FUNDAMENTALS OF FEDERAL INCOME TAXATION Freeland Text; 12th Edition OUTLINE I. GROSS INCOME Statute Analysis – Sections that include gross income are to be broadly construed (ie. ―includes but not limited to‖). But sections of the code that exclude items from gross income – are narrowly construed. Bias for more revenue
A. Introduction a. Basis: initial investment b. Amount Realized: amount received when asset is sold c. Gain: if amount realized is greater than basis—profit d. Loss: if amount realized is less than basis e. Gross income: gains derived from dealing in property—accretion to wealth i. T/p will get basis back tax free ii. Does not become gross income until there is a taxable event— realization. Has to be a realization event. B. Who are taxpayers? a. Individuals, corporations, trusts, estates b. Corporations: files its own return and pays its own taxes i. Corporate earnings are taxed twice ii. Example: Corp has income of $1000. Deductions of $600. Taxed on $400. Tax rate = 30%. Amt of tax = $120. When Corp pays out $120 in tax, it is left w/ $280. Can pay out $280 in dividends. S/h would have to pay tax on dividends (g.i. under 61(a)(3)). T/f $204 in taxes has been paid at corp and s/h level Two tier tax on corps iii. SEE HANDOUT #1A c. Trusts & Estates: are considered separate t/p’s from grantors or beneficiaries i. Trust income is taxed only once 1. Trust can get tax credit if tax already paid by beneficiary d. Partnerships: Not a t/p i. Pass-through entity: items of p’ship are passed through and reported by partner (proportional to p’ship shares) ii. Just a Conduit. C. Three Questions for each item of income or deduction – a. (1) for what taxable year b. (2) what is the character (ie. capital gain, loss, ordinary income or loss) of various items? c. (3) is the gain or loss immediately recognized?
D. Steps to get a Refund a. Taxpayer has to first file a refund claim b. Then must file an amended return c. (If US is the Def. in a tax refund case – t/p feels taxes were erroneously paid, and you are in federal court. If the Def. is Commissioner – then you know that litigated in the US tax court, t/p has not paid the taxes yet) ) E. Gross Income - What is it? a. General concepts i. Under § 61: ―all income from whatever source derived‖ ii. Cessarini v. United States 1. Taxpayers purchase piano in 1957 for $15; in 1964, taxpayers discover $5,000 cash inside the piano. 2. The Court rules that the discovery of ―treasure trove‖ is gross income—an accretion to wealth 3. Ct’s analysis: (hierarchy of analysis) a. Code: Starts w/ §61. Exclusion sections do not mention this type of money (found money) b. Regulations: Reg. § 1.61-1(a), ―gross income includes income realized in any form…‖ i. Pronouncements issued by Treas. Dept. to flesh out language of statute c. Rulings: Rev.Rul. 61, 1953-1, Cum.Bull. 17.; ―The finder of treasure trove is in receipt of taxable income‖ i. IRS Revenue Rulings: administrative interpretation of IRC (2ndary authority) d. The t/p had an ―accretion to wealth‖ 4. SOL: IRS has three years w/in which to assess an additional amt of tax in ordinary cases 5. When must treasure trove be reported: gross income of this type, under Reg. 1.61-14(a), must be reported in the year it was ―reduced to undisputed possession.‖ a. Treasure trove was reduced to possession when found in 1964 iii. Old Colony Trust Co. v. Commissioner 1. 3rd party pays debt owed by taxpayers a. Corp pays income tax arising from salary of president (pays the president’s indebtedness) i. Amt paid was sent directly from Corp to IRS (never passed through t/p) 2. If a third party pays indebtedness of t/p, t/p has an accretion to wealth and t/f amt paid is additional gross income to t/p a. Court held: t/p had gross income b/c having his debt paid by third party increased his net asset
value and thereby amounted to a realized accession to wealth iv. Commissioner v. Glenshaw Glass 1. Punitive damages are an ―accretion to wealth‖ a. Unearned b. Taxable 2. Compensatory damages restore t/p to a previous condition. a. Not taxable 3. This case defines – the criteria for Gross income 4. Criteria for Determining Gross Income: a. An undeniable accession to wealth, (get it w/o doing anything else) b. Clearly realized (some taxable event) and c. Over which the t/p has complete dominion v. Problem p.65: 1. What if piano was worth $500,000? (only purchased for $15) Transaction is a Bargain Purchase a. Did Cesarini’s have g.i. upon acquiring piano? i. No. Undeniable accession to wealth but not clearly realized ii. No realization event (until they cash in on investment in tax-realization event) b. Analogical Income: non-cash benefits and imputed income i. Dean v. Commissioner 1. Taxpayer (DuPont family) owns house and 80% of a corporation (is an officer of corp) a. The bank advises t/p to transfer the house to the corporation as corporation is in financial straights and needed additional assets 2. As t/p owns the corporation, does t/p have to include fair rental value of house, which is now owned by the corporation, in t/p’s gross income? a. Corporation: an entity separate and apart from s/h’s (s/h’s own the corp) 3. Court ruled: Fair rental value could be deemed g.i. a. T/p got a valuable economic benefit and this amounts to an accretion to wealth (received a valuable economic benefit) b. Their net worth was increased by virtue of the notional forgiveness of rent ($4000) and t/f this is gross income 4. There can be constructive g.i. by receipt of a valuable benefit by t/p even w/out payment or receipt
of money or property or services (No cash exchanged hands). a. Note: there was no expenditure of cash by corp but there was a measurable economic benefit 5. IRS usually raises this argument where actual or notional payor is related to or controlled by t/p ii. Note: It is necessary to characterize gross income 1. ex: dividends received by s/h; salary received by employee iii. Helvering v. Independent Life Ins. Co. 1. Does t/p have to include in g.i. the rental value of a building owned and occupied by t/p? - NO a. Owner / operator does not have to report b/c t/p has 100% of bundle of rights in property b. If you transfer right to use it to someone else, you have severed the rt and you have accretion to wealth from rent paid by that person iv. Building a chair? Self Created Property 1. Production and use of an item is not considered gross income, unless the item produced is sold for gain (you would have cashed in on value of labor and material) v. Problem 2 p.68: Exchange of services? 1. What happens if a doctor and a lawyer exchange services in lieu of cash payments? a. The fair market value of the services rendered is considered gross income t/p’s have g.i. from barter exchanges 2. What if lawyer had $200/ hr rate but Dr. did not have hourly rate? a. Dr. gets $200 g.i. from lawyer. b. For lawyer’s g.i.: (1) look at what other doctors charge; (2) assumer Dr’s services worth $200 b/c of quid pro quo (one side of bargain good evi of other side) 3. Rev. Ruling 79-24 4. What if lawyer does her own tax return a. The lawyer realizes no gain—no realization event b. Self-created value in hands of creator of that value is not gross income (No realization event) c. Income from discharge of indebtedness i. Under § 61(a)(12): if a loan is forgiven at any point, the discharge of indebtedness constitutes gross income. 1. Loan proceeds (borrowed money) are not g.i.
a. They are an asset but simultaneously create a countervailing liability to repay—t/f net worth does not increase b/c asset and liability cancel each other out. Liability offsets – any gain. 2. If debt is discharged: At time debt is cancelled, liability disappears t/f freeing up amt received—there is an accretion to wealth which 61(a)(12) makes g.i. a. Discharge of indebtedness: if borrower doesn’t pay the loan and lender forgives or cancels some or all of the debt either voluntarily or involuntarily in a bankruptcy case ii. United States v. Kirby Lumber Company 1. Kirby issues bonds (evi of indebtedness) at $12 million (holders pay face amt to Kirby—lending Kirby money) 2. But Kirby buys the bonds back at $10 million (purchase for less erases previous higher debt—debt cancellation of $2 million) a. This constitutes a gain of $2 million b. Kirby rationale: increase in net worth that results from debt forgiveness is an accretion to the t/p’s wealth. 3. Black Letter Law – loan proceeds is not gross income. Debt forgiveness can give rise to gross income. iii. Exceptions: iv. Insolvency: exception to § 61(a)(3) debt forgiveness rule 1. Under § 108(d)(3), insolvent is defined as the excess of liabilities over fair market value of assets. (Negative net worth) 2. § 108(a)(1)(B): If a t/p is insolvent before debt discharge and still insolvent after debt discharge, the cancelled debt will not be included as gross income a. Trade-off; § 108(b)(2)(A): if a t/p takes advantage of § 108(a), the amount excluded from g.i. shall be applied to reduce certain favorable tax attributes i. Specifically, amt of debt forgiveness under § 108(a) in Year One will reduce the amount of net-operating loss carryover under § 172 to Year Two. ii. If a t/p has a net-operating of $250 and debt discharge of $100 in Year One, the carry-over to Year Two will be $150 (that is $250 net-operating loss less the $100 of debt relief in Year One). iii. SEE HANDOUT (1)
d. Deductions v. Exclusions – Deduction = subtraction from existing gross income Exclusion = never taxable income in the first place
F. Exclusions from gross income a. Gifts i. § 102(a): the value of property acquired by gift is not included in gross income. 1. gifts are taxed in other ways: on transfer, not receipt 2. tax arises when amount exceeds certain threshold amts 3. Gift – proceeds from a ―detached and disinterested generosity… out of affection, respect, admiration, charity or like impulses‖ 4. Many times will need to know more facts to determine why the property was acquired (Ask ―what is going on here‖) ii. Characterization issue: must characterize the payment—Has a gift actually been made? iii. What is a gift? 1. Commissioner v. Duberstein a. Berman gives Duberstein a Cadillac because Duberstein had given Berman significant business advice. i. Berman reports the car as a business expense ii. Duberstein fails to include the car in gross income. b. The Court concludes that determination of whether a gift has occurred is a factual determination – no set law. i. Footnote 9 - ―Life in all it’s fullness must supply the answer to the riddle‖ ii. Common Law factors: 1. The transferor’s intent 2. Detached and disinterested generosity to natural object of bounty c. The Court rules that the car was consideration for services rendered; not a gift 2. From a planning perspective: shape the facts (structure the transaction) to appear as a gift. Can’t be in exchange for something, draft something – to show the BOD had gift in their mind. T/P has the burden of proof here – fact that they got advice from attorney – shows wants to be a gift.
a. Form over substance rule: in viewing t/p’s transaction, the form of trans will control and if form doesn’t follow substance, will disregard form. iv. Employer-Employee Gifts 1. § 102(c): includes amounts transferred by an employer to an employee as gross income a. Should t/f make gift after employment relationship is terminated b. Should not be made as compensation for services 2. Exceptions to the rule of § 102(c): a. Extraordinary transfers will not be considered transfers to or for benefit of employee if employee can show that the transfer was not made in recognition of employee’s achievement (Reg. Sec. 1.102-1(f)(2)) b. Traditional retirement gifts (§ 132(e) de minimis fringe benefits) c. Employee achievement awards (§ 74(c)). i. § 274(j)(2)(A) and (B) limit the amount excluded from gross income 1. $400 for awards not part of a qualified plan. 2. $1600 for awards that are part of a qualified plan. 3. Under § 274(j)(B), a ―qualified plan‖ is a written plan, which does not favor highly compensated employees. 3. Problems p.82 a. (3): Congregation gives Reverend $5000 when she retires—Does Reverend have g.i.? i. Depends on organizational structure of Church—here, congregation is donor ii. This is a gift 1. No employer / employee relationship b. (4): Retiree receives $5000 trip on his retirement. Employees pitch in $3000. Employer gives $2000. Does Retiree have g.i.? i. $3000 excluded by §102(a) from g.i. ii. $2000 employer contribution is g.i. b. Inheritances i. § 102(a): the value of property acquired through inheritance is not included in gross income.
1. Under § 102(b), Income from inherited property must be included in gross income. (The income from the property – ii. Wolder v. Commissioner – attorney attempting to get paid through inheritance – can’t do it – look to the origin of the transaction, not a true inheritance, more like compensation. iii. Problem 2 p.91: 1. Life partner promised a bequest is suing estate of ―husband.‖ Settles in palimony suit for quantum meruit. Is amount she recovers from estate excludable under §102? a. In order to characterize payment, look at origin of claim b. Here, this settlement was not ―acquired by bequest‖ but rather by contract and t/f § 102 does not apply and this is includable as g.i. c. Prizes i. Gift v. Prize 1. Gift - get something for nothing 2. Prize or Award – you do something for it. ii. § 74(a): prizes are included in gross income subject to the exceptions in § 74(b) (prizes made primarily in recognition of religious, charitable, scientific, educational, artistic, literary or civic achievement but only if: 1. The recipient was selected with no action on his part to enter the contest or proceeding. 2. The recipient is not required to render future services as a result of receiving the reward and 3. The recipient transfers the prize to a §170(c) governmental unit or organization. iii. Exclusions from inclusionary rule: § 74(c) employee achievement awards. iv. 74(c) Gross income shall not include the value of an EE achievement award (as defined in section 274(j)) a. Employee achievement awards (§ 74(c)). i. § 274(j)(2)(A) and (B) limit the amount excluded from gross income 1. $400 for awards not part of a qualified plan. 2. $1600 for awards that are part of a qualified plan. 3. Under § 274(j)(B), a ―qualified plan‖ is a written plan which does not favor highly compensated employees.
v. General rule: Prizes and awards are always included in g.i. and taxable unless specific exceptions in 74(b) or 74(c) apply. d. Scholarships i. § 117(a): attempts to draw the line b/t scholarship payments (more like gifts) and fellowship payments (more like payment for services) 1. § 117(b): payments for purpose of study (qualified scholarships) are not included in g.i. a. a qualified scholarship is defined as a scholarship that is (has to be) used for tuition and fees required for the enrollment of a student. 2. § 117(c): payments for services performed (teaching, research, etc) by the student required as a condition for receiving the qualified scholarship are included in g.i. a. In essence, where the scholarship appears to be compensatory. 3. § 127: if tuition paid by employer for employee to attend school, may exclude up to $5250 from g.i. of employee per taxable year – a. Can split up to pay $5k for one semester and $5k for the next semester ii. Problem 2 p.116: Lawyer takes leave of absence from firm to get LLM degree and required to return to firm afterward. Receives $10,000 stipend from firm. 1. Taxable consequences for lawyer: a. Cannot exclude under §117 b/c 117(c) says the amt cannot be pymt for services (past, present or future) and here, she is required to return to work. b. If §127 applied (if the requirements of (b)(2) through (6) are met, and if the amount is used for books, tuition and similar academic items), she could only exclude $5250 /taxable yr. i. Could have employer break up amt so that she gets $5000 pd in Dec and $5000 pd in Jan and can exclude full amount 2. What if she is not required to return to firm? a. May be compensation for past services. If so, section 117 still doesn’t apply. Taxpayer has the burden of proof, and it’s probably pretty tough to prove there isn’t a compensatory element. b. But, section 127 could still apply as in previous example
3. What if she is not an employee and receives stipend as prize in essay contest? a. Taxable under §74 b/c she does not meet two major exceptions in §74 4. What if she receives scholarship from law firm b/c of essay and firm pays money directly to school? a. Elements of §117(a) are met: qualified scholarship, she is individual, she is candidate for degree. Could be excludable depending on how it is structured. e. Gain on the sale of personal residence i. § 121: if you own personal residence and sell it, you can exclude from g.i., amount of gain up to the first $250,000 if you file alone or $500,000 gain if you file joint return 1. Only excludes 61(a)(3) gain (amount realized minus basis) and not sales price 2. Qualifications: a. Must be lived in for 2 out of last 5 years b. Not for vacation homes or rental property c. Principal residence: depends on facts and circumstances i. Regs Sec. 1.121-1(b)(2) contain factors to look for (where you register phone, receive mail, eat & sleep most of time, etc) 3. Obviously, § 121(a) creates an implicit 2-year waiting period following any § 121(b) exclusion of $250,000 ($500,000). ii. Problem 1 p.226 1. If someone has not met 2 year period and wants to sell and is w/in commuting distance, advise them to hold on to the house and use it as personal residence for at least 2 years a. Use for weekends, maintain residence status b. Can enter into contract to sell that would be completed at end of 2 yr period c. Would save a lot by going through slightly inconvenient process f. Income earned abroad i. § 911: an American citizen present in a foreign country for full year or 330 days of a taxable year may exclude from g.i. $80,000 derived from the performance of services. 1. Reimbursements for foreign housing expenses are also excluded by § 911 (with specific limitations). 2.
II. GROSS INCOME FROM EMPLOYMENT
A. Section 132 Fringe Benefits a. § 132: identifies 8 classes of fringe benefits that are excluded from g.i. i. anything besides these 8 named benefits does not fall under fringe benefits (but may receive treatment under other provisions of Code—ex: §119 meals & lodging). Attempts to bring uniformity. ii. §132(a) identifies items to be excluded and 132(b) – end explains excludable items w/ conditions and limitations (see below) iii. Exclusions under §132(a)(1) & (a)(2) must also meet §132(j): 1. fringe benefits cannot be discriminatory in favor of highly compensated employees b. No-additional cost benefits (§ 132(b)) i. Gross income shall not include any benefit where an employer provides services to an employee and . . . 1. Such service is offered for sale to customers in ordinary course of the line of business of the employer and 2. The employer incurs no substantial additional cost (including forgone revenue) in providing such service to employee (132(a)(2) – gives examples as to what is substantial – really a proportionality test). ii. Examples include airline, railroad, or subway seats and hotel rooms. 1. Regs: if airline employee permitted to fly by making reservation in advance, there is forgone revenue 2. if no reservation but employee shows up and there is space on place, then it is excluded under §132 c. Qualified employee discounts (§ 132(c)) i. Gross income shall not include any benefit derived from employee discounts where . . . 1. In the case of property, the percentage of profit (aggregate sales price less costs) over aggregate sales price determines the allowable discount. (§ 132(c)(1)(A)). a. The fraction is based on sales of all property in the employees line of business (not just the discounted item). b. If the employer has an aggregate sales price of $800 and costs of $600, profit equals $200, and the allowable employee discount is equivalent to $200/$800 or 25%. 2. In the case of services, the percentage of discount is 20%. (§ 132(c)(1)(B)). d. Working condition fringe (§ 132(d))
i. Gross income shall not include any property or service provided to an employee by an employer where the cost of the property or service would have been deductible by the employee under other sections of the IRC. 1. A wash provision ii. One example is a company car. e. De minimis fringe (§ 132(e)) i. Gross income shall not include any property or service provided by an employer to an employee where . . . 1. The value of the property or service is so small as to make accounting for it unreasonable or administratively impracticable. ii. Examples include personal use of the company copying machine, occasional employee parties, coffee and donuts, occasional theater or sporting event tickets, and low value holiday gifts. f. Qualified transportation fringe (§ 132(f)) i. Gross income shall not include the value of transportation furnished by employers to employees in the following three forms: 1. Transportation in a commuter highway vehicle in connection with transportation between residence and place of employment (§ 132(f)(1)(A)). a. Limited to a value of $100 per month by § 132(f)(2)(A). b. A ―commuter highway vehicle‖ is defined by § 132(f)(B) as a vehicle that has . . . i. A seating capacity of six adults or more ii. 80% of the mileage used for purposes of transportation between residence and employment on trips where ½ the seating capacity of the vehicle is occupied. 2. Transit pass a. Limited to a value of $100 per month by § 132(f)(2)(A). b. A ―transit pass‖ is defined by § 132(f)(5)(A) as: i. A token, farecard or voucher for public transportation or for transportation provided by persons in the transportation business. 3. Qualified parking a. Limited to a value of $175 per month by § 132(f)(2)(B) b. Qualified parking is described by § 132(f)(5)(C) as . . .
i. Parking on or near the business premises ii. Parking on or near a location from which the employee commutes to work via commuter highway vehicle or public transit. ii. 132(j) Special Rules – has to be applied evenly – cannot discriminate in favor of highly compensated employees. B. Meals and lodging a. Meals i. Generally, if employer provides your lodging and meals, there is an accretion to wealth ii. § 119(a)(1): meals shall not be included in gross income where they are furnished on the business premises. iii. Regs – say excluded if meals are served on employer premises and for the convenience of the employer. b. Lodging i. § 119(a)(2): lodging shall not be included in gross income where 3 conditions are met: 1. The lodging is located on the business premises of employer 2. The employee is required to accept such lodging as a condition of employment 3. The lodging is for the convenience of the employer c. Hebert G. Hatt i. Hatt owns a corporation that owns a funeral home ii. Hatt lives in apartment on the premises above funeral home iii. Court allows Hatt to exclude the fair rental value from gross income as he satisfied the § 119 conditions. 1. Hatt was both employer and employee a. T/f ct looked at every other funeral home in town Hatt lived in 2. Different from Dean case b/c that was not for convenience of employer d. Problem 2 p.106: i. Planner incorporated motel business and corp purchased residential property adjacent to motel. Corp by contract requires Planner to use residence and also furnished her meals. Planner worked at motel and was on call 24hrs/day. May Planner exclude value or residence and meals from g.i? 1. Lodging: a. Is her role s/h or employee b. Is business premises test met i. Adjacent property okay c. Here she contracted w/ herself and this is suspect
d. Look at facts themselves to see if conditions are met 2. Meals: a. Regs section 1.119-1(a)(2)(1) b. Are meals furnished for business purpose (noncompensatory business reason of employer) c. If lodging is excluded from g.i. then meals at lodging place are assumed to meet §119 test 3. What if she is the sole proprietor—could she exclude value of lodging and meals? No a. She is not an employee b. Could incorporate and work for it—then okay e. Jurisdiction and Venue for Tax issues – can lead to forum shopping C. Social security and Unemployment Benefits a. Social security i. 3 Components: (1) Old Age Tax, (2) Survivors Benefits (3) Disability Insurance. ii. Social security is the Federal retirement plan 1. 6.2% of the first $87,000 of gross income is taxed to fund social security a. 2 ½ % contribution is paid by the employer i. This 2 ½ % is an inducement for employers to classify employees as independent contractors, thereby avoiding the 2 ½ % contribution. iii. Under § 86, receipt of social security payments is taxable according to various factors and at various rates (must be included in gross income). Up to 85% are included in the recipients of gross income . iv. SS payments are taxable to the recipient above a certain adjusted g.i. threshold v. The greater the adjusted g.i. above that point, the greater is the percentage of inclusion of the SS payments b. Unemployment benefits i. Under § 85, receipt of unemployment benefits is taxable (must be included in gross income). III. GROSS INCOME FROM PROPERTY DISPOSITIONS A. General a. Basis Generally i. Basis is t/p’s investment in the property ii. All property has a basis even if it is zero .
iii. Always subtract basis from amount realized to ensure than t/p gets his investment back b. Loss i. If basis is greater than amount realized, there is a loss ii. Loss = amount realized – basis producing a negative figure c. Gains as gross income i. Under § 61(a)(3), gains derived from dealings in property shall be included in gross income. ii. § 1001(a): Establishes arithmetic for gain or loss on disposition of property 1. Gain = amount realized minus adjusted basis 2. Not all gains and losses are recognized; see section D iii. § 1001(b): Amount realized: 1. when property is disposed of, amt realized can be in several different forms (cash or property) 2. amount realized is the sum of any money received plus the fair market value of any property received. B. Basis a. Starting Point Basis—depends on how property was acquired by the t/p: i. Property purchased 1. § 1012: a t/p’s basis in property is the cost paid for the property (cost basis) ii. Property inherited 1. § 1014: a t/p’s basis where property is inherited is the fair market value at the death of the decedent. a. Note: FMV is often greater than its basis in the decedent’s hands at the time of death. Descendant takes a stepped up basis. Death is the ultimate tax shelter because the decedent on his estate pays no accretion of value (no tax on gain) because the descendant takes the property with a stepped up basis. Beneficiary can immediately sell the property for the date of death value. iii. Property gifted 1. § 1015: a t/p’s basis in property is equivalent to the basis of the donor; the donor’s basis carries over to the donee. a. Taft v. Bowers i. When a donor grants property that donor no gain or loss on disposition b/c he has no amount realized ii. Donee takes carryover basis from donor and also has no gain or loss from receiving the property
iii. When a gift is sold by donee, gain is determined using basis of donor (the carryover basis) 1. Donee will pay tax on donee’s gain and also on donor’s gain that donor didn’t have to pay b. Adjusted basis i. § 1016: a t/p’s basis in property can be adjusted upwards or downward depending on tax significant events that occur in relation to property while in t/p’s hands: 1. To reflect expenditures properly chargeable to capital accounts (CAPITAL INVESTMENTS) 2. For exhaustion, wear and tear, obsolescence, amortization, and depletion. (DEPRECIATION) ii. Determine Starting point basis under § 1012, § 1014, § 1015 and this can be ―adjusted‖ under § 1016 iii. Basis does not get adjusted for inflation. c. Philadelphia Park Amusement Co.v United States i. Philadelphia Park Amusement trades Strawberry Bridge for a 10-year extension to their franchise. ii. Exchange: disposition of property in which amt realized is paid in property rather than in cash iii. Court rules: 1. both parties to an exchange of property are disposing of property, hence each has section 61(a)(3) gain or section 165 loss, depending on their respective basis and amount realized. a. since seller receives amount realized in form of property it is necessary to determine cash equivalent of the property received in order to plug that figure into the section 1001(a) computation of gain or loss 2. Fair Market Value Definition = In the arm lengths exchange of property, cost basis of property you exchanged = fmv of property you received a. The value of property given equals the value of property received. b. assuming parties are dealing at arm’s length c. fmv is a question of fact look to best evidence iv. Footnotes from Philadelphia Park 1. Abandonment: disposition of property (& taxable event) where your amt realized is zero and t/f a loss is measured by adjusted basis in property 2. Fair market value a. What a willing buyer would pay a willing seller (Reg. § 1.170A-1(c)).
d. Notes from Problem 1 p.121 i. Amount paid for an option becomes part of basis in property for buyer and part of seller’s amt realized ii. For grantor of option: if it isn’t exercised, he has a gain (included in year in which option expires unexercised) and not in year in which payment received e. Farid-Es-Sultaneh v. Commissioner i. Kresge transfers 700 shares of stock worth $300/per share to Sultaneh in exchange for a release from liability (terms of a pre-nuptial). ii. Must characterize how she received the stock iii. She wants it to be a sale – so the purchase price would have been the fmv in 1938. (the fmv either of the shares or her marital rights serves as the basis) iv. IRS argues that revenue transaction was a gift – so her Basis would be his carryover basis ($0.15/share – he bought early), and therefore would be a huge gain (huge tax). v. Court treats this transaction as a sale t/f gain determine acc to 1012 (agree with her – see it as a sale). 1. What is the cost/basis in a release from liability? a. Her basis = fmv of rights she relinquished = fmv of stock she received i. Her basis is impt when she later disposes of the stock b. Relinquishment of a right is equivalent to the amount of property received. vi. Tax effects on Farid in 1924 exchange: 1. sold her marital rights 2. her basis = zero (never pd anything for marital rights) 3. She would have a gain on disposition of marital rights a. Amt realized (fmv of stock) – basis (0) = gain vii. Tax effects on Mr. Kresge in 1924 exchange: a. His basis (15cents / share) b. His amount realized (value of her relinquishment of rights = fmv of stock she received) c. Amt realized (330/share) – basis (15cents/share) = gain d. The Court held that the release of liability must be equivalent in value to the 700 shares of stock. e. C. Amount realized/relief from indebtedness a. Definition i. 1001(b): amount realized is the sum of any money received plus the fair market value of any property received. b. International Freighting Corporation v. Commissioner
c. SEE HANDOUT 2 i. International Freighting’s performance bonus plan pays employees in common stock. ii. International Freighting pays out stock with a fair market value of $24,000 and a basis of $16,000 to employees for services rendered 1. What was International Freighting’s amount realized? a. Dollar amt of amt realized could not be valued by looking at service b/c no hourly wage b. Court ruled: that the value of the services must have been equal to the fair market value of stock if sold in open market ($24,000) (FaridEs-Sultaneh). c. Tax effects on the corporation: i. §162 business expense deduction for the bonus which was equal to fmv of stock ii. amt realized (amt equal to the fair market value of the stock= $24,000) – basis ($16,000) = gain d. Thus, International Freighting received $24,000 in services but, in reality, only paid $16,000. e. Tax effects on employees: i. Had compensatory §61(a)(1) g.i. = fmv of stock ii. Use 1012 cost basis of stock to determine gain or loss when eventually disposed of in a taxable event d. Relief from indebtedness i. Crane v. Commissioner 1. Husband bequeaths apartment building to wife with a mortgage outstanding for $255,000. a. The wife sells the apartment building for $258,000 b. Stepped up basis: her basis in bldg = fmv of bldg at date of his death ($255,000) 2. The wife reports only $2,500 in gain ($3K - attys fees) 3. Court rules: the $255,000 of debt assumed by the buyer (debt relief) must be included in the amount realized and t/f she had received $23,500 in gain a. Amount realized: debt relief + amt of additional cash (255K + 3K) 4. When property that is subject to a mortgage is disposed of, and if the mortgage goes w/ the property (buyer assumes obligation of mortgage) then the amt of the mortgage is included in the amt
realized w/out regard to whether the debt is recourse or non-recourse a. Non-recourse = only the property that secures the mortgage is the source for repayment in the event of borrowers default. b. Recourse = can be secured by property but the lender can look beyond to borrower’s other assets in the case of default. c. The amt of indebtedness relief to the t/p when the property is transferred is part of the amt realized but is it not g.i. as such to seller i. Debt has not gone away, it has simply been shifted to purchaser d. The base amt of mortgage is part of buyer’s cost and is included in starting point cost basis i. Applies whether fmv is greater or less than amt of mortgage ii. Commissioner v. Tufts – court said that it does not make any difference if the fair market value is greater or less than the amount of debt relief. Look to 1.1001-2 Regs – iii. NOTE: Important to distinguish between 61(a)(12) and Crane Rule (component of debt relief is amount realized). iv. Remember Amount realized is not the same as gross income. 1. Discharge of Indebtedness is Gross Income 2. Debt Relief is not gross income, but rather instead a part of amount realized. v. SEE HANDOUT # 2B vi. Net Gift 1. Occurs when a donor transfers property to a donee on the condition that the donee pay the amt of the gift tax arising from the transfer a. Obligation to pay gift tax belongs to donor 2. ex: Dad transfers $150K stock to son who pays $50K gift tax a. Sup Ct says it is really part gift, part sale b. Bargain Purchase—the $50K is really consideration t/f result is that amt realized by dad is $50K. Dad’s basis was $10K t/f §61(a)(3) gain on transfer of $40K vii. Problem 1 p.153 1. Taxpayer buys land for $100k. Borrows $80k from a bank and puts up another $20k to make up his own purchase price. a. Idea of Section 1016 – Adjusted Upward Basis
D. Nonrecognition of realized gain a. Means you don’t have to report the realized gain on the return in the year of realization. If you don’t have to recognize it, then you don’t have to pay tax on it. b. § 1001: Determination of amt of and recognition of gain or loss i. § 1001(c): all gain or loss that is realized is also recognized unless something else says that what is realized is not recognized 1. realized: target income (gain or less) has ripened and is to be accounted for by t/p 2. recognized: the gain or loss is reported on t/p’s return for taxable year of realization event ii. Nonrecognition: sometimes when you dispose of property in taxable event, you do not have to report the gain in the taxable year of the taxable event 1. Three aspects: 1041, 1031 & 1033 c. Spousal transfers i. § 1041(a): no gain or loss is recognized on all transfers of property between spouses while they are married or incident to divorce. Treated as a Gift – for basis purposes. 1. No gain or loss is recognized on all transfers by an individual to a: a. spouse b. former spouse (if the transfer is incident to divorce). 2. There must be consideration; does not apply to gifts.(?) 3. If you realize gain or loss, it is not recognized ii. § 1041(b): the recipient spouse acquires a § 1015 basis; equivalent to the donor’s basis (not the cost basis) iii. Under § 1041(c), transfers incident to divorce are unrecognized where . . . 1. The transfer occurs one year after the marriage 2. The transfer is related to the cessation of the marriage. a. Under Reg. § 1.1041-1T(a), ―cessation of the marriage‖ is defined as a transfer pursuant to a divorce or separation instrument not more than 6 years after the marriage ceases. iv. Problem 1 p.131 1. X purchased some land ten years ago for $4k cash. The property appreciated to $7k at which time X sold it to shi wife for $7k, its fair market value. This fits section 1041 because they are married. He had a realized gain of $3k but the gain is not recognized because of section 1041(a). She would take the basis of $4k even though she bought it for $7k. If she sells it for $7k to third party, she would have realized, recognized gain of $3k
under Section 1001 – which says all gain realized unless some provision says different – 1041 not applicable to third party sales. If property went down in value and she bought it for $3k from husband, while she has a realized loss of $1k she has recognized loss of $0. 2. Example (e): What if wife transfers property with a basis of $5k and value of $7k to H for his property? This is a taxable event to each of them, there is a realized gain to each of them (basis is less than amt realized for each). While there is a taxable event, a nonrecognition provision of code steps in to say there is gain but they don’t have to report it. d. Exchange of like-kind property i. § 1031(a): no gain or loss is recognized on the exchange of property where: (ELEMENTS) 1. Where there is an exchange 2. Where the exchanged property is held for productive use in a trade or business 3. Where the exchanged property is of like kind ii. Does not apply to: stock in trade or property held primarily for sale, stocks, bonds, or notes, interests in a partnership, certificates of trust, choses in action. 1. Substituted basis: (1031(d)) a. Property you receive in exchange takes the basis of the property disposed of i. This is determined for depreciation purposes and for determining gain or loss on later disposition 2. Must be an exchange and not a sale: a. Bloomington Coca-Cola Bottling v. Comm. i. The presence of a small amount of cash in a transaction will not necessarily prevent the transaction from being considered an exchange 1. equalizing payment 2. Boot Payment is recognized and reported on return. b. Leslie Co. v Commissioner i. Leslie built a structure and sold it at a loss to Prudential before leasing it back. 1. The court ruled that the sale-andlease-back arrangement constituted a sale, not an exchange.
ii. The Darkside of § 1031 1. The IRS argued that the arrangement constituted an exchange thus the losses to Leslie would be unrecognized. 3. The exchanged property must be of like kind: a. Commissioner v. Crichton i. The court ruled that the exchange of a city lot and mineral rights in land constituted a like-kind exchange ii. Like-kind is interpreted very broadly when real property is exchanged. iii. Like-kind is interpreted very narrowly when personal property is exchanged. 1. Computer→printer = same class 2. Airplane→truck = different class iii. Exchanges not solely in like kind of property 1. § 1031(b): a. The equalizing payment is recognized gain b. The value of the property is unrecognized. i. boot: equalizing payment in cash or property 2. Handout: T/p exchanges her apt bldg for the City’s parking garage plus a $100K equalizing payment. 3. SEE HANDOUT #3 4. ALSO SEE PROBLEM ON BbC -HANDOUT #4 iv. Exceptions 1. § 1031 does not apply to the following types of property. a. Stock in trade or property held primarily for sale, stocks, bonds, or notes, interests in a partnership, certificates of trust, chooses in action. v. Basis under § 1031 1. Generally, under § 1031(d), basis in new property (received) is equivalent to one’s basis in the old property (exchanged). 2. In a not solely-in-kind exchange, under § 1031(d), special rules apply. a. The basis of the old (exchanged) property (which is attributed to the new property) must be reduced by any cash equalizing payments. b. After the basis has been reduced by cash payments, it must be increased by the amount of gain recognized on the transaction or decreased
by the amount of loss recognized on the transaction. c. Subsequently, the recomputed basis must be allocated first to any not solely-in-kind property according to fair market value i. The remainder is reallocated to the new(received) property. 3. Three Corner Exchange – R.E. investors use to save money. – bring in a third party e. Problem pg. 897 – Question 2 – i. SEE HANDOUT #4 f. Involuntary conversions i. Under § 1033 (a), property is involuntarily converted by 1. destruction, theft, seizure, requisition of condemnation or threat or imminence ii. § 1033(a): no gain is recognized where . . . 1. (a)(1): Property is converted into similar property a. similar or related in service or use 2. TWO Tests Used – may lead to forum shopping or different results based on the area you are in. a. (1) The test for similarity is strict i. Under Revenue Ruling 76-319, the Service determined that bowling equipment and billiards equipment were not similar property. 1. equipment and method of operation of 2 facilities were different 2. Money spent on dissimilar property is recognized. b. (1) Clifton v. Commissioner 1. inquiry re: similar or related in service or use focuses on how the t/p treated the property c. Basis: the new similar property takes a substituted basis that is the same as the basis in the old involuntarily converted property. i. substituted basis is decreased by any boot received that was not spent on the similar property, and increased by any gain, or decreased by any loss, otherwise recognized on the involuntary conversion exchange
3. (a)(2): Property is converted into money (followed by an investment in similar replacement property) a. Under § 1033(a)(2), basis is the cost of the replacement property reduced by any unrecognized gain. b. Example: My car, with a basis of $1,000, is totaled; I receive $1,500 in insurance; I buy a new car for $1,500; my basis is $1,500 less the $500 difference between the basis of my old car ($1,000) and the cost of the replacement car; $1,000 basis. c. gain is recognized where property is converted into money to the extent that: i. Any excess money after replacement of property ii. Any money spent on dissimilar property 1. See Rev.Rul. above.
IV. CERTAIN OTHER KINDS OF GROSS INCOME
A. Dividends, interest a. Under § 61(a)(4) and (7), interest and dividends shall be included in gross income. i. Dividends 1. 61(a)(7): dividends are g.i. to s/h recipient 2. There may be a characterization issue when s/h has another relationship w/ corp 3. dividends are not deductible outlay for corp payor 4. Revenue Act of 2003 – dividend income is taxed as if it were capital gains (gains from disposition of a capital asset, which ordinarily is taxed at a lower rate) prior to this, dividends were taxed as regular income. a. Dividends is taxed as a capital gain which is usually 15% as opposed to the top income tax bracket of 35%. 5. Form 1099 - When you first get stock in publicly held corp. you will get a form for a social security. Payor of dividend sends form to recipient and to the IRS. IRS computerizes and can find – if discrepancy. ii. Interest 1. A payment for the use or forbearance of money. 2. 61(a)(4): Interest received by the lender is gross income 3. Interest payment may be deductible by the payor under § 163
iii. Exception 1. Under § 103, gross income shall not include any interest paid on any State or local bonds. a. Exceptions to the exception i. Private activity bonds 1. Government uses more than 10% of the money from the sale of the bonds to supplement nongovernment undertakings. ii. Arbitrage bond 1. Government uses the money from the sale of the bonds to acquire a higher yielding investment. iii. Bond not in registered form iv. Payors of interest and dividends are required to file with the Service an information return, Form 1099, to report those payments B. Life insurance a. By reason of death i. Under § 101(a)(1), gross income shall not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. b. For valuable consideration i. Under § 101(a)(2), where a transfer of a life insurance policy (and its proceeds) for valuable consideration occurs . . . 1. The value of the consideration plus any subsequent premiums paid by the transferee shall be included in the gross income of the transferor. a. Transfer for valuable consideration escapes the § 101(a)(1) limitation of ―by reason of death.‖ c. Term insurance = covers insured for just a single year. The premium paid by the insured relates only to a single year. The premium as a couple of components – first it covers the actuarily risk that the person will die within that year, plus it covers the administrative costs needed. d. Whole life insurance = can be definite period (20years) or life of the insured. The insured names a beneficiary often a family member. The beneficiary is the designated person in the contract to whom the policy benefits will be paid. e. Premium paid – goes to fund three parts: (1) administrative costs, (2) risk of death (3) uncommitted fund – to pay claims (which is invested) f. Cash surrender value i. Under § 101(c), cash surrender value shall be included in gross income only to the extent that cash surrender value exceeds basis.
1. The excess over basis escapes the § 101(a)(1) limitation of ―by reason of death.‖ 2. § 101(c) includes interest in gross income. g. Payment schedule i. Under § 101(d), where a beneficiary chooses to accept payments for a fixed period of years (rather than one lump sum), the unpaid principal will garner interest; this interest must be included in gross income. 1. Example: The policy is worth $100,000 and the beneficiary chooses to accept payments over 10 years. Suppose $20,000 interest will accrue on the unpaid principal. a. The annual payments would equal $12,000 (or $120,000 divided by 10 years), thus $2,000 of each payment is attributable to interest. i. Under § 101(c), interest shall be included in gross income. ii. Anything over – premiums paid is income. iii. But if have payments for life and you live past expectancy – then the portion of the annual payment which was not interest is still not gross income. iv. (this differs from annuities, where – this amount would be considered income along with the interest – after basis has been paid back) h. Accelerated payments i. Under § 101(g), accelerated payments made where the insured is ―terminally ill‖ or ―chronically ill‖ shall not be included in gross income. 1. Terminally ill a. Physician certifies the insured as one whom can reasonably be expected to die with 24 months. (§ 101(g)(4)(A)). b. Limitations i. No limitations on payments to terminally ill patients 2. Chronically ill a. Physician certifies that the insured is unable to perform 2 activities of daily living for 90 days b. Physician certifies that the insured has severe cognitive impairment requiring substantial supervision to protect the individual from threats to health and safety. (§ 101(g)(4)(B)).
c. Limitations i. Accelerated payments are limited to $175 per day under § 101(g)(3)(D). i. Problem 1 p.158 Insured died in the current year owning a policy of insurance that would pay Beneficiary $100k but under which several alternatives were available to beneficiary. j. (a) What result if Beneficiary simply accepts the $100k in cash? i. Not taxable under 101(a)(1) k. (b) What result in (a), above if Beneficiary instead leaves all the proceeds with the company and they pay her $10k interest in the current year? i. Section 101(c) specifies that such interest payments are fully taxable like interest on a bank. l. (c) What result if Insured’s Daughter is Beneficiary of the policy and, in accordance with an option that she elects, the company pays her $12k in the current year? Assume that such payments will be made annually for her life and that she has a 25-year life expectancy? i. $4k a year will be excluded ii. $8k a year will have to be included. Section 101(d) applies. m. (d) What result in (c), above, if Insured’s Daughter lives beyond her 25-year life expectancy and receives $12k in the 26th year? i. If she lives years beyond her life expectancy, the same exclusionary rule continues to apply in subsequent years. C. Annuities a. What is an annuity? i. A contractual relationship between an investor and a financial organization where the investor exchanges a sum of money in exchange for payments over an identified period of time. 1. Components: Typically, annuity payments involve a return of basis component and a return of investment component. b. The IRC approach to annuities i. Under § 72(b)(1), gross income includes the portion of any annuity payment remaining after the ―exclusion ratio‖ is applied. 1. Exclusion ratio a. The amount of investment (numerator) over the entire amt expected to receive under the contract over the expected term (denominator) ii. Example: The t/p transfers $10,000 for payments of $3,000 a year over 5 years. 1. The exclusion ratio is 2/3rds ($10,000 over $15,000($3,000 *5)) 2. Thus, 2/3rds of every $3,000 payment may be excluded from gross income; $1,000 must be included as gross income.
iii. Problem 1 p.163 – In the current year T buys an annuity for $48k. Under the Contract T is to receive $3k per year for life. T has a 24-year life expectancy. 1. How much is excludable and includable? a. Life Exp. Is 24 years. T/P gets $3k a year. So the total amount expected to be received is $74k. The T/P paid $48k for this annuity. 48/72 = 2/3. b. So the first $2k is excluded from gross income and the $1k is includable. 2. After 24 years T still alive. a. The entire amount is included in gross income – when you live past the life expectancy (72(b)(2)). c. Payments for life i. Life expectancy is determined actuarily 1. Reg. §1.72-9; tables provide multiples for calculation of expected return under a lifetime annuity. a. Page 1045 in the IRC Supplement. ii. If an annuitant predeceases life expectancy, the unrecovered investment (basis) may be excluded from gross income. 1. 72(b)(3) says that the unrecovered basis in the contract becomes a deduction on the final return filed for the year in which annuitant dies iii. If an annuitant exceeds life expectancy, the entire portion of the annuity payments are included in gross income. iv. NOTE: Insurance rule and annuity rule are different for life expectancy concerning deductions/excludable income. V. WHOSE INCOME IS IT? A. Assignment of income a. Shifting income – to lower tax bracket family members. b. Lucas v. Earl (compensatory income) i. Husband and wife make a contract to hold all property/income under joint tenancy with right of survivorship 1. Thus, the husband claims the one half of his income is taxed at his wife’s tax rate (a lower rate). ii. Court rules: 1. husband is actually disposing of income that belonged to him b/c he earned it; 2. he had power of disposition over income—first right to it full amount of the husband’s income is taxable at the husband’s rate. a. Fruit of the tree metaphor .
iii. If t/p already has vested interest in income and then assigns it, it is taxable Commissioner v. Giannini (compensatory income) i. Giannini refuses to accept $1.5 million in compensation under his contract; he suggests that the corporation use the funds for a good cause. ii. Court rules: 1. Giannini waived the right to income; he never exercised dominion as was the case in Lucas iii. If right to receive income is declined before t/p has control over it, then it is not taxable to t/p Black Letter Law: in the context of assignment of income if the t/p has a vested interest in the income and then assigns and transfers the interest then it is taxable, but if the right of the income is declined before the income is earned then it is not taxable. Helvering v. Horst (anticipatory income) i. Horst gives his son interest coupons from bonds and allows his son to collect ii. Anticipatory assignment of income: gives son right to interest b/f interest payment date iii. Court rules: 1. power to dispose of income is equivalent to reducing it to ownership iv. If gift is made of income from property while t/p retains ownership of the income producing property, the income continues to be taxable to owner of the property (even though she never gets her hands on it) 1. t/p owns the tree producing the fruit v. Contrast: if you give away the bonds, the recipient has g.i. from any interest paid after the transfer b/c transferee now owns the tree Stranahan v. Commissioner (anticipatory income) i. Father sells his son the right to $122,000 in future dividend payments in exchange for $115,000. ii. Court rules: 1. Father did not avoid the inclusion of an amt of g.i. a. He included the $115,000 in g.i.—the present value of right to receive income in future 2. The father had an amount realized of $115,000 (no basis in dividend payments). Problem 2, page 274: i. If Heffner declined the dividend before he was entitled to it, then under the Giannini case he would have no gross income because he never had the unfettered right to receive it. ii. But, if he declined to receive the dividend after he became lawfully entitled to it then he is taxed on it.
h. The kiddie tax i. Under § 73, earned income of a child is included in his gross income; not that of his parents ii. Under §1(g), unearned income of a child is included in his parent’s gross income. 1. This rule discourages parents from assigning income to children to gain the advantage of a lower tax rate. B. Income in connection with divorce and separation a. Alimony and Separate Maintenance Payments received i. Alimony = the financial obligation by one party to make continuous payments to the other party usually in cash. ii. Line 32 on 1040 – Above the line or preferred deduction to arrive at adjusted gross income (as opposed to standard deductions or itemized deductions) 1. § 71(a): alimony is included in gross income (of recipient) 2. § 71(b): alimony is defined as a payment of cash that arises under the following circumstances: a. The payment is received under a divorce or separation agreement (§ 71(b)(1)(A)) i. Need not be legally divorced; separation agmt counts b. The payment is designated as alimony, (§71(b)(1)(B)) i. Parties can t/f opt out of the result of §71 by stating so in their agreement c. The divorcees are members of different households (§ 71(b)(1)(C)) i. Cannot be members of same household d. Alimony payments may not be made after death (§ 71(b)(1)(D)) e. Section 71(F) – Recapture Rule – applies if the true alimony payment is front end loaded. Large payment up front followed by smaller payments down the road – and these appear to be at least part property settlements. This section provides a formula to determine if there was an excess amount. b. Alimony paid i. § 215(a): payor can deduct alimony payment from gross income 1. deduction for alimony is an above-the-line deduction which is a direct subtraction from gross income 2. Under § 215(b), definition of alimony under § 215 is the same as under § 71
c. Child support i. § 71(c): child support payments are not alimony and are not included in g.i. of recipient spouse ii. §71(c): child support payment is not deductible by payor iii. You can specify what portion of pymt is alimony and what portion is child support to change the tax consequences d. Property Settlement i. Savings and property owned by marital unit in divorce is split among two spouses ii. §1041: excludes gain or loss from transfers of property b/t spouses or former spouses incident to divorce (nonrecognition) iii. Front-loading payments: 1. Mulroney’s summary: 71(f) says that if payments made in the first two years and deducted by the payor spouse as alimony are deemed excessive relative to the payment made in the third year then that excessive amount is required to be added back to the payor’s income and an equivalent amount can be deducted by the recipient under a formula in section 71(f) that provides a test for determining whether there is an excessive amount. 2. Under § 71(f), excessive alimony payments in years 1 and 2 are perceived as payments for property settlement a. § 71(f) is an excessive alimony recapture provision. 3. Under § 71(f)(4), if the amount in year 2 is more than the amount paid in year 3 plus $15,000, the excess of the year 2 payment will be recaptured as gross income. 4. Under § 71(f)(3), if the amount in year 1 is more than the average of the year 2 amount after recapture and the year 3 amount plus $15,000, the excess of the year 1 payment will be recaptured as gross income. iv. Simple Rule 1. If the amounts paid in year 1, 2, and 3 are all within $15,000 of each other, there will be no recapture. 2. Example on page 202 of the Freeland text. e. Joint returns i. Under § 71(e), § 71 and § 215 do not apply in the case of a couple filing a joint return. C. Income producing entities a. Partnerships, corporations, and trusts b. Not covered in detail VI. DEDUCTIONS A. Deductions .
The world’s greatest subsidy program i. Instead of making a payment to taxpayers, the government allows taxpayers to keep money already possessed. ii. Indirect gov’t financial assistance B. Adjusted Gross Income of Individual Taxpayers: Categories of Deductions a. Above-the-line deductions (Preferred Deductions) i. Direct subtractions from g.i. to arrive at adjusted g.i. ii. § 62: free of limitations or ceiling imposed by itemized deductions 1. §62 & 63 tell you how to treat deductions that are authorized by some other section of Code 2. Deductions allowed by § 62 a. Trade and business deductions, losses from sale or exchange of property, alimony, etc. 3. Personal expenses not deductible a. Under § 262, personal expenses must be included in gross income. 4. Capital expense not deductible a. Under § 263, capital expenses must be included in gross income i. Basis rules protect capital expenditures from double taxation upon disposition. 5. Adjusted gross income is a measuring rod a. Adjusted gross income levels all types of income so that they can be measured fairly against the appropriate tax rate. b. Below-the-line deductions (Itemized Deductions) i. Those subtracted from adjusted gross income to arrive at taxable income 1. 63(d): identifies these deductions 2. These deductions are elective a. There is no reason to elect itemized deductions unless the total value of itemized deductions exceeds the value of the standard deduction. 3. the ―line‖ is adjusted g.i. on Form 1040 c. Standard Deduction- an alternative to itemized deduction (plug figure) i. §63(c): available to individual t/p’s who don’t have enough itemized deductions to over limitations that apply to itemized deductions C. Business-related deductions a. Basic concepts – (note: capital expenditures not deductible here) i. § 162: a deduction is permitted for: 1. all ordinary and 2. necessary expenses 3. incurred during the taxable year 4. in carrying on a.
5. in a trade or business, including 6. A reasonable allowance for salaries or other compensation 7. Traveling expenses (unless lavish or extravagant) while away from home in the pursuit of trade or business. 8. Rental payments required to be made as a condition to the continued use, for purposes of trade or business. ii. Ordinary and necessary expenses 1. Welch v. Helvering a. Following a bankruptcy of his corporation, Welch attempts to deduct back payments from personal finances to creditors designed to enhance his reputation i. The debts were those of the corporation; not his own. b. Are the payments ordinary and necessary? i. The court rules that although the payments may be necessary, they are not ordinary, rather extraordinary. 1. One does not ordinarily pay the debts of another t/f W loses ii. Life in all its fullness must supply the answer to this riddle. b. Capital costs, start-up expenses i. Under § 263, capital expenses shall not be included in gross income. ii. Difference b/t deduction for business expenses and capital expenditure 1. INDOPCO, Inc. v. Commissioner a. §162 deduction: if utility of expenditure to business is one year or less, it is deductible b. §263 capital expenditure: if it has outlay of more than one year, it is not currently deductible but a ratable portion of the outlay can be deducted in each of the years under §167 i. Professional expenses incurred in the course of a merger are deemed to be capital expenses. 2. Norwest Corp. v. Commissioner a. Norwest had to remove asbestos before commencing a remodeling plan for their building. i. Is the removal of asbestos a deductible ordinary and necessary business expense or is the removal of asbestos a capital expense?
1. The court rules that the removal of asbestos alone would have constituted a business expense, BUT the removal was intermingled with an overall costs of remodeling which were capital investment under §263 iii. Start-up expenditures 1. § 195: permits start-up expenditures to be accumulated and when you have begun to operate business (and meet carrying on test) then total of start up expenses can be may be amortized over 60 month period a. These expenses will be allowed as a deduction and prorated over a period of not less than 60 months. 2. Carrying on in a trade or business a. Morton Frank (pre-§195) i. Expenses incurred searching for a radio station to purchase were not deductible under § 162, because they were not incurred in ―carrying on in a trade or business.‖ 1. Such expenses may be deducted under § 195 where the t/p successfully enters a trade or business after the search. c. Reasonable compensation i. § 162(a)(1): the t/p may deduct expenses for salary payments and compensation for personal services actually rendered ii. Exacto Spring Corporation v. Commissioner 1. a closely held corp. 2. The independent investor test a. Use the rate of return to the individual investor to gauge the reasonableness of compensation. iii. § 162(m): IRC limits the deduction of salary payments to $1 million for the four most highly compensated employees in a public corporation. (does not apply to close corps) iv. Where non-controlling employee receives a salary: there is a presumption that amt of compensation was bargained for on arm’s length basis and is reasonable v. Where employee is a controlling s/h, may not be reasonable amt of comp—is this amt pd actually compensation or is it something else?
d. Travel and commuting expenses – area where there is a tension between business outlays necessary to do business (deductible) and typical living expenses. i. § 162(a)(2): traveling expenses incurred while away from home in the pursuit of a trade or business are deductible 1. ―Home‖ means tax home a. T/P’s general place of business and not necessarily t/p’s residence b. Rosenspan v. United States i. Rosenspan was a traveling salesman in the Midwest. 1. Rosenspan claimed no permanent residence. ii. The court ruled that Rosenspan could not deduct traveling expenses because he had no ―home‖ to be away from. c. C.I.R. v.Flowers i. Flowers commuted to Mobile from Jackson 1. Flowers attempted to deduct traveling expenses ii. The court lays out the three requirements for a deduction 1. Reasonable and necessary 2. Incurred away from home 3. Incurred in the pursuit of business iii. The court ruled that Flowers commuting expenses failed under the 3rd prong, ―in the pursuit of business.‖ 1. Flowers employer gained nothing from having Flowers live in Jackson. 2. Commuting fares are not deductible as traveling expenses (Reg. § 1.162-2(e)). iv. Rev. Ruling 99-7 – general rule is that commuting from your residence to principle place of business and back is a personal expense and is therefore not deductible. But travel between on business location to another business location is deductible. 2. Permutations (Part business, part pleasure) a. Part pleasure/part business trips
i. If the primary purpose of the trip is business, all business related TRAVEL expenses are deductible. (Reg. § 1.1622) 1. Any private expenses would not be deductible. b. Overnight rule i. Rule: Meals and lodging are only deductible where the t/p is away from home overnight (US v. Corell – traveling salesman tried to deduct meals each day when would return home each night) ii. If away overnight, meals are deductible even if meals are not related to business (§162(a)(2)) iii. Philly to NY Business trip hypo – (if you stayed over – could deduct diner, breakfast, and lunch) c. Temporary employment i. If you work at remote location (greater than 50 miles) on temp basis, travel expenses and meals & lodging are deductible under the away from home rule ii. If temp home can be expected to last for more than one year, then the temp home becomes tax home e. Meals and entertainment expenses i. § 274(a)(1)(A): item of entertainment activity cannot be deducted unless t/p shows that item of expenditure directly related to or associated with the active conduct of t/p’s trade or business ii. the deductions allowed for meals and entertainment costs are limited to situations where the t/p demonstrates: 1. That such costs were directly preceded or followed a substantial and bona fide business discussion a. Occurs on the same day (Reg. § 1.2742(d)(3)(ii)). 2. That such costs were associated with the active conduct of the t/p’s trade or business a. If a t/p and his wife entertain a business customer and his wife, the expenses of all four persons are considered to be associated with the trade or business. (Reg. § 1.274-2(d)(4)).
3. The t/p cannot deduct payments for the entertainment of business clients unless the t/p is present. iii. Limitations 1. § 274(k): no deduction is allowed where entertainment and meal expenses are lavish and extravagant under the circumstances 2. § 274(n): only 50% of amt incurred from meal and entertainment expenses are allowable as deductions (whether overnight or not!) a. §274(n)(3) adjusts the percentage to 65% for inflation. 3. § 274(d): allowed expenses must be substantiated before allowable as deductions. 4. Old Rule - Cohan Rule did not need receipts. NO good anymore. a. No records = no deduction b. No longer allow approximation f. Business losses for individuals i. Aggregate loss from doing business is not itself deductible. 1. Instead, each of its components is separately deductible ii. Stand alone loss: where property is disposed of and the basis in the property is greater than the amount realized 1. separately deductible under section 165 (if it meets the requirements of section 165) iii. Both kinds of losses are subject to a number of disallowances, limitations, and special rules supplied by Code sections other then those sections that grant the deduction. iv. § 165(a)—Stand alone loss: there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise v. Loss = when you sell something for less than its basis 1. Limitations a. loss has to be realized (actual realization event giving rise to loss) b. refers to loss arising from property distribution c. loss is only deductible in year it arises (is discovered) d. 165(a) loss deduction does not apply to realized losses of personal assets (unless casualty loss) 2. Deduction limited to 1 of 3 categories of losses: a. Losses incurred in a trade or business (§ 165(c)(1)) b. Investment losses (§ 165(c)(2))
i. Losses incurred in any transaction into for profit, though not connected with a trade or business. c. Casualty losses/theft (§ 165(c)(3)). i. Exception to personal loss disallowance rule: section 165(c)(3) says that a loss of personal property resulting from a casualty is deductible, subject to certain dollar limits provided in section 165(h). 1. if you lose property as result of fire, storm, shipwreck, other casualty, or from theft, even if the property is not business or investment property you can still deduct the loss d. Reg. 1.165-7(b)(1): Example, if D buys a boat which he operates for hire at a resort, and it is not insured, and demolished in a storm: D’s loss is a casualty loss, and since his boat is totally destroyed, his loss is the amount of his basis in the boat. If the boat were only damaged, D’s casualty loss would be measured by the difference between its FMV before and after the storm, limited, however by the adjusted basis of the property. e. SEE CODE LOSS TREATMENT HANDOUT - #4B1 f. A loss is really a good deal because it goes to diminish adjusted gross income or gross income to arrive at taxable income. vi. Losses on transactions between related taxpayers 1. § 267(a): no deduction is allowed for losses on transfers between members of a family (related persons) a. Loss that would ordinarily be deductible is disallowed b. § 267(b)(1) and § 267(c)(4): members of the family include brothers and sisters (whole or half), spouse, ancestors, and lineal descendants. c. If sale to son-in-law is really a sale to daughter, then real party in interest is daughter and §267 applies d. McWilliams v. Commissioner – describes the purpose of this rule, to prevent t/p’s from artificially creating a loss deduction. 2. Non-recognition of gain upon subsequent disposition a. §267(d): Recoupment Rule
i. Where a loss is disallowed under § 267(a) on a transfer from a t/p to a family member, if the family resells (disposes) of the property, his/her gain is recognized only to the extent that gain exceeds the previously disallowed loss to the original transferor. 1. So the loss may not be gone forever, but enjoyed by the related purchaser. b. Example: Problem p.873 i. Father buys stock of $50,000 ii. The father then sells the stock to his daughter for $40,000 1. Under § 267(a), the loss of $10,000 is disallowed. iii. The daughter then resells the stock for $55,000. iv. Under § 267(d), the amount of gain recognized is $5,000 1. a gain of $15,000 2. basis of $40,000 less $55,000 amount realized equals a gain of $15,000 3. $15,000 less the $10,000 of disallowed loss to the father equals $5,000 of recognized gain to the daughter. c. Focus on – in class – said good exam question.
g. Depreciation i. Mulroney’s explanation: business asset wears out over time and t/p’s investment in the business asset diminishes in value as the asset contributes to the production of income 1. Over the span of years during which the depreciable asset is used in the business t/p is allowed to recover ratable portion of his investment in asset, and is required by section 1016 to adjust downwards the basis in asset in an amount equal to the amount of annual depreciation deduction ii. § 167(a): authorizes depreciation deduction—it shall be a reasonable allowance for wear and tear. 1. For property used in a trade or business. 2. For property held for the production of income. 3. Depreciation does not apply to:
a. inventories in stock or trade, or b. land Reg. §1.167(a)-2; (not depreciable – nothing is used up) c. goodwill 4. improvements to land are depreciable iii. Other factors 1. Depreciation relies upon the existence of a ―determinable useful life‖ for the depreciated property. 2. Any depreciation deduction must be accompanied by a reduction in § 1016 adjusted basis. 3. Salvage value a. Amount realized when property is at the end of its useful life in the business b. The total amount of depreciation must be reduced by the salvage value under § 167. 4. applies to tangible property (for intangible property, it is amortization iv. Hypo: If t/p buys (1) land, (2) building, (3) fence & improvements Purchase price must be allocated among the three assets so as to determine starting price for assets so we can determine depreciation v. Types of depreciation 1. Straight-line depreciation a. Depreciation occurs at a constant rate over the determinable useful life (§ 167) b. 4 components of straight-line depreciation: i. Determine starting point basis in prop ii. Determine salvage value of asset (see above) iii. Subtract salvage value from starting pt basis of machine iv. Determine estimated useful life of machine in business v. SEE HANDOUTS – NEED 2. Accelerated Depreciation (§ 168) (ACRS) a. Depreciation deductions are front end loaded and the determinable useful life is set by the IRC. b. Current method for determining depreciation i. § 168(e) divides property into various classifications ii. Each item of classification is assigned to a recovery period 1. Tangible property: 3, 5, or 7 yrs 2. Real property: 26 ½ for residential real property and 39
years for nonresidential real property. iii. Recovery period determine amt of depreciation that can be claimed as a deduction in each year c. See Appendix page 4 d. § 168 disregards salvage value e. Under § 168(d), property placed in service at various points throughout the year is afforded special treatment. (§ 168(d)(4)) i. Half-year, mid-month, mid-quarter – CONVENTION 1. Property placed in service during any of these time periods is treated as though it was placed in service at the mid-point. f. SEE HANDOUT #4C 3. Modified ACRS – MACRS – is the current regime of depreciation. The concept of the useful life of the property has been scrapped. Now the number of years of useful life is determined in two steps (Called the Class System or the Recovery Period System) – this is roughly estimated to be the same time as a reasonable useful life. This was done because T/P’s would try to take shorter useful lives so they get a bigger deduction. Now you don’t argue – just look to the table. a. Simon v. Commissioner i. The t/p, a violin player, takes depreciation deductions for antique violin bows used in his trade or business 1. The value of the violin bows as a collector’s item increased, while the bows usefulness in the trade or business decreased. ii. Ct says: Under § 168, depreciation is theoretical and actual value is not contemplated 1. The bows fell within a specific class under the § 168 ACRS and may be depreciated thusly. vi. §168(k): bonus depreciation 1. depreciable property that meets the qualification reqs gets an additional 30% depreciation deduction in first year it is placed in service. a. 30% of starting-point basis (usually cost basis under section 1012) is deducted in the first year,
then the remaining 70 percent balance is depreciated under the regular ACRS rules of section 168. vii. Election to treat some depreciable property as a business expense 1. § 179(a): a t/p may elect to deduct the full cost of depreciable property in the year it is acquired, instead of depreciating it over a period of years any § 179 a. it is elective b. § 179(b) limits the election to $100,000 in 2003 i. to the extent that all section 179 property acquired in any one year costs in excess of 200,000, the 100,000 amount is ratably reducedt/f this is mainly for small businesses c. Reg. 1.170-(f) reduces the basis in accordance with the amount deducted . d. Property for which the section 179 deduction is available is generally tangible personal property used in a trade or business (does not apply to real estate) viii. Interaction of the depreciation sections 1. Freeland text; page 439. ix. Section 280F(a) Limitation of depreciation for luxury automobiles; limitation where certain property used for personal purposes. h. Amortization – depreciation of intangible assets. i. Goodwill and Intangibles ii. Two types of Goodwill – 1. Self created good will – no basis because you created it (going out of your way to make customers happy) 2. Purchased Good Will – has a basis so you amortize it. 3. § 167: general statutory authority for amortization a. t/p determines the useful life of intangible, then deducts an equal amount of cost of intangible per year over that estimated useful life. b. An accelerated method for amortization can’t be used. 4. Goodwill: propensity of customers to return to their place of custom 5. § 197: a t/p may take a depreciation deduction for intangible property on a straight-line basis over a 15year period. a. Goodwill can be amortized
b. § 197(d) lays out types of intangibles that can be amortized c. Basic examples: i. Purchased good will ii. Consumer mailing list. 1. Newark Morning Ledger a. List can be amortized where the t/p can prove that the asset can be valued and it has a limited useful life. i. Employee business expenses i. Most employee expenses are reimbursed by the employer 1. Thus, the employer takes the deduction; constitutes a wash to the employee. ii. In appropriate circumstances employee’s expenditures that go to producing his employment income are his ordinary and necessary expenses of that employment. 1. As such, they can be deducted by employee under §162 2. Subject to same rules as other 162 expenditures a. Ex: application of ―carrying on‖ rule to employees iii. Drawbacks: 1. Employee business expenses are considered to be below-the-line itemized deductions i. employee must be able to itemize in order to take advantage of them. ii. employees at modest income level probably can’t get the benefit of the deduction because, for them, the standard deduction ordinarily provides a greater tax savings. b. Are Miscellaneous itemized deductions: subject to the 2 % floor on miscellaneous itemized deductions. i. Unless the total employee miscellaneous expenses are proportionately large in reference to adjusted gross income the employee gets no benefit from them. iv. Seeking employment 1. In the case of an individual seeking further employment (varies from one seeking to start a business under § 195), job search expenses are deductible only if . . . a. Previously employed
i. Continuity between past employment and future employment required 1. No certain time limit establishes lack of continuity. b. In the same field j. Education expenses paid by employer i. Ordinary and necessary 1. Hill v. Commissioner a. Virginia school teacher required to read five books or take college credit to renew her teaching certificate. i. The teacher chooses to attend college classes at Columbia University in New York. b. The court rules that the expense meets all the § 162 requirements. i. The teacher attended college classes to maintain her current position; not to attain a new one. 2. Coughlin v. Commissioner a. A lawyer required to keep afoot of changes in the tax code deducts expenses for attendance at a tax conference. i. Analogous to Hill ii. The lawyer was attempting to fulfill his professional duty to keep sharp. ii. Issues: 1. whether expense is directly applicable to his current income-generating business, either as an employee or self-employed person, and thereby survives carrying on test. (ex: Continuing legal education expenses) 2. whether education expense is incurred to permit t/p to move into a new field of economic activity. a. If yes: not deductible b/c fails carrying-on test of § 162 i. Ex: revenue agent who goes to law school or businessman who goes to school to get MBA. 3. Whether expenditure for education is solely (or predominantly) for personal motives. a. Ex: fourth grade teacher who goes to Spain in vacation, looks at the Alhambra or Goya masterpieces, then mentions them to her students during a 15-minute period when she is teaching an art class. iii. Limitations on Education expenses.
1. Under § 274(m), expenses from travel for educational purposes may not be allowed as a deduction. D. Deductions related to for-profit, non-business activities a. Individuals i. § 212: individuals may deduct all the ordinary and necessary expenses paid or incurred during the taxable year: 1. For the production of income 2. For the management, conservation, or maintenance of property held for the production of income. 3. In connection with the determination, collection, or refund of any tax. ii. Limitation: For expense to be deductible, it must be proximately related to the expenditure and the production of income iii. Higgins v. Commissioner 1. Prior to enactment of § 212, fees for investment or tax counsel were not deductible; under § 212, such fees are deductible. (Reg. 1.212-1(a)(2)(f)). iv. Meyer J. Fleischman 1. T/p attempts to deduct legal fees as related to ―conservation of property‖ a. The litigation was in connection with divorce 2. The origin of the legal fees was the divorce proceedings, not the conservation of property. a. Gilmore-―the origin of the claim‖ i. The character of the expenditure is shaped by the incident/event giving rise to said expenditure. v. Rev. Ruling 64-236 – must be an identifiable relationship between the expenditure and the production of income. vi. In a divorce, legal fees must be characterized properly to achieve deductible status 1. Services related to the marriage are personal and may not be deducted; § 262. 2. Services related to alimony and related to tax may be deducted under §212(3). 3. burden of proof on t/p vii. § 212(3): Fees that relate to general legal representation can be deducted under section 212 if they relate to taxes. viii. § 274(h)(7): attendance at a conference for the purposes listed in § 212 is not a deductible event. 1. ex: cruises where passengers sit in on 1hr lecture from investment company 2. Problem 465-2 - SEE HANDOUT # 4D E. Ubiquitous deductions a. Interest, overt and covert; time value of money
i. § 163(a): there shall be allowed as a deduction all interest paid or accrued on indebtedness within the taxable year. 1. Rev. Rul. 69-188: the amount one has contracted to pay for the use of borrowed money. 2. Only certain categories are deductible: a. Business interest b. Investment interest c. Interest on residence 3. No deduction for personal interest ii. Limitation on Investment Interest 1. § 163(d): deductions for investment interest shall not exceed net investment income. a. Net investment income = investment income minus deductions associated w/ that income i. Investment income = g.i. from property held for investment plus any gain from disposition iii. Personal Interest 1. Under § 163(h), no deductions are allowed for personal interest. a. Examples include credit card balances and car loans. iv. Qualified residence interest 1. § 163(h)(2)(D): qualified residence interest is deductible 2. Types of qualified residence interest: a. Acquisition interest: proceeds of loan used to buy new residence or to fix residence that t/p already owns i. Incurred in acquiring, constructing, or substantially improving any qualified residence ii. The loan is secured by such residence iii. Limit: amount of interest on loan in principal amount up to $1 million is deductible b. Home equity interest: any loan secured by one of two kinds of qualifying residence (t/p’s principal residence or one other residence) i. Limit: is deductible if principal amt of loan is $100,000 or less ($50,000 in the case of a married individual filing a separate return). v. Rev. Ruling 69-108 – points- a lender may charge a loan processing fee, or points up front. Under this ruling the Revenue Service has taken the position that since points are
really interest for the use of the entire mortgage and not taken over the first year. But this ruling – says that you can deduct this up front now. A deduction paid today is worth more today then in the future because of the time value of money. But there are exceptions – depends on the source of the funds. If the T/P pays from personal savings then the points are deductible. But if the T/P borrows money to pay these points up front, then not deductible. 1. so if you want to deduct points from the mortgage up front, have to pay from funds outside of the money borrowed to buy the property. vi. Installment Plans 1. Entitled for an interest deduction as long as meets the other requirements under section 163. 2. Under contracts where the interest and principal components of each payment are not clearly identified, § 163(b) imposes an interest rate of 6% to the average unpaid balance of the contract. (See summary #22) vii. SEE HANDOUT – problem pg. 502-3 - #5 viii. Time value of money 1. A dollar today is worth more than dollar paid in future a. Amt is a function of interest rate 2. Want to claim deductions now but postpone the inclusion of an item in income until some future point in time a. This provides incentive to taxpayers to accelerate deductions by any means possible. 3. Points a. A lender may charge a loan processing fee, or points, up front. i. Essentially, these points are additional interest payments b. Points are deductible in year in which points are paid, if paid out of funds other than what t/p is borrowing (if paid out of funds other than loan proceeds) i. Where points are paid with loan proceeds (calculated into amount of loan) they must be amortized over the life of the loan. 4. SEE HANDOUT # 5B 5. Rev. Ruling 69-108 – since points are really interest for the use of the entire mortgage, points have to be amortized over the life of the mortgage and not taken
over the first year. This ruling says that you can deduct this up front right now. A deduction paid today is worth more today then in the future because of the time value of money. If the t/p pays points from their own savings then the points are deductible. But if the t/p borrows money to pay these points up front – then not deductible. 6. It is impt to know what interest component is (in installment plan) (ex: if buying house from seller) a. B/c it is interest: i. The seller of property should include that amt as income (§61(a)(4) g.i. from interest) ii. T/p should deduct interest under §163 ix. No interest / below-market interest of loans 1. § 7872: where a loan agreement utilizes a below-market or no interest rate, transaction will be recharacterized to impute pymt and receipt of interest to both lender and borrower a. rate of interest will be determine in reference to market rate for US gov’t publicly traded securities (Applicable Federal Rate AFR) 2. constructive interest is applied See §7872 handout #6 a. Constructive interest i. Forgone interest will be treated as though transferred from the lendor to the lendee. ii. Subsequently, a constructive retransfer from the lendee to the lendor constitutes the interest payment. 1. This creates § 62(a) interest income to the lendor and a possible interest deduction for the lendee. 3. Where loan is concerned, if parties do not identify reasonable amount of interest, Code steps in and recharacterizes transaction so reasonable amount of interest is charged to both parties (g.i. to one, deduction to other) 4. SEE HANDOUT - #6 b. Taxes i. § 164: deduction for taxes ii. §164(a): 5 enumerated kinds of taxes allowed as deductions
1. if tax is not listed, it cannot be deducted a. state income taxes deductible b. federal income taxes not deductible c. excise taxes not listed are not deductible d. state, local, and federal income taxes based on real property are deductible e. state or local taxes not based on real property are not deductible 2. Remember you might be able to pick up a deduction elsewhere, ex: if used for business purpose 3. Cramer v. Commissioner a. State, local, and foreign taxes may only be deducted by the t/p on whom they are imposed. 4. § 164(d): in the case of a sale of property, the deduction for property taxes is apportioned between the buyer and the seller according to date of purchase and part of year each owned property c. Casualty losses i. § 165(c)(3): casualty losses are deductible 1. Rule: one of the natures of a casualty loss is that it has to be quick ii. Exceptions 1. Rev.Rul. 63-232 a. Termite damage is not a casualty loss i. Under § 165(c)(3), casualty losses must occur quickly and suddenly. 2. Pulvers v. Commissioner a. Decline in value due to geographic location (i.e. proximity to Mt. St. Helens after it erupted) is not a casualty loss unless there is physical damage i. Losses can be recouped upon disposition—realization event 3. Mary Frances Allen a. The mere disappearance of property is not necessarily a casualty loss without more proof of theft. i. Timing: A theft matter be reported as a casualty loss in the year it is discovered; not necessarily in the year when it occurs. iii. Timing: Casualty losses are reported in the year in which they are sustained 1. If there is doubt about amt of casualty, deduction is taken in year in which contingency as to amt is resolved d. Charitable contributions
i. § 170(a): there shall be allowed as a deduction any charitable contribution during any taxable year. ii. What are charitable contributions: 1. to gov’t orgs 2. to orgs that get a ruling from IRS that org meets qualifications—listed in Publication 78 a. a tax exempt org is not necessarily a 170(c) qualifying org iii. Three-step analysis for determine deductibility under §170: 1. must be a Contribution a. voluntary transfer of money or property that is made with no receipt of a financial benefit. (Reg. 1.170A-1(c)(5)) 2. org must qualify under 170(c) a. A deduction is only allowed where the charitable organization qualifies under § 170(c). i. Usually, a determination letter is required to officially qualify as a charity. 3. Amount of contribution must be determined a. Transfer by parent to educational institution i. A voluntary transfer by a parent to an educational institution where the parent’s child attends creates a rebuttable presumption that the payment was tuition. (Rev.Rul. 83-104) ii. Rev. Ruling 67-246 – cannot make full deduction if you receive gift in exchange for donation – have to subtract FMV. b. Quid pro quo contribution i. Where there is a quid pro quo charitable contribution, the allowable deduction shall be the difference between the contribution and fair market value of consideration. c. Part sale/part gift i. The donor’s basis must be allocated between the charity and the donor’s amount realized Example 1. Property worth $200,000 2. Basis of $100,000 3. Donor gives to charity in exchange for $100,000 a. Essentially, a $100,000 gift to charity
4. The donor’s basis becomes $50,000 and the gift comes with a basis of $50,000. d. Hypo: Charity will take over mortgage i. Relief from mortgage indebtedness is an amt realized ii. Apportion value of property b/t paid for part and unpaid for part 4. Starting pt for determining amt of contribution: a. If contribution is in property, the starting pt is fmv of property b. If property has appreciated in value (greater than basis) in some cases, amt of contribution deductible must be deducted by amt that would be treated as gain if property was disposed of i. If when prop was sold, gain would result, amt of contribution will only equal t/p’s basis in property ii. *not in all cases if the full amt of the fmv of prop the measure of the deduction 5. Services a. Contribution may only be in money or property; services cannot be deducted (Reg. § 1.170A-1(g)) i. Out of pocket expenses in connection with service may be deducted ii. T/p can deduct mileage rate iv. Limitations of amount of contribution that can be claimed in taxable year 1. Percentage a. Under, § 170(b), contributions are limited to an aggregate amount equivalent to 50% of the taxpayer’s contribution base i. Contribution base is adjusted gross income (§ 170(b)(1)(F)). b. Under § 170(d), amounts in excess of the 50% limitation may be carried over to subsequent tax years. F. Deductions unique to individuals a. Medical expenses i. § 213(a): individuals may deduct expenses for medical care and dental expenses so long as not compensated by insurance or otherwise
1. amt of medical expense that may be deducted must exceed 7.5% of adjusted gross income b/f t/p can benefit 2. An itemized deduction subject to the standard deduction ii. § 213(d)(1)(D): individuals may deduct premiums for medical insurance such that they exceed 7.5% of adjusted gross income. iii. Raymond Gerard 1. The t/p’s doctor prescribed the installation of a central air unit in the t/p’s home a. The cost of installation was $1300, but the increase in value to the home was only $800. 2. deductible only to extent that medical expenditure exceeded the increase in value of property that resulted b. Expenses of education paid by individual i. Under § 222(a), qualified tuition paid during the taxable year is deductible 1. generally include only tuition ii. the higher your adjusted g.i., the smaller the deduction available to you 1. above the line deduction 2. § 222(b) limits the deductible amount to $4,000. c. Pg. 564 – 1 and 2 G. Limitations and restrictions on certain deductions a. Hobby losses (activities not engaged in for profit) i. § 183: if activity engaged in by individual not engaged in for profit, then no deduction except as provided in this section 1. can deduct losses up until they exceed income, then no deduction ii. To the extent that total deductible expenses of activity exceed income of activity, then the excess of aggregate of allowable deduction over income is not deductible 1. Thus, if a hobby farmer (compare to an honest farmer) expends $100,000 in the operation of his farm and has income from the farm of $20,000, the allowable deduction under § 183 is $20,000. a. In essence, deductions may only offset gain from the hobby. b. There is no carry forward if §183 applies to these expenses iii. When is a t/p ―not engaged for profit‖? 1. Where the t/p has no reasonable expectation of profit a. A factual determination b. Taxpayer has the burden of proof 2. Presumption
a. § 183(d), if gross income from a hobby exceeds deductions for 3 out of 5 consecutive taxable years, a presumption arises that the t/p was engaged for profit i. 2 out 7 years for horse farmers. b. Rental of personal residence i. § 280A(a): no deductions are permitted for a dwelling unit used as a residence (usually some type of vacation home). 1. A dwelling unit remains a residence where: a. (1) t/p uses it for personal use more than 14 days during the taxable year,. (§ 280A(d)) or b. (2) Used for personal use more than 10% of the rental period. (§ 280A(d)) ii. If it remains a residence, deductions are not allowed because the residence remains personal and 280A(a) applies. 1. Benefit: rental income is not included in gross income. (whether deduction is allowed or not) 2. § 183 (hobby losses) may apply. iii. If rented 15 days or more or not used for personal purposes more than 10% of the rental period, deductions for operating expenses are allowed only up to the amount of gross income from the rental. (§ 280A(c)(5)). iv. If rented 14 days or less, cannot deduct any operating loss but do not have to include rental in g.i. v. Business use 1. § 280A(c): deductions allowed if : a. portion of a home must be used exclusively for business purposes b. Must be either: t/p’s principal place of business or where t/p meets w/ customers or clients in normal course of business 2. If t/p is employee, may claim an expense for a home office deduction only if used for “the convenience of the employer.” vi. Pg. 523 # 1 -- SEE HANDOUT # 6B c. Deductions limited to amount of risk i. § 465(a): aggregate deduction in excess of income can be claimed only up to amt of t/p’s own funds that are invested in the business that generates the aggregate loss 1. prevents taxpayers from taking a current deduction based on borrowed money a. directed toward non-recourse borrowing aspect of tax shelters
2. aggregate losses of the business can be deducted only up to but not in excess of the amt of the t/p’s own funds that are invested in the business 3. at risk amount = total of t/p’s own out of pocket funds invested + the proceeds of any recourse borrowing (where t/p is personally liable) that t/p has invested (465(b)) a. proceeds from non-recourse loans are not included in the at risk amount b/c t/p is not personally liable 4. is a loss deferral device—the deduction is not lost forever ii. See handout on §465 –HANDOUT #7 1. Excess risk is carried over from year to year in a suspense account (§ 465(a)(2)). a. The amount at risk, however, can only be used once. i. If $20,000 is at risk in year 1, and the business has a loss of $5,000, $15,000 is carried over. In year 2, even though the $20,000 is still at risk, only the $15,000 not previously used to generate deductions remains available to offset losses. (§ 465(b)(5)). 2. Deductions are specific to the venture; may not be spread across several businesses. iii. The IRS in § 465 aims to defeat nonrecourse loans and tax shelters. 1. A loss deferral system; not a disallowance system a. Reverses the front-end loading phenomenon 2. Consider the Crane case. d. Passive losses i. § 469(a): passive activity losses are only deductible from passive activity gains. 1. Passive activity losses from one passive activity may be spread over several other passive activities. ii. Under § 469(b), excess passive activity losses may be carried over to the next taxable year. iii. § 469(c), a passive activity—if t/p is not actively, substantially and materially involved in operations of business (aka limited partner) of which she is owner, she can deduct aggregate losses of business due to her ownership only from any income of a passive activity 1. When does one materially participate or passively participate?
a. Involvement; § 469(c) b. Nature of the income i. Limited partnerships are inherently passive (§ 469(h)(2)). ii. Gross income from interest, dividends, annuities, or royalties. (§469(e)(1)). iv. If a passive activity loss is not allowed in a particular year, it is suspended and carried over to the first of any succeeding year in which the t/p has positive passive activity income v. Sale of a passive business 1. If passive activity is disposed of at a gain, you can deduct passive activity loss of another p’ship from this gain a. any disallowed losses (but not credits) are fully deductible when a t/p sells her interest in the passive activity i. If passive losses remain after sale of all passive activity interests, the passive losses become ordinary losses. vi. The IRS in § 469 aims to defeat by-standing investors and tax shelters 1. a loss deferral system; not a disallowance a. Reverses the front-end loading phenomenon e. Expenses contra bono mores i. Expenditures from illegal activity or expenditures that are contrary to public policy are included in gross income 1. Under § 162(f), no deduction is allowed for fines and penalties 2. Under § 162(c), no deduction for payment of illegal bribes and kickbacks. 3. Under § 280E, no deduction is allowed for drug dealers ii. Commissioner v. Tellier 1. If an expenditure is contrary to public policy, the IRS will usually attempt to disallow any deductions.
a. Indicates the problems courts have had, on the broad grounds of public policy. In defending against the charges of illegality of its business – IRS felt that expenses incurred in defending yourself are contrary to public policy. The S.Ct. disagreed to the IRS, and said that you have a constitutional right to defend yourself and can be deducted if the origin/reason of these payments arose out of a business activity and are ordinary and necessary in such business then they can be deducted.
H. Personal deductions and dependency exemptions see notes a. Moving from Gross Income to the Eventual Determination of Tax liability b. From adjusted gross income
i. See Appendix pages 5-7 c. Standard deduction i. Under § 63(c), the standard deduction is equivalent to . . 1. $5,000 in the case of a joint return or surviving spouse 2. $4,400 in the case of a head of household 3. $3,000 in the case an individual who is not married and who is not a surviving spouse or head of household 4. $2,500 in the case of a married individual filing a separate return. d. Itemized deductions i. Under § 67(a), itemized deductions are only allowed to the extent that they exceed 2% of adjusted gross income (and as a practical matter, the standard deduction). In Class told us to look to the Blackboard Classroom – Personal Deductions and Dependency Exemptions 1. From Adjusted Gross Income to Taxable Income ***See Chart in Blackboard Classroom - schematic of how t/p moves from gross income to amt of tax liability if any Above the line deductions: §62 - direct subtractions from gross income - possible that some t/p’s will have no above the line deductions -the ―line‖ is the last line on Form 1040 Below the line deductions: §63 - 2 categories o if t/p does not have enough itemized deductions to exceed standard deduction then the t/p will claim the standard deduction b/c it is a greater diminution in arriving at taxable income o there are several preferred deductions (itemized) which are preferred b/c they do not have any external limitations or caps Exemptions: - t/p is entitled to certain exemptions - are personal in nature - are different than standard or itemized deductions - are subtractions from adjusted gross income in arriving at taxable income Not all taxpayers are entitled to all itemized deductions or credits! Once taxable income has been arrived at, a Tentative Tax is determined - that tentative tax has potential for being further adjusted by credits against tax
Deduction v. Credit - Deduction: subtraction at arriving at taxable income - Credit: a direct dollar for dollar offset against tentative tax liability o Is a direct reduction of tax and is not a subtraction o ex: a prepayment of tax—wage withholdings If t/p’s total prepayments of tax is greater than tax liability - can ask IRS to send you a refund check or - can ask IRS to apply the refund to your estimated tax liability for the next year
IX. Timing: When to Report Income and Claim Deductions The Taxable Year: - Kind of analogous to the idea of cause of action. - sets boundaries for when to report deductions, income, etc. - if t/p has books and records, can use accrual method of accounting o possible for business to have taxable year not built on calendar year but still built on 12 month period—fiscal year - if t/p has no books and records, then taxable year is calendar year - t/p can treat his business as separate and distinct from his other income generating activities so long as t/p keeps books and records of business in a way consistent with fiscal year o can use one method for t/p personally and one method for the t/p’s business Once taxable year has been identified, t/p chooses a method of tax accounting A. Principles and Methods Methods of Accounting (know difference b/t the two) Described on p.1426 of Code book - Cash receipts and disbursements method of accounting: o T/p accounts for items of income in year in which items received (receipt must be either in cash or cash equivalent)—can be constructive receipt Constructive receipt: requires inclusion in income for year of receipt if t/p has right to receive item of income in that year Is different from postponement of income o Ex: If t/p agrees w/ purchaser of house that payment is not to be made until year 2, this is not constructive receipt b/c under the contract, t/p had no right to it
o Ex: If t/p tells purchaser to give check to lawyer who will hold it until next year—this is constructive receipt b/c t/p had power and the right to receive it T/p’s actual control over timing of payment is pivotal Is a note received in payment of property capable of being valued—capable of being cash equivalent? Cash Equivalent Question – is this the equivalent of cash and treated as income if received. If promissory note is negotiable, and is accepted by t/p as full payment, then t/p has received a cash equivalent and it is taxable What is the value of the note? The value t/p would get if transferred to 3rd party o What would t/p gets if t/p offers note to bank Bank would pay discounted amt (less than face value of note) So if a negotiable promissory note is received. It is treated as a cash equivalent, but the amount of income – is not the face value but rather the amount that the holder of the note could sell to a third party (going to be less than face value). If promissory note is non-negotiable: these are not considered cash equivalents b/c they ordinarily cannot be sold to third party o T/f value of note does not enter gross income when note is received but rather, when note is paid o Deductions are claimed in year in which t/p pays expense in cash o This is default method: If you do not affirmatively choose another method, you will use this method (unless your business requires use of inventory) Accrual method of accounting: ordinary used by businesses, and the accrual method of accounting is required to be used if the business uses inventory (ie. retail seller) because the income of trade of inventory. o Income is to be included for taxable year when all events have occurred that fix the right to receive the income and the amt of the income can be determined w/ reasonable accuracy o Expenses are identified to a taxable year when taxpayer becomes legally obligated to pay them. (when the obligation to pay sets in) Obligation to pay expense arises when item of expense becomes fixed and determinable. When all conditions or contingencies relating to payment of expense are removed from the transaction o Business that uses inventory is required to use Accrual method o Two General Tests for Accrual Items of Income –
All Events Test & Reasonable Accuracy Test: income is reportable under accrual method when all expenses to determine income have occurred and can be determined w/ reasonable accuracy Rent example: Last months rent is also an accrual for the LL in the first taxable year. Determined with reasonable accuracy, and under the lease has the right to it now. Security deposit has not accrued in year 1 b/c all events to determine it have not occurred (we don’t know who will get that).
Problem p.639 Lawyer provides services to Client which are deductible to Client under 162. lawyer sends client a bill for $1k on December 24 of year one and client pays the bill on January 5 of year two. Cash Method – lawyer has gross income when he receives it (year 2) Client can deduct the expense when he pays it in year 2. Accrual Method – If client receives the bill in year one Then lawyer accrues the time of income in the 1st year, even though he has not paid. Client accrues the expense when she receives the bill (the first year) even if she does not pay for it until year 2. If lawyer does not receive the whole amount – can have a section 165 loss. If client pays less, she would have 61(a)(12) income under Kirby lumber. -Lawyer renders services for client worth $1000 - for client, these are deductible under §212 as business expenses or are expenses relating to investment -Lawyer sends client bill just b/f Christmas -Client pays on Jan 5 of Year 2 If client had received bill in year 1, Obligation of client to pay lawyer is fixed and determinable and not subject to any contingencies - For lawyer, this is an account receivable (atty establishes §1012 basis in receivable) o this is an asset that has basis of $1000 o lawyer has accrued income in year 1 If client had received bill in year 1, then as to client, all events have occurred determining liability—Economic performance test has been met - Then, in year 1, the client also has an accrued expense - If the expense is deductible, then the deduction falls w/in taxable year 1 If client received bill on Dec 30 but did not open it until January - Accrual arises when bill is received, not when opened o Date of receipt: date of timing for the deduction
Factoring: selling of accounts receivable When receivable has a basis: - when receivable is paid in full, there is neither gain nor loss - when obligation to pay arises, this is the time the t/p makes the inclusion in gross income In year 2, client disputes the bill. Lawyer agrees to reduce bill to $950. What happens to lawyer? -Lawyer has included $1000 in gross income for year 1 not knowing there was any dispute - Lawyer has a $50 loss (§165—business loss of t/p) b/c amt received is less than lawyer’s basis of $1000 If lawyer and client had disputed amt of bill in year 1. Once client gets bill, agree to talk further. Is the amount accruable as income by lawyer in year 1 when stmt is sent? No - Lawyer knows amt is subject to contingency o Amt might not be paid o Lawyer does not include an amt in g.i. for year 1 but only for year 2 when the amt is finally determined B. Installment Sale Reporting When t/p sells property and agrees to accept payments for property over time, special set of tax accounting rules apply to installment sale §453: - reporting method for reporting gain in installment sale - the gain involved in installment sale is to be spread over installment period with portion of gain reported in year in which installment payment is received o reportable amt is determined by fraction: gain over sales price that fraction of installment price is reported for year in which gain received Example: -Property sold in Dec of year 1 -Seller does not require down payment -If no payment is received in year of sale and bulk is received later, it is an installment payment entitling seller to use §453 §453 is elective - when there is a sale that meets installment sale definition, the §453 method applies unless the t/p elects out - it is presumptively elective - t/p informs IRS which way gain is to be reported simply by way in which t/p reports it o ex: reports all gain from transaction on return in year of sale, t/p is considered to have elected out of §453
§453(a): refers to income installment sale reporting applies only if property is sold at a gain - if property is sold at a loss, installment method does not apply and entire loss is deducted in the year of sale §453(i): installment method does not apply to the extent that depreciation recapture (§1245) constitutes a part or all of gain on property if there is an installment sale - All of the depreciation recapture is reported in gross income in year of sale - Example: Overall gain in installment sale is $150. Purchase price payable in 3 portions. $100 gain was depreciation capture gain t/f this goes into year 1. The remaining $50 is spread over 3 years.
C. Tax Benefit Rule What happens when tax benefit in earlier year is reversed (cancelled or reduced) in later year? Alice Phelan Sullivan Corp. v. US -t/p donated real property to charitable organization - caveat that prop had to be used for religious or educational purposes -years later, org deeded property back to t/p -earlier, t/p deducted fmv of property How does t/p treat return of the property? To what extent should prior tax benefit (deduction) be reversed on t/p’s current return? There should be an inclusion in gross income -Problem: applicable tax rate in current year different than tax rate in prior year - How much should be included in gross income §111: Tax Benefit Rule - Says that to the extent the t/p- received a benefit from the earlier event the benefit (amount of deduction claimed and utilized) the amount of the benefit is now returned to gross income in the taxable year. Notice this is no longer the FMV, but rather the inclusion is simply a reversal of the deduction which benefited the t/p in the earlier year. This is the tax benefit rule. - idea that inclusion of recovery amt in gross income should be gross income only to the extent that t/p actually received a benefit in the earlier taxable year - later reversal of earlier item of deduction, there is an inclusion in gross income only to extent t/p received a benefit from in earlier year from item now reversed Example: -t/p had itemized deduction for medical expenses under 213.
-b/c t/p would get more benefit from standard deduction (rather than itemized), t/p uses standard deduction -later year: t/p is reimbursed for portion of prior medical expenses Is later reimbursement includable in gross income? No According to §111: the reversal of the amt is not included in gross income b/c she didn’t use the deduction that she was entitled to in the earlier year. She received no prior benefit.
VII. CHARACTER. AND RECHARACTER. OF PROP. DISPOSIT. GAIN OR LOSS . A. Capital gain or loss B. Capital gain – preferential rate treatment C. Capital Loss – subject to limitations a. Capital assets described i. Under § 1221(a) all disposed property is exposed to capital gains rules with the exception of . . . 1. 1221(a)(1) Stock or inventory in the trade of the t/p a. Property held by the t/p primarily for sale to customers 2. 1221(a)(2) Property used in trade or business subject to the rules of depreciation 3. A copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property . . . a. Held by a t/p who produced such property b. In the case of a letter, memorandum, or similar property, held by the t/p for whom the article was produced. ii. 1222 Holding Period for Capital Assets - Short-term versus long-term capital assets (§ 1222) 1. Short-term a. A capital asset held for one year or less 2. Long-term a. A capital asset hold for more than one year b. Logistics i. Netting (§ 1(h)). 1. Short-term capital gains and losses are netted and included in ordinary income (taxed at the t/p’s applicable rate). 2. Long-terms capital assets are categorized and netted according to tax rate. (Anywhere from 5% -28%) a. The 28 percent rate i. Collectibles (artwork, gems, coins) b. The 25 percent rate i. Unrecaptured § 1250 gain c. The 20 percent rate
i. Stocks, bonds, investment in land, etc. d. The lower rates are discussed in the Freeland Text at page 690. 3. If it is a long term loss the excess of capital loss over capital gain can be deducted up to $3000 - can be excluded (deducted) from ordinary income a. Any excess capital loss is carries forward b. Net long term loss carryover is first used to reduce long term capital gain 4. If it is a long term gain gets capital treatment at 1(h) rates ii. Note: Under the Rate structure -- T/Ps at lower end of ordinary income rate may pay higher rates for capital gains. If this happens then the capital gain is taxed at the individual’s lower ordinary income rate and not at the higher capital gain rate. c. Revenue Act of 2003 – regular dividends paid by corps are now taxed at a preferential 15% tax rate. i. This does not make dividends capital assets – just made them subject to the preferential treatment. d. Section 1223 – Defines the Holding Period Rules – T/P’s holding period begins to run on the day that the t/p acquires the capital asset – but in some cases the T/P’s holding period of the asset includes the period of the prior holder. i. 1223(2) when the T/P’s basis derives from another person – then that person’s holding period is carried over. 1. ie. if T/P gets property as gift, he takes the basis of the donor. T/f for capital asset – the T/P’s holding period begins when donor took possession. This is called tacking. ii. Disposition – for both capital gain and capital loss treatment property has got to be disposed of by the T/P by a sale or exchange. 1. Sale or Exchange is a prerequisite for capital gains or capital loss. 2. Abandonment is a disposition of property – this does not seem to be a sale or exchange but courts have found that abandonment can be considered a sale or exchange. (So t/p can get a capital loss from the abandonment of property). 3. Mauldin case – dealt with question of was disposition a sale or exchange. a. If gain T/P wants it to be a capital asset for lower gains tax. Revenue Service wants opposite. But if loss – does not want capital consideration for capital loss limitations.
b. Application of the term ―held for sale to customers in the ordinary course of business‖ causes a lot of litigation. D. Quasi-capital assets a. Under § 1231, taxpayers are given the benefit of favorable tax treatment for gains and losses derived from the disposition of property used in connection with a trade or business (see § 1221(a)(2)) (depreciable property) or from involuntary conversions of long-term assets. b. Hotchpot: Net all 1231 gains and losses for the taxable year: i. If Gains exceed losses: 1. then each gain will be treated as capital gain (where there is a gain after netting). § 1231(a)(1) 2. losses are treated same as in 1221 ii. If Losses exceed gains: 1. then each gain and loss will be treated as ordinary loss (where there is a loss after netting). § 1231(a)(2) c. Subhotchpot i. Gains and losses from involuntary conversion are treated separately 1. Gains from involuntary conversion a. Gains from involuntary conversion are included in regular hotchpot 2. Losses from involuntary conversion a. Losses from involuntary conversion are included in ordinary income. 3. T/P can manipulate capital gain or loss to match other transactions – as a result so firms keep track of machinery because when they sell them can have tax consequences. d. SEE HANDOUT #8 e. Williams v. McGowan – f. When a proprietorship (operated by individual directly) is sold, the sale is not a bulk sale of the business as a whole i. it is a sale of assets, each of which is sold individually 1. ex: inventory, goodwill ii. each individual asset has to have gain or loss determined g. Remember: it is really a sale of separate, distinct individual assets
E. Depreciation recapture – enacted to prevent a. § 1245 applies to disposition of depreciable property i. § 1250 applies the same rules but applies only to real property b. Under, § 1245 ordinary income (recapture) is the difference between recomputed basis and adjusted basis (which is reduced annually by the amount of depreciation). i. Recomputed basis is the sum of adjusted basis plus depreciation claimed to date. c. Example i. TP buys a machine for $18,000; $3,000 of depreciation to date; $1,000 capital repair. 1. Adjusted basis is $16,000 (18-3+1=16) 2. Recomputed basis is $19,000 3. Thus, §1245 ordinary income (recapture) is $3,000 (1916) of the gain upon disposition. a. If TP has an amount realized equal to $21,000; the gain is $5,000. i. $3,000 is §1245 ordinary income ii. $2,000 is §1231 income. d. SEE HANDOUT # 9
X. Characterization/Recharacterization of Property Disposition Gain or Loss -See Blackboard classroom Realization: - when an item of expense or deduction arises and has taxable significance - is really recognition—Do I have to report it on return? Graduated Rates: - method IRS uses to tax different incomes at different levels - the more taxable income you have, the higher the rate o wealthy ppl pay more tax in relation to their income than poor ppl do - regressivity v. progressivity o progressive: rich should pay more than poor o regressive: imposes proportionately heavier tax burden on poor than the rich ex: sales tax—sales tax is the same on an item whether rich or poor 6% tax takes away more resources from poor person than rich person
Why would buyer like to allocate more of purchase price to depreciable property? - to the extent a higher price is attributed to depreciable property, more depreciation recapture for seller(??)
Why would seller want more of price allocated to goodwill? - goodwill self created by seller, seller would have an asset that under §1221 was a capital asset o in order to get favorable capital gains rate