Law School Outline - Basic Federal Taxation Class Notes-Carey

Basic Federal Taxation Summer 2003 Professor Carey I. Areas Covered a. State Tax i. Most state codes adopt the IRC and slightly modify it b. Federal Tax i. Types: 1. Wage Taxes – wages up to approx $80K per annum a. Personal Income Tax – tax on the increase of one‟s wealth i. Wages or salaries paid to employees ii. Investments 1. Dividends 2. Bonds 3. Interest iii. Royalties on Intellectual property iv. Rental Income b. Social Insurance and Retirement Receipts i. Social Security ii. Medicare iii. Medicaid c. Increase in wealth from other methods i. Deductions from other sources 2. Excise Taxes a. Consumption Taxes based on the value of the costs of goods or services (won‟t cover it) 3. Estate and Gift Tax (won‟t cover it) a. Estate – primary, donative transfer of wealth b. Gift c. Generations Giving 4. Corporation Income Taxes ii. Against whom can they be assessed? 1. Persons both natural and legal – there are about 285M people in the US population a. Humans (currently 5x as much as corporations; but in the 60‟s it was 2x) ** our focus this semester b. Legal Entities II. i. Corporations (currently 1/5th as much as humans; but in the 60‟s it was 1/3rd) ii. Trusts iii. Estates 2. Why the shift in the proportion of people paying more than corporations? Taxation Historically / Taxation Systems a. Egalitarian Taxation - Human Being Taxes on just being here in the US b. Flat taxes – same percentage levied against everyone equally c. Progressive Taxation System i. This is the systems we have employed in the US ii. People with high income contribute more than those who have less 1. In 1988, 57.28% of all tax paid was paid by those making the highest 10% of income 2. In 2003, the top 1% of people (those making approximately $967,959 AGI) paid 36.8% of the total tax paid in the US a. The top 5% overall paid 57.3% of all tax paid by the entire US population b. The top 10% overall paid 69.3% of all tax paid by the entire US population c. Bottom 5th paid -0.9% of the overall income tax paid (received refunds) and earned an AGI of 1.9% of the overall income i. EITC – Earned Income Tax Credit: Gov‟t provides low-wage earners credits when they have children and earn a low income 1. Usually received by the lowest 10% of the wage earners in the US 2. Largest Welfare Program in the US 3. Disbursing between $32-35M in the US each year 4. Pays all Soc. Sec. tax for the bottom-half of the earners iii. Generally – income tax is tax on most people making 100K or more per year because they pay the bulk of the US tax liabilities III. 1. Bottom half does not pay taxes because they receive EITC, their wage taxes are paid d. Regressive Tax i. Opposite to the progressive system in which the burden falls more heavily on those who have a harder time bearing it ii. This is the SALES TAX system 1. A smaller percentage of a wealthy family‟s income is used on sales tax 2. Poorer families have less disposable income to contribute to sales tax Calculating Tax Liability a. General Formula Gross Income Less IRC § 62 Deductions Equals Adjusted Gross Income b. Property Sold for $15,000 Purchased Property $10,000 Profit $ 5,000 c. Inventory Accounting – averages items on stock to determine their profitability i. Helps determine CGS – COST OF GOODS SOLD ii. GR = GROSS RECEIPTS iii. GI = GROSS INCOME calculated as: GR – CGS = GI [i.e., whatever increases your wealth] d. Taxes are Based on the NET INCOME and not the GROSS INCOME Trade of Business Expenses, §162 Less Expenses for the Production of Income, §212 Equals AGI Less Personal Deductions (Itemized Deductions), Less Personal Dependency Exemptions (the standard deduction) Equals Taxable Income Multiplied § 1 Tax Imposed based upon classification Equals Tax Due by Tax Payer (max is 40%) Less Credits* (worth much more than deductions) * Credits such as withheld taxes, EITC – a non-refundable credit, Foreign Tax Credit (US person‟s income subject to tax by a foreign entity §901) Equals Liability (positive or negative) e. Tax Rates/Brackets i. Marginal Tax Bracket 1. Highest Tax Bracket someone may be exposed to IV. V. 2. Used to be that only a portion would be subject to the higher % rate for those who are super rich ii. Effective Tax Rate 1. Percentage you pay in taxes Changing Tax Distribution a. Restructure deductions into Credits so that they are of equal impact to everyone, regardless of their tax bracket – it would equalize the benefit Gross Income – IRC § 61 a. Compensation for Services i. Payments “In Kind”: Non-cash payments, included in gross income; something other than money ii. Bargain-Purchase: Employer sells something to employee for below market-value; the difference is compensation income unless it falls within the definition of a “Fringe Benefit” under IRC § 132 iii. Compensation Without the Receipt of Cash or Property: employee uses a home owned by employer for free, so the market value of the home is considered as income iv. Excessive Compensation: whether the payment is for services rendered or to employee as a dividend payment – matters to the employer because the compensation to the employee for services is deductible but the dividend payment is not v. Fringe Benefits: an economic benefit, other than cash salary or wages, which is provided to an employee by her employer as compensation for services; e.g., group term-life insurance, health insurance vi. Illegal Income: still has to be reported; does not infringe your 5th Amendment Rights because you don‟t have to disclose the source of the illegal income b. Non-taxed: Some types of income present considerable practical problems of compliance, administration, and enforcement. i. Imputed Income: money you save when you do services yourself (such as cutting your own lawn) ii. Accretion in Income: increases in value of property are not taxed until it is realized (this is an economic/realworld concept, related to recognition) iii. Recognition: policy concept in which although something has been realized, it is not recognized as taxable iv. Others not taxed: 1. Qualified Employee Discounts for Property: for something the employer already sells to nonemployees in the course of their normal business a. Limited to under the “Gross Profit Percentage” as described in IRC § 132(c)(1)(A), (2), (4): GPP= (Aggregate sales price – cost of goods)/Aggregate Sales Price 2. Qualified Employee Discounts for Services: may not exceed 20% of the price @ which the services are offered to non-employees, regardless of the employer‟s normal gross profit percentage c. Gains Derived from Dealings in Property: IRC § 61(a)(3) – only a gain is subject to tax. How is gain determined? i. BASIS: how much is invested in the property IRC § 10121015 1. Cost: how much money you paid for the property 2. Exchanges: If the value of the property was received versus of the value of the property paid is equal, 3. Tax Cost Basis: When someone sells something they received for free (someone sells a car that was given to them) they will have to pay the tax basis for the transaction 4. Property from Decedents: IRC § 1014 says to calculate at the date of the decedent‟s tax and not for the entire lifetime that the decedent – the appreciation escapes income tax, but it may be subject to estate tax (which doesn‟t apply to the first $1M of transferred assets) a. § 1014(e): Limits within one year and gives it back to you with the same basis 5. Property Acquired by Gifts and Transfers in Trust: IRC § 1015 – says basis in hands on donee is same as that of the donor a. § 1015(a): allows a loss looking @ the basis using FMV – but you have to meet both exceptions here ** such as use the basis of the FMV only when it would result in a loss – otherwise, you could use the general basis i. However, if there is a situation, where if you apply one basis, it would result in a loss, so you have to apply 1015(a) but then it would create a gain in doing so – THIS IS CIRCULAR and the IRS will just then say – no gain or loss (When Donor‟s basis > Donor‟s FMV @ Date of Death) ii. Donor‟s Basis = $100K FMV @ Time of Gift = $300K If Gift tax to Donee = $150K ** Under § 1015(d)(6)(A) = Appreciation/FMV@ Time of Gift = the Donee‟s Basis iii. Exception to the Regular Gift Basis Rule: General rule for basis does not apply if both of the following apply – then Basis = date-of-gift FMV: 1. Donor‟s Adj. Basis in property > FMV [both viewed @ date of gift]; AND 2. Donee sells/disposes of property which produces a LOSS iv. Effects of Gift Tax: Net Appreciation in the Value of the Gift occurs when the item received by a donee has been taxed to the donor as gift tax and the donee would also have to pay tax on it in the basis – therefore, the basis gets increased for the donee to offset taxing the same portion of the economic value of the property b. Transferred Basis: Donor does not have realized gain when donating property to another, the donee is treated generally as stepping into the shoes of the donor and has what is called a „transferred basis‟ 6. Property Passing Between Spouses or Incident to Divorce: IRC § 1041 a. No tax for transfers of property between spouses or between former spouses if it is incidental to the divorce b. Basis stays the same for the transferee (similar to the general gift basis rule, but it has no exception for situations where there is a loss in value to the property) c. Gift tax basis of §1015 do not apply, although such a transfer is considered a gift 7. Estate Tax: Today scheduled to phase out in 2010 and come back in 2011 a. IRC § 1014 will also evaporate Jan. 1, 2010: with the following exceptions: i. If property passes through an estate in 2010, the basis is the same as it was in the hands of the decedent; but the executor can say $1.3M can have a basis @ that of the date of death ii. In addition to the $1.3M, the next $3M going to the spouse uses the basis @ date of death ii. Adjustments to Basis: IRC § 1016: Adjusted basis determines gain or loss (the nature of it increases one‟s basis) or as depreciation as a decrease in basis 1. Basis is used to reduce income a. Basis is increased in the amount of any capital additions to the property b. Basis is decreased in the amount of any deductions which have been taken reflecting a return to the taxpayer of his investment in the property i. Basis is reduced by an offset of income by depreciation, amortization or depletion given at the greatest amount „allowed‟ under §1016(a)(2) – (so you have a truck that you sell for $40K and depreciate it $10K) 1. This is to encourage taxpayers to claim their deductions under depreciation, etc. during each tax year they were able to do so, and not in only the years it is beneficial for them to do so – and can only be taken when the taxpayer has had an effective return of his investment c. Basis starts usually with cost of the property i. Or by gift ii. Inheritance 1014 @ date of death iii. By spouses = donee/donor‟s basis is same and not like a true gift 2. Amt rec‟d – adjusted basis = tax basis d. Amount Realized: money/consideration received for the property, which includes the sum of any money plus the FMV of any other prop received in the transaction i. FMV of Consideration: Question of fact determined as the amount for which the property would change hands between a willing buyer and seller; neither being under compulsion to buy/sell & both having reasonable knowledge of relevant facts 1. If it cannot be determined directly, then it = value of property given up in the exchange ii. Selling Expenses: Amount realized is reduced by commissions and other expenses connected with the disposition of the property (when incurred by a nondealer of such goods) 1. SELLING EXPENSES ARE NOT DEDUCTIONS: Expenses which reduce amount realized are the same types which are included in the cost basis of property if paid by the purchaser a. E.g., appraisal fees, fees for abstracts of title, brokerage fees, legal fees, recording fees, title insurance, title opinions, transfer taxes 2. You may deduct the amount of the broker‟s commissions from STOCK PURCHASE because it may be a long time until you realize the profit from a sales transaction § 212 to reduce ordinary income which is taxes @ higher rate a. Use this as a current operating expense b. Cost of acquisition and cost of disposition must be capitalized – so in a stock transaction – you can‟t do it iii. Apportionment: Sales of several items paid in a lump sum (such as purchasing a business) – each item‟s FMV is apportioned individually and gain or loss calculated for each item on its own iv. Mixed Motive Transactions: it is assumed that buyer/seller deal @ arm‟s length and any discrepancy between FVM and money rec‟d for the property does not alter the tax consequences of the transaction v. Role of Liabilities: Property encumbered by a liability which the buyer agrees to assume or under which the property is subject to, results in the amount of the liability being included in the seller‟s amount realized 1. Borrowing money and mortgaging property is not a taxable event because it does not result in an accession to wealth but it is included in the cost basis 2. HYPO: Purchase property for $1M selling price with 100K down and 900K mortgage (Crane v. Comm‟r, 331 US 1, 67) a. Basis in the property = cash + mortgage, or $1M; it does not matter where the money came from b. If sold later for $1.2M with no payments on the principal on the first mortgage; buyer puts down 300K i. Basis in the property = borrowed money is included in the amount realized because the mortgage received was $ towards the debt ii. Allows people to leverage their $ because once the property is depreciated, then the basis is lowered off of the sales price (cash received in down payment and mortgage payoff) and a small amount of $ is used to borrow a larger amount toward a more valuable asset 3. Recourse Loans: secured mortgage – buyer assumes the loan/mortgage 4. Non-recourse: unsecured mortgage with no personal debt, buyer takes property subject to the mortgage – the individual still has to include the mortgage amount in the basis for acquisition/disposition of assets vi. Realized Gain/Loss v. Recognized Gain/Loss: §1001(c) unless a specific provision specifies otherwise, the entire VI. VII. amount of a realized gain/loss is required to be recognized 1. Realized Gains = part of Gross Income (GI) 2. Realized Losses, even if Recognized, cannot be deducted from taxable income unless a statute says it‟s OK Items Statutorily INCLUDED in Gross Income (GI): determined by statute for clarity, uniformity and to identify exceptions to items included in GI a. Alimony and Separate Maintenance Payments §§ 71(a) and 215(a) deduction for payor i. Recipient = taxable income ii. Paying Spouse = deduction b. Services of a Child: § 73(a) i. $ received by a child for her services rendered are taxable to the child and not the parents 1. Even though the parents are the legal owners of the property and receive it on behalf of the child 2. Expenditures made by parent attributable to amounts included in child‟s GI = deductions for the child c. Reimbursement for Moving Expenses: i. § 82 includes reimbursements from employers as GI when they do not fall within the § 217 deductible expenses ii. Remembering that § 132(a)(6) excludes fringe benefits from GI iii. Income which is offset by the expenses themselves d. Annuities: § 72(a) i. Amounts received under an annuity, as an annuity, from an endowment, or from a life insurance contract ARE included in GI 1. EXCEPTION: Amounts attributable to the cost of purchasing the annuity may be EXCLUDED from GI Items Statutorily EXCLUDED from Gross Income: usually for policy reasons a. Proceeds from Life Insurance: § 101(a)(1) i. Generally: 1. Because it involves transferring risk, not generating wealth 2. Must be paid by reason of the death of the insured – not when the insured cashes in the policy 3. Items paid to insured during life, while terminally/chronically ill are considered paid by reason of the death of the insured and are excluded from GI 4. Term v. Whole Life: Term has no reserves associated with it and cannot be borrowed against, but whole life has a fund allocated against it‟s value 5. TITLE 26: Sets out tables for the following: a. 1 Income Tax b. Regulations – interpretation of the tax law by the treasury department – first published in the Federal Register (CFR) i. 26 CFR follows the organization of the USC Title 26 1. 26 CFR 1 = income tax a. 26 CFR 1.72 = 1 IRC § 72 2. 26 CFR 20 = estate tax 3. 26 CFR 25 = gift tax ii. Inclusion and Exclusion Ratios: § 72 for shorting/outliving life expectancy 1. Say we have a $1M policy for a 65 yr old male, under which the K price is $1M, payable @ age 65 $100K each year until death a. Look @ Reg. 1.72-9 for life expectancies and see that a 65 YO Male is expected to live another 15 years over 15 years b. The expected return on the investment is $1.5M c. The cost was $1M d. Divide the return by the cost and you get 10/15, or simplified as 2/3 exclusion ratio i. Multiply the exclusion ratio (.66) against the cost = amount excluded from GI ii. Multiply the Inclusion ratio (.33) against the expected return = amount included in GI iii. Installment Payment of Proceeds: regardless of whether paid in installments or lump sum to insured 1. EXCEPTION: § 101(c) and (d) If insurance company retains all of the principal and only pays insured interest amounts on that principal, those interest payments ARE considered GI iv. Transfer of Policy for Valuable Consideration: Exception from GI DOES NOT APPLY if the policy has been transferred for valuable consideration and WILL BE CONSIDERED PART OF GI; with the following 2 EXCEPTIONS: 1. If transferee of the policy has a transferred basis in the policy, OR a. So basis in the amount paid for the policy is increased by that amount 2. If the transferee is the insured, the insured‟s partner or a partnership in which the insured is a partner, or a corp. in which the insured is a shareholder or officer b. Gifts and Inheritance: § 102(a) i. Generally – the amounts themselves are excluded from GI, but the income those gifts generate IS part of GI 1. Gifts – Sup Ct says it is a gift if the reason of the transfer was out of „affection, respect, admiration, charity, or like impulses‟ [speaks to state of mind of transferor @ time of transfer] which is a narrower, subjective test and more often used by Gov‟t to lessen income tax GI exclusions; no question of motive when the parties are spouses a. Objectively defined as a gross disparity between the consideration for the property – broader inclusion of what could be called a gift, more often used by Gov‟t in gift tax to generate more tax revenue i. Gift Tax is incurred by the transferor when the transfer of property was for “less than adequate and full consideration in money or money‟s worth” 2. Inheritances – acquisition by bequest, devise, or inheritance (these terms are not defined in the code) – mainly excludes from GI anything acquired through “donative intent in the devolution of a decedent‟s estate” a. Post-death Estate Planning: HYPO – one heir who is the executor of the estate who is allowed to pay a statutory commission to the executor which could be a deduction paid to the executor which is a lower tax than the estate tax c. Interest on State and Local Bonds § 103 i. GI does not include interest received with respect to obligations issued by or on behalf of state, local or DC gov‟t - but interest paid on obligations issued by the FEDERAL GOV’T ARE INCLUDED IN GI 1. Does not include private activity bonds which are not qualified activity bonds, arbitrage bonds (trading on the difference between two markets), or a non-registered bond § 103(b) d. Compensation for Injuries or Sickness and Damages § 104 i. Damages for Personal Physical Injuries or Physical Sickness § 104(a)(2) – determined by the underlying nature of the claim 1. Defined under § 104(a) a. Doesn‟t include worker‟s comp $ in GI b. Tort compensatory damages included in GI – not punitive damages c. Pension for personal injuries or sickness resulting from active service in the armed forces, also disability annuities 2. If damages paid for loss of business or profession, then it adds to his wealth and is included in GI 3. Liquidated damages in K to sell property suits may be included in GI 4. § 213 Deductions for medical expenses in any prior tax year for a particular expense preclude the ability to exclude compensation for that same expense from GI – prevents double benefit ii. Punitive Damages 1. Not part of GI if they are from intentional or unintentional tort – can only exclude compensatory damages from GI and must have been for personal physical injuries § 104(a)(2) calls out tort damages specifically a. Damages for emotional distress are NOT considered physical injuries but the medical expenses incurred in the process of treating the emotional distress ARE EXCLUDABLE 2. If punitive damages from antitrust, then they are part of GI e. Recoveries Under Accident or Health Insurance § 104 (a)(3) i. Employer policies = § 104 (a)(3) excluded from GI ii. No limit to the amount that may be excluded from GI iii. 2 Exceptions where you cannot exclude these recoveries from GI: Payments made to an employee EITHER 1. Under an accident or health plan to which the employer made the contributions which were excluded from the employee‟s gross income under IRC § 106, OR 2. By the employer iv. If a payment does not meet the above exceptions, then look @ IRC § 105 or 106 1. If employer pays premium to a carrier on behalf of the employee & their family, that amount is excluded from the employee‟s GI 2. Benefits paid through that coverage are also not included in GI to the extent that it covers the actual costs f. Payments for and Recoveries Under Employer-Provided Accident or Health Plans § 106 i. §106 excludes from GI amounts an employer contributes to accident or health plans on the employee‟s behalf to compensate the employee for personal injuries or sickness; 1. BUT the following ARE included in GI under §105(a) if those payments were originally excluded from employee‟s GI: a. Payments made directly to an employee by the employer to compensate for personal injuries or sickness b. Payments under an accident or health plan to which the employer made contributions 2. §§ 105(e) and (g): Medical plans purchased by the employer for the employee and selfemployed persons paying for their own healthcare, may be eligible for an exemption because they are not considered “employees” for the exclusions under ii. Amounts Spent for Medical Care § 105(a) includes and § 105(b) excludes if the amounts were paid to reimburse the employee for medical expenses incurred for himself, his spouse, or dependents 1. Employee can‟t exclude from GI if they took a deduction for those medical expenses in ANY PRIOR year iii. Payments Unrelated to Absence from Work: 1. Amounts required to be INCLUDED in GI by § 105(a) may be EXCLUDED under § 105(c) IF they are payment for the permanent loss of a limb or disfigurement of an employee, her spouse or dependents and are computed with respect to the nature of the injury and not the length of time the employee is absent from work g. Bankruptcy and Insolvency i. Generally: GI does not include income from discharge of indebtedness if it occurred in accordance with a bankruptcy proceeding 1. Bankruptcy rules control 2. Insolvency exception applies only to the extent the taxpayer‟s liabilities exceed the FMV of his assets immediately prior to the discharge under §108(a)(3), (d)(3) ii. Reduction of Tax Attributes: if the discharge is excluded from GI, then other attributes of the taxpayer must also be reduced by the same amount excluded and include: 1. EITHER §108(b)(2) a. Net operating losses b. Certain tax credit carryovers c. Capital loss carryovers d. Adjusted basis of property e. Passive activity loss and credit carryovers f. Foreign tax credit carryovers 2. OR §108(b)(5) a. Taxpayer may reduce the basis of depreciable real property and real property inventory iii. Reduction of Basis§ 108, § 1017 1. If, under §108, basis was required to be reduced, special rules of §1017(b)(2) MUST BE APPLIED to effect the reduction in the basis of property which the taxpayer holds at the beginning of the taxable year following the year the discharge happened a. If the ??? iv. Solvency or Partial Solvency ??? 1. Purchase Price Adjustment ??? h. Educational Provisions i. Qualified Scholarships § 117(a) 1. Excluded from GI if it was for a degree at an educational institution 2. § 117 is the only section that covers scholarships – if any amount is not excluded as GI under §117, such as for those amounts that are not tuition, fees, books, supplies or equipment required for instruction in the program or amounts for teaching, research or other services that were required under the program of study – the taxpayer may not exclude the excess amount as a gift under §102 3. Any payment in the nature of compensation is not qualified for exclusion from GI ii. Qualified Tuition Reduction § 117(d) 1. the amount of any reduction in tuition provided to an employee of an educational institution for education below grad level or instruction at another institution 2. Special rule for grad students engaged in teaching or research activities a. Those students‟ reduction in tuition is excluded from GI as a qualified tuition reduction §117(d)(4) – for the employee, their dependent children, their spouse, and in some cases, the surviving spouse of a deceased employee §117(d)(2)(B) and 132(h) b. Tuition reduction programs may not discriminate to highly compensated employees iii. Educational Assistance Programs § 127(a) 1. Up to $5250 of income provided as educational assistance may be excluded from GI a. Can be the employer paying for the training b. Can be the value of the employer providing the training for the employee himself c. Exceeding amounts or non-qualifying amounts may be excluded from GI if they are “working condition fringe benefits” under §132(j)(8) iv. Education Savings Accounts § 530 1. Tax contributions to an educational savings fund are not deductible when made - max of $2000 for each beneficiary a. Income earned from that account is not taxed b. Distributions from that account, if used to pay for education expenses of the beneficiary of the account are not taxed c. §530(b)(1)(A), (c)(1) reduced the contribution amount to zero as the taxpayer‟s AGI exceeds a certain dollar amount which is adjusted for inflation v. Qualified Tuition Programs § 529(a) 1. States have programs where non-deductible funds are deposited into account and the income from those accounts are tax exempt; distributions to the beneficiary are excluded from the beneficiary‟s GI §529(c)(3)(B) 2. Similar to, but better than Education Savings Accounts because: a. No ceiling limits on the amounts of contributions b. No phase-out of allowable contributions based on AGI 3. If monies not used for qualified educational expenses, they are taxed under §72 vi. US Savings Bonds § 135(a) and (c)(2) 1. Income from redeeming US Savings Bonds may be excluded from GI in a taxable year in which the taxpayer pays qualified education expenses for herself, her spouse, or her dependents 2. Qualified bonds must have been issued at a discount after 1989 to an individual at least 24 years old §135(c)(1) 3. the exclusion from GI of the proceeds from the bond only applies if the amount redeemed in that tax year do not exceed the qualified education expenses paid during the year 4. Those with AGI > $40,000 or joint AGI > $60,000 get less benefit under this section VIII. vii. HOPE Scholarship and Lifetime Earning Credits = credits and not exclusions from GI 1. Monies from the HOPE scholarship and lifetime learning credits are NOT exclusions from GI, but are tax credits Deductions and Allowances a. Trade or Business Expenses § 162(a) i. Generally – a deduction is allowed for ordinary and necessary expenses paid or incurred during a taxable year in carrying on a trade or business 1. Ordinary and Necessary Expenses a. Ordinary: expenditure which is common within the business community to which the taxpayer belongs b. Necessary: expenditure which is appropriate and helpful to the trade or business i. Not necessary when they could be reimbursed or compensated or if it is unreasonable in light of the circumstances 2. Expenses a. Capital Expenditures v. Repairs: added to basis of the property § 1016(a)(1) i. Capital expenditure is not deductible at the time it was spent, but my be depreciated and deducted later ii. Includes the cost of constructing buildings, machinery, equipment or anything that has a substantial life beyond the taxable year; also anything which adds to the value of property substantially prolonging the useful life of the property, or to adapt the property to a new use iii. Amount of capital expenditure is added to the basis of the property iv. Repair: incidental repair or maintenance are expenses and immediately deductible b. Advertising (Reg. § 1.162-1(a)) i. Deductible as well as “institutional or goodwill” ads which encourage others to do well – even though the benefits may outlast through the current taxable year 1. If the medium of the advertisement is such that it will outlast the taxable year – something possibly tangible, then it may be considered a capital expenditure ii. Carrying On 1. Generally: a. Startup costs do not qualify as deductions because you are not “carrying on” the business @ that time b. Money spent to expand an existing business is deductible 2. Expenses Incurred as an Entrepreneur § 165(c)(2) a. Money spent in investigating a new trade or business are treated as capital expenditures and not currently deductible i. If the investigation reaches a transactional stage and is dropped before a trade business is started the transactional expenditures may give rise to a loss deduction ii. These expenses can be written off for 60 months equally once the business has started 3. Expenses Incurred in Obtaining Employment as an Employee § 195 a. If you are seeking employment in a job similar to one you already had, then these expenses are deductible iii. Trade or Business § 162 and 212 1. Not recreational activities – these are not deductible 2. Must be for profit a. For the production or collection of income b. §183 and Reg. 1.183-2: defined what constitutes activity not engaged in for profit iv. Salaries 1. Reasonable Compensation § 162(a)(1) a. Reasonable salaries and compensation is deductible if they are for services i. Reasonable depends upon how it compares with amounts paid in similar situations ii. Has to be for services actually rendered 2. Golden Parachute Payments § 280G a. Executives‟ large bonus programs paid to give them an incentive to stay during a corporate takeover are not deductible and may be subject to an excise tax i. Complex rules regarding what a disqualified individual is, and how to calculate their base amount of salary v. Traveling Expenses §162(a)(2) 1. 3 conditions must be satisfied: a. Reasonable an necessary travel expense b. Incurred while away from home c. Incurred in the pursuit of business 2. Home a. For tax purposes, it is the business office – “home office” the local office you drive to in order to get to work each day i. Distinguished from an office in your home ii. No deduction for commuting costs 3. Away From Home a. When on assignment away from the principal business office for less than a year b. Not away from home if they are there for an indefinite period 4. Overnight Rule a. Lodging and 50% of meals so long as taxpayer is away long enough to require her to stop for substantial rest no matter what mode of travel she uses or what distance she travels b. Generally meals and lodging only when away overnight c. Travel are not subject to the overnight stay requirement 5. Travel for Business and Personal Reasons 6. 7. 8. 9. a. Even if some personal days are used on a business trip, the airfare is deductible if the principal reason/purpose of the trip is for business i. Usually by counting the number of days in which some useful/significant amount of business is performed – more than half of the days have to be principally business-related days ii. When the business period is interrupted by a weekend or holiday, those interior weekend/holiday days are considered business days b. Meals and lodging go day by day – on personal days, those days‟ lodging are not deductible c. Client entertainment §274 Foreign Travel a. Only applies when personal days are less than 50% and more than 25% b. Satisfy §162 or 212 before you can deduct part of the airfare portion of expenses under §274(c) - §162 gives all or nothing for this if not principal i. §274 gives a portion of the foreign airfare as a deduction – if 6 of 10 days are for business, 60% will be deductible 1. If the travel does not exceed one week, then §274 does not apply (see §274(c)(2)(A); OR 2. If the portion of travel time is less than personal days or less than 25% Water Transportation Other Persons Traveling with Taxpayer a. After 1993, no deduction is allowed for those traveling with someone on business travel Legislators a. Tax home of a US Senator or Representative is his residence in the district which he was elected to represent vi. vii. viii. ix. b. Meals and lodging while in Washington, D.C. are deductible Meals § 274(k) Rentals § 162(a)(3) 1. Generally 2. Transfer and Lease-Back § 162(a)(3) Expenses for Education: NOT Addressed under § 162 1. Generally: Must meet the two tests of deductibility and non-deductibility 2. Tests for Deductibility a. Maintaining or Improving Skills of an EXISTING trade or business ARE DEDUCTIBLE b. Meeting Requirements of Employer or Law 3. Tests for Non-deductibility a. Minimum educational requirements for a new trade or business NOT deductible b. Qualification for New Trade or Business c. Carrying On Requirement i. Travel as Education § 274(m)(2) 1. I was learning through the experience of traveling across Europe - sorry, NOT DEDUCTIBLE ii. Travel to Obtain Education iii. Qualified Tuition and Related Expenses 1. School uniforms, tuition and fees 2. Other sections may also apply – if they were excluded from GI, then you can‟t claim a deduction for them also Miscellaneous Business Deductions 1. Entertainment – if a demonstrable business benefit will be derived from the expenditure 2. Uniforms – if not suitable for street wear 3. Dues – paid to an organization directly related to taxpayer‟s trade or business 4. Periodicals – if directly related to taxpayer‟s trade or business and satisfy requirements under §162 5. Utilities – ordinarily and necessarily required to operate the business 6. Taxes – certain taxes are deductible; see §§ 164, 164(a), 275 7. Health Insurance for Self-employed Individuals x. Substantiation Requirements 1. taxpayers should be able to prove that they actually incurred and paid for the expenditure they want to claim a deduction for b. Non-Business Expenses [§212 parallels §162] of individuals, estates or trusts i. Generally: 1. Must be ordinary and necessary 2. Must be an expense 3. Must not be inherently in nature ii. Itemized Deductions for individuals 1. Those authorized under §212 are generally miscellaneous itemized deductions, deductible only if a taxpayer elects to itemize deductions and then only to the extent that the total amount of miscellaneous itemized deductions exceeds 2% of the taxpayer‟s AGI iii. Production or Collection of Income § 212(1) 1. But not activities such as management of investments in stocks or bonds (Sup. Ct. decision – Higgins v. Comm‟r, 312 U.S. 212 (1941)) 2. Rents, dividends, interest, alimony and other current receipts, income in the nature of gain from the disposition of property a. Expenses incurred in protecting or asserting one‟s rights to property or income from property as an heir or beneficiary are capital expenditures and are not deductible iv. Management of Income Producing Property § 212(2) 1. Management, conservation, or maintenance of property held for the production of income are deductible a. Even when the property is not producing income or would not disposed at a gain – it is sufficient if the property is being held in order to minimize an unrealized loss in its value b. Deductions are allowed if they were incurred to change one‟s relationship from personal to business reasons v. Expenses in Connection with Taxes § 212(3) 1. Expenses incurred or paid in connection with the determination, collection, or refund of any tax (not just income taxes) are deductible (Federal, state, or local government) – for preparing tax returns, contesting a tax liability, or determining the tax consequences of anticipated action c. Losses §165(c)(1), (2) i. In General: essentially more deductions than income 1. Anything not compensated for by insurance or otherwise 2. Losses must be sustained to be deductible – such as a closed and completed transaction, identifiable event 3. Losses incurred in a trade or business, transactions entered into for profit, and certain casualty losses a. Rules differ between business/profitseeking losses and personal losses b. §165(c)(2) – “transactions entered into for profit, though not connected with a trade or business” i. Such as stocks which produce income while not “carrying on” business ii. Amount of Loss: §100(a) 1. Amount of a loss from the sale or other disposition of property is the excess of the adjusted basis of the property over the amount realized 2. If by fire or other casualty, then it is the lesser of the difference between the FMV of the property immediately before and after the damage and the adjusted basis of the property – therefore the amount of loss may never exceed the amount of the property‟s adjusted basis 3. If totally destroyed, and FMV before destruction is less than adjusted basis, the amount of loss is the adjusted basis 4. Losses covered by insurance: §165(h)(4)(e) a. Losses covered by insurance are deductible to the extent that it is not covered by insurance (damaged or stolen property) b. Even if taxpayer does not file a claim with the insurance company for reimbursement c. Does not apply to personal casualty losses 5. Losses on Property Converted from Personal Use to Business Use a. If originally acquired for personal use then converted to business use, and FMV is less than adjusted basis on the date of conversion, sustained loss is limited to FMV iii. Classification of Losses 1. Capital Loss v Ordinary Loss: a. Capital gain/loss has to do with a capital asset sold or exchanged and the capital asset (as defined in §1221 – often other than inventory) continues to exist after the event i. Such as sale of stock at a loss (because it wasn‟t inventory) b. Ordinary loss = Where there is no sale or exchange, what is sold or exchanged is not a capital asset c. Long and Short Term – based on a year timeframe; < 1 year = short-term capital loss which is treated the same as income i. 15% max tax on long-term capital losses, thus it is better to claim an ordinary deduction/loss than capital loss 2. Trade or Business Losses: losses from the sale or distribution of property used in a trade or business are deductible; §162 defines whether one is engaged in a trade or business 3. Losses sustained in a Transaction Entered Into for Profit: Allowable; the threshold for deducting losses in a “transaction entered into for profit” is higher than the threshold for deducting expenses paid for incurred for the production of income, or for managing property held for the production of income a. Limitations: Worthless Securities: Capital assets which become worthless during a tax year become “disposed of” on the last day of the tax year; securities are: §165(g)(2) i. Share of stock in a corporation ii. Right to subscribe for a share or stock in a corporation iii. Bond or other evidence of indebtedness issued by a corporation or by a governmental authority, but only if it has interest coupons or is in registered form 4. Casualty Losses: §1231 a. Property losses sustained by theft or destruction when used in a trade or business or for the production of income iv. Timing of Losses: 1. In the year sustained 2. Special rules for timing of business, profit seeking, or personal casualty losses d. Bad Debts: i. Generally: Deduction allowed for a debt which become worthless during a taxable year §166(a) 1. Depends upon the nature of the debt – business debt, non-business debt, or security ii. Bona Fide Debt Requirement: only one arising from a debtor/creditor relationship based upon an obligation to pay a fixed or determinable sum of money 1. Cr/DR Relationship is a question of fact based upon intention of parties 2. If lender had reasonable expectation of being paid 3. If gift intended – no deduction 4. Loans between families and friends are closely scrutinized by IRS iii. Determination of Worthlessness: Taxpayer has burden to prove worthlessness in the year it is claimed; creditor does not have to institute legal action to demonstrate that debt is worthless; debtor‟s bankruptcy is generally evidence that unsecured debts are worthless 1. Must be worthless and uncollectible; gratuitous forgiveness of a debt does not make it deductible iv. Amount of Deduction: §166(b) Amt is limited to the adjusted basis of the debt v. Special Rules for Bad Business Debts: §165 1. deduction for a worthless business debt is an ordinary loss 2. Business debts not defined in the code, but are debts which are neither “non-business debts” under §166(d) nor “securities” under §165(g) a. Partially worthless business debts are deductible during a taxable year §166(a) vi. Special Rules for Non-business Debts: 1. Defined as any debt OTHER THAN A: a. Debt which was created or acquired in connection with a trade or business of the taxpayer b. Debt which becomes worthless, producing a loss which is incurred in the taxpayer‟s trade or business 2. Generally: as to taxpayers who are not corporations, “non-business debts” are subject to other rules: a. non-business debt must become wholly worthless before deduction is allowable b. the amount of a worthless non-business debt is deemed to be a short-term capital loss and is deductible as such vii. Worthless Securities 1. Debts issued by a corporation, gov‟t or political subdivision and evidenced by a bond, certificate, or other evidence of indebtedness with interest coupons or in registered form are treated as “securities” under §165(g)(2)(C) 2. If a security is a capital asset and it becomes worthless, the bad debt rules of §166 do not apply – loss is characterized as a long-term or short-term capital loss under the loss rules of §165(g) e. Property i. Generally: cost of acquiring property used in a trade or business or prop held for the production of income is generally a nondeductible capital expenditure because it has a useful life > 1 year 1. If some items are used up in the production of income their cost may be deductible, but not in the case of real property because it is never really “used up” while producing income 2. Property not “used up” in the production of income = no deduction 3. Depreciation deduction – spreads the costs using the property over the number of taxable years it is used in producing income (useful life of property §167) ii. Capital Expenditures: 1. Depreciation (AKA “Capital Reductions”) takes care of the cost of doing business by spreading that cost out over time (taxable years) iii. ACRS (Accelerated Cost Recovery System): 1. 1981 ACRS: §168(e) permits the entire cost of qualifying property to be deducted over a period of time which is usually much shorter than the property will actually be used in producing income 2. Tax Reform Act of 1986: altered ACRS rules = “Current ACRS” a. Varying situations, property may be subject to one or the other version of ACRS (“Current” or “old” ACRS) b. Prior to 1981 – use depreciation deductions under §167, the old ACRS, or the new ACRS i. Basis of property which qualifies for depreciation deductions must be reduced by the amount of the deductions allowed or allowable for such deductions 3. Depreciation Deduction (property not subject to the ACRS rules = NON-ACRS): §167(a) a. Generally: depreciation deduction is allowed in the amount of a “Reasonable Allowance” for the exhaustion, wear, and tear or obsolescence of property which is either used in a trade or business or held for the production of income b. Cost or Other Basis: Depreciation deduction for an item of property is generally computed with reference to its adjusted basis used for determining gain on the sale or other disposition of the property under §167(c) i. If it was used for personal purposes, before being used for income purposes FMV of the property as of date of conversion is used to compute the depreciation deduction if that amount is lower than the property‟s adjusted basis ii. If it was used partly for business, partly for personal, then depreciation deductions are allowed only with respect to the property‟s basis allocated to the business use 1. Restrictions apply if it was not used solely for business – on certain types of property c. Useful Life: length of time the property may reasonably be expected to be used in the taxpayer‟s particular income seeking activity i. Question of fact which was defined by congress in 1971 when it authorized the IRS to prescribe useful lives for particular classes of property; IF: 1. Unascertainable/indefinite: no depreciation can be taken 2. Some intangibles have no ascertainable useful life (goodwill) which may be open to question, but deductions can be taken sometimes IF THE TAXPAYER CREATED THE ASSET a. §197(a),(c) define amortization deduction schedules which run over a 15-year period; i. e.g., goodwill, going concern value, business records, copyright/patent b. Some things not allowed to be amortized deductions under §167(f)(1)(A) like computer software (but you may be able to use depreciation deductions on these items) ii. §195 – Start-up Expenditures – may be amortized over NO MORE THAN a 60-month period d. Salvage Value e. Asset Depreciation Range i. Shortened the useful life of goods (1971) ii. Was published in “Bulletin F” f. Methods of Computing Depreciation i. Straight Line Depreciation 1. Cost of property, e.g., $10,000 2. Minus Salvage Value, e.g., $2,000 3. Equals Depreciable Base, e.g. $8,000 4. Take number of years useful life, e.g., 5 and make that the denominator which is the depreciation rate 5. Multiply the depreciation rate by the Depreciable base for each year of useful life to get the depreciation schedule: a. Y1 Depreciation Deduction = 8000x1/5 = 1600 deduction to the asset for depreciation ii. ** ONLY USED THIS SINCE 1981: Declining Balance Method; Double Declining Balance shown below: 1. Take the cost of the property or other basis of the property, e.g., $10,000 2. Do not reduce the salvage value 3. Take number of years to create the depreciation rate (just as in the straight-line method), e.g., 5 years = 1/5 4. To do a double declining balance method, you would multiply the denominator in the fraction by 2, e.g., 200% x1/5 [2 is the max rate, or could be 150%] which gives the depreciation rate 5. Double Depreciation Rate = 200% x 1/5 = 40% 6. Y1 deduction = 10,000 x 40% = 4000 Y2 depreciable base lowers: Y1 Depreciable base – Y1 deduction = Y2 depreciable base: a. 10,000-4,000=6,000 Y2 Depreciable Base Then calculate the allowance against the Y2 6,000: 6,000x40%=6,000-2400 deduction = Y3 depreciable base of 3.600 iii. Sum of the Years–Digits Method 1. Count up to the number of years of useful life 2. Add those numbers (if 5, then the total is 15, or 1+2+3+4+5) 3. That number becomes the denominator for each year of the depreciation from highest to lowest 4. Year 1= 5/15, Y2=4/15, Y3=3/15, Y4=2/15, Y5=1/15 iv. Other Methods g. Relationship of Depreciation Deductions to Basis iv. ACRS: Accelerated Cost Recovery System 1. Generally 2. Anti-Churning Rules a. Can‟t use a piece of property which was put into service and deducted under ACRS b. If the “current ACRS” results in a higher deduction because someone related to you had already placed the property in service, you (and the previous person) can‟t use the current ACRS for deductions for that piece of property i. Related persons include: spouse, family members, trusts/estates in which TP has an economic interest 3. Operation of Current ACRS or MACRS (Modified ACRS) a. Shorten useful lives b. 200% declining depreciable balance v. Related Concept Depletion vi. Special Rules for Personal Property – the amended rule as of May 28, 2003 – Bush Jr.’s tax law to get reelected 1. Introduction/Generally: 2. Section 179 Bonus Depreciation a. Section 179 Property i. Any items not chargeable to a capital account ii. §179(d) defines it as any tangible personalty actively used in a trade or business 1. Must be depreciable: must be of a character which wears out over time – usually not an issue 2. Must be tangible: able to touch and hold; intangible property such as intellectual property (copyrights and patents) do not qualify – usually not an issue 3. Personalty: Real estate (buildings) does not qualify as §179 property; this is the language referring to §1245 property iii. Used in an active trade or business; property held as investments do not qualify as §179 property b. Limitations i. Dollar Limitation 1. the amount of money you can spend on these types of asset before hitting the dollar limit §179 a. Was $25,000 but has been amended up to $100,000 for property defined under 179 b. The amount of deductions is reduced dollar for dollar by the cost of §179 property (see above for types of property) c. 50% of the amount for husband/wife not filing joint return – the total between them cannot be above the maximum amount allowed ii. Taxable Income Limitation 1. §179(b)(3) limits the amount deductible in a tax year based on income from a trade or business, regardless of the cost of the §179 property, any overage can be carried over into another tax year c. Recapture i. If a §179 piece of property ceases to be used predominantly for business purposes, even if the property is not disposed of or sold, the benefit realized from the deduction must be shown as income 3. Special Depreciation Allowance for Certain Property Acquired after September 10, 2001 and before September 11, 2004 - §168(k) – this deduction can be waived by a taxpayer a. 30% of the adjusted basis deduction; requires i. Qualified New Property (includes software, water utility property, or leasehold improvement property) 1. Property which is depreciable under §168(g) is NOT qualified ii. Acquired after 9/10/2001 iii. Acquired before 9/11/2004 iv. Placed in service for business before 1/1/05 v. Recovery period of <= 20 years b. Deduction is in addition to the §179 bonus depreciation c. Adjusted basis is reduced by the amount of this deduction before calculating depreciation allowed under §168 4. Regular Investment Tax Credit a. Tax credit for the purchase of certain depreciable property used in a trade or business b. If taken, basis of property must be reduced by the amount of the credit prior to computing depreciation – if disposed of prior to the ACRS recovery period expires, all or a portion of the credit will be recaptured by adding it to a taxpayer‟s tax liability 5. Section 168 Accelerated Cost Recovery System (ACRS) – TABLE IN 2003 version of CODE BOOK ON PAGE 1793 a. Generally: i. Taken with respect to tangible property §168(a) ii. If a piece of property qualifies, §168(a) or (g) must be used to compute depreciation deductions iii. MANDATORY deduction under §168(f)(1) b. Applicable Depreciation Methods – salvage value is always set to 0 zero for these methods i. Double Declining Balance Method, switching to a straight line method (applied to the adjusted basis as of the beginning of the year) when the deduction under straight line is greater than that of double declining balance method ii. 150% method for property in the 15 and 20 year classes §168(b)(2) switching to straight line depreciation if it will yield a higher deduction over 150% method iii. Alternatively, TP (taxpayer) may use straight line dep. if it is an irrevocable election applicable to all items in the same classification of deductible prop. iv. Certain property uses the alternative depreciation system c. Applicable Recovery Period i. Determined by classification §168(c) ii. 6 types of classification, including personal property and some real property iii. Based on “class life” determined by IRS defined in §168(e)(1): Property Shall be treated as: 3-year property 5-year property 7-year property 10-year property 15-year property 20-year property If such property has a class life (in years) of: 4 or less > 4 < 10 >= 10 but < 16 >= 16 but < 20 >= 20 but < 25 >= 25 Some items are placed in certain classifications regardless of their class life (e.g., racehorses > 2yrs = 3-year property) d. Applicable Convention i. Generally: 1. Must be during the time period while property is in use, not before or after put or removed from service 2. Conventions developed for identifying start-up and ending times for the property ii. Half-year Convention 1. As if the property was placed in service in the middle of the year 2. Makes such items have a +1 year recovery period than their normal classification iv. iii. Mid-quarter Convention §168(d)(4)(c) = 7/8 of a year‟s depreciation 1. Applies if total basis of property put in service during last 3 months of the year exceeds 40% of the total basis of property placed in service that entire year (keeps from end-loading) a. Does not include real property and residential property 2. Treats any property placed in service during any quarter of the year to be set at the midpoint of the quarter 3. When mid-quarter convention used, the 40% convention does not apply e. Alternative Depreciation System i. Certain property cannot use ACRS 1. Personal property used outside the US 2. Prop leased to tax-exempt entities ii. Irrevocable election may be made to use an alternative depreciation system for any items used in any classification iii. Uses the straight line method (no salvage value accounted for), the applicable convention, and a recovery period = class life and not „applicable recovery period‟ (specific class life in cases like automobiles) iv. Slows and spreads out the depreciation allowable for property to which it applies 6. Section 167 Depreciation a. Intangible property which does not qualify for ACRS, must use §167 depreciation b. §167 deductions allowed so long as they do not exceed the salvage value of the prop and they must be spread out over the useful life of the property c. Must use straight line depreciation method i. Used items may qualify for declining balance @ 150% of the straight line rate 7. Section 280F Limitations a. Luxury Automobiles: deductions for autos limited to $2560 in Y1, $4100 in Y2, $2450 in Y3 and $1475 in succeeding years i. Luxury auto costs more than $12,800 or if it qualifies for §168, $17,400 (increased each year for inflation) ii. May qualify for the 9/11 §168(k) bonus deduction and have a Y1 depreciation deduction of $4600 iii. If auto continues to be used for business after the recovery period, you can still deduct $1475 off the basis until the basis = 0 b. Listed Property §280F i. Also limits deductions for specifically listed items which are used in part for personal purposes 1. Passenger automobiles 2. Other property used as a means of transportation 3. Property generally used for entertainment, recreation or amusement 4. Computer/peripheral equipment 5. Cell/mobile phones 6. Other property designated under §280F(d)(4) ii. Use of these items must be substantiated by TP or it will be disallowed 8. Summary of Interrelationship of Special Rules for Personal Property a. Steps: i. Is it subject to ACRS? ii. If not, NO bonus depreciation available under §179 or ACRS under §168 1. Depreciate under §197 iii. If subject to ACRS: 1. Does it qualify for the bonus depreciation under §179? a. If so, and TP elects to use it, reduce the basis by the amount of the deduction before applying ACRS depreciation 2. Is it qualified property under §168(k) for the special allowance? a. If so, reduce the basis of the property by the amount of the deduction iv. Compute the depreciation under ACRS §168 or §167 vii. Special Rules for Real Property 1. Generally: a. Does not qualify for the special §179 bonus depreciation b. If real property is subject to ACRS deductions, it will be called out specifically in the classifications – e.g., a greenhouse c. Old ACRS applies to prop in svc after 1980 and before 1987 d. Current ACRS applies to prop in svs after „86 e. It is the building that is getting depreciated, not the land f. §1245 property or §1250 property 2. Section 168 Accelerated Cost Recovery System (ACRS): use the depreciation method, recovery method and convention applicable to the property‟s classification a. Classifications of Real Property i. Nonresidential real property under current ACRS: §168(e)(2)(B) and §1250(c) Depreciable real property other than residential rental property OR property which has class life of < 27.5 years; e.g., shopping centers, retail stores 1. The more income such a property generates, the more income it generates is deductible ii. Residential rental property under current ACRS: §168(e)(2)(A) bldg or other structure from which 80% or more of the rental income is from dwelling units; e.g., apartment buildings, townhouses 3. Applicable Depreciation Method a. For Real Prop = straight line method with zero salvage value §168(b)(3) and (4) 4. Applicable Recovery Method a. Residential Prop = 27.5 years b. Nonresidential Real Prop = 39 years 5. Applicable Convention §168(d)(4)(B) – so always remember to multiply and carry the half-month a. Mid-month convention for both b. Prop is placed in svc @ mid-point of month it was placed in service 6. Alternative Depreciation System a. May be used for some real property b. Recovery = 40 years for both types c. The election to use alternative depreciation does not require the use of it for all items in a classification 7. Anti-Churning Rules – do not apply to residential rental property or nonresidential real property viii. Section 167 Depreciation 1. Most RP in svc before 12/31/80 qualifies for old or current ACRS deductions 2. If not allowed under old/current ACRS, then §167 deduction are allowed if they are spread out over the useful life of the property and the cost or other basis of the property exceeds its salvage value f. Net Operating Loss Deductions §172 i. Small Business most often use this ii. Solely business expense deductions – NOL (Net Operating Loss) 1. Excess of allowable business expenses over gross income for a taxable year 2. Annual carryovers and carrybacks are allowed for businesses a. Carryback must be as far back as the second preceding year (default treatment) from the tax year in which the NOL occurred – lets them get their tax back from the previous two years b. Carryforward c. It is not an amended return, but it is an expedited refund for the NOL year g. Personal Deductions and Allowances i. Personal Exemptions – not allowed for one making a payment of someone else‟s obligation; Consumer Price Index increases the standard deduction from the original $2,000 1989 amount (e.g., 2001 was $2900) 1. TP and Spouse § 151 – both get a personal exemption; if one person has all the income and supports the other, the first gets to claim the second as a dependent (e.g., the basic stuff on tax returns) a. More than ½ of someone‟s support b. That dependent does not make more than $4000 2. Exemptions for Dependents a. Generally: §151(c) b. Gross Income Test: dependent‟s income cannot be > TP unless dependent is child of TP under 19 c. Relationship Test i. Son/daughter – adopted and foster children included ii. Stepson/stepdaughter iii. Brother/sister, half-brother/half-sister iv. Father/mother v. Niece/nephew vi. Aunt/uncle vii. Son-in-law, daughter-in-law, fatherin-law, etc… viii. An individual other than the TP‟s spouse who has his principal place of abode in the home of the TP and is a member of the TP‟s household so long as the relationship is not in violation of local law d. Support Test i. Over ½ of the person‟s support ii. Includes medical, food, lodging – but not a scholarship e. Children of Divorced Parents i. Custodial parent unless the parties agree otherwise ii. Interest 1. Generally a. Trade or Business Interest – for debts incurred in a Trade or Business but not interest for debts incurred as an employee b. Investment Interest §163 i. Indebtedness incurred to purchase or carry property held for investment ii. Limited to the net income from such investments c. Interest in Connection with a Passive Activity §163 – such as interest on credit cards is NOT deductible d. Qualified Residence Interest – limit of $1,000,000 to count as acquisition indebtedness – loans secured by a personal residence i. Interest on a mortgage ii. Acquisition indebtedness – interest on money you borrowed to get the loan 1. Often people use a home equity credit card iii. Limit of 2 residences allowed in any given tax year – doesn‟t have to be the same 2 each year if you have > 2 1. Personal residence can be a house boat, RVs, essentially anything with a place to sleep and bathroom 2. Year of Deductions a. Using the accrual method – deduction applies in the year in which the interest accrues b. Using the cash method – deduction applies in the year in which the TP pays the interest; for loans, it is the amount of interest paid on the loan in that tax year c. Does not apply to points paid for mortgages obtained to purchase or improve a residence 3. Additional Restrictions on Interest Deductions a. No allowance for deduction of interest used to purchase life insurance or annuities or obligations which pay interest which is exempt from taxable income b. Interest may also not apply if the debtor/creditor are related 4. Unstated Interest a. Installment purchased where the interest is not stated under §163(b) is deductible b. Interest on certain 5. Interest on Education Loans iii. Taxes 1. Generally a. State income tax, property tax, school board tax, foreign tax §164 but see §901 for the foreign income tax credit which is worth more 2. Property Taxes a. Personal property tax is deductible b. iv. Personal Casualty and Theft Losses §165(c)(3) 1. Nature of the Casualty a. Fire, storm, shipwreck, or other casualty §165(h) b. Identifiable event of a sudden, unusual or unexpected nature c. Theft, criminal appropriation of your property TP bears burden to prove theft d. Actual physical damage must be sustained 2. Measure of the loss and is the lesser of: a. Excess of FMV of prop immediately before casualty over FMV immediately after casualty b. TP‟s adjusted basis for the prop 3. Amount of deduction a. Generally: i. §165(c)(3) – only to the extent that the amount of the loss arising from each casualty exceeds $100 – see §165(h)(1) b. Definitions of Personal Casualty Gains and Losses i. Involuntary Conversion from a fire, storm, etc. §165(h)(3)(a) c. Excess of Personal Casualty Losses over Personal Casualty Gains i. Total personal casualty > personal casualty gains for a year, losses may be deducted to the extent of: 1. amount of personal casualty gains 2. Amount by which excess of personal casualty losses over gains exceeds 10% of the TP‟s AGI for that year a. Treated as a deduction in computing AGI up to the 10% threshold d. Excess of Personal Casualty Gains Over Personal Casualty Losses 4. Year of Deduction v. Worthless Nonbusiness Debts vi. Charitable Contributions §170 1. Qualified Donees a. Traditional Charities: Churches and schools – organizations exempt from tax under 501(c)(3) b. Governmental/State Entities – those exempt because they are part of the gov‟t 2. Contributions a. In General: given with donative intent and without consideration §170; if some benefit derived to donee will not be to the general public, it is not a contribution and cannot be deducted but may be allowable as an ordinary and necessary business expense §162 i. Cash ii. Services iii. Property b. Partial consideration: the deduction will be allowed for the excess of the consideration i. Special Rule for contributions to institutions of higher education 1. If the donation results in being able to purchase tickets @ said institution, then 80% of the amount transferred (not including the price of the tickets) is a charitable contribution §170(l); right to purchase tickets is an economic benefit to the donor, so 100% deduction wouldn‟t be fair – 80% is more appropriate (according to Congress) c. Bargain Sale to a Qualified Donee §1101(b) i. If less than the FMV of the property then it is a part-gift ii. Adjusted basis apportioned to sale = adjusted basis X (amount realized/FMV) 3. Amount of Charitable Contribution a. Cash – deduction is the amount given less any consideration received for the transfer b. Property – deduction is the FMV of the property @ time of donation, less any consideration received and any other reductions from §170(e) i. Ordinary Income and Short-term Capital Gain Property 1. Amount of charitable contribution reduced by the amount of gain which would have been realized as ordinary income or short-term capital gain if donor would have sold it for full FMV ii. Long-term Capital Gain Property 1. Amount of charitable contribution is reduced by amount of gain which would have been long-term capital gain §1231; it applies when: a. Donor sells the property at date-of-contribution FMV b. Contribution is: i. Tangible personal property used in a way unrelated to the exempt purpose of the donee (property for an organization which isn‟t related to the purpose of the organization); OR ii. To or for the use of a non-operating foundation c. If the contribution is “qualified appreciated stock” (stock for which quotations are available) the reduction does not apply to nonoperating foundations and such stock may not exceed 10% of the outstanding stock of the corporation iii. Services 1. Generally no deduction allowed 2. Can look, @ such svcs as appreciated ordinary income which has a zero basis 3. If there are expenditures during the course of providing those svcs, then those constitute a charitable contribution under Reg. 1.170A-1(g) 4. If a car was used to provide svcs, you can deduct actual expenses such as gas or $0.14 per mile 5. Travel expenses are deductible if there is no significant element of personal pleasure, recreation or vacation involved iv. Partial Interests in Property §170(f) 1. Generally: a. Remainder interests, income interests, partial interests in property deductible in limited circumstances b. Essential requirement is that the trust property must be adequately preserved for the charitable organization 2. Must be in the form of a guaranteed annuity or have a fixed percentage of the FMV distributed annually to the charity in order for it to be deductible 3. §664(d)(1), (2) – these result in a deduction for the donee 4. CRT: Charitable Remainder Trust a. O to A for life, remainder to charity (charity‟s remainder = deduction) 5. Transfers in Trust 6. Transfers not in Trust a. A transfer to use property or a transfer which is not in trust is deductible only when: i. The partial interest would be deductible if transferred in trust; OR ii. Remainder interest in personal residence; OR iii. Remainder interest in a farm; or iv. Undivided portion of donor‟s entire interest v. Qualified conservation contribution §170(f)(3), (h) 7. Charitable Remainder Unit Trust §664(d)(2): fixed percentage of a trust‟s income 5-50% which is paid to someone for a term of year =< 20 years c. Limitations on Contributions Amounts i. Generally: §170(b) 1. Depends upon the form in which it was made, nature of the donee, nature of the property contributed, contributed base of the TP ii. Contribution Base: §170(b)(1)(f) 1. Is TPs AGI (w/o Net Operating Loss carryback to the taxable year) iii. Public Charities 1. 50% limitation 2. Contribution must be “to” the organization and not “for the use of” the organization iv. Capital Gain Property – 30% limitation v. Private Foundations 1. 30% limitation 2. Capital Gain Property – 20% limitation vi. Carryovers d. Year of Deduction e. Verification vii. Extraordinary Medical Expenses §213 1. Generally: not routine expenses for general care; those in relation to the TP‟s AGI 2. Medical Care 3. Capital Expenditures viii. Alimony 1. Deduction allowed for alimony and separate maintenance payments §213 h. Restrictions on Deductions i. Personal, Living and Family Expenses 1. Personal standard deduction and dependency deduction 2. No itemized deductions for personal, living and family expenses unless specifically authorized under the Code ii. Illegal Activities §162(c) 1. No deductions for bribes, kickbacks, or fine paid to gov‟t official i. Expenses and Interest Relating to Tax-exempt Income §265(a)(2) i. No deduction for expenditures which would otherwise be allowed as deductions allocable to income exempt from Fed Inc. tax ii. Not on interest on indebtedness which was used to continue to purchase or carry obligations which pay interest which is exempt from Fed Inc Tax j. Transactions Between Related TPs §267(a) i. In General: 1. No deduction for losses resulting from sale/exch. of property between related TPs 2. TP on the accrual method of accounting may not take deductions for interest or other expenses to be paid to a related TP who is on the cash method of accounting until the amount is actively or constructively paid ii. Relationships §267(c) 1. Individual and his or her brother or sisters, spouse, ancestors, lineal descendants 2. Individual and a corporation which the individual owns, directly or indirectly, > 50% of the value of its outstanding stock 3. Fiduciary of a trust and the grantor of that trust 4. Various fiduciaries and beneficiaries of 2 or more trusts with respect to which the same person is the grantor 5. Constructive ownership of stock held by your family members iii. Losses and Relief on Subsequent Sales 1. If, under §267(a), a deduction was not allowed between related TPs, but later, one of them sells the property at a gain – the gain amount is only the amount of excess over the amount disallowed under §267(a) iv. Deferred Timing of Deductions §267(a)(2) 1. Cash Accounting: report income as received 2. Accrual Method: report income when you earn it, not when you get it (e.g., when the $ is on the books, but not in the bank) a. Inventory Accounting accompanies Accrual Accounting 3. TP on accrual method of accounting may not take deductions for interest or other expenses to be paid by a related TP who is on the cash method of accounting until the amount is actually or constructively paid k. Entertainment Expenses §274 i. Generally: §274 is a disallowance section – no deduction unless statutorily defined elsewhere in IRC ii. Activity: no deduction if it is not directly related to conduct of TPs trade or business; 50% deduction when it meets trade/business criteria – higher percentages for those whose employment keeps them away from home or is regulated by the DOT iii. Facility: no deduction for places used for entertainment, amusement or recreation, or for membership dues to a club organized for business, pleasure, recreation or other social purpose iv. Entertainment Tickets: §274(n) - no deduction for the expenses of obtaining tickets to an entertainment facility or event in excess of face value of the ticket – unless it is the a ticket to a qualifying charitable sports event IX. X. v. Skyboxes: §274(l)(2) vi. Exceptions to the Disallowance Rules:‟ §274(e) vii. Substantiation Taxable Period a. Annual Account principle which keeps track of the tax year b. 12-month period c. Sometimes calendar, sometimes fiscal (not ending on Dec 31) Methods of Accounting a. Cash Receipts and Disbursement Method i. Receipts 1. Generally 2. Constructive Receipt – whether or not you actually had the money in hand (a client or receivable which doesn‟t really hit the books before the end of the tax year – holding over until the next year to lower one‟s taxable income) a. Some organizations are prohibited from using such methods ii. Disbursements 1. Generally 2. Prepaid Expenses b. Accrual Method i. Effect of Economic and Legal Contingencies on Income and Deductions 1. Economic Contingencies 2. Legal Contingencies ii. Income 1. Generally 2. Advance Payments for Services 3. Exceptions Under Case Law 4. Exceptions Allowed by the IRS 5. Exceptions Under Statutes iii. Advance Payment for Goods iv. Advance Payment for Use of Property c. Deductions i. Generally ii. Reserve Accounting: generally not allowed for tax accounting although it is the standard treatment in financial accounting d. Inventories: Determining profit when selling goods – taxes are only paid on the profit portion i. Cost of Goods Sold ii. Valuation of Inventories iii. Last-In, First-Out Inventories: 1. LIFO (last-in, first-out) – defers income 2. FIFO (first-in, first-out) is a Conformity requirement 3. GI = GR (gross receipts) - CGS 4. CGS=OI (opening inventory) + purchases – closing inventory iv. Mark-to-mark Method for Securities Dealers e. Installment Method ** Started class of 6/11 here i. Transactions under §453 1. Example: a. Piece of property: FMV 100,000 Cost 50,000 Sold by TP, terms: 20,000 cash down, financed by TP seller @ $20,000/year for 4 years Financing Statement secured by the property Realized gain for TP: §453 50,000 Profit/Payments: 50,000/100,000 = ½ of each payment is profit, the other half is ROI @ closing, when TP receives $20K – $10K = $10K as return of basis which is not taxed If purchase subject to 3rd party, then the payments denominator is the PAYMENTS TO THE SELLER If payments to 3rd party exceed those to buyer, making the fraction upside down, then TP seller had gain – SUBTRACT THE LIABIITIES TO THE 3RD PARTY FROM THE BASIS TO GET THE GAIN, AND THE FRACTION BECOMES 1/1 2. Installment Sales 3. Installment Method a. Generally b. Contingent Payment Sales c. Property Encumbered by Indebtedness ii. iii. iv. v. vi. vii. viii. 4. Character of Gain a. Fixed @ time the deal closes – and fixes all the character of the gain going forward Situations in Which §453 Does Not Apply 1. Losses 2. Recapture Income 3. Sale of Depreciable Property to Controlled Entity 4. Revolving Credit Plans and Stock or Securities 5. Dealer Dispositions §445 Depreciation Recapture 1. §179 property which has depreciated basis that is low compared to FMV – if the property is sold during the useful life, the basis will be so much lower than FMV, TP got a better deduction on that property than if they had depreciated it until it was worth nothing (TP takes benefit from fast deductions then selling off @ profit) §1245 a. Usually would be considered Capital Gain b. E.g., if a TP depreciated something as follows: 150,000 Cost -75,000 Depreciation Taken =75,000 Basis Then TP sells for > $150K, they had an unauthorized tax shelter §483 Interest on Certain Deferred Payments 1. K for sale of prop – if seller does not charge appropriate interest rate, then TP will be charged imputed interest income tax on the market rate of income tax of similar loans Second Disposition by Related Person Disposition of an Installment Obligation Special Rules 1. Interest Payment on Certain Deferred Tax Liabilities 2. Pledges of Installment Obligations Transactions Elected Out of §453 1. Election – this is an „elect out‟ provision, so it is assumed that you elect in 2. Consequences of Election – you have to report all of the gain on these transactions up front 3. Open Transaction Doctrine XI. Judicial Doctrines a. Claim of Right Doctrine: TP must include in GI amounts rec‟d which TP has claim to and unrestricted use of i. Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right: §1341 b. Tax Benefit Rule i. Generally: ii. Recovery of Tax Benefit Items XII. Non-recognition Provisions: a. Gain or loss which is realized upon the sale, exchange, or other disposition of property must be recognized or included in GI i. Means that the TP does not have to pay tax now on the gain or loss from the exchange b. Some things may be allowed “non-recognition” treatment under §1031 – deferral provision i. Certain transactions ii. Postpones gain (but does not recognize loss) if and when the newly acquired property is subsequently disposed of in a transaction where a non-recognition provision does not apply 1. Holding period of the old property is tacked onto the new property iii. Special provisions: 1. Property of a like-kind that is exchanged will not have realized gain or loss for the property which was given up in the exchange §1031 2. Gain (but not loss) from a compulsory or involuntary conversion may not be recognized if the new property, “similar or related in service or use” is acquired within certain time limits §1033 3. Sale or exchange of a principal residence resulting in a gain – the gain will not be recognized to the extent of $250K or $550K for married people filing jointly §121 iv. Like-kind Exchanges: 1. Generally: a. No gain or loss when qualifying property is exchanged solely for other qualifying property of a like kind – like kind is a very broad term, e.g., real estate = real estate (whether raw land given for developed land or apartment building given for office building) b. If property other than qualifying property is received in the exchange then some portion of the gain (but not loss) realized with respect to the relinquished property will be recognized §1031(a)(1), (b) and (c) c. Non-recognition does not apply to exchanges between related parties if either of them disposes of the property within 2 years §1031(f) d. CANNOT BE AN EXCHANGE IF MONEY WAS TRANSFERRED AS CONSIDERATION – if money was exchanged for the transfer of property, it is a sale, which is property transferred in consideration of a definite price expressed in terms of money i. Look @ the transaction‟s character of whether something similar was exchanged, or a lease back to the transferor may be considered an exchange 2. Qualifying Property: §1031 covers property held for productive use in a trade or business or investment property; qualifying property is NOT: a. Stock in trade or other property held primarily for sale such as inventory b. Stocks, bonds, or notes c. Other securities or evidences of indebtedness or interest v. Non-Like Kind Property 1. §1031(b) when the exchange was not SOLELY for like kind property, the difference of the property exchanged is called “Boot” and the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of money and the FMV of such other property 2. Mortgages assumed or property taken „subject to‟ a mortgage – the amount of the liability (the mortgage) is treated as Boot – AKA “Mortgage Netting” a. Only the person who has more liabilities relieved (a net reduction in their liabilities) will have a Boot for purposes of – under the Regs… not the Code XIII. 3. Deferred Exchanges – J.P. Starker story – “Starker Exchanges” §1031(a)(3) a. Exchanges do not have to be simultaneous i. Property has to be identified within 45 days ii. Deal has to close within 180 days b. The way to sell a property and not pay taxes on it – use an intermediary who is acting as a trustee then the exchange is like kind and not for $ 4. Liabilities 5. Exchanges Between Related Persons vi. Basis of Property Acquired in an Exchange 1. Basis of the property exchanged is the original basis of the property §1031(d) 2. The basis should result in the same amount of gain as if TP had either sold the property received in the exchange or sold the original property instead of exchanging it 3. Old Basis – money + gain = new property basis (which should equal the recognized gain, had the TP sold the property) 4. Realized Gain = amt rec‟d – adj basis c. Involuntary Conversions §1033 i. Generally: fire, condemnation, etc 1. Allows you to go from property > money > property ii. Compulsory or Involuntary Conversion iii. Conversion into Similar Property iv. Conversion into Money or Dissimilar Property 1. Purchase 2. Qualifying Corporate Stock 3. Period for Replacement v. Similar Property 1. Owner-Users 2. Owner-Investors d. Condemnation of Real Property e. Basis of Replacement Property i. Conversion Into Money or Dissimilar Property ii. Conversion Into Qualifying Corporate Stock f. Property Damaged by Presidentially-Declared Disaster Sale of Principal Residence §121 a. Generally b. Principal Residence XIV. XV. XVI. c. Limitations on the Exclusion of Gain Realized from the Sale or Exchange of a Principal Residence d. Exclusion for Taxpayers Failing to Meet Certain Requirements e. Recognition of Gain Attributable to Depreciation Transfer of Property Between Spouses or Incident to Divorce §1041(a) a. No gain or loss for property exchanged between one spouse to another or between one person and a former spouse if it was incident to divorce Miscellaneous Non-Recognition Provisions Unstated Interest a. Generally: timing and character of income in certain situations when money is borrowed under terms which do not call for payment of a reasonable interest rate while the loan is outstanding or payments occur over an extended period of time i. Arms-length Interest Rate: based on the Government‟s borrowing; AFR (Applicable Federal Rate) is the reference-standard b. Loans with Below-Market Interest Rates §7872 i. Generally: Lender Gives something of value to borrower 1. foregone interest is the interest that isn‟t being charged 2. Term Loan: Foregone interest = difference between amt going to borrower and Present Value of all payments called for a. Constant Interest Rate – the interest not being charged is due over each year the loan is due 3. Demand Loan a. If the interest rate is 2%, the interest fluctuates over the life of the loan 4. Present Value 5. $30K loan Transfer (lender to Retransfer (B > L) borrower) Gift Loan Gift Tax > Lender? Income to Lender Deduction to B? Compensation Deduction to L, Income to Income to L? B Deduction to B? Corporate Income to B Income to L, Shareholder Deductions to B? ii. Gift Loans 1. Term Gift Loans 2. Demand Gift Loans 3. Exceptions – Gift loans between individuals (parents to kids, etc. under §7872(c)(2) there‟s a $10K de minimis exception for gift loans between individuals if the loan is not for acquisition of an asset which produces income iii. Non-Gift Loans 1. Term Non-Gift Loans 2. Demand Non-Gift Loans 3. Exceptions iv. Compensation Loan v. Corporation Shareholder Loan c. Original Issue Discount i. Deferred Payments for Property 1. Debt Instruments Without Adequate Stated Interest 2. Debt Instruments With Adequate Stated Interest 3. Exceptions ii. Loans d. Interest on Certain Deferred Payments XVII. Special Rules a. Generally: Income from annuities and deferred compensation plans are subject to special rules governing their inclusion in gross income b. Annuities: c. Deferred Compensation XVIII. Families XIX. Assignment of Income a. Generally: i. Income taxed against the TP who earns it or TP who owns property which generates income ii. Lucas v. Earle: Husband and wife K to split their income when they filed their returns 1. Fundamentally, income is taxed to the person who earns it 2. Includes income from services when those services are performed 3. ** Does not matter anymore now that we have joint returns b. Income from Services i. GI is of the person who performs the services, even when 1. TP makes a K agreement w/another saying they will share tax burden of the income 2. TP arranges that their pay be assigned/diverted to someone else 3. TP may avoid being taxed for svcs they provide gratuitously ii. Income generated by a person acting as an agent or employee of another is taxed against the principal or employer iii. Giannini: 1. Not income when you don‟t control who gets it 2. Not income when the money is not paid to you – gratuity to someone else c. Income from Property i. Generally: 1. Rents from real property, interest from bonds, dividends from stock 2. Such income cannot be redirected to someone else and is charged to the owner of the property (e.g., bond holder will be taxed even though he gives someone else the coupons to collect on the bond) ii. Income Interest in Property 1. Splitting an estate into current and future estates (life estates w/remainder, etc.) – taxes assessed against the fee owner if there is one, or the transferee-holder of the current estate 2. e.g., “Fruit is taxed to the owner of the tree.” 3. Sales proceeds create property income: a. Salvatore Case: Salvatore owned a Texaco station and Texaco wanted to buy the station, Salvatore wanted to divvy up the station so that her relatives could have some of the proceeds and she would lower her tax liability – ct said the income/gain is taxed against the owner of the property iii. Ripeness: 1. Income taxed to the TP who owns the property at the time the income is paid or when the right to the income becomes fixed 2. Cannot be diverted by transfer to another party once the income is sufficiently ripe d. Anticipatory Assignment for Value e. Income Producing Entities i. Generally: 1. Assignment of Income Doctrine: TP may shift income to an entity such as a corp., partnership, or a trust 2. The Corp is taxed as a separate TP – tax rates of corps is §11(b) – and taxed a second time when it is distributed as dividends to shareholders ii. Aggregation :: Partnership §§701-761 1. Does the partnership or the owners of the partnership pay taxes? Does it pass through? a. Partnership = 0 tax; Partners of the Co. = $ tax on income iii. Entity :: Corporation 1. Corp has to pay its own taxes (from 15% to 35%) §11(b) 2. S Corps (smaller corps) not subject to inc tax itself but the items of income flow through to shareholders as GI and the S corp can deduct or credit those payments iv. Trust: Complex or Simple Trust (Simple is the distribution of all income current) Tax to the beneficiary when the beneficiary gets the 1. Depending on the terms of the trust, income of the trust may be taxable to the grantor, beneficiaries, or the trust itself 2. When trust‟s income is taxable, $1850 taxed @ 15%; taxable income over $1850 taxed @ increasing rate until it hits the amount of $9200 §1(e) f. Assignment of Income through a Partnership (Assignment of Income generally [704(e)(2)] i. Is the partnership valid? Facts are scrutinized in order to ensure the partnership is not being used to assign income 1. If one of the partners appears to be doing all the work, but income is being divided between that XX. partner and another, then the partnership may not be recognized by the Service ii. Partnership where Capital is a Material IncomeProducing Factor 1. Generally: when the capital generates the income in a partnership, income and it‟s tax liability is allocated among the partners based on the partnership agreement 2. Reallocation of Partnership Income: g. Allocation of Income and Deductions Among Taxpayers h. Grantor Trust – Clifford Trust – Reversionary Trusts: i. §673 – if the grantor has a reversionary interest in either the corpus or the interest generated from the trust, and if as of the beginning of adding that property to the trust, the interest value is more than 5% greater than the original corpus or portion that generated the income, then the grantor is considered still to be the owner ii. §676 – Power to Revoke: if you retain any power to revoke the trust to yourself, you will be taxed because you are still essentially the owner iii. §677 – Power to Revoke: 1. Income imputed to the grantor of the trust, either now or later Alimony, Child Support, and Property Settlements §71 a. Alimony i. Payor: deduction ii. Payee: income iii. Must be payment in cash, and not payment “in kind” 1. Received under a written agreement under a divorce or a separation agreement or decree 2. Something cannot be taken “in kind” and deemed alimony 3. You can take something that is alimony and deem it not alimony 4. Can‟t be living together plus divorced under a decree, have one person pay the other cash toward living expenses, and then call it alimony – but the rule does not apply if you are not legally divorced and are living under the same roof (part of the same household), REMEMBER TO HAVE A WRITTEN INSTRUMENT SETTING THE AGREEMENT OUT in order to live under the same roof iv. Death terminates obligation to pay alimony, v. Nunc Pro Tunc - §71(c)(2) anything changing the amount of child support and reducing the amount, then the reduced amount will be attributable to child support obligation to the payor vi. §71(f): Front-loading of alimony payments: 1. Excess Alimony: after the close of the third year for alimony payments, if the amount is excess over the agreed-upon amount, then the Payor will have to take the excess as income Year 1: $200K Y2: $100,000 Y3: $50,000 Payor Deducts 200K Deducts 100K Deducts 50K Payee Income 200K Income 100K Income 50K Y1: 100K (67.5K Y2: 75K (50K excess) Y3: 10K excess) Payor 100K deduction 75K deduction 10K deduction Payee 100K income 75K income 10K income 2. Computation: a. Start @ the 1st post-separation year‟s amount b. See page 281-282 of supplement for formula c. HOW: i. Take Y2, subtract (sum Y3 + 15K [because of fluctuation of 15K is permitted]) ii. Take that excess and it is the excess for Y2 iii. Take the excess and subtract it from Y2 iv. Take that amount and add it to + Y3 and divide by 2 v. Take that number and add 15K, the result from this calculation is subtracted from Y1 and becomes the Y1 excess vi. Take Y3 and add to the payor‟s deduction the excess amounts from Y1 and Y2 – this is his net income vii. Take the same amounts and add them to payee‟s income calculation – the amount may be so high that no payee would have enough deductions to make use of the income they never received or to receive a benefit to use the high amount of deductions b. Child Support i. Payor: no deduction ii. Payee: not income c. Property Settlements i. Payor: no deduction ii. Payee: Not income d. Indirect Alimony e. Property Transferred Incident to Divorce §1041 i. Subsection (a): no gain/loss for prop transferred to a spouse or to an ex-spouse incident to divorce ii. Subsection (b): transfer is treated as a gift and the basis of the transferee is the same as that of the transferor (Differs from §1015 gift-basis rule and does not contain the exceptions) 1. It would be best to receive property with the highest basis possible or a basis as close to FMV as possible because the tax will be calculated based on the difference between the basis and the FMV of the property a. §71(b)(1)(b) iii. Subsection (c): must be incident to divorce and is considered so if: 1. within 1 year of dissolution 2. related to the cessation f. *** Exam: Domestic Relations: Issues will include whether an agreement is written and the consequences of the transaction to the payee Capital Gains and Losses §1222 a. Generally b. Capital Gains i. Long Term Capital Gains: 1. Generally: gets preference except for the time period of 1986 Act which lowered long term cap gains – only lasted for 4 years 2. Justified because gains accrued over a long period of time push TPs up into brackets they shouldn‟t normally be in – they didn‟t build that gain over night, but to tax those gains normally would disproportionately tax the gain 3. 15% max preference rate §1h XXI. c. d. e. f. g. ii. Net Long-Term Capital Gain: 1. Defined: gain/loss from sale/exchange of capital asset iii. Adjusted Net Capital Gain iv. 28% Rate Gain v. Collectibles Gain vi. Unrecaptured Section 1250 Gain vii. Section 1202 Gain Maximum Rates for Capital Gains i. General Rate Structure ii. Exceptions to the General Rates Application of Capital Gain Rates Capital Losses i. Generally ii. Limitation on Capital Losses 1. Losses to the Extent of Gains 2. Additional Amount 3. Netting Long-term Capital Gains Against Longterm Capital Losses iii. Capital Loss Carryovers Capital Assets §1221 (a) i. Investment and personal use property ARE capital assets ii. Property held by TP IS capital asset, with some exceptions, such as: 1. Inventory held primarily for sale to public or used for ordinary course of TPs trade or business 2. Careful here – that a capital asset does not get converted by your activities into ordinary income (hypo where you have 50 acres and then instead of selling it all in 1 parcel, you sell it in pieces – those pieces become inventory and part of your income. You then have to pay ordinary income tax rates on the $ made in all those transactions instead of 1 set of lower (max 15%) cap gain tax iii. §1223: We will not cover the distinction between short and long term capital gains iv. Separate Capital Gains/Losses from other gains/losses 1. Look @ long term v. short term – if you have more long term than short term Statutory Definition of Capital Assets i. Inventory 1. Property Primarily held for sale to customers in the ordinary course of business 2. Real property subdivided for sale 3. Depreciable property and real property used in trade or business 4. Copyrights and similar property 5. Accounts Receivable 6. Publications of the US Government 7. Commodities Derivative Financial Instruments 8. Hedging transactions 9. Supplies ii. Income Property h. §1211-1212 Computations: i. Take STCG First ii. Deduct $3K/year ord deds iii. Carry forward what you don‟t use iv. Take your left over LTCG/L as carry over i. §1231 – (Determining Gains/Losses – Special Rules) Property used in the trade or business and involuntary conversions i. §1221(a)(2) – only applies to prop used in trade/business, not investment property (that is not a capital asset) and such property must be held for > 1 year ii. §1231 was sort of brought forth to help businesses maximize their gains (LTCG treatment) and losses (Ord Losses treatment) 1. Gains > Losses = LTCG (and then you balance them against losses using §1222) 2. Losses => Gain = OL iii. “The Main Hotchpot” §1231(a)(3), (4) 1. §1231 gathers the gains and losses, especially those from involuntary conversions resulting in gains and losses a. If net gain – LTCG (see §1242 for CG) b. If net loss – Ord Loss c. BUT look @ §1231(c)(2) – you will have to do the recapture of gain as ordinary income for following years because of this subsection because there is a 5 year grandfathering of gains/losses i. So essentially, if the capital gains rate remains the same for that 5 year period – you will end up paying the same amount of tax as if you had sold them both at the same time. j. 2. “The Sub-hotchpot” – takes the involuntary conversions, through CASUALTY, FIRST – and if there‟s an involuntary loss, such that it is one that is not from a sale or exchange, then it makes it an ordinary loss and better treatment a. If they come out with an involuntary gain, then the amount is thrown into the Main Hotchpot b. If it amounts to a net loss on invol. Loss from casualty, then these items are thrown out of §1231 and called an ordinary loss because of no sale or exchange 3. Essentially: a. Involuntary conversion: falls under §1231 b. Test casualties twice, because there are 2 kinds of involuntary losses i. Casualty – fire, storm, etc. ii. Condemnation – Gov‟t taking; property converted may already be part of §1231 if it was used in trade or business 1. If the asset was iv. Takes into account rapid depreciation which was taken 1. If rapid depreciation was taken then v. Applies to property held > 1 year and used in the TPs trade or business 1. Real property 2. Property of a character subject to depreciation 3. Certain property excluded under §1231(b)(1) a. Inventory on hand @ end of year b. Property held for sale to customers c. Copyrights, literary or musical compositions [or property defined in §1221(a) d. Government published works e. Timber, Ore, Coal f. Livestock – cattle, horses, dairy (but poultry sales may be subject to CGs) g. Unharvested crops §1245 – (Determining Gains/Losses – Special Rules) Gains from dispositions of certain depreciable property – recaptures income, regardless of §1231 i. Gains exceed losses – if gains > losses, then they are LT CG ii. Machines, trucks, etc. §179 property == §1245 property iii. Gain is OI to extent of the lesser of (whichever is smaller): 1. Gain (the difference between the depreciation taken and the gain then goes over to §1231 possibly) 2. Depreciation taken (this amt will then be recaptured as OI) iv. You would need to report the smaller of the two as Ord Inc k. §1250 (mechanics of this section is not on exam) – Gain from disposition of certain depreciable realty i. Less rigorous than §1245 ii. Allows: Amt actually taken less the amount TP would have been able to take under straight line depreciation iii. Up to 1987 – real property could have accelerated depreciation, but now it is not allowed – HOWEVER, it is as of the date the property was put in service, because, remember, once you set forth a depreciation scheme, you can keep using such a method until you dispose of the property (the new owner who purchases after 1986, then they cannot use accelerated depreciation) 1. Even so, the useful life back then for say a commercial building, is only 20 years and as of 1/1/2006, the timeframe will be up l. Sale or Exchange Requirement i. Generally ii. Special Rules 1. Worthless Securities 2. Nonbusiness Bad Debts 3. Options 4. Cancellation of Lease of Distributor‟s Agreement 5. Transfers of Franchises, Trademarks, and Trade Names 6. Amounts Received on Retirement of Debt Instruments m. Holding Period i. Generally ii. Special Rules 1. Nonbusiness Bad Debts 2. Exchanged Basis Property 3. Transferred or Carryover Basis Property XXII. XXIII. XXIV. XXV. XXVI. XXVII. 4. Wash Sales of Stock or Securities 5. Property Acquired from a Decedent 6. Short Sales of Property n. Correlation with Prior Transactions i. There has to be symmetry of transactions – when you liquidate a business and get the $$ then you will have to pay it back if for some reason you have a judgment against the company later o. Special Provisions i. Options ii. Patents iii. Dealers in Securities iv. Small Business Stock v. Conversion Transactions Quasi-Capital Assets a. Generally b. Section 1231 Assets c. The Subhotchpot d. The Main Hotchpot e. Recapture Sale of Depreciable Property Between Related Taxpayers Recapture of Depreciation a. Generally b. Recapture Under Section 1245 i. Generally Retained Earnings: running earnings of the company retained to make payment to stockholders Eisner v. Macomber: Income is gain derived from capital, labor or both combined a. Puts the burden on the State to prove the source of the income as being derived from capital or labor or a combination of both b. In 1955 – the Sup Ct looked @ antitrust case (RICO treble damage award) to see if a damage provision such as this could be considered income Medical expenses – limited to that which exceeds 7.5% of AGI