Morgan Stephens

INDIVIDUAL TAX OUTLINEFALL 2011

DAVIS

IntroductionCh. 2 – Gross IncomeCh. 3 – Effects of an Obligation to RepayCh. 4 – Gains Derived from Dealings in PropertyCh. 5 – Gifts, Bequests, and InheritancesCh. 6 – Sale of Principal ResidenceCh. 8 – Life Insurance, Annuities, & IRAsCh. 9 – Discharge of IndebtednessCh. 10 –Personal Injury & Sickness

Ch. 11 – Fringe BenefitsIntroduction to DeductionsCh. 15 – Losses and Bad DebtsCh. 12 – Business and Profit-Seeking ExpensesCh. 14 – DepreciationCh. 13 – Capital ExpendituresCh. 16 – Travel ExpensesCh. 17 – Entertainment and Business MealsCh. 31 – Capital GainsCh. 31 - Capital Losses

Introduction

I. WHERE DOES TAX LAW COME FROM?a. Early Days

i. During Civil War, tax imposed. Challenged after and struck down by the Courtii. Early 1900s, politics pits Western rural Americans against Eastern bankers

1. Most taxes came from property and heavy tariffs2. 16th Amendment- “The Congress shall have the power to lay and

collect taxes on income, from whatever source derived, without apportionment among the several states and without regard to any census or enumeration”

a. Previously had been considered a “direct tax” and therefore unconstitutional

b. 1913 Tax Act – beginning of modern income taxiii. WWI / WWII caused Income Tax to tremendously

1. Expanded tax base, i.e. tax more Americans2. WWII – withholding at the source, i.e. take money directly from your

paycheckb. Tax Law Today

i. Touches more Americans than any other source of lawii. Congress

1. Passes Tax Code, which is a system of taxation (Income x Tax Rate = Tax Liability)

a. What goes into gross income (i.e. the basket)?b. What is excluded from gross income?

2. Purpose of Tax Code

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a. Primary purpose is to raise revenueb. Secondary purpose is to carry out social and economic policy

i.Social – credit for adopting a child; energy efficient home credits

ii.Economic – dealing with spending money, not raising revenue

iii. Where does tax law come from after Congress? Two avenues of interpretation

1. Courts – interpret statutory language with “judicial gloss”a. Which Courts? Two with original jurisdiction

i.Tax Court – don’t pay tax, then contestii.Federal District Court – pay tax, sue seeking refund

b. Where do you appeal too? i.Circuit Court of Appeal

ii.If lose here, appeal to Supreme Courts2. Dept. of Treasury (Executive) Internal Revenue Service (admin)

a. Dept. of Treasury – make regulations which interpret the Tax Code

b. IRS – puts outi.Revenue Rulings – factual patters where IRS wants to

give guidance1. Lower level of authority than regulations2. To overturn regulation, must be contrary to

statuteii.Revenue Procedures – “how too” advice

1. Ex – want to do pension plan the right way, so make “darn sure” you’ve got it right.

iii.Private Letter Rulings – answers to specific tax payer question. Binding on service only with respect to that tax payer.

1. Ex – have merger, want to be tax free, so need assurance that transaction is tax free. Write letter to IRS disclosing material aspects, advocate for your side, and then ask service to rule in your favor.

2. Note – must attach letter to transaction, so may want to withdraw your request if getting negative feedback

II. HOW DOES TAX LAW WORK?a. Income Tax Begin with the total amount of income that will be taxedb. Tax Issues

i. Alimony – amount to replace costs of marriage1. Under § 71 – alimony is included in gross income of recipient spouse

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a. Giver gets deduction so that money isn’t taxed twiceii. Married people have two choices

1. File separate returns2. File joint return

iii. Child support1. No deduction to giver, no income to receiver2. Giving spouse pays taxes on the money

iv. Options for property after divorce1. Sell and divide proceeds

a. See § 121 – transfer of property not included in gross income, even if they wait to sell it

2. § 1041 (a) – No gain or loss when there is a transfer between spouses (or ex-spouses during divorce)

a. Transfers before marriage give rise to tax liabilityb. No one is taxed now, but will be taxed when sell the property

3. Continue to own it jointly4. One could buy the other’s share

a. Same issues apply as though the property is transferred to onec. Definitions

i. Income – gain on property subject to tax (sell price – buy price = income)ii. Amount realized – money amount you get for selling propertyiii. Basis – investment in the property; typically, how much you paidiv. Gain – same as “taxable income” (amount realized – basis = gain)v. General rules

1. Disposition of appreciated property is taxable, unless there is an exception

2. In taxes, one would always rather pay later that pay now, i.e. defer tax consequences until later date

d. Statute of Limitations i. Statute of limitations starts to run from the time the return is filed

1. If tax payer gets extension, statute of limitations does NOT begin to run until later date when return is filed

ii. Normal statute of limitations is 3 yearsiii. But, if tax payer…

1. Under-reports, may be subject to longer statute of limitations and stiff penalties

a. If by 25% or more, the statute of limitations is 6 years2. Does not file, then statute of limitations does not start and tax payer

will be liable forever3. Files but commits fraud, the statute of limitations does NOT start to

rune. Audits

i. Individual audit rate at 2-3%, which on its face seems low. But, higher for wealthy people.

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ii. Usually conducted in the 2nd yeariii. Types

1. Correspondence Audita. Lowest level where IRS sends tax payer letter stating that he

owes money. tax payer either sends money or explains that he doesn’t owe it

b. Have 30 days to appeal to IRS.i.Often able to settle some issues

ii.After 30 days have passed, get a 90 day letter2. Office Audit

a. Middle level where tax payer gets letter from IRS and must bring records to IRS office

b. Note – should not give IRS any more than is required, otherwise, may fish around and find something negative

3. Field Audita. Highest level – IRS comes to tax payer to look at books and

recordsiv. Possible Outcomes

1. Agent finds no additional tax liability2. Taxpayer gives up and pays3. Dispute

v. What if tax payer does owe more money after the audit?1. First , tax payer should try to negotiate a settlement price2. Second , if can’t reach an agreement, tax payer will receive a 30-day

letter (revenue agent’s report) stating that he owes money to IRS. tax payer’s options –

a. Concede liability and pay moneyb. Request an administrative appeal (cheaper than a trial)

i.TP may discover more of what the IRS will bring up in litigation

ii.To collect attorneys’ fees, tax payer must have first gone through the administrative process

c. Do nothingi.If tax payer doesn’t file appeal within 30 days, then his

rights are cut off3. Third , if tax payer does nothing, IRS will send a 90-day letter

(Statutory Notice of Deficiency or “ticket-to-tax-court”)a. During period, IRS can NOT seize any assets UNLESS tax payer

is a flight riskb. Options for tax payer -

i.File petition (same as complaint) in tax courtii.Do nothing – tax payer’s rights have ended, and IRS can

seize property4. Fourth , if tax payer loses in tax court, he has two options …

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a. Give up and pay tax deficiencyb. Appeal to circuit court

vi. Important Tips1. NEVER give IRS original document, simply make copies 2. tax payers have a right to representation during audits3. Potentially Dangerous tax payer list – If tax payer makes threat, put

on this list, and required to meet with agents in a federal buildingf. Which court will tax payer be in ?

i. Tax court – hears ONLY deficiency cases (i.e. tax payer owes more money to IRS)

1. Pro – do not have to pay tax in order to get judicial review / decision2. Con – NO jury trial

ii. District court – hears ONLY refund claims (tax payer overpays IRS, asks for refund, and IRS refuses)

1. Pro – can get a jury trial, which helps if client’s story induces sympathy

a. Can you convert deficiency into refund case to get a jury? b. Yes! Pay tax, and receive refund.

2. Con – government already has your moneyg. Ethical Issues

i. What to report is ultimately up to clientii. ALWAYS put lawyer’s advice in a letter or memo

Ch. 2 – Gross Income

I. FORMULA FOR CALCULATING TAX LIABILITYa. Net income * tax rate = tentative tax liabilityb. Tentative tax liability – credits = tax liabilityc. Additions found in § 61 et seq.d. Deductions found in § 161 et seq.

II. IMPORTANT CODE SECTIONSa. Gross Income – § 61b. Adjusted Gross Income – § 62c. Personal Exemption Deduction – § 151 – determined by Revenue Procedures

i. money3,700 currentlyii. Dependents? Kids § 152

d. Standard Deduction – § 63 – determined by Revenue Proceduresi. Single – $5,800ii. Married – $11,600

e. Tax Rates – § 1 – determined by Congressi. Series of rate brackets in tables ii. Progressive rates – as income rises, rate rises

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iii. Today, rates are adjusted for inflation due to the Reagan-era Congressiv. Marital status is important

f. § 7703 – Determination of Marital Status i. Joint Tax Return = J & S Liabilityii. Innocent Spouse Relief – limits liability for spouses when …

1. It is an amount over a certain dollar limit;2. The spouse did not know of the inaccurate tax position (rare); AND3. The spouse did not benefit from the position taken on the return.

g. Note – mistake on form is NOT binding of federal government

III. TAX RATESa. Marginal Rate

i. Highest rate taxed at (excess over base amount)b. Effective Rate

i. Percentage paid in takes of total adjusted incomec. Capital Gains – typically <15%

i. Pull out of gross income because you get a lower rate

IV. GROSS INCOME DEFINED – § 61a. All income from whatever source derived, unless excluded by law, and including but

not limited to:i. Compensation for services, including fees, commissions, fringe benefits…ii. Gross income derived from businessiii. Gains derived from dealings in propertyiv. Interestv. Rentsvi. Royaltiesvii. Dividendsviii. Alimony and separate maintenance paymentsix. Annuitiesx. Income from life insurance and endowment contractsxi. Pensionsxii. Income from discharge of indebtednessxiii. Distributive share of partnership gross incomexiv. Income in respect to a decedent; ANDxv. Income from an interest in an estate or trust

b. Generally includes items that add to the taxpayer’s net worthc. Concerned with the substance received, not the form of income

i. Gross income may be realized in ANY form1. I.e., money, property, or services

d. Realization requirement – income is NOT taxed until realizede. Imputed income – NOT taxed

i. Property – homeowner vs. renter exampleii. Services – self-help, i.e. performing services for one’s self, family, friends, etc.

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V. SOURCES OF TAX LAWSa. U.S. Constitution

i. Pretty much all constitutional challenges are overb. Statutes c. Regulations

i. Binding on IRS and tax payersii. Are subject to challengeiii. What’s the standard for overturning regulations?

1. Tax regulations are held to the same standard (Chevron)a. Has Congress spoken directly on the issue? Is so, then the

statute must follow the intent of Congress – If not, can be overturned

b. Often however, regulations cover ambiguous parts of statutes, so the standard is agency’s answer based on a permissible interpretation of statute? If arbitrary or capricious, or manifestly contrast to the policy of the statute

i.Extremely high bar to overturn regulations2. This means that regulations can trump court cases

a. Treasury just needs to pass a new regulation to overturn an unfavorable ruling

d. Revenue Rulings and Revenue Procedures i. Created by the IRS, but not vetted by the Treasury Departmentii. These are binding on the IRS, but not binding on tax payersiii. Courts have used these rulings and procedures in different ways

1. Some give minimal to no weight2. Some, however, find that rulings and procedures can be useful

iv. Often, these are just a way for the IRS to put out information1. Question and answer guidance

v. Sometimes, however, it’s a shot across the bow1. A warning to change something

vi. Revenue Ruling 79-241. Rule – Barter for services IS taxable gross income

a. FMV of services taken in payment is amount realized2. What about situation were brother builds greenhouse for sister

because she did legal work for him?a. § 102 – presenting each other with gifts

e. Private Letter Ruling i. Written decisions by the IRS in response to taxpayer requests for guidanceii. Applies only to the tax payer who solicited the rulingiii. The tax payer can rely on the letter ruling even if the IRS got it wrongiv. May not be cited or relied upon as precedent

1. No one other than the requesting tax payer can rely on the private letter ruling

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2. BUT you can determine whether the IRS has a stance on a given issuev. You can always withdraw your request for a private letter ruling to avoid

negative rulingsvi. You are required to attach your private letter ruling, even if it is negative, to

your filingvii. Businesses used these private letter rulings to decide whether to go forth

with a transaction

VI. CASE LAW – Interprets vague or broad statutory language as well as regulationsa. Glenshaw Glass v. Commissioner

i. Touchstone for all future gross income questionsii. Facts – tax payer did not report punitive damages as income. Claimed not

income, because wasn’t earned by labor or capitol. iii. Held – Punitive damages are taxableiv. Analysis –

1. Court cites Eisner v. Macomber and distinguished from this casea. Macomber was about stock where income was NOT realized.

Therefore, NO change in the tax payer’s position.b. Here, income WAS realized

2. Court also cited Bruuna. Here, tax payer leased commercial building and allowed lessee

to make improvements. When lessee left, tax payer received an improved building

b. Improvements considered gross income3. Test for Determining Gross Income

a. Undeniable accession to wealth;b. Clearly realized by tax payer (when you recognize income);

ANDc. Tax payer has complete dominion

v. Rule – Compensatory and punitive damages awarded in trial ARE taxable ***

b. Cesarini v. United States i. Facts – Tax payer found money inside piano. Tax payer initially reported as

treasure and paid tax, but later filed an amended return seeking a refund.ii. Analysis –

1. Government cites revenue ruling, which isn’t always binding2. However, there was a regulation directly on point, which is ALWAYS

binding3. Treasure trove – when reduced to undisputed possession, income is

clearly realizediii. Rule –

1. Income is realized when discovered2. Thus, treasure trove is gross income when found (realization

event)***

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c. Roco v. Commissioner i. Facts –

1. Mr. Roco helped U.S. discover fraud against government and received reward through qui tam action. Roco’s were both accountants, and after looking for answer and finding none, filed separate returns. Mr. Roco did not claim reward in his return.

2. Qui Tam Action – action brought under statute that allows private person to sue for a penalty, part of which the government will receive

3. They had filed joint returns in the past, which suggests lack of good faith in filing

ii. Held – Court held that § 61 is Congress’ assertion to tax income to the constitutional limits; pay tax on award and 20% penalty

iii. Rule – Qui tam damages and rewards ARE included in gross incomed. Old Colony Trust v. Commissioner

i. Facts – Tax payer was deceased; Old Colony was executor of his estate. Tax payer’s employer paid his income taxes. Didn’t pyramid, but should have.

ii. Rule –1. A tax payer who has his tax paid for him by his employer receives

gross income in the form of the tax paid, and is liable for taxes on the tax paid.

2. Having someone pay your obligation is exactly the same thing as if you paid your obligation – it’s all gross income – no need for actual receipt of income, the benefit is sufficient

a. Satisfying the obligation of another is going to give the other person gross income

b. Glenshaw Glass does not require the accession to wealth to be “in hand.” Receiving the benefit of the item is sufficient to satisfy Glenshaw Glass.

iii. Notes –1. Creates an indefinite pyramid if employer continues to pay tax owed

on tax paida. Example 1 – Employee pays taxes by himself

i.Employer pays $167 in salary to employee – flat tax rate of 40%

ii.After tax, employee receives $100 in pocketiii.IRS gets $67

b. Example – Employer pays taxes for employee (compounding)i.$100 x 40% = $40

ii.$40 x 40% = $16iii.Government only gets $156 at first glance, but when we

keep compounding the IRS gets $67, the same as before

iv.BT = AT / 1 – r

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c. ***this matters for international employers who want to compensate their employees the same even though the tax structures differ from country to country***

e. Bargain Purchases i. Intentional – parties know the thing is worth more yet sold for less

1. Affects gross income because you receive some benefit2. Realization event3. Exercises dominion4. Often occurs within the context of employee stock options

ii. Unintentional – parties didn’t know the thing was valuable1. No realization event if the value of the object is not known2. Nothing changes once you discover it is worth more – it’s just like the

appreciation of stock (not taxable) – no realizationa. If the item is sold, then the gross income must be accounted

forf. McCann v. United States

i. Facts – Company flew employees to Vegas for fun, not businessii. Procedural History – why not in Tax Court? Because paid tax, sued for refund,

thus in Claims Court. Cases were consolidated for trial purposes.iii. Rule –

1. Compensation to employee in form of trip (non-cash benefit) is gross income

2. Cash bonus is NOT a Gift3. Requirement to go and meaningful business component would take

trip out of gross income4. Where is dividing line? Davis – issue of fact for the jury

iv. What are you required to include as gross income? FMV of trip 1. Ask – Primarily for the benefit of the company, or primarily for the

benefit of the employee? Substantive meetings?g. Tax Benefit Rule

i. A mistaken assumption regarding a tax benefit must be corrected in the second year

ii. Example 1. Rent building for 20K/year and deduct all because you plan on it

being business expense. However, 6 months into lease, you close business and live in building. Thus, you only spent 10K (6 months) as business expense.

2. The mistaken assumption (deduction of additional 10K) must be corrected the following year

h. Services / Property vs. Money as Income i. If services are paid for other than in money form, the FMV of the property or

services taken in payment must be included in incomeii. If services rendered at stipulated price, that price presumed to be FMV of

compensation received in absence of evidence otherwise

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iii. For business trips, examine facts to determine if business trip was really compensation (McCann)

Ch. 3 – Effects of an Obligation to Repay

I. LOANSa. A loan is NOT treatable as gross income because along with receiving money, tax

payer receives a an off-setting liability (debt) (i.e., NO accession to wealth)i. Thus, loan proceeds are NOT included in gross incomeii. Paying off a loan is NOT a deduction

b. Control i. Security deposits are NOT gross income for lender because has NO controlii. Pre-payment for services IS gross income for recipient because has controliii. Attorney refundable retainers are NOT gross income until attorney performs

services and payment is duec. Embezzlement / Extortion

i. NOT like a loan because with a loan, when money has been passed and agreement has been made that it will be repaid, the LH of repayment has

ii. With embezzled money, even if company knows money is gone, no acknowledgment that funds have passed hands or agreement to repay

1. Therefore, embezzled money IS gross income2. If repaid later, entitled to deduction

d. Discharged Loan – Although a loan is not gross income, the discharge of a loan is gross income the year it is discharged

II. Commissioner v. Indianapolis Power & Light Co. a. Facts – IPL sells power. Bad credit customers (5%) had to provide a deposit. Deposits

were NOT in a separate account, but were mingled with other monies.i. Interest paid to customerii. Company decides and can claim money for non-paymentiii. Customer can choose to apply money to another month’s billiv. To get deposit back, must establish credit worthiness

b. Arguments FOR gross income – pre-payment for servicesi. No separate account for deposit money, IPL had unfettered use of fundsii. Most customers (over half) will apply that money to bill

c. Arguments AGAINST gross income – security depositi. Interest goes to customer, suggest not IPL’s fundsii. money is within customers’ control because they decide if they want a

refund or bill credit. Thus, no unfettered control (NOT complete dominion).d. IRS – money is NOT really a deposit, but an advance payment for servicese. Rule –

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i. Security deposits are NOT gross income because holder doesn’t exercise control (have obligation to repay). WILL be gross income once monies applied to bill, though.

ii. Pre-payments for services, e.g., refundable retainers, are NOT gross income until holder of pre-payment is entitled to funds (service is performed) and it is gross income (dominion exists)

f. Holding – NOT gross income because IPL did not have control over what happened to money and therefore did not have complete dominion over money

III. North American Oil v. Burnet (1932) – “unfettered control”a. Facts –

i. Introduction1. Government thought it was the rightful owner of North American

Oil’s oilfield2. Set up a receivership to control the money until the legal proceedings

are resolvedii. 1916 – proceeds from oil put into escrow (receivership) because there was a

dispute over who owned the land. Did not report income.iii. 1917 – trial court ruled that NA Oil gets moneyiv. 1918 – file amended return for 1916 which included proceeds because of

1916’s lower tax rates (15% vs. 67%)v. 1920 – appellate court affirmed trial court’s decisionvi. 1922 – appeal rights expired

b. Issue – not whether NA Oil has gross income, but WHEN it became gross incomec. NA Oil’s Arguments –

i. Gross income in 1916 – before WWI started, tax rates were low. Court says NO, didn’t realize income that year! Highest rate in 1916 = 15%; highest rate in 1917 = 67%

1. Argued that revenues were earned in 19162. Court rejects this because NA Oil didn’t receive it then and only might

receive the moneyii. Gross income in 1922 – push liability as far into the future as possible when

they knew they could keep the income for sure1. Court says NO, income received in 19172. Fact that tax payer may have to give money back after appeals

process is an insufficient risk to warrant not reporting gross incomed. Holding – 1917 is the income year because that’s when NA Oil first became entitled

to money and actually received moneye. Claim of Right Doctrine

i. If a tax payer receives earnings under a claim of right and without restriction as to its disposition, he has received income he must report

ii. This is true even if tax payer may have to return moneyf. Imagine that NA Oil lost the appeal and in 1922 and was forced to pay the money

back; § 1341 tax payer has choice…

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i. If forced to pay money back, tax payer may either take a tax credit or deduction

1. Requirements a. Appearance that tax payer had an unrestricted right the year

taxes paidb. Deduction allowed because after year’s close, tax payer did

not have an unrestricted right2. Equivalent of allowing an amended return3. MUST be over $3K4. ***Tax payer’s choice will be based on which year has the highest tax

rate ii. Deduction v. Tax Credit

1. A deduction is a function of the tax rate, i.e., it’s worth what it saves tax payer

2. A credit is a flat (money for money) reduction of tax liabilityiii. If tax rate > in prior year when taxes were paid than in year tax payer wants

deduction; under § 1341, tax payer can get tax liability reduced by the exact amount they paid in the prior year rather than a percent deduction based on the tax rate

IV. James v. United states a. Facts – tax payer was caught embezzling, didn’t want to report money as gross

incomeb. Issue – whether embezzled funds are included in gross incomec. Arguments – James says that this is essentially a loan because he is obligated to

repay the embezzled fundsd. Analysis – Court got rid of old rule that illegal income is NOT gross income; loans

require consensual agreement (implied or in fact) that the money will be paide. Held – tax payer actually wins this case because James embezzled money at the time

the Wilcox exception was still in effect; the element of willfulness could not be proved because he was not trying to evade

f. Rule – illegal income IS gross income and therefore, taxable. If dollars are later repaid, there can be a deduction

i. To send someone to jail for tax fraud, must prove intent to defraudii. Why can James not use § 1341

1. See § 1341(a)(1) – Because it did not appear that “Tax payer had an unrestricted right to such item.”

2. His only option is the deduction

Ch. 4 – Gains Derived from Dealings in Property

I. § 61(a)(3) – “Gross Income” includes “gains derived from dealings in property”-a. GAIN – § 1001(a)

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i. GAIN is the excess of amount realized there from over the adjusted basis provided in § 1011

1. Amount Realized – Adjusted Basis = Gain2. Adjusted Basis – Amount Realized = Loss

b. AMOUNT REALIZED – § 1001(b)i. The amount realized from the sale or other disposition of property shall be

the sum of any money received plus the fair market value of the property (other than money) received

ii. Amount Realized = Money Received + FMV of Any Other Property Receivedc. ORIGINAL BASIS – § 1011(a)

i. The adjusted basis for determining gain or loss from sale or disposition of property shall be the basis determined in § 1012 (through purchase) + § 1016 adjustments

ii. Where you start out on your basis depends on how you acquired the property

d. BASIS OF PURCHASED PROPERTY = COST – § 1012(a)i. Use this for the purchase of propertyii. Cost = value paid in cash or exchanged in propertyiii. Example

1. Adjusted Basis = Bought stock for $1002. Amount Realized = Sold stock for $1203. Gain = $20

e. BASIS OF PROPERTY BY GIFTi. § 1014 – Inheritanceii. § 1015 – Gift

f. ADJUSTED BASIS – § 1016i. Proper adjustments shall be made for expenditures, receipts, losses, or other

items, properly chargeable to capital account [money spent on improvements]

ii. Keeps track of your investment in the propertyiii. Example

1. Original Basis = Bought house for $100K2. § 1016 Adjustments = Improved by $10K (capital improvements)3. Adjusted Basis = $110K4. Amount Realized = Sold house for $120K5. Gain = $10K

II. REFINANCINGa. Two parts

i. Borrow enough to pay off old debt, so get lower interest rate.ii. Use money for other purposes

b. Woodsom – borrowing is NOT a realization event, so don’t have to recognize gainc. Refinancing a property mortgage does NOT change tax liability

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i. However, if more money is taken out upon refinancing, look to see where money was spent

ii. If money spent on remodeling, an adjustment to basis must be made (§ 1016)

III. BASIS OF PROPERTY ACQUIRED IN TAXABLE EXCHANGE a. When two pieces of property of equal value are exchanged, it is no different than a

cash transactionb. §1001 – Amount Realized = cash received + FMV of other property receivedc. Philadelphia Park

i. Facts – tax payer owes railroad franchise for 50 years. Build Strawberry Bridge for $10K. Later, tell city in return for 10 year extension on franchise, will give city Bridge. City agrees.

ii. Rule – 1. Basis of property received = FMV of property received, NOT FMV of

property given upa. Makes NO difference if the values areb. Only matters when the value of the property changes

between contract and closing2. If for some reason the property received can NOT be valued, assume

that property given up and property received have = valued. Questions to ask in determining tax liability with an exchange of property –

i. What is the Amount Realized? 1. §1001 – cash received + FMV of other property received

ii. What was the Adjusted Basis?1. 1011 – Adjusted Basis = basis (determined by §1012) and adjusted as

provided by §1016a. §1012 – Basis of property = costb. §1016 – Adjustments to basis made for

i.Expenditures;ii.Improvements; and iii.Depreciation

iii. What is the taxable Gain?1. Gain = Amount Realized – Basis

iv. What is the basis taken in the new property acquired?1. Philadelphia Park – basis = FMV of property received

Ch. 5 – Gifts, Bequests, and Inheritances

I. INTRODUCTIONa. Although gifts, bequests, and inheritances satisfy Glenshaw Glass (i.e., accession to

wealth, clearly realized, complete dominion), there has always been an exception to their inclusion as gross income of the recipient

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b. § 102 resolves the issue of whether to tax giver or recipienti. Gifts and bequests shall NOT be treated as gross income of the recipientii. Income from property received as a gift, bequest

1. NOT excluded from gross incomea. E.g., rent received from gift of apt. is taxable

2. Also, gifting income derived from property is NOT excludeda. I.e., giving rent payments from this part for next year

iii. Employer to employee gifts NOT excluded from gross income – §102(c)(1)1. Doesn’t apply to transfers between related parties if purpose can be:

a. Substantially attributed to family relationshipb. and not employment

c. What happens to the donor of gifts and bequests?i. NOT entitled to deduction, UNLESS it goes to a charity

d. Also, giving a gift is NOT a realization event by the donor i. If donor paid $60K for lot, it appreciates to $100K, and donor gifts the lotii. Donor does NOT have to recognize gain of $40K because there has been NO

realization event

II. GIFT DEFINEDa. Factors

i. Given in “detached and disinterested generosity . . . out of affection, respect, admiration, charity, or like impulse.” Duberstein

ii. Party’s intent is dominant factor in determining whether transfer is gift or income

iii. *Theme – compensation for services NOT gift

b. Cases i. Commissioner v. Duberstein

1. Facts – Duberstein given Cadillac for providing business contacts2. Test – interested in donor’s intent, i.e., “detached and disinterested

generosity out of affection, admiration, or respect”a. Question of fact

ii. Wolder v. Commissioner 1. Facts – Amount received by lawyer from client’s will2. Issue – Was compensation for services rendered by lawyer during

decedent’s lifetime or a bequest?3. Test – Whether in actuality the gift is a bona fide gift or simply a

method of paying compensationa. Examination of the parties’ intent, reasons for the transfer,

and parties’ performance in accordance with their intentions4. Held – this was income because purpose was to compensate

iii. OLK v. United States1. Facts – Casino worker regards tokens as compensation

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2. Rule – Casino tips are not gifts, because not given out of detached and disinterested generosity

a. Ultimate receipts are not distinguishable from wages – regularity of flow, equal division of receipts, daily amount received would lead reasonably dealer to think its compensation

iv. Goodwin v. United States1. Facts – congregation gave “bonuses” to pastor2. Rule – Regular, sizeable payments made by those to whom services

are provided is taxable income to the recipienta. Bonuses included in gross income

3. Factors to consider – routine, large amount, formality of process, relationship of declared salary to market value of services

c. More Gift Issues i. § 102(c) – “gifts” from employers to employees are NOT gifts and are,

therefore, NOT excluded from gross incomeii. § 274 – disallowance for certain entertainment (money 25 per person per

year)1. Doesn’t apply to employment situations – see § 102(c)

III. PROPERTY TRANSFERS AS GIFTSa. Introduction

i. A non-cash gift MUST have a basis, as cash is already taxed to donor (see § 1015 for basis of property acquired by gifts)

ii. Donor’s basis is transferred to recipient to become recipient’s basisiii. Donor is NOT taxed, because no realization eventiv. Recipient is taxed when there is a realization event (i.e., when recipient sells

property)b. Recipient’s basis from a GIFT

i. § 1015 – recipient of a gift takes the donor’s basis, with exceptions explained below

1. Generally, step into shoes of the donor 2. Happens when FMV of property at time of gift is greater than donor’s

basis3. However if FMV of property at time of gift is less than (loss property)

than donor’s basis . . . a. Sold for gain = general rule (step into donor’s basis)b. Sold for loss = basis is FMV at date of gift

ii. Example – X buys a stock worth $1001. Basis – how did you get it? Purchase = go to § 1012 = $1002. Overtime, FMV of stock then increases to $150

a. If you sold it = $50 of gain3. Give stock to child

a. Is the giving of a gift a realization event? No

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b. Donor has no gainc. Child’s basis is determined by § 1015 = step into the shoes of

the donor which is $100 in this example4. What about the $50 of gain that accrued?

a. Shifts tax liability to childb. I.e., if child sales stock, he has $50 in gainc. Pro-tax payer because the recipient often sits in a lower tax

bracketd. *one of the few places you can shift income between tax

payers5. If while child holds stock the FMV plumages to $90, and child sells =

$10 of loss which the child could deducta. If loss of value occurs while the parent still hold the stock

($100 to $90). THEN give the child the stock while it’s worth $90. Stock continues to fall and child sells for $80.

b. ***Exception to § 1015 says you CANNOT transfer loss from the donor to the donee***

i.Child can only deduct the loss that occurs while it’s in his hands, not the $10 it lost while the parent owned the stock

ii.Child basis is FMV at time of giftc. YOU CANNOT deduct the $10 loss after you gift the property

i.BAD idea to gift loss property6. If it loss $10 in your hands ($100 to $90) and you give to child. Child

sells stock for $120. Child needs to recognize $20 of gain because his basis was $100!!!!

c. Recipient’s basis from BEQUEST i. § 1014 – recipient’s basis

1. FMV of property on date of decedent’s death, or an alternate amount (basis determines amount of estate tax)

2. The gain on property acquired by bequest is NOT taxed3. No gain or loss recognized

ii. Estate taxes – amount of person’s value must be taxed (NOT an income tax)iii. Exception – if transfer made to dying person (who bequests back to original

owner) within 1 year of death, basis for recipient/original owner is his original basis, NOT FMV at date of death

1. Way around exception – original owner transfers property to his/her parent who bequests it to original owner’s child

2. My Ex – Mom gives property to Grandma, who bequests it to williv. Note – Bush tax cuts halved estate tax. If not renewed, will go

IV. GIFTS TO CHARITIES a. If tax payer gives substantial amount to charity, may claim deduction pursuant to

§ 170, even though no realization event

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i. Deduction = FMV of item(s)ii. Policy – encourage people to donate to charities

b. If tax payer has made a part gift / part sale to a § 501(c)(3) organization rather than a relative, § 1001(b) states that she must divide the basis up in the two portions of the transaction

i. The amount sold is proportional to the basis tax payer can useii. Ex –

1. If tax payer sells ½ the property, then she gets to use ½ the basis2. If tax payer sells 20% of the property, then she gets to use 20% of the

basisc. Tax payer does NOT get to deduct for part sale / part gift if he sells for < basis

i. Ex – if basis is $20K, FMV is $50K, and tax payer sells for $15K; NO deductiond. In a non-charitable sale, tax payer uses ALL of the basis

Ch. 6 – Sale of Principal Residence

I. FACTORS FOR PRIMARY vs. PRINCIPALa. Family is locatedb. Tax payer receives mailc. Tax payer does his bankingd. Car is registered/titlede. Tax payer is registered to votef. Tax payer has his driver’s licenseg. Tax payer pays state taxesh. Time spent at residence (most important factor Guinan)

II. EXCLUSION FOR GAIN ON SALE OF PROPERTYa. §121 – gross income shall not include gain from sale or exchange of property, if

during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by tax payer as the tax payer’s principal residence for periods aggregating 2 years or more

i. Use 2 out of 5 years – do not count vacations or short temporary absencesii. What if you can’t meet the 2 out of 5 years? See 121(c)

1. Even if you can’t meet the 2 out of 5 years, you can still get some of itb. § 121 Sympathy Provisions

i. To qualify, tax payer must . . . 1. Use house as principal residence; and 2. Use house for 2 years out of 5-year period, going back to date of sale

ii. §121(b) – Exclusion shall NOT exceed . . . 1. 250K for a single person; OR2. 500K for joint return3. Only 1 sale or exchange ever 2 years

iii. §121(b)(4) – Unqualified Use

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1.2. After you meet the 2 year out of 5 years requirement, you don’t have

to remain there the next 3 years to receive full exclusion!iv. § 121(d)(7) – out-of-residence care

1. If incapacitated and cannot live in house, then lack of meeting use requirement immaterial

v. § 121(c) – job transfers that result in sale of principal residence within two years of last use of this exclusion

1. Tax payer gets to exclude a proportionate amount of total exclusion available

2. Multiply total exclusion available by following fraction . . .a. Numerator = length of time tax payer owned and used house

as principal residence (in years)b. Denominator = 2 (always for two years)

3. If old house sold after moving, tax payer must use as numerator amount of time (years) that tax payer has owned and used new house SINCE the sale of old house

4. To qualify for a reduced maximum exclusion (i.e., less than 2 years at principal residence), sale or exchange must be by reason of a change in employment, health, or unforeseen circumstances

vi. § 121(d)(3) – if spouse dies, living spouse may use decedent’s ownership / use to qualify for § 121

III. LIMITS ON § 121 EXCLUSIONSa. $250K for single returnb. $500K for joint return IF:

i. Either spouse meets ownership requirements;ii. Both meet use requirements; AND iii. Neither spouse ineligible because used exclusion in past two years

c. More Issues i. Can use exclusion for one sale or exchange every 2 years ONLYii. If a purchase, then basis is § 1012 cost basisiii. Ownership and use do NOT have to be for the same periodsiv. Periods can be aggregated, but for principal residence, must be considered

principal residence for the whole year to count towards 2 years1. In other words, tax payer can’t take 5 months out of each of the 5

years to add up to 2 years2. However, if the house that tax payer lived in for 5 months is

considered principal residence for that year, then that year counts toward the 2 years

d. What is deductible?i. Interest on mortgageii. Property taxes on home

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IV. DIFFERENT TAX SYSTEMS OPERATE SIMULTANEOUSLYa. Income tax

i. Differs from excise taxes because comes due every yearii. Figured off of gross income

b. State property taxes i. Come due annually ii. Figured off of property values

c. Sales tax i. Excise tax payable upon saleii. Figured off of value of goods sold/purchased

d. Estate and gift tax (aka gratuitous transfer tax) – i. Excise tax payable upon transferii. Figured off of value of property transferred

e. *Tax planning must consider ramifications with regard to each tax system

V. REMAINING ISSUESa. If tax payer has 2 houses and sells one for $30K gain and other for $500K gain,

should NOT use exclusion on first sale because his spouse will only be able to deduct $250K on second sale

i. Better to use full $500K on second saleii. If single, use full $250K on second sale

b. If divorced and one parent gets to stay in house until child turns 18 and then sell house, both parents get to exclude because the one not living there gets to use the other’s use period

VI. CAPITAL GAINS TAXa. Capital assets

i. Held for > one yearii. Some taxed at 15% (special rates), some 25% (unreported depreciation),

some 28% (collectibles)iii. Character of asset determines the tax rate. § 1(h)iv. Defined in § 1221

Ch. 8 – Life Insurance, Annuities, & IRAs

I. INTRODUCTIONa. These three topics are tax-advantaged investmentsb. Types of tax-advantaged investments

i. Returns are excludable1. Ex – local municipal state bond earned interest.

ii. Deferral of tax liability1. Ex – tax payer can place money (pre-tax) into an IRA2. Benefits of deferred tax liability

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a. Tax payer can put money before taxes, so there’s more moneyb. Interest earned is tax free

II. INSURANCE a. Life insurance [§ 101]

i. Gross income does NOT include amounts received under life insurance contract, if such amounts are paid by reason of the death of the insured

ii. Terminal illness provision – exclusion applies to early payments made under policy to insured with terminal illness who is not expected to live more than 24 months

1. I.e., proceeds will be excluded just as they would if paid by reason of death

iii. § 101(d) 1. Exclusion does not apply to post-death earnings on life insurance

proceeds. 2. E.g. if insurer holds on to payout for 12 months, any interest accrued

which beneficiary receives is Gb. Three Categories of Life Insurance

i. Term life1. Pure insurance protection, no value built up. Tax payer makes bet

with insurance company that he will die during term; if he dies, he wins. If he doesn’t die, insurance company wins.

a. Risk component only (no savings component)b. Premiums go up with age because you’re more likely to die

(factors also include history, smoking, etc.)2. Tax Treatment

a. During contract – no tax treatment; CANNOT deduct premiums

b. Death proceeds excluded under § 101(a); also can get it early if terminally ill and allowed by contract

c. Cancellation – only get back unearned/unused premiumsii. Whole Life / Ordinary Life

1. Buying insurance and investing2. More expensive than term life in early years but less expensive in

later yearsa. Fixed / level premiumb. Contract renewable year-to-year

3. Two components of premium a. Pure riskb. Excess (after transactional costs) – invested by insurance co.;

earns return like savings would, except tax-free while appreciating

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c. *As time goes on, pure risk price rises and less money is invested, but investments earn money (tax-free building, unlike savings)

4. Payout a. Cash Surrender Value =

i.Savings Component + Investment Return – Fee Withheld by Insurer Upon Cash-In

ii.CSV – Premiums paid = gain (included in gross income)b. If cashed in prior to death, Gain Realized = Cash Surrender

Value – Total Premiums Paid i.Total Premiums Paid includes both risk and savings

component, which is a tax benefit! ii.Only time tax payer would have any gain is if cash

surrender value > total premiums paid, which is unlikely

1. Cash surrender value is the amount realized $25k

2. Premium and investment constitute basis $15k3. Gain $10k

iii. Modified Life1. Not really life insurance contracts2. Like whole life but with huge savings component and very small risk

component3. Primarily an investment vehicle, NOT a life insurance vehicle4. Certain % where savings is too high for it to still be considered life

insurancec. If life insurance proceeds payable to lender, remaining spouse will NOT have any

gross income even though she inherits spouse’s portion debt-freei. Lender does NOT have any gross income since money goes to pay off loanii. NOT because of § 101 but § 1001; i.e., AR – AB = 0iii. If lender is ALSO seller (i.e. seller-financing), then gain would still be AR – AB

1. Seller who sells on installment note can recognize the gain because payment is received [§ 453]

iv. Analysis1. Separate out two diff components2. Treat ins like ins, treat investment like investment

v. Investment1. Tax payer must pay taxes each year on interest2. No deferring

d. Consequences of Ending Policy i. Death – § 101 – life insurance proceeds paid “by reason of death of insured”

are excluded from gross income; same effect as a bequest. ii. Cancellation

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1. Term – get unused portion of premium – NO gross income (just re-payment of unused money)

2. Whole – get cash surrender valuea. Since not paid by reason of death, taxableb. Better tax consequences than typical investment [amount of

cash surrender value -- TOTAL premium paid = taxable gain]c. May sound good, but tax payer has to pay for insurance also,

so costs go upe. Other Insurance Policy Issues

i. Delayed payout1. Ins policies can have delayed payouts2. Reasoning – beneficiary is a minor and money meant for college

ii. “Insurable interest”1. Tax payer must have an insurable interest in order to take out an

insurance policy on someone else2. Policy -

a. Prevent abuse – i.e., may kill that person or push that person to suicide

b. Must have some interest in keeping that person alivei.Can take out a policy on close family member and close

business partnersii.Policy for one’s life is transferable

iii. How to obtain an ins policy1. Buy it yourself; OR2. Have existing policy transferred from someone else3. *Makes a difference for tax purposes, because tax benefits do NOT

transfer with policiesiv. Transfers – Limits on exclusions on transfers [§ 101(2)]

1. Gain on policy is taxable to recipient2. Ex –

a. Co. has policy on John worth $250K; it sold policy to 3rd party for $60K; 3rd party made additional payments of $40K.

b. 3rd party’s TI is gain of $150K (statute says get to exclude basis)

III. ANNUITIES a. Like life insurance, but with slightly different framework

i. Contractual right to series of paymentsii. Tax payer pays money in, tax-free buildup of money, then distributed

through payments over timeiii. Usually meant for retirement

b. Types of Annuities i. Deferred ii. Nondeferred

c. Defined

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i. Fixed stream of payments made over some time in return for a later payout, usually over a period of time

ii. Ex – 1. Pay $10K to insurance co for annuity2. In return, will get $1.5K per year for 10 years (adds up to $15K)3. Each of the payments will be part basis and part gain

iii. Taxed on withdrawald. Exclusion ratio for annuities [§ 72]

i. Amount received as an annuity * (Investment in K / Expected Return) = amount excluded

ii. In previous ex., $1.5K * ($10K / $15K) = $1K excluded and other $500 included

iii. Cumulatively, excludable income = $10K (amount of investment) and included income = $5K (amount of gain)

iv. Makes sure you get your basis back, tax freee. Payout for Indefinite Period (i.e., remainder of life)

i. Use regulations table of life expectancy to figure expected return1. After all of investment is paid and tax payer is still living, then all of

amount is includable income2. If tax payer dies before all of investment paid, then tax payer’s estate

will get a deductionii. Typically, annuities pay out for the life expectancy of two people

1. Longer life expectancy is usedf. § 72(q )

i. 10% penalty for taking out payments earlyii. Exceptions –

1. Payment made after tax payer turns 59½2. Payment made after death of holder3. Payment taken because of disability

iii. Congress trying to encourage retirement savingsg. Benefits

i. Inside tax-free buildupii. Additional deferral of tax liability on payout

h. Problems i. # 1

1. § 72(b) – 1K * (5K / 10K) = 500 exclusion, 500 TIii. # 2

1. 1K * [10K / (28.6 *1K)] = 350 excluded, 650 TIa. Pg. 929 – mortality chart

iii. # 31. 350 * 3 = 950 deduction already received. Thus, at death, may deduct

10K -- 950 = 8,9502. Whose deduction, decedent or estate of decedent? Here, decedent’s

iv. # 4

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1. See § 72(b)(2) – once use investment in K (get full 10k return), all other payments are fully taxable

v. # 51. Joint survivor annuity – agree to pay over life span of two people,

going till whoever lives longest dies2. Must consult joint survivor annuity table3. 1K * [10K / (33.6 *1K)] = 298 excluded, 702 TI

IV. INDIVIDUAL RETIREMENT ACCOUNT (IRA) a. Started out relatively simple, but have become complicated

i. Max deductible amount is $4K, unless tax payer is over 50 years old, then $4.5K

ii. Types1. Non-Deductible2. Deductible3. Roth

iii. INSIDE TAX FREE BUILDUP1. While the money is sitting in your IRA, you won’t be taxed

iv. To make IRA, all you have to do is designate account as IRA and fulfill the requirements of being an IRA

1. Holds pretty much every investment vehiclesv. Timeline of IRA

1. Pay-in2. IRA while it sits there (tax free)3. Payout

b. Non-Deductible IRA i. Least advantageous IRA

1. Earn money, taxed on money, put money in IRA, inside tax-free buildup until retire payout taxed pursuant to § 72

2. Same tax advantage as annuityii. NO deduction when tax payer adds moneyiii. Benefit –

1. Not taxed on earnings as long as funds are in IRA2. Inside tax-free build-up, so taxed on withdrawal

iv. There are penalties for pulling out money early1. Policy – encourage saving for retirement

c. Deductible IRA i. Advantageous IRA

1. Earn money, NOT taxed on money put in IRA, inside tax-free buildup until retire payout taxed pursuant to § 72

2. You get a deduction; fund your investment with untaxed dollars3. If you had $100 for IRA, you would not have to pay the normal $30 of

taxii. Pre-tax dollar investment

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iii. Inside tax-free build-upiv. Taxed on withdrawal / receipt of money

1. Taxed on full amount at payout because NEVER taxed due to initial deduction

d. Roth IRA i. Advantageous IRA

1. Earn money, taxed on money, put money in IRA, inside tax-free buildup, NOT taxed at payout

ii. NO deductioniii. Tax-free inside buildupiv. NO tax on payout/receipt of dollars by tax payer if withdrawn for appropriate

reasonsv. Has more flexible rules on contribution and withdrawal

e. Deductible vs. Roth IRA i. All things equal, the tax advantages are the same IF TRs remain the same

over time1. If TRs , Roth IRA better2. If TRs go , Deductible IRA better3. *TP can NOT predict what rates will do, but can only guess

ii. Questions to Determine which to Choose1. Does tax payer have a spouse?2. Is tax payer covered by an employer plan?3. How much total income does tax payer make?

f. Problems – pg. 157 (9/27 at 15 mins)i. 1

1. Deductible IRA2. Nondeductible IRA3. Roth IRA

ii. 2 (around 1:00)1. Payment x (nondeductible contributions/value at end of year +

distributions)

Ch. 9 – Discharge of Indebtedness

I. INTRODUCTION a. Discharge of indebtedness IS gross income [§ 61(a)(12)]

i. Firmly established, so no issue whether its gross incomeii. Only issue is whether tax payer has a discharge of debt

b. Kirby Lumber i. Too broad, because could apply to situations where there is not accession to

wealthii. Also, too narrow, because leads to insolvency issues where get freed of debt

c. Views

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i. Traditional 1. If someone pays off your debt, you are receiving a benefit which is

taxable2. Ex – if a corporation issued bonds and then bought them back at a

lower amount, that is taxableii. Accounting fix

1. Only tax discharge of debt if it was money you expected to repay2. Ex – give a gift to brother legally, but before you actually gave it to

him you hit hard times, and he said “don’t worry a/b it”d. Other Issues

i. Contingent debt – only considered your liability if “more likely than not that you will have to pay”

ii. Discharge by employer – relief of debt by an employer can likely be considered compensation and t/f gross income

iii. Gift – if the debt relief can properly be considered a gift under § 102/Duberstein, it will not generate gross income

II. DOES TAX PAYER HAVE DISCHARGE OF INDEBTEDNESS INCOME? a. Does tax payer have debt relief?

i. Contested debt – there is NO debt relief if the amount of debt was never certain

ii. Disputed price doctrine – FMV is disputed because there were defects in the property not discovered until after the sale

1. Ex – tax payer gets a bill for money10K; he disputes the bill; bill is reduced to $5K.

2. There is NO gross income for the reduction in priceiii. § 108(e)(4) – acquisition of debt by relative

1. If a qualifying family member pays off your debt, it is treated as if debtor paid it off

a. Ex – if tax payer allows family member to pay off a debt at a discount, unless tax payer has an exclusion, then the relief of debt is gross income

2. BUT, by the family member to you will likely be a gift (assumed)b. Is there an exclusion exemption?

i. Insolvency exemption [§ 108(a)] 1. Gross income does NOT include any amount which would be

includable in gross income by reason of discharge of indebtedness if it occurs because of Title 11 bankruptcy or insolvency

2. Note – this isn’t a permanent exclusion, but only a deferrala. ONLY applies to dischargeb. If give/sell property to pay debt, then gross income

3. “Insolvency” means the excess of liabilities > FMV of assetsa. Look at this immediately before the dischargeb. Example

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i.Liabilities = 200kii.Assets = 160kiii.Insolvency of 40k which is excludable

ii. Tax payer can only exclude the amount liabilities > assets1. Price of using § 108(a) § 108(b) – the amount excluded from gross

income shall be applied to reduce tax payer’s tax attributes2. Result – at some later point, tax payer must reduce a tax attribute by

the amount he excluded under § 108(a)3. Basis – tax payer always has the option of reducing his basis in

property, which defers paying the tax (best option)iii. Payment would have generated deduction [§ 108(e)(2)]

1. No gross income if payment of the discharged debt would have given rise to deduction

2. Implicit inclusion and deductioniv. Purchase price adjustment [§ 108(e)(5)]

1. Regardless of how the value changed, this exclusion could potentially apply; treated as a reduction of purchase price

a. Must reduce tax payer’s basis – if you get money back, adjust basis accordingly

b. Must be the same buyer and seller2. If buyer got a loan or seller sold the note, the exclusion would not

applyv. Purchase price adjustment (PPA) when debt was acquired for a business

purpose [§ 108(a)(1)(D)]1. Exclusion for tax payers that are not insolvent when renegotiate and

not same buyer/sellera. If debt on property was relieved by the person holding the

note, it may be excludedb. MUST be a debt on real property acquired by an individual in

connection with a business or trade2. This exclusion is used when the PPA would not apply because the

same buyer/seller are not still in the deal3. Again, tax payer must reduce a tax attribute after he uses this

exclusiona. Promotes “work outs”b. Can NOT reduce below FMV, though

vi. Problem 3 – 10/4 at 36 min1. Bill

a. Bill borrows 200k from Judyb. Bill becomes insolvent and Judy says she’ll take the property

(worth 150k) he owns and forgive the remaining 50k in debtc. Bill has a disposition of property -§ 1001

i.What’s the amount realized? 150k – same as if he sold itii.Basis is 50k (fact pattern)

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iii.Bill has a 100k of gain on the disposition of property1. No excluded under § 108

iv.50k of relief of indebtedness (because he’s insolvent)1. Excluded under § 108

d. FMV of assets vs. liabilitiesi.225k vs. 250k = insolvent

ii.***contingent debts are more likely than not that the tax payer would have to pay the debt*** Here, 50/50 chance so not included

iii.Insolvent by 25k, therefore, of the 50k of relief of indebtedness income, he can excluded 25k – the other 25k is included in his gross income

2. Judya. Basis in land is 150k = FMV of property receivedb. Also entitled to a bad debt deduction of 50k because Bill still

owed her moneyvii. Problem 4 in my book

1. Compensation for services income IS NOT deducted from gross income if your insolvent

III. IN OTHER WORDSa. Income from discharge of indebtedness – § 108 provides exclusion for discharge of

indebtedness income IF tax payer is insolventi. Limited to amount of insolvency immediately before dischargeii. Tax payer is also required to adjust basis in other property as result of

exclusioniii. The excludable amount of discharge of indebtedness is based on the amount

of the tax payer’s insolvency1. Position tax payer takes depends on whether he is insolvent (Gehl)2. A bankrupt gets to exclude

b. Acquisition of indebtedness by person related to debtor – § 108(e)(4) i. Definition of family; exclusion applies to non-family (basically people with

economic interests)1. Members of family include –

a. Individual’s spouse, children, grandchildren, parents and any spouse of children or grandchildren

2. Individual and a corporation with more 50% of corporation’s stock3. Two corporations that are members (owned) of the same controlled

groupii. Underlying assumption

1. Related 3rd party who pays off the debt will NOT want to collect itiii. TREATED AS RELIEF OF INDEBTEDNESS INCOME!!!!

a. See Problem 4c. Year debt relief occurs is year it is included

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i. As long as there is dispute, there is no dischargeii. Ex – tax payer borrows $5K and repays $3K; he is not insolvent; lender

forgives the rest of the debt1. If lender is local bank, then there is $2K of gross income2. If lender is tax payer’s employer, then there is $2K of gross income

because an employer cannot give a gift3. If lender is tax payer’s brother, then tax payer can argue that it is a

gift

IV. TO FIT UNDER § 108a. Tax payer must be insolvent, as defined by tax code (Liability > assets)b. Discharge of indebtedness that would otherwise be included in gross income

i. Exclusion – § 108(c) – qualified real property indebtedness

V. TWO CATEGORIES OF DEBTa. Recourse

i. Lender can obtain collateral AND OTHER ASSETS for paymentii. Most is this typeiii. Any unsatisfied amount of debt after recourse must be paid

1. Secured or unsecured debt2. If forgiven, considered relief of indebtedness (likely happens where

assets are shitty or non-existent)iv. Disposition of Property / Relief of Indebtedness

b. Non-Recourse i. Lender can obtain only collateral which stands as securityii. Risk of loss is on the lenderiii. Typically, it is a higher interest rate and/or a bigger down paymentiv. Always secured debtv. Disposition of Property

1. AR = amount of debt satisfiedvi. NO RELIEF OF INDEBTEDNESS WITH NON-RECOURSE DEBT

c. Generally, lender reduces debt amount only if debtor is insolvent because lender wants to get at least some money

d. Typically, the debtor can exclude this relief of indebtedness income because he/she is insolvent. § 108.

Ch. 10 – Compensation for Personal Injury & Sickness

I. INTRODUCTION TO DAMAGESa. Business/Contractb. Damage to propertyc. Personal injury [§ 104] – types of income excluded from gross income

i. A tort or a tort-type injury

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ii. Divided into physical and non-physical1. Physical – damages are further divided into compensatory and

punitive

II. DAMAGESa. Business/Contract cases – Raytheon

i. “In lieu of what were the damages awarded?”1. In lieu of what did tax payers receive the damages?2. Ex – damages are “in lieu of” lost profits

b. Damages to property i. Ask for FMV of destroyed property and probably lost profits if it’s commercial

propertyii. May be able to ask for rent of temporary work placeiii. Ask for interest, tooiv. *Involuntary disposition – if forced sale due to destruction of property and if

reinvest money, then tax deferredc. Personal injury

i. Physical1. Must be physical to get § 104 treatment and be excluded

a. Ex – pain and suffering, lost income, loss of consortium, medical expenses

2. Punitive damages are included/taxable3. If in car and it gets damaged, it does NOT fall in § 104 – look at

property damage section4. If tax payer has previously deducted medical expenses, he can NOT

deduct them laterii. Non-physical

1. If tax payer does NOT have a physical injury, then ALL damages are taxable

2. See § 62 and other sectionsd. Awards for Damages

i. § 104(a)(2) – were the damages received on account of personal physical injuries or physical sickness and not previously deducted under § 213?

1. Do NOT ask “in lieu of what” in personal injury cases; only ask that question in business and property damages suits

2. If you get into § 104(a)(2) then the damages amount is not taxable3. Punitive damages ARE included in gross income

ii. Damages for personal injuries requirements –1. Tort or tort-type2. “On account of”

a. Schleier – age discrimination suit where court emphasized that key question in applying § 104(a)(2) is whether the damages received were “on account of”, i.e., actual compensation for personal injury

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b. Damages are “on account of” personal injuries for § 104(a)(2) purposes ONLY IF they bear a close nexus to the personal injury

i.“The injury justifies the damages” or the damages intended to compensate tax payer for personal injury and consequences are causally linked to the injury

ii.If that relationship between the damages and personal injuries does not exist, no exclusion is available

c. Schleier doesn’t really matter anymore because of the amendments to § 104 – added “physical”

e. Medical Expenses – § 213 i. Can deduct medical expenses that are not compensated for by insurance or

otherwiseii. First 7.5% of AGI is not deductible

III. MONEY TO AND FROM INSURANCE COMPANY a. See §§ 104-106b. Payments for insurance plan

i. Tax payer paid (own insurance) [§ 104]1. NOT gross income2. Sometimes entitled to deduction, sometimes not

ii. Employer-provided 1. Purchased [§ 106]

a. NOT gross income for employersb. Government wants to encourage employers to provide insc. Tax exempt for employers

2. Self-insured [§ 106] – employer doesn’t go out and purchase, but tell employee “if you have expenses, we will pay them”

a. No specific exclusion or grant in § 106b. NOT gross income

c. Payments for insurance claimsi. Own paid [§ 104]

1. Not many limitations on what is excluded2. WC payments are excluded [§ 104(a)(1)]3. Exclude damages as long as employer did not provide [§ 104(a)(3)]

ii. Employer-provided 1. Purchased [§ 105]

a. Medical payments are excludedi.Only exclude up to your medical expenses

b. No restriction on exclusions2. Self-insured [§ 105]

a. Medical payments are excludedb. Self-insured plan must cover enough workers and not

discriminate in favor of the highly compensated [§ 105(h)]

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i.If doesn’t cover lower paid workers, too, then can’t take advantage of tax exempt status

d. Combination Plans i. If employer pays part of premium and tax payer pays part, then we must

allocate the % paid and allocate benefits paid accordingly

IV. V. Self Provided VI. Employer ProvidedVII. Medical Expenses VIII. 15K (fully

excludable)IX. 20K ($17,143)

X. Lost Wages XI. 10K XII. 12KXIII. Loss of Sight XIV. 25K XV. 20K

i. Employer Provided1. 20/35 * 30K (med. exp.) = $17,1432. Results in overpayment on employer side3. We can only exclude up to the medical expenses which means that

the $2,857 into gross incomeXVI. DENNIS RODMAN HYPO

a. Confidentiality agreement (gag order) – won’t defame, disclose settlement, won’t assist in criminal prosecution

b. Thus, which if these may be excluded from gross income? Must allocate between them

i. Were they on “account of physical injury?” ii. Almost every settlement comes with confidentiality agreement. Must

allocate some portion of award to agreement, thus including as gross income.

iii. “On account of” language starts to bite

XVII. ATTORNEY’S FEESa. Usually a contingency feeb. Ex – $1 million award; 40% goes to attorney. Options:

i. Plaintiff’s gross income is net award of $600Kii. Plaintiff’s gross income is $1 million and gets a deduction of $400Kiii. Problems

1. In option ii., tax payer may be overtaxed2. §§ 67 and 68 are hidden ways to get more money instead of being

taxed3. Alternative min tax – only allows a certain amount of deductions for

high income tax payersa. Not adjusted for inflationb. Takes away deductions

iv. Congress fixed problem of people being overtaxed by creating § 62(a)(20)1. Only for discrimination suits, though

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a. Problem: defamation and other non-physical injury suits are caught

b. Tax results in non-physical injury and non-discrimination suits are incoherent

c. Loss of consortium is excludable

Ch. 11 – Fringe Benefits

I. INTRODUCTION a. Statutory Fringe Benefits

i. Employee group term life insurance under $50K – § 79ii. Employer provided accident and health benefits – §§ 105 & 106iii. Dependent care assistance programs – § 129iv. Qualified retirement plans (§ 401)

II. Benaglia v. Commissioner (Tax Ct. 1937) – pg. 223a. Benaglias lived in a hotel suite in Hawaii and said they shouldn’t pay taxes because

they couldn’t do their job unless they were on site all the timeb. Court allowed the Benaglias to exclude from gross income the cost of the hotelc. Led to § 119

III. § 119 – Meals or lodging furnished for the convenience of the employera. MUST be

i. By or on behalf of the employer andii. For the convenience of the employeriii. Meals on the business premisesiv. Lodging – must accept as a condition of employment

b. § 119(d) Qualified campus lodgingi. Helps schools in communities with extremely high cost of livingii. Located in proximity to the campus and furnished to the employee for use as

a residence

IV. United States v. Gotcher (5th Cir. 1968)a. Facts –b. Holding – c. Rule – The value of any trip that is paid by the employer or by a businessman

primarily for his own benefit should be excluded from gross incomed. Notes –

V. § 132 – CERTAIN FRINGE BENEFITSa. Excludable benefits include

i. No-additional-cost service (extra seats) – § 132(b)(1)1. Must be for sale to customers

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2. Line of business requirement a. If a company has both transportation and hotel services, then

transportation employees may not exclude free hotel roomsb. However, performance of substantial services directly

benefiting more than one line of business is treated as the performance of substantial services in all such lines of business

3. Employer must not incur additional cost (not forgone revenue)a. Look at regulations

ii. Qualified employee discount – § 132(c)(3) 1. Limited to 20% of the price at which the services are being offered by

the employer to customers2. What about if employee gives the property as gift?

a. 1.132-3(b) – Giving property without consideration constitutes use by the employee

3. Basis for property4. What if these discounts are only available to executives?

a. § 132(j) – This would be a problem because you cannot discriminate in favor of highly compensated employees

iii. Working condition fringe – § 132(d) 1. Any property or services provided to an employee to the extent that

if the employee paid for the property or services himself, he would be allowed to deduct his cost as a business expense

iv. De minimis fringe – § 132(e)1. Property or services the value of which is so small to make accounting

for it unreasonable or administratively impracticable2. Consider the frequency as a factor for determining whether a benefit

is de minimisv. Qualified transportation fringe – § 132(a)(5)

1. Transportation in a commuter highway vehicle in connection with travel between employee’s residence and place of employment

2. A transit pass3. Qualified parking

vi. Qualified moving expense reimbursement – § 132(j)(4)

VI. ORDINARY INCOME VS. LONG TERM CAPITAL GAIN INCOME a. Different tax rates

i. For ordinary income, use the tax tablesii. For capital gains (if you’ve held them for more than one year), there are

three different levels in § 1(h)1. 28% rate – collectibles gains (artwork, antique rugs, coin collections)2. 25% rate – depreciation recapture3. 15% - other long term capital gains

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4. ***short term capital gain (less than one year) is taxed like ordinary income***

b. Capital gains – § 1221 i. Tend to be investments held longer than one yearii. Does not include –

1. Inventory2. Property used in trade or business3. Copy right, literary. Musical, or artistic composition, etc.

iii. Includes –1. Personal property

Introduction to Deductions

I. INTRODUCTION a. Review

i. What is gross income? [§ 61]ii. What deductions come back out?

1. Is tax payer entitled to a deduction? There is no deduction section like § 61, but § 62 defines adjusted gross income

a. Adjusted gross income means gross income minus deductions2. If YES, where in the tax process does the deduction come out?

Mechanical formulaiii. Typical Deductions

1. Trade or business deductions2. Production of incomes3. NOT personal expenses unless a section says it’s okay –

a. Casualty losses – § 165b. Mortgage expense – § 163c. Taxes – 165

b. Two Categories i. Above the Line

1. Listed in § 62a. All trade and business deductions

i.§§ 162 and 195b. Production of income (not all!)

i.Expenses associated with rents and royaltiesc. Alimony

ii. Below the Line1. Any deduction NOT listed in § 622. Subject to more limitations

a. Likely to have some or all disallowed3. Types

a. Production of income

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b. Personal expenses that are deductible iii. Why do we care?

1. The lower your AGI, the more you protect your deductions that are contingent on AGI

a. Medical expenses2. Must choose between itemized deduction or standard deduction

II. TAXABLE INCOME [§ 63]a. Allows tax payer to take either…

i. Standard deduction; ORii. Itemized “”

b. Once tax payer knows how much each are and decides which one to take, he subtracts from aggregate gross income to get taxable income

c. Formula i. § 61 Gross Income

1) Deductions in § 62 (ATL) ii. = § 62 Adjusted Gross Income

1) Personal exception2. Itemized deductions OR standard deductions

iii. = § 63 Taxable Incomed. Test for Deductions

i. Is tax payer entitled to deduction?ii. Are there specific limits on the deduction

1. There are specific limits in each code section that deal with deductions [§ 162]

2. Are there any specific disallowances?a. Under § 162 (trade or business deductions), (c) states that

illegal bribes, kickbacks, and other payments are not allowedb. Also, ALL expenses of illegal narcotics business

3. There can also be specific amount limitsa. I.e., medical expenses are deductible as long as re above

certain amt4. Timing restrictions

a. Tax payer entitled to deduction but not at this timeb. Ex – When tax payer buys equip, entitled to take deductions

throughout its UL (i.e. life is 10 years, so entitled to 10 years of deductions)

iii. Are there any general limits on the deduction?1. More difficult to characterize2. Passive activities

a. Tax payer can NOT offset professional fees with deductions from passive activity income

b. Ex

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i.If tax payer is doctor but also rents property, then can NOT offset income from doctor job with expenses from rental property

3. See §§ 67 and 68, which take away % of deductiona. Why? A backdoor way of making high income people pay

taxes without saying we’re going to raise tax ratesiv. Is the deduction above or below the line?

Ch. 15 – Losses and Bad Debts

I. INTRODUCTIONa. Purchasing assets creates a basis in each asset, after depreciation if applicable there

can be left over basis that is not recouped on saleb. Deductions allowed by §§165 &166 for losses and bad debts

II. LOSSESa. Introduction

i. § 165(a) – authorizes deduction for any uncompensated loss sustained during the year not compensated by insurance or otherwise

ii. § 165(c) – restricts loss deduction of individuals to –1. (1) Trade or business loses;2. (2) Losses in profit-seeking transactions not connected for trade or

business; OR3. (3) Shipwreck, fire, storm, casualty, or theft losses

b. Examples i. Bought rug for $15K (AB) in business and sold for $12K (AR) = $3K loss

1. § 165(c)(1) loss? Yes2. Only deduct $3K (up to AB of $15K)

ii. Bought stock for $10K (AB) and sold for $2K (AR) = $8K loss1. § 165(c)(2) loss? Yes2. Only deduct $8K (up to AB of $10K)3. § 1211 – General limit on capital gains = $3K

a. May deduct next $3K next year, and the rest in 2 yearsiii. Bought condo for $500K (AB) and sold for $400K (AR) = $100K loss

1. § 165(c)(3) loss? Noc. Business or Profit Requirement for Individuals

i. Must separate business / profit seeking activities from personal activities1. Trade or business is ATL2. Profit-Seeking is BTL unless its sale/exchange of property

ii. Note – Loss requires realization eventiii. § 165(c)

1. (1) losses incurred in trade or business;

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2. (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business

a. Ex – Loss investor incurs upon stock for lower purchase priced. When is a Loss Sustained?

i. § 1.165-1(b) – loss must “be evidenced by closed and completed transactions, fixed by identifiable events.”

1. Ex – Sale or exchange2. Not Ex – mere decline or increase in value

ii. Loss allowed for securities when they become worthless § 165(g)(2)e. Amount of the Deduction

i. §165(b) – Cannot deduct more that your basis ii. §165(a) – Loss is offset and deduction reduced when tax payer receives

insurance or other compensationiii. Loss happens and is reported in Year 1, reimbursement in Year 2

1. §§1.165-1(d)(2)/(3) – IF there is a reasonable prospect of recovery the loss in not treated as sustained until the matter of reimbursement is determined with reasonable certainty

f. Disallowed Losses i. Losses allowed under § 165 may be disallowed by other sectionsii. Ex – § 267(a)(1) disallows losses on related party sales

g. Conversion - § 1.165-9(b)(1) i. Actual rental is a conversionii. An offer to rent was sufficient to satisfy the “held for production of income”

standardiii. Basis for loss property at date of conversion is different than basis before

conversion – 1.167(b)1. Take FMV at time of conversion if less than AB OR take AB if your

property has appreciated at the time of conversion

III. BAD DEBTSa. Introduction

i. Special kind of lossii. If you loan money to someone then you have a basis of whatever you gave

them1. Loan $100K but borrower can only repay $25K then $25K is

deductable as a bad debtiii. §166 allows deduction for debts becoming worthless in taxable year to both

individuals and corporationsiv. §166(d) – business bad debts and non-business bad debtsv. §166(e) – Where debt is evidenced by a security, §165 applies

b. Bona Fide Debt Requirement i. §166 applies if there is a bona fide debt

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ii. §1.166-1(c) – Must be a debtor-creditor relationship based on a valid, enforceable obligation to pay a fixed or determinable sum of money . . . Gift is not a debt

1. When relationship is close, rebuttable presumption of giftc. Worthlessness

i. If not worthless, then no deduction allowed1. Forgiveness/cancellation of debt may be a gift and not worthless2. Even if not worthless, cancelled business debt may meet §162 and be

deductibleii. §1.166-2(a),(b) – not required to litigate to establish worthlessnessiii. § 6511(d) – Provides 7 year SOL for refund claims under §166

d. Business or Non-business Debts i. Business Debts

1. Deductible and apply to both kinds of tax payers2. §166(a)(1) – in the year they become wholly worthless3. §166(a)(2) – partially worthless ones are deductible up to the amount

charged off within year4. NOT SUBJECT TO §1211

ii. Non-Business Debts – covers both production of income and personal bad debts

1. Deductible only upon being wholly worthlessa. No bifurcating (dividing in two) of the debt allowed

2. §166(d)(1) – Deductible only as short term capital losses rather than ordinary losses as is case with business bad debts

a. ATL or BTL implications?3. SUBJECT TO §1211

a. Capital losses permitted = tax payer capital gains plus $3k 4. §166(d)(2)

a. Defines non-business debtb. Debt other than a debt created/acquired in connection with

the tax payer’s business or a debt the loss from the worthlessness of which is incurred in the tax payer’s business

iii. Shareholder employee has made un-repaid advances to a closely held corporation. Is it business or non-business debt?

1. Caselaw – controlling shareholders organizational, promotional, and managerial services to a corporation did not cause loans to the corporation to be business debts

2. §1.166-5(b) – Loan must bear proximate relationship to tax payer’s trade or business . . . business motive must be dominant

e. Amount Deductible i. Amount of bad debt deduction = ABii. §1.166-1(e) –

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1. No bad debt deduction is allowed unless amount uncollected have been included in income, which is not the case with cash method tax payer

2. However, accrual method tax payer would be able to get deductionf. Guarantees

i. §1.166-9 – 1. Losses arising out of loan guarantees are bad debts2. Characterized as business or non-business based on connection to tax

payer’s trade or business

IV. BAD DEBTS AND LOSSES – INTERPLAY B/T §§165 & 166a. Tax payer’s may seek to characterize a loss under either §165 or §166b. Examples –

i. Investment related losses are subject to capital loss implication of §166, but not under §165

ii. Personal losses are not allowed under §165, but a short term capital loss is allowed under §166

1. So long as bona fide, personal debts are deductiblec. IF both provisions apply, §166 is followed

Ch. 12 – Business and Profit-Seeking Expenses

I. INTRODUCTIONa. What does § 162 require?

i. “Ordinary” and “necessary”ii. Expenseiii. Paid or incurred during the tax yeariv. Carrying onv. Trade or business

b. Types i. “Reasonable” allowance for salaries

1. Factual inquirya. How are similar employees paid?b. What responsibilities does the employee have?

2. Executives’ salarya. Should not be interested in what businesses pay their CEO but

should consider how much the CEO is earning for the company – look for what a reasonable investor would be satisfied with

ii. Traveling expensesiii. Rent or lease payments

c. Clothing Expenses i. 3-prong test for deductibility (Donnelly; Pevsner)

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1. Clothing is of a type specifically required as condition of employment2. NOT adaptable to general usage as ordinary clothing3. NOT so worn

ii. Use objective test because subjective would be inconsistentd. What if you don’t meet one of the requirements?

i. Trade or business1. 162 or 165

ii. Transaction for production of income1. 212 or 165

e. Illegal bribes, kickbacks, etc. - § 165(c) i. No deduction allowed

II. ELEMENTS OF § 162 DEDUCTIONa. Ordinary

i. Definition1. Expenses that are customary or expected in the trade or business2. What occurs normally in business

a. Common within life of group or communityb. Unifying theme – is this really personal, OR is it really adding

to carrying on trade or business?ii. Two-Part Test

1. Ascertain the purpose or motive of the taxpayer in making the payments and

2. Determine whether there is sufficient connection between the expenditures and the taxpayer’s trade or business

iii. Welch v. Helvering (1933) 1. Facts – Worked for company that went out of business. Paid off some

of their expenses so he could go back to work. Wanted to use § 162 deduction.

2. Held – Court said NO, not ordinary expense to pay debts not yours to legally pay

a. Expenses that are customary or expected in the life of the trade or business in which the tax payer is involved

3. Rule – In order to be deductible, an expense must be “ordinary” in the business area practiced by the tax payer

a. Is it outside the norm or strange?iv. Jenkins v. Commissioner

1. Facts – Pay off debts not legally obligated to pay. Wanted to use § 162 to deduct business expenses

2. Held – Court allowed3. Rule – Ascertain the motive of making the payment and determine if

there is sufficient connection between expense and tax payer’s trade or business

4. How is this different from Welch?

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a. If didn’t pay debt, would damage his reputation as country signer

b. Davis – maybe, Welch just didn’t have good enough proof. Needed to be customary in the business involved

v. Pevsner v. Commissioner (5th Cir. 1980)1. Facts – Pevsner employed at a boutique that only sold women’s

clothes designed by Yves St. Laurent. Pevsner was required to wear the Yves St. Laurent clothes while working. She purchased $1,381.91 worth of clothes and wore them exclusively at work. Deducted cost of clothes as a business expensive. IRS disallowed the deduction, contending she could have worn the clothes away from worth. Tax court allowed deduction and IRS appealed.

2. Holding – Reversed3. Analysis –

a. Clothing was clearly a condition of employment. However, it was only by choice that Pevsner failed to wear the clothing away from work

b. Because the clothing was adaptable to ordinary use the deduction cannot be allowed

4. Rule – Clothing cost is deductible as a business expense only if the clothing:

a. Is specifically required as a condition of employmentb. Is not adaptable to general usage as ordinary cloth andc. Is not so wornd. Uniforms, safety clothing

b. Necessary i. Appropriate and helpful in carrying on trade or business

1. Fairly low standard UNLESS it’s too personal2. BUT remember yacht cases where guy tried to say that his yacht got

him clients – really just a personal expenditure where he’s trying to disguise as a business expenses

ii. Policy –1. Rule could be “absolutely” necessary, but government would be

interfering and second guessing business owner’s decisionsiii. Note –

1. Kickbacks NOT necessary2. Davis –

a. Judge was offended and thought kickbacks were against public policy. Wrongly decided.

b. NO public policy disallowance, must be found specifically in Code

iv. NOT extraordinary1. Translates into “not too unusual”2. Changes with time

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a. Pro – flexible standardb. Con – unfair to forward-thinking businesses

3. Must be sufficiently related to the business (minister case)4. Can’t be too large

c. Expense i. Ordinary and necessary expenses are used up in current tax year or lasts

beyond the current tax yearii. NOT an expenditure that will benefit multiple tax years (i.e. not capital

expenditure)1. If you buy front end loader to move plywood over several years –

cannot deduct full price of front end loader in first year (rather take depreciation deductions

d. Paid or incurred in tax year i. Methods of accounting

1. Casha. Focuses on actual receipt or payment within yrb. Most people use this type for tax purposes because easierc. Turns on when paid

2. Accruala. Focuses on right to receive income rather than actual receiptb. Uncommon methodc. Turns on when incurred

ii. *Difference – determines when tax payer takes deduction / timing of deduction

e. Carrying on i. Must already be in the businessii. Costs of opening a business are NOT deductible under this sectioniii. If working up to trade or business but not quite there, § 195 will cover you

f. Trade or Business i. Selling a product or services with intent to make profit ii. Business must be open to qualify for § 162 deductions – for expenses before

this time, see § 195 for start-up expendituresiii. Test for trade or business (Higgins)

1. “Tax payer must be involved in activity with continuity and regularity and tax payer’s primary purpose for engaging in activity must be for income or profit”

iv. Higgins v. Commissioner (1941)1. Full-time investor for own benefit

a. Court said with investing, even if full-time and trying to derive profit, NOT trade or business because no customers

2. Divided profit-seeking into two categories –a. Trade or businessb. Investing on own behalf (not as trader)

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3. To fix this problem, Congress enacted § 212 so that investing expenses ARE deductible

v. Commissioner v. Groetzinger (1987)1. Gambling can be a trade or business if it rises to a certain level2. RULE – Tax payer must

a. be involved in the activity with continuity and regularityb. primary purpose (intention) is income or profitc. *sporadic activity, hobby, amusement or distraction will not

qualify3. BUT does not over rule Higgins - § 212 still applies

III. OTHER SECTIONSa. § 165

i. Provision for loss of property value1. Ex – toxic dump moves in next door

ii. Can NOT take deduction for property value loss UNTIL realization, i.e. when tax payer sells property

iii. NOT deductible under this section for personal or family expenses (i.e. home)b. § 212

i. Provision allowing investors to deduct expensesii. Investors may deduct here when not allowed to deduct under § 162

1. Difference between this section and § 1622. Matters because there are special limits for BTL deductions (i.e. some

§ 212 deductions)c. § 195 – Start-up Expenditures

i. Relief provision for opening business1. Benefits small business in first year

ii. Limits1. Less than $50K in start up expenses – must deduct when business

starts!2. In between $5K and $50K in start up expenses

a. Say $14K – deduct $5K now and then spread remaining $14K evenly over 180 months – divide $14K by 180 = how much you can deduct each month

3. More than $50K in start up expenses – no current deduction (phase out)

iii. What is a start-up expense?1. Expenditure that is paid or incurred with investing or creating2. Ask, if I was already in a trade or business, would those expenses be

deductible under § 162? If yes, then they qualify under § 195

Ch. 14 – Depreciation

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I. INTRODUCTIONa. Deduct costs of generating income, i.e. recover of capital before disposition

i. Cost Recovery System – allows tax payer to write off or deduct capital investment over specified period of time (recovery period)

ii. Purpose is to allocate the expense of using an asset to the various periods which are benefited by that asset

b. Issues –i. What property is subject to depreciation?ii. Over what period may one’s costs be recovered through depreciation

deductions?iii. What method will be used for computing the amount of the depreciation

deductions?

II. COMPUTING THE DEPRECIATION DEDUCTION a. § 168(a) – depreciation deduction for tangible property shall be determined by using

–i. Recovery periodii. Applicable depreciation methodiii. Applicable convention

b. Steps i. Begin with adjusted basis of the property. §1.167(g)-1ii. Second, determine appropriate recovery period

1. §168(e)(3) classifies property 2. §168(c)(1) provides applicable recovery period

iii. Third, determine applicable depreciation method. §168(b)(1)1. §168(d)(1) provides applicable convention.

iv. Fourth, find depreciated rate from appropriate table in Rev. Proc. 87-57 (pg. 344)

1. Use unadjusted basis for year to year computation

III. METHODOLOGYa. Depreciable Property

i. § 167 – Reasonable allowance for the exhaustion, wear, and tear (including a reasonable allowance for obsolescence) of depreciable property, i.e.:

1. Right kind of asset (suffers wear and tear)2. Must be used RIGHT NOW (not when you purchased it)

a. In trade or business; ORb. For the production of income

3. Tax payer must be one who suffers lossii. § 1.167(a)-2 – Assets that do not decline in value predictably are Non

Depreciable:1. Land (see 167(e))2. Stock (see Reg. 1.167(a)-3)3. Artwork

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iii. Note – 1. Cannot depreciate personal residence2. Antiques suffer wear and tear, so depreciable. Famous paintings,

however, not depreciable.b. Recovery Period – The Useful Life Concept

i. Depreciating a capital asset is recognizing an expense over the period of life of the property

1. How long is this period of life? 2. Longer Useful Life = smaller deduction 3. Requires asset-by-asset determination

ii. Accelerated Cost Recovery System (ACRS) in 19811. Meant to stimulate economy2. De-emphasized useful life concept by assigning all tangible property

to one of vie recovery periods based on the asset’s “class-life” as defined in § 168(i)(1)

3. Classified most real property as 15-year property4. Most tangible personal property classified as 3 or 5 year property

a. Property with no assigned class life, e.g. 19th century violin from Simon, treated as 5 year property

iii. Modified Accelerated Cost Recover System (MACRS) passed in 19861. Expanded number of recovery periods and lengthened recovery

period of real property and some tangible personal propertya. Nonresidential real property = 39 yearsb. Residential rental property = 27.5 yearsc. Most important other categories

i.3 year – race horse when training beginsii.5 year – autos, computers, trucks, copying equipmentiii.7 year – default or catchall

1. I.e., furniture, fixtures, and equipment2. 168(e)(1) “Class life” – midpoint life in the Asset Depreciation Range

(ADR)a. Provides 3, 5, 7, 10, 15, and 20 year class livesb. If not specifically listed in § 168, use § 168(e)(1) which

converts class life to recovery periodc. If you can’t find it anywhere, it’s 7 year property

iv. Selig1. Tax payer allowed deduction on exotic autos owned and exhibited for

a fee at car shows2. Rule – autos must be subject to obsolescence; failure to show useful

life irrelevant c. Depreciation Methods – Three Types

i. Straight line Depreciation1. Simplest

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2. §1.167(b)-1 – cost or other basis of property less its estimated salvage value deductible in equal annual amounts over the period of the estimated UL of property

a. Formula – Cost of Asset / Number of years in Recovery Period = Deprecation Allowance

b. §168(b)(4) – Salvage value treated as zero, thereby allowing tax payer to recover entire cost of property during recovery period

3. 27.5 or more recovery period – Use Straight line4. §168(b)(3) – requires tax payer to use the straight line method to

depreciate residential rental property and nonresidential real property

ii. Accelerated Depreciation1. Permits larger deductions in early years, i.e. “front loaded”2. Methods

a. Declining balance (150%) – §1.167(b)-2(a)i.With 15 & 20 year property used in farming business,

use this methodb. Double declining balance (200%)

i.168(b)(1) – with 3,5, and 7 year property, this method shall be used, but tax payer shall shift to straight line method in the year that method, if applied to the adjusted basis at the beginning of such year would produce the larger deduction

1. I.e. once use declining method, switch over to straight line when it becomes more advantageous

iii. §§168(g)(2),(7) – allow tax payer to elect an alternative depreciation system allowing the tax payer to depreciate property over a longer time period using the straight line method

d. Conventions i. Assumption of when property gets placed into service, which determines

recovery period when depreciation may be claimed1. Real Estate – mid-month – assume placed in service on 15th of month2. Non-real Estate – half-a-year – assume all assets placed into service

on July 1ii. §1.46-3(d)(1)(ii) defines “placed in service” as placed in a condition or state

of readiness and availability for the specifically assigned function iii. Anti-Abuse Provision – §168(d)(3)

1. IF properties placed in service during last three months of year have aggregate bases greater than 40% of the aggregate bases of all properties place in service that year, a mid-quarter convention will apply instead of half year convention

2. When you’re calculating depreciated rate look at Table 5 (pg. 348)

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3. Applies to all assets!!!

IV. §179 – EXPENSING TANGIBLE PERSONAL PROPERTYa. Allows tax payer’s to expense (deduct currently) the cost of acquisition of certain

depreciable business assetsb. Applies to §179 property only

i. §179(c) – tangible personal property acquired by purchase for use in the active conduct of a trade of business

ii. §179 Limits deduction amount to 500Kc. Ex – Sale of Business

i. Buyer will want equipment with low UL periods and fast depreciation methods

ii. Seller will want purchase price allocated more to property for capital gain purposes

iii. Service will poke around terms of deal when neither party agrees on how to value each asset

d. Three part process –i. § 179 – 500K limit ii. §168(k) – deduct half remaining basisiii. Regular § 168(a) depreciation from remaining basis after § 168(k) deduction

V. AMORTIZATION OF INTANGIBLES a. Amortization – depreciation for intangiblesb. IRC Authority

i. § 167 – if have intangible asset with limited useful life, entitled to amortization deduction, i.e. straight line deduction for useful life of intangible. May ignore salvage value. If can’t estimate useful life, may use 15 years (catchall).

ii. § 197 – 1. Goodwill, covenants-not-to-compete, patent, copyrights

a. Calculate goodwill by adding up physical assets and subtracting from purchase price – this leaves you with a number for goodwill

2. If have asset falling within § 197, must be amortized over 15 yearsc. §197

i. Allows tax payer’s to amortize certain intangibles over a 15-year period using a straight line deduction

ii. Answers issue of whether an intangible has a limited useful life which can be estimated

VI. CASES /REVENUE RULINGSa. Revenue Ruling 68-232

i. Valuable art piece not considered depreciable property because did not have determinable UL

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b. Simon v. Commissioneri. Holding – allowed professional violinist to depreciate 19th century bows

c. Liddle v. Commissioneri. Holding – allowed professional musician to depreciated 17th century bass viol

d. Revenue Ruling 89-25i. Issue – If a home-builder temporarily used new houses for models and/or

sales offices, were the houses subject to an allowance for depreciation?ii. Rule –

1. “Used” means more than beneficial or held for sale2. I.e. “actually used in the trade or business”

iii. Holding – NO

Ch. 13 – Capital Expenditures

I. INTRODUCTIONa. Earlier in Semester

i. With disposition of property, had to determine basis. Got back tax free when disposed of asset. Thus, question of timing as to when get tax benefit.

ii. Capital expenditures are similar, in that often question of timing.1. Ex – Bulldozer is capital expenditure. 10 year UL, over time will get

“used-up.” Use depreciation to take tax-benefit over time. Deduct certain amount each year for 10 years.

2. What assets are depreciable? a. Depends on wear and tear or obsolescenceb. Land? Doesn’t get physically used up or obsolete

3. By saying something capital expenditure and not deductible doesn’t mean will never get benefit!

b. General Definition i. Look at § 263 and Reg. 1-263(a)-1(b)ii. Look at § 162 and its regulationsiii. Look at case law

1. Lincoln Savings and Loana. Anything that creates a separate and distinct asset will be

capital expenditure not currently deductibleb. Acquisition costs all are capital expenditures and become part

of basis in property2. Acquisition of assets

a. Tax payer must capitalize costs of acquiring property that will NOT be used up in one year

b. Two types of assetsi.Purchased

1. Capital expenditure2. Look for acquisition costs

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ii.Self-created. Idaho Power1. All costs have to be included, i.e. –

1) Design phase2) Direct costs – materials, labor, etc.

- Cannot deduct wages3) Indirect costs – administration, overhead, etc.4) Use of equipment (bulldozer)

2. Tax payer disagreed a/b including use of equipment as capital expenditure.

1) Contended entitled to § 167 depreciation expense.2) Government didn’t allow, as should be included in basis

of building and depreciated over building’s life.3. After Idaho Power, Congress enacted § 263A

which is Idaho Power with limits1) “Casts a pretty wide net” to include such expenses as part

acquisition costs, i.e. capital expenditures2) Not just direct costs, but indirect costs!

3. Mount Moris Drive-in Theatera. Facts – drive in theater causes drainage problems for

neighbor. Fixes by installing drainage system. b. Issue – capital expenditure?c. Analysis –

i.Yes. Should have done from beginning1. It would have been a capital expenditure then

and should be a capital expenditure nowii.Concurrence – meets definition of capital expenditure

4. INDOPCO, Inc. a. Facts – specific corporate takeover transactionb. Set up general standard for what is / is not capital expenditure

i.Does NOT have to have separate and distinct asset necessarily

ii.Look for expenditures that have long-term benefits (beyond current tax year)

1. Whether expenditure generates future benefits; AND

2. Whether those benefits are significantc. For qualifying expenses where benefit extends past the year,

tax payer can NOT deduct the entire costs in one year, but can depreciate it over time

c. General Rule i. If used up in current tax year and finished off in the next year, then just

deduct it now. Zininovichii. BUT . . . Congress has made some categories/exceptions to the general rule.

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II. DEPRECIATIONa. § 167 & 168

i. Depreciable property is that which…1. Will undergo wear and tear (i.e. equipment);2. Become obsolete (i.e. computer programs); OR 3. Time renders useless (i.e. copyright)

b. § 1016 i. If tax payer records depreciation, must adjust his basis downward to reflect it

III. IMPROVEMENT VS. MAINTENANCE/REPAIRa. Repairs are currently deductible under § 162. Improvements, however, are NOT

[§ 263].i. Costs become part of basisii. Improvement vs. Repair

1. Midland – repair – doesn’t UL or value2. Mount Morris – timing was different

a. In Midland, building there for 25 yearsb. Foreseeability – not in Midland, but was in Mount Morrisc. In Mount Morris, creating something that wasn’t there before.

In Midland, basement is no better for its intended use.3. See regulation § 1.162-4. See also p. 299, 301 language.

b. Midland Empire Packingi. Facts – Meat processing works in basement, which oozes oily substance from

next-door refinery. Finally get around to fixing it by cementing floor and wall.ii. Analysis –

1. Mount Morris would have held capital expenditure.2. However, court here held was ordinary and necessary expenditure,

i.e. repair, so deductible.3. Exception to 1 year rule, because here talking a/b building. Worked

fine for curing meats, something intervened, and “merely restored to its prior use.”

c. Catastrophic Events i. If catastrophic event (i.e. hurricane) damages item (i.e. roof), as long as tax

payer replaces to make same as before, deductible because is a repair ii. However, if tax payer replace item with better one (i.e. better, more

expensive shingles), then is an improvementd. Revenue Ruling 2001-4, p. 305

i. Improvements to airplanes by airlinersii. Situation 1 – Just because something is high cost doesn’t prevent from being

a repairiii. Situation 2 – upgrades – specific expenditures making better are capital

expendituresiv. Situation 3 – materially value and UL – everything capitalized. General plan

of rehabilitation, things normally would be § 162 will be capitalized.

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e. Should changes made due to new building code be deductible?i. Hypo –

1. Perfectly useful building, no sprinkler system, city passes law requiring?

2. Capital improvement because safer, better building

Ch. 16 – Travel Expenses

I. COMMUTING a. Arguably trade or business related. HOWEVER, personal choice determines

commuting expense, i.e. living in Batesville vs. Oxford if teaching at Ole Missi. So not deductable under § 262ii. When does travel cross line into production of income or trade or business?

b. § 162i. Deduction allowed for traveling expenses (including amounts expended for

meals and lodging other than amounts which are lavish or extravagant under the circumstances)

ii. While away from homeiii. In the pursuit of a trade or business

c. Commissioner v. Flowers (1946)i. Facts –Tax payer lives in Jackson and works in Mobile. Wants to deduct travel

expensesii. Rule

1. Incurred in pursuit of businessa. Direct connection between expenditure and the carrying on of

the trade or business of the taxpayer or his employer2. Necessary or appropriate to the development and pursuit of trade or

businessd. Exceptions

i. Tax payer who works in different locations on the same day for the same employer may deduct the cost of travelling from one work location to the other

ii. “On duty” police officers may deduct the maintenance and operating costs of driving their personal cars between their homes and police headquarters

II. OTHER TRANSPORTATION EXPENSESa. Flying/driving/taxi for deposition, trial, or client meeting. Deductible?

i. YES – solely business relatedb. Working from home

i. May deduct costs of driving to meet clients or engage in other business activity

c. What if had some personal time on trip as well?

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i. If primary purpose of travel was for business, tax payer MAY deduct transportation costs which are business related

ii. If primary purpose is personal, transportation and other travel expenses are NOT deductible

1. However, any expenses incurred while at destination and allocable to your business are deductible

d. Cruise Ship Limitation – § 274 i. (m)(1) – when mode of transportation is cruise ship or some other luxury

water transportation, deduction limitedii. (m)(2) – denies deduction for expenses for travel as a form of education

1. I.e., Latin teacher who spends summer in Rome cannot deduct travel expenses

III. EXPENSES FOR MEAL AND LODGING WHILE IN TRAVELa. Two Types

i. If § 162 requirements metii. Business and Entertainment Meals

1. 50% deductible if § 274 requirements metb. Travel Meals

i. Rule – In order to deduct meals while away on travel, must meet § 162 trade or business requirements (must also not be extraordinary or lavish)

ii. United States v. Correll (1967)1. Facts – Case starts out in D.C. where gets jury trial, who gave him a

sympathetic ruling2. Overnight Rule – in order to deduct meal / lodging, must be away

from home long enough to require sleep or rest. Only 503. Holding – Railroad employees who have been authorized to stop

performing their regular duties to get substantial sleep or rest prior to returning to their home terminals may deduct the costs of their meals and lodging

4. Analysis –a. General Regulation Authorityb. Delegated / Legislative Regulatory Authority

5. Conclusion –a. Tax payer can’t deduct meals. Must draw line b/t personal and

trade or business hats.

IV. “AWAY FROM HOME”a. “Home”, within meaning of § 162(a)(2), means tax payer’s principal place of

businessi. Factors –

1. Amount of time tax payer spends working in specific location2. Amount of business activity generated in a given location

b. Robertson v. Commissioner (5th Cir. 1999)

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i. MSSC Justice presides in Jackson and teaches class in Oxford; spent four days a week in Jackson, although he only was required to stay two days a week for court business. Received $75K for being judge and $15K for being professor.

ii. Rule – Primary tax home expenses are not deductibleiii. Analysis – Because he primarily worked in Jackson, all of his expenses related

to traveling and living in Oxford are deductible (Oxford is a trade or business)c. Henderson v. Commissioner (9th Cir. 1998)

i. Facts –Tax payer tours year-round with performing show. Wants to deduct travel expense. Claims parent’s house in Idaho as tax home.

ii. Issue – Should travel expenses be deductible/eiii. Rule – Must be “away from home” to deduct travel expensesiv. Analysis –

1. Court holds he has NO tax home. Not paying any home expenses, so know duplication of expenses. Also, no business connection to Idaho.

2. If no tax home, tax payer does not qualify for travel expensesv. Dissent –

1. “Where you leave your dog is your home”d. Temporary Jobs

i. Typically, travel to temporary worksite deductibleii. Peurifoy v. Commissioner (1958)

1. One year presumption – assignments away from home of one year or less generally considered temporary

2. In 1992, § 162(a) amended to read “Tax payer shall not be treated as temporarily away from home during any period of employment if such period exceeds one year”

iii. Seasonal Employment?

V. TRAVEL EXPENSES OF SPOUSEa. § 274(m)(3)

i. Severely restricts deductions for travel expenses incurred by spouses, dependent, or other’s accompanying tax payer

b. May NOT deduct, UNLESS –i. Individual is a bona fide employee of tax payer;ii. Individual’s travel is for bona fide business purpose; ANDiii. Individual could otherwise deduct the expense.

VI. REIMBURSED EMPLOYEE EXPENSESa. To deduct above the line, tax payer must satisfy § 62(c)b. Unreimbursed expenses or reimbursed expenses § 62(c)

i. Below the line deductions subject to reduction under 2% floor rule of § 67, and useful only if itemize deductions

c. Qualifying reimbursement plans called “accountable plans”i. Amounts paid to employee under accountable plans are EXCLUDED from

gross income

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ii. Three part test –1. “Business connection” – arrangement must provide reimbursements,

advances, or allowances only for deductible business expenses2. Expense must be properly substantiated (proved or supported)3. Arrangement must require employee to return any amount in excess

of substantiated expenses within reasonable time (excess treated as non-accountable and included in gross income)

VII. BUSINESS-RELATED MEALSa. Deductible

i. May take client to lunch where the cost of his meal generally deductible as business expense

b. § 274(a) – imposes stiff substantiation requirements for deduction of meal expensesc. § 274(k) – requires tax payer be present at meal for which expense deduction is

soughtd. § 274(n) – limits meal expense deduction to 50% of its cost

VIII. LIMITATIONS ON FOREIGN TRAVELa. Generally, same limitations imposed as with domestic travel

i. Business traveler entitled to deduct travel expenses if the travel is primarily related to his business

b. Limitations on Business Conventionsi. § 274(h)(1)

1. Factors to determine reasonableness of convention, seminar or meeting being held outside of North America

IX. RELATIONSHIP TO § 212a. Travel and meal expenses may be incurred in an income-producing activity which

does not rise to level of trade or businessb. However, § 274(c) and (d) indicate that Congress intended such expenses to be

deductible under § 212 subject to same rules as meals and lodging under § 162c. But . . . § 274(h)(7) denies deduction under § 212 for expenses allocable to

convention, seminar, or similar meetingi. Policy – prohibit deduction for attending overseas investment or tax shelter

seminars

X. SUBSTANTIATION REQUIREMENTSa. 274(d) requires tax payer substantiate with records or evidence, entertainment

expenses

Ch. 17 – Entertainment and Business Meals

I. BUSINESS & ENTERTAINMENT MEALS

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a. In order to deduct business or entertainment meals, must satisfy §§ 162 & 274b. Moss v. Commissioner (7th Cir. 1985)

i. Facts – Firm lunches every day at restaurant to discuss businessii. Issue – Is this a trade or business expense?iii. Holding – Simply discussing trade or business doesn’t change personal natureiv. Analysis –

1. Something else is needed, e.g., clients present, annual firm dinnera. Maybe building camaraderieb. Large firm, need central meeting time / place

2. Economic argument – utility – if cost of meal greater than personal utility received by tax payer, likely business meal

c. § 274 i. (a) In addition to meeting 162 trade or business requirements, expense must

meet one of two tests –1. Directly related test – item must be directly related to the active

conduct of the tax payer’s trade or business2. Associated with test – item must have been associated with and

directly preceding or following a substantial and bona fide business discussion

ii. Substantiation requirement (d)iii. Not lavish or extravagant (k)

II. ENTERTAINMENT EXPENSESa. Introduction

i. § 274(a)(1) disallows any deduction for an activity “of a type generally considered to constitute entertainment, amusement, or recreation” UNLESS tax payer satisfies one of two test –

1. Directly related2. Associated with

ii. § 274 generally denies deductions for entertainment facilities. § 274(a)(1)(B).b. Walliser v. Commissioner (Tax Ct. 1974)

i. Facts – tax payer takes trips with clients and would like to deduct cost of trips.

ii. Analysis –1. Does tax payer qualify under § 162?

a. Moss standard – trying to further trade or business.i.Tax payer – generating business, no personal

consumption because didn’t have fun.ii.Court bought it!

b. § 162 must be met before moving on. c. If entertainment expense found to be personal, NOT

deductible, stop here.2. Is expense for something defined as entertainment?

a. If for entertainment, § 274 will be “triggered”

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b. Obj. standard – is this something people generally engage in for entertainment purposes?

3. Does the expense satisfy § 274?a. Entertainment expenses subjected to heightened

requirements in determining deductibilityb. Under 274(a), there are two tests, only one of which must be

met –i.Directly Related Test

1. Requires entertainment expense be directly related to trade or business, i.e. will lead to immediate business (specific business pitch)

2. Building goodwill not enough!3. Must show something more than general

expectation of deriving income.ii.Associated with Test

1. Looser test2. Must directly precede or follow a bona fide

business discussion. 4. How much is deductible?

a. § 274(n) allows only 50% to be deductible.b. Policy – rough estimation that still some personal enjoyment

involvedc. Churchill Downs v. Commissioner (6th Cir. 2002)

i. Facts – providing entertainment at horse races to create goodwill, excitement, publicity, etc.

ii. Issue – want § 274 deductioniii. Analysis –

1. Satisfy § 1622. Satisfy § 274(a)3. Problem – §274(n)

a. Churchill try’s to fit exception, i.e. entertainment is “product tax payer is selling.” § 274(n)(1).

b. Ct. disagreed, because not making money here. iv. Conclusion –

1. May take deduction, but limited to 50%. Will remove lavish / extravagant expenses

2. Note – with casino comps, engaged in business of selling hotels and meals

d. Substantiation Requirement i. 274(d) requires tax payer substantiate with records or evidence

e. Face Value i. Only face value of tickets are deductibleii. Scalper’s fees are notiii. Hypo

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1. Take client to football game. 2. Can deduct tickets if football game is either directly related or directly

preceding or following substantial bona fide business discussion. 3. If game was right after a business lunch where business strategy was

discussed, could deduct. 4. How much? 50%. § 274(n)(1)

f. Specifics i. Exclusions

1. § 274 specifically excludes deductions for club dues.ii. Limitations

1. § 274 specifically limits deductions for –a. Conventions on cruise shipsb. Travel to learn foreign languagec. Seminars for § 212 (investment) purposes

Ch. 31 – Capital Gains

I. INTRODUCTIONa. Idea

i. Give preferential rates under §1(h) to long term capital gainsii. If long term (>1year) capital gain then get §1(h) tax rate, which are lower

than ordinary income tax rateb. Policy

i. Time restriction interesting, because creates a lock in effect. ii. Ex : Stock appreciates, iffy about holding, but if sale now will have to pay tax

at ordinary rateiii. IF hold on, rate from 35% to 15%.

c. Losses i. §1211(b)(1): Limited to gains from sales of capital assets + $3Kii. Generate more losses than gains, deduction will be limited

II. RATE SCHEDULES - § 1(h)a. 15% - everything elseb. 25% - depreciation recapture on RE

i. Ex: buy building for 500K, depreciates 50K. But, still able to sale for 500K, therefore realizing 50K gain. This 50K is depreciation recapture, and treated under 25% rate rather than ordinary income rate.

ii. Note: if sold for 600K, would have to split rates.c. 28% - primarily collectibles (§ 408)

i. Antiques, rugs, coin collections, etc.ii. CI: less worthy capital assets

d. Net Capital Gain § 1222(11): Sets Up Netting Process

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Long Term Capital Gain – Long Term Capital Loss

= Net Long Term Capital Gain (NLTCG) NLTCG goes into equation below

Short Term Capital Gain– Short Term Capital Loss = Net Short Term Capital Loss (NLTCL)

NSTCL goes into equation below NSTCG is ORDINARY INCOME!!!

Net Long Term Capital Gain (NLTCG)– Net Short Term Capital Loss (NSTCL)= Net Capital Gain (NCG)

i. Total Net Capital Gain goes to § 1(h)ii. Now figure out what rate schedule your net capital gains are taxed at

1. 15%2. 25%3. 28%

III. CAPITAL ASSET DEFINITIONa. Note

i. While statutory definition appears remarkably broad, clear that Congress intended capital gain treatment to be an exception, NOT a rule

ii. Courts have tended to construe “capital asset” narrowly, thus significantly limiting TP’s opportunities to claim preferential capital gain treatment

b. Corn Products Refining Co.i. Preferential treatment applies to transaction in property which are not the

normal source of business incomec. §1221(a) “capital asset” = property held by tax payer, but does not include . . .

i. (1): Inventory, Stock in Trade, and Property held Primarily for Sale to Customers in the Ordinary Course of the TP’s T or B

1. Inventory 2. Stock in Trade3. Property held primarily for sale to customers in the ordinary course of

TP’s trade/businessii. (2): Property used in TP’s T or B

1. Excludes from capital asset status property used in TP’s T or B that is either…

a. Depreciable; ORb. Real property

2. Property held for more than a year is given special treatment by §1231, which gives even better treatment

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a. Look at property as a group, if generating more gains than losses, all capital

b. If have more losses than gain, treated as ordinary deduction offsetting ordinary income

iii. (3): Copyrights, Literary, Musical, or Artistic Compositions, Etc.1. Special tax break2. TP may elect to have (1) or (3) apply and treat works as capital gains3. Hypo : write manuscript

a. Submit to publisher. Capital asset? NO because being paid for personal services

b. But . . . if give to husband, he sells, STILL don’t get around rule. Still generates ordinary income

c. If I die, leave manuscript to husband, FMV on date of death is his basis and therefore not a capital asset

iv. (4): Accounts Receivable for Services rendered or Inventory-Type Assets Sold

1. The denial of capital asset treatment demands that any gain or loss on the sale of A/R will be ordinary

2. Ex : Selling car for a note from the bank, can NOT deem note a capital asset, because this is note from property described in (1)(a), therefore treated as ordinary income if sell note

v. (5): Certain Publications of the U.S. Government1. Anti Agnew Provision – gave papers to charity and got deduction for

FMVvi. (8): Supplies Used or Consumed in the TP’s T or B

1. Hypo : airline buys too much jet fuel, need to sale somea. In absence of this provision, arguably capital because not

inventory, etc. b. Congress says NO if would have used up in business, would

have been ordinary deductionc. Therefore if sale at loss / gain, will be ordinary deduction /

income.2. Note : salary, dividends, interest, rate do NOT get into 1221, because

NOT propertyvii. What’s left = Capital Asset

1. Personal type assets2. Investment type assets

IV. SALE OR EXCHANGE REQUIREMENTa. §1222

i. Only gains or losses resulting from the “sale or exchange” of capital assets will be treated as capital gains and losses

ii. Forms of Sale or Exchange1. Actual market transaction

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2. Judicially defined sale / exchangea. Ex: Foreclosure treated as sale or exchange? Courts say YES

i.Defined by statuteb. Ex: 165(g) Worthless Securities - “will be treated as sale or

exchange on last day of the year”iii. Freeland

1. Congress intended “sale or exchange” to have a broad meaning, not to be limited to standard transfer of property by one person to another in exchange for stated consideration in money or money’s worth

V. EXAMPLE LEADING THROUGH § 1(h) a. Which gains get preferential rate? LTCG Offset by LTCLb. TP had five items of Income:

i. 300K of salaryii. 10K of dividendsiii. Sold 3 pieces of property

1. Vacation home for 240K. Basis of 170K. Gain of 70K. Held for 4 years. NOT PR.

2. Painting for 130K. Basis of 50K. 80K, held for 6 years.3. Stock sold for 70K. Basis of 60K. 10K gain. Held for 8 months.

c. § 1(h) Analysis :i. Identify any capital assets disposed of during year.

1. Vacation home2. Painting3. Stock

ii. Ask if any capital assets were sold or exchanged, as opposed to gotten rid of, transferred, etc.

1. Alliii. Which of these capital assets were held LT and which ST?

1. Vacation home and Painting – LT2. Stock – ST

iv. 1222 Netting Process1. LTCG -- LTCL = NLTCG or L

a. 150K -- 0 = 150K2. STCG -- STCL = NSTCG or L

a. 10K -- 0 = 10K3. *This tells us how much of gains gets §1(h) preferential rates (path to

1(h))v. Compute NCG

1. Defined in 1222(9): a. NLTG -- NSTCL = NCGb. 150K -- OK = 150K

2. *Why discard NSTCG here?

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a. B/c do NOT go to §1(h) preferential rates! Only LT capital assets get these rates!

b. NSTCG stuck at OI rates.vi. Take NCG directly to § 1(h)

1. Step One: any 28% gains (collectible gains -- collectibles losses)?a. 80K from painting @ 28%

2. Step Two: any 25% gains (un-recaptured depreciation on real property)?

a. None (b/c vacation home, no depreciation)3. Step Three: any 15% gains (everything else)?

a. Remaining 70K @ 15%.d. Suppose above painting had been stock…

i. 150K LTCG1. Netting process stays the same

ii. NCG stays the same1. Change happens when take NCG to § 1(h)

a. No longer have 28% gainb. Still, no 25% gain.c. Thus, all 150K taxed @ 15%.

iii. How are dividends treated?1. Taxed at 15%, but NOT included in CG calculation b/c not a capital

asset2. § 1(h)(11) tells us, though, to tax at 15%

e. §§ 1231 and 1245

CH. 31 - CAPITAL LOSSES

I. INTRODUCTIONa. How do losses work?

i. First offset gains of their OWN category1. LT2. ST

ii. If losses of any one category EXCEED gains from that category, losses will migrate elsewhere, i.e.

1. First: 28%2. Second: 25%3. Third: 15%

b. Pro TP Rule i. Offsetting highest tax gain until all used on, then next highest until used up,

etc.

II. STCL PROBLEMa. Same facts as above, except one additional sale:

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b. Investment land, purchased 11 months ago, paid 150K, sold for 90K @ loss of 60K.c. Loss Analysis :

i. Is it deductible?1. If NO, must STOP.

a. Here, yes, falls into § 165.ii. How long held?

1. 11 months, t/f ST capital assetiii. 1222 Netting Process

1. LTCG -- LTCL = NLTCG or La. 150K -- 0 = 150K

2. STCG -- STCL = NSTCG or La. 10K -- 60K = 50K

iv. Compute NCG1. NLTG -- NSTCL = NCG2. 150K -- 50K = 100K

v. Take NCG directly to § 1(h); Migrate Losses1. Step One

a. Any 28% gains?i.Collectibles Gain -- Collectibles Loss – NSTCL

ii.80K -- 0K -- 50K = 30K2. Step Two

a. Any 25% gains? NO3. Step Three

a. Any 15% gains? Yes, remaining 70K

III. LTCL PROBLEMa. Same facts as above, but held land for 13 months (thus, LTCL)b. Analysis :

i. 1222 Netting Process1. LTCG -- LTCL = NLTCG or L

a. 150K -- 60K = 90K2. STCG -- STCL = NSTCG or L

a. 10K -- 0K = 10K (taxed at OI rate!)ii. Compute NCG

1. NLTG -- NSTCL = NCG2. 90K -- 0 = 90K

iii. Take NCG directly to § 1(h); Migrate Losses, if Any1. Step One

a. Any 28% gains? 80K2. Step Two

a. Any 25% gains? NO3. Step Three

a. Any 15% gains? Yes, remaining 10K

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IV. STCL § 1211 PROBLEM, CARRIED OVER AS STCLa. Same as STCL problem, but now sold for land for loss of 160K. Also, sold LT Stock at

30K loss. i. Now, have more losses than gains!ii. Once have more losses than gains, § 1(h) no longer relevant, b/c ONLY

applies to net gains.iii. T/f, must turn to § 1211, Limitation on Capital Losses, which says can only

deduct our losses up to the amount of gains, plus 3Kb. § 1211 Analysis :

i. How much total loss?1. 160K

ii. Entitled to deduction?1. Yes, b/c investment property, deductible under § 165.

iii. How much can we deduct? §12111. How much capital gain generated? 160K (70K + 80K +10K). Thus, can

deduct up to this amount.2. BUT … don’t forget a/b the LT stock loss of 30K.

a. Entitled to deduction under § 165? Yes, profit transaction.b. How much? B/c already used 160K, only have 3K left over.

3. Thus, have total loss deduction of 163Ka. What happens to remaining 27K? Carried over to next year.

iv. Carryover Analysis :1. LT?

a. LTCG = 150Kb. LTCL = 30Kc. LTNCG = 120K

2. ST?a. STCG = 10Kb. STCL = 160Kc. NSTCL = 150K

v. Is 27K Carry Over ST or LT?1. Here, ST, b/c ONLY have ST Losses (150K). 2. Rule: carry over in their unchanged character.

a. Ex: here, if would have had 160K of NLTCL, and 10K of STCG, would carry over as LT

b. Why does it matter? B/c if LT, offsets LTCG’s first!c. So, w/ STCL carryover of 27K, what happens next year?

i. Assume zero GCs, how much can we deduct? 3K, carry over 24K.ii. Assume generate LTCG of 100K, STCG of 37K, no losses this year.

1. Netting Processa. NLTG = 100Kb. NSTCG = 37K -- 27K ST Carry Over = 10K

2. Compute NCGa. NCG = 100K -- 0 NSTCL= 100K (assume share of stock)

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3. Take NCG to § 1(h)a. 100K taxed at 15%

iii. Assume no LTCGs, only 10K STCG. Not interested in § 1(h) b/c losses > gains ( 27K > 10K).

1. Go to § 1211: can deduct up to CG + 3K = 13K2. Carry over 14K as STCL

V. NETTING PROCESS, REVISITEDa. Sale

i. Painting for LTCG of 100Kii. Rug for LTCL of 40Kiii. XYZ Stock for LTCG of 60Kiv. ABC Stock for STCG of 20K

b. Netting Process i. NLTG

1. 160K LTCG -- 40K LTCL = 120Kii. NSTCG

1. 20K STCG -- 0 STCL = 20Kc. Any NCG?

i. NLTCG -- NSTCL = 120Kd. Go to § 1(h)

i. 28% 1. Gain? Painting of 100K2. Losses? Rug of 40K3. 60K @ 28%

ii. 25%? Noneiii. 15%? None

e. Remaining 60K taxed at OI Rate

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