Docstoc

Federal Income Tax Outline -- McDermot (Skippy) -- Pepperdine School of Law

Document Sample
Federal Income Tax Outline -- McDermot (Skippy) --  Pepperdine School of Law Powered By Docstoc
					Gross Income
1. GROSS INCOME a. IRC § 61 (a) – Gross income includes all income from whatever source derived including1: i. Compensation for services, fringe benefits ii. Gross income iii. Gains from dealings in property iv. Interest v. Rents vi. Royalties vii. Dividends viii. Alimony and separate maintence payments ix. Annuities x. Income from life insurance and endowment contracts xi. Pensions xii. Income from discharge of indebtedness b. To be included as income, there has to be a realization of the wealth. i. Discovery of value does not constitute income. (i.e. Discovering worth of painting after purchase – not recognized as income until sold). ii. Inducing a third party to pay taxes for you will constitute income2. 1. Key: is it a gift or compensation for duties or position. Look to see if third person is unrelated or is receiving some type of benefit in return. c. Undeniable ascensions to wealth, clearly realized, and over which the taxpayer has complete dominion will be counted as income3. i. Source does not matter d. Reg 1.61-1.4 – “the finder of treasure trove is in receipt of taxable income, for Fed income tax purposes, for the taxable yr in which it is reduced to undisputed possession. i. i.e. Found money is taxable in the year that it is discovered. e. Property or money obtained illegally must be included in GI 2. IMPUTED INCOME a. Homeowner does not have to include the fair rental value of his house that he lives in as income or the value to him of doing his own taxes. b. Reg. § 1.61-2(d)(1) – if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. 4 i. If the services were rendered at a stipulated price, the price will be presumed to be the FMV of the services performed unless there is evidence to the contrary.

1

Cesarini v. United States -- P bought piano and found 4K in cash inside the piano. Included the amount in his tax return as gross income. Later attempted to amend his return to not and include the amount and demanded a return of the tax upon the amount. Is the money included as income? Court ruled that the discovery of cash was realization of wealth as thus taxable as income. 2 Old Colony Trust Co v. Commissioner -- Facts: P received salary from company. In his compensation package the company included paying for his income taxes. Issue: Did the payment by the employer of the income taxes constitute additional taxable income to the employee? Holding: Yes, P could not pass on his duty to pay taxes. It was if he had received the money himself from a 3P. They were paying his taxes in consideration for his services. It was not a gift. There was a discharge of a 3P (employer) to the government which was in consideration for services performed. It is equivalent to receipt by the person taxed. 3 Commissioner v. Glenshaw Glass Co. – Two P received damages in the form of punitive and treble damges. Neither included it as income. The court held that since the income was realized and was not a gift, it was to be included as taxable income. The law that applies is the law at the time the taxable income occurs. 4 Dean v. Commissioner -- Deans owned a house and they transfer the house to a C in which they were the sole SH of. They lived in the house for free or were not charged rent by the C. The government said the Deans had to be taxed on the fair market rental value of the house. This is different because C file their own income taxes. The C is a different entity or cash payer from the shareholders, thus the deans were receiving income form the C. This was a form of compensation to the Deans. Treating the Deans as SH living in the house rent free was like a dividend.

1

The Exclusion of Gifts and Inheritances
1. GIFTS a. IRC § 102– Gross income does not include property acquired by gift, bequest, devise, or inheritance. i. This does not exclude from gross income: 1. income from any property received by gift, bequest or inheritance; or 2. if derived form the property if it is income producing property. b. A gift in the statutory sense proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses, the most critical consideration is the transferor’s intention.5 i. Look for voluntary transfer of property without consideration. c. Settlements from will contests are inheritance and are excluded under GI6 d. Factors to determine if gift or income: i. Familial relationship; size or type of gift; services performed; employment status (preacher?) e. Employee Gifts i. IRC § 102(c) – gifts issued to employees by an employer are NOT excludable from income unless they are an employee achievement award OR a de minimis fringe. ii. Employee Benefits Not Included in Gross Income: 1. Reg . § 102-1(f)(2) -- for ―extraordinary transfers to the natural objects of an employer’s bounty if the employee can show that transfer was not made in recognition of employee’s employment a. i.e. like son getting color TV. 2. § 74(c) – Gross income does not include the value of an employee achievement award if the cost to the employer of the award does not exceed the amount allowable as a deduction to the employer for the cost of the award. a. If it is a length of stay award, it can only be given after employees first 5 years. 3. § 132(b) – No additional cost service which means any service offered by an employer to employee if: a. the service is offered for sale to customers in the ordinary course of line of business and; b. the employer incurs no substantial additional cost in providing such service to the employee. i. This includes forgone revenue. ii. This applies to family members as well c. Special Rule – Only apply to officers if no discrimination exists. 4. § 132(c) – Qualified employee discounts  As long as the discount is: a. Property, and the discount does not exceed the gross profit percentage of the price at which the property is being offered or; b. Services, 20% of the price at which the services are being offered. c. Must be in line of business d. Special Rule – Only apply to officers if no discrimination exists. 5. § 132(d) -- Working condition fringe

5

Commissioner v. Duberstien -- Duberstien Facts: Dub received a car from a business associate. The business associate said it was a gift for his help. The business associate deducted it from his taxes which alerted the IRS. The IRS said that Dub owed income tax on that the car. Tax court said that it was income and court of appeal reversed. Stanton Facts: Stanton worked for a church and resigned after 20 years. The church gave him 20K as a gift they said. Dist Ct. said it was a gift, the appeal ct reversed. Analysis: A gift in the statutory sense proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses, the most critical consideration is the transferor’s intention. An employee shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee. 6 Lyeth v. Hoey -- 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

2

a. Not income if employer pays for a business sexpense that would otherwise be deductible by the TP i. i.e Bar dues. 6. § 132(e) – De minimis fringe benefits a. Includes: i. Secretary typing letters, picknics, occasional events tickets, etc. ii. Eating facility for employees if 1) the facility is on or near workplace and; 2) revenue produced at the facility normally equals or exceeds the direct operating cost of the facility b. Does not include i. Season tickets ii. Auto for more than 1 day a month iii. Membership to club 7. § 132(f) – Qualified transportation fringe a. Commuter highway vehicle if used to travel between residence and place pf employment b. Any transit pass c. Qualified parking 8. § 132(g) – Moving expense reimbursement fringe 9. § 132(h) qualified retirement planning services 10. SPECIAL RULES – iii. Meals and Lodging 1. IRC § 119 -- Meals and Lodging can be excluded from gross income but only if: a. Meals – 1) on Employers Premises and 2) For Convenience of Employer i. Meals = food, not groceries (Kowalski) ii. If employee is required to pay charge for such meals, they are deductible under § 119(b)(3). b. Lodging – 1) Employers premises; 2) for convenience of employer and 3) Condition of employment 2. Employer premises = on or adjacent to (2 block away would not count) a. If required to live on employer premises for job, then do not have to include value in GI7 2. BEQUESTS, DEVISES AND INHERITANCES a. Property left by will, bequest or devise is not included as gross income. i. If property is left as repayment for something it could be considered income – analyze facts. ii. The true test of a gift is whether it is done disinterestedly or done in connection with something else.8 3. PRIZES a. IRC § 74 – Generally GI includes amounts received from awards and prizes. b. Exceptions i. Gross income does not include amounts rec’d as prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, but only if— 1. The recipient was selected without any action on his part to enter the contest or proceeding 2. The recipient is not required to render substantial future services as a condition to receiving the prize or award; and 3. The prize or award is transferred by the payor to a governmental unit/org pursuant to designation made by the recipient. ii. (c) Exception for certain employee achievement awards.—

7 8

Herbert g. Hatt Case – TP had to live at funeral home. Wolder v. Commissioner -- Atty made agreement with client to perform legal services and he would be paid through her will. She died and atty was given stock of 15K. He cashed in stock and tried to exclude stock from gross income under 102(a). The court disagreed. The true test of a gift is whether it is done disinterestedly or done in connection with something else

3

iii. In general.--Gross income shall not include the value of an employee achievement award received by the taxpayer if the cost to the employer of the employee achievement award does not exceed the amount allowable as a deduction to the employer for the cost of the employee achievement award. c. § 74(j) – Employee Achievement Award – means an item of tangible personal prop. i. Excess deduction award.--If the cost to the employer of the employee achievement award received by the T exceeds the amount allowable as a deduction to the employer, then gross income includes the greater of— 1. an amount equal to the portion of the cost to the employer of the award that is not allowable as a deduction to the employer (but not in excess of the value of the award), or 2. the amount by which the value of the award exceeds the amount allowable as a deduction to the employer. ii. The remaining portion of the value of such award shall not be included in the gross income of the recipient. 4. SCHOLARSHIPS AND FELLOWSHIPS a. IRC § 117 – Gross income does not include any amount received as a qualified scholarship. i. Scholarship or grant must be used for tuition or related expense. 1. tuition & fees required for the enrollment or attendance of a student at an educational organization; fees, books, supplies, and equipment required for courses of instruction at such an educational org ii. Gross income does not include tuition reduction 1. Does not apply for graduate school. 2. Cannot be only for high level employees. b. Limitations i. Does not include any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction. ii. Cannot be contingent on future services. iii. Does not include amounts for housing iv. Does not include amounts for food, or other spending

Gains from Dealings in Property
1. FACTOR IN DETERMINING GAIN (IRC §1001 – 1012) a. Gain =amount realized –adjusted basis b. Loss = AB - AR c. Adjusted Basis (§ 1016) – the cost of the property. i. Every time you take a depreciation it must come off the AB ii. The cost basis of the prop rec’d in a taxable exchange is the FMV of the prop rec’d in exchange.9 1. NOT the FMV of what was exchanged – avoid double taxation. iii. If difficult to ascertain the cost basis, use value of either item exchanged IF it was an armslength transaction. 1. Arms length –transaction b/w a willing buyer and seller where neither party is under any real pressure to make transaction. Would expect what is given up = what is rec’d
9

Philadelphia Park Amusements Co. v. United States -- Facts: TP gave bridge to city for 10 year extension to franchise agreement. Subsequently TP abandoned the 10 year extension with three years left on the contract. TP asserted a deprcision based upon the cost of the bridge and the loss they took by abandoning the franchise. TP needs to basis of the 10 year extension to figure out what their extension is. Issue: What is the basis of the cost of the 10 year extension? Decision: IRS said they did not have a basis in the extension. Ct. of claims said that the TP did have a basis in the extension. TP said franchise was not of any worth. People were no longer using it. The basis of property acquired in an exchange is its fair market value, unless otherwise provided in the Code or regulations. This case is asking how do you determine the cost basis of an asset when you do not pay case to receive an asset. Rule: The basis of property received in an exchange is its fair market value at the time of receipt. If you cannot value that asset, then you look to the value of the asset given in exchange for the asset received.

4

2.

3.

4.

5.

iv. Casulty Loss 1. Personal Casulty Losses  Reg. § 1.165-9(b) – for purposes of determining AR for casualty loss, it will the lessor of: a. The property’s AB just before the accident or; b. The FMV just before the accident. 2. Business Casulty Losses  the loss will be the AB just prior to the accident. PROPERTY ACQUIRED BY GIFT a. IRC § 1015 – Donee get the donor’s basis UNLESS donor’s basis is greater than FMV of the prop at time of the gift, then for purposes of determining loss the basis is the FMV. i. A transfer that should be classified as a gift under the gift tax laws is not necessarily treated as a gift for income tax purposes (Farcid) b. Property Acquired by Gift and by Sale??? i. Transofor – only has gain to the extent the AR exceeds his AB. No loss is realized if AR is below AB. ii. What is the new AB for purchaser/donee? Greater of either: 1. The amount paid for the property 2. Transforer’s AB at time of transfer PROPERTY ACQUIRED BY BETWEEN SPOUSES OF INCIDENT TO DIVORCE a. IRC § 1041 – Generally no gain or loss on a transfer of property from an individual to either: i. A spouse, or; ii. A former spouse, BUT only if the transfer is incident to divorce. 1. A transfer is incident to divorce if: a. Occurs within 1 year on which the date the marriage stops or; b. Is related to the cessation of the marriage 2. Does not apply to agreements or transfers that are entered into before marriage. If agreement was entered into before marriage but property was transferred until after marriage it would apply. b. Rule: Transforee keeps Transforer’s AB. PROPERTY ACQUIRED FROM A DECEDENT a. IRC § 1014 – Generally property acquired by a decedent reveives an AB equal to the FMV of the property on the date of the death of the decedent OR at the time of a gift (in the case of an inter vivos gift)  Stepped up basis i. Applies to property acquired from 1 year after decedents death. ii. 1014(e)  if you give away property and then get it back within 1 year, no stepped up basis 1. treated as a sham or like it never happened iii. Capital assets transferred by devise, automatically get a LT capital treatment. THE AMOUNT REALIZED a. IRC § 1001 – The amount realized is the amount from the sale or disposition received PLUS the FMV of the property (other than money) received. 10 i. Key Case: International Freighting  When you use appreciated property to discharge an obligation you recognize gain to the extent the FMV exceeds the adjusted basis. b. IRC § 1016 – AB is reduced by appreciation. 11

10

International Freighting Corp. v. Commissioner -- You have a tax payer who is IFC who gave stock dividends to some of its employees but the stock was not of its own stock. These dividends were more like bonuses, given to those employees who performed well. The stock was Dupont stock. The stock that was transferred to the employees that was transferred top the employees was worth 24K at the time is was transferred. The stock cost the tax payer 16K. The court is considering two issues. Business get to deduct reasonable salaries. Bonuses are a form of salaries. With regard to the second issue which is whether the TP had to recognize gain (which would be 16K to 24K). The Ct. said that they did. They had a gain of 8k. What we get then form this case is when you use appreciated property to discharge an obligation you recognize gain to the extent the FMV exceeds the adjusted basis. They were allowed to deduct 24K and recognize a 8K gain. 11 Crane v. Comm**. -- 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

5

i. Rules from Crane and Tufts** 12 1. The amount of a mortgage is to be included in basis when the mortgage is used to acquire the prop (doesn’t matter whether mortgage is recourse or nonrecourse) 2. When the prop is sold, whether mortgage is recourse or non, the seller must treat the amount of the mortgage as AR 3. If the value of the prop falls below the amount of the mortgage, it doesn’t matter ii. Notes: 1. If TP took out a second mortgage on his home or an home equity loan the amount of the loan would be added to his AB in his property if he spent the money on his home. 6. LIFE INSURANCE PROCEEDS AND ANNUITIES a. IRC § 101(a) – Generally GI does not include amounts from life insurance proceeds by received by reason of death of the insured. (if you cash out early this does not apply) i. In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to sum of actual value of such consideration and premiums and other amounts subsequently paid by the transferee. 1. This does not apply if: a. if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or b. if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. ii. IN OTHER WORDS  if an LI is transferred for money, only the amount paid + any payments are excluded. iii. Rules: Only the principle is excludable; not interest payments b. Payment at a Date Later than Death i. If payments are to made over term of years, what ever was due upon death would be excludable; the rest would be included as gross income.13 ii. If you leave the balance and only take the interest, the interest is fully included in GI. 7. ANNUITY PAYMENTS a. IRC § 72  Gross income includes any amount received from an annuity i. Gross income does not include the amount determined by the exclusion ratio. ii. Exclusion cannot exceed the amount invested in the annuity. 1. If you buy an annuity with after tax dollars, the investment that is returned to you is not taxed. a. The way that it is not taxed is the exclusion tax ratio under 72(b). This is the investment / expected return 8. DISCHARGE OF INEPTNESS a. Generally discharge of indebtedness is included in GI.14 b. Exceptions (§ 108): Not included in gross income if: i. Bankruptcy occurs ii. Discharge occurs while T is insolvent (liabilities exceed FMV of assets) iii. Indebtness discharge is qualified farm indebtness or iv. in the case of a T other than a C corp, the indebtedness discharged is qualified real prop business indebtedness.
12

Comm. V. Tufts ** -- 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 13 Hypo: X buys LI in favor of Y for 100K. X dies. Company pays her 12K for 25 years. 25 x 12 =300 (100 excluded as GI; 200 included as GI). Each year this would proated. 4k excluded and 8k included. 14 U.S. v. Kirby Lumber – P issued own bonds that were purchased by people. They later paid out a lessor amount on the bonds. Commissioner tried to say the amount realized by the bonds not paid for was income. P argued that it was not income. If a corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value is gain or income.

6

c. Contested Liability Doctrine -- if a taxpayer in good faith disputes the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt recognizable for tax purposes.15 i. If both parties agree on a debt amount and subsequently reach an agreement on that debt for a lessor amount, the remainder will be include as income. 9. DAMAGES AND RELATED RECEIPTS a. Damages in General i. Settlement damages in lieu of: 1. Lost profits --- taxed a. If payment was a result of physical injury then possible be excluable 2. Lost goodwill – not taxed. 3. Return of capital – not taxed 4. Interest – taxed 5. Punitive damages – taxed 6. Recovery of basis – not taxed (beyond basis is taxed) b. Damages and Other recoveries of Personal Injuries i. IRC § 104 – GI does not include amounts received on behalf of: 1. workers compensation; a. The death or injury must be job related (not merely under works compensation) 2. damages for personal injury or sickness a. As long as damages flow from physical injury then they are excludable16  this includes lost wages. b. NOTE  damages for a non-personal injury (including emotional distress) are included in GI. 3. accident or health insurance for personal injuries or sickness; 4. a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country; 5. amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action. ii. IRC §105(b) -- if an employer directly or indirectly reimburses an employee for expenses of medical care for the employee or the employee’s spouse or dependents, the amount rec’d is excluded from gross income iii. IRC § 106(a) – GI does include payment made by an employer for employee health insurance coverage. 10. SEPARATIONS AND DIVORCE a. Alimony i. IRC § 71 – Alimony must be included in GI by the PAYEE and may be deducted by the PAYOR 1. 71 = include in GI of payee 2. 215 = deduct from GO of payor ii. Requirements under § 71 1. Payments has to be in cash a. Not a promissory note or other forms of property 2. Received on behalf of spouse under divorce or separation agreement a. What Constitutes a divorce or separation agreement is defined in § 71(b)(2) i. Decree of divorce ii. Written Separation agreement iii. Support agreement
15

Zarin v. Commissioner – P was a gambler. Casino extended him credit way beyond what the law allowed. Casion was later reprimanded. P argued he dod not have to pay entire debt based upon wrongfulness of Casino. P made an agreement with Casino to reduce debt amount to 500K. Commissioner tried to argue that amount discharged was gross income pursuant to § 61(a)(2). P argued that he should not be taxed on this as income. Pursuant to contested liability doctrine, discharged protion was not taxable. The Contested Liability Doctrine holds that if a taxpayer in goodfaith disputes the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt recognizable for tax purposes. 16 X got in car crash resulting ED which woud be excludable. Damages for ED alone would not be excluade because they did not flow from personal injury.

7

3. The divorce/separation agreement does not designate the payments as nonalimony. 4. No liability after Payee’s death17 5. Must not be living in the same house a. Only in the case of divorce of legal separation b. If there is just a written separation agreement they can continue to live together. 6. *Payment is not for child support b. Indirect Payments i. Issue: whether premiums paid by a H on (1) a life insurance policy assigned to his former W and w/ respect to which she is the irrevocable beneficiary, and (2) a life insurance policy not assigned to the W and w/ respect to which she is only the contingent beneficiary, are includible in the gross income of the W and deductible by the H? 1. Held: (1) is includible gross income for W and deductible to H. (2) are neither includible in the gross income of the W nor deductible by the H. 2. Rule: Indirect payments must be received by or on behalf of a spouse. a. Cash payments to a third party (such as LL) would be an example, if they are pursuant to a divorce/separation agreement. c. Transfers on Property  see above

Deductions
1. INTRODUCTION TO BUSINESS DEDUCTIONS a. IRC §162(a) Deductions of business expenses are allowed if: i. Has to be ordinary and necessary18 1. An ordinary expense is not one that is habitual, but rather one that is common in the taxpayer’s particular industry or business. ii. Incurred or paid during the taxable year iii. Incurred in carrying on a trade or business b. § 162 Trade or business expenses deductions includes: i. A reasonable allowance for salaries or other compensation for personal services actually rendered; ii. 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 iii. 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 c. Expenses i. IRC § 263 – No deduction shall be allowed for: 1. Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. 2. Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. ii. Cost of acquiring capital asset is treated like a capital expenditure. iii. The cost of repairs is deductible.19 1. Cannot be problem created by the taxpayer 2. Should not be a problem known from beginning
17 18

If you made a provision that the payments are to be made for 10 years after divorce, then it would not count. Welch v. Helvering --H was the secretary for the W company. This was a corporate office that he held but it was his father that was calling the shots. Someone did not do a good job and the business went bankrupt. Son starts contract with Kellog and decides he wants to pay off his debt to help his future business and develop clients. The Comm. said that the payments made to pay off debts were not ordinary and necessary but rather capital expenditures. S.C. agreed. Why? They do not give a clear definition or ordinary and necessary. Paying debts without legal obligation was extraordinary. They said that it was necessary but not ordinary 19 Midland Empire Packing v. Commissioner -- What are they trying to deduct? Floor lining to their factor to protect against leakage from neighboring plant. Is this deductible or capital expenditure. Ct. says that it is deductible because it is a repair.

8

a. That cost should be included in overall cost of acquiring capital asset. iv. Need to draw line b/w cost related to tangible prop that are incurred as repairs (currently deductible expenses) and expenditures that are improvements to prop (amounts required to be capitalized)  Midland v. Question of capitalization of costs related to the acquisition or creation of various types of intangible assets  INDOPCO20 vi. Salaries 1. Unreasonable salaries are no deductible  a. Factors (majority): i. Type and extent of the services rendered ii. Scarcity of qualified employees iii. Qualifications and prior earning capacity of the employee iv. The contributions of the employee to the business venture v. Net earnings of the employer vi. Prevailing compensation paid to employees w/ comparable jobs vii. Peculiar characteristics of the employer’s business b. Independent Investor Test (minority): i. Executives’ salary is ―reasonable‖ (and deductible) if it’s proportional to investors’ profits. The more that the comp makes, the more the shareholders should be willing to give executive vii. Key Questions 1. Is it a repair? 2. Is it a capital improvement or asset? 3. Should it have been figured into cost of capital asset? d. Ordinary and Necessary i. Necessary test  look to the subjective view of TP (appropriate or helpful, they will be deemed necessary) ii. Ordinary Test  More of an objective standard  Is it common or customary/acceptable practice within this business. 21 2. CARRYING ON BUSINESS a. IRC § 195 – Generally there is no deduction allowed for start-up expenditures. i. Start-up expenditure means any amount paid in connection with: 1. investigating the creation or acquisition of a business or trade; 2. Creating an active trade or business; 3. Any activity engaged in for profit and for production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, ii. Limitations 1. 195(b)(1) -- TP can deduct for the taxable year in which the business begins an amount equal to the lessor of: 1) the amount of start-up expenditures or 2) 5K reduced by the amount by which such start-up expenditures exceed 50k. 2. The remainder can be amortized over the next 180 month period. 3. If the business stops before the amortization period, TP can deduct the rest of the expenses in that year as long as they comply with 165. 22 b. Rules:
20

INDOPCO, Inc. v. Comm. --- This is a friendly takeover. The tax payer at the time of the takeover was known as National Starch and after it was changed to INDOPCO. The acquiring company was called Unileaver. Is there something in the opinion that is a good argument for deductions? Court focuses on future benefit 21 Welch v. Helvering -- H was the secretary for the W company. This was a corporate office that he held but it was his father that was calling the shots. Someone did not do a good job and the business went bankrupt. Son starts contract with Kellog and decides he wants to pay off his debt to help his future business and develop clients. The Comm. said that the payments made to pay off debts were not ordinary and necessary but rather capital expenditures. S.C. agreed. Why? They do not give a clear definition or ordinary and necessary. Paying debts without legal obligation was extraordinary. They said that it was necessary but not ordinary 22 If TP started a business and spent $5,027, he would get to deduct 5k in the first year and the 27 over the next 160 months. If the business went under he could deduct what remained of the 27 in that year.

9

i. When taxpayer reaches the transactional stage, amounts paid to complete the transaction generally must be capitalized. ii. To get 195 deductions, TP must actually enter the business. iii. Expenditures must be of the type that are allowed on an existing business iv. Revenue Ruling 75-120 v. Job hunting is below the line as misc. expenses. c. Process: i. Step 1 – is the person ―carrying on‖? 1. If no, no deduction under 162, but you can get start-up costs for 195. ii. Step 2 – If yes how much start-up costs did TP spend? 1. If less than 50K, 5K in first year and rest amortized over next 15 years. 2. If over 50K, 5k reduced by the amount that is over 50K, amortize over 15 years. 3. TRAVEL AWAY FROM HOME a. IRC §162(a)(2) – Generally you can deduct traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business. b. Limitations i. Living expenses paid by a single taxpayer who has no home and is continuously employed on the road may not be deducted in computing net income. 23 ii. A T can have only one home for purposes of deducting travel expenses under § 162(a)(2). c. Rules: i. TP cost of going between residence and place of work are dedutible in 3 cases: 1. T may deduct daily transportation expenses incurred in going b/w the T’s residence and temporary work location outside the metropolitan area where T lives and normally works. 2. If a T has one or more regular work locations away from the T’s residence, the T may deduct daily transportation expenses incurred in going b/w the T’s residence and a temporary work location in the same trade or business, regardless of the distance. 3. If a T’S residence is the T’s principal place of business, the T may deduct daily transportation expenses incurred in going b/w the residence and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance. ii. What is Temporary? 1. If employment is realistically expected to last (and does in fact last) for 1 yr or less, the employment is temporary24 2. If employment at a work location is realistically expected to last for more than 1 yr or there is no realistic expectation that the employment will last for 1 yr or less, the employment is not temporary, regardless of whether it actually exceeds 1 yr 3. If employment initially is realistically expected to last for 1 yr or less, but at some later date the employment is realistically expected to exceed 1 yr, that employment will be treated as temporary until the date that the T’s realistic expectation change, and will be treated as not temporary after that date iii. Other 1. If you are self-employed, the transportation expense deduction is above the line (above AGI) 2. If you are an employee, the transportation expense is below the line (below AGI – usually part of itemized deductions)
23

Rosenspan v. U.S. – P is trying to deduct the cost of hotels and meals he uses and or stays in every night. He does not have a home and is a traveling salesman. § 162(a)(2) allows deductions for traveling expenses while away from home. Issue was what is your home or did you need to have a home. In this case P’s base was NY where he kept a room kind of at his brothers house. Court ruled that since, P did not have a home the deduction could not apply 24 Peurifoy Case – Construction workers were employed at a site in Kingston N.C. and they lived in some place else in the state of N.C. The question was whether they could deduct the cost of housing and meals at the Kingston job site. If they could establish that the work was temporary rather than indefinite, they received the deduction. Since that ime Congress codified the results in this case in § 162(a). § 162(a) – ―A taxpayer shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year

10

3. Transportation between 2 workplaces = deductible (i.e., law firm job to flipping burgers, the travel between the 2 jobs is deductible). 4. Travel between 2 regular places of business is deductible. 5. Going to and from a non-regular place of business is deductible 6. For meals to be deductible, you must stay over night. 4. EXPENSES OF EDUCATION a. IRC § 162 – Can be deductible if carrying on trade or business. b. Reg § 1.162-5(a) i. Education expenses incurred to fulfill requirements of a taxpayer’s employment or profession are deductible as necessary and ordinary business expenses.25 ii. A taxpayer may deduct education expenses incurred in maintaining or improving his professional skills.26 c. Exceptions i. Minimum education requirements or meeting requirements of employer are not deductible ii. Cannot be new education or trade iii. § 274(m)(2) – no deduction for travel as a form of education. 1. You can deduct travel expenses as a business expenses. d. Notes i. If someone gets a deduction for education if they have to travel they can get a deduction for travel, meals and lodging. 5. MISCELLANEOUS BUSINESS DEDUCTIONS a. IRC § 274 i. (a)(1)(A)  Activity – not deductible unless it is ―directly related‖ OR ―associated with‖ business. 1. directly related to‖ – requires that business go on during the entertainment for which an expense deduction is claimed 2. ―associated w/‖ – requires that the entertainment have a business purpose and either immediately precede or follow a bona fide business discussion 3. For meals, travel, gifts, etc. to get the deduction you must have substantial records. ii. (K) -- Business Meals – No deduction unless: 1. it is not lavish or extravagant 2. the TP is present 3. Actual business must be discussed a. Cannot just touch base. 4. ONLY GET 50% of meals iii. (a)(1)(B)  Facilities – § 274) precludes entertainment facilities deductions (yachts; summer homes; club dues for business, pleasure, recreation, or other social purp 1. Expenses of facilities to the extent used in business for non-entertainment purposes are deductible (airplane for business travel) a. Although expenditures for entertainment facilities are not deductible, nevertheless entertainment activities related to the use of such facilities remain 50% deductible if the rules for deduction of entertainment activity expenditures are satisfied. . iv. (l)(1) -- Entertainment Tickets – limited to 50% of the face value of the ticket 1. Only 50% of meals and entertainment is allowed. v. Advertising – deductible in the year the expenses occurs even if benefits go beyond a year. 1. Can be a capital expenditure if something is purchases like a billboard. vi. (a)(2)(3)  Dues – Dues paid to one’s business are deductible 1. Dues to a contry club are not; expenses at the country club could be.
25

Hill v. Comm. – Hill was teacher in VA. She had been teaching for 25 years. She had to take classes to renew her credential. She also had the option of reading books and taking tests on those books. She chose the classes. The tax court was concerned that this was not necessary since she could have stayed in VA and read the books. She did get the deductions. 26 Coughlin v. Commissioner -- P did not need to take course he took. He was not taking it for credit. It was a one week tax course that exists today. He had to stay up on tax matters so he could better service his firm. The court held that this was a deduction under 162(a).

11

vii. Reimbursed Expenses – you do not have to cut in half. They are a wash. viii. Uniforms -- Deductions for uniforms are allowed only if ―(1) the uniforms are specifically required as a condition of employment and (2) are not of a type adaptable to general or continued usage to the extent that they take place of ordinary clothing.‖ 1. Up keep costs such as dry cleaning and laundry are also deductible. ix. Lobbying Expenses -- Generally not deductible for influencing legislation, participation in or opposition to the political campaign for any candidate for public office, etc 1. Limitation not applicable to bus related costs incurred in: influencing legis at the local level, in-house lobbying expenses if don’t exceed $2k, and lobbying expenses incurred by prof lobbyist directly on behalf of another person x. (h)(1) -- Conventions – no deduction unless doen for trade or business 6. LOSSES a. IRC § 165(a) – Generally and loss sustained during the year is deductible as long as it is not compensated by insurance or otherwise. i. Individuals can only collect losses on: 1. (c)(1) --The loss incurred in a trade or business 2. (c)(2) -- The loss incurred in any transaction for profit, though not connected with a trade or business a. look for reasonable expectation for profit -- Horman 3. (c)(3) -- Losses from firm storm, casualty, or theft. ii. NOTE  If a individual is trying to take a personal loss, it might not be deductible. b. Determining Loss27 Reg. § 1.165-7(b)(1) i. If the property is damaged – Loss is the difference between the FMV before and the FMV after, limited by the AB ii. If the property is destroyed: 1. For income producing property or property used in a trade or business  if the FMV is below the AB, you take the AB 2. For all other property  Use the AB. c. Notes i. Only realized losses taken into account 1. Must be evidenced by a closed and completed transaction, such as a sale, or fixed by an identifiable event. 7. DEPRECIATION a. IRC § 167 – There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of: i. (a)(1) --Property uses in a trade or business or; ii. (a)(2) -- Property held for the production of income b. The Relationship of Depreciation to Basis i. When a T claims depreciation on prop, the deduction is attended by a commensurate reduction in the basis for the prop – the downward adjustment required is at least the amount of depreciation deduction permitted (allowable) under the depreciation method employed by the T. 28

27

Reg. 1.165-7(b)(1). Amount Deductible – In the case of any casualty loss whether or not incurred in a trade or business or in any transaction entered into for profit, the amount of loss to be taken into account for purposes of § 165(a) shall be the lesser of either – A) The amount which is equal to the FMV of the prop immediately before the casualty reduced by the FMV of the prop immediately after the casualty; or B) The amount of the AB prescribed in § 1.1011-1 for determining the loss from the sale or other disposition of the prop involved. 28 Sharp v. U.S. -- Facts: Partnership acquired airplane, total cost was $54k. Used only 26% for business purposes. Therefore, allowed only depreciation of $14,298. Took depreciation of $13,777. Sold plane for $35k. Issue: amount of gain or loss realized by the partnership? T’s analysis: Arguing no gain on sale. AB = cost – depreciation = $40,495. Therefore, loss of $5k. Govt’s analysis: AB on business purpose = $14,298 - $13,777 = $520. After sale, (taking into account same percentage for business purposes – sale on business purposes of 26% is $9,321) the gain is $8,800. There is a loss on the personal use of $13k. This loss doesn’t offset the business purposes gain b/c doesn’t satisfy § 165(c). Held: for govt

12

ii. Sharp Case – you can split the use of an object such as a plane into business and personal usage. If you take a business depreciation, it comes off the percentage of the business use of the object. KEEP THE PERENTAGE ON THE SALE c. Straight Line Depreciation -- cost or other basis of the prop, less its estimated salvage value, is deducted in equal annual installments over the period of its estimated useful life.

Deductions for Profit-Making Non-business Activities
1. SECTION 212 EXPENSES a. IRC § 212 – General rule is that you can deduct all the ordinary and necessary expenses incurred for the management, conversation or maintences of property held for the production of income or in the connection with the determination, collection, or refund of any tax. b. Rules i. Expenses must be ordinary and necessary29 1. Do not have to show proximate relationship – only must be R and N. ii. Revenue Ruling 64-236 1. Held: proxy fight expenditures are deductible by a stockholder under § 212, if such expenditures are proximately related to either the production or collection of income or to the management, conservation, or maintenance of prop held for the production of income. iii. NOTE  Make sure you look to capitalize if you cannot deduct such as attorneys fee being part of the cost 1. If something is viewed as being part of the cost the capitalize it and reduce the AB a. i.e. broker fees, commissions, attorney fees, etc. iv. §274 – no deductions for attending convention, seminars, or meetings, etc. c. Legal Expenses i. Legal fees that are NOT deductible: 1. Expenses incurred in defending income. 30 2. divorce expenses 3. defending antinumptual agreement ii. Legal fees that ARE deductible 1. tax advice (Carpenter Case) 2. alimony agreements (to get or set up) 2. CHARGES ARISING OUT OF TRANSACTIONS ENTERED INTO FOR PROFIT a. IRC §121(a) – GI does not include gain from sale of principle residence if it is held for more than 2 years within the 5 year period ending on the date of sale i. 121(b)(2)(A) --Excluded Gain Limitations: 1. 500K for married; 250K single ii. Exception: Does not apply if the gain does not exceed the depreciation31 b. 3 Possible Deductions i. § 165 – Losses sustained, not compensated by ins. 1. Can be for profit although not connected with trade. ii. § 167 – Depreciation of property held for production of income iii. § 212 – Ordinary and necessary expenses (production, maintenance, etc.)
29

Surasky v. United States – P bought stock in company at the suggestion of Wolfson. W wanted to make some changes to the C as a stock holder. Created proxy sub-committee with a goal to implement those actions through voting. P gave 17K to help fund the committee’s goal. It worked and created greater profit for her initial investment. Issue: is the 17K deductible? Held: . Showing of proximate relationship b/w nonbusiness expenses and producing or managing income producing prop is not necessary to claim nonbusiness deduction so long as expenses are ordinary and necessary. 30 Bowers v. Lumpkin – P bought stock from trustees. Attorney general took issue with the sale and challenged it. She had to incur expenses in fighting the litigation. She had to hire a lawyer to defend against suit, in which she was successful. Issue: can she deduct expenses for legal fees? Held: Not deductible. Nonbusiness expenses incurred for production or collection of income must meet restrictions applicable to business expenses in order to be deductiblePay attention to this case. He argued that hey should have capitalized meaning it would have reduced the AB down. This would not also be then deductible. 31 I.e. 100K home. Depreciated 20K. Sold for 100K. Must count 20K as GI.

13

c. Rule: Deductions for depreciation and maintenance are allowed when property is held for production of income, BUT a loss is not allowed unless the property constitutes a transaction entered into for profit. d. Rule: Generally, when prop has been used as a personal residence, it must be converted to a transaction entered into for profit. To show such a conversion, the owner must do more than abandon the prop and try to rent or sell it. 32 e. Rule: Deductions for depreciation and maintenance are allowed when prop is held for production of income, but a loss is not allowed unless the prop constitutes a transaction entered into for profit f. Losses on Sale of Real Property (Reg. § 1.165-9) i. Property used for personal use  no loss deduction under § 165. ii. Property converted from personal use (rental)  loss on sale is deductible 1. AB is the lesser of either: a. FMV at time of conversion b. AB at time of conversion subject to 1.1011-1 g. Rule: In determining whether a property has been converted look at all factors, not just if it was up for rent. 33 h. Exceptions to 2 year requirement: i. If the sale or exchange is the result of either 1) change in employment; 2) health; or 3) unforeseen circumstances, the amount will be excluded on an amortized basis. 1. i.e. if a single taxpayer is at a house for 1 year and moves because of job, he will get ½ of the possible deduction = ½ of 250K. if he were married it would be ½ of 500. 2. Unforseen events include a. Involuntary conversion of property; death; divorce; natural or manmade disaster.

Deductions Not Limited to Business or Profit-Seeking Activities
1. INTEREST a. IRC § 163(a) – All interest paid or accrued during taxable year is deductible on indebtedness i. 163(h)(1) – No personal interest is deductible 1. Exceptions to personal interest: § 163-a. (h)(2)(A) -- Interest paid on accrued on indebtedness properly allocable to a trade or business (NOT for employees) b. (h)(2)(B) – Any investment interest c. (h)(2)(D)* -- Any qualified residence interest d. (h)(2)(F) – Educational loan interest i. loan incurred by T solely to pay for the qualified higher education expenses of a student who is the T, the T’s spouse, or a dependent of the T if the student is at least a ½ time student

32

William c. Horrmann v. Commissioner – Inherits house from mother at a basis of 60K with 9k in expenses which gives him an AR of 69K. he moves in, later abandons. He decided to rent it when the FMV is worth 45K. He later puts it on the market and it is never rented. Later it is sold for 20K. H is trying to deduct cost of maintenance from time of conversion to the time of sale. And he wants to deduct losses on the sale. He gets to depreciate under 167(a)(2) and the maintence cost under 212(2). He does not get to deduct loss on sale because it was not covered as a transaction entered into for profit. At the time he moved out of the house and put it up for sale, he could not have received a profit because the market was so low so it could not have been a transaction entered into for profit. Prof. argued that you would need to take into consideration what profit he could make at the time of the sale. (Note this was not the rule in the case and I think the professor is wrong and applied the case wrong). The case said. Generally, when prop has been used as a personal residence, it must be converted to a transaction entered into for profit. 33 Lowry v. United States – L was trying to deduct cost of maintence of his vacation home when it was up for sale. The problem was that he never put the property up for rent. If he had there would not be must of an issue. Thus the issue is whether you can deduct maintenance expenses under 212 if you never put the property up for rent after living in it? Court held yes. whether a personal residence has been converted into income-producing prop is not determine by whether or not it was rented before sold, but rather by looking at all of the relevant facts and circumstances, including whether the taxpayer had an expectation of profit.

14

ii. amount of qualified expenses is reduced by any amounts excluded from gross income iii. interest is not deductible if loan is made by a related person iv. Phase Out - amount of deduction is phased out ratably for single Ts w/ modified adjusted gross income of b/w $50k - $65k (100k – 130k for couple) v. Limited to $2,500 b. Qualified Residence Interest i. 163(h)(2) – QRI includes any interest paid on: 1. Acquisition indebtedness or; a. (h)(3)(B)(i)(I)-(II) -- acquisition indebtedness includes any debt incurred: in acquiring, constructing, or substantially, improving any qualified residence of TP or 2) is secured by such residence i. includes refinancing ii. Can’t exceed $1,000,000.00 or $500,000 in the case of married individual filing separate tax return. 2. Home equity indebtedness a. (h)(3)(C)(i)(I)-(II) -- HEI means any debt secured by residence that does not exceed the FMV reduced by of debt. i. 100K limitation or 50K for married person filing separately. 3. Qualified Residence = the principle residence of the TP AND 1 other residence. ii. Revenue Ruling 69-188: Fees associated with the use or forbearance of money are deductible as interest.34 1. Cannot be payment for services such as closing costs or security investigation a. You might try to deduct fees like this as a business expense. 2. Points on received on behalf of loan are amortized over life of loan iii. Rule: No interest deductions on no interest loans (do not count at GI)35 c. Interest on Investment Income i. IRC § 163(d) imposes a limit on the deductibility of investment interest by noncorp taxpayers 1. only deductible to the extent that the T has net investment income 2. investment interest – interest paid or accrued on indebtedness incurred to purchase or carry prop held for investment 3. Net investment income – excess of investment income over investment expenses a. Investment income – gross income from prop held for investment plus some gains on the sale of such prop, but only if the prop is not a part of a trade or business, or an activity subject to the passive activity rules, or does not qualify for preferential net capital gain treatment under § 1(h) either on the sale of investment prop or as qualified dividend income. d. Interest on Education Loans i. IRC § 221 – You can deduct interest of education loan. 2. TAXES a. IRC § 164 Deductions on the following taxes shall be allowed: i. State, local and foreign real property taxes ii. State and local personal property taxes iii. State, local, and foreign income and excess property taxes. b. Tax deductions not allowed: i. Taxes assed against local benefit to increase value of property 1. NOTE – this does not apply to maintenance or interest charges
Rev. Ruling 69-188 -- Facts: borrows money, has to pay loan processing fee – is this fee interest (and  deductible)? YES, b/c T was able to est that fee was paid as compensation to the lender solely for the use or forbearance of money, and b/c he did not initially obtain the funds to pay this fee from the lender  points are deductible. 35 J Simpson Dean v. Commissioner -- Dean got an interest free loan. He took deductions on it. Commissioner said they could not take deductions and furthermore, no interest loans were income. The Court said that you cannot take deductions on nointerest loans but it did not count as income.
34

15

ii. Taxes on real property assessed to another taxpayer. 1. 164(d)(1) -- Taxes on real estate sold within a given year will be divided pro rata. iii. Federal income taxes (§ 275) iv. Estate, inheritance, legacy, succession, and gift taxes (275) v. State Sales tax. See 164(b)(5) c. Taxes on Real Estate i. Must be owner or on the deed. ii. No deduction if someone else is the owner but you are paying the taxes (Cramer v. Comm.) 1. Does not matter what each agreed to pay.

Deductions for Individuals Only
1. THE CONCEPT OF ADJUSTED GROSS INCOME a. IRC § 62  ABOVE THE LINE i. Adjusted Gross Income equal GI minus the following deductions: 1. (a)(1) – Trade and Business Deductions a. must be carried on by the TP b. trade or business cannot consist of performance of services by TP as employee c. KEY  Covers person who is sole proprietor but not employee. i. Person who owns the business but the employees get below the line. 2. (a)(2) Certain Trade and Business deductions a. (A) --Reimbursed expenses of employees i. Does not count if: 1. such arrangement does not require the employee to substantiate the expenses covered by the arrangement to the person providing the reimbursement or; 2. such arrangement provides the employee the right to retain any amount in excess of the substantiated expenses covered under the arrangement b. (B) -- Certain expenses of performing artists c. (C) – Certain expenses of officials d. (D) – certain expenses of elementary and secondary school teachers (limit to $250) 3. (a)(3) – Losses from sale or exchange of property 4. (a)(4) – Deductions attributable to rents and royalties a. these are 212 deductions or deductions involved with property held for the production of income. 5. (a)(5) -- Certain deductions for life tenants and income bfs of property 6. (a)(6) – Pension, profit sharing, and annuity plans for self employed individuals 7. (a)(7) – Retirement savings 8. (a)(10) – Alimony 9. (a)(15) -- moving expenses 10. (a)(17) – interest on education loans 11. (a)(18) – higher education expenses 12. (a)(19) – health savings account 13. (a)(20) – Costs involving discrimination suits 2. MOVING EXPENSES (ABOVE THE LINE) a. IRC § 217(a) -- There shall be allowed as a deduction moving expenses paid/incurred in connection w/ commencement of work by T as an employee or as a self-employed individual at a new principal place of work. b. 217(b) – Definition of moving expenses: i. moving of household goods and personal effects from one house to another ii. of traveling, including lodging, to new place (does not include meals) iii. Requirements – 217(c)

16

1. Distance -- Allowed only if the distance b/w T’s former residence and new principal place of work is at least 50 miles farther than the distance b/w T’s former residence and former principal place of business. (c)(1)(A) 2. If starting a new job for first time, like a law student, then it must be 50 miles away. a. FORMULA: (Distance from your old home to new job) – (Distance of your old home to old job)  5036 3. Time – (c)(2)(A) a. Full Time: 39 weeks of the 12 months b. Self-employed: 39 weeks of first 12 months AND 78 weeks of 24 months overall. c. In the case of a full-time employee who suffers involuntary separation from employment or who is transferred by an employer, the time requirement is waived if the employee could reasonably have been expected to satisfy the time requirement if there had been no separation or transfer 4. Timing a. In general a deduction may be taken only in a yr in which an expense is paid or accrued. This poses a dilemma for the deduction of moving expenses b/c the expense will frequently be paid or accrued in a yr prior to satisfaction of the time requirement b. In order to bring the deduction in line w/ the yr an expenses is paid or accrued, a deduction is allowed for the earlier yr, if at the time for filing an income tax return it is possible that the T may still satisfy the time requirement even though she has not yet done so i. If subsequently fail to meet requirement, T may either include the amount previously deducted in gross income for the 1st subsequent yr in which the deduction was taken 3. EXTRAORDINARY MEDICAL EXPENSES (BELOW THE LINE) a. IRC § 213 -- There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent, to the extent that such expenses exceed 7.5 percent of adjusted gross income. i. Limitations: 1. (b) – medicine and drugs are only deductible if they are prescribed by a doctor or insulin. 2. Lodging is paid for if: a. Not lavish or extravagant b. Required by a physician c. Not for pleasure d. Can’t exceed $50 per night per person. 3. ½ of meals 4. transportation costs are included 5. long term care insurance costs 6. Cosmetic surgery does not count as medical care. 7. Rule: If medical care is for permanent addition to TP’s home, it can only be deductible under 213 if it does not increase the FMV37 a. If cost of treatment exceeds value to home then the part exceeding value to home is deductible. 8. Rev. Ruling 2002-19 – An expense that is merely beneficial to general health is not deductible. 38
36

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 37 Raymon Gerald v. Comm. – TP installed air condition unit for illness prescribed by doctor. Increased FMV of house. Qualifed uner 213 but not deductible because of 263(a)(1). 38 Issue: are uncompensated amounts paid by individuals for participation in a weight-loss program as treatment for a specific disease or ailment diagnosed by a Dr and for diet food items expenses for medical care that are deductible under § 213? YES

17

a. Food is never deductible even if prescribed by doctor. 4. QUALIFIED TUITION AND RELATED EXPENSES (GO OVER THIS SECTION BETTER) a. IRC § 222 -- In the case of an individual, there shall be allowed as a deduction an amount equal to the qualified tuition and related expenses paid by the T during the taxable year. i. Dollar Limit: 1. If STP adjusted gross income does not exceed 65K (130K per couple) THEN deduct 4K 2. If STP adjusted gross income does not exceed 80K (160K for married) THEN 2K. b. IRC § 25(a) – Hope tuition credit and Life Time Learning Credit i. Hope Tuition 1. Get $1500.00 CREDIT 2. You can only take this in two years. ii. Life Time Learning Credit 1. Maximum of 2K or 20% of what is under 10K. c. RULE: cannot take tuition deduction and tax credit 5. PERSONAL AND DEPENDENCY EXEMPTIONS a. IRC § 151 i. Everyone who is alive gets a deduction 1. when you file you can combine deductions (i.e. include dependents) 6. THE STANDARD DEDUCTION a. IRC § 63 – Standard deduction is made up of basic standard deduction plus an additional deduction: i. 63(b)(2)(C) – every person get to deduct 3K (6k for married filing jointly; or surviving spouse) ii. (b)(2)(B) – head of household gets $4,400 1. Head of Household is a single person (not a surviving spouse) living in one house for more than half the year and has a kid. iii. Limitations 1. A married person cannot take the SD by filing separately if spouse itemized. 2. if over the age of 65 before close of taxable year he gets and additional $600 (works for spouse also). 3. Same deal applies for blind (if tp is blind or TP spouse is blind get 600) 4. If individuals are not married and not surviving spouse they get 750 instead of 600 in above two categories. b. Itemized Deduction (below the line deductions) i. Misc deductions – deducted only so much that exceeds 2% of adjusted gross income ii. Non-misc. deductions – listed in 67 – 100% deductible. THEY INLUCDE (IRC § 67): 1. § 163 (interest) 2. § 164 (taxes) 3. § 165(a) (casualty or theft) 4. §170 (charitable contributions) 5. § 213 (medical expenses) 6. etc. c. PROCESS i. Step 1: Figure out you gross income. ii. Step 2: Calculate and subtract “above the line” deductions to get AGI iii. Step 3: Figure out your itemized deduction 1. Itemized deductions = misc. (only amount over 2% AGI) + 100% non-misc deductions. iv. Step 4: Figure out your standard deduction 1. 3K for single, 6K for married. v. Step 5: Compare ID and SD and deduct the greater from AGI. 1. Add non-mic and misc that exceed 2% of AGI deductions together. If they are over the standard deduction  itemize

18

vi. Step 6: Subtract Personal deduction and itemized/standard deduction from AGI vii. Step 7: TAXABLE INCOME

Capital Gains and Losses
§ 1222. OTHER TERMS RELATING TO CAPITAL GAINS AND LOSSES (1) Short-term capital gain.--means gain from the sale or exchange of a capital asset held for not more than 1 year, if and to the extent such gain is taken into account in computing gross income. (2) Short-term capital loss.--means loss from the sale or exchange of a capital asset held for not more than 1 year, if and to the extent that such loss is taken into account in computing taxable income. (3) Long-term capital gain.--means gain from the sale or exchange of a capital asset held for more than 1 year, if and to the extent such gain is taken into account in computing gross income. (4) Long-term capital loss.--means loss from the sale or exchange of a capital asset held for more than 1 year, if and to the extent that such loss is taken into account in computing taxable income. (5) Net short-term capital gain.--means the excess of short-term capital gains for the taxable year over the short-term capital losses for such year. (6) Net short-term capital loss.--means the excess of short-term capital losses for the taxable year over the short-term capital gains for such year. (7) Net long-term capital gain.--means the excess of long-term capital gains for the taxable year over the long-term capital losses for such year. (8) Net long-term capital loss.--means the excess of long-term capital losses for the taxable year over the long-term capital gains for such year. (9) Capital gain net income.--means the excess of the gains from sales or exchanges of capital assets over the losses from such sales or exchanges. (10) Net capital loss.--means the excess of the losses from sales or exchanges of capital assets over the sum allowed under § 1211. In the case of a corporation, for the purpose of determining losses under this paragraph, amounts which are short-term capital losses under § 1212 shall be excluded. (11) Net capital gain.--means the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year.

1. THE MECHANICS OF CAPITAL GAIN (IRC § 1222) a. Capital losses are deductible to the extent of capital gains plus up to 3K of ordinary income. Any capital losses that exceed that amount get carried over. b. Netting Process i. Take STCG-STCL = net ST CG/CL ii. Take LTCG – LTCL = net LT CG/CL iii. Then net the LT verses the ST. 1. If there is a Net STCG, it is included in ordinary income 2. If there is a net LTCG, it get NCG special treatment a. Different rates: i. 28% rate  collectibles ii. 15% rate  most LTC included in NCG 1. capital assets  stocks, bonds, investment land, other types of capital assets which is statutorily labeled ―adjusted NCG‖ iii. 25% rate  1250 gains from sale of depreciable real property. iv. Process: 1. When you have a CL, you net within the categories. i.e. if you have a LTCL from the sale of a stock, you try and net it first against the LTCG from sale of stock, not a LTCG from a collectible 2. If CL has no corresponding CG category, you net it against the CG being taxed at the highest rate. 2. THE MECHANICS OF CAPITAL LOSS a. IRC § 1211 -- losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) the lower of-i. (1) $3,000 ($1,500 in the case of a married individual filing a separate return), or ii. (2) the excess of such losses over such gains.

19

b. § 1212(b) Carryover – capital losses not utilized in the yr incurred are carried over into subsequent taxable yrs and treated as LT or ST losses, depending on their original character. i. Must make the 1212(b)(2) computation first, before computing carryover losses under 1212(b)(1)  1212(b) tells us that the amount of the carryover will be the amount of the net ST and net LT capital losses reduced by the $3000 amount that wiped out ordinary income ii. B/c of 1212(b)(2) constructive STCG, the net STCL is used first and then the NLTCL 3. THE MEANING OF CAPITAL ASSET a. IRC § 1221 – Capital asset means property held by the T whether or not connected with trade or business except for: i. Stock in trade that TP would include inventory at end of taxable year ii. property held by the TP primarily for sale to customers in his trade or business iii. Property used in trade or business which is subject to depreciation iv. Real property used in trade or business v. a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by— 1. a taxpayer whose personal efforts created such property, 2. in the case of a letter, memorandum, or similar prop, a T for whom such prop was prepared/produced, or 3. a T in whose hands the basis of such prop is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such prop in the hands of a T described in (A) or (B); vi. Accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1) b. Rule: Property held by a T for sale to customers in the ordinary course of a trade or business is not a capital asset entitled to capital gain or loss treatment, regardless of T’s stated purpose. 39 i. Factors to look at: 1. Purpose for which property was acquired 2. Whether for sale or investment 3. Continuity and frequency of sales as opposed to isolated transactions c. Rule: when determining whether prop is held primarily for sale to customers in the course of a trade or business, and thus exempt from capital gain or loss treatment, primarily means of first importance or principally. i. ―Primarily‖ means of first importance or principally NOT primary or substantial as trial ct applied here (narrower interpretation rather than broader one) Good for taxpayer! 4. THE SALE OR EXCHANGE REQUIREMENT a. Rule: using stock to satisfy a specific monetary gift to a beneficiary results in a capital gain to the estate equal to the amount the stock had appreciated from the time of the decedent’s death to the time of transfer. i. Kenan v. Commissioner – Is the transfer of stock to a beneficiary in satisfaction of a monetary devise a sale or exchange of a capital asset? Yes. All of the stock that was transferred had appreciated from the time it was acquired by the trust to the time that it was transferred. The parties are taking two different positions. TP are trustees of the trust and their position is that there was no gain after all section 102 which would not require any income to be recognized so the same theory should apply to the trust itself. The IRS said that not only is there income when it makes the distributions of stcok but that the income must be ordinary income. The court takes a middle ground position. There is gain here when the obligation is debt. What does this sound like? International Freighting. Rule: using stock to satisfy a specific monetary gift to a beneficiary results in a capital gain to the estate
39

Mauldin v. Commissioner -- P bought a large piece of property to graze cattle. He never started because a rod was going to cut through land. He tried to sell the land and could not. He subdivided the land and platted it. He then tried to sell but could not. Started living on one of the tracts of land. Later the city places the land within city limits and he begins to sell the land. P wants to include the sale as a long term capital gain. IF they are not CA they will be taxed as ordinary gain and taxed at much higher rate. Court rules that this is not a CA. Falls under 1221(a)(1) exclusion. Why did they say this? They said that because he bought it for business purposes; there was not just one economic transaction.

20

equal to the amount the stock had appreciated from the time of the decedent’s death to the time of transfer. 1. If the instrument had created a trust that said you must distribute 5M worth of stock then there would not have been a taxable event. Since they had a choice that put Wise at risk. b. Rule: Collecting money to settle a judgment, even if the judgment was purchased from the original creditor, is not a sale or exchange.40 5. HOLDING PERIOD a. IRC § 1223 – The holding period on a capital asset begins to run the day following the date of acquisition. i. A capital asset acquired on the last day of any calendar month, regardless of whether the month has 31 days or less, must not be disposed of until on or after the first day of the 7th succeeding month of the calendar in order to have been held for more than 6 months ii. T buys 100 shares on Feb 1 and another 100 on Sept 1. On Feb 2 of the next yr T sells 100 shares. Which 100 shares has T sold? ―First in, first out‖. 6. RECHARACTERIZATION a. Ground rules: i. To come w/in 1231, need a holding period of more than 1 yr. 1. Whether the holding period is real or artificial doesn’t matter. ii. If net CG and CL and you get a gain  All treated as LTCG. iii. If you net the occurrences, and they produce a loss, then all of the transactions become ordinary, and you have a net ordinary loss iv. What is a 1231 Capital Gain: 1. Any recognized gain on the sale of property used in trade or business; 2. gain from compulsory or involuntary conversion of either – 1) property used in trade or business or 2) capital asset held for more than 1 year in a trade or business or transaction entered into for profit. v. Limitations: 1. 1211(a) – Corporations may only deduct capital losses to the extent of their capital gains 2. 1211(b) – Individuals may deduct up 3K of capital loss from ordinary income and any additional loss gets carried over to the following year. b. Steps41 i. First – Determine Sub-Hotchpot – 1. Qualifying Property: a. Property used in a trade or business OR; b. Capital assets held for over 1 year that is either used in a trade or business or held for the production of income. 2. § 1231(a)(4)(C) -- Provides that, before any gains and losses from involuntary conversions are to be included in the main hotchpot, gains from such conversions must equal or exceed losses from such conversions. THUS: a. If gains from involuntary conversion of property exceed losses  send them both over to MH b. If the losses exceed gains  losses and gains remain ordinary ii. Second – Determine Main Hotchpotch 1. First, Do the gains exceed the loss in the SH? If yes, bring them both over to MH 2. Second, Take all the 1231 gains and net them against the 1231 losses a. If the gains exceed the losses  all are treated as LTCG/CL
40

Hudson v. Comm – Mary H obtained a judgment in amount of $75K. 1943 T then purchased this judgment from Mary H’s estate…Each petitioner acquired a 50% interest in this judgment. Total cost of judgment was $11k…1945 taxpayers received $22K from this judgment as a full settlement of the judgment. Each T reported their profit on this settlement as long-term capital gains for 1945. Commissioner argued that Taxpayers had ordinary income not capital gain. Taxpayers argue that a sale is a K whereby one party acquires property in the thing sold for valuable consideration…Generally understood to mean transfer of property for $$$. Court rules that this is ordinary income because there is no sale or exchange. As to why there is no sale or exchange is because the claim arising form judgment was extinguished without any property or property right to the debtor
41

21

b. If the losses exceed the gain  then all are treated as ordinary losses. iii. Third – Determine Recapture 1. § 1231 requires the TP to look back and apply any losses that became ordinary income over the previous 5 years to be applied against a present year gain. a. Thus, if in 1990 TP had a MH loss which became ordinary income of 3K and a 5K same result in 1993, if in 1995 she had 10K gain, the 8K ordinary loss would be netted against the 10K gain, so she would only get 2K gain. b. ** Does not apply to casualty losses. 2. Question: do SH ordinary losses count?

Deductions Affected by Characterization Principles
1. BAD DEBTS AND WORTHLESS SECURITIES a. Bad Debts i. IRC §166(a) – Business bad debts is in ordinary loss (dollar for dollar) 1. Wholly worthless debts are deductible 2. Partially worthless debts are deductible to the extent they have not been paid 3. Basis for determining amount of debt is the adjusted basis. 4. INCLUDED Above the line if the person is a sole proprietor ii. IRC § 166(d) – Non-Business debts is treated a s STCL and can off set CG 1. Non-business debt is defined as a debt other than: a. A debt acquired in connection with a trade or business or, b. A debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. iii. Howard S. Bugbee v. Commissioner -- Why is this a debt? Bar owner loaned money for business reasons to bar patron. Howard wanted to say that it was a debt. These would be capital losses that would wipe out capital gain. To be a business bad debt you look at 166(d)(2). A debt created or acquired in connection with a trade or business of the taxpayer. These were not created in connection with the bar. The second part says a debt the loss from the worthlessness of which is incurred in the taxpayers trade or business. Is it bad? IT IS A NON BUSIENSS BAD DEBT. Reg § 1.166-2. You loan money with intention of being repaid. If it is a bad debt you do not have to sue 1. This was above the line under 62(a)(3) but not 62(a)(1). It is a STCL. 2. All capital gains and all capital losses are above the line. iv. Notes 1. There is a presumption that transfers between close friends and relatives 2. Gratuitous forgiveness of a loan generates no deduction 3. RULE: a debt will only qualify as a business bad debt if it bears a direct relationship to a T’s trade or business b. Worthless Securities i. IRC § 165(g) -- If any security which is a capital asset becomes worthless during taxable yr, the loss resulting there from shall be treated as a loss from sale or exchange (CL), on last day of the taxable year, of a capital asset 1. Security Defined: a. A share of stock in a corporation b. a right to subscribe for, or to receive, a share of stock in a corporation c. a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form 2. THE CHARITABLE DEDUCTION (BELOW THE LINE) a. IRC §170(a) – Charitable deductions are allowed i. Percentage Limitations (§ 170(b)) 1. Deduction cannot exceed 50% of TP adjusted gross income.

22

a. If deduction does exceed 50% of AGI, then you can carry that amount over for each of the next 5 years. i. EX: If your AGI is $100k, and make a charitable contribution of $50k, can get entire deduction. If contribution were $60k, still only able to deduct $50k this yr. The other $10k would carryover. 2. (e)(1)(A)  The amount of charitable contribution shall be reduced by the amount of gain the TP would have realized on a sale above his basis IF it is not a LTCG. a. In other words, if it is not a LTCG, when you give property you only get to deduct your basis, not how much it was worth. b. If LTCG  deduct FMV 3. Reg. § 1.170A-1(g)  No deduction is allowed for contribution of services a. You can deduct unreimbursed expenses made to an organization 4. (f)(12)  In the case of a contribution of a qualified vehicle which exceeds $500 – a. if the organization sells the car, without any material use or or improvement, the deduction shall not exceed the gross proceeds of the sale. 5. (J)  No deduction for travel expenses unless there is no significant element of personal pleasure. 6. NOTE  if the contribution is to like a private person, the deduction is 30% of AGI. b. Rev. Ruling 67-246 i. Rule: where a transaction involving a payment is in the form of a purchase of an item of value, the presumption arises that no gift has been made for charitable contribution purposes, the presumption being that the payment in such case is the purchase price 1. If you are paying more for the performance than you normally would you can deduct the value that is above the performance. a. i.e. TP purchases 5$ item from charity for 20$. If T can show that 15$ was not a gift, he can get deduction. 3. CASUALTY AND THEFT LOSSES a. Starting Questions  i. Is it a casualty loss/gain? ii. Is it personal or business? 1. If personal  165(c)(3), 165(h) 2. If business --? Use 1231 SH rule. b. IRC § 165(c)(3)  deduction for losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. 1. Termites do not count as ―other casualty‖. ii. Rule: To get deduction, TP must suffer actual (non-hypothetical) loss. 1. Pulvers v. Commisioner – TP tried to take a deduction on their house because of the loss in value as a result of a land slide that destroyed part of their neighborhood. Court held that since it did not physically affect the property, no deduction iii. Rule: Burden if on T to prove that theft occurred. 1. Mary Francis Allen Case – Necklass stolen at bar. Had to prove that it was theft and not just lost. c. IRC § 165(h)  Casualty losses are only allowed if they exceed 100$. (thus 100$ must be reduced off the loss). i. If the net casualty losses, exceed the net casualty gains  such losses shall only be allowed an amount = the net casualty gains + so much of the excess as exceeds 10% of the AGI. ii. If the net casualty gains exceed the net casualty losses  they both get LTCG/CL treatment. iii. When did the loss occur and for what yr is a deduction allowed? 1. Casualty losses are deductible for the yr in which the loss is sustained [Reg. 1.1657(a)(1)] a. Theft losses are generally a deduction for the yr in which the theft is discovered Reg 1.165-7(a)(1) i. Exception is cannot take deduction in yr loss occurs UNLESS it becomes clear there will be no recovery

23

ii. If subsequently recovered, amount recovered is treated as income when received in yr 2 etc after loss was taken in yr 1 d. Casulty Loss AR/AB determination i. Personal Casulty Losses  Reg. § 1.165-7(b) – for purposes of determining AR for casualty loss, it will the lessor of the amount of: 1. The property’s AB just before the accident or; 2. The FMV just before the accident compared to FMV just after the accident. ii. Business Casualty Losses  the loss will be the AB just prior to the accident. e.

24


				
DOCUMENT INFO
Shared By:
Stats:
views:11343
posted:1/17/2008
language:English
pages:24
mrdildine mrdildine
About