Pepperdine Law _Federal Income Tax -- Mendoza _2007__

GROSS INCOME –– DEDUCTIONS ** Above the line –– STANDARD OR ITEMIZED DEDUCTIONS Include Exclude 61 = GI: 71(c) = Child support (1) Compensation for services (§61(a)(1)) 102(a), (b) = Gifts (Duberstein) and (2) GI from business; inheritances (3) Gains from dealings in property (1001, 1012, 103 = Interest on state and local bonds 1014, 1015) 104(a) = Compensation for personal physical (4) Interest; injuries or sickness (5) Rents; (6) Royalties; (7) Dividends; 105 = Reimbursement for med expenses (8) Alimony (§71) under ER provided accident/insurance plan (9) Annuities; 106 = ER contributions to accident and health (10) Life insurance K; plans (11) Pensions; 108 = Discharge of indebtedness due to (12) Discharge of indebtedness (§108, Kirby, Zarin); bankruptcy, insolvency, qualified property (13) Partnership GI; real business debt, or public education? (14) Income in respect of a decedent; 109 = Improvements by lessee on lessor’s (15) Income from interest in estate or trust property 104(a), Raytheon = Compensation for non-physical 121 = Gain from sale of principal residence personal injury, punitive damages, and damages rec’d for 1041 = non-cash transfer incident to divorce lost business profits Trade or Business Transaction for Profit Personal **Deductible 212 = Expenses for 215 = Alimony (payor) 162 = Trade or business expenses production of income 262 = No deduction for personal, 163 = Interest 163 = Interest living or family expenses 165(c)(1) = Loss (closed transaction) 164 = Taxes 167 = Depreciation 165(c)(2) = Loss 168 = Accelerated cost recovery 167 = Depreciation **Not deductible 195 = Start-up expenditures = not deductible 263 = capitalizable ADJUSTED GROSS INCOME Standard Itemized Fixed amount based on filing status 163(d) = Investment interest to extent of net investment income 163(h) = Qualified residence interest = acquisition indebtedness & home equity indebtedness 164 = State and local income taxes 221 = interest on education loans (up to $2500) TAXABLE INCOME I. TAX FORMULA a. Gross Income – “Above the line” Deductions = Adjusted Gross Income (AGI) b. AGI – Personal Exemptions – [either standard or itemized deductions (use larger of the 2)] = Taxable Income c. Taxable Income x Tax Rate (§1) = Tentative Tax d. Tentative Tax + [Net Capital Gain x TP’s capital gains rate] – Tax Credits = Tax due (if positive) or refund (if negative) e. Analysis: i. Step 1: Identify taxpayer ii. Step 2: Does TP have income? iii. Step 3: What deductions may TP claim? iv. Step 4: What is the character of income or loss? v. Step 5: Timing issues 1. Income = when must TP include an item in GI? 2. Deduction = when may TP claim deduction? vi. Step 6: Determine TP’s rate of tax and whether entitled to credit IDENTIFICATION OF INCOME SUBJECT TO TAXATION II. GROSS INCOME a. Equivocal Receipt of Financial Benefit i. IRC §61: Except as otherwise provided in this subtitle GI means all income from whatever source derived 1. Case law has developed that concept as (Glenshaw Glass Co.): a. Undeniable accession to wealth i. E.g., GI does not include borrowings b/c no accession to wealth unless D.O.I. b. Clearly realized i. Treasure trove (Cesarini found money in piano) 1. Cf. Learn $1000 piano actually worth $500k ≠ clearly realized ii. Sell property (Buy $100K house, FMV now $300k, must sell to clearly realize) c. Over which TP has complete dominion 2. Gross income includes receipt of any financial benefit which is: a. Not a mere return of capital or return of cost, and b. Not accompanied by contemporaneously acknowledged obligation to repay, and c. Not excluded by a specific statutory provision ii. It is a broad rule w/ several specific enumerations designed to capture all types of income––Anything that results in accretion of wealth is included in GI unless explicitly excluded 1. Alimony and separate maintenance payments (§§61(8), 71(a)) 2. Direct / indirect obligations paid by third parties (Old Colony = ER paid EE’s taxes) a. TP’s income taxes paid by 3rd party must still make return and pay corresponding tax 3. Discharge of indebtedness (§§61(a)(12), 108) 4. Illegal Income (James) a. Thief has GI if actual command over stolen money, even if later obligated to return it to rightful owner 5. Prizes and awards (§74) a. If win prize (not cash), must include FMV in GI i. Fair Market Value (“FMV”): That amount in which a willing seller would sell and a willing buyer would buy both knowing all of the circumstances surrounding the sale and neither under the compulsion to sell 6. Punitive and exemplary damages (Glenshaw Glass) 7. Rent (§61(a)(1)) a. Improvements constitute income if substituted for rent i. Hypo: Owner rents tenant house for $4k = T pays $1k & makes $3k improvements: $4k GI to O; even if T ended up making $5k of improvements, entire amount would still be considered rent = GI b. Sweat Equity: T pays $1k & makes improvements himself at cost of $500: (1) $4k GI for Owner; (2) $2500 GI to T b/c she received the benefit 8. Treasure trove (Cesarini = money found in piano includable in GI) a. Treasury Reg. 1.61-14: Treasure trove to the extent its value in US currency constitutes GI for taxable yr in which reduced to undisputed possession b. Must be assessed w/in SOL = 3 yrs (§6501) b. Income w/o Receipt of Cash or Property i. GI includes receipt of cash, property, and/ or services ii. Barter (RR 79-24): Exchange of goods for services w/o using money creates income event on both sides 1. Rule: 1.61-2(d)(1): if services are paid for other than in money, include FMV of property or services taken in payment as income a. Legal advice for house painting = Att’y taxed at FMV of painter’s services (value rec’d) iii. Imputed Income Doctrine: When TP uses an asset he owns, FMV of that asset is not GI 1. Extends to personal property, services 2. Anything person owns and uses is not a taxable event a. Indep. Life Ins. Co.: TP owned and lived in bldg = not taxed b. Cf. Dean v. Comm’r: TP living in bldg he conveyed to corporation, in which he was major shareholder  TP taxed on fair rental value b/c corporation is a separate person. iv. Hypos: ∏ grows vegetables. GI when: 1. No tax event if (1) Harvests crops, or (2) Consumes $100 veggies (imputed income doctrine) 2. Yes tax event if (1) sells $100 worth of veggies, or (2) ∏ exchanges $100 veggies w/ ∏2 for $100 tuna (barter) c. Gain from Dealings in Property (§61(a)(3)) i. Analysis: 1. Step 1: Was there a realization? a. Sale, exchange, or casualty = yes b. Gift, inheritance, transfer on divorce = no  stop, report nothing 2. Step 2: Determine amount realized a. FMV > Mortgage balance: AR = recourse or non recourse note balance + boot (Crane) b. Mortgage balance > FMV i. Non recourse: AR = outstanding balance of non recourse mortgage (Tufts) ii. Recourse: AR = FMV  bifurcate gain b/c discharge of indebtedness 3. Step 3: Adjust basis a. Reduce basis by amount of depreciation and increase by cost of improvements (§1016) 4. Step 4: Determine original basis (see below) a. Gift, inheritance, purchased, exchange, rec’d compensation, incident to divorce 5. Step 5: Gain / Loss Realized = AR – AB (§1001) ii. Factors in Determination of Gain: 1. §1001(a) Computation of gain or loss: Gain from sale or other disposition of property is excess of AR over AB provided in §1011, and loss shall be excess of AB provided in §1011 for over AR. 2. §1001(c) Recognition of gain or loss: Except as otherwise provided, entire amount of gain or loss, on sale or exchange of property shall be recognized. a. §§1031-41: Prevent realized gain from becoming recognized gain iii. Determination of Basis: a. Note: If loss, is it deductible under §165(c)? 2. Purchase of property: Cost of property (§ 1012) a. Cash used = Cost of property is amount of cash paid i. Purchase includes in-kind exchanges like waiver of possible future legal claims 1. Farid-Es-Sultaneh: Pre-nup agmt w/ rich husband, labeled gift, not a gift b/c she “bought” stock for giving up her marital property rights, which was a condition of getting stock from H  use AB under 1012 b. Exchange = Property for other property (Philadelphia Park Amusement Co.): i. FMV of property rec’d = value of property rec’d is equal to what is given up in an arms length transaction, or ii. If unknown, FMV of property given up, or iii. If unknown, adjusted basis of property given up c. Hypo: If O is salesperson in art gallery and purchases $10k painting, but only req’d to pay $9k, not $10k; O sells painting for $16k i. AR ($16k) – AB ($10k) = Gain ($6k) 1. Basis = FMV (otherwise EE-TP will pay more gain) d. Hypo: A purchased real property for $10k, pays realtor $200 commission. AB = $10,200. 3. Property Acquired by Gift (§1015) a. §1015(a): i. For purposes of determining gain, donee takes carryover basis, e.g., same adjusted basis as it would be in hands of donor (Taft v. Bowers) ii. For purposes of determining loss: 1. AB > FMV = use FMV a. If adjusted basis is greater than FMV at time of transfer, for purposes of determining loss, the FMV must be used 2. FMV > Basis = use carryover basis iii. Donor’s basis > sale price > FMV = no gain or loss b. Hypos: i. Property cost Donor $20k, FMV = $30k at time of gift and donee sold it for: 1. $15k ($5k loss) = 15k – 20k 2. $25k ($5k gain) = 25k – 20k ii. Donor had cost $30k, FMV = $20k FMV at time of gift, and Donee sold if for: 1. $35k ($5k gain) = 35k – 30k 2. $15k ($5k loss) = 15k – 20k a. Exception applies b/c it is a loss [AR < Cost and AR < FMV] 3. $24k (no gain or loss) = Gain basis is $30k and loss basis is $20k, here, there is no gain under a gain basis and no loss under loss basis 4. Part Gift–Part Sale: Works to transferor’s benefit if property appreciated, but not if value declined a. Reg §1.1015-4: This may look like just a gift, but property subject to mortgages i. For gain: 1. Transferee-donee’s basis is sum of whichever is greater: a. Amount transferee pays for property (AB under §1012), or b. Transferor’s AB for property at time of transfer 2. And amount of increase, if any, authorized by §1015(d) for gift tax paid ii. For loss, AB of property in hands of transferee shall not be greater than FMV of property at time of transfer b. Hypo: TP bought land for $120k, increased to $180k, transferred to daughter for $120k in cash (part gift, part sale) i. TP has sale and a gift = No gain for TP b/c AR (120) – AB (120) = 0 ii. Basis to daughter: 1. AB (Carryover basis under 1015) = 120 2. AB (under 1012 = cost) = 120 a. Here, since they’re the same  AB = 120 5. Property Acquired b/w Spouses or Incident to Divorce (§1041) a. §1041(b): Transferee spouse treated same as if it were a gift = Carryover basis i. No exception like the one found in gift scenario b. No gain or loss is recognized in transfers of property b/w spouses or incident to divorce 6. Property Acquired from a Decedent (§1014) a. Basis of property is FMV of property at date of transfer, e.g., at death (stepped-up basis) b. §1014(e)(1): If (A) appreciated property acquired by decedent by gift during 1-year period ending on date of decedent’s death, and (B) property is acquired from decedent by (or passes from decedent to) donor of property (or donor’s spouse), basis of property in hands of donor (or spouse) shall be adjusted basis of property in hands of decedent immediately before death of decedent. c. Hypo: A holds 2 blocks identical stock worth $1M. Bought one for $950K, other for $50K. i. Donor should transfer $950k block inter vivos b/c upon death, $50k block will receive the stepped up basis 1. Give property w/ higher basis inter vivos 2. Give property w/ lower basis testate iv. Adjustments to Basis: 1. §1016(a)(1): Increases basis by amount of capital expenditures, such as cost of capital improvements made to property a. E.g., Buy land for $100k (§1012), then build bldg on it for $1M  AB thus far is $1.1M b. O bought land for $10k, spent $2k clearing land prior to sale  AB = $10k + $2k 2. §1016(a)(2): Decreases basis b/c of deductions for depreciation, amortization, or depletion a. Tangible property = depreciation (has nothing to do w/ value, could be going up in value and still depreciating) b. Note: Bldg is depreciable, land never is depreciable 3. §§1019, 109: Special case for improvements by lessee on lessor’s property a. Neither basis nor AB of any portion of real property shall, in case of lessor of such property, be increased or diminished on account of income derived by lessor in respect of such property and excludible from GI under §109 i. Hypo: O previously rented land for 5 yrs for $1k/ yr and permitted lessee to expend $2k for clearing property. O properly reported rental payments as GI, $2k expenditures were properly excluded under §109. v. Amount Realized: 1. §1001(b) Amount realized: AR from sale or other disposition of property is sum of any money rec’d plus FMV of property (other than money) rec’d. In determining AR: a. (1) Take into account any amount rec’d as reimbursement for real property taxes treated under §164(d) as imposed on purchaser, and b. (2) Take into account amounts representing real property taxes, treated under §164(d) as imposed on TP if such taxes are to be paid by purchaser. 2. AR includes money’s worth, e.g., services, property received (Int’l Freighting Corp. v. Comm’r) Non Recourse Taxable event? Remedy Property encumbered by liability sold to 3rd party Amount Realized FMV > Mortgage balance Amount Realized Mortgage balance > FMV Seizing property only Takes property subject to debt Recourse Tax neutral Seizing property, can keep going into personal assets of borrower Assumes debt AR = note balance + boot (Crane) Outstanding balance of non recourse mortgage (Tufts) ** FMV is immaterial FMV ** Bifurcate gain b/w 61(a)(3) and discharge of indebtedness 61(a)(12) III. 3. Recourse: a. AR from sale or other disposition of property shall be the sum of any money rec’d plus FMV of property (other than money) rec’d i. Selling expenses reduce AR (not deductions) b. Reg. 1.1001-2(c): AR includes discharge of indebtedness = Bifurcate gain b/w §61(a)(3) and §61(a)(12) i. Hypo: Recourse Mortgage = 10k; FMV = 8k; AB = 2k 1. Because note > FMV, AR = FMV 2. 61(a)(3) gain = FMV – AB = 8k – 2k = 6k 3. 61(a)(2) discharge of indebtedness = Mortgage – FMV = 10k – 8k = 2k 4. Non Recourse: a. AR on sale includes cash or other property rec’d and any unpaid balance from nonrecourse mortgage in both gain (Crane v. Comm’r) and loss situations (Tufts v. Comm’r) i. AR = Cash rec’d + Liability assumed (Crane v. Comm’r) 1. Cash (Boot) = FMV – note balance where FMV > note balance 5. Note: giving property as security is not a realization of gain 6. Hypo: Mortgagor pays 20k cash and gets 80k mortgage, then borrows 100k against property (uses 100k of loan proceeds to purchase stocks and bonds) = 100k does not increase AB of land a. FMV = 170k, Note balance = 180k, AB = 100k (20k + 80k) i. Non-recourse (§1001(a)): No bifurcation w/ non-recourse debt 1. AR = Note balance = 180k 2. AB = 100k 3. Gain = note balance – AB = 80k a. Better to take non-recourse debt b/c will be considered net capital gain ii. Recourse (§1001(c)) (Reg 1.1001-2a): Bifurcation w/ recourse debt 1. AR = FMV = 170k 2. AB = 100k 3. Gain = FMV – AB = 70k  other 10k discharge of debt (61(a)(12)) a. Bifurcated into 1001(c) and 61(a)(12) events b. Why does it matter? i. 61(a)(12) = taxed at 39% = ordinary income ii. 1001(c) = taxed at 20% (or as low as 8%) = may be net capital gain DISCHARGE OF INDEBTEDNESS (§§61(a)(12), 108) a. GI is derived from forgiveness of debt b/c it is considered accession of wealth. Thus, if a creditor forgoes collection under a debt or accepts less than the amount owed on a debt, debtor will have a benefit equal to amount of debt forgone. That difference is income from discharge of indebtedness and will be included as GI to TP under §61(a)(12). IV. i. **Kirby Lumber: Discharge of indebtedness under §61(a)(2) arises only out of recourse debt, no Kirby GI event w/ non recourse debt b. Indebtedness (§108(d)(1)): i. (a) For which the TP is liable; or 1. Enforceable Debt: To have DOI income, there must be an enforceable debt in the first place 2. Contested Liability Doctrine: If TP, in good faith, disputes amount of debt, a subsequent settlement of dispute is treated as amount of debt cognizable for tax purposes a. If amount of debt is disputed, there is no discharge of indebtedness ii. (b) Subject to which the TP holds property 1. Zarin v. Comm’r: Chips not property w/in meaning of §108(d)(1)(b), and TP not liable w/in meaning of §108(d)(1)(a) b/c amount disputed c. §108(a)(1): Do not include if (e.g., exclude discharge of indebtedness if): i. Bankruptcy = Discharge of title 11 ii. Insolvent = liabilities > assets 1. To extent TP is insolvent, amount of insolvency does not create taxable event under §61(a)(12) iii. Qualified farm indebtedness, or iv. Certain real property debt = In case of TP other than C corporation, indebtedness discharged is qualified real property business indebtedness d. §108(b)(2): Order of reduction (A) net operating loss, (B) General Business Credit, (C) Min tax credit, (D) Capital loss carryovers, (E) Basis reduction §1017, (F) Passive activity loss and credit carryovers, (G) Foreign tax credit carryover i. 108(b)(5): TP may elect to any extent to first reduce basis of depreciable property and real property inventory SEPARATION AND DIVORCE a. Alimony and Separate Maintenance Payments: i. Alimony is a tax advantage transaction because it is included w/in payee’s GI under §71(a), and deductible by payor under §215(a) ii. Direct Payments: 1. §71 Requirements: Pmt made in cash, check or money order qualifies as alimony or separate maintenance if: [promissory notes do not count] a. Rec’d by (or on behalf of spouse) under divorce or separation instrument i. §71(b)(2): Applies only to: (A) decree of divorce or separate maintenance or written instrument incident to such decree, (B) written separation agmt, or (B) decree requiring spouse to make pmt for support or maintenance of other spouse b. Not designated non-alimony (non-includable under §71 or non-deductible under §215) c. Parties not members of same household at time pmt is made i. **Only true if decree of divorce or decree of separate maintenance d. No liability to make pmt after death of payee spouse, and i. **Agmt to pay for 10 yrs would not qualify b/c spouse could die sooner e. Pmt is not for child support i. **If payee and payor are in same tax bracket, payee would want $$ to come in as child support so doesn’t have to add onto GI iii. Indirect Payments: 1. Pmt can qualify as alimony where cash payment is made to 3rd party for benefit of payee spouse a. Rent b. Mortgage c. Tax 2. To extent payments made merely to maintain property owned by payor spouse, which is simply being used by payee spouse do not qualify 3. Payments made in satisfaction of legal obligation b. Property Settlements (tax neutral) (§1041, §1015(e)) i. §1041 = Realized gain is not recognized (e.g. AR – AB = gain  but it is not recognized) 1. Reg 1.1041-1T(b): Incident to divorce if a. W/in 1 yr of cessation of marriage (§1041(C)(2)), or b. Related to the cessation of marriage = pursuant to divorce or separation instrument and not more than 6 yrs from date marriage ceases ii. If parties don’t fall under §1041, then fall under US v. Davis, where transfer b/w spouses is a taxable event c. Child Support (§71(b)(1)(D), (c)) = tax neutral b/c not deductible i. §71(c)(2): even though something not explicitly fixed in divorce decree, it could nonetheless be child support 1. If any amount specified in instrument will be reduced on a child attaining a specified age, marrying, dying, leaving school, or upon similar contingencies, amount of reduction will be treated as “fixed” as payable for support of child of payor spouse ii. If payor spouse pays both alimony and child support, but fails to pay full amount, allocate 1st to child support ITEMS SPECIFICALLY EXCLUDED FROM GROSS INCOME V. EXCLUSION OF GIFTS AND INHERITANCES a. Rules of Inclusion and Exclusion i. §102(a): GI does not include value of property acquired by gift, bequest, devise or inheritance ii. §102(b)(1): GI includes income from property referred to in (a) b. Gifts: i. Analysis: 1. Step 1: Who is donee? a. EE = Include (§102(c)) 2. Step 2: Look at intent of donor = Apply Duberstein test a. Duberstein Test: A gift in the statutory sense proceeds from a “detached and disinterest generosity out of affection, respect, charity, or like impulses” 3. Step 3: Is it income from a gift? (§102(b)) = include ii. EE gifts (general inclusion rule) 1. §102(c): Normally, transfers of money from an ER to an EE are treated as compensation for services rendered, past, present or future = thus, include a. Clergy are not EEs (RR 55-422) b. Exceptions: (1) De minimus fringe benefits, and (2) EE achievement awards 2. Hypo: ER gives all EEs except her son $100 tvs, but gives son a $400 tv a. EEs = must include $100 gift b. Son = bifurcate: include $100 gift, exclude $300 c. Bequests, Devises, & Inheritances: i. Settlement of will contest treated same as inheritance (Lyeth v. Hoey) = exclude 1. Hypo: Dad’s will leaves kid $20k b/c of “long and devoted service to him” = not compensation for services, language is generic enough ii. Bequeath in exchange for services fails Duberstein test = include 1. Wolder v. Comm’r: Att’y performed legal services for client & rec’d income when client bequeathed substantial sum to att’y in lieu of payment of fees during client’s lifetime DAMAGES AND RELATED RECEIPTS (§§104-06) a. To determine whether damages should be included in GI, courts ask in lieu of what were damages paid? (Raytheon Production Corp.) GI does not include recovery of cost because it is a return of capital. i. Compensatory damages designed to make someone whole. ii. Punitive awards = include 1. Of the type that are specifically included in GI unless for wrongful death action under longstanding state law (see below). GI and no code section to exclude it. iii. Income / Lost profits = include (§61(a)) iv. Goodwill = Include goodwill in excess of its costs (Raytheon) 1. Goodwill is not apportioned 2. If TP awarded damages (AR), gain is difference b/w AR and cost basis (cost basis = AB not FMV) 3. Hypo: GW w/ Basis = 4k, Worth = 10k a. Totally destroyed: Recovery = 10k. 10k – 4k = 6k GI b. Partially destroyed: Recovery = 4k. 4k – 4k = 0; New Basis = 0k c. Partially destroyed: Recovery = 3k. 4k – 3k =1k; Basis = 1k = no gain or loss v. Personal physical injuries or sickness (§§104, 105) 1. §104(a): Except in the case of amounts attributable to (and not in excess of) deductions allowed under §213 (relating to medical, etc., expenses) for any prior taxable year, GI does not include: a. (1) Exclude amounts rec’d under workmen’s compensation acts as compensation for personal injuries or sickness due to job-related injury VI. 2. 3. 4. 5. 6. b. (2) Exclude amount of any damages (other than punitive damages) rec’d on account of personal physical injuries or physical sickness i. **Recovery for emotional distress depends on nature of underlying action 1. If incurred on account of physical injury = exclude ii. **Damages not for personal physical injuries––defamation, First Amendment, sex and age discrimination, emotional distress = include (would have been excludable few yrs ago) iii. Note: “Allocated as compensation” does not make it lost profits, e.g., if gymnast missed performance as result of amputated leg = still excluded c. (3) Exclude amounts rec’d through self-funded accident or health insurance (or through arrangement having effect of such) for personal injuries or sickness 104(c): Include punitive damages awarded in civil action unless: a. For wrongful death action under state law if punitive damages are only wrongful death recovery (as in effect on Sept. 13, 1995) §106(a): EE can exclude ER’s contributions to accident or health plans set up to pay compensation to EE for personal injuries or sickness §105(a): Include amount rec’d by EE through accident or health insurance for personal injuries or sickness in GI to extent amounts: a. Not taxed to EE under 106(a), or b. Paid directly by ER §105(b): Exclude medical reimbursements regardless of whether an EE directly or indirectly receives payment of these benefits from his ER. Hypo: ∏ was ill but carried own and ER provided med insurance. ∏’s med expenses totaled $4k and rec’d $3k of benefits under her policy and $2k under ER policy. What benefits included in GI? a. §104(a)(3) = $3k is excluded by EE b. §105(b) = $2k rec’d from ER not excludable unless it went directly to med expenses i. Prorate (RR 69-154): 1. Exclude = §105(b) amount rec’d from ER policy ÷ total amount rec’d x total bill a. 2/5 = 40% x 2k = $1,600 = exclude 2. Include = §105(b) amount rec’d – amount excluded a. $2k - $1,600 = $400 include IDENTIFICATION OF THE PROPER TAXPAYER VII. ASSIGNMENT OF INCOME a. Income from Services: i. Step 1: Does TP have dominance and control over receipt of funds? If yes = taxable 1. TP cannot make anticipatory arrangements and contracts however skillfully devised to prevent salary when paid from vesting even for a second in man who earned it (Lucas v. Earl) a. If TP is member of Board, more like Lucas b. If TP not member, more like Giannini ii. Step 2: Did TP renounce before services rendered?  Still must show no dominance and control 1. If arrangement is made prior to entitlement of such income, TP may assign away his right to it, earnings do not vest a. Must be arranged before income is earned i. Comm’r v. Giannini: TP refused payment of $1.5M and said Company should do something worthwhile w/ $$ b. Cannot direct disposition of funds, must be a full refusal iii. Step 3: Is the service provider an agent of entity? 1. RR 74-581: Service provider is not charged w/ income event if service provider is an agent of entity he is providing services for and instantly signs over income to principal a. E.g., doctors turn over money to hospitals, legal aide b. Income from Property: i. Two issues: 1. Use / holding of property: ii. iii. iv. v. a. Attempt to assign income from T1  T2 b. Fruit: interest, dividends, rents, royalties (like from patent), gain 2. Sale / disposition of property Step 1: What did TP assign / convey? 1. Fruit may only be assigned w/ tree 2. Tax consequences to TP: a. Fruit only = fruit continues to be income event to TP i. Helvering v. Horst (TP gave fruit only––interest coupons): to successfully assign fruit, must give bond too b. Everything TP owns: i. When TP acquires various rights, in order to successfully assign income, must assign everything he owns (must rid all right, title and interest) 1. Transfer of fruit alone sufficient where that is all TP owned (Blair v. Comm’r: TP only owned interest in trust for life) 3. Tax consequences to recipient: a. If meets Duberstein = gift Step 2: Was the assignment valid? 1. Analyze whether bona fide transfer a. If transfer for sale or consideration, then valid assignment b. Estate of Stranahan: Stock properly assigned from father to child where (1) control was fully divested, (2) consideration was paid, (3) there was risk involved to assignee, and (4) there was no evidence that it was a loan Step 3: When was it assigned? 1. Fruit that is not ripe will be treated as valid assignment 2. Negotiations by a sale may have proceeded to a point although the sale is not complete, the agmt is so firmed up that it is treated as complete for tax purposes. Entering into substantial negotiations for a buyer, may generate income for a buyer, even though no income is assigned a. Susie Salvatore: Sale by one person cannot be transformed for tax purposes into sale by another by using latter as conduit to pass title b. Valid dates for dividends: (1) Declaration, (2) Record date, (3) Actual pmt, (4) Date rec’d i. Publicly Held Corp = record date (Bishop v. Chanesy) ii. Privately Held Corp = Declaration date (Estate of Smith) 3. TP is in receipt of taxable income for taxable yr in which endowment and annuity Ks were surrendered for their cash values by recipients Hypo: TP owns apt bldg w/ AB = $50k, FMV = $100k, annual rent of $12k; Apr. 30, TP deeds his son 1/2 apt bldg and all rent for this and subsequent yr. Annual rent due in Dec. 1. TP can successfully assign only 1/2 of rents 2. TP made gift to son of $8k = amount excess rents Son receives a. 1/3 rents ripe at time of transfer; although Son receives $12k rent in Dec., ripe rent ($4k) and 1/2 of $8k of remaining rents ($4k) are GI to TP; 1/2 of rent attributable to last 2/3 of yr is GI to Son ($4k) 3. TP also made gift of $50k value of apt (§1015) DEDUCTIONS IN COMPUTING TAXABLE INCOME BUSINESS DEDUCTIONS c. Potential Alternatives in Tax Treatment of Expenditures i. There are 3 possible treatments for expenditures: (1) Deduction, (2) Capital Expenditure, or (3) Personal. 1. Deductions include business expenses (162), expenses incurred in transaction entered into for profit (212), loss incurred in trade or business (165(c)(1)), or transaction entered into for profit (165(c)(2)), interest (163), and taxes (164) = Currently deductible, no future benefit 2. Capital expenditures are not deductible (263) and subject to 2 consequences: a. Subject to depreciation––subject to slight tax benefit which comes from change in basis; may deduct depreciation over period of time b. Not subject to depreciation––reduces gain upon subsequent sale 3. Personal expenditures are not deductible and have no current or future tax benefits (262) §162 Trade or business expenses = deductible §163 Interest = deductible §164 Taxes = deductible §165(c) Loss = deductible §212 Individual non business expenses = deductible §263 Capital Expenditure = not deductible, e.g., add to AB           §262 Personal living, and family expenses = not deductible       Real estate = deductible under §§162, 212 (Higgins) Edu expenses = deductible if incurred to maintain or improve skill required by current trade / bus Reasonable salaries (§162(a)) Interest expenses = deductible up to net investment income (§163(d)) Property taxes = deductible by owner (§164) Loss in trade or business / transaction entered into for profit / not connected w/ trade or business or transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft (amount over $100) = Must be closed transaction Personal investing, securities (never reach trade or business status) (Higgins) If expense does not directly produce income, may deduct if proximate cause (Surasky v. US)) Note: To deduct under §212 there must be an existing interest Legal expenses involved in defending or perfecting title to property not ordinary and necessary in recovering property (other than investment property and amounts of income which, if and when recovered, must be included in income) or in developing or improving property, constitute a part of cost of property = not deductible, capitalizable (Bowers v. Lumpkin) Broker fees, commissions on stocks Prepaid insurance = if extends beyond yr, capitalize and amortize over which policy relates Origin of Claims Test: Look to see what legal claim is for Att’y fees in divorce action = personal expenses = not deductible (§262, Meyer J. Fleischman) Extent fees for tax advice = deductible under §212(3) Extent fees related to alimony = deductible under §212(1) d. §162: There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business i. “Ordinary and Necessary” (§162(a)) 1. Ordinary = Relate to transaction of common or frequent occurrence in the type of business involved a. Payment of debt is necessary but not ordinary (Welch v. Helvering) 2. Necessary = defer to TP a. If TP entitled to reimbursement, but fails to take steps to get reimbursed and instead deducts under §162, expenses not necessary ii. “Expenses” (§§162(a), 263(a)) 1. Test: Does it add significant future benefit (extend life of the asset) and appreciable value? a. No = Utilities, maintenance & repair = Deduct (§162) i. Treas. Reg. 1.162-4: When you have an expenditure: incidental repairs which neither add nor appreciably prolong its life but keep it ordinary condition may be deducted as an expense ii. Midland Empire Packing Co.: expenditure for concrete lining in basement to oilproof against oil nuisance iii. Painting rooms in apt bldg / replacing roof over one apt unit (capital expenditure if increases value of apt complex or replaces entire roof) / patching entire asphalt parking lot / advertising for new tenant b. Yes = Capital expenditures (§263) = Not deductible i. §263(a)(1): Amount paid out for new bldgs or permanent improvements or betterments made to increase the value of any property or estate 1. E.g., adding a carport ii. §263(a)(2): Amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. iii. Expenses incurred for purpose of changing the corporate structure for the benefit of future operations 1. INDOPCO: Corporate merger––wanted to deduct investment banker and att’y fees iii. “Carrying on” Business (§§162(a), 195, 262) 1. Must be engaged in same trade or business at time a. Does not include start–up expenditures (§195): not deductible under §162, nor capitalizable under §263 i. TP may elect to treat start-up expenditures as deferred expenses, which are allowed as a deduction prorated equally over such period of not less than 180months as may be selected by TP. ii. If business folds before amortization period, the unamortized expenditures may be deducted to extent provided by §165(c)(2) and §195(b)(2) iii. Contingency pmt deductible (Hundley: Former ball player would be paid by receiving 50% of any signing bonuses his son got when he signed K. Son was obligated to pay his father 50%. Held: deductible b/c not payable until he became a professional player (making him carry on a trade or business)) b. EE at work in trade or business is said to be carrying on that business 2. Not preparatory a. Not include expenses of investigating and looking for a new biz and trips preparatory to entering a business (Morton Frank: newspaper) 3. Not transactional stage (must be capitalized): When investigation narrowed to one business, all expenditures incurred for acquisition of that asset must be capitalized a. Capitalized costs include: i. Expenditures for appraisals ii. Transactional documents iii. Regulatory approvals iv. Advice on tax consequences of transaction e. Specific Business Deduction i. “Reasonable” salaries (§162(a)(1), (m)): deductible to extent reasonable 1. Step 1: Apply 7 factor test (Exacto Spring Corp.: ct held salaries of $1M, $1.3M = rx) a. 7 Factor Test: i. Type and extent of services rendered = What did person do to warrant salary? ii. Scarcity of qualified EEs iii. Qualifications and prior earning capacity of EE iv. Contributions of EE to business venture v. Net earnings of ER vi. Prevailing compensation paid to EE w/ comparable job: arms length standard vii. Peculiar characteristics of ER’s business b. Independent Investor Test (many courts made this an 8th factor): When investors are obtaining a higher rate of return than they had any reason to expect, salary is presumptively rx (rebuttable presumption) i. Higher rate of return a mgr can generate, greater salary he can command 2. Step 2: Is it a contingent or non-contingent contract? a. Non-contingent (Exacto) i. End analysis = Deduct only if reasonable under 7-factor test b. Contingent: i. Contingent Agmt––When corporation cannot afford to hire a head person, corporation and EE negotiate a contingency agmt where salary is contingent upon operations, usually net income ii. If contingency and conclude unrx, if prove contingency agmt was negotiated as result of free bargain b/w payor and payee, can deduct under §162(a)(1) 1. More person owns = less likely result of free bargain 2. Harolds Club: not free bargain where Dad b/c he had dominant personality and owned no stock; rx measured in light of circumstances in yr paid, not yr agmt entered into 3. Step 3: Ceiling limits amount of salary that can be paid at $1M ii. Necessary Rental and Similar Payments (§162(a)(3)) 1. Lease = deduct a. For tax purposes, form can be disregarded for substance and where practical effect of rent is to produce title eventually, rental agmt can be treated as sale i. Starr’s Estate: 5 yr agmt for sprinkler maintenance was sale disguised as lease 2. Sale = capitalize f. Miscellaneous Business Deductions i. Business losses (§165(c)(1)): Losses incurred in trade or business 1. Unlike §162 (continuous expenditure), §165 must be a closed transaction 2. Involuntary sale or exchange 3. Hypo: Car used solely in business purchased for $40k, result of depreciation AB = $22k, when car worth $30k, destroyed in accident, rec’d $15k in insurance: a. AB – AR = Gain / Loss i. 22k – 15k = <7k>  deductible under 165(c)(1) 4. Reg. § 1.165-7(b)(1): In case of casualty loss, amount of loss is lesser of (1) property’s AB, or (2) loss in value (FMV property before loss – FMV after loss) a. Hypo: Car only partially destroyed, now worth $10k i. FMV before = $30k, FMV after = $10k ii. Loss in value = 30k – 10k = 20k; AB = 22k  use loss in value 1. AR – (lesser of loss in value or AB) = 15k – 20k  5k deductible iii. If TP makes repairs to property, deduct loss under 1016(a)(2)(b) DEDUCTIONS FOR PROFIT-MAKING, NON BUSINESS ACTIVITIES g. Expenses (§§ 212, 274(h)(7)) i. §212: Individuals can deduct all ordinary and necessary expenses paid or incurred during taxable year: 1. For production or collection of income; 2. For management, conservation, or maintenance of property held for production of income; or 3. In connection with the determination, collection, or refund of any tax. ii. §1.212-1(d): Expenses to be deductible under 212 must be ordinary and necessary. Such expenses must be reasonable in amount and bear a reasonable and proximate relation to production or collection of taxable income or to management, conservation, or maintenance of property held for production of income 1. Surasky Test: May deduct expenses genuinely incurred in exercise of reasonable business judgment in effort to produce income that may fall short of C/L definition of proximate cause a. Surasky: Money spent to set up a committee to oust Montgomery Ward’s prior management where TP is large shareholder in stock iii. §274(h)(7): Expenses for seminars are not deductible h. Charges Arising out of Transactions Entered into for Profit (§§ 121(a), (d)(6); 165(a), (b), (c)(2); 167(a)(2); 168(a); 212) i. For gain = treat same as trade or business ii. For loss = to be deductible under §165(c)(2), must be transaction entered into for profit iii. Principal Residence: 1. Not deductible under §§162, 212 b/c personal a. Note: Do not deduct for depreciation b/c personal 2. §121(a): Exclusion of gain from sale of principal residence a. GI shall not include gain from sale or exchange of property if during 5-yr period ending on date of sale or exchange, such property has been owned and used by TP as his principal residence for periods aggregating 2+ yrs = exclude i. May not exceed $250k (§121(b)(1)) (or $500k if joint return) 3. §165(c): Loss not deductible unless connected w/ trade or business, transaction entered into for profit, or arises from fire, storm, shipwreck, or other casualty or theft iv. Depreciation (§167), Maintenance & Repairs (§212): 1. Step 1: Did TP attempt to rent? a. May deduct provided property held for production of income = fact put up for rent is determinative, does not matter if nobody actually rented it (Horrmann) 2. Step 2: If TP did not attempt to rent, did TP intend an “expectation of profit”? (Lowry v. US) a. Newcombe Test: i. Length of time TP occupied his former residence prior to abandonment ii. Availability of house for TP’s personal use while it was unoccupied iii. Recreation character of property iv. Attempts to rent v. **Whether offer to sell was an attempt to realize post conversion appreciation 1. If TP believes value of property may appreciate and decides to hold it for some period to realize such anticipated appreciation, as well as an excess over his investment, property is held for production of income v. Loss (§165(c)(2)) = closed transaction 1. Deductions for property held for production of income (Horrmann) a. To deduct under §165(c)(2) = TP must actually rent property unless never lived in it b. Reg. 1.165-9(b)(2): When FMV at time of abandonment is less than basis, basis for loss would be FMV, and basis for gain would be the cost. i. FMV < basis, use FMV as AB to calculate loss ii. AR b/w basis for computing gain and basis for computing loss = no gain or loss DEDUCTIONS NOT LIMITED TO BUSINESS OR PROFIT-SEEKING-ACTIVITIES i. Interest (§163(a), (d), (f), (h), 221, 265(a)(2)-(4), 266, 280A(d)(1)) i. §163: Deduct all interest paid or accrued w/in taxable year on indebtedness 1. Interest = Payment must be compensation for use or forbearance of money per se and not payment for specific services which the lender performed in connection w/ borrowers (RR 69-188) a. Test: whether loan is made i. Unrelated = armed length transaction, look at data (loan amt, interest rate, etc) ii. Related = terms are suspect (parent / child §7872) 2. Categories of interest: a. Personal interest = not allowed (§163(h)(1)) b. Trade / business interest = allowed (§163(h)(2)(A)) c. Investment interest = allowed (§163(h)(2)(B)) d. Qualified residence interest = allowed e. Educational loan interest = allowed ii. Is it deductible? 1. Step 1: Is this a qualified residence? a. §163(h)(4): Qualified residence = principal residence + 1 other residence of TP i. Must be there for 14 days / yr b. §163(h)(3): Qualified residence interest is any interest which is paid or accrued during taxable year on: i. Acquisition indebtedness w/ respect to any qualified residence of TP, or ii. Home equity indebtedness w/ respect to any qualified residence of TP. 2. Step 2: Is this acquisition debt? ((§163(h)(3)(B)) a. Incurred in acquiring, constructing, or substantially improving any qualified residence, and secured by such residence i. May deduct up to $1M ii. If for refinancing, limit is principal amount of refinanced loan 3. Step 3: Is it home equity indebtedness? (§163(h)(3)(C)) a. Debt for any purpose secured by a qualified residence to extent aggregate amount of such indebtedness does not exceed: i. FMV less amount of acquisition indebtedness w/ respect to such residence. ii. $100k limitation b. Can use proceeds under 163(h)(3)(A) for anything and still deduct interest: i. Hypo: If TP uses 2nd mortgage proceeds to buy a Ferrari, he can deduct interest under §163(h)(3)(A)(ii) as home equity interest ii. Cannot deduct I f under 163(h)(3)(B) 4. Step 5: Was debt incurred on or before Oct. 13, 1987? a. If yes, treat it as acquisition debt w/ no limit b. Refinancing limit is principal amount of debt 5. Step 4: Is there remaining debt? a. §163(h)(1): In case of TP other than corporation, no deduction shall be allowed for personal interest paid or accrued during taxable yr i. If TP already deducted max under acquisition and home equity, remainder falls here and is not deductible iii. Qualified Education Loans: 1. §221: Itemized deduction (below the line) for interest on qualified education loans a. Max deduction = $2500 (§221(b)(1)) i. AGI < $50k = TP can deduct $2500 ($100k for joint returns) ii. AGI > $65k = TP cannot deduct any ($130k for joint returns) b. Limit based on AGI (§221(b)(2)(B)) i. Amount determined is amount bearing same ratio to amount which would be taken into account as: j. 1. [Modified adjusted gross income for taxable year –– $50k] ÷ $15k a. If joint return subtract 100k and divide by $30k ii. Hypo: TP’s AGI = $57k 1. (57k – 50k) / 15k = 7.5k/15k = 0.5 x $2500 = $1250 deduction 2. If someone pays another’s loans, ask whether gift. Only deductible by person who’s loans they are. Thus, donee could deduct, but donor could not. iv. Investment interest: 1. §163(d)(3)(A): "Investment interest" means any interest allowable as a deduction paid or accrued on indebtedness properly allocable to property held for investment. 2. §163(d): Limits amount of investment interest deductible to amount of net investment income a. Net investment Income = GI – fees (§212) b. GI = Gain + Dividends i. Hypo: TP incurs $100k investment interest, sells stock: Gain = 60k, Dividends = 20k, Fees = 10k  Net investment income = 60k + 20k – 10k = 70k 1. She may deduct up to $70k, must roll remaining $30k into next yr v. Interest on tax exempt items: 1. Not deductible (§265(a)(2)) Taxes (§164(a), (b)(1), (b)(5), (c), (d)(1), 275, 1001(b)(2)) i. §164(a): Deduct following taxes for taxable year w/in which paid or accrued: 1. State, local, foreign, real property taxes (ad velorum taxes = taxes on value) 2. State, local personal property taxes. 3. State, local, foreign, income, war profits, and excess profits taxes. ii. §164(b): Election to deduct State and local sales tax in lieu of State and local income taxes (e.g., no income tax in TX) iii. §164(d): Apportionment of taxes on real property b/w seller and purchaser sold during any real prop tax yr, s/t allocate that part of such yr that ends on day before date of sale as tax on seller, and that part of such yr that begins on date of sale as tax on purchaser. iv. Taxes only deductible by person who’s liable to pay, e.g., title must be in TP’s name (Cramer v. Comm’r) 1. If paying someone else, like an EE’s property taxes, may be able to deduct as salary THE YEAR OF INCLUSION OR DEDUCTION FUNDAMENTAL TIMING PRINCIPLES CASH (cash or its equivalent) ACCRUAL INCOME Actual or constructive receipt Right / entitlement DEDUCTIONS Actual payment––payor loses control All Events Test §461(h)(4) and Economic Performance Test Exception for recurring items §461(h)(3) k. Cash Receipt and Disbursement Methods: i. Cash method measures tax liability by including an item in income at the time that cash or equivalent is actually or constructively received or allowing a deduction at the time it is actually paid. ii. Cash or Equivalent: 1. Includes: a. Cash b. Check = Treated as cash and included in yr received even if banks are closed––Reducing income to cash is not a condition precedent to falling into receipt i. Charles F. Kahler: Check rec’d Dec. 31, Y1, cashed Y2. Taxable event in Y1. c. Promissory note––sometimes (Williams) i. Step 1: Is it meant as payment for services? 1. Note rec’d only as security, or as an evidence of indebtedness, and not as payment = not regarded as income at time of receipt ii. Step 2: If find it’s not as payment, determine whether note equivalent to cash to extent has FMV 1. If it can be discounted by a bank, good evidence of income l. d. Supplemental Income (Cowden) e. Property = include FMV of property on date of receipt (Hornung) 2. Does not include = executory agmt (lease agmts) a. Executory agmt: remaining obligations that must be done iii. Receipt (§446, 451(a)): 1. Actual receipt = GI in taxable year in which received a. Kahler = TP rec’d check on Dec. 31, Y1 = actual receipt Y1 2. Constructive receipt = Arises when no actual transfer of cash or equivalent a. Occurs when only thing preventing its reduction to possession is TP’s own volition i. If subject to substantial limitations or restrictions, no constructive receipt 1. Hornung v. Comm’r: No receipt where TP won car on Dec. 31, Y1 that was in another state, no access to keys 3. Legal and Economic Contingencies = No income event in either case b/c no income rec’d. a. Claim of Right Doctrine (N. Am. Oil) applies if contingency paid but party files an appeal, e.g., include in income iv. Disbursements (§461(a), (g)): 1. Date deduction is allowed: a. Amount must be removed from control of payor i. Pmt by check considered made when check delivered 1. Mailbox rule: Check considered paid when placed in mailbox ii. Payment by Credit Card = Relevant date is date TP signs AMEX charge (not date credit card company is paid) b. No constructive payment (Vander Poel, Francis & Co.) 2. Prepaid Expenses: a. Expenses w/ useful life over 1 yr must capitalize and amortize = for each tax year, deduct pro rate portion of prepaid expense applicable to that year i. Boylston Market Ass’n: TP who bought fire insurance covering 3 yr period must deduct pro rata amount for each of 3 yrs b. Exception: Prepaid expenses may be deducted in year they’re paid, even though they span period that touches 2 taxable yrs, as long as expenses do not relate to a period greater than one year i. Reg. 1.263(a)-4(f)(1): 12-month safe harbor = TP not req’d to capitalize amounts paid to create any right or benefit for TP that extends beyond earlier of (1) 12 months after 1st date TP realizes right or benefit; or (2) end of taxable yr following taxable yr in which payment made c. Note: Although debtor must deduct pro rata, creditor rec’d entire amount so must report entire amount as income unless restrictions on their use 3. Prepaid Interest: a. §461(g)(1): Deduct pro rata amount––If you have an expenditure that extends beyond a 1 yr period, required to capitalize and amortize over period which the policy relates to and deduct over contract period over time which period relates b. Exception: Deduct all in Y1 i. §461(g)(2): Does not apply to points paid in respect to any indebtedness incurred in connection w/ purchase or improvement of and secured by principal residence 1. Must be a point a. Point = sum of money paid to induce loan transaction 2. Points must be actually paid, rather than simply being added to principal amount of loan (Cathcart) 3. Must be principal residence = acquisition or improvement of c. Hypo: Debtor pays $25k (5 yrs interest) in Y1 b/c Lender makes it a condition of extending D another loan = Debtor can deduct entire $25k even though spans 5 yrs b/c point (note: do not know whether meets principal residence requirement) 4. Bunching: E.g., TP supposed to make payment Dec. 31 Y1 and makes it Jan. 2 Y2, makes 2nd payment Dec. 31 Y2 = may deduct both payment for Y2 Accrual Method: i. Measures tax liability by including item in income at time TP becomes entitled to it and allowing a deduction at time a deduction obligation becomes fixed and certain, e.g., when all events have occurred to fix the right to receive payments or to fix duty to make payment but sometimes only after economic performance, where in either instance the amount can be determined w/ reasonable accuracy 1. The accrual method does not operate on generally accepted accounting principles. ii. Income Items: 1. Income recognized when: a. Right to receive an amount becomes fixed, right accrues, does not matter when actually rec’d (Spring City Foundry), and b. Amount of income can be determined w/ reasonable accuracy 2. Contingencies: a. Economic: Does not impact date when right accrues (Spring City Foundry: bankruptcy) b. Legal (RR 7-151): Legal contingency can impact right to receive money. As relates to lawsuit, receipt occurs once judgment becomes final––not entitled to income until appeals process exhausted i. Claim of Right Doctrine (N. Am. Oil Consolidated v. Burnet): 1. But, if TP receives earnings under Claim of Right and w/o restriction as to its disposition, he has rec’d income which he is req’d to return, even though it may still be claimed that he is not entitled to retain money, even though he may still be adjudged liable to restore its equivalent 3. Clearly Reflect Income Doctrine: a. Reg. 1.446-1(a)(2): No method of accounting is acceptable unless, in opinion of Comm’r, it clearly reflects income (New Capital Hotel) b. However, deferral may be proper if it approximately matches income and expenses i. TP may defer including prepayment until taxable yr in which services performed so receipt of income and corresponding deductible expenses will be properly matched, thereby clearly reflecting TP’s net income 1. Artnell: Receive pmt for future services and time and extent is relatively certain, you can defer income event (2 yr limit) c. Rev. Proc. 70-21: Income can be deferred for one yr when prepayment rec’d for services that will be rendered by end of following yr (n/a to prepayment for rent or interest) i. Advance prepayment for use of property cannot be deferred (New Capital Hotel: $30k in Y1 for rent in Y10 includable in G1 of Y1) iii. Deduction Items: Actual pmt is irrelevant 1. All Events Test (§461(h)(4)) = All events test is met w/ respect to any item if all events have occurred which determine the fact of liability and amount of such liability can be determined w/ reasonable accuracy a. Schuessler: TP guaranteed he’d service furnace for 5 yrs. Allowed to deduct total amount of expenditure in Y1 even though rendering services 5 yrs in future 2. Economic Performance Test = All economic performance by payee is complete a. If liability of TP requires TP to provide property or services, economic performance occurs as TP provides such property or services (changes rule in Schuessler) 3. Recurring Items Exception (§461(h)(3)(A)): May treat as incurred during taxable yr if: a. All events test met and economic performance occurs w/in shorter of rx period after close of such taxable yr or 8.5 months CHARACTERIZATION OF INCOME AND DEDUCTIONS CAPITAL GAINS AND LOSSES GAIN LOSS ORDINARY §1(a)-(e) (39.6%) §165 = Completely deductible against ordinary income CAPITAL §1(h) = substantial benefit Deduction capped at $3k (§1211(b)), but excess may be Net Capital Gain = LTCG – STCL (§1222) carried over to subsequent taxable year *Collectibles (28%) *Recaptured property (§1250) (25%) ***Stocks, bonds, investment land (majority) (15%) ***If there’s a gain, TP wants asset to be capital b/c lower tax rate. Thus, do not want it excluded under §1221(a). ***If there’s a loss, TP wants asset to be ordinary b/c greater deduction available. Thus, try to exclude under §1221(a). m. Capital Transaction: i. “Capital Asset” (§1221(a)) ii. Sale or Exchange (§1222) iii. Holding Period n. Analysis: i. Step 1: Is the property a capital asset? 1. A capital asset is property held by the TP except §1221(a): a. Inventory for sale in trade or business, e.g., is it held for resale to consumers? i. Sale more like regular activity = inventory (Mauldin v. Comm’r) 1. TP’s stock in trade or inventory held primarily for sale to customers in ordinary course of business is not a capital asset a. Primarily means principal (Malat v. Riddell) i. **Look at intent for holding, not intent at acquisition ii. Sale more like isolated transaction = capital asset b. Property used in trade or business c. Copyright, literary, musical, or artistic composition ii. Step 2: Has there been a sale or exchange? 1. Only occurs in closed transactions / does not qualify if recurring transaction a. Sale or exchange where trustee must pay capital gains on stock given to a beneficiary instead of cash (Kenan v. Comm’r) b. No sale or exchange where judgment obligor paid obligee cash (Hudson v. Comm’r) iii. Step 3: Has there been a recognized gain or loss? 1. There must be a realization event = sale or other disposition event iv. Step 4: Is the property §1231 property? 1. §1231: Property used in trade or business: a. Gain = treat as capital gain (taxed at lower rate) b. Loss = treat as ordinary loss (deduct full amount) v. Step 5: What is the holding period for the property? 1. 1 yr or less = short term  short term capital gains can never be capital gains 2. More than 1 yr = long term vi. Step 6: Calculate capital gain and loss. 1. “Net the nets”: Net long term cap gain (NLTCG) – Net short term cap loss (NSTCL) a. Net capital gains = [LTCG – LTCL] – [STCG – STCL] b. Exception: i. Do not net the nets if both NLTCG and NSTCG (both gains) 1. NLTCG meets criteria of §1222(11) = §1(h) ii. If NLTCG – NSTCL = gain, then falls under §1(a)-(e) 2. NLCG only = Include in net capital gain 3. NLCG & NSCG (both gains) = Include NLCG in net cap gain; include NSCG in ordinary income 4. NSCG only = Include in ordinary income 5. NLCG & NSCL a. NLCG > NSCL, then net capital gain = NLCG – NSCL b. NLCG < NSCL, then net loss = NSCL – NLCG = deduct up to $3k 6. NLCL only = net loss = deduct up to $3k 7. NLCL & NSCL = net loss = NLCL + NSCL = deduct up to $3k 8. NSCL only = net loss = deduct up to $3k 9. NLCL & NSCG a. NLCL > NSCG, then net loss = NLCL – NSCG = deduct up to $3k b. NLCL < NSCG, then net gain = NSCL – NLCG = include in ordinary income Amount Net Net the nets Taxable income Amount Net Net the nets Taxable income LTCG $2k NLTCL = <4k> LTCL <$6k> STCG $2,600 NSTCG = $1600 STCL <$1k> <$2,400> $10k - $2400 = $7600 LTCG $2k NLTCL = <8k> LTCL <$10k> STCG $2k NSTCL = <$2k> STCL <$4k> <$10k> $10k - $3k = $7000 * Can only deduct max $3k under §1211(b)  remainder of $10k rolled over to future income * Rule: First consume STCL, then consume LTCL, so here, would use entire $2k of NSTCL first, then use $1k of NLTCL rolling over remaining $7k VIII. PROCEDURE a. Tax Practitioner’s Tools i. Legislative Materials = Internal Revenue Code (1986) ii. Administrative Materials 1. Regulations: a. Interpretative Regulations: Promulgated under authority of § 7805 b. Legislative Regulations; Regulation that is part of statute itself 2. Revenue Rulings: Treasury’s answer to specific question concerning a specific TP’s tax liability 3. Private Letter Ruling: Now available through Freedom of Information Act 4. Actions on Decisions: Issues letters of (1) Nonacquiesces (disagrees), and (2) Acquiesces (agrees) iii. Judicial Materials 1. Art. III Cts: District  Appellate  S. Ct. a. To get into District Court  TP must PAY tax and seek refund i. Right to jury trial 2. Art. I Cts (not part of judiciary): a. Tax Court decisions i. To get to Tax Ct, TP need not pay  TP won’t have to pay unless and until Tax Ct decides against him 1. No jury ii. Can appeal decision to Fed. Ct. Appeal b. Court of Claims b. Presumptions: i. Gross Income: Include unless Code states not to (broad) ii. Deductions: Only include if Code state to (narrow)