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FEDERAL INCOME TAXATION-OUTLINE POPOVICH 07 INTRODUCTION: A. FEDERAL INCOME TAX AS IT APPLIES TO INDIVIDUALS: 1. Not corporations, partnerships, estates, trusts, etc. 2. Not state income tax. 3. Not other kind of taxes, such as a. Excise, b. Estate & gifts, c. Capital gains, d. Social security, e. Property, etc. B. HISTORY OF FEDERAL INCOME TAX: 1. 16th Amendment in 1913 allowed for a federal income tax. 2. Revenue Act of 1913 provides the original tax act. C. SOURCES OF TAX LAW: 1. Internal Revenue Code (Title 26 of the U.S. Code) 2. Interpretations of the Code (IRC) sections. a. Regulations (Treasury Department‘s interpretations of the Code) (1) regulations can be overturned, not law b. Committee Reports-legislative history c. IRS pronouncements –enforcement arm of the IRS 3. Courts a. when do we need a court decision b. most tax issues resolved within the IRS c. Otherwise, need to go to court; 3 types of trial courts: (1) tax court-trial court, only tax matters, federal i. appeals w/ US crt of appeals, then US Sup. court (2) US district courts i. appeal-US court of appeals, then US Sup. crt (3) Court of federal claims-have tax jurisdiction i. unique appeal to US court of appeals for the DC circuit D. INCOME TAX ASSESSED ON AN INDIVIDUAL’S ANNUAL NET INCOME: 1. Gross Income: everything included in income without any deductions. 2. Deductions: subtracted from gross income, difference is the taxable income. a. Common ones: (1) dependency deductions (2) business/entertainment expenses (3) charitable contributions GROSS INCOME: THE SCOPE OF § 61 A. INTRODUCTION TO INCOME: What is included in gross income? Wages, interest, pretty much everything, unless the Code specifically excludes it. Deductions – none, unless the Code specifically grants it. 1. § 61 or the Regs: a. Gross income means ALL income from WHATEVER SOURCE derived, unless excluded by law. (1) Example: compensation for services (including fringe benefits), gains from dealings in property, interest, rents, royalties, dividends, alimony, etc. 2. § 1.61-1 – Gross Income: GI includes income realized in any form, whether money, property, or services. B. EQUIVOCAL RECEIPT OF FINANCIAL BENEFIT: 1. Cesarini v. U.S. (1970), p. 49 Couple bought a piano for $15, decided to clean it out, finds a sack of money. Report as GI on their tax forms. Filed an amended return, didn‘t declare it. Gov‘t says they must pay taxes on it. Sued government for a refund. Argued (1) not included within § 61 as GI, and (2) should have been income in 1957, not 1964, and the 3-year statute had run. Held: The only way it is not GI under § 61 is if one of the exceptions apply. Government says found money is not a listed exception, and GI is interpreted broadly. a. § 1.61-14: Misc. Items of GI – Treasure trove, to the extent of its value in U.S. currency, constitutes GI for the taxable year in which it is reduced to undisputed possession. b. They gained possession of it in 1964, so under the same section, proper year for the tax is 1964. Problem 1 (page 63): Would the answer in Cesarini be different if piano was actually worth $500,000? 1
No – There is no realization for the change in value. However, once the piano is sold, there is realized income. This triggering event must occur before the income is realized. Once the income is realized, then it is taxed as part of gross income. Must be realized to be income.
Old Colony Trust Co. (1929), p. 54 Mr. Wood is making $900,000 in salary in 1918. In 1919, he makes $550,000. His company, besides paying his salary, also pays his income tax, which was $681,000 that year. IRS wants to tax the company‘s payment of his taxes. But, Wood never saw the money, company paid it directly to IRS. Still GI because Wood benefited directly. Held: You don’t have to receive something, i.e. money, directly for it to be income. The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed, and should be included in gross income. a. General Rule under § 1.61-14 – Misc. Items of GI: another person‘s payment of the taxpayer‘s income taxes constitutes gross income to the taxpayer unless excluded by law. b. Wood still got a nice financial gain, because he only has to pay taxes on the $681,000, and not the million. Problem 3 (page 63): E receives stock from employer as a benefit. It‘s GI because he receives some financial gain from it, even though it is property. Taxed on the fair market value of the property received. § 1.61-2(d)(1) – Compensation paid other than in cash: If services are paid for in property, the FMV of the property is included in income as compensation. 3. Glenshaw Glass (1955), p. 56 2 actual cases – consolidated into 1. Whether money received as exemplary damages for fraud or as the punitive 2/3 portion of a treble-damage antitrust recovery must be reported by a TP as GI? YES a. Taxpayers were relying on Eisner v. Macomber, USSC case which narrowly defined GI as capital, labor, or both combined. b. Court here says Eisner definition too narrow. GI is broader than that. GLENSHAW GLASS RULE: whether something is income: 1-instances of undeniable net accessions to wealth 2-that is clearly realized, 3-over which the taxpayer has complete dominion. Used when unsure whether something is income. If it is in the code – don‘t use this test. Treble damages generally are included (§ 1.61-14). Problem 2 (page 63) – W receives free raffle ticket. Must W report anything she wins in the raffle? Yes. Under GG Test – it is a net accession to wealth, clearly realized, over which W has complete dominion. 4. Loans are not gross income – there is no net accession to wealth. . . 5. Illegal income is still GI – must be reported. Problem 4 (page 65: IA refers clients to auto repair firm that gives him a kickback. GI? Yes. Even if it is illegal. C. INCOME WITHOUT RECEIPT OF CASH OR PROPERTY: 1. There are some situations where you do NOT have to report income because it is imputed income. a. Rental value of own home – Helvering v. Independent Life Ins. Co held that the rental value of the building used by owner as his principal residence does not constitute income w/in the meaning of the 16th Amendment. The exception to this rule is the separate entity theory (Dean case). b. Value of services rendered to yourself – the value of services performed by yourself (i.e. lawyer makes a will for himself or prepares his own tax return) is NOT considered income for tax purposes 2. Separate Entity Theory a. Dean v. Commissioner (1951), p.67 Wife owned property prior to marriage. Husband and Wife start a corporation, transfer their house to the corporation. They live in it and don‘t pay rent to the corporation. Held: The court said they should have paid rent to the corporation at the FMV of the house‘s rent. These are separate entities and you have to respect the entities. Thus, the H & W have income for the FMVE of the rent on the house. b. Hypo: A works at a law firm. $11,000/month salary. Law firm also pays for A‘s apartment, where rent would have been $2,500/month. Is there any gross income? Yes, the $2,500 is income to A b/c separate entities. 3. Bartering – An Exchange of Services: Revenue Ruling 79-24 2
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Lawyer drafts a will for the painter in exchange for the painter painting the lawyer‘s house. Is there income? Each is responsible for the FMV of their services. Just because they bartered for each other‘s services, does not mean were not compensated for their services. Each party has gross income equal to the FMV of the service or property received. Problem 1 (page 66): V grows veggies in her garden. Does she have GI when: She harvests her crop? NO Her and her family consume $100 worth of veggies? NO (unless she is a corporation). She sells veggies for $100? YES She exchanges $100 worth of veggies with Charlie for $100 worth of tuna that Charlie caught? YES – income for both. a. III. EXCLUSION OF GIFTS AND INHERITANCES: A. RULES OF INCLUSION AND EXCLUSION: 1. A gift or an inheritance is income because it is a net accession to wealth, but each is specifically excluded from income, and do not count (§ 102). You do not have to pay income tax on this 2. § 102 – Gifts and Inheritances: GI does not include the value of the property acquired by gift, bequest, devise, or inheritance. a. § 102 does NOT exclude income subsequently generated or earned from the gift (such as interest and dividends). The interest and dividends is included in gross income. B. THE INCOME TAX MEANING OF GIFT: 1. GIFT: For tax purposes you must look to the intent of the donor. a. Was the donor acting out of detached and disinterested generosity? (1) If donor expected something in return – not a gift. (2) If donor acting out of love, affection, admiration, respect, etc. – gift. (3) In a business setting, will most likely be presumed that the donor was not acting out of a detached and disinterested generosity. Especially if the donor claims it as a business expense on his taxes. 2. Duberstein (1960) Berman and Duberstein do business together. B is so happy with the fact D has given his business that he gives him a Cadillac. D does not report it on his taxes, believes it to be a gift. B claimed it as a write-off. Held: This was not a gift. Berman was not acting out of detached and disinterested generosity. The court held that the FMV of the Cadillac was includable as gross income, and was not a gift. To determine if there was a ―gift‖ for income tax purposes, the court held that there are several factors that must be analyzed to determine the intent of the donor (not donative intent under common law principles): Detached and disinterested generosity Out of affection, respect, admiration, charity, or like impulses EMPLOYEE GIFTS: 1. § 102(c) – Employee Gifts: If you receive something in an employment setting, the code says it is NOT a gift, it‘s income. Problem 1 (page 80): Employer gave all of her employees, except her son, a black and white TV at Christmas, worth $100. Son, also an employee, gets a color TV, worth $500. What about the employees? Does Son have gross income? Under § 102(c) says that the employee cannot exclude the gift as income. However, according to § 102(c), the son has gross income. But what about the fact that Son is also her son? There is some detached and disinterested generosity b/c the son got a more expensive TV. See Regulation below. Under § 1.102-1f(2) ER/EE transfers: for purposes of section 102(c), extraordinary transfers to an employee will not be considered income if the employee can show that the transfer was not made in recognition of the employee‘s employment. Accordingly, § 102(c) shall not apply to amounts transferred between related parties (e.g. father/son) 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. Therefore, the first $100 is probably income for the son, but not the rest – the rest is a gift. The gift of $500 is bifurcated – the $100 is included as EE and $400 is excluded.
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THE INCOME MEANING OF INHERITANCE: 1. Lyeth v. Hoey (1938): TP contests will of his grandmother, receives a settlement. Does not report the settlement money as income. IRS says it is income because it wasn‘t the direct result of an inheritance. Held: Because the settlement came as a result of an inheritance, so it fit the mechanism for the exclusion. If it had been a successful will contest, would have been treated as an inheritance, so this is close enough. Not income. Settlements from will contests are inheritances, and are excluded from gross income. Problem 1 (page 91): Consider whether it is likely that § 102 applies: Father leaves daughter $20,000 in his will? YES (excluded). F dies intestate and D receives $20,000 worth of property as his heir? YES. F leaves several members of family out of his will and D contests will. D wins, receives settlement of $20,000? YES F leaves D $20,000 in his will, stating that it is an appreciation of D‘s long and devoted service to him? YES F leaves D $20,000 pursuant to a written agreement under which D agreed to care for F in his declining years? NO (not excluded, it‘s income) – more like a contract for the compensation of services.
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LIMITATIONS IN EMPLOYMENT RELATIONSHIPS: A. FRINGE BENEFITS: (§ 132, § 1.102-1(f)(2)) 7 Basic Types of Fringe Benefits: 1. No Additional Cost Service Fringe Benefit (§ 132(b)): Get free stuff as a result of your employment (free travel, free hotel rooms, free parking, etc.) Excluded because it is not a loss to the employer, so there is no benefit passing to a detriment. a. Requirements -- § 132(b) (1) Service is offered to customers in the ordinary line of business (line of business test) in which the employee works; AND Takes care of unfair advantages to large conglomerates, but still allows executives to enjoy all employees § 1.132-2(a)(1)(i): Must be substantial services in the line of business to get the freebie. (2) Employer must not incur any substantial additional cost. Note: can‘t be when flight/hotel is full. b. § 132(h): family members can receive, as can dependent kids, widow or widower if spouse died while employed, parents (only for travel), retired/disabled employees. c. § 132(j)(1): cannot discriminate in favor of highly compensated individuals (e.g. officers). 2. Qualified Employee Discount Fringe Benefit (§ 132(c)): because you are an employee, you get a certain percentage off of the normal price of goods. Would be income if not for § 132(c). a. Requirements: (1) Must be in the line of business (2) Can‘t give it to you for below cost (3) Can‘t give different discount to highly compensated groups b. Hypo: ER sells product for $1,000. EE buys it for $600. As a discount, you as an EE can only get a discount down to $600. Income would be difference between maximum discount allowed and actual discount received. c. § 132(c)(4): Real property is not included as an EE discount. d. § 132(h): Same definition for employee as above. 3. Working Condition Fringe Benefit (§ 132(d)): It is not income if an ER pays for a service or product that if an EE were to pay for it, it would be deductible. a. Example: If a law firm pays your bar dues for you, that is a working condition fringe benefit, because it would be a business expense deduction for you. b. Discrimination rules do not apply here, because if you don‘t receive it, it is still a deduction. De Minimis Fringe Benefit (§ 132(e)): Any benefit that is so small that it makes accounting for it unreasonable or administratively impracticable. a. § 1.132-6(e)(1): Examples of de minimis fringe benefit: Occasional typing of personal letters by company secretary, occasional use of employer copier, picnics, cocktails, birthday or holiday gifts that are not cash, occasional events tickets, local phone calls, coffee, doughnuts and sodas, etc. b. § 132(e)(2): ER eating facilities are treated as a de minimis fringe benefit so long as: (1) It is on or near premises; and (2) Employer breaks even on operating the cafeteria. 4
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No discrimination is allowed for a de minimis fringe benefit. Limit-regulation 1.132(6)(e)(2) (1) season tickets to a sporting event (2) auto for more than 1day a month (3) membership to private county club or gym (4) use of employer owned cabin/facility for the weekend
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Qualified Transportation Fringe Benefit (§ 132(f)): Most common are transportation in a commuting vehicle (i.e. vanpool), transit passes, and qualified free parking. Any amounts above the limitations below must be included in gross income. a. Limitations: § 132(f)(2) – employer provided parking provided on or near the business premises or on or near the location from which employee is picked up by a commuter (1) Cannot exceed a certain dollar amount per month for parking, but can be adjusted for inflation: 2006-$205/month 2007-$215/month b. Can discriminate. c. Any amounts paid for qualified transportation which exceed the limits provided may not be excluded by any other subsection of § 132. d. If a choice is given to take parking or cash, then (5) Those who take parking, can exclude up to $215/month from gross income (6) Those who take the cash, must include ALL of the $215/mo. in gross income Qualified Moving Expense Reimbursement Fringe Benefit (§ 132(g)): Can deduct moving expenses reimbursed by ER when moving b/c of work. On Premise Athletic Facility Fringe Benefit (§ 132(j)(4)): Any gym or athletic facility operated by ER on ER‘s premises if substantially all the facility‘s use is by EE‘s and their families. Qualified retirement planning services-132(m)-relatively new -if employer provides you w/ a retirement planning services, free fringe benefit
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Problem 1 (pg. 98) – Is there an applicable exclusion from gross income? a) EE of a national hotel chain stays in one of the hotels rent-free while on vacation. There are several empty rooms. YES – not costing ER any money, and part of his business. This is not gross income under § 132(b) b) Same as (a) above, except desk clerk bounces a paying guest to give the EE a room. NO – costing ER money, so does not fit under § 132(b). However, may fit as a qualified employee discount. Hotels are a service, so you can still get max discount of 20% excluded. If the room costs $200, then $40 is excluded and $160 is included in gross income. Look to § 1.132-2(a)(2): If you don’t meet one fringe benefit, you can try under another. c) Same as (a) above, except EE pays the bill and receives a cash rebate from the chain. YES. The amount is excluded. It doesn‘t matter if the amount is reimbursed. § 1.132-2(a)(3), it can be rent-free or reimbursed. d) Same as (a) above, except that EE‘s spouse and dependent children travelling without the employee use the room on their vacation. YES. Under expandable definition of ―employee‖ under § 132(h). e) Same as above, except that EE stays in the hotel of a rival chain under a written reciprocal agreement under which EE‘s pay 50% of normal rent. YES. Under § 132(i) says you can have reciprocal agreements between companies in the same line of business for the no-additional cost service fringe (only applies to this fringe). f) Same as above, except that EE is an officer in a hotel chain and rent-free use is only allowed for officers. NO. This is discrimination. EE has to declare the full price as income – punishment for being discriminatory. Under § 1.132-8(a)(2): If ER maintains more than one fringe benefit program, and one is discriminatory in favor of highly-compensated EEs, then the highly-compensated EEs will be unable to exclude anything. Hypo: All highly compensated EE‘s get free rent, but all other EE‘s get 40% discount. The full amount of the officer is included in officer‘s gross income under § 1.132-8(a)(2). g) Same as above, Hotel chain is owned by a conglomerate which also owns a shipping line. EE works for the shipping line, stays in the hotel free. NO. This person works in shipping line, not hotel line, fails line of business test under § 132(b). He must include in gross income. 5
h) Same as above, except that EE is comptroller of organization. YES. Under § 132(b), EE can work for more than one line of business. Since he is comptroller, he provides substantial services in all lines of business of the company. i) ER sells insurance and ER allows EE 20% off $1,000 cost of policy. YES. Insurance is a service, and 20% is the maximum discount excluded from gross income, b/c this fits under § 132(b). Also, does not exceed the maximum under § 132(c). j) EE is a salesman in a home electronics store. During the year, store has $1,000,000 in sales, and $600,000 cost of goods sold. EE buys a $2,000 VCR from ER for $1,000. Under § 132(c)(2): Qualified EE discount cannot exceed GPP. Maximum EE discount = GPP. Gross Profit Percentage = Sales – Costs of Goods Sold Sales Here, Gross profit is $400,000. Maximum discount under formula is 40%. The Gross Profit Percentage (GPP) is Sales – COGS / Sales, or Gross Profit / Sales = $1,000,000 - $600,000/ $1,000,000. Minimum amount paid by the EE must not make the ER incur a loss. Thus, EE can only get a max 40% discount. Here, EE buys a $2,000 VCR. The max discount is 40%. Thus, the max exclusion is $800 ($2,000 x 40%). The actual discount was Fair Market Value less the Actual Paid ($2,000 - $1,000 = $1,000 discount). Thus, the EE must include $1,000 - $800 = $200 in gross income. k) EE attends a business convention in another town. ER picks up EE‘s costs. YES. Under § 132(a)(3) and § 132(d), would be deductible if EE paid for it, so it qualifies as a working condition fringe benefit. l) ER has a bar and provides EE with happy hour cocktails at the end of each week‘s work. YES. Under § 132(a)(4) and § 132(e), happy hour cocktails is a de minimis fringe benefit. m) ER gives EE a case of scotch each Christmas. Probably NO. Non-cash holiday gift from ER, but most likely it is too high in value to be de minimis. n) EE is an officer of a corporation which pays EE‘s parking fees at a lot one block from the corporate headquarters. Non-officers pay their own parking fees. YES. Under § 132(a)(5) and § 132(f), EE can only be given $215/month worth of parking (as of 2007), the rest is income. Qualified parking can discriminate. o) ER puts in a gym at the business facilities for the use of the EE‘s and their families. OK. On-premise athletic facility fringe benefit. B. EXCLUSIONS FOR MEALS AND LODGING: § 119 – Meals and lodging furnished for convenience of the ER: meals and lodging will be excluded from GI if provided by ER because the ER needs you to be there (for the convenience of the ER) and 1. Meals (1)must be furnished on the business premises of the ER and (2)for the convenience of the ER; a. § 1.119-1(b): Usually meals must be because EE has short meal period, such as 30-45 minutes, and because EE is expected to eat at work. 2. Lodging must be a. on the premises of his ER, b. must be a condition of employment (i.e. part of a contract) c. must be for the convenience of the employer Herbert G. Hatt case (1969) Hatt lived at the funeral home with his wife as part of her employment. Hatt becomes president, GM, and majority stockholder of the corporation. Corporation owns the apartment and Hatt and wife don‘t pay rent. IRS sued and claimed that § 119 did not apply. The corporation is a separate entity. Held: The court said that Hatt met the requirements of § 119, even though as a boss, he made the rules, and the corporation was the one requiring him to live there. The court considered it reasonable for Hatt to be required ―to be on premises‖ b/c it was part of the industry and a condition of the employment (even though Hatt was setting the requirement and getting the benefits of the condition). 3. Test for “on the business premises” – in Commissioner v. Anderson the court held that ownership was no the test, and that the term means ‗either at a place where the employee performs a significant portion of his duties or where the employer conducts a significant portion of his business.‖ Linderman case held that a residence adjacent to the motel (across the street) was not geographically separated from the motel and was therefore ―on the business premises.‖
Problem 1 (page 103): ER provides EE, spouse, and child, a residence on ER‘s business premises, having a rental value of $5,000 per year, but charges them $2,000 per year. Are the following amounts excluded? 6
What result if the nature of EE‘s work does not require EE to live on the premises as a condition of employment? NO – If EE not required to be there as a condition of employment then it is not deductible, and has a GI of $3,000 b/c it is a net accession to wealth. b) What result if ER and EE simply agreed to a clause in the employment contract requiring EE to live in the residence? NO – Not for the convenience of ER (plus, would make it too easy). GI of $3,000. c) What result if EE‘s work and contract require EE to live on the premises and ER furnishes EE and family $3,000 worth of groceries during the year? It depends. Under, § 119, the housing meets requirements. However, the groceries would be on premises, and at convenience of ER, but case law states groceries are meals and that groceries are not meals (it depends). Popovich believes that groceries are meals b/c the distinction is not apparent on its face. d) What result if ER transferred the residence to EE in fee simple in the year that EE accepted the position and commenced work? Does the value of the residence constitute excluded lodging? NO – § 119 implies that ER lets EE stay in it, but retains ownership and control. Cannot transfer property to EE. Income value is FMV. Beyond scope of § 119. a) Problem 2 (pg. 106): Planner incorporated her motel business. Motel purchased a house next to the motel, ―required‖ P to use the house and gave her meals. P worked at the motel and was on call 24 hours a day. Excludable? P is setting the condition for employment (okay under Hatt case), and is part of the nature of the business of a motel. Lodging is excluded because it is reasonable because the motel business requires you to be available at all times. People come in at all times. Even though the house is adjacent, the court says it is close enough to be on premises (see Linderman case). Meals: OK as long as it is on the business premises. V. AWARDS: A. PRIZES: § 74 1. Prizes or awards made to specialized fields: under § 74(b), if recipient is selected w/o any action on his part to enter the contest or proceeding and was not required to render substantial future services as a condition to receiving the prize or award. Such fields include – religious, charitable, scientific, educational, artistic, literary or civic. 2. Employee achievement awards: under § 74(c) creates an exclusion for employee achievement awards – may qualify if it relates to length of service or to safety B. SCHOLARSHIPS AND FELLOWSHIPS: § 117 1. GI does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at any qualified educational organization described in § 170(b)(1)(A)(ii). a. Qualified Scholarship: under § 117(b) is any amount received as a scholarship or grant to the extent the individual establishes that such amount was used for qualified tuition and related expenses. b. Tuition/related expenses: must be for the enrollment or attendance of a student, or fees, books, supplies, and equipment required for courses of instruction. 2. Scholarships do NOT cover room and board. Room and board does not qualify under tuition and related expenses. 3. What if we call it a gift? a. Regulation for § 117 says that no other provisions apply to qualified scholarships. GAIN FROM DEALINGS IN PROPERTY: A. FACTORS IN THE DETERMINATION OF GAIN: 1. You buy a diamond for $500. Today, it is worth $750. Do you have any income yet? No – not yet realized. a. How do you realize gain? Sell the diamond. You now have a realized gain of $250, thus you have income. b. There are some instances when you do not have to declare income on your tax return: (1) e.g. – when you sell your personal residence, and do something right under § 1035 (buy a new house within a certain period of time), then you do not have to report it. 2. Anytime you have a sale of property, ask: (3-step test) a. Is there a realized gain/loss? (triggering event)(AR-AB=realized G or L) b. If yes, is the gain (or loss) recognized? (is it taxable) c. If yes, is there any special character? (treatment) 7
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(1) Such as capital gain or loss § 1001 – Determination of Amount/Recognition of Gain/Loss: A gain is the excess of the amount realized over the adjusted basis and a loss is the excess of the adjusted basis over the amount realized. (AR-AB = Gain or Loss). § 1001(b): Amount Realized: is the sum of any money received plus the FMV of any property received. § 1001(c): Recognition of gain/loss – except as otherwise provided, the entire amount of gain/loss shall be recognized. § 1011: Adjusted Basis for Determining Gain or Loss: 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 § 1012 or other applicable sections of this subchapter and adjusted as provided in § 1016.
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DETERMINATION OF BASIS: 1. COST AS BASIS: Almost always the starting point. a. § 1012: Basis of Property – cost. The basis shall be the cost, except as otherwise provided. Example: bought a house in Encino, cost $15,000. Made $100,000 in improvements. Sold for $750,000. Gain is not just the increase. Get to account for improvements – that‘s why we call it an adjusted basis. Problems (page 118): Owner purchases some land for $10,000, and later sells it for $16,000. a) Determine the amount of O‘s gain: AR ($16,000) less AB ($10,000) = $6,000 b) What difference from (a) above if O purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option? Option = the right to buy at a certain price (can have AR and AB in the options – see next problem). Basis is still the same – total of $10,000 (option cost + exercise price = AB). c) What difference from (b) above if O did not buy the land but sold the option to investor for $1,500? AB in the option is $1,000 and the AR is $1,500, so O realized a gain of $500 from the sale of the option. d) What result in (a) if O purchased the land for $10,000, spent $2,000 clearing the land prior to its sale, and sold it for $18,000? AR = $18,000 AB = $10,000 + $2,000 = $12,000 Gain = $6,000 **§ 1016: Proper adjustments shall be made in all cases for expenditures, receipts, losses, etc. There are certain costs by their nature that are added to the adjusted basis (i.e. capital expenditures – those expenses that are capitalized or depreciate in value). Things that are permanent, add to basis. You must distinguish between improvements and maintenance. -ie patio, roof, carpet, bathroom **§ 1.61-2(d)(2)(i) – Property transferred to EE or Independent contractor: If property is transferred by an ER to an EE or Independent contractor, as compensation for services, for an amount less than its fmv, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fmv at the time of the transfer is compensation and shall be included in the gross income of the EE or independent contractor. In computing the gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of such difference included in gross income. 2. PROPERTY ACQUIRED BY GIFT: If you paid nothing for it, then cost is $0, but is that the AB? Taft v. Bowers (1929), pg. 122 Mr. Taft (―Dad‖) of Elizabeth Taft (―Daughter‖) buys stock for $1,000. Dad‘s AB is $1,000. In 1923, the stock was worth $2,000, Dad gave stock to Daughter. Daughter sold it that same year for $5,000. Daughter‘s AR is $5,000. On her tax return, Daughter used $2,000 as her AB. She wants a higher AB and reports a $3,000 gain. IRS says AB should be $1,000, cites to § 1.1015-1, and claims she paid nothing for it, so it was a gift. As a gift, the donee must use the donor’s AB when computing the gain. Held: Under § 1015, when a donee receives a true gift (detached and disinterested generosity) from a donor, the donee receives the donor‘s AB in the property, and he must use that AB if he sells the property in computing the realized gain. This is also called the carryover basis. a. § 1015 – AB carries over from donor to donee, EXCEPT if the AB exceeds the FMV at the time of the gift, then use the FMV as the AB. 8
Known as the SPECIAL LOSS RULE – only applies if the FMV @ the time of gift is less than the AB . If it‘s not, don‘t worry about it. Hypo: Pop gives property he bought for $5,000 to student, but at the time, property is only worth $3,000. Student sells it for $1,000. AR = $1,000 AB = $3,000 (applying the special loss rule) Loss = <$2,000>
Problem 1 (page 126): Donor gave Donee property. What gain or loss does DE incur, when DE sells it? a) (1) DR bought for $20,000 (AB), and when he gave it to DE, had a FMV of $30,000. DE sells for $35,000. DE‘s AB = $20,000 (carryover) DE‘s AR = $35,000 Gain = $15,000 (2) DE sells it for $15,000? DE‘s AB = $20,000 (no special loss rule) DE‘s AR = $15,000 Loss = <$5,000> (may not be recognized) (3) DE sold for $25,000? AB = $20,000 AR = $25,000 Gain = $5,000 b) (1) DR bought for $30,000. At the time of the gift, only worth $20,000. DE sold for $35,000. DE‘s AB = $30,000 (no SLR because DE sold for a gain) DE‘s AR = $35,000 Gain = $5,000 (2) DE sold for $15,000 AB = $20,000 (SLR applies because a loss) AR = $15,000 Loss = <$5,000> (3) DE sold for $24,000 AB = ???? AR = $24,000 Gain = no gain or loss, b/c it should be a loss, but using the FMV would make it a gain, which isn‘t fair. Use the regulation below. Reg. § 1.1015-1(a)(2): When AR is between FMV and the carryover AB, there is neither a gain nor a loss. Gift Tax: Wholly separate from income taxes. If I make a gift of anything to anybody, I may be taxed on the privilege of transferring wealth. (1) Gift or estate are taxed at the same rate. ESTATE TAX REPEALED IN 2010. NOT GIFT TAX!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! (2) Tax is on the transferor‘s estate before the recipient receives it. (3) Gift tax figures into what the donee's basis is. (4) § 1015(d)(1) – Increased basis for gift tax paid: Basis shall be increased by amount of the gift tax paid with respect to such gift. Apply Special Rule for Gifts BEFORE 1/1/77, and cannot exceed FMV at time of the gift. Example: DR‘s AB = $300 FMV @ time of gift = 400 DR‘s gift tax paid = $20 DE‘s AB = DR‘s AB + DR‘s Gift Tax Paid DE‘s AB = $300 + $20 = $320 b.
9
c.
§ 1015(d)(6) –Special Rule for Gifts AFTER 1/1/77: Increase in AB shall be an amount which bears the same ratio to the amount of tax paid as the net appreciation in value of the gift (in DR‘s hands) to the amount of the gift (FMV at the time of the gift). X = gift tax paid adjusted Net appreciation = (FMV at time of gift – DR‘s AB) X Gift tax paid x 20 = Net Appreciation = (FMV – DR‘s AB) Total Amount of gift = FMV 4x = 20 x=5
= (400-300) 400
DE‘s AB = X + DR‘s AB DE‘s AB = $5 + $300 = $305 RULE: If at the time of gift, the FMV of property is equal to or less than the DR‘s AB, there is no gift tax adjustment. d. Problem Sally made a gift of property with a fair market value of $40,000, to her brother, Brian. Sally's cost (and adjusted basis (AB)) for this property was $10,000. Assume that Sally paid $8,000 in gift taxes on the transfer of this property. In each of the following independent scenarios, what is Brian's adjusted basis (AB) in this property? DR‘s AB=10k, Gift‘s FMV=40k, gift tax paid=8k (a)Assume that the gift to Brian was made in 1976 and the property is now worth $80,000. start with 10,000 B‘s AB +8000tax=18,000 (for pre 1977) (b)Assume that the gift to Brian was made in 1985 and the property is now worth $80,000. after 1977… X=gift tax paid adjustment x/gift tax paid=net appreciation in donor‘s hands/amount of the gift x/8,000=30,000/40,000 x=6000 10,000+6000=16,000 (this is Brian‘s AB) (c)Assume that the gift to Brian was made in 1976 and that Sally's adjusted basis in the property was $36,000 instead of $10,000. -pre 1977-amount of gift tax paid 36000+8,000=44,000 (adjusted basis can‘t be greater than FMV at time received), so would limit this to 40,000 10 Determining AB (Adjusted Basis)-When Property is Acquired by Gift-Special Rules When There is "Gift Tax" Paid on Transfer
(d) Assume the gift to Brian was made in 1985 but that the property was worth only $10,000 at the time of the gift, and the gift tax paid by Sally was only $4,000. Would it make any difference if the gift to Brian had been made in 1976? -post 1977, x/4000=0/10000, x=0 So, 10,000+0=10000 (e)Same as part (d) except that the fair market value of the property at the time of the gift and the gift tax paid by Sally was only $8,000 and $2,000, respectively. x/4000=0/8000, no gift tax paid adjustment -at the time of the gift anytime the FMV is equal to or less than the doner‘s AB, there will be no gift tax adjustment 3. PROPERTY ACQUIRED BETWEEN SPOUSES OR INCIDENT TO DIVORCE: a. § 1041(b) – Transfer treated as a gift: Any transfer between spouses, whether a gift or as part of divorce, the basis is carried over absolutely, regardless of FMV. (1) Known as Special Spouse Carryover Rule. (2) No Special Loss Rule (3) Normally, no gift tax paid on gifts between spouses. (4) Example: H & W own stock A and stock B. They paid $10,000 for stock A and $45,000 for stock B. At time of divorce, stock A is worth $55,000, and stock B is worth $50,000. Because of the special spouse carryover rule, you would want stock B because the basis was much higher, even though it is worth less now. b. § 1041(a): No gain or loss recognized on a transfer of property from an individual to a spouse or former spouse, but only if the transfer is incident to the divorce. Problem 1 (p. 128): Donald (D) purchased some land ten years ago for $4,000 cash. The property appreciated to $7,000 at which time D sent it to his wife, Marla (M), for $7,000 cash, its FMV. (a) What are the income tax consequences to D? AR = $7,000 AB = $4,000 Realized gain = $3,000 FMV sold to M = $7,000 No gains or losses from transfers between spouses are recognized (b) What is M‘s basis in the property? AB = $4,000 Under § 1041(b)(2), M is wife so she gets D‘s basis or the carryover basis that D had in the property = $4,000 (c) What gain to M if she immediately resells the property? AR = $7,000 AB = $4,000; The realized gain = $3,000 Since M resold the property to someone other than her spouse, then the gain is RECOGNIZED. (d) What results in (a)-(c) above, if the property had declined in value to $3,000 and D sold it to M for $3,000? No consequence to D b/c transfer between spouses. Under § 1041(b)(2), M‘s AB is D‘s AB, or $4,000 When M resells the property for $3,000, her AB was $4,000, so a realized loss of $1,000 is RECOGNIZED b/c she resold to someone other than her spouse. PROPERTY ACQUIRED FROM A DECEDENT: § 1014 a. § 1014(a): Basis of property acquired from a decedent is the FMV at the time of decedent‘s death or at the time of the gift (in case of inter vivos gift). (1) The beneficiary gets a stepped up basis (or stepped down basis if less). (2) Example: Dad paid $1,000 for property. Dies and property worth $5,000 at the time of the gift. AB of whoever receives it will be $5,000.
4.
11
(3) Hypo: H & W bought a house in 1970 for $100,000 in joint tenancy. Today, house has a FMV of $600,000. Each spouse has an AB of $50,000. W dies, H gets her ½ as well. What is H‘s new AB? ½ of W‘s AB at the time of death = ½ FMV = $300,000. H‘s original AB = $50,000 H‘s new AB = $350,000. b. § 1014(b)(6): In a community property state, the surviving spouse‘s ½ will be deemed to have come from the decedent, and will give him FMV at the time of death. (1) Double step-up in basis. (2) Hypo (facts from above): H‘s original AB from above = $300,000, not $50,000. So, H‘s new AB = $600,000. § 1014(e) – Appreciated property acquired by decedent by gift within 1 year of death. If so, will not get the double step-up, because the IRS will call it a sham. If you transfer property and get it back within a year, it is treated like you never gave it away. § 1022—Decedent‘s estate can elect to use as the recipients‘ basis for FMV for property up to 1.3 million dollars in value. On transfer to spouses, can receive up to 3 million dollars in basis. ONLY IN 2010.
c.
d.
C.
AMOUNT REALIZED: (AR-AB=Realized G or L) 1. § 1001(b) – Amount Realized: AR is the sum of any money (or money‘s worth) received plus the FMV of any property received. International Freighting v. Commissioner (1943), p. 133 Employee gets a bonus of stocks with a FMV of $25,000. ER had an AB of $16,000. Does ER have an AR when ER gave stocks to EEs as bonus? Held: ER did not receive any money or property, but the ER did receive money‘s worth of services. The court valued AR at $25,000 because that was the amount of property given in return for services. Gain for ER was $9,000. 2. Your AB when you buy property is what you paid for it – including any loans taken out. So, if you buy a house for $100,000, and put $20,000 down on it, and finance $80,000, your AB is $100,000. a. Years later, when you go to sell your house, the FMV is $500,000. But, you still owe $80,000 (the bal. of loan) (1) Equity: what it‘s worth (FMV) less what you owe (i.e Mortgages, Loans, Debts). So, equity here is $420,000. b. Buyer could buy a house, and seller could pay off loan with proceeds, or buyer could assume loan, or buyer could take subject to the loan. (1) Regardless, the seller sold it for $500,000, so that is his AR. It doesn‘t matter in what way he sold it (cash + taking on the loan) or ($470,000 + $30,000 loan bal.) (2) Gain on the sale = AR – AB. Here, the AB = $100,000, and the AR = $500,000. Thus, the Gain = $400,000. (3) Equity has NOTHING to do w/ the computation of gain or loss on the sale of the home. § 1016 – Adjustment to Basis: AB is reduced by depreciation. Crane v. Commissioner (1947), pg. 136 Crane inherits property from her husband, worth $262,000 when he died, along with a loan on the property of $262,000. Her equity is $0. She ―sells‖ property for $3,000 less expenses ($2,500 cash + $500 expenses). Buyer took the property subject to the loan. Crane says she had a gain of $2,500 (AR of $2,500 – AB of $0). Held: The court said Mrs. Crane‘s AB is $262,000, the FMV at the time she received the property from the decedent. Also, the IRS says Crane should have taken $28,000 as a depreciation, so it reduced her basis accordingly to $234,000. Crane‘s AR is the amount she sold the property for, $2,500 + assumption of the loan of $255,000. Her AR = $257,500. Thus, Crane‘s gain is $23,500. **Crane says AR = cash received plus amount of mortgage buyer takes (whether they assume it or take the property subject to).
3.
12
4.
Reg. § 1.1001-2(b), when the mortgage exceeds the FMV of the property, apply this rule. Commissioner v. Tufts (1983), p. 145 Held: The court examined whether the same rule in Crane applies when the unpaid amount of the nonrecourse mortgage exceeds the FMV of the property sold. The amount of the mortgage is still part of the AR even if the person leaves the home w/o paying off the remaining part of the mortgage. The FMV of the property is irrelevant in computing the gain or loss. Thus, the gain/loss is still computed by taking the AR less the AB; equity is NOT part of this analysis. **When you sell or transfer property, and whether the buyer assumes or takes subject to the mortgage, the AR includes the value of the remaining mortgage.
5.
Part Gift / Part Sale Diedrich v. Commissioner (1982), p. 152 The court held that a donor who makes a gift of property on condition that the donee pay the resulting gift taxes realizes taxable income to the extent that the gift taxes paid by the donee exceed donor‘s adjusted basis in the property transferred. Reg. § 1.1015-4(a): in a part sale/gift, the donees/purchaser‘s AB is the greater of the consideration paid OR the sellers/donor‘s AB. Hypo: P has a watch worth $1,000. He is selling it to K for $400. In reality, this is part sale of $400 and part gift of $600. Apply the rule in Reg. § 1.1001-1(e). P had AB of $100. P has a gain equals the $400 less $100, or $300 gain; K‘s AB is $400. If P had AB of $500, then use the carryover AB for K, or $500, and not the $400 paid by K.
6.
Hypo: buy bldg. for $140,000. Take out loan for entire amount. Over time, it depreciates $30,000, so your AB is $110,000. The FMV is now $120,000. What is the AR? a. According to Crane, the mortgage value should be used ($140,000), which would make it a gain of $30,000. b. But note 37 of Crane states that you use the lower value when the mortgage exceeds the FMV. (1) So, AR = $120,000, and gain = $10,000. (2) But, the Supreme Court reversed itself in Tufts, said full amount of mortgage is the AR, regardless of whether it exceeds value or not.
Problem 1 (p. 150-51): M buys a parcel of land for $100,000. $80,000 from a mortgage to the bank, and $20,000 cash. The bank has a non-recourse mortgage on the land, which has the land as security. a) M‘s AB = $100,000 [cash = $20,000 + mortgage = $80,000] b) If M borrows $100,000 more on the equity, it does not count as income because there is no accession to wealth. c) If M uses the loan to pay for capital improvements, it increases his basis to $200,000. [Original AB + improvements]. d) If M uses $100,000 to buy stocks and bonds, the basis stays the same. e) Under facts of (d) above, what if M sells house for $120,000, what is his gain? AR = $120k cash + $180k assumption of the loan = $300,000 AB = $100k Gain = $300k - $100k = $200,000 The buyer‘s AB in the property is = $300,000 Equity has nothing to do with computing gain f) Under facts of (d) above, what if M gives land, subject to her mortgage, to her son? Part-sale, part-gift = son is assuming the mortgage. So, AR of $180,000 and AB of $100,000 = a gain of $80,000. What is son‘s basis? -- Son‘s AB is $180,000 (greater of carryover basis and consideration paid). g) What results under facts of (f) above, if M gives land to her Spouse and not her Son? What is Spouse‘s basis? No gain to M (§ 1041(a)). Spouse has a carryover basis -- $100,000 (§ 1041(b)). Transfer to a spouse or former spouse incident to divorce, no gains or losses recognized by transferor spouse Receiving spouse uses a carryover basis no matter what h) What results under (d) above, if the land declines in value from $300 to $180 and M transfers the land by quitclaim deed to Bank? A gain of $80,000 (AR of $180k – AB of $100k). 13
i)
What results under (h) above, if the land declines in value from $300 to $170 at the time of the quitclaim? FMV is irrelevant, so same gain as in (h).
VII.
ANNUITIES AND LIFE INSURANCE PROCEEDS: A. LIFE INSURANCE: You are gambling with the life insurance company. They are gambling that you will live longer than you think you will. You gamble that you will die before they think you will. 1. Example: A young married couple buys a $100,000 policy. Premiums are lower when you are younger because you aren‘t as close to death -- $100 per year. H dies. W gets $100,000. a. Does she have a net accession to wealth? Yes. b. But, there is an exclusion for life insurance proceeds. 2. § 101(a) – Proceeds of Life Insurance contracts payable by reason of death: GI does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. a. Does NOT apply if you cash out your policy for the cash surrender value
Problem 1 (pg. 155): Insured died in the current year owning a policy that pays $100,000 but under which several alternatives were available to Beneficiary. a) What result if B simply accepts the $100,000? Excluded because the person received money as a result of death. b) What result if B instead leaves all the proceeds with the company and they pay her $10,000 interest in the current year? $10,000 is not excluded (§ 101(c)). It is not the $100,000 policy. Regular interest is taxable. c) What result if B is the daughter of I and, in accordance with the option she elects, company pays her $12,000 each year for the rest of her life (she is supposed to live 25 years)? Of the $12,000 she receives in year one, only $4,000 is excluded. Take the face amount of the policy, divide by your life expectancy, to determine the amount that is tax-free. $100,000/25 years = $4,000 excludable each year. § 101(d) [Reg. 1.101-4]: Have to recognize income on a prorated basis. d) What if daughter lives longer than her expectancy and is still receiving the $12,000 per year? § 1.101-4(c): Same amount is excluded per payment, no matter how long you live. However, if you die before your life expectancy, then the money is gone and the heirs would not receive any money. Problem 2 (pg. 158): Jock plays football for Pro Corporation. Pro, fearful that Jock might not survive, acquired a $1,000,000 insurance policy on Jock‘s life. If Jock dies during the term and proceeds are paid to Pro, what different consequences will occur? a) With Jock‘s consent Pro took out and paid $20,000 for a 2-year term policy on Jock‘s life. Excluded pursuant to § 101(a)(1). [Permission – state law requires that the beneficiary have an insurable interest in the person‘s life (i.e. family, business, partners, etc.)]. b) Jock owned a paid-up two year term $1 million policy on his life which he sold to Pro for $20,000, and Pro was named beneficiary. § 101(a)(2): Pro can only exclude up to the amount of the consideration paid, or $20,000; the difference between the face value and the consideration is included in GI = $980,000 If the policy is transferred for valuable consideration only the amount of consideration and amount of other premium payments is excluded. Policy reasons – buying someone else‘s life insurance policy is more like an investment than it is insurance. c) Same as above, except that Jock was a shareholder in Pro Corporation. § 101(a)(2)(B): It is all excludable because Jock is a shareholder of Pro Corporation – so go back up to § 101(a)(1), get full exclusion. You are transferring to an entity that is kind of you, so the earlier policy reasons are superceded. IRS can argue “substance over form” to deny the full exclusion. However, if it is a sham, the courts can disregard the sham under the doctrine of Substance over form. Problem 3 (pg. 156): Insured purchases a single premium $100,000 life insurance policy on her life for $40,000. Consider the income tax consequences to Insured and the purchaser of the policy in each of the following alternative situations: a) Insured sells the policy to her Child for its $60,000 FMV, on the Insured‘s death, the $100,000 of proceeds are paid to the Child. 14
For Child, not excluded because of the consideration rule. Only $60,000 excluded; So face of policy is $100,000 less $60,000 excluded, thus $40,000 is income. Insured sells it for $60,000 (AR) less her AB of $40,000 gives Insured a $20,000 gain. b) Insured sells the policy to her Spouse for its $60,000 FMV and, on Insured‘s death, the $100,000 of proceeds are paid to Spouse. Under § 101(a)(2)(A), if the transferee has a carryover basis (under § 1041(b)), then the exception to the exception applies, and thus the exclusion under § 101(a)(1) applies, get full exclusion. § 1041(b): transfers between spouses receive carryover basis. On test – LOOK FOR THE SAME TYPE OF SCENARIO UNDER PART-SALE/PART-GIFT TRANSACTIONS. Full exclusion – when transferee‘s basis is a carryover basis (and not the FMV paid) No exclusion – when transferee‘s basis is not the carryover basis. c) The IRS did not want to enforce the rule that must tax payment to the insured prior to insured‘s death. § 101(g). If there is a terminally ill patient with mounting medical bills, want insurance company to pay out less prior to death, won‘t tax. VIII. DISCHARGE OF INDEBTEDNESS: Income includes any discharged indebtedness. NOTE: Discharged indebtedness is NOT paying a debt off, but having a debt forgiven in whole or in part. Business forgiveness is considered income, whereas gratuitous forgiveness is not. A. ESTABLISHED DEBT: For discharge of indebtedness, you must have an established debt.
Zarin v. Commissioner, pg. 165 Zarin has a gambling problem. Lost $2.5 million on craps and paid it off. Resorts Int‘l was ordered to cut him off, they didn‘t. Zarin then lost $3.435 million more on craps, didn‘t have the money to pay it off, and claimed Resorts Int‘l couldn‘t collect because it was illegal for them to give him credit. Resorts and Zarin settled for $500,000. IRS steps in, claiming the $2,935 million that Resorts forgave Zarin was GI. Zarin claims he could not have a gain because he was not liable for the rest. Zarin claims the $500,000 was the debt, and he paid it, so none was forgiven and none could be GI. Held: Zarin argues under Disputed or Contested Liability Doctrine, there was no debt established because the amount was unenforceable. The court agreed and said that Zarin‘s debt was the amount agreed upon. No forgiveness of debt, and thus no income. If the debt is undetermined, the debt is whatever the liquidated debt agreement is or the $500,000 paid to Resorts. Problem 1 (pg. 179): Poor borrowed $10,000 from Rich several years ago. What tax consequences to Poor if Poor pays off the so far undiminished debt with: a) A settlement of $7,000 in cash? There is a settled debt, with a forgiveness of $3,000 ($10,000 less $7,000), so the GI is $3,000. b) A painting with a basis and FMV of $8,000? The debt is $10,000, less FMV of painting of $8,000. Thus, the income to Poor is $2,000. There is no gain b/c basis equals FMV. c) A painting with a value of $8,000 and a basis of $5,000? The debt is $10,000 less the FMV of painting of $8,000. Thus, the income to Poor of $2,000. Also, Poor has a gain b/c his AR is $8,000 less his AB of $5,000, will result in gain of $3,000. Thus, the total amounts included in income for Poor is $5,000. Actually 2 components of income here: $2,000 from discharge of indebtedness, and $3,000 the gain realized from a basis of $5,000. § 1001 covers all sales or other dispositions of property.
d) Services, in the form of remodeling Rich‘s office, which are worth $10,000? No income under discharge of indebtedness. BUT, there is still income from compensation, so the $10,000 in gross income. e) Services that are worth $8,000? Yes, discharge of indebtedness. The debt is $10,000 less the service income worth $8,000, results inclusion in income of $2,000. Plus, $8,000 included in income from compensation. Same as (a) above, except that Poor‘s employer makes the $7,000 payment to Rich, renouncing any claim to repayment by Poor. 15
f)
$10,000 less $7,000 settlement = $3,000 income from discharge of indebtedness, and $7,000 from indirect employee compensation (Old Colony case) – as if Employer gives to Poor, he gives to Rich.
Problem 2 (pg. 179): Mortgagor purchases a parcel of land held for investment from Seller for $100,000 with $20,000 of cash paid directly by Mortgagor and $80,000 paid from the proceeds of a recourse mortgage incurred from Bank. Mortgagor is personally liable for the loan and the land is security for the loan. When the land increases in value to $300,000, Mortgagor borrows another $100,000 from Bank again incurring personal liability and again with the land as security. Mortgagor uses the $100,000 of loan proceeds to purchase stocks and bonds. Several years later when the principal amount of the mortgages is still $180,000, the land declines in value to $170,000, Mortgagor transfers the land to the Bank, and the Bank discharges all of Mortgagor‘s indebtedness. a) What are the tax consequences to Mortgagor? Reg. § 1001-2(a),(c) Loan was a recourse loan, so it sounds like the bank has discharged some of the loan because the property‘s value has gone down and the bank has forgiven $10,000 Loan = $180,000 - $10,000 (discharge) = $170,000 AR = 170,000 AB = <100,000> 70,000 gain b) What are the tax consequences to Mortgagor if the liabilities had been non-recourse liabilities. Loan = $80,000 + 2nd of $100,000 AR = 180,000 AB = <100,000> 80,000 gain B. SPECIFIC EXCLUSIONS UNDER § 108: A safe haven (or non-recognition area) for those who would normally be taxed, but are in no shape to be able to pay the taxes. 1. § 108(a)(2): If the debt is discharged in bankruptcy, you don‘t have to pay taxes. a. No limitations because this is subject to bankruptcy rules. 2. § 108(a)(3): If the debt is discharged and the debtor is insolvent (liabilities exceed FMV of your assets) the discharge is excluded, up to the amount the debtor is insolvent. a. Look at insolvency at the moment of discharge of indebtedness. b. If you have liabilities of $102,000 and assets of $100,000, you are insolvent by $2,000, and you can exclude up to $2,000 of the discharge. Problem 3 (pg. 180): Businessman borrows $100,000 from creditor to start an ambulance service. Spends $100,000 on ambulances. Assume ambulances are his only depreciable property, and that their AB is still $100,000. What consequences if: a) B is solvent but having financial difficulties, and Creditor compromises debt for $60,000 (forgave $40,000): Classic income from discharge of indebtedness – $40,000 income. No exclusions. b) Same as (a) above, except that C is also the ambulance dealer who sold the ambulances to B, and as a result of depreciation deductions, the AB of the ambulance is $35,000? § 108(e)(5) – Purchase money debt reduction: applies to someone not insolvent or bankrupt, but will still give the person a break if: the lender is the person who extended credit for the purpose of selling their property (a car dealer who finances their own cars). If so, the property is treated as if the dealer reduced the purchase price. c) Assume same facts as (a) above, but B is insolvent and his liabilities of $225,000 exceed his assets of $100,000. Is any or all amounts excludable? Yes, all amounts are excludable because discharge does not exceed insolvency ($125,000 insolvency, only a $40,000 discharge). d) Same as (c) above, but B is only insolvent by $25,000. Only $25,000 is excludable, while $15,000 is income. IX. DAMAGES AND RELATED RECEIPTS: 16
Hypo: You are injured in an auto accident, and you receive a settlement of $50,000. Is that income? Clearly. Are there any exclusions? YES. A. DAMAGES AND OTHER RECOVERIES FOR PERSONAL INJURIES: 1. 2. 3. 4. § 104(a)(1): GI does not include damages received on account of personal injuries or sickness (whether received by suit or agreement and whether as lump sums or as periodic payments). Damages received as a result of non-physical torts are not excluded (i.e., emotional distress, libel, slander, discrimination, etc.). Punitive damages are not excluded. You can only exclude amounts received as a result of physical injuries, suffering from physical injuries, and any related expenses.
Problem 1 (pg. 191): Plaintiff brought suit and successfully recovered in the following situations. Discuss the tax consequences to Plaintiff. Plaintiff, a professional gymnast, lost the use of her leg after a psychotic fan assaulted her with a tire iron. Plaintiff was awarded damages of $100,000. Excluded because damages were received as a result of physical personal injuries. b) $50,000 of the recovery in (a), above, is specifically allocated as compensation for scheduled performances Plaintiff failed to make as a result of the injured leg. Excluded because wages were lost as a result of the physical personal injuries. c) The jury also awards Plaintiff $200,000 in punitive damages. Not excluded. d) The jury also awards Plaintiff damages of $200,000 to compensate for Plaintiff‘s suicidal tendencies resulting from the loss of the use of her leg. Excluded because the suicidal tendencies were a result of the physical personal injuries. e) Plaintiff in a separate suit recovered $100,000 of damages from a fan who mercilessly taunted Plaintiff about her unnaturally high, squeaky voice, causing Plaintiff extreme anxiety and stress. Not excluded because the damages were received as a result of non-physical personal injury. f) Plaintiff recovered $200,000 in a suit of sexual harassment against her former coach. Included in gross income b/c sexual harassment is a non-physical personal injury. g) Plaintiff dies as a result of the leg injury, and Plaintiff‘s parents recover $1,000,000 of punitive damages awarded in a wrongful death action under long-standing State statute? Excluded under § 104(c) when the punitive damages are the only wrongful death recovery under state statute; this is the exception to the general rule of inclusion in GI for punitive damages. X. SEPARATION AND DIVORCE: Alimony is income to the payee spouse and a deduction to the payor spouse. Child support is not income to payee spouse, nor a deduction for payor spouse There is no gain or loss recognized on transfers of property relating to divorce A. ALIMONY AND SEPARATE MAINTENANCE PAYMENTS: 1. § 71: GI of the payee includes amounts received as alimony or separate maintenance payments. 2. § 215: gives deduction to payor spouse for alimony for what is GI under § 71. 3. 6 Requirements To Qualify as Alimony: § 71(b)(1) a. Under § 71(b)(1) and Temp.Reg. § 1.71-1T(b): It must be paid in CASH (money order or check) (1) NOT promissory notes (2) NOT other forms of property Under § 71(b)(1)(A): Payment must be received b/c of divorce or separation instrument (one of 4 fact patterns): (1) (2) (3) (4) Legally divorced;-most common Legally separated by a court decree; Married but payments are directed by a written separation agreement; or Married but payments are directed per a support decree. i. court ordered support decree ii. couple files for divorce, but not divorced right away a)
b.
17
c.
Under § 71(b)(1)(B): Instrument does NOT say it‘s non-alimony (spouses can agree to change the tax treatement) Under § 71(b)(1)(C): In cases of divorce or legal separation (only these two), the couple cannot live in the same household at the time such payment is made/received. Under § 71(b)(1)(D): There is no liability to make any such payment after the death of the payee spouse. Under § 71(c): Payment is not for child support.
d.
e.
f.
Problem 1 (p. 201-202): Determine whether the following payments are accorded ―alimony or separate maintenance‖ status and therefore are included in the recipient‘s gross income under § 71(a) and deductible by the payor under § 215(a). Unless otherwise stated, Andy and Fergie are divorced and payments are called for by the divorce decree a) Divorce decree directs Andy to make payments of $10,000 per year to Fergie for her life or until she remarries. Andy makes a $10,000 cash payment to Fergie in the current year. This is alimony. $10,000 income to Fergie and deductible by Andy. Same as (a), above, except that Andy, finding himself short on cash during the year, transfers his $10,000 promissory note to Fergie. Not alimony. Promissory note is not cash, check, money order, etc. Same as (b), above, except that instead of transferring his promissory note to Fergie, Andy transfers a piece of artwork, having a FMV of $10,000. Not alimony because payment fails the cash requirement and is in the form of property. Same as (a), above, except that in addition the decree provides that the payments are nondeductible by Andy and are excludible from Fergie‘s gross income. Not alimony because the couple does not want to treat it as alimony. Would it make any difference in (d), above, if you learned that Andy anticipated that he would have little or no taxable income in the immediate future, making the § 215 deduction practically worthless to him, and as a consequence of this agreed to the ―non-deductibility‖ provision in order to enable Fergie to avoid the imposition of federal income taxes on the payments? No! What result in (a), above, if the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years? Not alimony because of the potential liability for payment after death. However, if state law eliminates post-death payments, as in California, then it is alimony. Same as (f), above, except that under local law Andy is not required to make any post-death payments. This is alimony because there is no liability after death. Same as (a), above, except the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years or her life, whichever ends sooner. Additionally, the decree requires Andy to pay $15,000 cash each year to Fergie or her estate for a period of 10 years. Andy makes a $25,000 cash payment to Fergie in the year. $10,000 is alimony and $15,000 is not. Same as (a), above, except that at the time of the payment, Andy and Fergie are living in the same house. No alimony. Same as (i), above, except that Andy and Fergie are not divorced or legally separated and the payments are made pursuant to a written separation agreement instead of a divorce decree. This is alimony. It is ok if they live together because they are not divorced or legally separated. Temp. Reg. § 1.71-1T(b) – Question & Answer 9: even if they are physically separated in the same house, if they are both in the same dwelling unit, they are still deemed to be living together. Thus, there is NO alimony (i.e. movie War of the Roses) INDIRECT ALIMONY PAYMENTS: If the spouse makes payments to a 3rd party on behalf of the other spouse, then it qualifies as income under § 71(b)(1)(A) – focus on the nature of the payments (i.e. premiums paid on life insurance, rental payments, mortgage payments). a. Indirect Payments to Spouses: under § 71(b)(1)(A) requires that payment be received by or on behalf of a spouse under a divorce or separation instrument. To determine the type that qualify must focus on the nature of the payments. 18
b)
c)
d)
e)
f)
ON THE EXAM, GIVE BOTH ANSWERS IF NOT PECIFIED.
g) h)
i) j)
4.
5.
Problem 1 (pg. 204): Ted and 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 the § 71(b) requirements. Discuss the tax consequences to both Ted and Joan. Rental payments of $1,000 per month to Joan‘s landlord. It is indirect alimony. Just as if Joan received the money and turned around and paid it to the landlord. Therefore, income to Joan and deductible to Ted. Temp. Reg. § 1.71-1T(b): If spouse made payments of cash to a third party pursuant to a divorce instrument, it qualifies as alimony (i.e., rent). b) Mortgage payments of $1,000 per month on their family home which is transferred outright to Joan in the divorce proceedings. Yes, income to Joan, deductible to Ted. Payment on behalf of Joan. c) Mortgage payments of $1,000 per month as well as real estate taxes and upkeep expenses on the house where Joan is living which is owned by Ted. This is not deductible by Ted and no income to Joan (even if made pursuant to divorce agreement). It is like alimony, but payments are made to benefit the payor‘s property. Helps Tom‘s property, not Joan What if court decided to maintain house as ½ owned by each spouse as tenants in common and Ted was required to make the $1,000 payments? Then Ted could deduct ½ = $500 and $500 as income to Joan. a) B. PROPERTY SETTLEMENTS: 1. § 1041(c) – Transfers of property between spouses or incident to divorce: a. General Rule: No gain or loss shall be recognized on a transfer of property from an individual to (1) A spouse, or (2) A former spouse, but only if the transfer is incident to divorce. b. The transferee‘s basis is the transferor‘s carryover basis c. What is ―incident to divorce:‖ (1) Any transfer which occurs within 1 year after the date on which the marriage ceases; OR (2) Is related to the cessation of marriage - § 71(b)(2) 2. Reg. § 1.71-1T(b) Q/A-7 – when is a transfer of property ―related to the cessation of marriage?‖ a. If it is pursuant to a divorce decree or separation instrument, and transfer occurs not more than 6 years after the date. b. Rebuttable presumption if transfer is beyond 6 years that it is not related to the cessation of the marriage If the property settlement does not fall into one of the confines of § 1041, then it is treated like U.S. v. Davis – a gain.
3.
Problem 1 (pg. 209): Michael and Lisa Marie‘s divorce decree becomes final on January 1, 2000. Discuss the tax consequences of the following transactions. Pursuant to their divorce decree, Michael transfers to Lisa Marie in March, 2000 a parcel of unimproved land he purchased 10 years ago. The land has a basis of $100,000 and a FMV of $500,000. Lisa Marie sells the land in April, 2000 for $600,000. No gain recognized for Michael because the transaction was made within one year of divorce under § 1041(c). Lisa Marie‘s AB is $100,000 because of carryover basis, and her AR is $600,000, so she has taxable income of $500,000. It is a non-rebuttable presumption that the transfer is incident to divorce if it is within 1-year. Hypo-if sold back to Michael, would not be recognized because sold within the year to the ex-spouse b) Same as (a), above, except that the land is transferred to satisfy a debt that Michael owes Lisa Marie. The land has a basis of $500,000 and a FMV of $400,000 at the time of the transfer. Lisa Marie sells the land for $350,000. § 1041(c) applies. It doesn‘t matter why the transaction was made as long as it is within the 1-year period Michael has no gain or loss and Lisa Marie has a carryover basis of $500,000, so she has a loss of $150,000. The special loss rule does not apply because if § 1041 applies it is a carryover basis no matter what. c) What result if pursuant to the divorce decree, Michael transfers the land in (a), above, to Lisa Marie in March, 2005. 19 a)
§ 1041 applies because the transaction was incident to divorce (related to the cessation of the marriage under Reg. § 1.71-1T(b) Q/A-7, and because it was called for by the divorce decree and occurred within 6 years. d) Same as (c), above, except that the transfer is required by a written instrument incident to the divorce decree. Still the same as above, it is within 6 years, so you are fine. e) Same as (c), above, except the transfer is made in March, 2005. This could still be within § 1041, if you can prove it is related to the cessation of marriage, even though beyond the 6-year limit. The 6-year period is a rebuttable period. You have to look at the facts if after 6 years. In this type of situation, if the transaction is called for by the decree, it is usually brought under § 1041 (there was just some kind of delay). C. OTHER TAX ASPECTS OF DIVORCE: 1. CHILD SUPPORT: Basically, it is not income to the payee spouse, and it is not a deduction for the payor spouse. a. § 71(c): any amount that is fixed as child support is not income to the payee spouse or a deduction to the payor spouse. b. Can be fixed as a percentage or as a set dollar amount. c. Any amount that can be reduced in the event of marriage or death or emancipation is still treated as fixed child support (reaction to Lester case).
Problem 1 (pg. 212): Sean and 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 Madonna‘s custody. Discuss the tax consequences in the following alternative situations: a) The agreement requires Sean to pay Madonna $10,000 per year and it provides that $4,000 of the $10,000 is for the support of their child. Fixed, so $4,000 is child support and $6,000 is alimony. b) The agreement requires Sean to pay Madonna $10,000 per year, but when their child reaches age twenty-one, dies, or marries prior to reaching twenty-one, the amount is to be reduced to $6,000 per year. Still fixed, so $4,000 is child support. c) Did not do. d) What result in (a), above, if Sean pays Madonna only $5,000 of the $10,000 obligation in the current year? Under § 71(c)(3), $4,000 is child support and $1,000 is alimony. XI. OTHER EXCLUSIONS FROM GROSS INCOME: A. GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE: 1. § 121 – Exclusion of gain from sale of principal residence: 2 requirements. a. Own property for at least 2 years out of 5 years; and b. Use property as a principal residence. 2. To be a residence for purposes of § 121 you need: a. Sleeping quarters; b. Eating/kitchen area; and c. Bathroom facilities. ** you do not need a foundation for a residence (i.e., a motor home = a residence) Can use this provision once every 2 years. Amount of gain excluded for individuals cannot exceed $250,000. Amount of gain excluded for joint returns cannot exceed $500,000. § 121(c) – exclusion for taxpayers failing to meet certain requirements. If the taxpayer fails to meet the ownership and use requirements or the 1 sale or exchange every 2 years and the sale or exchange is because of a. Change in place of employment; or b. Health; or c. Unforeseen circumstances, then the amount excluded will be pro-rated ([amount of time spent / the two year requirement] x the max exclusion applicable). 20
3. 4. 5. 6.
**Pro-rate according to a percentage of the maximum exclusion (i.e., % of $250,000 for single returners and $ of $500,000 for joint returners). **if a couple, both must meet the use test, but only 1 spouse needs to meet the ownership test 7. Problems, p.223, problem 2: Single tax payer purchased a principal resident for $500k and after using it for 1 year sold the residence for $600k because employer transferred single to a new job a. There‘s a $100k gain, 121 (c) allows for prorated exclusion under certain circumstances: -change of place in employment, -health or -unforeseen circumstances Because single was there 1 of 2 years, he can prorate it, so it‘s ½ of the exclusion, so he can exclude up to 125k, so 100k gain is fully excluded c. what if single sold for $700k, so there is a 200k gain, thus single would have to recognize 75k of income on the sale 8. Regulation 1.121-3-what is included under circumstances that allow to prorate: a. for health reasons b. unforeseen events i. involuntary conversion of your residence ii. natural or manmade disaster resulting your house being destroyed iii. death iv. divorce v. multiple births from same pregnancy
B.
SOCIAL SECURITY PAYMENTS: 1. Tax Ramifications of social security payments: a. § 86 is a specific inclusion provision that makes social security subject to tax (a portion of some recipient‘s social payments were made subject to income). b. If you make a lot of money, your social security payments are subject to tax. c. Who is taxable is based on threshold amounts. BONDS FOR FEDERAL, STATE AND LOCAL MUNICIPALITIES: 1. Interest on State and Local Bonds: (specific exclusion) a. § 103 – except as provided in subsection (b), GI does not include interest on any State or local bonds. b. Exceptions: § 103(b): (1) Private activity bond: which is not a qualified bond (under § 141). Proceeds of these bonds are used to fund private activity not contributing to the public. (2) Arbitrage Bond (within § 148): Where a state/local government borrows money at a low rate, issues bonds at a higher rate, and profits off the spread. (3) Bonds not in registered form (within meaning of § 149): Bearer bonds (unregistered bonds). Bonds with no name on it (i.e., who it is registered to). 2. Interest earned on bonds in § 103(b) is gross income. 3. U.S. Treasury Bonds, T-Bills, or Double E Bonds (interest earned for U.S. obligation is income). No exclusion for U.S. obligations. 4. State income taxes do not apply to federal interests. 5. State or municipality obligation (i.e., mutual funds) is generally not included in federal income tax. INCOME EARNED ABROAD 1. The Requirements to meet § 911 exclusion: a. Under § 911(d)(1)(A): To qualify for exclusion an American citizen must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year, OR b. Under § 911(d)(1)(B): An American citizen or resident must be preset in a foreign country or countries for at least 330 days during any period of twelve consecutive months. The exclusion applies only to foreign earned income which is defined as income from a foreign source which is attributable to the taxpayer‘s performance of services (i.e. salary income). UNEMPLOYMENT COMPENSATION: 1. § 85 – generally, GI includes unemployment compensation. 21 2.
C.
D.
E.
XII.
BUSINESS DEDUCTIONS: A. INTRODUCTION: Two very broad classes of deductions: 1. Business/Investment-Related Expenses 2. Personal Expenses a. Medical expenses, charitable contributions, property tax interest on their home, etc. Gross Income (ABOVE THE LINE) Adjusted Gross Income (§ 62) (BELOW THE LINE) Taxable Income 3. Business expense deductions are above the line when you are a self-employed, unincorporated sole proprietor, independent contractor. a. alimony, if it qualifies, also counts as above the line Below the line when you have unreimbursed employee § 162 expenses – job search, local transport, travel away from home, 50% of meals). a. below the line has caps b. also, deductions may be so small that they are less then the standard deduction Deductions for trade or business expenses: § 162 (can be self employed or independent contractor). 4 requirements and all 4 must be met: a. Ordinary & necessary; b. Expenses; c. Paid or incurred in the taxable year; and d. In connection with carrying on trade or business. § 162 Trade or business expenses deductions includes: a. A reasonable allowance for salaries or other compensation for personal services actually rendered; b. 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 c. 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.
4.
5.
6.
B.
THE ANATOMY OF THE BUSINESS DEDUCTION WORKHORSE: 1. “ORDINARY AND NECESSARY”: a. Necessary Test: Look to the subjective view of the taxpayer. If the taxpayer thought expenses were necessary, i.e., appropriate or helpful, then they will be deemed necessary. Ordinary Test: More of an objective standard. Is it common or customary/acceptable practice within this business for a person to do something like this? What are ordinary and necessary business expenses? i. advertising ii. car and truck expenses iii. labor iv. insurance v. office expenses vi. rent or lease vii. travel viii. meals ix. utilities
b.
c.
Welch v. Helvering, pg. 310 22
Welch, is the taxpayer who was the secretary of a grain company that was adjudged involuntary bankrupt. Welch paid off some of the corporation‘s debts to reestablish his relations with customers whom he knew. Welch was under no obligation to pay the corporation‘s debt Held: The court said Welch thought the payments were necessary. However, the court found that it was NOT ordinary for someone to pay the debts of someone else in this business community. Welch fails the ordinary prong and thus, the expense is not deductible. 2. EXPENSES: in order to qualify as a §162 deduction, the expense must be business related. If it is a capital expenditure, then it is an adjustment to basis (under § 1016). a. Repairs (to keep in ordinarily efficient operating condition) tend to be expenses, but replacements (to prolong life of property, increase its value or make adaptable to different use) tend to be capital expenditures. If you ―put‖ in an efficient operating condition = capital expenditure. If you ―keep‖ in an efficient operating condition = deductible because it is an expense. Reg. § 1.162-4 – Repairs: Look to whether the expense keeps the property in an ordinary efficient operating condition. Does it add value? If so, not an expense. § 263 – Capital Expenditure: Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate – must be amortized, added to basis, and expensed over time a period of time. i. Reg. 1.263(a)-1 – Capital Expenditures in general ii. Reg. 1.263(a)-2 – Examples of Capital Expenditures: cost of acquisition or construction of buildings, machinery, equipment, and similar property having a useful life substantially beyond the taxable year. If it‘s something that should have been part of the original cost of buying the item, not an expense i. ie. If you put a back window on a car; can‘t count as an expense b/c should have come with the car when it was first bought
b.
c.
d.
e.
Indopco v. Commissioner, pg. 313 To qualify for § 162 payment, must be an expense and not a capital expenditure. An expense = a possible deduction. A capital expenditure is not a deduction because it is an increase in adjusted basis. Norwest v. Commissioner, pg. 320 Taxpayer remodeling and had to remove asbestos from building. Tried to claim removal expenses a § 162 deduction. Taxpayer claims this was a repair. IRS contends that it is only a part of a grand remodeling scheme and therefore a capital expenditure. Held: Because the removal of the asbestos-containing materials were part of a general plan of rehabilitation and renovation that improved the Douglas Street building, the costs must be capitalized. 3. Paid or incurred in the taxable year (3rd prong) a. will never be an issue for this class “CARRY ON” BUSINESS: a. General question: are you in the business when you incur this expense? If you are, then you are carrying on. Must use the following considerations: (1) How long has person been in a specific trade or business before making the business expense? (2) If a person has been away from a specific trade or business, how long has his participation in that trade or business lapsed? Rev. Ruling 75-120. b. Non-deductible Start-Up Costs § 195(c)(1)(A): defines non-deductible start-up costs as (1) Investigating the creation or acquisition of an active trade or business (2) Creating an active trade or business, OR (3) Activities engaged in for profit before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. c. § 195 – Non-deductible start-up costs: those expenses that but-for the carrying-on requirement would have been deductible under § 162, these costs are capitalized: 23
4.
(1) Old section allowed for amortization over a period not less than 60 months, but NEW section, the maximum you can deduct in year ONE is 5,000 and the rest deductible over 15 years i. i.e. you have 45k of start up fees, 5k is deducted the first year and remaining 40k is deducted over the next 15 years (2) But if you are over 50 k in start up fees, the first year gets reduced b the amount that exceeds 50k i. EX. You have 52k in start up fees, get 3k in the first year (5k-2k over 50k) and 49k in the next 15 years (3) Amortization: just like depreciation, but not dealing with a tangible asset. Ratable write-off, or expensing of an asset. Tangible assets are associated with depreciation. **Section 195 presumes you actually enter the business Morton Frank, pg. 338 Morton and his wife toured the country looking for the perfect newspaper or radio station. They tried to deduct travel expenses incurred during their nationwide search. Held: Because Morton and his wife were not in their business yet, they were not carrying-on business. This cost incurred while trying to acquire the business is part of the acquisition cost, so it is capitalized. Morton can add the cost to basis. Problem 1 (pg. 342): Determ the deductibility under §§ 162 & 195 of expenses incurred in the following situations. a) Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation. NO, not deductible. Not carrying on a trade or business. These are start-up expenses under § 195, however, and can be amortized. b) The facts are the same as in (a), above, except that Tycoon, rather than having been a doctor, was a successful developer of residential and shopping center properties. YES, probably within the same line of business. An expansion of one‘s business is normally treated as being within one‘s line of business. c) The facts are the same as in (b), above, except that Tycoon, desiring to diversify her investments, incurs expenses in investigating the possibility of purchasing a professional sports team. NO, not within line of business, or even a normal expansion thereof. Can go to 195 **Section 195 is exclusively related to startup expenses Ex. Can NOT amortize law school once you start working 5. JOB HUNTING: § 162 Expenses as an Employee (i.e., job-hunting): Have to be in the business long enough to be considered in the business. a. Deductible below the line as ―Misc. Itemized‖ Deductions (subject to a 2% of AGI floor).
Problem 2 (pg. 343): Law student‘s Spouse completed secretarial school just prior to student entering law school. Consider whether Spouse‘s employment agency fees are deductible in the following circumstances: a) Agency is unsuccessful in finding Spouse a job. NO, she is not employed. b) Agency is successful in finding Spouse a job. NO, still not in trade or business when expense was incurred. § 195? Probably no. Not applicable to an individual unless they buy the business and become self employed. c) Same as (b), above, except that Agency‘s fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse has begun working. No, still not in connection w/ a trade or business d) Same as (a) and (b), above, except that Spouse previously worked as a secretary in Old Town and seeks employment in New Town where student attends law school. Yes, spouse is already a secretary and these are in connection w/ carrying on same trade or biz Must be a substantial amount of time, probably around 6 months Rev. Ruling 75-120: job-hunting expenses are deductible if trying to find new work in the same line of business. But, if too much time elapses (uncertain how much), continuity is broken and deemed no longer in that line of business. 24
e)
Same as (d), above, except that Agency is successful in finding Spouse a job in New Town as a bank teller. No, not the same line of business. What if the Spouse asked the Agency to find her a job as a secretary, but the Agency was only able to find her a job as a bank teller, are these expenses deductible? These expenses will be deductible if the Spouse was already a secretary even if she takes the bank teller position b/c all that matters is her initial intent to find a job as a secretary – the Agency‘s success is not a condition to the deduction.
Your deductions, as an employee, depend on your AGI. Can only deduct the excess of your § 162 expenses that exceed 2% of your AGI. So, if you have $1,000 of § 162 expenses, and $30,000 of AGI, 2% of which is $600. a. So, can only deduct $400, which is the excess of $1,000 from the 2% floor. b. BUT, IF YOU CAN DEDUCT ABOVE THE LINE, NO LIMIT. c. Employee related expenses are under misc. itemized deduction 7. When you are looking at itemized deduction: a. medical b. taxes paid c. interest d. Misc. itemized deductions-employee related business expenses are under this category –misc. expenses i. All of these misc. itemized deductions are subject to a 2% AGI floor (above) e. Ex. Gross income of 120k, above the line deductions=20k i. since AGI 100k, 2% floor =2k ii. So, to get any deduction, you have to have misc. itemized deductions of at least 2k, can only deduct what is above the floor f. Look @ 1040 form a. itemized deduction in form A b. add them up and see if they are greater than the standard deductions 8. Travel Expenses: a. If you are self-employed, the transportation expense deduction is above the line (above AGI) b. If you are an employee, the transportation expense is below the line (below AGI – usually part of itemized deductions) c. Transportation between 2 workplaces = deductible (i.e., law firm job to flipping burgers, the travel between the 2 jobs is deductible). d. Travel between 2 regular places of business is deductible. e. Going to and from a non-regular place of business is deductible. f. Anytime you are local, your meal is not deductible (unless you are entertaining clients). g. For mileage in 2006 =44.5 cents/mile, for 2007= 48.5 cents/minute h. To calculate actual costs: figure out based on your business miles; car insurance, repairs, gas costs, and then pro-rate your business miles (if your business miles are ¼ of all miles-then take ¼ of all costs associated with the car and expense those) C. SPECIFIC BUSINESS DEDUCTIONS: 1. TRAVEL “AWAY FROM HOME”: a. Transportation Expenses – § 162: If you commute 40 miles each way to work and back, can you deduct the resulting expenses? NO. You are not carrying on a trade or business until you are at work. § 1.162-2(e) – Commuters‘ fares are not considered as business expenses and are not deductible. § 262 – except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses. § 1.262-1(b)(5) – Taxpayer‘s cost of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses. Local commuting is not deductible; you chose where to live b. Get to work and have to pay for parking. Deductible? No, still not carrying on business/trade. Employer providing parking - $180 per month is deductible post-2001; pre-2001 it is $175 per month.
6.
25
If self-employed, and must pay for parking, it is NOT deductible b/c still part of your commute.
c.
LOCAL EXPENSES ARE DEDUCTIBLE ABOVE-THE-LINE AS SOLE PROPRIETORS, BUT BELOW-THE-LINE AS ―MISC. ITEMIZED‖ DEDUCTIONS FOR EEs.
Problem 1 (pg. 374): Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch in various restaurants in the City. a) May Commuter deduct his costs of transportation and/or meals? Transportation = commuting and therefore are not deductible. Can‘t deduct lunches because those are personal costs. b) Same as (a), above, but Commuter is an attorney and often must travel between his office and the City Court House to file papers, try cases, etc. May Commuter deduct all or any of his costs of transportation and meals? Yes this is a local transportation expense; going between two places of work is deductible You CAN deduct going from home to a temporary place of business, i.e. client‘s home, or someplace you don‘t go all the time. c) Commuter resides and works in City, but occasionally must fly to Other city on business for his employer. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or a part of his costs? Transportation is deductible, but the cost of the meals is not because it is considered local (i.e., a day trip). d. Meals – § 162(a)(2): Are deductible if incurred while traveling away from home overnight, or for a period that would be considered overnight. e. Limitation on Meals/Entertainment Expenses: (1) § 274(n)(1): anytime a meal or entertainment is deductible, you can only deduct 50% of it. f. How to determine what is ―Home‖ per the IRS? (1) Home for tax purposes is where your principle place of business is located (―tax home‖). If there is no principle place of business, then will look at where you live. If no home, then you are itinerant, and have no home, and have no deduction for meals. Problem 2 (pg. 375): Taxpayer lives with her husband and children in City and works there. a) If her employer sends her to Metro on business for two days and one night each week and if taxpayer is not reimbursed for her expenses, what may she deduct? Transportation is deductible. Lodging is deductible for those 2 days. Meals are deductible at 50%. Incidentals (tips, telephone, etc.) are deductible as well. b) Same as (a), above, except that she works three days and spends two nights each week in Metro and maintains an apartment there. If home is City, then Metro business expenses are fully deductible (minority view) if reasonable. If home was Metro, then City business expenses are deductible. Your tax home is your principle place of business c) Taxpayer and Husband own a home in City and Husband works there. Taxpayer works in Metro, maintaining an apartment there, and travels to City each weekend to visit her husband and family. What may she deduct? IRS would make Metro tax home, and thus everything would be commuting expenses, and not deductible. Andrews v. Commissioner, pg. 363 A had 2 homes – one in New England and one in Florida. Had a swimming pool construction business in NE. In Florida, A works with horses. Tries to write-off expenses in Florida, saying that principle place of business is NE. IRS maintains that A has 2 tax homes. Held: Court said it is not possible to have 2 tax homes. The underlying rationale is to ease the burden of duplicative expenses, which A in this case had. Factors looked at are (1) where you make the most money, (2) where you spend most of your time, (3) where your car is registered, etc. Note: If facts were different, and A merely rented space in both NE and FL, then he would resemble a traveling salesman, and would not be able to deduct anything. 26
g.
h.
i.
Normal situation where you can incur business expenses away from home – go to a convention, seminar, other city for short period of time, etc. (1) Then you can deduct meals, lodging, etc. (2) You are required to be gone long enough and far enough away where you need to sleep over. Rev. Ruling 75-4320: “Overnight Rule”: To be away from home, you need to be away far enough and long enough that it would be logical for you to stay overnight. Does not require overnight stay and therefore, you can deduct meals, but not lodging because you didn‘t incur lodging expenses. What if you are looking for a job? Only deductible if you are already in that business . . .
Problem 5 (pg. 376): Traveler flies from her personal and tax home in NY to a business meeting in Florida on Monday. The meeting ends late Wednesday and she flies home on Friday afternoon after two days in the sunshine. a) To what extent are Traveler‘s transportation, meals, and lodging deductible? Just because she had pleasure time does not mean she loses her deductions. Can still deduct airfare (§ 1.162-2(b)(1&2)) if trip was primarily business rather than personal. Time spent on each is an important factor. Here, clearly had a business purpose. Transportation is either all or not deductible, here it is all. Lodging is deductible through Wednesday, but Thursday and Friday are not. Meals are 50% deductible through Wed., but not Thurs. or Fri. Same with incidentals. b) May Traveler deduct any of her spouse‘s expenses if he joins her on the trip? No. he is not related to the business. If lodging is a flat rate, then that‘s fine, still deductible but any extra costs per person are not deductible. c) What result in (a), above, if Traveler stays in Florida until Sunday afternoon? If time is the only factor, this would be a fun trip, but, not only factor. Can argue that weekends don‘t apply b/c can‘t work anywhere, merely sandwich the work week. Can still argue that the main purpose was business, and can deduct all travel, plus business meals, lodging, and incidentals. Hypo: W,Th, F business trip. Airfare is $800. Per day meals and lodging are $150. What‘s deductible? $800 airfare, + $450 in meals and lodging = $1,250 Hypo: What if stay over until Sunday morning to get a better airfare? $600 airfare deductible + $450, + $150 for next day because cheaper than it was before, so you are actually saving company money. If it is not cheaper, can‘t do it. Can only deduct up to how much would have cost if paid airfare of $800. Therefore, up to $200 of fun could be deductible. **Deductible travel expenses are above the line if self employed, but below the line if not 2. EXPENSES FOR EDUCATION: (that is related to your trade or business) a. You are a practicing lawyer and go to CEB seminar. Deductible? Yes. § 162 deduction. b. What if you are a student and you take a bar review course? No, not carrying on a trade or business. c. What if law student graduates and then decides to get an LL.M. in Tax? No, probably not. d. What if doctor and spend 2 years studying to get a specialty? Maybe. e. still under 162, ordinary & necessary, paid/incurred in year, expense, existing biz
Hill v. Commissioner, pg. 385 Taxpayer was a schoolteacher for 27 years. TP took summer school classes at Columbia University to keep her teaching certificate current. The state requires teachers to have a valid teaching certificate. State law allowed teachers to choose between 2 types of education: (1) acquiring college credits; and (2) passing exam on 5 selected books. Held: The expenses/tuition was deductible. Just because most people choose the other way to do it, does not mean the expense was not ordinary and necessary. § 1.162-5 – You are entitled to an education deduction if it is required by an employer or some regulatory body or if the education maintains or improves skills required by individuals in his employment or other trade or business. 27
Coughlin v. Commissioner, pg. 389 TP is an attorney who attended NYU‘s Annual Institute on Federal Taxation. TP tries to deduct travel, tuition, meals, & lodging. Conference attendance was not required, but TP went so that he could keep up-to-date on current tax issues. Held: Court says TP was morally bound to keep informed and therefore, the expenses are deductible. § 1.162-5(1) – You are entitled to an education deduction if it maintains or improves skills required by the individual in his employment or trade or business. Can deduct tuition, traveling expenses, meals, and lodging to the same extent as business expenses are. Therefore, no deduction for meals or lodging if TP is not traveling away from home. Still get local expenses e. What is not deductible? § 1.162-5(b) – Minimum education required to get into trade/business (i.e. law school is not deductible). Rationale: Not in connection with trade/business. § 1.162-5(b)(3) – Qualification for new trade or business: Second category of nondeductible educational expenses are expenditures made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.
f.
Problem 1 (pg. 389): Alice, Barbara, Cathy, and Denise were college roommates who after graduating went on to become a doctor, a dentist, an accountant (C.P.A.), and a lawyer, respectively. In the current year, after sometime in practice as an orthopedic surgeon, Alice, who was often called upon to give medical testimony in malpractice suits, decided to go to law school so as to better understand this aspect of her medical practice. Barbara enrolled in a course of postgraduate study in orthodontics, intending to restrict her dental practice to that specialty in the future. Cathy enrolled part time in law school (with eventual prospects of attaining a degree) so as better to perform her accounting duties in areas in which law and accounting tend to overlap. And Denise took a leave of absence from her firm to enroll in an LL.M. course in taxation, intending to practice exclusively in the tax area. Which, if any, is incurring deductible expenses of education? A = not deductible expenses because it qualifies her for a new profession. B = IRS says it is deductible because it‘s just like you are becoming a better dentist. § 1.162-5, example 4 (pg. 932). C = not deductible because it qualifies her for a different trade or business. D = If she was a tax attorney, then it is deductible. Problem 2 (pg. 389): Assume Denise‘s expenses in problem 1, above, are deductible. If she is a practitioner in Seattle, Wash., who travels to Gainesville, FL for a year to participate in their LL.M. program, what expenses, in addition to tuition and books, may she deduct? Travel, lodging, and meals(50%) that are related to her educational pursuit. Any travel, lodging and meals that occur due to personal trips during this time will not be deductible. Problem 3 (pg. 389): Carl earned a bachelor‘s degree in education and he teaches world history in a junior high school. In the current year he contemplates a summer European tour doing things that will be beneficial to his teaching efforts. He wishes to know if he may deduct his expenses. What do you advise? No, he cannot deduct his expenses. § 274(m)(2) – Travel as form of education: No deduction shall be allowed under this chapter for expenses for travel as a form of education. Problem 4 (pg. 380-381): Dentist attends a five day dental seminar at a ski resort. All of the seminar proceedings are taped and Dentist skis on clear days and watches all of the tapes on snowy days or in other off-the-slopes time prior to his return home. Are Dentist‘s travel, meals and lodging deductible? No! There is no reason for D to go…not primarily for business D. MISCELLANEOUS BUSINESS DEDUCTIONS: 1. ENTERTAINMENT ACTIVITY EXPENSES: If self-employed, deduct above the line. If an EE, then deduct below the line. a. § 274(a)(1)(A): Only get a deduction if activity was directly related to, or, associated with legitimate business conduct. b. Directly Related To Test under § 1.274-2(c) – directly related to the act or conduct of a trade or business, OR have to be actually talking about business at the game or concert or dinner. § 1.274-2(c)(7) says that some places are so distracting that no business can take place or if taxpayer not present, cannot take the deduction. (ie concert or nightclub) 28
c.
d. e.
Associated With Test under § 1.274-2(d) – immediately following or immediately preceding a substantial and bona fide business discussion (i.e. have business meeting in office, and then goto dinner – it‘s deductible; have business meeting in office, and then goto play golf or basketball game – it‘s deductible). § 274(n)(1) – There is a 50% limitation for any entertainment expense that qualifies under § 274. § 274(d) – Substantiation requirement: To get the deduction, you must substantiate it. (1) You need to keep a record – receipts, or a log of how much, time, place, business purpose, etc. (2) Cohan rule says you can estimate expenses. However, for entertainment expenses, you must meet the substantiation requirement.
2.
3.
ENTERTAINMENT FACILITY EXPENSE: a. § 274(a)(1)(B): cannot deduct any entertainment facility. b. Dues to country club, athletic clubs, luncheon clubs are considered facilities and therefore are NOT deductible. c. However, expenses incurred while you are using one of those facilities may be deductible. GIFTS: § 274(b)(1) – You can only deduct $25.00/year/recipient.
Problem 1 (pg. 396): Employee (EE) spends $100 taking 3 business clients to lunch at a local restaurant to discuss a particular business matter. The $100 cost includes $5 in tax and $15 for a tip. They each have 2 martinis before lunch. a) To what extent are EE‘s expenses deductible? Passes directly related to test, as well as § 162, so can deduct 50% of the entire tab = $50. b) To what extent are the meals deductible if the lunch is merely to touch base with the clients? If you are just saying hi, remember me, then not deductible – b/c it doesn‘t meet directly related to or associated with test. c) What result if EE merely sends the 3 clients to lunch without going herself but picks up their $75 tab? Not deductible because the taxpayer must be present at the entertainment to deduct it. § 274(k)(1)(B). Possibility that this could be a business gift – § 274(b). If so, can only give $25/year. d) What result in (a), above, if, in addition, EE incurs a $15 cab fare to transport the clients to lunch? This is 100% deductible because it is like going to the client (i.e. local transportation). Problem 2 (pg. 399): Businessperson who is in New York on business meets with two clients and afterward takes them to the Broadway production of The Phantom of the Opera. To what extent is the $600 cost of their tickets deductible if the marked price on the tickets is $100 each, but businessperson buys them from the hotel concierge for $200 each? Meets the associated with test because he met with clients before the show. Presumed to be unable to meet the directly related to test because of the nature of the entertainment (Broadway show). $150 is deductible, because under § 274(l)(1)(A) can only deduct 50% of the face value of each ticket. 4. MISCELLANEOUS BUSINESS EXPENSES: a. Uniforms under Rev. Ruling 70-474: Uniforms can only be deducted if (1) They are specifically required as a condition of employment, and (2) Are not the type adaptable or suitable to general or continued usage such that it replaces ordinary clothing Examples: police officers, firemen, jockeys, Fed Ex/UPS, baseball player, pilots, etc. EXCEPTION: has been made for a fashion coordinator who fits some extreme conditions. ALL UPKEEP COSTS, such as dry cleaning and laundry associated w/ approved uniforms = ARE deductible. Military Uniforms under Reg. § 1.262-1(b)(8): IRS takes the position that uniforms of military personnel are for general use and generate no deductions; EXCEPTION for uniforms of reservists and also for swords.
b.
Dues: ordinarily business dues or dues for clubs or professional organizations are deductible under § 162. (1) What about subscriptions to magazines that relate to your work? Deductible, but not general publications 29
(2) What about contributions directly or indirectly to political candidates and political parties? NOT deductible. Problem 3 (pg. 388): Airline pilot incurs the following expenses in the current year: (1) $250 for the cost of a new uniform. Yes deductible. (2) $30 for dry cleaning the uniform. Yes – care and maintenance of a deductible uniform. (3) $100 in newspaper ads to acquire a new job as a property manager in his spare time. No – not in connection with carrying on a trade or business. (4) $200 in union dues. Yes – deductible. (5) $50 in political contributions to his local legislator who he hopes will push legislation beneficial to airline pilots. No – not deductible. (6) $500 in fees to a local gym to keep in physical shape for flying. No – not deductible. XIII. DEDUCTIONS FOR PROFIT-MAKING, NONBUSINESS ACTIVITIES: A. SECTION 212 EXPENSES: Expenses for the production of income. Similar to § 162 expenses. Semi-business, profit-related expenses. Requirements: 1. Allowed as a deduction for all ordinary and necessary expenses paid or incurred in the taxable year for: a. Production or collection of income, b. c. 2. 3. The management, conservation, or maintenance of property held for the production of income, OR In connection with the determination, collection, or refund of any tax.
§ 212 Expenses are non-business expenses and are deductible BELOW-THE-LINE. The only expenses that are deductible above the line are those relating to RENTS and ROYALTIES. Examples: a. You have a condo that you rent out for a profit and incur maintenance expenses. Deductible because it is related to maintenance of property for income. b. You pay a lawyer to collect money from renters. Deductible. c. You pay a gardener $50/month to maintain rental property? Deductible. d. What if you add on a new garage? No – not an expense, it is a capital improvement e. You pay your accountant for preparing your tax returns? Deductible.
Higgins v. Commissioner, pg. 440 Higgins was an investor, but only invested his own money. H incurred expenses for investments of stocks, bonds, securities, etc. and hired people to assist him in his investments. He has an entire staff, office, etc. in NYC to handle the investments. IRS said he wasn‘t engaged in a trade or business. Held: The court held that this did not qualify as a deduction under § 162 because it was not done for carrying on business. Note: As a result because Congress was unhappy w/ the resutl, Congress passed § 212 to encourage business. B. Under § 62(a)(4): Allows certain § 212 expenses to be deductible above the line (i.e., rents or royalties). 1. Example: you own an investment home and incur management expenses, gardening, maintenance expenses, etc. These are not rental or royalties related and therefore must be deducted below the line.
XIV.
DEDUCTIONS – MOSTLY PERSONAL IN NATURE: A. INTEREST EXPENSE 1. Interest Associated with a Trade or Business: a. You are a sole proprietor and buy office furniture, it is deductible. 30
2.
Personal Interest: § 163(h) – No deduction allowed for personal interest paid or accrued during the taxable year by a taxpayer other than a corporation. a. § 163(h)(2)(A) – Personal interest is any interest paid or accrued other than: (1) Interest paid or accrued on indebtedness properly allocated to a trade or business. (2) Any investment interest. (3) Any interest which is taken into account (4) Any qualified residence interest. b. Interest incurred as an EE = personal interest. c. Interest incurred as a sole proprietor is not personal interest d. Credit card interest, school loans, car loans, etc. are not deductible under § 163. e. Interest for home mortgages is deductible.
Problem 1 (Handout – Deductions for Interest Paid): In 2006, Tricia purchased a new car for $40,000, financing the entire purchase with a car loan from the bank (the loan was secured by the new car). In 2006, she paid interest in the amount of $4,200 on the loan and she expects to pay another $3,600 in interest in 2007. In each of the following independent scenarios, what is Tricia’s interest deduction for 2006 and 2007? a) For this part only, assume Tricia uses the car only for personal use. Not deductible because use was personal [§ 163(h)]. b) For this part only, assume Tricia is an EE of a law firm in L.A. and uses the car 80% for commuting to and from work and 20% for pleasure. Not deductible because she is an employee [§ 163(h)(2)(A)]. c) Same as part (b), above, except that Tricia uses the car 30% for driving between the office and clients‘ offices, 40% for commuting to and from the office, and 30% for pleasure. Not deductible because she is an employee and this is dealing w/ interst If you were dealing w/ mileage 30% would be deductible d) Same as part (c), except that Tricia has her own law practice (Self-employed as an unincorporated sole proprietorship). 30% of the interest is deductible because she is self-employed and therefore, it is not a personal interest, but a business or trade interest. 2006: 30% of $42000 interest paid = 1260 2007: 30% of $3,600 interest paid = 1080 3. Qualified Residence Interest – § 163(h)(2)(D): Qualified Residence Interest Personal Interest a. Requirements: § 163(h)(3) (1) Qualified residence; and (2) Proper type of debt (acquisition loan/debt or home equity loan/debt). b. (1) Qualified Residence: § 163(h)(4)(A) A qualified residence can be a primary residence, as well as one other residence. If you have 2 or more secondary residences, each year choose which one you want to count. § 280(a)(D)(1) – To qualify a second home you must either: (1) Not rent it out; or (2) If rented out, you and your family must use it for personal use during the year for more than the greater of 14 days or 10% of the time it was rented out. i.e., the greater of either 14 days + 1 or 10% + 1. Hypo: You rent out your condo for 100 days. You and your family must use it for 15 days during the year. Hypo: You rent out your condo for 200 days. You and your family must use it for 21 days during the year. (2) Proper type of indebtedness: There are 2. (1) Acquisition Debt or Loan: Borrowed funds used to buy a home. Acquisition Indebtedness is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence. [**Limited to $1 million of the loan mortgage amount]. (2) Home Equity Debt or Loan: Money borrowed that is secured by a home and does not need to be used for home. [**Limited to the amount of equity in your home and cannot exceed $100,000]. 31
c.
d.
Equity = FMV – the amount you owe. Also known as a 2nd mortgage. § 163(h)(3)(C): Any indebtedness secured by the qualified residence and does not exceed the equity in your house.
Problem 2 (Handout: Deductions for Interest Paid): Jack purchased a home in 2005 which is used as a principal residence. Unless otherwise indicated, all loans obtained by Jack 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? The purchase price (and FMV) of the home was $350,000, Jack paying $100,000 as a cash down payment and obtaining a non-recourse loan for the balance of the purchase price. The interest on the $250,000 loan is deductible b/c it is acquisition indebtedness and under $1M b) The facts are the same as in part (a), above, except it is now 2007. 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 FMV of the home is now $380,000. Jack decides to take out a 2 nd mortgage loan for $60,000 and uses the proceeds to remodel the kitchen and to add a fourth bedroom. Equity is $150,000 [380k – 230k] May not be home equity indebtedness, but may be acquisition indebtedness b/c money was used for improvements. Still under $1 million, so interest on $60,000 is deductible. c) The facts are the same as in part (b), above, except that Jack uses the new loan proceeds to buy a new expensive car instead of making the home additions. Now it is a home equity indebtedness and the interest is fully deductible because the amount is below $100,000. d) The facts are the same as in part (a), above, and it is now the year 2007. 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 FMV of the home is now $380,000. Interests rates have declined since 2005 and Jack ―refinances‖ (obtaining a new loan to replace the old loan). This is acquisition indebtedness b/c it takes the place of what was an acquisition indebtedness and therefore, the interest is deductible. § 163(h)(3)(B): If it replaces an existing loan, it takes on the same character. e) Same as part (d) above, except that Jack does a ―cash-out refinance,‖ obtaining a new loan in the amount of $340,000. The $110,000 in cash available to Jack ($340,000 loan less pay-off of old $230,000 loan) was used to acquire a pleasure boat. Typically a refinance is a recourse loan. $230,000 is acquisition indebtedness and the interest is deductible. $110,000 is home equity indebtedness and b/c there is a $100,000 cap, interest on $100,000 is deductible, but remaining $10,000 is not. f) Same as part (a), above, except that in addition to the purchase of the house, Jack bought a condo at Mammoth Mountain for $160,000, paying $50,000 down and obtaining a loan for $110,000. In 1998, Jack obtained a second mortgage loan on the condo 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. Condo is a qualified residence because it is not rented out. Interest on $110,000 is deductible as Acquisition Indebtedness, as is $10,000 (1/2 of 2 nd loan of $20,000); the half used for the vacation is not deductible Interest on the other $10,000 which is a home equity loan is fully deductible. 4. Points: Interest that you are paying the lending institution up front. a. 1 point = 1% of the amount you are borrowing. b. § 461(g) – Prepaid Interest: Prepaid interest can be paid so long as it is amortized over the life of the loan. You can‘t deduct interest in that year for interest that should have been deducted at a later date. Example: $300,000 loan @ 1 point, over 30years means that you can only deduct $100/year. § 221 Interest on Educational Loans: a. This deduction is above the line. b. Must meet 3 requirements: (1) Qualified education loan [§ 221 (e)(1) (2) Used for qualified higher education expenses [§ 221(e)(2)]; and 32 a)
5.
c.
(3) At a qualified educational institution [post high school education (i.e., undergraduate, advanced degree, trade school, non-correspondence school)]. 2 Important Limitations: (1) Maximum deductions allowed [§ 221(b)]. (2) Deduction phased out [reduced or eliminated] if you make too much money [§ 221(b)(2)].
B.
Deductions for TAXES PAID 1. Under § 164: Except as otherwise provided, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued: (1) State, local & foreign real property taxes; (2) State & local personal property taxes; Examples: boats, cars, etc. So you can deduct your DMV registration fees which is based on value (i.e., ad valorem). (3) State, local & foreign income, war profits, & excess profits taxes; Any state tax withheld, paid in estimated tax payments, or paid on April 15 th are all deductible. (4) Federal income tax is NOT deductible (5) 164(b)(2) you can choose betw. deducting state sales tax or state income tax 2. Automobile registration fees – are deductible as a personal property tax in California 3. Real Property Taxes - § 164(d) Cramer v. Commissioner, pg. 492 Cramer paid taxes in ‘64, ‘65, and ‘66, some of which were incurred by her mother. 1) Atkinson Property: Plaintiff‘s mother‘s property. Plaintiff paid property taxes for ‘65 and ‘66. Plaintiff had no legal or equitable interest in the property during ‘65, or ‘66. Held: The court held that plaintiff was not the obligor and taxes are deductible only if you are obligated to pay them. Court said that the payments = a gift or other kind of advances. Auburn Property: In August 1963, plaintiff sold property to Osborn under a land sale contract. 2) § 164(d)(1): Apportionment of real property taxes between the seller and purchaser based on the number of days owned by each of the respective parties: Allocate portion of taxes while seller owned it. Buyer entitled to deduct the balance of the allocated portion for the year. Problem 1 (pg. 503): Which of the following taxes would be deductible as such under § 164? a) A state sales tax imposed at a single rate on sellers but required to be separately stated and paid by purchasers to sellers, applicable to retail sales of any property except food, clothing, and medicine. § 164(b)(2)(5)-it depends, can choose between state sales tax or state income tax. b) A state real property tax of $1,000 for which A became liable as owner of Blackacre on January 1 st but which B agreed to pay half of when he acquired Blackacre from A on July 1 st. ½ of taxes is deductible = $500. c) A state income tax. Deductible on federal return. d) The federal income tax. Not deductible. e) A state (or federal) gasoline tax imposed on consumers. Not deductible, but used to be deductible before 1986. Problem 3 (pg. 495): Son who is still in college owns substantial securities. Father, when paying his own intangibles tax to State X, pays the intangibles tax due by Son. Intangibles tax is based on the value of the intangible property you own (i.e., stocks/bonds). You pay a % of the value of your securities. It is imposed by the state. a) May Father deduct the tax paid? No. Father must the obligor and dad is probably not on title. b) Is it deductible by Son? Yes. This is the same scenario as if dad gave money to son to pay. In this transaction, it is deductible, so, son can deduct.
XV.
DEDUCTIONS FOR INDIVIDUALS: A. MOVING EXPENSES: Movers, a truck, transportation for you and your family, lodging, etc. 33
1.
2.
DEDUCTIBLE ABOVE THE LINE. § 62(15) § 217(b)(1) – Defines moving expenses: moving expenses include the reasonable expenses of moving household goods and personal effects from former residence to new residence, and of traveling (including lodging) from former residence to new residence. Meals are not deductible. 2 requirements: (1) Distance Test; and (2) Time Test. a. Distance Test – § 217(c)(1): concerned with old home, old work, and new work. Measured by the shortest, most common route between 2 places. FORMULA: (Distance from your old home to new job) – (Distance of your old home to old job) 50 Example 1: If your old house is in Malibu and your old job is in Calabassas (10 miles away) & your new job is in Ventura which is 55 miles away, then, 55 – 10 = 45 miles so you don‘t meet the distance test. Example 2: If your new job is in Carpenteria which is 75 miles from your old house, then 75 – 10 = 65 miles, so you meet the test BUT if you‘ve never worked or haven‘t worked in a while, then you can deduct if old home to new job exceeds 50 miles. Time (or work-related test) – § 217(c)(2): in general, the job must be in the same general location for a certain period of time after the move. (1) Employees: You need to work full-time for 39 weeks after you move. It doesn‘t matter if it‘s the same job or not. Must work 39 weeks of 1st year in that new place once you get there. What happens if I move in November? Meet distance test, but what about time test? You still get the deduction if you expect to qualify, but if you don‘t then amend it later Exceptions if you get laid off or become disabled, etc. (2) Self-Employed: Need to look at 2 periods. (a) Need to work a minimum 39 weeks the first year; and (b) 78 weeks out of the first two years. This prevents you from bunching the weeks up into the 2 nd year. You can work 52 weeks the first year and only 26 weeks the 2nd year.
b.
Problem 1 (pg. 547): Lawyer has been practicing law in Town X and he and his family live in Suburb of Town X ten miles away. He decides to open an office in Town Y. Consequently he moves himself and his family to a home in Town Y. a) How far away from Suburb must Town Y be located in order for Lawyer to be allowed a moving expense deduction? 60 miles [x – 10 = 50] b) 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 in Town X and he was not employed? 50 miles. c) Assuming Lawyer is a sole practitioner what time requirements are imposed on him in order for § 217 to apply? 39 weeks in the first year, and 78 over the first 2 years. d) What difference in result in (c), above, if Lawyer joins a firm in Town Y as a partner? Minimum of 39 weeks in first year and a total of 78 weeks over the first 2 years b/c a partner is not an EE, but an owner – self-employed. e) What difference in result in (c), above, if Lawyer goes to work for a firm in Town Y but as an associate rather than a partner? 39 weeks in the first year. f) Assuming the necessary time and distance requirements are met, and that a joint return is filed, what is the amount of Lawyer‘s § 217 deduction if he incurs the following expenses: $400 in moving his family‘s belongings; $150 in transporting his family; and $100 in lodging and $200 in meals in conjunction with transporting the family? Everything but the meals is deductible. [400 + 150 + 100 = 650]. g) Is there any difference in the result in (f), above, if Lawyer‘s spouse also takes a job in Town Y and meets the necessary time and distance requirements? 34
No – only one spouse has to qualify all by herself or himself. h) If Lawyer‘s firm reimburses Lawyer for $850 of his expenses in the year they are incurred, what tax consequences will the reimbursement have? This is a fringe benefit and it is a qualified moving fringe [§ 132(a)(6)]. Thus, $650 is excluded, but $200 is income. B. EXTRAORDINARY MEDICAL EXPENSES: § 213 1. 2. DEDUCTIBLE BELOW THE LINE. Only get to deduct medical expenses if they exceed 7.5% of your AGI. So you‘re probably looking at a catastrophic illness or someone without insurance for it to be deductible. Only get to deduct what exceeds the 7.5% floor. Example: Your AGI is $100,000, then your medical expenses must exceed $7,500 in order to deduct. § 213(b): Medicine and drugs are deductible is it is prescribed. Over the counter stuff is not deductible. Non-smoking programs deductible, but not non-prescription drugs (the patch, nicotine gum). § 213(d)(1): Medical care means amounts paid for: a. Diagnosis, cure, mitigation, treatment, prevention, etc. Includes hospital stay, meals, etc. But not for purely cosmetic surgery. b. Transportation relating to medical care (i.e. ambulance) c. Insurance premiums
3. 4.
Raymon Gerard, pg. 540 RG tried to deduct a $1,300 central a/c unit as a medical expense b/c his doctor recommended it for his daughter who has cystic fibrosis. IRS said it was a capital expenditure, and not deductible, relying on § 263, which disallows a deduction, but allows for an increase in basis. Held: The court said the mere fact that medical expenditure is also a capital expenditure does not automatically disqualify it as a deduction. The court held that the increased value of the home by $800 was a capital expenditure and nondeductible. However, the difference of $500 is a medical expense deduction and is deductible. § 1.213-1(e)(iii): Codified Raymon Gerard. Capital expenditures are not deductible for income tax. However, look to see how much value of home goes up (this is the capital expenditure) and the excess is qualified as a medical expense. Also made fully deductible things such as glasses, artificial limbs, seeing eye dogs, false teeth or eyeballs, wheelchairs, ramps and grab bars to strictly facilitate the handicapped, etc. 5. § 213(d)(9): Cosmetic surgery, lyposuction, hair transplant, hair electorolysis, face lift, dance lesson, teeth whitening etc. are generally not deductible. Rev. Ruling 99-28: allows deduction for doctor prescribed ―Stop-Smoking Clinics‖ as a medical expense. Rev. Rulings 79-151: cost of program to lose weight where the program is designed to improve general health, even if recommended by a doctor, is generally not deductible. However, if the recommendation is made to cure a particular problem of the taxpayer, the expense should be held deductible.
6. 7.
Problem 1 (pg. 551): Divorced Homeowner installed a $4,100 a/c unit for her 20 year-old dependent daughter, which Dr. said was required. Increased home value by $2,100. Other expenses included prescriptions in the amount of $320, Dr.‘s bills in the amount of $400, and insurance premiums in the amount of $300. a) If HO‘s AGI is $12,000 for the year, what will be the amount of her medical expense deduction? Excess of $2,000 for a/c unit, plus total of $1,020 other medical expenses for a total of $3,020. 7.5% of AGI (12,000) = 900 $3,020 – $900 = $2,120 = total medical expense deduction b) If in the current year HO incurs maintenance expenses of $300 on the air conditioning system can that be taken into account as a medical expense? Would a $150 deduction for those expenses be more supportable assuming, of course, Daughter is still there and still asthmatic? And what about an estimate that $400 of the year‘s electricity bill is attributable to running the air conditioning system? § 1.213-1(e)(iii): if a capital expenditure qualifies as a medical expense, operation and maintenance expenses are deductible. Maintenance is entirely deductible even if none of the capital expenditure qualifies. Thus, $300 deductible. $400 electricity bill is also deductible. 35
C.
CHARITABLE CONTRIBUTIONS: You get a deduction for stuff you give to charity = BELOW THE LINE DEDUCTIONS 1. Generally you get to deduct the FMV of what you give to charity. 2. § 170(c): lists the places you can make charitable contributions to. 3. To be deductible, the benefit cannot inure to an individual. (i.e., you can give money to UCLA, but you can‘t say it‘s for my friend‘s operation). 4. A contribution to help somebody out in case of death or disaster is NOT deductible, but people often do it. People get around it by making check out to church, not to the individual. 5. There is no minimum floor for charitable contributions, but there is a cap on the amounts given, and other limitations. a. For cash = 50% of AGI (you can carryover the excess for the next 5 years). CASUALTY AND THEFT LOSSES: § 165(h) 1. § 165(h): Entitled to a deduction for destruction of property by acts of God or accidents and no insurance or insurance doesn‘t fully cover or if something is stolen. 2. 2 Limitations: a. § 165(h)(1): First $100 per casualty or event is non-deductible (sort of like a deductible to the government); AND b. There is no deduction until aggregate lost exceeds 10% of your AGI. c. These are part of itemized deductions THE STANDARD DEDUCTION: You take the greater of standard deductions or itemized deductions. GROSS INCOME AGI TAXABLE INCOME 1) Itemized Deductions OR Standard Deductions Personal Exemption Deductions
D.
E.
2)
1. 2. 3.
People don‘t take itemized deductions because their standard deduction is greater. Standard deduction = one lump sum deduction. § 63(c): Standard deduction amount depends on: a. Filing status; b. Age; and c. Blindness Standard deduction: Filing Status Single Married Filing Joint Head of Household
4.
2006 $5,150 $10,300 $7550
2007 $5,350 $10,700 $7850
5.
6.
Under § 63(c)(3)(2) & (f): add-on standard deductions for age (over 65) or blindness: Filing Status 2006 2007 Single $1,250 $1,300 Married filing joint $1000 $1050 a. You get to add to your standard deduction, the above if you are blind or old. b. Blindness: must see worse than 20/200 with corrective lenses with your best eye. c. Age: 65 or older measured on the last day of the year. d. If you are old and blind, you get 2 extra deductions. Caveat: If you are married filing separate, you either both have to itemize or both take the standard deduction.
F.
PERSONAL AND DEPENDENCY EXEMPTIONS: §§ 151 & 152 Automatically get this for yourself and your spouse if you are filing joint and your dependents. 1. § 151 – Personal exemptions. Added to the standard deduction. 2006 2007 36
2.
$3,300 $3,400 § 152 – can also get a deduction for dependents. Only one per person. a. The 2-Prong Test to determine a dependent: (1) Relationship requirement; and (2) Support requirement
XVI.
COMPUTATIONS OF TAX LIABILITY: A. COMPUTATION OF TAXABLE INCOME: Six step approach to computing taxable income: 1.) Figure out Gross Income. 2.) Compute adjusted gross income [check § 62 to see if deductions are above the line to get AGI]. 3.) Figure out Itemized Deductions ―below the line‖ a.) Make sure you are aware of the limitations, the floors, etc. 4.) Figure out person‘s standard deductions. a.) Make sure you see if there are extra deductions. 5.) Figure out personal exemption deductions. 6.) Determine taxable income. GROSS INCOME(1) AGI (2) TAXABLE INCOME Itemized Deductions (3) OR Standard Deductions (4) (6) Personal Exemption Deduct. (5)
Problem 1 (Handout – Computation of Taxable Income): Tad, a single individual under age 65 and with good eyesight, had gross income of $106,000 in 2006. He incurred and paid the following items in 2006: Qualified § 217 moving expenses of $6,000. § 163 ―qualified residence interest‖ of $4,000. (below the line) Medical expenses (as defined in § 213(d)) in the amount of $7000. § 164 property taxes in the amount of $900. (below the line) Unreimbursed § 162 business expenses (as an EE) in the amount of $1900. Tax preparation fees in the amount of $400. (§ 212) Please compute Tad’s Taxable Income for 2002 1) GI: $106,000 <$6,000> (Moving § 217) <$ 0> (§ 221 N/A b/c GI over $65,000) 2) AGI: $100,000 3) Itemized: a) $4,000 interest b) $7,000 (7.5% Medical Expenses) c) $900 (Real property taxes) d) $300 (Misc.) ($1900 Bus. Expenses+ $400 Tax Return—$2000 floor)* 4) Stand. Ded: $5200 (itemized deductions are more) 5) Pers. Exe: $3,300 (personal deduction) TOTAL: $91,500 2) Gross Income $106,000-married <6,000> (§217 Deduction-moving ) AG $94,500 -----------------------------Itemized a) Interest $4,000 b) Medical $7,000 (NO DEDUCTION) c) Real Property $900 d) Misc. $300 TOTAL: $4710 Standard $ 10,300 (married couple 2002) Personal $ 6600 Total $ 83100
37