12/04/2006 Revision 0.6 Author: Philip Larson Federal Income Tax: Outline Disclaimer: These notes and outlines are provided asii without any warranty as to their correctness, completeness, or quality. They are not meant to be a substitute for your own efforts. You may copy and forward this document as long as you do not alter its contents. Federal Income Tax: Outline Philip Larson Page 2 Table of Contents 1. FEDERAL INCOME TAX: OUTLINE............................................................................... 3 1.1 FEDERAL INCOME TAX.......................................................................................... 3 1.1.1 BACKGROUND IN FEDERAL INCOME TAX...................................................... 3 1.1.2 CHARACTERISTICS OF INCOME......................................................................... 3 1.1.3 TO WHOM IS THE INCOME TAXABLE?............................................................. 5 1.1.4 DEDUCTIONS – BUSINESS & INVESTMENT..................................................... 6 1.1.5 PERSONAL DEDUCTIONS, EXEMPTIONS, AND CREDITS ........................... 13 1.1.6 GAIN OR LOSS ON SALE OR EXCHANGE OF PROPERTY............................ 16 1.1.7 CAPITAL GAINS AND LOSSES........................................................................... 20 Federal Income Tax: Outline Philip Larson Page 3 1. FEDERAL INCOME TAX: OUTLINE 1.1 FEDERAL INCOME TAX 1.1.1 BACKGROUND IN FEDERAL INCOME TAX A. BIG PICTURE a. Tax Calculation: i. AGI = Gross Income (§ 61) – Certain deductions (business expenses § 162) ii. Taxable Income = AGI – Standard or Itemized Deductions – Personal Exemptions iii. Tentative Tax = Taxable Income * Tax Rates iv. Tax Due or Tax Refund = Tentative Tax – Tax Credits. b. Gross Income § 61: gross income includes all income “from whatever sources derived.” § 61(a). c. Exclusions: some types of income are statutorily excluded from income. d. Deductions: deductions are subtractions from income in computing taxable income. There are two types of deductions available when calculating taxable income. i. Deductions from Gross Income in Computing AGI: some expenditures are deducted (subtracted) from gross income in computing AGI. ii. Deductions from AGI in Computing Taxable Income: the TxP subtracts his or her personal exemptions and also takes the larger of either the standard deduction or the itemized deduction. The standard deduction is set by statute and the itemized deduction is the sum of all allowable itemized deductions. e. Multiply Taxable Income by the Tax Rates: the TxP’s tax rate typically depends on his filing status and is multiplied by taxable income to produce tentative tax. Tax rates for individuals range from 10% to 35% for ordinary income, and 5% to 28% for capital gains. § 1. f. Subtract available credits: a tax credit is a dollar-for-dollar reduction in the amount of tax due. Available tax credits are subtracted from the tentative tax to produce the actual tax due. 1.1.2 CHARACTERISTICS OF INCOME A. INTRODUCTION a. Key Questions: i. Is an item income under § 61? 1. Does the item increase TxP’s net worth? 2. Did it merely involve a change of form, like borrowing money or recovering basis? ii. Does the item fall under a statutory exclusion from gross income? 1. Gifts, some fringe benefits, meals and lodging for convenience of employer, etc. iii. Is the item debt cancellation income and if so, does it qualify for exclusion? iv. Is the item spousal or child support? 1. Alimony is taxable to recipient and deductible by payor. Child support is neither taxable nor deductible. B. INCLUDABLE vs. EXCLUDABLE INCOME ITEMS a. Includable items – from “whatever source derived” § 61 i. Compensation for services § 61 – 1. Payment of employee’s income taxes – Old Colony Trust Co. v. Commissioner. 2. Awards vs. serving the business – Rudolph v. US (trip to NY for salesman was taxable as a reward) ii. Claim of right doctrine, see infra iii. Gratuities and tips – Olk v. US (gambling “tokes” are not gifts and are includible in income) iv. Interest payments (not for state and local bonds) – many types of investment income are included in gross income such as dividends, interest, rents, and income from annuities. § 61(a)(4)-(7) 1. Imputed interest: if K doesn’t include interest payments, IRC will recharacterize the loan or investment to impute interest (unless intended to be a gift). v. Punitive damages -§ 104(a)(2); Glenshaw Glass (damage awards are income – this was pre-§104); vi. Alimony vii. Discharge of indebtedness – taxable income is realized when a legal obligation is settled for less than the total amount of the obligation. US v. Kirby. Federal Income Tax: Outline Philip Larson Page 4 1. Repayment of indebtedness – if debtor repays “at par”, there is no income to debtor or creditor. If debt is repaid below par value, difference is taxable income. Jacobson (held partial loan forgiveness is not a gift from creditors) 2. Exceptions: since the Kirby rule can discourage TxP’s from accepting relief from debt, § 108 enacted to grant exclusions for a. bankruptcy, b. insolvency – but limited to extent of insolvency c. it is meant as a genuine gift § 108(A)(1), d. no net economic benefit to TxP, e. debt is disputed and cancellation is part of a settlement, Zarin, f. or is a student loan canceled as part of an agreement for student to work in particular field. g. Debt must also be legally enforceable -Zarin v. Commissioner (cancellation of gambling debt) 3. Sale of Encumbered property: amount realized by TxP on sale is cash received plus amount of mortgage TxP no longer has to pay, regardless of whether it is recourse or nonrecourse. viii. Windfalls – Cesarini (money found in piano is income in year found) ix. Awards & Prizes § 74(a) – included in income unless recipient did nothing to be selected, has no future obligations, and immediately transfers it to charity. x. Scholarships and fellowships § 117 – unless it is a “qualified scholarship” used to pay tuition and fees or for required books and supplies. xi. Gambling Winnings § 165(d) – gains realized from gambling are includable to extent they exceed gambling losses. xii. Illegal activities that result in earnings – James v. US (embezzler has taxable income); Gilbert v. Commissioner (illegal loan that TxP intends to repay is not taxable income – it is a loan). b. Excludible items i. Tax Benefit Rule, see infra ii. Meals and lodging for employer’s convenience § 119 codifies Benaglia v. Commissioner but requires they be on the business premises of employer and, for lodging, required as condition of employment. “Convenience” requires “substantial noncompensatory business reason” or “business necessity” (SC). iii. Fringe Benefits § 132 – the value of a qualifying fringe benefit can be excluded from gross income. 1. No additional cost services – employer 1) routinely offers services for sale and 2) does not incur substantial add’l cost 2. Qualified employee discount – if discount does not 1) reduce sale price to below cost of products or 2) exceed 20% of the normal price for services 3. Working condition fringe – if item or service would have been deductible to employee had employee paid 4. Qualified transportation expenses – if the amount does not exceed 1) $100 for transit passes, or 2) $185 for parking. 5. De minimis fringes – if fringe is too small to track. 6. Qualified moving expenses – if amount does not exceed the employee’s actual expenses and employee would have been able to deduct expense if employee paid. iv. Imputed Income – value of services one performs for oneself or one’s family and value of property one uses that one owns is generally excluded from income. v. Reimbursable business expenses: § 132, traveling expenses are excluded from income if paid by employer and would have been deductible as a business expense. vi. Gifts § 102 – value of property “acquired by gift…or inheritance” is generally excluded from income. hinges on motives of donor. Must be “detached and disinterested generosity”. Commissioner v. Duberstein. 1. Basis of gifted property: Basis is donor’s basis, Taft v. Bowers, unless FMV at time of transfer is less than donor’s basis. § 1015. For inheritance, donee’s basis is the FMV of property at time of donor’s death (or at valuation date). § 1014 2. Holding period: § 1223(2) entitles a donee of property to “tack” the holding period of the donor to the period of time the property is held by the donee if the property has the same basis. This is important in determining whether property disposed of by donee qualifies for long-term capital gain treatment. Federal Income Tax: Outline Philip Larson Page 5 3. Exception – Future Income from gifts and Employer gifts a. Future income -Income derived from gifts § 102(b)(1) is included in income b. Employer gifts -“gifts” from employer to employee are included in income. § 102(c). This is compensation income. vii. Interest on state & local bonds -§ 103 – note federal bonds are taxable. § 103(b). this encourages investment in state and municipal bonds and is basically a subsidy from fed. gov’t to state gov’t. To prevent tax arbitrage (borrowing at 6% to make 5% return), interest on loans to purchase tax exempt bonds cannot be deducted and gains realized on their sale are taxed. § 265 viii. Damages for personal physical injury § 104(a)(2) – damages compensating for personal physical injuries are excludable from income. Does not apply to nonphysical injuries like discrimination or emotional distress. If TxP receives insurance benefits for which he paid premiums, the benefits are excluded from income. § 104(a)(3). 1. Exceptions: however, punitive damages are included, § 104(a)(2), as well as previously deducted medical expenses. If damages compensate for medical expenses previously deducted, it must be included. 2. Payments: TxP should structure settlement to have D insurance company invest the lump sum and make periodic, excludable payments, rather than having TxP receive lump sum, invest in his own annuity, but be taxed on income from the investment. ix. Lessee Improvements – lessee’s improvements to leased property is not income to landlord. § 109 (unless improvements substitute for rent) x. Child support xi. Cafeteria plans -§ 125 -employees are allowed to choose the forms of non-wage compensation they receive, thus allowing employees to choose what forms of nontaxable benefits they receive. xii. Life & medical insurance recovery § 101(a) – benefits paid on a life insurance policy by reason of insured’s death are excludible regardless of who paid premiums. If insurance is paid in installments rather than lump sum, the interest portion of installments is taxable. For group life insurance, $50k is excludable from an employee’s income. § 79. xiii. Recovery of Capital – income that is the return of capital is excludable from income. 1. Subdividing & Reselling -Treas. Reg. § 1.61-6 states that on the sale of a subdivided property, gain or loss shall be computed on the sale of each parcel, notwithstanding that the TxP has not recouped the entire investment. Attempt to find the FMV of the parcel. Inaja (couldn’t calculate basis for the easement on the land so entire amount was recovery of capital) 2. Annuities (return of capital) – an annuity is an investment paid back w/interest over time. The interest portion is income § 72, while the return of capital portion is excludable a. Exclusion ratio: excludible amount = payment x investment /total expected return. b. After death: if you die before recovering all of your capital (basis), you can deduct what is left. If you outlive projections, the whole payment constitutes income after you have recovered your basis. § 72(b)(2)-(3). c. Loan: income must be recognized when TxP receives a loan against an annuity policy. xiv. Sale of principle residence § 121 – gross income does not include the gain from the sale or exchange of your principal residence if you have lived their 2 of the last 5 years. 1. Limits: (b)(1) gain excluded cannot exceed $250k or $500k for joint returns, (b)(3) only 1 sale or exchange every 2 yrs allowed. 1.1.3 TO WHOM IS THE INCOME TAXABLE? A. INTRODUCTION a. Key Questions i. Assuming an item is income, who is it taxable to? Generally, income is taxable to the person who earned it, to the owner of the property that produced it, or to the person who controls it. Problems arise when TxP’s spread income by making gifts, etc. ii. Income from property – income is shifted in the case of a gift of the income-producing property, but does not shift with a gift of the income from the property. 1. Does the donor actually give up control over the property or is the transfer a sham? 2. Has the income already accrued or matured? If so, it may be too late to shift the income. Federal Income Tax: Outline Philip Larson Page 6 iii. Income from services – generally, income cannot be shifted by gift either before or after services are rendered. It is possible to work for free, without imputed income, but if payment is made to anyone, it is taxable to the earner. B. INCOME SPLITTING a. Generally: generally, an item of income is taxed to the person who earned it or owns the producing property. Lucas v. Earl. b. GIFT OF PROPERTY: generally, if a TxP makes a gift of the income from property, but retains ownership of the property, the income remains taxable to donor. However, if donor gives the whole property, tax burden on future income shifts to donee. i. Transferring income while retaining the property -If donor transfers income from property to donee while retaining the income-producing property, the income is taxed to the donor at time donee collects it. 1. Compare: Helvering v. Horst (father taxed on income when son collected interest on a coupon bond) and Blair v. Commissioner (owners of life estate transferred it to his daughter giving her $9k/year. Held income had shifted to daughter). ii. Consequences of Gift of Property 1. Consequences to donor a. Donor does not realize a gain or loss when making a gift of property. Tax liability for any future capital gain or benefit from capital loss is transferred to donee. b. Donor won’t be taxed on income produced after the transfer c. May be liable for gift tax on transfer. 2. Consequences to the donee a. Will be liable for income tax on the income the property produces after the transfer b. Usually has the same basis in the property as the donor, unless the FMV is < the basis at time of transfer and donee sells for a loss. Then, for calculating loss basis is FMV. c. Excludes the value of the property from income. § 102 iii. Gift to charity: gain or loss is not realized when TxP gives an asset to a charity even though the making of the gift provides immediate tax benefits to the donor-TxP. Deduction is FMV not donor’s basis. iv. Assignment for consideration: these rules apply only to gifts of income. If transfer is for bona fide consideration, tax burden on future income is shifted to transferee. Commissioner v. PG Lake. c. PERSONAL SERVICE INCOME i. Income from services generally can’t be shifted by gift: Income from personal services is taxed to the person who earns it. Lucas v. Earl (can’t transfer compensation to wife; this is considered a gift). 1. Assignment to third parties: income must be taxed to the person who earns it. Anticipatory arrangements trying to deflect income violate Lucas v. Earl. Armantrout v. Commissioner (education benefit to children given by employer was taxable income to parent) 2. Gifts: if a husband makes a gift to his wife, the subsequent income from the property is taxed to her. If the property is put into joint tenancy, the income is divided b/w the two. However, earned income cannot be split, and subsequent income from gifted property may be attributed to the grantor spouse if they retain exclusive control over it. ii. Income of Children: a dependent child’s income is taxable to him and not his parents. § 151(e), a child may be claimed as a dependent even though he earnes over the exemption amount if he is under 19 or is a student. This is true only if the TxP furnishes over ½ of the dependent’s support costs. iii. Charity: while you can work for a charity for free w/o being taxed, you cannot divert income from employment to charity. iv. Below market interest on loans: loans that carry no interest were once useful in splitting income. Now, the IRC requires that interest be imputed to the lender, wiping out the income tax advantage. 1.1.4 DEDUCTIONS – BUSINESS & INVESTMENT A. INTRODUCTION: a. Deduction: deductions are either from gross income or from AGI. In both cases, the deduction reduces taxable income. b. Above-the-line (ATL) vs. Below-the-Line (BTL) Deductions: ATL are taken from gross income whereas BTL are taken from AGI. ATL are better than BTL because 1) if TxP’s BTL deductions are less than the standard deduction, they are useless whereas ATL deductions can be used in addition to the standard deduction, 2) miscellaneous itemized below-the-line deductions are subject to a 2% floor. i. Above-the-Line Examples: Federal Income Tax: Outline Philip Larson Page 7 1. Trade or Business Deductions (except trade of business deductions of employees): 2. “Non-business” expenses of Producing Rent & Royalty income § 212 3. Capital losses § 62(a)(3) – capital losses may not be fully deductible. § 1211. 4. Losses from sale or exchange of property § 62(a)(4) 5. Reimbursed expenses of employees 6. Alimony 7. Higher-Education expenses § 62(a)(18) ii. Below-the-Line deductions 1. Subject to 2% floor (“Miscellaneous Itemized Deductions”) a. Unreimbursed employee expenses (travel, entertainment, union dues) b. “Non-business” expenses of producing income (other than rents or royalties)§ 212 c. Moving Expenses § 217; § 62(a)(5) d. Cost of preparing tax returns 2. Not subject to 2% floor (“Itemized Deductions”) a. Home Mortgage Interest b. Taxes c. Casualty losses (>$100 and >10% AGI) d. Charitable contributions (< 50% of AGI) e. Medical expenses (> 7.5% of AGI) iii. No deductions 1. Personal property losses (primary residence) – these are consumption expenses. B. TRADE OR BUSINESS DEDUCTIONS a. Trade or Business expenses: § 162 – this is the most important provision for deducting costs of doing business. Says that in 1) a trade or business, 2) current expenses that are 3) “ordinary and necessary” and 4) do not frustrate public policy, that are paid in a taxable year in carrying on a business are deductible. i. ELEMENT 1: “TRADE OR BUSINESS”: a TxP in a trade or business can deduct depreciation on business property, § 167(a)(1), business expenses, § 162, and business losses, § 165(c)(1). They can also be deducted for transactions entered into for profit, even if it is not a trade or business. § 167(a)(2), § 212(1)-(2), § 165(c)(2). 1. Definition of “Trade or Business”: to be a “trade or business” expense under § 162 you must 1) entered into with the expectation of making a profit, (otherwise, it is probably a hobby. However, § 183 says profit in 3 of last 5 years created rebuttable presumption activity was engaged in for profit), 2) regularity and continuity in operation, and 3) TxP must be actively engaged in pursuing it. 2. Business vs. Personal: § 262 states that “no deduction shall be allowed for personal, living, or family expenses.” expenses incurred by corporation are presumed to be “in connection with” trade or business, while individual TxPs must prove an expenditure was in connection with a trade or business rather than incurred for personal, family or living expense which is not deductible. § 262. Henderson v. Commissioner (deduction is not allowed if there is only some remote or incidental connection with TxP’s business – buying a plant and painting for office) a. Types: Travel expenses, hobbies, home offices, moving expenses, vacation homes, legal expenses, education expenses, clothing. ii. ELEMENT 2: CURRENT VERSUS CAPITAL EXPENDITURE : to be deductible as a business expense under § 162(a), the item must be an current expense not a capital outlay. Capital outlays are expressly not deductible. § 263. Both require that the expenditures be “ordinary and necessary” to the trade or business. § 263 requires TxP’s to capitalize costs incurred for improvements, betterments, restorations, and expenditures that add value or substantially prolong the life of the property or adapt the property to a new and different use. 1. Purpose: permitting TxP to deduct expenses currently which are incurred to produce income in future years is a form of tax deferral. Capitalization is also encouraged to avoid allowing the TxP to deduct an expense from ordinary income when the benefit will be taxed at lower capital gains rates. See § 263. 2. Test: Generally, an expenditure should be treated as a capital outlay if it brings about acquisition of an asset or some advantage to TxP having useful life in excess of one year. Here, the TxP has purchased an asset, not incurred an expense. While expenses can be deducted in the year incurred, if it is capitalized, it can either be 1) deducted over a period of years (as a depreciation or Federal Income Tax: Outline Philip Larson Page 8 amortization) or 2) the capitalization will reduce the amount of gain recognized when the asset is finally sold. a. Factors: factors include 1) whether item is recurring as opposed to extraordinary; recurring items are more likely to be expenses; PNC Bancorp (could take deductions for recurring expenses even when benefits lasted more than a year), and 2) the administrative burden of matching income to expenditure. Encyclopedia Britannica (publisher must capitalize the cost of acquiring a manuscript) b. “Long term benefit” does not have to be an asset: The long term benefit does not have to itself be a capital asset. Moreover, it doesn’t have to be an asset at all. INDOPCO v. Commissioner (costs of arranging a takeover would produce long-term benefits and required capitalization). 3. Experimental Costs: § 174 allows a TxP to deduct “experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to the capital account.” This was enacted to stimulate the search for new products and ideas. a. Patents, Copyrights, etc.: The courts usually allow the deduction of these costs even b/f a business is being carried on or sales have begun. § 174 also allows the current deduction of research and experimental costs in creating patents, copyrights, etc. even though the benefits of such costs will stretch over future tax years (and would ordinarily be capital expenditures). 4. Start-up Expenditures: originally, these were permanently nondeductible but § 195 now allows a TxP may elect to amortize “start-up” expenditures over 60 months from when the business begins. These include 1) costs of investigating creation of a new business, and 2) costs of creating the new business. 5. UNICAP: in 1986, § 263A, the Uniform Capitalization (“UNICAP”) rules were enacted to provide extensive guidelines for the capitalization of all costs involved in the production of selfcreeate assets, such as in-house production of a manuscript. 6. Repair & Maintenance Expenses: if property’s useful life or value is increased, cost must be capitalized. Otherwise, cost is deductible as a current expense. Midland Empire Packing v. Commissioner (repairs made to keep property in a normal operating condition are immediately deductible as ordinary and necessary business expenses) a. Factors Include: 1) Whether expenditure prolongs the life of the property, 2) Whether improvements will endure over and beyond the taxable year. 3) Whether expenditure adds to the value of the property. , 4) Whether the expenditure was part of an overall improvement or merely a replacement of minor or recurring items., 5) Whether there is a change or alteration in use or function. b. Groundwater Remediation Costs: deductible. Although, cost of creating a new groundwater treatment facility would be capitalized as it creates a new asset w/life greater than 1-yr. c. General Plan of Rehabilitation: Norwest Corporation and Subsidiaries v. Commissioner (asbestos case -costs incurred for repair, though normally deductible, must be capitalized when made in connection w/improvements) 7. Prepaid expenses: A TxP is usually entitled to deduct expense items in the year in which they are paid. However, this generally does not apply to the prepayment of goods and services to be received in future years. Worldcom (they were prepaying leases and capitalizing them but not allocating them to the appropriate tax year to hide $3.8B in prepaid leases to telephone companies). To allow a deduction of prepaid expenses would permit a TxP to distort income by making voluntary prepayments to reduce taxes in years of high income. 8. Patents, Copyrights, Trademarks: costs of buying them are capitalized. Costs of developing them are deducted. iii. ELEMENT 3 : “ORDINARY & NECESSARY” 1. Definition: Even if an expense is of business (rather than personal) nature, and is current (rather than capital), to be deductible it must be “ordinary and necessary” to the TxP’s business. a. Welch v. Helvering, SC says necessary means “appropriate and helpful” and ordinary means “common and accepted” -paying another’s debts w/o obligation is not ordinary in the grain purchasing business); Federal Income Tax: Outline Philip Larson Page 9 b. Gilliam v. Commissioner (guy attacks another passenger on a plane – wanted to deduct legal fees as business expense; Held: they must be directly in conduct of TxP’s trade or business). c. Danville Plywood v. US (120 ppl going to Superbowl was not an ordinary & necessary expense under §162 – entertainment expenses must meet the requirements of both § 162 and § 274) d. Factors: is it 1) voluntary or unsavory – less likely to pass, 2) customary – more likely to pass 2. Reasonable Compensation: § 162(a)(1) allows a TxP to deduct a “reasonable allowance for salaries and other compensation for personal services actually rendered. Reasonable compensation is determined by all relevant facts and circumstances. § 280G restricts deduction for substantial bonuses paid to corporate executives contingent on the change in control of the company. iv. ELEMENT 4: NO PUBLIC POLICY VIOLATION 1. Illegal or Unethical Activities: § 162 expenses and losses which would be deductible are not if to do so would violate public policy. a. Case: Commissioner v. Tellier (securities underwriter could deduct legal expenses for securities fraud b/c they were “ordinary and necessary” to protection of his business – IRS failed to prove they were contrary to public policy) b. Case: Stephens v. Commissioner (deductions that severely and immediately frustrate public policy are not allowed -TxP can claim a deduction for a restitution payment of embezzled funds he paid tax on) 2. Bribes and Kickbacks: No deduction is allowed for any bribe, kickback, or payment to a gov’t official or employee. Bribes and kickbacks to those outside of the gov’t are also not deductible if their illegality can be established by criminal law or by a statute which subjects the violator to loss of a license or privilege of doing business. 3. Fines and Penalties: § 162(f) disallows deduction for payment of any fine or penalty to the gov’t for violation of any law. This includes penalties imposed under civil statutes as well as criminal statutes if the purpose is the same as would be accomplished under a criminal statute. 4. Lobbying Activities: Lobbying expenses incurred to influence any legislative body on a matter which is of direct interest to the TxP may be deducted as a business expense. § 162(e). A deduction is also allowed for that portion of membership dues paid to an organization attributable to that organization’s expense in carrying on lobbying activities. Except as provided in § 218,Expenses of participation in political campaigns or influencing the general public are not deductible. b. TRAVEL AND ENTERTAINMENT i. Travel Expenses: § 162(a)(2) allows the deduction of expenses for traveling, meals and lodging while 1) “away from home”, and 2) in the “pursuit of a trade or business,” if they are not “lavish and extravagant”. Under § 132, traveling expenses are excluded from income if paid by employer and would have been deductible as a business expense. Rudolph v. US (purpose of trip to NY was not primarily related to business -merely personal in nature and therefore does not qualify for deduction) 1. Away from home: IRS says “home” is the TxP’s business headquarters. TxPs with no business headquarters can treat their residence as “home”. If they have no home, they can’t deduct travel expenses b/c they don’t have duplicate living expenses. 2. Abuse led to § 274: § 274 has stricter limitations than § 162, requiring the item be “directly related to” or “associated with” the active conduct of the TxP’s trade or business. ii. Deductible Travel & Entertainment Expenses 1. Home-to-business commute if: a. “home” is the principal place of business & “work” is a second place of business, § 280A(c)(1) b. “work” is a temporary location out-side the metropolitan area in which TxP lives 2. Commute between business locations 3. Meals that pass the “sleep or rest” rule (US v. Correll): § 119 excludes from income the value of meals provided by an employer to his employees for his convenience, but only if they are provided on the employer’s premises. Off premises, the question is whether the meals are “ordinary and necessary” business expenses under § 162(a) or if they are personal expenses (not deductible Federal Income Tax: Outline Philip Larson Page 10 under § 262). after 1987, meals must be related to the active conduct of a trade or business (e.g. follow a bona fide business discussion). 50% limitation under § 274(n). 4. Lodging for a temporary (less than 1 yr) job assignment: § 162(a)(2) travel and living expenses are deductible if reasonable to maintain residence a distance from trade or business or if the work is temporary. a. One year rule: if TxP expects job assignment to last more than one year, living expenses at job site are not deductible. 5. Travel Expenses for Business Purposes: transportation expenses incurred on combined businesspleaasur trip are deductible if primary purpose of trip was business, but lodging and meals must be fairly allocated between business & pleasure. If primary purpose was pleasure, then no part of the transportation expense is deductible (although meals and lodging attributable to business would be). a. Maintaining two homes: to deduct expenses at a temporary job location, there must be a business reason for maintaining a home at the permanent location. Hantzis v. Commissioner (law student w/summer job in NY kept house in Boston by law school – could not deduct). 6. Entertainment expenses: § 274(a) allows deduction of entertainment or recreation expenses only if directly related to the active conduct of business. (e.g. socializing in nightclubs, casinos, etc. are only deductible if they precede or follow a substantial bona fide business discussion). Not just to establish goodwill. It is subject to the 50% limitation of § 274(n). a. Meals: to deduct meals as entertainment expenses, TxP must meet general standards including 1) TxP must be present, 2) meal must be directly related to active conduct of business (or precede or follow a bona fide business discussion. Only 50% are deductible. § 274(k),(n). b. Danville Plywood v. US (120 ppl going to Superbowl was not an ordinary & necessary expense under §162 – entertainment expenses must meet the requirements of both § 162 and § 274) iii. Nondeductible Travel & Entertainment expenses 1. “Normal” home-to-work commute: this is a choice of where to live, not a “necessary” business expense under § 162. Commissioner v. Flowers (lawyer commuting 250 miles could not deduct) 2. Travel Expenses for “pleasure”: in a mixed purpose trip, transportation expenses incurred on combined business-pleasure trip are deductible if primary purpose of trip was business, but lodging and meals must be fairly allocated between business & pleasure. If primary purpose was pleasure, then no part of the transportation expense is deductible (although meals and lodging attributable to business would be). 3. Travel expenses of spouse – unless they have an independent basis for a deduction. § 274(m)(3). c. HOBBIES: § 183 allows deduction for ordinary and necessary business expenses incurred for profit. Nickerson v. Commissioner (TxP needs to have a bona fide expectation of profit to deduct expenses) i. Classification: depending on facts, “hobby” activities will be treated as 1) activity engaged in for profit, such that losses can offset other income, 2) a passive activity, with result being losses can only offset income from other passive activities, and 3) a hobby loss, such that losses can only offset gains from that activity. § 183(b). ii. TxP’s Motive: To determine motive, court looks to facts and circumstances including expertise of TxP in the business and the time and effort expended and profits earned. A TxP may deduct only the losses of a profit-seeking activity. iii. Presumption of “For Profit”: An activity is presumed to be for profit-making purposes if, for at least 2 of the last 5 taxable years, the activity brought TxP a net profit. Otherwise, facts are explored to ascertain the TxP’s intent. If the losses were sustained in a nonprofit-seeking activity, TxP may deduct interest, taxes, and other costs not to exceed the income produced from the investment. § 183(b) d. HOME OFFICES: generally, no business deductions are allowed for costs relating to the TxP’s personal residence. § 280A. However, some costs can be deducted if that portion is the principal place of business and is used exclusively for business. § 280A(c)(1). i. Trade or business: Moller v. US (Managing one’s own investments in securities is not the carrying on of a trade or business and you can’t take a “home office” deduction) Here, P was an investor not a trader so P was not engaged in a trade or business under § 162(a), although some expenses may be deductible under § 212 but not those of a home office. Federal Income Tax: Outline Philip Larson Page 11 ii. Principal place of business: Popov v. Commissioner (a living room used exclusively for music practice is a “home office.”) Factors include: 1) relative importance of activities performed at each business location, and 2) amount of time spent in each business location. 1. Home Management: home office qualifies as principal place of business if admin & management of TxP’s trade or business are done and there is no other fixed location where they could be performed. § 280A(c)(1). iii. Self-employed individuals vs. Employees: costs of a portion of a TxP’s residence are deductible as a business expense if used exclusively for a principal place of business or dealing with patients, clients or customers. § 280A(c)(1). For employees, use of a residence as a business is deductible only if it is for the employer’s convenience. This is narrowly construed. e. MOVING EXPENSES: Moving expenses: typically, moving costs are personal expenditures. However, § 217 allows employees or self-employed people to deduct expenses for moving family and belongings to a new home if the new job must be over 50 miles farther from his old house than his old job site was. §217(c) Also, he may not deduct over $1500 for travel and temporary housing, nor over $3k for selling his old home and buying a new one. After 1987, these are only allowed as itemized deductions from AGI (below the line deductions). f. VACATION HOMES: § 280A has limitations on deductions for dwellings that are rented out. Two rules: 1) deductions must be prorated between personal and rental use, and 2) if the dwelling is “used as a residence”, business deductions are limited to income generated by the property. § 280A(c)(5) i. “Used as a residence”: means personal use of unit for the greater of 14 days or 10% of the days it is rented. ii. Maintenance costs: § 280A(c)(3) allows deduction of maintenance expenses attributed to renting of the unit. Amount deductible is the pro rata portion attributable to days rented compared with total days unit was used. g. LEGAL EXPENSES i. General: if litigation costs are related to TxP’s business, they may be deductible if “ordinary and necessary”. 1. Expenses of Acquiring Property: Typically, legal fees paid in connection with the acquisition of property are treated as capital items, not deductible expenses. HYPO: A buys property for $10k. Neighbor claims he owns 10 ft of the property. A pays him $2k for a quitclaim deed. $2k is added to the cost basis of the property. 2. Tax Advice: § 212(3) allows TxP to deduct expenses incurred in determining or resisting any tax liability. Thus, legal fees paid in determining the tax consequences of a divorce or property settlement may be deducted by TxP. h. EXPENSES OF EDUCATION i. General Rule: educational costs which either qualify the TxP for a new trade or business, or which constitute the minimum educational requirement for qualification for his job, are never deductible. ii. Deductible Educational Costs: they are deductible if they 1) maintain or improve skills required to do her job, 2) education that meet the express requirements of the individual’s employer as a condition of retention. 1. Carroll v. Commissioner (police officer could not deduct philosophy classes -while college education improves job skills, relationship is not sufficient to remove expense from § 262 personal expenses). i. CLOTHING: cost of clothing is a deductible business expense only if: 1) The clothing is of a type specifically required as a condition of employment, 2) The clothing is not adaptable to general usage as ordinary clothing, and 3) The clothing is not generally used outside of employment by the TxP. Donnelly v. Commissioner; Pevsner v. Commissioner (clothing test is objective not subjective, based on the taste and lifestyle of the TxP) j. CHILD CARE EXPENSES i. Basic Statutory Law: deducting cost of child care was traditionally not permitted as a business expense. However, Congress has provided a deduction for these costs (as a tax credit). A TxP can deduct from taxes owed up to 30% of the costs of caring for dependents under 15, plus household services, if the costs are incurred so the TxP can be employed. Expense cannot exceed the earned income of the lower earning spouse (unless a student). Maximum credit is $2400 for one child and $4800 for two or more children. § 21. The formula is somewhat complex. ii. Other limitations: expenses for out-of-home, noninstitutional care of a disabled spouse or dependent are made eligible for the credit, but expenditures at a child care center not in compliance with state or local Federal Income Tax: Outline Philip Larson Page 12 regulations will not be eligible for the credit. Finally, amounts provided by an employer under a nondiscriminatory child care plan are not included in the employee’s income. C. DEPRECIATION a. Introduction: § 167 permits as a depreciation deduction a “reasonable allowance for the exhaustion, wear, and tear” of assets used in a trade or business, or held for the production of income. If the asset is intangible (like a copyright) it is known as amortization. All physical property used in a trade or business or for the production of income may be depreciated if it has a limited useful life. Also, intangible assets (copyrights, etc.) may be depreciated unless their useful life is indefinite. i. Rationale: depreciation tries to match the asset’s declining value against the income it produces in a given year. However, deductions under § 168 for ACRS departs from this theory and acts as a subsidy for encouraging investment in plants & equipment. ii. Cost recovery options: 1) § 162 ordinary & necessary expense deduction, 2) G/L = AR – AB, basis offset at sale, 3) depreciation or amortization (middle ground). iii. Depreciation as Exception to Realization Doctrine: realization, a timing doctrine, holds that not every change in wealth prompts recognition of income or deductions. Depreciation is an exception because the loss is recognized before a sale or disposition of the asset. iv. Tangible vs. Intangible assets: depreciation rules for tangible assets set out in § 168 replace previous rules in § 167. System under § 168 is called the “accelerated cost recovery system” (ACRS). b. Limitations on Depreciation: i. Passive Loss Rules: deductions related to passive activities cannot exceed income from those activities. § 469. Deductions disallowed are often real estate depreciation. ii. “At Risk” limitation: § 465 says depreciation cannot exceed the amount of the TxP’s actual investment and his personal liability obligations. c. What Property can be depreciated? i. Intangibles: intangible assets including goodwill that have a basis can be amortized over an arbitrary 15-yr life. § 197. Production costs of books, films, recordings, etc. produced by TxP are amortized over the period during which they are expected to produce income. ii. Property with unlimited useful life: assets that do not wear out (e.g. works of art, land) cannot be depreciated. Thus, land or stocks cannot be depreciated. When a building is purchased, it is necessary to allocate the cost between the building and the land on which it was built. d. Who is entitled to depreciation? The person who suffers the economic loss as a result of decrease in the value of the property due to depreciation is the one who can claim the deduction. i. Landlord/Tenant: when lessor improves land and then leases the property to tenant, lessor can claim depreciation deductions. However, if tenant is required to maintain the property so it is of equivalent value, lessor cannot take depreciation. ii. Expensing Purchase Prices: § 179 allows TxP’s to expense up to $25k/yr for purchasing of tangible personal property used in business. iii. Limitations for “Listed Property”: § 280F places limitations on deductions for listed property including cars, cell phones, and home computers. e. Computation of Depreciation i. Recovery periods: 3, 5, 7, 10, 15, 20 years. 3-yr (special tools, racehorses), 5-yr (automobiles, computers, copiers, typewriters, etc.), 7-yr (office furniture, fixtures, equipment, etc.) 10-yr (petroleum refining assets), 15-yr (sewage treatment plants), and 20-yr (municipal sewers). ii. Salvage value: value an asset is expected to have at the end of its useful life. Salvage value is ignored for the ACRS § 168 depreciation. iii. Methods of depreciation: ACRS provides for two kinds of depreciation: straight-line and accelerated. iv. Personal Property – Accelerated Depreciation: Method proscribed for personal property is 200% declining balance method for 3, 5, 7 and 10 and 150% DBM for 15 and 20 yr. 1. Declining balance methods: compute straight-line rate. Increase that by appropriate factor (2 or 1.5). Apply that factor to the adjusted basis each year. Eventually, basis will be reduced to point that straight-line depreciation would provide greater allowance. Use straight-line until basis is zero. § 168(b). 2. Half-year convention: personal property is deemed to have been acquired and sold exactly halfway through the year. Therefore, the first year’s depreciation is only half a full-year’s depreciation. Federal Income Tax: Outline Philip Larson Page 13 3. Straight-line election: TxP may elect to use straight-line depreciation instead of accelerated. § 168(a)(3)(C). v. Amortization of Intangibles: 1. Purchased intangibles: amortization of purchased intangibles (including goodwill) over a 15-yr period. § 197. Applies to 1) purchased goodwill, 2) purchased going concern value, 3) purchased patents, copyrights, etc., 4) purchased customer-based intangibles like subscription lists, 5) franchise, trademark or trade name. 2. Self-created intangibles: under § 167, these can be amortized over the asset’s useful life. 3. Intangibles not covered by § 197: does not apply to 1) an interest in a corporation, partnership, 2) interest in land, 3) inventories, 4) can interest in a film, video, book, etc. vi. Real Property: real property can only be depreciated using the straight-line method. Nonresidential real property (e.g. factory) is depreciated over 39 years. Residential real property is depreciated over 27.5 years. Depreciation is on a mid-month convention. f. CAUTION – Depreciation reduces basis: the depreciation deduction taken each year reduces the TxP’s basis. The more depreciation taken, the more gain (or less loss) there is when the property is ultimately sold. i. Note: in many cases, a gain will result from the fact that depreciation exceeded the decline in value. Because of “depreciation recapture”, these gains are often ordinary income rather than capital gain. § 1245. g. Disposition of Depreciable Property: much of the property eligible for § 1231 (or capital gain) treatment is also property that can be depreciated under § 167. Thus, a TxP could take ordinary depreciation deductions and then claim a capital gain upon disposition of the property. § 1245 and 1250 were enacted to eliminate this TxP practice, which had the effect of converting ordinary income into taxable gain. These sections require a TxP to report certain portions of § 1231 gain as ordinary income. i. § 1245 – Depreciable Personal Property: requires that upon the sale of depreciable personal property, any gain realized is ordinary income to the extent of all depreciation deductions taken after 1963. HYPO: TxP buys machine in 19970 for $20k and deducted $12k depreciation over 9 years. TxP then sells machine for $23k. The gain realized is $15k. $12k ordinary income and $3k getting favorable capital gain treatment. ii. § 1250 – Depreciation on buildings: requires that “additional” depreciation claimed on buildings be recaptured. This means that any depreciation in excess of the straight-line rate. HYPO: TxP buys building for $100k w/expected useful life of 50 yrs. Building is sold 10 yrs with total depreciation of $32k claimed. Of this, the straight-line amount is $20k. If sale price was $85k, the gain would be $17k b/c the basis at that date was $68k. § 1250 requires that $12k of the $17k gain be recognized as ordinary income, since that amount represents accelerated depreciation over the straight-line rate. § 1250(a)(1)(B) relaxes the recapture rule for owners of housing units for low-income renters. iii. ERTA qualification: ERTA leaves the law unchanged for residential real property. However, it requires the entire amount of prior depreciation be recaptured as ordinary income if accelerated depreciation was used for nonresidential real property. h. Basis for Depreciating Debt-Financed Property: i. General Rule: the amount of debt incurred in financing a depreciable asset is included in the property’s basis for purposes of computing depreciation. This is the “basis” side of the Crane holding. ii. Limitation – non-real estate investments: § 465 states that depreciation and other deductions cannot exceed the TxP’s actual investment or liability in the investment. These are known as the “at risk” limitations and apply to all investments other than real estate. 1.1.5 PERSONAL DEDUCTIONS, EXEMPTIONS, AND CREDITS A. INTRODUCTION: a number of items are deductible even though they have no relationship to business or investment. The rationale is that they probably diminish a TxP’s ability to pay taxes (medical expenses, casualty loss) or we want to encourage the behavior (interest, state & local taxes (not sales tax), charitable contributions). a. Standard Deduction: some deductions, such as those for business expenses, are allowed in reducing gross income to AGI. Other deductions, such as interest, tax, contributions, and medical expenses, are allwed to reduce AGI to taxable income. Taxpayers can elect to take the standard deduction in lieu of these later group of deductions. This is good for those who don’t own a mortgaged home or make a lot of contributions. b. Miscellaneous Itemized Deductions: many, but not all, itemized deductions (BTL deductions from AGI) are subject to a 2% floor. § 67. See above for comparison chart. i. Whitten v. Commissioner (expenses incurred in participating in a game show are not gambling losses, and are not deductible – they would be BTL deductions subject to 2% floor) Federal Income Tax: Outline Philip Larson Page 14 c. Phaseout of itemized deductions: itemized deductions are reduced by 3% of excess of AGI over the applicable amount ($137,700 in 2002) § 68. However, no more than 80% of itemized deductions are wiped out by this provision. This provision is applied after all other deduction limitation provisions (such as the 2% floor). i. Exceptions: phaseout does not apply to medical expenses, investment interest or casualty losses. B. “NON-BUSINESS” EXPENSES – EXPENSES FOR THE PRODUCTION OF INCOME a. Generally: an individual TxP is entitled to deduct expenses paid or incurred 1) for production of income, 2) for management conservation or maintenance of property held for production of income. § 212 b. Scope: while the scope of the deductibility of § 212 expenses is basically the same (e.g. “current”, “ordinary and necessary” and “no violation of public policy”), § 212 expenses are below-the-line deductions from AGI and are subject to rule that only allows miscellaneous itemized deductions in excess of 2% of AGI. i. Example: Divorce and Property Settlements: US v. Gilmore (divorce settlements and “conserving” property held for the production of income did not arise in connection with the profit seeking activities. They arose from the martial relationship. Therefore, not deductible under § 212) C. INTEREST: interest on personal debts (other than qualified residence interest) are not deductible (e.g. credit cards). Interest on investment and business debts is deductible, with certain limitations. a. What is interest? Payments for the use of money qualify as interest. These could be thought of as rental payments for the use of money. However, service charges for the lender’s services are not deductible as interest. i. Points: when lenders charge an additional “loan processing fee” (points), these are considered payments for the use of money and are deductible as interest. ii. Imputed interest: if a loan agreement calls for interest below the applicable federal rate, interest is imputed. b. Limitations: interest incurred in a trade or business will be fully deductible. Interest incurred in acquiring investments will be deductible only to the extent of net investment income. c. HOME MORTGAGE LOANS: Home mortgage interest is deductible on the first and second residence. Qualified residence interest has two categories: i. Acquisition indebtedness: debt incurred to acquire, construct or substantially improve a qualified residence. Aggregate amount of acquisition debt cannot exceed $1M. Refinancing acquisition debt is still acquisition debt, but only to the extent of the original acquisition debt. § 163(h)(3)(B). ii. Home equity indebtedness: debt (other than acquisition debt) secured by a qualified residence. Cannot exceed $100,000 or the FMV of residence reduced by amount of acquisition debt on residence. § 163(h)(4)(C). d. Tax-exempt interest: interest on debt used to purchase tax-exempt state or municipal bonds is not deductible. § 265(2). However, to disallow this deduction, some purposeful connection must exist b/w the funds borrowed and the investment. Wisconsin Cheeseman v. US. Tracing: Treas. Reg. 1.163-8T provides rules for tracing interest. D. TAXES: taxes may be 1) deductible as taxes, 2) deductible as business or investment expenses, or 3) not deductible at all. a. Deductible Taxes: every TxP can deduct state and local taxes, including income tax, real and personal property taxes. § 164. b. Taxes as Business Expense: A TxP may also deduct certain taxes paid in connection with a business or investment that would not otherwise be deductible, such as excise taxes and social security taxes paid on employees. c. Taxes entirely nondeductible: However, other types of taxes are never deductible such as federal income taxes, federal estate and gift taxes, and state inheritance taxes. E. CHARITABLE CONTRIBUTIONS a. Introduction: § 170(c) allows a TxP to deduct contributions made to any entity organized and operated predominantly for charitable, scientific, literary, or educational purposes. i. Bob Jones Univ. v. US (educational institutions w/racially-discriminatory admissions policies do not qualify for tax-exempt status under § 501(c)(3)) – organization must be “charitable” and charitable organizations can’t violate public policy. b. Limitations: Individual TxPs can deduct up to 50% of AGI to public charities and private operating foundations (where >50% of resources directly engaged in charitable work). However, gifts of appreciated capital assets and gifts to private charities are subject to 30% ceiling. § 170(b), (d) Corporations can deduct gifts up to 10% of a corporate TxP’s taxable income. § 170(b)(2). i. Carryover: individuals contribution’s exceeding the 50% and 30% ceilings can carryover and deduct excess in the next 5 years. ii. No deduction if TxP benefits: Ottawa Silica v. US (Quid pro quo contributions: if a party receives a substantial benefit in return for a charitable contribution, there is quid pro quo and no deduction is allowed) Federal Income Tax: Outline Philip Larson Page 15 c. Gifts in kind: A TxP may deduct the FMV of contributions of property, not his basis. However, there are limitations. i. Gifts of Future Interest: only becomes deductible when charity’s interest becomes possessory. § 170(a)(3). ii. Donated services and Free Use of Property: no deduction for contribution of TxP services or use of his property. However, out-of-pocket expenses in aiding a charity are deductible. d. Contributions of Appreciated Property: i. Long-term capital assets given to public charities: capital assets sold after being held for more than one year and given to public charities, TxP can deduct FMV of property w/o recognizing a gain for appreciation. (deduction limited to 30% of AGI). This makes gift of capital gain property more advantageous than sale of property followed by gift of proceeds. 1. Private charity: if gift is to private foundation, amount deductible is donor’s basis unless the foundation is directly engaged in doing charitable work rather than merely funneling money to other charities. 2. Unrelated tangible personal property: if gift is unrelated to charity’s purpose or function, deduction is donor’s basis. (HYPO: painting worth $10k with $7k basis given to art museum. TxP deducts $10k. If given to a medical institution, deduction is donor’s basis.) ii. Short term capital gain or noncapital assets: if property is held for less than 1 yr, the amount deductible is limited to donor’s basis. Therefore, all gifts of noncapital assets (inventories), or capital assets held for < 1 yr are deductible only at donor’s basis. e. Bargain sales: when TxP sells his property to a charitable organization for a price below FMV, the difference is deductible as a charitable contribution. TxP must apportion his basis b/w gift part and sale part. f. Contributions to Athletic Programs: In 1988, § 170(m) enacted allowing a deduction of 80% of any amount paid to a university athletic program if the deduction would be deductible but for the fact the TxP gets the right to purchase tickets. F. MEDICAL EXPENSES a. Introduction: § 213 provides a limited deduction for amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease” of for affecting the structure or function of the body. Analysis must determine whether TxP is 1) making a consumption expenditure (not deductible), or 2) restoring himself to some minimal state of health. i. Types of Expenses – 7.5% Floor: Medical expenses, including drugs and insurance premiums, transportation essential to medical care, etc. are deductible to the extent they exceed 7.5% of AGI. § 213(a). ii. Cosmetic surgery is not deductible unless it fixes a deformity from personal injury or a disfiguring disease. b. Distinguish -Personal Expenses: an expenditure must have a proximate relationship to medical care to be deductible. i. Case: Taylor v. Commissioner (doctor recommended not mowing lawn -not all doctor recommendations are deductible medical expenses.) This was a § 262 personal expense. ii. Case: Ochs v. Commissioner (sending children to boarding school for medical benefit of ill parent does not make the cost of boarding school a deductible medical expense – but for causation not enough) iii. Food and lodging: while food and lodging are generally not deductible because they would be incurred anyway, § 213(d)(2) provides that amounts paid for lodging when provided by a doctor in a licensed hospital, and there si no significant element of personal pleasure, recreation or vacation, is deductible up to $50/night. c. Capital Expenditures: if a capital improvement is prescribed by a physician (e.g. air conditioner, elevator) they are deductible as a medical expense, but deduction is limited to the excess of the cost of improvement over the increase in value of the property. d. Depreciation: depreciation on a car used for medical transportation is not deductible b/c it is not an “amount paid” for medical expenses. Moreover, this is not deductible as a trade or business expense. This is a nondeductible personal expense (consumption) Henderson v. Commissioner (depreciation of van used to transport disabled child is not deductible) e. Insurance: medical insurance payments are either deductible or excludable. Generally, other types of insurance payments are viewed as nondeductible consumption expenses. Largely insurance is not deductible b/c of 7.5% floor. i. Reimbursed medical expenses: Medical expenses are not deductible if compensated by insurance or otherwise. Federal Income Tax: Outline Philip Larson Page 16 ii. Medical Insurance for Employees: When an employer pays the premium on an employee’s medical insurance, the premium is deductible by the employer but is not included in the employee’s income. Also, an employer-financed plan to reimburse all employees for medical expenses is not taxable to the employee. G. LOSSES § 165: occur when a transaction comes to an end and the TxP has not recovered her basis for the assets involved. Loss is typically only deductible when “realized” (e.g. sale, exchange, theft, destruction, abandonment, worthlessness. Realization of loss for abandonment occurs when there is 1) both intent to abandon, and 2) affirmative act of abandonment. a. TRADE OR BUSINESS LOSSES: any loss incurred in a trade or business is deductible. § 165(c)(1). A corporate TxP is a business entity so its losses are generally deductible as business losses. For individuals, only certain types of losses are deductible. These are ATL deductions. i. Exchanges: Cottage Savings Association (exchanges of property that are materially different constitute a realization event and losses can be deducted) b. LOSSES ON TRANSACTIONS ENTERED INTO FOR PROFIT: losses incurred in transactions entered into for profit are deductible. § 165(c)(2). For costs of producing rents and royalties, these are ATL deductions taken from gross income, for all other § 212 deductions they are BTL subject to 2% floor. i. Personal residences: are not deemed held for profit so losses on sale are not deductible. ii. Gambling: wagering losses are deductible but only to extent of gains. § 165(d). c. CASUALTY LOSSES: § 165(c)(3) allows deductions for personal losses arising from “fire, storm, shipwreck, or other casualty or from theft.” Limitations: They are deductible only to the extent that the total casualty losses for the year exceed 10% of AGI and each individual casualty loss must > $100 (deduction must subtract the $100 if personal, if investment no need to subtract). Also, no loss will be allowed if TxP’s do not file timely insurance claims on losses covered by insurance. i. What is a Casualty? 1. Gross Negligence Bars: Blackman v. Commissioner (gross negligence of TxP bars a casualty loss – setting fire to clothes in own house) 2. Suddenness: to be deductible there must be sudden & unusual. “An accident, a mishap.” Nonphysical causes (OJ’s neighbor’s house) are not enough. 3. Similar to Fire, Storm, Shipwreck: Dyer v. Commissioner (cat breaking vase is not a casualty -casualty must be substantially similar to a fire, storm, or shipwreck); Chamales v. Commissioner (OJs neighbor experiences temporary decline in home value – Held: not a casualty loss -requires permanent damage or abandonment) Termite damage: A rev. rul. stated that termite damage to non-business property is not deductible as a casualty loss under § 165(c)(3). ii. Amount deductible: the amount deductible is the lesser of 1) the adjusted basis of the property, or 2) the difference b/w the value of the property before and after the casualty. For personal casualty loss, each must be reduced by $100 if personal (if held for investment, no need to reduce) and is only allowed to the extent it exceeds 10% of AGI. 1. Insurance: any insurance recoveries reduce casualty losses. 1.1.6 GAIN OR LOSS ON SALE OR EXCHANGE OF PROPERTY A. COMPUTATION OF BASIS, GAIN OR LOSS a. Summary of Basis i. Unadjusted Basis = cost of property (purchase money debt + purchase expenses + amount paid for options + any income to TxP as result of transaction) 1. General Basis: cost of property. § 1012 2. Gifts Basis: gain – donee’s basis is donor’s basis + portion of any gift tax donor paid; loss – donee’s basis is lower of the FMV at time of gift or donor’s basis + portion of gift tax paid. § 1015. 3. Tax-free exchange: basis in new property is basis of transferred property plus adjustments for any nonqualifying consideration paid or received. 4. Inheritance: Generally -basis is property’s value at time of death (or 6 months later); Community property – both surviving spouse and new legatee receive stepped up basis; Tenancy in common or joint tenancy – legatee’s basis in property is value at time of decedent’s death but surviving spouse’s basis does not change. § 1014 ii. Adjusted Basis = unadjusted basis + capital expenditures – losses – depreciation/amortization. b. Computation Formula: i. Adjusted basis = unadjusted basis + capital expenditures (not deducted as current expenses) – reductions (such as depreciation). Federal Income Tax: Outline Philip Larson Page 17 ii. Gain or Loss = amount realized (AR) -adjusted basis (AB) c. BASIS: basis must be known for both computation of gain or loss and for computing depreciation. i. Unadjusted basis: this is usually the cost. However, there are special rules for gifts, inherited property, and tax-free exchanges. 1. Cost Basis: generally, the basis of property is the cost of the property. § 1012. a. Mortgages: cost also includes any purchase money mortgage regardless of whether the TxP is personally liable on the mortgage (recourse) or takes subject to existing mortgages. i. Depreciation: since basis of property includes purchase-money debt, TxP’s basis will often be high even though TxP has not expended much of their own cash. This means property will generate high depreciation deductions (if it is held in a trade or business or for the production of income). However, ability to deduct losses is greatly limited by “at risk” rules if debt is nonrecourse and by passive loss rules if property is held for rental or other passive activity. b. Expenses of acquisition: such as broker’s or attorney’s fees are added to basis. c. Noncash sources of Basis: cost basis of property includes more than just the cash exchanged between the parties. Cost also includes debts incurred to purchase the property, purchase expenses, and any income charged to TxP as a result of the transaction. (e.g. TxP pays $10 for stock in her company worth $30, the “bargain purchase” being a form of additional compensation of $20. TxP’s basis is $30. 2. Gifts: for computing gain (as well as for depreciation purposes), donee takes the donor’s basis on property acquired by gift. However, for computing loss, the donee’s basis is the FMV at the time of gift, or donee’s basis, whichever is lower. § 1015. a. Gift Tax: donee can increase her basis by a portion of the gift tax paid by donor. 3. Tax-Free Exchanges: the basis of property acquired in a tax-free exchange is that of the property transferred. However, it must be adjusted for any nonqualifying consideration paid or received. 4. Inherited property: basis of inherited property is its value at the date of decedent’s death or the value six months after the date of death. § 1014. d. ADJUSTED BASIS: this is determined by adding to unadjusted basis all capital expenditures (e.g. items not deductible as current expenses). From this sum is subtracted 1) losses, 2) depreciation/amortization on the capital asset. § 1016. i. Depreciation: if TxP fails to claim as much depreciation as was “allowable”, the full amount allowable reduces the basis anyway. ii. Tenant’s improvements: lessor has no income if lessee makes improvements, § 109, but he also can’t increase basis. If improvements were in lieu of rent, they are taxable and do increase basis. § 1019. § 109 reverses Helvering v. Bruun (an increase in the value of a capital asset may be taxed as realized income). e. ALLOCATION OF BASIS i. Partial sale: when a TxP sells only part of an asset, he must allocate basis between the part sold and the part retained “in some reasonable manner.” If this is infeasible, amount received is simply applied against the basis of the part retained. Inaja Land Co. v. Commissioner (easement sold on land reduced basis of retained land – no capital gain or loss). B. REQUIREMENT OF REALIZATION a. Generally: before any increase in net worth becomes taxable (or a decline becomes a deductible loss), a realization must occur. This is a crystallizing event that makes it reasonable and convenient to compute gain or loss. Cottage Savings Ass’n v. Commissioner. Gain or loss must be both realized and recognized to be taxable. Eisner v. Macomber (gains must be realized before they are taxed) i. Purpose: administrative imprecision of appraising all real property for tax gain. Moreover, they may fluctuate. ii. Types of Realization events: 1) sale, 2) payment of debt, 3) mortgage foreclosure, 4) exchange of materially different property. b. Realization in property transactions: owner of property realizes gain or loss only on the sale or other disposition of property. § 1001. i. Mortgages: mortgaging is not a realization event even when TxP borrows more than the basis of the property. Woodsam Associates v. Commissioner (execution of a nonrecourse mortgage is not a realization event – Mrs. Wood bought property for $300k and refinanced increasing her debt to $400k and making Federal Income Tax: Outline Philip Larson Page 18 mortgage nonrecourse so she wasn’t personally liable. She sold to P and P got Wood’s carryover basis of $300k. P wanted Wood to have to recognize gain so her carryover basis would be $400k) ii. Transfers as payment of debt: the transfer of appreciated property by TxP in satisfaction of a claim against him is a realization – this is equivalent to an exchange. 1. Mortgage + Gift: while gift of property is not a realization and mortgaging is not, if the two are combined the result may be a realization (HYPO: TxP owns property w/$100 basis worth $400. He mortgages borrowing $250 w/no personal liability and gives property to kids subject to the mortgage. TxP relieved of debt $250 liability -$100 basis so he has realized gain of $150.) iii. Exchanges: exchanges are a realization event if the property received “differs materially” either in kind or in extent from the property given up. Cottage Savings Ass’n v. Commissioner (an exchange of two properties is a realizing event only if the two properties are, from a legal point of view, “materially different” – here swap of pooled mortgages is a realization even if done only for tax purposes) c. AMOUNT REALIZED: the amount realized is the sum of the money + FMV of any other property received by Txp in a realizing transaction. § 1001(b). i. Mortgaged property: upon disposing of mortgaged property, TxP’s amount realized is the sum of cash + the amount of debt secured by the property for which the TxP is no longer liable. 1. Crane v. Commissioner (the Crane Rule – TxP inherited an apartment building where property equaled mortgage; SC held she realized the full amount of the outstanding note even though she had no personal obligation to pay it and received only a token amount of cash from buyer) a. Significance: in many deals, buyer of property acquires it with small down payment and borrows the balance with a nonrecourse loan. TxP’s basis for depreciation includes the down payment and the full amount of the nonrecourse loan. This can produce a substantial gain when the TxP has depreciated property more than the actual decline in property value. 2. Property worth less than nonrecourse loan: if the property is worth less than the amount of the recourse loan, the TxP might sell the property subject to the loan. Since the loan is nonrecourse, the lender cannot claim a deficiency. Nevertheless, the TxP still is treated as realizing the full amount of the mortgage outstanding. Any other treatment would be inconsistent with allowing her to include the nonrecourse loan in her basis when she acquired the property. Commissioner v. Tufts (nonrecourse debts are treated the same as any other debts for tax purposes). a. When realized: the transferor realizes the amount of the mortgage when property is disposed of (given away, mortgage is foreclosed, etc.) 3. Nonrecourse vs. Recourse debt: rules are not entirely the same. a. Disposition of property under nonrecourse debt: TxP realizes full amount of debt when disposing of the property. The debt is simply treated as part of the sale price. The gain is capital gain (except to the extent it is turned ordinary by the depreciation recapture rules). b. Recourse debt: if a creditor under a recourse debt forecloses his mortgage and forgives the deficiency judgment (if property is worth less than mortgage), this is treated as debt cancellation income. Debt cancellation income is ordinary income, not capital gain. c. HYPO: TxP owns property w/basis of $4k subject to mortgage of $9k but worth $8k. TxP transfers property to lender or third party. If debt is nonrecourse, TxP has capital gain of $5k. If the debt is recourse, TxP has gain of $4k and $1k of ordinary (not capital) debt cancellation income. If TxP is insolvent, TxP can exclude debt cancellation income. § 108. d. HYPO 2: Borrowing Against Appreciation: If TxP buys property for $10k and value goes to $100k so TxP has unrecognized gain of $90k, and then he borrows $60k on a nonrecourse basis with lender’s sole security being the property, the TxP has effectively “locked in” $50k gain. However, this gain is not taxed at the time of the loan. It is taxed when the property is sold. C. NONRECOGNITION OF GAIN OR LOSS a. Summary of Nonrecognition: Gains from the following events generally are not recognized and therefore may not be currently taxable: i. Like kind exchanges – § 1031 -when real property held for investment or business is replaced by other real property, no gain or loss is recognized. When tangible personal property held for investment or business is replaced with other property having the same character, gain or loss is not recognized. If the Federal Income Tax: Outline Philip Larson Page 19 TxP receives “boot”, gain but not loss is recognized in amount of the lesser of amount realized or boot value. “Transfers” include replacement property identified within 45 days and actually transferred within 180 days. ii. Involuntary conversion – § 1033 -gain on property that was involuntarily converted need not be recognized if replaced with property “similar or related in service or use” within 2 yrs of conversion. Loss must be recognized. iii. Sale of principal residence -§ 121 – gain of up to $250k on sale of TxP principal residence is not recognized, provided that the TxP 1) owned and used the principal residence for 2 of last 5 years, and 2) TxP has not used this provision in past two years. Losses on principal residence cannot be recognized. iv. Exchanges between spouses in divorce – no gain or loss recognized on sales or other transfers between spouses or former spouses when incident to divorce. b. General: while § 1001 says gain or loss is realized on the sale or exchange of an asset, it is recognized only to the extent provided in § 1002 (listing exceptions). Therefore, gain or loss must be both realized and recognized. c. Nonrecognition Provisions: IRC has many exceptions to rule that all gain or loss is recognized at time of sale or exchange. i. Like-kind Exchanges: no gain or loss is recognized on an exchange of business property or property held for investment for receipt of property of a like kind. § 1031(a). “Like kind” refers to the general nature of the property, not to its grade, value or quality. For example, unimproved investment real estate could be exchanged for investment real estate with improvements and still qualify. 1. Limited to tangible property that is not inventory: § 1031 does not apply to stocks, bonds, partnership interests, or inventory (or other property held for sale to customers in ordinary course of business). Only covers real or tangible property held for investment or used in business (e.g. buildings, machinery, fixtures) 2. Triangle exchanges: a three-way exchange might qualify under the statute. (e.g. TxP wants to sell property A to P and buy property B. He has P buy B and then exchange A for B). a. Deferred exchanges: Starker v. US (P entered a “land exchange” agreement in which P gave X land in exchange for promise to acquire and give P suitable replacement property w/i 5 years + 6% growth factor – Held: this was a § 1031 like kind exchange and the growth factor was ordinary income as disguised interest). b. Statutory Limit: Starker was limited so now the replacement property must be identified in 45 days after the TxP transfers property to purchaser, and replacement property must be actually received within 180 days. § 1031(a)(3). 3. Sale and Leaseback: if TxP sells his building to X for much less than his basis and then leases it back from X on a long-term lease, can TxP claim a loss on the transaction? a. IRS: if lease is held for more than 30 years IRS deems it equivalent to a fee interest, so like kind requirement is met and loss is not recognized. b. Judicial Approach: trend is that sale and leaseback cannot be treated as an “exchange” and § 1031 is inapplicable. Jordan Marsh Co. v. Commissioner (a bona fide sale and leaseback is not an exchange of like-kind property) 4. Effect of “boot”: If a TxP receives both like kind and non-like-kind property (e.g. “boot”), realized gain is recognized to the extent of the boot. § 1031(b). That is, the lesser of the realized gain and the boot must be recognized. a. HYPO: TxP exchanges aptmt building w/basis of $60k (FMV of $85k) for an apartment building with value of $80k +$5k in cash. Her realized gain is $25k of which she has to recognize $5k (the amount of the boot). b. Transfer of boot: a TxP transferring boot to the other party doesn’t not recognize any gain on the like-kind property also transferred. However, if the TxP’s boot is property other than money and the property is worth more or less than its basis, TxP must recognize the lesser of the realized gain or the value of the boot. c. Carryover basis: if property is given up for other property in a transaction which qualifies as a like-kind exchange, § 1031(d) requires TxP to use the basis of her traded property as the new basis of her acquired property. However, if there is boot: i. New Basis of property received = old basis of property given + gain recognized – boot money received. (why add gain recognized and subtract boot when this is usually just adding zero? If the boot exceeds the gain, basis should be reduced). Federal Income Tax: Outline Philip Larson Page 20 5. Exchanges b/w related persons: if TxP exchanges property under § 1031 with a related person and related person disposes of property within 2 yrs of exchange, the TxP must recognize gain or loss on the original exchange. 6. Nonelective: § 1031 is not a provision applicable at the choice of the TxP. Thus, when a loss occurs on an exchange of like-kind property, its recognition will be deferred even though the TxP would normally like to claim the loss at the time of the exchange. ii. Involuntary Conversion: gain is frequently realized when a TxP’s property is condemned or destroyed and TxP recovers insurance proceeds. These are “involuntary conversions”. Since the realization was probably undesired, the Code allows TxP to elect not to recognize the gains. § 1033. 1. 2-yr requirement: § 1033 on involuntary conversions requires TxP to replace the property “involuntarily converted” within two years after the close of the tax year in which she receives proceeds from the conversion with property “similar or related” in use to the property converted. Realized gain will only be recognized to the extent the amount realized exceeds the cost of replacement. a. HYPO: TxP owns building worth $100k with adjusted basis of $60k and it is destroyed in a fire. TxP invests $86k in a new factory within 2 years and elects to take advantage of § 1033. Her realized gain is $40k and recognized gain is $14k (the proceeds not reinvested). 2. Elective: § 1033 is elective, not mandatory. 3. Applies only to involuntary gains, not losses: However, it only applies to nonrecognition of gain – not loss. Realized losses on involuntary conversion must be recognized. iii. Nonrecognition of gain on sale of principal residence: no loss can be recognized on the sale of a personal residence. In most cases, gain from the sale of a principal residence is not recognized. However, gains in excess of $250,000 (or $500,000 for joint returns) are taxable as capital gain. § 121. 1. Requirements of § 121: to qualify, TxP must have owned and used the dwelling as a principal residence for periods aggregating 2 yrs or more of the last 5. § 121(a). Moreover, the exclusion is only available once every 2 yrs. iv. Sales between spouses: § 1041 says no gain or loss is recognized on sales or transfers between spouses or former spouses if the sale was incident to a divorce. Recipient’s basis remains same as transferor’s basis. 1.1.7 CAPITAL GAINS AND LOSSES A. Summary of Statutory treatment of capital and noncapital assets a. Capital assets i. Real estate for investment ii. Securities in hands of “average” investor or in hands of a “trader” iii. Copyrights held by purchaser iv. Patents in hands of the inventor or person who financed the invention b. Noncapital assets i. Property held primarily for sale to customers 1. Real estate held primarily for sale 2. Securities in hands of a “dealer” 3. Assets held in a “hedging transaction” ii. Receivables from selling inventory iii. Real and depreciable property used in a trade or business (although these are quasi-capital) iv. Copyrights in the creator’s hands B. BACKGROUND: long-term capital gain is taxed at a lower rate than ordinary income. a. Definitions i. Long-term capital gain – assets held for more than 12 months. ii. Short-term capital gain – assets held for less than 12 months. b. Sales of real estate: gains on depreciable real estate is recaptured to the extent of depreciation of the property. c. CAPITAL LOSS: can be deducted against capital gain for the year (long-term or short-term) plus $3k. If capital loss exceeds capital gain plus $3k, the excess can be carried forward to future years and offset against capital gains in that year + $3k. § 1211(b), § 1212. d. Implications of Capital Asset Treatment: capital versus ordinary distinction must be drawn for number purposes in the code. For example, a charitable contribution deduction is reduced by the amount of gain that would have been either ordinary income or short-term capital gain had the asset been sold. § 170(e)(1)(A). Federal Income Tax: Outline Philip Larson Page 21 e. Approach to classification i. Is the property a “capital asset”? ii. Was there a “sale or exchange”? iii. Is the gain or loss long-term or short-term? iv. Apply rules for limitation of capital loss deductions and capital loss carryforwards. C. IS IT A CAPITAL ASSET? a. General rule: § 1221 says that all property held by TxP is a capital asset, except specific types of property. § 1221 includes all of a TxP’s property as capital assets, except for 1) stock in trade or inventory of a business, 2) depreciable property and real property used in trade or business, 3) literary or artistic property held by its creator, 4) trade accounts or notes receivable, 5) certain governmental obligations. Distinction is between profits of the “business” (which do not receive capital gain or loss treatment) and “investment” (which do). A sale of securities by an average investor is an investment, but the sale of inventory by a merchant would be a business sale. i. Judicial interpretation: despite this broad language, courts have created more exceptions. b. Statutory Exceptions: § 1221 specifically states that the following are not capital assets: i. “PRIMARILY FOR SALE TO CUSTOMERS”: inventory and property held for sale to customers in ordinary course of business are not capital assets. § 1221(1). Any gain or loss from these types of property is ordinary income. 1. Real estate: most of the interpretation problems come from real estate. While land and building can be held for investment, this is frequently not the case. When a TxP buys a large parcel of land and splits it into smaller lots, ,the lots generally are not capital assets since they were held “primarily for sale to customers.” Problem is deciding whether TxP is an investor (capital asset) or a dealer (ordinary assets primarily for sale to customers). a. Factors: 1) number and continuity of sales If sales are isolated, TxP is investor. If steady flow of sales, TxP is a dealer.; 2) extent of improvements or subdivision of property. Subdivision or building on property means it is probably not a capital asset. i. Biedenharn Realty v. US (even if initial intent is “investment” subject to capital gain, property may later be considered for “business” subject to ordinary income) b. Dual purpose: if the property is held for several purposes, look to the most important purpose. 2. Securities: unlike real property, securities are generally treated as capital assets. Dealers generally have ordinary gains and losses and traders have capital gains and losses. Bielfeldt v. Commissioner (bonds trader, investor, argued he was a dealer and trading losses were connected with his “trade” of being a dealer – he wanted his losses to be ordinary, not capital. Held: these were capital losses) 3. Hedging Transactions: assets acquired in a “hedging transaction”, which are so identified on the date they are acquired, are not capital assets. § 1221(7). A hedging transaction is a transaction entered into in the normal course of trade or business to manage risk of price, currency, or interest rate fluctuations. a. Prior law – Corn Products: Until recently, the Corn Products case seemed to require an otherwise qualifying capital asset to be treated as ordinary if it was purchased as “an integral part of the TxP’s business.” Corn Products Refining v. Commissioner (manufacturer of corn products purchasing corn futures was an “integral part of his business” not for investment. Gains are ordinary.) Corn Products was superseded by regulations. b. Prior law – Arkansas Best: limited Corn Products to its facts: Arkansas Best Corp. v. Commissioner (SC retreats from earlier reliance on TxP’s motive to determine whether property is a capital asset) Motivation in purchasing an asset (business vs. investment) has no relevance to whether or not it is a capital asset. ii. Receivables: an account receivable or note acquired in the ordinary course of business or on sale of inventory is not a capital asset. § 1221(4). iii. Depreciable property and realty: depreciable property and real property used in a trade or business are not capital assets. If held for more than 1-yr, these are “quasi-capital assets” under § 1231 and get very favorable tax treatment. Generally, losses on sales of such assets are treated as ordinary (fully deductible) while gains are capital gains. Federal Income Tax: Outline Philip Larson Page 22 iv. Copyrights: are not capital assets in the hands of the TxP whose personal effort created them. § 1221(3). Purchasers of artwork and copyrightable works may be entitled to treat them as capital assets (unless they are a dealer and purchased them for resale in ordinary course of business). v. Patents: § 1235 says patents are capital assets in the hands of the inventor or anyone who financed the invention. Therefore, money derived from sale are capital gains. c. Exceptions Developed in Case Law: courts have developed additional categories of items that are not capital assets. The purpose is to avoid granting favorable capital gains treatment. They typically distinguish between items that are investments and those which produce ordinary income. i. Sale of rights to income: sales of rights to income while retaining underlying property are taxable as ordinary income. Commissioner v. PG Lake (SC holds that the transfer of an oil payment right, carved out of an oil lease, produced ordinary income rather than capital gain) § 636 now treats assignments like this one as loans. Therefore, P would not have recognized income until the oil payments were actually paid. 1. Distinguish Sale of life estates: even though this is merely the right to receive income during her life, courts have held this is a sale of an interest in property and gets capital gains treatment. McAllister v. Commissioner. (federal court rules that a life estate in the income from a trust is a capital asset) ii. Contract Rights: classifying proceeds from the sale of contract rights as capital gain or ordinary income is difficult. 1. Protectible in equity: One test is whether the contract right is “protectible in equity.” Case: Commissioner v. Ferrer (federal court finds theatrical production rights constitute a capital asset – “lease” of right to play was capital but right to proceeds from movie were ordinary) a. The Challenge: Ferrer requires allocating a lump-sum purchase price into its various component parts, some of which are capital gains and some ordinary income. 2. Termination Payments: are not capital gains. Baker v. Commissioner (a return of assets is not a sale when the returnee did not own the assets – there was no sale) a. Factors for a “Sale”: factors include 1) whether title passes, 2) how parties treat the transaction, 3) whether an equity was acquired in the property, 4) whether the K creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments, 5) whether the right of possession is vested in the purchaser, 6) which party pays the property taxes, 7) which party bears the risk of loss or damage to the property, and 8) which party receives the profits from the operation and sale of the property. iii. Leases: amounts paid by lessee for release from a lease is not capital gain. Hort v. Commissioner (cancellation of a lease does not create a capital loss for the landlord) iv. “Personal rights” and Payments for Invasion of Privacy: while § 1221 says “all property” held by TxP (other than statutory exceptions) are capital assets, it appears personal rights are not property. Miller v. Commissioner (widow sold “right” to make movie based on husband’s life – not everything that commands payment is property) v. Correlation with related transactions: transactions have been classified as either capital or ordinary because they are deemed part of a related transaction. 1. Tax Benefit Rule: Merchants National Bank v. Commissioner (asset must be treated the same in different tax years -sale of a note previously written off as ordinary is not a capital gain) 2. Lookback Rule: Arrowsmith v. Commissioner -SC -(Examining related transactions to classify one of them is not an attempt to reopen or readjust a previous tax year. It is clear that P should not be allowed to receive favorable capital gains treatment on original distribution and then claim ordinary loss treatment on payment of the judgment.) vi. Sale of a Sole Proprietorship – fragmentation theory: Case: Williams v. McGowan (§ 1221 sale of a sole proprietorship – assets must be looked at individually. They must be carved into capital assets and ordinary assets). 1. Sale of partnership: Sale of a partnership interest is treated as a capital transaction. If a partnership or corporation sells all its assets, result is the fragmentation test. d. QUASI-CAPITAL ASSETS: Assets used in trade or business § 1221(2) provides that certain assets used in a trade or business and held for > 1yr are not capital assets. § 1231 provides for these quasi-capital assets and they are treated more favorably. i. Coverage: quasi-capital assets are real property used in a trade or business and personal property used in trade or business that are subject to depreciation under § 167 (machines & trucks) Federal Income Tax: Outline Philip Larson Page 23 1. Inventory excluded: § 1231 excludes inventories and property held primarily for sale. ii. Computation: gains and losses from § 1231 assets are grouped together. If the gains exceed losses, gains are long-term capital gains. If the losses exceed the gains, transactions are ordinary. iii. Special rules for casualties: TxPs must aggregate all recognized gains and losses from casualties of assets used in the trade or business or for investment. If the gains exceed the losses, all transactions are included in § 1231. If losses exceed gains, none of the gains or losses are included in the § 1231 calculation. 1. Distinguish -Personal casualty gains or losses: gains or losses on personal assets (one’s personal car or residence) are not included under § 1231. If personal casualty gains exceed personal casualty losses, they are capital. If losses exceed gains, losses are deductible to the extent of the gains subject to 10% floor and reduced by $100. D. WAS THERE A “SALE OR EXCHANGE”? a. Generally: there must be a “sale or exchange” of a capital asset for the transaction to be taxed as a capital gain or loss. b. Foreclosure: when a creditor forecloses and takes back property that secured a debt, this is treated as a sale or exchange by the debtor. Gain or loss is capital. Helvering v. Hammel. c. Abandonment: if property becomes worthless or is abandoned, there is no sale or exchange and TxP has ordinary loss. d. Bailout of Corporate earnings: i. Business purpose Rule: Gregory v. Helvering (SC questions a corporate reorganization lacking a business purpose other than tax avoidance – there must be a valid business purpose for transferring assets from one company to another other than converting ordinary income into capital gain) E. STATUTORY FRAMEWORK a. The Mechanics: In order to have gains and losses, the TxP must determine whether he has “realized” gain or loss from the “sale or exchange” of a “capital asset.” It then must be determined whether the gain or loss realized must be “recognized.” The gain or loss is then computed by subtracted the adjusted basis from the amount realized. i. Definitions 1. Formula: Gain = AR-AB 2. Adjusted Basis: is the property’s basis (acquisition cost) plus other capitalized expenditures (i.e. amounts not deductible as current expenses) minus depreciation and other receipts chargeable to the capital account. 3. Amount Realized: the amount realized from the sale of a capital asset is the sum of money received on sale plus the FMV of any property received. ii. Noncorporate TxP’s: To arrive at the net gain or loss on capital transactions, the individual must do the following: 1. Segregate long-term and short-term transactions: Capital assets that a TxP sells or exchanges b/f he has held them for more than one yr are treated differently than “long-term” capital assets. 2. Net the amounts: After the transactions are segregated by term, the short-term capital gains and losses are netted to reach a net short-term capital gain (or loss). Same is done for long-term. The tax treatment then depends on these amounts: a. Net short-term capital gain exceeds net long-term capital loss: where this occurs, the excess short-term amount is treated as ordinary income. b. Net long-term capital gain exceeds net short-term capital loss: the excess long-term capital gain is treated as ordinary income. HYPO: p142 c. Both short-term and long-term gains: if both net amounts show gains, the combined amount is included in gross income. d. Net short-term capital loss exceeds net long-term capital gain: § 1211 allows up to $3k of the excess net capital loss be deducted against ordinary income. The excess must be carried over to future years. e. Net long-term capital loss exceeds net short-term capital gain: same as above. f. Both short-term and long-term losses: if both short-and long-term have net losses, the short-term loss is used first against the $3k ceiling. Excess amounts are carried over. iii. Corporate TxP’s: corporations determine their net capital gains and losses the same way as noncorporate TxP’s. 1. Net capital gains: under prior law, the excess of net long-term capital gains over net short-term capital losses was subject to an alternative tax of 28%. This aided only those corporations whose Federal Income Tax: Outline Philip Larson Page 24 tax rate on ordinary income exceeded 28%. Beginning in 1987, corporations get no preferential treatment on capital gains. 2. Net capital losses: § 1211(a) allows corporations to deduct capital losses only to offset capital gains. The amount which is not used to offset capital gains may be carried back three years and carried forward five years and offset against those years’ capital gains. Individual’s can carry forward forever. iv. § 1231: this section is a means of allowing capital gain treatment for noninventory business investment assets. § 1231 was enacted for the TxP who uses long-term “investment” property in his business. Therefore, to qualify , the property must be more akin to long-term investment than to short-term use as inventory or business property. In addition to this “investment” test, property must also not fall under other exclusions. Depreciable personal property does not qualify if it is “primarily for sale to customers in the ordinary course of business.” Same exclusion applies to real property. Inventory does not qualify under § 1231. It is difficult to assure whether an asset will qualify under § 1231. This has been largely left to judicial interpretation. v. Depreciation Recapture: Much of the property eligible for § 1231 treatment is also property that can be depreciated under § 167. Thus, a TxP could take ordinary depreciation deductions and then claim a capital gain upon disposition of the property. § 1245 and § 1250 were enacted to eliminate this practice, which has the effect of converting ordinary income into capital gain. These sections require TxP to report certain portions of § 1231 gain as ordinary income. 1. § 1245: requires that upon the sale of depreciable personal property, any gain realized is ordinary income to the extent of all depreciation deductions taken after 1963. HYPO: TxP buys machine for $20k, deducts $12k over 9 years, then sells for $23k. Gain realized is $15k. § 1245 requires that $12k be recognized as ordinary income. The remaining $3k is treated as capital gain. 2. § 1250: requires that “additional” depreciation claimed on buildings be recaptured. Any accelerated depreciation (above straight-line) must be recaptured and recognized as ordinary income when asset is sold. F. POLICY OF CAPITAL GAINS a. Introduction: increases in the value of capital assets are a part of income, just like wages, salaries, rents, interest, royalties, etc. The question is whether capital gains warrant special or privileged treatment relative to other elements of income. Here are some of the reasons Congress has given them favorable treatment. i. Bunching of Income: gains realized in one year that have accrued (been earned) over a period of years subject the TxP to unfairly high tax rates under the graduated income tax structure. ii. Inflation: In a period of inflation, capital gains are at least partly not real income to the extent that they merely reflect the rise in general prices. iii. Lock-in effect: Subjecting capital gains to a full tax induces investors to refrain from selling appreciated assets. This “lock-in” effect reduces liquidity and impairs the mobility of capital. iv. Investment deterrent: taxation of capital gains tends to deter investors’ willingness to bear the risks of investment. W/o a tax benefit to the investor, society must pay for risk-taking through the high price that would have to be paid for high-risk activities. v. Interest rates: when interest rates fluctuate, a portion of capital gain reflects a change in the rates at which income is capitalized, rather than reflecting true income. G. ANNUAL ACCOUNTING AND ITS CONSEQUENCES a. Annual not transactional accounting: Burnet v. Sanford & Brooks (tax system uses annual accounting, rather than transactional) – NOTE: for long term K’s, . b. Claim of Right Doctrine – if TxP receives money or property and claims he is entitled to it, and he is free to dispose of it, he is immediately taxable. The fact that he might have to give it back is disregarded. i. Judicial Awards: North American Oil Consolidated v. Burnet (money received in trial court judgment is income when received, notwithstanding the possibility of having to give it back on appeal. ) ii. Mistaken Claims United States v. Lewis (amounts received by mistake are taxable when received even though they may have to be repaid). § 1341 allows a deduction, if the amount is > $3k, when he gives it back. c. The Tax Benefit Doctrine: where a deduction in the prior yr is followed by a recovery of the item deducted, the recovery constitutes income to the TxP in the yr received. However, such recovery is taxable only if the previous deduction gave the TxP some tax benefit the prior yr. d. § 111: gross income does not include income attributable to recovery during the taxable yr of any amount deducted in any prior yr to the extent such amount did not reduce income subject to tax.” Federal Income Tax: Outline Philip Larson Page 25 INDEX Acquisition indebtedness .......................................................14 Adjusted Basis .................................................................16, 23 Adjusted gross income.......................3, 6, 7, 11, 13, 14, 15, 16 Amount Realized .................................................12, 17, 18, 23 Annuity ....................................................................................5 Exclusion Ratio ...................................................................5 Awards & Prizes ............................................................3, 4, 24 Bargain sales ..........................................................................15 Basis........... 3, 4, 5, 6, 10, 11, 12, 13, 15, 16, 17, 18, 19, 20, 23 Boot........................................................................................19 Business Expenses Capital assets......................................14, 15, 20, 21, 22, 23, 24 Capital expenditure ..................................................7, 8, 16, 17 Capital gain........ 2, 3, 4, 6, 7, 13, 15, 17, 18, 20, 21, 22, 23, 24 Casualty Losses................................................7, 13, 14, 16, 23 Ceiling Charitable Contributions (30%) ............................11, 14, 15 Charitable Contributions (50%) ..........................7, 9, 10, 14 Charitable contributions...........................4, 6, 7, 13, 14, 15, 20 Charitable Contributions ........................................................14 Child Care..............................................................................11 Claim of Right Doctrine.....................................................3, 24 Clothing Expenses .................................................................11 Commuting Expenses ........................................................9, 10 Cost Basis ..............................................................................17 Crane Rule .......................................................................13, 18 Deductions ......... 3, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 20, 24 Above-the-line ..............................................................6, 16 Below-the-line.............................................6, 11, 13, 14, 16 Trade or Business... 6, 7, 8, 9, 10, 11, 12, 14, 16, 17, 20, 21, 22, 23 Depreciation................. 7, 12, 13, 15, 16, 17, 18, 20, 22, 23, 24 Declining-Balance Method ...............................................12 Straight-Line Method ........................................................13 Depreciation Recapture..............................................13, 18, 24 Discharge of Indebtedness .......................................3, 4, 18, 22 Education Expenses ...................................................4, 6, 7, 11 Embezzling ..............................................................................4 Exchanges ................................................16, 17, 18, 19, 20, 23 Exclusions..........................................................3, 5, 18, 20, 24 Experimental costs ...................................................................8 Floor Casualty Losses (10%) ............................3, 7, 11, 14, 16, 23 Medical Expenses (7.5%)..............................................7, 15 Miscellaneous Itemized Deductions (2%).....6, 7, 13, 14, 16 Fringe Benefits.....................................................................3, 4 Gambling .................................................................3, 4, 13, 16 Gifts ............................................... 3, 4, 5, 6, 14, 15, 16, 17, 18 of Property ....................................................................6, 18 Hedging transaction.........................................................20, 21 Hobbies..............................................................................7, 10 Home equity indebtedness.....................................................14 Home Offices...............................................................7, 10, 11 Illegal Activities ..................................................................4, 9 Income Imputed ...........................................................................4, 5 Income splitting .......................................................................5 Inheritance ..................... 4, 6, 12, 13, 14, 16, 17, 19, 20, 21, 22 Interest ..................... 3, 5, 6, 7, 9, 10, 13, 14, 15, 19, 21, 22, 24 Home Mortgage Interest ...................................................14 Imputed .........................................................................3, 14 State & Local bonds................................ 3, 5, 13, 14, 19, 21 Legal Expenses ..............................................................7, 9, 11 Life & Medical Insurance........................................................5 Like-kind exchanges........................................................19, 20 Loan..................................................................... 3, 4, 5, 14, 18 Lobbying..................................................................................9 Long-term capital gains ...................................................15, 20 Losses ........ 2, 5, 6, 9, 10, 12, 13, 16, 17, 18, 19, 20, 21, 22, 23 Meals & Lodging................................................. 3, 4, 9, 10, 15 Medical Expenses ..................................................................15 Moving Expenses ......................................................4, 6, 7, 11 Noncapital assets .............................................................15, 20 Nonrecognition ..........................................................18, 19, 20 Nonrecourse debt.........................................................4, 17, 18 Personal service income ..........................................................6 Principal Residence .....................................................5, 19, 20 Production of Income Expenses ................................12, 14, 17 Punitive damages.................................................................3, 5 Quasi-capital assets....................................................20, 21, 22 Realization Doctrine .................................. 6, 12, 16, 17, 18, 20 Recognition Doctrine........................................... 12, 18, 19, 20 Recovery of Capital .................................................................5 Repair & Maintenance.............................................................8 Securities ...............................................................9, 10, 20, 21 Short-term capital gains......................... 4, 8, 19, 20, 21, 23, 24 Start-up costs ...........................................................................8 Tax Benefit Rule..........................................................4, 22, 24 Tracing...................................................................................14 Travel & Entertainment Expenses ...........................7, 9, 10, 11 Unadjusted Basis .............................................................16, 17 Vacation Homes ....................................................................11 Windfalls .................................................................................4