Tax Outline Prof. Billman Fall 2005
PART I: DEFINING GROSS INCOME .................................................................................................... 1 Unit I – Introduction to Tax Law. ............................................................................................ 1 Unit II – What is Income?: Fringe Benefits, Employee Compensation. .................... 1 Unit III. Swapped Services, Imputed Income, Gifts......................................................... 4 Unit IV – Basis Recovery, Realization, Annuities, Life Insurance .............................. 5 Unit V – Transactions for Borrowed Income, Illegal Income ........................................ 7 Unit VI – Tax Expenditures; Tax Exempt Bonds ............................................................... 9 PART II: D EDUCTIONS AND EXPENSES ............................................................................................ 10 Unit VII – Introduction; Business Deductions ................................................................. 10 Unit VIII – Deductions for Employee Business Expenses.......................................... 13 Unit IX – Timing; Depreciation and Amortization ........................................................... 16 Unit X – Deductions for Interest Expenses; Tax Arbitrage ......................................... 19 Unit XI – Allowable Personal Deductions.......................................................................... 21 PART III: INCOME FROM CAPITAL: COMPLEX ACQUISITIONS AND D ISPOSITIONS ........................ 24 Overview of Part III .................................................................................................................... 24 Unit XII – Gains and Losses: Debt-Based Acquisition and Disposition of Property ........................................................................................................................................ 24 Unit XIII – Recognition of Gains and Losses ................................................................... 27 Unit XIV – Capital Gains .......................................................................................................... 32 Unit XV – Tax Accounting ....................................................................................................... 38 PART I: DEFINING GROSS INCOME
Unit I – Introduction to Tax Law. 1) Goals of Tax. a) Money for Important Govt functions. b) Redistribute Wealth. 2) Shape of Tax System. Two components: (1) base and (2) rate. We deal with base in this course. Base of US system is income. 3) Income. Not defined in Code. Broad definition through case law and vague statutory construction in § 61. 4) Assessing Tax Structure a) Equity. US tax system reflects TPs’ “ability to pay.” Question is how fair the law treats TP in similar economic situations. Differences raise equity concerns. b) Efficiency. Taxes should not induce TPs to change their behavior. Questionable how well system achieves this. c) Complexity. Overall Code flunks this. But various provisions can be viewed through this lens. System is self-assessment, so simplicity is the goal. Unit II – What is Income?: Fringe Benefits, Employee Compensation. 1) Section 61. Gross Income Defined a) Statute. “gross income means all income from whatever source derived,” including compensation. b) Glenshaw Glass. Income is “undeniable accessions to wealth, clearly realized, over which the taxpayers have complete dominion.
Tax Outline Prof. Billman Fall 2005 2) Section 102(c). Employee Gifts. Gift given by ER to EE to or for benefit of EE is treated as income. 3) Section 262. General prohibition on deductions for food and other personal expenses. Too much room for abuse 4) Fringe Benefits and Employee Compensation a) Form. Compensation is whatever ERs pay for services. Form does not matter. Old Colony Trust. b) Benefit of Employer. EE costs that are primarily for benefit of ER are excluded from GI. Thus, one can take advantage of exclusion even if one does not fall into clear statutory language of Section 132. C puts high burden on TP to show spouse is there for business purposes (§ 274(m)(3) and Disney. Gotcher. c) § 132. Excludes Certain Fringe Benefits from GI i) No-additional-cost service defined. Any service provided by ER to EE for use by EE if (1) offered for sale to customers in (1) ordinary course of the line of business…and (2) ER incurs no substantial additional costs in providing such service to ER. See § 1-1.132. ii) Qualified EE discounts. Any EE discount w/ respect to qualified property or services to extent does not exceed (A) for property, gross profit percentage of price at which ER offers to customers, or (B) for services, 20 percent of price ER offers to customers. iii) Working condition fringe Prop or services provided to EE of ER such that if EE paid for it, it would be allowable as a deduction under 162 or 167. iv) De minimis fringe. (1) In general. Any property or service that has value (taking into account frequency with which similar fringes provided by EE to all ERs) so small as to make accounting for it unreasonable or administratively impossible. (2) Treatment of certain eating facilities. De min fringe if (A) located on or near business premises and (B) revenue from facility normally equals or exceeds direct operating costs. Special rules for highly-paid executives. v) Qualified transportation fringe defined. (1) in general. Includes (A) transportation on commuter highway if in connection with travel btwn EE’s resident and place of employement; (B) any transit pass; (C) qualified parking. (2) Limitation on exclusion. (3) Cash reimbursements. Cash reimbursement allowed. Allowed for transit pass only if a voucher or similar is not readily available. (4) No constructive receipt. Doesn’t matter if EE has a choice between fringe (which is excludible) and compensation (which is not). vi) (h) Certain individuals treated as EEs for purposes of subsections (a)(1) and (a)(2). vii) (j)(4) Special Rules; On-premises gyms and other athletic facilities. d) § 119 Meals or Lodging Furnished for Convenience of Employer. i) Excludable if… Meals are for convenience of employer and are furnished on business premises ii) Kowalski. Cash payment or reimbursement for meals not excludable, even if meals are eaten on premises and are for convenience of ER. Voucher with a lot of spending potential looks more like cash. 5) Section 83. Transfer of Property in Connection with Services (see handout). a) Real Property. Does not come under § 132(c) because it is real. § 132(c) only deals with ER discounts other than real property and stock.
Tax Outline Prof. Billman Fall 2005 b) Applicability. Section 83 applies to situations where, but for ER-EE relationship, EE would not have received discount on property. Issue is when to tax the actual income: today or when restrictions lapse? c) § 83 Default. Measure amount of ability to pay when restrictions on property lapse. This is consistent with Glenshaw Glass. Thus when restrictions lapse EE has compensation income. EE will have income from sale (LTCG or STCG) when property is sold. Basis in property is FMV of property received, including any extra cash paid for property. d) § 83(b) Election. EE can elect to include value of property immediately upon receipt of property, before restrictions lapse. Two risks: (1) property drops in value and/or (2) EE does not meet restrictions (no deduction given). Also, worry about capital gains: taking election sooner rather than later is compensation; waiting allows for LTCG treatment of additional increase in value. Basis in this case changes in terms of timing – basis before restrictions lapse is only amount paid for property, but increases once the restrictions lapse and the property becomes taxable income.
Tax Outline Prof. Billman Fall 2005 Unit III. Swapped Services, Imputed Income, Gifts 1) Section 262. Disallows personal deduction for “personal, living, or family expenses.” 2) Imputed Income a) Defined. Benefits derived from labor on one’s own behalf or benefits from ownership of property. Taxing would be too difficult and politically unfeasible. i) Inequality? Fact we don’t tax imputed income may lead to inequality. Compare a homeowner with no mortgage with renter. Homeowner has distinct advantage. Those who can afford houses get benefits non-homeowners don’t ii) Inefficient. Tax law affects price (labor, etc.) and causes us to see the decisionmaking process differently than if there were no tax law. 3) Barter Taxable. Service’s position is that barter is taxable. However it is very difficult to do for many reasons. Try and fit into fringe benefits such § 119 if there is an EE-ER relationship. 4) Section 102. Gifts and Inheritances. a) Not income. GI does not include the value of property received by gift. Value of gift is left in donor’s tax base. Other options are possible. b) Intra-family Support. Support provided by family members are not included in GI. c) Duberstein. Asset must be given with a “detached and disinterested generosity” to qualify for gift treatment. Based on facts and circumstances of any case. 5) Section 117. Qualified Scholarships. a) Exclusion. “Qualified scholarships” excluded from GI. QS defined particularly in (b) of statute. b) Effect of § 117. i) Many problems; see notes.
Tax Outline Prof. Billman Fall 2005 Unit IV – Basis Recovery, Realization, Annuities, Life Insurance 1) § 1001 Basis Recovery a) Gain. Income tax focuses on gain. “Gain” is excess of amount realized (AR) over basis (AB). b) Basis. Technical mechanism by which TPs are allowed to recover their capital investment when they sell property. Recovered in three ways: (1) immediate deduction; (2) capitalized and taken when sold; (3) depreciated over time. c) Determining Basis i) Bargain Purchase. Courts look at circumstances. If not a gift, then courts re-characterize it. If EE allowed to buy stock worth $100 for $80, the EE taxed on $20 and basis in stock is $100. ii) Exchange. Cost when property exchange is value of property received iii) Gifts, “Carry-over basis”. (1) Gain. Basis of property of computing gain in hands of done is same as basis in hands of donor. (2) Loss. Basis for loss is either donor’s basis or the FMV at time of transfer, whichever is lower. There is nothing if it falls between these two. iv) Future Losses. No portion of basis of property acquired subject to a favorable lease may be allocated to the lease, so if it is canceled it does not reduce basis. Hort, § 167(c)(2). 2) Realization Event a) Discrete Event. Code does not normally require listing unrealized appreciation in income. One does not include appreciation in income unless there is a discrete event such as a sale or exchange. We do this partly because there are concerns that TPs may have increased value but not increased ability to pay (liquidity problem). b) Lucky Cesarini. Cash found constitutes a realization event. In applying this case consider whether the value is (1) treasure trove (Cessarini) or (2) a marketplace bargain (not income until sold). i) Treasure Trove. Defined in regulation as not in realm of possible expectation. § 1.61-14. When something like treasure is found, it is taxed as realization event. Not taxed when sold. c) Haverly. Unsolicited goods received must be included in income when one exercises dominion over them and uses them as wealth. (Principal donated free books and tried to take deduction). Donation can trigger a realization event. d) Cottage Savings. Realization event occurs when there is a sale or other disposition of property that is materially different. Properties are different so long as their respective possessors enjoy legal entitlements that are different in kind or extent. 3) Timing. a) Early Deduction. Deduction given immediately is more valuable to TP. Timing of cost offset is almost as important as giving the offset itself. 4) Section 72 – Annuities. a) Defined. Situation where one person transfers money or other property and receives from transferee a promise to pay certain sums at intervals. b) Taxable amount. Income is any amount received above what annuitant paid for annuity. Could be taxed at the end or the same way a bank account it taxed. Code treats annuities favorably. c) § 72. Portion of each annuity payment is treated as recovery of investment and a portion is treated as taxable. Amount of payment excluded is determined by the exclusion ratio, which is calculated by taking the investment as numerator and expected return as denominator. See handout for example. i) Early Death. If TP dies before annuity pays-out, then under § 72(b), TP taxed on years that received income, year of death, and gets to deduct rest of investment (mortality loss). d) Deferred Annuities. Situation where TP purchases annuity and interest is paid at some point in future. Not taxable until TP receives payment from interest (§ 72(b)).
Tax Outline Prof. Billman Fall 2005 e) Amounts withdrawn before retirement. i) § 72(e). Treats cash withdrawal as return of capital, which is tax-free until TP’s entire investment is recovered. ii) § 72(q). Imposes penalty on amounts withdrawn before retirement. f) Efficiency. In non-tax world investor would be indifferent, but Code give special treatment. 5) Section 101 - Life Insurance. a) Excluded. GI does not include amounts received under life insurance contract, if they are paid as a result of death of insured.
Tax Outline Prof. Billman Fall 2005 Unit V – Transactions for Borrowed Income, Illegal Income 1) Loan Proceeds a) Not Taxable. Proceeds from loans are not taxable as income because an increase in a borrower’s assets is offset by an equivalent liability to repay. Tax law allows TP to have a balance sheet of zero. Basic issue: if something is a loan, then no income. If not a loan, then income. Cases turn on this issue. b) Form of Loan. Loans are identified by three factors: i) mutual understanding between borrower and lender of the ii) legal obligation to repay and iii) a bona fide intent on the borrower’s intent to repay acquired funds. 2) Illegal Income a) Taxable. TP has income when acquires money lawfully or unlawfully without consensual recognition, express or implied, of an obligation to repay that money. Collins. This grows out of expansive use of income under Glenshaw Glass. b) Illegality. Does not matter that income came from illegal activity. Sullivan. How a person spends monies obtained illegally is irrelevant to question of income. Does not violate 5th Amendment bc TP need not disclose where income came from (of course not telling exposes one to both tax and criminal liability). c) Illegal Monies Repaid. Restitution only results in a deduction. TP cannot combine illegal income event and deduction to get zero. § 165(c)(2) Rev. Rul 65-254; § 162(c), Stephens v. Comm. d) Line between Loan and Income. Sometimes this line is blurry. A few principles: i) One who steals money, but then later agrees to pay the money has income because they never intended to repay those funds (i.e. not a loan). Buff v. Comm. ii) However, court may find no income if there is evidence of a consensual recognition of obligation to repay despite absence of loan agreement. Gilbert v. Comm (pp. 176) 3) Discharge of Indebtedness a) Taxable Income. Discharge of indebtedness generally gives rise to income because such discharge eliminates the liability which originally gave the loan its non-income character. b) Code Provisions i) Section 61(a)(12). Includes in GI “[i]ncome from discharge of indebtedness.” ii) Section 108. Exception to § 61(a)(12). GI does not include amount of discharge of indebtedness resulting from: (1) (a)(1)(A). Title II bankruptcy (2) (a)(1)(B). Insolvency of TP. Insolvency is further limited to amount which TP is insovlent (§ 108(a)(3)) (3) Definitions (d)(1) – (3) (a) Indebtedness of TP. Means any indebtedness for which TP is liable or to which TP hold property (b) Title 11. Bankruptcy. TP must be under jurisdiction of Court and grant by court. (c) Insolvent. Means excess of liability over FMV of assets held. c) Permutations i) Disputed Debt. Under contested liability doctrine, if TP disputes amount of debt the subsequent settlement is treated as actual amount indebtedness, so no income. ii) Gambling Debts (1) Loan-as-Winnings. § 165(d) allows TP to deduct losses from gambling insofar the extent of winnings.
Tax Outline Prof. Billman Fall 2005 (2) Loan nonenforeceable. Gambling credit may not be enforceable so no discharge of indebtedness. 3rd Cir. Zarin (3) Bargain Purchase. Argue that money extended to Zarin and settled was simply bargain purchase of consumption (see below). 4) Purchase Price Reduction a) Section 108(e)(5). If seller of specific property reduces debt of the buyer arising out of purchase, reduction is treated by both parties as an adjustment of the purchase price. Similar to contested liability doctrine. b) Limits. This provision does not apply if i) Purchaser is insolvent; ii) Purchaser is object of bankruptcy iii) Seller transferred debt to a third party iv) purchaser transferred debt to a third party
Tax Outline Prof. Billman Fall 2005 Unit VI – Tax Expenditures; Tax Exempt Bonds 1) Tax Expenditures a) Definition. TEs are amount of money that the federal govt could receive as revenue through tax but chooses not to. Generally is some sort of special exclusion, exemption or deduction which provide a special credit, preferential tax rate, or a deferral of tax liability. Calculated by taking difference between tax liability under present law and tax liability that would result from recomputation of tax w/out benefit of TE provision 2) Section 103(a). Excludes State or local bonds from GI. Presented as example of a TE. 3) TE and Budget Outlays Are Economically Equal, but TEs Are Inefficient TP Bracket 40% 35% 28% 15% After Tax Rate Corp. Bond: 10% 6% 6.5% 7.2% 8.5% After Tax Rate Municipal Bond: 7.2% 7.2 7.2 7.2 7.2
MB attracts TP above this.
4) Policy Debate: Direct Budget Outlay v. TE i) Simplicity. (1) TE (a) Pretty simple way to provide benefit. C does not have to put outlay; no new administrative structure. (b) Service has to ensure compliance costs. (2) DBO (a) Transactions costs higher for DBO. Some agency has to do it (b) But compliance costs are lower than with TE; agency ensures compliance (c) ii) Equity. (1) TE (a) not open to people who don’t pay taxes. . (b) TE is more open to wealthy than poor because of brackets; have upside-down effect (Bittker). Good if we want people to invest in particular area; bad if we want to give basic needs to the poor. (2) DBO (a) Direct budget outlays are for everyone iii) Efficiency (1) TE (a) Not sure how much it will cost until people file returnes (b) Gives more discretion to TP (c) May alter the way people invest their money, for example with 103, pple are more likely to invest in state or municipal bonds to take advantage of TE. (2) DBO (a) Not sure how much money will be spent
Tax Outline Prof. Billman Fall 2005
PART II: D EDUCTIONS AND EXPENSES
Unit VII – Introduction; Business Deductions 1) Introduction. a) Purpose. Deductions necessary to measure income correctly. Must allow people to deduct cost of producing income. Difference between income and gross receipts. Deductions are same as exclusions economically, but TP may prefer exclusion rather than deduction bc there are limits on deductions. b) Where Deductions Fit-In. Deductions are different for corporations and citizens i) Corporation. Allowable deductions reduce GI to TI ii) Individuals. (1) Compute GI. See Part I. (2) AGI, Section 62. Subtract allowable deductions (above the line) from GI to reach AGI. (3) TI, Section 63(c). AGI reduced by subtracting larger of (a) standard deduction, or (b) “itemized deductions.” (i) Some itemized deductions fully allowable, others subject to floors (percent of AGI) (ii) “Misc itemized deductions” only allowed if they exceed 2% of AGI. § 67(a). (4) Credits. Dollar of credit saves dollar of tax (rather than fraction of amount provided by deduction). Subtract from TI. c) Three Types of Spending. i) Trade or business enterprise – deductible costs ii) Income producing activity – maybe deduct iii) Personal consumption – non-deductible if “inherently personal in nature” (Trebilcock v. Comm) 2) Business Expenses a) Section 212. i) Non-“Trade or Business,” Income-Producing Activities. Permits individuals to deduct “ordinary and necessary expenses” from income-producing activities that do not qualify as “trade or business.” ii) Differences from § 162. (1) Itemized Deduction. Applies only to individuals and is only deduction from AGI to obtain TI. TP must have itemized deductions exceeding standard deduction to take advantage. (2) 2% of AGI Floor. Are miscellaneous deductions and subject to 2% floor. b) Section 162. i) Generally. (1) § 162(a). Allows deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.” (2) Scope. This includes reasonable (1) salaries; (2) traveling expenses, and (3) rentals or payments for continued possession or of trade or business. Also included are management expenses, commission, labor, supplies, incidental repairs, operating expenses of automobiles, advertising and selling costs (i.e. parties), and insurance premiums against fire, theft, etc,. § 1-162-1. (3) Relation to § 165. § 165 (a) and (c) permit deductions for losses incurred in a “trade or business” or in a “profit-seeking activity.” Can become blurred with § 162.
Tax Outline Prof. Billman Fall 2005 ii) Section 162 Requirements (1) “Trade or Business” (a) Active Pursuit of Business Activity. TP engages in a trade or business if involved in activity with “continuity and regularity” and with primary purpose of earning income or profit. More than a “but for” test. Comm v. Groetzinger (b) Question is whether TP reasonably anticipated availing themselves of the privileges they possessed on paper. Levin v. Comm. (2) § 162(a): “Ordinary and Necessary.” (a) Definition of Terms (i) “Necessary” means any payments which are appropriate and helpful in developing a business. Not very high bar. Welch (ii) “Ordinary” means those situations which are common to the “life of the group, the community” of which the person is a part. Can be once-in-a-lifetime-even. Look to the nature and scope of the particular business.” Welch, Gilliam (b) Examples and Applications (i) Reputational costs must be capitalized; can only be deducted when company is disposed of. Welch (ii) Not “ordinary” for a corporate officer to make personal payments in order to increase reputation of company. Welch (iii) Legal fees for criminal defense not “ordinary” part of being an artist. Gilliam (iv) Legal fees associated with car accident that occurred during a business trip are “ordinary,” even through TP found negligent. Dancer (v) Legal fees incurred in splitting up business during divorce are not “ordinary.” Gilmore (3) Public Policy Exception (a) Even if business expenses are in a trade or business and ordinary and necessary, a court may disallow deduction for public reasons. Such policy reasons much be “national or state policies evidenced by some governmental declaration of them.” Tellier (b) Court has ignored public policy and allowed deduction for costs associated with criminal defense fees (even if one is found guilty). Tellier (c) Court has disallowed deductions where doing otherwise would have “directly and substantially diluted the actual punishment imposed.” iii) Section 162 Details (1) § 162(a): Deduction for Employee Salaries. (a) Reasonable Compensation. (i) Code Test: For deductibility of compensation payments is whether they are (1) reasonable and (2) payments purely for services. § 1.162-7. (ii) Repayment. May be evidence that compensation is unreasonable if EE repays it. Charles Schneider. (b) Salary-as-Dividend Problem. (i) Dividends Taxed Twice. Payor is denied deduction (i.e. it is unreasonable) and recipient must include amount in income. Corporations get deductions for EE salaries, but not dividends, so what payment to EE to be salary. 1. Regs. Excessive payments close to stockholdings which are found to be distribution of earnings or profits treated as dividend (non-deductible). § 1.162-8. 2. Absence of dividends. Sometimes per se evidence of corp disguising dividends through salary. McCandless.
Tax Outline Prof. Billman Fall 2005 (ii) Different Tests: 1. Independent Investor Test: Consider whether co’s earnings on equity, overall performance and compensation levels are at a level that would satisfy an independent investor. 2. Multiple Factor Test: Focus on (1) type and extent of service rendered; (2) scarcity of qualified employees; (3) qualifications and prior earnying capacity of EE; (4) contribution of EE to business venture; (5) net earning of EE; (6) pay to EEs with comparable jobs; (7) peculiar characterists. Exacto Spring (Posner thinks this is silly) 3. Indirect Market Test: Think of corporate relationship as K situation. Corp pays manager to manage business. Thus, higher rate of return, the greater salary for the manager. Harder to not justify high salary in this situation. Exacto Spring. (iii) Criticism. Body of law sets-up courts as “superpersonnel” department. Service has not won a lot of these cases. Tough area of the law to fashion substance. (c) Girts-as-Payment (i) Incentive to make a “gift” of salary. Overcompensates EE in lower tax bracket. Putting a family member on corp payroll may permit TP to make support payments out of pre-tax income. (2) § 162(c): Illegal bribes, Kickbacks and Other Payments. (a) Not generally included in deduction. Linked to state and federal laws. Also deal with Medicare, Medicaid and Social Security. (3) § 162(e): Lobbying. (a) Deductible only if directly related to producing income in trade or business (b) Can deduct only cost of lobbying local officials, not C. Can lobby through newpaper ads, institutional advertising, as long as no mention of specific legislation. (4) § 162(f): Fines and Penalties. (a) Govt No deduction. No deduction for fines or penalty paid to government for violation of law. (b) Private Party Deduction. Fines paid to third parties for violations of law or private agreements are deductible, unless they are more like a fine (i.e. they are punitive, as in restitution from theft or fine). (5) § 162(g): Treble damage payment under antitrust laws (a) No deduction allowed for two-thirds of damages paid as a result of anti-trust suit. (6) § 162(m): Excessive employee remuneration (a) Code Provisions (i) General Rule. For public corporation, no deduction for salary paid to “covered employee” which exceeds $1m. (ii) “Covered EE.” Means (1) CEO (or acting CEO) or. (2) an EE whose compensation is reported to shareholders because she is among 4 highest compensated officers. (iii) Exception for Commission. If pay is tied to individual performance, then that amount is deductible. (iv) Performance-Based Compensation. Deduction includes performance-based compensation if (1) there is a comp committee; (2) materials terms are disclosed to shareholders and approved, and (3) the compensation committee certifies payment before it is made. This is a huge loophole and corps are adept at getting around it.
Tax Outline Prof. Billman Fall 2005 Unit VIII – Deductions for Employee Business Expenses 1) Overview a) Where this Fits In. Continues study of §§ 162 and 212. Deals with employee who incurs deductible business expenses. Three types of benefits: i) Fringe (Excluded from GI). ER pays for something, ii) Deducted Above the Line. EE pays and is reimbursed. iii) Deducted Below the Line. EE pays w/out reimbursement (may have increase in salary to cover this) b) Relation to Fringe Benefits (§ 132). Situation here is very similar to discussion about fringe benefits. There question was whether something paid by the firm was covered by fringe benefits. Note that § 132(d) expressly defines “working condition fringe” as any property or services provided to EE by ER such that if EE paid for it, it would be allowed deduction under § 162. c) Statutory Framework. i) Deductible Employee Expenses. First EE must determine whether deduction allowed (1) Section 162. Expenses are “ordinary and necessary” in carrying on a “trade or business.” (2) Personal/Family v. Business/Investment. Issue is often whether expenses are personal and thus non-deductible under § 262, which generally disallows deduction for “personal, family or living expenses” (see below) ii) Above the Line or Itemized Deductions. Second step is to determine type of deduction. Hinges on whether EE is reimbursed. (1) Above Line. Means deductible from AGI. (a) Reimbursed expenses are deductible above the line. TP can take deduction and standard deduction (§ 62(a)(2)(A)). (b) Substantiation. EE must provide substantiation. (c) Limit. Cannot be reimbursed for more than deductible expense. § 62(c). (d) Special Exceptions. (i) Performing Artists. EE business expenses deductible in computing AGI. § 62(a)(2)(B). (ii) Military. Above line deduction for certain military costs. (iii) Self-Employed “Ind. Contractor.” Deduct all business expenses above line. 62(a)(1). (2) Itemized Deductions (Below the Line). All unreimbursed expenss are deductible only if EE itemizes and meet 2% floor. Additionally, § 68 reduces deduction by 3% excess of AGI greater than $100k. (a) Misc. Deductions. Include only itemized deductions. Subject to 2% floor (very tough to beat). Eliminates bookkeeping. § 67(a)-(b). (b) Non-Misc. Deductions. Not subject to 2% floor, but only for wealthy. Examples are interest, medical expenses, annuity losses, charity, gambling losses, casualty losses. 2) Personal or Family Expenses v. Business or Deductible Expenses a) Generally. Need to draw line between business expenses and personal expenses. This done through code, precedent, and various tests for certain areas. b) Inherently Personal Standard i) Expenditures that are “inherently personal in nature” are non-deductible. Trebilcock.
Tax Outline Prof. Billman Fall 2005 c) Benefit of ER. i) EE generally does not have to report expenses that are solely for benefit of ER for which EE receives reimbursement. §162-17(b). d) Clothing i) Everyday Use. Clothing purchased by EE for work, but which is suitable for everyday usage, is not deductible as a business expense. Pevsner ii) Uniforms. Deduction for uniforms allowed if (1) they are specially required as condition of employment and (2) not adequate for general wear. Rev. Rul. 70-474. e) Public Employee Exception i) Limited exception for public employees, as long as the position entails “a definite work assignment” and not “a tax dodge.” Frank. f) Child Care i) Inherently Personal. Decision to have a child is “inherently personal” and thus costs to support that child are non-deductible. Smith v. Comm. ii) Section 21. (1) C’s Middle Road. Tax credit for qualifying child care expenses: (a) TPs with AGI of $15k or less may offset tax liability by 35 percent of employmentrelated dependent care expenses. (b) Percentage is reduced one percentage point for each additional $2k AGI until it reaches 20 percent for TPs with incomes above $43k. (2) Assement. (a) TE for those who works 10 hr/wk and pays for childcare for 40. (b) Tax penalty for anyone who needs child care for all hours worked. iii) Section 129. (1) Permits EE to exclude up to $5k in any taxable year in dependent care costs covered by or provided by the employer.
g) Travel Expenses i) Business Travel. (1) Deductible. Travel expenses generally deductible when trip is “undertaken for” business purposes. § 1.162-2(b)(1) (2) Mix Business with Pleasure. When there is a mix of business and pleasure, it is a factual inquiry under 1.162-2(b)(2). ii) Commuting. (1) Non-deductible. (a) Commuting from home to work and back nondeductible because decision to live beyond walking distance is a personal one. § 1.162-2(e), Flowers. (b) Decision to reside where commuting is more expensive is personal decision and nondeductible. McCabe (2) Exceptions (a) Begin Job on Road. Commuting is deductible if one begins their jobs during the commute (e.g., officer in patrol car) Pollei. (b) Temp Employment. Can deduct daily transportation expenses incurred in going btwn TP’s residence and temporary work location (if that work location is different than normal). Rev. Rul. 99-7. (c) Safety. Can deduct ER-paid transportation if traveling via public transportation at the time is unreasonably unsafe. Valued at $1.50 (regardless of actual value). h) Food and Lodging Away from Home. i) § 162(a)(2). Allows deductions for travel expenses incurred “while away from home in the pursuit of a trade or business.” (1) Unreimbursed. Misc. itemized deduction, subject to 2% floor (2) Reimbursed. Deductible from GI under § 62(a)(2)(A), not subject to 2% floor.
Tax Outline Prof. Billman Fall 2005 ii) Overnight Rule. Deduction for food and lodging allowed only if TP is away from home and stays overnight. Correll. Allows TP to deduct duplicative costs. iii) Flowers Test. Lodging expenses deductible only if (1) Reasonable and necessary, (2) Incurred away from home, and (3) Necessitated by exigencies of business. iv) Exigency of Business. Only TP who lives in one place, works in another and has business ties to both is in the situation that the temporary employment doctrine is designed to resolve. Flowers. v) Home. Home for purposes of § 162(a)(2) is TP’s regular or principal place of business. If no principal place of business, then “tax home” is regular place of abode. i) Entertainment and Business Meals. i) Sutter Test. Business meals deductible if they are in excess of what firms normally would spend. Daily meals are an inherently personal expense, and a taxpayer bears a heavy burden in proving they are routinely deductible. ii) Section 274 Test. Can deduct cost of business meals if (1) TP has more than general expectation of deriving income or a specific business benefit (2) TP engaged in business discussions during or directly before or after the meal or entertainment (3) Principal reason for the expense was active conduct of TP’s business. iii) Section 274 Limitation Even if Sutter is met, there are limitations: (1) 50 percent. Only 50 percent of meal is deductible. § 274(n) (2) Substantiation Required. § 274(d). (3) Business Premises. Cannot apply to food and beverages served on business premises. § 274(e) (4) Lavish. Business meals cannot be lavish. § 274(k) iv) Other Employees at Lunch. Employers have choice how to deal with other EEs at the lunch. Can be either compensation or reimbursement under § 274(e)(3). If ER treats its as reimbursement, then all §§ 162 and 274 limitations apply to the employer rather than the EE. Education and Professional Expenses i) Education expenses are deductible if they “maintain or improve skills required” for a trade or meet the requirements of a current ER. § 1.162-5. ii) Deductions for a wide-range of expenses incurred in the pursuit of a profession are deductible. § 1.162-6.
j)
k) Home Office i) Principal Place of Business. Home office qualifies as principal place of business in the TP uses the office to conduct administrative or management activities and there is no other fixed location of the business where the TP conducts substantial administrative or management activities. Section 280A. ii) Examples (1) TP can deduct expenses of home office if it is used by patients, clients or customers in meeting with the TP. Solimon, § 280A. (2) Telephone calls from clients are not enough to deduct expenses. Green v. Comm. (3) If TP is an EE, then the home office must be provided for convenience of ER.
Tax Outline Prof. Billman Fall 2005 Unit IX – Timing; Depreciation and Amortization 1) Background a) Income. Tax is focused on income, not just receipts. Tax does this by separating basis from income. Units XII and XIII did this through deductions. This unit focuses on deductions on assets that must be capitalized (i.e. included in business records as assets rather than expenses) or depreciated over time. b) Caselaw and Regs. Line is drawn by an intersection of common law and the regs. Focus on intricacy of the Code and Regs. c) Timing. Huge issue in deductions. Better for deduction to TP earlier (unless there is no income to benefit from deduction) Deductions can be done in three ways (unit IX focuses on (ii) and (iii): i) deducted when paid (expensed); ii) deducted over time as they produce income (capitalized and depreciated), or; iii) accounted for when asset is sold (capitalized and not depreciated). 2) What Must Be Capitalized. a) Guiding Principles i) Generally. TP must capitalize purchased assets such as: (1) Financial assets: Stock, bonds, real estate, tangible personal property (machinery and equipment). (2) Intangible assets: Contracts, patents. Cost of issuing stock or reorganizing. Cost on entering new trade or business (3) Tangible assets: Construction costs, improvements ii) “Separate and Distinct Asset.” Required to capitalize expenditures to create a “separate and distinct asset.” IDOPCO. Defined in § 1.263(a)-4(b)(3) (see below) iii) Future Benefits, 1-Year Guidepost. Often must capitalize future benefits that go beyond the taxable year. Automatic deduction if use is less than a year. An exception to this rule is advertising. INDOPCO suggests that most benefits beyond a year will be capitalized (Service as avoided broad approach to the case thgough). b) Statutes i) Section 263(a). Denies deduction (i.e. § 162) for payments for (1) new buildings, permanent improvements, or betterments made to increase value of any property or estate, or (2) a restoring property or in making good exhaustion thereof for which an allowance has been made. ii) Section 263A (1) Direct and Indirect Costs. Costs such as direct costs and indirect costs (such as taxes) of inventory and “any other property” are capitalized. 263A(a)(1)(B), 263A (a)(2). (2) Created Property. Real or tangible property “produced” (term of art) by TP is capitalized. 263A(b). (3) Personal Use Property Exception. Section does NOT apply to property produced by TP but which is not used in a “trade or business” or to produce income. (4) “Produced” Defined. Includes construct, build, install, manufacture, develop or improve. c) Regulations i) Intangibles (§1.263(a)-4(b)(1)). Must capitalize amounts paid to: (1) Acquire intangible assets. Intangible assets include: (a) Ownership interest in corporation, partnership, trust, estate, limited liability company or other entity. §1.263(a)-4(c)(1)(i); (c)(4)(Ex. 4). (b) Computer software. §1.263(a)-4(c)(1)(xiv). (c) Debt instruments (c)(1)(ii). (d) Financial instruments (future contract, foreign currency K) (c)(1)(iii). (e) Endowment contract (c)(1)(iv). (f) Lease (c)(1)(vi).
Tax Outline Prof. Billman Fall 2005 (g) Patent or copyright (c)(1)(vii). (2) Create an intangible. Determination is based on all of the facts and circumstance, disregarding distinctions between the labels used to describe the intangible and the labels used by the TP and other parties. §1.263(a)-(4)(d). (3) Create or enhance a “separate and distinct” asset (INDOPCO). (a) Defined in §1.263(a)-(4)(b)(3) as “property of ascertainable and measurable value in money’s worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged…separate and apart from a trade or business.” (4) Create or enhance a future benefit. (Rev. Rul. 2001-4) (a) Deductible Expenses. Repair and maintenance expenses are incurred for the purpose of keeping property in a repair when the property is returned to the uses for which it was acquired. Illinois Merchant Trust. (b) Capitalized Expenses. Must capitalize replacements, alterations, improvements, or additions that appreciably prolong the life of the property, materially increase its value, or make it adaptable to a different use. Ill. Mech. Trust. (c) Rehabilitation Plan. Expenditures that are part of a “general plan of rehabilitation, modernization, and improvement of property” must be capitalized. US v. Wehril. (5) Facilitate acquisition or creation of intangible. Capitalized costs include: (a) Amounts paid in the process of investigating or otherwise pursuing a “transaction” (term of art) §1.263(a)-4(e)(1)(i). (b) “Transaction” means factual elements comprising an acquisition or creation of an intangible. Includes a series of steps. §1.263(a)-4(e)(3). (c) Exceptions (i) Overhead and de minimis costs (less than $5k) need not be capitalized. §1.263(a)-4(e)(4)(i) (ii) In-house Employee compensation paid to EE by TP need not be capitalized. §1.263(a)-4(e)(4)(ii)(A). 1. “EE compensation” encompasses (1) annual comp; (2) regular meetings 2. “EE comp” does not included (1) special meetings; (2) someone who is not EE of TP. §1.263(a)-4(e)(4)(ii)(B). (iii) Example: Bank does not need to capitalize cost of salaries paid to EEs in loan acquisition dept. (Ex. 8). ii) Exception to §1.263(a)-4. (1) 12-month Rule. TP not required to capitalize amounts paid to create or facilitate creation of any right or benefit for TP that does not extend beyond 12 months. §1.263(a)4(f)(1)(i). d) Application to Specific Situations i) Corporate Reorganizations and Takeovers (1) Regulations require capitalization of certain expenses to facilitate takeovers and reorganizations. (2) “Inherently facilitative” costs must be capitalized. Other costs must be capitalized only if they occur after a bright-line date such as an agreement between acquirer and the target or board authorization. ii) New Business Expenses v. Ongoing Business Expenses (1) New Business. Expenses for entering new business must be capitalized (a) Pre-Opening Costs. Pre-opening costs are part of cost of acquiring a capital asset and must be capitalized. Sorrell. (b) Start-Up Expenses. TP can deduct up to $5k of start-up costs. § 195. Phased out if expenses > $15k. (2) Maintain Business. Expenses for maintaining need not be capitalized. (a) Cases turn on interpretation of Lincoln Savings, which seemed to require the existence of a new asset for capitalization. But this holding was overruled by INDOPCO.
Tax Outline Prof. Billman Fall 2005 iii) Nonrecurring Expenses. (1) Nonrecurring expenses are more likely to be capitalized. Encyc. Britannicca v. Comm. Makes sense – not “ordinary” business expenses. iv) Author’s Expenses. (1) Writes, photographers, and artists are allowed to deduct in the year paid or incurred expenses of creating literary property. Hadley v. Comm., §263A(h). (2) Must be expenses incurred by an individual in the “trade or business” of being an artist, writer or photographer to qualify. Defined narrowly. 3) Methods of Recovery of Capital Expenditures (see Handout in Unit IX) a) Section 167. i) Deduction. Allows deduction for “reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence”). of property used in a trade or business or property held for production of income. ii) Basis. For depreciation, basis includes TP’s basis, §1011, adjusted for any capital expenditures added under § 1016. Basis is reduced by periodic deductions. b) Section 179. Special Property Recovery i) Currently $100k deduction (although there is a dollar limit). ii) Treated as current expense deduction and is not chargeable to capital account. iii) Applies to intangible property such as computer software (pp. 199). c) Section 168. Method of Depreciation Allowed in § 167. i) Formula §168(a). Need to know three things: (1) depreciation method (2) recovery period (3) convention. ii) Depreciation Method §168(b). (1) Generally. (a) 200% DDB (DDB = 2 times rate of recovery for class life. Use reciprocal of class life times adjusted basis), (b) Switch to straightline method for first taxable year for which straightline allows greater allowance. § 168(b)(1). (2) Straightline. Use only straightline for (1) nonresidential real property; (2) residential rental property; (3) RR grading or tunnel; (4) election? §168(b)(3). (3) Salvage Value. Treated as zero. § 168(b)(4). iii) Recovery Period §§ 168(c) and (e) (tables, pp. 166). (1) Class life. Determined by § 168(e). (2) Use class life to determine applicable recovery period. § 168(c) iv) Convention § 168(d). (1) Half-year convention is generally used for property put into service during the year. (2) means that “all property placed in service during any taxable year (or disposed of during any taxable year)” is considered placed in service at the mid-point of the year. § 168(d)(4)(A). (3) Be sure to account for this in both DDB and straightline. d) Amortization of Goodwill and Other Intangibles § 197 i) Most intangibles, such as goodwill, are amortized on a straightline basis over 15-yr. period. ii) Applies to going concern value, workforce in place, information base, know how, etc. Rough justice.
Tax Outline Prof. Billman Fall 2005 Unit X – Deductions for Interest Expenses; Tax Arbitrage 1) Background a) Controversial. Deduction for interest is controversial. Currently hinges on purpose of debt, which is hard to track (see Regs). b) Purpose. Whether interest is deductible turns on the purpose of the indebtedness (see below) c) Tax Arbitrage. Because of interest deduction, the interest deduction increases ability of TPs to make money off tax system by doing non-economic pre-tax transactions that after tax become economic transactions 2) Rules a) Generally. Deduction allowed on all interest paid or accrued within taxable year on indebtedness. § 163a. The provisions following § 163(a) create exceptions and variations to this general role, depending on how indebtedness is used. b) Business and Investment Interest. i) Business Interest. Interest on interest used to operate a trade or business is a cost to the TP of doing business and thus is deductible like any other business expense (except unless capitalized). Generally no limit on deduction. § 163(a), § 163(h)(2)(A). ii) Investment Interest. (1) Interest on debt incurred for investment property is limited to net “investment income” (defined as total investment income less investment expenses) In other words, cannot deduct against ordinary income. § 163(d)(3)(A) and § 163(d)(4)). (2) Deduction has an indefinite carryforward of interest disallowed for following TY. (3) Defined interest connected to “production of income.” § 163(d)(4)(C0) iii) What Counts? Management of one’s own securities typically is not a business. Yaeger. c) Personal Interest. i) Controversial. Some argue that credit-card debt should be deductible to create parity between those who have money and those who must purchase with debt. ii) Not Deductible. Personal nonbusiness interest generally is not deductible. § 163(h). “Personal interest” defined by omission, does not include: (1) interest paid or incurred in connection with a trade or business § 163(h)(2)(A). (2) investment interest (§163(h(2)(B); (3) interest deductible in connection with a passive activity (4) (d) “qualified residence interest” (defined in § 163(h)(3) (see below)), and (5) (e) interest on certain deferred estate tax payments. § 163(h)(1). d) Home Mortgage Interest i) Generally. Code allows for deduction for interest on acquisition indebtedness and home equity indebtedness for “qualified residences.” § 163(h)(3)(A)(i)-(ii). ii) Qualified Residence. Defined as the principal residence of TP and 1 other residence of the TP which is selected by TP for purposes of the section. § 163(h)(4) iii) Acquisition indebtedness. (1) Defined. Indebtedness incurred in “acquiring, constructiong, or substantially improving” a qualified residence and is “secured by such residence.” § 163(h)(3)(B)(i)(I)-(II) (2) Limitation. Aggregate amount cannot exceed $1m (500 k for married individual filing separately). § 163(h)(3)(B)(ii). iv) Home Equity Indebtedness (1) Defined. Any indebtedness other than acquisition secured by qualified residence to extent amount does not exceed FMV of property and amount of acquisition indebt. § 163(h)(3)(C)(i)(I)-(II). (2) Limitation. Cannot exceed $100k.
Tax Outline Prof. Billman Fall 2005 e) Education Loans (see pp. 346 and § 221) 3) Tracing (Regulations) a) Hard to Know. Difficult to know what debt money is used on: TPs often borrow to keep an asset and acquire another. Book is skeptical of provisions, but regulations attempt to do impossible. b) Regulations (Very Detailed) i) § 1.163-8T(a)(1). Provides rules for tracing costs to the non-business interest limitations in §§ 163(d) and (h). ii) Generally. Interest expense on a debt is same as the debt. Debt is allocated by “tracing disbursements of the debt proceeds to specific expenditures.” §1.163-8T(a)(3). iii) Trade or Business. Interest expense for trade or business taken into account under § 163(h)(2) (defining personal asset as not including this.) § 1.163-8T(a)(4)(i)(A). iv) Tracing Rules (1) Use of Proceeds. Debt allocated to expenditures with the use of the proceeds and interest expense accruing on a debt is allocated in the same manner as the debt. §1.163-8T(c)(1). (2) Allocation Period. Debt allocated as expenditure for period beginning on date proceeds of debt are used or treated as used. § 163-8T(c)(2)(i). Ends when debt repaid or reallocated. (3) Allocation of Interest. Interest is allocated the same as the debt for the period. § 1638T(c)(2)(ii)(A). (4) Third-Party Financing. If lender disburses to a third-party instead of the borrower, debt is treated as if borrower used an amount of the debt proceeds equal to disbursement for the expenditure. § 163-8T(c)(3). (5) Debt Proceeds Put Into a Bank Account (Code, pp. 1002) (a) Generally. Debt put into an account is treated as investment expenditure (see above) and amounts held in an account are property held for investment. Once debt it is used, it must be reallocated. § 163-8T(c)(4)(i). (b) Expenditures from Account (General Ordering). Mixed funds. Debt proceeds in an account treated as expended before any unborrowed amounts in the account when money is deposited and any amounts deposited (borrowed or not) after such debt proceeds are deposited. § 163-8T(c)(4)(ii)(A)-(B). (c) Supplemental Ordering. Provides special rules for checks and such.
4) Tax Arbitrage (see specific problems in Unit X) a) Defined. Problems that arises when assets eligible for favored tax rate are acquired with debt. (See old outline for example). Interest-disallowance provisions permit wealth TPS to obtain relatively greater benefits from tax-favored assets because they can acquire tax-favored by liquidating their existing assets. b) § 265(a)(2). Bars tax arbitrage by disallowing interest deductions on borrowing to purchase or carry tax-exempt bonds. c) Solutions? i) Eliminate preferential treatment for interest on state and municipal bonds (§ 103) d) Sham. Courts are wary of tax arbitrage and will strike it down even if it is not in the regulations. Knetsch i) Be wary. Of situations where TP enters into transaction that, absent tax consequences, would not generate income. Also situations where there is a loan, but no money is changing hands.
Tax Outline Prof. Billman Fall 2005 Unit XI – Allowable Personal Deductions 1) Background a) Purpose. Some TPs do not have enough income to merit being taxed. Standard deduction, personal exemption, and earned income credit are all ways to deal with this reality. b) Tax Formula: Where This Fits In i) AGI = GI – Above the Line Deductions (i.e. § 162, above) ii) TI = AGI – (Greater of S/D or Itemized Deductions) + any personal exemptions § 151) c) Marriage Defined. § 7703. 2) Types of Personal Deductions a) Standard Deduction i) Generally. Flat amount indexed by inflation that may be taken regardless of whether TP actually has expenditures. Standardized deduction is used unless TP elects to itemize deductions. SD is used to calculate AGI. § 63(b). ii) Purpose. Believed to allow simplicity and set a floor for taxable income (once called “zero bracket amount.” iii) Calculation. Amount of allowed SD depends on variations in marital status. Computed by looking at “basic standard deduction” and “additional standard deduction.” § 63(c). $6k on joint return; $4,400 for head of household; and $3k for unmarried individuals and married individuals filing separately. § 63(c)(2)(A) Additional amounts for people over 65 and the blind. § 63(c)(3). iv) Marriage Penalty. See Handout. Recognize the SD creates both marriage penalties and bonuses. C has dealt with the penalty in §§ 1(f)(8) and 1(f). b) Itemized Deductions i) Election. No itemized deductions unless TP elects to do so. § 63(e)(1). ii) Limits. (1) If TP has AGI in excess of 100k (or 50k if married filing jointly), the amount of the deduction is reduced by lesser of (1) 3% of AGI over 100k, or (2) 80 percent of the amount of itemized deductions otherwise allowable for the TY. § 68(a)(1)-(2). (2) Exception to Limit. Itemized deductions do not include medical deductions (§ 213), investment interest (§163, above) or casualty loss or theft (§ 165(c), below). iii) General Itemized Deductions (1) EE Business Expenses (§ 212, above) (2) State and local taxes (didn’t cover) (3) Medical and Charitable Deductions (See below) c) Personal Exemptions. i) Generally. Each TP gets deduction of $2k, adjusted for inflation phased out as income increases. Joint filers are entitled to two exemptions; married filing separately get only one § 151(a)(b) ii) Dependants. (1) Additional exemption. TPs get exemption for dependant. § 151(c). Section § 152 defines dependant as including children, grandchildren, parents, other relatives, and unrelated members of TP’s household who TP supports. § 152(b). Parent cannot claim exemption for child if more than half of support comes from public assistance. (2) § 24. Entitles TP a $1k credit for each qualifying child who is under age 17. Phased out for single TPs whose AGI exceeds $75k. d) Earned Income Tax Credit i) Generally. Credit to low-income individuals who have earnings. § 32. Credit is refundable; increase for TPs with children. Phased-out for certain income amounts. ii) Purpose. Supposed to lessen burden of SS tax on poor. Now used to remove people with poverty-level income from tax and provide subsidy to low-wage workers.
Tax Outline Prof. Billman Fall 2005 3) Specific Personal Itemized Deductions a) Charitable Contributions i) Generally. Deduction allowed for contribution to charity made during TY by an individual or corp of cash or FMV of property (but not services or time, consider Haverly). Not subject to 2 percent floor in § 67, but is subject to cap in section 68. § 170(a)(1). ii) Two parts needed for deduction: (1) right kind of gift; (2) right kind of organization. (1) Charitable Contribution (Type of Gift). Charitable contribution is usually limited to the excess of the amount transferred to the charity over the value of any benefit received by the donor. Service is more skeptical when donors receive tangible benefits in return for their donations (like the Scientologists) Hernandez. Also an application of the “detached and disinterested generosity” principle found in Duberstein. (2) Charity (Type of Organization). Has to be charity organized and operated exclusively for charitable purposes. No part of net earnings can benefit any private individual and can’t lobby. § 170(c). iii) Deduction Limits. Individuals can’t deduct more than 50 percent of AGI for certain organizations. § 170(b)(1)(A). Organizations include (1) church; (2) educational organization; (3) non-profit 501(a); (4) govt unit; (5) certain private foundations and (6) 509(a)(2) organization. Corporation can deduction only up to 10% of TI § 170(b)(2). iv) Special Rules (1) College Sporting Events. Special treatment in §§ 274(l) and 170(l). Allow deduction of 80 percent whenever a contribution makes donor eligible for athletic tix. (2) Schools and Nursing Homes. Voluntary transfer by parent to school is deductible when it was made with no expectation of obtaining a commensurate benefit, enrollment was not contingent on the payment, and that payment was not made pursuant to any plan. Rev. Rul. 83-104. v) Policy Concerns (1) Deduction is inappropriate because charitable giving is a form of consumption. From this view charitable giving deductions are a huge TE. (2) Not clear whether the deductions actually hinder or increase charitable giving. Obviously the charitable organizations think it is helpful.f b) Medical Expenses i) Background. Medical costs can be paid for by many different sources. Can come from (1) tort damages; (2) insurance plan paid for by TP; (3) insurance plan paid for by TP’s ER, and (4) deductions allowable under § 213. Section 213, however, is limited (7.5% floor) and is supposed to promoted the use of insurance. Also note that the tax structure only gives a tax break to recovery of tangible, physical damage (irrespective of human capital). ii) Types of Damages (1) Human Capital. These provisions are difficult because they raise the issue of how to value human capital. Any amount received that is over the basis is taxable. But what is the basis in something like a human arm or nose? (2) Uncompensated. People who have no insurance or must use public health are arguably worse-off because their worse care is not included in the tax scheme (consider the woman whose nose is worse off after going to public assistance). iii) Recovery Type and TCs (1) Civil Damages. (a) Excluded. Section 104(a)(2) excludes from income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or illness.”
Tax Outline Prof. Billman Fall 2005 (b) Physical Damages. If tort damages are not clear, TP and IRS must figure it out. Note that tort damages are more likely to get taxed; contractual damages are less so. Any amount paid to TP over the amount of physical damages (such as punitive damages) are included in GI Glenshaw Glass. Also, does not include damages from employment discrimination, sexual harassment or civil rights violations. (2) TP-Paid Insurance Plans (a) Premiums Not Usually Deductible (7.5% Floor). Premium payments for insurance plans created by individual TPs are deductible under §213(d); however, because these deductions are subject to 7.5 percent floor of AGI, must TPs do not get to deduction such costs. (b) Proceeds Excluded. The proceeds from TP-paid plans, however, are not taxed. §104(a)(3). This makes sense – creates parity. If one pays for the premiums on a non-deductible basis, the benefits are just returning the premium. If we don’t deduct the premium, then we shouldn’t tax the proceeds either. Not much of a TE here (3) ER-Paid Insurance Plans. (a) Premiums Paid by ER Not Income. Section 106(a) excludes from GI “employerprovided coverage under an accident or health plan.” This benefits EEs who would not itemize their deductions or would be subject to the 7.5% floor. (b) Proceeds Excluded. §105(a)-(b) Creates a scheme whereby benefits received from an ER-paid insurance plan are also not taxed. Specifically, § 105(a) includes the proceeds in GI, but GI § 105(b) excludes from that inclusion amounts “paid, directly or indirectly, to the TP to reimburse the TP” for “medical care” as defined in § 213(d). (c) TE! The effect of §§ 105 and 106 is to create only of the largest tax expenditures in the entire code. Chirelstein says “it is by far the largest single exclusion allowed to individual taxpayers in the entire Code.” (4) Medical Deductions. (a) Section 213. This section is basically a safety-net for TPs who do not have insurance and costs from extraordinary medical expenses. Arguably, this makes the tax code a virtual health care provider. (b) How it Works. § 213 places a 7.5% floor on such deductions. Limited in many circumstances – does not include things such as non-prescription drugs. Swimming pools are difficult (special rules). See Regs. §1.213-1(e)(1)(i) (defining “medical care” as including only “prevention or alleviation of a physical or mental defect or illness.” Note also that the Regs allow for deduction of costs that would otherwise be capitalized. § 1.213-1(e)(1)(iii).
Tax Outline Prof. Billman Fall 2005
PART III: INCOME FROM CAPITAL: COMPLEX ACQUISITIONS AND D ISPOSITIONS
Overview of Part III Four Key Questions. Final parts of course focus on 4 key questions when dealing with acquisition and disposition of assets. Always use these questions: 1) Has there been a realization event? (Unit IV) a) Sale. Realization event. b) Exchange. Realization event. c) Bargain Purchase. If ER to EE, then still sale. If not treasure trove, no realization event. d) Gift. No realization event. e) Divorce. No realization event 2) Has there been a realized gain or loss? (Know AR and AB) If so, how much? (Unit XII) a) Yes. Consider next question. b) No. No tax consequences; no need to recognize anything 3) Is the gain or loss recognized? (Unit XIII) a) Gains. Generally all gains are reported. Exception is where specific non-recognition provisions apply (e.g., like-kind exchange). b) Losses. Must have specific statutory authority for taking a loss (see §165). i) Personal losses. Generally not deductible because most are consumption. Some personal losses are deductible. ii) Business or Investment Losses. Generally deductible, but some are not. 4) If the gain or loss is recognized, is it capital or ordinary? (Unit XIV) a) Capital. TP wants capital treatment for gains but and ordinary treatment for losses. b) Ordinary. Service wants ordinary treatment for TP’s gains and capital treatment for losses (bc lower deduction for TP). Unit XII – Gains and Losses: Debt-Based Acquisition and Disposition of Property 1) Background a) Basis. Basis is crucial in this last part of the course. Basis preserves the principle that things taxed once should not be taxed again. Basis, in effect, creates an account with the govt of amounts that have been taxed somewhere and should not be taxed again. It is the key to answering the question of whether there has been a gain or loss. b) Specific Situations. How basis is calculated is governed generally by §§ 1001, 1011(a), and 1012. However, basis changes in specific situations, such as property inherited by decedent, divorce, or gift. (see below). 2) General Basis Rules (§§1001, 1011, 1012 and 1016) a) Gain/Loss Calculation. G/L = AR-AB. Basis needed to calculate AB. § 1001(a). i) AB. Basis for “sale or other disposition of property” is basis provided in §1012 or other “applicable sections” (see below). § 1011(a) and § 1001(a). ii) AR. From sale or disposition of property is the “sum of any money received plus the FMV of the property (other than money) received. § 1001(b). b) Basis Adjustments. i) Capitalized Costs. Capitalized expenditures are added to basis. Does not include taxes or benefits lasting less than 1 year. § 1016(a)(1). ii) Depreciation. Depreciation deductions must be deducted from basis. Reduce depreciation by amount allowable, not by amount actually taken. Must affirmatively elect depreciation under § 179. If one fails to take depreciation (bc one is dumb or does not have enough assets, then still have to take of basis. § 1016(a)(2). iii) Substituted Basis. Capitalization and depreciation adjustments are required even if TP has substituted basis. § 1016(b).
Tax Outline Prof. Billman Fall 2005 3) Basis in Specific Situations a) Purchases and Exchanges of Property i) Exchange for Services. (1) FMV Exchange. Basis in the case of property transferred in exchange for services is the FMV of the property. §1.61-2(d)(2)(i). FMV is included in GI under § 83. (2) Less than FMV Exchange. If property is exchanged at price less than FMV, the difference between transfer and FMV is compensation (§83). Basis remains the same as the FMV. §1.61-2(d)(2)(i). ii) In-Kind Exchanges. (1) Defined. Arms-length transaction of properties of equal value or with any difference in the values accounted for by transfer of cash or other property. (2) Basis. Realization event. Basis in new property is the value of the property received (FMV at time TP reported income §1.61-1). This makes sense – we don’t want to give someone a basis that is less their original property, especially if they could sell that new property and claim a loss. (3) Personal Use Asset. Remember no deduction for personal-use assets. Tax does not take personal choices into account. iii) Bargain Purchases. Court focuses on relationship of parties. (1) Unrelated Parties. Treat basis as actual cost. § 1012. (2) Related Parties. If ER to EE, T to L, or family, court will treat differently. b) Gifts of Property. i) Different Bases for Loss and Gain. Gift counts as disposition of property under § 1001. Generally, basis in case of property acquired by gift is the donor’s basis. §1015(a). However, basis is treated differently when donee disposes of property, depending on whether property is sold at a loss or gain. (1) Gain. In the case of sale a gain, the basis is the carryover basis. §1015(a). (2) Loss. In case of sale at a loss, basis is the current FMV of property. (3) Grey Area. If amount of property is between the two bases for loss and gain, then it is treated as nothing. (strange….) ii) Reasons for Rules. (1) C does not have to treat gains and losses the same. Losses are a matter of legislative grace according to Court. (2) Allow property to be used efficiently. Perhaps encourage exchange of property. c) Inherited Property i) Stepped-Up Basis. Basis in inherited property is the FMV of the property at the date of the decedent’s death. § 1014(a)(1). ii) Policy Concerns (1) Lock-in. Potential decedent will hold any gain property in order to take full advantage if the step-up. (2) Estate tax. Worry about wealthy people at death purging income from tax system. (3) Admin concerns. Stepped-up basis is easier. Does not require record-keeping of property that may have been held for a long period of time by decedent. (4) Efficient? May be leading people to deal with their property in ways they wouldn’t absent tax system. d) Transfer of Property Incident to Divorce or Between Current Spouses. i) Not Recognized. Transfer of property between spouses or former spouses (if incident to a divorce) is not recognized. §1041(a). ii) Carryover Basis. Property is treated as a gift. Basis in the property is adjusted basis of the transferor. (E.g. would have been $.15 in Farid) (NOTE: Different from gift rule because basis does not change for gain or loss). §1041(b). Different from old law (Davis), where saw event as giving income to transferor.
Tax Outline Prof. Billman Fall 2005 iii) “Incident to Divorce.” Broadly defined as transfer within year after marriage ceases or related to cessation of marriage (court involvement). §1041(c). However, unilateral letters are not enough. Harlow. iv) Pre-Nups. Antenuptial agreements are excluded from current §1041. Instead, the common law rule (Davis) holds: when interest in property vests (say at end of marriage), the transfer of property is considered a disposition and thus a realization event (bc wife is giving up rights for property). New basis is the FMV of the property transferred (instead of spouse’s basis). Farid. v) Human Capital? Difference in treatment raises tricky human capital questions. Assumes that the FMV of property received in the pre-nup context is equal to the marital rights surrendered. Like medical expenses, this is a very hard question to answer. e) Property Encumbered by Debt i) Nonrecourse Debt (1) Effect on Basis (a) FMV of Property at Acquisition ≥ NR Debt. (i) Crane Rule. NR debt is treated as a real cost when property is acquired and is thus included in the basis. * NOTE: Second mortgages are not included in basis unless they are put into the property. (ii) Benefit to TP. Benefit to TP. Allows TP to take depreciation deduction on an amount not yet paid. (b) FMV of Property at Acquisition NR Debt. (i) Franklin Problems. Tufts rule creates incentive for TPs to acquire property with little investment, but a large mortgage in order to take advantage of depreciation deductions (remember the basis is included in the mortgage). This is the situation in Franklin. (ii) Franklin Rule. Where property is known to be worth less than the RN debt at the time the property is acquired, the purchaser’s basis should be limited to either the lower value (true FMV) or even the TP’s cash investment (equity). There is rarely a problem where (1) FMV of property is greater than or equal to property at the time of acquisition, or (2) there is an unrelated third party lender. (2) Effect on Amount Realized (a) Crane Symmetry. Amount realized includes the nonrecourse liability to which the property is subject. Makes sense: If, under Crane, tax law treats NR debt as a real cost when property is acquired (i.e., included in basis), then “relief” from such debt has to be treated as a real benefit when property is sold. (b) Tufts. Crane holds regardless of whether the FMV at disposition is less than the amount of a nonrecourse loan encumbering the property (TPs had argued that they could only be limited to the value of the property in NR situation). See also §1.10012(b). ii) Recourse Debt (1) Effect on Basis. Basis includes the extent of TP’s personal liabilities. (2) Effect on Amount Realized. (a) Discharge of Indebtedness Income. TP who settles a debt at a discount generally has discharge of indebtedness income Kirby Lumber. (b) If Recourse Debt at Disposition < FMV, then AR is equal to the extent of that release of liability (it is as if they paid-off the loan with the property). §1.1001-2(a)(1) (See Unit XII, Questions 6(a)-(b)). (c) If Recourse Debt at Disposition > FMV, then situation is “bifurcated.” (i) Rule: Where FMV exceeds basis, but is less than outstanding debt (Tufts situation), AR is value of the property and any amount over basis is gain. The remaining amount is treated separately as “income for discharge of indebtedness.” IF lender cannot get assets, then owner as discharge of indebtedness of remaining amount §1.1001-2(a)(2). See Unit XII, Question 6(c)). See text, pp. 1483
Tax Outline Prof. Billman Fall 2005 Unit XIII – Recognition of Gains and Losses 1) Background a) Recognition v. Realization. Although TP might realize gain or loss, it may be something that Code does not recognize b) Generally. i) Section 1001(c). All gains or losses are recognized in full unless “otherwise provided.” (1) Gains. For majority of transactions, TP must recognize gain. (2) Losses. Usually only losses from property used in a trade or business or in an income producing activity, and casualty losses are deductible. c) Courts Wary. Courts pay attention to TPs trying to convernt non-deductible personal losses into deductible losses and there are rules designed to prevent this. 2) Non-Recognized Losses a) Personal Assets i) Not Recognized. Code allows deduction for losses, but only those which are connected to a trade or business, transactions entered into for profit or casualty losses of private property. §§ 165(a), (c). b) Wash Sales i) Not Recognized (30-day Rule). Losses from sales of certain stocks not recognized if TP acquired or planned to acquire the same or similar stock 30 days before disposition of the asset at issue §1091(a). TP can’t try to force this. ii) Includes. Sales of stock and securities. iii) Basis. New basis in such property becomes the cost of getting the property back. Losses are thus deferred, not lost. So, if TP sells stock for $500 (and basis is $700) and repurchases the stock 17 days later for $550, the $200 loss is disallowed. New basis is $750. c) Transactions between Related TPs i) Not Recognized. Losses resulting from “sale or exchange of property, directly or indirectly” to certain relatives are not recognized. § 267(a)(1) (Does not apply to complete liquidation of corporate property). Transferor cannot take a deduction for the loss. § 267(d)(1). ii) Barred Relationships. (§267(b)) (1) Members of a family (defined in (c)(4). §267(b)(1). (2) Individual and corporation more than 50 percent in value of the outstanding stock of which is owned. (b)(2). (3) Two corporations which are members of same controlled group.(b)(3) (4) Grantor and fiduciary of any trust. (b)(4). (5) Fiduciary of a trust and a fiduciary of another trust, if same person is grantor. (b)(5). (6) Fiduciary and beneficiary of different trusts if same person is grantor of both. (b)(6). iii) Constructive Ownership (§267(c)) (1) Stocked owned directly or indirectly by or for a corporation, partnership, estate, or trust. (c)(1) (2) Individual considered owning the stock owned by his or her family. (c)(2). (3) Individual owning any stock in a corporation is considered owning for his partner. (c)(3). (4) Family of an individual includes only his brothers and sisters (whether by whole or half blood), spouse, ancestors, and lineal descendants. (c)(4). iv) Fender (1) Control. Even outside this statutory scheme, a loss is not allowed if the TP has control over the property when it is sold. (2) If TP sells to family member (esp a minor), court will not recognize the loss (3) Written K. Absence a written K will mean nothing; control is inferred absent it. 3) Recognized Losses/Gains a) Losses on Trade or Business or Income-Producing Assets i) Deductible. Allowed under §165(c)(2).
Tax Outline Prof. Billman Fall 2005 ii) Difference between Personal and Business Losses (1) Primary Motive. Courts consider the “primary motive” of the purchase of the property in making the determination. For instance, Court disallowed deduction from loss of home which TP had bought for live-in, but had then rented. Austin. (2) Multiple Use Property. When property used for one purpose and part for another or used at different times, losses from sales or property must be allocated between different uses. Deduction allowed in proportion to business or income-producing activity. Sharp. b) Sale of Personal Residence i) Special Exclusion. If TP sells principle residence (i.e. where she spends majority of her time), and it is occupied for at least 2 of the past 5 years, then that amount is excludable up to $250k ($500k for joint filing). Can happen once every two years. § 121(a), (b). c) Casualty Losses i) Generally (1) Personal and Business. Although § 165(c) seems limited to only personal losses, the regulations extend it to include deduction for “trade or business or any transaction entered into for profit or” personal loss.” §1.165-7(a)(1). (2) Insurance. Section § 165(a) deals with insurance by only allowing deductions for losses that are “not compensated by insurance or otherwise.” Only uninsured casualty losses exceeding $100 are taken into account. No deduction allowed if TP does not file timely insurance claim. (3) Elements. (1) Mens Rea. Must not be evidence of willfulness or negligence; (2) Suddenness. May be necessary but alone is not sufficient. (3) Often requires physical damage (OJ Simpson neighbor case). ii) Method of Valuation. (1) Generally. Loss calculated by looking at FMV before and immediately after the casualty. Must recognize effects of any market decline affected undamaged as well as damaged property that may occur simultaneously. Rules structured so as to prevent deductions which exceed TP’s basis. § 1.165-7(a)(2). (2) Repairs. Amount of repairs ok if TP can show costs are (1) necessary for restoration; (2) amount is not excessive; (3) repairs do not care for more than damaged suffered, and (4) value of property after repairs is not more than value before casualty. (a)(2). (3) Automobiles. (a) Cars. Deduction allowed for casualty to automobile used for business or trade or for pleasure. § 1.165-7(a)(3). (b) Cause of Damage. Allowed when (1) damage results from fault of driving TP or other person operating car (as long as not willful) or (2) damage results from faulty driving of operator of other vehicle. §1.165-7(a)(3). iii) Deductible Amounts. (1) Generally. Take lesser of either (a) FMV. Difference between FMV of asset immediately before and after casualty (i.e. amount actually destroyed), or (b) Adjusted Basis. Amount of AB prescribed in § 1.1011-1. §1.165-7(b). (2) Special Rule for Business Property Totally Lost to Casualty (a) Basis. If (1) Property used in trade or business or held for income is totally destroyed by casualty, and (2) the FMV immediately before casualty is less than the AB, the amount of loss is the basis. §1.165-7(b). (b) Policy. C sees this as last chance to deal with this property. (3) Personal Limits. Net personal casualty losses are allowed only to the extent they exceed 10% of AGI. §§ 165(c)(3), (h)(2)(A).
Tax Outline Prof. Billman Fall 2005 4) Limited Recognized Losses/Gains a) Bad Debts. i) Classes. Code creates four classes of bad debts: Business Debts Bad Debt Deductible in full as ordinary loss. §166(a)(1) Non-Business Debts Only deductible as a STCL, which is not as valuable as ordinary loss. §166(d)(1)(B). Non-deductible. §166(d)(1)(A).
Partially Worthless
Deducted to extent charged off by TP on the books. § 166(a)(2).
ii) What is a Business Debt? (1) Business Relationship. Court has allowed deduction for bad debt between brothers because they conducted their business as businessmen. Mann. (2) Time. Court denied TP’s argument that he was engaged in the business of lending money because he did not spend a lot of time on projects, did not advertise, and did not keep books. Bounds. iii) What is a Loan? (1) Debtor-creditor relationship must exist based on a valid and enforceable obligation to pay a fixed or determinable sum of money. If lender is not in the business of making loans, then it is usually regarded as a non-business debt. Generes. (2) Unpaid Services (Imputed Income). One cannot collect on a debt theory for unpaid services. A right to receive payment in the future is not income. In order to create a basis there that would give rise to a bad debt, there would need to be out-of-pocket cash or property. Like Haverly, there is no deduction sans basis and no basis until something is included in income. iv) Policy. (1) C wanted to prevent TPs from lending money to friends or relatives who they knew would not repay it and then deduct against ordinary income in the amount of the loan. (2) Political Contributions. § 271 specifically disallows deductions for worthlessness of debts owed by a political party. b) Exchanges of Like-Kind Property (§1031) i) Generally. (1) Non-Recognition. No gain or loss recognized when “like kind” properties held for investment or use in a trade or business are exchanged. “Non-recognition” means that a gain is deferred until a later date. This section is mandatory. §1031. (2) Requirements (a) “Like-Kind” (i) Regs deal with this in §1.1031(a)-2. (b) “Productive Use in a Trade or Business or for Investment.” (i) Often depends on circumstances. Wagensen, transfer of ranch still not a gain even though given to children afterwards bc the land had been used as a ranch and there had been no previous desire to transfer the land to children. (3) Key Questions (a) Is gain recognized? (b) How does gain figure into basis?
Tax Outline Prof. Billman Fall 2005 ii) Gains and Losses from Exchange of Non-Like Kind Property (1) Gains Recognized. If exchange includes non-1031 property, then gain is recognized up to the amount of the money or the FMV of the other property. Mortgages can give a gain to the extent that the net gain is greater than the mortgage assumed. §1031(b). (2) Losses Not Recognized. No loss is recognized to the extent of boot received. §1031(c). iii) Computing Basis. Basis must ALWAYS account for any non-recognized gain!! (1) Pure Like-Kind Exchange (a) In situation of pure exchange, basis of property given-up becomes the basis of the property received. §1031(d). (2) Like-Kind Exchange + Boot and Unrecognized Gain (§1.1031(d)-1(a)) (a) Basis of property acquired is (i) Basis of property transferred plus (ii) Amount of boot given. (3) Like-Kind Exchange + Boot and Recognized Gain (§1.1031(d)-1(b)) (a) Basis of property acquired is (i) Basis of property transferred, minus (ii) Amount of money received, plus (iii) Gain recognized on exchange. (4) Like-Kind Exchange + Other Property Exchanged and Recognized Gain (§1.1031(d)-1(c)) (a) Basis is allocated between property by equivalence of FMV: (i) Basis of property transferred, minus (ii) Amount of money received, plus (iii) Gain recognized on exchange. (5) Like-Kind Exchange + Boot and Unrecognized Loss (§1.1031(d)-1(d)) (a) Basis of property received is (i) Basis of property transferred, minus (ii) Amount of money received. (6) Like-Kind Exchange + Non-Like-Kind Exchange with Recognized G/L (§1.1031(d)1(e)) (a) Basis of property acquired is (i) Total basis of properties transferred, plus (ii) Amount of gain recognized, minus (iii) Amount of loss recognized on the other property. (7) Like-Kind Exchange + Mortgages (§1.1031(d)-2) (a) Boot. Amount of liabilities assumed by other party treated as money received by the TP, regardless of whether it was a recognized gain or loss. However, gain is only recognized to the extent that the difference between mortgages is greater than net gain. (b) Basis of property received is (i) Basis of property transferred, minus (ii) Mtg given-up (i.e. recognized), as if cash received, plus (iii) Mtg assumed, as if cash paid. c) Other Types of Exchanges i) Third-Party Exchanges. See Notes.
Tax Outline Prof. Billman Fall 2005 ii) Delayed Exchanges. See § 1031(a)(3). 5) Involuntary Conversions (§1033) If TP’s appreciated property was involuntarily destroyed, stolen, seized, requisitioned or condemned, was the property converted into similar use property? a) Yes. TP must recognize gain only to the extent that the proceeds are not reinvested in similar use property, i.e.., gain recognized is equal to the lesser of the realized gain or the portion not reinvested. TP’s basis in the new similar use property is equal to its costs minus any unrecognized gain on the converted property. b) NO. Any gain must be recognized.
Tax Outline Prof. Billman Fall 2005 Unit XIV – Capital Gains 1) Background a) History and Purpose. C has always taxed income from the sale of property preferentially. No clear reason why this is done, but it is – and it is very, very important. Problem of capital gains treatment would not exist if our tax system used mark-to-market and not an accrual system. Below are a few pros and cons. i) More Investment. Argue that capital gains encourages investments. Not clear, however, that we need this to lower to encourage risk taking. ii) Bunching. Not fair to put a lump of tax in one year, especially when it may have been in a lesser bracket if spread-out over time. But doesn’t work for people who do not change tax brackets. iii) Prevent Lock-In. Give founders of companies incentives to sell their stock, when they otherwise wouldn’t. But we still allow bigger lock-ins, such as stepped-up basis. iv) Inflation. Capital gains deals with fact that increase in long-held asset may reflect inflation and not real gain. But we could deal with this by just indexing the system, like we do with standard deduction. b) Where Capital Gains Fit-in. Remember the four questions at the beginning of Part III. Characterization of capital or ordinary assets comes after (1) there has been a realization event, (2) resulting in a recognized gain or loss. c) “Capital Transaction.” Three requirements to receive preferential capital gains treatment i) Capital Asset. Transaction must involve as “capital asset.” ii) Holding Period. Minimum period must be met (more than 12 months). iii) Sale or Exchange. Transaction must be sale or exchange.
d) Netting Process (§1221). Short-term (ST) and long-term (LT) gains and losses; dividing line is a holding period of 12 months. TP must have held a capital asset (see below) for more than twelve months before any gain from its sale qualifies for LTCG. i) Two-Step “Netting Process.” (1) Step 1. Separately net ST gains against ST losses. (a) If STG > STL, then NSTG. (b) If STL > STG, then NSTL * Same for LT gains and losses. (2) Step 2. Net STG/L against LTG/L (a) If NSTG > NLTL, then excess STG is ordinary tax. (b) If NLTG > NSTL, then excess net CG is capital gain rate (c) If TP has NSTG and NLTG, then STG is ordinary tax rate and LTG is at favorable CG rate. ii) Possible Outcomes (1) Net LT and ST gains. NSTG is taxed at ordinary rates, and NLTG is generally subject to 15% rate limitation. (Example 2, pp. 531-32) (2) Net LT and ST losses. Net losses combined and can be offset against up to $3k of ordinary income (with unlimited carryforward) (§1222) (Examples 3 and 4, pp. 532) (3) Net Loss in one Category and Gain in the Other. Loss in former category, whether short or long, offset against gain in latter category. So, (a) If excess STG over LGL, excess is STG and taxed at ordinary rates. (b) If excess LTG over STL, excess is LTG and generally taxed at 15% (Example 1, pp. 531) (c) If net loss in either category exceeds net gain in the other, excess loss is offset against $3k of ordinary income. e) Capital Gains Rates (pp. 529) (§1(h)). (See Appendix).
Tax Outline Prof. Billman Fall 2005 2) Sales, Abandonment, or Extinguishment of Rights a) “Sale or Exchange” i) Abandonment. One who abandons property subject to a non-recourse debt receives a benefit and thus the abandonment is legally “a sale or exchange.” Yarbro (In-line with Tufts and Crane). ii) Foreclosure. Treated as a “sale or exchange.” Hammel. iii) Tax Lien. Constitutes a “sale or exchange.” Nebraska Bridge. iv) Cancellation of Lease or Distributor’s Agreement. §1241 treats as capital gain or loss amounts received by a lessee (not a lessor) for cancellation of a lease, or by a distributor (not his supplier) for cancellation of the distributor’s agreement. b) Not “Sale or Exchange” i) Sale or Extinguishment of Contract Rights. Receipt of payment in an exchange for the termination of contract rights does not constitute a “sale or exchange” because those rights are extinguished upon payment. Foote (Crt ruled that buy-out of tenured university professorship was not a “sale or exchange” because the “tenure did not pass to the university, but was extinguished.”) ii) Stocks and Bonds that Become Worthless. Not a “sale or exchange.” Code has special treatment in such situations: §§ 165(a) and (c)(2) allow deduction for loss in such a case. 3) Holding Period. a) Generally. i) More than a year. Exactly a year does not cut it. ii) What Counts. Day an asset is purchased is excluded and day asset is sold is included (“less one rule”). However, rule becomes a “plus one rule” where period is counted backward from a designated event. iii) Tacking. §1223 allows TPs in some circumstances to “tack on” to their own holding period a period of time before their acquisition of the capital asset. b) Inherited Property. Exempted from holding period. §1223(11). 4) Capital Assets (§1221). a) Basic Concepts. i) Investment Property. (1) Capital asset definition was meant to apply to investment property (e.g., securities and real estate), which appreciates over ownership. (2) Recurring income does not usually fall within the negative definition of a capital asset. ii) Section 1221. Capital asset defined as all property, except certain categories. These categories are affected by (1) §1221, (2) common law, and (3) additional statutes. iii) Common Law. §1221 is not always dispositive. Sometimes courts look deeper in classifying property as either ordinary or capital. (see below).
Keep it Clear: (1) If an asset falls under one of these categories, it is ordinary. (2) If an asset does not fall under one these, it is a capital asset.
Tax Outline Prof. Billman Fall 2005 b) Property Held for Sale to Customers §1221(a)(1). Exempts from definition of capital asset property “held by the TP primarily for sale to customers in the ordinary course of his trade or business.” i) “Primarily.” “Primarily” means “of first importance” or “principally.” Courts often find that purpose is the TP’s purpose at the time of sale. Malat ii) Issues. Three issues predominate (1) Dealer? Whether TP’s activities make her a dealer holding property in course of business. (2) Change Purpose? Whether TP bought property for investment, but then changed purpose to that of a dealer. (3) Dual Purpose? Whether TP had two purposes, or even no purpose at all. iii) Factors. Courts consider many factors in deciding whether TP is engaged in a trade or business. (1) Frequency and Substantiality of Sales. Most important factor cited in many cases is the number, frequency, and substantiality of sales. Numerous sales that extend over a long period of time are more likely to have occurred in ordinary course of business. cf Bramblett. (2) Seller’s Passivity. TP is seldom found to have engaged in a trade or business where he had done little, if anything, to acquire, improve, or market his properties. Adams (TP did little in sale, but sold 118 parcels over 7 year, rec’v cap gains treatment) (3) Bulk Sales. Cases suggest it is better to engage in bulk sales to avoid running afoul of §1221(a)(1). c) Depreciable Personal Property and Real Property Used in a Trade or Business § 1221(a)(2). Excludes from definition of capital assets depreciable personal property and real property used in a trade or business. i) Special Provision for Property Used in a Trade or Business and Involuntary Conversions (§1231). (1) Purpose. Allows real and depreciable property used in a trade or business to yield capital gains treatment when disposed of at a gain and ordinary loss when disposed of at a loss. §1231(a)(1)-(2). (2) Type of Property. (a) Applies to (i) Real or depreciable property (land, machinery, buildings) used in a trade or business or income-producing activity (generally excluded by §1221(a)(2)). §1231(a)(3)(A)(i)-(ii). (ii) Capital assets held for more than 1 year in connection with trade or business or income producing activity. (iii) Business property such as livestock, timber, coal, minerals. (b) Does not apply to (i) Inventory, property held primarily for sale to customers in ordinary course of business, or certain copyrights and artistic property. §1231(b). (3) Type of Disposition. Applies to (a) G/L from sales and exchanges. §1231(a)(3)(A)(i). (b) G/L from condemnations and involuntary conversions (such as casualty or theft). § 1231(a)(3)(A)(ii). (4) Netting Process. Two-stage netting process (§1231(a)(4)). (a) Firepot. Consider conversions from fire, storm, or other similar casualties. TP nets gains from casualty and theft losses (i.e. insurance) against losses from such involuntary conversions. (i) Losses > Gains §1231 does not apply. 1. No sale/exchange.
Tax Outline Prof. Billman Fall 2005 2. Losses deductible from ordinary income. (ii) Gains > Losses On to step 2. (b) Hotchpot. TP compares total gains with total losses from (1) involuntary conversions carried over from firepot and (2) condemnations, sales, and exchanges of business property. (i) Losses > Gains Gains includible in ordinary income, losses deductible from ordinary income. (ii) Gains > Losses Gains treated as LTCG and losses treated as LTCL, which are then combined with LTCGs and LTCLs from other sources (see above) ii) Recapture Provisions (§§1245 and 1250) (1) Generally. If TP were able to have depreciation deductions which offset ordinary income, and get capital gain treatment on a sale via §1231, then would be able to convert ordinary income into capital gains. §§1245 and 1250 were enacted to prevent this. (2) §1245. Certain Depreciable Property (a) How it Works. If depreciable property is sold for more than its adjusted basis, any gain not exceeding the total depreciation allowed is taxed as ordinary income (i.e. not given capital gains treatment). Also recaptures § 179 property. §1245(a)(1)-(2). (b) Applications. Applies to depreciated property (i.e. §167) such as personal property, property held in a trade or business and manufacturing. §1245(a)(3). (c) Limitations. Does not apply to transactions such as gifts, transfers at death, and like-kind exchanges or involuntary conversions. §1245(b)(1)-(30. (d) Examples. (i) A purchases machine for 100k to use in business. Takes 61,600 depreciation deductions. 1. If A sells machines for 90k Gain = 51,600 (90k AR – 38400 AB). Taxed as ordinary because depreciations deductions are greater than amount of gain (i.e. 61600 > 51600) 2. If A sells machine for 105k Gain = 66k (105k AR – 38400 AB). 61,600 (amount of deduction) is ordinary, while remaining 5k is capital gain. (3) § 1250. Certain Depreciable Real Estate (a) Generally. Provides less complete “recapture” mechanism for dispositions of real property. Recaptures excess of accelerated depreciation over straight line depreciation on certain real estate. Gain up to the amount of depreciation allowed on real property held for more than 12 months is taxed at special capital gains rate of 25 percent. d) Copyrights and Artistic Materials §1221(a)(3). Excludes, along with § 1231(b)(1)(C) (see above), from definition of capital assets certain copyrights and artistic materials. i) Scope. (1) Excludes. A copyright, literary, musical, or artistic composition, a letter or memorandum, or similar property, held by (a) TP whose personal efforts created the property. §1221(a)(3)(A). (b) TP for whom such property was prepared or produced §1221(a)(3)(B). (c) TP whose basis is determined by looking to basis of person who created it. §1221(a)(3)(C). (d) “Similar Property.” Regulations define this broadly as a “a draft of a speech, a manuscript, a research paper, an oral recording,… a personal or business diary, a log or journal, a corporate archive,…office correspondence, a financial record, a draw, a photo…” §1.1221-1(c)(2). Important for computer software. (2) Does not exclude. Copyrights and literary, musical, or artistic creations which are in the hands of buyers or most legatees unless they are held for sale to customers in the ordinary course of a trade or business. (see §1221(a)(1)). ii) §1235 Inventor Exception. (1) Scope.
Tax Outline Prof. Billman Fall 2005 (a) Permits capital gain treatment on sale of a patent by the inventor even when he is a “professional” who makes the sale in the ordinary course of his business. (b) Allows capital gain even if the consideration received by the inventor is dependent upon the transferee’s sales or use and even if the minimum holding period is not satisfied. (c) Applies to those who financed inventor’s work. (d) Does not apply to corporations. (2) Requirements. (a) Inventor must transfer “all substantial rights” in a patent to get cap gains. e) Accounts and Notes Receivable §1221(a)(4). Excludes from capital asset accounts or notes receivable acquired in the ordinary course of trade or business. i) Accrual. Accrual basis TP includes an account receivable as ordinary income at the time of its receipt. ii) Cash. Cash basis TP would include payments on the receivable as ordinary income. iii) If note is subsequently less than the amount included, there is ordinary loss, if sold more than basis, then there is an ordinary gain. f) Government Publications Received Free or at Discounted §1221(a)(5). Excludes from capital asset publications received by TP without charge or at a reduced price. Designed to deprive TPs of charitable deductions for the FMV of materials when they are contributed to a charity such as a university or library.
g) Derivatives, Hedging Transactions, and Supplies used in a Business i) Common Law Rules. (1) Futures. Although certain futures are not “actual inventory,” they will be considered as such if they act as substitutes or surrogates for the business inventory itself. Corn Products, altered by AR Best. (2) Stock. A loss realized on a sale of stock was capital even though the stock was purchased for a business, rather than an investment, purpose. AR Best. ii) Provisions. These provisions came in 1999 to limit “whipsaw potential.” (1) § 1221(a)(6). Excludes from capital asset (i.e. makes ordinary) commodities derivative financial instrument held by a commodities derivate dealer, unless (1) it has not connection to activities of the dealer and (2) it is described as such. (2) §1221(a)(8). Excludes from capital asset supplies of a type regularly used or consumed by TP in ordinary course of a trade or business of TP. (3) §1221(a)(7). Excludes from capital asset (i.e. makes ordinary) hedging transaction clearly identified as such before close of day on which it was acquired. * NOTE: Purchase or sale of a debt instrument, an equity security or an annuity K is not a hedging transaction even if the transaction reduces the TP’s risk. Generally, stock is never considered a hedging transaction. §1.1221-2(d)(5). (a) Regulations on Hedging Transaction (pp. 1527). (i) Hedge Defined. Transaction TP enters into in the normal course of TP’s trade or business primarily to 1. Manage risk of price changes or currency fluctuations with respect to ordinary property §1.1221-2(b)(1) 2. Manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred by TP. §1.1221-2(b)(2). h) Capital Gain on Small Business Stock (§1202). Individual can exclude 50 percent of gain on sale or exchange of “qualified small business stock” held for at least 5 years.
Tax Outline Prof. Billman Fall 2005 i) Rates. Includible portion is taxed at maximum 28 percent rate, so maximum rate is 14 percent. ii) Amount of Gain. Amount of eligible gain for exclusion is greater of ten times TP’s basis in the stock or $10 million of gain on stock in corporation. iii) Requirements. (1) TP must have acquired stock at its original issuance. (2) Eligible corporation has net worth at time of issuance of $50m or less. (3) At least 80 precent of assets must be used in conduct of an active trade or business during substantially all of TP’s holding period. (4) Business must be something other than one where one of the principal assets is the reputation of one or more of its EEs (such as law, accounting, etc.) Cannot involve banking, insurance, leasing, financing, farming, operating a hotel. i) Dividends. Corporate stock dividends taxed as capital gains. Maximum rate is 15 percent (or 5 percent if the recipient is otherwise in the 10 or 15 percent bracket). §§301, 316. Common Law Narrowing of § 1221. (1) Generally. §1221 suggests that all property qualifies as a capital asset unless it falls within a listed exception. Courts have, however, narrowed the definition of a capital asset. (2) Gillette. Holds that all property that is in a common sense is not property within meaning of § 1221 (i.e. “property” under §1221 means something different than normal property rules). (3) Hort. Denies capital asset status when a substitute for future ordinary income is perceived.
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5) Charitable Deduction for Donation Appreciated Property (§170(e)). a) Generally. Depends on i) whether recipient is a private foundation or a public charity, ii) whether the appreciation would be taxed as a capital gain or ordinary income if sold, and iii) whether gift consists of tangible property or securities. b) Framework. i) Private Foundation. If private foundation, then deduction equal to FMV, minus any capital or ordinary income (basically basis) ii) Public Charity. If public charity, then FMV minus amount of gain that would not have been LTCG. iii) Personal Property. If not used by charity, then deduction is FMV reduced by full amount of the appreciation. c) Examples. Assume AB = $100; FMV = $300. i) If TP contributes stock to public charity (1) If held for more than 1 yr, then LTCG and deduction is $300. (2) If held less than 1 yr, then STCG and deduction is $100 (basis). ii) If TP contributes painting to charity that will not be hung. (1) Would have been LTCG if held for more than a year, but bc not hung, then deduction limited to basis. iii) If TP contributes painting to an art museum (i.e. will be used). §170(e)(1)(B) (1) If held more than 1 yr, then LTCG. Deduction is $300. (2) If held less than 1 yr, then STCG. Deduction is $100 (basis). iv) Real Estate. If TP contributes RE to private foundation. Deduction is $100 bc property other than marketable securities has been donated to a private foundation. v) Artist’s Painting. If painting donated by artist (creator), then it would have been ordinary income and would have been limited to FMV minus ordinary income (basis). vi) Patent. If donate patent or other IP, then deduction is FMV minus amount of gain that would have been LTCG.
Tax Outline Prof. Billman Fall 2005 Unit XV – Tax Accounting 1) Statutory Framework a) § 446. TP shall compute taxable income “under the method of accounting on the basis of which the TP regularly computes his income in keeping his books” so long as that method “clearly reflects income.” b) § 451. Requires TPs to include items in GI in the taxable year of receipt unless their method of accounting requires that the income be included in a different taxable year. c) §461. Deductions and credits “shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.” 2) Cash Method a) Generally. i) How it Works. Items ordinarily included in income in the year received and deductions are taken in year paid. Unlike the accrual method, CM allows one to defer income for later years. ii) Who Uses it. Used by majority of TPs – individuals, service industries. iii) Pros and Cons (1) Simple. (2) Inaccurate. b) Constructive Receipt Doctrine. i) Purpose. One way to prevent TPs from having complete freedom to decide when to report income. ii) Rule. Income is constructively received when: (1) Set apart for TP (credited to account, or made available), and (2) TP can draw upon it at any time or (3) Can draw on it if intention is given. Carter, §1.451-2(a). (4) Reference Point: Focus on when services are preformed. a TP can choose to defer payment before it has been earned. iAs long as decision to defer occurs before the service is rendered, it is not constructive receipt Rev. Rul. 60-31. iii) Examples. (1) Win Car. Car won at football game not constructively received because car was not available at time of winning announcement. Hornung. (2) Promise to Pay. TPs do not have constructive receipt merely because they could have entered into an arrangement to receive payment earlier. No CR unless the money/note/etc. has been earned. Schneirs. (3) Bonuses. Would appear that CR would apply – the EEs have earned the bonus. But courts have created an exception if decision to defer occurs before one knows they are in the bonus pool. (4) Adjusted Contracts. (a) Oates. K that non-transferable, non-assignable and limited to commissions actually earned was not constructive receipt. (b) Olmsted. ? c) Deferred Compensation. i) Issue. ERs often delay payment for personal services across time. Question is how to deal with it. ii) Qualified Plans. (1) Requirements. Cannot discriminate in favor of highly compensated EES. iii) Nonqualified. (1) Requirements (§409A) (a) Deferred compensation generally cannot be distributed earlier than separation from service, disability, death, a fixed time, or under a fixed schedule. (b) Plan cannot provide for accelerated distribution (c) Election to defer must be made in a year before services are performed. (d) Transfer of restricted property (ie §83) is NOT deferred compensation. (2) Examples (Revenue Ruling 60-31)
Tax Outline Prof. Billman Fall 2005 (a) Executive. EE has salary plus compensation for additional years. Additional compensation is credited to third party, and only pays out in limited circumstances. NOT deferred compensation because does not count as constructive receipt. (b) Football Player. Has signing bonus put in escrow account. IS deferred comp because it is specified, it is in his name, and will become part of his estate. iv) Escrow. EE gets, in addition to K, an interest in an escrow fund. Whether it is cash depends on whether the assets are set aside from ER’s creditors. If it is, then it is taxable to the EE. (1) “Rabbi Trust.” If ER puts money in a trust that does not produce income for the ER, then it is not taxable to the EE. Still subject to the ER’s creditors, but gives a bit more security to the EE. d) Receipt of Equivalent of Cash or “Economic Benefit.” i) Rule. Different from constructive receipt. Requires the actual receipt of property or of a right to receive property in the future. Inquires whether the property or right received confers a present – and often marketable – economic benefit. Rev. Rul. 80-52. ii) Checks. Treated like cash. Kuehner. iii) Notes. * Remember: Income is not just cash, but also “property” §61(a)(12). Note is considered cash when it is more like property. (1) Considered Cash. (a) Unconditional promise to pay by solvent obligor that is assignable, not subject to setoffs and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the prevailing premium for the use of money, then it is cash. Cowden. (b) Control. TP in control of funds of a corporation who issued himself notes for salary treated as cash. Newark. (2) Not Considered Cash. (a) No funds. Note from maker without funds is not the equivalent of cash, not includable in income. Williams. (b) No funds and intent. Unendorsed and unsecured note that parties did not intend as payment, but only evidence if original debt is not cash income. Schlemmer. (c) Accounts Receivable. Not income when received (account receivable is nonnegotiable note or debt instrument). e) Payments. i) Rule. Under the cash method, allowable deductions are taken into account for the taxable year in which paid. §1.461-1(a)(1). (No such thing as “constructive payment.”) ii) What and When is “Payment”? (1) Pay by Phone. Payment occurs on the date that a financial institution mails checks, transfers funds, or actually delivers checks as the agent of the TP. Rev. Rul. 80-335. (2) Charitable Giving via Credit Card. Use of a bank care to make a charitable contribution is equal to using borrowed funds to make a contribution. Thus, the deduction is not postponed until year debt is paid, but can be deducted in the year paid. Rev. Rul.78-38. (3) Accounts and Notes Payable. Cash method TP typically cannot deduct until paid-off. In other words, notes are not considered cash on payment side. Asymmetrical treatment makes sense: writing note is not the same as cash. (4) orrowed Funds. TP must have unrestricted control over borrowed funds before the funds are used to pay the inters to the lender. Noble. iii) Prepayments (1) Capital Expenditures. Cash expenditure in creation or possession of an asset having a useful life substantially beyond the close of the taxable year is not deductible. § 1.4611(a); Boylston. (2) Interest. Must allocate and deduct prepaid interest over the loan period. Basically puts cash TPs on accrual method for interest deduction. Bolyston.
Tax Outline Prof. Billman Fall 2005 3) Accrual Method a) Generally. One has income when there is (1) a right to that income and (2) that amount can be determined accurately. Distinguish between a right accruing and a payment accruing. One might have a right, but be paid significantly later. Theoretically, this is the most accurate method. b) “All Events” Test. General test for determine whether items of income and deduction have accrued for tax purposes. i) §461(h)4). Test is met if “all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.” ii) §1.451-1(a). Complements the test. Amounts included in income “when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.” c) Economic Performance §461(h)(1). All events test not satisfied unless is “economic performance.” i) Timing. Economic performance occurs when (1) Services and property provided to TP. Occurs as person performs services for TP. (h)(2)(A). (2) Services and property provided by TP. Occurs as TP provides such property or services. (3) Workers Comp and Tort Liability. Occurs as the payments to others are made. ii) Recurring Items (§461(h)(3)). Basically puts accrual TPs on cash method for certain costs. An item is treated as incurred during taxable year if (1) All events test is met; (2) EP occurs within shorter of reasonable period or 8.5 months after close of taxable year, (3) Item is “recurring in nature,” and (4) Item is not material item, according the item in the proper year provides “a more proper match” against income than accruing in year economic performance occurs. d) Advanced Payments on Unearned Items i) Basic Principles. (1) Amount Fixed. If company can fix performance dates, then argument for deferral on accrual method is stronger. In the case of the baseball team, the game is played regardless of whether anyone shows; for RCA, no performance is mandatory. (2) Deferral is Limited. Longer the period of deferral, the more attenuated the need for deferral. ii) Examples. (1) Deferral Disallowed. Indefinite promises to perform services, along with money in the TP’s hand will likely require payment of income tax. RCA (2) Deferral Allowed. If future services are definite and limited to a short, or specific period of time (eg a year), then TP can defer income. Artnell Co. (White Sox)
Tax Outline Prof. Billman Fall 2005 4) Interest a) Background. i) Imputed Compound Interest. Prior to 1982, the Code did not deal with compound interest. However, §§ 163(e) and §§ 1272 now deal with it by putting both lender and borrower on the accrual method. (1) Deductions. §163 requires that the portion of “original issue discount” allowed as a deduction be equal to the “aggregate daily portions” of the OID. Section §163(e) is linked to §§1272, et seq. (2) Income. §§ 1271 and 1272 provide that OID is taxed to the bondholder as ordinary interest income (ie not capital gain), and that the bondholder accrue such interest annually (rather than at sale), even if the holder is on the cash method. ii) “OID.” Exists when the original “issue price” of a debt instrument is less than the amount to be paid at maturity. Difference between amount received (issue price) and amount repaid (stated redemption price at maturity) is compensation to the lender for the use of the money and is functionally equivalent to interest. b) Statutory Framework. (Looks like a bank account)(see example, pp. 730). i) OID as Income (§1272). (1) Trigger. §1272 is triggered when there is OID (defined as excess of stated redemption price at maturity over issue price, §1273(a)(1)). (2) Income. GI includes OID equal to the “daily portions” of the OID. §1272(a)(1). (3) Daily Portions. OID for each accrual period is calculated by multiplying (a) Adjusted issue price (defined in §1272(a)(4)) at the beginning of the period by (b) Yield to maturity. §1272(a)(3). (4) Accrual Period. Means a 6-month period (generally). §1272(a)(5). (5) Basis Adjustment. Basis of debt instrument is increased by the amount included in GI. §1272(d)(2). This makes sense in order to prevent double taxation. ii) Definitions (1) OID. Excess of stated redemption price at maturity over issue price. §1272(a)(1)(A)(B). (a) Stated Redemption Price. Amount to be paid by borrower at maturity, excluding any interest payments made at regular intervals of a year or less. §1273(a)(2). (b) Issue Price. (i) Publicly offered debt instrument. If debt instrument is (a) publicly offered and (b) not issued for property, then issue price is initial offering price to the public at which it was sold. §1273(b)(1). (ii) Other debt instrument. Equal to the cash (price) paid by the buyer (lender). §1273(b)(2). (2) Debt Instrument. Means “bond, debenture, note, or certificate or other evidence of indebtedness.” §1273(a)(1)(A). iii) Exceptions. (1) Inapplicability. Section 1272 does not apply to tax-exempt obligations, US savings bonds, short-term obligations, and loans between natural persons. §1272(a)(2). (2) Cash Method. If debt instrument is (a) Personal. Incurred in connection with acquisition of carrying on personal use property and (b) OID. Has OID and (c) TP usually uses cash method, the OId is deductible only when paid (despite §163(e)). §1275(b)(2).
Tax Outline Prof. Billman Fall 2005 5) Market Discount a) Section 1276. 6) Imputed Interest: Low Interest and Interest-Free Loans (Section 7872) a) Generally. Section 7872 applies to below-market loans that are characterized as gift loans, compensation-related loans, corporate-shareholder loans, and tax avoidance. Precludes the use of interest-free or low-interest loans between ERs and EEs to avoid employment taxes or limitations on interest deductions, between family members. b) Demand Loans i) Defined. Gift loan or loan payable on demand, where interest payable on the loan is less than the applicable federal rate. “Gift” is the forgone interest. §7872(f)(5) and (3). ii) Tax Consequences. For each taxable year the loan is outstanding, the amount if interest that would have been payable if the interest rate had been the AFT is treated as if it had been transferred by the lender to the borrower and then retransferred to the lender as interest. §7872 (a)(1)(A)-(B). iii) Example (1) Employer Demand Loan (a) ER lends EE $100k payable on demand. (b) On last day of year, ER deemed to transfer $10,250 to EE (amount of interest that would have been due at 10% compounded semiannually). 10,250 is compensation income. (c) EE is then deemed to transfer the same amount to the ER, which is deductible to the EE if interest is deductible under §163 (perhaps business expenses, or investment deductions). (d) Result. Often the sums zero out, but employment taxes apply to additional compensation. (2) Gift Loan. Assume transfer above is between donor and donee. In that case, donor would have no deduction for the transfer of the gift, but would be taxable on the deemed interest income. Donee may be entitle to a deduction for deemed interest paid under §163, but may not be, for example, if the loan is used for personal purposes or if he does not itemize deductions. c) Term Loans. i) Defined. Term loan has a fixed maturity date. Below-market loan if amount loaned exceeds the present value of all payments to be made under the loan, using the AFR at the date the loan is entered into as the discount rate. If there is no interest, or if interest (stated or OID) is less than the AFR, the section applies. §7872(e). ii) Tax Consequences. On date of loan, lender treated as having transferred cash equal to the amount loaned over the present value of all payments required to be made Present becomes issue price of debt obligation, which is less than redemption price, creating OID. Borrower treated as paying interest at statutory rate for each accrual period. This results in income that is taxed to the lender on an economic accrual basis and, generally, in a deduction for the borrower. §7872 (b)(1) and (2). iii) Example (pp. 734). (1) Employer Term Loan (a) Facts. ER loans EE 100k to be repaid at end of three years. No stated interest, AFR is 10 percent compounded semiannually. (b) Tax Consequences. This is a below-market loan, so ER treated as if he loaned the EE 74,620 (i.e. the present value of the loan) and transferred 25,380 of additional compensation on the date of the loan. ER deducts and EE includes 25380 of additional compensation. (i) OID. Because issue price of the loan (PV) is less than redemption price, it is an OID. EE treated as if he paid to the ER interest each six months at the AFR. For first year, EE would be deemed to have paid 7650 in interest (which may be deductible) and ER is treated as if he received 7650 of interest income.
Tax Outline Prof. Billman Fall 2005 d) De minimis Exception. §7872 does not apply to loans less than $10k between individuals. §7872(c)(2). 7) Installment Sales (§453) a) Generally. Section 453 provides special rules for the disposition of property where at least one payment is to be received in a yare after the year of sale. Applies only to persons who are not dealers. Must have “adequately stated interest” for future payments. b) Framework. i) Applicability. (1) Trigger. Applies to “installment sales,” where “at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.” Does not apply to losses; only gains. §453(b)(1). (2) Election-out. TP can elect to opt-out of the installment method. §453(d)(1). (3) Exception. Inapplicable to sale of stock or other securities. §453(k). ii) “Installment Method” (Section 453(c)). (1) Formula. Reportable gain = Payments received in taxable year x “gross profit” ratio on “contract price” (a) Gross Profit Ratio = Gross Profit/Contract Price (i) Gross Profit = selling price – adjusted basis. (ii) Contract Price = total amount paid for property. (2) Example. (a) S sells Bacre to B (i) Basis = $200. (ii) Note = $500. Y1 = 100 (+ interest); Y2 = 150; Y3 = 250. (b) Gross Profit Ratio = 300/500 = 60% (i) Gross Profit = 300 (500 selling price – 200 AB) (ii) Contract Price = 500 (c) Yearly Breakdown – Apply gross profit ratio for each year. Year 1 Year 2 Payment 100 150 Basis 40 60 Taxable Gain 60 90 ****NOTE: Basis and Gain Equal Payments Received!! Year 3 250 100 150
(3) Interest. If there is no interest on the obligation or an insufficient amount of stated interest is payable annually, part of the principal will be redesignated as interest and taxed as accrued (see section above). §453A imposes an interest charge on the deferred tax liability on any sale where the sales price exceeds 150k and the TP has outstanding obligations that arose during the taxable year exceeding 5mll. see p 727.
Tax Outline Prof. Billman Fall 2005 iii) “Installment Method”: Mortgages. SEE MORE EXAMPLES, PP. 1209 of the CODE! (1) Not Payment. Payment does not include receipt of indebtedness of the person acquiring the property. “Qualifying indebtedness” is a mortgage or other encumberance on the property that the purchaser assumes or takes subject to as part of the acquisition cost of the property. Does not include indebtedness unrelated to the property. §15A.453-1(b)(2)(iv), (f)(4), (2) Gross Profit Ratio = Gross Profit/Contract Price (§1.453-4(c)) (a) Gross Profit = selling price (including mortgage assumed or taken) – adjusted basis (b) Contract Price = total amount paid for property + mortgage amount over basis. (3) Example 1. (a) S sells Bacre to B. (i) Basis = 200 (ii) Mtg = 100 (iii) FMV = 600 (b) Buyer (i) Assumes mtg. (ii) 500 note: Y2: 300, Y3: 200. (c) S’ Gross Profit Ratio = 400/500 = 80% (i) Gross Profit = Selling price of 600 (500 (amount paid) + 100 (mtg assumed)) – 200 (AB) = 400 (ii) Contract Price = 500 = 500 (no mtg because mtg (100) is less than basis (200)). (d) Yearly Breakdown. Year 1 Year 2 Qualified 100 (mtg) 0 Indebted. (mtg) Payment 100 (i.e. the mtg) 300 Basis 100 60 Gain 0 240 ****NOTE: Basis and Gain Equal Payments Received!! Year 3 0 200 40 160 Total 100 600 200 400
(4) Example 2 (Changes from 1 in bold) (a) S sells Bacre to B. (i) Basis = 200 (ii) Mtg = 250 (iii) FMV = 600 (b) Buyer (i) Assumes mtg. (ii) 350 note: Y2: 200, Y3: 150 (c) S’ Gross Profit Ratio = 400/500 = 100% (i) Gross Profit = Selling price of 600 (350 (paid) + 250 (mtg assumed)) – 200 (AB) = 400 (ii) Contract Price = 350 (amount of note) + 50 (amt over basis) = 400 Year 1 250 250 (mtg) 200 50 Year 2 0 200 0 200 Year 3 0 150 0 150 Total 250 600 200 400
Qualified Indebted. (mtg) Payment Basis Gain
Tax Outline Prof. Billman Fall 2005 Appendix Capital Gains Rates Type of Capital Asset Assets held for more than one year if otherwise taxable at 10% or 15% If TP is otherwise in the 15% bracket: (1) Assets held for one year or less, (2) gain to the extent of depreciation on real estate held for more than one year, and (3) gain on collectibles, and (4) gain on small business stock (§1202) after 50% exclusion If TP is otherwise in 15% bracket: (1) Assets held for one year or less, (2) gain to the extent of depreciation on real estate held for more than one year, (3) gain on collectibles, and (4) gain on small business stock (§1202) after 50% exclusion Assets held for more than one year if TP is otherwise taxable at 25% or higher rate Gain to the extent of depreciation on real estate held for more than one year if the TP is otherwise taxable at 25% or higher rate. If TP is otherwise taxable at 25% rate, (1) gain on collectibles and (2) gain on small business stock after 50% exclusion Gain on collectibles held for more than one year if the TP is otherwise taxable at a 28% or higher rate. Gain on small business stock after 50% exclusion if TP is otherwise taxable at a 28% or higher rate. Rate 5% 10%
15%
15% 25%
25%
28% 28%
Unit XV a) S sells Bacre to B. i) Basis = 400 ii) FMV = 711k? b) Buyer i) Pays: 1,011,000 ii) Down Payment: 100k iii) Note paid at end of 3 yrs. (1) Redemption price: 911k (2) No state interest c) S’ Gross Profit Ratio = 611/911 = 60% i) Gross Profit = 1,011,000 - 400000 = 611000 ii) Contract Price = 911000 + 100000 = 1011000 Year 1 171750 (100k + 71750) 103050 68700 Year 2 79104.375 47462.625 31641.75 Year 3 87212.5734375 52327.5440625 34885.029375 Total 338066 202840.1690625 135226.779375
Payment Basis Gain
OID - This is below-market because amount loaned (911k) is less than PV (700k). As if the seller loaned the buyer 700k and transferred 211k of additional funds. Have to include interest over period in income. Year 1: 700000 x .05 = 735000; 735000 x .05 = 771750 Year 2: 771750 x .05 = 810337.5; 810337.5 x .05 = 850854.375
Tax Outline Prof. Billman Fall 2005 Year 3: 850854.375 x .05 = 893397.09375; 893397.09375 x .05 = 938066.9484375