Docstoc

Federal Tax Lecture Notes

Document Sample
Federal Tax Lecture Notes Powered By Docstoc
					                                 Federal Income Tax
                                        Prof. O’Reilly
                                          Fall 2005

EXAM: review case names and contents for those cases that appear in our assigned reading
    PRINT OUT problem set answers!!!!

For 100,000, Tax rate is about 27%. But Employer also pays 5% for Social Security so tax rate
is around 31%. But there are other benefits. Total tax rate is about 30%

Federal Tax Law
   - Internal Revenue Code (Commonly called “The Code" or "IRC of 1986") includes all of
       USC 26,
   - Estate & Gift Tax, Social Security and Excise Tax
   - Regulations by Department of Treasury.
   - IRS rulings.
   - Interpretation of Code by Courts.

Federal Income Tax is authorized by the 16th Amendment of the US Constitution.
   - § 7805 – Agency is authorized to pass “Needful” regulations for enforcing the Code;
       "treasury regulations"
   - US Statutes at large: often contain exceptions to various code provisions (for particular
       taxpayers or grandfathered provisions) that may not appear in the USC
           o tax lawyer should also review the "notes" contained in USCA
   - tax lawyers can't say how something is treated under the law, but can give an opinion as
       to how something will likely be treated under The Code

What is Income?
  - Gross Income Defined § 61.
           o All Income from whatever source derived, including Income from Business, gains
             from Property, Interest, Rents, Royalties, Dividends, Alimony, Annuities, Life
             Insurance, Pensions, Discharges of debt, Income from Wills, Income from Trust
             and Estates.
                 Does not have to be for compensation for goods and services.
                 Can include things not expressly innumerated
                 §§71-90 make further clarifications of what is income: e.g., prizes and
                    awards; unemployment compensation
                 §§101-138 specifically exclude some items: e.g., gifts; interest on state
                    and local bonds
                 Barter also constitutes income (i.e., if you are paid for your services with
                    property, the income is the FMV of the property or services (Reg §1.61-
                    2(d)(1)) [i.e., form of payment doesn't matter]
           o Gross Income Test § 61: 1. There must be an Economic Gain, 2. Economic Gain
             must primarily benefit taxpayer.
                   All Expense Paid business trip by Prospective Employer is not income for
                       non-employee. Primary benefit of such a trip is prospective employer.
                       Doesn’t matter if non-employee enjoyed the trip. (US v. Gotcher)
                   Meals and lodging for employee is not income if furnished for the
                       convenience of the employer. (Benaglia v. Commissioner)
            o Income = Accessions of wealth, clearly realized, over which the taxpayer has
               Complete Control. If no complete control, then not taxpayer’s income.
                   All Expense Paid Business Trip
                            Whether the traveler had any choice in going on trip
                            Whether the traveler had any say on itinerary of trip
                   If Actual Employer paid for the trip, then it not income at all, for business
                       expense. § 162
      -   Compensation for Services
            o Any payment in return for the transfer of goods and services [form of
               compensation doesn't matter]
                   Company paying taxes for employee is considered income for employee
                       (Old Colony Trust v. Commissioner)
                   Meal Allowances is income while Meals Supplied on the business premise
                       of the employer is not income. (Commissioner v. Kowalski)
            o Non-Monetary Payments for goods and services is still income. Calculated by
               Fair Market Value (FMV).
                   Fair Market Value – Price at which the property would change hands
                       without any compulsion to buy or sell and both have reasonable
                       knowledge of relevant facts. (Arm’s Length Transaction) Reg §1.170A-
                       1(c)(2); see also US v. Cartwright, 411 US 546, 551 (1973))
                   Usually widely sold goods, so price is obvious
            o Bargain Purchase Rule: If property is sold at a discount, and the discount is
               compensation for goods and services, then the discount is considered income to
               the buyer; Reg §1.61-2(d)(2)(i)
                   UNLESS: Qualified Employee exception § 132(a)(2), § 132(c) [i.e.,
                       employee discount].
                   INCLUDES: Discount of Stock Purchase for goods and services.
                       Included as income when the stock vests, at the price it vest at, when
                       restrictions on use of stock (transferability or substantial risk of
                       forfeiture) terminate. § 83(a). If no restrictions, then § 62 applies.
                            ALSO, Can choose to include as income when stock is granted at
                               the price it is granted. Employee will still have to pay tax on the
                               sale of the stock. (Allows for tax deferment). see §83(b).
                            BUT: if stock went down or if the stock is forfeited, then employee
                               looses out.
            o Stock Options1 not covered by Transfer of Property Rules § 83(e)(3), UNLESS:
               FMV can be calculated at the time of granting.




1
    be sure to know the difference between STOCK and STOCK OPTIONS accounting
                      Options granted by Companies have restrictions. Can’t place a FMV on
                         restrictions, so FMV of Employee Stock Options can’t be calculated [i.e.,
                         received as compensation only when option exercised]
                      Tax applies when the option is exercised or if option is sold. NOT: when
                         option is granted or when the option vests. Regs § 1.83-7 (Applying § 83)
                         [i.e., this is a delayed Bargain Purchase Rule]
                      the taxable income is the difference between the exercise price and the
                         market price (i.e., the profit)
                      vesting therefore does not trigger taxation with options (the way vesting
                         does with stock)
    -    Indirect Income
             o 3rd Party Beneficiaries: Payments made by A to B for benefit of C are income to C
                 if the payments represent compensation for C’s services. (Old Colony Trust, p.
                 88ff)
                      Ie: Employer withholds income for social security paid to the
                         government. That withholding is still considered gross income. Amount
                         is taxable again.
                      If payments are compensation for goods, some or all of the payments are
                         potentially income to C if C has Gained with respect to the goods.
                      If A is a business, payments will be deductible by A.
             o Fringe Benefits [most often tested area of tax]2
                      Fringe Benefits are included in income unless it fits into exclusion. §
                         61(a)(1)
                      Person who earns the fringe benefit is taxed. Doesn’t matter who actually
                         benefits. Applies even if beneficiary didn’t actually benefit Regs § 1.61-
                         21(a)(4)(i)
                      Calculated at FMV3 of the fringe benefit Minus amount beneficiary paid
                         for the benefit
                               Not based on subjective costs. Actual cost is not taken into
                                   account
                      Exclusions:
                               Employer-Provided Health Insurance is excluded from gross
                                   income. § 106(a)
                                       o If you actually become sick and receive treatment, the
                                           insurance reimbursement for medical care is excluded from
                                           gross income. § 105(b)


2
  fringe benefits, gifts/bequests, etc should be excluded from gross income - keep in mind that this is the broad
category: "items that look like income but are excluded"
3
  Reg 1.61-21(b)(2): Fair market value. In general, fair market value is determined on the basis of all the facts and
circumstances. Specifically, the fair market value of a fringe benefit is the amount that an individual would have to
pay for the particular fringe benefit in an arm's-length transaction. Thus, for example, the effect of any special
relationship that may exist between the employer and the employee must be disregarded [e.g., employee-employer
are child-parent]. Similarly, an employee's subjective perception of the value of a fringe benefit is not relevant to the
determination of the fringe benefit's fair market value nor is the cost incurred by the employer determinative of its
fair market value. For special rules relating to the valuation of certain fringe benefits, see paragraph (c) of this
section.
                                      o Amounts paid by employers directly to the employee for
                                          medical costs (even if there is no insurance) is excluded
                                          from gross income. § 105(e)(1)
                                      o Anti-Discrimination: Amounts Paid doesn’t apply unless
                                          employer pays medical costs of most of the employees; i.e.,
                                          if an employer self-funds as in §105(e)(1), then the
                                          employer must provide it to most employees, otherwise
                                          those top officers who receive compensation must include it
                                          in their income. Doesn’t apply to Insurance. § 105(h)
                                 Miscellaneous Work Related Fringe Benefits (8 Categories). § 132
                                      o No-Additional Cost Service § 132(b), Regs § 1.132-2
                                          (Exactly the same language)
                                              Offered to sale to customers in the ordinary course
                                                   of business and in the line of business4 the
                                                   employee is performing
                                              AND: Employer incurs no substantial additional
                                                   costs (such as, foregone revenue) to provide such
                                                   service to employee.
                                              Does not have to be the actual employer providing
                                                   the service.
                                                        Reciprocal Agreements (complimentary
                                                           benefits provided by competitors of
                                                           employee’s employer, ie: one airline agrees
                                                           to fly another airline’s employee for free)
                                                           are also considered no additional cost
                                                           services.§ 132(i)
                                              Examples: (Reg. 1.132-2(a)(2), (5)(ii))
                                                        Hotel employees given the use of vacant
                                                           hotel rooms even if maid service is provided
                                                        Airline employees allowed to occupy empty
                                                           seats, even if they have meal service.
                                      o Qualified Employee Discount § 132(a)(2)
                                              Discounts on merchandise cannot be below cost
                                              Discounts on services, employee must pay at least
                                                   80% of what customers pay
                                                        If discount exceeded, tax is on the exceeded
                                                           amount, not the entire discount
                                              Some goods and services do not fall under the
                                                   qualifications (see Reg 1.132-3(a)(2))
                                                        all property qualifies except: real property
                                                           and personal property held for investment
                                                        must be something offered to customers in
                                                           the ordinary course of the line of business of

4
 NB: if work for a conglomerate and you don't work for the part of the business that offers the service you want to
deem a no-additional cost fringe, you are screwed because you aren't in the "line of business" that offers the service.
                the employer in which the employee is
                performing services
o Working Condition Fringe § 132(a)(3)
     Property or service provided by an employer to the
        extent that if the employee paid for the property or
        service, the payment would be deductible under §
        162, 167
             Ie: If employer didn’t provide pens and you
                bought your own pens, the pens would be
                deductible. So they would be deductible if
                the employer provided the pens.
             Ie: Vehicle provided by an employer to an
                employee that is used exclusively for
                business. Regs § 1.132-5(b)
             I.e.: bodyguards for business-oriented
                security concerns. Regs 1.132-5(m)
             Deductions for Trade or Business expense §
                162
                     o All "ordinary and necessary
                         expenses" paid or incurred is
                         deductible
                              Salaries and wages paid to
                                 employees
                              Rent payments
                              Meals and lodging
             Deductions for depreciation § 167
     If the employer did provide the fringe, then the
        value is NOT income to employee
o De Minimis Fringe § 132(e)(1)
     Any property or service the value of which is so
        small as to make accounting for it unreasonable or
        administratively impracticable.
     Language clearly rules out some benefits, but leaves
        a lot up in the air
             Look at regulations for more
                examples/clarification. Regs § 1.132-6(e)
                     o Occasional personal use of an
                         employer’s copying machine (At
                         least 85% of the use of the machine
                         is for business purposes)
                     o Occasional cocktail parties, group
                         meals, or picnics for employees and
                         their guests
                     o Traditional birthday or holiday gifts
                         of property (Not Cash) with a low
                         fair market value
           o Occasional Theater or sporting event
               tickets, coffee, doughnuts, and soft
               drinks, Local Telephone calls,
           o Flowers, fruit, books or similar
               property provided to employees
               under special circumstances.
     NOT De Minimis Fringe. Regs 1.132-
       6(e)(2)
           o Season Tickets to sporting events
           o Membership in a private country
               club
OTHER Miscellaneous Benefits
     Athletic Facilities provided in connection
       with a job § 132(j)(4)
           o On-premises athletic facility
               provided by employer to employees
                    Located on premises of
                        employer, operated by
                        employer, substantially all
                        the use of which is by
                        employees, spouses and
                        dependent children
     Meals or Lodging for Convenience of the
       employer (Deductible to the employee). §
       119
           o Meals must be on business premises
           o Lodging must 1) be on business
               premises; AND
                                2) required as a
                            condition of employment
           o Examples (Not Inclusive but works
               best if meals provided everyday):
               Regs § 1.119-1(a)(2)(ii)
                    Employees on call for
                        emergencies
                    Job requires short meal
                        periods
                    No places to eat near job site
           o Cash Allowances for meals does not
               fall under § 119. (Commission v.
               Kowalski)
           o Meals and Cash Allowances for
               meals can also qualify under De
               Minimis fringe if provided to enable
               an employee to work overtime.
                                                               o Business Meal might be excluded
                                                                   under § 132(a)(3) and § 162 as a
                                                                   Working Condition Fringe.
                                                                       Regs § 1.62-2(h)
                                          o Qualified transportation fringe
                                          o Qualified moving expense
                                          o Qualified retirement planning services
               o Imputed Income
                     Income which derive from a person’s own work. (ie: homemaker doing
                         the work of domestic housekeepers).
                     Generally not taxed in the US.
               o Gifts and Bequests
                     Gifts and bequests are excluded from gross income. § 102(a)
                              Gift Defined(In tax): A detached and disinterested generosity out
                                  of affection, respect, admiration, charity or like impulse.
                                  (Commissioner v. Duberstein5)
                     Transfers from employer to employees are never gifts. § 102(c)
                              Saying something is a gift does not make it so.
                              Key is Intent of the giver. Must not for any business benefit.
                                  Determined by the fact-finder
                     Scholarships are excluded if used to pay tuition, fees and equipment, not
                         for living expenses. § 117
                              Scholarship cannot be compensation for work. Ie: teaching,
                                  research assistant, etc.
                     Prizes and Awards
                              Prizes and awards are not considered gifts. Included in gross
                                  income – § 74(a); Regs § 1.102-1 – unless some other exception
                                  applies (e.g., scholarship exception) or
                              Exception: Employee Achievement Awards. § 74(c)
               o Income from Sales of Property [TO: very important section]
                     Income includes Gains from the sale of property. § 61(a)(3)
                     Ie: If purchase property for $X and sell for $Y, Gain = $Y-$X
                              $X = Basis, $Y = Amount Realized.
                              Basis = The amount of money paid for the property. § 1012
                              Amount Realized = The sum of money received plus the fair
                                  market value of the property (other than money) received. §
                                  1001(b)
                              Gain = Excess amount realized over the Adjusted Basis § 1001(a)
                                      o Adjusted Basis = Original Basis and adjusted according to
                                          § 1016; § 1012
                     Example:
                              Acquire property in 1999 in exchange for $1000 + Bicycle ($200)
                              Sell property in 2003 for $100 and Used car ($2000)


5
    Judy heard that this case would be important for the final exam
      Basis = $1200, Amount Realized = $2100, Gain = $900. §
         1001(b).
      Depreciation is not taken into account
Property received as compensation for goods and services
      Generally
             o If Amount realized by Donee > FMV @ donation Date >
                 Donor’s Basis  Cary over basis since donor’s sale on
                 donation date would have produced gain. Donee has gain
                 since amount realized > donor basis
             o If FMV @ donation Date > Amount realized by Donee >
                 Donor’s Basis  Cary over basis since donor sale on
                 donation date would’ve produced gain. Donee has gain,
                 since amount realized > donor basis
             o IF FMV @ donation date > Donor’s Basis > Amount
                 realized by Donee  Cary over basis & Donee has loss
                 since amount realized < donor basis
             o If Amount realized by donee > Donor’s Basis > FMV @
                 donation date  Donor sale on donation date would’ve
                 produced loss. Donee has gain measured with donor’s
                 basis, since amount realized > donor’s basis
             o If Donor’s basis > Amount realized by donee > FMV @
                 donation date  Donor sale on donation date would’ve
                 produced loss. Donee has neither gain nor loss, since no
                 gain using donor basis and no loss using FMV basis
             o If donor’s basis > FMV @ donation date > amount realized
                 by donee  Donor sale on donation date would’ve
                 produced loss. Donee has a loss since no gain using dnor
                 basis and loss using FMV basis.
      the Original Basis of such property received as compensation =
         Amount included in the employee’s gross income
             o if property received as a fringe benefit, it is not included in
                 income and employee has no basis in the property (e.g., if
                 you get an employee achievement award and then turn
                 around and sell it, the entire gain is taxed because the basis
                 was 0)
      If employee pays something for the property, but less than FMV,
         Basis of the property is still the property’s FMV at the time of
         purchase [counter-intuitive] Regs §1.61-2(d)(2)
             o don't forget the Bargain Purchase Rule overlay as shown in
                 example below
      Example:
             o In 1998, X lets E buy property worth $5000 for $3000 in
                 compensation for services,
             o In 2000 car is sold for $6000, which is the amount realized
             o E has $2000 in wages for 1998 and a $1000 gain in 2000
                 (because original basis was $5000)
                                        o [don't forget Qualified Employee discount]
                                   Property received as a Gift
                                        o Gift is not included in the income of the recipient. § 102
                                        o Gift tax is imposed on the donor, not the recipient. § 2501
                                        o Gain for sale of gift property = Donor’s basis of the
                                            property is the recipient's original basis. 6 § 1015(a)
                                        o Example:
                                                A buys land in 1945 for $20,000 and gives land to B
                                                    in 2000 now worth $100,000
                                                B sells land to C in 2002 for $95,000
                                                B’s Basis in the land is $20,000, the same basis as
                                                    A if A had sold the land
                                                B’s gain is $95,000-$20,000 = $75,000
                                   Loss:
                                        o If the amount realized is less than the basis of property
                                            sold, the owner of the property does not have income from
                                            the sale of the property
                                        o Loss = Basis – Amount Realized            (if Basis < Amount
                                            Realized)
                                        o Loss may sometimes be used to offset income (as a
                                            deduction)
                                        o Example:
                                                X works in an office next to a restraint
                                                While eating, X hears owner talk about expanding
                                                    restaurant
                                                So X buys parking lot next to restaurant for $10,000
                                                Restaurant burns down, X sells parking lot for
                                                    $9,000
                                                Loss = Basis (10,000) – Amount Realized (9,000).
                                                X can use $1000 of loss to offset other income
                                                    earned. § 165(a)
                                        o Deduction of losses
                                                Individuals can only deduct losses incurred in
                                                    pursuit of profit or a business
                                                Example:
                                                          Z buys dog for $250, Z’s son doesn’t take
                                                            care of dog, Z sells dog for $200
                                                          $50 of loss is not deductible. § 165(c) 
                                                            "personal loses are not deductible"
                                                          But if dog sold for $350, the $75 gain is
                                                            taxable
                                        o Losses from Property received as a gift
                                                If Basis > FMV at time of gift  Basis = FMV at
                                                    time of gift. § 1015(a)7

6
    "carryover basis" or "transfer basis"
                                                          If donor would have had a loss if sold
                                                             property for FMV at time of gift AND
                                                             Recipient sells property for less than the
                                                             donor’s Basis.
                                                          If donor would not have had a loss if the
                                                             donor had sold the property for FMV, rather
                                                             than making a gift,
                                                                  o Then Use donor’s basis to calculate
                                                                      gain or loss
                                                          If donor would have had a loss, at time of
                                                             gift, but donee sells it for more than the
                                                             basis at time of gift,
                                                                  o Then still use donor’s basis to
                                                                      calculate gift
                                                 Example:
                                                          C runs a Gas Station, O runs a Body Shop
                                                          In 1995, C buys Tow Truck for $20,000
                                                          In 1997, C gives truck to O, now worth
                                                             $11,000
                                                          In 1998, O sells truck for $10,500
                                                          Since $20,000 > $11,000  Basis =
                                                             $11,000.
                                                          Loss = Basis ($11,000) – Amount Realized
                                                             ($10,500)= $500
                                                 Example:
                                                          if O sells the truck for $15,000, he has
                                                             neither a loss nor a gain (and likewise no
                                                             gain)
                                                          but if O sells the truck for $21,000, then he
                                                             has a $1,000 gain.
                                                 Very possible that there is neither gain nor loss
                                                          Recipient has a loss only if the selling price
                                                             is less than the FMV of the property at the
                                                             time of the gift
                                                          Recipient has a gain only if the selling price
                                                             is more than the Donor’s Basis.
                                            o Property received from a decedent ["very important rule"]
                                                 Basis of property = FMV on date of the decedent’s
                                                     death. § 1014(a)
                                                 Example:
                                                          C buys truck for $20,000, C dies
                                                          O inherits truck now worth $11,000 on date
                                                             of C's death.
                                                          O sells truck for $15,000
7
    NB: this is only for determining loss
                                               O has a gain of $4,000
                                     Example:
                                               If C dies when truck is worth $25,000
                                               O sells truck for $22,000
                                               O has a loss of $3,000
                              o Transfers between husband & wife
                                     Basis stays the same for gains and loss. § 1015(e)
                              o Allocation of Basis
                                     If a property is acquired and part of it is sold, the
                                          general rule is that basis is allocated among the
                                          parts according to the FMV of the parts at the time
                                          the property was acquired. Regs § 1.61-6(a)
                                     Example:
                                               O buys 50 shares of MSFT for $100/share
                                                  on Jan 15 2003
                                               O sells 20 shares for $2200 on Feb 20, 2003
                                               O has a basis of $5000 in 50 shares of stock
                                               Since at the time of the purchase, each share
                                                  presumably had the same value, the basis is
                                                  allocated equally among the shares - $
                                                  100/share
                                               So 20 shares = basis of $2000
                                               O has a gain of $200
                                     Example:
                                               In 1994 J buys Cascade for $1 million
                                               In 1997 J sells Cascade’s self-storage
                                                  operations for $600,000
                                               In 1994 Cascade’s self storage operations =
                                                  $200,000
                                               J has a gain of $400,000 since the basis of
                                                  the franchise is determined in the year
                                                  acquired.
-   IRS Code, Regulations, Ruling
       o Regulations have the force of law unless they are in conflict with legislation
       o Rulings will sometimes respond to individual taxpayer’s request to clarify the
          application of the tax law and regulations to particular circumstances
              IRS occasionally publishes the responses as a “revenue ruling”
       o Revenue rulings are not as authoritative as regulations, but most people would
          rather follow the ruling than risk a suit
       o Revenue Ruling 80-99
              Facts
                       An individual employed by a state government in an appointive
                          position was invited to attend and address a political fund-raising
                          event sponsored by a political organization described in § 527 of
                          the Code, and was authorized to do so by the individual’s superiors
                                The political organization reimbursed the individual for expenses
                                   incurred in attending the fund-raising event, in an amount not
                                   exceeding the individual’s actual expenditures for the reasonable
                                   costs of traveling away from home to and form the event, including
                                   meals and lodging in connection
                       Law and Analysis
                                § 61
                                Old Colony Trust (reimbursement for personal expenses are
                                   includable in gross income)
                                Other revenue rulings (Reimbursements for expenses on behalf of
                                   another in a non-employment is not includible in gross income)
                       Holding
                                Reimbursement received by individual is not includible because
                                   was not made in employment context, on behalf of the political
                                   organization and didn’t exceed individual’s actual expenses [
                                   this is the true rule: anything reimbursement about what you
                                   actually spent would be income]
              o Does 55-555 apply to carpool arrangements in which one member uses his own
                   car and members pay him a stated sum of money
                       Holding
                                Not includable for computing gross income
                                Person is not running a taxi service from which a profit is derived.
              o Revenue Ruling 67-30
                       Facts
                                Retired executive, performs a gratuitous service for a charity,
                                   receives an allowance to cover his travel expenses and meals and
                                   lodging
                       Holding
                                Includible in gross income to the extent it exceeds the taxpayer’s
                                   actual travel expenses8
              o In light of theses rulings, why did IRS go after Gotcher?
                       No substantial benefit for the automobile company; i.e., aspects of the trip
                           seemed like a vacation  this issue was one of factual interpretation, not
                           of IRS principles
      -    There is a difference between having a lost and having a deduction. Loss ≠ deduction
      -    Allocation of Basis: Hort v. Commissioner (US Supreme Court 1941)
              o original basis generally starts with the purchase price
              o sometimes only part of the original purchase is sold
                       what are the rules for allocation of basis in this situation
      -    Hort v. Commissioner
              o Father leaves office building to his son in 1928
              o Ownership of building including rental contracts + rights and obligations under
                   existing leases


8
    traditional Bar Exam section
o In 1927, Irving Trust Co, entered into a lease to begin in 1932 for a number of
  years
o In 1933 Irving decided it was losing money and sought to get out of the lease
  (25K a year)
o From the owner’s POV, the lease was a good deal
o By 1933, going rate is lower (10K a year for 15 yrs)
o If Irving got out, Landlord would have 15K less per year (i.e., a discounted value
  of a $160k loss over term of lease)
o After negotiating, landlord agreed to let Irving out of lease for 140,000
o Rather than report income of $140,000, landlord claimed a loss of $20,000
       Key: landlord received the property from a decedent. So basis = FMV at
          time father died (1928)
       Say FMV was 2 million in 1928, so Basis = 2 million
       Sale of part of the building would require allocation of the $2 million basis
          between the parts of the building
       Issue in Hort: how much of the basis do you allocate to the lease?
       Landlord was claiming that he was selling lease for less than it was worth
          in 1933, so he should get a loss
               Landlord was wrong
o Example: Simpler case
       In 1928 N agrees to sell a coin to S for $10,000 in 1933 (Forward
          Contract)
       If 1927, N bought coin for $6000
       In Sept 1933, value of coin falls to $8000
       In Oct 1933, N assigns contract to sell gold coin to E for $2000
               E doesn’t own a coin, but can buy one for $8000, so it’s wroth
                  $2000 to have a contract to sell coin for $10,000
       In Nov 1933, S doesn’t have money to buy coin
       E agrees to cancel contract for $500
       Tax Consequences
               E can probably claim a $1500 loss, she bought contract for $2000,
                  sold for $500
o Hort claims to be E (i.e., had a basis in the lease and selling it for less than it was
  worth)
o Hort is not like E but more like N who paid nothing for right to sell coin
o In 1928, Right to sell a $10K coin for $10K isn’t worth anything so N’s basis in
  the contract would be $0
o Hort it would have been possible to allocate Hort’s basis in the building between
  building and rental contract
o But allocation would have been based on the FMV of the rental contract and the
  FMV of the building w/o the lease in 1928 (i.e., the date at which the lease – a
  property interest – was acquired [or purchased])
o In 1928, FMV of the lease was likely 0 since economy was stronger in 1928 than
  in 1933.
o IF Hort’s basis was worth $2 million in 1928, so 2 million is Hort’s basis
             o Ownership of the building entailed rights under the lease to receive $25K in 15
               years in 1933
             o Then FMV of the lease contract was 0 in 1928, and no basis would be allocated
                   Basis = 0 because when you first start lease, you don’t have to pay a
                       premium for the lease itself. Just have to pay the rent.9
             o Settlement of the lease in 1933 meant the settlement proceeds = amount realized
               and basis = 0
                   Gain = amount realized minus basis
             o All of the settlement proceeds would be income
             o Now Codified in § 167(c)(2) if you purchase a building subject to a favorable
               lease10, none of the purchase price may be allocated to the value of the favorable
               lease

    -    Negative basis
            o Suppose A buys Blackacre in 1915 for $100,000 and uses NE sector for waste
                disposal
            o 1980, A sells Blackacre to B for $1 million
            o If no waste disposal, Blackacre would be worth $1.5 million in 1980
            o In 2005, environmental laws are relaxed, and B sells the NE sector for $200,000.
            o Prof: there is no certain answer for this; however, in general, negative basis is not
                used in Federal Tax practice today

    -    Allocation of Basis: Futures Contract
             o futures contract: agreement to purchase a commodity at a future date
             o On Jan 5, 2006, D might agree with E that D will purchase an ounce of gold from
                E for $400 on March 5, 2006
             o under the terms of the agreement, no money is to change hands until March
             o terms of K may permit either party to assign it
             o e.g., if price of fold rises to $500/oz in Feb 5, 2006, D would be able to assign
                (sell) the K to a F for $100
                    D would have a gain of $100
                    If price of gold rose and F sold the K for $150, then F would have a $50
                         gain
             o e.g., if the price of gold falls to $300/oz by Feb 5, 2006, the D would have to pay
                H $100 to assume the K
                    D would have a loss of $100
                    Then gold rises to $450, and H sells the K to J for $150
                    H has income of $250


Cancellation of Debt
   - General rule is that the discharge of a debt give rise to income. § 61(a)(12), Regs § 1.61-
       12(a)

9
  NB: basis is 0 because although landlord is entitled to payments, the landlord also has liabilities to provide a space
to the lessee. therefore, in theory, the lease is a wash for both parties.
10
   favorable lease: a lease under terms that you could no longer get from a tenant
       -   Example
              o In 1994, W borrows 100K from bank
              o In 1994, W is the president of bank and earned 150k
              o In 1998, Bank forgives the loan
              o In 1998, W realizes 100k in income from cancellation of debt 11
       -   Exceptions
              o If debtor is insolvent or in bankruptcy, cancellation of debt ≠ income § 108(a)
              o Purchase Price Reductions – Debtor buys property on credit, a reduction in the
                 debt by agreement between the seller and debtor does not result in income §
                 108(e)(5)
                     Cancellation is treated as if buyer had purchased the property by a smaller
                        amount with reduction in price equal to the amount of debt cancelled.
                     Example
                              W buys cell phone for $200 credit
                              She complains that it doesn’t work
                              Seller reduces debt to $140  No cancellation of debt income
                              Basis is reduced to $140

Sale of a right for a limited duration is more like a lease. Gilbertz v. US [not in case book]
    - Income from sale of property is generally offset against the basis of property § 1001(a)
    - Rental income from property is included in its entirety in income § 61(a), Hort v.
        Commissioner
    - Grant of an easement can constitute a sale of property rather than rental income rev ruling
        59-121
            o Hunting rights may be considered an easement. An interest in land rather than a
                lease although technically they are a profit since they include the right to take
                something from land
            o If easement is not perpetual, but limited in time, then income will be treated as
                rental income
    - § 109 – Improvements by the lessee on the Lessor’s Property – Gross income does not
        include income derived by improvements made by the lessee
    - § 1019 – Neither the basis nor the adjusted basis shall be increased or diminished under §
        109

Deductions & Credits
   - Previously, only about inclusions and exclusions in Gross Income
   - Deductions are different.
   - Taxes are not imposed on gross income, but rather taxable income, which is gross income
      minus deductions and tax credits
   - Key Section § 162 – Ordinary and necessary expenses paid or incurred during the taxable
      year in carrying out any trade or business
          o Most arguments surround whether expense is "ordinary and necessary"
          o Sometimes also about what is a trade or business
                  Must be involved in the activity with continuity and regularity +

11
     i.e., the year in which the indebtedness is cancelled is the year in which the $ amount is included in income
                       Primary purpose for engaging in the activity must be for income or profit
                           (Commisioner v. Groetzinger)
                                Ie: Full Time Gambler making wages at racetrack on his own
                                    account was engaged in a trade/business
                       Conventional employees are in the trade or business of providing services
                           for hire
                       Investing in stock or managing one’s investment is not a trade or business
                           even if done full time. Deductions for personal investment is under § 212.
                           BUT Trading stock is engaging a trade or business (more frequent)
                                Investor = Purchases securities for capital appreciation and
                                    income, usually without regard to short term developments that
                                    would influence the price of securities on the daily market. (Buy
                                    & Hold)
                                Trader = buys securities with reasonable frequency in an endeavor
                                    to catch the swings in the daily market movements and profit
                                    thereby on a short term basis. (Day trading)
                                        o Cases: Meyer, King.
                       Expenditures for investing in securities does not work under § 162, but are
                           generally deductible under § 212 (Though not as good).
                       Expenditures attributable to hobbies (not primarily for profit) are not
                           deductible even if the hobby is very profitable under § 162 but deductible
                           under § 183
       -   There are other deductions that can be taken but are treated less favorably than § 162
       -   If there are 2 deductions, can only deduct once

Welch v. Helvering  capital expenditures: expenditures made to acquire or improve capital
assets
    - Facts
          o Salesman who had co-owned a business that had gone bankrupt
          o The saleman paid some of the debts of the business he had owned, even though
              the debts of the business had been discharged in bankruptcy
          o Salesman then claimed deductions for the amounts he paid
    - S.Ct denied deductions on the grounds that they were not ordinary.
          o Cardozo saids that it was odd for person to pay off debt that they weren’t legally
              obligated to pay.
                  Some read If something is too weird, it is usually not deductible.
                      (minority)
                  Others read Welch as the expenses to be capital expenditures
                      (expenditures related to reputation) and not under § 16212 (Majority)
                      Commissioner v. Teiller
                           Ordinary in § 162 is to clarify the distinction between those
                              expenses that are currently deductible and those that are in the
                              nature of capital expenditures which must be amortized over the
                              life of the asset.

12
     TO: gave a list of descending importance of §162 deductions: a – c – f –g –e
                             Basically Capital Expenditures are not ordinary, so not within §
                                162
                             Also, Capital expenditures are not deductible § 26313
                                    o § 263(a) No deduction allowed for amount paid out for new
                                        buildings, permanent improvements or betterments made to
                                        increase the value of any property or estate
                                    o So reputation and learning are like capital assets, therefore
                                        not an ordinary expense in the operation of business.
                                        Counts as property for tax purposes
                                    o Capital expenditure is generally added to the basis of the
                                        asset14 (but not deductible)
                             So if asset is sold in the same year the expenditure is made, it may
                                not matter whether the expenditure is classified as a capital
                                expenditure or a deductible expense
                             If asset is not sold, then not taxable income right away; only
                                reduces income as property is sold or as it is depreciated15
                       So generally better to have a deduction than a capital expenditure.
                         Deduction reduces your tax right away, capital expenditure adds to basis
                         and reduces the income later when realization occurs
                             Example:
                                    o E Corp. buys patent for $10k, and sells patent for $10k w/in
                                        same year
                                    o E Corp. has income of 100K
                                    o If expenditures were deductible, it is not addible to the
                                        basis of anything AND it would reduce income to 90K
                                            But when E Corp. sold the patent, then E would
                                                gain 10K, increases income back up to 100K
                                    o If patent expenditure were not deductible it could not
                                        reduce equinox’s taxable income to $90k
                                            But when E Corp. sells the patent for $10k, E Corp
                                                has no gain, Patent would have a 10k basis.
                                    o In both Example, E Corp. still has 100K of income.
                             Example:
                                    o If asset is not sold, it does make a difference
                                    o M Corp spends $20K on new bushes
                                    o M Corp will have $50K in Gross Income in each of the
                                        next 5 years
                                    o If cost of the bushes is deductible, M Corp would have
                                        taxable income of $30K this year and 50K in each of the
                                        following 4 years



13
   TO: in short, you can cite both §162 and §263 as reasons why you can't deduct capital expeditures [do so on
EXAM]
14
   TO: therefore, principle is to take account of the expense in some way (in this case, by additing to the basis)
15
   TO: says that the underlined text is very important to know
             o If costs of the bushes can be depreciated over 5 years, then
                M corp. will have taxable income of 46k this year and in
                each of the following 4 years.
             o If cost of the bushes can neither be deducted nor
                depreciated then M Corp would add $20K to the basis with
                income of $50K each year.
             o If M Corp paid 100K for the land, and now sold for 200K
                with the bushes
                    if cost of bushes is deductible, then there is $50k
                        annual income and $100k gain on the sale of land
                        and therefore, taxable income of $150k for the year
                    if bushes not deductible or depreciable, then $50k
                        for income plus $80k for gain because basis of the
                        land is now $120k, i.e., total taxable income of
                        $130k.
                    suppose bushes are depreciable for $4k/year, then
                        $46k for first 4 years, and $146k for fifth year
                    NB: if we add the taxable income up in all of the
                        five years in each of the examples, we get $330k.
                        This is a good way to check the math.
Capital Expenditure – Principle §162(a)
      Some see income tax as a pure tax on income. And dependent on
         how closely the activity is related to income
             o Of course, political and practical reason acknowledge that
                some income cannot be taxed.
             o Believe that government should attempt to measure and tax
                as close to income as possible
      Most of the time, it is pretty obvious that there is a right way and a
         wrong way to determine what is income.
             o Obvious case: Hot dog stand and take in 40k a year, pretty
                obvious that you don’t have 40k of income if you spent 14k
                on hot dogs, 1k on buns and 2k on condiments.
                    Most would agree that you had 23k in income
                    Net worth only went up by the excess of proceeds
                        over expenses. Got no personal benefit from the
                        expense items.
             o Non-obvious case: Taxi driver takes in 50k, spends 3k on
                gas, 2k on insurance and 30k on new cab, it is not clear
                whether you should subtract 30k from proceeds
                    At the end of the year, the gas is gone (doesn’t add
                        to net worth), but you still have a cab
                    So in Taxi business, expenditure on a car would be
                        a capital expense not deductible except for
                        depreciation (see §167, below)
                    RULE: Spending is deductible only to the extent it
                        is attributable to income earned during the current
                          year, not attributable to income produced in future
                          years.
                      So Not all of the 30k spent on the cab is attributable
                          to generating current year’s proceeds.
                      BUT: an car dealer could deduct the cost of the cars
                          sold because they no longer have the car, doesn’t
                          add to net worth. All the cost of the car is
                          attributable to this year’s income for dealer
              o Extreme Case: Non-deductible capital expenditure would
                  be money spent on undeveloped land.
                      Generally, Raw land offsets the current receipts of a
                          business because just as much land left at the end of
                          the year as at the start. No land is used up and net
                          worth does not change. See Reg §1.167(a)-2
              o Welch Case: Reputation is a capital asset – so value of
                  reputation may depreciate over time.
                      If you spend 40k to enhance your reputation, it does
                          not all disappear this year
                      So not all deductible and may not be deductible at
                          all though reputation expense may be added to the
                          basis of a business entity.
Illegal Payments (§162(c))
       Some illegal payments are deductible, but many are not.
       § 162(c)(1) – Bribes and kickbacks paid to government employees
          are not deductible
              o Also bribes to foreign government officials or employees
                  are not deductible
                      Test: See if the payments to the official or employee
                          would be illegal if paid to domestic employee under
                          federal law, then it is not deductible if given to a
                          foreigner
                      See Reg §1.162-18(a)(1)(ii)
       § 162(c)(2) – Illegal payments besides those disallowed by §
          162(c)(1) are not deductible if the penalty is sufficiently serious
              o If it violates federal or state criminal law
              o Or subjects person making payment to loss of a license or
                  right to engage in a business (particular business they were
                  engaged in before).
       Fines and penalties paid to federal, state, local or foreign
          governments are not deductible. § 162(f); Regs 1.162-21(a)
              o BUT: Compensatory damages are not considered a fine or
                  penalty even if paid to a government. Regs § 1.162-
                  21(b)(2)
              o BUT: If company is required to pay treble damages, only
                  1/3rd of the amount is deductible. Only a 1/3 of the amount
                  is compensatory, the 2/3 is a penalty. § 162(g)
                                     o So have to define what is a fine and what is compensatory
                                     o Ie: R Corp. convicted for violating Anti-Trust act and fined
                                          $15k, then in civil suit, Gov gets compensatory 100k
                                             § 162(f) Fines can’t be deducted, but compensatory
                                                 damages can be deducted.
                     Political payments
                              Lobbying expenses, costs of political ads and campaign
                                  contributions are not deductible under § 162(e)(1)
                              EXCEPTION: Lobbying Local governments directly related to
                                  your trade or business. § 162(e)(2)
       -   Other Deductions
              o Some are more valuable than others
              o Have to review how income tax basically works
                     Tax payer migh have income from various sources say $80,000 in Salary
                         and 10,000 in interest from savings
                     Suppose that taxpayer has 10000 in deductions and 5k in tax credits
                     Setting aside tax credits, taxpayer has 80k in net income
                              Net Income = Revenue – COGS
                     Income tax taxes net income, not gross income
                     Federal income tax applies a tax rate to net income to determine tax
                         liability
                              There are a variety of rates depending on the taxpayer’s net income
                              Assume:
                                     o 10% on Net income up to $20,000
                                     o 20% on Net Income up to $20-50,000
                                     o 30% on Net Income up to $50,000
                     Tax liability = 20,000 *. 1 + 30,000 * .2 + 30,000 * .3 = 17,000
                     Tax credit subtract from tax liability. So 17,000 – 5,000 = 12,000
                     So deduction reduces Net Income, Tax credit reduces tax liability
                     $1 in tax credit is worth more than $1 in deduction.
                              If 5,000 is a deduction, then tax liability = 20k*.1 + 30k*.2 +
                                  25k*.3 = 15.5k
              o Essentially Net Income = Gross income – deductions. Code calls it differently
                  (Adjusted gross income [§ 62] and Taxable income [§ 63])
              o Adjusted Gross income § 62
              o Gross income defined by § 61 sweeps in most of the main sources of income
                     Some § 61 income not counted as gross income16
                              Interest on most state and local bonds § 103(a)
                              Certain health benefits § 105, 106
              o Adjusted Gross income17 = Gross income - certain deductions
                     Deductions attributable to a trade or business carried on by the taxpayer, if
                         such trade or business does not consist of performance of services by the
                         taxpayer as an employee18

16
     TO: in other words, items specifically excluded from income is not the same as a deduction
17
     term of art in IRC
                     Among other deductions (reimbursed expenses of employees, losses on
                        property sales, alimony… etc)
                o Taxable income19 § 63
                     If you do itemize, Taxable income = gross income – deductions allowed in
                        § 63a
                     If you do not itemize, Taxable income = adjusted gross income – standard
                        deductions – deductions for personal exemptions. § 63b
                     Itemize deductions = (1)deductions allowable in arriving at AGI and (2)
                        deductions for personal exemptions

Types of Deductions [EXAM: draw a chart with each step and available deductions]
   - There are different types of deductions, some are more valuable than others
   - A few deductions are taken from gross income (§ 61) IN CALCULATING ADJUSTED
       GROSS INCOME (§ 62)
          o In most cases, such deductions are the most valuable type
   - Then there are deductions allowed under § 151 for personal exemptions
          o These are about as good as the deductions above
   - Then there are itemized deductions (§ 63(d)). 2 Types of itemized deductions
          o Miscellaneous itemized deductions (§ 67(b)) which are the least valuable because
             of limits
          o Other itemized deductions
   - To calculate deductions: Tax Measure of Income
          o Gross Income = § 61(a) which includes main sources of income
          o Adjusted Gross Income = § 62(a) gross income – certain favored deductions
                  Trade and Business deductions
                  Reimbursed expenses of employees
                  Losses on Property sales
                  Alimony
          o Taxable income = § 63(a) Gross income – all deductions
                  Taxable income = adjusted gross income – deductions not permitted in
                     determining adjusted gross income
                  § 63(a) –> Taxable income = gross income minus the deductions allowed
                     in this chapter (other than the standard deduction)
                          §63(b): If you do not itemize, taxable income = adjusted gross
                              income minus the standard deductions and minus deductions for
                              personal exemptions under §151
                          Itemized deductions = deductions other than (1) the deductions
                              allowable in arriving at AGI and (2) deductions for personal
                              exemptions
                          Reason why AGI is defined separately from taxable income
                              instead of just limiting certain deductions is that the limits on
                              deductions are defined in terms of AGI



18
     TO: this is an important distinction
19
     term of art in IRC
                             Distinction between AGI and taxable income is import because
                               there are certain arbitary limit on most of the deductions that are
                               not allowed in computing AGI
                             Tax rates are applied to taxable income
                             For taxable entitles20, there’s just gross income, and taxable
                               income. No AGI
                      Federal Tax Forms
                             10-40, you first calculate Gross Income based on your salary
                      Then you subtract certain deductions, to determine AGI
                      Then subtract other deductions to determine Taxable Income
                      Then determine tax liability using tax rates and subtract any tax credits to
                        determine the tax you owe
                      On tax return21
                             1st Calculate AGI by taking certain deductions
                             2nd. Calculate taxable income by taking any other deductions,
                                   o taxable income is just defined in the statute as gross income
                                       minus all allowable deductions,
                                   o adjusted gross income is defined as gross income minus
                                       certain specified deductions
                             the determination of taxable income comes to the same thing either
                               way
                             AGI is only calculated for individuals. For Businesses, there is
                               only gross income and taxable income

             o § 67 (a) general rule – In the case of an individual, the Miscellaneous itemized
               deductions for any taxable year shall be allowable only to the extent that the
               aggregate of such deductions exceed 2% of AGI 22
             o § 67 (b) Deductions under § 212 are miscellaneous itemized deductions subject to
               § 67
                   Not all inclusive (Miscellaneous itemized deductions don’t include other
                       deductions)
             o § 212 is one important example of a “miscellaneous itemized deduction” defined
               in § 67(b) and subject to the limits of § 67(a)
                   Have to look at § 212 to see how § 67 works.
                   § 212 – Individuals can deduct all ordinary and necessary expenses paid or
                       incurred during the taxable year
                            For production or collection of income
                            For management, conservation or maintenance of property held for
                              the production of income
                                  o OR
                            In connection with the determination, collection or refund of any
                              tax

20
   e.g., corporations
21
   TO: KNOW these steps; UNDERSTAND the process
22
   Therefore, you want to get AGI as small as possible so it is easier to exceed 2%
                  § 212 does not require that the expense be incurred in carrying out a trade
                     or business
                          Only need to be ordinary and necessary expenses – Same language
                             that appears in § 162(a)
                  Other than eliminating “trade or business” the requirement, the limits
                     imposed by case law under § 162(a) are generally applicable to § 212
                          Sorrell v. Commissioner
            o Difference between § 162 and § 21223
                  Expenses deducted under § 162 reduces adjusted gross income
                  Expenses deductible under § 212 do not reduce adjusted gross income,
                     only taxable income
                  Expenses deductible under § 212 are miscellaneous itemized deductions
                     (MID never reduce AGI; they are "below-the-line" deductions)
                          So § 212 is Limited under § 67(a)
                          Miscellaneous itemized deductions, expenses deductible under §
                             212 can only be deducted only if they exceed 2% of the AGI
                          Example
                                 o X has Gross income of $100,000
                                 o X has $20,000 of deductions under § 162
                                 o X has $5,000 of deductions under § 212
                                 o X’s adjusted gross income is $80,000
                                         § 62(a)(1) – above the line deductions [important
                                             for EXAM]
                                 o X’s Taxable income is $76,600
                                         § 63, 67(a)
                                 o 2% of AGI = 1600, so $5000 - $1600 = 3400 is deductible.
                                     (80000-3400 = 76600)
                                         because of §67(a), taxpayer loses 1/3 of his §212
                                             deductions in this case
                  § 212 is one of the most important itemized deductions
                          Regulations state: § 212(1) or § 212(2), Expense must be
                             reasonable in amount and reasonably and proximately related to
                             the production or collection of income or the management,
                             conservation or maintenance of property held for the production of
                             income Regs § 1.212-1(d)
                          Common categories of expenses falling under § 212(1) or § 212(2)
                                 o Reasonable expenses of investing in securities (Stocks,
                                     bonds) fees for investment advice, custodial fees, expenses
                                     for clerical service or office rent. Regs § 1.212-1(g)
                                 o Reasonable expenses of earning income from rental
                                     property (if not considered a trade or business) –
                                     management expense, repairs, travel to visit properties (if
                                     the expenses are not capital in nature). Regs § 1.212-1(h)


23
     KNOW THIS
                      o Reasonable expenses of administering trusts and estates –
                          fiduciary fees, legal expenses. Regs § 1.21-1(i)
               Things that don’t’ fall under § 212(1), (2)
                      o Commuting expenses
                      o Expense of improving personal appearance
                      o Expenses of seeking employment
                      o Bar exam fees and other bar admission costs
                              Regs § 1.212-1(f)
               § 212(3)
                      o If individual, then allow as a deduction all the ordinary and
                          necessary expenses paid or incurred during the taxable year
                          in connection with the determination, collection or refund
                          of any tax
                              So Tax advice, preparing tax returns, contesting tax
                                  liability before the IRS or courts,
                              Rule applies to federal, state and local taxes of any
                                  kind. Regs § 1.212-1(l)
o § 62 (a)(1), “Trade or business deduction” are deductible in determining AGI. If
  trade or business does not consist of the performance of services by the taxpayer
  as an employee
      A deduction that lowers AGI is particularly beneficial because such
          deductions are generally not limited and
               For most purposes, the lower AGI the better, since the number of
                  deductions, the higher AGI the greater the limit on those
                  deductions
o § 62 (a)(2) permits reimbursed expenses of employees to be deducted in
  determining AGI
      Reimbursed expenses – Expenses paid by a taxpayer in connection with
          the performance by him of services as an employee, under a
          reimbursement arrangement with his employer
      Reimbursement (§ 62(c), To qualify as a reimbursement arrangement,
          them employee must generally substantiate the expense to the employer
          and must not be permitted to retain any unsubstantiated amounts
               substantiation can be based on company policy rather than receipts
                      o e.g., The IRS deems per diem allowance to be substantiated
                          under rules issued annually
                      o see Rev Proc 2005-67
      If employer reimburses a legitimate employee expense and there is proper
          substantiation, you can just ignore the amount neither deducting it nor
          including it in gross income (Unless the employer reports it as part of
          gross income on form W-2) Regs § 1.62-2(h)
               Form W-2 = form the employer sends to the IRS and you reporting
                  the amount you’re paid
      You are still technically allowed to deduct the kind of expenses that would
          qualify as reimbursed expenses if they were reimbursed, but if the
                   expenses aren’t reimbursed only the amount that exceeds 2% of AGI is
                   deductible
                        So if you earn $70,000 and had $1000 of legitimate non-
                           reimbursed employee expenses, probably none would actually be
                           deductible. 2% of 70,000 = 14,000 > 1000. § 67(a)
                        IRS usually skeptical about non-reimbursed expenses. Employer
                           would usually reimburse if legitimate
-   Travel Expenses § 162(a)(2)
       o Travel expenses which include expenses for meals and lodging if they are not
           lavish or extravagant are deductible under § 162 if the expenses are incurred while
           away from home in pursuit of a trade or business
       o The IRS considers home for this purpose to mean the location where the taxpayer
           is employed or conducts business
               Rev Rul 75-432
       o Some courts define home as the taxpayer’s dwelling place
               Wallace 144 F.2d 407
       o “Away from home generally means overnight
       o Transportation expenses for single-day trips are deductible but not meals/lodging
               on the other hand, commuting expenses, for example, are not deductible
       o Special rules apply for temporary work locations
       o If part of a business trip is spent on personal activities, travel expenses are
           deductible only if the primary purpose of the trip is business
       o Conventions on cruise ships and generally travel to a convention or seminar
           outside of North America are not deductible § 274(h)
       o Travel expenses connected with seminars and conventions are not deductible
           under § 212 which applies to investment activities and not certain other profit-
           seeking activities not qualifying as a trade or business. § 274(h)(7)
       o Strict limitation on deductions (By person incurring the expense) for the expenses
           of a husband/wife companion on a business trip
               274(m)(3) husband or wife must be an employee and there has to be a
                   bona fide business purpose for the husband’s or wife’s presence
               § 274(n) only half of the expenses of business meals is deductible
                   [emphasized in class]
               Exceptions: Expenses of food and beverages qualifying de minimis fringe
                   benefits under § 132(e) are deductible in full. § 274(n)(2)(b)
                        De Minimis fringe as applied to meals
                               o Regs § 1.132-6(d)(2), a meal or meal money provided on
                                   an occasional basis to permit an employee to work needed
                                   overtime is a de minimis fringe
                               o Other means can constitute a de minimis fringe too based
                                   on regulations enacted after 1992 Regulations
                               o If you work thorugh § 132(e)(2), you find that most
                                   cafeteria meals excluded under § 119 can also qualify as a
                                   de minimis fringe
                              § 119(a) allows employees to exclude from income meals
                                  furnished on the business premises of the employer for the
                                  convenience of the employer
                              § 119(b)(4) all meals furnished to employees on premises are
                                  considered furnished for the employer’s convenience if more than
                                  half really are.
                     So in light of § 274(n)(2)(b) meals furnished on the premises of an
                         employer will often be deductible in full
                     Restaurants can deduct in full the cost of business meals that customers
                         pay for § 274 (n)(2)(A), (E)(7)(8)
                     But otherwise, just 50% of the cost of business meals is deductible,
                         including employee meals that constitute travel expenses or means with
                         customers/clients
             o IRS generally permits a deduction (up to 50% limit) for the costs of the meal of
                 taxpayer who takes a client or customer to dinner, in addition to the cost of the
                 client/customer’s meal (this goes against rule that an employee's own meal eaten
                 by himself is not deductible, see Rev Rul 63-144)
             o § 274(n) applies more broadly to allow only half the expenses of meals and
                 entertainment
                     Business is allowed to deduct entertainment expenses and although there’s
                         a limit to what you can ge away with, lot’s of business entertainment
                         deductions are allowed subject to 50% rule
             o Entertainment, amusement and recreational expenses are generally deductible if
                     The activity is directly related to or associated with the active conduct of
                         the taxpayer’s trade or business
                     In principle, entertainment directly related to or associated with
                         investment activities is deductible under § 212. § 274(a)(2)(B).
                     Entertainment, amusement and recreational expenses include entertaining
                         at
                              Night club, cocktail lounges, theaters, country club, golf club,
                                  entertaining on a hunting trip or fishing trip Regs § 1.274-2(b)
                              the fact that IRS mentions certain activities means that implicitly
                                  you can take a client to a night club and get the deduction
                     Even if it is deductible, only half the cost is deductible if the activity is
                         directly related or associated with the active conduct of the taxpayer’s
                         trade or business
     -   § 274 limits what can be deductible. In other words, it is a negative provision in that it
         disallows things that would normally be allowed in §162. So even if they are listed under
         § 274, they are still other rules which might apply.
             o § 274 (d) – Special substantiation rules24 apply to the deductibility of travel and
                 entertainment expense
                     Records are required for establishing:
                              Amount of the expense

24
  part of the process: when claiming a deduction under this section, you need to keep the following information on
record
                        Time and place of the activity
                        Business purpose of the activity
               In case of Entertainment
                        Have to keep records of the business relationship between the
                           taxpayer and client/customer being entertained.
-   Education expenses
       o In certain cases, educational expenses made by an individual for the individuals’
           own benefit are deductible under § 162 as part of the expense of engaging in a
           trade or business
       o Most educational expenses probably are not deductible, however, either because
           they are considered personal expenses or capital expenditures
       o § 127, up to $5250 of educational assistance furnished by an employer to an
           employee (including certain former employees) is generally excluded from the
           employee’s taxable gross income
       o It should apply to most employer paid or reimbursed training or higher education
           costs up to $5250
               Ie: This provision generally should permit a law firm associate to exclude
                   the value of reimbursed expenses for bar review courses
       o BUT: individual’s payment of his or her own bar review course expenses are not
           deductible under § 162(a) and, if bar review courses are reimbursed but § 127
           does not apply, then reimbursed amount is a taxable fringe benefit since
               § 132(a)(3) Working condition fringe only excused income fringe benefits
                   that would be deductible by the employee absent reimbursement [**]
                   [you need an independent provision to exclude it from taxable income]
               No other section of § 132(a) applies.
       o Bar review expenses are not deductible under § 162(a) because “expenditures
           made by an individual for education which is required of him to meet the
           minimum educational requirements for qualification in any trade or business are
           not deductible
               Regs § 1.162-5(b)(2), (3)
               This rule has been applied quite restrictively
               IE: A is working in a non-legal position and for some reason the employer
                   requires him to obtain a law degree
                        Even though A does not intend to become a lawyer, just continue
                           in his non-legal position, the costs of obtaining the law degree are
                           not deductible because the education qualifies him for a new trade
                           or business
                               o Regs § 1.162-5(b)(3), example 2
               Ie: Member of the Oregon bar taking a bar review course to prepare for the
                   California bar exam is not allowed a deduction under § 162(a), on the
                   grounds that practicing in California is a different trade or business than
                   practicing in Oregon
                        Sharon, 591 F.2d 1273
       o Expenses of education to move from elementary school to secondary school
           teacher, or to specialize within a profession are deductible under § 162(a), Regs §
           1.162-5(b)(3)
                   Expense of obtaining an LLM generally should be deductible or if the
                    expenses are covered by an employer, treated as a working condition
                    fringe (That is, a non taxable benefit) under § 132(a)(3)
                         Assuming you earn money as a lawyer for some period prior to
                            starting the LLM

           o Educational expenditures are deductible if the education       [general
             principles]
                 Maintains or improves skills required by the individual in the individual’s
                     job or trade
                          Or
                 Is required by the individual’s employer, or by law or regulation
                 Unless the education “qualifies the individual for a new trade or business"
                          Regs. § 1.162-5(a)
                 Often an LLM should meet these tests

   -   Statute of Limitations for individuals
           o § 6501(a) – Income taxes must be assessed within 3 years after the filing of a
               return
                   If a return is filed early, it is deemed filed on the due date for this purpose.
                       § 6501(b)
                   If a return is filed late, the 3 year period begins on the filing date
                   The IRS must make a record of the assessment and notify the taxpayer but
                       late notice probably will not matter
           o If no return is filed, the statute of limitations does not apply. § 6501(b)(3); Elliot,
               113 TC 125 (1999)
           o No statute of limitations applies to a false return or fraudulent return or a willful
               attempt to evade tax
                   § 6229(c)(1), 6501(c)(1); 6501(c)(2)
           o If gross income is understated by more than 25%, the statute of limitations is 6
               years § 6501(e)(1)
           o Before the statute of limitations period expires, the IRS may ask a taxpayer to
               extend it (under circumstances that typically make refusal difficult) § 6501(c)(4)
           o Claims for refund generally must be make within 3 years of the filing of the
               relevant return or 2 years from the time the tax was paid, whichever is later. §
               6511(a)
   -   Exceptions to the Statute of Limitations
           o Exist when tax liability in one year may be relevant to tax liability in another
               (e.g., §§1311-14)

Capitalization
   - Under § 263(a), certain costs are not deductible because they are considered to be capital
       expenditures
   - The role of deductions is to make sure, to some degree at least, that a taxpayer is taxed
       based on the taxpayer’s annual net income in other words, on the sum of the taxpayer’s
            o Annual consumption of wealth
                   And
          o Increase in wealth during the year.
   - Roughly speaking, a cost of a trade or business or of a potentially profitable activity must
      be capitalized, at least in part, if there is something of value left over from the
      expenditure at the close of the taxable year, on the other hand, the cost is deductible if the
      benefit from the expenditure is exhausted by the current year’s business activities.
   - § 263(a) certain costs are not deductible because they are considered to be capital
      expenditures
          o § 263(a)(1) no deductions is allowed for any amount paid out for new buildings or
               for permanent improvements or betterments made to increase the value of any
               property or estate with a few listed exceptions
          o § 263(a)(2) no deductions is allowed for any amount expended in restoring
               property or in making good the exhaustion thereof for which an allowance has
               been made [ie: if you have depreciation and you spend money to upkeep the
               property to counter the depreciation, can’t take deduction]
          o Effect of these provisions is to deny deductions for the cost of acquisition,
               construction or erection of buildings, machinery and equipment, furniture and
               fixtures and similar property having a useful life substantially beyond the taxable
               year” Regs § 1.263(a)
          o No deductions for amounts paid or incurred to add to the value or substantially
               prolong the useful life, of property owned by the taxpayer, such as plant and
               equipment or to adapt property to a new or different use. Regs § 1.263(a)-(b)
                   Ie: No deduction for getting a plant and no deduction for modernizing the
                       plant and no deduction for converting the plant.
Uniform Capitalization
   - If a taxpayer constructs or produces a capital asset for the taxpayer’s OWN business, per
      § 263A the taxpayer’s expenses are not deductible, in stead the expenses must be
      capitalized
   - Ie: If company buys a building or heavy machinery, the purchase price is generally not
      immediately deductible, per § 263
   - Ie: If a construction company purchases land and builds an apartment complex on the
      land, § 263A prohibits the construction company from deducting its own building cots –
      just in case it was not clear that § 263 applied
          o Under § 263A, the amount the construction company spends on fuel for the
               construction equipment used on the site is not deductible
                   The cost of the fuel is added to the basis of the property [NB: if producing
                       the apartment complex for another company, then the expenditures would
                       be deductible]
                   Salary costs used to produce the property is not deductible, salary is
                       generally deductible, but not if it is used to produce capital asset for its
                       own use.
                   Legal costs of the project are not deductible whether in the form of in-
                       house lawyer salaries or the fees of outside counsel
          o It was clear that even before § 263A, most of the costs we discussed were not
               deductible. So § 263A is somewhat redundant
                But if the construction bought some construction equipment in 1998 and
                   in 2002 uses the equipment in building the shopping center
           o § 263A also applies to depreciation deductions
                ie: Under § 263A, the 2002 depreciation deduction that the company
                   would normally be allowed on the equipment are disallowed and instead
                   added to the basis of the property being built
                If the equipment were also used in 2002 for other projects, the
                   depreciation would have to be allocated among those uses, some portion
                   might still be deductible
Repairs
   - The cost of incidental repairs that neither materially increase the value of property nor
       appreciably prolong its life but keep it in an ordinary efficient operating condition are
       deductible and not added to the property’s basis
   - Repairs in the nature of replacements, to the extent the repairs arrest deterioration and
       appreciably prolong the life of the property are capital expenditures. Regs § 1.162-4
   - As is often the case, with laws and regulations, the statement of a general principle often
       falls short of resolving issues that typically arise in practice
   - In the practice of course, property is usually worth more after it’s repaired so the
       purported principle that a deductible repair should not materially increase the property’s
       value is not a particularly useful one
   - ***In practice, the test of whether a repair is deductible is often whether the value of the
       property increased when compared to the time just before some unexpected casualty
       occurs***
   - On the other hand, significant expenditures to correct predictable deterioration or defects
       existing when the property is acquired are often not considered deductible if the value of
       the property is materially increased
           o Therefore, this is not a settled principle and the two potential options come from
               case law [i.e., the unexpected-expected distinction].

Depreciation
   - In general, an expenditure for long-lived property for use in a trade or business is not
      deductible--- the amount of the purchase is added to the basis of the property. § 263,
      263A
   - In the typical case, however, some form of depreciation is allowed for property used in a
      trade or business so that the owner of the property is allowed a deduction of, roughly
      speaking a portion of the property’s cost. § 167, 168, 197, 195, 248, 611
   - In general, the total depreciation allowed with respect to property should, over the years,
      add up to the cost of the property
   - Generally, the basis of depreciable property is reduced by the amount of any depreciation
      deductions. § 1016(a)(2)
   - IE: B buys a piece of heavy machinery for 1 million
           o Suppose, B is allowed to deduct $100,000 for the cost each year as an allowance
              for depreciation
           o After 5 years, Bruiser sells the machine for $700,000
           o B has a gain of $200,000 because basis of property has been reduced by a total of
              $500,000 over 5 years
-   IE: If B doesn’t sell the machine, after 10 years
        o Total cost will have been depreciated
        o The basis of the machine will be 0
        o No further depreciation is allowed
-   Under § 167(a)
        o There shall be allowed as a deprecation deduction a reasonable allowance for the
            exhaustion , wear and tear including a reasonable allowance for obsolescence)
                 1. Of property used in a trade or business or
                 2. Of property held for the production of income
-   Other kinds of property
        o For most Tangible property, the size of the depreciation deduction is determined
            under § 168, which specifies the method of depreciation to be used and the period
            over which the property is depreciated
        o For Intangible property – Depreciation is called amortization § 197
        o For Natural Resources – Called Depletion § 611. Oil, gas, minerals, timber… etc
-   The reason some routine, legitimate business expenses are not deductible is that the
    money is spent on items that have value beyond the current quarter. So such expenses
    must be capitalized
        o But most items do not last forever, and capitalization usually does not mean that
            the expense of an item is never deductible
                 Just that the deduction of the total expense is spread out over the number
                     of years the item contributes to production
        o Ie: If item costs $10,000 and last 3 years, then to properly measure net income,
            the $10,000 should be deductible over 3 years.
-   Stright Line Method: Some capital expenditures are deductible according to the straight-
    line method of depreciation
        o The straight line method of depreciation is based on the useful life of an asset and
            its salvage value
                 The useful life of an asset is expected period of time during which the
                     asset will be used to produce income
                 IRS has determined many useful lives of different assets: a truck might
                     have a useful life of 6 years
        o Salvage value is the estimate value of an asset at the end of its useful life for a
            particular function
                 The annual depreciation allowed by the straight-line method is the
                     difference between the asset’s original basis and its salvage value
                     DIVIDED by the asset’s useful life
                 IE:
                          Suppose an asset costing $10,000 has a useful life of 3 years and
                             salvage value of 1000
                          (10,000 – 1000) /3 = 3000
                          So taxpayer can deduct 3000 each year for 3 years
                 Basis then drops by depreciation amount
                          Year 1  Deduction $3000  Basis $7000
                          Year 2  Deduction $3000  Basis $4000
                          Year 3  Deduction $3000  Basis $1000
                        No further depreciation after year 3
               IE:
                       Suppose an asset costing $100,000 has a useful life of 5 years and
                          salvage value of 0
                       Annual depreciation is (100,000 – 0)/5 = $20,000
-   Double Declining Balance Method
             In order to determine the allowed depreciation, divide cost of asset by the
                  asset’s useful life and convert to a percent
             Then double the percentage (DDB rate)
             Multiply the DDB rate by the asset’s basis, That’s the depreciation
                  deduction for the first year
             For the next year, begin with the adjusted basis of the asset at the start of
                  the year
             So as time goes on, depreciation declines as basis is smaller each year.
             IE:
                       Suppose an asset costs $100,000 and useful life of 10 years
                       So get 10% * 2 = 20% * 100,000 = 20,000
                       New basis = 100,000 - 80,000
                       2nd Year’s deduction = 80,000 * 20% = 16,000
             IE:
                       Suppose an asset cost $9000 and useful life of 3 years and salvage
                          of 0
                       Annual straight-line depreciation is $3000
                       Year 1  1/3 * 2 = 2/3 * 9000 = 6000. Basis = 9000 – 6000 =
                          3000
                       Year 2  2/3 * 3000 = 2000. Basis = 3000 – 2000 = 1000
                       Year 3  2/3 * 1000 = 666. Basis = 1000 – 666 = 332
                       Can keep going for subsequent depreciation
             IE:
                       Suppose an Asset costs $5000 and useful life of 5 years and
                          Salvage of 0
                       Year 1  2/5 * 5000 = 2000. Basis = 5000 – 2000 = 3000
                       Year 2  2/5 * 3000 = 1200. Basis = 3000 – 1200 = 1800
                       Year 3  2/5 * 1800 = 720. Basis = 1800 – 720 = 1080
                       Year 3  2/5 * 1080 = 432. Basis = 1080 – 432 = 648
                       Year 5  2/5 * 648 = 259.2. Basis = 648 – 259.2 = 388.8
                       Full cost is not recovered over useful life.
             In comparison with straight line depreciation the DDB method permits
                  larger deductions sooner, which is usually preferable even though total
                  depreciation under straight line method is the same or sometimes larger
             Under § 168(b)(1), for most assets, depreciation is determined using the
                  double declining balance method until the straight-line method produces
                  larger deductions
       o IRS requires Accelerated Cost Reduction (ACR). Actual Method.
             Basicly take the most deductions you can between DDB and Straight Line
                 Straight line here based on adjusted basis over remaining years
Year              DDB                 SL                 ACR                 Basis
1(Use DDB)        2000                1000               2000                3000
2                 1200                750                1200                1800
3                 720                 600                720                 1080
4(Switch over to  432                 540                540                 540
SL)
5                 259                 540                540                 0

   -   For purposes of computing depreciation under § 168, assets are classified into categories
       such as –
           o Office equipment and furniture
           o Information systems
           o Water transportation equipment
           o Cattle
           o Assets used to produce knitted goods
           o And so on
           o § 168(c), (e)(1),(3), (i)(1); Rev Proc 87-56
   -   Most assets are assigned recovery periods of 3, 5, 7, 10, 15 or 20 years depending on
       category (§ 168(c), (e)(1)
           o Assets with 3-10 year recovery period uses the double declining balance/SL
               method (§ 168(b)(1))
           o Assets with 15 or 20 year recovery periods use the 150% declining balance/SL
               method (§ 168(b)(2))
           o Farming Assets use 150% Declining balance/SL method (§ 168(b)(2))
   -   Buildings are depreciable over 27.5 years (residential) or 39 years (Non-Residential)
       using the straight-line method § 168(b)(3), (c)
   -   Raw land is not depreciable. Regs § 1.167(a)-2
   -   The straight-line method CAN be used for other property too § 168(b)(5), (g)
   -   § 168 is complicated,
           o Technically, most assets are assumed to be acquired in the middle of the taxable
               year, even if they acquired at the very beginning or very end of the year (§
               168(d))
           o Under certain circumstances assets are assumed to be acquired mid month or the
               middle of the last quarter
           o So encourages assets to be acquired at the end of the year/month/quarter
           o So assets with a 5 year recovery period are actually depreciated over 6 years
           o You are allowed half a year’s depreciation the first year and the last year
           o So you are not allowed to depreciate property bought and sold during the same
               taxable year Regs § 1.168(d)-1(b)(3)
   -   But Only responsible for knowing simplified version of the § 168
   -   § 168 only applies to tangible property, Intangible property is depreciated according to
       the straight-line method under § 167 or § 197.
   -   Many rules change from year to year. We don’t go into that.
   -   § 167 only applies to property used in business or for the production of income.
       Depreciation deductions are not allowed for property used for personal purposes
   - Property held for sale is not depreciable Rev Rul 87-54
Amoritization – Depreciation of intangible Assets
   - § 167 applies to intangible assets, but § 197 overrides 167. So start with 197 which rules
      out certain intangible assets. If it doesn’t fall within 197, then usually won’t be
      amoritized. Sometimes may be able to use 167.
   - § 197(a)
           o Taxpayer shall be entitled to an amoritization deduction with respect to any
              amortizable § 197 intangible
           o The amount of such deduction shall be determined by amortizing the adjusted
              basis… of such intangible ratably over the 15 year period beginning with the
              month in which such intangible was acquired.
           o Includes
                   Patents
                   Copyrights
                   Trade Secrets/Formulas
                   As long as they are acquired not if they are created by the taxpayer. §
                      197(c)(1), (2), (d)
                           Some self created assets are not amoritizable
           o Others that are amoritizable if created
                   Covenants not to compete
                   Government licenses and permits unless related to real property
                   Franchisees
                   Trademarks
                   Even if they are created by the taxpayer § 197(c)(2)(A)
   - Intangibles not covered by § 197 may nevertheless be depreciable under § 167, although
      generally a limited useful life must be established
           o IE: Computer software excluded from § 197 may be depreciable over 3 years
              under § 167(f)(1)
   - Special Rules apply to:
           o Research and development expenses
           o Costs of starting up a business §§ 174, 195
Deductions for interest expense
   - The cost of borrowing, as an expense of a trade or business is generally deductible. §
      163(a)
   - Example – Borrow $50,000 to buy inventory to sell to customers, and you pay annual
      interest at 5% - $2,500.
   - The $2500 interest expense is deductible.
   - An interest deduction under § 163 is not a miscellaneous itemized deduction so 2% floor
      of § 67(a) does not apply
   - But this is another example in which what seems to be a simple rule is significantly
      qualified by other provisions of the Code
           o If you borrow in order to construct capital equipment, the expense is not
              deductible – it’s added to the basis of the equipment § 263A(f)
   - Further, since 1986, no deduction is allowed for interest expense with respect to
      borrowing for personal purchases – with a few exceptions such as a deduction for
      mortgage interest § 163(h)
        o So if you borrow money to buy a car for personal use, interest on the loan is not
            deductible
-   Personal interest include interest on indebtedness incurred in the trade or business of
    being an employee. Considered personal
-   If you borrow to finance deductible educational expense, the interest is not deductible
    under § 163 if you are an employee § 163(h)(2)(A)
-   You are allowed to deduct interest with respect to loans used to acquire investment
    property – assets that produce income from an activity that does not constitute a trade or
    business, such as shares of stock
-   You are allowed to deduct such interest, however, only to the extent you have investment
    income, § 163(d)(1)
-   Example
        o You borrow $1000 at 5% interest to buy $1000 of MS stock
        o The stock goes up in value from $1000 to $120-0 over the year, but you don’t sell
            any shares during the year and the stock pays no dividends.
        o You would have $50 of interest expense but it’s not deductible because you have
            no investment income
        o You can carry the amounts forward and may be able to deduct them later when
            you do have investment income.
-   Example
        o You sell 1 share for $20 gain
        o You can deduct $20 of the $50 interest (or pay capital gains tax on the $20 and
            hope you have investment income later)
                § 163(d)(4)(B)(iii)
-   Exceptions:
        o Interest on a home mortage is generally deductible even though the loan is used
            for personal purposes. § 163(h)(2)(D), (3).
        o Because this is under § 163, it’s not a MID under § 67(a). § 67(b)(1)
        o Under § 163(h)(3)(A), Qualified residence interest means any interest which is
            paid or accrued during the taxable year on
                Acquisition indebtedness or
                Home Equity indebtedness
        o With respect to any qualified residence of the taxpayer
                Qualifed Residence =
                         Taxpayer’s principal residence or
                         One other residence selected by the taxpayer § 163(h)(4)(i), (iii)
                There are rules governing what is a principal residence, but usually a
                    pretty easy call
                         2nd residence can be a house, condominium, mobile home, boat or
                            house trailer, but must contain sleeping space, toilet, cooking
                            facilities. Regs § 163-10T(p)(3)(ii)
                         If taxpayer rents out the second residence, the taxpayer must use
                            the property as personal purposes for a minimum number of days
                            during the year. § 163(h)(4)(A)(i)(II); 280A(d)(1)
        o Interest with respect to no more than a total of $1 million of acquisition
            indebtedness” for both residences is deductible under § 163(h)(3)
                   Acquisition indebtedness includes a mortgage financing the acquisition,
                       construction or substantial improvement of a qualified residence
           o You can also deduct interest under this provision if you refinance a mortgage that
               originally qualifed under the rule, as long as the principal remaining at the time of
               refinancing is not increased. § 163(h)(3)(B)25
                   Acquisition indebtedness has to be used on the residence, (which could
                       even be a boat you could live on), but “home equity indebtedness” does
                       not
                   Can use home equity indebtedness money for anything
           o Home equity indebtedness max deduction is 100,000. § 163(h)(3)(C).
               REMEMBER, only deduction on the interest of $100,000 not the $100,000 itself
           o Like acquisition indebtedness,” the debt must be a genuine mortgage, that is
                   Secured by the residence and
                   The sum of the acquisition indebtedness and home equity indebtedness
                       must not exceed the FMV of the residence
§ 121: Sale of principal Residence
   - Taxpayer who sells his/her principal residence is allowed to exclude from income to
       $250,000 of gain from its sale
   - For married taxpayers filing jointly, up to $500,000 of gain can be excluded.
   - Taxpayer must use the property as his or her principal residence for 2 years during the 5
       year period preceding the sale.
§ 221
   - In some circumstances, up to $2500 of interest on educational loans is deductible
       annually
   - The provisions dealing with tax preferences for higher education are among the most
       wretchedly drafted sections of the code, and even some obvious questions about how they
       work have no clear answers
   - But a few general statements about § 221 can be made
           o Loan must finance tuition, fees, or room and borad for postsecondary education
               leading to a degree or credential
                   Only the portion of tution, not covered by certain other tax-favored
                       educational benefits (such as qualified scholarships) counts for this
                       purpose
           o Have to be enrolled at least half time. § 221(d)(3), 25A(b)(3)(B)
           o No deductions is allowed for single taxpayers earning more than about $70,000
                   Deduction is limited for taxpayers earning around $55,000
                   The exact cutoffs are absurdly complicated to compute but often reduce to
                       $65K/$50K AGI
           o In some circumstances, up to $2400 of interest on educational loans is deductible
               annually
           o No deduction is allowed for married taxpayers filing jointly and earning more
               than about $140,000
                   The deduction is limited for married taxpayers earning around $110,000
                   Exact cutoffs hard to calculate, but often reduce to $130k/$100k AGI


25
     TO: "this is a somewhat important point"
              o If the deduction is available, it’s above the line – it is taken in computing adjusted
                gross income § 62(a)(17)
              o Expense covered by tax-free scholarships cannot be deducted under § 222
                     Up to $4000 of qualified tuition and related expenses are allowed as an
                        annual above the line deduction (§62(a)(18))
                            expires at end of 2005
                     If AGI exceeds $65k ($130k), then only $2000 deductible
                     If AGI exceeds $80 ($160k), then no deduction allowed (§222(b)(2)(B))

Losses26
   - According to § 165(a), There shall be allowed as a deduction any loss sustained during
       the taxable year and not compensated for by insurance or otherwise
   - But we know from experience with subsection (a) of other Code provisions that the
       statement is probably not true.
   - Skip down to subsection (c) of § 165 and you find limitation on losses in the case of
       individuals
   - In case of an individual the deduction under § 165(a) shall be limited to
           o Losses incurred in a trade or business
           o Losses incurred in any transaction entered into for profit, though not connected
               with a trade or business
                   And
           o Except as provided in § 165(h), 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
   - Typically, losses are deductible when the property is sold, but in principle, a loss can be
       deducted when property is abandoned or discarded27
           o A loss incurred in business… arising from the sudden termination of the
               usefulness in such business… of any nondepreciable property… where such
               property is permanently discarded from use therein, shall be allowed under §
               165(a) for the taxable year in which the loss is actually sustained 28
           o The taxable year in which the loss is sustained is not necessarily the taxable year
               in which the overt act of abandonment, or the loss of title to the property occurs.
               Regs 1.165-2(a)
           o For depreciable property,
                   In order to qualify for the recognition of loss from physical abandonment,
                       the intent of the taxpayer must be irrevocably to discard the asset so that it
                       will neither be used again by him nor retrieved by him for sale, exchange
                       or other disposition
                            Regs § 1.167(a)-8(a)(4)
                   There are also some situations in which a loss can be recognized when an
                       asset is retired but not abandoned. Regs § 1.167(a)-8(a)(3)

26
   As with gain, loss is not taken into account until it is realized. Loss generally refers to a reduction in the value of
property.
27
   TO: this is really the KEY point to understand
28
   This may require amending a tax return because you might sustain the loss in 2004, but not discard the property
until 2006. Therefore, need to amend 2004 return to take account of the loss.
              o But you can’t deduct a loss when you demolish a building – the loss you’d
                  otherwise deduct is instead added to the basis of the property
                      § 280B
                      You can’t even deduct the cost of the demolition
                      § 280B(1)(A)
              o It is theoretically possible to obtain a loss deduction from abandoning- rather than
                  demolishing – a building. Decou, 103 TC 80 (1994)
      -   With respect to Casualty losses, it is not necessary to sell or abandon the property to take
          the loss into account29
              o Regs § 1.165-7(a), (b) (Loss is the difference between the FMV of the property
                  before and after the casualty)
      -   Amount of loss deduction under § 165
              o Assuming a loss is not covered by insurance, the loss deduction for a business
                  asset or asset held for the production of income is the basis of the asset. § 165(b)
              o Example: A piece of machinery costing $100,000 but worth $120,000 is
                  destroyed
                      $12,000 of depreciating deductions were taken already
                      The loss deduction is $88,000 – the adjusted basis
              o In the case of casualty loss of Non- Business, personal property, the loss
                  deduction is the smaller of
                      The basis of the property and
                      The property’s FMV at the time of the loss
                               Reg 1.165-7(b)
                      Example: Personal car cost $20,000 but worth FMV $12,000 is totaled
                               No more than 12,000 is deductible even though the basis is
                                  $20,000
                               Then there are additional limits on personal casualty losses
                      Further limits on casualty loss deductions of individuals
                               An individual’s deduction for a casualty loss is only allowed to the
                                  extent the loss exceeds $100 § 165(h)(1)  i.e., subtract $100
                                  from the loss
                               After $100 has been eliminated from the loss, the amount
                                  remaining is deductible only to the extent it exceeds 10% of the
                                  taxpayer’s AGI. § 165(h)(2)(A)
                               Example – A car costing $20,000 but worth $12,000 is totaled (no
                                  insurance)
                                      o Loss is $12,000
                                      o Take amount over $100  $11,900
                                      o Suppose 10% of Taxpayers AGI is $5000, so AGI = 50,000
                                      o Only $6900 is deductible under § 165(a)
              o Casualty Loss = A loss resembling the explicitly enumerated ones “Fire, storm, or
                  shipwreck”. § 165(c)(3)
                      Key Characteristics are
                               Suddenness (not gradual)

29
     TO: often shows up on the BAR
                              Unexpectedness (not predicable, not intended)
                              Unusual (Atypical for the taxpayer)
                              Rev. Ruling 72-592
                    On these principles, earthquakes and floods count as casualties, but rust
                        and termite attacks do not.
                    Most serous auto accidents fit the definition of casualty, assuming the
                        driver’s negligence was not too severe Regs. 1.165-7(a)(3)
                    But if you buy a car and it turns out to be grossly effective, that’s probably
                        not going to be considered a casualty loss.
                    An individual can also deduct a theft loss, at lest, like a casualty loss, if
                        it’s big enough
                              Theft covers larceny, embezzlement, robbery, extortion, ransom,
                                 blackmail. Rev Rul 72-112
                              Appropriation of property that does not constitute a crime is not
                                 considered “theft” in this context.
                    A theft loss is deductible when discovered30 § 165(e)
                    If an individual has insurance, the individual has to file a claim in order to
                        be eligible for a casualty loss deduction § 165(h)(4)(E)
                              Maybe this suggests having a high deductible, so you get a tax
                                 deductions for costs of minor accidents
                    If you receive insurance proceeds for your loss, typically this rule applies
                        to casualty losses, you are not allowed to deduct the amount covered by
                        insurance, and you may in fact have net income if the insurance proceeds
                        exceed your basis in the property
                              § 165(h)(2)(B)
                              In some cases, under § 1033, gain from insurance proceeds with
                                 respect to casualties is not recognized if the property is replaced.
     -   The basis of property damaged or destroyed by casualty must be
            o Reduced by
                    The amount of the deduction allowable under § 165 AND
                    The amount of any insurance or other compensation received or
                        recoverable in the year the casualty loss is sustained31
            o Increased by
                    Any capital expenditures made to repair or restore the damaged property
            o Example
                    A car purchased for $30K sustains $20K damage in an accident
                    The car was worth $27K just before.
                    Insurance covered 9K of damage
                    Of the remaining $11K loss, suppose $3500 is deductible under § 165(h)
                    The basis of the car is $17,500 = 30,000 – 9,000 (insurance) – 3,500
                        (Allowable Loss)

30
  Makes sense; similar to realization principle for loss/gain deductions
31
  This could take the basis below zero if the proceeds exceed the fair market value. In this case, you would not
have a negative basis in this case, you would have GAIN. E.g., Purchase house for $150k. House appreciates to be
worth $300k. You get $250k in insurance benefits. Therefore, you have $100k gain, which may be excludible
under §121(a), (d)(5) or 1033(a).
                Suppose you spend 8k on repairs
                The basis of the car is $25,500 = $17,500 + $8000
                         $27,000 - $100 is the max deduction if AGI = 0 + total destruction
                            of the car (For individuals: Because it’s the smaller of Basis and
                            FMV).
        o Steps:
                What Deduction is Permitted? - $3500 was given in this problem.
                What is the Basis Adjustment?
-   Assuming a loss is not covered by insurance, the loss deduction for a business asset or
    asset held for the production of income is the basis of the asset § 165
-   Example:
        o A piece of machinery costing $100,000, FMV = 120,000 is destroyed. Basis =
            $100,000, not FMV.
        o 12,000 of depreciation deductions were taken
        o The loss deduction is based on $88,000
-   In the case of a casualty loss of non-business, personal property, the loss deduction is the
    smaller of
        o The basis of the property AND
        o The property’s FMV at the time of the loss
                Owens, 305 US 468 (1939)
-   Further limits on casualty loss deductions of individuals
        o Deduction for a casualty loss has to be calculated from real loss… loss not
            covered by insurance
        o An individual’s deduction for a casualty loss is only allowed to the extent the loss
            exceeds $100. So if you have $105 loss, then can deduct $5.
        o After $100 has been eliminated from the loss, the amount remaining is deductible
            only to the extent it exceeds 10% of the taxpayer’s AGI. § 165(h)(2)(A)
-   Loss on sale to related party
        o § 267(a) disallows a deduction for a loss on the sale of property to a “related
            party” § 267(b)
        o Among the persons who are considered related to a taxpayer under § 267(b) are
                Members of the taxpayer’s family § 267(b)(1), (c)(4)
                A corporation, if the individual is a controlling shareholder of the
                    corporation § 267(b)(1)
                Example:
                         In 1990, H purchases 100 shares of T. Corp. stock for $100,000
                         In 1995, H Sells the share to her sister M for $85,000
                         H realizes a loss for $15,000 on the sale, but the loss is not
                            deductible, per § 267(a)(1)
        o § 267(d) Amount of gain where loss previously disallowed if
                Taxpayer sustains a loss by sale of property is not allowable to the
                    transferor as a deduction AND
                Taxpayer sells or disposes of such property at a gain, then can use gain to
                    offset the loss. Any gain that exceeds related party’s losses have to be
                    reported.
                Example
                              M sells the stock to an unrelated person for $95,000
                              M does not recognize any gain § 267(d).
                              Her basis was $85,000 so she has $10,000 gain but less than H’s
                                 $15,000 loss.
                              So M does not recognize any gain
                     Example
                              M sells stock to an unrelated person for $105,000
                              M recognizes a gain of $5,000
                     Example
                              M sells stock to an unrelated person for $84,000
                              M has a loss of $1000, § 267(d) does not apply.
              o § 267(b) – Who counts as a related person
                     § 267(b)(1) members of family
                     § 267(c)(4) the family of an individual shall include only
                              Brothers and sisters
                              Spouses
                              Ancestors
                              Lineal descendants.
                     § 267(b)(2) An individual and a corporation more than 50% in value of the
                         outstanding stock of which is owned, directly or indirectly by or for such
                         individual
                     § 267(c)(2) An individual shall be considered as owning the stock owned
                         directly or indirectly, by or for his family32
                     Example
                              A Corp issued 100 shares
                              J owns 20 shares
                              J’s sister owns 20 shares
                              J’s mother owns 15 shares
                              J sells 40 acres of land to A Corp at a $7000 loss
                              J is not allowed to deduct the loss because J is treated as owning 35
                                 shares owning by members of his family as well as his own. So J
                                 owns 55% of the shares.
       -   § 1041 – Non-recognition provision  NB: slightly different from gift rule
              o Neither gain nor loss is recognized in a sale of property between husband and
                  wife
              o The transferee inherits the basis of the property from the transferor
              o Example
                     H buys 100 shares of B corp for $5000 in 1955
                     H marries M in 1963
                     In 2000 H sells shares to M for $7000
                     In 2001 H dies
                     In 2003 M sells shares for $6600
                     M has gain of $1600. § 1041(b)
       -   § 165(d) Gambling Losses can only be deducted against gambling winnings
32
     Constructive ownership is not limited to stock
        o E goes to gamble. Wins $325, loses $500
        o E has gain of $325 of gross income and allowed to deduct $325 of her $500 in
            losses
        o § 67(a) does not apply to limit her losses § 67(b)(3)
-   § 183 – Hobby Losses
        o General Rule: in the case of an activity engaged in by an individual… if such
            activity is not engaged in for profit, no deduction attributable to such activity shall
            be allowed under this chapter except as provided in this section
        o The actual rule is significantly different from the general rule
        o § 183(b)(2), you’re allowed to deduct hobby losses to the extent of hobby gains
        o § 183(b)(1), you’re allowed to deduct otherwise deductible state and local taxes
            and casualty losses
        o Example
                Husband and Wife operate Amway distributorship, but have day jobs
                They did not bother to keep records that would have shown whether the
                    activity was earning money
                Losses is still taxed. Have to prove that it’s not profitable.
                          Elliot 90 TC 960.
        o Under § 183(d), if an activity is consistently profitable, it is presumed to be
            engaged in for profit, although it is still open to the IRS to establish the contrary
        o The activity doesn’t have to be profitable every year, just 3 years out of 5.
        o There’s a modified rule for horse racing and horse breeding that isn’t quite as
            demanding.
        o If an activity doesn’t satisfy the conditions of § 183(d), § 183(a) doesn’t
            necessarily apply, but if the activity otherwise resembles a hobby, /sec 183(d) can
            be helpful in getting around § 183(a)
-   Deductions and Exemptions
        o The tax rates specified in § 1 are applied to taxable income, which is gross income
            minus allowable deductions
        o Right off the top, most who have earned serious money will have had experience
            with the personal exemption allowed by § 151 at least to the extent of
            incorporating it into your tax return by following the instructions for form 1040.
        o Under § 151, most taxpayers are allowed to deduct 1 or more personal exemptions
            from gross income in determining their taxable income
        o The amount of the deduction per exemption is indexed to inflation, so it typically
            increases a bit each year
        o For 2005, the exemption amount is $3200
        o A taxpayer is generally allowed an exemption for himself or herself and a
            deduction for each dependent of the taxpayer
                Dependent = children under 24, or if a child is not a student, under 19
                § 151(c)(3),(4); NEW § 151(c); 152(a),(c)(3)
-   Filing Status
        o When a natural person files a tax return, you file either as either a
                Married person filing a joint return
                Head of household
                Unmarried individual
        Married individual filing a separate return
o   A married person filing a joint return combines the income and deductions of his
    wife or her husband
o   A head of household is generally an unmarried individual with children or other
    dependents living under the same roof. § 2(b)
        Head of Household = Must pay more than half of the cost of maintaining
            the household
o   When married persons file separately, the husband and wife each files a return
    which includes only his or her income and deductions
        There are different rate schedules for each of these 4 categories
                 § 1(a)-(d)
        The way the rates are set, married person filing separately generally will
            pay more in total tax than a couple filing jointly
        Married persons filing a joint return are allowed 2 personal exemptions – 1
            each Regs § 1.151-1(b)
                 since married persons filing jointly almost never are treated as
                    dependents of another taxpayer, they are entitled to the 2
                    exemptions. §152(b)(2)
        In general, a taxpayer who is a dependent of another taxpayer is not
            entitled to a personal exemption. §151(d)(2)
        
o   Unmarried taxpayer (Marginal Tax Rates) – Numbers are for Adjusted Gross
    Income. Does not include Social Security Tax.
        0% Up to 8.2K
        10% on income from 8.2K to 15.5K
        15% on income from 15.5K to 38K
        25% on income from 38K to 80K
        28% on income from 80K to 158.4K
        33% on income from 158.4K to 335K
        35% on income from 335K upwards.
o   Married Persons filing joint returns (Combined income of husband and wife)
        0% up to 16.4K
        10% on income from 16.4K to 31K
        15% on income from 31K to 76K
        25% on income from 76K to 136.4K
        28% on income from 136.4K to 199K
        33% on income from 199K to 335K
        35% on income from 335K onwards
o   So 2 unmarried workers are taxed less than 2 married workers earning the same
    income. But if just one person works in the household, then married person is
    taxed less than 1 unmarried person. (Marriage Penalty).
        Marriage Penalty starts at around 68.2K per person (Average income)
o   Can’t get around marriage penalty by filing separately
        For AGI under around $68,200, there is no marriage penalty – even if both
            husband and wife work and each earns the same income, the average tax is
            the same as if they were single
                        And if only the husband or only the wife works, the tax rate
                           applied to income is the rate that would apply to an unmarried
                           earning half as much – generally a lower rate.
                        While there is a marriage penalty for couples each works and earns
                           average of more than 68,200, the tax brackets for married
                           individuals filing separate
                               o If only the husband or only the wife works, the tax rate
                                   applied to income is the rate that would apply to an
                                   unmarried earning half as much – generally a lower rate.
                                   (Marriage Benefit)
               There is a marriage penalty for couples when each works and earns an
                  average of more than $68,200, the tax brackets for married individuals
                  filing separate returns do not provide relief
               Up to AGI per person of $68,200, married filing separately brackets are
                  the same as those of unmarried, but as just noted, there’s no marriage
                  penalty at that level.
               At AGI = 68,200, married filing separately goes to the 28% rate while the
                  unmarried rate doesn’t do so until 80,150
               At AGI = 99,600 married filing separately goes to the 33% rate while the
                  unmarried rate doesn’t go up to 33% until 158,350
               So if both husband and wife earn the same income, they pay the same total
                  tax as married individuals filing separately as they would if they filed
                  jointly
                        If there is only 1 person with income, the tax for married filing
                           separate can be larger than for an unmarried couple with a single
                           earner, which is not the case for married filing jointly.
               If marriage penalty eliminated, then there would be a marriage benefit to
                  single-earner married couples where the single earner would pay the rates
                  of an unmarried person with half of the income. However, where both
                  parties work, then penalty eliminated, but no benefit if they have similar
                  incomes.
       o In general, a taxpayer who is a dependent of another taxpayer is not entitled to a
           personal exemption § 151(d)(2)
       o Married persons who file a joint return, however, are almost never treated as
           dependents of another taxpayer, and are therefore entitled to 2 exemptions
               See § 151(c)(2); SEE ALSO new § 152(b)(2)
-   § 151 & § 152
       o Under § 151, most taxpayers are allowed for deduct 1 or more personal
           exemptions from gross income in determining their taxable income
       o The amount of the deduction per exemption is indexed to inflation, so it typically
           increases a bit each year
       o For 2004, the exemption amount is $3100 per dependent
       o A taxpayer is generally allowed an exemption fro himself or herself and a
           deduction for each dependent of the taxpayer
       o Dependents are typically children under 24 (if student), under age 19 (not-
           student).
       o Married persons filing a joint return are allowed 2 personal exemptions – 1 each
       o In general, a taxpayer who is a dependent of another taxpayer is not entitled to a
           personal exemption
       o Married persons who files a joint return, however, are almost never treated as
           dependents of another taxpayer, and are therefore entitled to 2 exemptions
       o If a married person files a separate return, he can take a deduction for his wife, or
           she can take a deduction for her husband, ONLY if the wife or husband has no
           income (and is not a dependent of someone else). §151(b)
       o “dependent” is defined in § 152 to include
               A qualifying child and a qualifying relative
               You don’t have dependents if you yourself are a dependent (§ 152(b)(1))
               If you are a dependent, you have no personal exemption for yourself or for
                  anyone else. (§ 152(d)(2))
       o Qualifying child
               child, grandchild, brother or sisters, or nephews or nieces
               Must be under 19 or under 24 if student
               Has not provided more than ½ of the cost or his or her own support
               Apparently a rich uncle could provide the support
                        Must have the same principal place of abode as the taxpayer for
                          more than half the year. (§ 152(c))
                              o But the uncle and the parent can’t both take a deduction.
                                  There are separate rules.
                              o But if the child earns a living and earns more than ½ of the
                                  child’s own support then it disqualifies the parent.
                        Even if kicked out as qualifying child under new law, would
                          probably still fit into qualified relative
       o Qualifying Relative
               Includes the same categories of relative as qualifying child except
                  grandnephews and grandnieces (but remember there are other
                  requirements to be a qualifying child) PLUS
                        Father, mother, grandfathers and grandmothers, uncles and aunts,
                        In-laws
                        Other individuals living with the taxpayer as a member of the
                          taxpayer’s household.
               Must not have gross income equal to or above the exemption amount
                  ($3100 for 2004) § 152(d)(1)(B)
               Taxpayer must provide more than half a qualifying relative’s support for
                  the year
-   Phaseout
       o At least for the next few years, the deduction for personal exemption is reduced
           and eventually eliminated entirely, for taxpayers with sufficiently high AGI.
       o Phaseout are a common away the government raises the rates quietly. Allows for
           deniability
-   § 151 Example
       o J and M are married file joint return in 2005
       o J and M both work and their combined income is $100k
              o J & M’s daughter C is 12, C earns $5K in 2005 as a catalog model
              o J & M can claim 3 personal exemptions on their joint return ($9600), 1 for J, 1 for
                  M and 1 for C as their dependent
              o Because C is a child under 19, her income does not prevent her being claimed as a
                  dependent by her parents.
                      So income ≠ dependent rule only applies if over 19.
              o C will have to file a return on her own, on account of her modeling income
                      C gets no personal exemption since she’s a dependent of her parents, but
                         she is allowed a $5000 standard deduction under § 63(b)
                      So C’s taxable income is 5000-5000 = $0. Total tax is $0.
              o Most taxpayers will have at least 2 deductions from their gross income – their
                  personal exemption as just discussed and the standard deduction allowed by §
                  63(b). Or MIDs if MIDs are bigger
              o The numbers listed in § 63(b) are adjusted for inflation each year. § 63(c)(4).
              o For 2005, the standard deduction is $5000 for single taxpayer and $9700 [??] for
                  married filing jointly § 63(c)(2), (7)
       -   Dependents –
              o New law adds a
                      Residency test to Qualifying child
                               If child under 19/24 earns more than the exemption amount, the
                                  residency test must also be satisfied.
                      Income test to Qualifying relative (Must earn less than exempted amount)
              o Generally a dependent must be a US citizen or a resident of Canada or Mexico §
                  152(b)(3)(A)
              o There are rules that prevent more than one taxpayer from claiming a dependent,
                  generally favoring
                      The Parent [ where there is a dispute; possible EXAM question]
                      Between parents, the parent with which the child resided the longest
                         during the year
                      Tiebreaker, the parent with the highest AGI. § 152(c)(4)
              o In the case of divorced parents
                      Parents have the option to decide which is entitled to the dependent
                         deduction, if the decision is properly documented § 152(e)
              o In order to claim a dependent
                      Have to provide the dependent’s Taxpayer Identification Number (usually
                         social security number) on your tax return § 151(e)
                      Has lead to a substantial reduction in the number of dependent deductions
                         claimed.
       -   Standard Deductions (KNOW FOR TEST)33
              o Rates (adjusted for inflation each year) listed in §63(b)
                      $5000 for individuals
                      $10000 for married filing jointly
                      $5000 for married filing separately
                      $7150 for heads of households
                      Blind or 65  increase in $1000 for each condition
33
     everyone can take both the personal exemption and the standard deduction
               that increase is $1250 for certain unmarried taxpayers
o Can’t take the standardized deduction if you itemize
o If taxpayer does not elect to itemize deductions, the only deductions allowed are
       Deductions allowed in computing adjusted gross income (Above the line
          deductions)
               Trade and Business deductions § 162
               Moving expenses
               Alimony if any is deductible § 62(a)
                     o Under § 71: Gross income includes amounts received as
                         alimony or separate maintenance payments
                     o Generally, Alimony payments are taxable to the recipient
                         and deductible by the payer § 71, 215
                     o Rules are elective. If the divorce or separation instrument
                         states that these rules don’t apply, then they don’t apply.
                              When the payer is in a higher tax bracket, it makes
                                  sense for the payer to agree to higher payments that
                                  at least offset the recipient’s greater tax liability
                                  because
                                        The value of the deduction to the payer will
                                           be greater than the extra taxes of the
                                           recipient.
                     o The recipient may be divorced or just separated from the
                         payor; and
                     o Payments must be required under a judicial decree or a
                         written agreement § 71.
                     o Payments for child support not subject to these rules.
                         Payments are not included in the recipient’s income and are
                         not deductible. § 71, 215(b)
                     o § 71(a) applies to cash payments
                     o If recipients are married but separated, § 71(a) and 215
                         apply only if the parties don’t file a joint return
                              Separated couples must also not be members of the
                                  same household § 71(b)(1)(C)
                              If the parties are divorced, a joint return is not an
                                  issue b/c they can't file one
                              
               Some educational expenses
       The standard deductions AND
       Personal exemptions
o Itemized Deductions (Below the line deductions) (If you take the standard
  deduction, you cannot take these itemized deductions)
       SIDs – Standard itemized deductions
               Deduction for interest § 163
               Deduction for state and local income taxes § 164
               Deduction for casualty and theft loss § 165
               Deduction for charitable contributions § 170
                                     o Significant number of organizations are exempt from
                                         federal income tax but not ALL
                                     o Most organizations exempt from federal tax owe their tax-
                                         exempt status to § 501
                                     o For example, religious organizations, including churches,
                                         and educational institutions, including private colleges are
                                         exempt from federal tax per § 501(c)(3)
                                             Labor Unions § 501(c)(5)
                                             Political organizations § 527
                                             Trade Associations § 501(c)(6)
                                             Homeowners association § 528
                                             Private foundations, such as Ford foundation,
                                                 Carnegie Foundation… etc. § 501(c)(3), 509
                                     o Most favorable tax treatment is given to charitable,
                                         religious, educational and scientific organizations under §
                                         501(c)(3)
                                             Income of these organizations are exempt from tax,
                                                 Donors can generally deduct donations
                                             Must be organized and operated exclusively for
                                                 religious, chartiable, scientific, testing for public
                                                 safety, literary or educational purposes or to foster
                                                 certain amateur sports events or to prevent cruelty
                                                 to children or animals.
                                             Its net earning must not inure to the benefit of any
                                                 private shareholder or individual
                                             Must restrict its legislative activity and refrain from
                                                 intervening in any political campaign34
                               Deduction for medical expenses § 213
                       MIDs – Miscellaneous Itemized deductions - Only taken if they exceed
                          2% of the taxpayer’s AGI
                               Deduction for expenses connected with investments § 212
                               Un-reimbursed employee business expenses § 162 – this is the
                                 only trade and business expenses not deductible in computing AGI
       -    Deductible Taxes § 164
               o State local and foreign taxes on the ownership of real property
                       but not the acquisition or sale of real property
               o State and local taxes imposed on the value of personal property
                       Sales taxes are not deductible except for state and local sales taxes paid
                          during 2004 and 2005 § 164(b)(5)(A)
                       If a deduction for state and local sales taxes is taken, state and local
                          income taxes cannot be deducted.
               o State and local and foreign income taxes
                       Can choose between foreign tax credit or deduction of foreign taxes
                               Tax Credit is usually better than deduction

34
     TO did not discuss the italicized portion in this year's lecture
                Foreign income taxes may not be deducted if the foreign tax credit is used
                    § 27
       o State and local and foreign taxes incurred in connection with a trade or business
            or investment
       o General principle is that federal taxes are not deductible under § 164
                Exceptions: Some taxes in a trade or business or investment activity
-   Charities
       o A significant number of organizations are generally exempt from federal income
            tax, and in many, but not in all cases, donations to these tax-exempt organizations
            are deductible under § 170
       o Most organizations exempt from federal tax owe their tax-exempt status to § 501
       o The most favorable tax treatment is given to “charitable, religious, educational
            and scientific organizations under § 501(c)(3)
                Donors can generally deduct donations for these
                         must be for various public or religious purposes
                         earnings must not inure to benefit of any private shareholder or
                            individual
                         must restrict legislative activities and refrain from intervening in a
                            political campaign
                2 main classes in § 501(c)(3)
                         Public charities
                         Private Foundations
                The federal income tax treatment of public charities is more favorable than
                    the treatment of private foundations
                Although deductions to private foundations are tax deductible, a private
                    foundation is
                         Required to pay out about 5% of its endowment each year
                         Pay an annual excise tax, disguised as an “audit fee” of 2%
                            (sometimes 1%) of its annual net income
                         Also subject to other conditions, § 509 [4940, 4942, 4943, 4925]
                § 501(c)(3) organization is generally classified as private foundation
                    unless
                         it’s a church, educational institution or medical facility
                         It receives a substantial part of its funding from the general public,
                            as opposed to large contributions from a few founders or other
                            donors
                         OR affiliated with a public charity § 509(a), (d), (e)
                A typical foundation would be a non-profit organization
                         Funded by a large grant from a wealthy individual or family
                         That reviews grant applications and makes grants to public
                            charities
       o Exempt organizations
                Under § 501(c)(4), non-profit organizations that "promote social welfare"
                    as their exclusive objective are exempt from federal tax, including the
                    excise tax imposed on private foundations and may be involved in politics
                    to a degree
                     But donors cannot deduct donations as a charitable contributions under §
                        170, although may gets a deduction for some other code provision
     -   § 170 – (Itemized Deduction) Permits charitable contributions to be deducted from
         taxable income
             o There are limits to the size of the deduction in a single year
                     Individuals: Deduction can be no more than half of the taxpayer’s AGI,
                        and certain donations have limits of only 20% or 30% of AGI
                            NB: not a miscellaneous itemized deduction (i.e., no 2% problem)
                     Disallowed deductions (due to limit caps) can be carried forward for 5
                        years § 170(b), (d)
             o To be deductible, the contribution must be made to [EXAM: NB the non-
                501(c)(3) deductions]
                     Federal or state and local government exclusively for public purposes
                            § 170(c)(1)
                     Domestic § 501(c)(3) organization (except a testing organization)
                            § 170(c)(2)
                     War veterans society, lodges and non-profit cemeteries
                            § 170(c)(3)-(5)
             o Contributions to other non-profits are generally not deductible
                     Ie: Contributions to the NRA is not deductible because of its lobbying
                            § 501(c)(4) – not a § 501(c)(3)
                            The NRA has established charities, however, like the NRA
                                foundation that do not lobby and qualify under § 501(c)(3)
                            This is a common technique; have a lobbying organization and a
                                separate public charity
             o Deductions to veterans groups that lobby are deductible, since they do not qualify
                under § 170 through § 501(c)(3)
                     EXAM exception
             o Under § 501(f)(8), a donation of $250 or more is only deductible if the recipient
                provides the donor with a written acknowledgement of the donation

Capital Gains and Losses

     -   Gross income includes the gains from sale of property §61(a)(3)
     -   For individuals, most income for the sale of a capital asset35 is taxed at a 15% rate no
         matter what the taxable income of the taxpayer is
            o Exception: If the taxpayer is in the 10% or 15% tax bracket, most income from
                the sale of a capital asset is taxed at a 5% rate
                     § 1(h)
            o In order to take advantage of the capital gain tax rate, you generally must own
                (i.e., the holding period) the asset for more than 1 year § 1222(3)
                     You are the owner the day after you buy, but you are the owner the day
                         that you sell.

35
  NB: for one taxpayer, something will be merchandise (i.e., the producer of the capital asset), but subsequent sales
of the object will turn it into a capital asset
        o Ie: P buys $1000 of stock in T Corp.
                In 2003, P sells the stock for $2000
                P taxable income for 2003, including income from the stock sale, is
                    $100,000
                The tax rate applicable to the sale of the T stock is 15%
                The tax rate for single taxpayers will apply to the other $99,000 of her
                    taxable income
                $14,652.50 plus 28% of $99,000 minus $71,950 [ from the tax tables]
-   Corporations generally pay tax at a 35% rate on all income, including income from the
    sale of a capital asset. § 11
-   Capital Losses
        o Individual taxpayers are not allowed to deduct losses from the sale of property
        o Ie: in 2000, you buy TV for $5000, and in 2003 you sell it for $2000
                The loss is not deductible. Not under a trade or business expense § 162 or
                    a production of income expense under § 212
        o Ie: In 2001, you pay $150,000 for your house
                In 2003, you sell the house for $138,000
                Your loss is not deductible (§165(c))
        o Ie: You run a bona fide business buying and selling antiques retail
                In 2001, you buy a vase for $15,000
                In 2003, you sell the vase for $12,000
                Your loss is deductible under § 165(c)(1) (But not a capital loss in this
                    case)
        o Ie: you buy stock for $10,000
                In 2001, you sell the stock for $1000
                Loss is deductible under § 165(c)(2)
                Even if you have no investment income, since income requirement is
                    imposed under § 163(d) not § 165(c)(2)
-   Deductible losses from sales of property are deductible from gross income in determining
    adjusted gross income § 62(a)(3); i.e., it is an above-the-line deduction
        o So deductible losses from sales of property are not MIDS miscellaneous itemized
            deductions subject to the 2% limitation of § 67(a)
        o Capital losses cannot be deducted against other income, only against capital gains
        o For Individuals, a capital loss deduction that is disallowed under this rule can be
            carried forward and deducted against future capital gains, if any § 1212(b)
                Individuals are allowed to deduct up to $3000 of otherwise deductible
                    capital losses against other income
                         Must be an “otherwise deductible capital loss” § 1221(b)
                Ie:
                         In 1995 P pays $25,000 for stock in L corp and $8000 for stock in
                             O corp.
                         In 2003, P sells the L stock for $15,000
                         Although P recognizes a $10,000 loss on the L stock in 2003, she
                             is allowed to deduct only $3000 against other 2003 income.
                         In 2005 P sells O stock fro $11,000
                 In 2004 P may deduct $3000 of remaining $7000 loss carried over
                    on the Luna stock and
                 In 2005, she has $4000 carry forward (deduct $3000 of O-stock
                    gain from this) and 1000 remaining capital loss, so may deduct the
                    $1000 net capital loss against other income because within the
                    $3000 window
        Max carry over is 5 years
        § 62(a)(3) – To the extent the loss is deductible, it is used to compute
            adjusted gross income
        165(c)(2)
        1211(b) – Limit on the capital losses to those in 165(c)(2). Can deduct all
            capital losses to the amount you have capital gains + max of $3000 of loss
            if you don’t have capital gains.
        1212(b) – 5 Year carry forward.
o   § 1211 imposes an additional limitation on losses of individuals (just a limitation,
    but not an individual deduction by itself)
        Even if a loss would otherwise be deductible (ie: 162, 183, 212), no more
            than $3000 of a loss from the sale or exchange of a capital asset can be
            deducted in any year.
o   § 1211 by itself doesn’t allow an individual to deduct a loss
        So despite § 1211, not even $3000 of a loss from the sale of a personal
            residence is deductible since § 165(c) doesn’t apply
        No part of the loss from the sale of property used for a hobby is deductible
            even if the property is not a capital asset
                 Unless there are hobby gains that year for the same activity that
                    produced the loss, which probably will not happen very often.
        A casualty loss is usually not subject to § 1211 because it is not the result
            of the “sale or exchange of a capital asset”
        Capital losses that would be allowed under § 165 and not disallowed under
            § 1211 are still subject to § 267, which disallows losses on sales to related
            parties
o   Most gain from the sale of property is income, even if a loss would not be
    deductible. § 61, 1001
o   Generally, property is a capital asset unless an exception applies
        Merchandise is not a capital asset. § 1221(a)(1)
o   Ie:
        Say you run an unincorporated jewelry store, you buy and sell jewelry
        The jewels are not capital assets in this context, although the jewels you
            might own for personal use would be capital assets.
o   Examples of Capital Assets
        Stocks and bonds individuals buy for investment
        Property held for personal use – furniture, appliances, a car or truck, a
            house
o   Most property owned by a business for use in the business – other than
    merchandise – is technically not a capital asset, but this sort of property is treated
    in some ways like a capital asset under § 1231 (aka "section 1231 property")
Below are NOT capital assets
       Under § 1221(a)(2), property used in a trade or business that is
             o Subject to depreciation under § 167
             o or Real property (buildings or equipment)
             o or subject to amortization under § 197
Capital Asset is primary depended on how something is used, not what it
  is.
BUT:
       Under § 1231(a)(1), gain from the sale of such property is
         generally treated as gain from the sale of a capital asset if the
         property is owned for more than 1 year (i.e., capital gain treatment)
         [EXAM]
             o not important to corporations because no preferential rates
       Under § 1231(a)(2), loss from the sale of such property is generally
         treated as ordinary loss, not subject to the limitation of § 1211
             o **(So have benefit of capital asset, but not the disadvantage
                 of capital losses)**. Get it both ways because there are
                 limitations on capital losses
             o This is important even to corporations because they can
                 take the loss

Ordinary Income and Loss
      Gain from the sale of property that is not a capital asset or treated
         as a capital asset under § 1231 is called ordinary income § 64
      Loss from the sale of property that is not a capital asset is called
         ordinary loss § 65
      Capital gain is almost always better than ordinary income because
             o Ordinary income is taxed at regular tax rate, not at the
                 capital gains rate
             o Capital losses (over $3000) cannot be offset by ordinary
                 income
      An ordinary loss is generally better than a capital loss, because its
         deductibility is not restricted by § 1211
      Ie: [know these examples for EXAM]
             o I purchases property X in 1995 for $9000
             o I purchases property Y in 1997 for $50,000
             o In 2003, I has a $400,000 salary and sells property X for
                 $4000 and property y for $55,000
             o Suppose X is a capital asset and Y is not
             o Then I has $5000 capital loss and $5000 of ordinary
                 income
             o Per § 1211, $2000 of the loss must be carried forward
             o Together the 2003 property sales produce $2000 of income
                 taxed at 35% (another $700 of tax), even though Iris broke
                 even economically.
      Ie:
                                          o Suppose Y is a capital asset and X is not
                                          o Then Iris has a $5000 capital gain and a $5000 ordinary
                                            loss
                                          o The ordinary loss can offset $5000 of salary and the capital
                                            gain is taxed at 15%, so although Iris broke even
                                            economically, her tax is reduced by 1000. Rate falls from
                                            35% to 15%.
                                  Ie:
                                          o S owns and operates an unincorporated self-storage
                                            business with 3 locations in the county
                                          o He bought his North location for $10,000 in 1995, West
                                            location for $12,000 in 1998
                                          o In 2002 he sells the North location for $12,000
                                          o In 2003 he sells the West location for $10,000
                                          o He has a $2000 capital gain in 2002 and an ordinary loss of
                                            $2000 in 2003
                                          o § 1231 Property is taxed at capital gains levels
               o Holding Periods
                    In order for gain from the sale of a capital asset to be taxed at the
                       favorable capital gains rate, the asset generally must have been held for
                       more than 1 year § 1(h), 1222(3), (11). Would still be capital gains if held
                       for less than 1 year, but wouldn’t be taxed at the capital gains rate
                            § 1(h)(1)(c) Specifies that the 15% rate applies to adjusted net
                               capital gain
                            per § 1(h)(3)(A) adjusted net capital gain includes net capital gain
                            Net capital gain is defined by § 1222(11) as the excess of net long-
                               term capital gain over net short term capital loss
                            Long-Term capital gain is defined by § 1222(3) as gain from the
                               sale or exchange of a capital asset held for more than 1 year.
                            To hold a capital asset typically means to own it (And not to
                               simply have custody of it or posses it as a renter)
                                   o So usually you must own an asset for at least a year and a
                                       day to have long-term capital gain
                            Tacking36
                                   o Under § 1223, one taxpayer’s holding period is added to
                                       another’s in certain cases
                                   o Under § 1223(2), the holding period of property includes
                                       the holding period of the previous owner if the new
                                       owner’s basis is the property is carried over from the
                                       previous owner’s basis
                                           In situation of a gift
                                   o Ie: H buys P corp stock in 1985 for $10,000
                                   o In June 2003, H gives the stock to his nephew E when it’s
                                       forth $11,000

36
     NB: technicalities mean that you can't always equate the holding period with ownership period
                                o In August 2003, E sells the stock for $12,000
                                o E’s basis is $10,000 per § 1015(a)
                                o The gain is long-term capital gain per § 1223(2)
                          § 1223(1) – Basis being carried over is the basis for a different
                            property, same person (Tax free exchanges). Ie: if A Corp is
                            bought by T Corp, A corp stock is exchanged for T corp stock.
                          § 1223(2) – Basis being carried over is the basis for same property
                            but different person
          o Dividends
                  Dividends from domestic corporations are generally taxed as long-term
                     capital gain § 1(h)(11)
                          15% in most brackets
                          5% in the 10% and 15% tax brackets
                  The recipient of the dividend must have been held the stock at least 61
                     days (120 days in the case of preferred stock). 1(h)(B)(iii)
                  This provision set to expire after 2008
   -   DEPRECIATION RECAPTURE
          o under §1245(a), gain with respect to tangible depreciable property is generally
              ordinary income to the extent of depreciation allowable over the period between
              the purchase and the sale of the property
          o Example
                  start of 2002, W purchases a truck for $60,000 to use in a nursery business
                  at the end of 2003, W sells truck for $61,000
                  W deducted $21,600 for depreciation
                  Under §§1231 and 1245, W has $21,600 ordinary income and $1000 in
                     long-term capital gains.
                          i.e., whatever portion of the depreciation can be recaptured as part
                             of gain, must be accounted for as ordinary income
          o Generally doesn't apply to capital assets because they are not generally
              depreciable
   -   Clean up.
          o Standard Deductions
                  The standard deduction is higher for a taxpayer who is
                          at least 65
                          blind § 13(c)(3), (f)
                  For 2004, the standard deduction is raised by $950 for each condition
                  The increase is $1200, rather than 950 for certain unmarried taxpayers
                          § 63(f)(3)

Non-Recognition Exchanges
    general rule is that an exchange of property is treated like a sale
         o FMV is treated like cash
         o gain or loss is recognized based on the difference between the amount realized
             and the basis of the property surrendered in the exchange
    Example: M buys a car for $50k in 1988
         o M exchanges car for a car worth $75k in 2004
           o M recognizes $25k in income from the exchange
§ 1031(a)(1)
   - No gain or loss shall be recognized37 on the exchange of property held
           o For productive use
           o In a trade or business [e.g., exchanging a house with neighbor won't work because
               the houses are for personal use]
           o Or for investment
   - If such property is exchanged solely for property
           o Of like kind
   - Which is to be held either
           o For productive use
           o In a trade or business
           o Or for investment
   - So basically both the held property and the exchanged property must be for productive
       use in Trade/bus or investment
   - 1031(a) does not apply to:
           o Exchanges of stock in trade/property held primarily for sale (Inventory)
           o Stocks, bonds, notes
           o Partnership interests. § 1031(a)(2)
   - The exchange must be completed within 180 days from the initial transfer
           o § 1031(a)(3)
   - Stricter rules apply to transfers between related persons
           o § 1031(f)
   - § 1031 Basis
           o If property exchanged qualifies for non-recognition under § 1031(a), the
               taxpayer’s basis of the property received is the same as the taxpayer’s basis in the
               property surrendered § 1031(d)
                   So unlike gift, the basis carried over is your own, not the transferor’s
           o The taxpayer’s holding period for the property received includes the taxpayer’s
               holding period for the property surrendered. § 1223(1) [i.e., a continuous holding
               period]
           o So for taxes purposes, the basis and the holding period is the same as your old
               property
   - § 1031 also applies to the exchange of properties of unequal values where the person
       exchanging the less valuable property also provides cash compensation for the difference
           o The party receiving the cash will recognize gain to the extent of the cash received
               and basis rules are more complicated, but the same principles apply. §
               1031(b),(d)
           o The party paying the cash takes a basis in the property received equal to
                   the basis in the property surrendered
                            plus
                   the amount of the cash (Reg 1.1031(d)-1(a))
           o The party receiving the cash takes a basis in the property received equal to the
               basis of the property surrendered, increased by any gain recognized and
               decreased by cash received (or the value of the property) §1031(d)
37
     this is the key phrase and concept
                         possible that the gain recognized and the cash received will offset each
                           other exactly
                         e.g., A and C are in moving and storage business
                         A owns a truck worth $100, basis $60
                         C owns truck worth $150, basis $135
                         A and C exchange trucks under §1031, and A paying C $50
                         There is no gain for Carlos because he is giving up something worth $150
                           and receiving something worth $150 (i.e., a truck worth $100 and $50 in
                           cash); there is no gain for Arturo because he gives up cash and a truck
                           worth $150 and gets a truck worth $150.
                         C recognizes $15 of the gain.
                         C has a new basis of $100 ($135 + $15 gain [to the extent of the cash and
                           the gain if any38] - $50 cash)
                         A recognizes none of the $40 gain39 (i.e., difference between original
                           basis and $100 FMV of truck)
                         A has a new basis of $110.




38
     in other words, if basis is equal to the value received, then there is no gain and cash cannot be applied to that gain
39
     party paying cash never recognizes gain

				
DOCUMENT INFO
Description: Lecture notes of federal tax course at law school. Notes from 2005.