TAX outline ........................................................................................................................... 1
I. INTRODUCTION.................................................. 1
A. Government taxes as means to provide income for the
country so that it can do its business. Amount it
collects is a product of two things:..................... 1
B. Three goals of tax system:............................... 1
C. Important Tax Terms/Economic Concepts.................... 1
II. GROSS INCOME INCLUDES INCOME FROM WHATEVER SOURCE UNLESS
EXCLUDED UNDER CODE (§61)..................................... 2
A. Glenshaw Glass - defines income as anything that increases
an individual’s net worth that is an“undeniable accessions
to wealth over which the taxpayer has complete dominion.” 2
B. Found money is taxable. Cesarini........................ 2
C. § 101 begins exceptions that are carved out of GI. (§§
119 & 132) exclude certain fringe benefits even though
§61(a)(1) states that compensation for services is
taxable, including fringe benefits:...................... 2
D. Imputed Income is income that is imputed to services one
does for himself and is excluded from GI: Involves
following situation:..................................... 5
E. Windfalls and Gifts: Gross income includes all things
that are an “accession to wealth.” §61................... 5
F. Recovery of Capital: Recovering amounts expended to earn
income -- Income does not include returns or recoveries of
one’s capital............................................ 6
G. Annual Accounting: Essentially, our government uses
annual, as opposed to transactional, accounting. This
means that business outlays are looked at in total for the
year, and not on transaction by transaction basis. See
Burnet v. Sanford & Brooks; North American Consolidated.. 8
H. Loans and discharge of Indebtedness:..................... 9
I. Transfer of Property subject to Debt (See Schematic, pg 2-
J. Illegal income, tax-exempt interest..................... 12
III. TIMING ISSUES (DISPOSITIONS OF PROPERTY) SEE SCHEMATIC, 2-4.. 12
A. Analysis................................................ 12
B. Realization and recognition Taxable Events - §1001(a): In
analying gain, need to ask: At what point is gain in an
asset measured, recognized, or “realized?” § 1001(a)
speaks of “gain from the sale or other disposition of
property,” so no gain w/o sale or other disposition. A
realization event is one that makes it possible to
determine gain or loss”................................. 13
C. Computation of Realized Loss or Gain §1001(a) & (b) (See
Schematic, pg 2-4)...................................... 14
D. Basis: Basis is defined as actual or constructive cost of
an asset in the hands of a particular T. Rules for basis
are found in § 1011-1021................................ 15
E. Nonrecognition provisions............................... 17
F. Original Issue Discount (OID): Statutory fix that imputes
interest in situations where one amount borrowed and a
larger amount must be repaid after a certain amount of
time with no stated interest. OID is the difference
between amount loaned and amount paid................... 20
G. Open transactions, installment sales, deferred sales,
constructive receipt.................................... 22
H. § 83 Receipt of property for services -- Focus primarily
on property other than cash............................. 24
I. Divorce Four issues: alimony, child support, property,
dependency deduction.................................... 25
J. Cash and Accrual methods of accounting.................. 28
IV. PERSONAL DEDUCTIONS:......................................... 29
A. When T incurs an expense, 3 things can happen:.......... 29
B. Personal exemptions, casualty losses, medical deductions 30
C. Charitable Contributions - §170......................... 31
D. Interest, taxes, personal and dependency exemptions,
personal tax credits.................................... 33
E. Taxes and Personal Tax Credits: As a general rule, the
following taxes are deductible in the year paid:........ 34
F. Mixed business and personal deductions §183: If mixed
activity with profit motive but also personal use, then
deduction allowed to extent of income generated (same as
wagering loss).......................................... 36
G. Hobby Losses, home offices, etc......................... 36
H. Commuting, travel and entertainment (see IRS printout).. 37
I. Miscellaneous........................................... 40
V. BUSINESS DEDUCTIONS.......................................... 42
A. Expense v. Capital expenditure (See schematic 6-8)...... 42
B. Depreciation, amortization and depletion (522-32) See
schematic, pg. 6: Depreciation is an attempt to match
consumption with income - recover cost over life of the
C. Tax Shelters (532-34, 542-46, 548-53, 559-61, 568-72)... 45
VI. SPLITTING OF INCOME/ASSIGNMENT OF INCOME..................... 46
A. Assignment of income from services (573-91)............. 46
B. Assignment of income from property (591-603)............ 46
VII. CAPITAL GAINS AND LOSSES (SEE SCHEMATIC, PG 5)............... 47
A. General Issues.......................................... 47
B. Disadvantageous treatment............................... 49
C. Recapture of Depreciation - §1245 & §1250............... 49
D. Sale of a business...................................... 50
1. Always argue TP and IRS positions
2. Always look at the TP’s tax bracket: variable that may affect TPs decisions
A. Government taxes as means to provide income for the country so that it can do its
business. Amount it collects is a product of two things:
1. Tax Rate (percentage of income taxed) X Tax base (number of people taxed)
(see extended formula on schematic, pg. 8).
B. Three goals of tax system:
1. Efficiency: Tax system shouldn’t’ interfere with decision making on part of
a. Reality is that tax increases/decreases will affect people who are at the
2. Fairness: Need both horizontal and vertical fairness
a. Horizontal fairness means if two taxpayers earn same amount, then
should be taxed equally.
b. Vertical fairness means if one taxpayer earns $30K and the other $300K,
then higher paid should pay more in taxes.
i To some, satisfying vertical fairness requires graduated tax rate,
where first part taxed at one rate, next part at a higher rate, and on
up until the highest tax rate is reached. (§1)
a. To determine tax, need three things needed:
i Gross Income (§61)
ii Adjusted Gross Income (§62)
iii Taxable Income (§63)
C. Important Tax Terms/Economic Concepts
1. Basis - T’s original investment in the property (cost of the property). This
amount determines depreciation deduction and gain/loss.
2. Adjusted basis - Basis plus or minus adjustments that are necessary to reflect
T’s un-recovered investment in the property at the time the adjusted basis is
3. Realization - an event has occurred whereby the TP may be able to take a loss
or a gain as a result of the event
4. Amount realized - cash rec’d plus FMV of any other prop received by the TP
5. Gain/loss - difference between adjusted basis in the prop and amount realized
6. Recognition - The gain or loss realized is taxable as a recognized gain or loss
(something can be realized but not recognized - provisions of Code determine
what is and is not recognized).
7. Depreciation/Cost recovery - recovery for the cost of an investment used to
earn income. The cost is spread out over the (expected) life of the investment by
way of depreciation deductions. Method is statutorily prescribed.
8. Deferral - a tax liability deferred to the future enables the TP to use/invest the
amount that would otherwise be taxed.
9. Time-Value of money - generally, a dollar received today is worth more than a
dollar received tomorrow because a dollar today can be invested. The “present
value” of one dollar to be received at some future time is the amount of money
that would have to be invested today to generate a total of $1.00 (initial
investment plus accumulated interest) at the end of the time period in question.
a. FV=PV(1+r)n or PV=FV/(1+r)n - PV=present value, FV=future
value, r=interest rate, n=number of years
10. Taxes affect behavior - taxes can determine the behavior of consumers; Cong
uses the tax code to try to encourage/discourage certain types of behavior.
II. GROSS INCOME INCLUDES INCOME FROM WHATEVER SOURCE UNLESS
EXCLUDED UNDER CODE (§61)
A. Glenshaw Glass - defines income as anything that increases an individual’s net worth
that is an“undeniable accessions to wealth over which the taxpayer has complete
1. Actual holding of the case - punitive and compensatory damages for lost profits
B. Found money is taxable. Cesarini.
C. § 101 begins exceptions that are carved out of GI. (§§ 119 & 132) exclude certain
fringe benefits even though §61(a)(1) states that compensation for services is
taxable, including fringe benefits:
1. Under § 119, meals or lodging furnished for the convenience of the employer,
his spouse or dependent(s) pursuant to employment is not taxable (See
Benaglia (holding that the value of housing provided to hotel manager was not
taxable because it was done for the convenience of his employer and was
pursuant to his employment).
a. Does not apply to self-employed (See handout example below)
i -GH operates a dairy farm on which he works full time with the
assistance of hired labor. Farm makes a net profit of 50k per
annum. To house his family he spends 10k per annum. He is a
40% bracket tax payer. Assume every dollar earned is taxed at
40%. Tax payer will be taxable on 50k with no deduction on
housing. So he pays 20k in tax and 10k must pay for housing. Net
ii 119 only applies to employees, not to self employed people.
Could apply to a partnership or any situation where taxpayer is an
iii Every job could conceivably do this. There is incentive for both
the employee and employer by sharing in changing the overall
amount paid to the employee, --In most situations it won’t work.
b. Must be on business premises and must be for convenience of
2. Under § 132, additional fringe benefits are made tax exempt. They include:
a. (b)(1): No additional cost service - Any service provided to the
Employee if the same service is:
i routinely offered for sale to customers, and
ii the Employer incurs no substantial additional cost (and forgoes
no revenue - could have sold to customer) in providing the
iii Must be offered in a non-discriminatory manner to all employees.
iv Spouse and dependent child treated the same as Employee.
v Example: Airline lets stewardess fly standby for free. (If airline
facts, always cross with 132(h)(3) - if parent of Employee uses,
same as Employee using.)
b. (b)(2): Qualified employee discount: Any discount extended to
employees for the purchase of goods or services offered to customers, to
the extent that such discount does not exceed:
i )in the case of property, the gross profit percentage of the price at
which the Employer is offering the prop to consumers
(essentially, Employer still covers cost of prop),
ii in the case of services, a 20% discount.
iii Must be offered in a non-discriminatory manner to all
iv Spouse and dependent child treated same as Employee.
v Example: Dept. store allows employees to buy goods at 10%
discount. As long as Employerr recovers cost, Employee not
taxed. If discount exceeds gross profit percentage (Employee
gets 30% discount, but Employer only realizes 25% profit), then
5% of the price at which item is being offered to the public is
includable in Employee’s income. Same applies for excess of
20% discount for services - 20% of price is excludable, all else
included in GI. (No cliff affect; counters IRS argument exceed
so lose all.)
c. (b)(3): Working condition fringe: Prop or services provided to
Employee to the extent that, if the Employee paid for such prop or
services, the payment would be allowed as a deduction under §162 (trade
or business expenses) or §167 (depreciation).
d. (b)(4): De minimus fringe: Property or service the value of which is so
small as to make an accounting for it unreasonable or administratively
i Meals, money for meals or local transportation fare are
excluded from GI as a de minimus fringe if the following are
i provided on an occasional basis,
ii provided because the Employee is working overtime, and
iii in the case of meal or meal money, it is provided to enable the
Employee to work overtime.
ii If meal/money/fare is calculated on the basis of number of hours
worked, i.e. $1 for every hour over eight hours, then not a de
e. (b)(5): Qualified transportation fringe: Transit pass, qualified parking
(on or near business premises) or commuter highway vehicle (van that
seats at least 6)
f. (b)(6): Qualified moving expense reimbursement: Payment or
reimbursement by Employer for Employee’s moving expenses are not
included in GI, only if Employee could have deducted the expenses
under §217 (moving expenses in connection with the commencement of
work as an Employee or self-employed in a new principal place of work
at least 50 miles away from former place of work or residence)
g. (b)(7): Qualified retirement planning services
3. Old Colony case: T enters into agreement with employer to pay salary and
federal income taxes on salary due. He reported salary and not taxes. When
IRS sued for deficiency, ct held taxpayer taxable on indirect benefit he received.
Therefore, even if taxpayer doesn’t receive a direct benefit, he may still be
subject to taxation upon receipt of an indirect benefit.
a. Only one layer of taxation, so not taxed on benefit received when
employer also pays tax on tax.
4. Reimbursements for medical expenses under employer provided accident/
health insurance plans §105 and employer contributions to accident and
health plans §106 are excluded.
5. §79 Group term life insurance purchased for employee is excluded up to
a. §125 Cafeteria plans where employee chooses among variety of
noncash, nontaxable benefits or chooses to take cash (which is taxable).
Note: Just because cash is an option doesn’t mean that the non-cash
benefit is taxable.
6. Frequent flyer miles are excluded because too difficult to value.
D. Imputed Income is income that is imputed to services one does for himself and is
excluded from GI: Involves following situation:
1. Two taxpayers, A & B. A lives in his home worth $1million while B rents his
million dollar home to C for $100K. B has $100K in rental income that is
taxable, which is taxable. C also has $100K in expenses for the rental that isn’t
deductible. Issue is that B is paying more in tax than A even though both
similarly situated. To impute income to A simply means to impute the value of
his home as income.
a. CF. Rev. Rul. 79-24, which says that if you exchange something for
something else, then the exchange is taxable to both parties.
i E.g. A & B exchange services worth 50K each. Basically, as
soon as some exchange for services, then subject to taxation.
Essentially measures difference in value of service received and
E. Windfalls and Gifts: Gross income includes all things that are an “accession to
1. Punitive Damages are taxable, see Glenshaw Glass Co.,71.
2. Prizes and Awards are specifically includable under §74.
a. See Commissioner v. Duberstein, 75. In Duberstein, two guys worked
together on some deals. One appreciated the efforts of the other so much
that he gave him a Cadillac. He wrote the gift off as a business expense,
but the other person did not report it as income. But since the car was
treated as a write-off by one party, the court held that it was
compensation to the other, since it was not given out of detached and
disinterested generosity, which is the test for a gift.
b. Restrictions on prize important in determining value. If none, then value
c. The only way to exclude a prize/award from taxes is donate it in the
i Must be for altruistic purposes;
ii No future services;
iii And transferred to governmental unit or organization described in
paragraph 1 or 2 of § 140(c) (essentially not for profit
organization). This essentially enables T to get credit for
donation without claiming it as income.
3. Gifts: Gifts are specifically excluded under § 102, but need to determine
donor’s intent (see test, above).
a. Generally relegated to family
b. §102(1) Gifts in employment context: Anything coming from
employer usually cannot be a gift. See also §274(b)
i Employer gets no deduction for gifts over $25.
c. Income derived from gifts is not excludable, §102(a)
i E.g. Dividends from stock given as gift. If dividend itself is the
gift, then that gift of income is taxable.
4. Scholarships for tuition are ok to the extent they are for tuition, books, fees and
supplies not condition on teaching.
F. Recovery of Capital: Recovering amounts expended to earn income -- Income does
not include returns or recoveries of one’s capital.
1. Basis: Under §1012, basis is the “cost” of property “adjusted as provided in §
1016.” Three different situations:
a. Cost basis: Property has a basis equal to its cost.
b. § 1015: Gift Basis -- Donee’s basis is the same as the donor’s basis
(substituted basis). See Taft v. Bowers, 95, holding that donee takes his
donor’s basis in stock and is taxed on the entire gain realized when the
stock is sold, not simply the amount of gain occurring during the time
donee held stock. Exception:
i IF at time of gift the donor’s basis is greater than fmv of property
(so that donor would have a loss if sold or trade property), then
for purposes of computing the donee’s loss (but not gain) on any
subsequent sale, the donee’s basis is the fmv at the time of the
c. Date of death Basis § 1014: FMV at time of decedent’s death
2. See Inaja Land Co. v. Commissioner, 106.
Facts: T paid $61K for 1236 acres of land. LA began polluting, so T threatened to sue. Two settled
for $50K. Issue is whether money paid was income for tax purposes. T said $50K was partial return
of capital. IRS argued $50K fully taxable because it was payment for an easement (rent). Ct. held
that payment should be treated as recovery of capital. Essentially three options:
a. T argument: Treat entire payment as recovery of capital;
b. IRS argument: Treat payment as rental income, so all taxable;
c. Middle ground: See tranx as T selling part of property and taxed
accordingly. Therefore, basis should be apportioned -- thus basis of
easement needs to be determined and T would be taxed on difference b/n
50K & whatever basis is agreed upon for the easement. This is the
position the court favored, but too much uncertainty in calculating value
of easement. Thus, court allowed Inaja to treat entire amount as recovery
of capital, since indeterminate amount.
3. Life insurance: Gross income doesn’t include money received under insurance
K if paid by reason of death of the insured (§101).
a. In policy transferred, however, purchaser can’t exclude.
b. Insurance dividends are not taxable
c. Corporate Owned Life Insurance (janitor’s insurance, prevented by
Code). See notes, Sept. 15.
i Tax payers could do this so long as the insurance didn’t exceed
50k, so they took them out on their workers and borrow against
the policies to pay the premiums. We’ll look at such a case: Winn
4. Annuities: Exclusion Ratio: Gross income does not include that part of any
amount received as an annuity which bears the same ratio to such amount as the
investment in the contract bears to the expected return under the contract. §
72(b) (Investment in K divided by Expected return)
i Investment in K = aggregate amount of premiums or other
consideration paid for the contract minus aggregate amount
received under the contract before such date, to the extent that
such amount was excludable under gross income. §72(c)
ii Expected Return: IF depends on life expectancy, then compute
based on actuarial tables; if not, expected return is aggregate of
amounts receivable under K as an annuity.
Annuity Hypo (pg. 115): A is 62 and invests $100K in annuity. Life expectancy is 20
years (Regs. § 1.72-9). What should insurance company be willing to pay? Assume $9K/year for 20 years. Is it
taxable? Yes (72(a)) How much? Using exclusion ratio formula, investment in K ($100K) divided by
expected return ($180) = 55.55%. Ratio is applied to each payment received, thus, from each 9K payment,
55% (5K) would be taxable. If A dies before twenty years, then entitled on final tax return to deduct portion of
investment not recovered. IF lives more than 20 years, then entire 9K after that includable as income.
5. Gambling winnings and losses
a. Gambling winnings go into GI, but losses are only deductible to the
extent of gambling winnings.
6. Recovery from Personal Injury (§§104-106)_Gross income does not include
recovery for personal injury or sickness so long as it takes the following form:
a. Worker’s compensation;
b. Damages (as long as not punitive);
c. Accident & Health Insurance: GI does not include employer provided
coverage under an accident or health plan § 106.
d. Structured settlements: -we draft so that the amount received is treated
as a tort recovery. Tax payer given two choices. 1 million now or 1.1
million one year from now. We’re in a world where the interest rate is
10%. So the 1 million now is tax free, and he earns a return of 10%.the
100k is taxable under 61. In the alternative where you get the 1.1 a year
later, the plaintiff is all excludable under 104a2. Our defendant can earn
100k on the money. They earn the million from whatever source and
pays it out in the first example and then doesn’t pay any tax. In situation
2, the result is the same
G. Annual Accounting: Essentially, our government uses annual, as opposed to
transactional, accounting. This means that business outlays are looked at in total for the
year, and not on transaction by transaction basis. See Burnet v. Sanford & Brooks;
North American Consolidated
P.125 Burnet v. Sanford and Brooks
-Sanford had a contract to do something in the Delaware river. In 1913-1916, they added payments
made under the contract under GI. In a couple of years expenses exceeded payments, so they showed
net losses of 176k in 1916. Then in 1915, the contract is abandoned, so they brought a claim for breach
and recovered 176k in 1920. The issue is whether that is taxable in 1920. This would not be taxable if
seen as recovery of loss. It would be taxable under the annual accounting system. Annual accounting
method wins, therefore its taxable
1. Post Sanford and Brooks, since annual accounting is unfair we have rules to
relax, such as § 172, saying that you may deduct your NOL(net operating loss).
a. It can now be carried backward and forward until used up, as seen in b.
P.130, the chart in problem 4. 97 we have an NOL of 3k. We can carry
back two and forward 20. You generally carry it back as far as you can.
So you take the loss and file and amended return for 95. so you now take
part of your NOL and offset the 400 you owed for that year. That means
you get a check. Can even get a quickie refund. 700 used in 96. then use
the 1900 going forward from 98.
i not every expense goes into NOL. In general business
deductions do go in and personal deductions do not. If I suffer a
casualty loss I cannot carry that to another year.
2. North American Consolidated
North American Oil--. Earn 2 mill income in 1916. But there are strings attached. We are on gov
property and they said its our money not yours. We got the money in 1917 for services rendered in 16,
and the final year we look at is 1922 when we find out that the payer wins. Tax payer wants to report
the income in 1922. The service wants to report the income in 1916. 1916 would make sense for an
accrual tax payer as opposed to cash basis tax payer. Otherwise we would need some kind of
constructive receipt. Until its cleared up, it is kind of like a loan. The tax payer wanted to include this
in 1916 or 1922. but not between. IRS said 1917. There were lower tax rates in 1916, two percent. In
1917 due to war tax rates tripled.
Holding: If T receives earnings under a claim of right and w/o restriction as to its disposition,
he has received income that he goes into GI.
- you are not taxable if you have to pay it back in the end. That would put the resolution in 1922. The
problem is the tax payer has the use of the money and could drag out litigation and make it conditional
with a small chance of forfeit.
-don’t do anything until we have a resolution, then we will act accordingly. That would make it taxable
in 1916 in accrual, 1917 if a cash basis. The problem is no tax return could ever be closed
-do third year as closely as possible. 50% chance of forfeiture. Include the half the money. 25% chance
next year and then pay 25%.
-final way is you get the money, you’re taxable, burden is on you. We do this one.
That’s not always the case. If you’re a utility company, you get a deposit, that’s income.
3. Claim of Right Doctrine § 1341: If item was included in GI for a prior taxable
year because it appeared T had unrestricted right to such item; a deduction is
allowable for the taxable year because it was established after the close of such
prior taxable year that T did not have an unrestricted right; and the amount of
such deduction exceeds 3K.
a. E.g. T includes $1 mil. in income in Yr1. In Yr2, he realizes he didn’t
really have the $1mil and must pay it back. Under claim of right
doctrine, his tax would be the lesser of:
i -Tax in Yr3 with a million dollar deduction from income or;
ii a credit for the amount paid in tax for the income
4. § 111-The Tax Benefit Rule: GI does not include income attributable to
recovery of any amount deducted in any prior taxable year to the extent such
amount did not reduce amount of tax imposed.
Eg. tax payer takes a deduction of 100 in year one. In year three tax payer
includes 100. It doesn’t work exactly the same as 1341, rule is an all or nothing,
if you can show that the deduction in year one didn’t do you any good(and you
can no longer take the deduction), then(so we don’t use NOL, cause you can
carry that forward for 20 years). When the 100 comes in in year three, you are
allowed to exclude the 100. If it gave you a little benefit this doesn’t work. So it
is a fairly limited provision. An example of when it could occur is a situation
where you lost money as a result of theft and you took a theft deduction for 100.
later on they catch the perpetrator and you get the 100 back. But you had so
many other deductions that year that you didn’t use it, so it can be used later
a. The tax benefit doctrine requires inclusion of income of amount involved
when events inconsistent with prior deduction occur, unless
nonrecognition applies. See Hillsboro Nat’l Bank v. Comm.
b. Cf. Alice Phelan v. United States (Where donee returned gift to donor
some 20 years after receipt. Donor had already deducted amount of gift
and thus was required to include amount of deduction as income when
H. Loans and discharge of Indebtedness:
1. Depending upon the nature of the relationship, usually when a lender discharges
a debt, that discharge is taxable income unless the debtor is insolvent or in
bankruptcy. See § 108.
a. §108(e)(2): No income is realized from the discharge to the extent that
payment of the liability would have given rise to a deduction.
i HYPO: T = lawyer just starting who agrees to buy supplies from
V for $10K. T promises to pay, but then can’t. V discharges
debt. Supplies that were purchased would have given rise to a
deduction under § 162 (ordinary/necessary expenses incurred in
course of trade or business).
ii N/A to accrual method taxpayers. E.g. MHC is accrual basis T
and has $2mil in paid accounts currently outstanding. Makes a
proposal to borrow more ($2.25mil) to get a lower interest rate.
To determine whether discharge of indebtedness issue, need to
determine present value of $2.25mil ($1.65mil). Difference,
350K taxable income. Can’t deduct b/c as accrual taxpayer,
already deducted $2mil when received services.
b. §108(e)(4)(B)Parent/child relationship, then seen as gift.
c. § 108(e)(5)Purchase price adjustment occurs when debt of a purchaser
of property to seller of such property is reduced and the reduction is not
the result of bankruptcy or insolvency.
i Hypo: B buys car from L for 25K, who also finances. Car is a
lemon, but parties reach agreement where B pays only 15K.
Basis is reduced, but no income. Cf. Zarin v. Commisioner, 149
(holding that gambling chips did not qualify for this section
because they were not deemed “property,” thus no discharge
from indebtedness when Zarin settled with casino for much
smaller amount than owed).
d. § 108 (e)(8): IF a debtor corporation transfers stock to creditor in
satisfaction of its indebtedness, the corp. shall be treated as having
satisfied the indebtedness with an amount of money equal to fmv of
i E.g. 2 million outstanding in 10% subordinated bonds. (get paid
in the event of bankruptcy less than other bond holders).
Exchange for a stock with a mandatory, cumulative dividend of
12. So its worth about 2 million dollars. Holders of the bonds
will accept it even though it will only be valued at 1.7 million.
We are told under 108e8. If debtor transfers stock says they have
relieved it based on what the stock has as a FMV. Here relief is
300K, since FMV of stock is 1.7mil.
ii Parent Company/Foreign Subsidiary: Hypo - USCO has
foreign sub. & makes loan of 100K. Sub required to pay back
but can’t and parent cancels debt. USCO may not take bad debt
deduction, since sub is foreign and can’t be taxed. Essentially
treated as capital contribution and non-event for tax purposes.
e. Loan Default - §166. If a borrower defaults on a loan, she has taxable
income equal to the default amount and the lender has a deduction of the
f. Tax attributes must be reduced based on discharged indebtedness which
is excluded under §108 (see 104(b))
i Net operating loss carryover (NOL) - First attribute reduced.
Loss incurred in day to day business operations; if loss deduction
in one year produces no benefit, then it can be carried over to the
next year and deducted against that year’s income. Discharged
indebtedness must be applied to the carryover. In example
above, TP must reduce any NOL carryover by $600.
ii Reduction in basis - Basis T’s assets must be reduced by the
amount of excluded discharged indebtedness. Really a deferral
because lowering the basis leads to more income later because of
reduced depreciation deductions or increased gain when the
property is sold.
g. Debt forgiven as part of settlement agreement - Revenue ruling 84-
176. TP owes seller 1K, but not paying, so seller sues. TP has
counterclaim for breach against seller. Seller forgives $500 of TP’s debt
if TP pays $500 to seller and drops the counterclaim. (TP trying to say
discharge indebt, and then find exclusion under §108. Not sure which
i Forgiven debt is treated as lost profit damages, thus taxable.
ii IRS views as two transactions:
i TP actually received damages arising out of the seller’s breach,
ii TP paid full amount of the account payable
h. Student loan forgiveness programs - §108(f) - amount forgiven not
included in GI
I. Transfer of Property subject to Debt (See Schematic, pg 2-3)
1. Schematic for analyzing tax issue: 1) §61(a)(3) gain →1001(a) --need a
disposition (sale, get something in return)→§1001(b) adjusted basis (money
received plus FMV of property = amount realized)→§1011 (what is the basis
adjusted as provided in §1016 -- §§1012 (cost), 1015 (gift) or 1014 (death)→
§1016 (adjusted basis) adjust down for depreciation (§1016(a)(2) or upward if
improvements made by investing more in property→§1001(c) Entire amount of
gain/loss recognized for tax purposes unless provision to contrary: 1) § 1033
(involuntary converstion -- take insurance proceeds and invest in similar
property no need to recognize gain, basis same as original property); 2) § 1031
(If piece of appreciate property exchanged for like kind, then no need to
recognize gain. Basis remains same as with original property.
2. A donee’s assumption of gift tax liability is treated as gain for tax purposes. See
3. When relieved of debt, amount realized is amount of that debt whether it is non-
recourse or recourse. See Commissioner v. Tufts, 172. Essentially, nonrecourse
loan assumed for property with FMV less than amount of mortage still qualifies
as relief from indebtedness.
4. Debt included in basis only to extent it does not exceed fmv. IF it exceed fmv,
then cannot count debt at all. See Estate of Franklin, note, pg 170.
a. If no fraud, however, courts split over whether or not to allow mortgage
debt that exceeds fmv to count as basis. See e.g. , Pleasant Summit Land
Corp. v. Commissioner, pg 171 (holding that nonrecourse debt exceeding
fmv of property could be included as basis where purchaser received
from third party and not seller).
J. Illegal income, tax-exempt interest
1. Gross income does not include interest on any state (including DC and
possessions) or local bond. §103
a. Exclusion is a subsidy which allows govts. to compete in the market.
But its a leaky subsidy, because it only benefits investors. Whether an
investor will choose a govt. bond over a private bond will depend on the
investor’s tax bracket.
i Ex: Investor in 40% bracket. Can buy a GA bond for 8% or GM
bond for 10%. The TP would be willing to buy a GA bond as
low as 6%, but receives a benefit because receiving an 8% return.
(100 bond - if taxed on 10, then gets only $6, if not taxed, gets $6
at 6%; $8 at 8%)
i Arbitrage bonds not exempt under §103(b)(2): Arbitrage -
state takes the $ from sale of bonds and invests in corporate
bonds, the interest from which the state doesn’t pay taxes (§115 -
states not taxed on their income).
ii Private Activity Bonds limited by §103(b)(1): Private activity -
State issues bonds to construct building, then leases the building
to a private entity for amount which is enough to cover principle
and amortization. Benefit is passed to the private entity because
it now has a building which is essentially financed at a rate less
than the market rate.
i Must be a “qualified bond.” (Enterprise zones qualify.)
iii §265(a)(2) - No deduction allowed for money borrowed to
purchase tax-exempt security
2. Illegal income is included in GI (it is an undeniable accession to wealth).
III. TIMING ISSUES (DISPOSITIONS OF PROPERTY) SEE SCHEMATIC, 2-4.
1. Has a taxable event (realization event) occurred?
a. Sale, exchange or casualty but not;
b. Gift, inheritance, transfer on divorce or charitable contribution.
2. What’s the amount of the gain or loss - difference between amount realized and
3. Is the gain or loss recognized? - Presumption is yes unless disposition falls
within non-recognition provision.
4. If recognizable loss, is it allowable?
5. What’s the character of the gain or loss - ordinary or capital?
B. Realization and recognition Taxable Events - §1001(a): In analying gain, need to
ask: At what point is gain in an asset measured, recognized, or “realized?” § 1001(a)
speaks of “gain from the sale or other disposition of property,” so no gain w/o sale or
other disposition. A realization event is one that makes it possible to determine gain or
1. Sale of property is always a realization event
2. Exchanges of property - Realization event occurs if the properties exchanged
are materially different. Properties are materially different if the owners of the
properties enjoy legal entitlements that are different in kind or extent. Cottage
Savings (broad category - just about anything will fit in)
3. Losses: Once a loss materializes, the T has a realization event. See Cottage
If you lend 100k at 6 percent, your basis is 100k, your cost basis is your basis 1012.
Banks bundle mortgages together then they sell them or keep them. Interest rates went up so the value
of the mortgages went down. So they generate a loss by selling at a lower price and they may want to
rent out money at a higher rate. They had a loss as soon as interest rates went up, so they might as well
want to actualize it. So this bank swaps the mortgages for another bank’s bag of mortgages. This
transaction would not be entered into in a normal situation, as if it generates a loss that must be
reported to their share holders they’re not going to want to do it even if they get a tax benefit for it.
Here they didn’t have to report it for financial purposes but still get the tax benefit.
-IRS argues that there has not been a realization event, tax payer says I have a 30k loss which I can use
to offset, court goes with tax player by saying this is a realization event. So there is a very low
threshold for realization events. That is the point of this case. What wouldn’t be a realization event?
If I had corn in a silo and I swapped it with someone who owns corn in the same silo, here the bundle
of mortgages is a little different. But the tax payer even with the realization still needs a provision
giving them a right to deduct the loss. Here it would be 165.
a. Cottage Savings sets low standard for realization event. But even if
there is a loss, must still have a provision allowing deduction for loss.
Here, it is § 165.
4. Mere appreciation does not equal a taxable event, See Eisner v. Macomber
(holding that receipt of stock does not constitute a realization event where stock
distributed after increase in par value).
a. Applies even if stock dividend. Realization occurs only if cash given.
5. Helvering v. Bruun. IN this case, Supreme Court said that landlord realized
income as soon as tenant who had erected improvements on property vacated.
a. § 109 changes this result to the extent that the landlord could defer the
gain until he sold the property. Under the section, GI does not include
income (other than rent) derived by a lessor of real property upon
termination of the lease, representing the value of such property
attributable to buildings erected or other improvements made by the
6. Receipt of proceeds for non-recourse loan secured by T real property not a
realization event even if money not used for property. See Woodsdam
109 Realization HYPO: -landlord has asked for our suggestion, his 132 unit motel leased to B
unfurnished with a 15 year lease at 300k, plus 6 percent of gross rentals and receipts in excess of 250k.
Article 18 of the lease provides that the lessee must erect a structure of a nightclub. It is estimated to
have a life of 40 years and will cost 400k to construct. He shall also within 6 months equip the lease
premises with furnishing, fixtures, and stuff. Lessee has no obligation to make any further
improvements. It is the intent for B to maintain it as a first class motel, on termination of the lease
everything goes back to the Owner. Resort complies, now Owner gets it all back and operates the
whole facilities. Shortly after taking possession, resort adds a cabana bar, life of 30 years, cost 75k,
worth 40k. We must figure out the tax consequences of the termination of the lease.
-Cabana There is no reference in the lease to it at all thus, it clearly was not anticipated. IF there is no
such evidence, then 109 will apply to it.
-night club: 109 here doesn’t apply;it’s a rent substitute, how do you show that its not a rent
substitute? It is because the lease lasts 15 years, the building, lasts 40 years, the other 25 goes to the
landlord. Nobody builds something to last if they don’t have the property that long. On the other hand,
tax payer will have to show that in fact the rental payments called for under the lease are arms
length. Bring in comparables and all. If it were deemed to be a rent substitute theoretically it
should be taxable at the end of the lease, but there is a problem in valuing the residual value at the
end of 15 years, so the IRS has, and 109 anticipates that the value will be taxable when the lease
concludes cause we’ll have better info then.
-the personal property 109 says that the value of such property attributable to buildings erected or
other improvements, before we get to the rent substituted issue, is this a building erected or other
improvements? Its an improvement but the regs say that……don’t know, check…..doesn’t say,
probably would come down to whats bolted to the floor….whats part of the real property. So most
of it wouldn’t qualify. Then if you determine that it is a rent substitute, you go into the valuation
issue. If it is includable as it is not an improvement within the meaning of 109 or it is a rent substitute
and is therefore included, the amount is probably 125k. the argument would be that its not the totalitiy
of it, its just the value of what I get that’s not in place.
C. Computation of Realized Loss or Gain §1001(a) & (b) (See Schematic, pg 2-4)
1. Gain/loss is difference between adjusted basis in the prop and the amount
a. Amount realized - cash rec’d plus FMV of any other prop received by
the TP + recourse liability if T is discharged as result of disposition +
non-recourse liability to which property is subject (Crane) minus
b. Adjusted basis - Original basis - amount of depreciation allowed + cost
of improvements made (if any) §1016.
i Hypo 1 - A 300/1000 & B 500/1200 exchange property
i A has a gain of 900, and A’s basis in the new property is 1200
ii B has a gain of 500, and B’s basis in the new property is 1000
ii Important principles
i Cost must be amount realized for tax purposes (justification for
A & B’s basis in newly acquired property)
2. Once event takes place qualifying as realization event, then compute gain
under § 1001. Then question is whether to recognize gain or loss, §1001(c).
a. If loss, must be provision that allows loss to be deducted (§165).
i Bad Debt Loss § 166: Special kind of loss for bad debt. If
house sold at loss, then non-event for tax purposes, but if part of
trade or business, then can be realized.
D. Basis: Basis is defined as actual or constructive cost of an asset in the hands of a
particular T. Rules for basis are found in § 1011-1021.
1. Cost Basis, § 1012: Cost in its accounting sense is usual starting point for
determining basis. In swap of unequal property, 2 parties involved will each
wind up with different basis; party getting better end winds up with higher basis,
measured by value of asset he gets. Other party gets lower basis for less
valuable property received.
2. Carryover Basis -- Some transactions are “nonrecognition” transactions and no
gain or loss results even though realization event takes place:
a. Basis in property acquired by gift - §1015
i General rule - Transferred basis: basis stays the same. Upon
transfer of a gift, the donee’s basis in the gift is the donor’s basis
at the time of the transfer.
ii Exception to general rule if loss upon disposition. - For the
purpose of computing loss, if the donor’s basis is greater than the
FMV of the prop at the time of the gift, the donee’s basis shall be
i Bouncing basis phenomenon - if FMV is used as basis, and the
disposition yields a gain, the transaction enters the nether world
of the bouncing basis. Because gain now realized, don’t use
FMV, but donor’s basis, but when donor’s basis is used, it
yields a loss, so you use FMV, but FMV . . . and so on into
infinity. When this occurs, there is neither a gain nor a loss.
ii Upon disposition where FMV is used, if amount realized is a
loss, then no bouncing basis phenomenon.
iii Hypo - Mom 1K/300Son. If son sells prop for 299 or less,
then his basis is deemed to be 300 and son takes a loss. If son
sells for 301 or greater, however, neither gain nor loss -
bouncing basis phenomenon.
3. Stepped-up Basis: When property received from decedent, basis becomes
FMV at time of death. § 1014. If greater than decedent’s basis, then “stepped-
up” basis. IN effect, increased value never taxed.
a. Great planning provision - if have prop with low FMV, give it to your
grandparent, and then have them will it to you - BUT 1014(e) is a
b. Transfer within year before death exception to the general rule -
§1014(e). If appreciated property was acquired by the decedent within
one year of his death, and prop passes from decedent to original donor,
the donor’s (now donee) basis is the decedent’s adjusted basis in the prop
(essentially gift rule).
a. General rule - Mortgages, whether recourse or non-recourse, are
included in basis and are depreciable under §167 if the prop is used in a
trade or business or is held for the production of income.
b. Crane rule - amt realized by the seller of mtged prop includes both cash
rec’d from the buyer and face amount of the mtg to which the prop was
subject (regardless of whether mtg recourse, or non-recourse).
c. Depreciation - For mtged prop that falls under §167, loss/gain is
difference between adjusted basis (basis minus depreciation) and amt
realized (cash plus balance on the mtg). Release from mtg liability can
constitute amount realized.
i Ex: P purchases prop for 273K (assumes mtg of 273K).
Depreciation deduction of 45K allowed, and P pays 14K on the
mtg. Prop then sold for mtg balance - 259K (new purchaser
assumes the mtg). Adj basis is 228K and amount realized is
259K, thus gain is 31K.
d. Tufts Rule - Upon disposition of property subject to a non-recourse mtg
where the FMV of the prop is less than the amount owed on the mtg, TP
still treated as if relieved of full mtg amt, even though on non-recourse
loan mtgee could not get more that the FMV of the prop.
i Rationale is consistent with allowing TP to include non-recourse
loan in basis when prop purchased.
ii Basis is always limited to FMV of prop - don’t want TP to
benefit from an inflated depreciation deduction.
e. Recourse v. Non-recourse and cancellation of indebtedness
i Relief of the obligation to repay a non-recourse loan is treated as
ii Relief of obligation to repay a recourse loan is bifurcated into
cancellation of indebtedness and gain.
i Ex: 100K/100K w/100K mtg. FMV declines to 75K and
depreciation of 40K = 60K/75K. If default occurs and lender
forecloses, amount realized is 40K.
1. Non-recourse loan - 40K is gain (Tufts)
2. Recourse loan
a. Discharge of indebtedness is difference between amt owed
and FMV - 25K.
b. Gain is difference between adjusted basis and FMV - 15K.
f. Statutory analysis - Prop initially 100/100, but goes up in value to 190K
and 10K depreciated.
i Original cost (§1012) - 100K
ii Addition to basis (§1016 - amount pd on mtg) - 0
iii Depreciation allowed (§167) - 10K
iv Adjusted basis (§1016 - cost minus depreciation) - 90K
v Amount realized on disposition (§1001(b)) - 190K
vi Gain (§1001(a) - difference between adjusted basis and amount
realized) - 100K
5. Part gift/part sale (conditional gifts/bargain sale)
a. Principle of Tufts rule applied - if encumbered property is transferred as
a gift, and the donor of the prop is relieved of the encumbrance, donor
has realized a gain. Donee’s basis must be adjusted accordingly
(designed to prevent families/friends from taking advantage of the
b. Transferee’s Basis - Tres.Reg.§1.1015-4
i Where transfer of prop that is part gift/part sale, transferee’s basis
is the greater of:
i amt paid for the prop, or
ii transferor’s basis at the time of the transfer,
iii plus increase in the basis, if any, for payment of the gift tax.
ii For determining loss, transferee’s basis shall not be greater
than the FMV of the prop at the time of the transfer.
c. Ex: Mom 60K/120K Son for 90K. Mom realized a gain of 30K and
son has 90/120 prop.
d. Part gift/part sale (bargain sale) to charitable org - bifurcation used - Gift
is divided proportionally. Same numbers as above:
i 90K purchase price is 3/4ths of 120, so 60/120 divided
proportionally - 45/90 is treated as the sale and 15/30 is treated as
ii TP only gets charitable deduction on gift part. Charitable org’s
cost basis is 105K (60-45=15: 90+15=105).
E. Nonrecognition provisions
1. § 1091 (Wash Sale Rule): If sell stock for loss and buy back similar stock
within 90 days, then can realize loss.
a. Hypo: Buy stock for 100 and it depreciates to $10. Can sell and take
$90 loss. Under §165, loss could be realized.
2. § 1031 Exchange of Property held for productive use or investment: NO
gain or loss recognized on exchange of property held for productive use in trade
or business or for investment if it is exchanged solely for property of like kind,
which is to be held either for productive use or for investment.
a. Administrative provision - not a good time to tax the parties - no cash on
hand as a result of the transaction.
b. Like kind defn - Tres.Reg. § 1.1031(a)-1. Like kind is a reference to the
nature or character of the property(held for business or investment
purposes), not its grade or quality. Prop held for trade or business can be
exchanged for prop held for investment.
c. Securities and dealers excluded - Corporate securities are specifically
excluded from §1031 coverage. Likewise, a person in the business of
buying and selling prop doesn’t fall under §1031 - the properties are the
d. Basis formula §1031(d) - orig basis minus boot rec’d plus gain
recognized (unless unrecognized loss, basis in the new prop should be
the same as the basis in the old prop).
e. Provision can apply to one party only (party A currently using prop in
trade/bus or for investment and will use new prop for trade/bus or for
investment, but party B has no such plans). Whether prop qualifies is
determinative, not the exchange.
f. 45 day window for exchange - §1031(a)(3). As long as prop to be
received is identified within 45 days of relinquishing your prop, then fit
under 1031. Parties have 180 days to transfer the last piece of property.
g. Hypo - C has 300/800 prop, wants cash. A wants C’s prop and B want’s
A’s prop. How to structure the deal
h. B buys C’s property - C satisfied because he now has cash. B has
800/800 prop from C (cost basis of 800). A & B exchange - A can take
advantage of §1031.
i. Boot - §1031(b). If like-kind requirement otherwise met, but boot is
received/given, the boot is taxable gain. Boot recognized only to the
extent of the gain.
i Hypo 1 - A 100/800 B 300/700 w/100 boot. A is taxed on
the 100K rec’d.
i A’s basis is 100 - using formula 100 - 100 + 100=100
ii 600 will be recognized down the line (when prop sold)
ii Hypo 2 - A 750/800 B 300/700 w/100 boot
i A has unrecognized loss of 50, but with boot, gain of 50
(remaining 50 of boot is A’s return on investment - reduces A’s
basis in the new building). Taxed on this $50.
ii Basis - 750 - 100 + 50=700K. When A sells the prop,
shouldn’t be taxed again.
iii Hypo 3 - A 100/800 w/100 boot B 300/900
i A not taxed - A’s exchanging like-kind for like-kind and not
ii A’s basis will include the 100K boot, thus 200K basis in the
new property; preserves the 700 K on which A needs to be
taxed when prop sold.
iv Rational analysis - think about unrecognized gain that needs to be
taxed when prop is sold - new basis must preserve this gain.
j. Leaseholds and §1031
i General rule - If transfer includes a premium lease, §1031 will
apply. If lease has no capital value, §1031 does not apply.
ii Jordan Marsh - A has prop 1M/400K - wants to recognize loss,
but needs to retain use of prop. A enters into sale/lease back with
B and takes a loss.
i TP said it was a sale and tried to deduct as a loss the difference
between his adj basis and cash received.
ii IRS said it was a like-kind exchange - long lease for fee w/cash
as boot, thus loss not recognized.
iii Ct. sided w/TP and allowed loss. Determinative factor was
whether leasehold itself had value (premium lease situation).
Ct. found that amount pd was FMV and rents required by the
lease were normal, thus TP did not have any thing of value to
which §1031 could attach.
iii If purchaser pays less than FMV and gives favorable lease, then
§1031 will apply.
i Hypo -B pays 0 for prop and A gets 50 yr lease at below mkt
rent; assume lease has value of 400K because of below market
1. Because rent is below market, A is getting a benefit - A’s right
to pay has a value.
2. §1031 will apply because of 400K value - loss not allowed.
3. Involuntary conversion of destroyed/taken property - §1033
a. Addresses situation where TP takes insurance or eminent domain
proceeds and replaces old prop with new prop. Normally, these funds
would be recognized as gain under §61.
b. General rule - 1033(a). No recognition if, within two years after the
close of the tax year in which proceeds are received, TP replaces the
“involuntarily converted” property with property similar or related in
service or use to the converted property.
i Provision is elective - TP can chose to have the gain recognized
ii Similar or related in service test - more narrow than like-kind
test; end uses of the property must be similar.
iii Basis of the old prop is reserved in the new prop.
c. Statutory stream - income under §61, gain or loss recognized unless
otherwise stated - §1001(c), §1033 says otherwise
d. Hypo: 100/900 - prop destroyed by fire and get 900 from ins.co.
i If spend 900 on new prop, no recognition of 800 gain and basis in
the new prop is 100.
ii If spend 800 on new prop, 100 gain is recognized, but still have
basis of 100K.
4. §121 - Exclusion of gain from sale or principle residence: General rule -
Gain from the sale of a person’s principle residence is not included in GI
a. Principle residence - during the five years prior to the sale, the person
used the prop as principle residence for at least two years in the
i Limitation - maximum amount that can be excluded is 250K for
individuals, 500K for joint return
b. Not a non-recognition provision, its an exclusion provision. Replaced
prior non-recognition provision 1034 which benefited only those who
reinvested the funds from the sale into a new home (discriminated
against people who move from home to apt).
F. Original Issue Discount (OID): Statutory fix that imputes interest in situations where
one amount borrowed and a larger amount must be repaid after a certain amount of time
with no stated interest. OID is the difference between amount loaned and amount paid.
1. Constant-rate basis used - Two aspects:
a. Both parties are treated as using the accrual based method of accounting
b. Transaction treated as if lender receives the interest payment, then re-
lends that amount to the borrower. This re-characterization occurs each
year for the life of the loan. The lender pays taxes and the borrower
deducts the amounts rec’d/paid each year.
c. Ex: Lender loans $6209 to borrower and borrower agrees to pay 10K
in 5 years. What interest rate causes $6209 to be 10K in 5 yrs? - 10%.
i YR1 - parties treated as if lender receives $621 in interest, on
which he’s taxed, and borrower gets to deduct $621.
ii YR2 - debt “increased” by 621 (as if lender gave 621 to
borrower) so outstanding loan is now $6830, on which 10%
interest is paid, etc., etc.
iii When borrower pays 10K, lender not treated as if receiving any
income - lender pd the appropriate taxes during the 5 year period;
its basis in the note increased each year, and in year five basis of
10K equal to 10K received
2. Loans with below market interest rates - §7872
a. Imputed interest rule - interest foregone by borrower is imputed to the
lender. (Forgone interest is based on Treas. Dept. numbers)
b. Applies in three contexts
c. Demand loans/gifts - §7872(a)
i Hypo -Employer gives Employee demand loan of 100K interest
free §7872 re-characterizes the transaction as an arms-length
transaction. Two steps:
i §7872(a)(1)(A) - Parties treated as if Er paid Employee 10K in
compensation (assumes 10% is forgone interest). Employer
will get deduction under §162 and Employee has taxable
ii §7872(a)(1)(B) - Parties treated as if Employee paid back 10K
as interest, giving Employer interest income. Employer taxed
on 10K (so deduction and tax are netted out as to Employer).
Whether Employee can deduct 10K interest depends on what
money was used for; if used for personal, then can’t deduct -
163(h), but if meets investment requirements of 163(d) then
can deduct, thus canceling out income in step 1.
ii Hypo 2 - same as above, but between corp and shareholder.
i 10K of compensation becomes dividend - corp can’t deduct
dividend payment, so will be taxed on 10K interest recd.
ii Combo of shareholder/Ee - from corp standpoint, want to give
to recipient in his capacity as Ee, not shareholder (no taxable
iii Shareholder/child - same as above, but compensation/dividend is
re-characterized as a gift. Parent will have to pay tax on 10K
because gift not deductible. Taxes for child depends on how
money is used. If invested, then can get investment deduction
under 163(d) and income/deduction net out each other.
d. Fixed term loans with below market rate - §7872(b)
i Same rules apply as under 7872(a), but also apply Original Issue
ii Hypo - 100K, 5 year term, no interest
iii Re-characterization occurs - arms-length transaction applying
market rate. 100K loan deemed to be loan for $62,090 (present
value of loan at 10% rate). Difference - $37,910 is treated as
iv YR1 - Employer has 6,290 in interest, Employee has 37,710 in
income, but $6290 in interest that might be deductible, depending
on what it is used for.
v YR2 - no further compensation, but interest pmt of $6830
vi YR3 - interest pmt of $7510, etc. etc. until interest payments
vii Employer gets to deduct compensation of 37K, but when interest
comes in, its taxed.
viii Rationale - economic view - 62,090 can grow to 100K in five
years, giving Ee an extra 37K for whatever use
3. Market discount (see discussion, pg. 43): Applies when person buys an existing
debt instrument at discounted present value rate. No need to account for share
of discount, but taxed at capital gain rate at maturity.
G. Open transactions, installment sales, deferred sales, constructive receipt
1. Installment Reporting - §453
a. Installment sale defined - §453(b). Disposition of property where at
least one payment is made before the end of the taxable year in which the
disposition occurs, and subsequent payments are made on a yearly basis
over an extended period.
b. Installment sale does not include
i Sale of inventories of personal property
ii Dealer dispositions - dealer selling inventory of real or personal
c. §453 General rule - Gains from deferred payment transactions
involving investment property shall be spread out proportionately over
the entire payment period. (Similar conceptually to annuities - recover
investment over a period of years.)
i Formula §453(c) - Taxpayer recognizes as gain (y) for each year
that proportion of the payments rec’d during the year which the
gross profit (realized or to be realized when payment complete)
bears to the K price. Y/pmt recd = gross profit/K price
ii Hypo - 40/100, sold for 100 w/10 down and rest paid over next
nine years. Gross profit is 60, fraction is 60/100 so 1/6 of 10
(6K) will be taxed in the first year. 6K will be recognized gain
for each subsequent year.
d. Recapture income - §453(i). To the extent gain is due to depreciation
recapture, such recapture must be recognized in YR1 (year of
i Recaptured amount is treated as ordinary income in the year of
sale, and is added to the basis of the property for the purposes of
determining the installment method fraction (gross profit/K
e. Sale to a related person - §453(e). Two year time limit on resale to
i Where a seller sells to a related person on a deferred payment
basis, and the related person resells the property for cash within
two years, the original seller is treated as if she received the cash
for purposes of accounting under the installment method.
f. Sale of mtgd prop - mtg is not taken into account for determining
payments rec’d or K price. Tres.Reg.§1.453-4(c).
i Hypo 1: S- 3K/10K, 2K mtg. P puts 1K down, assumes mtg and
gives S note for 7K, which is secured by a second mtg on the
prop, calling for two payments over the next two years of 3.5K.
i Gross profit is 7K - fraction is 7K/8K = 87.5%. $875 of down
payment is taxed, and 3,062.50 of the two mtg payments is
ii Hypo 2: S- 4K/10K, 2K mtg. P puts 1K down and pays 1K
each year, 2-8, assumes mtg. 6K gross profit, fraction is
6K/10K - 600 recognized gain each year.
g. Installment method is automatic, but TP can elect not to use it under
2. Constructive receipt - income is received by a cash method TP when it is made
subject to the will and control of the TP and can be reduced to actual possession.
Case-by-case analysis required.
a. AS long as enter into K calling for payment in subsequent years prior to
performance, then realized in year contracted for (See Minor v. US,
where physician who contracted to have part of his pay deferred to trust,
which purchased an annuity was not taxed b/c company only made mere
promise to pay in future. No constructive receipt, since entered into
ahead of time. NO economic benefit either, since money may be taken
by creditors of corp. See also Amend v. Commissioner (holding that T’s
decision to delay payment was made in good faith, and thus legally
enforceable, so constructive receipt doctrine did not apply).
3. Economic benefit doctrine - income is recognized as received by the TP for tax
purposes because the TP is in a better economic position than prior to the
income producing event See Pulsifer. In Pulsifer, father won money off ticket
with his and his children’s name. While he was paid his share, children’s
winnings were escrowed until they turned 21 or until their guardian applied for
it. Ct applied economic benefit doctrine b/c money essentially available right
now, and there is no risk of loss, thus taxable.
a. Usual situation - Employer sets up fund for Employee, free from any
claims by creditors. Although Employee may not be able to access the
funds, Employee is now in a better position economically.
b. Analysis - key facts
i Creditor’s don’t have access to the funds; if creditor’s have
access, TP’s eventual receipt is not certain, thus no income.
ii If Employer and Employee enter into a deferral agreement before
fund set up/services rendered, then IRS will usually respect the
K. If TP asks for deferral after services rendered, then IRS prob
4. Qualified Employee Plans are excluded: Employers are permitted to establish
qualified pension, profit-sharing, or stock bonus plans that have the following
attractive tax features:
a. Amounts paid into plan not taxed to employees who become entitled to
future benefits by virtue of such payments, even if vested. Taxed only
upon receipt of payment at retirement.
b. If 401(k) plan, not taxable on amount up to $11K per year, even if had
option to take cash.
c. Employer take immediate deduction for amount paid into plan.
d. Earnings on funds paid into plan not taxed except to extent they are
taxed to employees when paid to them.
e. Types of plans:
i Defined benefit plan -- Tells you what you can expect to get
when you retire.
ii Defined contribution plan -- Tells employee that employee will
contribute a certain amount and whatever it grows to belongs to
iii KEOGH plan: Allows self-employed to take income from their
job and invest in KEOGH plan and take deduction for
iv IRA -- another plan for deduction, no tax on contributions, but
taxed when disbursed.
v Roth IRA -- No deduction for contribution, but when money
taken out, not taxes.
5. Tax Policy -- Consumption tax: Presents issue as to whether we should raise
money through income tax or consumption tax. Formula:
a. Y(income) = C(consumption) + S(investment) -- essentially argument is
that we should not be taxed on investment money, so C = Y-S.
b. Basically equates to a sales tax.
c. Can also get consumption tax by allowing deduction for everything not
consumed (stock purchase, savings account, business expenditures, etc).
d. Consumption tax not as effective, so would have to raise tax rate.
e. Allowing deduction for deferred compensation plans or IRAs is element
of consumption tax
H. § 83 Receipt of property for services -- Focus primarily on property other than cash
1. E.g. Employee performs services for employer & employer gives property, then
employee is taxed on difference b/n FMV of property & amount employer paid
for it. Issue is when tax is payable.
2. In particular, want to look at transfer of restricted stock under § 83. As soon as
stock transferable or when it is no longer forfeitable, then it is taxable.
a. Hypo: A→B 100K in stock w/ restrictions. Under §83, not taxable in
year 1. In year 3, restriction lifted and stock worth $150K. Under 83,
stock taxable in yr3 at FMV, or $150K. Basis after taxing is $150. At
end of year 6, stock worth 250K. Since basis is 150, if sold, then taxed
on additional 100K of gain.
b. Hypo: What if can transfer stock immediately --
i Property only transferable if right of transferee not subject to
substantial risk of forfeiture (83(c))
c. IF there is restriction that never lapses, then value tax at year 1.
3. § 83(b) Election: 83(b) allows T to elect to be taxed based on FMV at time of
a. Favorable b/c allows T to avoid declaring increase when restriction ends,
so T taxed on entire gain, but taxed at more favorable capital gain rate.
b. If don’t make election, then gain at end of restriction is ordinary
c. Not allowed for options, since they have no readily ascertainable value
unless openly traded and can thus determine FMV.
d. Incentive Stock Options § 421-- If a share of stock is conveyed to an
Employee in accordance with §422 requirements, the Employee is only
taxed upon sale of the stock and Employer is not allowed a deduction.
Formula - Sale price minus Amt Pd.
e. Requirements - §422(a)(1) &(2)
i Employee cannot sell the share/option within two years of date
option granted nor sale that share within one year after the date
the option is exercised, AND
ii From time of granting up to three months before exercise,
Employee was in fact an Employee of either the corp. issuing the
option or its parent or subsidiary
f. If requirements above not met, then Employee taxed when option is
g. Employer gets deduction in the year of the exercise. §421(b)
h. ISOs used 1) by start up corps that don’t have any cash, 2) financial
reporting reasons—the books don’t reflect an expense, and 3) to instill in
Ees sense of ownership/pride.
I. Divorce Four issues: alimony, child support, property, dependency deduction
1. Alimony - §71(b): Alimony is included in GI under §71. Six requirements for
a. Payment must be in cash
b. Payment must be received under a divorce or separation agreement by or
on behalf of spouse
c. The divorce or separation agreement must not designate the payment as
not includable in income under §71and not deductible under §215
(recognition of parties’ ability to K around the Code)
d. Spouses/former spouses cannot be living in the same household when the
payment is made. But:
i Spouses will not be treated as living in the same household if one
spouse is preparing to depart from the household and does so
within one month of the date the payment is made.
ii If spouses are not legally separated under a divorce or separation
decree, but payment is made under a decree requiring such
payment (see §71(b)(2)(C )), then such payment may qualify as
alimony notwithstanding that the spouses are members of the
e. Liability for payments must cease on the death of the payee spouse. Any
attempt to circumvent this rule prevents all payments from qualifying as
f. Payment cannot be for child support
2. Alimony is deductible under §215, as long as payment is includable in
recipient’s GI under §71
3. Payments to a third party under terms of divorce/separation agreement or at the
written request of the spouse which are “on behalf of the spouse” count under
§71 - Treas.Reg.§1.71-1T(b).
a. Cash payments of rent, mortgage, tax or tuition liabilities qualify
b. Payments to maintain property owned by the payor spouse and used by
the payee spouse, such as mtg. payments, real estate taxes and insurance
premiums, are not on behalf of the spouse, even if made pursuant to the
c. Premiums pd by the payor for term or whole life insurance on the
payor’s life under the terms of the separation agreement will qualify as
payments on behalf of the payee spouse to the extent that the payee is the
owner of that policy.
4. Hypo - S1 doesn’t want to pay more than 60K, but S2 wants 80K. S1 in 40%
bracket and S2 in 10% bracket. S1 can write a check for 90K, but with
deduction, actually only pays 54K (40% x 90 = 36K; 90-36=54, or view S1 as
saving $.40 on every dollar spent.) S2 gets 81K after taxes (10% x 90=9; 90-
5. § 1041: Basically a non-recognition provision dealing with any transfer b/n
spouses. No gain or loss recognized for transfer of property for benefit of
spouse or former spouse, but only if incident to divorce. Treated as gift and
basis is adjusted basis of transferor.
a. Must take place w/n one year of divorce.
6. Recapture - §71(f)
a. Payments in the first three years need to be steady -first year payments
cannot exceed second or third year payments by more than $15,000.
b. Under recapture, excess over $15,000 is treated as income in the third
year (and deducted in that year).
i E.g. T receives alimony payments of 60K, 60K, 5K & 5K. She
gets to deduct the high payments, but there is a recapture event in
yr3 b/c 5K substantially less than 60K. Since only 5 in Yr3, can
deduct but need to recapture some of deduction in year 1 & 2, &
recipient will get inclusion for some of the earlier payments:
ii Analysis: Start w/ different b/n Yr2 & 3. If less than 15K, then
ok. Since more, then three things:
i Deduction of 5K
ii 60K-15K = 45K. 45K-5K - 40K inclusion.
iii Difference b/n 5K & average of 60K & 5K (but remember
already recaptured 40K, so 60K-40K-20K. 20K + 5K = 25K.
25K/2 = 12.5K. So recapture an additional 12.5K in year
three, so 45K-12.5K = 32.5K recapture for year 3.
7. Child support - §71(c): Under this section, child support is neither deductible
or includable. A payment is treated as child support if:
a. it is designated as such in the agreement,
b. if not designated as child support, it is reduced:
i on the happening of a contingency relating to a child of the
ii at a time which can clearly be associated with such a contingency
iii A contingency relates to a child of the payor if it depends on any
event relating to that child, regardless of whether the event is
likely to occur.
c. Two situations where a reduction in payments is presumed to be based
on a contingency related to the child - Treas.Reg.§1.71-1T(c)
i Payments reduced within 6 months before or after the date the
child tuns 18, 21 or the local age of majority.
ii Payments are reduced on two or more occasions which occur
within one year before or after a child of the payor attains a
certain age between the ages of 18 and 24.
8. Property settlements/transfers of property between spouses - §1041
a. No gain or loss is recognized on the transfer of property from an
i a spouse, or
ii former spouse,
iii if the transfer is incident to the divorce.
iv The transferee assumes the basis of the transferor.
v A transfer is incident to divorce if such transfer:
i occurs within one year after the date on which the marriage
ii is related to the cessation of the marriage.
b. Antenuptial agreements: § 1041 is inapplicable to transfers made in
contemplation of marriage. Where a couple makes a property transfer in
contemplation of marriage, but before they are spouses, the person
receiving the property surrenders prospective marital rights that can’t be
ascertained, so receives basis of the transferor , who must recognize
either gain or loss. See Farid-es-Sultaneh v. Commissioner
9. Dependency deduction - §§151, 152
a. §151(a) - exemption for each spouse; §151(d) - 2K plus inflation
adjustment, so now its about 2.5K
b. §151(c) - exemption for each dependent if:
i the dependent’s gross income in the taxable year is less than the
exemption amount, or
ii if the dependent is a child (son, stepson, daughter or
stepdaughter) of the TP, the child is younger than 19 at the end of
the tax year, or is a student under the age of 24 at the end of the
c. Dependent defined (§152) - TP must provide more than half of the
dependent’s support in the TP’s taxable year (covers just about every
d. §151(e) - Custodial exemption
i If parents divorced, and child receives more than half of his
support from his parents and is in the custody of at least one of
his parents for more than half of the year, then the parent who has
custody of the child for a greater portion of the year gets to take
the exemption (custodial ).
ii Non-custodial parent gets the exemption if
i the custodial parent signs a declaration that she will not take
the deduction for the taxable year, and
ii the non-custodial parent attaches the written declaration to his
iii Note: If non-custodial parent is in a higher tax bracket, he
should take the deduction and give more alimony to the
custodial parent - 40% TP w/2 kids: 4K deduction, saves 1600;
10% TP only saves 400.
10. Group care for a dependent (taking care of grandma) - §152(c). If group is
taking care of dependent but no one person gives greater than half of
dependent’s support, then one member of the group can take the dependent
deduction if that member contributed at least 10% of the dependent’s support
and the other members file a written declaration saying that they are not going to
take the deduction. Way to divide deduction among supporters.
11. Marriage Penalty
a. If both spouses have income, then joint return often higher than if each
spouse had filed a single return
b. Single person can come out better if marry someone with no income
c. Getting rid of marriage penalty would violate progressive principle of
J. Cash and Accrual methods of accounting
1. With cash basis taxpayers, two things to worry about
a. Constructive receipt (infra)
b. Economic benefit (infra).
2. With Accrual basis taxpayer, problems occur with delay in receipt of cash.
a. All events Test § 451, 461: When all events have occurred that fix the
amount of income & that amount can be Rx determined (Reg. § 1.451-
1(a,) then T is taxable. See Georgia School Book Depository v.
Commisoner Also applies to deductions.
3. Deposits v. Advance Payments: In order to avoid having advance payment
treated as income in year received, may characterize as security deposit made in
advance to protect against risk of being paid late or not at all.
a. Best situation is if deposits are actually returnable to customer upon
satisfaction of conditions
b. Simply calling deposit not dispositive. Ideal factors:
i 3rd party;
ii No control;
iii Reverts back to depositor;
iv Definite Date;
v Interest to payor.
c. Worse case factors:
i Money to payees bank account commingled with own funds;
ii Total control (invested and keep interest);
iii Use as final payment of rent
4. Current Deduction of Future Expenses, Reg. §1.461-1(a)2: Under accrual
method, liability accrues in tax year in which all events establish liability &
amount of liability can be determined with Rx certaintiy.
a. E.g. A rents space for office, but doesn’t have to make payments until
2004. IF move in and do everything in 2003, then can make deduction in
IV. PERSONAL DEDUCTIONS:
A. When T incurs an expense, 3 things can happen:
1. Completely ignored for tax purposes (buying a sweater = consumption);
2. Deductible for tax purposes (cost incurred in business, investment activity, some
3. Capitalize it (creating an asset, so goes into basis)
a. If basis, then one of two things:
i Deduct it slowly over life of property (depreciation). IF
intangible asset (trademark) can deduct cost over period of years
ii Don’t depreciate or amortize, but put into basis & take into
consideration when sold. Remember, however, if loss, can only
deduct loss if provision allows.
B. Personal exemptions, casualty losses, medical deductions
1. §62 - Adjusted Gross Income defined: AGI is GI minus certain deductions.
Commonly referred to as “the line” - above the line deductions or below the line
a. Business deductions (§162) often above the line - justified on economic
grounds (contribute to production of income)
b. Deductions allowed for social policy reasons are often below the line
(itemized deductions - don’t contribute to production of income)
c. When deduction allowed, govt is in essence a co-contributor - govt
2. Medical deductions - §213: Medical expenses paid during the year, including
amounts pd for spouse and dependents, which exceed 7.5% of AGI can be
deducted. (If insurance covers, no deduction allowed.) Some areas of dispute:
a. Is it a medical expense? - §213(d)(1) - Amounts paid for diagnosis,
cure, mitigation, treatment and prevention of disease/ailment and
transportation essential to medical care is deductible. Cosmetic surgery
i Schooling: Need legitimate reason for sending kid to special
school (autism) -- Test: to extent that what’s being paid for is
education, then cant’ deduct, but if something other than
education, then deduction likely.
ii Therapies: Arthritic woman could not deduct cost of ballroom
dancing even though recommended by doctor.
iii Travel must be motivated by desire to obtain or seek medical
treatment (person in NY can deduct cost of travel to LA to see
iv Medical expense or capital expenditure? If TP modifies house
to accommodate ailment, TP can deduct cost of expenditure to
extent it exceeds any increase in the value of the house. No
deduction if modification increases value of house by amount
equal to or greater than amount spent (increase in value of house
is a capital expenditure which goes into basis).
b. Planning advice - Putting all medical expenditures in the same year is
more beneficial: it increases chances of reaching the 7.5% threshold.
c. Surgery § 213(d)(9): Cost of surgery not compensated by insurance
only deductible if not cosmetic surgery.
d. Always try to find more favorable treatment - Actor/stuntman gets teeth
knocked out - business expense deduction under §162 probably more
favorable than medical deduction.
e. Archer MSA’s §220 allow T to deduct medical expenses above the line
by prepaying and getting reimbursed as the expenses are incurred
(medical savings account)
3. Casualty losses: § 165(c)(3): Except as provided in (h), there shall be allowed
a deduction for losses of property not connected with a trade or business or a
transaction entered into for profit, if such losses arise from fire, storm
shipwreck or other casualty or theft. See also, Regs. §1.165-7
a. Treatment of casualty gains/losses §165(h): Any loss of an individual
described above is allowed only to the extent that the amount of the loss
b. Net casualty loss is allowed only to extent it exceeds 10 percent of AGI.
Basically, personal casualty losses for year exceed personal casualty
losses, the losses are allowed only to the extent that the sum of:
i amount of the personal casualty gains for the taxable year,
ii so much of the such excess as exceeds 10% of AGI.
c. In computing loss for casualty, may deduct smaller of basis or difference
b/n value of property before or value of property after casualty (Reg
i E.g. Prop worth 100K/300K, basis = 100K & difference - 200K,
so deduct 100K, since less.
d. To qualify as casualty loss, must be sudden and unexpected.
i Termite damage doesn’t count unless takes place really quickly.
ii If claiming for theft, must be able to prove theft and not merely
iii Must be physical damage.
iv If casualty self-inflicted, then no loss. See Blackman v.
Commisioner, 349 holding that a husband who set clothes on fire
that ultimately burned his house was not able to claim casualty
loss, since he set the fire himself.
C. Charitable Contributions - §170
1. Two requirements to get a charitable deduction under §170:
a. Contribution must be a gift - “detached and disinterested generosity.”
If something received in return, then no deduction; if benefit less than
amount given, can deduct only that amount for which no benefit is
b. Must meet requirements of charitable contribution, as defined in
2. Charitable contribution defn - §170(c): Gift meets the defn if it:
a. is a gift to govt entity for public purposes
b. is a gift to organizations created exclusively for religious, charitable,
scientific, literary or educational purposes (contribution to educational
institution that practice racial discrimination - no deduction Bob Jones v.
c. does not benefit a private individual
d. does not go to an organization which lobbies the govt
e. does not go directly to an individual working for the charity/charitable
cause. Davis v. US
f. Note: foreign charitable orgs not covered
3. Limitation/Carryover - §170(b)
a. The amount of the deduction is limited to 50% of AGI, but §170(d)
allows for carryover of any amount over 50% into the next year.
4. What can be deducted - §170(e)
a. Cash & prop deductable, services not - Gifts of cash and property can
be deducted, gifts of services cannot (don’t give deduction for
something never taken in as income; can’t deduct foregone opportunity
costs). In kind prop same as prop.
b. Amount of deduction - General rule: give 1M in cash, get 1M
deduction. Likewise, give 1M in prop, get 1M deduction. (If prop, when
sold, would have produced long term cap gain, then deduction is FMV.)
c. Exceptions -
i If no long term cap gain, deduction is basis - Don’t get deduction
if, when prop sold, long term cap gain wouldn’t have been
realized. Deduction is basis in prop. Ex: If contributing
inventory, deduction is basis (selling inventory would not have
produced cap gain).
ii Donation unrelated to operations - §170(e)(1)(B)(i). If the
tangible personal property donated for a purpose that is unrelated
to the organization’s primary purpose (why its a tax exempt
organization), deduction is basis. Ex: TP gives High Museum
riding lawn mower; High doesn’t use ridding lawn mower as part
of its non-profit status.
5. Planning advice - giving prop probably better than selling prp and giving cash
a. Hypo - 10K/110K - give prop to charity, or sell prop and give cash?
Assume 40% rate
i Sell -TP taxed on 100K gain - 40K owed in taxes. Sale price
(110K) - taxes (40K) leaves only 70K for charitable contribution.
70K deduction from AGI saves only 28K (40% of 70K)
ii Give prop - TP can deduct 110K from AGI and charity now has
prop worth 110K. TP saves 44K (40% of 110K). Even if charity
doesn’t want the property, they can sell it and not have to pay any
6. Quid pro quo problem for businesses - notion that they must receive
something in return to justify contribution (no ultra vires actions allowed). Case
by case, fact based analysis often required.
7. Contributions to colleges w/sporting event tickets tied - §170(l)
a. Contribution to college which results in right to purchase tickets to
athletic event - only 80% of contribution is deductible.
b. If contribution results in tickets for “donor,” no deduction allowed.
8. Dominion and control rule - Haverly v. US - If TP receives something of
value but donor does not expect quid pro quo, and TP then gives it to a
charitable org., TP cannot take a deduction. Attempt to take deduction is
evidence of dominion and control, thus TP should be taxed. (Not taxed when
prop received because no dominion and control.) In case, principle received
books from publishers who wanted school’s business and principle gave books
to library and took a charitable deduction.
D. Interest, taxes, personal and dependency exemptions, personal tax credits
1. Begin w/general rule under §163(a) that interest is deductible unless some other
provision denies the deduction.
2. §163(h) - Personal interest is not allowed as deduction. Personal interest is any
interest other than:
a. interest paid or accrued on indebtedness allocable to a trade or business
b. investment interest subject to §163(d)
c. passive activities subject to §469
d. qualified residential interest - interest on a loan secured by the TP’s
principal residence which is either:
i acquisition indebtedness - money borrowed to purchase,
construct or improve the principal residence of the TP, not to
exceed 1M (500K for married individual filing separate return),
ii home equity indebtedness - any indebtedness secured by the
TP’s principal place of residence to the extent it does not exceed
FMV of residence minus the amount of the acquisition debt on
the prop, and in total does not exceed 100K
3. §265(a)(1) - no deduction is allowed for any expense, including interest or
attorney’s fees, attributable to the production of income that is tax exempt
under another provision of the code.
4. §265(a)(2) - no deduction for interest on debts incurred to purchase or carry
tax-exempt state or municipal bonds.
5. §163(d) - If an individual borrows money to make investments, individual can
deduct the interest on the amount borrowed only to the extent of the income
earned on the investments (interest above investment income is disallowed as
a. Disallowed amount can be carried forward and applied against future
income from the investment (future dividends or sale of the investment)
6. §469 - Passive activity limitation (written to cover RE investments) Losses
from the passive activity can only be deducted against income from the activity
(usually RE depreciation is the deduction affected).
7. Tracing - Treas.Reg.§1.163-8T.
a. Allocation of interest expenses for applying §§163(d) and (h) and §469
b. Flow-of-funds method of tracing - debt and interest on the debt is
allocated to the activity for which the debt is incurred (use of the debt).
i Ex: TP brws 100K, uses it to pay business expense, then uses
100K of previously accumulated funds to buy a personal item -
can deduct the interest on the debt.
ii Allocation is not affected by the use of an interest in any property
to secure the repayment of the debt. §1.163-8T(c)
c. Co-mingling - What to do when TP places borrowed funds in an account
that also has personal funds (from planning perspective, never co-
i Expenditures made from the account are treated as made from the
borrowed funds first. §1.163-8T(c)(4).
ii Special exception - TP can elect to treat any expenditure made
from the account within 15 days of the deposit as being made
from the borrowed funds, even if under (c)(4) the funds would be
treated as used to make one or more other expenditures. (Ex:
make personal expenditure on day 8 and business expenditure on
day 12 - can allocate debt proceeds to business expenditure.)
d. Ordering of repayment - §1.163-8T(d). - What to do when the TP
starts paying off the debt (affects whether deduction allowed on the
i If, at the time the is debt repaid, such debt is allocated to more
than one expenditure, the debt is treated as repaid in the
i amounts allocated to personal expenditures
ii amounts allocated to investment expenditures
iii amounts allocated to passive activity expenditures, including
former passive activity expenditures
iv amounts allocated to trade or business expenditures
E. Taxes and Personal Tax Credits: As a general rule, the following taxes are deductible
in the year paid:
1. real property taxes (including foreign taxes)
2. personal property taxes (including foreign taxes)
a. Duty to pay tax falls on prop owner, not tenant
3. Some taxes, which may not fall under §164, can be deducted under other
provisions - tax incurred as a business expense is deductible under §162.
4. Tax credits are a means by the government to achieve certain social goals. The
difference b/n a credit and a deduction is:
a. 1K deduction - wealthy TP (40% bracket) saves $400, while poor person
in the 15% bracket only saves $150
b. Credit is a dollar for dollar offset against the final tax bill, 2 TPs
benefited equally regardless of tax bracket
5. There are currently several different tax credits offered (See Schematic, pg.
a. Child care expenses - §21.
i Credit allowed for up to 30% of child care expenses, if the
expenses are employment-related and are for a qualifying
i Employment-related expenses - §21(b)(2). Amounts paid for
household services and for care of a “qualifying individual” if
those expenses are incurred to enable the TP to be employed.
ii Qualifying individual - §21(b)(1). Dependent under 13 for
whom TP can take an exemption, or a dependent who is unable
to take care of themselves.
ii Amount of credit - §21(a)(1). Credit is 30% of employment-
related expenses if TP’s AGI is 10K or less. The applicable
percentage is decreased by one percentage point for each 2K by
which AGI exceeds 10K, but the applicable percentage never
decreases below 20%.
i Cap on amount of employment-related expenses that can be
considered - §21(c). Maximum amount of employment
related expenses that can be used in determining the credit for a
single dependent is $2400, and $4800 for two or more. (Thus
maximum credit is $1440).
ii Expenses can’t exceed income - §21(d)(1). Employment related
expenses cannot exceed earned income. For married couple,
expenses cannot exceed the earned income of the spouse with
the lower earned income. But, 21(d)(2) - spouses who are full
time students or disabled (meets defn of dependent) are deemed
to make $200 if only one dependent, or $400 a month if two
b. HOPE Scholarship §25A - Maximum credit of $1500 for first two years
of post-secondary education. Up to 1K in YR1 and $500 in YR2.
Phased out begins if AGI exceeds 40K on single return and 80K on joint
c. Lifetime Learning Credit §25A - Credit of 20% on first 5K tuition paid
when HOPE not taken. Phase out is the same.
d. Foreign taxes are creditable
e. Earned Income Credit (EIC)
i Refundable credit (most are not)
F. Mixed business and personal deductions §183: If mixed activity with profit motive
but also personal use, then deduction allowed to extent of income generated (same as
1. E.g.., A has 3K income, 4K in property tax and income otherwise deductible,
and 6K that wouldn’t’ be deductible unless in business or trade. -- 1) then can
deduct the 4K, since no limitation under $183 w/ regard to income, but 2) since
only had 3k in income, then can’t deduct any of the additional 6K in expenses.
2. § 183(d). IF activity is profitable for 3 or more years in 5 consecutive years,
then activity deemed for profit, and § 183 inapplicable.
3. § 280A: No deduction for dwelling used by taxpayer during tax year as
residence. Amount of time devoted to work will be determinative. Used
mostly for home offices and vacation homes.
a. See Popov, 401, where court held that room devoted to violinist’s
practice sessions was allowed as deduction, since room used exclusively
for studying and violinist spent a great deal of time there.
b. Concern w/ vacation home is that T buys home & spends lots of time
there, but rents it out occasionally and thus wants to treat expenses as
deductions, since renting property (§212). Prevented by §280A(d)(1),
which doesn’t allow deduction for dwelling house used by T for more
than 14 days or 10% of time property used.
i IF not used for personal purposes, then can deduct all expenses
w/o limitation (d)(2)
ii IF used more than specified time, but less than 15 days, then
rental income excluded and no business deduction (essentially all
personal use other than the less than 15 days rented).
G. Hobby Losses, home offices, etc.
1. Where does the outlay fall -
a. §162 necessary and ordinary business expense deduction,
b. §212 deduction for production or collection of income,
c. §167 prop (§263 cap expenditure) held for production of income
d. §262 no deduction for personal expenses
2. Business expense v. investment expense
a. Difference btwn §212 and §162 expenses
i interest due to activities that fall within §162 is deductible
ii interest due to activities that fall within §212 is deductible
under §163(d), but the deduction is limited to amount of
b. Is the individual engaged in a “trade or business” or other profit
seeking income? Some guidelines
i Expenses of managing one’s own investments are not business
expenses even if management of the investments is the TP’s full
ii Active “trader” in securities—someone who buys and sells
securities in large quantities and who typically holds securities
for a short time—can be in a trade or business.
iii Person must be involved in the activity with continuity and
regularity if the activity is to be a trade or business
iv Person doesn’t have to hold herself out as offering goods or
services to others to be engaged in a trade or business
v Fact that ones’ livelihood derives from an activity is some
indication that the activity is a trade or business
3. Hobbies - §183
a. General rule - §183(a). No deduction allowed for hobbies. Hobby is
just about any activity that doesn’t fall under §162 or §212.
b. Exceptions - §183(b). If hobby is not for profit, can deduct
i items otherwise allowed (prop taxes, interest), and
ii other expenses up to the amount of income that is produced.
i Hypo - 20K income, 8K in prop taxes, 15K in other expenses.
Deduct all of 8K, deduct 12K of other expenses.
ii Note: even if otherwise allowable deductions exceed income,
get full deduction of the otherwise allowable deductions: 20K
income, 23K prop taxes - deduct all of prop taxes, but no
deduction of 15K expenses.
c. Factual analysis required to determine whether activity is a trade or
business or a hobby
i Record of activities - Are books kept? If so, closer to business
ii Number of years of loss/profit - §183(d). If income from the
activity for 3 or more of the 5 year period prior to the taxable
year exceeds deductions attributable to the activity (ignoring for
the moment how characterized), then activity presumed to be one
engaged in for profit (for that taxable year).
iii Business-like activities - Is the individual engaging in business-
d. Gambler can deduct losses (price of losing tickets) to extent of winnings.
H. Commuting, travel and entertainment (see IRS printout)
1. Analysis -
a. Does it fall within §162?
b. If so, is there a §274 limitation?
i Is there an exception under §274(e) - gets you out of §274(a). If
yes, go to (3) below, if no go to (2).
i If no exception, then must meet one of §274(a) tests - directly
related or associated.
ii Apply 274(n) 50% limitation
a. If not under 274(e) exception, 50% limitation always applies
b. Even if under 274(e) exception, 274(n) still applies if
i. Food and beverage for employees on the business
ii. Meetings of Ees, stockholders, etc
iii. Attendance of a business league meeting
2. Disallowance of certain entertainment expenses - §274.
a. No deduction for activity generally associated with entertainment/leisure
unless can meet one of two tests:
i Directly related test - event was directly related to the active
conduct of the client’s trade or business.
1. Tres.Reg.§1.274-2(c) - Activity is directly related if:
a. The TP had more than a general expectation of deriving
some trade or business benefit at the time the TP made the
entertainment expenditure (but don’t have to show specific
benefit actually resulted)
b. During the activity, TP actively engaged in a business
meeting, negotiation, discussion or other bona fide business
transaction for the purpose of obtaining the specific benefit
c. When all facts considered, the principal character or aspect
of the combined business and entertainment activity was the
active conduct of the TP’s trade or business.
i. More time does not have to be spent on business than
pleasure to meet this requirement
ii. Presumption against hunting, fishing and yachting
d. The expenditure was allocable to the TP and persons with
whom the TP engaged in the active conduct of trade or
business (or would have engaged if intervening factors exist)
2. Expenditures/circumstances that are presumed not to meet the
directly related test:
a. TP not present
b. Substantial distractions, such as a meeting at a night club,
sporting event, theater or other essentially social gathering
c. Persons other than business associates are present and it is in
a social setting
ii Associated test - the event directly preceded or followed a
substantial and bona fide business discussion such that it was
associated with the active conduct of the TP’s trade or business.
1. Tres.Reg.§1.274-2(d) - Associated test met if:
a. TP established that he had a clear business purpose in
making the expenditure, such as obtaining new business or
encouraging the continuation of an existing relationship.
Expenditures for persons not closely connected with a
person who engaged in the substantial and bona fide
discussion are not allowed, except for spouses.
b. Preceding or following substantial discussion prong is met -
i. Discussion was substantial - argue the facts. If at
convention, discussion presumed substantial if expenses
are necessary to TP’s attendance and there was a
program of business activities which was the principle
activity of the convention
ii. Preceding or following- occurs on the same day; if
not on same day, argue facts
iii No deduction for use of a facility - can’t deduct costs associated
with ski lodge (but costs of holding a meeting at the ski lodge
deductible - see 274(e)(5).)
iv No deduction for dues or fees to a club
v Deduction limited to 50% of food/entertainment expenses.
274(n) Exceptions to 50% limitation - 274(e):
i Expenses treated as compensation
ii Reimbursement expenses - see Code 274(e)(3)
iii Expenses for recreational, social or other activities primarily
for the benefit of employees (but not club dues)
iv items available to the public
v Entertainment sold to customers
vi Expenses includable in income of persons who are not Ees -
vi Can’t deduct expenses otherwise deductible under §162 as
b. Substantiation requirements - 274(d), also Tres.Reg.§1.274-5T
Records must show:
i For travel
i amount of each expense
ii time and place of the expense
iii business purpose of the expense
ii For entertainment
i amount of each expense
ii time and place of the expense
iii business purpose of the expense
iv business relationship of the person receiving the gift to the
c. Specific activities that may or may not fall under §274 - generally a
case-by-case fact based analysis
i Commuting - trying to get into §162. Generally, once on the job,
travel expenses are deductible. Expenses for getting to work are
i Commute to work in the morning not deductible - getting TP to
position of work; where one lives is a personal decision.
ii Go to see client from work - cost of going to see the client is
deductible. Two ways
1. mileage deduction published by IRS
2. depreciation based on percentage of car’s basis used for
iii Go from home to see client - not deductible; getting TP to work
theory same as in from home to work
iv Go from home to bank, do business for the company, and then
go to work - conceptually, trip from bank to work deductible,
but if do it every day then probably not.
v If Er provides car, may be deductible under §132 - working
ii Lunch expenses
i Generally, lunch w/client is deductible under §162, but must
cross with §274.
ii Business lunch w/associates - if every day then no, if
occasional then probably.
iii Travel expenses
i Must meet requirements of §162(a) -
1. away from home (home is where principal place of business is
2. in pursuit of a trade or business
ii Primary relation test -Tres.Reg.§162-2(b)(1). Applied when
mixing business and pleasure.
1. Travel expenses are deductible only if the trip is related
primarily to the TP’s trade or business.
2. If trip not primarily related, but do work while on vacation, can
deduct business related expenses.
iii Temporary assignments
1. If live at the location of the temporary assignment for less than
one year, then can deduct living costs.
2. If more then one year, presumption rises against temporary
nature of assignment - test becomes: if TP genuinely thought
assignment was going to be for less than one year, can deduct.
Fact based analysis. But, point at which TP realizes job going
to be more than one year, deductions should stop.
iv Traveling salesman - no principle place of business, so never
away from home.
v Luxury water travel §274(m)(1) - no deduction if such
expenses exceed twice the aggregate per diem amounts for
days of such transportation. Per diem amount based on that
allowed for executive branch officials.
iv Conventions/meetings - §274(h)
i If outside the US, no deduction allowed unless TP can establish
that the meeting is directly related to the active conduct of his
trade or business and for various reasons it is reasonable to
hold the meeting outside the US. See §274(h)(1).
ii If on cruise ships, must meet requirements of §274(h)(2) and
v Entertainment tickets - value for tax purposes is face value
1. Litigation expenses - Origin of the claim test. From what did the claim arise -
business activities or personal? If business then deductable under 162 or 212, if
personal, deduction prohibited by 262. BUT legal expenses of wife going after
alimony deductible under 212 “production of income” language.
2. Tax planning advice - 212(3). Can deduct amounts spent in connection with
determination, refund or collection of any tax. When paying lump sum to
atty/firm, try to parcel out amount paid for tax planning.
3. Clothes/accessories - Employer requires the employee to purchase clothes to
wear on the job. Objective analysis required. A few factors:
a. Clothes kept at workplace or taken home
b. Specialized garments or general clothing anyone might wear
c. Wear clothes outside the workplace
4. “Necessary and Ordinary” requirement of §162 (Welch v. Helvering)
a. necessary - appropriate and helpful
b. ordinary - must look to time, place and circumstance
5. “Carrying on” requirement of §162
a. General rule - must be currently operating a business to deduct under
b. Start-up costs §195 - TP can elect to deduct start-up costs on a pro-rata
basis over the first 5 years of the life of the business (amortize as capital
i Start-up costs include amounts paid in connection with:
i investigating the creation or acquisition of an active trade or
ii creating an active trade or business.
ii Time line for stating up a business - at some point cross the line
that separates mere investigation (personal expenses not
deductible) from the “active” zone - point at which the new
business is imminent. Hard to draw line - argue the facts. One
guideline - to deduct under 195, must have been able to deduct
under 162 if carrying on requirement met.
c. Seeking employment in the field - Cremona. If seeking employment in
the same field, can deduct costs of trying to find new job, regardless of
whether job hunt is successful, under 162. If seeking new trade or
business, not deductible.
a. General rule - For compensation to fall under §162, it must be 1)
reasonable, and 2) for services.
b. Dividend or income? From Employee’s perspective, it doesn’t matter,
from corp’s perspective, want income over dividend (dividend not
c. Fact based analysis required. Factors to consider - from perspective of
independent investor, would she be willing to pay the amount?:
i nature of the work performed - is the compensation
normal/justified for the level of work?
ii what’s the effect of services rendered on investor’s return -
increase (compensation) or no effect (dividend).
d. Golden parachutes - Attempt to thwart hostile takeovers by requiring
large cash payments to managers if they are dismissed as a result of the
takeover. Congress viewed this as a promotion of inefficiency, so tax
excess parachute payments under §280G - excess parachute payment -
amount above normal income.
e. Under §162(m), in publicly held corp., no deduction for
compensation in excess of $1 million.
7. Education Expenses - Treas.Reg.§1.162-5: Education is deductible as an
ordinary and necessary expense of carrying on a trade or business if the
a. maintains or improves skills required by the individual in his
employment or other trade or business, or
b. is required by the Er or law as a condition of employment, position or
c. If receiving education to prepare oneself to enter a field (obtaining
minimum education requirements) then no deduction allowed.
V. BUSINESS DEDUCTIONS
A. Expense v. Capital expenditure (See schematic 6-8)
1. Where does the outlay fall - §162 necessary and ordinary business expenses, or
§263 capital expenditures?
a. Ordinary = Word used to signify whether potentially deductible expense
b. Necessary = If determined to be deductible, then is it appropriate or
2. From planning perspective, the issue is timing - If outlay is an expense, then
deduct immediately, if it is an expenditure, then depreciate.
a. TP will want to characterize outlay as ordinary and necessary business
expense and deduct immediately under §162.
b. IRS will want to characterize outlay as capital expenditure under §273
and allow depreciation, or no deduction at all (see INDOPCO infra).
Always argue both on exam.
3. No set line as to what is an expense and what is expenditure, just argue the facts.
A few guidelines:
a. Repairs are deductible, improvements are an expenditure. Ques - is
the prop same as before repair or in a better condition (new asset)?
b. Depreciation schedule for outlays that go toward building the
improvement is based on the life of the improvement--§263(a). No
deduction for “any amount paid out . . .” (Ex. - rental of trucks, workers
c. Intangible assets - INDOPCO v. Commissioner
i If future benefits (economic benefits) will accrue to the TP as a
result of the outlay, no deduction allowed.
i If benefit finite, then depreciate
ii If benefit indeterminable, then recover cost upon sale
ii Costs connected to a friendly take-over are capitalized, but since
not finite, no depreciation.
iii Costs to resist hostile takeover are deductible immediately
(Staley Mfg. Co. v. Commissioner)
iv Other examples of future benefits - employee recruitment and
training, plant closing costs, environmental clean-up costs.
B. Depreciation, amortization and depletion (522-32) See schematic, pg. 6:
Depreciation is an attempt to match consumption with income - recover cost over life of
1. §167 - authorizes depreciation - depreciation allowed for property:
a. used in a trade or business
b. held for the production of income
c. Note: neither raw land nor stock is depreciable
2. §168 - mechanics of depreciation (by way of §167(b)): Three part analysis to
a. Applicable depreciation method - 168(b)
b. Applicable recovery period - 168(c)
c. Applicable convention - 168(d)
3. Depreciation method - two possibilities §168(b):
a. Straight-line depreciation §168(b)(3). Cost (basis) of the asset, less its
salvage value, is deductible in equal annual amounts over the useful life
of the asset. Basis is reduced by depreciation deduction each year.
i Example - Machine costs 4K, w/life of 5 years. Depreciattion
deduction is 800 each of the five years - 4K basis reduced by 800
ii Straight-line method used for:
i Non-residential real property,
ii Residential rental property,
iii Railroad grading or tunnel bore, and
iv TP can elect to use straight-line for 1 or more classes of
b. Declining balance method §168(b)(1) - Two possibilities
i 200 percent method - First determine straight-line percentage rate
for the asset (20% in ex. above). This rate is then multiplied by
200% (40%). Yearly depreciation determined by multiplying
adjusted basis of the asset by that rate (basis adjusted each year
by subtracting prior year’s deduction). Salvage value - instead of
reducing depreciable basis by salvage value, the depreciation
deduction is disallowed to the extent that it would reduce the
adjusted basis below the salvage value (back-end fix, instead of
i Ex: Machine cost 10K w/5 yr life. YR1 - $1600 deduction
(4K x 40%), YR2 - $960 deduction (2400 x 40%), YR3 - $576,
and so forth.
ii TP can switch to straight-line method for the first taxable year
in which using the straight line method would result in a larger
iii 200 method applies to everything accept that covered by 150
iv 150 percent method - Same as 200, but 150 used. Applies to
15 and 20 year property, and any property which TP elects to
have it apply, except those to which straight-line applies.
ii Major difference btwn straight-line and double recovery methods
- present value of net-cash flow. Under double-recovery, because
the discounted value of near-term reciepts is greater than that of
distant ones, a greater likelihood exists that a current investment
will have a positive present net value.
4. Recovery period - See chart at §168(c), and definitions (e)(3). May also have
to cross with chart in §168(e) if property has a class life.
5. Convention - §168(d)
a. Half-year convention - applicable convention is the half-year convention
unless otherwise stated (see §168(d)(2)); all property placed into service
during the year is treated as placed in service at the mid-point of the year
(affects first and last year depreciation).
i 5YR prop - Y1 - ½ depreciation, Ys2-5 full depreciation, Y6 - ½
ii Mid-quarter convention special rule - §168(d)(3). Because half
year convention creates incentive to place lots of property into
service in 2nd half of year, mid-quarter rule created. If more than
40% of all assets are bought/placed into service during the last
three months of the year, then all assets acquired during the year
are deemed to have been purchased in the middle of the quarter
when they were purchased - only get 11/2 months of
b. Mid-month convention- §168(d)(2). All property placed into service
during a month is treated as placed into service at the mid-point of the
month (look at middle of month to end of year). Applies to:
i non-residential real property
ii residential rental property
iii railroad grading or tunnel bore
6. Amortization of Intangibles (assets not depreciated)
a. Fifteen year amortization period - §197. Amortization deduction
allowed for intangible asset over a 15 year period, starting on the month
when the intangible is acquired.
b. Intangibles covered - §197(d)
i Goodwill (goodwill is obtained when business is purchased for
amount greater than assets - pay 140K for business w/assets of
100K - 40K in goodwill)
ii Going concern value - pay amount above assets because
purchaser doesn’t have to expend any start-up costs.
iii Covenant not to compete
7. Leased property
a. Useful life of RE must extend beyond lease to depreciate - DeMatteo. If
TP buys prop with building that’s being leased, but useful life of the
building (based on depreciation) will expire before the lease runs out
(purchaser obtains possession of the building), then the purchaser cannot
allocate a portion of the purchase price to basis in the building - taxpayer
has no interest of substance in the building.
b. Premium lease - always argue paying for premium lease; it can be
amortized over the life of the lease under §167
c. Buildings erected on leased property and improvements made to leased
property must be depreciated under ordinary-cost recovery rules (lease
ignored, in effect)
C. Tax Shelters (532-34, 542-46, 548-53, 559-61, 568-72)
1. Defn - situation where investor can take a deduction now, but not have to
make the expenditure for several years. TP can earn interest on the $ saved as
a result of the current deduction and have more than enough to cover the
expenditure when it comes due.
2. Attempts to close the shelters - §§ 465 & 469
a. At-Risk Rule - §465. TP can take a deduction only to the extent that the
$ is at risk. Asset by asset analysis.
i At-risk defn §465(b) - Amts invested/borrowerd that the TP puts
into an investment on which the TP is personally liable. One
exception - Non-recourse loan made by a third party bank or
institutional lender (fed govt.) is considered at-risk. Non-
recourse from individual (such as seller or promoter) is not at-
ii Calculation - If losses exceed income, can deduct a loss only to
the extent that it is at-risk.
b. Passive activity losses - §469 - Matching provision; aggregate analysis.
i General rule - For those activities which qualify as a trade or
business, but in which the TP does not materially participate,
losses from the activities can’t be offset w/income from sources
other than the activities.
i Rental activity is specifically designated as a passive activity,
but special carve out for individuals in §469(i).
ii Matching required/carryover allowed - Losses must be matched
with income from the activity. However, losses can be carried
iii If losses are continually carried forward and no deduction is
allowed, losses will eventually exceed income from all sources -
when prop is sold, accounting will take losses into account.
(reduction of gain).
iv Exception - §469(i) - For individuals only; designed for
homeowners who rent out a second piece of property.
i Even if income from the investment is less than losses, losses
from the passive activity can be deducted against other sources
of income, but the deduction cannot exceed 25K.
c. Combo of 465 & 469
i If the activity is passive and loss exceeds income, 469 prevails.
ii If the activity is active investment and loss exceeds income, 465
3. Alternative Minimum Tax § 55 (see also § 6011 -- Tax shelter regulations)
which requires certain preferences be added back
VI. SPLITTING OF INCOME/ASSIGNMENT OF INCOME
A. Assignment of income from services (573-91)
1. Gen rule - Assignment of income received for services not allowed - person who
earns the income will be taxed on the income.
2. Assignment battles today - US corp trying to assign its income to a foreign
B. Assignment of income from property (591-603)
1. Gen rule - owner of proper can’t assign the income from the prop to another
person while retaining ownership of the prop; the owner of the prop will be
taxed on the income from the prop.
2. Dividing the “tree” (“The fruit is not to be attributed to a different tree from that
on which it grew.” Horst)
a. Vertical slice - if part of prop given with right to receive income from
that portion, then tax law respects
b. Horizontal slice -if owner tries to give only right to receive income
without the income earning prop, tax law will not respect
3. Bond w/coupons - §1286. Requires the donor of coupons stripped from the
bond to take into income on a daily basis the increase in bond value and the
donee to take into income on a daily basis the increase in the value of the
VII. CAPITAL GAINS AND LOSSES (SEE SCHEMATIC, PG 5)
A. General Issues
1. Gains and losses from sales of investment property are taxed at rates lower than
ordinary income. 20% is the usual rate, but a few other rates for special items
and if the TP is in the 15% tax bracket.
2. Cap gains are separated out from ordinary income and each is taxed at its own
rate. Thus, from a planning perspective, a TP will want to fit as many gains as
possible into the capital gain category, and as many losses as possible in the
ordinary income category. (Converse true from IRS perspective.)
3. Mechanics - §§1(h), 1222
a. §1(h) - Capital gain preference is given to net capital gains
b. §1222 - Definitions
i Net capital gain is the excess of net long term capital gain over
net short term capital loss (NLTCG - NSTCL)
i NLTCG - excess of long term cap gain over long tern cap loss
(LTCG - LTCL)
1. LTCG/LTCL - Three components. Gain/loss from:
a. sale or exchange of
b. a capital asset
c. held for more than 1 year
2. NSTCL - short term cap loss minus short term cap gain (STCL -
a. STCL/STCG - Gain/loss from:
i. sale or exchange of
ii. a capital asset
iii. held for 1 year or less
ii Thus, to qualify for a net capital gain, must have positive LTCG.
If the only transaction is a short-term cap gain, won’t lead to
NCG, so its treated as ordinary income.
iii Formula - NCG = (LTCG - LTCL) - (STCL - STCG)
a. Sale or exchange requirement - can be broader than plain meaning.
Some examples that fit the requirement:
i Casualty loss under §165(h) and involuntary conversion under
can have capital gain/loss treatment
ii Taking by condemnation
iii Receipt of $ by creditor in satisfaction of a claim
iv Transfer of property in satisfaction of an obligation
v Mtgor transfers prop subject to non-recourse mtg to the mtgee
b. Capital Asset defn - §1221. Cap asset is everything except:
i Inventory and prop held for sale to customers
i TP investor or dealer? Case-by-case analysis required -
1. Number and continuity of sales. Greater the number and
frequency of sales, the closer the TP is to a dealer.
2. Percentage of GI from the activity.
3. In real prop context:
a. Prop sold as one piece or divided up and sold? If divided,
prob not a cap asset.
b. Prop purchased, improved, then resold. If frequent, prob not
a cap asset.
ii Two rules of thumb:
1. If TP buys and sells stock for customers and makes a profit, the
stock is treated as inventory, not a cap asset.
2. If TP (builds) buys and sells real prop, qualifies as a dealer and
the prop is not a cap asset. (Note: Sell your house for less than
basis - it meets all the cap asset requirements, but loss not
allowed under §165.)
ii Prop used in a trade or business, including real prop
i BUT SEE §1231 - Gives cap gains preference to net gain on
dispositions of “1231 assets.”
1. If the recognized gains for the year exceed the recognized
losses, then the gain is treated as a capital gain. If recognized
losses exceed recognized gains, then gains and losses are treated
as ordinary income.
2. 1231 assets -
a. Prop used in trade or business subject to depreciation under
167 and held for more than 1 year, which is not
ii. prop held for sale to customers
iii. copyright, literary, artistic or musical composition
iv. US Govt publication
3. Also gives cap gains preference to gain recognized from
involuntary conversion if
a. prop used in a trade or business, or
b. any capital asset that is held for more than 1 year and is held
in connection with a trade or business or a transaction
entered into for profit.
4. Once its determined that a gain is a 1231 asset gain, then its
lumped in with all other capital gains.
ii Right to receive rents - Courts have held the right to receive
rent is not property, thus a sale of this right is subject to
ordinary income taxation.
iii Copyright, literary, musical or artistic composition held by TP
and sold by TP
iv Notes receivable for the sale of inventory or services (selling
your accounts receivable)
v A publication by the US govt
c. Holding period - §1223.
i Tacking provision, allows prop owner to meet one-year
ii Applies mostly to like-kind exchanges.
iii Rule - If prop held by the TP as a result of an exchange has the
same basis as the prop given up by the TP, then the TP can tack
the holding period of the old prop onto the current holding period
of the new prop.
B. Disadvantageous treatment
1. Limitation on losses - §1211
a. Corporations - losses from the sale or exchange of capital assets can only
be deducted to the extent of capital gains.
b. Individuals - losses can only be deducted to the extent of capital gains,
BUT, if additional capital losses exist, they can be deducted against
ordinary GI up to 3K (or 1.5K for married individual filing separate
2. Carryover - §1212. Excess loss not allowed as a deduction can be carried
forward to the next year. Two possible characterizations. Whichever is greater
applies in the succeeding year.
a. Excess of NSTCL - NLTCG for such year is characterized as STCL is
b. Excess of NLTCL - NSTCG for such year is characterized as LTCL in
the succeeding year.
i NLTCL - excess of long term cap loss over long tern cap gain
(LTCL - LTCG).
ii NSTCG - excess of short term cap gain over short term cap loss
3. Hypo - 20 LTCL, no CG.
a. Loss is allowed under 165(f).
b. §1211 limits deduction to 3K.
c. 17K is carried over to the next year. 17K characterized as LTCL.
C. Recapture of Depreciation - §1245 & §1250
1. Necessary because of 1231 cap gain treatment of depreciable property - don’t
want to give TP a double benefit.
2. Recapture rule (combo of §1245(a) and 1250(a)) - Upon sale of prop, to the
extent gain is attributable to depreciation deductions, such gain is treated as
ordinary income, notwithstanding §1231.
a. Recapture of depreciation on personal property, machinery and fixtures -
§1245. If gain results from a combination of depreciation and high
FMV, then amount above original cost basis is given cap gains
i Hypo 1 - 10K purchase, upon sale 6K/9K. 3K gain is
“recaptured” as ordinary income.
ii Hypo 2 - same numbers, sold for 11K. 4K is recaptured ordinary
income and 1K is 1231 cap gain.
b. Recapture of depreciation on real property - §1250.
i Applies only to “additional” depreciation - depreciation in excess
of straight-line depreciation (excess of accelerated depreciation
over straight-line depreciation).
ii Since only straight-line depreciation is allowed on buildings
placed into service after 1986, §1250 only applies to buildings
placed into service before that date.
D. Sale of a business
1. Fragmentation required - Upon sale of a sole proprietorship or the sale of a
corporate business by the corporation, the sale must be fragmented and the
amount and character of gain or loss on each of the business’s assets--cash,
accounts receivable, fixtures, inventory and goodwill--determined separately.
2. Allocation of purchase price among assets - Temp.Tres.Reg.§1.1060-1T.
a. Purchase price first reduced by any cash or cash-equivalent items
received by the purchaser/TP
b. Remainder of purchase price allocated to identifiable tangible and
intangible assets (except goodwill) to the extent of their value.
c. Excess is apportioned to goodwill (which is amortized over 15 year
period - §197)
3. If purchaser pays a premium price, the premium amount must be allocated to
goodwill or going-concern