Legal Three

Federal Income Taxation (Tax 1) – Outline

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Federal Income Taxation Outline (Tax 1)

Federal Income Tax Supplements for Law School

TAX I

 

  1. INTRODUCTION

 

General Background Points

  • This is really a federal income tax class
  • Other types of tax- sales, excise, property
  • States
    • States have the capacity to impose any kinds of taxes they want.
    • State tax income is diversified and less affected by a recession.
    • Federal tax law yields to state law in the area of family law.
  • Federal government
    • Federal government has not chosen to implement the full range of taxes. What we have:
      • Federal income tax- 43% of fed budget
      • Payroll taxes- 32% of fed budget
      • Corporate income tax- 13% of fed budget
      • Excise taxes, like estate and gift tax- 6% of fed budget
      • There is also borrowing, which is not a tax, but another way to balance the budget. 6% of fed budget. This is the federal deficit.
      • No property or sales/use taxes at the federal level. In other countries, there are national sales taxes like the VAT tax in Europe and the consumption tax in Canada. One reason we do not have a federal sales tax is that states rely heavily on sales tax for their income.
    • The federal tax system really relies on taxing income in different ways. So when there is a recession, it is difficult for the federal government because tax sources are not diversified.
    • Where does the revenue go?
      • Social security, medicare, retirement- 38% of the fed budget. This will get bigger, so where will the money come from?
    • All of this info came from the instructions for the 1040 tax form
  • Who pays these federal taxes? What does the government get?
    • In 2006, the number of returns filed was 138 million. The population was 300 million.
    • Adjusted gross income was about 8 trillion.
    • Of the 138 million returns, only 92 million were taxable.
    • Of the taxable returns, the taxable income was 5.4 trillion.
    • Of the 5.4 trillion, the tax income generated was 1 trillion. This was the overall take for the federal government in 2006.
    • Of the 138 million returns, about 53 million were joint returns, so 181 million people participated in tax returns. There are also children and elderly who have no income and do not file, and there are dependents. 93 million dependents were claimed in 2006. 275 million people altogether showed up on income tax returns.
    • Bottom 50% of returns generate 5% of the income tax collected. Top 1% contribute over 25% collected.

 

Structure

  • Income tax
  • Annual tax event
    • Planning is always roaming around because of this
    • What deductions you have one year may not affect next year
  • Tax base- “gross income”
    • Defines what is included to be subjected to the income tax.
    • We include some things and exclude others.
    • Not the same as gross receipts because there are things excluded.
  • There is a zero bracket
    • If a person has no gross income, there is a zero bracket.
      • It seems almost impossible to have no gross income, but some people are provided for.
    • Perhaps you have state bonds, of which the right kinds are exempted from federal income tax.
    • No taxable income- zero bracket.
    • No tax payable because of tax credits, like the earned income tax credit or the child credit.
  • Deductions
    • There is a standard deduction and itemization
    • Each person takes the greater of the standard deduction or itemization.
    • One policy question is whether we should have deductions or credits. Credits tend to help people in lower tax brackets, and deductions help people in higher tax brackets. Democrats thus prefer credits. Obama is proposing new tax credits.
  • Taxable income
    • This is where we calculate tax due, then reduce by available credits
      • Some credits are refundable- Reduce payment to zero and also can get you money back above that.
      • Non-refundable can take you to zero only.
    • Then wind up with remaining tax payable

 

  • The Big Picture
    • Gross Income (§61) (all income from whatever sources derived-except for statutorily excluded)
      • Less: Certain Deductions (i.e.Business Expense (§61)
    • =Adjusted Gross Income
      • Less: Personal Exemptions
      • Less: Standard or Itemized Deductions
    • = Taxable Income
      • Multiplied by Tax Rate (from tables in §1)
    • =Tax Due on Taxable Income
      • Less: Credits
    • = Tax Due/Refund
      • Filing Categories and Rate -§1
        • Progressive: Proportional tax rate.
        • Marginal: Rate at which the last dollar is taxed at the top tax rate to which the taxpayer is exposed.
        • Effective: Average tax rate applied to every dollar.
  • Relevant Questions to Consider in Working Tax Problems
    • What is gross income?
    • Who pays tax on it?
    • What deductions are allowed on that gross income?
      • “Above the line” deductions are subtracted from gross income and are available to all taxpayers whether they choose to itemize or not
        • Common deductions: Contributions to IRA, non-employee trade or business expenses, employee expenses paid by the taxpayer under a reimbursement arrangement with her employer, losses from the sale or exchange of property, expense related to the production of rents or royalties, employer contributions to the taxpayer’s pension or profit-sharing plan, contributions to qualified retirement savings plans, alimony payments made by the taxpayer, employment-related moving expenses that were not reimbursed by the taxpayer, qualified contributions to medical savings accounts, and interest paid on qualifying education loans.
      • “Below the line” deductions are subtracted from adjusted gross income to arrive at taxable income. These include the standard deductions, regular itemized deductions, and miscellaneous itemized deductions. The TP may choose either the standard below-the-line deduction or itemized deductions, but not both.
        • Common itemized deductions: Interest paid §163, taxes paid to state and local governments §164, charitable contributions §170, business and investment losses §165, personal casualty losses, medical expense §213, moving expenses, education §222
        • Common miscellaneous itemized deductions: §67 Unreimbursed employee expenses, expenses related to generating investment income, and tax preparation fees. The key fact to remember about these deductions is this: 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.
    • For what year is an item income or deductible?
    • What is the character of various items?
    • Is a gain or loss to be immediately recognized?
    • What is the taxpayer’s tax liability?
    • Are any credits available?
    • Have any mistakes been made and what would happen in the event that one was?

 

 

  1. GROSS INCOME

 

  1. INTRO TO INCOME

 

  • Filing status
    • People are expected to be personally responsible for filing their taxes each year.
    • Married people usually file jointly, and those who file separately are subject to a different tax schedule because the government does not like it. This is a penalty.
      • Ex. 100k taxable income.
        • Single- 21, 971
        • Married jointly- 17, 681
        • Separately- 22, 365
    • We are choosing to draw a line based on marital status rather than relationship status. This is not the case in other countries. Canada, for example, gives cohabitors a benefit. What is it about marriage that justifies special treatment? If it is not marriage itself, but the underlying aspects of it, like interdependence, then maybe marriage is too narrow.
    • Depending on what each partner’s income is, it may be in their interests to not get married and to just file as single persons.
    • It may be worth it to put assets in children’s names even if they are dependents because they will be filing as single persons. That way you can split the income across multiple people. Congress has pushed back on this with the “kiddie tax” so that unearned income may be charged at the parents’ rate. This applies for children up to the age of majority.
  • What do we want the tax system to be like?
    • Fair
    • Efficient- How much does it cost to raise/collect taxes?
    • Administrability- Can we administer the tax system? Can we answer questions about what counts as income?
  • How do we find answers to tax questions?
    • First look to the code.
    • Then go to the interpretive materials, like the regulations.

 

B. GROSS INCOME INCLUSIONS AND EXCLUSIONS

 

  • These are all things that are subject to the federal income tax, and thus become the tax base.
  • Gross income defined- Income from whatever source derived. §61
    • It boils down to: What is income?
    • Haig-Simons definition: Income in any given period may be determined by a change in wealth (net worth) in the period plus consumption.
      • You look at the difference between the net worth at the opening and closing periods.
      • Consumption is included in this because you could not spend it unless you had it. It counts what came in and then went back out.
      • Ex. At the beginning of the year, 500k, end 650k, 100k consumption. Income for the year is 250k. Assets went up 150k and they were able to fund spending of 100k. The next year end at 700k plus 100k consumption, 150k income. The next year end with 400k plus 100k consumption, the change is negative 200k. In theory, we should allow this person to take the loss into account.
        • Maybe allow the person to move it into the next year or the previous year when there was income.
        • Maybe you should get a refund.
      • This definition of income may not be efficient because of what you would have to do in years where the taxpayer suffers losses.
    • Our definition of gross income- Undeniable accession to wealth, clearly realized, over which the taxpayer (T) has complete dominion and control.
      • This is somewhat of an overstatement, because there are some events that we artificially treat as clearly realized.
      • We look for events that happen to the taxpayer to define what income is.
  • Realization and Recognition: A gain or loss is said to be “realized” when there has been some change in circumstances such that a gain or loss might be taken into account for tax purposes. Realization requires the accrual or receipt of cash, property, or services, or change in the form or nature of an investment. A realized gain is then said to be “recognized” when the change in circumstances is such that the gain or loss is actually taken into account. Therefore, a realization of gain does not necessarily bring forth immediate gain recognition.
    • Pure Income: Tax immediately.
    • Capital Investment: Tax when owner pulls the realization trigger.
      • Example: A taxpayer owns stock for which she paid $100 and the stock goes up in value to $150. There is no realized gain even though there has been an increase in the taxpayer’s wealth. Gain is realized when the shares are sold for $150 or exchanged for other property worth $150.
  • 4 Steps to determine income (always apply):
    • IS there income? Income is whatever the Tax Code says it is.
    • AMOUNT of GI
    • WHO’s income is it? You can only tax T if it’s T’s income.
    • WHEN did it occur? Income tax system is annual so that if the income did not come in that taxable period it might be subject to another period.
  • GI includes the receipt of any financial benefit which is:
    • Not a mere return of capital, and
    • not accompanied by a contemporaneously acknowledged obligation to repay, and
    • not excluded by a statute.

 

 

(1) Inclusions

 

  • Treasure trove, to the extent of its value in US currency, constitutes GI. §1.61-14.
    • Taxed in the year in which it is reduced to undisputed possession. Revenue Ruling 61, 1953-1 CB 17, specifically provides that “the finder of treasure trove is in receipt of taxable income…for the taxable year in which it is reduced to undisputed possession.” Because this money was not found until 1964, it is not income for 1957.
      • Cesarini
        • Money found in piano.
        • If the amount found is large in relation to net worth, it seems like an undeniable accession to wealth.
        • Rule: General items of treasure trove (found property) must be gross income.
        • Could argue that the person who bought the piano was also buying the cash inside. But it is unlikely that the buyer knew that the money was in the piano. The transaction for a piano did not include the treasure trove in the transaction.
    • In order to access income one must have ownership. Ownership derived from State Law if not expressly provided by the Tax Code.
    • No economic activity needed – No affirmative attempt to acquire income is necessary; there does not need to be economic activity associated with the amount for it to be considered GI.
    • What if the piano is worth much more than the person who bought it thought?
      • For example, the piano is a limited edition of a special maker. Bought for 5k but worth 500k.
      • Not gross income because it was not been clearly realized. The piano is not sold at the thigh price, and the value can fluctuate in the mean time.
      • The piano itself is the transaction. Must be sold to have gross income. Change in perception of value does not trigger a tax event. Recognition v. Realization. Mere appreciation in value happens all of the time, until you convert it to cash it is not income.
  • Income Tax paid by ER – §61(a)(12)– The discharge by a third party of an obligation owed by the taxpayer is an economic benefit to the taxpayer, and is includable in gross income. Although not technically received by Δ, it is a benefit received for services rendered and is thus income. §1.61-14. A lack of physical receipt to the EE does not render it non-income. Old Colony
    • The tax paid on one year’s salary becomes gross income in the year the tax is paid, which is the year after the salary upon which it is based. Therefore, it ratchets each year and increases incrementally.
    • Overseas EEs (modern relevance): Situations often arise when ER sends EE to a foreign country and offers to pay for the [move + benefits + EE’s US tax] as an incentive/courtesy for the EE to take the job. The price paid for the move + benefits + EE’s US tax = compensation since ER and EE agreed upon the compensation before EE takes the move. US tax system follows you wherever you go, though you can get deductions if you pay taxes in another foreign land §164)
    • Regs: Money can be gross income regardless of the form in which it arrives. Does not have to be cash.
  • Non-Cash Goods/Services §1.61-2 – If something is paid for other than in $$, the FMV of the property/service taken in payment (received) mustbe included in GI. Revenue Ruling 79-24. (p8/9c)
    • Housing provided for by ER and EE & family housed at no cost – FMV of the rental value of the housing provided = GI. Rent avoided is the benefit received by reason of employment by a 3rd party. Dean v. Commissioner (p7c)
    • BUT one does not derive gross income from living in the building they own, they generate imputed income. The benefit does not come from a 3rd party. If you live in the building you own, the FMV of your rent does not equal GI. Independent Life Ins. Co. (p66b) Also, if a tax attorney does his own taxes, that’s not GI either.
    • Ex. You are an attorney and you get 6k to draft a will. What if the client is a painter, and agrees to paint your house in exchange for a will?
    • Ex. Owner agrees to rent Tenant her lake house for the summer for $4K. How much income does Owner realize is she agrees to charge only $1K if Tenant makes $3K worth of improvements to the house? $4K of rent income.
  • Is there a difference in result to Owner in (i), above, if Tenant effects exactly the same improvements but does all the labor himself and incurs a total cost of only $500? No, still receives a $3K in improvement value.
  • Are there any tax consequences to Tenant in part (ii) above? Yes, benefit was received by the tenant by only having to pay $500 instead of $3K, therefore net income of $2.5K or gross income of $3K with a $500 deductible.
  • Other incentives by employer
    • Stock- Look at whether the stock is a gift or for consideration. If for consideration to obtain the employee’s services, it is income.
    • Car- Part of the compensation package? If yes, income. If the car is going to the spouse of the employee, it does not matter. There is no relationship between the employer and the spouse. The employer is transferring the car to obtain services of the employee, so for tax purposes that is what matters. The employee is technically making a gift to the spouse. The employee benefits, so GI.
    • The employee’s compensation includes the salary, stock, and car if there is consideration given for the stock and car.
  • Illegally Obtained $$ – Illegally acquired wealth is no defense to taxation, if you have it, you must pay taxes on it.
    • “Illegal gains constitute GI.” §1.61-14.
    • Until you are caught, you must claim as income because you are holding it out as yours against everyone else even though it was never yours.
    • If you get caught, may be able to get a loss deduction at that time.
  • Items or money won
    • Ignore the fact that there is a specific provision which says that it is taxable.
    • All money won in raffles, gambling, etc. is gross income.
    • Does it meet the test for gift? No, it seems like advertising, not just a generous gift, therefore watch is income.
  • Court Awards– §104
    • Punitive damages – such as treble damages and exemplary damages are GI. §1.61-14. (p5c)
      • Punitive damage awards are taxable as gross income (unless from personal injury). Glenshaw Glass.
    • Personal Physical Injury: Damages received as compensation for a physical personal injury are excluded from gross income. This rule applies even though a portion of the payments represents compensation for earnings lost because of the injury.
  • Business trips and frequent flyer miles
    • If the employee takes 5 business trips and racks up enough frequent flyer miles to take 1 personal trip, the value seems like undeniable accession to wealth.
    • The employer does not exactly give the free trip, just allows the employee to keep the miles for future personal travel.
    • The IRS will not assert that a person has understated gross income if the value is left off, but they are not saying that the miles do not count as gross income.
    • Basically, you do not have to count the value of the miles as gross income even though conceptually they should probably count.

 

(2) Exclusions

 

Generally

  • Not all things that are undeniable accessions to wealth are included in gross income. This is for efficiency considerations.
  • No deduction for personal, family, or living expenses.
  • Two fairness measures
    • Horizontal- Identically situated taxpayers should be in the same tax situation.
    • Vertical
  • Since exclusions serve to reduce the tax base, Congress reads them narrowly.

 

Exclusions from gross income

  • Imputed Income
    • Expense has been avoided.
    • ”Imputed Income” defined (Black’s): the benefit one receives from the use of one’s own property, use of one’s own services, or use of one’s own property and services.
    • The rental value of a building used by the owner does not constitute income within the meaning of the 16th Amendment. Helvering.
    • Imputed income is created when a taxpayer works for or uses his property for his own benefit. “The value of one’s own services or goods that are used to benefit oneself.” If a taxpayer lives in his own house, he is theoretically paying himself rental income. Likewise, a homemaker receives imputed income for domestic services rendered in the home. Or if an attorney represents himself in a case. While Congress is generally recognized to have the power to tax imputed income under the IRC, it has never attempted to do so.
  • Frequent Flyer Miles – because of the difficulty in enforcement/administerability and efficiency there has been an agency determination that there is NO GI from frequent flyer miles (in year 2000), regardless of how they were acquired, unless they are cashed out. Cashed out = GI.
  • Loans– §61a4
    • Loans are not gifts. There is an expectation of repayment. However, loans are not income events and do not count as gross income. Same outcome as a gift, but for a different reason.
  • Capital Recovery
    • A taxpayer’s income from the sale or exchange of property is his or her profit on the transaction, not the total amount received. A taxpayer is entitled to receive his or her capital investment in the property tax free, although the timing of this recovery is a matter for legislative determination.
  • Life Insurance & Annuities
  • Gains from sale of principle residence §121
  • Certain types of damages§104
  • Municipal Interest Income §103
  • Higher Education Expenses§117
  • Child Support §71
  • Gifts §102
  • §102(a) GI does not include the value of property acquired (transferee) by gift, bequest, devise or inheritance.
  • Gift defined:
    • Gift to be determined by the donor’s subjective intent as against the objective facts and circumstances. The dominant motivation for the transfer must proceed from a, “detached and disinterested generosity out of affection, respect, admiration, charity or like impulses.” Duberstein
    • This intent is determined by the fact finder, reviewed on appeal under the “clearly erroneous” standard.
    • Gifts are excluded from gross income, but not the income from such a gift, or where the gift is income from property §102(b).
  • ER & EE relationship: §102(c) states that there is no exclusion from GI of any amount transferred between ERs and EEs. Must be an ER-EE relationship. An employee “shall … not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.”
    • RA: because under the Duberstein definition of gift, it’s hard to find a gift in the ER-EE context. Since whether something is a gift or not is determined by the fact finder = unequal results = unfair for some EEs to consider it taxable and others to not. So, Congress remedied this by adopting §102(c) to avoid the unequal/uniform results.
    • Attorneys are NOT considered to be EEs of their clients, so §102(c) does not apply to an attorney-client relationship. It is a service to the client.
  • Limited exceptions:
    • IRC § 132(e) Retirement Gifts allows traditional retirement gifts to be treated as de minimus fringe benefits.
    • IRC § 74(c) Employee Achievement Awards (Excludes)
      • IRC §274(j): Limited to items of tangible personal property (the value of which is subject to certain limitations) receive in recognition of length of service or safety achievement
    • IRC § 10(b) Employee Death Payment: allows $5,000 exclusion for payments made by employers on account of an employee’s death. Amount received must not represent benefits that the employee would have enjoyed had he lived (i.e. retirement benefits, pension plans).
    • IRC § 274(b)(1) Business Gifts: limits the deductible amount of business (non-employee) gifts to $25 per donee per year. However, there is no limit on deductibility by employer of employee business gifts since employee must report the gift as income per IRC § 102 (c).
    • Quid Pro Quo – if there is any quid pro quo (something for something) then it is not motivated from a detached and disinterested generosity out of affection, respect… so therefore it is GI.
      • Tips- The something for something does not have to be a rational quid pro quo. Like if a poker player tips the dealer he is tipping him for a good outcome. This is GI because it is a quid pro quo, albeit an irrational one.
    • Splitting $$ between Excludable Gift and GI:
      • Single gift from a single transferor cannot be split. It cannot be ½ from EE-ER status and ½ from mother-son status. There can only be one primary motive. Duberstein
      • Gift from multiple transferors can be split.
        • Ex: EE gets a 5k trip to Hawaii for retirement. ER gives 2k of the gift, fellow EEs give 3k of the gift. ER’s 2k is GI, EEs’ 3k (bc this would be a EE-EE not EE-ER relationship) excludable under §102(a).
    • Income from the gift: Income generated from the gift is taxable.
      • Ex: Gift of stocks – dividends are taxable when received. Gift of apt bldg – rent collected from it is taxable when received.
    • Hypos:
      • Parent runs a business with 10 employees, and an 11th person who is the child. At the holidays, all employees including C receive a TV set worth 400.
        • With the 10 employees, each of them has 400 in gross income from receiving the TV (unless there is some exemption that applies).
        • What about the gross income to C? C is both an employee and a child. It depends on P’s intent with respect to the 1 TV to C. Is the transfer motivated by the ER-EE relationship, or some other detached reason?
      • The congregation for whom Reverend serves as a minister gives her a check for $5,000 on her retirement. Does Reverend have gross income? NO: Long line of cases decided that the reverend/congregation relationship was very special and was therefore not a normal ER/EE relationship and were therefore excludable from gross income. $5K from congregation probably not GI, intent is gift, no duty to give her $ for retirement
      • Retiree receives a $5,000 trip on his retirement. To pay for the cost of the trip, Employer contributed $2,000, and fellow employees of Retiree contributed $3,000. Does Retiree have gross income?
        • Can you determine the intent for all the individual contributions? Argue that all they have is an EE-EE relationship which is not tainted by § 102(c)
        • Some of it is an ER transfer ($2K), therefore would NOT be excludable under Duberstein or § 102(c). At least 2k is NOT excludable.
        • In actual case, court divided up the group of people into seven groups and decided the dominant intent of each group.
  • Inheritance
    • §102(a) GI does NOT include the value of property acquired by gift, bequest, devise or inheritance. However, the exclusion does NOT apply to the income from any property received as a bequest, devise or inheritance.
    • Determine T’s position/relationship to Donor
      • If the succession to a decedent’s estate comes from T’s position/relationship as successor by law as heir to the donor, then it is excludable. Lyeth v. Hoey
      • When there is a settlement to a contested will, the payments come through the settlement agreement (contractual). However, the money comes from T’s position as heir so it’s excludable under §102(a). Lyeth v. Hoey
    • Substance over form: form does NOT govern. If form was to govern, significant taxable income would escape collection.
      • Bargained-for Agreements: Look for contract/obligation/creditor/crediting/quantum meruit/etc. When there is payment of services through bequest, it is still GI because substance over form: is the underlying arrangement compensation for services/res? If so, it is just deferred compensation and thus GI. Wolder
      • Even if the bequest/devise is made for services after death, Wolder applies because it is compensation agreement for services and satisfies a contractual obligation.
        • But if it is to a daughter/son/family/friend for services as executrix, there is a line of cases that suggest that she can waive the compensation and get it as an inheritance, so as to make it excludable under 102.
          • Look for Estate Tax issue re: collecting as GI or for services rendered.
      • Even if it says “for his service”, look for a bargained-for agreement. If it isn’t a bargained-for agreement, then it counts as an exclusion under §102(a).
    • Hypos: Consider whether it is likely that § 102 applies in the following circumstances:
  • Father leaves daughter $20,000 in his will. Yes.
  • Father dies intestate and daughter receives $20,000 worth of real estate as his heir. Yes.
  • Father leaves several family members out of his will and daughter and others attack will. As a result of a settlement of the controversy daughter receives $20,000. Yes, this is Lyeth case.
  • Father leaves daughter $20,000 in his will stating that the amount is in appreciation of daughter’s long and devoted service to him. Yes.
  • Father leaves daughter $20,000 pursuant to a written agreement under which daughter agreed to care for father in his declining years. No.
    • Would that always be taxable? Ask why recipient is receiving it!
  • Same agreement as in (e), above, except that father died intestate and daughter successfully enforced her $20,000 claim under the agreement against the estate. No.
  • Same as (f), above, except that daughter settles her $20,000 claim for a $10,000 payment. No.
  • Father appointed daughter executrix of his estate and father’s will provided daughter was to receive $20,000 for services as executrix. No.
  • Father appointed daughter executrix of his estate and made a $20,000 bequest to her in lieu of all compensation or commissions to which she would otherwise be entitled as executrix. No. Statutes provided percentage amounts to the executrix and the lawyer also gets a percentage as well-therefore the system is set up so that the executrix will get something even if the will is silent.(however the decedent can change that)
    • If daughter was not in the will but would get the entire estate, when would it be advantageous for her to decline the $20,000 commission and do the work for free?
      • If she declines the commission then it stays in the estate and comes to her as the heir and it is not taxed. If she takes the commission then it will be taxed as gross income.
      • What if the estate was subject to estate tax?
        • Then the $20,000 seen as a deductible for the maintenance of the estate with a 45% estate tax, because then she would only get taxed 35%.
  • Employee Gifts – §102(c) & Fringe Benefits- §132, §119
    • Generally
      • Fringe benefits are entirely statutory now. They are included in GI unless specifically excluded by statute. Passed §132 in 1984.
      • The form of payment does NOT matter. Substance over form. Can be a price reduction or a reimbursement.
      • Purposes:
        • Codify custom
        • Identify eligibles
        • Limiting amount
        • Clear guidelines, administrable for EEs, ERs, government
        • Prevention of abuse- Have an all inclusive with exclusions approach; non-discrimination in that not restricted to a small group of EEs
      • Employee defined: currently employed persons, retired and disabled ex-EEs, and surviving spouses of EEs of retired/disabled ex-EEs, and spouses and dependents of EEs
      • If any of the answers to the following questions are NO, §132 does not apply:
        • is this benefit being provided to an EE?
        • is this benefit being provided by the EE’s ER?
        • is this benefit being provided as part of the EE’s compensation for services?
    • No additional cost services– §132b– EEs may exclude a no-additional-cost service – a service provided to the EE by the ER that is regularly offered for sale to customers where the ER incurs no substantial additional cost (and forgoes no revenue) in providing the service
      • Spouse and dependent children qualify as EE.
      • Requirements:
        • The services are offered for sale to customers in the same line of business of the ER for which the EE is working. Example: Airline offers free standby flights for its EEs.
        • The ER incurs no substantial additional cost (including foregone revenue) in providing the service to the EE.
          • Example: Airline tickets will NOT be included in gross income if the EE is flying standby, however if the EE is required or has the ability to book the tickets in advance means that the airline lost the opportunity to sell the tickets to a paying customer.
          • Forgoing revenue is per se a substantial additional cost.
          • Incidental costs: ER generally incurs no substantial additional cost if the services provided to the EE are merely incidental. In-flight services, in-flight meals, and maid services are merely incidental to the primary service being provided. §1.132(a)(5)(ii)
          • Labor-Intensive services: ER must include the cost of labor incurred in providing services to EEs when determining whether ER has incurred additional substantial costs. If outside normal business hours or if time spent attending the EE, other EEs or ER would’ve been “idle” at the time. §1.132(a)(5)(ii)
        • The services must be provided in a nondiscriminatory basis such that the upper echelon EEs do NOT receive services unavailable to lower echelon EEs.
          • “Highly Compensated EE” defined §414(q) – any employee who
            • Was a 5% owner at any time during the year or preceding year or
            • For the preceding yr – Had compensation from the ER in excess of $80k (adjusted by 2004 inflation) or
            • For the preceding yr – If EE was in the top-paid group of EEs (in the group consisting of the top 20% of the EEs when ranked on the basis of compensation paid during such year).
      • Reciprocal Agreements: IRC §132(i)Services provided to an employee of another employer Treats a service provided to an employee of another employer as a no-additional cost service fringe benefit if that service is provided. Requirements: 1) pursuant to a written agreement between the ERs 2) neither ER incurs substantial additional costs in providing the service, 3) and the service provided by the other ER is the same type of service offered by the EE’s ER in the same line of business in which the EE works
        • If one ER pays/receives a substantial payment with respect to the reciprocal agreement, then this is a substantial cost incurred by ER and consequently services provided under the K will NOT qualify for exclusion. (If it is your ER, then you are okay still – but not ok if it is the other ER whom you don’t work for.)
    • Qualified EE Discount– §132c– The value of discounts on services or property (except real or investment property) provided to the public by the ER, purchased from ER by EE may be excludible.
      • Spouse and dependent children qualify as EE.
      • Requirements:
        • In the ordinary course of the same line of business
        • Nondiscriminatorily awarded
      • Reciprocal agreement is inapplicable to EE discounts
      • Then, you must decide between whether it is a service or property in order to deal with the right percentage to apply.
        • Service – the exclusion may NOT exceed 20% of the price at which services are offered to customers. Anything exceeding 20% = GI.
        • Property – may discount gross profit percentage:
          • Aggregate sales price (using last yrs #s) – cost of goods (all) / Aggregate sales price (using last yrs #s)= Gross Profit Percentage
          • Formula explained: All net sales from previous year minus COGS (cost of goods sold) = x. X divided by all net sales from previous year = Gross Profit Percentage. Take that percentage against the cost of the item that EE is trying to buy and that percentage is what’s excludable. Anything beyond that percentage is GI.
          • Why do we use last year’s numbers? Congress cares about administerability and reasonableness = fair.
    • Working Condition Fringe– §132d– EE NOT taxed on ER-provided item if the EE would have been entitled to deduct the item as a business expense, or depreciation deduction under §§ 162 and 167, if she had paid for it herself. Example: Use of company car for business purposes, business periodicals, bodyguards, free or subsidized parking.
      • Only applies to the actual EE, NOT spouse or children.
      • Can be discriminatory.
      • Any property or services provided to an EE of the ER to the extent that, if the EE paid for such property or services, such payment would be allowable as a deduction under §162 or §167. §132(d)
        • Ex: EE goes to business convention, bodyguard to EE, on-the-job training provided by ER, use of company car/airplane for business purposes, etc. = working condition fringe and so therefore is not GI to EE.
      • Auto-salesmen: Qualified automobile demonstration use is a working condition fringe if (a) use if provided primarily to facilitate salesman’s performance for the ER and (b) if there are substantial restrictions on the personal use of such automobiles by such salesmen. §132(j)(3)(B).
    • De Minimis Fringe– §132e– Property or services are excludable if the value (after taking into account the frequency with which similar fringes are provided to EEs by ER) is so small as to make accounting for it unreasonable or administratively impractical.
      • Only applies to the actual EE, not spouse or children.
      • **Non-discrimination provision does NOT apply except to ER-operated eating facility.
      • Consider Frequency
        • Excluded under §132(a)(4): Occasional personal use of ER’s copy machine (so long as at least 85% of the machine’s use is for business purposes), typing of personal letters by secretary, occasional cocktail parties, group meals, picnics for EEs & their guests, occasional theatre/sporting event tickets (but not season tickets to sporting or theatrical events), donuts, coffee, local telephone calls, flowers, books or similar property provided to EEs under special circumstances. §1.132-6(e).
        • NOT EXCLUDED: Season tickets, weekend getaways, membership at private country clubs or athletic facility, use of ER owned or leased facility for a weekend, commuting using ER car for more than one day a month (working condition fringe though?), etc. §1.132-6(e)(2)
      • Consider Administerability:
        • A cash equivalent fringe benefit is NEVER excludable (except as provided under “special rules” below) because any fringe benefit that would not be unreasonable or administratively impracticable to account for is never excludable under de minimus fringe benefit. It doesn’t matter that the same kind of property or service would be excludable.
          • This includes: gift certificates, charges on credit cards, cash for theatre ticket, etc.
      • Eating facilities
        • Bargains provided to EEs by ER’s eating facilities can be de minimus fringe if:
          • It is located on or near business premises and
          • the revenue generated from their operation normally exceeds or equals their operating costs(charge them equal to the operating cost of facility)
        • Note that spouse + kids cannot get this. §132(h) only applies to §132(a)(1)&(2).
        • Non-discrimination requirement applies for ER-operated eating facility fringe.
      • “Special Rules”- Regs. 1.132-6(d)
    • Qualified Transportation Fringe– §132f– “Qualified Parking” includes parking provided to an EE on or near the business premises of the ER
      • The following transportation fringe benefits are excludible:
        • IRC §132(f)(5)(B): Transportation in a commuter highway vehicle if in connection with travel between EE residence and job
          • commuter highway vehicle: 6 adults seated not including driver, 80% used for transporting EEs and 80% of the time has at least ½ seating capacity (3) full.
        • IRC §132(f)(5)(A): Any transit pass, token, farecard, voucher or similar item for mass transit
        • IRC §132(f)(5)(C): Qualified parking provided to EE on or near business premises or from where commutes by commuter highway vehicle (parking at meeting place where commuter highway vehicle picks up everyone)
        • Limitations: $100 per month for commuter vehicle and transit pass. $175 per month for qualified parking.
      • Cash options =GI, unless it is a cash reimbursement for qualifying items.
      • Non-Discrimination Requirement does NOT apply (can discriminate)
    • Qualified Moving Expense Reimbursement– §132g
      • To the extent that the EE would have been entitled to a moving expense deduction if she had paid for moving expenses herself, she will have no tax if the ER pays or reimburses her moving expenses.
    • On-Premise Athletic Facilities– §132j4
      • GI does NOT include the value of any on-premises athletic facility provided by an ER to his EEs.
      • Non-Discrimination Requirement does NOT apply because under a related provision the ER would NOT get a deduction if ER used it discriminatorily.
      • Requirements:
        • Gym must be on premises. Can be gym, golf course, pool, tennis courts, etc.
        • Must be owned and operated by ER. But ER can K it out to 3rd parties
        • Substantially all the use of which is by EEs of the ER, their spouses and their dependent children.
    • Qualified Retirement Planning Services– §132a7
      • Retirement planning advice excludable from GI or
      • Retirement planning information excludable from GI
      • Non-discrimination provision does apply.
    • Meals and Lodging– §119
  • Meals and Lodging In General – IRC § 119 (a): Meals and lodging provided by the ER to EE, spouse and dependents are excludible from GI if all the requirements are satisfied:
    • Employer Convenience: It is for the convenience of ER. ER has a “substantial non-compensatory business reason” for supplying the meals and lodging
    • On Business Premises: Meals and lodging are on business premises of ER.
      • “On the business premises” means that a significant part of business must be performed at that location.
      • Example: Planner was required to live in house adjacent to motel. Planner worked at motel and was on-call 24 hours a day. House is considered “on business premises” and lodging was excludible.
    • Condition of Employment: The lodging must be required as a condition of employment. Usually showing that the EE is on call for the business of the ER
      • Meals: EEs who must work through lunch/dinner hours to service food, cook, EE must be available for emergency call during meal periods or deal with customers for ER during those times to get the exclusion. These are NOT substantial non-compensatory business reasons for meals and therefore do NOT get the exclusion: meals to promote morale of EE or to attract prospective EEs.
  • If the requirements are met, the exclusion will apply irrespective of whether under an employment K or statute fixing the terms of employment such meals/lodging are furnished as compensation. Substance over form, always.
    • Note: There must be an ER-EE relationship. If EE is sole proprietor he cannot take the §110 exclusion because then there is no ER-EE relationship. But if he incorporates the business then you can have the corporation “employ” EE and then you’ve got §119.
  • 9th Circuit says: Meals = meals. Meals ≠ groceries (think firefighters). Meals ≠ lunch allowance.
  • EEs of Educational Institutions: allows EE of educational institution to exclude value of lodging from GI if lodging is located on or in the proximity of the campus of the institution. §119(d)
  • Hypos:
    • ER provides EE, spouse and child a residence on ER’s business premises, having a rental value of $5,000 per year, but charging the EE only $2,000.
    • What result if the nature of the EE’s work does NOT require EE to live on the premises as a condition of employment? Income of $3,000 to employee.
    • What result if ER and EE simply agreed to a clause in the employment contract requiring EE to live in the residence? It has to be a condition of employment or, as in Hatt, it has to be of the convenience of the ER. Look at nature of circumstances
    • What result if EE’s work and contract require EE to live on the premises and ER furnishes EE and family $3,000 worth of groceries during the year? Groceries can’t be excluded, even if they can be turned into meals.
    • What result if ER transferred the residence to EE in fee simple in the year that employee accepted the position and commenced work? Does the value of the residence constitute excluded lodging? No, only applies to the rental value NOT the direct transfers, the property has to be under the employer’s name to qualify for 119.
  • State highway patrolman is required to be on duty from 8am to 5pm. At noon he eats lunch at various privately owned restaurants which are adjacent to the state highway. At the end of each month the state reimburses him for his luncheon expenses. Are such case reimbursements included in his gross income? Commissioner v. Kowalski determined that such meals are technically on the premises.
  • Housing provided to ministers of the gospel– §107
    • The fair rental value of housing provided to a minister of the gospel as part of his compensation is excluded from GI.
    • It must be provided as remuneration for services.
  • Statutory Exclusion of Other Fringe Benefits: §132 indicates that if another Code section provides an exclusion for a type of benefit, Section 132 is generally inapplicable to that type of benefit; an ad hoc provision prevails over the general rules of Section 132. Some other sections excluding fringe benefits from GI are:
    • IRC §79 – excludes group term life insurance premiums for up to $50K coverage
    • IRC §112 – excludes compensation received by military personnel for service in a combat zone and compensation for periods during which the person is hospitalized as a result of wounds, disease, or injury incurred while serving in a combat zone
    • IRC §129 – excludes amounts paid by an ER for “dependent care assistance” up to a maximum annual amount of $5K
    • IRC §137 – excludes ER payments of qualified adoption expenses
    • IRC §134 – excludes some additional military benefits
  • Hypos: Consider whether or to what extent the fringe benefits listed below may be excluded from gross income and, where possible, support your conclusions with statutory authority:
    • (a) Employee of a national hotel chain stays in one of the chain’s hotels in another town rent-free while on vacation. The hotel has several empty rooms. ExcludedNo additional cost involved. Fringe is excludible under IRC § 132 (a) (1).
    • Same as (a), above, except that the desk clerk bounces a paying guest so employee can stay rent-free. . See Reg. §1.132-2(a)(2) and (5) Not Excluded:(Declining a customer in place of an employee counts automatically as “substantial additional cost”) .
    • Same as (a), above, except that the employee pays the bill and receives a cash rebate from the chain. see Reg. §1.132-2(a)(3) Yes – excluded as no additional cost service.
    • Same as (a), above, except that the employee’s spouse and dependant children traveling without the employee use the room on their vacation Excluded IRC §132 (h) extends the benefit to family and nothing requires the employee to be there, ergo it is not taxable to the employee. Retired, disabled employees, spouses and dependent children qualify under 132(a)(1) and (2).
    • Same as (a), above, except that employee stays in the hotel of a rival chain under a written reciprocal agreement under which employees pay 50% of the normal rent. ExcludedThe 50% is a red herring. It is still no-cost to the employer. The mere fact that the employee has to pay 50% doesn’t cause us to abandon it from inclusion under no-cost.
    • Same as (a), above, except that employee is an officer in the hotel chain and rent-free use is provided only to officers of the chain and all other employees pay 60% of the normal rent. Not ExcludedIRC § 132(j) says that these benefits must be paid in a non-discriminatory fashion. Benefit cannot discriminate just highly paid employees.
    • (g) Hotel chain is owned by a conglomerate that also owns a shipping line. The facts are the same as in (a), above, except that the employee works for the shipping line. No. The benefit must be in the same line of business according toIRC § 132 (b) (1).
    • Same as (g) above, except that EE is comptroller of the conglomerate. See Reg. § 1.132–4(a)(1)(iv). Excluded because an EE of both business is employee for both and is in the same line of business for both.
    • EE sells insurance and ER Ins. Co. allows EE 20% off the $1,000 cost of the policy. It’s excludable under §132a)2), defined in 132c)1)B) as an employee discount of up to 20%. Purchasing of insurance policies is a service.
    • Employee is a salesman in a home electronics appliance store. The prior year the store had $1,000,000 in sales and a $600,000 cost of good sold. Employee buys a $2,000 video cassette recorder from Employer for $1,000. The maximum you could exclude is $800. But he made $1,000, so he has $200 taxable income (unlike non discrimination requirement, this can be partial, purpose of this section is to prohibit disguised compensation to highly paid officers).
    • Employee attends a business convention in another town. Employer picks up employee’s costs. ExcludedWorking condition fringe underIRC § 132 (d) since the trip would have been deductable by the employee (convention requirements), it can be excluded.
    • Employer has a bar and provides the employees with happy hour cocktails at the end of each week’s work. De minimus fringe under Section 132(a)(4) However, is weekly too frequent, because the section states “occasional cocktail parties” (since it is a weekly thing, it would depend on how the bar is set up, whether or not accounting for it would be impractical.)
    • Employer gives employee a case of scotch each Christmas. See Reg. §§ 1.132-6(e)(1)Under 132(e), occasional holiday gift can be excluded if it’s NOT cash and it’s of low value. It would depend on how expensive the scotch is.
    • Employee is an officer of corporation that pays employee’s parking fees at a lot one block from the corporate headquarters. Nonofficers pay their own parking fees. Assume there is no post-2001 inflation. Excluded, if it takes one of the three forms under Section 132(a)(5) Qualified Transportation Fringe: 1) commuter highway vehicle 2) transit pass 3) qualified parking. The proximity of the parking space can qualify for transportation fringe under 132(f)(2)(B) and there is no non-discrimination requirement according to 132(j). The fee just has to be under 175 dollars.
    • Employer provides employee with $110 worth of vouchers for commuting on a public mass transit system during the year. Assume there is no post-2001 inflation. . Excluded ($105) Not Excluded ($5-gross income) Note: For parking it is now $205 a year.
      • NOTE: It will be noted in the statutes whether there is inflation for the number or not.
    • Employer puts in a gym at the business facilities for the use of employees and their families. Excluded IRC §132(j)(4) covers on-premises gyms.

 

  1. GAINS & LOSSES

 

Realized change in value of an asset during T’s holding period.

 

§1001(a) Computation of Gain or Loss: Excess of amount realized over the adjusted basis.

 

Equation: Gain (or) Loss = AR (amount realized) – AB (adjusted basis)

 

Gain In General: Five Step Approach:

  • (1) Realization Event: §1001 Occurs when a taxpayer exchanges property, receiving some materially different item, (one that bestows on a taxpayer a different legal interest than what she or he had before.
  • (2) Compute Realized Gain or Loss: §1001(a): measured by the difference between the amount realized (fair market value of property received in transaction) and the adjusted basis (value of transferred property including appreciation and depreciation). Therefore, in order to determine the return on capital, the basis in property must be determined.
    • Example: The taxpayer owns stock with a basis of $5. He sells the stock for $8, realizes $8 on the sale, and thereby has a gain of $3 on the sale of the stock.
    • Example: Purchased book for $15. The purchase transaction (acquisition) is not a gross income tax event at that time. End of the semester going to engage in an arm’s length transaction whereby the book is sold in Jan 07 for $35. Is the sale a tax event? Yes. Now what is the Glenshaw Glass amount(i.e. What is the accession to wealth that is now clearly realized)? One’s wealth has been increased by $20 (not $35 because have to minus the investment cost of $15) and therefore is the gross income in the form of gain.
      • Look further…do you really buy a law school book for $15? Therefore, the question is was the book purchased for fair market value? NOTE: Fair market value is defined as “the price at which the item changes hands in an arms length transaction between two parties that know everything about the transaction.” Not going to look into the motive of the parties. When the book was purchased for $15 that was the fair market value at the time. When the book was sold for $35 that was the fair market value at the time.
      • What year is this transaction going to be taxed in?
        • Probably 2007, the year the transaction took place §1001(c)…HOWEVER the tax can be deferred in certain circumstances (i.e. payments into a retirement program)
  • (3) Amount Realized: §1001(b) A taxpayer’s amount realized on the sale or other disposition of property is equal to the sum of the cash and fair market value of property or services received, plus the amount of liabilities assumed by the other part to the transaction (i.e. mortgage)
  • (4) Determine Character: The character of the gain or loss recognized as capital or ordinary will depend on the nature of the asset in the hands of the transferor.
  • (5) Determine Adjusted Basis: Equal to its initial basis adjusted upward for improvements and downward for capital recovery (depreciation) deductions- see below for further detail.
  • Formula:
    • Gain =Amount realized(AR) – adjusted basis (AB) for determining gain (Section 1001(a))
      • AR= amount of money received and the fair market value of property (other than money) received on the disposition.
    • Loss = Excess of AB for loss – AR (Section 1001(a))
      • Considered a deduction

 

 

 

A. ADJUSTED BASIS

 

  • Adjusted Basis = Cost at acquisition point §1012 or original basis §1011 + adjustments §1016. [AB] = [Subcategories below (a) through (g)] + [(h) adjustments]. When something cannot be put in a category (a) through (g), the default provision is (a) §1012.
    • Purchases at Arms-Length Transactions
      • The basis of property shall be the cost of such property. §1012
      • Cost = FMV of the asset acquired (received). Initial basis attaches to the item itself, not the amount you’ve paid.
        • To determine FMV of item:
          • Appraisal (value the item) but if you cannot do this, then
          • Value of the Asset Surrendered (amount used to acquire the asset received, i.e., what you paid for it) Philadelphia Park Amusement Co.
        • Options – If you pay for an option to buy land, then subsequently buy the land, then the option + price paid for land = AB.
          • But if you buy/sell the option without purchasing the land, then the option is treated like an asset in itself.
        • If a taxpayer performs services and receives property in payment, the amount the taxpayer includes in GI as payment will constitute the basis of the property.
      • A transfer of assets is a taxable event unless exempted by statute. The taxpayer is taxed on the difference between the AB of the property given in exchange and the FMV of the property received in exchange.
        • Just because there is an equal exchange does not mean there is no tax (i.e. artist-attorney barter income).
          • Thus, the taxpayer’s basis in the new property is its fair market value on the date of transfer. When the transfer is at arm-length, and the new asset can’t be valued, the value of the new asset is deemed to be equal to the value of the old.
      • Attorney’s and broker’s fees and the like spent in acquiring property are added to the cost basis.
      • Property Resale Hypothetical: Owner purchases some land for $10,000 and later sells it for $16,000.
        • Determine the amount of owner’s gain on the sale. $6,000 Gain.
        • What difference in result in (i), above, if owner purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option? $1K option, then $9K paid, still paid $10K and sold for $16K. Therefore the AR = $16K and the AB = $10K ($1K + $9K) so $16K-$10K= $6K (Gain)–No difference NOTE: Not going to take into account the option as a completed transaction but as a step to the purchase of the land in the event it is exercised for that purchase.
        • What result to owner in (ii), above, if rather than ever actually acquiring the land, owner sold the option to investor for $1,500? $500 gain.
        • What difference in result in (i), above, if Owner purchased the land by making a $2K cash payment from Owner’s funds and an $8K payment by borrowing $8K from the bank in a recourse mortgage (on which Owner is personally liable)? (2)Would it make any difference if the mortgage was a nonrecourse liability (on which only the land was security for the obligation)?
          • Raised purchase price by engaging in a borrowing transaction producing $8K. AR=$16K and AB=$10K(Do NOT take into account where the $ came from IF there is an offsetting obligation in the form of a binding transaction to pay it back) therefore $16K-$10K= $6K(Gain)
          • For tax purposes it does NOT matter if it is recourse or nonrecourse. Under Crane, whether or not it is a recourse loan does not make a difference when it comes to the basis, loans are part of the cost of the property. Under Taft, it might affect the amount realized if the FMV is higher than the sale price.
        • What difference in result in (i), above, if owner purchased the land sold for $10,000, spent $2,000 in clearing the land prior to its sale, and sold it for $18,000? $6,000 gain.
        • What difference in result in (i), above, if owner had previously rented the land to lessee for five years for $1,000 per year cash rental and permitted the lessee to expend $2,000 clearing the property? Assume that, although owner properly reported the cash rental payments as gross income, the $2,000 expenditures were properly excluded under IRC § 109.
          • If improvements are made to property and not in lieu of rent, then owner doesn’t need to report as income. AR = $16K, AB = $10K, therefore $16K-$10K= $6K(Gain). NOTE: Exclusions Sections to defer the $2K from the year that get the property back with increased value to the year when the property is sold. §109 “Gross income does not include income (other than rent) derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee.” ( POLICY: When the land comes back to the lessor with the increased value, there is no actual cash for the lessor to pay the increased tax that would be attached to the increased value. ) And § 1019 whichsays that the adjusted basis shall not be increased or diminished on account of income derived by the lessor in respect of such property and excludable from gross income under §109
        • What difference in result in (i), above, if when the land had a value of $10,000, owner a real estate salesperson, received it from employer as a bonus for putting together a major real estate development, and owner’s income tax was increased $3,000 by reason of the receipt of the land? The amount realized is still $16,000. $10,000 is the basis. The basis of money is always its face value. AR = $16K, AB = $10K, therefore $16K-$10K= $6K(gain) ; $3K of income tax NOT included to adjust basis since it was actually an income event in the form of property and was already taxed. The acquisition was a tax income event therefore the basis needed the $10K or it would be taxed again. Section 1012 basis even though nothing was paid.
        • What difference if owner is a salesperson in an art gallery and owner purchases a $10,000 painting from the art gallery, but is required to pay only $9,000 for it (instead of $10,000) because owner is allowed a 10% employee discount which is excluded from gross income under IRC § 132 (a) (2), and the owner later sells the painting for $16,000? The gain would be $6,000 and the basis is $10,000. AR = $16K, AB = $10K, therefore $16K-$10K = $6K(gain)
          • §132(a)(1) excludes employee benefit as GI. If you only use basis of $9K would actually act as a deferral until the sale of the painting when the income would be taxed as part of the gain. Need the cost concept of $10K to realize the purpose of §132(a)(1), so you treat basis as if discount does not exist and = value of product w/o discount.
    • Windfalls: Basis is FMV on acquisition.
    • Property Acquired by Gift
      • §1015– Property acquired as a gift generally retains the same basis as it had in the hands of the donor, a case of transferred basis.
        • However, if such basis is greater than the FMV of the property at the time of the gift, then solely for purposes of determining loss, the basis is such FMV of the property on the date of the gift.
      • When calculating Donee’s gain or loss, consider Donor’s basis. However, if at the end of the calculation, donee’s basis is negative, then you cannot use donor’s loss to augment donee’s loss. But if Donee’s gain/loss # is in between Donor’s AB and FMV, the Donee incurs neither gain nor loss. §1.1015-1(2)
      • Depreciated Property Hypo: Property cost $2,000. It declines in value to $1,000 and is given to donee.
        • Donee sells property at $2,500 – $500 gain.
        • Donee sells at $500 – $500 loss because basis was greater than fair market value so refer to fair market value to determine gain.
        • Donee sells at $1,500 – neither gain (not above the $2K basis) nor loss (not below the FMV $1K)
      • Analysis of Property Disposition: Is disposition quid pro quo or gratuitous?
        • Quid Pro Quo (Farid-Es-Sultaneh v. Commissioner)
          • What is the amount realized in the exchange?
          • Subtract basis of whatever property was transferred in exchange.
          • Remainder will be gain or loss realized.
        • Gratuitous (Taft v. Bowers)
          • What is the donor’s basis under §1015?
          • Is fair market value less than the donor’s basis? Use fair market value for loss calculation purposes.
          • Subtract (a) and (b) from amount realized when donee later sells gift property.
      • Split Basis: when there is one basis used to determine gain, and another basis to determine loss.
        • Examples: Donor gave donee property under circumstances that required no payment of gift tax. What gain or loss to donee on the subsequent sale of property if
  • (a) the property had cost donor $20,000, had a $30,000 fair market value at the time of the gift, and donee sold it for:
    • $35,000. AR $35K-AB $20K=$15K Gain Donee gets the cost basis of the Donor Section 1015(a)
    • $15,000. $5,000 loss. AB $20-AR$15K= $5K LossSection 1015(a): For the basis of loss take the fair market value. This is not ok. You cannot augment the donee’s loss using donor’s loss.
    • $24,000. No gain or loss. AR $25K-AB $20K=$5K Gain. In the situation where the donor’s amount is greater than the FMV and the donee’s amount is in between, there will be neither gain nor loss.
  • (b) The property had cost Donor $30K, had a $20K fair market value at the time of the gift, and Donee sold it for:
    • $35,000 AR $35K-AB $30K= ($5K Gain)§1001(c) and §102 applies to donee (not donor)
    • $15,000 AB $20K-AR $15K= $5K Loss§1015(a) allows the basis to be FMV-not going to let the donee get the loss from the donor. Donor (AB $30K)——–Gift (FMV $20K)———-Sell ($15K)
    • $24,000 AR $24 –AB $30K = $0 GainDonee has not recovered the full basis($30K) of Donor, therefore no gain. AR $20 –AR $24K = $0 LossConversely the FMV has increased from the time of gift and therefore there is no loss during the time of donee’s possession
  • RA: There is a lot of room for manipulation otherwise ppl could shift losses incurred by one person to another person who could incur less taxes by using those losses as deductions.
  • Time of acquisition – is when donee gains an interest in the property even if he does not receive title of the property yet. The FMV of that date on that property is set at that time.
  • §1015 does NOT apply to ante-nuptial exchanges (promise to marry for something like stocks) because that is an arms-length-transaction. Farid-Es-Sultaneh
  • Gift tax§1015(d)(6) allows one to step up in basis when a percentage of the gift tax is paid so that you are not taxed twice. R: Increase in basis is limited to the amount that bears the same ratio to the amount of gift tax paid as the net appreciation in value of the gift bears to the amount of the gift.
    • [ (appreciation amount) / (total amount of gift) ] X (amount paid for gift tax) = (amount you can add to existing basis to adjust basis). **Now take that amount, add it to original basis to get adjusted basis (AB)
  • Hypos:
  • Father had some land that he had purchased for $100K (Original Basis= AB 100) but which had increased in value to $200K (FMV). He transferred it to Daughter for $100K in case in a transaction properly identified as in part a gift and in part a sale. Assume no gift tax was paid on the transfer.
    • What gain to Father and what basis to Daughter under Reg. §§ 1.1001-1(e) and 1.1015-4(a)(1)?
      • Father: AR $100K – AB $100K = Gain of $0
        • If Father had sold it there would have been a gain of $100K
        • Now, there is a $100K gain (unrealized). There should there be a preservation of that gain, and when the donee sells the property she will realize the $100K gain and it will be taxed. Example of shifting of gain.
      • Daughter: AB $100K
    • Suppose the transaction were viewed as a sale of one-half of the land for full consideration and an outright gift of the other one half. How would this affect Father’s gain and Daughter’s basis? Is it a more realistic view than that of the Regulations? Cf. §§170(e)(2) and 1011(b), relating to bargain sales to charities.
      • Step 1: Pretend you have two severed transactions (gave ½ on Monday and sold the other half on Tuesday):
        • Monday
          • Father: No gain
          • Daughter: AB $50K (remaining half)
        • Tuesday
          • Father: AR $100K –AB $50K= $50K Gain Going to subdivide the property
          • Daughter: AB $100K
      • Step 2: Now reunite the transactions:
        • Daughter: AB $150K (1/2 sale +1/2 gift)
    • Bargain sale: Part sale and part gift
      • When a transfer of property is in part a sale and in part a gift, the AB for the transferee is the greater of:
        • Amount paid by transferee or
        • Transferor’s AB in the property at time of transfer or
      • If transferor’s AB in property is greater than the FMV of the property and the FMV of the property is greater than amount paid by transferee, the FMV of the property shall be the unadjusted basis. §1.1015-4(b)(ex.4)
    • Marriage / Divorce
      • No gain or loss shall be recognized on a transfer of property from an individual to a spouse, or former spouse if the transfer is incident to divorce. §1041
      • Transfer of property between spouses or incident to divorce is NOT A TAX EVENT. So even if there is an augmenting of loss, split basis, whatever: NOT a tax event.
      • Basis is transferred from transferor to transferee because transfers under §1041 are treated as gift. In §1041, transferor’s basis is also used to calculate loss and augmenting loss is ok.
      • “Incident to Divorce”§1041(c) if –
        • Occurs within 1 year after the date on which the marriage ceases, or
          • **Thus, a transfer occurring NOT more than one year after the date on which the marriage ceases need not be related to the cessation of the marriage to qualify for §1041 treatment.
        • Is related to the cessation of the marriage.
          • Transfer pursuant to divorce or separation instrument + and transfer occurs not more than 6 years after cessation of marriage.
            • *If in years 2-6 and not pursuant to divorce or separation instrument = rebuttable presumption that transfer is not incident to cessation of marriage.
          • Rebuttable presumption that the transfer is not incident to cessation of marriage when transfer of property is after more than 6 yrs after divorce/separation + not pursuant to divorce or separation instrument. §1041-1Ta
          • §1041 does NOT cover: transfer of property acquired after marriage or pursuant an ante-nuptial because that is a before-marriage event.
      • Hypo: H owns something and the AB is 4,000 and FMV is 3,000, but he sells it to W. W’s AB is still 4,000. W sells to someone else for 3,000. The 1,000 loss is W’s.
        • If H had just given it to W as a gift: §1041 applies still because they are married. It does not matter; W still takes H’s basis. If they were not married in the loss situation, W would take the basis of the FMV of 3,000 instead of imputing the basis from H. The split basis rule applies in the gift situation for non-married people.
    • Death / Inheritance
      • Basis of property acquired from decedent is the FMV at the date of decedent’s death or the alternate valuation date if that date was elected by the estate administrator for valuation purposes. The Code affirmatively disregards gain in decedent’s property. §1014
        • Ex: $10 AB, @ Decedent’s death its FMV is $90, when it’s given to you the AB is $90. $80 gain has been ignored pursuant to §1014. (i.e., inherent FMV gain at time of death and gain is ignored)
        • §1014 applies to property acquired by bequest, devise, inheritance, or decedent’s estate, or surviving spouse’s ½ share of community property held by decedent and spouse as community property.
      • Appreciation while in the hands of the donor does NOT count into donee’s income taxes, but is still subject to estate tax.
      • One exception: §1014e
        • If decedent or decedent’s spouse receives a gift of property within 1 year before decedent’s death and if the property has appreciated then the inheritor gets donor’s basis.
          • But this is only with appreciated property, NOT depreciated property – which then is just FMV on decedent’s death.
          • Ex: F gives D a house with AB of $100k. D dies within a year and the house is given to T in D’s will. The house’s FMV on date of D’s death is $150k. T’s basis in the property is $100k. Note that if the FMV of the house on D’s death was 50k, then T’s basis in the property is 50k because then the house isn’t appreciated property.
    • Basis in Assets Subject to Exclusions
      • When an EE acquires an asset at a reduced price due to a §132 exclusion (such as qualified EE discounts), the basis will be the FMV, before the reduction is taken. The excludable amount is UNTAXABLE, so keep the basis at its FMV or whatever customers are paying for it.
        • Ex. What difference if owner is a sales person in an art gallery and owner purchases a painting worth 10k for 9k (10% EE discount) and owner later sells the painting for 16k? The basis is 10k because as per §132, the 1k discount is EXCLUDED and UNTAXABLE. So in order to make sure EE is NOT taxed on the 1k, we say the basis is 10k.
    • Adjustments§1016
      • Improvements not paid by owner – expending amounts for improvements/betterments adjusts the basis. (capital expenditures). For example, when Lessee pays for them.
        • Tenant Improvements – IRC § 1019: Basis will NOT be increased by capital improvements made by a tenant or lessee, unless owner realizes a financial benefit from such improvements when the property is sold.
        • §1019 – Deferred valuation of tenant’s improvements to owner’s land for purposes of gains and or AR. The improvements DO NOT go into AB so that Lessor can get the gain ($$) even though the gain will be taxed. (i.e., improvements are NOT calculated in AB, only when property is sold)
        • Additional expenditure to prolong its life gets added into AB.
      • Receipts with respect to the property (but not receipts from employing the property in productive activities like leasing/renting/etc.)
      • Recovery of basis during the holding period through allowable tax deductions relating to the ownership of the property (depreciation deductions). See Deductions
    • Basis when paid in part or whole by a loan
      • Nature of debt does NOT affect the basis. Crane.
  • Hypos:
  • Bought in 1999 for $100 cash. There is no accession to wealth because your $100 is converted to the asset. The basis should be $100, using the idea of cost. You got the asset and parted with $100 to get it. We don’t ask where the 100 came from. Cost is the FMV of the acquired item; it is not the amount paid.
    • Say you pay 20 in cash and borrow 80 to pay the 100. Borrowing is not a tax event. What you have basically bought is the net equity, so should the basis be different? If so, then 2 people would have a different basis for the same asset because one of them borrowed. The basis is NOT different. Crane. Basis is FMV of the property acquired in full.
  • T in 1999 was in Switzerland. He was a non-resident alien. He exchanges asset 1, which he had bought years before in Switzerland, and acquires asset 2. T comes to the US and becomes a resident alien and subject to US tax. T sells asset 2 in 2009 for an amount realized of 500. What are T’s consequences in 2009? How do we establish the 1999 basis with no records? Philadelphia Park applies. (1) We might be able to find the FMV of asset 2 in 1999. If so, do that. (2) If not possible, then assume the exchange was equal in value and value asset 2 by using the value of asset 1 at the date of the exchange. Maybe there are records of the value of what was exchanged. (3) If that is not possible, then use the basis of asset 1 as the basis of asset 2. If you cannot establish a basis, then your basis is zero, and the entire amount received is your gain. It is up to you to reduce your gain.
  • T buys an option to land for 1000 in 2006. The option is an asset, and it needs to have a basis. The basis is 1000. If the option is sold or transferred, there should be a gain or loss. Expiration of the option is equivalent to sale at amount realized zero, so there is a loss of 1000. If the option is exercised, and you pay another 9000 and get the land, you just consider the initial basis of the land as 10000. The transaction is what fixes the FMV for the land, and 10000 is what was in the transaction.
    • Say there is a tenant and the tenant makes an improvement and leaves. The landlord gets back an improved piece of property without having to pay for it. The property is more valuable, but it may not be entirely fair to tax the owner on an increased value. Plus, how do you value it? §109 says there is no income to a landlord at the end of a lease other than as rent. If we had said that the improvements were 2000, then there would be an adjusted basis of 12000. But Congress legislated that there is no income. It is just a deferral. §1019 says that to the extent of an exclusion under §109, there is no increase in GI and no basis adjustment. If the amount realized is 18000, the gain is 8000 instead of the 6000 that it would have been. So it is just a deferral to the point of sale instead of counting it in GI.

 

 

B. AMOUNT REALIZED

 

  • §1001(b)– The amount realized = the amount of cash received + fair market value of any property or services received or obligation satisfied + the amount of any liabilities assumed by the other party to the transaction (mortgage).
  • International Freighting Corp
    • When a taxpayer disposes of property in exchange for services, there is an “amount realized” equal to the fair market value of the services
    • Even when there is no sale, when there is an exchange of something (like stock) for something (like services) with 3rd party – that is a tax event and gain/loss is realized on that event.
    • Facts: T (ER) used stock of another company (with a basis of 16k) to provide bonuses to EEs for services performed. The FMV of the stock at the time of transfer to EEs was 24k. Court held: T has a gain of 8k because used the stock for services received; in effect T gained 24k and then gave it away to EEs as bonuses. EEs will have a basis of 24k.
  • Disposition of Property with Debt
    • Recourse Mortgage – personal liability on debt.
    • Non-Recourse Mortgage – no personal liability on debt; debt secured by collateral (property).
      • “Long Term” Holding – Money can be continually taken out against the property (if bank issues it anyway) and cash out money tax-free until death when heirs get property stepped-up basis pursuant to §1014.
      • Non recourse mortgage avoids litigation in regard to mortgagor’s deficiency in the event of default. Lender will foreclose on the collateral and lender will recover their money off of the value of the collateral.
      • Note that this means the lender is taking a higher risk because the collateral’s value can depreciate (and it can also appreciate).
    • Mortgage– The amount of a mortgage assumed by the purchaser, or to which the property is subject at the date of the property’s sale, is treated as part of the seller’s proceeds. There is no relevance in taxes for a property’s fair market value.
    • Cancellation of Indebtedness – A taxpayer who sells property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the amount realized on the sale.
    • Rules
      • (a) The discharge of debt under a recourse mortgage is GI as there has been a clear accession to wealth over which there is complete dominion.
      • (b) Full amount of debt must be included in AR at time of disposition of property. Crane
      • (c) Full amount of debt must be included into AR even when the FMV of the property is less than the amount of debt. Tufts
      • (d) GI can come from the cancellation of debt (COD).
  • FMV > Debt:
    • AR is the money received plus any amount of debt. AR on property is at least the balance owed on the debt.
  • FMV < Debt:
    • When a party transfers property encumbered by a nonrecourse mortgage with an unpaid balance that exceeds the fair market value of the property, the transferor has realized an amount equal to the unpaid mortgage balance. Tufts.
    • Non-recourse Mortgage: Absence of personal liability on a mortgage does NOT relieve the borrower of his obligation to repay, but only limits the mortgagee’s remedies on default
    • Recourse Mortgage: The buyer would NOT assume it because it would place his other assets in risk.
    • (1) Disposition of property to 3rd party (not lender/creditor) –
      • The value of property as fixed in the transaction replaces will be the amount of debt relieved.
    • (2) Disposition of property to the creditor/lender –
      • Apply bottom row of table above.
      • Recourse: COD income if the lender agrees to forgive the debt for less than the amount owed.
      • Nonrecourse: No COD income. AR = Balance of Debt. Tufts
      • SEE ANSWERS – Pg. 151-52

 

 

C. SPECIAL CALCULATIONS IN GAINS & LOSSES

 

  • GAIN/LOSS when selling small pieces of big land §1.61-6(a)
    • If the lots were purchased as a single unit, then a FMV determination at purchase would have to be made post hoc and the percentages of value would then determine the basis for each lot.
      • Equation is always AR – AB = gain/loss
        • AR = amount received for the small piece
        • AB = (FMV of piece at acquisition)/(sum of all pieces at acquisition) = %. Then take that % and multiply it with the (sum of all pieces at acquisition)
        • FMV = value of parcel depends on the land quality/other factors.
      • Since it’s all based on percentage: if one of the lots prices is affected by something (like an easement) then all the lots is affected.
    • Discharge of Indebtedness §61(a)(12)
      • A taxpayer may realize income by the payment or purchase of his obligations at less than their face value.
      • When the amount or value of debt is greater than the quantum of debt which eliminates the debt, it is GI. If debt is paid off at less than face value, the difference is GI. US v. Kirby Lumber Co. Doesn’t matter if mortgage is assumed because the responsibility to repay has disappeared.

 

 

  1. LIFE INSURANCE & ANNUITIES

 

A. LIFE INSURANCE §101(a)(c)(d)(g) Regulations: Sections 1.101-1(a)(1), (b)(1), -4(a)(1)(i), (b)(1), (c)

 

  • Life Insurance Policy
    • Contractual agreement between the insurance company and the purchaser of the policy (owner).
    • In exchange for premiums paid, the company promises that when the insured dies, the company will pay the agreed-upon amount (proceeds) to the beneficiary designated by the owner.
    • 3 parties other than the insurance company- They can be different people or one person.
      • Insured– The life that the policy is based on. The measuring life does not have to be the owner or the beneficiary.
      • Owner– The person paying for the policy. If the owner is not the insured, he must have an insurable interest in the insured’s life.
      • Beneficiary– Gets the proceeds upon death of the insured.
    • In a sense the policy is like a gambling contract. The insurance company wants the insured to die later so they can stay afloat. The owner wants the insured to die sooner.
  • Income Tax Issue
    • Upon the death of the insured, the proceeds go to the beneficiary. This is an undeniable accession to wealth, so there is a potential income tax issue.
    • It is NOT an inheritance, even through proceeds are because of a death. The proceeds are coming from a contract with the insurance company, NOT from the insured’s estate.
  • §101
    • 101(a)(1)
      • Deals with the exclusion of life insurance.
      • The plain thrust of §101 is to exclude the proceeds of life insurance from the GI of recipients.
      • 100% of amounts received under a life insurance policy that are paid by reason of death of insured are excluded from the recipient’s income. The face amount of the policy (the fixed sum) to be paid at death is the amount that is to be received tax free.
      • If you get the money by reason of death and take the money lump sum, then no tax. If you take it by payments, then there are calculations that need to be done. §101(d)
      • MAIN RULE: Gross income does NOT include amount received under a life insurance contract if amounts are paid by reason of the death insured.
        • Beneficiary does NOT have gross income.
      • Amounts received for any reason besides death of the insured are NOT covered by 101.
    • 101(a)(2)
      • Situation in which there is a inter vivos transfer of the preexisting policy for value
        • The entire exclusion does NOT apply, and you can only exclude your costs in the policy
      • Analogous to a regular purchase of an asset for investment. It is already existing, just buying an investment.
      • Exclusion = cost (recovery of basis). The exclusion is the amount paid for the policy plus subsequent premiums.
      • Does NOT include a regular sale or exchange. We are only dealing here with the TRANSFER of PROCEEDS.
      • Transfer can include sale, exchange, surrender to company, gift, etc.
      • The basis of the transferee is determined by the basis in the hands of the transferor.

 

  • Exclusions – Amounts excluded from § 101 treatment:
    • Interest Only Payments: §101(c) The beneficiary only draws on the interest from the insurer (100% taxable). At the end of the term, the original amount is given to beneficiary (100% NOT taxable)
    • Installment Payments: § 101(d) If the benefits are paid in installments rather than in a lump sum.
      • Example: $100K at $250/month($3K/yr) for life. Life expectancy is 50 yrs. Will receive $150K ($50K more than entitled) Therefore will exclude $2K from and include $1K in GI each year (Look at tables for life expectancy)
      • Hypo: When Matt’s Aunt Harriet passed away, he learned that he was the beneficiary under a $50K life insurance policy that she had purchased. Under the terms of the policy, the proceeds will be paid out in five annual installments of $12K. He must include $2K of each $12K payment in his GI each year.
    • Cash Surrender Value: If the insured elects to take the cash surrender value of the policy, that value might exceed his basis. In that case, he would have taxable income on the excess income over the premiums you have paid thus far because it was NOT paid by reason of his death
    • Viatical Settlements – Transfer for Value– §101(a)(2)
      • This is where the policy holder has sold/bought the policy for value during insured’s life (selling the policy – which is a property). Any amount paid by buyer (AB) set aside by amount received by policy (AR) = gain = GI.
      • Any loss is NOT a deduction
      • If the insurance contract is transferred for valuable consideration, the exclusion no longer applies unless the transfer is to (i) transferee who acquired the policy with a transferred basis §101(a)(2)(A) (ii) the insured, (iii) her partner, (iv) her partnership or (v) a corporation in which she is a shareholder or an officer. § 101(a)(2)(B) NOTE: Only taxed on the excess of the original investment NOTE: Don’t need to actually use the transfer basis, just that the basis was established from looking at the transferor’s.
    • Any receipts from policy NOT resulting from death of insured
    • Conversion to lifetime annuities for insured
      • If the policy is converted to lifetime annuities for the insured (not by beneficiary), the proceeds are NOT excludable from GI if there are any sums received in excess of premiums paid.
      • Exceptions to this exclusion explained below (Terminally Ill or Chronically Ill) – in the case of exceptions, the beneficiary can take the exclusion but 3rd party cannot.
  • Exceptions to the exclusions (thus restoring the 100% exclusion of proceeds from GI)
    • Viatical Settlements
      • Between Spouses and Divorced – When it is a transfer between spouses or property settlement incident to dissolution of marriage under §1041 then §1041 would provide for the exclusion of the amount from GI.
      • Between business partners – When transfer is gratuitous made by or to the insured or business partners (or SH or officer of a corp.), the proceeds are excludable. §101(a)(2)(B); §101-1(b)(2)
      • Terminally ill – §101g – When someone has an illness/physical condition that can reasonably be expected to result in death within 24 months of certification by physician. Beneficiary can take exclusion, viatical settlement company cannot.
        • No ceiling on excludable amounts paid w/respect to policies.
      • Chronically ill – §101g – When someone has an illness/physical condition that has been certified within preceding 12-month period as unable to perform at least 2 activities of daily living for a period of at least 90 days due to loss of functional capacity or as having severe cognitive impairment requiring substantial supervision. Beneficiary can take exclusion, viatical settlement company cannot.
        • Limited to costs of qualified long-term care or payments of $175/day or $63,875/yr both reduced by reimbursements from medical insurance proceeds.
  • Calculations §101(d): If the policy allows for an option to elect fixed monthly payments, determined by beneficiary’s age & life expectancy, for the rest of beneficiary’s life, then you must determine what sum of those payments are excludable/non-excludable.
    • Take the lump sum amount and divide by life expectancy (set by insurance company’s own mortality tables) = amount that is excludable per year. Anything above that will be taxed as GI.
      • Ex: 100k/25years = 4k a year excludable.
    • If person lives beyond calculated expectancy, he can continue to take the exclusions even after the entire 100k has been received. If a person dies before the entire 100k is received, he’s out of luck.
  • Hypos:
    • Insured died in the current year owning a policy of insurance that would pay beneficiary $100,000 but under which several alternatives were available to beneficiary.
      • What result if beneficiary simply accepts the $100,000 in cash? No income, under IRC § 101 (a).
      • What result in (a), above, if beneficiary instead leaves all the proceeds with the company and they pay her $10,000 interest in the current year? Interest is taxable.
      • What result if insured’s daughter is beneficiary of the policy and in accordance with an option that she elects, the company pays her $12,000 in the current year? Assume that such payments will be made annually for her life and that she has a 25 year life expectancy. $12K x 25 = $300K gross payout. $200K is taxable. $100K – $12K payment is excluded.
      • What result in (c), above, if insured’s daughter lives beyond her 25 year life expectancy and receives $12,000 in the 26th year? Under IRC § 72, the 26th payment of $12,000 is all taxed.
    • Jock agreed to play football for Pro Corporation. Pro, fearful that Jock might not survive, acquired a $1million insurance policy on Jock’s life. If Jock dies during the term of the policy and the proceeds of the policy are paid to Pro, what different consequences will Pro incur under the following alternatives?
      • With Jock’s consent Pro took out and paid $20K for a two year term policy on Jock’s life. §101(a)(1) allows for theexclusion of the $1 mil from being taxed.
      • Jock owned a paid-up two year term $1mill. Policy on his life which he sold to Pro for $20K, Pro being named beneficiary of the policy. $1mil – $20K (paid for policy)=$980K taxable
      • Same as (b), above, except that Jock was a shareholder of Pro Corporation. Full $1mil is not taxable. §101(a)(2)(B)
    • Insured purchases a single premium $100K life insurance policy on her life for a cost of $40K. Consider the income tax consequences to Insured and the purchaser of the policy in each of the following alternative situations:
      • Insured sells the policy to her Child for its $60K fair market value and, on Insured’s death, the $100K of proceeds are paid to Child. $100K-$60K (paid for policy)= $40K taxable for Child$60K-$40K= $20K taxable for Insured §1012 (Basis of Property)
        • NOTE: If gave as gift, then there is no transfer of value issue and the proceeds/benefits are not taxable.
        • NOTE: If half gift/sale: Change price to $50K. Therefore, AR$50K and AB$40K= $10K gain. Insured dies so the $100K goes to child. Are there any exceptions? Yes, because § 1015 enabled to establish a basis for the child ($50K)and therefore §101(a)(2)(A) applies as that basis was established by looking at the transferor.(Similar to transfer of basis under § 1041)
      • Insured sells the policy to her Spouse for its $60K fair market value and, on Insured’s death, the $100K of proceeds are paid to Spouse. Insured: §1041(Transfers of property between spouses or incident to divorce) Not taxable for Insured Spouse: §1041(b)(2) states that the basis of the transferee in the property shall be the adjusted basis of the transferor. Therefore, under §101(a)(2)(A) it is excluded because the transferee basis was determined by reference to the basis of the transferor (carryover) as mandated by §1041(b)(2) Not taxable for Spouse
      • Insured is certified by her physician as terminally ill and she sells the policy for its $80K fair market value to Viatical Settlement Provider who collects the $100K of proceeds on Insured’s death. IRC § 101 (g)(2)(a) “If any portion of the death benefit under a life insurance contract on the life of an insured described in paragraph (1) is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance contract by reason of the death of such insured.” Therefore Non-taxable for InsuredHowever, there is no exception for the company,therefore $100K -$80k-subsequent premiums (§101(a)(2) shall NOT exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee”)= taxable income for Company

 

 

B. ANNUITIES §72(a)(b)(c); Regs 1.72-4(a)-9

 

  • An annuity contract is one in which the taxpayer invests a fixed sum, which is later paid back, with interest, in installments for a set period or for life. That part of each annuity payment that represents the taxpayer’s investment in the policy is exempt as a return of capital. The interest portion, however, is income and therefore taxable under IRC § 72.
  • An annuity is a K that plays with risk. Insurer hopes you die, if you live then you get all of X. You will always get all of Y deducted, because if you die early, the rest of the Y you had will be deducted on your last income tax return.
  • Annuity Categories
    • Single Life Annuity: Fixed payments to one annuitant for his life.
    • Self and Survivor Annuity: Payments to one person for life and then to another for life.
    • Joint and Survivor Annuity: Payments to two persons and then to survivor of the two.
    • Refund Feature: An annuity guarantees a minimum payment if the annuitant dies early.
    • Fixed Term Annuity: Annuity pays for fixed term rather than life. If annuitant dies early, payments go to beneficiary.
    • Variable Annuity: Payment varies based on performance of investments.
  • IRC recognizes that each annuity is made of income and a return on capital. A portion of each payment is excluded as a return of capital and not taxed (ratio of the investment in the contract to the expected return under the contract) The amount of payment in excess of the portion (excluded amount) is included in gross income.
  • § 72(b)—Exclusion Ratio: Calculating the return of capital portion is done by determining the exclusion ratio, “the cost of the annuity divided by the expected return. The expected return is calculated by either a fixed contract or by reference to the life expectancy of the investor (determined from the actuarial tables pg. 926/927)”. The amount excluded from each payment is the product of the exclusion ratio and the payment. The amount of each payment that exceeds this return-of-capital portion is then taxed as net income. Note that certain employee pension plans that work quite similarly to annuities are treated differently. Example: Mr. A pays $60,000 for an annuity for life at $500 per year. Mr. A’s life expectancy is 20 years, so he hopes to have a return of $100,000. Ratio is 60/100 = 60% ($300 of each $500) payment is excluded from tax.
    • IRC provides that if annuitant lives beyond his life expectancy and recovers investment in contract, full amount of any subsequent payments are gross income. If annuitant dies before recovering investment in contract, the estate gets a deduction §72(b)(3)(B) of the rest of the investment on deceased’s last income tax return.
    • Average life expectancy wrt to Annuity Payments is determined by tax book tables!

 

    • Here’s the deal:
      • Y = your (insured’s) investment in the K (how much money you put in).
      • X = total expected return on the K (how much you expect to get).
      • Z = payment received (you will have a number of Zs determined by your K).
      • The K probably provides that X>Y at average life expectancy.
    • The equation:
      • Y/X = %
      • X = (payment amount) X (life expectancy)
      • Apply the % to Z = amount excluded from GI §72(b). The rest of Z will be GI §72(a).
    • The rules:
      • Annuity payments representing Y are excluded from GI. §72(b).
      • If annuitant lives beyond her life expectancy and fully recovers her investment in the K, the full amount of any subsequent payments is included in GI.
      • If annuitant dies before life expectancy, the unrecovered investment in the K is allowed as a deduction on her last income tax return. §1.72-7(b).
  • Hypo: In the current year, T purchases a single life annuity with no refund feature for $48K. Under the contract T is to receive $3K per year for life. T has a 24-year life expectancy.
    • To what extent, if at all, is T taxable on the $3K received in the first year? $3000 X $48000/$72000= $2000 non taxable, therefore $1000 is taxable.
    • If the law remains the same and T is still alive, how will T be taxed on the $3K received in the thirtieth year of the annuity payments? It will be treated as full income § 72(b)(2)
    • If T dies after nine years of payments will T or T’s estate be allowed an income tax deduction? How much? Yes, $2000(nontaxable) X 9(years)= $18000 $48000-$18000= $30000 will be allowed for deduction.§72(b)(3)(A)(ii) NOTE: Make sure to include the payment in the year of the deceased if received.
    • To what extent are T and T’s spouse taxable on the $3K received in the current year if at a cost of $76,500 they purchase a joint and survivorship annuity to pay $3K per year as long as either lives and they have a joint life expectancy of 34 years? Look at page 929

 

 

  1. DAMAGES

 

First, determine whether your damages are listed under a statute or if it is a common-law damage. Then, follow one of the two accordingly. You should probably sift through statutory damages first because those preempt common-law damages rules.

 

  • Common law damages: Damages in general
    • “In Lieu of” Test: Damages are taxed according to what they are replacing/if they are replacing lost sums. “In lieu of what were the damages awarded?” – Raytheon v. Commissioner
    • Thus, if a damage award is compensation for lost profit, the award is income. Where the award is for damage to an asset, the recovery is applied against the basis of the asset damaged, reducing the basis of the asset. If the award exceeds the basis of the asset involved, the excess is taxable gain §61(a)(3) and the basis of the asset thereafter is zero
    • What is the underlying nature of the claim?
      • Lost profits/income = GI because the profit you would’ve gained would’ve been GI.
      • Recovery to property –
        • Loss or Damaged property: money received for damaged property is NOT GI, unless the amount you received is greater than your original basis in the property in which case there is a gain. Any excess in damages in relation to basis is GI.
          • NOTE: Any money you receive for damaged property that is equal to or greater than your basis in the property adjusts your basis in the property for gain/loss purposes.
        • Punitive damages are GI. Glenshaw Glass But THIS DOESN’T APPLY because §104(a)(2) applies. Statutory instructions trump c/l.
      • Goodwill – is treated as if it is property.
    • Hypo: Bldg owned by T. Defendant (D) interacts with bldg causing it damage. Bldg’s FMV is $80k. T’s AB in bldg is $10k. T vs. D in court and T wins damages as follows:
      • $12,000 for damage to the property
        • T rec’d 12k by virtue of owning the property. His basis in the bldg was 10k. Any excess in damages in relation to basis is GI. Therefore, there is a 2k gain (12k award – 10k basis) that will be included in T’s GI.
        • Basis in property: The basis in property is zero if T takes the money and doesn’t fix the bldg. The basis in property is 12k if you take the 12k and put it into repairing the bldg. Basis never goes negative so if T doesn’t use the money to fix the bldg and D damages another side, those damages for wrecking the bldg are all gains.
      • $15,000 substitute for lost rent due to the damage
        • Lost rent = lost profits. T would’ve been taxed on his lost profit, so GI.
      • $100,000 punitive damages
        • Glenshaw Glass this is GI: Instance of undeniable accessions to wealth, clearly realized, and over which T has complete dominion.
  • Statutory Damages: Damages and recoveries for physical/personal injuries §§104(a); 105(a)-(c) and (e); 106(a); Reg. 1.104-1(a), (c), (d), 1.105-1(a); 1.106-1
    • These do NOT follow the c/l approach! These are excepted from the “in lieu of” test.
    • EXCLUDE IF PERSONAL PHYSICAL INJURY/SICKESS & NOT PUNITIVE DAMAGES! Doesn’t matter if its lost profits or whatever as long as those elements are met.
      • EMOTIONAL DISTRESS ALONE IS NOT EXCLUDED!
    • Injuries or Sickness- §104 (a) Except as deductible under §213 (medical expenses not covered by insurance are deductible), GI does NOT include:
      • §104(a)(1)Worker’s Comp: Amount received under workers’ compensation statutes NOT GI.
        • There must be a state system of worker’s comp (its state law) and the damages are for a workers’ comp situation. Congress doesn’t care to exclude because worker’s comp board is ensuring that there is no excessive recovery.
      • §104(a)(2)Tort damages for physical injuries/sickness: Amount received under tort damages for physical personal injuries or physical sickness NOT included in GI. Can be in lump sum or in payments, it doesn’t matter. Doesn’t have to be received by injured.
        • Ifemotional damages are associated/attached with a personal injury, then excluded; if emotional distress is incurred by physical injury, then excluded. Otherwise, emotional distress damages awards are GI (NOT excluded). Emotional damages causing physical symptoms = GI.
        • However, under §213, if money is spent to treat the emotional distress, that amount may be deducted.
        • NOT fair to plaintiffs because they are taxed on the entire amount even those 1/3rd or so going to attorneys fees –
          • §62(a)(9) Allows for deduction of attorney’s fees from GI. Only applies to cases settled after October 12th, 2004 or so. New statute.
      • §104(a)(3) Health Insurance: Amounts received under accident and health insurance policies for personal injuries or sickness where the employer pays
        • If you pay for the health insurance, all amounts are excludable from GI.
        • If ER pays for the health insurance, see §105(a/b).
      • §104(a)(2) Punitive Damages are a no-go: punitive damages = GI.
      • §104(c)(1) Punitive Damages in wrongful death action & pursuant to state statute only allowing punitive damages shall be excluded from GI.
      • §104(a)(5) & (6) – narrow provisions concerning disability income and pensions from foreign governments and hazardous US duty.
    • §105(a)–(c) Situations where ER pays for health insurance
      • §105(a) Amounts received by EE from health insurance paid for by ER or amounts received by EE from health insurance attributable to ER’s contributions to a plan not taxed under §106(a),
        • those amounts are included in GI. Thereafter, EE can deduct the amounts spent on medical bills through §213.
      • §105(b) If an ER directly or indirectly reimburses an EE for expenses of medical care for the EE/EE’s spouse/EE’s dependents – these amounts are excluded from GI
        • Spending Test – If EE has health insurance that he pays for on his own (§104) then you prorate the ER money and get the proper exclusion that way.
        • (ER provided $ total) / [(ER provided $ total) + (personal insurance $ total) = %. THEN APPLY THAT %AGE TO THE ER INS. AMOUNT AND THAT AMOUNT IS EXCLUDED, THE REST IS INCLUDED.
      • §105(b): Restricts exclusions under IRC §104 by disallowing any exclusion for deductions relating to medical expenses, as under IRC §123, for the prior tax year. No double dipping. Taxpayer can’t take a deduction in one year and then seek an exclusion for the same amount the following year.
      • §105(c) GI does NOT include payments by health insurance paid for by ER (or amounts received by EE from health insurance attributable to ER’s contributions to a plan not taxed under §106(a))
        • If EE gets payments by ER for the permanent loss or loss of use of a member or function on the body, or the permanent disfigurement, of the T, his spouse or a dependent
        • and the amount is computed with reference to the nature of the injury without regard to the period EE is absent from work.
        • *§104(a)(1) Worker’s Comp preempts §105(c) when EE receives payment for casualties of this type under Worker’s Comp legislation.
    • §106a – Except as otherwise provided, gross income of an employee does not include employer-provided coverage under an accident or health plan
      • §106d- Qualified amounts contributed by the employer to an eligible employee’s “medical savings account” are also excludible
  • Hypos:
    • If there is a policy where EE pays 3000 and ER pays 2000, and the medical expenses are 4000, the split is 60% 40%. 400 would be GI, which is the portion that exceeded the expenses from the employer.
  • Plaintiff brought suit and successfully recovered in the following situations. Discuss the tax consequences to Plaintiff.
    • P, a professional gymnast, lost the use of her leg after a psychotic fan assaulted her with a tire iron. P was awarded damages of $100K. No gross income
    • $50K of the recovery in (a) above, is specifically allocated as compensation for scheduled performances P failed to make as a result of the injured leg. Loss profit 104(a)(2), so would be completely included as income
    • The jury also awards P $200K in punitive damages. Punitive damages are not excludible, so she would have to include the full amount as gross income
    • The jury also awards P damages of $200K to compensate for P’s suicidal tendencies resulting from the loss of the use of her leg. If attached to the physical injury which is covered by 104(a)(2), it will be excluded from gross income
    • P in a separate suit recovered $100K of damages from a fan that mercilessly taunted P about her unnaturally high, squeaky voice, causing P extreme anxiety and stress. Emotional damage that stands alone and is not attached to a physical injury is generally not excludible. However could exclude amount under 213(d) medical expenses.
    • P recovered $200K in a suit of sexual harassment against her former coach. Any recovery on the sexual harassment would constitute income for tax purposes, unless she is able to prove that a portion is compensation for physical injuries under Code § 104.
    • P dies as a result of the leg injury, and P’s parents recover $1M of punitive damages awarded in a wrongful death action under long-standing state statute. Subsection 104(c) provides a narrow exception to the rule of inclusion for punitive damages in a wrongful death action where state law provides the only damages that may be awarded are punitive damages.
  • Injured and Spouse were injured in an automobile accident. Their total medical expenses incurred were $2500.
    • In the year of the accident they properly deducted $1500 of the expenses on their joint income tax return and filed suit against Wrongdoer. In the succeeding year, they settled their claim against Wrongdoer for $2500. What income tax consequences on receipt of the $2500 settlement? They can only exclude $1000 because they would be double dipping if they were allowed to exclude the full settlement. They already had a deduction in the previous year and are simply recovering the same amount.
    • In the succeeding year Spouse was ill but, fortunately, they carried medical insurance and additionally Spouse had insurance benefits under a policy provided by Employer. Spouse’s medical expenses totaled $4K and they received $3K of benefits under their policy and $2K of benefits under Employer’s policy. To what extent are the benefits included in their gross income? $3,000 from employee paid policy is not income. $2,000 from employer paid policy is taxed unless a reimbursement. 2,000/5,000 x 4,000 = 1,600. $400 of employer policy is taxable.
    • Under the facts of (b), may Injured and Spouse deduct the medical expenses? See §213(a). They can only deduct expenses paid during the taxable year not compensated for by insurance or otherwise.
  • Spouse was ill but, fortunately, they carried medical insurance and additionally spouse had insurance benefits under a policy provided by employer. Spouse’s medical expenses totaled $4,000 and they received $3,000 of benefits under their policy and $2,000 of benefits under the employer’s policy. To what extent are the benefits included in their gross income? $4,000 in medical expenses. $5,000 in benefits. $3,000 from employee paid policy is not income. $2,000 from employer paid policy is taxed unless a reimbursement. 2,000/5,000 x 4,000 = 1,600. $400 of employer policy is taxable.

 

 

  1. SEPARATION & DIVORCE

 

  • You do not get a deduction for paying support for a child or parent.
  • §1041- Property transfers between spouses
  • §§71, 215- Non property transfers
  • 3 types of relationships that would generate obligatory payments
    • Parent of the taxpayer
      • CA 4400- An adult child shall support a parent in need if they are able
    • Spouse of the taxpayer
      • §§71, 215 provide an income shifting for these payments.
      • Count in GI of the payee and as a deduction for the payor
    • Child of the taxpayer
      • No income shifting
      • Payments are not to the child, but to the custodial parent. That parent may conceivably be one receiving spousal support as well.

 

A. ALIMONY AND SPOUSAL SUPPORT

 

  • This can be structured to manipulate tax consequences to both parties. The tax consequences for both parties change with this shift: For example, if wife makes less money and H transfers the amount to wife, then wife’s tax on x amount be less than H’s tax on the same amount.
  • Requirements: §71b
    • In cash- cash, check, or money order
    • Not for child support
    • Payment received by or on behalf of a spouse under a divorce or separation instrument
      • Indirect Payments – Cash payment to a 3rd party for the benefit of payee qualifies for a §71/§215 transfer. This is subject to the Ownership Test.
      • Ownership Test: Who owns the asset?
        • If the paying spouse is making the payments on his property, then no shift.
        • If the paying spouse is making payments on the other spouse’s property, then it can have §71/§215 treatment.
      • Indirect payment must be irrevocably and economically benefiting spouse on whose behalf payments are made.
      • Life insurance premiums may qualify as indirect payments provided that the policy is irrevocably signed so that the payee ex-spouse owns it and the policy must irrevocably designate payee as beneficiary.
    • The divorce or separation instrument does not designate the payment as a non-alimony payment
    • In the case of a decree of legal separation or divorce, the parties are not members of the same household when the payment is made
    • No liability to make any payment in cash or property after the death of the payee spouse
      • Can add more contingencies, but the only requirement is that it must end by the death of the payee because there is no more support need.
  • 3 Forms of Dissolution:
    • Decree of Divorce or Separate Maintenance or Written Instrument Incident to Such a Decree or Court Order (Judicial decrees)
      • H & W cannot live together.
      • H & W will not be treated as living together if H/W is preparing to depart from the household of the other spouse and does depart not more than one month after the payment is made. §1.71-1T(b)
      • Divorce- adjusts the status of the marriage. Decree- only requires maintenance.
    • Written Separation Agreement
      • H & W can live together if it is not pursuant to a judicial decree
    • Support Decree
      • H & W can live together if it is not pursuant to a judicial decree
  • You may want to write the agreement with steps down but say that it is all maintenance. There are reasons why you would want to do that. So you have to be cognizant of that when you write the agreement. T’s can opt-out of this treatment by claiming the amount as “non-alimony” in the divorce instrument/separation agreement
  • There may be some negotiation between the parties because of the tax consequences and because of §71b1B.
  • Property settlements with respect to divorce/separation: Basically, no gain/loss on transfer of property (just exchange each others basis) from an individual to a former spouse if incident to divorce. “Incident to divorce” see §1041(c) under gains/losses.
  • Hypos:
    • If 7000 is paid to a spouse and none of that is child support, all of that is GI to the payee and deductible by the payor.
    • If the payor transfers a piece of art, does not count under §71 because not in cash. However, will not be taxable because it is a transfer of property under §1041.
    • Unless otherwise stated, Andy and Fergie are divorced and payments are called for by the divorce decree.
  • The divorce decree directs Andy to make payments of $10,000 per year to Fergie for her life or until she remarries. Andy makes a $10,000 cash payment to Fergie in the current year. Treated as alimony. Alimony is in cash and pursuant to divorce decree.
  • Same as (1), above, except that Andy, finding himself short on cash during the year, transfers his $10,000 promissory note to Fergie. Not alimony. Not in cash but promissory note.
  • Same as (2), above, except that instead of transferring his promissory note to Fergie, Andy transfers a piece of artwork, having a market value of $10,000. Not alimony. Not in cash but artwork. In this case §1041 applies as it is a transfer between spouses and allows for it to be nontaxable as there is no gain since it is incident to the divorce
  • Same as (1), above, except that in addition the decree provides that the payments are nondeductible by Andy and are excludible from Fergie’s gross income. Not alimony. Taxpayer cannot opt out of IRC.
  • Would it make any difference in (4) above, if you learned that Andy anticipated that he would have little or no taxable income in the immediate future, making the §215 deduction practically worthless to him, and as a consequence of this agreed to the “nondeductibility” provision in order to enable Fergie to avoid the imposition of federal income taxes on the payments? No, because there is no motive inquiry.
  • What result in (1), above, if the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years? Not alimony. Alimony must be limited by death of recipient. IRC § 71(b)(1)(D)
  • Same as (5), above, except that under local law Andy is not required to make any post-death payments. Alimony. Local law cures defect in (5).
  • Same as (1), above, except the divorce decree directs Andy to pay $10,000 cash each year to Fergie for a period of 10 years or her life, whichever ends sooner. Additionally, the decree requires Andy to pay $15,000 cash each year to Fergie or her estate for a period of ten years. Andy makes a $25,000 cash payment to Fergie in the year. $10,000 is alimony. $15,000 is not alimony.
  • Same as (1), above, except that at the time of the payment, Andy and Fergie are living in the same house. Not alimony. IRC requires divorced individuals are not in the same household. IRC § 71(b)(1)(C)
  • Same as (1), above, except that Andy and Fergie are not divorced or legally separated and the payments are made pursuant to a written separation agreement instead of a divorce decree. Alimony. Payments are made pursuant to a separation agreement.
  • Alternative Payments Hypothetical: Tom and Nicole are divorced. Pursuant to their written separation agreement incorporated in the divorce decree, Ted is required to make the following alternative payments that satisfy the IRC § 71 (b) requirements. Discuss the tax consequences to both Tom and Nicole:
    • Rental payments of $1,000 per month to Nicole’s landlord. This is indirect alimony. Payment receives alimony treatment.
    • Mortgage payments of $1K per month on their family home which is transferred outright to Nicole in the divorce proceedings. Payment receives alimony treatment.
    • Mortgage payments of $1,000 per month as well as real estate taxes and upkeep expenses on the house where Nicole is living which is owned by Tom. Not indirect payment. Tom can’t deduct because he owns the beneficiary.
  • Brad and Jen Hypothetical: Brad agrees to pay Jen $15,000 a year in alimony until the death of either or the remarriage of Jen. The alimony satisfies the IRC § 71 (b) requirements. After 3 years, Jen is concerned about Brad’s life expectancy and they agree to reduce the alimony amount to $10,000 a year if Brad provides Jen $100,000 of life insurance on his life.
    • What are the tax consequences to Brad and Jen if Brad purchases a single premium $100,000 policy on his life for $60,000 and he transfers it to Jen? It is indirect alimony on the $60K
    • What result in (1), above, if Brad instead pays Jen $60,000 cash and she purchases the policy for $60,000? Brad can deductbecause it is in cash. Assuming that there is an instrument then it does get shifted.
    • What result if Brad buys an ordinary policy on his life for $5K transfers it to Jen, and agrees to transfer $5K cash to her each year so she can pay the annual premiums on the policy? No shift on first $5K (look at (1)). The $5/yr would be shifted.
    • Same as (3) above, except that Brad pays the $5K annual premiums directly to the insurance company. Indirect payment, as long as pursuant to instrument and all other requirements are met it is a cash benefit for the spouse and it is shifted.
    • Same as (4) above, except that instead of transferring the policy to Jen, Brad retains ownership of the policy but irrevocably names Jen as its beneficiary. No shift, because he retains property rights.

 

 

B. CHILD SUPPORT

 

  • Child support is NOT within §71/§215 and therefore cannot be transferred. So payor has GI on that amount and payee has no GI. You can, in effect, disguise the child support as alimony because there is only a problem if an amount is deemed child support.
  • §71c
    • If a payment is fixed as child support, that is what it is.
    • Contingencies: Age, marriage, leaving the spouse’s household, becoming employed, dying, leaving school
    • Child support comes out first in full. What is left remains available as spousal support.
    • If a payment is reduced on a specific date, it could still be counted as child support if it is clearly associated with a contingency. §71c2B
      • Regs: Payment reduction will be associated with a contingency if the date is not more than 6 months before or after the child turns 18, 21, or a local age of majority. Or, if the payments are reduced at least twice which occur not more than one year before or after a different child of the payor spouse attains a certain age between 18 and 24, inclusive. The age must be the same for each child but need not be a whole number of years. Basically this is when you step down the payments more or less at the same time for each child.
      • Raises a presumption, but the presumption is rebuttable.
      • This is not how you want to write your agreement. Why would you write it that way?
  • It’s child support if –
    • Agreement says it is or
    • If there are contingencies put on payments pursuant to the child’s life.
  • Contingency language –
    • Payments that are reduced within 6 months of the child turning 18, 21, or the local age of majority; OR
    • Reduction of payments 2 or more times which occur within a year (before or after) a different child obtaining a certain age between 18 and 24.
      • The age must be the same for each child, but does not have to be a whole number.
      • How to do this: On the date that first reduction in payment occurs, calculate oldest kid’s age. On the date the second reduction in payment occurs, calculate the next younger kids age. Then look at the two ages and try to find a middle point. The middle point is an age – if both kids are within that age by a year, then §71/215 does not apply. If they are not within the age by a year, then §71/215 applies.
    • In all other situations reductions will not be treated as clearly associated with the happening of a contingency related to a child.
  • Insufficient Payments:
    • Payments for less than the amount fixed in the divorce or separation instrument are applied to child support first and only the amount in excess of the child support payment is GI to the payee.
    • Ex: H owes $1,000 in child support and $1,000 in alimony but only pays $1,000. W has no gross income because the entire $1,000 is treated as child support.
  • Hypos:
    • 7000 paid to spouse. Reduced to 5000 to spouse in 3 years, when child turns 18. This is specified in the decree. This year, 5000 is maintenance, and 2000 is support.
  • Michael and Lisa Marie Hypothetical: Michael and Lisa Marie’s divorce decree becomes final on January 1 of year one. Discuss the tax consequences of the following transactions to both Michael and Lisa Marie:
    • Pursuant to their divorce decree, Michael transfers to Lisa Marie in March of year one a parcel of unimproved land he purchased 10 years ago. The land has a basis of $100K and a fair market value of $500K. Lisa Marie sells the land in April of year one for $600K. His basis of $100K transfers under §1041(b) to her so that when she sells it for a gain of $500K. Taxed on the gain of $400K when Michael owned it and then the gain of $100K when she owned it.
    • Same as (i) above, except that the land is transferred to satisfy a debt that Michael owes Lisa Marie. The land has a basis of $500K and a fair market value of $400K at the time of the transfer. Lisa Marie sells the land for $350K. Does not matter. Transfer between spouses. §1041(b) covers it as long as incident to the divorce (within a year)
    • What result if pursuant to the divorce decree, Michael transfers the land in (i) above, to Lisa Marie in march of year four. §1041 “ A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce and the transfer occurs not more than 6 years after the date on which the marriage ceases.”
    • Same as (iii) above, except that the transfer is required by a written instrument incident to the divorce decree.
    • Same as (iii) above, except the transfer is made in March of year seven. If after the 6 years then the presumption that the transfer was not made pursuant to the divorce can be rebutted. §1041 “ A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce and the transfer occurs not more than 6 years after the date on which the marriage ceases.”

 

 

C. TRUSTS

 

  • preferable to annuity, preferable to alimony
  • §682
    • Payor spouse transfers property to a trust to generate income which is paid to the payee spouse. Transferring the property to a trust = no GI for payor spouse.
    • The payee spouse is the beneficial owner of the income interest in a trust.
    • The payments from the trust to the payee are GI to the payee and the trust can take a deduction.
  • As a general rule, trust income is taxable to the grantor where it is used for the support of any beneficiary whom the trustor is legally obligated to support. However, under IRC § 682 (a), a trust set up by a spouse, the income of which is paid to a divorced or separated spouse, is effective to shift the tax burden from the grantor to the beneficiary. Payee is taxed on trust payments.
  • If the parties are divorce or legally separated and the decrees are later declared invalid in the same jurisdiction, the IRS views the parties as still married. Payments made thereafter absent a written separation agreement are not taxable to payee nor deductible to payor.

 

 

  1. OTHER EXCLUSIONS FROM GROSS INCOME

 

A. GAIN FROM THE SALE OF PRINCIPLE RESIDENCE § 121

 

  • §121 provides for an exclusion from GI of gain resulting from sale of a principle residence if all requirements are met. The exclusion is limited: $250k for a single T, $500k for married Ts filing by joint return. No more frequently than once every two years and has to have occupied it as a principal residence for at least two of the five years prior to the sale or exchange.
  • Gain: If there is a gain resulting from the sale of a house, this is a capital gain if you fit all the requirements, and the gain will be taxed at a lower rate than regular GI.
  • Loss: However, you cannot deduct the loss for the sale/exchange or a personal asset. §165 (Unless loss due to casualties as per §165(c)(3).)
  • 4 Requirements to get §121 exclusion on gain
    • Residence was used as principle residence for a period of 2 years out of the past 5, and
      • If you have a part of the land not used as residence, gain on that part of the land will be GI bc §121 will not apply to it. 1.121-1(e)
    • Has owned the residence for a period of 2 years out of the past 5 years, and
    • Has not used the exclusion in the last two years, and
      • T can opt-out of using this so that T can use it the next year on a more expensive property or something.
      • Or, T can opt-out of it retrospectively by amending a past return (limit of 3 years back). Be careful though, tax rates could’ve been harsher the year(s) before.
    • Is not an expatriate.
  • Marriage – Joint Returns wrt §121
    • If you are married and are filing a joint return, you can take a $500k exclusion, but the requirements get changed:
      • Either meets the 2 year own requirement
      • Both meet the 2 year use requirement
      • Neither used §121 in the last 2 years
    • Other Exceptions to the requirements
      • One year of use/own is okay if you are sick and moving to a health care living facility.
      • T can claim a reduced maximum exclusion under §121(c) if the primary reason forthe sale/exchange is bc of change in employment, health, or unforeseen circumstances.
        • If Primary reason is location of employment. ER doesn’t matter.
          • §1.121-3T(c)(2) Distance safe harbor requirements:
            • T owns principle residence
            • New place of employment is at least 50 miles farther than former place of employment or if T had no employment, 50 miles farther from former residence.
          • Even if Safe Harbor not met, you can still be qualified for reduced maximum exclusion if under the facts and circumstances, the primary reason for the sale is the change in place of employment.
        • If Primary reason is health:
          • §1.121-3T(d)(1) to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of a disease, illness, or injury of a qualified individual (T, T’s spouse, co-owner of the residence, etc. Sale or exchange that’s merely beneficial to general health or well-being is not included here.
          • Safe Harbor §1.121-3T(d)(2) If physician recommends a change of residence for reasons of health listed above.
        • Unforseen circumstances: such as natural or man-made disasters or acts of war or terrorism resulting in a casualty to the residence, cessation of employment as a result of which the EE is able to collect unemployment compensation, change in employment where you are unable to pay, divorce, multiple births from same pregnancy, etc.
      • Calculating Reduced Maximum Exclusion §1.121-3(g)
  • Hypos:
  • Determine the amount of the gain that taxpayers (a married couple filing a joint return) must include in gross income in the follow situations:
    • Taxpayers sold their principal residence for $600,000. They had purchased the residence several years ago for $200,000 and lived in it over those years. $400,000 gain. Each spouse has ability to exclude $250,000. Therefore the $400K is excluded.
    • Taxpayers in (a), above, purchased another principal residence for $600,000 and sold it 2 ½ years later for $1 million. Exclusion revived every two years. $400,000 is excluded.
    • What result in (b), above, if the second sale occurred 1 ½ years later? §121(b)(3)(A) applies and it would not qualify for the exclusion. $400,000 gain realized.
    • What result in (b), above, if Taxpayers had sold their first residence and were granted nonrecognition under former Section 1034 (the rollover provision) and, as a result, their basis in the second residence was $200,000? They are rolling their $200,000 basis forward, so here, they would have to pay tax on the remainder of the exclusions, which would be $300,000 ($800,000 gain – $500,000 exclusion).
    • What result in (a), above if the residence was Taxpayers’ summer home which they used 3 months of the year? Would not be excluded because it is not their principal residence.
    • What result if Taxpayer who met the ownership and use requirements is a single taxpayer who sold a principal residence for $400,000 and it had an adjusted basis of $190,000 after Taxpayer validly took $10,000 of post-1997 depreciation deductions on the residence which served as an office in Taxpayer’s home? Under §1016 every $1 of depreciation decreases the basis by a $1. Therefore under §121(D)(6) the $10K is gross income and cannot be excluded because it was deferred by the deduction and is now recaptured when the residence is sold.
  • Single Taxpayer purchased a principal residence for $500,000 and after using it for one year, Single sold the residence for $600,000 because Single’s employer transferred Single to a new job location.
    • How much gain must Single include in gross income? §121(c)(1)(B)(i)(I or II)(how long property has been owned as principal residence or period after the date of the most recent sale-USE THE SHORTER) divided by (how long supposed to live in residence)X $250(maximum allowable exclusion)=$125K gain
    • What result in (a), above, if Single sold the residence for $700,000? $75K
  • Taxpayer has owned and lived in Taxpayer’s principal residence for 10 years, the last year with Taxpayer’s Spouse after they married. Spouses decide to sell the residence which has a $100,000 basis for $500,000.
    • If the Spouses file a joint return do they have any gross income? They do meet the ownership requirement however (only one needs to meet this), the spouse does not satisfy the use (both need to meet this requirement) Since they don’t meet the eligibility for that joint return look at§121(b)(2)(B) Other joint returns Q1: Does T have two years ownership and use?T satisfies the 2 yr ownership and the use, therefore eligible for the $250,000 exclusion. Spouse (looking at last sentence-“each spouse shall be treated as owning the property during the period that either spouse owned the property”, therefore eligible for the 2 yr ownership but does not meet the use, therefore not eligible for any exclusion so….$400,000-$250,000=$150,000 Gain
    • What result if the Spouses had lived together for two years in Taxpayer’s residence prior to their marriage and sold the residence after one year of marriage for $500,000?
    • What result in (a), above, after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Spouse lived in the residence while Taxpayer moved out and, one year later, they sold the residence for $500,000? Each owns ½ of the house at time of sale. Not married and are not going to file joint returns so the $500,000 is not going to be allowed. T is selling ½ (only allowed to take exclusion on that) $250,000 allowed because meets the requirements. Spouse has used it for more than 2 years, however only had 1 year of ownership. Look at §121(D)(3)(A) Property transferred to individual from spouse or former spouse-can tack ownership so the spouse will qualify for the $250,000. (Remember §1041-transfer must be incident to the divorce-if you fall out of §1041 you fall out of the tacking provision)
    • What result in (a), above, if after one year of marriage Taxpayer pursuant to their divorce decree deeded one-half of the residence to Spouse and Taxpayer continued to occupy the residence while Spouse moved out, and, one year later, they sold the residence for $500,000? Q1: Does T have two years ownership and use? Yes, Q2: Does Spouse have two years ownership and use? YES §121(D)(3)(B) Property used by former spouse pursuant to divorce decree.
  • Estate planner sold a remainder interest in Planner’s principal residence of $300,000(its fair market value) to Planner’s Son. Planner’s basis in the remainder interest was $125,000. Does Planner have any gross income? §121(D)(8) Sales Remainder Interest However the son is a related party see §121(D)(8)(B) Related Parties and then cross reference to §267(b) for a definition as a related party. Therefore $300,000-$125,000= $175,000 gross income because the son is a related party and does not apply for the exclusion.

 

 

B. MUNICIPAL BOND TAX FREE INTEREST EXEMPTION § 103

 

  • Interests from state or local bonds are except from taxation.
  • Note that usually, the individuals who hold these are the very rich, banks, insurance companies, etc.
  • Why do we have this? Policy: If there were no such exemptions that cities/states would have to compete with private large companies in bond issuance. This tax break allows these governments to borrow money at a reduced rate, since the exclusion of interest will add to the investor’s rate of return, particularly an investor in a higher tax bracket. In effect, this is a subsidy from the federal to the state and local governments. The reason behind this exclusion is to encourage investment in state and municipal bonds. Also, it is constitutionally questionable whether taxing these obligations would be an improper infringement on state and local government.

 

 

  1. IDENTIFICATION OF THE PROPER TAXPAYER

 

  • Why do we care about this?
    • If you move income to another taxpayer, it could make a difference for the two people’s tax brackets.
  • If you earn the income or own the income-producing-asset you cannot assign the income for tax distribution/fragmentation benefit.
  • Income from Services
    • Lucas v. Earl – Who ever earns the money pays the income tax on it, even if the compensation goes to someone else. You can’t get rid of income by assigning it/giving it to someone else.
    • Anticipatory Assignments: A taxpayer who makes an unqualified refusal to accept compensation, without a direction of its disposition, does not realize taxable income. Giannini.
  • Revenue Ruling 66-167: Taxpayer elected not to receive compensation for services as executor of his deceased wife’s estate. The main consideration was whether the waiver involved would at least primarily constitute evidence of an intent to render a gratuitous service. The taxpayer was determined not to be in receipt of taxable income of the amounts he would otherwise have received as fees and commissions. It is not always desirable for executor to disclaim fee since it denies the estate a deduction that may be more valuable.
  • Revenue Ruling 74-581: The IRS allowed law school professors to assign their income from legal clinics and services to their law school and successfully shift their income. The following are some of the factors which are considered in determining whether personal services can be assigned: (1) Would the taxpayer normally be expected to receive the income? (2) What was the relationship between the assigning parties? (3) Who bore the risk of loss? (4) Did the assignor of the income receive something in return close to fair market value? Faculty did not have the right to keep this income anyway because they operated as agents of the law school.
  • Income from Property
    • The property is the generator of income. The owner of the property which is generating the income is the taxpayer regardless of who receives it.
    • You can give the property to someone else before it generates income, if you want to get rid of income. “Give the tree to someone else.”
    • You can put the tree in a trust and have children pay the tax on interest received from trust.
    • Transfer or Assignment of Property: When a right to receive income has matured before the taxpayer assigns the property producing it, the income will be taxable to the assignor at the time that the property is transferred to the assignee. Any income earned after the date of the transfer to the donee will be taxable to the donee.
  • Income-shifting methods
    • Earnings – hire your family. You still get business deductions (salary – operation expenses) and your children are taxed at a minimal amount compared to you.
    • Trusts
    • Entities for tax purposes (corporations, LLC, partnerships, etc.)
  • Congress has enacted a number of rules to prevent assignment of income:
    • “Kiddie” Tax§1(g) Parents cannot shift income to children to avoid taxes. Children under age 14 are taxed at their parents’ rate for all unearned income.  For example, if X, a child under 14 receives property from her parents that produces passive, unearned income her parents have successfully transferred the income.  But, X will be taxed at her parent’s income tax rate.
    • Trusts – People used to shift money to trusts to avoid higher tax rates.  In 1986, Congress essentially eliminated the ability to do this by changing income tax levels on trusts.  Now, if the trust earns $7500 income, it is taxed at the 39.6% rate; $5500 taxed at 36% rate; $3500 taxed at 31% rate.
    • §482 Reallocation of income and deductions-under broad statutory authority granted in this statute, the IRS may reallocate among related entities items of gross income, deduction, and credit if necessary to prevent the evasion of tax or clearly to reflect income. Gives the IRS a powerful tool to combat the misallocation of tax items.
  • Hypo
    • There is a legal clinic. The faculty member accepts the fees and then turns them over to the school per a K. The faculty member does not have to report the income.

 

 

  1. BUSINESS DEDUCTIONS

 

  • There is nothing unconstitutional about the government putting a tax on gross receipts (everything that came in). But we don’t have that system, we have an income tax.
  • If you have a business and you have 1 million in sales, we would not think that you have 1 million in undeniable accession to wealth because there were costs associated with making those sales.
  • Exemptions and the standard deduction serve to wipe out the lowest level of income earners from the tax base. Basically creates a zero bracket.
  • In order to claim a deduction, you must find one, and then satisfy every requirement in it.

 

 

  • Generally
    • Deductions adjust GI to determine TI (Taxable Income): GI – Deductions = TI
    • MUST have specific statutory authorization to take a deduction – deductions are “a legislative grace” (puke) since deductions are not constitutionally required.
    • And MUST satisfy every single element of the provision or else T will not get the deduction.
  • Three categories of amount spend/incurred wrt deductions:
    • (1) Amount not allowed to be deducted ever. (non-economic)
      • §165 – T cannot deduct the loss for the sale/exchange or a personal asset. §165 (Unless loss due to casualties as per §165(c)(3).)
      • §262 Personal & family living expenses, except for:
        • Interest payments
        • Medical expenses; OR
        • State Income and Property Taxes
    • (2) Amount allowable to be deducted, but not now – deduction is deferred to some later time.
      • Capital expenditures
      • §195 Start up expenditures (amortize)
        • Under §195, you have to set aside the expenses incurred in starting up the business and then amortize them over 180 months during the operational stage of the business. If the business ends before all deductions are taken, then the rest can be taken out as a full deduction on last business return.
      • §167 Depreciation
    • (3) Amounts eligible for deduction in full this year. (economic)
      • §162 Trade or business expenses; operation expenses
      • § 274
      • § 212- expenses for production of income are deductible

 

 

A. TRADE OR BUSINESS EXPENSES § 162

 

  • Business Expenses: repair (keep property in current condition and do not add value to value or appreciably prolong the property’s life), maintain, preserve and restore. Generally, small financial outlays.
  • § 162, Reg. 1.162-1(a): “All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business” are deductible.”
  • Deductible in full this year
  • Business losses carry over into the future (20 year max) or can be applied backwards by amending past returns (limited to 2 years back). §172
  • As a general matter, if an expense relates to a business activity, we should in general allow a deduction so that we will arrive at a true and accurate figure of net gain or accession to wealth.
  • 162 only applies when the business is running. Anything spent while scouting and researching does not get deducted under 162. However, some startup costs can be deducted under another section, §195. In the transactional phase, costs will mostly be §263 capital expenditures.
  • 6 requirements to have a deduction
    • (1) Trade/Business
      • what a trade or business is isn’t defined anywhere in the code.
    • (2) Ordinary/Necessary
      • “Ordinary and Necessary” means “appropriate and helpful” (standard). Welch v. Helvering
      • Ordinary: foreseeable in the life of that business. The expense should be reasonable – what is reasonable is determined by the expected reaction to that type of expense in a like typical situation. ‘Ordinary’ is transactions that have a common or frequent occurrence in the type of business involved.
        • The standard of reasonableness is very important. Paying off another’s debt is extraordinary, paying off debt when there is no legal obligation is extraordinary if everyone else in the industry would never do it.
        • Extraordinary: attorney’s fees incurred by president of corporation in slander suit to protect reputation, assuming expense of lawsuit when he/she is defendant, gratuitous payments to S/Hs in settlement of disputes between them.
      • Necessary: something that is “appropriate and helpful.” This gives businesses discretion to decide what the corporation needs.
      • Does not mean that expenses must be habitual or normal in the sense that the same taxpayer will have to make them often.
      • Hypos:
  • Taxpayer is a businessman, local politician who is also an officer-director of a savings and loan association of which he was a founder. When, partially due to his mismanagement, the savings and loan began to go under, he voluntarily donated nearly one half a million dollars to help bail it out. Is the payment deductible under §162?TP’s expenditure was proximately related to his business activities and was made to preserve and protect his business reputation in order to enable him to continue to carry on such activities. Consequently, he is entitled to a deduction in that amount under section 162(a).
  • Employee incurred ordinary and necessary expenses on a business trip for which she was entitled to reimbursement upon filing a voucher. However, Employee did not file a voucher and was not reimbursed but, instead, deducted her costs on her income tax return. Is Employee entitled to a §162 deduction? She voluntarily gave up reimbursement from her employer to which she was entitled by promulgation of an alleged oral rule which applied only to herself, the expenses did not constitute ‘ordinary and necessary expenses of carrying on any trade or business’ and hence were not deductible since taxpayer could not convert the employer’s right to a deduction into a right of his own.
  • (3) Expense§162(a) and §263(a)
    • NOT a capital expenditure! Capital expenditures governed by §263. The difference between expense and capital expenditure is one of degree not of type. INDOPCO
    • §162 – Routine maintenance is an expense: if it is merely to maintain it in an operation condition then it is an expense (repair & maintenance).
      • If it is improving the property or prolonging its life/prosperity or an “enhancement” in the property then that is a capital expenditure. Midland Empire Packing
      • Repair: An expenditure made for the purpose of restoring property to a sound state, or for keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor appreciably prolong its life. A structural change to a building which does not add to the life or usefulness of the building, and is the normal manner of dealing with a specific situation, can be deducted as a business expense.
      • §162/§263 is a matter of degree: [but there is a preference for §263 in the service]
        • Fixing basement to prevent damage to goods? §162. Midland Empire Packing
        • Painting 3 rooms? Deductible
        • Fixing roof? Deductible. §162, if it is business property and trying to get into working order.
        • Replacing roof? §263, if it is business property and the whole roof is being replaced.
        • Replacing ratty rug with tile floor? Capital Expenditure. §263
        • Replacing ratty rug with new ratty rug? Deductible. §162
      • How about periodic replacement of 10mm engines in planes? So long as it is not as an “enhancement” but rather only done to maintain, the periodic replacement of engines, even though it costs millions, is an expense and thus deductible under §162.
      • See section ‘B. Capital Expenditures’ below.
  • (4) Carrying on a trade/business§162(a) §195 §262 Regulations §1.195-1(a)
    • Expenses deductible under §162 are limited to amounts incurred while the business is up and running. It must be attributable to carrying on in business that year – while the business is in its Operational Phase.
      • §162 deductions not limited to business that generate GI. Businesses can lose money.
      • Going Concern: A taxpayer is carrying on trade or business from the date that it is a going concern, i.e, has regular activity in the areas in which the business is organized
    • Not “Carrying on Trade/Business”:
      • Investigatory phase – looking into the industry, not narrowed in on a particular transaction. Morton Frank
        • So what can you do with these expenses? You can put some of them in §195 start-up expenditures and amortize them.
        • See section “C. Start-up Expenditures” below.
      • Transactional phase – attempting to purchase a specific business.
        • See section “C. Start-up Expenditures” below.
        • If abandon during this stage then the deduction claimed should be for a loss on a transaction entered into for profit §165(c)(2)
      • Pre-opening expenses§195: expenses incurred prior to opening must be capitalized. Expenses that would have been deductible if the taxpayer had been engaged in a trade or business may be amortized over a period of 60 months beginning with the month of opening
      • Travel expenses and legal fees spent in searching for a business to purchase cannot be deducted under §162(a)
    • Expansion Expenditures: Ordinary and necessary expenditures incurred in the expansion of an existing business are currently deductible under §162
    • WRT Employees
      • It is clearly established that an employee is carrying on a trade or business in his role as an employee.
      • Unreimbursed expenses – EEs can deduct unreimbursed expenses incurred in their capacity as EE if the expenses meet the §162 reqs (and subject to §274 limitations).
      • Payment Contingent on Employment – Where services are rendered prior to employment with payment contingent on receiving employment,the payor can deduct the payments under §162.
        • Ex: Job-seeker agrees to pay career consultant $100 upon gaining employment. The $100 is deductible as a business expense under §162 once job-seeker has become employed and paid career consultant.
      • EEs seeking new employment – Once EE has entered a trade/business he can deduct expenses related to looking for a new job, even if he loses his original job.
        • These deductions not allowed if the T has been unemployed for such a period of time that there is a lack of continuity between their past employments and their endeavors to find new employment. That precise period of time is unknown.
        • Deductibility of an employee’s expenses in seeking employment elsewhere in the same trade is not contingent on success in finding a new job.
      • EE Education Expenses §1.162-5 – Deductible only if incurred to maintain or improve a skill required by a current trade or business.
  • Hypos:
    • Determine the deductibility under §162 and §195 of expenses incurred in the following situations.
      • Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation. Not Deductible (Look at §195- would be handled under the Morton Frank)
      • The facts are the same as in (a), above, except that Tycoon, rather than having been a doctor, was a successfully developer of residential and shopping center properties. Would be deductible unless attributable to specific properties.
      • The facts are the same as in (b), above, except that Tycoon, desiring to diversity her investments, incurs expenses in investigating the possibility of purchasing a professional sports team. Not an extension and are not §162 deductions but could possibly be §195 deductions.
      • The facts are the same as in (c), above, and Tycoon purchases a sports team. However, after two years Tycoon’s fortunes turn sour and she sells the team at a loss. What happens to the deferred investigation expenses? §195 would allow it be accelerated it and take it as a §195 loss
    • Law student’s Spouse completed secretarial school just prior to student entering law school. Consider whether Spouse’s employment agency fees are deductible in the following circumstances
      • Agency is unsuccessful in finding Spouse a job. No, first job, not deductible under §162 and §195 is not applicable to employees and their expenses.
      • Agency is successful in finding Spouse a job. No, still first job
      • Same as (b), above, except the Agency’s fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse has begun working. It is the Hundley case, where the expenses are not paid until actually in the job.
      • Same as (a) and (b), above, except that Spouse previously worked as a secretary in Old Town and seeks employment in New Town where student attends law school. Generally okay, because same job in different employment. Being an employee is a trade or business-§162 would probably apply but have to look at exceptions (gap in time of employment-too long it would be a first job again)
      • Same as (d), above, except that Agency is successful in finding Spouse a job in New Town as a bank teller(different job). It would depend on whether it is a new job/different employment. If she hired them to find her a bank teller job, then first job and no deduction. If she hired them to find her a secretary job and they found her the bank teller job then it might be deductible.
  • (5) Actually paid/outlaid/incurred
  • (6) During the taxable year

 

B. CAPITAL EXPENDITURES § 263

 

  • Capital Investment: acquires, replaces, alters, rehabilitates or improves. Generally, large financial outlays. Capital improvements are a charge against income that it helps to earn over the expected useful life of the property. Repairs to a building which appreciably extends its useful life is capital. A few new shingles are an expense.
  • The general rule is that any expenditure that will yield value beyond one year is a capital expenditure.
  • The difference between an expense and a capital expenditure is one of degree not of type. INDOPCO
  • §263 applies to expenditures that are improvements or upgrades which prolong the operating life beyond which it would otherwise have (unlike a repair/maintenance outlay which only keeps the property in operation condition).
  • A capital expenditure need not be tied to property. INDOPCO
  • Cash outlays for lawyers fees, investment banking fees and SEC fees in connection with a corporate acquisition are capital expenditures not necessary and ordinary deductible expenses.
    • RA: The transaction produced substantial benefit and additional value for INDOPCO that extend beyond the taxable year in which they were incurred.
    • Courts have long held that expenses incurred for the purpose of changing corporate structure for the benefit of future operations are not ordinary and necessary business expenses. INDOPCO
  • The following expenditures must be capitalized:
    • Amounts paid to acquire, create, or enhance an intangible asset. Like stock, partnership interest, bonds, debt instruments, options, patents and copyrights, franchise, goodwill, computer software
    • An amount paid to facilitate the acquisition, creation, or enhancement of an intangible.

 

C. START-UP EXPENDITURES § 195

 

  • §195(b)(1) Start up expenditures may at the election of the taxpayer, be treated as deferred expenses. Such deferred expenses shall be allowed as a deduction prorated equally over such a period of 180 months (beginning with the month in which the active trade of business begins).
  • If taxpayer elects not amortize start up expenditures, they are to be capitalized and treated as nondeductible expenditures.
  • Start up is any amount investigating or creating a business (See definitions under §195(c)(1)(a) and §195(c)(1)(a))
    • Start-up expenses incurred by an individual already in the trade or business seeking to expand is not covered under §195. Such a person can deduct their expenses under §162 or capitalize them under §263.
  • Start-up costs are definedas1) amounts incurred in investigating the creation or acquisition of an active trade or business 2) creating an active trade or business; or 3) activities engaged in for profit, before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. (Anything that would be deductible in a trade or business.)
  • You cannot amortize a start-up expenditure couldn’t be deductible under §162. Alternatively, start-up expenses can be capitalized under §263.
  • Only amounts that could’ve been deductible under §162 can be amortized under §195.
  • Amounts deductible under §163 (interest), §164 (taxes) and §174 (research expenses) do not constitute start-up expenses and are deductible to extent allowed under each statute.
  • Section 195 is inapplicable to persons seeking first time employment.

 

D. SPECIFIC BUSINESS DEDUCTIONS

 

Two that we went over in class: (1) Reasonable Salaries & (2) Travel Away From Home

  • Reasonable Salaries §162a1
    • Reasonable Salaries: allows the deduction of reasonable salaries. If it is not reasonable, then the business and the EE pay taxes on all of it (taxed twice). There is no upper limit that states an amount is unreasonable per se.
      • What is “Reasonable” – Return on Investment Test
        • Amount of salary balanced against the rate of return (adjusted for risk); regardless of the seemingly exorbitant nature of the salary. Executive’s salary is presumed reasonable if he generates correspondingly high returns for investors. Thus a very profitable company in a challenging field may pay a lot for their CEO.
        • But if the return on investment is high due to some fact outside the control of the employee then the presumption disappears.
        • Executives salary is “reasonable” if its proportional to investor’s profits
      • “Factors Test” stated as unreliable by Posner because there is no direct correlation between factors and the determination of a reasonable salary. Factors:
    • Rendered services type and extent
    • Scarcity of qualified employees
    • Employee’s qualifications and prior earnings
    • Employees contribution to the business
    • Employer’s net earnings
    • Comparable employee’s prevailing compensation
    • Employer’s business peculiar characteristics
  • Not reasonable if not made pursuant to an arm’s length free bargain. Harold’s Club.
  • Not reasonable if trying to hide dividends in the salaries or like payments.
  • Hypo: Employee is the majority shareholder (248 of 250 outstanding shares) and president of Corporation. Shortly after Corporation was incorporated, its Directors adopted a resolution establishing a contingent compensation contract for Employee. The plan provided for Corporation to pay Employee a nominal salary plus an annual bonus based on a percentage of Corporation’s net income. In the early years of the plan, payments to Employee averaged $50,000 annually. In recent years, Corporation’s profits have increased substantially and, as a consequence, Employee has received payments averaging more than $200,000 a year.
  • What are Corporation’s possible alternative tax treatments for the payments? Suggestion that as majority shareholder makes it close to Harold (no free bargain). Not sure how much of it would be unreasonable. $50,000 would not be unreasonable since it was allowed in the past.
  • What factors should be considered in determining the proper tax treatment for the payments? Even though the Seventh Circuit advocates the independent investor test, most jurisdictions still use the seven-factor test. See above for exact factors.
  • The problem assumes Employee always owned 248 of the Corporation’s 250 shares. Might it be important to learn that the compensation contract was made at a time when Employee held only 10 out of the 250 outstanding shares? I think the court might take it into consideration with regard to “free bargain”
    • Shareholder-Employees: Corporations frequently attempt to deduct as business expenses large salaries paid to executives who are also shareholders of the corporation. The IRS tries to get these salaries classified as nondeductible dividends. Salary payments which have no real relationship to the value of the services rendered are therefore not deductible as ordinary business expenses.
    • Corporate Salary Cap
      • $1 Million Ceiling: IRC §162(m) on the amount of compensation (cash or anything else) a publicly held corporation may deduct in year as renumeration for services by a covered employee (CEO, and one of the next four highest compensated officers in the corporation)
      • Exception: Compensation in excess of $1mm is deductible if
        • It is performance-based compensation and
        • Voted on by S/Hs
      • Private companies that are not corporations – any reasonable salary is deductible (there is no $1 million limit).
        • The primary concern in this area is whether the company is actually paying a salary or a dividend to the employee in question.
        • Why? bc salary is deductible by the company and dividends are not and bc dividends are taxed at a different rate than salary for employees.
    • Contingent Salaries §1.162-7(b)(2)
      • Okay if three elements are met –
        • Made pursuant to free bargain (arms-length transaction)
        • Under reasonable circumstances
        • At the time of execution.
      • Contingent salaries meeting these qualifications are deductible even if they yield higher payments than would ordinarily be paid.
      • Be on the lookout for fact situations where the company is family owned so there is no arm’s length bargain.
        • Ex : EE was found to have significant control/influence over the S/Hs (his kids) and thus the K for contingent salary did not meet standards. Harolds Club
    • Golden Parachutes:are payments made to an officer/highly-compensated EE (top 1% or highest paid 250 EEs §280G(c))/or S/H who leaves a company after a change of control (“payments contingent on a change of control”). Prevents deductions of CEO buyouts upon takeovers by other corporations.
      • Section restricts deductions for substantial bonuses paid to corporate executives contingent (contract formed within one year of change of ownership §280(G)(b)(2)(A)(i) )on the change in control of the company and the aggregate present value §280(G)(d)(4) of all such payments §280(G)(d)(3) must equal or exceed three times the disqualified individual’s base amount. §280(G)(b)(2)(A)(ii)
      • If the payment is 3 times the base salary (average of past 5 years salary) or more, the payment is unreasonable and not allowable as a deduction under §162.
        • — ineffective because EE/CEO on the way could care less about the impact on corporation under new ownership
      • The recipient of the golden parachute is also taxed an additional 20% on the excess amount. These payments are dealt with by §280G.
  • Business Travel Away from Home §162a2
    • Notes
      • §262 – there is no deduction for personal, living and family expenses.
      • §274 – you need to substantiate deductions under this section (need proof). (p94c)
      • §274 serves to further limit §162.
      • Whoever pays for the expense gets the deduction, so if ER reimburses EE for expenses, ER gets the deduction. §274(c)(3) & (k)(2)
    • 3 Requirements to get a deduction (3-prong test set out in Rosenspan):
      • (1) Traveling- Expenses must be reasonable and ordinary/necessary
        • “Traveling” includes
          • Transportation
            • §262 – Commuting- Generally expenses incurred in traveling between the taxpayer’s residence and his place of work are not deductible as business expenses
            • §162 – Home to Workplace: 3 exceptions
              • If you leave home and travel outside your metro area on a daily basis to a work site that is temporary (not more than 1yr) then you may deduct expenses. BUT T must have a principle place of business.
              • If T has principle place of business + other regular places of business, daily transportation to the temporary work locations deductible. Ex: home to courthouse for an attorney
              • If you work at home as your principle place of business within the meaning of §280A(c)(1)(A) then T may deduct transportation expenses to temporary work locations regardless of the distance.
            • §162 – Traveling entirely outside of the area w/ work purpose @ destination
              • Airfare – deductible if the principle reason for trip is business (largely depends on time spent there). This is an all or nothing deduction.
                • A reasonable standby day will qualify as a business day even if no business is conducted on that day (weekends, holidays). §1.274-4(d)(2)(v)
                • First class is okay because what is necessary is given business discretion – just has to be appropriate and helpful.
            • §274(m) – Luxury water transportation (cruises) – You only receive a deduction of 2x the federal per diem amount.
              • If a conference is held on a cruise ship though, that is d/d only if the cruise ship is registered in the US and all ports/calls are on US lands. §274(h)(2)
            • §274(m)(2) Travel as a form of education is not deductible.
            • §274(c) Certain Foreign Travel
              • You can receive the deduction for foreign (outside US) expenses if less than a week (7 days).
              • However, you cannot take the deduction if
                • The travel is in excess of a week (7 days) or
                • Personal time is greater than 25% of the total time on the business trip.
            • Travel between business locations:costs of going between one business location and another business location generally are deductible. However, if the taxpayer carries work related materials (e.g. tools) with him, only those extra costs incurred to transport those materials (e.g. trailer rental) are deductible
          • Meals
            • §262 – eating because you’re hungry or on lunch break with exceptions listed in 162 & 274 (not excluded/deductible)
            • §162 – Further limited by §274(k) –
              • Meals while traveling entirely outside of home area:
              • Meals will not get a deduction unless the trip is long enough to require sleep. And if it qualifies, you still only get a ½ deduction.
              • 2. The only other way deduction follows is if the meal immediately follows or is during a business transaction. If qualifies, you get ½ d/d.
              • 3. Networking during meal: meal is not deductible.
              • 4. Meal can’t be lavish or extravagant. §274(k)(1)(a)
              • 5. The deducting T (EE) must be present at the meal. §274(k)(1)(b)
              • 6. At best, all meals get 50% d/d only! §274(n)(1)
              • 7. Meals must be substantiated (proof). §274(d)
          • Lodging
            • §162 – Travel entirely outside of the area w/ work purpose @ destination
              • Personal days (no business conducted) are non d/d.
              • Business days & nights are d/d.
              • A reasonable standby day will qualify as a business day even if no business is conducted on that day (weekends, holidays). §1.274-4(d)(2)(v)
            • §262 – sleeping in your own home (not excluded/deductible)
      • (2) Away from home
        • To be away from home, you must have a home! Nomads get no §162 deduction.
        • One’s home for tax purposes is the city in which one carries on his principal trade or business. When a taxpayer leaves the city on a business trip for a short time(overnight) he is entitled to deduct traveling expenses. But if he stays away for many months, the IRS may argue that he has shifted his tax home and that he is no longer “away from home” within the meaning of the IRC. If the taxpayer chooses to in a city other than the one where he works the deduction is not allowed either.
        • Generally (but not always), the Tax Home is the same as the business headquarters of T. Flowers
        • Deductions on a “second home” (if T has two homes – determine which is Tax Home 1st) are allowed so long as there is business conducted at that location, even if it is a different business. Andrews
        • “Overnight” Rule: IRS insists that “away from home” means away overnight or long enough for sleep/rest.
        • “Temporary” v. “Indefinite” Rule: Taxpayer is entitled to deduct his transportation, food and lodging if a job assignment at a distant location is temporary, but not if the assignment is of indefinite duration
      • (3) Pursuant to a business
        • Expenses must have been incurred primarily in furtherance of business rather than personal objectives.
    • Business and Pleasure Trips: When a trip is incurred for these dual reasons, the expenses are deductible if the primary purpose of the trip was business. However, the expenses must be allocated between business and pleasure.
  • Hypos:
  • Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch in various restaurants in City.
    • May Commuter deduct his costs of transportation and/or meals? NO
    • Same as previous, but Commuter is an attorney and often must travel between his office and the City Court House to file papers, try cases, etc. May Commuter deduct all or any of his costs of transportation and meals? YES for transportation, NO for meals (unless conducting business over meals)
    • Commuter resides and works in City, but occasionally must fly to Other City on business for his employer. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or a part of his costs? YES, Transportation, NO for Meal because it is§162personal meal (even if traveling away from home in accordance with §162(a)(2)still under the “Overnight Rule” to qualify for deduction.) Would be allowed if had clients. Because he left town in morning and returned in the early evening, was not away long enough to require sleep or rest no deduction for meals
  • Taxpayer lives with her husband and children in city and works there.
    • If her employer sends her to Metro on business for two days and one night each week and if Taxpayer is not reimbursed for her expenses, what may she deduct? See §274(n)(1) Transportation is allowable, lodging is appropriate for business time and is allowable. Meals allowed because she is required to stay over. BUT, IRC §270(n) limits her to 50% on meals.
    • Same as (i), above, except that she works three days and spends two nights each week in Metro and maintains an apartment there. Spending more of her time in Metro and under Andrews have to determine which one is the “tax home”. Since most of contacts are in City that would probably be qualified as her “tax home” and Metro would be qualified for the deductions. Still under argument about which “tax home”
    • Taxpayer and Husband own a home in City and Husband works there. Taxpayer works in metro, maintaining an apartment there, and travels to City each weekend to visit her husband and family. What may she deduct? NOTHING
  • Burly is a professional football player for the City Stompers. He and his wife own a home in Metro where they reside during the 7 month “off season.”
    • If Burly’s only source of income is his salary from the Stomper, may Burly deduct any of his City living expenses which he incurs during the football season? NO. He chose to live in a city other than where his work was located. (Look at Flowers case)
    • Would there be any difference in result in (i) above, if during the 7-month “off season” Burly worked as an insurance salesman in Metro? POSSIBLY, (Look at Andrews case)-Use a multi factor test: where does he spend most of his time? What are the relative amounts of income for the different sites? What are the contacts with the different locations? (don’t forget the 50% deduction on meals)
  • Temporary works for Employer in City were Temporary and his family live.
    • Employer has trouble in Branch City office in another state. She asks Temporary to supervise the Branch city office for nine months. Temporary’s family stays in City and he rents an apartment in Branch City. Are Temporary’s expenses in Branch City deductible? Yes, all transportation and lodging and 50% of meals.
    • What result in (i), above, if the time period is expected to be nine months, but after eight months it is extended to fifteen months? See Rev. Rul 93-86, 1993-2 C.B. 71 No longer temporary because over the one year mark. (However, can salvage the deductions if it was projected as temporary for 8 months and then after the 8 months it was no longer going to be temporary and no longer available for deductions.)
    • What result in (i), above, if Temporary and his family had lived in a furnished apartment in City and he and family gave the apartment up and moved to Branch City where they lived in a furnished apartment for the nine months? Depends. No duplication of deductions (against the policy of allowing deductions), if believe it depends on the duplication then NO, not allowed for deductions. However, if you only require being away from original location then duplication is irrelevant and deduction would be allowed.
  • Traveler flies from her personal and tax home in New York to a business meeting in Florida on Monday. The meeting ends late Wednesday and she flies home on Friday afternoon after two days in the sunshine.
    • To what extent are Traveler’s transportation, meals and lodging deductible? Reg. §1.162-2(a) and (b) Lodging (100% deductible days related to business, 0% deductible days not related to business) Meals: 50% of meals related to business Transportation: Have to look at purpose: Mixed purpose, have to look at days (in this case more business than fun) so can deduct 100%.
    • May Traveler deduct any of her spouse’s expenses if he joins her on the trip. See §274(m)(3) No, not unless employee and can deduct on their own terms.
    • What result in (i) above, if Traveler stays in Florida until Sunday afternoon? Larger proportion of the trip for pleasure therefore 0% deduction on transportation. Lodging and Meals stay the same.
    • What result in (i), above if Traveler takes a cruise ship leaving Florida on Wednesday night and arriving in New York on Friday? See §274(m)(1). No extra days involved in trip, so still primarily business, but look to see about luxury water travel and there is a $ limitation (Twice the government per diem) (pg. 257-TC)
    • What result in (i), above, if Traveler’s trip is to Mexico City rather than Florida? See §274(c) Within the one week allowable time period to be the exception to the non allowable deductions and therefore the deductions would be allowable. (if more than one week look at the next paragraph for deduction if business is more than 75% of the trip)
    • What result in (v) above, if Traveler went to Mexico City on Thursday and conducted business on Thursday, Friday, Monday and Tuesday, and returned to New York on the succeeding Friday night? See §1.274-4(d)(2)(v) If conducting business and need layover time (days between meetings) then allowed as business days. Therefore 6 days are business days so 2/3 of transportation is allowed.(Going between 25%-50% of primary business where a portion is going to be lost)
    • What result in (v) above if Traveler’s trip to Mexico City is to attend a business convention? See §274(h). Treat like US trip if can meet the requirements of the section.

 

 

E. MISCELLANEOUS DEDUCTIONS

 

  • Entertainment deductions
    • 50% deductible but the activity must be directly related to business. Business must be conducted during the entertainment, or directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or other wise).
    • In order to deduct 50% of the cost of a meal, the taxpayer or his employee must be present at the meal (k)(1)(B) and the meal must not be lavish (k)(1)(A)
    • Spouses: Can deduct spouse’s expenses if they are closely connected to the business activity.
    • Must establish that the business was substantial in relation to the entertainment. However, it is not necessary that more time be devoted to business than to entertainment. §1.274-2(d)(ii)(3)
      • Tickets §274(l) – d/d is limited to the face value of the ticket. If the ticket says 20$ and you paid vendor 22$ then you are 2$ out of luck. (Don’t forget the d/d is limited to 50%.)
      • Skyboxes §274(l)(2) – d/d limited to face value of non-luxury box ticket.
    • Entertainment wrt Facilities: facility used in connection with the activity – that is not deductible. Ex: Dues to an athletic, social, or sporting club/organization/facility.
    • Recordkeeping:§274(d): Section requires that the taxpayer keep adequate records or corroborative evidence supporting his entertainment expense claims
  • Dues
    • dues paid to professional organizations directly relating to your business are deductible unless some of the dues goes towards a political affiliation/contribution.
    • Ex: Bar fees, union dues (unless a portion of that goes to some political thing) are okay but not okay: dues to an athletic, social, or sporting club/organization/facility.
  • Summer Homes – IRC § 280A: Section allows limited deductions for homes that are rented out part-time. If a dwelling is used as a personal home for over 14 days or 10% of the days it was rented, it is subject to this section, and expenses must be prorated between rental time and personal time (which is not deductible).
  • Child-Care Expenses: A taxpayer can claim a credit for up to 30% of the costs caring for a dependent under age 15 and the costs of household services, if the costs are incurred so that the taxpayer can be employed. The credit cannot exceed $2,400 for one individual and $4,800 for two or more individuals. Also, the expense cannot exceed the earned income of the lower earning spouse (unless a student).
  • Expenses for Tax Advice – IRC §212(3): Section allows a deduction for expenses in determining, collecting or refunding taxes. This covers return preparation, tax litigation and tax planning services
  • Business Gifts
    • Deduction limited to $25.
    • See EE Fringe Benefits
  • Uniforms
    • Deductible if
      • They are required as a condition of employment
      • They are not of a type that is applicable to a general usage
        • Examples: firemen, police, baseball player
        • Congress has excluded military uniforms but recognized an exception for uniforms of reservists and swords, etc.
  • Dry Cleaning
    • of qualified uniforms is deductible
  • Advertising
    • Generally deductible
    • Unless identifiable as being for a political purpose.
    • They can be a capital expenditure if you purchase a piece of property or construct a billboard to last for several years.
  • Political Contributions
    • not deductible. §162(e)(1)(A)
  • Hypos:
  • Employee spends $100 taking three business clients to lunch at a local restaurant to discuss a particular business matter. The $100 cost includes $5 in tax and $15 for a trip. They each have two martinis before lunch.
    • To what extent are Employee’s expenses deductible? Look at §162, then to §274(a) need the meal to be directly related to business or specific business being done or associated with business being done. In this case going to pass the directly related to business test. Next, §274(k)-lavish or extravagant? Probably not, Next, §274(n) cutback, so the $100 including tax and tip gets cut to $50. §274(d) is there substantiation (get a receipt)-look at regulations for allowable recordkeeping. At the end $50 deduction
    • To what extent are the meals deductible if the lunch is merely to touch base with the clients? No deduction allowed. Not directly related
    • What result if employee merely sends the three clients to lunch without going herself but picks up their $75 tab? Fail §274(k) requirement that the employer attend.
    • What result if in addition employee incurs a $15 cab fare to transport the clients to lunch? Allowed
    • What result if employer reimburses employee for the $100 tab? Employee is allowed to deduct the $50 but is receiving the $100 back. The ultimate taxpayer the employer will be subject to §274(e)(4), (k)(2), (n)(2) where the employee is under a reimbursement program, not going to apply limitations to employee but to the employer so the employee will have zero net effect, while the employer will incur the $100 cost and get the $50 deduction.
  • Businessperson who is in New York on business meets with two clients and afterward takes them to a Broadway production of The Producers. To what extent is the $600 cost of their tickets deductible if the marked price on the tickets is $100 each, but businessperson buys them from the hotel concierge for $200 each? §274(l) Only allows for face value $300 and then 50% of that so total allowed for deduction $150. (Note, what about service fees? Not deductible since not the “face value”)
  • Airline Pilot incurs the following expenses in the current year:
    • $250 for the cost of a new uniform. Deductible. “Special purpose clothing”
      • Example:modeling-high cost clothes-would not wear outside the workplace, therefore allowed as deduction.
    • $30 for dry cleaning the uniform. Deductible.-Maintenance
    • $100 in newspaper ads to acquire a new job as a property manager in his spare time. NotDeductible.-Change in job field.
    • $200 in union dues. Deductible. §162(e)(3)Even if discretionary-look to see if helpful
    • $50 in political contributions to his local legislator who he hopes will push legislation beneficial to airline pilots. NotDeductible. §162(e) limit on political lobbying
    • $500 in fees to a local gym to keep in physical shape for flying. NotDeductible. Too remote from the actual requirements of the job.
    • What is the total of Pilot’s deductible §162 expenses? $480

 

F. BUSINESS LOSSES

 

  • GeGneral Info: If a transaction or event produces a “loss” §1.165-1, the threshold question whether the loss may deductible must always be answered on the basis of §165. Losses of property used in a business or profit-seeking activity are deductible whether or not they are due to casualty or theft §165(c)(1)-(2)
    • §165(c)(1), §280(B) Section permits an individual to deduct any loss “incurred in a trade or business.”-Gives Authorization (parallel §162)-liberal
    • §165(c)(2): losses incurred in any transaction entered into for profit, though not connected with a trade or business(parallel §212)-liberal
  • Realization Requirement: The loss must be realized (i.e. evidenced by a closed and completed transaction, or fixed by an identifiable event). Mere decline in the value of property is not enough. However, not every closed transaction that results in financial disadvantage qualifies as a loss.
    • Example: Deduction is allowed for loss sustained on demolition of building used in trade or business or held for rent production. However, if the building was purchased with demolition in mind, the cost of the building would be treated as part of the land cost, and no loss would be allowed and amounts described above shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located §280B
  • Amount of Deduction: The amount of loss deductible is the difference between the value of the property immediately preceding the loss and the value of the property immediately afterwards. §1.165-7(a)(2)(i) and (b)(1) The difference in value claimed as a loss cannot exceed the adjusted basis of the property §165(7) and is reduced by any insurance or other compensation received as a result of the loss.
    • Example: You owned a duplex used as rental property that cost you $40,000, of which $35,000 was allocated to the building and $5,000 to the land. You added an improvement to the duplex that cost $10,000. In February last year, the duplex was damaged by fire. Up to that time, you had been allowed depreciation of $23,000. You sold some salvaged material for $1,300 and collected $19,700 from your insurance company. You deducted a casualty loss of $1,000 on your income tax return for last year. You spent $19,000 of the insurance proceeds for restoration of the duplex, which was completed this year. You must use the duplex’s adjusted basis after the restoration to determine depreciation for the rest of the property’s recovery period. Figure the adjusted basis of the duplex as follows:
Original cost of duplex $35,000
Addition to duplex 10,000
Total cost of duplex $45,000
Minus: Depreciation 23,000
Adjusted basis before casualty $22,000
Minus: Insurance proceeds $19,700
Deducted casualty loss 1,000
Salvage proceeds 1,300 22,000
Adjusted basis after casualty $-0-
Add: Cost of restoring duplex 19,000
Adjusted basis after restoration $19,000
NOTE: Land still has original basis of $5K.

 

  • Example: D buys a Chris Craft which he operates for hire at a resort, but the boat, which is not insured is demolished in a storm. His loss is a casualty loss:
    • Total Destruction(pg. 398) §165(b)Boat is destroyed AB=$6K FMV Pre- $10K FMV Post-$0 Amount of Loss $10K however cannot exceed the adjusted basis and therefore only $6K is allowed(which ever is less between the AB or the Amt of Loss) Function of a loss deduction is when an event has happened and will allow to recover the tax cost which will make the tax account whole. Can’t deal with negative basis in tax. If abandoned then would be the difference of the AB and the amount realized ($6K).
    • Partial Destruction: Reg §1.165-7(b)(1)Boat damaged: FMV before $10K and after storm $7K limited by AB$6K in the property. Still going to use lesser of two figures. Difference would be that there is a difference of $3k which is the lesser of the two. When it is not totally destroyed have to recognize that the AB has to be different therefore, $6K-$3K(amount deducted by loss and recovered partial basis) and therefore the AB will now be $3K to carry forward.
    • Insurance: To the extent that the loss is compensated by insurance D’s deductible loss is reduced, if the insurance recovery exceeds D’s AB in the boat he has a casualty gain §1001(a)
  • Example: AB $6K and totally destroyed when FMV of $4K and no insurance. $4K loss in economic terms or $6K basis-usually the lesser value is taken but under the rule in the reg when there is total destruction and the FMV is less then the reg allows the $6K deduction. Rationale: Economic loss is $4K in economic value but the asset is totally destroyed and if don’t give full basis deduction there will be no other opportunity to recover the $6K basis. Otherwise would have a AB of $2K and no asset…how silly. If receive $4K in insurance then the $6K loss would be offset by how much insurance was received so actual loss would be $2K. Now AB $6K with a loss deduction of $2K on the tax return and received $4K and returns to you $4K of the $6K basis and have received the total amount.
  • Problem: Taxpayer has an automobile used exclusively in his business that was purchased for $40K and, as a result of depreciation deductions (§1016), has an adjusted basis of $22K. When the automobile was worth $30K, it was totally destroyed in an accident and TP received $15K of insurance proceeds.
    • What is TP’s deductible loss under §165? FORMULA:Determine your adjusted basis in the property before the casualty or theft and determine the decrease in fair market value (FMV) of the property as a result of the casualty or theft. From the smaller of the amounts determined above, subtract any insurance or other reimbursement received or expected to be received. Therefore Economic loss $30K AB=$22K Loss=lesser of the two $22K reduced by the insurance $15K with a loss deduction of $7K
    • What result above if the automobile had not been totally destroyed but was worth $10K after the accident? FMV pre $30K FMV(post) $10K the economic loss is $20K and the AB is $22K. going to take the $20K which is less and then take away the insurance $15K so with a loss of $5K $10K – $15K = ($5K) Gain – may be deferred until later time §1001(a)
    • What is TP’s adjusted basis in the automobile in b if TP incurs $17K repairing the automobile? $7K + $17K = $24K

 

G. CARRY OVER & CARRY BACK

 

  • Net operating losses: Under a §172(a) and (b)(1), a net operating loss suffered in any year can be carried back to the previous two taxable years. Enables the tax payer to file an amended return for the prior year reducing its income for that year by the loss carryback which produces a refund. Can apply to individuals as well as corporations, although salaried employees cannot have an operating loss and the interaction of the net operating loss rules with the regime of personal deductions can be quite complex.
    • A NOL is generated when a corporation’s allowable deductions for a tax year exceed its gross income.
    • When an NOL is carried over, it is referred to as a net operating loss deduction (NOLD) in the year it is used.
    • A corporation must first carryback an NOL 2 years, starting with the earliest of the 2 years. If the NOL exceeds taxable income for the carryback years, the excess is carried forward for 20 years (or less if it is used up before the end of 20 years).
    • A corporation may elect to forego the carryback period and instead, only carry the NOL forward for 20 years. The election must be made on a timely–filed tax return, including extension, for the year the NOL was created
    • Example: If produce $20,000 of revenue and in connection with that activity, incur $14,000 in wages, $5,000 in utilities, $8,000 in depreciation on equipment $3,000 of interest, $2000 for travel and entertainment.= $32000 totally allowable deductions. Allocate that to the business and we have produced a situation where there is $12,000 allowable deduction in excess of income. What are the consequences of this situation? If can’t use the deductions this year than can take it back 2 years and forward 20 years. Under §172 Take it back to the earliest of the years, if it can be used, use as much as can be used and then keep going until the 20 years runs out. Can recalculate with the carry back and get a refund from the previous year, which gives you money to offset the cash that you lost because the recent operations and still have enough to bring to the next previous year. Depending on projected financing might decide to carry forward as it would be more valuable. Have to do it sequentially. Have to keep an amount in suspension and keep account of it as each year goes by. Departing from the pure accounting formula. Very valuable deduction.

 

  1. DEPRECIATION

 

A. §§167 & 168

 

  • Depreciation is the deduction available during the 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 estimate useful life of that asset.
  • §167 & §168 treats depreciation like an operating expense by allowing an annual deduction for exhaustion, wear and tear, and obsolescence of property. They allow for depreciation on property held for producing income. What depreciation does is allow you to recover the cost (basis) of a property over a certain numbers of years. If you get the item as a gift, you can still write it off as a deduction (just use gift’s basis).
  • The Process
    • (1) What property is it? Determine the useful life. §168(c) & §168(e) or §167 (§1.167(a)-1(b))
    • (2) Determine the cost of the asset = basis + adjustments (capital expenditures/improvements)
    • (3) Determine the recovery period. §168(e)
      • Brief Synopsis:
        • Tangible: 3/5/7/10/15/20 yrs
        • Intangible: 15 yrs* §168 does not apply to intangible property.
        • Residential real property: 27.5 yrs
        • Nonresidential real property: 39 yrs
        • Or if §168 doesn’t apply, use the class life or useful life §1.167(a)-1(b)
    • (4) Choose your method of depreciation according to its recovery period (unless you are in §167 in which case you can use any one except §168(g)).
      • (1) SL or (2) 200% or (3) 150% or (4) §168(g)
      • Remember: you can elect to depreciate slower but you cannot depreciate faster. But once you’ve elected one, you gotta stick with it – you can’t go back and change the method to a faster/slower one.
      • Ex: If you are eligible for 200% DB, then you can choose 150% or SL, or 168(g).
    • (5) Apply the conventions (For §168 depreciations)
      • Half-year, Mid-month or Mid-quarter.
    • (6) Do any Extra Deductions Apply?
      • §168(k), §179.
      • Remember: real property does not get §168(k) or §179 treatment.
  • The Specifics
    • (1) §167 Allows for the basic authorization and calculation of depreciation
      • Depreciation deductions are for
        • Property used in a trade/business or
        • Property held for the production of income
          • Inventory and property held for sale to customers do not apply and therefore do not get a depreciation deduction
        • §167 allows for depreciation of business and investment property (apt bldg, office bldg.) if you can determine its useful life
          • Intangible Assets can be depreciated when the useful life is determinable. But this is called “amortization” instead of depreciation. §197
      • You must know these three things in order to depreciate an asset:
        • Adjusted Basis
          • Salvage Value – when depreciating under §167, subtract salvage value from asset before depreciating. When depreciating under §168, salvage value = zero (§168(b)(4)) always, so don’t subtract a number other than zero from asset before depreciating.
        • Useful life
          • Property with no determinable useful life cannot be depreciated even if used in a trade or business or are held for the production of income. (Land, artwork, stocks, bonds, speculative real estate investments.. etc.)
          • Under §168 you use the §168(c) & §168(e) tables to determine the recovery period.
          • If §168 doesn’t apply and you are kicked back into §167 (and §167(h) doesn’t apply), then use the useful life or class life of your property as the recovery period. §1.167(a)-1(b)
            • To figure out class life, look at regs §1.167(a)-1(a). Most likely, you won’t have to do this so don’t worry.
        • Method of Depreciation (section “B. Methods of Depreciation” below).
      • §168 determines the amount of depreciation deduction for most property.
        • §168 is mandatory, not elective. If it applies you must use §168. Any depreciation not governed by §168 is then thrown back to §167.
      • In the case that §168 does not govern, depreciation is determined by the useful life/class life ADR (Asset Depreciation Range) system (instead of the §168 ACRS system – which uses shorter recovery periods).
        • The only thing that changes is the useful life – instead of using the 168c and 168e tables, you just use the class life of the property.
    • (2) §168 Accelerated Cost Recovery System (ACRS) – only for tangible property!
      • Computation: Depreciation is computed by taking the cost of the asset (less salvage value) and allocating it over the useful life of the asset by an accepted depreciation method. Purpose: To recover basis in assets before the disposition of the asset. Can do depreciation write offs while the property value goes up. Purely a cost recovery mechanism
      • Useful Life: The asset depreciation range (ADR) system, under IRC §168 (c), (e)(1), is a list of broad classes of assets with estimated useful lives, published by the IRS. A taxpayer may elect a useful life within 20% of these guidelines, and the IRS will not challenge it. If the taxpayer chooses a useful life outside this range, she has the burden of showing the reasonableness of her estimation.
      • Land:Land is not depreciable since it has an unlimited useful life. Therefore, when a taxpayer purchases land and buildings he must allocate the purchase price between the buildings (which may be depreciated) and the land.
      • When depreciating under §168, salvage value = zero (§168(b)(4)).
      • Recovery Period: determine the recovery period to determine # of years to depreciate over.
        • See Recovery Table §168(c) – see below.
      • Methods of depreciation – see below
      • Conventions
        • Half-Year: §168(d)(1) The applicable convention is the half-year convention unless otherwise provided.
          • Under the half-year convention, property is deemed to be placed in service in the midpoint of the year. So in the first and last years, you get ½ depreciation.
        • Mid-Month: §168(d)(2) applies to nonresidential real property, residential rental property, and any railroad grading or tunnel bore
          • Under the mid-month convention, property is deemed to be placed into service in the midpoint of such month it is placed in service. §168(d)(4)(B).
        • Mid-Quarter: §168(d)(3)(A)Applies when the aggregate bases of depreciable property put into use during the last 3 months of the year exceed 40% of the total amount of depreciable property put into use in the year.
          • Property is deemed to be placed into service on the midpoint of such quarter that it is placed into service. §168(d)(4)(C)

 

Table: Recovery Table §168(c) Recovery Period:

3 year property (168e3) Any race horse that is older than 2 years old when placed into use, or any horse other than a race horse which is more than 12 years old at the time it is placed in service. 3 years
5 year property (168eb) Any car or truck, semiconductor mnfg equip, computer based phone central office switching equip, qualified tech equip (p172), any §1245 equipment used with experimentation/research, etc 5 years
7 year property (168 ec) RR track, agricultural structure, any property that doesn’t have a class-life and is not a residential rental property or non-residential real property. 7 years
10 year property (168ed) Horticultural structure, tree or vine bearing fruit or nuts 10 years
15 year property (168Ei) Any municipal wastewater treatment plan, telephone distribution plant, retail motor fuel outlet and intangible assets, equipment for voice & data communications 15 years
20 year property 20 years
Water Utility Property 25 years
Residential Rental Property (168e21) Any building or structure if 80% or more of G rental I is from dwelling units (apt, not hotel) 27.5 years
Nonresidential Real Property (168eb) 39 years
Any railroad Grading or Tunnel Bore 50 years

 

 

B. METHODS OF DEPRECIATION

 

Any “reasonable” method for allocating the cost of the wasting asset over its useful life is acceptable, but may not result in a faster write-off than that allowed by the “double-declining balance method.” IRC § 167 outlines the numerous limitations and rules with respect to depreciation methods, with particular attention given to the rules governing the different declining-balance methods

 

  • (1) Straight-Line depreciation (SL) §168(b)
    • To compute yearly depreciation, the cost of the property, less salvage value, is divided by the useful life of the property. Suppose that a taxpayer purchases a machine for $10,500 that has a useful life of five years and a salvage value of $500. Each year she could claim depreciation of $2,000 [ ($10,500 – $500)/5 ]. There exists a point at which the straight-line method becomes more desirable than an accelerated method. Taxpayer can change to that method at that time. Congress Intent: encourages investment in capital equipment and the economy benefits
    • Same deduction every year during the recovery period. If you are doing the SL depreciation under §168, which you probably are, don’t forget that ½ year convention (or quarter/month) applies, so the first and last year you pay ½ (or follow quarter/month).
    • Ex: $500 depreciated over 5 years.
      • Year 1 – take $50 d/d
      • Year 2 – $100 d/d
      • Year 3 – $100 d/d
      • Year 4 – $100 d/d
      • Year 5 – $100 d/d
      • Year 6 – take $50 d/d
  • (2) Declining-Balance Method
    • Each year’s depreciation is computed by subtracting from the property’s basis the amount already written off, and applying a constant rate to the remaining basis. The rate should not be more than twice the rate used in the straight-line method above, and the salvage value is not deducted, but is equal to what remains at the end of the useful life. For example, if a taxpayer purchases a machine for $10,500 with a useful life of five years, she would compute depreciation under the double-declining balance method (200% the straight-line rate) as follows:

Year Rate Year’s Depreciation Remaining Basis

$10,500

1 200% $4,200 $6,300

2 200% $2,520 $3,780

3 200% $1,512 $2,268

4 200% $907 $1,361

5 remainder $544 $817

(salvage)

    • 200% Declining Balance (200% DB) §168(b)(1): 2xSL until SL produces bigger d/d.
      • Method prescribed for three-year, five-year, seven-year and ten-year personal property, switching to the straight line method for the year when that method yields a greater depreciation allowance.
      • But IRS gave us an easy way to calculate this:
        • Look up page 1824 in the big tax book.
        • (That’s for ½ year convention – page 1825 has mid-month).
        • Apply the percentage to the adjusted basis.
        • That’s all there is to it. Same goes for 150% DB.
    • 150% Declining Balance (150% DB) §168(b)(2): 1.5xSL until SL produces bigger d/d.
      • Method prescribed for fifteen-year and twenty-year personal property, switching to the straight line method for the year when that method yields a greater depreciation allowance.
  • (3) §168(g) – Extended SL depreciation for certain properties
    • Use straight-line depreciation method with recovery life listed in §168(g)(2)(C) and applicable convention in §168(d).

 

C. EXTRA DEDUCTIONS

 

  • Extra Deductions are taken before depreciation method(s) are applied. These Adjust the BASIS!
  • Relationship of Depreciation to Basis:Under IRC §1016(a)(2), when a taxpayer claims depreciation on property, the basis must also be reduced by that amount. However, since depreciation is viewed as a continuing expense each year, basis is reduced even if the taxpayer claims no depreciation deduction. Thus the cost or other basis for depreciable property may be likened to a limited supply of deductions from which the taxpayer may draw in accordance with various methods until the supply is used up. If the supply is to be tapped over a period of several years, there must be a device for keeping track of the supply. Basis is the device, although of course it serves other purposes as well. As deductions are claimed, downward basis adjustments effect a shrinkage of the supply, and “adjusted” basis reflects the remaining amount that can be claimed as deductions.
  • (1) §168(k) 30% or 50% additional deductions (these are optional and T can opt out of either/both):
    • 30% – Property Acquired After September 10, 2001 and before January 1, 2005:
      • Optional deduction: take a 30% deduction off of the AB in the first year. This is computed before any depreciation methods are applied
    • 50% – Property Acquired After May 5, 2003 and before January 1, 2005:
      • Optional deduction: take a 50% deduction off of the AB in the first year. This is computed before any depreciation methods are applied.
    • Adjusted Basis – §168(k) adjusts the basis in the property.
      • This adjusted basis (Initial cost – §168(k) deduction = AB) must be used when applying the subsequent depreciation method.
    • For property to qualify for a §168(k) d/d it must be:
      • Tangible property that §168 could apply to with a recovery period of 20 years or less, or
      • Business software as defined under §197(e)(3)(B) (no data bases, unless the data base is incidental to the use of the computer software), or
      • Water Utility property, or
      • Qualified leasehold property.
    • Property that must use the extended SL depreciation method under §168(g) cannot use §168(k).
  • (2) §179 Bonus Depreciations – may elect to take these, so optional:
    • §179 allows T to treat some property as an expense and can be deducted in the year it is put into service. §179 applies to the aggregate amount of all the properties. §179 deductions can only be taken on §168 properties that ACRS applies to.
    • Section allows owners of a wasting asset (e.g. oil, gas, minerals, gravel, timber) to deduct a reasonable allowance for its use or exploitation. A “wasting asset” is any deposit that is consumed by use or exploitation. There are two methods of deducting depletion.
    • Cost Method: The cost of the wasting asset is divided by the estimated number of units recoverable, to obtain a cost per unit. This figure is the deduction that may be claimed for each unit that is extracted. For example, if the total cost of drilling an oil well was $30 million and it is estimated that five million barrels of oil will be recovered from the well, the owner could claim $6 depletion for each barrel of oil that is ultimately recovered
    • Percentage Method: §613 A fixed percentage of gross income may be deducted. Congress sets the percentage figure, which ranges from 5% (for gravel deposits) to 22% (for gas and oil). This method has the advantage of continued life, in contrast with cost depletion, which runs out when the cost of the asset is fully recovered
      • Note that in no circumstances may this deduction exceed 50% of the net income. The large oil companies are now precluded from using the percentage depletion. Only the independents with no retail outlets or independents producing up to 1,000 barrels per day may use percentage depletion
    • There are limits:
      • Years 2003 – 2005 = $100,000/yr
        • If T puts more than $400k worth of property to use then each dollar after 400k will be taken out of the $100k to determine the deduction.
        • Ex. Item is 450k. 450k item – 400k max = 50k over. 100k allowable d/d – 50k over amount = 50k allowed to be deducted under §179 this year.
        • Don’t forget that the 50k d/d adjusts the basis before determining amount applicable to the subsequent depreciation method applied.§179(a) & §1016(a)(2)
      • Years 2006 = $25,000/yr
        • If T puts more than $200k worth of property to use then each dollar after 200k will be take out of the 25k to determine the deduction.
    • Property that qualifies:
      • For property to qualify for a §179 deduction it must be:
        • Tangible property that §168 could apply to or business computer software,
        • §1245 property defined by §1245(a)(3), and
        • Which is acquired for use in the active conduct for trade/business.
      • Property that does not qualify:
        • Investment property (property used for production of income not in a trade or business).
        • Real Property

 

  1. LIMITATIONS ON TAX SHELTERS

 

  • Tax Shelter:Tax shelter is a situation in which the taxpayer generates deductions in excess of income from one activity and uses that excess to reduce income from another unrelated activity. However, some deductions are not allowed to spill over into other activities.
    • Example: A successful investor who has high-bracket income generated by services, or by dividends or interest on investments, may become a gentleman farmer in an enjoyable rural area. In the absence of statutory limitations, if the farm activity generates deductions in excess of income, the taxpayer can use excess deductions from the farm to reduce taxable income (and correspondingly the tax on the income) from other sources.
  • Limiting losses
    • There are limits on the amount of deductions for overall losses in two categories:
      • Mixed Use – of what would otherwise be a trade or business.
        • This is not determined on an item-by-item analysis. Instead we look at the entire activity.
        • Example- the home office situation (you use it both for a residence and an office). – See §280
      • Timing Discrepancies
    • Hypo: You have 100k GI from a business and 240k in business expenses. The net is 140k loss for schedule C. under 165c1, should be able to deduct business losses, but there is no other income. Say there is other unrelated income totaling 50k. Any amount of the 140k that you cannot use in deductions, you can carry back 5 years or forward 20 years. It is just a question of timing. The carry back device has the result of generating refunds available in the current year. With respect to the 50k of income, suppose the person creates a business that cost 100k with a cash flow of 5k and a tax loss of 10k. If it is taxed 70%, you get 700 back in your pocket plus 5k of cash flow in your pocket. This is a tax shelter. To deal with the tax shelter problem, before you can count the schedule C deductions against your income, you have to pass through some additional screening.
  • Three main limitations
    • (1) Hobby Loss Provision §183
      • The goal is to not allow hobby losses to offset other income. Otherwise, people could just take on a hobby and offset normal income all the time (manipulation dangers).
      • To deduct the annual loss, T must demonstrate that at least a significant purpose of the venture was to earn a profit.
      • To determine this you must look at:
        • The facts and circumstances to look for T’s purpose for conducting the business.
        • Rebuttable Presumption – §183 will be satisfied if T produced a profit for 2 of the last 5 years.
          • 2/7 years if with race horses.
      • Amount of Deduction (applies to all tax shelters actually)
        • You can reduce your income to $ 0 for that activity, but you cannot offset other income.
      • If you get through §183, then §465 now applies. §465 treats the activity as an asset with a basis. The amount you can deduct through losses in limited by the amount at risk in the business. Since you’ve passed §183, the ‘activity’ is a trade/business.
    • (2) At Risk Limitations § 465
      • Need a separate account cumulating the entire activity. Calculate the amount at risk, and take that amount as a loss that year.
      • §465 limits a T’s deductible losses from a specific business/investment activity to the amount he has at risk in that activity. §465 is applicable to individuals and closely held C Corps (50% of stocked owned directly/indirectly by 5 or fewer individuals).
      • Definition of at risk
        • The term means the amount of the taxpayer’s investment in the property, but not counting purchase-money loans for which the taxpayer has no personal liability
        • You must be personally liable
          • Therefore non-recourse loans do not count.
            • Exception: real estate. T is considered at risk wrt a nonrecourse loan from a qualified lender (bank, etc.) for real estate investments only.
            • Debt to relatives and others w/interest in the venture and activity does not count.
      • §465 applies to all business and investment activities.
      • Running Tab – When you claim the deduction, you decrease the amount at risk for future deductions.
        • Therefore, this is a timing provision.
      • If you get past §465, now §469 applies. Losses from passive activities can only be taken against gains from passive activities. They cannot be taken against active income.
    • (3) Passive Activity Limitations §469
      • A person engages in a passive activity cannot deduct the losses except against income from passive activities.
      • Form 8582
      • “Passive” defined: a passive activity is a business in which the taxpayer does not materially participate. (Material = regular, continuous, and substantial).
        • Material participation is one who is involved in the operations on a regular, continuous and substantial basis, and the activity is the taxpayer’s principal business IRC§ 469(h) & 1.469-5T (Note: If spouse participates it is attributed to the taxpayer)
  • 500 or more hours per year
  • Does all the work of activity
  • >100 hours but no one else worked more than that
  • It is a significant participation activity and aggregate amount of all significant participation act is >500 hours
  • Materially participated for 5 out of the last 10 years
    • Automatically considered Passive Activities: Limited Partnership interests, all rental activities (buy an airplane and lease it to an airline, real estate).
    • Why? Limited partnership – because of the nature of the relationship; rental activities – nature of the activity can be done with very little involvement.
    • Real Estate Exceptions
      • Mom & Pop – even though it’s rental real estate and is a passive activity, if their income is low enough, then they can take a $250k deduction per yr. (Duplex owners, etc.)
      • Real Estate Professionals – can take passive losses for real estate activities (that are active income).
    • Agent or Representative: Activities of one’s own agent are not attributed to a taxpayer in establishing material participation
    • Legal Services: Providing legal services to a business as an independent contractor is not materially participating
    • Management functions: Passive if merely formal and nominal participation, does not allow for independent discretion and judgment. Can have an active intermittent role
    • An estate or trust is treated as materially participating in an activity if an executor or other fiduciary, in one’s capacity as such, materially participates in the activity
  • Objective test (§1.469-5T)
    • T’s participation is material if he participates more than 500 hours per year,
    • Or at least 100 hours and his participation is not less than that of other individuals.
      • Married individuals can combine the work of both to meet these tests (so as to say it’s an active activity and get the money deducted from other active activity).
    • A limited partner is almost always passive in a partnership.
  • Limited Deductions:
    • Passive activity losses can only be used to offset income generated by those passive activities (PIGs – Passive Income Generator).
    • Any remaining loss can be carried over to the next year.
      • When you exit the activity you can claim the loss for these carryovers.
  • To the extent anything is left after these screens, that is what counts against the 50k from the hypo above. This is sequential and should be done for every business activity every year.
  • Rental real estate: Automatic passive activity. Also, limited partnership.

 

 

  1. CAPITAL GAINS & LOSSES

 

  • Capital gains and losses are identified for special treatment. Capital gains are income; they just get taxed at special (lower) rates. Capital loss deductions are restricted.
  • Identifying and tagging transactions. In a given year, a person may buy and sell assets. We are concerned about sales and exchanges of assets. They produce gains and losses. Each transaction needs to be examined to see if it involves a capital asset, as defined in §1221.
  • §1221 Capital asset- almost everything. What is not: business assets, inventory, accounts receivable, literary, artistic, or musical compositions, etc. All these things not covered are treated as ordinary income, and business assets are treated differently in 1231 which we will not get to.
  • These assets must be sub-identified as long term or short term. Two special treatments depending on whether there is more gain than loss or more loss than gain when netted.
  • §1h- special rates when gains exceed losses. §1211 and 1212- limitations when losses exceed gains. There is a carry forward under 1212.
  • Rates: 0, 5, 10, 15, 25, 28 under §1h. Schedule D instructions are for this and provide the correct overall result.
  • Congress’s purpose: Long term gains should not be taxed at full rates currently.
  • You can use a capital asset and charity to take a deduction against your regular income.

 

 

  • What is a capital gain/loss?
    • Gain or Loss from
    • A Sale or Exchange of
      • Exception: worthless stock is treated as a sale or exchange, dividends get same capital gains tax rate.
    • A capital asset defined in §1221.
      • Excludes ordinary sales of stock or inventory or sales of real property or property used in trade or business (business assets) or publications of the US govt.
      • Accounts or notes receivable are not capital gains because they replace ordinary income.
      • Included are sales of your personal property (cars, houses (beware of §121 principle place of residence), etc).
      • If it is not a capital asset, then it’s an ordinary gain or loss and §1222 doesn’t apply.
    • Capital Gain: An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on income taxes
    • Capital Loss: An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on income taxes
  • Short Term Capital Gain/Loss (STCG/L) vs. Long Term Capital Gain/Loss (LTCG/L)
    • Short Term – whether a gain or loss is short-term depends on the length of time you have had the asset. If the length of holding was 12 months or less, then it is short-term.
      • If there is a short-term capital gain, T’s normal tax rate will apply.
    • Long Term – If the length of holding was more than 12 months.
      • If there is a long-term capital gain, special tax rates apply.
  • Special Rates wrt to Capital Gains
    • To determine the net capital gains and losses, the taxpayer must determine whether he has “realized” gain or loss from the “sale or exchange” of a “capital asset.” Then it must be determined whether the gain or loss realized must be “recognized.” The gain or loss is then computed by subtracting the adjusted basis from the amount realized. The adjusted basis is the property’s basis (acquisition cost) plus other capitalized expenditures (i.e. amounts not deductible as current expenses), less depreciation and other receipts chargeable to the capital account. The amount realized from the sale of a capital asset is the sum of money received on sale plus the fair market value of property received (if any).
    • To arrive at the tax on capital transactions, the individual taxpayer follows these steps:
      • Segregate Long-Term and Short-Term Transactions: Capital assets that a taxpayer sells or exchanges before he has held them for more than one year are treated differently than “long-term” capital assets.
      • Net the Amounts – IRC § 1222: After the transactions are segregated by term, the short-term capital gains and losses are netted to reach a net short-term capital gains or losses. The same is done with the long-term transactions to arrive at a net long-term capital gain or loss. The tax treatment depends on the amounts and classifications of the net long-term and net short-term amounts
    • Short Term Capital Gain minus Short Term Capital Loss=Net Short Term Capital Gain or Loss §1222(5) or (6)
    • Long Term Capital Gain minus Long Term Capital Loss= Net Long Term Capital Gain or Loss §1222 (7) or (8)
    • Results:
      • Net Short-Term Capital Gain Exceeds Net Long-Term Capital Loss: Where this occurs, the excess short-term amount is treated as ordinary income. Ordinary income is not subject to capital gains ceiling.
      • Net Long-Term Capital Gain Exceeds Net Short-Term Capital Loss: The excess long-term capital gain is included in gross income. Long term gain is subject to capital gains ceiling. For example, suppose a taxpayer has taxable income of $15,000 and capital gains and losses as follows:
        • Long-term capital gain $5,000
        • Long-term capital loss $1,000
        • Short-term capital gain $2,000
        • Short-term capital loss $3,500
        • Netting the amounts would give the taxpayer a net long-term capital gain of $4,000 and a net short-term capital loss of $1,500. The excess of net long-term capital gain is therefore $2,500. This total is added to ordinary income to arrive at a gross income of $17,500.
        • Some type of preferential treatment is provided to the “net capital gain” which is defined by §1222(11) as the excess of net long-term capital gain over net short-term capital loss. All assets making up net capital gain must have been held more than one year §1222(3)(7)(11)
      • Both Short-Term and Long-Term Gains: If both net amounts show gains, the combined amount is included in gross income. Capital gains are subject to capital gains rate ceiling.
      • Net Short-Term Capital Loss Exceeds Net Long-Term Capital Gain: IRC § 1211 (b) allows up to $3,000 of the excess net short-term capital loss to be deducted against ordinary income. The excess must be carried over to future years.
      • Net Long-Term Capital Loss Exceeds Net Short-Term Capital Gain: IRC § 1211 (b) allows up to $3,000 of the excess net long-term capital loss to be deducted against ordinary income. The excess must be carried over to future years.
      • Both Short-Term and Long-Term Losses: If both netted amounts show losses, the short-term loss is used first against the $3,000 ceiling. Excess amounts are carried over to future years.
  • Difference in Rate Treatment: Long-term capital gains receive only a minor favorable rate treatment and short-term capital gains receive no favorable rate treatment
      • 28% – Applies to “Collectibles.” These are stamps, most coins, antiques, gems, art work, etc.) §1(h)(4)(a), §1(h)(1)(E)
      • 25% – Applies to gain on sale of depreciable real property and §1250 gains (penalty provision wrt to real estate). §1(h)(1)(D)
      • 15% – Applies to “adjusted net capital gain.” This applies to everything else that these other percentages don’t apply to – including gains on stocks, bonds, investment land, other types of capital assets. §1(h)(1)(C)
      • 10% & 5% – §1(h)(1)(B) When T has inadequate ordinary income (when their income tax rates are less than 25%) there is special treatment. (p686 text book – confusing as hell and I seriously doubt we need to know this.)
        • When T makes only little money and so gets taxed @ 15% on his entire TI, then 10% applies to his capital gains up until those capital gains take him out of that 15% bracket.
    • Corporate Taxpayers: Corporations determine their net capital gains and losses the same way as non-corporate taxpayers.
  • Special Limitations wrt to Capital Losses
    • General Rule: Capital Losses cannot be used to deduct anything else but Capital Gains.
      • One exception: When you are an individual (not a corporation), and you have net capital losses, you can use at max $3,000 of those losses to offset your other income.
    • First: Net all the gains and losses within the rate classifications.
  • Short-term capital losses including carryovers are combined with short-term capital gains. Any net short-term capital loss is used to reduce long-term capital gains in the following order: 28% sale gain, unrecaptured § 1250 gain (25%), and adjusted net capital gain (20%).
  • Gains and losses are netted within the three long-term capital gain groups to determine a net capital gain or loss for each group. There can be no net loss in the 25% group, which is limited to gain to the extent of straight-line depreciation
  • A net loss from the 28% group (including long-term capital loss carryovers) is used to reduce gain in the 25% group, and then any net loss balance is carried to the 20% group
  • A net loss from the 20% group is used to reduce gain from the 28% group and any remaining net loss is carried to the 25% group.
  • Second: Any Net Losses left will wipe out gains in favor of Ts: Use your losses to wipe out the highest taxed gains first, and trickle down the list.
    • Ex. You sold an asset that would’ve been taxed at a 15% tax rate if you had made a gain, but you made a loss of 1k. You didn’t sell any other assets other than this collectable asset. You sold the collectable asset and made a gain of 1k on it (since it is a collectable, you will be taxed @ 28% on that gain).
    • Result: Net loss of 1k in 15% rate classification, Net gain of 1k in 28% classification.
  • You can use your 1k loss from the 15% bracket against your gain made in the
    • 28% bracket and thus = 0 capital gain.
  • The Section 1212(b) Carryover: (Allows the excess capital loss not allowed past the $3K to carry over and tells which loss to apply to ordinary income first) The carryover statute for noncorporate taxpayers, §1212(b), provides that capital losses not utilized in the year incurred retain their original character in succeeding years and are carried over into subsequent taxable years. The “if” clause at the beginning of §1212(b)(1) makes the carryover provisions dependent upon the taxpayer having a “net capital loss,” which is defined in §1222(10) as “the excess of losses from the sales or exchanges of capital assets over the sum allowed in §1211.” If the sum allowed under §1211(b) does not exceed $3K of excess losses over gains, there is no “net capital loss,” no carryover, and no need or permission to use §1212(b).
    • However, if for any year capital losses exceed capital gains by more than $3K, §1212(b) applies and questions arise both as to the amount and the character of any carryovers. The secret of interpreting §1212(b) and of answering the questions of what to do with the excess capital loss and which net loss (short or long term) is first consumed against ordinary income is found in §1212(b)(2) and thus one must make the §1212(b)(2) computation first, before computing carryover losses under §1212(b)(1)
  • Corporations: The major difference in the treatment of capital losses of corporations and individuals is that §1211(b), authorizing noncorporate taxpayers a limited deduction in excess capital losses from ordinary income, is neither applicable nor duplicated for corporations. In the case of a corporation, §1211(a) provides that losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.

 

 

  1. ALTERNATIVE MINIMUM TAX

 

  • In essence, the intention of the AMT is to set a minimum tax rate of about 27% on the highest earning tax payers so that they can not use loop holes or other tax reduction strategies to entirely avoid paying a substantial amount of income tax. The AMT affects taxpayers who have what are known as “tax preference items.” These include (among others):
    • Long term capital gains
    • Accelerated depreciation
    • Percentage depletion, and
    • Certain tax-exempt income which are all considered to have favorable tax treatment and could trigger the alternative minimum tax.
  • In addition to the normal tax code calculations, the AMT system uses a different set of rules for determining taxable income and allowable deductions, and uses a simple 26/28%rate calculation to determine the “Tentative Minimum Tax” (TMT). The TMT is compared to the income tax amount calculated for the taxpayer.
    • If the regular income tax amount is greater than the TMT, no special action is required.
    • If the TMT is greater than the tax calculated using the regular rules, the difference between the TMT and the regular tax is added to the regular tax amount, so the taxpayer pays the full amount of the TMT (although some of that tax is considered regular tax and some is considered AMT).
  • The portion of the tax which is considered AMT may be available in later years as a “Minimum Tax Credit”, reducing the regular income tax due in later years, but only to the taxpayer’s TMT level in those later years.
  • Essentially, this is a way to require us to take our regular taxable income and add back elements that originally Congress thought we shouldn’t have gotten, but didn’t want to change the Code, and now thinks will better reflect our income.
  • Process:
    • Start with TI, add back taxable preferences – some medicals, some state taxes, exemptions for personal exemptions (dependents), etc. = X
    • You then get an AMT exemption:
      • 40.250 for singles
      • 58.000 for married people
    • X (minus) AMT exemption = Y
    • 26% or 28% on Y = amount.
    • Whichever tax is greater is what T pays.

 

 

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