fundamental concepts of income taxation slides 2 tax principles income – an accession to wealth...

Fundamental Concepts of Income Taxation

Slides

2

Tax principles

• Income – an accession to wealth• Fairness

– Ability and capability to pay– Fairness – persons with the same income

should pay the same tax

• Administrability– Simple– Certain

3

Administration and practice

• Income tax returns are filed annually, typically for a calendar year. In filing the return, a taxpayer “voluntarily” assesses the tax due.

• Each year, the IRS audits a small fraction of returns filed.– Triggered by suspicious entry– Random

4

Statutes of limitation

• Within three years after a return is filed, the IRS must assess (i.e., record) any tax allegedly due for the return year. § 6501(a). See also § 6501(b)(1) (providing that a early return is generally deemed filed on its due date).

• The IRS must generally begin the collection of tax (by suit or levy) within 10 years of its assessment. § 6501(a)(1).

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Statutes of limitation (cont’d)

• A taxpayer may agree to extend the assessment or collection period.

• Those periods are also tolled by the IRS filing a statutory notice of deficiency (a “90-day letter”).– Each period is tolled until 90 days after the notice is

filed unless the taxpayer petitions the Tax Court to redetermine the deficiency. In that case, the period is tolled until 60 days after the Tax Court (and all appellate decisions) become final.

– The IRS can neither assess nor collect a deficiency while the statute of limitations is tolled.

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The Tax Court

• If the taxpayer disputes a tax deficiency but does not pay the disputed tax, he or she can litigate the dispute only in the Tax Court. In a dispute before the Tax Court --– The “Commissioner” is the named government party.

– There is no right to jury.

• A Tax Court decision is appealed to the U.S. Circuit Court of Appeals in which the taxpayer resides.

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Refund claims

A taxpayer must file a refund claim by the later of three years after the relevant return is filed or two years after the tax to be refunded is paid. § 6511(a).

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Other courts

• If the taxpayer pays an alleged deficiency and files a claim for refund, he or she can litigate the deficiency in the District Court or U.S. Court of Federal Claims if the refund claim is denied.

• The “United States” is the named government party in these cases.

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Other courts (cont’d)

• The District Court that hears the taxpayer’s refund claim is the one with jurisdiction over the taxpayer’s place of residence.

• The U.S. Court of Federal Claims has concurrent jurisdiction over the refund claim.

• A taxpayer has the right to a trial by jury only in the District Court.

• A District Court decision is appealed to the U.S. Circuit Court of Appeals in which the taxpayer resides, while a Claims Court decision is appealed to the Federal Circuit.

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Statutory noticeof deficiency; tax not paid

Tax paid and refund claim denied

Tax Court District Court Claims Court

Circuit Court in whichtaxpayer resides

Federal Circuit

U.S. Supreme Court

Forum shopping?

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Sources of federal income tax law

• The Internal Revenue Code• Legislative history• Regulations• Case law• Administrative pronouncements

– Revenue rulings– Revenue procedures– Private letter rulings– Notices and announcements– Internal legal memoranda

12

Tax deferral

• Generally, a dollar today is worth more than a dollar tomorrow.

• The longer tax is deferred, the lower its present value.

• The higher the discount rate, the lower the present value.

• Tax deferred for one taxpayer may mean tax accelerated for another taxpayer.

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Factors in deferring income

• Taxpayer's rate of return on investment

• The risk that any investment may lose money

• The deferral period

• Risk that tax rates may change

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Question 1 (page 12)

• You have $10,000 to invest and you could invest the money for a year earning --– A 5-percent return, paying no expenses; or– An 8-percent return, but paying a $320 broker's fee.

• Which investment choice would you make? Why?

• In making an investment, would you look at the investment’s gross return or its net return (i.e., its return after expenses)?

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• You have $10,000 to invest and you could invest the money for a year earning --– A 5-percent return, paying no taxes; or

– An 8-percent return, but paying a 40-percent tax on the return.

• Which investment choice would you make? Why?

• In making an investment, would you consider the before-tax or after-tax return?

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• You have $60. Would you rather --– Spend the $60 to buy a textbook today and sell

the textbook at the end of the semester for $20; or

– Rent the textbook for the semester for $40?

• Why?

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Income -- Glenshaw Glass

Income

Income is an accession to wealth, clearly realized,over which the taxpayer has complete dominion.

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Gross income -- § 61

Income

Gross income is all income, except as provided in the Code.

Grossincome

Income

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Gross income -- § 61 restated

Except as the Code provides, gross income is any accession to wealth, clearly realized, over which the taxpayer has complete dominion.

Grossincome

Income

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Definition of value

For estate tax purposes, a property’s fair market value is –

The price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts.

§ 20.2031-1(b).

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Valuation -- factors

• Retail or wholesale price, if any• Stipulated price at which the asset or service may be

sold• Comparable sales or offers• Income stream produced by asset or service• Any restrictions on the use of the asset or service• Manner of receipt

– Commercial or non-commercial setting– Choice among alternatives or “forced” receipt

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Compensation income

If a taxpayer provides services to another and receives property or services in exchange, the taxpayer has gross income equal to the value of the property or services received.

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Presumptions

• We presume that both sides of an arm’s-length exchange have an equal value. Philadelphia Park Amusement.

Thus, when the property received cannot be readily valued but the property exchanged can be, the value of the property received is deemed equal to the value of the property exchanged.

• If property or services are received for services rendered at a stipulated price, the value of the property or services received is deemed equal to that stipulated price. § 1.61-2(d)(1).

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Assumptions

• In an arm’s-length setting, if property or services are acquired solely for cash, they are deemed to have a value equal to that cash.

• If a person transfers property or services to satisfy an obligation, the person is treated just like he or she had received cash equal to the obligation amount for the property or services. (The obligation is also treated as satisfied for that amount).

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Questions 2 and 3 (page 84)

• Two couples exchange baby-sitting services. Do the couples have gross income because each receives an economic benefit (in the form of services) for its performance of services?

• A couple joins a cooperative day care center and either must contribute $50 each month or work at the center for two hours each week. Should the parents who work at the center have income each month?

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Questions 4 and 6 (page 84)

• Attorney Ann receives credits in a barter service for services performed (like in the medieval times, when services were paid for with livestock). Does she have gross income?

• A bank customer can receive interest-free checking and not pay service charges or receive interest and pay service charges. What are the income tax consequences to the customer of either alternative?

Standard deduction

Anne, age 23 and a law student, is single, perfectly sighted, and claimed as a dependent on her parent’s return. What is her standard deduction (disregarding any inflation adjustment) if her earned income for the year is –

– $200;– $1,500; or– $3,000?

§ 63(c)(2) and (5).

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Imputed income

• An individual has imputed income when he or she --– Creates or improves an asset or performs a

service for his or her own benefit; or– Uses (or even holds) an asset that he or she owns.

• The imputed income equals what the individual would pay another for the same benefit.

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Bertha's bookshelf

• She is a computer programmer and receives $25/hour as a programmer. She pays $6.25 tax on each $25 she earns, netting $18.75 after tax.

• Bertha builds a bookshelf in three hours using $30 of materials. When finished, the bookshelf is worth $90.

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Question 1(a)-(e), page 24

Sam grows vegetables in his garden. Does Sam (or any other person) have gross income when --– He grows his crop?– He harvests his crop?– Sam and his wife eat the vegetables?– Sam sells the vegetables for $100?– Sam exchanges the vegetables for $150 worth

of tuna that Charlie caught?

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Question 1(f), page 24

• Sam agrees with the grocer that Sam can sell his vegetables in the grocery store and keep all of the proceeds of sale.

• The landlord of the grocery store charges the grocer $400 rent, and on a square-foot basis $50 is allocable to the portion of the space that Sam will use. The grocer does not charge Sam any rent.

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Question 1(f) (cont’d)

• How much is Sam’s rental space worth?

• Is your analysis affected if –– The landlord charges the grocer $400 whether

or not Sam uses the space?– The grocer is Sam’s father?

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Question 1(f) (cont’d)

• Assume that the rental space is worth $50 and that Sam does not receive a gift. How should he and the grocer be treated for tax purposes?

• How about if the grocer paid Sam $50 for selling vegetables in the store and –– Sam paid the landlord $50 for his rental space and

the grocer paid the landlord the remaining $350?– Sam paid the grocer $50 and the grocer paid the

landlord the full $400 of rent?

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Sam and the grocer --The first structure

Sellingvegetables

$400 rent

Grocery

Sam

Partof

grocery

Grocer Landlord

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Sam and the grocer --A second structure

Sellingveggies

$350 rent

Part of grocery

Sam

$50

Landlord Grocer

$50 rent

Part ofgrocery

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Sam and the grocer --A third structure

Sellingveggies

$400 rent

grocery

Sam

$50

Landlord Grocer

$50rent

Part ofgrocery

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Sam and the grocer --The first structure

Sellingveggies

$400 rent

Grocery

Sam

Partof

grocery

Grocer Landlord

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Question 2, page 25

A doctor wants her income tax return prepared and a lawyer wants a general medical check-up. Each normally would charge $200 for the service.– What happens if they swap services without

exchanging money?

– How is your analysis affected if the doctor normally charges $250 for the check-up?

– Does the lawyer realize income when she fills out her own return?

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Question 3, page 25

John, while shopping at Kroger's, buys a loaf of bread for $1.50. Mary buys the same brand and size of bread at Kroger's but uses a 25-cent coupon.– Does Mary have income?– What if Mary, shopping at Food City and

without using a coupon, buys the bread for $1.25?

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Question 5, page 78, KBS

• One hundred people pool their resources and buy land in Colorado, where they set up a commune. They perform various tasks for each other according to their skills.

• Do they have income for tax purposes?

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Section 119(a)

Gross income of an employee does not include the value of –– Meals and lodging– “Furnished” to the employee, spouse, or

dependents– For the “convenience” of the employer– If furnished on the employer’s business

premises and (for lodging) required as a condition of employment.

Exclusion of meal benefit

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Is the meal provided while the employeetravels away from home on the employer’s behalf?

YesExcluded

No

Is the meal primarily necessitatedby the employer’s business?

YesExcluded

No

Is the meal a de minimis fringe benefit?Yes

Excluded

No

Is the meal provided to the employee, his or her spouseor dependents and furnished by the employer on its business premises and for its convenience?

YesExcluded

No

Included

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Section 132

• Under § 132, certain fringe benefits are excluded from an employee’s gross income, including –– No-additional-cost fringe benefits– Qualifying discounts on employer products or services– Working condition fringe benefits– De minimis fringe benefits– Employer-provided eating facilities– On-site athletic facilities

• Other non-includable benefits include group-term life insurance, health insurance, and dependent care assistance programs.

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De minimis fringe benefit

• This type of benefit is property (generally other than cash) or services the value of which is so small that accounting for it would be unreasonable or administratively impractical. § 132(e).

• For examples, see § 1.132-6(e).

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Section 102

• “Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.” § 102(a).

• The provision above does “not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.” § 102(c).

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Factors

Relevant factors to determine whether a transfer is a gift include whether –– The transferee is a natural object of bounty;– The transferor is an individual or corporation;– The transferor is the transferee’s employer;– The payment is tied to specific services;– The transfer is one of a series of regular or periodic

payments;– The transferor deducts the payment;– The transferor has non-donative motives for the

transfer.

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Annuities and life insurance

• With a “classic” annuity policy, the annuitant receives periodic payments, typically beginning at retirement and lasting until death.

• With a “classic” life insurance policy, the insured’s beneficiaries receive a payment upon the insured’s death.

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Comparison of a savings account, annuity, and life insurance

Gertrude, age 40, has a life expectancy of 35 years, she can invest $20,000 in a savings account, annuity, or life insurance. Assume each investment bears the same investment return and bears no tax.– The savings account will have a $20,000 present value,

no matter when Gertrude dies.– If she will die at age 75, the life insurance and annuity

also have a $20,000 present value.– If she will die before age 75, the life insurance’s

present value is more than $20,000, but the annuity’s present value is less than that amount. If she will die after age 75, the opposite is true.

Comparing those accounts but taking taxes into account

Assume that each investment earns a 5% return but Gertrude, now 40, is taxed at a 30% rate on any investment amount included in gross income. Her after-tax rate of return is therefore 3.5% (70% of 5%) and Gertrude is expected to live until age 75.

– Her savings account will always have a present value of $20,000.

– Her annuity will have a present value of at least $20,000 if she lives until age 73.

– Her life insurance policy will have a present value of at least $20,000 unless she lives beyond age 89½.

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Terminology

• Tax expenditure = the tax revenue lost because of a tax exemption.

• Putative tax = the difference between the investment returns on comparable taxable and tax-exempt investments.

• Deadweight cost = the excess, if any, of the tax expenditure over the putative tax.

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Recoveries for personal injury or sickness

• Worker’s compensation benefits• Health insurance

– Employer-provided– Purchased by self-employed– Employee-provided

• Disability insurance– Purchased by employer– Purchased by employee

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Section 104(a)(2)

• Under § 104(a)(2), gross income does not include –

The amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or sickness.

• Emotional distress generally is not treated as a physical injury or physical sickness.

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Settlement options for tort claims

• Lump sum– Invest in a bank or investment account– Purchase an annuity

• Periodic payments– From the tortfeasor– Structured settlement

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Example

• Joe has a $5,000 profit on his sale of the car. He treats that profit as income, as you might expect.

• Using tax terms, Joe has a $5,000 realized and recognized gain, equal to the excess of his $15,000 amount realized over his $10,000 basis in the car.

Joe buys a car for $10,000.

He sells it for $15,000.

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Realization and recognition

In this portion of the course, we will consider the following terms, among others --

• realization

• recognition

• basis

• amount realized

• gain realized

• loss realized

• sale

• exchange

You must learnthe definitions

of each of these terms

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Definitions

• Section 1001 (and corresponding regulations) contain the definitions of most of these terms.

• Sections 1011-1016 contain the general definition of basis.

• You probably already intuitively understand most of these terms.

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Section 1001(a)

• Section 1001(a) states that -- The gain from the sale or other disposition of

property [is] the excess of the amount realized therefrom over the adjusted basis [for gain], and the loss [is] the excess of the adjusted basis [for loss] over the amount realized.

• Typically, the adjusted basis for gain is the same as the adjusted basis for loss.

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Revision of § 1001(a)

If, as is typically true, the adjusted bases for gain and loss are the same, we could restate § 1001(a) as follows: On a sale or other disposition of property,

realized gain or loss equals the difference between (i) the amount realized for the property and (ii) the property's adjusted basis.

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Section 1001(a) formulas

Restating the previous definition in formula form -- Realized gain = A/R - , or

Realized loss = - A/R, where --

A/R is the amount realized for the property, and

is the property's adjusted basis.

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Section 1001(c)

• Section 1001(c) provides that gain or loss realized on a sale or exchange of property is recognized (i.e., reported on the taxpayer's federal income tax return) except as otherwise provided in the Code.

• We will study two significant exceptions to recognition when we consider §§ 1031 and 1041 later in the course.

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Other definitions

• A sale is a transfer of property for cash (or the assumption of liabilities).

• An exchange of property is the transfer of property for non-cash property that differs materially in kind or extent from the property transferred. See Cottage Savings (a case we will consider later in the course).

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Amount realized

• Under § 1001(b), the amount realized on a disposition of property is the sum of (i) any money received plus (ii) the fair market value of any property (other than money) received.

• More simply, the amount realized by a seller equals the fair market value of the property he or she receives from the buyer.

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Liabilities

• If a buyer assumes the seller's liabilities, the buyer and seller are treated just as if the buyer paid the seller cash equal to the amount of the assumed liabilities.

• For example, the seller's amount realized includes the amount of any liabilities assumed by the buyer.

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Basis

A buyer's basis in property acquired in a recognition transaction equals his or her "cost" for the property. § 1012.

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"Cost" basis

• If the buyer acquires property for cash, the property's basis equals the cash used in the acquisition.

• If the buyer acquires property in a taxable exchange for non-cash property, the acquired property's basis equals its fair market value.

• If a person acquires property as compensation for services, the acquired property’s basis equals the compensation amount.

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"Cost" basis (cont'd)

• If the buyer acquires property for the assumption of liabilities, the property's basis equals the amount of liabilities assumed.

• Consistent rules apply if the person acquires property for a combination of cash, non-cash property, services, and the assumption of liabilities.

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Basis adjustments

• A taxpayer may increase a property's basis to account for improvements or decrease it to account for wear and tear.

• These adjustments reflect an increase or decrease in the taxpayer's investment in the property for tax purposes.

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Question 1

In Year 1, Paul buys land for $200. In Year 3, he sells the land to Rachel for $250. How are Paul and Rachel treated for federal income tax purposes?– Would the results change if Paul purchased the land using

$200 of interest he received from a tax-exempt state bond?

– How about if Paul had sold the land for only $160?

Paul

Year 1

$200

Xland

Paul

land

$250

Year 3

Rachel

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Question 2

In Year 1, Paul receives land as compensation for services when the land has a value of $180. In Year 3, he sells the land to Rachel for $250. How are Paul and Rachel treated for federal income tax purposes?

Paul

Year 1

services

Employerland

($180 value)

Paul

land

$250

Year 3

Rachel

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Question 3(a)

In Year 1, Paul buys land for $50 plus the assumption of a $150 liability. In Year 3, he sells the land to Rachel for $250. How are Paul and Rachel treated for federal income tax purposes?

Paul

Year 1

$50 + $150 liability

Xland

Paul

land

$250

Year 3

Rachel

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Question 3(b)

In Year 1, Paul buys land for $50 plus the assumption of a $150 liability. In Year 3, he sells the land to Rachel for $100 plus Rachel's assumption of the $150 liability. How are Paul and Rachel treated for federal income tax purposes?

Paul

Year 1

$50 + $150 liability

Xland

Paul

land

$100 +$150

liability

Year 3

Rachel

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Question 4

In Year 1, Paul buys land for $200. In Year 3, he exchanges the land for Rachel's car. At the time of the exchange, the land and car each have a $250 value and Rachel has a $100 basis in the car. How are Paul and Rachel treated for federal income tax purposes?

Paul

Year 1

$200

Xland

Paul

land

car

Year 3

Rachel

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Question 5

– In Year 1, Rick buys land and a building for $1,000, when the land is worth $200 and the building $800.

– In Years 1 through 6, he takes $50 of annual depreciation deductions on the building.

– At the end of Year 6, he sells the land and building to Barb for $800, when the land is worth $150 and the building $650.

What are the tax consequences to Rick and Barb?

Rick

Year 1

$1,000

Xland +

buildingRick

land +building

$800

Year 6

Barb

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Question 5

To answer Question 5 we need to answer the following:– What are Rick's bases in the land and building when acquired?

– How does Rick adjust these bases before the sale to Barb?

– What is Rick's amount realized for the land and for the building on his sale of these assets to Barb?

– What are Barb's bases in the land and building when acquired?

Rick

Year 1

$1,000

Xland +

buildingRick

land +building

$800

Year 6

Barb

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Fair market value purchase --Allocation of purchase price

among assets

If a buyer buys assets for an amount equal to their aggregate fair market value, the buyer's cost (and the seller's amount realized) for each asset equals that asset's fair market value.

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Section 1015(a)

In relevant part, § 1015(a) states --If property [is] acquired by gift . . ., the basis shall be the same as in the hands of the donor . . ., except that if such basis . . . is greater than the fair market value of the property at the time of the gift, then for purposes of determining loss, the basis shall be such fair market value.

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Section 1001(a)

Section 1001(a) states that -- The gain from the sale or other disposition of

property [is] the excess of the amount realized therefrom over the adjusted basis [for gain], and the loss [is] the excess of the adjusted basis [for loss] over the amount realized.

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Section 1001(a) formulasRestating the previous definition in formula form --Realized gain = A/R - gain, and

Realized loss = loss - A/R, where --

A/R is the amount realized for the property,

gain is the property's adjusted basis for determining gain, and

loss is the property's adjusted basis for determining loss.

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Section 1015(a)

In relevant part, § 1015(a) states --If property [is] acquired by gift . . ., the basis shall be the same as in the hands of the donor . . ., except that if such basis . . . is greater than the fair market value of the property at the time of the gift, then for purposes of determining loss, the basis shall be such fair market value.

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Section 1015(a)

In relevant part, § 1015(a) states --If property [is] acquired by gift . . .,the basis shall be the same as in the hands of the donor . . ., except that if such basis . . . is greater than the fair market value of the property at the time of the gift, then for purposes of determining loss, the basis shall be such fair market value.

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If property is acquired by gift -- (a) General rule. Generally to determine

gain or loss, the donee’s basis in the property is the donor’s adjusted basis in the property.

(b) Exception. If the donor’s adjusted basis exceeds the property’s fair market value at the time of the gift, the donee’s basis for determining loss is the property’s fair market value at that time.

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Section 1015(a) -- formulas

Restating the previous definition in formula form, if property is received by gift, the donee's --

(i) gain is the donor’s adjusted basis, and

(ii) loss is the smaller of the donor’s adjusted basis or the fair market value of the gifted property at the time of the gift.

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Section 1014(a)

Property acquired by bequest, devise or inheritance generally takes a basis equal the property’s fair market value at the decedent’s death.

84

Question 1 (page 109 BSS)• A buys stock for $1,000 and later gives the

stock to B when its value is $2,500. What is B’s basis in the stock?

• How much gain or loss will B recognize if she later sells the stock for --

(a) $3,500?

(b) $1,500?

(c) $400?

• How do these answers change if B acquired the stock from A by bequest?

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Question 2 (page 109 BSS)• C buys stock for $2,000 and later gives the

stock to D when its value is $1,000. What is D’s basis in the stock?

• How much gain or loss will D recognize if she later sells the stock for --

(a) $2,500?

(b) $500?

(c) $1,500?

• How do these answers change if D acquired the stock from C by bequest?

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Gift of loss propertyIf a donee receives loss property, the property’s basis for determining gain will be the donor’s adjusted basis but its basis for determining loss will be its fair market value at the time of the gift.

loss no gain or loss gain

Selling priceloss gain

87

Question 3 (pages 109-110)

Over the next four years, Ana, Ernesto's daughter needs $80,000 for college. Ana does not pay tax and Ernesto is in the highest bracket. What should he do if --

(a) He has a single asset with a $20,000 basis and $80,000 value?

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Should Ernesto give the asset to Ana?

What would a typicalcollege freshmanthink about if heor she received

$80,000?

89

Should Ernesto give the asset to Ana?

What would a typicalcollege freshmanthink about if heor she received

$80,000?

90

Question 3 (page 110) (cont'd)


(b) He has a single asset with a $120,000 basis and $80,000 value?

(c) He has an asset with a $20,000 basis and $80,000 value and $80,000 in cash?

91

Question 3 (page 110) (cont'd)


(d) He has a low-basis and high-basis asset, each with an $80,000 value?

(e) He has a single asset with a $20,000 basis and $80,000 value but is 88 years old and in poor health?

92

Debt proceeds

• When a person borrows money, he or she includes none of the debt proceeds in gross income, primarily because we assume that the debt will be repaid in full.

• In limited cases, the assumption proves wrong and the creditor reduces the debt without receiving full consideration for the reduction (or otherwise making a gift to the debtor).

• To that extent the debtor has cancellation of indebtedness income (“COD income”), which is included in gross income except as provided under § 108.

93

Debt reduction

The tax consequences of a debt reduction to the debtor and creditor depend on whether the debt is satisfied or cancelled.– The debt is satisfied to the extent the creditor

receives consideration for the debt (in cash, property, or services) or makes a gift of the reduction to the debtor.

– Otherwise, the debt is cancelled.

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Satisfaction -- tax consequences• The creditor has no bad debt deduction to the extent a

debt is satisfied.• The debtor has --

– No income or loss to the extent the debt is satisfied because the creditor makes a gift or the debtor pays cash;

– Compensation income to the extent the debt is satisfied because the debtor performed services for the creditor; or

– Gain or loss under § 1001 to the extent the debt is satisfied in exchange for non-cash property. The debtor's amount realized equals that debt satisfaction.

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Cancellation -- tax consequences

To the extent that a debt is cancelled --– The creditor may have a bad debt deduction

under § 165 and § 166.– The debtor has COD income, included in his or

her gross income except to the extent provided in to § 108.

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COD Income

• Under § 61(a)(12), gross income includes COD income, except as otherwise provided in the Code.

• Section 108 may limit the COD income included in the debtor's gross income.

97

Question 1

Describe the general rule of § 108.

98

Section 108(a)(1)(A) and (B)

• A debtor does not include COD income in his or her gross income if the debt cancellation occurs in a title 11 case.

• The debtor also does not include COD income in gross income if the cancellation occurs while the debtor is insolvent but only to the extent the debtor is insolvent immediately before the cncellation.

99

What is a title 11 case?

A title 11 case is a "case under title 11 of the United States Code [a federal bankruptcy case], but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court." § 108(d)(2).

100


A title 11 case is a "case under title 11 of the United States Code [a federal bankruptcy case], but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court." § 108(d)(2).

101


A title 11 case is a federal bankruptcy case in which –– The taxpayer is under the jurisdiction of the

court in that case; and– The cancellation of indebtedness is granted by

the court or is under a plan approved by the court.

§ 108(d)(2).

102

When is a taxpayer insolvent?

• A taxpayer is insolvent when his or her liabilities exceed the aggregate fair market value of his or her assets. § 108(d)(3).

• This determination is made immediately before the debt cancellation. Id.

103

How much COD income may be excluded under the insolvency

exception?

• Under § 108(a)(3), the amount excluded cannot exceed the amount by which the debtor is insolvent.

• Thus, the excluded amount cannot be greater than the excess, if any, of the debtor's liabilities over the aggregate value of his or her assets, immediately before the cancellation. See § 108(d)(3).

104

How much COD income may be included in gross income if the insolvency exception applies?

Under the insolvency exception, the debtor includes COD income in gross income to the extent it exceeds the amount by which he or she was insolvent (i.e., in the hole) immediately before the cancellation.

105

How much COD income may be included in gross income if the insolvency exception applies?

• Stated differently, the debtor includes COD in gross income up to the excess, if any, of the aggregate value of the debtor's assets over his or her liabilities immediately after the cancellation.

• Thus, the debtor has includible COD to the extent the cancellation creates positive net worth.

106

Problem 2

• Harold has assets worth $12,000 and liabilities of $25,000. How much COD income must Harold include in his gross income under the insolvency exception if --

(a) $10,000 of debt is cancelled?

(b) $20,000 of debt is cancelled?

• How do your answers change if the bankruptcy exception applies?

107

Additional questions

• If either the bankruptcy exception or the insolvency exception could apply, which applies?

• Is there any cost to the exclusion provided under the bankruptcy or insolvency exception?

108

Debt reduction

The tax consequences of a debt reduction to the debtor and creditor depend on whether the debt is satisfied or cancelled.– The debt is satisfied to the extent the creditor

receives consideration for the debt (in cash, property, or services) or makes a gift of the reduction to the debtor.

– Otherwise, the debt is cancelled.

109

Question 1

George owes Sally $900. He transfers a stamp collection to her that has a $250 basis and $900 value. Sally relinquishes the debt.– What portion, if any of the debt is satisfied by

George's transfer of the stamp collection?– What portion, if any, of the debt is cancelled?– What are the tax consequences of the transfer

and extinguishment to George and Sally?

110

Question 2

George owes Sally $900. He transfers a stamp collection to her that has a $250 basis and $600 value. Sally relinquishes the debt.– What portion, if any of the debt is satisfied by

George's transfer of the stamp collection?– What portion, if any, of the debt is cancelled?– What are the tax consequences of the transfer

and extinguishment to George and Sally?

111

Part-sale/part-gift

Horace Myrtle

Horace transfers a house worth $100,000 to Myrtle, andMyrtle transfers a car worth $30,000 to Horace. Horaceintends to make a gift of the $70,000 portion of the house.

Horace has made a part-sale, part-gift of the house to Myrtle. Myrtle has made a § 1001 exchange of her car for a $30,000 portion of Horace’s house.

112

The seller/donor’s gain or loss

When a seller/donor transfers property in a part-sale/part gift, he or she has gain to the extent the amount realized exceeds his or her adjusted basis in the property transferred. He or she does not recognize loss. § 1.1001-1(e).

113

The buyer/donee’s basis

Under § 1.1015-4(a)(1), the buyer/donee takes a basis in the property received in a part-sale/part-gift equal to the greater of --– The value of the property he or she transferred

to the seller/donor; or– The basis amount determined under § 1015.

114

Basis amount under § 1015(a)

If property is acquired by gift -- (a) General rule. The donee takes the

same basis in the property as the donor.

(b) Exception. If the donor’s basis exceeds the property’s fair market value at the time of the gift, the donee’s basis for determining loss is the property’s fair market value.

115

The buyer/donee’s basis

• In a part-sale, part-gift, the buyer-donee generally takes a basis in the property received equal to the greater of --– The seller/donor's adjusted basis in that property; or– The value of the property the buyer/donee

transferred to the seller/donor.

• For purposes of determining loss, however, the buyer-donee's basis in that property cannot exceed its value when received.

116

Questions 7(a) and (b)

Sally makes a part-sale/part-gift of IBM stock to her son Tom. The stock has a $40 basis and $100 value. What are the tax consequences to Sally and Tom if Tom pays Sally --– $25?– $45?

117

Buyer/donee's amount realized

• If a buyer/donee transfers non-cash property to the seller/donor in the part-sale/part-gift, the buyer/donee has gain or loss under § 1001.

• His or her amount realized equals the value of the property received for the transferred property. See § 1001(b). Typically, that amount equals the value of the property transferred by the buyer-donee.

The seller/donor’s basis in the property received

The seller/donor takes a cost basis in any property received in the "sales" portion of the transfer. § 1012.

118

119

Refinement of question 7(b)

What happens in question 7(b) if, instead of Tom transferring $45 cash to Sally, he transfers land to Sally and --– The land has a $30 basis and $45 value?– The land has an $80 basis and $45 value?

120

Recourse debt --Amount realized on transfer

• If a person transfers property that secures a recourse debt to the creditor, his or her amount realized for the property equals the amount of the debt satisfied on the transfer.

• The amount satisfied equals the value of the transferred property.

• If the creditor relinquishes the remaining debt without receiving additional consideration or making a gift to the debtor, the debtor has COD income equal to the amount of the remaining.

121

Non-recourse debt --Amount realized on transfer

• If a debtor transfers the property that secures a non-recourse debt to the creditor, his or her amount realized generally equals the amount of the debt.

• Because the creditor has agreed to accept the property in full satisfaction of the debt, the debtor will not have COD income, regardless of the property's value when transferred.

122

Non-recourse debt --Amount realized on transfer

• If a person transfers all property that secures a non-recourse debt, his or her amount realized includes the amount of the debt if --– The transferor acquired the property subject to the

debt (to the extent he or she included the debt amount in basis); or

– The transferor incurred the debt.

• Regardless of the property's value when transferred, the transferor will not have COD income.

123

Non-recourse debt --Basis of acquired property

• If a person acquires property that is the collateral for a non-recourse debt and the value of the property exceeds the debt amount, the person's cost for the property includes the amount of the debt.

• Under § 1012, that cost is included in the person's basis in the property.

124

Non-recourse debt --Basis of acquired property

(cont'd)

If a person acquires property that is the collateral for a non-recourse debt but the debt amount exceeds the value of the property, it is not clear --– Whether the person has acquired the property for tax

purposes; or– If he or she is treated as acquiring the property for tax

purposes, what basis the person takes in the property.

125

“Claim of right” doctrine

• If a person receives income under a “claim of right” in one year, he or she must include that amount in gross income in that year.

• If the person repays a portion of that amount in a later year, he or she is entitled to a deduction in the later year.

• Would this doctrine apply to a person if a bank credited interest to his or her account in error at the end of the year and shortly thereafter corrected its error?

126

Section 1341

Section 1341 applies to a repayment if --– A taxpayer includes a payment in gross income because

it appears he or she had an unrestricted right to the payment;

– After the close of the payment year, it was established that the taxpayer did not have an unrestricted right to the payment;

– The taxpayer repays all or part of that amount and deducts the repayment; and

– The deduction exceeds $3,000.

127

Section 1341 (cont’d)

If § 1341 applies to a repayment, the taxpayer’s tax for the repayment year is the smaller of –– The tax computed for that year, determined by

including the deduction; or– The tax computed for that year (i) determined

by excluding the deduction but (ii) decreased by the tax savings that would have arisen if the deduction had been taken in the payment year.

The Arrowsmith Doctrine

The net taxable income for two related events should be the same as it would have been if the two events had occurred in the same taxable year.

128

129

Transactional accounting

First event Related but inconsistent event

Payment received --

No income

Income

Repayment made --

No deduction*

Deduction

Payment made --

Deduction

No deduction

Reimbursement received --

Income

No income

* Note that if a payment is received and excluded, to the extent that a repayment is expected but not made, the recipient has income.

130

Questions (pages 126-27, BSS)

• Tom loses a pay envelop with $300 of wages. Can he deduct the loss?

• What happens if he finds that $300 the next year?• How does your answer change if he could deduct

the loss?• Assume that he could not deduct the loss. What

happens if he finds another $300 the next year?• What if he could deduct the loss but failed to do so

and finds the $300 either the next year or five years after he lost it?

131

Substance-over-form doctrine

• A Code provision often can be interpreted several ways. Generally, the best interpretation furthers the provision’s purpose.

• Sometimes, a Code provision is interpreted to further its purpose, despite an apparently inconsistent literal meaning. The interpretation is said to follow the provision’s “substance,” not its “form,” illustrating an aspect of the substance-over-form doctrine.

• The following film clip shows someone who does not understand this doctrine.

132

Question 1 (page 226, BSS)

Joe and Barbara, both cotton dealers, bought cotton of the same grade and quality from the same area and stored it in the same warehouse. Each has an unrealized loss in the cotton. They swap their interests.– Can they recognize a loss? – Suppose that Joe’s cotton was picked in a different area

than Barbara’s?– Suppose that the warehouse roof leaked over Joe’s

cotton?– Suppose that Joe’s cotton was stored in California and

Barbara’s cotton was stored in Tennessee?

133

Question 2 (page 226, BSS)

• Susan and Josh, dealers in “exotic” sports cars, have each purchased a hand-made Italian sports car, a Machorari Streaker.

• Susan was assigned car no. 13 and Josh car no. 14, but Josh’s car was shipped to Susan in New York and Susan’s car was shipped to Josh in Miami.

• What happens if they swap titles?• Does it matter if the colors of the cars are different

and colors are of great importance to buyers?

134

Section 1001 checklist

1. Is property disposed of?– Any transfer of property (other than a gift) is a

disposition of that property, except as provided in Cottage Savings.

– Under Cottage Savings, a swap of properties is a disposition only if the properties have different legal entitlements.

135

Section 1001 checklist (cont'd)

2. If the answer to question 1 is yes (i.e., if there is a realization event), calculate the realized gain or loss.– Realized gain or loss equals the difference between

the amount realized and the adjusted basis of the property transferred. § 1001(a).

– The amount realized equals the value of property received for the transferred property. § 1001(b).

– Adjusted basis is determined under §§ 1011-1016.

136


3. If there is a realization event, is there a sale or exchange?– A sale of property is a transfer of property for

cash or the assumption of liabilities.– An exchange of property is a transfer of

property for materially different property (i.e., property with different legal entitlements than the transferred property).

137


4. If the answer to question 3 is yes, any realized gain or loss is recognized except as provided in the Code.

138

Non-recognition provisions

The Code sometimes provides that realized gain or loss is not recognized. The "non-recognition" provisions could be grouped as follows--– Continuity of investment cases (in which gain

and loss may be deferred);– Hardship cases (in which gain is deferred); and– Anti-abuse cases (in which loss is deferred or

eliminated).

139

Section 1031

Section 1031 is a non-recognition provision that applies when a person transfers property and receives property in exchange that represents a continuation of his or her investment.

140

Section 1031(a)

Section 1031(a) states that --No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

141

Section 1031(a)

Section 1031(a) states that --– No gain or loss shall be recognized on the

exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

142


A person recognizes no gain or loss on an exchange of property if the person --

(i) Surrenders that property solely for like-kind property;

(ii) Held the surrendered property for a qualified use;

(iii) Plans to hold the property received for a qualified use.

143

Like-kind property

• Property is of like-kind if it is of the "same nature or character." § 1.1031(a)-1(b).

• For example, all real estate located in the United States, whether or not improved, is of the same nature and character. See § 1.1031(a)-1(c).

144

Qualified use

• Property is held for qualified use if it is held either for productive use in a trade or business or for investment.

• A person will not have held property surrendered in an exchange for a qualified use if --– It is personal-use property; or

– It is acquired for purposes of the exchange.

• A person will not plan to hold property received in an exchange for a qualified use if--– He or she plans to hold it as personal use property; or

– The property is sold or transferred under a plan in effect at the time of the exchange.

145

Basis -- solely like-kind exchange

In a solely like-kind exchange, the basis of the property received in the exchange equals the adjusted basis of the property surrendered. § 1031(d).

146

Section 1031(a)

If § 1031(a) applies to a taxpayer's exchange of property for other property --– The taxpayer will recognize no gain or loss on

the exchange. § 1031(a).– The taxpayer's basis in the property received

will be the same as his or her adjusted basis in the property surrendered. § 1031(d).

147

Question 2(a)

• Joan's basis in Tract 1 is $15,000, and she sells Tract 1 to Bob for $20,000.

• What are the tax consequences of the sale to Joan and Bob?

Joan Bob

Tract 1

$20,000

148

Question 2(b)

• Joan's basis in Tract 1 is $15,000, and Trent's basis in Tract 2 is $18,000. Both tracts are worth $20,000.

• Joan and Trent exchange Tract 1 and Tract 2.• What are the tax consequences of the exchange to

Joan?

Joan Trent

Tract 1

Tract 2

149

Question 2(c)



Trent?

Joan Trent

Tract 1

Tract 2

150

Question 2(d)

Will the answers to 2(b) or 2(c) change if --– Joan holds the properties for investment but Trent uses the

properties in a trade or business?

– Trent uses Tract 2 in a trade or business but holds Tract 1 for investment?

– Trent purchases Tract 2 shortly before the exchange (and with the intent to go through with the exchange)?

Joan Trent

Tract 1

Tract 2

151

Other questions

• Will the answers to 2(b) or 2(c) change if --– Trent was a dealer in real property and held Tract 2 in his

business?

– Could Joan's exchange qualify under § 1031 even if Trent's didn't?

• Is § 1031 elective?

Joan Trent

Tract 1

Tract 2

152

Other questions



Joan and Trent?

Joan Trent

Tract 1

Tract 2

153

Other questions


• Joan buys Tract 2 from Trent for $20,000?• What are the tax consequences of the two steps to

to Joan?

Joan

Tract 1

$20,000

Step 1

Joan Trent

$20,000

Tract 2

Bob

Step 2

154

Other questions


• Joan buys Tract 2 from Trent for $20,000?• What are the tax consequences of the two steps to

to Joan?

Joan

Tract 1

$20,000

Step 1

Joan Trent

$20,000

Tract 2

Bob

Step 2

155

Other questions

• Joan sells Tract 1 to Trent for $20,000, and her basis in Tract 1 is $35,000.

• Trent sells Tract 2 to Joan for $20,000, and his basis in Tract 2 is $38,000.

• What are the tax consequences of these two steps to Joan and Trent?

Joan

Tract 1

Tract 2Trent

$20,000

$20,000

156

Question 3(a)

• Tom owns Tract 1, and Sally owns Tract 2.

– Tract 1 has a $20,000 basis and $25,000 value.

– Tract 2 has an $18,000 basis and $21,000 value.

• Tom transfers Tract 1 to Sally. In exchange, Sally transfers Tract 2 and $4,000 cash to Tom.

• What are the tax consequences of the exchange to Tom?

Tom Sally

Tract 1

Tract 2 + $4,000

157

Section 1031(a) -- qualification

A person's exchange of property qualifies under § 1031(a) if the person --

(i) Transfers that property solely for like-kind property;

(ii) Held the transferred property for a qualified use;


158

Section 1031(a) -- qualification

A person's exchange of property qualifies under § 1031(a) if the person --

(i) Transfers that property solely for like-kind property;



159

Section 1031 -- qualification

A person's exchange of property qualifies under § 1031 if the person --

(i) Transfers that property for like-kind property;



160

Receipt of boot

Under § 1031(b) and (c), if person makes a § 1031 exchange but receives boot, the person recognizes no loss and recognizes gain "but in an amount not in excess of the sum of the [boot received]."

161

Restatement of boot rule

Under § 1031(b) and (c), if person makes a § 1031 exchange but receives boot, the person --– Recognizes no loss and– Recognizes gain equal to the smaller of (i) his

or her realized gain or (ii) the value of boot received.

162

Restatement of § 1031

On an exchange of like-kind property in a § 1031 exchange --– The person making the exchange will

recognize gain equal to the smaller of (i) his or her realized gain and (ii) the value of boot received, if any.

– The person will not recognize loss.

163

Basis of like-kind property

Section 1031(d) states that --If property was acquired in a [§ 1031 exchange], the basis shall be the same as the property exchanged, decreased by any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss [recognized by the taxpayer]. If the property so acquired [included non-cash boot], the basis provided in this subsection shall be allocated between the properties (other than money) received, and . . . there shall be assigned to [the boot] an amount equivalent to its fair market value at the date of the exchange.

164

Revision of § 1031(d)

• If a person acquires like-kind property in a § 1031 exchange, the basis of that property equals --

(i) His or her total basis in the property surrendered, plus

(ii) Any gain he or she recognized on the exchange, minus

(ii) The value of any boot he or she received, minus

(iv) Any loss he or she recognized on the exchange.

• Boot takes a basis equal to its fair market value when received.

165

Section 1031(d) -- formulas

like-kind rec = surr prop + Gainrecog - Lossrecog - Valueboot rec where -- like-kind rec = The basis of the like-kind property received;

surr prop = The total basis of the surrendered property;

– Gainrecog = The transferor's recognized gain, if any;

– Lossrecog = The transferor's recognized loss, if any; and

– Valueboot rec = The value of any boot when received.

boot = Valueboot rec.

166

Question 3(a)






Tom Sally

Tract 1

Tract 2 + $4,000

167

Question 3(b)






Tom Sally

Tract 1

Tract 2 + $4,000

168

Variation of question 3(b)






Tom Sally

Tract 1

Tract 2 + $4,000

169

Question 3(c)





• What are the tax consequences of the exchange to Sally?

Tom Sally

Tract 1

Tract 2 + $4,000

170

Sally's exchange

$4,000

Tract 2(worth

$21,000)Tract 1(worth

$25,000)

+

171

Sally's exchanges

$4,000

Tract 2(worth

$21,000)

$21,000portion

$4,000portion

Tract 1

172

Fair market value purchase --Several assets exchanged for one

asset

If a buyer transfers several assets for a single asset in a fair market value exchange, each transferred asset is exchanged for an undivided portion of the asset received that has the same value as the transferred asset.

173

Presumption

• If a taxpayer transfers (but does not receive) boot in a § 1031 exchange, the boot is deemed exchanged for property of equal value. See § 1.1031(d)-1(e) and § 1.1031(j)-1(b)(3)(i).

• Because of this presumption –– If the boot is non-cash property, the taxpayer recognizes

gain or loss equal to the difference between the boot’s value and adjusted basis. § 1001(a)-(c).

– The taxpayer’s basis in the like-kind property received equals (i) his or her adjusted basis in the like-kind property transferred plus (ii) the value of the boot transferred. § 1.1031(d)-1(a) (last sentence).

174

Question 3(c)





• What are the tax consequences of the exchange to Sally?

Tom Sally

Tract 1

Tract 2 + $4,000

175

Question 3(d)




• Tom transfers Tract 1 to Sally. In exchange, Sally transfers Tract 2 and Ford stock (with a $2,500 basis and $4,000 value) to Tom.

• What are the tax consequences of the exchange to Sally and Tom?

Tom Sally

Tract 1

Tract 2 + stock

176

Sally's exchanges

Stockworth $4,000

Tract 2(worth

$21,000)

$21,000portion

$4,000portion

Tract 1

177

Question 3(d)




• Tom transfers Tract 1 to Sally. In exchange, Sally transfers Tract 2 and Ford stock (with a $2,500 basis and $4,000 value) to Tom.


Tom Sally

Tract 1

Tract 2 + stock

178

Variation of question 3(d)




• Tom transfers Tract 1 to Sally. In exchange, Sally transfers Tract 2 and GM stock (with a $6,000 basis and $4,000 value) to Tom.


Tom Sally

Tract 1

Tract 2 + stock

179

Section 1031(d) -- formulas

When a person transfers like-kind property plus boot but receives solely like-kind property in exchange, the basis of the like-kind property received can be determined as follows:

like-kind rec. = surr. prop. + Gainrecog - Lossrecog - Valueboot rec.

= surr. prop. + Gainrecog - Lossrecog - 0

= surr. like-kind + surr. boot + Gainrecog - Lossrecog

= surr. like-kind + (surr. boot + Gainrecog - Lossrecog)

= surr. like-kind + Valuesurr. boot

180

Accounting methods

• A taxpayer’s accounting method should “clearly reflect” his or her income.

• Among other things, items of income and expense should be taken into account once and only once.

• Further, income and corresponding expense, to the extent possible, should be matched (i.e., taken into account in the same year).

181

Cash method

• Under the cash receipts and disbursements method (commonly called the cash method), income is taken into account when received and deductions are accounted for when paid.

• There are exceptions for –– Sales;

– Dividends;

– Certain types of interest.

182

Constructive receipt doctrine

Under the constructive receipt doctrine, a taxpayer constructively receives (i.e., is deemed to receive) an amount when it is made available to the taxpayer without substantial limitation or restriction.

§ 1.451-2

183

Question 1, page 81

• In a fit of unexpected generosity, an employer offers an employee a cash bonus of $1,000 on December 31 of Year 1.

• The employee, knowing that tax rates are likely to go down in Year 2, refuses to pick up the cash until early January of Year 2.

• When does the employee have gross income?

184

Question 2, page 81

• A large entertainment corporation, known for its family image, fires an employee on December 24 of Year 1 and offers $200 cash as a meager severance payment.

• The employee angrily demands more and refuses to accept the payment, fearing her acceptance would jeopardize any subsequent recovery.

• After her attorney threatens the Scrooge-like employer with costly litigation, the employer buckles under and agrees to a $3,000 severance payment, which the employee accepts in July of Year 2.


185

Question 3, page 81

• Mary's employer gives her a $2,000 paycheck on December 31 of Year 1.

• Because Mary had been working late, when she finally received the check, all other businesses already are closed and the she could not possibly cash the check until Year 2.

• When does Mary have gross income?• Is your answer affected if Mary loses the check in

a poker game shortly before midnight that night?

186

Question 4, page 82

• John receives his wages in the form of a check.• His employer mails him a $1,000 check on

December 31 of Year 1, which John receives and cashes on January 2 of Year 2.

• When does John have gross income?• Does your analysis change if before John's pay

period began, his employer offered John automatic deposit of wages for the pay period, but John did not choose that option?

187

Economic benefit doctrine

• Gross income may be received in a form other than cash.

• For example, an employee may have gross income when he or she receives non-cash compensation.

• The economic benefit doctrine is most difficult to apply when an employee receives a promise of future payments from his or her employer.

188

Promised payments

• If an employer unconditionally promises to make future payments to an employee, the promise is not an economic benefit if –– It is unfunded (i.e., not free from claims of the

employer’s creditor’s); and

– It is unsecured.

• If the employer transfers a third-party promise to the employee, the employee receives an economic benefit on the transfer.

189

Economic benefit and constructive receipt -- flowchart

Has the taxpayer received a promise from someone for a

future payment?

Yes

Was the promise an economic benefit?

YesWhen the taxpayer receives the promise, he or she has gross income equal to its value. The promise has a basis equal to that income.

No

Taxpayer must include the value of promised payments ingross income when actually or constructively received.


• In Year 1, an employer promises to pay an employee a $1,000 bonus in Year 2.– The promise is neither funded nor secured.

• The employer makes the promised payment in Year 2.

190

191

Question 6, page 82

• As a bonus, an employer puts $1,000 in a bank account in the name of a spendthrift employee on February 1 of Year 1, but the employee can withdraw nothing from the account until January 2 of Year 2.


192

Question 7, page 82

• A Green Bay Packer wins the Sport magazine award for the National Football League's most valuable player.

• The award is presented at a game in Green Bay on December 31 of Year 1.

• The player is entitled to receive a Corvette (owned by the magazine) from a New York City Chevrolet dealer.

• The dealer is closed on December 31 of Year 1, and the first day that the player can take delivery of (and title to) the car is January 2 of Year 2.

• Does the employee have gross income? When?

193

Computing taxable income

An individual computes his or her taxable income as follows:– Begin with gross income.– Subtract expenses described in § 62. The result

is adjusted gross income.– Subtract personal exemptions.– Subtract either the standard deduction or

itemized deductions.

194

Computing tax

• An individual computes his or her federal income tax by –– Computing the tax on his or her taxable income; and

– Subtracting any credits to which the individual is entitled.

• Note that a dollar of deductions reduces taxable income by a dollar but reduces tax by only a fraction of a dollar, while a dollar of credits reduces tax by a full dollar.

195

Checklist for expenses

1. Must the expense be “capitalized?”

2. If it is not a capitalizable expense, is there a Code section that authorizes its deduction?– Note that business expenses are generally

deductible while personal expenses are generally non-deductible.

196

Rules of capitalization

• The cost to acquire an asset must be capitalized unless the cost is de minimis or the asset does not have a useful life that extends substantially beyond the end of the taxable year.

• With some exceptions, the cost to create an asset must be capitalized. See, e.g., § 263A.

• A cost associated with property already owned and used by the taxpayer must be capitalized if its consequence is to –– Add material value to the property;– Substantially prolong its useful life;– Adapt it to a new or different use; or– Return non-functioning property to its ordinary operating condition

after it has deteriorated to a state of disrepair.

197

Repair costs

• Amounts paid or incurred for incidental repairs or maintenance are not capitalized if not part of a general plan of rehabilitation.

• A repair cost is a cost to keep property in ordinary operating condition.

198

Question 1, page 84

• What happens when a cost is capitalized?

• In what ways can a cost capitalized by a taxpayer provide a tax benefit to the taxpayer?

199

Question 2(a)-(f), page 84

• Sarah owns a building in which she and her employees manufacture and sell furniture.

• Occasionally, maintenance work must be performed on the building.

• Consider whether the cost of the following maintenance items is capitalized or immediately deducted:a. Replacing an unbroken regular window in the storefront with a

stained-glass window;b. Replacing a broken regular window with a regular window;c. Replacing a broken regular window with a stained-glass window;d. Painting the store;e. Cleaning a canopy;f. Changing a lock;

200

Question 2(g)-(l), pages 84-85

• Consider whether the cost of the following maintenance items is capitalized or immediately deducted:g. Replacing two worn shingles on the roof;h. Replacing all shingles on the roof;i. As a plan of rehabilitation, replacing a broken window, painting

the store, cleaning the canopy, changing a lock, and replacing two worn shingles on the roof;

j. Modifying an entrance way because the street level is raised;k. Adding a sprinkler system required under the fire code; orl. Replacing all asbestos ceiling tiles in the building, where the tiles

are deteriorating.

201

Questions 3 and 4, page 85

• Sarah's building also requires fire insurance. She can prepay premiums on either a six-month or three-year policy. In either case, are the prepayments capitalized or immediately deducted?

• A bar is considering two advertising options. It can purchase uniforms for a local softball team or it can buy a scoreboard at the local softball field. How should the cost of each acquisition be treated for tax purposes?

202

“Ordinary and necessary” expense

• Under § 162(a), an expense may be deducted if –– It is an “ordinary and necessary” expense– Paid or incurred during the taxable year in carrying on

the taxpayer’s trade or business.• If the expense is one that a typical business person

would incur, it should meet this test.• Often (but not always), these expenses recur from

year to year.• A non-recurring expense may satisfy this test if it

is incurred because of a risk that a reasonable business person would accept or anticipate.

203

“Public policy” exception

Under § 162, no deduction is allowed for –– An illegal bribe, illegal kickback, or other

illegal payment (§ 162(c));– A fine or penalty paid to a government for a

violation of the law (§ 162(f)); or– Treble damages under the anti-trust laws

(§ 162(g)).

204

Personal deductions

Generally, personal losses and expenses are not deductible, although an individual can either take the standard deduction or itemize deductions. Itemized deductions include deductions for –– Extraordinary medical expenses

– Mortgage interest deduction

– State and local income taxes (and sometimes sales taxes)

– State and local property taxes

– Charitable contributions

205

Education expenses

• Generally, no deduction is allowed for costs to meet minimum educational requirements to qualify for employment in a new trade or business. § 1.162-5(b).

• The taxpayer may deduct costs to maintain or improve skill in an ongoing business (e.g., continuing legal education). See§ 1.162-5(a).

206

Special credits and deductions

• A taxpayer may qualify for special tax credits or deductions for an academic period if –– The taxpayer or his or her spouse or dependent pays “qualified

tuition” (i.e., tuition to an “eligible” educational institution like UT); and

– The student (an “eligible student”) takes at least one-half of the “normal” full-time work load for a full-time student for the academic period.

• The taxpayer cannot be allowed as a dependent on another individual’s (e.g., parent’s) return.

• To be eligible for the credit, a married taxpayer must file a joint return.

• See generally § 25A.

207

Credits

• For the first two years of post-secondary education, the taxpayer may be eligible to take the Hope Scholarship Credit equal to –– 100% of qualified tuition up to $1,000, plus– 50% of qualified tuition between $1,000 and

$2,000.

• The Lifetime Learning Credit equals 20% of qualified tuition up to $10,000.

208

Credits (cont’d)

• Generally, the tuition taken into account is the tuition paid for schooling during that year, reduced by any tuition payment funded with excluded scholarships.

• However, tuition prepaid during a year is taken into account in the payment year if paid for an academic period that begins during the first three months of the next year.

• These credits are phased out for taxpayers with “modified” adjusted gross income between $40,000 and $50,000 (or double those amounts if the taxpayer is married and files a joint return).

209

Section 222

• An individual can deduct up to $4,000 of qualified tuition for a taxable year if –– But for the income limits, the individual would qualify for either

§ 25A credit, and– The individual does not take either credit.

• The taxpayer can take this deduction without itemizing.• The deduction equals is limited to $2,000 if the taxpayer

has adjusted gross income between $65,000 and $80,000 (or double those amounts if the taxpayer is married and files a joint return). If the taxpayer has greater adjusted gross income, he or she can take no deduction under this section.

• This deduction is not available for taxable years beginning after December 31, 2013.

210

Interest on education loans

• Under § 221, an individual can deduct up to $2,500 of interest paid –– On a loan incurred to pay or refinance expenses

attributable to post-secondary education;– For the individual or his or her spouse or dependent.

• The student must be an “eligible student.”• The taxpayer cannot be allowed as a dependent on

another individual’s return and, if married, must file a joint return.

• The deduction is phased out for higher-income taxpayers.

211

Deduction for losses

• Under § 165(a), a taxpayer can deduct a business or investment loss sustained during the taxable year and not compensated by insurance or otherwise.

• Note that the deduction is limited to the taxpayer’s basis in the asset.

212

Deductions for individuals

An individual can deduct only –– Losses incurred in a trade or business;– Losses incurred in a transaction entered into for

profit; or– Losses arising “from fire, storm, shipwreck, or

other casualty, or from theft.”

§ 165(c).

213

Casualty losses

• A casualty loss on personal-use property cannot exceed the smaller of –– The adjusted basis of the property for determining loss;

or– The difference between the fair market value of the

property immediately before and after the casualty.

• Note that if property is converted from personal use to business use, its basis to determine loss is limited to its value when converted. See § 1.165-9(b).

214

Casualty losses (cont’d)

• A casualty loss must be sudden, not willful on the part of the owner of the damaged property, and not expected (i.e., not an “ordinary” risk of ownership of the property).

• An individual’s deduction of casualty losses is limited under § 165(h).– He or she can deduct casualty losses up to casualty gains for a

year.– He or she can deduct any excess casualty losses only to the extent

they exceed 10% of his or her adjusted gross income.– For these purposes, each casualty loss is taken into account only to

the extent it exceeds $100.

215

Travel and entertainment expenses

• If an individual’s travel and entertainment (“T&E”) expenses have a “sufficient” business connection –– The individual can deduct the amount of those

expenses he or she pays (assuming they do not have to be capitalized).

– The individual excludes the economic benefit of the T&E from his or her gross income if the T&E expenses are paid by the individual’s employer or client.

216

Section 274

• Section 274 applies to entertainment expenses. An entertainment expenses may be disallowed under § 274 even though it would otherwise be allowed under § 162.

• Thus, for this type of expense, you ask –– Is it allowed under § 162?– Is it disallowed under § 274?

• If the expense is allowed under § 162, not capitalized, and not disallowed under § 274, it is deductible.

217

Substantiation

Entertainment expenses often must be substantiated, meaning that the taxpayer must document –– The amount of the expense;– Its business purpose;– The time and place for the entertainment; and– Where relevant, the business relationship with the

person being entertained.

This documentation must be made when the expense is incurred.

218

Expenses disallowed under § 274

The deduction of certain expenses is strictly disallowed under § 274, including for –– Country club dues (§ 274(a)(3));– Total business gifts to a person to the extent in excess of $25

annually (§ 274(b)(1));– Most cruises (§ 274(m)(1));– Amounts paid to a spouse, dependent, or other individual

accompanying the taxpayer on business travel, unless –• That person is the taxpayer’s employee;• That person’s travel is for a bona fide business purpose; and• That person could otherwise deduct the travel expenses;

§ 274(m)(3);– 50% of meal and entertainment expenses (with several exceptions)

(§ 274(n)).

219

Goodwill

• Goodwill is the expectation of continued patronage.

• Entertainment costs to produce customer goodwill are not deductible.

• See § 1.274-2(c)(3)(i) (providing that a deduction for an expenditure is disallowed under § 274 unless the taxpayer made the expenditure with “more than a general expectation” of deriving income at “some indefinite future time”).

220

Assignment of income doctrine

• A person generally cannot shift income from personal services by gift, whether the income relates to future or past services.– However, gifts of services in kind generally do not

result in income to the service provider.– Further, gifts of self-created assets may shift income

from the donor to the donee.• Gifts of income rights (unless co-extensive with

all of the donor’s rights in the property) will not shift income to the donee if the donor retains a remainder interest in the property.

221

Related issues

• Gifts of appreciated property generally shift gain to the donee.

• Special rules apply to married or recently divorced individuals.– Generally on a transfer of property between these

individuals, the transferor recognizes no gain or loss and the transferee takes the transferor’s basis in the property. See § 1041.

– Alimony, however, is deductible by the payor and included in the gross income of the payee.

– Child support is neither deductible by the payor nor included in the gross income of the payee.

222

Property settlement

If one person transfers property to another person and § 1041 applies to the transfer --– Neither the transferor nor transferee recognizes

gain or loss on the transfer; and– The transferee takes the transferor's basis in the

transferred property.

§ 1041(a) and (b).

223

Section 1041

• Section 1041 applies to any transfer of property between spouses or between former spouses incident to a divorce.

• A transfer is incident to a divorce if --– It occurs not more than one year after the

cessation of marriage; or– It is related to the cessation of marriage.

§ 1041(c) and § 1.1041-1T(b), A-6.

224

Transfers related to the cessation of marriage

• A transfer is related to the cessation of marriage if it occurs not more than six years after the marriage ceases and is pursuant to a divorce or separation instrument (including an amended instrument).

• Any other transfer is not related to the cessation of marriage, unless it is shown that the transfer was made to effect a division of property between the former spouses.

• See § 1.1041-1T(b), A-7.

225

Problem 1

Ricky Lucy

Guitar

$80

Ricky and Lucy are husband and wife. Ricky owns a guitarwith a $50 adjusted basis that he sells to Lucy for $80.

What are the federal income tax consequences of the sale toRicky and Lucy?

226

Problem 2

Durwood Samanatha

Car

Golf club

Durwood and Samantha are husband and wife. Durwood owns a car with a $5,000 basis and $4,000 value. Samantha owns apitching wedge with a $20 basis and $4,000 value. They swapthese assets.

What are the federal income tax consequences of the sale toDurwood and Samantha?

227

Problems – page 296 BSS

• Henry and Wilma jointly own a home with a $100,000 basis.

• They divorce, and Henry will take care of their children, staying in the home for five years. After five years, the house will be sold, assume for $400,000.

• How should Henry and Wilma deal with the home? Consider the following two options:– Under the divorce decree, Henry would take title to the home

and transfer a $200,000 promissory note to Wilma.– Under the divorce decree, Henry would take possession of the

home, Henry and Wilma would retain joint ownership of the home, and they would split the $400,000 sales proceeds when the home is sold in five years.

228

Planning problem

• Mary and Fred divorce in March of 2012.• In January 2013, Mary plans to sell IBM stock

with a $0 basis for $10,000, resulting in a $10,000 gain.– Because she pays tax at a 40% rate, she would incur a

$4,000 tax (40% of $10,000), netting $6,000.

• Fred pays tax at a 20% rate. What happens if Mary sells the stock to Fred for $7,000, and then Fred sells the stock for $10,000?

229

Alimony

If one spouse pays alimony to another --– The payor has a deduction in computing his or

her adjusted gross income; and– The payee must include the alimony in gross

income.

§§ 71 and 215 (providing, respectively, for income and deduction). See also § 62(a)(10) (providing that alimony is deductible in computing adjusted gross income).

230

Support

• In contrast, payments for or on behalf of children (i.e., child support) are not deductible by the payor or included in the gross income of the children or payee parent.

• Section 71 defines alimony. A property transfer that is not alimony may be child support, a marital property settlement, or something else.

231

Characteristics of alimony

Alimony payments have the following six characteristics:– They must be cash paid to (or on behalf of) the

spouse or former spouse. § 71(b)(1).– They must be made pursuant to a separation or

divorce decree, a decree of temporary support, or a written separation or divorce agreement. § 71(b)(1)(A) and (2). Thus, they must made be pursuant to a written instrument.

232

Characteristics of alimony (cont'd)

– The payee and payor cannot be members of the same household or (if merely separated) file joint returns. § 71(b)(1)(C) and (e).

– There must be no liability to continue the payment (or to make a substitute payment) after the non-paying spouse's death. § 71(b)(1)(D).

– The instrument requiring payment cannot designate the payment as a non-deductible, non-includible payment. § 71(b)(1)(B).

233

Characteristics of alimony (cont'd)

– The payment cannot be for the support of the payor's children. § 71(c)(1).

• To the extent a payment may be reduced because of a contingency related to such a child (e.g., the child's reaching age 18, going to college, marrying, death, and so on), the amount of the possible reduction is treated as child support. § 71(c)(2).

• As an incentive for the payor to make child support payments, payments made under an agreement or decree are first allocated to child support. § 71(c)(3).

234

Long- and short-term capital gain and loss

• Capital gain or loss can be long- or short-term.

• Long-term capital gain or loss includes gain or loss from the sale or exchange of a capital asset held for more than one year.

• If capital gain or loss is not long-term, it is short-term.

235

Capital gain or loss

• Net long-term capital gain is taxed at preferential rates for individuals, while net short-term capital gain is taxed at the same rates as ordinary income.

• Short- and long-term capital loss can offset capital gain without limitation, but can offset only up to $3,000 of an individual’s ordinary income.

236

Comparison of ordinary and capital amounts

Long-termcapital gain

Ordinary loss

CapitalLoss

Ordinary income;Short-term capital gain

Good

Good

Bad

Bad

237

Netting of capital gain and loss

• The treatment of capital gain or loss depends on the net amounts of short- and long-term capital gain or loss.

• That treatment can be determined under the following five steps:

238

Step 1 -- Net short- and long-term amounts

Calculate the net amount of long-term and short-term capital gain or loss as follows:– Short-term capital gain (“STCG”) and short-

term capital loss (“STCL”) are netted.– Long-term capital gain (“LTCG”) and long-

term capital loss (LTCL”) are netted.

239

Step 2 -- Net gains in both categories

If there are net gains in both categories, for an individual, the net short-term capital gain is taxed at ordinary-income rates, and the net long-term capital gain is taxed at a rate no greater than 28 percent.

240

Step 3 -- Net losses in both categories

• If there are net losses in both categories, the losses can offset up to $3,000 of an individual’s ordinary income. § 1211(b).

• The net short-term capital loss is used first and then the net long-term capital loss. § 1211(b)(2).

• Any unused net short-term or long-term capital loss is treated as STCL or LTCL, respectively, that arises in the succeeding year. § 1212(b)(1).

241

Step 4 -- Net gain in one category and net loss in the other

• If there is a net gain in one category and a net loss in the other, the net loss will first offset the net gain.– If an individual’s net long-term capital gain exceeds

net short-term capital loss, the excess net long-term capital gain is taxed at preferential rates under § 1(h).

– If net short-term capital gain exceeds net long-term capital loss, the excess net short-term capital gain is taxed at ordinary-income rates.

242

Step 4 -- Net gain in one category and net loss in the other (cont’d)

– If net short-term capital loss exceeds net long-term capital gain (or if net long-term capital loss exceeds not short-term capital gain), the net loss may offset an individual’s ordinary income up to $3,000.

– Any excess is treated as STCL (or LTCL) that arises in the next year.

243

Step 5 -- excess ordinary deductions

• Ordinary deductions first offset ordinary income.• Any excess ordinary deductions offset any net

capital gain amounts (determined after the netting described in the previous four steps)

• Net ordinary deductions will offset any net short-term capital gain before offsetting any net long-term capital gain.

244

Netting

LTCG

LTCL

STCG

STCL

Net long-term capital gain or loss

Net short-term capitalgain or loss

245

Netting (cont’d)

Net LTCG

Net STCL

Net STCG

Net LTCL

Net long-term capital gain or net short-term capital loss

Net short-term capital gain or net long-term capital loss

246

Capital gain or loss

• Capital gain or loss results from the (i) the sale or exchange (ii) of a capital asset.

• Long-term capital gain or loss may also result from the disposition of § 1231 property.

247

Capital assets

Capital assets include all property except assets described in § 1221(a)(1)-(8). The most important exceptions are for --– Stock in trade, inventory, or property held primarily for

sale in the taxpayer’s trade or business (§ 1221(a)(1));– Real and depreciable property used in the taxpayer’s trade

or business (§ 1221(a)(2));– Self-created copyrights, letters, memoranda, musical or

artistic compositions, and the like (§ 1221(a)(3));– Accounts receivable for goods (or services) sold (or

rendered) in the ordinary course of business (§ 1221(a)(4)); and

– Other property regularly used or consumed by the taxpayer in a trade or business (§ 1221(a)(8)).

248

Section 1231

• Section 1231 establishes a special category of gain and loss.

• If a taxpayer's § 1231 gains for a year exceed his or her § 1231 losses, those gains and losses are all treated as long-term capital gains and losses. Then, overall, the taxpayer recognizes a net long-term capital gain.

249

Section 1231 (cont'd)

• If, however, the taxpayer's § 1231 losses for a year equal or exceed his or her § 1231 gains, those gains and losses are all ordinary. Then, overall, the taxpayer has a net ordinary loss (or no net gain or loss).

• Thus, § 1231 offers the best of both worlds -- net long-term capital gain or net ordinary loss.

250

Applying § 1231

To apply § 1231, you may do the following:– Identify the assets subject to § 1231 (the "§ 1231

assets");– Calculate the portion of any recognized gain or

loss on these assets that is § 1231 gain or loss; and

– Net these § 1231 amounts for the taxable year.

251

Section 1231 assets

Section 1231 assets generally include --– Real or depreciable property used in a trade or business, held

for more than one year, but not described in § 1221(a)(1), (3), or (5);

– Rights in timber, coal, and iron ore held for more than one year;

– Cattle and horses held for 24 months or more and other livestock (except poultry) held for 12 months or more; and

– Unharvested crops on land used in a trade or business and held for more than one year.

§ 1231(b).

252

Section 1231 assets (cont'd)

• For limited purposes, § 1231 assets also include capital assets held for more than one year and used in connection with a trade or business or a transaction entered into for profit. § 1231(a)(3).

• For convenience, I call these assets the "special" § 1231 assets and the § 1231 assets described on the previous slide the "general" § 1231 assets.

253

Section 1231 gains and losses

• With two exceptions, § 1231 gains and losses include --– All gains and losses recognized on the sale or

exchange of any general § 1231 assets; and– All gains and losses recognized on the

involuntary or compulsory conversion of any general or special § 1231 assets.

254

Involuntary and compulsory conversions

• An asset is involuntarily converted if it is destroyed (or damaged) by fire, storm, shipwreck, or other casualty or lost through theft. See § 1231(a)(4)(B) and (C).

• An asset is compulsorily converted if it is taken through eminent domain.

255

First exception -- recapture gain

• Section 1231 gains exclude any gain treated as recapture gain under § 1245 and certain other sections of the Code.

• Broadly under § 1245, gain recognized on depreciable personal property is "recaptured" as ordinary income to the extent the tax depreciation taken on the property exceeded any economic decline in the property's value.

256

Second exception -- involuntary conversions

• Section 1231 applies to any gain or loss recognized on the involuntary conversion of general or special § 1231 property only if --– the aggregate conversion gain equals or exceeds – the aggregate conversion loss.

§ 1231(b)(4)(C).• If § 1231 does not apply to this gain or loss, it is all

ordinary income or loss.

257

Netting § 1231 gains and losses

Once a taxpayer computes his or her § 1231 gains and losses for a year, the taxpayer nets them.– If he or she has a net gain, the § 1231 gains and

losses are long-term capital gains and losses.– Otherwise, the § 1231 gains and losses are

ordinary income and loss.

258

Example 1

• Mary uses land and a building in her trade or business and has owned the assets for more than one year.

• She has $50,000 and $35,000 bases in the land and building, and she sells them for $40,000 and $60,000.

• Assume that none of her gain is § 1245 recapture gain and that she has no other potential § 1231 gain or loss for that year.

• How does § 1231 apply to Mary?

259

Example 2

• Mary uses land and a building in her trade or business and has owned the assets for more than one year.

• She has $50,000 and $55,000 bases in the land and building, and she sells them for $40,000 and $60,000.

• Assume that none of her gain is § 1245 recapture gain and that she has no other potential § 1231 gain or loss for that year.

• How does § 1231 apply to Mary?

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