Income Tax IIProf. DavisSpring 2011

CH. 31 - CAPITAL GAINS & LOSSES

I. EXPLAIN SIGNIFICANCE OF THE CHARACTER OF GAIN AND LOSSA. Preferential Tax Rates Applied To LTCG

i. CG is a gain derived from the sale of a capital asset.ii. LTCG taxed at a lower rate than OI.

1. NLTCG taxed at 15%.2. LT held for more than 12 months.

B. Limitation on the Deduction of CL i. CL can be deducted a/g CG for the year (ST or LT) plus $3000.

ii. If CL exceeds CG + $3000, the excess loss can be carried forward into future years and offset against CG in that year + $3000.

C. Justification For CG Treatment i. Bunching

1. Get lumped into a higher tax bracket, the gain is accrued each year 2. But … is only realized in one.

ii. Encourage Investments1. Allows people with excess income to invest and receive preferential rates2. Problem?

a. Plus of encouraging investment occurs with new investment, not shifting around existing investment.

b. If want to really encourage investment, would apply CG treatment only to new stocks, those that generate additional investment.

c. Does not account for the risk element of investmenti. Winners in investing are already compensated

ii. Losers don’t get any benefit. iii. Lock In Effect

1. I bought the asset, it has appreciated, and as long as I hold on to the asset I don’t have to pay the tax liability

2. If I sell it then I must pay the taxes. iv. Inflation

1. Many of the gains are inflationary gains. 2. Traditionally the tax code has been very bad at dealing with inflation, which

leads to over taxing people. a. Tradeoff between complexity and accuracy.

II. IDENTIFY CAPITAL ASSETS - §1221(a) - PROPERTY HELD BY TP, BUT NOT…A. (1) Stock in trade, inventory, or property held by TP primarily for sale to customers in the

OCOBi. Language is an attempt to exclude TP’s normal, operating profits

ii. Note :1. Specially made inventory may or may not be categorized as stock in trade

(depends on whether in OCOB)B. (2) T/B real property (non-depreciable) or T/B property eligible for §167 T/B deductions

i. Has its own code section for preferential ax treatmentii. See infra

C. (3) Copyright or literary/musical/artistic composition held by…

i. (A) TP who created the property;ii. (B) IF a letter or memo, TP for whom it was made (Anti-Agnew Provision); OR

iii. (C) TP who takes the same AB as the creator (gift)D. (4) A/R acquired in OCOB

i. Prevents you from taking A/R, selling them, and categorizing as CG.ii. Ex :

1. Sale car, get note, sell note to bank and attempt to categorize as CG. 2. Works same way w/ salary, can’t convert salary to CG.

iii. Back stop / Anti-Abuse ProvisionE. (5) Fed Gov’t publication

i. Anti-politicianF. (6) Commodities held by commodities dealer

i. Arkansas Bestii. Corn Products

iii. Inventory / dealer provisionG. (7) Hedging TransactionsH. (8) Supplies regularly used by the TP in OCOB

i. Ex: 1. Airline company w/ jets, primary cost is fuel. If prices , worried will

continue, buy a lot of fuel. Stockpile. However, prices . 2. Costing a lot to hold fuel. Decide to sale for loss. 3. W/out this provision, would be capital loss. Congress added provision b/c

would normally be § 162 ordinary deduction.ii. Ex:

1. Don’t buy actual fuel, but options to purchase fuel. Prices , options now worth essentially nothing.

2. Statue says were buy options to hedge ordinary transactions, any loss deduction will also be ordinary.

III. CHARACTERIZE GAIN OR LOSS IN ANY GIVEN SITUATIONA. Issue :

i. What constitutes inventory, property held primarily for sale to customers in the OCOB?

B. Rule : i. Balance of factors under Bynum

1. Frequency and substantiality of sales2. Improvements made to the land3. TP’s solicitation and advertising efforts4. Utilization of real estate brokers and agents5. Proportion of income

C. Bynumi. Facts :

1. Own land used as nursery in T or B. Divided / developed land for sale. 2. IRS says income from sale was OI and the TP says it is CG.

a. Held land for a long period of timeb. There is a bunching problemc. There is likely an inflation problemd. Also a gain from the development of the land, which looks like OI.

ii. Analysis : 1. For someone in the business of developing land it would definitely be OI. 2. Is there an alternative view for the policy of CG?

a. Treat the ordinary profit of a business as OI and everything else as CG.

b. However here the TP has both. c. Shows the “all or nothing” problem, i.e. classify as either all CG or

no CG. iii. Rule : The only time you can divide between CG and OI is if sale falls under §1237,

real property subdivided for sale1. Rule : if take land and subdivide it, sale is capital UNLESS…

a. You are a dealerb. No substantial improvement to value has been made upon the land; c. Property has been held for five years

2. Note : Can’t use your family to do it (anti-abuse provisions)3. §1237(b) gives pass for the first five that are sold, but on the sixth, 5% of the

gain is OI and the rest is CG4. (b)(3)

a. Can improve if have held ppty for 10 years, and improvements are limited to those listed.

5. If don’t qualify for 1237 you can still argue it is not in 1221(a)(1) anyway.iv. Holding :

1. Bynum’s argue they started selling off property because they were in a financial jam and bank suggested.

2. If had sold off big lots, would not have generate enough $ so decided to sell off in smaller lots.

3. If Bynums had just sold off enough ppty to satisfy the bank then they may have had a more sympathetic position to argue not in T or B.

a. Argument doesn’t work b/c sold a lot more than they would have needed to satisfy the bank debt.

v. Conclusion : 1. Property? Yes.2. Held for sale? Advertised property, had a large number of lots, listed with

other realtors3. To customers? Automatic if selling real property4. In OCOB? Regularly selling, not something unusual or exceptional5. In T or B? Husband spent a lot of time on it, regularity of sales, he gets a

realtor license

IV. RECOGNIZE OI SUBSTITUTES, UNDER HORT & DAVISA. Lease buyout, where disputed amount was essentially a substitute for rental payments which

are GIi. Must be regarded as OI.

ii. Note: 1. Also applies to lottery payments 2. Sale of rights to payments is OI, NOT CG

B. Horti. Facts :

1. Mr. Hort has commercial rental building received by bequest, at which time there was an existing lease on building for 15 yrs

2. So, got the building and 14 year lease. 3. Bank decided to cancel lease and had to pay $140,000 for cancellation. 4. TP claims loss of 20K, b/c under lease would have collected $160,000.

ii. Issue :

1. Does he have a tax loss? iii. Analysis :

1. Basis in the uncollected rent is 0, b/c received it by devise and it went into the building.

2. He has never paid tax on the uncollected rent b/c only paid tax as it was received.

3. Court says the 140K is GI b/c it was a substitution for the rent and the rent would have been OI.

a. Doesn’t fit nicely into the statute. b. Judicially created exception, substitution for another type of income. c. What if the bank had not paid to cancel the lease but had sold the

lease, would they have GIC. Davis

i. Facts :1. TP wins lottery w/ winnings paid out over time2. Collects the first couple of payments of 600K and then sells right to receive

the rest of payments for a lump sum. ii. TP argues this should be a capital asset and therefore a CG. What is different from

Hort? 1. Hort had a right to underlying building and the rent payments, here there is

no other underlying ppty to function as the capital asset2. He only has stream of income. 3. The right to the payments is property but the court says this is like Hort in

that it is only a substitute for income. iii. TP second argument is that b/c of Arkansas Best it should be CG.

1. Ark Best - shouldn’t have carved out list of judicial exceptions but should stick to the statute.

2. TP argues Ark Best overturns the other cases that made judicial exceptions. 3. Court said that Ark best only applied to its own particular situation

iv. Rule : if something is merely a substitute of OI, will STILL be treated as OID. Keenan

V. RECOGNIZE CORN PRODUCTS PROPERTYA. Corn Products

i. Facts : 1. TP protected self from price increases by buying “futures” whenever the K

price was favorable2. Treated as OI

ii. Holding : 1. Preferential treatment of §1221 applies to transactions of property which are

not the normal source of business incomeiii. Note :

1. TPs were using the holding of Corn Products to take ordinary losses on holdings that had a dual purpose: Stock assuring a source of supply AND investment

B. Arkansas Besti. Facts :

1. TP buys stock in bank, end up w/ loss.2. Differs from Corn Products in the rights available to TP by exercising

option. Don’t get right to particular asset, so doesn’t fit.

3. TPs used the Corn Products doctrine to avoid characterization of stock losses as capital losses. Arguing investment, not business purpose.

ii. Holding : 1. Narrow Corn Products to simply a broad reading of the inventory exclusion

of §1221iii. Significance :

1. Buying stock in companies is buying a capital asset, t/f it is a CLiv. Went to Far :

1. Congress makes adjustment via § 1221(a)(7) - as soon as buy asset, must classify as hedging or not hedging

2. Defined in (b)(2)a. Normal course of T or Bb. If actual item would have been ordinary asset, hedging risk of that

asset will be ordinaryc. Managing risk of price or interest rate changes

3. Essentially, reinstating part of Corn Products 4. Note that regs say can NOT use stocks as a hedge for reasons contained in

Arkansas Best

VI. COMPUTE NCG & ADJUSTED NCGA. NCG

i. Preferential rates only apply when TP has Net CG (§1211(11))1. Net CG: Excess of Net LTCG over Net STCL2. Net LTCG = LTCG – LTCL3. Net STCL = STCG – STCL

ii. STCG are subject to OI ratesB. Adjusted NCG

i. 15% and 5% rates1. §1(h)(3) NCG by 28% gains and un-recaptured §1250 gain = adjusted NCG2. If TP in the 15% tax bracket he will get a preferential rate of 5%.

ii. Qualified dividend income1. Previously

a. Taxed as OIb. However, Congress felt preferential rate would cost of capital and

lead to economic growth / job creation. 2. Currently

a. Treated as part of ANCG and will thus be taxed at the 15% or 5% rates.

b. Expires at the end of 2008 unless extended.iii. §1(h)(3)

1. ANCG determined by subtracting the 28% gains from the NCG and then adding the qualified dividend income.

2. This assures that gain from dividend income will be preserved even where there is no NCG or when there is a CL

VII. §1(h) AND MAX RATES APPLICABLE TO VARIOUS COMPONENTS OF NCGA. Components of Net CG

i. 28%, ii. 25%,

iii. 15%B. 28% Rate Gain: Collectibles Gain and §1202 Gain

i. Note 1. IF TP OI rate bracket is lower than 28%, the CG gets OI rate

ii. Collectibles Gain (§1(h)(5))1. Gain from sale/exchange of any rug, antique, metal, gem stamp, coin, or

other collectible under §408(m), which is a capital asset held for more than one year

iii. §1202 Gain1. 50% of the gain from the sale/exchange of certain stock under §12022. Policy

a. Small corps generate employment and ideas, but are risky. b. Want to encourage investment in these, t/f give preferential rate of

tax for investment. c. Questionable, b/c no guarantee if corp fails. To get benefit of

preferential rate, corp must succeed (i.e. have gain)C. 25% Rate Gain: Unrecaptured §1250 Gain

i. LTCG attributable to depreciation allowed w/r/t RE (buildings) held for more than 1 year taxed at 25%. §1(h)(6)

1. Other part of gain gets 15% rateii. Any time TP sells depreciable real property at a gain, TP must determine how much

of gain constitutes un-recaptured §1250 gainiii. Policy

1. Much RE gains caused not by appreciation of RE, but b/c depreciation, which generates OI deductions.

2. Want to give RE a good deal, but not quite that good of a deal.3. Ex: 25 min

iv. Technical catchup provisionD. 15% Rate Gain: Adjusted Net CG

i. Leftover CG - everything not taxed somewhere elseE. Qualified Dividend Income: §1(h)(11)(B)

i. Included in NCG computation; dividend income increases NCGii. Taxed at 15% even if there is no NCG

iii. NOT a CG, b/c not gain from sale or exchange of a capital assetiv. Can NOT be used to offset capital losses

VIII. TAX PREFERENCE AFFORDED QUALIFIED SMALL BUSINESS STOCK HELD > 5 YEARS 27 min - 1/20

A. §1202 i. Partial Exclusion for Gain from Certain Small Business Stock

ii. Exclusion from GI of 50% of the gain from the sale or exchange of qualified small business stock held for more than five years.

B. Congressional Steps i. If have 1202 stock acquired w/in certain period of time, 75% would be excluded

1. 1(h) taxes only 25% of your gain, creating effective tax rate of 7%ii. Latest step

1. Completely excluded, if acquired during certain years2. Kicked in 2010, been extended

C. See statutory handout - 1/25, 27 min

IX. COMPUTE AMOUNT OF CL WHICH MAY BE DEDUCTED BY TP IN GIVEN YEARA. CL may be deducted $ for $ to the extent of CG; doesn’t matter if they are LT or ST.

i. Up to 3K of the excess may be deducted as well to offset OI

ii. Any amount that was disallowed can carryover to the next year.iii. Dividend income, although taxed at the preferential rate, is not CG, and t/f is not

considered in the loss calculation.B. STCL are netted first against STCG.

i. The excess will then be netted a/g LTCG. ii. STCL will be deemed to have been deducted first in the OI offset part of §1211(b).

iii. First applied to STCG, any net STCL is then applied to 28% net gain property, then 25% then 15%

C. Limitation on Deduction of CL i. §1211(b)

1. To the extent that CL > CG, up to $3K may be deducted2. Note that § 1211 is NOT a deduction granting provision

ii. § 1651. (f) Permits CL to be deducted to extent of 12112. (c)(2) Permits deduction on loss of sale of stock as transaction entered into

for profitiii. §1212(b)

1. Losses that could not be used will be carried over

X. APPLY THE ARROWSMITH RULEA. IF you have a transaction in this year that is related to previous transaction it is legitimate to

look at the characterization of the transaction in the previous yearB. Holding :

i. In the previous year, it would have been a capital gain/loss transaction. ii. So deduction is going to be a capital loss

C. Significance: i. Gains/losses generated as a result of a transaction covering more than one year may

be characterized as CG/CL even though technically the sale/exchange requirement may not be met

XI. IMPACT OF CG & CL ON TIA. Sale or Exchange Requirement

i. Broad meaning1. Satisfaction of a bequest with appreciated property2. Abandonment of unimproved real estate subject to a nonrecourse mortgage

exceeding FMV is a capital loss3. Owner’s conveyance of land by quitclaim deed

ii. §165(g)(1)1. IF any security which is a capital asset becomes worthless, shall be treated

as sale/exchange of a capital assetiii. §1271(a)

1. Amounts received on the retirement of a debt instrument shall be treated as received in exchange for that instrument

iv. §1231 property, involuntary conversions may get sale or exchange treatmentB. Holding Period

i. LT must be held for more than one yearC. Kenan 1/25

i. Facts :1. Someone dies and put their property into trust, income to beneficiary, corpus

distributed later

2. Trust got a step up in basis, the trustees had the option of paying cash or in securities at their discretion, may avoid transaction cost that way.

ii. Analysis :1. Assume the trust pays in cash, what happens?

a. They would have to sell assets to a third party and recognize gain because sell or exchange transaction.

2. What if they had to give specified property? a. This would not be a sell because it would be specific property held

for the beneficiaryb. The beneficiary would then bear the risk of fluctuations in the price.

3. So why does the court decide here that the trust essentially sold the assets?a. Because she had a right to cash or property worth that muchb. The trustee owes this beneficiary $5Mc. The trust has satisfied their obligation to pay this amount.

iii. Significance :1. Giving assets to satisfy an obligation is a sell or exchange, 2. Also judicial gloss on foreclosure or abandonment cases, doesn’t matter if

done voluntarily or forced, it satisfies debt so it is a sell or exchange.

CH. 32 - QUASI-CAPITAL ASSETS - § 1231

I. INTRODUCTION 1/25 33 minA. Davis

i. Win on upside, best possible treatment on downsideB. Gains & losses are characterized under §1231, which is NOT deduction granting provision

i. Deductions are granted under §§165, 167 and 179ii. Deductions disallowed under §267

C. Primary Purpose of § 1231 i. Provide special, favorable tax treatment to the sale, exchange or involuntary

conversion of real or depreciable property used in the TP’s T or Bii. Under § 1231, a recognized gain on the sale, exchange or involuntary conversion of

such property may be characterized as CG, where a recognized loss may remain characterized as an ordinary loss

II. TYPES OF PROPERTY & TYPES OF DISPOSITIONS TO WHICH §1231 APPLIESA. Applies to…

i. Sale or exchange or involuntary conversion (theft, seizure, destruction, or threat or imminence of condemnation);

1. Davis : typically, can’t have sale or exchange if unable to resale propertyii. Of real or depreciable property used in T/B; OR

iii. Any capital asset which is held for more than 1 year and is held in connection with a 1. T or B; OR2. Transaction entered into for profit

B. Essentially, property that is included in §1221(2)i. T/f, NO inventory

C. Summary : to determine whether a TP’s recognized gains or losses are §1231 gains or losses and thus subject to the rules of § 1231, one must consider both…

i. The event that triggers the gain or loss; ANDii. The nature of the property involved

D. Examples

i. Gain / loss recognized on sale / exchange of depreciable equip held > year and used in TP’s business will get § 1231 treatment, as would involuntary conversion of such

ii. However, gain / loss from sale / exchange of a capital asset held > year would NOT get § 1231 treatment

1. Not needed, though, b/c will be LT CG or CL under § 1222

III. NETTING PROVISIONS OF §1231 & HOW THEY FAVOR TPA. Introduction

i. Once TP has identified all of their §1231 gains and losses for the year, §1231(a)(1) and (2) require the TP to compare total §1231 gains to total §1231 losses

1. If gains > losses THEN its CG2. If gains < losses THEN its ordinary loss

ii. Hotchpot analysis, i.e. all § 1231 gains and losses are combined in a hotchpot for purposes of characterization

B. The SUB Netting Process (Preliminary Netting Analysis)i. Essentially, § 1231 gains / losses resulting from certain involuntary conversions will

not be subject to characterization under § 12311. Will NOT enter the Principal Hotchpot2. Thus, will be ignored for §1231 purposes, if the total of such losses exceeds

the total of such gainsii. (a)(4)(C): In the case of any involuntary conversion arising from fire, storm,

shipwreck, or other casualty, or from theft, of any—1. (i) property used in the T/B, or2. (ii) any capital asset which is held for more than 1 year AND is held in

connection with a T/B or a transaction entered into for profit3. Note :

a. Does NOT include condemnationiii. IF Gains exceed the Losses THEN put assets in the REG Nettingiv. IF Losses exceed the Gains THEN these assets are ordinary

1. TP will deduct losses as ordinary under §165 or other;2. Gain reported under §61

v. If Losses = Gains, enter REG analysisvi. See examples p. 799-800

C. The REG Netting Process (Primary Netting Process)i. (a)(1): GAINS EXCEED LOSSES

1. IF 1231 gains for any taxable year exceed 1231 losses for such taxable year, THEN

2. Such gains and losses shall be treated as LTCG or LTCLii. (a)(2): GAINS DO NOT EXCEED LOSSES

1. IF 1231 gains for any taxable year, do NOT exceed 1231 losses for such taxable year, THEN

2. Such gains and losses shall NOT be treated as LTCG or LTCL3. *Note this catches situations where gains = losses

IV. RECAPTURE OF NET ORDINARY LOSSES: § 1231(c) 55 minA. Introduction

i. Certain tax problems create situations whereby if two assets are sold in the same year, a LTCG and LTCL will be generated

1. If the same assets were sold in different years, would have LTCG and ordinary loss

2. Recapture provision is attempt to curtail such tax planning problems

ii. (c)(1)1. “The net § 1231 gain for any taxable year shall be treated as OI to the extent

such gain does not exceed the “non-recaptured net section 1231 losses.”2. Functions as Anti-Abuse Provision

B. Non-Recaptured Net Section 1231 Losses i. EXCESS of the aggregate amount of the net section 1231 losses for the 5 most recent

years beginning OVERii. The portion of such losses taken into account as net 1231 gain for such preceding

taxable yearsC. Rule

i. Only applies to taking losses firstii. IF TP takes gains first then 1231(c) does not apply

CH. 33 - RECAPTURE OF DEPRECIATION

I. RATIONALE FOR §1245 DEPRECIATION RECAPTURE RULES 1/27A. Recapture of excess depreciation deductions, w/out the deductions taken by TP there would

not have been as much gaini. Ex :

1. Purchase equipment for 100, take depreciation deductions of 30, sale for 80. T/f, realize gain of 10 where property has in value by 20.

2. B/c of “excess depreciation of 10, TP’s OI was 10 less than otherwise would have been.

3. If OI taxed at higher rate than CGs, “excess” saves more in taxes than is produced by its “recapture” in year equipment is sold.

B. §1245 - Fixing Perceived Unfairness i. Rule :

1. Recognized recapture income is characterized as OI. (a)(1)2. Ordinary deduction = Ordinary income

ii. Gain on the disposition of personal property that is attributable to depreciation deductions, rather than economic appreciation in value, is not eligible for CG treatment

iii. Trump Provision1. To this extent, § 1245 overrides § 1231. 2. T/f, while § 1221(a) may classify as OI, §1231 may classify as LTCG; if §

1245 applies, has final say in classifying as OI.C. Recapture Provisions, Generally

i. Primarily characterization provisions, however, also recognition provisionsii. In certain situations, will require recognition of income earlier than would otherwise

be the case (see § 453(i))D. What’s the major benefit? 29 min

i. Time vale of money. Subsidize purchasing of certain types of assets. Get to pay tax liab later, t/f taking advantage of time value.

ii. Difference in views

II. INTERRELATIONSHIP AMONG §§ 1221(2), 1231, 1245, & 1250A. Under §1221(a)(2) property may not be a capital asset, and t/f any gain characterized as OI…

BUT under §1231 the gain might be characterized as capital gain

i. IF there is some gain that is attributable to economic appreciation THEN that gain is characterized based on 1221 or 1231

B. §1245 i. Recognized gain on the disposition of “Section 1245 property” shall be include in

income as OI to the extent of depreciation deductions taken w/ respect to the propertyii. Generally, § 1245 applies to depreciable personal property, while § 1250 applies

depreciable real property1. Term “personal property” encompasses both tangible and intangible. Reg. §

1.1245-3(b)iii. Remember, recapturing gain attributed to depreciation deduction, not gain from in

value1. Rule : label OI as difference b/t…

a. TP’s adjusted basis; ANDb. Lesser of…

i. “Recomputed basis”; ORii. The amount realized (or FMV, if disposition is not a sale,

exchange, or involuntary conversion)2. Recomputed basis = basis resulting from AB and depreciation /

amortization previously taken, or any other adjustments. (a)(2)(A)a. Generally, will be TP’s original basis in property (i.e. in above

example, would be 100)b. Note: § 179 deductions treated as amortization deductions

3. What happens to remaining gain?a. Not treated by § 1245b. Likely, will be characterized by §§ 1231 and 1221(2), and may be

characterized as LTCG. Reg. § 1-1245-6(a)iv. Does NOT apply to lossesv. Striking Scope

1. Recapture may result whenever §1245 property is disposed of by sale, exchange, involuntary conversion, or other disposition

2. Any escape must be found w/in § 1245(b) - Exceptionsa. Main deal w/ dispositions where property basis of property

transferred carries over to the transfereeb. “Recapture potential” t/f preserved in hands of transferee

C. §1250 Recapture – Mostly Dead Letter i. Applies to depreciable real property, except for limited categories of real property in

§1245. (c)ii. Rule

1. When §1250 property is disposed of at a gain, the depreciation subject to recapture and characterization as OI is, in general, only the depreciation taken in excess of SL depreciation. (a)(1)(A), (b)(1)

2. SL depreciation is §168a. §168 says depreciation is only SL, so there can be no excess of SL

depreciation thus no § 1250 appliediii. Under current law taking effect after 1986, depreciation on real property must be

taken on a SL basis1. In general, then, can be no “additional depreciation” on real property

acquired after 19862. However, if § 1250 property not held for more than one year, all depreciation

taken Is additional depreciation. (b)(1)

III. § 179 RECAPTUREA. §179 Election to Expense certain depreciable business assets

i. Not applicable if §1245 applies. Reg. § 179-1(e)(3).ii. Rev. Ruling: conversion of an auto from business to personal use is NOT a

“disposition” of the autoB. (d)(10) - Owner Version of Recapture

i. IF property w/r/t §179 deduction was taken is converted to personal use - specifically, if such property is not used predominately in a To or B at any time during the recovery period - TP must give up the benefit of §179 deduction.

ii. The benefit = difference between the §179 deduction and the §168 deduction that would have been allowed for the period of business use involved. Reg. § 1.179-1(e)(1), (5).

iii. AB to the extent there is §179 recapture - reflect income which has been triggered

IV. UNRECAPTURED § 1250 GAINA. Recall §1(h)

i. LTCG given preferential treatment, determined by the nature of the asset sold / exchanged and the holding period of the asset

ii. 25% rate applies to unrecaptured §1250 gain. (1)(D)1. More favorable than 28% rate applied to collectibles2. Less favorable than 15% rate applied to stock held for over a year

B. §1(h)(6) - Unrecaptured §1250 Gain i. LTCG from §1250 property attributable to depreciation deductions allowed to the TP

and not otherwise recaptured as OIii. While unrecaptured § 1250 gain will receive 25% rate, remaining portion of gain

receives max 15% rateC. Recall § 121 - Gain from Sale of PR

i. Gain attributable to depreciation allowed w/ respect to residence NOT excludable. (d)(6)

ii. See w/ home offices

V. § 1239 ORDINARY INCOMEA. Anti-Abuse Provision 1hr, 3 min

i. If sell depreciable prop to related party, will be depreciable in their hands, then will ALL be OI

ii. Any gain recognized to the transferor shall be treated as OI1. Note: § 167 entitles deduction; § 168 gives amount

B. Related Persons? i. Controlled entities - “for purposes of this section, means a corporation more where

more than 50% of corporation owned by TP”ii. § 267(c): constructive ownership rules

1. Corporate ownership and family ownershipa. Family - brothers, sisters, spouses, ancestors, and lineal decedentsb.

C. §1239 provision is Characterization, not Recapture rule like §§ 1245 and 1250i. Rule :

1. Any gain recognized on a sale/exchange of depreciable property between certain related parties must be characterized as OI; none of the recognized gain is eligible for CG treatment under § 1231

2. Significance: b/t related parties, all gain will be OIii. Narrower, in that applies only to related party transactions

iii. Broader, in that it characterizes all recognized gain as OID. Example

i. Individual sells depreciable property to wholly owned corp; parties are related persons

ii. All gains would thus be OI

VI. DISPOSITIONS WHERE §§1245 & 1250 APPLY; EXCEPTIONSA. Dispositions where §1245 & §1250 Apply

i. §1245 property 1. Any property which is or has been property of a character subject to the

allowance for depreciation provided in section 167 and is personal property, real property, see (a)(3)

ii. §1250 Property 1. Same definition but includes things not in 1245

B. Exceptions to Recapture 50 mini. 1245(b); 1250(d)

ii. Gifts, Transfers at Death, LK exchanges, Involuntary Conversions, P property =>P, Transfer to Tax-exempt org, Timber property AND

1. Dispositions in which the AB of the property transferred carries over to the transferee; preserve taint for later recapture

2. Limit on LK Property!

CH. 38 - NONRECOURSE DEBT: AB & AR REVISITED

I. INTRODUCTION 2/1A. Sedge way Into Anti-Tax Shelter Material

i. Typically, TPs engage in sheltering activity; congress reacts; shelter shifts; congress reacts

ii. Often, after congress’ reaction, TPs move on creates body of law intended to stop sheltering, which continues to exist

iii. POINT - don’t unintentionally break law, or at least know they are out thereiv. Estate of Franklin - classic shelter case

B. What is Chapter About ?i. Interaction of AR, Basis, Depreciation, and Debt

C. Distinction b/t Recourse and Non-Recourse Debt i. Remedies available to the lender

ii. Recourse1. Secured

a. Particular piece of property stands for security for the loan, so secured creditor can “grab it” w/out procedural speed bumps

b. If property is not enough, lender can collect from other assetsi) Risk of loss stays w/ owner of the property, as they still must

repay loan2. Unsecured

a. Right to collect full debt from assets of the borrower, except for those protected from seizure

iii. Nonrecourse1. Always secured, by nature

2. Property that stands for security of the debt will always satisfy the debt; even if value of property , lenders only recourse is to that property

a. Shifts part of the risk of loss to lenderb. Creates incentive for borrower to default on mortgage; if let go back

to lender, satisfies entire debtc. Tipping point is the FMV of the property

i) Once your equity is gone, risk of loss shifts to the lenderiv. Should recourse and nonrecourse debt be included in basis? 14 min

1. Must repay recourse, so more logical to include in basis2. If assume will pay unless property loses value, more conditional obligation

II. CRANE AND TUFTS A. Question Presented

i. Relationship b/t debt, especially nonrecourse debt, and basis and ARB. Rule

i. Recourse / nonrecourse liabilities are to be treated as equivalent for purposes of determining AB and AR

C. Crane and FN 37 i. Facts

1. TP inherited property encumbered by considerable nonrecourse debt; claimed depreciation based on FMV of prop at time of decedent’s death

2. Later sold prop and purchaser took subject to outstanding debtii. Issue : amount of gain realized on sale

1. TP’s basis upon inheritancea. § 1014(a): FMV @ date of decedent’s deathb. TP: should subtract debt encumbering propertyc. IRS: NO adjustment for outstanding liab, including nonrecourse liab

2. AR?a. SCOTUS: nonrecourse debt taken subject to by the purchaser must

be considered part of the ARiii. Rules :

1. Liabilities, whether recourse or nonrecourse, assumed, taken subject to or otherwise incurred in the acquisition of property are included in TP’s Basis

2. Liabilities of a Seller, whether recourse or nonrecourse, assumed or taken subject to by a purchaser, are included in the seller’s AR

iv. IF FMV > Debt AR includes debt assumed + FMV of other property1. Debt is treated as Cash2. Here, NO difference between nonrecourse and recourse debt for purposes of

both basis and AR3. Justification: economic benefit

v. Holding :1. Seller must include in AR any nonrecourse liability taken subject to by a

buyer2. A mortgagor, not personally liable on a debt who sell the property subject to

the mortgage and for additional consideration realizes a benefit in the amount of the mortgage as well as the boot

3. FN 37 Qualification: a. IF FMV < Debt (amount of mortgage), a mortgagor who is not

personally liable for it cannot realize a benefit = mortgagei) Here, borrower care much more a/b the value of the property

b. T/f, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage w/out receiving boot

vi. Millar, 3d Cir.1. FN 37 did not allow seller to exclude from AR the nonrecourse indebtedness

even if that indebtedness exceeded the FMV of the property2. Reasoned that allowing such would enable TPs to claim large depreciation

deductions3. T/f, seller had to include in AR entire amount of any nonrecourse

indebtedness encumbering the property soldD. Aizawa - Recourse Debt 24 min

i. Facts 1. TP continued to be liable on a recourse debt following a foreclosure sale of

the property secured by the debt2. Specifically, TP remained liable for part of recourse debt not satisfied by the

proceeds from the foreclosure sale3. Have financing and property transaction

a. Is foreclosure a disposition? Yesb. AR? 250 FMV of propertyc. AB? 300(500 - 200)d. Loss? 50

ii. Rule 1. W/ Recourse debt, IF FMV < Debt AR includes the debt satisfied (here,

was FMV).2. Justification:

a. If paid later, would be entitled to deductionb. If didn’t repay, would have RoI and would be double taxed

iii. Holding 1. For purposes of determining gain or loss on the foreclosure sale, the AR

equaled the proceeds of the foreclosure sale2. When he repays remaining amount, not entitled to deduction. If later

forgiving of debt, will have RoI. However, may seek shelter from insolvency exception in § 108.

E. The Tufts Controversy 36 mini. Facts :

1. Partnership bought housing; after holding, economy , FMV < DEBT2. TPs claim sold at loss, IRS says sold at gain

ii. Issue : 1. Should debt be included in AB?

a. TP: FMV -- AB = Lossb. Gov’t: Debt -- AB = Gain

2. Ultimately, gov’t winsiii. 5 th Cir :

1. Any tax benefits in the form of prior deductions are factored into the gain equation through adjustments to basis

2. Relief from a nonrecourse debt is not an economic benefit if it can be obtained only by giving up the mortgaged property

iv. SCOTUS :1. Reversed 5th Cir; held that the entire amount of nonrecourse indebtedness had

to be included in the TP’s amount realized2. Received proceeds of debt tax-free

v. Rule :1. In Nonrecourse debt, IF FMV < Debt AR includes debt assumed + FMV

of other property2. Debt is treated as Cash

vi. Justifications 40 min1. TP’s Point of View

a. In recourse situation, debt still outstanding, some independent step had to happen, i.e. borrower had to repay or did not repay (RoI)

i) Either way, tax consequences depended on the transaction that resulted

b. Here, will never be any further relief of debt; no continuing existence of debt, b/c full debt is satisfied

i) Using FMV would not get the right result2. Why does TP end up w/ gain?

a. Took depreciation deductionsb. Allowed to include entire amount of debt in their basis and take

deductions as if they were suffering the loss, when in fact loss shifted to lender

c. Essentially, this is a recapture of depreciation deductionsi) Included in basis, even though might not have to pay back

ii) T/f, include in AR, too essentially balance out fact your allowed to take depreciation deductions on that amount

3. Put optiona. Have strike price of 500, may force someone to buy property for

500. If FMV , will exercise option. b. In recourse debt, AR = cash rec’d. Have shifted risk of loss to

someone else. c. W/ nonrecourse debt, have debt + put option.

i) However, lender is on the other side of the option, t/f can always put to lender for amt of debt.

ii) Sounds great, but taking depreciation deductions on investment may never make.

1. OK where value > debt2. However, problem where value < debt

d. Tax sheltering almost always built on time value of $.vii. § 108 does NOT apply here; only applies to relief of indebtedness, NOT disposition

of property

III. NONRECOURSE BORROWING & THE § 108 INSOLVENCY EXCLUSIONA. Rev. Ruling 92-53

i. Issue : 1. Nonrecourse debt in excess of FMV of property securing the debt, on the

determination of insolvency for purposes of the § 108 exclusionii. Holding :

1. Amount by which a nonrecourse debt exceeds the FMV of property securing the debt is taken into account in determining whether and to what extent a TP is insolvent w/in meaning of § 108(d)(3), but only to the extent that the excess nonrecourse debt is discharged

iii. Reasoning :1. Ensure fresh start intended by § 108; don’t want to give rise to current tax

when TP can’t pay

B. Ex., p. 893

IV. NONRECOURSE BORROWING & APPRECIATED PROPERTYA. Ex., p. 894

i. Issue : does new borrowing…1. Generate additional basis for X in the building; OR2. Represent a realization event resulting in gain recognition

ii. Rules 1. Basis: B/c new loan used in an unrelated venture and not to improve the

building, loan does NOT result in any adjustment of the building’s basis. § 1016

2. Realization???B. Woodsam Assoc.

i. Facts :1. Improved real prop purchased in NYC; TP later borrowed on nonrecourse

basis an amount > AB in the property2. Later contributed property to corp, who disposed of at foreclosure sale; corp

had taken same basis as TPii. Issue :

1. Corp argued that when TP borrowed a/g property on nonrecourse basis, recognized gain = Debt -- AB; if true, would basis corp received

iii. Holding :1. TP, by borrowing a/g her equity, had not disposed of the property but had

merely augmented the indebtedness outstanding a/g the propertyiv. Significance

1. Decision favorable to TPs who have considerable equity in property w/ a low AB, b/c enables them to w/draw (via nonrecourse liab) from the property an amount far greater and yet not be deemed to have “realized” gain

V. IMPACT OF CONTINGENT LIABILITIES 2/3A. Opportunity for Abuse

i. TP could agree to pay inflated prices for depreciable property and finance their purchase by giving the seller a nonrecourse note

ii. If respected, would enable TP to claim a basis in acquired property equal to the inflated purchase price

1. T/f, buyer could claim greater depreciation than would otherwise be available if property purchased @ FMV; also, could claim interest deduction on outstanding indebtedness

2. Seller could report sale on an installment basis and thus report gain only if and when paid

B. Rev. Ruling 91-31 6 mini. Different, b/c in other scenarios, the owner gave up the property (disposition of

property which triggers § 1001)ii. If the debtor is still in possession of the property, NO sale or other disposition, t/f

1001 not triggered, t/f w/in RoIiii. Also, this ruling assumes that no exceptions to § 108 apply

1. If did apply, would have RoI, but it would be excluded. However, must reduce basis (NOT a permanent exclusion).

iv. Arguments for Speculator Simply Holding Property

1. Even though in form, took property subject to debt and debt was reduced, deal from beginning was that he would take the full debt (economic substance argument)

2. Here, FMV is NOT higher than the debt; t/f, not true debt and shouldn’t have to recognize RoI

a. Not allowed to treat as true debt for basis purposes, t/f shouldn’t force RoI treatment

C. Tax Benefit Rule i. Issue: whether taxes and interest, which have increased the amt of the loan, become

part of basis. OR, should they be treated some other way (tax benefit rule)ii. Rule :

1. If I take a deduction in an earlier year to which I’m entitled, then have recovery of those dollars in a later year, have to include in GI

2. If receive tax benefit in earlier year, and have a recovery, have to pay taxes on those dollars in the later year

iii. Ex: challenge assessment of property taxes; you were right, they must return those amounts. In later year, have recovery of previously deducted dollars, t/f HAVE GI.

iv. See Problem 5, p. 886D. Estate of Franklin

i. Because the purchase price of certain real prop exceeded its FMV, the TP could not be expected to make the investment in the property represented by the nonrecourse debt

ii. As a result, court ignored the nonrecourse debt for purposes of depreciation and interest deductions

iii. Rev. Ruling 77-1101. Nonrecourse debt is too contingent to be considered for purposes of basis,

interest, and depreciation2. Allows inclusion in basis only that portion of the purchase price paid in cash

E. Evaluating the Genuineness of Nonrecourse Debt i. Bergstrom - When nonrecourse purchase money debt exceeds a R approximation of

the property’s FMV, the debt is disregarded in its entirety for the purposes of determining depreciation and interest deductions

ii. Note that Tufts and Franklin are factually distinguishable1. Franklin - debt incurred > FMV of property securing its payment, t/f NOT

true debt (contingent)2. Tufts - original debt did not exceed value of the property

CH. 44, PART A: TAX SHELTERS, § 465 - THE AT RISK RULES

I. INTRODUCTION 31 minA. Methods

i. Use benefit of time value of $ and conversion of rates ii. Funneling income to tax exempt related party (e.g. exempt from U.S. taxes)

1. Ex: parent corporation in no-tax juris; child corp in U.S, pays 35% tax. Want income out of U.S. corp into parent corp

2. Ex: set up partnership b/t foreign corp and U.S. corp. Make transaction to generate income in early years w/ offsetting deductions in later year. Foreign corp is 99% partner in income year, U.S. corp is 99% partner in deduction years.

B. Correlation b/t AB & Depreciation

i. Cost basis of acquired property includes that part of the purchase price financed by nonrecourse borrowing

1. T/f, TP’s basis may reflect borrowed funds w/ respect to which the borrower has no personal liability

2. Created tax shelter by enabling TPs to claim deductions far in excess of $s actually at risk

ii. Issue : 1. Opportunity for tax deferral afford by nonrecourse financing of investments

encouraged TPs to invest in activities which were unsound economically2. Estate of Franklin - TPs sought to generate substantial interest and

depreciation deductions computed w/ reference to an inflated purchase price3. Problem w/ System

a. Accorded TPs advance credit in basis for making the investment reflected by NR financing

b. Permitted TPs to utilized deductions attributable to NR financing to offset income from other unrelated activities

C. Estate of Franklin 38 mini. Facts :

1. Set up partnership of doctors, Romneys on other side who own hotel. Partnership buys hotel from Romneys then leaseback. Here, shifting depreciation deductions.

2. Terms: a. Hotel partnership for 1.2 million SP on 10 year note, payments of

9K (mainly interest). 75K of prepaid interest, balloon payment at end of 1 mil.

b. Partnership lease Romneys. Lease payment of 9K.c. Problem is that partnership wants depreciation deductions in

exchange for 75K upfront.ii. Court :

1. Depreciation deductions were based on 1.2 mil of basis. 2. Court says never made any actual investment, they were never going to, and

the purchase price was extremely overstated.a. Only get depreciation on actual investment; won’t have any equity in

property until value above 1.2 mil, you pay balloon, or pay the principal

b. Court realizes will never happeniii. Significance :

1. Pigs get fed, hogs get slaughtered, i.e. this was too abusiveD. Congressional Response - § 465

i. Prevent TPs from claiming artificial deductions of the type claimed in Estate of Franklin

ii. Purpose:1. Prevent TP from deducting losses generated by certain business or income

producing activities in excess of the aggregate amount w/r/t which a TP is at risk (i.e. amt TP could actually lose) in each activity

2. Didn’t want abuse of tax policy through….a. Timing (§ 465)b. Sheltering (§ 469)

3. Remember, sheltering started w/ the inclusion of NR debt in basisE. General Rule

i. TP’s basis in property generally limits the amount of deductions allowable w/ respect to that property

1. Ex: loss deduction under § 165 cannot exceed AB; depreciation determined w/r/t TP’s AB

ii. § 465: Deductions limited to Amount at Riskiii. Activities Subject to Rules

1. Rules apply to individuals, estates, trusts and most closely held corporations2. Any business or income producing activity, including real estate activity,

engaged in by a TP is covered. § 466(c)(3)(A)a. Note there is an important exception for RE activity

II. OPERATION OF AT RISK RULES 58 minA. §465 At Risk Limitations

i. Can take deductions up to…1. The income from the activity; AND2. The amount of risk

a. Moneyb. Propertyc. Money / property pledged as debtd. *Essentially, your assets on the line

ii. Doesn’t shut down all sheltering behavior, just that abusive type1. E.g., qualified NR debt2. Fairly big loophole

iii. (d) Loss Limits1. Excess of the deductions attributable to the activity over income from the

activity2. Disallowed, unless have amt at risk or generate more income3. Not permanent, but deferred (suspended). Remember, worth less in the

future.B. Determination of Initial Amount at Risk

i. TP’s initial amt oat risk is the sum of…1. TP’s cash contributions to the activity;2. AB of other property contributed by TP to activity3. Recourse debt used to pay for activity4. NR debt up to extent have pledged other property to pay the debt5. Qualified Nonrecourse Borrowing

a. Government loans, government is guarantor of debt, borrow from qualified person (FG regulated Bank)

b. NOT Seller of the property or promoter of property (person who gets a fee w/r/t TP’s investment)

c. BUT Related Person borrowing is qualified if has commercially R terms

ii. Amounts borrowed from any person with interest in activity or from a person related to such person is NOT considered. § 465(b)(3)(A)

iii. Likewise, TP is not at risk w/ respect to amounts protected a/g loss through nonrecourse financing, guarantees or other similar arrangements. § 465(b)(4)

C. Qualified NR Financing - § 465(b)(6) i. Involves funds borrowed by the TP w/ respect to the activity of holding real property

and w/ repect to which no person is personally liable for paymentii. Reg. 1.465-27(b)(1): Includes…

1. Amts borrowed by TP from any Federal, State, or local government or instrumentality thereof;

2. Borrowed amts guaranteed by such governments;3. Amts borrowed from a qualified person

a. “Qualified person” - includes any person actively and regularly engaged in the business of lending money

b. Does NOT include…i. Any person form whom the TP acquired property (or related

person);ii. Any person who receives a fee (promoter) w/r/t the TP’s

investment in the property (or related person)iii. Related Persons

1. WILL constitute “qualified NR financing” if it is commercially R and on substantially the same terms as loans involving unrelated persons. § 465(b)(6)(D)(ii)

2. Commercially R a. Financing is a written unconditional promise to pay on demand or a

specific dateb. Interest rate is a R mkt rate of interest (considering maturity of

obligation)3. NOT Commercially R

a. Term of the loan exceeds the UL of the property; ORb. The right to foreclosure or collection w/ respect t the debt is limited

(except to the extent provided under local law)

III. ADJUSTMENTS TO AMOUNT AT RISKA. The amount a TP has at risk in an activity is adjusted each year for income and losses

generated by the activity and for withdrawals from the activity. Reg. §. 1465-22(b) & (c)B. Computation

i. Amount at Risk adjusted annually for1. Income, 2. Loss and 3. Withdrawal

ii. Rule: 1. Repayment of a nonrecourse loan from cash generated by the activity has no

effect on the amount at risk2. Loss in excess of Amount at Risk is disallowed, and sometimes carried over3. Reporting Income w/no deductions to offset increases Amt at Risk

iii. Increase Amount at Risk by:1. Direct payment of the nonrecourse indebtedness2. Additional cash contributions by TP3. Additional Property contributions by TP

iv. At disposition, suspended losses may be deductedC. Recapture Rule - 465(e)

i. Withdrawal in excess of Amount at Risk triggers Recaptureii. Withdrawal in excess must be reported as GI

iii. Recapture deductions taken in excess of Amount at Risk, those will be carried over upon recapture

D. Example

i. 10K cash down payment; 90K borrowed on NR basis. Initial amt at risk is 10K. Assume in Year 1, suffers 5K loss from interest and depreciation (excess of deductions over income).

1. If activity not passive, loss deductible a/g income from other sources.ii. Assume in Year 2, another 8K loss generated, 5K income generated and used to

repay part of borrowed funds, and w/draw 2K from activity.1. Must reduce amt at risk from 10K to 5K as result of loss from Year 12. Must reduce amt at risk from 5K to 3K b/c of 2K of cash w/drawn3. Repayment of NR loan from cash generated by the activity has NO effect on

the amt at risk. Reg. 1.465-25(b)(2)(i). a. Makes sense, b/c doesn’t TP’s investment in the B activityb. If, however, other funds used, would amt at risk

4. T/f, at year’s end, only 3K at riska. § 465(a)(1) limits loss deduction in Year 2 to this amount. T/f, at

risk amt reduced to zero.b. Remaining 5K of loss disallowed and treated as deduction allocable

to activities in Year 3iii. Assume in Year 3, income from activity = available deductions (other than

carryover), and that TP w/draws 2K from cash flow of activity.1. At end of Year 2, at risk amt was zero.2. 5K carryover can’t be used here, t/f must carryover to Year 43. W/drawal of 2K creates negative 2K balance in the at risk account

a. Triggers § 465(e) recapture rule, which requires TP to include the 2K in income

b. § 465(e)(1): TP must include in income amt equal to deductions taken in excess of amt at risk

c. § 465(e)(1)(B) allows that amt as a deduction allocable to the activity in Year 4

4. T/f, now have carryover of 7K (5K + 2K)iv. Assume in Year 4, activity generates 5K of NI

1. May use 5K of 7K carryover to offset § 465(a)(2)2. Remaining 2K must be carried forward, b/c at risk amt is still at zero

v. Assume in Year 5, 5K income generated, and no deductions other than carryover1. TP may offset the 5K income by 2K carryover2. Must report remaining 3K of income, which TP’s amt at risk. T/f, he can

now w/draw 3K w/out triggering recapture rules of § 465(e)

CH. 44, PART B: § 469 PASSIVE ACTIVITY LOSSES & CREDITS LIMITED

I. INTRODUCTION TO § 469 2/8A. TP Behavior Triggers Congressional Response

i. § 465 did not address whether and when deductions from one activity could be used to offset income from another activity

ii. Needed provision to address harmful and excessive tax sheltering, w/out eliminating substantially all tax preferences in the IRC

1. Certain preferences are socially and economically beneficial2. Prohibitively difficult, and likely impossible, to design tax system that

measured income perfectly3. Congress intended to benefit and provide incentives to TPs active in the

businesses to which the preferences where directed

iii. By creating a bar a/g the use of losses from B activities in which the TP does not materially participate to offset positive income sources, Congress believed that it was possible to significantly reduce the tax shelter problem

B. § 469 - In General i. Most significant anti-tax shelter legis enacted by Congress

1. Apply § 465 first, if pass, then apply § 469ii. Rules apply to individuals, estates, trusts and closely held corporations. § 469(a)(2)

1. C Corps NOT caught! See prospectus 40 miniii. Essentially, rules states that TPs must classify: Income, losses, and credits as being

generated by Passive or Non-Passive Activities1. Passive activity deductions may only be used to offset income from passive

activities; and tax credits related to passive activities may only offset tax liability of passive activities

2. Losses are carried over and suspended until disposition. § 469(b).a. No limits to the carryover of passive activity losesb. Generally, suspended losses are allowed in full when the TP disposes

of the interest in the passive activity. § 469(g)(1)(A)iv. Result

1. Deferral and not the permanent disallowance of excess deductions and credits generated by passive activities

II. PASSIVE ACTIVITIESA. Identifying Passive Activities

i. (c)(1) A passive activity involves the conduct of any T or B in which the TP does not materially participate

1. T or B includes those activities involving the conduct of a T or B w/in meaning of § 162

2. (c)(6) includes, to the extent provided by the Regs, any activity w/ respect to which expenses are allowable as a deduction under § 212

3. Excludes real property business. See (c)(7)ii. (h)(1) Material Participation: involvement is regular, continuous, and substantial

1. Determines whether passive or non-passive2. Rationale

a. Benefits of tax preferences should be directed primarily to TPs w/ a substantial and bona fide involvement in the activities to which preference relates

b. Such a TP more likely than passive investor to approach the activity w/ a significant nontax economic profit motive, and to form a sound judgment as to the activities’ genuine econ significance and value

3. Seven Alternative Tests (must examine all!): Temp. Reg. 1.469-5T(a)a. TP hours of participation > 500 per yearb. TP participation constitutes substantially all of the participation in

the activityc. TP participation >100 hours per year, AND is not less than any

other persond. If materially participated in any 5 of the previous 10 yrse. Material participation found based on all facts and circumstancesf. Personal Service Test

i) Personal service activities are T or B, such as law, in which capital is not a material income-producing factor

ii) TP materially participates in such an activity if TP materially participated in the activity for any three prior years

iii. Special Rule for Limited Partners1. Except as provided by regulation, a limited partner does NOT materially

participate w/ respect to his interest in the limited partnership. (h)(2)2. Thus, generally, limited partnership interest generates passive income or loss3. Exception :

a. Satisfy 500-hr, 5-years-out-of-10, or personal service-activity testsiv. Bakery Hypo 47 min - important!!!

1. Have Bakery and restaurant. Bakery showing positive income. Must decide where to spend time. If can argue all one activity, may be helpful.

2. Have opposite incentive, however, when don’t put a lot of time into either one.

B. Rental Activities i. Material Participation

1. Rental activity is generally a passive activity. (c)(2) a. Rental activity: any activity “where payments are principally for the

use of tangible property.” (j)(8)b. BUT IF significant services are rendered in connection w/rental then

it’s a non-passive activityi) Ex: renting hotel rooms, car rental

2. (c)(7)(B): Not considered passive per se IF…a. (1) More than half of the personal services the TP performs in T/B

during the taxable year are performed in real property T or B in which the TP martially participates; AND

b. (2) TP performs more than 750 hours of service during the taxable year in real property T/B in which TP materially participates

i) Real prop T or B: “real prop development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation mgmt, leasing, or brokerage T or B. (c)(7)(B)

ii. Exception for Active Participation in Rental RE - § 469(i)1. Congress not interested in “Average Joe” sheltering2. $25K Offset Rule of § 469(i)

a. IF a TP, who is a natural person, actively participates in rental RE activity, TP may apply the losses and credits from that activity a/g up to $25K of the TP’s non-passive income. (1), (2).

b. Relief is phased out for TPs with GI > 100K. (3)(A)3. Active Participant ?

a. TP must own at least 10% interest in it. (i)(6).b. More lenient standard than materially participate

i) Does NOT require regular, continuous, and substantial involvement in the operations

ii) TP is active IF TP participates in a significant and bona fide sense in making mgmt decisions or arranges for the provision of services such as repairs

iii) Examples (mgmt decisions): 1. Selecting or approving new Ts2. Establishing rental terms3. Hiring a rental agent4. Hiring a person to provide repair services5. Approving capital or repair expenditures

C. Scope of Activity i. Importance

1. Must determine to ascertain material participation2. Must know b/f apply § 469(g), which allows deducting suspended losses of a

passive activity when a TP disposes of the entire interest in that activityii. TP can combine hours into one activity

1. Multiple undertakings if related can combine into one activity2. If enough undertakings combined, may lead to Material Participation3. IF TP does not then TP wants them to be separate activities, that way sale of

one crosses over to non-passiveiii. Factors - Reg. § 1.469-4(c)(2)

1. Similarities and difference in types of businesses;2. Extent of common control;3. Geographical location;4. Interdependence between activities

D. Treatment of Losses and Credits i. § 469 requires TP to compute the gains and losses from each passive activity

ii. Losses from an activity are first offset by gains from that activity. 1. Excess loss is used to offset gain from other passive activities2. Excess loss in aggregate must be carried forward

E. Portfolio Income and Expenses i. § 469(e)(1): portfolio income and expenses are excluded form the determination of

passive activity gains and lossesii. Rationale

1. Portfolio investments ordinarily give rise to positive income, and are not likely to generate losses which could be applied to shelter other income

III. DISPOSITION OF TP’s ENTIRE INTEREST IN PASSIVE ACTIVITYA. Deduction Available TP Disposes Entirely of Interest In Passive Activity

i. IF TP disposes of the entire interest in a passive activity, any suspended losses allocable to that activity no longer are passive activity losses but are deductible against income. (g)(1)(A)

ii. Passive loss offsets passive income, then NET Passive loss offsets non-passive income

iii. TP must have a fully taxable disposition of TP’s interest to an unrelated party. (g)(1)(A), (B)

B. §469 Consequences of a TP’s Death i. The suspended losses are allowed only to the extent they exceed the amount, if any,

by which the AB of the property in the activity is by §1014ii. To the extent the basis of property in the activity is by § 1014, suspended losses of

the activity are forever disallowedC. § 469 Consequences of Gift

i. Gift of part or all of TP’s interest in an activity will not cause the release of the suspended losses allocable to the activity. (j)(6)

ii. Donor’s AB will be by suspended lossesiii. Donee gets that AB, except when there is a computation of a loss, then that loss is

disallowed

CH. 45 - ALTERNATIVE MINIMUM TAX

I. INTRODUCTION 2/15 19 minA. Originally …

i. Designed to apply to 2 dozen very wealthy people; using special subsidy provisions to reduce taxable income to point were paying less tax than their secretaries

ii. These TPs were abusing system, and Congress didn’t appreciation thatiii. Companion tax: if stack up to many benefits in one year, we will limit those; wealthy

individuals should pay some minimum amount of tax liabilityB. Congress’ Rationale

i. Provisions of the code constitute tax preferences, apt to be utilized disproportionately by high income persons, and the TP’s ability to reduce tax liability through the use of certain tax preferences should be restricted

ii. AMT objective: Ensure that no TP with substantial income can avoid significant tax liability by using exclusions, deductions, and credits

C. § 55(a) i. AMT defined as excess of tentative minimum tax over regular tax

ii. In effect, TP pays the regular tax or the tentative minimum tax, whichever is greateriii. Separate out AMT, b/c might be credit available to offset AMT. Have to know how

much paid in additional min tax to know how much can offset.

II. MECHANICSA. TMT for individuals is generally equal to 26% of the first $175K in “taxable excess” plus

28% thereafter. § 55(b)(1)(A).i. Separate lower maximum rates, drawn from §1(h), on that portion of the taxable

excess that consists of NCG. § 55(b)(3)ii. “Taxable Excess,” in turn, is the excess of AMTI over the exemption amount. §

55(b)(1)(A)(ii).1. $ 42.5K for individuals not married and not a surviving spouse2. $ 31,275 for married individuals filling separately3. Exemption amount phases out when AMTI reaches sufficiently high levels.

§ 55(d)(3)a. $ 112.5K for individuals

B. Adjustments made to TI to come up with AMTI

III. DETERMINING AMTIA. AMTI = TI, adjusted by §§ 56 and 58 ( or ), and by items in § 57. § 55(b)(2).

i. Supposed to be closer to economic incomeii. Impose lower rate, but bigger base

B. Analysis Framework i. Start with TI.

1. GI ATL AGI BTL TI2. Deductions:

a. ATL;b. BTL;c. Misc itemized deductions (2% floor, § 67);d. Overall limitation on itemized deductions § 68; e. Standard deduction; and f. Personal exemptions

ii. Make §§ 56 and 58 adjustments1. Depreciation:

a. §1250 property (real property) is depreciated under SL method, convert to 150% declining balance

b. Note : i) Since 1999, same recovery period used for regular tax and

minimum tax purposes c. Tangible personal property using 200% declining balance must be

adjusted to 150%. i) Upward adjustment

ii) Because total depreciation deductions over the life of the property are the same under both the regular tax and the AMT, may need two depreciation schedules

2. Limitation on Itemized Deductions, Std Deductions and Personal Exemptionsa. Misc. itemized deductions NOT allowed. § 56(b)(1)(A)

i) State and Local taxes NOT allowed. § 56(b)(1)(A)ii) adjustment

iii) Potentially substantial impact, e.g. attorney fees…b. Atty fees:

i) IF deductible under § 212 and not § 162; AND ii) If not ATL under § 62(a)(4)/(20);

iii) THEN NOT allowed (misc itemized deduction)c. Medical expenses limited to excess of 10% of AGI. § 56(b)(1)(B)d. Standard deduction and personal exemption NOT allowed. § 56(b)

(1)(E)e. § 68 overall limitation on itemized deduction does NOT apply. §

56(b)(1)(F)i) adjustment

iii. TI adjusted per § 571. Certain tax exempt interest included

a. Pursuant to § 57(a)(5), interest on “specified private activity bond” ( by deductions that were nondeductible in computing regular tax liability) is an item of tax preference accounted for

2. Qualified Small Business Stocka. 7% of the amt excluded under the QSBS rules of § 1202 is an item of

tax preference. § 57(a)(7)iv. Subtract out Exemption, watch for phase outs

1. Taxable excess = AMTI – Exemption Amount2. Exemption (2006) = $ 42.5 Indiv TP; $ 62,550 married TPs

a. Exemption phases out at high income levels. § 55(d)(3)b. Every $ 4 in excess reduces exemption by $1

3. IF NCG, use lower rates in §55(b)(3)

IV. DETERMINING TAX LIABILITYA. AMTI

i. TI +/- adjustments under §§ 55-57ii. Subtract out exemptions, determine phase out

B. Tentative Minimum Tax i. 26% of the first $ 175K of this taxable excess, plus 28% of the amount above $ 175K

(less any AMT foreign tax credit)ii. Also, must take into account special NCG rates of § 55(b)(3)

C. Pay regular tax liability plus (excess over Alt Min Tax liability)i. Reason we care about the distinction, in some years TP could owe AMT or not.

1. Timing differentials could make TP end up owing too much

ii. Know how much AMT paid and in later years some of it may be a credit owed to TP, broken down between permanent and timing ones

V. CREDITS ALLOWEDA. Once the amount of the tax imposed has been calculated, it is then necessary to determine

whether the TP is entitled to claim any credits a/g it

VI. KLAASSEN v. COMMISSIONERA. Facts :

i. Δ had 10 children; filed joint return claiming 12 exemptions and IDsii. IRS issued Δ a notice of deficiency for the taxable year 1994, determining they were

liable for the AMT prescribed by § 55B. Issue :

i. Does the AMT impose a tax whenever the sum of specified % of the excess of AMTI over the applicable exemption amount exceeds the regular tax for the taxable year?

C. Rule :i. Yes.

D. Rationale :i. Original purpose of the AMT was to ensure that TPs w/ substantial economic income

pay a minimum amount of tax on it

CH. 42 - SALE OF BUSINESS & SALE-LEASEBACKS

I. INTRODUCTION 2/22A. Sale (or purchase) of an unincorporated business, as well as sale-leaseback arrangements

i. Seller concern is the character of the gainii. Buyer concern is the basis in new property

B. What are we selling?i. Creates allocation problem

ii. If purchase price always totaled to neat number would be easy. However, often have some premium paid

iii. TPs (buyers and sellers) had different incentives1. Created buyer allocation and seller allocation which were not the same;

public fisc gets whip sawed2. Congress created 1060…

C. 1060 : If have sale of assets that make up T or B, must value property category by category (seven total classes of property)

i. Things really easy to value come firstii. Have less purchase price to allocate to those harder to value elements of the purchase

price

II. SALE OF SOLE PROPRIETORSHIP - SINGLE OR SEPARATE ASSET?A. Williams v. McGowan Standard

i. Facts :1. Π sold his hardware store after buying out deceased partner’s interest;

reported sale as ordinary loss2. Service determined business was capital asset that demanded CG trtmt

ii. Rule :

1. Sale of a business must be fragmented and a separate gain or loss analysis made for each tangible and intangible asset of the business

iii. Holding :1. Could not treat sale as sale of unified asset;2. Despite functional interrelationship of a business’ assets and the fact that the

assets would not be as valuable if sold separately, separate tax analysis had to be made w/ respect to each business asset sold

a. Determine character of each asset sold, i.e. ordinary, capital, §1231; AND

b. Must calculate gain or loss recognized w/ respect to its disposition by allocating portion of the purchase price to each asset

iv. Policy :1. To view sale of business as a sale of a single asset would distort the operation

of the tax system and enable TPs to avoid tax2. E.g. would negate distinctions b/t LT / ST and Gain / Loss3. See example, p. 1008

III. GOODWILL, GOING CONCERN VALUE, & COVENANTS NOT TO COMPETEA. Doesn’t apply only in acquisition of T or B; but, this is where it has most of its biteB. Solomon Solution

i. All of these kinds of assets (lists); some have NO identifiable ULs, some have very short ULs.

ii. T/f, will give 15 years on all of them (rough justice by Congress)iii. Whether in § 197 depends on whether acquired by acquisition of entire T or B

1. If not in § 197, will be in § 167, and may write off over UL2. Otherwise, must use 15 year period, regardless of UL

iv. Assets involved…1. Workforce in place2. Business books and records / office systems3. Customer relationships4. Other similar items

C. Valuable intangible items are often included in the sale of a business, and under Williams, part of purchase price must be allocated to these items…

D. Goodwill : i. Ex: business has lots of loyal patrons; when sale, charge more than merely FMV of

all assets soldii. Reg. §1.197-2(b)(1): “value of a T or B attributable to the expectancy of continued

customer patronage. This expectancy may be due to the name or reputation of a T or B or any other factor.”

iii. Purchase price in excess of FMV of the tangible and intangible items of a business indicate a payment for GW

iv. Common factors…1. Established reputation in an area2. Good location3. Well-recognized trademark or tradename

E. Going Concern Value :i. In cases where the existence of GW was questionable, courts have held that portion

of the PP should be allocated to “GCV”ii. Reg. §1.197-2(b)(2):

1. “the add’l value that attaches to property by reason of its existence as an integral part of an ongoing business activity” and

2. “includes the value attributable to the ability of a T or B to continue functioning or generating income w/out interruption n/w/s a change in ownership”

iii. Ex: fixtures and furniture sold in conjuncture w/ bar likely to have more value than if sold separately

F. Covenant Not to Compete : i. B/f purchasing business, buyer insists that the seller agree not to compete w/ the

buyer in the same kind of business for a stated period of time; often necessary to ensure effective transfer of GW

ii. Tax trtmt of amts allocated to CNC differs from that of amts allocated to GW1. Seller may claim CG trtmt w/ GW2. Seller must report as OI amts received as CNC

iii. Severability Test :1. Used to determine whether a CNC could be segregated and valued

independently from other assets transferred, particularly GW2. If CNC serves only to assure that the transferor will enjoy the benefit of the

GW he has acquired, no part of PP will be allocated to it3. If CNC understood by the parties to be separate and distinct item, court will

respect R allocations to the covenantiv. Economic Reality Test :

1. More common; see Annabelle Candy Co. 2. Asks whether buyer and seller intended that part of the PP be allocated to the

CNC and whether CNC has some independent basis in fact or some relationship to business reality

IV. TAX CONSEQUENCES OF ALLOCATION OF PP TO GW, GCV, & CNCA. Strategic Decisions

i. Seller: Allocation determines AR, Amount of G/L, Characterii. Buyer: Allocation determines deprecation deductions, Amount of G/L & Character

on later salesB. Historic Allocation Strategies

i. Until 1993, GW and GCV considered assets w/out a determinable UL and t/f not depreciable

1. Thus, buyers sought to minimize amount of PP allocated to those assets by carving them out and treating them as separate intangible assets w/ limited ULs, thereby making it possible to amortize the PP allocated to those items

ii. Buyers and sellers disagreed over trtmt of CNC, which have limited life, with amts allocated amortized over that period

1. Buyers t/f sought to allocated as much of the PP as possible to such covenants

2. For sellers, amts received were OI, t/f preferred minimal allocation to CNCC. §197 – Amortization of Business Intangibles

i. Amortization for Goodwill, CNC, GCV, and other business intangibles over a 15 year period

1. Negates incentives for carve outs from Newark2. Creates new planning considerations for buyers and sellers

a. Buyers get amortizationb. Sellers get capital asset character

ii. Note : 1. 5 Year CNC is amortized over 15 years

iii. Issue :

1. Buyer’s efforts to maximize allocations to depreciable assets with a short UL (3,5,7 yr property)

2. B/c of recapture potential, increased allocation to such property might mean increased OI. See § 1245.

D. Exceptions to Amortized Intangibles i. (e)(4): Patents, copyrights not acquired as part of acquisition of assets constituting

T/B or substantial portion thereofii. (e)(3):

1. Certain computer software, see §167(f)2. Depreciation here is over 36 month period using SL depreciation

iii. (c)(2): 1. Certain self-created § 197 intangibles2. Ex: Advertising expenditures deducted in year incurred or paid

iv. No losses permitted on resale of intangibles, IF…1. TP still retains the other amortizable § 197 intangibles. § 197(f)(1)2. Loss allocated among remaining intangibles, thus AB

E. Recapture Rules i. 197(f)(7): Treats amortizable § 197 intangibles as properties “of a character subject

to the allowance for depreciation under § 167ii. IF the sale of 197 intangible results in a gain to the TP the gain may be subject to the

recapture rules of § 1245 and/or characterization under § 1231

V. VALUATION OF GW, GCV, AND CNCA. Introduction

i. Generally, service will respect values established by K-ing parties in their sales agreement, particularly where the interests of the parties are adverse

ii. T/f, allocation should generally be negotiated by parties and be specifically reflected in their agreement

B. § 1060 i. Requires that residual method of valuation be used in valuing GW and GCV in

“applicable assets transactions”, i.e. purchase of the assets of a T/B. (c)ii. Residual Method Calculation

1. GW/GCV = PP – aggregate FMV of tangible and identifiable intangible assets (other than GW/GCV)

2. Policy: curve difficulty of establishing the value of GW and GCV / potential for abuse (“whipsaw” potential)

C. Reg. § 1.1060-1(c)(2) i. Requires allocation of PP amongst seven classes of assets in following order…

1. Class I: Cash and general DAs2. Class II: Actively traded personal property as defined in §1092(d),

certificates of deposit and foreign currency; 3. Class III: Assets TP marks to market at least annually for federal income tax

purposes and debt instrumentsa. Mark to market : have to take in gains and losses each yearb. Ex : purchase stock during year for 50. At end of year, stock trading

for 60. Must substitute 60 as value, and recognize 10 of gain, even though haven’t had a disposition event. T/f, if required to mark to market, must recognize gains and losses each year. Only required for certain TPs, industries, and assets

c. Ex : A/R

d. NOT Ex : certain contingent or convertible debt instruments; debt instruments issued by related persons

4. Class IV: Stock in trade of TP (inventory)5. Class V: All other assets not included above

a. Will often be bulk of assets6. Class VI: All §197 intangibles except GW or GCV7. Class VII: GW and GCV

a. Residual method: allocating whatever’s leftD. 1060(a)

i. Parties bound to allocation in a written agreement regarding FMV of any asset UNLESS Treasury says its inappropriate

ii. While service free to challenge any allocation or the valuation of any asset, parties themselves are bound by their written agreement, unless they are “able to refute the allocation or valuation under standards set forth in Danielson”

VI. SALE-LEASEBACKA. Strategic Concerns

i. Benefits of characterizing a transaction as a sale or lease1. IF Lease, TP lessee could claim rental deductions in excess of depreciation

and interest deduction available to purchaser of the same propertyii. IF respected, sale-leaseback may shift tax benefits from one TP to another

1. Seller-lessee gets a deduction for rent perhaps greater than deductions available to it as an owner of the property

2. May enable seller-lessee to raise a substantial amount of cash, continue to possess and use the property, and pay “rent” lower than any interest expense

iii. Service wants to prevent shifting of tax benefits and resulting in tax revenue; t/f, may re-characterize sale-leaseback transactions

B. Characterized as Financing Arrangement i. When TP sells the property to lender and then leases it back from lender with option

to purchase…Service may call this a Financing Arrangement if they disregard the sale-leaseback form of the transaction, more akin to a mortgage

ii. But see Frank Lyon – not disregarded and TP got depreciation and interest deductionsC. Characterized as a Tax-Free Exchange

i. Service could disregard sale-leaseback and call it a LK exchange1. See 1.1031(a)-1(c): lease with 30 or more years to run and a fee interest in

real estate are LK properties2. Policy: § 1031 negates G/L in transactions where TP is in essentially the

same economic position after the transaction as beforeii. But see Leslie – TP overcame Service challenge

VII. CASE LAW 2/24A. Frank Lyon

i. See class notes

CH. 39 - LIKE KIND EXCHANGES

I. INTRODUCTIONA. § 1001(c) : Gains or losses realized on the sale or exchange of property must generally be

recognized

i. Under § 1031, h/w, no gain or loss is recognized when property held for productive use in T/B or for Investment is exchanged solely for property of LK to held be for productive use in T/B or for Investment

1. Don’t really mean solely. ii. “Non-recognition” rule

1. Deferral, not permanent2. Have specific basis rules (see infra)

B. § 1031(a)(2) : Six Exceptionsi. Stock in trade or other property held primarily for sale (compare w/ § 1221(1),

excluding certain property from definition of capital asset);ii. Additional exceptions for exchanges of …

1. Stocks;2. Bonds;3. Notes;4. Choses in action;

a. Negotiable / enforceable things representing rights (ex: check)5. Certificates of trust or beneficial interest; OR6. Other securities or evidences of indebtedness or interest7. Why add these?

a. LK provision was abused by brokers and investment houses who established “exchange departments” to exchange appreciated securities w/out recognition of gain, while selling for cash and recognizing losses on those securities that had in value

iii. § 1031(a)(2)(D): exception for interests in an partnership1. Added in response to court decisions holding that in certain circumstances,

an exchange of an interest in one partnership for an interest in another could qualify under § 1031. Meyers v. Commissioner

2. Congress, however, accepted the position of the Service that partnership interests were investment interests similar to those already excluded from § 1031 and thus not appropriate candidates for non-recognition treatment

II. CONTINUITY OF INTERESTA. For tax purposes, an exchange is typically equivalent to cashing in one’s investment in the

property exchangedi. NR rules of § 1031, h/w, assume properties received in an exchange is simply a

continuation that investment in a modified formii. Since investment is in substance a continuing one, the TP has only technically, but

not effectively, “realized” gain or loss, and exchange thus regarded as an inappropriate time to levy a tax or permit a deduction

B. Policy Underlying §1031 i. Exchange is a continuity of investment in a modified form

ii. Admin difficulty in valuing property in LK exchange

III. THE LIKE KIND REQUIREMENTA. Are Particular Properties LK ?

i. LK = Nature/character of property, Kind/Class, NOT quality/grade. Reg. § 1.1031(a)-1(b)

ii. Whether real estate is improved or unimproved is immaterial (strikingly broad)iii. Examples of qualifying transactions:

1. Exchange of city RE for a ranch or farm2. Exchange of 30-year leasehold in RE for RE

3. Exchange of improved RE for unimproved REiv. Liberal approach where interest in question constitutes an interest in real property…

1. Exchange of remainder interests in two parcels of land2. Tenancy in common interest in land for 100% ownership thereof3. Leasehold in a building for a sublease in another part of the building4. Exchange of a leasehold interest in a producing oil lease constituting real

property for an improved ranch5. Undivided interest in mineral rights in certain land for an undivided interest

in improved realty6. Golf club property for property subject to 99-year condo leases7. Perpetual water rights recognized under local law as real property for a fee

interest in landB. Generalizing When Properties are LK - Reg. § 1.1031(a)-2

i. LK requirement met IF depreciable tangible personal property is exchanged for property that is either of a LK or of a like class

1. Depreciable tangible personal property is of like class to other depreciable tangible personal property if both are in same General Asset Class. (b)(1)

2. Thirteen General Business Asset Classes, drawn from Rev. Pro. 87-56, and described in Regs.

a. Ex: office furniture, fixtures, and equipment are all w/in the same General Business Asset Class

3. Depreciable tangible personal properties are also of like class if w/in the same “Product Class.” (b)(1)

ii. Once you get into intangible properties, get into court holdings, which can be rather narrow

1. Ex: Copyright for book for Copyright for book ok, but not for Song. 2-(c)(3)2. Ex: GW or GCV of one business is not LK to GW or GCV of another

business. 2-(c)(2)

IV. THE HOLDING REQUIREMENTSA. Personal Use property excluded from §1031, one TP may qualify though while the other does

notB. Two Holding Requirements

i. Property given up must be held for T/B/Iii. Property received must be held for T/B/I

C. §1031 applies when TP exchanged real property and then promptly transferred the real property received to a two person partnership in return for a general interest in the partnership

i. Property received was regarded as held for investment on the ground that its contribution to the partnership was a mere change in form, not a liquidation of the investment

D. §1031(g) : Two Year holding period of exchanges b/t related personsi. See example, p. 928

ii. §1031(f) prevents swapping of basis between related parties1. Each will have to recognize G/L2. Recognize currently not past

iii. Rev Ruling 72-151 shows that §1031(d) controls, loss preserved even if Boot received

iv. IF RP disposes within 2 years of first transaction, TP recognize currently

V. BASIS CALCULATIONSA. Deferral, NOT Permanent Exclusion

i. Unrecognized gain or loss is preserved, through the basic mechanism, in the LK property received

ii. Since non-LK property constitutes boot, such property winds up w/ a FMV basis in the recipient’s hands

iii. In effect, TP treated as having purchased the non-LK propertyB. Formula

i. AB of all LK and Non-LK property given up;ii. + Gain recognized, liability taken on, or cash paid;

iii. – Loss recognized, liability shed, or cash received;iv. = The Basis to be allocated v. Rules:

1. Basis allocated first to non-LK property received to extent of FMV2. Remaining total Basis constituting the basis of LK property

C. Basic Concept i. TP is in effect receiving a partial return of investment, and should t/f basis to reflect

that fact when…1. Money is received;2. Liability relief occurs; OR3. Loss is recognized

ii. TP is in effect investment, and t/f should basis as a result, when…1. Money is paid;2. Liabilities are taken on; OR3. Gain is recognized

D. Testing Your Answers i. Non-LK property received should have a FMV basis

ii. LK property received should have a basis that preserves the unrecognized gain or loss in the property given up

VI. SOLELY FOR LK PROPERTY: THE PRESENCE OF “BOOT” 3/1A. Boot is non-LK property added in to even up the exchange

i. TP giving but NOT receiving cash or other non-LK property, remains w/in 1031(a) since he receives solely LK property for the property he gives up

1. Cash or other nonqualifying property he conveys will be reflected in the basis of the property acquired

ii. TP receiving boot is not receiving solely LK property1. Must recognize gain to amount of boot, but not in excess of gain realized, LK

exchange still permitted2. Recognition of loss on LK property, however, is prohibited

iii. Gain or loss on non-LK property is not governed by § 1031, and such gain or loss is recognized under the general rule of § 1001(c)

VII. TREATMENT OF LIABILITIES 59 minA. Introduction

i. Common for properties in LK exchange to be transferred subject to a liability, or for one party to assume a liability of another party

ii. Such liability relief is treated under § 1031 as money received by TP relieved of liability. See 1031(d) last sentence

iii. Liability relief, t/f, constitutes a form of bootB. Complication

i. Suppose both properties in a LK exchange are transferred subject to liabilities

ii. Reg. § 1.1031(d)-2: only the net liability relief, reduced by any cash paid, constitutes money received.

iii. See examples, p. 930

VIII. RELATIONSHIP B/T § 267(a)(1) & § 1031 48 minA. The preservation of unrecognized loss in cases where exchanges occur b/t related persons as

defined in § 267(b) may result in what appears to be inconsistency b/t § 1031 and §267(a)(1)B. Example

i. TP gives to daughter land worth 100K w/ AB of 120K in exchange for 20K cash and RE worth 80K.

1. Under 1031(c), even though TP recieives boot, no loss can be recognized. 2. § 1031(d), however, preserves TP’s loss in the basis of RE received by TP,

e.g. TP would take basis of 100K in RE. If later sold RE for 100K, would recognize 20K loss

ii. What if § 1031 did not exist?1. § 267(a)(1) would disallow TP’s 20K loss on the taxable exchange2. TP would take FMV basis of 80K in RE; daughter would likewise take FMV

basis in land3. Note that § 267(d) may provide some relief to the TP / daughter family unit if

the daughter were later to sell the land at a gainC. Rev. Ruling 72-151

i. Confirms that § 1031(d) controls in situation above

IX. SALE OR EXCHANGE?A. Former Reg. § 1.1002-1(d) describes an exchange as, ordinarily, “a reciprocal transfer of

property, as distinguished from a transfer of property for a money consideration only.”i. Hypo : TP “sells” qualifying property for cash, then immediately “purchases”

qualifying LK property from the same personii. Rule : If the transaction is ins substance an exchange rather than a sale and purchase,

the provisions of § 1031 will governB. Exchange in Substance Rule

i. §1031 applies when TP sells qualifying property for cash to buyer then by prearrangement immediately purchases qualifying LK property from the same person

ii. Can apply when TP is parent selling and subsidiary buyingiii. Sale and Lease Back Context

1. If lease is 30 yrs or more then its LK. Reg. § 1.1031(a)-1(c)2. TP may want sale/leaseback context

X. THREE-WAY EXCHANGES & DEFERRED EXCHANGESA. Three-way Exchange Defined

i. Not necessary to receive the LK property from the same person to whom one has transferred property

ii. Receipt of cash in return for one’s property, even if the proceeds are immediately invested in LK property is fatal to § 1031

iii. Regs authorize use of a qualified intermediary in a simultaneous exchange. Reg. § 1.1031(b)-2

iv. See Rev. Ruling 77-297B. Applicable Situations

i. Three way trade of LK property; ORii. Use of qualified intermediary, qualified escrow accounts or security or guarantee

agreements

iii. Use of qualified intermediary is a safe harbor, e.g. if person is an agent of one of the TPs then that is not fatal. See Reg. § 1.1031(k)-1(d)(1).

1. Authorizes a TP to utilize services of a person or entity (who is not a “disqualified person”) to acquire and transfer properties, thereby accommodating the exchange

C. Simultaneous Transfer Required ?i. Starker - TP entitled to §1031 treatment on the ultimate receipt of LK property even

though…1. Property to be received had not been ID at the time of the transfer of the

property given up, and 2. TP had reserved the right for up to 5 years to get one property, several or

cash3. Note: Congress did not like open ended deferral, enacted § 1031(a)(3)…

ii. (a)(3): TP required to …1. ID replacement property w/in 45 days of the transfer of the relinquished

property AND 2. To receive replacement property no later than 180 days after transfer or due

date for TP’s tax return of that year, whichever is earlierD. Apply the Anti- Starker Rule

i. TP may identify 3 replacement properties of any value (the three-property rule) OR any number of replacement properties that in the aggregate do not exceed twice the value of the property relinquished (200-percent rule). See Reg. § 1.1031(k)-1(c)(4)(i).

ii. IF TP identifies too much property TP is treated as identifying none and t/f will not be entitled to the benefit of § 1031 nonrecognition.

1. BUT IF TP receives property within 95% of aggregate FMV then 1031 will apply

E. Reverse Starker Exchanges i. Exchanges where the replacement property is acquired before the relinquished

property is transferred1. Reg. § 1031(k)-1 (3 property, 200% or 95% rules) do not apply

ii. Rev. Pro. 2000-37, included in materials, provides a safe harbor whereby reverse Starker arrangements will qualify for § 1031 treatment

1. Rule : exchange accommodator must hold “qualified indicia of ownership” of the property

XI. INTERFACE OF §§ 121 & 1031A. Introduction

i. Recall that § 121 provides an exclusion for gain realized on the sale or exchange of a PR if TP has owned and used property as PR for periods aggregating two years in the five year period preceding the date of the sale or exchange

ii. T/f, TP may qualify for exclusion even though at time of disposition the TP is holding the property for B or I purposes

iii. Raises possibility that § 1031 may also apply if there is an exchange of the property for other LK property

B. How is § 1031 applied when §121 is also applicable?i. Provisions Distinguished

1. § 1031 is essentially a deferral provision2. § 121 is an exclusion provision

ii. Rev. Pro. 2005-141. §121 must be applied to gain realized before applying §1031

2. Under §121(d)(6), the §121 exclusion does not apply to depreciation deductions, but §1031 may apply to such gain

3. In applying §1031, Boot received in exchange for the property used in the TP’s T/B/I is taken into account only to the extent the boot exceeds the gain excluded under §121

4. In determining AB in property received, §121 excluded gain counts as to increasing AB

a. Thus, under § 1031(d), the basis of the replacement B property is by any gain attributable to the relinquished B property that is excluded under § 121

C. §121(d)(10) - Property Acquired in a LK Exchange i. IF property is acquired in LK exchange, the property must be held for at least five

years before gain on its sale or exchange may be excluded under §121ii. In 2005, extended so as to apply not only to the TP who acquired property in a §

1031 exchange, but also to any person whose basis in the property is determined by reference to the TP’s basis

1. E.g. those who may receive the property from the TP as a giftD. See Problem 4

XII. CASE LAW 3/3A. Rev. Ruling 77-297

i. Facts : 1. Prefer LK exchange so they can not recognize gain, but if can’t, should still

sale property?a. A obviously already decided to sale (Ranch 1), b/c enter agreementb. B will put into escrow 100 of cash; pay 200 at closing; assume 160

of liability; and sign note for 540 (should add up to 1,000 ranch)c. A will have 1001 disposition

i) Recognize gainii) Likely may defer some of gain recognition b/c takes note

(installment sale)2. A convinces B to buy C’s property (Ranch 2)

a. Permissible, so long as A doesn’t get any cash for certain period of time

b. B/t B and C, B will buy landi) FMV of 2,000; 40 in escrow; 800 at closing; assume debt of

400; and signs note for 760ii) Sale goes through

3. A exchanges Ranch 1 w/ B for Ranch 2a. Original agreement b/t A and B essentially doesn’t go throughb. Instead, simply exchange properties w/ debt on both sides…

i) Ranch 1 subject to debt of 160, t/f net package worth 840 (1000 -- 160)

ii) Ranch 2 subject to debt of 400, and the note of 760; t/f ne package worth 840 (2000 -- 400 -- 760)

c. A has good deald. B, h/w, fails b/c never held the property for T or B or I

i) Can’t get 1031 exchange, but doesn’t care b/c won’t have gain when sale

ii) Basis will be FMV of 2,000, b/c simply bought w/ cashii. Problems:

1. Asking a lot of Ba. High transaction costsb. Puts himself potentially in chain of title (want as few people in chain

of title as possible, b/c may slap lien on it)2. If B wasn’t willing to do this, A could find way around

iii. Rev. Rul. 75-291: Non-recognition provisions of § 1031 do not apply to a TP who acquired property solely for the purpose of exchanging it for LK property

iv. Note :1. Involves a simultaneous exchange as opposed to a deferred exchange

arrangement2. Today, could be structured using a qualified intermediary under Reg. §

1.1031(b)-2B. Rev. Ruling 72-151

i. Facts: property exchanged b/t corporation and its sole SHii. § 267:

1. No deduction allowed for losses from sales / exchanges b/t persons specified in (b)

2. (b)(2): individual and corporation of which that individual owns more than 50% of the outstanding stock represents relationship described above

C. Bolker v. Commissioneri. Facts :

1. TP exchanged real ppty and then promptly transferred the real ppty received to a two person partnership in return for a general interest in the partnership

ii. Holding :1. TPs satisfy the holding requirement for LK exchanges by a lack of intent to

liquidate the investment or to use it for personal pursuits2. The continuity of investment is the principle underlying § 1031(a)

D. Bell Lines, Inc. v. United Statesi. Facts :

1. Bell Lines sold their old trucks, purchased new trucks, and then claimed depreciation at the full purchase price of the new trucks

ii. Holding :1. Independent sales of old equipment and the purchase of new equipment do

not give rise to a LK exchange2. Purpose of § 1031(a) is to defer recognition of gain or loss when there is a

direct exchange of property3. Distinction b/t an exchange and two separate transactions depends on

whether they are mutually dependent transactionsE. Rev. Ruling 90-34

i. Significance : shows how a transfer may qualify for nonrecognition even where the transferee never holds

ii. Holding:1. X’s transfer of property to Y, in exchange for LK property, qualifies as to X

for nonrecognition of gain or loss on the exchange under § 1031, even though legal title to the property rec’d by X is never held by Y

F. Rev. Pro. 2000-37 1 hr, 5 mini. Safe Harbor

1. If you meet these requirements, get benefits of § 10312. If don’t f(x) w/in Safe Harbor, we’ll come after you

ii. See Problem 3 3/8

CH. 40 - INVOLUNTARY CONVERSIONS

I. INTRODUCTION 45 minA. General Policy

i. §1033 is relief provision affording TP the benefit of nonrecognition of gain when recognition would create severe hardship

ii. Ex: State condemns farm land for highway use; AB minimal in relation to FMV1. Farmer uses state compensation to purchase replacement land; technically

has realized gain (condemnation award -- AB)2. Gain will NOT be recognized, and the non-recognition will not be

attributable to § 1031iii. Congress : understood the recognition of gain and resulting tax liability might

frustrate TP’s efforts to replace condemned landB. Operates when …

i. TP property is “compulsorily or involuntarily converted” as a result of destruction, theft, seizure, or requisition or condemnation; AND

ii. TP gets new property or cash for new property1. (a)(1): TP gets new property (qualified replacement property) direct

conversion § 1033 mandatory2. (a)(2): TP first gets money / non-qualified property and is subsequently

replaced w/ qualified § 1033 elective3. *Policy: direct conversion seems so akin to §1031 that Congress believed it

should be treated as such for tax purposesiii. Note :

1. Losses specifically exempt from § 1033 (contrast w/ § 1031)2. Applies to both property held for use in T / B / I AND property held for

personal use, e.g. one’s residence (a/g, contrast w/ § 1031)C. Involuntary Conversion Events

i. “Destruction” has been analogized to term “casualty”; t/f, destruction as a result of fire, storm, or shipwreck would be an involuntary conversion w/in meaning of § 1033

1. Ex: a. Destruction of livestock by lightningb. Destruction of crops by hail

2. Note, however, that destruction need not be sudden, unusual or unexpectedii. “Seizure” generally means confiscation of property by a gov’t entity w/out the

payment of compensation1. Issue : seizure of boat or car used in illegal drug operation constitute seizure?2. Presumably, but, terms “requisition” and “condemnation” suggest taking of

property by gov’t for public use3. SCOTUS: “taking or the treat of taking property by some public or quasi-

public corporation -- by some instrumentality that has the power to do so a/g the will of the owner, and for the use of the taker”

II. SIMILAR OR RELATED IN SERVICE OR USEA. Whether properties are similar or related in service or use

i. (a)(2): requires Similar or Related in Service or Useii. Liant

1. Standard differs when dealing w/owner-occupied v. rentaliii. Reg. § 1033(a)-2(c)(9): circumstances where replacement property will NOT meet

standard1. (i) Proceeds from unimproved condemnation invested in improved RE;

2. (ii) Proceeds from conversion of real property used to reduce indebtedness previously incurred on leasehold;

3. (iii) Owner of requisition tug uses money to buy bargesiv. Rev Ruling: Service uses a functionality test

B. Standard in § 1033 vs. Standard in § 1031 i. §1033 is more narrow standard than §1031

ii. The application of §1033(g) adopts LK/1031 standard1. Condemnation held for productive use in T/B/I

iii. And in §1033(h) a broader standard is used1. (1): in case of property damaged in Presidentially declared disasters, provide

favorable treatment for PRs and their contents2. (2): affords special treatment to B and I property for purposes of meeting the

“similar or related in service or use” standarda. Policy: property damage may be so great that some businesses might

be forced to suspend operations for such a substantial period that they fail

b. Relief measure to avoid current taxation if want to reinvest in new, different B ventures

C. Time for Replacement i. Unlike § 1031, § 1033 does not specifically impose any holding requirements

ii. (a)(2)(B): to assure that continuity of investment exists, replacement property must be replaced w/in two years following the conversion of the property

iii. (a)(2)(A): specifically requires that the replacement property be purchased “for the purpose of replacing the property so converted”

1. Property acquired b/f the disposition of the converted property will not be deemed to have been acquired as replacement property unless it is held by the TP on the date of the disposition of converted property

2. Property considered purchased only if, but for special basis rules of § 1033(b), the unadjusted basis of such property would be its cost w/in §1012

a. Ex: prop rec’d as gift NOT purchased b/c basis determined by § 1015, not § 1012. Reg. § 1.1033(a)-2(c)(4).

iv. (i): If replacement property acquired for a related person, nonrecognition treatment may be lost.

1. Applies to individual TPs if aggregate realized gain for the year, on all involuntarily converted property w/ realized gain, exceeds 100K

2. Does NOT apply if related person acquired replacement property from an unrelated person during the replacement period

v. Holding Period of Replacement Property1. §1033, unlike §1031, is NOT limited to investment property or T/B Property2. §1223: Holding period tacks if capital asset involved

III. BASIC COMPUTATIONSA. Gain Recognized

i. Nonrecognition Requirements1. 2 year period to find replacement property2. All of proceeds spent on new property3. Property similar or related in use, if circumstances require it

ii. Partial Recognition of Gain1. Realized gain will be recognized under §1033(a)(2) to the extent AR upon

conversion > Cost of replacement property2. Ex: farmer in initial hypo

a. If rec’d award of 50K and replaced converted property w/ that costing 40K, max of 10K of gain realized would be recognized

b. If farmer’s basis had been 45K, then only 5K gain would have been realized and thus only 5K of gain would be recognized

B. Basis of Replacement Property i. Basis provisions of §§1033 and 1031 are different when proceeds received lead to

replacement propertyii. (b): Computation – Two Rules

1. (1): Direct conversion to qualified replacement propertya. Same as AB rules of § 1031

2. (2): Proceeds received then converted to qualified replacement propertya. Ex: insurance proceedsb. AB replacement property = Cost of replacement property – Amount

of gain realized on the conversion that is NOT recognized b/c of 1033.

iii. Gain t/f NOT permanently excluded, but is merely deferred

IV. INVOLUNTARY CONVERSION OF PRA. § 121 excludes up to 250K (500K for joint returns) of the gain on the sale or exchange of a

PR if certain requirements are metB. In certain situations, §1033 may apply where §121 is also applicable

i. § 121(d)(5)(A): involuntary conversion permits use of 121ii. § 121(d)(5)(B): For 1033 purposes, AR = Proceeds of involuntary conversion –

amount of gain excluded under 1211. In effect, requires that § 121 be applied b/f applying § 1033

C. See examples, p. 968-69

V. CASE LAW & REV. RULINGS 3/10A. Liant Record, Inc. - “Similar or Related Use”

i. Facts :1. 82 commercial T building condemned (now, if condemnation, get LK

standard, so might not be issue today)2. Liant took the proceeds from a forced sale of a commercial building and

acquired three residential apartment buildingsii. Arguments:

1. Gov’t: commercial T residential end user NOT “similar or related in use”2. Court: test means use by TP (investor test)

iii. Rule :1. In determining whether replacement property acquired by an investor is

similar in use to involuntarily converted property, a comparison of the service or use that the properties have to the TP-owner is critical

2. § 1033 does not allow the TP to alter the nature of the investment tax-free3. However, if the TP-owner is an investor rather than a user, it is not the T’s

use but the nature of the lessor’s relation to the property that mattersiv. Factors :

1. Extent and type of Liant’s mgmt activity2. Amount and kind of services rendered by him to the Ts3. Nature of Liant’s business risks connected w/ the properties

B. Rev. Ruling 64-237 i. Disagreement regarding “Similar or Related in Service or Use” standard’s meaning

and application

ii. Service adopted position of Liant Record by rejecting the functional-use test in favor of the service-or-use-relationship test

1. B/f, only had to apply in 2nd Cir.2. Reinforcing that still will use functional use test when dealing w/ owner-

users of propertyC. Rev. Ruling 79-261 6:30 min

i. 1033 doesn’t have explicit ability to divide b/t getting back some similar or related use property

ii. Service says if get back and use for two functions, can divide b/t the twoD. Rev. Ruling 89-2

i. Issue : what are proceeds from involuntary conversion?ii. Facts :

1. Dealt w/ chemical contamination of property as an involuntary conversion; TP sold to gov’t authority

2. Is this type of conversion described in (a)?iii. Service says YES, doesn’t have to be storm / fire / shipwreck; anything that renders

property unfit for its useiv. Caveat: payments can’t be for compensation for damages

1. Ex: have ship damaged at 10K; person receives payment; turns around and sells unrepaired ship at 86K

2. Was this really an involuntary conversion?3. Test: Property been destroyed for intended use?4. Service: NO. Later sale to 3rd party not involuntary conversion, b/c ship had

not been destroyed for its intended f(x), but was repairableE. Willamette Industries, Inc. 12:30 min

i. Facts :1. Π, who owned and processed timber, suffered damage to some of its standing

trees from various natural causesa. Note: if would have stopped here and sold trees to 3rd party, would be

w/in § 1033, b/c rises to level of involuntary conversion, and would know w/ definity what proceeds were

2. Π salvaged the trees, processed them, then sought to defer portion of gain attributable to difference b/t its basis and the FMV of the trees at time the salvage began

a. Being paid for damaged wood AND the processingb. Service argued that by processing damaged trees into end products

which it then sold, Π was not entitled to claim the damages resulted in an involuntary conversion

c. TP: we’re mitigating our damage; only deferring proceeds attributable to the involuntary conversion (not processing profit)

ii. Rule :1. Court agree w/ TP2. A TP is not disqualified from electing deferral of gain under § 1033 b/c it is

able to salvage and process damaged raw materials into finished products rather than being forced to sell the damaged property to a 3rd party

iii. Analysis :1. Critical factor was that Π was compelled to harvest the damaged trees prior

to the time it had intendediv. Factual Difficulties :

1. Won’t always be able to separate FMV as was done in this case2. Hard to determine what damaged goods would have sold for

3. How would boat case play out? 20 min4. Davis : kicker here was that damages were so extensive

CH. 41 - INSTALLMENT SALES

I. OVERVIEW – 453 & 453AA. Introduction

i. Typically, TP recognizes gain or loss at time of the sale. § 1001(a), (c)ii. However, what if property sold at a gain on a deferred payment or installment basis,

w/ all or part of the SP to be paid following the year of sale?1. May be harsh to apply ordinary rules and tax all gain currently 2. Congress: “possible liquidity problems may arise from bunching of gain in

the year of sale when portion of SP has not actually been received”B. Congressional Response

i. Enact § 453, which says gain on the sale is spread over the period during which the payments are received

1. Income recognized under the installment method, whether in the year of sale or thereafter, is income from the disposition of property, NOT income from collection of an obligation

2. Ex : if property disposed was capital asset and later disposition was sale, gain recognized both in the year of sale and later years will be capital gain

ii. BP: 1. Does TP have the cash to pay the tax liability on a sale?2. B/c of the nature of the deal the TP can defer tax liability

iii. Exception: cannot use § 453…1. W/ publicly traded stock; OR2. If you are a dealer in certain property

C. Statutory Framework - § 453 i. (a): Income from installment sale is to be reported under installment method; statute

does NOT apply to lossesii. (b)(1): Installment Sale Defined

1. Generally, disposition of property where at least one payment is to be received following the year of disposition

2. No requirement that pmt be received in the first year; similarly, no prohibition on use when substantial % of total pmt rec’d in disposition year

iii. (c): Installment Method Defined1. Prorates total gain on the sale over the total payments to be received2. Gross profit ratio = gross profit / total K price

a. E.g. Gain / AR3. Gross profit ratio x payment = income for year

II. PAYMENTS & LIABILITIESA. Mortgage or Debt Assumed

i. Treated as tax free return of basis, keeping w/ PP of alleviating potential liquidity problems on installment sales. Reg. § 15A.453-1(b)(3)(i)

1. So, it is not included in gross profit2. the total K price

ii. BUT IF liabilities > AB excess is treated as pmt, so total K price will 1. Gross profit ratio will be 100%2. Qualifying indebtedness offsets the SP only to the extent of basis. (2)(iii)

B. Debt Instruments as $ (PN) i. Normally notes issued will not be $/payment, even if guaranteed by a 3rd party. See

(f)(3)ii. BUT instruments payable on demand or readily tradable will be considered payment.

See (f)(4),(5).1. Why? Sometimes, a debt instrument is so close to cash that deferral of gain

is inappropriateC. Nonqualifying Debt

i. Does not total K price, t/f does not gross profit ratioii. Why distinguish? Don’t want to treat nonqualifying debt relief as return of basis to

the seller, rather than payment which is in part a return of basis and in part incomeiii. Ex :

1. Post-acquisition taken on in contemplation of disposition2. Debts taken at acquisition but related to property

III. RECAPTURE INCOMEA. § 453(i)

i. Exception to normal rules of installment method reporting1. Since seller has already benefitted taxwise from depreciation taken on the

property prior to the sale, (i) requires recognition in year of sale for any depreciation recapture

ii. Recapture Inc: amount that §§ 1245 or 1250 would classify as OI if all payments to be rec’d were rec’d in the year of sale

B. Since recapture income is recognized regardless of any actual payments, the recaptured amount must be added to the seller’s AB so as to avoid over-reporting of income

i. Significance : Adjust gross profit , since recapture basis

IV. ELECTING OUT OF THE INSTALLMENT METHODA. § 453(d):

i. Installment Method NOT mandatory, TP reports under normal method of accountingii. TP must elect out (automatically applied otherwise)

1. Election must be made w/in a timely manner2. May be revoked only w/ the consent of the IRS

B. Effect of Electing Out - Reg. § 15A.453-1(d)(2) i. Use FMV of the installment obligation, regardless of whether it is a cash equivalent.

(i).ii. AR cannot be less than FMV of property received. (ii)

iii. Regs clearly reject the election-out as a deferral of income technique, and instead make it, in effect, an occasion for acceleration of income.

V. EXCLUSIONSA. § 453(k) : Not allowed for certain deferred payment sales, e.g…

i. Publicly traded property 1. Why? Such property considered sufficiently liquid to be treated the same as

a payment of cash.2. Also, b/c TP can easily sell property for cash in public market, does not have

same liquidity problem § 453 intended to alleviateii. Sales pursuant to a revolving credit plan

1. Why? Such sales more closely resemble provision of a flexible line of credit accompanied by cash sales by the seller

B. § 453(b)(2)

i. (A): Installment reporting generally not permitted for “dealer dispositions”, e.g. any disposition of…

1. Personal property by one who regularly sells or otherwise disposes of personal property of the same type on the installment plan; OR

2. Real property held by the TP for sale to customers in the OCOB. § (l)(1)3. Exceptions, p. 993 - § (l)(2), (3)

ii. (B): Disposition of personal property includable in inventory also do not qualify as installment sales

VI. CONTINGENT PMT SALESA. Introduction

i. In some cases, a property’s SP is made contingent on future events, such as future profits or rents, and the aggregate SP thus cannot be determined in year of sale

ii. Issue: How do you account for the gain on such a sale?B. Multiple Approaches

i. Burnett 1. Facts: sale of stock contingent on future mining operations2. Open transaction accounting - hold transaction open until all the payments

have been madea. TP recovers tax free basis then tax gain (rare application)b. SCOTUS: purchaser’s promise of future money payments had no

ascertainable FMVii. (j)(2): Apply basis recovery ratably over term to payments when gross profit and

total K price cannot be determined1. Thus, unless TP elects out of § 453, contingent payment sales are to be

reported on the installment method. Reg. § 15A.453-1(c)(1).2. No loss allowed until last year of payment

iii. IF elect out, then use FMV of contingent payments1. Cannot be less than FMV of property sold2. §1001(c): AR -- AB = Gain / Loss

VII. DISPOSITION OF INSTALLMENT OBLIGATIONSA. §453B: When TP disposes of an installment obligation, the tax deferral ends, G/L determined

by subtracting the basis of the obligation from either…i. (a)(1): FMV of Obligation: IF TP makes note a gift, if parties are related then FMV

of note is not less than face value (a)ii. (a)(2): AR on Disposition: IF TP sells or exchanges note (f)

iii. Note : 1. Character of the recognized gain or loss will depend on the character of the

underlying property. (a)2. In transfer of an installment obligation b/t spouses or incident to a divorce,

rules do not apply and spouse steps into shoes of transferor. § 453B(g)B. Basis of an Obligation

i. Difference b/t its face value and the amount that would constitute income were the obligation satisfied in full. § 453B(b)

ii. Ex : TP sells property w/ basis of 10 for 50 in cash, plus the buyer’s PN for 50 payable in subsequent year.

1. Gross profit ratio = 90%2. If 50 note paid in full, 45 reported as income3. Thus, notes basis = 5

C. Rev. Ruling 79-371

i. Addresses question of the transferee’s basis in an installment obligation following a disposition by gift under § 453B(a)(2)

ii. Transferee’s basis is (augmented) to reflected the income recognized by the transferor

VIII. SECOND DISPOSITIONS BY RELATED PERSONSA. Hypo :

i. Father sells property to Daughter at FMV on installment basis. Until payment rec’d, Father recognizes no income. Daughter takes costs basis, equal to FMV. § 1012

ii. If Daughter promptly sells property for cash to 3rd party at same FMV, what happens?1. Family unit has converted property into cash2. No gain realized by Daughter3. No gain recognized by Father until Daughter makes payment to Father

iii. Congress responds to outcome w/ § 453(e)…B. (e) - Second Dispositions by Related TPs :

i. Resale by related TP triggers recognition of gain by initial seller ONLY to extent that AR from 2nd disposition > actual payments made under installment sale

ii. So, if AR is cash, initial seller must report gain using GP ratioiii. Exceptions / Limitations

1. Unless property is marketable securities, rule applies only w/ respect to second dispositions occurring w/in 2 years of the initial installment sale

2. If 2nd disposition is involuntary, and the first sale occurred b/f the threat of imminence of conversion, does NOT apply

iv. Significance1. Use § 1001 principles to determine gain for initial seller

IX. SALE OF DEPRECIABLE PROPERTY TO RELATED PERSONSA. Generally …

i. Installment method not available in case of installment sales of depreciable property b/t related persons. § 453(g)(1)

ii. (g)(2): “Related persons” shall have the meaning given that term by § 1239(b).B. Related Persons - §1239

i. (b): Installment method cannot be used w/ respect to a sale b/t TP and…1. Controlled entity as defined by § 1239(c), e.g. a corporation whereby more

than 50 % of stock is owned (directly or indirectly) by TP;2. Trust in which TP or her spouse is a beneficiary; OR3. Executor of an estate and a beneficiary of the estate.

ii. § 267: family of TP shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants

iii. Purpose of Rule1. Deter transactions structured to give related purchaser the benefit of

depreciation (measured from a stepped up basis) b/f seller must include in income the corresponding gain on the sale

2. Rule does not apply where the sale does not have the avoidance of federal income tax as one of its principal purposes. § 453(g)(2).

X. SPECIAL RULES FOR NON-DEALERSA. Rules

i. IF a 453A installment obligation is itself pledged as security for any debt, the net proceeds of the secured debt are treated as payment on the obligation. § 453A(d)(1).

ii. Subsequent payments are disregarded up to aggregate amount of the deemed payment. § 453A(d)(3).

B. § 453A(a)(1) : i. TPs must pay interest on deferred amount unless amount obligated < 5M

ii. If this 5M threshold isn’t reached, NO interest is payable. § 453A(b)(2).iii. Deferred tax liability

1. Unrecognized gain on § 453A installment obligations, multiplied by the max tax rate in effect for the year in question. § 453A(c)(3)

C. SP must > 150K. § 453A(b)(1)

XI. INSTALLMENT OBLIGATIONS AND LK EXCHANGESA. Hypo :

i. TP exchanges LK property and receives as “boot” an installment obligation issued by the other party

ii. Conceptually, both policies of §§ 1031 and 453 should be carried outB. T/f, § 453(f)(6) provides…

i. The LK property is not treated as a “payment” ANDii. Total K price does not include LK property and gross profit by amount of gain not

recognized by 1031 exchangeC. Basis Calculation

i. TP’s basis in property transferred will first be allocated to the LK property rec’d (but not in excess of its FMV) and any remaining basis will be used to determine GP ratio

ii. See example, p. 999-1000D. TP should get nonrecognition treatment on LK exchange

XII. CASE LAW & REV. RULINGSA. Burnet v. Logan 3/10 - 55 min - Open Transaction Doctrine

i. Facts :1. When Youngstown Sheet and Pipe purchased their shares in Andrews and

Hitchcock Co., Π Logan and the other SHs rec’d, among other things, 60 cents per ton of ore mined each year from a particular leased mine

a. Contingent payment: amount not set, contingent on some other eventb. TP: can’t be valued / predicted, t/f can’t assign accurate value to it,

t/f may never have any gain or get basis back2. Δ Commissioner found this was an ascertainable value and called it a closed

transaction, making payments subject to allocation b/t return of capital and income

3. The district court affirmed, and the court of appeals overruleda. Allowed Π to escape assessments until she recovered her basis,

holding the transaction was an open oneb. Commissioner appealed

ii. Issue :1. If the compensation to be rec’d for sale of property is indeterminate and

speculative, is the seller entitled to recover his basis b/f any tax can be assessed on the transaction?

2. Yes. Court agreed w/ TP. Didn’t want to tax TP on speculative gains, t/f treat as open transaction, and TP can collect payments tax free until recovers basis, after which will have to pay tax.

iii. Holding :

1. Where the value of the compensation cannot be determined, as here, there exists an open transaction that requires a return of basis b/f any taxes can be assessed thereon.

2. Obvious that nobody can ascertain what 60 cents per ton will be worth or is worth when there is no min or max amt to be mined under the lease, Youngstown’s future needs are unpredictable, and the value of the ore left in mine is uncertain

iv. Note:1. Had there been a method to estimate the value of the ore payment, the court

would have accepted it readilyB. Rev. Ruling 79-371 , p. 1002

i. Under § 1015(a), the basis of the obligation in the hands of B was the same as it would be in hands of A.

ii. B/c this amount equals the FMV of the obligation at the time of the gift, no adjustment under § 1015(d) is made.

CH. 43 - OID

I. INTRODUCTION 3/24A. Generally …

i. Issue is dealing w/ the time value of moneyii. OID provisions impute an interest equivalent (e.g. OID) to debt instruments that do

not bear an adequate rate of interest, and require that this interest equivalent be included in income on a current basis

B. Topical Preview i. Computation and treatment of “OID” on debt instruments issued for cash or for

property (§§ 1271 - 1275)ii. Computation and treatment of “unstated interest” on certain deferred-payment sales

of property (§ 483)C. Hypo :

i. Corp issues 10-year, 1 mil noninterest bearing bond (zero coupon). Value of bond will move closer to 1 mil as maturity date draws nearer, but value considerably less initially

ii. Assume investor purchase bond on issuance for 385K, and then holds until maturity 10 years later where it is redeemed for 1 mil

iii. Although bond pays no interest, obvious that 615K difference (OID) serves the same purpose as interest

iv. How should investor be taxed on 615K gain? Assuming bond is CA, should such appreciation be treated as capital gain?

1. To extent attributable to OID (economic equivalent of interest), answer is NO

2. Treated as OI, regardless of whether collect 1 mil at maturity or sell for less prior to maturity.

3. SCOTUS rejected opposite position in Midland Ross Corporationa. Notes were sold at a gain attributable to OIDb. Opinion based on “application of general principles of tax law”, and

confirmed by statutesv. When should gain be taxed? Three potential answers…

1. For cash method TPs, could tax earned OID on receipt, e.g. when bond sold, redeemed, or otherwise disposed of

a. Accrual would report interest income as it accruesb. Approach now rejected due to mismatching of income and

deductions2. Treat OID as earned ratably over 10 years

a. Require current reporting of OID by lender and borrowerb. Dealt w/ mismatching by putting TPs on accrual methodc. Problem: unrealistic to treat interest as accruing in equal amts each

yeari) Amt of interest earned should be treated as each year, b/c

unpaid Year 1 int added to 385K principalii) Corp obligor’s real debt (principal and interest) each year;

hence interest on debt d. Did not reflect an “economic accrual of interest,” b/c overstated in

early year and understated in later yearsi) Obligor like, b/c accelerated deductions into early years

ii) Unattractive to ordinary investor, b/c accelerated income receipt, but w/out cash payments

3. Current regime continues to place both parties on the accrual method for OID purposes, but rejects ratable accrual for “economic accrual”…

D. Compounding of Interest i. Simple interest provides for payment of interest only on the principal amount of the

loan; no interest is earned on the unpaid interestii. BP:

1. The more rapidly interest is compounded, the greater the aggregate amount of interest earned

2. As the frequency of compounding , the interest rate must in order to earn the same total interest over the same time period

II. OID: DEBT INSTRUMENTS ISSUED FOR CASHA. Determining the Amount of OID

i. To compute OID & amount included in income must know four things…1. Redemption Price2. Maturity Date3. Issue Price4. Interest Rate

ii. §1273: Determination of Amount of OID 1. (a)(1): OID = Stated Redemption Price – Issue Price

a. Stated redemption price does NOT include qualified stated interest, e.g. based on fixed IR and unconditionally payable at least annually

2. (a)(2): Stated Redemption Price = all payments and unqualified stated interest

3. (b)(2): Issue Price = public offering pricea. Ex : GE decides to float bond issue. Issues bonds. Initial offering

sets prices.b. If not public, issue price is whatever price of bond is.

4. (a)(3): De Minimus Rule 44:30 mina. OID is zero IF OID < ¼% of stated redemption price x years to

maturityb. See Problem 1(a)

iii. See examples, p. 1048-49B. Current Inclusion OID - § 1272

i. General Rule1. Holder of instrument with OID must currently include the earned portion in

incomeii. (a)(1)

1. Include daily portions of OID for each day during the taxable year on which TP held instrument

iii. Exclusions1. (a)(2): inclusion rule does NOT apply to…

a. Tax exempt obligations;b. US Savings Bonds;c. Debt instruments w/ fixed terms of one year or less;d. Obligations issued by natural persons prior to March 2, 1984;e. Outstanding loans b/t natural persons < 10K, not issued in lender’s

T/B, and not for tax avoidancei) 1272(a)(1)(E)

ii) See Problem 22. (c)(1)

a. Bonds bought at premium, amount > principal amountiv. (a)(3): Determine Daily Portions of OID

1. Yield to Maturity = Constant IR x Issue Price, compounded at least annually, usually semiannually

2. KIM: If semiannually, ½ the IR and apply ratably per dayC. Deduction of OID

i. §163(e)(1): Interest – OIDii. Policy

1. Rules designed to match interest income and expense by putting both parties on the accrual basis w/r/t the interest

2. Deductibility subject to any other rules that may deny, limit, or defer the deduction

iii. Issuer of instrument has debt expense = to daily portions of OIDD. G/L on Sale, Exchange, or Retirement

i. IF bond is a CA it generates G/L based on AR – AB1. If held to maturity, h/w, retirement of bond would not constitute a sale or

exchange and thus would not produce capital G/L. Fairbanks2. Such result has been reversed, e.g., in general, amts rec’d on retirement of a

debt instrument are treated as amts rec’d on an exchange. § 1271(a)(1)ii. OID is OI, and it AB in the CA

iii. § 1272(d)(2): in AB of bond when OID is included in income1. Corporation pays on maturity2. Deemed exchange on retirement produces no G/L

iv. Note :1. Debt instruments having OID can change hands2. In general, subsequent holder must include OID in income pursuant to §

1271(a)(1)3. Under § 1272(a)(7), the daily portions of OID are to take “premium” into

account and eliminate the built-in loss and “excess” OIDE. Market Discount

i. Hypo : 10 year bond w/ face amt of 100K, pays 10% int semiannually, and has issue price of 100K.

1. Since issue price = or > stated redemption price at maturity, bond has NO OID. § 1278(a)(2)(A).

2. BUT, if b/f issuance, interest rates , and already issued bond now sold by original holder for 90K. 10K in value constitutes “market discount”

ii. Included as OI, but included ratably, although election can be made to include it just like OID. § 1276(a)(1) & (b)

III. OID & UNSTATED INTEREST: DEBT INSTRUMENTS ISSUED FOR PROPERTY 3/29A. Introduction

i. B/f dealt w/ OID w/r/t debt instruments issued for cash; here, considering OID in connection w/ a debt instrument issued on a sale or exchange of property

ii. Incentive for Buyer and Seller to interest rates1. For seller, higher SP (w/ lower int rate) may produce extra CG in lieu of

ordinary interest income2. For buyer, if property depreciable, higher SP means add’l basis to depreciate,

rather than add’l interest expenseiii. When property sold on a deferred payment basis, parties generally required to

provide for adequate interest on the unpaid balanceiv. IF adequate stated interest is NOT provided, it will be imputed, and the nominal SP

will be adjusted to take account of the unstated interestB. Determining Issue Price Under § 1274: Inadequate Stated Interest

i. § 1273(b)(3):1. When property is publicly traded, FMV = issue price

ii. § 1274: Determination of Issue Price When Debt Issued for Property1. (d): Applicable Federal Rate

a. IR will be < rate used by TP, issue price will be higher and OID lessb. (2): Use the Test Rate: Lowest applicable federal rate (based on

appropriate compounding period) in three month period…i) Ending w/ the month the sale or exchange occurs; OR

ii) Ending w/ the moth in which there is a binding written K for the sale or exchange

2. (a): Where there is NO adequate stated interest, and a zero IR is surely inadequate, issue price is the imputed principal amount of the note

a. (b)(1): Imputed principal amount = sum of the PVs of all payments due under such debt instrument

b. PV determined by discounting payments to the date of sale using compounding period and test rate

3. (c): a. (1): Whether this section applies

i) Debt instrument given up for sale/exchange of property;ii) Stated redemption price > imputed principal amount; AND

iii) Some or all payments due after saleb. (2): Stated interest: Only adequate IF the imputed principal amount

of the note > or = stated principal amount of notec. Note : IF there is some interest and it’s NOT adequate, it will serve to

redemption priceC. Determine Issue Price Under § 1274: Adequate Stated Interest

i. (c)(2): 1. When Stated Principal Amount < Imputed Principal Amount, there IS

adequate stated interest

2. No need to re-characterize principal as interest, b/c sufficient interest is being charged

ii. There will be OID, what is labeled interest and is includable as OID. § 1272(a)iii. In effect, what the parties labeled “interest” is indeed treated as interest, but it is also

relabeled “OID” and must be currently include in income.D. Adequate Interest Charged and Paid Currently: No OID

i. When adequate interest is charged & paid currently there is no OID. § 1273(a)(1)ii. Likely, issue price and redemption price here will be the same.

E. Exceptions to § 1274 i. Sales of PR & certain farm sale not subject to § 1274. See § 1274(c)(3)(A), (B)

ii. Nor sales involving any debt instrument arising from the sale or exchange of property IF the sum of the following amounts does not exceed $250K threshold requirement of § 1274(c)(3)(C)

F. Unstated Interest: §483, When Sales < $250K i. Imputed Interest under 483 is called unstated interest

ii. Unlike OID, interest included in income based on TP’s regular method of accounting, cash method TP includes upon receipt

iii. Determine if there is unstated interest: § 483(c)(1)1. Is there a deferred payment?

a. § 483 may apply to any payment on account of sale/exchange due > 6 months later, where at least 1 payment due > 1 yr after sale

2. Is there total unstated interest under this K?a. Unstated interest = Total deferred payments due under the K – PV of

such payments and any interest payments dueb. PV determined using test rate

3. Unstated interest earned same as OID by using test rate, but not included until maturity

a. § 483 does NOT apply to cash for debt instrument dealsiv. Issue : First payment on loan includes interest and principal

1. Calculate how much is interest, rest is principalv. §483 does not apply to sales less than $3K

G. Special Rules 3/31 22 mini. Cash Method Election of § 1274A - $2M Rule

1. Pursuant to § 1274A(c), parties may be able to make an election to apply cash method accounting principles to the transaction

2. § 1274A(c)(2): Special Rules where stated principal amount does NOT exceed $2.8M

a. (c): Election to use cash method where stated principal < $2Mb. Requirements…

i) Qualified debt instrumentii) Cannot be new § 38 property (not tangible personal

property)iii) Stated principal < $2Miv) Seller must not use accrual methodv) Property sold must not be dealer property

vi) § 1274 must otherwise be applicablevii) Seller and purchaser must jointly elect to use cash method

3. Significancea. Seller takes unstated interest computed under § 483 as income as

payments are madeb. Buyer gets interest expense deductions as interest is paid

ii. IR Limitation on Qualifying Sales of $2.8M or Less1. § 1274(a): In the case of any qualified debt instrument, discount rate under

§§ 1274 or 483 is limited to 9% compounded semiannuallya. Note: Test rate is likely now lower than this; use test rate

2. Qualifying Debt Instrument: Stated Principal Amount is less than $2.8M and property is NOT new § 38 property. § 1274A(b)

iii. IR Limitation on Certain Land Transfers in Family1. In determining unstated interest on a sale of land b/t family members, the

max discount rate is 6%, compounded semiannually. § 483(e)(1).2. Rule does not apply if sales in calendar year > $500k. § 483(e)(3).

iv. Personal Use Property1. §§ 1274 and 483 do not apply to obligor on a deferred-payment sale of

personal use propertya. Property not used in T/B or for income producing purposesb. Deduct OID when it is paid, not as it accrues

IV. UNITED STATES v. MIDLAND-ROSS CORPORATIONA. Facts :

i. Π bough non-interest bearing PNs from the issuers at prices discounted below face amounts; held for over six months, then sold for > issue price, but < face amount

ii. Π sought to treat earned OID as CGB. Issue :

i. Does CG treatment apply only to situations in which appreciation in value accrues over a substantial period of time?

C. Rule :i. Yes.

ii. CG treatment applies only to gains on the sale or exchange of a CA; however, term CA must be construed narrowly in accord w/ CI to give CG treatment only for appreciations in value accrued over a long period

D. Analysis :i. Earned OID serves the same f(x) as stated interest; it is the equivalent of

compensation of the use of money to the date of saleii. Unlike typical capital appreciations, the earning of discount to maturity is predictable

and measurable1. T/f, since earned OID is so similar to stated interest income, it must be

treated as OI2. Thus, Π should have reported its gain from the purchase and sale of

discounted notes as OI.

CH. 37 - TAX CONSEQUENCES OF DIVORCE

I. INTRODUCTION 4/5A. § 71 provides for the inclusion of alimony in incomeB. § 215 allows a deduction for alimony paidC. Property transfers b/t spouses and former spouses, incident to divorce, are nontaxable events

under the special nonrecognition rule of § 1041D. Also have various special rule relating to the personal exemptions for dependent children of

divorced parents, and to the proper filing status of parents following separation or divorceE. Issues :

i. Who is the proper TP?ii. PP : prior to divorce, tax burden was borne w/in a single economic unit, and now

must be allocated b/t TPs who’s interests are often adverse

II. ALIMONY: GENERAL REQUIREMENTSA. Generally …

i. § 71: Alimony is GIii. § 215: Payment of Alimony is deductible

B. However, from 1917 until 1942, alimony was not GI, and payments for such were not deductible. Gould v. Gould

i. Congress decided to change, given that wartime high tax rates coupled w/ alimony rules created an excessive tax burden

ii. Revised in 1984 by changing definition of alimony1. Eliminated req that pmts be periodic, and that they be made in discharge of a

legal obligation of support arising out of the marital or family relationship2. Current definition found in 71(b)…

C. §71(b)(1) : Alimony Requirementsi. Payment in $, not property;

ii. (A) Made to spouse or on behalf of spouse;1. N: $ pmts to third parties may sometimes qualify (ex: mortgage pmts made

by one spouse w/r/t property occupied by other). Rev. Rul. 67-420iii. (A), (2) Received by spouse under written (divorce / separation) agreement;

1. N: oral agreement NOT enough; requires “mutual assent or a meeting of the minds.” Ewell v. Comm’r

iv. (B) Divorce agreement does not designate it as not includible in GI by payor, and not deductible by recipient;

1. Gives parties ability to designate cash payments as being part of a property settlement, and t/f not taxed as alimony

v. (C) If spouses legally separated under a decree of divorce or separate mtnc, must not be living in the same house at time pmts made;

1. PP : concern that spouses who may go through “tax divorces” to avoid the so-called “marriage penalty,” but continue to live together, should be treated the same as never-married individuals living together, and should not be able to engage in income-shifting b/t themselves

vi. (D) No liability after death of payee spouse;1. PP: payments after death lack spousal support f(x); want to prevent disguised

property settlements2. Two part inquiry:

a. Unambiguous condition terminating the payments (K or state law)?b. If non, independently evaluate “the language of the decree” as a

whole to determine whether (D) satisfied3. Substitute Pmt Provision: no liability to make pmts after death of payee

spouse, and also no liability to make any other pmt as a substitute therefor D. 3rd Party Payments on Behalf of Spouse v. Those Not on Behalf of a Spouse

i. Cash paid on behalf of former spouse that is rent or mortgage or utilities will qualify provided §71(b) requirements met

ii. BUT when TP spouse is still on lease or mortgage, such as joint Ts with right of survivorship…

1. ½ of payment is alimony, other ½ is not

2. ½ is deductible, other ½ gets home mortgage interest deduction; if it were his residence, 163(h) allows it to count since he is paying on a residence where his children live

iii. TP buys term LI with FS as beneficiary1. 1.71: pmts not treated as on behalf of spouse unless FS owns the policy; TP

is really insuring his child support

III. CHILD SUPPORTA. 71(c) : Obligation of noncustodial parent to take care of child is NOT deductible, and NOT

includible by recipientB. Temp. Reg. § 1.71-T(c) : Reduction in alimony that may really be child support

i. Presumption that this is child support if is w/in six months of age of majority. ii. Ex: at year 7, kid is 18 yrs three months and reduction is presumed; but IF after the

sixth post separation year then no presumption

IV. EXCESS FRONT-LOADING - § 71(f)A. Excess front-loading of alimony (accelerate deductions currently)

i. § 71(f) is basically a recapture provisionii. Pmts characterized as “excess alimony,” having been included by the payee and

deducted by the payor in a prior year, are “recaptured” in the subsequent yeariii. Tax treatment is then reversed: the excess amt is deductible by the payee and

includable by the payor1. The payor, who is the real target of § 71(f), is forced to give back the excess

deduction (excess, in sense that, retroactively, § 71(f) determines the prior alimony treatment was unwarranted at least in part)

2. Rather than reopen and adjust the tax return of the payor and payee for the year of pmt, the give-back occurs in year determination of excess is made

B. Under § 71(f), recapture can take place in one year only, e.g. the “3rd post separation year,” a term defined in § 71(f)(6)

i. Excess alimony pmts, fi any, determined based on alimony payments in three years, the 1st, 2nd, and 3rd post separation years

ii. Essentially, based on the alimony paid in these three years, it may be determined in year three that excess alimony was paid in years one and two

C. Ex: 60K, 48K, 18K. Yr 2-4 respectively, 1-3 post-separation yeari. When post-separation year 2 and 3 have big drop off this should be a concern

1. (4) excess of 2nd post year over (3rd post year + 15K)a. Excess of 15, 48 over 33K, dropped too much

2. (3) excess of 1st post separation year over (treated alimony for yr 2 (33) + 3rd year average the two)

a. 60K less average of 51 + 15.b. 60K is more than 40.5K, excess payment of 19.5K in yr 1 post

separation payment3. In all excess, payment of 34.5K

ii. Payor has been deducting, payee has been including1. 71(f) reverses the treatment, payor must include it, payee must take

deduction 2. Recapture occurs in only yr 3

V. ALIMONY TRUSTS - § 682A. Hypo: divorced or separate spouse (husband) establishes and funds a trust, income from

which is to be paid to the other spouse (wife)

B. § 682: attributes for tax purposes the income from a so-called alimony trust (otherwise taxable to the husband) to the wife, the trust beneficiary

i. No deduction allowed for husband on account of trust income taxed to the wife. § 215(d)

VI. DEPENDENCY EXEMPTION - § 152A. Parent having custody of child for the greater part of the year will ordinarily be entield to the

dependency exemption for the child. § 152(a)(1), (c)(1)(B),(c)(4)(b)B. Custodial parent gets dependency exemption and paying on 50% of the home, unless

otherwise agreed upon. § 152(e)(2)C. § 152(e)(1): Threshold Requirements

i. Parents must satisfy a divorce or separation requirementii. Provide more than half of the child’s support

iii. Have custody of the child for over half the year

VII. FILING STATUSA. File…

i. Single; ORii. Head of household

B. Carries tax significance…i. Different tax rates

ii. “Head of household” defined in § 2(b)1. Custodial parent does not lose such status by releasing the claim to the

dependency exemption2. Can NOT be married at the close of the tax year

VIII. PROPERTY TRANSFERSA. § 1041(a), (b): No G/L Recognition, recipient steps into shoes of transferor even if there is a

loss, carryover in ABi. PP: transfers b/t spouses are, in effect, transfers w/in a single economic unit, and

accordingly, should not be taxed1. Policy extended to encompass transfers incident to divorce as well, as part of

effort to keep tax laws “as unintrusive as possible w/r/t relations b/t spouses”B. Any time cash is rec’d there is a RE

IX. SPECIAL RULES REGARDING PR - §121(d)(3) A. Tack ownership period of former spouses. (A)B. Hypo: TP continues to have ownership interest in PR but does not live there b/c, pursuant to

divorce or separation, the TP’s spouse or former spouse is granted use of the PRi. TP treated as using residence while the residence is used by the TP’s spouse of

former spouse. (B)

X. LEGAL EXPENSES - DEDUCTIBLE?A. Misc Itemized Deduction for tax preparation/planning

i. that amount for divorce proceedings is deduction subject to 2% AGI limitationB. Bifurcate out tax advice on divorce and representation in divorceC. Former spouse’s attorney fees

i. § 212 expenses to generate income, tax advice D. TP paid attorney fees for former spouses

i. As long as terminates at deathE. TP’s own attorney’s fees - Bifurcate

XI. CASE LAW & REV. RULINGSA. Rev. Rul. 2002-22

i. Reaffirmed result of Rev. Rul. 87-112 on basis of § 454, and clarified that ruling by eliminating references to assignment of income principles

B. United States v. Gilmore, 1963i. Facts :

1. Π’s wife brought divorce action, alleged Π’s interest in three companies was community property; Π successfully defended himself at cost of 40K

2. Π sought to deduct the costs of his successful defense a/g his wife’s claims during divorce proceedings

3. Lower court allowed 80% of litigation costs deduction; gov’t appealedii. Issue :

1. Are all litigation costs for resisting claims deductible?2. No

iii. Rule :1. Litigation costs for resisting a claim are deductible only if the claim arises in

connection w/ the TP’s profit-seeking activities. § 212iv. Analysis:

1. Π was defending a/g claims of a personal nature2. Divorce proceedings had no connection w/ the business interests of Π other

than the consequences3. Accordingly, Π’s litigation expenses were not deductible.

C. Rev. Rul. 67-420

CH. 35 - THE KIDDIE TAX

I. INTRODUCTION 4/7A. Fundamental Income Tax Principles

i. Income form services be taxed to the service-performer; AND ii. Income from property be taxed to the property owner

B. Lucas v. Earl and its Progeny Guard i. Guard a/g assignment of service income, but it has long been recognized that income

from property can be shifted by transferring ownership of propertyii. Tax benefits of such income shifting, of course, are affected by changes in tax rates,

but the practice retains utility as long as marginal differences are presentC. The “Kiddie Tax” substantially eliminates the benefits of income-shifting to a child subject

to the tax (“covered child”)i. Prior to enactment of § 1(g), TPs spread income-producing assets among the various

members of the family (e.g. those in lower tax brackets), thereby reducing the tax billii. Congress: such income shifting amounts to manipulation of the progressive rate

structure, and a form of tax avoidance that should be restrictediii. § 1(g): generally, tax the “net unearned income” of a covered child at the top

marginal tax rate of their parents (unless child in a higher bracket)1. Net unearned income still taxed to child, but it is taxed to the child as if it

were add’l parental TI2. Applies to ALL net unearned income of a covered child, regardless of the

source of income. a. Earned Income : basically, personal services income. § 911(d)(2).

b. Unearned : not only income attributable to property transferred from parents, but also income attributable to property transferred from other relatives, friends or strangers

i) BL: income here is subject to tax at the parental rate3. Also applies to unearned income attributable to assets acquired w/ the child’s

OWN earned income, such as interest on bank deposits attributable to a child’s newspaper route’s earnings

iv. PP of Expansion: administrative difficulties would arise if provision was dependent on the source of the income producing asset

II. KIDDIE TAX APPLIEDA. § 1(g) - Who Does it Apply To?

i. Applies to certain unearned income of kids; taxed as if parent’s incomeii. Limitation: applies to kids who have NOT attained the age of 18. (2)(A)(i)

iii. 2007 Amendments: also applies to child if…1. Child has attained the age of 18 by the tax year end but is not yet 19, or the

child is a full-time student under the age of 24 (§§ 1(g)(2)(A)(ii)(I) & 152(c)(3)); AND

2. The child’s earned income does not exceed ½ of the amount of the child’s support (§ 1(g)(2)(A)(ii)(II))

iv. Under NO circumstance will the kiddie tax apply UNLESS…1. Child has at least one living parent, AND 2. It does not apply to a married child who files a joint return. (2)(B), (C)

B. Special Provisions i. § 63(c)(4)

1. Standard deduction adjusted for inflationii. § 63(c)(5)

1. Limitation on STND Deduction for Certain Dependants2. (A) fixed amount OR fixed amount plus earned income

a. Exemption for child is 500 (adjusted for inflation, e.g. in 2010, $950) or 250 ($300 in 2010) + earned income

iii. § 151(d)(2)1. If a dependency deduction w/ respect to an individual is allowable to another

TP, that individual may NOT claim a PE on their tax returnC. Tax Imposed

i. Greater of…1. Tax imposed w/out regard to § 1(g) (greater amount when child is in a higher

tax bracket than the parents); OR2. The sum of:

a. The normal tax that would be imposed if the child’s taxable income were reduced by net unearned income, AND

b. The child’s share of the “allocable parental tax.” § 1(g)(1).ii. “Net unearned income” essentially, unearned income, minus the sum of two

amts…1. Limited std deduction of § 63(c)(5)(A), as described above; AND2. A second § 63(c)(5)(A) deduction, or the allowable itemized deductions

directly connected w/ the unearned income, whichever is greater. § 1(g)(4)3. Note:

a. *Typically, will equal the child’s unearned income, minus twice the § 63(c)(5)(A) limited standard deduction.

b. *Can NOT exceed TI. § 1(g)(4)(b).

iii. “Allocable Parental Tax” tax generated by taxing, at the parental marginal rate, all of the net unearned income all children of the parent to who § 1(g) applies. § 1(g)(3)(A)(i).

iv. Compute net unearned income on a given set of facts1. Net Unearned income – 1(g)(4) =

a. Unearned income – (exemption amount (850) + greater of exemption amount (850) or child’s itemized deductions)

b. Assume §63(c)(5)(A) limitation on basic STND deduction adjusted for inflation is $850

c. Excess is taxed at parent’s rate

III. RATIONALE FOR THE KIDDIE TAXA. Response to perceived abuses, parent transferring income producing assets to child, income

belong to child and taxed at kiddie rate, income splitting.B. Some legitimate transfers, appointing trustee to be a custodian of the property

CH. 19 - MOVING , CHILD CARE, & LEGAL EXPENSES

I. MOVING EXPENSES 47 minA. Contrast w/ §162

i. Here, not already in T or B, t/f 162 deduction NOT availableB. § 217

i. Must move a certain distance1. Ensures you moved for B purpose; otherwise, would cover simple moves

ii. Timing Requirement1. Must work certain amt of weeks (39)2. Sympathy provisions, e.g. dead, fired, etc.

iii. Distance Requirement1. Current commute, plus 50 miles2. N: if don’t have commute, just 50 miles from residence3. N: can’t get over threshold by taking scenic route (anti-abuse)

C. What’s Deductible ?i. N: regs haven’t caught up yet

ii. Basic two items1. Cost of transporting TP and other household members and belongings2. R cost of lodging in route

iii. R-ness requirement

II. CHILD CARE EXPENSES 1 hr, 4 minA. Personal & Business Elements

i. Allows parents to not go insane, and to workii. H/w, still have personal obligation to children

iii. Issue: how do you devy b/t the two?B. Credit’s in General

i. Deduction: subtract from GI; value is reduction of overall income subject to TR, t/f value connected to tax rate

1. Ex: in 35% bracket, 1 dollar deduction, value = 35 cents2. Leads to up-side-down effect, e.g. more valuable to TP’s in higher income

bracketa. Ex: home mortgage interest 1 hr, 6 min

b. How do you fix? Make a credit rather than deductionii. Credit: dollar for dollar reduction of tax liab

1. Ex: if entitled to 2K child care credit, reduces overall tax liab by 2K2. NOT a f(x) of tax bracket, unless made specifically related by code provison3. Neither progressive nor regressive, b/c regardless of your tax bracket, get

exact same benefitC. § 21 - Business / Employment related Child Credits

i. Allows credit for certain child care XPs that allow parent to be gainfully employedii. Overall, progressive, b/c declines as GI goes up

1. Ex: 1 hr, 10 miniii. Refundable v. Nonrefundable Credit 4/12

1. Non-Refundable : tax liab dollar for dollar down to zero, but don’t get refund of excess credit

a. Ex: § 212. Refundable : tax liab down to zero, then get leftover as refund

a. Ex: 2000 TL -- 2500 Credit = 500 refundiv. Statute Mechanics 3:30 min

1. Credit if have dependent children below the age of 13a. Dependent: 152(a)(1): qualifying child or relative

i) (c): Child: 1) Indiv who bears relationship w/ TP, or a decedent of

such child (grandchild)2) Has same principal place of abode for more than ½

of year3) Who has not attained age of 19 or is a student who

has not attained age of 244) Who has not provided over ½ of their own support 5) Who has NOT filed joint return w/ spouse

ii) What a/b elderly parent? 7:30 min1) (3): special rules relating to multiple support

agreementsb. Employment related expense

i) Overnight camp NOT an XPii) Can have outside of home if…

1) Qualified individual; 2) Spends 8 hrs a day in household;

a) Catches those who go to assisted living every day

3) Day care must be qualified / licensed2. Maximum of 3K for qualifying child, max of 6K if have more than one

a. H/w, credit phases out as income i) Phases down, NOT fully out

b. Other limitations…i) Joint return limited to lesser of incomes

c. Computation 13 mini) Qualifying XP * % available to you

ii) % starts out at 35% if TP’s AGI is 15% or less, gets reduced by one percentage point for every 2K in AGI. 21(a)(2)

III. LEGAL EXPENSES 27 minA. Standard :

i. Origin of the claim; did the claim originate in a personal XP or a T/B?ii. See Gilmore

B. Problem , p. 471i. I: is origin of claim Junior’s social life, or is it B related b/c truck belongs to B?

ii. Here, it is personal, t/f no deductioniii. N: success of claim / defense NOT relevant; also, using B lawyer irrelevantiv. What if had no permission?

1. Dad: origin of this claim is differenta. T or B related; if stranger stole truck, likely would be T/B

2. Counter: this is familial relationshipv. What if Tri-City is a corp?

1. Deductible; assumption that corps ONLY have T/B persona2. However, if dad head of corp and gives son permission, all three participants

sued, dad’s expenses still NOT deductibleC. Hypo :

i. Artist w/ mental health issues; gets on plane, has breakdown, criminally charged for damage persons and property; used diminished capacity defense

ii. Deductible?1. TP: T or B travel2. Court: NO; personal mental health break led to misbehavior on plane

iii. But… if driving to see client in Tupelo, N on drive there and have accident, is this T or B?

1. YES. N is kind of personal, but doesn’t rise to level of making origin of the claim personal.

2. Court: ordinary and necessary? Is this common in the life of a T or B?

CH. 7 - SCHOLARSHIPS & PRIZES

I. INTRODUCTIONA. Historical Background

i. Single simple code provision on gifts; issue comes up whether prizes / awards are covered

ii. Regulatory action; congress wants separate treatmentB. Issue : can you know argue these are gifts under § 102? NO

i. Rule of Interpretation: if have more specific code section, stuck their; can NOT default back to gift argument

ii. Must truly be a gift1. Ex: room and board from grandparents; could still say was a gift

II. § 74 - PRIZES & AWARDS 38 minA. Generally , GI includes prizes and awards.

i. Issue: how much?ii. Rule: FMV

1. Willing buyer, willing seller, each party knowing all material facts2. Much more easily stated than applied

B. (b) : Exception 48 mini. Prizes/awards in recognition of religious, charitable, scientific, educational, artistic,

literary, or civic achievement; ANDii. You give the prize away to charity.

iii. N:

1. If not in recognition of above, prize gets taxed. 2. BUT, can take charitable ded.

C. (c) : Exception for E’ee Achievement Awards 52 mini. Will NOT be taxed except for amt above which the e’er can deduct.

1. 400 Limit if NOT qualified plan2. 1600 Limit IF qualified plan

ii. Ns :1. If there is a formal plan (i.e.-every 20 yrs, watch), amt of award can be up to

$1600.2. W/out a formal plan, amt of award can only be $400 (highest amt they can

deduct). iii. Def’n § 274 tangible personal property which is…

1. Transferred from e’er to e’ee for lengthy service or safety;2. Part of a meaningful presentation;3. NOT disguised compensation.

III. § 117: SCHOLARSHIPS 1 hr, 4 minA. Rule :

i. Qualified educational costs are not included in GI UP TO the amt of qualified expenses incurred (don’t have to trace amt)

1. Must be candidate for degree; can’t be simply part time picking up courses2. Qualified scholarship: amts used for qualified tuition and expense

a. Tuition and feesb. Books / suppliesc. Equipment required for educationd. Leaves out room and board

ii. Ex: 10K scholarship, 8K QE, 2K taxed.B. Qualified v. Not Qualified

i. Qualified: Books, tuition, etc. ii. Not qualified: room and board

IV. CASE LAWA. McCoy v. Comm’r 44:30 min

i. Facts : 1. Π McCoy won a new car from his e’er (4,453 for GE), which he then traded

in for cash and a different vehicle (1K + 3.6K)2. Π reported the value of the cash and trade-in-car on his taxes3. IRS assessed a deficiency in Π’s taxes; filed suit in tax court

ii. Issue :1. If an e’ee receives property as part of his compensation wages, is it the cost

of the property to the e’er that must be reported as GI?iii. Rule :

1. No. 2. When an e’ee receives property as part of his compensation wages, it is the

FMV of property that must be presorted as GI, NOT the cost of the property to the e’er

iv. Analysis :1. Here, car rec’d as a bonus for sales; well-established that cars immediately

lose resale-value when purchased2. Here, neither the price paid by GE nor the price rec’d by Π determines the

FMV at the time Π rec’d the car

a. Value when taken into possession by GE, and a/g when driven by Π

b. Since no clear evidence as to the value at each of these times, FMV of 3.9K applied, which falls b/t purchase and disposition prices

B. Bingler v. Johnsoni. Facts :

1. Π e’ees at WH took part in a program whereby they would receive a portion of their regular salary while working and going to school for advance degrees

2. However, they took exception when WH w/held taxes from the salary paid while they were in school

ii. Issue :1. Is a salary rec’d by an e’ee on educational leave forma an e’er excludable

form GI as a scholarship or fellowship grant?iii. Rule :

1. NO. Reversed.2. While Congress has not specifically defined what constitutes a scholarship

for purposes of the tax code, it does not seem inconsistent w/ the code to exclude from the definition any amts rec’d as compensation for services

3. Exclusion from GI was merely a recognition by Congress that these categories were special, rather than an attempt to exclude all income, regardless of the source, given to support the student

iv. Analysis :1. Jury R-ly found that amts rec’d by Π e’ees were compensation rather than

scholarships2. E’ees required to hold jobs during Phase 1, and had to work for WH for two

years following the completion of their educationv. Note :

1. Appearance of quid pro quo b/t e’er and e’ee has often led to the conclusion that any amts rec’d by e’ees in these programs are more properly construed as compensation, rather than scholarships

2. H/w, qualified-tuition-reduction plans NOT TI

V. PROBLEMSA. Problem 1 41:30 min

i. Joan won computer through competition; teacher also got one. Computers usually sell for 2K (1600 when on sale). The corp. paid 900. Kid kept it; T sold it for 1200.

ii. Tax Consequences: 1. Receipt is taxable. 2. Basis for T is an issue for finder of fact.

iii. Big Issue: what is the FMV of the computer?1. Cost store 900; lists at 2K; been on sale for 1600; Ted gets and immediately

sells for 1200.2. Generally, look at retail rather than wholesale

a. IRS: 2K computer. This is like McCoyb. Ted: 1.2K immediate sale is best evidence; unlike McCoy, have

stronger argument that wasn’t his use that priceiv. Assume 1.6K FMV

1. Both must include in GI2. Both will have basis of 1.6K

a. Creates 400 loss for Ted. Deductible?i) NOT T/B.

ii) Is this a transaction entered for profit? Arguably made profitB. Problem 2 54 min

i. Teacher received a computer worth 1200 for 25 yrs of teaching. ii. Not a gift b/c it is given for past services (e’er / e’ee relationship dis-entitles you to

an exclusion)iii. Stuck w/ § 274(c): Employment achievement award

1. Generally, § 274 is deduction disallowance section2. Defined as item of…

a. Tangible personal property (e.g. gold watch, etc., NOT $)b. Transferred to e’ee for safety / length of servicec. Awarded as part of meaningful presentationd. Circumstances do not create disguised compensation inference

3. Only allowed every 4 yearsiv. What do we need to know? Whether this is a qualified plan, b/c sets deduction amt

1. Qualified: part of established / written plan; doesn’t discriminate as to highly compensated e’ees

2. What if e’er has no plan?a. Max deduction of 400; Mary can only exclude 400, and must include

800 (1200 --400)3. What if IS qualified plan?

a. E’er: can deduct how much paid for (1K)b. TP: can exclude full 1200

v. What if computer worth 2K?1. Regs: difference b/t basis and FMV; if basis is ½ of FMV, NO deduction, b/c

spread represents disguised compensation2. Prevents e’er from buying assets that appreciate; deducting cost, and

allowing e’ee to exclude full amt, so long as below 1.6Ka. Abuse / disguised compensationb. 1.274-2(c) Example 2

C. Problem 3 4/21i. Tuition is 15K for nonresident; 5K for resident. Nancy is an out of state student who

got her out of state tuition waived for doing certain work. The work was 200 hrs; she gets 3 credits; all students are required to do the course; and they usually get $10/hr.

ii. Tax Consequences: 1. If no services-it would’ve been a QE XP and tax free. 2. BUT, universities can’t use scholarships as a hidden way to compensate

e’ees. 3. TP will argue that she should only be taxed on 2K and that the other was a

scholarship. a. Probably the way it should be since she did get credit.

D. Problem 4 i. Athletic Scholarships

ii. Tax Consequences:1. Treated as a typical scholarship for QE2. Room and board amt will be taxable though.

E. Problem 5 i. Law firm gives 5K tuition scholarships. Simultaneously offers her a job.

ii. Tax Consequences: 1. If she ONLY gets scholarship for going to work there, taxable.

2. BUT, if she could get the scholarships and work anywhere, excluded up to the amt qualified.

DEFERRED COMPENSATION

I. TWO TYPES OF DEFERRED PLANS - begin 4/14 w/ introA. Unqualified Deferred Plans

i. Ex : 1. Promise to provide something in future, like stock2. NOT includable nor deductible

ii. Funded deferred1. Putting $ in account that can NOT be touched

iii. § 831. Transfer of property for services is GI UNLESS there is substantial risk of

forfeitureiv. E’er can leave them completely unfunded; e’ee stuck relying on GF and solvency of

e’erB. Qualified Deferred Plans: Qualified Retirement Plan

i. Get mismatch of timing and tax free buildupii. E’er sets up a plan and plan has a trust; e’er makes contributions currently to trust

fund, gets current deductioniii. E’ee does NOT have to include in GI until receiptiv. Trust fund is tax exempt, e.g. tax free buildup

II. REQUIREMENTS OF A QUALIFIED DEFERRED PLAN 1 hr, 10:30A. Generally …

i. Written plan;ii. Trust;

1. Exception: only buy annuitiesiii. Exclusive benefit of e’ees;iv. Cannot block e’ees;v. Cover portions of workforce; AND

vi. Have minimum accrual and vesting standardsB. Vesting Stds 12 min

i. Defined Contribution Vesting1. Cliff vesting : no vesting, no vesting, then after year three complete vesting

a. Ex : 5 year cliff vesting. If work only 4 years, get nothing, if work 5 years, 100% vested

2. Gradual “”: yr 1 no vesting, then 20% per year, so at yr 6 then 100% vestinga. Can stretch out, but must have partial vesting earlier

3. Can go faster but not slowerii. Defined Benefit Vesting

1. Cliff is five years NOT three2. Graduated is seven years not six

C. Written Plan Requirement: Covered By ERISA i. ERSIA has two components…

1. Labor regulations/statutes2. Tax regulations/statutes

ii. IF you have a plan and terminate it, all e’ees are immediately 100% vested in benefits

iii. E’ers want maximum flexibility, so if you contribute nothing year after year, IRS will argue e’r has terminated the plan and e’ees are 100% vested

D. Plan Must be for Exclusive Benefit of E’ees i. E’er can NOT draw out benefits of e’ees where there is turnover and forfeiture of

dollars; benefit though to e’er in reduced subsequent contributionsii. 410 Minimum participation requirements – cannot block e’ees based on age and

serviceE. Add’l Req

i. When benefits must commenceii. How benefits must be paid out

iii. Benefits cannot be alienated or reassignediv. Exceptions

1. QDRO – qualified divorce relation order2. Cannot have beyond some limited terms such as salary or years where too

much goes to one class or another3. Limit on how much salary you can count: 245K (2% of salary)

III. DEFINED CONTRIBUTION v. DEFINED BENEFIT A. Defined Benefit Plans

i. Defines what e’ee receives upon retirement1. E’er’s required contribution must be enough to fund promised plan2. ERISA: big e’ers promising pensions, not paying; Congress decided to

regulate; o/w, gov’t must foot bill in yrs when can’t go back to worka. If promise benefits, must set aside sufficient fundsb. Much requirements come from ERISA

ii. Variance in Formula1. Flat: e.g. 30% of compensation, defined as average of 3 highest years;

problem: no years of service componenta. Useful in specific situations 8 minb. Benefit is simplicity for one have flat structure or tax exempt

organization w/ “everyone gets same thing” attitude2. 2% of average highest 3 years of compensation * years of service

a. N: in statute, terms not self defining, so must define yourselfiii. Fewer and fewer exist: expensive and complex 16 min

1. Administrative complex, b/c need professionally service2. Investment risk shifted to e’er

iv. One benefit: encourages e’ees staying around (could be problem where want to fire someone to get out of pension plan)

v. Need to know what e’er contribution is going to be, cause you know what e’ee gets1. Get actuary to calculate this

vi. Company bears the risk of making sure the e’ee gets defined benefitvii. Typically underfunded but federally insured

B. Defined Contribution Plans – Opposite Approach i. E’er gives set amount, tax exempt buildup, e’ee gets contributions made on behalf

plus earningsii. Must determine how the money will be allocated

iii. Obligation to contribute remains even if company has bad year

IV. TYPES OF PLANSA. Money Purchase Plans

i. Focus on what e’er must contribute

ii. Those plans tend to be less common; e’ers want more flexibilityB. Target Benefit Plan

i. Key off defined benefitii. Target determines contribution

C. Profit Sharing Plan i. E’er flexibility

D. ESOPs – § 83 i. Plans that are designed to invest in e’er stock

ii. Never about helping e’eesE. 401k or CODA Plans 54 min

i. Most common, popular until market crash (best thing since sliced bread or worst thing since…)

1. E’er likes them as well as e’ee2. E’ee elects to make contribution; good, b/c can tailor retirement savings too

point you are in your life3. E’er matching encourages e’ee participation

ii. Set aside % of salary pre-tax in 401Kiii. Better than IRA since contribution rates are higheriv. POs w/ deductions for e’ee contribution are higher than IRAv. E’er likes this in order to favor high level e’ees

vi. Downside: pressure to not save for retirement, especially middle/lower income people

F. 403(b) Plans i. Tax exempt institutions

G. Keogh Plans i. Self employed

ii. How do you define minimum coverage?1. Test: who is eligible (up to e’ee to decide whether want to participate)?

H. Generic IRAs i. Seps: small e’ers use these

1. Simplified e’ee pension2. E’er can make contribution to e’ee IRA

ii. Simples: small e’er 401K plan

V. QUALIFIED PLANS, CONTINUED 4/19A. Requirements

i. Must be primarily a retirement plan w/ only incidental other benefitsii. Must be minimum coverage standards (must appear in your plan)

1. Ex: w/ defined benefit plans, must cover at least …2. Can’t have qualified trust, unless cover certain amt of rank & file; can’t be

only for key e’ees3. Purpose: broader range of e’ees covered; trying to encourage retirement

savings for e’eesiii. Explicit coverage rules

1. Can’t discriminate in favor of highly compensated e’eesa. Issue: who are highly compensated e’ees? 414(q) 8 min

i) In top paid group (20%)2. Full vesting on termination

a. If some 20%, some 70%, when plan terminates, they are all vested 100%

b. Purpose: keeps plans ongoing / funded

3. Minimum distributiona. Don’t really respond all that well, b/c can defer pmt fairly lateb. H/w, some requirement that at certain point, have to start paying out

4. Limits on contributions / benefitsa. How many benefits can be contributed to any one participants plan in

a given year. 415(c)(1)(A)b. Prevents benefits from flowing too heavily to higly compensated

peoplec. Elected deferrals in Keg: 65,500

5. Limit on amount of compensation you can take into accounta. Max is 245K. 401(e)(17)

iv. Special rules for top heavy plans1. Meet all requirements (no discrimination, don’t take more into account, etc.),

but still mostly help top e’ees2. Key e’ees have more than 60% of accrued benefit3. Who is a key e’ee? 14 min - likely important

a. If defined benefit, mustv. Minimum Funding Requirements 19:30 min

1. Mostly for defined benefit plans2. Typically, e’er promises benefit, has bad year, and problems ensue

a. Go to Congress, or regulatory agency, and say can’t afford to make contributions; can you lower them now, and will make up later?

b. H/w, never really catch upc. Also, use some rosey assumptions a/b investment

3. § 415(b)(1)(A): 195K limit 25 min4. N : when draft plan, must have language that meets every single requirement!

a. Must keep them in compliance, so when Congress changes, must keep up w/ current law

b. Review / monitor all the time; if don’t may become unqualifiedB. Minimizing Burdens

i. Small e’er, use some simplified plans, where don’t have to set up on trust; use IRA mechanism, but make e’er contributions

ii. Or, use model or prototype plans1. Service updates2. If adopt, have met all requirements for a qualified plan3. Very straight forward, generous in coverage4. Model plans offered by law firms; keep updated

iii. H/w, often don’t want to use the model / prototypes1. Have specific needs, e.g. compensating highly compensated e’ees2. Want to have terms, clauses, and provisions that are pretty aggressive in not

including rank & file e’ees3. Slow vesting period: favors highly compensated, b/c assume will be around

long time (low turnover rate, as opposed to high turnover w/ rank & file)a. Minimizing amt of people coveringb. Draft formula language to sen as much benefits as possible to highly

compensated4. Risk: plan may fail requirements

a. Solution: seek Private Letter Rulingb. N: won’t protect you down line, but tells at beginning have qualified

plan5. Downside: expensive, b/c involves lawyers, & takes a lot of hours

C. Process Framework i. E’er gets deduction w/in limits; trust / annuity income tax expemt

ii. Payout1. If only contributions e’er, payout fully taxable (OI), b/c never have been

taxed on income, & pmts for services2. If e’ee has made non-deductible contributions (e.g. non-deductible IRA), at

payout, get amts back tax freea. Same annuity rules, e.g. exclusion formulab. If annuity pmt will last over e’ee’s life, look up life expectancy, use

as expected return on Kc. Non-taxed portion is basis over time

iii. Debate: good or bad idea? 36:30 min1. Money mostly ends up w/ upper middle, higher class citizens2. Shuts out lower income people, who likely won’t do private savings; also,

shuts out people w/ high turnover3. Essentially, publicly subsidized b/c get tax benefits

a. Would think, wouldn’t shut out poor people4. Counter: limits on highly compensated

a. Evens playing field, b/c wealthy can afford to buy stocks, which get preferential trtmt through CG rates

b. Quid pro quo5. Counter to counter: get rid of loopholes for wealthy

a. Job mobility has increased dramatically, which means can never reach high enough vesting level

6. Highly Compensated: plan forms base layer of retirementsa. On top, get the gravy, e.g. non qualified plan

VI. NON-QUALIFIED PLAN 45 minA. Two Types

i. Unfunded: promise to pay in the future (no tax consequences); no accession to wealth, RE, etc.

1. Problem: risk of non-pmt; depends on whether e’er new start up or blue-chip 2. Had rules allowing for deferral of income for e’ee, but e’er didn’t get

deduction until e’ee realized incomea. Gets rid of mismatching of income & deductionb. Not taxed advantaged in same way, but… question remains when

should e’ee include income?3. E’ee taxed on receipt or constructive receipt 50 min

a. Constructive: can’t turn back on income available to you, unless do b/f earned, and income for fixed period of time

b. Substantial risk of forfeiture: 409Aii. Funded 53:30 min

1. E’ee taxed when $ set aside on their behalf; but, cash method TP doesn’t usually have income until receipt

2. Economic Benefit: there when money set aside for e’ee; t/f, tax when $ set aside for e’ees benefit

3. Ex: e’er puts $ in trust, e’ee eventually gets payouta. E’er gets deduction in same year; led to Rabbi Trusts

4. Rabbi Trustsa. E’er sets aside $ in trust, e’ee entitled to everything put in, plus

earnings, BUT… subject to claims of creditors

b. TP: substantial risk of forfeiture, t/f no inclusion when monies set aside

c. I: how significant is that risk of forfeiture? A/g, depends on e’er’s status

B. 409A 58:30 mini. Trigger: Enron; w/ Rabbi plans, high level mgmt e’ees quitting so get payouts b/f

creditors show up (solution: put penalty in language, but still less of a hit than being unsecured creditor of e’er)

ii. Rule: unless meet requirements, current inclusion (works off definition of constructive receipt)…

1. Redefines substantial risk of forfeiture2. Also, not just this years income will be taxed, but all past years also must be

taken into account to extent not included in the pastiii. Requirements

1. (a)(2) Distributions: can’t distribute earlier than…a. (i) Separation from service (special 6 month rule for certain e’ees

(top hat), where have to wait 6 months after separation)b. (ii) Disability;c. (iii) Death;d. (iv) Specified time;e. (v) Change of ownership;f. (vi) Unforeseen emergency (defined narrowly)

2. (4) Electionsa. Must defer earlier than other plans, and must for long period of time

3. (3) Acceleration of Benefitsiv. Funding 1 hr, 10 min

1. Saying subject to creditors, but prohibitively expensive for creditors to grab2. (4)(b): 3. § 83

a. If get compensation for services (transfer of prop), included by e’ee at time of transfer of property, UNLESS have substantial risk of forfeiture

i) Actually transferring moneyb. § 409 essentially says not a risk of forfeiture (can’t just move out of

country)v. Do Rabbi Trusts still work?

1. Yes, but must meet 409A requirementsa. Can’t transfer outside of US, etc.

VII. HOW DO THESE PROVISIONS FIT TOGETHER? 4/26 14 minA. § 83 Funded : Must include, unless there is a substantial risk of forfeiture

i. Money very available to TPii. Included once substantial risk of forfeiture lapses

iii. Options: a little different1. Ex : e’er gives e’ee option to purchase stock (no susbt risk of forfeiture)2. Do you have to include FMV at time of grant?

a. T: has there been a transfer of property?b. Very mobile; easy to value “Readily ascertainable value”

i) This is rare, b/c if not publicly traded option, harder to adjustii) Usually, if got option, if NOT readily ascertainable, transfer

of prop doesn’t happen until option exercised

3. Ex: e’er grant $50 option; § 83 NOT triggered, b/c no transfer of propertya. When exercise, FMV is 75, NOW have a transfer of property

triggering § 83b. Must include in GI 75 -- 50 = 25 OI

4. N : Generally, does exercise of option trigger gain?a. NO; when exercise, just purchased stock, so not a recognition event;

just completing a purchase; basis = option price + purchase priceb. No gain recognition until dispose

5. N: what if sale option? GI of SP -- OPB. “Unfunded Plans:” not taxable to e’ee until receipt, or constructive receipt

i. What is constructive receipt? 409(a):1. Unless meets these requirements, will have current inclusion (e.g. looks

pretty funded to us)2. S: tells you when e’ee includes

ii. 404(a)(5): anything that is NOT a qualified plan1. Can’t deduct until e’ee includes (forced matching)2. S : tells you when e’er deducts

C. § 401: Basic Requirements 29 mini. Hopes you have to go through to have a qualified plan

ii. Vesting: 1. Defined Benefit :

a. Two methods availablei) 5 year cliff vesting (not vested at all until been their 5 years)

ii) Graduate plan: gradually vest 20% in year2. Defined Contribution :

a. 3 year cliff vestingb. 2-6 year graduated vesting

3. COTA : e’ee elects to put in part of salarya. 100% vested from beginning

4. What is good w/ cliff vesting?a. If have lots of turnover, easier to keep track of b. Danger: more likely benefits will be found to be discriminatory

CH. 18 - EDUCATION EXPENSES

I. DEDUCTIBILITY OF EDUCATIONAL EXPENSES UNDER § 162 4/21 17 minA. Cost of college education generally not deductible b/c courts consider the costs to be a

personal expenditure. Carroll v. Comm’r.B. H/w, individual is allowed to deduct educational expenses if the education either…

i. Maintains or improves skills required by the indiv in his T/B; ORii. Meets express requirements of the individual’s employer or legal requirements

imposed by law as a condition of doing work of the type performed by the TPC. Clearly Deductible

i. Already lawyer, have continuing education requirements. ii. If required to take 12 hours during every year, deductible.

D. Blurry Groundi. Maintain skills, but prepare you to enter another T or B

E. Education XP incurred to meet the minimum requirements of a NEW T/B are NOT deductible. Reg. 1.162-5(a) &(b)

II. EDUCATION TAX INCENTIVESA. The Hope Scholarship Credit - § 25A

i. Non refundable 100% credit on first 1K of “qualified tuition & related XP” & 50% credit for next 1K of such expenses. (b)(1)(A), (B)

1. Adjusted for inflation. (h)(1)ii. Creditable education XP by scholarships that are excluded from income and certain

forms of educational assistance (e.g. grants). (g)(2)iii. Must be enrolled on at least a half-time basis at a qualified education institution. (b)

(2)(B), b(3), (f)(2)iv. Can be taken only for the first two years of post-secondary education, and no more

than twice by one student. (b)(2)(A), (c)v. Disallowed if student convicted of federal or state drug offense. (b)(2)(D)

vi. Determined on a student by student basis. (b)(1)B. The Lifetime Learning Credit - § 25A

i. Nonrefundable credit of 20% of up to 10K of “qualified tuition and related XP” paid by the TP. (c)(1)

ii. Creditable education XP by scholarships excluded from income & certain forms of educational assistance (e.g. grants). (g)(2)

iii. Unlike Hope Scholarship Credit, can take each ear of undergraduate education and for graduate education

iv. Qualified Tuition and XP1. Does NOT included cost of books, room & board, student activity fees, or

insurance unrelated to a student’s course of study. (f)(1)(C)2. Education XP related to sports, games, or hobbies are not eligible unless

those activities are part of the student’s degree program. (f)(1)(B)v. If student dependent on parent’s tax return, they take the credit.

vi. NOT determined on student by student basis. (c)(1)C. Coverdell Education Savings Accounts - § 530 D. Deduction for Qualified Higher Education Expenses - § 222E. Interest Deduction for Interest on QE Loans - § 221F. § 529 Qualified Tuition Plans G. Educational Assistance Programs - § 127H. Income from U.S. Savings Bonds Used to Pay Higher Education Expenses - § 135

III. DISTINGUISHING CHARACTERISTICS OF COVERDALL & 529 PLANS 4/26A. Tuition, books, fees, supplies, equipment, room & board w/ ½ limitsB. Distinctions C. Coverdall: college, post secondary, and pre education (e.g. private school)

i. Sort of like IRA, but for educationii. Limit on what can be contributed each year (2K per beneficiary)

1. Can be difficult when multiple people contrib.2. Still limited to 2K total; if screw up, must w/draw, or will pay penalty

iii. Phase out: AGI over 110 if single, 220 if married; over these amts, cant contributeiv. Contrib must be in cashv. Beneficiary must be under 18, or have special needs

vi. What if child 1 gets free ride, but have lots of money in there?1. Amts must be paid out when child reaches age 302. If take out for non-education XP, get taxed on portion of earnings, but won’t

be taxed on contrib. amounts; 10% penalty3. Can roll over for another child, e.g. child 2

vii. S : MUST use if for primary of pre-secondary; o/w, 529 much better

D. 529 Qualified Tuition Plans : i. Only available for post-secondary

ii. Initially offered only be states; basically, tuition pre-pmt plans (current prices for future education); state wants to earn enough return on your investment

iii. Two Types :1. State prepayment plan: restricts were kids can go to school2. Qualified Tutution Plan: more like Coverdall, but specifically for higher

educationiv. Benefits :

1. Don’t have same limits as Coverdall, e.g. no phase out2. Still, h/w, contributions not deductible3. Earnings are tax free4. Can be rolled over for another beneficiary who is family member (broadly

defined)5. Overall limit on contrib., which is much more broad

v. What if you take out too much1. Excess divvied up b/t part basis and part earnings2. Portion of earnings taxed, pay penalty on excess

IV. CASE LAWA. Takahashi v. Comm’r

i. Facts : Π Takahashi, a science teacher, attended a seminar on cultural diversity in Hawaii in an effort to comply w/ the discretionary multicultural education requirements of the employing school district

ii. Issue : Are all educational expenses related to the TP’s T or B deductible?iii. Rule : NO.

1. Educational XPs are deductible as O and N B expenses if the education…a. Enhances skills required by the individual in his trade; ORb. Meets the express requirements of the individual’s e’er

2. Burden on TP to show a R allocation exists b/t B education CP on the trip and personal vacation XPs

iv. Analysis :1. Stretch to believe multicultural learning in Hawaii could help science teacher

in Los Angeles2. Trip was not required, an content of seminar did not seem rationally linked to

the teaching of scienceB. Wassenaar v. Comm’r

i. Facts : attorney attempts to deduct the cost of obtaining a master’s degree in taxation as an e’ee B XP

ii. Issue : May the cost of obtaining a master’s degree in taxation be deducted as O and N XP incurred in T or B if the TP has not yet practiced in the profession?

iii. Rule : NO.1. In order for educational XPs to be properly deducted, must be incurred in

maintaining or improving skills of a profession in which TP is already firmly established

2. Generally, cot of learning a T or profession is not deductible if the TP is learning a new T or profession

iv. Analysis :1. Π had never practiced as an attorney prior to enrolling in tax school (wasn’t

even admitted to bar until finishing program)2. This was ongoing endeavor to be tax specialist

C. Furner v. Comm’ri. Facts : Π Furner, a school teacher, left her position and returned to grad school in

order to be more fully versed in relevant subject matterii. Issue : Are costs incurred in graduate study deductible as educational XP?

iii. Rule : YES.1. If the course of study is such that the XP thereof can be considered O and N

in carrying on the B of teaching, costs incurred in grad study are deductible as educational XPs.

2. Permissibility of deduction not contingent upon whether or not the attainment of add’l relevant skills interrupts the carrying on of the T or B

iv. Analysis :1. Trend in teaching was to return to grad school if add’l skills in a subject were

required for advancement and job security2. Education must be analyzed in context of the T or B in question

D. Rev. Rul. 68-591i. Issue : Whether a TP, having clearly at one time carried on a T or B, has abandoned or

w/drawn form that T or B when the educational XPs are incurredii. Rule : Suspension of employment for a year or less will ordinarily be considered

temporary.E. Sharon v. Comm’r

i. Facts : Π Sharon, an attorney, attempted to deduct various bar admission fees and educational XPs incurred in completing licensing requirements.

ii. Issues :1. (1) May the cost of obtaining a license to practice law be amortized over

expected work life?2. (2) Are capital costs incurred in obtaining a new professional license

amortizable?iii. Rules :

1. (1) No. All costs of min educational req for qualification in employment are personal expenditures or constitute an inseparable aggregate of personal and capital expenditures.

2. (2) Yes. Capital costs incurred in obtaining a new professional license are amortizable, but educational XPs that qualify an individual for a new T or B, by virtue of professional certifications, are NOT deductible.

a. Where UL of license extends beyond one year, it cannot be deducted as an XP, but rather, must be treated as a capital expenditure

TAX RESEARCH

I. LAW REVIEWS / JOURNALS 40 minII. CCH MATERIALS

III. TAX MANAGEMENTA. Whole idea is not to spin your wheelsB. Could subscribe to tax notes; comes out weekly

IV. AUTHORITY OF REGULATIONS 53 minA. National Muffler

i. Court’s evaluating the validity of regulationB. Chevron

i. Never completely clear whether overturned National Muffler in the tax areaC. Mayo Foundation: SCOTUS clarified

i. Issue : are medical residents or e’ees for unemployment tax purposes (circuit split)ii. Held : e’ees

iii. Two kinds of regs:1. Dep’t of Treasury: general authority to make regs (necessary & helpful)2. Some places, Congress says “make regs in this area and make them say this,

e.g. fix anti-abuse or define X”iv. Line of cases said specific grants of regulatory authority can’t be overturned unless

arbitrary and capricious1. Consensus that lower bar to overturn general authority regs2. Test of Validity : Nat’l Muffler 57 min

a. Congressional intent & purposeb. Contemporaneousness

v. Court: overturn cases that say specific has more discretion than genera; overturn Nat’l Muffler, Chevron now applies

vi. Chevron Test:1. 1st: has congress directly spoke to precise question at issue? If so, must

follow unambiguous intent of congress (not talking about origin, intent, or purpose, but focusing on language)

a. Con: lang NEVER that clear2. 2nd: if silent /ambiguous to specific issue, is agencies answer based on

permissible construction of the statute?a. Must be capricious to overturnb. Immaterial to analysis that reg prompted by litigationc. S: Separation of Powers, e.g. executive agency (Treasury) can

overturn a court decision by regulation; only way to change outcome, is for congress to step in