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					Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

   I.     Introduction
          a. Federal Government‘s right to collect taxes
                  i. 16th Amendment: ―The Congress shall have power to lay and collect taxes on incomes,
                     from whatever source derived, without apportionment among the several States, and
                     without regard to any census or enumeration‖
                 ii. Statutory Basis—Internal Revenue Code—Title 26 of the U.S.C.
                         1. Administered by the IRS
                                 a. Treasury Regulations—Carry the weight of a statute if the Code
                                     specifically calls for them; otherwise they hold persuasive value.
                                 b. Revenue Rulings—Statement by the IRS interpreting and applying the law
                                     to a specific set of facts. IRS is bound by these, the courts are not,
                                     however they are persuasive.
                                 c. Private Letter Rulings—Issued on request to individual taxpayers for a
                                     fee. Binding on the IRS only with respect to the particular taxpayer who
                                     submits the request. Courts use them as evidence of how the IRS may
                                     respond to a given set of facts.
          b. Income—The measure of a taxpayer‘s ability to pay his or her fair share of the costs of
                  i. Any compensation or economic benefit received by the taxpayer during the tax year. Can
                     be in the form of cash, cash equivalents, property or services.
                         1. Can be in the form of wages and salaries or of gain from the sale or disposition of
                             an asset
                         2. Three most significant measures of income in computing tax:
                                 a. Gross income—§ 61—all income received by the taxpayer, from
                                     whatever source, that may be subject to tax in the year in question. The
                                     only items of income that are not part of gross income are those items that
                                     are specifically excluded by statute (gifts, inheritances, etc…)
                                          i. Starting point for most other calculations.
                                 b. Adjusted gross income—an arbitrary measure of a taxpayer‘s income. It
                                     is gross income minus certain statutory-specific deductions, such as
                                     certain education expenses, moving expense, self-employment expenses,
                                     and alimony. It is the basis for computing other specified deductions such
                                     as charitable contributions
                                 c. Taxable income—net amount on which the taxpayer must pay tax. To
                                     arrive at the taxable income, we subtract from Adjusted Gross Income any
                                     below-the-line deductions and personal exemptions. §§ 61, 62, 63, 67
          c. Exclusion—A transaction by a taxpayer that does not have to be taken into income even though
             it may result in an increase in his net worth.
                  i. A transaction which may increase a taxpayer‘s net worth but which does not have to be
                     taken into gross income.
                 ii. § 61 defines ―gross income‖ as ―all income from whatever source derived‖, except as
                     otherwise provided by statute.
                         1. §§ 101-135 cover most of the statutory exceptions. These statutes list those
                             sources of income that can be excluded from gross income.
                iii. Example: property acquired by gift does not have to be reported as income. The same is
                     true of property acquired through inheritance.

Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                iv. Keep in mind the difference between an exclusion and a deduction. Exclusions are not
                     included in income in the first place. Deductions, on the other hand, are subtracted from
                     either gross or adjusted gross income to arrive at taxable income.
          d. Deductions
                  i. Expense incurred during a taxpayer‘s tax year that may be subtracted, in whole or in part,
                     from the taxpayer‘s gross income for the year to compute her tax liability.
                 ii. Deductions are divided into ―above-the-line‖ deductions and ―below-the-line‖
                     deductions. These distinguish between deductions subtracted from gross income to
                     compute adjusted gross income (AGI), and those subtracted from adjusted gross income
                     to compute taxable income (TI). The so-called ―line‖ is the place on the annual tax return
                     in which a taxpayer enters his adjusted gross income.
                         1. ―Above-the-line‖—Class of deductions available to all individual taxpayers-both
                             those who choose to use the standard deduction and those who itemize their
                                 a. Above-the-line deductions are subtracted from gross income to arrive at
                                 b. Above-the-line deductions include contributions to IRA‘s, student loan
                                     interest, moving expenses, and alimony.
                         2. ―Below-the-line‖—items subtracted from adjusted gross income to arrive at
                             taxable income.
                                 a. In computing below-the-line deductions, the taxpayer may avail himself of
                                     the standard deduction or he may itemize his deductions. He may do
                                     either, but not both.
                         3. Standard Deduction—a fixed amount set by statute that the taxpayer can deduct
                             from AGI in order to arrive at taxable income.
                                 a. The standard deduction can be taken in lieu of itemized deductions and
                                     miscellaneous itemized deductions, not in addition to them.
                         4. Itemized Deduction—a class of deductions that can be subtracted from AGI as
                             an alternative to the standard deduction.
                                 a. These include the home mortgage interest deduction, the deduction for
                                     state, local and real property taxes paid, and the deductions for charitable
                                     contributions and medical expenses
                                 b. The taxpayer must elect to take the itemized deductions instead of the
                                     standard deductions. Itemized deductions can be limited once AGI
                                     exceeds a specified amount.
                         5. Miscellaneous Itemized Deductions—other deductions that can be added to the
                             itemized deductions and subtracted from AGI. Can only be subtracted to the
                             extent that they cumulatively exceed 2% of AGI.
          e. Personal Exemption—Taxpayers are permitted to reduce their taxes by taking personal
             exemptions. These vary with the number of persons in the taxpayer‘s household and are phased
             out with increasing AGI.
                  i. They recognize certain physical conditions of the taxpayer or his family.
                 ii. Each exemption is allowed at least one exemption.
                iii. Husbands and wives filing joint returns receive one exemption each.
                iv. An exemption is allowed for each of the taxpayer‘s dependents, as well as for conditions
                     such as old age or blindness.
          f. Credit—An amount the taxpayer can subtract from taxes due after her tax is calculated.
                  i. Credits reduce a taxpayer‘s tax liability dollar for dollar.
Federal Income Taxation Outline                                                        Mary Andriko—Fall 2007

                  ii. Two classes:
                          1. Nonrefundable—The best a taxpayer can achieve is to reduce her tax liability to
                             zero. (some credits also allow any unused portion to be carried forward into
                             future tax years or carried back to prior tax years.)
                          2. Refundable—taxpayer is entitled to an immediate tax refund or to a credit against
                             future taxes, to the full extent of the credit. Examples: child tax credit, education
                             credits, foreign tax credits.
          g.   Ordinary Income—All compensation, income, or gain except capital gain
          h.   Capital gain—The profit derived from the sale or other disposition of a capital asset.
                   i. Capital asset—any property held by the taxpayer except stock-in-trade or inventory,
                      property used in a trade or business, and copyrights.
                  ii. Both ordinary income & capital gains are considered income subject to tax, though not
                      necessarily at the same rates.
          i.   Basis—The actual or constructive cost of an asset to the taxpayer.
                   i. How basis is calculated depends upon how the asset was acquired. For example, if the
                      asset was purchased, the basis equals the purchase price.
                          1. Basis can be adjusted upward or downward, based on events that occur after
                             acquisition. The resulting amount is called ―adjusted basis‖. For example, if the
                             taxpayer invests to upgrade an asset (e.g., he adds a second story to a one-story
                             property), the cost of the upgrade is added o the original purchase price in order to
                             compute the adjusted basis of the asset.
                          2. Conversely, if the taxpayer has taken a deduction based on the asset, such as for
                             depreciation on a piece of equipment, the basis is adjusted downward to reflect
                             the deduction.
          j.   Gain—The income resulting from the sale or exchange of an asset.
                   i. Under the Code, gain is calculated as follows: Gross proceeds (i.e., the sales price or the
                      value of consideration) minus adjusted basis. It is only the gain—not the gross
                      proceeds—that must be recognized as income for tax purposes.
                  ii. Capital gain—the gain realized from the sale or exchange of a capital asset
                          1. Capital asset—essentially any asset held for investment purposes
                          2. Following are not capital assets:
                                 a. Business inventory, depreciable property used in a trade or business
                                 b. Real property used in a trade or business
                                 c. Copyrights
                                 d. Accounts receivable
                                 e. Supplies used in a trade or business
                                 f. Hedging transactions
                                 g. Certain US government publications
                                 h. Commodities derivative financial instruments
                          3. Capital gain is taxed at different rates from ordinary income.
                          4. Gains from the sale of capital assets held for more than one year (long term gains)
                             are taxed at lower rates
                          5. Gains from the sale of capital assets held for less than one year (short term gains)
          k.   Depreciation—the annual deduction a taxpayer can take to adjust for the ―wear and tear‖ of an
               income-producing asset that has a limited useful life.
                   i. Various methods are used to measure the rate of deprecation—i.e., the amount the
                      taxpayer can deduct in the year in question.

Federal Income Taxation Outline                                                     Mary Andriko—Fall 2007

                 ii. The formulas depend in part upon the ―life‖ of the asset—the number of years that the
                     asset will be in use.
                          1. The life attributed to any given asset is set by statute, based upon asset type.
                iii. Depreciation is only available on assets that are employed in a trade or business, or that
                     are expended in the production of income. Personal assets such as a home or car cannot
                     be depreciated for tax purposes.
          l. Net Worth—the excess of a taxpayer‘s assets over her liabilities.
                  i. The amount a taxpayer would have at the end of the say if she liquidated everything she
                     owned and paid off all her outgoing debts.
                 ii. If liabilities exceed assets, the taxpayer is said to have a negative net worth.
          m. Realization—occurs whenever the taxpayer derives a tangible economic benefit from a
                  i. Income is subject to tax only when it is realized.
                 ii. Ask yourself the following to determine whether or not the amount in question should be
                     considered ‗income‘ for tax purposes: (If not to all three, income probably is § 61
                          1. Is the ―income‖ actually only a return of capital? (Is the taxpayer getting back
                              only what she put into an asset or investment?)
                          2. Is the ―income‖ really loan proceeds accompanied by a contemporaneous promise
                              to repay?
                          3. Is the ―income‖ excluded under a specific statutory provision?

   II.    Personal Injury Recoveries
          a. Recoveries that are Excluded from gross income:
                 i. Any of the following received as compensation for physical injury or sickness:
                        1. Amounts received under a Worker’s Compensation Act
                        2. Damages received by suit or agreement, except for punitive damages
                        3. Amounts received through accident, health or disability insurance 9as long as it
                            is unrelated to an employee‘s age or length of service (§ 104)
          b. Recovers that must be Included in gross income:
                 i. Recoveries for damage to business or property must be included in gross income
                        1. Punitive damages in tort or ―tort type‖ actions (because these are designed to
                            punish the tortfeasor rather than to compensate for taxpayer‘s injuries are
                            therefore akin to a windfall); and
                        2. Damages paid to compensate for nonphysical injuries, such as emotional distress
                            or defamation. (§ 104)
                ii. These rules apply only to the extent that there is any gain. In other words, a taxpayer
                    must include in her gross income only that amount of any recovery that exceeds her
                    basis in the property in question.

   III.   Sale or Exchange of Property
          a. When a taxpayer sells or exchanges property, she must declare as income any gain she receives
             as a result. § 61(a)(3)
                  i. ―Gain‖ is defined as the excess of the amount realized from the sale or exchange of
                     property over the taxpayer‘s adjusted basis in the property
                 ii. ―Amount Realized‖ is defined as the sum of any money received, plus the fair market
                     value of any property received. § 1001

Federal Income Taxation Outline                                                        Mary Andriko—Fall 2007

              iii. How you determine the taxpayer‘s basis depends upon how the asset in question was
               iv. The taxpayer does not have to report as income that portion of the amount realized that
                   represents her basis because this is considered a ―return of capital‖—the taxpayer is
                   simply getting back the net cost of the asset to her.
                v. The taxpayer can declare a loss on her tax return to the extent that her basis exceeds the
                   amount realized.
          b. When a taxpayer sells her principal residence for a profit
                i. A married couple can exclude from income up to $500,000 of gain on the sale or
                   exchange of their principal residence.
                       1. In order to do so, they must have owned the home and used it as their principal
                          residence for a period aggregating at least two years out of the last five. This
                          exclusion is available only once every two years. § 121
                       2. In order to exclude up to $500,000, married taxpayers must file a joint return. If
                          they file separately (and for single taxpayers), the limit is $250,000.
                       3. Under prior law, taxpayers were allowed a much smaller exemption and ten only
                          once in a lifetime. Virtually all residence sales are now exempt from tax, since
                          less than 1% of all home sales generate gains in excess of $500,000.

   IV.    Basis
          a. Basis of an asset acquired by purchase or through contract
                  i. Basis equals the purchase price, if the asset was purchased.
                 ii. If it was acquired pursuant to a contract, the basis equals the fair market value of the asset
                     at the time of acquisition.
                iii. The basis can be adjusted from its original amount by various subsequent events.
                          1. Example: the basis will be adjusted downward if the taxpayer uses some portion
                              of the asset‘s basis to generate a deduction—i.e., by taking depreciation
                              deductions during the property‘s useful life. In the same way, the basis will be
                              adjusted upward if the taxpayer spends money to increase the value of the asset,
                              such as by putting an addition onto a building.
                          2. Note: it is useful to think of basis as a kind of savings account for each asset. The
                              taxpayer makes withdrawals by using portions of basis to generate deductions,
                              and makes deposits by spending money to improve the asset. The higher the
                              basis, the smaller the gain ―realized.‖
          b. Basis of an asset acquired by gift
                  i. The taxpayer ―stands in the shoes‖ of the giver and acquires his basis, which is increased
                     by any gift tax paid by the donor. This is called a ―transferred basis‖. In other words,
                     the basis is transferred from the person who gave the gift to the recipient of the gift. §
                 ii. Gifts do not have to be reported as income at the time they are received, but subsequent
                     sales or exchanges of the assets must be included in calculating income. § 102
          c. Basis of an asset acquired by inheritance
                  i. Basis is the asset‘s fair market value at the time of the transferor‘s death. § 1014

   V.     Spousal Support
          a. Parties to a divorce agreement can choose how they want their spousal support to be treated for
             tax purposes—the support payments can be treated either as taxable income to the payee and
             deductible to the payor, or as a nontaxable transfer of assets.
Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

          b. In order for the payments to qualify for inclusion to the payee and for deduction to the payor, the
             following requirements must be met:
                  i. The payments must be made in cash (or cash equivalent, such as by check);
                 ii. They must be made pursuant to a divorce or separation instrument—i.e. settlement
                     agreement or judgment;
                iii. The instrument cannot contain a provision requiring the payments to be treated as a
                     nontaxable transfer;
                iv. The payee and payor must not be members of the same household at the time the
                     payments are made;
                 v. The payor‘s liability to make the payments must terminate completely at (or before) the
                     death of the payee-spouse;
                vi. No portion of the spousal support amount can be tied to any contingency involving a
                     child. § 71
          c. Note: Child support payments are always nontaxable transfers. The reason for requirement 6
             above is to weed out any child support payments disguised as spousal support.

   VI.    Annuities
          a. Annuities are a contract between an insured and a carrier (usually an insurance company) under
             which the insured makes contributions to a policy and the carrier repays the contributions plus
             interest to the insured in periodic payments, usually for a fixed term of years, or for the rest of
             the insured‘s life.
                  i. Example: a person might invest $100,000 to buy an annuity that will pay her $1000 a
                     month for 10 years.
          b. Annuity payments don‘t necessarily have to be included in gross income.
                  i. Income derives from gain, so any payment constituting a ―return of invested capital‖ is
                     not income. § 72 excludes from income that portion of every annuity payment received
                     by the insured that represents a pro rata return of the insured‘ investment (contributions)
                     in the contract.
                 ii. To figure out what portion of each payment the recipient can exclude:
                          1. Figure out the total cost of the contract
                          2. Using life expectancy tables, calculate the total expected payout.
                          3. Divide the total cost by the expected payout to come up with the ratio for
                              exclusion for any given payment.
                          4. Multiply each installment by the ratio to compute the amounts to be excluded and
                              included in calculating income.
                iii. If the annuitant lives beyond her life expectancy, the full amount of each payment
                     following the date to which her life expectancy was calculated is taxable income. If she
                     dies before her life expectancy, any unrecovered investment in the annuity can be
                     deducted from her final tax return. § 72(b)

   VII.   Health Insurance
          a. Taxpayers can exclude from gross income payments received from employer-funded health and
             accident insurance plans if the payments fall into one of the following two categories:
                 i. The payments cover actual medical expenses incurred by the employee, his or her
                    spouse, or dependants

Federal Income Taxation Outline                                                     Mary Andriko—Fall 2007

                        1. Exception: if the taxpayer took a deduction for the medical expenses in a prior
                            year, then she must declare the reimbursement as income in the current year to
                            avoid ―double dipping.‖ § 213
                ii. The payments are compensation for a permanent disability or disfigurement and were
                    calculated by reference to the extent of the injury, rather than by reference to the
                    employee‘s lost wages during the period he or she was away from work. (If the
                    payments were just replacement for lost wages, the would be taxable as compensation.)
                        1. Related issue: the taxpayer also can exclude from gross income the amount of
                            money her employer paid to secure coverage on the employee‘s behalf under a
                            group accident and health insurance plan. § 106
   VIII. Interest from State or Local Bonds
         a. Gross income does not include interest from any state or local bond. § 103(a)
                 i. Exceptions:
                        1. ―Private activity bond‖: bonds issued by a state or local government that are
                            designed to finance projects of a private, rather than a public nature. Example: a
                            municipality may issue a bond to buy land that it will then give to a private
                            company as an incentive for that company to relocate to the municipality.
                        2. Interest earned on private activity bonds, even though issued by a state or local
                            government, must be included in gross income.
                        3. Arbitrage bonds and state or local bonds not issued in registered form. § 103(b)
   IX.   Gifts
         a. Assets received as gifts or by inheritance are not excluded in income.
         b. The value of cash or real or personal property acquired by gift or through inheritance is not
            included in income—regardless of amount.
                 i. However, any subsequent income from property following the acquisition through gift or
                    inheritance is not exempt from taxation, nor is any gift or inheritance of an income
                    interest in property. § 102
                ii. § 102(c) excludes from ―gift‖ designation amount transferred by employers to their
                    employees, unless those amounts fall within some other specific statutory exclusion, such
                    as the exclusion for employee achievement awards found in § 74(c), or the exclusion of
                    some fringe benefits, § 132.
         c. Gifts from an employer
                 i. Employee can exclude from their gross income the following types of fringe benefits
                    provided by their employers:
                        1. No-additional-cost services: Benefits the company gives to its employees that do
                            not cost the company anything to provide—i.e., empty seats to airline employees
                            and unbooked hotel rooms to hotel employees. These ―perks‖ can be provided
                            either for free or at a reduced rate.
                        2. Qualified employee discounts: The company‘s products or services purchased
                            by the employee at a discount—e.g., a department store offering its goods to its
                            employees at a 20% discount. (Note: this exclusion does not apply to real
                            property or investment property, such as securities.)
                        3. Working condition fringe: Goods and services that could have been deducted as
                            business expenses had the employee purchased them himself—e.g., subscriptions
                            to professional journals, computer equipment, training seminars.
                        4. De minimis fringes: Goods and services whose value is too small to warrant
                            accounting—i.e., coffee and muffins at a staff meeting, personal use of the
                            company copy machine, cab fare home for employees who work overtime.
Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

                          5. Qualified transportation fringe: This includes parking in the employer‘s
                              building, bus vouchers, and van services.
                          6. Qualified moving expense reimbursement: Payment for or reimbursement of
                              expenses that could have been deducted as moving expenses under § 217 had the
                              employee paid for them directly.
                          7. On premises athletic facility: Payment for the use of an athletic facility or gym
                              that is located on the employer‘s premises, that is run by the employer, and is
                              used principally by employees or their families.
                 ii. An employee can exclude from gross income the value of meals and lodging
                     furnished by her employer to herself, her spouse, and her dependents if:
                          1. They were provided for the convenience of the employer;
                          2. In the case of food, they were furnished on the employer‘s premises; and
                          3. In the case of lodging, the employee was required to accept the lodging as a
                              condition of her employment. § 119
                                  a. Note: the ―convenience of the employer‖ and ―conditions of employment‖
                                       tests are basically the same. The employee must prove that she was
                                       required to accept the lodging to perform the duties of her job. This
                                       generally comes into play when an employee must be available for
                                       emergencies 24 hours a day.
   X.      Income Interest
           a. The right to receive the income produced from or by a capital asset.
                  i. Examples: interest from a savings account or from a bond; dividends from stock; rents
                     from real estate; royalties from a book or song; etc…

       The Internal Revenue code anticipates that each taxpayer will maintain his own record of receipts and
expenditures. Some items of a taxpayer‘s income are reported to the IRS by third parties—e.g., the employer‘s
Form W-2 reporting wages and salaries; the Form 1099 which reports such items as interest, royalties, etc. The
taxpayer must be prepared to support all transactions reported to the IRS.

   XI.     Most common above-the-line deductions:
           a. Contributions to the taxpayer‘s IRA;
           b. Non-employee trade or business expenses;
           c. Employee expenses paid by the taxpayer under a reimbursement arrangement with her employer;
           d. Losses from the sale or exchange of property;
           e. Expenses related to the production of rents or royalties;
           f. Employer contributions to the taxpayer‘s pension or profit-sharing plan;
           g. Contributions to qualified retirement savings plans;
           h. Alimony payments;
           i. Employment-related moving expenses that were not reimbursed by the taxpayer‘s employer;
           j. Qualified contributions to medical savings accounts (renamed ―Archer MSAs‖); and
           k. Interest paid on qualifying educational loans. § 62
   XII.    Standard deduction
           a. Taxpayers can calculate their deductions from adjusted gross income either by taking the
              standard deduction or by choosing to itemize their deductions.
           b. The standard deduction is a pre-calculated deduction from AGI that is set at the same amount for
              all taxpayers of a given class. For example, the 2003 standard deduction for married joint filers

Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

            was $9500, and for single filers it was $4750. (These amounts are adjusted annually for
         c. The alternative to taking the standard deduction is to calculate and list all available itemized
            deductions. Itemized deductions are divided between regular itemized deductions and
            miscellaneous itemized deductions. Taxpayers will choose to itemize their deductions only if the
            resulting total is greater than the standard deduction.
                 i. Most common regular itemized deductions:
                         1. Interest paid (all ―home mortgage interest,‖ as well as investment interest paid)
                         2. Taxes paid to state and local governments, and on real property
                         3. Charitable contributions (limited to a maximum of 50% of AGI for certain
                             charities, and 30% for others)
                         4. Business and investment losses, to the extent that they were not reimbursed by
                         5. Personal casualty losses in excess of $100 (but only to the extent that they
                             exceed 10% of AGI)
                         6. Medical expenses, but only to the extent that they exceed 7.5% of AGI
                         7. Moving expenses
                ii. Miscellaneous itemized deductions—In addition to the regular itemized deductions
                    listed, the taxpayer is allowed to deduct certain miscellaneous expenses including:
                         1. Unreimbursed employee expenses,
                         2. Expenses relating to generating investment income
                         3. Tax preparation fees.
                                 a. Remember: only that amount of miscellaneous itemized deductions, added
                                     together, which exceeds 2% of AGI may be deducted from AGI. The 2%
                                     floor does not apply to pass through entities such as partnerships.
   XIII. Deductions for “trade or business expenses” § 162(a)
         a. § 162(a) allows a taxpayer to deduct from gross income all ―ordinary and necessary expenses
            paid or incurred during the taxable year in carrying on any trade or business,‖ including:
                 i. Reasonable compensation paid out for personal services actually rendered to the
                ii. Reasonable travel expenses while away from home in pursuit of the trade or business;
               iii. Lease or rental payments necessary to carry out the trade or business, provided the
                    owner of the business has neither title nor equity in the premises in which the trade or
                    business is conducted.
         b. Exceptions due to violation of public policy §§ 162, 280E (Business expenses that cannot be
                 i. Illegal bribes and kickbacks. Check for the following three types:
                         1. Questionable payments to government officials;
                         2. Bribes or kickbacks by service providers in connection with services paid for by
                             Medicare or Medicaid; and
                         3. Payments made to third parties when the payments violate local or state law or
                             subject the payor to criminal penalty or the loss of a business or trade license. §
                ii. Lobbying expenses and campaign contributions. Although these are not in general
                    deductible, expenses incurred to influence a local council on legislation of direct interest
                    to the taxpayer can be deducted.
               iii. Fines and penalties paid to the government. § 162(f)
Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

                 iv. Two-thirds of treble damage payments in a criminal anti-trust proceeding. § 162(g)
                  v. Any business expenses incurred by illegal drug dealers. § 280E

   XIV. Personal Expenses
        a. Most personal expenses are not deductible and a clear and firm line is drawn between business
           expenses and personal expenses. § 262
        b. Disputes with the IRS are mostly over expenses such as lodging, meals, travel, and
           entertainment. Taxpayers have claimed such items as the cost of baby-sitters for a parent who
           must work.
        c. Statutory exceptions: §§ 163(h)(2)(D), 170, 213
                i. Home mortgage interest expenses
               ii. Contributions to charitable causes
              iii. Some medical expenses
        d. Rules for meals & lodging expenses for business travel
                i. § 162(a)(2) allows a deduction for meals and lodging ―while away from home in the
                   pursuit of a trade or business.‖
                        1. ―Home‖ is not where the taxpayer lives, but where he works.
               ii. If the taxpayer has traveled from his office on a temporary assignment, his permanent
                   workplace remains his ―home,‖ and he can deduct his meals and lodging while away.
                        1. Any assignment of less than one year is presumed temporary.
                        2. If the assignment is longer than a year but less than two years, the employee can
                            rebut the presumption than the assignment is permanent. After two years, the
                            place of assignment becomes his tax ―home‖.
              iii. The IRS has adopted a bright-line rule for defining when someone is ―away‖ from home.
                   A taxpayer is away from home for purposes of § 162(a)(2) only if it is reasonable to
                   expect the taxpayer to either sleep or rest during the trip away.
              iv. Exceptions to the no-deduction-for-commuting costs rule:
                        1. Daily expenses for travel between the taxpayer‘s residence and a temporary work
                            location outside the metro area in which the taxpayer lives or works.
                                a. ―Temporary‖ means one year or less.
                        2. For taxpayers who are allowed to deduct the expenses of a home office, the cost
                            of going between home and another work location, temporary or permanent.
               v. A taxpayer can deduct the cost of local meals and entertainment:
                        1. Only if they are ―directly related to, or…associated with, the active conduct of the
                            taxpayer‘s trade or business.‖ In other words, the taxpayer must conduct business
                            either during the meal or event itself or immediately before or after the meal or
                            event. § 274(a)(1)(A)
                        2. The taxpayer must be present at the meal or event. § 274(k)(1)(B)
                        3. Facilities: Club dues and vacation home expenses are no longer deductible at all.
                            However, the cost of activities that are conducted at these facilities can be
                            deducted if the activities meet the ―active conduct of business‖ test. §
                                a. Note: Unlike social or business clubs, dues for professional organizations
                                    such as the ABA remain deductible under § 162

Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                        4. Deductions for tickets to entertainment events are limited to the face value of the
                            tickets. (The taxpayer absorbs any agency commissions or scalper premiums.) §
                        5. The taxpayer must have records to document her expenses in order to take these
                            deductions. (The records should include the amount spent, the time, place, and
                            business purpose of the event, and the business relationship of the person fed or
                            entertained.) § 274(d)
                        6. The deduction available for business gifts is limited to $25 per recipient per
                            year. (Married couples are treated as a single taxpayer for purposes of this rule.)
                            § 274(b)
                        7. Finally, even after an expense meets all of the above requirements, it can be
                            deducted only to the extent of 50% of the total spent. § 274(n)
          e. Clothing is generally considered inherently personal and is therefore nondeductible.
                 i. Exception: Uniforms, provided that use of the uniform is a condition of employment and
                    the uniform is not adaptable to general personal use. Pevsner v. Comm’r.
          f. Education Expenses are considered personal expenses are not deductible.
                 i. Exception: Education expenditures that maintain or improve skills required in the
                    taxpayer‘s current trade or business.
                        1. The taxpayer must be employed in the trade or business in question to qualify for
                            the deduction.
                        2. If the education is designed to train the taxpayer to start working in a new trade or
                            business, the expenses are not deductible. Example: an accountant cannot deduct
                            the cost of going to law school, but he can deduct the cost of a course in securities
          g. Moving Expenses
                 i. Covered Expenses:
                        1. The costs of moving household goods and personal effects from the old
                            residence to the new residence;
                        2. The costs of traveling (including lodging, but not meals) from the old residence
                            to the new residence;
                        3. The moving expenses of the other members of the taxpayer‘s household,
                            provided both their former and present homes are the same as the taxpayer‘s
                ii. Can be deducted only if:
                        1. The move is made in conjunction with a transfer by the taxpayer to a new
                            principal place of work; and
                        2. The new principal place of work is at least 50 miles farther from his former home
                            than the former principal place of work, or, if there was no former principal place
                            of work, from the taxpayer‘s former residence.
   XV.    Home Office Expenses
          a. Under § 280A(c), a taxpayer can take a home office deduction if a portion of the taxpayer‘s
             home is used exclusively on a regular basis as one of the following:
                 i. As the principal place of business for a trade or business of the taxpayer;
                ii. As a place the taxpayer uses to meet with customers, clients, or patients in the normal
                    course of her trade or business (the taxpayer must be present at a meeting before it can
                    be expensed); or
               iii. As a place to store inventory for sale or use by the taxpayer in her trade or business (but
                    only if the house is the sole fixed location for the trade or business).

Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

        b. A taxpayer may take a deduction for the cost of administrative or management activities of her
           trade or business that are conducted at her home if she has no fixed location other than her home.
                i. Congress expanded the definition of ―principal place of business‖ in 1997 to include the
                   residence of the taxpayer if she has no other fixed location for her trade or business and
                   she performs the majority of her administrative or managerial activities in the residence.
               ii. Example: An anesthesiologist who performs her profession in various hospitals and
                   clinics and has no fixed office can now take a home office deduction for bookkeeping
                   and other paperwork she does at home. § 280(A)(c)(1)(C)
              iii. Home office expenses a taxpayer may deduct if she has no other fixed location other than
                   her home in which to conduct her business:
                        1. Billing clients, customers, or patients;
                        2. Keeping books and records;
                        3. Ordering supplies;
                        4. Writing reports; and
                        5. Arranging appointments.
                        6. See IRS Publication 523.
   XVI. Expenses that must be capitalized
        a. Difference between ―ordinary‖ expenses that may be deducted in the current year versus
           expenses that must be capitalized lies in the nature of the service or commodity purchased:
                i. If the purchase is for property whose useful life extends beyond the current year, the
                   expense is a capital expenditure.
                        1. Examples: land and buildings, machinery and equipment, patents and trademarks.
               ii. If, on the other hand, the purchase is for services or supplies that are utilized in the
                   ordinary every day operation of the business, the expense is an ordinary expense that
                   may be deducted in the current year.
                        1. Examples: payroll, rents, utilities, supplies, etc…
                        2. Say a hotel adds a new wing costing $1million. If the expenditure is treated as an
                            ordinary deduction available in the current year, it will result in a reduction in
                            current taxable income and therefore less tax. On the other hand, if the
                            expenditure is treated as a capital expenditure, it will be deducted in much smaller
                            amounts each year over a period of years. Less expense each year means the
                            profits are greater and the tax is larger. Obviously, the IRS and the taxpayer have
                            opposing interests in the characterization of the expenditure. Under the Code, the
                            new wing must be treated as a capital expenditure for a capital asset.
        b. Given the time value of money, taxpayers would always prefer to take a current deduction for an
           expense rather than capitalize the expense and have to wait to get the tax benefit over a period of
           years. In general, the choice is not theirs to make.
        c. Rules governing when an expense must be capitalized instead of deducted in the current
                i. Expenses to acquire or improve a business asset or property which will have a utility
                   beyond one year cannot be deducted as a current business expense. Instead, they must be
                   capitalized. § 263
                        1. Reasoning is that a capital asset is used over several years to produce income and
                            that the cost of the asset should be allocated to each year in proportion to the
                            annual income stream.
                        2. Money spent to repair or maintain property is a deductible current business

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                           3. Money spent to acquire or improve the property, whether by increasing its value,
                               extending its useful life, or making it suitable for a different use, is considered a
                               capital outlay and must be capitalized. Reg. § 1.162-4
                  ii. Note: often it‘s difficult to characterize a particular expense. You need to look at the
                      circumstances surrounding the expense to determine how it should be treated.
                 iii. Example: Suppose you have some trash hauled away from your office building.
                      Ordinarily, trash removal would represent a maintenance expense that can be deducted
                      currently. But if the trash is hauled away by your contractor as part of a major renovation
                      of your building, then it must be lumped in with all the other renovation expenses and
          d. Start up expenses include amounts spent in investigating the acquisition of a trade or business
             or in creating a new trade or business as well as in any activity intended for the production of
             profit or income before the date on which an active trade or business begins. § 195
                   i. Start up expenses cannot be deducted as regular business expenses. Rather, they must
                      be capitalized or deferred and amortized. § 195
                  ii. Note: the taxpayer can, at his election, treat the start-up costs as deferred expenses and
                      amortize them over a period of not less than five years. If the taxpayer elects to defer, he
                      simply deducts a pro rata portion of the start up costs during each of the years in the
                      period he elects, beginning with the date the trade or business begins. The election to
                      defer and amortize start-up expenses must be made not later than the date upon which the
                      first tax return for the new trade or business is due.
          e. It is important to determine the start-up date of a new or newly acquired business because those
             expenses that fall before the start-up date can be amortized over five years and those that fall
             after the date must be capitalized and depreciated.
                   i. Examples of expenses that can be amortized:
                           1. Research in a new industry or area of business development
                           2. Study of public financial data
                           3. Due diligence in investigating a potential target
                           4. Evaluating competitors
                  ii. Examples of expenses that must be capitalized:
                           1. Appraisal of a target company or its business or assets.
                           2. Analysis of a target company‘s books and records
                           3. Drafting acquisition agreements
                           4. Drafting documents for submission to regulatory agencies.
                 iii. To determine when a trade or business begins, it depends on whether the trade or
                      business was started from scratch or is acquired as an ongoing business.
                           1. If business was acquired, the beginning date is the date on which the taxpayer
                               acquires the business.
                           2. If started from scratch, the taxpayer has to consult current tax regulations issued
                               by the IRS


   XVII. Depreciation is the accounting process by which the cost of a capital asset is allocated over its
         estimated useful life. In the tax sense, depreciation is the deduction available during the

Federal Income Taxation Outline                                                          Mary Andriko—Fall 2007

          current tax year for that portion of the cost of a capital asset chargeable to that tax year in
          accordance with a schedule giving effect to the estimated useful life of that asset.
          a. Depreciation is available only on capital assets that are utilized in a trade or business. Personal
             assets such as a home or car can be depreciated only to the extent they are utilized by the
             taxpayer to produce income.
          b. Tangible Capital Assets
                  i. The rules for depreciating tangible capital assets are collectively referred to as the
                     ―Modified Accelerated Cost Recovery System.‖ They are codified in § 168.
                 ii. In calculating depreciation, the first step is to determine the asset‘s cost and its useful life.
                     The cost, less salvage value, will be charged, prorated, or ―recovered‖ over the asset‘s
                     useful life on a year-by-year basis.
                iii. Accounting methods used for ―recovering‖ the cost allocated to each year.
                         1. Straight-line method—the taxpayer takes the same deduction in each of the
                             recovery years.
                                 a. Taxpayer divides the asset‘s total cost by the number of years in the
                                     recovery period assigned to the class of assets in which that asset belongs.
                                 b. Example: if the taxpayer pays $45,000 for a truck, he may use a five-year
                                     recovery period. This will yield an annual recovery of $9,000, which he
                                     may deduct in each of the five recovery years. The Code requires that the
                                     straight-line method be used for some assets—e.g., nonresidential real
                                     property and residential rental property.
                         2. Accelerated declining balance method—deductions are larger in the earlier years
                             and smaller in the later years. This allows the taxpayer to recover his costs sooner
                             and thus encourages investment in new plant and facilities.
                                 a. Taxpayer first performs a straight-line analysis to see what percentage of
                                     cost would be depreciated each year. He then multiplies this percentage
                                     either by 2 (for property with a recovery period of 3 to 10 years) or by 1.4
                                     (for property with a recovery period of 15 or 20 years) to come up with the
                                     declining balance percentage (DBP). This new percentage is then
                                     multiplied by the asset‘s cost. The result is the depreciation deduction for
                                     the first year after acquisition. In the second year and each year thereafter,
                                     compute the remaining undepreciated balance and multiply it by the DBP
                                     to arrive at the year‘s deduction.
                                 b. If the result of multiplying the cost by the DBP in any tax year is less than
                                     it would have been for that tax year under the straight-line method, the
                                     taxpayer can switch to the straight-line method and take the larger
                                     deduction until the entire cost or basis has been depreciated. (In the ―real‖
                                     world, there are handy tax tables that do these horrible computations for
                                 c. Because most assets are not purchased on January 1, Congress has come
                                     up with a way to calculate depreciation that takes into account a partial
                                     year of use. The ―half-year convention‖ applies to all assets except real
                                     property and assumes that all personal property assets were purchased at
                                     the mid-point of the tax year. It results in allowing only one-half the
                                     annual deduction in Year 1. The second half of the acquisition year is
                                     deducted in the year following the expiration of the asset‘s recovery
                                 d. Assets such as land and art can never be depreciated.
Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                iv. Calculating Recovery Period for Tangible Capital Assets § 168(c), (e), (f), (g)
                        1. Three year property—assets with a useful life of four years or less (includes
                        2. Five year property—assets with a useful life of five to nine years (includes
                            computers, cars, trucks, most machinery and equipment, and high-tech office
                        3. Seven year property—assets with a useful life of 10 to 15 years (includes
                            furniture, heavy equipment and fixtures);
                        4. Ten year property—assets with a useful life of 16 to 19 years (orchards, barges,
                            and tugs);
                        5. Fifteen year property—assets with a useful life of 20 to 24 years;
                        6. Twenty year property—assets with a useful life of 25 years or more, excluding
                            residential and rental property and nonresidential real property;
                        7. Residential rental property—apartment buildings and rental homes have a 27.5
                            year recovery period;
                        8. Nonresidential real property—shopping complexes and office buildings have a
                            39-year recovery period.
          c. Good Will—a measure for valuing the intangible assets of a business, including the business
             name, its ―earning power,‖ it‘s customer lists, patents, copyrights, franchises, etc. The value of a
             business‘s good will is generally computed by capitalizing net earnings over a period of years
             and then deducting a factor equal to a reasonable return on the value of its tangible assets.
                 i. Rules for amortizing good will and other intangible income-producing assets
                        1. Taxpayers can recover the cost of their intangible income-producing assets by
                            amortizing them over a 15-year period, starting with the month in which the asset
                            is acquired.
                        2. Assets that can be amortized under this section include good will, going-concern
                            value, customer lists, an in-place workforce, patents, copyrights, franchises and
                        3. Note: only assets that have been acquired by the taxpayer and are held in
                            connection with a trade or business can be amortized. Assets that the taxpayer
                            creates herself cannot.


   XVIII. Income from a trade or business v. income from investments
          a. Income from a trade or business is income derived from the production and sale of goods,
             commodities, and/or services.
          b. Income from investments is the income derived by a taxpayer for his own account from his
             private investment activity.
                 i. Examples:
                         1. Interest on notes, bonds, or bank accounts;
                         2. Purchase and sale of stocks or bonds;
                         3. Investments in real estate;
                         4. Collection of rents.
          c. ―Above-the-line‖ v. ―Below-the-line‖ deductions
                 i. Trade and business expenses are ―above-the-line‖ expenses which may be deducted in
                     their entirety from gross income.

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                  ii. Investment expenses are ―below-the-line‖ expenses subject to the ―miscellaneous
                      itemized deduction‖ limitation, which provides that miscellaneous deductions are allowed
                      only to the extent that, taken together, they exceed 2% of the taxpayer‘s adjusted gross
                 iii. Congress enacted § 212 in 1942 in response to the Court‘s decision that investment
                      expenses could not be deducted because they were not the expenses of a trade or
                      business. Courts now look to the facts of each case to decide if an activity qualifies as a
                      trade or business, or if it is an investment activity. If the activity qualifies as a trade or
                      business, the deductions can be taken ―above-the-line‖ under §§ 62 and 162. If not, they
                      must be taken ―below-the-line‖ via §§ 67 and 212.
                          1. Under § 212, individual taxpayers can include the following investment-related
                              expenses in their miscellaneous itemized deductions:
                                  a. Expenses for the production or collection of income;
                                  b. Expense incurred in managing or maintaining property held for the
                                      production of income; and
                                  c. Expenses involved in the determination, collection, or refund of any tax.
                 iv. You are permitted to deduct expenses incurred in an income-producing activity that is not
                      conducted for profit only to the extent of any income produced in that activity during the
                      tax year. Activities that are not conducted for a profit are called ―hobby‖ activities.
                          1. ―Hobby‖ deductions come into play when a taxpayer engaged in an activity that is
                              not intended for profit—e.g., dog breeding or gardening—but produces some
                              income, although not enough to offset its usual expenses.
                          2. § 183(b)(2) allows a taxpayer to recognize expenses related to a hobby activity
                              only to the extent of any income produced. The effect is to prevent the taxpayer
                              from deducting his hobby losses. (In a trade or business, all ordinary and
                              necessary expenses can be deducted—even if the deductions result in a loss)
                          3. To qualify as a trade or business, the taxpayer must show that the activity in
                              question was engaged in primarily for profit rather than pleasure.
                                  a. Note: if the activity has produced a profit in three out of the last five tax
                                      years, it is presumed to be an activity engaged in primarily for profit.


   XIX. Tax Loss
        a. A tax loss is any loss (diminution in value) sustained during the taxable year and not
           compensated for by insurance or otherwise. Losses may be taken as deductions to the extent of
           the adjusted basis provided in § 1011, as in the case of a sale or other disposition of property
        b. Losses recognized by the Code:
                i. Losses incurred in a trade or business;
               ii. Losses incurred in any transaction entered into for profit, though not connected with a
                   trade or business;
              iii. Losses to property arising from fire, storm, shipwreck or other casualty, or from theft,
                   even though the property is not used in a trade or business or for profit (subject, however,
                   to certain limitations).
        c. “Personal-use property” consists of all tangible items used for personal, rather than business or
           income-producing purposes. Examples: clothes, jewelry, cars, and appliances.

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                  i. No deduction is available for personal property that is lost or misplaced. If his personal-
                     use property is damaged, destroyed or stolen, a taxpayer can take a loss deduction, but the
                     amount he is allowed to deduct is limited as follows:
                         1. Each personal property loss can be deducted only to the extent that it exceeds
                         2. Each loss is limited to the lesser of the taxpayer‘s adjusted basis in the property
                             or the difference in the property’s value as measured immediately before and
                             after the casualty;
                         3. All casualty and theft losses together are deductible only to the extent that they
                             exceed 10% of AGI.
          d. “Bad Debt”—debt owed by a third person to the taxpayer that becomes worthless because of
             some event that occurs during the tax year, such as the insolvency of the debtor. A bad debt can
             be deducted from income. The rules controlling the deduction differ depending on the type of
             the debt involved:
                  i. Business bad debts—i.e., those that arise in the taxpayer‘s trade or business—can be
                     deducted to the full extent of the taxpayer‘s adjusted basis in the debt.
                 ii. Non business bad debts—i.e., those that arise out of personal or investment activities—
                     are deductible as short-term capital losses, which means that bad debt and other net
                     capital loss deductions together cannot exceed a total of $3,000 a year.


   XX.    A taxpayer can take a deduction for taxes paid or accrued during the tax year only if the taxes
          qualify under the Code.
          a. The following kinds of taxes can be deducted in the year in which they were paid or accrued:
                  i. State and local real property taxes. (However, real property taxes levied to further the
                     development of real property must be capitalized as part of the cost of the property)
                 ii. State and local personal property taxes. (This category does not include sales tax.) To
                     qualify for deduction, the tax must be on personal property only, imposed on an annual
                     basis and be proportionate to the value of the personal property in question.
                iii. State and local income taxes.
                iv. Other state, local, and foreign taxes imposed on a trade or business, or on a § 212
                     investment activity. (If the tax in question is paid in conjunction with the purchase of
                     property, it must be capitalized; if paid in conjunction with the sale of property, it must
                     be deducted from the amount realized at the sale.)
                         1. Note: when real property changes hands, real property taxes for the tax year are
                             allocated between the buyer and the seller based upon the percentage of the tax
                             year in during which each owns the property.
          b. You are not allowed to take a tax deduction for interest paid on personal loans, such as car
             loans, vacation loans, and credit card debt.
                  i. Exception: Interest on a loan secured by a mortgage on a qualified personal residence is
                 ii. Two kinds of personal residence loans that qualify for interest deductions:
                         1. Acquisition Indebtedness—what we normally think of as a ―first mortgage,‖
                             loans to buy, build, or substantially improve a house, as well as loans to refinance
                             debt on a house. To qualify for deduction, the loan must be secured by the
                             residence itself. The taxpayer can take a deduction only to the extent that the loan

Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

                             does not exceed her adjusted basis in the property, and to the extent that the loan
                             does not exceed $1 million.
                         2. Home Equity Indebtedness—another term for what we commonly call an
                             ―improvement loan.‖ It usually takes the form of a second mortgage. Interest on
                             home equity loans is deductible to the extent that the loan does not exceed
                             $100,000, or the fair market value of the home minus any mortgage outstanding.
                             (The excess of value over indebtedness is called the homeowner‘s ―equity.‖) A
                             home equity loan must be secured by a mortgage on the house itself to qualify for
                             deduction, but the proceeds can be used for anything the taxpayer wants.
              iii. Taxpayers can take the home mortgage interest deduction on one or two houses a year
                    provided they live in them. However, a residence which is otherwise qualified will lose
                    its status as a ―qualified residence‖ if the house is rented out for any portion of the tax
        c. Generally, a taxpayer may take a deduction for interest on money borrowed in connection with a
           business or investment.
                i. When money is borrowed with the expectation of generating income through business or
                    investment activities, the interest on the loan is deductible.
               ii. However, because crafty taxpayers began to abuse this rule by borrowing to invest in tax-
                    exempt investments, Congress created numerous exceptions to the interest deduction rule
                    in an attempt to close the ―tax arbitrage‖ loophole:
                         1. You can‘t deduct interest on a loan whose proceeds were used to buy tax-exempt
                             obligations such as municipal bonds. § 265(a)(2)
                         2. You can‘t deduct interest on a loan whose proceeds were used to buy a single-
                             premium annuity or life insurance or endowment contract. § 264(a)(2)
                         3. You can‘t deduct more in interest on a loan for investment purposes than the
                             amount of income generated by the investment. (Any excess interest expense can
                             be carried forward to future years.) § 163(d)(4)(C)
   XXI. Charitable organizations can be deducted under § 170.
        a. Taxpayers can deduct contributions totaling up to 50% of their AGI to certain public qualified
           charities. Gifts may be made in cash or property. If the gift is of an appreciated capital asset—
           e.g., stock—that would have generated long-term capital gains to the donor if sold, the deduction
           ceiling drops to 30% of AGI. It also drops to 30% for certain private qualified charities. But the
           taxpayer is allowed to deduct the asset at its current market value, rather than at her basis,
           making this a popular way to give to charity. Whichever cap applies, taxpayers can carry over
           any excess contributions and deduct them over the next five taxable years. Contributions of
           long-term capital gain property to 30% charities is limited to 20% of AGI
        b. In order to qualify for deduction, the contribution must truly be a donation rather than a payment
           for services rendered. For example, if you buy a ticket to a charity ball, only that portion of the
           ticket that exceeds to value of the entertainment and food received will qualify for deduction.
        c. To qualify as charitable organizations for deduction purposes, the organizations cannot engage in
           lobbying activities. The classes of organizations that qualify as charities include:
                i. State and local governments (when the contribution is for ―exclusively public purposes‖);
               ii. Religious organizations;
              iii. Charitable organizations (i.e., homeless shelters, child abuse prevention groups, United
              iv. Scientific organizations;
               v. Literary organizations; and

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                 vi. Educational organizations (excluding those that practice racial discrimination—Bob
                      Jones Univ. v. U.S.)
   XXII. Medical Expenses
          a. Taxpayers can deduct their qualifying medical expenses to the extent that they are not
             compensated by insurance and exceed 7.5% of AGI.
                   i. Deductible medical expenses include the following unreimbursed costs paid during the
                      tax year on behalf of the taxpayer, his or her spouse, and/or their dependents:
                          1. Money paid to diagnose, cure, mitigate, treat or prevent disease, ―or for the
                              purpose of affecting any structure or function of the body,‖
                          2. Transportation costs related to essential medical care;
                          3. The cost of qualified long-term care services;
                          4. Premiums or co-pays for medical or long-term care insurance; and
                          5. The cost of prescription drugs.
                  ii. Note: any medical expense that has been reimbursed to the taxpayer by insurance or
                      otherwise does not qualify as a deductible medical expense, since this would be ―double
                iii. Note: Cosmetic surgery is not deductible unless it is necessary to correct a congenital
                      deformity or a personal injury that resulted from an accident, trauma, or disfiguring
   XXIII. Personal Exemption
          a. Deductions all taxpayers can take to further reduce their tax burden. Unlike most deductions,
             however, they do not relate to a particular category of spending or expenses. Rather, they are a
             fixed amount that all taxpayers get to deduct from AGI, and the amount is not subject to the 2%
             floor rule.
          b. Each exemption is calibrated each year to equal a $2,000 exemption in 1989 dollars. The
             formula adjusts the amount each year for inflation. Joint filers can claim one exemption each for
             themselves, and one for each qualified dependent.
          c. Note: the personal exemptions benefit is phased out progressively for high-income taxpayers,
             starting when AGI exceeds $209,250 for joint filers, and phasing out completely when AGI
             reaches $331,750. (2003 numbers.)
          d. You can claim one personal exemption for each dependent who qualifies under the Code.
             ―Qualifying dependents‖ are defined as those people who receive over half of their support
             during the tax year in question from the taxpayer, and who bear one of the following
             relationships to the taxpayer:
                   i. A child or step-child, or a descendant of either;
                  ii. A sibling or step-sibling;
                iii. A parent or step-parent, or an ancestor of either;
                 iv. A niece or nephew;
                  v. An aunt or uncle;
                 vi. An in-law; or
                vii. An individual other than the taxpayer‘s spouse whose principal residence is the
                      taxpayer‘s home and who is a member of the taxpayer‘s household.
               viii. Note: In addition to the above requirements, the dependent in question must either:
                          1. Have no more gross income than the exemption amount allowed for him in that
                              year, or
                          2. Be a child of the taxpayer who is either under age 19, or a full-time student who
                              has not reached the age of 24 at the end of the tax year. §§ 151 and 152

Federal Income Taxation Outline                                                     Mary Andriko—Fall 2007


   XXIV. Tax Credits
         a. Deductions are subtracted from either gross income or adjusted gross income. Deductions
            therefore reduce the taxpayer‘s tax liability in proportion to her tax bracket. Example: a $500
            deduction to a taxpayer in the 28% tax bracket is worth .28 x $500 = $140 in savings.
         b. A credit is subtracted from all taxes due—i.e., the bottom line—and reduces a taxpayer‘s tax
            liability dollar for dollar. In other words, a $500 credit equals $500 in tax savings.
         c. Two broad classes of credits:
                 i. Nonrefundable credits can be applied only to the extent that they reduce taxes to zero.
                     (Some nonrefundable credits allow any unapplied portion to be carried forward into
                     future tax years or carried back to past tax years.)
                         1. Credits for expenses for household and dependent care services necessary for
                             gainful employment. Under this credit (the ―dependent care credit‖), taxpayers
                             who maintain a household that has a qualifying individual can get a credit of
                             between 20% and 35% of the dependent care expenses they incur in order to be
                             able to work. A qualifying individual is a dependent who is either under age 13
                             or physically or mentally disabled (a disabled spouse is included). From 2003-
                             2010, the maximum dependent credit is $1050 for one qualifying dependent and
                             $2100 for two or more. § 21
                         2. Credits for the elderly and disabled. This is an asset for those who are over 65
                             or who are retired and disabled and fall within low-to-middle-income brackets.
                             People under 65 qualify only if they are totally and permanently disabled. § 22
                         3. Child Tax Credit. Taxpayers can take a credit of up to $1000 (as of 2003), for
                             each child under the age of 17.
                         4. Hope and Lifetime Learning Credits. Both of these credits are available to a
                             taxpayer who foots a college tuition bill. They were designed to benefit middle-
                             income families. Hope Credit applies to students in their first two years of
                             college and the maximum credit is $1500 per student. Lifetime Learning Credit
                             max out is $2000 per year and taxpayer may take the credit for only any one
                             student in each tax year.
                ii. Refundable credits entitle the taxpayer to a tax refund to the extent that they bring her
                     tax liability below zero. §§ 21-53
                         1. Credits for taxes withheld on wages—e.g., on wages or salaries paid through
                             weekly withholding. Employers are required to withhold from salaries and wages
                             earned by employees a portion that serves as an estimate of taxes to be paid in
                             each tax year by the employees. Employees who have these taxes withheld from
                             their paychecks get to take a credit equal to the total amount of tax withheld. If
                             the amount withheld is greater than the amount owed, the taxpayer is entitled to a
                             refund of the difference. § 31
                         2. Earned Income Tax Credit (EITC). To encourage them to work rather than
                             collect welfare, low-income workers are allowed a credit against their tax
                             liability. Unlike most refundable credits, which allow a taxpayer to recoup money
                             he overpaid to the government, this credit functions as a subsidy to people with
                             incomes at or below the poverty level.
                         3. Credit for overpayment of tax. Taxpayers may take a credit for all other
                             payments towards income taxes made by them or for their account during the tax

Federal Income Taxation Outline                                                     Mary Andriko—Fall 2007

                              year. As in the case of withholding wages, taxpayers who overpaid their taxes are
                              entitled to a refund equal to the amount of the overpayment. §§ 35 and 6401
                 iii. Credits available to Businesses. A number of credits are provided to businesses as
                      incentives to undertake such things as research and the development of low-income
                      housing. These credits are not refundable, but many offer the taxpayer the opportunity to
                      carry any unused credits either forward or back.
                          1. Nonrefundable credits available to businesses. Includes:
                                  a. Credit for increasing research activities.
                                  b. Credit for developing low-income housing.
                                  c. Credit for expenditures incurred to provide access to the disabled. § 38

   XXV. Attribution of Income. Our tax system imposes a variety of tax rates. Example: The rates
        imposed on corporations are different from those charged to individual taxpayers. Also, individual
        tax rates are progressive—i.e., they rise as income rises. Under this system, taxpayers will attempt
        to achieve lower taxes by moving income to a tax entity with a lower possible rate. The government,
        on the other hand, will discourage efforts to divert income solely for tax purposes. The phrase
        ―attribution of income‖ refers to the process of identifying which taxpayer will be charged for a
        particular item of income (or which taxpayer may take a particular deduction.)
        a. High-income taxpayers are motivated to create ways to shift income from their own higher tax
            brackets to someone else‘s lower bracket. This is done trough gifts, or by restructuring the form
            of an asset or business, such as by creating a trust or a partnership or corporation.
        b. Families are not considered a single taxpaying unit in attributing income.
                 i. The family is treated as a single unit in some respects. Example: A married couple may
                     file a joint tax return even though each party has his or her own income and generates
                     some of his or her own deductions. The assumption is that married persons share their
                     income equally. §§ 1(a) and 6013. In addition, a married couple can claim a single
                     deduction for the mortgage interest they pay on their home, even though it may be
                     occupied by people other than the taxpayers themselves—i.e., their children. §
                ii. Children must file their own returns and report their own income. A child‘s earned
                     income—i.e., paper routes, appearance on a TV sitcom—is taxed to her at her own
                     marginal rate.
                          1. Children are allowed to claim as deductions on their own returns the expenses
                              incurred to generate their earned income—whether the expenses were actually
                              paid with their own money or with their parents‘ money. § 73
                          2. ―Kiddie tax.‖ The rules are different for a child‘s unearned income, since
                              unearned income often flows from property given to the child by family members
                              (sometimes in an attempt to take advantage of a child‘s lower tax bracket).
                              Children under the age of 14 are required to pay tax on their net unearned income
                              at their parents‘ tax rate § 1(g). It was designed to deter parents from shifting
                              income-producing assets to their kids in order to save a few tax dollars.
                          3. Standard deduction is minimal and can only be used to reduce earned income. In
                              addition, children can‘t claim a personal exemption because their parents are
                              eligible to claim one on their behalf on the parental return. §§ 63(c)(5) and
        c. 4 different rate tables apply to adult taxpayers.

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                  i. Single Individuals (to be used by all unmarried persons who do not qualify for any of the
                     other tables);
                 ii. Married Individuals Filing Jointly, and Surviving Spouses (to be used by anyone who
                     is married and wishes to file a joint return, or by anyone defined as a surviving spouse. A
                     surviving spouse is one whose spouse died within the two years preceding the tax year,
                     who has not remarried, and who has a dependent child living at home.) § 2(a)(1)
                iii. Married Individuals Filing Separate (to be used by anyone who is married but does not
                     want to file a joint return); and
                iv. Heads of Household (to be used by a taxpayer who is neither married nor a ―surviving
                     spouse,‖ but who maintains a household which includes a child, grandchild, or parent).
                 v. Note: The tax rates for individual taxpayers range from 10% to 35%. The same rates are
                     used within each of the four tables but they are applied at different levels of income.
                     Thus, taxes increase more or less rapidly, depending on the table you use. The table that
                     increases taxes the fastest is the ―Married Filing Separately‖ table, followed in
                     descending order by the Single table, the Head of Household table and finally, the Joint
                     Return table. § 1
          d. Income from personal services is attributed to the person who does the work and has earned the
             compensation—no matter who receives the paycheck.
          e. Income from property can be shifted, but several restrictions apply:
                  i. The income must be generated as a passive return on an investment, not as disguised
                     compensation for services rendered.
                 ii. The income cannot be ―carved out‖ of the taxpayer‘s right to income from that
                     property—i.e., the donor cannot retain any significant interest or control over the asset he
                     gives away. Example: He cannot retain the right to get the property back at some future
                     date, or to use the income for or on behalf of himself. Nor can he retain the right to
                     change who will own the asset in the future. In simple terms, if the transferor retains a
                     remainder in the property, he will probably be considered the recipient of all income
                     during any prior term.
          f. Trusts are treated for tax purposes as independent entities. They are allowed to deduct from
             income all distributions to the persons designated as trust beneficiaries. As a practical matter,
             then, the net income of the trust is taxed to the beneficiaries. (The trust itself is taxed only on net
             income it does not distribute to the beneficiaries during the tax year.)
                  i. The exception is: Income from assets in an inter vivos trust (a trust created during the
                     grantor‘s lifetime) is attributed to the grantor if the grantor is viewed as the ―substantial
                     owner‖ of the trust. The grantor will be viewed as the ―substantial owner‖ if:
                         1. At the inception of the trust, he or his spouse has a reversionary interest in more
                             tan 5% of the value of the trust‘s income or more than 5% of the value of the trust
                         2. He or his spouse retains substantial powers of disposition over the income or
                             corpus of the trust—i.e., they get to decide who gets the money and when;
                         3. He or his spouse retains the power to revoke the trust;
                         4. He or his spouse benefits from an accumulation or distribution of trust
                             income without the consent of an ―adverse party‖ (a beneficiary whose interests
                             would be adversely affected);
                         5. Trust income is used to help pay premiums for a life insurance policy on the life
                             of the grantor or his spouse (known as an ―insurance trust‖); or
                         6. Trust income or corpus is used to support the grantor‘s legal dependents (but only
                             to the extent that it is used for this purpose). §§ 671-679
Federal Income Taxation Outline                                                        Mary Andriko—Fall 2007

                          7. Note: These issues arise only in connection with lifetime or inter vivos trusts—
                             trusts created by the grantor while he‘s still alive. Testamentary trusts are not
                             affected because it would be pretty hard for the grantor to remain the ―substantial
          g. Corporations are treated as separate tax entities, but partnerships are not. Instead, the net income
             of a partnership is taxed to the individual partners in the same proportion as their capital
             investments in the partnership.
                  i. If a partner gives a portion of his capital interest in the partnership to another, the income
                     from that investment will be taxed to the donee, but only after there is deducted from
                     such income the value of services contributed to the partnership by the donor partner.
                     Also, the donor partner cannot give away more income than is attributable to his capital
                     interest in the partnership. § 704(e)
                 ii. Because corporations are organized as legal entities with perpetual life, they are
                     considered independent tax entities, so the corporation itself pays the tax on its income.
                     (Subchapter C, § 301) Except for close corporations that elect to be taxed under
                     Subchapter S (S corporation), business corporations are known as C corporations.
                          1. In reality, the income of C corporations is subject to a double tax—it is taxed
                             first to the corporation (at the corporate tax rate) and then to the individual
                             shareholders (at their individual rates), to the extent that the income is distributed
                             to the shareholders in the form of corporate dividends.
                          2. Closely held corporations (corporations with only a few shareholders) can elect to
                             take advantage of Subchapter S (§ 1361). Under Subchapter S, a corporation can
                             elect to be taxed as either a partnership or sole proprietorship instead of as a
                             corporation. In either case, the company‘s earnings will be taxed directly to the
                             individual shareholders; no corporate tax is due. To qualify under Subchapter S,
                             a corporation must have:
                                  a. No more than 75 shareholders,
                                  b. Only one class of stock, and
                                  c. No shareholder who is a non-resident alien.
                                  d. Note: shareholders may be resident individuals, estates, certain trusts, and
                                      certain tax-exempt organizations.
          h. Below-market-rate loans from one individual to another are treated as gift loans.
          i. An individual who loans money to another has complete discretion what interest rate to charge,
             of course. He can charge the going rate or a rate well below the current market rate. Or he can
             charge no interest at all. If a less than reasonable return is received by the lender for the use of
             his money, the loan is deemed either an interest-free or below-market gift loan.
                  i. Gift loans were used for years as an income-shifting device—savvy parents would loan
                     money to a child either interest-free or at very low rates. The child would then invest the
                     money and pay the taxes on the interest generated at her lower tax bracket. Then at some
                     future date, the child would pay the principal back to the parent.
                 ii. Congress sought to avoid the income-shifting scheme of interest-free and below-market
                     gift loans between individuals by enacting § 7872 in 1984. The attribution-of-income
                     principles in this statutory scheme are complicated:
                          1. The loan is treated as if it had been made at the prevailing federal rate of
                          2. The difference between the interest at the rate charged and the interest at the
                             federal interest rate is treated as a gift from the lender to the borrower.

Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                       3. The borrower is treated as if he had received that difference, and then paid it
                           back to the lender as interest.
                       4. The lender is then treated as if she had received that difference as interest
                           income. § 7872.
          j. Two types of loans where interest charged to the lender is at federal interest rates:
                i. Below-Market Loans between a corporation and a shareholder;
               ii. Below-Market Compensation Loans (loans between an employer and employee, or
                   between an independent contractor and the person for whom the contractor provides
                   services). § 7872(c)(1)(B), (C)


   XXVI. Capital gains and capital losses are the profits or losses that are realized by a taxpayer when she
         sells or exchanges assets classified as ―capital assets.‖ Think in terms of assets that produce
         investment income, then contrast this income with ordinary income—e.g., stock dividends versus
         salaries. Only assets producing investment income get capital gains treatment. Beginning in 2003,
         dividends are taxed at the same rate as capital gains.
         a. Some capital gains receive preferential tax treatment by being taxed at a lower rate than ordinary
             income. § 1(h). In addition, capital losses are treated differently from ordinary losses—there are
             limitations on the deduction of capital losses. The rules for capital losses by corporations are
             different from those for individual taxpayers. § 1211
         b. Both capital gains and capital losses are divided into short-term and long-term gains and losses.
             Currently, the sale or exchange of any capital asset held for more than one year will result in a
             long-term gain or loss. Anything held for one year or less will result in a short-term gain or loss.
             § 1222
         c. In general, when you approach a set of facts that suggest a capital transaction ask yourself the
                   i. Does the transaction involve a capital asset?
                  ii. Does the income or loss, of any, arise from this transaction?
                iii. Is the transaction the ―sale or exchange‖ of the capital asset?
                 iv. How long did the taxpayer hold the asset before the sale or exchange?
         d. “Capital Assets” are all property held by the taxpayer except the following:
                   i. Inventory or other property held primarily for sale to customers in the ordinary course of
                      the taxpayer‘s trade or business;
                  ii. Depreciable property used in the taxpayer‘s trade or business—i.e., office equipment or
                      machinery—or real property used in the trade or business;
                iii. Intellectual property—other than patents and trademarks—created by the taxpayer‘s
                      personal efforts (e.g., copyrights and works of art);
                 iv. Accounts receivable;
                  v. Government publications held by taxpayers who receive them free from a government
                      agency—e.g., the Congressional Record. § 1221
                 vi. Note: In most cases, gain or loss resulting from the sale or exchange of property that falls
                      within one of the above exceptions is treated as ordinary income or loss.
         e. ―Quasi-capital assets‖ are non-capital assets that are both depreciable property and real
             property used in a trade or business and held for more than one year, and are treated as
                   i. All gains and losses for § 1231 property are netted together. If the net shows that gains
                      exceeded losses, then all the individual transactions are treated as long-term capital
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                       transactions. If the net shows that losses exceed gains, then all the individual
                       transactions are treated as ordinary transactions resulting in ordinary loss treatment.
                   ii. In other words, holding § 1231 assets is a win-win situation for the taxpayer. She gets to
                       be taxed at the lower capital gains rate if she has a net gain, but she gets to deduct her
                       losses against her ordinary income—thereby taking advantage of the higher tax rate—if
                       she has a net loss.
          f.   A taxpayer who divides his income interest in an asset into term portions and a remainder cannot
               claim capital asset status for the carved-out term portions.
          g.   In order for a transaction to qualify as a capital transaction and be subject to capital gains
               treatment, the transaction must involve the ―sale or exchange‖ of a capital asset. § 1222 and
               156(f). Several Code sections deal with transactions that qualify as sales or exchanges requiring
               capital treatment; the most common ones are:
                    i. Non-business bad debts are treated as capital assets sold or exchanged in the year in
                       which they became worthless. They are deemed to have been held for less than one year.
                       § 166(d)(1)(B)
                   ii. Worthless securities which are capital assets are treated as if sold or exchanged in the
                       year in which they became worthless. § 165(g)
                  iii. If a business asset or other capital asset is the subject of an involuntary conversion
                       [defined as whole or partial destruction (e.g., by fire), theft, or seizure (as in
                       condemnation)], the conversion will be treated as a sale or exchange of the asset in the
                       year of conversion. § 1231(a)(3)
                  iv. A transfer of all substantial rights to a patent will be treated as a capital sale or
                       exchange, even if the payment in exchange is made only periodically, or is contingent
                       upon the production of products from the patent. § 1235
                   v. Related Issue: The transfer of a franchise, trademark, or trade name is not treated as a
                       capital sale or exchange if the transferor retains any significant powers or rights in the
                       property transferred. § 1253.
          h.   A long-term capital gain is defined as gain from the sale or exchange of a capital asset held for
               more than one year. Similarly, long-term capital loss is defined as loss from the sale or exchange
               of a capital asset held for more than one year.
                    i. The holding period is measured from the time the asset is acquired until the time it is
                       transferred. The day of acquisition is excluded from the calculation, but the day of
                       disposition is included. § 1222
                   ii. Note: when a taxpayer acquires an asset with a substituted basis—e.g., by gift or
                       inheritance—the transferor‘s holding period is substituted as well. In other words, the
                       taxpayer gets to add on to his holding period the period of time during which the previous
                       owner held the asset.
          i.   Net capital gain is taxed at a rate lower than ordinary income. Example: in 2003, the
               maximum tax rate for net capital gain was 5% for taxpayers in the 15% or lower income bracket,
               and 15% for taxpayers in higher brackets. §§ 1(h) and 1222(11).
                    i. In order to determine net capital gain, you have to perform a series of ―netting‖
                            1. Total each of the following separately: all the long-term capital gains together, the
                                long-term capital losses together, the short-term capital gains together, and the
                                short-term capital losses together.
                            2. Subtract the taxpayer‘s short-term losses from his short-term gains. If the result is
                                positive, it‘s his net short-term gain; if negative, his net short-term loss.

Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

                        3. Net the taxpayer‘s long-term capital gains against his long-term capital losses.
                             The result is his net long-term gain or loss.
                        4. If your calculations show both a net long- and a net short-term capital gain, the
                             net long-term capital gain is the entire net capital gain for tax reporting
                             purposes. The net short-term gain must be reported as ordinary income.
                             (Although net short-term capital gains do not get subtracted from net long-term
                             capital gains, they serve a purpose by offsetting short-term capital losses, which
                             are otherwise difficult to deduct.)
                        5. If you show a net long-term capital gain and a net short-term capital loss, you may
                             subtract the loss from the gain. If your result is a positive number it is your net
                             capital gain. Otherwise, refer to the following card for treatment of net capital
                        6. If you show a net long-term capital loss and net short-term capital gain, subtract
                             the loss from the gain. If your result is a positive number, it must be reported as
                             ordinary income, since it stemmed form a short-term gain. If the result is a
                             negative number, refer to the following card for treatment of net capital losses. §
          j. Capital losses are not deductible in full.
                 i. A capital loss occurs when a taxpayer sells or exchanges a capital asset for less than the
                    asset‘s adjusted basis. Capital losses are deductible only against capital gains—plus, up
                    to $3000 each year, against ordinary income. If a taxpayer who has both long- and short-
                    term loss takes a deduction from ordinary income to the extent of not more than $3000,
                    the presumption is that the deduction comes first out of her short-term loss. Any
                    remaining capital losses not deducted in the tax year can be carried forward to future tax
                    years, to be used against future capital gains in the netting process, plus again, against
                    ordinary income to the extent of not more than $3000 a year. §§ 1211(b) and 1212
                ii. Note: any capital loss that is carried forward will retain its original character as either
                    long-term loss or short-term loss.


   XXVII. The Tax Year
        a. For most taxpayers, the tax year coincides with the calendar year—it starts on January 1 and it
           ends on December 31. This is the rule for individuals, as well as most partnerships, S
           corporations, and personal service corporations (PSC‘s). These entities must follow certain
           procedures to obtain automatic approval to adopt, change, or retain their annual accounting
           period. In general, these entities must choose a tax year that conforms with the taxable years of
           its partners, shareholders, or owner-employees. §§ 441, 706(b)(1)(B) and 1378
                i. C corporations have a 365-day tax year as well, but they can elect to have their tax year
                    match their corporate fiscal year. This election must be made when the corporation files
                    its very first return, and it cannot be changed thereafter without approval of the IRS. §
        b. The Tax Benefit Doctrine stands for the proposition that an adjustment to a previously reported
           transaction may be made by the taxpayer in the later year—but only to the extent that he received
           a tax benefit in the prior year. § 1111
        c. The Claim of Right Doctrine is sort of the flip side of the Tax Benefit doctrine. This doctrine
           deals with the receipt of income in the current tax year that may have to be repaid or refunded by
           the taxpayer in a subsequent year.
Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

                 i. The general principle is that a taxpayer must include as income money she receives in the
                    current tax year as to which she asserts a rightful claim, even if the payor of the money
                    (or someone else) contests that claim and even if her claim is in fact invalid. The income
                    must be included in the year of receipt.
                ii. If some or all of the money has to be refunded in a future year, the taxpayer can take a
                    deduction then. However, the deduction must be symmetrical with the treatment in the
                    tax year in which the income was received. Example: If the money was originally
                    included in income as a capital gain, then the subsequent deduction would be treated as a
                    capital loss.
          d. Accounting
                 i. The cash method of accounting focuses on money out and money in; a taxpayer has
                    income when she receives a payment (as opposed to when she bills someone or has a
                    right to receive the payment), and has a deduction when she makes a payment (as
                    opposed to when she becomes liable to make the payment).
                        1. Under the cash method of accounting, what matters is when the money changes
                            hands. Therefore, a taxpayer can take a deduction only when he makes the
                            payment in question.
                        2. Payments do not have to be made in cash, however. Payments in cash or ―cash
                            equivalents‖ will qualify. Example: a taxpayer who pays by check may take the
                            deduction when the check is mailed. A taxpayer who pays for an item with a
                            charge card may take the deduction in question when his card is charged by the
                            retailer—not when he later pays off the bank which issued the card.
                        3. Note: Not all payments are deductible in full in the year that they‘re made, even if
                            made in cash. As we discussed earlier, expenses that are incurred to purchase or
                            create an asset with a life longer than one year cannot be deducted as a business
                            expense in the year incurred. Instead, they must be capitalized as a business
                            expense in the year incurred. Instead, they must be capitalized and depreciated or
                            amortized over a period of years. § 263.
                ii. The accrual method of accounting focuses on rights and obligations: an item is income
                    when the right to receive it is earned (as opposed to when the income is actually
                    received), and an item is deductible when the taxpayer becomes liable to pay the item
                    (as opposed to when she actually pays it).
                        1. The general rule for accrual taxpayers is that income must be reported by them
                            when it is earned. Income is considered ―earned‖ when:
                                 a. All the events fixing the right to receive the income have occurred; and
                                 b. The amount can be determined with reasonable accuracy.
                        2. Sometimes accrual taxpayers receive payments in advance of earning the income.
                            If the prepayments are for goods sold, the taxpayer can defer the income until the
                            goods are shipped. If, however, the payments are for services to be rendered, the
                            rules are less clear. Most of the cases have held that in the case of services to be
                            rendered, a prepayment should be included as income upon its receipt.
                        3. Taxpayers who use the accrual method of accounting cannot take a
                            deduction for an expense until “economic performance” of the expense has
                            occurred and the “all events test” has been satisfied. The definition of
                            ―economic performance‖ depends upon the type of expense involved:
                                 a. Expenses for services to the taxpayer are deductible when the services are

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                                  b. The cost of property is deductible as the property is provided to the
                                  c. Lease payments for rental property are deductible as the taxpayer uses the
                                     property; and
                                  d. Obligations for tort and worker’s compensation claims are deductible
                                     when paid.
                         4. The ―all events test‖ is satisfied if:
                                  a. All events have occurred which determine the fact of liability; and
                                  b. The amount of the liability can be determined with reasonable accuracy. §
                                     461(h)(2) and (4)
                iii. Note: Individuals are required to use the cash method of accounting. Other taxpayers are
                     required to use the same method of accounting for tax purposes as they use to keep their
                     books. However, the IRS can change the method if it does not ―clearly reflect income‖ of
                     the business. § 446. C corporations are required to use the accrual method. § 448(a)
                iv. Taxpayers in the business of selling goods for profit—whether raw materials or finished
                     products—must use the accrual method of accounting. In addition, they must account for
                         1. Taxpayers who sell goods compute their income for the year by using the
                             following formula: Gross Profit = Gross Receipts – Cost of Goods Sold.
                         2. To calculate the cost of goods sold, the taxpayer must use the following formula:
                             Cost of Goods Sold = (Opening Inventory + Purchases) – Closing Inventory.
                         3. Opening Inventory is the cost to the taxpayer of all inventory on hand at the start
                             of the year. This amount should be exactly the same as the amount the taxpayer
                             reported as last year‘s closing inventory.
                         4. Purchases consist of all those items bought by the seller for resale during the tax
                             year, computed at the cost of each item. Closing inventory is the cost of all items
                             remaining in inventory at the end of the year. The art of inventory accounting
                             comes into play in calculating this closing inventory figure.
                         5. There are two primary methods for costing out the items that remain on the shelf
                             at the end of the year:
                                  a. First-in, first-out (FIFO)—The assumption is that goods first acquired
                                     were those first sold. Under FIFO, closing inventory is valued as if it
                                     consisted of the goods most recently purchased.
                                  b. Last-in, first-out (LIFO)—The assumption is that the goods most recently
                                     purchased are the ones that were first sold. Under LIFO, closing inventory
                                     is valued as if it consisted of those goods that were purchased the earliest.
                                     §§ 471 and 472
                 v. Installment Sales of Property
                         1. The Code recognizes that a seller who has to report a capital gain on an
                             installment sale may not have the ability to pay the corresponding tax except out
                             of the installments as they come due.
                         2. Under § 453, a taxpayer can use the installment method of accounting to report
                             the gain he receives at the same rate as the payments he receives.
                         3. Under the installment method, the taxpayer divides his gross profit (the selling
                             price minus his adjusted basis) by the selling price. This is his percentage of
                             profit. He then applies this percentage to each payment as it is received, and
                             reports the resulting product as income in the year received.

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                        4. § 453 applies to property only, not services, and applies only when a sale results
                           in a gain, not a loss. The section is not available to taxpayers who deal regularly
                           in installment sales of a particular kind of product.
                        5. An ―installment sale‖ is any disposition of property in which at least one
                           payment is to be received after the close of the taxable year in which the
                           disposition occurs.
                               a. The two exceptions to this general definition are:
                                        i. Any dealer disposition; and
                                       ii. Any disposition of personal property of a kind which is required to
                                           be included in the inventory of the taxpayer if on hand at the close
                                           of the taxable year. § 453(b)

          e. Receipt
                 i. In recognizing receipt, constructive receipt is treated in the same way as actual receipt.
                    Cash, property, and services constitute when they are actually or constructively received.
                        1. Constructive receipt is the attribution of income to a taxpayer whenever she has
                            the power to collect it without having to satisfy a restriction or condition.
                        2. Income is constructively received when the taxpayer can draw upon it at any time
                            at her option, without first having to meet some stipulation.
                        3. If a taxpayer has the right to immediate payment, the payment will be considered
                            constructively received. If she has to complete an additional step before she can
                            receive the payment, there has not been constructive receipt.
                        4. Example: A farmer who only had to sign some forms before receiving payments
                            from the government was deemed in constructive receipt of the payments in the
                            year in which the forms were available to him. His failure to sign them until the
                            following year did not move the realization of income to the later year. But
                            another farmer was held not to be in constructive receipt of advance payments
                            under a potato growing agreement. In order to receive the money, he first had to
                            purchase insurance on the crop. This was a condition that prevented the
                            recognition of constructive receipt until it was satisfied.
          f. Reporting Income
                 i. Interest—Every business or organization that pays interest to a taxpayer is required to
                    prepare and file a form known as a 1099 form. The original form is filed directly with the
                    IRS as part of a 1096 summary, which lists all individual taxpayers who have received
                    compensation from the business or organization during the tax year, including interest,
                    royalties, and other compensation not reported as salaries and wages in a W-2 form. The
                    taxpayer receives a copy of each 1099 filed for him with the IRS.
                ii. Salary & Wages—In general, an employee must report income when it is earned, unless
                    there is a risk that the money may never actually be paid.
          g. 401(k)
                 i. Qualified Pension and profit sharing plans are usually composed of an employer
                    contribution and an employee contribution. The Code limits the amount that each can
                    contribute in any tax year.
                ii. The employee’s contributions are generally made through a payroll deduction plan.
                    Contributions are computed on a pre-tax basis. In other words, the employee gets to
                    deduct her contributions from her gross income for the year, thereby deferring the taxes
                    on them. The employer‘s contribution also is excluded form the employee‘s gross
                    income for the year, thereby deferring the taxes on them.
Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                  iii. The employer’s contribution also is excluded form the employee’s gross income for
                       the year. Increases in the value of the fund are also treated as tax-deferred. The
                       employee does not pay any taxes either on the original contributions to the plan or on any
                       appreciation in its value until she withdraws the money, usually on retirement.
                  iv. Note: the employer is able to expense its contributions to the employee‘s 401(k) as they
                       are paid; it gets to take the deduction in the year the contribution is made. § 401-404
          h.   IRA
                    i. Individual Retirement Account. Every taxpayer is entitled to create and maintain an IRA.
                       Under the traditional pre-Roth-IRA, a taxpayer who is not covered by a qualified
                       employee benefit plan is allowed to contribute up to $3000 (03-04 amount) of his annual
                       earnings into an account designated as his personal IRA and he can deduction the
                       contribution from his gross income. Neither the account nor his annual contribution is
                       taxed until he withdraws part or all of the funds. He is required to begin his withdrawals
                       at a fixed retirement age and annually thereafter in accordance with life expectancy
                   ii. There are two types of IRAs
                             1. Under a standard IRA, the taxpayer can deduct the amount contributed from her
                                 gross income in the year the contribution is made. (In effect contributions are
                                 made with pre-tax dollars). Earnings also accumulate on a tax-deferred basis.
                                 The taxpayer pays tax on both contributions and value-appreciation when the
                                 funds are withdrawn.
                             2. Contributors to a Roth IRA do not take a deduction for the amount contributed
                                 (contributions are made with post-tax dollars). But Roth IRA participants enjoy
                                 tax-free earnings and accumulations on the amounts contributed. There is no tax
                                 to pay upon withdrawal, provided the withdrawal is done at the appropriate
                                 time—i.e., after age 59 ½ or in a few other specific situations, such as to meet
                                 first-time home-buying expenses. For taxpayers who start to contribute early and
                                 live long enough to reap the bounty of decades of tax-free appreciation, the
                                 benefits of the Roth IRA can far exceed those of the standard IRA.
                             3. Note: Lots of restrictions apply to IRA‘s. In general, taxpayers who withdraw
                                 funds prior to age 59 ½ face a 10% withdrawal penalty. There are some
                                 exceptions to these penalties, such as withdrawals to pay for medical or
                                 educational expenses. Also, taxpayers who participate in a 401(k) plan are
                                 limited in their ability to contribute to an IRA. §§ 408 and 408A.
   XXVIII.     Like Kind Exchanges
        a.     In general, whenever an asset is sold or otherwise disposed of, gain or loss from the sale or
               disposition must be recognized by the taxpayer. § 1001
          b.   Under the § 1031 exception, a taxpayer who exchanges property for other property of “like
               kind” can defer recognition of any gain or loss until the newly acquired property is sold.
               (In fact, if the property meets the three requirements of the section, gain or loss must be
               deferred—there is no way to opt out of the provision.)
          c.   The three requirements for a § 1031 exchange are:
                    i. Both the property given and the property received must be held for “productive use in
                       trade or business or for investment.” (This requirement must be satisfied by the
                       taxpayer claiming coverage under § 1031. How the other party reports the transaction is

Federal Income Taxation Outline                                                       Mary Andriko—Fall 2007

                 ii. The transaction must qualify as an exchange—a swap of property for other property.
                     (Selling an asset and then reinvesting the proceeds in another asset, however similar, does
                     not qualify.)
                iii. The properties exchanged must be of ―like kind.‖ (This refers to the general nature or
                     character of the property, not to its quality or grade.)
                iv. Note: Several kinds of property are excepted from this provision. The exceptions include
                     inventory or stock in trade; stocks, bonds, and other securities; partnership interests; and
                     choses in action. § 1031(a)(2)
   XXIX. Carry Forwards and Carry Backs
         a. Under § 172, taxpayers whose business deductions exceed their business income in a tax year
            can take advantage of the excess deductions by applying them to tax returns for other years—
            first to the two years before the net operating loss, and, if necessary, for up to 20 years after the
            net operating loss.
         b. These are called ―carrybacks‖ and ―carryforwards‖ (or ―carryovers‖), because the deduction is
            carried back to returns of prior years, and/or carried forward to returns of future years. (With
            carrybacks, the prior tax obligation is actually recomputed, taking into account the ―carryback‖
            deduction. In most cases, the taxpayer will wind up receiving a refund.)
         c. § 172(b)(2) requires the taxpayer to attempt to ―use up‖ the deduction in the earliest year
            possible, starting with two years before the year of the loss and moving forward from there.
            However, § 172(b)(3) allows the taxpayer to elect to waive all carrybacks and to apply any
            excess loss only to future tax years.
   XXX. Alternative Minimum Tax
         a. Under the Alternative Minimum Tax (AMT), taxpayers use a different set of rules and tables to
            calculate their income and the tax (called alternative minimum taxable income or AMTI), the
            result is then compared with the tax as regularly computed. The alternative calculation becomes
            relevant only if the AMT amount is higher than the amount owed under the traditional tax
            scheme. When that is the case, the taxpayer must pay the AMT amount. §§ 55-58
         b. The first step in computing AMT is to compute AMTI. You start with the taxpayer‘s regular
            taxable income, and then adjust it upward based upon the rules found at §§ 56-58.
                  i. § 56 includes a different formula for calculating the depreciation deduction, and it
                     eliminates many other deductions completely, including the standard deduction and all
                     personal exemptions.
                 ii. § 57 requires that certain items of ―tax preference‖ as defined in the statute be added back
                     into taxable income. These include tax-exempt interest on private activity bonds and
                     accelerated depreciation on pre-1987 depreciable property.
                iii. § 58 requires the taxpayer to recalculate some deductions associated with losses.
                iv. Once these adjustment have been made, the result is AMTI.
                          1. The next step is to subtract from AMTI the statutory exemption amounts found at
                             § 55(d). The result of this calculation is called the ―taxable excess‖
                          2. Finally you need to apply the applicable tax rate to determine the AMT
                             obligation. The applicable tax rate is 26% ―of so much of the taxable excess as
                             does not exceed $175,000,‖ plus 28% ―of so much of the taxable excess as
                             exceeds $175,000.‖ § 55(b)
   XXXI. Calculating a Taxpayer’s Liability
         a. Calculate Gross Income (GI). Add up all items of income, from whatever source, which were
            realized and must be recognized during the taxable year. Do not include any items that are
            excluded form income by statute. §§ 61 and 101.

Federal Income Taxation Outline                                                      Mary Andriko—Fall 2007

          b. Calculate Adjusted Gross Income (AGI). AGI = GI – ―above-the-line‖ deductions, such as
             non-employee business expenses. § 62
          c. Calculate Taxable Income (TI). For those taxpayers choosing not to itemize deductions, TI =
             AGI – (Standard deduction + personal exemptions). For those taxpayers choosing to itemize
             their deductions, TI = AGI – (―below-the-line‖ itemized deductions + combined miscellaneous
             itemized deductions in excess of 2% of AGI + personal exemptions). § 63
          d. Compute tax. Choose the appropriate tax table—i.e. married filing jointly, married filing
             separately, head of household, or single—and then apply that table to TI to determine the tax
             obligation preliminarily. (Rates for ordinary income are found at § 1(a)-(d); Capital gains rates
             are found at § 1(h).)
          e. Subtract nonrefundable tax credits from the preliminary tax obligation. (These include
             dependent care expenses and the Child Tax Credit.) If your result is zero or below, put down
             zero. §§ 21-26
          f. Add any other taxes owed to your result in e. above. (These may include self-employment
             taxes and/or household employment taxes.) The result is the taxpayer‘s total tax.
          g. Subtract all refundable tax credits from total tax. (These will include any taxes already paid
             through wage withholdings or by making quarterly estimated payments, as well as the Earned
             Income Tax Credit, if applicable.) If your result is greater than zero, the result is the amount of
             tax that should be paid. If your result is less than zero, the result will be refunded to the
          h. Note: Taxpayers must also compute their Alternative Minimum Tax obligation. If the AMT is
             higher than the taxpayer‘s tax as first computed, then the AMT is the amount owed.


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