Law School Outline - Basic Tax Outline - Carey

Basic Tax I - Carey Summer 2003 Page 1 of 56 Basic Tax I I. Background Information A. Kinds of Federal Taxes 1. Income Tax a. Personal b. Corporate 2. Excise Tax a. Tax on consumption or buying of goods and services. 3. Estate Taxes a. Tax on the privilege of transferring wealth. b. Three components i. Estate Tax ii. Gift Tax iii. Generation Skipping Tax 4. Sales Tax a. Tax on consumption or buying of goods and services. 5. Payroll Taxes a. Taxes taken out of wages for social security, unemployment, disability, etc. b. Social Security Tax i. Percentage of wage base that you get as a benefit lowers as income rises. ii. Replacement Ratio – the amount of income replaced by benefit. iii. Basically, this is an income transfer program. B. Income Tax 1. Tax on receiving wealth. 2. Evolution of income tax a. 1960 – Individuals paid 2/3 of tax, corporations paid 1/3 of tax. b. 2000 – Individuals paid 5/6 of tax, corporations paid 1/6 of tax. 3. Focus of this class is individual income taxes. 4. History of Individual Income Taxes a. Tax on increase in wealth. b. Taxes are imposed by legislation – specifically, Congress. c. U.S. Constitution provides for collection of taxes. d. First income tax enacted during Civil War ~ 1862. e. After Civil War, income tax was terminated ~ 1868. f. Progressive Income Tax enacted in 1892. g. U.S. Supreme Court held the Act unconstitutional as to individuals because direct taxes must be apportioned among the several states. h. Tax was abolished ~ 1895 as per individuals. i. Tax on corporations was valid. j. Sixteenth Amendment to U.S. Constitution – 1913 i. Provided for individual income tax. ii. Very low tax rates. C. D. E. F. G. H. Basic Tax I - Carey Summer 2003 Page 2 of 56 iii. Did not become significant in most people’s lives until WWII. k. Internal Revenue Code of 1939 l. Most taxes are paid by people in upper income brackets. i. Roughly 1/3 of income taxes paid by upper 1% of income earners. ii. Roughly 1/2 of income taxes paid by upper 5% of income earners. iii. Bottom half of income earners pay virtually nothing. Tax system is a lousy way to distribute social policy benefits because it cannot reach all people – particularly those people who need the benefits the most. Homeless people don’t file taxes. Tax Bills 1. Begins in House of Representatives 2. Goes to House Ways and Means Committee a. Issue a House Ways and Means Committee Report 3. Goes to Senate 4. Goes to Senate Finance Committee a. Issue a Senate Finance Committee Report 5. Appoint Conference Committee a. Representatives from House and Senate b. Reconciles House and Senate recommendations 6. Bill goes to President Three most common ways for audit 1. Discrete variable analysis a. Computer compares numbers on returns and flags unusual entries. b. Analysis of relationship between variables. 2. Taxpayer Compliance Measurement a. Statistical audits 3. Someone turns the taxpayer in to the IRS. Cash and Accrual Taxpayers 1. Cash Method a. Income when received. b. Deductions when paid. 2. Accrual Method a. Income when all events have occurred which fix his right to receive the item and fix the amount of the item. b. Deductions when all events have occurred which fix his liability to pay items, the amount payable becomes fixed, and certain tests of economic performance are satisfied. Letter Rulings are issued by IRS at request of taxpayer to determine tax consequences of specific fact scenarios. Sections of IRC Covered in Class 1. § 1 – Tax Imposed 2. § 61 – Gross Income Defined 3. § 71 – Alimony and Separate Maintenance Payments Basic Tax I - Carey Summer 2003 Page 3 of 56 4. § 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts 5. § 101 – Certain Death Benefits 6. § 102 – Gifts and Inheritances 7. § 103 – Interest on State and Local Bonds 8. § 104 – Compensation for Injuries or Sickness 9. § 105 – Amounts Received Under Accident and Health Plans 10. § 106 – Contributions by Employer to Accident and Health Plans 11. § 111 – Recovery of Tax Benefit Items 12. § 117 – Qualified Scholarships 13. § 121 – Exclusion of Gain from Sale of Principal Residence 14. § 127 – Educational Assistance Programs 15. § 135 – Income from United States Savings Bonds Used to Pay Higher Education Tuition and Fees 16. § 151 – Allowance of Deductions for Personal Exemptions 17. § 152 – Dependent Defined 18. § 162 – Trade or Business Expenses 19. § 163 – Interest 20. § 164 – Taxes 21. § 165 – Losses 22. § 166 – Bad Debts 23. § 167 – Depreciation 24. § 168 – Accelerated Cost Recovery System (ACRS) 25. § 170 – Charitable, etc., Contributions and Gifts 26. § 178 – Amortization of Cost of Acquiring a Lease 27. § 179 – Election to Expense Certain Depreciable Business Assets 28. § 183 – Activities Not Engaged in for Profit 29. § 212 – Expenses for Production of Income 30. § 213 – Medical, Dental, etc., Expenses 31. § 215 – Alimony, etc., Payments 32. § 262 – Personal, Living, and Family Expenses 33. § 265 – Expenses and Interest Relating to Tax-Exempt Income 34. § 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers. 35. § 274 – Disallowance of Certain Entertainment, etc., Expenses 36. § 453 – Installment Method 37. § 483 – Interest on Certain Deferred Payments 38. § 529 – Qualified Tuition Programs 39. § 530 – Coverdell Education Savings Accounts 40. § 673 – Reversionary Interests 41. § 676 – Power to Revoke 42. § 677 – Income for Benefit of Grantor 43. § 704 – Partner’s Distributive Share 44. § 1014 – Basis of Property Acquired from a Decedent 45. § 1015 – Basis of Property Acquired by Gifts and Transfers in Trust 46. § 1033 – Involuntary Conversion II. Basic Tax I - Carey Summer 2003 Page 4 of 56 47. § 1041 – Transfers of Property Between Spouses or Incident to Divorce 48. § 1031 – Exchange of Property Held for Productive Use or Investment 49. § 1221 – Capital Asset Defined 50. § 1222 – Other Terms Relating to Capital Gains and Losses 51. § 1223 – Holding Period of Property 52. § 1231 – Property Used in the Trade or Business and Involuntary Conversions 53. § 1245 – Gain from Dispositions of Certain Depreciable Property 54. § 1250 – Gain from Dispositions of Certain Depreciable Realty 55. § 1341 – Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right 56. § 7872 – Treatment of Loans with Below-Market Interest Rates Determining Income Tax Liability A. Gross Receipts – Cost of Goods Sold = Gross Income B. Gross Income = Increase in wealth. 1. This is the first step for most people. 2. IRC § 61 Gross Income Includes a. Compensation for services, including fees, commissions, fringe benefits, and similar items; b. Gross income derived from business; c. Gains derived from dealings in property; d. Interest; e. Rents; f. Royalties; g. Dividends; h. Alimony and separate maintenance payments; i. Annuities; j. Income from life insurance and endowment contracts; k. Pensions; l. Income from discharge of indebtedness; m. Distributive share of partnership gross income; n. Income in respect of a decedent; and o. Income from an interest in an estate or trust. 3. List is not all inclusive. C. Minus 1. Trade or business expenses a. IRC § 162 2. Investment expenses a. IRC § 212 D. Equals Adjusted Gross Income (AGI) 1. Only applies to individuals E. Minus 1. Itemized or Standard Deductions 2. Personal and Dependent Exemptions 3. Deductions and exemptions are a subtraction from the amount subject to tax. Basic Tax I - Carey Summer 2003 Page 5 of 56 F. Equals Taxable Income G. Multiply by Rate in Tax Tables 1. IRC § 1 H. Equals Tentative Tax Liability I. Minus Tax Credits 1. Earned Income Tax Credit (EITC) 2. Foreign Tax Credits 3. Credits are a subtraction from tax liability itself. 4. If credit results in negative tax liability (refund), the refund will only be given if the tax credit is refundable. a. EITC is the only refundable tax credit. J. Equals Tax Liability Formula for Determining Tax Liability: Gross Receipts Cost of Goods Sold = Gross Income Trade of Business Expenses Investment Expenses = Adjusted Gross Income Itemized or Standard Deductions Personal and Dependency Exemptions = Taxable Income X Tax Rate = Tentative Tax Liability Tax Credits = Tax Liability K. Tax Rates 1. Use maximum tax rate of 40% for class. a. Can be used to analyze investments and tax savings. b. Called the marginal bracket. 2. Married Filing Jointly – IRC § 1(a) 3. Heads of Households – IRC § 1(b) 4. Unmarried Individuals – IRC § 1(c) 5. Married Filing Separately – IRC § 1(d) 6. Estates and Trusts – IRC § 1(e) L. Savings from deductions are tied to tax bracket. 1. If in 40% bracket, deductions save 40%. 2. If in 15% bracket, deductions save 15%. 3. When we subsidize through tax deductions, this gives more money in terms of tax savings to the more affluent people. M. Savings from credits are NOT tied to tax bracket. 1. Credits come off of tax liability, NOT the amount subject to tax. 2. Some credits have limits as to the maximum. Basic Tax I - Carey Summer 2003 Page 6 of 56 III. 3. Some credits are based on percentages. Gross Income A. IRC § 61 1. List is not all inclusive. 2. Income from discharge of indebtedness is an interesting one to look at. Starting point is Net Worth Net Worth is the value of all assets MINUS all liabilities. Assets Cash House Investments Total Liabilities Short-term debts $7,000 Mortgage $180,000 Total $187,000 $10,000 $200,000 $50,000 $260,000 Net Worth is $260,000 Minus $187,000 or $73,000 If mortgage was satisfied by paying $150,000, Net Worth would increase by $30,000 and must be included as income under income from discharge of indebtedness. B. Imputed Income 1. The monetary value of goods and services which someone produces and consumes within the family unit, as well as the monetary value of using property which someone owns. 2. The economic return from the use of property by the person who owns it. 3. Imputed income is not taxed. C. Increase in Value 1. For income tax purposes, income does not include the mere increase in value of an item of property between two points in time. 2. There must be some sale or other disposition of an item of property before the appreciation is realized and becomes gain included in gross income. 3. Example: Bought 1,000 shares for $10/share. Appreciated in value to $12/share. Do not have to pay taxes on $2,000 unless it is realized. 4. Realization is required for income. a. A related concept is ―recognition‖ – Legislature can decide when gain or loss has been realized is not appropriate for taxation, based upon policy reasons. D. Borrowing 1. If there is an obligation to repay money, it is not income. 2. There is a receipt of income plus an offsetting liability due to debt, there is no taxable income. E. Illegal Gains Basic Tax I - Carey Summer 2003 Page 7 of 56 1. Money or other property which is illegally acquired is included in gross income for tax purposes. F. Rebates 1. Amount of rebate is not income to the purchaser. 2. Amount of rebate is simply a reduction in the purchase price of the item of property. G. Damages 1. Amounts received as damages may provide an economic benefit to the recipient, and thus the amount received may be included in gross income. H. Examples of Gross Income 1. Compensation for Services a. Types i. Payment ―In Kind‖ 1) Included in gross income in the amount of fair market value. 2) When you get income in kind, it is treated as an investment. Therefore, when sold, would only pay taxes on increase over investment. ii. Compensation Without the Receipt of Cash or Property 1) If, as compensation for services rendered, an employee receives an economic benefit, she has income even though she did not directly receive any cash or other property. 2) Indirect compensation for services rendered. 3) Also would be income if conferred benefit on someone close. 4) Must be intended as compensation for services rendered. iii. Bargain-Purchase 1) If, as compensation for services rendered, an employer sells property to employee for less than market value, the employee must declare the difference as income. 2) Can be reduced as a qualifying fringe benefit. iv. Excessive Compensation 1) Payments made to an individual who is both an employee and a shareholder in the form of dividends. 2) Must be declared as income for tax purposes if done for compensation for services rendered. 2. Gains Derived from Dealings in Property a. Basis i. Starting point for determining whether there is a gain or loss on the sale of property. Basic Tax I - Carey Summer 2003 Page 8 of 56 ii. Basis is a tax term for the amount of money invested in a certain piece of property. iii. In most cases, basis is derived from the cost of the item. iv. Gain/Loss = Amount Received – Basis v. Example: 1000 shares of stock at $20/share. Want to exchange for 2 acres of land. Cost basis for stockholder would be $20,000. If dealing at arm’s length, basis for landowner would be the same $20,000. vi. Basis of property acquired from a decedent 1) IRC § 1014 2) General Rule - Basis is the fair market value of the property at the time of death. 3) Basis is ―stepped up‖ to the fair market value. 4) Example – Property bought for $50K, Appreciates to $500K, Owner Dies, Heir Sells for $600K. Basis is $500K, so Heir would only pay taxes on $600K-$500K=$100K 5) Essentially, original cost is irrelevant. 6) Considered one of the greatest loopholes in the tax code. 7) Part of Estate Tax phase-out is elimination of IRC § 1014. 1/1/2010. Except for some exceptions. 8) IRC § 1014(e) prevents abuse by transferring property to relatives about to die by gift and then they will the property back. i) § 1014(e) disallows this if appreciated property was acquired by the decedent by gift within a year of the date of death AND such property was returned to the original donor (or their spouse). vii. Property Acquired by Gift 1) IRC § 1015 2) General Rule - Basis of the property in the hands of the donee is the same as it was in the donor. 3) Basis is NOT stepped up as in property acquired from a decedent. 4) Example – Property bought for $50K, Appreciates to $500K, Owner Gives Gift to Child, Child Sells for $600K. Basis is $50K. Child would pay taxes on $600K - $50K = $550K. 5) Exception i) Rule does not apply if (both must be met) a) The donor’s adjusted basis in the property is greater than the fair market value of the property, both Basic Tax I - Carey Summer 2003 Page 9 of 56 amounts computed as of the date of the gift, AND b) The donee sells or otherwise disposes of the property in a transaction which would produce a loss. ii) If the exception is triggered, the property’s basis is the fair market value on the date of the gift. iii) If the final sales price is between the original basis and the fair market value, there is NO gain or loss on the sale of the property. a) Between donor’s original basis and the fair market value, there is NO gain or loss. 6) Effect of Gift Tax i) IRC § 1015(d) – Increased basis for gift tax paid ii) Limits to a fraction of the gift tax paid. iii) Increase to Basis = (Gift Tax Paid) X ((FMV of Gift – Donor’s Basis)/(FMV of Gift)) iv) Example: Gift Tax Paid = $100K, Donor’s Basis = $100K, FMV = $300K, Appreciation = $200K. ((300-100)/300)) X $100K = $67K. Therefore, new basis would be $100K + $67K = $167K v) Increase to basis was intended to mitigate against double taxation. vi) Another Example: Gift Tax Paid = $200K, Donor’s Original Basis = $100K, FMV = $400K, Appreciation = $300K. ((400100)/400) X $200K = $150K. New basis would be $100K + $150K = $250K. viii. Property Acquired from a Spouse 1) IRC § 1041 2) When property is transferred from an individual to her spouse or to ex-spouse incident to divorce, the property is received by the transferee as a gift, and its value is thereby excluded from gross income. 3) There is no gift tax on transfers between spouses. 4) There is no exception in § 1041. The basis is ALWAYS the transferor’s original basis. 5) Can pass losses around between spouses. ix. Adjustments to Basis 1) Increases Basic Tax I - Carey Summer 2003 Page 10 of 56 i) The basis is increased by the amount of capital expenditures, such as the cost of capital improvements made to the property. ii) Cost of acquisition is included in the basis. a) Commissions and other expenses connected with the acquisition of property is included in the basis of the property. 2) Reductions i) The amount of the reduction in basis on account of deductions for depreciation, amortization, or depletion is the greater of the amount allowed (taken) or the amount allowable (could have been taken). ii) Most common reduction in basis is depreciation. a) Deduction of the cost of a capital asset spread out over the useful life of the asset. b. Amount Realized i. Fair Market Value of Consideration Received 1) Price at which the property would change hands between a willing buyer and seller. 2) The amount realized includes the receipt of services and other economic benefits, including being relieved of a liability. ii. Selling Expenses 1) Cost of acquisition is included in the basis. i) Commissions and other expenses connected with the acquisition of property is included in the basis of the property. 2) Cost of disposition is included in the amount received. i) Commissions and other expenses connected with the disposition of property is deducted from the amount received. iii. Apportionment 1) If several items of property are sold for one lump sum, purchase price must be apportioned among the items being sold. 2) Apportioned according to the relative fair market values. iv. Mixed Motive Transactions 1) If the facts indicate that a portion of the payment is being made for purposes other than the sale of the property, such amount will not be included in Basic Tax I - Carey Summer 2003 Page 11 of 56 the amount realized for the disposition of the property. v. Role of Liabilities 1) If property which is encumbered by a liability is sold or otherwise disposed of and the liability is assumed by the buyer or the property is taken subject to the liability, the amount of the liability is included in the seller’s amount realized. 2) Example - $1,000,000 cost of house, buyer paid $100,000 in cash and obtained a mortgage for $900,000. Later, sold the house for $1,200,000. Mortgage was still $900,000. Would net $300,000. However, owner took depreciation of $200K on the house based on entire $1,000K. Therefore, the basis was $800K. To calculate gain or loss, must include take over of liabilities as an amount received. Gain in this example would be $1,200K - $800K = $400K. 3) When someone takes over your liability, it is treated as though you received the amount of the liability. 4) Crane v. Commissioner, 331 U.S. 1. The reason Crane is so important is that it basically holds that depreciation can be taken on the total amount of the asset, including the amount encumbered by a liability. c. Realized Gain (Loss) v. Recognized Gain (Loss) i. The entire amount of a realized gain or loss is required to be recognized, unless a specific provision provides otherwise. ii. If a realized gain is recognized, it is included as an item of gross income. 3. Items Specifically Included in Gross Income By Statute a. Alimony and Separate Maintenance Payments i. Alimony is income. ii. Child support is not income. b. Services of a Child c. Reimbursement for Expenses of Moving d. Annuities I. Items Specifically Excluded from Gross Income by Statute 1. Proceeds of Life Insurance a. In General i. IRC § 101 ii. Excludable benefits must be paid ―by reason of the death of the insured‖. iii. Congress modified this by IRC § 101(g) which allows to exclude if a viatical settlement. Basic Tax I - Carey Summer 2003 Page 12 of 56 iv. Exclusion is not applicable for 1) Person who receives Cash Surrender Value paid prior to death. 2) Person who elects to receive annuity payments or other lifetime benefits. b. Installment Payments of Proceeds i. Income is only excluded in the amount of the lump sum payable at the date of insured’s death or, if payments are to be made in the future, the date-of-death present value of such future payments. ii. If the beneficiary chooses to receive benefits in the future in installments, would only be able to exclude the apportioned lump sum value in each year of distribution. 1) Example - $100,000 lump sum benefit or $12,000 in each of the next 10 years. Would be able to exclude $10,000 in each of the next 10 years but would have to include $2,000 as income in those 10 years. iii. IRC § 72 discusses annuities of this sort. iv. Insurance companies base annuities on 1) Life Expectancy 2) Rate of Return on Investment v. To determine amount of income from annuity subject to tax 1) Compute ―Exclusion Ratio‖ i) Lump Sum Payment Divided by ii) ―Expected Return‖ = Life Expectancy X Annual Benefit Equals iii) ―Exclusion Ratio‖ 2) Multiply Exclusion Ratio by Annual Benefit – This is the amount of the annual benefit that is NOT subject to tax. 3) If you outlive the initial assumptions for life expectancy, the exclusion is LOST because the proceeds are all profit. i) Must pay taxes on total annual benefit. 4) If you do not outlive initial assumptions for life expectancy, estate gets a deduction in the amount of difference between lump sum and amount that has been excluded from tax. c. Transfer of Policy for Valuable Consideration i. In the case of a transfer for valuable consideration, the general rule for exclusion as income does not apply. 1) Two Exceptions that would make the exclusion apply – would NOT count as income. i) If the transferee of the policy has a transferred basis in the policy; or Basic Tax I - Carey Summer 2003 Page 13 of 56 ii) If the transferee is the insured, the insured’s partner, or a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or an officer. 2. Gifts and Inheritances a. IRC § 102 b. Gross income does not include amounts received as a gift, bequest, devise, or inheritance. c. Gifts i. For purposes of income tax, gift is defined as ―the transfer of property out of affection, respect, admiration, charity, or like impulses or from the transferor’s detached and disinterested generosity.‖ 1) This is a subjective approach. 2) Narrower definition of gift. ii. For purposes of gift tax, gift is defined as ―the transfer of property for less than an adequate and full consideration in money or money’s worth.‖ 1) This is an objective approach. 2) Broader definition of gift. d. Inheritances i. Inheritances are excluded from gross income. ii. Assumption is that inheritance is of a donative nature. iii. If the legacy is not of a donative nature, it CANNOT be excluded from gross income. 1) Motives such as for compensation, payment for property, repayment of debt, etc. would not be donative and thus, must be included in gross income. iv. If executor of estate is paid from the estate, the commission would be considered income to the executor and must be included in gross income. 3. Interest on State and Local (Municipal) Bonds a. IRC § 103 b. Generally, gross income does not include interest received with respect to obligations issued by or on behalf of the government of DC, any State, or any of their political subdivisions. i. Political subdivisions are those that have the authority to exercise sovereign powers. c. Interest received with respect to obligations issued by the Federal government does not qualify for the exemption and must be included in gross income. d. Allows States to borrow money at lower rates because they can give lower interest rates for their bonds and the investor will still find it attractive because of the tax benefits. Basic Tax I - Carey Summer 2003 Page 14 of 56 i. Basically, it is a subsidy for investment in State and Local governments. e. Exceptions i. Arbitrage Bonds – State or Local bond where the proceeds are reasonably expected to be used, directly or indirectly, by the State or Local government to acquire higher yielding investments. ii. Private Activity Bond which is not a qualified bond. 4. Compensation for Injuries or Sickness and Damages a. Introduction b. IRC §§ 104, 105, 106 c. Compensation for Injuries or Sickness i. Damages for Personal Physical Injuries or Physical Sickness 1) Generally i) IRC § 104(a) ii) Amount of any damages received on account of personal physical injury or physical sickness. iii) Damages recovered for mental anguish must be included in gross income. iv) Only excludes compensatory damages. Punitive damages must be included in gross income. v) Damages recovered for business-related injury must be included in gross income. 2) Defining Physical Injury or Physical Sickness i) Exclusion is limited to any damages received for physical injury and physical sickness. ii) Includes emotional distress that had its origin in a physical injury or physical sickness. ii. Recoveries Under Accident or Health Insurance – IRC 104(a)(3) 1) Amounts received from accident or health insurance for personal injuries or sickness are excludable from gross income. 2) Exclusion does not apply if the payments are made to an employee either 1)under an accident or health plan to which the employer made contributions which were excluded from the employee’s gross income, or 2)by the employer. d. Payments for and recoveries under Employer-provided accident or health plans i. IRC § 105 and 106 ii. An employee may exclude from gross income amounts which his employer contributes on his behalf to accident or health Basic Tax I - Carey Summer 2003 Page 15 of 56 plans to compensate the employee for personal injuries or sickness. iii. Payments made to an employee either directly by the employer or under an accident or health plan to which the employer made contributions which were excluded from the employee’s gross income under IRC § 106 are required to be included in gross income under IRC § 105(a), but may qualify for exclusion under another subsection of §105. iv. Amounts spent for medical care. v. Payments unrelated to absence from work. 5. Educational Provisions a. Qualified Scholarships i. IRC § 117 ii. Amounts received as a qualified scholarship by a candidate for a degree at an educational institution are excluded from gross income. b. Qualified Tuition Reduction i. IRC § 117 ii. The amount of a qualified tuition reduction is excluded from gross income. iii. Qualified tuition reduction is the amount of any reduction in tuition provided to an employee of an educational institution for education (below the graduate level) at that institution or at another educational institution. iv. Applies to tuition reductions for employee and relatives. c. Educational Assistance Programs i. IRC 127 ii. An employee may exclude from gross income up to $5,250 of the value of benefits received from his employer under an educational assistance program. d. Education Savings Accounts i. IRC § 530 ii. Income earned on Education Savings Accounts is not taxed. iii. Distributions from the account used to pay qualified education expenses are also not taxed. e. Qualified Tuition Programs i. IRC § 529 ii. Income earned on Qualified Tuition Programs are not taxed. iii. Distributions from the account used to pay qualified education expenses are also not taxed. f. United States Savings Bonds i. IRC § 135 ii. Income from redemption of U.S. savings bonds may be excluded from gross income in a taxable year in which the taxpayer pays tuition and fees for herself, spouse, or dependents. IV. Basic Tax I - Carey Summer 2003 Page 16 of 56 g. HOPE Scholarship and Lifetime Learning Credits Deductions and Allowances A. Profit Related Deductions and Allowances 1. Trade or Business Expenses a. IRC § 162 i. A deduction is allowed for ordinary and necessary expenses paid or incurred during a taxable year in carrying on a trade or business. b. Deduction i. Subtraction from gross income. c. Ordinary and Necessary i. Ordinary expenses are expenditures that are common within the business community to which the taxpayer belongs. ii. Appropriate and helpful to the business. iii. Necessary does not mean that the business would close if expense was not incurred. iv. Ultimately a question of fact, determined by surrounding circumstances. d. Expenses i. A deduction is allowed only for an item of ―expense‖, NOT a ―capital expenditure‖. ii. Capital expenditures include costs of acquiring or constructing buildings, machinery, equipment, and other property that has a useful life beyond the taxable year. iii. Expenses are amounts spent for items that will be used up within the taxable year. iv. Capital Expenditures v. Repairs 1) Incidental repair or maintenance of business property is an expense. 2) Expenditures that add to the value or useful life of the business are classified as capital expenditures. v. Advertising 1) Typically, advertising is an expense. 2) However, if the medium of advertising has a useful life of significantly more than one year, it may be considered a capital expenditure. e. Carrying On i. Ordinary and necessary expenses are deductible only if incurred while ―carrying on‖ a trade or business. ii. Expenses incurred in acquiring or starting a NEW trade or business are generally not deductible. iii. Expenses Incurred as an Entrepreneur 1) Expenses incurred in investigating a new trade or business are treated as capital expenditures and are not deductible. iv. Expenses Incurred in Obtaining Employment as an Employee Basic Tax I - Carey Summer 2003 Page 17 of 56 1) Expenses incurred in obtaining another job in the same line of work are deductible because they are incurred while carrying on a trade or business. f. Trade or Business i. Profit motive versus personal/hobby motives. ii. Expenses incurred for personal purposes are not deductible. iii. Touchstone is a profit motive. iv. IRC § 183 – Gives factors for determining whether activity is for profit. 1) Factors i) Manner in which the taxpayer carries on the activity. ii) The expertise of the taxpayer or his advisors. iii) The time and effort expended by the taxpayer in carrying on the activity. iv) Expectation that assets used in activity may appreciate in value. v) The success of the taxpayer in carrying on other similar or dissimilar activities. vi) The taxpayer’s history of income or losses with respect to the activity. vii) The amount of occasional profits, if any, which are earned. viii) The financial status of the taxpayer. ix) Elements of personal pleasure or recreation. 2) § 183 allows deduction up to the profit from the activity. g. Salaries i. IRC § 162 (a)(1) ii. Reasonable compensation paid for personal services actually rendered may be deducted. iii. Reasonableness largely based on comparisons among other similar companies. iv. Contingent Compensation Agreements 1) Compensation based on some performance measure. 2) Generally considered reasonable if the agreement was made at arm’s length and if the terms of the agreement were reasonable when the agreement was made. v. Golden Parachute Payments 1) Parachute payments are compensatory payments which has a present value h. Travel Expenses i. Cohan Rule Basic Tax I - Carey Summer 2003 Page 18 of 56 1) Under IRC § 162, do not have to have receipts – just reasonable estimate. 2) Overruled for entertainment expenses by IRC § 274. Entertainment expenses were required to be substantiated by receipts. ii. Reasonable expenses are deductible for travel away from home in pursuit of a trade or business. iii. Three requirements 1) Reasonable and necessary 2) Incurred while away from home 3) Incurred in the pursuit of business iv. If a taxpayer has both an abode and a principal place of business, home for tax purposes is the principal place of business. v. Commuting costs are not deductible because they are not done in pursuit of business. Going from job location to another job location is NOT commuting and IS deductible. vi. If assigned to work in another location temporarily for less than one year, it is away from home. vii. Golson Rule viii. In order for meals and lodging to be deductible, the travel must be overnight (24 hours). ix. Mixture of Business and Non-Business Activities 1) Transportation expenses for trips taken for both business and personal reasons are only deductible if the PRIMARY reason for the trip is for trade or business. 2) Boils down to count of number of days spent for personal and for business. Must be MORE days spent on business. 3) If you do business on a day, it is a business day. 4) Meals and Lodging are deducted ―day by day.‖ If meals and lodging are for business, you would be able to deduct. x. Foreign Travel 1) IRC § 274(c) i) Only applies to deductions that are possible under § 162. ii) Would disallow the portion of the transportation expense that the trip was for personal reasons. iii) IRC § 274 does not disallow transportation expenses if a) Such travel does not exceed one week OR i. j. k. l. Basic Tax I - Carey Summer 2003 Page 19 of 56 b) The personal portion of the trip does not exceed 25%. xi. Other Persons Traveling with Taxpayer 1) No deduction allowed for a spouse, dependent, or other person who accompanies taxpayer on trip, unless an employee. Meals i. No deduction for the cost of food or beverages is allowed if, the expenditure is lavish or extravagant or if the taxpayer or and employee is not present when the food or beverages are furnished. ii. Amount which can be deducted is generally limited to 50% of the cost. Rentals i. Expenditures for rentals or other payments required to be made for the use of property in a taxpayer’s trade or business are deductible. Education i. Expenses incurred by an individual for education are deductible if one of two test of deductibility are satisfied and neither test of non-deductibility are violated. 1) Tests for deductibility i) Maintaining or improving skills used in trade or business ii) Meeting requirements of employer or law 2) Tests for Non-deductibility i) Minimum educational requirements – expenses are non-deductible if law, regulations, or professional standards require a taxpayer to obtain the education in order to meet minimum educational requirements ii) Qualification for new trade or business ii. Travel as Education 1) Expenses for travel as a form of education are not deductible. 2) IRC § 274(m)(2) Miscellaneous Business Deductions i. Entertainment 1) Generally, only 50% of cost is allowed. 2) Must be a business benefit derived. 3) Must be ordinary and necessary. ii. Uniforms 1) Deduction is allowed if the clothing is specifically required as a condition of employment AND are not adaptable to general use. 2) Also allowed to deduct cost of maintenance. Basic Tax I - Carey Summer 2003 Page 20 of 56 iii. Dues 1) Payment of dues to an organization which is directly related to a taxpayer’s employment or other trade or business. iv. Periodicals v. Utilities vi. Taxes vii. Health Insurance for Self-Employed Individuals 2. Non-Business Expenses a. An individual may deduct all ordinary and necessary expenses paid or incurred during a taxable year i. For the production or collection of income - Investments 1) IRC § 212(1) 2) Ordinary and necessary expenses paid or incurred in a taxable year for the production or collection of income are deductible by an individual taxpayer. 3) 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. ii. For the management of property held for the production of income 1) IRC § 212(2) 2) Ordinary and necessary expenses paid or incurred in a taxable year for the management, conservation, or maintenance of property held for the production of income are deductible. 3) Deductions are not allowed for expenses incurred with respect to property which is held for personal purposes. iii. For dealing with tax matters. 1) IRC § 212(3) 2) Expenses incurred or paid in connection with the determination, collection, or refund of ANY tax are deductible. b. Losses i. In General 1) IRC § 165 2) A deduction is allowed for any loss sustained during a taxable year which is not compensated for by insurance or otherwise. 3) An unrealized decline in the value of property does not give rise to a deductible loss. 4) IRC § 165(c) – Limitations on losses of individuals Basic Tax I - Carey Summer 2003 Page 21 of 56 i) Losses incurred in trade or business – appears to look at current trade or business ii) Losses incurred in any transaction entered into for profit, though not connected with trade or business (investments) – appears to look at prior investment activities ii. Amount of Loss 1) In General i) Excess of adjusted basis of the property over the amount realized. ii) The amount of the loss may never exceed the amount of the property’s adjusted basis. 2) Compensated for by Insurance or Otherwise i) A deduction may be taken with respect to a loss ONLY to the extent that it is not compensated for by insurance or otherwise. 3) Losses on Property Converted from Personal Use to Business Use iii. Classification of Losses 1) Losses Incurred in a Transaction Entered Into for Profit i) Worthless Securities a) IRC § 165(g) b) If a taxpayer owns a security which is a capital asset, and if the security becomes worthless during the taxable year, it is deemed to be disposed of in a sale or exchange transaction occurring on the last day of the taxpayer’s taxable year. c) Securities include 1)a share of stock in a corporation, 2)a right to subscribe for, or to receive, a share of stock in a corporation, or 3)a bond, debenture, note, or certificate, or other evidence of indebtedness issued by a corporation or by government. 2) Casualty Losses i) Theft or destruction of property which is used in a trade or business or profit-seeking activities may give rise to a loss deduction. iv. Timing of Losses 1) Losses are deductible in the year in which sustained following normal accounting rules. c. Bad Debts – IRC § 166 Basic Tax I - Carey Summer 2003 Page 22 of 56 i. In General 1) A deduction is allowed for any debt which becomes worthless during a taxable year. ii. Bona Fide Debt Requirement 1) Only a bona fide debt, arising from a debtor/creditor relationship, based on a valid and enforceable obligation to pay a fixed or determinable sum of money, may provide a deduction if it becomes worthless. iii. Determination of Worthlessness 1) A taxpayer has the burden of demonstrating that a debt becomes worthless in the taxable year in which the deduction is claimed. iv. Amount of Deduction - § 166(b) 1) The amount of the deduction for any bad debt is limited to the adjusted basis of the debt. v. Special Rules for Business Bad Debts - § 166(a) 1) A deduction may be allowed for a business debt which becomes wholly worthless during a taxable year, or to the extent it becomes partially worthless during a taxable year. vi. Special Rules for Nonbusiness Debts - § 166(d) 1) With respect to taxpayers other than corporations, a nonbusiness debt is subject to different rules. i) The nonbusiness debt must become wholly worthless before any deduction is allowable; and ii) The amount of a worthless nonbusiness debt is deemed to be a short-term capital loss and is deductible as such. vii. Worthless Securities - § 166(e) 1) Debts which are issued by a corporation, government, or political subdivision and which are evidenced by a bond, certificate, or other evidence of indebtedness with interest coupons or in registered form are treated as securities. 2) If a security is a capital asset and it becomes worthless, the bad debt rules of § 166 do not apply; the loss is characterized as a long-term or short-term capital loss under the loss rule of § 165. d. Property i. Depreciation Deductions – Non-ACRS – IRC §167 1) Cost or Other Basis i) The depreciation deduction for an item of property is generally computed with Basic Tax I - Carey Summer 2003 Page 23 of 56 reference to its adjusted basis used for determining gain on the sale or other disposition of the property. ii) If item is used for both business and personal purposes, depreciation deductions are only allowed with respect to the proportion of the basis attributed to business purposes. 2) Useful Life i) The useful life of an item of property is the length of time the property may reasonably be expected to be used in the taxpayer’s income seeking activity ii) It is not the period of time the property might actually be physically useful in some other trade or business or to some other taxpayer. iii) Question of fact. iv) IRS has developed classifications of useful life for various types of property. v) If useful life is indefinite or unascertainable, no depreciation may be taken. 3) Salvage Value i) The salvage value of property is the amount, determined at the time of acquisition, which is estimated the property could be sold for at the end of its useful life to the taxpayer. ii) Depreciation may not exceed salvage value of the property. 4) Methods of Computing Depreciation i) Straight line a) Depreciable base of the property is its cost or other basis less the salvage value multiplied the fraction of 1/years of useful life. ii) Sum of the Years Digits a) Add up the total of years. Example 5 year depreciation. 5+4+3+2+1=15. b) Multiply Cost Basis – Salvage Value by fraction of year over total. c) Accelerated method. iii) Declining Balance a) Under the declining balance method, the depreciable base of the property is its cost or other basis reduced by depreciation deductions allowed or allowable in prior years. b) Not reduced by the salvage value. Basic Tax I - Carey Summer 2003 Page 24 of 56 c) Property may not be depreciated below its salvage value. d) Double declining balance is used. e) Base changes each year. f) Accelerated method. 5) Relationship of Depreciation Deductions to Basis i) The basis of the property must be reduced to account for the amounts allowed (actually taken) or allowable (could have been taken) for depreciation deductions. ii. Accelerated Cost Recovery System (ACRS) 1) IRC § 168 2) In general i) Allows deductions in the nature of depreciation deductions to be taken at a rate faster than prior law permitted. ii) Differences from depreciation under § 167 a) Kept accelerated depreciation. b) Just uses double declining balance for accelerated depreciation. c) May elect to use straight-line for some types of property d) Shortened useful lives of property and simplified into classifications. e) Salvage value is 0 - salvage value is not taken into account. iii. Related concept of depreciation. iv. Special Rules for Personal Property – IRC § 179 1) ―Depreciable tangible personalty used in an active trade or business‖ i) Depreciable. The property must be of a character that wears out over time. Usually not an issue. ii) Tangible. Able to touch and hold -- intangible property such as intellectual property (e.g., copyrights, patents) does not qualify. Usually not an issue. iii) Personalty. Real estate (buildings) do not qualify as Section 179 property. This is the meaning of the language in Section 179(d) referring to "section 1245 property." iv) Used in an active trade or business. Property held for use in an investment does not qualify. Basic Tax I - Carey Summer 2003 Page 25 of 56 2) A taxpayer MAY elect to deduct all or a portion of the cost of any § 179 property in the taxable year in which it is placed in service. 3) Deduction is allowed in addition to normal depreciation deductions. 4) Basis must be adjusted after this deduction is taken and before depreciation deduction is taken. 5) Limitations i) Dollar Limitation – IRC § 179(b)(1) a) Can only take deductions up to a certain amount. b) For 2003, the amount is $25,000. c) New tax bill increased this amount to $100,000. d) Under the new tax bill, it goes back to $25,000 in 2006. ii) Reduction in Limitation – IRC § 179(b)(2) a) If more than $200,000 was purchased, the limit is reduced dollar for dollar for every dollar over $200,000. b) New tax bill increases this to $400,000. c) Under the new tax bill, it goes back to $200,000 in 2006. iii) Taxable Income Limitation - § 179(b)(3) a) Bonus depreciation is limited in a taxable year to the amount of the taxpayer’s taxable income. 6) Under new tax bill, off-the-shelf software becomes § 179 property. v. Special Depreciation Allowance for Certain Property Acquired after September 10, 2001, and before September 11, 2004. – IRC 168(k) 1) Deduction is allowed in addition to the § 179 bonus depreciation deduction. 2) Adjusted basis must be adjusted by any § 168(k) reduction. vi. Applicable Convention 1) IRC § 168(d) 2) Conventions are used to indicate when property is acquired. 3) General rule is to use Half-Year convention, unless requirements of mid-quarter convention is met. 4) Half-Year Convention Basic Tax I - Carey Summer 2003 Page 26 of 56 i) Anything bought during the year is treated as if purchased at mid-year. 5) Mid-Quarter Convention i) Mid-quarter convention applies ONLY if the total basis of property placed in service during the last 3 months of the year exceeds 40% of the total basis of property placed in service during the entire year. ii) Mid-quarter convention treats property placed in service during any quarter of the taxable year as if it were placed in service at the mid point of the quarter. iii) If the mid-quarter convention applies, then all property placed in service during a taxable year is subject to the mid-quarter convention and the mid-year convention DOES NOT apply. vii. How to approach problems 1) Determine if depreciation property is depreciable tangible personalty used in active trade or business. 2) If yes, calculate bonus IRC § 179 depreciation 3) Reduce basis. viii. Example 1) Taxpayer buys 8 pieces 5-year property for $480,000 total. 6@$60,000, 1@$50,000, 1@$70,000. 2) Calculate bonus § 179 depreciation. i) Exceeds $400,000 allowance by $80,000. ii) Can only take $100,000 - $80,000 or $20,000 in bonus depreciation. iii) Taxpayer allocates entire $20,000 to $70,000 truck. 3) Reduce basis of one piece of property by $20,000 to $50,000. 4) Calculate IRC § 168 depreciation i) Use DDB (40%) to multiply by basis of truck ($50,000) to determine depreciation for first year of $20,000. ii) Apply mid-year convention, resulting in $10,000 depreciation for year 1 under IRC § 168. 5) Total year 1 depreciation = $30,000 ($20,000 for IRC § 179 + $10,000 for IRC § 168) 6) Reduce basis and continue with IRC § 168 depreciation. Basic Tax I - Carey Summer 2003 Page 27 of 56 7) Year 2 = $40,000 basis X 0.40 = $16,000. 8) Year 3 = $24,000 basis X 0.40 = $9,600 9) Year 4 = $14,400 basis / 2.5 years remaining under straight line depreciation = $5,760 10) Year 5 = $5,760 11) Year 6 = $2,880 12) Could have lumped all trucks together because they have the same useful life. ix. Real Property 1) Real property does not qualify for the bonus depreciation deduction under IRC § 179. 2) Residential real property and non-residential real property are depreciated under IRC § 168. 3) Applicable recovery periods i) Residential rental property = 27.5 years a) Residential rental property is property from which 80% or more of the rental income is rental income from dwelling units. ii) Non-residential real property = 39 years a) Non-residential real property is depreciable real property other than residential rental property or property with a class life of less than 27.5 years. 4) Applicable depreciation method is straight line with zero salvage value. 5) Applicable convention is the mid-month convention. i) Property is treated as if placed in service as if it was placed in service at the mid-point of the month it was purchased. ii) Item purchased on 3/10/03 – treated as if acquired on 3/15/03 and would be allowed 9.5 months of depreciation. 9.5/12 of depreciation in year 1. iii) Paid $1,000,000 for 39 year property on 3/10/03. Year 1 depreciation would be 1/39 of $1,000,000 multiplied by 9.5/12. e. Net Operating Loss Deduction i. IRC § 172 ii. A deduction may be taken in a taxable year in the amount of the net operating loss carryovers and carrybacks to the year. iii. A net operating loss is the excess of allowable business deductions over gross income for a taxable year. Basic Tax I - Carey Summer 2003 Page 28 of 56 iv. Only business deductions count. Some deductions do not count towards a loss. 1) Capital losses in excess of capital gains. 2) Personal exemptions authorized by IRC § 151. 3) Other non-business deductions. v. Can elect to only carry the loss forward. vi. Example 1) Year 0 had a net operating loss of $20K. 2) Year -2 had a net operating profit of $5K and paid $1K in tax. 3) Year -1 had a net operating profit of $10K and paid $3K in tax. 4) Take year 0 net operating loss of $20K back to Year -2 to get refund. Apply against $5K loss to do this. Still have $15K left. 5) Take $15K remaining from #4 above to wipe out profit in Year -1 and get back $3K paid in tax. Still have $5K left. 6) Can carry any remaining amounts forward. B. Personal Deductions and Allowances 1. Personal and Dependent Exemptions a. IRC § 151 and § 152 b. Deductions are authorized for the exemptions provided for a taxpayer, certain dependents of the taxpayer, and in very limited situations, the taxpayer’s spouse. c. Taxpayers may claim exemptions for himself and spouse. d. Exemptions are allowed for dependents. i. Must meet three tests. 1) Gross income test. i) Dependent may not have gross income in excess of the exemption amount, unless the dependent is a child of the taxpayer who is either under 19 years of age OR a full-time student for at least 5 calendar months during the year. 2) Relationship test. i) Person claimed as a dependent must have one of several relationships with the taxpayer. 3) Support test. i) An otherwise qualified individual must receive over one-half of his support from the taxpayer. ii. Children of Divorced Parents 1) Generally, dependency exemption goes to the custodial parent. 2. Interest Basic Tax I - Carey Summer 2003 Page 29 of 56 a. In General i. IRC § 163 ii. Interest is an amount one pays for the use of borrowed money, and as the compensation paid for the use or forebearance of money. iii. A deduction is allowed for interest paid or accrued during the taxable year on indebtedness. iv. Trade or Business Interest 1) Interest may be deducted if the debt was incurred in connection with the conduct of a trade or business, other than the trade or business of performing services as an employee. v. Investment Interest - § 163(d) 1) A deduction may be taken for interest paid or accrued on indebtedness to purchase or carry property held for investment. 2) The amount of investment interest which may be deducted in a taxable year is limited, however, to the amount of net investment income for that year. 3) Must defer the investment interest until there is net investment income. vi. Home Mortgage Interest 1) Can deduct interest on two personal residences. 2) Requirements of residence. i) Place to sleep ii) Bathroom 3) Two kinds of indebtedness i) Acquisition Indebtedness a) Up to $1,000,000 in borrowing. b) Interest on loan secured by residence used to acquire or substantially improve the residence. c) § 163 (h)(3)(B) ii) Home Equity Indebtedness a) Up to $100,000 in borrowing. b) Interest on loan secured by residence used to do anything else. c) § 163 (h)(3)(c) 3. Taxes a. IRC § 164 b. Almost all taxes, except Federal, are deductible from income. c. Property taxes, county taxes, foreign taxes, etc. are deductible. d. Excluded taxes i. Federal income taxes ii. Federal estate or gift taxes iii. FICA taxes Basic Tax I - Carey Summer 2003 Page 30 of 56 4. Casualty and Theft Losses a. IRC § 165 b. A deduction is authorized for losses of property even though not connected with a trade or business if the loss arises from fire, storm, shipwreck, or other casualty, or from theft subject to two limitations. i. $100 per casualty event deductible. ii. 10% ???? c. Cannot deduct amount reimbursed by insurance. d. Determined as LESSER of value before – value after the event OR the taxpayer’s adjusted basis for the property. 5. Charitable Contributions – IRC § 170 a. Qualified Donees i. Cannot take deduction for a contribution to an individual. ii. Must be to an organization. iii. Must serve public, non-profit purpose. iv. Examples 1) Federal, state, or local government to be used for public purposes; 2) Religious; 3) Charitable; 4) Scientific; 5) Literary; 6) Educational organizations; 7) Etc. b. Contributions i. Must be voluntary transfer of money or other property with donative intent and without consideration. ii. If money or other property is transferred to a qualified donee and the transferor receives partial consideration for the transfer, a deduction may be allowable to the extent that the amount of money or the value of transferred property exceeds the partial consideration. c. Amount of Charitable Contributions i. Cash ii. Property 1) Typically, the amount of a charitable contribution of property is the fair market value of the contributed property at the time of contribution, less the value of any consideration received for the transfer, subject to further reduction under IRC § 170(e) 2) Ordinary Income and Short-Term Capital Gain Property i) The amount of a charitable contribution of property is reduced by the amount of gain Basic Tax I - Carey Summer 2003 Page 31 of 56 which would have been ordinary income or short-term capital gain if the donor had sold the property at its date-of-contribution fair market value. 3) Long-Term Capital Gain Property i) The amount of a charitable contribution of property is reduced by all of the amount of gain which would have been long-term capital gain if the donor had sold the property at its date-of-contribution fair market value, AND if the contribution is: 1)of tangible personal property the use of which is unrelated to the exempt purpose of the donee or 2)to or for the use of nonoperating private foundation. iii. Services 1) No deduction is allowed for a contribution of services to a charitable organization. 2) Unreimbursed expenditures can be deducted. iv. Partial Interest in Property 1) A charitable contribution of a remainder interest, an income interest, or other partial interest in property may be deducted only in certain limited circumstances. 2) Transfers in Trust d. Limitations on Contribution Amounts i. Excess of charitable contributions over the applicable percentage limitations may be carried over in the succeeding 5 years. ii. Public Charities 1) A taxpayer may deduct charitable contributions made during a taxable year to public charities to the extent that the total does not exceed 50% of the taxpayer’s contribution base. iii. Charitable contributions to Public Charities of property which, if sold, would produce long-term capital gain may be deducted only to the extent that the total amount does not exceed 30% of the taxpayer’s contribution base. 6. Extraordinary Medical Expenses – IRC § 213 a. A deduction is allowed for expenses actually paid during a taxable year, not compensated by insurance or otherwise, for medical care to the extent that such expenses exceed 7.5% of taxpayer’s AGI. b. Allowed for taxpayer, spouse or dependents. 7. Alimony – IRC § 215 a. A deduction is allowed for amounts paid during a taxable year for alimony or separate maintenance payments. Basic Tax I - Carey Summer 2003 Page 32 of 56 C. Restrictions on Deductions 1. Personal, Living and Family Expenses – IRC § 262 a. No deduction is allowed for personal, living, or family expenses unless there is specific authorization for a deduction under another provision of the IRC. 2. Illegal Activities a. No deduction is allowed for illegal bribes or kickbacks, any fine or similarly penalty paid to a government for violation of any law – IRC § 162 (c), (f), and (g). b. Other business expenses of an illegal business are deductible; however, no deduction is allowed for any amount paid or incurred in carrying on the trade or business of trafficking in illicit drugs – IRC § 280E 3. Expenses and Interest Relating to Tax-Exempt Income – IRC § 265 a. No deduction is allowed for expenditures which would otherwise be allowed as deductions to the extent the expenditures are allocable to income which is exempt from the Federal income tax. b. Most of the time applies to buying tax exempt securities. c. Courts have not backed up IRS in sophisticated dealings. 4. Transactions Between Related Taxpayers – IRC § 267 a. No deduction is allowed for the sale or exchange of property between related taxpayers. b. Related Taxpayers i. An individual and her brothers, sisters, spouse, ancestors, and lineal descendants; ii. An individual and a corporation which the individual owns, directly or indirectly, more than 50% of the value of its outstanding stock; iii. The fiduciary of a trust and the grantor of that trust; iv. Various fiduciaries and beneficiaries of 2 or more trusts with respect to which the same person is the grantor; v. Various other relationships between certain corporations, partnerships, and educational and charitable organizations. c. Stock constructively owned by a person because of a relationship is not then constructively owned by their other relatives. i. Example 1) H married to W 2) W’s brother owns 1000 shares of XYZ 3) W constructively owns 1000 shares of XYZ 4) H DOES NOT constructively own 1000 shares of XYZ by virtue of relationship to W. d. Between related taxpayers, if a loss is disallowed with respect to an item of property and the property is later sold or disposed of at a gain by the transferee related party, the gain is recognized only to the extent it exceeds the amount of the previously disallowed loss – IRC § 267(d) Basic Tax I - Carey Summer 2003 Page 33 of 56 e. A taxpayer on the accrual method of accounting may not take deductions for interest or other expenses to be paid by a related taxpayer who is on the cash method of accounting until the amount is actually or constructively paid – IRC § 267(a)(2). 5. Entertainment Expenses – IRC § 274 a. Activity i. No deduction is allowed for an expenditure with respect to an activity which is of a type generally considered to constitute entertainment, meals, amusement, or recreation unless the taxpayer establishes that the expenditure is directly related to the active conduct of the taxpayer’s trade or business or income-producing activities or associated with the active conduct of the taxpayer’s trade or business if the expenditure directly precedes or follows a substantial and bona fide business discussion. ii. A deduction is allowed for only 50% of the cost of any otherwise deductible expenditure for food, beverages, or for any entertainment activity. b. Facility i. No deduction is allowed for any expenditure incurred with respect to a facility used in connection with entertainment, amusement, or recreation. ii. No deduction is allowed for membership dues paid to any club organized for business, pleasure, recreation, or other social purpose. c. Entertainment Tickets i. No deduction is allowed for an expenditure for an otherwise deductible ticket to an entertainment facility or event in excess of the face value of the ticket, unless it is a ticket to a qualifying charitable sports event. ii. Deduction is limited to 50% of the face value of the ticket. d. Skyboxes i. The amount which may be deducted for the cost of leasing a skybox or other private luxury box for more than one event is limited to the sum of the face value of the same number of non-luxury tickets available to the general public. ii. Deduction is limited to 50% of the cost of the non-luxury tickets. e. Exceptions to the Disallowance Rules i. IRC § 274(e) f. Substantiation i. A taxpayer must be able to substantiate entertainment expenses in accordance with the regulations or no deductions will be allowed. V. Timing A. Taxable Period Basic Tax I - Carey Summer 2003 Page 34 of 56 1. The taxable period for computing the Federal income tax is a taxpayer’s taxable year. 2. A taxpayer may elect to have his taxable year be a fiscal year. a. Fiscal year ends on the last day of a month other than December. 3. A taxpayer must get prior approval of the IRS to change. a. Must demonstrate substantial business purpose. B. Methods of Accounting 1. Cash Receipts and Disbursements Method a. Receipts i. A taxpayer using the cash method must include items of gross income in the taxable year in which he receives the item, regardless of whether the amount is paid in cash, by check, or with property other than money. ii. Notes or contracts are not treated as equivalent of cash and no amount is included in gross income because of its receipt. iii. Property received is included in gross income is fair market value at time of receipt. iv. Constructive Receipt 1) A taxpayer using the cash method must include items of gross income in the taxable year in which they are constructively received, if that is earlier than the year in which they are actually received. i) Constructive receipt = credited to account OR set apart for him OR otherwise made available so that he may draw upon it at any time. b. Disbursements i. A taxpayer using the cash method generally may take allowable deductions in the taxable year in which the actual payment takes place. ii. Payment by check when check is given. iii. Payment considered to be when check is mailed. 2. Accrual Method a. A taxpayer using the accrual method of accounting generally includes items in gross income in the taxable year in which all events have occurred which fix his right to receive the item and fix the amount of the item. b. An accrual method taxpayer deducts items in the taxable year in which all events have occurred which fix his liability to pay items, the amount payable becomes fixed, and certain tests of economic performance are satisfied. c. Reserve Accounting i. A way of deferring a pre-payment of income. ii. Courts have consistently said that for Federal tax purposes, taxpayer is not permitted to use reserve accounting. d. e. f. g. h. Basic Tax I - Carey Summer 2003 Page 35 of 56 Generally speaking, an accrual method taxpayer must include things in income when they are actually paid – they cannot use reserve accounting. Effect of Economic and Legal Contingencies on Income and Deductions i. Economic Contingencies 1) Accrual method taxpayer must include as gross income even though there are economic contingencies which make it uncertain that a taxpayer will actually receive the item of income or pay the deductible item. ii. Legal Contingencies 1) Accrual method taxpayer must include income in year when there is a claim of right, even though there are legal contingencies outstanding. Under limited circumstances, developed by case law and IRS regulations, the IRS permits an accrual taxpayer who receives prepaid income for services to defer for one year the inclusion of such income in gross income. For most accrual taxpayers, pre-paid income must be reported when received. Inventories i. A taxpayer who is required to use inventories must also use the accrual method of accounting. ii. Gross income derived from businesses using inventories includes the total receipts from the sale of inventory items LESS the cost of goods sold. iii. Cost of Goods Sold 1) COGS = Value of Inventory at Beginning of Taxable Year + Value of Inventory Items Acquired During the Taxable Year – Value of Inventory Items at End of Taxable Year 2) COGS = Opening Inventory + Purchases – Closing Inventory iv. Inventory Accounting Methods 1) FIFO – First In First Out 2) LIFO – Last In First Out 3) When costs are increasing, LIFO will show a lower profit. 4) When costs are decreasing, FIFO will show a lower profit. 5) Same way must be done for tax purposes and for reporting income to shareholders. 6) Choice of LIFO or FIFO affects opening inventory for following year. Basic Tax I - Carey Summer 2003 Page 36 of 56 7) LIFO inventory method essentially defers income while cost is rising. Thus, one is deferring taxes. And since taxes are an expense, the company is deferring expenses. 8) Essentially, LIFO is a time bomb waiting to happen – it has its issues. v. Relationships Between CI, COGS, and GI. 1) As CI goes up, COGS goes down. 2) As CI goes down, COGS goes up. 3) As COGS goes up, GI goes down. 4) As COGS goes down, GI goes up. 5) As CI goes up, GI goes up. 6) As CI goes down, GI goes down. 3. Installment Method – IRC § 453 a. A gain or a loss which is realized upon the sale or other disposition of property is generally required to be recognized, or included in gross income. However, the installment method permits a taxpayer who has realized a gain from the sale or other disposition of property to spread out the recognition of the gain. b. Essentially, § 453 allows the deferral of taxes until payments are actually made. c. When there is an installment sale, § 453 automatically applies. Taxpayer may elect not to use § 453. d. Transactions under IRC § 453 i. Gain from the installment sale of property is recognized in accordance with the installment method, unless the taxpayer elects to have the installment method no apply. ii. Installment Sale 1) Installment sale of property is the disposition of property under terms where at least one payment is to be received in a taxable year subsequent to the year in which the disposition takes place. iii. Installment Method 1) The installment method requires a portion of payments received from an installment sale in a taxable year to be recognized gain and included in gross income. 2) Multiply payments received by gross profit ratio (gross profit/total contract price) e. IRC § 483 – Imputed Interest. i. If seller structures deal at low interest rate, IRS will impute a more realistic interest rate. ii. IRS will shift payments to interest from principal. iii. Interest is ordinary income taxed at a full rate. Principal is capital gain taxed at a lower rate. f. Recapture Basic Tax I - Carey Summer 2003 Page 37 of 56 i. IRC § 1245 ii. When you sell property and equipment on which you have taken depreciation, you must report the gain as ordinary income to the extent you took depreciation. iii. The installment method does not apply to the extent any gain from the sale of property would be characterized as ordinary income under the recapture provisions of § 1245. g. Property Encumbered by Indebtedness i. The installment method of recognizing gain may be used in the sale of property encumbered by indebtedness. ii. To determine the gross profit, the selling price is the gross selling price without any reduction to reflect either selling expenses or any existing mortgage on the property. The total contract price is the selling price reduced by any qualifying indebtedness which the buyer takes the property subject to or assumes, but only to the extent the indebtedness does not exceed the adjusted basis of the property. 1) Gross Profit Ratio = Gross Profit / (Total Contract Price – Amount of Indebtedness Assumed) 2) Example – Sell property for $100K with mortgage of $70K, Basis is $50K. Gross Profit Ratio = 50 / (100 – 70) = 50/30. Then, when each payment of $10K was received, would have to pay $10K X 5/3 or $16.7K. This is counterintuitive. Would include $10K received in 1st year PLUS excess of mortgage over basis. In this example, it would be $10K + $20K = $30K. As each $10K payment is received in subsequent years, it is taxed 100%. 3) Example – Property cost $80K, $30K depreciation taken, leaving $50K basis. Sold property for $100K. Would have to pay tax on $30K of recapture income. The numerator would then become $20K, not $50K. h. Example – Basis of property is $50K, Sold for $100K. Profit is $50K. Contract terms $20K at closing, $20K every year for four years. Sell note for $75K. Basis of note is $40K ($50K - $10K reduction in basis from the receipt at closing). Thus, would owe tax on difference in $75K of note minus the $40K of basis in note or $35K. C. Judicial Doctrines 1. Claim of Right Doctrine a. In General i. A taxpayer must include in gross income amounts which he receives during a taxable year if he has a claim to the amount and unrestricted use of it, even though he may become obligated to return the amount in a later year. Basic Tax I - Carey Summer 2003 Page 38 of 56 ii. If the taxpayer does repay the amount in a taxable year subsequent to the year in which it was received, he may take a deduction in the year of repayment, but he may not file an amended return for the earlier taxable year. b. Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right – IRC § 1341 i. If an item 1)was included in gross income in an earlier taxable year because it appeared the taxpayer had unrestricted right to such item, 2)if a deduction is allowable in the current taxable year because it was established that the taxpayer did NOT have an unrestricted right to the item, and 3)the amount of the deduction exceeds $3,000, the taxpayer may compute his tax liability in the year of repayment according to one of two prescribed methods below, whichever results in the lower tax liability 1) Compute the tax liability for the current year, taking a deduction for the repaid amount OR 2) Compute the amount of tax liability for the current year without taking a deduction for the repaid amount but then subtract amount by which his tax liability in the earlier year would have been reduced if the repaid amount had not been included in gross income in the earlier year. ii. Example – In year 2000, had claim of right income of $10K and this cost you tax of $4,000 based on 40% rate. In year 2003, had to pay back the $10K. Now tax rate has changed to 35% and would only get $3,500 tax savings. Would be able to get the larger of the two or $4,000. 2. Tax Benefit Rule a. If a taxpayer takes a deduction for an item in a taxable year which is proper on the basis of the facts which are then known, the IRS may not reopen the tax return for that year. Instead, the taxpayer must include in gross income any amount which is recovered in a later year relating to an earlier deduction. b. IRC § 111 i. (a) Provides the exclusion from gross income amounts which are recovered or refunded in a taxable year to the extent the amount was deducted in a prior taxable year but did not reduce the amount of the taxpayer’s income tax in the prior year. 1) Refunded item is the last item deducted in the prior year. ii. (b) Provides if a tax credit was taken in a prior taxable year and in the current year there is a downward price adjustment so that the amount of the tax credit should also be lowered, requiring an increase in the current year’s tax liability to the extent the prior credit resulted in a tax benefit. Basic Tax I - Carey Summer 2003 Page 39 of 56 D. Non-Recognition Provisions 1. Like-Kind Exchanges – IRC § 1031 a. Like-kind exchanges are interpreted very broadly. b. Extremely popular with real-estate investments. c. No gain or loss is recognized if qualifying property is exchanged solely for other qualifying property of a like kind. d. Non-recognition generally does not apply, to exchanges between related parties if either of them disposes of the exchanged property within 2 years. e. A qualifying property must be an exchange in the sense of transferring property for other property without the intervention of money. f. Later on, will expect taxpayer to pay taxes – when the property is sold for money. g. Qualifying Property i. Property held solely for productive use in trade or business or property held for investment. ii. Property received in exchange must be held solely for productive use in trade or business or property held for investment. iii. Does NOT include 1) Stock in trade or other property held for sale such as inventory; 2) Stocks, bonds, or notes; 3) Other securities or evidences of indebtedness or interest; 4) Interest in a partnership; 5) Certificates of trust or beneficial interests; 6) Choses in action h. Like Kind Property i. Nature and character of property and not to its grade or quality. ii. Real property is like kind to other real property. iii. Real property outside the U.S. is not like kind with property in the U.S. i. Exchanges Not Solely in Kind i. If property received in exchange includes not only like kind qualifying property but also other property, the gain realized with respect to the property relinquished will be recognized but only to the extent of the other property received. ii. Realized gain is recognized to the extent of the ―boot.‖ j. IRC § 1031 is a Deferral of Taxes i. IRC § 1031 is a deferral of taxes – it is NOT an exemption on taxes. ii. Adjustment to basis is how the Code deals with the deferment of taxes. k. l. m. n. Basic Tax I - Carey Summer 2003 Page 40 of 56 iii. Generally, the basis of the property received is equal to the basis of the property relinquished. iv. Basis under IRC § 1031 1) Basis of Acquired Property = Basis of Relinquished Property – Money Received in Exchange + Gain Recognized Example 1 – Taxpayer has apartment building with a basis of $500K and is going to exchange for office building with fair market value of $1,500K. This results in a realized gain of $1,000K. However, § 1031 permits the exchange to qualify for NON-RECOGNITION treatment. Under general tax provisions, the basis would become $1,500K. However, under IRC § 1031, taxpayer’s basis in the new office building would be $500K – the basis of the property relinquished. Thus, the taxpayer does not escape taxation on the gain received in the transaction. Example 2 – Taxpayer has apartment building worth $1,500K and a basis of $500K and is going to exchange for office building with fair market value of $1,300K and cash of $200K (called ―boot‖). Realized gain would be $1,000K. Recognized gain would be $200K. Taxpayer would pay tax on $200K. Basis of exchanged property would be $500K - $200K + $200K or $500K. i. To test, assume sale for fair market value of $1,300K and subtract basis of $500K. Taxpayer would pay taxes on $800,000. Total amount of money that taxes were based on would be $1,000K ($800K + $200K). Example 3 – Taxpayer has apartment building worth $1,500K with a basis of $1,400K and exchanges for office building worth $1,300K and $200K cash. Would realize a gain of $100K. Would recognize a gain of the amount of boot, but only up to realized gain. Therefore, would recognize $100K. Basis would be $1,400K - $200K + $100K or $1,300K. i. To test, assume sale for fair market value of $1,300K and subtract basis of $1,300K. Taxpayer would pay zero taxes on this sale. She paid taxes on exchange amount recognized of $100K. Example 4 – Taxpayer has apartment building worth $1,700K and is subject to a mortgage of $400K with a basis of $500K. She wishes to exchange for an office building worth $1,300K and takeover of the mortgage. Realized gain would be $1,200K ($1,300K + $400K mortgage - $500K basis). Takeover of liability is treated as boot or money received. The taxpayer would have recognized gain of $400K and must pay taxes on this amount. Basis would be $500K – $400 + $400K or $500K. i. To test, assume sale for fair market value of $1,300 and subtract basis of $500K. Would have to pay taxes on $800K. Basic Tax I - Carey Summer 2003 Page 41 of 56 This is what taxpayer would have paid had the original transaction been a sale. o. Example 5 – Taxpayer has apartment building worth $1,700K and is subject to mortgage of $600K with a basis of $500K. Wishes to exchange for an office building worth $1,300K with a mortgage of $200K. Concept of mortgage netting – the taxpayer with the larger liabilities to be taken over would treat excess as boot and calculations would be the same as in Example 4. p. IRC § 1031 ONLY applies when property is exchanged for property. q. Deferred Exchanges i. The non-recognition rule of § 1031 may apply even if property is relinquished in an exchange at a different time than the new property is received. ii. Property received is NOT treated as like-kind property if it is not identified as property to be received by the taxpayer on or before 45 days after the taxpayer transfers the property relinquished in the exchange OR if it is received more than 180 days after the taxpayer transfers the property relinquished in the exchange. 45 days to identify exchange property and 180 days to finish the deal. r. Escrow/Trust Example – Taxpayer has an apartment building and other party has office building. They do not want to exchange directly. Taxpayer conveys to a third-party agent. Agent then finds a buyer for the apartment building. Buyer gives cash to agent and agent gives apartment building to buyer. Agent then gives cash to owner of office building and owner of office building conveys title of office building to taxpayer. Then agent conveys title to the taxpayer. Taxpayer would claim that they went from property to property through the use of the agent. i. Commissioner held that this going through an agent was constructive receipt. ii. Commissioner was overruled and the transaction is treated as exchange of property if agent is agent of all parties. iii. There are regulations as to how the intermediary must act in the transactions. iv. This has become standard stuff in real estate transactions to defer tax consequences. 2. Involuntary Conversions – IRC § 1033 a. Can include all casualty events such as fire, theft, etc. b. Can also include condemnation or imminent domain. c. If property is compulsorily or involuntarily converted, the realized gain may be entitled to non-recognition. d. Conversion into Similar Property Basic Tax I - Carey Summer 2003 Page 42 of 56 i. If property is involuntarily converted into other property which is similar property, no gain is recognized, regardless of when the disposition of the converted property occurred. e. If property is involuntarily converted into money or property which is not similar or related in service or sue to the converted property, realized gain must be recognized unless, within certain time limits (2 or 3 years), the taxpayer either purchases similar property. 3. Sale of Principal Residence – IRC § 121 a. If a taxpayer sells or exchanges his principal residence, he may exclude some or all of his realized gain if the taxpayer satisfies an ownership and use test. b. The property must have been owned by the taxpayer and used as the principal residence of the taxpayer for a period or periods totaling at least 2 years during the 5-year period ending on the date of the disposition. c. Limitations i. Maximum amount of gain on sale of residence is $250K ($500K for married filing jointly). ii. Can only be done once every two years. E. Unstated Interest – IRC § 7872 1. Loans with Below-Market Interest Rates a. Simultaneous gift and income tax provision. b. Loans made under terms which do not provide for the payment of a reasonable rate of interest while they are outstanding are subject to rules requiring the borrower and the lender to be treated for tax purposes as if interest at a reasonable rate has been paid. c. Foregone interest is the amount of interest by which the applicable Federal rate exceeds the stated rate for the loan. d. Three types of loans under § 7872 and the potential taxes for each. i. Gift Loans 1) Deemed Transfer = Possible Gift Tax Liability And No Income Tax Liability to Borrower 2) Deemed Retransfer = Income to Lender in the Amount of Foregone Interest Leads to Tax Liability AND Possible Income Tax Deduction for Borrower for Interest 3) Only certain tax consequences are to the lender. ii. Shareholder Loans 1) Corporation lends money to shareholders – very common way for shareholders to get money out of closely held corporations. 2) IRS sees this as a disguised dividend disbursement. 3) Deemed Transfer = Dividend Income to Shareholder Basic Tax I - Carey Summer 2003 Page 43 of 56 4) Deemed Retransfer = Income to Corporation from Payment of Interest by Shareholder, Possible Income Tax Deduction for Shareholder for Interest iii. Employee 1) Employer loans money to employee as an employee benefit. 2) IRS sees this as disguised compensation. 3) Deemed Transfer = Deductible as Compensation Expense for Employer, Compensation Income to Employee 4) Deemed Retransfer = Interest Income to Employer, Possible Income Tax Deduction for Employee for Interest e. Gift Loans i. A gift loan is a below market loan made in circumstances where the foregoing of the interest is in the nature of a gift, such as a loan between members of a family. ii. Term Gift Loans 1) If a below-market gift loan is made for a specified period of time, the amount of forgone interest is the present value, using a discount rate equal to the applicable Federal rate, of all payments which the borrower is required to make, regardless of whether the payments are for interest or repayment of the principal amount of the loan. 2) Difference between amount transferred to borrower and the present value of all payments to be made to the lender is subject to tax. 3) Present value is the amount of money that has to be set aside today to yield a certain amount at a future date, given a specified interest rate. iii. Demand Gift Loans 1) The borrower may be required to repay the loan at any time. 2) Foregone interest is computed on 12/31 of each year the loan is outstanding. 3) A gift in the amount of the foregone interest is deemed to be made to the borrower on that date, and the interest is deemed to be immediately retransferred by the borrower to the lender as interest. 4) Use applicable federal rate multiplied by the principal outstanding to determine the foregone interest. f. Exceptions Basic Tax I - Carey Summer 2003 Page 44 of 56 i. De minimus rules 1) Does not apply to gift loans on any day the total amount of loans do not exceed $10K, unless the proceeds are used to acquire income-producing assets. 2) In the case of any shareholder and employee loan that does not exceed $10K, unless the proceeds are used to acquire income-producing assets OR the purpose of the loan is for tax avoidance. ii. Special Rules for Gift Loans 1) If a gift loan for less than $100K is made between individuals, the amount of interest which the borrower is deemed to retransfer to the lender may not exceed the borrower’s net income from investments for the taxable year. 2) If the borrower’s net income from investments for the taxable year does not exceed $1,000, no interest payments are imputed. Who is the Proper Taxpayer? A. Assignment of Income 1. Income is generally taxed to the taxpayer who earns it, or to the taxpayer who owns property which produces income. 2. Income From Services a. Income in the nature of compensation for the performance of services is generally included in the gross income of the person who performs the services. b. Lucas v. Earl Case Principles i. Income should be taxed to the person who earns it. ii. You earn income from services from performing the services. c. Comm’r v Giannini Case Principle i. Court held that if 1)you refuse to take income before you earn it and 2)you do not influence where the money goes, you do not have to pay taxes on the income. d. A taxpayer may avoid being taxed on income which she would otherwise earn for performance of services if she intends to perform the services gratuitously. e. If a taxpayer performs services as an employee or as an agent, income derived therefrom is included in the gross income of the employer or principal, not the gross income of the employee/agent. 3. Income from Property a. Income derived from property, such as rents from real property, interest from bonds, or dividends from stock, is generally included in the gross income of the owner of the property. b. Helvering v. Horst Case i. Had a coupon bond. ii. Coupons were redeemable on specified dates for the interest. VI. Basic Tax I - Carey Summer 2003 Page 45 of 56 iii. Gave coupons to son so that son could redeem them for income. iv. Father kept the bond. v. Question for court was who should be taxed for interest income from coupons. vi. Court focused on the fact that father held the bond and the only reason the bond issuer would pay the interest coupons is if the bond itself was owned. vii. Court held that income from property is owned from owning the property. viii. Essentially, owner of the bond would record interest income when the coupons were redeemed. ix. Owner of the bond would also have potential gift tax liability for the interest going to the child. x. ―The person who owns the tree is taxed on the fruit.‖ c. Income Interest in Property i. If the owner of all of the interests in an item of property (the fee owner) transfers the property to two or more other taxpayers, dividing the ownership into present and future interests, income derived from the property is included in the gross income of the transferee of the present interest. ii. The transferee can transfer a coterminous portion (one ending at the same time as his interest) of his interest and that portion would be transferred to the second transferee. 1) Blair v. Comm’r Case d. Ripeness i. The right to income from property may have become sufficiently definite that the income may not be diverted to another taxpayer by a transfer of the property. ii. The person who owns the income when it ripens is taxed on the income, even though he does not actually receive the income. 4. Income Producing Entities a. Within the parameters of the assignment of income doctrine, an individual taxpayer may shift income to an entity such as a corporation, partnership, or a trust. b. Aggregations i. Partnership ii. Primary liability lies with individuals. c. Entities i. Corporation ii. Primary liability lies with the corporation itself. d. Tax system basically follows the same principles. Income in partnership is taxed at individual level; income in corporation is taxed at the corporate level. e. Corporations f. g. h. i. Basic Tax I - Carey Summer 2003 Page 46 of 56 i. General treated as a separate taxpayer, distinct from shareholders and creditors, and its annual taxable income is subject to income tax according to rates applicable to corporations. ii. Also, when the corporation’s income is distributed as dividends, the recipient has to pay taxes. iii. Very easy to shift income in corporations because it can be done through the transfer of stock; however, the double tax implications of corporations make this inefficient. Partnership i. Partnership is not subject to tax itself. ii. Partners must include in their gross incomes the items of partnership income. Trust i. A trust is treated under the income tax law as an entity separate and apart from its grantor and beneficiaries. ii. Income which is attributable to a trust may be taxable to the grantor, the beneficiaries, or to the trust itself. Assignment of Income Through a Partnership i. Example – Parent wants to shift income from printing business to a child. Parent proposes a partnership. ii. First question is whether the partnership is valid. 1) If members of a family are partners in a partnership, the surrounding facts and circumstances will be closely scrutinized to ensure that the partnership is valid and is not being done to assign income. 2) Supreme Court said that if partnership was valid under state law, it had to be treated as a partnership for tax purposes. iii. When capital is material income-producing factor in a partnership, partnership income will be allocated among the partners in accordance with the partnership agreement, even though one or more of the partners received their partnership interest as a gift from another partner. 1) IRC § 704(e) – Family Partnerships i) Before you can shift income to family partner by gift, the donor partner must be compensated for fair value of services. Assignment of Income Through a Trust i. In order to shift income, you must let go of the trust property. ii. Helvering v. Clifford Case 1) Grantor Trusts 2) Taxpayer declared himself trustee of part of capital he owned and made his wife the beneficiary. Basic Tax I - Carey Summer 2003 Page 47 of 56 3) Each reported portion of income from trust. 4) Court held that because duration of trust was short and corpus reverted to taxpayer, the income from the property held in trust must be paid by taxpayer – not split between taxpayer and wife. 5) Created doctrine of substantial ownership. 6) Congress then codified rules to apply to this type of situation. 7) IRC § 676 – Power to Revoke i) If trust is revocable, income from trust is taxable to grantor. 8) IRC § 673 – Reversionary Interests i) The grantor shall be treated as the owner of any trust in which he has a reversionary interest, if the value of the reversionary interest exceeds 5% of the value of the corpus. ii) If present value of reversion is greater than 5% of the value of the corpus, the grantor must pay taxes on income. 9) IRC § 677 – Income for Benefit of Grantor i) The grantor shall be treated as the owner of the trust and have to pay tax on the income if the income from the trust is distributed to the grantor or the grantor’s spouse. B. Alimony, Child Support, and Property Settlements 1. IRC § 71 and IRC § 215 2. Alimony a. Alimony means i. Any payment in cash and must be 1) Received by or on behalf of a spouse under a divorce or separation instrument, 2) The divorce or separation instrument does not designate such payment as a payment which is not includible in gross income, 3) In the case of an individual legally separated from his spouse under a decree of divorce or separate maintenance, the payor and payee must not be members of the same household at the time the payment is made, and i) MUST PICK UP ON THE FIRST PART OF THIS PROVISION – IF THERE IS NOT A DECREE OF DIVORCE OR SEPARATE MAINTENANCE AND SPOUSES LIVE TOGETHER, THERE IS STILL ALIMONY. Basic Tax I - Carey Summer 2003 Page 48 of 56 4) There is no liability to make any such payment for any period after the death of the payee spouse. ii. Divorce or separation instrument means 1) A decree of divorce or separate maintenance or a WRITTEN instrument incident to such a decree, 2) A written separation agreement, or 3) A decree requiring a spouse to make payments for the support or maintenance of the other spouse. iii. Alimony in Gross 1) Parties agree that alimony is a set sum – example is $1,000 per month for 10 years. b. Front-Loading Rules – IRC § 71(f) i. Intent is to basically say that if payments are front loaded, it is a property settlement, NOT alimony. ii. Only first three years are looked at. iii. Example – Year One Payment = $200,000, Year Two Payment = $100,000, and Year Three = $50,000. Question is how much is alimony? 1) Adjustments will go on Year Three tax returns. 2) Step One – Determining Excess Payments for 2nd Post-Separation Year i) 2nd Year Payments minus the sum of 3rd Year Payments and $15,000. ii) $100,000 – ($50,000 + $15,000) = $35,000 3) Step Two – Determining Excess Payments for 1st Post-Separation Year i) 1st Year Payments minus the sum of $15,000 and the average of 1)2nd Year Payments minus Step One and 2)3rd Year Payments ii) $200,000 – ($15,000+ $57,500) = $127,500 4) Step Three – Determining Total Excess Alimony Payments i) Excess payments for the 2nd Year PLUS Excess Payments for 1st Year ii) $35,000 + $127,500 = $162,500 5) In 3rd Year, Payor would deduct $50,000 for 3rd Year Payment but would add income of $162,500; Payee would have $50,000 of income and $162,500 of deductions. iv. Example 2 – Year One Payment = $100,000, Year Two Payment = $75,000, Year Three Payment = $10,000. 1) Adjustments will go on Year Three Tax Returns 2) Step One – Determine Excess Payments for 2nd Post-Separation Year i) 2nd Year Payments minus the sum of 3rd Year Payments and $15,000 Basic Tax I - Carey Summer 2003 Page 49 of 56 ii) $75,000 – ($10,000 + $15,000) = $50,000 3) Step Two – Determining Excess Payments for 1st Post-Separation Year i) 1st Year Payments minus the sum of $15,000 and the average of 1)2nd Year Payments minus Step One and 2)3rd Year Payments ii) $100,000 – ($15,000 + (($25,000+$10,000)/2)) = $67,500 4) Step Three – Determining Total Excess Alimony Payments i) Excess payments for the 2nd Year PLUS Excess Payments for 1st Year ii) $50,000 + $67,500 = $117,500 5) In 3rd Year, Payor would deduct $10,000 for 3rd Year Payment but would add income of $117,500; Payee would have $10,000 of income and $117,500 of deductions. c. 71(b)(1)(B) allows payee to have excess payments designated as payment which is not includible in gross income. d. Deductible for payor. e. Income to payee. 3. Child Support a. Child support is any payment for the support of children. b. No tax consequences or deductions for child support that is FIXED in divorce or separation instrument. c. Tax incentive for ―deadbeat dads‖ – if payment is less than the amount specified in instrument, the dollars first go toward child support. Only after child support is satisfied will the taxpayer get the deduction for alimony. d. No deduction for payor. e. Not income to payee. 4. Property Settlement – IRC § 1041 a. No gain or loss is recognized when an individual transfers property to his spouse or his former spouse if the transfer is incident to divorce. b. Basis of property is the same in the hand of the transferee as it was in the hand of the transferor. c. Must occur within 6 years of the date of cessation of marriage. d. No deduction for payor. e. Not income to payee. f. Example – Basis of $50K and FMV of $200K. One spouse transfers to other spouse at divorce. Basis in hands of transferee would be $50K. g. Example 2 – Basis of $50K and FMV of $40K. One spouse transfers to other spouse at divorce. Basis in hands of transferee would be $50K. VII. Basic Tax I - Carey Summer 2003 Page 50 of 56 i. This is different from normal gift provision because, under normal provision, basis would have been $40K in hands of transferee. h. Effect of this provision is that tax liability is shifted from transferor to transferee because transferee would pay taxes on subsequent sale of the transferred property. Characterization of Income and Deductions A. Treatment of Capital Gains and Losses 1. Capital gains or losses arise from the sale or exchange of property which is a capital asset. a. ―Gains or losses‖ – as we have discussed in class. b. ―Sale or Exchange‖ – property must exist after the sale or exchange. If property is destroyed and insurance is paid, there is NOT a sale or exchange. c. ―Capital Asset‖ – IRC § 1221. Capital asset means property held by the taxpayer (whether or not connected with his trade or business) but does NOT include i. (1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business; 1) An example of this would be dividing up property and selling off. In this situation, taxpayer is ―holding property primarily for sale to customers in the ordinary course of his trade or business.‖ With this situation, it would not be a capital asset. ii. (2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business; 1) Provision ONLY applies to depreciable property used in a trade or business. 2) Not all depreciable property is used in a trade or business. 3) This is not really adverse to business because it funnels people into IRC § 1231 which is beneficial. iii. (3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by— 1) (A) a taxpayer whose personal efforts created such property, 2) (B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or iv. v. vi. vii. Basic Tax I - Carey Summer 2003 Page 51 of 56 3) (C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B); i) Essentially, authors do not get capital gain treatment. ii) However, patents do get capital gain treatment. (4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1); (5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by— 1) (A) a taxpayer who so received such publication, or 2) (B) a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A); i) This provision deals with government publications acquired for free by politicians and given to charities. Congress removed this from capital gains property. (6) any commodities derivative financial instrument held by a commodities derivatives dealer, unless— 1) (A) it is established to the satisfaction of the Secretary that such instrument has no connection to the activities of such dealer as a dealer, and 2) (B) such instrument is clearly identified in such dealer's records as being described in subparagraph (A) before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); (7) any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); or 2. 3. 4. 5. 6. Basic Tax I - Carey Summer 2003 Page 52 of 56 viii. (8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer. Capital gains are subject to a preferential tax rate. An argument for capital gains is that gains are recognized in ONE taxable year and person should not be penalized for long-term appreciation of capital. Another argument is that this encourages investment in economy. Definitions a. Long-Term = Held greater than 1 year b. Short-Term = Held 1 year or less c. Net Long-Term Capital Gains i. Long-Term Capital Gains – Long-Term Capital Losses = Net Long-Term Capital Gains d. Net Short-Term Capital Losses i. Short-Term Capital Losses – Short-Term Capital Gains = Net Short-Term Capital Losses e. Net Capital Gain i. Net Long-Term Capital Gains – Net Short-Term Capital Losses = Net Capital Gain f. Adjusted Net Capital Gain g. 28% Rate Gain h. Collectibles Gain i. Unrecaptured Section 1250 Gain j. Section 1202 Gain Steps in Working Capital Gains Problems a. Classify gains and losses as short-term or long-term. b. Determine net of each. c. If signs are different, net the overall results. i. Final result takes character of the type with larger net result. d. If signs are same, do not net against each other. i. Final result is calculated separately for each type. e. Net long-term capital gains get 15% preferential rate. f. Net short-term capital gains are treated as ordinary income with no preferential treatment. g. If there is a net capital loss, i. $7,000 net long-term capital loss. ii. $4,000 net short-term capital loss. 1) Take short-term first 2) Deduct first $3,000 (set amount) from ordinary income. 3) Carry forward amount not used – in this case, $1,000 of short-term capital loss and $7,000 of long-term capital loss. 4) Add these carryovers into the piles of capital gains and losses for next year. Basic Tax I - Carey Summer 2003 Page 53 of 56 5) In the following year, deduct $1,000 of short-term capital loss and $2,000 of long-term capital losses. 6) Carry forward amount not used – in this case $5,000 of long-term capital loss. 7) Add this carryover into the pile of capital gains and losses for the next year. If there is a net capital loss, would go through Step g again. 8) And so on... 7. Correlation with Prior Transactions a. Arrowsmith case i. Distributions received by liquidation of corporation would be treated as long-term capital gains. ii. If there is a subsequent liability of the corporation that must be repaid, any repayment by shareholder is to be considered a capital loss. iii. Essentially, payback must be treated in the same manner as the receipt. b. Skelly Oil case i. Income from sale of oil of $1,000,000. ii. Took depletion deduction of 27.5% of $1,000,000 or $275,000. iii. After deduction, reported income of $725,000. iv. Later, there is a judgment to pay back $1,000,000. v. Since taxpayer only reported income of $725,000, they are only allowed to deduct $725,000 when they pay back. 8. Hedging Transactions a. Corn Products case i. When trading in futures is interwoven with inventory, gain or loss is applied to ordinary income – not capital gains. b. Arkansas Best case i. Corn Products doctrine should only be applied in the narrow instance when there is a true connection with inventory process. B. Quasi-Capital Assets - § 1231 1. Property used in a taxpayer’s trade or business of a character which is subject to the allowance for depreciation and real property used in a taxpayer’s trade or business are excluded from the statutory definition of capital asset. The sale of such property produces ordinary income. 2. § 1231 Assets a. The rules of § 1231 may apply to 2 categories of property included in the classification of § 1231 assets: 1)property used in the trade or business, or 2)capital assets held for more than 1 year AND held in connection with a trade or business or a transaction entered into for profit. 3. § 1231 Has a Netting Process Basic Tax I - Carey Summer 2003 Page 54 of 56 a. Example – Taxpayer sold two pieces of real property used in a trade or business. One is sold for $150K with basis of $100K – gain of $50K. The other is sold for $160K with basis of $200K – loss of $40K. Hotchpot has +$50K (LTCG) and -$40K(LTCL). Thus, there is a net +$10K(LTCG). This now goes to § 1222 to be netted out along with other capital gains and losses. b. Example 2 – Suppose there is a big piece of machinery with basis of $70K and is sold for $130K. Gain of $60K. §1245 overrides § 1231. § 1245 would then recapture to the extent of the smaller of the gain or depreciation taken and it would count as ordinary income. Any excess of gain over amount recaptured by § 1245 would then go into the hotchpot. c. Main hotchpot consists of stuff thrown out by § 1221(a)(2), stuff that comes up through sub-hotchpot, and involuntary conversions other than casualty events. 4. The Sub-Hotchpot a. Applies to involuntary conversions through casualty events. b. § 1231(a)(4) – In the sub-hotchpot, if the losses exceed the gains, then all the sub-hotpot items are thrown out of § 1231 and become ordinary loss. If the losses are less than or equal to the gains, the sub-hotchpot items go into the main hotchpot. i. Example – Duplex with basis of $100K and FMV of $150K. No insurance and is destroyed by fire. Loss of $100K Under §1231, this is involuntary conversion of capital asset, the loss goes into the sub-hotchpot. There is only one item of -$100K loss. In this case, the loss exceeds the gain and the item is excluded from § 1231 and is an ordinary loss of $100K. ii. Example 2 – Same as above but insurance company pays $150K. This would result in gain of $50K. In this case, the gain in the sub-hotchpot would then get kicked up to the main hotchpot. c. Two types of involuntary conversions: casualty or condemnation. d. Under §1231(a)(3)(ii)(II), investment property that is involuntarily converted goes into the sub-hotchpot 5. Complete Example a. Duplex is investment property and has FMV of $150K with basis of $100K. Insurance of $150K so there is a gain of $50K. This goes to the sub-hotchpot. Since gain is greater than loss, the $50K goes to main hotchpot. Other property that is trade or business property has basis of $75K and is sold for $150K. Gain of $75K goes to main hotchpot. Now, the main hotchpot contains LTCG of $125K. b. Same as above but other property has basis of $150K and is sold for $75K, resulting in a loss of $75K. This would go to main hotchpot and would result in a $25K loss. This loss would be treated as an ordinary loss. Basic Tax I - Carey Summer 2003 Page 55 of 56 6. Another Complete Example a. Two pieces of real property used in trade or business. Property 1 has basis of $500K and FMV of $400K. Property 2 has a basis of $1000K and FMV of $1200K. Both are § 1231 main hotchpot property. In December, we sell #1 for loss of $100K. Main hotchpot would have loss of $100K. This would be ordinary loss. In January, we sell #2 for gain of $200K. Main hotchpot would have $200K. This would be $200K LTCG taxed at 15% rate. Thus, by separating, we achieved tax advantages. Congress saw this as a loophole and if there is a gain in the 5 years following a loss treated as ordinary loss, the previous years’ loss is treated as ordinary income and the difference as capital gain. Essentially, this closes the loophole and makes tax consequences the same as if both properties had been sold in the same tax year. i. Can avoid this by selling gain property prior to selling loss property. C. Recapture of Depreciation 1. Depreciation deductions taken with respect to property used in a trade or business, or property held for the production of income, are ordinary deductions and are subtracted from ordinary income. 2. Basis is correspondingly reduced by the amount of the deductions taken. 3. In addition, such property may be treated as a quasi-capital asset and the gain realized on its disposition may be treated as long-term capital gain. 4. Recapture provisions of IRC §§1245 and 1250 characterize gain as ordinary income realized with respect to the deductions that have been taken. 5. Recapture Under § 1245 a. § 1245 Only applies to depreciable tangible personal property. Real property is NOT included in § 1245 property. b. If § 1245 property is disposed of, the EXCESS of the lower of either 1)the recomputed basis of the property or 2)the amount realized or the fair market value OVER the adjusted basis of the property. c. Smaller of the 1)the gain or 2)the depreciation taken is ordinary income. d. Example – Truck cost $50,000 and depreciation deductions have been taken in amount of $40,000. This leaves basis of $10,000. The truck is sold for $30,000. The gain is $20,000. The gain of $20,000 is smaller of gain or depreciation and is counted as ordinary income. e. Example 2 – Same as above but truck is sold for $70,000. Gain is $60,000. Depreciation of $40,000 is smaller of gain and depreciation and $40,000 is treated as ordinary income. The remaining $20,000 must be characterized by § 1231. 6. Recapture Under § 1250 – Carey does not care about § 1250. a. b. c. d. Basic Tax I - Carey Summer 2003 Page 56 of 56 If § 1250 property is disposed of, a portion of the realized gain may be required to be treated as ordinary income. Only ACCELERATED depreciation is recaptured under § 1250. i. The accelerated part of the depreciation is the amount by which the depreciation actually taken exceeds the amount which would have been taken under straight-line depreciation. § 1250 property means any real property which is or has been property of a character subject to the allowance of depreciation. § 1250 is still in the code but is rapidly becoming meaningless.