Federal Tax Entire Tax Equation Gross income (s. 61) Less - Above the line deductions (s. 62) Equals - Adjusted Gross Income (s. 62) Less - The Greater of (s. 63) Itemized deductions plus deduction for personal exemptions OR Standard Deduction plus Deduction for Personal Exemptions Equals - Taxable Income (s. 63) Times - Tax Rate (s. 1) Equals - Amount of Tentative Tax Less - Tax Credits - (s. 21-53) Equals - Tax Due Gross Income s. 61 - Gross income includes all income from whatever sources derived. Accession to wealth where a person has dominion "economic benefit" definition - Income is the value of any economic benefit received by the taxpayer regardless of the form of the benefit Realization Tax the person when they use the wealth Stock value increases, but the stock isn't taxed quite yet until the person sells the stock and realizes the value But if you get $500 worth of stock for $100, the $400 is taxed since you realized the value Ask if it is double taxed? The $400 then the value after you sell it? Policy - for/against Against - Don't sell homes, sit there since no one wants to be taxed For - measure depreciation and appreciation is a pain in the ass, people might not be able to pay the tax on the property Income Compensation income - s. 61(a)(1) Gross income from business - s. 61(a)(2) Gains derived from dealings in property - s. 61(a)(3) Investment income - s. 61(a)(4)-(7) Dividends - s. 61(a)(7) Annuities - s. 61(a)(9) Alimony - s. 61(a)(8) Discharge of indebtedness - s. 61(a)(12) Prizes and Awards - s. 74 Helpful Payments - ss. 82, 85, 86 Unemployment Compensation - s. 85 Gross income includes a potion of income payments from social security - s. 86 Assignment of Income Doctrine - You can’t avoid income by assigning it to someone else. If it’s generally income earned by you performing services –
income from property you own. If it’s income off of William’s property he will be viewed as transferring it to her by Not Income Imputed Income Self help activities, not taxed Would be extremely difficult to tax Giving flowers to loved one for romantic purposes - imputed income Trading services (dentist gives $200 worth of services for doctor's services worth $200) - not imputed income Bargain Purchases What if you purchase an item and the value is more than you paid for it, should you be taxed for the increase in value? No, would be tough to track, and a number of those purchases are so insignificant, wouldn't be worth doing Must be a bonafide purchase Capital Recovery Taxpayer is entitled to receive his or her capital investment in the property tax free, although the timing of this recovery is a matter for legislative determination. Loans Neither creation nor the repayment of a loan is a taxable event. However, forgiveness or discharge of a loan may generate income to the debtor. Must actually enter into an agreement Death Benefits - s. 101 (unless you transfer it for valuable consideration) Gifts - s. 102 (unless it is income from property or employee gifts) Compensation for Personal Injury or Sickness - s. 104 Discharge of Indebtedness - s. 108 Qualified Scholarships - s. 117 Exclusion for Gain on Principal Residence - s. 121 Employment-Related Exclusions s. 61(a) has specific items which are income Commissioner v. Glenshaw Glass Facts: Respondent receives punitive damages, doesn't believe they should be taxed. Not in the definition provided by Eisner v. Macomber, "the gain derived from capital, from labor, or from both combined." Issue: Can punitive damages rewarded to a company be taxed as income? Holding: Money received as punitive damages must be included as gross income. Everything seems to be gross income unless explicitly excluded. There is nothing in the code that says this is not taxable. Court uses the general definition in s. 22 of Gross Income - …or gains or profits and income derived from any source whatsoever Looks very similar to the 16th Amendment definition This description is not the end all be all to gross income questions. Instead, it's a very good starting point Roco v. Commissioner Facts: Petitioner works at company. Tells company they did give enough money to the United States. The company fires the petitioner.
Plaintiff argues Eisner, that he didn't derive this from capital or labor. But there
are cases like Glenshaw that squash this. Petitioner brings qui tam claim against the company. If done, the United States will get money while the petitioner will get some as well. Here, the two sides settle and the US gets $15,000,000, $1.5mm of which goes to petitioner. Petitioner doesn't pay taxes since he believes this isn't from capital or labor. But the gov't compares this to a reward, which stated in 1.61-2(a), rewards are includable in gross income. Also, in s. 61, "gross income is any income except excluded by law. And qui tam claims are not excluded by law. Seems again, unless specifically excluded, if it is an accession to wealth, it will be included in gross income and taxed. Old Colony Trust Company v. Commissioner Facts: Company pays officer's taxes (all of them). Issue: Were the taxes paid by the company additional income for the officers? Holding: Yes, taxes were paid as services rendered. It was not a gift, the officers did something to receive that taxable income In exchange for the services rendered, the person gets a salary and compensation to pay the taxes Taxpayer tries to argue by stating two things: This is a gift (flows from a detached generosity) and basically a tax on a tax is not administrable Cesarini v. United States Facts: P purchased piano. Find 4k+ in it. Reported it as tax, then file amended income tax report without the cash. 61(a) in the book states Except as otherwise provided…gross income means all income from whatever source derived, including (but not limited to) the following items…treasure not listed in those items IRS also states treasure trove is taxable in the year it is undoubtedly in your possession. Regulation 1.61-1.4 - "The finder of treasure trove is in receipt of taxable income, for Fed income tax purposes, for the taxable yr in which it is reduced to undisputed possession." McCann v. United States P wants refund on income tax. Mrs. McCann received a trip from her employer, Security Insurance. P never reported on her income tax statement. Pays the tax then tries to fight it. Income includes any economic or financial benefit. Since the reward was paid by the employer due to employment, the value of the reward must be regarded as income. Gifts and Inheritance (first exclusion provision) Looking at income tax consequences of gifts, bequests, and inheritance s. 102 - Gifts and Inheritances Gifts are characterized by "detached and disinterested generosity". Both intent of the donor as well as the objective appearance of the transaction govern whether the transfer qualifies as a gift. Very important to find the motive between the gift. Was it given out of affection, respect, admiration, probably a gift. If given for business reasons, not a gift.
The recipient of a gift or an inheritance may exclude the cash or value of the
property received from gross income, regardless of amount s. 102(s) 102(a) Gross income (s.61) does not include the value of property acquired by gift, bequest, devise, or inheritance Must be alive in order to make a gift (inter vivos) Bequest is a transfer of property that occurs at death by a decedent by will of their last will and testament Inheritance is a transfer of property at death by state intestacy laws If property comes to you because of a gift, it is taxed (since the person is dead and can't make a gift) 102(b) A gift in the statutory sense proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses, the most critical consideration is the transferor’s intention. Look for voluntary transfer of property without consideration. 102(c) Settlements from will contests are inheritance and are excluded under GI 102(d) Factors to determine if gift or income: Familial relationship; size or type of gift; services performed; employment status Basis - s. 1015 - Property Received by Gift - Recipient takes basis in the gift unless the FMV is lower than the basis, in which the new basis is the FMV. Basis - s. 1014 - Property Received by Inheritance - Take the FMV of the property on the date of the decedent's death. i. Example: H transfers property, which has an adjusted basis to her of 20k, and a fmv of 60k, to her Son, I for 30k. H has a gain of 10k and I has a basis for the property of 30k because the amount he pays exceeds H’s adjusted basis in the property. If the property had an adjusted basis to H of 40k (instead of 20k), she will not have a loss, and I takes the property with the basis of 40k. See Reg 1.1101-1(e). If the property had an adjusted basis to H of 90k (instead of 20), H will not have a loss. I takes the property with a basis for determining gain of 90k, and a basis for determining loss of 60k . See Reg 1.1015-4(b), ex. 4. Remember, its different if its a husband wife situation - nonrecognition. Ex: R transfers property which has an adjusted basis of $100 and a fair market value of $80 to his wife S. S takes the property with a basis of $100 under § 1041(b). If she later sells the property for $90, she has a loss of $10.
Commissioner v. Duberstein Facts: Duberstein, taxpayer, received Cadillac from Berman for piece of business
advice. Berman says the Cadillac was a gift. Duberstein believes he wouldn't have received the Cadillac without the information. Berman deducted the value as a business expense, but Duberstein said the car was a gift. Issue: Does the intent of the donor matter when attempting to find if the car was a gift or income? No Holding: No, tests in this sense do not lend itself to a strict test, but instead a case by case analysis. Gift used in a colloquial sense, not common law. Cannot look solely at the donor's intention, but must look at it in an objective way as well. All the factors must be looked at to determine.
Duberstein does use it as a business expense, it was created because of a business transaction, they are not family Gift for income tax is a transfer that is made from detached and generous point of view Wolder v. Commissioner Facts: Written agreement made by Wolder giving Boyce lifetime legal services for shares of stock in her will. Wolder argues that this is a bequest and it is excluded from taxable income. But the $ was for services rendered and not a gift. Issue: Does an individual receive income when he is bequeathed money for giving lifetime legal services? Holding: Yes, must look at the intent of the parties and reasons for the transfer. Also, look at the party's performance in accordance with their intentions. He received this because of work, not because of a true bequest. Olk v. United States Facts - Dealers work in casinos and receive "tokes" from patrons. "Tokes" are money given to the dealers in turn to get "luck" from the casino gods. Plaintiff received about 10-20 dollars per day in tokes. Plaintiff states that tokes are gifts, not taxable income. Issue - Whether "tokes" received by the taxpayer constitute taxable income or gifts within the meaning of s. 102(a)? Holding - Yes. The regularity of tokes and equal distribution between them indicate that a reasonable dealer would regard them like wages. Also, the connection as the dealer is providing a service for the tokes makes them like income. Goodwin v. United States Facts - For three years, Reverend Goodwin received $15,000 per year in gifts from the congregation. This was much more than the amount they made as a base salary. Issue - Should Reverend Goodwin prevail by not having to pay taxes or does he owe taxes for the "special occasion money?" Holding - Owes taxes. The gifts made by the congregation were made as a whole. Regularly scheduled payments. Did it so he wouldn't leave. The gifts were substantial compared to Goodwin's annual salary. Very different from getting money for an inspiring mass. For it to be a gift, all of these events couldn't occur like they did. Exceptions Bequests and Prizes Bequests, Devises and Inheritances s. 102 - Property left by will, bequest or devise is not included as gross income. If property is left as repayment for something it could be considered income – analyze facts. The true test of a gift is whether it is done disinterestedly or done in connection with something else. Prizes IRC § 74 – Generally GI includes amounts received from awards and prizes. Exceptions
Gross income does not include amounts rec’d as prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, but only if— The recipient was selected without any action on his part to enter the contest or proceeding The recipient is not required to render substantial future services as a condition to receiving the prize or award; and The prize or award is transferred by the payor to a governmental unit/org pursuant to designation made by the recipient. If exception used, may not then deduct the income under Reg. 1.74-1 In general.--Gross income shall not include the value of an employee achievement award received by the taxpayer if the cost to the employer of the employee achievement award does not exceed the amount allowable as a deduction to the employer for the cost of the employee achievement award. § 74(c) Employee Achievement Award – means an item of tangible personal prop. Excess deduction award.--If the cost to the employer of the employee achievement award received by the T exceeds the amount allowable as a deduction to the employer, then gross income includes the greater of— an amount equal to the portion of the cost to the employer of the award that is not allowable as a deduction to the employer (but not in excess of the value of the award), or the amount by which the value of the award exceeds the amount allowable as a deduction to the employer. The remaining portion of the value of such award shall not be included in the gross income of the recipient. Definition of Employee Achievement Award under s. 274(j)(3)(A) - Must be for safety or length of service. Effect of an Obligation to Repay Loans Loans are not considered to be gross income Not an accession to wealth Accompanied by equal liability Repayment not a deductable expense However, forgiveness or discharge of a loan may generate income to the debtor Reg. s. 1.61-(a) Gain realized on the sale or exchange of property is included in gross income, unless excluded by law. For this purpose property includes tangible items, such as a building, and intangible items, such as goodwill. Generally, the gain is the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged. The specific rules for computing the amount of gain or loss are contained in section 1001 and the regulations thereunder." s. 1001 Tells you how to tell a gain/loss. Realized amounts must be recognized unless an exception applies.
s. 1001(a) "The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain…" Excess of AR over AB, it means Amount Realized - Adjusted Basis Thus, gain realized = Amount realized - Adjusted basis Amount Realized - s 1001(b) The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received." Amount realized = $ received + FMV of other property Basis s. 1001- s. 1023 (basis aka as unrecovered cost) S 1011 - The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under s. 1012 or other applicable sections of this subchapter…), adjusted as provided in s. 1016 Essentially a record keeping system designed to keep track of what dollars that have already been subject to tax or we assume that they will be subject to tax. Basis only subject to tax once, not twice You recover your investment in the property without being taxed Need to adjust basis on what you do to your property If you invest in your property, your basis can go up. If you can withdraw on your investment, your basis can go down So by having a basis, you can keep track of how much you can take out without being subject to tax s. 1001(c) "Except as otherwise provided in this subtitle, the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized." Amount of gain or loss someone receives is recognized Philadelphia Park Amusement v. United States Facts: Taxpayer owned 50 year franchise in Philadelphia. Constructed bridge, handed it to Philadelphia in exchange for 10 year extension allowing use from the taxpayer. Taxpayer abandoned the railroad and started the bus company. Issue: Is the basis of property established as of the date of a taxable transfer? Holding: Yes. Here, the asset of the franchise was unable to be valued, the item that was given in place of the franchise can be valued, the bridge. Remanded to find the value of the bridge to use as the fair market value for the franchise (since items normally dealt for each other are of similar value). Notes Bridge for a ten year extension on a franchise. Taxpayer takes the bridge, but abandons the franchise. Wants to take a loss on the extension. Case is about trying to figure out what is the unrecovered cost of the taxpayer in the ten year extension. s. 1012 Cost Basis (basis = cost) Per Philadelphia Park
IF exchange is unequal, THEN cost = FMV of Property Received IF one side of the exchange can't be valued, THEN assume it is equal to the value of the other side of the transaction s. 1015(a) Gift Basis General Rule ---- step-in-shoes, carryover basis BUT, IF at the time of the gift, the property is depreciated (i.e. FMV < AB), THEN for the purpose of determining loss the basis = FMV (Note: can increase basis by amount of gift tax paid according to s. 1015(d) Donee's fair market value of gift property is the donor's adjusted basis in the property This means that donee incurs a gain only if he sells the property for greater than his donor's basis. s. 1014(a)(1) Property Acquired from Decedent Basis Basis = "date of death" FMV BUT see s. 1014(e) (Note: there are alternative valuation dates available other than date of death) Taxpayer's basis in property How to approach dealing with gains in dealing with property 1. Do we have a realization event? (e.g., sale or other disposition) 2. If yes, calculate s. 1001 (amount of money received plus something I missed plus any liabilities) gain realized Need to determine amount realized and adjusted basis 3. Is the gain recognized (i.e., included in gross income)? Or is there an applicable exclusion? Or is there an applicable non recognition/partial recognition provision? 4. If gain, what is the character of the gain? (e.g., ordinary, capital, 1231, recapture, etc.) Haven't got here yet Sale of Principal Residence s. 121 allows a taxpayer to exclude from gross income $250,000 ($500,000 for joint returns) s. 121: Statutory Language & General Requirements (a) Exclusion: Gross income (s. 61) shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence or periods aggregating 2 years or more (b)(3)(A) In general. Subsection (a) shall not apply to any sale or exchange by the taxpayer if, during the 2-year period ending on the date of such sale or exchange, there was any other sale or exchange by the taxpayer to which subsection (a) applied. Three main requirements of s. 121 Ownership Must own the property for two of the past five years. Do not have to be consecutive years If joint, only one owner needs to satisfy. Policy reason, marriage might come later. Use
Must use the property for two of the past five years, does not have to be consecutive years. Both people living there must live there for two years if filing joint. May only use this once every two years If the exception if used within the last two years, cannot use it How to determine the principle residence if the owner has multiple properties Length of time in the property Taxpayer's place of employment Principal place of abode of the taxpayer's family members Address listed on federal tax returns, driver's license, automobile registration, and voter registration card Taxpayer's mailing address for bills/correspondence Location of taxpayer's banks Location of religious organizations and recreational clubs with which the taxpayer is affiliated Married Taxpayer Limitation Options s. 121(b)(1): Each spouse can file an individual tax return If each spouse meets the requirements of s. 121, they may each exclude their portion of the gain up to $250,000 each s. 121(b)(2): The spouses can file a joint return. Two possibilities: 121(b)(2)(A): If certain requirements are met, they may jointly exclude up to $500,000 of gain The requirements for the increased exclusion are that: Either spouse meets the ownership requirement AND Both spouses meet the use requirement AND Neither is ineligible for the benefits of s. 121 by reason of having taken advantage of its exclusion in the two year period ending on the date of sale 121(b)(2)(B): if the requirements for the increased exclusion are NOT met by one of the spouses, the spouses can file a joint return on which The amount excluded is the sum of the separate amounts that each spouse qualifies for individually, as if they were not filing a joint return If you leave for a reason such as a job change, you may exclude a certain percentage of your property For instance, Chris and Matt live together. It is Matt's principal residence and he satisfies all the requirements. Gets 250k tax exemption. Chris has only lived there a year. Instead of getting the full 250k exemption, she only gets the 125k since she lived there for one year when the minimum is two years. s. 121(c) - Look at exceptions to the rule for two year window Discharge of Indebtedness (Look into it more) s. 108 - Certain situations allow the discharge of indebtedness Where a debt is discharged or forgiven, the amount of the discharge is included in the gross income of the debtor because it constitutes a liability for which the debtor is no longer responsible. Look to see if the transfer is a gift (normally between family members)
Bankruptcy - 108(a)(1)(A) - if the discharge occurs in a Title 11 (bankruptcy)
case, the discharge of indebtedness income is excluded from gross income Insolvency - 108(a)(1)(B) - if the discharge occurs at a time the taxpayer is insolvent, the discharge of indebtedness income is excluded from gross income to the extent of the insolvency. Insolvency is the amount of the taxpayer's debts over the fair market value of the person's property. Acquisition of Indebtedness by Person Related to Debtor s. 108(e)(4) - If a person related to a debtor acquires the indebtedness, the acquisition shall be treated as an acquisition by the debtor. Discharge of Deductible Debt 108(e)(2) - Forgiveness of a debt does not generate income if the payment of the debt would have been deductible s. 108(e)(5) - Reduction for a solvent debtor allows a retroactive reduction in price and no tax consequences Revenue Ruling 84-176 Facts: Taxpayer and company made two contracts. Company refuses to send anymore since taxpayer had high accounts payable to seller. Taxpayer refuses to pay any more money. Both file suit. But then both parties settle the suit allowing the taxpayer to pay $500 instead of $1000. The remaining $500 was forgiven for dropping the suit. Issue: Is the amount owed by a taxpayer forgiven by a seller in return for a release of a contract counterclaim income from discharge of indebtedness and thereby subject to exclusion under s. 108. Holding: May get income even if not received. Treated as a payment for lost profits rather than a discharge of indebtedness, so must pay tax. Generally discharge of indebtedness is included in GI. Exceptions (§ 108): Not included in gross income if: Bankruptcy occurs Discharge occurs while T is insolvent (liabilities exceed FMV of assets) Indebtedness discharge is qualified farm indebtedness or in the case of a T other than a C corp., the indebtedness discharged is qualified real prop business indebtedness. Approach to these problems Recognize the transaction Ask, do we have a discharge of income situation? Be careful to make sure that it is not some other type of income or just the medium for payment What are the tax consequences when the debt is satisfied for less than full face value? Do we have discharge of income under s. 61(a)(12)? Ask, does a judicial exception apply (e.g., disputed debt)? Can any of this income be excluded under s. 108? (Pay attention to definitions) Do we have satisfaction of debt by transfer of property? United States v. Kirby Lumber Co.
Facts: KLC issued bonds for $12,126,800. KLC purchased the bonds back for less
than past, gaining $137,521.34. KLC says they shouldn't have to pay tax on the gain Issue: Is this a taxable gain? Holding: Yes, if bonds repurchased at a lesser value, that is considered gross income. If it is gross income, it is subject to tax. Gehl v. Commissioner Facts: Taxpayer borrowed money from PCA. Mortgage on land given as security against loan. 12/30/99, TP were insolvent and unable to make payments on loan which had an outstanding balance of $152,260. PCA forecloses on one piece of land worth $39k with a basis of $14,384. PCA forecloses on other piece of land $77,725 with a basis of $32,000). TP also paid $6,123 and for this, PCA forgives remaining debt of $29,412. TP was insolvent before and after all of this. Older case Issue: Does a transfer of property in lieu of foreclosure constitute a sale or exchange for federal income tax purposes? Holding: Yes. GI includes 1. gains derived from dealings in property and 2. income realized from discharge of indebtedness. Insolvency exception for $29k plus since they were insolvent before and after. But TP states this isn't a sale of property. Court says transfer in property constitutes a sale or exchange for federal income tax purposes. TP also states no amount was realized, but simply because the TP didn't receive cash doesn't mean there wasn't no amount realized. There was a gain since FMV exceeded the TP basis. TP also believed all income should be excluded due to their insolvency. But s. 108 gives exception only for discharge of indebtedness. Does not preclude the realization if income. Land transfers outside the scope. Life Insurance/Annuities (Read more in-depth) Life Insurance IRC § 101(a) – Generally GI does not include amounts from life insurance proceeds received by reason of death of the insured. (if you cash out early this does not apply) In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to sum of actual value of such consideration and premiums and other amounts subsequently paid by the transferee. Person A received $100k, but paid $88k in premiums. Only the $12k is taxable, the rest is not. This does not apply if: if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or 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.
IN OTHER WORDS - if an LI is transferred for money, only the amount paid + any payments are excluded. Rules: Only the principle is excludable; not interest payments Payment at a Date Later than Death If payments are to made over term of years, what ever was due upon death would be excludable; the rest would be included as gross income. If you leave the balance and only take the interest, the interest is fully included in GI. 101(a)(1) - Insurance proceeds from the death of a person are not taxed 101(a)(2) - Transfer for value rule In the case of a transfer of value or consideration of a life insurance contract or any interest therein, the amount of income shall not exceed the actual amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. If I were to buy a life insurance policy from someone and the insurance policy said it would pay $1000 on the death of the neighbor. Guy wants cash for the policy and sells it to another person for $600. When the neighbor dies, the person with the policy may only exclude $600, cannot exclude $400. The $600 is like a basis, you can receive that back without tax consequences, but the $400 is subject to tax. Can recover cost and only be taxed on the gain of the product. If survivor gets life insurance payment, but decides to take payments over a period of time instead of a lump sum, this is taxable because person may receive amounts in excess of the original lump sum, 101(c) - Interest is taxable Interest on Proceeds Left with Insurer If beneficiary elects to leave the proceeds with the insurer and take periodic payments with interest, the interest earned on the policy proceeds are included in gross income. This occurs when the insurer agrees to retain the proceeds and pay the beneficiary periodic payments of a certain amount for the remainder of the beneficiary's life. Determining the Periodic Exclusion Insurer allocates policy proceeds over beneficiary's life expectancy and pays periodic payments of part principal/partinterest. This payment amount remains the same throughout the beneficiary's life. The amount of the period payments allocated to interest are included in gross income. The amount allocated to the disbursement of the policy proceeds are excluded from gross income. Exceeding/Predeceasing Life Expectancy If the beneficiary exceeds his/her life expectancy, the life insurance payouts continue and the beneficiary continues to receive inclusion/exclusion consistent with the structure
above, EVEN THOUGH the beneficiary has technically received the entire amount of the policy proceeds If the beneficiary predeceases his/her life expectancy, the beneficiary receives NO deduction for the amount of the undisbursed proceeds EVEN THOUGH the beneficiary has technically not been able to take full advantage of the policy.
Annuity Payments Sequence of equal payments made at equal time intervals. Annuitant (person receiving annuity) pays the company a premium(s)
and the company takes that money, invests it, earns interest and the company guarantees to make stated payments to annuitant for life. Main question, how much of each annual payment should be treated as taxable interest-income and how much as tax-free return of capital? IRC § 72 - Gross income includes any amount received from an annuity Gross income does not include the amount determined by the exclusion ratio. Exclusion cannot exceed the amount invested in the annuity. If you buy an annuity with after tax dollars, the investment that is returned to you is not taxed. The way that it is not taxed is the exclusion tax ratio under 72(b). This is the investment / expected return Take that answer and multiply it by the amount you receive s. 72(b)(3)(A)(ii) - Amount of any unrecovered investment shall be allowed as a deduction to the annuitant for his last taxable year s. 72(b)(3)(B) - if goes to another person, may exclude in gross income Exceeding/Predeceasing Life Expectancy If the beneficiary of an annuity exceeds his/her life expectancy, the ENTIRE amount of the annuity payments is INCLUDED in gross income you only get the exclusion to the extent that you receive a return on capital. If the beneficiary predeceased his/her life expectancy, the estate received a deduction equal to the unrecouped capital. To determine this final deduction, subtract recouped amounts attributable to return of capital from original capital investment (i.e., interest is NOT included for determining the final deduction). From the Summary Book Taxpayer receiving a regular annuity payment is receiving a partial return of his or her invested capital, and the balance of the payment is income. To determine the amount of a payment that is excluded from gross income, multiply the payment by the exclusion ratio. The exclusion ratio is the following fraction: Investment in the contract / Total expected return under the contract The amount of the payment in excess of the excluded amount is included in gross income to the taxpayer, subject to certain limitations. Fringe Benefits
A number of expenses are not excludable from gross income. This would be unfair to
some businesses and people who can offer a ton of non-taxable fringe benefits (free car, apartment, etc.). But there are a number of benefits that may be exempt Meals and Lodging s. 119 - Meals and lodging An employee may exclude from GI the value of meals and lodging provided by an employer if the meals or lodging are provided for the convenience of the employer, are provided on the business premises of the employer, and in the case of lodging, the employee is required to accept the lodging as a condition of employment. 1. Convenience of the employer: Convenience of the employer means that the employer has a substantial noncompensatory business reason for supplying the meals and lodging, considering all the facts and circumstance of the situation 2. Business premises are the premises of an employer on the grounds of the employer's place of business. Though if the others are met and it's near the premises, this is ok 3. Condition of employment is the requirement that is generally satisfied by showing that the employee is on call for the business of the employer Cash allowances for meals excludable under s. 119? No, if it was every now and then, it would be ok under the de minimis exemption. But since it was continuous, it is taxable. s. 107 - Lodging for Ministers Minister may exclude from gross income 1. Rental value of a home furnished as compensation An allowance for housing, provided it does not exceed the costs associated with the housing. Fringe Benefits and Section 132 No Additional Cost Service - 132(b) If the employer regularly provides the service to the public and provides it to the employee without incurring any significant additional cost, it will be excluded from the gross income of the employee who receives the service. --- i.e., Person getting on a plane that isn't full. Not income. But if they make reservations and it's a full plane, this is income. Service must be offered by employer that employee is already doing. Employee must be in that business This stops major conglomerates and small business will not be disadvantaged by their competitors But if you work in both sides (hotel/airline), you get the benefit of both Employer doesn't incur any significant cost Includes lost revenue
In order for this exclusion to apply, it must be available to all employees, not simply to highly compensated employees. This exclusion is available to the employee's family, even if they do not accompany the family - s. 132(h) Qualified Employee Discount - 132(c) If employees enjoy a discount on property or services provided to the public by the employer, and the discount does not exceed a stated percentage, the value of the discount will be excluded from the gross income of the employees taking advantage of the discount Do not tax since it is difficult to put a value on the exact number Number limited on the discount which is excludable. Any amount over the % is taxed. Assume instead that the gross profit margin is 40% Working Condition Fringe Benefits - 132(d) An employee receiving a benefit that would have generate a deduction as a trade or business expense or as depreciation to the employee had he or she purchased the benefit individually may exclude the benefit from gross income When items are provided to employees which are deductible, they shouldn't be taxed. Cash payments are not under this part unless they are for business expenses and excess is returned to business Employee going on business trip paid for by the company De Minimis Fringe Benefits - 132(e) If the benefit provided to the employees is so small that accounting for it would be unreasonable or administratively impractical, it will be excluded from the gross income of the employees receiving it. Cash bonuses are not de minimis fringe benefits. Qualified Transportation Fringe - 132(f) An employee who receives transit passes, van transportation, or parking may exclude the benefit from gross income, within specified dollar limitations Cash reimbursements for these items are also excludable On-Premises Gyms and Other Athletic Facilities - 132(j)(4) The value of an on-premises athletic facility may be excluded from the gross income of an employee if it is operated by the employer and is used mostly by employees Exception can only be used by employees, their spouses, and their dependent children. Benaglia v. Commissioner Facts: Benaglia employed as manager of hotels in Honolulu. Constantly on duty as manager. Hotel owner acquired he stay in a room in one of the hotels. Also
got meals. Didn't include this in his gross income. There was a deficiency of $7,845. Issue: Are meals and lodging provided to Benaglia excluded from GI? Holding: Yes. When these things are provided to the employee for the primary benefit of benefitting the employer, the value is excluded from GI. The employer required he live at the hotel due to the continuous working, and because of this he let go of his freedom. Since he let go of his freedom, he's given the benefit of excluding GI. United States v. Gotcher Facts: Mr. and Mrs. Gotcher received a $1,372.30 expense paid, twelve-day trip to Germany from Volkswagen in order to tour the company's facilities and encourage the purchase of Volkswagen vehicles for American dealerships. Wound up becoming partners with Volkswagen. The Gotcher's though did not report any income. Issue: Should the value of the trip that is paid by the employer/businessman for his own benefit be excluded from GI of the recipient? Holding: Yes for Mr. Gotcher, no for Mrs. Gotcher. While the trips might have been pleasurable in part, its dominant purpose was business. The key to s. 61 is the concept of economic gain to the taxpayer: (1) an economic gain and (2) a gain that benefits the taxpayer. If this is given for the employer's convenience, not reportable. The circumstances prompting the trip and the objective achieved, we conclude that the primary purpose of the trip was to induce Mr. Gotcher to take out a WV dealership interest. Compensation for Injury or Sickness s. 104 and 105 exclude from GI certain amounts received on account of personal physical injury or sickness. Regarded as an expression of Congressional compassion for those who suffer personal physical injury or illness. s. 104 - Excludes from gross income amounts received as a result of personal physical injury or sickness. Compensatory damages from suit or settlement of personal physical injury actions (lump sums/structured settlements) Punitive damages are not included Need two things to exempt Action giving rise must be based upon the tort Damages received were based on the injury or sickness Personal injury for purposes of s. 104(a)(2) referred to "any invasion of the rights that an individual is granted by virtue of being a person in the sight of the law." Damages were exempt in a case for violation of free speech rights, discrimination on the basis of sex and national origin 1996 Amendment to s. 104 The 1996 Amendments to s. 104 Even after the two cases, Congress thought s. 104(a)(2) was still too broad. Congress therefore chose to limit the exclusion by restricting it to those damages received on account of "physical" injuries or "physical" sickness. "Emotional distress" alone is not to be treated as a physical sickness ore injury, unless it has to do with a physical injury itself.
If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party Conference Committee Report clarifies two other points If the claim has its origin in a personal physical injury, a recovery for emotional distress may be excludable If the claim has its origin in a physical injury, it is not necessary that the recipient of the damages is the individual who suffered the physical injury Accident and Health Insurance Under 104(a)(3) payments received through accident or health insurance policies are excluded from gross income provided the policy was not financed by the taxpayer's employer or by employer contributions Essentially if the taxpayer is willing to finance his own accident and health insurance with after-tax dollars, payments will be tax-free Workers' Compensation s. 104(a)(1) excludes from income amounts received under workers' compensation acts for personal injuries or sickness Business or Property Damages "In lieu of what were the damages awarded." Essentially the main question to ask to see if damages are excludable in this provision is "Why were the damages awarded?" If you get money for lost profits, that will be taxed Money from damages not taxed, but money from gain realized is taxed Guy buys home for $5k. Years later it's worth $50k and someone intentionally burns it down. The money for the insurance isn't taxed, but the gain realized ($45k) is taxed. IRC § 104 – GI does not include amounts received on behalf of: workers compensation; The death or injury must be job related (not merely under works compensation) damages for personal injury or sickness As long as damages flow from physical injury then they are excludable this includes lost wages. NOTE - damages for a non-personal injury (including emotional distress) are included in GI. accident or health insurance for personal injuries or sickness; a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country; amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action. IRC §105(b) -- if an employer directly or indirectly reimburses an employee for expenses of medical care for the employee or the employee’s spouse or dependents, the amount rec’d is excluded from gross income IRC § 106(a) – GI does include payment made by an employer for employee health insurance coverage. Commissioner v. Schleier
Facts: Respondent says his award of back pay and liquidated damages should be
exempt. Issue: Whether s. 104(a)(2) if the IRC authorizes a taxpayer to exclude from gross income the amount received for back pay and liquidated damages under the Age Discrimination in Employment Act of 1967 (ADEA)? Holding: No. In order to be exempt, need two things. First the action giving rise to recovery must be based upon tort or tort type rights. Second the taxpayer must show that the damages were received on account of personal injuries or sickness. In both scenarios, neither was shown. Business and Profit Seeking Expenses Principal limitations on the scope of the section are usually said to involve the following issues: (1) Whether or not the particular expense was "ordinary and necessary;" (2) Whether the expenditure was a current expense or a capital investment; and (3) Whether the expense was incurred in business or for personal reasons s. 162 - Business Deductions - the workhouse deduction code. s. 212 - The Expense Must Be "Ordinary and Necessary" Is the Expense "Ordinary"? Requires that a cost be customary or expected in the life of a business. What is customary or expected in a business? Life in all its fullness must supply the answer Things to look at in order to be an ordinary business expense Ascertain the purpose or motive of the taxpayer in making the payments. Determine whether there is a sufficient connection between the expenditures and the taxpayer's trade or business. Conway Twitty - trying to protect his reputation. This is normal, did it all the time. Person driving car all the time gets in an accident and wants to deduct bills, this is normal since he was in the car all the time Is the Expense "Necessary"? Necessary means appropriate and helpful. Determination of whether an expense is "necessary" is a factual determination. Must establish something is necessary for the business Expenses must have a proximate relationship "Reasonable salaries" - 162(a)(1) - only reasonable salaries may be deducted "Clothing" If clothing is business-related in nature and cannot be worn off duty, it can be deducted. Who decides? Pevsner case. What Constitutes a "Trade or Business"? Taxpayer must be involved in the activity with continuity and regularity and the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify
The "Carrying On" Requirement Development of a new business ordinarily involves two stages before the trade or business becomes operational Investigatory stage - person may review various kinds of business before deciding to acquire or to enter into a specific business Prepping for a business can't be deducted. But unsuccessful attempt at investigating are deductible (maybe) Taxpayer has decided to acquire or establish a specific business and commences preparations for its operation All these things give benefits long after the current tax year and shouldn't be currently deductible (training, lining-up distributors, suppliers or potential customers, setting up books, etc. Introduction to Business Deductions IRC §162(a) Deductions of business expenses are allowed if: Has to be ordinary and necessary An ordinary expense is not one that is habitual, but rather one that is common in the taxpayer’s particular industry or business. Incurred or paid during the taxable year Incurred in carrying on a trade or business § 162 Trade or business expenses deductions includes: A reasonable allowance for salaries or other compensation for personal services actually rendered; Traveling expenses (including meals and lodging that are not lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; AND Rentals or other payments to be made as a condition to the continued use or possession, for purposes of trade or business, of property to which the taxpayer is not or has not taken title or in which he has no equity Ordinary and Necessary Necessary test à look to the subjective view of TP (appropriate or helpful, they will be deemed necessary) Ordinary Test à More of an objective standard à Is it common or customary/acceptable practice within this business.  Carrying On Business IRC § 195 – Generally there is no deduction allowed for start-up expenditures. Start-up expenditure means any amount paid in connection with: investigating the creation or acquisition of a business or trade; Creating an active trade or business;
Any activity engaged in for profit and for production of
income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, Limitations 195(b)(1) -- TP can deduct for the taxable year in which the business begins an amount equal to the lessor of: 1) the amount of start-up expenditures or 2) 5K reduced by the amount by which such start-up expenditures exceed 50k. The remainder can be amortized over the next 180 month period. If the business stops before the amortization period, TP can deduct the rest of the expenses in that year as long as they comply with 165. 
When taxpayer reaches the transactional stage, amounts paid
to complete the transaction generally must be capitalized. To get 195 deductions, TP must actually enter the business. Expenditures must be of the type that are allowed on an existing business Revenue Ruling 75-120 Job hunting is below the line as misc. expenses. Process: Step 1 – is the person “carrying on”? If no, no deduction under 162, but you can get start-up costs for 195. Step 2 – If yes how much start-up costs did TP spend? If less than 50K, 5K in first year and rest amortized over next 15 years. If over 50K, 5k reduced by the amount that is over 50K, amortize over 15 years. Welch v. Helvering Facts: Welch paid back debts for a bankrupt company in order to deduct the money as business expenses. Issue: May extraordinary expenses be deducted from income as business expenses? Holding: No. In order to be deductible, an expense must be "ordinary" in the business area practiced by the taxpayer. The mere fact that an individual conceives of a moral duty or necessity for a given expense is not determinative. Higgins v. Commissioner Facts: Higgins hired people to watch over his personal investments (stocks, real estate, bonds) and deducted their salaries as business expense. Commissioner denies. Issue: If someone hires an individual to aid in the management of personal assets, are those salaries and other expenses deductible as business expenses?
Holding: No. Only those expenses related to carrying on a business are
deductible. Management of personal investments does not carry a business. This is the choice of the individual investor to hire outside help. Commissioner v. Groetzinger Facts: P attempted to make a living through wagering on dog races. In one year, he had a $2,032 loss. The government wanted to subject him to a minimum tax; P says this is a business expense and he had a loss for the year. Issue: Is the occupation of attempting to make a living at dog racing a business? Holding: Yes. P was engaged in a diligent, regular, full-time effort to earn an income through wagering. These factors alone make it a compelling case that his wagering was an attempt at earning a livelihood, not just a hobby. Pevsner v. Commissioner Facts: P employed as manager of store. She spent $1,381.91 on clothes to wear while at work. She doesn't wear the clothes while at home. She deducted the cost of the clothes as a business expense, but the IRS said no. Issue: Can P deduct the clothes as a business expense? Holding: Yes. Clothing cost is deductible as a business expense only if the clothing is specifically required as a condition of employment, it is not adaptable to general usage as ordinary clothing, and it is not so worn. Here, the clothing was required to wear at the store. It is not adaptable to general usage and not worn (never wears the clothing). Capital Expenditures On test - Will only hit on buildings, machines - no small stuff Deductible Expense or Capital Expenditure? Because our tax system taxes net income, taxpayers are generally allowed to deduct their business expenses from their business income. If we looked solely to s. 162, we would probably conclude the taxpayer's costs were properly deductible under that section. But under s. 162, deductions are subject to exceptions. Most important expenditure is s. 263 which denies a deduction for the cost of new buildings or for permanent improvements or betterments increasing the value of the property, and for restoration costs for which an allowance is made. Disallowance applies to expenditures that "add to value, or substantially prolong the useful life" of property, or "adapt property to a new and different use," but not to "incidental repairs and maintenance." Treasury Regulation -1.263(a)-1(b) Capital expenditure, we're generally looking for something to Add value to, OR Substantially prolong the useful life of, OR Adapt to a new and different use BUT NOT - incidental repairs and maintenance Defining Capital Expenditure - INDOPCO INDOPCO v. Commissioner - distinguishing capital expenditures from currently deductible expenses is difficult -- "the decisive distinctions' between current expenses and capital expenditures 'are those of degree and not of kind.' " Taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization
Question to really ask --- "Did the transaction create benefits and was the future
benefit significant" If something is purchased and its useful life extends past the taxable years, it must be capitalized. If something is purchased and its useful life does not extend past the taxable year, it can be deducted. If this is the case, is it ordinary/necessary under s. 162; personal expense under s. 262, or an expense incurred due to profit making under s. 212 Dissent - Money didn't create an asset in the future, but instead you paid money for someone to use skills for the future Repair or Improvement 1.162-4 and 1.263(a)-1(b) - expenditures for repairs (incidental) or maintenance, which do not materially add to value or appreciably prolong useful life, are deductible; replacements or improvements, on the contrary, are not and must be capitalized (thus added to the taxpayer's basis in the property) Repair is described by the Regulations as an outlay whose limited purpose is to continue the property's operation for the duration of its expected life or to maintain its normal output and existing capacity. General plan of rehabilitation, modernization, and improvement of the property, must be capitalized, even though, standing alone, the item may appropriately be classified as one of repair Intangible Assets General rule requires the capitalization of amounts paid to acquire or create an intangible, to "facilitate" the acquisition or creation of an intangible, or to create or enhance a separate and distinct asset Items that must be capitalized Ownership interests in corporations, partnerships or other entities; debt instruments; options to provide or acquire property; leases; patents or copyrights; and franchises or trademarks. Also fire insurance (purchase three years fire insurance) When you prorate payments over a long period of time, can't take full deduction in that year Items that are not capitalized De minimis costs (not over $5k) Advertising Expenses Revenue Ruling 92-80, 1992-2 - Long standing practice, treat as deductible Purchase or Lease Total rent, no equity in the building, can be treated as deductible De minimis deduction If the expense if $5000 or less, IRS will not sweat it and allow you to deduct it. Costs to Install Capitalized Item Normally capitalized as well. Goes toward the Examples Real answer - $3,500 to sprinkler system with option to purchase for $100. Problem to figure out here is if though she's paying $3,500 per year on a lease or a rental. This is probably a sale because she has the opportunity to buy it for $100. If it's a sale, she has to capitalize her deductions
MAY BE SOMETHING LIKE THIS ON THE EXAM Real answer - Must look to see if they are investigative costs (currently
deductible), but once you get a building, that must be capitalized.
What about if this was a possibility of owning a health and fitness center? Same thing, amount "paid in the process of investigating or otherwise
pursuing the transaction is capitalized -- Reg. 1.263(a)(4)(e)(1)(i)
Midland Capital - Oil seepage case. Add protection to stop oil seepage; can you
deduct it or capital expenditure? Deduct. A repair serves to keep property in an operating condition over the probable life of the property and for the purpose for which it was used. Adds nothing of value to the property, but merely maintains it. The life nor use of the basement has changed. It is a deduction. Mt. Morris Drive-In - P built a drive-in movie theater. It had to remove vegetation from the land which increased water drainage onto their land. P had to construct a drainage system. They tried deducting the expense; commissioner say it was a capital expenditure. Was the drainage system a capital expenditure or deduction? Holding: Capital expenditure. Would have been capital when the theater was built; nothing should now change. IRC § 263 – No deduction shall be allowed for: Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. Cost of acquiring capital asset is treated like a capital expenditure. The cost of repairs is deductible. Cannot be problem created by the taxpayer Should not be a problem known from beginning That cost should be included in overall cost of acquiring capital asset. Need to draw line b/w cost related to tangible prop that are incurred as repairs (currently deductible expenses) and expenditures that are improvements to prop (amounts required to be capitalized) à Midland Question of capitalization of costs related to the acquisition or creation of various types of intangible assets à INDOPCO Salaries Unreasonable salaries are no deductible à Factors (majority): 1. Type and extent of the services rendered 2. Scarcity of qualified employees 3. Qualifications and prior earning capacity of the employee 4. The contributions of the employee to the business venture 5. Net earnings of the employer 6. Prevailing compensation paid to employees w/ comparable jobs 7. Peculiar characteristics of the employer’s business
Independent Investor Test (minority): 1. Executives’ salary is “reasonable” (and deductible) if it’s proportional to investors’ profits. The more that the comp makes, the more the shareholders should be willing to give executive
Key Questions Is it a repair? Is it a capital improvement or asset? Should it have been figured into cost of capital asset? Commissioner v. Idaho Power Co. Facts: P used equipment it owned in the construction of improvements to its
capital facilities. Claimed a deduction from gross income all the year's depreciation on such equipment, including the part attributable to the construction. Issue: Depreciation allocable to the use of equipment in constructing capital improvements be capitalized and recovered over the useful life? Holding: Yes, depreciation is allocable over the useful life of the asset constructed. Such capital expenditures are not deductible from current income. The exhaustion of construction equipment does not represent the final disposition of the taxpayer's investment in that equipment; rather, the investment in the equipment is assimilated into the cost of the capital asset construction. They appropriately recognized as a part of the taxpayer's cost or investment in the capital asset Depreciation s. 167 - Eligible property includes plant, equipment and other long-lived business and investment property. Allows annual deduction for depreciation. Company buys machine for $4500. Company expects to use the machine in its business for 5 years and sell it as "scrap" for $500. Straight-line method, taxpayer would deduct $800 a year over the 5-year term, total of $4,000. Taxpayer's basis must be reduced by $800 per year when using depreciation. If they sell the machine for more/less than $500, gain or loss is used. Taxpayer's original expenditure of $4,500 is "returned" to it through a combo of (a) depreciation deductions during the property's useful life, (b) the amount realized as salvage, and (c) taxable gain or deductible loss on the final disposition of the asset. Limitation to cost - Depreciation allowance is limited in total to the taxpayer's basis (cost for property) Estimating an asset's useful life - By enacting Accelerated Cost Recovery System (ACRS), the aim was to stimulate investment in plant and equipment Two ways to go about it -- straight line method/accelerated method (larger deductions earlier) But when can you choose one? s. 168 - MACRS System Used s. 179 - Election to Expense Certain Depreciable Business Assets (a) A taxpayer may elect to treat the cost of any s. 179 property as an expense which is not chargeable to capital account. Any cost so treated shall be allowed as a deduction for the taxable year in which the s. 179 property is placed in service.
(b) Limitations (1) Aggregate cost which may be taken into account under subsection
ACRS Has the effect of increasing after-tax returns to the owners of depreciable
(a) for any taxable year shall not exceed $25,000 ($125,000 in the case of taxable years beginning after 2006 and before 2011). (2)
property. Encourages businesses to replace and expand their existing stock of capital goods. Defers their current income tax liabilities to later periods. s. 168 - largely discards the concepts of actual service life and instead frankly treats the depreciation allowance as a means of subsidizing capital investments. Most tangible personal property (machines/equipment) - depreciable over periods of 5 to 10 years Real property (previously 60 years) - depreciable over periods of 27.5 years for residential buildings and 39 years for other business structures. MACRS MACRS replaced ACRS in the United States in 1986 with the passing of the Tax Reform Act of 1986 (TRA-86), as the depreciation method condoned by the IRS and is in force today. It is exceedingly similar to ACRS save for two key features; the number of property classes was expanded, a half year convention was added to simplify the first and final years of a property's recovery life. It was meant to stimulate capital purchasing by lowering the after tax net present value by allowing for faster depreciation of capital assets. MACRS allows for more depreciation towards the beginning of the life of the capital asset (similar to double declining balance), allowing the tax deductible depreciation expense to be taken sooner, thus increasing the net present value of the capital purchase, thus allowing a company to retain more income early in the depreciation cycle. In essence, it's a more heavily "front loaded" tax benefit. Your use of either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) to depreciate property under MACRS determines what depreciation method and recovery period you use. You generally must use GDS unless you are specifically required by law to use ADS or you elect to use ADS. Each system differs largely in the class lives of property, illustrated in the tables below. Example For example, office equipment is depreciated with a class life of seven years, and water vessels are depreciated over ten years. Each MACRS class has a predetermined schedule, which determines the percentage of the asset's cost which is depreciated each year (see tables). Specifically, to calculate the depreciation charge for recovery tax year six of a Municipal sewage treatment plant that had an original cost of 2.2 Million: 1. Look up its property class (GDS class life): 15-Year property 2. Trace down the percentage table along 15-Year property to year 6: 6.23% 3. Multiply the original cost by the value found in the table: 0.0623 * $2,200,000 = $137,060
The depreciation charge is $137,060.
WHEN LOOKING AT THIS, TO DETERMINE THE RECOVERY YEAR, LOOK AT CLASS
LIFE, RIGHT? a. Depreciation a. IRC § 167 – There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of: i. (a)(1) --Property uses in a trade or business or; ii. (a)(2) -- Property held for the production of income b. The Relationship of Depreciation to Basis i. When a T claims depreciation on prop, the deduction is attended by a commensurate reduction in the basis for the prop – the downward adjustment required is at least the amount of depreciation deduction permitted (allowable) under the depreciation method employed by the T. ii. Sharp Case – you can split the use of an object such as a plane into business and personal usage. If you take a business depreciation, it comes off the percentage of the business use of the object. KEEP THE PERENTAGE ON THE SALE c. Straight Line Depreciation -- cost or other basis of the prop, less its estimated salvage value, is deducted in equal annual installments over the period of its estimated useful life. How to approach a depreciation problem Look at s. 179 first**** Determine whether the property is depreciable §167(a):“There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)-- (1) of property used in the trade or business, or (2) of property held for the production of income.” Thus, two initial elements: Is the property subject to exhaustion, wear and tear or obsolescence? Is the property (a) used in trade or business, or (b) held for the production of income? Determine basis for depreciation Determine: The property’s classification: (e) & (i) §168(i)(1): Except as provided in this section, the term "class life" means . . . §168(e)(1): Except as otherwise provided in this subsection, property shall be classified under the following table: The applicable depreciation method: (b) Personalty: In general, 200% (double) declining balance method. See §168(b)(1) Some property (e.g., 15-year, 20-year, farming)à150%. See §168(b)(2) Taxpayer can elect less generous methods §168(b)(5) Realty:
Default is straight-line. See §168(b)(3)(A)-(C) Understanding the Methods Straight-line: The amount to be depreciated is divided evenly over the number of years in the depreciation period. E.g. $10,000 investment and 10-year recovery period. Ignoring conventions, this is $1,000 per year. Accelerated: The amount of depreciation for the early years is proportionately more than the amount in later years, determined under a variety of arithmetic methods (double declining balance, 150% declining balance, sum-of-the-years-digits, etc.). The applicable recovery period: (c) The applicable convention: (d) In General: half-year (See §168(d)(1)&(4)(A)) Treated as placed in service in the middle of the year Thus, taxpayer gets 1/2 of what otherwise would be the depreciation Personal property uses a midyear convention Realty: mid-month (See §168(d)(2)&(4)(B)) Treated as placed in service in the middle of the month If placed in service in January of the first year, get 23/24 of what otherwise would be Real property uses a midmonth convention Anti-Abuse: mid-quarter (See §168(d)(3)&(4)(c)) Treated as placed in service in middle of the quarter Applies if more than 40% of property for the year placed in service in the last quarter.
Apply the above information to determine the allowable depreciation deduction
Losses and Bad Debt s. 166 - Debt which becomes worthless during the taxable year is deductible from gross income If debt is "business" debt - as it would always be in the case of a corporation - it may be deducted when it comes wholly worthless or when it is partially worthless. In the case of an individual tax payer, deduction is also permitted for "nonbusiness" debts - incurred in profit-seeking activity or in a personal setting such as a loan to a relative - but such debts must have become wholly worthless. Deductions for partial debts are not allowed. The line between business/nonbusiness requires a line be drawn between those activities of the individual taxpayer which constitute a "trade or business" and those of his pursuits which, although profit-seeking, solely involve the management or conservation of investment capital. Also must look at the nature of the asset disposed of. Whipple v. Commissioner - Not a business debt when "entrepreneurial activity devoting one's energies to the promotion and management of corporate enterprises - was not of itself a "trade or business." Taxpayer's aim was to generate dividends
and capital gains for himself by producing business income for his corporations. The corporation was obviously in business, but the individual was not. ALWAYS CHARACTERIZE IF IT'S BUSINESS/NON-BUSINESSS Bad Debts IRC §166(a) – Business bad debts is in ordinary loss (dollar for dollar) 1. Wholly worthless debts are deductible 2. Partially worthless debts are deductible to the extent they have not been paid 3. Basis for determining amount of debt is the adjusted basis. 4. INCLUDED Above the line if the person is a sole proprietor IRC § 166(d) – Non-Business debts is treated a s STCL and can off set CG 1. Non-business debt is defined as a debt other than: a. A debt acquired in connection with a trade or business or, b. A debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. Howard S. Bugbee v. Commissioner -- Why is this a debt? Bar owner loaned money for business reasons to bar patron. Howard wanted to say that it was a debt. These would be capital losses that would wipe out capital gain. To be a business bad debt you look at 166(d)(2). A debt created or acquired in connection with a trade or business of the taxpayer. These were not created in connection with the bar. The second part says a debt the loss from the worthlessness of which is incurred in the taxpayers trade or business. Is it bad? IT IS A NON BUSIENSS BAD DEBT. Reg § 1.166-2. You loan money with intention of being repaid. If it is a bad debt you do not have to sue 1. This was above the line under 62(a)(3) but not 62(a)(1). It is a STCL. 2. All capital gains and all capital losses are above the line. Notes 1. There is a presumption that transfers between close friends and relatives 2. Gratuitous forgiveness of a loan generates no deduction 3. RULE: a debt will only qualify as a business bad debt if it bears a direct relationship to a T’s trade or business Interest Deduction 163(a) allows a deduction for interest paid or accrued during the taxable year. The borrower hopes and expects to generate gross income by putting the borrowed funds to work in its business/investment activities. Interest paid to the lender subtracts from the borrower's profits, so that deductibility fully accords with the goal of the system, which is to impose a tax on net income s. 163 - Interest Personal interest is not deductible. Personal interest is interest other than (1) trade or business interest; (2) investment interest; (3) qualified residence interest; or (4) passive activity interest. Prepaid interest - pg. 514 book, "In the typical situation involving a home loan, points represent prepaid interest. Allows them to do all the services of the loan (prepare deed, fees for the preliminary title report, etc.). As indicated by the service, in addition to these fees, the loan agreement requires the
borrower to pay points based on "economic factors that usually dictate an acceptable rate of interest (amount/duration of loan0, the points constitute interest. Investment Interests - 163(d) - A taxpayer may deduct interest to finance the purchase of investments, but only to the extent of net income from those investments. o Ex. Taxpayer has interest income of $2,000 and dividend income of $3,000 for a total "investment income" of $5,000. Assume further the taxpayer has paid a fully-deductible $1,000 for investment advice related to dividend-producing stock, for a total of $1,000 in "investment expenses." The taxpayer's "net investment income" is $4,000. When deducting interest, you may not go above the $4,000 mark. Taxpayer can carry forward to the succeeding taxable year investment interest. Under Rev. Ruling 95-16, 1995, a taxpayer will be entitled to use the interest deduction if and when the investment becomes profitable. Qualified Residence Interest - 163(h) - Qualified residence interest is deductible by individuals. There are two types of qualified residence interest attributable to loans on the taxpayer's principal residence and one other qualifying residence o Acquisition of indebtedness - Interest is deductible on loans up to $1 million, the proceeds of which are used to acquire or construct a qualifying residence, and which are secured by that residence. Make improvements to the property - can deduct interest up to $1mm o Home equity indebtedness - Interest is deductible on loans up to $100,000, which are secured by a principal residence and do not exceed the taxpayer's "equity" in the residence, i.e., the difference between the FMV and any indebtedness secured by that residence. Get a car with the money, can deduct interest Interest IRC § 163(a) – All interest paid or accrued during taxable year is deductible on indebtedness o 163(h)(1) – No personal interest is deductible Exceptions to personal interest: § 163-1. (h)(2)(A) -- Interest paid on accrued on indebtedness properly allocable to a trade or business (NOT for employees) 2. (h)(2)(B) – Any investment interest 3. (h)(2)(D)* -- Any qualified residence interest 4. (h)(2)(F) – Educational loan interest 1. loan incurred by T solely to pay for the qualified higher education expenses of a student who is the T, the T’s spouse, or a dependent of the T if the student is at least a ½ time student
2. amount of qualified expenses is reduced by any amounts excluded from gross income 3. interest is not deductible if loan is made by a related person 4. Phase Out - amount of deduction is phased out ratably for single Ts w/ modified adjusted gross income of b/w $50k - $65k (100k – 130k for couple) 5. Limited to $2,500
Qualified Residence Interest o 163(h)(2) – QRI includes any interest paid on: Acquisition indebtedness or;
1. (h)(3)(B)(i)(I)-(II) -- acquisition indebtedness includes any debt incurred: in acquiring, constructing, or substantially, improving any qualified residence of TP or 2) is secured by such residence 1. includes refinancing 2. Can’t exceed $1,000,000.00 or $500,000 in the case of married individual filing separate tax return. Home equity indebtedness 1. (h)(3)(C)(i)(I)-(II) -- HEI means any debt secured by residence that does not exceed the FMV reduced by of debt. 1. 100K limitation or 50K for married person filing separately. Qualified Residence = the principle residence of the TP AND 1 other residence. o Revenue Ruling 69-188: Fees associated with the use or forbearance of money are deductible as interest Cannot be payment for services such as closing costs or security investigation 1. You might try to deduct fees like this as a business expense. Points on received on behalf of loan are amortized over life of loan o Rule: No interest deductions on no interest loans (do not count at GI) Interest on Investment Income o IRC § 163(d) imposes a limit on the deductibility of investment interest by noncorp taxpayers only deductible to the extent that the T has net investment income investment interest – interest paid or accrued on indebtedness incurred to purchase or carry prop held for investment Net investment income – excess of investment income over investment expenses
1. Investment income – gross income from prop held for investment plus some gains on the sale of such prop, but only if the prop is not a part of a trade or business, or an activity subject to the passive activity rules, or does not qualify for preferential net capital gain treatment under § 1(h) either on the sale of investment prop or as qualified dividend income. Interest on Education Loans o IRC § 221 – You can deduct interest of education loan. Limitations on Deductions s. 267 and 265 s. 267 - Losses, Expenses and Interest with Respect to Transactions Between Related Taxpayers Reg s. 1.165-1(b) - To be deductible - "a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and…actually sustained during the taxable year." 267(a)(1) - Denies a deduction for any loss incurred on the sale or exchange of property "directly or indirectly" between certain related persons (267(b)) o Whoever gets the new property takes the updated cash basis under s. 1012 267(a)(2) - Essentially puts accrual method tax payers on cash method accounting with respect to (a)(1) o Example on page 611. Person works for corporation. Corporation is accrual method tax payer; person uses cash method. Corporation is not allowed to deduct salary until they actually pay it. 267(b) - Relationships - people referred to in 267(a)(1) o Members of family, individual/corporation, etc. s. 265 - Expenses and Interest Relating to Tax-Exempt Income Prevents taxpayers from claiming double tax benefits as a result of tax-exempt income. Specifically, it disallows certain deductions allocable to such income. s. 265(a)(1) - 1. Disallows all deductions allocable to tax-exempt income (other than tax-exempt interest) and 2. disallows s. 212 expenses allocable to taxexempt interest s. 265(a)(2) - disallows a deduction for "interest on indebtedness incurred to purchase or carry obligations the interest on which is wholly exempt from taxes" o Example - Interest generated by a municipal bond may be excludable under s. 103(), a taxpayer may not deduct any interest paid on money borrowed to purchase the municipal bonds. Cannot deduct an item of expense if it's not 265 - Someone gets advice on what Capital Gains General requirements of capital characterization (§1222): Sale or Exchange o Keep in mind some provisions deem a gain or loss to be from the sale or exchange of a capital asset while other provisions will deem gain or loss to be NOT from the sale or exchange of a capital asset Capital Asset
“taken into account in computing gross income” What do you know for this chapter? Identify what a capital asset is s. 1221 - Property held by the taxpayer EXCEPT Inventory - 1221(1) Depreciable trade or business property 1221(2) Trade or business realty 1221(2) Copyrights, literary and musical works 1221(3) Receivables arising from trade/business 1221(4) U.S. government publications 1221(5) Whether or not you have a capital asset Look at the statute to see if it does not fall within the exception? Eight
things are not capital assets, everything else is. s. 1221 to find out.
Whether or not on the sale or exchange of the capital asset if it's a long term or
short term capital asset s. 1222(1) - Short-term Capital Gain - Gain from the sale/exchange of a capital asset held for not more than 1 year, if and to the extent such gain is taken into account in computing gross income s. 1222(2) - Short-term Capital Loss - Loss from the sale/exchange of a capital asset held for not more than 1 year, if and to the extent that such loss is taken into account in computing taxable income. s. 1222(3) - Long-Term Capital Gain - Gain from the sale/exchange of a capital asset held for more than 1 year, if and to the extent such gain is taken into account in computing gross income s. 1222(4) - Long-Term Capital Loss - loss from the sale/exchange of a capital asset held for more than 1 year, if and to the extent that such loss is taken into account in computing taxable income. NEED A LOSS LIKE A BUSINESS EXPENSE Figure out if you have a net capital gain s. 1222(11) - To determine if you have a net capital gain Excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year. NLTCG - NSTCL (LTCG - LTCL) - (STCL - STCG) To find net long-term capital gain - excess of long-term capital gains for the taxable year - long-term capital losses for such year To find net short-term capital loss - excess of short term capital losses for the taxable year over the short-term capital gains for such year Seven Step Approach to Characterizing Gain or Loss 1. Has there been a recognized gain or loss? For a taxpayer to have a capital gain or loss, there must be a realization event (sale/disposition of property) - any gains or losses from that event must be recognized 2. Has there been a sale or exchange?
For the taxpayer to have a capital gain or loss, the recognized gain or loss must arise from the "sale or exchange" of certain property. This generally requires "a giving, a receipt, and a causal connection between the two." 3. Is the property a capital asset? The item in question must constitute a sale or exchange of property, not the prepayment of income. s. 1221 defines a capital asset as "property held by the taxpayer" except for eight enumerated categories of property, of which five are usually relevant. Thus, an item is a capital asset unless it falls within any of these categories. s. 1221(1) - Inventory/stock in trade - Taxpayer's stock in trade or inventory held primarily for sale to customers in the ordinary course of business is not a capital asset s. 1221(2) - Real and depreciable property - Real property used in a trade/business or property used in a trade/business that is subject to depreciation under s. 167 is not a capital asset. s. 1221(3) - Creative works - Creative works generated by the taxpayer (copyright, letters, memoranda) are not capital assets. s. 1221(4) - Accounts/notes receivable - A taxpayer's accounts or notes receivable from the sale of inventory are not capital assets s. 1221(8) - Supplies of the kind the taxpayer generally uses in his or her trade/business - e.g., cleaning supplies for a janitorial company. 4. Is the property s. 1231 property? 5. Do any special recharacterization rules apply? 6. What is the holding period for the property? 7. Calculate capital gain and loss