tax master outline: law school
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Fed Income Tax Outline from Law SchoolTRANSCRIPT
Tax Master Outline 11/23/11 11:58 AM
II: Gross Income- Concepts and Limitations
A: What is Gross Income? – “accession to wealth”
o i: Internal Revenue Code
§61: Gross Income: Gross income means all income from whatever source
derived, including but not limited to: compensation for services (fees,
commissions, fringe benefits etc), gross income derived from business, gains
derived from dealings in property, interest, rents, royalties, dividends,
alimony and separate maintenance payments, annuities, income from life
insurance and endowment contracts, pensions, income from discharge of
indebtedness, distributive share of partnership gross income, income from a
decedent or income from an interest in a trust or estate.
§85: Unemployment compensation is included under gross income
§86: Social Security is generally included under gross income.
o ii: Treasury Regulations
§§1.61-1: Gross Income: All income from whatever source derived unless
excluded by law. Realized in any form.
§§1.61-2(a)(1): Compensation For Services: Taxable income includes wages,
salaries, commissions, tips, bonuses, severance pay, rewards, jury fees,
marriage fees to clergymen, retirement, pensions
§§1.61-2(d)(1): Compensation Paid Other than in Cash: If services are paid
for in property the FAIR MARKET VALUE of the property must be included in
income as compensation. If paid for in other services the fair market value
of those services must be taken in income as compensation- if given at a
stipulated price, that price will be taken as the FMV.
§§1.61-2(i): Property Transferred to An Employee or Independent
Contractor: if property if transferred by an employer to an
employee as compensation for an amount less than its FMA, the
difference between the amount paid and the FMW at the time of
transfer is compensation and shall be included in gross income. In
subsequent sale, to compute gain or loss, the basis shall be the
amount paid for the property increased by the amount included in
gross income.
§§1.61-8(a) Rents and Royalties: Gross income includes rentals received or
accrued for the occupancy of real estate or the use of personal property.
Gross income also includes royalties (like from publishing a book)
§§1.61-9(a): Dividends: Dividends are included in gross income. Dividends
may give rise to a credit against tax under §34.
§§1.61-11(a): Pensions: Pensions and retirement are income unless
excluded by law. If employer did not contribute to pension then the full
amount is taxable gain. If the employer did contribute then the amount in
excess of the contribution might be taxed as capital gain rather than
income.
§§1.61-14(a): Misc. Taxable Income: Punitive damages, another person’s
payment of income tax, illegal gains treasure trove, prizes, awards, damages
for personal injury, income taxes paid by the lessee corporation,
scholarships and fellowships, tax free covenant bonds, notional principal
contracts.
o iii: Cases:
US v. Kirby Lumber Co: Discharge of a corporate debt for an amount less
than the face of the debt does not result in income to the debtor
Commissioner v Glenshaw Glass: Glenshaw sued Hartford Empire Co for
damages for fraud and damages for violation of antitrust laws. Hartford paid
Glenshaw a settlement of $800,000. $324,529 of that represented payment
of punitive damages for fraud and anti-trust violations, Glenshaw did not
report this as income claiming it was a wind fall from the culpable conduct
of a third party and was not within the scope of taxable income. However
the court held that all gains are taxable except those which are specifically
exempted. SC defined income as an accession to wealth clearly realized and
over which the tax players have complete dominion.
Old Colony Trust: Mr. Woods company paid his taxes for him based on his
pay. The Board claimed that Mr. Woods should have included the amount
paid by his employer as additional income.
Held: The SC stated that it made no different whether the party had
bargained for the payment or merely acquiesced in it. The Court
found that the payment was in consideration for services rendered
and therefore was includable in income . Form of payment made no
difference. The taxpayer owed a tax, it was discharged by the
employer, the discharge was equivalent to receipt. Discharge will
not likely be a gift when it arises out of employer-employee
relationship.
McCann: McCann and her husband went on a business trip which
was paid by her emplyoeer. They did not claim the trips expenses
on their taxes. They were sued, claiming that they should have
reported the cost of the trip. Gross income may be in any form. If an
employeer pays an employees expenses on a trip as a reward for
services rendered then this amounts to an award and must be
taxed.
B: Realization Requirement
o i: Treasury Regulation
§§1.1001-1(a): Gain or loss is realized from the conversion of property into
cash or from the exchange of property for other property differing
materially in kind or extent.
o ii: Cases
Eisner v. Macomber: P owned stock, of which she and the other
shareholders received a 50% stock dividend in the form of additional
corporate stock rather than cash dividend. Court held that because no gain
and no income had been realized by reason of the stock dividend Congress
had no power to tax it.
Cottage Savings Association v. Commissioner: The issue presented was
whether a savings and loan association “realized” losses on the exchange of
its interest in one group of home mortgage loans for interests in a different
group of home mortgage loans, the court concluded that losses had been
realized because the exchanged property were materially different under
1001(a).
o iii: Measure of Gain or Loss
Code §1001(a): Gain or loss is the difference between the aggregate amount
realized and the adjusted basis for the property
Amount realized is the sum of money received plus the FMV of the
property (1001(b))
Adjusted basis is the
C: Imputed Income
o i: Imputed Income is income that is not taxable and usually comes from owning and
using one’s own property or in using self-help (ie: helping one’s own family)
D: Bargain Purchases
o i: If you purchase an asset at bargain price, the difference between the bargain price
and the fair market value does not constitute gross income.
o ii: Cases
Pellar v. Commissioner: Pellar built a home for cheaper than the fair market
cost because the person building it for them wanted to stay in their
goodwill. The court held that this difference did not constitute taxable
income (bargain purchase).
EXCEPTION: Keep in mind §1.61-2(d)(2)(i): if property is transferred
as compensation for services in an amount less than its FMV, the
difference between the FMV and the amount paid is gross income.
III: Effect of an Obligation to Repay
A: Loans
o i: Loans are NOT gross income. It does not represent an accession to wealth”. The
borrower has an obligation to repay the loan, it is this obligation that negates a loan
as income.
Commissioner v. Tufts:
Facts: Tufts contended that the assumption of a mortgage that
exceeded the FMV of the property by the purchaser was not taxable
Held: This is taxable. When an obligation to repay is relieved, the
taxpayer has recognized income. When the mortgage is assumed, it
is as if the mortgagor was paid the amount in cash and then paid off
his mortgage.
o ii: HOWEVER, a failure to repay a loan may generate tax consequences.
If a third party pays off the loan of behalf of the borrower
If the debt is forgiven by the lender.
Old Colony Trust v: (See Chapter 2 PG ____)
o iii: What constitutes a loan?
In order for a transfer of funds to constitute a loan, at the time the funds are
transferred there must be an unconditional obligation to repay and an
unconditional intention of the part of the transferor to secure repayment.
Look objectively at factors such as the presence or absence of a debt
instrument, collateral securing the loan, interest accruing, repayments of
the transferred funds, attributes indicative of an enforceable obligation.
Morrison v. Commissioner: Tax Court held that payments and
disbursements made to a shareholder were loans because the court found
that the corporation has enough funds to make the loans, the shareholder
has enough income to repay the loans, and there was evidence that the
shareholder has made repayments including interest.
B: Claim of Right
o i: If a taxpayer receives earning under a claim of right and without restriction as to
its disposition, he has received income which he is required to report on his tax
return, even though it may still be claimed that he is not entitled to retain the
money and even though he may still be adjudged liable to restore its equivalent.
(North American Oil Consolidated v. Burnet)
Deduction: Rightfully so, a taxpayer who reports income under a claim of
right is entitled to a deduction if he is required to refund the money.
See Section §1341 of the Code. (a) If— (1) an item was included in gross
income for a prior taxable year (or years) because it appeared that the
taxpayer had an unrestricted right to such item; (2) a deduction is allowable
for the taxable year because it was established after the close of such prior
taxable year (or years) that the taxpayer did not have an unrestricted right
to such item or to a portion of such item.
o ii: Funds over which a taxpayer only acts as a conduit are not received under claim
of right.
ex: Nonprofit corporation receiving funds to be solely for nonprofit
purposes. Court held funds were received in trust with no gain accruing to
the taxpayer (Ford Dealers Advertising Fund v. Commissioner)
C: Illegal Income
o i: Gains from illegal funds ( US v. Sullivan) or embezzlement may be taxed (James v
US).
Gilbert v. Commissioner: Taxpayer illegally withdrew corporate funds.
However, he has informed several of the officers and his withdraws and
believed he was acting in the best interest of the corporation. The Court
held that the taxpayer did not realize income but the withdraws were
merely loans which he intended to repay.
o ii: Repayment of illegal income entitles the taxpayer to a deduction. (Rev Ruling 65-
254)
D: Deposits
o i: Rent paid in advance generally constitutes gross income in the year it is received
regardless of the period covered or the taxpayer’s method of accounting. Reg §1.61-
8(b)
o ii: Security deposits
Commissioner v.Indianapolis Power and Light: Control over the conditions
of the refund if the determining factor in deciding whether a “deposit” will
be taxable. If the payor controls the conditions under which the money will
be repaid then the payment is not income to the recipient. On the other
hand, if the recipient has control over the conditions under which the
payment will be repaid then the recipient has some guaranty that it will be
allowed to keep the money and hence has dominion over it.
Highland Farms v. Commissioner: Residents of an apartment complex were
required to pay an entry fee prior to occupancy and monthly rentals
thereafter. At the end of five years the entry fee was fully nonrefundable,
however a resident who terminated occupancy before this period ended
was entitled to a pro rata refund. Court held the refunds were within the
tenants control and the petitioner needed to only include in his income the
portion of the entry fee which become nonrefundable after each year.
Perry Funeral Homes: Taxpayer prepaid for funeral goods, contract could be
cancelled anytime prior to actual provision of the goods. Therefore this was
not income until the funds were used to purchase the items.
IV: Gains Derived from Dealings in Property
A: Terminology
o i: Gain
§1.61-6(a) is the excess of the amount realized over the unrecovered cost or
other basis for the property sold or exchanged.
§1001(a): excess of the amount realized over the adjusted basis
(unrecovered cost).
o ii: Amount realized
§1001(b): Amount realized on the sale or other disposition of property
equals the money received plus the FMV of any other property received.
o iii: Adjusted Basis:
§1011(a): adjusted basis is equal to the basis as determined under §1012
adjusted as provided in §1016. According to §1012, adjusted basis equals
costs (amount paid for an item), except as otherwise provided. §1016
requires a taxpayer to adjust the basis to reflect any recovery of her
investment or any additional investment made in her property (ie: additions
to a home must be added in figuring the adjusted basis)
B: Tax Cost Basis
o i: §1.61-2(d)(2)(i): Basis is the value of property received (Ex: If I perform $50k worth
of legal work and X gives me property work 50K, which I then sell for 60K, my basis
in the property is 50K. Another example is, if lawyer does 50k worth of worth and
client gives lawyer property worth 60K but only makes lawyer pay 10K then lawyers
basis in the land is not merely 10k but the total 60K)
C :Impact of Liabilities
o i: Impact on Basis
Loans: When using loans to pay for land or other items, because of the
obligation to repay the taxpayer is entitled to include the amount of the
loan in computing the basis in the property. Commissioner v. Tufts
§1012: The loan is a part of the basis even if the lender is the seller
or if the buyer pays in installments over time.
o ii: Impact on Amount Realized
§1.1001-2(a)(1): The amount realized from a sale or other disposition of
property includes the amount of liabilities from which the transferor is
discharged as a result of the sale or disposition.
Recourse liabilities incurred by a taxpayer in the acquisition of property are
included in the taxpayer’s basis in that property and the recourse liabilities
of a seller, assumed by a purchaser, are included in the seller’s amount
realized.
D: Basis of Property Acquired in Taxable Exchange
o i: The cost basis of property received in a taxable exchange is the fair market value
of the property received in the exchange plus any cash or other property given for
the property in question. Philadelphia Park Amusement Co v. US
o Where the transfer was made at arm’s length and the new asset cannot be valued,
it is deemed to be equal to the value of the asset that was given up by the taxpayer.
V: Gifts, Bequests, and Inheritance
A: What is Excluded From Income?
o i: 102 excludes gifts as well as property acquired from a decedent through bequest,
devise or inheritance
What is a gift?: The motive of the donor is critical in characterizing receipts
as gifts. In Commissioner v. Duberstien the court said to look to the motive
of the donor but to also apply the mainsprings of human conduct to the
facts of each case. In Duberstein the D was given a car by a business
associate as a result of a useful referral but did not declare the car as
taxable income, deeming it a gift. Court held that the car was not given out
of a detached and disinterested generosity, or out of affection, respect,
admiration, or charity, and therefore was not a gift.
o ii: Exclusions
§103(a) does not allow a deduction for amounts transferred by an employer
to, or for the benefit of an employee.
§274(b) disallows a deduction for gifts made by businesses to individuals in
excess of $25. (this does not include employees because as listed above,
gifts from employers to employees are never deductible)
B: The Nature of the Bequest or Inheritance
o i: Must evaluate whether the inheritance or bequest is cash or property received as
a gift or as compensation or some other form of taxable income.
Wolder v. Commissioner: P agreed to render legal services to a client
without billing for them in exchange for money and stocks bequeathed to
him in her will. Court held that when a gift or bequest if given for the
purpose of payment for services performed it because taxable income.
Olk v. US: P was a craps dealer who claimed that tokes given to him by
players at the casino were non-taxable gifts given out of superstition. Court
held that money received by taxpayers who are engaged in rendering
services, contributed by those with whom the taxpayers have some
personal or functional contact are taxable income when in conformity with
the practices of their area of work. Furthermore, the regularity of receipt of
the money indicated it was likely income.
Goodwin v US: Revered Goodwin was given a “special occasion gift” from
the members of their congregation and claimed that it was nontaxable.
Court held that regular sizeable payments made by persons to whom the
taxpayer provides services are customarily regarded as a form of
compensation and therefore is taxable income.
C: Basis of Property Received by Gift, Bequest, or Inheritance
o i: Gifts of Appreciated Property
§1015: a receiver of a gift gets whatever basis the giver has in the gift
(transferred basis)
ex: Stock purchased for $200, is worth $500 when is gift as a
gift. The receiver of the gift takes the $200 basis in the
stock.
Taft v. Bowers: Father gave stock to his daughter. Daughter
sold the stock and argued that she was only taxable on the
appreciation of the stock while she owned it, not while her
father owned it. The court disagreed. The daughter takes
the father’s original basis, thus she will be taxed on the full
value of the gain.
o ii: Gifts of Property Where the Basis is in Excess of the FMV
§1015 shifts gain from donors to done, however, losses may not be shifted.
If X gives Y a stock with a basis of $200, and Y sell it for $100, Y does
not report the loss according to §1015(a) and Reg §1.105-1(a)(2) it
simply disappears.
o iii: Basis of Property Received by Bequest or Inheritance
§1014 provides that property acquired from a decedent generally takes a
basis equal to the fair marker value of the property at the date of the
decedent’s death.
This provides an amnesty for gain. The heir receiving the stepped up
basis can sell the property for its value as of the decedent’s death
and not have to report any gain for their taxes.
o iv: Part-Gift, Part-Sale:
Seller’s gain/loss: §1.1001-1(e) states that the seller-donor has gain to the
extent that the amount realized exceeds the adjusted basis of the property.
No loss is recognized on such a transaction.
Donee’s Basis: §1.1015-4 provides that the donee’s basis will be the greater
of the amount the done paid for the property or the adjusted basis of the
donor.
For the purpose of computing losses however the donee’s basis is
limited to the FMV of the property at the time of transfer to the
donee.
Liability assumed by the donee is treated as an amount paid. §1.1001-2(a)
(1), (4)(ii)
Gain can be recognized on the part of the donor the liability
assumed exceeds the donor’s basis in the property.
Example: If S sells land to E for $15K, S had an adjusted basis of 30k and the
land had a FMV of 60K. S has no gain or loss because her amount realized
does not exceed her adjusted basis. E has an adjusted basis of 30k because
her adjusted basis is the greater of the amount she paid (15k) or the donor’s
adjusted basis (30K). Is instead of paying 15K, E assumes S’s liability of 45k,
then S has a gain of 15K and E has an adjusted basis of 45K.
VI: Sale of Principal Residence
A: Ownership and Use Requirements of §121
o i: Under §121 taxpayers may exclude up to $250,000 (or 500K for joint returns) of
the gain on the sale or exchange of a qualifying principal residence, it does not need
to be one’s principal place of residence at the time of the sale or exchange but
rather the sellers must have lived in the property as a PPR and owner the property
for periods aggregating to two years (does not need to be continuous) or more
during the five year period prior to the sale 121(a).
o ii: Ownership and use requirements may be satisfied during nonconcurrent periods
so long as the taxpayer satisfied each of them within the five year period ending on
the date of sale or exchange. §1.121-1(c)
ex: Rented home in 2000, purchased in 2004, sold in 2006, they can exclude
gain upon sale because they lived in home as PPR for 2 of 5 years and
owned the home for previous 2 of 5 years.
o iii: Short temporary absences will be counted in periods of use (ie vaca)
o iv: If an unmarried individual sells or exchanges property subsequent to the death of
his or her spouse, the individuals’ use and ownership period will include the period
the deceased spouse owned and used the property. §121(d)(2)
o v: If receives property from transaction described in §1021 (spouse or former
spouse), ownership period (not use) will include ownership period of transferor
ex: Anna and Bob divorce, Anna transfers title to a home she owned to Bob.
Although Bob never had any ownership interest in the home for purposes of
121(a), Bob will be considered to have owned the home for the period that
Anna owned the home. (however the use requirement will not transfer)
o vi: If an individual continues to have ownership interests in a residence but is not
living in the residence because the individual’s former spouse is granted use of the
residence under the divorce, the individual with nonetheless be deemed to use the
property during the period her former spouse is granted use of the property.
§121(d)(3)(B)
o vii: The use rules are modified if someone becomes physically or mentally incapable
of self-care. If the individual owns and uses the residence for one year in the five
year period, the individual will be treated as using the property for any period
during the five year period in which the individual resides while owning the
property. §121(d)(7).
o viii: To prevent a windowed spouse from having to rush to complete a sale of their
home within the same year of the death of the spouse to claim the $500,000
exclusion, Congress enacted §121(b)(4) which allows a widowed taxpayer who has
not remarried, to claim the entire $500,000 exclusion if he sells or exchanges the
residence within two years of the date of the death and the original requirements
were met before the date of the spouse’s death.
B: Amounts Excludable Under §121
o i: Taxpayers are allowed to exclude up to $250,000 on the sale of their PPR, this
exclusion applies to only one sale or exchange every two years. §121(b)(3)
o ii: Couples are able to exclude up to $500,000 if they files joint returns, and if certain
requirements are met under §121(c)
1) One of the spouses must satisfy the ownership requirement
2) Both spouses must satisfy the use requirement
3) Neither spouse has used the exclusion within the past two years
o iii: If sale or exchange occurs because of change in place on employment(new job
must be at least 50 miles from the old residence), health (requiring a physician
recommended change in residence), or other unforeseen circumstances and the
taxpayer consequently fails to meet the ownership and use requirements of
§121(a), §121 (c) provides that some or all of the gain may still be excluded. The
amount excludable will be a fraction of the $250,000 (or $500,000) limit.
§121(c)(1) gives the formula for finding what amount is excludable under
this situation. The fraction will have as its numerator, the length of the time
the taxpayer owned and used the home as his PPR, and the denominator
will be 2 years.
Ex: If X lived in the home as his PPR for 1 year then had to move
because of a job he can claim ½ or half of the $250,000 limit.
Ex: X and Y are married July 1, 2007 and move into X’s PPR as their
PPR. A year later they have to move because of jobs. Because they
both did own and use the house for the required time, they cannot
claim the joint $500,000 but must file separately. X can exclude the
entire $250,000 because he satisfied the requirements. Y must take
a fraction, ½ of the $250,000. Therefore together they can exclude
$375,000.
If a spouse has to move because of a husbands change in
business she can still qualify for this safe harbor provision
under §1.121-3(c)(1).
C: Principal Residence
o i: PPR: If the taxpayer has two residence, the residence the taxpayer uses for the
majority of the year will be considered his PPR §1.121-1(a)(2)
Regulation 1.121-1(a)(2) includes factors relevant in identifying a property
as a taxpayers PPR 1) taxpayers place of employment 2) principal place of
abode for family members 3) address listed on the taxpayer’s federal and
state tax returns, drivers license etc 4) tax payers mailing address for
bills/letters 5) Location of the taxpayers banks 6) location of religious
organizations and clubs which the taxpayer is part of.
Guinan v. US: P owned residences in GA, AZ and WI, and contended that he
could exclude the gain from the sale of his house in WI because he resided
there for more days that he resided at the other places during the 5 year
period. Court held that the time spent at the residence is not the single
determining factor as to whether a residence is a PPR. In evaluating the
taxpayer under other factors it found that the home in WI was not his PPR.
o ii: Property owned in conjunction with the dwelling may be considered as part of
the PPR.
Bogley v. Commissioner: Taxpayer subdivided his 13 acres of land on which
his house sat and sold all the different sections. Because all the land was
used as the PPR each sale could be applied to the exclusion.
o iii: If a vacation home is not the PPR then time spent there will not be able to be
aggregated to satisfy the two year period, since it isn’t the PPR.
IX: Discharge of Indebtedness
A: Overview
o §61(a)(12): income from discharge of debt is indebtedness
o §108 provides an exclusion from income when discharge occurs in certain
circumstance (bankruptcy or insolvency)
o Kirby Lumber Co: KL issued bonds at par value and then later repurchased some on
them at below market par. Difference between the issuing price and the repurchase
price was taxable gain. Taxpayer was solvent at all times.
Established the “freeing of assets theory” : taxpayer realizes gain when a
debt is discharged because after the discharge the taxpayer has fewer
liabilities to offset her assets.
B: Specific Rules Governing Exclusions
o i: Discharge of Indebtedness when the taxpayer is insolvent
§108(a)(1) specifically provides the discharge of indebtedness will not
generate gross income if the discharge occurs in a bankruptcy or if the
discharge occurs when the debtor is insolvent.
§108(a)(3): Limits the amount of the insolvency exclusion to the
amount that the debtor is insolvent
ex: D owes $100 to C, D has assets of $130 and another
liability of $100. C discharged D’s debt for the price of $20.
The debtor was insolvent by $70 (liabilities (200) – assets
(130) = $70) so the amount of D’s exclusion cannot be
greater than that. D has realized gain of $80 because C
discharged him of $80 worth of debt. He cannot exclude the
full $80 because he was only insolvent by $70, so he can
exclude the $70 and need report only $10 worth of gain.
§108(d)(3): Insolvent means an excess of liabilities over the fair
market value of the assets
Gehl v. Commissioner: P transferred farmland (with a FMV above basis) to
satisfy debt, creditor forgave the rest of the debt. Court held that while the
actual discharge of debt was not taxed, the amount realized on the land sale
(FMV-adjusted basis) was taxable sale or exchange of property under §1001
because the transaction was not a discharge of indebtedness .
Revenue Ruling 84-176: Facts: Amount owed was forgiien in exchange for
realize of contract counterclaim Amount was paid as settlement for lost
profits in a contract suit and therefore was NOT INCOME but merely
recovery of lost profits.
o ii: Disputed or Contested Debts
Excess of the original debt over the amount determined to have been due is
to be disregarded in calculating gross income. Preslar v. Commissioner
Payne v. Commissioner: Credit card debt was reduced from $21,270 to
$4,592. The cardholders did not report $16, 678 worth of income. Tax court
ruled that no exclusion applied to the taxpayers and that they should have
report the discharged debt as income.
o iii: Purchase Money Debt Reduction for Solvent Debtors
§108(e)(5) codifies a rule that if a purchaser of property refuses to pay the
balance due to an irregularity with the sale or a defect in the property and
the seller agrees to a reduction in the purchase price this does not
constitute a discharge of debt but rather a retroactive reduction in purchase
price.
o iv: Acquisition of Indebtedness by person related to the debtor
§108(e)(4): if a person related to a debtor acquires the indebtedness, the
acquisition shall be treated as an acquisition to the debtor.
ex: D owns more than 50% of stock in X corporation and is therefore
related to X within the meaning of §108(e)(4). X issues its own
bonds for which it receives par value, D repurchases the bonds on
the open market for an amount considerably less than par. D’s
acquisition of the bonds is treated as being the same as X’s
acquisition of the bonds because the two are related.
o v: Discharge of deductible debt
§108(e)(2) provides that forgiveness of a debt does not generate income if
the payment of the debt would have been deductible.
ex: If a landlord doesn’t make you pay rent.
o vi: Discharge of certain student loans
§108(f)(1) discharge of student loans in certain circumstances is not income
if it is discharged for certain work (Ie: if the student engages in public
services occupations or areas with unmet needs such as rural or low-income
areas)
o vii: Discharge of qualified principal residence indebtedness
In response to the foreclosure problem (house goes into foreclosure and
the taxpayer does not have enough to pay off the outstanding mortgage,
lenders often forgive the remainder) Congress enacted §108(a)(1)(E) and (h)
which provides for an exclusion for qualified PPR indebtedness discharged
after Jan 1, 2007 and before Jan 1, 2013.
This is not limited to foreclosure sales but also includes if there is a
discharge of debt directly related to a decline in the value of the
house or the employment condition of the taxpayer (h)(3)
A taxpayer taking advantage of the above exclusion must reduce her basis
in the residence by the amount excluded.
o vii: Other Exclusions
§108(a)(1)(C): qualified farm indebtedness discharge rule permits certain
solvent and insolvent farmers to exclude from gross income the discharge of
farm debt up to the combined amount of certain tax attributes and the basis
of qualifying property.
§108(a)(1)(D): a non-corporate taxpayer can avoid gross income where, as a
result of the decline in the value of the business property, there is a
discharge of acquisition indebtedness with respect to that property. The
taxpayer must however reduce the basis of the business property.
C: Discharge of Indebtedness as gift, compensation etc
o i: Gift exclusion is not applicable where the debtor purchased his own obligations at
a discount Commissioner v Jacobson
o ii: In certain contexts the cancellation of indebtedness can be an excludable gift.
ex: If a parent lends money to a child and then forgives the debt this
forgiveness would likely be considered a gift under §102(a)
o iii: Where an employer discharges indebtedness, it is likely compensation income
rather than discharge of indebtedness
X: Compensation for Personal Injury and Sickness
A: Damages
o i: Business or Property Damages
Raytheon Products Corp v Commissioner instructs that with respect to
business or property damages we ask what the damages were in lieu of.
Damages awarded on account of lost profits would be taxable. A
recovery for property damage would be measured against the basis
of the property to determine the taxpayer’s realized gain or loss.
Where the damages are awarded for injury to good will then it is
not taxable.
o ii: Damages Received on Account of Personal Physical Injuries or Sickness
§104(a)(2) excludes from income any damages received, whether by suit or
agreement, as a lump-sum or periodic payment, on account of personal
physical injuries or physical sickness.
Policy: They do not add wealth but merely loss of capital
Us v. Gerber: The exclusion necessitates some sort of tort claim
against the payor. The mere fact that the taxpayer experienced pain
and discomfort is not enough.
The Tax Court in Threlkeld v. Commissioner (1986) held that personal injury
referred to any invasion of the rights that an individual is granted by virtue
of being a person in the sight of the law.
Thus, prior to the amendments made in 1996, employees
recovering damages for wrongful discharge, sex discrimination or
any employment related claim constituting personal injury within
this definition could exclude the damages received as well as lost
wages.
o iii: Supreme Court Limitations on §104(a)(2)
Burke v US: Employees of the Tennessee Valley Authority settled an action
under the civil rights act alleging that TVA had engaged in illegal sex
discrimination. The SC linked the personal injury definition with tort
principals. In holding that the statute under which the damages were
awarded did not create a tort-type claim, the damages were not excluded
under §104(a)(2) (THIS WAS REVERSED IN 2009)
Commissioner v. Schleier: The court shifted their focus to the statutory
language, emphasizing that the key question to be asked in apply 104(a)(2)
is whether the damages received were on account of (ie actually
compensated for) personal injury.
Damages are on account of personal injury only if they bear a close
nexus to the personal injury. If this relationship does not exist then
no exclusion is available.
o iv: 1996 Amendment to §104
Congress still considered 104 too broad in scope. Therefore they limited the
exclusion by restricting it to those damages received on account of physical
injuries or physical sickness.
Emotional distress was not be treated (save only for related
medical care expenses) as a physical injury or sickness. (see next
point)
Origin of claim notions: If an action has its origin in a physical injury or
physical sickness then all damages that flow therefrom are treated as
payments received on account of physical injury. Conference Committee
Report
If the claim has its origin in personal injury then a recovery for
emotional distress may be excludable.
If the claim has its origin in a physical injury it is not necessary that
the recipient of the damages is the individual who suffered the
physical injury.
Physical Injury as defined by Private Letter Ruling 200041022: “direct
unwanted or uninvited physical contact resulting in observable bodily harms
such bruises, cuts, swelling, and bleeding are personal physical injuries
under 104(a)(2).
Physical restraint from being handcuffed and searched are not
physical injuries (Stadnyk v. Commissioner).
o v: Punitive Damages
104(a)(2) exclusion doe not apply to punitive damages.
o vi: Allocation of Awards
Defendant’s will be tempted to settle cases insisting that the entire
settlement amount be allocated to physical injury rather than punitive
damages so that the money need not be reported as income. However
courts reserve the right to inquire into this allocation.
Robison v Commissioner: Jury awarded damages for personal injury as well
as $50 million in punitive damages. The P entered into a settlement
agreement for much less, in return of the defendant allocation the damages
to physical injury. The tax court made its own judgment and held that he
could exclude a portion of the settlement as damages for physical injury but
not the entire amount.
Bagley v. Commissioner: Key question in settlement is what the damages
were in lieu of.
o vii: Periodic Payments
Periodic payments are excludable under 104(a)(2).
B: Accident and Health Insurance
o 104(a)(3) payments received through accident or health insurance policies are
excluded from gross income provided the policy was not financed by the taxpayer’s
employer or by employer contributions not includable in the taxpayer’s income.
C: Previously Deducted Medical Expenses
o Section 213 permits a deduction for unreimbursed medical expenses on account of
physical injury.
o However, if these expenses are reimbursed the following year the amounts
attributable to previously deducted medical expenses are not excluded from income
104(a) and 105(b).
D: Workers’ Compensation
o 104(a)(1) excludes from income amounts received under workers’ compensation
acts as compensation for personal injuries or sickness.
Compensation for nonoccupational injury or illness does not fall under this
section even if the label of workers comp is placed on the payment
E: Certain Disability Pensions
o 104(a)(4) excludes military disability pensions.
However, this is limited by 104(b) to compensation for combat related
injuries and to those who would on application receive disability
compensation from the Veterans’ Administration.
XI: Fringe Benefits
A: What are fringe benefits
o Fringe benefits are taxable income
61(a)(1) provides that among other things, gross income includes fringe
benefits
1.61-1(a) provides that income may be realized in the form of services,
meals, accommodations, stock, or other property as well as cash.
B: Meals and Lodging
o Convenience to the employer: Meals and lodging provided to employees are
excludable if the exclusions were premised on the notion that the benefits given
were for the convenience of the employer.
Required the taxpayer to establish that the benefits were grounded in
business necessity.
Benaglia v. Commissioner:
Facts: Occupied a suite of rooms in a hotel where he was required
to be constantly on duty. He did not report the lodging as income.
Held: This was for the purpose of benefitting the employer so it was
properly excludable from income. Being on the property at all time
was necessary for his job.
§119(b) clarified that the service must be for the convenience of the
employer and that the taxpayer need not be an employee by contract.
Regulation 1.119-1(b)(3) provides that condition of employment means that
the employee be required to accept the lodging in order to enable him
properly to perform the duties of his employment
Employees spouse and dependents are also excluded under 119(a)
When the employee needs to be available at all time: Caratan v.
Commissioner: P failed to establish that he was required to accept the
lodging as a condition of employment and there was available lodging ten
minutes away. However, the appeals court reversed, relying on 1.119-1(b)
(3), holding that it was enough that the taxpayer established that he was
required to be available for duty at all time. It was not necessary to show
that the duties would be impossible to perform without such lodging.
Commissioner v. Kowalski: Case payments were made to state police
troopers as meal allowances. Court held that these payments were not
excludable. Occasional supper money is excludable as a de minimis fringe
benefit, however it would not be applicable to meal allowances provided to
the state troopers because they were regularly paid and could not be
considered occasional.
C: Fringe Benefits and §132
o i: §132
132 lists seven categories of excludable fringe benefits
1) no-additional cost service
2) qualified employee discount
3) working condition fringe benefit
4) de minimis fringe
5) qualified transportation fringe
6) qualified moving expenses
7) qualified retirement planning services
o i: No-Additional-Cost Service
Companies engage in airline, railroad or hotel businesses often have excess
capacity which will remain unused for lack of paying customers. Such
business will commonly make this excess capacity available to employees
and their families free of charge. Because there is no cost to the employer
this can be excluded from income subject to some restrictions:
1) the service must be one offered for sale to customers in the
ordinary course of business 132(b)(1)
2) The service must be offered in the line of business of the
employer in which the employee is performing services.
3) The employer cannot incur substantial additional cost including
foregone revenue 132(b)(2)
1.132-2(a)(5): for purposes of determining whether any
revenue is forgone it is assumed that the employee would
not have purchased the service unless it were available to
the employee for the price which they accepted it
4) Prohibits discrimination in favor of highly compensated
employees. 132(j)(1)
132(i) allowes for reciprocal agreements between employers in the same
line of business, thus enabling the employers to provide tax free benefit to
one another’s employees.
Exclusion is limited to services provided to employees
employees is defined by section 132(h) as one’s spouse and
dependents as well as certain retired and disabled employees and
the surviving spouse of a deceased employee.
Charley v. Commissioner: D excluded income amounts he received for
frequent flyer miles which he converted to cash. The court held tat the
company did not offer frequent flyer miles for sale to customers in the
ordinary course of business and therefore constituted gross income.
o ii: Qualified Employee Discount
Businesses provide discounts to their employees on the same goods as
services they sell to the general public. These employee discounts are not
taxable.
132(c) however provides some limitation. The exclusion for employee
discounts on services is limited to 20% of the price at which the services are
being charged to customers. The exclusion for discounts on property is
limited to the employer’s gross profit percentage, which is the excess of the
aggregate sales price for the property to the employer over the aggregate
cost of such property to the employer, divided by the aggregate sales price.
132(c)(4) defines qualified property or service as the same for sale to
customers in the employees line of business. Does not apply to stocks,
bonds, gold coins, or residential and commercial real estate.
o iii: Working Condition Fringe Benefits
When employers provide employees with tools connected to job
performance (office space, supplies, etc) to facilitate the employees work
they should not be considered compensation and are excludable as working
condition fringe under 132(a)(3).
Cash payments do not qualify unless the employee is required to use the
payments for expenses incurred in a specific or pre-arranged qualifying
activity, verify such use, and return any excess to the employer. 1.132-5(a)
(1)(v)
If an employer derives a substantial business benefit from the provision of
such outplacement services, such as promoting positive corporate image,
maintaining employee morale, etc, the service may generally be treated as
working condition fringe.
Townsend Industries v. US : Employees attended an annual fishing trip held
and paid for by the employer. Although the trips were voluntary nearly all
employees felt an obligation to attend, considerable business discussions
took place on these trips, and the company had reason to expect future
benefits from these trips. Therefore the taxpayers were able to exclude the
cost of the trip as a working condition fringe.
o iv: De Minimis Fringe Benefits
Frequency is key to determining whether something is a de minimis fringe
benefit
Does not require an employer-employee relationship
Special rules exclude meals and occasional meal money received and the
value of meals provided in an employer-operated eating facility 1.132-6(d)
(2)
Denied to cash or cash equivalent other than those allowed by special rules.
o v: Qualified Transportation Fringe Benefits
Qualified transportation benefits include parking, transit passes, vanpool
benefits and bicycle commuting reimbursement benefits.
Section 132(a)(5) excludes these benefits. Cash reimbursement for these
items is also excludable.
D: Valuation
o Fringe benefits which are not exclude are subject to tax. The measure of the taxable
income is the fair market value of the fringe benefit less any, less any excludable
portion of the fringe benefit an any amount paid by the recipient 1.61-21(b)(1)
XII: Business and Profit Seeking Expenses (Deductions for ordinary personal living and family expense
not allowed 262)
A: Business Deductions §162
o The Business deductions of 162 and the profit seeking deductions of 212 reflect the
principal that “net income” rather than gross income, should be subject to tax and
that expenses necessary to the earning of items of gross income ought to be
allowed as deductions.
o Regulation 1.61-3(a): interprets the language of 61(a)(2) to mean “gross income
derived from business” to mean “total sales, less the cost of goods sold.”
o 162(a) establishes a number of requirements for the deductions
1) the cost must be an expense
2) the expense must be ordinary
3) it must be necessary
4) it must be paid or incurred during the taxable year
5) it must be paid or incurred in carrying on a trade or business
o i: Ordinary and Necessary
a: Ordinary
Ordinary means customary or expected in the life of a business
(Welch)
Must be distinguished from capital expenditures such as goodwill
Welch v. Helvering: A grain commission agent, Welch repaid debts
of the bankrupt corporation he used to work for to reestablish
relations with his customers. The commissioner disallowed
deductions claiming they were capital expenditures for reputation
and goodwill.
Court ruled that in order to be deductible an expense must
be ordinary and necessary and that ordinary means
accepted practice in a given segment of the business world.
Conway Twitty paid back people who invested in his Twitty burger
business and claimed that he paid them back in order to protect his
personal business reputation so the court deemed that the
payments were excludable.
Deputy v. Dupont: Ordinary means that the transaction which gives
rise to the expense must be of common or frequent occurrence in
the type of business involved.
Dancer v. Commissioner: Court allowed a deduction for costs a
taxpayer occurred in settling a negligence action arising from an
automobile accident which occurred while he was traveling on
business, because automobile travel was an integral part of his
business.
However, did not allow exclusion for damages incurred
when an artist had an outburst on a plane and had to settle
for damages because that was not general conduct that
artists engage in (Gillian)
b: Necessary
In the Welch case, the court interpreted the term “necessary” to
mean appropriate and helpful and indicated that it would be slow to
override the judgment of a business person regarding the necessity
of any costs incurred.
Henry v Commissioner: Taxpayer bought a yacht on which he flew a
flag with 1040 on it (he was a tax lawyer) he claimed use of his yacht
promoted his business. Tax court held this was not necessary for his
trade or business.
Courts have held that proof that the activity is the main and
exclusive way of procuring clients is helpful in establishing if it is
necessary (Topping)
An unreasonably large salary is not an ordinary and necessary
expense of a business.
162(a)(1) provides that only reasonable salaries may be
deducted.
The court has come up with a number of factors that are
relevant to determining whether the compensation at issue
was reasonable and attributable to the taxpayer’s
employment or it’s role as shareholder (ie would he have
paid a normal employee what he was getting paid?)
o 1) employee’s role in the company (hours, duties,
importance, etc)
o 2) Comparison of the employee’s salary to salaries
paid by similar companies for similar services
o 3) the size and complexity of the company and
general economic conditions
o 4) the existence of relationship between company
and employee which would permit nondeductible
corporate dividends to be disguised as deductible
compensation.
o 5) whether the compensation at issue stems from a
compensation program that itself is reasonable,
longstanding, and consistently applied.
These factors are part of the independent investor test:
whether an inactive, independent investor, would be willing
to compensate the employee as he was being
compensated. (Elliotts Inc, v. Commissioner)
1.162-7(b)(3) provides that reasonable compensation is only
such amount as would ordinarily be paid for like services by
like enterprises under like circumstances.
o Exacto Spring Corporation (243):
o Menard v. Commissioner (244-245):
In some circumstances the business related nature of the taxpayer’s
clothing may warrant a deduction.
Pevsner v. Commissioner: P contended that because the
clothing she was required to purchase and wear in her
employment was not consistent with her personal lifestyle
she could deduct their cost as a business expense. The court
held that clothing cost is deductible as a business expense
only if the clothing is specifically required as a condition of
employment, it is not adaptable to general usage as
ordinary clothing, and it is not worn as ordinary clothing. In
this case, P’s clothing were adaptable to ordinary use, she
simply chose not to wear them as such, but the
determination is an objective standard not subjective.
Costs cannot be considered necessary if allowance of the deduction
would frustrate sharply defined national or state policies prohibiting
particular types of conduct. (ie allowing a truck company to deduct
a fine or violating state maximum weight laws)
162(e) disallows deducted for amounts paid to influence legislation
or an office (ie bribes)
o ii: Carrying On a Trade or Business
A: What is a trade or business
The court to Groetzinger state that “we accept the fact that 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. A
sporadic activity, a hobby, or an amusement diversion does not
qualify.
Commissioner v. Groetzinger: G attempted to earn a living
solely through wagering on dog races, but he suffered a net
loss for the for the year and declared no gross winning from
gambling. Court found that determining what consisutes a
trade or business is predominantly a case-by-case factual
endeavor, an activity pursued with a full-time, good faith
intention to produce income will usually qualify as a trade
or business. Court held that P was engage in a diligent,
regular, full-time effort to earn an income through
wagering-it was an attempt to earn a livelihood, not just a
hobby, so he shouldn’t have to file the tax preference for
gambling losses because this is a business not a hobby.
Reg 1.183-2(a) lists the following factors for determining whether
an activity is engaged in for profit: 1) the manner in which the
taxpayer carries on the trade or business 2) the expertise of the
taxpayer or his or her advisers 3) the time and effort expended by
the taxpayer in carrying on the activity 4) the expectation that
assets used in the activity may appreciate in value 5) the success of
the taxpayer in carrying on other similar or dissimilar activities 6)
the taxpayer’s history of income or losses with respect to the
activity 7) the amount of occasional profits, if any, which are earned
8) the financial status of the taxpayer 9) elements of personal
pleasure ore recreation
Trader v. investor: a trader is considered to be engaged in a trade or
business, while an investor is not.
Higgins v. Commissioner: Higgins, who employed individuals
and incurred substantial expenses incident to managing his
properties and investments, sought a business deduction
for salaries and expense. Salaries and other expenses
incurred in the management of personal assets are not
deductible business expenses. Management of personal
finances does not fall into the category of carrying on a
business, even if done with substantial investment of time.
However, not under 212 investor expenses would be
deductible as costs related to the production of income.
B: The Carrying on Requirement
The investigatory stage In which a person may review various kinds
of business before decided to enter into a specific business DOES
NOT COUNT. (Frank v. Commissioner: Searching for a newspaper
business).
Preparing for a business/pre-operating costs are also not deductible
because the taxpayer has not actually begun to be engaged in
carrying on a trade or business. (Richmond Television)
Such costs incurred in investigating a business, training personnel,
lining up distributors, suppliers, etc, provide benefits long beyond
the current tax year and should not be deducted.
o iii: Section 195 and the Amortization of Certain Pre-Operational or Start Up Costs
In 1979 Congress added §195 to the Code authorizing amortization of start
up expenses.
To qualify for amortization under §195, the expenditure must be paid or
incurred in connection with creating or investigating the creation or
acquisition of a trade or business entered into by the taxpayer. Second, the
expenditure involved must be one which would be allowed as a deduction
for the taxable year in which it is paid or incurred if it were paid or incurred
in connection with the expansion of an existing trade or field as that entered
into by the taxpayer.
In 2003 the legislation was changed to allow a taxpayer to deduct $5,000 of
start up expenditures in the taxable year in which the active trade or
business begins. However, the 5k amount if reduced by the amount the
start-up costs exceed 50k.
If the costs are 5k or less they are fully deductible, if the costs are
between 5k and 50k the deduction is 5k and the remainder is
amortized over 180 months, if the start up costs are above 50k and
between 55k the amount is reduced by how much it exceed 50k (ie
at 55k there is no deduction) and the amount is amortized over the
180.
o iv: Application of the “carrying on” requirement to employees
Taxpayers may be in the trade or business of “being an employee”
If expenses were incurred by an employee in finding work in the same trade
or business, the “carrying on” requirement would be satisfied and the costs
(resume costs, postage, etc) would be deductible. However, if the employee
is seeking employment in a new trade or commencing a new trade, the
carrying on requirement would not be satisfied and the expenses will be
treated as capital expenditures.
Revenue Ruling 75-120: Expenses incurred in seeking new employment in
the employee’s present trade or business are deductible under 162 even if
new employment is not secured. However, such expenses are not
deductible if an individual is seeking new employment in a new trade or
business even if employment is secured.
While it is possible for an employee to retain, at least temporarily, his status
of carrying on a business, it holds true that a prolonged period of
unemployment will terminate one’s status as being engaged in a trade or
business.
Furner v. Commissioner (252):
B: Section 212 Deductions
o Section 212 allows a deduction for the “ordinary and necessary” expenses of
producing or collecting income, maintaining property held for the production of
income, or determining, collecting, or refunding any tax. (investors would be able to
deduct their expenses under 212)
allows the deduction of expenses incurred in the production or collection of
income or in the management, conservation, or maintenance of property
held for the production of income. However, traveling to start an income
does not fall under this because they were trying to start a business which
might in the future produce income.
XIII: Capital Expenditures
A: Deductible Expense or Capital Expenditure?
o §263 denies deductions for the cost of capital expenditures.
denies deductions for new buildings or for permanent improvements or
betterments increasing the value of property and for restoration costs for
which an allowance is made.
The regulations add that the disallowance applies to expenditures that add
to value or substantially prolong the useful life of property or adapt
property to new an different use but not to incidental repairs or
maintenance. (1.263(a)-2(a))
o A capital expenditure provides a benefit that persists, that continues generating
income over a period of year,
B: Defining Capital Expenditure – INDOPCO
o INDOPCO v. Commissioner: The third court held that consulting and legal fees
related to takeover are capital expenditures because they provide longterm benefit.
SC affirmed, P failed its burden of establishing that the expenses were ordinary and
necessary within the meaning of 162(a), rather the facts demonstrated that the
transactions produced significant benefits that stretched beyond the year in
questions.
o Lincoln Savings and Loan: Established a new test, the “separate and distinct asset”
test for determining whether expenditures had to be capitalized. In Lincoln the
court required the taxpayer to capitalize the additional premium (paid to insure
their deposits) because the additional premium created a “separate and distinct
asset”. The creation of a separate and distinct asset may well be a sufficient but not
a necessary condition to classification as a capital expenditure.
o US Freightways Corp v. Commissioner: Purchased a permit in year one and
continued to use it into year 2 but deducted it on it’s tax returns in year one as a
business expense. Court held that the expense should have been deducted ratably
over year 1 and 2. No matter what other characteristics an expenditure has, if it is
made in one tax year and its useful life extends substantially beyond the close of
that year then it must be capitalized.
C: Selected Categories of Capital Expenditures
o i: Cost of Acquisition and Costs Incurred in Perfecting and Defending Title
Acquisition costs constitute capital expenditures (ie: buildings, machines,
vehicles, or such intangible property as a copyright, patent or interest in a
corporation or partnership. The asset produces a continuing, long term
benefit and its cost must be capitalized which means that the taxpayer will
take a basis in the asset equal to the cost.
ex: If the taxpayer pays $500,00 for a building to be used in the
taxpayer’s business, the building cost must be capitalized and
become the taxpayer’s initial basis in the building. Other costs
associated with acquiring the building (brokerage fees etc) would
also be capitalized as part of the cost of the building and would be
factored into the building’s basis. If two years later the taxpayer
spent $300,000 to repair the building it would also be capitalized
and would result in an upward adjustment of the basis under
1016(a)(1)
PROPOSED Regulations require capitalization of amounts paid to
acquire or produce a unit of real or personal property, including the
purchase or invoice price, transaction costs, and cost for work
performed prior to the date the unit of property is placed in service.
1.263-(a)-2(d)(1)(i)
Transaction costs are costs paid to facilitate acquisition of
real or personal property and include among other items
amounts paid for 1) negotiating the terms or structure of
the acquisition 2) preparing and reviewing the documents
that effectuate the acquisition (ie preparing the bid, offer,
sales contract or purchase agreement 3) conveying property
between the parties, including sale and transfer taxes and
title registration costs and 4) broker’s commissions
Proposed Regs 1.263-(a)-2(d)(1), 3(i), (ii)(A), (B)
Woodward v. Commissioner: The issue was the deductibility of
appraisal and litigation costs the taxpayers incurred in determining
the price of stock they were required to purchase. The relevant
question is not whether the purpose of the litigation was to acquire
stock but whether the origin of the claim litigated was in the
acquisition of stock, if so then it was a capital expenditure.
Costs incurred in defending or protecting title are capital
expenditures and cannot be deducted (Georator Corp v. US)
However, if the dispute doesn’t relate to title, but rather
income from title (ie additional royalty payments) the cost
related to litigation can be deducted. (Southland Royalty Co.
v. US)
The cost of disposing of an asset may also in a sense be regarded as
part of its acquisition. (Woodward)
However, if it is simply retired and discarded then it is
deductible. (ex: old telephone poles taken out, new ones
put in, cost of removal is deductible because it’s allocated
to old poles (Rev. Ruling 2000-7)
Stegar v. Commissioner: Taxpayer, upon retirement from law
practice, purchased a non-practicing malpractice insurance policy,
the purpose of which was to provide insurance coverage for an
indefinite period of time for any malpractice the taxpayer may have
committed prior to the retirement. Rule: if a taxpayer incurs a
business expense but is unable to deduct it as a current expense or
through yearly depreciation deductions, the taxpayer is allowed to
deduct the expense for the year in which the business ceases to
operate.
Commissioner v. Idaho Power Co: Idaho Power Co attempted to
completely deduct the amount of depreciation attributable to
construction equipment for the year, even though the equipment
was partially used for that year to make additions and
improvements to capital facilities.
Held: The part of the equipment that was used in
constructing capital improvements must be capitalized over
the useful life of the asset constructed.
§263A requires capitalization of direct and indirect costs, including
certain interest costs, incurred by taxpayers who manufacture,
construct, or produce real or tangible personal property or who
acquire or hold inventory property for resale.
o ii: Repair or Improvement
a: Old Rules
1.162-4 and 1,263(a)-1(b) provide that expenditures for repairs or
maintenance, which do not materially add value or appreciably
prolong useful life are deductible; replacements or improvements,
on the contrary are not and must be capitalized.
Midland Empire Packing Co v. Commissioner: Midland Empire
Packing oil-proofed its basement to protect against oil seepage from
a nearby refinery. A structural change that does not increase the
useful life or use of a building and that is the normal method of
dealing with a given problem, is a repair for tax purposes. Held that
the oil-proofing was merely to keep the property in an operating
condition and thus was a deductible expense. The repair must be
“ordinary” but not habitual, merely the common means of
combating a given problem.
Mt. Morris Drive-In Theatre v. Commissioner: P cleared land to build
a drive in theatre, it was evident by the way in which the land was
cleared that there would be a drainage problem. So P build a
drainage system under threat of litigation from his neighbor.
Because this problem was foreseeable when construction began,
the cost of the constructing the drainage system was really part of
the process of completing the initial investment in the land for its
intended use, so it was a capital expenditure.
United States v. Wehrli: Taxpayer sought to deduct as repairs the
costs involved in preparing the building for a new tenant. The court
established what was called the one-year rule of thumb under
which an expenditure could be capitalized if it brings about the
acquisition of an asset having a period of useful life in excess of one
year, or if it secures a like advantage to the taxpayer which has a life
of more than one year. However, we think this to be more of a
guidepost. Expenses such as replacement of a broken window, a
damaged lock, or a door, or even a periodic repainting of the entire
structure may be treated as a deductible even though the benefits
extend beyond one year.
General Plan: Expenditures made for an item which is part of a
general plan of rehabilitation, modernization, and improvement of
the property, must be capitalized, even though standing alone the
item may appropriately be classified as one of repair. (Wehrli)
Revenue Ruling 2001-4: The taxpayer, an owner of a commercial
airline was required by the FAA to make and stick to a continuous
maintenance program. This included a heavy maintenance visit
every 8 years. Are costs incurred by this visit deductible as ordinary
and necessary business expenses under 161 or must they be
capitalized under 263? Costs incurred by a taxpayer to perform
work on its aircraft airframe as part of a heavy maintenance visit
generally are deductible as ordinary and necessary business
expenses under 162, however, costs incurred in conjunction with a
heavy maintenance visit must be capitalized to the extent they
materially add to the value of, substantially prolong the useful life
of, or adapt the airframe to a new or different use. In addition costs
incurred as part of a plan of rehabilitation, modernization, or
improvement must be capitalized.
Illinois Merchant Trust: Repair and maintenance expenses are
incurred for the purpose of keeping the property in an ordinarily
efficient operating condition over its probable life for the uses for
which the property was acquired. Capital expenditures are for
replacement, alterations or additions that prolong the life of the
property, materially increase its value or make it adaptable to a
different use.
Plainfield Union: Court stated that if the expenditure merely
restores the property to the state it was in before the situation
prompting the expenditure arose and does not make the property
more useful, valuable or longer lived, then it is deductible.
b: Proposed Regulations: Improvements and Repairs
The existing regulations focus on whether expenditures materially
increase the value of property, the PROPOSED regulations steer
clear of focusing of value in addressing amounts paid to improve
tangible property. The PR provide general rules for determining the
appropriate unit of property to which the improvement regulations
apply and require capitalization of amounts paid to bring about a
betterment to a unit of property, to restore a unit of property, or to
adapt a unit of property to a new or different use (PR 1.263(a)-3(d)
(1) and (2))
One must FIRST identify the unit of property that will be the focus of
the repair/improvement analysis.
The unit of property determination will be made using a
functional interdependence standard. All components that
are functionally interdependent comprise a single unit of
property. Components of property are functionally
interdependent if the placing in service of one component is
dependent on the placing in service of the other component
by the taxpayer. (PR 1.263(a)-3(d)(2)(iii))
Betterment: An amount paid results in a betterment of property if:
1) it ameliorates a material condition or defect that existed prior to
the taxpayer’s acquisition of the unit of property 2) results in a
material addition to the unit of property 3) results in a material
increase in capacity, productivity, efficiency, strength or quality of
the unit of property. PR 1.263(a)-3(f) (and see examples)
Restoration: Identifies a range of situations in which am amount will
be treated as restoring a unit of property:
1) if it returns the unit of property to its ordinarily efficient
operating condition after the property has deteriorated to a
state of disrepair and is no longer functional for its intended
use. 2) if it results in the rebuilding of the unit of property to
a like-new condition after the end of the economic useful
life of the property. 3) if it is for the replacement of a major
component or a substantial structural part of the unit of
property. PR 1.263(a)-3(g)(1)
Percentage SAFE HARBOUR: replacement of a major
component or substantial structural part means the
replacement of a) a part of the unit of property, the cost of
which comprises 50% or more of the replacement cost of
the unit b) a part of the unit of property that comprises 50%
or more of the physical structure of the unit of property PR
1.263-(a)-3(g)(3)(i)
New or different use: Amount paid will be treated as being paid to
adapt a unit of property to a new or different use if the adaptation
is not consistent with the taxpayer’s intended ordinary use of the
unit of property at the time originally placed in service by the
taxpayer. ( PR 1.263-(a)-3(h)(1)).
Routine maintenance SAFE HARBOUR: An amount will not be
deemed to improve the unit of property if it Is merely routine
maintenance. (ie: the inspection, cleaning, and testing the unit of
property, and the replacement of part of the unit of property with
comparable and commercially available and reasonable
replacement parts. PR 1.263(a)-3(e)
Employee training costs are deductible (unless it provides a benefit
significantly beyond those traditionally associated with training in
the ordinary course of business)
o iii: Intangible Assets
Amounts paid to acquire or create an intangible not otherwise required to
be capitalized by the regulations is not required to be capitalized on the
ground that it produces significant future benefits for the taxpayer, unless
the IRS publishes guidance requiring capitalization of the expenditure.
The general rule of regulations requires the capitalization of amounts paid
to acquire or create an intangible, to facilitate the acquisition or creation of
an intangible, or to create or enhances a separate and distinct asset (reg
1.263(a)-4(b)(1).
ACQUIRED INTANGIBLES include: ownership interests in corporations,
partnerships or other entities, debt instruments, options to provide or
acquire property, leases, patents or copyrights and franchise or trademarks.
1.263-(a)-4(c)(1). Cost of acquiring these must be capitalized.
CREATED INTANGIBLES: Financial interests (ownership interest in
corporations, partnerships, or other entities, debt instruments, and options
to provide or acquire property), prepaid expenses, certain membership fees,
amounts paid to create or terminate certain contracts for property or
services, and amounts paid to defend title to intangible property. 1.263-(a)-
4(d)(2). Cost of creating these intangibles must be capitalized.
The regulations also provide for capitalizing amounts paid to facilitate the
acquisition or creation of an intangible. The rule of regulations is that an
amount facilitates a transaction and thus must be capitalized, if the amount
is paid in the process of investigating or otherwise pursuing the transaction.
1.263(a)-4(e)(1)(i)
“12 month rule”: capitalization is not required for amount paid for a right or
benefit that does not extend beyond the earlier of (1) 12 months from first
realizing the right or benefit or 2) the end of the tax year following the year
of payment.
Amounts paid to facilitate the acquisition of a trade or business or to change
the business’ capital structure must also be capitalized. 1.263(a)-5(a)
o iv: Expansion Costs
Briarcliff Candy Corp v. Commissioner: Cost’s in establishing a “franchise”
division to promote sales in new retail outlets were held to be deductible.
Organizational changes which the taxpayer had made in that case in order
to spread its sales into a new territory were not comparable to the
acquisition of a new additional branch or division to make and sell a new
and different product.
Colorado Springs Bank v US: The issue was whether costs incurred by a bank
in creating credit card services for customers was currently deductible or
had to be capitalized. The court held that the bank had no property interest
in the credit card procedures, so the costs incurred in establishing the credit
card operation were deductible.
Downsizing (ex: severance payments) does not need to be capitalized. It
relates to previous services of employees rather than creating future
benefits.
o v: Advertising Costs
Advertising is generally treated as being deductible under 162 even though
advertising may have some future effects on the business.
RJR Nabisco v. Commissioner: Tax court held that expenditures for ordinary
business advertising are ordinary business expenses if the taxpayer can
show a significant connection between the expenditure and the taxpayer’s
business. However, expenditures for billboards, signs and other tangible
assets associated with advertising remain subject to the usual rules
regarding capitalization.
D: Purchase or Lease
o i: 162(a)(3) specifically authorizes the deduction of rental payments with respect to
property used in a trade or business, but only if the taxpayer does not take title and
has no equity in the property.
o Estate of Starr v. Commissioner: “lease” of a custom-made automatic sprinkler
system installed in a building was in fact a sales arrangement. No way they would
come back to reclaim the system, and no property owner would agree to this
XIV: Depreciation
A: Depreciation: Depreciation is an accounting device which recognizes that the physical
consumption of a capital asset is a true cost, since the asset is being depleted. As the
process of consumption continues and depreciation is claimed and allowed, the asset’s
adjusted income tax basis is reduced to reflect the distribution of its cost over the
accounting periods affected.
o i: Depreciable Property
§167 defines depreciation as a reasonable allowance for the exhaustion,
wear and tear (including a reasonable allowance for obsolescence)- 1) the
property used in the trade or business or 2) of property held for the
production of income.
Trade, business, and investment limitation applies, one may not depreciate
a personal residence.
Depreciable items must be subject to wear and tear, decay or decline from
natural causes. Land, stock (1.177(a)-3), and other assets that do not decline
in value are not depreciable.
o ii: Recovery Period- The Useful Life Concept
A direct correlation exists between the useful life of an asset and the size of
the annual depreciation deduction.
Congress in 1971 enacted §167(m) authorized the treasury to create an
Asset Depreciation Range providing an industry wide set of useful lives for
classes of assets. This system did not provide useful lives for real property
which continued to be governed by earlier guidelines providing useful lives
ranging from 40 years for apartment buildings to 60 years for warehouses.
in 1981 the ACRS (accelerated Cost Recovery System, significantly de-
emphasized the useful life concept by assigning all tangible property to one
of five recovery period based on assets class life.
Most real property was classified as 15 year property.
Most tangible property was classified as 3 year property or 5 year
property.
1986 Modified Accelerated Cost Recovery System (MARCS)
Non-residential rental property is depreciated over 39
years.
Residential real property over 27,5 years
Other property must be classified within one of six recovery
periods- 3, 5, 7, 10, 15, 20
168(e)(1) defined each of these classes by reference to the
class life of assets.
168(e)(3)(B)(i) provides that 5 year property includes among
other things, automobiles or light general purpose trucks,
computers, copying equipment, and heavy general purpose
trucks.
The 7 year property class is now the catchall class and
includes personal property such as office furniture, fixtures,
and equipment.
Historically, only assets with a determinable useful life were
depreciable.
Revenue Ruling 68-232: Valuable piece of art was not
considered depreciable property because it did not have a
determinable useful life.
Simon v. Commissioner: P, a professional violinist claimed
depreciation on two 19th century violin bows use in their
trade or business. The court reasoned that the availability of
a deduction for depreciation on tangible personal property
depends on whether the asset falls within the meaning of
“recovery property.” Property is “recovery property” under
the ERTA of 1981 if it is (1) tangible and (2) placed in service
after 1980 (3) of a character subject to the allowance for
depreciation and (4) used in the trade or business, or held
for the production of income. The court held that 1,2, and 3
are met because the bows are subject to exhaustion, wear
and tear and old age. 4 is met.
o Liddle v. Commissioner: P sought a depreciation
deduction under ACRS on a 17th century viol. Same
analysis as above
o iii: Depreciation Methods
There are two categories of depreciation methods.
1) Straight Line Depreciation Method
Under this method you divide the cost of the asset by the
number of years in the recovery period to determine the
depreciation allowance for the given year.
o ex: $275,000 asset, useful life of 27.5 years.
$275,000/27.5 =$10,000 each year (to find what
rate this is you would then take
$10,000/275000-.036, so you are deducting at a
rate of 3.6% each year)
Reg §1.176(b)-1: Under the straight line method the cost or
basis of the property less its estimated salvage value is
deductible in equal annual amounts over the period of the
useful life of the property.
Code §168(b)(4): Provides that the salvage value is treated
as zero, this allowing the taxpayer to recover the entire cost
of property during the recovery period.
2) Accelerated Depreciation Methods
Declining Balance Method: Under the declining balance
method a uniform rate is applied each year to the
unrecovered cost or other basis of the property. (1.167(b)-
2(a). Most common declining balance methods are the so-
called double or 200% method and the 150% declining
method.
ex: (double) $30,000 asset with a useful life
of 5 years, the straight line deduction would
be 20% ($30,000/5=6000/30,000= 20%), so
using the double deduction method the
taxpayer can deduct 40% each year from
the unrecovered cost:
Year 1: Can deduct $12,000
(.4X30,000)
Year 2: Can deduct $7,200 (30,000-
12,000= 18,000 unrecovered cost,
x .4)
Year 3: $4, 320 ( $18,000-7, 200=
10, 800 x .4)
Year 4= 2592 ( 10,800-4, 320= 6480
x.4)
Year 5= 1555 (6480-2592=3888x.4)
168(b)(1) provides that, with respect to the 3,5, and 7 year property the
200% declining balance method should be used, but the taxpayer shall
switch to the straight line method in the year that method, if applied to the
adjusted basis at the beginning of such year would produce a large
deduction.
§168(b)(3) requires taxpayer to use STRAIGHT LINE METHOD FOR
RESIDENTIAL RENTAL PROPERTY AND NONRESIDENTIAL REAL PROPERTY.
The acceleration method may be used with respect to real property and will
lengthen period over which the deductions occur.
o iv: Conventions (When can property begin to be deducted)
Recovery period during which depreciation may be claimed begins when the
property is placed in service.
(1.46-3(d)(1)(ii) defines placed in service to mean placed in a condition or
state of readiness.
according to 168(d)(2)(4)(B), residential rental property and nonresidential
real property placed into service during any month, are deemed to be
placed in service on the mid-point of such month
No depreciation deduction is allowed for property placed in service and
disposed of during the same taxable year (1.168(d)-1(b)(3)(ii)
All other classes of property are generally subject to a half-year convention,
meaning that any property placed in service, during the tax year is deemed
placed in service on the mid-point of the tax year 1.168(d)-1(b)(3)(ii)
Intangible property follows the 167 depreciation rules unless the fall under
197.
Computer software is depreciable over a 36 month period 167(f)(1)
B: Computing the Depreciation Deduction
o i: 168(a) provides the depreciation deduction shall be determined by using the (1)
applicable depreciation method (2) the applicable recovery period and (3) the
applicable convention.
Start with the adjusted basis of the property which will usually be the cost
1.167(g)-(1)
Then find the appropriate recovery period under 168
Find if the half year or half month convention applies.
If the half year applies, then for the first year of deduction you are
only going to deduct half of the percentage you would otherwise
deduct for a full year. (ie: if the 200% was 40% and you start in a
half year, then you deduct 20% the first time)
Look at table 87-57 for deduction percentages
Qualified Property: Because of the economy crisis, congress added 168(k) in
2008 which permits an additional first-year depreciation deduction equal to
50% of the adjusted basis of qualified property. This is taken first and then
the additional deduction provisions also apply in the first year and in
subsequent years. Ex. If $1000 5 year property. Year 1 you get $500
deduction under 168(k) (1,000-500) and another $100 ($500 x .2=100)
deduction for a total first year of $600.
To qualify for additional first year depreciation, property must meet
all of the following requirements:
Property to which the MACRS applies with an applicable
recovery period of 20 years or less
Original use of property must commence with the TP after
12/31/07
TP must purchase property within applicable time period.
C: Amortization of Intangibles
o i: 1993 Congress added 197 which allows TP’s to amortize certain intangibles ratably
over a 15-year period. Negates the concern over whether intangibles have a useful
life.
D: Relationship Between Basis and Depreciation
o Depreciation is the means whereby a taxpayer recovers the cost of property used in
a trade or business or investment activity because he was required to capitalize it
rather than currently deduct/expense it. Taxpayer recovers basis through
depreciation deductions, thus, Adjusted basis thus reflects the unrecovered cost of
property.
o TP must reduce basis in depreciable asset by depreciation claimed but not less than
the amount allowable.
Means you can’t choose when deprecation will be deducted, even if TP fails
to claim an allowable depreciation deduction with respect to an asset, must
still reduce basis by allowable depreciation amount.
ex: Buys building for $200,000, uses it for business for ten years,
sells it for 150,000. During the then years owned, the depreciation
was 75,000. Adjusted basis in the house is 200,000-75,000=
125,000. Her gain realized on the sale of the house therefore would
be 25,000.
E: Section 179- Expensing Tangible Personal Property
o i: 179 is an exception that permits a taxpayer to currently expense what would
otherwise be capitalized property subject to depreciation.
This elective provision applies only to 179 property—tangible personal
property acquired by purchase for use in the active conduct of a trade or
business.
o 179(b)(1) limits the amount that can be expensed to $250k for years beginning after
2007 and before 2011. In 2011 it is to change to $25k.
o 179(b)(5) has a special rule for SUV’s, the current expense cannot exceed $25k.
o The $250k deductible amount is reduced dollar for dollar by the amount the
cumulative 179 property placed in service during the taxable year exceeds $800k.
(Will be reduced to $200k in 2011).—suggests that this section was intended as a
break for small business.
o 179(b)(3) limits the deduction to the amount of income from the TP’s trade or
business during the year
o But TP may carryover the amount of any deduction which would otherwise be
allowable. 179(b)(3)(A)
o Adjustment must be made to basis in property to the extent of the expense taken
1.179-1(f)
o This deduction is take before computing the depreciation deduction, thus the
reduced basis is used for application of the relevant percentage
o If there are multiple pieces of equipment, the TP may divide the $250k in any
proportion she wishes between the pieces of equipment.
F: The Relationship of Debt to Depreciation
o 179 is applicable regardless of whether the taxpayer used her own funds or
borrowed funds to purchase the property.
o Benefits to TP because he has not yet incurred any expense but is still permitted to
take depreciation deduction.
XV: Losses and Bad Debts
A: Losses
o i: The Business or Profit Requirement for Individuals
165(a) authorizes a deduction for any uncompensated loss sustained
However the loss MUST be for trade or business losses, losses in
profit-seeking transactions and casualty or theft losses. (165(c)(1)
and (2)). Does it qualify as a trade or business for §162.
Under the regulations, personal property may be converted into income-
producing property so as to qualify for a 165(c)(2) deduction on disposition.
Cowles v. Commissioner: P listed their personal residence for sale or
rent and then claimed a loss on the eventual sale as a tax deduction.
Holding/Rule: Mere offers to rent or sell a personal
residence to not provide the necessary foundation for the
deduction of a loss under 165(c)(2)
If a taxpayer believes that the value of property may appreciate and decides
to hold it for some period in order to realize upon such anticipated
appreciation, as well as any excess over his investment, it can be said that
the property is being held for the production of income.
Taxpayers primary purpose will be controlling
If property is used partly for personal and partly for profit purposes,
allocation of a loss for the profit part is permissible.
Ex: If a residence is converted to profit purpose, the period of
personal use in non-deductible.
A loss in excess of the basis is not permitted. Basis is, for loss purposes, is
limited to the lesser of the FMV OR basis at the time of conversion for
adjusted item (1.167-g(1))
ex: FMV at time of conversion of car from personal is business use is
$15k. (loss cannot exceed 15k) Taxpayer initially paid $30k for car.
Depreciation deductions calculated with references to $15k. If
$5,400 in depreciation, Taxpayer’s adjusted basis is $9,600 (15-5.4).
If the taxpayer sells the car for anything less than $9.6k he will be
entitled to a loss. For purposes of gain, you don’t apply the “lesser
of” rule. The taxpayer’s adjusted basis is $24.6k (30-5.4). Thus for a
sale price between $9.6 and $24.6 neither gain or loss will be
realized.
Devisee: Uses property as solely personal, transfers it upon death and
devisee immediately sells it without ever having made personal use of it and
sustains a loss. Courts have allowed a deduction under these circumstances
holding that the tax status of the property became neutral at the moment
of death and the use the devisee made of it determined it’s status. If sells
immediately then it was for profit and loss can be sustained.
o ii: When is a Loss Sustained
A loss must be evidenced by closed and completed transactions, fixed by
identifiable events 1.165-1(b)
A sale or exchange typically fixes a loss but a mere decline in value is not
necessarily a loss sustained.
A loss for securities is allowed when they become worthless (165(g)(2))
Theft losses are treated as sustained in the year the theft occurs. 165(e)
Revenue Ruling 2009-9: PONZI SCHEME. B intent to deprive A of her
investment money by criminal acts, therefore B’s action constituted
a theft and therefore a theft loss may be claimed.
Had B not had the intent to deprive A of money then A’s
lost investment would be a capital loss. A loss that is
sustained on the open market for investment is a capital
loss, even if the decline in value of the stock is attributable
to fraudulent activities on the part of the directors, so long
as there was not specific intent to deprive.
o iii: Amount of the Deduction
165(b) limits the amount of the loss deduction to the adjusted basis of the
property in question.
To the extent that the taxpayer receives insurance or other compensation
the loss is offset and the deduction reduced. 165(a)
Rev Ruling 2009-9: The amount of theft loss from a fraudulent investment
arrangement will, under some circumstances, include not only the amount
the taxpayer initially invested but also the amount of income the taxpayer
reported on the investment.
If there is a reasonable prospect of recovery in year 1, the loss is not treated
as sustained until the matter of reimbursement is determined with
“reasonable certainty” 1.165-1(d)(2) and (3)
If there is no reasonable prospect of recovery and a loss is allowed in year 1
and then in year 2 a recovery does occur, the recovery is treated as income
in year 2.
B: Bad Debts
o i: Bona Fide Debt Requirement
Section 166 allows a deduction for debts becoming worthless within the
taxable year.
166 is applicable ONLY if a bona fide debt exists. There must be a debtor-
creditor relationship based on a valid, enforceable obligation to pay a fixed
or determinable sum of money (Reg 1.166-1(c))
o ii: Worthlessness
Debt must be a BAD debt
Even if a bona fide debt is present, forgiveness or cancellation of the
debt may constitute a gift rather than evidence of worthlessness
6511 provides a 7 year SOL for refund claims under 166
o iii: Business or Nonbusiness Debts
Business debts are deductible under 166 in the year that they become
totally worthless. Partially worthless business debts are also deductible
under 166(a)(2) up to the amount charged off within the yea.
Nonbusiness bad debts are deductible only upon becoming wholly
worthless.
Nonbusiness debt is define in 166(d)(2) as a debt other than a debt
created or acquired in connection with the taxpayers business.
Nonbusiness debts, even when completely worthless, are
deductible only as short term capital losses rather than as ordinary
losses.
Capital loss under 1211 is limited in a given year only to the
extent of the individuals capital gain plus an additional
3,000
An employee engages in a trade or business as an employee, and if
a loan is required to continue employment it can be counted as a
loss.
US v. Generes: Generes attempted to deduct funds paid by him
under the terms of an indemnification agreement of a corporation
that become insolvent as a bad business debt.
Holding/Rule: Generes was a shareholder (nonbusiness) and
an office (business), his shareholder motive was the primary
motive so this was a nonbusiness debt and only short term
capital can be claimed.
o iv: Amount Deductible
The amount of a bad debt deduction is the debt’s adjusted basis 166(b)
No bad debt deduction is allowed unless such amounts have been included
in income, which would not be the case with the cash method taxpayer.
(1.166-1(e)).
o v: Guarantees
Losses arising out of loan guarantees are treated as losses fro bad debt
(1.166-9)
C: Bad Debts and Losses: The Interplay Between 165 and 166
o Depending on the circumstances taxpayer may seek to characterize a loss under 166
rather than 165.
o Investment related loss is capital loss if under 166 (not under 165)
o If a personal loss, 165 denies deduction except for casualty and theft, while 166
allows short-term capital loss.
XVI: Travel Expenses
A: Commuting
o i: Commuting costs are viewed as personal in nature since you can choose how close
or far you’d like to live to work, and therefore are nondeductible under 262.
o ii: Flowers for deductibility TEST
To be deductible, a travel expenses must satisfy three elements:
1) It must be necessary and reasonable
2) It must be incurred away from home
3) It must be incurred in the pursuit of business
o Revenue Ruling 55-109: A taxpayer who works in two different locations on the
same day for the same employer may deduct the cost of travelling from one work
location to the other. “If at the end of the workday he goes directly home from his
second place of employment, his trip would ordinarily be regarded as commuting
and nondeductible (if the distance from the second location to home does not
exceed the distance from the headquarters to home). (pg 370)
o TEMPORARY WORK LOCATION
Revenue Ruling 99-7: In general daily transportation expenses incurred in
going between a taxpayer’s residence and a work location are
nondeductible commuting expenses. However such expenses are
deductible under these circumstances:
(1) Going between residence and temporary work location outside
metropolitan area where taxpayer lives and normally works are
deductible, but temporary work locations within the metropolitan
area where taxpayer lives/works are non-deductible unless (2) and
(3) apply
(2) if the taxpayer has a temporary work location and has
one or more regular work locations away from residence
(more than just a temp. location) then expenses incurred in
going between the residence and temp work location in
same trade or business are deductible
(3) if residence is principal place of business, taxpayer may
deduct transportation expense between residence and
another work location.
Temporary is based on a reasonable belief that it will be less than a year.
Doesn’t matter if you think more than a year and it ends up being less.
Treated as temporary until you realistically believe that it will last more than
a year.
Pollei v. Commissioner: Police were able to deduct the maintenance and
operating costs of driving their personal cars between their homes and
police headquarters based on their being “on-duty” status at such times.
Other people will not be allowed to deduct their travel expenses simply
because they voluntarily chose to do work when they travel. A personal
expense may become a business expense when it loses it’s voluntary nature
and is proscribed by company regulations.
B: Other Transportation Expenses
o Ordinary and necessary travel that is solely business related is deductible (i.e. fly
somewhere to take a deposition)
o If you use your own car to travel across town to interview a client, it’s deductible
o If your principal place of business is your own residence, the entire amount of
transportation driving from home for business is deductible.
o If primary purpose of travel is business, transportation costs are deductible. If
personal, then transportation costs not deductible, but expenses incurred allocable
to business are deducible. 1.162-2(b)(1)
o 247(m)(1) disallows deductions for business expenses incurred on luxury water
transportation.
o Travel as a form of education is also non-deductible 247(m)(2).
Ex: Latin teacher who spends the summer in Rome cannot deduct as an
educational expense.
C: Expenses for Meals and Lodging
o Initially, 162(a)(2) allowed a taxpayer to deduct the entire amount of meal an
lodging when the taxpayer was away from home, however, now 274(n) limits the
deduction of meals to 50% of their cost.
o Over-night Rule
Employees who have been authorized to stop performing their regular
duties to get substantial sleep or rest prior to returning to their home
terminals may deduct the costs of their meals and lodging
US v. Correll: Corell was a traveling salesman who sought to deduct the cost
of breakfast and lunch eaten on the road as a business expense.
Holding/Rule: Taxpayer traveling on business may deduct the cost
of his meals only if his trip requires him to stop for rest or sleep. His
travels did not require this so the deduction was disallowed.
o 162(a)(2) applies when a taxpayer who because of the exigencies of his trade or
business must maintain two places of abode and thereby incur additional and
duplicate living expenses.
D: Away from Home
o Home within the meaning of 162(a)(2) is the taxpayer’s principal place of business.
If taxpayer has more than one PPB look to amount of time and business
activities located in each place.
Robertson v. Commissioner (375)
o Rosenpan v. US: Traveling salesperson, had no home to be away from so could not
deduct business expenses.
o Henderson v. Commissioner: Deducted living expenses he incurred while living away
from home with his traveling ice show.
Holding/Rule: When a taxpayer does not have a business connection to a
place and is not duplicating his expenses, he cannot claim it was his home
for tax purposes. H had no legal tax home since he continuously traveled for
work
o Expenses incurred in connection with the temporary assignment away from home
are deductible, BUT it is not temporary if it exceeds one year
ex: Taxpayer reasonably expects to be on assignment for only nine months,
but once she is there she is asked to stay for 7 more months. Service
concluded that the first 9 months can be treated as temporary and the
remaining seven treated as permanent.
o A seasonal job to which an employee regularly returns year after year is regarded as
being permanent rather than temporary.
BUT see Andrews v. Commissioner: Man worked part of the year in boston
and part in florida and had homes in each.
Holding: taxpayer could only have one “home” for purposes of
§162(a)(2) and that duplicative living expenses while on business at
the other home (“the minor post of duty”) were a cost of producing
income and therefore deductible.
E: Spouse Travel Expense
o 274(m)(3) severely restricts deductions for the travel expenses of a spouse. Under
this provision, taxpayer may deduct for a spouse if
1 ) spouse is a bona fide employee of the taxpayer
2) travel of the spouse is for a bona fide business purpose
3) spouse could otherwise deduct the expense.
o May be treated by employer (if not deductible under §274(m)(3)) as deductible
compensation to the employee pursuant to §274(e)(2), this employer-paid expense
is presumable a fringe benefit.
F: Reimbursed Employee Expenses
o Follow the special rule of §62(c) they will qualify as an above the line deduction
rather than a below the line deduction (subject to reduction under 2% floor rule of
§67 and useful only for taxpayers who itemize). This means that the expense is
essentially eliminated from gross income, and thus the expense is not deductible.
o Qualifying reimbursement arrangements are “accountable plans” (1.62-2(c)(4)).
Amounts paid under a “nonaccountable plan” are included in gross income and the
expense is deductible only as a below the line miscellaneous itemized deduction
(1.62-2(c)(5)).
o Accountable plan must satisfy a 3 part test:
“business connection”—allowances only for deductible business expenses
1.62-2(d)(1)
Must be properly substantiated (amount, time, place submitted) 1.62-2(e)
(1)
employee must be required to return any excess of substantiated expense
(f)(1) any amount not returned is included in income (non-account)(c)(3)
G: Business-related Meals
o If not away from home 162(a)(2) applies and meals can still be deductible as
ordinary and necessary business expenses 1.262-1(b)(5), meal expense deduction
limited to 50%
o 274(a) requires the taxpayer to be present at a meal for which an expenses
deduction is sought
o 274(n) limits the deduction to 50% its cost
XVII: Entertainment
A: Business or Pleasure
o Because of the close call between business entertainment and pleasure, Congress
limited the deduction for business meals and entertainment to 50% of the cost. 274
o Churchill Downs v. Commissioner: P was owner and operator of horse race track
which argued that several of the events it hosted were deductible as ordinary
business expenses spent to publicize the taxpayers racing events.
Holding: Court held that purely social, public relations events hosted by a
taxpayer for the purpose of promoting its product are entertainment, and
are therefore limited to the deductibility of entertainment expenses to 50%.
B: Entertainment Activities
o 274(a)(1) disallows any deduction for an activity of a type generally considered to
constitute entertainment, amusement, or recreation UNLESS the taxpayer satisfies
one of two tests:
1) the expenditure is directly related to the active conduct of the trade or
business
The “directly related to” standard requires that the taxpayer:
1) reasonably anticipate some income or specific business
benefit from the expense
2) actively engage in a business discussion
3) be motivated principally by the business aspect of the
business-entertainment combination
4) establish the expenditure is allocable to the taxpayer and
persons with whom the taxpayer is engaged in the active
conduct of the trade or business. (not necessary that more
time be spent on business than entertainment)
2) the expenditure is associated with the active conduct of the trade or
business and directly preceded or followed by a substantial and bona fide
business discussion.
Much looser standard. Taxpayer must have a clear business purpose
for making the expenditure but an intent to maintain business
goodwill or obtain new business satisfies this requirement. 1.274-
2(d)(2)
o If taxpayers are not present, or if there are substantial distractions such as at
nightclubs, theatres, sporting events and cocktail parties, the expenditure is not
considered directly related to the taxpayers business 1.274-2(c)(7).
o Meal deduction is not allowed if the meal is lavish or extravagant.
If it is extravagant under 274(k) take away the amount that it is extravagant
and deduct 50% of the remaining amount
If an employee gets reimbursed by the employer, the employer gets to
report the 50% deduction.
o Walliser v. Commissioner: P was VP and branch manager of a bank. He and his wife
traveled in tour groups for people involved in the building industry because it gave
the P a chance to associate with potential customers. P deducted for his travel
expenses.
Held: – trip was “entertainment” and requires directly related test of §274.
More than general expectation of deriving some income at some indefinite
future date
C: Entertainment Facilities
o 274 generally denies any deductions for entertainment facilities (ie hunting lodges,
swimming pools, etc)
There is an exception where the facility is used primarily for business
purposes (ie: more than 50% business use.
o A taxpayer will establish under 1.274-2(e)(4)(iii)(b) that a faculty was used primarily
for furtherance of his trade or business if he establishes that more than 50% of the
total calendar days of use of the facility, by the taxpayer during the taxable year
were days of business use.
If on a given day the taxpayer uses the facility in the ordinary and necessary
course of business that will constitute a day of business use.
D: Substantiation Requirements
o Section 274(d) imposes special substantiation requirements on entertainment
expenses, travel expenses, etc. A taxpayer is required to substantiate either by
adequate record or by sufficient evidence:
1) The amount of the expense
2) The time and place it was incurred
3) The business purpose for the expense
4) the business relationship to the taxpayer of the person entertained.
o Without this substantiation requirement the deduction is disallowed.
o The adequate record requirement is satisfied by maintaining a book, diary, or similar
record, together with bills and receipts (1.274-5T(c)(2). However for under $75 the
documentary evidence is not needed.
E: Business Meals
o Sutter v. Commissioner: Cost of meals, entertainment and similar items for one’s
self and dependents, at leas while not away from home, is a personal expense and
nondeductible. Unless it can be shown by clear and convincing evidence that the
expenditure in question was different in form or in excess of what which would have
been made for the taxpayer’s personal purpose.
o Moss v. Commissioner: Moss was a partner in a firm. Firm members met for lunch
DAILY where they discussed cases, etc. Lunch was the most convenient meeting
time. Sought to deduct.
Dailey business meeting lunches among co-workersare not deductible.
XVIII: Education Expenses
A: Deductibility of Educational Expenses Under Section 162
o Under 162 an individual may deduct educational expenses that either
1) maintain or improve skills required in his employment or trade or
business
2) meet the express requirements of his employer, or applicable law,
necessary to retain his established employment relationship, status, or rate
of compensation. (1.162-5(a)
o HOWEVER an expense is NOT deductible under 162 even though it satisfies the
above tests if
1) it meets the minimum educational requirements for qualification in the
taxpayer’s employment or trade or business
2) if it qualifies the taxpayer for a new trade or business
B: The Skill-Maintenance or Employer-Requirement Tests of 1.162-5(a)
o 1) Skill Mainenance
Refresher courses or courses dealing with current developments as well as
academic or vocational courses fall in this category (1.162-5(c)(1)
Sufficient Relationship
Carrol v. Commissioner: Police officer was not permitted to deduct
the cost of college studies in philosophy because even though the
police department encouraged policemen to attend college and
although it may improve their job skills, the taxpayer failed to
demonstrate A SUFFICIENT RELATIONSHIP between the education
and the particular job skills required by policemen.
Takahashi v. Commissioner : Petitioners were science teachers. By
law they had to complete a minimum of two semester units in a
course of study dealing with multicultural societies. Petitioner
attended a seminar held in Hawaii about Hawaiian culture. They
spent 10 days in Hawaii with their son. Seminar was 9 out of the 10
days. This course was held to not have maintained or improved the
skills required by them to perform their jobs as science teachers.
They would have had to demonstrate a connection between the
course of study and the particular job skills
Carrying on Trade or Business
Another issue is whether the taxpayer was carrying on a trade or
business at the time the educational expense occurred.
Implicit in both 162 and the regs, is that the taxpayer must be
established in a trade or business before any expenses are
deductible.
Wassenaar v. Commissioner: A taxpayer who has not
practiced law as an attorney was not allowed to deduct the
cost of his master of laws degree in taxation.
Link v. Commissioner: TP graduated from college and
enrolled in an MBA program, after working at Xerox for
three months. Court held Xerox was just a temporary hiatus
between education and not a trade.
Rev Ruling 68-591: Suspension of employment for a year or less will
be considered temporary. (however, there is no magic limit here,
and all the facts and circumstances must be evaluated. If the
taxpayer is found to have abandoned his trade or profession then
he cannot deduct educational expenses claiming to further his trade
or business.
Furner v. Commissioner: Petitioner majored in social studies at a
teachers college where she received her BA. To gain greater depth
of understanding on the subject she enrolled as a full time grad
student at Northwestern. She had to resign from school for a year
to do so. It was not unusual for teachers to enroll in full time
graduate study for an academic year in order to keep up with
expanding knowledge and improve their understanding of the
subjects they teach. A year of graduate study is a normal incident of
carrying on the business of teaching.
o 2) Employer Requirement
To meet the deduction, the requirements must be imposed for a bona fide
business purpose.
In addition only the minimum education necessary for retention of the job,
status or pay will qualify.
Hill v Commissioner (423)
C: The Minimum-Educational Requirements and New trade or Business tests of regulation
1.162-5(b)
o 1) Minimum Educational Requirements Block
162-5(b)(2): An individual may not deduct educational expenses required to
meet the minimum educational requirements for qualification in his
employment or trade or business.
o 2) New Trade or Business Block
162-5(b)(3)(i): individual is prohibited from deducting educational expenses
which are part of a program of study that will lead to qualifying him in a new
trade or business.
The fact than an individual may not intend to pursue the new trade or
business but may simply wish to improve his skills in his present
employment does not make the expense deductible.
Warren v. Commissioner (pg 424): Taxpayer took courses he deemed
relevant to his ministry. Applying the objective test of the regulations, the
Tax Court concluded that the degree program qualified the taxpayer for a
new trade or business.
Mere change of duties is not equivalent to a new trade or business if the
new duties involve the same general type of work as the present
employment.
Glen v. Commissioner (pg 424): Common sense approach to determining
when new titles or abilities constitute a new trade or business. Compare the
types oft asks and activities which the taxpayer was qualified to perform
before the acquisition of a particular title or degree and those which he is
qualified to perform afterwards. This case held public accountants and
certified public accounts to be in separate trades or businesses given this
test.
Sharon v. Commissioner: Using the common sense approach, held that a NY
attorney qualified for a new trade or business on obtaining his California
license to practice law.
Allemeier v. Commissioner (pg 425): MBA deductible because getting it did
not qualify him for activities he was not able to perform prior to getting the
MBA.
Foster v Commissioner (pg 425): MBA nondeductible because taxpayer was
a project manager for an engineering consulting company and getting the
MBA qualified him to perform activities he was not qualified to perform
prior.
TEACHER EXCEPTION: For a teacher who moves from elementary to
secondary school or from one subject matter to another is not considered to
have a new trade or business, ALSO a change from teacher to guidance
counselor or principal is also NOT a new trade or business (1.162-5(b)(3)(i))
D: Travel Expenses
o 247(m)(2) disallowed any deduction for travel as a form of education.
o Any business purpose served by traveling for general education purposes, in the
absence of specific need such as engaging in research which can only be performed
at a particular facility is at most indirect and insubstantial.
o Committee bill disallows deductions for travel that can be claimed only on the
grounds that the travel itself is educational but DOES ALLOW for travel that is a
necessary adjunct to engaging in an activity that gives rise to a business deduction
relating to education.
o 162-5(e)(1): Travel expenses, meals and lodging remain deductible where an
individual travels away from home “primarily” to obtain education, the expenses of
which are deductible.
XIX (C) : Legal Expenses
Origin of the Claim Test
o If the origin of the claim lies in personal, as oppose to business o profit-seeking
transactions the legal expenses are non-deductible.
o US v. Gilmore: Whether the claim arises in connection with the taxpayers profit-
seeking activities. Does not depend on consequences that might result to a
taxpayer’s income producing property from a failure to defeat the claim
Wife’s claim to income producing property stemmed entirely from the
marital relationship
o US v. Patrick: Deny deduction for legal fees related to a property settlement.
o 1.262-1(b)(7): permits a deduction for fees and costs property attributable to the
production or collection of alimony which is taxable income under §71.
o Even if business related, legal expenses are still subject to 263 capital expenditure
rule
Capital Expenditures:
o 212(3) Expenses of contesting tax liabilities are deductible, as well as a deduction for
tax planning advice (ex. portion of estate planning attributable to tax advice)
o 1.263(a)-(5) Amounts paid or incurred to facilitate an acquisition of a trade or
business, a change in the capital structure of a business entity and certain other
transactions (??)
XX: Hobby Losses
A: Historical Development
o In making the determination of whether an activity is NOT engaged in for profit, an
objective rather than a subjective approach is employed, thus although reasonable
expectation of profit is not required, facts and circumstances would have to indicate
that the taxpayer entered the activity with the objective of making a profit.
o Can qualify under this test even if the expectation of profit were unreasonable.
1.183-2(a)
B: Section 183 Activities
o 183 applies to activities not engaged in for profit.
o Each activity must be tested separately as to whether it is an activity “not engaged
in for profit”
Ie: Those activities which do not qualify for deductions under 162 or 212
o The following factors help to determine whether an activity is engaged in for profit
(1.183-2(b))
i: Manner is which the taxpayer carries on the activity
ii: Expertise of taxpayer or his advisors
iii: Time and effort expended by the taxpayer in carrying on the activity
iv: Expectation that assets used in the activity may appreciate in value
v: Success of the taxpayer in carrying on other similar or dissimilar activities
vi: Taxpayer history of income or losses with respect to the activity
vii: Amount of occasional profits which are earned
viii: Financial status of the taxpayer
ix: Elements of personal pleasure or recreation
o Regulations employ an “all the facts and circumstances” test with greater weight
given to objective facts than to the taxpayer’s mere statement of his intent
Antonides v. Commissioner: Court held that a yacht chartering venture was
an activity not engaged in for profit. Taxpayer was not actually motivated by
the prospect of profit in acquiring the yacht.
Missley v. Commissioner: Taxpayers operated an Amway distributorship.
The tax court noted that the distributorship generated consistent and
substantial losses, the taxpayers failed to maintain a written business plan
or budget, they had substantial income from other sources, and they
derived personal pleasure from the Amway activities. The court thus held
they had not engaged in the Amway activity for profit.
C: Deductions Allowable Under Section 183
o 183(b) establishes 3 categories of permitted deductions:
Category 1: Those such as home mortgage interest under 163(h)(3) and
state and local property taxes under 164 which are allowed to a taxpayer
whether or not an activity is engaged in for profit
Deductions that are attributable to the activity but don’t come
within the first category are allowed only to the extent that the
gross income from the activity exceeds the total Category 1
deductions 183(b)(2).
Ex. Profit $1000, Category 1 deduction of $1100—all is
deductible. But if $700 is Category 1 only $300 of Category
2 can be deducted.
o Non Category 1 deductions are divided into 2 other categories.
Category 2: do not result in a basis adjustment and would otherwise be
allowed if the activity were engaged in for profit (garden variety 162 or 212
expenses)
Category 3: deductions such as depreciation, result in basis adjustments and
would be allowed if the activity were engaged in for profit. (may only be
taken after Category 2 deductions)
o 1.183(b)(2) In the event the activity use more than one depreciable asset, there’s a
formula for allocating the basis adjustments among the depreciable assets.
o Policy: 183 Adopts the basic policy that deductions attributable to a not-engaged-in-
for-profit activity should always be allowable at least to the extent of the income
from the activity.
o Dreicher v. Commissioner : Dreicer (P) claimed deductible losses for expenses related
to his alleged profession as a writer.
RULE: deductible losses under §183 of the IRC are allowed even if the
taxpayer entered into an activity with the actual and honest objective of
making a profit
HELD: Taxpayer’s motive is the ultimate question, and it must be
determined by a careful analysis of all the surrounding objective facts.
Statement of intent should only be one of the relevant factors. Here there
were large losses for many years, expenses were not conducted in a
businesslike manner to earn a profit, thus the deductions are disallowed on
the grounds that the expenses arose from activities not pursued for profit.
o Remuzzi v. Commissioner : a surgeon claimed losses from operating a farm where his
family lived
RULE: in determining whether an activity is engaged in for profit, objective
facts regarding the manner, success, and history of the taxpayer’s efforts
are given greater weight than the taxpayer’s stated interest.
HELD: Section 183 of the IRC allows deductible expenses if an activity is
engaged in for profit and lists 9 factors to be taken into account. No
evidence surgeon tried to decreased expenses and maximize revenues of
farm, had no expertise, and moved to the farm for personal enjoyment.
Failed to prove he entered business for profit.
XXI: Home Offices, Vacation Homes and Other Dual Use Property
A: Home Office Deductions
o Bodin v. Commissioner: P , a lawyer, used an office at home for work in the evenings
and weekends because it was more convenient than traveling back to the office. He
tried to claim a deduction for use of his study as a home office.
Holding: The applicable test for judging the deductibility of home office
expenses is whether, like any other business expense, the maintenance of
an office in the home is appropriate and helpful under all circumstances.
Tax court held that it made no difference that the petitioner was not
required to maintain a home office. The expense was “necessary” because
they were appropriate and helpful in the conduct of his business. They
enabled him to jeep a facility in his home wherein he could and did work,
they were ordinary in nature
o With the enactment of 280A(c)(1), taxpayers can deduct their home office expenses
if they satisfy the exclusivity and regular use standards and the convenience of the
employer standard. (Bodin would have failed these standards)
o Determining PPB: Soliman v. Commissioner: A self-employed anesthesiologist
worked at 3 different hospitals and did all of his administration and management
work for his job at home because he had no office in any of the buildings.
Rule: In determine the PPB consider:
The relative importance of the activities performed at each business
location and
The time spent at each place.
While this court held that he could not deduct, this case has since been
reversed however the two rules still apply.
o 280A(c)(I), says that a home office can be a principal place of business if it is used for
administrative or management activities and if there is no other fixed location of
such trade or business where the taxpayer conducts substantial administrative or
management activities. (reversed Solimon)
o Convenience of the employer standard:
ex: Weissman v. Commissioner: P working at a home office spared the
employer the cost of providing a suitable private office and thereby served
the convenience of the employer.
o Popov v. Commissioner: Popov was a professional violinist who sought to obtain a
home office deduction for the space she used in her home to practice for orchestra
performances and studio recordings.
Rule: A professional musician is entitled to deduct the expenses from the
portion of her home used exclusively for musical practice when the activities
performed and the time spent at each business location are considered and
weighed in favor of the musician. Relative importance of activities
performed at each location and the time spend at each place are to be
considered. Here importance of practice is essential and she spent more
time practicing than performing. Thus she was entitled to a deduction since
the home space was used exclusively for PPB.
o 280A(c)(5) severely limits the deductions allowed for a home office
The gross income from the use of the residence for trade or business
purposes is the ceiling for the deductions. This ceiling is the reduced by
1) the deductions the taxpayer can claim regardless of whether the
home office were used for trade or business purposes (real estate
taxes allocable to the home office) and
2) those deductions attributable to the trade or business activities
but not allocable to the dwelling unit itself (such as secretarial
expenses, supplies, business phones, etc)
EXAMPLE: Sum of allowable business deductions of office is 1,050 ($1,900 of
gross income less $850 of expenditures not allocable to the unit).
Gross Income from consulting services $1900
Less
(1) Always Allowable deductions ((§280A(c)(5)(B)(i))
Total Allocable to Office
Mortgage $5,000 $500
Real Estate $2,000 $200
Total Allocable to Office. . . . . . . . . . . . . $700
(2) Expenditures not allocable to use of (§280A(c)(5)(B)(ii))
Secretarial $500
Business Telephone $150
Supplies $200
Total . . . . . . . . . . . . . . . . . . . . . . . $850
Sum of (1) and (2) . . . . . . . . . . . . . . . . . . . . .$1550
o Section 280A(c)(5) limit on further deductions
Gross income $1900 less $1550 . . . . . . . . . . . . . . $350 (thus only
$350 of the taxpayers other expenses may be deducted under 280A(c)(5)
o Assume other expenses attributable to home office are
Total Allocable to Office
Insurance Utilities $600 $60
Utilities $900 $90
Lawn Care $500 $0
Depreciation $3200 $320
Total Allocable to Office . . . . . . . . . . . . $470 (only $350 can be
deducted, the utility and insurance charges totaling 150 would be
deductible first, leaving 200 of the depreciation able to be deducted. The
120 left over from the depreciation may be carried over to the succeeding
tax year.
B : Vacation Home Deductions
o 280A limits deductions a taxpayer may claim with respect to rental of a dwelling unit
if taxpayer uses dwelling unit for greater of 14 days or 10% of number of days for
which home is rented for a fair value 280A(d)(1)
o Deductions may not exceed the excess of the amount y which the gross income
derived from the rental activity exceeds the deductions otherwise allowable without
regard to such rental activity (ie: mortgage interest, and real estate taxes).
o The portion of expenses (insurance, depreciation, utilities) allocable to rental
activities is limited to an amount determined on the basis of the ratio of time the
home is actually rented for a fair rental, to the total time the vacation home is used
during the taxable year for all purposes, including rental.
C: Other Dual Use Property
o i: Computer and other “Listed Property”
Unless the business use percentage for the taxable year exceeds 50%, the
taxpayer is required to use the alternative depreciation system of 168(g)
and is limited to straight line depreciation on the property. (280F(b)(1),(3).
Recapture Rule 280F(d)(3), to address situations where, in a year following
the year the “listed property” is placed In service, the taxpayer fails to meet
the 50% use standard.
If the employee uses his own computer in connection with his employment,
no depreciation is available to the employee unless he can establish that the
use of the computer is for the convenience of the employer and is required
as a condition of his employment 280F(d)(3)
o ii: Passenger Automobiles
Are also treated as “listed property” and subject to the same limitations as
above., thus unless the taxpayer uses the passenger automible more than
50% of the time for trade or business purposes the taxpayer may not use
the accelerated depreciation provided by 168 and no 179 election is
available.
280F(a)(1)(A) Congress limited the depreciation allowable with respect to a
passenger automobile in the year it is placed in service and succeeding years
Yr 1 max depreciation allowed is 2,560
Yr 2 – 4,100
Yr 3- 2, 450
Each yr after – 1, 475
Limitation is applied after depreciation is computed under §168 and amount
is reduced to reflect portion used for personal use.
Ex. 25% business and 75% personal can’t use accelerated
depreciation so must use straight line. Total car was $30k. Max
depreciation is still as listed above. Under 168(g) it would have
been 10% of $30k. or $3000 but according to 280F(a)(1)(A) it’s only
$2560. Then you can only deduct the portion attributable to
business use (25%). Thus, $640 is deductible. Even if the auto was
used exclusively in her business, the maximum depreciation
allowance means that only $2560 is deductible in year 1. Under
simple §168, $6000 would have been deductible (straight line over 5
years).
XXII MECHANICS NOT ON EXAM
XXIII: MECHANICS NOT ON EXAM
XXIV: Casualty Losses
A : Definitional Questions
o 165(c)(3) authorizes a deduction for an individuals uncompensated casualty and
theft losses unconnected with a trade or business.
Each lost is first subject to a $100 nondeductible floor, in addition the new
casualty loss for the year is allowed only to the extent that it exceeds 10% of
the taxpayer’s adjusted gross income. 165(h)(1), (2)
o The average taxpayer rarely get to apply the casualty loss since it must be a loss
uncompensated by insurance and it must be more than 10% of gross income.
o Loss can be collected in the case of a “fire, storm, shipwreck or other casualty” Rev
Ruling 72-592
What is “other casualty”?
Event MUST be “identifiable of a sudden, unexpected, and unusual
nature”
o Examples of Deductions Permitted :
White v. Commissioner:
Deduction was allowed for a diamond ring lost when a car door was
slammed on a woman’s hand.
Revenue Ruling 75-592: (reviewed the white case above) Ruled that
property that is accidentally and irretrievably lost can be the basis for a
causality loss deduction if it meets the other qualifications and must be
1) Identifiable
2) Damaging to property
3) Sudden (swift, not gradual or progressive), unexpected
(unanticipated, without intent of the one who suffers) and unusual
(does not commonly occur in the course of day to day living) in
nature
Carpenter v. Commissioner:
Deduction was allowed when a woman placed her ring in a glass on
ammonia for cleaning and her husband poured it in the sink by
accident and ruined it.
o Example of Deductions NOT permitted:
Keenan v. Bowers
No deduction was allowed when a woman took off her wedding
rings, wrapped them in tissue and her husband accidentally flushed
them down the toilet. RULE: Damage that results from the
taxpayer’s willful act or willful negligence” will not be allowed.
TERMITE damage is not sudden, unusual or unexpected in nature
Maher v. Commissioner
Water heater burst from rust and corrosion was not a casualty loss
but the damage to the rugs and carpet due to bursting was.
o Foreseeability or negligence will not take an occurrence outside the ambit of “other
casualty”
Heyn v. Commissioner: While meteorological forecasts may warn of
impending hurricanes or tornados they are still casualty losses under the
law. In addition, even though a drivers negligence may have contributed to
a car accident, thus will not deprive him of a casualty loss.
1.165-7(a)(3)
o While the regulations do not require it, the court has held that PHYSCIAL DAMAGE
must be shown in order to establish a casualty loss.
Chamales v. Commisioner: Chamales lives near OJ Simpson the year he was
charged with murder. Because of the high amount of press, Chamales’
broker said that his house decreased in value by 20-30%.
Rule/Holding: A casualty loss arises when the nature of the
occurrence precipitating the damage to the property qualifies as a
casualty loss under 165 and when physical damage or permanent
abandonment of property has occurred. Temporary decline in
marker value will not be allowed as a deduction.
Lund v. US
Court denied a loss when taxpayers claimed that avalanche risk
lowered the value of their home.
o However, some courts have not required a showing of physical damages
Finkbohner: When PERMANENT buyer resistance exists (ie total change in
the result of the neighborhood) and impact the FMV of the property, the
taxpayer may claim a casualty loss deduction. The loss deduction is the
difference between the FMV before the casualty and the FMV after
casualty.
Theft Loss
o The regulations provide that theft includes, but is not limited to, larceny,
embezzlement and robbery. 1.165-8(d)
o Illegal taking of property, done with criminal intent, constitutes a theft loss for
purposes of 165(c)(3) even though the act may not fall under the state law
definition of theft.
Kriener v. Commissioner: Fortunetellers charged him $19,000 claiming to be
able to improve his health and sole his problems. Tax court noted that theft
constitutes a broad field including and criminal appropriation of another’s
property to the use of the taker, particularly including theft by swindling,
false pretenses, and any other form of guile.
o Taxpayer must prove a theft has occurred, a mere mysterious disappearance of
property will not suffice (Allen v. Commissioner)
o However, the taxpayer need not prove who stole the property, it is sufficient that
the reasonable interference from the evidence point to theft rather than mysterious
disappearance (Jacobson v. Commissioner)
Popa v. Commissioner:
facts: Popa an executive in Vietnam, lost his possessions when the
government collapsed and Americans were ordered to evacuate.
Rule/Holding: Under certain circumstances taxpayers are
not required to eliminate all possible noncasualty causes of
a loss in order to claim a 164 deduction. Here the most
reasonably conclusion is that Popa suffered a qualifying
casualty loss.
B: Timing of the Loss
o A casualty loss is deductible in the year sustained, theft loss is deductible in the year
discovered! (165(a),(e))
o If a taxpayer has made a claim for reimbursement, allowance of a deduction must
await the resolution of the claim with reasonable certainty. 1.265-1(d)(2),(3).
C: Amount of the Loss
o The amount of casualty loss under 165(c)(3) is the lesser of THE ADJUSTED BASIS
and the DIFFERENCE BETWEEN THE FMV of the property before vs the property
after. 1.165-7(b)(1)
o For THEFT it is the lesser of the basis or value 1.165-8(c)
ex: Diamond ring purchased for $1,000 increases to $3,000 in value, then it
is stolen, there can only be a $1,000 deduction.
ex: Car purchases at 10k, declines in value to 4k then it is wrecked, can only
get a 4k deduction.
o With respect to business related property , if the basis exceeds the value, the lesser
of rule does NOT apply (1.165-7(b)(1))
o The amount of the loss must be reduced by an reimbursement and by $100 (the
$100 is applied to each casualty or theft rather than each item destroyed in a single
casualty or theft) 165(h)(1) and 1.165-7(b)(4)(ii)
Once the personal casualty and theft losses have been determined they will
be deductible to the extent of any personal casualty gains for the year
165(h)(4)A)
ex: You lose a ring worth $1,000 and you get $2,000 from your
insurance claim, you now have a $1,000 casualty gain which can be
deducted
If the losses exceed the gain for the year, the net casualty loss is deductible
only to the extent that it exceeds 10% of the taxpayer’s adjusted gross
income 165(h)(2)
ex: Taxpayer sustains 2 casualty losses, one worth 1,700 and
another worth 80. He has NO personal casualty gains. He has a gross
income of $20,000. The resulting 165(c)(3) deduction would only be
$300. The losses total 2500, and they must be reduced by 100 per
casualty which leaves him with 2300. Then the 2300 can only be
collected in the amount which exceeds 10% of the taxpayers
income. He has income of 20,000 so 10% is 2,000. 2300-2000 is 300.
D: Insurance Coverage
o Casualty losses may only be taken into account if timely insurance claim is filed, to
the extent items are covered by insurance. 165(h)(4)(E)
o To obtain this deduction, a taxpayer is now required to file an insurance claim if he
has obtained insurance coverage, but is not required to obtain the insurance
coverage to being with.
XXVII: NOT ON EXAM
XXVIII: Cash Method Accounting
A: Income Under the Cash Method
o i: In General
Section 446(c)(1) authorizes the use of the cash method of accounting so
long as it clearly reflects the taxpayers income.
This method requires taxpayers to report cash (and income in other forms)
as received and to deduct expenses as they are paid.
o ii: Constructive Receipt
a: Specific Factors Affecting Application of Constructive Receipt Doctrine
Generally under this method, all items which constitute gross
income are to be included for the year in which they are actively or
constructively received. 1.446-1(c)(1)(i)
Constructive receipt occurs in the year which the income is
credited to his account, set apart for him, or otherwise
made available so that he may draw upon it at any time, or
so that he could have drawn upon it during the taxable year.
(1.451-2(a))
ex: Dec 1, tenant offers landlord the rent check for December. Even
though rent was then due, the LL tells T to hold onto the check and
give it to him in January. LL must report the rent for the December
year because he is in constructive receipt of the check.
Two requirements must be satisfied before the doctrine of
constructive receipt is applicable 1.451-2(a)
o 1) the amount must be available to the taxpayer
o 2) The txapayer’s control over receipt must not be
subject to substantial restrictions or limitations
Hornung v. Commissioner: Basis of constructive receipt is
essentially unfettered control by the recipient over the date
of actual receipt.
Baxter v. Commissioner: Although the notion of
constructive receipt blends a factual determination of what
actually happened and a legal assessment of its significance,
we have held that a finding of constructive receipt is a
finding of fact. ..and can be set aside only if clearly
erroneous.
Ames v. Commissioner: Did Ames constructively receive
income from illegal espionage activities when it was
allegedly promise him or when it was deposit in his
account?
o Held: Taxpayer did not have access to the funds
initially. They were held in a bank until certain tasks
were completed by taxpayer, of which there was no
certainty that they could be completed. So long as
the soviets had the funds taxpayer did not need to
report income
Courts will evaluate several factors relevant to whether a
taxpayer had unfettered control over income
o 1) Distance: Geographic proximity to the location
where an item of income is being made available to
the taxpayer.
ex: Hornung wins car for being MVP.
However, he is in Wisconsin and the car is in
New York and the dealership was closed for
the weekend. Court held he did not have
control necessary for constructive receipt.
Generally the date a check is RECEIVED and
not the date it is MAILED determined the
year of taxation, but if the taxpayer could
have picked up the check he will have
constructive receipt (Rev-Ruling 73-99)
o 2) Knowledge: Was the taxpayer aware that the
check was coming to him?
Rev Ruling 76-3 (pg 628)
Davis v Commissioner
o 3) Contractual Arrangement
If payment is made before it was due the
acceptor does not have to accept it and will
not be held to be in constructive receipt
(Rev Ruling 60-31)
o 4) Forfeitures or Other Penalties
Reg 1.451-2(a)(2) provides that there will be
no constructive receipt of interest on a
certificate of deposit or any other deposit
agreement if an amount equal to three
months interest must be forfeited upon
withdrawal or redemption before maturity
of deposit arrangements one year or less.
o 5) Relationship of the Taxpayer to the Payor
Before a shareholder-employee will be
considered in constructive receipt of the
salary owed her by her corporation, there
must be some corporate action to set aside
or otherwise make the salary available to
the shareholder-employee. In addition he
must have some authority to draw a check
to himself on corporate accounts. Rev-
Ruling 72-317 (pg 630)
b: Specific Exceptions to Constructive Receipt Rules
Various Exceptions Exist to the rule that one who has unfettered
control over the receipt of income must report it.
ex: a taxpayer who refuses a prize does not need to report it
as income. Rev-Rul 57-374
125 (cafeteria plans) an employee who chooses to receive
excludable fringe benefits in lieu of cash from his employer
has turned his back on income, under 125 he does not need
to report this.
o iii: Cash Equivalency Doctrine
1.61-1(a): gross income includes income in any form, whether in money,
property or services.
ex: Things that DO qualify as income
- receipt of an automobile (property with a clear value)
- stock in an account (property with a clear value)
- a bearer bond (represents a promise to pay and should be
included at its FMV at time of receipt 1.161-2(d)(4))
Ex; Things NOT qualified
- Promissory note to pay
- Letter acknowledging promise to pay
- Oral Promise
Cash Equivalency Doctrine: With reference to intangibles (like the
promissory note) this doctrine embodies the notion that certain intangibles
have so clear a value and are so readily marketable that a cash method
taxpayer receiving them should not be entitled to defer reporting of
income. By contrast, other intangibles have no market or even clear
property flavor.
Cowden v. Commissioner
Facts: Cowden and wife leased mineral rights in exchange
for an advance of royalty payment. The payments were
deferred over a period of year. Coweden report them as
long term capital gains, Commissioner say they should have
been taxed on the full amount regardless of the deferred
payment arrangement because it was equivalent to cash.
Rule: A promise to pay will be considered a case equivalent
if it is made by a solvent obligor, “is unconditional and
assignable, not subject to set offs, and is of a kind that is
frequently transferred to lenders or investors at a discount
not substantially greater than the generally prevailing
premium for money.
Williams v. Commissioner:
Facts: Taxpayer performed services for a client who gave
the taxpayer a promissory note payable approximately 8
months later. At the time he gave the taxpayer the note he
has no funds to pay it. He did not report it as income
o Court agreed with the taxpayer reasoning that the
note had been given only as a security for
indebtedness. Considering the note bore no interest
and was not marketable it had no fair market value.
Rev Ruling 68-606: Deferred payment obligation which is readily
marketable and immediately convertible to cash is properly
includable on receipt under the cash method to the extent of its
FMV.
Kahler v. Commissioner: The taxpayer received a commission check
on Dec, 31st after bank hours had closed. Court still held that the
taxpayer should have reported the check as income for that year.
Where services are paid for other than by money, the amount to be
included as income is the FMV of the property taken in payment.
Post-dated checks however will not likely meet the
requirements to result in income.
o iv: Economic Benefit Doctrine
Economic Benefit Doctrine: Gross income includes any economic benefit
conferred upon a taxpayer to the extent that the benefit has an
ascertainable fair market value.
Sproull v. Commissioner: An amount irrevocably placed in trust for the
benefit of an employee constituted income to the employee in that year,
even though the money was not payable to the employee until subsequent
years.
Commissioner v. Smith: Recognized that an economic or financial
benefit conferred upon an employee as compensation was included
in the concept of income.
Minor v. US: Under this doctrine, 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.
o v: Deferred Compensation
a: Non-qualified Deferred Compensation Arrangements
A non-qualified deferred compensation plan is any elective or non-
elective plan, agreement, method or arrangement between an
employer and an employee to pay the employee compensation
some time in the future. Nonqualified deferred compensation plans
do not afford employers and employees the tax benefits associate
with qualified plans because they do not satisfy all of the
requirements.
Establishing constructive receipt requires a determination that the
taxpayer had control of the receipt of the deferred amounts and
that such control was not subject to substantial limitations or
restrictions.
If an employee has unfettered control over deferred
amounts then the doctrine of constructive receipt will
defeat the deferral objectives of employees possessing such
control .
If a promise to pay in unconditional, assignable,, and the kind
frequently transferred to lenders or investors, such a promise is the
equivalent of cash and taxable in a like manner.
b: Property Transfer Under Section 83 ??
Property transferred in connection with the performance of services
is taxable to the extent that the FMV of the property exceeds the
amount paid for the property by the transferee
Section 83 was designed to heal with situations where the
recipient is the employee of the transferor and the
employee must return the property to the employer if the
employee quits.
o ex: Employer transfers to an employee a share of
corporate stock requiring the employee to earn out
the right to keep the stock by continuing to work for
the employer for a requisite time. If the employee
quit before the time passed he forfeited the stock.
Compensation income would only be reported
when the time of forfeiture lapses.
c: Section 409A and Revenue Ruling 60-31
Rev Ruling 60-31: Hold that a mere promise by the service recipient
to pay the service provider, not represented by ntoes or secured in
any way, does not consititute receipt of income.
Section 409A requires that all amounts deferred under a non-
qualified plan, unless subject to substantial risk of forfeiture, are
currently includable in income UNLESS certain requirements are
satisfied
1) Distributions of deferred compensation must be allowed
only upon separation from service, death, a time specified
in a plan, change in corporation ownership, disability or
unforeseen emergency 409A(a)(2)
2) Except as provided by regulations, acceleration of
benefits is prohibited 409A(a)(3)
3) The election to defer compensation must be made no
layer than the close of the preceding taxable year (before
income has actually been earned) (409A(a)(4)(B)
4) Certain requirements must be met if the plan permits a
delay in payment or change in the form of payment (such a
plan shall not take effect until at least 12 months after the
date on which the election is made) 409A(a)(4)(c)
409A does not apply to arrangements between a service provider
and service recipient if:
1) the service provider is actively engaged in the trade or
business of providing substantial services other than
o a) as an employee
o b) as a director of a corporation
2) The service provider provides such services to two or
more recipient’s to which the provider is not related and
they are not related to one another.
o vi: Prepayments
If the taxpayer is prepaid he must include it in income
1.61-8(b) specifically requires prepayments of rent to be included in the
year of receipt regardless of the period covered.
B: Deductions Under the Cash Method
o i: In General
Expenses are deductible when paid 1.446-1(c)(1)(i), 1.461-1(a)(1)
Deductions are allowed for payments only when “actually made” for
expenditures only “when paid”
When a tax payer “pays” with borrowed funds it is treated as payment for
tax purposes.
Payment is considered as being made when a check is delivered 1.170A-1(b)
The mailing of a check is regarded as delivery
Issuing of a promissory note is not considered payment (Helvering v. Price)
o ii: Cash Method Payments
The deduction method rules of 461 are subject to the capital expenditure
rules of 261
Capital expenditures are not currently deductible
One Year Rule:
Zaninovich v. Commissioner: The ninth circuit adopted the rule in
this case, allowing a taxpayer to deduct a rental payment made in
December for a lease year that extended through November, eleven
months into the following year. The one year-rule preserves the
simplicity of the cash method.
263: 12 month rule under which a taxpayer is not required to
capitalize benefits not extending beyond 12 months, or does not
extend beyond the end of the taxable year in which the payment is
made. 1.263-a-4(d)(3)(1)
ex: On Dec 31, 2010 a taxpayer makes a payment for
insurance which starts on January 10, 2011 and lasts for a
year. The 12 month rule does not apply because the right
attributable to the premium payments extends beyond the
end of the taxable year following the taxable year in which
the payment was made.
XXX: Annual Accounting
A: Restoring Amounts Received Under Claim of Right
o Income is an amount received under a claim of right, without restriction as to
disposition (North American Oil case)
o A tax increase that results from including in income an amount received under a
claim of right will not always be the same as the tax savings resulting from deducting
its repayment in a later year.
o A taxpayer who meets the requirements of 1341(a)(1)-(a)(3) is directed to compute
tax liability under the approach that meets the more favorable tax result
If the tax rate has gone up in year 2, you take a DEDUCTION under 1341(a)
(4) using the year 2 tax rate
If the tax rate has gone down in year 2 you take a TAX CREDIT under 1341(a)
(5) in an amount equal to the added tax occasioned by the prior year’s
inclusion in income. (when you first acquired the income under a claim of
right you compute it’s tax cost (marginal tax rate x amount), and the gain is
this amount)
Credit is only applied when it produces a bigger tax savings than the
deduction alternative
o What are the requirements?
1) There is a $3,000 dollar threshold requirement
2) The restored item must have been included in income for a prior year
because it appeared the taxpayer had an unrestricted right to the income.
You don’t need to have an unchallenged right to the money, but you
have to have more than NO right. You just need to have an
apparent right to the funds.
IRS defines an apparent right as “a semblance of an
unrestricted right in the year received.” Depends on all the
facts available at the end of such year (Rev Rul 68-153)
Does not apply to repayment of funds where taxpayers mere error
or sub sequent event causes taxpayer to have to repay funds which
it did not have a clear right to in the first place.
Dominion Resources v. US: Public Utility company applied 1341 to
customer refunds made in when rates were lower than they had
been when payments were collected in prior years. Service tried to
argue that 1341 does not apply where the taxpayer had actual right
to income
Rule/Holding: There is no a test for actual vs. apparent
control, the test is the “same circumstances rule” –requisite
lack of an unrestricted right to an income item.
3) 1341(a)(2) requires the taxpayer to establish that he did not have an
unrestricted right to the amount received in the prior year.
ie: Voluntary payments would not qualify.
Barret v. Commissioner : TP brought proceeds of option sales into
income. SEC brought charges. TP settled by repaying proceeds.
HELD: good faith, arm’s length settlement of the dispute
had the same effect as a judgment in establishing the fact
and amount of taxpayer’s legal obligation for repayment
and establishing that he didn’t have an “unrestricted right”
when funds were received.
This approach was rejected by Parks v. United States: man sold
business for profit and subsequently settled fraud litigation.
HELD: that the settlement didn’t allow the government the
opportunity to determine if the settlement was the result of
fraud thus making 1341 inapplicable. To refuse to look
behind the settlement essentially reads 1341(a)(1) out of
the statute.
Distinguished in Wang v. Commissioner: TP sold inside info, SEC
initiated criminal proceedings. Settlement, TP repaid funds.
HELD: no initial claim of right, or appearance thereof, for
funds received
B: The Tax Benefit Rule (when TP receives income for items previously deducted)
o Taxpayer recovers an amount that had been deducted in a prior year (you thought it
was a loss, but now you recover it). Ex. Bad Debt Expense was deducted, then
someone repaid, or you paid your state taxes, but then got a refund. TP includes
the recovered amount in income, essentially giving back the tax benefit.
o The inclusionary aspect of the tax benefit rule provides that the recovery constitutes
gross income
However, Section 111 codified the exclusionary aspect. To the extent that a
previously deducted amount did not produce a tax savings, its recovery will
not constitute income.
o Alice Phelan Sullivan Corp v US: (1341 does not have a TAX BENEFIT equivalent)
Facts: 2 Parcels of property were donated to charity by the corporation and
during that year P claimed a charitable deduction and enjoyed a tax benefit.
The lands were returned and taxed as income during the year of recovery.
Held/Rule: Return of charitable gifts is treated as income in the year of their
recovery. Can’t apply tax rate of year of gift.
o No actual recovery of funds in necessary in order to apply the tax benefit rule, all
that is necessary is that the event be fundamentally inconsistent with the prior
deductions
Hillsboro National Bank v. Commissioner:
Facts: Commissioner claimed that H should have reported as
income a refund for tax for which H had taken a deduction even
though the actual funds were returned to shareholders, not to H.
Held/Rule: The basic purpose of the tax benefit rule is not
simply to tax recoveries but to approximate the results of a
transaction-based tax system. Even if TP didn’t get money
back from shares, if it’s later determined he shouldn’t have
taken the deduction in the first instance, he must include
the previous deduction taken in income.
C: Net Operating Losses
o §172: provides that a loss in one year may be used to offset income in another year
so the loss is not wasted.
o §172 is form of relief from harsh result in Burnet v. Sanford & Brooks Co.
Burnet v. Sanford and Brooks Co: Sanford was paid under performance
installments for a long-term dredging contract. Sanford brought suit when
the contract was abandoned. They recovered their losses from the suit and
Commissioner assessed a delinquent tax in the year the funds were
recovered. Was the recovered loss income that needed to be reported?
Holding: Money received was from a contract entered into for profit
and any money earned from the contract must be reported.
172 was created to provide a carryback or carryover period
to lessen this burden
o It may be carried back two years and carried forward twenty years until it has been
fully absorbed.
o TP may elect to totally dispense with the entire two-year carry back period and carry
the loss forward only. 172(b)(3).
ex: Assume a year 3 loss of $100,000. Assume taxable income of $20,000 in
years 1 and 2 and 4. The $100,000 loss is first carried back to year 1 where it
fully offsets the income, Year 1 is therefore reduced to zero and the
taxpayer will file an amended year 1 tax return to this effect and obtain a
tax refund. The remaining $80,000 is then absorbed by year 2 in the same
manner. The unused $60,000 is then carried forward to year 4, where
20,000 more is absorbed. This leaves 40,000 of unused loss to carry forward
to year 5 etc.
o Losses that may be carried forward and backwards are business losses, capital losses
have a different carryover provision. 172(d)(2)
o Unused personal exemptions may not be carried over to other years. 172(d)(3)
o Nonbusiness deductions of individuals are allowable in computing a net operating
loss only to the extent of nonbusiness income. 172(d)(4).
SUMMARY: add together business deductions and nonbusiness deduction
to the extent they do not exceed nonbusiness income. From this total
subtract taxpayer’s gross income and the balance is the individual
taxpayer’s net operating loss.
XXXI: Capital Gains and Losses
A: Historical Overview
o i: Preferential Treatment for Long-Term Capital Gain
The idea is that gain on capital assets accrues over a number of years, and
favorable capital gains treatment is meant to prevent a bunching problem of
having to pay all appreciation tax at the end.
Currently, 15% is the maximum tax rate on capital assets, which must be
held for more than 1 year. See section 1(h)
To encourage investors to fund new ventures and small businesses,
Congress in §1202 allows an exclusion from gross income of 50% of the gain
from the sale or exchange of small business stock held for more than 5
years.
The remainder (other 50%) is taxed at 28% for an effective rate of
14%. 1202 is limited to the greater of (1) 10 times the basis in the
stock or (2) $10k of gain from the disposition of stock 1202(b)(1).
Must be original issue. See 1202 for all requirements.
o ii: Limitation on the Deduction of Capital Gain
Capital losses may only be deducted to the extent of capital gains plus
$3000, and can be carried forward until used.
o iii: Justification for Preferential Capital Gain Treatment
Pros: we shouldn’t tax inflation, prevents lock-in—people wouldn’t transfer
highly appreciated assets until death, this would harm the economy,
encourages investments (stock) which means higher economic growth
Cons: creates needs for complex statutory provisions, better ways to
address issues i.e. adjust basis for inflation.
B: Current Law: Section 1(h)
o i: Maximum Rates on Long-term Capital Gain under the Current Law
Preferential rates of 1(h) apply only to “net capital gain” (NCG)—1222(11)
which is the excess of net long-term capital gain defined as:
[Excess of net long term capital gain (LTCG – LTCL)] – [Short term
capital loss (STCL-STCG)]
Net capital gain is NLTCG-NSTCL
Preferential treatment exists only for long-term capital gains, and
technically only when LTCG exceeds the sum of LTCL and STCL.
STCG are accorded no preference and are therefore subject to tax at
ordinary income rates.
Example 1: STCG Only: Held stock for 10 months and had a $10k
gain. No NCG because this is short term and thus NCG = $0 and
$10k is subject to ordinary income.
Example 2: LTCG Only: Held stock for 2 years. NCG of $10k (NLTCG
of $10k – NSTCL of $0 = NCG of $10k). Thus, $10k is taxed at a
preferential rate of 15% under current law.
Example 3: LTCG and STCG: Assume in addition to facts above, also
has STCG of $10k. NCG would still be $10k. NLTCG of $10k – NSTCL
of $0 = $0). Would pay preferential rate on NCG of $10k and
ordinary income rates on STCG of $10k.
Example 4: LTCG and LTCL: Assume Ex. 2 but also LTCL of $10k. $0-
NCG. NLTCG is $0 – NSTCL is $0 thus NCG = $0.
After 1997 1(h) amendments Congress provided a different rate structure
but kept 1222 definitions.
o ii: The Components of Net Capital Gain
Under 1(h), maximum capital gain rate on NCG will vary depending on
nature of assets giving rise to LTCG.
Will not exceed 28%.
3 components to NCG:
(1) determine portion of NCG which is made up of 28% rate gain
(taxed at max rate of 28%)
(2) determine which portion is unrecaptured 1250 gain (taxed at
max rate of 25%)
(3) any remaining NCG is “adjusted net capital gain” 1(h)(3)
a: 28-Percent Rate Gain
Only subject to 28% tax if 28% is less than income tax. If income tax
is less than 28%, only that amount of tax will be applied to taxes
under this provision. Ex. if ordinary income is 15%, tax this gain
under 15%. If ordinary income is 32%, tax this gain at 28%.
Formula : 28% Rate Gain = Collectibles Gain + 1202 Gain.
Collectibles Gain : 1(h)(5) gain from the sale or exchange of
any rug or antique, metal, gem stamp or coin or other
collectible as defined by 408(m), which is a capital asset
held for more than one year.
1202 gain : defined in 1(h)(7) is 50% of the gain from the sale
or exchange of certain stock (certain small business stock)
described in 1202
Example:
TP in 35% bracket. $5k in LTCG from sale of antique
furniture and $10k in LTCG from a work of art held for three
years. NCG is $15k. Gains from sale of both are 28% rate
gain assets as collectibles under 1(h)(5). Thus subject to
28% on $15k and 35% on other income. If only in 15%
bracket, subject to 15% on all income.
b: Unrecaptured Section 1250 Gain
Subject to a max tax rate of 25% 1(h)(1)(D)
Attributable to long-term capital gain from depreciation allowed
with respect to real estate held for more than one year. 1(h)(6).
Ex: Anna purchased building for $100k. Over 10 years to
$25k in deductions. 10 years later sold building for $100k.
Basis was $75k, so gain was $25k. The only reason Anna
had gain was because she had claimed deprecation and had
to adjust her basis down, thus all $25k is the result of
depreciation deductions and is 1250 gain subject to 25%
tax.
c: Adjusted Net Capital Gain
Total capital gain- 28% gain- unrecaptured 1250 gain = adjusted net
capital gain which is subject to a max tax rate of 15%.
If the taxpayer is in the 15% bracket already, the adjusted net
capital gain is zero.
Classic example of this kind of gain is the sale of stock that is non
qualified small business stock under 1202 that was held by the tp
for more than one year.
Example 1 : Mark is in 35% tax bracket, had $10k in LTCG as
a result of sale of IBM stock held for more than one year.
No other capital gain/loss. Adjusted net cap. Gain is thus
$10k. Thus Mark will pay 15% on his $10k.
Example 2 : Carl has $100k of income. $66 is ordinary, and
$34 is LTCG from sale of Microsoft stock held for more than
one year. First $70 of income is subject to 15% tax.
Amounts less than $140 taxed at 28%. Thus, were it not for
special rules in 1(h), $4k of the capital gain would be subject
to 15% tax, and the remaining $30k would be subject to
28% tax. Thus because of 1(h)(1)(B) the portion of capital
gains that would have been subject to 15% is now subject to
0% and the portion subject to rates higher than 15% is now
subject to 15%. Thus $4k*0%+ $30k*15% = tax on capital
gains.
Example : Mixture of Short-Term Gain, 28-Percent Rate Gain and
Adjusted Net Capital Gain:
Martin is in the 35% tax bracket, during 2010 he has STCG of
$10k, LTCG from sale of work of art of $10k, LTCG from sale
of stock held for more than 2 years. Thus NCG is $20k
(NLTCG-NSTCL). His NCG will be taxed as follows: $10 at
28%, $10k at 15%, and the remaining income (including
STCG) will be taxed at 35%.
d: Adjusted Net Capital Gain: Qualified Dividend Income
Qualified dividend income is treated as part of adjusted net capital
gain and thus taxed at 15% or 0%. 1(h)(3)—first you calculate NCG
absent qualified dividend income, and then add dividend income.
Scheduled to expire at the end of 2010
Qualified dividend income includes dividends from U.S>
corporations and from certain foreign corporations 1(h)(11)(B).
Example 1 : Qualified Dividend Income, With Additional Net
Capital Gain
o L has $10k LTCG from sale of stock, $5k LTCG from
sale of collectible and $3k qualified dividend
income. Thus NCG is $15k (gain sans dividends) -
$5k = $10k; Then $10k + $3k = $13k adjusted net
capital gain.
Qualified dividend income is added only after the preliminary
determination so that if you have a net LTCL, the dividend income
will still be taxed.
Example 2 : Stock sale produces a LTCL rather than a gain.
So NCG is $0. (-$10k - $5k—can’t have negative). Then
adding dividend income produces an adjusted net capital
gain of $3k.
Thus qualified dividend income is assured of taxation at preferential
rates even when there otherwise is no NCG.
o iii: Attribution of Capital Losses Included in the Computation of Net Capital Gain
It is important to determine which long term gains are offset by which
losses. The rules are very pro-TP
STCL are first offset against STCG, and it is only net STCL that must be
attributed to one of the categories of LTCG.
Ex. $5 STCG, $10 STCL, $15 LTCG NCG = $10k
STCG – STCL = $5 NSTCL; LTCG – NSTCL = $10 NCG
Short-term Capital Losses : STCL are first applied to reduce STCG. NSTCL is
then applied to reduce any net gain in the 38% category, then any
unrecaptured 1250 gain, then to reduce any adjusted net capital gain
Long-term Capital Losses : first applied against the LTCG in the same
category (e.g. collectibles to collectibles) then net loss in the 28% category is
applied to reduce unrecaptured 1250 then adjusted net capital gain. Any
net loss in 15% group first reduces 28% gain then reduces unrecaptured
1250 gain.
Example 1: Allocating a NSTCL among Multiple Categories of LTCG
Assume TP is in 35% bracket and has a total LTCG of $15, $9
of which is attributable to sale of stock, and $6 of which is
from the sale of antiques. Also assume $5 NSTCL. Thus,
NCG is $10k ($15-5). The NSTCL first applies to the 28%
gain, so $6-5 is $1. Then to get ANCG subtract 28% gain
from NCG ($10-1)= $9. So $1 will be taxed at 28% and $9
will be taxed at 15%.
Example 2: Allocating Collectibles Loss Among Multiple Categories
of LTCG straight forward pg. 741 if confused
Example 3: Allocating Other LTCL Among Multiple Categories of
LTCG
$5 LTCL resulting from sale of stock held for more than 1
year. NCG is again $10k. ($15-$5) LTCL must be attributed
to the $9k stock sale rather than the 28% gain. Thus, ANCG
is $4 ($10 NCG - $6 28% gain). The remaining $4 is taxed at
15%.
C: Current Law: Application of Section 1211(b) Limitation on the Deduction of Capital Losses
o Capital Losses may be deducted dollar for dollar to the extent of capital gains. For
this limitation makes no difference whether CG and CL are ST or LT.
o To the extent CL exceed CG, up to $3k of additional CL may be deducted from
ordinary income in a given tax year.
o CL which a TP could not deduct because of the 1211(b) limitation may be carried
over to the next tax year 1212(b)
o 1211 is not a deduction granting provision, rather it serves to limit the deduction of
losses which are deductible under other provisions of the code.
Example 1:
Assume Salary is $75k, $5k LTCG from sale of stock, $1k STCG from
sale of stock, $8k LTCL from sale of stock. Thus Gross Income is
$81k ($75k+$5k+1k).
Loss from sale of stock is deductible under §165(c)(2) as a loss on a
transaction entered into for profit.
§165(f) provides that a capital loss may be deducted only to the
extent provided in 1211 and 1212.
1211(b) has two limitations:
Capital gain offset rule : capital losses may be deducted to the extent
of capital gains. PLUS
Ordinary Income offset rule : under 1211(b)(1) and (2), up to $3k of
any capital losses in excess of capital gains may be deducted against
ordinary income.
Thus, total capital loss is $8k and exceeds total capital gains
by $2k. T may deduct capital losses of $6k under the Capital
Gain Offset Rule and $2k of excess capital loss as well under
the Ordinary Income Offset Rule since that amount is less
than $3k—here T may deduct all losses and Adjusted Gross
Income will be $73k ($81k-$8k).
Example 2:
Assume Salary is $75k, $5k LTCG from sale of stock, $1k STCG from
sale of stock, $8k LTCL from sale of stock, $3k STCL from sale of
other investment property. Thus Gross Income is $81k ($75k+
$5k+1k). Total of $11k in capital losses ($8k LTCL and $3k STCL).
§165(c)(2) authorizes a deduction for these losses subject to the
1211(b) limitation. The deduction for capital losses will be limited
under 1211(b) to $9000. She may deduct CL to the extent of CG
($6k) plus up to $3k of the excess of capital losses over capital gains
($3k). AGI is $72 ($81-$9) and T may carry forward $2k of CL.
o Loss of stock is deduction under 165(c)(2), 1211(b) only represents a potential
limitation on the amount of the deduction which may be claimed in the current
year.
o Qualified dividend income is not treated as capital gain income for purposes of
determining the dollar limitation on deductible capital losses because it is not a gain
from the sale or exchange of a capital asset (§1221(1), (3)), thus it is not part of the
1211(b) calculation on deduction capital losses.
o Under 1212(b), capital losses carried over retain their LT or ST status and are
deemed to have been incurred in the carry over year. Excess losses are carried over
from year to year to offset gain or income until used. At death the disappear.
1212(b) establishes two rules for determining which losses were deducted (ST or LT)
and therefore which losses remain to be carried over:
RULE 1 :STCL are netted first against STCL, and LTCL will be netted first
against LTCG. Remaining STCL will then be netted against LTCG. If LTCL
exceed LTCG, excess LTCL ill be netted against STCG if any.
RULE 2 : STCL are deemed to have been deducted first in the ordinary
income offset part of 1211(b), because 1212(b) says the ordinary income
part shall be treated as STCG.
Example : use above facts. First use $5k LTCL to offset LTCG. $3k
LTCL remains. Then use $$1k STCL to offset $1k STCG. $2 STCL
remains. Then the offset the $3k of ordinary income by the
remaining $2k STCL. $1k of ordinary income remains to be offset by
the $3k LTCL. Thus, $2k LTCL carries forward.
D: Definition of Capital Asset
o i: Section 1221(a)(1): Inventory, Stock in Trade, and Property Held Primarily for Sale
The three types of assets listed above are excluded from the definition of
capital asset. Losses on Property in the normal course of business should be
ordinary rather than the recipient of preferential treatment.
Although these categories have some overlap, there are certain things
which might be included in one category, but not another. Ex. Tracts of
land held by a dealer in real property might not be considered either
inventory or stock in trade. Raw materials while inventory might not be
considered property held for sale in ordinary course…
a: Most difficult determination had been the meaning of “property
held primarily for sale to customers in the ordinary course of
business”
Malat v. Riddell: TP was in a joint venture which had
acquired property with intent to develop commercially or
sell at a profit
o Held: Primarily means “of first importance” . TP’s
sole purpose in holding the property was to sell it.
b: Other big issue is gains derived from sales of subdivided real
estate
Ex: TP farmer decides it would be more profitable to dvide
his land and sell it. What is the character of the farmers gain
on the subdivided land?
o Bynum v. Commissioner: B purchased land and lived
on property and conducted a nursery and
landscaping business on the property. Business
borrowed money but was unprofitable, B in an
attempt to pay off the mortgage, improved and
subdivided part of the property and advertised lots
for sale. 20 lots were sold directly by B who
continued to spend 90% of time on nursery, then
claimed resulting income from lot sales as general
contractor. Commissioner said income was ordinary
income since B was in the business of selling lots.
Rule: Capital gains treatment for real estate
is available only for passive investors
Held: LTCG rates should be construed
narrowly. Each determination must be
made on particular facts of case. B was
doing more than simply trying to get out of
debt, he was attempting to subdivide his
lots and personally conduct the
improvements and promotional activities. B
was in essence actively engaged in a second
business. Thus no LTCG treatment.
o ii: Section 1221(a)(2): Property Used in the Taxpayer’s Trade or Business
Real or depreciable property used in a TP’s trade or business does not
qualify as a capital asset (Also see next chapter on Quasi-Capital Assets--
§1231)
o iii: Section 1221(a)(3): Copyrights, Literary, Musical, or Artistic Composition
Copyright, literary, musical, or artistic composition; or similar property was
not a capital asset if held by a taxpayer whose persona efforts created the
property or 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 a
person whose efforts created the property.
Expanded in 1969 to include letters, memoranda, and similar property.
2006 congress provided special tax break for self-created musical works, TP
may elect to have 1221(a)(1) and (a)(3) not apply to sales or exchanges of
TP-created musical compositions or copyrights in musical works—thus they
will receive capital gains treatment, rather than ordinary income treatment
at the election of the TP
o iv: Section 1221(a)(4): Accounts Receivable
No capital asset status for sale of accounts receivable for services rendered
or for inventory type assets sold. Gain realized from sale of AR will be
ordinary income. (Or for accrual TP loss will be ordinary loss).
o v: Section 1221(a)(5): Certain Publications of the US Government
TP contributing publications will not be entitled to charitable deduction, and
if he sells the publications, it will be ordinary income gain.
Only applicable if publications are held but then received the publication or
by a TP whose basis in the publication is determined by reference to the
basis of the publication in the hands of the TP who received the publication.
Ex. If gov. pub. Received by a member of congress free of charge and
donated, no charitable deduction if donated, and if sold, generates ordinary
income. Also if given to a family member who then sells or donates,
ordinary income/no donation.
o vi: Section 1221(a)(8): Supplies Used or Consumed in the Taxpayer’s Trade/Business
No capital asset status for supplies of a type regularly used on consumed by
the TP in the ordinary course of trade or business—so close to inventory
might have been excluded under 1221(a)(1).
o vii: Judicially Established Limited on Capital Asset Characterization
Corn Products Refining Co. v. Commissioner (SCT 1955): a manufacturer of
products made from grain corn sought to protect itself from share increases
in raw corn prices by buying “corn futures” (K for future delivery of raw corn
at a set price) whenever the price of these futures was favorable. TP took
delivery on the futures Ks when necessary to its operations. TP made a
profit on futures contracts, and contended that the futures were capital
assets, generating capital gains and losses on their sales.
HELD: noting the TP’s purchases of futures K’s had been found to
“constitute an integral part of its manufacturing business” held to
the contrary and said that although corn futures do not come within
the literal set of 1221 exclusions, Congress intended that profits and
losses arising from the everyday operation of a business be
considered as ordinary income or loss rather than capital gain or
loss. Capital gains treatment applies only to transactions in
property not a normal sources of business income. Capital assets
definition must be narrowly applied and its exclusions interpreted
broadly.
Essentially added a gloss to 1221.
Thus, when dual purposes applied (held stock to assure source of supply as
well as for investment purposes), TP realizing gain on sale of stock found it
advantageous to emphasize an investment purpose, thus hoping to assure
capital gain treatment. BUT if a loss were realized on sale of stock of
securities, TP relied on Corn Products, and argue that the primary purpose
had been for business reasons, thus qualifying for an ordinary loss.
Tax Court eventually held in WW Windle Company v. Commissioner: “stock
purchased with a substantial investment purpose is a capital asset even if
there is a more substantial business motive for the purchase” and that a
subsequent abandonment of the investment motive was irrelevant. BUT
the Supreme Court rejected this motivation test in Arkansas Best Corp and
said characterization of Corn Products was simply a broad reading of the
inventory exclusion in 1221(a)(1).
Arkansas Best Corp v. Commissioner (1988): a diversified holding company
began acquiring stock in National Bank of Commerce in 1968. Bank
prospered until 1972, when it began to experience problems because of
heavy real estate loans. ABC continued to purchase stock in Bank, and
sought to take an ordinary loss. Tax court said acquisitions after 1972 were
made and held exclusively for business and not investment purposes and
got ordinary loss treatment
RULE: A TP’s motivation in purchasing as asset is irrelevant in
determining whether the asset is a capital asset and thus subject to
capital loss treatment.
HELD: This is a capital loss. Although the stock was bought for
business rather than investment purposes, 1221 does not discuss
motive, listed exceptions to 1221 were meant to be exclusive, to
read a motive requirement into the 1221 exceptions would render
the list superfluous. Corn Products involves an application of 1221’s
inventory exception. ABC is not a dealer in securities, and has never
suggested that Bank stock falls within the inventory exception.
Cenex Inc. v. United States : TP sold petroleum products and, to assure a
sources of supply of refined petroleum products, acquired stock in a
corporation that operated an oil refinery. TP said purchased as an inventory
substitute.
RULE: a TP may not argue that stock is held to ensure a source of
supply and that the loss upon the sale of stock is therefore ordinary.
HELD: inventory subs must bear a close relationship to actual
inventory and can do so if they are closely related to the TP’s
inventory purchase system. Corn futures in Cord Products satisfied
this bc they were redeemable for corn and bc the cost of inventory
was directly related to the cost of the corn futures (gains and losses
on futures was same as gains and losses on corn). Source of supply
doctrine is incompatible with Arkansas Best and not a basis on
which to treat the stock as an ordinary asset.
Azar Nut Company v. Commissioner : part of an employment package offered
to a high level executive was an agreement to purchase the executive’s
house for FMV in the event that he was fired. He was, and company sold
house at a substantial loss. Claimed ordinary loss because residence was
used in trade or business because under a K it was part of an agreement
that was integral to the TP’s trade or business even if asset never played a
role in business operations.
HELD: business purpose is irrelevant to determining whether an
asset is capital. Must play a role in TP’s business operations to not
be capital. To qualify for the “used in” trade or business exception,
an asset must be “used in” the TP’s business, and an asset that has
no meaningful association with the TP’s business operations after it
is acquired cannot reasonably fall within the plain words of the
statute.
Substitute for Ordinary Income Doctrine : Another issue is how to
characterize payments received by the TP who has sold his right to collect
future income:
Stranaham v. Commissioner : TP sold right to collect future dividends
on certain stock
RULE: When proceeds are a substitute for ordinary income,
TP is not entitled to preferential capital gain treatment on
sale.
HELD: Amounts received for the right to collect dividends
must be treated as ordinary income
Hort v. Commissioner : Hort was left a building under the term so fhis
father’s will. One of the tenants wishes to terminate the lease prior
to its expiration date. They settled the leas by paying Hort $140k in
exchange for being released from it. Hort did not report the $140k
as income and claimed a deduction for the difference between the
FMV of the space for the lease and the $140k received.
Commissioner disallowed the deduction and assessed a deficiency
tax on the $140k, Hort claimed $140k as a capital gain, and even if
ordinary income he sustained a loss on the unexpired portion of the
lease.
RULE: When a lease is terminated prior to the expiration
date and the TP received cash compensation, it must be
reported as ordinary income.
HELD: Hort received the payments as substitute for rent,
and 61(a) would have required Hort to include prepaid rent
or an award for breach of K as income. H received money in
lieu of rental income he was entitled to under the lease.
Since it was a substitute for ordinary income it must be
treated in the same manner. Furthermore no loss was
sustained, he released a lega right for a settlement sum, he
didn’t have to do so, injury can only be fixed when extent of
loss can be ascertained, i.e. when property is re-rented.
Until that time, no loss is deductible.
Davis v. Commissioner : Davis claimed that amounts he received in
exchange for his assignment of his right to receive a portion of
annual lottery payments that he had won were capital gains, but the
IRS determined that they were ordinary income.
RULE: Amounts received by a TP in exchange for the
assignment of their right to receive a portion of certain
future annual lottery payments are ordinary income.
HELD: The issue is whether the right to receive future
annual lottery payments constitutes a “capital asset” as
defined in IRC 1221. Right to receive future lottery
payments is not a capital asset, thus payment for that right
is not a capital asset
E: The Sale or Exchange Requirement
o 1222 requires a sale or exchange before gains and losses on capital assets can be
treated as capital gains and losses, but sale or exchange has been given a broad
meaning.
o Examples:
Kenan v. Commissioner : satisfaction of a bequest with appreciated property
constituted a sale or exchange.
Yarbro v . Commissioner: abanconment of inimproved real estate subject to
a nonrecourse mortgage exceeding the market value is sale or exchange
Helvering v. Nebraska Bridge Supply & Lumber Co .: tax forfeiture constituted
a “sale or exchange”
Helvering v. Hammel : involuntary foreclosure sale of real estate is a sale or
exchange
Freeland v. Commissioner : conveyance of land to a mortgagee by a quitclaim
deed is a sale or exchange
o These things are different in substance but not form from a sale or exchange and a
TP should not be able to avoid capital characterization simply by not “actually”
selling.
F: The Arrowsmith Rule: Characterization of Certain Gains or Losses Dependent on Prior Tax
Treatment of Related Gains or Losses.
o When a company liquidates, liquidation proceeds are considered gains or losses
from an exchange of stock and thus a capital gain or loss. Subsequent to liquidation,
however, shareholders may be held liable for unpaid debts of the corporation, and
then is entitled to claim a loss, an issue arises as to the characterization of that loss.
o Arrowsmith v. Commissioner : even though payment of corporate debt does not
constitute sale or exchange, it is considered a sale or exchange because it is
considered in conjunction with the overall liquidation, and if payment would have
been made before sh received pay out it would have been a reduction in capital
gain.
o U.S. v. Skelly Oil : TP refunded approximately $505,000 to certain customers for
overcharges on sale of natural gas in prior years, had included in income in prior
year, thus sought a deduction under the claim-of-right doctrine. However, in prior
year, TP had taken a 28% depletion deduction
HELD: Annual accounting doesn’t require court to close eyes to what
happened in prior years. TP should not be given a deduction for refunding
money that was not taxed when received, thus the 28% will not give rise to
a deduction but the remaining amount of the refund may be deducted.
o OVERALL RULE: gains or losses generated as a result of a transaction covering more
than one year may be characterized as capital gains or losses even though
technically the sale or exchange requirement does not appear to be met.
G: Holding Period
o Property must be held for more than one year before its sale or exchange if there is
to be a long-term capital gain or loss.
o Limitation on deductibility of capital losses does not depend on long term or short
term nature of the loss.
XXXIV: Assignment of Income
A: Progressive Rate Structure
o There is an obvious tax savings to taxpayers in shifting income from a higher-bracket
taxpayer to a lower-bracket taxpayer
o Our tax system taxes people at progressive rates on net income.
B: Development of Rules for Limiting Income Shifting
o Stranahan v. Commissioner : Decedent Stranahan assigned his rights to anticipated
dividends to avoid tax liability. Assigned his rights to anticipated dividends in certain
tocks to his son in consideration of $115k.
RULE: a taxpayer stockholder may assign his rights to anticipated dividends
in exchange for the present discounted value of those dividends in order to
avoid tax liability so long as the assignment is a bona fide, good-faith
commercial transaction. (Outcome would have been different if assignment
was gratuitous rather than for consideration)
HELD: Must be a commercial transaction, here it was economically
realistic, P received payment, and divested himself of interest in the
dividends.
o Characterizing income as capital gains may also lower the tax
o 2 general rules for determining the “who” question
(1) Income is taxed to the taxpayer who controls the earning of the income
i.e. high tax bracket employee can’t direct his income to be paid to
his low income bracket child in order to avoid taxes
Lucas v. Earl: Earls entered into a contract whereby they agree that
whatever each acquired in any way during their marriage would be
received and owned by them as joint tenants. Hear claimed he
could be taxed for only half of his income.
RULE: a statute can tax salaries of those who earned them
and can provide that a tax cannot be escaped by
anticipatory arrangements or contracts that prevent salary
from vesting even for a second in the person who earned it.
tree fruit metaphor : fruits cannot be attributed to a
different tree than that from which they grew.
Helvering v. Eubank : Eubank was terminated as a life insurance
agent, after his termination he assigned commissions to become
payable for services performed before his termination.
RULE: commissions assigned by the taxpayer are taxable in
the year in which they became payable, thus he is
responsible for paying the tax on them rather than the
individuals to which he assigned his earlier earned income.
(2) Income from property is taxed to the one who owns the property
i.e. landlord can’t direct tenant payments to child
Helvering v. Horst : Shortly before their due date, Horst detached
negotiable interest coupons from negotiable bonds and gave them
to his son, who in the same year collected them at maturity
RULE: For income tax purposes, the power to dispose of
income is the equivalent of ownership of it, and the exercise
of that power to transfer payment of the income to another
is the equivalent of realization of the income.
HELD: the owner of bonds is lender, and when by gift of
coupons he separates his right to interest payments and
procures payment of interest to donee, he is essentially
transferring earnings. The fruit is not to be attributed to a
different tree from that on which it grew. Horst must pay
taxes. (donor)
May v. Commissioner : May deeded property to an irrevocable trust
for the benefit of his children and then leased back the property
from the trust for $1k per month. Attempted to deduct rental
expense as a ordinary and business expense deduction.
RULE: in a gift-leaseback situation, rental payments are
deductible if the transfer was irrevocable and the benefits
inure to the trust
HELD: The issue is the sufficiency of the property interest
transferred. 4 factors must be considered:
o Duration of the transfer
o Controls retained by the donor
o Use of the property for the benefit of the donor
o Independence of the trustee
o Community Property
Earnings during marriage are deemed the property of the husband-wife
community and not the property of the spouse performing the services
generating the earnings.
Poe v. Seaborn : each spouse was taxable on half of his or her earnings and
on half of the spouse’s earnings. This permits spouses to split their income.
This rule means couple’s tax rate could vary depending on if they live in CL
or community property jurisdiction—Congress now allows joint returns.
Where community property jurisdiction applies, Eatinger v. Commisioner:
employee spouse required as part of a divorce decree to pay half of pension
to non-employee ex spouse. Each will be taxable on half the pension
benefits. Also applies when spouse postponed benefits
Dunkin v. Commissioner . Giving spouse could deduct half from income,
receiving spouse had to report half in her income.
Court distinguished Lucas as this being a community property case
C: Application of the Assignment of Income Rules
o Kochansky v. Commissioner : husband agreed to pay wife part of contingent fee for
client representation in divorce settlement. Court said this was governed by Lucas
and the husband had to pay the entire tax because he earned the income.
o Commissioner v. Ginnini : taxpayer refused to accept compensation for his services
to BOD. Said they could donate it. Court said he had refused a right to property,
when there is abandonment, without transfer of property to another, the property
cannot be taxed upon the theory that it was received. He didn’t tell the corp. to
give money to any specific corporation—therefore this is not an assignment of
income. He never had income to begin with.
o Sometimes turns on Agency Law:
Worked in clinic for law school and gave all funds to school—no income
received
Psychologist taking vow of poverty still received amounts as income
because he selected clients, established fees, maintained records (even
though he turned over money, he still received it in the first instance).
Foggerty v. Commissioner: Priest who received salary for teaching had to
pay taxes on salary, not merely an agent of the church.
o Sometimes services create property.
Ex. author mother gives copyright to son. One might argue income from
story is personal services income, but the copyright would be treated as
property and the amounts received by the son upon the sale of the story to
a publisher would constitute income to the son and not to the author.
o When you must transfer property—before income has actually been realized
(distinction between declaration and record date as it relates to stocks)
Bishop v. Shaughnessy : if a corp declares a stock dividend payable to
holders on record date, a gratuitous transfer on record date will not deflect
dividend to the donee
Caruth v. U.S. : s/h transferred stock after dividend but before record date,
dividend income not taxed to donor
Crucial question is whether the asset itself or merely the income
from it has been transferred. If the taxpayer gives away the entire
asset, the assignment of income doctrine does not apply.
Fail to see why the ripeness of the fruit is relevant so long as the
entire tree is transplanted before the fruit is harvested
o Rauenhorst v. Commissioner : corp received notice that corp. would be acquired,
and taxpayers gave their warrants to stock to charities. Charities under no
obligation to sell to acquirers, but did. Taxpayer not responsible for taxes, because
charities had discretion of what to do with warrants—could have kept them.
o Salvatore v. Commissioner: Salvatore conveyed half of her gas station to her
children as a gift just prior to selling it.
RULE: The true nature of a transaction, rather than formalisms, determines
the tax consequences
HELD: Salvatore’s tax liabilities cannot be altered by a rearrangement of the
legal title after the sale was already contracted. Therefore, all of the gain on
the sale was property taxable to Salvatore.
D: Income Shifting Within Families and Between Related Parties
o Intra-family income shifting “kiddie tax” §1(g)effect of taxing the unearned income
of certain children at the top marginal rate of their parents. Negates benefit of
shifting income to a lower-bracket taxpayer.
o If one corporation does work for the other and under or over charges for work,
income has been artificially shifted
o Individual service provider makes corp which hires service provider and contracts
with third parties
o Ordinarily corporate formalities are respected but sometimes there are
controversies
Sargent v. Commissioner : professional hockey player formed personal
service corp. which hired payer as employee and contracted with
professional hockey team.
Court of appeals found he was employee of corp. didn’t matter that
team had control
Leavell v. Commissioner : same facts, except a basketball player
Tax court found basketball team not personal service corp
controlled manner in which the taxpayer provided services, thus he
was an employee of the team
XXXVIII: Nonrecourse Debt: Basis and Amount Realized Revisited
A: Crane v. Commissioner
o Facts: TP inherited property encumbered by considerable nonrecourse debt.
Claimed depreciation deduction based on FMV of property at time of decedents
death. Later sold for small amount of cash, and purchaser took property subject to
outstanding debt.
o Question: what was the amount of gain realized on the sale.
o Basis: on property when acquired is FMV at decedents time of death §1014(a)
o Amount Realized: includes amount of nonrecourse debt taken subject to by the
purchaser
o RULE:
Liabilities, whether recourse or nonrecourse, taken subject to or otherwise
incurred in the acquisition of property, are included in TP/purchasers basis
Liabilities of seller, recourse or nonrecourse, assumed are included in
seller’s amount realized
o FN 37 : considered the idea that nonrecourse assumed might not be included in
amount realized if the mortgage is greater than the FMV of the property.
B: Commissioner v. Tufts
o FACTS: FMV of property went down so that mortgage ended up exceeding FMV. TP
sold property and contended that the assumption of a mortgage that exceeded the
FMV of the property by the purchaser should not be included in amount realized.
o RULE: The assumption of nonrecourse mortgage constitutes a taxable gain t the
mortgagor even if the mortgage exceeds the FMV of the property.
o Held: Supreme Court reversed the lower court’s decision and found that the entire
amount of nonrecourse indebtedness had to be included in the amount realized.
See also §7701(g). Entire amount of mortgage is included in the orginal basis and
must be taken into account on sale.
o 1001-2(b) FMV of property is not relevant in determining the TP’s amount realized.
o Revenue Ruling 91-31 : nonrecourse debt reduced by creditor (not the seller of the
property), service held this was discharge of indebtedness under 61(a)(12) rather
than reduction in basis of property.
What result of seller was also creditor? Purchase Money Debt Reduction
(see chapter 9).
o Aizawa v. Commissioner : A purchased property for $120k and gave a recourse
mortgage for $90k. Defaulted, creditor said entire deficiency judgment (including
interest) was $133,506. Sold land for $72,700—reduced deficiency judgment to
$60,806k. A claimed his amount realized on the sell should be the amount of debt
forgiven, which he calculated as the original principal, minus the new deficiency
judgment owed--$29,193 ($90k-60,806).
HELD: The remaining deficiency judgment against A includes not only
principal amounts, but also interest, atty’s fees and other costs. Where the
discharge of recourse liability is separated from the foreclosure, the amount
of the proceeds from the sale becomes insignificant, thus the true amount
realized is $72,700 (the amount the property sold for) which can be
deducted from A’s original basis to determine his loss. Thus, A’s loss is
original basis of $100,091 (depreciation deductions) - $72,700 = $27,391.
RULE: Amount realized on a foreclosure sale is represented by the proceeds
of the sale.
o But think about 1.1001-2(a)(1): amount realized includes the amount of liabilities
from which the transferor is discharged on account of the sale
C: Nonrecourse Borrowing and the 108 Insolvency Exclusion
o The amount by which a nonrecourse debt exceeds the FMV of the property securing
the debt should be treated as a liability in determining insolvency for purposes of
§108(d)(3) of the Code to the extent that the excess nonrecourse debt is discharged.
Revenue Ruling 92-53. Otherwise the discharge could give rise to a current tax
when the taxpayer lacks the ability to pay that tax.
o Nonrecourse debt should also be treated as a liability in determining insolvency
under §108 to the extent of the FMV of the property securing the debt.
o However, when that debt is not discharged, it should not be treated as a liability for
insolvency purposes.
o Ex.
Figures:
TP owed $500k on nonrecourse loan, secured by property FMV
fallen to $400k.
Other assets FMV $100k. Other debts $50k.
Bank agreed to reduce nonrecourse debt by $75k.
Indebtedness for purposes of the 108(a)(1)(B) exclusion:
Recourse debt $50k
Nonrecourse up to FMV $400k (see b above)
Nonrecourse forgiven $75k (see a above)
The $25k remaining non-recourse is not included because the
creditor did not forgive this nonrecourse debt. (see c above)
Total indebtedness = $525k
Taxpayer’s total assets are $500k
$400k in property + $100k in other assets
Thus, the taxpayer’s debt exceeds his assets by $25k ($525-$500),
and the TP is considered insolvent to that extent, thus, $25k of the
$75k of discharged indebtedness will be excluded from income and
he will only be taxed on $50k.
D: Nonrecourse Borrowing and Appreciated Property
o Example:
Facts:
B purchased building for $100k ($20k cash + $80k nonrecourse loan)
Paid loan down to $30k.
Building is now worth $500k FMV.
B refinances and borrows $280k
$30k, pays off old mortgage
$250k invests in business venture
B’s adjusted basis in the building is $40k (resulting from $60k
depreciation)
B sells he building a year later for $600k ($320k in cash and subject
to the $280k mortgage)
Analysis:
Because loan is not used to improve building, doesn’t result in any
adjustment of the building’s basis.
Thus, B’s amount realized is $600k, his adjusted basis is $40k, thus
his gain recognized is $560k
o Woodsam Associates, Inc. v. Commissioner: (1952): Woods borrowed on a
nonrecourse basis an amount in excess of her adjusted basis in the property. Later
contributed property to corp, which disposed of property at foreclosure sale. Court
held that borrowing against property didn’t increase basis in property.
E: Impact of Contingent Liabilities
o Potential for abuse. A buyer could purchase property with a nonrecourse note and
pay an inflated purchase price so that deductions would be larger and interest
payments would be deductible. Seller would have no risk because he could just
report gain only if and when paid on an installment basis.
o Some circuits deny any inclusion in basis for nonrecourse debt when the amount is
excessive in relation to the property’s fmv:
Estate of Franklin (9th Cir.):
HELD: purchase price for certain real property exceeded its fair
market value and therefore the TP could not be expected to make
the investment represented by the nonrecourse debt. As a result,
the court ignored the nonrecourse payment for purposes of
depreciation and interest deductions.
RULE: depreciation is not predicated upon ownership of property
but rather upon an investment in the property
Berstrom v. U.S. (Fed. Cir.) when nonrecourse purchase money debt
exceeds a reasonable approximation of the property’s FMV, the debt is
disregarded in its entirety for the purposes of determining depreciation and
interest deductions.
o Other circuit’s permit inclusion of nonrecourse debt in basis up to the FMV of the
property:
Pleasant Summit (1988) (3rd Cir.): permitted the nonrecourse debt itself to
generate basis to the extent of the FMV of the property.
Lebowitze v. Commissioner: (2d Cir.) Even if the value of the underlying
asset was “substantially less” than the nonrecourse debt, the TP was still
entitled to a basis in the asset up to the FMV.
Lukens v. Commissioner (5th Cir.): relevant question is whether it would be
reasonable for the buyer/debtor to make a capital investment in the unpaid
purchase price.
o Reconciling the rules in Tufts and Estate of Franklin
Tufts requires nonrecourse debt to be included in the amount realized on
the disposition of property even though the debt exceeds the FMV of the
property
Estate of Franklin court refused to recognize debt because it exceeded FMV
The two cases are factually distinguishable:
Tufts: original debt did not exceed the value of the property
Estate of Franklin: debt incurred exceeded the FMV of
property securing its payment
F: Bifurcation of Recourse Liability Assumed
(This section is based on a John Lee class discussion)
o RULE: When you transfer property to a creditor that is subject to a nonrecourse
debt and you transfer the property back to the creditor in satisfaction of that debt,
the entire amount of the debt is included in the amount realized, even if the FMV of
the property is less than the value of the debt. See Treas. Reg. § 1.1001-2(c) ex. 7.
Also see example 8—the entire amount of nonrecourse debt is the amount realized.
HOWERVER, if the debt is recourse, you bifurcate the debt. First transaction
is the discharge of debt (which is ordinary gain/loss), the second is the land
sale (which is capital gain /loss)
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