1 Basic Tax – Outline I Intro Types of taxes and Calculations A. Types of Taxes • Here the class is concerned with mostly Federal taxes and income tax o State income tax – unusually determined by making a few adjustments from federal from income tax. • Kinds of federal taxes o Social security/Medicaid – taken from Gross wages (on paycheck) o Income tax o Consumptions taxes – taxes on goods and services o Estate and gift taxes – taxes on the transfer of wealth • Income Taxes – determined from a “person’s” increase in wealth o Ways that one increases wealth Salaries Money from investments (dividends, interests in stock etc.) Royalties from Intellectual property Buying and selling stock When liabilities are decreased thus increasing your wealth o Person definition – can be human beings (individual), corporations, partnerships, trusts, estates o Distribution of the taxes among the populous Human beings contribute more to total tax then corporations (refer pages 6 and 7 of class one handout) Top 10% (incomes just over 100,000 and up) pay about 70% of the total income tax for the country Top 50% pay about 97% of the total income tax of the country. Bottom 50% -pay only about 3% of the total income tax and many in the tow lowest Quintiles (30%) actual pay negative tax and thus receive some money back • EITC – earned income tax credit – where the welfare system is tied into the income tax system – people of low enough income receive money if their income is too low. o Largest welfare system in the US – about 32 million was spent on this welfare (covers their payroll taxes) o Three Types of Tax systems 1) Everyone pays the same amount of taxes (Ex: $2,000 a year) a. Never has been done 2) Flat tax – the same percentage of income by everyone (Ex: all pay 25% of their income) a. Several proposals 3) Progressive tax – the more income one has the higher percentage of tax that you pay – the more you make the more you contribute to society a. This is how the current income tax system is set up. 4) Regressive Tax – one where the burden falls more heavily on those with lower than higher income. a. Ex: sales tax – people with less money have to spend more money to survive – almost all income is subjected to tax (hence why most states no longer have a tax on food) o Calculation of Income Tax Sales – when individual is in the bus of sales • First Step: Gross receipts (the price of the goods sold) – Cost of selling the goods (manu costs etc.) = GI (gross income) 2 o § 61 – defines gross income and list items it can be derived from. Individuals not in the sales bus skip first step. – here any increase in wealth is presumably gross income (buy land for 10 sell for 15 you get 5 on income) • GI – Business expenses = AGI (adjusted gross income) • AGI – personal deductions and pub exemptions = TI (taxable income) o AGI is only a stop for individuals not corps o It is the not GI that is being taxed but the net income whereas SS is tax on gross income not net. (different in handling income v. just the profits) • TI – then find tax rates in the code to get your tax = T (tax) o § 1 – lists tax rates on individuals/estates and trusts (get to 40% faster) Depending on the amount of income will determine which marginal bracket you fit into. – highest marginal bracket runs around 40%. o § 11 – lists tax rates for corps o Ex: if over 250,000 you pay a certain rate and then 39.6% over than amount. • T (tax) – Credits (worth more than deductions) = liabilities (this number can be positive or negative) o If neg you do not need to pay any taxes and they may owe you? Deductions v. Credit • Reasons for deductions – where it would help to buy houses b/c of policy reasons in that encourages people to live in communities and stimulates economy. • Credit examples – o the amount of money withheld from income by employer – sometimes they hold too much and thus this leftover money is subtracted as a credit o Foreign tax credit – if one is subject to taxation by a foreign country section 901 of the code gives credit for US tax that has to be paid to a foreign country. o EITC – earned income tax credit. • Will save more on a credit than a deduction. o If you are in the last tax bracket and you save $1 As a credit you save the whole dollar As a deduction you only save 40 cents (b/c of bracket) o Problem is that people with higher incomes save more on deductions than people with lower incomes. Ex: person in lowest bracket would only save 15 cents on deduction while the party in the highest would save 40 cents. If the deductions are viewed as public expenditures (help people buy houses) then most of those expenditures are going to people with higher incomes. – Expenditure of gov money. Solution: perhaps those expenditures should be made as credits rather than deductions. • Recently expenses on household children and day care was made a credit when it had previously been a deductions -§ 21 3 II. Gross Income A. What is Gorss income? Any time there is an increase in wealth. • § 61 – lists items that are GI but is not exemplary – Congress has listed other items as well o Decrease is liabilities is GI -Ex: An increase in networth by a decrease in liabilities is GI (networth = assesrts – liabilities) Proprietorship – the capital that is paid by the original shareholder for the original stock Bonds/interest rates – if sell a bond at a higher interest rate and then rates go down the bond will sell for money and will sell for less money if interests rates go up. Dividend – profits appropriated for division amount stockholders • If shareholders get money then this increases GI • Eisner v. Macomber: As long as shareholder get common on common or the dividend is paid to common shareholders in common stock and nobody gets cash, then that new stock is tax free – it is not part of Gross income o Damages: (coming back to) Compensatory – tax free – not party of GI Punitive – a part of GI o Stealing money – you have to pay income tax on the money that you stole even though you have to pay it bacl if you have to pay it back it is a deduction. Resolution – the government gets the money rather than the person it is stolen from. 5th amendment – does not mean you cannot refuse to report income – you still have to report the income but do not need to report the details. – need to state “I preserve 5th amendment rights” so you do not have to describe details. o Realized and Recognized gains (see below under D) Gains realized by dealings in property (see section B) o Compensation for Goods or services Be paid by money “In kind” being paid by property rather than by money or checks. Employer gives discount to Employee – here the difference in value is the GI and would be party of compensation for services Employer pays employees tax return – here this is regarded as additional compensation and thus the amount paid is GI and will be taxed as well. • Tax can be paid directly – by you • Tax can be paid indirectly – by employer. o Alimony – is included in GI for the recipient spouse (§ 71) and the paying spouse can normally take it as a deduction (§ 216). o Reimbursement for moving Expenses – are included in an employers GI B. Gains by dealings in Property • Calculations – The amount received – Basis = Gain or loss • Basis – the amount you have invested into the property – usually is the cost of the property item when you bought (plus adjustments) and this accounts for the majority of situations. o Supreme Court Presumption – If you are dealing in at arms length – if the value on one side can be determined and not on the other then it can be presumed the other’s value is the same (trolly v. Bridge example) • Different Situations and their basis o “Payment in Kind” – the cost basis of the property will be income that they had reported. (Ex: employer gives employee $6,000 value car instead of $6,000 in money for compensation – here $6,000 would be her basis if she chose to sell the car later) • Basis of property acquired for a Decedent § 1014. 4 o “Stepped up Basis” § 1014 (a) – here the basis is the FMV of the Date of Death (DOD) not the decedents basis for the property Here this is very controversial – Sunset Bill (10 year period) was passed to phase out the rule and thus in 2010 this provision will not be applicable and then in 2011 it will show up again • Two exceptions to the Bill ?????? (1) the executor can designate 1 million of the property (2) in addition, the first 3 million takes the DOD value basis and everything else gets an adjusted basis? Here an appreciation on the property is not taxed and thus families tend to save a tremendous amount of tax. Denial of “Stepped Up Basis: 1014(e) – appreciated property will not receive a stepped up basis if it is acquired by gift by a decedent within one year of his death and it passes back to the initial donor or the donor’s spouse. Instead the property will have the transferred basis = to the donor’s basis of the proerpty prior to the gift to the decedent. • Basis of property acquired as a Gift -§ 1015 – here the basis is the same as it was for the donor. (Ex: if basis is $50,000 and sell it for $550,000 – the income is $500,000) o Exceptions: (so families will not pass loss around so one can save on paying taxes) (1) if the basis is greater than the FMV (B> FMV) and 2) there is an actual loss on the sale) then the basis will be the FMV and not the donor’s basis. If the amount realized is in between the donor’s basis and FMV then there will be no gain or loss Basis is $200,000 – any amount realized on prop sale that is > or = to then use the basis FMV is $100,000 – any amount realized on prop sale that is < or = to use the FMV as the basis Any sale in between $100,000 or $200,000 then there is no gain or loss. This would apply if the property was sold at $150,000 o Gift Tax -part of gift tax is added to basis – here a formula isolates the portion of the value that is being taxed twice. Appreciation of value – here this is the amount the FMV exceeds to basis • You take this value and multiply it by the gift tax to determine what portion of the gift tax you would ad to the basis. Calculation: Increase in Basis = (gift tax paid) x (FMV – Donor’s basis) (FMV of Gift) • Basis for property given to spouses or former spouses § 1041 – no gain or loss shall be recognized on a transfer of property from spouses of former spouses. o The transferee spouse steps in the shoes of the transferor spouse for basis purposes – the given spouse takes over the others basis. o No exceptions here as under Fit basis for decreases in FMV and basis values. • Adjustments to basis – basis can be adjusted (increased or decrease) o Increases – occurs when owner invests in the property – Ex: adds a room to his house. o Decreases (more common than increases) Depreciation – when an item is a bus cost and the party needs to spread the cost of the item over the years for tax liability (concerns when to make deductions) When you anticipate a $40,000 truck to last for 4 years you would deduct $10,000 a year. • After the first year you would deduct $10,000 from your tax return. • If you then sold your truck for $50,000 – the Adjusted basis would now be $30,000 ($40gs -$10gs deduction) = $20,000 in GI • Amount Realized (amount received) o Craine Case – borrowed money is counted into basis and amount realized. (Ex: if one buys a house with a loan, the basis will include the amount of the loan – if one assumes the a loan as party of buying the property then the amount of the loan assumed is part of the amount realized) – Note: house is good financial leverage b/c when you have a loan 5 you can take deductions (depreciations) for money you have not paid yet) – applies to loans concerning recourse and non-recourse liability Recourse liability – when you take a mortgage on your house and (1) sign a personal note saying you will promise to pay and (2) give the lender a security interest that offers them a right to foreclose if you do not payj (if foreclose gives less then total owed amount the bank can come after you for the remainder) – Buyer would assume the mortgage for the amount realized Non – recourse liability – you take a mortgage and give house for security but do not sign a person note promising to pay. Thus the lender can only take the money received from the foreclose. Buyer would buy the property subject to the loan for the amount realized. – done more in commercial settings. o Selling Expenses – expenses paid when one invests in property to sell it must be capitalized and thus must be added to the basis or subtracted from the amount realized depending on how it is spent. (commissions etc.) Ex: Party buys stock and pays $50 to stock broker to buy it. Here this investment would add $50 to the basis of the stock. Later when he sells the stock and he pays another $50 to have this done, then $50 would be subtracted from the amount realized. (discussed how people would rather take the money as a deduction b/c you would get the cost off now rather than later when you sell it if you do and because the capital gain is taxed at a different rate?) C. What is not Income • Imputed Income – Market value of rights exercised in consumption – when you do something yourself you could have hired another to do (mow lawn) or chose to live in a house when you could have increased wealth by renting it. o Imputed income is not factored into GI -an agreement by concensus o Ex that appear to by imputed income but is not. – If guy owns bus and transfers house to his corp and then lives in it – then the rental value will be GI b/c the corp by allowing him to live rent free is transferring its wealth to the shareholder. • Unrealized gains and losses – when property increases in value it is not income until that increase in value is realized by selling it and making some sort of a profit. Simply b/c you have stock and the stock value increases – you do not actually gain until you sell that stock. • Borrowing – Do not tax b/c it is not an increase in wealth b/c you have to pay it back o ut if your liabilities are decreased (the bank agree that you do not have to pay the whole loan) then this decrease in liability will be GI • Rebates – a reduction in purchase price not added to GI • Damages §104 – Compensatory damages are excluded from GI, specifically insures arising from physical injury or physical sickness (this may include physical manifestation injuries from Emotional distress. (§ 213 – a deduction would just be for medical expenses that exceed 7.5% or your income) o Exceptions: Recipient has already taken a deduction on the amount for (medical expenses) in any taxable year prior to receiving compensation. Punitive damages Damages arising from Dignity torts (discrimination cases) – such as emotional distress, humiliation, mental anguish etc o Health Insurance – money given for medical expenses Employee Provided benfits § 105/106 1) If the employer paid a premium to the insurance co – the insurance premium paid to the employee is excluded from income 2) If someone gets sick and the policy of the employer is to the pay a benefit to the employee or his family that money is excluded from GI to the extent that it pays for actual cost. (problem it causes more people to seek health assistance which raises demand for that assistance and thus doctors raise up costs. 6 Benefits over a policy you pay yourself § 104a3 – here the policy is not limited to the insurance money that reimburses you for medical costs, whatever the co pays even if it exceeds medical costs is the amount that can be excluded from GI. (today unlikely to get extra dough, could have in the past if being reimbursed by employer and health co.) • Proceeds of Life Insurance § 101 – are not included as GI for the beneficiaries. (includes workers comp, health etc.) o Amounts paid by an insurer to the terminally (die in next 24 months) or chronically ill (unable to perform some essential daily activities) are not GI either – advent of aids (§ 101g) o Provision does not apply if one cashes in on their policy are borrows on it. No reserve term policy – payment each year depends on ones mortality rate and will increase significantly when they get older, thus one would have no reserve and can not cash in or borrow Whole life policy – pay the same amount yearly but would pay more at a younger age then one above/here there would be a reserve to cash in on or borrow. o Annuity (§ 101d/72) – stream of payments over time (installments) – part of the payment will be the principal and another party will be income (mortgage) -§ 101d applies when the insurance co. gets the beneficially to agree to payment of the life insurance in installments instead of in a lump sum/if the ben takes the money and goes across the street to another co then § 72 would apply. Co will determine amount of payments by a mortality table (Reg § 72) – 925 of supplement. Party will not pay Income tax on the principal but the income/interest would be a party of their GI. • Calculation – take a faction Numerator – the installment # Denominator-installment x mortal years Differences between 101d and 72 • If party lives over the years that was calculated for in the table o 101 – You keep the exclusion rate forever o 72 – once the years have passed you no longer have an exclusion and all is GI after that and thus taxed • If the party dies before the years designated on the table – short recovering original investment. o 101 – out of luck o 72 – your estate would get a deduction for the rest of the amount you are owed. o Transfers – the exclusion from GI does not apply if the policy has been transferred for valuable consideration – you are taxed on the amount that exceeds the consideration (pay $3,000 and got $10,000 after guys death you would be taxed on $7,000) – If one gives the policy to another then the donor’s basis will be deemed = to the basis of the transferor (what money he invested into the policy) Two Exceptions to above when the exclusion would apply. 1) If the transferee of the policy has a transferred base in the policy or 2) If the transferee is the insured, the insured’s partner or a partnership in which the insured is a party, or a corporation in which the insured is a shareholder or officer. • Gifts and Inheritance § 102-amounts received as a gift, or by bequest, devise or inheritance are excluded from GI o For Income the gift definition is Subjective – when party makes gift out of affection or generosity (a question of fact) – done b/c then gov would get more money o Gift tax gift definition – is objective where one simply gains an excess amount with no form of payment for that amount. 7 o Inheritance-generally applies to any property received under a will. However if there is any indication the money given is for compensation (not donative purpose) then that amount will be GI. Post death estate planning – can fine tune tax even after ones death by the executor. The executor gets a statutory commission/which would be compensation and taxed. – however if executor is an heir there may be some problems? • Interests on State and Local Bonds § 103 – interests received on municipal bonds is excluded form GI (does not apply to federal bonds) o Purpose – an incentive to generate the economy and for people to buy bonds from their state governments rather than corporate bonds b/c often even though the corporate bond would have a higher interest rate the state bond would still yield more wealth b/c of the amount you do not have to pay in taxes. o The federal government hear however losses more than the state gains. o Arbitrage Bond Exception – an exception when one buys an arbitrage bond. – when you (government official) buys a bond and just trades on the difference in too markets. If her borrows $10,000 at a 3% interests rate and invests that money in an area that has a 4% interest. He would make $400,000 on the interest (which he is not taxed for) and would only have to repay $300,000 on the bond and thus would get an estra $100,000 per year. • Educational provisions – the following are excluded from GI to the extent they pay for tuition and or fees and books not lodging and food. o Qualified Scholarship o Qualified Tuition Reduction – the amount an institution reduces tuition o Education Assistance Programs – an employee may exclude up to $5,250 of the value of benefits received by an employer under an education assistance program (employers written plan providing educational assistance exclusively for his employees) o Educational Savings Accounts – Cash is contributed to an educational savings account which is used to pay for educational expenses – limited to $2,000 per beneficiary o Qualified Tuition Programs – where a state or educational program makes cash contributions to an account in order to pay qualified higher education expenses – not limited to a dollar amount. o 529 Plan – if you set aside money is a State plan, then the fund can be used to pay college tuition and expenses – there is no limit on money and tends to be flexible/can put into different states. D. Realized v. Recognized – • Recognition – a policy concept concerning whether a realized gain should or should not be taken into account as GI o Some sections of the Code do not recognize realized gains. (Ex: two apartment owners swap buildings) • Realized gains – a real world fact situation III. Deductions (Bus expenses to acquire AGI) A. Trade or Bus Expenses § 162(a) – a deduction is allowed for ordinary and nec expenses paid or incurred during a taxable year in carrying on a trade or bus. • Ordinary – the expense is common to the business community to which the taxpayer belongs. (though common the expense can still be once in lifetime – damages) – the expense is not outlandish • Necessary – It is appropriate and helpful and reasonably beneficial to the trade or businss. o Ex: Holding daughter wedding at store is not nec bus expense/deducting a generator rather than getting insurance b/c it would cause problems w/co you are trying to do bus with is reasonable. 8 • Carrying On – the expense must be incurred while carrying on the bus. Expenses incurred while acquiring or starting a new trade are not deductible, only applies to expense incurred while carrying on an existing trade. o Entrepreneur/Starting Up Costs § 195 -the expense while non deductible while investing a new trade may be deducted if the party enters the trade must be deducted ratably over certain period selected by taxpayer but no less than 60 months. (Ex: deduct start up expenses the first five years of business. • Trade or Bus. – you need to be engaged in a activity seeking profit. – really a factual question (does this look like a hobby farm – white fences?) o Exemption § 183 – a deduction can be entered for an activity not for profit to that extent that the gross income derived from the activity for the taxable year exceeds the deductions allowable by reason of paragraph one (deductions allowable under chapter) – Can deduct your income? B. Expense (deductible) v. Capital Expenditure (nondectible) • Expense/Period – includes amounts spent for incidental repair or maintenance of bus property – not likely to substantially prolong life of the property – an expense that arises that is not foreseeable but you must spend so you can keep doing what you where doing before/advertising. (Oil example) • Capital Expenditure – money paid which cause property to have a useful life well beyond the taxable year, an amount that adds value to the property or adapt property to a new and different use, it completes an expense you have already foreseen by entering into the business (drive in theater – could foresee having to put in drain) C. Typical Business Expenses Deducted • Salaries – are deductible to the bus (corp) if the amount is reasonable compensation and are purely for services. (compare the pay with that of other jobs, is it contingent on commission/income of co.?) o Generally you focus on the dollar figure but some focus on the reasonableness of the method – is it based on co. income? o Some ways they have been abused: Princeton Example – put kin on mom and dads co. payroll so she would have income and less tax and thus would make total cost of schooling less. – problem not reasonable b/c she renders no services Dividends – to avoid double taxation (taxed once of income of co. and then again for income of shareholder) some companies have put the shareholders on the payroll so the co. can deduct the money they pay out in dividends. – there would be some service rendered – there is a problem if the co. grows and gets huge profits which would make the dividends large and thus make compensation unreasonable. Golden Parachute payments § 280g– larger severance payments to people in corp if there is a takeover. The payment must be at least three times the individual’s base pay. (Subtract payment from base and that excess would not be deducted.) • Traveling Expenses § 505 – deductions are allowed for traveling expenses, including lodging and a portion of the cost of meals (50%) which the taxpayer accrues while traveling away from home pursuant to a trade or business. o Away from Home – this concerns tax home which is your principal work location. (principal place of business) Commuting – expenses non deducted – if you travel away from tax home and then travel back to real home without going to tax home the ride home is considered commuting and thus not deductible. • Exception – difficulty in transporting tools when it would incur additional costs in commuting – would only allow deduction for costs that exceed the base (normal cost of commuting) (can appeal to US 9 state tax court and then appeal from there to circuit court – Galson – the tax courts will follow holdings of the circuit courts to which there decisions can be appealed. o Time – the time period must be temporary – if the time period is permanent or indefinite then the deduction will not be allowed b/c you effectively have established a new tax home. (1 year rule – sort of an indicator of what is permanent but not conclusive) o Overnight Rule – deduction is only allowed if the taxpayer is away from home long enough to require here to stop for substantial sleep or rest no what distance she has to travel – generally can only deduct if you stay overnight. Transportation cost is not subject to overnight rules, only meals and lodging are. o Bus and personal Transportation – can deduct if business is the primary reason for the trip (over 50% of the days must be bus – exclude travel days unless have bus engagements on those days or work on laptop) Determine if meals or lodging can be deducted on a day by day basis – deduct on bus days do not deduct on personal days. If Holidays interrupts period, this holiday will be considered a bus day. o Foreign Travel § 274c – if travel last more than one week, or if the non-business activities constitute 25% or more of the time, then only a portion is deductible though the primary reason my be bus. Here the only limit airfare – would deduct the airfare by the ration of days that constituted business. – if 6 of ten days where bus, then you would multiply the airfare against 6/10 and that # would be what you deduct. o Proof § 274 – for most bus expenses you can estimate if you can prove the expenses where made but under this section for travel and entertainment expenses you have to keep an accurage record of the amount of money spend with who where etc and prove receipts. o Rentals – expenditures for rentals or other payments required to be made for the use of property in a taxpayers trade or bus are deductible. (Prin can be used as a way to shift income from one to another) • Expenses for Education o When Expenses for education can be deducted 1) If the education maintains or improves skills required by the taxpayer in his existing trade or business/helps the employee to qualify to perform ;new duties if the new duties involve the same general type of work as is involved in her present employment. 2) The education meets express requirements imposed by law of the taxpayer’s employer as a condition to the retention of the taxpayers employment, rate, or compensation (teachers who continually have take courses) o When Expenses for education cannot be deducted Not deductible if the expenses are not made while carrying on a trade or bus or if the education is required to meet the minimum educational requirements for the taxpayer’s employment or which is needed to lead the taxpayer to a new trade or business (law school – even if using it to improve your bus b/c the min requirement to be an attorney) • Not considered carrying on if the taxpayer had abandoned the trade or business and is getting education to return. o Travel and Eduction: Travel as education per se – expenses as a form or education are not deductible (if world history teacher traveled to see Mayan ruins) Travel to Obtain Education – if the taxpayer travels away from home to primarily obtain an education, and the education expenses are deductible, then the traveling expenses are also deductible (lodging and 50% or food) • Entertainment – expenses incurred for means and entertaining may be deducted if there is a business benefit for the expenditure and that expenditure is “ordinary and nec” – entertaining customers and prospective customers is generally deductible. 10 • Uniforms – a deduction is allowable for the cost of uniforms and work clothing, if they are specifically required as a condition of employment and if they are not adaptable to general use (street ware – blue suit of railway conductors was deemed street ware b/c easily could buy in a store) • Dues – a deduction is generally allowed of the payment of dues to an organization which is directly related to a taxpayer’s employment or other trade or business (local union/bar) D. Non-business Expenses § 212 – an individual may deduct all ordinary and nec expenses paid or incurred during a taxable year for expenses incurred or paid during (same limitations as bus expenses – cannot be cap expenditure etc.) • The production or collection of Income – might include attorneys fees attributable to obtaining alimony • For the management of property held for the production of income • For dealings in tax matters – expenses may be used for preparing tax returns, contesting tax liability, or determining the tax consequences of anticipated action. E. Losses (deductions) -General • Loss: Occurs when there are more deductions than income • § 165c(1) – applied when the loss was incurred in a trade or business • § 165c(2) – investment losses – these are losses incurred in a transaction entered into for profit o Consider original motivation or purpose of the transaction (personal not profit if selling house you bought to live in – consider how long you have rented it/longer then argue the transaction became one you entered into for profit – a conversion) o Gambling – winnings are profit and losses to the extent of the winnings can be deducted • §164c(3) – casualty losses – losses from a sudden and unexpected event • Worthless security § 165g(1) – is security or capital becomes worthless in a taxable year the loss resulting from the security can be treated as a loss though the worthless security was not sold (no one would be worthless security – bypasses the requirement that the gain/loss be realized) o Here this would be a capital loss so can only deduct 3,000 and would have to carry the rest forward to be deducted in later years up to that limit o Security must become worthless in the taxable year you take the loss/IRS if testing your return would probably try to argue with you on this one Note: the tax procedure • Tax Return – your own invoice of what you owe – few employees of IRS actually do audits of individuals – only less than 1% of returns are audited each year – level of compliance under 80% • How they pick returns to audit o Enemies/informants/people who win sweepstakes/bounty –turn in boss o Computer analysis – from numbers entered into for statistical sampling of audits – if numbers seem way off they will audit you Discrete variable analysis – process of how they get the average statistical numbers where they audit several people around country every few years/Congress has now limited number they can do this too Usually do not audit people until they are getting in their third year of the SOL • Will ask you to sign form that you waive the SOL • If do not waive they will assert the tax they think you owe them then you can fight it out in court. • SOL o If file return then 3 years – will be longer if person commits fraud o No SOL if party did not file a tax return F. Losses: Bad debts §166 • §166(a) Business Debts – can deduct if the debt becomes wholly worthless or partially worthless (deduct to the extent it is worthless) 11 o The creditor deducts the loss not the one who owes the debt o All debts from the corp is presumed to be a bus debt. o Here the deduction is an ordinary loss not a capital loss o Ex: customers goes bankrupt and can not pay all they owe for the product • Non bus debt – here can only deduct if the debt is wholly worthless, also it is considered a capital loss thus subject to capital loss limitations (only 3,000 per year) o Definition – A nonbus debt is a debt other than 1) A debt which is created or acquired in connection with a trade or bus of the taxpayer 2) A debt which may become worthless, producing a loss which is incurred in the taxpayer’s trade or business. o A shareholder giving money to corp so it does not go under is considered a nonbus debt because the debt not incurred in the shareholder trade or bus unless she can prove that motivation of giving money was to protect their job. (lesson: do not create a corp) • Two methods of accounting o Cash method – take in income when you receive and take a deduction when you pay the money (money in/money out) – used by most attorneys o Accrual Income – take in income when the right arises and deducts when the obligation arises (if you send out a bill you treat it as if it is actually paid and if a bill (utility) arises in your office you go ahead and count is as a deduction. Poor furniture store example (partially worthless debt) – here they sell to low income and know from the get go that a certain percentage will not be able to pay. • Inventory accounting is the accrual method of accounting – here when the customer signs paper for credit the store will book the sale as revenue is the accounts receivable section of the balance sheet, but at the same time will take a percentage of that sale (from overall percentage of those who do not pay) and but that percentage of the sale in the Reserve of uncollectable accounts section of the balance sheet. The # in the reserve section of the sheet is the amount they will deduct on their tax return. Would need to adjust the percentage each month on experience (some months more will pay v. other months) G. Capital loss v. Ordinary Loss (most will come later) • Capital gain or loss – the gain or loss of a capital assert in a sale or exchange o Capital Asset § 1241 – it is property other than what is listed – most common exclusion is inventory (furniture store example –was losing inventory) o Loss – when the basis of the property is more than the amount realized from the property and thus would result is a capital loss o How long you hold property – short term is less than a year/long term if more than a year Short term is treated as ordinary income but treated as a capital loss with limitations even if held short term (3,000 deduction – with rest carried forward) o Examples: Sale of house is a capital loss/but insurance would be an ordinary loss b/c there is no sale or transaction. H. Depreciation (167, 168, 179) – applies to capital expenditures – the cost of doing bus in multiple years • Concept-applies to capital expenditures – it is the cost of doing business in more than one taxable year/it is the method of spreading the cost over a large period of time • Three Methods of Depreciation o Straight line method – spread the deduction evenly over the useful of life of the product (make 1 the numerator/and useful life # the denominator – 1/5) – thus would deduct 1/5 of the cost each year until you reach the right amount Useful life – the years in which the individual plans to use the product (in trade or bus) not the potential life of the property (Ex: rental car place may only use trucks for 2 years b/c people to not like to rent older cars) 12 o Sum of all year method (accelerated) – here would multiply the number by a fraction each year (here the numerator would be the # of year of the products useful life he is taking the deduction and the denominator would be the sum of all the numbers used in the useful life/Ex: the useful life would be 5 years so 1+2+3+4+5 = 15/the first year would be 5/15, the second 4/15 etc.) – multiply these fraction by the depreciable base. o Declining balance (acclerated) – a multiple of the straight line method. Here decline the balance rate by 200% -thus multiply 2 by the straight line method fraction against the amount left on the depreciable base (here the depreciable base would go down each year less the amount you deducted the previous year) (Ex: 2 x 1/5 = 40%/thus you take 40% of the remaining base each year) – page 1794 of book Once you have deducted 2/3 of the base you deduct the rest under the straight line method. • History Lesson o 1954 – here cut back of gov programs and used deductions to stimulate economy – here under § 24d a child tax credit was created, if the credit exceeds tax liability the gov would cut a check for that amount – thus a form of welfare line EITC Prior to 1954 Here the mechanism used was the straight line method of above (the taxable base would be the cost of the property less the salvage value) – useful life would be the actual useful life of the product /a factual question. Change: added the two accelerated methods (sum of years/declining balance) so that the larger deductions where allowed in the early years and thus the economy was stimulated – encouraged people to buy trucks b/c it made trucks cheaper as a whole o 1962 – Kennedy shortened the useful life of property to stimulate the economy by creating the Bulletin F (compilation of averages) – it created certainty and shortened useful lives by applying an average o 1971 – here again useful lives where shortened – here asserted a depreciation range – where a party could depreciate on the bulletin plus or minus 50% o 1981 – Reagon tax bill called the ACRS (accelerated cost recovery system) – here the depreciation method was set at a 200% declining balance method, did not account for salvage value, and useful lives where shortened. o 1986 – MACS – the modified depreciation system – just shortened lives some more a table in 168 • Sections in the Code – depreciation generally o 167 – where depreciation is allowed o 168 – sets up the MACS – Does include property used for investment purposes unlike 179 the salvage value is deemed at zero 200% declining balance method (switch to straight line at 2/3) – page 1794of book breaks down the percentage taken of depreciation base for each year with the half year convention. has a recovery period table – 1st determine useful life in bulletin (few refer to b/c most now) and then the table will tell you how many years to apply • Most property items fit in the recovery period under 3,5 and 7 • 10, 15,and 20 is for strange stuff you do not deal with much such as single purpose agricultural property – chicken coup • Bonus Deductions o 168k (don’t apply on exam) – allows an additional depreciation or 50% (30%) until Dec. 31, 2004 of the property in the first year and then that amount deducted is subtracted from the depreciable base and the rest is depreciable under 168. o 179 bonus deductions – under this section a taxpayer may elect to deduct all or a portion of the cost of the property under this section in the taxable year in which the property is placed. (exam – apply this then 168) Requirements 13 • Applies to depreciable tangible property personalty used in an active trade or business/must be of character that wears over time (intangible like patants and copyrights do not apply)/does not include property used for investment purposes • Personalty real estate – does not apply under this section • Property held for use in investment does not apply under this section. Limitations • Can deduct up to $100,000 (recently changed) – chose what property you wish for the amount to be deducted from • Amount is reduced dollar by dollar by the cost of the section 179 property placed in service during that year over $400,000 (subtract the amount over $400,000 from the amount of deduction allowed) • Applicable Conventions o Mid year convention (majority) 168– assumes property was placed in service mid year and thus would take the depreciation for half of the year on the first year – default standard (thus depreciation would take about 6 years for the property though the useful life of the property is 5) o Mid quarter Convention 168d3 – if 40% or depreciable property is purchased in the last 3 months of the year, the applicable convention is the midquarter convention where property is deemed to be placed in service in the middle of the quarter it is placed in service (the denominator is 8 b/c 8 half quarters.) • Depreciation of real Estate-depreciate the buildings and not the land (Note: personalty is referred to s 1245 property and reality is refered to as § 1250 property) o Residential Real Property – a building or structure where 80% or more of rental income is income coming from dwelling units/Useful life = 27.5 years o Non – residential real estate – office buildings etc./Useful life = 39 years o Depreciation method – straight line and the salvage value is zero o Applicable Convention – mid-month convention. Property deemed to be placed in service in the middle of the month that it was. (if placed in service in Jan you would take 11.5/12 of the depreciation for the first year under the straight line method) • Luxury Autos 280F limitation (cars more than $12,800) o First Year = $2,560 o Second Year = $4,100 o Third Year = $2,450 o Succeeding = $1,475 I. Net Operating Loss deductions § 172 – • “Net Operating Loss” here the net operating loss is the excess of allowable business deductions over GI. ($100,000 GI but $120,000 in bus deductions = $20,000 net operating loss) o Carry back – can carry back the loss to the two proceeding years but must start at year 2 back (here you would get a return of taxes from the proceeding years) o Carry-forward – here you can elect to carry forward – here you have 15 years (can carry forward after you carry back) IV. Personal Deductions and Allowances A. Personal Exemptions § 152 – (Threshold – after a certain amount the amount gets phased out)/around $3,000 • Taxpayer – each taxpayer takes an exemption • Taxpayer and Spouse – can claim to exemption for each spouse on the joint return/if file separate returns and one spouse has not GI and thus is a dependant of the other spouse then the supporting spouse can claim to exemptions on her return • Dependants – a taxpayer can claim an exemption of each dependant. Here there is a three factor test: 14 o GI – GI of dependant can not exceed exemption amount unless under 19 or under 24 but is a full time student for 5 calendar months of the year. o Relationship – (1) a relative including steps and in-laws or (2) an individual who has his principal place of abode in the taxpayers home and the relationship is not a violation of local law (second part not really an issue but was with archaic laws when unmarried couples lived together or homosexuals) o Support test – here the taxpayer must provide ½ of the support for the dependant (food, shelter, clothing, education, medical care etc.) Multiple support agreement – a taxpayer may claim one as a dependant if he provide over 10% support and over half of the support for the dependant is provided by those with a qualifying relationship (none which provided over ½ support) – all others who qualify must file a written declaration that they will not claim his as a dependant as well Divorce – the custodial parent for the majority of the year can claim the child as a dependant unless he singes a written declaration that he will not claim the child as a dependant. B. Interest • Trade of Bus interest-interest can be deducted if it was incurred in connection with the conduct of a trade or bus other than the trade or bus of performing services as an employee • Investment Interest § 163d – can deduct interest paid or accrued from indebtedness incurred in purchasing or carrying property held for investment ------The amount deducted cannot exceed “net investment income” (separate that income derived from investments – expense deductions)-if the interest exceeds this amount then the interest will roll forward and be deducted in another year. • Personal interests deductions – 1986 Act eliminated most personal interest deductions but the following: o Qualified Residence Interests § 163h -here interest secured by borrowing money off qualified property can be deducted. Here the primary residence need not be used unless the party us deducting from loans on two residences then one must be the primary residence. Limited to two residences (a house boat or an RV where one lives qualifies as long as there is (1) a place to sleep and (2) a bathroom) Acquisition Indebtedness – a debt incurred in acquiring, constructing, or improving a qualified residence. Amount of debt is limited to 1 million • Can not add to the original debt by refinancing can only deduct such interest if you buy another house. Home Equity Indebtedness -a debt which is secured on a qualified residence but the loan is spent on other things then acquiring or improving the residence such as for education etc. Amount of debt is limited to $100,000 (in book said that the lesser of $100,000 of the excess in FMV over the acquisition indebtedness) C. Taxes – deductions typically allowed for any taxes but Federal income. The following taxes apply: 1) State, local and foreign property taxes 2) State and local personal property taxes 3) State, local and foreign taxes on income, war profits, and excess profits. 4) Some taxes incurred in carrying on a trade or bus • Foreign taxes – most people rather take the foreign taxes as a credit – will only take a deduction typically if they cannot take the foreign taxes as a credit for some reason. C. Personal Casualty and Theft losses §165h • Bus or Casualty losses – just treated as regular bus and casualty expense • Person Casualty loss – when a loss arises from fire, storm, shipwreck or theft (burden of proof on you), or an event that is sudden, unusual or unexpected in danger – must cause physical damaged. 15 o Measure of Loss – the excess of the FMV before the casualty over the FMV after the casualty. (would be a gain rather than a loss if this calculation exceeds more than your basis – insurance) Applicable floors to the deduction 1) Can only claim for loss that exceeds $100 per casualty event (car accident though lots or property may be damaged) 2) Can only claim a deduction on a loss that exceeds 10% of the parties gross income. D. Charitable Contributions § 170 – can deduct contributions to charities • Qualified Donees – To be exempt the organization/institution has to be (1) charitable and (2) serve a pubic interest: o Typically charities Churches and schools – organizations that are exempt from tax under §501c Government entities (state and federal government) – here they are exempt b/c of constitutional interpretation. o Public policy – the government may declare that contributions are not tax exempt if made to an organization whose actions and views are against public policy (where the segregate on the basis of race – be beware of gender discrimination) • Measure of the amounts given to charities o Cash/check-deductions is in the amount given o Property § 164 and 165 Ordinary income and short term Capital gain property – here applies if the contributor held the property for less than a year. The amount of contribution is limited to the properties basis Long-term Capital Gain property • Deduct the Fair Market value if the taxpayer donates the property to an organization that is related to the property donated (give a painting to an art gallery) • If that relationship does not exist then the basis of the property will be deducted (give painting to red cross who then in turn sells it for a profit.) • Partial Interests in Property – Charitable remainder trusts – where the property is put in a trust and where the trusts provides income for the grantor till his death and then the remainder interest would go to the charitable organization. The remainder value increases as the grantors life expectancy diminishes. o Transfers in trust §170f – a remainder interest is only deductible if the trust is: §664d -Charity annuity trust (look up) §664d – Charitable remainder Unitrust (look up) • Limitations on Contribution Amounts o Public Charities General – limited to 50% of the taxpayers AGI – must be “to” organization thus does not includes trusts (which would be 30%) Capital gain limitation – applies when the property given would produce longteer capital gain if it had been sold – here the deduction is limited to 30% of the taxpayer’s AGI o Private Foundations General – limited to 30% of the taxpayers AGI Capital gain limitation – applies when the property given would have produced long term capital gain if it had been sold – here the deduction is limited to 20% of the taxpayer’s AGI E. Extraordinary Medical Expenses § 213 16 • Here one can deduct from unusually large medical expenses actually paid during a taxable year which is not compensated by insurance or otherwise for medical expenses which exceed 7.5% of a taxpayers income. o Typical medical expenses – can be fluid and change with times – typically covers expenses for a diagnosis, cure, treatment or prevention, prescription drugs, obesity treatment or smoking cessation programs F. Alimony – deduct under §215 but included as income under § 72 V. Restrictions on Deductions (personal exemptions) A. Personal, Living, Family Expenses – no deduction is allowed for typical living expenses authorized under the code (insurance, food, rent etc.) B. Illegal Activities § 162(c), (f) and (g) • 1977 Foreign Practice Statute – made it illegal for a US corp to bribe a gov official and it required all corporations that are all publicly traded to have accounting systems and controls • § 162c – disallowed bus deductions for illegal bribes, kickbacks (ex: related to medical care) and other illegal payments o Federal statutes in Code or Statutes at Large – here all the IRS needs there is a provision in force which makes the activity illegal though in practice when the party engages in such legal activity the statute is not applied for law enforcement purposes o State Laws – deduction is only disallowed b/c of an illegal payment under State law if the law is normally enforced. • § 162f – A deduction is disallowed for any fine or penalty paid to the government for violation of any law • § 162g – A deduction is disallowed for any treble damage payments under antitrust laws. (this does not apply to the compensatory damages but the punitive damages which are tripled b/c of the treble provision) • Public Policy-the above disallowances where set in place b/c of public policy – legislative history limits these provisions to disallowances for public policy. C. Expenses or Interest relating to Tax-exempt Income § 265 • § 265(a)1 – when an gain is not included as GI (gifts, inheritances) then you can not deduct expenses that is related to that gain. (Ex: can not deduct attorneys fees for claiming a will is invalid and you should have inherited a higher portion of the estate) • § 256 (a) 2 Interest – no deduction is allowed for the payment of interest on indebtedness incurred or continued to purchase or carry on obligations which pay interests wish is exempt from Federal income tax – Ex: you borrow money to buy a municipal bond – here you may not deduct the interest on the borrowed money b/c you used it to purchase the bond whose interest is tax exempt. o Masking Transactions – key is to mask the transaction among several transactions so it can not be traced and thus the loan from the bank interest can be deducted. Step Transaction Doctrine – if the IRS can show that you tried to disguise the transaction is a series of steps, the court can ignore the steps and simply draw a line from A to B thus not allowing the deduction in interests. – Solutions is to make each step old and cold before going to the nest one Bank – uses a fraction system to determine what securities are tax exempt? D. Transactions Between Related Taxpayers § 267 • No deduction is allowed for any loss arising from the sale or exchange of property between related taxpayers. (Ex: Parent sells land to kid at a loss) o Relationships 1) §267b1 Siblings, spouse, ancestor, and lineal descendants 17 2) § 267b2 An individual and corp where the individual owns 50% of the value of outstanding stock. • §267c2 – you are deemed to own stock of the members of your family under this rule (Ex: GC owns 30% or stock and GM owns 25% -here the corp and GC are in a relationship for tax purposes b/c she is deemed to own 55% of stock) – hence one can own 100% of a companies stock though they do not directly own any. 3) The fiduciary of a trust and the grantor of that trust 4) Various fiduciaries and beneficiaries or 2 or mor turst with respect to which the same person is the grantor. o Losses and relieve Subsequent Sales § 267d – if the transferee (related party) later sells the property and receives a gain, the gain shall only be recognized to the extent it exceeds the loss of the transferor. (Ex: parents when sell land to child have a $200 loss to which they can not deduct b/c of the relationship. If the child subsequently sells the land at a $50 gain. Then he does not report the gain as income on his tax return b/c the gain here does not exceed the loss) – the transforee selling the property does not resurrect the loss but gives the subsequent buyer a free ride on some of his gain. o Deferred timing of deductions – a taxpayer on the accrual method of accounting may not take a deduction for interest or other expenses paid to a related taxpayer until the amount is actually or constructively paid. (Ex: the shareholder (with proper relationship) loans $80,000 to the corporation with interest due in December but the corp does not pay that interest until Jan in the subsequent tax year. – the corp though on the accrual method does not deduct the expense in Dec when the obligation to pay arose but must rather deduct is the subsequent year) (Note: method for a corp to prevent double taxation so it capitalizes with debt and not equity where it is loaned money from a shareholder.) D. Entertainment § 274 – already went over – need receipts and documentation. VI. Timing/Methods of Accounting A. Taxable year – a 12 month period o Typical – the calendar year (individuals) o Fiscal year – a 12 month year ending on another month then December o Reasons: person engaged in bus where the income and expenses related to that income would show up better in a different configuration that the taxable year (Ex: agriculture with the harvest season) B. Cash, Receipts method of accounting o Method – items are including in ones income when payment is actually or constructively received and deductions are taken when they are actually paid. (receipts are cash, or check) o Constructive Receipt – when an item has been credited to a taxpayers account of made available to the taxpayer (person in Dec can not ask the paying party offering a check to come back in a few weeks in pay it – when the check is originally offered it is deemed constructively received./there is no doctrine of constructive payment – party can not ad item to GI if the party needed to pay has deducted the cost on his return but has not paid. C. Accrual Method of Accounting – o here one ads an item to GI when the right to that money occurs (they have performed the service) and deducts an item from GI when the obligation to pay occurs (invoice) o Reserve Accounting § 461h5-reserve accounting is when you report income you want to go ahead and deduct the expenses which you expect you will need to pay to perform the service. – here this is only allowed when specifically authorized by the code. – the party seeking to deduct the expense needs to show that the amount clearly reflects a very close to accurate amount of the expected expenses and when those expenses will need to be paid. (Ex: white Sox tickets – here the co. knew the salaries of the players and when all the games where scheduled to be played) 18 D. Inventory Accounting – a Form of Accrual Acconting o Required parties – must be used by taxpayers for whom the products, purchase or sale of merchandize is an income producing factor (manufactures, retailers, wholesalers) o Calculations – GI = total receipts – the cost of goods sold o Cost of goods = OI + purchases – CI (OI = Opening Inventory/CI = Closing Inventory) o Conventions – Determines the number of CI (the higher the CI the higher the GI – the lower the CI then the lower the GI) o FIFO (first in first out) – here the price of the units for CI is valued at the cost of those items purchased most recently – thus would technically sell first those items bought first – relevant when the price of the product changes as bought. o LIFO (last in first out) – here the price of the units included in CI is valued at the price of the oldest items bought. Corporations will prefer this method if the price of items rises b/c they then would account for less GI and thus lose less in taxes. /if inflation companies tend to want to use this mthod. If use this method the taxpayer has to use it for all purposes and must conform to other transaction/would cause the company to show lower profits to its shareholder typically then the other method. Problem – it defers income and taxes every year and allows for the same units to stay for a long period of time if they are not selling all the products. When those units are eventually sold it will create a time bomb where income will substantially jump as well as tax liability. – now some companies have to account for the deferral as a warning to shareholders. E. Installment Method of Accounting §453 • General – Here the method is applicable when one taxpayer sells property and gets payment in installment over different tax years. – idea is that you do not get income until you get paid, hence the entire amount that would be realized would not be included in income during the first year. A fraction of each payment will result in the amount realized that is recognized for that tax year and a part of the basis. o Calculation –(fraction) Installment x Profit (amount realized – basis) Total payment to tax payer o Note: Prevention of adding interest as part of the overall payment and thus not charging interest – if there is a deferred payment and you do not charge interest at arms length, then the commissioner is authorized to rewrite payment schedule to find one part of the payment interest and another part of the payment principal. • Recapture § 1245-to prevent capital gain when one sells depreciated property though it has not nearly depreciated as much from actual use -Note -o If the gain is smaller than the amount depreciated then that gain is counted as an ordinary gain (if depreciated from 150 to 70 then gain of 50 is an ordinary gain (higher tax bracket) o If the gain is more than the original cost of the item (more than the amount depreciated) – then that amount that exceeds the amount depreciated is a capital gain. (above if depreciated from 150 to 70 but sell for 160 then 10,000 is a capital gain) • When buyer assumes debt on property or takes it subject to: o When the profit is still lower than the total amount received by taxpayer -here the numerator would be profits and the numerator would be total amount received by the taxpayer (hence would not include the amount being paid to third party – bank) Example-seller has a basis in estate at $50,000 and its FMV is $100,000. She sells it to buyer on an installment contract where she receives 20,000 in the first year and 20,000 is subsequent years. The buyer also assumes a 40,000 mortgage/Profit = 50,0000 (100-50) – Total amount to payer = 60,000 (100 – 40) = the fraction 50,000/60,000 (5/6) -----Calculation is 60,000 (amount paid to buyer x 5/6 = $50,000 19 o When the profits are higher than the amount received by taxpayer – the amount the mortgage exceeds the basis is treated as a payment at the time of the closing. Then the rest of the amount paid in installments should be recorded as gain is subsequent years. Example-here the mortgages if $70,000 and the basis is $50,000 (70-50 = 20,0000) Here 20,000 would be recorded as GI in year one, and when she receives $10,000 in the second year all that amount would be treated as GI. o Depreciation Recapture -§ 1245 overides deferral under §453 – here the gain as generated by depreciation thus gain is recognized as to the extent of that spread of the depreciation amount. – in the fraction the numerator is reduced by depreciation recapture Calculation Installment amount x Profit – depreciation recapture Total amount paid to seller If numerator is 0 then all gain needs to be reported at once Example: Bought at $150,000 but property had depreciated to $50,000 – Hence $100,000 must be subtracted from profit. If sell at $150 then the realized gain would be 50. (profit = 50 -100 and thus would record numerator at 0) Hence all 50,000 would be recognized and thus recorded for that tax year. • Election -§ 453 requires you to elect out if you do not want to follow this method of recognizing gain. F. Claim of right Doctrine § 1341 • General – a party is required to include an amount as GI (gain) when he receives the payment though it is a prepayment for services that will be performed later. If any portion of the amount is returned in a later year then that amount will be deducted. (receiving money establishes a claim of right) o Exception – when the taxpayer is required to return amount previously paid and that amount exceeds $3,000 she may chose one of two option whichever gives her the most money back (would apply if the tax bracket percentages are different in the two years/no SOL) Option 1 – simply deduct the repaid amount on the year the amount is repaid Option 2 – compute tax in the current year w/o the deduction then subtract a credit in the amount his tax liability would have been reduced in the prior year had he not included the amount as GI • Tax Benefit Rule – if one takes a deduction in one year which is later found to be disallowed, the tax payer must include that amount as GI in the year it is discovered that the amount of deduction disallowed. o Exception §111 – congress has provided the exception when the amount that is disallowed did not reduced the taxpayers income tax in the year it was allowed to be deducted. Example: Party had a GI of 10,000 but deductions adding up to 17,000 (7 + 4+ 6) – hence if a 6,000 deduction was later to be found disallowed then that amount would not be included as GI b/c it had exceeded GI in that year and thus was not actually deducted. Congress will assume that the deduction that is disallowed is the last deduction you included on you income tax return (that way IRS can not always argue that it was other deductions that did not actually count – like the 7 is above example. What if later disallowance was 3,000 instead of 6,000 above where GI=10,000 and deductions = 13,000 (7 and 6). • Here 3,000 of the six was deducted and 3,000 was not. – The refunded dollars will be considered to be the part of the money that was deducted and thus the 3,000 will be counted as GI. (If 4,000 refund then 3,000 is is counted as GI and the last 1,000 would be tax free.) VII. Unrecognized Gains A. Like Kind Exchanges § 1031 (non-recognition) 20 • General 1031(a)(1) – no gain or loss will be accounted for if like kind property is exchanged SOLELY for like kind property (no cash involved) if the property exchanged is held for productive use in a trade or bus or for investment is exchanged for property that is held for productive use in a trade bus or for investment. – do not have to recognize a gain on transaction. o When taxpayers swap like kind property it is assumed that they both have to same value o The gain her is realized but not recognized – it is a policy judgment by congress on whether it is the appropriate time to tax. o Exceptions: property that is used for personal use (residence), stocks, bonds or inventory. • Like Kind – very liberal, two interests in real estate is considered like kind though one might be improved and the other not or that one is a fee simple while the other is a 20 year lease hold estate. o Does not include transaction where property is given for case or for securities. • Basis §1031d – the basis of the new property is the same basis of the property that was exchanged -any money received + any recognized gains (or decreased if any loss). • When the property is not exchanged solely for property but some money is also received §1031b.-the realized gain is recognized to the extent of the boot. o Ex: If a party exchanged property worth 1.5 million (500,000 basis) for property worth 1.3 million and $200,000 in cash (boot) – then the amount recognized is $200,000 (amount realized = 1 million (1.5 -.5 basis) Recognized = $200,000) Basis: 500,000 (old basis) – 200,000 (money received) + 200,000 = 500,000 basis. (if later sell new property for 1.3 million then the 800,000 would be recognized that was deferred before) o Ex: Property is 1.5 million with a 1.4 million basis exchanged for 1.3 million property and 200,000. Here the amount realized is $100,000 (1.5 – 1.4 basis). Here all of the 100,000 is recognized. Basis: 1.4 (old basis) – 200,000 + 100,000 = 1.3 million. • When the two properties are exchanged and one party assumes a mortgage. When a mortgage is assumed, the amount of liability assumed is regarded as a boot and the rules above apply. • When both parties exchanging property assume liabilities (mortgages) on their respective property. – if read 1031b literally then the amount would count as a boot for both parties/however as normally applied as stated under regulations there is a mitigation rule – here only the party who has more liability taken from them has a net boot and the other does not, o Ex: If one property has a mortgage of $150,000 and the other property has a mortgage of $200,000 – then the one is relieved of the $200,000 liability would have a $50,000 boot. • Starker Exchanges – when there is a delay in the time of exchange. One party gives his property before receiving the other property – the exchanges are no simultaneous. Under § 1031(a)(3) there are two requirements: (Ga. Pacific exchanged timber land) o (1) The property has to be identified in 45 days after you transfer your property to them. o (2) you have to receive title to the new land within 180 days of your transfer. • Intermediary – in order to have an transfer fall under §1031 an intermediary can interceded to make sure there is a transfer between like kind properties. Here you would convey title to property to the intermediary and the intermediary would sell the land to the buyer and gests cash from the buyer and uses that cash to buy like kind property for the party that had conveyed title. Regulations allows trustees, and escrow agents to serve at intermediaries (beware: party conveying title can not be the only beneficiary of the trust)/1031 Exchange facilities – a bus full of intermediaries. B. Involuntary Conversion §1033 (non-recognition) • General – if property is compulsorily or involuntarily converted, then realized gain may be entitled to non-recognition. Non recognition applies if (1) the property is converted directly into similar property or (2) if property is converted into money or non-similar property and then the taxpayer purchases similar property o Involuntarily Converted – property condemned, when property is wholly or partially destroyed, if stolen, seized, or sold under threat of or imminence of seizure. Livestock destroyed by disease etc. 21 o Similar property – stricter than like-kind property. Look at relationship between converted property and then the relationship with new property. C. Sale of Principal Residence §121 (non-recognition) • General-a taxpayer who sells his principal residence, may exclude realized gains if that taxpayer has owned and used the residence as a principle residence for two of the last 5 years. Can only use this provision for one residence at a time for it has to be the principal residence and can only do once every two years. o Amount limits – can not exclude more than $250,000 on an individual return of $500,000 on a joint return between spouses. VIII Unstated Interests. A. General – When someone makes a loan at less than that AFR (applicable federal rate/arms length interest) the amount not accounted as interests is deemed to be transferred by the borrower to the lender as if they interest where at the applicable rate and then retransferred from lender to borrower as either a (1) gift loan (2) Compensation loan (employer/employee) or (3) a corp-shareholder loan. B. Foregone Interest Calculations • PV – how much you would have to put aside to accumulate the desired amount in a certain time period. (ask what amount would I have to put down where if there is a 3% interest rate it would equale 10,000 in 10 years/PC = $7.500) • Two types of Loans (calculations for foregone interest) o Term loan – difference between the amount transferred to borrowed and the present value of all payments called for on the loan by its terms. If lend 1 million and the present value is $750,000 then the foregone interest would be $250,000 (1 million – 750 thousand) o Demand loan – just the applicable federal rate for the taxable year. If loan is 1 million and the rate is 2%, then 2% of the 1 million would = the foregone interest. Would add the interest each year until paid. Less certainty here then above – you can not lock down the interest b/c do not know when amount will be demanded. (transfer and retransfer the amount of foregone interest each year) 22 Transfer (lender to borrower) Retransfer (borrower to lender) – as if real loan Exceptions/Limitation Gift Loan Borrower – the foregone interest in loan is not counted as GI b/c it is a gift (102) Lender – has no tax consequences for giving away the foregone interest Borrower – the foregone interest may be deducted depending on how loaned money is used. Lender – the foregone interest is recorded as GI for the year. If loans do not exceed 10,000 unless the money is used to purchase or carry on income producing activities. Limitation on retransfers for loans that do not exceed $100,000 – here the amount retransferred shall not exceed the borrowers net investment income Compensation Loan Borrower – the foregone interest is additionally compensation to be added into his GI Lender – the amount would be deducted as a bus expense if a reasonable salary. Borrower – the foregone interest may be deducted depending on how the money is used. Lender – the foregone interest is recorded as GI for the year. Corp-shareholder Loan Borrower – transfer would be a dividend and thus would be recorded as GI Corp – cannot deduct expense b/c it is a dividend and not salary. Borrower – the foregone interest may be deducted depending on how the money is used. Lender – the foregone interest is recorded as GI for the year. The provision shall not apply to any loan that does not exceed 10,000 unless the loan was made for the principal purpose of avoiding tax. IX. Proper taxpayer Assignment of Income A. Married Parties – Joint return (prevents shifting income between spouses for lower tax purposes to fall in smaller brackets – some tax benefits) B. Two Main Rules regarding the Property taxpayer on the Income • Income tax should be taxed to the person who earns it and income is earned by performing services – Lucus v. Earle o Exception: one may not be taxed on earned income if they (1) relinquish the right to be paid before performing the service and (2) he does not control where the money went (although would be a deduction if charitable contribution) – from case where Bank of America guy did not want to be compensated as much as was given to him. • Income from property is earned by only the property owner (Give interest coupons on bond you own to son you would be taxed on the interest though you did not collect from it) – Horst o Ripeness – property owner will only be taxed on the income when the income becomes due (therefore the father would not be taxed on interest at the time he transferred the coupons to son but rather when the interest on the coupons become due) 23 o Earned income from sale of property – the owner of the title who does the work of finding a buyer and negotiating has earned the income – hence cannot transfer income to child by tranferring part of the title before closing. C. Assigning Income through the Use of entitles • Partnership-under a partnership each partner is liable for debts of partnership – a court will look through the group as a whole to the individual partners. (need capital and skills to be successful) o Tax-the partnership pays 0 tax on income, thus the individual partners pay tax on the income received by the partnership though they may never get actual income. o Assignment (family./gift) §704e – A person can create a partnership and make someone a partner as a gift b/c a partnership can be created that way under state law. The donee may only have a capital interest (owner of property earns income on property) but the donor may do all the work. So the following steps would apply. (1) first allocate income to donor for compensation for his services at the FMV. (2) then allocate the donnee and donor’s interest with the remaining income. • Corporation – Here a whole corporation would be liable if sued not the individual taxpayers – thus if a corp is bankrupt then the plaintiff would receive nothing. o Tax-the corporation pays tax and then distributes the profits to shareholders as dividends which are then taxed for a second time (lesser tax rate the second time). o Assignment of income – if taxpayer transfers stock to a family member it will shift the income of the dividend to that new family member. However it is expensive to shift b/c of double taxation. • Trust – Tax – income is taxed at the beneficiary level if and when an amount is distributed to them -the trust itself is not taxed. o Ways that the income in a trust is taxed. Simple – distributes the income in the trust currently when made and thus the trust does not pay any current income b/c it deducts all it makes. Complex – tax the trust currently give the trust a tax credit when it distributes the income. o Clifford/Grantor trust – when the Grantor is taxed on income from the trust The power to revoke § 670-if the grantor creates a trust where he has the power to revoke then the grantor will be taxed on the income from the trust. Reversionary interests § 673 – if there is a reversionary interest then the grantor will be taxed on the income if the value of the reversionary interest exceeds 5% of the value of the original corpus. (A time rule b/c time affects the present value of the reversionary interest) § 677 – a grantor is treated as the owner of a trust and thus taxed of any portion of a trust if without the approval of an adverse party the income of the trust may be distributed to the grantor or the grantor’s spouse. (might be applicable if income needs to be used to satisfy an obligation) • §677b exception – income of a trust shall not be considered GI for the owner under this provision if the money may be used to support a child (a legal obligation) – however if actually used for such purposes then it will be taxed. -be careful b/c using money to send the child to camp is not “support” within the definition of the law. X. Alimony, Child Support and Property Settlements §71 Payor (ex) Spouse Payee (ex) Spouse Alimony Deduction (§215) Income Child Support No deduction Not Income Property Settlment No deduction Not Income 24 A. Alimony §71 b • The following must be satisfied 1) Payment must be made in cash (check/money order) 2) The payments is received by the spouse – can be made on behalf of (pay bills) 3) The payments must be made under a divorce or separation instrument: A decree (court) of divorce or separate maintance or written instrument incident to such decree A written separation agreement (oral separation agreement does not give rise to alimony) 4) If the instrument is a court decree then you cannot be members of the same household and call it alimony. This provision does not apply if a separation agreement (would encourage reconciliation) 5) There must be no liability to continue making payments after the payee spouse dies. (do not have to use these magic words in agreement if State law calls for the automatic termination of payments on payees death. 6) By agreement the parties may make payments that qualify as alimony not treat it as so for tax purposes (can not do vice versa – the payments have to satisfy all to apply) 7) The payment may not be child support. B. Property Settlement – Front Loading Rules • General – rule is set up to prevent parties from structuring what would be a property settlement as alimony. Alimony usually is spread out over a long period of time and does not fluctuate much whereas a property settlement would be spread out in a shorter amount of time. – Look out for large payments in the few years compared to later. • Rule §71f – the amount of excess alimony payments is required to be included in the alimony payors GI in the 3rd post separation years and to be deducted from the alimony reciepeing. o Calculation o First – determine 2nd year excess/Excess = (2nd year – (3rd year + 15,000) o Second – determine 1st year Excess = (1st year – (2 and 3 average + 15gs) To determine number to average in year two subtract the excess from amount paid in year two. Add this # to 3rd and divide by 2) o Third -Excess = 1st excess + 2nd excess • Problems the lawyer will run into – hence let the spouse be very aware of rules o Payor – will be angry b/c he will have to include a huge amount as GI in the third year. Advantage by taking those deductions he was given an interest free loan from the government and so he benefits. o Payee – the Payee loses time value in money from the past two years and the deduction will not be worth much unless she has earned enough income from that tax year to be able to deduct the whole amount which is unlikely. o Solution – in divorce/separation agreement state that the property settlement payments do not classify as alimony under §71 so these front loading rules do not apply. C. Child Support – a payment is not treated as alimony is for child support. The amount may be stated in the agreement as child support or the amount may simply be reduced on the happening of a contingency related to the child or could be associated with the child (Ex: the amounts stated as alimony are reduced when the child reaches majority. § 71c3) • Lawyering – would want to go ahead and state clearly what amount is “child support” in the agreement. • Dead beat dads – if amount paid is less than that called for in the agreement then the first dollars paid will be paid toward child support. Here the dad can not start taking a deduction on the amount until all of the child support is paid. D. § 1041 Property Settlement/Basis • 1041(a) – no gain or loss shall be recognized for an exchange of property between spouses or exspoouse incident to divorce. 25 o Regs provide what is incident toe divorce – generally if the transfer occurs in the first 6 years it is presumed the transfer is incident to divorce but if it occurs afterwards then one needs to show some nexus. • 1041(b) – for exchanges of property between spouses or ex-spouses incident to divorce the basis of property would be the adjusted basis of the transferor. Generally follows same rules as gift transfers but does not have the exceptions under 1015. o Thus payee spouse would want to acquire property with a high basis from the basis so they report less income when they sell it (two items can have the same FMV while one has a higher basis than another) XI. Capital Gain and Loss A. General • Capital gains are taxed at a different rate than ordinary income. The maximum rate is 15%, people in lower income brackets (25% or lower) have their capital gain taxed at a 10% rate. • Reasons: Economic – to stimulate economy/idea that income for long-term capital investments accrues over a period of years and would have been taxed less overall if that amount had been taxed when it accrued rather than one big lump sum. B. Capital Gain or Loss §1221 – the gain or loss from the sale or exchange of a capital asst. • Sale or Exchange – here this is usually not an issue/the thing transferred has to continue to exist, thus when receive insurance after a house has been burned the contract is extinguished from the transaction (insurance pays because of contract not to get the house), thus that transaction would not be a sale or exchange. • Capital asset – property whether or not connected with a trade or bus (personal, investment, bus property) – Stream of income can be property (buying the future possibility of income is not property – renewal commissions) but the following: o Not capital Assets: Inventory – property held primarily for the sale to customers in the ordinary course of the taxpayer’s business (retailer, manufacturer) • Futures contracts – taking a risk to sell a product at a certain price though the price might rise or fall-locking in price – can be used as a mechanism to lock in inventory – though futures contracts are securities and thus capital assets the gain and losses may be classified as ordinary if futures contracts are highly interrelated with inventory (corn example in class) • Property subdivided for sale – though ones reason for buying was not to sell, if he later subdivides it for sale it will be classified as inventory and thus not a capital asset o Exception: if (1) the property had not previously been held for sale (2) no substantial improvements have been made to the property and (3) it has bee subdivided in 5 lots or less. Depreciable property and real property used in a trade or bus – does not apply to all depreciable property or all real property only that is used in a trade or bus (there is depreciable property held for investment) Copyrights and similar property – (literature, music, letter, memo etc) is not a capital asset in the hands of (1) the person who created it (2) the person who it was created for or (3) a taxpayer who received the property with a transferred basis from those above (spouse or gift) • §1235 – you can sell your rights to the product and thus there is capital gain treatment. Accounts receivable – ARs acquired in the ordinary course of bus/records a co makes of what people owe are not capital assets. Publications of the US government – not a capital asset if held by the taxpayer who received the publication or by one who received it with a transferred basis 26 from the original recipient. (not capital asset if purchased from gov at price offered to the public. C. Holding Period § 1223 • Long-term capital gains or losses-would apply to property that is held for more than a year and a day from the date it was acquired. • Short-term capital gain or losses – applies to property that is held for less than a year D. Calculations • Separate long-term and short-term capital gains and losses from each other and subtract losses from gains. o Long term Gain 10 Short term gain 8 Long term loss 6 Short term loss 5 4 (positive) 3 (positive) • Look at the signs (both positive or both negative numbers) – if they both have the same sign then you would treat them separately. o For gains Net Short-term – treat the short-term gain as ordinary income and thus tax at the higher tax rage Net Long-term – the net long-term capital gain is treated as a capital gain and thus is taxed at the 15% (10%) rate. o For Losses (1) take the short term loss first (2) deduct a total of 3,000 per year for capital losses (first take the amount from the short-term and then any excess from the long term) – thus the whole of short term would be deduced if the two numbers above where negative (3) carry forward what you do not use to year two. Thus would have mostly likely long-term perhaps some short term to carry over.. • First subtract the long-term carry over losses from long term gains in the next year. Thus if there where 5 long term gains in year two and no losses then the -4 from the previous year would be subtracted from 5 in year to for a total of 1 gain. • If the signs are different – then we net the two numbers against each other to get a net loss or net gain. Thus if the 4 above where positive and the 3 negative we would have a net capital gain of 1. o The character of the gain or loss is determined by looking at the absolute value of two number. The gain or loss will take the character of the largest absolute value. (look at absolute value with no regard to positives or negatives, thus from the numbers of -4 and +3 the -4 has the higher absolute value though the +3 is technically a higher number) o Thus if in the example above there was a +4 long term gain and a -3 short-term loss with a net of +1 – the gain here will be characterized as a long term gain b/c the four has the higher absolute value and thus that 1 will be taxed at the 15% rate. Had the +4 been a short-term gain and the -3 a long-term loss, the +1 net gain here would h ave been characterized as a short-term gain and thus would have been a ordinary gain and thus taxed at the higher tax rate. E. Corporate Liquidation – if one closes down a corporation and retires they would liquidate all assets, pay off the creditors and the rest is distributed to shareholders. The liquidation is treated as if they shareholders have sold stock. The amount they receive will be subtracted from their basis in their stock shares-and the liquidated amount is considered a capital gain. F. Pay back of a Capital gain (could be a judgment in a case) 27 • If you took the amount as a capital gain in the year you recorded it, then when you have to payback the amount you took as a gain, you would report it as a long-term capital loss. G. § 1245 Recapture -personalty (same as 179 property) • Provision applies to depreciable personalty used in a trade or business. Because you take depreciation deductions against ordinary income then the depreciated amount that constitutes gain if the product is later sold should be ordinary income. (to depreciate property would have been held over one year) • Rule – the gain realized from the sale of depreciable property is ordinary income to the extent of the lessor of (the smaller is ordinary income) – this amount is recaptured into ordinary income o (1)the gain realized, or o (2) the depreciation taken • If the amount realized is higher then the amount of depreciation taken, then the excess would enter the main hotchpotch under § 1231 o Ex: The truck depreciated to $40,000, but the amount realized was $ 60,000 after the basis was subtracted. Thus the $40,000 would be considered ordinary income and the remaining $20,000 gain would enter the main hotchpotch under §1231 H. §1250 Recapture – Real estate (Depreciable/thus buildings) • The amount recaptured as ordinary income would be the difference between the amount of depreciation taken under an accelerated method (sum of years/declining balance) and the amount that would have been allowed under the straight line method. • After 1986 the code was changed to required that 1250 property be depreciated under the straight line method therefore this provision has become almost irrelevant – it only applies to parties who have bought their property before 1986 and started to use an accelerated method, they must however still own that property today b/c if they had sold it after 1986 the new owner must use the straight line method. o Exception – some low-income housing is entitled to accelerated depreciation. I. § 1231 Property-only applies to the extent of amounts not recaptured under 1245. • § 1221(a)(2) – this section declared that depreciable property and real estate used in a trade or bus was not a capital asset. However § 1231 picks that property up and provides rules where gains from selling or exchanging such property may be classified as a capital asset. Thus be a “quasicappita asset” /§1231 property also includes property that was involuntarily converted b/c of condemnation (also other involuntary conversion from casualty under a subsection of rule) o Main Hotchpot – all gains and losses from section 1231 property are netted together to have a net gain or loss. – The best of both worlds Rule If gains exceed losses – then the net gain is a long-term capital gain that is entered into the § 1222 netting process. (just characterizes it as a long-term gain, does not complete the answer) If the losses are equal to or exceed the gains-then the loss is treated as an ordinary loss o Subhotchpot – applies to gains and losses that from involuntary conversions due to casualty events (not condemnation – those gains and losses enter main hotchpot). We test these items twice. (1) is subhotchpot and then (2) in main hotchpot if applicable Net the gains and loss together from Involuntary conversions • If an overall net loss – then the loss is characterized as an ordinary loss (the loss is thrown out of 1231 and would not be capital assets under 1221 b/c there is no sale or exchange in an involuntary conversion) • If there is a net gain – then the itesm go into the main hotchput and follow the rules applicable there. Casualty Involuntary conversions – are conversions arising from fire, theft and other sudden unexpected disasters (only these items get two bites at the apple) 28 • §1231c Net section 1231 gain shall be treated as ordinary income to that extent that the gain does not exceed nonrecaptured ordinary losses from the five preceding years. (look at the losses from the 5 proceeding years but subtract any amounts that had been recaptured as under this section). o Treats the gain and losses the same as if you had the gain and loss in the same year so you can not trick the system into having less tax consequences o Solution – just sell the property with a gain first before you sell the property that would produce a loss.