Gross Income

WHO IS THE TAXPAYER?....................................................................................................................... 4 HYPOS ON WHEN INCOME IS ASSIGNED [PPT 319]: .................................................................................... 4 Code §1(g)[3]: Unearned income of children (kiddie tax).................................................................. 4 WHAT IS INCOME ..................................................................................................................................... 4 Code §62 [49]: Adjusted gross income defined (above the line deductions)....................................... 4 Code §63 [52]: Taxable income defined (below the line deductions) ................................................. 5 GROSS INCOME......................................................................................................................................... 5 Code § 61(a) [49]: All income from whatever source derived ............................................................ 5 Code §111 [89]: Recovery of tax benefit items (tax benefit rule) ....................................................... 5 Code §7872 [692]: “prevents no-interest loans”................................................................................. 6 Code § 6045: Barter Transactions ....................................................................................................... 6 CODE: § 108 [83]: DISCHARGE FROM DEBT.............................................................................................. 7 Code: § 61(a)(12)[49]: Gross income = income from discharge of indebtedness ............................. 7 Code: § 108 [83]: Income from Discharge of Indebtedness............................................................... 7 Code: § 108(d)(1)[85]: Definition of indebtedness ............................................................................. 7 Code: § 108(a)(1)(A),(B) [83]: Exclusions for Bankruptcy/Insolvency, but: ..................................... 7 Code: § 108(b)(2)(e)[83]: Basis reduction (see 1017)......................................................................... 7 Code: § 1017(b)(2)(A),(B) 493]: Basis reduction analysis ................................................................. 7 [SEE: CASHPOOR HYPO: PPT., P.41-45] .................................................................................................... 7 NON-RECOURSE DEBT: ................................................................................................................................ 8 Rev.Ruling 90-16 [txt p.80]: (two step analysis) [SEE PPT. 54, for codes] ......................................... 8 International Freignthing Corporation v Commissioner [stock shares as bonus = gain] .................... 8 EXEMPTIONS FROM GROSS INCOME ................................................................................................ 8 Code § 102 [78]: Gifts and inheritance ............................................................................................... 8 Code § 132 [105]: Certain fringe benefits (excluded from gross income) [SEE txt 117: cites] ......... 8 Also: Employee Gifts: § 102 (c)(1): ―any amount transferred by or for an employer to, or for the benefit of, an employee is not excludable, except: .................................................................................................................. 9 Code § 119 [193]: Meals or lodging furnished for the convenience of employer.............................10 OPHRA HYPO: SEE PPT. 100 ??? ..............................................................................................................10 Code § 104 [79]: Compensation for injuries or sickness - see ppt. 100.....................................10 REVIEW PROBLEMS [PPT.103] .................................................................................................................10 DEDUCTIONS ............................................................................................................................................10 Code § 161 [130]: Allowances for deductions ...................................................................................10 Code §165 [147]: Losses .....................................................................................................................10 o o o Incurred in trade/business ..................................................................................................................... 10 Incurred in transaction entered into for profit, and ............................................................................... 10 Casualty losses...................................................................................................................................... 10 Code §166(b) [149]: Bad Debts ..........................................................................................................11 Regs.1.166-5(a)(2): Bad debt deduction ..............................................................................................11 Code § 162 [130]: Trade or business expenses ..................................................................................11 Code § 212 [198]: Expenses for the production of income ...............................................................13 Reg1.262-1(b)(7): attny‘s fees for divorce ...................................................................................................... 13 Code § 261 [223]: General rule for disallowance of deductions .......................................................13 Code § 262 [223]: Personal, living, and family expenses (plus phones) ...........................................13 Code § 183 [190]: Activities not engaged in for profit (hobbies) class notes: down pink tab. .........13 Code § 163 [136]: Interest (deduction) ..............................................................................................14 Code § 221 [210]: Student loan interest (deduction) .........................................................................14 Code § 265 [229]: ”exemption on expenses incurred to produce income” .......................................14 REVIEW PROBLEMS #1 [PPT.137] ....................................................................................................14 1 ACCOUTNING ISSUES.............................................................................................................................14 Code §446 [343]: Methods of accounting (ppt.177) ..........................................................................14 Code §451 [437]: General Rule for Taxable Year of Inclusion ........................................................14 Reg1.446-1: General rule for methods of accounting ..........................................................................14 Reg1.451-2(a): Constructive receipt ....................................................................................................14 Code §461(h) [359]: Economic performance.....................................................................................15 Code §109 [89]: Improvements by lessee on lessor’s property ..........................................................15 Rev. Proc. 71-21: Payments received in one taxable year for services to be performed in the next can be deferred ...........................................................................................................................................15 Code §461(h)(2)(C) [360]: “economic performance occurs as payments to injured parties are made” ..................................................................................................................................................16 Code §72 [60]: “must also include portion of amount paid that represents interest growth as gross income” ...............................................................................................................................................16 BASIS IN PROPERTY TRANSACTIONS ...............................................................................................16 Code § 1001 [487]: Determination of Amount of and Recognition of Gain or Loss ........................16 Code § 1011 [488]: Adjusted basis (see 1012; 1016) .........................................................................16 Code § 1012 [488]: Basis of Property: Cost (except cap ex) (not including real prop. Tax) ............16 Code § 1016 [491]: Adjustment to Basis ............................................................................................16 PROPERTY TRANSACTION ANALYSIS: ........................................................................................................16 WHEN BASIS CANNOT BE ACCURATELY DETERMINED: ...................................................................................17 Code § 1014 [488]: Basis for Property Acquired From a Decedent ................................................17 Code § 101 [76]: Certain Death Benefits (treating life insurance) ....................................................17 Code §1015 [490]: Basis for property acquired as gift .....................................................................17  [SEE „PARIS‟ HYPO. PP.T81] ...........................................................................................................17 Code § 1041 [507]: Transfers of property b/w spouses incident to divorce ......................................17 Code § 71 [58]: Alimony .....................................................................................................................18 CAP EX ANALYSIS [PPT.152] .................................................................................................................18 Code § 263 [223]: Capital expenditures .............................................................................................18 Revenue Ruling 2001-4 [airliner maintenance: deductible repairs or capital investment?] ...............18 Code §167 [150]: Depreciation ..........................................................................................................19 NOTE: §1016(A)(2): DOWNWARD ADJUSTMENT TO BASIS REQUIRED EVEN IF YOU DON‘T TAKE THE DEDUCTION: SO MUST TAKE! [PPT. 163-4 / HYPO]: WHENEVER DEPRECIATION PROBLEM: BASIS ADJUSTMENT. ............................................................................................................................................19 Reg1.167(a)-1(b): Useful life of asset .................................................................................................19 Code §179 [188]: Election to expense certain depreciable business assets (ppt.180)??? .................19 SEE HYPO PPT.180??? .............................................................................................................................19 Code §168 [152]: Accelerated cost recovery system (ppt.168: ACRS/ hypo: 171-4)..........................19 CAPITAL GAINS / LOSSES [MECHANICS: PPT. 213] ......................................................................20 Code §1211 [526]: Limitation on capital losses (not corps) [see ppt. 216-19] .................................20 Code §1212 [526]: Capital loss carrybacks and carryovers [see ppt. 223] .......................................20 Code §1(h) [4] “maximum capital gains rate”...................................................................................20 TREATMENT .............................................................................................................................................21 STG are taxed at regular rates ...................................................................................................21 LTG are taxed at preferential ‘capital gains rate’ .....................................................................21 If STL < LTG, then net CG, preferential treatment ....................................................................21 If L > G, then offset upto 1211(b) limits. (non corporate) ..........................................................21 1211(b) amount then ‘recharacterized’ as STG and new netting [under 1212] .........................21 Code §1222 [530] Terms for capital gains/loss ..................................................................................21 Code §1221 [529] Capital Assets defined ...........................................................................................21 WHAT IS A CAPITAL ASSET? ....................................................................................................................21 WHAT IS NOT A CAPITAL ASSET? ...........................................................................................................22 2 TRADE OR BUSINESS PROPERTY .......................................................................................................23 Code §1231 [533] Property used in trade or business & involuntary conversions ...........................23 RECAPTURE [PPT. 267].............................................................................................................................24 Code §1245 [542]: Gain from disposition of certain depreciable property .......................................24 INCOME PRODUCING INCOME TRANSFERRED TO TRUST [PPT.251] ........................................................24 SALE OF A BUSINESS [PPT. .........................................................................................................................24 Code §1060 [513]: Special Allocation Rules for Certain Asset Acquisitions ...................................24 Code §197 Amortization of Goodwill and Other Intangibles [ppt 309] ..............................................24 Code §197(d)(1)(E)[194]: “covenant not to compete = intangible = amortized” pt266] .................24 3 WHO IS THE TAXPAYER? HYPOS on when income is assigned [ppt 319]: - timing of transfer - retaining control of underlying asset Medina: drug deal case: lifestyle shows he didn‘t have the money Lucas v Earl: husband and wife case: tax those who earn the income o Today: joint-income pensions: Congresses way around Earl for married couples Blair: assigns life estate in trust: valid o Asset = life estate in trust; no control after transfer; therefore is effective Helvery v Horst: assigns bearer bonds (principal and interest): invalid o Assigns interest, but maintains control over the principal. Note: was also transferred shortly before due date ~ attempt at tax avoidance? BUT: what if clipped all coupons well in advance of payment? Meisner; Royalties from song copyrights for divorce: valid o No control retained. o What if transferred 100% for 99 years? Significant portion of ‗bundle of right‘ so also strong argument. - - - Code §1(g)[3]: Unearned income of children (kiddie tax) - 14 years or younger - at least one parent is living - parents could elect to have unearned income taxed to them o presume unearned income of child will come from ‗parents,;‘ so will tax at parents rate. (attempt to move down tax bracket) o Note: tax avoidance possible if income is from grandparents in higher tax bracket Allen: baseball prodigy‘s bonus goes in part to mother o He is taxed the entire amount (mother performed no ‗services‘ for Phillies – it wasn‘t her income. - WHAT IS INCOME Code §62 [49]: Adjusted gross income defined (above the line deductions) - (a)(2)(A) Reimbursed expenses - (a)(3): losses on sale/exchange of property (allowed by 161) and capital losses - (a)(4) deductions for rents and royalties - (a)(10): Alimony (allowed by 215) - (a)(17) moving expense: allowed by 217) - (a)(17) student loans (allowed by 221) 4 Code §63 [52]: Taxable income defined (below the line deductions) - (d) Itemized deductions o Deductions other than 62 and 151 deductions o Sec67 (2%) limit on misc. itemized deductions - Itemized: o Interest (163) o Tax (164) o Wagering losses (165) o Charitable contributions (170 o Medical expenses (213)   Basically: gross income – deductions. Distinction b/w:  Itemizers (161 deductions) and  non-itemizers (151 deductions) GROSS INCOME Code § 61(a) [49]: All income from whatever source derived (except those specifically exempted ~ Glenshaw Glass) (Not loans ~ net out to zero) Glenshaw Glass: Three Part Test: i) Is it an accession to wealth? ii) Is it clearly realized? (sufficiently at hand?) iii) Does the tax payer have ―complete dominion‖ (control) over it? Code §111 [89]: Recovery of tax benefit items (tax benefit rule) - What if money is returned to you after you take a deduction for it? - (a) Income to extent of deductions previously allowed for items - TEST: i) amount deducted in a prior year ii) resulted in a tax benefit iii) recover inconsistent w/ previous dedication iv) no other code section prevents taxation (tax benefit rule) Alice Phelan: tax rate on return of charitable land donations - Return of charitable contribution gave rise to income to the extent of the deduction previously allowed - Deduction ―gain‖ on returned ―donated land‖ should be taxed at time of recovery - Basic principle of ‗annual‘ accounting 5 (timing and manipulation) Estate of Stranahan: Money for dividends: sale, not loan [see ppt.203] - ―cash basis‖ father sells anticipated stock dividends to son; reports payment as ordinary income in year received: valid - IRS says it was loan masquerading as a sale, but: o Cash basis taxpayer ordinarily realizes income in year of receipt rather than year earned o Taxpayer who assigns future income for consideration in bona fide commercial transaction generally realizes ordinary income in year of receipt o Taxpayer is free to arrange his financial affairs to minimize tax liability Here: not claims that transaction was a sham: consideration was based on reasonable estimation of present value of future income Presence of tax avoidance motives will not nullify an otherwise bona fide transaction (timing and manipulation) Al-Hakim v Comm: Client ‗loans‘ money to agent - Sports agent receives ―loan‖ from client, then uses faux payments on loan to ‗offset‘ fee owed him by client. - Court finds valid loan (therefore, agent receives full amount of payment in year 1, but does not have to record income until offset time) Note: tax consequences for client. Today, invalid: see below Code §7872 [692]: “prevents no-interest loans” Code § 6045: Barter Transactions - but will reach brokers, dealers, and ‗barter exchanges‘ o If your are ‗in the business‘ and they are ‗in the business,‘ then it looks like a barter exchange. Bery facts driven: e.g., value of services (e.g., legal services v manicure) . Or relationship among the principals (e.g. familial v casual acquaintance) Generally: - if ‗quid-pro-quo,‘ then taxable - if not, then favor, then not taxable How to distinguish barter from loan? Loan = no accession to wealth Barter = accession to wealth on both sides - Found property (when reduced to 'undisputed possession') - Bargain purchases (taxable when sold) Palmer v Comm. / Reg.1.64-14. 6 Code: § 108 [83]: Discharge from Debt Code: § 61(a)(12)[49]: Gross income = income from discharge of indebtedness Code: § 108 [83]: Income from Discharge of Indebtedness Code: § 108(d)(1)[85]: Definition of indebtedness Old Colony: 3rd party (by employer here) discharge of debt = income. [reclassifies (deems) payment as coming from taxpayer rather than 3rd party]. Kirby Lumber: Corp repurchase of bonds at below issue price is discharge [so even if obligation is reduced by taxpayers own action, still gross income] Cite:Reg.1.61-12(a). - Note: if mom pays your taxes; then is gross income under §108; but probably excludable under §102. Indebtedness exceptions (Exceptions for bankruptcy (108(a)(1)(A); insolvency w/ limits (108(a)(1)(B). [83]) Code: § 108(a)(1)(A),(B) [83]: Exclusions for Bankruptcy/Insolvency, but: Code: § 108(b)(2)(e)[83]: Basis reduction (see 1017) Code: § 1017(b)(2)(A),(B) 493]: Basis reduction analysis Exclusion Analysis: i) Is taxpayer insolvent b/4 discharge w/in meaning of 108? (d)(3). ii) Then can exclude up to extent of insolvency. Basis Reduction Analysis: i) Calculate aggregate basis of property held immediately after discharge. ii) Calculate aggregate liabilities immediate after discharge. iii) If aggregate basis is greater than aggregate liability, there will be a reduction in basis. If not, no adjustment. [see: cashpoor hypo: ppt., p.41-45] Recourse vs. Non-Recourse debt [what‘s the point?] [problems ppt.49]  Recourse: lend can go after debtor personally for repayment.  Non-Recourse: lender can only go after property securing debt.  Non-recourse debt is included in basis. Crane 7 Non-Recourse Debt: Tufts: AR (relief of debt) – AB = tax liability (cap ex treatment) Recourse Debt: Rev.Ruling 90-16 [txt p.80]: (two step analysis) [SEE PPT. 54, for codes] o Sale or Exchange: To extent FMV exceeds adjusted basis, the transfer of the property (recourse) is a realized gain for the transferring taxpayer. > FMV – AB = tax liability (cap ex ~ probably equal, therefore zero) o Cancellation of Debt: Also, taxpayer can be hit with income from discharge of debt to extent that debt exceed FMV of property > liability relief – FMV = realized gross income (ordinary gain) International Freignthing Corporation v Commissioner [stock shares as bonus = gain] o If stock was wroth more than basis (price at time of acquisition by the company), then there was a gain realized by the company of the difference in the amounts. Also see reg 1.61-2(d)(2) EXEMPTIONS FROM GROSS INCOME Code § 102 [78]: Gifts and inheritance What is a gift? - Duberstein: Key is detached and disinterested generosity‖ ―out of affection, respect, admiration, charity, or like impulses. (intention of transferor controls). - Note: Employee gifts (p.91) §102(c)(1), (2); §132(2): not excluded. Tipping (clearly not ‗detached and disinterested generosity): rate presumed to be 8%. Code § 132 [105]: Certain fringe benefits (excluded from gross income) [SEE txt 117: cites] i. No-additional-cost service (service is ordinarily offered for sale to customers, AND no additional expense are incurred when providing to employees; e.g., empty seats on a passenger jet) ii. Qualified employee discount (discount does not exceed gross profit percentage; based on all products, OR reasonable classification of selected property) iii. Working condition fringe (correlated w/ §§162 ir 167) iv. De minimis fringe (value is so small as to make accounting for it unreasonable or administratively impracticable; including: certain eating facilities) Note: think not just individual transaction amount, but also # of transactions v. Transportation fringe (e.g., commuter highway vehicle, parking; limits of $100; $175) vi. Qualified moving expense (correlated w/ §217) vii. Retirement planning viii. Military 8 - (h)(i): Reciprocal Agreements, for i and ii above, if o Written agreement b/w employers o No employer incurs any substantial costs (j) Special rules o (i) and (ii0 apply to highly compensated employees only if no discrimination (same members of reasonable classification; not discriminating in favor of highly compensated) o Gross income shall not include value of on premise athletic facility (see definition) (l) Does not apply to Fringe Benefits provided elsewhere o §119: meals or lodging furnished for convenience of employer i. Meals furnished on business premises ii. Lodging, if employee is required to accept such lodging as condition of employment - - Turner v Comm: winning first-class tickets as ‗forced consumption‘ (not needed in ordinary course of their lives and would not have purchased ~ beyond their means): include less-than-FMV into gross income. [what is importance of this case?] Cf Haverly v Comm: unsolicited textbooks: must include FMV into gross income. [intent to exercise complete dominion was demonstrated by donating samples to charity and taking a tax deduction.] Also: Employee Gifts: § 102 (c)(1): ―any amount transferred by or for an employer to, or for the benefit of, an employee is not excludable, except: 74(c): Employee Achievement Awards o If award cost does not exceed amount allowable as a deduction to the employer (for the cost of the award), then gross income of the recipient includes greater of  Amount greater than deduction but less than value of award  Amount by which award value exceeds allowable deduction 132 (e): De Minimus Fringe o Any property or service, the value of which so small as to make it unreasonable or administratively impracticable (taking into account frequency provided) o Eating facility: treated as de minimis fringe, if,  Located near business premises, AND  Revenue from facility normally equals or exceeds direct operating costs - 9 Code § 119 [193]: Meals or lodging furnished for the convenience of employer (interpreted by: U.S. Jr. Chamber. of Com. v. U.S.) To be excludable, lodging must i) be furnished for the convenience of the employer ii) employee is required to accept lodging as condition of employment (required for employee to properly perform duties) iii) lodging must be on the business premises of the employer (premises of employer where duties of employee are to be performed) Note: in this determination, intention of employer is not very important. Provisions of contract are not controlling. (e.g., even if employer intended as part of compensation, employee could exclude if conditions met) To be excludable, meals must: be on the premises Ophra Hypo: see ppt. 100 ??? Code § 104 [79]: Compensation for injuries or sickness - see ppt. 100 ―putative damages‖ and ―non-physical damages‖ (emotional distress / discrimination / libel) are taxable‖ - direct medical expenses (a)(2): flush language [pp.102] Review Problems [ppt.103] DEDUCTIONS Code § 161 [130]: Allowances for deductions Code §165 [147]: Losses - (c) limitations on losses to individuals: only for o Incurred in trade/business o Incurred in transaction entered into for profit, and o Casualty losses  (h)(1): each item must exceed $100; and total must exceed 10% of adjusted gross income [hypo ppt. (ii)7] IF personal casualty gains exceed personal casualty losses: o All such gains treated as capital gains o All such losses treated as capital losses 10 - Corbaley: what is a casualty loss? o When unexpected, accidental force is exerted on property and the taxpayer is powerless to prevent [ppt. (ii)8] RevRul 70-91: Rust and corrosion of weather heater was gradually progressive, therefore not casualty. But damage caused by bursting of water heater was. Blackman: allowing casualty loss where man sets own house on fire would be against public policy. - - Code §166(b) [149]: Bad Debts - (a)(1) General Rule: deduction allowed for any debt which becomes worthless during taxable year - (b): See §1011 for determining amount - (d): individuals do not get bad debt deduction for ―non-business‖ (may be able to take a capital loss?) o [e.g, if mother loans money to daughter; the following year the debt is declare worthless, then can deduct basis in that debt. Note: cash method = no basis; accrual = basis (see ppt.192)] Regs.1.166-5(a)(2): Bad debt deduction - only if and when becomes totally worthless; no deduction for nonbusiness debt which is recoverable in part during the taxable year. Code § 162 [130]: Trade or business expenses - a deduction of all ordinary and necessary expenses in caring on any business, including (ordinary = common & accepted means / not just ―habitual‖ or ―normal‖) o reasonable compensation for services actually rendered o traveling expenses (not lavish/extravagant given the circumstances), and o rentals or other payments for use of property Welch v Helverling[ppt111]: what is ‗ordinary and necessary‘ - ‗ordinary‘: common and accepted means (habitual does not automatically mean ordinary) - ‗necessary‘: for the development of the petitioner‘s business (at least appropriate and helpful) Lilly v Commissioner: Expense are deductible if common to the industry Twity Burger case (Jenkins) [ppt115]: if sufficient connection b/w expenditures and taxpayer‘s trade or business. Business Reputation argument. 11 - Traveling: meals and lodging away from home (a)(2); If i) reasonable and necessary; away from home; not if expected to exceed one-year. (Flowers). o IRS: Home = principal place of business o Circuits: Home = where you live o Away from home: Rev.Rule 93-86 [ppt.292] o Two homes: Hantzis. [293] & Andrews [294] - Meals & entertainment : ½ (274(n)(1): If away overnight. o Commuting: if overnight, deductible [ppt.294] o Exceptions: reimbursed: don‘t want to hit the taxpayer twice o o Moss: weekly meals by lawyers not deductible [ppt.298] Danville Plywood: superbowl not deductible [ppt.299] - Primarily biz. Or personal? [ppt.296] - Pevsner: designer clothes as not deductible [ppt.300] Three rules: o Required for employment o Not adaptable o Not so warn Coughlin: Continuing education deductible if: maintaining or improving skills (not meeting minimum educational requirements). [ppt.304] Hudgens: Hiatus argument: only if in same TorB before and after. [ppt.305] Sharon: school expenses not deductible; lisence fee amortizable; bar expenses deductible. [ppt.308] Higgins: private stock trading not T&B expense. [ppt.310] - - - [company minister cases ppt. 113] Exacto Spring Corp. v Commissioner [CEO‘s 1 mil. salary is reasonable] - 162(a)(1)‘s ―reasonable‖ requirement is to prevent dividends/gifts from being disguised as salary (b/c apparent that payment is not for services to the company) - Reasonableness depends, not on taxable income, but on corporation‘s profitability (as that is what investors care about; the investors‘ ‗rate of return‘) ) - Test: ―independent investor‖: When the investors are obtaining a far higher return than they had any reason to expect, the CEOs salary is presumptively reasonable (can be rebutted if the company‘s earnings are from something other than the CEOs exertions.) 12  Note: some jurisdictions still used the multifactor test disprioved of by Posner in the opinion for this case. Consider: § 162(m): Certain Excessive Employee Remuneration (in general, limited salary tax deduction for an employee to $1 million; but excludes ―commission‖—performance-based—remuneration) Code § 212 [198]: Expenses for the production of income (1) for production of income (2) for income-producing property management (3): legal fees relating to tax advice United States v Gilmore [corp president cannot deduct his divorce costs] o Expense must ―profit seeking‖ nexus: must arise from ―profitseeking‖ activities (origin of the claim test). (c): Losses [ppt.311] - Horrmann: ex-house is ‗property held for production of income o When he moved out of house, no longer principle residence o Therefore, deprecation and maintenance expenses are deductible o ‗tipping point b/w 212 property and 165 (entered into for profit): i.e., when can you change your mind: ―enter into‖ house to live, but ―hold‖ it for the production of income. Reg1.262-1(b)(7): attny‘s fees for divorce Kopp‘s Company v U.S. [Son‘s auto accident costs are deductible] o b/c company was named as defendant, therefore claim was not merely a personal claim; it directly jeopardized its assets. Code § 261 [223]: General rule for disallowance of deductions Code § 262 [223]: Personal, living, and family expenses (plus phones) Code § 183 [190]: Activities not engaged in for profit (hobbies) class notes: down pink tab. - (a): if allowable under other sections (so as not to loose them) - (b) limits your deductions on losses from ‗ordinary and necessary‘ hobby expenses to your income generated from the hobby. - Note: related to Sec. 67 (2%) limit on Misc. itemized deductions 13 Code § 163 [136]: Interest (deduction) - (a) Gen: deduction on all interest on debt paid or accrued w/in taxable year - (h) disallowance for personal interest (individuals); BUT: - (h)(2)(D) Ok for ―qualified residence interest” - Qualified residence is (3)(A)(i) 1 million in ‗acquisition debt‘, or ii) 100,000 in ‗home equity‘ debt Code § 221 [210]: Student loan interest (deduction) - $2,5000 maximum - Probably only first year (b/c of salary cap) Code § 265 [229]: ”exemption on expenses incurred to produce income” - e.g., exception for tax exempt items, e.g., tax exempt bonds - REVIEW PROBLEMS #1 [PPT.137] ACCOUTNING ISSUES Code §446 [343]: Methods of accounting (ppt.177) - (a) General Rule: Taxable income shall be computed under accounting method the taxpayer uses to keep books - (b) If no method has been regularly used, or if method does not clearly reflect income, the Secretary can assign a method (that does clearly reflect income) - (c)Permissible Methods [see ppt. 178] - Note: default is cash basis Code §451 [437]: General Rule for Taxable Year of Inclusion - (a) General Rule: Amount shall be included in gross income for taxable year received unless properly accounted for in a different period Reg1.446-1: General rule for methods of accounting - (c): permissible methods o (i) Cash method: deduction in year actually or constructive received o (ii) Accural method: deduction in year when i) all events have occurred, ii) the income and amount can be determined (reasonably), and iii) economic performance has occurred. (e.g., when bill is sent. [See pp.186-7]) Reg1.451-2(a): Constructive receipt - When credited to taxpayer‘s account, set apart, or otherwise made available [see ppt. 187] - (taxpayer can‘t push away income to avoid constructive receipt) - It is NOT constructively received if taxpayer‘s control is subject to substantial limitations or restrictions. 14 Code §461(h) [359]: Economic performance - if only accrue liability over time; only for the year at issue (e.g., year lease for 500k = 100k per year Hornung v CIR [Cash basis taxpayer: no constructive possession of Corvette] - Basis of constructive receipt is ‗unfettered control‘ by the recipient over the date of actual receipt - Here: car was in different city in closed retail store; P did not have title or keys or other evidence of ownership or right to possess car at that time Cf.: Ames v Comm [CIA agent had no constructive possession of Soviet bribes] - Constructive receipt when ‗unqualified, vested right to receive immediate payment: unfettered control over actual receipt - Here: did not have ready access to money in account: had to arrange transfer; no certainty that could be arranged; substantial risk; Soviets retained control Code §109 [89]: Improvements by lessee on lessor‟s property - Basis and deferral - No gross income on improvements, unless made for rent - Will be taken in to account when sold (since no basis adjustment) - Note: therefore, w/ rent, basis adjustment Rev. Proc. 71-21: Payments received in one taxable year for services to be performed in the next can be deferred (credit card fee cases) Barnett Bank v Comm: Part of fees deferred (to match services performed) - Accrual method taxpayer - Reconcile tax and financial accounting treatment - Burden is on taxpayer to maintain books to allow verification - Note here: pro rata refund if credit card is cancelled Cf. Signet Bank v Comm: No deferral of credit card fees - Here: under cardholder agreement: fee paid in full upon issuance; not refundable, not contingent on performing any services - Petitioner must show that payment was made at least in part for services to be performed in the next taxable year; here, agreement clearly shows this is not the case 15 (Comm.‘s considerable discretion under §446(b)) Ford Motor v Comm: changes method from accrual to cash basis - Structured settlement for auto accident torts: Buys annuities, to be paid out over 40+ years; claims deductions for total amount of payments due - Comm says: method did not clearly reflect income (§446(b)); Comm has broad discretion to make this determination: should not be ‗interfered w/ unless clearly unlawful: Three stage analysis (txt 268) - Comm.‘s discretion is not limited to methods that Ford could have adopted on its own - Especially here: ‗incongruous result: the greater nominal liability for negligence, the benefits - See also Reg.1.461-4(g)(8) Code §461(h)(2)(C) [360]: “economic performance occurs as payments to injured parties are made” Code §72 [60]: “must also include portion of amount paid that represents interest growth as gross income” BASIS in Property Transactions Property Transactions No taxable income until "realization event" (ala Glenshaw Glass) (taxable income is the gain) Code § 1001 [487]: Determination of Amount of and Recognition of Gain or Loss Code § 1011 [488]: Adjusted basis (see 1012; 1016) Code § 1012 [488]: Basis of Property: Cost (except cap ex) (not including real prop. Tax) Code § 1016 [491]: Adjustment to Basis Property Transaction analysis: 1012: Basis ±1016: Adjustments 1011: Adjusted Basis 1001(b): Amount Realized <1011>: Adjusted Basis 1001(a): Gain / Loss (gains included in gross income; loss depends on type) 16 When basis cannot be accurately determined: - First Northwest: Where property is sold, if the basis cannot be determined, all income is taxable. (no basis offset). - Cf.: Inaja: If basis cannot be determined, income will be sued to reduce basis to zero. Remainder will be taxable. [better for taxpayers: current value of money] Code § 1014 [488]: Basis for Property Acquired From a Decedent (a) (generally: fair market value) (b) (when to characterized as ‗acquired from decedent). [―Stepped-up‖ i.e., basis is the fair market value of the property on the date of the decedent‘s death. (yet another tax advantage to property owners over renters).] [SEE ppt. 82] (e) not one-year limitation on gift pass-back (then carryover) (post 1981) - Note: for decedent who passes on appreciated property: no income. Taft v Bowers Code § 101 [76]: Certain Death Benefits (treating life insurance) Life Insurance: bequests (cash) are tax free under §102. BUT: transaction which appear to have a commercial flavor, rather than a testamentary flavor, tend to be excepted from the exclusionary treatment. (see §101(a)(2)(A),(B). - if paid ‗valuable consideration,‘ then no exclusion beyond the value of that consideration. But (exception to exception) (A) and (B). [SEE ppt. 61-62] Code §1015 [490]: Basis for property acquired as gift - Basically: carry over basis: ―my basis is your basis‖ (post-1920) - Unless i) if FMV is less than basis at time of gift, and ii) at time of disposition, it is sold at a loss, then use FMV (lesser of the two). [But: see ppt. 79: no income if gain=loss/loss=gain] (Note: no recognition until ‗sale or other disposition‘) Farid-es-sultaneh v Comm: Pre-nup agreement payment not gift. Was payment for ‗valuable consideration‘: therefore, acquired basis of market-value at time of transfer.  [See „paris‟ hypo. Pp.t81] Code § 1041 [507]: Transfers of property b/w spouses incident to divorce  Imposes ‗gift treatment‘ on transfers b/w spouses OR incident to divorce 17 Code § 71 [58]: Alimony - Deductible by donee; income to donor - Seven elements: o Cash (not property ~ 1041 covers) o Terminates upon death of payee o Not front loaded (otherwise looks like property settlement) o Received by or on behave of (does not need to be direct) o Divorce decree (or other written agreement) o Do not say ―not alimony‖ o Not child support (not income; not deductible) CAP EX ANALYSIS [ppt.152] Code § 263 [223]: Capital expenditures - May get depreciation deduction under 167/168, if: o Held for production of income o Has ascertainable useful life. - (a)(2) general rule: expenses for restoring property not deductible from income (would instead be capital expenditure) Revenue Ruling 2001-4 [airliner maintenance: deductible repairs or capital investment?] What are capital expenditures?  Appreciably prolong the life of the property  Materially increase its value, or  Make it adaptable to a different use  Specifically, where an expenditures is made as part of a plan of rehabilitation or modernization, must be capitalized even though, standing alone, the item may be classified as one of repair or maintenance. Northwest Corp.: Asbestos case [ppt.157] Fall River Gas [cost of installing leased appliances into homes as capital expenditure] - Capital expenditure is one which o Secures an advantage to taxpayer for more than one year, and o Taxpayer acquires something of ‗permanent use or value‘ - Here: taxpayer plainly anticipated over-all duration of leases would result in rental income and increased consumption of gas - Totality of expenditure was made in anticipation of a continuing economic benefit over a period of years Note: Dana Corp. v US: law firm retainer usually deducted as ‗ordinary and necessary‘ business expense as was to prevent firm 18 from representing adverse parties in takeover situations; but when large M&A fees charged, retainer had to be capitalized. Indopco [expenses related to friendly takeover: capital investment] - Deductions are a matter of ‗legislative grace‘ and burden is on taxpayer to clearly show provision - §263(a)(1): envisions inquiry into the duration and extent of the benefits realized - Changing corporate structure is not ‗ordinary and necessary‘ Code §167 [150]: Depreciation (a) General Rule: reasonable depreciation allowance for exhaustion, wear and tear (including obsolescence) of: o Property used in trade or business o Property held for the production of income (b) Correlation w/ §168 (accelerated cost recovery system) (c) Basis for depreciation: §1011 Note: deduct salvage value first. [see ppt.165 hypo] Note: §1016(a)(2): Downward adjustment to basis required even if you don‘t take the deduction: so must take! [ppt. 163-4 / hypo]: whenever depreciation problem: basis adjustment. - Reg1.167(a)-1(b): Useful life of asset - Not necessarily ‗inherent‘ useful life; rather, period over which asset may reasonably be useful to taxpayer in trade/business/production of income Code §179 [188]: Election to expense certain depreciable business assets (ppt.180)??? - treat as expense; and therefore immediately write off - vs. 168 calculations: then to tables SEE HYPO ppt.180??? Code §168 [152]: Accelerated cost recovery system (ppt.168: ACRS/ hypo: 171-4) - ‗assigns‘ depreciation years to property - only applies to tangible real and personal property (intangibles are not eligible for accelerated depreciation. - allows deprecation for full basis (w/o salvage value subtraction) - When straight-line is greater deduction, taxpayer can switch. - Note: 168(k): sep.2001 property: see low orange tab in notes. [ppt.181] 19 Fribourg navigation v Comm: [liberty ship bonanza] [ppt. 175] - Can sales of depreciable asset for amount in excess of its adjusted bases at the beginning of the year bar deduction of depreciation for that year? Harrah‘s Club [casino must capitalize for restoration of antique autos] - Restoration increases indefinitely the life of an antique car - Property w/ an indeterminate life is not depreciable [ppt. 176] - (no limit can be put on use of vehicles as museum objects) Cf. Selig v Comm: Depreciation deductions allowed for ‗state-of-the-art‘ cars (Lotus and Ferrari) Ccf. Simon and Liddle: Allows deduction for ‗antique violin bows‘ o Tax court recognizes that, while bows wear out, they have no determinable life. Moreover, even a ‗played out‘ ‗Tourte bow‘ would be pricy as an antique covetable. Affirmed by Second Circuit Courts distinguish ‗artwork‘ hanging on office wall. o CAPITAL GAINS / LOSSES [mechanics: ppt. 213] - Must have sale or exchange (1222) or a capital asset (1221). Code §1211 [526]: Limitation on capital losses (not corps) [see ppt. 216-19] Code §1212 [526]: Capital loss carrybacks and carryovers [see ppt. 223] Code §1(h) [4] “maximum capital gains rate” Gray v Darlington: capital gains are not income. - Not taxed at ordinary rate: taxed at ‗cap.gains rate.‘ o Why it matters: avoid ‗bunching‘ of gains into one year  Don‘t want to bump tax bracket  Want to take inflation into account  Want to provide investment incentives 20 Treatment - STG are taxed at regular rates - LTG are taxed at preferential ‗capital gains rate‘ - If STL < LTG, then net CG, preferential treatment - If L > G, then offset upto 1211(b) limits. (non corporate) 1211(b) amount then ‗recharacterized‘ as STG and new netting [under 1212] o If in new netting: STL > LTG, then STL carryover o If in new netting: LTL > STG, the LTL carryover > SEE HYPOs: ppt. 228-33] Code §1222 [530] Terms for capital gains/loss (11): Net capital gains = LTCG > STCL (10): Net capital loss = CL > CG (subject to 1211 limits) (7): Net long-term capital gain = LTCG > LTCL (6): Net short-term capital loss = STCL > STCG (1): (2): (3): (4): STCG = gain on sale/exchange capital assets held one year or less STCL = loss on sale/exchange capital assets held one year or less LTCG = gain on sales/exchange of capital asset held for more than one year LTCL = loss on sales/exchange of capital asset held for more than one year Code §1221 [529] Capital Assets defined o ‗property‘ held by the taxpayer that is NOT:  Stock in trade or other types of ‗inventory, or Primarily held for sale to customers in the ordinary course of trade/business  Property subject to depreciation (§167) , or reap property used in trade/business  Copyrighted or artistic composition or similar (intangible) property held by:  Taxpayer whose personal efforts created such property, or  In case of letter/memorandum, etc., taxpayer for whom such property was prepared   Accounts or notes receivable Hedging transactions What is a capital asset? (for real estate sales) Byram v US: Seven pillars of capital gains treatment o Q: is primary purpose for investment or for sales to customer in the ordinary courts of trade/business o Is a factual (cases-by-case) consideration, looking into: - 21 i. ii. iii. iv. v. vi. vii. Nature and purpose of the acquisition (and duration of ownership) Extent and nature of efforts to sell Number / extent / continuity of sales Extent of subdividing / developing / advertising Use of business office Character / degree of supervision / control Time and effort - (ultimate question for property is ‗purpose for which held‘) Hollis v US: art expert pillaging Japanese market was making ordinary income o Merely designating purchase/sell of art as ‗investment‘ is not decisive o Contemplated that sales were to be made immediate upon return o Considering nature of market (esp. limited number of wellinformed potential buyers), lack of advertising not critical o Anticipated long-term engagement in business (Securities: Corn products doctrine: ‗integral part of business‘) - Corn Products v Comm.: gains on futures transactions ‗vitally connected‘ to the companies manufacturing operations not capital investments [not §1221] o Nothing in record supports idea that ‗futures trades‘ were ‗separate and apart‘ from manufacturing operation (in contrast, appears vitally important) o Transactions sued as substitute for building/operating additional storage facilities (closely geared to manufacturing operation) - (Narrowing Corn Products Doctrine) Arkansas Best v Comm.: Capital stock held by holding company was capital asset o Tax payers motivation/purpose is irrelevant o It‘s property unless it‘s a 1221 exception. (puts corn products into ‗inventory‘ exception) What is NOT a capital asset? Hort v Comm: Cancellation of a lease contract NOT ‗return of capital; rather, is ordinary income o Payment was ―merely‖ substitute for the rent reserved in the lease (which §61 clearly characterizes as gross income)  Cf. McAllister v Comm.: Sales of life estate in trust fund is return of capital 22 o o Distinguished from Hort b/c here, is vested remainder (as opposed to Hort‘s term-ofyears) Right to income from life estate was a right in the estate itself (fee interest) TRADE OR BUSINESS PROPERTY Code §1231 [533] Property used in trade or business & involuntary conversions Basically: - if have net gains both LT and ST: o Net 1231 gains = LT cap treatment o Net 1231 losses = ordinary loss treatment - If have net losses in both, then o Losses are combined and o Can be offset against ordinary income (up to 3K) - If net loss in one, net gain in another: o If excess ST gain, the ordinary treatment o If excess LT gain, then cap gain o If net loss (of either) exceeds, then can be offset against upto 3K, w/ unlimited caryforward 1231 analysis : [ppt.255-263] 1) Is it a 1231 transaction? Involuntary Conversion [netting: see ppt. 255] (see 1231(a)(4)(C)) i. Is it involuntary conversion? (stolen/destroyed) ii. Is it 1. property used in trade or business, or 2. any capital asset held for more than one year AND held in connection with trade or business or entered into for profit? If (4)(C) loss exceeds gain, not included in 1231 calculations) Other “property used in trade or business” 1231(b) [534]: such property defined (and exceptions) 1. General rule (held more than one year: not inventory, etc.) 2. Timber, Coal, or Domestic Iron Ore 3. Livestock 4. Un-harvested Crop 23 2) What is the net Gain / Loss of 1231 transactions? i. If 1231 gains exceeded 1231 losses, then all such gains and losses will be long-term (capital) gains and losses (Note, this is an exception to the general rule of 1221(2) regarding treatment of property used in trade or business.) ii. If 1231 losses exceed or equal gains, then all such gains and losses are treated as ordinary. Recapture [ppt. 267] - To prevent depreciation deductions from being used to create capital gain; treats certain 1231 gains as ordinary income. Our focus: 1245. [See class notes, low blue. Diagram] - Analysis: ppt. 270Code §1245 [542]: Gain from disposition of certain depreciable property Income producing income transferred to trust [ppt.251] - The beneficiaries, not the trust, are taxed: so there is more property which can be distributed. - When income is paid to beneficiaries, they are taxed. (102 does not exclude the amounts from gross income. (b)Subchapter J. Sale of a business [ppt. Code §1060 [513]: Special Allocation Rules for Certain Asset Acquisitions - requires treatment like certain corporate sales; however, taxpayer can escape that treatment by signing an agreement on allocating purchase price among assets (unless gov. finds overreaching). [ppt. 266] Code §197 Amortization of Goodwill and Other Intangibles [ppt 309] Code §197(d)(1)(E)[194]: “covenant not to compete = intangible = amortized” pt266] Williams v McGowan (2nd Cr. Crt.App; 1945) L Hand opinion o Issue: whether sale of going business is accounted as whole, or broken into fragments (e.g, cash, receivables, inventory, fixtures, etc.) o Sec. 1221: property is ‗capital asset‘ except for three exceptions  Stock in trade… or other inventory  Property held primarily for sale to customers  Property used in trade/business that is subject to depreciation o o No way to treat whole business as ‗stock in trade‘ Congress ‗plainly‘ did not regard whole as ‗capital assets‘  Here: fixtures are not capital b/c subject to depreciation allowance  Gain / loss on every other item should be treated as ordinary - 24