay back $3K and we’re even.” $7K gross income.
2. Exceptions are made for Bankruptcy and Insolvency
- However, going broke or BK makes you give up certain other future tax benefits.
(Zarin) - Gambler owed $3.5M to casino. Settled for $500K. IRS wants $3M cancellation of indebtedness. Gambler not
liable because the debt was suspect (perhaps illegal).
II. GAINS FROM DEALINGS IN PROPERTY
A. IRC § 1001 - Upon the sale of property, you are taxed only on the profit you’ve made on the property
- This is the amount realized above your basis in the property.
B. Determination of Basis
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John Demeter Federal Income Taxation Rosenberg Fall 2004
1. Your basis in property is the price you acquired it for, +/- many other things (depreciation, etc).
2. Property acquired by gift
- Your basis is the basis that the donor had in the property
e.g. A has a basis of $100 in Blackacre. A gives B Blackacre. B’s basis is $100.
- A’s basis is $100. A gives to B, FMV of $50
a. If B sells it for more than $100, must report gain (basis is $100)
b. If B sells it for less than $50, B can take a loss (basis is $50)
c. If B sells is for less than $100, but more than $50, there is no tax liability.
3. Property transferred between spouses
a. IRC § 1041 - For transfers of property between spouses pursuant to divorce or dissolution settlement,
there is not gain, the basis stays the same.
EXAMPLE: In divorce, H buys from W for $4.1M. Basis is $150K. Because of this, W gets $4M
tax free (marriage settlement). H’s basis is $150K. When he sells property for $4.2M,
he owes tax on $4.05M
4. Property acquired from a decedent
a. IRC § 1014 - Upon death, the taker of the property gets a “step up” in basis to the fair market value at the
time of the death.
EXAMPLE: Dad owns land with basis of $10K. When he dies, he gives it to Son, FMV $150K.
Son’s basis in land is $150K.
b. To be eligible for the step up, the decedent must hold the property for 1 year if acquired from the devisee
EXAMPLE. Son owns land with basis of $100K and FMV of $300K. Conveys to Dad, who dies
and leaves land to Son in will. If Dad did not hold property for 1 year, son will not get
the step-up in basis.
5. Property acquired by prize
a. If you win a prize and include the value in income when you get the prize, your basis is the amount you included
in income.
EXAMPLE: Win a car worth $60K. You sell it for $47K, its FMV. You include $47K on your taxes for
the prize. $47K is your basis, so you pay no extra taxes when you sell it.
6. Tenant improvements
a. IRC § 1019
- If a landlord gets tenant improvements, his basis in such improvements is $0 - all gain
- If a landlord gets tenant improvements in lieu of rent, the landlord must:
- include in gross income the FMV of the improvements
- But this also increases his basis in the property
(its as if he took the rent $ as gross income and made the improvements himself).
7. Improvements to property
a. If you improve property, your basis in the property increases.
EXAMPLE: Purchase Land for $100K. Basis is $100. Later, you borrow another $100K to improve. Basis is
now $200K. If you sell for $300K, your gain is $100K.
b. Whenever you dispose of property subject to debt, the amount realized includes the amount of debt relieved
from
C. Determining Amount Realized
1. IRC § 1001 - Unless otherwise noted, all gain shall be recognized
a. Whenever you dispose of property subject to debt, the amount realized includes the amount or debt relieved
from
b. Whenever you acquire property subject to debt, your cost includes the amount of that debt
EXAMPLE: FMV is $300K. AB is $100K. Debt of $180K. Land is given to Son. Donor’s gain is
$80K ($180-100). Son’s basis is $180K (amount of debt he is responsible for).
c. If the donor’s amount realized is greater than the basis, treat the donation as a sale
d. If the donor’s amount realized is less than the basis, treat the donation as a gift
III. NONRECOGNITION OF INCOME
A. Like Kind Exchanges
1. IRC § 1031
a. Exchange of property. Really only applies to real estate
- Can apply to other property, but it is very restricted. Mainly property for investment or use in business or
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John Demeter Federal Income Taxation Rosenberg Fall 2004
trade.
- Does not apply to:
- stock & trade inventory
- stocks, bonds, notes
- Partnership interests
- Certificates of deposit
- Choses in action
b. The exchange is tax free.
- Must identify a replacement property within 45 days of sale, and entire transaction must conclude within
180 days.
c. The basis in from the old property moves over to the new property.
- Called the exchange basis
d. Any additional cash the exchanger gets it return is called the boot.
- The boot is taxable
e. Possible scenarios:
i) A has a basis in Blackacre of $10K. A sells Blackacre for $100K. Within 45 days he designates
Whiteacre, and purchases Whiteacre within 180 days for $100K. Basis in Whiteacre is $10K. A
owes no taxes.
ii) A has a basis in Blackacre of $10K. A sells Blackacre for $100K. Within 45 days he designates
Whiteacre, and purchases Whiteacre within 180 days for $150K. Basis in Whiteacre is
$60K (10K from Blackacre, plus $50K A owes no taxes.
iii) A has a basis in Blackacre of $10K. A sells Blackacre for $100K. Within 45 days he designates
Whiteacre, and purchases Whiteacre within 180 days for $80K. Basis in Whiteacre is $10K.
A owes taxes on $20K of boot.
NOTE: You can never have a loss in a 1031. You’re better off selling, taking the loss & buying something new.
2. IRC § 1033 - Involuntary exchanges
a. If you get money due to destruction of property and re-invest it in similar property, no gain is recognized
- Basis stays the same
b. Same goes for emminent domain.
B. Annuities and Life Insurance
1. Life insurance proceeds payable upon death are excluded from gross income
- IRC § 101
- If you agree to let the insurance company keep the $ and pay you with interest, the interest is taxable.
a. If you purchase a life insurance policy for consideration, your basis is the price you paid.
EXAMPLE: Dad paid $40K for $100K ins. Policy. Son purchases for $60K. Dad has $20K taxable
gain. Son’s basis is $60K. Must pay $40K in taxes when dad dies.
b. A gift of a life insurance policy is tax free to the donee
2. Accelerated Insurance Benefits
- IRC § 101(g)
- If the doctor says you will die within two years, the acceleration of death benefits will be tax free
3. Viatic Settlements
- Companies that purchase your life insurance policy. They will get the full payout when you die, you get the $
now.
- If doc says you’ll die within 2 years, you get the settlement amount tax free.
4. Annuity Payments
- IRC § 72
- You are taxed on the amount paid out each pay period above your pro-rated principal.
- Once principal is all used up, you pay tax on all the income.
EXAMPLE: You purchase an annuity for $48K. Annuity pays $3K a year for life. Life expectancy is 24 years.
i) You live for 24 years. You get $2K each year tax free (principal) and $1K taxable (interest)
ii) You live 30 years. First 24 years, same as above, last 6 years all $3K is taxable
iii) You live for 20 years. You get $2K each year tax free and $1K taxable. Upon death, your estate has $8K tax
loss (undistributed principal)
C. Damages
1. Workers compensation awards are excluded from gross income
2. Personal injury or sickness damages are excluded
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John Demeter Federal Income Taxation Rosenberg Fall 2004
- This will include emot. Distress, lost wages, etc., so long as coupled with personal damages recovery
- Applies to settlements as well as court judgments.
NOTE: Punitive damages are taxable (in some jx. They are not if they only recovery the defendant could get).
3. Recovery for damage to property from insurance or damages
- The recovery of $ lowers the basis of the property, until the basis reaches $0.
- If your recovery exceeds your basis in the property, you have income (ASK RB ABOUT THIS).
- If you decide to re-invest the $ into the property, the basis increases with the re-investment.
EXAMPLE: Car with basis of $8K. FMV of car is $10K. Car damaged in accident and recovers $2K (loss of
FMV from $10K to $8K). Basis of the car is now $6K. (If you were to use to 2K to repair the car, the
basis would be back up to $8K.)
D. Sale of Principal Residence
1. IRC § 121 - allows you to exclude a certain amount from gross income generated from the sale of your primary residence
a. You must have used the residence as your primary residence for 2 of the past 5 years.
- If single, the amount is $250,000.
- If married and 1 spouse has owned it for two years, and both have lived there for 2 years, the amount is
$500K.
b. If you MUST move, you can get a partial exclusion
- 1 year = ½ of the amount
- 1.5 years = ¾ of the amount.
E. State and Local Bonds
1. IRC § 103 - There is no gross income on interest resulting from state or local government issued bonds
- This does not apply to arbitrage bonds
Government cannot get $ from a tax exempt bond and use that to invest.
- Does not apply to private activity bonds
Used to finance baseball stadiums, etc.
IV. ASSIGNMENT OF INCOME
A. The main question is who’s income is it?
Think Tree-Fruit - No matter who gets the fruit, tax the tree it came from.
1. Income from Services
a. If you give your paycheck to someone, you are taxed on the income - cannot do this to avoid paying taxes.
- It is treated as if the owner got the $, then gave it as a gift.
2. Income from Property
- The owner of the property is taxed on the income, regardless of who gets it.
- If you give away the property, the new owner gets the income
- The owner of stock at the dividend date gets all the $, and pays all the taxes
a. Special rules with bonds
- If you sell the bond and the right to interest, you are only taxed upon the % time you owned it during the
interest payment period.
- If you only sell the rights to the interest coupons, you must pay taxes on the sale price of the coupon.
3. Deductions from Property
a. If you give your property to your child and rent it back, you have created a deduction and gross income for your
child.
4. Income from money: Interest
This used to happen when Parent would lend Child $ interest free, and Child would make interest on the $. Who
should pay the tax on the interest? The parent at the higher rate, or the child at the lower rate?
a. IRC § 7872 - Treats this problem as if Child is Paying parent interest on the principal and the principal returned
was a gift to the parent from the child.
b. Amount of interest is the Applicable Federal Rate (AFR)
c. De-minimum provision - if the loan is for $10K, this does not apply
d. If the loan is for less than $100K
- the amount of interest imputed to the parent will not exceed the child’s net investment income for the year
NOTE: This applies to ALL child’s investments, not just from the gift loan.
EXAMPLE: Dad loans Son $200K interest free. Son invests $200K. Dad must record $6K in gross income from
imputed interest each year. ($200K x 3% AFR = $6K).
V. INCOME PRODUCING ENTITIES
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For all of these, you can create persons for tax purposes. These are “people” in they eyes of the IRS
A. Trusts
1. If the trust keeps the interest, the trust is taxed
2. If the beneficiary keeps the interest, the beneficiary is taxed
NOTE: If the settlor keeps too many strings, he will be taxed, not the trust. Only way to avoid this - irrevocable trust
B. Partnerships
1. Income in partnerships passes thru to the partners.
2. Each partner is taxed on their % share of the income of the year earned, regardless if it was paid or not
- Nobody is a partner unless they contribure
3, Family partnerships - tax each on contribution to partnership
C. Corporations
Don’t need to know
Just know that any publicly traded entity is treated as a corporation.
VI. BUSINESS DEDUCTIONS
A. IRC § 162 - There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year
in carrying on a trade or business.
NOTE: IRC § 262 is the bookend to $162 - No deductions for personal, living, or family expenses
1. Ordinary and Necessary
a. These are all expenses that are legitimate business expenses.
b. Things you need to help you keep doing business
e.g. Malpractice insurance.
NOTE: A malpractice judgment against a lawyer can be deducted as “ordinary and necessary”.
2. Expenses
a. These must be expenses
e.g. Paying a secretary’s salary, paying rent, phone bill, insurance premiums
b. Limit on Expenses
IRC § 263 - if you acquire something that will last beyond the tax year, it must be capitalized and
depreciated
NOTE: Advertising is deductible, even though it lasts beyond a year
c. Repairs are deductible, improvements are not
- The law is not clear here.
- Buying a building - not deductible
- Removing asbestos from a building - repairs are deductible
- Renovate and repair a building - no on the renovate, don’t know about the repairs
Rosenberg example: $100 is a repair, $10,000 is an improvement
(Indopco) - Tried to get attorneys fees in friendly takeover as expenses - deemed capital expenditures.
3. Carrying on a trade or business
a. The taxpayer must be “carrying on” the trade or business to get the deduction
- Somewhat of a state of mind question
b. You do not need to be “busy.” Now you can deduct for passive income producing professions (see below)
4. Start-up expenses
IRC § 195 - Start up costs must be amortized over at least 60 months.
a. This applies to expenses that would have been deductible had you been in business, instead of starting the
business.
- If you close up shop before the 60 months, you may deduct the remainder at that time
B. Specific Business Deductions
1. Reasonable Salaries
a. Reasonable salaries are allowed to be deductible under § 162.
b. Dividends are not deductible
- This appears when owner of corp is only employee and pays himself lots.
c. Limit on excessive executive salaries in publicly held companies
IRC § 162(m) - cannot deduct more than $1M in salary
- This does not affect bonuses
- This does not apply to sports
d. Limit on “Golden Parachute” payments
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IRC 280G - cannot deduct more than 3 times annual compensation
2. Travel away from home
a. You cannot deduct expenses for travel to home/work.
- Your home is where you PPB is located. So if you work in LA & want to live in SF - You pay.
- Your tax home is where your PPB is located.
- If you are away from home for work for less than 1 year, it still remains your home & you can deduct.
b. No deduction for meals while at work - personal expenses
c. When away from home for business you can deduct your expenses (airfare, hotel, rental car, meals) because you
have no choice to go home
- Cannot deduct for spouse/children if they join you
d. Investors are allowed to deduct expenses to go to annual meetings
- IRC § 212
- Must be a pretty big shareholder or risk IRS looking into it.
e. Limit on deductibility of meals
IRC § 274(n) - You can only deduct 50% of meal expenses.
- If for a business meeting, you must document discussions of the meal
- Same goes for entertainment expenses incurred for business
f. Limits on conventions
IRC § 274(h) - Cannot deduct convention expenses if it occurs outside N. America. Only allowed to
deduct if the meeting is directly related and only makes sense to occur there.
IRC § 274(m)(1) - Cannot deduct conventions aboard cruise ships
g. You must substantiate your travel expenses
NOTE: Also limits on deductibility on club dues, skyboxes and facilities
- you get 50% of face amount of tickets; 50% off face value of seats, not whole luxury box.
3. Necessary rental and similar payments
a. You can deduct your office rent
- You cannot classify land payments as rent to avoid taxes.
- You cannot “lease” fire sprinkler system to deduct the cost. It is a capital improvement. Too bad.
b. Way to deduct land payments:
A sets up AB Corp. A rents land for $100K a year. At end of 10 years, AB Corp (A’s alter ego)
purchases the land on an option. Deductions allowed. (Probably not on the exam).
4. Expenses for education
a. If you are carrying on a trade or business, you may deduct expenses to educate yourself.
- Law school is not deductible because you are not “carrying on”
- Once a lawyer, getting an LLM - deductible
b. You cannot amortize your education expenses as “start up” costs
C. Business Losses
IRC § 165 - Deductions
Allowed for transactions entered into for profit
1. If property is sold, destroyed or junked, you can deduct a loss
- Deductions allowed up to the basis of the property
- Loss = Actual Basis-Amount Realized
EXAMPLE: AB of $40, sold for $18 - Loss is for $22
2. If property is damages, but retained, this is a realization event.
- Loss = Old FMV - New FMV + insurance proceeds
EXAMPLE: Old FMV $100, New FMV $65, insurance of $30 - Loss is for $5
3. You cannot deduct a loss from destroying your own building to make a new one
IRC § 280B
D. Depreciation
IRC § 168 determines the depreciation for all tangible property
Can only depreciate property used primarily for a trade or business
- If less than primary, e.g. 45% business, only get that much depreciation
1. Personal Property
a. All personal property can be classified as type of property (3 year, 5 year, etc.)
b. To determine the rate of depreciation, just look at the table
c. Half year convention - e.g. 3 year property is depreciated over 4 years. ½ year in Y1, Y2, Y3, ½ year in Y4.
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d. Once fully depreciated, the basis in the property becomes $0.
e. Mid Quarter convention - If more than 40% of your depreciable property purchased in Q4, look at a different
table
f. Taxpayers may elect to depreciated more slowly, by either straight line, or even slower than that
NOTE: Depreciation of luxury cars - there is a strict limit on depreciation of autos. Anything over $12K is luxury
2. Small Business Assets
IRC § 179 - Election to expense certain depreciable business assets
a. If a small business, some assets purchased in the current taxable year are immediately deductible
b. To be a “small business” you do not acquire more than $400K of depreciable property in any given year
c. You can deduct the first $100K of depreciable property you put into service over the year
3. Personal Property Attack Plan
- Is the property for use in Business?
- If no, and its for investment, see table
- If yes, small business under § 179 - deduct right now
- If no to § 179, did you put 40% into use in Q4? - If no, see table
- If yes, see different table
4. Real Property
a. You can depreciate the cost to build a building
- and wear and tear on the building
b. When you purchase land + building on it, you must allocate purchase cost to each.
- $500K land & $500K building
c. Classification:
- Residential is 27.5 year property
- Non-residential is 39 years
d. Depreciation for real property occurs straight line.
- Whatever month you put it into service, you get ½ month deduction only that month
- Use the tables
e. If you purchase duplex and live in 1, rent the other, you must treat it as two separate investments
NOTE: R&D is deductible. It helps pharmaceutical companies
VII. PROFIT MAKING DEDUCTIONS
IRC § 212 - Allows deductions for ordinary and necessary expenses for the year related to the production of income (investing)
- This expanded § 162 to non-business, but profit making activities
A. Commissions and Capital Expenses
1. These are factored into the property’s basis and amount realized in the transaction
EXAMPLE: Buy stock for $3000, commission of $50 is factored into your basis. AB of $3050. You sell it later for
$4000 and pay a commission of $50. The commission reduces your amount realized. AR of $3950.
Recognized gain is $900.
B. Maintenance Expenses
1. These are deductible if used for the production of income
e.g. maintaining apartment buildings, etc.
2. Limits on deductions by shareholders
IRC § 274(h)(7) - Some investment seminars may not be allowed as deductions.
- If you are a major shareholder, you can deduct your costs to attend a shareholder meeting
NOTE: Meals are still only 50% deductible
C. Attorneys Fees
1. Tax attorneys fees are always deductible. Same goes for estate planning - trying to avoid paying taxes.
- because they write the code
2. Fees for plaintiff
a. If you are trying to get gross income, fees are deductible because this is the cost of getting gross income
b. If you are not suing for gross income, the fees are not deductible
3. Fees for defendants
a. If something you already got was used in business, the fees are deductible
- NOTE: If what you already got last beyond the taxable year, it must be capitalized & depreciated
b. If something you already got was for personal use, no deduction.
4. Fees in divorce
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John Demeter Federal Income Taxation Rosenberg Fall 2004
a. Alimony is gross income, and thus attorneys fees to get this are deductible
b. Getting property in a settlement is not gross income, the fees are not deductible.
c. Defending a suit against spousal support, property, etc. is personal - no deductions allowed.
5. Sexual Harassment
a. If you are suing with no injury to yourself, the recovery is counted as gross income, and thus, deductible
6. All Personal Injury
a. Since all recovery that goes along with personal injury is not gross income, there is no deduction for fees
7. Punitive Damages
a. Taxed as gross income, so you can deduct the fees award.
D. Charges arising out of Transactions entered into for profit.
1. You can deduct expenses for property held for business (IRC § 162) or investment (IRC § 212)
2. You can deduct losses upon disposition of profit-seeking property (IRC § 165)
3. The showing to deduct expenses or losses is different
a. To deduct expenses for maintaining the property, it must be held for business or investment
- You can “convert” a property for deducting expenses easily, just say it’s for rent.
b. To deduct a loss on property, you must have acquired the property for profit
EXAMPLE: Buy a condo to live in for $1M FMV. AB is $1M. Try to rent it for 6 months and cannot (you can deduct
expenses for maintenance and depreciation because held for trade or business). Sell it for $700K. Cannot deduct
$300K loss because did not ENTER INTO purchase looking for profit.
NOTE: If you convert personal to for profit, you take the basis of the property at the time of the conversion.
EXAMPLE: Buy house for $1M. AB is $1M. After 2 years, FMV is $800K. Convert to for profit. New AB is
$800K. If you sell for $750K, you have a $50K loss.
VIII. DEDUCTIONS NOT LIMITED TO BUSINESS
A. Itemized Deductions
1. These deductions are not related to business or profit seeking activities
2. Itemized deductions include:
- Medical expenses are deductible if they exceed 7.5% of your adjusted gross income
- State & local taxes
- Real property taxes
- Certain types of interest
- Gifts to charity
- Theft losses
- Job Expenses
NOTE: If your itemized deductions are less than your standard deductions, you take the standard.
A. Interest
1. Types of Interest
a. Qualified Residence Interest
b. Interest from business, investment or personal use
2. Qualified Residence Interest
a. Interest generated from your home mortgage in deductible
b. The mortgage must be secured by your residence
3. Limits on Deductibility of Qualified Residence Interest
a. There is a $1M limit on the amount of acquisition indebtedness interest you may deduct
b. This limit cover the aggregate total from up to two homes
c. This is money that is used at the outset to purchase the home
NOTE: Re-financing exiting acquisition indebtedness is treated under the $1M umbrella
d. Home equity line of credit (second mortgage) allows deduction of interest on up to $100K.
e. So this mean that you can deduct interest from a total of $1.1M from two homes. For amounts over, see below
for deductibility.
4. Interest from home loan used for business, investment, or personal use
a. Business
- Interest generated that you borrowed for business is deductible
b. Investment
- Deduction of interest shall not exceed the net investment income of the taxpayer
EXAMPLES: 1. Borrow $100K. Above $1.1M cap. Invest in stock. After 1 year, sell stock for
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John Demeter Federal Income Taxation Rosenberg Fall 2004
$120K. Net investment income of $20K. Interest of $10K can be deducted.
2. Borrow $100K. Above $1.1M cap. Invest in stock. After 1 year, sell stock for
$100K. Net investment income is $0. Interest of $10K cannot be deducted.
c. Personal use
- This interest is not deductible
B. State and Local Taxes
IRC § 164
1. State, local, foreign, real and personal property taxes are deductible
2. Sales tax is not deductible
C. Charitable Contributions
IRC § 170
1. Charitable contributions are deductible
2. Limits on charitable deductions
a. Items purchased at auction, you can deduct the excess paid over the item’s FMV
b. Property donated to a charity, you can deduct your basis in the property
c. Stocks donated to a charity, you can deduct the FMV of the property, even if more than your basis
d. Services donated to charity, you can deduct the lesser of the value of the services or the ultimate sale price.
3. How much can you deduct for donations to charity
a. Up to 50% of your gross income for public charities
b. Up to 30% of your gross income for private charities
IX. RESTRICTIONS ON DEDUCTIONS
Each of these is a bucket, and deductions can only apply to the amount of $ made from each of these ventures
A. Limited to Amount at Risk (Tax Shelters)
1. IRC § 469 ended tax shelters
- You can only deduct your losses to the extent that you are at risk in the venture
- Tax shelters still exist for corporations
2. Now if you have a tax shelter, the gain/loss stays in the tax shelters basket.
3. Targets “passive activities” which means there is some business going on, but you are not active in that business
- includes any rental activity.
4. Limited partners do not participate, and are therefore passive
IRC § 469(h)
5. Stock and bonds are not passive activities
IRC § 469(e)
6. Young Lawyer Exception
- IRC § 469(c) If you buy something small (duplex) and you have losses (depreciation, etc) you can deduct up to
$25K of your losses.
- This small loophole applies to real estate investments
- This also applies only if your adjusted gross income is less than $100K
- If over $100K, you can only deduct the following: $25K - (50% of the amount over $100K.)
B. Activities not engaged in for profit (hobbies)
1. Key question is your goal to make a profit or to have fun
- If for profit, this is a business - see §§ 162, 212.
2. If you have a hobby and make $ from your hobby, you can deduct expenses up to the amount of $ you make
EXAMPLE: You like to play guitar. You buy a new one for $300. Normally you cannot deduct the $300. If
you get paid $300 to play at a wedding, you can deduct your $300 expense.
C. Deductions of Homes
1. You cannot normally deduct the costs of your home
- but you can deduct mortgage interest and taxes
2. If you have a home office, you can deduct normal business expenses that you would be able to do with a regular office
e.g. Depreciation, utilities, repairs & maintenance
3. These deductions are restricted to the % of square footage which occupies your home office
e.g. Home office is 30% of square footage, can deduct up to 30% of utilities, etc.
4. Your home office must meet the following criteria:
- It is the principal place of business or regular meeting place of your business clients
- It is used exclusively and regularly for business
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- Good if it is a separate structure
5. Further limitation on home office deductions
- In addition to all the above limits, your deduction is cannot exceed you net/net income produced from the home
office business.
EXAMPLE:
Home office business generated $9K this year.
Secretary cost $2K
Net income is $7K
Mortgage and taxes for % of home office were $3K
Net/net is $4K
NOW: Depreciation, utilities, repairs, etc. may be deducted up to 4K.
If there is an excess, you can carry it forward indefinitely, but can only be used to offset $ made from THIS home
office venture.
D. Illegal activities
- Cannot deduct illegal fines or bribes
X. TIMING OF INCLUSION AND DEDUCTIONS
A. The Cash Method
1. Basic Rules
- You include something when you get it
- You deduct something when you pay for it
- It follows the money
- Most individuals use the cash method
2. Constructive Receipt of Payment
a. You have income when you get it constructively
b. You have income when you turn your back on payment to defer taxation
c. An IOU is not constructive income
d. Payment by bond is just like receiving $, it’s a negotiable instrument.
e. Same goes for money given to you in an irrevocable trust. It’s yours now and you must pay tax on it now.
- If revocable or contains some condition not yet triggered, its not yours and no income
3. Disbursements
a. You get the deduction when you pay
b. If you pay for something up front and it will last for substantially longer than 1 year, you must capitalize the
expense and depreciate it.
EXAMPLE: Pay $50K up front for 5 years of service. Must capitalize & depreciate.
B. The Accrual Method
1. Basic Rules
- You have income when all events have occurred that fix your right to be paid and can be determined with
reasonable certainty.
- You have deductions when all events have occurred that fix your liability and can be determined with reasonable
liability.
- Follows rights and liabilities
- Most businesses follow the accrual method
2. Accrual Income
a. When you render services and bill for them, you record income THEN, whether or not you get paid.
b. If you get paid up front for a service that will last longer than 1 year, you must include the money now, unless:
- the contract will not last beyond the next taxable year, then you can split the income over 2 years
- If longer than 2 years, you must prove to the IRS that you will have to do something else to earn this $.
c. If the contract will last for longer than 1 year and you must pay up front, you can estimate your expense
deductions relating to that income for the term of the contract.
EXAMPLE: Contract for 5 years. Cannot prove you will earn it over 5 years. Must pay tax on $1M this
year (K price of $200K/yr for 5 years). You can estimate $400K expenses ($80K/yr for
5 years).
3. Accrual Deductions
a. You can deduct when all events occur that fix your liability and the amount can be determined with reasonably
liability.
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b. Economic Performance Rule
- Limits large up front deductions where liability is fixed and amount is determined
- No deduction before economic performance occurs
- So, Tort claims, if paid yearly, can only be deducted yearly
- Same goes for toxics deductions as property is provided
- Same goes for services - economic performance occurs as person performs services.
C. Forced Matching
1. This occurs when the parties to the transactions are on the cash and accrual methods respectively
- If this occurs, they must both use the cash method
2. IRC § 267 - Matching of income
- If 2 parties and each are cash and accrual respectively and if they are closely related (family members, corp
&major shareholder), the payor does not get the deduction until payee includes the payment in income.
D. Inventories
1. FIFO (First in, first out)
- Gives the larger profit margin on items sold, thus greater taxable income
EXAMPLE: AB of old inventory is 10, new inventory is 15. Sale for $20. Under FIFO, AR is $10
- Used when cost of goods is dropping
2. LIFO (Last in, first out)
- Gives smaller profit margin on items sold, thus less taxable income
EXAMPLE: AB of old inventory is 10, new inventory is 15. Sale for $20. Under LIFO, AR is $5.
- Used when cost of goods in increasing
3. Whichever method a company chooses, it must stick with for the entire year.
- Usually it is very hard to change once FIFO/LIFO is selected.
XI. CAPITAL GAINS AND LOSSES
A. Capital Assets
IRC § 1221 - A capital asset is investment property.
Applies to ALL property except for:
- Inventory
- Property held for sale (inventory)
- Depreciable or real property used in a trade or business
e.g. equipment and office buildings
- Maybe your home (cannot deduct losses on your home)
If you make property and sell it, it counts as ordinary income, not capital income
1. A leasehold can be a property interest, so selling it off can result in a capital gain
NOTE: A sub-lease is not a property interest, to you get gross income when you sell it.
B. Sale or Exchange Requirement
1. You must sell or exchange to trigger a capital gain/loss
2. With sales, it is easy, it’s a sale
3. With exchanges, you get the difference between your basis and the FMV of the goods exchanged for.
EXAMPLE: You own stock AB $8K. FMV is now $20K. You trade it for a car worth $20K. You have 12K
capital gains.
C. Statutorily created capital gains or losses
1. IRC § 1231 - The purchase/sale/exchange of real property or equipment used in a trade or business during the taxable
year
a. If your net from all these transactions is a gain, you can treat the net gain as a capital gain for tax purposes
b. If your net from all these transaction is a loss, you can deduct the net loss as an ordinary loss for tax purposes.
NOTE: There are limitations on manipulation of timing for tax advantages
2. IRC § 1245 - Recapture
a. Applies when you sell depreciated property, used in a trade or business
b. Only applies to equipment. This does NOT apply to real property/buildings.
c. When you sell a depreciated asset, the amount you gain attributable to depreciation must be treated as ordinary
income. Any amount over that is treated as capital gain.
EXAMPLE: Purchase tractor for $100. AB is now $40 due to depreciation. If you sell it for $120K,
$20K capital gain, $60K ordinary income (recapture). If you sell it for $80K, $40K is treated as
ordinary income (recapture)
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D. Capital Gain Attack Plan
1. Is the property inventory?
- if yes, the gain or loss is treated as ordinary income/loss
2. Is the property for business (real or depreciable)?
- Any recapture § 1245
- Anything above recapture is §1231 gain
- All losses are § 1231 losses
- If a net gain, capital gain treatment
- If a net loss, ordinary loss treatment
3. Non-business investment property
- Any recapture § 1245
- Anything above this is capital gain
4. Losses
- Is it a personal loss (never deductible)
- If for business or investment (for profit), you can deduct the loss
E. Examples
1. Stock (investment) Plane (investment) Widget Machine (business)
Cost - $100 Cost - $100 Cost - $100
AB - $100 AB - $40 (depreciation) AB - $40 (depreciation)
AR - $150 AR - $150 AR - $150
Gain - $50K Gain $110K Gain - $110K
Capital gain of $50 § 1245 gain of $60K (recapture) § 1245 gain of $60K
(sale of prop. Not inventory Capital gain of $50K § 1231 gain of $50K
And not used in business) (sale of prop not inventory (if net gain for tax year)
And not used in business)
XII. TIMING AND CHARACTERIZATION
A. Installment sales
IRC § 453
1. Applies to instances of seller carry-back financing. You get annual payments plus interest
2. Usually shows up in land transactions
3. You are only responsible for a % of the gain on each year’s payments
4. Can be used so long as at least 1 payment is not made in the taxable year
5. This gain is treated as capital gains
EXAMPLE: AB in land of $500K. Sell land for $800K. Buyer makes payments over 10 years. You have
$300K capital gain. You do not need to pay it all up front. Instead, 3/8 of each payment you pay capital
gains on. ($300K gain / $800K sale price)
6. § 453 treatment does not apply to:
- Inventories
- Publicly traded stocks
7. Closely related persons
IRC § 453(e) - If you sell property to a closely related person on the installment method and within 2 years they sell
it and get cash, you are taxed as if you got the cash.
EXAMPLE: You have land AB $10K worth $1M. You want the cash, but not to pay tax. Sell it to sister on
“installment” method for $1M, due and payable in 10 years. Sister’s basis is $1M, sells it for $1M - no
tax. Now the sale proceeds and tax liability are imputed to the original seller.
B. Imputed Interest on Installment Sales
IRC § 483 - Congress will tax on interest, even if not earned for agreements to pay $X Y years from now for the right to
occupy right now.
1. To figure out how much interest will be imputed to the seller,
- Get the number of years of the agreement, e.g. 30
- Find the appropriate interest rate for 30 year loans (in a table)
- Take the payment due at the end of 30 years and back out along the lines of the table
- Result is the AB for the property at the time of “sale” to the buyer.
2. Congress controls when interest accrues, when the buyer gets the deduction, and when the seller gets gross income
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- They are forced to both use the accrual method.
3. Now, the seller MUST include interest as gross income every year even if he collected none
Buyer can deduct the interest amount, even though not paid
4. Limits on § 483
a. If the amount of principal is under $500K, there are some limits as to how much must be included when
b. If the amount of principal is under $250K, these limits do not apply.
- Simply pay tax when you get the income from the sale.
EXAMPLE: Property of AB of $100K. Sell for 10 annual payments of $1M each. Using equations, find that FMV today
is $6M and $4M will be allocated to interest. So, the seller will get taxed on $590K ($10K is basis) a year
capital gain and $X for interest, as ordinary income.
C. Property transfers in connection with Services
1. An employee must pay income tax on property received in lieu of salary
- If the employee receives a non-vested stock option, he pays the tax later because he does not have the stock yet
2. IRC § 83 - If you get property from services but it is restricted, it is not taxed until the restrictions lapse
3. IRC § 85(d) - If you wish to pay the tax now on restricted property, you may do so.
NOTE: There is no deduction if you later forfeit your right to the property.
4. This was popular with start-up companies. Often people elected to pay the taxes now.
XIII. EDUCATIONAL EXPENSES
A. Education covers lots of areas of taxation, and is sprinkled throughout the code.
B. IRC § 127 Employee Education Assistant Program
- If your employer will pay for your college, you can exclude up to $5250 of the amount they pay from your gross income
C. Scholarships
1. Qualified Scholarships are not gross income
Only covers tuition and related expenses (books)
- No room & Board
2. Athletic scholarships avoid being gross income because they are not compensations
- You get a scholarship for 1 year. If you play football great. If you do not, we may not renew next year
- if you stop playing mid-year, they must keep the scholarship to you for full year.
D. IRC § 529 Educational IRA’s
E. If already in profession, you can deduct education expenses
e.g. LLM degree for an attorney
F. Tax credits for children in college.
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