Chapter 6
p.465
Deductions for Business
§162 enables an income tax deduction for
business expenses & §212 enables a deduction
for investment expenses.
But, §263 limits the deduction where a “capital
expenditure” is made.
What is a “capital expenditure”: the cost for
the improvement or betterment of property.
11/16/2012
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1
When Recover Capital
Cost for Tax Purposes?
Choices:
1) Immediate income tax deduction.
2) Spread cost of item over the life of the asset.
3) Cost recovery upon final disposition of asset.
Cf., consumption tax approach.
What is the dividing line between (1) current
expense, and (2) a capital expenditure
(requiring capitalization of cost for federal
income tax purposes)?
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Expenditures to be
Capitalized
p.466
Encyclopaedia Britannica, p.466.
Expenditures were incurred to acquire a
completed manuscript. Tax Court says cost is
deductible since a payment for services.
Ct. of Appeals: Book is just another rental
property. Income is to be received over several
years. This was the expense for a “turnkey
project” and was required to be capitalized.
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3
Idaho Power, Sup. Ct
p.467, fn.1
Deductions for the depreciation of trucks and
other equipment which items were used in
constructing capital assets (e.g., power stations
for the electric utility). These items were
required to be capitalized since incorporated
into the new capital asset (the new power
station).
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§263A & Uniform Cap.
Rules
P.472
Cost of producing inventory must be capitalized
– to be recovered through inventory costing.
Includes both direct and indirect expenses.
What are indirect expenses in this context?
Depreciation on manufacturing plant?
Utilities, taxes & insurance on manufacturing
building?
Fringe benefits for manufacturing employees?
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Exceptions from §263A
Capitalization Rules P.473
Retailers and wholesalers with annual gross
receipts less than $10 million.
Freelance writers, artists and photographers.
See §263A(h).
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Indopco case &
regulations
P.473
Indopco case - investment banking fees
incurred in merger transaction must be
capitalized.
Incurred by the target corporation?
Why incur these fees?
Basic premise in Indopco: is a “future benefit”
to be realized from the particular expenditure?
What response to this decision and “future
benefit” language? E.g., the Indopco
regulations.
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Repair and Maintenance
Expenses
p.475
What is the income tax issue concerning
“repairs”?
Is the cost a “period cost” or does this cost
produce some continuing value?
If continuing value, then needs to be capitalized
and recovered over time (thereby increasing
current income from reduced current
deduction).
11/16/2012
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Repair and Maintenance
Expenses
p.475
Midland Empire Packing Co.
P.476
Concrete lining installed in basement to protect
against neighboring refinery leakage, etc.
Problem with federal meat inspectors.
Expenditure did not add value to building.
IRS asserts capital expenditures made and
recovery of cost to be through depreciation.
Not an enlargement; only a “repair” and
currently deductible. See Reg. §1.162-4T.
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Repair and Maintenance
Expenses Regulations
Reg. §1.162-4T (noted at p.478) providing new
rules defining “repairs”:
1)Identify the “unit of property” to which
expense relates, e.g., a building.
2)Does the expense produce a “betterment,” a
“restoration”(when no longer working) or an
“adaptation to new or different use”?
These expenses are to be capitalized.
Issue: Does a “material increase” result?
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Environmental
Remediation Costs p.480
Rev. Rul. 2004-18, re inventory costing.
Land clean-up costs at manufacturing facility
location to be included in inventory costs (under
§263A)? Remediation mandated by various
environmental requirements.
Is this an inventory production cost? These costs
are not repairs, but are to be capitalized, here
into the cost of the inventory being produced in
the manufacturing plant.
11/16/2012
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11
Inventory Accounting
p.483
Inventory accounting is mandated for the seller
of goods who either (1) purchases the goods sold
for resale or (2) manufactures the goods for sale
to customers. §263A(a)(1)(A) specifies that for a
taxpayer’s having inventory the costs for this
inventory shall be included in “inventory costs”.
These costs include both “direct costs” and
“indirect costs.”
Exception for taxpayer with gross receipts of
$10 million or less. §263A(b)(2)(B).
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Determining Inventory
Cost for a Tax Year
Gross income from a business selling inventory
is computed as follows:
Gross receipts:
_____
Less: Inventory cost
_____ (next slide)
(Cost of goods sold;
how determined?)
Equals: gross income ______
Note: Not all inventory will be sold during a
particular tax year (unless liquidation).
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Determining CGS (the
Cost of Goods Sold)
Calculation:
1) Opening inventory
2) Plus: additions to the inventory during the
tax year (whether purchased goods for resale or
goods are produced)
3) Less: Closing inventory
4) Equals: Cost of goods sold (CGS)
Tax planning objective: minimize the closing
inventory amount (thereby increasing CGS).
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Method for Identifying
Closing Inventory Items
Use the FIFO or LIFO method?
FIFO – the remaining inventory consists of
goods most recently added to inventory (the
“conveyor belt” approach).
LIFO – the remaining goods are those first
going into inventory (those goods still held are
at the “bottom of the barrel”); the goods sold
during the year are those which were the most
recently acquired (the most expensive if
inflation is occurring).
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Inventory Accounting
Example
§61(a)(2) identifies gross income as being
sourced from business sales. How determined?
Year 1: buy 100 of Item X for $10 = $1,000
Year 2: buy 100 of Item X for $13 = $1,300
& sell 120 of Item X for $15 each = $1,800
Year 2 gross income computation:
a)FIFO - 100 items @$10 & 20 items @$13 =
$1,260 cost & $540 income (1,800 less 1,260).
b) LIFO – 100 items @$13 and 20 @$10 =
$1,500 cost & $300(c)income
($1,800 less 1,500).
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“Booking Requirement”
§472(c)&(e)(2)
If taxpayer uses LIFO for federal income tax
purposes this method must also be used for
reporting to shareholders and creditors (i.e., for
GAP purposes).
What is the purpose of this financial statement
consistency requirement?
Why might a company not choose LIFO when
inventory costs are rising?
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Rent v. Installment
Purchase
p.485
Starr’s Estate – Sprinkler system installed and
treated as “leased” by a seller for 5 years. Lease
renewal agreed for a nominal amount.
Would lessor ever retrieve this property?
What is the income tax issue? Deduction for
(1) depreciation (lesser amount – longer
recovery period), or (2) rent/lease payments
(faster tax deductions & ownership eventually
will reside with the property where the
sprinkler is installed).
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Defining “Ordinary and
Necessary”
p.489
Welch v. Helvering - Welch paid debts of the
former E.L. Welch Company to improve his
personal relationships with creditors of old Co.
Held: Payments by the taxpayer were not
ordinary (but were they necessary?) business
expenses (§162); but, were these “capital
expenditures” (extraordinary) for the
development of the “goodwill” of the business
(and, therefore, not “personal expenses).
Note (p.490) re “life in all its fullness…”
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Defining “Ordinary and
Necessary”
Three possible categories of expenditures:
Personal expense (no deduction, unless statutory
exception)
Vs.
Ordinary & Necessary Expense (current
deduction)
Vs.
Extraordinary (Capital) Expense (future
deductions, or frozen cost)
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Advertising Expenses
p.493
Are costs for advertising currently deductible or
do they create a “future benefit” (noting the
Indopco case) which requires capitalization?
Current deductions for marketing, selling and
advertising are not disallowed under §263A.
See Reg. §1.263A-1(e)(3)(iii)(A).
But, does advertising expense (hopefully)
provide a continuing benefit (beyond the
current year)?
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Education Expenses
p.493
No deduction for meeting the minimum
educational requirements for employment
qualification. Reg. §1.162-5(b)(2)(i).
Including a law school education.
But, deduction for CLE expenses: Reg. §1.1625(a)(1) provides deduction for cost of
maintaining skills required in current
employment.
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Job-hunting Expense
p.494
Reg. §1.212-1(f) denies current deductions
(under §212) for expenses incurred in seeking
employment.
But, see Rev. Rul. 77-254 where expenses in
identifying a specific opportunity are to be
capitalized and amortized. But, general search
expenses are “personal” and are not deductible
(and not to be capitalized?).
Deduction if looking for new position in one’s
current trade or business. Rev. Rul. 77-16.
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Extraordinary Expenses
Gilliam case
p.495
Irrational/disoriented painter/airline passenger
– on a business trip – arrested by Feds.
Acquitted by reason of temporary insanity, but
incurred legal fees to accomplish the acquittal.
Does §262 preclude a business expense
deduction (legal fees and civil claims)?
Held: These expenses are not ordinary (under
§162) to his (artist) trade or business.
Crazy episodes in an airplane are not ordinary
nor in course of one’s
trade or business.
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Other examples of
“ordinanry” expense p.501
Friedman – lawyer’s client does not fulfill
commitment to fund an agreed settlement, so
lawyer then does. Deductible expense to
lawyer? No. Payment was voluntary.
Trebilcock – cost paid to a religious minister to
pray for success of the business and for the
employees of the business – personal benefits,
and not deductible. What about psychologist on
location?
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Reasonable
Compensation
p.502
§162(a)(1) provides for deduction for reasonable
allowance for salaries and other compensation.
But, if amount is too large is this really a nondeductible (to employer) amount which should
be treated as a profits distribution (i.e.,
dividend)?
See §162(m) re limit of $1 million compensation
for top executives of a publicly held company.
Note the exception to this limitation for
“performance-based compensation.”
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§162 and public policy
limit on deductions p.502
U.S. Supreme Court decisions:
1) Tank Truck Rentals – no deduction to
trucking company for weight limit violations.
2) Sullivan – deduction permitted for rent and
wages paid by illegal gambling operation.
3) Tellier – deduction to securities dealer is
permitted for lawyer’s fees paid for
unsuccessful defense in securities fraud case.
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Deduction, Public Policy
& Statutory Limits p.503
§162(f) – no deduction for fine or similar
penalty.
§162(c) – no deduction for illegal bribes and
kickbacks. See FCPA, including re “grease
payments.”
§162(g) – denying 2/3rds (punitive) portion of
anti-trust payment.
§280E – no deduction for drug trafficking
expenses; but, deduction for inventory costs of a
drug dealer (why?).
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Depreciation Deduction
p.504
Cost for “wasting assets” should be recovered
over time – associating the cost of the assets with
the income productivity from particular asset.
Choices: 1) Deduction for the entire cost in the
acquisition year.
2) No deduction until disposition of the asset.
3) Determine actual value decline during year.
4) Allocate some amount of the acquisition cost
to each year of asset’s anticipated usage.
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Current Depreciation
Deduction System p.505
1) Determine the useful life (e.g., machinery &
equipment; office and industrial buildings).
2) Determine anticipated salvage value (but,
not relevant under current system, MACRS).
3) Determine the method of allocation to each
year (e.g., does a greater decline in value occur
during earlier years)? Straight line, declining
balance (e.g., DDB); other system (e.g., income
forecast)?
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Additional depreciation
Issues
p.506-7
First year – full year’s depreciation? Allocated?
Or, use an accounting convention?
“Component” depreciation – divide parts of a
building (e.g., elevators) into its various
components to allocate useful lives?
Too much depreciation: recapture the excess
depreciation at disposition? Ordinary income?
See §1245. Also, impose an interest charge for
excess deduction? What about “market gain?
E.g., buy at 100x, depreciate to 85x, sell at 110x.
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§168 – Statutory
Depreciation Rules
p.508
1) Recovery period – depends on the class of
property. See §168(e).
2) Recovery method - §168(b). Choices include
DDB, 150% DB and straight line.
With salvage value at zero. §168(b)(4).
3) Placed in service conventions - §168(d) re
half-year convention, except for real
property.
4) Limited expensing – without regard to the
11/16/2012 rules above - §179.
(c) William
P. Streng
For
2012 - $139,000, as
32
Intangibles & Cost
Recovery
p.510
§167 enable straight line amortization of
intangibles – e.g., patents, trademarks.
§197 provides special rules for goodwill and
purchased intangibles, including customer lists,
skilled work force, etc.
Does the value of these items decline?
Note Newark Morning Ledger case, and §197
response. Was enacting §197 a “tax increase”?
Cf., “going off the cliff,” tax rate increase, and
then a tax rate reduction
for 2013, etc.?
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Depletion for Oil & Gas
and Minerals
p.512
Cost depletion for (1) oil & gas and (2) hard
minerals properties is allowed under §611.
Tax basis is allocated over the estimated
recoverable units for the property.
Alternative method: §613 - Percentage depletion
enables a deduction for a percentage of the
gross income derived from the production
(except for major, integrated oil companies).
But, no limitation on deduction amount applies
even after cost basis equivalent recovered.
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Percentage Limitation
Questions
p.514
What limits on the % depletion deduction?
- Percentage limit for 50 percent of the taxable
income from the property.
- What is the “cutoff point for determining
“gross income from mining”? See Cannelton
Sewer Pipe Co., p. 514. When the clay comes
from the mine? When the pipe is sold?
Cf., oil & gas production – the “cutoff point” is
at the wellhead.
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Defining an “Economic
Interest”
p.513
To qualify for a depletion deduction the
taxpayer must have an “economic interest” in
the property. What is the purpose of this
concept?
An “economic interest” can include a royalty
interest, working interest, carved-out interest,
etc.
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Intangible Drilling Costs
& G&G Costs
p.514
§263(c) authorizes regulations to enable current
expensing for “intangible drilling and
development” costs. What are IDCs? What
percentage of total drilling costs? Why permit?
Consider the tax benefit of the combination of
(1) the IDC deduction (no cost basis is
established), and (2) percentage depletion
deduction (no cost basis is necessary).
Cf., hard minerals: See § 616 (development)
and §617 (exploration). Cf., O&G exploration.
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Tax Avoidance
Arrangements
p.515
What is a “tax shelter”? P.516
An investment unrelated to the taxpayer’s
normal business/investment activities & having
an objective to produce a tax loss (but not an
economic loss).
Remember the Tufts case (large depreciation
deductions were available for property
investment when the taxpayer’s tax basis is
increased with non-recourse debt – but no
economic risk).
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Tax Shelters
Basic Premises
p.516
1) Tax deferral (exploit time value of money).
2) Conversion of ordinary income into capital
gains (35% vs. 15% tax rate).
3) Tax arbitrage – deduct expenses incurred
for non-included gross income.
4) Misattribution of income to another
taxpayer (e.g., low tax bracket or tax exempt).
Plus: Accompanied by debt leveraging
(including non-recourse debt) to increase basis.
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Tax Shelter Limitation
Provisions
1) Passive activity loss rules - §469 –
Deduction limit on loss incurred on investment
where investor does not “materially
participate.” Defined as spending at least 500
hours per year on the activity. Special real
estate investment tax deduction of $25,000.
2) Deduction of interest is limited when
“investment indebtedness.” §163(d).
Limitation of current interest expense deduction
to amount of “net investment income.”
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Tax Shelter Limitation
Provisions, continued
3) At risk rules - §465. Losses are disallowed
when in excess of the taxpayer’s amount “at
risk” in that investment. Nonrecourse debt is
not included in the amount at risk. Amount
at risk includes: (a) cash investment by
taxpayer, plus (b) recourse debt, or debt
where other property is pledged as collateral.
Non-deductible loss can be carried forward for
later deduction. Exception for real estate
with qualified nonrecourse financing; but, cf.
11/16/2012§465(b).
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Estate of Franklin
p.523
Ltd. partnership acquires the Thunderbird
motel in Arizona for $1,224,000. Prepaid
interest but then deferral over ten years for
large principal payments, with large balloon due
after 10 year period. Nonrecourse debt.
Warranty deed is placed in escrow. Leaseback
with net lease payments approximating the P&I
payments on the debt. No potential for equity
growth for taxpayer. Tax depreciation
deduction is predicated on owning the property.
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The Option Transaction
p.527
Consider example of a deal for a property
acquisition for $100,000:
1) $30,000 option price;
2) $70,000 at closing in a subsequent year.
What is the objective of this arrangement? To
postpone the “seller’s” time of gain recognition,
when “seller” has received significant cash?
Will the “buyer” not close the transaction?
Is the transaction complete in the first year?
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The Era of Corporate Tax
Shelters
p.527
E.g., the “lease-strip” shelter, conducted
through a partnership: (1) most lease income is
prepaid and allocated to the tax-exempt
partner; & (2) other partner (U.S. corporate
taxpayer) is allocated cost recovery deductions
(to enable tax-sheltering effect).
Effect of significantly reducing federal income
tax liability of the U.S. corporate investor:
1) low effective tax rate, and 2) increased profits
since no (or little) tax cost.
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Economic Substance
Doctrine
p.529
Knetch v. U.S. – permitted deductions for
interest expense? Knetch bought deferred
annuity bonds for $4 million, paying with $4,000
check and $4 million promissory note. Debt
secured by bonds. Prepaid 1st year’s interest of
$140,000 and borrowed back $99,000 and then
prepaid $3,465 interest on this borrowing.
Procedure repeated in subsequent year.
In fourth year terminated this arrangement and
received net equity from the contract of $1,000.
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continued
45
Knetsch case, cont.
Trial court declares transaction as a “sham.”
Sup. Ct. analysis: taxpayer paid a fee of $91,570
to produce this loan arrangement attempting to
facilitate a $294,540 interest expense deduction,
thereby enabling a tax reduction of $233,298
(assuming an 80 percent FIT rate).
Post-transaction enacted tax provision limited
this arrangement.
Held: here a sham transaction and no interest
expense deduction. But: Douglas dissent.
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Goldstein & “Economic
Substance” Rule
p.534
Taxpayer won $140,000 in Sweepstakes and (1)
borrowed funds and (2) prepaid interest
expense (to partially offset some of winnings).
Loan proceeds were used to buy U.S. Treasury
obligations to provide interest income in later
year. Current economic loss but expected tax
savings: reduced current tax savings and
pushing certain earnings forward.
Holding: No §163 interest expense deduction
since no non-tax purpose for the borrowing.
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Winn-Dixie Stores
p.535
Deduction for interest and fees for borrowing on
life insurance policies on lives of employees?
Company owned life insurance purchased on
lives of employees. Interest expense and
administrative costs vs. benefits under policies.
Tax Court says no business purpose.
11th Circuit: No deduction for interest and fees.
No special tax statute protective status for
transactions. No function other than generating
interest expense deductions.
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Codification of Economic
Substance Doctrine p.538
§7701(o) provides for codification of the
“economic substance” doctrine.
Transaction has “economic substance” only if
transaction is changing taxpayer’s pre-tax
economic position in a meaningful manner and
has a nontax goal.
Many questions remain in implementation and
application of this provision.
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Rules v. Standards
p.540
Better to use (1) statutory rules or (2) general
judicial doctrine/standards to seek to limit tax
shelters? Can IRS get “ahead of the curve” in
this context?
Will the economic doctrine codification help
remedy the corporate tax shelter problem?
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Responsibilities of the
Tax Lawyer
p.540
What is the responsibility of the tax
lawyer/advisor in this context?
What responsibility imposed on lawyer in
providing a “tax opinion”?
Note responsibilities of the tax advisor as
prescribed in U.S. Treasury Circular 230
concerning “covered opinions.” P.541.
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Sale & Leaseback
Transactions
p.543
Property is purchased by a high income tax
bracket taxpayer and then leased to a low/zero
tax bracket taxpayer. Owner/lessor has the
benefit of tax depreciation deductions, thereby
reducing its income tax liability, and passes
some of that tax benefit to the lessee.
How differentiate between ownership (by
nominal lessee) and a lease relationship?
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Alternative Minimum Tax
p.545
An alternative tax is imposed at a reduced rate
on an expanded tax base. What origin for this
tax system? What are items which expand the
relevant tax base?
Tax-exempt interest (private activity bonds)
Percentage depletion
Intangible drilling costs
R&D deducted expenses
Itemized deductions.
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Klaasen v. Commr.
p.547
AMT as a violation of 1st & 5th Amendments to
U.S. Constitution?
Here AMT limited (1) state and local taxes, (2)
medical expenses, and (3) twelve personal
exemptions, producing an AMT liability.
Held: AMT liability applies.
Concurring opinion: Correct result, but
Congress needs to change AMT rules, since
inequitable to apply to these taxpayers.
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