Federal Income Tax Supplements for Law School
- Examples & Explanations: Federal Income Tax, 5th Edition
- Selected Federal Taxation Statutes & Regulations, with Motro Tax Map, 2012
- Emanuel Law Outlines: Basic Federal Income Tax 2011 (Emanual Law Outlines)
- Law in a Flash Cards: Federal Income Tax, 2010
- Basic Federal Income Tax Crunchtime 2009
CHAPTER 1 – BASICS
Federal income tax is the largest source of federal revenue.
California also assesses income tax. There are differences between the two schemes, however. California’s top bracket starts at $50,000 (as opposed to $250,000 in the federal scheme). Also, California, unlike the federal scheme offers no rate break for capital gains.
Other types of tax
Sales
Gross receipts (i.e. payroll taxes)
Import duties
Sin taxes
gas taxes
etc.
Basic Income Tax Formula
Federal income tax is imposed on taxable income
Start with gross income (§ 61)
subtract exclusions(§§ 101-150)
i.e. gift, inheritance, personal injury awards, fringe benefits
subtract business expenses (§ 161)
ordinary and necessary expenditures make while carrying on a trade or business.
subtract specified deductions (§ 62)
alimony
retirement contributions
losses from the sale of capital assets
job related moving expenses
reimbursed work expenses
= Adjusted gross income
Then you take adjusted gross income and you
subtract personal exemption
subtract standard or itemized deductions
itemized deductions are mainly medical and charitable expenses. Also includes employee business expenses.
= taxable income
After you apply the tax rates (§1) to taxable income, you add credits. What’s left is your tax due.
Deductions v. credits
Credits are applied after your tax rate. Thus, they reduce you overall tax. The effect is the same for low-income and high-income taxpayers.
Deductions are applied before the tax rate, thus they produce a greater savings for the high-income taxpayer.
To determine someone’s tax situation, ask:
Who is the taxpayer?
What is at issue? (is this an income item? if so, is it compensation, dividend, interest?)
When?
Why (what are the circumstances in which you received it? What about a scholarship, for example. you may be entitled to a credit, adjustment, etc.)
How much?
What are the characteristics of a good tax?
Fairness, equity
Ability to pay (our system has progressive rates, for example). The argument is that dollars mean more to lower income people than upper income.
Neutrality/efficiency
As a general goal a particular tax should neither encourage nor discourage taxpayer choice. (this is pretty theoretical, of course taxes dictate taxpayer activity).
State and local municipal bonds are one way congress DOES influence investment choices, but that’s a congressional choice. Same things with a capital gains tax.
Administerability
Sometimes, difficulties assessing timing and/or valuation lead to a policy choice that something shouldn’t be taxed.
CHAPTER 2 – GROSS INCOME
The starting point for calculating tax owed is “gross income”
Haig-Simons definition: Change in net worth plus consumption. This is close to, but not quite, the definition used by the IRC.
§ 61. Gross income
Definition: “all income from whatever source derived.”
This is a broad, sweeping definition.
It includes all “undeniable accessions to wealth, clearly realized, over which the taxpayers have complete dominion.” Glenshaw Glass.
“Undeniable” means that it can’t be taken away.
Examples of gross income: wages, rent, dividends, alimony, tips, bonuses, raffle prizes, etc. It does not have to be cash!
Treasure trove is gross income for the taxable year in which it is reduced to undisputed possession (Cessarini).
Questions about when title vests is ordinarily determined by state law. When there’s no statute on point, the English common law rule is that “title belongs to the finder as against all the world except the true owner.” In other words, title vests when you actually find the property.
Prizes and awards are generally gross income
Except for prizes and awards made in recognition of charitable, religious, artistic, scientific or civil achievement, but only if
recipient took no action to enter contest,
recipient doesn’t have to do anything for the award, AND
recipient gives it to charity or governmental unit before he actually receives it (in other words, this isn’t much of an exclusion)
Payment of someone’s financial obligation (i.e. a tax obligation) in return for services is gross income. Old Colony.
Punitive damages in a lawsuit are gross income. Glenshaw Glass.
Even illegal gain is income, despite the legal obligation to make restitution. James v. US.
Loans and security deposits are not gross income
Constructive receipt.
In some circumstances, you can be taxed on income before you actually receive it.
In general, if payment is made in property or services, the fair market value of the property or services is used to determine gross income. If services are rendered for a stipulated price, the price is presumed to be the fair market value of the compensation (unless there is evidence to the contrary).
Imputed income is not gross incomes
The rental value of a building used by the owner does not constitute income. Helvering.
But what about the child who moves back home? Typically constitutes a gift and is not gross income.
Lawyer who does own tax return does not receive gross income
Person who grows own food does not receive gross income
In sum, gross income includes the receipt of any financial benefit which is:
Not a mere return of capital
Not accompanied by a contemporaneously acknowledged obligation to repay, and
Not excluded by a specific statutory provision. (see below)
Rules of inclusion and exclusion
When applicable, these take precedence over the general rule of gross income.
§71-90. Items specifically included (or partially included) in gross income
alimony, annuities, prizes, employer-provided group life insurance, reimbursement for moving expenses, property transferred for services, property transferred to a political organization
§101-139. Items specifically excluded from gross income
death benefits, gifts, inheritances, interest on state and local bonds, gains from the sale of principal residence, compensation for injuries, amount received under a health plan, employer contribution to a health plan, improvements by lessor on lessees property, certain combat pay, qualified scholarships, meals or lodging furnished for the convenience of employer, etc.
Most of these have specific requirements.
EXCLUSIONS
GIFTS § 102.
The “the value of property acquired by gift, bequest, devise, or inheritance” is excluded from gross income.
Note, however, that income from that property is not excludable from gross incomes
What is “gift”?
Whether something is or is not a gift is a question of fact.
The mere absence of a legal or moral obligation to make a payment does not establish it as a gift. If a transfer of property made in anticipation of future benefit is not a gift. The most critical consideration is the transferor’s intention. A donor’s characterization of the act is not determinative.
The transfer must be the product of a “detached and disinterested generosity.”Duberstein. This is a highly fact dependent review. Look for the motive that dominated the conduct. If there’s a quid pro quo, it’s not a gift.
Employee gifts
102(c) states clearly that an employee “shall not exclude from gross income any amount transferred by of for an employer to, or for the benefit of, an employee.”
This indicates a broad congressional intent to deny gift classification to all transfers by employers to employees.
Note: probe the nature of a relationship. A congregation giving to a pastor may not be employer-employee, for example. It depends on the nature of the arrangement.
A gift with multiple transferors can be split: If employee and fellow employees go in on a gift, the portion paid for by the other employees is a gift, the portion paid for by the employer is gross income.
Exceptions to the exception:
“extraordinary transfers to the natural objects of an employer’s bounty if the employee can show that the transfer was not made in recognition of the employee’s employment” (regs)
Gifts between related parties
If employer-employee are related, look for what relationship prompted the gift.
Certain retirement gifts are treated as de minimis fringe benefits.132(e).
Certain employee achievement awards are free from tax.74(c).
These have to be items of tangible personal property given for a length of service or safety achievement. There are dollar limits.
Up to $5,000 can be excluded for employee death benefits. The amount received must not represent benefits the employee would have enjoyed had he lived.
Note for employers: section 274(b)(1) generally limits the deductible amount of business gifts to $25 per donee per year. But employee gifts are not subject to this ceiling.
What is a bequest, devise or inheritance?
Traditionally, these terms mean the passage of property through a will. But this is not always the case in tax law.
Form does not govern substance. As with gifts, there must be a motive of detached and disinterest generosity. You can’t disguise payment for services upon death as a bequest. Wolder.
An inheritance may include property received in compromise of a claim as heir. There need not be a formal bequest. Lyeth v. Hoey
EMPLOYEE BENEFITS §132 and §119
“Compensation for services” is gross income. But what about fringe benefits? Do we really want to tax the free coffee employees get at work?
The Service, even without statutory authorization, used to allow some items to go unreported. Nowadays, the tax law on fringe benefits is completely statutory (most spelled out in § 132 (fringe benefits) and §119 (meals and lodging). The logic is that these benefits often serve business goals and are not merely a substitute for compensation.
If a benefit is not specifically excluded from gross income, its value must be included within gross income!
Nondiscrimination requirement
Some fringe benefits are “tax free” only if provided on substantially equal terms to all employees. The following are only excludable from gross income for highly compensated employees only if offered to other employees on a nondiscriminatory basis (note: if offered on a discriminatory basis, the exclusion still applies to non-highly-compensated employees)
No additional cost services
Qualified employee discounts
Employee eating facilities
Qualified retirement and planning services
A highly compensated employee
was a 5% owner at any time during the year or previous year,
made more than $80,000 the previous year, or
was in the top 20% highest paid in previous year
Who gets to exclude fringes?
Fringe benefits are provided to “employees” – or in the case of no-additional-cost services and qualified employee discounts, to retired and disabled employees, spouses, dependent children, etc.
No-Additional-Cost Services. § 132(a)(1)
Service has to be offered for sale to customers in the same line of business as that in which the employee is performing services.
Exception, if two companies have a reciprocal agreement to offer the same benefits to the others’ employees (benefits must still be in the other employees’ line of business)
Employer must incur no substantial additional cost in providing the service to employee. Incidental cost is okay.
The services must be provided on a nondiscriminatory basis.
Examples:
airlines seats provided to employees in a way that doesn’t displace customers.
free telephone service to telephone company employees.
It doesn’t matter if the services are provided free, partial charge, cash rebate, etc.
Qualified Employee Discounts. § 132(a)(2)
An employee can generally exclude from gross income the value of “courtesy discounts” on items purchased from employer for use by the employee.
Nondiscrimination and same line–of-business limitations apply
Exclusion does not include loans to employees of financial institutions.
For services, the exclusion can’t exceed 20% of the price the services are offered to customers.
insurance policies are considered services.
For property, the maximum excludable discount is the employer’s “gross profit percentage” from the previous year
(aggregate sales price reduced by cost)/(aggregate sales price)
Working Condition Fringe. § 132(a)(3)
Covers things like use of a company car, an employer’s subscription to a business periodical, on-the-job training. Ask whether the expense would have been deductible as a business expense if the employee had to pay for it himself.
Note: this does not have a nondiscrimination requirement!
De Minimis Fringes. § 132(a)(4)
Any property or service whose value is so small as to make required accounting for it unreasonable or administratively impracticable is excluded as a fringe benefit.
i.e. taxi fare for overtime work, personal use of company copying machine, coffee at work, low value holiday gifts, traditional retirement gifts, tickets (but not season tickets)
Eating facilities
Bargains provided to employees at employer eating facilities are a de minimus fringe if it is located on the premises and the facility normally breaks even at least.
Qualified Transportation Fringe. § 132(a)(5)
Generally, cash reimbursements for qualified items: transportation in a commuter highway vehicle between residence and work, transit pass, fare card, etc, qualified parking, reimbursement for bike commuting, etc.
Limited to $100 per month for transportation in commuter vehicle or transit pass, $175 per month for parking, $20 per month for bike commuting.
Cash reimbursement counts
Athletic Facilities – 132(j)(4)
Use of on-premises athletic facility is excludable if the gym is operated by the employers and substantially all use is by employees, their spouses, and dependent children.
No non-discrimination requirement.
Moving expenses (132(g) and retirement planning services (132(a)(7)) are also excludable fringes.
Meals or lodging (119) furnishedby employersare excludable if:
Meals are furnished on the business premises (doesn’t matter if employee can decline) and its provided for the convenience of the employer.
Does not apply to cash reimbursements for meals
Doesn’t cover groceries (i.e. firefighters)
Employee is required to accept lodging on the business premises as a condition of employment and its provided for the convenience of the employer.
Employees of educations institutions do not have to include qualified campus housing in gross income (this is sort of an exception because technically these employees aren’t required to accept lodging there)
For a minister, gross income does not include rental value of home furnished as part of compensation, or the rental allowance paid to him (as long as it does not exceed the fair rental value of the home). It must be specifically earmarked in the minister’s contract. And it’s only excludable to the extent that it is actually used to buy a home.
Note: ownership is not the test of “on the business premesis.” IF there’s a geographical separation, the exclusion may not apply.
Other fringe benefits
Group term life insurance premiums for up to 50K coverage. §79.
Combat pay. §112
Child care, up to 5K. §129
Qualified adoption expenses. §137
CONSTRUCTIVE RECIEPT DOCTRINE
Deferred compensation
Under the case receipts and disbursements method of accounting, a taxpayer is required to include compensation in gross income only for the taxable year in which it is actually or constructively received.
What is constructive receipt?
A taxpayer seeking deferral under a deferred compensation arrangement must pass muster under Revenue Ruling 60-31 and circumvent the § 409A penalty
Revenue Ruling 60-31
When the taxpayer has enough dominion or control to determine when he will receive it, the money is taxed immediately. When he doesn’t have that much control, it isn’t taxed immediately. Unpaid amounts can be excluded from the income unless it appears that 1) the money was available to employee, 2) corporation was ready to pay, 3) right to receive was not restricted, 4) failure to receive was due to employee’s own choice.
generally, if an escrow agent has been set up for the benefit of the taxpayer, there has been constructive receipt.
Merely having a contractual arrangement for future payment probably isn’t enough – taxpayer is an unsecured creditor, whose rights are subordinated to other creditors’ rights.
§ 409A adds a number of general statutory requirements to the principles of constructive receipt.
Previously deferred amounts must be included in gross income in the current year (and taxpayer must pay a penalty), unless the compensation arrangement meets three criteria
Distributions may not be made available before 1) the participant’s separation from service, 2) the participant becomes disabled, 4) the participant’s death, 4) a specified date, 5) a change in ownership of the corporation, or 6) the occurrence of an unforeseen emergency
the arrangement must not permit the acceleration of any payment
taxpayer must make a timely election to avoid the inclusion rule.
GAINS AND LOSS
Loans and repayments of loans do not constitute gross income. But when a taxpayer settles its debt for less than the amount owed, a taxable gain has occurred. Kirby Lumber Co.
An exception is when the discharge is part of a title 11 case or the taxpayer is insolvent. § 108
Formula for calculating gain or loss. §1001
Two basic variables
adjusted basis
the amount that aggregates what the taxpayer has invested in tax-significant ways in the property. You take the basis and adjust it up for improvements and down for capital recovery
amount realized: what you get
Gain = (amount realized) minus (adjusted basis).
Adjusted Basis
The form of acquisition (the taxable event) sets the rule for determining basis.
Where do you get the initial basis from?
§ 1012 is the default basis provision.
§ 1015 (gift)
§ 1014 (inheritance)
§ 1041 (transfer from spouse)
§ 1012. Default basis provision
The initial basis of an asset, unless otherwise provided shall be the cost of the asset.
Philadelphia Park shows that “cost” has a tax meaning that’s different from everyday parlance. “Cost” for tax purposes is the Fair Market Value of the item received. In an arms length transaction, that should equal the amount paid. In Philadelphia Park we don’t have dollars paid, we have one person swapping with another. That’s why FMV is used to set basis.
How do you determine FMV? There are three options, in order of preference:
Value the item, and if you can’t do that…
Reference what you paid (this should work in an arm’s length transaction)
if neither possible, swap your basis in the old item and put it on the new item. The Service says this method is almost never necessary.
Employee discount rule: If you buy something at an employee discount, the basis is the cost an ordinary person would pay, not what you paid.
Attorneys and brokers fees and the like spent acquiring property are added to the cost basis.
Windfalls: basis is FMV on acquisition
§ 1015. Property Acquired by Gift
If property has appreciated in the hands of the donor, the donee takes the donor’s basis.
If the property has depreciated before given to donee, the donee’s basis for determining loss is the FMV at the time of transfer. The donee’s basis for determining gain is the donor’s basis
If donee realizes an amount between the donor’s basis and the FMV and the time of transfer, the donee incurs neither gain nor loss.
What is a gift?
Remember there must be detached and disinterest generosity. An antenuptual agreement, for example, is not a gift; it is an arms length transaction.
Gift tax
Allows you to step up the basis. The basis for property acquired by gift is the original basis increased by the amount of gift tax multiplied by the ratio of appreciation. § 1015(d)(6). In other words, if you paid 60 gift tax on property that had a basis of 200, then sold it to someone for 300, the adjusted basis would be 220.
[(appreciation amount)/(total amount of gift)] X (Amount of gift tax paid) = (amount you can adjust basis)
Bargain sale (part sale / part gift)
When a transfer of property is part sale part gift, the adjusted basis for the transferee is the greater of:
Amount paid by transferee or
Transferor’s adjusted basis in the property at the time of transfer
Exception: If the transferor’s adjusted basis in the property is greater than the fair market value of the property and the fair market value of the property is greater than the amount paid by the transferee, the fair market value of the property is the transferee’s unadjusted basis.
§ 1041. Property acquired through spouses or incident to divorce
The transfer of property to your spouse (or former spouse) is not a taxable event.
A transfer is incident to divorce if it occurred within 1 year of marriage and is related to the cessation of marriage (which means the transfer is pursuant to a divorce or separation agreement and within 6 years.
If it’s been more than 6 years, there’s a rebuttable presumption that it’s not incident to divorce.
The recipient takes the transferor’s basis (treated as a gift) except that, unlike for property acquired by gift, this is the case even when computing a loss.
§ 1014. Property acquired from a decedent (bequest, devise, or inheritance)
Basis is equal to the fair market value on the date of transfer.
Note, this results in a “stepped up” or “stepped down” basis. This encourages people to hold onto property until they die because the appreciation of property escapes the income tax.
In community property states, a surviving spouse gets a “stepped up” basis for the one-half share of community property.
Abuse preventer: If “appreciated property” is acquired by decedent within one year before death and if the property passes back to the donor or donor’s spouse, the basis is the adjusted basis in the hands of the decedent immediately before death.
§ 1019. Improvements made by lessee
If you own property on which lessee has made improvements, your basis does not change. (but you will probably have a larger gain when you sell)
Amount Realized
1001(b). Amount realized is the money received (or fair market value of property received) for the sale or disposition of property.
“Property” in this context might also mean services. International Freighting Corp.
Facts: Company paid merit-based employee bonuses in stock. Reported as its basis the FMV of the stock. Its actual cost for those shares was less.
QP: Did the transaction result in a taxable gain to the company?
Holding: Yes. The delivery of shares constituted a disposition for valid consideration (services) equal to at least the market value of the shares. The taxable gain was the difference between the cost of the shares and that market value.
Selling property encumbered by a mortgage
Nonrecourse
A taxpayer who sells property encumbered by a nonrecourse mortgage, must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale. Crane v. Commissioner. It doesn’t matter whether the unpaid debt exceeds or is less than the FMV of the property.
The justification for this is that the indebtedness was included in the basis, permitting the taxpayer to tax depreciation deductions on the property in excess of the cash investment.
Takeaway: Taxpayers can trade current deprecation deductions on encumbered depreciable property for deferred gain on the later disposition of the property.
Recourse
Debt discharge is included in amount realized, but only up to the fair market value of the property. Any additional debt discharge is treated as § 61(a)(12) debt discharge income. (when you add those numbers together, this usually amounts to the same total gain as in a nonrecourse mortgage, but the portion of debt discharge income MAY be excludable under § 108.)
LIFE INSURANCE PROCEEDS AND ANNUITIES
Life Insurance
§ 101(A)(1). If you receive the proceeds of life insurance by reason of the death of the insured, you don’t have gross income as a result of receiving that.
There are restrictions and conditions to this exclusion, however.
The exclusion only applies to amounts “paid by reason of the death of the insured.” If an insured elects to take the cash surrender value of a policy, the insured will realize an amount in excess of the basis.
There is an exception to the exception, however. § 101(g) states that accelerated death benefits received from a life insurance policy on the life of a “terminally ill” or “chronically ill” insured person are treated as paid by reason of the death of the insured and are excludable from gross income.
Terminally ill must by physician certified as having na illness or physical condition that can reasonably be expected to result in death within 2 years.
No ceiling on amounts paid.
Chronically ill must be certified as being unable to perform as least two activities of a period of daily living for at least 90 days.
Payments are limited to costs of qualified long-term care.
The § 101(a) exclusion generally does not apply to the proceeds of a policy if the policy has been transferred for valuable consideration during the insured’s life. The excess over the transferee’s costs incurred (consideration plus premiums) is included in the recipients gross income. 101(a)(2). Basically, only the amount you paid into it is excludable (it’s recovery of income).
Even here there’s two exceptions, however.
If the transferee acquired the policy with a transferred basis (i.e. if it’s a gift or transferred incident to divorce), or the transfer was to the insured, a partner of the insured, or a partnership or corporation in which the insured has an interest, proceeds are excludable (this might happen if a company took out a policy on an employee)
If the beneficiary only draws on the interest, that’s taxable.
Installment payments
§ 101(d). When proceeds are paid out over time, the excludable amount shall be prorated (even division over the life of the payouts).
The proration term is figured out by using life expectancy tables from an insurance company. You can’t exclude the interest.
If the beneficiary lives beyond his expectancy, he still gets to prorate.
Annuities
§ 72. An annuity is an arrangement under which one buys a right to future money payments.
How are annuities taxed?
Prorata method. In general, annuity payments are gross income, but a taxpayer can exclude from each annuity payment the product of the payment multiplied by the exclusion ratio (total cost/expected return). That number is treated as a recovery of capital and is not gross income.
To figure out expected return, use the tables on page 933.
If the taxpayer outlives his life expectancy, all of the subsequent annuity payments are gross income. Note, this is different than with life insurance payments.
If the annuitant dies before recovering his investment, the estate gets a deduction of the rest of the investment on the deceased’s last income tax return.
DAMAGES AND RELATED RECIEPTS
Two types of damages
personal injuries and sickness.
everything else.
For personal injuries and sickness, there’s legislation: §§ 104-106.
If you’re not covered by those sections, you’re in the area of general tax principles.
Common law damages: Damages in general
First step in determining the taxability of damages is to identify the nature of the injury. Raytheon Production Corp. v. Commissioner (1st Cir). Ask this question: “In lieu of what were the damages awarded?”
If a suit is to recover lost profits, the damages are probably taxable (just as profits would be).
Punitive or exemplary damages are also taxable. Glenshaw Glass.
If suit is for injury to property or goodwill, the recovery represents a return on capital, which is not taxable. That said, however, the recovery of damages in monetary form is a taxable event. So, if A buys Blackacre for $5, and it appreciates to $100, the B tortiously destroys it and A sues and recovers $100, the appreciation in value is taxable.
Sometimes, this basic principle is altered by statute. In instances of recovery for patent infringement, antitrust violations, breach of contract, breach of fiduciary duty, a compensating deduction may nullify the inclusion of gross income.
Statutory damages: Damages for personal injuries
(note: these do not follow the common law approach)
104. Damages incurred on account of personal physical injuries or physical sickness are excluded from gross income. This includes recovery for lost wages, lost profits, medical expenses, pain and suffering. It also includes compensatory recoveries received under workers comp acts.
The injured need not be the one recovering the funds (for example, a spouse can recover damages due to an injury to her husband).
Damages for nonphysical injuries, such as injury to reputation, are not excludable.
Recoveries for emotional distress depend on the nature of the underlying action; the emotional distress must stem from a physical injury or sickness to be excluded. Medical expenses to treat emotional distress are always excluded.
Punitive damages recovered in a physical injury suit are not excludable from gross income.
But they are excludable in a wrongful death action if a statute allows only punitive damages.
Interest earned on damages is taxable, but if payments are received over a period of years, the entire recovery is excludable.
The personal injury exemption doesn’t apply to recoveries of medical expenses already deducted under § 213.
Health care plans (THIS IS A MESS)
Benefits received under non-employer-funded accident and health insurance policies for personal injuries or sickness are excluded from gross income.
Services provided through an employer-funded accident or health plans are included in gross income to the extent attributable to the employer’s contributions. 105(a). But any portion that is a reimbursement is excluded. An employer’s contributions to accident and health plans are excluded from gross income. 106(a).
Hypo: Man injured. Has 4000 in medical expenses. He gets 3000 from his own policy and 2000 from an employer-funded policy. The 3000 is not gross income. The 2000 is gross incomes except for the portion that is a reimbursement. 2,000/5,000 X 4,000 = 1600 (this represents the reimbursable portion). So 400 of employer policy is taxable.
SEPARATION AND DIVORCE
The income tax consequences of property settlements and alimony payments are very different. In general, property transfers between spouses and former spouses are not gross income. Alimony is gross income.
Direct alimony payments
§ 71. Alimony and separate maintenance payments
payments that qualify as alimony or “separate maintenance” qualify as gross income to the payee spouse.
the key question is what qualifies as alimony (see below)
§ 71 (income rule) works together with § 215 (deduction rule) in alimony calculations. In general, deductibility by the paying spouse is made dependent upon includability of the payment of gross income of the recipient spouse. In effect, divorced people can allocate taxability between the two of them.
What is alimony for tax purposes?
A cash payment made is alimony if five conditions are met:
The payment is received by, or on behalf of, a spouse under a divorce or separation instrument.
The divorce or separation instrument does not designate the payment as non-alimony payment
In the case of a decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made. (If they only have a written separation agreement, they can still live together)
There is no liability to make any payment in cash or property, after the death of the payee spouse, and
the payment is not for child support.
This means that a non-cash payment is not alimony.
The simple designation of any payment as “non-alimony” yields tax relief to the recipient (it’s not gross income) but it adds to the tax burden of the payor (it’s not deductible).
Indirect alimony payments
§71(b)(1)(a). Alimony payments can be made indirectly to the payee (i.e. a husband could pay life insurance premiums under a policy assigned to his former wife with respect to which she is an irrevocable beneficiary).
What types of indirect payments qualify as alimony?
It depends on who owns the asset. To the extent payments are made merely to maintain property owned by the payor spouse which is simply being used by the payee, they do not qualify as indirect alimony payments. (the payor can’t have a legal interest in the property if the payee is going to exclude the payment from gross income). But if the payor has no legal interest in the property, payments could be indirect alimony.
Property settlements incident to divorce or separation
§ 1041. Provides for nonrecognition of gains and losses with respect to any transfer of property between married persons and former spouses incident to divorce. The transferee spouse takes the property with a transferred basis (basically, it’s treated like a gift).
Policy: Makes the tax laws as unintrusive as possible with respect to relations between spouses.
A transfer is “incident to divorce” if it occurs within one year or is related to the divorce.
When is a transfer related to the cessation of marriage?
Treasury regulations provide a safe harbor to transfers made within six years of divorce if also pursuant to a divorce or separation instrument.
A property transfer not made pursuant to a divorce instrument “is presumed to be not related to the cessation of the marriage”
This presumption can be rebutted “by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of marriage.
Young v. Commissioner (4 Cir)
Man and woman divorced. Under a settlement, the woman got a promissory noted of $1.5 million, payable in five annual installments, plus interest, secured by a deed of trust on 71 acres of property. Man defaulted. Man and woman entered into separate settlement that man would transfer to woman 59 acres in full settlement of his obligations (42.3 acres were part of the original 71). Man retained an option to repurchase the land for $2.2 million. He assigned that option to a third party, who exercised it.
What are the tax consequences?
Court said that ts irrelevant that the separation of property incident to divorce took two settlements. the second settlement was still related to the cessation of marriage, so woman took the basis in the land that the couple had when married (1041). When she sold it, she had a taxable gain.
Note that she wouldn’t have had to pay tax on the original cash settlement. But here, she bore the tax burden of the property’s appreciated value after selling it and receiving the proceeds.
Other tax aspects of divorce
Child support
Unlike alimony, child support is nontaxable income.
When it’s a single payment for alimony and child support, calculate the portion that represent child support by looking at the amount that disappears when a child reaches the age of majority.
OTHER EXCLUSIONS FROM GROSS INCOME
§ 121. Gain from the sale of a principle residence
A taxpayer can exclude up to $250,000 (500,000 is married filling jointly) on the sale or exchange of a principal residence – but generally no more frequently than once every 2 years. Taxpayer must have owned the residence and occupied it for at least 2 of the five years prior to the sale or exchange.
(if married, one spouse has to meet the ownership requirement and both have to meet the occupation requirement – neither can have used 121 in last two years)
A taxpayer who moves due to health, employment or unforeseen circumstances can exclude the prorated portion of the 250,000.
It helps if the new place of employment is more than 50 miles away from last place of employment
If moving for health, helps to have a doctor’s note.
A “residence” includes a house, trailer, boat, co-op, etc.
If part of the property is not used for a residence, gain on that portion is gross income and doesn’t fit under 121.
IF there is gain, it’s capital gain. If there is a loss, you can’t deduct it (unless due to casualties).
§ 911. Income earned abroad.
Income earned abroad is excludable if the taxpayer is an American citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year.
Maximum exclusion is $80,000 (indexed for inflation)
§ 103 Municipal Bond interest exemption
Interest from state and local bonds are exempt from taxation
ASSIGNMENT OF INCOME – WHO IS THE TAXPAYER?
Tax is imposed on taxable income at progressive rates. The tax brackets have changed over the years. During the 80s, the highest tax bracket was 70 percent (now it’s around 35 percent). This encourages high income taxpayers to fragment their income.
Income from personal services
Income is taxable to the person who performs services and can’t be shifted to a lower bracket. Lucas v. Earl. There’s an exception for gratuitous services. If a taxpayer refuses to accept salary and doesn’t direct it to a destination, it’s not gross income (he has a strong case if he refuses to accept before performing the services) Commissioner v. Giannini. Even if he refuses to accept after performing the services, he may be able to keep from being taxed if he intends to render a truly gratuitous service (i.e. the executor of an estate declining statutory fees).
One who is entitled to receive, at a future date, interest or compensation for services and who makes a gift of it by anticipatory assignment, realizes taxable income quite as much as if he had collected the income and paid it over to the object of his bounty.
Key: the power to dispose of income is the equivalent of ownership of it and the exercise of power to procure its payment to another, whether to pay a debt or make a gift, is within the reach of the statute taxing income derived from any source whatever.
If a person is just a middle man (i.e. law professor who earns fees for running a clinic but has to turn them over to the university) then he probably won’t be taxed on it.
Income from property
Income from property can be shifted if there is a complete shifting of income producing property, but not if you keep the property and shift something like interest. If you own the tree, you are taxed on the fruit.
Helvering v. Horst
Paul Horst, the owner of negotiable bonds, detached negotiable interest coupons prior to their due date and gave them as a gift to his son. His son thus collected the interest coupons at maturity. A coupon bond holder owns two independent and separable rights: (1) the right to receive at maturity the principal amount of the bond, and (2) the right to receive interim payments of interest on the investment of the amounts specified by the coupons. The Court held that Paul Horst was liable for income tax on the interest payments received by his son. The Court reasoned that the power to dispose of income is the equivalent of ownership.[2] Because he was able to separate the interest coupons from the bonds and procure payment of the interest to his son, Paul Horst enjoyed the economic benefits of the income.
If Horst had given both the bond and the interest coupons to his son, the interest would have been taxable to his son.
When must the owner report shifted income that is nevertheless attributed to him?
Usually when the income is realized by the donee.
DEDUCTIONS – BUSINESS EXPENSES
An income tax deduction is a matter of legislative grace. The burden of clearly showing the right to the claimed deduction is on the taxpayer.
§ 162. Trade or business expenses
All “ordinary and necessary” “expenses” paid or incurred during the taxable year in “carrying on” any trade or business are deductible that year.
An employee can’t convert an employer’s right to a deduction into his own by making a business expense and declining to apply for reimbursement for which he is eligible.
What is “ordinary and necessary”?
Supreme Court said in Welch v. Helvring that “necessary” means appropriate and helpful.
“Ordinary,” too, is read broadly, and doesn’t necessarily mean repeated or habitual. It means foreseeable in the life of the business.
In Welch, the Court said that paying off someone else’s debts to build good will did not meet that definition. Paying debts without legal obligation is extraordinary.
The Court’s decision could also be attributed to the fact that money spent to create good will more closely resembles a capital expenditure (the benefits of which are enjoyed for longer than a year) than an expense (see next section)
note, however, that paying off a debt to preserve or restore a business’s reputation or earning capacity might be okay.
Current expense vs. capital outlay?
Expenses are deductible, but capital outlays are not.
Capital outlays are amounts paid to increase the value of any property, i.e. money spent on building improvements. These are governed by § 263.
Drawing the line between expenses and capital expenditures can be tricky (although there is a preference for the later).
Reasonable wages paid in the carrying on of a trade or business qualify for a deduction from gross income, but when wages are paid in connection with the construction or acquisition of a capital asset, they are usually capitalized and then are entitled to be amortized over the life of the capital asset acquired.
Factors that distinguish capitalizations from expenses.
Whether the expenditure prolongs the life of the property;
Whether the improvements will endure over and beyond the taxable year;
whether the expenditure adds to the value of the property
Whether the expenditure was part of an overall improvement or only a replacement of minor or recurring items;
Whether there is a change or alteration in use or function.
When an expenditure adds nothing of value to an asset but merely maintains it, it is an ordinary and necessary business expense. Midland Empire. Compensation paid to employees, overhead, and de minimis costs (less than $5,000) do not have to be capitalized.
The Supreme Court has said that capitalization is required for expenditures that produce a significant future benefit. The Treasury has clarified that to mean that capitalization is required for:
an amount paid to acquire, create, or enhance an intangible asset
an amount paid to facilitate an acquisition or creation of an intangible asset
i.e. paying the government to create a trademark.
an amount paid to facilitate a restructuring or reorganization or a business entity (Indopco) or a transaction involving the acquisition of capital, including a stock issuance, borrowing or recapitalization.
The consequences of this distinction between current expenses and capital investment is the timing of the taxpayer’s cost recovery. The cost incurred will either be deducted immediately (expenditures) or capitalized and written off over a period of time by way of depreciation deductions or taken into account on a realization of gain or losses from property.
Generally, it’s preferable to write something off immediately as an expenditure (time value of money).
What is “carrying on” business?
Before you can carry on a business, you typically need to have a trade or business. and it needs to be in its operational phase.
The Tax Court held in Morton Frank v. Commissioner that a couple, travelling the country in search of a newspaper to buy, could not deduct their travel expenses and legal fees incurred in an unsuccessful purchase. The court said that when the expenses were incurred, the couple was not engaged in any trade or business.
This does not mean that costs incurred in seeking employment can never give rise to a 162 deduction. If the couple was seeking to expand an existing business, those expenses probably would have been deductible.
Start up expenses can be amortized under 195.
What if you’ve entered a trade or business, but are then unemployed?
The Treasury will not allow deductions under 162 for expenses incurred by individuals who have been unemployed for such a period of time that there is a substantial lack of continuity between their past employments and their endeavors to find new employments, but the length of time necessary to establish this substantial lack of continuity remains uncertain.
An employee’s expenses in seeking employment elsewhere but in the same trade are deductible, whether or not successful. Success is not an element in the deductibility of employment-seeking expenses.
“Reasonable salaries”
Included in the definition of “ordinary and necessary” business expenses is a reasonable allowance for salaries or other compensation for personal services actually rendered. The purpose is to prevents gifts or dividends are being disguised as salary.
What are “reasonable salaries”?
Exacto Spring Corporation v. Commissioner
Company paid CEO in excess of $1 million in annual salary. IRS thought it was excessive. The Seventh Circuit said that judges aren’t equipped to determine the proper salaries of corporate officers. Judge Posner discards traditional multi-factor test for reasonableness and adopts a “independent investor test.” When investors in a company are obtaining a far higher return than they had reason to expect, a managers salary is presumptively reasonable (this could be rebutted with facts that show the return is not due to the manager’s exertions).
Other circuits have retained a multi-factor test, looking at things like the scarcity of qualified employees, the qualifications and prior earning capacity of the employee, etc.
Harolds Club v. Commissioner
The brains behind a gaming establishment had a contract with the owners (his sons) that paid him a small annual salary plus 20 percent of yearly net profits. Company claimed the salary as a business expense deduction. Over four years, the club did very well and the brains got more than he ordinarily would under a straight salary agreement. The key is whether this type of contingent fee contract was the result of a “free bargain” when signed. This is a question of fact. Here, there brains dominated his adult sons, so it wasn’t a free bargain, and therefore, wasn’t reasonable.
Note: the regs say that if independent parties make a compensation agreement at arms length, and its reasonable at its inception, the company will get the full deduction in later years, even if it is no longer reasonable.
Congress has imposed a $1million ceiling on the amount a publically held corporation may deduct in any year as remuneration for services performed by a covered employee (generally this is the CEO and four highest compensated officials).
This doesn’t have much teeth, however, because corporations will just swap in incentive contracts, which can’ be deducted if negotiated at arms length.
Other possible business deductions. §162 and § 274
Business meals and entertainment
Limitations
Only 50 percent of business meals and entertainment is deductible
The business meals or entertainment must be “directly related to” or “associated with” the taxpayer’s trade or business.
In other words, business must go on during the meal or entertainment. (meals while travelling on business away from home are not subject to this limitation)
Meals can’t be lavish
Expenses related to entertainment facilities, such as yacht, summer homes, club dues, are not deductible.
This does not apply to facilities used for businesses or non-entertainment purposes – that’s still deductible.
It also doesn’t apply to entertainment associate with such facilities (i.e. lift tickets are 50 percent deductible as an entertainment activity even if the cost of renting a ski home are not).
Travel
A taxpayer can deduct travel expenses, including meals and lodging, if reasonable, incurred away from home, and are motivated by the exigencies of the business. A taxpayer is “away from home” only if gone overnight.
Expenses are not deductible if you choose to live away from work for personal reasons.
Business gifts
Deductible up to $25 per recipient.
Uniforms
A common deduction for employees is the cost of obtaining and maintaining a work uniform. The uniform must be specifically required as a condition of employment and not of a type generally adaptable to general or continued usage (uniforms for military personnel are for general use and generate no deductions).
Advertising
Advertising expenses are generally deducible for the year in which they’re incurred (unless the expense is capital in nature, such as the construction of a billboard).
Advertising that could be classed a political contribution is not deductible
Dues
Dues paid to organizations directly related to one’s business (i.e. bar dues) are deductible under 162.
Lobbying expenses
Generally nondeductible. This includes all amounts paid for influencing legislation, participation in political campaigns, attempting to influence the general public with respect to elections, etc.
§ 195. “Start up” expenditures.
Startup expenditures are defined as:
amounts incurred investigating the creation or acquisition of an active trade or business
creating an active trade or business
activities engaged in for profit before the day on which the active trade or business beings in anticipation of such activity becoming an active trade or business.
The section is inapplicable to people seeking first time employment
A taxpayer can deduct up to $5,000 in the year a business begins, reduced by the amount of start up expenditures exceeding $5,000.
Remaining expenditures are amortized over a period of not less than 180 months from the month in which the business begins.
§ 165. Business losses
§ 165 discusses whether a transaction or event that produces a loss is deductible. This section is the switchboard for all losses.
For corporate taxpayers, all losses are deductible.
An individual taxpayer can only deduct some losses.
Any loss “incurred in a trade or business” is deductible. § 165(c)(1).
Only realized losses are taken into account. A loss must be evidenced by a closed and completed transaction.
Amount of deduction: Take the lesser of the decrease in FMV or the adjusted basis, then subtract any insurance or other reimbursement received or expected to be received
Exception: If there is depreciated property (the FMV at time of destruction is less than the adjusted basis), and there is total destruction, you can take the higher number as the loss (if you don’t give a full basis deduction, you’re left with basis but not asset).
Carryover and carry-back
We have long had statutory provisions that permit operating losses in one year to be utilized in a redetermination of tax liability for another year. § 172. This is really an income averaging device.
You can carry back losses two year and carry them forward twenty. The loss must be utilized, to the extent that it can be, in the earliest year, except that the statute permits an elective relinquishment of the carryback period.
A net operating loss is generated when a corporation’s allowable deductions for a tax year exceed its gross income.
Depreciation
For income tax purposes, §§ 167 and 168 treat depreciation as if it were an operating expense by allowing an annual deduction for wear and tear of property
167 provides the basic authorization for depreciation. The deduction is limited to
property used in a trade or business
property held for the production of income
Does not include inventory
Intangible assets can be depreciated when a useful life is determinable but this is called “amortization” instead of depreciation. It if governed by 197.
When a taxpayer claims depreciation on property, the deduction is attended by a commensurate reduction in the basis of the property.
The downward adjustment required is at least the amount of depreciation deduction permitted under the depreciation method employed by the taxpayer. You can’t time depreciation deductions for your own convenience. Basis is reduced even if the taxpayer claims no depreciation deduction.
Section 168 (the Accelerated Cost Recovery System) governs the depreciation of tangible property. If it applies, you must use 168. Any depreciation not governed by 168 is kicked back to 167.
You need to know three things to depreciate:
Adjusted basis
Useful life
property with no useful like ,ie. land, artwork, can’t be depreciated. If a taxpayer purchases land with building on it, he has to divide the purchase price between the two
use the 168(c) and 168(e) tables to determine recovery period
Method of depreciation
Process for determining the deduction
1) Determine what type of property it is and what is its useful life.
2) Determine the cost of the asset (basis + adjustments)
3) Determine the recovery period
Tangible: 3/5/7/10/15/20 years
Intangible: 15 years
Residential real property: 27.5 years
Nonresidential real property: 39 years
4) Choose your method of depreciation according to its recovery period. Your options are:
Straight line
200% (method for 3, 5, 7, 10 year personal property)
150% (method for 15 and 20 year property)
168(g) – extended straight line deduction for certain properties
5) Apply the conventions
Half-year (standard)
mid-month (applies to real property)
mid-quarter (applies when the aggregate bases of depreciable property put into use during the last three months of the year exceed 40 percent of the total amount of depreciable property put into use in the year
6) Do any extra deductions apply?
168(k), 179
LIMITATIONS ON TAX SHELTERS
The code has several restrictions aimed at tax shelters – circumstances in which a taxpayer generates deductions in excess of income from one activity to avoid tax in some or all of the income from another unrelated activity.
Hobby Loss Provision: § 183. To deduct an annual loss, the taxpayer must demonstrate that a significant purpose of the venture was to earn a profit. If not, you can only reduce you income for THAT activity.
183 will be satisfied if the taxpayer produced a profit for two of the last five years.
If you get past § 183 (and most businesses do), then § 465 comes into play.
At risk limitation: § 465. Limits a taxpayer’s deductible losses from a specific business or investment activity to the amount he actually has at risk in that activity. The distinction between recourse and nonrecourse debt matters here. If it’s recourse debt, you can include it in your at-risk amount. If it is non-recourse, you can’t include it in your at-risk amount..
If you get past § 465, then § 469 applies
Passive Activity limitation: § 469. A person engages in a passive activity can’t deduct the losses except against income from passive activities.
Material participation:
500 or more hours per year, or
Does all the work, or
> 100 hours and no one else worked more than that
Materially participated for five out of the last 10 years.
(married individuals can combine work to meet these tests)
Passive activities include: limited partnership interests, all rental activities.
Whatever is left after these three screens can be used to offset other income.
CAPITAL GAINS AND LOSSES
Capital gains are taxed under special rules. Capital losses are subject to some limitations. Every transaction needs to be examined to see if it involved a capital asset as defined by §1221.
Note: capital gains recognized by a corporation do not receive favorable treatment.
Whether gain or loss is capital, as opposed to ordinary, depends upon:
whether it arises in a transaction involving a capital asset
A capital asset is almost everything. It does not include business assets, inventory, accounts receivable, collectibles
whether the capital asset has been the subject of a sale or exchange
how long the taxpayer has held the asset
Capital gains
The tax rate for capital gains has been, historically, less than that for ordinary income.
When you have capital gains in excess of losses, you have to separate net capital gain into net short term gain and net long term gain. the short term component is taxed at regular rates. the long term component (called net capital gain) gets a special rate under 1(h).
The gain from the sale of a capital asset held for more than one year is taxed at 15 percent (unless you’re in the lowest tax bracket, in which case it’s taxed at 0 percent)
If the taxpayer acquires the asset by gift, the holding period is cumulative.
If the taxpayer acquires by inheritance, it is automatically considered a long term capital asset.
Other rates (use unless the ordinary tax rate is lower, in which case, use that)
Gains from the sale of collectibles is taxed at 28 percent
Depreciation recapture is taxed at 25 percent.
Corporations treat capital gains the same ways as ordinary taxpayers.
Capital losses
Corporations can only deduct capital losses to offset capital gains. They can carry excess capital loss back three years and forward five years
If you are an individual (not a corporation) and have excess capital loss, you can take 3000 and use it against your actual income. Any excess can be carried forward indefinitely. The biggest problem with that is that you might die in the meantime. If you die before you use it all, it expires.