FEDERAL INCOME TAX Gross Income Amounts Included Minus - Deductions and Adjustments Equals Adjusted Gross Income Adjustments above AGI are “Above the line” Adjustments The opposite are “Below the line” Below the line deductions: Interest Minus - Below the line itemized deductions Equals Taxable Income Times: Marginal Tax Brackets: 1-39% Equals Gross Tax Liability Minus Tax Credits and Pre-Payments Equals Net Tax Liability Constitution: 16th Amend. Courts Interpret that Tax is generally not privy to Constitutional attack. Primary Laws that Regulate Taxation: 3 Subcategories: (1) Legislative Materials Starting in 1913 In 1939 these were cleaned up and codified into the Internal Revenue Code. We are currently on the third version. “Tax Code of 1986.” Title 26 USC Sec. 1 All Tax legislation begins in House of Representatives, Ways and Means Committee collaborates with Senate finance and then presents to President. Treaties - Article 6, Clause 2: Treaties shall be equal to federal statutory law and be the law of the land. UK and Western Europe, Mexico all have tax treaties with US. (2) Administrative Materials – Legislature has delegated it’s authority to interpret the code to the executive branch that has assigned it to the dept. of treasury, subpart IRS. Promulgates Regulations that are rules of interpretation and action. IRS regulations must match up to the IRS Code, otherwise may be struck down by the judiciary branch, if creates broader or stricter rights. IRS only must acquiesce to the US Supreme Court. (3) Judicial Materials – Federal District Court – Pay tax and seek refund and go to court about it. Article 3 Court. Tax Court – Article 1 court. No Jury. Judges expert in tax law. Don’t pay tax before litigate. Court of Claims – All courts on equal footing. DEFINITION OF GROSS INCOME “All income from whatever source derived” subject to certain statutory deductions. IRC Section 61. 15 express deductions. Glanshaw Glass Test. Includes FMV of improvements to assets from services.
Gross Income includes the receipt of any financial benefit which is: (1) Not a mere return of capital, and (2) Not accompanied by a contemporaneously acknowledged obligation to repay (3) Not excluded by a specific statutory provision. Timing: Income taxable when it is REALIZED. Statute of Limitations: 3 years, except where there is a substantial underpayment of tax, then 6 years. If fraud – no SOL. Starts to run at time when return is filed. Code Sec. 64.01 Cesarini v. U.S.: Treasure Trove: Treasure Trove: IRS 1964 Regs say “Treasure Trove is Ordinary Income when undisputed possession occurs” Timing of Income Events: Look to laws of jurisdiction then common law to determine what the law says on when property possession occurs. Usually upon discovery and depravation of liberty. Old Colony Trust Co. v. Commissioner Can another entity pay taxes on someone else’s behalf? NO. Viewed as consideration for services and therefore gross income. RULE: When an obligation is paid by a third party the payment can be an income event for the party having the obligation relieved. Timing: Falls under cash method so occurs when paid. Qualified as such if: Payment is a form of consideration Not Qualified as such if: A gift. Under §102a not income event to recipient in gift scenario. Commissioner v. Glenshaw RULE: Punitive Damages are gross income. Loans: If there is a contemporary obligation to repay then there is no economic windfall. Unless the borrower never intended to pay it back. Security Deposits: i.e. Bank Deposits – Not Gross Income because obligation to pay back. Illegal Income: Gross Income. Realization: Purchase of Assets at less than value: Income event timed to when sale of asset is realized. Realization refers to appreciation in value of an asset and when it is taxed. Gifts: Know: “Duberstein Test.” = Must have a donative intent. If not, economic gain = taxable gain. IRC § 74. What happens when Gift is taxable and is property, i.e. not cash: Must determine fair market value of property. FMV = arms length transaction between willing buyer and seller under no compulsion and with competent knowledge. P.1616 of supplement. § 102(A) Employer gives “gift” with intent of it being consideration to Employee’s spouse or assignee, income event to Employee because it is consideration. Stock as consideration is property that is an income event. The later sale of the stock may have a realization above the acquisition value (tax base) and therefore there might be a realization of taxable income. Rental Income: If improvements are rendered as substitute for rent, the value of improvements are §61(a)(5) rental income. If the improvements are done not in
consideration of rent, they are capital improvements that will have a realized gain when the asset is liquidated. Said differently, when services are rendered in consideration of obligation there may be taxable income to obligee. Imputed Income – Not included in gross taxable income Dean v. Commissioner P.67 Transaction where property transferred into c-corp from Dean to his wholly owned c-corp created an income event for Dean because the c-corp did not charge him rent to live in the property. Rule: Using assets that do not belong to one can cause an imputed income equal to the fair market value of the use. Weight of Authority Rule: Converting Real Property to Personal Property is not generally an income event. Bartering: Revenue Ruling 79-24, Rule on P.66 Rule: Section 1.61-2(d)(1) If services are paid for other than in money, the FMV of property or services taken in payment is income. If a price or value is stipulated it will be presumed the FMV. Tip: Don’t barter is large assets, rather purchase for small value so gain is realized on sale at some later time. Tip: Find authority for position in IRS pronouncement, IRS agents don’t like case law. Exchange of Rights: Compensation received for waiver of rights is ordinary income, as if it has been worked for. Problems P.68 (1) NO, conversion from real to personal is not income (2) NO (3) YES, Accretion to wealth (4) YES EXCLUSIONS: P. 69 Sec. 61 – Sec. 102(a)-Sec. 102 (c) Gifts: IRC Section 102(a) – The Duberstein test. For Inter-Vivo’s gifts 102(a) is a Deferral of Income. Value of gift excluded, but not income from gift. 102(b)(2) Deduction of Gifts limited to $25 under current IRC. Supreme Court Rule in Duberstein: Totality of intent as discovered objectively on facts determines if a purported gift is a treated as a true gift. Trier of facts conclusions have primary weight. Must be: “detached and disinterested transfer out of generosity” Procedure: Look for the dominant reason that explains the transfer. IRS rule overruled: “Transfers of property for personal reasons, rather than business reasons.” Statutory meaning of gift different from common law meaning of gift. CL (overruled): “Voluntary transfer without any compensation” Employee Gifts: IRC 102(c) Supplants 102(a) with regard to employees. Employee gifts in general shall not exclude from gross income any amount transferred by or for an employer to or for the benefit of an employee.
When a “gift” is made to someone who has a dual designation, perhaps a family member who is also an employee, then see Treasury Regulation P. 942, 1-102-1(f)(2) “Extraordinary transfers will not be shown to be employer employee transfer if employee can show it was not in recognition of employment.” Sometimes a half construal could be made where part of gift is in mode of employment and extraordinary part is under 102(c). Rev. Ruling 55-422 Ministers are not considered employees of the congregation therefore 102(c) does not apply therefore it must be analyzed under 102(a). ?IRC 132(e) – Fringe Benefits and Retirement Gifts can fall under diminimus fringe, but when we look at legislative intent they only mention gold watches. ? Problems on P. 82: (4) Employer contribution is taxable because of 102(c), $3000 is not if meets 102(a). Inheritances, Bequests, and devises. Must be bona fide gift under §102, or taxable. Under Wolder, bequest as consideration is economic accretion under §61. CH 6. GAIN FROM DEALINGS IN PROPERTY IRC § 61(a)(3) – Strong possibility of being treated as Capital Gains. IRC §1001(a) – Definition of Gain: Recognition of gain or loss. Basis = Purchase Price (§ 1012) or FMV if exchange or carryover if gift. Adjusted Basis = Amortized or Depreciated Basis + capital improvements (§1016(a)(1) expenditures). Real Property, depreciate only improvements, land has infinite useful term. §1012 = to Determine unadjusted tax basis: (1) Use cost of property acquired, or if that is problematic, (2) use cost / fmv of property given up as consideration. An arms length transaction is presumed to have an equal exchange so this math works. Ex. Bridge deeded for 10 year franchise extension. Valuing franchise received problematic, so use value of bridge given up. Realization = § 1001(b) Gross Income does not involve “Realized Gain”, rather it involves “Recognized Gain”. Amount realized = Amount realized in sale. Amount Realized over adjusted basis of property is amount of realized “Gain”. §1001(c) = All of Realized Gain is recognized except: §1031 Like kind exchange – Real Property for Real Property, Personal Property for Personal Property §1032 Exchange of Shares for money §1041 Transfer of property between spouses incident to divorce. Recognition = § 61(a)(3) Gross Income involves recognized gain Is 132(a)(2) an exemption or a deferral? Basis Provisions: §1019 – Cost as Basis, linked with §109, 1012, 1016. §1015 – Property Acquired by Gift: Deferral §1014 – Property Acquired from a Decedent - Exclusion §1041 – Property Acquired Between Spouses or Incident to Divorce. Deferral PROPERTY ACQUIRED BY INTER VIVOS GIFT:
§1015(a) et seq. Rule: Basis in the hands of the Donor is the tax basis in a gift transfer. Ex. Gift of stock when stock price is greater than original purchase price. What is basis. (1) mkt value on gift or mkt value on (2) donor’s original purchase. Answer is (2). Exception: For computing a loss - When mkt value at time of gift is less than original basis, a new basis is set at the time of transfer. Reg: 1.1015-1(a)(2) When the exception throws calculation back to general rule when original price of gifted property is lower than mkt value but final sale is less than mkt value at gift transfer, then no gain or loss. See code book. 10,000 original basis 8,000 mkt value on gift 8,000 is new basis 9,000 donee sells Therefore no gain or loss under this section. No elevation of form (terminology) over substance. P. 128 Question 2, Part purchase part gift. Split out Purchased portion from Gift Portion. Assign basis to each portion according to the rules that apply to purchases and gifts, respectively. Donor Basis: $120K Donee Basis: $120K because that is purchase price. Donee Basis: Greater of : Amount paid, or Transferors Adjusted basis at time of transfer. Difference between price and mkt value at time of transfer is exempt under 102(a). The 60K is not realizable gross income at time of transfer. It is when liquidated. § 1041 Property Acquired between spouses or incident to divorce. P.129 General Rule: A sale is not a sale when 1041 applies. Carryover Basis Only. Tax Neutrality. Therefore consideration that causes gain under §102 is actually exempt because §1041 applies. §1041 also makes an exception to basis: What is paid however does not set the new basis, the old basis is carried over. §1014 Property Acquired from a Decedent Inter Vivos Transfer: See Rule: 1015(a). Testamentary Transfer: Basis is FMV, as opposed to adjusted basis of donor. Huge estate planning tool. 1015(d)(6) Gift Tax Basis Bump (What is the purpose of this?) Ratio of Giftee’s Gain on Sale to actual FMV at time of sale times Gift tax paid by Giftor = the allowable increase in basis for the Giftee. AMOUNT REALIZED (Four Way Matrix). Dealing with mortgages and the sale of land at a profit (Crane): Amount Realized = Sale Price = Cash + Assumed or Dismissed Debt. Adjusted Basis = Basis (FMV or Purchase Price) – Depreciation. Gain = Amount Realized minus Adjusted Basis. Non-recourse Debt: Dealing with sale of land at a loss less than Note (Tufts)
Amount Realized = (Full or unpaid? – Unpaid I believe) Amount of Note (not diminished FMV sale price) [this is because the note amount is included in depreciation allowance]. Adjusted Basis = Depreciated Basis Gain = AR – AB. (1) Recourse Mortgages: Mortgagee personally liable for debt satisfaction 3rd parties can “assume” the obligation (2) Non-Recourse Mortgages Mortgagor can only look to property to recoup, not personal guarantee. 3rd parties may take the property “subject to” the note. SIDE NOTE: Balance Sheet: Assets minus Liabilities = Net Worth Income Statement (For a period of time) = Revenue minus deductions equals taxable income. (1) Find Exclusion (2) Push Income to Future (3) Accelerate Deductions Ex. 100,000 Asset with a 100,000 Liability. 40,000 of liability forgiven, write down asset value to 60,000. Pushing the realization of 100K mkt value into the future. DISCHARGE OF INDEBTEDNESS No Tax implications on creation or payment of the principal of a debt. US v. Kirby Lumber Purchasing one’s own bonds back from the market for less than face value so they don’t have to be repaid causes an economic accretion. 61(a)(12): Gross Income includes income from discharge of indebtedness. Known as “Kirby Income Rule” Treated as Ordinary Income. Code Sections 101-139 have exclusions from gross income. Section 108: Discharge of debt scenarios that are not Gross Income Events. Threshold Question is: Is there a debt? Next, was it forgiven? Then, there is an income event unless it falls under an exception. 108(a): Bankruptcy, Insolvency, Qualified farming debt, Qualified real property business debt, 108(a)(1)(b) Says that there is no “Kirby” Ordinary Income from forgiveness of debt when the debtor is insolvent (more debt that equity). 108(b): Tax Attribute – A Tax attribute is a tax characteristic of the tax payer. (1) Accounting Method, (2) Earning and Profits, (3) Section 108 Attributes: Net OP Loss, Gen. Bus. Credit, Capital Loss Carryover, 108(d)(1): Unenforceable obligations do not cause gain on forgiveness, unless property is held by the party that was indebted. i.e. when a note is illegal, it’s discharge (forgiveness) does not cause gain. Exception: When the indebted one acknowledges the debt as bona fide. As in when a settlement is made (the settlement amount becomes the debt amount).
108(e)(5) Purchase Money Adjustment Debt = Zarin Test Forgiveness = 61(a)(12), but 108 applies negating 61. Problem: 2, P.170 Always use Amount Realized minus Adjusted Basis = Gain. Recourse Debt: Reg. § 1.1001-2(a) Amount Realized is amount of debt extinguished (when land is at below mkt value). Under Non-Recourse Debt Gain is converted into capital gains Under Recourse Debt, part of gain is capital gain and part is ordinary income. “boot” = cash Asset Basis reduction: 108(e)(5) = [applies to real & personal property] Allows for an assets basis to be reduced when the corresponding liability for the debt (from seller carried financing) is forgiven to a lesser level. It is treated as an adjustment to the purchase price of the asset. If basis goes below zero there is an income event. Known as the tax benefit doctrine. In Insolvency Situation: Test for insolvency before the discharge / forgiveness of debt. 108(a)(1)(b). In the case of a discharge, the amount under 108(a)(1)(b) shall not exceed the amount taxpayer is insolvent. Therefore there may be gain for part over insolvency. Net Operating Loss (NOL): More beneficial to taxpayer than basis reduction. BIZ PLAN NOTE: If you have depreciation on the original purchase price and some time later that price is adjusted down (adjusting the basis down), you get the benefit of the greater depreciation for the period of time prior to the adjustment to the basis. Depreciation schedule is recast going forward when basis is adjusted down. Therefore there is a free lunch before basis is adjusted. Inflated purchase price of real estate, seller carries financing over mortgage amount lent by bank (the appraised value of property). Seller, several years later, then forgives all or part of seller financed portion under 108(e)(5). Therefore a huge depreciation benefit is realized. (If contracted for, this may violate from other statute. I contract with a condition causing the reduction may need to be written, such as buyer performing some task). Further, Seller carries financing and buyer puts 20% down. Seller does not record the note until after Buyer gets a home equity line of credit to pull out the 20%, or maybe more if home equity line based on purchase price. Another Scenario: Buyer buys for 1/3 market price or some low number from seller through escrow (read CA prop 13), and has a side agreement… §1017: Know DAMAGES AND RELATED RECEIPTS: (P. 181) § 104-106 Recovery of Cost: Not Ordinary income Lost Profits: Ordinary Income § 61(a)(2) Punitive Damages: (Glenshaw Glass): Historically treated as taxable ordinary income. §104(c) : Shall not apply to punitive damages for a wrongful death civil action. Damage to Goodwill: Gain over basis (aka excess over cost of goodwill) taxed as ordinary income. Use basis as baseline to calculate gain or loss.
Goodwill is non-divisible, all or nothing. BIZ NOTE: Amortizing goodwill might be a great tax write-off. Buy a company using a lot of personal recourse leverage (because of at risk rules), such as an LBO by collateralizing the companies assets as security for the note, and personal liability secondly, then use the pass through nature of an LLC to amortize the Goodwill. § 104(a)(2) Person has suffered enough, lets not tax them. “Gross income does not include any amounts received in redress for tort like personal injury” “On account of personal, physical injuries or physical sickness and emotional stress directly based on such” Damages for non physical injury, such as defamation, are not excludable Even references to lost profits when there are damages from an injury are exempt under this section. Allocation of damage money to compensatory and punitive categories: According to IRS: based on the ratio that was pleaded for; According to tax court: Look to settlement agreement to find ratio (must be good faith arms length settlement). This view prevails. §106(a) Employers contribution to health plans is not income to employee § 104(a)(1): Amounts received under workers compensation insurance is treated as if from personal injury or sickness and is exempt. §104(a)(3): Amount received from insurance policies purchased by the employee are exempt? § 105(b): Amount received from insurance policies purchased by an employer are not tax exempt, except amounts paid to pay for medical bills. Scenario: 1M damages excludable under 104(a)(2) put in an annuity paying 100K a year for 20 years. Answer: Must split out interest received and that is ordinary interest income. SEPARATION AND DIVORCE (CH 10) P. 193 Always make sure that form is not over substance. READ: IRC § 71 & Reg. 1.71 [Alimony is taxable to payee and deductible to payor] and child support on page 211. IRC § 215 Deduction – Makes sense if payor is in higher tax bracket than payee. If payor is in lower tax bracket, then alimony deduction status doesn’t make sense from a tax advantaged perspective. Requirements for Taxable and Deductible Alimony 1. §71(b) The payment is received by, or on behalf of, a spouse under a divorce or separation instrument. 2. The divorce or separation instrument does not designate the payment as a nonalimony payment. [this means alimony status can be elected out of in the instrument, to avoid negative tax consequences]. 3. In the case of a decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made. 4. There is no liability to make any payment in cash or property after the death of the payee spouse.
5. The payment is not for child support. Payment must be made in cash or check or money transfer. Not art, not notes, not other assets. Problems on Page 212: 1(b) – 1(c) 1.71(1)tc Q&A 18 Amounts: §71(f) - Disproportionate year over year settlement cash flow is a red flag for disguising property distributions if there is a lot of front loading. This section causes a computation to smooth the cash flows for tax purposes into equal cash flows each period. INDIRECT PAYMENTS: P.204 § 71(b)(1)(a) – a payment received on behalf and for the benefit of a spouse can qualify as alimony. Incident to Divorce: §1041, see below. PROPERTY SETTLEMENTS (Between spouses): § 1041: Transfer or property to a spouse incident to a divorce shall be treated as a gift. Repeals the Davis ruling in a limited fact scenario. Must be Incident to Divorce: Within a year of divorce. Or Reg 1.104-1 within 6 years of date if incident to the divorce as called for in divorce agreement. 6 year rule creates a rebuttable presumption that it is related to secession of marriage, if outside 6 years, then you can prove it is related to marriage with the right facts. If does not meet the criteria above falls under U.S. v. Davis case “Tax Hell.” CH 12. ASSIGNMENT OF INCOME [WHO IS THE TAXPAYER?] Income shifting is an important tactic (especially in families) to minimize tax liability. Lucas v. Earl P. 242: Rule: Where one party in a marriage where there is a K for joint tenancy of all property and receipts, and one party has dominance over an income stream, it is as if the income producer owns the income and is taxable on the income prior to it becoming community property. Fancy contracts, while valid and enforceable for other purposes do not change the tax nature of the transaction. Commissioner v. Gianini: Directed payment on one’s behalf is an income event if director has (1) dominance over payment. If payment is refused and then disposed of not under dominant control of refuser then no income event. In Gianini he refused to accept so didn’t even dominate the money and so wasn’t taxed. Note: assign income before you earn it for it to be tax free. Rev Reuling 74-581 Agency Relationships. Not so important. Income in agency is not gross income to the agent if it has to be turned over to client. Similarly, a check to a person who is an agent to the corp is not GI to person because the person is agent for corporation. Rev Ruling 66-167: Statutory commissions: Disclaimer.
Blair v. Commissioner (A trust transaction) Grantor ->Property into ->Trust (which vests legal title in trustee and beneficial title in grantor or other). I.e. Trust has a bond granted into it as an income producing asset. Critical Test in Blair: If you convey everything you own (i.e. the “tree”) to a trust, it is like conveying the tree in the Horst Case, and is valid. You the fruit of the tree can then be assigned to beneficiaries as a property interest that is freely alienable. But must give the “tree” to the trust first. Facts: Blair grants bond to Trust and assigns beneficial interest (in interest stream) to son. Blair does not have to pay tax on income, rather son pays. Estate of Stranahan v. Commissioner Taxpayer 1 has a large deduction, and wanted to accelerate income to the present year so could get it tax free. Taxpayer 1 assigned his future income to son in law from stock dividends and in consideration got a check for a lesser amount now. Taxpayer 1 reports check from son as ordinary income in year 1. Taxpayer 2 reports the dividend income as ordinary income (interest & dividend income always is ordinary income) and can deduct the cost incurred in generating the right to receive the income stream. Susie Salvatore P.262 IRS contends that real property sale occurs when the negotiations began (that were concluded in a sales K). Owner conveyed half of property to children at the day of closing of escrow. Owner contends her and children each have ½ tax load. IRS contends owner has all tax load. Owner should have transferred interest to kids at beginning of negotiation to prevent from having a “sham” transaction that the court saw right through and voided as to the tax consequences. Problems on P. 272: (Need to learn fruit of the tree doctrine) 1(a): (b): effective assignment (c): Rule: When there are set installment payments, and an assignment is made between installments, part of the next payment has “ripened” pro-rata based on the amount of time passed between payments. Therefore when the next installment occurs the assignor will have to pay income on the ripened sum, even if the actual money goes to assignee. If you concoct scheme to avoid tax that is enough to knock it down. Cannot elevate form over substance. Cannot have a sham transaction. Must follow the economics. Look for valuable consideration, economic risk. ASSIGNMENT OF STOCK INTEREST AND DIVIDEND INCOME. Publicly Held Corporations: Income recognized to owner at Record Date. Closely Held Corporations: Income recognized to owner at Declaration Date.
There may be a bump up in basis on stock due to dividend. Clarify with Prof. ASSIGNMENT OF INTELLECTUAL PROPERTY INTERESTS Generally speaking, courts treat a patent as a transfer of property. Revenue Ruling 54599. Patent owner transfers patent to company and takes a royalty interest. Then transfers royalty interest to third party. Third party disposes of K to forth party. Rule: Assignment of royalty contract is a transfer of the income producing property itself – this correlates to a sale of the tree. This is a generous treatment. Must transfer all of interest. DEDUCTIONS: Reg: 101-139 and § 1031-1041 Presumption is reversed: Deductions must be precisely within the statute for a deduction to qualify. § 262A: No Deductions for living expenses unless specifically noted. Generally: Allowance for systematic recovery of cost for certain assets. Stock and Goodwill: Must wait until sell it to take advantage of it’s basis. BUSINESS DEDUCTIONS: § 162 Ordinary and Necessary Expenses Paid or Incurred during taxable year In the carrying on of any trade or business Welch v. Helvering P.310: Interperetation of Ordinary and Necessary. Welch pays the debts of a company he used to be a partner of that was insolvent. To make sure that his reputation would remain intact. This was deemed to be extra-ordinary, even though it may be necessary for him to maintain his ability to transact business. Therefore did not qualify as a business deduction. If it had been a business enterprise making the payments then it might be goodwill and ordinary in nature. When a business owner bails out a business: Those expenditures that protect existing business interests and earnings capacity are ordinary and necessary and are deductible.
Intent of taxpayer can convert something that is ordinary and necessary in the course of business into a non-deductible item if it was done for personal reasons. EXPENSES: Do we charge to a capital account (capitalize) or deduct under § 162? § 263: Capitalization. Ties to Balance Sheet. Criteria: Serves to create or enhance a separate and distinct asset. P.317 (1) Must be expenditure in course of actual purchase of asset. (2) Repairs: Tres. Reg. 1.162-4 Test: Must increase life of asset or PUT into “ordinarily efficient operating condition.” Incidental Repair to KEEP in efficient operating condition is an expense no capitalizable.
Matching Principal: Must match expenses to the revenue that the expense will generate. Expenses incurred in changing the corporate structure for the benefit of future operations are not ordinary and necessary.
§ 162: Expenses. Ties to income statement. Criteria: All ordinary (common and frequent) and necessary expenses paid or incurred in carrying out trade or business. (a) Contingent Compensation: allowable deduction if paid pursuant to a free bargain between employer and individual. DIVIDENDS ARE ON NET INCOME AND DO NOT REDUCE CORP. TAX LIABILITY – BUT SALARIES DO. THEREFORE USE CONTINGENT COMPENSATION SALARY CONTRACTS. COULD BE CONSTRUED AS A CONSTRUCTIVE DIVIDEND IF NOT REASONABLE SALARY. Best way to show reasonable is to find comparable compensation in other businesses. 7 prong test to determine if reasonable otherwise: Nature of work Comparison of Salaries Complexity Supply and Demand
What the salaried added to the business gross income Don’t declare a bonus, it looks fishy. 7th Circuit looks are independent investor test. All else look to 7 factor test above. An employee automatically has trade or business expense status. § 368: Transaction between two corporations: Takeover: Must fall under this section to be a non-taxable event. Known as reorganizations, sectioned A-G (don’t need to know). INDOPCO ,Inc v. Commissioner Friendly takeover by Unilever. INDOPCO spent $2.9M in expenditures on investment bankers and lawyers pursuant to consummate the transaction. The bankers and lawyers were meant to look out for the shareholders and preserve their interest. § 195 Start Up Expenses Must capitalize and amortize over time. Must get into business for it to be a valid amortizable capitalization. (b)(2) Basis Recovery: In any case where a business is completely disposed of by a tax payer, and there is unamortized capitalized expenses, they may be deducted as allowable under §165. § 165 Losses (selling at a loss)(how does this relate to § 212) (c)(1): Trade or business loss (c)(2): Losses from sale in a transaction “entered into for profit” are deductible. Some expenditures may not meet §162 but might meet this section. (c)(3) DEDUCTIONS FOR PROFIT MAKING NON-BUSINESS ACTIVITIES IRC § 23 and § 212 P.431 IRC § 23 “In computing Net income, there shall be allowed as deductions: (a) Business Expenses… (b) Non-Business Expenses – In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of the property held for the production of income.”
§ 212 Quasi-Business Deductions - “Production or Collection of Income” Test replaces “trade or business concept.” Still must be ordinary and necessary. § 167(a)(2) – If a property is held for the production of income” it is depreciable. § 263 issue – deductible § 262 issue – non-deductible Bowers Case: Expenditures in defending or perfecting title to property, in recovering property, or in developing or improving property constitute a part of the cost of the property and are not deductible under § 212. Surasky Case: § 212 only requires reasonable business judgment in an effort to produce income (or protect income), and any such benefit need not proximately be caused by such actions. Rev. Ruling 64-236 Fleischman Case: Expenses for maintaining ownership of property not deductible. However, the management, conservation and maintenance costs of property held for production of income deductible. Must look to origin of claim. “But for” test §212(1) – attorney’s fee’s in divorce proceedings are not deductible unless incurred for the production of income. It can relate to production of income by focusing on the alimony aspects. § 212(2) Proximate Cause § 212(3) – Payment and collection of tax Questions: 1.(c) – Depends on whether the value of the stock is important enough to warrant such travel expenditure to the annual meeting AND the trip must be to vote or bring a proxy fight (business purpose). 1.(d) – More likely to be deductible because there is a legitimate investment interest with a 10% interest in the company. 1.(e) – Could be deductible because may fit under the broad idea of the production of income, however 274(h)(7) says no deduction for attending a convention.
1.(f) – If shows reasonable business judgment under Surasky test, then it could be conservation expense to preserve the production of income, so deductible. Does not have to do with a purchase so no capitalizable. 2.(a) – CONVERSION OF AN ASSET FROM PERSONAL TO FOR-PROFIT (I.E. MOVING OUT OF A HOUSE AND RENTING IT). Ex. Does a loss on sale of a converted house mean it can be deducted under § 165(c)(2). MISSING CLASS ON 10/27/05 11/1/05 DEDUCTIONS NOT LIMITED TO BUSINESS OR PROFIT SEEKING ACTIVITIES P. 462 Generally § 262 precludes deductions for personal, living or family expenses. The deductions in this section are exeptions. TAX CREDITS INTEREST Revenue Ruling 69-188 § 163(a) There shall be allowed as a deduction all interest paid or for the use or forbearance of money (must be cash indebtedness). Foregone interest is seen as interest paid (a deduction to payor and income to payee). Deductibility of interest is conditioned upon it not being construed as personal interest. And personal interest does not include trade or business interest, or interest paid pursuant to investment activities, unless there is an exception, such as “qualified residence interest.” QUALIFIED RESIDENTIAL INTEREST: (P.483). Two Categories: (1) Acquisition Indebtedness Indebtedness incurred in acquiring, constructing or substantially improving a qualified residence. ( § 183 or 280?) Refinancing: Deductible amount cannot ever exceed balance of original acquisition debt outstanding.
$1M ceiling on deductible debt service interest (the interest on $1M of debt). Debt greater than $1M prior to 1987 can be grandfathered in. (2) Home Equity Indebtedness Debt secured by a qualified residence to the extent the debt does not exceed the FMV, capped at $100K. Amount over $1M ceiling under #1 above may be qualified under this section. Home equity used to substantially improve a qualified residence is seen as Acquisition Indebtedness. QUALIFIED EDUCATIONAL LOANS. P.485 INVESTMENT INTEREST: P. 486 § 163(d) imposes a limit on the deductibility of investment interest by non-corporate taxpayers. You can only deduct investment interest to the extent that you have investment income. i.e. you can only deduct gambling losses against gambling winnings. The excess of investment income over investment expenses. § 265(a)(2) Interest on money borrowed for investment in investment in tax deductible bonds is not deductible. TIMING RESTRICTIONS p. 489 TAXES Only deductible to the person whom has an obligation to pay. Corporate Payroll Taxes: § 162 allows deduction as an ordinary and necessary expense, even though § 275 says can’t deduct FUTA or FICA taxes. § 164 No deduction for capital expenditures by a municipality that might increase the basis of a property.
P. 501-507. (Not explicitly on test) Know § 161-198 (corp and ind. Deductions), § 211-221 (ind. Deductions), 261280H Non Deductible items. (§ 274 business reporting to get deductions). DEDUCTIONS LIMITED TO AMOUNT AT RISK § 465
ACTIVITIES NOT ENGAGES IN FOR PROFIT § 183
RESTRICTIONS ON DEDUCTIONS OF HOMES § 280A § 280(a)(d)(1) For purposes of this section a taxpayer uses a dwelling as a personal residence if he uses it for the greater of 14 days or 10% of the days it is rented. If does not meet this criteria, then not subject to limitations of § 280. Then: § 183 determines qualified deductions. If rental of the dwelling is engaged in for profit, allocable expenses incurred plus all expenses otherwise deductible (interest and taxes) can be deducted. S 280(a)(C)(5) Controls the computation of deductions from rental activity. § 163(A)(2) 1985 Date is important. P. 149 § 163 – Aggregate of debt shall not exceed 1M.
§ 221(b)(2) Imposes limitation on the deductibility of interest based on a taxpayers Adjusted Gross Income.
CHAPTER 19 FUNDAMENTAL TIMING PRINCIPLES P. 584ish. § 441(a)-(e), 442, 446, 451(a), 461(a). Timing depends on the accounting methodology the tax payer is using. § 446(c) Cash or accrual method, or any other hybrid that is approved by the commissioner. Cash method: income and expense booked in year when actually received or paid, unless it is a capital expense under which it then must be depreciated (because of the matching principle). Constructive receipt(available for pickup) is valid, as long as have control over it being available (check on this). Actual payment is making the payment available (out of immediate control). Rule said differently: When the life of an asset extends substantially beyond the taxable year it needs to be pro-rated. Capitalization under IRC 461(a) and Regulation 1.461-1(a)(1). Exception: 461(g) Points on a mortgage are deductible. If not a specific exception would have to be pro-rated. “Cash method taxpayers who pre-pay points with cash from the lender may deduct” When is a credit card payment booked? Mail Box Rule: When dropped in the mail (control relinquished) then payment made. Generally, no form over substance. Negotiate payment terms first before signing K, I play around after then form over substance and it is invalid.
Reg. 70-151 Claim of Right Doctrine. If there is an unfettered control over money it is an income event. Ex. Debtor pays Lender a large sum of pre-paid interest, that sum is income to Lender, even if Lender might have to pay it back to Debtor later if Debtor pays the note off prior to that much interest being accrued (at which time Debtor would have an income event in being paid back).
ACCRUAL TIMING INCOME IRC § 451 Any item of gross income shall be included in GR for the tax year in which it is received unless, under the method of accounting used, such amount is to be properly accounted for as to a different period. Regulation § 1`.451 Clarifies that “properly accounted for in a different period” refers to income being includible in GR when all events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. GAAP Accrual Timing in Installment Contracts Tax payer will want to string out income per installments – even if installments paid up front. IRS will want to book all income immediately. Tax Payer can argue that it is not entitled to income until it has performed in each period under the K. Standard: Must show the IRS Abused its discretion in asserting that their system most clearly reflects income. Rev. Procedure 70-21: Allows pro-ration Artnell Case P.600 Deferred Income: Income should be booked for tax purposes when it is earned. There must be reasonable certainty as to when it is earned, otherwise it should be booked when received (See referece to AAA case where premiums received where uncertain as to when the services due for the premium would occur).
New Capital Hotel Case Check Section 22(a) of IRC of 1939\ Check Section 21 of IRC Court recognizes that the inclusion of prepaid income in gross income in the year of receipt of the item representing it, rather that in a subsequent year, is not in accord with principles of commercial accounting. DEDUCTIONS Revenue matching principle on capitalized items
Exception if the items in question meet the statutory criteria 461(h)(3)(a) of a recurring item.
CHARACTERISTICS OF INCOME Taxable Income can either be: Ordinary or Capital Gains To be a Capital Gain it must be: Capital Asset, that is the subject of a: Sale or Exchange, after the requisite, Holding Period. Ordinary Income § 61(a)(1) – compensation for services or fees or from business (Interest, Rents, Royalties). Grey Area: § 61(a)(3) Gains Derived from dealings in property. May be Ordinary may be Capital. § 1(a)-(e) Marginal Tax Rates for ordinary income. Up to 35% currently. § 1(h) Capital Gains – (1) Must have a Capital Asset, (2) Must have sale or exchange. Rates are 28%, 25%, 15% (most), 10%, 5%. Don’t have to distinguish between which category applies on the test. Critical Terminology: Net Capital Gains: Defined in IRC §1222(1)-(4). The excess of the long term capital gain over the net short term capital loss. Short Term Gain / Loss: Asset held for not more than 1 year Long Term Gain / Loss: Asset held for 1 year or more. § 11 is the section for computing the tax on corporations. NETTING PROCESS: Net gains and losses that are Long Term Net gains and losses that are Short Term Net “Net Long Term Gain” with “Net Short Term Loss” = Net Capital Gain. If there is Net Short Term Gain, then Net Short Term Loss is 0 in the calculation above, and Net Short Term Gain is taxed as Ordinary Income. P. 667-668 Distinguish between tax rate categories (don’t need to know).
Sale of Asset AR 100K AB 500K Loss 400K § 165(c)(2) Deductions if entered into for profit § 1211 Characterization: Can only take capital losses against capital gains § 1211(b)(1) = Individuals can pass through $3K a year of capital loss to offset ordinary gains. The remaining balance is a capital loss carryover. So may want to recharacterize the loss as ordinary income, might have to sell within one year of getting the asset for that to be able to happen (is short term cap gain and loss TAXED as ordiany income, or TREATED as ordinary income?) DEFINITION OF CAPITAL ASSET (§ 1221(a)(1): Generally: All Property held, even in the course of business, unless it is held as inventory. You must have a capital asset to have a capital gain. Split on Property used in the course of trade or business (inventory not capital asset, other property is): § 1231: General rule.--The term "property used in the trade or business" means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year, which is not-(A) property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year, (B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, (C) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by a taxpayer described in paragraph (3) of section 1221(a), or
Not a capital asset §1221(a): THE INVENTORY EXCLUSION:
Stock and Trade of a taxpayer that would be properly included in inventory, or Property held by the taxpayer for sale to customers in the ordinary course of business. 1221(a)(2) Property used in trade or business that is depreciated is not a capital asset § 1231 – overrides 1221: Gain is capital gains, Loss is ordinary loss. Copyright is not a capital asset Patent can be a capital asset Commodities Hedging Transactions Supplies Mauldin v. Commissioner Rule: Look to determine the facts of the circumstances to see if the item is inventory or not. Look to the intent for which it is held. Frequent sales of property more like inventory. Is it in the course of his occupation? DEFINITION OF SALE OR EXCHANGE: Cash to extinguish a debt is not an actual two way transfer, rather one way transfer to extinguish obligation, thus does not constitute a sale or exchange and does not qualify for capital gains treatment. 1271(a)(1) Anomaly: Keenan Case p. 710 and Galvin Hudson Case CHECK ON THIS: A debtor with a capital asset that has appreciated transfers the asset to a creditor to extinguish a debt. The Debtor has a taxable capital gain on the “exchange” on the appreciated capital asset and the creditor has an ordinary income event when liquidating the asset because it was in the course of inventory?
HOLDING PERIOD Less than 1 year ordinary Greater than 1 year capital Must consider how taxpayer acquired the property The holding periods can be tacked in certain circumstances. Stocks: First in first out (FIFO) – Allowable by Treas. Reg 1.1223-(1)(i). Last in first out (LIFO) Sale vs. Delivery Trade Date Controls for both cash and accrual methods. Even is cash is settled up later. Transfers (in death) Date of death FMV sets an adjusted basis for the donee. § 1221(10) controls, “in the case of a person acquiring property from a decedent, then such person shall be considered to have held such property for more than 1 year” Questions on P.735 (3) go: AR 600K AB 500K Gain 100K It is a capital asset under the definition because it is not inventory. But we have to split out the land from the improvements for timing purposes because the land will be long term capital gains because held more than a year and the improvements short term capital gains because less than one year.
ALTERNATIVE MINIMUM TAX (not on final) Flat tax, if your deductions meet a certain level then you have to recomputed tax and pay the higher of the tax due under ordinary computation and the AMT as calculated.