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Federal Income Taxation Federal Income Taxation 1. Introduction

2. Gross Income

3. Obligation to Repay

4. Gains from Dealings in Property

5. Gifts, Bequests, Inheritance

6. Discharge of Indebtedness

7. Fringe Benefits

8. Business and Profit Seeking Expenses

9. Capital Expenditures

10.Depreciation

11.Travel Expenses

12.The Interest Deduction

13.Cash-Method Accounting

14.Accrual-Method Accounting

15.Annual Accounting

16.Capital Gains and Losses

17.Quasi-Capital Assets

18.Recapture of Depreciation

19.Assignment of Income

20.Tax Consequences of Divorce

21.Like Kind Exchanges

Prof. WOOTEN: Federal Income Tax

IntroductionIntroductionFive Questions

1. What items must be included?2. What items may be deducted?3. When is an item included or deducted?4. Whose income or deduction is it?5. What is the character of items of income or deductions?

Formula for Taxation

Taxable Income = [(Gross Income – § 62 deductions) – § 63 deductions]

§ 62 and § 63 say when a deduction is applied in the tax formula, but they don’t list when something is deductible or not.

§ 151ff – what you can deduct§ 261ff – what you cannot deduct.

What is included in Gross Income?

General rule: if something makes you better off, it is income, unless you can find a statutory or judicial exclusion.

DEDUCTIONS

1. The income tax is a tax on net income. In general a person may deduct from his gross income the costs incurred in producing his gross income.

2. The most important deductions are for costs incurred to produce gross income. IRC §§ 62(a)(1), 162, 212.

3. The deduction provisions of the Code begin with § 161.

4. Deductions are a matter of statutory grace. Every time you have a deduction which you believe is deductible, you must find a specific Code section or case authorizing the deduction.

Above the Line Income: subtracted from gross income pursuant to § 62.Below the Line Deductions: subtracted from adjusted gross income pursuant to § 63.

Taxable Income

Itemized Deductions: the taxpayer can deduct all of the below the line deductionsStandard Deductions: the taxpayer can deduct a specified amount

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Section 67: the 2% Floor on Miscellaneous Itemized Deductions

§ 67: provides that certain itemized deductions may not be deducted except to the extent that in the aggregate such deductions exceed 2% of the taxpayer’s adjusted gross income. But, some deductions (mortgage interest, state tax, real property tax, charity) are not subject to this rule.

Section 68: The Overall Limitation on Itemized Deductions

§ 68: As income increases by a specified amount, itemized deductions are reduced by 3%

Personal Exemptions

Under § 151, the Taxpayers can claim exemptions for each dependent and for themselves.

Note: The personal exemption and the standard deduction provide a floor assuring that taxpayers will not be taxed unless they have income greater than the combined amount of the personal exemptions allowed and the standard deduction.

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Gross IncomeGross Income

A. The Search for a Definition of Income

a. IRC § 61(a): Gross Income is all income from whatever source derived. While 61(a) includes a list of what counts as gross income, that list is not exhaustive.

b. For a variety of policy reasons, Congress has specifically excluded certain items from gross income.

i. § 102: excludes gifs and bequests. ii. § 102(c): the exclusion for gifts shall not include any amount transferred from an

employer to an employee.

c. Basically, income generally includes items which add to the taxpayer’s net worth.

B. Income Realized in Any Form

a. Reg. § 1.61-1(a): Gross income may be realized in any form, whether money, property, or services.

b. Reg. § 1.61-2(d)(1): If services are paid for in property, the fair market value of the property is the measure of compensation. If paid for in the form services, the value of the services received is the amount of compensation.

c. Comm’r v. Glenshaw Glass Co. , Supreme Court (1955) (GROSS INCOME)

TEST:There is gross income when there are instances of

(1) ACCESSIONS TO WEALTH, (2) CLEARLY REALIZED (realization rule), AND (3) over which the taxpayers have COMPLETE DOMINION.

Money received as part of punitive damages counts as gross income.

Holding: The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients.

d. Cesarini v. U.S. , US District Court of OH (1969) (WINDFALL)

According to Reg. § 1.61-14, treasure, or found money, is taxable for the year in which the finder has undisputed possession of it. The finder has undisputed possession only when he actually has found the money and not when he merely bought something with money hidden in it, without finding the money.

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Income from all sources is taxed unless the taxpayer can point to an express exemption.

Facts: In 1957, Δ bought a piano. In 1964, they discovered $4,467 in the piano.

e. Old Colony Trust Co. v. Comm’r , Supreme Court (1929) (PAYMENT OF BILLS)

Rule: If an employer pays an employee’s tax as consideration for services rendered by the employee, then the amount that the employer pays is gross income for the employee.

You view this as if the employer actually paid the employee and then the employee paid the tax.

Facts: The president of a company did not pay taxes on his income because the company had a policy to pay all of the taxes that were due on the salaries of the company’s officers.

f. Revenue Ruling 79-24 (1979) (BARTER)

Reg. § 1.61-2(d)(1): If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in the income.

o Hence, if a lawyer and a painter trade services, then the fair market value of each of those services should be included in their gross incomes. In other words, the lawyer is taxed as if she provided services, was paid in cash, then paid the painter with the cash.

g. McCann v. US , US Court of Claims (1981) (ALL EXPENSE PAID TRIPS)

The Supreme Court has said that Congress intended to tax all gains, except those specifically exempted (Glenshaw Glass), and that the term “income” includes any economic or financial benefit conferred as compensation, however accomplished (Comm’r v. Smith).

Thus, in a situation where an employer pays an employee’s expenses on an OPTIONAL trip that is a reward for services rendered by the employee, the value of the reward must be regarded as income to the employee.

Facts: The Δ and her husband went on an all-expenses paid trip to Las Vegas, paid for by the Δ’s employer, as a reward for good work performed by the Δ. The

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Δ was able to attend and bring his spouse, but was not required to. The trip included cocktail parties along with business seminars.

Holding: The all-expenses paid trip was an economic benefit to the Δ, as the Δ received the benefit as a reward for her good work in increasing her sales..

C. Realization, Imputed Income and Bargain Purchases

a. Realization Requirement :

i. Mere appreciation in the value of property or stocks is not taxed.

1. There are administrative difficulties in measuring the appreciation. At the time people sell something, the values are known.

2. People may not be able to pay the taxes on appreciated property unless they sell, or realize, it!

ii. Realization is fundamentally a matter of timing – when you realize the gain, you allow yourself to be taxed.

b. Imputed Income

i. SELF PROVIDED SERVICES ARE NOT TAXED1. This is an incentive to do things yourself.

ii. Imputed Income from Owning Property

1. If you buy a house for $100,000 which has a rental value of $10,000, you don’t have to pay rent, but you gain a $10,000 benefit by living in it. You don’t have to pay any taxes on that benefit.

iii. Imputed Income from Performing Services for Oneself

1. You can pay someone to mow your lawn for $8, but with a 20% tax rate, you really need to earn $10, paying a $2 tax, to pay for that service.

2. But, you can mow the lawn yourself, get an $8 value out of the lawn mowing, without paying any taxes.

3. The tax questions related to imputed income tend to arise in self-employment activities.

a. Morris v. Comm’r: the value of farm products consumed by the farmer is not income.

c. Bargain Purchases

i. Bargain purchases are not income (Pellar v. Comm’r)

Pellar v. Comm’r, US Tax Court (1955)

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Bargain purchases DO NOT count as Gross Income!

If someone buys a property at below fair market value or receives services at below fair market value, the benefit he gets is not gross income, unless the benefit was given to him in exchange for services that he was legally obligated to perform.

Facts: The Δ entered into an agreement with a construction company to build a house on property that they owned. The company gave the Δ a good deal, as he wanted to keep the Δ’s goodwill in the hope of future business. The Δ ended up paying $55,000 for services worth $70,000.

Holding: Since the Δ was not obligated to return the favor, the benefit that he received from the company was not in exchange for any services that he was obligated to render. Hence, the benefit was not income.

ii. Compensation for services is income.

1. Reg. § 1.61-2(d)(2): If property is transferred as compensation for services in an amount less than fair market value, the difference between the fair market value and purchase price is gross income.

a. EXAMPLE: If A gives B, his employee, stock worth $500 in return for payment of $100, then B clearly has a gross income of $400, even though the stock has yet to be realized.

b. The property was given to the employee as compensation and it is the fair market value of that property that must be used in order to measure the compensatory element in the transaction.

Two competing theories of Income:

SOURCES VIEW: If there is a trip that is for the employer’s convenience, then the trip is not included.

Under the sources theory, compensation is a result of labor.

USES VIEW: According to the “uses” or Haig-Simon theory, if something makes you better off, it

is included in income, unless there is a specific exclusion. The trip is valuable and therefore must be included under this theory.

The law has been moving from the Sources view to the Uses view. Under the sources view, when an employee receives something from an employer that is not derived from labor, then it is not compensation that can be included. Under the Uses view, the trip can be a fringe benefit, and must be included unless there is exclusion.

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Effect of an Obligation to RepayEffect of an Obligation to Repay

A. Loans

1. Loans are not gross income because the borrower has an obligation to repay the loan. Therefore, they are not an “accession to wealth.”

2. Repayment is not a deductible expense. Similarly, the lender has no income when the loan is repaid because the repayment is merely a recovery of capital.

B. Claim of Right

1. §1341 is the relevant provision.

2. Money received under a claim of right, without restriction as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan.

3. North American Oil Consolidated v. Burnet , US Supreme Court, 1932, p54

Rule: Money received under a claim of right, without restriction as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan.

There is no obligation, however, to claim profits that have not yet been received.

Facts: In 1916, the money made from the oil property was paid to a receiver and not NAO. In 1917, the US government loses in the trial court. At that point, the receiver pays the money it was collecting to NAO. In 1920, the US government loses its appeal.

Class Notes: The Court said that if you receive money under a claim of right, even if it is a contingent claim, it is included! In a claim of right, you receive the money but you MAY have to pay it back. Hence, it is different than a loan, where you MUST pay it back. Therefore, it is not like a loan and must be included.

C. Illegal Income

1. Deductions : Repayment of illegal income entitles the taxpayer to a deduction.

2. Loan vs. Illegal Income : In distinguishing between a loan and illegal income, courts have taken into consideration whether the taxpayer intended to repay the money. A person who takes out a loan has the intent to repay.

3. Rights of the Victim : creditors, not victims, get first dibs on illegally acquired income.

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James v. United States, US Supreme Court, 1961, p59

Rule: Embezzled funds constitute gross income.

When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, he has received income.

Class Notes: Should embezzled money count as income? There isn’t a contractual obligation to repay – there is a legal obligation, but no contract was made that if you embezzle funds you must repay them. There is no mutual understanding between embezzler and victim. Hence, it is not like a loan and the money must be included.

D. Deposits

1. Reg. § 1.61-8(b) : Rent paid in advance constitutes gross income in the year it is received regardless of the period covered or the taxpayer’s method of accounting.

2. Whether security and other such deposits constitute income is unclear.

Commissioner v. Indianapolis Power & Light Co., US Supreme Court, 1990, p63

Rule: Whether a deposit constitutes income turns upon the nature of the rights and obligations assumed by the receiver of such deposits when they were made—not upon whether the receiver realized some economic benefit.

Facts: IPL requires certain customers to make deposits to ensure payment of future bills. The Commission argues that these deposits are advance payments for electricity and therefore constitute taxable income. IPL contends that the deposits, because they are returned with interest to the customer, are similar to loans.

Holding: The individual who makes an advance payment receives no right to insist upon the return of funds. The customer who submits a deposit, retains the right to insist upon repayment in cash. IPL’s right to retain the money is contingent upon events outside its control, namely whether the customer insists on a refund of the deposit they are not taxed.

Notes: If deposits look like a loan, they are not income. If they look like advance payments, they are income.

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The effect of an Obligation to Repay

Transaction Description Taxation

Loan Accession to wealth with a consensual obligation to repay

No inclusion

Deposit Accession to wealth with a consensual obligation to repay

No inclusion

Receipt under a claim of right Accession to wealth with a contingent obligation to repay

Inclusion

Embezzlement Accession to wealth with a legal (but not consensual) obligation to repay

Inclusion

Extortion Accession to wealth with a legal (but not consensual) obligation to repay

Inclusion

Loan (no inclusion) ------- Repayment (no deduction)

TAX PLANNING: With a loan, you accelerate deductions. You take the money you borrow and buy something that gets a deduction. This is important for tax planning purposes:

EXAMPLE: I want to give a gift to my alma mater. It is the end of 2003. I don’t have $25,000 to give to them. At the end of the year, I borrow $25,000 and give it to my alma mater. I get a deduction for my charitable contribution in 2003. I am going to earn the money to repay the loan in later years. I do not get a deduction for repaying the loan. I earn $25,000 and pay the loan back in later years. So, in effect, I can take a $25,000 charitable donation deduction BEFORE I pay taxes on the income I earn to repay the loan. By taking out the loan, I can give a charity and take the deduction earlier.

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Gains Derived From Dealings in PropertyGains Derived From Dealings in PropertyA. OVERVIEW

Defining Gain

IRC § 1001(a):

Gain: If amount realized > adjusted basis, then:

Gain = amount realized – adjusted basis

Loss: If adjusted basis > amount realized, then:

Loss = adjusted basis – amount realized

IRC § 1001(b)

Amount realized = sum of any money received + fair market value of property other than money received.

REG. § 1.1001-2(a)(1):

The amount realized includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. When I owe money on property and someone else assumes that debt, I realize the amount of loan. The amount of my debt that someone else assumes is money to me. The amount of debt someone assumes is included in the basis.

Defining Basis And Adjusted Basis:

1. IRC §1012 : Definition of Basis

(a) Basis = Cost (except as otherwise provided).

(b) Cost refers to the amount paid for an item.

2. IRC § 1016(a): Basis should be adjusted for

(1): expenditures, receipts, losses, or other items(2)(A): for deductions of depreciations

(a) Adjusted basis reflects the impact of events subsequent to property acquisition on the amount of one’s investment.

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(b) When there has been an addition to property or a depreciation of the property, the basis will be adjusted.

Recovery Of Capital Or Return Of Capital:

a. A fundamental principle in our income tax system is that the taxpayer must recover tax-free her investment (capital) in property before being charged with income from a disposition of the property. ONLY REAL GAIN WILL COUNT AS INCOME.

b. No Double Tax: Basis prevents dollars that have already been taxed from being taxed again.

B. TAX COST BASIS

1. EXAMPLE: T receives car from employer in lieu of cash compensation. The fair market value of the car is $5,000. He later sells the car for $5,500. T reported $5,000 of income. His tax cost basis in the car is $5,000. When T sells the car for $5,500, his gain will only be $500. The total income from the receipt and sale of the car is thus $5,500, just as though T received $5,000 in cash, purchased the car for that amount, and sold the car for $500.

2. TR §1.61-2(d)(2)(i): Property transferred to employee or independent contractor : if property is transferred by an employer to an employee or if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fair market value at the time of the transfer is compensation and shall be included in the gross income of the employee or independent contractor. In computing the gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of such difference included in gross income.

C. IMPACT OF LIABILITIES

1. Impact on Basis

a. Recourse liabilities (loans that must be repaid) assumed by a taxpayer in the acquisition of property are included in the taxpayer’s basis in that property.

b. RULES:

(1) Loan Amount = Basis : Because of the obligation to repay, the taxpayer is entitled to include the amount of a loan in computing his basis in the property. The loan is part of the cost of the property. (Tufts). It makes no difference whether the lender is also the seller.

(2) IMPORTANT EXAMPLE : I borrow $100K to buy a house. My basis is $100K. If I pay back $25K, my basis is still $100K, because that money isn’t going into the property – it is going to pay off the debt. If I take out a new

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loan to refinance my mortgage in the amount of $40K and use $10K of that loan on a new piano and $30K on the home, my basis increases by $30K, because that is the amount I am investing in the home.

2. Impact on Amount Realized

a. Recourse liabilities of a seller, assumed by a purchaser, are included in the seller’s amount realized. In other words, loans of the seller that are assumed by the purchaser are included in amount realized.

D. BASIS OF PROPERTY ACQUIRED IN TAXABLE EXCHANGE

Philadelphia Park Amusement Co. v. United States, U.S. Court of Claims (1954), p82

Rule: The cost BASIS of the property received in a taxable exchange is the fair market value of the property RECEIVED in the exchange, not the fair market value of the property GIVEN in the exchange.

Class Notes:

EXAMPLE:

Joe expects to give Nicole $10,000 in property in exchange for $10,000 in property. But at the time of the transaction, Joe gives Nicole $10,000 in property in exchange for $12,000 in property.

Joe paid taxes on the $10,000 in the property he gave Nicole. He must also pay taxes on the gain from the sale (which is another $2,000 or 12,000-10,000). Hence, he paid taxes on $12,000. Therefore, Joe’s basis is $12,000. It is not $10,000.

In Philadelphia Park Amusement, my basis will be $12,000 and NOT $10,000. Basis is the fair market value of the items that I receive and not the value that I give.

If Joe’s basis was $10,000 then he’d have to pay taxes on the $2,000 difference (12,000-10,000) twice. He would have paid for it once when he received the property from Nicole. If he sold the property, then that $2,000 would not be part of the basis and hence could be taxed.

Philadelphia Park says that the basis is the amount of the received property. Why does it say this? Because, this way, Joe won’t be taxed twice.

If Joe gave Nicole property worth $12,000 in exchange for $10,000 and the basis is the amount given, not received, then Joe would have an increased basis (his basis would be 12,000 and not 10,000). This would allow Joe to include an extra $2,000 in his basis that he was not ever

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taxed for. Hence, the Philadelphia rule also prevents unfair tax advantages like this one.

o When you receive multiple items in a transfer, you must allocate basis among them.

o Assuming debt is treated like paying cash.

1. Claire/artist has to pay Liz/lawyer 10,000 in legal fees by giving her painting worth about 5,500 (therefore Claire still owes 4,500). Liz sells painting for 10,000 5 years later.

a. Tax consequences for Liz?

(1) Liz did work worth $10,000. She got paid in a painting worth $5,500. This a transfer of goods (barter) that is treated just like a transfer of money. Liz will be taxed on the fair market value of the painting. She will have $5,500 of income to pay taxes on. Liz’s basis will be $5,500. When Liz sells the painting for $10,000, her gain will be $4,500 as her basis is $5,500.

b. Tax consequences for Claire (assuming she spent $100 on materials and 25 hours of her time)?

(1) Claire realizes $5,500 (amount of debt that is paid off by the transfer of the painting). Claire gets no basis on the 25 hours, since she’s never been taxed on the work. The only amount she’s already been taxed on is the 100 after tax dollars. That is her basis. Her basis is not $5,500 because the painting has not been taxed at this point. Hence, Claire’s gain is $5,500 - $100 or $5,400.

Realization: I don’t get taxed on gains and losses until I realize them. It is a prerequisite for recognition.

Recognition: Recognizing the gain means that I pay taxes on it.

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Gifts, Bequests, and InheritanceGifts, Bequests, and Inheritance

Overview

1. Gifts are not included as income for the donee.

2. Generally, there is no deduction for gifts for the donor.

PROCESS:1. § 102(a): excludes gifts, bequests or inheritances.

a. What is a gift?b. What is a bequest/inheritance?

2. § 102(b): Limitations on the exclusion3. § 1015(a): Basis in gift4. § 1015(b): Basis in bequest5. Part-Gift/Part-Sale

A. What is Excluded by §102?

1. The Nature of a Gift

i. § 102: excludes gifts, as well as property acquired through bequest, devise or inheritance.

ii. Threshold question : Whether that which is received can be characterized as a bequest, devise or inheritance?

1. The motive of the donor is critical in characterizing receipts as gifts under § 102.

2. Limitations on Gifts by Employers:

a. § 102(c)(1): denies a § 102(a) exclusion for amounts transferred by an employer to, or for the benefit of, an employee.

b. § 274(b): disallows a deduction for gifts to individuals in excess of $25. Therefore, employers who give gifts cannot deduct them, like they could with salaries!

3. Commissioner v. Duberstein , US Supreme Court (1960), p98

Rule: A gift proceeds from a DETACHED and DISINTERESTED GENEROSITY, out of affection, respect, admiration, charity, etc. The most critical consideration is therefore the transferor’s

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intention. The donor’s characterization is not determinative – there must be an objective inquiry in what the dominant reason was in his making the transfer.

Facts: Berman was in business with Duberstein and gave him a Cadillac after information Duberstein provided was helpful for Berman’s business. The court said that Berman was compensating Duberstein for past services and was hoping to secure future services from him as well. The motive was not detached or disinterested.

4. Olk v. United States , US Court of Appeals (1976), p104

Regular, sizable payments made by people to whom the taxpayer provides services are customarily regarded as a form of compensation and may therefore be treated as taxable income.

Facts: The π was a dealer at a casino. He received “tokes” from the gamblers. He contended that tokes are non-taxable gifts. Most patrons do not give tokes and there is no obligation to give a toke. Tokes are not gifts. They are more like tips, as they were regular, there was a reasonable expectation for the dealer to view the tokes as part of his compensation. Hence, tokes are like tips and are not excludable as gifts.

5. Goodwin v. United States , US Court of Appeals (1995), p106

When a congregation, as a whole (not individual members), and with a routine, structured program, gives regular, sizable cash payments to a pastor on account of his services, these payments are not gifts and are taxable.

Facts: Goodwin, a pastor, received sizable payments from the congregation on special occasions. The court said the payments are not gifts. The critical fact was that the payments were made by the congregation as a whole, rather than by individual Church members. The case payments were gathered in a routine, structured program. The Congregation knew that without the on-going cash payments to Goodwin, the Church could not retain his services.

2. The Nature of a Bequest or Inheritance

i. What happens when a will is challenged and there is a consequential settlement over the inheritance – is the settlement still considered part of the inheritance and therefore excluded under § 102?

1. Yes, amounts received through the settlement agreement are excludable under § 102 (Lyeth v. Hoey).

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ii. Wolder v. Commissioner , US Court of Appeals (1974), p102

Rule: A transfer in the form of a bequest is not a gift if it is compensating someone for services performed while the donor was alive.

Facts: Instead of paying Wolder for legal fees, Boyce provided in her will that he shall be given money. Wolder says that the money was excluded under § 102 as a bequeath. The court held that a transfer in the form of a bequest was the method that the parties chose to compensate Wolder for legal services. The transfer is therefore subject to taxation, whatever its label may be.

3. Statutory Limitations on The Exclusion-- §102(b)

i. § 102(b)(1): Income from property excluded as gift, bequest, devise, and inheritance is not excluded.

1. If X gives Y a share of IBM stock, the value of the stock is excluded from Y’s income, but the dividends which IBM distributes to Y are not.

ii. § 102(b)(2): Denies an exclusion to gifts, whether made during life or at death, of income from property.

1. EXAMPLE: Mother dies leaving a portfolio of stocks in trust. The trust will distribute all income from the stocks to the son. When he dies, the trust will terminate and all the property will be distributed to the grandchildren. In this situation, the son is not allowed to exclude the income he receives from the property. He must pay tax on that income. The grandchildren are, however, allowed to exclude the property they receive.

B. Basis of Property Received by Gift, Bequest, or Inheritance

1. Gifts of Appreciated Property

i. § 1015(a): Transferred Basis Rule:

Basically § 1015(a), the Transferred Basis Rule, says:

FMV > Donor’s Basis Donee’s Basis = Donor’s Basis

FMV = Donor’s Basis Donee’s Basis = Donor’s Basis

FMV < Donor’s Basis Donee’s Basis depends on how much he sells the property for:

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Gain = Amount realized - Donor’s basis

Loss = Amount realized - FMV at time of transfer

If the donee sells the property for a price in between the donor’s basis and FMV at time of transfer no gain

or loss.

EXAMPLE: A buys property for $1000. A gives it to B when it’s FMV is $500. B’s basis depends on how much he sells the property for. If B sells it for $1001, then his basis is the same as A’s basis ($1000) and he has a gain of $1. If B sells it for $499, his basis is the FMV of the property at the time of the transfer of it from A to B ($500). Hence, his loss is $1. If B sells the property for $750 (in between A’s basis and the FMV), B realizes no gain or loss.

1. EXAMPLE: If A buys stock for $200 and gives it to B when it is worth $400, B’s basis is the same as A’s ($200) and not $400. If B sells it for $400, she must pay tax on the gain, which would be $200 (400 – 200 basis). Hence, the rule shifts the tax burden associated with the appreciated value of the stock to B.

2. EXAMPLE: Jill buys land for $25K. Jill gives the land to Jane and its FMV at the time is $30K. Jane’s basis is $25K.

a. But, suppose the FMV equals $20K and Jane sells the land for $30K. Jane’s basis is Jill’s basis and her gain is $5K (30K sale – 25 basis).

b. Jill’s basis is still $25K. The FMV equals $20K and Jane sells the property for $15K. Jane’s basis is the FMV because the FMV is less than the donor’s basis and we are calculating a loss. Hence, the loss is $5K (15K Sale – 20K FMV = - 5K).

2. Gifts of Property—Basis in Excess of Fair Market Value

i. The Transferred Basis Rule allows for shifting potential gain (income) to the donee:

1. A taxpayer in a high tax bracket may be encouraged to make gifts of appreciated property to a related taxpayer in a lower tax bracket so as to assure that the gain will be taxed at the lowest possible rates.

ii. But, shifting losses is not permitted.

1. A, who is in a lower tax bracket, gives stock to B, who is in a higher tax bracket. A bought the stock for $200, but it is now worth $100. The loss deduction will be worth more to B than A because he is in a higher tax bracket. B’s basis will be the FMV of the stock and not A’s basis, so it will be $100. If he sells the stock for that much, he has no loss to claim!

3. Basis of Property Received by Bequest or Inheritance

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i. § 1014(a)(1): the provision “steps-up” or “steps-down” the basis of property acquired from a decedent to the fair market value of the property at the time of the decedent’s death.

ii. Only the appreciation occurring AFTER the decedent’s death will be subject to tax . The appreciation before the death will not be subject to tax.

iii. However, § 1014(a) negates the deductible loss when property is devised and did not appreciate over the life span of the decedent.

iv. If you want to save money, you sell all of the property that you will take a loss on, so that you can deduct the loss and you save all of the property that increased in value, so that at the time of death, the basis is stepped up.

C. Part-Gift, Part-Sale

1. Reg. § 1.1001-1(e): the seller-donor has gain to the extent that the amount realized exceeds the adjusted basis of the property. Also, no loss is recognized on such a transaction. (LOOK AT THE REG’S EXAMPLES).

2. Reg. § 1.1015-4: the donee’s basis in a part-gift, part-sale will be the GREATER of (1) the amount the donee paid for the property OR (2) the adjusted basis of the donor.

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Discharge of Indebtedness Discharge of Indebtedness

OVERVIEW

§ 61(a)(12): income from the discharge of indebtedness constitutes income.

Bowers v. Kerbaugh-Empire Co. Supreme Court, 1926

Rule: The mere diminution of loss is not gain, profit or income.

o Facts: a taxpayer borrowed money repayable in Deutschmarks and repaid them with greatly devalued marks.

o Issue: Did the taxpayer have income because he needed fewer dollars to repay the loan than the dollar equivalent of the original loan proceeds? No, he didn’t have income.

U.S. v. Kirby Lumber Co. Supreme Court, 1931

“Freeing-of-Assets” Theory: a taxpayer realizes gain when a debt is discharged because after the discharge the taxpayer has fewer liabilities to offset her assets. The taxpayer’s existing assets, which otherwise would have gone toward repaying the debt are freed – this is a gain.

o Holding: Repayment of corporate debt at less than its face value constituted income.

§ 108: provides an exclusion from gross income when discharge of indebtedness occurs in certain limited circumstances, including bankruptcy or insolvency.

A. SPECIFIC RULES GOVERNING EXCLUSION

a. Discharge of Indebtedness When Taxpayer is Insolvent

i. § 108

Discharge of indebtedness will not generate gross income if the discharge occurs in a title 11 bankruptcy case or if the discharge occurs when the taxpayer is insolvent.

1. § 108(a)(3): limits the insolvency exclusion to the amount by which the taxpayer is insolvent.

a. Lakeland Grocery Co. v. Comm’r: a debtor realized income to the extent that the discharge of indebtedness made the debtor

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solvent.

2. § 108(d)(3): insolvent means the excess of liabilities over the fair market value of assets.

3. Example:Debt Assets Discharge Solvent or Insolvent? Include?200 100 50 Insolvent by $50 0100 100 50 Solvent by $50 50

4. § 108 also has its costs

a. If you take a § 108 exclusion, then there is a reduction in the taxpayer’s basis in property (§ 108(b)(2)(E)).

i. A reduction in basis will increase the taxable gain realized on the property or decrease the deductible loss, forcing the selling taxpayer to pay more in taxes.

5. § 108 replaced the Judicial Exception in 1980

b. Disputed or Contested Debts

i. If the amount of a debt is disputed, settlement of that amount does not constitute a discharge of indebtedness.

ii. Zarin v. Comm’r : excess of the original debt over the amount determined to have been due may be disregarded in calculating gross income.

1. It doesn’t matter what the parties originally agreed upon – what matters is what they settled for.

c. Purchase-Money Debt Reduction for Solvent Debtors

i. A taxpayer buys property, agreeing to pay the seller over time. The taxpayer refuses to pay because there were irregularities in the sale or property defects. The parties resolve the dispute, agreeing to a reduction of purchase price.

ii. No income results – it is merely a retroactive reduction in purchase price. As, a result, the basis of the taxpayer is reduced as well. § 108(e)(5).

d. Acquisition of Indebtedness by Person Related to Debtor

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i. § 108(e)(4): if a person related to a debtor acquires indebtedness, the acquisition shall be treated as an acquisition by the debtor.

ii. It prevents parties from circumventing the Kirby rule.

1. For example, Donna owns more than 50% of the stock in XYZ Corp. and is therefore related to XYZ. XYZ issues bonds for $100. Donna repurchases the stock for less. Does XYZ have discharge of indebtedness income under Kirby, “Freeing of the Assets” theory? YES!! Even though it was Donna that bought the bonds, her acquisition is attributed to XYZ and thereby prevents XYZ from avoiding discharge of indebtedness income.

e. Discharge of Deductible Debt

i. § 108(e)(2): forgiveness of a debt does not generate income if the payment of the debt would have been deductible.

B. DISCHARGE OF INDEBTEDNESS AS GIFT, COMPENSATION, ETC.

a. Whether a discharge of indebtedness could be considered an excludable gift under § 102(a) and its predecessors?

i. Comm’r v. Jacobson : in light of this case, it is doubtful that any taxpayer will be successful in arguing the discharge of indebtedness in a commercial context constitutes an excludable gift.

ii. But , in certain contexts (family situations), the cancellation of indebtedness can be an excludable gift under § 102(a).

iii. Also, cancellation of indebtedness may represent a form of compensation which should not be considered income from the discharge of indebtedness within the meaning of § 61(a)(12). When debt is paid off, not in cash, but in services, it is treated as compensation. It is similar to a bartering situation.

b. Revenue Ruling 84-176 (1984)

Rule: If a cancellation of indebtedness is simply the medium for payment of some other form of income (gift or a salary), § 108 does not apply.

Facts: The taxpayer owed the seller money and agreed to pay the seller $500 of the $1000 outstanding indebtedness. The remaining $500 was forgiven by the seller in return for dropping the counterclaim.

Holding: The $500 not paid by the taxpayer to the seller was the medium through which income from the damages for breach of contract arose. The

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taxpayer gave up the counterclaim. The $500 was not forgiven – it was deemed to be paid for the taxpayer to give up the counterclaim. This amount is not treated as discharge of indebtedness.

Gehl v. Comm’r, Court of Appeals (1995)

Reg. § 1.1001-2: The amount realized on the transfer or sale of property to repay a recourse loan, DOES NOT include amounts that are income from discharge of indebtedness.

A owes $10,000A transfers property with the value of $6,000 as a repayment of some of the loan. A is discharged of $7,500 in loans

Amount Realized from Property Transfer is its Fair Market Value = $6,000Income from the discharge of indebtedness = Amount Discharged – FMV of property transferred = $1,500 (7,500-6,000).

Facts: Jim is insolvent. Jim owes $100K to the Bank. Jim owns a lot. His basis in the lot is $25K and its FMV is $70K. He gives the lot to the Bank in exchange for the debt. He says the difference between what he owes and the lot’s FMV is all discharge of indebtedness income. He wants it like that because he is insolvent.

Holding: But, the court bifurcates the transaction. The court says that the property transfer was not a discharge of indebtedness. It treats it as a property transfer. Therefore, Jim realized $70K on the sale, his basis was $25K and his gain was $45K. Whether he is insolvent or not, he must pay taxes on this $45K gain. The $30K that the Bank forgave is discharge of indebtedness income. Therefore, Jim does not have to pay taxes on the $30K, as he is insolvent. Instead of Jim having discharge of indebtedness income only, he now has to pay taxes on the gains from selling the property!

1. Bill borrows $75,000 from Judy and later, when Bill was insolvent, Judy accepted land from Bill in satisfaction of the debt. Bill bought the land for $20,000 and its FMV was $60,000 when he gave it to Judy. Immediately prior to the transaction, Bill’s liabilities included the $75,000 debt to Judy and $50,000 of indebtedness to other parties. Bill also guaranteed a $25,000 loan repayment for his son, where there was a 50% chance he would have to repay it. Bill’s assets, besides the land that he gave, are valued at $55,000. He continues to owe $50,000 to 3rd parties and to be the guarantor of his son’s $25,000 loan.

a. How much discharge of indebtedness income must Bill report?

Before After

Liabilities Assets Liabilities Assets

75K 60K 50K 55K

50K 55K

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25K doesn’t count because repayment isn’t guaranteed

25K doesn’t count because repayment isn’t guaranteed

Total: 125K Total: 115K Total: 50K Total: 55K

55K assets – 50K liabilities = 5K taxable income

i. Immediately prior to the discharge, Bill had liabilities of $75,000 (Judy), $50,000 (3rd parties), $25,000 (loan guarantee), for a total of $150,000. He had assets of $60,000 (land) and $55,000 (other property), for a total of $115,000. Bill was insolvent by $35,000. BUT, because the loan guarantee had only a 50/50 chance of repayment, according to Merkel, it does not qualify for the insolvency exception. Hence, Bill’s liabilities were really only $125,000. Therefore, Bill was insolvent by $10,000. [This is figured out with the § 108(d)(3) formula].

ii. Bill’s discharge of indebtedness income is $15,000 (75,000 – 60,000 FMV of the land). But, because of the insolvency exception, he does not have to declare this whole amount of income.

iii. According to § 108(a)(3), Bill can deduct the amount he was insolvent (10,000) from the discharge of indebtedness income (15,000). Hence, he only has to report $5,000 of income. His taxable income was only $5,000.

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Fringe Benefits Fringe Benefits

OVERVIEW

§ 61(a)(1): gross income includes fringe benefits.

Key Elements:(1) Include? Yes or No.

a. No (it is excluded)i. Health benefits (§ 105, 106)

ii. Meals and lodging (§ 119)iii. Cafeteria Plans (§ 125)iv. Fringe Benefits (§ 132)

b. Yes. How much is included?i. If you include, it will be the FMV (Reg. § 1.61-2(d)).

A. Meals and Lodging

a. Convenience of Employer Doctrine: benefits given to the employee for the convenience of the employer are excluded. This doctrine was replaced by § 119.

i. Benaglia v. Comm’r , US Board of Tax Appeals (1937)

When lodging or meals are provided for the convenience of the employer, they are not income, even though they may relieve the employee of an expense he would otherwise have to bear.

Facts: Benaglia was an employee of a hotel and ran the hotel. The hotel provided him with lodging and meals. He did not include this as part of his income.

Holding: Benaglia’s residence at the hotel was not compensation for his services, nor for his personal convenience. It was because his duty was continuous and required him to be present at a moment’s call. Occupation of the premises was imposed on him by the employer. Under such circumstances, the value of meals and lodging were not income, even though it may relieve him of an expense he would otherwise have to bear.

ii. U.S. v. Gotcher , US Court of Appeals (1968)

If an expense-paid item is received by the taxpayer, it is not gross income if the items are primarily for the convenience of the employer.

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If the personal benefits to the employee are subordinate to the dominant purpose of an all-expenses-paid trip, then the trip is a fringe benefit and not income to the employee.

When considering whether the trip was for the convenience of the employer, one must look at the (1) choice and (2) control of the employee.

Facts: VW paid Gotcher to go to Germany and tour their facilities in order to induce Gotcher to take out a VW dealership interest. Gotcher took his wife with him and she didn’t go on any of the VW tours.

Holding: The cost of the trip was not income to Mr. Gotcher, as the trip was for the convenience of the employer and not for his personal benefit. Even though Gotcher was not forced to go, he had no real choice, as sound business judgment necessitated his acceptance of the offer. He had no control over the schedule or money spent as VW did all the planning. The personal benefits to Gotcher were clearly subordinate to the dominant purpose of improving VW. Hence, his trip was not income.

But, the wife’s expenses constituted income because she did not go on any of the tours of the VW plants. Furthermore, VW’s payment of the trip relieved him of financial responsibility for the wife’s expenses.

b. § 119: Meals or lodging given to an employee for the convenience of the employer are excluded only if:

The meals are furnished on business premises.

With lodging, the employee is required to accept such lodging on the business premises as a condition of his employment.

c. Reg. § 1.119-1(b)(3): Lodging is furnished because the employee is required to be available for duty at all times OR because the employee could not perform the services required of him unless he is furnished such lodging.

d. Relatives: § 119 excludes meal and lodging provided to an employee’s spouse and dependents as well.

e. Cash Payments for Food: Under Comm’r v. Kowalski, cash payments for food are not excludable under § 119. Such payments are not a de minimis fringe benefit because they were regularly paid.

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B. Fringe Benefits and § 132

a. § 132: lists categories of excludable fringe benefits

i. No Additional Cost Service (§ 132(b))

1. Businesses often have excess capacity (airlines, trains), which remain unused for lack of paying customers and make this excess capacity free of charge to employees.

2. Four restrictions:

a. The service must be offered for sale to customers in the ordinary course of business.

b. The service must be in the line of business of the employer in which the employee is performing services.

i. If one company has two lines of business (airline, hotel), the employees of the airline business may not exclude the value of free hotel rooms provided to them.

ii. Reg. § 1.132-4(a)(1)(iv): Performance of substantial services directly benefiting more than one line of business is treated as the performance of substantial services in all such lines of business.

c. The employer cannot incur any substantial additional cost (including forgone revenue) by giving the employee this service.

d. Discrimination in favor of highly compensated employees is disfavored.

i. Reg. § 1.132-8(a)(2): if this rule is violated, only the members of the highly compensated group, rather than all employees receiving benefits, will be subject to tax.

3. Reciprocal Agreements: § 132(i): authorizes reciprocal agreements between employers in the same line of business, thus enabling the employers to provide tax-free benefits to one another’s employees (flight attendants who commute to work on an airline they don’t work for).

a. Must be written agreementb. Neither employer can incur a substantial additional cost.

4. Relatives: The exclusion of no-additional cost services is limited to services provided by employees. “Employee” includes spouses and dependent children. § 132(h)(2).

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ii. Qualified Employee Discount (§ 132(c))

1. Discounts given to the employees on the same goods and services which they sell to the general public are excluded.

2. Discounts for Services

a. The exclusion for employee discounts on services is limited to 20% of the price at which the services are being offered by the employer to customers.

3. Discounts for Property

a. If the total sales of merchandise was 1,000,000 and the employer’s total cost for the merchandise was 600,000, then the gross profit was 400,000 or 40% of the total sales. Thus, an employee’s discount on that merchandise is excluded to the extent that it does not exceed 40% of the selling price of the merchandise to non-employee customers. If it is 50%, it exceeds the 40% mark by 10%. This excess 10% must be included in the employee’s gross income.

b. (Aggregate Sales Price – Aggregate Purchase Price) / Aggregate Sales Price.

i. If the employee can buy it at more than the employer’s cost the property is available for discount. If the employee can buy it at less than the employer’s cost only a % of the property is available as a discount.

ii. If the employer paid $500 for something and the employee’s discount enabled her to buy it for $600 she excludes the discount. But, if she bought it for $400 she cannot exclude the $100 difference between employer cost and her purchase price.

4. § 132(c)(4): contains the same “for sale to customers” and “line of business” requirements as § 132(b) (no additional cost benefits).

5. Real property and personal property held for investment: they do not qualify for § 132(c) exclusions because such properties (stocks, bonds) can be sold by the employee at the same price the employer sells it to its non-employee customers.

6. Scope of the term “Employee”: same as § 132(b)

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7. Anti-discrimination rules (high-compensated employees): applicable to this, just as it was applicable to § 132(b).

8. Reciprocal agreements: UNLIKE § 132(b), they do not apply for § 132(c).

iii. Working Condition Fringe Benefits (§ 132(d))

1. Any services or property that are deductible under 162 or 167.

2. Tools, office space, and supplies that an employer provides and that an employee needs are excluded.

3. Such property and services are so connected to job performance that if the employee rather than the employer, were to pay for them, the employee would be able to deduct their cost as a business expense. Thus, when they are provided by the employer, they should not be considered compensation to the employee.

4. Reg. § 1.132-5(a)(1)(v): Cash payments to the employee do not qualify as working condition fringes unless the employee is required to use the payments for expenses incurred in specific or pre-arranged qualified activity, verify such use, and return any excess to the employer.

iv. De Minimis Fringe Benefits (§ 132(e))

1. They are of such a small value, that for administrative convenience they are excluded.

2. There is an emphasis on the frequency of the benefits as a factor for determining whether it qualifies under § 132(e) – the more frequent, the less likely it qualifies.

3. The de minimis exception does not necessitate an employer-employee relationship, so the director of a corporation can exclude them. This is unlike the previous three fringe benefits.

4. Reg. § 1.132-6(d)(2): excludes benefits for meals and occasional meal money.

v. Qualified Transportation Fringe Benefit (§ 132(f))

1. A qualified transportation fringe benefit is:a. Transportation in a commuter highway vehicle in connection

with travel between the employee’s residence and place of employment;

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b. A transit pass; ORc. Qualified Parking

2. § 132(f)(3): Cash reimbursements for these items are also excluded.

vi. Qualified Moving Expense Reimbursement (§ 132(g))

vii. Qualified Retirement Planning Services (§ 132(i))

viii. On-Premises Gyms and Other Athletic Facilities (§ 132(j)(4))

1. The exclusion is only applicable if the use of such facilities is limited to employees, their spouses, and dependent children.

C. Valuation

a. Fringe benefits not excluded under § 132 are subject to tax pursuant to § 61(a)(1).

b. Reg. § 1.61-21(b)(1): the measure of income is the FMV of the fringe benefit, minus any excludable portion of the fringe benefit and amount paid by the recipient.

c. The regulations explicitly tax the value of the fringe benefit to the employee, even though the benefit may actually be received by someone else.

Personal Use of Gov’t Aircraft by the President’s Family and Friends

Rule: If a taxpayer entertains or benefits his friends by the use of his employer’s property, this does not change the result that their use is income to the taxpayer. In other words, if a employee lets his friends and family share in a fringe benefit when they have no official business, their use of the benefit is income to him. (Similar to the Gotcher case).

Holding: The President realized taxable income where members of his family or his friends had free use of Gov’t transportation for personal excursions or where it had not been established they were on Government business. When the President uses the plane for his own personal use, it is not taxable, because he is on call at any time.

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BUSINESS AND PROFIT SEEKING EXPENSESBUSINESS AND PROFIT SEEKING EXPENSES

OVERVIEW

§ 162: Business Deduction§ 212: Profit-seeking Deduction

Net income, rather than gross income, should be subject to tax. Expenses necessary to the earning of taxable income should be allowed as deductions.

1. Personal expenses are not deductible. § 262(a).2. Capital expenditures (made to obtain an asset that lasts for some substantial or indefinite period)

may not be deducted in full at the time of the expenditure.

“Personal” versus “Business” Expenditures “Current Expenses” versus “Capital Expenditures”

Capital Expenditure – purchases or creates a good that will not be used up within a year.

Current Expense – purchases or creates a good that will be used up within a year.

Personal Personal/Capital – for example, an automobile, stereo, refrigerator, etc. for personal use. Not deductible per §262(a). Not depreciable per §§167(a) and (b).

Current/Personal –

for example, personal expenses such as rent, food, clothing, entertainment, etc. Not deductible per §262(a).

Trade or Business Business/Capital – purchases or creates a long-lived asset for business use.

Not deductible per §§263(a) and 263A. Depreciable per §§167 and 168.

Business/Current – purchases or creates a good for business purposes that will be used up within a year. Deductible if meet requirements of §162(a). See also §212.

You get a deduction for using property up in the context of making money. You don’t get a deduction just for spending money!

Depreciation: deduct the cost of property as I earn income on it.

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A. BUSINESS DEDUCTIONS—SECTION 162

Rent, wages, and supplies are classic examples of deductible business expenses.

§ 162: Distinctions

(1) Personal (Consumption) vs. Business (Income Producing)(2) Current Expense (Deductible) vs. Capital Expenditure (Capitalized) – the key word is “ordinary”

– capital expenditures on not ordinary.

Elements of § 162(a):

a. Cost must be an EXPENSEb. The expense must be ORDINARYc. The expense must be NECESSARYd. The expense must be PAID OR INCURRED DURING THE TAXABLE YEARe. The expense must be paid or incurred in CARRYING ONf. A TRADE OR BUSINESS.

1. The Expense Must be “Ordinary and Necessary”

a.a. IS THE EXPENSE “ORDINARY”?IS THE EXPENSE “ORDINARY”?

i. Welch v. Helvering, US Supreme Court (1933)

a. “Ordinary” requires that a cost be customary or expected in the life of a business. Life in all its fullness will supply the answer. An expense may be ordinary even though it occurs but once in the life of a taxpayer.

Facts: Taxpayer made payments to the creditors of his former employer Welch (now bankrupt) in order to reestablish his relations with customers whom he had known when acting for Welch and to solidify his credit and standing. The Court held there was no deduction of payments made by taxpayer to creditors of bankrupt employer because “ordinary” requires that a cost be customary or expected in the life of a business.

ii. Deputy v. Dupont , US Supreme Court (1940)

a. An expense may be “ordinary” even though it happens once in the taxpayer’s lifetime, as long as the transaction that gives rise to it is of common or frequent occurrence in the type of business involved.

b. Hence, the fact that a particular expense would be an ordinary or common one in the course of one business and so deductible does not necessarily make it such in connection with another business.

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b.b. IS THE EXPENSE “NECESSARY”?IS THE EXPENSE “NECESSARY”?

i. Welch v. Helvering, US Supreme Court (1933)

a. Necessary: means appropriate and helpfulb. The Court will be slow to override the judgment of a business

person regarding the necessity of any costs incurred.

ii. Henry v. Comm’r , Tax Court (1961)

a. In determining what is necessary to a taxpayer’s business, the court would normally trust the taxpayer’s judgment as to whether an expenditure is appropriate and helpful.

But, where the expenditures were made to further ends which are primarily personal, the ordinary judicial constraint does not prevail.

b. Facts: The taxpayer claimed that his yacht served to promote his business by providing him with contacts in yachting circles.

c. Holding: The taxpayer did not show how any specific fee resulted from his operating a yacht he didn’t show it was necessary.

iii. REASONABLE SALARIES

a. § 162(a)(1): Only reasonable salaries may be deducted.

b. Independent Investor Test:

The reasonableness of compensation paid to a shareholder-employee shall be evaluated from the perspective of a hypothetical independent investor (Elliots, Inc. v. Comm’r).

c. Multi Factor Test:

i. Factors to be considered in determining whether a salary is reasonable, although no single factor is determinative, are:

1. Nature and quality of the shareholder’s services2. The effect compensation has on the corporation’s

rate of return.

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3. The position held by the employee4. Hours worked and duties performed5. The general importance of the employee to the

corporation’s success6. Comparison of past duties and salary to current

duties and salary7. Comparison of employee’s salary with those paid by

similar companies for similar services. 8. The size of the company and the complexities of its

business9. The existence of a potentially exploitable

relationship between the company and its employees10. The existence of a bonus system that distributes

most of the pre-tax earnings to the company.

d. Indirect Market Test

The higher the rate of return a manager can generate the greater salary he can command. If the rate of return is extremely high, it will be difficult to prove he is overpaid.

e. § 162(m)

i. Disallows the deduction of certain employee compensation in excess of $1,000,000.

ii. This limitation is applicable to CEOs of publicly held corporations or an employee that is among the 4 highest compensated officers.

iv. CLOTHING

a. Generally, clothing is a personal, non-deductible expense, but in some circumstances, the business-related nature of the clothing may warrant a deduction.

b. Revenue Ruling 70-474: People who are required to wear distinctive types of uniforms while at work, which are not suitable for ordinary wear, can deduct the costs of such clothing.

c. Revenue Ruling 67-115: The cost of military uniforms, which were prohibited to wear ff-duty, was deductible.

d. Pevsner v. Commissioner , US Ct of Appeals (1980), p259

Rule: This Court adopts an objective test wherein no reference is made to the individual taxpayer’s lifestyle or personal taste. Instead, adaptability for personal or general

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use depends on what is generally accepted for ordinary street wear and not whether the individual taxpayer would wear the particular clothes or not.

Facts: Taxpayer works for Yves St. Laurent and is required to wear their clothes to work, at fashion shows, and at business luncheons. She does not wear the clothes off-work hours because she feels they don’t conform to her simple everyday lifestyle. The Court said it was not a business expense.

v. PUBLIC POLICY CONSIDERATIONS

a. Tank Trunk Rentals v. Comm’r : The court held that the truck company could not deduct fines paid for violating state weight laws because such a deduction of fines would take the sting out of the penalty. The deduction would have been a device for avoiding state limits.

b. § 162(c), (f), (g): disallow deductions for certain fines, penalties, bribes and antitrust payments.

vi. LOBBYING EXPENSES

a. § 162(e): disallows any deduction for amounts paid or incurred in connection with

i. influencing legislation; ii. participating in a political campaign

iii. any attempt to influence the public with respect to elections, referendums, legislation; OR

iv. any direct communication with a covered executive branch official in an attempt to influence official actions or positions.

b. § 162(e)(2): Exception: The rule about influencing legislation does not apply to legislation of any local council or similar body.

2. “Carrying On a Trade or Business”

a. What Constitutes a “Trade or a Business”?

i. Higgins v. Commissioner , US Supreme Court (1941), p252

NO TRADE OR BUSINESS

Regardless of how long an investor has engaged in investment activities or how large his investments are, he has not operated a

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trade or business by merely setting up an office dedicated to monitoring his own securities.

A full time activity in managing and preserving one’s investments is not “carrying on business” and salaries and other expenses incident to that operation are not deductible under § 162.

ii. Commissioner v. Groetzinger , US Supreme Court (1987), p254

YES TRADE OR BUSINESS

a. If one’s gambling activity is pursued full time, in good faith and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the meaning of § 162.

a. Facts: Δ was a gambler. The Δ made a constant and large scale effort to earn income by gambling. Skill was required and applied. This was not a hobby and an occasional bet was not just for amusement.

b. The “Carrying On” Requirement

i. Two stages in the development of business:

a. Investigatory stage : review kinds of businesses before deciding to acquire or start a specific business.

i. Investigatory expenses are viewed as nondeductible personal expenses and not business or trade expenses.

b. Development of business : occurs when the taxpayer decided to acquire or start the business but has yet to start it.

i. Richmond TV Corp. v. US (1965): Even though the taxpayer made a firm decision to enter into business and spent a lot of money in preparation, he is still not engaged in carrying on any trade or business within the meaning of § 162(a) until such time as the business has begun to function.

c. Section 195 and the Amortization of Certain Pre-Operational or Start- Up Costs

i. § 195: permits the taxpayer to elect to amortize (pro-rate at an even level) business start-up expenditures over a period of at least 60 months.

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a. The expenditure must be paid or incurred in connection with creating or investigating a trade or business entered into by the taxpayer.

b. Investigatory and startup costs are both eligible expenses.

c. One must actually engage in the trade or business to be eligible to amortize under § 195.

ii. § 162 by itself meant that investigatory expenses conducted by a taxpayer not yet carrying on a trade or business OR where a taxpayer was carrying on a trade or business but incurred costs to investigate the creation or acquisition of another trade or business, could not be deducted as business expenses. However, a taxpayer incurring costs to investigate the expansion of an existing business could deduct the costs under § 162.

iii. BUT , § 195 was enacted to encourage the formation of new businesses by providing an amortization deduction for eligible investigatory expenses.

iv. An expenditure must be an ordinary expense under § 162 (even though the “carrying on” requirement has not been met), and not a capital expenditure, to be a start-up expenditure under § 195.

d. Application of the “Carrying On” Requirement to Employees

i. The “carrying-on” requirement applies to employees as well.

a. Primuth v. Comm’r : a corporate executive that hired an employment agency to seek new work and got a new job as an executive at another company was able to deduct that expense as he was continuing to carry on the same trade, albeit with a different employer.

ii. Revenue Ruling 75-120 , p258: preserves the pre-operating/operating notion, but eliminates the seeking/securing standard. Therefore, an employee that is seeking work in the same trade or business, but has yet to secure it can deduct expenses, whereas a taxpayer looking to acquire a business cannot deduct pre-operating expenses.

a. If costs were incurred in an effort to commence a new trade, they will not be deductible. If, on the other hand, they were incurred by an employee seeking work in the same trade or business, the “carrying on” requirement would be satisfied and the costs would be deductible.

b. A short hiatus from work will not terminate one’s status as being engaged in a trade or business, but a prolonged period of unemployment will. {One year has been held as the standard}

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c. Travel expenses to and from a destination related primarily to seeking new employment will be deductible as long as the taxpayer spends more time at the destination for employment purposes than for personal purposes.

B. SECTION 212 DEDUCTIONS

1. Allows a deduction for “ordinary and necessary” expenses of producing or collecting income, maintaining property held or the production of income, or determining, collecting or refunding any tax.

2. Thus, with the enactment of § 212, an investor like the one in Higgins can deduct expenses under § 212 even though he would not be deemed to carry on a trade or business under § 162.

3. § 212 may not be used as a backup when § 162 fails there is a basic distinction between allowing deductions for the expense of producing or collecting income, in which one has an existent interest or right, and expenses incurred in an attempt to obtain income by the creation of some new interest (Frank).

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CAPITAL EXPENDITURESCAPITAL EXPENDITURES

When you buy an asset, you can recover the asset’s cost in a few ways:

1. Immediate Deduction : costs of assets that are used up in one year can be deducted immediately (business expense).

2. During Life of Asset : you can recover the cost of the asset as it is used up. a. Depreciation: tangible assetsb. Amortization: intangible assetsc. Annuities

3. Upon Disposition : can only recover the cost of the asset when you sell it (it isn’t capitalized because it doesn’t wear out).

a. Stockb. Land

A. DEDUCTIBLE EXPENSE OR CAPITAL EXPENDITURE

1. Capital Expenditures:

a. A capital expenditure provides a benefit that persists, that contributes to income over a period of years; its value is not consumed or dissipated within the current year. Since it contributes to income over a period of years, a deduction for its cost in the current year will not generally be permitted.

2. CODE:

a. § 161: warns that § 162 deductions are subject to exceptions

b. § 263: denies deductions for capital expendituresi. A deduction is denied for the cost of new buildings or for permanent

improvements or betterments increasing the value of the property, and for restoration costs for which an allowance is made.

3. TREASURY REGULATIONS:

a. Reg. § 1.263(b): disallowance of deductions applies to expenditures that add to value or substantially prolong the useful life of property but not to incidental repairs and maintenance.

4. The matching of current expenditures with future benefits is at the heart of the capitalization requirement. It is the concern with matching income and related expenses that underlies the capitalization requirement.

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5. WOOTEN:

a. MATCHING – Match expense to the income it produces

b. ACCURACY – You get to deduct something when you use something up. You want to make sure you represent income accurately. Hence, it is not accurate to deduct something in full when you use it up over time.

c. WHY DO WE CARE?

i. TIMING: If I deduct the expense earlier, I reduce my taxes in that year, and can put my money in the bank and make interest on it. If I deduct in later years and capitalize my expense, I will not reduce my taxes as much, I will have less money and I will end up getting less interest on my money I put in the bank. Therefore, the government makes money when I capitalize and I make money when I deduct all at once!

ii. Hence, taxpayers like to take the deductions as early as possible.

d. EXAMPLE: i. Oven lasts several years – must capitalizeii. Ingredients used up right away – can deduct

e. KEY QUESTION: HOW LONG IS WHAT I’M BUYING GOING TO LAST?

B. DEFINING CAPITAL EXPENDITURE – INDOPCO

1. INDOPCO, Inc. v. Comm’r , US Supreme Court (1992), p267

NO DEDUCTION ALLOWED

Duration and Significance Test: Where expenditures generate FUTURE BENEFITS that are SIGNIFICANT, they must be capitalized.

2. Staley Manufacturing Co. v. Comm’r , Ct of Appeals (1997), p268

DEDUCTION ALLOWED

Expenses incurred in defending business from hostile takeovers are deductible.

3. US Freightways Corp. v. Comm’r , Ct of Appeals, p269

DEDUCTION ALLOWED

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Expenses that are fixed one-year, ordinary, necessary and recurring business expenses will be treated as deductible expenses (even if they cover two tax years).

Facts: Taxpayer annually pays for permits, licenses, and insurance premiums b/c they are only good for 12 months. The 12 month period covers 2 tax years.

C. SELECTED CATEGORIES OF CAPITAL EXPENDITURES, p271

1. Cost Of Acquisition And Costs Incurred In Perfecting And Defending Title

a. Purchasing Title

i. Acquisition costs constitute capital expenditures because the asset produces a long term benefit (e.g. purchasing title to a building, machine, vehicle, copyright, patent, etc.).

b. Defending Title

i. Costs incurred in defending title of property are capitalized (e.g. legal fees incurred in resisting efforts to cancel trademark or in a trademark infringement action). This includes costs incurred in perfecting a recently-acquired title and costs incurred in the defense of a pre-existing title.

ii. Yet, when the dispute relates to income from the title, it has been held deductible (e.g. recovering royalties).

c. Disposing Assets

i. Disposition costs are to be treated as capital expenditures except that costs are deductible when the asset is merely retired and discarded (e.g. removing telephone polls in order to install new ones -- deductible expense).

d. Comm’r v. Idaho Power Co., US Supreme Court (1974), p280

Costs that ordinarily may be currently deductible (wages, rent) may take on a different status when they are part of an acquisition cost of constructed property. For example, if you hire a carpenter to build a tree house that you plan to rent out, his wage is a capital expenditure to you.

Company/taxpayer can deduct for their own equipment. But you only get deduction for using things up. Here, you are turning equipment into the facilities. They now have a new plant from using the equipment up! You must capitalize if you create something that lasts (not just if you buy something that lasts).

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e. Normal and routine costs are NOT capitalized.

f. An expenditure must be capitalized to the extent that it (1) creates/enhances separate/distinct asset (2) produces significant future benefit (3) is related to acquisition of capital asset.

g. REVENUE RULING 99-23 , p291

Expenditures incurred in the course of a general search for, or investigation of, an active trade or business in order to determine whether to enter a new business and which new business to enter (other than costs incurred to acquire capital assets that are used in the search or investigation) qualify as investigatory costs that are eligible for amortization as start-up expenditures under § 195.

However, expenditures incurred in the attempt to acquire a specific business do not qualify as start-up expenditures because they are acquisition costs under § 263 and hence are capitalized.

Facts: corporation U hired an investment banker to evaluate the possibility of acquiring a trade or business unrelated to U's existing business.

Holding: (1) conducting research and evaluating publicly available financial info = investigatory costs, because they are used in deciding whether to enter a business. BUT (2) costs related to appraisals of V’s assets and review of V’s books = acquisition costs/capital expenditures because they are incurred once the decision to acquire a specific business was made.

Note: A taxpayer incurring costs to investigate the expansion of an existing business generally can deduct those costs under § 162.

2. Repair Or Improvement

a. Reg. §§ 1.162-4, 1.263(a)-1(b): Repairs that don’t materially add to value or appreciably prolong useful life are deductible.

b. Midland Empire Packing Company v. Comm’r (1950), p285

When an unexpected damage to a building occurs, a repair that restores the building to its state before the damage is deductible, as long as it does not add value or appreciably prolong the life of the property.

When the repairs merely serve to keep the property in an operating condition over its probable useful life for the purpose for which it was used, it is currently deductible.

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Facts: Oil of nearby refinery starts leaking into basement of Midland. The refinery was built after Midland’s business began. Midland oil proofs the basement and then deducts the costs. Comm’r argues it is a capital expense.

Holding: expenditures for lining basement walls and floor were repairs and thus deductible as ordinary and necessary business expenses.

Class Notes: if refinery was already there, and basement oil-proofed, this would be capitalized. But since this was unexpected and necessary to keep the building in same place, then the deductible was a repair.

c. Mt. Morris Drive-In Theatre Co. v. Comm’r (1955), p288

When there is (1) no sudden catastrophic loss caused by a physical fault undetected by the taxpayer and (2) there is no unforeseeable external factor changes made in response to the foreseeable damage are improvements and not repairs. Hence, they must be capitalized.

Facts: Taxpayer buys property for outdoor theatre knowing that a drainage system would have to be installed. After lawsuit, he constructs drainage system but asserts the costs associated are fully deductible.

Holding: It is a capital expenditure b/c (1) there was no “unforeseen” circumstance which occurred here; (2) it was obvious when the taxpayer bought the land that a drainage system would have to be constructed; (3) this was not restoration of asset; rather it was acquisition and construction of an asset (new drainage system) that is not entitled to deduction.

d. Revenue Ruling 2001-4 , p294

AIRCRAFT MAINTENANCE COSTS

If the replacements are a relatively minor portion of the physical structure of the asset, such that the asset as a whole has not gained materially in value or useful life, the costs may be deducted.

But, if a major component or a substantial structural part of the asset is replaced and, as a result, the asset as a whole has increased in value, life, expectancy or use, then the cost of the replacement must be capitalized.

Where an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expenditure must be capitalized.

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e. One Year Rule of Thumb : costs of repairs should be capitalized if they bring about acquisition of asset having period of useful life in excess of one year. This is a mere guidepost and not an absolute rule (Wehrli).

f. General Plan of Rehabilitation Rule : expenditure that is part of a “general plan” of rehabilitation, modernization, and improvement of the property, must be capitalized, even though, standing alone, the item may appropriately be classified as one of repair. Whether such a plan exists is a question of fact determined by looking at purpose, nature, extent, and value of work done (Wehrli).

g. Environmental Cleanup : Section 198 provides that costs incurred to control hazardous substances (environmental cleanup costs) may be deducted.

h. Employee Training : will generally be deductible business expenses, but it must be capitalized in unusual circumstances where training provides benefits significantly beyond those traditionally associated with training in the ordinary course of business.

3. Prepaid Expenses

a. Prepaid fire insurance for a 3 year span constituted an asset and thus must be capitalized (Boylston).

b. § 461(g): prepaid interest is governed by statute, which requires that it generally be capitalized.

4. Expansion Costs

a. Costs associated with establishing a franchise were held to be deductible.

b. Revenue Ruling 99-23: a taxpayer incurring costs to investigate the expansion of an existing business generally could deduct those costs under § 162.

c. Briarcliff: the mere ability to sell in new markets and to new customers, without more, does not result in significant future benefits and costs associated with it do not have to be capitalized.

d. Down-Sizing : Severance payments are deductible because these payments principally relate to previously rendered services of those employees (Rev. Ruling 94-77).

5. Advertising Expenses

a. Advertising expenses may often provide benefits that continue well beyond the current taxable year, but they generally are deductible. Only in unusual circumstances must the cost of advertising be capitalized.

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b. For purposes of obtaining a deduction, no distinction should be made between developing and executing advertisement campaigns. (RJR Nabisco).

c. If the advertising takes the form of a physical asset, the cost must generally be capitalized and recovered over the life of the asset.

D. PURCHASE OR LEASE

1. § 162(a)(3): specifically authorizes the deduction of rental payments with respect to property used in a trade or business but only if the taxpayer does not take title and has no equity in the property.

2. There may be an issue, however, as to whether acquisition costs are being disguised in terms of “rental” costs.

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DEPRECIATIONDEPRECIATION

A. DEPRECIATION

1. Overview

a. The decrease in property’s value should be a deductible cost of producing income.

b. Depreciation represents (1) the year’s reduction of the underlying asset through wear and tear and (2) a return to the taxpayer of his investment in the income-producing property over the years in which depreciation is allowed.

2. Wooten’s Class

a. Goals/Purposes

1. Accurate Measurement of Income

2. Promoting Investmenta. Earlier and larger the depreciation deduction, the better for the

taxpayer as investment of the money from the deduction becomes possible.

b. Classification

1. What kind of property can be depreciated?a. Land and stock are not depreciatedb. Machinesc. Intangibles (copyright) can be used up and hence can be amortized.

2. Over what period should property be depreciated?a. 3, 5, 7 year propertyb. Residential rentalc. Non-residential

c. Application of Depreciation Provisions

3. Depreciable Property

a. § 167: Defines the depreciation deduction as a reasonable allowance for the exhaustion, wear and tear, and obsolescence (1) of property used in the trade or business or (2) of property held for the production of income.

b. One may not claim a depreciation deduction for a personal residence as it is not used for a trade or business.

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c. Land, stock, and other assets that do not decline in value predictably are not depreciable.

d. Revenue Ruling 89-25 (1989)

Property used just for demonstration purposes may be depreciated, but property held primarily for the sale to customers (“inventories or stock in trade”) may not be depreciated. See Reg. § 1.167(a)-2.

Facts: The taxpayer temporarily used new houses for models to show customers. They generated no income and were eventually intended to be sold. He wanted to depreciate the wear and tear of those houses. The court said no.

4. Recovery Period – The Useful Life Concept

a. Depreciation deductions should be taken throughout the period that an asset is used in the production of income. Because we don’t know how long an asset lasts, we estimate how long it can be expected to be useful in an income producing activity. The determination of useful life thus requires an asset-by-asset determination.

b. The longer the useful life, the smaller the deduction. Hence, taxpayers would rather have shorter useful lives.

1. Historically only assets with a determinable useful life were depreciable

a. Revenue Ruling 68-232 (1968): Even though its condition may affect its value, a valuable piece of art is not depreciable because it does not have a determinable useful life.

b. Does a taxpayer still have to show that an asset has a determinable useful life in order for the asset to be depreciable?

i. Simon v. Comm’r , US Tax Court, 1994:

When an asset is necessary to a profession and wear and tear of that asset is attributable to its use in that profession, THEN the cost of that asset may be depreciated EVEN THOUGH it does not have a determinable useful life OR its value increased over time.

Facts: Violinist bought an old violin bow. The violin bow was used for the violinist’s performances and created a better sound. The bow’s condition deteriorated over time. The Δ wanted to depreciate the cost of the bow. The IRS claimed that the bow wasn’t depreciable because it had no determinable useful life and its value

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rose while the Δ had it.

Holding: The court held that professional violinists could depreciate 19th century violin bows. The bows were necessary to the taxpayer’s profession and wear and tear of the bows was attributable to their use in that profession. The concept of useful life has been deemphasized in favor of the class of property system (3 year, 5 year, etc.).

ii. Liddle v. Comm’r , US Tax Court, 1994: allowed professional musician to depreciate 17th century bass.

B. AMORTIZATION OF INTANGIBLES – SECTION 197

1. It allows taxpayers to amortize certain intangibles ratably over a 15 year period.

2. It allows for the amortization of goodwill and going concern value.

C. RELATIONSHIP BETWEEN BASIS AND DEPRECIATION

1. Basis must be adjusted to reflect the depreciation amount!

2. § 1016(a)(2): provides for the adjustment of basis for the amount allowable for depreciation.

3. M buys a violin for 100K. She depreciates all of it over the 7 year catchall period. Her basis is now zero. If she sells it for 100K, she realizes a gain of $100K because her basis is zero. Therefore, she must pay taxes on that amount.

4. M buys a building for $200,000, uses it for business over 10 years, then sells it for $150,000. Assume she could depreciate $75,000 for the building. Therefore, her adjusted basis would be $125,000 (200K – 75K). According to § 1001, her gain would be $25K (150K-125K), even though she sold the property for less than she paid for it. Why does she realize gain? Because she used the property for 10 years to earn income with her business.

D. THE RELATIONSHIP OF DEBT TO DEPRECIATION

1. With respect to basis, it makes no difference whether the purchase of property is with a loan or not. It makes no difference whether the money is borrowed from a 3rd person or the seller of the equipment.

2. So, you can borrow 50K to buy equipment for a business and depreciate the equipment using 50K as the basis for depreciation. This allows the taxpayer to claim depreciation deductions without incurring any out of pocket expenses!

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TRAVEL EXPENSESTRAVEL EXPENSES

A. COMMUTING

1. Commuting costs are personal in nature and NOT deductible under § 262 because you have the choice to live nearer to the workplace.

2. When conditions of employment restrict an employee’s discretion in typically personal choices such as meals eaten during working hours or mode of commuting, that which may be a personal expense under some circumstances can, when prescribed by company regulations, lose its character as a personal expense and become a deductible business expense.

i. Pollei v. Comm’r : Two police captains were permitted to deduct maintenance and operating costs of driving their personal cars between their homes and police headquarters because they were on-duty at those times. They had no choice but to use their own cars.

B. OTHER TRANSPORTATION EXPENSES

1. Taking a taxi to meet a client, flying to another city to argue a case, etc. are all deductible.

2. Where the primary purpose for the travel is business, you can deduct the transportation costs which are business related.

3. On the other hand, when the trip is primarily personal in nature, the transportation expenses (and other traveling expenses) are not deductible, although any expenses incurred while at the destination that are allocable to the taxpayer’s trade or business are deductible. See Reg. § 1.162-2(b)(1).

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Revenue Ruling 99-7 p. 381

Starting point Destination

Principal place of business

Regular work location

Temporary work location outside metro area

Temporary work location inside metro area

Regular Work Location or Principal Place of Business (Other than Residence)

(same) Deductible Deductible Deductible

Home office (same) – i.e. home is principal place of business

Deductible Deductible Deductible

Residence = regular work location, but not a home office

It’s a commute. Not deductible.


Deductible Deductible if taxpayer has another regular work location other than home.Otherwise, not deductible.

Residence is not a regular work location or a home office



Deductible Deductible if taxpayer has another regular work location other than home.Otherwise, not deductible.

Temporary Work Location: realistically expected to last (and does in fact last) for 1 year or less.Home Office: an office in the taxpayer’s residence that satisfies the principal place of business requirements of § 280A(c)(1)(A).

C. EXPENSES FOR MEALS AND LODGING WHILE IN TRAVEL STATUS

1. Overnight Rule / Sleep or Rest Rule: If the taxpayers cannot complete the round trip without stopping the performance of their duties to obtain substantial rest or sleep, then they may deduct the cost of their meals and lodging. If you’re gone long enough so that you need to take time to rest away from home for tax purposes.

i. United States v. Correll, US Supreme Court (1967), p377

If a taxpayer’s business travel requires him to spend the night away from home (i.e., requiring him to sleep or rest), then he can deduct meals as a travel expense.

Facts: The taxpayer, a traveling salesman, wanted to deduct the cost of his meals

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as a travel expense under § 162(a). He couldn’t because his trips required neither sleep nor rest and hence was a personal living expense under § 262.

ii. Christey v. U.S.: The Court held that state troopers could deduct their meals at restaurants because they remained on duty throughout their meals and were frequently interrupted during meals.

2. The deduction for lodging recognizes that a taxpayer on a business trip incurs duplicate expenses in maintaining an apartment or home at his principal place of work and incurring additional expense in securing lodging in some other city while on business.

D. “AWAY FROM HOME”

1. Robertson v. Comm’r (1999): “Home” means the vicinity of the taxpayer’s principal place of business and not where his personal residence is located. Thus a taxpayer’s home for purposes of § 162 is that place where he performs his most important functions or spends most of his working time.

2. Rosenspan v. Comm’r (1971): “Home” means one’s actual residence – this places an emphasis on the business necessity of incurring travel expenses. Hence, when the taxpayer has no permanent residence, he has no “home” to be “away from” and therefore cannot claim a deduction for traveling expenses.

3. Henderson v. Comm’r, Court of Appeals (1998)

A taxpayer only has a tax home – and can claim a deduction for being away from that home – when it appears that he incurs substantial, continuous living expenses at a permanent place of residence (in order to prevent the taxpayer from duplicating living expenses).

Three Factors to be considered:1. Business connection to the locale of the claimed home. 2. The duplicative nature of the taxpayer’s living expenses while traveling and at

the claimed home. 3. Personal attachments to the claimed home.

Facts: The taxpayer worked for a Disney ice show. He traveled most of the year and when the tour was completed, he returned to his parent’s home in Boise. He didn’t pay rent at their house, but he got his mail there, kept his dog there, etc.

Holding: (1) He had no business reason to return to Boise – it was a personal choice to live there, as his work required him to travel across the country and not to live in Boise. (2) He did not have substantial, continuing living expenses in Boise that were duplicated by his travel expenses, as he paid no rent to his parents. Because he doesn’t have a tax home, he was never “away from home” and hence could not deduct his travel expenses under § 162.

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4. Temporary Jobs: Generally, a taxpayer that works at a temporary job is considered to be in “travel status” and travel expenses paid or incurred in connection with the temporary assignment away from home are deductible.

i. § 162(a)(2): a taxpayer shall not be treated as temporarily away from home during any period of employment if such period exceeds one year.

ii. A seasonal job to which an employee regularly returns, year after year, is regarded as being permanent rather than temporary employment.

E. TRAVEL EXPENSES OF SPOUSE

1. § 274(m)(3): A taxpayer may not deduct expenses for a spouse or dependent unless (1) the spouse/dependent is a bona fide employee of the taxpayer, (2) the travel of the spouse/dependent is for a bona fide business purpose, and (3) the spouse/dependent could otherwise deduct the expense.

2. Employer paid expenses for spousal travel may be treated by the employer as deductible compensation to the employee under § 274(e)(2).

3. If not so treated, a nondeductible employer-paid expense is presumably a working condition fringe benefit (§ 132).

F. REIMBURSED EMPLOYEE EXPENSES

1. It is common for employees to be reimbursed by their employers for travel expenses incurred for business purposes, but they can be deducted above the line only if the reimbursed expenses that satisfy § 62(c).

2. Qualified Reimbursement Arrangements (Accountable Plans)

i. The reimbursement arrangement must provide reimbursements, advances or allowance only for deductible business expenses (“business connection” requirement). See Reg. § 1.62-2(d)(1).

ii. The expense must be properly substantiated. Reg. § 1.62-2(e)(1).

iii. The reimbursement arrangement must require the employee to return within a reasonable time any amount in excess of the substantiated expenses.

G. BUSINESS-RELATED MEALS

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1. Meals may qualify and be deductible as ordinary and necessary expenses under § 162(a) even when the taxpayer is not away from home.

2. § 274(a): stiff substantiation requirements for the deduction of meal expenses

3. § 274(k): taxpayer is required to be present at a meal for which an expense deduction is sought.

4. § 274(n): limits the meal expense deduction to 50% of its cost.

H. LIMITATIONS ON FOREIGN TRAVEL

1. Generally, travel outside of the US is subject to the same standards as domestic travels.

2. § 274(h)(1): when a taxpayer travels outside of North America to attend a business convention, certain facts must be considered when determining if it was a reasonable business expense.

I. RELATIONSHIP TO SECTION 212

1. Meals and lodging expenses could be deducted under § 212 (deductions for investment expenses) subject to the same rules as meals and lodging expenses under § 162. For example, a taxpayer could deduct expenses in traveling to property which he was holding for investment.

2. § 274(h)(7): denies a deduction under § 212 for expenses allocable to a convention, seminar, or similar meeting.

J. SUBSTANTIATION REQUIREMENTS

1. In addition to the requirements of §§ 162 and 212, taxpayers must meet the substantiation requirements imposed by § 274(d).

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INTEREST DEDUCTIONINTEREST DEDUCTION

A. Deduction of Personal Interest

1. § 163(h)(1): Personal interest may not be deducted. This is a disincentive to saving.

2. § 163(h)(2): allows certain categories of personal interest to be deducted:

i. Interest paid or accrued on indebtedness properly allocable to a TRADE OR BUSINESS.

ii. Any INVESTMENT interest.

iii. Any QUALIFIED RESIDENCE interest.

1. Deduction for Mortgage interests is allowed. See Reg. § 1.163-1.

2. A qualified residence interest is any interest which is paid or accrued during the taxable year on certain acquisition indebtedness and home equity indebtedness secured by the taxpayer’s principal residence and on one other residence:

a. Acquisition Indebtedness : it may not exceed $1,000,000 and it is incurred in acquiring, constructing or substantially improving any qualified residence of the taxpayer.

b. Home Equity Indebtedness : it is secured by a second mortgage, and is limited to the excess of the FMV of the qualified residence over the amount of acquisition with respect to such residence. It may not be greater than $100,000.

c. Thus, the overall limit of indebtedness on a principal and second residence, the interest on which will be deductible, is $1,100,000.

3. § 221(a): authorizes a limited deduction for interest paid by an individual on any “QUALIFIED EDUCATION loan.”

i. Includes tuition, room and board, etc. for the taxpayer, his spouse, and dependents. ii. Under § 221(d), a loan from a family member cannot be deducted if the family

member is listed in § 267(b) or 707(b)(1).

B. Investment Interest

1. § 163(d): Investment interest for any taxable year cannot be deducted in an amount greater than the taxpayer’s net investment income.

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i. Net investment income = investment income – investment expenses.

ii. EXAMPLE: Interest income = $200. Dividends = $300. Total investment income = $500. BUT, investment advice cost $100. The net investment income for the year is then $400. If you take out a loan to buy stocks, the interest on that loan is deductible up to $400.

C. Timing Issues and Limitations

1. Section 461(g)

i. Prevents a cash method taxpayer from claiming a current deduction for interest payments which compensate a lender for the use of money in future years.

ii. Rather, the taxpayer is permitted to deduct only the interest expense related to the current year; the balance may be deducted in the year(s) to which it relates.

2. Section 263A

i. § 263A: disallows a current deduction for interest incurred during the production period (time between when production of property begins and when the property is ready to be placed in service) on indebtedness directly or indirectly attributable to a taxpayer’s production of certain real or tangible personal property for use in a trade or business or activity conducted for profit.

ii. The interest must be added to the basis and will be recovered through depreciation deductions or when the taxpayer sells or otherwise disposes of the property.

3. Payment Issues

i. Helvering v. Price : The mere giving of a promissory note by a cash method taxpayer does not constitute a payment, even if the note is secured by collateral.

3. EXAMPLE: Ben borrows $9K. He gives the lender two promissory notes – one for 9K and the other for a $1K interest. The delivery of the promissory note for interest would not constitute a payment of interest – it is not equal to cash, as Ben has not reduced his own funds by giving the note.

ii. Davison v. Comm’r , US Tax Court (1996)

UNRESTRICTED CONTROL TEST: (1) When a lender gives up control of borrowed funds, (2) the funds are commingled with the taxpayer’s other funds in an account at an institution separate from the lender, and (3) the interest obligation is satisfied with funds from the separate account, THEN there has been a deductible payment of interest under § 163(a).

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A borrower who borrows funds for the purpose of satisfying an interest obligation to the same lender in order to avoid a default DOES NOT have unrestricted control of the funds and is therefore NOT entitled to a deduction. [Substance over form].

Facts: White Tail borrowed money from John Hancock Co. In order to pay the interest on that amount, John Hancock Co. lent White Tail more money. Basically, White Tail took out a second loan from the same lender to pay the interest on the first loan. White Tail contends that this was a deductible interest payment, while the IRS claims that the interest was not paid – it was postponed, and hence a deduction is not allowed under § 163(a).

Holding: The court agreed with the IRS. White Tail specifically agreed to borrow money from John Hancock to satisfy its interest obligation in order to prevent a default. The effect of this was to postpone the interest payment, and therefore, the taxpayer is not entitled to a deduction.

PROBLEMS

FORMER EXAM QUESTION:

A owns an ice rink and residence. If he wants to take out a $25K loan, what advice would you give him?

He shouldn’t take out a mortgage on the ice rink – the loan proceeds are not being spent on business. Therefore, he cannot deduct the interest. If it was used for business, the whole loan would be deductible. But, if he took out a second mortgage on the residence, he could deduct the interest on the loan (but not the loan itself) even if he didn’t use it for a business purpose.

SEE Tracing Rule: Reg. § 1.163-8(t)!!

1. May Kevin deduct the following payments in the current year?

a. $3000 interest on a bank loan used to pay expenses for K’s business.

i. Deductible, as it is interest on a loan for a business expense.

b. $500 interest on a loan for a personal car and $1,000 in interest on credit cards used to make personal purchases.

i. Neither is deductible, as they represent interest on loans for personal expenses.

c. K prepaid $5,000 in interest pursuant to the terms of an installment contract whereby K purchased land on which he intends to construct a building to house his shoe business.

i. The prepayment of interest must be capitalized. It can be deducted as income is produced by the land.

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CASH METHOD ACCOUNTINGCASH METHOD ACCOUNTINGA. INCOME UNDER THE CASH METHOD

a. In General

i. A taxpayer is required to report cash (and other income) as received and to deduct expenses as they are paid.

b. Constructive Receipt

If you have the choice between getting money now or later, then you will be taxed as if you received it now, even if you are going to receive it later.

The cash method taxpayer who has control over his actual receipt of income must report it, regardless of whether he has actual possession of it.

o Example : an employee cannot pick up a December check until January and thereby defer reporting her December earnings.

Reg. § 1.451-2(a): For constructive receipt to be applicable: (1) the amount must be available to the taxpayer and (2) the taxpayer’s control over the receipt must not be subject to substantial restrictions or limitations the taxpayer must then recognize the funds as income even though he does not receive the money or property!

Ames v. Comm’r , US Tax Court (1999), p628 {Espionage Case)

Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. If there is no certainty of getting the money and there are substantial risks, limitations, and restrictions, he is not in constructive receipt even if the money was segregated for his exclusive benefit.

Facts: Δ was a spy for the KGB. The KGB told him in 1985 that they would pay him money for spying. He received the money several years later in a series of sneaky drop offs of suitcases. Because there was no certainty that he would ever get the money, the Δ was not in constructive receipt.

i. Specific Factors Affecting Application of Constructive Receipt Doctrine

1. Distance:

a. Taxpayer’s geographic proximity to the location where an item of income is being made available to the taxpayer.

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b. Generally, it is the date when a check is received and not the date that it is mailed that determines the year of taxation. But, if the taxpayer could have picked up the check before the year end, he will be deemed to be in constructive receipt of the check.

2. Knowledge:

a. If you do not know that a check is being made available to you in Year 1, you are not in constructive receipt of that check.

3. Contractual Arrangements:

a. The IRC does not require someone to forego contractual rights.

i. If a rental payment is not due until Jan. 1, the landlord should not be required to accept it before that time.

4. Forfeitures or Other Penalties:

a. A penalty on an early withdrawal from a bank or CD account may constitute a sufficient restriction to negate constructive receipt. See Reg. § 1.451-2(a)(1)-(4).

5. Relationship of the Taxpayer to the Payor :

a. If an officer/shareholder of a close corporation is not paid during the year, she will not be deemed to be in constructive receipt of the salary. Even though she has control over the corporation, they are separate legal entities.

b. For a shareholder-employee to be in constructive receipt of the salary owed to her by an employee, several factors must be present:

i. There must be corporate action to set aside the salary for her.

ii. There must be some authority on the part of the shareholder-employee to draw a check to herself from corporate accounts.

iii. The corporation must be able to make the salary payment.

ii. Deferred Compensation Arrangements and Constructive Receipt

1. DEFERRED INCOME IS NOT CONSTRUCTIVE RECEIPT WHEN: When ruling that deferred income from a new contract did not constitute constructive receipt, the courts in Oates and Veit emphasized:

(1) A business reason for the deferral, (2) New contract was not a unilateral arrangement, AND

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(3) That both parties negotiated to their best advantage.

iii. Specific Exceptions to Constructive Receipt Rules

1. Prizes : Although prizes are generally income, if that taxpayer refuses a prize, he does not have to report it as income.

2. § 125: If the employee chooses to receive excludable benefits (cafeteria plans) in lieu of cash from the employer, he can exclude such money, even though it is arguable that he is in constructive receipt of income.

c. Cash Equivalency Doctrine

i. When a promise to pay money in the future is unconditional, not subject to set-off, and has a readily determinable market value, receiving the promise is like receiving a payment because the taxpayer could sell the promise (e.g., a bond or promissory note) for money. (See Cowden).

i. If a taxpayer receives goods or stocks in lieu of cash, those amounts are includable as income, as they are the equivalent to cash.

ii. But, an oral promise or a letter acknowledging debt is not equivalent to cash – it is just an “account receivable” and will be included only upon payment of that debt.

iii. Cowden v. Comm’r : US Court of Appeals (1961)

Rule: If a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation.

iv. Treatment of Checks: Checks received at year’s end by a cash method taxpayer must be included in income just as though cash had been received, even if it is impossible to cash that check before the end of the year.

d. Economic Benefit Doctrine

i. Definition: gross income can include any economic benefit conferred upon a taxpayer to the extent that the benefit has an ascertainable fair market value.

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1. Common Context: the use of an escrow account to assure payment and yet at the same time to insulate a cash method taxpayer from receipt.

ii. TRUST ACCOUNTS : If money is irrevocably placed in trust or an escrow account to be distributed to the taxpayer (in an account only accessible by the taxpayer and not by the business) that amount is income as:

1. It is irrevocably paid for the sole benefit of the taxpayer and

2. The amount is fixed.

iii. Revenue Ruling 60-31 :

1. Economic Benefit Doctrine does apply – because the football player was assured to get the money (it was in an escrow account), he had an unqualified right to it and must include it as income for Year 1.

e. Prepayments

i. If the taxpayer is prepaid for services to be rendered, the taxpayer will be required to report the prepayment received, regardless of the period covered or the method of accounting. See Reg. § 1.61-8(b).

B. DEDUCTIONS UNDER THE CASH METHOD

a. In General

i. Under the cash method, expenses are deductible when paid.

ii. Deductions are allowed for payments only when “actually made,” for expenditures only “when paid.” Thus, there is no counterpart on the deduction side of the Cash Method Doctrine to constructive receipt with respect to income.

iii. What is Payment?

1. Payment in cash, property, borrowed funds

2. A check is payment when it is delivered.

3. Payment by a credit card constitutes payment at the time the charge is made, and not when the taxpayer pays the bank.

iv. What is NOT Payment?

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1. Transferring Funds to an agent

2. Deposit of funds by a cash-basis taxpayer as an offer in compromise of a disputed amount is not payment until the offer is accepted.

3. Issuance of a Promissory Note

a. The note may never be paid and if it is not paid, the taxpayer has parted with nothing more than his promise to pay. (See Helvering v. Price).

b. Cash Method Prepayments

i. If a cash-method taxpayer pays a deductible expense now, he may take an immediate deduction, which makes sense from an economic standpoint if the value of the earlier deduction exceeds the cost of making the prepayment.

ii. BUT, the deduction timing rules of § 461 are subject to the capital expenditure rules of § 263. Thus, a current deduction may be denied if it is a capital expenditure.

iii. Grynberg v. Comm’r : 3-part test with respect to the deductibility of prepaid rentals: (1) the expenditure must constitute an actual payment rather than a deposit, (2) it must be made for a substantial business reason (and not just to accelerate a tax deduction), and (3) it must cause no material distortion of income.

iv. Zaninovich v. Comm’r , US Court of Appeals, 1980 p. 637

Under the one-year rule, an expenditure is treated as a capital expenditure if it creates an asset that has a useful life of more than one year. If it has a useful life of less than one year, it may be deductible now, even if the useful life extends over two taxable years.

Holding: Dec. 1973 prepayment of rent for a period between 12/73 and 12/74 was deductible in 1973 and not 1974.

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Accrual Method AccountingAccrual Method Accounting

INCLUSION: It is the earning of income, rather than the receipt of it, that is the critical event for inclusion purposes.

DEDUCTION: It is the fixing of the obligation to pay, not payment itself, that is the critical event for deduction purposes.

WOOTEN:

EXAMPLE: A performs services to B in 2003. B does not have to pay until 2004. But, A has a fixed right to be paid and he must therefore include in 2003.

EXAM QUESTIONS: may deal with (1) the economic performance test, (2) when income must be recognized, (3) when a deduction must be taken, (4) when economic performance occurs.

A. The All Events Test

INCLUSION: An item of income is includable in gross income when All the events have occurred which fix the right to such income and The amount thereof can be determined with reasonable accuracy. Reg. §§

1.451-1(a)(1); 1.446-1(c)(1)(ii).

DEDUCTION: An expense is deductible when All the events occur which establish the fact of liability, The amount can be determined with reasonable accuracy, and Economic performance has occurred with respect to the liability.

Reg. §§ 1.461-1(a)(2); 1.446-1(c)(ii).

B. Accrual of Income

a. Income Prior to Receipt: Accrual Issues

i. COLLECTIBILITY OF INCOME EXCEPTION: There is a limited exception to the accrual of income when sufficient doubt as to the collectibility of the income at the time the right to the income arises.

1. For example, interest income was not accruable while “reasonable doubt” existed as to the collectibility, but when collectibility was established (no doubt about the ultimate receipt), accrual was required.

ii. § 448(d)(5): a taxpayer does not need to accrue any portion of amounts to be received for the performance of services that, on the basis of experience, will not be collected.

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iii. CONTESTED CLAIMS: An unconditional right to income is necessary before the income is accrued. If the claim is disputed, income accrual awaits resolution of the dispute.

iv. INTEREST INCOME: Interest income is treated as accruing as it is earned over the life of the loan. But, that accrual is not required with respect to income, including interest, that cannot be collected at the time “performance” occurs.

1. Whether interest must be included depends on whether it could be collected at the time the interest accrues.

v. DIVIDEND INCOME: Accrual method taxpayers are placed on the cash method with respect to dividend income, and ordinarily will be taxed on receipt of the dividend. Reg. § 1.301-1(b).

b. Receipt Prior to Earning: Prepayments

i. Schlude v. Comm’r : accrual method taxpayers are required to include advance payments in income.

1. But, where it was certain that performance of White Sox games would happen in the future, deferral of income until the year of performance will be found to reflect income clearly. See Artnell v. Comm’r.

ii. Revenue Ruling 74-607 : “Earliest of” Rule: All the events that fix the right to receive income occur when (1) the required performance occurs, (2) payment is due, or (3) payment is made, whichever happens earliest.

iii. Revenue Procedure 71-21 : permits a one-year deferral for the prepaid services income covered by its terms.

iv. Deposits vs. Prepayments: The more restricted the taxpayer’s use of the funds received, the more likely it is a deposit and therefore it doesn’t constitute income

C. Deductions Under the Accrual Method

a. General Rules

DEDUCTION: Under the accrual method, an expense is deductible when

i. All the events occur which establish the fact of liability,

1. A liability must be fixed and certain, unconditional, or absolute to meet the all events test.

2. In general the event fixing the fact of liability is performance of services.

ii. The amount can be determined with reasonable accuracy, and

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iii. Economic performance has occurred with respect to the liability.

1. § 461(h)(2): Economic performance occurs:

a. If the liability arises as a result of another person providing services to the taxpayer, economic performance occurs as the services are provided.

b. If the liability results from the taxpayer’s use of property (rent), economic performance occurs ratably over the period of time the taxpayer is entitled to the use of the property.

c. If the liability results from the taxpayer providing services or property, economic performance occurs as the taxpayer provides the service or the property.

i. ABILITY TO PAY: Accrual of a liability turns on the fixing not the payment of liability, and therefore the financial condition of the taxpayer at the time of accrual generally will NOT BAR a deduction.

1. Where there is no certainty of an accrual method taxpayer’s ability to pay, a deduction is still proper. However, if the taxpayer cannot pay even a fraction of the amount, then a deduction is not proper.

b. Premature Accruals

It is generally in the taxpayer’s interest to assert that a liability has accrued for tax purposes at the earliest possible time.

If an accrued liability creates an asset with a useful life extending substantially beyond the taxable year, the liability must be capitalized. See Reg. § 1.461-1(a)(2). Deductions are subject to § 263.

The one-year rule to deduct an annual rent payment in its entirety in the year of payment, even though eleven months of the rent was allocable to the following year applies to accrual method as well.

c. Contested Liabilities

In general, a contested liability cannot be deducted by an accrual method taxpayer because the contest, in effect, renders the liability contingent and prevents it from being fixed or established.

§ 461(f): the payment of a contested liability accrues the liability and provides a current deduction in the year of payment.

If a contested liability is not paid, it will not accrue until after the contest is resolved.

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D. Choice of Accounting Methods

A taxpayer may use one method for a business and another method for personal purposes. Reg. § 1.446-1(c)(1)(iv)(b).

A taxpayer using the cash method for gross income purposes must also use it for expenses, and the use of the accrual method for business expenses requires its use for gross income. Reg. § 1.44501(c)(1)(iv)(a).

In any case in which it is necessary to use an inventory, the accrual method is required with respect to purchases and sales. Reg. § 1.446-1(c)(2)(i).

Include Deduct

Payment Before Performance Schlude: if you’re paid before you perform, you must include

Include when paid except

Rev. Ruling 71-21 &

Artnell case

Performance

+

All Events

+

Reasonable Estimate

Performance Before Payment All Events

+

Reasonable Estimate

Performance

+

All Events

+

Reasonable Estimate

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Annual AccountingAnnual Accounting

A. Restoring Amounts Received Under a Claim of Right

a. Example: Taxpayer recovers an amount that was included in a prior year.

b. § 1341: the taxpayer who meets the following requirements is directed to compute tax liability under the approach that produces the most favorable tax result (either recomputation of income, which works as a tax credit, or deduction).

i. The restored item must have been included in income for a prior year because it appeared that the taxpayer had an unrestricted right to the income. § 1341(a)(1).

ii. The taxpayer must establish in the later year that he did not have an unrestricted right to the amount received in the prior year. § 1341(a)(2). Thus, voluntary repayments do not come within § 1341.

iii. § 1341(a)(3): $3000 threshold

B. The Tax Benefit Rule

a. Example: Taxpayer recovers an amount that was deducted in a prior year.

b. Definition: the restoration or refund of previously deducted amounts constitutes income.

i. Inclusionary Aspect: If a taxpayer recovers an amount that was deducted in a prior year, that amount must be included as income.

1. The deduction gave rise to a tax benefit that, in light of later events, turned out to be unwarranted, and the taxpayer in effect gives back the tax benefit by including the recovered amount in income.

2. Alice Phelan Corp. v. US : under the inclusionary rule, you undo the deduction, but you do it in the later year.

ii. Exclusionary Aspect: § 111: To the extent a previously deducted amount did not produce a tax savings, its recovery will not constitute income.

1. It attempts to put the taxpayer in approximately the same position as if only the proper amount had been deducted originally.

2. § 111(a) excludes those recovered amounts that, when deducted, did not reduce tax.

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c. Hillsboro Nat’l Bank v. Comm’r : The Tax Benefit Rule will cancel out an earlier deduction only when a careful examination shows that the later event is fundamentally inconsistent with the premise on which the deduction was initially based. This is, if the event had occurred within the same taxable year, it would have foreclosed the deduction.

i. If A deducts stamps in Y1 for business reasons and then uses the stamps for personal purposes in Y2, that personal use is fundamentally inconsistent with the deduction in the earlier year. The deduction must be reversed.

C. Net Operating Losses

a. § 172: provides that a loss in one year may be used to offset income in another year so long that the loss is not wasted.

i. Generally speaking, the loss is ordinarily carried back 2 years and carried forward 20 years until it has been fully absorbed, and thus it is very likely that a net business loss will be deducted by an ultimately profitable business.

b. An individual computes a net operating loss as follows:

i. Add together:

1. Business Deductions AND

2. Non-business deductions to the extent that they do not exceed nonbusiness income.

ii. From this total, subtract the taxpayer’s gross income.

iii. The balance is the individual taxpayer’s net operating loss.

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Capital Gains and LossesCapital Gains and LossesWooten:

Realization Rule: gains and losses upon disposition of the property.

§ 1221(a): What is a capital asset? § 1222: What is a capital gain or capital loss? Capital Gains and Capital Losses – arise from the

sale or exchange of capital assets. § 1(h): Capital gains § 1211(b): Capital losses

A. Historical Overview

a. Preferential Treatment for Long Term Capital Gain

i. To tax capital gains like all other income would be harsh, considering that the gain often represents appreciation accruing over a number of years.

ii. Because you are not taxed until the capital asset is sold, the gain accruing over years is bunched into one tax year. Congress has sought to mitigate the bunching problem, by having lower tax rates for long term capital gains.

iii. Only the gains and losses from the sale of capital assets held for more than one year will be long term and therefore eligible for preferential tax treatment.

b. Limitation on the Deduction of Capital Losses

i. Capital losses can only be deducted to the extent of capital gains. Up to $3,000 of any excess of capital losses over gains could also be deducted.

B. Current Law: Section 1(h)

a. Maximum Rates on Long Term Capital Gain under the Current Law

i. Net Capital Gain = Net Long Term Capital Gain – Net Short Term Capital Loss

ii. NCG = NTLCG – NSTCL

iii. This formula shows the tax preference for long term capital gains, as short term capital gains are accorded no preference, as they do not factor into the formula at all.

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iv. IMPORTANCE OF IT: Net Capital Gain is taxed at a preferential rate!

b. The Components of Net Capital Gain – 28% Rate Gain; Unrecaptured § 1250 Gain; and Adjusted Net Capital Gain

i. The 28% Rate Gain: Collectibles Gain and § 1202 Gain

1. The 28% rate gain is the sum of collectibles gain and § 1202 gain.

2. DEFINITION: Collectibles gain = gain from the sale of rug, antique, metal, gem, coin, etc. as defined by § 408(m).

3. Basically, if the taxpayer is in the 38.6% tax bracket, he only has to pay a 28% rate on long term capital gain. If he is in a 15% bracket, he has to pay a 15% rate. Hence, the preferential treatment is only to the extent that the taxpayer is in a bracket higher than 28%.

ii. Unrecaptured § 1250 Gain: 25% Rate

1. NCG to the extent of “unrecaptured § 1250 gain” is subject to a maximum rate of 25% (§ 1(h)(1)(D)).

2. DEFINITION: Unrecaptured § 1250 Gain = LTCG attributable to depreciation with respect to real estate held for more than one year.

iii. Adjusted Net Capital Gain: 20% and 10% Rates

1. NCG reduced by a taxpayer’s 28% rate gain and unrecaptured § 1250 gain = Adjusted Net Capital Gain (§ 1(h)(4)).

2. Adjusted Net Capital Gain is subject to a maximum tax rate of 20% and a 10% rate when the taxpayer is in the 15% bracket (hence, there is preferential treatment in such a low bracket).

c. Attribution of Capital Losses Included in the Computation of Net Capital Gain

i. Short term losses are applied first to reduce short term capital gains net gain in 28% rate unrecaptured § 1250 gain adjusted net capital gain.

ii. Long term capital losses applied first to reduce long term capital gains in the same category (collectible losses to collectible gain).

C. Current Law: Application of the § 1211(b) Limitation on the Deduction of Capital Losses

1. § 1211(b)

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a. CAPITAL GAIN OFFSET RULE: Capital losses may be deducted dollar for dollar to the extent of capital gains and for this it makes no difference whether the capital gains and losses are long term or short term.

i. According to § 1212(b), STCL will be applied first against STCG and LTCL against LTCG. If STCL > STCG, the excess of the STCL will be applied against the excess of LTCG, if any. The same holds true for when LTCL > LTCG (it is applied against STCG).

b. ORDINARY INCOME OFFSET RULE: To the extent that capital losses > capital gains, up to $3000 of the excess may be deducted.

i. In effect, a taxpayer may use capital losses (whether long term or short term) to offset on a dollar to dollar basis up to $3000 of ordinary income in a given tax year.

2. § 1212(b)

a. Capital losses which the taxpayer could not deduct because of the § 1211(b) limitation, may be carried over to the next tax year.

D. Definition of Capital Asset

a. Property acquired and held by the taxpayer (whether or not connected with his trade or business) is a capital asset, EXCEPT for the following:

i. § 1221(a)(1): Inventory, Stock in Trade, and Property Held Primarily for Sale to Customers in the Ordinary Course of the Taxpayer’s Trade or Business

ii. § 1221(a)(2): Property Used in the Taxpayer’s Trade or Business

1. Property used in the taxpayer’s trade or business that is either depreciable property under § 167 or real property is NOT a capital asset.

iii. § 1221(a)(3): Copyrights, Literary, Musical, or Artistic Compositions, etc.

1. Copyrights, literary, musical or artistic compositions are NOT capital assets if held (1) by a taxpayer whose personal efforts created the property OR (2) by a taxpayer whose basis in the property was determined in whole or in part by reference to the basis of the property in the hands of the person who created it (generally, this talks about gifts, or part-gift, part-sale).

a. Bonnie makes a painting. This isn’t a capital asset because she created the property. Bonnie gives the painting to Betty. Betty’s basis is reliant on Bonnie’s basis. If Bonnie’s basis was $50, so would Betty’s as the donee takes the donor’s basis with gifts.

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b. BUT, if Bonnie dies and Betty gets the painting by bequest, her basis is now the FMV of the painting (stepped-up basis, § 1014). Therefore, the basis isn’t reliant on the taxpayer who created the painting, and consequently the painting is a capital asset.

iv. § 1221(a)(4): Accounts Receivable for Services Rendered or Inventory-Type Assets Sold

1. An account receivable is ordinary income, NOT a capital asset.

v. § 1221(a)(5): Certain Publications of the U.S. Government

1. It limits charitable deductions for gifts of government publications to public libraries, universities, etc.

vi. § 1221(a)(8): Supplies Used or Consumed in the Taxpayer’s Trade or Business

1. Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of business are NOT capital assets.

vii. Judicially Established Limits on Capital Asset Definition

1. Arkansas Best Corp. v. Comm’r (1988): business purpose is irrelevant to determining whether an asset falls within the general definition of a capital asset. Hence, it is immaterial whether stock was purchased for investment or business when determining if it was a capital asset.

a. The court is trying to focus on the statutory language. b. The stock at issue is property held by the taxpayer and it doesn’t

fall within a 1221 exclusion, so it is a capital asset.c. An investment would normally be a capital asset as it is typically

not property used in trade or business.

2. Hort v. Comm’r : A payment in lieu of ordinary income is ordinary income. You can’t take ordinary income and change it into capital gain by accelerating the payment (by paying in one lump sump).

E. The Sale or Exchange Requirement

a. Pursuant to § 1222, only gains or losses resulting from the sale or exchange of capital assets will be treated as capital gains and losses.

i. The following are “sales and exchanges:” bequests, forfeiture, involuntary forfeiture.

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QUASI-CAPITAL ASSETS: SECTION 1231QUASI-CAPITAL ASSETS: SECTION 1231

A. DEFINITIONS: SECTION 1231 TRANSACTIONS

1. The primary purpose of 1231 is to provide special, favorable tax treatment to the sale of exchange of real or depreciable property used in the taxpayer’s trade or business

2. Under 1231, gain characterized as capital gain; loss characterized as ordinary loss. When the gain exceeds losses, all of my gains and losses are seen as long term capital gains/losses. When the losses exceed gains, all of my gains and losses are ordinary gains/losses.

3. 1231 applies to two categories of transactions:

a. Sale or exchange of property used in trade or businessi. Must be depreciable or real property used in trade or businessii. Must be held for more than one year. (there’s no such thing as short term

1231 transaction.)

b. Involuntary or compulsory conversions of (1) property used in trade or business AND (2) capital assets held for more than one year in connection with trade or business OR transaction entered into for profit.

4. Some gains from property excluded from being a capital asset by § 1221(a)(2) (depreciable or real property used in a trade or business) may be capital gains under § 1231!! BUT, any other gain excluded from § 1221 is not covered by § 1231.

B. THE PRELIMINARY HOTCHPOT

1. Section 1231(a)(4)(C) says that involuntary conversions in which the losses exceed the gains are NOT covered under 1231.

2. In light of this, the following PROCESS should be utilized in characterizing gains and losses:

a. List all 1231 gains and losses for the year.

b. Determine which of these gains and losses are subject to the preliminary hotchpot (or TIER I analysis).

c. If losses of involuntary conversions exceed gains, such losses will be characterized outside of 1231. If gains exceed losses, the gains and losses will be characterized by the principal hotchpot…

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THE PRINCIPAL HOTCHPOT

1. Principal hotchpot covers events that the preliminary does not: sales, exchanges, and compulsory conversions.

2. The gain or loss from a sale or exchange of a capital asset is NOT treated under 1231.

3. Unrecognized loss will not count under 1231 (e.g. loss on sale of home).

4. Condemnations do not enter the preliminary hotchpot, but are instead treated directly by the principal hotchpot.

C. RECAPTURE OF NET ORDINARY LOSSES: SECTION 1231(c)

1. 1231(c) attempts to curtail taxpayers selling assets in different years in order to avoid capital loss treatment.

2. EXAMPLE: T/P tries to sell truck first (5K loss), then land (10K gain). 1231(c) says that if land is sold in any of the next 5 years, producing in the year of sale a net 1231 gain of 10K, 1231(c) requires that the 5K of that gain be treated as ordinary income; the remaining 5K of the net 1231 gain will remain long term capital gain. The effect is to LIMIT the T/P’s long term capital gain to 5K instead of 10K.

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RECAPTURE OF DEPRECIATIONRECAPTURE OF DEPRECIATION

Where a taxpayer’s gain under § 1231 is really a result of over-depreciation, § 1245 recaptures the gain as ordinary income, rather than capital gain.

Example: T buys a tractor for $50K and sells it for $35K. He took $30K in depreciation deductions, so his adjusted basis will be 20K (50K-30K). The tractor is not a capital asset under § 1221, because it is excluded by 1221(a)(2) (it is a depreciable property used in business). But, the tractor is covered under § 1231. The gain under § 1231, would therefore be 15K (35K sale – 20K adjusted basis). BUT, this gain is just a result of taking too many depreciation deductions. Those deductions were granted faster than the property devalued (the property was worth 35K – he sold it for that – but he depreciated it to 20K). Hence, § 1245 recaptures the 15K gain and treats it as ordinary income, which is taxed at a higher rate.

To find out the amount to be recaptured, take lesser of (Recomputed Basis and Amount Realized) and subtract adjusted basis:

Recomputed Basis = 50K Amount Realized = 35K (LESSER AMOUNT) Adjusted Basis = 20L 35K – 20K = 15K that must be recaptured

Example: If T buys the tractor for $50K, takes $30K in depreciation, but sells it for $65K. The adjusted basis is 20K, so T has a gain of 45K (65K-20K). Not all of the gain is due to depreciation – only 30K is. So, 30K is treated as ordinary income, and 15K is treated as a capital gain.

Recomputed Basis = 50K (LESSER AMOUNT) Amount Realized = 65K Adjusted Basis = 20L 50K – 20K = 30K that must be recaptured The 15K left over is treated as a capital gain

A. SECTION 1245 RECAPTURE (applies to depreciable PERSONAL PROPERTY)

1. 1245 gain is gain recognized solely from the taking of depreciation deductions—not from any appreciation in the value of the equipment.

2. EXAMPLE:

a. T/P buys equipment for 100. T/P takes 30 in depreciation deductions. T/P’s adjusted basis is now 70. T/P sells equipment for 80. T/P realizes gain of 10 even though she bought for more than she sold. This excess depreciation is recaptured in the form of a gain.

3. Recomputed basis is generally T/P’s original basis in the property.4. 1245 does not apply to losses.

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ASSIGNMENT OF INCOMEASSIGNMENT OF INCOME

A. The Progressive Rate Structure

WHO has income is important because: (1) Individuals are viewed as the taxpaying unit; (2) Without safeguards, the higher bracket taxpayer could shift income to a low bracket taxpayer.

B. Development of Rules Limiting Income-Shifting

Income is taxed to the taxpayer that controls the earning of the income.

Lucas v. Earl, U.S. Supreme Court (1930)

Income will be taxed to the earner of income. With services, the performer of services is taxed.

Facts: The Earls had a contract, whereby Mrs. Earl had a 50% interest in Mr. Earl’s income. The husband had control over the income and should therefore be taxed on it.

§ 83: When someone does work and a payment is made to anybody with regards to that work, the person who actually does the work is taxed on that income.

Between Helvering v. Eubank (which held that you can’t transfer deferred compensation) and Lucas v. Earl (you can’t transfer wages), it is almost impossible to transfer income.

Helvering v. Horst, U.S. Supreme Court (1940)

The owner of property pays taxes on the income produced by the property.

Income from property is taxed to the one who owns the property. For example, the landlord-parent directing that rent be paid to her child is still taxed on that rental income.

Facts: The taxpayer had a bond that had a coupon on it. He gave the coupon to his son, who cashed the bond at the bank. The court held that the taxpayer must pay, because it was his property. Property is taxed to the owner.

Comm’r v. Giannini: taxpayer told the corp. not to pay him. The corp. paid a charity instead. This isn’t income to the taxpayer because the taxpayer (1) abandoned his right to wages and (2) did not direct the corp. to donate the money to any specific org.

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Salvatore v. Comm’r, TC Memo (1970)

In other words, a taxpayer cannot shift income to A, who is in a lower tax bracket, by giving property to him, and he will then sell it to B. If A paid nothing or even a nominal amount for the property and is only a conduit to pass title, then the gain from the sale is attributed to the taxpayer.

Facts: Woman contracts to sell gas station to Texaco. Instead of selling her whole stake to Texaco and giving her children half of the money, Woman then gives her children ½ of her stake in it. They then sold their ½ stake and the woman sold her stake.

ACCELERATION OF INCOME: If the same income will be taxed at a higher rate in Y2 than it is in Y1, there is an incentive to find a way to accelerate future income into the present tax period, and it may become necessary, for tax purposes, to determine whether and when the taxpayer has realized income.

Stranahan v. Comm’r, US Court of Appeals, 1973

It is a valid transaction when A pays good and sufficient consideration to the taxpayer for property in order for the taxpayer to accelerate his income into an earlier year, as long as there is a legitimate economic reason for it and it is a legitimate sale.

Facts: The taxpayer assigned his son anticipated stock dividends and the son paid his father for them. The son paid the father to receive future income from the dividends. The son took a risk, because it wasn’t guaranteed that he’d receive the same or more money from the transaction. This is therefore not an invalid transaction, because there was economic reason to it. Hence, the agreement is valid.

May v. Comm’r, U.S. Court of Appeals (1984)

Under § 162(a)(3), the transfer of a sufficient property interest under a GIFT-LEASEBACK justifies the taxation of donees and the deduction of rental payments as ordinary and necessary business expenses by the donor.

In a GIFT-LEASEBACK situation, the sufficiency of the property interest transferred must be assessed using the following factors:

1. The duration of the transfer. 2. The controls retained by the donor. 3. The use of the gift property for the benefit of the donor. AND4. The independence of the trustee.

Facts: May gave property to a trust. He then rented the property for his business from the trust. He wants to deduct the rental payments under this “gift-leaseback” as a business expense. The court said that this was an irrevocable transfer of property, the taxpayer retained few controls over the property, the trust benefits do not go to the taxpayer, and the trustee is independent. Because the elements of the test were met, the rental payments may be deducted as a business expense.

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THE TAX CONSEQUENCES OF DIVORCETHE TAX CONSEQUENCES OF DIVORCE

Overview:

§ 71: inclusion of alimony in income

§ 215: allows deduction for alimony paid

§ 1041: “Non Recognition Rule”: property transfers between spouses and former spouses, incident to divorce, are nontaxable events.

A. Alimony: General Requirements

1. The payment must be in cash. § 71(b)(1). Property does not qualify as alimony.

2. The payment must be received by or on behalf of the spouse. § 71(b)(1)(A). They must be made under a divorce agreement to count. Therefore, cash payments to 3rd parties may in some circumstances qualify as alimony. See Regulations.

3. The payment must be made under a divorce OR separation instrument. § 71(b)(1)(A),(2). The agreement requires mutual assent or a meeting of the minds.

4. The cash payment must not be designated as one that is excludable from the gross income of the recipient and nondeductible to the payor. § 71(b)(1)(B). Hence, the cash cannot be part of a property settlement agreement.

5. The spouses cannot be members of the same household at the time payment is made. § 71(b)(1)(C).

6. The payor spouse must have no obligation to make payments for any period after the death of the payee spouse. § 71(b)(1)(D).

i. If there is an obligation that MAY have to be paid after death, then this is not alimony, even if it was actually paid before death.

B. Child Support

1. A payment fixed as child support by the divorce or separation instrument is NOT alimony.

2. Under Temp. Reg. § 1.71-1T(c), a payment which is clearly associated with a contingency related to a child is child support and not alimony.

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a. Example: Alimony was to stop within 6 months of the child turning 18. But, because that this was mere coincidence and the date was determined independently of the birthday, it was not child support and it was treated as alimony.

EXAMPLE: Child is 7 when parents divorce. H pays W $2000/month. When child is 14, payment is reduced to $1000. When child is 18, payment is reduced to 0. The $1000 reduction from when the child is 14 to when he is 18 is child support as it is contingent on the child’s age and is not in the 6th post-separation year. The share of the payment that is reduced on a contingency of the child will never be alimony. So, only $1000 of the $2000 from when the child was 7 to 14 is deductible. The other is child support. The money paid from when the child is 14 – 18 is not deductible at all, as it’s child support.

C. Excess Front Loading

1. § 71(f): Recapture provision

2. If too much alimony was included or deducted in a prior year, it is recaptured in a subsequent year.

3. The tax treatment is then reversed. The payee may take a deduction of the excess amount and the payor must include that excess amount as income.

4. Formula :

a. Y1 alimony – [{(Y2 Alimony – Y2 Excess) + Y3 Alimony} / 2] + 15K = amount that’s recaptured for 1st post-separation year.

b. Y2 alimony – (Y3 alimony + 15K) = amount recaptured for 2nd post separation year.

c. Add them together, and you get the amount that must be recaptured.

E. Dependency Exemption – § 152(e)

1. In the case of a child of divorced or separated parents, the parent with custody of the child for the greater part of the year will ordinarily be entitled to the dependency exemption for the child, provided that the parents together are entitled to the exemption. § 152(e).

2. § 152(e): The custodial parent receives the exemption even though the noncustodial parent may have provided more support than the custodial parent. § 152(e)(1).

a. The noncustodial parent is ordinarily allowed the exemption only where the custodial parent has released the claim to the exemption in writing. § 152(e)(2).

3. One of the general income, age, or status tests of § 151(c) must also be satisfied before the custodial parent is entitled to the exemption.

F. Filing Status

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1. A custodial parent with head of household status does not lose it by virtue of releasing the claim to the dependency exemption. § 2(b).

G. Property Transfers – § 1041

1. U.S. v. Davis: the taxpayer’s transfer of his appreciated property to his ex-wife, pursuant to their property settlement agreement, in return for her release of her marital rights, produced recognized taxable gain to the husband. The wife, in turn, took the FMV of the property. Basically, the husband had to pay income on giving the wife the property for more than his basis in exchange for her relinquishing her marital rights.

a. A sues B. A wins $105K. Instead of paying cash, B gives A stock. The stock’s basis is $50K and the FMV is $105K. This is treated as though B sold the stock for $105K, paid it to A, and then purchased the shares for $105K. B has a $55K gain, A has $105K income and a basis of $105K in the stock.

b. THIS NO LONGER APPLIES TO MARRIED COUPLES – § 1041. If this was a divorce proceeding, A’s basis would be B’s basis ($50K) and neither A nor B would recognize a gain!

2. BUT, Davis was regarded as inappropriate in marriage and divorce cases – the built-up gain in the property was not being transferred outside the two-spouse community, and hence the husband shouldn’t have to pay taxes on the gain. So § 1041 was added and created an EXCEPTION to the general rule of Davis.

3. § 1041: No gain or loss is recognized on a property transfer between spouses incident to divorce.

a. § 1041(a),(b): the transfer between spouses is treated as a gift, with the transferee taking the transferor’s basis, and NOT the FMV, as was the case in Davis.

b. Applies to both divorce couples and married couples transferring property.

c. Since neither gain nor loss is recognized, and the transferor’s basis carries over to the transferee, the parties effectively determine who bears the future tax burden in appreciated party and who receives the future tax benefit on property with a value less than its basis.

d. EXAMPLE:

i. § 1015(a): NORMAL RULE WITH GIFTS: DONOR DONEE stock with Basis of $1K and FMV of 500K. If he sells it at a gain (for more than $1000), his basis will be the donor’s basis. If he sells it for a loss (for less than 500), his basis will be the FMV. So, if he sells it for $1500, he’ll have a 500 gain. If he sells it for 300, he’ll have a $200 loss. If he sells it for $700 (in between), he won’t have a gain or a loss.

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ii. § 1041: HUSBAND WIFE stock with Basis of $1000. The Wife takes the husband’s basis. Hence, if she sells it for $1500, she has a 500 gain. If she sells it for 700, she has a 300 loss. If she sells it for 300, she’ll have a 700 loss. So it is very different than the normal situation with gifts!

H. Special Rules Regarding Personal Residence – § 121

1. See § 121(d)(3)(A),(B) for rules regarding the sale of the personal residence in divorce contexts.

I. Legal Expenses

1. U.S. v. Gilmore :

Legal expenses may be deducted to defend claims that arise out of business, but not those that arise out of personal reasons (divorce).

The Origin of the Claim Test: The origin and character of the claim with respect to which an expense has incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling test of whether the expense was business or personal and hence whether it is deductible or not under § 212.

Facts: A taxpayer argued that because his wife’s divorce claims would hurt his business, his litigation costs could be deducted as business expenses. But, under the Origin of the Claim Test, even though a spouse’s claims may affect a taxpayer’s business, if it arose from personal reasons, then the litigation costs in defending those claims are not deductible.

2. Under the origin-of-the-claim test, legal expenses in conjunction with a divorce will generally be nondeductible.

3. However, subject to the 2% floor rule of § 67, the cost of tax planning advice is generally regarded as deductible, as are the legal expenses attributable to amounts includable in income as alimony. Reg. § 1.262-1(b)(7).

Revenue Ruling 67-420: If (1) a husband and wife hold property as joint tenants and jointly owe money on a mortgage, and (2) pursuant to divorce agreements, (3) the husband pays the mortgage and the wife owes nothing, the wife received income under Old Colony Trust as she was relieved of her debt.

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LIKE-KIND EXCHANGESLIKE-KIND EXCHANGES

§ 1031

§ 1031(a)(1): No gain or loss is recognized when property held for productive use in a trade or business or for investment is exchanged solely for property of “like kind” to be held for productive use in a trade or business or for investment.

§ 1031(a)(2): Six exceptions

LIKE-KIND REQUIREMENT

“Like kind” refers to the nature or character or property, or its kind or class, not to its grade or quality. See Reg. § 1.1031(a)-1(b). Whether real estate is improved or unimproved is immaterial.

BOOT Where a taxpayer receives boot in a like-kind exchange, he only has to recognize gain to the

extent that the boot exceeds the sum of the boot and the FMV of the other property.

PROBLEMS:

1. K owns farm land with an adjusted basis of $100K and a value of $500K. He exchanges the land with A for improved commercial real estate to conduct a farm implement business there.

a. A’s real estate is worth $500K.

i. Kevin is transferring property held for productive use in a trade and will receive property for trade or business. He qualifies for a deferral under § 1031. He realizes a gain of $400K, but does not recognize it. Per § 1031(d), K’s basis is $100K.

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