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Federal Income Tax – Outline
I. Introduction A. What is income? – based on a standard, not a definition B. How is tax law created? – this course is more about the underlying policy that gets us to the tax numbers C. Three characteristics 1. Equity – treats similarly situated taxpayers in the same way 2. Efficient – doesn’t unduly interfere with economy 3. Administrability – must be doable D. Purposes: 1. Can be manipulated to promote stability, encourage economic growth 2. Fair distribution of govt. burden 3. Protection of normal economic incentives E. Progressive tax – more you have, the more you are able to pay II. Characteristics of Income A. Intro 1. Why tax income? – no one has come up with better way 2. “Gross income means all income from whatever source derived” (§ 61) 3. Eisner – “gain derived from capital, from labor, or from both combined” 4. Glenshaw Glass – Congress implied no limitations, nor restrictions on its nature – “accession to wealth” B. Fringe Benefits 1. Meals and Lodging for Employees – (forced consumption rationale) a. Cannot deduct cost of personal, living, or family expenses (§ 262) – everyone could deduct them b. If services paid for in property, FMV must be included in income (Regs § 1.61-1(a)) c. Ex: employee takes salary of $40,000 + apartment & meals i. Employer doesn’t care – cost to him is the same, and employee is happy ii. Employee – thinks meals & apartment can’t really be income iii. If income means wages only, employee is better off – personal living expenses would be tax free iv. But it’s not fair to treat similarly situated taxpayers differently d. Ex 2: employer buys insurance policy for employee i. Employer pays $10,000 to insurer, policy fully vested ii. Purchase of life insurance isn’t deductible iii. Income for purchase year = $10,000 e. If meals and lodging for convenience of employer, excluded (Benaglia, p. 42) f. Follow-up: (§ 119) i. Meals and lodging must be on business premises of employer ii. Spouse and dependents included as well iii. Convenience = only way employee can do the job iv. Business premises (limits latitude of parties, reduces desirability) v. Meal = meals, not groceries – administrability g. Still a gray area – self-employed farmer incorporated farm, requiring himself to live there (J. Grant Farms) h. Section 162 – employer deducts expenses of doing business – employee outlays business expense, employer reimburses employee, employer deducts i. Valuation – FMV, but what about subjective value? – impossible to administer 2. Other Fringe Benefits a. Ubiquitous, next to impossible to capture value b. Taxpayer morale is important c. Section 132 (1984) – covers fringe benefits – Congress wanted to exclude all, but lobbyists won some d. Exclusionary treatment – people try it, and statute is silent – becomes a habit e. Avoids some administrative difficulties, but still some present
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i. If you can show that benefit lies in § 132, value doesn’t matter ii. If doesn’t fall in § 132, must value it f. Taxpayers gain strategic advantage – will take benefit in-kind, instead of cash g. Types: i. No-additional-cost service – excluded; for spouse, dependents, and parents (if airline) (a) (ex: flying standby at reduced cost) ii. Working condition fringe – anything provided to employee, if would be deductible business expense (a) (ex: executive flying to LA on corporate jet) iii. Qualified retirement planning – cannot discriminate (higher paid people have more bargaining power) iv. Employee discounts – can’t discriminate, can’t exceed employer’s normal markup (employer can’t take a loss, then deduct it, while employee’s benefit is excluded) v. De minimis fringe – costly to administer, businesses will police themselves (a) (ex: paying cost of evening meal, if working late) vi. Qualified transportation fringe – commuter highway vehicle, transit pass, parking (a) Limits: transport & transit pass = $100, parking = $175 (b) No constructive receipt applied – allows employer to offer free parking or $ h. Conceptualization: concentric circles i. Section 132 – work-related perks (a) Mostly no cash option; employee has no room to bargain ii. Cafeteria plans (§ 125) – value depends upon state in life – can take benefits or cash – no constructive receipt (a) Life insurance – transforms non-deductible personal expense into excluded income (b) Health-care coverage (§ 104-6) (c) Deferred comp arrangements (d) Qualified legal services programs (§ 120) (e) Dependent care expenses (§ 129) iii. Other benefits: (a) Educational assistance for employees (§ 127) – generally personal expenses (b) Adoption assistance programs (§ 137) C. Valuation 1. Prizes and awards are specifically included in income (§ 74) 2. Determining value of income is difficult 3. Courts inclined to split the difference between Commissioner and taxpayer a. (cruise tickets, retailed at $2220, Turners reported $520, court ruled $1400 – Turner, p. 59) 4. Complication – prizes that have huge subjective valuation (Extreme Personal Makeover, etc) 5. Finding property a. Historic home run balls – not taxed until sale, because of valuation problem b. Cash – immediate inclusion c. Property – more difficult, depending upon type D. Imputed Income 1. Benefit that flows from ownership of goods/services for taxpayer’s own use 2. Ex: home ownership – homeowners don’t have to report value that owning home gains them 3. Applies to ownership of almost any good, and to personal services 4. Argument can be made for including most in income, but Congress has never touched any of it 5. Applies to taxpayer’s family also, but concept of family is changing 6. Dividing line: whether activity is being done for personal or business reasons 7. Drawing the line a. Neighbors casually exchange services – income, but IRS won’t pursue b. Barter club – market for services – bad idea c. Landlord gets artwork for 6 months free apartment – long-term arrangement – risky
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8. RULE: As activity gets more profit-seeking, commercial, regular, and long-term, more risky 9. Part of tax gap is attributable to bartering activity E. Windfalls and Gifts 1. Punitive Damages a. Money received as punitive damages is income i. Glenshaw Glass, p. 69 – claim arose out of antitrust – Congress intended to create incentive for private suits, but taxing awards reduces this b. Income standard: undeniable accession to wealth, clearly realized, over which TP has dominion 2. Basic Gift Concept a. Gifts are excluded from income, but no deduction allowed either (§ 102) 3. Defining Gifts a. Man receiving Cadillac from business associate = income; but manager receiving final payments upon leaving = gift (Duberstein, p. 74) b. Test = detached and disinterested generosity c. Quid pro quo dooms the transaction d. Employer-employee transfers are not excludable as gifts (§ 102(c)) e. Businesses can give gifts, but only deductible up to $25 (§ 274(b)) f. Tips – without transferor focus, seems appropriate to call them income g. Factual determinations important regarding transferor’s state of mind (intent) i. Ex: Man transferred $500k to sisters; letters admissible to establish their state of mind regarding money (Harris, p. 82) ii. Viewpoint of third party matters: relationship between parties, future relations, circumstances, etc 4. Applications a. Tips – appropriate to treat as income b. Surviving spouses – generally successful for exclusion, while companies usually can deduct c. Prizes, awards, etc. – § 74 and § 117 – inclusion for prizes and scholarships in excess of tuition d. Bequests – excluded e. Regularity cuts against gift status 5. Transfer of Unrealized Gain by Gift While Donor is Alive (HANDOUT 1) a. Basis – allows for recovery of capital; limits concept of gift b. TP only has to report gain when a taxable event occurs c. § 1001, 1011, 1012, 1015: i. Gain = Amount Realized – Adjusted Basis ii. Amount Realized = amount realized from sale or other disposition iii. Adjusted Basis = cost of such property d. Other Disposition i. Transfer in which there is exchange of consideration ii. Without consideration, § 1001 not triggered e. Congress can require succeeding owner to assume place of predecessor for taxation i. A bought 100 shares for $1000, gave to B when FMV is $2000; B sells shares for $5000, has gain of $4000 (Taft, p. 95) f. Rules for basis: i. Purchase – § 1012 – cost ii. Gift – § 1015 – carry-over from donor; but if basis > FMV on gift date, basis for determining loss is FMV iii. Death – § 1014 – FMV on date of death g. Death of owner i. Allows step up in basis – pre-mortem appreciation escapes taxation ii. § 1014(e) – if donor gets back what he gave to decedent, basis = original basis 6. Gifts of Divided Interests a. Rule: basis allocation goes entirely to remaindermen
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b. Ex: trust setup for child; son-in-law gets $5k annually for child’s care – annual payments are income 7. Limits – gift tax a. $11,000, per individual, annually – exempt from gift tax b. $1 million available credit for gift tax F. Recovery of Capital 1. Intro a. Difficult to allocate basis among some property b. Real property – expert appraiser can determine allocation properly c. Chattels – difficult to do d. Natural resources – rules allow for deduction while depleting resources (§ 611) 2. Sale of Easements a. For sale of indeterminate easement, Service must wait for a future event to account for it i. Ex: landowner realized gain from City’s settling damages claim, but gets to defer (Inaia, p. 106) b. Computation of gain or loss – § 1001 i. Adjustments to basis shall be made for receipts properly chargeable to capital account (§ 1016) 3. Life Insurance, Annuities, Pensions a. Insurance i. Premiums not deductible – capital investment in the policy ii. If policy pays out, would expect premium recovery excluded from income iii. § 101(a) – proceeds of life insurance, paid because of death – tax-free (forgiveness of tax) iv. Mortality gain / loss (a) Gain – if PH dies prematurely (b) Loss – if PH does not die within time v. Fringe benefit (a) Employee – allocable premiums – excluded – § 79 (up to $50k of coverage) (b) Employer – deduct cost of group policies – § 162 (business expenses) (c) Beneficiary – proceeds excluded – § 101 vi. Limitations: (a) Tax-free loans limited (b) Policies on lives of executives limited (§ 264(a)(1)) (c) Policies purchased for investments – ended vii. Exclusion from income not available, if policy acquired for valuable consideration viii. PH can cash in policy tax-free, if mortally ill & should die within a year (§ 101(g)) b. Annuities and Pensions i. Annuity – agreement for II to pay annual sum to annuitant, in return for payment of consideration ii. Deferral of tax, until annuitant gets payments iii. Difficult to determine how much capital is recovered each year: (a) Investment-first – TP favors (b) Income-first – pro-Service (c) Arbitrary rule – “exclusion ratio” – § 72 – every payment is allocated 4. Gains and Losses from Gambling a. Wager amounts can be thought of as capital b. Successful gambler will want to recover payments before accounting for gain c. § 165 – controls deduction of all losses d. (d) – wagering losses – only allowed to extent of gain from wagering e. What constitutes wagering gain / loss? – comps? 5. Recovery of Loss (HANDOUT 2) a. Being made whole by having erroneous tax liability repaid by preparer is not income (Clark, p. 120) i. Ordinary refund by Treasury != income ii. Overpayment was loss of TP’s “capital” – TP is being made whole b. Clark’s Resolution:
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i. Preparer failed to file spouses separately, since CA is community property state (lowering taxes) ii. Without a separate rate structure for married filing jointly, single TPs (wherever located) and married TPs (in CL states) would have tax DISADVANTAGE compared to married couples in community property states iii. 1984 – Congress created “married filing jointly,” which removed disadvantage for CL married couples – since most couples had single wage earner, resulted in “marriage bonus” iv. However, with rise in two wage earners, this creates “marriage penalty” v. Generally: if incomes equal, penalty; if incomes disparate, bonus G. Annual Accounting 1. Tax system does not take a transactional approach – uses tax year concept 2. Use of Hindsight a. Company experienced losses in several years, then later recoups money; recovery taxable in year received (Sanford & Brooks, p. 125) b. § 172 – can save Net Operating Losses and carry them to other years (2 back, 20 forward) i. If you get to $0 AGI, stop – don’t get to personal items 3. Claim of Right a. Income is taxable in year where TP has a right to the money (North American Oil, p. 130 – getting money from receiver) b. If TP has to pay back money that was reported in income, cannot re-open return, if you reported what appeared to be the facts (Lewis, p. 133) c. § 1341 – if amount is over $3000 i. TP pays lesser of: tax in current year, with deduction OR tax in later year, without deduction, but reduced by earlier year’s tax attributable to item 4. Tax Benefit Rule a. TP deducts in one year, then recovers deducted property in a later year b. If there has been a benefit, it must be repaid (Alice Phelan, p. 138) c. Exclusionary rule (§ 111) – if deduction didn’t help tax-wise, nothing to report H. Recoveries for Personal and Business Injuries 1. Look if case sounds in contract or tort a. If contract, recovery goes into base b. If for damage to property, can recover basis 2. § 104(a)(2) – physical injury a. Compensatory components – excluded b. Punitive damages – included 3. Medical expenses a. Exclusion unavailable to extent expenses have been deducted b. Must meet certain minimum to deduct (§ 213) 4. Reach – dignitary torts were leaning toward exclusion, but Congress included explicitly 5. Deferred payments & structure settlements – desirable – interest component comes tax-free I. Transactions Involving Loans/Debt 1. Loan proceeds are not income a. Doesn’t increase net worth, because of obligation to pay b. Recourse – personally liable for loan; Non-recourse – only liable to extent of collateral c. Gain from foreign currency inflation = income (Kerbaugh-Empire, hp. 47) d. Corporation paying income taxes for executive = income (Old Colony, hp. 49) i. Code contemplates that federal income taxes are paid out of TP’s after-tax income (§ 275) 2. Discharge of Indebtedness a. If TP repays less than is required, releasing obligation to pay, gain is income b. Ex: company issued bonds, then bought some back at discounted rates = taxable gain (Kirby Lumber, p. 146) 3. Relief Provision
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a. § 108(b) – holds insolvent / bankrupt people harmless b. But if TP can absorb some of this later, must do it c. Student loan forgiveness – excluded, if working for charitable / educational institution 4. Misconceived Discharge Theory a. X borrows from parents, they forgive loan – gift b. Poker player settling debt with casino falls under contested liability, not discharge of debt (Zarin, p. 149) i. Tax Court – chips represented true loan – TP expected to repay them, esp. if he won c. Requiring donee to pay gift tax on gift is discharging tax debt of donor (Diedrich, p. 158) 5. Transfer of Property Subject to Debt (HANDOUT 3) a. Looking at TP who owns “durable” property, acquired through “purchase money mortgage” b. Use important – property used in trade or business, or held for production of income c. TP can deduct expenses in carrying out trade/business (§ 162), but not personal expenses (§ 262) i. Must “capitalize” property used for > 1 year (§ 263) ii. Wasting asset – has a determinable useful life iii. Method of allocation – straightline, declining balance iv. Allowed reasonable depreciation deduction for wear & tear (§ 167(a)) v. Computation of depreciation (§ 168) (a) Useful life, determined by categories (§ 168c) (b) Method (§ 168b) – 200% declining, 150% declining, straightline (TP chooses) vi. Gain from disposal = ordinary income (a) Depreciation shelters income that would’ve otherwise been ordinary (b) Capital assets (§ 1221) – excludes property used in trade/business, subject to depreciation (a)(2) (c) Quasi-capital assets (§ 1231) – gains/losses from depreciable property in trade/business (1) Gain = capital (2) Loss = ordinary d. Amount realized by seller of mortgaged property includes cash AND face amount of mortgage i. Symmetry – if nonrecourse mortgage included in basis for depreciation (cost), unpaid balance of mortgage must be included to determine AR ii. (Crane, p. 164 – inherited from husband, non-recourse mortgage – took depreciation) iii. Adjusted basis ALSO includes mortgage amount at acquisition iv. (Parker, hp. 309 – AR includes mortgage balance, even without cash receipt) v. Magruder rule (dissent in Parker) – include borrowed funds in basis only to extent of principal actually repaid vi. Without Crane, depreciation would be limited to cash basis, not allowing deferral of income vii. Comparison: (a) Ideally – taxable income starts high and slowly goes down (b) Crane – goes in opposite direction (low – high) (c) Magruder – goes in right direction – but downward progression is too steep e. At-risk and passive loss limitations i. Amount of deductible loss restricted to amount of TP’s economic investment (§ 465) (a) Borrowed funds are “at risk” if TP is personally liable or secured by personal assets (b) Initially, only applied to non-real estate, but Congress extended to all but third-party real estate financing ii. Any activity without “material” participation (rental activity, etc) is in basket (§ 469) (a) Material = regular, continuous, substantial (§ 469(h)) (b) Dividend income = earned income, not passive f. Mortgage value included in AR, even if FMV < mortgage (Tufts, p. 172 – apt complex lost money) i. Rationale – TPs included loan in basis “on understanding” that they had to repay full amount – with obligation relieved, they realized full loan amount – FMV of property becomes irrelevant ii. O’Connor – two transactions: sale, cancellation of debt – ordinary income, not capital gain
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iii. FMV is relevant for “cost” at time of acquisition, but irrelevant at time of disposition (symmetry) III. Problems of Timing A. Illegal Income 1. Taxable – “from whatever source derived” (§ 61) 2. Embezzled funds can constitute income (James), but not if clear intent to repay (Gilbert, p. 179 – executed promissory notes & assigned property as security) 3. But stolen funds have two competitors: Service wants taxes, but victim needs to be made whole 4. Illegal business expenses are deductible B. Gains on Home Sale 1. Depreciation only allowed for property used in trade/business or in pursuit of income 2. Homeowners hope to sell at a gain – treated as capital gain, but loss is nondeductible (personal) 3. Gain excluded, if lived there at least 2 years in 5 year period preceding sale (§ 121) a. Limit = $250k, or $500k for joint return (§ 121(b)(1)) b. Can be pro-rated, if lived there less than 2 years 4. Service might recast transaction, if it is profit-oriented 5. Special rules for hardship: deceased spouse, divorce, involuntary conversions C. Gains and Losses 1. Realization & Recognition a. § 1001 b. Realization – point at which you determine gain/loss has accrued to TP c. Unless something else happens, realized gain/loss is recognized d. Specific provisions say non-recognition in some cases e. Unrealized appreciation is not taxed (no cash, no change in investment, difficult administration) f. Must have a taxable event to make TP account for gain/loss g. § 1001 – look for “sale or other disposition of the property” h. Found property – accession to wealth, not same problem as unrealized appreciation 2. Stock dividend is not a recognized gain (Eisner, p. 192) a. Continuum – stock split cash dividend b. Stock dividend is more like a stock split: no cash option, didn’t enrich TP c. Congress specifically excludes stock dividends (§ 305(a)) d. But dividend is taxable if TP has option to take cash or other property (§ 305(b)) 3. Tenant building on landlord’s property = realized gain, when lease terminates (Bruun, p. 204) a. Building’s useful life would expire before end of lease b. But tenant defaulted while building still useful c. TP has clear gain, even though it’s not severed from the land d. Can have gain without having cash, even though TP not happy e. BUT gross income doesn’t include improvements made by T under lease (§ 109) i. Doesn’t apply to rent payments, made with property improvements ii. Deferral only, not forgiveness D. Nonrecourse Borrowing 1. Mortgage on appreciated property will be accounted for at sale (Woodsam, p. 209) a. Facts – W argued for realization at mortgage, since that year was closed – Service avoided whipsaw b. Treats recourse and non-recourse borrowers the same – administratively preferable c. Mortgage is not a “disposition” which produces a taxable gain d. Subsequent borrowing represents untaxed property appreciation and is not included in basis 2. Use of borrowed funds can be important, but don’t care about personal liability a. Borrowing without investment – no adjustment to basis b. Borrowing with re-investment – adjust basis! E. Losses 1. Background a. S&L organizations were everywhere
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b. Low-interest mortgages proliferated c. Interest rates shot up d. S&L’s exchanged mortgages, generating paper losses e. FHLBB – this isn’t a disposition for regulatory purposes – no loss 2. Portfolios of mortgages exchanged are different enough to constitute realization (Cottage Savings, p. 213) a. It is enough that different properties secure the loans b. Threshold set very low 3. TPs want to be able to take losses, but also want to be able to exchange things without incurring gain F. Nonrecognition Provisions 1. Three categories: a. Continuity-of-investment (gains/losses) – like-kind exchanges, corporate mergers b. Hardship situations (gains) – leasehold terminations, involuntary conversions c. Tax-avoidance “schemes” (losses) – wash sales, sales between family members 2. Code provisions: stock (1032), involuntary conversion (1033), lock-in effect at death 3. Like-kind exchanges (§ 1031) a. Must exchange property held for investment or productive use for property in like kind b. Doesn’t include all property – explicitly excludes: inventory, stock in trade, partnership interests c. Gives relief for lock-in effect, where TP needs to reconfigure holdings d. Deferral, not forgiveness e. Applies only to exchanges, not sales (§ 1031(a)) 4. Revenue Ruling 82-166 – swapping gold for silver – recognizable, since property is different a. TP wants to get gain under § 1032 to defer recognition b. Regs § 1.1031(a)-2 – non-recognition doesn’t apply for property of different kind – look beyond TP’s intent to underlying transaction c. BUT, general asset classes (2(b)(2)) allow computer for printer exchange to fit under § 1031 5. Sale-and-leaseback transaction doesn’t fall under § 1031 – gain/loss = recognized (Jordan Marsh, p. 225) a. Regs said that long-term leasehold = fee interest – but that surely contemplated different properties b. JM took leaseback on its original property – seeking to claim a tax loss – court allowed c. But isn’t this an alternative route to mortgaging property? (which doesn’t recognize gain/loss) 6. Deferred exchanges = non-recognition, if replacement shown in 45 days and received in 180 (§ 1031(a)(3)) 7. Involuntary conversions (§ 1033) a. If exchange, mandatory non-recognition b. If sale and re-investment in “similar or related in service or use,” TP can choose to report or not 8. Boot and Basis (HANDOUTS 4 and 5) a. Boot = $ and/or property that is part of exchange, but not of like-kind (throw in, “to boot”) b. Separate qualifying property from non-qualifying property – based on § 1031 c. If boot present, gain is recognized, but not in excess of boot (§ 1031(b)) i. But loss is not recognized (§ 1031(c)) d. Basis = basis in property exchanged – cash received + gain recognized – loss recognized (§ 1031(d)) i. Allocate between property other than cash, using FMV of boot first e. Giving boot qualifies under 1031 (Regs § 1.1031(a)-2) i. If boot paid, it becomes part of basis in qualifying property 9. Examine situation one TP at a time 10. Time constraints – must be completed within 180 days (§ 1031(a)(3)) G. Recognition of Losses 1. Losses occur over time – TP with property of declining value is aware of this 2. Must have a defining moment (taxable event) to deduct a loss – sever any possibility for future gain 3. Loss must be “fixed by identifiable events” and sustained during tax year (§ 165(a)) H. Open Transactions 1. Transactions sometimes do not have clear closing point a. If gain, TP will argue for not closing, to defer gain
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b. If loss, TP will want to close it and take loss 2. When amount to be received is speculative, transaction is open & basis recouped before reporting gain a. (Logan, p. 244 – TP had high basis, received less in cash + future payments from mine – open) 3. Commissioner presses to put a value to Amount Realized – correct to press for closed transactions 4. Original Issue Discount – rules to make bond-holders account for interest each year 5. When obligation stretches over time, increased value = appreciation + forbearance a. Seller is compensated for declining to demand entire payment up front b. Appreciation can be appropriately treated as capital gain c. But payment for forbearance is interest, which is ordinary income I. Constructive Receipt 1. Basic Principles a. Limit to cash basis doctrine (= must report when right to receive is in hand) b. Different from economic benefit c. Applies when TP has choice of receiving income in particular year or delaying d. If bona fide contract & TP has no right to receive payment, no constructive receipt i. (Amend, p. 251 – wheat seller had longstanding business practice & good business reasons) ii. Now, sale of wheat is installment sale (§ 453(b)(1)) but can opt out (d) (a) If no opt out, report entire gain in year received 100% of purchase price (b) If opted out, report FMV of obligation in year wheat sold e. Money set aside, beyond reach of creditors of transferor = constructive receipt i. (Pulsifer, p. 256 – TP won horserace, money put in trust fund for children – even if father could collect, economic benefit kicks in) f. Economic detriment – transferor loses use of funds – require symmetry by transferee 2. Retirement Benefits: Early Case Law a. TPs attempt to end-run constructive receipt & economic benefit b. Annuity irrevocably set aside for TP = income – right to receive payments, death benefits, could realize cash by having someone hold in trust i. (Drescher, p. 257 – corp. purchases $5000 annuity for manager, giving $50k at retirement) ii. No obligation to account for annuity interest (§ 72) iii. When policy pays out, split between recovery of basis & amount received (exclusion ratio) c. If money set aside for benefit of employee, out of control of employer, TP accountable (Ruling 60-31) d. Trick = put money out of control of transferor, but not within reach of transferee 3. Deferred Compensation a. Can form corp., setting aside fees; setup trust with employees = trustees, corp. = beneficiary (Minor, p. 266) i. Economic benefit – no – not set aside of funds ii. Constructive receipt – no option for TPs to collect iii. Greater risk of attribution – TP has a lot of exposure iv. Downsides: amounts not deductible by employer, risky (but closed corp., so employees know risk) v. No restructuring, if you follow the menu vi. Because corp. is beneficiary of trust, no deduction available at transfer for corp. – but can deduct when transfer made to TP b. Bad example – give interest free loan, deducting payment each year, forgiving annual amount due (AlHakim, p. 272 – this is a loan, not payment of fee) i. § 7872 – if loan has below market interest rate = imputed income c. (II issued annuities in lieu of future commissions to agents – tax payments as received – this is novation, change in terms of contract – Olmstead, p. 274) 4. Qualified Employee Plans a. Depart from Rev Ruling 60-31 (reverses outcome, if use Code rules) i. Accounts can be funded w/out immediate employee liability ii. Employer gets immediate deduction
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b. Two types: defined benefit plans, defined contribution plans c. Q: Is this really desirable across the board? d. Characteristics: i. Employee not taxed when benefits earned, but when received ii. Employer can deduct contributions currently iii. Inside building is protected as it accrues e. Downside: non-discrimination rules apply here – less attractive for highly paid employees f. Vesting requirements must be met to be qualified g. Difficulties: w/out plan, employees get no benefit; smaller employers = expensive; part-time = $0 h. Policy: Should there be mandatory retirement plans? Is this the best way? J. Transfers Incident to Marriage and Divorce 1. Three separate strands: a. Property settlement i. Divide marital wealth ii. Not taxable to transferee or transferor iii. Income tax and transfer tax free b. Alimony i. Provide income maintenance to needy ii. Payor – deduct iii. Payee – taxed c. Child support i. Payor – NO deduction ii. Payee – NOT taxed 2. Property Settlement a. Old rule – transfer from H to W incident to divorce = recognition event triggering taxation i. Consideration = wife giving up marital rights in exchange for property ii. Not a gift, since no affection, love, or charitable incentive iii. (Davis, p. 298 – H transferred stock to wife, as part of divorce – tax stock on transfer) b. NEW = § 1041 – no gain/loss recognized to either H or W, if transfer incident to divorce i. § 1041(c) – if w/in one year of marriage, OR related to cessation of marriage ii. Transferee takes transferor’s basis iii. Not forgiveness, but deferral of taxation iv. Trumps economic benefit v. Allows transfer of loss (can’t usually do this) vi. When property transferred, period transferee owns such property includes period transferor owned the property (§ 121(d)(3)(A)) c. Common Law State Couples i. Important to look at title of property ii. Joint tenants w/ right of survivorship – division among co-owners – each takes ½ - no tax consequence iii. Tenants in the entirety – each owns indivisible part of the whole – no tax consequence iv. In community property state, can divide without § 1041 – if you take no more than you already had d. Timing is critical – if not married, § 1041 doesn’t apply i. (Farid-Es-Sultaneh, p. 303 – H gave stock to future W, get divorced, W sells – transfer = sale for income tax, but gift for gift tax (promise to marry isn’t consideration)) 3. Alimony (HANDOUT 7) a. Payor = deduct; payee = taxed b. Conditions: i. Must be cash (§ 71(b)(1)) ii. Must be received under “instrument” of divorce or separate maintenance (§§ 71(b)(1)(A), 71(b)(2)) iii. Must not have agreed that payments are nontaxable and nondeductible
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iv. Must not be members of same household (§ 71(b)(1(C)) v. Cannot continue after death of payee spouse (§ 71(b)(1)(D)) vi. Must not be for child support (§ 71(c)) vii. Only payments that are substantially equal for first 3 years are alimony (§ 71(f)) – distinguishes between “property settlements” and regular support payments (a) If payments are “front-loaded,” some portion of amount paid is not treated as alimony (b) Payments treated as alimony, but excess amounts are “recaptured” in third year c. Above the line deduction 4. Child Support a. Payor – no deduct; payee – no inclusion b. If custodial parent must make up for defaulting non-custodial parent, no bad debt deduction (DiezArguelles, p. 311) c. Usually person with custody can claim as dependent i. But non-custodial parent can get dependency deduction, if parties agree (§ 152(e)) IV. Personal Deductions, Exemptions, and Credits A. Personal Deductions 1. Intro a. Gross income doesn’t constitute tax base – narrowing of base comes through deductions & exemptions b. Formula: (HANDOUT 8) i. Gross Income ii. – § 62 deductions (trade/business, employee trade/business, retirement savings, alimony, moving) iii. = Adjusted Gross Income iv. – (§ 63 deductions (standard (63(c)) or itemized) + personal exemptions (§ 151)) v. = Taxable Income vi. TI * marginal rate = tentative tax liability vii. – Credits viii. = Tax Liability c. Above line = § 62; below line = § 63 d. Itemized deductions i. Medical expenses (if > 7.5% of AGI) ii. Casualty losses (if > 10% of AGI) iii. Interest iv. Misc. business deductions (2% floor) v. Charitable deductions e. Rationales for deductions differ i. Interest – mortgage, student loans, investing – differ ii. Casualty losses / medical expenses – both have thresholds, will cause disruption in income iii. Mortgage interest = inverted subsidy – the more you make, more value you get 2. Casualty Losses a. Losses from “fire, storm, shipwreck, or other casualty, or from theft” (§ 165(c)(3)) b. Not absolute, since it is qualified c. Amount lost must exceed $100 d. Overall, net casualty losses must exceed 10% of AGI e. Suddenness requirement – lots of litigation (no: dry rot, termites; yes: certain loss of rings) f. Cat having a “fit” and breaking a vase – not deductible (Dyer, p. 339) g. Look to cause of the loss – can’t deduct cost of car repair, if no II claim (§ 165(h)(4)(E)) h. Loss must be real, permanent, and physical i. (OJ’s neighbor couldn’t deduct loss in market value, due to media attention – Chamales, p. 341) i. Might not get casualty loss, if would violate public policy i. (TP grossly negligent in starting fire; allowing deduction would violate policy against arson & domestic violence – but this punishes Mrs. B also – Blackman, p. 348)
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3. Medical Expenses (§ 213) a. Deductible, to extent not reimbursed, and exceed 7.5% of AGI b. Diagnosis, cure, or mitigating treatment, but not preventive treatment c. Both cosmetics & life-saving surgery included d. Available without limit, regardless of circumstances that put person here e. Can deduct cost of weight loss surgery, but not fitness club f. Western-oriented – non-western methods are sketchy for deduction B. Charitable Deductions 1. Intro a. From inception, Code provided deduction for gifts to charity (§ 170) – individual & corp. b. Any “charitable contribution … payment of which is made within taxable year” (§ 170(a)(1)) c. “contribution or gift to or for the use of” eligible donees (§ 170(c)) d. Need absence of quid pro quo e. Limits: i. Corp. – 10% of income in given year (§ 170(b)(2)) ii. Individuals – limited to 50% of contribution base (lowers depending upon property type & entity) iii. Can carryover excess contributions for 5 years f. Exempt organizations controlled by Subchapter F – not perfectly parallel to § 501(c)(3) 2. Policy a. Grassroots individuals best able to identify needs b. If deductible, need arguably is govt. job c. Continuum – altruism --- church --- tithing --- benefit d. Only 25% of people itemize – people would still donate – but entities need large “leadership” gifts 3. Requirements: qualifying recipient, contribution (not payment), limited to cash or qualified property 4. Private benefits a. Deduction = “Donation” (payment) – Private Benefit b. If facts show substantial benefit to contributor, deduction denied i. (co. donated land, increasing value by getting access roads – denied – Ottawa Silica, p. 363) c. Collegiate athletics – contributor can deduct 80% of total amount paid for tickets (§ 170(1)) d. If contribution over $75, charity must provide written statement that donor must estimate goods received in good faith (§ 6115) e. Solicitor must tell contributor FMV of “gift” f. Psychic returns – building named after you – deductible 5. Voluntariness – deduction denied, if payments not voluntary a. (TP donated, instead of going to prison – Lombardo, p. 370) 6. Religious a. “pew rents, building fund assessment, and periodic dues to church… are deductible” (Rev. Rul. 70-47) b. Amounts paid for “training” and “auditing” to Scientology Church not deductible (Hernandez, p. 369) c. Can’t deduct payments for tuition, even portion allocated for religious instruction (Skylar, p. 370) 7. Valuation a. If property value > $5k, donor must obtain qualified appraisal & attach signed summary to return b. If deduct anything > $250, must substantiate w/ written acknowledgement by donee (§ 170(f)(8)) i. Donee organization can file form with IRS instead (§ 170(f)(8)(D)) 8. What is charitable? a. To be exempt, org must conform to “notion” of charity – can’t violate public policy i. (Racially discriminatory admission – violates public policy – not tax exempt – Bob Jones U, p. 371) C. Interest 1. General rule – deductibility applies only to business/investment income (§ 163(a)) – basket (§ 163(d)) 2. Limits: a. Individual – if not business/investment, but personal interest – § 163(h) 3. Mortgages (h)(3)(A)(i) – includes principal residence & 2nd home – capped at $1 million (h)(3)(B)(ii)
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4. Home equity (h)(3)(A)(ii) – limited to $100k (h)(3)(C)(ii) 5. Commission’s Report – reduce mortgage interest deduction, convert to 15% credit 6. Student loan interest – deductible, but limits on interest & income you can make 7. Tracing a. Deduction disallowed if funds used for tax-exempt purchase b. Can deduct interest if you buy car from savings, then borrow for business c. If buy tax-exempt instrument, interest not deductible (§ 265(a)(2)) D. Credits 1. Tax Liability = Taxable Income – Credits 2. Dollar for dollar reduction in tax liability 3. Child Care Credit (§ 24) a. Allows $500 credit for each dependent child < 17 b. Credit reduced by $50, as income rises every $1000 over thresholds 4. Earned Income Credit (§ 32) a. Percentage of earned income up to specified level b. Having up to 2 children increases credits c. Only “refundable” credit – resulting in payments from govt. 5. Credit for Elderly and Disabled (§ 22) 6. Credit for Adoption Expenses (§ 23) V. Allowances for Mixed Business and Personal Outlays A. Mixed Business/Personal 1. Spectrum a. TPs seek to characterize personal outlay as outlay for trade/business b. Transformation – use home equity line to deduct interest for purchases of personal nature c. Trade/business – above the line (moving from Gross Income to AGI) d. § 212 – below the line (moving from AGI to Taxable Income) 2. Below the line – why significant? a. § 67 – 2% floor applied if moving from AGI to Taxable Income b. Applies to § 212 (income producing expenses) c. Self-employed – above the line d. Employee – below the line 3. Approaches: a. Inherently personal – no deduction – child care (§ 121) – generally (§ 262) b. More expensive, due to business – deduct excess cost (subject to § 274 limits) c. Allocate (§ 280A – vacation homes) d. Primarily business (§ 162 / § 212) – if personal is mere byproduct, full deduction allowed B. Hobbies 1. § 183 a. Hobby = activity NOT engaged in for profit – not deductible b. Basket – income sheltered by expenses, but subject to 2% floor (§ 183(b)) 2. Primary purpose doctrine (§ 162) a. Must have intent to turn a profit, but doesn’t have to be reasonable intent b. Any losses from trade/business can be used to offset other gains c. Presumption – § 162 applies if there is profit in 3 out of 5 years 3. Factors: (Regs § 1.183-2(b)(1)-(9)) a. Manner in which TP carries on activity b. Expertise of TP or his advisors c. Time and effort expended by TP in carrying on activity d. Expectation that assets used in activity may appreciate e. Success of TP in carrying on other similar or dissimilar activities f. TP’s history of income or losses with respect to activity
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g. Amount of occasional profits, if any, which are earned h. Financial status of TP i. Elements of personal pleasure or recreation 4. (Possible to have more than one trade/business – farming on weekends sufficient, if concrete plan – Nickerson, p. 391) 5. Passive activity rules (§ 469) a. Definition – any activity which involves conduct of trade/business without material participation i. Includes rental activity ii. Measured by level of participation b. Basket – if applies, activity’s gains/losses can only be offset against one another c. Losses can be carried over d. Passive = minimal, if any, involvement e. Material = regular, continuous, and substantial participation 6. Jump from personal to trade/business – regularity – look for profit-oriented C. Homes & Offices 1. Rule: § 280A a. Home Offices i. Except as provided, can’t deduct use of dwelling unit which is used by TP during year as residence ii. Exceptions: (a) If you have deduction under § 163 (interest),4,5 then § 280A doesn’t apply (b) (b) Exclusively used on regular basis as principal place of business (c)(1)(A) (c) Out building, if used for business (c)(1)(C) iii. Goal – limit ability of TP to carve out part of home & deduct nondeductible expense b. Vacation Homes i. Goal – allow TP to deduct if he makes minimal use of vacation home (a) Hold TP harmless for incidental income – too difficult to administer (b) Transform nondeductible items into deductions for TPs that meet requirements ii. As long as don’t use it for more than proscribed period, deductions for using it as income-producing property are available iii. Depreciation available, if investment property iv. Four possible treatments (a) No personal use of property at all (1) Property held for production of income (2) Deductions – without limit (b) Some personal use that exceeds some limits, but incidental (< 14 days) (1) No § 162 deductions (trade/business) (2) However, don’t report rent as income (c) Personal use less than time specified in statute (1) Can take § 162 deductions, but pro-rated (2) Must tease out personal use – whatever left is deductible (3) Deductions for taxes (§ 164) & interest (§ 163) still allowed (pro-rate) (d) Personal use is more than specified time (1) Able to take some deductions under § 162 (2) Deductions denied for that portion used for personal use v. Continuum (a) Purely personal use (1) No deductions under § 162 (2) No income (b) Incidental rental (< 15 days) (1) No deductions under § 162 (2) No income
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(c) Excessive personal use (1) Rental income absorbs all deductions, including § 163 and § 164 (2) By “absorbs,” we mean that the deductions apply against that income (d) Permissible personal use (1) Itemized deductions remain deductible (2) Income absorbs § 162 and § 167 items (3) Upshot is more in terms of deductions when using property within personal limits rather than excessively (e) No personal use (1) All business-related deductions available 2. Office test = relative importance + amount of time a. (Pro musician practiced daily in home & did recording there – office deduction – Popov, p. 401) 3. To qualify for § 280A home office, must first qualify for § 162 trade/business a. (Couple with rooms exclusively for managing investments – investors, so not in trade/business – not deductible as home office – Moller, p. 406) b. Distinguish traders (are in trade/business) vs. investors (not in trade/business) i. Trader – one whose profits derived from the “direct management of purchasing and selling” (a) Short-term trading + income principally from sale of securities, not dividends or interest ii. Investor – long-term view iii. Factors: (a) Investment intent (b) Nature of income to be derived (c) Frequency, extent, and regularity of transactions 4. (Wheel of Fortune player, tried to characterize as gambling expenses (§ 165(d)) – should be under § 212, but subject to 2% threshold – Whitten, p. 413) 5. Need essential nexus between expenses and carrying on of trade/business a. (TP buys plant & picture for office – personal expenses, nondeductible – Henderson, p. 416) b. Employee expenses i. If employee anticipates reimbursement – TP can deduct cost to him, above the line ii. If no arrangement with employer – below the line, subject to 2% threshold (misc. itemized deduction) c. Parking space – no deduction – falls under § 262 (personal & living expense) 6. If employee acquires property, business use requirement not met unless use is “for the convenience of the employer and required as a condition of employment” (§ 280F(d)(3)) D. Travel & Entertainment 1. Intro a. Assumption that entertainment can be appropriate part of business (relationship building) b. Also satisfies personal needs (food, travel, lodging) c. Universal expenses = meals, lodging, clothing, travel – not deductible d. § 162 – trade/business expense i. (a) – no need to be away from home ii. (a)(2) – meals & lodging away from home (overnight rule) 2. Rule: deduction allowed, if there is sufficient business justification – doesn’t mean that personal elements will become deductible a. (One week trip to NYC for employees and wives, with one business meeting – vacation = income – Rudolph, p. 420) b. “Forced consumption” argument, not pleasurable outing (Rudolph, dissent) 3. Disallowance of certain entertainment expenses (§ 274) a. To get to § 162 deduction, must make it through § 274 disallowances b. Rule: i. Required relationship between business purpose & expense
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(a) Entertainment directly related to business purpose (a)(1)(A) (b) Entertainment associated w/ business & follows or precedes a substantial business discussion (“) ii. Percentage limitation on deduction: 50% on meals & entertainment (n) iii. (§ 67, 2% threshold – if TP itemizes, threshold will further reduce benefit of deduction) iv. Spouse – usually no deduction – unless bona fide business reason (m)(3) v. Substantiation requirements (d) (a) TP must provide records as to amount, time, and place of outlay (b) Some of the documentation is done away with: < $75, unless for lodging; per diem and mileage allowances, unless over limits; employees who have substantiated with employer vi. Exceptions (e) vii. Foreign travel (c) (a) If business & pleasure on trip to foreign country, air fare can be partially disallowed viii. Cruises and foreign conventions (h) (a) Disallow conventions outside “North American area” unless “it is as reasonable for meeting to be held outside the North American area as within” (b) Special rule for conventions & seminars on cruise ships (h)(2) 4. Deduction allowed for meal expenses for highway patrolman – Christey, p. 429) 5. Business lunches: coworkers don’t get as much benefit as strangers; people might spend more, if for business a. (Lawyers met at restaurant everyday for business lunch – not deductible – Moss, p. 427) b. Examples: i. Lawyer takes client to lunch to discuss case – deductible ii. Client takes lawyer to lunch to discuss case – client can deduct meal (business expense) iii. Lawyer takes client to lunch for goodwill – business development – code says NO iv. Partner takes associate to lunch to discuss future with firm – deductible (mentoring requirement) v. Partner takes associate to lunch to discuss pending case – deductible (business meeting) vi. Partners lunch once a week to discuss case – deductible, as long as not everyday 6. (Company takes customers, wives, employees to Super Bowl – not primarily business – Danville Plywood, p. 430) a. How to make deductible: isolate who could come, have actual meetings, keep records! 7. § 274 is § 162’s hammer to beat down inappropriate deductions for trade/business 8. Ordinary & necessary a. Ordinary – not interpreted literally b. Necessary – rarely invoked, since it’s not worthwhile for business to make unnecessary payments to unrelated party E. Commuting Expenses 1. Commuting – nondeductible outlay a. Global disallowance b. Includes cost of transportation (fare, vehicle), depreciation, parking 2. Travel – deductible a. If in travel status (begins at door of home), can deduct meals & lodging b. No need to show duplication c. Must substantiate (§ 274) 3. Commuting v. Travel a. Back & forth between home and office – no deduction b. Driving from office to court / client’s office – deductible, assuming business purpose (§ 162(a)) c. Drive to D.C. for day & eat on the road – meals deductible d. Overnight stay in NYC for client meeting – all deductible 4. Three requirements (§ 162(a)(2)) a. Reasonable and necessary (from employer’s perception) b. Incurred “while away from home”
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c. Incurred in pursuit of trade/business 5. Where is “home”? a. Tax home (basically) = employer’s main place of business, or where employee is posted b. (Maintaining home in Jackson, but working in Mobile – expenses not incurred in trade/business, but due to personal preference – nondeductible – Flowers, p. 440) c. Traveling salesman – probably doesn’t have tax home i. Court will make home be business headquarters ii. Or maybe not allow deduction, since no “home” to be “away from” d. Married – must establish independent basis for deductions e. If two business posts, “home” = principal duty location – can deduct expenses going to minor duty post f. (Wife working in NYC, but husband living & working in Boston – expenses in NYC not deductible – tax home = NYC – Hantzis, p. 446) 6. Moving expenses a. Deductible under § 217 b. Whether itemize or not, if expenses are not reimbursed, deduction is given c. Must establish new place of employment > 50 miles from former residence d. Includes moving household items & transportation e. § 162(a)(2) – mutually exclusive with § 217 f. § 217 assumes TP will be here at least 12 months or longer g. § 162(a)(2) assumes travel status is temporary 7. If taking temporary job away from home, can deduct travel & living costs (Peurifoy, p. 452) a. Must be less than 1 year – § 162(a)(2) 8. Doctor can deduct cost of driving between hospitals, but not from a hospital to home (Fillerup, p. 453) 9. TP needed her car for work, but couldn’t deduct commute costs, even though she would otherwise ride the bus – co. didn’t require her to bring car home at night (Croughan, p. 453) 10. Daily transportation expenses a. Not generally deductible, but can be if: (Rev Ruling 99-7) i. Work location is temporary & located outside normal metro area ii. Work location is temporary & has one or more regular work locations, away from residence, in same trade/business iii. TP’s residence is principal place of business & work location is in same trade/business b. Logger allowed deduction, even though doesn’t meet criteria – his home is “regular” place of business (Walker, p. 454) F. Legal Expenses 1. Expenses arising in purely business context – deductible 2. If business has employee that negligently causes wreck, sued for tort – deductible 3. Consequential rationale doesn’t work a. (H defending controlling stock interests during divorce – personal expenses – nondeductible – § 212(2) is concerned with safeguarding/upkeep of property, not retention – Gilmore, p. 459) b. Look to origin of the litigated claim, not consequences of success/failure c. Simpler rationale: costs of rearranging ownership within family = personal expense 4. “Primary purpose” might be better test than “origins” 5. (H’s payments for legal fees for property settlement not deductible – Patrick, p. 464) 6. Can add legal fees to basis, since they are costs of defending title 7. (Organized crime boss acquitted, so he couldn’t deduct legal fees as business expenses – Accardo, p. 464) 8. § 280E – expenditures in connection with illegal sale of drugs – specifically denies deductions for trade/business of trafficking in controlled substances G. Education Expenses 1. Must maintain/improve skills OR meet requirements of employer after employment has been obtained 2. Expenses barred by § 262 if TP meeting minimal education requirements OR for a new trade/business 3. (Full-time detective, attending undergrad college = personal outlay – nondeductible – Carroll, p. 465)
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4. Once education qualifies for deduction, travel expenses are also deductible (§ 162(a)(2)) 5. Advanced training – if established in a specialty, expense of pursuing degree is deductible 6. Higher education expenses, generally (§ 222) a. Six separate tax benefits fro college costs b. President’s Commission – do away with these & institute college savings plan VI. Deductions for the Cost of Earning Income A. Current Expenses vs. Capital Expenditures 1. Timing issues – deduct now or later? – three options: a. Immediately deduct entire amount b. Capitalize & depreciate (if useful life) c. No deduction until sale or other disposition (ex: land) 2. § 263 – disallowance provision for § 162 (screen) – capitalize “capital expenditures” a. No deduction for new buildings, permanent improvements, or betterments that ↑ property value b. Bars deduction for acquiring, constructing, or erecting building, machinery, equipment 3. If outsource development of asset that should produce income stream – capital expenditure – no deduction a. (Co. outsourced manuscript that would be sold – if used own staff, would’ve been deductible – no deduction, since outsourced – Encyclopedia Britannica, p. 471) 4. Congressional response – § 263A (Uniform Capitalization Rules – UNICAP) a. Capitalize inventory, construction, and development costs b. Match up labor with asset c. Accounting concern: outsource = easily categorize labor into specific account; in-house = harder d. Indirect expenses – difficulties – what about support system that makes company run? e. Levels playing field from EB – doesn’t matter if company out sources or not f. Requires capitalization of BOTH direct and indirect costs g. Salaries: i. Overturns rule of thumb for salaries ii. § 263(a)(1) – salary expenses currently deductible iii. § 263A – salaries also must be capitalized, when acquisition of new item h. Exempt – marketing & advertising, administrative expenses not relating to production i. Small businesses exempt j. Research & development expense – deduct currently (§ 174) k. Ex: drug company – continuing experimentation on drug i. Maintaining? – deduct (§ 162) ii. Enhancing or improving? – none (§ 263) iii. Research & development? – deduct (§ 174) 5. Legal claims – market for these now – tort recovery is income – but what is pre-sale? 6. Farmers a. Deduction for “cost of seeds and young plants” – but only for original purchaser, not someone who subsequently buys land which has been planted (Regs § 1.162-12(a)) b. Costs of developing farms, orchards, and ranches – expense (Regs § 1.162-12) c. (Not allowed deduction for crops already growing when farm is purchased, but value is capitalized – Rev Ruling 85-82, p. 478) 7. Capitalization for long term benefits applies to expenses that create tangible assets + expenses that enhance overall business operation a. (Big enterprise incurred costs during merger – must capitalize & recover over time – Indopco, p. 481) b. To recover pro rata, must have useful life (§ 167, 168) c. Intangible – amortization allowance over 15 years (§ 197(a)) 8. Regs have detailed explanations – don’t have to rely on fuzzy tests like “origin” of claim B. Repair and Maintenance Expenses 1. Deduct only if outlay is for “incidental” repairs a. Doesn’t increase value of property
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b. No prolongation of life c. Keeps the status quo d. No increase in basis of property e. Restore to sound state / mend 2. If repairs are really “replacements” – capitalize a. Arrests deterioration b. Prolongs life c. Adapts to new use d. Connotes substitute 3. To be deductible under § 162, repair must be ordinary & necessary business expense a. (Oil-proofing basement, due to damage – necessary & helpful/appropriate right now – if not § 162, deductible as loss under § 165 – this is repair = expense – Midland Packing, p. 483) b. But should be under § 263 – enhancement in value of property – capitalize & add to basis c. (Drive-in theater opens, creating drainage problem – capitalize repair (should’ve been anticipated & included in construction – Mount Morris Drive-In, p. 486) 4. What happens when weather risks exist simply because choice of residence? 5. What about code changes (building, etc) that require outlays? 6. Distinction: a. Expenditures which create/enhance asset w/ useful life > 1 year – capitalize b. New paint, light bulbs – if individually, just repair – if all at once, capitalize c. When there is casualty, courts usually allow deduction d. Merely replacing/rehabilitating to prior level (complying with codes) – probably deduct 7. (Removal of asbestos during remodeling – bifurcation inappropriate – capitalize (enhances value, since no longer contains known hazard) – Norwest, p. 489) a. But if you had removed asbestos separately, would be repair 8. Material increase without more – capital expenditure a. But, if you have unexpected events – argue for repair 9. Periodic, small expenditures – deduct (likely) 10. If part of overall remodeling program – capital (likely) 11. Adaptation of property for different purposes – capital (likely) 12. (TP allowed to separate soil cleanup (repair) from constructing treatment facilities (capital) – Rev Ruling 94-38, p. 486) C. Goodwill 1. Expenses to build reputation – capital expenditure 2. 162 (not current) --------- 263 (goodwill, reputation) -------- 262 (nothing ordinary) (education) 3. (Man paid off business debts of bankrupt co., trying to build up his own business – capital – Welch, p. 503) 4. Distinction: ordinary (rewards now) v. capital (pays off in future) 5. Corporation could deduct outlays to employees who lent funds to former president who lost money & died insolvent – retaining existing goodwill (Dunn & McCarthy, p. 505) 6. Corporation allowed to deduct debts of predecessor corporation that had become insolvent – payments made to establish credit (M. L. Eakes Co., p. 505) 7. Recovery of cost a. Goodwill can be amortized (15 years), but only previously acquired goodwill (§ 197) b. When you sell a going business, you sell collection of assets (Williams, p. 716) c. Determine status of each item for tax purposes – want lots of value assigned to goodwill 8. Education a. Generally, nondeductible – typically personal b. If maintaining / improving skills currently used in trade/business – deductible c. If meeting requirements imposed as condition of retention – deductible 9. Costs of finding a job – nondeductible a. Don’t yet have a trade/business
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b. Entrepreneurs – might be able to aggregate startup costs & deduct over period of 5 years (§ 195) c. But moving expenses are deductible, even before you have your first job D. “Ordinary and Necessary” 1. Just because something happens on business trip != business expense a. (Artist suffered psychotropic reaction en route to lecture, injured passenger, deducted legal fees – expenses not ordinary – Gilliam, p. 508) i. But deductible for personal reasons (might be medical care, § 214) ii. But he was deducting attorney’s fees, litigation costs – personal episode – nondeductible 2. Origin of the claim – must arise out of “ordinary & necessary” business conduct 3. Context can make a difference 4. Old rule – not allowed deduction for hiring ordained minister to conduct prayer meetings (Trebilcock, p. 514) 5. NOW, deduction allowed – helps employees be grounded, focused, work through difficulties a. Could even be spiritual advisor or professional counselor b. What about fitness instructor, yoga instructor, nutritionists? 6. On-site gym – not income to employees (§ 132(j)(4)) a. But what about employer who can only set aside a meeting room each morning? 7. Reasonable Compensation a. Deduct “reasonable allowance for salaries or other compensation for personal services rendered” (§ 162(a)(1)) b. Initially, to force TPs to deduct i. During WW I, TPs didn’t always deduct salaries ii. Could exploit strategic advantage of tax brackets – if employer in lower bracket, better not to pay c. Now, this is used to make sure compensation isn’t more than “reasonable” d. Possibilities: Enterprise Employee i. Salary, 162(a)(1) Deduct Income (taxed once) ii. Dividend, ordinary No deduct Income, 61(a)(7) (double taxed) iii. Dividend, qualified Capital gain iv. Gift No deduct, 274 Exclusion (↓ preferable) v. Purchase as lease Ded. rent. 162(a)(3) Income e. Qualified Dividends (HANDOUT 11) i. Law until Jan 1, 2011 ii. Provides advantageous treatment for qualified dividends, if conditions met (a) Received in correct period (Jan 1, 2003 – Dec 31, 2008) (b) Paid by domestic corporation or qualified foreign corporation (c) Shareholder must meet specified holding period iii. Tax rates: (a) 25% bracket or higher – dividends taxed at 15% (b) 10 & 15% brackets – dividends taxed at 5% (tax-free in 2008) iv. Employee prefers: qualified dividends, then indifferent between ord. dividends or salary v. Employer prefers: salary f. Factors: (salary v. dividends) i. Kinds of services employee is performing (significant) ii. How employees compare with others in a like situation iii. Employees who own stock or are related to proprietor iv. Economic conditions v. If contingent on performance, more like salary 8. Illegal or Unethical Activities a. Business expenses associated w/ illegal income – deductible b. Used to, deduction denied through “so-called” public policy c. § 162
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i. Includes wherever the activity occurs ii. (f) – no deduction for “any fine or similar penalty paid to a govt. for violation of any law” iii. (c) – bribes and kickbacks (a) 1 – no deduction for bribe or kickback to govt. employee (b) 2 – payments to other people, if the law is generally enforced (c) 3 – no deductions for healthcare people for bribes, rebates, etc, connected with Medicare or Medicaid iv. (g) – no deduction for punitive damages paid in violation of Clayton Act v. § 280E – denies deductions for expenses in drug trafficking d. Deduction ok for restitution payments, since punishment is imprisonment (Stephens, p. 518) E. Tax Shelters 1. Hallmarks of tax shelter investor a. Relatively high income TP b. Probably risk-averse c. Wants to limit liability to extent possible d. In long run, wants to come out ahead e. If possible, use nonrecourse financing to do it 2. Methods a. Leveraging – use of borrowed money to create amount of available deductions b. Deferral – push income into future by incurring currently deductible costs c. Conversion – converting ordinary income into tax favored income (ex: capital gain) d. Arbitrage – incur expenses that are deductible to generate tax-favored income, creating tax loss > economic loss 3. Substance over form will apply to destroy “sham” arrangements that lack economic reality a. (TP purchased annuities with nonrecourse borrowed money – generated yearly “loss” that he deducted – not allowed – Knetsch, p. 534) b. (Sale w/ leaseback disallowed – no transfer of ownership, no equity in new “owners,” paper price too high – to justify deduction, debt must exist – Estate of Franklin, p. 542) 4. Congressional Response a. Penalties: i. § 6700 – imposes penalty (> of $1000 or 10% of gross income) on promoters & sellers of false shelters ii. § 6662 – 20% tax on any “substantial understatement of income tax” (exceeds > of 10% of proper tax or $5,000) iii. § 6701 – penalty for aiding and abetting the understatement of tax liability iv. § 7408 – injunctions against promoters of tax shelters b. Arbitrage i. Increased limits on deduction of interest under § 163 (a) Now use basketing (§ 163(d)) & deny purely personal interest (except mortgages) (b) Basket includes ALL investments, but w/ qualified dividends, you can opt in or out ii. Interest on loans for investment – still deductible iii. § 264 – bars deduction of interest on loans taken to purchase insurance products iv. § 265 – disallows deduction of interest on loans for purchasing tax-exempt instruments c. Leveraging i. § 465 – applies to non-realty shelters – deductions limited to amounts actually “at risk” ii. § 469 – passive activity losses d. Deferral i. § 465, 469 – passive loss rules come in here ii. If you can’t deduct, you can’t defer e. Conversion i. § 1245 – relating to depreciable personal property
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ii. § 1250 – limits depreciation under straight line F. Alternative Minimum Tax (HANDOUT 9) 1. Background a. Established in 1969 – to prevent high rollers from avoiding liability entirely (or mostly) b. § 55-59 c. Expanded in 1986 2. Take taxable income, then re-determine income base – add back items for which deductions were allowed 3. What can cause liability? a. Lost credits b. No head of household distinction c. Lose personal exemptions (Klaassen) d. Standard deduction not allowed e. No state/local tax deduction f. No interest on 2nd mortgage g. Medical expenses – raises floor to 10% of AGI h. Misc. itemized deductions i. Income from incentive stock options – no income for regular tax, but included for AMT j. Large capital gain k. Tax-exempt interest – may not be exempt for AMT 4. Exemption available under AMT a. Corp. - $40k b. Married individual - $45k c. Single individual - $33.75k d. Amended in 2001 – until 2006, married people get $58k (§ 55(d)(1)(A)) 5. 2006 – reversion to higher rates, exempt amounts drop – people previously affected will pay more 6. (Couple with 10 children hit by AMT, clawed back dependency exemptions – argued: inconsistent with Congress’ intent, infringement of free religion, EP & DP – AMT applied – Klaassen, p. 562) 7. (Computer consultant’s un-reimbursed expenses, claimed as misc. itemized deductions, clawed back for AMT – Prosman, p. 565) 8. Effects: a. By 2010, AMT will affect 33 million TPs (almost 1/3 of all returns) b. Very expensive to fix the AMT 9. Policy: a. Pointlessly complex b. Effectively raises marginal rates c. Poorly targeted d. Taxes marriage e. Adversely affects people providing for children f. President’s Commission i. Recommended repeal of AMT (would cost $27 billion) ii. To pay for this, recommended lower cap for mortgage interest deduction & no state/local tax deduct VII. Capital Gains and Losses (HANDOUT 10) A. Background 1. Capital gains – resulting from sale/exchange of property held for investment 2. Rates have differed over time – 50%, 60%, & even more preferential 3. Qualified dividends specially carved out as capital gains, until 2008 4. Objective – provide investment incentive, but deter “fake” losses (limit ability to deduct losses) 5. Separate business income from capital gain 6. Gains & losses are either short-term or long-term a. Long-term – held for more than 1 year b. Short-term – held for 1 year or less
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7. Basket capital gains – bring one net figure into income base (§ 1222) a. Sort gains & losses (short-term v. long-term) b. Net short-term, net long-term c. Net short-term – net long-term = net overall (gain/loss) d. If overall net loss, can offset <= $3000 of ordinary income (carry forward extra) 8. Quasi capital gains/losses (§ 1231) a. Assets that wouldn’t ordinarily be capital, can magically become capital gains b. If § 1231 nets negative, can deduct losses without limit 9. Ultimately, only gain that gets preference = long-term gain 10. Net short-term gain is teased out in process in (1)(h), and treated just like ordinary income a. But it can offset losses without limit 11. Capital gain doesn’t push ordinary income into higher marginal rate bracket 12. 1(h) determines tax rate for capital gain pile of income B. Policy 1. General incentive a. In part, it is a consumption tax b. Taxes on consumption have built in preference for saving c. BUT we don’t know the use to which this money would be put otherwise 2. Incentive to new industries a. Tend to generate capital gain – favorable treatment stimulates that b. Is this a good thing? 3. Unrealized gains aren’t taxed a. Reduces disparity in treatment of realized & unrealized gains 4. Inflation a. Mitigates unfairness of taxing gains attributable only to inflation (but indexing is better) 5. Lock-in a. Induces people who would otherwise continue to hold appreciated assets – sell & reinvest C. Cases 1. Characterization problems 2. “Held primarily for sale to customers” a. What if TP has ineligible property, but decides to liquidate? i. Selling piece of rental property ii. Without more, building would go through § 1231 – if only transaction, becomes capital gain iii. But this is inventory – controlled by § 1221(1) 3. Transactions related to TP’s regular business a. Corn Products i. Corn syrup company bought corn futures to ensure supply of corn ii. Held: If you have business operating as investor, can treat investment as capital asset b. Arkansas Best i. Sold investments at gain – wanted capital gain