Introduction to Federal Taxation by JohnMValentine

VIEWS: 497 PAGES: 88

OVERVIEW I) Definitions i) Types of taxes: i) Progressive income tax structure – tax rates increase as income level increases. ii)Regressive income tax – tax rates decrease as income level increases. iii) Direct tax – a tax demanded from the person who is intended to pay it, i.e. flat income tax. iv) Indirect tax - tax paid primarily by one who can shift the burden to others, i.e. sales tax. ii) Tax liability - Tax computed on taxable income. Is computed at time of return. i) Individual rates §1 ii)Congress publishes tables of rates §3 iii) §1(f) - the rates are adjusted for inflation iv) Corporate rates §11 iii) Taxable income - is gross income minus appropriate deductions. Gross income §61 - all income from whatever source derived. i) §§70-80s are gross income sections, what is included ii)§§100s show exclusions from gross income iv) Deductions - those allowed by the Code i) Allowed - to let you have something, something you can claim. Is different from allowable. ii)There are 654 deductions possible (1) Some politically motivated (2) Some are intended to encourage certain behaviors (3) Some make sense in taxation issues iii) There are also restrictions on deduction (anti-abuse provisions) such as passive loss requirements. iv) Standard deduction - another possibility as distinct from itemizing deductions. Taxpayer takes the larger of the itemized deductions or the standard deduction. General Issues i) Tax Liability checklist i) Does the transaction generate gross income? ii)Is the gross income included or excluded? If there is any doubt the income is included. iii) Are there any deductions to offset the gain? If there is any doubt do not get the deduction. iv) Adjusted Gross Income (AGI) is calculated then the personal and itemized deductions are taken off. AGI is also used as a baseline for determining the amount of some other deductions to take, i.e. medical expenses. (1) GI less preferred deductions = AGI (adjusted gross income) (2) AGI less other deductions = taxable income (a) Other deductions may be standard or itemized (taxpayer's election to take greater of the two) (b) Preferred deductions you don't have to give anything up for v) Taxable income x applicable tax rate = tax due. Recall tax rates are progressive. vi) Tax due less tax credits = tax / refund due; (1) Credits = (a) Amounts paid (e.g. withholding) = [refundable credit] OR (b) Narrowly defined credits allowed for policy reasons = non-refundable credit 1 1


(2) Tax credits are better than deductions for lower incomes because they reduce tax liability dollar for dollar, not taxable income. ii) Constitutional Issues i) Government power to tax derived from Article I, §8, clause 1. ii)Retroactivity (1) Congress has never tried to retroactively initiate a new tax, will never happen. (2) The retroactive change of an existing tax, i.e. disallowing a deduction, has been found to be constitutionally OK. iii) Uniformity (1) Tax does not have to be apportioned equally among the states but federal taxes must be uniform. Amendment 16 says so. (2) When some manner of mode of tax is used in one area must be used in all. For example, cannot tax bonds in NY but not in PA iv) If a tax law is so arbitrary and capricious as to be confiscation or spoiling it can be defeated under 5th Amendment issues. iii) Tax Policy Issues i) Policy helps resolve ambiguous and/or conflicting statutes and sections. ii)Revenue estimation issue - If one section is instituted that will decrease government revenues this is usually balanced by changes in other sections to maintain level of revenue. Called "revenue neutrality" (take something out, have to replace revenue). iii) General principle in interpretation is horizontal equity: all those similarly situated should be similarly taxed. iv) Statutory Sources Issues i) Internal Revenue Code - Title 26 USC (1) Is dynamic, not static. Present Code = 1986 tax law as amended (real world, applicable law can be as of 20 years ago). (2) Some portions of code are only valid for pre-arranged periods of time and then expire; allows for legislative re-review. (3) New sections are continually added. ii)Reasons to be aware of Code changes (1) Rules are constantly changing and in practice need to be aware so do not review client tax issues looking at wrong year in Code. (2) A repealed code section may continue to apply to property placed in service or acquired before the repeal. Depreciation and basis are two examples. (3) Case law decided under the provision may be relevant in determining what similar provisions mean, and interpreting that case law will require another look at a repealed section. (4) Even absent case law, there may be clues in a repealed section that would help resolve the meaning of other code sections. (5) The impact of prior rules on current and future costs and planning are important. (6) For example, depreciation and the method in which it must be taken affects taxpayer for years to come. (7) It is relevant for someone who has failed to file a income tax return for that year. (8) Relevant for IRS and client during an audit and if the audit leads to litigation. (9) Relevant if someone needs to amend a tax return during that year. iii) The changes occur through amending acts, not through re-writing Code. (1) Annotated versions of Code contain prior rules by dates. (2) Effective dates for provisions are not in the Code, they are in the public law bill. Effective dates are cause of complexity. 2 2

(3) Some congressional provisions that affect the tax code are never in the Code, they remain in separate but related legislation. iv) Moratorium attempt v) Structure: See M9 vi) Legislative History: Not written by the legislature, written by their staff. (1) They are helpful, but not binding. (2) Textualism: if you write it, that’s what you wrote AND meant. v) Administrative Source Issues i) Regulations - § 7805 allows regulations written by administrator of agencies enacted to administer the Code (Treasury Dept., IRS). (1) Have to follow the Administrative Procedure Act (APA) system of notice, comment, public hearings before regulation passed. Very slow process. (2) Legislative vs. Interpretative: The bulk of regulations are interpretations of the Code. Legislative regulations- sometimes Congress just delegates authority to IRS to issue regulations to further particular principles. (3) Temporary regulations can last up to 3 years due to length of APA process for permanent regulations. Regulations with T in number are temporary: to become permanent have to be passed per APA. (4) All regulations, including temporary ones, can be challenged but usually survive challenges. (5) There is a Congressional 60-day rejection period of proposed regulations. (6) Delay: there are more regulations to be written than people to write them. (7) Inconsistency with statute: regulations sometimes lag behind an updated statute. The applicable code section may be wrong if the regulation lagged behind the statute and wasn’t changed yet. (8) Structure: see M9 ii)Revenue Rulings - the opinion of the IRS tax attorneys (1) Interprets regulations/code- IRS' position on application of Code to certain facts. Taxpayer advice memo (TAM)- IRS agent in the field writes for advice. Private Letter Ruling (PLR). (2) Should be given weight and deference but are not dispositive. Not binding on IRS for anyone but requestor unless published. Courts treat as opinion of IRS attorney. (3) Gives taxpayer (TP) the IRS view on a given issue and how it will decide during an audit. (4) Found in Cumulative Bulletin. iii) Private Rulings (1) At request of taxpayer (2) Give TP ruling as to the consequence of a proposed transaction. Is protection but not necessarily precedent. Probably shouldn’t cite to them (3) Service now charges for these, so people don’t request them as much iv) Other sources (1) Internal material: GCM, AOD, Mem., Mimeo, O.D. (2) Form instructions (3) Notices, announcements, news releases, etc. (4) General counsel memos (5) Action on Decisions (6) IRS publications (7) See 88 Tax Notes 305 (2000) for full inventory of IRS Guidance Documents (in materials) 3 3

vi) Tax Research i) CCH and other publishers ii)IRA iii) BNA Tax Management - multi-volume discourse on tax issues with sections on (1) Legislative history (2) Amendments (3) Regulations (4) Tax cases annotated (5) Editorial explanations vii) Processing of Tax Returns i) Is a self-compliance system with approximately a 99% compliance rate for salary and 75% for interest/dividends. Filing of return through self-compliance system (vs. property tax, e.g.). (1) Recall if withholding, filing is only way to get refund (thus compliance w/ W-2's = 98% whereas w/ 1099's = 30%). (a) Withholding is one practical compulsion. Income not subject to withholding has a much lower compliance rate. Resistance to wider scope of withholding. (b) Reporting is another practical compulsion. When required social security numbers for dependents of a certain age, millions of dependents disappeared. (2) Moving toward electronic filing: paperless returns. (3) Once in computer, checked for arithmetic and cross-checked against info on forms (W-2's etc.); IRS also checks itself (did it run through system correctly ?). (4) Revenue shortfall: 200 billion. As of right now, there are people not complying. ii)Everyone with income that basically exceeds the personal deduction and standard deduction needs to file a return. iii) Once you start to file, file from then on because may be audit criteria if you disappear and then re-appear. iv) Audits - focus generally on new hot areas of the law and areas where misrepresentation commonly occurs. (1) Taxpayer Client Measurement Program (TCMP) - worst kind of audit to be called for. Service checks everything and TP either proves it or loses it. Service uses TCMP process to determine what areas to audit in general process. (2) Chance of audit - 1 in 104 but is misleading because Service is also looking for TPs who fit the particular profile base they are after. (3) Discriminate Income Function Test (a) Program IRS runs on returns looking for certain "red flags". (b) The lower the TP's DIFT score the better. (c) Score items on the return (that look suspicious or and audit concentrating on those items. Items includes changes in law, certain types of people (lawyers) and items with typically low compliance. (d) "Today's hot issue"(e) Note hierarchy: examiner; auditor; agent; special agent. Special agent in audit only if suspect criminal fraud. (4) Specific Occasion Audit (a) If go work for government, particularly for IRS get audited. (b) Tips from neighbors. (5) There is a reward program for tattling on other TPs to IRS. (6) Criminal Charges - Handled by the Special Agents. TP should not try and handle this without a criminal tax attorney. 4 4

(7) If audited: (a) Get along with auditor (b) Once audit outcome is that TP owes the Service issues a deficiency notice to the TP to receive payment. TP can (i) Pay (ii) Pay and then sue for refund. 1. Conflicting authority: IRS position is go with them (even if all Courts of Appeals disagree); IRS doesn't regard any nonSupreme Court decision as binding one more than party involved. 2. Notice of deficiency gives you 90 days to pay or file in Tax Court. 3. One out of eight cases gets dismissed. Six out of eight are settled. One out of eight makes it to the Tax Court for determination. 4. Presumption is in favor of IRS, IRS has burden of showing civil tax liability. (iii) Refuse to pay and appeal (petition must be within 90 days of notice or late fees/interests start). (8) Scope of audit (a) Theoretically: everything. (b) Practically: usually limited. v) Preparer is potentially liable- anyone whose advice leads to something on return. Issues include: (1) Competence (2) Loyalty to client (3) Conflict of interest (4) Client confidences vi) Due dates (1) April 15 for individuals. Automatic four-month (is it 6?) extension but taxpayer must pay tax. (2) March 15 for corporations. viii) Statute of Limitations i) § 6501(a)- Normal statute limitations: IRS has 3 years from date return filed or due (whichever is later) to issue notice of deficiency. Exceptions: (1) It is 6 years from date return filed or due (whichever later) if IRS can prove greater than 25% omission of GI. See § 6501(e)(1)(A). (2) Can be waived or extended by agreement and IRS often asks for waiver/extension of statute of limitations. See § 6501(c)(4). (3) No limit if there is fraud. See § 6501(c)(1). (4) If the client never filed a return, the statute of limitations never starts to run. See § 6501(c)(3). (5) Interest calculated from date of liability. See 6601(a). Interest allowed for refund as well under § 6611(a) and the rate is in § 6621(a). ii)For taxpayer, has 3 years from actual filing or 2 years from time tax was paid if later. See § 6511(a). iii) Suspended while judicial proceedings underway.



GROSS INCOME I. Scope of Gross Income A. Defined in § 61: ―Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.‖ B. Provides examples in § 61: ―including (but not limited to) the following items:‖ 1. Compensation for services, including fees, commissions, fringe benefits, and similar items; 2. Gross income derived from business; 3. Gross income derived from dealings in property; 4. Interest; 5. Rents; 6. Royalties; 7. Dividends; (Note: includes cash dividends, but not stock dividends or stock splits (See Eisner v. Macomber) 8. Alimony and separate maintenance payments; 9. Annuities; 10. Income from life insurance and endowment contracts; 11. Pensions 12. Income from discharge of indebtedness; 13. Distributive share of partnership gross income; 14. Income in respect of a decedent; and 15. Income from an interest in an estate or trust. C. Reg 1.61-14(a) provides other examples: “For example, punitive damages such as treble damages, under the antitrust laws and exemplary damages for fraud are gross income. Another person’s payment of the taxpayer’s income taxes constitutes gross income to the taxpayer unless excluded by law. Illegal gains constitute gross income. Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.” 1. Reduced to undisputed possession- it seems like property, but it is really wealth. D. Have to have an increase in economic wealth. Amount of cash and the fair market value of property found is gross income. Realization: act by which your relationship with the property is changed in a way that causes you to come into an exploitation of wealth.

1. Have to extract wealth. Finder of treasure trove examples: i. Find cash, gross income ii. Find diamonds, return to owner, not gross income iii. Diamonds found and kept, it is already realized and there is gross income. iv. Buy picture on sale, not gross income v. If turns out to be worth more than thought, then not gross income. vi. Picture and artist dies, have not yet extracted wealth, not gross income. vii. Buy picture frame and find original declaration of independence, gross income. viii. Buy a piano and find diamonds, bought piano and found diamond, so gross income. (kind of like Cesarini v. United States: Bought piano and found money in it. Court held that finder of treasure trove is in receipt of gross income. Found cash which is per se extracted.) ix. Buy house, find diamond, gross income x. Buy ―house and all its contents‖ and find diamond, not gross income xi. Buy a grab bag, you buy its contents, if it contains diamond, then got a good price for a diamond, not gross income. 6 6


xii. Buy grab bag after store announces only one of all grab bags has a diamond in it (i.e. lottery), gross income xiii. Buy grab bag and find cash exceeding cost of bag, gross income 2. Reduce all transaction down to cash transactions KNOWN AS: Substance over Form / Step Transaction i. Employer purchases a car for employee’s spouse. Transaction is treated as transfer from employer of compensation gross income to employee, then employee buy’s car for his spouse. (Reverse step – transaction doctrine, breaking it down into all the steps.) ii. Employer who pays employee’s federal and state taxes, is treated as though employer paid compensation gross income to employee, then employee paid taxes himself. See Old Colony Trust Co. V. Commissioner. 3. Exchanges of services: You can also be wealthier having someone do something for you that you couldn’t have done before. i. Revenue Ruling 79-24 1. Situation 1: In return for personal legal services performed by a lawyer, house painter painted the lawyer’s personal residence. Reg 1.61.-2(d)(1) provides that if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. 2. Situation 2: An individual who owned an apartment building received a work of art created by a professional artist in return for rent free use for 6 months. Fair market value of work and 6 months rental value are includible in gross income. 3. Example: Owner agrees to rent cabin which ordinarily rents for $4000 to Tenant for $1000 if T makes $3000 worth of improvements using $500 materials supplied by O. O has $4000 GI ($1000 cash + $3000 services) [fn: $3000 improvements in real estate increase his basis in it]. T has $2500 GI (compensation for services in making improvements; assuming improvements worth $500 materials & $2500 labor). 4. Miscellaneous: i. Sale- unless facts indicate something other than a bona fide, arm’s length transaction, sale indicates that new fair market value of the item is the sale price. ii. Imputed income: Usually when a transaction involves yourself. 1. For example, carpenter who does a lot of gardening and raises value of property. Not gross income because administratively difficult to figure out. More examples: a. No GI when harvest (imputed income) b. No GI when you eat the harvest (imputed income) c. BUT, GI when sell the harvest (realization event); i. Calculated by Amount Realized (AR) less Adjusted Basis (AB)Note: basis does NOT include labor (because imputed all along) Gifts § 102 a. What constitutes a gift: i. What is a gift checklist: A. Did you provide consideration? B. Why was the transfer made? a. Need sufficient intent and Harris says look to: i. Circumstances ii. Relationships iii. Transactions 7 7

b. Need detached and disinterested generosity: Commissioner v. Duberstein- There must be a showing of ―detached and disinterested generosity.‖ The transfer must be made ―out of affection, respect, admiration, charity or like impulses.‖ Note that this is really a case by case factual determination. c. The motive of the donor determines whether it was a gift. If the donor had mixed motives, his primary motive controls. ii. § 1041(b)(1)- Note that when property is transferred to a spouse (or to a former spouse, if the transfer is incident to divorce), the property is treated by the transferee as a gift, and thus is excluded from the transferee’s gross income. b. Gift Rules In general: § 102(a)- Amounts received as a gift, bequest, devise or inheritance are excluded from gross income. i. § 102(b)- The exclusion does not apply, however, to income from property received by gift or inheritance; nor does the exclusion apply to a gift or devise of income from property. A. § 102(b)(1)- Income derived from gifts: even though property is transferred as a tax free gift, any income subsequently derived by the donee from the property is taxable. B. § 102(b)(2)- Gift of future income: if the gift involved is solely of future income, then all money received is taxable to the donee. ii. § 102(c)- The exclusion does not apply to a gift from an employer to an employee. A. Gifts vs. Compensation examples: a. Commission v. Dubesrstein: Duberstein had frequently told Berman of potential customers for Berman’s products so Berman gave Duberstein a car. This was really in recognition of past services and to encourage future referrals. The Supreme Court held that it was not a gift. Here the primary motive was not a ―detached and disinterested generosity.‖ b. Stanton v. US: Stanton was the church treasurer who was given a bonus by the church when he retired. The court held that was for the trier of fact to decide the church’s primary motivation, it was possible that it could meet the ―detached and disinterested generosity‖ test. It was subsequently held that the payment was a gift. c. United States v. Harris: Payments to mistress, were not gross income because of the donor’s intention. The court suggested that such payments should generally be treated as gifts under § 102. d. Goodwin v. United States: Pastor received gifts on every birthday, Christmas, and anniversary of becoming a pastor of each year from congregation. Court held this was gross income. Court looked at: compensation on its face given it exceeded his annual salary; method of collection which was organized and directly tied to congregation; and the identity of the transferor which the court said was clearly the congregation acting as an aggregate body. B. Proposed Reg 1.102-1(f)(2) a. Employer to employee: For purposes of section 102(c), extraordinary transfers to the natural objects of an employer’s bounty will not be considered transfers to, or for the benefit of, an employee if the employee can show that the transfer was not made in recognition of the employee’s employment. b. Related-party employer-employees: Accordingly, section 102(c) shall not apply to amounts transferred between related parties (e.g. father and 8 8



son) if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment. i. Thus, parent who employs kid and gives gift is excluded from gross income. c. What is the relationship between the parties becomes an extremely important question. If congregation gives reverend a $5,000 check on retirement. Is it gross income? i. If reverend is an employee of congregation, then § 102(c) would apply and while may need more info, sounds like it will be gross income. ii. If reverend is employed by higher entity outside congregation or is an independent contractor, then analyze under detached and disinterested generosity. If that is met, then excluded. iii. Example: If retiree receives a $5,000 trip on retirement and employer contributed $ 2,000 and employees contributed $ 3,000, does retiree have gross income. Where part of money comes from fellow employees, treat as two transactions. One part from fellow employees which is excluded from gross income as a gift and one part from employer which is gross income unless de minimus. C. Note that under § 102(c), the transfer to the priest would be treated as income regardless of the church’s motivation because a transfer to an employee cannot be excluded as a gift. D. In summary: No amount received by an employee from his employer is excluded from gross income as a gift, although there are two limited exceptions to this exception. a. Some employer provided economic benefits, such as fringe benefits, are excluded under other Code provisions. See § 132. b. Under § 74(c), certain employee achievement awards are freed from tax. c. Gift tax consequences- Imposed on taxable gifts except to charity and spouse. i. Up to $10,000 for single person, up to $20,000 for married couple. Inheritances- § 102 : a. § 102(a)- The value of property acquired by bequest, devise or inheritance is excluded from gross income. b. Reg 1.102-1(a): “Property received as a gift, or received under a will or under statutes of descent and distribution, is not includible in gross income, although the income from such property is includable in gross income.” c. The statue has been broadly construed to exclude from gross income virtually all acquisitions made with donative intent in the devolution of a decedent’s estate. d. An amount is not excluded from gross income, however, merely because it is provided for in a will. i. The exclusion does not apply if the transfer is not of a donative intent and is instead compensation for services, payment for property or some other payment which would be included in income if received directly rather tan by means of a will. e. Suing for inheritance: Does not matter if party had to sue for inheritance, it will be excluded. i. Except the way in which you sue can influence tax. If you sue under quantum meruit, then you are saying you did something and there was a failure to pay. Therefore, it wouldn’t really be of donative intent! Prizes and Awards: § 74 9 9

a. § 74(a)- Gross income includes prizes or awards. Therefore, the Noble Prize is included in gross income. b. Exceptions (not included in gross income) i. § 74(b)- Charitable transfers. A. 74(b) and 74(b)(3): A prize or award is excluded from gross income if it is made primarily in recognition of religious, charitable, scientific, educational, artistic, literary or civic achievement, and it is transferred directly by the payor to the charity or governmental unit designated by the recipient without any possession or use by the recipient. B. 74(b)(1) and (2): The exclusion applies only if the recipient is selected without any action on his part to enter the contest and if he is not required to render substantial future services as a condition to receiving the prize or award. C. If a qualifying assignment is made and the prize or award is excluded from the winner’s income, no charitable contribution deduction is allowed. D. Example: if the Noble prize winner directs the Noble committee to transfer the award to the American Cancer Society, the recipient would not include the award in gross income (but would also not get a charitable deduction for the transfer) ii. § 74(c)- Employee Achievement Awards A. First, look at definition of an employee achievement award. a. § 274(j)(3)(A)- An employee achievement award is an item of tangible personal property transferred as part of a meaningful presentation by an employer to an employee in recognition of length of service or safety achievement, but it does not include disguised compensation. i. “item of tangible personal property” 1. Stock- not tangible - certificate just shows ownership. 2. Gift certificate- represent a credit or right to acquire something which is intangible. BUT regs look past form and see what certificate represents. So OK (tangible) if: a. Non-negotiable- cannot get cash because cash is not tangible as it represents an obligation of federal reserve bank. b. Redeemed only for tangible property. No good if good for use of resort home. And if for superstore, does not matter if turn in for intangible property because has to be only for tangible property. ii. “transferred by an employer to an employee for length of service achievement or safety achievement” iii. “awarded as part of a meaningful presentation” 1. Need to find out what happened to present award. 2. Address facts of issue. iv. “awarded under conditions and circumstances that do not create a significant likelihood of the payment of disguised compensation” 1. Not excluded if negotiated as part of deal. b. The dollar limits are also the maximum amounts the employer may deduct in computing its taxable income See § 74(c) and 274 (j). B. Second, make sure award complies with special rules a. If receiving a length of service award, make sure that employee has worked 5 years and not awarded a prize in last 4 years under § 274(j)(4)(B). 10 10


C. Third, go to Flow chart for § 74(c) Nonqualified Plan Award (*****For a qualified plan award, use $ 1600, not $ 400 in this flow chart*****). a. Does the total cost exceed $ 400? [§274(j)(2)] i. If Yes, go to b. ii. If No, exclude value of award from gross income under § 74(c)(1). b. Does nondeductible cost exceed value of award? § 74(c)(2)(A). i. If Yes, gross income includes greater of: § 74(c)(2)(A) which is nondeductible cost of award or § 74(c)(2)(B) which is value minus $ 400, so here § 74(c)(2)(A) is greater. ii. If No, go to c. c. Does value of award exceed $ 400? i. If No, then § 74(c)(2)(B) is zero and gross income includes nondeductible cost of award under § 74(c)(2)(A) (because §74(c)(2)(A) is greater than §74(c)(2)(B) because it is zero). ii. If Yes, then go to d. d. Does nondeductible cost exceed (value minus $ 400)? i. If No, then gross income includes value minus $ 400. ii. If Yes, §74(c)(2)(B) is zero and gross income includes nondeductible cost of award under §74(c)(2)(A) (because §74(c)(2)(A) is greater than §74(c)(2)(B) because it is zero.) D. Summary: An employee achievement award is excluded from the recipient’s gross income to the extent that the cost to the employer of providing the award (and all other awards during the taxable year) to that employee does not exceed certain dollar limits. Scholarships: § 74 and § 117 (a)-(c) a. § 117(a)- Gross income does not include a qualified scholarship. i. Qualified recipient A. Individual B. Candidate for degree- Reg 1.117-6(c)(4) states that a candidate for a degree is a. a primary or secondary school student b. an undergraduate or graduate student at a college or university who: i. is pursuing studies or conducting research ii. for an academic or professional degree c. student at a § 170(b)(1)(A)(ii) educational organization that is i. academically qualified 1. Educational program for bachelors or higher; or 2. Training for employment in recognized occupation ii. authorized under law AND nationally accredited. C. Attending a § 170(b)(1)(A)(ii) educational organization (see Reg. § 1.1176(c)(5)): a. normally maintains regular faculty b. normally maintains regular curriculum c. primary function: presentation of formal instruction d. normally has regularly enrolled student body e. students in attendance at organization’s campus (may bring in new questions about distance learning!!!) ii. Qualified scholarship [§117(b)] A. Permissible source 11 11


a. Scholarship or fellowship grant- Reg 1.117-6(c)(3): ―Generally, a scholarship or fellowship grant is a cash amount paid or allowed to, or for the benefit of, an individual to aid such individual in the pursuit of study or research.‖ b. Not received as compensation under § 117(c). B. Permissible use- See reg 1.117-6(c)(1) which states that a qualified scholarship is ―any amount received by an individual as a scholarship or fellowship grant to extent the individual establishes that a. In accordance with conditions of grant; b. such amount was used for qualified tuition and related expenses”- § 117(b)(2). i. Tuition and fees Ok Reg. 1.117-6(c)(2)(i) ii. Fees, books, supplies and equipment- OK if required for course and required of all students in course. Reg 1.117-6(c)(2)(ii) iii. Not an incidental expense- reg 1.117-6(c)(2)(ii) 1. Incidental expenses are not considered related expenses. 2. Incidental expenses include expenses incurred for room and board, travel, research, clerical help, and equipment and other expenses that are not required for either enrollment or attendance at an educational organization, or in a course of instruction at such educational organization. b. Example: Prob 115:1: Usage of money and compensation of services problems i. Scholarship that includes $ 3000 for books and $ 3000 for room and board. Additionally, getting $ 3000 for faculty research. Regs presume that the $ 3000 compensation for services is for $ 3000 room and board. Thus, presumed to be used first for outlays not permissible. Take amounts for compensation of services and use first for nonqualified stuff. For value, regs look to similar work in university by similar people. ii. Athletic scholarships A. Does tax that portion which is not used for tuition, such as room and board. B. In some instances, the remainder of the scholarship is not taxed because the student is not required to play in order to receive the financial assistance. a. And to the extent that the remainder is not taxed even though performance is expected, it is Congress that muzzles any attempt to deal correctly with tax issues involving college athletics. Athletes are not responsible for filing forms 1099, universities are and not forced to. C. Revenue Ruling 77-263: If athlete expected to play but not required, then exclusion is not jeopardized. D. IRS doesn’t enforce athlete scholarships strictly because of Congressional pressure (same with academic scholarships) iii. Lawyer receives money to go to get LLM from her firm. A. Gross income because have to provide future services. B. If not required to come back, payment for past services, and its gross income. C. Won as part of essay prize, look to § 74 which was amended to include scholarships, thus if have to use it, then excluded. SCHOLARHSIPS ARE USED FIRST FOR PERMISSIBLE USES ( look at slides for explanation) Discharge of Indebtedness- (NOT COVERED IN CLASS) § 61(a)(12), §108 a. § 61(a)(12)- Gross income generally includes income for the discharge of indebtedness. b. § 108 There are several statutory exceptions to the general rule. 12 12


i. Bankruptcy and Insolvency: Gross income does not include income for the discharge of indebtedness if the discharge occurs: A. in bankruptcy- § 108(a)(1)(A). a. If the discharge of indebtedness occurs in bankruptcy and the discharge also qualifies for exclusions from gross income under one of the other statutory exceptions, the bankruptcy rules control. See § 108(a)(2)(A). B. when the tax payer is insolvent- § 108(a)(1)(B). Defined as when your liabilities exceed your assets. a. The insolvency exception applies only to the extent the tp’s liabilities exceed the fair market value of his assets immediately prior to the discharge. See § 108(a)(3), (d)(3). ii. Gratuitous debt forgiveness- A debt cancellation which constitutes a gift or bequest is not included in gi of the recipient. Employment a. Transactions: in general i. Forms of Compensation A. Salary, wages. Etc. §61(a)(1) B. Employee awards §74 C. Pensions, deferred compensation §401 et seq. D. Employer payment of health and accident insurance §106 E. Group life insurance §79 F. Group legal services plans §120 G. Educational assistance §127 H. Dependent care assistance §129 I. Rental value of parsonage §109 J. Tuition remission §117(d) K. Meals and lodging §119 L. Other frings benefits §132 M. Others (military employees §134; adoption assistance §137, etc etc etc) ii. General Treatment of non-salary compensation A. Conditions for exclusion: (1) policy goals, (2) primarily definitional, (3) highly compensated employees B. Deferral v. untaxed C. Coordination with deductions iii. Pattern for Qualified deferred compensation A. Deferred income until withdrawn under § 401 et seq. for qualified deferred compensation plans. B. Advantages a. Rate differentiation advantage i. Excluded while in higher bracket. ii. Included while in lower bracket. b. Deferral advantage i. No tax today is good. ii. Tax in future is good. c. Growth advantage i. Usually investment earnings accrue to employee. ii. Not taxed until withdrawn. b. Fringe Benefits: § 132 c. No additional Cost Service 13 13

i. § 132(a)(1)- General rule excludes from gross income any fringe benefit that is a noadditional cost service. ii. No-additional cost service defined in § 132(b)(1)-(2). Two principle requirements must be met before it qualifies as a no additional cost service: A. § 132(b)(1)- that service must be one which is offered for sale in the ordinary course of the line of business of the employer in which the employee is performing the services. a. No additional cost services generally must be provided by an employee’s own employer to qualify for the exclusion. b. § 132(i)(2); Reg 1.132-2(b): Reciprocal Agreements: Provision is made, however, for 2 or more employers engaged in the same line of business to enter into a written reciprocal agreement under which services may be provided to an employee of another employer if non of the employers incurs any substantial additional cost (including lost revenue) in providing the service under the agreement. B. § 132(b)(2)- the benefit must constitute a service that imposes no substantial additional cost to the employer: a. Factors to look at in determining whether the no additional cost services fringe benefit exclusion applies: i. The amount of foregone revenue of the employer because of providing the service to an employee rather than to a paying customer, and ii. The amt of time spent by the employees in providing a service for an employee are factors taken into b. Ex: XYZ corp is engaged in 2 separate businesses, providing airline services and hotel accommodations. G works for them as an airline pilot, and when he is off-duty he is entitled to fly for fee on XYZ’s scheduled airline flights, on a space available basis. He is also entitled to free lodging in XYZ’s hotels if a room is available after 6pm G may exclude from gi the value of the airline services which he receives, but he may not exclude the value of the hotel services, because he does not perform services for XYZ crop I the line of business of providing hotel accommodations. C. Rebates: What if pays hotel bill and receives cash rebate? Literally, no exclusion because no service provided for free - money was given. However: a. Legislative history- bluebook and house report has language saying that they are the same thing and thus a cash rebate qualifies as excluded under § 132(a)(1) and § 132(b). b. Reg 1.132-2(a)(3) “The exclusion for a no-additional cost service applies whether the service is provided at no charge or at a reduced price. The exclusion also applies if the benefit is provided through a partial or total cash rebate of an amount paid for the service.‖ c. In other words, collapse the transaction, and it works. D. § 132(j)(1)- the no additional cost service exclusions are conditioned upon compliance with a nondiscrimination provision. a. this provision requires that the benefit be made available to a wide cross section or employees, including non-highly compensated employee b. Highly compensated employee: under reg 1.132-8(f)(1) an employee is a highly compensated employee if the employee i. owns 5 percent or more of the employer 14 14

ii. is paid salary or more than $75k, iii. is paid salary or more tan 50k and is one of the employer’s top wage earners or iv. is paid more than 150% of the amt specified in §415(c)(1)(A), which limits qualified pension plan contributions to $30k

d. Qualified Employee Discounts i. § 132(a)(2)- General rule excludes from gross income qualified employee discounts ii. § 132(c)- defines qualified employee discounts which means: A. any employee discount- got to § 132(c)(3)- which states that an employee discount is: a. the price at which the property or services are offered to non employee customers b. MINUS c. the price at which the property or services are provided to employees B. with respect to qualified property for services- go to § 132(c)(4) which defines qualified property or services. This includes: a. any services or property (other than real property or investment property) b. which are offered for sale by the employer c. to nonemployee customers d. in the ordinary course of the employer’s line of business e. in which the employee works. f. Qualified property means no stocks and bonds. C. Limits: Go back to § 132 (c)(1) which states that in the case of: a. Qualified Employee discounts for property i. Partial inclusion and partial exclusion- The exclusion for an employee discount with respect to qualified property may not exceed: 1. An amount equal to the ―gross profit percentage‖ of the price at which the property is offered for sale to other customers. 2. Thus, if discount is less than or equal to gross profit percentage, then OK. If more, then not forgoing just profit and treated as though transferring income. ii. Gross profit percentage: the gross profit percentage is essentially the employers average mark-up on his goods, and is determined by dividing the difference between the aggregate sales price of such property sold to customers by the employer, less the cost of the goods, divided by the aggregate sales price of the property. § 132(c)(a)(2) iii. Gross profit %=(aggregate sale price-cost of goods) Aggregate sales price 1. Regs say look back over three years for gross income percentage. iv. Ex: H is employed as a sales clerk in a home electronics appliance store. The employer gives her a $ 2,000 video recorder for $ 1,000. Her employer’s total sales of electronics during a year were 15 15

$1 million, and the employer’s aggregate cost for the goods was $600k. The employer’s gross profit percentage for the year is: 40% = ($1million - $600K) $ 1 million 1. The employee discount is excluded from H’s gi only to the extent of 40% of the selling price of the recorder ($ 800); the excess discount on the purchase ($ 200) is include in her gross income. b. Qualified employee discounts for services i. The exclusion of an employee discount with respect to qualified services may not exceed: 1. 20% of the price at which the services are offered to customers in the ordinary course of business, regardless of the employer’s gross profit percentage. [132(c)(1)(B)] ii. Ex: K is an employee of a corp engaged in providing life insurance, an insurance policy is considered a service rather than property. A particular policy normally requires a premium payment of $100, but K is entitled to the coverage for only $75. K may exclude only $20 of the employee discount with respect to the insurance coverage, the excess discount on the purchase of the insurance ($5) is included in gross income. iii. § 132(j)(1)- The qualified employee discount exclusions are conditioned upon compliance with a nondiscrimination provision. (Already discussed above) e. Working Condition Fringe Benefit i. General rule in § 132(a)(3) that gross income does not include the value of a working condition fringe. ii. Definition: § 132(d)- Working condition fringe is defined as ―any property or services provided to an employee by her employer to the extent that, it the employee paid for the property or services, herself, she would be entitled to a deduction under §162 (trade or business expenses) and 167 (depreciation).” A. Thus an employee who would be entitled to deduct the costs of a subscription to a professional journal if she bore those costs herself does not have to include the subscription as gross income This includes only those items which qualify under §§ 162 and 167. The terms include costs that are ordinary and necessary for one’s employment. B. if her employer supplies the journal free of charge. a. Some examples include: furniture, equipment, meals, lodging and transportation while the tp is out of town on business trips. C. If required to visit customer and you have to pay for it, then can be taken as deduction. a. Provided in kind- just ignore it if just gives you it. b. Reimbursement i. Exact match- nothing done. ii. Reimbursement exceeds cost- gross income to extent its over cost. iii. Cost exceeds reimbursement, get a § 132(d) deduction.



f. De Minimis Fringe Benefits. i. General rule in § 132(a)(4) which excludes from gross income de minimis fringe. ii. Under § 132(e)(1), de minimis fringe is defined as ―any property or service the value of which is so small as to make accounting for it unreasonable or administratively impracticable.‖ A. Reg: 1.132-6(e) lists the following as examples of de minimis fringe benefits: a. Occasional parties, b. Occasional theater or sporting event tickets, c. Coffee, donuts, soft drinks, and local telephone calls. d. There are MANY more examples listed in this regulation. Go there to see. e. This regulation also provides examples of what are NOT de minimus fringe benfits. B. Seems that there is around a $ 100 line. Giving something worth $ 125 is close. Add up $ 30, $ 25 and $ 15 gifts, starts to add up but probably not. C. Special Rule for Eating Facilities: [132(e)(2)] provides a practical rule for eating facilities operated by employers for their employees. a. The eating facility will be treated as a de minimis fringe benefits if: i. it is on or near the employer’s business premises and ii. the revenue from the facility generally equals or exceeds the employer’s cost of operating the facility. b. If a benefit is provided under an arrangement which discriminates in favor of the highly compensate employees, the exclusions for special eating facilities are not available. (this is similar to §132(j)). g. Qualified Transportation Fringe Benefits i. § 132(a)(5)- general rule which excludes from gross income qualified transportation fringe. Means transportation between residence and place of employment. ii. § 132(f)(1)- defines qualified transportation fringe as any of the following: A. Transportation in a commuter highway vehicle if such transportation is in connection with travel between the employee’s residence and place of employment. A “commuter highway vehicle”- § 132(f)(5)(B) is one that can seat at least 6 adults (not including the driver) and is used at least 80% of the time, measured by mile, to their transportation of employees between their residences and work or to transport at least 3 employees on business related trips. B. A transit pass- which is any pass or similar item allowing the taxpayer to travel on any mass transit or similar facility- § 132(f)(5)(A). C. Qualified Parking a. Parking provided to an employee on or near the employer’s business premises can be excluded from the employees’ gi up to a value of $185 per month. See § 132(f)(1)(C), (f)(2)(B, (f)(5)(C). b. The same exclusions is allowed where an employer furnishes parking at a location on or near the place from which an employee commutes to work by use of a transit pass, a commuter vehicle or by car pool-§ 132(f)(5)(C). iii. Limitations on Transportation Fringe Benefits: A. To qualify for exclusion for gi, the qualified transportation fringe benefit must be provided in addition to any other compensation paid to the employee, not in lieu of another compensation. § 132(f)(4). B. Cash reimbursements for qualified transportation fringes qualify for the exclusion, but if the reimbursement is for a transit pass, it will not qualify if a 17 17

voucher which could be exchanged for a transit pass is readily available for distribution by an employer to employees § 132(f)(3). C. § 132(f)(2)- Amount shall not exceed a. § 132(f)(2)(A)- 100 dollars a month which applies to the aggregate of the commuter highway vehicle and transit pass benefits. Thus if an employer provides an employee with both a transit pass and transportation in a commuter vehicle, the total exclusion allowed cannot exceed 100 dollars per month; any amt in excess of $100 is included in the employees gross income. b. § 132(f)(2)(B)- $ 185 a month in case of qualified parking. h. Non Discrimination rules i. If a benefit is provided under an arrangement which discriminates in favor or the employer’s highly compensated employees, the exclusions for some of the above fringes do not apply to those highly compensated employees. ii. Non discrimination rules only apply to these fringes: A. No add cost services B. Qualified employee discounts C. Employer provided eating facilities- § 132(e)(2). i. Definition of Employee i. No add cost services, qualified employee discounts, and employer provided gyms may be provided to an employee, as well as the spouse and dependent children of an employee. ii. With respect to the above fringes only, an employee includes an individual who is currently employed. A. Former employees who were separated from service by retirement or disability B. Widow and widowers of individuals who died while employed or while a retired or disabled employee- § 132(h)(1). iii. Use by the employee’s spouse and children. Each fringe benefit says provided by an employer to an employee, but: A. § 132(h)(2)- Use by the employee’s spouse or dependent children is use by the employee for no additional cost and employee discounts. B. § 132(h)(3)- Use by the employee’s parents of air transportation is use by the employee. This is a special rule because the chair of the house ways and means committee had two daughters that were flight attendants! j. § 132(l)- No other fringe benefits allowed other then provided for in this section. VIII. Meals and Lodging: § 107, 119 a. Meals- § 119(a)- excludes from gi the value of meals if: i. The employer furnishes meals to an employee, her spouse or dependents; ii. The meals are provided for the convenience of the employer; and A. Only if there is a substantial noncompensatory business purpose for providing the meals and if the meals are furnished without charge or if a flat fee forth meals is charged (§119(b)(3)). B. If an employer provides meals which an employee may or may not purchase, the meals will not be regarded as furnished for the convenience of the employer.. Reg 1.119-1(a)(3)(i). C. If there is a substantial noncompensatory business purpose for providing the meals, they are considered to be furnished for the convenience of the employer even though the meals may also be furnished as compensation. Reg 1.1191(a)(2)(i). 18 18

D. An employer furnished meals for a substantial noncompensatory business purpose if they are furnished to an employee during his working hours in order to have the employee available for emergency calls or because the nature of the employer’s business requires that meal periods be too short to reasonable expect employees to eat elsewhere. Reg 1.119-1(a)(2)(ii). iii. The meals are provided on the business premises of the employer. The business premises of the employer is the place where the employee carries on significant employment duties or the employer conducts a significant portion of his business. (Reg. §1.119-1(c)(1))


b. Lodging- § 119(a)- also excludes the value of lodging from gross income if the lodging: i. Is furnished on the business premises by the employer to an employee, her spouse or her dependents- § 119(a)(2); and A. The business premises of the employer is the place where the employee carries on significant employment duties or the employer conducts a significant portion of his business. (Reg. §1.119-1(c)(1)) ii. It is provided for the convenience of the employer and the employee is required to accept the lodging as a condition of their employment. A. In the case of lodging this section not only requires that the lodging must be furnished for the convenience of the employer, but also that the employee must be required to accept such lodging as a condition of this employment. § 119(a)(2). B. Regs state that terms of contract are not determinative and must show that nature of job requires to be on the premise. These reqs are satisfied if the employee is required to accept the lodging in order to enable him properly to perform his duties of his employment Reg 1.119-1(b). c. Additional considerations i. The exclusion provided by §119 is only for meals furnished to an employee; it does not authorize the exclusion of cash allowances or reimbursements for meals. ii. Employees family: the value of meals furnished to an employee’s spouse or any of his dependents may be excluded for the employee’s gi if the meals satisfy the business premises and convenience of the employer requirement. iii. Meals and lodging: if the value of lodging furnished to an employee is excluded from the gi, the value of any meal furnished without charge to the employee, her spouse and dependents is also excluded from her gross income Reg 1.119-1(a)(2)(i). iv. Groceries- j-split- tax court says no and third circuit says yes. Golson rule: Tax court would defer to the third circuit in the case of an appeal. v. Note that section 119 was really designed to cover situations in which the employee is constrained in his or her choice of food or eating places d. Rental value or Parsonage i. A ―minister of the gospel‖ may exclude from gi the rental value of a home furnished to him, or a rental allowance paid to him to the extent he uses the allowance for housing- § 107. ii. The language of the statute, notwithstanding, the exclusion is not confined to Christians Unemployment Compensation: § 85 and Social Security Payments: §86 a. Unemployment compensation- gross income includes amounts received under Federal or state law as unemployment compensation. See §85. b. Social Security Benefit - Taxable Amount: Somewhere along the line someone needed revenue. 19 19

i. Look at § 86(a): Is the taxpayer described in subsection (b)? A. §86(b)(1): Does the sum of the Modified Adjusted Gross Income (MAGI) plus ½ of the social security benefits received during the taxable year exceed the base amount (which is 32k on a joint return or 25k on a separate return (§86(c)(1)). a. MAGI equals i. Adjusted gross income, plus ii. Tax exempt interest b. Add: 50% of social security benefits plus MAGI. c. Then see if (a) plus (b) exceeds the base amount by Subtracting base amount (32k for joint return or 25k for separate return) from (a) plus (b). B. Is there an excess? a. If no, then enter zero as social security gross income. Finished process. b. If yes, how much. (Subtract base amount from MAGI plus 50% of social security benefits). Go on. C. Go back to § 86(a)(1): gross income equals the lesser of: a. 50% of social security benefits b. 50% of excess amount from B(b). c. Take the amount in (a) or (b), whichever is lesser, and continue (we’ll need this amount soon). D. Look at § 86(a)(2)- is this person a tax payer whom has an excess when: a. Take MAGI plus 50% of social security benefits b. And SUBTRACT adjusted base amount (44k if joint return or 34k on separate return). E. Is there an excess? a. If no, gross income is whatever was in C(c). Finished process. b. If yes, how much. (Subtract base amount from MAGI and 50% social security benefits). Proceed with this number – we’ll need it soon. F. Return to § 86(a)(2): gross income equals lesser of: a. 85% of social security benefits (§ 86(a)(2)(b)) b. § 86(a)(2)(a): sum of 85% of excess (excess is amount in 5(b)) plus an incremental amount which is lesser of: i. Amount in C(c) or ii. 50% of difference between old base amount and the adjusted base amount (always 4,500 because for separate returns this amount is $34000 – 25000 (§86(c)(1), (2)). G. Get this far, the amount in (F) is social security gross income. c. Bubble impact- By earning an additional $13,000 in gross income, an additional $6550 of social security is included in gross income. See M30 to show an illustration of what happens when someone receiving social security benefits chooses to earn income from a job. You’re still taxed as though you earned $19,000 if they earned $13,000. i. The wealthier person’s decision to make $13,000 additional income is taxed less than the poorer person’s decision to do the same. Income Earned Abroad: § 911 (textbook) a. Income Earned Abroad: Taxpayers working abroad can exclude up to 80k per year of their service income from foreign sources. i. To qualify, the tp must be either a bona fide resident of an uninterrupted period that includes an entire taxable yr or present for 330 days in a foreign country during a period of 12 consecutive months. 20 20



ii. The exclusion only applies to foreign earned income which is defined as income for a foreign source which is attributable to the tp’s performance of services. And the max. is 80k. iii. In addition, such taxpayers can exclude substantial amounts of housing reimbursements (or deduct a substantial part of their housing costs) A. House expenses include reasonable amounts paid for housing (including utility bills and insurance) in a foreign country for the tp and family members if they live together. B. Housing amounts do not include amounts paid as interest or taxes which are independently deductible. iv. Both the earned income and foreign housing cost exclusions are elective. Elections for each are made separately and once made remain in effect in future years unless revoked. v. The exclusions are denied to a tp for earned income and housing expenses in a foreign country in which travel by US citizens and residents is restricted. Gains From Dealings in Real Property: Always from seller’s perspective (because trying to determine what would be included in gross income.) a. Realization and Basis: i. In general A. Checklist a. Realization event? b. Amount realized? c. Adjusted basis? (measuring point) d. Gain or loss realized? e. Any excluded gain? f. Gain or loss recognized? (taking it into account on our return) g. Deductible loss? h. Character of gain or loss? B. § 61(a)(3) says that gross income includes gains derived from dealings in property. Whether you buy or sell it is considered a dealing in property for purposes of the tax code. ii. Realization Event A. Example: sale, not abandonment iii. Amount Realized A. In general terms, the amount realized is the consideration received for the property; it includes any money plus the fmv of any other property received in the transaction. §1001(b) The ―amount we get.‖ B. Fair Market Value of Consideration Received a. The fmv of property received as consideration for the sale or other disposition of property is included in the amt realized. The determination of the fmv of an item of property is a question of fact, involving a search for ―the price at which the property would change hands bt a willing buyer and a willing seller, nether being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Reg. 20.2031-1(b) b. If the value of property received in a taxable exchange cannot be determined directly, it is presumed to be equal to the value of the property given up in the exchange [Philadelphia Amusement Co v. U.S.] c. Only in rare cases will it not be possible to ascertain the fmv of property and thus compute an amt realized. 1.1001-1(a) 21 21

d. The amount realized includes the receipt of services and other economic benefits, including being relieved of liability. e. Ex: S brought a truck several yrs ago borrowing part of the purchase price from a finance co. today, he transfers the truck to T, who is a dentist. In addition to paying S 3k, t repairs S’s teeth (a service for which she normally charges $200), and she assumes Steve’s remaining $1500 debt to the finance company. Steve’s amount realized is 4700. C. Selling Expenses a. Commissions, and other expenses connected with the disposition of property which are incurred by a non-dealer seller reduce the amount realized. b. Generally, the type of expenditures which reduce the amt realized, if paid by the seller, are the same expenditures which would be included in the cost basis if the property if paid by the purchaser. c. Examples of such fees are: i. Appraisal fees, ii. Fees for abstracts of title, iii. Brokerage fees, iv. Legal fees, v. Recording fees, vi. Title insurance, vii. Title opinions, and viii. Transfer taxes. d. It is important to remember that the proper treatment of selling expenses is to reduce the amt realized, they are not deductions. D. Apportionment- several items are sold for one lump sum, the purchase price must be apportioned among the various items being sold so that the amount of gain or loss with respect to teach time may be computed. A lump sum purchase is generally apportioned according to the relative fmv of the items of property being sold. E. Mixed Motive Transactions a. Generally, if consideration received when property is sold is greater that (or less than) the fmv of the property, the discrepancy is disregarded. b. It is assumed that the buyer and seller negotiate at arm’s length and that the tax consequences should not be altered if the seller (or the buyer) is the better negotiator and thus receives more or less) than the property is worth. c. If the facts indicate that a portion of the payment is being made for purposes other than the sale of the property, however, such amount will not be included in the amt realized fro the disposition of the property. d. Ex: X agrees to sell a machine worth 8k fro 10k, and as part of the K, he agrees to keep the machine in good repair for a period of 3 yrs. Only 8k of the purchase price is allocated to the amt realized for the machine while the remaining 2k is compensation for the services which X has agreed to perform. iv. Basis A. In general a. The basis of an item of property is the amount which a taxpayer has invested, in a tax sense, in the property. 22 22

b. A taxpayer’s basis in an item of property is determined initially upon acquiring the property, and may be adjusted as a consequence of subsequent events. c. The adjusted basis of an item of property is used to calculate several important tax consequences with respect to the property, including the amount of depreciation, deductions which may be allowed, and the amount of a loss deduction allowable if the property is stolen or destroyed.

B. Cost Basis (§1012) a. § 1012- The basis of property shall be the cost of such property. i. If the property is purchased for cash, it is clear that the ―cost basis‖ of the property is the amount which was paid. Reg 1.10121(a). ii. However, property may be acquired in transactions other than a cash purchase, and still have a cost basis. The costs of acquiring property, such as soles commissions which are paid by the purchasers are properly included in the property’s cost basis, even though such amounts are not paid to the seller. See Woodward v. Commissioner. iii. Ex: Kathy purchases a parcel of unimproved real property for $10k cash, the cost basis of the property is 10k. If Kathy pays a real estate agent a commission of 200, for finding the land, in addition to the $10k which Kathy pays to the seller of the land, her cost basis for the land includes the commissions and thus the cost basis of the land is 10200. b. Deferred Payment: The cost basis of property is generally determined at the time the property is acquired, based upon the amount the party acquiring the property pays at the time of acquisition, or agrees to pay in the future (not including interest). i. This rule is based on the assumption that the purchaser will ultimately pay the full purchase price agreed upon, if the seller later agrees to accept a lesser amount, the cost basis of the property is reduced. c. Exchange basis i. Property is often acquired for consideration other than money (cash) or its equivalent (check) such as when one item of property is exchanged for another item of property. ii. In determining the cost basis of property received in an exchange, it seems logical to look at the fair market value of the property which is given up in the exchange. There is a presumption to this effect. iii. However, in the exchange of 2 items of property, there are tax consequences with respect to both items of property involved. 1. With regard to the property that is given up, it has an adjusted basis to the transferor, and thus there will be gain 23 23

or loss depending on what the ―amount realized‖ is in the exchange. 2. The amount realized for the property which is given up is the fair market value of the property received. §1001(b) iv. As to the property which Is received in the exchange, the tp must determine its property cost basis. In addition, the tax consequence of the property given up in the exchange must be determined at the same time. 1. Because it is the fair market value of the property received in an exchange which determines the amount realized with regard to the property given up, it is appropriate in an income tax context to determine the cost of the property received in a taxable exchange to the fmv of the property received, rather than the fmv of the property given up. 2. Note that these rules (in ii and iii) become significant only if the properties exchanged have different values; if, as is usually the case, they have equal values the above issue does not arise. v. Ex: M purchases a car from Ned for her personal use which has a sticker price of $15k, but instead of paying that amount, she exchanges her truck, which has a fmv of $15k and an adjusted basis to her of 10k. Mary’s cost basis for the car she received in the exchange is $15k, the fmv of the property received in the exchange. [In addition, M has a realized gain of $5k (15k - 10k) with respect to her truck]. if M had made a good deal and her truck was worth only $14k but the car was worth $15 (her gain is still $5k) and the cost basis of the car is still 15k, while Ned has an amount realized and cost basis of 14 for the truck. d. Tax Cost Basis i. A person may receive property without transferring cash or other property to the transferor, and yet receipt of the property results in tax consequences to the transferee. The cost basis of the property received is its fair market value ii. Ex: D performs services for his employer, and his compensation includes 25k cash and a motorcycle worth 4k. . D’s gross income includes the fmv of the motorcycle. Bc the motorcycle is included in his gi at its fmv of $4k, he has a‖tax cost‖ basis if the motorcycle is 4k. Reg 1.61-2(d)(2). e. Role of Liabilities i. If property which is encumbered by a liability is sold or otherwise disposed of and the liability is either assumed by the buyer (personal liability) or the property is taken subject to the liability (nonrecourse liability), the amt of the liability is included in the seller’s amount realized. ii. If the tp borrows money and mortgages property which he owns as security for the loan, he does not have gain or gross income bc borrowing is not a taxable event as there is no accession to wealth iii. Ex: z owns a parcel of real property which has an adjusted basis of 5k and a fmv of 20k when he borrows 10k, mortgaging the 24 24

property as security for the debt. Z does not have gain or gi because he does not have any accession to wealth (he must repay the loan. [ Woodsam Associates v. Comm’r]. Several years later after no repayment of principal on the loan Z transfers the property to Alice for 25k cash in addition to her agreement to assume the 10k mortgage. Z’s amt realized is 35k. The result would be the same if Alice merely took the property subject to the mortgage rather than assuming it [Crane v. Comm’r] reg 1.1001(2)(c) ex 2. Alternatively, if the property had a fmv of 9k but it was encumbered by a nonrecourse mortgage of 10k, and Z transferred it to Alice subject of the mortgage, Z’s amt realized is still 10k [Comm’r v. Tufts] C. Property Acquired from a Decedent: a. The basis of property acquired from a decedent is generally the fair market value of the property as of the date of the decedent’s death. §1014(a)(1). b. Because the date or death fair market value is often higher than its adjusted basis in the hands of the decedent just prior to death, it is common to refer to such property as receiving a “stepped up basis.” c. The effect of this rule permits the appreciation in the value of property which occurs during the life of the decedent to totally escape income tax. d. Ex: O bought a parcel of real estate 50 yrs ago for 2k, and on the date she died it was worth 1 million. Peter, O’s son, receives the property by devise under her will, his basis for the property is 1 million, If Peter immediately sells the land for 1 million, he does not realize any gain. (note that the appreciation in the land of 998k is never taxed because of the fact that P took the land at the fmv of it at O’s death and did not take it with a basis equivalent to O’s adjusted basis or basis). D. Basis for Property Acquired by Gift a. (INSERT numerical examples from Power Point slides) b. A donor does not have any realized gain when he transfers property by gift because he generally doesn’t have any amt realized on the transfer c. In addition, a statutory exclusions provides that gi does not include the value of property received as a gift by a donee. §102(a) i. However, the donee is generally treated as stepping into the shoes of the donor with respect to the gift property and in doing so the adjusted basis of the property acquired by the gift is the same in the hands of the donee as it was in the hands of the donor. § 1015(a) ii. Property acquired by gift is refereed to as having a ―transferred basis.‖ §7701(a)(42) iii. Ex: D gives E property which has a fmv of $120 and an adjusted basis to D of $100. One year later, E sells the property for $150. In computing E’s gain on the sale, E has an adjusted basis for the property of $100; thus the amt of his realized gain is $50 ($150 amt realized - $100 adjusted basis). d. Exception: The general rule does not apply if



i. The donor’s adjusted basis in the property is greater than the fair market value of the property, both amounts computed as of the date of the gift, and ii. The donee sells or otherwise disposes of the property in a transaction which would produce a loss. iii. If the exception applies, the property’s basis (prior to any adjustments which might be necessary because of events which have transpired while the property was in the hands of the donee) is its date of gift fair market value. [§1015(a), first sentence, “except clause”] iv. This exception prevents one person who holds loss property from effectively transferring (i.e. assigning or shifting) that loss deduction to someone else. The exception to the transferred basis rule produces a curious result if a donee disposes of gift property for an amount somewhere bt the donor’s adjusted basis and the date of gift fmv. In such a situation ,the donee has neither any gain nor any loss. v. Example: D gives E property which has an adjusted basis to D of $100 but a fmv of only $80. One year later, E sells the property for $50 cash. In computing the loss (defined by § 1001(a) ―as the excess of the adjusted basis . . . over the amount realized‖ ) on the sale, E has an adjusted basis for the property of $80, and thus the amt of loss is $30 ($80-50). Alternatively, E sells the gift property for $90, which is the ―amount realized.‖ the adjusted basis for determining gain, under the general rule, is $100 (the donor’s adjusted basis); however, there is not any excess amount realized over the adjusted basis, and thus there is no gain. The adjusted basis for determining loss ,under the exception to the general rule, is $80 (date of gift fmv); however, there is not any excess adjusted basis over the amount realized ($90), and thus there is no loss. See § 1001(a). Hence Ernie has neither a gain nor a loss on a sale at a price between $80 and $100. Reg 1.10151(a)(2) example. e. Part Gift-Part Sale-In General i. If the transfer of the property is part gift, part sale, rules provided in the regs work to the benefit of the transferor-donor if the property has appreciated, but not if the property has declined in value. ii. First the transferor-donor recognizes gain only to the extent that the amount realized exceeds the adjusted basis in the property. Reg §1.1001-1(e) 1. Second, however, no loss is sustained if the amount realized is greater than the adjusted basis. iii. The transferee-donee takes the property with a basis equal to or the larger of: 1. The amount the transferee pays for the property, or 2. The amount of the transferor’s basis in the property. See Reg 1.1015-4(a). iv. Example: H transfers property, which has an adjusted basis to her of 20k, and a fmv of 60k, to her Son, I for 30k. H has a gain of 26 26

10k and I has a basis for the property of 30k because the amount he pays exceeds H’s adjusted basis in the property. If the property had an adjusted basis to H of 40k (instead of 20k), she will not have a loss, and I takes the property with the basis of 40k. See Reg 1.1101-1(e). If the property had an adjusted basis to H of 90k (instead of 20), H will not have a loss. I takes the property with a basis for determining gain of 90k, and a basis for determining loss of 60k . See Reg 1.1015-4(b), ex. 4. E. Property Acquired from a nonrecognition transaction: § 1041 a. When property is transferred from an individual to her spouse (or to her former spouse, if the property is transferred incident to their divorce), the property is treated as received by the transferee as a gift, and its value is thereby excluded from gross income. § 1041(b). b. The adjusted basis of such property in the hands of the recipient is the same as the transferor’s adjusted basis. § 1041(b)(2). c. This special rule applies for transfers of property between spouses (or former spouses) d. The gift basis rules of § 1015 do not apply. See § 1015(e). e. Ex: R transfers property which has an adjusted basis of $100 and a fair market value of $80 to his wife S. S takes the property with a basis of $100 under § 1041(b). If she later sells the property for $90, she has a loss of $10. v. Adjustments to Basis A. In general: The adjusted basis for determining gain or loss upon the disposition of property is the property’s basis determined under the appropriate provisions of §§ 1012-1015, adjusted as provided by § 1016. See § 1011(a). a. In general,adjustments called for under § 1016 are necessary in order to accurately measure the amt of the property owner’s investment, in a tax sense, in the property. b. Therefore, property’s basis is increased in amt of any capital additions to the property and decreased in the amt of any deductions that have been taken reflecting a return to the tp of his investment in the property. B. Increases a. The basis of property is increased by the amount of capital expenditures, such as the cost of capital improvements to the property. § 1016(a). i. Ex: K purchased a lot and a house 2 yrs ago for 100k. Last yr he had a pool installed in the yard at a cost of 15k and a garage built at a cost of 10k. K’s adjusted basis in the property is 125k. Reg 1.1016-2(b). C. Reduction: a. In general: The amt of reduction in basis on account of deductions for depreciation, amortization or depletion is the greater of the amt ―allowed‖ (taken) or the amount ―allowable‖ (could have been take). § 1016(a)(2). D. Items with no effect on basis a. Rental improvements by lessee. i. § 109- provides that gross income does not include anything other than rent. Like a nonrecognition provision because goes into gross income later. ii. § 1019 provides that neither the basis nor the adjusted basis changes when have improvements made by lessee. Pay tax on 27 27

improvements when sell property. Despite fact that when owner takes full title back, person realize increase because not lessee improvements anymore and relationship with property has changed. vi. Any Gain or Loss Realized- § 1001(a) A. In general: The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis and the losee should be the excess of the adjusted basis over the amount realized. §1001(a). a. In general terms, the amount realized is the consideration received for the property; it includes any money plus the fmv of any other property received in the transaction. §1001(b) b. Any Excluded Gain? i. Principal Residence Exclusion A. § 121(a)- gross income shall not include gain from the sale or exchange of property if, during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the tax payer as the taxpayer’s principal residence for periods aggregating 2 years or more. B. Consequence: exclusion of first $250,000 of gain ($500,000 on joint return) (§121(b)(1)-(2))) a. Have gain realized, but can exclude some or all of it. C. §121(b) Conditions: a. Own and use property as principal residence for periods aggregating at least 2 years during past 5 years b. No exclusion during previous 2 years (§121(b)(3)) D. §121(c): If failure to meet ownership/use requirement due to change in employment, health, or unforeseen circumstances, then the dollar limitation on the exclusion is reduced to the regular dollar limitation multiplied by: (Shorter of ownership/use period during 5 year period or amount of time since last use of §121 exclusion) 2 years c. Gain or loss recognized? Nonrecognition: Basic concept of nonrecognition: realized gain, not otherwise excluded from gross income, is not reported as gross income if certain requirements are met. i. Deferral via modification of adjusted basis: nonrecognized gain ―inherent‖ in replacement property or in the property now held by the transferee ii. Requirements vary depending on the transaction iii. Marital Property Transfers §1041 A. No gain or loss is recognized on sales or other transfers between spouses or former spouses if the sale is: a. Connected with marriage, which is either a: i. Transfer to spouse ii. Transfer to former spouse if incident to the divorce. b. Transferee’s basis equals transferor’s adjusted basis. B. Recipient’s Basis: the recipient’s basis and the holding period remain the same as the transferor’s basis -- whether the property was appreciated or depreciated and regardless of whether the acquiring party paid for the property. §1041(b)(2). C. Incident to Divorce § 1041(c), Reg 1.1041-1T: 28 28

a. Even if a property division occurs after divorce, it still falls under the nonrecognition rule if it occurs within one year after the cessation of the marriage. § 1041(c). i. A transfer is treated as related to the cessation of the marriage if it is made pursuant to a divorce or separation instrument and the transfer occurs within 6 years of the date the marriage ceases, or if the parties can demonstrate that the transfer was made to effect the division of property owned by the former spouses at the time the marriage ceased. Reg 1.1041-1T(b), Q & A-7. ii. The non recognition rule of §1041(a) does not apply, however, if the property is transferred to a trust and liabilities on the property exceed the adjusted basis of the property. §1041(e) b. If transfer occurs more than six years after marriage, presumed to not be connected with cessation of marriage and have to rebut. D. Note that the Non Recognition on transfers between spouses or incident to divorce the recipient takes with the adjusted basis of the transferor and in this sense it is like a gift under § 102, where the recipient gets the donor’s basis, therefore the value of the property is excluded from gross income under §102. E. Example: A and W own property accumulated during their marriage worth 500k. The property is in H’s name. As a part of a property division ordered by the family court, an asset worth 250k is conveyed to W. H’s adjusted basis for this asset was 60k. under § 1041, H recognizes no gain on this transfer. W’s basis for the asset is 60k. F. Ex: In yr 2, R transfer to his former spouse, S, shares of stock in X corp which have a fmv of 250k and an adjusted basis to R of 100k. The transfer is made pursuant to a written agreement bt R and S which provides that the stock is to be transferred in consideration of S’s release of any dower or any other marital rights she might have in R’s property; the agreement is incorporated in their divorce de decree, rendered in Year 1. R has realized a gains of $150k ($2050100k) on the transfer but bc the transfer is incident to the divorce, none of the gain is recognized. S does not include the value of the stock in her gi; S’s adjusted basis for the stock is the same as R’s adjusted basis, 100k and she also tacks his holding period. iv. § 1031: Like Kind Exchanges A. § 1031(a): No gain or loss is recognized on an exchange where property held either for investment or use in a trade/business is exchanged solely for property of a like kind. Need the following: a. Exchange- property being surrendered and other property being received. b. Property i. Held- § 1031(a)(1) 1. For productive use in trade/business- cannot just be sitting around or not contributing to activities of business (this is unproductive use) 2. For investment a. Holding for investment b. Does not count if for personal use. 3. Not a disqualified intangible- see § 1031(a)(2) which says section does not provide to list of intangibles.



c. Solely for property of a like kind i. If non-like kind property is received (boot) or cash received, gain recognized to extent property fair market value and cash. See § 1031(b). Partial recognition. ii. Regs state for like kind defined by example. iii. Nature of property: truck for a truck, does not apply to shoe making machine for farm machine. iv. But no loss recognized if boot/cash received- § 1031(c). v. Real property like kind to real property. d. Identify acquired property within 45 days- § 1031(a)(3). e. Receive property within 180 days/return due date. Earliest date of 180 days or due date for return. B. Like Kind Defined: §1031(h): ―Like Kind‖ refers to the general nature or character of the property, not to its grade or quality. C. Personal Property: the definition of ―like kind‖ is stricter for personal property. For example coins that are valuable or collecting purposes are not of like kind with foreign currency. [Cal Federal Life Insurance Co. v. Commissioner]. Indeed, the IRS asserts that gold bullion and silver bullion are not of like kind since silver is used primarily as an industrial commodity and gold primarily an investment. D. Basis in property received in exchange- § 1031(d) a. Basis in property surrendered MINUS cash received PLUS gain recognized MINUS loss recognized. E. Allocate that amount among the properties received, assigning to boot a basis equal to fair market value. d. Realized gain (loss) vs. Recognized gain (loss) i. The entire amount of realized gain or loss is required to be recognized, unless a specified provision provides otherwise. 1001(c) ii. If a realized gain is recognized, it is included as an item of gi. A. A realized loss, even if it is a recognized loss, must find statutory authority before it can be deducted in computing taxable income. B. Further, in some situations a loss may be realized and recognized but a deduction for the loss may be disallowed (§276(a)(1)). C. All or a portion of a realized gain or loss may be entitled to a non-recognition under certain circumstances. e. Deductible Loss? i. General Rule: A deduction is allowed for any loss during a taxable yr which is not compensated by insurance or otherwise. § 165(a) A. A loss must be sustained to be deductible. a. An unrealized decline in the value or property does not give rise to a deductible loss. Reg 1.162-1(b). B. Individuals: § 165(c): may take deductions only for losses which are incurred in ―a: a. Trade or business (165(c)(1)) b. Losses incurred in transactions entered into for profit (165(c)(2)) c. And certain casualty losses - see Casualty loss Section (165(c)(3)) ii. Amount of Loss §165(b) A. The amt of a loss from the sale or other disposition of property is the excess of the adjusted basis of the property over the amount realized. § 1001(a). iii. Gifts of Property - No shifting of Loss 30 30

A. When a gift of property is made and the fair market value is less than the adjusted basis, the recipient takes the property/gift with his basis as the fair market value (the lower amt). B. Thus, there is no shifting of losses. iv. Related Party Transactions §267: Can the shifting of the loss problem be gotten around by selling it to the kid? A. General Rule: No deduction is allowed for any loss arising for the sale or exchange of property between related taxpayers. § 267(a). B. Timing issue: In addition, a taxpayer on the accrual method of accounting may not take deductions for interest or other expenses to be paid to a related to who is on the cash method of accounting until the amt is actually or constructively paid. § 267(a) C. “Related taxpayers” include : a. An individual and her brothers and sisters, spouse, ancestors and lineal descendants (§267(b)(1) and (c)(4)) b. An individual and a corp which the individual owns directly or indirectly, more than 50% of the value of its outstanding stock c. The fiduciary of a trust and the grantor if that trust d. Various fiduciaries and beneficiaries of 2 or more trusts with relationships betwen certain corps, partnerships and educational and charitable organizations. § 267(b) e. Many others in §267(b) v. Losses and Relief on Subsequent Sales: § 267(d) A. Generally: No deduction is allowed for any loss incurred on the sale or exchange of property between related taxpayers. § 267(a)(1) B. Exception: However, if a loss is disallowed with respect to an item of property and the property is later sold or disposed of at a gain by the transferee related a party, the gain is recognized only to the extent it exceed the amount of the previously disallowed loss. § 267(d) vi. Examples are included in the Loss section under ―deductions‖ f. Character of Gain or Loss? i. Property dispositions A. Characterization: Introduction a. Nature of characterization: i. Some gains are characterized as ―capital gains‖ 1. Gains that are not capital gains are ―ordinary income‖ (§64) ii. Some losses are characterized as ―capital losses‖ 1. Losses that are not capital losses are ―ordinary losses‖ (§65) B. Terminology (“capital”) a. NOT the same as the term ―capital‖ as used in the phrase ―properly chargeable to capital account‖ which means ―capitalization‖ b. NOT the same as the term ―capital‖ as used in the phrase ―return of capital‖ which means recovery of basis. ii. Significance of capital characterization: A. Capital gains are: a. Subject to special lower rates (8%, 10%, 18%, 20%, 25%, 28%). They apply to different categories or capital gain (such as ―qualified 5-year 31 31





gain,‖ ―adjusted net capital gain,‖ ―collectibles gain,‖ ―mid-term gain,‖ ―net capital gain,‖ and ―unrecaptured section 1250 gain.‖) §1(h) i. Actual computation = exercise in arithmetic gymnastics that would be a challenge if §1(h) was free of definitional inconsistencies and other errors. B. Capital losses a. Corporations: capital losses are deductible only to the extent of capital gains. §1211(a) b. Individuals: Capital losses are deductible only to the extent of capital gains plus $3000. §1211(b) i. This is what I’m doing this year – get by income down to $3000. c. Capital losses are not deductible under the §1211 limitations are carried forward to the next taxable year. §1212 So what is a capital gain or loss? A. Positive tests: either a. Gain or loss from sale or exchange of capital asset. See §1222(1)-(8), OR i. Abandonment is not sale/exchange b. Deemed to be gain or loss from sale or exchange of a capital asset (e.g. §1235(a) (patents)) B. Negative test a. Must not be deemed NOT to be gain or loss from sale or exchange of a capital asset (e.g. §1239(a)(sale of depreciable property between related parties)). Sale or exchange A. For our purposes, essentially what the words mean. a. Remember that a gift of property subject to a liability is treated as a sale (part-gift, part-sale) b. Abandonment: not a sale or exchange c. Collecting receivables: not a sale or exchange d. Destruction by casualty: not a sale or exchange e. Theft: not a sale or exchange B. There are provisions that DEEM a transaction to be a sale or exchange: e.g.: a. §1241 (treating amounts received by a lessee for cancellation of a lease as though received in exchange for the lease) b. §165(h)(2)(B)(treating personal casualty gains and losses as capital gain/capital loss if personal casualty gains exceed personal casualty losses) Capital Asset (§1221): A. Property held by the taxpayer is a capital asset. B. Except: a. Inventory (§1221(1)) b. Depreciable trade or business property (§1221(2)) c. Trade or business realty (§1221(2)) d. Receivables arising from trade or business (§1221(4)) e. Copyrights, literary and musical works, etc etc (§1221(3)) f. US govt. publications (§1221(5)) g. Basically, taking out trade or business property because they want to treat it specially  best of both worlds  §1231 §1231 property 32 32

A. Covers (generally) depreciable trade or business property and trade or business realty if held for more than 1 year (see §1231(b)) (Again, inventory, receivable, and some other items excluded form the definition) [§1231(b)(1)(A)-(D)] B. If gains from sale/exchange of §1231 property exceed losses from sale/exchange of §1231 property, then all those §1231 gains and losses are treated as capital gains/capital losses. C. If gains from sale/exchange of §1231 property do NOT exceed losses from sale/exchange of §1231 property, then all those §1231 gains and losses are NOT treated as capital gains/capital losses. a. Treated as ordinary losses b. Let’s see why . . . .

vii. Why §1231? A. In essence, if there is a net gain from the sale/exchange of §1231 business assets, then it is treated as a capital gain, giving the taxpayer the benefit of the §1(h) rate limitations. B. Whereas, if there is a net loss from the sale/exchange of §1231 business assets, then it is treated as an ordinary losses, thus escaping the §1211 capital loss limitation. a. This is the best of both worlds. b. We’d rather have less ordinary income (taxed at a higher rate) and more capital gain (taxed at special rates – lower) viii. §1231 gets complicated for 3 reasons: A. It also applies to gains and losses from condemnation or casualty destruction of: a. Trade or business property (§1231(a)(3)(A)(ii)(I)) b. Capital asset held for more than 1 year in connection with a trade/business or for-profit activity (§1231(a)(3)(A)(ii)(II)) i. We won’t dwell on this, just know it exists. B. Casualty gains and losses are netted separately and put into the overall gain/loss comparison only if ―business‖ casualty gains exceed ―business‖ casualty losses (thus net ―business‖ casualty loss is ordinary loss.) (§1231(a)(4)(C)) a. So, only net gains from business casualty losses are included in the other §1231 gains/losses. C. Recapture provision to deter deliberate bunching of gain sales in one year and loss sales in another. (§1231(c)) a. We won’t cover this, just know it is there (very complicated) D. Note: casualty gains/losses from casualties are either going to be capital or ordinary  you can’t split them. ix. Depreciation Recapture (§1245, 1250)



A. What it does: recharacterizes some or all of the gain from the sale or exchange of depreciable property as ordinary income, even if the property is a capital asset or within the §1231 rules. B. Why these provisions were enacted: a. The theory is that the depreciation deductions were used to reduce ordinary income. Those deductions also reduced the property’s adjusted basis. This causes gain to be more than it would otherwise be. Thus, this gain should be ordinary income because it can be traced to an ―ordinary deduction.‖ i. But what if when you sell it you realize the property didn’t go down in value? ii. Depreciation is a ―fake deduction‖ iii. You take it because Congress says you can C. Exceptions for some nonrecognition provision (taint carries over), gifts (same, will deal with it when donee sells), death (taint expunged, will never have depreciation recapture) D. The rules differ for personalty and realty. Many differences but the essential ones are these: a. §1245 applies to personalty; §1250 to realty b. Under §1245 all depreciation is subject to recapture recharacterization whereas c. Under §1250 only the excess of actual depreciation over what would have been claimed using straight-line depreciation is subject to recapture recharacterization. E. Note: depreciation of MACRS realty is limited to straight-line so by definition, no recapture a. That’s why MACRS property isn’t subject to depreciation recapture b. Tax law clearly encourages investment in real estate F. Observe: for pre-MACRS real property, once the property is fully depreciated, straight-line = accelerated and thus there is no recapture. a. But this is dwindling down, not much left. G. INSERT EXAMPLES FROM POWER POINT SLIDES and NOTES ATTACHED. XII. Investment Income: Some common types of investment income: a. CONSISTS OF: i. Rent ii. Interest and Dividend income iii. Higher education and bond interest income iv. Tax-exempt interest v. Life insurance, why? A. Transfer for value B. Prorated Amount vi. Annuities A. Return of capital B. Investment in contract: what you put into the annuity to buy it. C. Expected rterun D. Living past payout E. Dying before expected vii. Compare life insurance with proceeds received over time and annuities 34 34

b. Dividends, Interest: § 61, 103: While § 61(4) and (7) say that interest and dividends are in taxable income, § 103 excludes some interest on State and local bonds, dividends. c. § 103- Interest on State and Local Bonds i. Generally: Interest earned on bonds and other obligations of state and local governments is excluded from the federal income taxation - i.e. excluded from gi. § 103(a). ii. Exception: §103 (b): The exceptions are: §103(b)(1)-(3) A. Private activity bond which is not a qualified bond. Any private activity bond which is not qualified bond within § 141. B. Arbitrage Bond - any bond within the meaning of § 148. C. Bond not in registered form. etc. Any bond unless such bond meets the applicable requirements of §148. iii. However, if the proceeds of the bond issue are used for private purposes (e.g. construction of factories) the interest is included in gi. iv. Note that interest on federal bonds is in gross income - § 103(b). d. Interest- Reg 1.61-7(a): As a general rule, interest received by or credited to the tp constitutes gi and is fully taxable. Interest income includes interest on savings or other bank deposits, interest on coupon bonds, interest on an open account, a promissory note, a mortgage, or a corporate bond or debenture, the interest portion of a condemnation award, usurious interest, interest on legacies, interest on life insurance proceeds held under an agreement to pay interest thereon, and interest on refunds of federal taxes. e. Higher Education Bond Interest § 135 i. The code excludes the income resolution from the redemption of US savings bonds, if a tax payer spends an amount equal to the redemption proceeds for ―qualified higher education expenses.‖ ii. The bonds must be purchased after 1989 and the tp must be at least 24 yrs old when the bonds are purchased. iii. The exclusion is phased out at AGI exceeding 60k (40k for singles). iv. This exclusion is designed to give a tax break to middle class parents for higher education expenses of their children; it will seldom apply to bonds purchased by the students themselves (since to take advantage of the exclusions a tp must be at least 24 yrs old when the bonds are issued, as opposed to when they are redeemed. §135. v. Note the assumption made by § 135: The rising redemption value of the savings bond is deferred until the bonds are cashed in; the Code allows this deferral (unless the tp elects to include the interest in gi during the yr). §454 f. Life Insurance and Annuities: § 101 i. § 101 Life Insurance A. General Rule - Amounts Paid by Reason of Insured’s Death: Benefits paid under an insurance contract, by reason of the death of the insured, are excluded from gross income - § 101(a). a. Excludable benefits: must be paid ―by reason of the death of the insured. §101(a)(1) b. Exclusion not applicable: to payments made under an insurance policy for reasons other than death of the insured. i. Such as when the insured cashes in on the policy and receives its cash surrender value during his life, or ii. When she elects to receive annuity payments or other lifetime benefits B. Life Insurance Defined: Neither the Code or the Regs define what constitutes life insurance as used in § 101(a). 35 35

a. However, the Supreme Court has indicated that ―life insurance historically and commonly involves risk shifting and risk distributing.‖ See Helvering v. Le Gierse. b. Therefore, if the particular contract does not shift any risk of premature death to the insurance co., it is not life insurance. [Rev. Rule 65-57]. c. Annuities Different: because life insurance involves some shifting of the economic risk of death of the insured, the exclusion does not apply to a contract for the payment of a future annuity, but provided further that if the annuitant dies before the first annuity payment is due, his estate is to receive the greater of the premiums paid for the K or its cash surrender value, the contract does not involve any risk with regard to the death of annuitant. C. Exceptions to § 101(a). ***GO OVER THIS BETTER*** a. Transfer of Policy For Valuable Consideration- § 101(a)(2) i. The general rule for excluding the proceeds of life insurance does not apply if the policy has been ―transferred for a valuable consideration...‖ ii. The amount which can be excluded from gi is the amt paid for the policy by the purchaser/transferee and any subsequent premiums he pays. The exclusion may not exceed this amount. 101(a)(2). iii. Ex: Donald pays 5k for a life insurance policy worth 100k. He sells it to Ella for 5k. At Donald’s death, Ella may not exclude the proceeds from Donald’s death, she must include the 100k less the 5k she paid for it, in her gi - i.e. 95k. b. Installment Payments: i. If the death benefits are payable by the insurer in installments, and the unpaid balance bears interest, that portion of the installment payments that represents interest is taxable, although the balance is exclude from gross income. ii. If the insurer simply holds the proceeds and pays interest thereon, the interest is taxable. 101(c), (d). iii. If the installment payments are computed without a separate allocation of interest in each payment, the amt treated as interest is determined in the same manner as for annuities. c. Insurance Company Keeps the Principal sum/Interest: i. An alternative rule applies if the insurance company keeps all or part of the principal sum, and the beneficiary receives primarily interest earned on the principal sum. ii. In such circumstances the § 101(d) proration rule does not apply, and the interest payments are included in gross income in full. § 101(c). iii. Qualified insurance payments are excludable whether they are paid in a lump sum or in several payments. 101(a)(1) iv. The exclusion: however, is only available in the amount of the lump sum payable at the date of the insured’s death or if payments are to be made in the future, the date of death present value of such future payments. 1. If future payments are to be made, the excludable amt is computed as of the date of the insured’s death, and prorated over future payments. 101(d)(1) 36 36

2. The effect of this rule is to exclude the principal amount payable at the death of the insured, but to require the beneficiary to be taxed on amounts earned by that principal sum 3. Ex: A life insurance co gives the policy beneficiary, C, the choice of receiving a lump sum of 100k cash or annual payments of 12k for 10 yrs. The maximum amount C may exclude is 100; if she elects to receive the annual payments, the 100k excludable amount is prorated over the 10 year period, or 10k/yr. For each 12k annual payment, C will exclude 10k from her gi, and she will include the remaining 2k. a. This same rule applies if C elects to take an annuity for here life and she has a 10yr life expenctancy. However, if she lives beyond her 10yr life expectancy the exclusion continues to apply. b. Compare with annuities - different result. c. But if she dies she loses all the remaining exclusions 4. The regulations provide that the question of whether a payment falls within 101(c) or (d) depends on whether there is a ―substantial diminution of the principal amount during the period when such interest payments are made....‖ Reg 1.101-3(a). ii. Annuities § 72(a)-(c) A. General Rule: Gross income includes annuities. (§72(a)) B. Annuity Contract: is one in which the tp invests a fixed sum which is later paid back with interest, in installments for a set period or for life. a. Annuity: Payment paid to a person for their life under an annuity contract. The opposite of life insurance. Protection against living too long. C. That part of each annuity payment that represents the tp’s investment in the policy is exempt as a return on capital. The interest portion, however is income. D. Computation of Excluded Portion: § 72(b)(1) a. Exclusion Ratio = Investment in the Contract Expected Return under the Contract b. Investment in the Contract: is usually the amount of premiums paid for the contract. § 72(c)(1). c. Expected Return: under the contract is determined by multiplying the payments made to the purchaser by either i. the number of payments called for under the K ii. or if the period for making payments is determined with reference to someone’s life expectancy, by an appropriate actuarial value provided in the regulations. E. Total Amount of Exclusion: the total amount of exclusion which may be excluded over a period of years is limited, however to the amount of the tp’s investment in the annuity contract. 72(b)(2) and (4). Thus if the purchaser outlives his life expectancy then all of the subsequent payments are in gi, if he dies early - see below. 37 37

F. Death of TP Before Return on Investment: If the tp dies before the has received payments equaling or exceeding his investment in the annuity contract, a deduction is allowed for the unrecovered investment amount on his final tax return. § 72(b)(3) and (4). a. The deduction only equals the amount of his investment whcih he has not yet received back. No deduction for the fact that he will lose the expected profit bc they would be taxable anyway. b. If Payments on Annuity Contract were made to other persons and the purchaser dies: then under 72(b)(3) if the recipient falls under c(2)(B) and (C) (i.e someone who was to get the payments as a benefit after purchasers death) then the person who received the payments gets the deduction. iii. Comparing Life Insurance to Annuities A. If live beyond life expectancy a. § 101 exclusions continue b. § 72 exclusions stop B. If Die prior to Life expectancy a. § 101 you will not get a deduction for the amounts not yet recovered on the policy b. § 72: the tp will get a final deduction for his unrecovered investment on his final tax return X. Damages- § 104(a) A. § 104(a): provides: a. That except in the case of amounts attributable (and not in excess of) deductions allowed under § 213 (relating to medical, etc, expenses) for any prior taxable year, gross income does not include: i. Amounts received under workmen’s comp acts as compensation for personal injuries or sickness; ii. The amount of damages -other than punitive damages- received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. iii. Amounts received through health or accident insurance for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts 1. Are attributable to contributions by the employer which are not includable in gi of the employee or 2. Are paid by the employer iv. Amounts received as a pension, annuity or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geo Servey or the Public health services, or as a disability annuity payable under the provisions of §808 of the Foreign service Act of 1980 and v. Amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2)). vi. In flush language: . . . Under para (2), emotional distress shall not be treated as a physical injury or physical sickness. This sentence shall not apply to an amount of damages not in excess of the amt paid for medical care (described in (a) or (b) of § 213(d)(1) attributable to emotional distress. B. Generally: Look at substance of the claim not form. Generally the tax consequences of receiving an award of damages (or settlement) will be determined by the nature of the underlying claim. 38 38






a. Damages for lost business profits are included in gi, as a liquidated damages for the breach of contract to sell property i. If the underlying claim is based on an alleged injury to a tp’s business or profession, an award of damages generally adds to his wealth rather than merely compensating him for a loss. ii. As well as punitive and exemplary damages under anti trust statutes. b. If an award of damages “makes the person whole” by compensating for a loss, she does not have gi to the extent the compensation does not exceed her adjusted basis in the damaged property. Similarly, a recovery which is in the nature of a recovery of capital is excluded from gi. i. Ex: In year one, U lends V 10k cash. V did not pay it back so U sues him. In yr 5, before the case went to trial, V settled the action by paying U 12k, 2k of which was interest. The 10k is excluded from gi, as repayment of the principal amt of the loan, the 2k interest is included in gi. Compensation for Injuries and Sickness: §104(a) i. In general: § 104 excludes from gi amounts received from several sources as compensation for personal injury or sickness. But if the source is a suit or settlement the award must be for personal physical injury or personal physical sickness. ii. Limit to exclusion: The exclusion is not available, however, if the recipient has taken a deduction, in any taxable year prior to receiving the compensation, on account of the medical expenses that he is not being compensated for. 104(a), 213 1. This rule prevents the tp from getting a double benefit for medical expenses, once by taking a deduction under § 213 in the year the expense is paid and again by excluding amounts received to compensate for the expenditure. 2. § 213 has a corresponding provision which disallows a deduction for medical expenses that the tp has already received compensation for. Workmens Compensation: § 104(a)(1) a. Amounts received from workman’s compensation are excludable from gi. b. Amounts received by certain governmental employees and retired armed forces for personal injuries or sickness are excludable under provisions conceptually similar to the workmen’s comp provisions. See 104(a)(4) and (5). Defining Personal Injury: a. Generally those physical injuries and physical sickness due to torts - intentional and unintentional. b. The Supreme Court in US v. Burke, held that the exclusions for personal injury [now physical] applies only to damages redressing a tort like personal injury. c. Tort like injuries usually includes lost wages, medical expenses, lost future earnings. Punitive Damages: a. Now are included in gross income. b. Actually, § 104(a)(2) just says not within § 104 and § 61 states that it is income derived from whatever source so included because no other provision excluding it. Recoveries under Accident or Health Insurance: § 104(a)(3) a. Amounts received from accident or health insurance for personal injuries or sickness are excludable from gi. There is no limitation the amount which may be excluded under this provision b. However, the exclusion does not apply if the payments are made to an employee either: i. Under an accident or health plan to which the employer made contributions which were excluded from the employee’s gi under § 106 or ii. By the employer. 39 39

c. Amounts received by an employee, which do not qualify for this exclusion may qualify, however, for an exclusion under § 105. XI. Alimony- § 215, 71, 7701(a)(17) A. Alimony – General Rule 1. A deduction is allowed for amounts paid as alimony or separate maintenance payments. § 215. 2. Alimony and Separate Maintenance payments are included in the gi of the recipient. § 71(a) a. The deduction/inclusion provisions are interdependent, thus, the deduction is authorized only for payments which are includable in the gi of the recipient. b. The deduction for alimony or separate maintenance payments may be subtracted from the gi in computing agi and therefore is not subject to any limitation on itemized deduction. It is an above the line deduction. § 62(a)(10)

B. Definition of Alimony or Separate Maintenance Payments. §71 1. A payment qualifies as alimony if its satisfies all of the following requirements: a. The payment must be in cash (including check, or money orders payable on demand)- § 71(b)(1) b. It must be received by or for spouse- § 71(b)(1)(A) c. It must be received under a “divorce or separation instrument”- § 71(b)(1)(A) d. The payment must not be designated as not income/deductible in the divorce/separation instrument- § 71(b)(1)(B) e. If legally separated under divorce/separate maintenance decree, payor and payee must not be in same household- § 71(b)(1)(C) 1. This is important in front loading also because if the first payment is made and then in the following three yrs, if in the first yr they live together after divorce decree, then the first payment made when don’t live together is the first post separation year payment. Note also that there would be no deduction/inclusion for the years they lived together after the divorce. 2. The above does not apply if they are living in the same house under a separation decree because it is not under 71(b)(1)(C) which says separate maintenance decree. So there the first yr payment even if live in same house counts for the first post sep yr. 3. Thus, two events trigger the divorce agreement and separate maintenance payments. 4. Regs give thirty-day period to move out. Courts say that they can’t live in the same house at all if they are divorced. 5. Create two dwelling units? That is factual issue. f. No obligation to make payments after death of the payee- § 71(b)(1)(D) g. No obligation to make payments after payee’s death as substitute for those payments- § 71(b)(1)(D) 2. If the spouses are still marred to each other they must not file a joint return. § 71(c)(1). C. Divorce/Separation Instrument: §71(b)(2) 1. A divorce or a separation instrument is a. A decree of divorce or separate maintenance or a written instrument incident to such a decree b. A written separation agreement or 1. Can’t be oral c. A decree (other than of divorce or separate maintenance) requiring a spouse to make payments for the support or maintenance of the other spouse. 71(b)(2) 40 40

1. Ex: A divorce decree provides that C is to make annual payments to D of 30k for a period of 6 yrs, or until D dies. In addition, the decree requires C to pay D or D’s estate 20k each yr for a period of 10yrs. The 30k annual payments will qualify as alimony, if D and C do not share the same dwelling unit at the time the payments are made. The 20k annual payments, however, do not qualify as alimony because they do not terminate at D’s death. Reg 1.71-1T(b), Q& A-10 D. Alimony Recapture: Front-Loading Rules- § 71(f) 1. Concept a. An adjustment to ―undo‖ a previous year’s reporting of tax consequences that were proper when reported but which are viewed from hindsight as incorrect in light of events occurring in subsequent taxable years. i. Contrast the situation where if the tax consequences were improperly reported in the first instance, then an amended return or IRS change to the return is the appropriate remedy. b. As applied to alimony: i. For alimony to ―undo‖ the payor’s deduction and the payee’s inclusion to income, the recapture requires: (§71(f)(1)) 1. Payor has gross income in the amount of the recapture 2. Payee has a deduction in the amount of the recapture ii. This is the REVERSE of the original reporting, i.e., ―undo‖, because if you want to undo a deduction you have gross income and if you want to undo gross income you have a deduction. iii. Recapture is computed and taken into account in the 3rd post-separation year, i.e., the 3rd year in which deductible alimony is paid 2. Purpose is to prevent front loading. a. Otherwise, it is too easy to disguise nondeductible property settlement as deductible alimony, particularly if payee spouse is in zero or low tax bracket and payor spouse is in high bracket. b. Even if the payments made satisfy all the requirements of alimony, there are 2 additional limitations which may affect the deduction/inclusion of the payments. These results are intended to prevent the parties in a divorce from structuring a property settlement so that it will qualify as alimony. c. A property settlement generally is larger than alimony and paid shortly after the divorce is granted; unlike alimony, amounts paid as property settlement incident to a divorce are not deductible by the payor and are not included in the gi of the recipient. d. Front loading: refers to making payments shortly after a divorce or separation which are ostensibly ―alimony‖ but which are significantly larger in amount than payments made in years later. 3. Exceptions to Front Loading Requirements: § 71(f)(5)(A) and (B). First look for an exception because if there is one there is no need to do the recapture calculation. No recapture if: a. The payments actually cease upon the death of either spouse- § 71(f)(5)(A); b. The payments stop upon the remarriage of the recipient spouse- § 71(f)(5)(A); c. The payments are made under (b)(2)(C) support decree- § 71(f)(5)(B) d. The payments are made under provision requiring fixed portion of income from a business, income from a property, from compensation, or from self-employment- § 71(f)(5)(C). 4. Computations: Mechanics of alimony recapture a. The amount included in gross income by payor and deducted by payee is the ―excess alimony payments.‖- § 71(f)(1). b. Excess alimony payments are the sum of: i. The excess payments for the first post separation year- § 71(f)(2)(A) 1. First Post Separation yr -§ 71(f)(6): is the first calendar year in 41 41

which the payor spouse pays deductible alimony. ii. Plus the excess payments for the 2nd post separation year- § 71(f)(2)(B). 1. Second and Third Post Sep years: are the next 2 succeeding calendar years, respectively. § 71(f)(6). iii. Thus, there are 2 computations, and the results are added together to yield ―excess alimony payments.‖ Must do the ‖excess payments for the 2ndpost-separation year‖ before doing the ―excess payments for the 1st postseparation year‖ because the former is an element in computing the latter. See § 71(f)(3)(B)(i)(I). c. Excess payments for the 2nd Post Separation year: § 71(f)(4) equals: i. Alimony payments made in the second post sep year over (MINUS)- §74(f)(4)(A) ii. Alimony payments made in the 3rd post separation year increased by $15,000- § 71(f)(4)(B)(i). iii. Thus, excess payments for 2nd post separation year= 2nd year payments - (3rd year payments + 15,000). iv. So if payments of 80k, 40k, 10k, 40k - (10k + 15k) = 15k*. d. Excess Payments for the 1st Post Separation Year: § 71(f)(3) i. Alimony paid in the 1st post-separation year over (MINUS) the sum of: § 71(f)(3)(A) 1. The 2nd and 3rd year average which is: (§71(f)(3)(B)(i)) a. Alimony paid in the 2nd post-separation year REDUCED by (the excess payment in the 2nd post-separation year* PLUS the alimony payments made in the 3rd post separation year) DIVIDED by 2. b. So if 80k, 40k, 10k, the average would be (40k - 15k*) + 10k DIVIDED by 2 = 17.5k. 2. PLUS $ 15,000 (§ 71(f)(3)(B)(ii)._ ii. =1st yr paid - [(2d yr paid -2d yr excess*)+ (3d yr paid) 2 +15k] iii. So if 80k, 40k, 10k, then 80k - [sum of ((40k-15k*) + 10k) / 2) PLUS 15k] = 80k (17.5k + 15k) = 47.5k. e. Excess payment = (1st year excess + 2nd year excess*) and the payee is entitled to deduction in computing gi or payor must include the amount in gi. So if 80k, 40k, 10k, total recapture is 47.5k + 15k = 62.5k. 5. Why Front Load? a. Because the payor is usually in a higher bracket than the payee and he may be in a position to be in a lower bracket in the 3d yr by calculating losses then, so then the 3rd year would be a good year to recapture and take it in gross income. b. Note that even with recapture there is an incentive to play around with front-loading because of the 15k leeway built into the calculation. So look to see if there is a drop between the 2nd and 3rd year payments. i. This allows the payment to drop in a subsequent year and not be in recapture. ii. Ex: payments = 80, 70, 60. There is no recapture because between the 70 and 60 (i.e. 2nd and 3rd year) payment there wasn’t a 15k drop, so here there will be no recapture. iii. Back load payments: 30, 40, 80. There will be no recapture because the payments are increasing. 6. Effect of Recapture: a. Note that even when there is recapture, since the payor has taken a deduction in earlier years, when there is a recapture it is not total because of the prior deductions. b. Recapture will never be as much as the total amount of alimony paid bc of the 15k in the calculation. 7. Risk with Recapture: 42 42

a. Because of the expectations regarding death and remarriage, if you try to use the recapture provisions to your advantage, and the person dies or remarries in the 2d post separation year, then there will be not recapture. i. Note that the payee will lose their deduction ii. And the payor will not have to include it in gi and perhaps he wanted to. b. The first payment may not be the first post sep yr for purposes of recapture, because you are divorced and you lived in the same house, so that year doesn’t count. i. Thus if you pay 80,80,80,0 in the first 4 yrs and in the first year you were divorced and lived in the same house, the first post separation is year 2 really and then despite the fact that you made three equal payments the first three years, there will be recapture because the first post sep year (2d payment) was really yr two (now = first post sep yr)and as between years 3 and 4 they now become the 2d and 3d post sep yrs and there is an 80k difference! So there will be recapture. This will be true also if you were only told to pay for 3 yrs because even though nothing was due in yr 4, its still the third [post sep yr for purposes of recapture. ii. Note here that if the difference had been 15k or less then no recapture because of the 15k leeway in the formula. c. Spouse dies before 3rd post-separation year, no recapture. E. Child Support § 71(c) a. General Rule: Child support is not deductible by payor, nor is it includable as gross income by payee. i. A payment under the terms of a divorce or separation instrument is not treated as alimony to the extent it is fixed, in terms of an amount of money or a part of the payment, as an amount payable for child support of children of the payor spouse. § 71(c) ii. Fixed Amt: an amt is treated as ―fixed‖ for child support if a payment is to be reduced, either on the happening of a specified contingency relating to a child, such as reaching the age of majority, marrying or dying or at a time which can be clearly associated with such a contingency. § 71(c)(2) iii. Less than Full Amount paid § 71(c)(3): if the payments actually made in any year are less than the full amount specified in the divorce or separation instrument, the amount which is paid is treated first as made for child support, up to the fixed amount for that purpose in the instrument and the remainder is treated as alimony. b. Ex: divorce degree provides for 10k/yr and 4k of which is child support. The payor only pays 5k the first yr. The result is that the fist 4k is child support and the remaining 1k is alimony. c. Here there is a social policy at work. The idea is that you don’t get your alimony deduction until the child support is paid in full. Thus if you always pay less than or equal to the child support amount but less than the alimony amount, it will all go the child support for tax purposes and the payor will get no deduction and it will also not be in the gi of the payee. i. If try and hide child support in alimony until 18, but § 71(c)(2) will stop and regs say have one year window if reductions occur.



XIII. Deductions Generally a. Categories of deductions: i. Trade or business ii. Income-generating activities (only for individuals) iii. Allowable ―in any event‖ without regard to existence of trade, business or incomegenerating activity iv. Special deductions for individuals b. Analysis of deductions i. Is it deductible? ii. Is it subject to a general restriction or limitation on deductions? iii. Whose deduction is it? iv. When is it deductible? v. Individuals: is it subtracted in computing adjusted gross income? XIV. Trade or Business §162 a. Trade or Business Expenses - §162(a) i. General Rule: § 162(a): A deduction is allowed for ordinary and necessary expenses paid or incurred during a taxable yr in carrying on a trade or business. Thus, basic requirements: A. Ordinary and necessary: An otherwise qualified expenditure must be both ―ordinary‖ and ―necessary‖ to be deductible. B. Expenses paid or incurred C. During the taxable year D. In carrying on E. Any trade or business ii. Ordinary: An expenditure is ordinary and necessary if it is one which is common within the business community to which the tp belongs, even though the expenditure may be ―extraordinary‖ to a particular taxpayer in the sense that its once in a lifetime. A. Term of art that is within usual scope of that trade or business and if not necessary, extremely helpful in conducting business or trade. B. Welch standard is way of life. C. Ex: a tort action is filed against Anita’s business, and in order to preserve and protect her business, Anita incurs an expense for attorney fees to defend the suit. She has never been involved in such a suit before and it is of such a nature that it is unlikely that she will ever be involved in such an action again. Nonetheless it is common an accepted in the business community to incur attorney fees for defending such lawsuits. The expense for the attorney fees is ordinary. See Welch v. Helvering. iii. Necessary: an expenditure is necessary if it is appropriate and helpful to the trade or business. Not optional. A. An expenditure is not necessary and thus not deductible, if the tp could be compensated or reimbursed for the expense or if the amount of the expenses is unreasonable in light of the circumstances. B. Question of Fact: the determination of whether and expenditure is ordinary and necessary is ultimately a question of fact, determined by surrounding facts and circumstances. They may change over time. C. Ex: Welch v. Hevering (1933): in 1922, Tom was an officer of a corp which field for bankruptcy ands was discharged from it s debts. In subsequent yrs, he 44 44

paid some of the crop’s discharged debts because he continued to be involved in the same line of business as the corp and he wanted to solidify his won credit rating and reputation in the community. The ct sustained the IRS’s assertion that Tom could not deduct the payment of the corp’s discharged debts as ordinary and necessary expenses. D. Ex: Jenkins v. Comm’r (1983): In 1968 Conway Twitty started his fast food restaurant chain, and several of his friends and business associates invested in the enterprise. In 1970, the corp encountered financial difficulties and it was decided to cease operations and to close all of the franchise outlets. in 1973 and 1974, Conway repaid some of the investors because he wanted to protect his personal business reputation and earning capacity. The court held that the repayments were ordinary and necessary business expenses. iv. Expenses paid or incurred A. A deduction is allowed only for an item of ―expense‖ as contrasted with a capital expenditure. a. Expenses: outlays that are not expenditures; expense: acquiring something you can consume, not in exchange for a capital asset. i. Generally no deductions is allowed or a capital expenditure at the time the amount is paid, however, a capital expenditure may give rise to deductions for depreciation at a later time. See §§ 263, 167,168. b. Per Maule: The expenses are things we normally consider expenses such as supplies, advertising. c. Timing issue- incurred as an accrual and take obligation into account. v. In carrying on A. If business is not yet under way, divide into payments. a. Has to do with business? b. When ready to deal with customers- not open yet, no deduction. c. Start up costs not deductible. B. Revenue Ruling 75-120: IRS will not allow deductions under §162 for expenses incurred by individuals who have been unemployed for such a period of time that there is a substantial lack of continuity between their past employments and their endeavors to find new employments, but the length of time necessary to establish this substantial lack of continuity remains uncertain. C. Expenses Incurred in Obtaining Employment as an Employee a. An individual may be in the trade or business of providing services as an employee. b. Thus expenses incurred in obtaining another job in the same line of work are deductible because they are incurred while carrying on a trade or business. c. Expenses incurred in obtaining employment in a new line of work, or in obtaining a first job are not deductible, because a trade or business is not being carried on at the time the expenditure was incurred. d. Ex: Adam who had previously worked as a licensed electrician, incurs expenses traveling to union halls seeking employment as an electrician. Adam’s expenses are deductible. Betty, a recent graduate, incurs expense traveling to a nearby city seeking employment as a teacher, Betty’s expenses are not deductible.



In business as (employed as): Nothing Nothing Secretary Secretary Secretary Secretary * **

Searching for: Whatever Whatever Secretary Secretary Teller Teller

Successful? No Yes No Yes No Yes

Deduction?* No No** Yes*** Yes No No****

Assuming other requirements satisfied. Unless cost of the search is dependent on success and payable after new job begins, then yes deductible. See Hundley. *** Even if find job as non-secretary (e.g. teller). **** Logic says Hundley applies here too so Yes deduction. Trade or Business A. Ordinary and necessary expenses are deductible pursuant to § 162 only if they are paid or incurred while carrying on a ―trade or business.‖ B. Trade or business: offering for sale something to the public. a. There is a fuzzy margin though. Courts have held professional gamblers are in a trade or business! C. The issue of whether an individual’s profit seeking constitutes a trade or business for the purpose of determining the deduction of expenses, does not often arise today because § 212 authorizes deductions for ordinary and necessary expenses incurred either in the production or collection of income or in dealing with property which is held for the production or collection of income, even if the tp is not carrying on an active t/b. D. The § 162 trade or business requirement is important primarily to emphasize that expenses incurred for personal purposes are not deductible, and in this regard, the touchstone is that the tp must have a profit motive for engaging in the activity which gives rise to the expense. See Comm’r v Groetzinger. a. Note: §262(a): Except as otherwise provided, no deduction shall be allowed for personal, living, or family expenses. b. Reasonable compensation/Salaries - §162(a)(1) i. General Rule: Reasonable salaries or compensation paid for personal services actually rendered may be deducted. § 162(a)(1). See Exacto Springs case in textbook. c. Travel Expenses - § 162(a)(2) i. General Rule: A deduction is allowed for traveling expenses, including lodging and a portion of the cost of meals incurred while the tp is away from home. in the pursuit of a trade or business. 162(a)(2) ii. Policy concern: Because of the inherently personal nature of expenditures for food and place to sleep, for which no deduction is allowed under normal circumstances [§262(a)], the IRS and the courts have been careful in limiting the circumstances in which a deduction is appropriate. iii. Three Conditions (§162(a)(2)): must be satisfied before a travel expense deduction is allowed and all must be met: vi.



A. The expense must be a reasonable and necessary traveling expense, B. The expense must be incurred while away from home, and C. The expense must be incurred in the pursuit of business. iv. “Reasonable and Necessary Travel Expenses” generally include: A. The cost of the travel itself, such as for airplane tickets and cabs, as well as meals and lodging and other expenses incident to travel. B. Incidental to Travel include a. Telephone calls b. Public stenographer c. Sample rooms d. Tips e. Baggage charges f. Laundry Reg 1.162-2(a) C. The amt of the expenditure must be reasonable: the expenses not be lavish or extravagant under the circumstances. (4) All deductible travel expenses must also be “ordinary and necessary” and paid or incurred in carrying on a t/b‖ 162(a) v. “Away from Home” A. General Rule: Travel expenses are only deductible if they are incurred while away from home. a. This requirement has been interpreted, but if the tp does not have a permanent residence she cannot deduct the travel expenses because she is not ―away from home.‖ B. Abode and Principal Place of Business: if the tp has both an abode and a principal place of business, the IRS considers the ―tax home‖ to be the location of the principal place of business. Tax home is the metropolitan area in which you conduct your trade or business. a. If the tp has more than one place of business, the location of the ―principal‖ business is the tax home. b. The determination of which is principal is a determination of fact. C. Temporary Located in Another Place a. If a tp has a principal place of business and is assigned to work in another location for a temporary period, reasonably expected to last less than one year, he is ―away from home‖ while on the assignment. b. However, if the period exceeds one year, the tp is not considered ―temporarily away from home‖ for any portion of the period. 162(a), last sentence. D. Reassignment to New Location permanent/Indefinite: If a tp is assigned to work at a new location on a permanent basis, for an indefinite period of time, her tax home changes to the new location which is her ―principal place of business,‖ her travel expenses incurred while at the new tax home are thus not deductible under 162(a)(2) even though her abode remains at the old location. E. Overnight Rule: a. Expenses incurred for lodging and 50% of meals are deductible only if the tp is away from home long enough to require them to stop for substantial sleep or rest no matter what the distance she travels or what the mode of transportation she uses. b. Otherwise the expenditures are non deductible personal expenses under § 262. 47 47

F. Tax Home for Legislators: § 162(a): The tax home of a US senator or representative is his residence in the district which he was elected to represent. Expenses for meal and lodging incurred while he is in DC, therefore are incurred while he is ―away from home‖ and are deductible, up to 3k per yr. vi. “Incurred in the Pursuit of Business” A. Travel for Business and Personal Reasons: a. If the tp is away from home and engages in both business and personal activities, the expenses of traveling to and from the distant location are deductible only if the primary reason for the trip relates to his t/b. b. If the primary reason for the travel is to engage in personal activities, none of the expenses for the travel are deductible. c. The determination of the primary reason for travel is a question of fact. (Reg. §1.162-2(b)(2)) d. Expenses incurred at the location away from home which are properly allocable to the t/b are deductible, even though the expenses or traveling there are not deductible and vice versa. Reg 1.162-2(b)(1). e. Ex: Gale travels from her home and principal place employment in DC to NYC. While in NYC, she spends 1 week on activities directly related to her business and 3 weeks on vacation. The travel is primarily for personal reasons, and the costs of her airplane ticket and other travel expenses are thus not deductible. However, expenses including lodging and 50% of meals, incurred during the week she is engaged in business activities are deductible. Reg 1.162-2(b). vii. Meals: §162(a)(2), §274(k) and (n)(1) A. No deduction for the cost of food or beverages is allowed if, under the circumstances, the expenditure is lavish or extravagant or if the tp or an employee is not present when the food or beverages are furnished. § 274(k). B. Deduction Amount: the amt that can be deducted for the cost of food or beverages is generally limited to 50% of the cost. § 274(n)(1) C. Can deduct meals up to 50% if get into business conversation with client before, after or during meal. viii. Transportation costs A. Home to office: not deductible because not ordinary and necessary expense of trade because your decision to live far away and incur expense is your own choice. Commuting not deductible. B. Office to client: deduction for transportation. While travel refers to away from tax home, this is transportation. No meals because not overnight. C. Client to office: deduction. D. Office to Home: no deduction. E. Home to client or client to home: no deduction. IRS tried to say that cannot when have office/home but now if have deductible office at home, its OK to deduct transportation costs to client. d. Rentals: § 162(a)(3) i. General Rule: Expenditures for rental or other payments required to be made of the use of property in a tp’s t/b are deductible. § 162(a)(3). ii. The property being used may be real property, tangible personal property or intangible personal property. iii. Deductible payments include royalties for the use of intangible personal property, or royalties paid for the right to exact minerals from real property. 48 48

iv. The deductions are available for payments made for the ―continued use or possession‖ of property. But the payments made to acquire title or an equity interest in property are not deductible. v. Transfer and Lease Back: A. Only ordinary and necessary business expenses are deductible. § 162(a)(3) provides that a deduction is available for ―rentals or other payments required to be made as a condition for the continued use or possession‖ of property B. Where it is a gift or lease back, the nature of the transaction is a negative assignment of income by means of a deduction (for rent) on the donor’s part. e. Expenses For Education i. Expenses for education are not in § 162. A. The regs, however, do attempt to describe situations where such expenditures would satisfy the requirements of §162 and thus a deduction is allowable and to distinguish them from situations where expenditures have a predominantly personal character and thus no deduction allowed. Reg 1.162-5. B. Generally, expenses incurred by an individual for education, whether or not the education leads to a degree are deductible if: a. The expenses pass 1 of 2 tests of deductibility [ii(1) or ii(2) below]. If neither of 2 tests are satisfied, then not deductible. (Link case, Hiatus principle?) b. The expenses pass both the tests for nondeductibility [iii(3) and iii(4) below]. If it fails either, (i.e. the answer is YES), then not deductible. ii. Test of Deductibility Checklist: Reg 1.162-5 A. Does the education maintain or improve the skills required for employment, trade or business? a. If Yes, go to (3). b. If No, go to (2). B. Is the education required by the employer, law or regulations as condition to keeping employment, trade or business? a. If No, NOT DEDUCTIBLE. b. If Yes, go to (3). C. Does the education satisfy minimum educational requirements for qualification for employment, trade or business? a. If Yes, NOT DEDUCTIBLE. b. If No, go to (4). D. Does the education qualify the person for a new trade or business? a. If Yes, NOT DEDUCTIBLE. b. If No, DEDUCTIBLE. iii. Explaining the test for deductibility of education expenses A. “Maintaining or Improving Skills”: to be deductible, the education must maintain or improve skills required by a taxpayer in his employment or other trade or business. Reg 1.162-5(c)(1). a. This includes refresher courses or courses dealing with current developments as well as academic or vocational courses provided the expenditures for the courses are deductible under parts ii(3) and ii(4) above. Reg. 1.162-5(c)(1). b. Ex: George is an attorney whose practice involves considerable work in matters pertaining to Federal Taxation. He attends an Institute on Federal Taxation sponsored by NYU, where he learns about trends, thinking and developments in Federal Taxation from experts accomplished in that 49 49

field. The costs of attending the Institute are deductible. See Coughlin v .Comm’r c. Ex: James is a Chicago police detective. He enrolls in courses in Philosophy, English, History and Political science at a local university. James is unable to demonstrate that his skills as a policeman are improved or maintained by the education and thus the education expenses are not deductible. Carrol v Comm’r B. “Minimum requirements of Employer or law”: If the education expenses do not maintain or improve the skills required for employment or other trade or business, to be deductible, the education must meet the express requirements imposed by law of the taxpayer’s employer as a condition to the retention of the taxpayer’s employment, status or rate of compensation. a. If the employer requires, it must be a bona fide purpose by the employer. Reg 1.162-5(c)(2). b. Ex: Nora is engaged in the business of teaching in school in Virginia where state law requires teachers to have a valid teaching certificate. Regulations promulgated under the statute req teachers to renew their certificates every few years, and req a teacher to either pass an examination or to acquire credits for taking certain college courses in order to renew her certificate. Although most teachers use the examination alternative, Nora enrolls in two college courses so that she can qualify to have her teaching cert renewed. Nora’s expenses for taking the 2 courses are deductible. See Hill v. Comm’r C. “Expenses for education must be incurred while carrying on a trade or business.” a. They are not deductible, even though they satisfy either of the two tests of deductibility, if the education satisfies minimum educational requirements for qualification for employment, trade or business. i. Is the education required in order to meet minimum education requirements for the taxpayer’s employment or other trade or business? ii. Expenses are nondeductible if applicable laws, regulations, or professional standards require a taxpayer to obtain an education in order to meet the minimum education requirement for employment or other trade or business. iii. If a taxpayer satisfies the minimum education requirements for a particular job he is first employed in the position, he is considered to satisfy them even though they are subsequently changed. Reg 1.162(b)(2)(i). iv. Ex: D who has a BA, obtains a temporary job as an instructor at Y university and at the same time he enrolls in graduate courses leading to a PHD. Under university policy, D may not become a full time faculty member unless he has a PHD, and he may hold his position as an instructor only while he continues to make satisfactory progress towards his graduate degrees. The graduate course are to satisfy the min education requirements for qualification in D’s trade or business, the expenditures for the grad courses thus are not deductible. Reg 1.162-5(b)(ii), ex 2.



b. They are not deductible, even though they satisfy either of the two tests of deductibility, if the education qualifies the person for a new trade or business. i. Is education part of a program of study which will lead the tp to qualify for a new trade or business? ii. Expenses for education may not be deducted if the education is part of a program of study leading to qualifying for a new trade or business. iii. This rule does not apply if the employee obtains education to qualify her to perform new duties if the new duties involve the same general type of work as is involved her present employment. Generally all teaching and related duties are considered to involve the same general type or work. Reg 1.162-5(b)(2)(ii). iv. Undergraduate degree 1. Most do not have a current trade or business. 2. Mechanic in aerospace industry gets degree in mechanical engineering. Tax court held no deduction because undergraduate degree qualifies you for new trade or business. 3. Minister who gets college education, held no new trade or business and got deduction. v. Lawyers and bar review classes- no deduction. vi. Ex: E is a high school math teacher. She enrolls in college courses so that she may teach high school science courses. The education qualifies her for new duties involving the same general type of work, not a new trade or business; ; the expenses are thus deductible. Frank is self-employed as an accountant, and he enrolls in law school. F’s costs are not deductible bc the course of study qualifies him for a new trade or business. G is engaged in the private practice of psychiatry. She attends a program of study which qualifies her to practice psychoanalysis. G may deduct her education expenses because the education maintains or improves skills required by her trade or business and the education does not qualify her for a new trade or business. Reg 1.162-5(b)(3), ex 1 and 4. vii. Ex: Dentist goes to school for orthodontists. It improves skills in dentistry and does not qualify as dentist, but is it a new trade. May depend on state licensing rules. Revenue Ruling treated orthodontists as specialists and deduction was allowed. viii.Lawyer who attains LLM should get deduction because practice of law is not different than practice of law. But case below held no deduction and may have been because was not carrying on trade or business and went straight to LLM.



iv. The Carrying on Requirement A. The deduction for education expenses must satisfy the fundamental requirements of §162, including the requirement that the expense be incurred while the taxpayer is “carrying on” a trade or business. This requirement may preclude the deduction for education expenses incurred when a taxpayer has not yet begun a trade or business, or when he has abandoned a trade or business. B. Ex: Jay, an accountant was employed by the IRS and a revenue agent while enrolled in night classes as a law student. While attending law school, Jay was promoted to appeals officer with the IRS. Several months after obtaining his JD and admission to the bar, J resigned from the IRS and enrolled in a Graduate Tax program at a University. After receiving his LLM in tax, he joined a firm as an associate . Jay was denied a deduction for his expenses incurred pursing the LLM despite his admission to the bar (before) and his employment at the IRS. Even though his t/b as an appeal officer involved skills associated with the practice of law, the exercise of such skills by non lawyers constitutes a trade or business separate and distinct from the practice of law. Jay was not engaged in the practice of law or the legal profession at the time he incurred the expenses of the LLM degree. See Goldenberg v. Comm’r v. Travel as Education: § 274(m)(2): Expenses for travel as a form of education are not deductible. vi. Travel to Obtain Education: Reg 1.162-5(e): If a taxpayer travels away from home primarily to obtain education, and the education expenses are deductible, then the traveling expenses, including lodging and 50% of the cost of meals, are also deductible. f. Miscellaneous Business Deductions: § 274(a), (d), (e) i. General Rule: §274 provides for several categories of deductible expenses that frequently occur in a trade or business (in addition to those specifically authorized in §162). A. Entertainment: §274(a) a. Expenses incurred for meals and entertaining may be deducted if there is a demonstrable business benefit to be derived from the expenditure, and if the expenditure is ―ordinary and necessary.‖ i. It is customary to entertain customers, prospective customers, or suppliers in most business, and thus such an expenditures are generally deductible. ii. Deductions for expenditures for entertainment are subject the § 274 restriction. 1. Generally only 50% of the cost of deductible entertainment well as 50% of food and beverages may be deducted. 2. Note that if the taxpayer is traveling away from home on business, the cost of food and beverages is treated as an entertainment expense and is deductible only if the meal is related to or associated with the trade or business. § 274(a) 3. Food or beverages expenses incurred by a taxpayer who is traveling away from home on business will also be treated as entertainment expenses unless she eats alone or with persons, such a family members, who are not business connected (and then only 50% of the cost of the taxpayer’s meal qualifies for a deduction). See Meals. 52 52

B. Dues: § 274(a)(3) a. A deduction is generally allowed for the payment of dues to an organization which is directly related to a taxpayer’s employment or other trade or business. b. Thus dues paid to a local chamber of commerce, trade association, or professional society are generally deductible. c. Likewise dues paid by a plumber to her local union or annual dues paid by an attorney to the state bar are deductible. d. However, dues paid to clubs or organizations for business, pleasure, recreation or other social purposes are not deductible. § 274(a)(3) C. Substantiation Requirements § 274(d) a. If the IRS allows a deduction and if the tp does not have substantiating proof of an expenditure, the tp may be able to obtain a deduction for the approximate amt which would have been spent in light of the circumstances, unless a statute requires more specific substantiation. b. Ex: J leases a small store where he is engaged in the business of selling children’s clothing at retail. He takes a deduction for his expenses for rent and utilities at the store, but the IRS disallows the deductions because he does not have any receipts or other records reflecting the amounts he spent. Because it is reasonable for someone to pay 300/month rent and 75/month for utilities, for a store of the same size and general location as Jasper’s, a ct may allow him a deduction in those mats, despite his lack of substantiation. See Cohan v. Comm’r c. § 274(d) provides an exception to the Cohan estimate rule (in example above in (b)) and specifically disallows deductions for traveling expenses (including meals and lodging while away from home), business gifts, entertainment expenses, business meals and certain ―list property‖ including cars, cell phones, and personal computers, unless the tp substantiates by adequate records or other evidence the amt of the expense, the time and place of the travel or entertainment or the date and description of the gift, the business purpose of the expenditure, and the business relationship to the tp of the person entertained or receiving the gift. See also § 280(F)(d)(4) D. Facilities: § 274(a)(1)(b) and (a)(3) a. No deduction is allowed for any expenditure incurred with respect to a facility used in connection with entertainment, or recreation. § 274(a)(1)(B). b. No deduction is allowed for membership dues paid to any club organized for business, pleasure, recreation or other social purpose. § 274(a)(3) E. Exceptions to Disallowance Rules: § 274(e): The rules which disallow deductions for entertainment, amusement or recreation activities or facilities do not apply in various situations listed in § 274(d), such as: a. Food and beverages furnished to employees by an employee on his business premises; b. Expenses treated as compensation c. Reimbursed expenses, and d. Expenses incurred at business meetings for employees, stockholders or directors.



g. Losses: § 165, 267 i. Generally: A. General Rule: A deduction is allowed for any loss during a taxable yr which is not compensated by insurance or otherwise. § 165(a) B. A loss must be sustained to be deductible. a. Thus some ―closed and completed transaction‖ such as a sale or exchange or some ―identifiable event‖ such as a theft, fire must occur before a deductible loss arises b. An unrealized decline in the value or property does not give rise to a deductible loss. Reg 1.162-1(b). C. Individuals: § 165(c): may take deductions only for losses which are incurred in ―a: a. Trade or business (165(c)(1)) b. Losses incurred in transactions entered into for profit (165(c)(2)) c. And certain casualty losses - see Casualty loss Section (165(c)(3)) ii. Amount of Loss §165(b) A. The amt of a loss from the sale or other disposition of property is the excess of the adjusted basis of the property over the amount realized. § 1001(a). B. “Compensated for by Insurance or Otherwise”: § 165(a) a. A deduction may be taken with respect to a loss only to the extent that is ―not compensated for by insurance or otherwise.‖ b. If a taxpayer has insurance covering the damaged or stolen property, but he does not file a claim with the insurance company for reimbursement, the deductions are still limited to the amount realized minus the amount taxpayer ―would have recovered‖ from the insurance company. This does not apply to personal casualty losses. § 165(h)(4)(E). IS THIS RIGHT? c. Ex: if E’s truck (above) was covered by insurance and he recovered 8k in insurance or a lawsuit, his loss would be limited to 1k (9k ded - 8k recovery) If he recovered 10k he would not have any loss and would instead have a casualty gains (the excess of his insurance amt realized less his adjusted basis in the property). If E’s only prospect for reimbursement, however, was to file a claim under his own comprehensive coverage policy, but he does not want to file such a claim, a loss would be sustained and a deduction would be allowed. Hills v Comm’r C. Homes: do not fit under the loss deductions allowed in §165 for individuals, so personal use deductions are not deductible. iii. Gifts of Property - No shifting of Loss A. When a gift of property is made and the fair market value is less than the adjusted basis, the recipient takes the property/gift with his basis as the fair market value (the lower amt). B. Thus, there is no shifting of losses. iv. Related Party Transactions §267: Can the shifting of the loss problem be gotten around by selling it to the kid? A. General Rule: No deduction is allowed for any loss arising for the sale or exchange of property between related taxpayers. § 267(a). B. Timing issue: In addition, a taxpayer on the accrual method of accounting may not take deductions for interest or other expenses to be paid to a related to who is 54 54

on the cash method of accounting until the amt is actually or constructively paid. § 267(a) C. “Related taxpayers” include : a. An individual and her brothers and sisters, spouse, ancestors and lineal descendants (§267(b)(1) and (c)(4)) b. An individual and a corp which the individual owns directly or indirectly, more than 50% of the value of its outstanding stock c. The fiduciary of a trust and the grantor if that trust d. Various fiduciaries and beneficiaries of 2 or more trusts with relationships betwen certain corps, partnerships and educational and charitable organizations. § 267(b) e. Many others in §267(b) D. Relationship between individual and corporation: In determining whether an individual is within the prescribed relationship to a corp, stock of the corp actually own by a corp, partnership estate or trust is considered to be owned proportionately by its share holders, partners or beneficiaries. a. In addition, an individual is consider to own stock actually owned by other members of his family, and if an individual is a partner in a partnership, he is considered to own stock actually owned by other partners of the partnership § 267(c) v. Losses and Relief on Subsequent Sales: § 267(d) A. Generally: No deduction is allowed for any loss incurred on the sale or exchange of property between related taxpayers. § 267(a)(1) B. Exception: However, if a loss is disallowed with respect to an item of property and the property is later sold or disposed of at a gain by the transferee related a party, the gain is recognized only to the extent it exceed the amount of the previously disallowed loss. § 267(d) a. Ex: G purchased stock in XYZ Corp several yrs ago for 50k and he sells it on Jan 1 of the current yr to his daughter Heather for 40k. G may not deduct the 10k loss. If Heather later sells the stock to an unrelated person for 55k, her realized gain of 15k (55-40) will be recognized only to the extent it exceeds the previously disallowed loss of 10k, thus only 5k of gain will be recognized on the subsequent sale. b. Thus the gain on the subsequent sale is only recognized to the extent that it exceed the parents loss. This is a non Recognition provision. The loss of the parent is deferred in the case where the child later sells the item for profit. c. Example: So if Dad had a basis of 50 and sold to daughter for 40k, then there is a 10k loss which is not recognized, but is deferred until the daughter sells it. if the daughter later sells for 45k, she realized a 5k gain, but it is only recognized to the extent that it exceeds her dad’s loss, so here she has no gain recognized bc there was a 10k loss and she only realized 5k gain. i. Note that the entire loss is not offset here. ii. If she had a gain realized of 15k then 5k gain recognized because of the non recognition of 10k (dad’s loss). iii. If daughter also sells at a loss for 35k to a 3d party (her basis was 40), She realized a 5k loss. She can’t do anything with the disallowed loss of her dad, because dad’s initial loss can only be 55 55

used to reduce here gain. So she cannot deduct the loss under § 267. 1. Note however, that investment property is under § 165(c)(2) and she could probably deduct the loss there. 2. The point is that the initial transferor’s [dad] loss is only available to offset gain realized but it is not added to loss realized. iv. What if daughter with a basis of 40k then gives it to her son when it is worth 45 and the son then sells it for 48. 1. Here the son under § 1015 takes with the fmv basis of 40 (bc adjusted basis is greater than the fmv - so no loss shifting here). sop when the son sells here for 48k,he has a gain of 8k realized. Note that the son cannot offset the gain realized with the initial transferor’s loss (granddad) bc 267(d) says it applies tot he sale or exchange and that it is only available to the immediate purchaser. 2. So here the son’s mother didn’t have a disallowed loss (bc she had a gain) and the son thus has no loss to offset his gain. 3. The mother also cannot use the dad’s 10k loss bc she gave it to her son. By doing this she wiped out her chance to use the 10k loss. But if she had sold: she would have been able to offset the gain with dad’s 10k loss. 4. Thus under § 267(d) the tp can only look to the immediate seller for a loss that can offset his gain on subsequent sale. There is no cumulative effect, i.e. if dad sells to mom and mom sells to son, son can only look to mom’s loss to offset his gain and mom can only look to dad to offset her gain. 5. Thus dad has basis of 50k, and sells to daughter for 40k, she later sells to son for 35k and her son later sells for 70k. 6. Dad has a realized/unrecognized loss of 10. 7. Daughter has a loss realized of 5k, thus no offset and son has a basis of 35k and an gain of 35k of which he can offset 10k of it with his mom’s 5k loss, so he has a 30k gain recognized. 8. Thus originally if the dad wanted to be able to recognize the loss on the sale he should have sold it to a stranger. h. Depreciation: § 167 i. Generally A. What is depreciation? a. A way to spread deductions for the cost of an asset over the period of time the asset is presumed to be of use to the owner. b. An analog: amortization – simply another way of spreading the deductions. Differs primarily in method of computation rather than concept. c. § 167: traditionally allows the deduction by spreading the cost of the property over the number of taxable yrs it is used in producing income (the useful property life). 56 56

B. Prerequisites for depreciation a. Trade, business or for-profit activity use of the property i. The cost of acquiring property used in a t/b or property held for the production of income is generally a non-deductible capital expenditure bc such property has a useful life of more than 1 yr. [see §263] ii. Because income tax is imposed on net income, however, it is appropriate to allow a deduction in some manner and at some pt in time, for the cost of items of property which are used up while producing income. b. Not an intangible (though many intangibles can be amortized). c. Not an item that traditionally does not lose value, such as land, art works. i. No depreciation for land as it is assumed to increase in value. C. History a. Beginning in 1981, depreciation deductions have been computed using the Accelerated Cost Recovery System (ACRS) which permits the entire cost of qualifying property to be deducted over a period of time which is usually much shorter tan the time the property will actually be sued in producing income. § 168(e) b. 1986 Tax Reform: changed ACRS rules and the new ones are called MACRS. c. Depending on the situation, property may be subject to pre ACRS (i.e. before 1981) rules of depreciation under §167, ACRS or MACRS - this depends on when the property was placed in service. d. Three Systems still in effect i. Property ―placed in service‖ generally before January 1, 1981 (the §167 system) ii. Property ―placed in service‖ generally after December 31, 1980 and before January 1, 1987 (the old §168 ACRS) iii. Property ―placed in service‖ generally after December 31, 1986 (the current §168 MACRS) 1. But some things were excluded from the 1986 MACRS and are within the pre 1981 system. Here the point is that certain property placed in service after 1986 is within the pre 1981 system of depreciation, so this system is still viable. a. Certain public utility property b. Films and video tapes c. Sound recordings 2. MACRS: (which is a ―system‖ – that’s what the S stands for), actually has two systems within it…. a. The general depreciation system – used for all property not in the other system, and b. The alternative depreciation system – used for these properties: a) Tax exempt use property b) Tax exempt bond financed property c) Certain imported property 57 57

d) Tangible property used predominantly outside US e) Property as to which the taxpayer elects. See §168(g)(1). iv. Note: yet another system (NCS) has been proposed but the legislation hasn’t progressed past the Ways & Means Committee….yet…… v. A taxpayer can easily own various properties, some within each of the three systems – an example of how a repealed Code section can retain applicability. ii. General Rule: § 167(a): a depreciation deduction is allowed for the wear and tear and exhaustion of property used in a t/b or held for the production of income. A. Not available for: a. Inventory b. Land c. Property held for sale to customers or d. Property used for personal purposes e. Or art work, intangibles B. A deduction for depreciation may be taken only with respect to property, which by its nature, is subject to being exhausted, worn out or becoming obsolete. C. The basis of the property which qualifies for depreciation deductions must be reduced by the amt of the deductions allowed or allowable for such deductions. § 1016(a)(2) D. § 280F limitations also relate to the depreciation rules iii. How to compute Depreciation under ACRS and MACRS A. Basics: a. Find the correct chart i. Charts Reflect 1. A period of time = recovery period [macrs] or useful life [pre 1981] a. Pre 1981: requires a factual determination of the estimated actual period of time for which there is economic return from the asset. 2. A depreciation method [straight line, or accelerated types] a. Note: ACRS and pre-1981 systems permitted accelerated depreciation methods for realty. b. No salvage value in ACRS. 3. A convention [half yr, mid month, mid quarter ii. Finding the table: 1. There are ACRS and MACRS tables 2. Each table is numbered, and contains labels that describe the system (general or alternative), the type of property, the recovery period, and the convention. b. Look up % for each yr and multiply it be the unadjusted basis of the property i. For Pre-1981 1. Find a commercial chart, subtract the salvage value for the unadjusted cost. 2. Look up a % for each yr and multiply it by the net of the cost minus the salvage value. 58 58

B. MACRS/ACRS - need to know a. First, the applicable depreciation period b. The applicable recovery period and c. The applicable convention iv. “Applicable Depreciation Method” - §168(b): A. Understanding the method: a. Straight Line: the amount to be depreciated is divided evenly over the number of years in the depreciation period. i. Example: $10000 investment and 10-year recovery period. Ignoring conventions, this is $1000 per year. ii. A tp must use straight line to depreciate real property and may elect to use it for other types of property. 168(b)(3)(D), 168(b)(5). See below under personalty. b. Accelerated Method:The amount of depreciation for the early years is proportionately more than the amount in later years, determined under a variety of arithmetic methods (double declining balance, 150% declining balance, sum-of-the-years digits, etc.). i. Ex: if a tp places in service 5yr property, with a 5yr recovery period, the tp would be allowed to deduct 20% (1/5) of the cost of the property each yr (disregarding the conventions) under the straight-line method, so the tp would be allowed to deduct 40% of the cost of the property under the 200% declining balance method. (however, he would then have to apply the correct convention to determine the tps’ actual yr one depreciation deductions). The tp’s basis in the property is then reduced by the amt of depreciation taken in yr one and the tp’s yr 2 depreciation deduction equals 40% (200 percent of the 20 percent straight line) of that adjusted basis. ii. If we kept deduction 40% of an ever decreasing adjusted basis, we would never fully depreciate the asset, so 168 provides that we switch to the straight line deductions in the firs yr. in which the straight line deduction is more than the deduction computed using the declining balance method. iii. However in this context the straight line deduction is calculated based on the adjusted basis of the property in that yr and the remaining recovery period of the property. B. Personalty: default is either the 200% (double) declining method for some property (§168(b)(1) – i.e. not 15 or 20year property), 150% for others (§168(b)(2) – i.e. 15 or 20 year property) [general system – Table 1], but taxpayer can elect less generous 150% method for 200% property (§168(b)(2)(C)). a. Taxpayer may elect straight-line (§168(b)(2)(C): It applies to all property placed in service in a given year that is in the same recovery period. §168(b)(5), 168(b)(3)(A)-(C). b. We’re under the general system (Table 1) unless we elect into another system or something triggers another system. C. Realty: default is straight-line. §168(b)(3)(A)-(C).



D. Alternative System 168(g): Uses straight-line. §168(g)(2)(A). a. General rule: For those types of property specified in 168(g)(1), 168(g) provides an alternative depreciation system. Property subject to this system has a longer recovery period and is depreciated using the straight line method. 168(g)(2) b. Types of Property under 168(g)(1) i. Any tangible property which during the taxable yr is used predominantly outside the US ii. Any tax exempt use property iii. Any tax exempt bond financed property iv. Any imported property covered by an Executive order under para 6 v. Any property to which an election under par 7 applies E. No salvage value in MACRS. §168(b)(4), (g)(2)(A). v. “The applicable Recovery Period” A. Personalty: The applicable recovery period for tangible property is determined under 168(c) and (e)(1). a. The recovery periods are generally based upon the class life of the property ad determined by the Sec of Treasury and issued in a Revenue Procedure statement. b. The recovery period specified in 168(c) and (e)(1) for an asset is often shorter than the useful life of an asset. i. Example: property with a 9 yr class life has a 5 yr recovery period. B. Realty: applicable recovery period is in 168(e)(2). a. § 168(c)- Residential real property = recovery period of 27.5 and for Non Residential Real Property 39.5 yr. C. For certain assets, §168 provides recovery periods through special rules. §168(e)(3). a. Classification Types - examples i. A car or light general purpose truck is ―5 yr property‖ §168(e)(3)(B)(i). D. Alternative System: The alternative depreciation system uses the actual class life as the recovery period. vi. “Applicable Convention”: § 168(d) A. Is determined under § 168(d): Same for general and alternative systems B. The section determines the date on which the depreciable property is deemed to have been placed into service by the tp. The date on which the property is placed in service, not the date on which the tp acquired the property, is used to determine when the depreciation deduction begins. C. Personalty: Half Yr Convention: 168(d)(1): a. In the year of acquisition, taxpayer gets ½ of what otherwise would be the depreciation (built into the table). In year of disposition, same rule, but not built into table. b. However, this convention creates some potential for abuse who could place personalty into service at the very end of the yr and sill try to take a half a year’s depreciation. To discourage this type of abuse, a mid quarter convention applies (1/2 of 1/2yr) if a disproportionate amt of depreciable property is placed in service in the last 3 months of the yr. 168(d)(3). See below 60 60

c. Mid-quarter: Treated as placed in service in middle of the quarter, applies if more than 40% of property for the year placed in service in last quarter. 168(d)(3). D. Realty: Mid Month Convention: a. Treated as placed in service in middle of the month (i.e. placed in service in May first year is 15/24 of what otherwise would be)(built into table) §168(d)(2). b. Real property: i. Non residential real property ii. Residential rental property and iii. Any railroad grading or tunnel bore. vii. §168(k) Additional Allowance: A. New as of 9/11 events – further complicates the depreciation deduction B. §168(k) ―additional allowance‖ applies to property which is: a. Certain types of personalty b. Acquired after 9/10/01 and placed in service before 1/1/05 or 1/1/06 depending on the type of property c. Which is not within the alternative system (other than by election) C. Permits the taxpayer to deduct 30% of the cost of the eligible property, leaving the rest of the cost to generate MACRS deduction using the tables. a. Taxpayer can deduct 30% right up front, then following the rest of the MACRS table (with leftover amount) D. Why this additional allowance? E. Note that it is computed BEFORE going to the MACRS table, not additionally. F. Also subject to some limitations: a. Personalty b. Dates c. Not within alternative system other than by election viii. § 179 Election to Expense Certain Depreciable Business Assets A. The deprecation deduction is further complicated by the existence of §179, which permits the tp to ―expense‖ (i.e. deduct) the cost of §179 property. 179(A). a. Can deduct it all right now, don’t worry about tables. B. 179 Property is a. Tangible property b. Within the MACRS system (i.e. not films, etc.) c. Which is §1245 property (generally personalty for our purposes) d. Acquired by PURCHASE e. For use in ACTIVE CONDUCT of t/b, see 179(d)(1) C. There are two limitations on the §179 deduction a. The first is an absolute dollar limitation i. For 2002, that amount is $24,000. §179(b)(1). It has been increasing in stages. SBJPA 1996 §1111(a) amended the statute, so references to $17,500 are out-of-date! ii. This amount is REDUCED by the excess of the cost of §179 property placed in service for the year over $200K. §179(b)(2). iii. Ex: Cost of §179 property placed in service for the year is $216000, so the excess over $200000 is $16000. The limitation for 2002 would be $8000 ($24000 - $16000).



b. Second Limitation on §179 Deduction: variable dollar limitation. i. The deduction is limited to the amt of taxable income that the tp derives from the active conduct of a t/b 179(b)(3)(A). 1. Basically, won’t apply if you have a loss. ii. Carry Forward: any amt disallowed under this limitation is carried forward. 179(b)(3)(B) D. Impact of §179 on MACRS a. The impact of §179 on MACRS is determined by assuming that it is the same as the impact on ACRS (which was set forth in withdrawn proposed regulations under §168 as in effect with respect to ACRS) because there are not yet regulations under MACRS: i. The amount deducted under §179 is subtracted from the unadjusted basis before going to the MACRS table. 1. This is what is §168(k) requires to be done for the ―additional allowance‖ ii. The remaining amount goes to the MACRS table after §179 deduction and after any §168(k) deduction (if any). See examples. b. Ex: In 2002, T Purchases 3yr equipment at a cost of 124,000. No other purchases. Taxable income of 40k. §179 deduction is 24,000. The remaining 100k (124000-24000) is subject to MACRS. The MACRS deduction for the first yr is 33,330 (100k x 33.33). Total deduction for 2002 is 24,000 + 33330 = 57,330. i. $24000 under §179 and $33,330 under §168. ii. What if eligible for the ―additional allowance‖? Let’s see…. 1. Assume the same facts as above, but that it is also eligible for the ―additional allowance.‖ Additional allowance is $30,000. Remaining $70,000 of cost: subject to MACRS table. MACRS table for the first year: $23,331($70,000 x .3333). TOTAL deduction for 2002 is $77,331: $24,000 (§179), $30,000 (§168(k) ―additional allowance‖), $23,331 (§168(a) from MACRS table). iii. Economic incentive and relief at the cost of complexity. c. Note since get to deduct under 2 systems it called the §179 bonus depreciation ix. 280F Limitations on Depreciation for Luxury Automobiles, Limitations Where Certain Property used for Personal Purposes A. Depreciation deductions: are subject to further limitations with respect to ―luxury cars‖ and certain ―listed property‖ which is used for personal purposes. 280F B. Depreciation with respect of a luxury auto under 280F(a) is limited (amt changes with inflation). For cars placed into service in 2002 the depreciation deduction is limited to 3060, 4900 in 2003, 2950 in 2004, 1775 each year thereafter until fully depreciated. C. Under 280F(b): the alternative depreciation system of MACRS must be used for ―listed property‖ that is mixed business/personal use if the business use is 50% or less. Listed property items 280F(d)(4) a. Cars (i.e. not luxury but others) b. Other transportation vehicles c. Entertainment property d. Computers 62 62


e. Cell phones x. Depreciation Recapture §1245 A. As property is depreciated, its adjusted basis is reduced by the amount of deductions take. 1016(a)(2). B. This increase the gain realized by the tp when the property is sold. C. Under 1231, gain from the sale of a depreciable assets may be a capital gain. 1231(a)(1). D. However, depreciation deductions are ordinary deductions. Therefore the portion of any gain on the sale of a depreciable property that is attributable to having taken depreciation deductions is re-characterized as ordinary gain under the deprecation recapture rule of 1245. E. Ex: If property acquired for 1k is fully depreciated, then sold for 1200, the tp, tat the time of sale had a basis of 0(1000 basis -1k depreciation deductions) thus the to has a gain of 1200 - 1k of which would be ordinary gain an d200 of which would be capital gain. F. 1250 property: for real property, depreciation is recaptured only to extent that the deprecation taken is greater than straight-line. 1250. This seldom occurs bc straight-line depreciation is required or almost all real property and so the straight-line amt will equal the deprecation taken. Much simpler – no §168(k), no §179, only available choice is the alternative depreciation system. Deductions in For Profit Activities a. §212 - Expenses for Production of Income allows deduction of all ordinary & necessary expenses paid or incurred during the taxable year for (1) production of income,(2) management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax. i. “Production or collection of income” A. Note per Supreme Ct: The cost of acquiring investment property (i.e. stocks) is a capital expense so is not a deduction under §212. Instead any commissions are added to purchase price (and therefore basis) and commission charges on sale are subtracted from the gain realized. This is how these costs are captured. a. E.g. $200 paid to lawyer to help you collect your last $6000 paycheck is deductible, but attorney's fees in connection w/ disputed ownership of stock become part of basis B. Cannot deduct personal expenses. a. § 212 limited by § 262 which makes personal expenses non-deductible and by § 263 benefit > 1 year rule C. Timing & characterization questions a. Subject to limitations, timing determinations, etc. in the same manner as are §162 deductions. D. Also includes expenses incurred in obtaining alimony includable in GI but not regarding property settlement (Note: BUT if one party pays other's fees, they are non-deductible personal expense) E. Note: ordinary & necessary limitation rests in part on extent of investment (e.g. it is ordinary & necessary to spend $500 to attend holders meeting if own 25% of stock but not if own .1%).



ii. “Management, conservation, or maintenance of property held for production of income” A. Necessary because if sell property at a loss, to be deductible, must still fulfill §165(c)(2) requirement that it be a transaction entered into for profit a. §165(c)(2) - Losses: Can deduct losses that result from any activities entered into for profit. b. The definition of "holding property for income" (§212) is slightly broader than "property used for profit" (§165) so loss-related issues may arise more frequently. c. Important mostly for residence converted to rental briefly before sale (how long must be rental to make operating expenses deductible under § 212 unclear) iii. “In connection with determination, collection or refund of any tax.” A. If you incur attorney fees in conjunction with tax planning or preparation advice these fees may be deductible. (§212(3)) a. Have divorce/corporate attorney itemize the bills to show the amount spent on tax planning. b. If spouse is the payee spouse in an alimony situation who needs to retain attorney to assist in getting alimony paid these legal fees are deductible since being used re production or collection of income. c. Some courts allow full estate planning fees to be deducted under this clause. Others limit to pure tax planning, do not include, i.e. establishment of inter vivos trusts etc. B. Per Wassenar does not include expenses of getting an LLM to better prepare your returns. b. Broader than t/b deductions (allows deducting for those who just manage their money). XVI. Deductions Allowed in Any Event a. Interest i. General Rule: Interest is deductible. §163(a). A. Interest - is money paid for use in obtaining money. a. To calculate need to know: i. How much of the payment made is debt ii. How much of payment is principal and how much interest. B. Requirement of valid indebtedness. Usually an issue in related party transactions and tax shelter deals. C. Failure to provide sufficient interest. a. Example: Sell property for $100000 payable in 3 years, no interest. For seller, this ―hides‖ interest OI as part of the capital gain gross income, taxable at lower rates. For Buyer, foregoes interest deduction but may get depreciation. b. This subterfuge is prevented by 3 sets of provisions: i. The OID rules (§§1272-1275) ii. The imputed interest rules (§482) iii. The below-market interest rules (§7872) c. Conceptually they are similar, in detail they differ. Our focus will be on §7872 a few slides from now.



ii. The general rule is misleading. Why? A. No deduction for interest on debt used to finances purchase of tax-exempt bonds. §265 a. Prevents tax arbitrage (borrow $ to invest in tax-exempt incomeproducing property, then deduct interest to make it work) b. Elaborate tracing mechanism B. No deduction for interest on debt used to finance any investments that generate investment income (e.g. interest, dividends), except to the extent of the investment income. §163(d) a. Example: Borrow $100000 to buy $100000 of stock. No other investment transactions. Pay interest of $12000 on loan. Dividends received of $9000. Of the $12000 interest paid, only $9000 is deductible. C. No deduction for personal interest. §163(h). D. Pre-paid interest is not deductible: a. Cash method txp must allocate interest actually paid like accrual method (only interest due is deductible) b. To prevent tax sheltering: get loss out early iii. What is personal interest? (§163(h)) It is ALL INTEREST except…* A. Trade or business interest B. Interest subject to the 163(d) limit C. Interest subject to the §469 passive loss limitation rules (which apply to other expenses and not just interest)[limitation to be examined later] D. Qualified residence interest (next slides) E. Interest on certain estate taxes F. Education loan interest (new in 1998) a. Limited deduction (increases from $1000 to $2500) b. Phased out as AGI exceeds $40/$60K c. Only first five years of interest qualifies d. 2001 legislation removes (c), raises (b) to $50,000/$100,000, beginning in 2002, sunset in 2011. G. *Note how general rule is overshadowed by the exception. iv. What is qualified residence interest? See §163(h)(3)(A) a. Interest b. Paid or accrued c. During the taxable year d. On acquisition indebtedness or home equity indebtedness e. With respect to a qualified residence. B. What is a qualified residence? See §163(h)(5)(A)* a. The taxpayer’s principal residence AND, if it exists, b. One other residence of the taxpayer selected by the taxpayer, provided it is i. Used by the taxpayer as a residence (§280A(d)(1): more than 14 days or 10% of fair rental days – whichever is greater) OR ii. Not rented (163(h)(5)(A)(iii)) c. *Which is really (h)(4)(A) but they goofed in numbering it d. If only 1 residence, need not be principal, but if 2, 1 must be principal e. Motor homes & live-in boats included



C. What is acquisition indebtedness? See §163(h)(3)(B) a. General rule § 163(h)(3)(B)(i): indebtedness is --i. Incurred in acquiring, constructing, or substantially improving any qualified residence AND ii. Secured by the residence b. Chain rule (flush language of § 163(h)(3)(B)(i)) i. Indebtedness ii. Secured by the residence iii. Resulting from refinancing of indebtedness qualified under general rule or chain rule iv. To extent of refinanced indebtedness so qualified. c. Limited to $1,000,000 d. Note: includes refinancing which does not exceed amount refinanced D. What is home equity indebtedness? See §163(h)(3)(C) a. General Rule: i. Indebtedness ii. Not acquisition indebtedness iii. Secured by qualified residence iv. Not in excess of residence net equity 1. Net equity: fair market value minus acquisition indebtedness (= "equity" in home). 2. This element is an anti-abuse rule (no bank would lend more than net equity). b. Limited to $100,000 c. Doesn’t matter what you use the $ for (likely to be next chip at interest deduction) d. Note: just because a bank may call it a home equity loan doesn’t mean it is home equity indebtedness for tax purposes. v. Order of analysis: A. Is it acquisition indebtedness? B. Home equity? C. Rest goes into § 163(d) investment interest calculation (deduction limited to investment income — thus if sufficient income from elsewhere may be deductible) vi. Examples: A. $50 left on 1st mortgage, take out new loan for $200 a. $50 is acquisition/refinancing — ¼ interest deductible b. $100 is home equity ½ interest deductible c. Other ¼ of interest paid goes into investment interest calculation B. Mortgage on 1st house = $250,000 and acquisition = 350,000; on 2d = $950,000 and acquisition = $1.2M. a. Mortgage on #1 is acquisition indebtedness. b. Mortgage on #2 is acquisition indebtedness but only 750,000 because limited to $1M. Thus 1/1.2 = 5/6 of interest paid on each mortgage is deductible acquisition interest c. Additional $100,000 of home equity interest deductible thus 100/1200 = 1/12 of interest paid on each is deductible home equity interest d. Total deductible interest = 11/12 (last 1/12 goes into investment interest calculation and does not qualify.) e. Does it matter which mortgage accounts for the $100,000? 66 66

i. Yes, taxpayer would want disqualified 100,000 to come from the mortgage with the lower interest rate. ii. No authority, legislative history suggests chronological rather than proportional rule. Thus, 100/950 of interest on the $950,000 mortgage is not deductible. C. Original mortgage = $250 now reduced to $175; refinance for $300 a. Acquisition indebtedness: refinancing limited to reduced principal of old mortgage = $175 of interest paid on refinanced indebtedness deductible b. Interest deductible on another $100 of home equity indebtedness c. Total = $275 thus 275/300 of interest paid on refinanced indebtedness is deductible (rest to investment int calc'n) D. Purchase price and FMV of home are 350,000; TP gets 250,000 mortgage. After paying off 200,000 of original mortgage TP borrows another 200,000 on the residence, pays off the 50,000 outstanding on first mortgage and invests rest in stock. a. Interest on the 50,000 that equals the 50,000 refinance indebtedness from the first mortgage can be considered acquisition indebtedness and the interest deductible. b. Home equity indebtedness is limited to net FMV of 5000,000 fmv 50,000 acquisition indebtedness and limited to 100,000, so 100,000 can be considered home equity indebtedness and this interest deductible c. 50,000 does not fall into any slot and interest not deductible (might be able to treat as investment income interest but this is an open question). vii. § 7872: gift or below market interest loans A. New provision to deal with parent "loaning" $ to child for investment so that proceeds taxed at child's rate. New provision taxes imputed income: a. Theoretical transfer in amount of foregone interest to child (potential GI) and returned to parent (potential interest GI) B. If loan is parent to child, § 7872 applies when: a. It is a below market loan- § 7872(e)(1)(A)- less than applicable federal interest rate. b. It is a gift loan- § 7872(f)(3)- do facts suggest it is a gift loan? c. If meet these requirements, it is a below market loan to which § 7872 applies- § 7872(c)(1)(A). C. What happens. a. What is the foregone interest? See §7872(e)(2) i. Need interest rate- see § 7872(f)(2). b. What happens with the foregone interest? i. Foregone interest treated as, as of last day of year, transferred from lender to borrower- § 7872(a)(1)(A). 1. Gross income for parent of foregone interest amount. ii. And then retransferred from borrower to lender- § 7872(a)(1)(B). 1. Child excludes as gift under § 102. 2. Deduction to child if within § 163. D. § 7872 Just provides characterization. Does not tell you tax consequences. The consequences come from Code provisions we already examined: a. For the transfer from parent to child: i. § 2501(a)(1) perhaps a gift tax on the parent ii. § 102(a)- a gift excluded from the child’s gross income. b. For the transfer back from the child to the parent: 67 67


F. G.


i. §61(a)(4): Interest gross income for the parent. ii. § 163 et al- MAYBE an interest deduction for child if used as principal residence, if used as vacation home, no deduction. Note that this is an EXCEPTION to the general principle that we examined in connection with the nature of gross income, namely, that gross income does not include so-called « imputed income » such as the perosn who does her own tax return. a. Section 7872 does indeed IMPUTE income (and a possible deduction and an exclusion and a transfer subject to the gift tax) where otherwise ther ewas nothing. b. Don’t be confused by the loan iteslf, which has no tax consequences because neither the parent nor the child is richer or poorer when the loan is made. LIMITS to § 7872 a. $10,000 limitation § 7872(d) special rule for gift loans between individuals: a. IF loan is less than $100,000 then interest amount shall not exceed borrower's net investment income. b. If net investment income is under $1000, then treat as 0 (thus "interest" paid = 0: no GI to lender). c. If net investment income is from 1000 to 10250, then adjust to dollar amount it is. Thus, 4444 of investment income will impute 4444 of interest paid and GI to lender. d. If net investment is over 10250, then 10250. §7872 simply says: We pretend that there was interest paid from the borrower to the lender and money transferred from the lender to the borrower and we go elsewhere for the consequences. a. There are adverse tax consequences arising from the interest component.

b. Taxes- § 164 i. Can take deductions for: A. Real property taxes- § 164(a)(1) B. State and local income taxes- § 164(a)(3) C. Personal property taxes- § 164(a)(2) D. Foreign income taxes- § 164(a)(3) unless credit taken (§275(a)(4)(A)) E. Other taxes paid or accrued in carrying on a trade or business- § 164(a) (flush language). F. Some other stuff in §164(a)not of concern to us in this course. ii. Exceptions: no deductions for: A. Taxes listed in § 164(a)(1)-(5) if paid or accrued in connection with the acquisition or disposition of property. § 164(a) flush language, 2d sentence). a. The former increase basis (§§263, 1016(a)(1)) b. The latter decrease amount realized (various cases) B. Federal income taxes, including FICA taxes- § 275(a)(1). a. Employer can deduct, as salary expense, any amount paid as salary and withheld for taxes, and the matching funds required (i.e. for FICA). i. Independent contractors, i.e. Do not have taxes withheld by employer so employer does not have this deduction. The independent contractor also has to pay the matching funds portion so taxes are higher. 68 68

ii. no employee can deduct the matching funds since this is to pay a federal tax, not on list. iii. To determine if independent contractor or employee: where is work performed? Who is work performed for? Provides supplies? C. Estate, gift, inheritance taxes- § 275(a)(2). D. Some other stuff in §275(a) not of concern to us. c. Casualty Losses- § 165 i. Remember that under § 165(c), individuals are permitted to deduct losses only if they are: A. Trade or business losses 165(c)(1) B. Losses from transaction entered into for profit 165(c)(2) C. Casualty losses 165(c)(3) ii. Checklist: steps for determining casualty loss deduction: A. Is there a loss? B. Is there a casualty/theft? a. Casualty losses are losses of property not connected with T/B or transaction entered into for profit if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. Theft considered sustained in the year the theft is discovered. (§165(c)(3)). b. A casualty is a sudden, unexpected, unusual event i. Sudden, unexpected occurrence is not rot, gradual erosion or (per case) termites. BUT IRS says Southern pine beetle = casualty (can destroy tree in 3 days). ii. Wear and tear is not casualty such as weather wearing down. iii. Gradual insect infestation causing tree to fall over is not event but its cause. iv. Automobile accidents are casualty losses v. Ransom also casualty loss (sudden & unexpected even though voluntary) vi. Rotting things: gradual, not unexpected. c. Negligent acts (i.e. MVA) may be casualty but intentional acts (i.e. arson) may not. i. Cannot bring it about- Blackman. ii. Arson is casualty loss unless you do it (would violate public policy) iii. d. Whether casualty loss & causation are fact issues C. Did the casualty cause the loss? D. What is the amount of the loss? a. Decrease in value of the property- Reg 1.165-7(a)(2)(ii). Declining value test - the value immediately before the damage is done minus the value immediately after the loss. b. BUT cannot exceed adjusted basis in property- Reg 1.165-7(b)(1)(ii). i. Thus if buy for 100 and worth 1000, and fire occurs, cannot let 1000 deduction because never had it, was unrealized. ii. If insurance pays 1000, this is casualty gain. c. If repairs are made, permitted to use the cost of the repairs as measure of the decrease in value of the property caused by the casualty. Reg 1.1657(a)(2)(ii). i. Thus, if cost 3500 to repair, then that is what went down in value. 69 69

d. BUT if it is trade or business property that is fully destroyed and the value immediately before the destruction is less that the adjusted basis, amount of loss equals adjusted basis- reg 1.165-7(b)(1)(flush language). i. So if buy property in trade or business for 1000 and destroyed at time worth 800, still have 1000 basis and deduction. ii. Example: E purchase a truck of ruse in his business for 20k and he takes 11k in depreciation deductions over the next several yrs, thereby reducing the truck’s adjuste4d basis to 9k. At the time when the truck’s fmv is 12k it is damaged in a hit and run accident. Elliotte [pays 10k to fix the damages on the truck, for which he is not compensated. The work done only takes the truck to its pre accident condition and fmv. Reg 1.165-7(a)(2)(ii). The amt of Elliots loss is 10k, but he may deduct only 9k, the amt of the trucks adjusted basis immediately prior to the accident [Elliots basis in the truck after the transaction is 10k: 9k pre accident basis less 9k deduction plus 10 repair 9capital expenditure0}. iii. Totally Destroyed: If the truck had a fmv of 6k and an adjusted basis of 9k and it had been totally destroyed in an accident, the amt of the loss would be 9k, but if the truck were not totally destroyed and was worth 2k after the accident, Elliots loss would be limited to 4k 1. Total destruction: if the fmv b/f accident is < adjusted basis Üthen tp gets loss ded of adjusted basis, but if fmv>adjusted basis, then apply the normal rule Ü get lesser of diff bt fmv bf and fmv after and adjusted basis. 2. 6k-2k = 4k and this is less than his adjusted basis of 6k E. Reduce the loss by the amount of the insurance or other recovery- § 165(a). a. Treat as insurance recovery the amount that would have been recovered had a claim been made with the insurance company. § 165(h)(4)(E). b. If the recovery exceeds adjusted basis, then there is no loss but casualty GAIN included in gross income (unless exclusion (e.g. §121) or nonrecognition provision (e.g. §1033) applies). i. What is the character of the gain? § 165 (h)(2)(B) - if gains exceed losses for the year all gains and all losses will be treated as capital. ii. Capital losses are taken in computing AGI, not as itemized deductions (see §62(a)(3) & §165(h)(4)(A)). iii. Capital gains are included in GI. F. Combine casualty losses for each damaged property damaged by the same casualty event and subtract $100: § 165(h)(1). a. Thus, if hurricane destroys car, house, boat, take off 100 per casualty. G. Compare the personal casualty gains with the personal casualty losses (leave out trade and business losses or gains). a. If the personal casualty gains equal or exceed the personal casualty losses: i. Gains are included in gross income. ii. Losses are deducted. 1. Treated as loss from sale of capital asset- § 165(h)(2)(B). 2. Thus, deductible in computing AGI because loss from sale of property is so deductible. § 62(a)(3). 70 70

b. If the personal casualty losses exceed the personal casualty gains: i. The gains are included in gross income. ii. The total personal casualty losses are divided into two parts- see § 165(h)(2)(A): 1. Part 1 is a portion equal to the amount of the gains. a. The Part 1 portion is deducted in computing AGI. Thus, in effect, offsetting the gains that are in gross income- See § 165(h)(4)(A). 2. Part 2 amount is everything else. a. The Part 2 amount is reduced by 10% of AGI. This is what § 165(h)(2)(A)(ii) is saying. It is included in itemized deductions. (Because only allowed to the extent the casualty loss is extraordinary. Only extraordinary if they exceed 10% of AGI.) iii. Example A. Car value of 8,000 before & 1,000 after. vase in car value of 10,000 and 0 after. AGI of 30,000 that year. Insurance received 1,000 on car; 20,000 on vase a. Have total loss on car of 5900 (7000 declining value rule minus the insurance received & $100 de minimis deduction). b. Have total gain of 10,000 on vase c. Will declare both gain and loss; end result is a 4100 gain. B. Insurance received 1,000 on car: 12,000 on vase a. Still have total loss on car of 5900 b. Have a gain of 2000 on vase - this goes into GI. c. Can deduct losses up to the amount of gain and the excess over 10% of GI. So can deduct: i. 2,000 (equal to gain) and ii. 900 (10% of 30,000 is 3000 so of the remaining 3900 of loss 900 can be deducted). d. Charitable Contributions- § 170 i. General Rule - can deduct contributions to qualified charities as long as meet requirements. ii. Analysis A. Is it a charitable contribution? a. A gift i. NO quid pro quo (Rev. Ruling 80-77). ii. Gratitude OK (if b/c Red Cross put you up after hurricane you give them $1000, still charitable contribution); 1. Gift to local fire company, gift to scouts to which child belongs. iii. See § 170(l) football ticket exception (if "contribution" is for right to buy tix, then only 80% deductible). iv. Send $60 to channel 6 and get $30 book, then requires charity to show what got for it. v. Another example - if spend $125 for charity dinner can only deduct the difference between FMV and the amount spent since are getting something (dinner) for the price. vi. Is different definition than the gift (detached disinterested generosity). 71 71

vii. If give tangible personal property it has to relate to the activities/purposes of the charitable organization, i.e. cannot give yacht to VLS b. An appropriate donee: i. There must be a proper donee (i.e. list in §501, §170) ii. Governments, public charities, some private charities. iii. Charity1. A group doing relief work for poor (narrow) or 2. Educational, scientific or church organizations. iv. Kessler- distinction between organizes religions as donees and nonconventional religious practices. 1. Individual on street give $10, no deduction because that is individual, not charity. B. Limitations a. Corporations: Corporations can deduct no more than 10% of taxable income (rest can be carried forward). b. Individual contributions i. General – public charities: Cannot exceed 50% of the TP's contribution base (AGI) for the taxable year. 1. Carryover Provision - if contribute more than 50% can carry deduction over and take it over the next 5 years as long as does not exceed the 50% mark for any year. But must be given to: a. Churches b. Organization that does medical care/research c. Organization which receives substantial support for US d. Governmental units e. Corporate charitable foundations f. Private foundation g. §509(a)(2) or (3) organizations ii. "Private" charities: 30% AGI limit iii. Gifts of capital gain property to private charities: 20% AGI limit. 1. If have capital property with built-in gain then your charitable contribution begins with the present value (with gain in) - not basis. 2. Thus, if buy for 1000 and fmv 10000 and give to red cross, get 10000 deduction. c. Cannot deduct for services provided; there is no imputed income. i. Donation of blood is characterized as a service by IRS so cannot deduct. Blood is also not a capital asset. This keeps the IRS out of the controversy re property interest in body parts. ii. While no deduction for services, get deduction for expenses not reimbursed. d. § 170(j)- No traveling expenses unless there is no significant element of personal pleasure, recreation or vacation in such travel.



XVII. Deductions for Individuals Only a. Moving Expenses i. §82 - Reimbursement for Moving Expenses A. General rule §82: Except as provided in section 132(a)(6), there shall be included in gross income (as compensation for services) any amount received or accrued, directly or indirectly, by an individual as a payment for or reimbursement of expenses of moving from one residence to another residence which is attributable to employment or self-employment. a. Must include in GI any amount received, directly or indirectly, as reimbursement for moving which is attributable to employment or selfemployment. b. Reimbursements of expenses are included in GI then taxpayer takes deductions as defined. B. § 82 allows a deduction for moving expenses from moving from 1 residence to another attributable to employment or self-employment a. Allowed for taxpayer and/or member of household i. Note: if husband and wife both get jobs in new area, rule applied as 1 commencement of work b. Policy: i. Congress reasoned that these expenses are a cost of earning income ii. Congress tries to equalize tax treatment of new employees & transferred employees ii. §217 - Moving Expenses A. General Rule: Can deduct moving expenses related to move attributed to employment or self-employment. (217(a)) B. Moving expenses include: a. Reasonable expenses of moving household goods and personal effect from the former residence to the new residence, and (217(b)(1)(A) b. Of traveling (including lodging) from the former residence to the new place of residence. (217(b)(1)(B) c. Does not include expenses for meals. (217(b)(1)(B) – flush) C. Conditions imposed a. New principle place of work has to be at least 50 miles farther from former residence than old place of work by shortest route. (217(c)(1)(A)) b. If no old place of work has to be 50 miles from old residence (by shortest route) and (217(c)(1)(B)) c. Once in new place of work taxpayer has to meet certain number of weeks as full-time employee. (217(c)(2)(A)-(B)) D. Other Rules a. Do not have to meet subsection (c) rules if death, disability or fired from new job for reason other than willful misconduct occurs. (217(d)) b. If do not end up meeting the conditions above and have taken the deduction have to include the amount in GI in the taxable year the lapse is discovered. E. Cannot use Code sections to obtain a double benefit. F. Timing: deduction can only be taken in the year expense was paid or accrued.



b. Medical Expenses- § 213 - Medical, Dental Expenses i. General Rule: Can deduct qualified expenses that were not reimbursed by insurance only to the extent such costs exceed 7.5% of the Taxpayer’s AGI. (§213(a)) A. "medical expense" is a factual determination: a. Includes: i. Specifically includes prescription drugs & insulin ii. § 213(d)(1)(B) includes "transportation" 1. Includes travel as medical care (where doctor prescribes different climate) but not living expenses while there 2. Also includes transportation to/from place of treatment including necessary food & lodging en route 3. Congress intended to counter abusive fully deductible medical vacations to resort areas iii. § 213(d)(2) includes expenses for lodging 1. Must be away from home primarily for medical reason 2. And can be no personal pleasure, etc. 3. Also limited to $50 per (medically necessary) person per night iv. Does include: hearing-aid cat; close caption TV; special diet b. Does NOT include i. General expenses w/ remote connection w/ medical procedure 1. Food even though dies w/o it 2. Amounts paid to increase general health / well-being ii. § 213(d)(9) cosmetic surgery unless necessary to correct deformity resulting from congenital or disfiguring disease or personal injury iii. Drugs other than prescribed drugs and insulin. B. Medical care includes a. Diagnosis, cure, mitigation, treatment, or prevention of disease (213(d)(1)(A) b. Transportation primarily for and essential to medical care (213(d)(1)(B)) c. Insurance premiums 213(d)(1)(D) d. Lodgings away from home as long as closely related to medical care and there is no significant element of pleasure involved (213(d)(2)) c. Higher Education Expenses §222 i. In general: In the case of an individual, there shall be allowed as a deduction an amount equal to the qualified tuition and related expenses paid by the taxpayer during the taxable year. A. Qualified tuition and related expenses: the costs of enrollment or attendance at an eligible educational institution of higher education for a student who is the taxpayer or spouse or dependent of the taxpayer. a. Such costs do not include costs for books, housing, student sports activities unrelated to academic instruction, or courses related to sports or hobbies, unless a part of the student’s degree program. b. Any tuition or related fee that is funded with an amount that is excluded from gross income (i.e. §117 or 127) does not qualify as such an expense. c. However, tuition and related fees that are funded as gifts excluded from gross income by §102(a) do qualify. ii. Limitations: Taxpayer must choose between the deduction and the credit in §25A (if eligible) – can’t take both (222(c)) 74 74

A. No other double deductions allowed B. No deduction allowed to an individual if that individual is the dependent of another taxpayer or if the taxpayer is a married taxpayer who doesn’t file a joint return. iii. Dollar Limit: Ceiling: in 2002, a taxpayer with AGI that does not exceed $65000 ($130000 in the case of married filing jointly) is entitled to a maximum deduction of $3000 per year. A. This is adjusted for the next few years. (§222(b)(2)(A)(i)) XVIII. Deduction Restrictions: There are FIVE limitations that apply to clusters of deductions, usually in connection with an activity. a. Amount at Risk- § 465 (just know the basics) i. Concept: cumulative aggregate deductions allowed with respect to an activity are limited to the amount at risk. ii. Generally, the amount at risk is what the taxpayer has contributed to the activity, what the taxpayer borrows with personal liability, some arms length third party nonrecourse financing for real estate activities, and gross income not withdrawn from the activity. iii. Example: If T pays 10k and borrows 40k on a nonrecourse loan to invest in cattle. GI of 16k and deductions of 38k under § 212. Only 26k can be deducted because that is amount paid in (10k) plus gross income (16k) = 26k. iv. If not at risk by using nonrecourse debt to pay for deductions, lose deductions. b. Activities Not Engaged in For Profit- § 183 i. No deduction for not-for-profit activities (hobbies)- § 183(a). Except for presumption, just hammers home point that personal expenses are not deductible. ii. Whether activity is for profit within § 212 is factual issue: A. If not in § 162 or § 2112, it is not for profit under § 183(c). B. Presumption in § 183(d) that if show a profit in 3 of 5 years, then presumed for profit. iii. Exceptions A. Permitted to deduct expenses that are deductible without regard to for-profit status including interest, taxes and other in any event deductions. § 183(b)(1). B. Permitted to deduct expenses that would be deductible if activity were for-profit, but only to the extent that activity’s GI exceeds the amounts deductible on account of the § 183(b)(1) portion of the exception [§183(b)(2)]. iv. Examples A. John ―runs‖ a farm, and has dividend and interest income of 170k, farm gross receipts of 80k, farm real estate taxes of 26k, farm wages paid to laborers of 65k and farm supplies of 16k. a. If farm is for profit: John’s GI is 250k and deductions are 107k for a TI of 143k. Farm is sheltering part of the investment income. b. If farm is not for profit, John’s GI si 250k and deductions are 80k (26 + 54) for TI of 170k. (§164  183(a)  183(b)(2)) i. So 26k in real estate taxes get whether trade or business or not. (§183(b)(1)). ii. 80 GI – 26 (§183(b)(1)) = 54K deductible under 183(b)(2). iii. NO CARRYFORWARD. c. Note that when not for profit, the farm loss does not shelter any of the nonfarm income accomplishing the purposes of § 183.



B. John runs a farm, and has dividend and interest income of 170k, farm gross receipts of 21k, farm real estate taxes of 26k, farm wages paid to laborers of 65k and farm supplies of 16k. a. If farm is for profit: John’s Gi is 191k, deductions of 107k and TI of 84k. b. If farm is not for profit, John’s GI is 191k, deductions of 26k and TI of 165k. Note that the farm real estate taxes shelter 5k of the nonfarm income because it is an in any event deduction. i. 21k does not limit 26k tax deduction because get it anyway. ii. Gets deduction for supplies and wages to extent gross income recovered from activity. iii. Note: no 183(b)(2) deduction because no excess between gross receipts and farm real estate taxes (21 – 26). c. Dwelling Unit Limitation §280A i. In general A. Buy vacation home, expenses in depreciation, utilities, so make if for profit rental activity. BUT this section limits. a. General note: there are two types of expenses: 1) those in connection with the T/B and 2) those not in connection with the T/B. B. Applies to individuals and S corporations- § 280A(a). C. Affects dwelling unit used as a residence- § 280A(a). a. Dwelling unit used as a residence if it or a portion is used by the taxpayer for personal purposes for a number of days exceeding the greater of 14 or 10% of fair rental days. § 280A(d)(1). b. If fair rental days exceed 140, then number begins to creep up. c. If do not use at all, then does not apply. d. De minimus- 1 or 3 days personal use not enough. e. Personal purposes: i. Personal use by a taxpayer or family member- § 280A(d)(2)(A). 1. If family enjoys, that is OK as long as one member is doing work. (If family comes with you when you’re doing maintenance) a. Limit to repair days: what is reasonable 2. Regs- go to place with purpose to deal with rental, not personal purpose such as maintenance and cleaning. (doesn’t count as a day of personal use) ii. Personal use swaps- § 280A(d)(2)(B). iii. Use by tenant if rental is not fair rental- § 280A(d)(2)(C). If rental is not fair then gets counted such as to kid for $10 a day. D. General impact: no deduction otherwise allowable with respect to the dwelling unit is allowed. § 280A(a). E. The de minimis rental exception- § 280A(g): If the dwelling unit is used by the taxpayer as a residence and is rented for less than 15 days during the year: a. Then no deduction (other than in any event deductions such as interest or taxes) attributable to the rental use of the dwelling unit is allowable. b. The rental gross income is excluded from gross income. (280A(g)(2)) c. WARNING: this is an exclusion area of the code buried far from the usual exclusion area of the code. d. Note: Proposed repeal of this provision was dropped by the Conference for TRA97. Has resurfaced several times; not surprising given that it is a revenue raiser. (the ―Augusta exclusion.‖) 76 76

F. Easing the § 280A deduction denial: a. Deductions allowable in any event (interest, taxes, etc.) Are not subject to the § 280A(a) limitation. § 280A(b). b. Exceptions for deduction items allocable to : i. Qualified office in home- § 280A(c)(1) which is : 1. Exclusively used 2. On a regular basis 3. As: a. The principal place of business for any trade or business (this is a factual determination) b. A place of business for clients/customers to meet or deal with taxpayer in normal course of trade or business c. Separate structure used in connection with trade or business. ii. Certain storage use- § 280A(c)(2). iii. Rental use- § 280A(c)(3). – easy iv. Day care use- § 280A(c)(4). v. We won’t really go into these very much G. Taking back from the exceptions a. § 280A(e): If dwelling unit is being rented and taxpayer uses unit for personal purposes on ANY day (even if not over 14/10% fair rental days), then amount deductible as rental expense (other than in any event deductions - §280A(e)(2)) is limited to the expense multiplied by days of fair rental DIVIDED BY total days of use. i. Escape only if rent it out exclusively. ii. Ex: days of use is 10 and days of fair rental is 100 then with 4k repair expense, limited to 4k x 90/100 or 3600 iii. Note that this is nothing more than a restatement of § 262's disallowance of personal use expense and no deductions allowed for personal, family household expenses. b. § 280A(c)(5)- Applies to qualified office in home, storage, day care and rental where dwelling unit is used as a residence. i. The deductions that are allowed because of that use (depreciation, repairs, utilities, etc. that are deductible under § 162 (start at §162 and §212 to see if they are deductible) or § 212) are limited to: 1. The excess of GI derived from the use over (subtract) 2. The sum of a. Deductions allocable to the use that are allowable without regard to the use of the dwelling unit (in any event deductions such as interest, taxes, etc.) b. Deductions allocable to the trade or business or rental activity in which the use occurs but not allocable to that use such as nondwelling unit expenses of the trade or business (like lexis, transportation, expenses regardless of whether at home or in business) or rental ii. Amount disallowed by limit is carried forward to next year. (You can offset GI, but you cannot create a loss) 77 77

iii. Put another way, § 280A(c)(5) is describing something that could be called ―net income of the trade or business or activity ignoring deductions that are allowable ONLY because there is a trade or business or for-profit use of the dwelling unit.‖ iv. So, For an office in home situations: § 280A(c)(5) is describing GI from the trade or business MINUS the nondwelling unit expenses of the trade or business such as supplies, advertising, travel, etc. v. For a rental situation: § 280A(c)(5) is describing rental GI MINUS the nondwelling unit expenses of rental, such as advertising, travel to inspect the property, etc. vi. More simply, § 280A(c)(5) is a limit on the deductions that are allowable ONLY because there is trade or business or for profit use of the dwelling unit. vii. ***What § 280A(c)(5) prevents is creating or increasing a net loss from the trade or business or rental activity through use of the dwelling unit. viii. Example (schedule C): Qualified office in home use for a home business. Gi of 50k, deductions not related to home (advertising, supplies) 40k, allocable interest and real estates taxes is 3k. Then the § 280A(c)(5) limit is 7k 1. Even if allocable repairs, insurance, utilities, etc. (Expenses of the dwelling unit deductible only because of the use of part of the dwelling unit s an office) are say 9k, then only 7k is deducitble 2k is CARRIED FORWARD (different than hobby). 2. If have 18k in repairs and § 280A(e) allows 50% deduction of 9k, then only 7k can be deducted. 2k carried forward. ii. Example of analysis (Prob:524-1(a) – (c)) A. Rental property of 30 days personal use, 90 fair rental days, GI of 3000. a. 280A applies because 30 days of personal use exceeds greater of 14 and 10% of 90. b. 280A(g) does not apply because exceeds 14 days of rental days. c. 280A(e) applies as there is personal use of at least one day. i. Thus of 3600 expenses not in any event, only 90/120 are deductible for 2700. ii. Other 900 is nondeductible personal use under 262. d. §280(c)(3) overrides §280A (rental use) e. 280A(c)(5) limit applies because the dwelling unit is used as a residence by taxpayer. i. Remember: $2700 of expenses survived §280A(c) ii. §280A(c)(5) limit is rental Gi of 3000 minus the sum of: iii. allocable portion [not defined] of in any event deductions 1. Courts says its fair rental days divided by total days so here 90/365 x 2000 =500. 2. IRS says its fair rental days divided by total in use days so here 90/120 x 2000 = 1500. iv. plus nondwelling unit expenses of rental activity (none here) 78 78

v. Limit per IRS is 3000 - 1500 = 1500 and thus 2700 - 1500 (c)(5) limit = 1200 carried forward. vi. Limit per courts is 3000 - 500 = 2500 so 2700 - 2500 = 200 carried forward. vii. Remaining amount of interest and taxes claimed as itemized deductions so for IRS it is 2000 - 1500 = 500 and for courts it is 2000 - 500 = 1500. Fight is over how much itemized deductions which is not limited. f. Both approaches show zero net rental income. B. Prob. 525:1(d) Rental property of 7 days personal use with 21 fair rental days. 36k in expenses not allowable in any event. 3k GI. a. 280A(a) does not apply because 7 days not greater than 14 or 10% of 21 (2.1) b. Rental days exceed 14 so 280A(g) does not apply. c. 280A(e) does apply because at least one day personal use. i. Of the 3600 in any event expenses, 21/28 are deductible or 2700. ii. Other 900 is nondeductible personal use expense. (see also §262) d. 280A(c)(5) limit does not apply because not used as residence. e. But §183 is relevant i. if rental is not for profit and just happened not sought rental (accidental rental  hobby) 1. 183(a) applies no deductions but 2. 183(b) allows 2000 in any event and 1000 of other expenses to wipe out GI. 3. No carry forward for rest of remaining expenses 4. Rental schedule: GI 3K, deductions 3K; schedule A: zero. ii. If rental is for profit, and this was bad year, 1. 183 irrelevant 2. All interest and taxes and 2700 other expenses are deductible. 3. Interest and taxes must be allocated between rental and personal so 21/365 x 2000 = 115 which is rental and the remaining 1885 is itemized (personal) deduction 4. 3000 GI - 2815 (2700+115) deductions; schedule A: $1885 itemized deductions d. Passive Losses- § 469 i. No deduction for taxpayer’s passive loss. § 469(a). ii. Passive loss is the excess of aggregate losses from all passive activities over the aggregate income from all passive activities. § 469(d)(1) A. Comment: Thus, in effect, passive losses are deductible only to extent of passive income. iii. Any passive losses disallowed under this rule are carried forward, but can by used only against future year passive income from the same activity. § 469(b) and regs thereunder. iv. On disposition of activity, accumulated undeducted passive losses are allowed as deductions. § 469(g)



v. Passive activity: A. Any trade or business in which the taxpayer does not materially participate - § 469(c)(1) B. rental activites- § 469(c)(2) per se passive. With exception for taxpayers who put more than ½ of their efforts into real estate trades or businesses in which they materially participate, provided that they perform more than 750 hours of service in those trade or businesses.(§469(c)(7)) vi. Material participation A. Statute: involvement that is regular, continuous, and substantial. § 469(h)(1). B. Reg 1.469-5: variety of hours tests, such as a. More than 500 hours b. Substantially only person c. More than 100 hours and more than anyone else d. We’re not responsible for these, not in book vii. Active management exception- § 469(i) A. Passive loss denial does not apply to passive losses arising from rental real estate activities in which the taxpayer actively participated. B. Limited to 25,000 of losses. C. Phase out exemption (i)(3): BUT the 25,000 limit is reduced by 50% of the excess of AGI over 100,000. a. Examples: So if AGI of 140,000, the excess over 100,000 is 40,000 and 50% of that is 20,000 so limit is 5,000. b. If AGI is over 150,000, then limit is zero. D. **Active management is not defined in code or regs. a. Other than excluding limited partners and less than 10% owners. b. **Legislative history suggests it is a lower level of involvement than material participation such as policy making. viii. Impact A. Until § 469 most tax shelter losses escaped limitations. a. §465 avoided through use of 3d party financing b. §183 avoided because long-term expectation of pr…? c. §280A avoided: no personal use of the property B. Problems: tax shelter arises because depreciation deductions allowed even if property not declining in value and basis includes the nonrecourse debt so taxpayer need not make outlay to get deductions. C. Once § 469 enacted, the tax shelter losses (which are passive) were useless unless there was passive income. D. So taxpayers shift investments from things generating interest/dividends (which are not passive) to passive income generators (PIGs). e. Policy Restrictions i. §162(c) - Cannot take deductions for illegal bribes, kickbacks etc. made directly or indirectly in business, to foreign governments, as payment for referral, or as disallowed under Medicare regulations. The IRS has burden of showing the illegality. ii. §162(g) - Cannot deduct any treble damages or settlement leveled against taxpayer for violation of antitrust laws. Fines and penalties also nondeductible. iii. Generally expenditures that are against the law and/or against public policy are not deductible. iv. What are deductible



A. Expenses that bear only a remote relation to illegal acts. B. Legal expenses are deductible if otherwise within §162 (T/B) or §212 (activity engaged in for profit). XIX. Personal & Dependency Exemptions- § 151-152 a. § 151(a) grants a personal exemption for calculating Taxable Income i. Note: Personal exemption reduces AGI b. § 151(b) allows Personal Exemption for: i. The taxpayer ii. And for spouse if A. Spouse has no GI B. Taxpayer and spouse do not file a joint return C. Spouse is not claimed as a dependent by another taxpayer c. § 151(c) grants additional dependent exemption i. Person must be a dependent under § 152. Must meet both of the following tests: A. Relationship test- § 152(a)(1)-(9) a. A son or daughter of the taxpayer, or a descendant of either b. A stepson or stepdaughter of the taxpayer c. A brother, sister, stepbrother, or stepsister of the taxpayer d. The father or mother of the taxpayer, or an ancestor of either, e. A stepfather or stepmother of the taxpayer f. A son or daughter of a brother or sister of the taxpayer g. A brother or sister of the father or mother of the taxpayer h. A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-inlaw, or sister-in-law of the taxpayer or i. Brother in law = sister's husband or spouse's brother ii. Presume Congress meant legal not common usage sense i. An individual (other than an individual who at any time during the taxable year was the spouse, determined without regard to §7703, of the taxpayer) who, for the taxable year of the taxpayer, has as his principal place of abode the home of the taxpayer and is a member of the taxpayer’s household. i. Note that this includes unrelated member of household B. Support test- § 152(a) a. Taxpayer provided more than 50% support, or b. Multiple support agreements: no one contributed over half the support, but will treat it as though the taxpayer contributed half the support if: i. No one person contributed over half the support ii. These contributors would otherwise have been eligible to claim the individual as a dependent iii. The taxpayer contributed over 10% of such support, and iv. Each person (other than the taxpayer) who contributed over 10% of support files a written declaration that he will not claim the individual as a dependent. c. Support i. Under multiple support agreements, Where number people provide support (no 1 provides > ½) they may agree to "rotate" the Dependency exemption ii. Qualified (non GI) scholarships are not included in dependant's support per § 152(d) 81 81

C. Note that child of divorced parents is a problem (usually custodial parent gets Dependency Exemption) ii. Person must meet one of the following two tests- § 151(c)(1) A. Dependent’s GI must be under exemption amount for taxpayer to claim dependent exemption (if equals 3,000, no dependent exemption)[151(c)(1)(A)] B. Be a child of the taxpayer who meets one of two tests § 151(c)(1)(B) a. Child not yet age of 19- § 151(c)(1)(B)(i) b. Child who is full time student not yet age 24- § 151(c)(1)(B)(ii) C. Additional notes: a. "Attain" age day before birthday (full Dependency Exemption for baby born 12/31) b. No Dependency Exemption if dependant files joint return w/ spouse i. Exception where neither has GI, just filing for refund ii. Return treated as claim for refund iii. Flow Chart Relationship Dependent < AND Support AND GI less than exemption amount GI test < OR Child of txp who is either< OR f/t student AND under 24 d. Exemption Amount i. Set at 2000 in § 151(d)(1) but adjusted for inflation each year. $3000 in 2002 (Rev. Proc. 2001-59). For 2001, $2900 (Rev. Proc. 2001-13) ii. Reduced if AGI exceeds threshold - § 151(d)(3) A. Threshold depends on filing statutes - § 151(d)(3)(C) B. Threshold is adjusted for inflation- § 151(d)(4)(B) a. 2002 joint return $206,000 b. 2002 single return $137,300 C. Reduction computed as follows per § 151(d)(3)(B) a. Compute excess of AGI over threshold b. Divide excess by $2,500 c. Round result up to next whole number d. Multiply by 2% e. Multiply exemption amount by result in (d). D. This phaseout is itself phased out beginning in 2006, complete by 2009, then restored in 2011. E. Reduced to zero for taxpayer who can be claimed as a dependent by another taxpayer- § 151(d)(2) under 19




Deductions in Computing AGI a. Basic Concepts: “Preferred” Deductions i. Look again at the schematic chart ii. This step occurs AFTER deductions are determined iii. §62 does not allow deductions: it merely CLASSIFIES certain ones as allowable in computing AGI iv. Technical term: ―Deductions allowable in computing AGI v. Other terms: ―preferred deductions‖, ―above the line deductions‖ vi. Only relevant for individuals vii. Note other provisions (e.g.§165(h) similarly classify deductions as allowable in computing AGI), but didn’t put in §62 viii. These deductions allowed even if the taxpayer uses the standard deductions in lieu of itemized deductions. b. §62: When computing AGI the following “preferred” deductions are taken "above the line" by subtracting them from GI to get AGI: i. T/B deductions ii. Certain T/B deductions of employees A. Reimbursed expenses of employees - have to be added to GI as well. B. Certain performing artists expenses iii. Losses from sale or exchange of property iv. Rent and royalty deductions v. Life tenant and income beneficiary deductions vi. Pension, profit-sharing and annuity plans of self-employed individuals vii. Retirement savings viii. Penalties from premature withdrawal of funds from savings ix. Alimony x. Reforestation expenses xi. Certain supplemental unemployment benefits xii. Jury duty pay xiii. Clean-fuel vehicles xiv. Moving expenses xv. Archer MSA’s xvi. Interest on education loans xvii. Higher education expenses c. § 62 does not add any additional provisions to the Code; it just identifies which of the various deduction provisions are to be taken above the line in computing AGI. The remaining deduction provisions, i.e. medical expenses, are taken as itemized deductions if elected by the TP. i. Note: "preferred" deductions get to be taken in full even if taxpayer takes the standard deduction (v. itemized) d. Miscellaneous itemized deductions are taken on schedule A because they are not listed in §62(a). Itemized deductions: i. Medical expenses ii. Taxes paid iii. Interest paid iv. Charitable contributions v. Casualty losses vi. unreimbursed t/b expenses e. Effect on other computations i. Medical 7.5% limit 83 83

ii. Personal casualty 10% floor iii. Social security inclusion formula iv. 50%/30%/20% charitable contribution limit v. §469(i) phaseout vi. Personal and dependency exemption phaseout vii. 2% floor on misc. itemized deductions §67 viii. 3% cut-down of itemized deductions §68 f. Benchmark for economists’ analyses of taxpayer income levels and tax burde g. Measuring stick for eligibility for various federal and state social assistance program h. Many others Standard Deductions and Computation of Taxable Income Overview. Remember: i) Determine all items of GI ii) Determine all deductions and apply deduction limitations iii) Determine deductions allowable in computing AGI iv) Compute AGI v) Rest of deductions (other than personal and dependency exemption) are ―itemized deductions‖ vi) Specific itemized deductions have their own limits vii) Itemized deductions reduced if § 68 applies i) Reduced by lesser of : (1) 3% of Agi (minus applicable amount) - § 68(a)(1) (2) 80% of ―reduceable‖ itemized deductions- § 68(a)(2) ii) Applicable amount in 2002 is $137,000 (1/2 that for married separate) (Rev.Proc. 200159) iii) ―Reduceable‖ itemized deductions are listed in § 68(c). Of the deductions examined in this course, only medial expenses and casualty losses escape reduction iv) This phaseout is itself phased out beginning in 2006, complete by 2009, then restored in 2011. viii) Determine standard deduction i) Equals sum of basic and additional standard deduction- § 63(c)(1) ii) Basic deduction depends on filing status and is adjusted for inflation (§63(c)(2), (4), see Rev Proc 2001-59) (1) Single 4700 in 2002 (2) Joint 7850 in 2002 iii) Additional standard deduction for age 65 and for blind (1) Amount is 900 if married (§63(c)(2), (f)(1), (c)(4)) in 2002 (2) Amount is 1150 if unmarried (§63(f)(3)) in 2002 (3) Get both for blind and over age 65 (1800 or 2300) (4) Standard deduction for joint returns will be increased in proportion to standard deduction for single returns, starting in 2005, complete in 2009, removed in 2011 iv) Standard deduction for someone who is dependent is limited to greater of (1) 750 or (2) Earned income- § 63(c)(5) (3) Cannot exceed 4700 if earned income is over 4700. ix) Take larger of standard or itemized deductions x) Subtract larger (ix) deduction from AGI xi) Subtract personal/dependency exemption (after application of phaseout reduction) xii) = Taxable Income 84 84



Computation of Taxable Income i) Tax is computed using §1 rate schedules i) Particular rate schedule depends on filing status. See §1(a)-(e) ii) These tax rate schedules are adjusted for inflation. §1(f) iii) Process from Code to actual rate schedules: (1) Rate schedule in §1(a), (b), (c), (d), or (e) (2) IRS adjusts ―bracket boundaries‖ (3) 2001 legislation changes the rates [see item in materials – because not included in code except for §1(i)] (a) 15% bracket split into 10%/15% beginning in 2002 (b) No inflation adjustment on this boundary until 2007 (c) Other rates drop each year beginning in 2001 (d) 15% joint return bracket boundary adjusted, begin in 2005 (e) All of this ―expires‖ in 2011: back to 2000 rate structure (but inflation adjustment for bracket boundaries continue) (4) So what is in Code is useless in and of itself iv) The IRS provides Tax Tables for taxable income under $100,000 pursuant to authorization in §3 (1) Find taxable income in first column, find tax liability under column matching filing status. (2) Commercial publishers and software do the same for all levels of taxable income (3) Tables for 2001 are in material. Final 2002 Tables not yet released by IRS. (a) They may have just been released (go look at (4) Using the tax rate schedules helps see the impact of a progressive tax. v) See examples in power point slides ii) STEP-CHART for IRC §1(g) Computations when §1(g)(7) election not in effect: i) Compute child’s tax liability on child’s entire TI, using child’s rates- § 1(g)(1)(A). ii) Compute child’s NUI (net unearned income): (1) Determine child’s GUI (gross unearned income)- § 1(g)(4)(A)(i) (2) Determine IRC § 63(c)(5)(A) amount which is 750 in 2002- § 1(g)(4)(A)(ii)(I) (3) If child is not itemizing, use zero. If child is itemizing, determine portion of itemized deductions connected with production of amounts in (1).- § 1(g)(4)(A)(ii)(II) (a) Generally, child won’t itemize (as a practical matter) (4) Select greater of results in (2) Or (3). (5) Add result in (4) To result in (2). If not itemizing 750 + 750 or 1500. §1(g)(4)(A)(ii) (6) Subtract result in (5) From amount in (1). §1(g)(4)(A) iii) Add to the TI of the child’s parents not only the child’s NUI but also the NUI of all other children of the parents subject to this special computation rule- § 1(g)(3)(A)(i) and §1(g)(1)(B)(ii). iv) Determine the tax liability on result (iii), using parents rates- § 1(g)(3)(A)(i). v) Determine tax liability on parents TI using parents rate- § 1(g)(3)(A)(ii). vi) Subtract result in (v) from result in (iv). §1(g)(3)(A) vii) Allocated the result in (vi) among the children in proportion to their NUIs. This produces the ―allocable parental tax‖ for each child. - § 1(g)(3)(B). viii) Determine tax liability, using child’s rates, on child’s TI reduced by the child’s NUI- § 1(g)(1)(B)(i). ix) Add child’s allocable parental tax determined in step (vii) to result in reached in step (viii). §1(g)(1)(B) x) The child’s tax liability is the greater of the result in (i) or (ix).- § 1(g)(1). 85 85

xi) Parents can elect to ignore this and report child’s income on their return, if certain conditions are satisfied. §1(g)(7) xii) Other issues (1) If child is over 15 years, do not worry about it. (2) Unless made election, child has to find TI of parents. (3) Does not matter where income came from so child could have earned income and put in trust or bank or uncle could give money to the kid. (4) Does not make parents tax liability higher, makes kids liability higher. (5) Have to look at parents tax and cannot simply multiply because of step chart. (6) NUI equals GUI minus 750 + 750 usually unless more than 750 deductions relating to unearned income. (7) Greater of kid’s tax rate over parent’s tax rate, (8) Policy: it was presumed by Congress that any kid with greater than $1500 GUI had it as a result of income shifting by parent. III. Credits a. Nonrefundable personal credits: reduce the tax payable for a taxable year. i. IRC §21: Child and Dependent care credit: See e-file training guide for checklists and definitions. See textbook p. 943-944. ii. IRC §22: Credit for the elderly and the permanently and totally disabled 1. General Rule: In the case of a qualified individual, there shall be allowed as a credit an amount equal to 15% of such individual’s section 22 amount for such taxable year. 2. Qualified individual - §22(b) 3. Section 22 amount - §22(c) 4. Designed to provide tax relief to low and middle income elderly and retired disabled persons who do not have significant social security, retirement, pension and disability benefits. i. IRC §23: Credit for Qualified adoption expenses – textbook pp. 944-945 ii. IRC §24: Child Tax Credit 1. General Rule: There is a credit allowed with respect to each qualifying child of the taxpayer. 2. Amount: $600 in 2002 3. Limitations: §22(b) 4. Textbook p. 945 iii. IRC §25: credit for interest on certain home mortgages – textbook p. 946 iv. IRC §25A: Hope and Lifetime Learning Credits: See e-file training guide for checklists and definitions. Textbook p. 946 v. IRC §25B: IRA contributions: Limited to $2000 per year and limited to the amount of earned income if less than $2000. Textbook p.946. b. Miscellaneous Nonrefundable credits: Reduce the amount of tax payable in a year. Do not qualify for a carry-over. i. IRC §27: The foreign tax credit – textbook p.946 ii. IRC §29: Credit for producing fuel from a nonconventional source – textbook p.946 iii. IRC §30: Credit for qualified electric vehicles – textbook p.946 c. Nonrefundable business credits: textbook pp. 846-950 d. Nonrefundable Minimum Tax Credit: textbook p. 950 e. Refundable Credits: these are considered only after other credits. They can generate a tax refund. i. IRC §31: Tax withheld on wages – textbook p.950-951 1. In general: The amount withheld as tax shall be allowed to the recipient of the income as a credit against the tax imposed by this subtitle. 86 86

2. Year of credit: The amount so withheld during any calendar year shall be allowed as a credit for the taxable year beginning in such calendar year. If more than one taxable year begins in a calendar year, such amount shall be allowed as a credit for the last taxable year so beginning. ii. IRC §32: Earned income credit: See e-file training guide for checklists, see textbook p. 952-953 iii. IRC §33, 34, 35 – other credits: textbook pp. 953-954. f. IRC §26: Limitation of tax liability; definition of tax liability i. The amount of credits taken may not exceed tax liability. Basically, they can only take the amount down to zero. Miscellaneous XXI. Timing Issues a. Why does timing matter? i. Deferral of income generally to taxpayer’s advantage ii. Acceleration of deductions generally to taxpayer’s advantage iii. Significant differences in taxpayer’s marginal rate from one year to the next can intensify or offset the effects of items (i) and (ii) A. It’s a crapshoot – a total guessing game b. Timing issues already seen in topics such as: i. Recovery of investment in annuity (§72) ii. Alimony recapture (§71) iii. Depreciation iv. Carryforward of restricted or limited losses (i.e. §§465, 469, 280A, 1212) c. Determination of applicable timing rules i. General timing issues resolved based on the taxpayer’s METHOD OF ACCOUNTING ii. Two principal methods for income tax purposes: A. CASH METHOD a. Income: reported when cash or its equivalent is actually or constructively received. §451, regs. §1.451-1(a) i. Constructive receipt: if income is credited, set apart, or made available to taxpayer. Regs. §1.451-2 ii. This, receipt of a check representing gross income is included in year received even if banks closed b. Deductions: when paid. §461, regs. §1.461-1(a)(1) i. Unless relates to period extending beyond one year ii. Payment not needed for depreciation, casualty loss iii. Payment includes sending a check, signing a credit card slip B. ACCRUAL METHOD: certain businesses where inventory is a significant source of income must use accrual. a. Income: when earned. Reported when all events have occurred (―all events test‖) that fix the right to receive the income and the amount can be determined with reasonable accuracy. §451, regs. §1.451-1(a)(1) b. Deductions: reported when all events have occurred that establish fact of liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. §461, regs. §1.4511(a)(2) c. Expenses: when incurred.



C. There are others (i.e. completed contract method) D. Generally, can just choose method (with some exceptions) d. Installment sale provisions §453 i. Apply to sales of most property ii. Apply when any portion of sales price is to be received in a subsequent taxable year A. Even if only one installment iii. Step 1: determine contract price (amount realized) iv. Step 2: Determine gross profit (essentially contract price minus adjusted basis, with some adjustments we’ll ignore; hence, essentially gain realized) v. Step 3: Divide gross profit by contract price to obtain gross profit ratio. A. Gross profit/contract price = gross profit ration vi. Step 4: Multiply gross profit ratio by amount received during the year to get gain reported for that year. A. Gross profit ratio X amount received during year = gain reported for the year. e. Bad gifts: gift of installment sale, part-gift/part-sale (subject to mortgate) f. Tax Benefit Rule i. What happens if a payment properly deducted in a previous taxable year is returned to the taxpayer because of a subsequent event? ii. §111: taxpayer has gross income to the extent the previous deduction generated a tax benefit iii. How do we know if there has been a tax benefit? iv. Computation of tax benefit: Technically, compare the actual taxable income for the taxable year in which the deduction was properly taken to the taxable income that the taxpayer would have had in that previous taxable year had the deduction not been taken. v. The difference is a tax benefit, reported in the taxable year in which the refund occurs. vi. No amendment of previous year return. A. It’s not really comparing difference in taxable income. Not the difference in taxes paid. Also, there is nothing that takes into account whether a different tax rate would have been applicable. vii. General Rule: If you don’t itemize deductions (or if itemizing doesn’t matter because the standard deduction is used because it is bigger), then the later year refund of an itemized deduction doesn’t make a difference (it’s meaningless). So no problem with the Tax Benefit Rule! A. Later refund is not Gross income XXII. Assignment of income a. Applies to both ―who gets the income‖ and ―who gets the deduction‖ b. Nature and source of “law” affecting who is taxed i. Very little statutory material ii. Developed through case law iii. Principles rather than rules A. Principles: policy/concept B. Rules: a mechanical thing iv. Some principles: A. Compensation income taxed to the person who earned it B. Income from property taxed to the person who owns it. ―Fruit and tree‖ doctrine. C. Income from a sale of property taxed to the person who arranged the sale. a. Person who owns the property and is responsible for deciding to sell it. D. Attribute actions of an agent to the principal. a. It’s the principal’s income or deduction, not the agent’s 88 88

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