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I. Basic Structure A. Purposes of Taxation 1. Encourage/Discourage certain types of behavior 2. Raise government revenue B. Marginal Tax Rates 1. Progressive Rate Structure – The more you make, the more able you are to pay 2. As income increases, the tax rate increases 3. The marginally increased income is taxed at the higher rate

II. Scope of Gross Income A. General Definitions (Gross Income = income from whatever source derived = all income that is subject to tax) 1. [IRC §61] – all income from whatever source derived 2. Definition Includes a. Imputed Income b. Accretion in Value 3. Citizenship a. Cannot renounce citizenship to avoid taxation. Still must pay for 10 years. b. Still must pay taxes if citizenship is in US, while living in a different country 4. Realization of Income a. Realization = Receipt of an Economic Benefit b. Must have the realization of income to have it recognized as taxable. c. There must be some triggering event to realize the income. d. Unrealized Appreciation: appreciation of property is not income until it is sold. 5. Gross Income includes all income unless there is some specific code section that excludes it. B. Equivocal Receipt of Financial Benefit 1. Treasure Trove a. The finder of treasure-trove is in receipt of taxable income to the extent of its value in US currency b. Gross Income is taxable in the year when it comes into undisputed possession (not when it is found). c. Gross Income does not have to be actual money. d. [Reg. §1.61-14] Treasure trove, to the extent of its value in US currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession. e. Cesarini v. US: Piano bought in 1957; $ found inside it in 1964. Money was realized and taxable in 1964 f. However, if you buy a piano and later find out that it is a Steinway, realization requires a triggering event. 2. 3rd Party paying taxes a. If a 3rd Party pays taxes on the individual‟s behalf, it is considered income to the individual b. Employment is consideration for tax payment c. Issue: There is an equation to be used when a 3rd party pays taxes for the individual to equalize payments without receiving income in perpetuity d. Old Colony Trust Co. v. Commissioner: Employer paying employee‟s taxes is income to the employee 3. Glenshaw Glass Test a. Commissioner v. Glenshaw Glass Co: Awards of punitive / treble-damages in antitrust suits were taxable b. Gross income is “undeniable accession to wealth, clearly realized and over which the taxpayer has complete dominion” i. Net accession to wealth Glenshaw ii. Clearly realized Glass iii. Dominion and control c. Money Damages in a Lawsuit i. Awards of damages are income ii. Considered “gains or profits” d. Charley v. Commissioner: Money from employee‟s “cashed-in” frequent-flyer miles was taxable income e. James v. US: Illegal Gain = Income, despite a legal obligation to make restitution C. Income Without Receipt of Cash or Property 1. Corporations a. Benefit from the corporation, regardless of whether the corporation is owned by the taxpayer, is income b. Dean v. Commissioner: Holding own home in name of corporation did not prevent fair value of occupancy/rent from being income. 2. Barter a. Benefit through barter of services, even without exchange of cash, is income equal to fair market value b. [Rev.Rul. 79-24] If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income (at fair market value) c. Barter is assumed to be of equal value 3. Helvering v. Independent Life Ins. Co: Rental value of a building owned by the taxpayer does not constitute income within the XVI Amendment 4. [Reg. §1.61-2] Compensation paid in property is taxable as much as its fair market value


Problems: What is income when Vegy grows vegetables in her crop?  Vegy harvests her crop – No  Vegy and her family consume $100 worth of vegetables – No  Vegy sells vegetables for $100 – Yes  Vegy exchanges $100 worth of vegetables for $100 worth of Tuna - Yes  Vegy sells in Grocery store in exchange for rent paid by Grocer to landlord – Yes, for rental value of space in store


I. Exclusions for Gifts & Inheritances Received A. Rules of Inclusion and Exclusion 1. Gross Income includes all income unless there is some specific code section that excludes it. 2. General Rule a. [IRC §102(a)] Gross income does not include the value of property acquired by gift, bequest, devise or inheritance. b. [IRC §102(b)] Income from a gift is not an exclusion 3. Gross Income includes the receipt of any financial benefit which is: a. Not a mere return of capital (interest), and b. Not accompanied by a contemporaneously acknowledged obligation to repay (loan), and c. Not excluded by a specific statutory provision 4. Income is interpreted broadly, while exclusions are interpreted narrowly 5. Differentiate between exclusions from gross income and deductions available B. Gifts 1. The Income Tax Meaning of Gift a. Determination of whether a transfer is a gift is based on the ad-hoc assessment of the fact-finder b. Intent i. A gift proceeds from a detached and disinterested generosity, (out of affection, respect, admiration, charity, or like impulses) ii. To determine whether income is a gift, look to the dominant reason that explains the transfer iii. Fact-finder objectively evaluates the nature of the transfer to determine whether it was a gift c. “Maxims of Experience” to determine whether a transfer is a gift: i. Payments by an employer to an employee, even though voluntary, ought to be taxable ii. The concept of a gift is inconsistent with a payment‟s being a deductible business expense iii. A gift involves “personal” elements iv. A business corporation cannot properly make a gift of its assets d. Commissioner v. Duberstein: Supreme Court refused to clearly define what constitutes a gift, but maintained the “detached and disinterested generosity” test 2. Employee Gifts (prima facie: no gifts) a. The issue arises in transfers: i. To an employee during an ongoing relationship, ii. To an employee upon or after retirement, and iii. To survivors upon the death of an employee b. [IRC §102(c)(1)] An employee shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee. c. [Reg. §1.102-1(f)(2)] – [IRC §102(c)] does not apply if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment d. To be excepted, employee must show that the transfer was not made in recognition of the employee‟s employment C. Does the transferor pay taxes? 1. Yes - based upon value of what is given, whether intervivos or at death. 2. Not an income tax, however. D. Bequests, Devises, and Inheritances 1. [IRC §102(a)] exempts “property acquired by gift, bequest, devise, or inheritance” from federal taxation 2. State Power a. Interpretation of the construction of this exemption in the federal statute is not determined by local law b. What does State Law determine? i. State law controls only when the federal taxing statute, by express language or necessary implication, makes its operation dependent upon state law. ii. State law helps determine people‟s rights in property. c. Lyeth v. Hoey: i. Inheritance was not taxable under federal law, regardless of state law ii. Inheritance is excluded, whether by devise or by settlement (cash or property; testate or intestate) 3. What is a bequest, devise, or inheritance a. Wolder v. Commissioner: Payment for legal fees through devise in will was income to devisee b. The test is whether the gift is a bona fide gift or simply a method of paying consideration, based on i. Intent of the parties ii. Reasons for the transfers iii. Parties‟ performance in accordance with their intentions Problems: Does §102 apply in the following situations?  Father leaves daughter $20K – Yes  Father dies intestate & daughter gets $20K – Yes  Father leaves several family members out of will. Daughter & others attack the will & daughter gets $20K – Yes  Father leaves daughter $20K in appreciation of long and devoted service - Yes  Father leaves daughter $20K pursuant to a contract for service - No


II. Exclusions for Employee Fringe Benefits & Certain Employee Provided Meals & Lodging A. General 1. The tax law on fringe benefits is completely statutory. 2. Although it is subject to customary administrative and judicial interpretative refinements, it cannot be created administratively. 3. Contiguous Theme - Government is willing to exclude these benefits from gross income because: a. They are relatively small b. They would be cumbersome to account for 4. If a benefit is not specifically excluded from gross income, its value must be included within gross income B. [IRC §132] Certain Fringe Benefits 1. [IRC §132(a)]: Enumerated exclusions from gross income are: IRC §132(b) No-additional-cost service [THINK OF EXCESS CAPACITY], i. Line of Business Test: (a) Benefit must be provided in the same line of business as that in which the employee is working (b) Doesn‟t apply if employee is working for a conglomerate and the benefit is not in the employee‟s line of business (c) [Reg. §1.132-4(a)(1)(iii)] Employee may work in multiple lines of business and exclude fringe benefits from every line she works in ii. No substantial additional cost test: (a) Employer must incur no substantial additional cost in providing the service to the employee (b) [Reg. §1.132-2(a)(5)(i)] Revenue forgone is an additional cost that is not excluded (eg. Bumping a passenger off a flight for an employee) (c) [Reg. §1.132-2(a)(5)(ii)] If service is fundamentally labor intensive, it is not excludable (eg. Lawyer having his estate plan done by the firm he works for during down-time) iii. [IRC §132(i)] Employee can exclude based on reciprocal agreements between rival companies IRC §132(c) Qualified employee discount [THINK OF RETAIL COURTESY DISCOUNTS], i. [IRC §132(c)(4)] Qualified Property or Services: Discount does not apply to real property or personal property held for investment purposes ii. Restrictions (ceilings) (a) Services (i) May not exceed 20% of the price at which the services are offered to customers (ii) [Reg. §1.132-2(a)(2)] allows exclusion of excess capacity services up to 20% (b) Property (i) May not exceed the employer‟s “gross profit percentage” [(aggregate sales price - cost)  (aggregate sales price)] (ii) Nuance: If a customer is bumped, then there may be no [IRC §132(b)] fringe benefit; but there may be an [IRC §132(c)] fringe benefit up to the ceiling. iii. The „nondiscrimination‟ and the „same-line-of-business‟ restrictions both apply IRC §132(d) Working condition fringe benefit, i. Something an employer provides for you which, if you bought it, would be a deductible business expense is a fringe. ii. If the employee could have deducted the benefit (pursuant to [IRC §162] & [IRC §167]), then the employee can exclude the benefit. iii. No non-discrimination clause - Can be discriminatory IRC §132(e) De minimis fringe benefit, i. Any property of service whose value is so small as to make required accounting unreasonable or administratively impracticable ii. [Reg. §1.132-6(e)] (a) Included (1) 85% must be for business purposes (2) Eg. cocktail parties, group meals, traditional holiday gift @ fair market value, etc. (b) Excluded: Eg. season tickets, use of employer-owned facilities, etc. iii. Considerations (a) Frequency of benefit (b) Low-value + difficulty in accounting iv. On-Premises Eating Facilities (a) Treatment of certain eating facilities shall be treated as fringe when: (1) Facility is located on or near the business premises; and (2) Revenue derived from such facility normally equals or exceeds the direct operating costs of such facility. [not a free meal – but, can sell food at cost]. (b) Non-discriminatory clause: can discriminate, but not in favor of „highly compensated employees‟ IRC §132(f) Qualified transportation fringe benefit, or i. Transportation between the employee‟s residence and place of employment ii. [IRC §132(f)(5)(C)] Qualified Parking provided to an employee on or near the business premises of the employer is excluded up to $175 per month, adjusted for inflation (a) FY 2002 = $185 (b) FY 2003 = $190 iii. No non-discrimination clause - Can be discriminatory IRC §132(g) Qualified moving expense reimbursement i. Any amount received by an individual from an employer as a payment for expenses which would be deductible as moving expenses if directly paid or incurred by the individual (then reimbursed). ii. No non-discrimination clause - Can be discriminatory


IRC §132(a)(7) Qualified Retirement Planning Services i. General: The term 'qualified retirement planning services' means any retirement planning advice or information provided to an employee and his spouse by an employer with a qualified employer plan. ii. Non-Discrimination applies iii. Qualified employer plan: The term 'qualified employer plan' means a plan, contract, pension, or account described in section [IRC §219(g)(5)] IRC §132(j)(4) Athletic facilities are excluded when they are: i. Located on premises ii. Operated by employer iii. Substantially all use is by employees, their spouses, children. Cannot include outside people. 2. Other excludable fringe benefits a. Employer-provided day care facilities b. Group life-insurance c. Group legal service plans d. Military benefits 3. [IRC §132(h)] Who is an employee for purposes of [IRC §132(a)(1)&(2)]? a. Persons currently employed; b. Retired and disabled ex-employees; c. Surviving spouses of employees or retired or disabled ex-employees; d. Spouses and dependent children of employees e. [IRC §132(h)(3)] Parents of an employee can exclude air transportation from gross income 4. [IRC §132(j)(1)] Non-Discrimination a. Some services must be provided on a nondiscriminatory basis b. Can‟t discriminate in favor of highly compensated employees c. Applies to: i. [IRC §132(b)] No-Additional-Cost Service ii. [IRC §132(c)] Qualified Employee Discount iii. [IRC §132(e)(2)] On-Premises Eating Facilities iv. [IRC §132(a)(7)] Qualified Retirement Planning Services [IRC §132(m)] d. [Reg. §1.132-8(a)(2)] Consequences of Discrimination: If the fringe benefits provided to a highly compensated individual do not satisfy the nondiscrimination rules, then the individual cannot exclude any income from gross income Problems Employee of a national hotel chain stays in one of the chain‟s hotels in another town rent-free on his vacation. The hotel has several empty rooms. This is an additional no cost fringe and excluded from income.  Same as (1) except that the desk clerk bounces a paying guest so Employee can stay free. This causes the Employer to incur substantial cost so not excluded and it is income. BUT could get a qualified employee discount of up to 20% and exclude that from income. (Example – 200/day and max discount is 20% of 200 so can exclude 40 and 160 is income)  Same as (1) except that Employee pays the bill and receives a cash rebate from the chain. This is also excludable from income. [Reg. §1.132-2(a)(3)] no additional cost benefit if get by way of cash rebate.  Same as (1) except that Employee‟s spouse and kids traveled w/o Employee and stayed in the room for free. Excluded b/c spouse = employee.  Same as (1) except that Employee stays in the hotel of a rival chain under a written agreement in which Employees pay 50% of the normal rent. As long as in the same line of business, there was an agreement to allow for discount, and there were no substantial costs incurred, can exclude that discount from income.  Same as (1) except that Employee is an officer in the hotel chain and rent free use is provided only to officers of the chain and all other Employee‟s pay 60% of the normal rent. Not excludable b/c discrimination not allowed in no cost fringes and qualified Employee discount fringes. [Reg. §1.132-8(a)(2)(i)] If Employer discriminates in favor of highly compensated employees, those employees get no discount and all is really income to penalize them and others still get their discount.  Hotel chain is owned by a conglomerate, which also owns a shipping line. The facts are the same as in (a) except that Employee works for the shipping line. Can‟t exclude from income b/c fails line of business test.  Same as (7) except that the Employee is comptroller of the conglomerate. Have to perform substantial services and if comptroller then perform that amount in all lines of business of conglomerate.  Employee sells insurance and Employer Insurance Co. allows him 20% off the 1000 cost of his policy. Discount excluded b/c can exclude up to 20%. Insurance is considered a service.  Employee is a salesman in a home electronics appliance store. During the year the store has 1M in sales ad 600k cost of goods sold. Profit = 400k.Employee buys a 2000 VCR from Employer for 1000. Will be okay as long as it doesn‟t exceed the Gross Profit %. Gross Profit % is the maximum discount that the Employee can receive. GP=X. X= Profit  Sales = $400k  $1M = 40%

So, 40% is the maximum amount allowed for discount to be excluded. 40% of 2000 is 800. Employee paid $1000 for his VCR so $800 is excluded and $200 is income.  Employer has a bar and provides the Employees w/ happy hour cocktails at the end of the week. De minimis fringe so excluded from income.  Employer gives Employee a case of scotch for Christmas. De minimis if low market value. If too expense then income. No bright-line test as to what is too expensive.  Employee is an officer of a corporation, which pays his parking fees at a lot one block from the headquarters. Non officers pay their own parking fees. Qualified parking fringes and can discriminate. Can exclude up to 175 and any amount over that is income. If Employer gave Employee choice of if he wants parking paid or the cash, in case some don‟t drive, if take cash, that is income, but if take parking only that in excess of 175 is income.  Employer puts in a gym at the business facilities for the use of the Employees and their families. Excluded. 5/54

C. Exclusions for Meals and Lodging 1. [IRC §119] Meals or Lodging furnished for the convenience of the employer a. [IRC §119(a)] Not included in gross income as long as i. Meals – 2 conditions are: (a) Meals must be furnished on the employer‟s premises (b) Must be for the (objective) convenience of the employer ii. Lodging – 3 conditions are: (a) Lodging must be on the business premises of the employer; (b) Employee must be required to accept such lodging as a condition of his employment. (c) Lodging is furnished for the convenience of the employer. b. Herbert G. Hatt: Manager of funeral home excluded meals and lodging c. Grocery allowances or restaurant credits are allowable as long as they satisfy the 2 conditions. 2. [IRC §107] Rental Value of Parsonages a. Ministers do not have to pay the rental value of a home furnished as part of their compensation b. Must be clearly delineated in the agreement between the church and the minister Problem #1 Employer provides Employee and spouse and child a residence on Employer‟s business premises, having a rental value of 5000/yr but charging Employee only 2000. Employee gets 3000 benefit.  What result if the nature of Employee‟s work doesn‟t require Employee to live on the premises as a condition of his employment? The 3000 is income b/c not a condition.  What result if Employer and Employee simply agreed to clause in the employment K requiring Employee to live in the residence? Not excludable b/c doesn‟t show that it is for the convenience of the Employer.  What result if Employee‟s work and K require Employee to live on the premises and Employer furnishes Employee and family w/ 3000 worth of groceries during the year? Lodging is excluded but issue to as if groceries are b/c they may not be considered meals.  What result if Employer transferred the residence to Employee in fee simple in the year that Employee accepted the position and commenced work? Does value of the residence constitute excluded lodging? Under §119, the premises must be owned by the Employer and not the Employee so otherwise it is income. Problem #2 Planner incorporated her motel business and the Corp purchased a piece of residential property adjacent to the motel. The corp. by K required Planner to use the residence and also furnished her meals. Planner worked at the motel and was on call 24 hrs a day. May Planner exclude the value of the residence or the meals or both from GI? Answer: Corporation is furnishing her meals even though she owns corporation, so excluded. Residence is excluded and even though adjacent to motel still considered on business premises.

III. Exclusions for Certain Prizes / Awards & Scholarships A. Prizes & Awards [IRC §74] 1. [IRC §74(a)] Gross income generally includes amounts received as prizes and awards 2. [IRC §74(b)] Gross income does not include prizes & awards for religious, charitable, scientific, educational, artistic, literary, or civic achievement if: a. Recipient was selected without any action on his part; b. Prize is not conditioned on future services by recipient; c. Prize is transferred by payer to a specific (approved) charity 3. [IRC §74(c)] Exception for certain employee achievement awards a. Must relate to length of service or safety b. Aspects of excepted awards: i. Must be employed for at least (5) years and never received such an award previously ii. Amount (a) Amount is geared to the amount the employer qualifies for a deduction under [IRC §274(j)] (b) Value cannot exceed $400. iii. Must be tangible personal property; iv. Must be awarded as a part of a meaningful ceremony v. Award cannot be mere disguised compensation - Cash awards are not excluded c. Safety Awards i. Must be awarded to individuals other than managers, administrators, clerical employee or other employee ii. Only excepted if 10% of an employer‟s qualified employees receive such awards during the year. 4. Cross-Reference [IRC §274(j)(4)] B. Scholarships & Fellowships [IRC §117] 1. [IRC §117(a)] Excludes amounts received as a “qualified scholarship” by a degree candidate at an educational organization. 2. [IRC §117(b)] Qualified Scholarship: any amount received as a scholarship/fellowship grant to the extent it is used for qualified tuition and related expenses a. Must be a candidate for a degree b. [IRC §170(b)(1)(A)(ii)] Qualified Institution: must be a real place–where there is a campus, formalized instruction c. [IRC §117(b)(2)] Qualified Tuition and Related Expenses that are Excluded from Gross Income include: i. Tuition; ii. Enrollment fees; iii. Books; iv. Supplies and equipment d. Not excluded from Gross Income:


Personal living expenses Meals and lodging Travel and research [IRC §117(c)] Payment for teaching, research or other services by the student required as a condition for receiving the otherwise excludable amount. 3. [IRC §117(d)] Employment-related exclusions a. Qualified tuition reduction for education below the graduate level b. Qualified tuition reduction for education at the graduate level if the graduate student is engaged in teaching or research c. [IRC §127] permits an employee to exclude up to $5,250 from gross income for amounts paid by the employer for educational assistance

i. ii. iii. iv.


IV. Gains from Dealings in Property [BIG AREA] A. Questions to ask when analyzing gains while dealing in property. 1. Do you have a realized gain? (Is there a sale or disposition of an asset that creates a realized gain/loss?) 2. Is the realized gain/loss recognized? (Must the gain/loss be reported as gross income?) 3. Does the realized & recognized gain/loss receive any special tax treatment? (eg. capital gains/losses) B. [IRC §1001] Determination of Amount of and Recognition of Gain or Loss 1. [IRC §1001(a)] Gain = Amount Realized - Adjusted Basis 2. [IRC §1001(b)] Amount Realized = Money Received + Fair Market Value of Property (other than money) received 3. [IRC §1001(c)] Except as otherwise provided, the entire amount of gain or loss TERMS from sale or exchange of property shall be recognized. Amount Realized = AR C. Determination of Basis Adjusted Basis = AB 1. General Gain = AR - AB a. The basis of an item of property is the amount a taxpayer has invested, in a tax sense, in the property. b. A taxpayer's basis in an item of property is determined initially upon acquiring the property. 2. [IRC §§1011 & 1012] Adjusted Basis a. The adjusted basis for gain/loss determined by cost – see [IRC §1012]. As adjusted in [IRC §1016] b. Basis may be adjusted as a consequence of subsequent events to give an adjusted basis. c. The adjusted basis of property is used to calculate several important tax consequences with respect to the property, including the amount of depreciation deductions allowable. d. [IRC §1016] Adjustments to Basis i. Adjustments shall be made for expenditures, receipts, losses or other items properly chargeable to capital account. ii. A major improvement / capital expenditure or substantial addition can be added to AB. iii. Mere maintenance isn‟t added to basis. iv. In terms of adjusting basis, a taxpayer wants an improvement to be considered a capital expenditure as opposed to a mere expense in order to increase the basis.      Problems Determine the amount of Owner‟s gain on the sale. AR=16. AB=10. 16-10=6k gain. What difference in result above if Owner purchased the land by paying 1k for an option to purchase the land for an additional 9k and later exercised the option? Gain is still 6k because doesn‟t matter how one purchases the property. What result to Owner if rather than ever actually acquiring the land Owner sold the option to investor for 1500? Property = option itself. AR=1500. AB=1000. Gain = 500. What if Owner purchased the land for 10k, spent 2000 in clearing the land prior to its sale, and sold it for 18k. So AR=18. AB=12. Gain of 6k. What if when the land had a value of 10k, owner (a real estate salesman) received it from his employer as a bonus for putting together a major real estate development. Owner‟s income tax was increased 3k by reason of his receipt of the land? [IRC §121] [Reg. §1.61-2(d)(2)(i)] Value of property received = 10k, so gain of 6k. Extra 3k tax doesn‟t matter. 10k is income to the employee because same as if employer had given employee 10k to buy the land but gave it to him instead. 3. Property Acquired by Gift a. [IRC §1015(a)-(c)] Basis of property acquired by gifts and transfers in trust. i. General Rule – Carry-Over-Basis Rule: When a donee receives property as a gift, the basis is that of the donor ii. [Reg. §1015-1] 2 methods for calculation of basis for gifts/transfers in trust: (a) Gain: Basis is the same as it would have been in the hands of the donor, or the last preceding owner by whom it was not acquired by gift (b) Loss: Special Loss Rule - If at the time of the gift the FMV is less then the donor‟s basis and the donee sells for a loss, then the donee‟s basis is the FMV at the time of the gift. iii. Taft v. Bowers: The gain taxable to the donee is the difference between the price realized by him and the price paid by the donor. Problem 1: Donor gave Donee property under circumstances that required no payment of gift taxes. What gain or loss to Donee on the subsequent sale of property if:  The property had cost donor 20k=AB, had a 30k FMV at the time of the gift, and donee sold it for 35k=AR. 35-20=15 of gain. Don‟t use the special loss rule.  AR=15,AB=20, FMV=30. 15-20=-5, but 30-20=10 but then don‟t have a loss so can‟t use special loss rule. Can only use when have a loss. So have to use carryover basis and get a loss of –5.  AR=25, FMV=30, AB=20. 25-20=5 gain. No special loss rule. Problem 2: The property had cost donor 30k=AB, had a 20k FMV and Donee sold it for:  35k=AR, 35-30=5 gain.  15=AR, 15-30= -15 loss so use special loss rule. 15-20=-5 loss.  24=AR, if use AB have a loss and if use FMV you get a gain. Reg. §1.1015-1(a)(2): If using „carry-over‟ gives a loss and „FMV‟ gives a gain, then there is no loss or gain. b. [IRC §1015(d)] Increased basis for Gift Tax paid i. General (a) Transferee does not pay for receipt of gifts or inheritance of estate


(b) However, transferor pays for the right to donate (c) Estate Tax = A tax on the privilege of transferring wealth ii. Basis can be adjusted upwards for gift taxes paid by the donor. iii. If property acquired by gift, can only adjust if property has not been sold, exchanged, or otherwise disposed of prior to the time of the transfer. iv. Limits (a) $10k per year per person (b) $675k over lifetime exclusion v. Computing Adjusted Basis (a) General Rule (i) If at the time of the gift, the FMV was equal to or less than the Donor‟s AB, then the Donee gets no gift tax paid adjustment. (ii) So, the gift tax paid adjustment only applies when the FMV appreciates in the Donor‟s hands. (b) Equation (i) x = Gift Tax Paid Adjustment (ii) Net Appreciation (in donor‟s hands) = FMV @ time of gift – Donor‟s AB POST 1976 EQUATION X Amount of Gift Tax Paid Gift Tax Net Appreciation FMV of Gift X $20 x = = $100 $400 $5 = $305 = = = = Net Appreciation (in donor‟s hands) Total Amount of Gift (FMV of Gift)

$20 $100 $400

Adjusted Basis

4. [IRC §1041] Property Acquired Between Spouses or Incident to Divorce a. General Rule  Non-recognition: No gain or loss shall be recognized (will not be reported) on a transfer (can be sale or gift) of property from an individual to (or in trust for the benefit) of: i. a spouse or, ii. a former spouse, but only if the transfer is incident to the divorce. b. A transfer of property is incident to the divorce if such transfer: i. occurs within 1 year after the date on which the marriage ceases; or ii. is related to the cessation of the marriage c. Always use carry over basis between spouses. i. No special-loss rule ii. No gift-tax paid adjustment d. When the spouse then resells the property, you use the carry over basis to compute the recognized gain or loss. Problem: Donald purchased land 10 years ago for $4000. Property appreciated to $7000, then Donald sold it to his wife Marla for $7000 cash (FMV)  What are income tax consequences to Donald? None – [IRC §1041(a)]  What is Marla‟s basis in the property? Carry-Over Basis = $4000 [IRC §1041(b)]  What gain to Marla if she immediately resells the property? AR ($7000) – AB ($4000) = Gain ($3000)  What result if the property had declined in value to $3000 and Donald sold it for $3000? Same result – Carry-Over basis rule still applies, even though property depreciated. As for D, his $1000 realized loss is not recognized.  What results to Donald and Marla if Marla transfers other property with a basis of $5000 and value of $7000 (instead of cash) to Donald in return for his property? Carry-Over basis rule still applies, whether transfer for cash or other property, or other consideration.


5. Property Acquired From a Decedent a. Stepped-Up Basis for property acquired from the decedent i. [IRC §1014(a)(1)] Fair market value of the property at the date of the decedent‟s death ii. Property acquired from a decedent generally receives a basis equal to its fair market value on the date on which it was valued for federal estate tax purposes iii. Note: New tax law that repeals Estate Tax will eradicate the “step-up” in basis (to an elective extent) and replace it with a “carry-over” basis for property acquired from a decedent in the year 2010. (a) This might show up in a multiple choice question but not in an essay; §1014 is valid for our purposes    Examples Property appreciates during decedent‟s lifetime: Property receives a “stepped-up” basis with no income tax cost to anyone. Property depreciates during decedent‟s lifetime: Property receives a “stepped down” basis without deductible loss. You sell stock received from a decedent: Use the fair market value of the stock at the time of decedent‟s death.

b. [Reg. §1.1014-1] Basis of property acquired from a decedent. i. The basis of property acquired from a decedent is the fair market value of such property at the date of decedent‟s death, or if the decedent so elects, at the alternate valuation date prescribed in §2032. ii. Fair Market Value. (a) The value of property as of the date of the decedent‟s death as appraised for the purpose of the Federal estate tax, shall be determined to be the fair market value. (b) If no estate tax return is required to be filed, the value of the property appraised as of the date of the decedent‟s death for the purpose of State inheritance or transmission taxes shall be deemed to be its fair market value. c. [IRC §1014(b)(6)] Double Step-Up (down) for Community Property Jurisdictions i. If decedent died after Dec 31, 1947: Community property owned by surviving spouse is deemed to have come from the decedent ii. Therefore, surviving spouse‟s basis is the FMV at time of death (gets stepped-up basis).  Example Husband and Wife buy property in 1980 for $200K; AB = $200K together ($100K/each). Property held in Joint Tenancy. Property increases in FMV to $800K. Husband dies. What result? In JT, the spouse automatically gets it. His ½ goes to the wife. Her adjusted basis is $100K (her ½) + $400K (his stepped-up half at FMV) = $500K is adjusted basis and so Gain = $300K. Husband and Wife buy property in 1980 for $200K; AB = $200K together ($100K/each). Property is held as Community Property. Property increases to $800K. Husband dies & wills his part to the spouse. What is her basis? $400K (husband‟s ½) + $400K (wife‟s ½ = FMV at time of death [look at §1014(b)(6)]) = $800K [BOTH HALVES GET STEPPEDUP]


d. [IRC §1014(e)] Appreciated Property acquired by decedent by gift within 1-year of death: i. Basis for appreciated property acquired by decedent by gift within 1 year of death is the adjusted basis of the property in the hands of the decedent immediately before death. ii. Basis is the adjusted basis of the property in the hands of the decedent immediately before death. iii. Rationale: (a) Used to prevent COLLUSION between donor/donee from getting a stepped-up basis and having no real intentions to make a transfer. (b) If you transfer the property and get it back within 1-year, then you don‟t get the stepped-up basis iv. Example: Son buys property for $20K; gives to mom when property is worth $100K; mom dies within 1 year of gift; property goes back to son but, son‟s basis is still $20K (no stepped-up basis).


D. The Amount Realized 1. General a. § 1001 - Amount Realized of sale or disposition = Cash Received + FMV of any Property Received b. The entire amount of a realized gain or loss is required to be recognized, unless a specific provision provides otherwise. c. [Reg. §1001-1] Computation of Gain or Loss: i. The amount that remains after the adjusted basis has been restored to the taxpayer constitutes the realized gain. ii. A loss may be sustained to the extent of the adjusted basis minus the amount realized 2. What is the Amount Realized a. International Freighting Corp v. Commissioner: i. Where employer gave employee stock as bonuses, market value of stock at time of delivery and not cost of stock to corporation was proper basis for claiming deduction in income tax computation as an "ordinary expense of business." ii. Amount realized was the fair market value of the „money‟s worth‟ of the services of the employees ($25k), not the cost of stock ($16k). iii. Amount Realized can equal service in money’s worth, even though the code says cash received + FMV of any property received. b. The sum of any money received plus the fair market value of the property (other than money) received c. The consideration received for the property, including the sum of any money plus the fair market value of any other property received in the transaction. 3. What happens when property is purchased or sold subject to or assuming a mortgage? a. Mortgage Terms i. Recourse vs. Non-recourse Loans (a) Recourse (personally liable on house) or (b) Non-recourse (the lender can take the house back but, cannot come after you personally) (i) First mortgages in CA are required to be non-recourse (c) Refinance loans are typically non-recourse loans (?), but are not required to be. ii. Assuming vs. Taking Subject to the Loan (a) Assume Loan: Become liable on the loan (b) Take subject to the loan: (i) Not taking personal liability (ii) Original borrower still on the loan and lender thinks original buyer is the owner iii. Equity [FMV – Loan] (a) Helps define what your net worth is. (b) Equity increases for 2 reasons: (i) Increase in value (ii) Decrease in debt (c) When you have a lot of equity you can borrow against the equity b. AB/AR i. Adjusted Basis [AB = Cash + Loan Amount] (a) When purchasing property, no matter how you pay for it (cash and / or mortgage), that amount is the adjusted basis. (b) Included in the basis is value paid in cash and value of any mortgage taken to acquire property ii. Amount Realized (a) When you sell the property, no matter if you receive cash or other party bought subject to or assuming a mortgage, the AR is the entire amount you get. (b) AR = cash received + any loans assumed (what did you sell it for) (c) [Reg. §1.1001-2] Discharge of Liabilities (i) If property is encumbered by a liability and the buyer either assumes the liability or takes the property subject to the liability, the amount of the liability is included in the seller's AR. (ii) [Reg. §1.1001-2:(a)(2)] Discharge of Indebtedness: The amount on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be realized and recognized) income from the discharge of indebtedness. c. Crane v. Commissioner i. When you sell property, whether you receive cash or sell subject to a mortgage, the Amount Realized is calculated by the entire amount you get. ii. Equity means nothing in determining amount realized. iii. A liability associated with transferred property is considered an amount realized even though the liability is nonrecourse to the transferor and the transferee takes the property subject to the mortgage. d. Commissioner v. Tufts i. The amount of the nonrecourse liability is to be included in calculating both the basis and the amount realized on disposition. ii. Don‟t limit the Amount Realized to Fair Market Value. If someone purchases property and takes subject to a loan, that entire loan is part of the amount realized even if it exceeds the fair market value iii. Upside Down = Purchase when the property is less than FMV iv. The fact that the mortgage balance at the time of the gift exceeded the fair market value of the property does not alter the Crane result.


Examples 1. Buy a house in 1980; Sales price = 100K; Buy using $20K cash / $80K loan. AB is 100K. [does not matter whether you used cash, or loans]  Later, loan balance is $30K and house is sold for FMV, which has appreciated to $500K.  So, buyer‟s AB = 500K (cash + loans)  Seller‟s Gain: 500K - 100K = 400K gain 2. Same Problem, using Crane Analysis: Bought property for $100K; $20K cash / $80K loans.  Later, FMV has appreciated to $500K.  Existing loan balance is $30K & Net Equity is $470K.  New Loan (2nd Mortgage or Refinance), for $450K on the equity of your house; Total Loans = $480K  Equity now is: FMV ($500K) - loan balance ($480K) = $20K.  Brandon wants to buy house - FMV is $500K; Buyer‟s AB = $500K  Seller‟s AR = $500K (seller gets $20K in cash + benefit of buyer assuming the $480K loan)  Seller‟s Gain: $500K - $100K = $400K gain 3. Same facts as above, but FMV later decreases to $480K  Equity in house is zero, because there are $480K in loans on the house.  Sell to Brandon for 480K.  Seller‟s AR = $480K [money received ZERO + mortgage assumed (480K)]  Seller‟s gain = $480K - $100K = $380K 4. Same facts as above, but FMV later decreases to $470K  Equity in house is zero - because you still have $480 in loans on the house (borrower is “upside-down” he owes more than his house is worth).  Buyer buys property subject to the mortgage ($480K)  What is seller‟s AR? still $480K (does not matter that FMV is less than loan amount – Tufts Case)  Seller‟s gain = $480K -$100K = $380K (this means that the seller, who thought they could just get out of the mortgage and was happy to do so because property values went down, will now have a taxable gain of $380K. Problem Mortgagor (buyer) pays 100k for land, used loan of 80k and 20k in cash.  Buyer‟s cost basis = AB = 100k (cash + mortgage)  2 years later the land has a FMV = 300k. Still has 80k mortgage and takes out another mortgage of 100k (have 220k in equity prior to 2nd loan) No income from this loan because there is an obligation to pay it back (does not pass Glenshaw Glass test - no net accession to wealth).  Mortgagor‟s AB of land if the 100k mortgage is used to improve the land? AB is affected because improvements adjust AB upward. Doesn‟t matter that the money was borrowed and then used to improve the land. New AB = 200k. (original AB = 100 + loan used to improve = 100 = 200 new AB)  Mortgagor‟s AB if the 100k was used to purchase stock? Borrowed money wasn‟t used for the house, so no affect to the AB. AB = 100k (initial cost paid for the land).  Same facts as previous, principal of both loans = 180k and the FMV is 300k. Mortgagor sells subject to both mortgages and 120k in cash (300k). What results? AB = 100k, loans = 180k, 300k(AR) -100k(AB) = 200k gain. Purchaser‟s AB = 300k.  Mom bought property for 100k (20 cash and 80 loan). AB=100k. FMV increased to 300k and she took out a 2nd loan on the equity for 100k. Total loan is 180k. Mom gives property to son which has a FMV of 300k, although her AB is still 100k. Son took land subject to the loan so consideration = 180k (the value of the loan) = AR. (part gift and part sale) Mom‟s Gain: 180K (AR) – 100K (AB) = 80K Gain. Son‟s AB (treated like a sale) = 180k (what he paid - he assumed the loan).  Mortgagor gives to spouse rather than son = no gain or loss recognized under §1041, and spouse gets transferor‟s carryover basis. Husband gets carry-over basis of $100k.  FMV declines to $180K. What would buyer pay if taking subject to loan? Seller: 180 (AR) – 100 (AB) = 80. Buyer‟s AB = 180.  Buys property for 100k (20 cash and 80 loans). FMV = 300. Takes out another loan on equity = 100. Used money to buy stocks and not for house improvements. No effect to AB. FMV goes down = 170.. If bought subject to loans, then price paid is 180. 180(AR)-100(AB)=80k gain. (Does not matter that FMV is less). E. Part Sale – Part Gift [treated as a sale at a bargain-price] 1. Transferor [Reg. §1.1001-1(e)] a. Transferor has gain if Consideration Paid by transferee is more than transferor‟s Adjusted Basis: AR  AB b. No loss can be sustained c. Gift Amount = FMV – Consideration Paid (AR) 2. Transferee [Reg. §1.1015-4(a)] a. Look to the transferor‟s basis. b. Transferee‟s basis is the greater of the Consideration Paid or the gift Carry-Over basis [AB] c. Factor in any gift-tax-paid adjustment, if applicable Examples Transferor gives watch worth $1000 to transferee in exchange for $300. Transferor paid $200 for the watch.  Transferor‟s Gain = $300 (AR) - $200 (AB) = $100  Transferee‟s AB = $300 Transferor gives watch worth $1000 to transferee in exchange for $300. Transferor paid $400 for the watch.  Transferor has no gain



Transferee‟s AB = $400


V. Exclusions for Life Insurance Proceeds A. [IRC §101(a)(1)] Proceeds of life insurance contracts payable by reason of death 1. General Rule (for this exclusion): Gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. 2. The plain thrust of [IRC §101(a)(1)] is to exclude the proceeds of life insurance policies from the gross income of the recipients. 3. [Reg. §1.101–1] Exclusion from gross income of proceeds of life insurance contracts payable by reason of death. a. [Reg. §1.101-1(a)(1)] In general, death benefit payments having the characteristics of life insurance proceeds (worker‟s compensation, endowment contracts, accident/health insurance contracts) are covered by IRC §101 b. [Reg. §1.101-1(a)(2)] Transfers of life insurance policies. If you buy the life insurance contract from another and pay valuable consideration and collect the proceeds of insurance plan, you can exclude only the consideration paid and any later premium payments you make. B. [IRC §101(a)(2)] Transfer for Valuable Consideration (exception to the exclusion) 1. The amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts paid by the transferee. 2. General Rule: Decrease the amount of gross income by the amount of valuable consideration paid 3. Exceptions (to the exception) where the amount excluded is not decreased: a. [IRC §101(a)(2)(A)] Carry-Over Basis Exception i. If there is an applicable carry-over basis, then the exception to the exception applies. ii. The consideration rule will not apply if the transferee‟s basis is a carry-over basis from the transferor–therefore the whole amount can be excluded not merely the consideration paid iii. Eg. Transfer between husband & wife - whole amount can be excluded. iv. In a part-gift, part-sale situation, this exception only applies when the carry-over basis is greater than the consideration paid; if the consideration is greater than the carry-over basis then only the consideration can be excluded, not the whole thing. b. [IRC §101(a)(2)(B)] Transfer to a Stakeholder i. If such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. ii. Transfer of policy from shareholder to corporation – the corporation can exclude the total amount of the policy and not merely the consideration paid. C. [IRC §101(c)] Interest 1. Any amounts made as interest, from insurance proceeds that are excluded, will be included in gross income. 2. Only the face value of the policy (principal) is excluded. 3. Any amount that accrues as interest during payments over time is considered taxable as gross income. D. [IRC §101(d)] Payments of life-insurance proceeds at a date later than death 1. General Rule. These payments are excluded from gross income. 2. These are considered Annuity-Type Payments, where you only exclude what you put in. 3. The amount that is held by the life-insurance company by agreement is considered paid by reason of the death of the insured even when it is paid at a date later than death. 4. It is prorated over the period or periods over which payments are to be made. E. [IRC §101(g)] The following will be treated as an amount paid by reason of the death of the insured: 1. Amount received under life insurance on the life of a terminally ill individual; 2. Amount received under life insurance on the life of a chronically ill individual. Problem 1 Insured dies w/ a policy of 100k but under which several options were available to beneficiary.  What result if beneficiary accepts 100k? Policy excluded from gross income, because paid by reason of death [IRC §101(a)]  What result if beneficiary instead leaves all proceeds with the Co. and they pay him 10% / 10k interest this year? Its interest earned from proceeds and not excluded from gross income under [IRC §101(c)] Only the face value (principal) is excluded from gross income. Amortize the excludable amount over the payment period  What result if the insured‟s daughter is the beneficiary and she elects to be paid 12k annually for her life expectancy of 25 years? Only 100k can be excluded. So, 4k will be excluded and 8k will be considered income annually  What if the daughter lives past the 25 years? The prorating continues even if she lives past the life expectancy of 25 years (1.101-4(c)). Problem 2 Jock agreed to play football for Pro Corp, who took out a policy on him for 1M. If Jock dies during the term of the policy and the proceeds of the policy are paid to Pro, what different consequences will Pro incur under the following alternatives?  With Jock‟s consent, Pro took out and paid 20k for a 2-year term? If Jock dies the money is excluded for Pro [IRC §101(a)], and if he doesn‟t die, then the policy just expires after the term.  Jock owned a paid-up 2 year term for 1M on his life which he sold to Pro for 20k. If Jock dies, the 20k will be excluded because that is the consideration paid for it. [IRC §101(a)(2)]. Pro can exclude 20k (only the amount they paid + any additional premiums).  Same, except Jock was a shareholder of Pro Corp. Full amount is paid [IRC §101(a)(2)(B)]. Therefore, the entire 1M policy is excluded as gross income–this is an exception to the exception. Problem 3


Insured purchases a single premium 100k life insurance policy on her life for a cost of 40k. Consider the income tax consequences to insured and the purchaser of the policy in each of the following alternative situations.  Insured sells the policy to her Kid for its 60k FMV and on insured‟s death, the 100k proceeds are paid to Kid. Can only exclude 60k because that is amount that was paid for the policy. 40k is income to kid [IRC §101(a)(2)]. From Mom‟s side: what is AR? 60k. AB= 40k (what she paid); Mom‟s gain = 60k-40k=20k gain.  Insured sells policy to spouse for 60k. Wife dies and spouse gets 100k. Valuable consideration rule will not apply if basis to husband is carry-over basis of policy from the wife, then the whole exclusion applies. [IRC §101(a)(2)(A)] No gain or loss is recognized for the transferor. For the transferee, if there is a carry over basis (transfer to a spouse) then no gain or loss is recognized for the transferee.


VI. Income from Discharge of Indebtedness (and possible exclusion) A. General 1. Basic Questions: a. Is this a non-gratuitous discharge of indebtedness? b. Does the exclusion apply? [IRC §108] 2. Discharge of indebtedness does not relieve tax liability. 3. Talking about the forgiveness of a debt. 4. Income is realized when indebtedness is forgiven or in other ways cancelled. B. Recourse vs. Non-Recourse Indebtedness 1. When does this issue arise? a. When transferring property to a 3rd party, don‟t consider whether the loan was recourse vs. non-recourse or assumed vs. taken subject to b. When transferring property back to the bank, consider whether the loan was recourse vs. non-recourse 2. 2 Situations a. If a recourse situation and bank takes back property, the AR is the FMV. i. Here, there is income from discharge of indebtedness ii. May have to separate income from discharge of indebtedness and income from gains from dealings in property b. If non-recourse and bank takes only property, then amount of loans is AR. C. Contested Liability Doctrine [must have a debt that you know the value of] 1. If a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the dispute is treated as the amount of debt cognizable for tax purposes. a. If taxpayer contests legality of debt, he does not have liability until he settles on the amount b. Thus, the settlement sets the amount of debt 2. Liquidated Debt = determined/actual/uncontested 3. To have discharge you need liquidated debt Problem #1 [PRIME FOR EXAM]: Poor borrowed 10k from Rich several years ago. What tax consequences to Poor if he pays off the so far undiminished debt with:  A settlement of 7k cash: Had set amount and forgave 3k. [not a contested liability–the 10k is the original debt amount]. 3k income because no dispute over amount.  A painting with a basis and FMV of 8k: 2k is income, and the fact that he paid with property doesn‟t matter, still forgave 2k of an already settled amount.  A painting w/ a value of 8k and a basis of 5k: Poor‟s debt was settled for 8k so had income of 2k here, but there is also a gain to P because the AB was less then what he got for it. Poor got 8k for a 5k painting so he had a gain of 3k. In total, P‟s taxable income from this transaction is 5k. Cross-over question – [IRC §101] states that you can have gain from the sale or “other distribution of property”; therefore, there is a gain here because the basis was 5k and sold it for 8k]. You must split it up because this is only the first inquiry. You still have to ask if it is recognized and whether it has a special character.  Services, in the form of remodeling R‟s office, which are worth 10k: Debt has been paid in full, but the 10k is income to Poor because he is getting paid for services rendered Compensation for services rendered is a gain.  Services that are worth 8k: 2k is taxable income to Poor from discharge of indebtedness 8k is income to Poor because he was paid for services rendered. Compensation for services rendered is a gain.  Same as (1) except that Poor‟s Employer makes the 7k payment to Rich, renouncing any claim to repayment by Poor: 3k is income for debt forgiveness and 7k is income to Poor because it was an indirect benefit from Employer (remember Old Colony, when someone pays your obligation, it is income to you) Problem #2 [RECOURSE / NON-RECOURSE CALCULATIONS WITH DISCHARGE OF INDEBTEDNESS] Mortgagor buys land for 80k loan and 20k cash. AB = 100k. FMV increases to 300k. M takes out another loan on equity of 100k and used that to buy stocks. The loans = 180k, and the FMV decreases to 170k. M transfers all to the bank and the bank discharges the indebtedness.  What are the tax consequences to M: 180k was owed and accepted 170k so 10k was discharged. M had 10k income from discharge of indebtedness and 70k gain income from giving the house over to the bank, so he had 80k as total income. This was a recourse loan but after got property agreed not to go after M personally. Split Situation: 10k is discharge of debt; 70k from gain of sale transaction = 80k gain total [Reg. §1.1001-2a]  What are the tax consequences to M if the liabilities had been non recourse? 80k because here the AR will be the full amount of the loans and not the FMV. [180k - 100k] If a recourse situation and bank takes back property, the AR is the FMV. If nonrecourse and bank takes only property, then amount of loans is AR. Taking subject to or assuming the loan does not matter; calculation is the same.


D. Exceptions to the Exclusion 1. [IRC §108(a)] Gross income does not include any amount which would be includible in gross income by reason of the discharge of the indebtedness if: a. The discharge occurs in bankruptcy [Title 11]; b. The discharge occurs when the taxpayer is insolvent; c. The discharge is qualified farm indebtedness (Don‟t worry about this) d. The indebtedness is qualified real property business indebtedness (Don‟t worry about this) 2. Insolvency a. [IRC §108(d)(3)] Insolvency Defined: i. Taxpayer owes more than she owns. ii. The excess of liabilities over the fair market value of assets immediately before the debt discharge. b. [IRC §108(a)(3)] Insolvency exclusion is limited to the amount of the insolvency c. [IRC §108(b)(2)(E)] AB is reduced by the amount of forgiveness    Examples Businessman is solvent but is having financial difficulties and Creditor compromises the debt for $60k. Here income is 40k. Assume businessman is insolvent. His liabilities exceed his assets by 125k. Here, the exclusion applies and therefore, he can be released for up to 125k. Here, he was released from 40k – therefore, the full 40k is excluded. Businessman‟s liabilities exceed his assets by 25k. Exclusion up to the 25k. Therefore, 15k income and is not excluded for forgiveness of debt.


VII. Receipt of Damages and Related Receipts A. [IRC §104] Compensation for injuries or sickness. 1. Concept - Taxpayer has incurred an injury & we are going to give her a break and not tax her on what she receives in damages 2. Important Damages Exclusions a. [IRC §104(a)(1)] Gross income does not exclude amounts received under workmen‟s compensation acts as compensation for personal injuries or sickness. b. [IRC §104(a)(2)] Gross income does not include amounts of damages (other than punitive) received (by suit or agreement or settlement) for personal physical injuries or physical sickness; c. Note: Emotional distress is not treated as a physical injury or physical sickness unless it stems B. Emotional Distress [Note on IRC §104(a)(2)] 1. If the basis for the injury is NIED/IIED (emotional), it is not a physical injury, so any recovery counts as gross income. 2. However, any physical medical costs are excluded. 3. If the basis for the cause of action is physical, then the emotional distress resulting is excludable. C. Attributes of the Damages 1. [Reg. §1.104-1(c)] Damages (whether by suit or agreement) received on account of personal injuries or sickness are excluded from gross income. For tort, or tort-type rights [non-contractual actions]. 2. Damage must be tort-like; 3. Damages must be incurred on account of personal physical injuries or physical sickness (1996 addition). 4. [Rev.Rul. 65-29] When taxpayer receives the present value of an award for a personal injury in a lump sum and invests it, any interest earned on the amount invested is taxable. D. [IRC §104(c)] Punitive damages can be excluded where: 1. They are awarded in a wrongful death action and, 2. The state law that awards the damages was in effect prior to 13 SEP 95 and restricted the recovery to punitive damages in wrongful death actions Problem  bought suit and successfully recovered. Discuss the tax consequences in the following alternative situations:  , a gymnast, suffers loss of a leg in an accident and is awarded damages of 100k Excluded from gross income because physical injury  What result in (1) if 50k of the award is specifically identified by the jury as compensation for income (50% pain and suffering; 50% for lost wages) All excluded even though it might seem otherwise because it is a part of injury award.  Awarded 200k in punitive damages Part of gross income and not excluded.  Got 20k compensation for ‟s suicidal tendencies as a result of loss of her leg: Excluded because emotional distress stems from the physical injury. Underlying cause was physical.  Got 100k because of stress after taunting: income and not excluded because emotional distress  Got 200k in sexual harassment case: income and not excluded (not tort or tort-like / no physical injury).   dies as a result of her leg injury and plaintiff‟s parents recover under a wrongful death statute? Excluded under 104(c).


VIII. Income Issues Regarding Separation & Divorce A. General 1. Payee Spouse (does not want the payment to qualify as alimony) a. Alimony is income to the payee spouse under [IRC §61(a)(8)] b. Alimony is gross income to the payee (recipient) spouse  [IRC §71(a)] 2. Payor Spouse (wants the payment to qualify as alimony) a. Alimony is a deduction to the payor spouse  [IRC §215] b. In the case of an individual, there shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such tax year [IRC §215] 3. Bottom Line a. Deductibility by the payor spouse is dependent upon includability of the alimony payment in the gross income of the payee (recipient) spouse. b. “Alimony or Separate Maintenance” status = Includable for the Payee & Deductible for the Payor c. Deductible by Payor = Income to Payee AND Non-Deductible by Payor = Not Income to Payee d. Deductible Above the Line B. Qualifications as alimony for tax purposes; to qualify you need: 1. [IRC §71(b)] Payment must be in cash. a. No substitution of promissory notes, property, or services [Reg. §1.71-1Tb Q/A 5] b. Rationale: to ensure that there is money to pay the taxes 2. [IRC §71(b)(1)(A)] Must be received by (or behalf of) a spouse under a divorce or legal separation instrument; [IRC §71(b)(2)] Instruments are as follows: a. Most Common = Divorced (by decree); b. Legally separated by decree; c. “Informal” separation (still married) with a written separation agreement; d. Still Married, but payments are required under a court ordered support decree i. Temporary support ii. Typical during the waiting period for finalization of divorce. 3. [IRC §71(b)(1)(B)] Instrument cannot identify payment as non-alimony (exclude it or allow it as a deduction) a. Spouses can opt-out of the alimony classification; b. Spouses cannot opt-in to the alimony classification 4. [IRC §71(b)(1)(C)] If couple is legally divorced or legally separated, they cannot still be living together when payment is made, or it will not be alimony a. Can be alimony if you merely have an informal agreement or, support decree. b. Must live in separate households (cannot use a dwelling unit on their property) and not just split up and sharing a house [Reg. §1.71-1Tb Q/A 9] 5. [IRC §71(b)(1)(D)] There is no liability to make payments after the death of the payee spouse. a. If there is any possibility from the wording of the divorce decree that payments could be made after death, then it is not alimony. b. Eg. Payments made annually for 10 years. 6. [IRC §71(c)(1)] Payment cannot be for child support. C. Indirect Payments 1. Can be alimony: [Reg. §1.71-1T(b)(Q6)] 2. Look to the rights and legal interests of the payor and payee with respect to the payments. 3. Eg. H & W are tenants in common-H made all payments for house? ½ of payments would be indirect alimony 4. [IT4001] - insurance policy if you are paying for something that you own - this is not alimony Problem Determine whether the following payments are accorded “alimony or separate maintenance.” Andy & Fergie are divorced & payments are called for by the divorce decree.  Divorce decree directs Andy to pay 10k annually to Fergie for life or until she remarries. He pays 10k this year. Yes. Divorce Decree  Same, but with a promissory note. No. Not cash [Reg. 1.71-1T(b) Q/A 5]  Same, but with a piece of art that has FMV of 10k No. Not cash  Same, as (a), but Decree says payments are nondeductible by Andy and are excludible from Fergie‟s gross income No. Defined as non-alimony in Decree  Does it make a difference if Andy anticipates that he will have no taxable income in the future, making the deduction worthless to him? No.  What if the divorce decree directs Andy to pay 10k annually for 10 years? Depends on whether she lives that long  Same, but local law prohibits post-death payments. Pay until she dies (CA prohibits post-death payments as such)  What if decree says 10k to Fergie and 15k to her estate annually? Only 10k to Fergie is alimony  What if they live in the same house? Not alimony  What if alimony is pursuant to a written separation agreement instead of a divorce decree? OK. The „no living together‟ prohibition only applies to legal divorce and legal separation


Problem Ted & Joan are divorced. Pursuant to their written separation agreement incorporated in the divorce decree, Ted is required to make the following alternative payments, which satisfy [IRC §71(b)] requirements. Discuss the tax consequences to both Ted and Joan:  Rental requirements of 1000 per month to Joan‟s landlord: Alimony by indirect payment. [Reg. §1.71-1T(b)(Q6)]  Mortgage payments of 1000 per month on the family home that Joan got in the divorce Alimony, but she has to own the house. [Reg. §1.71-1T(b)(Q6)]  Mortgage payments of 1000 per month as well as real estate taxes and upkeep expenses on the house that Ted still owns but Joan lives in Not alimony because if payor spouse owns the house just maintaining his property. [Reg. §1.71-1T(b)(Q6)] Child Support Payments [IRC §71(c)] 5. Bottom Line a. Child Support IS NOT Gross Income to the Payee (recipient) b. Child Support IS NOT a Deduction for the Payor Fixed Payments [IRC §71(c)(1)] c. Payments previously had to be “fixed” d. The divorce agreement specifically states the amounts or parts thereof allocable to the support of children Non-express “fixed payments”: e. If the amount is reduced based on the occurrence of a contingency relating to a child (such as reaching a certain age, marrying, dying, leaving school, etc.) the amount will still be treated as “fixed amount” payable for child support of the child. f. [IRC §71(c)(2)] Will be treated as child support even if not labeled as such. 6. [IRC §71(c)(3)] If payment is less than the full specified amount, the child support is allocated 1 st. Problem Sean & Madonna enter into a written support agreement which is incorporated into their divorce decree at the time of their divorce. They have one child who is in M‟s custody. Discuss the tax consequences in the following alternative situations:  The agreement requires Sean to pay Madonna 10k per year and it provides that 4k of the 10k is for the support of their child: 4k is child support and not income or a deduction. 6k is alimony.  The agreement requires Sean to pay Madonna 10k per year, but when their child reaches 21, dies or marries prior to reaching 21, the amount is reduced to 6k annually. Alimony is only 6k per year: 4k is still child support no matter what.  What result if Sean pays to Madonna only 5k of the 10k obligation 4k is child support and 1k is alimony; allocate to child support first. [IRC §71(c)(3)]


D. Transfers of Property Incident to Divorce 1. [IRC §1041(a)] No gain or loss shall be recognized on a transfer of property from an individual to a spouse or former spouse (when incident to divorce). 2. [IRC §1041(b)] Transferee‟s basis is the carry-over basis. 3. [IRC §1041(c)] Incident to divorce: a. Transfer of property is incident to divorce if such transfer i. Occurs within 1 year after the date the marriage ceases, or ii. [Reg. §1.1041-1T(b) Q/A 7] Is related to the cessation of the marriage. (a) Pursuant to the divorce/separation decree (b) Not more than 6 years after the cessation of the marriage (possibly more) (i) If the transfer is beyond 6 years, it is presumed not to be related to the cessation of marriage but that may be rebutted by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of marriage. (ii) A transfer is still incident to divorce if:  It was not made within the 1 and 6 year period because of factors which hampered an earlier transfer of the property (eg. legal/business impediments to transfer or disputes concerning the value of the property); and  The transfer is made right after the impediment is removed. b. Can be a separate transaction not related to the divorce at all. Can be an outright sale to spouse. 4. [IRC §1015] Basis of property acquired by gifts and transfers (between spouses) in trust: The basis of such property in the hands of the transferee shall be the adjusted basis of the transferor (carry-over) [IRC §1041(b)(2)]. 5. All of this applies to transfers between spouses incident to divorce. Example H&W wanted to keep house after divorce. Pursuant to divorce decree each spouse owned the house (½ each as tenants in common); H wanted the entire house (after 10 months). AB was 100k – each have a basis of 50k. FMV at time was 800k. H wants to pay 400k for W‟s ½. Wife should sell it to him because §1041 applies if within the year. Therefore, wife had gain of 350k but it is not recognized. Poor H, has an AB of 100k instead of 450k. Problem Michael and Lisa-Marie‟s divorce decree becomes final on Jan 1, 1998. Discuss the tax consequences of the following transactions to both Michael and Lisa-Marie.  Pursuant to their divorce decree, Michael transfers to Lisa-Marie in March 1998, a parcel of unimproved land he bought 10 years ago. The land has a AB = 100k and FMV = 500k. Lisa-Marie sells the land in April 1998 for 600k Michael has no gain or loss from transfer [IRC §1041]. Lisa-Marie gets Michael‟s basis of 100k (carry-over basis) and her gain is 500k from the sale of the land (Lisa-Marie gets the short end of the stick here).  Same as (1) except that the land is transferred to satisfy a debt that Michael owed Lisa-Marie. The land has AB = 500k and FMV = 400k at the time of the transfer. Lisa-Marie sells it for 350k Not related to cessation of marriage but since it‟s within one year [IRC §1041] Michael recognizes no gain or loss. No matter what, she gets a carry-over basis, so Lisa-Marie loses 150k.  What result if pursuant to the divorce decree, Michael transfers the land in (1) to Lisa-Marie on March 2003. Relates to the cessation of marriage and done within 6 years, so no gain or loss to Michael and Lisa-Marie has a gain of 500k.  Same as (3) except that the transfer is required by a written instrument incident to the divorce agreement. Same results.  Same as (3) except the transfer if made in March 2007: When beyond (6) years, there is a rebuttable presumption that it is not incident to divorce. In practice, if it clearly relates to the decree this can still be okay.


IX. Exclusion of Gain from Sale of Home [DEFINITELY ON THE EXAM] A. General 1. Gain from the sale of a Principle Residence may be excluded. 2. Rationale: encourage pursuit of the American dream. 3. Example: AB of house is 100k; sell 3 years later for 500k (AR); realized gain of 400k. But, there is an exclusion so the gain is not recognized under [IRC §121]. B. Exclusion of gain from sale of principle residence for all sales after May 6, 1997: [IRC §121] 1. Scope: a. Can exclude the gain from the sale or exchange of property excluded if during a 5 year period ending on the date of sale or exchange, such property has been owned and used by the property owner as his principle residence aggregating 2 years or more [IRC §121]. b. Can take advantage of this exclusion every 2 years c. Principal Place of Residence i. Home; mobile home; motor home; boats – as long as (a) Sleeping facilities, (b) Eating facilities, and (c) Bathroom facilities ii. Where you live permanently d. If you have two homes, you can choose which home you are going to use the exclusion on. 2. Bounds a. The amount of gain excluded shall not exceed 250k. b. [IRC§121(b)(2)(A)] Married couple (filing jointly) can exclude up to 500k. c. This exclusion can only be used once every 2 years. d. The time for the use and own tests can accrue concurrently in multiple residences, but the exclusion can only be used once every 2 years. C. Use/Own Requirements 1. 2 Tests [IRC §121(a)] a. Own Test i. Have to have owned the residence for at least 2 of last 5 years ii. [IRC §121(b)(2)(A)(i)] Only one spouse needs to meet the „own‟ test for full exclusion iii. [IRC §121(d)(3)(A)] Tacking of ownership time: (a) The period that the transferor spouse owned the house is tacked onto the transferee spouse‟s ownership time. (b) Can tack from time of transfer backwards b. Use Test i. Need to have used it as a main/principle residence for at least 2 of the last 5 years ii. [IRC§121(b)(2)(A)(ii)] Both spouses need to meet the „use‟ test to get full exclusion iii. Temporary absences from the home (vacation/business trips) are not counted as reducing the 2 year use test. iv. [IRC §121(d)(3)(B)] Tacking of use time: (a) For divorce or separation, the time of the spouse who lives there contributes to the time of the spouse not living there. (b) Can only tack forward from the time of the divorce Need to fulfill both tests, but doesn‟t have to be the same 2 years to do so. c. Does not have to be concurrent use-ownership d. Time doesn‟t need to be consecutive 2 years e. Example: can live there for 6 months and come back and live there for 1½ years, so long as there are a total of 2 out of last 5 years f. If a married couple, only one must meet own test, but both must meet use test in order for both to get 250k exclusion. 2. Pro-Rate provision: [IRC §121(c)] a. If moving and have to sell house for employment reasons, health, or unforeseen circumstances, you don‟t have to meet the 2 year own and use tests. b. You can pro-rate the exclusion for the time that you fulfilled the own and use test. 3. Single taxpayer doesn‟t meet regular own and use test but there is another test for those who fail the own and use test. Problem 1 Determine the amount of gain the Taxpayers (a married couple filing jointly) must include in gross income (recognize) for each of following:  Sold main home for 600k. They bought house several years ago for 200k and lived in it for those years. AR=600, AB=200, 600-200=400k gain. Can exclude all of it because as a married couple have 500k worth of exclusion and had a gain of only 400k. Meets the own and use tests.  Taxpayers purchase another home for 600k and sold it for 1M 2½ years later. AR=1M, AB=600k, 1M-600k=400k gain. Can exclude all of this because has been over two years and can only use exclusion once every two years.  What result if sale occurred 1½ years later. Realized gain of 400k would be recognized as gross income because hasn‟t been more than 2 years.  What result if the residence was taxpayer‟s summer-house which they used 3 months of the year? Not principal residence so not excluded and even if add up the three months for the 5 years, won‟t meet time requirements anyway.


Problem 3 Taxpayer has owned and used main residence for 10 years, the last year with taxpayer‟s spouse after they married. Sell the house for 500k, AB was 100k.  If they file jointly, do they have any income here? 500-100=400k gain. They meet the ownership test because only one spouse has to. They don‟t meet the use test, because must meet it and only taxpayer does. So only get taxpayer‟s exclusion, 250k and so 150 is recognized as income and 250 excluded. (Treat taxpayers as single individuals [IRC §121(d)(1)]).  What result if the spouses had lived together for two years in taxpayer‟s house prior to marriage and sold the house after 1 year of marriage for 500k. 400k gain, but not recognized. Can exclude up to 500, 250 for each, so all excluded, no income. One meets ownership test and both meet use test because doesn‟t matter if married during that time or not still used it.  What result in (1) if after one year of marriage, taxpayer pursuant to their divorce decree deeded one half of the residence to spouse and spouse lived there while taxpayer moved out, and one year later sold for 500k Still have a total of 400k gain. Not married so no 500k exclusion. Have to figure out for each whether each can independently take the 250 exclusion. Each of them has an AB=50k because each owns half. AR = 250k for same reason. Taxpayer meets both tests because owned for 10 years and lived there for the needed time. Taxpayer can exclude all because meets tests and no gain for him. Spouse lived there long enough so use test is fulfilled because one year before marriage and one year after, but she hasn‟t owned it for 2 years because just got it a year ago when divorced. But, spouse can tack on taxpayer‟s ownership from [IRC §121(d)(3)(A)] So now, spouse has also owned for 10 years, so meet both tests and can exclude her gain, so no income.  What result if after one year of marriage taxpayer, pursuant to the divorce decree, deeded ½ of the house to spouse and taxpayer continued to occupy the home while spouse moved out and then one year later sold the home for 500k? Same gain as above for each and each still has same AR and AB. Taxpayer meets both so all excluded. Spouse meets ownership because tacks on taxpayers time [IRC §121(d)(3)(A)] but for the use test, need help from [IRC §121(d)(3)(B)] (is this an example of spouse tacking on use time which only tacks forward? So spouse has one year living there during marriage, and one year tacking on to taxpayer living there after divorce). Problem 2 Single taxpayer bought a home for 500k and after one single year sold it for 600k b/c single‟s Employer transferred single to a new job?  How much gain must single include in gross income? AR=600, AB=500, 600-500=100 realized gain.  What result in (1) above if Single sold the residence for 700k? 200 realized gain, and can exclude 125, so 75 would be income to single. If this person was married, you would have ½ of 500k or, 250k so, you would be able to exclude the full amount.


X. Potential Exclusion of Income Earned Abroad [IRC §911] A. General 1. Generally, the US can tax on worldwide income based on citizenship, regardless of location 2. The US has a jurisdictionally based (as opposed to a territorial basis) of citizenship 3. There is a system of tax credits that applies against US taxes if another country is already taxing your income B. When does the exclusion apply? 1. Alternative qualifications for exclusion a. An American must: i. Be a bona fide resident of a foreign country or countries [IRC §911(d)] ii. For an uninterrupted period that includes an entire taxable year; or b. Be physically present outside of the U.S. for at least 330 days during a 365-day period 2. Only applies to foreign-earned income, which is defined as income from a foreign source which is attributable to the taxpayer‟s performance of services. 3. Limitations on Exclusion Amount [IRC §911(b)(2)(D)] a. 1998: $72,000 b. 1999: $74,000 c. 2000: $76,000 d. 2001: $78,000 e. 2002: $80,000 4. Taxpayers can also elect to exclude housing costs. XI. Exclusion of State, Local & Municipal Bond Interest A. General 1. [IRC §61] Income from bonds is included as gross income and is taxable 2. Interest on government bonds (federal obligations) is subject to federal taxation B. [IRC §103] Gross income does not include interest on State or Local Bonds (municipal-bonds) C. [IRC §115] Income of states, municipalities, etc: Gross income does not include – 1. Income derived from any public utility or the exercise of any essential government function and accruing to the State; 2. Income accruing to the government of any possession of the US XII. Social Security Benefits [IRC §86] A portion of your social security can be included as gross income (as of mid-1980‟s); if you have made enough $ A. If you make a lot of money, then the amount of social security that you receive over your income may be subject to tax as gross income. B. The excess portion is subject to tax. C. Originally, up to 50% of your gross income over the threshold level of income was subject to income. D. Then, in 1993, the maximum amount that could be included in gross income became 85%. E. Currently, a maximum of 85% of your social security benefits can be included in your gross income. F. [IRC §86(b)(2)] Interest from municipal bonds is included in the calculation of the „modified adjusted gross income‟ used as the threshold over which social security benefits will be figured in.


I. General Concepts of Deductions A. Review on Computing Tax Liability 1. Gross Income - [IRC §62] Deductions = Adjusted Gross Income 2. AGI - Personal Exemptions & Standard or Itemized Deductions = Taxable Income 3. Taxable Income  Tax Rate = Gross Tax Liability 4. Gross Liability - Credits = Net Liability/Refund B. Adjusted Gross Income [AGI] 1. Adjusted gross income is computed by subtracting from gross income certain deductions which are otherwise allowable, which are described in [IRC §62(a)] 2. [IRC §62] deductions are generally the types of expenditures made in order to produce income. 3. AGI is used as a basis for some additional below the line deductions C. Historical Footnote (still kind of important): Above-the-Line Deductions vs. Below-the-Line Deductions 1. Above-the-Line Deductions a. General i. Gross Income <MINUS> Above-the-Line Deductions <EQUAL> AGI ii. These deductions are preferable, because they lower the threshold for deductions below the line. b. Some Types mentioned in [IRC §62] i. [IRC §62(a)(1) & (2)] Trade & Business Deductions: Business & Investment Expenses & Activities ii. [IRC §62(a)(3)] Losses from sale or exchange of property. iii. [IRC §62(a)(10)] Alimony iv. [IRC §62(a)(15)] Moving Expenses v. [IRC §62(a)(17)] Interest on Education Loans vi. [IRC §62(a)(18)] Deductions for Certain Higher Education Expenses c. Self-employed expenses. HOW DOES FEDERAL TAXATION WORK? 2. Below-the-Line Deductions: AGI <MINUS> Below-the Gross Income – Deductions = Net Income line Deductions <EQUAL> Taxable Income  Net Income = Taxable Income a. Personal/Individual Deductions  Taxable Income  Tax Rates = Tax (liability or refund) b. Employee Deductions c. Property Tax Deductions d. Eg. Charitable deductions, children, interest on your house D. Itemized Deductions 1. Taxpayers get the greater between the “ITEMIZED” or “STANDARD” deduction 2. Itemized deductions are ones, other than for personal exemptions, which are not [IRC §62] deductions 3. Miscellaneous itemized deductions a. Subject to 2% of Adjusted Gross Income base to deduct them. b. So you can deduct all expenses in excess of 2% of AGI. c. So, if your AGI is 100k, you can only deduct expenses above 2k.


II. Business Deductions [IRC §162] A. General Concepts and Requirements 1. [IRC §162(a)] There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. a. Ordinary & Necessary [IRC §162] BUSINESS DEDUCTION REQUIREMENTS i. Tests  Ordinary & Necessary (a) Necessary (Subjective Test)  Expense (not a capital expenditure) (i) Is it appropriate or helpful in the taxpayer‟s  In Connection w/ Carrying on Trade/Business mind?  Paid or Incurred (ii) Not strictly evaluated; easier to meet (b) Ordinary (Objective Test) (i) The average reasonable person in that profession (ii) Harder test to meet (iii) A course adopted by a taxpayer is ordinary if it is a response that a reasonable person would normally and naturally make under the specific circumstances ii. Welch v. Helvering (a) Taxpayer worked for grain company which went bankrupt and paid its debts because wanted people to still do business w/ him–even though the debts were discharged in bankruptcy. (b) Now he wants to deduct that expense. (c) Held, not ordinary to pay debts of someone else–cannot use as a deduction. This is not, however, a blanket rule that paying off debts are not ordinary. b. Expense [Not a Capital Expenditure] i. Expense and Capital Expenditure are mutually exclusive ii. Expense vs. Capital Expenditure (a) In terms of identifying deductions, a taxpayer wants money paid to be rendered an expense as opposed to a capital expenditure so it will be counted as a deduction. (b) Expenses (i) [Reg. §1.162-4] Repairs: Expenses are incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but it keeps it in an ordinary working condition (ii) An expense may be a deduction (c) Capital Expenditure (i) [IRC §263] A capital expenditure adds to the value or prolongs its life, then it is a capital expenditure, and you get no deduction because its added to your basis. (ii) [Reg §1.263(a)1-2] Capital expenditures in general, and examples of capital expenditures. (iii) A capital expenditure is not an expense and is not deductible. (iv) Tend to be larger, more permanent, increase value of the asset. (d) Examples (i) Painting rooms in apt. bldg. you own – repairs so expense (ii) Replacing roof on bldg. – capital expenditure (iii) Replace frig – capital expenditure because extends past year bought (iv) Advertising – expense (v) Buy a truck for business – capital expenditure, repairs to a car would be an expense; leasing a car would be an expense. c. In Connection with Carrying on the Trade or Business i. Morton Frank: (a) Taxpayers looked all over the country for a radio or newspaper business to buy and wanted to deduct the traveling expenses (gas, hotels, meals, rental house) they incurred. (b) IRS said no because they were not carrying on an existing trade or business, just looking for one (c) Outcome: when they finally bought a business, they could amortize the expenses. (d) However, they could add the start-up expenses to their adjusted basis [AB] ii. Start-up Expenses (expenses incurred before you actually owned the business) (a) Not deductible because not yet carrying on a trade or business (b) Deductible ABOVE the Line (c) [IRC §195] (i) This is an elective section (ii) Taxpayer can elect to amortize start-up expenditures over a period of not less than 5 years (iii) Does not apply to an individual seeking employment (d) Amortization (i) Amortization period begins when business begins (ii) Can be amortized so you deduct expenses over a period of years once you end up buying the business to deduct start up expenses (iii) Amortization: Ratable expensing of the intangible asset of start-up expenses d. Paid or Incurred


2. Employment Setting a. General i. Employees are considered to be in the trade or business in which they are employed. ii. Seeking a first job doesn‟t meet requirements because the taxpayer is not yet in trade or business. iii. Interning or clerking in a profession is not the same as carrying on trade or profession. b. Employee vs. Independent Contractors i. Employee (a) [IRC §62(a)(1)] Employee Expenses are usually deductible (below the line) (b) Employee expenses qualify as „miscellaneous itemized deductions‟ (i) Subject to 2% of Adjusted Gross Income base to deduct them. (ii) So you can deduct all expenses in excess of 2% of AGI. (iii) So, if your AGI is 100k; you can only deduct expenses above 2k. ii. [IRC §162] Business Deductions apply to individuals (above the line) in various circumstances (a) Unincorporated Individual (b) Sole Proprietor (c) Self-Employed (Independent Contractor as opposed to an employee) iii. Employees deduct below the line and self-employed deduct above the line. c. [Rev.Rul. 75-120] When you stop working and then start to look again for a job, if there is a substantial lack of continuity between jobs, you may not get to deduct the expenses. d. How long must you be in the trade or business? i. No bright line test as to how long is long enough to be considered in a trade or business. ii. You must be in the trade or business for a sufficient period of time. Problem #1 Determine the deductibility under §§162 and 195 of expenses incurred in the following situations:  Tycoon, a doctor, unexpectedly inherited a lot of money. Tycoon invested some in industrial properties and he incurred expenses in making his preliminary investigation Not deductible because not yet in the trade or business and so just start up expenses even though ordinary and necessary Not currently deductible, but can elect to amortize over a five year period when the business starts [IRC §195]  The same as above but Tycoon is a residential developer and invests in industrial property Can deduct costs but sometimes if different categories of same business, then the deduction is not allowed.  Same facts as (2) except that Tycoon, desiring to diversify himself, incurs expenses in investigating the possibility of buying a pro sports team Not deductible as expenses because not the same trade or business. This is start up and so under [IRC §195] can amortize if he does buy it. Problem #2 Law student‟s Spouse completed secretarial school just prior to student entering law school. Consider whether Spouse‟s employment agency fees (Spouse is looking for a job) are deductible:  Agency is unsuccessful in finding Spouse a job Spouse not yet in trade or business so not deductible. Success on finding job doesn‟t matter. This may be ordinary or necessary but, this is Spouse‟s first job so, she is not yet in the trade or business [Rev.Ruling 75-120]  Agency is successful in finding a job Not yet in trade or business. Success means nothing in terms of deductibility  Same as (2) except that Agency‟s fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse begins work Deductible, because expenses were incurred after she started working [Hundley Case] [Hundley, however, is suspect because the secretary will not have worked in that trade or business very long]  Same as (1) and (2) except that Spouse previously worked as a secretary in Old Town and seeks employment in New town where student attends school Successful or not the expenses can be deducted because already in trade or business, just looking for new job. The expenses are ordinary and necessary and Spouse worked as a secretary previously.


B. Travel Away from Home & Local Transportation 1. Local Transportation Costs a. Must be business related (includes airfare, mileage, bus fare, etc.) and meals aren‟t included. b. Getting to Work [Commuting Costs] i. Costs getting to work are not deductible. ii. Commuting costs are not business expenses because you are not actually working yet. iii. [Reg. §1.162-2(e)] Commuting costs are not business expenses, they are personal iv. [Reg. §1.262-1(b)(5)] Getting to work is considered personal and non-deductible commuting. Getting to work is not work. v. [IRC §262] Personal expenses are not deductible c. Examples i. Not Deductible (a) If you have an ad on your car? Not deductible, still considered commuting. (b) What if you have a cell phone and are conducting business? Not deductible. (c) Home directly to a regular place of work, even if not the office? Not deductible. (d) Parking expenses at work? (i) Not deductible; still considered commuting. (ii) But, can exclude $175 under qualified parking fringe. ii. Deductible (a) Drive from home to see client, which would increase trip to go to office first? Deductible - if you go from home to the client (not a regular place of work it is deductible); (old rule, if you left from home it is not deductible-you had to go to the office first for it to be deductible). (b) Once you are at work: (i) All transportation costs, once you get to work and then leave from there, are deductible. (ii) Also parking associated with these business-related trips are deductible. (c) Unless perhaps go from home to a non-regular place of business, then that mileage may be deductible. d. Two ways to compute costs to your car i. Actual Cost (a) Keep track of all car costs related to business (b) Includes gas, repairs, maintenance, depreciation, insurance (c) Calculate that amount as a percentage and deduct it. (d) Need to keep receipts. (Travel 100k and 20k for business, deduct 20% of car expenses) ii. Standard Mileage Rate (a) Deduct so much per business mile. (b) 2000  32.5¢ per mile so if traveled 2000 miles, would deduct $700. (c) 2001  34.5¢ per mile  (d) Just keep track of total business miles. e. [Rev.Rul. 99-7]: Circumstances regarding local transportation (not meals): i. Travel between 2 regular places of business – deductible (eg. Dr. from office to hospital; attorney to courthouse). ii. Travel between 2 job sites (could be different jobs) – deductible iii. Travel from home to non-regular place of business – deductible iv. Going to and from non-regular place of business – deductible Problem #1 Commuter owns a home in Suburb and drives to work in City each day. He eats lunch in various restaurants in the City.  May Commuter deduct his costs of transportation and/or meals Transportation costs are not deductible because he is just commuting and there is no local deduction for meals either (personal).  Same, but Commuter is an attorney and often must travel between his office and City Courthouse to file papers, etc. May Commuter deduct all or any of his costs of transportation or meals? Home to office non-deductible; but office to courthouse is deductible. [Rev.Rul. 99-7]  Commuter resides and works in City, but occasionally must fly to Other City on business for ER. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or part of costs? Still considered local transportation because gone for the day and came back. Transportation costs are deductible (airfare, costs to get to airport, car parking, cab ride, etc.) but meals are non-deductible (unless meeting with the client-possible entertainment expense). You cannot deduct meals unless it is an overnight trip.


2. [IRC §162(a)] Traveling Away from Home – Overnight [Sleep & Rest Rule] a. [Rev.Rul. 75-432] Sleep and Rest Rule i. You have to be gone far enough and long enough that a normal person would need to sleep and not be able to get home easily. ii. Does not need to be impossible to get home. You can stay over when a reasonable person would. iii. Meals, lodging and incidentals (phone calls, cab fares, dry cleaning, baggage handling) are all deductible when incurred when carrying on business (but, cannot be lavish): iv. [IRC §274(n)(1)] Meals Deduction: (a) 50% deduction (imposed in 1993). (b) Only 50% of meal expenses are deductible when traveling away from home. (c) Tips are included as part of meals. (d) Groceries count as meals. (e) If you stay at a bed & breakfast, you have to separate the costs. v. May be to see a client or, for an educational seminar, job-hunting. b. Job Search Trip i. Must know whether you are already in the trade or business. ii. If you are seeking a job in a new profession you are not yet in that trade or business, so expenditures are not deductible. [IRC §162] REQUIREMENTS iii. If you are in the trade or business, they are deductible.  Ordinary & Necessary c. Where is your home? You can only have one tax home.  Expense i. IRS Hierarchy  In Pursuit of a Trade/Business (a) Tax Home: Where you reside with respect to your principal place of  Paid or Incurred business is your home. (i) IRS home is PPB when you live far away from work (ii) If you have multiple places of business, IRS home is where you live (b) Where you Live: If you have no principal place of business, then where you live is your home. (c) Itinerant Status: If you have no principal place of business and no home, you are considered to have no home; you are an itinerant (and never can be considered away from home). ii. 2nd Circuit and other jurisdictions say where you live is home. (a) Rosenspan v. US (i) Traveling salesman who travels over 300 days/year who had no principle abode. (ii) Returns to offices in Brooklyn. He is trying to deduct his lodging and meals during his travels. (iii) He could not use the 162 deduction for meals and lodging because he had no home to be away from. (iv) He could, however, deduct the traveling expenses (locally). (b) Exception (i) Possible exception to principle place of business when you are on temporary assignment. (ii) For employees, deduct below the line and for self employed deduct above the line Problem #2 Taxpayer lives with her husband and children in City and works there.  If her employer sends her to Metro on business for 2 days and 1 night each week and if taxpayer is not reimbursed for her expenses, what may she deduct? The costs to get back and forth are deductible because she‟s on business. Her home here is in City, Metro is therefore, away from home. Transportation and lodging are deductible; incidentals are deductible and meals at 50%.  What if she stays at a bed and breakfast? Deduct in full lodging but subtract cost of meals and only deduct 50% of that.  Same, except that she works 3 days and spends 2 nights in Metro and maintains an apartment there? IRS says that home is where your principal place of business is, so determine how much she works at each place. 2nd Circuit & some others would say it is her home in City. This is a close call.  Saying her home is City, her transportation costs are deductible and lodging assuming that the apartment is as reasonable as cost of getting a hotel for those nights. Meals at 50%.  Saying it is Metro, her expenses of traveling back to City, her meals at 50% which are eaten in City during work days, the cost of her housing.  Taxpayer and Husband own a home in City and Husband works there. Taxpayer works in Metro, maintaining an apt there, and travels to City each weekend to visit her husband and family. Deduct? Nothing because Metro is her home, where she is working all of the time. She is not going to City for business. There is no deduction for travel not connected with trade of business. If home is considered City as per 2nd Circuit – this would be commuting and not deductible. If you choose to live far away, that is your choice, and commuting expenses are not deductible. iii. [Reg §1.162-2(b)] Traveling Expenses [transportation] (a) [Reg §1.162-2(b)(1)] If traveler engages in both business and personal activities, to be deductible the focus of the trip must primarily be for business. (b) [Reg §1.162-2(b)(2)] Look to the facts & circumstances, time of trip for each activity.


Problem #5 Traveler flies from her personal and tax home in NY to a business meeting in FL on Monday. The meeting ends Wednesday and she stays until Friday. To what extent are Traveler‟s transportation, meals, etc. deductible?  For business days, meals are deductible at 50%. Transportation there and back is fully deductible. What was the trip primarily for? No prorating (all or nothing): You do not need to pro-rate domestic travel as long as the trip is primarily for business If your trip was primarily for pleasure, your travel there and back is not deductible).  May traveler deduct any of her spouse’s expenses [IRC §274(m)(3)(C)] No transportation expenses are deductible (unless they drove because it would have cost the same amount if only one person drove alone) But, if lodging is still the same price even with husband along then can deduct.  What result if Traveler stays in FL until Sunday (more fun days than business days)? Business days (3) are still deductible and if main purpose was to go there for business and they decided to just vacation awhile since they were there, it‟s still okay and transportation costs are deductible b/c only went there at first b/c of business. Days are just 1 factor to consider whether the business days can still be deducted. Hypothetical  [SATURDAY STAY-OVER WHICH MAKES TRIP LESS EXPENSIVE] What if you live in LA and you are traveling to Denver on business for (3) day business trip. Transportation to Denver is $800. Your hotel per night is $125/day. Total deductible = $800 travel + $450 hotel = $1250. What if you wanted to stay for a few extra days and stayed over a Saturday night which made your plane flight: $500. Taxpayer can argue that you are saving $300 by staying over and therefore, should be able to deduct that amount (could take (2) more fun days of hotel = $300) [Private Letter Ruling 92-37-014] – If you save air-fare by staying over, then you can incorporate any additional pleasure days not to exceed what you could have otherwise deducted  [DIFFERENCE IN AIR-FARE PRICE]: If stayed extra days to get a cheaper airfare that business had to pay, can deduct those savings from the other amounts. (fun and business days) Deduct the amount you save on airfare from other expenses.


C. Expenses for Education 1. Deductibility Revisited [IRC §162] REQUIREMENTS a. [IRC §162] expenses for self-employed = deductible above the line  Ordinary & Necessary b. [IRC §162] expenses for employees are deductible below the line  Expense 2. [Reg. §1.162-5(a)] Expenses for Education  In Pursuit of a Trade/Business a. [Reg. §1.162-5(a)] Deductible Education Expenses  Paid or Incurred i. Required Education (a) Education to maintain or retain an existing job, job status, or rate of pay, as required by the employer or the trade or business (b) Hill v. Commissioner (i) School teacher who was required to take a summer college course or, literary exam to renew her teaching certificate attempted to deduct the college tuition expenses as “ordinary and necessary” expenses incurred in the practice of her profession. (ii) Held that they were deductible as „ordinary‟ expenses. (iii) Modernly, this would be deductible below the line, because she was an employee. ii. Un-required Education (to maintain or improve skills) (a) Deductible, even if the education is not required by the employer; employee just needs to keep up to date (b) General Rule: The general rule is that acquiring learning is a “personal” expense and therefore, not deductible. (c) Coughlin v. Commissioner (i) Although taxpayer here was not required to attend the conference in order to retain his license to practice law, the need to incur the expenses in order to perform his work with due regard overshadowed any personal aspect. (ii) Necessary? Yes, appropriate and helpful. (iii) Ordinary? Not required but, he was morally bound because he was the tax guy at the firm. (d) [Rev.Rul. 74-78] Medical Specialty: Learning of a medical specialty qualifies as an extension of one‟s trade or business and is deductible. iii. Transportation costs out of town for education are deductible under [IRC §162]. iv. Food out of town is deductible at 50% (can only deduct 50% of meals included in seminars) v. Local Transportation costs for education are deductible under [IRC §162] (Meals are not deductible because it is a local seminar. If the meal is included in the seminar price you have to carve out this portion and not deduct it) b. [Reg. §1.162-5(b)] Non-Deductible Expenses for Education i. Minimum educational requirements: getting BA, etc. (not yet in a trade or business so fails) ii. Qualification for new Trade or Business: attorney goes to med-school not deductible. Doesn‟t matter if never practice in new trade but just to be better in your trade. Problem #1 Alice-Doctor, Barbara-Dentist, Cathy-Accountant, and Denise-Lawyer were college roommates.  Alice went to law school so she would know more when she testified as an expert in medical law suits. This is not deductible because it qualifies her for a new trade/business. The fact that you choose not to pursue this new trade does not matter. [Reg 1.162-5(b)(3)] If Alice had gone to continued education courses sponsered by the AMA – probably deductible. These courses do not qualify Alice for a new trade or business.  Barbara enrolled in a course of orthodontics. This is deductible because it is within the trade/business of Dentistry.  Cathy enrolled part time in law school to study tax. Not deductible because it qualifies her for a new trade or business. She is getting a new degree. When you have a structured education it is not deductible.  Denise left her practice to get an LLM. Deductible because already in tax area – not considered a new trade or business. If in a different legal area, then there would be an argument that it is not deductible because not in that same trade/business Expenses which are deductible: transportation, lodging, costs of program, incidentals, meals at 50%. Law is different than the dentistry and ortho stuff. Problem #2  What if Denise lives in Seattle, but goes to get her LLM in Florida Can deduct transportation to and from Florida, incidentals, tuition Can deduct 50% of meals Problem #3 Carl is a teacher who wants to travel in order to better teach her students.  Not Deductible. Travel for the sake of education is not a deductible expense. [IRC §274(m)(2)]  Traveling to a location for legitimate education (to take a course) is deductible. Problem #4 Dentist attends 5-day seminar at ski resort. All of the seminar proceedings are taped, he watches the tapes at his leisure and skis during the sunny days. Are travel, lodging, meals deductible?  No, Because this is not a real seminar. There is no reason to be sent to some location to view tapes. It fails the “ordinary” test to fly to some ski resort to watch tapes.



   

Hypotheticals on Education Expenses You take the bar exam and start an LLM program before starting in the firm? This is not deductible because you are not yet engaged in the trade or business. You fail the requirements of [IRC §162] Even if you worked as a law student for the firm, this does not qualify you to say that you are already in the trade or business. (Summer work is different from being a lawyer after you pass the bar) Earning an MBA Does not qualify you for a new trade or business; therefore, many taxpayers are able to deduct these expenses because they are still in the same trade or business. Dues to local bar Ordinary and necessary and in trade or business  deductible. Seminars that have meetings in the early morning where you have the rest of the day to yourself? This is okay. Deductible. Popovich chose the seminar at Lake Tahoe when he was overseas in London. This is deductible. You could make same argument that it was offered and therefore, ordinary–same as education certification–test or, course [Hill]. D. Miscellaneous Business Deductions [IRC §162] REQUIREMENTS 1. [IRC §274] Business Meals and Entertainment  Ordinary & Necessary a. Must still meet other [IRC §162] business requirements  Expense b. [IRC §274(n)] Deductions limited to 50%  In Pursuit of a Trade/Business i. Meals  Paid or Incurred (a) Meals can‟t be lavish or extraordinary; (b) If it is deemed entertainment, the deduction for meals is still limited to 50%. ii. Entertainment is limited to 50%. (a) Can deduct 50% of the face price of tickets; [IRC §274(1)(A)] (b) [IRC §162(a)] Transportation to entertainment is not limited to 50%. c. [IRC §274] Tests i. Must meet one of two [IRC §274] tests in addition [IRC §162] requirements (a) [Reg §1.274-2(c)] Activity must be DIRECTLY RELATED to the active conduct of a trade or business (i) Business must be going on during the activity itself. (ii) [Reg §1.274-2(c)(7)(i)] Can‟t send clients away for lunch and then deduct the cost as a business lunch. (iii) [Reg §1.274-2(c)(7)(ii)] Can‟t have substantial distractions (b) [Reg §1.274-2(d)] Activity must be ASSOCIATED WITH the active conduct of a trade or business (i) Activity must be immediately following or before a bona fide business discussion. (ii) Tests are applied in the alternative. ii. [IRC §274(b)(1)] If does not fit under one of these tests, could be deductible under business gifts which is $25 per year per client. d. Entertaining Categories: i. Activity – going and doing something (client to lunch, ball-game) (a) Activity must be directly related to the act or conduct of trade or business (b) [IRC §274(k)(1)(B)] Employee must be present at meals. (c) For tickets bought, the amount deductible is 50% of face value of ticket or if paid less, then it is 50% of that. ii. Facility (a) [IRC §274(a)(1)(B)] A place used to entertain; can‟t deduct costs for maintaining facility but can deduct costs incurred if using facility. (b) Examples: ski cabins, hunting lodge, boats, country clubs, athletic clubs, swimming pools, tennis courts, bowling alley. (c) [IRC §274(l)(2)] For skyboxes or other private luxury boxes, the excludable amount can‟t exceed the facevalue of the seats nearest the private seats e. Substantiation Requirement i. [IRC §274(d)] You have to substantiate the costs for these deductions [keep track of stuff–who, where, what was discussed]. ii. Can‟t estimate entertainment expenses.

Problem #1 Employee spends $100 taking 3 business clients to lunch at a local restaurant to discuss business. The $100 includes tax and tip and drinks.  To what extent are expenses deductible? Meets directly related to test so 50% of lunch is deductible–food, drinks, tax, tips, are all included (including taxpayers meal). Is this lavish? No - $25 per person is not lavish.  If lunch is merely to touch base with clients? Not deductible because not discussing business.  What result if employee merely sends the 3 clients on their own and picks up the tab? Employee must be there. Could be deductible under business gifts, which is $25 per year per client. [IRC §274(b)(1)] What result in (1) if, in addition, employee incurs a $15 cab fare to transport the clients to the lunch? Could be 100% deductible under [IRC §162(a)] as local transportation; if not lavish. Problem #2


Business person who is in NY on business meets with 2 clients and afterwards takes them to a Broadway production. To what extent is the $300 cost of their tickets deductible if they marked price on the tickets is $50 each, but Businessperson buys them from the hotel concierge for $100 each?  Could be deductible because activity transpires after a business meeting.  50% of the face price of the tickets is deductible. [IRC §274(l)(1)(A)]  3 tickets @ $50 each = $150 x 50% = $75.  If you pay less, you cannot deduct the face price of the ticket you deduct 50% of what you paid. 2. Uniforms [IRC §162] a. Deductions for uniforms are allowed if [Rev.Rul. 70-474] i. The uniforms are specifically required as a condition of employment and ii. The uniforms are not adaptable to wear for everyday. b. Examples i. Professor suits – not deductible ii. Military uniforms – not deductible because can wear outside of job iii. Reserve uniforms – deductible because legally not allowed to wear them except for when on duty iv. Police officers, jockeys, fireman, athletes, – deductible c. As long as uniform is deductible, the incidental maintenance for it is deductible (dry cleaning) Problem #3 Airline Pilot incurs the following expenses in the current year:  $250 for the cost of a new uniform? Deductible.  $30 for dry cleaning the uniform? Deductible because the underlying uniform is deductible.  $100 in newspaper ads to acquire a new job as a property manager in his spare time? Probably not deductible because not directly related to his work (not in connection with carrying on a trade or business)  $200 in union dues? Deductible when in connection with your trade or business.  $500 in fees to local gym to keep in physical shape for flying? Probably not deductible because the business activity is not transpiring during the activity itself. 3. Dues & Professional Fees are deductible [IRC §162] [Reg. §1.162-20(3)]


III. Deductions for Profit-Making, Non-business Activities [outside of a trade/business] A. General 1. This covers expenses not associated with a trade or business, but associated with a profit-making (investment) activity. 2. Where are [IRC §212] expenses deductible: a. [IRC §62(a)(4)] If it relates to rents/royalties then it is deductible ABOVE THE LINE. b. All other [IRC §212] expenses are deducted BELOW THE LINE. 3. Expenses not deductible under [IRC §212] a. Defending or perfecting title [Reg §1.212-1(k)] b. Recovering property; c. Developing or improving property 4. Where [IRC §212] expenses are deducted – [IRC §62(a)(4)] a. If the expense is attributable to rental property, deducted ABOVE THE LINE. b. All other [IRC §212] expenses are deductible BELOW THE LINE. B. [IRC §212] In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year: 1. For the production or collection of income; 2. For the management, conservation, or maintenance of property held for the production of income; or 3. In connection with the determination, collection, or refund of any tax (preparing a tax return). C. Tax Preparation Deductions (examples) 1. Classic: An employee had tax return prepared 2. Contesting a tax liability - deductible. 3. Fees for tax planning advice - deductible. 4. Fees for sales tax return preparation for investments - deductible; also includes tax software. 5. Note: If the bill is not itemized to delineate which portion is attributable to determination of tax liability, you cannot deduct anything. So, ask for bill to be itemized. D. Specific Situations 1. Investment advice, portfolio management advice – deductible 2. [Reg 1.263a-2(e)] Sale of Stock a. Amounts paid for a stock transaction are deductible under [IRC §212] b. Commission paid from the sale of stock (securities) is part of the selling price and is not deductible under [IRC §212] 3. [IRC §274(h)(7)] Seminars. No deduction shall be allowed under [IRC §212] for expenses allocable to a convention, seminar, or similar meeting. Examples You have a rental property and hire attorney to sue a tenant not paying rent? Deductible under [IRC §212] ordinary and necessary for the collection of income.  Plumber? $500 repair of waterline Deductible under [IRC §212] - ordinary and necessary for the maintenance of income producing property.  Plumber? $3000 new piping Not Deductible, it is ordinary and necessary but, this is a capital expenditure which is added to the basis (AB)  Paying a gardener? Deductible  Building a garage? Not deductible, capital expense.  Broker charging management fee? Probably be deductible for ordinary and necessary expenses for the management of property producing income. Problem Spec. buys 100 shares of stock for $3k, and pays broker a commission of $50 on the purchase. 14 months later, he sells the shares for 4k and paying a commission of $60 on the sale.  He wants to treat the $110 in commission fees as [IRC §212] expenses. Can he? No, [Reg. §1.263a-2(e)] because they are considered part of the purchase (AB) and selling (AR) price of the stock Commission goes to decrease gain. Buying stock = $3000+$50=$3050; Selling stock = $4000-$60=$3940;  $890 gain  What result if he instead sells the shares for $2500, paying $45 on the sale. Same. AR = 2455. There will be a loss of 595.  What result to Spec if he incurred the expense to attend a seminar on investments? [IRC §274(h)(7)] Not deductible; expenses for conventions and seminars are not deductible. Problem Planner consults his attorneys with respect to his estate plan. They decide to make various inter vivos gifts and draft his will. To what extent, if any, are Planner‟s legal fees deductible as [IRC §212(3)] expenses incurred in the determination or refund of any tax?  Tax advice in relation to the estate would be deductible under [IRC 212(3)]; but, estate advice would not fit under [IRC 212(3)] it is a personal expense. Example Bill is $3000; $1500 for drafting the document and $1500 is for tax advice.  $1500 for tax advice is deductible under [IRC §212(3)], but, other $1500 not deductible because it is a personal expense. 


IV. Interest Deductions A. Deduction for Interest Paid 1. General a. These deductions can be either business-related or, personal. b. Deductions are created to encourage or discourage certain behaviors. c. Before Tax Reform Act of 1986, interest was all deductible with few limitations. d. Concept: good for Americans to borrow money to pump money into the American economy. e. In 1986, the Tax Reform Act broadened the tax base by restricting a lot of deductions. f. Deductions for almost all personal interest is now NOT deductible. 2. [IRC §163] Interest (personal/business/investment) a. [IRC §163(a)] General Rule. There is allowed a deduction of all interest paid or accrued within the taxable year or indebtedness. b. [IRC §163(d)] Limitation on Investment Interest. The amount allowed as a deduction shall not exceed the net investment income of the taxpayer for the taxable year. c. [IRC §163(h)] Disallowance of Deduction for Personal interest. i. No deduction shall be allowed for personal interest paid or accrued during the taxable year. ii. What is Personal Interest [IRC §163(h)(2)]? (a) Business interest in a self-employment situation is deductible. (b) Business interest in an employee situation is personal, so it is non-deductible iii. Two Inquiries (a) Determine whether the interest is business or personal (b) Categorize the employee status (self-employed or employee) d. [IRC §163(h)(2)(D)] Qualified Residence Interest is not personal interest and is deductible i. Two Requirements QUALIFIED (a) Must have a qualified residence RESIDENCE (b) Must have the proper type of loan (indebtedness) INTEREST ii. What is a qualified residence [IRC §163(h)(4)(A)]? (a) [IRC §163(h)(4)(A)(i)(I)] Home (i) Vacation home (ii) Can be foreign home (iii) Can be boats, motor-homes (need bathroom facilities to qualify) (b) [IRC §163(h)(4)(A)(i)(II)] 1-other residence (i) Either the place must not be rented out at all during the year, or (ii) If it is rented during the year, you or your family must use it for personal use for more than: the greater of 14 days, or 10% of the time rented out. iii. What is the proper type of indebtedness? (a) [IRC §163(h)(3)(B)] Acquisition Debt (i) Borrowed funds used to acquire, construct, or substantially improve a qualified residence, & (ii) The loan must be secured by residence. Loan must be used for that residence. (iii) Limitations: [IRC §163(h)(3)(B)(ii)] (1) $1M Cap: only interest on the first million of loan is deductible (not 1M in interest but interest on the first million of loan); (2) If have two loans, the loans are combined and together can‟t exceed the 1M limitation. (iv) Refinance: [IRC §163(h)(3)(B)(i)(II)] (1) Refinancing = Getting a new loan to replace the old loan (eg. first mortgage). (2) Refinancing is acquisition indebtedness and therefore, deductible. (3) Recourse - most refinances are recourse and the lender can go after you personally. (4) Cash-Out Refinance: can deduct as acquisition indebtedness up to the amount owed. The remainder if used for personal items, is home equity debt and has a 100k limit (b) [IRC §163(h)(3)(C)] Home Equity Debt (i) Allows you to get a loan for non-house expenditures and have the interest deducted (1) Used for things like paying off student loans, going on vacation, etc… (ii) Home equity debt is money borrowed against the equity and secured by the house and used for any purpose (iii) Note: When acquiring property, the home equity debt cap can also apply. So, the cap for acquisition indebtedness is more like $1 million (iv) [IRC §163(h)(3)(C)(ii)] Limitations (1) Can‟t get loan for more than equity, so can‟t exceed equity or value of the house [FMV v. loans] (2) Maximum aggregate home equity loans is 100k; can only deduct interest on money spent up to 100k. ($50k if married and filing separately).    Example Rent out house for 100 days of the year. Would need to use it for 15 days to be a qualified residence because need to be more than greater of 14 days or 10% of time rented which here would be 10 days. 15 is more than the greater of those two. A condo that is not rented out at all qualifies as second residence. Condo rented out for 200 days. 10% is 20 days. So, must use for 21 days or, MORE than the greater of 14 or 20. Here the greater than 20.


3. [IRC §461] General Rule for taxable year of deduction - When to Deduct? - Points a. [IRC §461(g)] Prepaid Interest [Points] i. General Rule – Matching Concept: You cannot get a deduction for pre-paying interest or taxes that are not due in the current year. (a) Deduction of points will be made over the period of the new mortgage loan. [Rev.Rul. 87-22] (b) Refinancing loan is deductible over the period of the new mortgage loan (amortized), not in the taxable year. ii. [IRC §461(g)(2)] Exception. Can deduct in taxable year (up front) when points are used to: (a) Purchase (not the same as acquisition indebtedness) a taxpayer‟s principal residence (up front) (b) Substantially improve a taxpayer‟s principal residence (amortized) b. [Rev.Rul. 87-22] Points for Refinancing: i. A point is one percent of the amount borrowed. It must still be qualified residence interest. ii. Points paid as a result of the refinancing of a mortgage secured by the principal residence of a taxpayer ARE NOT deductible in full for the taxable year paid. iii. Not deductible upfront because it is not used to improve or buy a home; therefore, the exception in [IRC §461(g)(2)] does not apply. iv. You can only deduct it over the life of the loan. c. [Rev.Rul. 92-12] POINTS paid after 31 December 1990 i. Addresses the requirements regarding the acquisition of a principle residence ii. Does not exclude when you substantially improve iii. Only addressing the issue of deducting points when acquiring a principle residence. iv. Points are deductible if 5 requirements are satisfied: (a) Designated as points on Uniform Settlement Statement (“loan origination fees,” “loan discount,” “discount points,” or “points”) (b) Computed as % of amount borrowed. (c) Charged under established business practice. (d) Paid for acquisition of principal residence (e) Paid directly by the taxpayer STUDENT LOANS B. Interest on Student Loans [IRC §221] REQUIREMENTS FOR EXCLUSION 1. Personal student loan interest may be deductible ABOVE THE LINE starting in  Qualified Educational Loans 1999.  Qualified Higher Education 2. Must meet 3 requirements  Eligible Higher Education Institution a. [IRC §221(e)(1)] Must be a Qualified Educational Loan. i. The loan must be a legitimate loan (from outside party) borrowed by taxpayer, taxpayer‟s spouse, or dependent of the taxpayer. ii. Student must be at least ½ time. iii. Must be borrowed from an unrelated institutional lender (not from a spouse, parent, relative, etc) b. [IRC §221(e)(2)] Must be used for qualified higher education expenses: i. Money borrowed for tuition, books, fees, room and board (living expenses included). ii. Remember scholarship money cannot be excluded if it is only used for room & board c. [IRC §221(e)(2)(B)] at an eligible higher educational institution: i. Post-high school education/ college or trade school ii. Must be a regular college where there is an actual institution where classes transpire 3. Limitations with respect to this deduction a. [IRC §221(b)(1)] Maximum deduction of interest allowed in any one year: i. 2000 is $2000 ii. 2001, or thereafter is $2500 MAGI b. [IRC §221(d)] Time Limitation Modified Adjusted Gross Income i. Only qualify for deduction for first 60 months (5 years). ii. [2001 Tax Act] Effective in 2002, the time limitation goes away. c. [IRC §221(b)(2)(B)] Deduction is reduced or eliminated (phased out) if you make too much money i. [IRC §221(b)(2)(C)] Modified Adjusted Gross Income (MAGI) (a) Apply all deductions to determine AGI, except (b) MAGI = AGI, applying other deductions without applying this deduction ii. Differences for Married or Single Persons (these numbers may not be right ?). (a) Single Maximum Deduction: MAGI if less than 40k okay; if more than 55k deduction gone (b) Married Maximum Deduction: MAGI if less than 60k okay; if more than 75k deduction gone (c) Within the ranges (Single 40-55k; Married 60-75k), the deduction is reduced (phased out) (i) The phase-out is proportional to the amount of income over the limit. (ii) Reduction Amount = [(MAGI – Base Amount)/1500]  Maximum Allowable Deduction (iii) Single person‟s income is 47500. 55000 – 47500 = 7500. 7500  15000. ½  2500 = 1250. iii. [2001 Tax Act] Changes to Student Loans Interest Deductions (a) Ranges (i) Single 50-65k; Married 100-130k (ii) Beginning on the 2003 tax return (for income from 2002), the thresholds will be indexed for inflation (iii) Phase-Out Spread will not change (b) Ratable reduction is still worked out the same. C. [IRC §163(d)] Investment Interest (NOT ON ESSAYS, BUT MAYBE 1 QUESTION ON M/C) 1. General Rule a. Can deduct interest, but need income from investment to offset deduction. b. Investment income is generally deductible to the extent that the taxpayer has net investment income. 2. But there must be net investment income for it to offset 3. [IRC §163(d)(3)(A)] Investment interest is any interest allowable as a deduction which is incurred on investment property


PROBLEM SET FOR INTEREST DEDUCTIONS 1. In 2002, Brenda purchased a new automobile for $40,000, financing the entire purchase price with a car loan from the bank (the loan was secured by the new car). In 2002, she paid interest in the amount of $4,200 on the loan and she expects to pay another $3,600 in interest in 2003. In each of the following independent scenarios, what is Brenda's interest deduction for 2002 and 2003? (a) For this part only, assume Brenda uses the automobile only for personal use. -This is personal and so not deductible. (b) For this part only, assume Brenda is an employee of a law firm in Los Angeles and uses the automobile 80% for commuting to and from work and 20% for pleasure. -Commuting to and from work is considered personal and not a deduction. (c) Same as part (b) except that Brenda uses the automobile 30% for driving between the office and clients' offices, 40% for commuting to and from the office, and 30% for pleasure. -0 (d) Same as part (c), except that Brenda has her own law practice (self-employed as an unincorporated sole proprietorship). -As self employed, can she deduct 30% of the interest under 163 Adam purchased a home, which he uses as his principal residence, in 2001. Unless otherwise indicated, all loans obtained by Adam are secured by such residence and are payable over thirty years. In each of the following independent scenarios, what portion of the interest paid on the indicated loans is deductible? (a) The purchase price (and fair market value) of the home was $350,000, Adam paying $100,000 as a cash down payment and obtaining a non-recourse loan for the balance of the purchase price. - interest is deductible The facts are the same as in part (a), above except it is now 2003. Due to payments over the years on the original purchase loan, the outstanding principal balance on such loan has been reduced to $230,000. The fair market value of the home is now $380,000. Adam decides to take out a second mortgage loan for $60,000 and uses the proceeds to remodel the kitchen and to add a fourth bedroom. - this is acquisition debt b/c it is an substantial improvement of the house. The facts are the same as in part (b), above, except that Adam uses the new loan proceeds to buy a new car instead of making the home additions. -This is a home equity loan since the proceeds aren‟t going to acquire, construct, or substantially improve a qualified residence. But it still fits the requirements for deducting the interest. However, there is a cap that applies of 100K. this means that he can deduct the interest on the first 100K The facts are the same as in part (a), above and it is now the year 2003. Due to payments over the years on the original purchase loan, the outstanding principal balance on such loan has been reduced to $230,000. The fair market value of the home is now $380,000. Interests rates have declined since 2001 and Adam "refinances" (obtaining a new loan to replace the old loan). -Refinancing is still acquisition indebtedness. Same as part (d), above, except that Adam does a "cash-out refinance," obtaining a new loan in the amount of $340,000. The $110,000 in cash available to Adam ($340,000 loan less pay-off of old $230,000 loan) was used to acquire a pleasure boat. Answer: 230,000 is acquisition indebtedness and the interest is deductable. 100,000 is home equity indebtedness (max is 100,000 according to rule) and interest is deductable. 10,000 is personal and interest is not deductable. -What about a point? Then the point on the 100,000 is deductable over the course of the loan (look at 461(g)(2) and the point on the remaining 10,000 is not deductable at all. Same as part (a), above, except that in addition to the purchase of the house, Adam bought a condominium at Mammoth Mountain for $160,000, paying $50,000 down and obtaining a loan for $110,000. In 2003, Adam obtained a second mortgage loan on the condominium in the amount of $20,000 and used half of the proceeds to substantially improve the condo and the other half to go on a European vacation. Answer: Assume he does not rent it out at all - it is a qualified residence and the interest on this loan is deductable as acquisition indebtedness. If he pays a point on it, the 1,100 is also deductable (461(g)(2) says it is deductable up front if it is interest on ones principle residence, which this is not) over the life of it. -10,000 of the 20,000 is deductable as acquisition indebtedness, but not up front; rather, over the life of it.








Assume that Adam (in question 2 above) was required to pay one (1) "point" in connection with obtaining any loan. Please determine to what extent Adam can deduct, as interest, points paid on loans in parts (a) through (f) of question two. Cathy, a single individual, graduated from law school in 2001. She financed a portion of her education with loans. In each of the following independent scenarios, what is Cathy’s deductible interest? Answers for #4 are Posted but will not be tested (a) The loans for Cathy‟s education came from her grandfather. She paid $1,300 and $1,100 of interest to her grandfather in 2001 and 2002, respectively. In 2003, she expects to pay him interest totaling $900. (b) Cathy borrowed the money for her education from “normal” sources (i.e., school-arranged Stafford, Perkins, etc.). In 2001 she paid interest of $1,900 on these loans. She paid interest of $2,300 in 2002 and expects to pay interest of $2,600 in 2003. Cathy had no income in 2001. In 2002 she had $45,000 of “modified adjusted gross income” (pursuant to §221(b)(2)(C)) and expects that amount to be the same in 2003. Same as part (b), above, except that Cathy expects to have $57,500 of “modified adjusted gross income” (pursuant to new §221(b)(2)(C)) in 2002 and 2003. How do the rules change if instead of being single, Cathy is married?





V. Other Deductions – Mostly Personal in Nature (with some exceptions) A. [IRC §164] Taxes Paid 1. General a. Taxes that are deductible are usually deductible below the line b. They can be personal or business related c. Intangible Tax i. A tax on investments, which are regarded as personal property ii. Only observed in some jurisdictions 2. [IRC §164(a)(1)] State and Local REAL property taxes a. To get a deduction for tax, taxpayer must be the obligor (the one who has to legally pay the tax) b. Cramer v. Commissioner i. First Aspect (a) Daughter tried to deduct property taxes she paid on her sick mother‟s behalf. (b) Not deductible by daughter. (c) Payment of tax is not income to Mom, because it is a gift. ii. Second Aspect (a) When property is sold under land contract, the selling owner‟s name stays on the title until the last payment is made. (b) Therefore, the seller (with record title) pays taxes and deducts them because she still owns it c. [IRC §164(d)(1)] Apportionment of taxes between buyer and seller: i. Prorated for the portion of the year the buyer/seller owns the property (a) Taxes will be apportioned in the year of sale between the buyer and the seller for the period in the year each owned the land (b) Seller, even if he pays the full property taxes for the year, only gets to deduct for the part of the year in which actually owned the land. ii. Formula = (# days obligated to pay ÷ 365)  Amount of Tax 3. [IRC §164(a)(2)] State and Local PERSONAL property taxes a. Ad valorem: If fees are paid based the on value of something, then can deduct. b. Example i. DMV fees based on value of your car are deductible ii. DMV fees based on a blanket requirement ($30 registration fee) are not 4. [IRC §164(a)(3)] State and Local and foreign, INCOME, war profits, and excess profits taxes a. For federal income tax purposes, deduction is allowed for state and local income taxes. b. [IRC §275] Federal income taxes are not deductible c. State Disability Insurance: this is deductible also. Ends up being about $240/year Problem #1 Which of the following would be deductible as such under [IRC §164]?  State sales tax applied to anything but food and clothing - Not deductible  State real property tax of 1000 for which A became liable as a owner on 1 Jan but which B agreed to pay ½ of when he acquired land on 1 July. Deductible as real property of 500 each. Apportioned based on ½ year.  A state income tax - Deductible  Federal income tax - Not deductible  Gas tax - Not deductible Problem #3 Dad paid son‟s intangible tax which is a tax based on value of stocks and bonds that one owns.  May dad deduct the tax paid that son owed? No because Dad is not the obligor. The son is the obligor.  Deductible by son? Probably yes. It was a gift, so it would not be income; but the deduction is like a part of the gift.


B. [IRC §217] Moving Expenses 1. General a. [IRC §62] Adjusted Gross Income (AGI) = Gross Income – Deductions b. [IRC §62(a)(15)] Moving Expenses are one of these deductions c. Two Requirements for the deduction under [IRC §217] i. Distance Requirement ii. Time Requirement d. Deductible above the line 2. [IRC §82] Reimbursement for Expenses of Moving a. [IRC §132(a)(6)] Allows a fringe benefit for expenses from moving i. If Employee gets reimbursed by Employer, Employee excludes the amount from gross income ii. Employee does not also get to deduct it. b. [IRC §217] Moving Expenses i. General Rule (a) A deduction is allowed for moving expenses paid or incurred during the taxable year in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work. (b) You can take the deduction in the year of the move even though the time test has not been met (c) If you do not meet the time test you have to go back and amend the prior return. ii. [IRC §217(b)] Definition of Moving Expenses (a) Transportation Costs (Hard-Moving Costs) (i) Moving household goods and personal effects for you and your family from the former residence to the new residence (ii) Eg. drive you car, you can deduct a standard mileage rate of 10¢ per mile (b) Traveling Costs (i) Traveling, including lodging, from the former place to the new place. (ii) Meals are not included iii. Requirements: Conditions for allowance (a) [IRC §217(c)(1)] Distance Test (i) Difference of distance between the old home and the new work – distance between old home and old work must be 50 miles or more. (Distance from New Job to Old Home) - (Distance from Old Job to Old Home) > 50mi (ii) If no old work, then new work must be more than 50 miles from old house. [Rev. Ruling suggests that new house must be in the same vicinity of new work] (Distance from Old Home to New Work) > 50 mi (iii) Note: need to meet both; if married only one spouse has to meet both tests (iv) Examples (1) Old house in Malibu and old work in Santa Monica (distance = 10 miles) New job in Ventura which is 55 miles from old house. 55-10=45 So doesn‟t meet distance test b/c not more than 50 miles (2) Same but move to Ojai and distance between old home and new job is 70 miles. 70-10=60 so passes test. (3) Recent law school grad starting new job Difference between house and new job is 75 miles so passes test. (b) [IRC §217(c)(1)] Work/Time test: Depends on if self-employed or employee (i) Employees: During the 12 month period immediately following taxpayer‟s arrival in the general location of his new job, he must be a full-time employee for at least 39 weeks. (1) Don‟t have to work for same employer. You just have to be working. (2) Could also move without a job lined up and just hoping to find one; so long as you get a job you meet the test. (3) Time of 39 weeks doesn‟t have to be continuous. (4) Exceptions to time test: you are laid off or become disabled. (ii) Self-employed: If you are self employed, you must work at least 39 weeks during the first 12 months, and a total of 78 weeks during the first 2 years. (1) You do not have to be at the same job. (2) Could work 50 weeks in the first year and 28 in the second, but need to work at least 39 in the first year to pass test. (3) Partners are considered self-employed.


Problem #1 Lawyer has been practicing law in Town X and he and his family live in Suburb of Town X 10 miles away. He decides to open an office in Town Y. Consequently he moves himself and his family to a home in Town Y. How far away must the new place of employment be from old house in order to qualify? 60 miles because has to be more than 50 miles (60-10 = 50 mi)  How far away from Suburb must Town Y be located in order for lawyer to be allowed a moving expense deduction if Lawyer has just graduated from law school and this is a first job? 50 miles; no old job to subtract.  Assuming Lawyer is a sole practitioner what time requirement are imposed on him in order to meet test? 39/78; at least 39 weeks in first year w/a total of 78 in first 2 years.  What difference if L joins a firm as a partner? 39/78 because partner is self employed.  What difference if L goes to work for a firm in Town Y but as an associate rather than a partner? 39 week test.  Assuming the necessary time and distance requirements have been met, and that a joint return is filed, what is the amount of lawyer‟s [IRC §217] deduction if he incurs the following? 400 in moving belongings – fully deductible 150 in transporting his family – fully deductible; if you drive your car you can deduct a standard mileage rate 100 in lodging – fully deductible 200 in meals in conjunction w/ transporting family – not deductible Total deduction is 650; deductible above the line.  Is there any difference in the above result if lawyer‟s wife also takes a job and meets distance and time requirements? No because both spouses don‟t need to meet the test, only one.  If lawyer‟s firm reimburses lawyer for 850 of his expenses in the year that they are incurred, what tax consequences will the reimbursement have? Under [IRC §132(a)(6)], a qualified moving fringe, and don‟t need to report under [IRC §217] So 650 of 850 is an amount otherwise deductible so excluded from gross income by [IRC §132] Don‟t also get the deduction. The other 200 is income. If it was a working condition fringe, then deducted below the line so would have to exclude b/c otherwise not same outcomes. C. Deductions for Extraordinary Medical Expenses [IRC §213] 1. General Rule a. You are entitled to deduct medical expenses for you and for dependents only to the extent that the expenses exceed 7.5% of AGI. b. Example: 100k of AGI; you can only deduct qualifying medical expenses to the extent they exceed 7500. If you have 8000 in expenses you only get a 500 deduction. 2. [IRC §213(d)(1)] Medical Care a. Diagnosis, insurance, cure, mitigation, treatment, or prevention of disease or for the purpose of affecting any structure of the body. b. Costs for doctors/dentists, hospital costs, hospital stays, c. Meals are fully deductible while in the hospital, taxes. d. Transportation expenses deductible when essential to care referred to in (A). e. Health Insurance deductible f. Examples i. Wheel chair ramps, bars in bathroom, etc. are completely deductible as medical expenses (even though capital expenditure). ii. Buying a wheelchair, seeing eye dog, artificial limbs: are fully deductible iii. Hot tubs, Jacuzzi, pools for bad backs are not allowed as a deduction [possible deduction for a portable unit for the bathtub]. iv. Interest: Borrow money to pay for a medical expenditure: is interest deductible? No. It is personal. g. Limitation: drugs must be prescribed or, be insulin to count. 3. Capital Expenditures a. Raymon Gerard i. Daughter had cystic fibrosis and the doctor told them to install a central air conditioning unit. ii. It cost 1300, and taxpayer said it was a medical expense but, IRS said it was a capital expenditure and therefore, no deduction. iii. Court held that you can deduct the amount spent that does not increase the value of your house. iv. Here, the unit increased the house‟s value by 800. v. Therefore, 500 is deductible [800 will go to increase AB]. b. [IRC §263] i. [IRC §263(a)(1)] There shall be no deduction for capital expenditures because capital expenditures increase your Adjusted Basis [AB]. ii. You can deduct the cost to the extent that it does not improve the value of the house. iii. This is the only time we are concerned with the increase in value of the house when determining the adjustment in the basis. c. [Reg. §1.213-1(e)(iii)] i. Codification of Raymon Gerard holding. ii. All maintenance costs are always deductible if considered a medical expense. iii. Electricity to run a medical device is also deductible in full.


4. Traveling for Medical Reasons a. Commissioner v. Bilder i. If doctor tells you to go to warm weather, the cost of going to Florida for 3 months first year and 2 months for second year is not deductible. ii. Simply moving for health reasons does not warrant a medical deduction. iii. Court says that rental costs are not deductible. iv. The transportation costs are deductible but, the costs of living there are not deductible. b. [IRC §213(d)(2)]: Medically-related transportation costs i. If you are going somewhere and receiving treatment on an outpatient basis, you can deduct up to $50 per day for your lodging and the lodging of anyone who accompanies you. ii. Determined by .10/mile if driving from your house to the Dr.‟s office. iii. Meals are not deductible. iv. Complete hospital stays are fully deductible. 5. [IRC §213(d)(9)] Cosmetic Surgery a. Not deductible unless necessary to fix abnormalities or deformities resulting from accident or disease. b. Elective surgery is not deductible at all. 6. Rehabilitation Programs a. Deductible, whether prescribed by a doctor or not, are deductible medical expenses (alcohol, smoking rehabs: but, not Nicorette gum b/c not a Rx drug). b. [Rev.Rul. 99-28] Smoking Cessation expenses are a deductible medical expense, even if self-prescribed c. If you buy nicorette patches on your own, with no doctor prescription or not a part of the program, it is not deductible. Problem Divorced Homeowner, who received neither alimony nor other support payments from her husband, fully supported her 20-year old daughter who had no income, lived w/ Homeowner and was a dependent of Homeowner. In the current year, Homeowner installed a central AC system at a cost of 4100, which Dr. said was an elementary requirement in caring for D‟s respiratory problems. After installation, Homeowner‟s home increased in value by 2100. Other medical expenses paid were for prescription medicine=320, insurance premiums=300, and Dr.‟s bills=400. No reimbursements as of yet.  If Homeowner‟s AGI is 12000 what will be the amount of her medical expense deduction? 4100-2100=2000 for AC. 320 for drugs. 400 for bills. 300 for health insurance. Total is 3020 and need to deduct the amount from here that exceeds the 7.5% of AGI. 7.5% of 12k is 900. So only can deduct expenses in excess of 900. [IRC §213(a)] Therefore, 3020-900 = 2120 is actual medical expense deduction.  If in the current year, Homeowner incurs maintenance expenses of 300 on the AC; can that be taken into account as a medical expense? All maintenance and operating costs are deductible. [Reg. 1.213-1(e)(iii)] D. Charitable Contributions [IRC §170] 1. General a. Gifts to charities are deductible Below the Line b. Concept for the deduction: philanthropy; encourages helping others. 2. [IRC §170(c)] Charitable Contribution Defined a. Must be a qualified charitable organization b. Examples of qualified charities: government, religious, educational, hospitals, veterans orgs., fraternal societies, non-profit cemetery companies. 3. Limitations: a. No minimum, deduct from first dollar given b. There are some maximum deductions based upon 50% of AGI and what you give. c. You can deduct cash and/or any property (FMV at time of gift) given to charity. d. If make a single gift of more than 250, need receipt. e. $75 or more gift with contribution i. If make a contribution to a charity dinner of 1000 but receive a dinner worth 80, you can only deduct net amount given = 920. ii. So, if value of what you are getting is $75 or more, subtract that amount from contribution and deduct the rest. f. Contribution must benefit organization as a whole. Can‟t earmark the money for a specific individual. 4. Examples a. Cannot give a gift of 10k to Pepperdine and want it to go to a scholarship for a particular student. b. Sponsor-a-Child organizations are okay because the money is actually going to the organization. c. Churches: give money to the general church fund and then the bishop gives out money to individuals (put name on the envelope but, check payable to the church). IRS does not pursue this even though this practice is technically improper.


E. [IRC §165(h)] Casualty and Theft Losses 1. Uninsured Losses: If something is damaged, stolen, etc. you may be entitled to a deduction for the part not covered by insurance. 2. Deduction taken BELOW the line (itemized). 3. Restrictions: a. Two Major Restrictions i. [IRC §165(h)(1)] The first $100 per incident does not count. (a) You get no deduction for the first $100. (b) Like deductible in car insurance, taxpayer must pay in the first $500 before insurance covers the rest. ii. [IRC §165(h)(2)] After the deductible, the rest of the expense is subject to a 10% of AGI floor. b. So, you can only deduct what is in excess of 10% of AGI. c. If your AGI is 100k you would only be able to deduct losses in excess of 10k.   Examples House damaged by an earthquake. Decline in FMV = 60k. Not compensated by insurance. AGI=200k. 10%=20k. So can deduct 40k. Loss=40k. Insurance covers 30k. No deduction because out of pocket expenses don‟t exceed 20k, the 10% floor of AGI.


VI. The “Standard” Deductions, Personal Exemptions & Calculation of “Taxable Income” A. Itemized Deductions (revisited) 1. Taxpayers get the greater between the “ITEMIZED” or “STANDARD” deduction 2. Itemized deductions are ones, other than for personal exemptions, which are not [IRC §62] deductions 3. Basic Itemized Deductions a. [IRC §213] Medical/Dental (s/t 7.5% of AGI floor) b. [IRC §164] Taxes Paid (other than taxes deductible above) c. [IRC §163] Interest Paid (no deduction for “personal” but can deduct “QUALIFIED RESIDENCE” interest) d. [IRC §170] Charitable Contributions (s/t limits) e. [IRC §165(h)] Casualty/theft losses (s/t $100 & 10% of AGI floor) 4. Miscellaneous Itemized Deductions a. Examples of General [IRC §162] Expenses i. Job hunting expenses; ii. Local business transportation costs; iii. Travel away from home (Sleep & Rest Rule) MISCELLANEOUS iv. Education expenses; ITEMIZED v. Entertainment/Meal expenses [IRC §274] DEDUCTIONS vi. Uniforms vii. Dues/Professional Fees viii. [IRC §212] expenses, other than rental related b. Subject to 2% of Adjusted Gross Income base to deduct them. c. So you can deduct all expenses in excess of 2% of AGI. d. So, if your AGI is 100k; you can only deduct expenses above 2k. B. Standard Deduction (introduced in 1944) 1. General a. An alternative to the itemized deduction (choose the greater one). b. Most people take the standard deduction until they buy a home. c. If you are a dependent, you may not be able to take the standardized deduction. 2. [IRC §63(c)] Standard Deductions a. [IRC §63(c)(2)] Standard Deduction = Basic Standard Deduction + Additional Standard Deduction i. [IRC §63(c)(2)(A)] Basic Standard Deductions (2002/2003) (a) 7850/7950 in the case of: (i) Joint return or (ii) Surviving spouse (b) 4700/4750 for single person (not surviving spouse or head of household) (c) 6900/7000 for head of household (single parent) ii. [IRC §63(f)] Additional standard deduction for aged or blind (added to basic std deduction) (a) Blind: Can‟t see better than 2200 in best eye with correction (b) Aged: 65 years (c) Married – Filing Joint: 900/950 (d) Singe / Head of Household – 1150/1150 (e) If blind and old, collect 2 of the additional standard deductions (f) Amounts are per person b. [IRC §63(c)(4)] Amounts are adjusted for Inflation c. Dependents i. Applicable for Dependents (2002/2003) ii. If you can be claimed as a dependent by someone else, your standard deduction is the greater of: (a) $750/$750 (same for both years) or, (b) Your earned income (wages & salaries, not interest) + $250 (c) There is a cap on this number: it can‟t exceed the basic std deduction.


C. [IRC §§151/152] Personal Exemption Deduction (in addition to itemized or std deduction, whichever is greater) 1. General a. Everyone is entitled to a deduction for just being alive. b. Sometimes one can be eligible to take a dependent‟s deduction, so get two personal exemptions if fulfill requirements. c. [IRC §151(b)] Personal exemption (deduction for being alive): for taxpayer & taxpayer‟s spouse. i. 2002: $3000 ii. 2003: $3050 d. If parents take the exemption, the dependent if they file doesn‟t get one also [one exemption per person]. e. If parents are entitled to take it and don‟t, the dependent is not then entitled to take the exemption. 2. [IRC §151(c)] Exemption for a Dependent: a. General i. First must determine if the person is even a dependent ii. To be a dependent, need to meet the citizenship requirement and the two tests in [IRC §152(a)]: iii. Person must be a US citizen, resident or national, or a resident of Canada/Mexico for any part of the tax year b. First Step - Determine whether there is a dependent [IRC §152(a)]: Two Tests i. [IRC §152(a)] - Relationship Test: (a) [IRC §§152(a)(1-8)] Must be a certain relationship to you - blood, adoption, foster, stepchild, relations (niece/nephew, aunts, parents, grandparents), in-laws (does not have to be living with you) (b) [IRC §152(a)(9)]: Non-related individuals: anyone not related who is living with you as a member of your household for the entire year; can be anyone. (c) [Reg. §1.152-2(d)] Relationships are not terminated by death or divorce. ii. [IRC §152(a)] Support Test: (a) Must provide more than ½ of such person‟s support for the year. (b) [IRC §152(d)] If child is getting a scholarship, it does not count as support from someone else if (i) It is a qualified scholarship (tuition, books, fees/qualified educational institution [IRC §117]) AND (ii) The child is a son, daughter, stepson or stepdaughter. (c) Student loans are deemed support by the student for the student. (d) [IRC §152(c)] In multiple support arrangements, dependency can be split c. Second Step – Determine whether you‟re entitled to take their exemption [IRC §151(c)] i. Dependent must not file a joint return with a spouse for the taxable year Exception: [Rev.Rul. 65-34]: this will be waived when the married child has no tax and only files to receive a refund. ii. Dependent must EITHER: (a) Have gross income less than the personal exemption amount for the year [$3000 OR $3050]; or (b) Be your child & have gross income more than exemption and child is under 19; or (c) Be your child and is under 24, and a full time student for some part of 5 months during the year, regardless of how much money made.

Year 2002 2003 Joint Return / Surviving Spouse $7850 $7950 Head of Household (single parent) $6900 $7000 Single (not surviving spouse or head of household) $4700 $4750 ADDITIONAL DEDUCTIONS FOR AGED OR BLIND Married – Filing Joint $900 $950 Singe, or Head of Household $1150 $1150 PERSONAL EXEMPTION Exemption Amount $3000 $3050 Reason for Deduction


Problem In each of the following parts, state whether T was entitled to a dependency exemption for that particular person. Assume the facts are: year is 1989, T was married but filed separately, and T furnished over ½ support for person involved (T meets support test). Person earned less than 2000 (less than personal exemption in 1989) during the year and did not live with T.  X was T‟s wife‟s brother (brother in law) Meets relationship test, given that support test was met and person earns less than exemption amount so: T can take it for X, meets all tests  Same as (1) but T‟s wife died the year before Same because death doesn‟t end relationship. [Reg. 1.152-2(d)]. In-laws are always considered to meet the relationship test.  Same as (1) but T and wife were divorced the year before Same because divorce doesn‟t sever the relationship. [Reg. 1.152-2(d)]. In-laws are always considered to meet the relationship test.  X was T‟s wife‟s sister‟s husband: Brother-in-law‟s wife or, sister-in-law‟s husband not a qualified relationship  Same as (4) except that X lived w/ T for the entire year Lived with him, so can deduct him: [IRC §152(a)(9)]  X is T‟s son who will be 19 next Jan. 1 and who earned 3000 for 2002 from summer work during the year and is also a full time student Must be less than 3000 so, X did not meet less than the exemption amount X also does not meet the under 19 test because if your birthday is Jan 1, you are deemed to have turned that age, the day before (how odd???) [Reg. §1.151-1(c)(2)] – Birthdays count the day before the actual birthdate. X does qualify as a dependent because he is the son and a student under 24. T gets X‟s personal exemption deduction. (won‟t be on exam).  X is T‟s 18 year old daughter who had only 500 in gross income during the year, but who is married and filed jointly T can‟t claim exemption because she is married and filed jointly. [IRC §151(c)(2)] [Rev.Rul. 65-34] This will be waived when the married child has no tax and only files to receive a refund. (won‟t be on exam).  X was T‟s 18 year old son for whom T contributed 2k in support while X, who had no income applied 3k from Uncle to support him Nope can‟t take it because didn‟t support him at least ½ Meets relationship test but, does not meet support test. Uncle can take X as a dependent and take exemption (meets relationship and support tests). There is no issue about “less than exemption amount” because X had no income.  Same as above except that X‟s only contribution to his own support was a $3k scholarship enabling him to attend college? Here, if the scholarship is qualified under [IRC §117 – scholarship for tuition, books, fees, not room and board], the 3k does not count toward his support therefore, T will be able to take X‟s deduction [IRC §152(d)].


I. Classification of Taxpayers, Rates & Tax Calculations A. Steps 1. Determine Gross Income 2. Determine Adjusted Gross Income (AGI) by finding deductions ABOVE the line. 3. Determine Itemized Deductions (& miscellaneous itemized deductions) by finding deductions BELOW the line. 4. Determine Standard Deduction 5. Determine Personal Exemption Deduction (for self & dependents) 6. AGI – [(either Itemized or Standard Deduction) + (applicable Personal Exemptions)] = Taxable Income B. Classification of Taxpayers 1. Married, Filing Joint & Surviving Status a. [IRC §1(a)(2)] Married Filing Joint i. [IRC §6013(d)(1)(A)] Marital Status is determined as of the last date of the year. ii. [IRC §6013(a)(3)] In the year in which the spouse dies, the widow/widower still gets to use the married-filing joint rates 2. [IRC §2(b)] Head of household a. A single parent b. Unmarried, and paid at least ½ the cost of maintaining the household that was the main home for more than ½ of the year for any number of people (child, grandchild, stepchild, adopted child) or, any other relative you can claim as a dependent c. What if dependents are not related? i. [IRC §2(b)(3)(B)(i)] Non-relative does not give head of household status ii. Cannot file this status if dependent child is not related. iii. Taking care of another‟s child: not head of household; but can take personal deduction. 3. [IRC §1(c)] Single: unmarried and no dependents 4. [IRC §1(d)] Married, Filing Separately (least favorable rates) C. Rates: See Table on Last Page


2003 TAX RATES Married Filing Joint Returns & Surviving Spouses [IRC §1(a)(2)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $12,000 10% of taxable income $12,000 $47,450 $1,200 15% of excess over $47,450 $47,450 27 $161,450 $23,965.50 30% of excess over $105,950 $161,450 $288,350 $41,170 35% of excess over $161,450 $288,350 $86,854.50 38.6% of excess over $288,350 $ Head of Household [IRC §1(b)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $35,150 10% of taxable income $35,150 $90,800 $5,272.50 15% of excess over $35,150 27% of excess over $90,800 $90,800 $147,050 $20,854.50 30 $147,050 $288,350 $38,292 35% of excess over $147,050 $288,350 $89,160 38.6% of excess over $288,350 $ Single [IRC §1(c)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $6000 10% of taxable income $6000 $28,400 $600 15% of excess over $26,250 $28,400 $68,000 $3,900 27% of excess over $28,000 $68,000 $143,500 $14868 30% of excess over $68,800 $132,600 $288,350 $35,787 35% of excess over $ $288,350 $91,857 38.6% of excess over $ $ Married Filing Separate [IRC §1(d)] – ½ of the Married Filing Joint Rates 2001 TAX RATES Married Filing Joint Returns & Surviving Spouses [IRC §1(a)(2)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $12,000 10% of taxable income $12,000 $45,200 $1,200 15% of excess over $12,000 $45,200 $109,250 $6,180 27.5% of excess over $45,200 $109,250 $166,500 $23,793.75 30.5% of excess over $109,250 $166,500 $297,350 $41,255 35.5% of excess over $166,500 $297,350 $87,706.75 39.1% of excess over $297,350 $ Head of Household [IRC §1(b)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $10,000 10% of taxable income $10,000 $36,250 $1,000 15% of excess over $10,000 $36,250 $93,650 $4,937 27.5% of excess over $36,250 $93,650 $151,650 $20,722.50 30.5% of excess over $93,650 $151,650 $297,350 $38,412.50 35.5% of excess over $151,650 $297,350 $90,137 39.1% of excess over $297,350 $ Single [IRC §1(c)] Taxable Income Tax More Than Less Than Base Amount Plus $0 $6,000 10% of taxable income $6,000 $27,050 $600 15% of excess over $6,000 $27,050 $65,550 $3,757.50 27.5% of excess over $27,050 $65,550 $136,750 $14,345 30.5% of excess over $65,550 $136,750 $297,350 $36,061 35.5% of excess over $136,750 $297,350 $93,074 39.1% of excess over $297,350 $ Married Filing Separate [IRC §1(d)] – ½ of the Married Filing Joint Rates


II. Capital Gains & Losses A. General 1. Losses & Gains a. Losses: Deducted above the line b. Gains: Added to Gross Income to determine AGI 2. When there is a gain or loss, you must ask 3 questions: a. Gain or Loss realized? b. Is the gain or loss recognized? i. Gains/Losses from sale of personal residence – not recognized ii. Gain from transfers between spouses, or incident to divorce – not recognized [IRC 1041] c. If recognized, is there any special tax treatment? Capital gains/losses may have special treatment. B. Are gains/losses recognized? 1. [IRC §1001(c)] Generally, All realized gains/losses are recognized (absent some special tax treatment), and so they must be reported in income unless there is some provision to exclude it. 2. [IRC §165] Gains/Losses for Personal Assets a. Gains: Personal Gains will be recognized and so included in income. b. Losses i. Personal Losses: not recognized although they may be realized, and so not deducted from income ii. [IRC §165(c)] Deductible Losses (recognized losses) (a) [IRC §165(c)(1)] Losses incurred in business or trade (b) [IRC §165(c)(2)] Losses incurred in any transaction entered into for profit, though not connected with a trade or business RECOGNIZED (i) Investment/rental/unimproved land sold at a loss (ii) Stocks/bonds sold at a loss (c) [IRC §165(c)(3)] Casualty Losses (even though personal) iii. Only these three recognized losses can be capital losses C. Special Treatment - must be recognized to get to this question 1. General a. A capital gain or loss arises from the "sale or exchange" of property which is a capital asset. b. Only consider special treatment after the gain/loss is realized and recognized. c. If the gain/loss has a special character, it will potentially receive preferential tax treatment and be taxed at a lower level than other income [max tax rate for these capital gains is 20%]. d. Three issues: i. Is it a capital asset? TREATMENT OF CAPITAL ii. What is its classification as to time or holding period? GAINS/LOSSES iii. Netting Process e. [IRC §165(c)] Loss from the sale of a personal use capital asset is not recognized. 2. [IRC §1221] Is it a Capital Asset? a. What is a capital asset? i. Defined in the negative: Anything that is not a capital asset (not trade or business property). ii. So what is? ALL PROPERTY OTHER THAN TRADE OR BUSINESS PROPERTY: (personal use or investment) (a) Investment property (stocks/bonds/real property/personal property/coins) assets are capital assets (b) Gains from personal use products (house, car, furniture, clothes, alarm clocks, bed): gains are capital gains (c) But, personal losses aren‟t capital losses because need to be recognized and they are not. b. Must be a capital asset to get preferential treatment


3. [IRC §1222] Classification: [If Capital Asset, classify it as to time of holding (short/long term)] a. Long-Term Gains/Losses i. Classification is significant because only long term capital gains get preferential treatment ii. This is to reward long-term investments iii. A capital gain or loss is "long-term" if the taxpayer's holding period for property at the time of its sale or exchange is more than 1 year. b. Short-Term Gains/Losses i. Exactly 1-year is short-term ii. More than 1-year is short-term c. [IRC §1222(1-4)] How are assets classified? 1 year basis i. If you hold an asset for more than one year and upon its sale or disposition, you recognize a gain/loss, then it is a LONG TERM ASSET ii. If you hold an asset for less than one year and upon its sale or disposition you recognize a gain/loss, then it is a

d. Four Categories i. STCL: short-term capital loss ii. STCG: short-term capital gain iii. LTCL: long-term capital loss iv. LTCG: long-term capital gain e. [IRC §1223(2)] Tacking of holding periods i. General Rule (a) If AB is determined in whole or in part in the hands of another person (via carry-over basis), their holding period can be tacked onto your holding period. (b) Example: (i) Uncle gives you stock as a gift and you sell it after having it for a month. (ii) To determine it‟s holding classification, you can add on the time that the uncle owns it because his basis is not your basis (carry-over rule) ii. Exceptions (a) Special Loss Rule: No tacking on periods for special loss rule because you are not using the carry-over basis; you are using the FMV (b) Part-Gift, Part-Sale: When you use the consideration paid (because then you are not using the carry-over basis) (c) Gift Tax Paid Adjustment: Can tack if part determine the AB. (d) [IRC §1223(11)] Gift from Decedent (i) You automatically get long-term holding status. (ii) If property is acquired from decedent, it is automatically classified as long-term, and you are deemed to have held for over a year. 4. [IRC §1221] Netting a. Two-Tier Process i. Group all long-term gains and losses together, and group all short-term gains and losses together ii. If gain on one side, and loss on the other - then subtract loss from gain again [net gain]. b. [IRC §1211(b)(1)] offset capital gains and deduct balance. i. Max deduction (ABOVE THE LINE) is $3000. ii. Remainder is carried into the next taxable year


Example ST LT CL: <$6000> CL: <$1000> CG: $5000 CG: $4000 <$1000> $3000 $2000 Gain (LT) Preferential Treatment Example ST LT CG: $1000 CL: <$200> $1000 <$200> $800 Gain (ST) No Preferential Treatment Example ST LT CG: $1000 CG: $2000 $1000 $2000 Both count toward AGI; But, LTCG gets special treatment Example ST LT CL: <$2000> CG: $500 <$2000> $500 <$1500> Loss (ST) Deducted from AGI (ABOVE THE LINE) Example ST LT CL: <$5000> CG: $500 <$5000> $500 <$4500> Loss (ST) <$3000> Deducted from AGI (ABOVE THE LINE) this year <$1500> Carried into next year Example ST LT CL: <$5000> CL: <$1000> <$5000> <$1000> <$3000> Loss (both) Deducted STCL from AGI (ABOVE THE LINE) first <$2000> STCL & <$1000> LTCL carry over into next year Example: 2002 ST LT <2000> <6000> You now have 8000 in losses and can deduct up to 3000 per year. But from which side can it be used – ST or LT? You take the ST losses first. So, here, 2000 from ST and 1000 from LT. So left with 5000 LT loss and the next year you have a carry over of 5000

Capital Gain/Loss Problem Set Problem 1 Tad, a single individual, had $60,000 from wages in 2002. In addition, he was involved in the following transactions during 2002:




Sold 100 shares of XYZ Co. stock in January 2002 and received $5,000 net of sales commissions. He purchased these shares in July 2001 for a total cost of $2,200 (this included a purchase commission charge of $200). -does he have realized gain or loss? AR = 5000, AB = 2200, Gain = 2800. Is it recognized? Yes, there is no exclusion for sale of stock. Capital asset? Yes, it is a capaital gain. Is it LT or ST? St because a year or less. Made a gift of a watch to a friend. The watch had cost him $800 in 1972 and was worth $4,000 at the time of the gift.

Sold a sailboat in March 2002 for $11,000. The boat originally cost him $9,000 when purchased in 1997 and has been used exclusively for pleasure. -Realized gain of 2000 and recognized. Capital asset? Yes and it is LT. - Sold a diamond lapel pin in April 2002 for $3,500. Tad received the pin as a gift from his grandfather just two months earlier. His grandfather had purchased the pin way back in 1941 at a cost of $150. -AR = 3500, AB = 150, Gain = 3350. Recognized? Yes because not excluded. Capital asset? Yes, and LT. - Sold a stereo set to a friend for its current fair market value of $500. Tad purchased the set in 1995 at a cost of $1800. -AR = 500, AB = 1800, Loss of 1300. Is it recognized? Not for sale of personal use items (165(c)). Never recognized so don‟t go further. Assuming there were no other tax-related items for 2002, please discuss the tax consequences to Tad as a result of the above items. Also, compute his “adjusted gross income” (AGI) for 2002. ST LT 2800 2000 3350 ____ ____ 2800 5350 8150 AGI = 68150 Problem 2 Wanda and Hal are married and file joint returns. In 2002 they had salaries of $80,000 and $60,000, respectively. Other than numerous capital gains and losses, they realized no additional income nor had any deductions for 2002. Their capital gains and losses for 2002 are as follows: (a) STCL of ($8,000) LTCL of ($2,000) STCL of ($1,200) LTCG of $3,000 STCG of $9,800 LTCL of ($5,000) Based upon the foregoing, please compute the couple's AGI for 2002? ST LT <8000> <2000> <1200> 3000 9800 <5000> _____ ______ 600 <4000> <3400> -They get a <3000> loss taken from GI leaving them 137,000 as their AGI. For the next year they would get a carry over of 400 LT loss. Same as part (a), above, but for this part only, assume the couple realized an additional STCL of ($1,000) in 2002. What is their AGI for 2002? Same as part (a), above, but for this part only, assume that the couple realized an additional STCL of ($3,000) in 2002. What is their AGI for 2002? Continuing from part (c), the couple is trying to estimate their taxes for 2003. During 2003, Wanda and Hal anticipate that they will have aggregate wages of $200,000 and will realize the following capital gains and losses: - STCG of $4,000 52/54




- STCL of ($2,000) - LTCL of ($1,000) - LTCG of $7,000 Please calculate the couple‟s AGI for 2003 based upon the foregoing. (e) In part (d), above, is it really necessary that we make the long-term/short-term distinction for capital gains and losses?

Answers to Taxable Income Problems Handout Problem 1 1. GI = 106,000 2. AGI = 100,000 1) 6000 for moving expenses 2) Possible deduction of 3000 for law school tuition (section 222) but doesn‟t get it – if single and AGI before this deduction is less than 65000 then you get deduction. 3. Itemized = 4600 1) interest of 4000 2) medical expenses have a 7 ½ % requirement so 7000 is not greater than 7500 (100,000 AGI); no deduction 3) real property taxes = 500 4)business expenses and tax prep fees qualify under misc. itemized deduction subject to 2% AGI floor. = 2000. So 1900 + 200 = 2100. So only 100 is deductible. 4. Standard = 4750 5. Personal exemption = 3050 6. 100,000 – (4750 + 3050) = 92,200 = Taxable Income Problem 2 1.What has changed: now Ted gets additional 3000 deduction for tuition. AGI = 97,000 2. 7 ½ % of 97,000 = 7275 3. 2% of 97,000 = 1940 4. so now only 160 is deductible 5. std deduction is 7950 6. personal exemption is 6100 7.Taxable income = 82950 Problem 3 a.Tina will have to be under 24 since she is claimed as a dependent and is making more than the exemption amount, and is a child who is a full time student. Aside from this, her taxable income is: 1)GI = 4500 2)Deductions = 0 3)AGI = 4500 4)Std: in 2002, 4,700 was the single std deduction. But if you can be claimed as a dependent, you‟re the dependent person‟s std deduction is the greater of 750 or earned income (salary and wages) + 250. Since all of her income is not from salary and wages, her std is 750. 5)personal exemption deduction is 0 because she is claimed as a dependent. 6)Taxable income is 4500 – 750 = 3750 b.Taxable Income = 2250 c. There is a cap of regular std deduction. In this case it is 4700. So taxable income = 0. d. There is no choice. If someone is allowed a dependent and choose not to, still recognized as a dependent. So the answer is the same as above a – c. Tina will not be allowed to take the personal exemption.


Hypotheticals for tax rate schedules: 1.Single person in 2002 with taxable income of 100,000. So 14,625 + 30% of 32,300 = 24,315. 2.Married person filing joint in 2002 with taxable income of 100,000. So 6,405 + 27% of 53,300 = 20, 796


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