introduction: chapter 1: pp 1-20 - phi alpha delta...

FED TAX OUTLINEI. INTRODUCTION TO FEDERAL INCOME TAX.....................................................................1

II. GROSS INCOME...........................................................................................................................2

III. EFFECT OF AN OBLIGATION TO REPAY LOANS AND PREPAYMENTS..............3

IV. GAINS FROM DEALINGS IN PROPERTY...........................................................................3

V. GIFTS...............................................................................................................................................3

VI. DISCHARGE OF INDEBTEDNESS........................................................................................3

VII. FRINGE BENEFITS...................................................................................................................3

VIII. BUSINESS & PROFIT-SEEKING EXPENSES......................................................................3

IX. CAPITAL EXPENDITURES.....................................................................................................3

X. DEPRECIATION............................................................................................................................3

XI. TRAVEL EXPENSES.................................................................................................................3

XII. INTEREST DEDUCTION.........................................................................................................3

XIII. CASH-METHOD ACCOUNTING...........................................................................................3

XIV. ACCRUAL METHOD ACCOUNTING...............................................................................3

XV. ANNUAL ACCOUNTING.........................................................................................................3

XVI. CAPITAL GAINS...................................................................................................................3

XVII. QUASI-CAPITAL ASSETS...................................................................................................3

XVIII. RECAPTURE OF DEPRECIATION--§1245.......................................................................3

XIX. ASSIGNMENT OF INCOME................................................................................................3

XX. TAX CONSEQUENCES OF DIVORCE..................................................................................3

XXI. LIKE-KIND EXCHANGES...................................................................................................3

I. INTRODUCTION TO FEDERAL INCOME TAX (chap 1, pp1-20)

a. PROCEDURE to go thru when analyzing INCOME QUESTION:

a. Is it income? Will be included unless you can think of an exclusionb. If income, what is it’s characterization? Ordinary income or capital gains?

The money will be taxed differently depending on its characterization.c. If not income, then may it be deducted? Must be able to find a specific

deduction section

b. TAX FORMULA: ([Gross Income - §62 Deductions= AGI] - § 63 Deductions) = Taxable Income apply rates to taxable income the result is someone’s tax

c. INCLUSIONS:

a. § 71 ff: things that are explicitly included. This was basically passed to clarify questions that people had.

of 77

FED TAX OUTLINEb. § 101 ff: things that are explicitly excludedc. Income is something that comes in that makes me better off. It is income unless I

can find statutory, judicial, or common law exclusion. If you can’t think of reason that it’s excluded, then it will be included in someone’s income. Err on the side of inclusion.

d. DEDUCTIONS:

a. § 151 ff: lists what is deductible.b. § 261 ff: lists what is not deductible.

II. GROSS INCOME (chap 2, pp21-46)

1. Theories of Income

a.Sources View (Eisner v. Macomber) NARROW DEFINITION OF INCOME

1. “Income may be defined as gain derived from capital, from labor, or from both combined.”

2. According to the Eisner definition, dividends are derived from capital.3. In Eisner v. Macomber, the Supreme Court said that “realization” was a

constitutional requirement and the Ms. Mac had not realized her gain.Her 150 shares of shares represent the same ownership as she did when she owned 100. The IRS tried to tax this. The S Ct agreed with her and said 2 things:

Income must be realized in order to be taxed. Ms. Mac did not realize her gain

b. Uses View (Glenshaw Glass) BROAD DEFINITION OF INCOME

Money received as part of punitive damages counts as gross income. All gains, except those specifically exempted, count as gross income.

The money here didn’t conform to Eisner’s definition. According to the GLENSHAW DEFINITION, punitive damages meet their three requirements: “Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” B&F, p. 35.

1. ACCESSIONS TO WEALTH2. CLEARLY REALIZED3. COMPLETE DOMINION: IPL case talks about this—whether

they are subject to constraints or can do anything they want with the money.

4. EXAMPLE: guy who finds barry bonds’ baseballs should be taxed on them according to IRS. This is Glenshaw Glass which was formerly Eisner rule. Glass says income is really broad.

c. Better Off

of 77

FED TAX OUTLINEOld Colony Trust v. Commissioner, Supreme Court , 1929 (p39)

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.

The form of payment is expressly declared to make no difference. It cannot be argued that the payment of the tax by the company was a gift. The payment for services, even though entirely voluntary, was nevertheless compensation within the statute. Therefore, the payment constituted income to the employee.

No exclusion applies therefore income. A payment by a 3rd party is income unless there is an express exclusion.

You’re BETTER OFF if someone pays your bills!—therefore, it should count as income.

Cesarini v. United States PIANO CASE

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.

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

Found money must be included in the year it’s found. Found goods will also be included in the year they are found, regardless of whether the gain from the goods was realized.

Compare to Pellar which wouldn’t tax bargain purchases 1) if IRS taxed every bargain purchase, the IRS would have to check up on everybody’s great bargains! 2) The money found in the piano was separate from the piano itself; whereas in Pellar, it was the house itself that was worth more than FMV.

2. Imputed Income: Property vs. Services

Imputed Income from Owning Propertya. 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.

of 77

FED TAX OUTLINEb. If you invest $100,000, paying you 10% or 10,000 a year, and you use

that money to rent a house for $10,000, you still have to pay taxes on your $10,000 gain from investment.

c. Hence, while the two people in the situations are economically equal, their tax positions are not.

d. This discrepancy in the tax code encourages home ownership.

Imputed Income from Performing Services for Oneselfa. 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. b. But, you can mow the lawn yourself, get an $8 value out of the lawn

mowing, without paying any taxes. c. Such activities are not taxed because the benefit is trivial. d. BUT, the value of full-time housewives is substantial.

e. Self-help is an example of where we don’t get taxed. Household services are one such example of a self-provided service that won’t be taxed. This gives people an incentive to do things for themselves rather than pay for things. This is a big tax incentive for one spouse to stay at home (usually women). FYI: Nancy Stout is a UB prof who writes on gender inequities evident in the tax code.

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

3. Bargain Purchases vs. Employee Compensation

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

Compensation for services is income

a. 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.

b. BUT, don’t misapply realization in connection with a compensator bargain purchase that constitutes gross income.

i. 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.

ii. 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.

Pellar v. Comm’r BARGAIN PURCHASES

Bargain purchases DO NOT count as Gross Income! of 77

FED TAX OUTLINE

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.

Holding: The Δ received more value than he paid for, but there was no obligation on the Δ to favor the construction company in the future. The company’s actions were more like lavish expenditures for presents or entertaining. 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 compensation/income.

Bargain vs. Compensation (employer/employee context): If an employer gives bargain to employee, then the above rule might not apply.

McCann v. United States COMPENSATION.

Trip to Las Vegas = Income b/c it was a form of compensation

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 a trip that is a reward for services rendered by the employee, the value of the reward must be regarded as income to the employee.

4. Bartering (Rev Rul 79-24)

a. 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. If a lawyer and house painter exchange their services with one another, each must include in income the FMV of the services he or she receives in payment. In other words, the lawyer is taxed as if she provided services, was paid in cash, then paid the painter with the cash. Likewise, for the painter.

b. Gift vs. Bartering in Family Context : The rule for bartering will be different in a family context

Marcella prepared will for brother and brother constructed a small greenhouse even though she expected nothing in return?

This is in the context of a family relationship—so the greenhouse looks more like a gift. There was no quid pro quo b/c she didn’t expect the greenhouse. She couldn’t sue the bro for no greenhouse b/c there was no K.

of 77

FED TAX OUTLINE On the other hand, if this was on-going, it begins to look like bartering. Compare to Rev Ruling 79-24 re: bartering. Two clear rules

a. Economic exchange is taxableb. A gift is not taxable

This case looks like both and decide what it looks more like.

5. Compensation vs. Gift in Employment Context

a) $300 Opera tickets from satisfied client?

Yes , if you consider this a tip. A tip is included as compensation. No , if you consider this a gift (§102). This can be distinguished from a tip by

arguing that opera tickets are not expected, whereas tips are expected. Tips received by waiters are income. But this is different b/c it’s not EXPECTED in the same way a waitor’s tip is. It’s generosity that doesn’t expect anything in return (detached and disinterested generosity).

She’ll have to work hard to exclude this b/c it’s in the context of a compensated relationship. But, it’s not necessarily income under these circumstances. If Marcella’s firm gave her opera tickets, then it would be a whole different story.

THIS IS A GREY AREA. If we got it on the exam, say: this looks like a tip; but it’s different from a tip in important ways (e.g. expectations). Whether something is business or personal is one of the biggest grey areas in tax law (e.g. firm benefits).

As long as it’s not INTENDED as compensation, then it’s not!

b) 2 round-trip business class airline tickets to Italy w/frequent flyer miles?

If all the frequent flyer miles were from personal flying, then it wouldn’t be income. Similarly, if you get an 11th cup of starbucks coffee free, then it’s not an extra—it’s just a pricing policy.

Frequent flyer miles for personal use are just a pricing policy—and you paid taxes on the flights that got you and extra flight.

But if you get FFM from work flights, you never paid for the initial flights. You are getting a flight for free.

The IRS doesn’t have clear guidelines for this issue. So this won’t be taxed—but only b/c the IRS has been lazy—not b/c business FFM aren’t conceptually income—b/c they should be considered income.

6. Compensation vs. Bargain Purchase in Employment Context

An antique oak desk and chair she purchased from firm?

Is this compensation or a bargain purchase?a. If compensation, then it is taxable (apply TR 1.61-2(d)(2)).

i. If the firm was wiling to sell it to someone else, then it IS compensation.

b. If bargain purchase, then it’s not taxable (see Pellar). of 77

FED TAX OUTLINEi. Because it’s in the firm’s benefit, then it’s NOT compensation

and therefore not taxable.ii. If both sides know the value, then it won’t be considered a

bargain value.

7. Compensation vs. Deductible Trip

a) A retreat in February at a popular SKI RESORT paid by the firm worth $2,500?

We would need to know more. §119 (food and lodging provision): it will be excluded—we wont even try to

value it. This is different from McCann b/c the trip was NOT mandatory. This

suggests that it is compensation. If the trip here is mandatory, that suggests that it’s not intended as

compensation. There is a valuation problem b/c if Marcella had an extra $2,500, she might not spend it on a ski resort.

a. Is everything excludable though? The ski lift expenses might not be excludable as income (although transportation, meals, and lodging won’t be included as income).

The issue of business vs. personal expenses are relevant to inclusion and exclusion. EXAMPLE: lawyer who gets shipped to the ski resort. She, as opposed to the claimant in Mann, does not have to include this trip because the trip is for the convenience of the employer. It’s not compensation (under sources view).

b) Two Competing Theories of Income:

1. Sources View (EISNER NARROW DEFINITION) :

a. For the Convenience of the Employer: something in furtherance of a business purpose should not be included in income.

b. The idea of compensation is based on the sources view b/c it is derived from labor.

c. Ski Trip ≠ Income: Under this view, the ski trip is NOT income b/c it is not gain derived from labor, capital or the combination of both.

d. §119: you can exclude employer-provided food and logic.e. Caselaw:

i. The guy who has to stay at hotel for his job ≠ incomeii. Gotcher Case (Chap 11): VW dealer’s trip to Germany ≠

income2. Uses View (GOTCHER BROAD DEFINTION) :

a. If I receive something that makes me better off, it’s included unless I can think of a reason to exclude it. Under this view, anything that you can’t find an exclusion for is income.

b. The tax code has been moving towards a uses view. But both theories can apply in some circumstances.

of 77

FED TAX OUTLINEc. Ski Trip = Income : It would be much harder to argue that the ski

resort was NOT income under the uses view.d. Fringe Benefit :

i. Under this theory, the ski trip might be a fringe benefit.ii. De Minimus Fringe

1. Access to baseball luxury boxes would be a de minimus fringe.

2. The firm provides sparkling water ≠ income. It’s not worth including this as income.

iii. Working Condition Fringe :1. Air conditioning in your office ≠ income

III. EFFECT OF AN OBLIGATION TO REPAY LOANS AND PREPAYMENTS: (chap 3)

Know the claim of right doctrine: include it as income when you get it—then worry about deducting it later. Embezzlement income is included in the year it’s received, then deducted when it’s paid back.

1. Loans

a. LOANS/DEPOSITS ≠ INCLUDED IN INCOME B/C OBLIGATION TO REPAY. No inclusion + no deduction.

b. PREPAYMENTS = INCLUDED IN INCOME B/C NO OBLIGATION TO REPAY

c. No inclusion and no deduction b/c it’s more administratively feasible.

d. LEASES & RENTALS : are very similar to a purchase with a loan.i. Tax treatment is better for rentals, even though the end result is the same as a

loan.ii. If you buy a car w/credit, you can’t depreciate. iii. If you lease a car, the leaser can depreciate it. iv. But the end is the same.v. “Tax Planning:” Renting or leasing instead of buying is an example of tax

planning—trying to get the best tax treatment. EXAMPLES: buying 2 packs of gum separately, renting/leasing instead of buying.

In arguing than a payment is a loan (and thus not taxable), a CONTRACTUAL OBLIGATION will substantially strengthen your claim!

2. Claim of Right (§1341)

a. Money received under a claim of right/contingent on repayment will be treated as taxable income. When the money is repaid, the taxpayer is entitled to a deduction.

b. A mere conduit for the flow of funds will not be taxed.

of 77

FED TAX OUTLINENorth American Oil (NAO) Consolidated v. Burnet

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.

NAO argues that they didn’t have a clear right to the $ in 1917! The Court doesn’t care—they say once you get the $, it’s included as income for tax purposes.

Loan vs. Claim of right: Loan you definitely have to pay back. Claim of right you may have to pay back.

1. Steve was overpaid 5,000 in royalties in Dec. and paid it back in Feb.

a. This is like NAO.b. He has a legal right to 20,000 but ended up getting 25,000.c. 25,000 will be considered income for the first year. Then he can deduct 5,000

the next year. Steve will get to deduct 5,000 in the next year under §165 as a loss. Section 165 says when he can take a deduction. Then, we would go to 62 and 63 to find out where he gets to deduct. § 67(b)(9) allows you to take your deduction under 1341—then, you would go to §63. 1341 would only come into play if a big loss was involved.

2. Steve knew in Dec that he was overpaid. He cashed the check anyway and returned the 5,000 the following year.

a. He includes the 5,000 in the earlier year and will deduct it the next year.b. He doesn’t have a claim of right to the $ and he didn’t pay it back. 1341 won’t

apply b/c Steve never received the money as a claim of right. c. He has a legal obligation to repay, not a consensual obligation b/c the publishing

company doesn’t see this as a loan—they just made a mistake.

3. Illegal Income

1. Repayment of illegal income entitles the taxpayer to a deduction when paid back.

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.

3. James v. United States Rule: Embezzled funds constitute gross income.

a. Argument against inclusion of embezzled funds : there is an obligation to repay—just like a loan!

b. Argument for inclusion of embezzled funds : embezzlement is different from extortion b/c embezzlers have NO contractual obligation to repay. In order for something to be considered a loan, there must be a contractual obligation to repay.

4. Deposits of 77

FED TAX OUTLINE

a. Rent paid in advance constitutes gross income. b. Whether security and other such deposits constitute income is unclear.

Commissioner v. Indianapolis Power & Light Company FOCUS HERE IS ON FORM, NOT SUBSTANCE. IPL CASE CARES ABOUT LEGAL RELATIONSHIPS B/W PARTIES

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.

DEPOSIT = INCOME ONLY IF PARTICULAR K RIGHTS ARE IMPLICATED

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 deposits do not constitute income just because IPL derived some economic benefit from them.

Loans & Deposits vs. Prepayment/ Advance Payment

Not included as income Included as income

This case emphasizes that you have to look at the legal rights at the time of the transfer. This court really looks at form; they emphasize the legal relationships, rather than economics!

5. Loan vs. Prepayment Look at the INTENT of the parties and CONTROL exercised over $

25,000 in loan, but Steve can keep it if he delivers a publishable manuscript. He must repay it if he doesn’t deliver the manuscript.

Steve would want this to be a loan b/c he wouldn’t have to pay taxes until later on. Loans are better than prepayments because there is no inclusion! You can defer the taxes you will pay until a later year.

a. This is either a loan or a prepayment. In either case, there is potential for pay-back. These are really similar. The contingent character of the $ is relevant to both a loan and a pay-back.

b. Wooten thinks this looks more like an advance payment than a loan. Therefore, he should include the $. But, whether something is a loan or a prepayment will depend on the INTENT of the parties. But, here we can’t really discover intent.

c. Two arguments :

of 77

FED TAX OUTLINEi. Control: If it’s a loan, there is a presupposition that you have to pay it

back. But, with this, Steve has control over whether he will have to pay it. If he produces a manuscript, he knows he has to pay it back.

ii. Also, you can argue that this is a voluntary claim of right (p54).

d. IF LOAN…i. Year 1: no inclusion

ii. Year 2: two options1. If manuscript is on time, loan is forgiven, $ included (61(a)(12));

no deduction 2. If not on time, must repay the $; no deduction b/c there was no

inclusion.iii. $0- $0 = $0

e. IF PREPAYMENT…i. Year 1: inclusion

ii. Year 2: two options1. If manuscript is delivered on time, he keeps the money2. If not on time, must repay the money, then gets to deduct the $.

iii. $25,000- $25,000 = $0

f. The tax code balances out on this! The end result is $0 either way.

6. Deposit vs. Advance Payment Look at FORM/legal rights vs. substance

Kevin rents to students and requires security deposit in the amount of the last month’s rent. The lease states that the deposit will be used 1) to compensate for damages OR 2) to cover unpaid rent. If neither applies, Kevin will return the deposit to the tenant. Kevin neither maintains a separate account for nor pays interest on the deposits. When a tenant damages property, Kevin bills the tenant for the full amount w/out deducting the deposit. Typically, tenants either ask that the deposit be applied to the last month’s rent or simply fail to pay the last month’s rent. It is rare that Kevin returns a deposit to a tenant. How would you advise Kevin treat the deposits for tax purposes?

Two arguments:

a. This is INCOME/ADVANCE PAYMENT and NOT A DEPOSIT:

i. Differences b/w this and IPL (this looks more an advance payment):1. In IPL, 40% of the deposits were refunded. Kevin refunds fewer

deposits.2. IPL paid 3% interest—but the court doesn’t look at this.3. In IPL, only 5% of consumers had to pay a deposit. Here, all

tenants must pay a deposit.

b. This is a DEPOSIT/LOAN:i. On the other hand, the lease constitutes a contractual obligation on the

part of the tenant. Kevin is not realizing any gain from the deposits—they never make him better off. In this sense, the deposits should be

of 77

FED TAX OUTLINEtreated as a loan. They shouldn’t be included as income nor should they be deducted.

1. Control : In IPL, the court places emphasis on control. Whether the $ is a deposit will depend on who gets to decide on what happens to the $. If the tenant decides, then it looks more like a deposit than an advance payment.

2. Form : what are the legal rights here? The court in IPL emphasizes legal rights. Here, what Kevin “usually” does says nothing about what the tenant’s legal rights are.

a. No claim of right b/c the money legally belongs to the tenant. Kevin has no right to the money—he has a legal right to pay the money back in some form. In any case, the money is the tenant’s.

b. Use footnote n.9, p68 to argue for landlord. 3. FORM v. SUBSTANCE : But Duberstein is at the other extreme

of IPL: they focus on substance, while IPL focuses on the form. Given Supreme Court’s emphasis on form over function in IPL, then Kevin has a good argument that the $ is not income.

IV. GAINS FROM DEALINGS IN PROPERTY (chap 4)

1. Relevant Provisions

a. 61(a)(3): property gains = gross incomeb. 1001: computation of gain/lossc. 1011/1012: def of basis and adjusted basis

2. Basic Concepts :

a. Amount Realized: The gross amt of everything you receive

(1) When you receive $ and property, the amt realized is the sum of both.(2) Debt (or liability?) is treated like $ for both the buyer and the seller.

b. Basis: is typically cost, which means FMV under Phil.Park. Reason for basis is that T/P must recover investment tax-free in order to avoid double taxation.

c. Adjusted Basis: basis is adjusted to reflect additions to or deductions taken for the property. Basis must be increased to reflect improvements to property. Basis must be reduced in order to reflect depreciation deductions.

REMEMBER: basis WILL NOT be reduced in LAND or STOCK b/c they are not depreciable—neither will wear out

d. Gain = Amount Realized – Adjusted Basis

e. Tax Cost Basis:

of 77

FED TAX OUTLINEi. EXAMPLE: Tom receives car from employer in lieu of compensation.

Car is worth 5,000 so Tom’s basis will be 5,000. When he sells the car for 5,500, he will have to recognize a 500 gain.

ii. EXAMPLE: Jack provide legal svs worth 6,000K while Jill provides painting worth 4,500K. Jack is getting money for services. This is compensation. Thus, Jack includes 4,500; his basis is 4,500.

1. Even though he didn’t buy it, he had to pay 4,500 in tax. This is why it’s called tax basis. If he’s paid 4,500 for painting, his cost basis would be 4500 here.

3. Liabilities

a. Buyer: liabilities will be ADDED to your basis.b. Seller: recourse liabilities transferred to the buyer will be included in the amount

realized by the seller.

4. Loans :

a. Loan amounts will also be ADDED to your basis. Often, a loan amount will be the actual amount of your 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.

i. EXAMPLE: Maggie purchased a summer home for $200,000 with $50,000 of her own funds and $150,000 which was borrowed from a local bank. Maggie’s basis in the home is $200,000. Her basis will remain 200K even after she pays off the loan.

1. Interest paid on the loan, however, will NOT be included in basis. Yet, some interest payments will be deductible anyway (e.g. home mortgage interest is deductible).

ii. EXAMPLE: After reducing the mortgage to $125,000 Maggie refinances the property, borrows $50,000 from bank (increasing mortgage to $175,000). She used 40,000 to remodel summer home and 10,000 for new piano. Her adjusted basis in the home will be 240,000 while her basis in the piano will be 10,000.

5. Philadelphia Park Amusement Co : 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

6. Cash Payments vs. Bartering :

a. Transfers of services must be treated just like cash.

i. EXAMPLE: Claire/artist pays 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. 5,500 should be counted as gross

of 77

FED TAX OUTLINEincome when Liz receives the painting. Then must declare 4,500 as gain when she sells the painting

1. Liz will include 5,500 as income when she receives painting. She will recognize 4,500 gain when she sells painting.

2. Liz’s basis in the painting is 5,500—it’s FMV.

3. Claire spent $100 on materials. Therefore, her basis is $100. Her amount realized is 5,500—the FMV of painting.

7. Important Concepts :

a. Realization vs. recognitioni. Recognition: recognizing the gain means paying taxes on it

ii. Realization: must happen before recognition; but you can have realization w/out recognition. You’ve actually incurred a gain or loss.

b. Your basis will be the same as FMV of what you receive

c. Debt is treated like cash

V. GIFTS (chap 5, 87-109) REVIEW GIFT PROBLEMS—pp47-50 NOTES

1. Basic Concepts :

a. No deduction for donorb. No inclusion for donee

2. Relevant Provisions :

a. 102(a): excludes gifts must ask 1) what is a gift? 2) what is a bequest?b. 102(b): limitation on what may be considered giftsc. 1015(a): basis in giftsd. 1014(a): basis in bequestse. Part-sale/part-gift

3. The further a transfer is removed from the FAMILY CONTEXT, the more strained becomes the justification for a gift exclusion and the more likely the IRS will question whether the transfer really is a gift.

4. § 102(a): excludes gifts, as well as property acquired through bequest, devise or inheritance. Property we receive as a result of the generosity of a person either during his lifetime or at his death is excluded from income.

5. The threshold question is whether that which is received can be characterized as a bequest, devise or inheritance.

a. Under §102, the following factors are important to the determination of whether a transfer will constitute a gift:

of 77

FED TAX OUTLINEi. Motive of the donor is critical in characterizing receipts as gifts.

ii. Limitations apply:1. NO EMPLOYER EMPLOYEE GIFTS (102(c)(1))i. NO DEDUCTIONS FOR GIFTS over $25 (274(b))

1. Businesses making gifts are then faced with a choice:1. It can transfer property to an individual and

characterize the transfer as compensation and take a business deduction for it; OR

2. It can support the recipient’s characterization of the transfer as an excludable gift, thereby losing the right to claim a deduction.

6. Gifts vs. Compensation:

a. Judicial Limitations on the Exclusion of Gifts:

i. Duberstein test is a SUBJECTIVE test that focuses on the INTENT of the donor.

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 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.

The court held that this was not a gift because it was, in essence, to compensate Duberstein’s past services and to insure more help in the future. The mere absence of a legal or moral obligation to make a payment does not establish it as a gift. If the payment proceeds from an anticipated benefit of an economic nature, it is not a gift.

NOTE: The court is looking at the substance of the transfer, rather than the form (the characterization of the transfer as a gift). The court also looked at substance in Wolder.

The IRS promotes a blanket rule that won’t exclude gifts in the business context. The Court rejects this blanket rule by looking at the intent of the donor. They emphasize that this should be a subjective, mushy rule.

Two important aspects of this case:a. Detached and disinterested generosity is required to call

something a giftb. Trial court has great discretion b/c this is a subjective test.

The determination of whether something is a give will depend on findings of fact.

of 77

FED TAX OUTLINEREMEMBER the test in this case EXAM QUESTION of whether donations to Clinton’s legal fees is gift or not. Here is the process you would go through:1. Detached and disinterested generosity? No?2. If not a gift, then income for Clinton? YES3. Could he deduct it?

ii. Regular and expected tips are compensation and NOT gifts and are taxable (Olk).

iii. Regular cash payments given to minister through a structured program are compensation and NOT gifts and are taxable (Goodwin). The Court seems to focus on the fact that the payments were large, regular, and not made individually.

iv. BEQUEST/INHERITANCE: A transfer in the form of a bequest is NOT a gift if it is compensating someone for legal services performed while the donor was alive (Wolder). The Court here didn’t look at the form (i.e. that he received the $ in a will). Instead, the Court looked at the broader circumstances of the case (substance).

b. Statutory Limitations on the Exclusion of Gifts (§102(b))

i. Property is excluded from income if it is a gift, bequest, devise, or inheritance. But income from such property is NOT excluded and will be taxed. (102(a), (b)(2))

1. EXAMPLE: 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. The reasoning behind this rule is that without it, those living on income from inherited wealth would never pay tax.

2. 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. The grandchildren are, however, allowed to exclude the property they receive.

3. EXAMPLE(Irwin v. Gavit, 93)

a. $100K bond in grandfather’s will—issuer of bond pays 8% interest every yr for 10yrs (8K in interest). In the 10th year, the whole principal becomes due.

b. If grandfather lived, he’d be taxed on interest payments but not principal (b/c the principal is his basis—it is money that has already been taxed!)

of 77

FED TAX OUTLINEc. If you don’t tax the 8K, you’d be treating the ancestors

better than the grandfather.d. The property itself is transferred tax-free (102b), but the

income from the property is taxable to the recipient of the property.

e. bond is similar to land. If I buy land for 100K and rent for 8K, I get taxed on the rent but not the land.

f. In Irwin, the father was perceived to receive income from gain on property—not the property itself!

c. EXAMPLE: Bernadette purchased a lot for $20,000. 3 years later, the lot increased in value to $50,000. Bernadette was offered $50,000 for it but refused. The next year it was worth the same. Bernadette deeded the lot to her son, Rob, as a gift. What if Bernadette is a realtor and her son Rob is one of the sales agents she employs?

i. Under § 102(c), as Bernadette’s employee, Rob is NOT entitled to exclude the property as a gift. If employee/er context, Rob’s gain would be 50K (FMV of what he receives).

ii. BUT, there are lots of circumstances where family members are employed by other family members!!!! What matters here is the INTENT of B. Is she transferring the property as his mom or as his boss? SEE TR §1.102-1(2).

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

a. Transferred Basis Rule (§1015(a)):

i. Donee takes donor’s basis in order to determine gain.ii. Donee takes basis of FMV in order to determine loss.

iii. If donee sells for a price in b/w donor’s basis and FMV @ time of first transfer, then there will be no gain or loss.

iv. EXAMPLE:

Donor basis: 2KFMV @ time of gift: 1KDonee Sells 3,500

Donee has gain of 1,500

Donor basis: 2KFMV @ time of gift: 1KDonee Sells 500

Donee has loss of 500 of 77

FED TAX OUTLINE

Donor basis: 2KFMV @ time of gift: 1KDonee Sells 1200

No gain or loss

b. 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. If A/low income wanted to give a gift of $100 to B/high income, while making the loss deductible, he should sell the stock, claim a deduction, and give the money he realized to B. A will be able to take a deduction, but he just can’t shift that deduction to B.

c. Basis of Property Received by Bequest or Inheritance

i. STEPPED UP BASIS: § 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. The devisee or heir receiving the stepped-up basis can sell the property for its value as of the decedent’s death and not realize any taxable gain. 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. But, if the property decreased in value during the lifetime of the decedent, so that the decedent’s basis exceeded the value of the property, § 1014(a) negates the deductible loss.

iv. § 1014(a) applies to property acquired through joint tenancy, community property, and trusts, as well as those transferred by wills or intestacy laws.

v. Gain or loss on the property before death will disappear—it can’t be taxed.

vi. Better to bequest property that has gained in value. The heirs will then get the benefit of the stepped-up basis when the giver dies. This is an unfair rule—it allows lots of $ to escape income taxation.

of 77

FED TAX OUTLINE

8. Part-Gift, Part-Sale

a. The sale of property for less than fair market value is common between family members. Substantively, the transaction involves a sale in part and a gift in part.

b. 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. READ EXAMPLES, p1461 of regs.

i. EXAMPLE: Sally pays $5000 for a lot. She sells it to grandchild for $2,500. The lot is worth $10,000 at the time of sale. Amount realized by Sally is $2,500. She loses money on the deal. There is NO gain for Sally. Hence, the amount realized does not exceed her adjusted basis. She realizes no gain to be taxed and according to the Regulation, no loss to be deducted. This part gift, part sale merely allows Sally to break even for tax purposes!

ii. But, if Sally’s grandchild assumed Sally’s liability of $7,500 on the lot, Sally’s amount realized would be $7,500 and her basis would be $5,000. The gain would be $2,500 and this would be taxed.

iii. Under this regulation, assumption of loans or liabilities in lieu of cash is treated the same as cash.

c. 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.

i. A liability assumed by the donee is treated as an amount paid.

VI. DISCHARGE OF INDEBTEDNESS (chap 9, 157-74)

1. There are two main questions on this issue:

a. What is income from indebtedness of cancellation of debt (COD)?i. General Rule: when a debt you owe is cancelled, this constitutes income.

ii. Subsidiary Rule (IRC §108(e)(4)): relative paying your debt does not constitute income.

b. What are the exclusions?i. Insolvency

ii. Disputed debts

2. CENTRAL QUESTION: Does the forgiveness of all or part of the loan generate income? Sometimes. The history of the legislative, judicial and administrative treatment of the forgiveness of debt is rife with confusion and inconsistency.

3. The mere diminution of loss is NOT gain, profit or income (Kerbaugh)

of 77

FED TAX OUTLINEBUT…

4. “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. (Kirby). NOTE: Insolvency and bankruptcy are exceptions to this theory.

5. See Charts page 52:

a. There is taxable surplus to the extent that assets exceed liabilities.

b. Legal expenses paid by firm for client treated as loan. Therefore, not deductible.

6. Relevant Rules:

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

b. § 108: provides an exclusion from gross income when discharge of indebtedness occurs in certain limited circumstances, including bankruptcy or insolvency. 108 is an EXCEPTION TO RULE THAT DISCHARGE OF INDEBTEDNESS IS INCOME.

i. Problem with 108 is that the taxpayer’s basis in property is one tax attribute subject to reduction if he takes a 108 exclusion (§108(b)(2)(E)).

7. When can discharge of indebtedness be EXCLUDED from income?

a. Insolvency

i. Insolvent means the excess of liabilities over the fair market value of assets. YOU OWE MORE THAN YOU OWN (§108(d)(3)).

ii. No income arises from discharge of indebtedness if the debtor is insolvent both before and after the transaction. If the transaction leaves the debtor with assets whose value exceeds remaining liabilities, income is realized only to that extent (§108 replaced judicial exceptions)

DEBTS ASSETS DISCHARGE SOLVENT or INSOLVENT?

200K 100K 50K Insolvent still by $50

130K 100K 50K Solvent by $20

b. Bankruptcy

c. Disputed or Contested Debts

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

of 77

FED TAX OUTLINEii. Contested Liability Doctrine: The settlement of a debt fixes the amount

of the debt that is cognizable for tax purposes. In other words, the excess of the original debt over the amount determined to have been due may be disregarded in calculating gross income. IT DOESN’T MATTER WHAT THE PARTIES ORGINIALLY AGREED UPON—WHAT MATTERS IS WHAT THEY SETTLED FOR.

d. Discharge of Indebtedness as GIFTS or Compensation

i. Debt discharge that is only a medium for some other form of payment, such as a gift or salary, is treated as that form of payment rather than under the debt discharge rules. 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 (Rev Rul 84-176).

1. EXAMPLE: 108 will not apply if an employee owes employer $100 and renders $100 worth of services in return for cancellation of the debt. The employee has received personal services income rather than income from cancellation of indebtedness

ii. COMMERCIAL CONTEXT: It is doubtful that any T/P will be successful in arguing that the discharge of indebtedness in a commercial context constitutes an excludable gift.

iii. FAMILY CONTEXT: But, in certain contexts, the cancellation of indebtedness can be an excludable gift under § 102(a).

1. If debt forgiven as a gift, then debtor doesn’t have to include the discharge as income. Whether it’s a gift will depend on whether it passes Duberstein test.

iv. COMPENSATION vs. DISCHARGE: 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)—but may be considered another form of gain not excludable under 108.

8. Contingent/Potential Liabilities (Personally guaranteeing another person’s loan):

a. A taxpayer claiming to be insolvent for purposes of § 108 must show by a preponderance of evidence that he will have to pay an obligation claimed to be a liability and that the total amount of liabilities exceed the FMV of his assets (Merkel).

9. Purchase-Money Debt Reduction for Solvent Debtors

a. Reduction of purchase price ≠ Income from discharge of indebtedness. 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. No

of 77

Parents pay your discharge = Excludable as gift

Employers pays your discharge = Includable as compensation

FED TAX OUTLINEincome 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)).

i. EXAMPLE: This occurs when you receive services. Law firm sends bill for services. Client freaks out. Firm reduces bill. Client has no income because there was no loan; there was a bargaining of the price.

ii. EXAMPLE: Kevin contracted with Ashley to buy a building for $150,000 over the next 30 years. The building’s value decreased, so that when Kevin owed $130,000, its FMV was $115,000. To prevent Kevin from defaulting, Ashley agreed to reduce the balance owed to $115,000.

1. Purchase-money debt reduction (§ 108(e)(5)) – this is seen more as a reduction of purchase price, rather than as a discharge of debt. Therefore, it will not be included as income. The purchase price was decreased to 115,000.

2. Basis will be reduced accordingly to 115,000

3. Under 108(e)(5), a bank reduction in price would not be included as a purchase-money debt reduction because the bank is not the seller. § 108(e)(5) only applies when the seller and the lender are the same entity.

10. Acquisition of Indebtedness by Person RELATED to Debtor

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

i. EXAMPLE: D owns more than 50% XYZ and is therefore related to XYZ. XYZ issues bonds for par value. D then repurchases bonds on open market for less than par. Under 108(e)(4), XZY DOES have discharge of indebtedness income b/c Donna’s acquisition of the bonds is attributed to XYZ.

b. This rule prevents people from circumventing Kirby rule by having related party buy the debt rather than having debtor buy the debt.

11. Discharge of Deductible Debt: Forgiveness of a debt does not generate income if the payment of the debt would have been deductible (§108(e)(2)).

a. Why? if discharge of indebtedness income were to be imputed to the tenant, the tenant would be entitled to a deduction for the past due rent which would completely offset the discharge of indebtedness income.

b. EXAMPLE: An independent contractor reduced Kevin’s bill of 10,000 by 4,000. Had Kevin paid the full 10,000, he would have been entitled to a deduction in that amount. The discharge will NOT be included.

12. Sales of Property

of 77

FED TAX OUTLINEa. 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 (Reg. § 1.1001-2, Gehl)

i. EXAMPLE

A owes $10,000

A 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 = $6,000

Income from the discharge of indebtedness = $1,500 (7,500-6,000)

ii. EXAMPLE

Jim owes 100K to Bank but J owns lot

Basis in lot: 25K

FMV of lot: $70K

Bank takes land and forgives debt

Discharge of Indebtedness: $30K

Amt realized: $70K (FMV)

Gain: $45K (Amt realized 70 – Basis 25)

iii. EXAMPLE (see box below): 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 (BASIS) and its FMV was $60,000 when he gave it to Judy.

1. Bill’s discharge of indebtedness income is 15,000 (75,000 debt– 60,000 FMV of land).

2. Bill has income from the realization of his property. He used the land as money to satisfy $60,000 of his debt to Judy. His basis in that land was $20,000. Hence, he had $40,000 of income from the realization of his property (see Gehl)

BEFORE SALE AFTER SALE

Liabilities Assets Liabilities Assets

of 77

FED TAX OUTLINE75K 60K 50K 55K

50K 55K

TOTAL 125K

115K 50K 55K

Insolvent by 10K Insolvent by 5K

Therefore, there is 5K of taxable income

VII. FRINGE BENEFITS (chap 11, p197-223) (REVIEW PROBLEMS in this section)

Look at spring 2001 exam (prob 3, 4). Know these exclusions b/c they have been known to show up on exam.

Ask Yourself…

Include? Yes or No?If excluded, there are sections that allow you to completely exclude everything (105, 106)119: everything is excluded or included125132: there are specific provisions for what you can include and exclude.

If yes, how much?If included, the amount will be the FMV of the benefit (Reg. 1.61-2(d)).

1. Meals & Lodging (119)

a. Convenience of the Employer Doctrine : This doctrine requires that taxpayers establish that benefits accorded them as employees were grounded in business necessity and has been retained by § 119. 119 codified the convenience of the employer doctrine (the doctrine, however, is actually much broader than 119—which only excludes for meals and lodging).

i. Bengalia: 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. The Court here endorses a narrow sources view of income which focuses on why and where you’re getting the income from. Here, it’s not income b/c it’s not really compensation.

1. Bengalia is the basis for 119. See Regs on this issue too.

ii. Gotcher Rules:

of 77

FED TAX OUTLINE1. 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.

2. 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.

3. 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.

b. Under 119, meals and lodging given for convenience of employer may be excluded by the taxpayer only if…

i. The meals are furnished on business premises.

1. EXAMPLE: Common meal scenario: whether firefighters pitching in for a meal to eat at the hall can be considered a deduction or excludable

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

1. 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

c. § 119 was amended to exclude meals and lodging provided to spouse and dependents.

ASK YOURSELFWhat is meant by “business premises”?

What is meant by “condition of employment”?What is meant by “convenience of employer”?

EXAMPLE: Will is a university president. In addition to his salary, the university provides Will and his family with the use of a home near campus. The university bought the home to provide housing for its presidents.

a. In advising Will of the tax consequences, what information would you want from him and why?

i. Is living in the home mandatory?ii. Does Will have control over where he lives?

iii. Is Will on call at all times?iv. Could Will perform the functions of president without living

there (i.e. is it necessary for him to live there to perform his duties as president)?

of 77

FED TAX OUTLINEv. Whether this is on the premise of the university premise will

depend on how he uses it:1. Whether something is a “business premises” under

119(a)(1) is not necessarily a question of fact. If the President has to entertain alumni, etc. at his home, it may be considered a business premises. If you simply take work home, however, your home won’t be considered a business premises. The key here is that the President must entertain for business purposes.

2. If the house was on the UB campus, it would be clear that the house itself is a business premises.

3. EXAMPLE: University pays for Will’s summer cabin:

This fails 3 part test of 1.119-1:

a. Not on business premises of employerb. Not furnished for convenience of employerc. Employee not required to accept the lodging

d. Cash Payments for Food : in Kowalski, the Court concluded cash payments were not excludable under § 119’s convenience of the employer doctrine. However, supper money may have been excluded as a de minimus fringe benefit under §132(a)(4) if they were not regularly paid

2. Fringe Benefits (132 & Reg. 1.132-1)

Line of business requirement is for employee discount and no additional cost service!

a. No-Additional-Cost Service (§132(b)) :

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. Because there is essentially no cost incurred by allowing the employee to occupy an empty seat or room, Congress has excluded from income the entire value of such services.

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

ii. The service must be in the line of business for which the employee works. 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.

a. 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

iii. The employer cannot incur any substantial additional costs (including foregone revenue) by giving the employee this service.

of 77

FED TAX OUTLINEiv. Discrimination in favor of highly compensated employees is prohibited:

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.

v. 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.

b. The service is limited to “employees,” which may include:i. Retired or disabled employeesii. Spouse iii. Childreniv. Parent (air transportation only)

c. EXAMPLE: in Charley v. Commissioner, the Court noted that frequent flyer miles were not excluded under the “no-additional-cost” provision b/c the taxpayer’s company did not offer the miles for sale to customers. The Court held that either the travel credit arrangement represented 1) additional compensations OR 2) the taxpayer has simply sold his miles in which he had a zero basis. Either way, the travel credit was income.

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

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

ii. Discounts for Services:

1. 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

iii. Discounts on Property:

1. Limited to gross profit % 2. Gross Profit %: excess of aggregate sales price for the property

sold by the employer over the aggregate cost of such property to the employer divided by the aggregate sales price.

3. EXAMPLE: 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

of 77

FED TAX OUTLINE

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

v. 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.

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

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

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

c. Working Condition Fringe Benefits , (§ 132(d)), p210

i. EXAMPLE: tools, office space, and supplies

ii. Deduction Rule : The exclusion applies if the property and services are so closely connected to job performance that if the employee were to pay for them, she would get to deduct the costs as a business expense. Thus, when they are provided by the employer, they should not be considered compensation to the employee.

iii. Cash payment s: 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 (Reg. § 1.132-5(a)(1)(v)).

iv. The Regulations determine the working condition fringe portion of vehicle usage, consumer product testing.

v. Outplacement services : deductible if employer derives substantial benefit distinct from benefit it would derive from mere payment of additional compensation (e.g. promoting positive corporate image, etc).

d. De Minimus Fringe Benefits , p211

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

ii. 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.

of 77

FED TAX OUTLINEiii. 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.

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

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

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

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

2. A transit pass; OR3. Qualified Parking

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

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

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

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

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

3. 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.

VIII. BUSINESS & PROFIT-SEEKING EXPENSES (chap 12, pp231-62)

We are moving from §61 income to §62 deductions. And the most important 62 deductions are business expenses.

§162(a): Business Deduction. 162 is narrower than just income producing costs. Certain provisions of 162 are limiting (e.g. necessary, ordinary, trade or business). Rent, wages, and supplies are classic examples of deductible business expenses.

Two distinctions made in 162:

of 77

FED TAX OUTLINEPersonal (consumption expenses) vs. business (income production expenses)

Current expenses (deductible) vs. Capital expenditures (capitalized/added to basis)

§212: Profit-seeking Deduction

1. 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.

2. The Expense Must be “Ordinary and Necessary”

a. Ordinary

i. Payments to bankrupt company are not ordinary and therefore not deductible (Welch v. Helvering).

ii. The concept of ordinary can sometimes be used to distinguish between deductible business expenses and non-deductible capital expenditures.

iii. 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. Life insurance, for instance, taken out on Pres Roosevelt is not deductible b/c other similar business do not engage in this.

b. Necessary

i. Necessary merely means appropriate and helpful (Welch).

1. Tax lawyer was not entitled to deduction for yacht costs because the yacht was not necessary for taxpayer’s trade or business. The flag was primarily personal.

ii. This requirement is very broad and not hard to meet.

iii. “Reasonable” Salaries (§ 162(a)(1))

1. Reasonable salaries are deductible (162(a)). If salary is excessive, only the portion that is reasonable can be deducted. The rest will be counted as income for the employee.

2. Independent Investor Test : of 77

FED TAX OUTLINE

a. 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).

b. The following factors should be considered:i. Nature and quality of shareholder’s services

ii. The effect compensation has on the corporation’s rate of return

iii. Corporation’s rate of return on equity

3. Multi-Factor Test :a. The position held by the employeeb. Hours worked and duties performedc. The general importance of the employee to the

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

salarye. Comparison of employee’s salary with those paid by

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

businessg. The existence of a potentially exploitable relationship

between the company and its employeesh. The existence of a bonus system that distributes most of

the pre-tax earnings to the company.

4. Indirect Market Test (Rate of Revenue Test) (Exacto Spring):a. 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.

b. Exacto Spring Corp. v. Comm’r : disfavored the multi-factor test. Instead, it introduced the indirect market test.

iv. Clothing

1. When the clothing cannot be worn off duty, a deduction may be allowed for uniform acquisition and maintenance costs (e.g. cops, firemen, postmen, nurses, bus drivers, railway men, etc). 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. Revenue Ruling 67-115: The cost of military uniforms, which were prohibited to wear ff-duty, was deductible.

2. But when the clothing may be worn off duty, the Pevsner test may apply objective test wherein no reference is made to the individual taxpayer’s lifestyle or personal taste. Instead, adaptability for personal or general use depends on what is generally accepted for ordinary street wear

of 77

FED TAX OUTLINE

c. Trade or Business

i. Rents are deductible if they are related to trade or business.

ii. 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. Regardless of how long an investor has engaged in investment activities, he has not operated a trade or business by merely setting up an office dedicated to monitoring his own securities. (Higgins).

1. Intent, the nature of income, and the regularity of the securities transactions are all relevant. A trader may be considered as engaged in a trade or business, but an investor may not.

a. EXAMPLE: Vic has stock portfolio. Costs incurred in maintaining this portfolio are not deductible under 162 b/c Vic would be considered an investor and not a trader. However, his costs may be deducted under 212 as a profit-seeking expense.

2. Higgins led to the passage of § 212 allowing deductions for production of income.

iii. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. Resolution of the trade or business issue requires an examination of the facts. (Groetzinger Gambling case)

d. Carrying On

1. The development of a business involves two stages:

a. Investigatory :

i. The expense of investigating and looking for a new business and trips preparatory to entering a business are not deductible as an ordinary and necessary business expense incurred in carrying on a trade or business (Frank). Investigatory expenses are viewed as nondeductible personal expenses and not business or trade expenses

ii. However, taxpayers may deduct a loss for investigatory expenses incurred in an unsuccessful attempt to acquire a specific business.

b. Acquisition and Commencement of Operation: of 77

FED TAX OUTLINE

i. A taxpayer has not engaged in carrying on a trade or business under 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized (Richmond). Any pre-operating expenses should be treated as capital expenditures.

ii. A distinction between pre-opening/start-up costs and operating costs of a business can be justified for two reasons:

1. Start up costs may provide benefits long beyond the current tax year and therefore should not be deductible but rather capitalized (e.g. training, lining up distributors, etc.).

2. This prevents against the deduction of personal expenses. By forcing the taxpayer to establish that the expenses are actually associated with the operation of a trade or business makes it more likely that the expenses are genuinely business-related, as opposed to being merely personal expenses.

2. Eligible expenses include :

a. Investigatory costs : reviewing a prospective business through survey of markets, products, labor supply, etc.

b. Startup costs : incurred after deciding to establish a business and prior to actual commencement of said business.

3. One must actually engage in the trade or business to be eligible to amortize under § 195. 195(b) requires amortization period begin with the month in which the active trade or business begins.

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

1. Be wary of stuff that looks like a start-up cost. Start-up costs are not deductible. But you may be able to amortize them under 195.

2. The scope of the employee’s current trade or business will be determinative in evaluating the deductibility of costs incurred in seeking new employment. The Court will compare the position which the taxpayer occupied before and after the change (see Primuith; cf. Rockefeller).

of 77

FED TAX OUTLINEa. 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.

b. Rockefeller v. Comm’r: Rockefeller could not deduct expenses incurred in seeking the Vice Presidency, because the tasks and activities of the Vice President were not the same as those associated with the other governmental position he had held.

3. Job counseling fees may be deductible even thought the taxpayer did not actually succeed in obtaining the new employment (Cremona).

4. Travel reimbursements for interviews need not be included in gross income.

5. Whether an employee can deduct costs incurred in SEEKING EMPLOYMENT will depend on whether the costs were incurred in “carrying on” a trade or business. If they 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 (Rev Rul 75-120). Costs will be deductible even if you never received the job (if you’re in same line of business!)

GET JOB DON’T GET JOB

SAME LINE OF BUSINESS

Yes deductible

Yes deductible (recent rev ruling allows this)

NEW LINE OF BUSINESS

Not deductible

Not deductible

a. EXAMPLE: Rockefeller couldn’t deduct costs of running for President after being governor b/c these were NOT considered the same line of business.

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}

of 77

FED TAX OUTLINEc. Travel expenses to and from a destination related

primarily to seeking new employment will be deductible even if the taxpayer engaged in personal activities.

6. Generally speaking, a taxpayer may be unemployed for ONE YEAR and still be considered to be in the trade or business of his former employment. The taxpayer must establish that during the hiatus he intended to resume the same trade or business (Rockefeller case) and a prolonged period of unemployment will terminate one’s status as being engaged in the same trade

7. You don’t get to deduct EDUCATION expenses b/c you’re not in the business yet (WOOTEN).

a. EXAMPLE: Lawyers, for instance, can deduct the cost of CLE’s because they are already in the line of business.

8. THE GENERAL RULE FOR JOB SEEKING & EDUCATIONAL EXPENSES IS THAT THE COSTS ARE DEDUCTIBLE IF YOU’RE ALREADY IN THE LINE OF BUSINESS. IF, HOWEVER, YOU ARE SEEKING A NEW LINE OF BUSINESS, THEN THE COSTS INCURRED WILL NOT BE DEDUCTIBLE.

3. Section 212 Deductions: § 212 is sometimes referred to as the non-trade-or-business analog to § 162 and allows a deduction for the ordinary and necessary expenses of producing income. But, expenses incurred by an investor may still be deductible under 212 even if the investor is not deemed to carry on a trade or business. § 212 may not be used as a backup when § 162 fails there is a basic distinction b/w 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).

4. Business Travel Expenses

a. Travel reimbursements for interviews need not be included in gross income.b. Travel expenses to and from a destination related primarily to seeking new

employment will be deductible even if the taxpayer engaged in personal activities. Must look at the primary purpose of the trip.

5. Advertising

a. Advertising expenses are generally deductible.b. Advertising expenses incurred PRIOR to the start of the business are

development costs which are NON-deductible business expenses. Since advertising is deductible when you’re already in the line of business, start-up amortizing may be amortized under 195 b/c the benefits last past one year.

IX. CAPITAL EXPENDITURES (chap 13, 263-97)

of 77

FED TAX OUTLINEWhen you buy an asset, you can deduct it immediately or depreciate it over time.

a. Depreciation : tangible assetsb. Amortization : intangible assetsc. Annuities (§72): stream of payments over some period of time

When determining whether something should capitalized, must ask:

1. Does expenditure create long-lived asset or long-term benefit?2. How long does the asset last?

1. Deductible Expenses vs. Capital Expenditures

a. Relevant Provisions:

i. 263 : denies deductions for capital expendituresii. 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.

iii. Reg. §§ 1.162-3, 1.163-6 : hard to measure or incidental costs are deductible.

b. Generally, can deduct business expense when profit-seeking expense and will be used up w/in one year. Cannot take deduction until you use property up to produce income.

i. 20K in rent for law business = deductible. Rent is business expense.ii. But 20K to buy building must be = capitalized.

c. You must capitalize if you create something that lasts (not just if you buy something that lasts) (Idaho Power).

2. Start-Up Costs (deductible) vs. Capital Expenditures (non-deductible)

a. 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. (Rev Rul 99-23). NOTE: A taxpayer incurring costs to investigate the expansion of an existing business generally can deduct those costs under § 162.

b. Under 195, investigatory expenses are deductible IF THEY WOULD HAVE BEEN deductible IF THEY WERE PAID OR INCURRED IN CONNECTION w/operation of EXISTING trade or business. The operative word here is IF!!!!!

3. REASONS FOR CAPITALIZATION REQUIREMENT

of 77

FED TAX OUTLINEa. MATCHING: of current expenditures (cost of producing income) to the income

produced is at the heart of capitalization requirement.b. ACCURACY: you get a deduction for using things up—when it’s no longer of

value to you. You want to accurately represent income.c. COMMENTARY: the earlier you deduct, the more you get, then the more

interest you can earn on what you save. Taxpayers like to take deductions earlier b/c of this timing issue.

Assets (Oven EXAMPLE)

$1000 for oven

After 1 yr, it’s worth $900

This is clear case of capitalization b/c 1) I bought physical thing 2) that will obviously last several years.

Assets (Ingredients EXAMPLE)

$1000 for ingredients

After 1 yr, no ingredients left

This is clear case of deduction b/c 1) I bought physical thing 2) that will obviously be used up in 1 yr.

4. Defining Capital Expenditure

a. An expenditure which generates a significant future benefit must be capitalized (Indopco).

i. EXAMPLE: Consulting fees for friendly takeover bid are not deductible and must be capitalized b/c it creates substantial future benefits. But expenses incurred in defending business from attack in a hostile takeover bid are deductible.

b. 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) (Freightways).

5. Types of Capital Expenditures

a. Cost of Acquisition & Cost Incurred in Perfecting and Defending Title

i. Purchasing Title—Acquisition costs must be capitalized b/c the assets will produce long term benefits.

of 77

FED TAX OUTLINE1. EXAMPLE: Purchasing title to building, machine, vehicle,

copyright, or patent.

ii. Defending Title—Costs incurred in defending title are also capital expenditures. Yet when the dispute is related to INCOME from the title, costs incurred may be deductible.

1. EXAMPLE: Efforts to resist trademark infringement must be capitalized but efforts to recover royalties are deductible.

iii. Disposing Assets—Capitalized unless asset in merely discarded, in which case the costs are deductible.

b. Repair or Improvement

i. Repairs that don’t materially add to value are deductible. But repairs that are part of a general plan must be capitalized.

ii. Repair is deductible if you’re putting something back in working condition (Midland Empire).

iii. But repair must be capitalized if you’re building something extra (Mt. Morris).

c. Prepaid Expenses

i. Cost that results in creation of asset may not be deducted or it may be deducted only in part.

1. EXAMPLE: If you prepay for 5 years of insurance premiums this year, you should capitalize and amortize over the life of the policy.

ii. Boylston is seen as the law even though other courts have held that prepaid insurance is not a capital asset and thus deductible

d. Expansion Costs

i. Costs associated w/establishing franchise held deductible.ii. Branch banks held deductible under Lincoln Savings “separate and

distinct asset” approach.

e. Advertising Expenses

i. Advertising expenses generally treated as deductible. Only in unusual circumstances must the cost of advertising be capitalized.

1. EXAMPLE: 4,000 for new sign on restaurant capitalized b/c it provides future benefit. If the advertising takes the form of a

of 77

FED TAX OUTLINEphysical asset, the cost must generally be capitalized and recovered over the life of the asset

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

f. Purchase or Lease

i. Rental payments deductible only if taxpayer doesn’t take title and has no equity in the property. There may be an issue, however, as to whether acquisition costs are being disguised in terms of “rental” costs.

ii. In general, a lump sum for lease should be capitalized and amortized over the life of the lease b/c the benefit from the lease will extend beyond one year.

X. DEPRECIATION (chap 14, 299-340)

ON EXAM: we may be asked about 195, 179; we may be asked about expensing vs. capitalizing. We won’t have to apply 200% declining balance method, though.

1. General Principles of Depreciation

1. Goals/Purposes:a. Accurate measurement of incomeb. Accelerated depreciation provisions are meant to promote investment

2. Classification:a. What kind of property qualifies for depreciation?

i. Machineii. No stockiii. No land

b. Over what period should property be amortized?i. 3, 5, 7 year propertyii. Residential iii. Non-residential

3. Application of Depreciation

2. Depreciable Property

a. Under 167, property 1) used in trade or business OR to produce income AND 2) subject to wear and tear IS depreciable.

i. EXAMPLES:

1. Land and stock are NOT depreciable b/c they are not subject to wear and tear.

2. Rental property IS depreciable b/c it produces income (even though not used in trade or business).

of 77

FED TAX OUTLINE3. NO loss deduction for personal residence b/c it is a personal

expense.4. Term interests are NOT deductible (167(e)).

b. The longer the useful life of an asset, the smaller the deduction will be.

c. Args for no depreciation:

i. If the useful life of an asset is indeterminable (doesn’t meet requirements of 167), then it is NOT depreciable under 168 (Liddle Dissent).

ii. In Rev. Ruling 89-25 (p327), no depreciation for model houses was allowed b/c they were used primarily FOR SALE to customers and were not used in taxpayer’s TRADE or BUSINESS.

d. Args in favor of depreciation:

i. The test for depreciation deductions is whether the item would suffer wear and tear from being used in a business (Simon). Depreciation allowed on exotic automobile owner used and exhibited for fee at car show despite failure to show useful life and no evidence of wear and tear (Selig).

ii. The court held bows were subject to deductions because unlike a work of art that will hang on the wall, the bows will be subject to wear and tear over time, and eventually will totally wear out (Simon).

3. Depreciation Methods: 168(b) authorizes three methods that are generally applied to different types of property: 200%, 150% and straightline.

4. To determine depreciation of tangible property, determine adjusted basis of property, the determine 1) applicable depreciation method 2) applicable recovery period 3) applicable convention (§ 168).

5. Relationship between BASIS & depreciation Will probably be on exam! This is a very important concept.

a. You should know that you reduce basis by amt of depreciation deductions. You are not obligated to take deductions—but your basis will still be reduced even if you choose NOT to take deductions.

b. Because one must reduce basis by the amount of the depreciation claimed, it is possible that one will realize a gain when selling the property for less than one has paid for it

i. EXAMPLE: M buys bldg for 200,000 and sells it for 150,000 10 yrs later. The depreciation allowed was 75,000 thus reducing basis to 125,000. There was a 25,000 gain even though M sold the bldg for less than she paid

of 77

FED TAX OUTLINEc. Why reduce basis?

i. Land and stock don’t wear out and aren’t depreciable stock dividends are taxable in full. You recover basis when you sell

ii. BUT with ovens, equipment, etc—you recover cost (tax-free) over a period of time—not all at once.

iii. In both cases, you’re recovering the cost of your investment tax-free

6. SECTION 179 – EXPENSING TANGIBLE PERSONAL PROPERTY NOT LIKELY to be on EXAM

a. 179 allows taxpayers to expense (deduct currently) the cost of acquisition of certain depreciable business assets. 179 is elective. This is exception to rule that you must capitalize certain expenses

b. It stimulates economy by encouraging the production and acquisition of new business equipment. IT ENCOURAGES INVESTMENT.

c. No more than $25,000 can be expensed. 179 is designed primarily for small businesses.

d. An adjustment must be made to the basis of 179 property placed in service during the year to the extent that a 179 deduction was claimed.

i. EXAMPLE: Taxpayer buys $100,000 machine in 2003 and expenses $25,000 under 179. Before computing the depreciation deduction, the basis in machine must be adjusted to reflect 179 deduction Thus, adjusted basis to which depreciation percentage will be applied in 2003 will be $75,000 rather than $100,000.

7. THE RELATIONSHIP OF DEBT TO DEPRECIATION

a. Loan amount becomes basis for purposes of determining depreciation deduction. It makes no difference whether taxpayer borrowed $ from 3rd person or seller.

b. This really benefits taxpayer b/c they are allowed to claim depreciation deduction before they’ve incurred any expenses.

8. Depreciable Musical Instrument vs. Non-depreciable Work of Art

THIS TYPE OF PROBLEM COULD BE ON EXAM…P, aspiring rock star, plays guitar w/band that does gigs every weekend. Other than inheritance, P’s sole source of income is from playing w/band. B/c of inheritance, P was able to buy Elvis Presley guitar for $100,000. She uses it to practice and at special gigs.

a.May P deduct $100,000 cost currently?i. NO b/c the guitar will provide future benefits lasting beyond one year. P

MUST CAPITALIZE the guitar.

b. May P depreciate guitar? If so, what is total amt of depreciation deductions under 168 P may claim assuming she owns and uses guitar for next 8 yrs.?

i. YES. P may depreciate guitar. P’s guitar meets the 167(a) test – it’s subject to wear and tear AND used in trade or business. Therefore, P may depreciate the guitar under 168.

of 77

FED TAX OUTLINEii. BUT ART IS NOT DEPRECIABLE B/C NOT SUBJECT TO WEAR AND

TEAR. Should it make a difference that the guitar is valuable because of who used it rather than who made it? Should the guitar be viewed as a nondepreciable work of art (see Rev. Rul. 68-232), rather than as a depreciable musical instrument (see Simon)? What gives the guitar valuable has nothing to do with the way the guitar sounds. IF YOU’RE THE IRS, YOU WANT TO DISTINGUISH P’s case FROM SIMON. WHAT ARE SOME DIFFERENCE?

1. She’s not in trade or business like violin players were.2. Violin bow created better sound; guitar didn’t.

iii. If Patsy can depreciate the guitar, she is entitled to recover the entire $100,000 cost over 7 years. See IRC § 168(c).

9. Leasing and Bonus

THIS TYPE OF PROBLEM COULD BE ON EXAM… On March 30, E entered into 10yr lease of small commercial building located near court house. E plans to use it for law practice. E paid owner $10,000 as bonus for leasing him the property and agreed to pay owner rent of $2,000 per month. What tax consequences as result of the arrangement?

RENT: Erik’s monthly rent of $2,000 is deductible under IRC § 162(a) as a business expense. What about the $10,000 bonus? What does your intuition tell you?

BONUS: Not deductible because the $10,000 bonus is attributable to the entire lease and the lease lasts for ten years. So the bonus must be capitalized per IRC § 263(a). Erik must amortize the $10,000 bonus over the term of the lease. See Reg. § 1.162-11(a).

XI. TRAVEL EXPENSES (chap 16, 361-90) this will be on EXAM!

A. COMMUTING

1. Commuting expenses are viewed as personal in nature and usually nondeductible under §262 since you have the choice to live nearer to the workplace. Commuting costs incurred solely because the taxpayer maintains a home far from his work are not deductible as the business gains nothing from this arrangement except for the personal satisfaction of the taxpayer.

a.Comm’r v. Flowers : There are three conditions to a travel expense: (1) it must be reasonable and necessary, (2) it must be incurred away from home, and (3) the expense must be incurred in pursuit of business.

i. T/P’s home was Jackson, not Mobile.

2. People prohibited from living near their workplace cannot deduct the cost of their commute either, even though they have no choice to live close to work.

a.Sanders v. Comm’r : Even when people were prohibited from living near the workplace (air force base, nuclear power plant), they cannot deduct

of 77

FED TAX OUTLINEcommuting costs, as their hardships are no different than those confronting the many taxpayers who cannot find housing close to their place of employment and must daily commute to work.

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

a.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.

4. 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).

of 77

FED TAX OUTLINE

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. Business v. Personal: Where the primary purpose for the travel is business, you can deduct the transportation costs which are business related. 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).

3. § 274(m)(1): limits the amount which taxpayers could deduct when the mode of transportation is a cruise ship or some other form of luxury water transportation.

4. § 274(m)(2): denies a deduction for travel expenses when travel is considered by the taxpayer as a form of education.

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.

a. Railroad employees who were authorized to stop performing their regular duties to get substantial sleep or rest prior to returning to their home terminals may deduct the cost of their meals and lodging (Rev Rul 75-170)

b. 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 (Carroll)

c. 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. However, the dissent argued that this still was a personal expense under Correll and § 262.

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” VERY IMP CONCEPT

1. Two Issues:a. What counts as “away”?

of 77

FED TAX OUTLINEb. What counts as “home”?

i. T/P’s residence & principal place of business are located near each other = OK

ii. T/P residence & principal place of business are not near each other ≠ OK…

ii. Courts say different things about what counts as home. Some say tax home is residence and some say tax home is place of business.

a. In general, tax home is place you have business reason to be in. If you work in Buffalo, there’s no business reason to have a home in Syracuse. Your tax home is Buffalo in this case.

b. Tax home not always where you live.i. In Flowers, T/P lived in Jackson, but it wasn’t his

home for tax purposes.

2. Food away from home :

a. Subject to overnight rule.

b. EXAMPLE: D eats lunch in town he’s visiting. Not deductible b/c not “away from home.” Away from home means overnight. Yet, your meal may be 50% deductible if you eat lunch with the client and discuss business (see § 274(n)).

3. 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.

4. 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.

5. 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.

of 77

FED TAX OUTLINE

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. The taxpayer wanted to deduct the travel expenses under § 162 as expenses incurred “away from home.” The IRS said he had no legal tax home because he lacked the requisite business reasons for living in Boise in between ice show tours. His choice to live there had nothing to do with his needs of work.

Holding: The Court agreed with the IRS that the taxpayer had no tax home. (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.

Dissent: By going on the road in pursuit of his job, the taxpayer had to pay for food and lodging that he would not have had to buy had he stayed at home (because his parents paid for it at home). Furthermore, just because his home happens to be where his parents live does not make it less of a home. Hence, Boise was his tax home and he therefore can deduct his travel expenses.

6. 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.

a. § 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.

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

i. If there is more then one seasonal job, then a factual determination must be made in order to establish which of the seasonal jobs is the primary place of work. The employee may only deduct meal and lodging expenses at the minor place of employment while duties there require such employee to remain away from his principal post of duty.

ii. If there is more than one home, the taxpayer is reasonably expected to locate his home, for tax purposes, at his major post of duty (the location where he works the most, or gets the most money from) so as to minimize the amount of business travel away from home that is required.

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

of 77

FED TAX OUTLINEtravel of the spouse/dependent is for a bona fide business purpose, and (3) the spouse/dependent could otherwise deduct the expense.

F. REIMBURSED EMPLOYEE EXPENSES

Reimbursements can be excluded if the employer has an accountable plan.

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 they are reimbursed expenses that satisfy § 62(c).

2. Qualified Reimbursement Arrangements (Accountable Plans)

a.The reimbursement arrangement must provide reimbursements, advances or allowance only for deductible business expenses (“business connection” requirement). See Reg. § 1.62-2(d)(1)—p913—for discussion of accountable plans.

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

c.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

1. If meal qualifies as business or travel expense, it will be 50% deductible. Client’s lunch is generally deductible as a business expense. 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.

3. § 274(h)(2): no deduction is allowed for costs incurred in attending conventions or meetings on cruise ships outside of the US and a limitation of $2,000/year is placed on deductions for expenses of conventions held on cruise ships which meet the requirements of § 274(h)(2).

of 77

FED TAX OUTLINE

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.

XII. INTEREST DEDUCTION (chap 22, 493-510)

1. Definition of Interest

a. Interest has been defined as the amount one has contracted to pay for the use of borrowed money.

b. To qualify as interest, a payment cannot be made for services. Service charges ≠ interest!

2. Deduction of Personal Interest

Personal interest ≠ deductible unless it falls under one of the exceptions in 163(h) e.g. interest allocable to trade or business, investment interest, or qualified residence interest.

Exceptions:

a. Qualified Residence Interest = deductible. Mortgage interest in personal residences is deductible in order to encourage home ownership.

a. Acquisition Indebtedness: is incurred in acquiring, constructing, or improving residence and is limited to $1,000,000.

b. Home Equity Indebtedness: is indebtedness other that acquisition indebtedness secured by qualified residence and is limited to $100,000. Further, the amt is limited to the excess of FMV of residence over amt of acquisition indebtedness.

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

Take out 2nd mortgage to get the better interest treatment…

d. EXAMPLE: Owns icerink and residence and wants to take vacation for $25,000. He has to borrow money. Interest WILL NOT be deductible if he takes out loan on ice rink. BUT the tracing rule (Reg. 1.163-8T) says that they will look at what loan proceeds are spent on. If he takes out loan on residence, interest WILL be deductible. See handout for details on tracing rule.

of 77

FED TAX OUTLINEi. Education Loan = deductible. But 221 limits the max amount deductible to

$2,500.

1. EXAMPLE : K paid $1,200 interest on bank loan used to pay daughter’s tuition. Deductible under 221 b/c it is interest on educational loan. ON EXAM, MAKE SURE YOU KNOW THE SECTION NUMBER IF YOU SAY SOMEONE CAN DEDUCT SOMETHING!!!

b. Investment Interest = deductible for any taxable year but CANNOT be deducted in an AMOUNT GREATER than the taxpayer’s net investment income.

c. Trade or Business: In order to distinguish b/w personal and business interest deduction, look at what taxpayer spent the loan on. If loan spent on retail store, e.g., then it will be deductible.

3. Timing and Payment Issues

a. Cash method t/p can only claim deduction when payment has been made. And there is controversy over whether action constitutes actual payment or mere deferral of payment.

1. Promissory note ≠ payment and therefore not deductible. Prom note is merely a promise to pay.

2. When deductible payments are made w/borrowed money, such expenses must be deducted in the year they are paid, not when the loans are repaid.

b. No deduction for deferred interest: The interest has merely been deferred. The taxpayers are therefore NOT entitled to an interest deduction. The purpose of the advance from JH was to provide WT w/funds to satisfy the interest due on Jan 1, 1981 (Davison)

c. Interest Prepayments: should be capitalized and then amortized over remaining period of contract.

XIII. CASH-METHOD ACCOUNTING (chap 28, 603-44)

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

EXCEPTIONS: there are cases when cash-method will be treated like accrual-method taxpayers…

a. Constructive Receipt

If (1) money or property is set aside for a taxpayer (2) so that the taxpayer may draw on the money or property at any time, then the taxpayer must recognize the funds as income even though she does not receive the money or property. Reg. § 1.446-1(c)(1)(i) EXAMPLE: an employee cannot pick up a December check until January and thereby defer reporting her December earnings. EXAMPLE: Generally, it is the date when a check is received and

of 77

No constructive receipt if recipient cannot get to the money!

If there’s a condition precedent to getting the money, then it won’t be considered income.

FED TAX OUTLINEnot 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

o EXAMPLE: Important point: Suppose Jack agrees to paint Molly’s kitchen. The contract provides that Jack will paint the kitchen in October 2003, and that Molly will pay Jack in January of 2004. Both parties perform as specified in the contract. Jack recognizes income in 2004. Does it make any difference that Molly would have agreed to a contract that required her to pay Jack in 2003? No. The code cannot be administered by speculating whether the payor would have been willing to agree to an earlier payment. Rev. Rul. 60-31, p. 626.

i. Specific Factors Affecting Application of Constructive Receipt Doctrine

1. Distance2. Knowledge3. Contractual Arrangements4. Forfeitures or Other Penalties5. Relationship of the Taxpayer to the Payor

ii. Deferrals ≠ don’t always have to report

1. Money that’s been set aside is a sure thing and therefore must be included in income in the year that the escrow was set up (Rev Rul 60-31)NOTE: this case does not implicate constructive receipt b/c the money was not available in any sense until the 3rd year.

2. 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) that the new contract was not a unilateral arrangement, and (3) that both parties negotiated to their best advantage. UNDER THESE CIRCUMSTANCES, deferred income ≠ constructive receipt.

3. While so-called “qualified” pension and profit sharing plans cannot discriminate in favor of statutorily-defined highly compensated employees, “nonqualified” deferral arrangements may.

a. Such arrangements benefit key employees seeking tax benefits through deferrals.

b. However, there is a risk of nonpayment as such arrangements are typically not funded.

c. The employer may not deduct deferred compensation under a non-qualified plan until the employee includes it in

of 77

The key things to look at with deferrals are 1) whether there was business purpose and 2) who requested the deferral

FED TAX OUTLINEgross income.

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.

b. Cash Equivalency Doctrine

Applied often to PROMISSORY NOTE context.

i. As a rule, a cash-method taxpayer does not recognize income just because someone owes or promises to pay her money. A cash-method taxpayer generally recognizes income when she actually gets paid. In general, then, under the cash method a promise to pay money in the future is not treated like an actual payment of money.

ii. Sometimes, however, a promise to pay money in the future (for example, a government or corporate bond) is regularly traded in the market and so has a determinable market value. 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 negotiable promissory note) for money If the elements of the cash equivalent doctrine are met, the taxpayer must recognize income equal to the fair market value of the promise received (Cowden)

c. Economic Benefit Doctrine

This doctrine is applied most often in EMPLOYEE COMPENSATION/annuuity or ESCROW context

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

b. Under the doctrine of constructive receipt, a taxpayer recognizes income if the taxpayer may draw on funds at any time. Under certain circumstances, the taxpayer must recognize income even though there are restrictions that prevent the taxpayer from receiving the income until a later date. If (as in example (4) in Rev. Rul. 60-31) a taxpayer is unconditionally entitled to receive a payment in the future and the promisor sets aside money or property to make the payment (so that

of 77

Simple promise to pay ≠ Income

BUT…

Promise to pay + Setting aside money = Income

FED TAX OUTLINEthis money or property is beyond the reach of the promisor’s creditors), then the taxpayer must recognize income equal to the present value of the promised future payment.

i. EXAMPLE: Suppose Alice works for XCorp. In year 2003, as part of her compensation XCorp buys an annuity for Alice from an insurance company. The annuity provides that Alice will begin receiving payments when she turns 65 in 2015. Alice cannot receive any payments before 2015. The purchase of the annuity means that XCorp’s creditors cannot recover the amount XCorp paid. Alice must include the value of the annuity in her income in 2003. (Drescher)

ii. EXAMPLE: Suppose Alice’s employment contract with XCorp provides that XCorp will pay Alice deferred compensation beginning in 2015. XCorp creates a bookkeeping reserve on its balance sheet to reflect its obligation to Alice. No money is set aside exclusively to pay Alice’s deferred compensation. In this case, Alice need not recognize income until she actually receives payments.

ii. Comm’r v. Smith: an economic or financial benefit conferred upon an employee as compensation is included as income.

iii. If money is irrevocably placed in trust or an escrow account to be distributed to the taxpayer that amount is income as (1) it is irrevocably paid for the sole benefit of the taxpayer and (2) the amount is fixed. (Sproull v. Comm’r).

iv. An employer’s promise to pay deferred compensation in the future may itself constitute a taxable economic benefit if the current value of the employer’s promise can be given an appraised value.

1. The promise MUST be capable of valuation.

a. Capable of Valuation = contribution to an employee’s deferred compensation plan must be (1) nonforfeitable, (2) fully vested in the employee and (3) secured against the employer’s creditors by a trust arrangement.

d. Prepayments

i. Prepayments will be capitalized and amortized.

ii. 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)

iii. Credit card payment to the hospital is includable in the medical expenses deductions claimed on cardholder’s 1976 tax return (when the card was charged, not when the card was paid).

of 77

FED TAX OUTLINEiv. 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 (3) it must cause no material distortion of income

v. Prepayment of Interest: § 461(g): Cash method taxpayers must treat prepaid interest as having been paid in the period to which it is properly allocable. Thus, the cash-method taxpayer is treated as an accrual method taxpayer with respect to prepaid interest, with an exception allowed for “points” paid in connection with a principal residence

B. Deductions

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

2. 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.

C. §83: When property is unconditionally transferred in connection with services, the amount paid for such property shall be included in income UNLESS there is a substantial risk of forfeiture of the amount paid.

D. Loans: When a taxpayer takes out a loan the taxpayer does not have to include the loaned funds in income because the taxpayer has a counterbalancing obligation to repay the loan. So here a simple promise to repay has the effect of offsetting the actual receipt of money or property.

XIV. ACCRUAL METHOD ACCOUNTING (chap 29, 645-75)

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

1. T/P accrues income when a legal right to payment arises. T/P generally takes deduction when they incur obligation to be paid. But this is limited by economic performance rule. It is crucial to distinguish b/w when payor OWES money and when payor PAYS money.

INCLUDE DEDUCT

PAYMENT OR PAYMENT DUE (the earlier of) BEFORE PERFORMANCE

Include when paid (Schlude) except Rev Rul 71-21 + Artnell

Performance+ all events + reasonable estimate

PAYMENT AFTER

For inclusion purposes, you must include income as soon

For deduction purposes, there must be performance, all

of 77

FED TAX OUTLINEPERFORMANCE as all events occur + you can

reasonably estimate the amount.

events.

2. Inclusion

a. Occurs when:i. All events have occurred which fix the right to receive such income

ii. The amount can be determined with reasonable accuracy

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

3. Deduction

a. May be taken when:i. All events have occurred establish the fact of liability

ii. The amount can be determined with reasonable accuracyiii. Economic performance has occurred with respect to the liability

1. Econ Perf is laid out in Reg. 1.461-4.2. EP occurs when svs are provided, as property is used, or when

costs are incurred (see handout)

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. EXAMPLE: D can’t deduct his liability to provide service to another person until he incurs costs in satisfaction of the liability. In this case, he couldn’t deduct costs until he actually services the sprinklers. BUT if he pays 3rd party to service the sprinklers, he can take a deduction when he makes the contract! This is a LOOPHOLE to the “satisfying the liability” requirement!

b. It is the fixing of the obligation to pay, not payment itself, which is the critical event for deduction purposes. To have a legal right of payment is different than when payment is due. The accrual method is concerned when a legal obligation to pay or be paid comes into existence – not when payment is due.

of 77

The financial condition of the taxpayer at the time of accrual generally will NOT BAR a deduction

Prom note= income to accrual TP

≠ income to cash method TP

FED TAX OUTLINE4. Exceptions

a. Sometime accrual method TP treated like cash-method. Claim of right doctrine, for instance, requires TP to include income even if they don’t have a clear right to it.

5. Accrual Exceptions

i. COLLECTIBILITY OF INCOME: 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.

2. § 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.

ii. CONTESTED CLAIMS = no income : An unconditional right to income is necessary before the income is accrued. If the claim is disputed, income accrual awaits resolution of the dispute.

iii. CONTESTED LIABILITIES = no deduction: 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.

1. § 461(f): the payment of a contested liability accrues the liability and provides a current deduction in the year of payment.

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

iv. ESCROW: If the escrowed amount is not to be released until the taxpayer has rendered performance, then the taxpayer’s right to the income is not yet fixed under the all events test, and accrual is not appropriate.

v. 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.

of 77

FED TAX OUTLINEvi. 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).

6. Prepayments

i. Accrual method taxpayers are required to include advance payments in income (Schlude)

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. “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. Revenue Ruling 74-607:

iii. 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

7. Premature Accruals

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

ii. 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.

iii. 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.

iv. § 446(b): places a limitation on any deductions that are part of the accrual method that do not clearly reflect income.

1. Hence, if the related expenditure is so distant from the time the debt is incurred, then it shouldn’t be deducted when the debt is incurred, but when the expenditure is paid off (later).

XV. ANNUAL ACCOUNTING (chap 30)

A. Restoring Amounts Received Under a Claim of Right (Giving back $ in later year; Inclusion Deduction)

a. Example: Taxpayer received an improperly computed bonus in 2002, which he properly reported as income in that year. When he found out the mistake in 2004, he returned it to

of 77

FED TAX OUTLINEhis boss. Should he recomputed his 2002 tax or deduct the bonus in 2004?

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 (Including $ in a layer year; Deduction Inclusion)

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 recovery constitutes gross 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. Judicially developed. 3. This also happens with bad debts that have been paid back after you

already deducted the debt.

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.

3. The most common context for the application of the tax benefit rule involves the refund of previously deducted state income tax.

c. Alice Phelan Sullivan Corp. v. United States, US Court of Claims (1967), p701i. Class Notes: Alice donated to charity in late 1939 and took a deduction that

same year; but charity gives the property back.

of 77

FED TAX OUTLINE1. Here, the Court UNDID the deduction in the later year what happened in

the earlier year.

2. Inclusionary aspect of tax benefit rule: the corp. had to include what they deducted in the earlier year.

d. 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. See Problem (4) and (5) for this chapter and Wooten’s handout.

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.

XVI. CAPITAL GAINS (chap 31, 709-39; 748-55)

1. 1211(b): can only recog losses to the extent of gains + 3,0002. 1221: def of capital asset

EXAM We will have to say whether something constitutes a capital asset and ultimately whether there was a capital gain.

We will need to know 1231 and 1245

1231: if sell something excluded by 1231(a)(2), it will be CA if sold at gain. BUT if depreciable, it wont be CA.

of 77

FED TAX OUTLINEWe should know the distinction b/w CA gains and losses AND ordinary gains and losses.

Sell car at gain: this is characterized as capital gain

Sell car at loss: NOT deductible if you sell personal property at a loss. This is personal consumption.

CAPITAL GAINS: § 1(h) T/P want to use this!

Capital gains/losses result from SALES/EXCHANGES of capital ASSETS. You must first define capital asset, though. See § 1221(a) for definitions. See also § 1222.

THERE MUST BE A SALE/EXCHANGE!

CAPITAL LOSSES: § 1211(b) T/P don’t want to use this b/c 1221(b) limits the amount of capital losses a T/P can take.

REALIZATION = the fundamental reason we have to have rules for capital gains.

REALIZATION = gains and losses upon disposition of the property

CAPITAL LOSSES (§ 1211 (b)): can deduct CL against any CG and then deduct 3K.

Global T/P deducts all losses against all gains

Scheduler T/P will only deduct CL to the extent of your CG + $3,000. Why? We limit capital losses to prevent T/P from reducing tax liabilities by just selling all losing stocks and keeping all winning stocks. And, under § 1014, lots of money would escape taxation.

1211(b) limits deducting more than $3,000 of capital losses against ordinary income.

1211(b) will probably be on EXAM!!! reason = realization rule allows you to pick and choose when to realize losses and gains. w/out 1211(b), people could just choose to realize losses in order to offset work salary!

EXAMPLE:

500 Alpha Stock: Basis: 50; FMV: 201000 Beta Stock: Basis: 15, FMV: 75

On exam, high income spouse does not want to give loss to low income spouse b/c the loss taken by high income would yield more money.

BUT…

of 77

FED TAX OUTLINEIf high gave gains to low, then low pays tax at low tax rate. This is good!

EXAMPLE:Don Sr. 150K income @ 35% tax rate; basis 100, FMV 200Don Jr. 5K income It would make more sense for Sr to GIVE to JR the gain stocks, but not the loss stocks

EXAMPLE:

0-1000: 0% tax rate

1001-2000: 20%

2001- 40%

1. Orchard: orange treesa. each year you’ll sell fruit and get proceeds. This will fluctuate

according to weather, but relatively steady stream of income over time.

b. If 1,500/yr, will pay 0% on first 1000, and 20% on next 500.c. In yr 20, he’ll have made 30K.

2. Pine Trees: to be sold for timbera. no payout from years 1--? b/c it takes time for the trees to grow.

so you’ll have one big clump of income when you finally cut them down and sell.

b. In yr 20, sells for 30K (same as orange guy). But he’ll pay much more tax simply b/c he had to wait! THIS IS AN EXAMPLE OF THE BUNCHING PROBLEM. The gain had been accruing over the whole 20 yrs but he would be forced to realize 20 yrs worth of gain in one year.

3. Stock: all profits paid as dividendsa. Get income each year (like the orange guy)

4. Stock: all profits reinvesteda. Get income all at once.

5. A gold bara. Bought in 1980 for 10Kb. In 2000, worth 20Kc. The 10K does not accurately reflect gain. It merely reflects inflation.

i. In year 1, you could buy 10K Hershey bars at $1/bar. ii. But in year 20, you could still only buy 10K Hershey bars—

b/c the bars now cost $2/bar!

A. Historical Overview

of 77

FED TAX OUTLINEa. 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. 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.

ii. 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)

Gives special treatment to NCG (as defined in 1222(11)).

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.

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

2. This category of long-term capital gain preferential treatment applies only if the taxpayer is in a bracket higher than 28%. It has no effect when the taxpayer is in a lower bracket.

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

of 77

FED TAX OUTLINEextent 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. 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).

3. A classic example is the sale of corporate stock that does not constitute qualified small business stock under § 1202 and was held for more than 1 year.

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

1. § 1211(b): ORDINARY INCOME OFFSET RULE: To the extent that capital losses > capital gains, up to $3000 of the excess may be deducted. 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): 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—§ 1221

a. Property acquired and held by the taxpayer for more than 2 years (whether or not connected with his trade or business) is a capital asset, except for the following:

The following items are NOT capital assets…

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

1. These typically constitute ordinary business income, and hence are not capital assets.

of 77

FED TAX OUTLINEii. § 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 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.

2. T/P CREATED THE WORK : IF YOU’RE ALLOWED TO GET CG TREATMENT FOR A PAINTING YOU PAINTED, YOU BASICALLY GOT CG TREATMENT FOR YOUR WORK! THIS ISNT FAIR.

3. 3 RD PARTY CREATES : Not a capital asset if given to you by living person b/c their basis would become your basis. THE DONEE TAKES THE DONOR’S BASIS WHEN THERE’S A GIFT. THIS SECTION COULD BE ON THE EXAM!

a. WON’T BE CG IF BONNIE CREATOR SELLS PAINTING. AND IF BONNIE GIVES TO BETTY, IT STILL WON’T BE CG IF BETTY SELLS IT.

b. BUT, if a person transfers asset to you after they die, this will be a capital asset b/c you have a stepped up basis. WHEN SOMEONE DIES AND GIVES YOU PAINTING, YOUR BASIS BECOMES THE FMV OF THE PAINTING—NOT THE BASIS THAT THE DECEASED HAD.

c. GIVEN WHEN ALIVE = NO CAd. GIVEN WHEN DEAD = YES CA

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.

2. Amounts received by a service provider or by one selling inventory-type assets are clearly normal business income and should NOT be treated as capital assets.

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

of 77

FED TAX OUTLINE1. 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

REMEMBER THAT INTENT IS IRRELEVANT!

1. The Court in Corn developed intent test: investment purpose? Or business purpose?

i. If investment purpose, then capital gains/losses. ii. If business purposes, then ordinary gains/losses.

b. Wooten says this is a bad decisions b/c 1221(a) says nothing about intent! It’s a poor reading of the statute.

2. The Court in Arkansas Best does away w/Corn Product’s intent test. The court here reinterprets Corn case. See page 751 for Arkansas Best interpretation of Corn. The loss arising from the sale of the stock is a capital loss.

3. In Hort. the T/P contended that money received for cancellation of the lease was capital rather than ordinary income and that it was therefore subject to §§ 101, 111-113, and 117 of the Revenue Act of 1932. T/P did not include an amount of money paid to him in consideration of cancelling a lease as gross income. Instead, he reported a loss. He sought review of the judgment of the Circuit Court of Appeals for the Second Circuit affirming a decision sustaining the determination of a deficiency in income

i. Holding: The Court held that the amount received by the taxpayer for cancellation of the lease had to be included in his gross income in its entirety. Section 22(a) of the Act defined gross income to include gains, profits, and income derived from rent, or gains or profits and income derived from any source whatever. The rent paid prior to cancellation was gross income, just as subsequent payments if the lease had never been cancelled would have been included. The consideration received for cancellation of the lease was not a return of capital. The disputed amount was a substitution for rental payments, and it was regarded as ordinary income.

E. The Sale or Exchange Requirement

of 77

FED TAX OUTLINEa. 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.

ii. “Where the taxpayer would be eligible for capital gains treatment upon the sale of property had it appreciated in value, he should not be allowed to avoid the limitations on deductions for capital losses by using an artfully timed abandonment rather than a sale.” Yarbro v. Comm’r.

b. While technically, § 1222 requires a particular type of disposition before there will be a capital gain or capital loss, Congress has in many cases negated the need for a sale or an exchange.

i. EXAMPLE: § 165(g)(1): if any security becomes worthless, the loss resulting shall be treated as a loss from the sale or exchange of a capital asset.

EXAMPLES:

a. Sedan: excluded under 1221(a)(1)b. Van: excluded by 1221(a)(2)c. Personal car: YES CA d. Land and building: excluded by 1221(a)(2)e. Prom note: YES CA b/c land is not excluded by 1221(a)(1)—pursuant to 1221(a)(4)f. Prom note based on sale of inventory: excluded by 1221(a)(4). The truck is inventory under

1221(a)(1)g. Home: YES CAh. Painting by mom:

i. Gift when mom was alive: excluded by 1221(a)(3)(C). the basis was transferred here.

ii. Gift when mom was dead: YES CA. 1221(a)(3)(C) does not apply b/c there’s a stepped up basis.

i. Stock: YES CA b/c there’s no exception; this is not used in trade or business!j. Computer: YES CA b/c now they’re no longer using it in a trade or business. It wasn’t CA

when they used it in trade or business.

Question 3:

k. This is like the Hort case! Home vs. Contract…

i. Hort: trust co had lease on prop that Hort rec’d from dad. Business/lessee wanted to buy out of the lease and paid Hort lots of $. Two issues: Hort rec’d lots of $ and tried to take capital loss. Court said character of the money was ordinary income and not capital.

Payment in lieu of ordinary income is ordinary income.

ii. So lessee buying out of the lease is in lieu of ordinary income. Therefore, the payment is ordinary income, capital gain!

of 77

FED TAX OUTLINEl. In this case, the univ is buying 2 things: the home and the contract.

i. Home: capital asset; gain on sale of home is excluded (see § 121 stating that gain on home excluded to certain extent).

ii. Contract: not CA; this is ordinary income—just like Hort or 1221(a)(4).

Question C(1):

1. Sharon buys stock in newsprint co. to ensure supply of paper.

How should the loss be characterized?

a. Argument that this is capital loss: hedging transactions are generally characterized as ordinary loss/gain (§ 1.1221-2(d)(5)). BUT this does not apply to stocks!!!

What if she entered into contract/ assigns right to 3rd party?

b. Now, it’s ordinary income b/c this is futures contract. Excluded under 1221(a)(1). The newsprint is stock in trade.

XVII. QUASI-CAPITAL ASSETS (chap 32, 761-70)

A. 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. BEST OF BOTH WORLDS!!! Under 1231, gain characterized as capital gain; loss characterized as ordinary loss.

3. Also, remember that 1231 is a characterization provision.

4. 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.

i. EXAMPLE : insurance from truck struck by lightening. This covers stuff that is NOT a sale or exchange and thus stuff that wouldn’t be covered by 1221.

B. THE PRELIMINARY HOTCHPOT

of 77

FED TAX OUTLINE1. Section 1231(a)(4)(C) says that involuntary conversions in which the losses exceed the

gains are NOT covered under 1231.

2. This 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…

C. 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.

D. 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.

i. 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.

XVIII. RECAPTURE OF DEPRECIATION--§1245 (chap 33, 771-78)

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

of 77

FED TAX OUTLINE 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.

B. SECTION 1239 ORDINARY INCOME (RELATED PARTIES PROVISION)

1. Any gain recognized on a sale or exchange of depreciable property b/w certain RELATED PARTIES should be characterized as ORDINARY INCOME.

XIX. ASSIGNMENT OF INCOME (chap 34, 779-803)

2 major rules: 1) earned income taxed to earner (Lucas/Helvering) 2) unearned income from property taxed to owner of property (Horst)

REMEMBER: if owner GIVES away fruit, owner will be taxed. But if owner gives away fruit AND tree, then fruitholder will be taxed. And if SELLS right to income, the transferee will be taxed.

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.

of 77

FED TAX OUTLINE

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.

NOTE: the couple here tried to divert income to wife through a contract. This is not allowed. However, if the couple lived in a community property state, the property would be owned equally by both spouses—half salary taxed to one spouse and half to the other (Poe v. Sebourn)

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

§ 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. 83 codifies the holdings of Lucas and Eubank

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.

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.

of 77

FED TAX OUTLINE

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; more indefinite more likely donee taxed2. The controls retained by the donor; more donor controls, more likely donor taxed3. 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.

XX. TAX CONSEQUENCES OF DIVORCE (chap 37)

Alimony usually on exam. issues will be:1. does it look like child support?2. is it in cash?3. is it given to transferee after death?

Relevant Provisions:

§ 71: inclusion of alimony in income § 215: allows (above-the-line) deduction for alimony paid § 1041: “Non Recognition Rule”: PROPERTY TRANSFERS between spouses and

former spouses, incident to divorce, are nontaxable events. 1041 creates an exception for married and divorce transactions. When 1041 applies, each transfer is treated like a GIFT. So neither spouse

(or ex-spouse) will realize a gain or loss.

of 77

FED TAX OUTLINE Transferee will take BASIS of transferor even when FMV of property at time

of transfer is LESS than transferor’s basis.

EXAMPLE—ALIMONY VS. TRANSFER OF PROPERTY:

1. ALIMONY: If husband pays $50K in alimony to wife, he deducts 50K and she includes 50K. If he is in a 40% bracket, he saves $20K in taxes (40% x 50K). If she’s in a 15% bracket, she pays $7,500 in taxes (15% x 50K). Hence, this shifts the money from high bracket to low bracket and saves a lot of money.

Wealthy couples would prefer this over property transfer. Property does not qualify as alimony.

2. TRANSFER of PROPERTY: If it is a $50K transfer in property, the husband has no deduction and the wife has no income. If this counts as alimony, it would save a bundle. The husband and wife could agree to alimony and split the gain between them! Hence, from a tax perspective, alimony has a big effect. That is why it’s important to decide whether the payment counts as alimony.

With wealthy couples, it could make more sense to call a property settlement “alimony” b/c the tax treatment of alimony can have distinct advantages over the rules of §1041. Under 1041, when there is transfer of property (no alimony), no income included to transferee and no deduction transferor. If giver is wealthier than receiver, then he would have to pay more money under 1041 than he would if he paid alimony

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). Therefore, cash payments to 3rd parties may in some circumstances qualify as alimony.

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).

of 77

FED TAX OUTLINEi. 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.

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.

b. 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 -- § 71(f)

1. § 71(f): Recapture provision2. 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.5. 71(f) prevents spouses from calling property settlements alimony.

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).

of 77

FED TAX OUTLINEa. 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

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

The point of 1041 was to overrule Davis only w/respect to spouses or parties incident to a divorce. 1041 applies to transfers incident to divorce AND to all spouses!!!

Transfers treated as though each spouse made a gift! But the difference b/w gift rules and this rule is that in GIFT context is For purpose of calculating donee’s gain, basis would be donor’s. For purposes of loss, basis would be FMV at time of transfer. But under 1041, the chart we learned for 1015 doesn’t apply. See handwritten chart on back of divorce handout.

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.

When there is a quid pro quo transfer, and one pays w/appreciated property, you must pay on your gain. The general rule laid out in Davis is current law.

2. BUT, this 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

of 77

FED TAX OUTLINEappreciated 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.

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

2. U.S. v. Gilmore

a. None of the wife’s claims arose in connection with respondent/husband’s profit-seeking activities. The claims stemmed entirely from the marital relationship. Therefore, none of the respondent’s expenditures in resisting these claims can be deemed “business expenses” and are thus not deductible under § 212.

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.

You can deduct legal expense when they arise out of business activity. You can’t deduct legal expenses that arise out of personal life.

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

of 77

FED TAX OUTLINEthose claims are not deductible.

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

c. 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).

d. There are lots of criticisms of this case

e. This is important case. Similar to Clinton EXAM problem where people helped out to pay Paula Jones legal expenses. Would ask:

i. Is it gift? Would have to be detached and disinterested generosity.ii. If no gift, then includable in income. Then would ask…

iii. Is it deductible? You would consider whether Gilmore was applicable.

1. Arg for Clinton: costs incurred in business seeking role. He was at conference for work, etc. when the allegation arose.

2. Arg against: sexual harassment not part of profit seeking.

3. 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.

EXAMPLES:

Rent and/or utilities?a. Rent = yes alimony under Rev 1.71-1T, Q&A 6. He deducts/she includes.

But utility payments ≠ alimony b/c not part of agreement. Tax treatment of utility thus gift—no deduction or inclusion.

Mortgage payments?

b. If F owned house, he couldn’t deduct mortgage payments as alimony even if made under divorce or separation agreement (See p916 of Regs, Q&A6). If you own house, etc, your payments on this house will not constitute alimony even if other spouse uses the home. To the extent, though, that M owns the house, P can deduct whatever he pays for HER part of the house! If M is 50% owner, P can deduct $1250! M would have to include the $. Now, $1000 is principal and $250 is interest. So, M can deduct the $250 interest.

i. Under rev ruling, 64-20 F can deduct half the money.ii. F can deduct 1250 as alimony

iii. M must include 1250 portion of mortgage that counts as alimony.iv. But M can deduct 1000 b/c this is interest and mortgage interest is

deductible.v. What about Frank! CORRECTION: F CAN DEDUCT THE

INTEREST!!!!! Under Bitker, F couldn’t deduct if only wife living

of 77

FED TAX OUTLINEin house. But, his daughter is living in the house—so this counts as lineal ancestor!

1. Under 163(h), you can deduct qualified residence interest. 163(h)(4)(A)(i)(II) blah blah blah—go thru the process Wooten did.

c. If $200,000 realized on home. general rule is that if T/Ps living in home for % yrs, they can exclude up to $500,000 (see § 121). Each would have $100,000 gain. For purposes of 121, P’s is seen as using house. So, all of this gain is excludable. TAKE A LOOK at §121!

2. 5K/mo. decreasing each year. What tax consequences?

Total Payments:

Yr 2: 60K 1st post-separation payment (under 71(f)(6))Yr 3: 48K 2nd “”Yr 4: 18K 3rd “” Yr 5: 12K

This is 71(f) problem. Under 71(f)(4) calc, the formula would be this:

48K – (18K + 15K) = 15K (excess payment) 33K

Under 71(f)(3)(B)(i)

60K – 33K + 18K + 15K2

Excess payment = 19,500

TOTAL EXCESS PAYMENTS = 15K + 19.5K = $34,500 (71(f)(2))

P will have to add 34.5K and she will have to subtract it from the income.

3. Daughter Donna is now 12

a. Not alimony (under 71 (c)) b/c this is child support. No inclusion for M and no deduction for F.

b. Even if you don’t call something child support, it may be considered as such under 71(c).

i. 1st reduction: occurs when D is 15 and 3 months old. Under Reg. 1.71-1T(b), p918, this situation doesn’t fit exclusions.

ii. 2nd reduction occurs when D is 18 and 3 months old. This is w/in 6 months of turning 18!

of 77

FED TAX OUTLINEc. EXAMPLE:

i. Year 7: 2K/month called alimony—ii. Year 14:

iii. Year 18:iv. Can deduct 1K as alimonyv. Other 1K is alimony

vi. Share of payment that that is found to be child support will be non-deductible all the way through.

Parties can decide they don’t want something to be alimony. But they can’t say something is alimony when it isn’t!

XXI. LIKE-KIND EXCHANGES (chap 39)

Must be for business or investment purpose in order for 1031 to apply!

§ 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.

EXAMPLE:

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.

of 77

introduction: chapter 1: pp 1-20 - phi alpha delta...

Documents