Tax

Federal Income Tax Part One ...............................................................................................................................................................2 a) Introduction ......................................................................................................................................................2 i) Sources of Tax Law ....................................................................................................................................2 ii) Court Structure for Tax Law ........................................................................................................................2 iii) Administrative .............................................................................................................................................2 2) Identification of Income Subject to Taxation .........................................................................................................2 a) Gross Income: The Scope of Section 61 .........................................................................................................2 i) Section 1 .....................................................................................................................................................2 ii) Taxable Income Accounting ........................................................................................................................2 iii) Taxable Income ..........................................................................................................................................2 iv) Gross Income ..............................................................................................................................................3 v) Exclusion for Fringe Benefits ......................................................................................................................4 vi) Gifts and Inheritances .................................................................................................................................6 vii) Interest and Dividends ................................................................................................................................6 viii) Discharge of Indebtedness .....................................................................................................................6 ix) Damages and Related Receipts .................................................................................................................7 b) Gains from Dealing in Property ........................................................................................................................7 iii) Determining Basis .......................................................................................................................................7 iv) Amount Realized and Determination of Gain ..............................................................................................9 3) Assignment of Income ..........................................................................................................................................9 4) Deductions.......................................................................................................................................................... 10 a) Allowable deductions for AGI under §62 ........................................................................................................ 10 i) §62 Deductions ......................................................................................................................................... 10 b) Business Deductions ..................................................................................................................................... 10 c) “Carrying On” Business.................................................................................................................................. 11 d) No Deductions ............................................................................................................................................... 11 e) Travel Away from Home ................................................................................................................................ 12 f) Travel and Entertainment Expenses: Limitations ........................................................................................... 13 g) Recovery of Capital Expenditures: Depreciation and Amortization ................................................................ 13 h) Business Losses ............................................................................................................................................ 14 i) Deductions for Profit-Making Non-business Activities: §212 .......................................................................... 15 j) Taxes ............................................................................................................................................................. 15 k) Restrictions on Deductions: Hobbies, Illegal Payments; At Risk Limitation ................................................... 15 l) Passive Loss Limitation ................................................................................................................................. 16 m) Moving Expenses .......................................................................................................................................... 17 n) Medical Deductions ....................................................................................................................................... 17 5) Year of Inclusion or Deduction............................................................................................................................ 17 a) Fundamental Timing Principles ...................................................................................................................... 17 6) The Characterization of Income and Deductions ................................................................................................ 19 a) Capital Gains and Losses: Introduction, Mechanics and Policy ..................................................................... 19 b) Income and Deduction Preferences ............................................................................................................... 20 c) The Meaning of Capital Asset ........................................................................................................................ 20 d) Sale or Exchange .......................................................................................................................................... 21 e) Holding Period ............................................................................................................................................... 21 f) Sales and Exchanges of Depreciable Property: §1231 and §1239 ................................................................ 21 g) Recapture of Depreciation: §1245 and §1250 ............................................................................................... 22 h) Sale of a Business ......................................................................................................................................... 23 i) The Charitable Deduction .............................................................................................................................. 23 7) Deferral and Nonrecognition of Income and Deductions .................................................................................... 24 a) Deferred Reporting of Gains; Installment Sales ............................................................................................. 24 b) Nonrecognition: Like Kind Exchanges ........................................................................................................... 25 8) The Alternative Minimum Tax ............................................................................................................................. 25 9) Sophisticated Compensation Arrangements....................................................................................................... 25 a) §83 ................................................................................................................................................................. 25 iii) Stock Options ............................................................................................................................................ 25 10) Child Taxation ................................................................................................................................................ 26 11) Divorce and Alimony ...................................................................................................................................... 26 a) Cash Payments for Alimony........................................................................................................................... 26 b) Property divisions .......................................................................................................................................... 27 c) Dependency Exemption ................................................................................................................................. 28 12) Homes and Mortgages................................................................................................................................... 28 1) 1 a) b) c) d) 13) 14) a) b) c) The Home Mortgage Deduction ..................................................................................................................... 28 Sale of Principal Residence ........................................................................................................................... 28 Casualty and Theft Losses ............................................................................................................................ 29 The Home Office ............................................................................................................................................ 29 Education ....................................................................................................................................................... 29 Tax-Wise Investing ........................................................................................................................................ 30 Bad Debts and Worthless Securities ............................................................................................................. 30 Wash Sales.................................................................................................................................................... 30 Limitations on Deductions .............................................................................................................................. 30 I. The Basic Structure of the Federal Income Tax 1) Part One a) Introduction i) Sources of Tax Law (1) IRC of 1986 (2) Regulations put out by the IRS (a) The first number tells you the tax number (b) The second number tells you the code number that’s involved. (c) The last part tells you what regulations you’re dealing with. (3) IRS Pronouncements and Opinions (a) Revenue Rulings (Rev. Rul. 89-42) (i) The first number is the year, the second number is the ruling number of that year. (b) Revenue Procedures (Rev. Proc. 91-24) (i) The first number is the year, the second number is the ruling number of that year. (ii) These are supposed to be only procedures, but sometimes substance gets into them. ii) Court Structure for Tax Law (1) First Level (a) US Tax Court (i) Jurisdiction over deficiencies. (ii) Only judges deciding issues. (b) US District Court (i) Jurisdiction over refund suits. (ii) Juries decide issues. (c) Federal Claims (i) Jurisdiction over refund suits. (2) Appellate Level (a) Court of Appeals (i) From US Tax Court or US District Court (b) Federal Circuit (i) From Federal Claims (c) Supreme Court (i) From the Court of Appeals and the Federal Circuit (3) Court Functions (a) Interpret the Statutes (b) Make law by making judicially created doctrines. iii) Administrative (1) Department of Treasury heads the IRS. 2) Identification of Income Subject to Taxation a) Gross Income: The Scope of Section 61 i) Section 1 (1) Section 1 taxes someone’s taxable income for an annual accounting period. ii) Taxable Income Accounting (1) The Cash Receipts Method (a) The key events occur upon receipt of the income or payment of the deductions. (2) The Accrual Method (a) The key events occur when the income is earned and when the liability arises. iii) Taxable Income (1) Taxable Income means gross income minus the deductions allowed by this chapter other than the standard deduction. (§63(a)) TI = GI – all deductions (not SD) (2) Taxable Income means adjusted gross income minus the standard deductions, and the deduction for personal exemptions provided in §151. (§63(b)) TI = AGI – (SD + PE). AGI = GI - §62 Deduction. TI = GI - §62 Deductions - (SD + PE). 2 (a) §62 Deductions (i) Trade and business deductions (ii) Losses from sale or exchange of property (iii) Retirement savings (iv) Alimony (v) Moving expenses (vi) Interest on education loans (vii) Higher education expenses (viii) Health savings accounts (3) Therefore there are two formulas for finding taxable income and the taxpayer gets a choice. iv) Gross Income (1) Rule: Gross income means all income from whatever source derived. (2) Rule: Gross income is determined by an objective fair market value, not whether the object that the person gained is worth something to that particular taxpayer. (3) Rule: Gross income during a fair market purchase is not realized until there is a gain on the sale, not on finding a good bargain. (4) Rule: Gross income from services goes to the person who performed the services, not to the person that the benefits are paid to. (5) Rule: There is no gross income from imputed income, income that comes from your own work or property going to you. (6) Rule: If property is transferred as compensation for services in an amount less than its fair market value, the difference between the fair market value and the amount paid is gross income. (Reg. §1.612(d)(2).) (7) Cesarini v. United States US District Court, Northern District of Ohio 1969 (a) People bought a piano, and years later, found money in the piano. They paid taxes on it, and then later asked for a refund. (b) Rule: The statute of limitations is three years after the tax return for that year is due. (c) Rule: An income is realized when the taxpayer has dominion over the money. (d) They owed taxes on the money found in the piano when they discovered it in the piano, not when they bought the piano. (8) Old Colony Trust v. Commissioner US Supreme Court 1929 (a) The company agreed to pay the officer’s tax liability for them. The government then tried to collect more taxes on the extra payments. (b) Rule: If someone agrees to discharge obligations for them, those payments become extra income which will have to be taxed. (c) Rule: The form of receipt doesn’t matter. (d) The officer had to pay the extra taxes when the company discharged the tax obligations. (9) Commissioner v. Glenshaw Glass Co. US Supreme Court 1955 (a) Two parties got punitive damages from court cases. They were then charged for taxes. (b) Rule: It doesn’t matter if the taxpayer didn’t earn the money. They still owe taxes on it. (c) Rule: When there is an accession to wealth, clearly realized, and over which the taxpayer has complete dominion, there is income. (d) The parties were liable for taxes on the punitive damages. (10) Charley v. Commissioner US 9th Circuit Court of Appeals 1996 (a) An employee would charge people for first class flights and then only use coach and collecting the flight miles. (b) Rule: Miles gained from an employer during business flights are taxable. (c) The miles that the employee gained were taxable. Problems -Would the results to the taxpayers in the Cesarini case be different if, instead of discovering $4,467 in old currency in the piano, they discovered that the piano, a Steinway, was the first Steinway piano ever built and it is worth $500,000? Yes, because the purchase is presumed to be done at market prices, and they would just be taxed on the ascension of worth when they sold the piano. -Winner attends the opening of a new department store. All persons attending are given free raffle tickets for a digital watch worth $200. Disregarding any possible application of I.R.C. §74, must Winner include anything within gross income when she wins the watch in the raffle? Yes, once Winner has dominion over the watch, he must include it in gross income. -Employee has worked for Employer’s incorporated business for several years at a salary of $40,000 per year. Another company is attempting to hire Employee but Employer persuades Employee to agree to stay for at least two more years by giving Employee 2% of the company’s stock, which is worth $20,000, and by buying Employee’s spouse a new car worth $15,000. How much income does Employee realize from these transactions? $40,000 from salary, $20,000 from stock, and $15,000 from the car, totaling $75,000 in gross income. 3 -Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals. (a) Does Adjuster have gross income? (b) Even if the arrangement violates local law? Adjuster does have gross income from this arrangement, even if it violates local law. (See James v. US) -Flyer receives frequent flyer mileage credits in the following situations. Does Flyer have gross income? (a) Flyer receives the mileage credits as part of a purchase of ticket for a personal trip. The credits are assignable. Flyer does not have gross income here because it is simply an exchange of goods and services for their price. (b) Flyer receives credits from Employer for business flights Flyer takes for Employer. The credits are assignable. Flyer does have gross income here under Charley v. Commissioner. (c) Flyer receives the credits under the circumstances of (b), but they are nonassignable. Flyer still has gross income here. He simply must determine the fair market value as if they were assignable to determine the gross income. -Doctor needs to have his income tax return prepared. Lawyer would like a general physical check up. Doctor would normally charge $200 for the physical and Lawyer would normally charge $200 for the income tax return preparation. (a) What tax consequences to each if they simply swap services without any money changing hands? They each gain $200 in income (b) Does Lawyer realize any income when she fills out her own tax return? No, because you can’t pay yourself. v) Exclusion for Fringe Benefits (1) Rule: Excluding an item is not necessarily the same as getting income and then paying for the item, because the item might be excludable, but not deductible. (2) Annuities (a) §72(a) – Payments made from annuities are included in gross income. (b) §72(b) – The payments from annuities are excludable for the ratio of what you paid for it, until you’ve excluded the entire premium, after which the entire payment is included in gross income. If you die early, the estate can get a refund of whatever part of the premium you haven’t recovered yet. Problems -In the current year, T purchases a single life annuity with no refund feature for $48,000. Under the contract T is to receive $3,000 per year for life. T has a 24-year life expectancy. (a) To what extent, if at all, is T taxable on the $3,000 received in the first year? T’s expected total payments are $3,000 * 24 = $72,000. $48,000/$72,000 = 2/3. Thus, 1/3 of $3,000, or $1,000, must be included in gross income in year 1. (b) If the law remains the same and T is still alive, how will T be taxed on the $3,000 received in the thirtieth year of the annuity payments? T must be taxed on the full $3,000 after every year the recipient outlives his life expectancy. (c) If T dies after nine years of payments will T or T’s estate be allowed an income tax deduction? How much? T has received $2,000 * 9 = $18,000 of his premium in year nine. Thus, T’s estate will be allowed a $48,000 - $18,000 = $30,000 refund. (3) Life Insurance (a) §79 – Allows an employee to exclude up to $50,000 of group term life insurance that otherwise would not be deductible, so long as the plan is not discriminatory. (b) §101(a) – No payment of a life insurance policy to a beneficiary is included in gross income if it is paid out because of the insured’s death. (c) §101(c) – If insurance is held for interest, the interest is included in gross income. (d) §101(d) – When insurance is paid out in yearly installments for extra, the yearly payments are prorated for tax purposes. (e) §101(g) – If payment is accelerated because of terminal illness, the money collected is still not considered part of gross income. (f) Reg. §1.101-4(c) – The prorating for tax purposes is allowed to continue even if you outlive the life expectancy of the policy. Problems -Apricot Corporation has in effect a plan of group term life insurance for the benefit of its full time employees. Under the terms of the plan E is entitled to a $50,000 policy and has the right to designate the beneficiary. What result when E dies and the beneficiary receives $50,000? There is no gross income under §101(a)(1) and the beneficiary receives the $50,000 tax free. -Insured died in the current year owning a policy of insurance that would pay Beneficiary $100,000 but under which several alternatives were available to Beneficiary. (a) What result if Beneficiary simply accepts the $100,000 in cash? There is no gross income recognized under §101(a). (b) What result in (a) if Beneficiary instead leaves all the proceeds with the company and they pay her $10,000 interest in the current year. There is no gross income on the $100,000, but there is $10,000 gross income under §101(c) (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 $12,000 in the current year? Assume that such payments will be made annually for her life and that she has a 25-year life expectancy. Her expected total payments are $12,000 * 25 = $300,000, so there is 4 $200,000 gross income, and thus 2/3 of every payment is gross income. Therefore 2/3 of $12,000, or $8,000 is gross income every year. (d) What result in (c) if Insured’s Daughter lives beyond her 25-year life expectancy and receives $12,000 in the twenty-sixth year? She still only includes $8,000 in gross income. See Reg. §1.101-4(c) (4) Health Insurance (a) §105 (a), (b) – When an employee receives medical care from a group health insurance plan, the benefits received are not taxable. (b) §105 (e) – When an employer establishes an accident or health plan for its own employees, benefits received from those are not taxable so long as the plan is not discriminatory. (c) §106 (a) – Excludes the benefit of having coverage. Problem -Apricot Corporation pays all the costs of BlueCross/Blue Shield insurance for its employees and their families. E’s allocable share of such cost is $1,450 per month. What if instead Apricot’s board of directors adopts a resolution authorizing its president on a discretionary basis to reimburse employees for medical expenses incurred by them and members of their families? Assume E receives $1,500 this year for reimbursed medical expenses. E does not have any gross income from the $1,500 in benefits received per §105(b) as long as he’s not highly compensated and the plan doesn’t apply to everyone equally. If he is, then the $1,500 is gross income. (5) Education (a) §117(d) – When an employer pays for an employee’s kid’s education, it is gross income unless the employer is an educational institution. Problem -Apricot Corporation’s board of directors adopts a resolution authorizing its president on a discretionary basis to reimburse employees for educational expenses incurred in sending their children to private elementary or secondary school. E receives $5,000 this year for reimbursed educational expenses. What difference would it make if E were a professor at Apricot University and E’s child, Allison, is permitted to attend Apricot without paying the University’s $17,500 per year tuition? In the first question, the $5,000 is gross income per §117(d). In the second question, the $17,500 is not gross income so long as it’s not a discriminatory policy. (6) Other Fringe Benefits (a) §132(a)(1) – No-additional-cost service – Services given to employees at a discount that don’t add much cost for employers are excludable, so long as it is non-discriminatory and for sale to customers in the regular line of business. Also see §132(b). (b) §132(a)(2) – Qualified employee discount – Employee discounts are excludable so long as the discount isn’t larger than 20% for services or the profit margin for goods, and so long as the things being bought are ordinary business items. The discount must also be non-discriminatory. Also see §132(c). (c) §132(a)(3) – Working condition fringe – If the employee gets a deductible benefit from an employer, it’s excludable. Also see §132(d). (d) §132(a)(4) – De minimis fringe – Small benefits to employees are excludable, along with retirement gifts to long time employees. Also see §132(e). (e) §132(a)(5) – Qualified transportation fringe – Transportation and parking benefits are excludable up to $100 for transit and $175 for parking, adjusted for inflation. Also see §132(f). (f) §132(a)(6) – Qualified moving expense reimbursement – When an employer pays for an employee to move for work, it is excludable. Also see §132(g). (g) §132(a)(7) – Qualified retirement planning services – Retirement planning services are excludable, so long as it is non-discriminatory. Also see §132(m). (h) §132(i) – If companies have reciprocal agreements to use each other’s benefits, they are still excludable. (i) §132(j)(3) – Car use for car dealers is excludable. (j) §132(j)(4) – Gym access is excludable. (k) When an employee chooses between a salary and a fringe benefit, the fringe is still deductible. Problems -In the situations described below, consider whether the property, services or facilities furnished by the employer to the employee are includible in the employee’s gross income and, if so, at what value. (a) Madison is an executive of an advertising agency. When he was promoted to Vice President, his employer redecorated his office with comfortable furniture, thick pile carpeting and original modern art works. This is not includible in gross income unless Madison takes the stuff with him when he leaves. (b) Bev is an associate in a prominent San Francisco law firm. The firm, which is located in the Embarcadero Center Complex, provides associates with free parking the building. The normal monthly charge for a reserved space is $150. Nonprofessional employees do not receive free parking. This is excludible under §132(a)(5). §132(a)(5) benefits are not subject to the discrimination clause, so the exclusion is still allowed even though other employees don’t get it. 5 (c) Hugh is a secretary in Bev’s law firm. The firm provides Hugh with $75 of BART tickets each month. This is excludible under §132(a)(5). (d) Stew is a flight attendant for Friendly Airlines. The airlines has a policy under which any of its employees, along with members of their immediate family, may take a number of personal flights for a nominal charge on a spaceavailable basis. Stew, her husband and his mother took two such trips during the current year: to Hawaii and to Paris. The flights are excludible for her and Stew under §132(a)(1), but not for Stew’s husband’s mother. Stew must include the cost of the in-law’s flights in gross income. (e) Clerk is an employee of Sax McAllister Street, an elegant retail store. Sax has a policy under which all employees are given a 20% discount (equal to its “gross profit percentage”) from the ticketed sales price on any item sold by the store. During the current year, Clerk purchases clothes worth $1,000 (saving $200) and a microwave oven worth $600 (saving $120). Assuming the products are normally sold at their store, this is excludable under §132(a)(2). vi) Gifts and Inheritances (1) Commissioner v. Duberstein US Supreme Court 1960 (a) Rule: Whether a transfer of wealth is a gift is a factual determination based on what the motivation of the transfer of property was. (2) §102(a), (c) – Gifts, bequests, and inheritances aren’t gross income, unless it is profits from property or a gift from an employer. (3) §102(b) - §102(a) shall not exclude from gross income any income derived from property. (4) Wolder v. Commissioner US Supreme Court 1938 (a) In exchange for legal services, people agreed to not pay the lawyer but rather leave him a “bequest” in their will. The court found that this was in compensation for services and not a gift and so he had to include it in gross income. Problem -Employer gives all of her employees, except her son, a black and white television set at Christmas, worth $100. She gives Son, who also is an employee, a color television set, worth $500. Does Son have gross income? Probably not, because this looks like a gift from a mother to a son, which would not be included in gross income under §102. -Consider whether it is likely that §102 applies in the following circumstances: (a) Father leaves Daughter $20,000 in his will. Yes, §102 applies and there is no gross income for Daughter. (b) Father dies intestate and Daughter receives $20,000 worth of real estate as his heir. Yes, §102 applies and there is no gross income for Daughter. (c) Father leaves several family members out of his will and Daughter and others attack the will. As a result of a settlement of the controversy Daughter receives $20,000. Yes, §102 applies and there is no gross income for Daughter. (d) Father leaves Daughter $20,000 in his will stating that the amount is in appreciation of Daughter’s long and devoted service to him. Yes, §102 applies and there is no gross income for Daughter. (e) Father leaves Daughter $20,000 pursuant to a written agreement under which Daughter agreed to care for Father in his declining years. No, this seems more like an exchange for services per Commissioner v. Duberstein. vii) Interest and Dividends (1) §103(a) – Interest on government bonds are not taxed. (2) Rule: Dividends on stock investments are taxed. viii) Discharge of Indebtedness (1) United States v. Kirby Lumber Co. US Supreme Court 1931 (Holmes) (a) Rule: When a debt is discharged for less than its market value, it must be included in gross income. (2) §61(a) – Discharge of indebtedness must be included in gross income. (3) §108(a) – Discharge of indebtedness is not included in gross income if the taxpayer is bankrupt or insolvent. (4) §108(e)(5) – If two parties agree to exchange property for a certain price, and then later lower the amount owed on the property, it is not gross income but rather just an adjustment in the basis of the property. (5) Zarin v. Commissioner US 3rd Circuit Court of Appeals 1990 (Cowen) (a) Rule: If a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of that dispute is “treated as the amount of debt cognizable for tax purposes.” Problems -Poor borrowed $10,000 from Rich several years ago. What tax consequences to Poor if Poor pays off the so far undiminished debt with: (a) A settlement of $7,000 of cash? $3,000 gross income. (b) A painting with a basis and fair market value of $8,000? $2,000 gross income. (c) A painting with a value of $8,000 and a basis of $5,000? $5,000 gross income (d) Services in the form of remodeling Rich’s office, which are worth $10,000? $0 gross income. (e) Services that are worth $8,000? $2,000 gross income. 6 (f) Same as (a) except that Poor’s Employer makes the $7,000 payment to Rich, renouncing any clam to repayment by Poor. $10,000 gross income. ix) Damages and Related Receipts (1) Raytheon Production Corporation v. Commissioner US 1st Circuit Court of Appeals 1944 (Mahoney) (a) Rule: Recoveries which represent a reimbursement for lost profits are income. (b) Rule: Where recoveries are for injury to good will or a return of capital, it is not taxable. (2) §104(a) – Gross income doesn’t include worker’s comp., any damages from injury unless it’s emotional distress (although recovery for treatment of emotional problems are excludable), and health insurance payments, but does include punitive damages, any payments for emotional distress, and for lost profits. (3) §104(c) – Punitive damages are excludible from gross income when for a wrongful death action. (4) §105 – Money received from health insurance doesn’t count for gross income unless you have two simultaneous policies that both would pay. (5) §106(a) – Employer provided health plans are not gross income. Problems -Plaintiff brought suit and unless otherwise indicated successfully recovered. Discuss the tax consequences in the following alternative situations: (a) Plaintiff’s suit was based on a recovery of an $8,000 loan made to Debtor. Plaintiff recovered $8,500 cash, $8,000 for the loan plus $500 of interest. $500 of gross income. (b) What result to Debtor under the facts of (a) if instead Debtor transferred some land worth $8,500 with a basis of $2,000 to Plaintiff to satisfy the obligation? What is Plaintiff’s basis in the land? Plaintiff would have $500 in gross income and a basis of $8,500 in the property. Debtor would have $6,500 in gross income. (c) Plaintiff’s suit was based on a breach of a business contract and Plaintiff recovered $8,000 for lost profits and also recovered $16,000 of punitive damages. Plaintiff has $24,000 in gross income. - Plaintiff brought suit and successfully recovered in the following situations. Discuss the tax consequences to Plaintiff. (a) Plaintiff, a professional gymnast, lost the use of her leg after a psychotic fan assaulted her with a tire iron. Plaintiff was awarded damages of $100,000. No gross income to Plaintiff. (b) $50,000 of the recovery in (a) is specifically allocated as compensation for scheduled performances Plaintiff failed to make as a result of the injured leg. No gross income for Plaintiff, because there is no gross income for any physical damages. (c) The jury also awards Plaintiff $200,000 in punitive damages. Plaintiff has $200,000 in gross income. (d) The jury also awards Plaintiff damages of $200,000 to compensate for Plaintiff’s suicidal tendencies resulting from the loss of the use of her leg. No gross income for Plaintiff, because there is no gross income for any physical damages. (e) Plaintiff in a separate suit recovered $100,000 of damages from a fan who mercilessly taunted Plaintiff about her unnaturally high, squeaky voice, causing Plaintiff extreme anxiety and stress. Plaintiff has $100,000 in gross income because the damages are for mental damages. (f) Plaintiff recovered $200,000 in a suit of sexual harassment against her former coach. The $200,000 must be included in gross income, unless the coach physically assaulted here, in which case there is physical damages and the $200,000 is excluded from gross income. (g) Plaintiff dies as a result of the leg injury, and Plaintiff’s parents recover $1,000,000 of punitive damages award in a wrongful death action under long-standing State statute? There is no gross income here under §104(c). -Injured, who has a 20-year life expectancy, recovers $1 million in a personal injury suit arising out of a boating accident. (a) What are the tax consequences to Injured if the $1 million is deposited in a money market account paying 5% interest? The $1,000,000 is not included in gross income, but the interest in included in gross income. (b) What are the tax consequences to Injured if the $1 million is used by Injured to purchase an annuity to pay Injured $100,000 a year for Injured’s life? $1,000,000 is not included in gross income, and he will receive $100,000 * 20 = $2,000,000. $1,000,000/$2,000,000 = 1/2, so half of every annuity payment is gross income and half is not. (c) What are the tax consequences to Injured if the case was settled, and in the settlement, Injured received payments from Defendant of $100,000 a year for life? No gross income. See Rev. Rul. 79-313. b) Gains from Dealing in Property i) §1001(a) – The gain from the sale of property is the amount realized minus the adjusted basis, and the loss is the adjusted basis minus the amount realized. ii) §1001(c) – Unless otherwise stated, the entire gain or loss must be included in gross income. iii) Determining Basis (1) §1012 – The basis of property when exchanged for other property will equal the fair market value of the property received in exchange. The basis of property doesn’t include taxes. (2) §1016(a)(1) – Adjustments to basis are allowed for expenditures, receipts, losses, or other capital items except for taxes. 7 (3) §1016(a)(2) – Adjustments to basis are also allowed for depreciation. Depreciation is calculated with the straight line method unless another method has been adopted. (4) §1015 (Gift) – The basis for gifts is whatever the basis was for the buyer, unless it’s for loss, in which case it’s the fair market value at the time of transfer. If no one can figure out what the original basis was, it is fair market value. For part gift, part sales, the gain for the seller/donor is the difference between the amount realized and the basis (there is no loss), while the basis for the buyer/donee is the greater of what they paid or the original basis from the donor. If the buyer/donee is a charity, the IRS treats the sale as only a sale of part of the land, rather than a part sale and part gift. (5) §1041 (Spouses and Divorce) – Transfer of property between spouses or pursuant to a divorce don’t count for gains and losses. If the basis was higher than the fair market value at the time of transfer, the basis is still the original basis. (6) §1014 (Death) – If property is inherited, the basis is the fair market value at the date of death, which applies to bequests, devises, inheritances, estates, and community property between spouses. Also, property given to someone must be held for a year before it can be given back to the original donee for the fair market value basis. For spouses, example (A & B own property $20,000 AB, $100,000 FMV, if A dies, B has a new basis of $60,000 [$10,000 of his own, and $50,000 of A’s new basis]) For spouses with community property, example (A & B own community property with $20,000 AB, $100,000 FMV, if A dies, B has a new basis of $100,000 because of §1014(b)(6)). Problems -Owner purchases some land for $10,000 and later sells it for $16,000. (a) Determine the amount of Owner’s gain on the sale. $6,000 gain (b) What difference in result in (a) if Owner purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option? No difference (c) What result to Owner in (b) if rather than ever actually acquiring the land Owner sold the option to Investor for $1,500? $500 gain (d) What difference in result in (a) above if Owner purchased the land by making a $2,000 cash payment from Owner’s funds and an $8,000 payment by borrowing $8,000 from the bank in a recourse mortgage (on which Owner is personally liable)? Would it make any difference if the mortgage was a recourse liability (on which only the land was security for the obligation)? There is a $6,000 gain under a recourse mortgage. There is no difference if it is a non-recourse mortgage. (See Crane v. Commissioner) (e) What result in (a) if Owner purchased the land for $10,000, spent $2,000 in clearing the land prior to its sale, and sold it for $18,000. Still a $6,000 gain because new stepped up basis is $12,000. (g) What difference in result in (a) if when the land had a value of $10,000, Owner, a real estate salesperson, received it from Employer as a bonus for putting together a major real estate development, and Owner’s income tax was increased $3,000 by reason of the receipt of the land? He must realize a gain of $13,000 because the basis he received in the property was only $3,000. (h) What difference if Owner is a salesperson in an art gallery and Owner purchases a $10,000 painting from the art gallery, but is required to pay only $9,000 for it (instead of $10,000 because Owner is allowed a 10% employee discount which is excluded from gross income under §132(a)(2)), and Owner later sells the painting for $16,000? He must realize a gain of $7,000 because his basis in the property is only $9,000. -Donor gave Donee property under circumstances that required no payment of gift tax. What gain or loss to Donee on the subsequent sale of the property if: (a) The property had cost Donor $20,000, had a $30,000 fair market value at the time of the gift, and Donee sold it for: $35,000; $15,000; $25,000? $15,000 gain; $5,000 loss; $5,000 gain (b) The property had cost Donor $30,000, had a $20,000 fair market value at the time of the gift, and Donee sold it for: $35,000; $15,000; $24,000? $5,000 gain; $5,000 loss; no gain or loss. -Father had some land that he had purchased for $100,000 but which had increased in value to $200,000. He transferred it to Daughter for $100,000 in cash in a transaction properly identified as in part a gift and in part a sale. Assume no gift tax was paid on the transfer. What gain to Father and what basis to Daughter under Reg. §§1.10011(e) and 1.1015-4(a)(1)? No gain or loss to father, daughter has $100,000 basis in the property. -Andre purchased some land ten years ago for $4,000 cash. The property appreciated to $7,000 at which time Andre sold it to his wife Steffi for $7,000 cash, its fair market value. (a) What are the income tax consequences to Andre? No tax consequences to Andre. (b) What is Steffi’s basis in the property? $4,000 (c) What gain to Steffi if she immediately resells the property? $3,000 (d) What results in (a)-(c) if the property had declined in value to $3,000 and Andre sold it to Steffi for $3,000? There are still no tax consequences to Andre. Steffi’s basis in the property is still $4,000, and if she immediately resold it, she would recognize a $1,000 loss. (e) What result (gains, losses, and bases) to Andre and Steffi if Steffi transfers other property with a basis of $5,000 and value of $7,000 (rather than cash) to Andre in return for his property? When they sell their new property, Andre will realize a $2,000 gain, Steffi will realize a $3,000 gain. Until then, they won’t recognize any gain, the bases will simply be the same bases as they were before they transferred the property. 8 -In the current year, Giver holds two blocks of identical stock, both worth $1,000,000. Giver purchased the first block years ago for $50,000 and the second block more recently for $950,000. Giver plans to make an inter vivos gift of one block and retain the second until death. Which block of stock should Giver transfer inter vivos and why? He should give the $950,000, so that the donee has a basis of $950,000. Then, when he dies, the $50,000 basis stock will be inherited at market value, eliminating the huge gain that would need to be otherwise recognized. iv) Amount Realized and Determination of Gain (1) Mortgage Definitions (a) Recourse Mortgage – A mortgage where the person is personally liable on the debt on top of having to give up the property upon default. (b) Non-Recourse Mortgage – A mortgage where the person is not personally liable on the debt on top of having to give up the property upon default. (2) International Freighting Corp., Inc. v. Commissioner US 2nd Circuit Court of Appeal 1943 (Hand) (a) The company got stock, the stock went up in price, and then the company paid employees in the stock. (b) Rule: When property is given to satisfy a debt, the transaction is a taxable event and they must be taxed on the gain in the property. (c) The company was allowed to deduct the fair market value of the stock when paying in stock, but when the company pays in stock and the employee accepts it at market value, the company must pay the gain from stock from when they got it to when they gave it to the employees. (3) Crane v. Commissioner US Supreme Court 1947 (Vinson) (a) Mrs. Crane inherited an apartment building with a fair market value of $262,000 subject to a mortgage of $255,000. She took depreciation deductions of $28,000, but didn’t pay the mortgage at all. Eventually, the bank foreclosed the property, and she only got $2,500 cash. She tried to claim that she only realized $2,500 but the IRS said that she realized $257,500. (b) Rule: The amount realized includes not only the cash gained, but also the debt relieved (including mortgages, whether they are recourse or non-recourse mortgages). (c) Rule: We normally include all debt incurred while buying a property in the basis of the property, up to the fair market value. (d) Mrs. Crane realized $257,500, the $2,500 and the $255,000 of the mortgage that she was relieved from. Problems -Mortgagor purchases a parcel of land from Seller for $100,000. Mortgagor borrows $80,000 from Bank and pays that amount and an additional $20,000 of cash to Seller giving Bank a nonrecourse mortgage on the land. The land is the security for the mortgage which bears an adequate interest rate. (a) What is Mortgagor’s cost basis in the land? $100,000 (b) Two years later when the land has appreciated in value to $300,000 and Mortgagor has paid only interest on the $80,000 mortgage, Mortgagor takes out a second nonrecourse mortgage of $100,000 with adequate rates of interest from Bank again using the land as security. Does Mortgagor have income when she borrows the $100,000? No (c) What is Mortgagor’s basis in the land if the $100,000 of mortgage proceeds are used to improve the land? $200,000 (d) What is Mortgagor’s basis in the land if the $100,000 of mortgage proceeds are used to purchase stocks and bonds worth $100,000? $100,000 basis in the land, $100,000 basis in the stocks and bonds. (e) What result under the facts of (d) if when the principal amount of the two mortgages is still $180,000 and the land is still worth $300,000, Mortgagor sells the property subject to both mortgages to Purchaser for $120,000 of cash? What is Purchaser’s cost basis in the land? Mortgagor realizes $200,000 in gain. Purchaser has a basis of $300,000 in the land. (f) What result under the facts of (d) if instead Mortgagor gives the land subject to the mortgages and still worth $300,000 to her Son? What is Son’s basis in the land? Mortgagor realizes $80,000 gain on the property. Son has a basis of $180,000 in the property. (g) What results under the facts of (f) if Mortgagor gives the land to her Spouse rather than to her Son? What is Spouse’s basis in the land? What is Spouse’s basis in the land after Spouse pays off the $180,000 of mortgages? There are no tax consequences to Mortgagor from this transfer. Spouse’s basis in the land is still $100,000. (h) What results to Mortgagor under the facts of (d) if the land declines in value from $300,000 to $180,000 and Mortgagor transfers the land by means of a quitclaim deed to Bank? Mortgagor realizes an $80,000 gain on the transfer. -Investor purchased three acres of land, each acre worth $100,000 for $300,000. Investor sold one of the acres in year one for $140,000 and a second in year two for $160,000. The total amount realized by Investor was $300,000 which is not in excess of her total purchase price. Does Investor have any gain or loss on the sale? Yes, Investor has a $100,000 gain on the sales and has one piece of land left over with a basis of $100,000. 3) Assignment of Income a) Lucas v. Earl US Supreme Court 1930 (Holmes) i) Rule: Income from services gets taxed to the person that performs the services. 9 b) Helvering v. Horst US Supreme Court 1940 (Stone) i) Rule: The person that controls the income earning property must pay the taxes on the income. c) Blair v. Commissioner US Supreme Court 1937 (Hughes) i) Rule: If the only thing a person owns is the income earning part of property, that person can give away that income earning part and have the tax assigned to the donee. Problems -Executive has a salaried position with Hi Rolling Corporation under which she earns $80,000 each calendar year. (a) Who is taxed if Executive, at the beginning of the year, directs that $20,000 of her salary be paid to her parents? Executive is taxed. (d) Who is taxed if Executive, in her corporate role, gives a series of lectures on corporate finance at a local business school and, pursuant to her contract with Hi Rolling, turns her $1,000 honorarium over to Corporation? Corporation is taxed. - Father owns a registered corporate coupon bond which he purchased several years ago for $8,000. It has a $10,000 face amount and is to be paid off in 2010. The current fair market value of the bond is $9,000. The bond pays 8% interest, semi-annually April 1st and October 1st (i.e., $400 each payment). What tax consequences to Father and Daughter in the following alternative situations? (a) On April 2 of the current year, Father assigns Daughter all the interest coupons. Father must pay the tax on the bond and all the interest. (b) On April 2, Father gives Daughter the bond with the right to all the interest coupons. Daughter must pay the tax on the bond and all the interest. (c) On April 2, Father gives Daughter a one-half interest in the bond and the right to all the interest coupons. Each must pay tax on half the bond and half the interest. (d) Father owns an income interest in a trust which owns the bonds and on April 2, Father gives his income interest (the right to the succeeding interest coupons) to Daughter. Daughter must pay tax on all the interest. (e) On December 31, Father gives Daughter the bond with the right to all the interest coupons. Daughter must pay tax on the bond all the remaining interest. Father must pay tax on the interest accrued prior to December 31. (f) On April 2, Father sells Daughter the right to the two succeeding interest coupons for $600, their fair market value as of the time of sale. Daughter must pay tax on the two interest payments. Father must pay tax on the bond and any other interest payments. (g) On April 2, Father sells the bond and directs that the $9,000 sale price be paid to Daughter. Father must pay tax on the bond and any previously accrued interest. (h) Prior to April 2, Father negotiates the above sale and on April 2 he transfers the bond to Daughter who transfers the bond to Buyer who pays Daughter the $9,000. Father must pay tax on the bond and any previously accrued interest since he did all the work for the sale. 4) Deductions a) Allowable deductions for AGI under §62 i) §62 Deductions (1) Trade and business deductions (2) Losses from sale or exchange of property (3) Retirement savings (4) Alimony (5) Moving expenses (6) Interest on education loans (7) Higher education expenses (8) Health savings accounts b) Business Deductions i) §162(a) – There shall be allowed a deduction for ordinary and necessary business expenses in carrying on any trade or business for salaries, traveling expenses, and rents, except that traveling for the attorney general is not deductible. ii) §212 – In the case of an individual, deductions are allowed for ordinary and necessary expenses for the production or collection of income. iii) §274(b) – No deductions are allowed for gifts to individuals in excess of $25. iv) Welch v. Helvering US Supreme Court 1933 (Cardozo) (1) Welch worked for a company that went bankrupt. He later tried to start his own business, and so paid off a lot of the old debts from the old company. He then tried to deduct the payments as a business expense under §162. (2) Rule: Necessary expenditures are those that are appropriate and helpful for the business. (3) Rule: Ordinary expenses are those done on a regular basis by similarly situated businesses that don’t include capital expenditures such as reputation (goodwill) or learning. v) INDOPCO, Inc. v. Commissioner US Supreme Court 1992 (Blackmun) 10 vi) vii) viii) ix) (1) Unilever bought National Starch, which became INDOPCO. National starch tried to deduct over $2 million in expenses paid to lawyers and investment bankers because all they were doing was reorganizing companies and not adding wealth. (2) Rule: Expenses incurred for the purpose of changing the corporate structure for the benefit of future operations are not ordinary and necessary business expenses. Rule: Deductions are allowed for advertising expenses, incidental building repairs, and employer-incurred training costs, even though there are future benefits. Rule: Deductions are allowed for most expansion and down-sizing costs. Rule: Deductions are allowed for rents when there is no title and no equity in the property. No Deduction (1) §262 – There are no deductions for personal or living expenses. (2) §263 – No deductions are allowed for payments for new buildings, capital improvements, or for replacements of the property. (a) Repairs are deductible for business expenses; replacements, appreciations of the value of property, and acquisition of capital are capital improvements. (3) Midland Empire Packing Co. v. Commissioner US Tax Court 1950 (Arundell) (a) A meat packing company had to oil-proof its basement after oil started leaking into it. They then tried to deduct the cost of oil-proofing as a business expense and not a capital improvement. (b) The court held that the expenditure did not add value or prolong the expected life of the property over what they were before the event occurred which made the repairs necessary. (4) Rule: Generally, capitalization is required for an amount paid to acquire, create, or enhance an intangible asset, an amount paid to facilitate an acquisition or creation of an intangible, and an amount paid to facilitate a restructuring of a business entity or a transaction involving capital, stock issuance, borrowing, or recapitalization. Problem -Landlord incurs the following expenses during the current year on a ten-unit apartment complex. Is each expenditure a currently deductible repair or a capital expenditure? (a) $350 for painting three rooms of one of the apartments. Repair that is currently deductible. (b) $1,500 for replacing the roof over an apartment. The roof had suffered termite damage. Repair that is currently deductible if it is for part of the roof, but a capital expense if it is the whole ceiling. (c) $500 for patching the entire asphalt parking lot area. Repair that is currently deductible. (d) $750 for adding a carport to an apartment. Capital expense that is not currently deductible. (e) $100 for advertising for a tenant to occupy an empty apartment. Repair that is currently deductible. c) “Carrying On” Business i) §195(a) – No deductions are allowed for start-up expenditures unless otherwise provided, because it must be capitalized. ii) §195(b) – Deductions are allowed for lesser of your start-up costs or $5,000 for up to $50,000 spent for the year the business starts up, and then take out the rest over a 180 month period. iii) §195(c) – Start-up expenditures are costs for business that do not exist yet that, if done for an already existing business, would normally be deductible. iv) Rule – If you are seeking a new job in the same industry, those expenses are deductible. They are deductible even if the person is unsuccessful in obtaining a new job. If the expenses are incurred in an effort to commence a new trade or business, they are not deductible. v) Morton Frank v. Commissioner US Tax Court (Van Fossan) (1) A couple spent a lot on traveling around the county trying to find newspaper companies or facilities to buy. (2) Rule: Travel expenses and legal fees spent searching for business are not deductible under §162 because there was no business existing to “carry on.” Problem -Determine the deductibility under §§162 and 195 of expenses incurred in the following situations. (a) Tycoon, a doctor, unexpectedly inherited a sizable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation. This is not deductible under §162, but he can use §195(b) to slowly deduct the costs. (b) The facts are the same as in (a) except that Tycoon, rather than having been a doctor, was a successful developer of residential and shopping center properties. This is immediately deducible under §162 because it is merely expanding a current business. (c) The facts are the same as in (b) except that Tycoon, desiring to diversify her investments, incurs expenses in investigating the possibility of purchasing a professional sports team. This is not deductible under §162, but can use §195(b) to slowly deduct the costs. d) No Deductions i) §262 – There are no deductions for personal or living expenses. 11 §263 – No deductions are allowed for payments for new buildings, capital improvements, or for replacements of the property. (1) Repairs are deductible for business expenses; replacements, appreciations of the value of property, and acquisition of capital are capital improvements. iii) Midland Empire Packing Co. v. Commissioner US Tax Court 1950 (Arundell) (1) A meat packing company had to oil-proof its basement after oil started leaking into it. They then tried to deduct the cost of oil-proofing as a business expense and not a capital improvement. (2) The court held that the expenditure did not add value or prolong the expected life of the property over what they were before the event occurred which made the repairs necessary. iv) Rule: Generally, capitalization is required for an amount paid to acquire, create, or enhance an intangible asset, an amount paid to facilitate an acquisition or creation of an intangible, and an amount paid to facilitate a restructuring of a business entity or a transaction involving capital, stock issuance, borrowing, or recapitalization. e) Travel Away from Home i) §162(a)(2) – There shall be allowed a deduction for ordinary and necessary business expenses for traveling expenses, as long as the assignment is less than one year. ii) Reg §1.162-2(b)(1) – Travel that is part personal and part business is deductible if primarily for business. If primarily personal, the business expenses at the location are deductible even if the travel there is not. iii) §274(d) – Travel for entertainment is not deductible, nor are gifts, that are done for only personal trips. iv) §274(n) – When meals or entertainment are deductible as part of a business trip, only 50% of the costs are deductible. v) Rule – Commuting costs from a home to a business is non-deductible, (Reg. §1.162-2(e)) unless it is to a temporary work location outside the taxpayer’s metropolitan area or to multiple temporary work locations located anywhere, in which case it is deductible. (Rev. Rul. 190; Rev. Rul. 90-23) vi) Rule – Commuting costs from one business cite to another business cite are deducible. If the taxpayer goes home from the second business cite, he can only deduct the excess of the distance from the cite to home than from his regular business location to home. (Rev. Rul. 55-109) vii) Rule – When away from home for business, lodging, travel, and 50% of meals are deductible, but meals are only deductible when the taxpayer must sleep or rest in the other city. viii) Rosenspan v. United States US 2nd Circuit Court of Appeals 1971 (Friendly) (1) Rule: To qualify as being away from home, the taxpayer must have a home to be away from. ix) Andrews v. Commissioner US 1st Circuit Court of Appeals 1991 (Campbell) (1) Andrews had two residences and worked in two different cities part time. (2) Rule: A taxpayer can only have one home. Problems -Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch in various restaurants in City. (a) May Commuter deduct his costs of transportation and/or meals? No. (See Reg. §1.162-2(e)) (b) Same as (a) but Commuter is an attorney and often must travel between his office and City Court House to file papers, try cases, etc. May Commuter deduct all or any of his costs of transportation and meals? He can deduct his transportation expenses to and from the courthouse and his office, but not his meals. (See Rev. Rul. 55-109) (c)Commuter resides and works in City, but occasionally must fly to Other City on business for his employer. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or part of his costs? He can deduct his travel costs, but not his meal expenses. -Taxpayer lives with her husband and children in City and works there. (a) If her employer sends her to Metro on business for two days and one night each week and if Taxpayer is not reimbursed for her expenses, what may she deduct? Taxpayer may deduct her travel, hotel, and meal expenses in Metro. (b) Same as (a) except that she works three days and spends two nights each week in Metro and maintains an apartment there. The travel and meal expenses in Metro are deductible, along with the apartment upkeep if it is a rental. (c) Taxpayer and Husband own a home in City and Husband works there. Taxpayer works in Metro, maintaining an apartment there, and travels to City each weekend to visit her husband and family. What may she deduct? She cannot deduct any of her travel and meal because the trips are personal and not related to business. -Temporary works for Employer in City where Temporary and his family live. (a) Employer has trouble in Branch City office in another state. She asks Temporary to supervise the Branch City office for nine months. Temporary’s family stays in City and he rents an apartment in Branch City. Are Temporary’s expenses in Branch City deductible? Yes, the are deductible because it is a temporary assignment less than one year. (b) What result in (a) if the time period is expected to be nine months, but after eight months it is extended to fifteen months? The expenses are deductible until the extension makes it clear that the assignment will be more than one year, after which the extra seven months are not deductible. ii) 12 (c) What result in (a) if Temporary and his family had lived in a furnished apartment in City and he and family gave the apartment up and moved to Branch City where they lived in a furnished apartment for the nine months? The expenses are not deductible because they are duplicating costs; but in some courts it is deductible because the tax home can be the principle place of business. f) Travel and Entertainment Expenses: Limitations i) §162(a)(2) – There shall be allowed a deduction for ordinary and necessary business expenses for traveling expenses, as long as the assignment is less than one year. ii) §274(a) – No deductions for entertainment unless the conduct is directly related to or associated with trade or business, but there are no deductions for club membership, for buying skyboxes or luxury box seats, or for facilities that entertainment occurs at. iii) §274(c) – Travel outside the US is not deductible unless it is less than a week or less than 25% of the business travel. iv) §274(d) – Travel for entertainment is not deductible, nor are gifts that are done for only personal trips. If entertainment is going to be deducted, the business must show the amount of the expense, the time and place it was incurred, the business purpose for the expense, and the business relationship to the taxpayer of the persons entertained. v) §274(e) – Food for employees is deductible. vi) §274(h) – Conventions held outside the US are not deductible unless the secretary finds the foreign location reasonable. Cruise conventions generally are not deductible. No deductions under §212 for conventions. vii) §274(l) – Deductions for entertainment tickets are only allowed for face value (not scalped prices). viii) §274(m) – No deduction is allowed for a spouse unless the travel of the spouse is for a bona fide business purpose (Spouses coming along are considered necessary business purposes). ix) §274(n) – When meals or entertainment are deductible as part of a business trip, only 50% of the costs are deductible. g) Recovery of Capital Expenditures: Depreciation and Amortization i) §167(a) – Depreciation deductions are allowed for business or income producing property. ii) §168(b)(1) – Depreciation is 200% declining and then straight line when straight line is higher. After 2008, during the first year the taxpayer is allowed to expense a bonus of half the remaining basis during the first year. iii) §168(b)(2) – With 15-year, 20-year, or farm property, use 150% declining instead of 200%. iv) §168(b)(3) – For non-residential real property, residential rentals, or railroad grading, always use straight line depreciations. v) §168(b)(4) – Salvage value is disregarded completely in calculating depreciation. vi) §168(d) – Convention is half-year, unless it is nonresidential real property, residential rentals, or railroad grading, in which case it is mid-month. Convention is when the code considers you bought the property, regardless of when you actually bought the property. vii) §168(e)(2)(A) – Residential rental includes any property where 80% or more of the property is rented, other than hotels, motels, etc. It has a 27.5 year life. viii) §168(e)(2)(B) – Nonresidential real property is everything but property less than 27.5 years or residential rental. It has a 39 year life. ix) §168(e)(3)(A) – 3-year property is a 2-year old race horse or a 12 year old horse. x) §168(e)(3)(B) – 5-year property is a car, semi-conductor manufacturing equipment, phone switching equipment, and other technological and R&D equipment. xi) §168(e)(3)(C) – 7-year property is a railroad track, motorsports complex, Alaska pipeline, natural gas line, and other non-class life property. xii) §168(e)(3)(D) – 10-year property is agricultural structures and trees and vines. xiii) §168(e)(3)(E) – 15-year property is wastewater treatment plants, phone distribution plants and motor fuel outlets. xiv) §168(f) – Depreciation isn’t included for taxpayer excluded property, film, videos, and sound. xv) §179 – An automatic deduction of up to $125,000 for §179 property can automatically be deducted before considering depreciation. §179 property is tangible property or software, but not land or used property. The deduction is taken per taxpayer, not per property. After 2007, the number is $250,000. xvi) §197 – There is an amortization deduction over 15 years for §197 intangibles. A §197 intangible is goodwill, going concern value, workforce, business records, patent, copyrights, government licenses, covenants not to compete, and trademarks. §197 doesn’t include financial interests, land, software, interests in books or media, interest, mortgage, and transaction costs. Problems -On January 2 of the current year for $300,000 Depreciator purchases new equipment for use in her business. The purchase is made from an unrelated person. The equipment has a 6-year class life and is 5-year property under §168(c). Depreciator plans to use the equipment for seven years, and expects it to have a salvage value of $30,000 at the end of that time. Depreciator is a single, calendar year taxpayer, and she uses the equipment only in her 13 business. In the following problems compute the depreciation deductions with respect to the equipment in each year of its use and Depreciator’s adjusted basis for the property each year. (a) Depreciator elects under §168(b)(5) to use the straight-line method for the equipment and all other property in its class placed in service during the year. Year Annual Depreciation Adjusted Basis 1 $30,000 $270,000 2 $60,000 $210,000 3 $60,000 $150,000 4 $60,000 $90,000 5 $60,000 $30,000 6 $30,000 $0 (b)Depreciator uses the accelerated ACRS method provided by §168(a). Year Annual Depreciation Adjusted Basis 1 $60,000 $240,000 2 $96,000 $144,000 3 $57,600 $86,400 4 $34,560 $51,840 5 $34,560 $17,280 6 $17,280 $0 (c) Same as (b), except that Depreciator disposes of the equipment on December 1 of year five. Year Annual Depreciation Adjusted Basis 1 $60,000 $240,000 2 $96,000 $144,000 3 $57,600 $86,400 4 $34,560 $51,840 5 $17,280 $34,560 (d) What differences from (b) if Depreciator also elects to use §179? Assume there is no post-2002 inflation. What additional facts do you need to know? We would need to know if Depreciator had any other property that she had bought and use §179 with. Assuming none, though she would deduct $250,000 automatically. After that… Year Annual Depreciation Adjusted Basis 1 $10,000 $40,000 2 $16,000 $24,000 3 $9,600 $14,400 4 $5,760 $8,640 5 $5,760 $2,880 6 $2,880 $0 -During the current year, Depreciator purchases a piece of new improved real property at a cost of $130,000 of which $100,000 is attributable to the building and $30,000 to the land. Depreciator immediately rents the property to others. Compute Depreciator’s deprecation in the subsequent year in the following situations: (a) The building is an apartment building. $100,000/27.5 = $3,636.36 (b) The building is an office building. $100,000/39 = $2,564.10 h) Business Losses i) §165 – Losses allow for deductions if not covered by insurance, limited to losses incurred in a trade, business, profit-making enterprise, or loss from fire, storm, shipwreck, casualty, or theft. Loss from wagering are only allowed to offset gains from wagering. If property is sold, tax is prorated to buyer and seller as to that part of the year which they owned the property. ii) Reg. §1.165-7(b)(1) – The amount of loss taken into account for §165 shall be the lesser of either the fair market value of the property immediately before the casualty reduced from the fair market value of the property immediately after the casualty, or the adjusted basis from the sale or other disposition of the property. Problem -Taxpayer has an automobile used exclusively in Taxpayer’s business which was purchased for $40,000 and, as a result of depreciation deductions, has an adjusted basis of $22,000. When the automobile was worth $30,000, it was totally destroyed in an accident and Taxpayer received $15,000 of insurance proceeds. (a) What is Taxpayer’s deductible loss under §165? $30,000-$0 = $30,000. Adjusted basis is $22,000. The lesser is the adjusted basis, so $22,000-$15,000=$7,000 is the deductible loss. (b) What result in (a) if the automobile had not been totally destroyed but was worth $10,000 after the accident? $30,000-$10,000 = $20,000. Adjusted basis is $22,000. The lesser is $20,000, so $20,000-$15,000=$5,000 is the deductible loss. (c) What is the Taxpayer’s adjusted basis in the automobile in (b) if Taxpayer incurs $17,000 repairing the automobile? $22,000 (basis) - $15,000 (insurance) - $5,000 (loss) + $17,000 (repair) = $19,000 14 Deductions for Profit-Making Non-business Activities: §212 i) §212 – For individuals, there is a deduction for income production and collection, property management, and tax expenses, except that there are no deductions allowed for conventions, seminars, or similar meetings. Problem -Speculator buys 100 shares of Sound Company stock for $3,000, paying her broker a commission of $50 on the purchase. Fourteen months later she sells the shares for $4,000 paying a commission of $60 on the sale. (a) She would like to treat $110 paid as commissions as §212 expenses. Why? Can she? She would like to because it would allow her to deduct the $50 immediately, but she can’t because commissions are not deductible unless you’re a regular dealer. Otherwise they are capital expenses that are only deductible upon the sale of the stock. (b) What result in (a) if instead she sells the shares for $2,500 paying a $45 commission on the sale? There is a $595 loss on the sale ($500 from the loss in value and $95 from the commissions). (c)Speculator owned only one-tenth of one percent of the Sound Company stock but, being an eager investor during the time she owned the stock, she incurred $500 of transportation, meals, and lodging expenses in traveling 1,000 miles to New York City to attend Sound’s annual shareholder meeting. May she deduct her costs under §212(2)? No, because these are not ordinary and necessary expenses for a .1% shareholder. (d) What result in (c) if instead Speculator owned 10% of the total outstanding Sound stock, worth $300,000? The costs would be deductible as ordinary and necessary for the management of property held for income. j) Taxes i) §164 – State and local property and excess profit taxes are deductible, along with the GST tax and environmental tax. Sales taxes are deductible, even if they don’t apply to all items, and long as it applies to a broad range of items and not just one item. ii) §275 – Federal income taxes are not deductible. iii) §1001(b)(1) – If someone reimburses you for the taxes you owe, it doesn’t count for the amount realized on a capital sale. Problem -Which of the following taxes would be deductible as such under §164? (a) A state sales tax imposed at a single rate on sellers but required to be separately stated and paid by purchasers to sellers, applicable to retail sales of any property except food, clothing, and medicine. This is deductible under §164(b)(5). (b) A state real property tax of $1,000 for which A became liable as owner of Blackacre on January 1st but which B agreed to pay half of when he acquired Blackacre from A on July 1st. $500 is deductible for A and $500 is deductible for B under §164(d)(1). (c) A state income tax. This is deductible under §164(a)(3). (d) The federal income tax. This is not deductible under §275. (e) A state gasoline tax imposed on consumers. This is not deductible under §164(b)(5)(D) because it is a sales tax but not on a wide range of items. k) Restrictions on Deductions: Hobbies, Illegal Payments; At Risk Limitation i) §183 – Unless otherwise provided, unless an activity is for profit, there are only deductions for that activity equal to the profit made (Hobby-loss rule). Activity not for profit is everything not covered by §162 or §212. If gross income exceeds deductions 3 out of 5 years, it is for profit, unless it is for horses. ii) §162(c) – There are no deductions for bribes, kickbacks, and other illegal payments. iii) §465 – Any loss from the amount of money and adjusted basis contributed to an activity is limited to that amount contributed, and not by anything else that is secured for debts. Mortgages secured by property are considered contributed. The amount you are at risk for is the cash you put in, the basis you put in, and debts either personally secured or secured by personal property. Nonrecourse financing is not at risk, unless it is secured by the activity and the activity is holding real property. iv) Tax Shelters (1) Deferral – Allows the taxpayer to buy an investment before counting the money used for the investment as income. (2) Leverage – Allows the taxpayer to borrow money at a cheaper rate than what they would be allowed to deduct for taxes, in essence making a profit. (3) Conversion – Allows the taxpayer to get an investment and get taxed on it at a lower rate than at the person’s normal income tax rate. Problems -Discuss the extent to which §465 limits Taxpayer’s loss deductions, generates recapture income out of a previously allowed loss deductions, or allows the use of a loss carryover in the following situations: (a) Taxpayer purchased a farm for $50,000 cash and his personal note for $400,000 secured by a mortgage. In the first two years of operation he put in an additional $50,000 each year, by way of cash and personal loans, for feed, fertilizer and other supplies; but things did not go well. In the first year of operations his loss was $80,000 and he had another $80,000 loss in the second year of operations. No principal was paid on the liability in either year. He may i) 15 claim the $80,000 loss in both years because he is put in for $500,000 in year one (based on the secured mortgage), and an extra $50,000 in year two. (b) The facts are the same as in (a) except that the farm was acquired for $50,000 cash and $400,000 of nonrecourse financing. He may claim $80,000 loss in year one because he had $100,000 invested, but can only claim $70,000 in year two because of the $50,000 invested plus $20,000 carryover. -Steve Smith is a wealthy investor with dividend income of $200,000 a year. He also is a sculptor but not a very successful one. He incurs expenses in connection with artistic endeavors and occasionally sells some of his works. His net income or loss from sculpting for the past several years is as follows: 2004 – (400) 2005 – 1,300 2006 – (23,000) 2007 – 125 2008 – (14,000) (a) To what extent may Steve deduct the expenses of his artistic activities during the years 2004-2008? More specifically, is Steve engaged in an activity for profit? Will he get the benefit of the §183(d) presumption? Most likely he cannot deduct the expenses of his activities because it will be presumed to be not for profit since only two of the five years were profitable. (b) Suppose that in 2008, it is clear that Steve was not engaged in an activity for profit. His income from the sale of art works in 2008 was $1,300 and his expenses were: Interest on loan to buy equipment for art studio - $600 Art supplies - $300 Rent for art studio - $1,000 Travel - $700 What can Steve deduct? He made $1,300, so under §183(b) he can deduct $1,300 from the expenses above. l) Passive Loss Limitation i) §469 – No loss for passive activity. Any loss from a passive activity is a deduction or a credit for that activity next year. Passive activity is that which involved conduct of trade or business in which the taxpayer doesn’t materially participate including rental activity, unless the taxpayer is involved in real estate. ii) §469(f) – If a passive activity becomes an active activity, past losses from the passive activity can be counted toward the now active activity. iii) §469(g) – If a taxpayer disposes of his interests in his passive activity, any remaining loss can be counted as a regular loss. If an interest in a passive activity is transferred because of death, the loss must be factored against any basis change. iv) §469(h) – Material participation is that which is regular, continuous, and substantial, not including limited partnerships. v) §469(i) – No passive activity loss for rental activity the taxpayer actively participated in, up to $25,000, unless adjusted gross income is over $100,000, in which case the $25,000 is reduced by half of the amount over $100,000 the gross income is. No active participation for rentals if it is less than 10% of all interest in the activity. vi) §469(j) – If a passive activity is passed by gift, the basis must be adjusted up by the amount of the loss. vii) Reg. §1.469-5T – Material participation includes more than 500 hours of work, more than 100 hours of work and not less than any other individual, or if the taxpayer’s significant participation activities exceed 500 hours. viii) Appropriate Economic Unit Test – To determine if two activities are similar enough to count as active activity, four factors are considered: businesses are similar, there is common control, there is common ownership, and the geographical locations of the businesses. Typically the code allows the taxpayer to choose whether to put a new activity in an active or passive in the beginning, as long as there is support for the decision, although they won’t be able to change it later. Problems -Lawyer earns $200,000 of taxable income from her practice in the current year. Discuss the extent to which the following transactions affect her taxable income in the current year. (a) Lawyer also has $10,000 of dividends and interest in the year. She invests as a limited partner in a partnership that films and distributes movies. Her share in the partnership’s movie losses for the year is $50,000. Her net income is $210,000. She has a passive activity loss of $50,000. (b) Same as (a) except that Lawyer also has a $30,000 gain from her limited partnership investment in a windmill power tax shelter. Her net income is $210,000. She now has a passive activity loss of $20,000. (c) Same as (a) except that in the succeeding year the movie limited partnership makes a gain of $90,000 as a result of a successful movie, “Alligator Allee.” In year one she has $210,000 in net income with a $50,000 passive activity loss. Then next year she will have $240,000 in net income with no passive activity loss. (d) Same as (a) except that Lawyer sells her movie limited partnership interest at the beginning of the succeeding year at a gain. The following year she will have $150,000 in income. 16 -(a) In the current year Grocer purchases a grocery store and spends 35 hours per week operating it to the exclusion of all other business and investment activities. Grocer’s loss from the grocery store business is $50,000. How much of his loss is deductible? 35 * 52 = 1,820 of hours per week. This would qualify his participation as active and so he can deduct the full $50,000 in losses. (b) Same as (a) except Grocer is only irregularly involved in the operation of the grocery store. Intermittently, Grocer makes significant management decisions. His participation is only passive and therefore he has no regular losses. He will have to include the $50,000 as passive activity losses. (c) Same as (a) except that Grocer who is retired purchases the grocery store and hires a manager who has carte blanche power to make all business decisions. His participation is only passive and therefore he has no regular losses. He will have to include the $50,000 as passive activity losses. (d) Grocer, upset with the $50,000 loss in (c) fires manager at the end of the year and in the succeeding year, Grocer manages the store on a full-time basis and in that year makes a $60,000 profit. What tax consequences to Grocer for the succeeding year? His participation has changed from passive to active. This allows the passive activity loss from the same activity to carry over with the activity, and so he only needs to recognize $10,000 of gain this year. See §469(f)(1). -Julia owns and runs a catering business which is profitable in Town X. She opens a new catering business in Town Y which is essentially run by her staff in Town Y, although Julia makes management decisions for the business. Julia also has a limited partnership interest in a real estate limited partnership that currently generates losses and expects to do so for the next several years. Julia asks you to advise her how to treat her Town Y catering business under the passive activity rules. Under the appropriate economic unit test, she has the option here to choose to make the new business either active or passive. Because she already has passive losses, however, she probably wants to make the new business passive to offset the new gains with those losses. m) Moving Expenses i) §132(g) – When an employer pays for an employee to move for work, it is excludable. ii) §217 – Deductions are allowed for moving expenses if moving for work, including moving the stuff and the lodging while moving, but not meals, as long as the move in business is over 50 miles and the employee becomes a full-time employee. n) Medical Deductions i) §213 – Medical expenses can be deducted for the amount that they exceed 7.5% of adjusted gross income, including health insurance. If for drugs, amount excluded only includes prescriptions and insulin. Medical costs include treatment, transportation to and from medical care, long-term care, and insurance. ii) Reg. §1.213-1 – If the medical expenses are incurred by not paid during the taxable year, no deduction for such expenses shall be allowed for such year. iii) Raymon Gerard v. Commissioner US Tax Court 1962 (Mulroney) (1) Rule: When the medical care expenditure is for a permanent addition to the taxpayer’s home, the amount in excess of value enhancement is deductible as medical expense. Problem -Divorced Homeowner, who received neither alimony nor other support payments from her former husband, fully supported her 20 year old Daughter who had no income, lived with Homeowner and was a dependent of Homeowner under §152(d). In the current year, Homeowner installed a central air conditioning system at a cost of $4,100, which Dr. Watson said was an elementary requirement in caring for Daughter’s respiratory problems. After installation, Homeowner’s home had increased in value by $2,100. Other medical expenses paid during the year by Homeowner and Daughter consisted of prescription medicine in the amount of $320 and doctors’ bills in the amount of $400. Late in the year, she also paid $300 in premiums for health insurance but received no reimbursements under the policy that year. (a) If Homeowner’s adjusted gross income is $12,000 for the year, what will be the amount of her medical expense deduction? 7.5% of $12,000 is $900. The medical expenses are $2,000 for the air system, $320 for the medicine, $400 for the doctor, and $300 for premiums, equaling $3,020. The deduction therefore will be $3,020-$900 = $2,120. (b) Would it make better sense and, if so, be possible under the present statute to allow a deduction of $400 per year for the air conditioning expenditure, assuming the system has a 5-year life? It might make a little more sense for the Service, but not for the taxpayer, and regardless is not possible because depreciation like that is only allowed for income producing activities. (c) If in the current year Homeowner incurs maintenance expenses of $300 on the air conditioning system can that be taken into account as a medical expense? Would a $150 deduction for those expenses be more supportable assuming, of course, Daughter is still there and still asthmatic? And what about an estimate that $400 of the year’s electricity bill is attributable to running the air conditioning system? The full $300 is deductible as a medical expense because it is necessary for the maintenance of the medical purpose of the system. The $400 of electricity is also deductible as necessary for the maintenance of the medical purpose of the system. 5) Year of Inclusion or Deduction a) Fundamental Timing Principles i) §441 – Taxable year is the annual accounting period or the calendar year. The taxable year is the calendar year if there are no books, no declared accounting period, or the period isn’t 12 months. 17 ii) §442 – If the taxpayer changes their accounting period, it must be approved by the secretary. iii) §446 – The taxpayer accrues income on any accounting method as he or the secretary chooses from cash receipts method, the accrual method, or any method or combo approved by the secretary. A taxpayer can use different methods for different lines of business. To change methods, the secretary must consent. Under the accrual method, you receive the income in which all events have occurred which establish the right to the income, and you can deduct when all events have occurred which establish requirement to pay. iv) §451 – Unless otherwise elected, the amount included in gross income includes all amounts received by the taxpayer for that year. v) §461 – If the taxpayer transfers money to contest an asserted liability, and but for the transfer a deduction would be allowed, the deduction is allowed in the year of the transfer. Services and property are deducted when rendered or provided. Prepayments must be spread as if they were not prepaid, but late payments count only when they are actually or constructively paid. vi) Charles F. Kahler v. Commissioner US Tax Court 1952 (Rice) (1) Rule: It is immaterial that delivery of a check is made too late in the taxable year for the check to be cashed in that year. vii) Williams v. Commissioner US Tax Court 1957 (1) Rule: A note received only as security, or as an evidence of indebtedness, and not as payment, may not be regarded as income at the time of receipt. (2) Rule: Income is counted only when received through cash or a cash equivalent. viii) Horung v. Commissioner US Tax Court 1967 (Hoyt) (1) Rule: If items are constructively received when earned they can’t be treated as income in any later year. (2) Rule: Constructive receipt is when they person has unfettered control. ix) Commissioner v. Boylston Market Ass’n US 1st Circuit Court of Appeals 1942 (Mahoney) (1) Rule: Prepayments are all gross income in the year in which they are received, but they are deducted throughout the lifetime that the item or service being paid lasted. x) New Capital Hotel, Inc. v. Commissioner US Tax Court 1957 (Black) (1) Rule: Under the accrual method, a prepayment is included in income in the year for which the prepayment is received and not when it is due. xi) Artnell Co. v. Commissioner US 7th Circuit Court of Appeals 1968 (Fairchild) (1) Rule: There are a few rare situations where the deferral technique will so clearly reflect income that the prepayments can be included in the year which they’d match up to, like prepayments for sporting events. Problems -Lender lends out money at a legal interest rate to Debtor. Debtor is required to pay $5,000 interest each year on the loan which extends over a five year period. The interest is deductible by Debtor under §163. The agreement calls for payment of each year’s interest on December 31 of the year. Both parties are calendar year, cash method taxpayers. Discuss the tax consequences to both parties under the following alternatives: (a) Debtor mails a check for $5,000 interest to Lender on December 31 of year one. It is delivered to Lender on January 2 of year two. Debtor may deduct the payment in year one and Lender must include the payment in gross income in year two. (b) Debtor mails the check in (a) on December 30 of year one. It is delivered to Lender on December 31 of year one but after the banks are closed. Debtor may deduct the payment in year one and Lender must include the payment in gross income in year one. (c) Debtor pays all five years’ interest ($25,000) to Lender in cash on December 31 of year one. Debtor deducts $5,000 every year for five years, but Lender must include $25,000 in gross income in year one. (d) Same as (c) but Debtor does so because Lender makes it a condition of extending Debtor another loan. Debtor deducts $5,000 every year for five years, but Lender must include $25,000 in gross income in year one. (e) Debtor pays year one’s $5,000 interest in cash on January 2nd of year two and, as agreed, pays year two’s interest on December 31 of year two. Debtor may deduct $10,000 in year two and Lender must include the payments in gross income in year two. (f) Debtor offers to pay Lender the $5,000 interest due on December 31 of year one but Lender suggests that Debtor pay it on January 2nd of year two, which Debtor does. Debtor deducts $5,000 in year two, but Lender must include the $5,000 in gross income in year one. (g) Debtor gives Lender a promissory not on December 31 of year one agreeing to pay year one’s interest plus $50 on January 30 of year two. Debtor pays off the note on January 30 of year two. Debtor deducts $5,050 on year two and Lender must include the $5,050 in gross income in year two. -Lawyer renders services to Client which are deductible to Client under I.R.C. §162. Lawyer sends Client a bill for $1,000 on December 24 of year one and Client pays the bill on January 5 of year two. Discuss the tax consequences to Lawyer and Client assuming, even if unlikely, that both are calendar year, accrual method taxpayers. Client may deduct the $1,000 in year one and Lawyer must include the $1,000 in gross income for year one. 18 -Lender lends out money at a legal rate to Debtor. Debtor is required to pay $5,000 interest each year on the loan which extends over a five year period. The interest is deductible by Debtor under §163. The agreement calls for payment of each year’s interest on December 31 of the year. The loan is made on January 1st of year one. Both parties are calendar year, accrual method taxpayers. Discuss the tax consequences to both parties under the following alternatives: (a) Debtor pays all five years’ interest ($25,000) to Lender in cash on December 31 of year one. Debtor deducts $5,000 every year for five years, and Lender must include $25,000 of gross income in year one. (b) Debtor pays the first two years’ interest ($10,000) to Lender in cash on December 31 of year one. Debtor deducts $5,000 for years one and two, and Lender must include $10,000 of gross income in year one. (c) Debtor pays year one’s $5,000 of interest in cash on January 2nd of year two. Debtor deducts $5,000 for year one and Lender must include $5,000 of gross income in year one. (d) On December 31 of year one Debtor who is having “serious financial trouble” fails to pay Lender. Debtor deducts $5,000 for year one and Lender must include $5,000 of gross income in year one, so long as it looks like Debtor will eventually pay Lender. (e) On December 31 of year one Debtor does not pay the interest because of a legitimate dispute over Debtor’s obligation to pay the first year’s interest. Debtor cannot deduct the interest payments until he actually pays for them and Lender must include it in gross income whenever he receives the payment. (f) On December 15 of year one Debtor legitimately disputes the obligation to pay year one’s interest but Debtor does pay it and, in year two, sues to recover it. Debtor deducts the $5,000 for year one and Lender must include the $5,000 in gross income for year one. 6) The Characterization of Income and Deductions a) Capital Gains and Losses: Introduction, Mechanics and Policy i) A capital gain or loss only occurs after the sale or exchange of a capital asset. ii) A long-term capital asset is held for more than one year. iii) When determining capital gains or losses, we net all of the long-term and short-term capital gains/losses. After determining the long-term and short-term totals, if there is a gain in one and a loss in the other, we net them against each other. iv) §1222(11) – Net capital gain means the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year. If there is excess short-term capital gain, then it is taxed at the normal income. v) §1(h) – Total income minus net capital gain is taxed at the normal rate. Then, the different components of net capital gain are taxed at different rates. The amount taxed at each rate is determined by netting the same categories together, and then taking any leftover loss to cancel out the highest rates first. (1) 28% Rate – Applies to sales or exchanges of “collectables” held for more than one year, and §1202 gains, which is met when your stock meets certain size requirements. §1202 then allows your company to not pay tax on half the stock, and then the other half is taxed at 28%. (2) 25% Rate – Applies to unrecaptured §1250 gains, which is basically depreciable real property. (3) 15% Rate – Applies to sales or exchanges of capital assets held for more than one year that aren’t captured in the 28% or 25% rates, like stocks, bonds, and investment land. (4) 10%/15% Rate – Applies when the taxpayer’s normal rate is not higher than 10% or 15%, at which point the capital gain is just taxed at the rate the normal income is taxed. (5) 5%/0% Rate – Applies to taxpayers in the 10% or 15% bracket who would otherwise be taxed at 15% capital gain rate. vi) §1211(b), §1212(b) – The maximum a taxpayer can reduce taxable income with capital losses are $3,000. The rest is carried over to the next year. The short-term losses count to the limit before the longterm losses if both are losses. vii) If the taxpayer has net short-term capital gain, it is all taxed at the normal income rate, but if the taxpayer has net short-term capital loss, the taxpayer can only deduct up to $3,000 of it per year. Problems -T, a single taxpayer, has a salary of $50,000 in the current year. T also has the following transactions all involving the sale of capital assets: (1) a gain of $15,000 on a “collectible” held for 2 years; and (2) a gain of $20,000 on stock held for 15 months. (a) Determine the amount of T’s net capital gain. $35,000 NCG. (b) At what rate will the components of T’s net capital gain be taxed? $15,000 at 28% and $20,000 at 15%. (c) Assuming there is a flat 30% tax on ordinary income and disregarding any deductions (including the standard deduction and personal exemption), what is T’s tax liability in the current year? .3 * $50,000 = $15,000; .28 * $15,000 = $4,200; .15 * $20,000 = $3,000. $15,000 + $4,200 + $3,000 = $22,200. -Taxpayer who is the highest federal tax bracket in the current year, has a $5,000 gain from a collectible and a $5,000 gain from stock, both held long-term. (a) What is Taxpayer’s net capital gain and how is it taxed if taxpayer also has a $5,000 loss from a collectible held long-term? Taxpayer will have a $5,000 NCG taxed at 15% because the $5,000 gain from collectible is cancelled out by the $5,000 loss from collectible. 19 (b) What results in (a) if instead Taxpayer’s $5,000 loss is from stock held long-term? Taxpayer will have a $5,000 NCG taxed at 28% because the $5,000 gain from stock will be cancelled out by the $5,000 loss from stock. (c) What results in (a) if instead Taxpayer’s $5,000 loss is from stock held for 9 months rather than from the collectible? Taxpayer will have a $5,000 NCG taxed at 15% because the $5,000 gain from a long-term collectible is cancelled out by the $5,000 short-term loss. (d) What is Taxpayer’s net capital gain and how is it taxed if Taxpayer has a $5,000 gain from a collectible, a $5,000 unrecaptured §1250 gain, a $5,000 gain from stock, and a $10,000 loss from stock, all held long-term? Taxpayer has $5,000 NCG taxed at 25%, because the $10,000 loss from stock first cancels out the $5,000 gain from stock, and then goes to the highest tax bracket to cancel, which would be the $5,000 gain from a collectible. -Here are two questions on capital losses incurred in the current year. The figure for taxable income given in Column A reflects a single taxpayer’s taxable income for each of two years without regard to his capital gains and losses. Note that in computing gross income (as adjusted) on the return no gains will be included, since capital losses exceed capital gains and the §1211(b) excess amount will be a reduction. Taxable Income LTCG LTCL STCG STCL 1. $10,000 $2,000 $6,000 $2,600 $1,000 2. $10,000 $2,000 $10,000 $2,000 $4,000 For each year separately, without regard to computations for other years, determine the amount of the taxpayer’s capital loss that is allowed as a deduction from ordinary income under §1211(b)(1) or (2) and the amount and character of his capital loss carryover, if any, under §1212(b). Year 1 – Taxpayer has $4,000 NLTCL and $1,600 NSTCG. Taxpayer thus has $7,600 of taxable income. Year 2 – Taxpayer has $8,000 NLTCL and $2,000 NSTCL. Taxpayer thus has $7,000 of taxable income and a carryover of $7,000 LTCL. b) Income and Deduction Preferences i) For income, long-term capital gains are the best, then short-term capital gains, then ordinary income. ii) For deductions, ordinary loss is the best, and then capital losses. c) The Meaning of Capital Asset i) §1221(a) – A capital asset is property held by the taxpayer (whether or not connected with his trade or business), except: (1) Stock in trade of the taxpayer that would be included in inventory or for the sale to customers. (2) Property used in trade or business that allows for depreciation, or real property used in your trade or business. (3) Copyrights, literary compositions, artistic compositions, letters of memorandum held by a taxpayer whose personal efforts created the property or for whom the letter of memorandum was prepared for. (4) Accounts or notes receivable acquired in normal business in the sale of property described in paragraph (1). (5) A publication of the US Government held by a taxpayer who received the publication. (6) Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer. ii) §1221(b)(3) – At the election of the taxpayer, paragraphs (1) and (3) of subsection (a) shall not apply to musical compositions or copyrights in musical works sold or exchanged by a taxpayer described in subsection (a)(3). iii) §1235 – A transfer of a patent other than a gift, inheritance, or devise, is the sale or exchange of a capital asset held for more than one year. iv) Rule: A taxpayer can’t convert ordinary income into capital gains by selling the rights to the ordinary income (eg. By selling the right to a paycheck) v) Mauldin v. Commissioner US 10th Circuit Court of Appeals 1952 (Murrah) (1) Mauldin bought property for cattle, but later decided against doing cattle. He decided to hold the property, which eventually became valuable. He then sold it over a number of years. (2) Rule: There are a number of helpful factors to point the way, among which are the purposes for which the property was acquired, whether for sale or investment; and continuity and frequency of sales as opposed to isolated transactions. (3) Rule: While the purpose for which the property was acquired is of some weight, the ultimate question is the purpose for which it was held. (4) The court held that this was ordinary income because he held the property for sale and not for business. Problems -Robert Plack is a successful San Francisco oral surgeon. He works 40 hours a week in his dental practice and also has an interest in real estate investments. During the late 1990’s, Dr. Plack purchased 20 parcels of undeveloped real estate in the Santa Rosa area. He acquired the properties anticipating that they would appreciate in value and intended to resell them when he could make a profit. From 2005 to 2008, Dr. Plack has sold 15 parcels at profits ranging from $30,000 to $60,000 per parcel. During each of these years, his real estate profits represented 40% of his gross income. 20 (a) Based on the above facts, are Dr. Plack’s profits taxable as ordinary income or capital gain? What additional facts do you need? These are probably capital gains, assuming this is his only real estate, and he just held the property without doing anything to it. (b) What if Dr. Plack had purchased one 20 acre parcel with the intention of subdividing and developing the property? He later obtained approval for a subdivision and sold off 40 half-acre parcels of home sites? These facts show that he hold real estate as a regular act and thus it is probably ordinary income. (c) Same as (b) except that Dr. Plack originally intended to buy the 20 acre parcel purely for investment and later decided that the best way to liquidate his investment was through a subdivision? These facts are similar to those of Mauldin v. Commissioner and so this is probably ordinary income. (d) What if Dr. Plack owned five apartment buildings in San Francisco, which he now plans to sell gradually, all at substantial profits? This is probably ordinary income because with five buildings, it looks like he’s a normal apartment owner and derives a regular income from the buildings, and because it is a depreciable/real asset. d) Sale or Exchange i) Sale – An exchange of property for cash, even if involuntary. ii) Exchange – An exchange of property for other property. iii) Insurance – Not a sale or exchange because there is no buyer of the property when it is lost/destroyed. e) Holding Period i) §1223 – Holding period is the period for which the basis is the same for capital assets, including involuntary conversions, even if the property is actually held by other parties. If acquiring property through death, it is considered held for over a year if the original person held it for one year. ii) Rev. Rul. 66-7 – The holding period of a capital asset begins to run on the day following the date of acquisition of the asset involved. iii) Reg. §1.1223-1(i) – When you buy stock at two different times and then sell one block later, the first one you bought is the first one you sell, unless you can identify the block that you’re selling. Problems -Taxpayer, a cash method, calendar year taxpayer, engaged in the following transactions in shares of stock. Consider the amount and character of T’s gain or loss in each transaction: (a) T bought 100 shares of stock on January 15 of year one at a cost of $50 per share. T sold them on January 16 of year two at $60 per share. $1,000 LTCG because the holding period was January 16 through January 16, which is a year. (b) T bought 100 shares of stock on February 28 of year one at a cost of $50 per share. T sold them on February 29 of year two, a leap year, for $60 per share. $1,000 STCG because the holding period was March 1 through February 29, which is less than one year. (c) T bought 100 shares at $50 per share on February 10 of year one and another 100 shares at $50 per share on March 10 of year one. T sold 100 of the shares on February 15 of year two for $60 per share. $1,000 LTCG because the first stock bought is considered to be the first ones sold. (f) T’s father bought 100 shares of stock on January 10 of year one at $30 per share. On March 10 of year one when they were worth $40 per share he gave them to T who sold them on January 15 of year two for $60 per share. $3,000 LTCG because the basis never changed and for purposes of a gift, the holding period of the donor is continued to the donee. See §1223(2). (g) T’s father purchased 1,000 shares of stock for $10 per share several years ago. The stock was worth $50 per share on March 1 of year one, the date of Father’s death. The stock was distributed to T by the executor on January 5 of year two and T sold it for $60 per share on January 15 of year two. $1,000 LTCG. The basis changed at the time of death, but the holding period is considered long-term at death if the property was held long-term before the death. See §1223(9). $1,000 LTCG. The basis changed at the time of death, but the holding period is considered long-term at death if the property was held long-term before the death. It makes no difference for what purpose after death the property was sold. See §1223(9). (h)Same as (g) except that T was executor of T’s father’s estate and as such T sold the stock on January 15 of year two for $60 per share to pay the estate’s administration expenses. f) Sales and Exchanges of Depreciable Property: §1231 and §1239 i) §1231(a) – §1231 gains mean any gain greater than loss on property used in the trade or business. Thus, if there are more gains than losses, both the gains and losses are counted as long-term capital gains and long-term capital losses. If losses exceed gains, the gains and losses are counted as ordinary gains and ordinary losses, unless the conversion is because of fire, storm, shipwreck, other casualty, or from theft, in which case they are calculated first. If there are losses because of fire, storm, etc., they are taken out of the §1231 calculation before the rest of the property is calculated. ii) §1231(b) – Property used in the trade or business is real property or property subject to depreciation allowance, but not inventory stuff normally for sale, copyrights etc., and publications of the government. iii) §1231(c) – If there is any §1231 loss, it is counted as ordinary loss, but for the next five years if there is any §1231 gain, then that gain is ordinary gain up to the amount of the previous §1231 loss. 21 iv) §1239 – Any gain for property sales is ordinary income if the property is subject to depreciation if between related people, which are controlled entities (Over 50% owned businesses or relatives) with the taxpayer, a trust, or an executor. Problems -Hotchpot engaged in (or encountered) the following transactions (or events) in the current year. Determine separately for each part (a) through (e) how the matters indicated will be characterized for the current year, assuming in all parts that §1231(c) is inapplicable. (a) Hotchpot sells some land used in his business for four years for $20,000. It had cost him $10,000. He also receives $16,000 when the State condemns some other land that he had purchased for $18,000 three years ago which he has leased to a third person. He will recognize $8,000 of long-term capital gain. (b) Same as (a) except that both pieces of land were inherited from Hotchpot’s Uncle who died three months before the dispositions. At Uncle’s death, the business land was worth $16,000 and the leased land was worth $18,000. He will recognize $2,000 of long-term capital gain. (c) Hotchpot sells a building used for several years in his business, which he depreciated under the straight-line method. The sale price is $15,000 and the adjusted basis $5,000. His two year old car, used exclusively in business, is totally destroyed in a fire. The car had a $6,000 adjusted basis but was worth $8,000 prior to the fire. He received $4,000 in insurance proceeds. The fire damage is taken out first, so the $2,000 loss from the car is ordinary income. Then the $10,000 gain is capital gain. (d) In addition to the building and the car in (c), assume that Hotchpot had a painting that he had purchased two years ago which was held in connection with his business and which was also destroyed in the fire. The painting had been purchased for $4,000 and he received $8,000 in insurance proceeds. Fire gains exceed losses, so they are carried over to regular §1231 analysis. Therefore there is $12,000 of capital gains. (e) In addition to the building sale, car loss, and painting gain in (c) and (d), assume Hotchpot sells land used for several years in his business for $30,000. The land, which he had hoped contained oil, had been purchased for $50,000. He will have $8,000 of ordinary loss. g) Recapture of Depreciation: §1245 and §1250 i) §1245 – §1245 property is property subject to depreciation. If §1245 property is sold and amount realized is greater than adjusted basis, it is ordinary income up to the point of the original basis after which it is long-term capital gain, but this doesn’t apply to gifts or death related transactions. ii) §1250 – §1250 property is real property subject to depreciation. If §1250 property is disposed, the lower of the additional depreciation or the amount realized is ordinary income, but not for gift or death related transactions. Additional deprecation is depreciation adjustments that exceed current depreciations. Problems -Recap, a calendar year taxpayer, owns a piece of equipment that Recap uses in business. The equipment was purchased in year one for $100,000, is “5-year property” within the meaning of §168(c), and Recap has taken the ACRS deductions on it allowed by §168. Recap did not elect §179. Assume Recap has no net §1231 losses in prior years. (a) What result to Recap if Recap sells the equipment to Buyer in year seven for $30,000? $30,000 ordinary income. (b) What difference in result if Recap had elected to use §179? For year 7, there is no difference and Recap will recognize $30,000 ordinary income. (d) What results in (a) if Recap sells the equipment to Spouse? There are no tax consequences in this transaction because the property hasn’t been disposed of in a sale to Spouse. (e) What result if as a result of a scarcity of equipment Recap is able to sell the equipment to Desperate for $110,000? $100,000 ordinary income and $10,000 of long-term capital gain. (f) What result to Recap in (e), if in addition Recap sold some land used for storage in Recap’s business for $9,000? Recap had owned the land for three years and it had a $20,000 adjusted basis. Recap still has $100,000 of ordinary income from the disposition of the equipment. Now, however, there is $10,000 of §1231 long-term capital gain, and $11,000 of §1231 long-term capital loss. Therefore there is $1,000 of §1231 loss and thus $1,000 of ordinary loss. (g) Same as (f), but the sale price of the land is $15,000? Recap still has $100,000 of ordinary income from the disposition of the equipment. Now, there is $10,000 of §1231 long-term capital gain and $5,000 of §1231 long-term capital loss. Therefore there is $5,000 of long-term capital gain. -To what extent does §1250 apply to real property placed in service after 1986? It only applies to property sold before a holding period of one year. -Taxpayer acquired a parcel of commercial property prior to 1987. Over the years Taxpayer took $90,000 of accelerated depreciation on the building. The depreciation would have been $80,000 under the straight-line method of depreciation. The building has a value of $200,000 and has an adjusted basis of $10,000 and the land beneath it has a value of $300,000 and has an adjusted basis of $50,000. Assume Taxpayer has substantial amounts of other taxable income, all of Taxpayer’s §1231 gains in the year are LTCGs, and Taxpayer has no other capital gains and losses for the year. Discuss the tax consequences to Taxpayer if the building and land are sold for a total price of $500,000. First, separate the land. There is simply a long-term capital gain on the land of $250,000 taxed at 15%. Then, with the building, there is a gain of $190,000. $10,000 of is unrecaptured §1245 gain, $80,000 is unrecaptured 22 §1250 gain, and the rest is regular long-term capital gain. Therefore, he will be taxed at the ordinary rate for $10,000, 25% at $80,000, and 15% for the other $100,000. h) Sale of a Business i) Williams v. McGowan US 2nd Circuit Court of Appeals 1945 (Hand) (1) Rule: If someone sells a business as a sole proprietorship, the assets are sold asset by asset and split up accordingly for tax purposes. (2) Rule: If someone sells a business by selling their ownership stock, the sale is a capital gain/loss for tax purposes. Problems -Merchant who has been in business for four years sells her sole proprietorship consisting of the following assets, all of which, except for the inventory, have been held for more than one year. Adjusted Basis Fair Market Value Inventory $8,000 $16,000 Goodwill (generated by Merchant) $0 $20,000 Land (used in business) $30,000 $20,000 Building (used in business) $15,000 $20,000 Machinery & Equipment (used in business) $12,000 $14,000 Total $65,000 $90,000 Merchant also agrees, for an additional $10,000 that she will not compete in the same geographical area during the succeeding ten years. (a) Disregarding any consideration of §§1245 and 1250, what are the tax consequences to Merchant on her sale of the Business for $100,000? Merchant will have $17,000 of capital gain, and $18,000 of ordinary income. (b)What difference in result if Merchant’s business has always been incorporated, she is the sole shareholder, and she has a $70,000 basis in the stock which she sells for $90,000, assuming that she is again paid an additional $10,000 for her covenant not to compete? $20,000 capital gain and $10,000 ordinary income. i) The Charitable Deduction i) §170(a) – There are deductions for charitable contributions actually paid. ii) §170(b)(1)(A) – Charitable contributions only count up to 50% for churches, educational organizations, medical organizations, organizations which receive a substantial part of their funding from the government, a government unit, and §509(a)(2) and (3) organizations. Any extra is carried over for five years. iii) §170(b)(1)(B) – Charitable contributions count up to 30% of base if one hasn’t donated to (b)(1)(A) charities for private, non-(b)(1)(A) charities. Any extra is carried over for five years. iv) §170(b) – If you donate a mix to (b)(1)(A) and (b)(1)(B), you first deduct the max allowable (b)(1)(A) amount. Then you take what is less, either 30% of the base or 50% of the base minus the (b)(1)(A) donation, and that is deductible. The rest is carried over for five years. v) §170(c) – Charitable contributions are donations to governments, corporations, trusts, foundations, posts for war veterans, fraternities, and cemeteries. vi) §170(d) – If one donates over 50% base, it is carried over to the next year for up to five years. vii) §170(e)(1) – Contributions of property are reduced by the amount of gain which wouldn’t have been longterm capital gain, long-term capital gain on patents, copyrights, etc., if they had been sold normally (look to the amount of the basis). Services are non-deductible under §170. viii) Four issues (1) §170(c) (2) Actually paid (not promised) (3) Amount paid (reduced by §170(e)(1)) (4) §170(b)(1)(A) and §170(b)(1)(B) ix) Rev. Rul. 83-104 – Whether a transfer of money by a parent to an organization that operates a school is a voluntary transfer that is made with no expectation of obtaining a commensurate benefit depends upon whether a reasonable person, taking all the facts and circumstances of the case into account, would conclude that enrollment in the school was in no manner contingent upon making the payment. Problems -T’s contribution base for the year of the following gifts is $150,000. During the year T makes contributions to Suntan U., an organization within §170(b)(1)(A)(ii) and (c)(2), or to Private Foundation, which is within §170(c)(2) but not within §170(b)(1)(A)(vii). In each of the following circumstances assume all verification requirements are met and determine T’s §170 deduction for the current year, and what effect, if any, §170(d)(1)(A) will have: (a) T gives $100,000 cash to Suntan U. 50% of his contribution base is $75,000, so $75,000 is deductible and $25,000 is carried over. (b) T gives $100,000 cash to Private Foundation. 30% of his contribution base is $45,000, so $45,000 is deductible and $55,000 is carried over. 23 (c) T gives $60,000 cash to Suntan U. and $40,000 to Private Foundation. 30% of his base is $45,000 and 50% of his base minus the public contribution is $15,000. The lesser of the two is the $15,000 so he can deduct $60,000 + $15,000, with the $25,000 as carryover. (d) T gives $20,000 to Suntan U. and $80,000 to Private Foundation. 30% of his base is $45,000 and 50% of his base minus the public contribution is $55,000. The lesser of the two is $45,000, so he can deduct $20,000 + $45,000 with $35,000 as carryover. (e) T has a freshman daughter who attends Suntan U. and T pays $3,000 tuition for her and makes a $10,000 Sponsors’ Club contribution. Children of members of the Sponsor’s Club are automatically admitted to Suntan U. The tuition is not deductible under §170. It is unclear whether the $10,000 is deductible because it is unclear if this was the reason that daughter was admitted. If it was, then it is clearly not deductible. If not, it probably is deductible. -After completing his term of office Publius Maximus who has been in a high office for several years donates his private working papers to Charity U. The papers are properly valued at $100,000. (a) Will Publius be allowed a charitable deduction for the gift? He will not be allowed a charitable deduction for the gift because it is not a capital asset and so only the basis is deductible. The basis here is $0, so there is no deduction. (b) Publius also teaches Sunday School at his church. Will he be allowed a charitable deduction for the value of this services? No, services are not deductible under §170. (c) Publius donates blood (worth $100) during the year to the blood bank. Deductible? No, because Rev. Rul. 53-162 says blood donation is a service, which is not deductible. 7) Deferral and Nonrecognition of Income and Deductions a) Deferred Reporting of Gains; Installment Sales i) §453 – An installment sale is one where at least one payment is to be received after the taxable year closes. To see how much is deducted per year, first look to the gross profit (total selling price minus the basis and any other deductions like §1245) and then the total contract (total selling price). Take the percentage of gross profit over total contract, and that’s the percentage that can be recognized from the yearly payments per year. ii) §453(d) – A taxpayer may choose to elect out of §453 and make all the payments up front. iii) §453(e) – If a taxpayer sells property to a related party for installment payments, and then the related party sells the property to a third party within the installment period time, it is treated as if the original taxpayer sold the property all at once and all the taxes are owed in the year of the second disposition. iv) §453(i) – An recapture income must be reported immediately upon disposition of the property and the basis of the property for determining the installment percentage must be adjusted from that. v) §453A – If the property is over $150,000 and a loan is secured as a result of future installment payments, the value of the loan must be taken into account for tax purposes as a receipt of gross income for that year. vi) §453B(a) – If an installment obligation is satisfied at other than its face value, or distributed, transmitted, sold, or otherwise disposed of, gain or loss shall result to the extent of the difference between the basis of the obligation and the amount realized or the fair market value of the obligation. Problems -Seller owns a parcel of investment land which Seller purchased four years ago for $2,000. Seller sells it to Buyer under an arrangement where Buyer pays Seller $2,000 cash in the current year and four 8 percent interest bearing notes to be paid off in each of the succeeding four years. Each not has a $2,000 face amount and a $1,750 fair market value. Disregarding the tax consequences of any interest payments, what results to Seller in each of the five years if in the alternative: (a) Seller is a cash method taxpayer who makes no §453(d) election. Gross profit = $10,000-$2,000=$8,000. Total contract = $10,000. Therefore the percentage is 80%, and each year Seller must include 80% of $2,000, or $1,600, in gross income as long-term capital gain. (b) Seller is an accrual method taxpayer who makes no §453(d) election. No difference between cash method and accrual method taxpayers here. Gross profit = $10,000-$2,000=$8,000. Total contract = $10,000. Therefore the percentage is 80%, and each year Seller must include 80% of $2,000, or $1,600, in gross income as long-term capital gain. (c) What result to Seller in (b) if the property was instead some equipment used in business with an adjusted basis of $2,000 on which Seller had claimed deprecation and the §1245 recapture on the equipment amounted to $3,000? Seller must automatically include $3,000 in the year of the sale as ordinary income. The new gross profit is $5,000 and contract price is still $10,000. Therefore 50% of each payment, or $1,000 must be included in gross income as long-term capital gain. (f) What results to Seller in part (b) if the property was subject to a $2,000 mortgage which Buyer assumed and Buyer gave Seller $2,000 of cash and only three of the $2,000 notes. Gross profit = $8,000 and total contract = $8,000. Therefore Seller must include 100% of $2,000 in gross income every year as long-term capital gain. (h) What results to Seller in part (b) if the property was subject to a $3,000 mortgage which Buyer assumed and Buyer gave Seller $2,000 of cash and two $2,000 notes to be paid in each of the succeeding two years and a $1,000 note to be paid in the fourth year? 100% of the following amounts received must be included in gross income as long- 24 term capital gain: $3,000 in year 1 ($2,000 in payment plus the extra debt that is not covered by basis), $2,000 in year 2, $2,000 in year 3, and $1,000 in year 4. (i) What result to Seller in (b) if prior to collecting any of the four notes, Seller gives them to Daughter? Assume the notes are still worth $1,750 each. What results to Daughter when she receives full payment of the notes? Seller recognizes $2,000 long-term capital gain in year one. Sell also made the sale, so he is taxed on the $5,400 of notes. Daughter is taxed on $250 per note. b) Nonrecognition: Like Kind Exchanges i) §1031– No gain or loss is recognized on property exchanges for business property if the property is exchanged only for similar property held for productive use in business or for investments, but not for securities, interests in partnerships, certificates of trust, or choses in action, as long as the property is identified within 45 days or the property is received within 180 days of the transaction or before the due date of the tax return. If other property is also exchanged, the gain must be recognized, but the loss is not. Any gains recognized from the inclusion of other property are put into the basis instead of being recognized. Problems -T has 100 acres of unimproved land which T farms. Its cost basis is $10,000 but it value much greater. T trades it to B for city apartment building worth $70,000, which has a basis to B of $30,000, and B transfers to T, as well, $4,000 in cash and 100 shares of Corp. stock held for 3 years for which B’s basis is $40,000 but which have a fair market value of $26,000. None of the property involved is mortgaged, and B always claimed straight line depreciation on the apartment. (a) As regards T: (1) What is T’s realized gain on the exchange? $70,000 + $4,000 + $26,000 = $90,000 (2) What is T’s recognized gain on the exchange? $30,000 (3) What is T’s basis for the stock? $26,000 (4) What is T’s basis for the apartment building? $10,000 (b) As regards B: (1) What is B’s realized gain and loss on the exchange? $26,000 (2) What is B’s recognized gain or loss on the exchange? $14,000 loss because §1031(c) doesn’t apply. (3) What is B’s basis for the farm land acquired? $30,000 + $40,000 + $4,000 - $14,000 = $60,000 (4) Could §1250 affect B on these facts if, instead of straight line, B had claimed accelerated deprecation on the apartment? Yes, because any §1250 gain must be recognized immediately upon disposition when the traded property can’t recognize depreciation. 8) The Alternative Minimum Tax a) After determining the regular taxable income, a taxpayer has to determine their Tentative Minimum Tax, and then their Alternative Minimum Tax will equal the Tentative Minimum Tax minus the Regular Tax. (TMTRT=AMT) b) Tentative Minimum Tax equals 26% or 28% times the Alternative Minimum Taxable Income minus Exemption Amount. (TMT = AMTI – EA) c) To get the AMTI, get the regular TI and add back the personal exemptions, any tax exempt bonds, accelerated depreciation, miscellaneous deductions, the different depreciation rates for long-term capital lifespan, and medical changes. d) §62(a)(20) – Miscellaneous deductions for certain lawyer fees are still deductible for the proper claims. II. Sophisticated Compensation Arrangements 9) Sophisticated Compensation Arrangements a) §83 i) §83(a) – If property is transferred in connection with services performed, when the property becomes substantially vested the excess of the fair market value over any amount paid is included in the service provider’s gross income. Once the property is counted as ordinary income, any subsequent gains are taxed at capital gains rates. ii) §83(b) – Taxpayers can elect to pay the tax immediately, before the property is substantially vested, but if the property is forfeited or the market value of the property go down before the property is vested, there is no tax refund. iii) Stock Options (1) §83(e) – First you must look to see if it is an “incentive stock option” or a nonqualified stock option. If it is nonqualified, then you must look to see if the fair market value of the option is readily ascertainable. If it is readily ascertainable, the ordinary income gain is recognized when the option is granted at the fair market value. If it is not readily ascertainable, the ordinary income gain is not recognized until the option is exercised. For nonqualified, when the stock is eventually sold, there is capital gain. If it is an incentive stock option, then the gain is not recognized until the sale of the stock of the option as long-term capital gain. 25 (2) §421, §422 – For incentive stock options, the company gets no business deductions for the payments, while for nonqualified stock options, the company gets deductions when the taxpayer recognizes the ordinary income. (3) §56(b)(3) – For the alternative minimum tax with a incentive stock option, then gain is recognized when the option is exercised at the fair market value, and another gain or loss is recognized when the stock is sold. Problems -Apricot Corporation transfers to Executive, an employee, 100 shares of Apricot stock this year with a fair market value of $10 per share, under an agreement providing that: (1) the stock may not be sold or otherwise transferred for five years, and (2) if Executive leaves the employ of Apricot during this five-year period, he must return the stock to Apricot. Executive will pay $1 per share for the stock. After the five years have expired, Executive will be free to retain or sell the stock without restriction. Apricot is a growth company, and it expects to “go public” in three years at an offering price considerably higher than $10 per share. (a) Is §83 applicable to this transaction? If so, how will it affect the tax consequences of the transfer of stock to Executive? Yes, §83 is applicable to this transaction. Executive won’t recognize the stock until the five years are up unless he elects §83(b). (b) What are the advantages and disadvantages of this arrangement to Executive in the year of transfer and in the year when the restrictions expire? The advantages are that there are no taxes right now or if the property is forfeited, but there are potentially high taxes if the stock price goes way up in the five years. (c) What are the advantages and disadvantages of an election by Executive under §83(b) to include the value of stock in Executive’s taxable income this year? The advantage is that there are lower taxes if the stock price goes up, but there is no tax refund if the property is forfeited or goes down in price. -On March 1, Apricot Corporation transfers to Executive a nonqualified stock option to purchase 100 shares of Apricot stock at $10 per share. On March 1, an option to purchase one share of Apricot stock is selling for $2 on an established market. Executive exercised the option on May 1 of year two when Apricot stock is worth $22 per share. Executive sold the Apricot stock on May 10 for year five for $32 per share. (a) What are the tax results of these events to Executive? The nonqualified stock option here has a readily ascertainable fair market value of the option. Therefore there is ordinary income recognized from the value of the option = $2 * 100 = $200. After that, the gain on the stock is taxed in the form of $32 - $10 - $2 = $20 per share, or $2,000 in long-term capital gain. (b) What difference would it make in (a) if the option were an “incentive stock option?” In this case, the gain is not recognized until the sale of the stock, so $32 - $10 = $22 per share, or $2,200 in long term-term capital gain. III. Taxation and the Family 10) Child Taxation a) §1(g) – Children are taxed at the same rate as their parents would be if their parents had gained that money after the child receives the amount up to the amount of the personal exemption. Problem - In general, how much federal income tax can be saved by parents who shift interest or dividend income to a child who is under age 18? A child who is 18 or older? A parent can only shift income to a minor child up to the amount of the personal exemption. A parent can shift a lot of income to a child over 18, but it is subject to the gift tax. 11) Divorce and Alimony a) Cash Payments for Alimony i) §71, §215 – If the payment satisfies certain requirements, alimony payments are deductible to the payer and are taxable income to the recipient. The Requirements are: (1) The payment is received by, or on behalf of, a spouse under a divorce or separation instrument. (2) The divorce or separation instrument doesn’t designate the payment as a non-alimony payment. (3) In the case of a decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made. (4) There is no liability to make any payment in cash or property, after the death of the payee spouse. (5) The payment is not for child support. ii) §71(f) – Excess alimony payments are redistributed for tax purposes in year three, giving the receiver a deduction in year three for the excess payments and the giver an extra tax burden for the extra burden in year three. Excess alimony for year one is the average of alimony received over the next two years, minus the excess from year two, plus $15,000. Excess alimony for year two is the sum of year three payments plus $15,000. iii) §71(c) – There are no deductions for child support, and if a distinction can be made from an inference from the agreement, then the monthly payment will be split between alimony and child support. Problems -Herbert and Wendy have been married for 14 years and have two minor children Sigmund and Dolores. Herbert is a middle-management executive with Pacific Bell, earning $60,000 a year, and Wendy is a freelance writer with average net earnings of $20,000 a year. Herbert and Wendy separated on February 2, 2007. Wendy and the 26 children remained in the family home. The couple did not come to grips with the legal aspects of their marital breakup until January of 2008, when their attorneys commenced negotiations. (a) Assume that from the time Herbert and Wendy separated, through March of 2008, Herbert voluntarily paid Wendy $500 per month for Wendy’s support and an additional $800 per month for support of the children. What are the tax consequences of these payments? There are no tax consequences from these payments because there is no instrument for the payments. (b) Suppose that in February 2008, Wendy’s attorney called Herbert and suggested that Herbert could increase his spousal support payment to $700 per month without any additional out-of-pocket expense to Herbert Is that possible? Should Wendy ask for more? Could Wendy’s objective be met if these higher spousal support payments were incorporated in a court decree for temporary support pending a final decree of dissolution? First, the court should issue a decree because then there would be an instrument and the payments are deductible. If deductible right now, he would deduct $500 * 12 = $6,000 per year. Under the new plan, he would pay $700 * 12 = $8,400 per year, and looking at Herbert’s income, he is in the 25% tax bracket. Therefore he would save $8,400 * .25 = $2,100 in taxes a year. Herbert would not save money from this because $8,400 - $2,100 = $6,300, so he would end up paying $300 more. (c) In May, 2007, Herbert and Wendy entered into a written separation agreement providing, among other things, for spousal and child support. Consider the tax consequences of the following alternative proposals and, if necessary, suggest improvements: (1) Herbert will pay Wendy $800 per month for her support until the death of either spouse or the remarriage of Wendy. Because Herbert’s obligation will automatically terminate under California law on Wendy’s death or remarriage, the agreement makes no reference to the termination of spousal support payments. This qualifies under §71 and §215 because there are terminations for death. (2) Herbert will pay Wendy (or her estate, after her death) $800 per month in equal installments over a period of nine years. Payments are to be made in all events, by Herbert or by his estate in the event of his death. This does not qualify because payments could be made after death. (3) Same as (2) except that the agreement specifically provides that payments will cease on the death or remarriage of Wendy. This qualifies under §71 and §215 because there are terminations for Wendy’s death. (4) Same as (3) above except that Herbert and Wendy continue to reside in the family home, occupying separate bedrooms and rarely speaking to one another. This is fine under §71 and §215 because even though they are living in the same place, they are not under the same household for tax purposes. (5) Herbert will pay Wendy $24,000 per year for a period of three years and thereafter $18,000 per year for two additional years. The payment scheme is designed to assist Wendy while she attends law school so that she can prepare herself for a new career. The payments have no relationship to any division of property. This qualifies under §71 and §215 so long as the payments cease at death. (6) Herbert agrees to make annual payments to Wendy for four years under the following schedule: Year 1 $80,000 Year 2 $80,000 Year 3 $30,000 Year 4 $30,000 Herbert’s obligation will terminate, however, on Wendy’s death or remarriage. Under §71(f), year 2 excess would be $80,000 – ($30,000 + $15,000) = $80,000 - $45,000 = $35,000 in excess. Year 1 regular payments would be the average of the year 2 and 3 non-excess payments plus $15,000 = ($45,000 + $30,000) / 2 + 15,000 = $37,500 + $15,000 = $52,500. Therefore the year 1 excess is $80,000 - $52,500 = $27,500. Under this arrangement, year 3 alimony is taxed from $27,500 + $35,000 = $62,500. (7) Herbert agrees to pay Wendy for “family support” (i.e., the support of Wendy and the two minor children) the combined sum of $1,800 per month, such obligation to continue until the happening of the following contingencies: (1) if any child dies, marries or reaches age 18, Herbert’s obligation shall be reduced by $400 per month and (2) if Wendy dies or remarries, Herbert’s obligation shall be reduced by $1,000 per month. $1,000 is going to alimony and would be deductible under §71 and §215, but the $800 in child support is separated for tax purposes and is not deductible. b) Property divisions i) §1041 – Transfers of property between spouses or pursuant to a divorce don’t count for gains and losses. If this occurs, the basis is treated as a gift and doesn’t change. Problems -Assume that Herbert and Wendy from part 1, above, own the following unencumbered assets as community property: Assets Adjusted Basis Fair Market Value Family Home $50,000 $200,000 Pacific Telesis stock $80,000 $130,000 Unimproved land $100,000 $60,000 Automobile $20,000 $10,000 TOTAL $250,000 $400,000 27 Consider the tax consequences of the following alternative arrangements for dividing Herbert and Wendy’s community property: (a) Herbert will take the home; Wendy will take the other three assets. In the beginning, there is no difference, but when property is sold, Herbert might need to recognize $150,000 in gain while Wendy might have no tax gain or loss. However, if the house is the primary residence, the gain probably doesn’t need to be recognized, while the loss on the car probably isn’t allowed. (b) Wendy will take the house, the unimproved land and the automobile and Herbert will take the Pacific Telesis stock. To equalize the division, Wendy will pay Herbert $70,000 cash which she raises by borrowing against the home. Wendy gains $270,000 in assets, and Herbert gains $130,000, so the $70,000 would give them equal value. However Wendy would get to recognize $40,000 of loss while Herbert would have to recognize $50,000 of gain. (c) Same as (b) except that instead of cash, Wendy transfers to Herbert $70,000 of IBM stock that Wendy holds as separate property and in which she has a basis of $20,000. Again, the value is the same. Now, however, Herbert has $100,000 in gain and Wendy still has $40,000 of loss. c) Dependency Exemption i) §151 – Each dependent has a $3,400 dependency exemption for them. ii) §152 – The dependency exemption goes to the party with the larger amount of physical custody of the dependent, but the custodial parent can transfer the exemption to the non-custodial parent. Problems -Assume the basic facts of part 1, above. Wendy is awarded custody of the children. (a) Assuming that Herbert and Wendy together pay all of the support for their two minor children after their divorce, who will be entitled to claim the dependency exemptions? Wendy would get the exemption. (b) What if Herbert and Wendy have joint physical and legal custody? They each could claim half of the exemption. IV. Home is Where the Tax Savings Are 12) Homes and Mortgages a) The Home Mortgage Deduction i) §163(a) – There is a deduction for interest on debts for mortgages up to $1,000,000. ii) §163(h) – There is no deduction for personal interest, which is everything except for trade or business, investments, passive activity, education, and qualified residence interest. If it is a HELOC, up to $100,000 is deductible. Problems -Taxpayers purchase a home in the current year which they use as their principal residence. Unless otherwise stated, they obtain a loan secured by the residence and use the proceeds to acquire the residence. What portion of the interest paid on such loan may Taxpayers deduct in the following situations? (a) The purchase price and fair market value of the home is $350,000. Taxpayers obtain a mortgage for $250,000 of the purchase price. All $250,000 is deductible. (b) The facts are the same as in (a) except that in two years Taxpayers have reduced the outstanding principal balance of the mortgage to $200,000 and the fair market value of the residence has increased to $400,000. In the later year, Taxpayers take out a second mortgage for $100,000 secured by their residence to add a fourth bedroom and a den to the residence. All $100,000 is deductible. (c) The facts are the same as in (b) except that Taxpayers use the proceeds of the $100,000 mortgage to buy a Ferrari. This is deducible has HELOC under §163(h)(3)(C)(2) up to $100,000, so it is all deductible. (d) The facts are the same as in (a). Ten years later, Taxpayers have paid off $200,000 of the $250,000 mortgage and the residence is worth $500,000. In the later years, Taxpayers borrow $200,000 on the residence, $50,000 of which is used to pay off the remaining balance of the original mortgage and the remainder is used to pay personal debts. $150,000 is deductible. The $50,00 used to pay back the original loan was already originally deducted, so it can’t be deducted again. (e) The facts are the same as in (a), but additionally, towards the end of the current years, Taxpayers’ financial prospects improve dramatically and they purchase a luxury vacation residence in Florida for its fair market value of $1,250,000. They finance $950,000 of the purchase price with a note secured by a mortgage on the Florida house, use the house 45 days of the year, and elect to treat the residence as a qualified residence. They can only deduct $1,100,000 total. $250,00 was deducted earlier, so $850,000 of the $950,000 can be deducted. b) Sale of Principal Residence i) §121 – Gross income doesn’t include the sale of the taxpayer’s home if it is the principal residence for at least two years out of the last five, but can’t exceed $250,000 for single or $500,000 for married couples and can only apply to one sale every two years. If the taxpayer didn’t stay for two years, then they are allowed to deduct the fraction of the two years worth of $250,000/$500,000 unless there’s a hardship exception. If the taxpayer has taken depreciation on the property, the depreciation must be included in gross income. Problems -Determine the amount of gain that Taxpayers (a married couple filing a joint return) must include in gross income in the following situations: 28 (a) Taxpayers sold their principal residence for $600,000. They had purchased the residence several years ago for $200,000 and lived in it over those years. $0 (b) Taxpayers in (a) purchased another principal residence for $600,000 and sold it 2 ½ years later for $1 million. $0 (c)What result in (b) if the second sale occurred 1 ½ years later? Taxpayers are allowed to exclude 75%, so $100,000 must be included. (d) What result in (b) if Taxpayers had sold their first residence and were granted nonrecognition under former §1034 (the rollover provision) and, as a result, their basis in the second residence was $200,000? $500,000 is excludible under §1034, but the rest of the $300,000 must be included as long-term capital gain. (e) What result in (a) if the residence was Taxpayers’ summer home which they used 3 months of the year? They must include the $400,000 in gross income as long-term capital gain. (f) What result if Taxpayer who met the ownership and use requirements is a single taxpayer who sold a principal residence for $400,000 and it had an adjusted basis of $190,000 after Taxpayer validly took $10,000 of post-1997 depreciation deductions on the residence which served as an office in Taxpayer’s home? The $10,000 in depreciation must be recognized as regular income. -Single Taxpayer purchased a principal residence for $500,000 and after using it for one year, Singe sold the residence for $600,000 because Single’s employer transferred Single to a new job location. (a) How much gain must Single include in gross income? 50% of $250,000 deductible, so $0 must be included. (b) What result in (a) if Single sold the residence for $700,000? 50% of $250,000 deductible, so Single must include $200,000-$125,000 = $75,000 in gross income as long-term capital gain. c) Casualty and Theft Losses i) §165 – Losses allow for deductions if not covered by insurance, limited to losses incurred in a trade, business, profit-making enterprise, or loss from fire, storm, shipwreck, casualty, or theft. Casualty losses are determined by taking the lower of either the adjusted basis or the difference fair market value before and after the casualty. Casualty losses for personal property are deducted by $100 and for 10% of adjusted gross income. Casualty gains count as capital gains when greater than all casualty losses, but casualty loss count as ordinary loss when greater than casualty gain. Problem -T bought a new home a few years ago for $500,000 ($100,000 for the land and $400,000 for the house). T also spent $20,000 landscaping the residence. This year a fire destroyed T’s home and damaged the shrubbery and trees in the yard. Competent appraisers valued the property as a whole at $750,000 before the fire, but only $150,00 after the fire. Shortly after the fire, T’s insurance company paid $450,000 for the loss. T’s adjusted gross income for the year is $480,000. How much is T’s deductible casualty loss from the fire? $750,000 - $150,000 = $600,000 loss. T’s adjusted basis in the property is $520,000. 10% of T’s adjusted gross income is $48,000. The adjusted basis is smaller than the fair market value loss, so $520,000 is counted for the loss. $520,000 - $450,000 = $70,000 - $100 $48,000 = $21,900, so $21,900 is deductible casualty loss from the fire. d) The Home Office i) §280A – No deductions for dwelling units also used by the taxpayer as an office except for normal home loss rules, unless part of the home is specifically sectioned off or it is specifically rented separately. The deductions allowed for home businesses can’t exceed the gross income derived from such use over the sum of the deductions. Any leftover deductions are carried over to subsequent years. If you only rent out a residence for less than 15 days, all of the income derived from that is deductible. Problem -Taxpayer operates a consulting business out of his home. He uses an office in his home, exclusively and on a regular basis, as the principal place of business for his consulting business. Taxpayer has $2,000 gross income from his consulting business. He has business deductions of $1,600 for supplies and secretary expenses. Mortgage interest and real estate taxes allocable to his office total $400. Utilities and depreciation allocable to his office are $200 and $150, respectively. How much of the utility expense and deprecation is deductible? It is all deductible, but the utility and depreciation must be carried over to the following year because the total deductions exceed gross income. Therefore the $350 is not deducted this year. V. Education and the Internal Revenue Code 13) Education a) Education is deductible for: i) Maintaining or improving skills for your current career ii) Meeting the requirements for keeping your current job b) Education is not deductible for: i) Meeting the requirements for getting a job ii) Qualifying you for a new trade or business c) If your education falls under both deductible and non-deductible categories, it is non-deductible. Problems -Maureen is a practicing attorney in San Francisco. During the current year, she incurs the following expenses and would like to know if they are deductible for federal tax purpose. 29 (a) Maureen pays the cost of a refresher course in her area of practice? What result if the firm pays the cost of the course? They are deductible because they are maintaining education. (b) Maureen decides that law is not the career for her and she enrolls in a college program intending to get an elementary school teaching credential? This is not deductible because it is a new trade. (c) Maureen decides she wants to practice tax law and spends a year obtaining an LL.M. in Taxation at NYU or the University of Florida? This is deductible because it is for improving skills for her current career. (d) Maureen enrolls in a poetry class at a local college? What if her law firm reimburses her for the cost of the class? The enrollment would not be deductible by Maureen because it is personal, but if the law firm reimburses her it is excludable as a fringe benefit. VI. Tax-Wise Investing 14) Tax-Wise Investing a) Bad Debts and Worthless Securities i) §165(g) – If a security becomes worthless, it counts as a sale on the last day of the taxable year as a capital loss. ii) §166 – There are deductions for bad debts and for the unrecovered part of only partially paid debts. Individuals can’t deduct non-business bad debt normally but must rather deduct them as short-term capital losses and only to the extent they are completely worthless, with a heavy presumption against loans to relatives as gifts instead. Problem -During the current year, Cher Holder had two investments go sour. Two years ago, Cher bought 100 shares of Flibinite Corporation stock based on a hot tip from her brother-in-law. Cher paid $5,000 for the Flibinite stock. Unfortunately, Flibinite recently declared bankruptcy. In addition, last year Cher loaned $2,500 to the same brotherin-law. That loan is now worthless. Will Cher be entitled to a deduction as a result of these events? Cher can deduct the shares of the worthless stock as long-term capital gain loss, but might not be able to deduct the loan to the brother-in-law without a strong showing of legitimate intent to overcome the presumption against loans to relatives. b) Wash Sales i) §1091(a) – If a taxpayer buys or sells securities and then sells or acquires identical securities within 30 days, then no losses are recognized and the basis is merely changed by the difference in how much the taxpayer’s put into the investment. This does not affect gains at all. ii) §1223(4) – In a wash sale for loss, the holding period also tacks on. Problems -On December 1 of the current year Taxpayer sold 1,000 shares of X Corporation stock for $50,000. She had purchased the stock exactly two years earlier for $60,000. On December 15 of the current year she purchased another 1,000 shares of identical X corporation stock for $55,000. (a) What are the tax consequences of the December 1 sale? There are no immediate tax consequences of the sale. (b) What is Taxpayer’s basis for the newly acquired shares? $65,000 (c) What is Taxpayer’s holding period for the newly acquired shares as of January 1 of the next year? They are longterm capital. (d) What result to Taxpayer in (a)-(c) (gain or loss, basis and new holding period), if the December 1 sale had been for $75,000 and she had repurchased 1,000 shares of X stock on December 15 for $65,000? $15,000 long-term capital gain and new capital with a basis of $65,000. §1091 doesn’t apply to gains. (e) Is there any difference in result to Taxpayer in part (a) if she purchased the new shares on December 1 for $55,000 and sold the old shares on December 15 for $50,000? No. §1091 applies 30 days before or after sale date. c) Limitations on Deductions i) §103 – Gross income doesn’t include state and local interest on bonds. ii) §163 – There is generally a deduction for interest on debts. However, deduction for investment interest (interest on property held for investment and not qualified resident interest or passive activity) can’t exceed net investment income, and any extra is carried over to the following year. Also, no personal interest deductions, which are those on everything but trade or business, investment, passive activity, education, and qualified residence interest. iii) §265(a)(2) – A taxpayer can’t use interest deductions when they are used to buy tax exempt bonds. Problems -Investor incurs investment interest of $100,000. To what extent is it deductible in the current year if: (a) She sells stock during the year at a $60,000 gain and has $20,000 in dividends on all her stock, but assume that under §163(d)(4)(B)(iii) neither qualifies for §1(h) preferential treatment, and she has $10,000 in deductible investment adviser fees? Are there any other tax consequences to Investor? $60,000 + $20,000 - $10,000 = $70,000 investment income. She can only deduct $70,000 of the $100,000. (b) The interest of $100,000 is on loans whose proceeds are used to purchase tax exempt bonds? None of this is deductible under §265(a)(2). (c) The facts are the same as in (a) and 9b), except that the proceeds of the loans are used 50% to purchase tax exempt bonds and 50% to buy stock and the bonds and stock are her only investments? 50% is not deductible under §265(a)(2), but 50% is, so $50,000 is deductible because it is under the $70,000 limit. 30