PROPERTY TAX OUTLINE

FEDERAL INCOME TAX OUTLINE DEFINITION OF GROSS INCOME Glenshaw Glass Test for economic accretion Gifts: Duberstein Test Imputed Income Barter Income GAIN, BASIS, REALIZATION AND RECOGNITION DEALINGS IN PROPERTY Basis Adjusted Basis Real Property Amount Realized Amount Recognized GAIN FROM DAMAGES AND RELATED RECEIPTS 3 3 3 3 3 4 5 7 7 7 8 8 EXCLUSIONS Gifts Employee Gifts: Inheritances, Bequests, and Devises Discharge of Indebtedness SEPARATION AND DIVORCE Alimony ASSIGNMENT OF INCOME ASSIGNMENT OF STOCK AND DIVIDEND INTERESTS ASSIGNMENT OF INTELLECTUAL PROPERTY INTERESTS 9 9 9 9 9 10 10 11 11 12 DEDUCTIONS: Personal Business To Capitalize or Deduct 12 12 13 13 TIMING PRINCIPLES b. c. Cash Method Accrual Method 15 16 17 CHARACTERISTICS OF INCOME 18 1 GENERAL TAX OUTLINE: Gross Income (§ 61) that is not Excluded. - Above the line Deductions = Adjusted Gross Income - Below the line Deductions = Taxable Income x Marginal Tax Brackets = Gross Tax Liability - Tax Credits = Net Tax Liability ANALYSIS PROCEDURE: Determine if Open or Closed Transaction. Determine when Transaction Realized. Determine Accounting Method Calculate Amount Recognized from Amount Realized (deductions?) and Adjusted Basis (capitalizations?). Characterize Amount Recognized (Ordinary, Exempt, Depreciation Recapture, Capital Gains) Deductions Must the expense be capitalized or expensed? Is it a capital expenditure? Is it in the process of starting a business? Deductions for profit making non-business activities: Is there pursuit of production or collection of income? Is there reasonable business judgment (not necessarily actual profits). Statute of Limitations: 3 years from filing, unless substantial underpayment, then 6 years. 2 DEFINITION OF GROSS INCOME § 61 – All income (recognized gain) from whatever source derived. Glenshaw Glass Test for economic accretion. “Economic Accretion” includes any financial benefit that is: (1) Not a return of capital (2) Not accompanied by a contemporaneously acknowledged obligation to repay. (3) Not excluded by a specific statutory provision. (4) FMV = arms length transaction between competent buyer and seller under no compulsion and with competent knowledge. (5) Examples of GI: a. FMV of improvements to assets from services. b. Punitive Damages c. Illegal Income Timing of Income Recognition: (1) Generally, when income is realized. Payment of Taxes By Another: Old Colony Trust (1) If another pays taxes on my behalf that is relieving an obligation and is income itself. Exception: A gift. Gifts (and Inheritance): Duberstein Test (IRC § 74) (1) Property received as a gift, bequest, devise or inheritance isn't subject to income recognition at time of transfer. Amount realized is determined upon sale. a. Must have donative intent, if not then income. b. This exclusion doesn't apply to income from the transferred property, or to gifts of income. c. Nor does it apply to transfers from an employer to, or on behalf of, an employee. (2) Employee Gifts: if it is consideration, it is income. Even if given to spouse. Imputed Income: (1) Using assets that do not belong to one can cause an imputed income equal to the FMV of the use. a. Exception: Converting Real Property to Personal Property is generally not an income event. Barter Income: (1) Reg § 1.61(d)(1) if services are paid for other than in money, the FMV or property or services taken in payment is income. (2) If a value is stipulated it will be presumed as the FMV. (3) Practical Tip: Don’t barter in large assets, rather purchase for small value so gain is realized on sale at a later time. (4) Exchange of Rights: 3 a. Compensation received for waiver of rights is ordinary income. (5) Rental Income: §61(a)(5) a. Improvements as consideration in place of cash rent is income. Treasure Trove: (1) (2) (3) Treas. Reg: §61-14 – Treasure Trove is taxable. This likely includes property. Gain is sale price less cost. Unsolicited items are not income. Tax Free Property Exchanges (1031’s) Elements: (1) Exchange of Property (2) Held for investment or in trade / business a. What is duration for “held” i. Answer: Cannot have intent to sell immediately. There is a big presumption against someone who flips. (3) Property exchanged for must be held in a trade or business or for profit, and (4) Must be like kind. a. §1031(a)-(1)(b) – In reference to the nature and character of property, not to its extent or quality. i.e. land is land (if it’s a leasehold must be more than 30 years). Personal property must be of the same service code as the property exchanged for. Defined by IRS. b. Does not apply to: i. Anything held for sale, including inventory. ii. Securities or Debt or choses in action, or iii. Interest in a Partnership. 1. Step transaction doctrine applies. Cannot start with an interest in a partnership, liquidate and end in a partnership. 2. However, Partnership A and Partnership B can swap interests. 3. Can’t offset cash boot with liability boot. c. No loss is recognized 1. Tip: Do not sell property, take cash and reinvest. (5) Any property that is not of like kind (such as cash) is boot. a. Boot is recognizable., but b. You recognize the lesser of boot or gain. GAIN, BASIS, REALIZATION AND RECOGNITION DEALINGS IN PROPERTY (BASIS and AMOUNT REALIZED v. RECOGNIZED) (See also: Capital Gains). 4 Basis = Purchase Price (§ 1012), or basis of property given up + gain recognized (FMV of property received), or carryover value (gifted). (a) Contingent Values: If value is too contingent to be calculated than cannot calculate basis until the contingency occurs. (b) Stock Options: Option Price + Exercise Price. (c) Arms Length Transactions a. Presumption of FMV: When two parties at arms length, and consideration is cash, this presumptively sets the market price. b. Corporations: When purchasing a corporation must make an allocation table of how consideration is allocated to equipment, land, goodwill etc. c. Sales below MKT value: If not arms length, part sale part gift. (d) Taxable Property Exchanges: a. Basis of Property Received = FMV of Property Received. i. A has property with FMV = 25 and AB = 20. B has property with FMV = 26 and AB = 30. They exchange securities not subject to S 1031. Result = 1. B has AR = 25 and AB of 20 for Arec = 5. New basis will be 25 in next tax year.. 2. A has AR = 26 and AB of 30. Arec = -4. New basis will be 26 in next tax year. b. Sales of Sub-Divided Property i. §61-6. Basis must be equitably apportioned. Look to FMV of particular lots when purchased. (Ronald Reagon example). ii. If large parcel and later subdivided and sold in parts, reevaluate the proportion of how basis is allocated between the lots based on the FMV at the time each lot is sold. (e) Non-Taxable Property Exchanges (§ 1031) Boot = Cash (outgoing or incoming) + Non-recourse debt relieved. Gain Calculation Procedure: a. To Calculate “Gain Recognized” by a party to a 1031 exchange: Amount Realized = Value of property Received + Cash Received + Debt Relieved -Debt Acquired - Cash Paid Basis of Property Transferred = Given 5 Gain Realized = Amount Realized – Basis of Property Transferred Gain Recognized = Lesser of Boot or Gain Realized. Basis of New Property Acquired = Basis of Property Transferred + Gain Recognized (from above) + Amounts Paid (debt assumed + cash & other property paid) - Amounts Received (debt relieved+cash & property received). - Loss Recognized (??) To Check the Math: b. The potential gain (FMV+Gain Recognized-AB) after an exchange should be the same FMV-AB if there was no exchange. (f) § 1014 – Property Acquired from a Decedent (Exclusion) a. Testamentary transaction: Basis is FMV date of decedent’s death.. b. Not adjusted basis of decedent. Major estate planning tool. c. Estate Tax Marital Deduction: If property passes to a spouse, treated as one, so no tax. d. Community Property: The whole property steps up to the FMV on death of one spouse. Rev Ruling 92-37 on § 1014(a)(6). (g) §1015 – Property Acquired by inter vivos Gift (Deferral) a. Basis in the hands of the Donor is the tax basis in the hands of the transferee. b. Exception: When Market value is less than original basis, new basis is set at market value. i. Exception to Exception: When final sale price of gifted property is less than original owner’s basis and more than the FMV at time of gift, no gain recognized. ii. Ex. 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. c. Part Sale Part Gift i. Basis in the hands of donee is the greater of the amount paid or the donor’s basis. ii. Amount of Gift tax paid by donor added to donee’s basis (to avoid tax on a tax). § 1015(d)(6). iii. Donor: All of AR applied against AB. No regard for gifted portion. iv. No losses allowed on part sale part gift. v. § 267 disallows losses between any related people. 6 (h) 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. (Not on Test) (i) § 1041 Property Acquired between spouses or incident to divorce (Deferral) a. General Rule: a sale is not a sale when § 1041 applies. b. The transaction is tax neutral and the old basis is carried over. c. § 1041 creates an exception to basis: i. What is paid does not set new basis. Old basis is carried over no matter what. ii. Consideration that causes gain under § 102 is exempt. Adjusted Basis = Amortized or Depreciated Basis + Capital Improvements § 1016(a)(1) expenditures. Real Property: Depreciate only improvements, land has infinite useful term.. Determining unadjusted tax basis i. Use cost of acquiring, or secondly,. ii. FMV of property given up as consideration (assumed arms length transaction of equal exchange). Basis Adjustments for debt forgiveness iii. Is the debtor solvent? If yes: iv. When a seller carrying financing forgives all or part of the debt it is treated as an adjustment to the purchase price and the basis is adjusted down accordingly. v. If not Solvent: No income from forgiveness of indebtedness (§ 108) for amount up to level of taxpayer’s insolvency vi. Amount over insolvency will be income from forgiveness of debt. Lessee Improvements (§ 1019): No adjustments for lessee improvements to a land. Amount Realized: Generally: Amount received at sale in cash, property, services, and acquired debt. (1) Mortgages and sale of land at a profit (Crane) a. Amount realized = Sale Price = cash + assumed or dismissed debt. (2) Non-recourse Debt: a. Sale of land at a loss less than Note (Tufts) i. Amount Realized = Unpaid amount of note b. Sale of land at a gain: i. Gain is Capital Gain 7 (3) Recourse Debt (Sale at a Loss) a. Sale of land at a loss less than Note: i. Amount Realized is the FMV of the property. b. Sale of land at a gain: i. Gain is part capital and part ordinary income (deprec. Recapture) Amount Recognized: Amount Realized minus Basis (at Capital Gains rate) + Basis minus Adjusted Basis (at a depreciation recapture rate). Exclusions: § 1031 - Like Kind of Exchange § 1032 - Exchange of Shares for Money § 1041 – Transfer of Property to a spouse incident to divorce Scenarios: (1) Part Purchase Part Gift a. Split out purchases portion from Gift Portion. b. Assign basis to each portion according to the rules that apply to purchases and gifts, respectively c. Donor Basis: $120K d. Donee Basis: $120K because that is purchase price. e. Donee Basis: Greater of : Amount paid, or Transferors Adjusted basis at time of transfer. f. 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. (2) Sale for less than gift FMV but less than original basis i. Ex. 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. GAIN FROM DAMAGES AND RELATED RECEIPTS (1) Recovery of Cost: Not Income (2) Lost Profits: Ordinary Income (3) Punitive Damages: (Glenshaw Glass): Ordinary Income, except in a wrongful death civil action. (4) Damages to Goodwill: Gain over basis (aka excess over cost) taxed as ordinary income. Goodwill is non-divisible. All or nothing. (5) Workers Comp and Personally purchased Insurance: Not Income (6) Amounts from employer purchased insurance policies: Not Income to extent used for medical bills. All other remuneration is Ordinary Income (7) Damages received on account of personal injuries, sickness or emotional stress § 104: Not Income (except Punitive). (8) Damages for non-physical income: Defamation: Ordinary Income 8 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. EXCLUSIONS § 61 TO § 102. § 101-139 Gifts: § 102(a) – Inter Vivos Gifts. (1) Value of gift excluded, but not income from gift. (2) Deduction of gifts limited to $25. (3) Duberstein Test for Donative Intent a. Totality of intent as determined objectively on facts. b. Must be detached and disinterested transfer out of generosity. c. Look to dominant reason for transfer. Employee Gifts: IRC 102(c) Supplants 102(a) with regard to employees. (1) (2) 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. ? (3) (4) (5) Inheritances, Bequests, and Devises: (1) § 102(a) Must be bona fide gift under Duberstein Test, or taxable. a. Duberstein Test for Donative Intent i. Totality of intent as determined objectively on facts. ii. Must be detached and disinterested transfer out of generosity. iii. Look to dominant reason for transfer. (2) Bequest as consideration is income (Wolder Case). (3) Gift, Bequest, or devise of income from a property is taxable. Lessee Improvements: § 106: Exclude income derived from value of improvements made by a lessee on termination of lease. Discharge of Indebtedness. 9 (1) No tax consequences on the creation or payment of the principal of a debt. a. Exceptions : b. “Kirby Lumber Income Rule”:– Buying back one’s debt for less than face value is economic accretion. (2) § 108 Discharge of Debt that is not an income event a. Bankruptcy & Insolvency §108(a): No ordinary income per “Kirby” rule for forgiveness of debt when debtor is insolvent (more debt than equity). i. Only Taxed to extent solvent. ii. Not taxed in bankruptcy. b. Discharge of unenforceable obligations (debt) are not an income event § 108(d)(1). i. Exception: ii. When property held by indebted party iii. When indebted one acknowledges the debt iv. Zarin Test: Foregiveness of uncollectible gambling debt is income according to 61(a)(12), but 108 applies because insolvent. SEPARATION AND DIVORCE Alimony: Support payments made from one former spouse to another. (1) General Rule: Payments deductible to payor (§ 71) and includable in gross income to payee (§ 215) a. Specific requirements for payments to qualify as Alimony:. i. (1) Payment received by or on behalf of spouse under a divorce or separation instrument - §71(b). ii. (2) The instrument does not designate the payment as a nonalimony payment. iii. (3) The parties are not members of the same household at the time the payment is made iv. (4) There is no liability to make payment after the death of the payee. v. (5) The payment is not for child support. vi. (6) Payment in cash. Not art, notes, or other assets. b. Uneven Payments: §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. Property Settlements: (1) Transfer of property to a spouse incident to a divorce: Treated as a gift under § 1041. a. Specific Requirements: i. Must be within one year of divorce, or ii. Within 6 years of date if incident to the divorce as called for in divorce agreement. 10 1. Rebuttable presumption related to divorce 2. If outside 6 years, can still prove incident to divorce with right facts. If do not meet § 1041 requirements fall into: b. US. V. Davis “Tax Hell” i. When a distribution is not incident to divorce of cessation of marriage becomes a taxable event under 1001(a). ASSIGNMENT OF INCOME [i.e. who is the taxpayer] (1) General Rule: Must assign income before it is earned for it to be tax free to assignor. (Site Commission v. Giannini). (2) Marriage – Lucas v. Earl General Rule: When one party in a marriage (where there is a K for J/T of all property and receipts) 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. a. Fancy contracts: While valid for other purposes, don’t change the tax nature of the transaction. (3) Directed payment on one’s behalf – Commis. V. Giannini: Income event if director as dominance over payment. a. If payment is refused and then disposed of not under dominant control of refuser, then no income event. b. Gianini refused to accept a payment, so didn’t dominate, so wasn’t taxed. (4) Agency Relationships: Money is no income as it is just an agency capacity as a pass-through. (Rev. Ruling 74-581) (5) Fruit of the Tree Doctrine: The fruit is not to be attributed to a different tree than that which it grew on. a. Trust Dealings: Must convey the entire tree into trust, then can freely alienate the fruit and the receiver of the fruit shall pay tax on the income. b. Assignment of installment payments: 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. (6) No Form over Substance: 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. a. Look for valuable consideration, economic risk. ASSIGNMENT OF STOCK AND DIVIDEND INTERESTS (1) Publicly Held Corps: Income Recognized to owner as of Record Date. (2) Closely Held Corps: Income recognized to owner as of Declaration date. No bump in basis due to a dividend. 11 ASSIGNMENT OF INTELLECTUAL PROPERTY INTERESTS (1) Transfer of a patent is a transfer of property (Rev. Ruling 64599 (2) Scenario: 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. a. 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: Personal § 262 (1) General Rule: Deductions must be precisely within the statute for a deduction to qualify. a. No deductions for living expenses unless specifically noted (§ 262(a)) b. Exceptions: i. Interest paid for the use or forbearance of money (§ 163(a) & rev. ruling 69-188). ii. Foregone Interest is seen as interest paid (a deduction to payor and income to payee). iii. Only “qualified interest” is deductible Qualified Residential Interest 1. Two categories: a. Acquisition Indebtedness (1) Debt incurred in acquiring, constructing, or substantially improving a qualified residence. (2) $1M ceiling on deductible debt service (3) >$1M prior to 1987 grandfathered in (4) Points deductible § 461(g) & Rev. Ruling 69-188. b. Home Equity Indebtedness (1) Debt secured by a qualified residence (2) Debt may not exceed FMV, capped at $100K. (3) Amount over #1M ceiling under (a) above may be qualified under this section (4) Home equity used to substantially improve a qualified residence is seen as Acquisition Indebtedness. 2. Qualified Educational Loans a. Can deduct interest if a qualified educational loan so long as meet statutory requirements (§ 221). i. $2500 statutory limit per year. 12 ii. Limit based on AGI (above $50K have to go into a computation). 3. Investment Interest (P. 486) a. § 163(d) limits deductibility of interest by noncorporate tax payers b. General Rule: Can deduct investment interest to the extent that you have investment income. i. Interest on money borrowed to invest in tax deductible bonds is not deductible. 4. If purchase on an installment basis: then deduct interest at 6% pursuant to: § 163(a)(2). 5. Taxes a. Deductible only to the person whom has an obligation to pay Business (2) General Rule: All ordinary and necessary expenses incurred during taxable year in the carrying on of any trade or business (§ 162). a. Ordinary and Necessary: must be expenditure that protects existing business interests and earnings capacity. b. Intent: cannot be for personal reasons. c. Deductions limited to amount at risk § 465 (3) To Capitalize or Deduct? a. Capitalize if (§ 263): expense serves to create (i.e. production) or enhance a separate and distinct asset. i. Future Benefits Test: If asset is likely to yield a future benefit associated costs should be capitalized (INDOPCO v. Commissioner). ii. Principal Purpose Test: Suggests courts will look to the principal purpose of alterations in deciding whether they are capital in nature. (Norwest Case) 1. Repairs: Must (1) increase life of asset or put into (2) “ordinarily efficient operating condition” a. Incident repair to keep in efficient operating conditions is not capitalizable. 2. Start Up Expenses § 195 a. Must capitalize and amortize. Must get into business for it to be a valid amortizable calculation. b. 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 deductible as allowed under § 165. iii. Depreciation / Amortization (§ 167): Depreciate over the useful life of the asset. 1. Applies to all property used in a trade or business, and 13 2. Property held for the production of income. b. Deduct: Generally, if not capitalized. § 162 i. Deductible Losses § 165 1. Any trade or business loss a. Payroll, except for FUTA and FICA taxes. § 275 2. Losses from sale in a transaction “entered into for profit” are deductible. a. Some transactions that don’t meet § 162 may meet § 165. ii. Contingent Compensation: Allowable deduction if paid pursuant to a free bargain between employer and individual. 1. Contingent compensation salary contracts can reduce gross taxable income to a corporation (as opposed to dividends being paid on the net after tax income). a. Must be reasonable. 2. Reasonable when compared to compensation in other related businesses. a. 7 prong test: b. (1) Nature of Work c. (2) Comparison of Salaries d. (3) Complexity e. (4) Supply and Demand f. (5) What the salaried added to the business gross income. g. (6) Don’t déclassé a bonus, it looks fishy h. 7th Circuit looks to independent investor test. All else look to 7 factor test above. (4) Deductions for profit making non-business activities including property: (a) IRC § 23(b) DEDUCTIBLE: Non-Business ordinary and necessary expenses of an individual in the production or collection of income, or for the management, conservation, or maintenance of the property held for the production of income. (b) “Production or Collection of Income Test” replaces “trade or business” concept. Still must be ordinary and necessary. § 212 i. Only reasonable business judgment required in an effort to produce or protect income. Surasky Case. (c) Non-Deductible Property Expenses: Expenditures in defending & perfecting title to property, in recovering property, or in developing or improving property constitute a cost of the property and must be capitalized. (d) Deductible Property Expenses: Expenses for management, conservation and maintenance costs of property held for income production are deductible (all allocable costs). § 183.. i. Non-Deductibility test for residences: You are considered to use a dwelling as a “residence” if you use it for personal 14 purposes more than the greater of 14 days or 10% of the days it is rented at FMV in a year. § 280A(d)(1) 1. If use as a “residence”, then must divide expenses based on the # of days used as a residence and as a rental. § 280A a. All rental expenses & personal deductions (home mortgage interest etc) & business deductions (home business) are capped at income from rental. § 280A(c)(5) 2. If don’t use as a residence, and rented anytime, then treat as an all the time rental for deductibility purposes. ii. See § 221(b)(2) Limitation on the deductibility of interest based on a taxpayers Adj. Gross Income. (e) Look to origin of claim i. “But for” test for causality between expense and income potential ii. Income still must be proximately related to the expense. 1. §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. 2. § 274(h)(7) No deduction for attending a convention. (f) Conversation of an asset from personal to for profit use i. Ex. Moving out of a house and renting it. TIMING PRINCIPLES (1) Timing Depends on whether transaction is OPEN or CLOSED. a. Closed Transaction = Ascertainable Value. i. Assets will be valued except in rare and extraordinary circumstances where there is not even a rough ascertainable value. a. Gain realized at time asset acquired. b. Use FMV, or with bonds Face Value (unless interest is below Federal Rate).. i. Bonds: If subsequent payments above asset basis, it is ordinary income. b. Open Transaction = NO Ascertainable Value. i. Open transaction, subject to realization upon future cash flows. (Western Oaks Case) ii. Don’t include any gains until paid. iii. Future cash flows are capital gains. iv. There are not capital carrybacks if overvalue an asset. You end up with more realized gain that actually have!! c. (2) Timing depends on the accounting methodology the tax payer is using 15 a. Either Cash, Accrual, Installment or any other hybrid that is approved by the commissioner or that accurately reflects income. b. Cash Method: Income and Expense booked in year when actually received or paid, unless it is a capital expense under which it must then be depreciated. i. Claim of Right Doctrine: Unfettered control over money is an income event. 1. Ex. A 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). ii. Constructive income: As long as have control over it. iii. Constructive expense (payment): As long as have relinquished immediate control and made available. (i.e. Mail box rule, payment made when dropped in the mail – but not taxed to receiver until received). iv. When is a credit card payment booked? 1. When the receipt is signed. v. Receiving Indefinite Amounts (i.e. contract rights, bonds, unmarketable stock). 1. Asset will be valued except in rare and extraordinary circumstances where there is not even a rough ascertainable value (i.e. Contingent Compensation situations). a. If ascertainable, then it is a Closed Transaction i. Gain valued at time asset acquired. ii. Use FMV, or with bonds Face Value (unless interest is below Federal Rate).. iii. If subsequent payments above asset basis, it is ordinary income. b. If not, then it is an Open transaction, subject to valuation upon future cash flows. (Western Oaks Case) i. Don’t include any gains until paid. ii. Future cash flows are capital gains. iii. Contingent Compensation: Cite Burnett v. Logan and take open position. 2. Purchasing Notes & Bonds: Gain only after basis recovered. a. Basis = FMV at acquisition. b. Character is LTCG 3. Receipt of Gift of Notes or Bonds a. Bond worth: i. Less than Face Value - Low Interest Rate or Illiquid: FMV is Amount Realized. (Warren Jones Case) ii. Regular Interest Rate: Face Value is Amount Realized. 16 c. Accrual Method: i. Income: Any item of gross income shall be included for the tax year in which it is received, unless it is properly accounted for in a different period. § 451 1. “Properly Accounted for” refers to income being includible in income when all events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. 2. Installment Contracts: IRS will want to book all income up front. Taxpayer must show the IRS abused its discretion in asserting that their system most clearly reflects income. a. IRS Procedure 70-21 Allows pro-ration of income for services when payment is in installments over more than 1 tax period. b. Ex. Income not “earned” yet. There must be reasonable certainty that all conditions precedent have been met to being entitled to that income. Artnell Case. c. New Capital Hotel Case (check for code section.) i. 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. ii. Deductions: when can you deduct an expenditure as an accrual? (All events test 461(h)(4) & Economic performance Test) 1. Recognition: When all events have occurred that fix the right to receive the income and when the amount thereof can be ascertained with reasonable accuracy. 2. Exception: Economic performance need not happen when it falls under 461(h)(3) for reoccurring events. It Allows a deduction even though economic performance has not occurred. i.e, cleaning people coming in but the bill has been sent and they have not cleaned, if I have it done every year at this time, I can still deduct. d. Installment Method i. Used for Construction ii. Spreads the gain as the cash comes in. iii. Income is recognized for each tax year in the proportion of the Gross Profit payments received to the Total Contract Price. iv. Formula: (Sales Price – AB = Gross Profit) / (Sales Price – Qualified Debt = Total K Price). 1. Sales Price = 100 2. Basis = 40 3. Gross Profit = 60 17 4. Qualified Debt = 0 5. 100-40=60 / 100-0=100 = 6/10. = 60% is long term gain on each payment. e. Contingent Compensation Valuation (can be under cash or accrual or other method) i. If there is no ascertainable value report on open transaction basis. ii. Films have ascertainable value based on income forecast method. (Rev Ruling 55). CHARACTERISTICS OF INCOME Taxable income can either be: (1) Ordinary Income (Anything not a capital asset) (2) Depreciation Recapture a. Un-recaptured § 1250 Gain on sale of real property i. Amount between basis and adjusted basis is characterized as depreciation recapture and taxed at 25%. ii. In the case of any installment sale all recapture income shall be recognizable in the year of sale. IRC § 453(i). b. Un-Recaptured § 1245 Gain on sale of personal property i. Amount between the Adjusted basis and purchase price is §1245 gain at ordinary rates. The amount over purchase price is 1231 gain (business or regular) at capital gains rates. (3) Capital Gains a. Must be a: Capital Asset, that is the subject of a Sale or Exchange, after the Requisite Holding Period. b. § 61(a)(3) Gains derived from dealings in property may be ordinary or Capital. c. §1244 Losses on a small business stock up to $50k are ordinary. You must be an original investor and the business must generate less than a certain threshold of gross receipts. d. §1202 Sale of Small Business Stock. Deduction of 50% of Gain. (must be under $50 of basis in assets, acquired in an original issuance at least 5 years prior, and business active over whole life). Definitions: e. Capital Asset: All property held, even in the course of business, unless it is held as inventory or is a copyright (literary, musical, or artistic composition). § 1231 i. Mauldin v. Commiss. Look to facts of circumstances to determine if in inventory: 1. Intent for which sold 18 2. Are there frequent sales of property more like inventory 3. Is it in the course of his occupation: ii. § 1234(a) Gain attributable to the cancellation or termination of a right or obligation shall be treated as a capital asset.. iii. Must have a capital asset to have a capital gain. f. Sale or Exchange §1271(a)(1): i. Complete disposition of the property. Cannot keep any interest. ii. Excluded: Cash to extinguish a debt is not a two way transfer so not a sale or exchange. iii. Exception: Keenan and Galvin Hudson Cases: When an appreciated asset transferred to a creditor to extinguish a debt. 1. Kenan v. Commissioner Testamentary Conveyance. Will said they needed to pay legatee 5M. When they used appreciated property to pay that distribution was construed to be a sale. 2. Galvin Hudson vs. Commissioner: Payment of a judgment not construed to be a sale. No property being received by a payor. iv. Losses from worthless securities (stock or qualified debt) are considered a sale or exchange v. Common Law (subject to § 1234 above) Property must exist after transfer). g. Holding Period: i. Less than 1 year = ordinary ii. Greater than 1 year = capital iii. Tacking: Holding periods can sometimes be tacked. 1. § 1223. Inter Vivos Transfer allows tacking. 2. Testamentary Conveyance is controlled by § 1223(10) if sell w/in one year, still considered to have held it more than a year.. iv. Stocks: First in First Out (FIFO) – Tres. Reg. 1.1223(1)(i). 1. Trade Date is the date of sale. v. Testamentary Transfers: On date of death adjusted basis set at FMV. Acquirer is considered to have held property more than 1 year. vi. Real Estate: Split out land from improvements. h. Net Capital Gains § 1222(11): The excess of the “Net Long Term Capital Gain” over the “Net Short Term Capital Loss” i. Long Term Capital Gain / Loss: Asset held for more than 1 year j. Short Term Gain / Loss: Asset held for less than 1 year. k. § 1211: Can only take capital losses against capital gains 19 l. § 1211(b)(1): Individuals can pass through $3k a year of capital loss to offset ordinary gains. Remaining balance if capital loss carryover. Procedure: (1) Net Long Term Gains and Losses = NLTG or NLTL (2) Net Short Term Gains and Losses = NSTG or NSTL (3) “Net Long Term Gain” minus “Net Short Term Loss” = Net Capital Gain. a. Net Capital Gain is taxed at Capital Gains Rates (4) NSTCL is used first as pass-through then NLTCL is used if amount remaining under cap (3k cap). (5) NLTCL carry-forward is then subtracted from NSTCG??? a. Remaining “Net Short Term Gains” are taxed as ordinary income. (6) Remaining NSTCL and NLTCL are rolled forward and stay characterized as either short or long term loss. Corporations and Capital Gains: If C corp, Tax rate the same if it is ordinary income or capital gains. But prefer capital gains because can be rolled forward (no pass-through rules, just gains against losses). (1) Carry back losses three years first, then roll them five years forward. (2) Must use oldest losses first. (3) And can restate previous years taxes and file for a refund. (4) All carried forward losses are treated as STCL. §1231(b) Property (depreciable property held in a trade or business): Any gain recognized from the sale or exchange or casualty of property used in a trade or business or transaction entered into for profit. DIFFERENCE: 1231 Net loss is ordinary. (1) §1231(b) Sale or Exchange OF “Prop used for Business” a. “Used in Business” means §1221(2) property held for more than 1 year (depreciable property held for more than 1 year), which is not: i. Inventory ii. Held for sale in trade or business iii. Not publication 1. Does not mean timber, gold, iron ore, livestock other than cattle. (2) §1231(c) Casualty or Condemnation of Property used in Business or for profit. a. Fire, Storm, Act of God. b. Causality Losses > Causality Gains (Insurance) is ordinary income. c. Procedure: 20 i. Net Casualties ii. Bring Casualty Gain into larger LTCG picture iii. If Losses Exceed Gains then Ordinary Loss Said differently: Netting Process: **§1231 Gain > §1231 Loss, all items LTCG **§1231 Gain =< §1231 Lose all items: § 1231 does not apply and losses are ordinary (3) Additional Characterization Rules a. Gain from sale of depreciable property between certain related taxpayers. §1239 –When selling to an entity controlled at least 50% by seller, it is ordinary income (unless § 1221 applies and the corp cannot depreciate the property because it is inventory and held for development). b. Brokers and Dealers § 1221 (Ordinary gain and loss) A dealer is a guy who holds property: (1) Primarily For Sale (defined as of first importance or “a lot”) (2) To Customers (3) In ordinary course of business c. Businesses that Lease and Sell Equipment (Rev. Ruling 75-544) i. If in business of leasing and sell equipment at end of useful life to company, then the sale not in course of business and may be characterized as capital gains. ii. If sell with useful life left, then will be held to be in two business. Or is sell the leftovers from a manufacturing process (on a regular basis), will be held to be in two business. One sales and one leasing. Both are characterized as ordinary income. 21