Fed Income Tax Outline
Fall 2018
Federal Tax Dispute Procedures
Overview:
1. File a tax return
2. There is an audit – and IRS finds a deficiency
3. 30 day letter (preliminary notice of deficiency)
a. Pay
i. Then file for a claim for a refund with the claims court or the district courts
b. File a written protest within 30 days of issued letter
i. This will case an IRS appeals process
c. Do nothing
i. This will cause a 90-day letter and right to IRS appeal is lost
4. If you do nothing
a. 90 day letter will be sent
i. Stops the statute of limitations
5. If you file a written protest within 30 days of issued letter
a. You are assigned an IRS appeals officer and have an internal IRS appeal
b. You may get a 90 day letter saying you will owe the deficiency
6. Tax Court
a. If you still owe a deficiency after 90 day letter – taxpayer can pay or file petition to US tax court within
90 days of the letter
If you file a written protest within 30 days of issued letter
1. This will lead to an Internal IRS appeal
a. Appeals officer and taxpayers attorney will set up an appointment to discuss the case
i. Most cases are settled here
2. If the appeals officer agrees with attorney then all problems are over (and sets precedent for your clients future)
3. If appeals officer disagrees with attorney then IRS is required to send 90-day letter by certified mail
90-day Letter
1. Taxpayer has 90-days (from post mark) to file a petition with the US tax court
a. The case will be heard by a judge only – no jury
b. The IRS cannot collect deficiency if petition is filed within 90 days
c. Absolutely no extensions
2. If no petition is filed within 90-days
a. IRS may assess the tax and there is no recourse but to pay
i. After payment, taxpayer can sue for refund using the court system.
Statute of Limitations
§6501 Three Year Statute of Limitation:
1. Time starts from the date it was due to be filed (April 15)
1
2. If the tax return was filed later then its THREE YEARS from when the return was filed
3. Ex: tax year is 2015  return date will be April 15, 2016. Add three years from that date. 2016+3=2019.
a. Thus the SOL ends on April 15, 2019 and the 90-day letter must be sent before then.
4. IRS must mail the 90-day letter by certified mail and it must be postmarked before the statute of limitations
expires
§6531 Six Year Statute of Limitation:
1. A greater than 25% omission of income
2. Criminal cases
Statute of Limitations will be indefinite when:
1. No return was filed
2. Fraud
1. Which required specific intent
2. IRS must prove that the taxpayer knew he was cheating)
3. Agreement to extent
1. Taxpayer contractually agrees to extend the SOL
i. Why would a taxpayer do this? This allows the taxpayer to continue an appeals conference for a
year or two, if the taxpayer did not do this, IRS would send 90-day letter immediately.
The Court System
The Taxpayer gets to choose from three federal courts
The US Tax Court
1. *the taxpayer does not have to pay deficiency
until the case is decided/settled*
2. There are no juries, only bench trials
3. Small claims procedures for under $50,000
4. Appealed to the circuit court of appeals, then
SCOTUS
3. no jury trial – bench trials only
4. appealed to the Court of Appeals for the
Federal Circuit, and then SCOTUS
Federal District Courts
1. *must pay deficiency, refund only cases*
2. Jury trials are allowed
3. Rules of evidence are more strict in the District
Court
4. Appealed to circuit court of appeals, then
SCOTUS
United States Claim Courts
1. *must pay tax deficiency first – refund*
2. rarely used, based in Washington, DC.*
2
Tax
Court
District
Court
US
Claims
Court
Pay
NO
YES
YES
Jury
NO
YES
NO
The Tax Formula
The Tax Formula:
Gross income (any income from whatever source derived)
1. (-) Exclusions §101 - §151
2. (-) Business deductions §162
3. (-) Specific deduction §62
(=) Adjusted gross income
1. (-) Itemized deductions (or)
2. (-) Standardized deductions ($12,000 single; $24,000 married)
a. Whichever one is higher
= Taxable income
Income:
1. Definition:
a. increase in wealth, and
b. in the case of property, there must be a realization (sale or exchange of property or lucky find not
integrally connect to a purchase)
c. income can take a variety of forms: cash, property, discounts, services, free use of property
§61 Gross Income
1. Definition: Any income from whatever source derived, including but not limited to:
a. Compensation for services, including
i. Annuities
fees, commissions, fringe benefits, and
j. Income from life insurance and
similar items.
endowment contracts
b. Gross income derived from business
k. Pensions
c. Gains derived from dealings in property
l. Income from discharge of indebtedness
d. Interest
m. Distributive share of partnership gross
e. Rents
income
f. Royalties
n. Income in respect of a decedent
g. Dividends
o. Income from an interest in an estate or
h. Alimony and separate maintenance
trust
§62 Specific Deductions
1. IRA
2. Alimony, but not divorces after 2018
3. Loses from sales of capital assets (3,000
maximum)
4. Student loan interest
5. Others
§161 Itemized Deductions
1. §213 Medical (only in excess of 7.5% AGI)
2. §164 state/local taxes up to $10,000
3. §163 interest
a. Home mortgage, and one second home
up to $750,000
4. §170 charitable
5. Limited Others
Adjusted Gross Income
1. Gross Income minus (exclusions, business deduction, specific deduction)
3
Section 199 Deduction for Qualified Business Income
1. Rule: allows owners of certain pass through entities to take a deduction equal to 20% of their qualified business
income.
a. Pass through entities: sole proprietorships, partnerships, S corps, LLCs
b. Qualified business income: incomes only form a US trade or business
c. Formula: Net profit x .20 = deduction
Cases:
1. Commissioner v. Glenshaw Glass Co.
a. Except as otherwise provided, gross income means all income from whatever source derived. It does not
matter how taxpayer received the increase in wealth. Windfalls are taxable.
2. Cesarini v. US
a. Used $15 piano found almost 5 grand in old currency inside of the piano
i. The court ruled that the three year SOL has not expired
ii. The finder of treasure trove is in receipt of taxable income to the extent of its value in US
currency for the taxable year in which it is reduced to undisputed possession (when it is found).
Taxpayer did not have possession over the currency until they found the money
3. Old Colony Trust Company v. Commissioner
a. The company paid the employee’s income tax while he was employed
i. Discharge by a third person of taxpayer’s legal obligation is equivalent to receipt of that amount
by taxpayer. Income includes indirect economic benefit. (loan forgiveness can be income unless
it is a gift)
Gifts, Bequests, and Inheritances
Rule §102: Gross income doesn’t include the value of property acquired by gift, bequest, devise, inheritance. Gift in the
tax law statutory sense proceeds from a detached and disinterest generosity out of affection, respect, admiration,
charity or like impulses. Looking at the intent and motive of the transferor, the substance, determines whether it is a gift
in the tax law statutory sense, rather than the legal form.
1.
2.
3.
4.
Gift Factors:
No strings attached; goodness of heart
Family or noncommercial relationship
No obligation to make the transfer
Made out of love and affection
1.
2.
3.
4.
5.
Non-Gift Factors:
Strings attached; expecting something in return
Business associate or employee (non-family
member)
Obligatory
Compensation for future or past services
Not given out of love or affection
Exclusion:
1. §102(b)(1)
a. Exclusion from gross income does not apply to the income earned from the property received by gift
i. Dividends eared by the stock child receives as a gift from a parent
2. §102(b)(2)
a. Exclusion doesn’t apply if the gift itself is only the income from the property, to or for the rather than
the actual property
4
i. Ex: parent transfers stock to a trust and only gives the child right to income from the trust
corpus
3. §102(b)(c)
a. No gift classification to any amount transferred by or for an employer, to or for the benefit of the
employee.
i. You must say it was not for employment
ii. And past employment can be argued even if they no longer work for the company
Part Sell/Part Gift
1. This is a realization event for the donor as the donor is receiving some consideration, and has an amount
realized and that amount is therefore taxable
a. There is no loss allowed for the transferee
2. The transferee has no income; their basis is the greater of the amount paid by the transferee or the transferors
adjusted basis at the time of the transfer
3. Example:
a. Mom and Dad own house with basis of $25,000 and FMV of $100,000.
b. They sell their daughter the house for $75,000 – the daughters new basis is $75,000 and parents have a
taxable income of $50,000
Cases:
1. Wolder v. Commissioner – attorney performing legal services asked his client to bequest payment in lieu of fees
during her life (as a way to get around paying taxes)
a. The court held that substance of form is the most important thing!
b. The substance here was that the attorney was getting income and trying to cheat the system
2. Commissioner v. Duberstein – business associate gave another associate a car and the taxpayer did not claim it
as income
a. The court found that because the car was for recompense for a taxpayer’s past services and an
inducement for referrals in the future
b. DOTI: subjectivity is very important in Tax law e.g. §102 gifts is not clearly defined.
Gains Derived from Property
Rule: §61(a)(3) states that gross income includes gains derived from dealings in property. Section 1001(a) provides that
gain or loss from the sale or other disposition of property is the excess of amount realized over adjusted basis
Basis
§1012 Basis is determined by how the property was initially acquired and the amount the taxpayer has invested in a tax
sense into the property
1. Amount realized – adjusted basis = taxable gain or loss
2. We need to know how property was acquired to determine its basis
a. §1012 Purchase: Basis is the cost
b. Exchange: basis is basis of the property given up
c. §1015 Gift: Generally the donors basis
d. §1014 Inheritance: basis is the FMV at time of the decedent’s death
5
e. Lucky Find:
i. Taxable find: basis is FMV of property at the time of discovery
ii. Nontaxable find: basis is cost
§1016 Adjusted Basis: The initial basis may be adjusted as a result of a subsequent events to yield the property’s
adjusted basis
1. Initial basis of property is adjusted upward for the cost of any improvements to the property, and downward for
the cost recovery deductions that are allowed with respect to the property.
Co-ownership of property
Joint Tenancy/Tenants in Common:
1. If a spouse dies, surviving spouse’s basis would be one-half at acquisition and one-half fair market value at death
a. Examples: $100,000 purchase cost and $500,000 FMV on the date of the death
i. Spouse’s basis would be $50,000 +$250,000 =$300,000
ii. If sold for $500,000 taxable income would be $200,000
Community Property
1. §1014(b)(6) When one spouse dies the basis becomes the entire fair market value (“double step up”)
2. This is a significant advantage for survivor because the surviving spouse can sell the house for FMV and pay no
taxes
Compensation for Personal Physical Injury and Physical Sickness
IF THERE IS ANY PHYSICAL INJURY OR PHYSICAL SICKNESS THAN ALL COMPENSATORY DAMAGES ARE EXCLUDED,
INCLUDING LOSS WAGES
Under §104(a)(2) gross income does not include personal physical injury or sickness damages.
Required Elements:
1. Any damages received other than punitive
a. Punitive damages are always taxable!
2. By suit or agreement (do not have to have a lawsuit filed, purely contractual agreements are fine)
3. Generally a tort or tort-like cause of action
4. Personal physical injury or physical sickness
a. Emotional distress by itself (insomnia, headaches, and stomach disorders) is not treated as physical
injury. However, reimbursement of medical expenses attributable to emotional distress is excludable.
Notes:
1. In Collins (a case we didn’t have to read) the court ruled that hypertension (high blood pressure) is included with
insomnia, headaches, and stomachaches meaning, it’s an emotional distress
2. The difference, whether the settlement is received as a lump sum or periodic payments, each is excludable.
Cases:
1. Amos v. Commissioner – taxpayer was kicked by Denis Rodman
a. Settled for $200,000 and did not claim any taxable income.
6
2.
3.
4.
5.
b. Holding: as long as there is a good faith claim than the settlement is not invalid and the court arbitrarily
decided that $80,000 was for the NDA and $120,000 was for physical injuries
Stadnyk v. Commissioner – taxpayer was arrested wrongfully when her bank marked NSF on her cancelled check
a. The taxpayer said on stand that she was no physically injuries – therefore, all the income was for
emotional damages and therefore taxable
Barbato v. IRS – UPS worker injured on the job and harassed at work by new supervisor
a. There was too much time and too remote for the suit to be about the physical injuries, this suit was
about the emotional damages from being harassed at work
Parkinson v. IRS – Medical center worker had two heart attacks and was harassed at work
a. The court ruled that 50% of the damages were for physical injuries and 50% were for emotional
damages
b. DOTI: does not think the court should segregate the damages. The Lawyer should have stated “lawsuit
was a result from IIED causing a heart attack with resulting emotional distress brought on by the heart
attack
French v. IRS – couple harassed by BoA
a. The claim did not seek compensation for Mrs. French’s physical injuries or for ending up in the hospital
Tax Consequences of Divorce
There are three possible ways to treat payments from one spouse to another as a part of a divorce:
(1) Alimony
1. Pre 2019:
a. In order to be considered §71 taxable/§215 deductible
i. Must be in cash
ii. Must be received by spouse or on behalf of the spouse
iii. Must be made under a divorce or separation instrument
1. Cannot be an oral agreement
iv. Must not be designated in the instrument as one that is excludable from the gross income of the
recipient and nondeductible to the payer
1. This is an opt out clause
v. Cannot be members of the same households
1. Exception: Temporary support orders can still be living in the same house
vi. The payer spouse must have no obligations to make payments for any period after the death of
the payee
1. “payment for 4 years” is not alimony because the wife could die in one year
2. If the payor is obligated to make substituted payments to another upon the death of the
payee, none of the payments are alimony for tax purposes
b. If found to not be alimony, then payment is not deductible and not taxable income. It is treated §1041
transfer between spouses
2. Post 2019:
a. Alimony is not taxable income to the payee and not deductible by the payer
b. Alimony is now considered to be a 1041 property transfer – no taxable consequences at all
c. The transferee’s basis is the same as the transfer, but no income and no deductions
(2) Property settlements
7
1. §1041 provides that there is no gain or loss on a property transfer between spouses or incident to divorce. The
transfer is treated as a gift for income tax purposes, with the transferee taking the transferor’s basis
a. A transfer between spouse occurs:
i. If it happens within one year of the date of the end of the marriage (or)
ii. It happens within six years of the end of the marriage and it is related to the divorce
1. Meaning its pursuant to the divorce or separation agreement
(3) Child support
1. This reflects a pre-existing parental support obligation for which there is no deduction other than a possible
dependency deduction.
2. This is not income to the child, it is considered a gift to the child by the parents
3. Tax consequences:
a. Not deductible for the payor
b. Nor taxable for the payee
i. This is treated as a gift based on the love and affection for the children
Note:
1. When the payor is obligated to pay both alimony and child support, any shortfall in meeting those obligations
first reduces the child support to be paid. Meaning that whatever the payer pays will be first allocated as child
support and once that obligation is fulfilled, then alimony. This way the payer is not getting a deduction even
though they are short on payments.
Pre-nuptial Agreements:
1. Typically used to conduct out of the community property consequences so as to maintain separate property
ownership after marriage
2. If transfer of ownership under the pre-nuptial agreement occurs:
a. Before the Marriage:
i. then this is a taxable event because §1041 does not apply.
ii. Transferor has to pay taxes on FMV, and the transferee will get the entire FMV step up basis
b. After Marriage
i. §1041 does apply and this will now be a nontaxable event
ii. The transferor does not have to pay taxes and the transferee’s basis is the transferor’s basis
Family Support:
1. Family support is alimony. When the decree does not state which part is alimony or child support, then the
whole thing is alimony
a. Exception: when the amount goes down per the decree (when the child hits a certain age, graduate,
gets a job, moves out) then the amount it goes down is considered child support.
Discharge of Indebtedness
General Rule:
1. §108 states that the discharge of indebtedness is included in income.
Exceptions:
8
1. If the discharge is on account of the taxpayer’s bankruptcy
2. If the taxpayer is insolvent (owes more than his current assets)
a. Then exclude from taxable income!
Notes:
1. If the discharge is made by a parent out of love and affection, then it can be argued that the discharge is a gift
and therefore, not taxable income.
2. Also, discharged student loans are not taxable, if the student works for a public service organization for the
minimum period of time.
3. Unpaid taxes are discharged in bankruptcy, if taxes are more than 3 years old at time of bankruptcy filing, no
fraud involved, and IRS did not have a prior lien on taxpayers property
Fringe Benefits
Section 132 5 categories of excludable benefits:
1. No additional cost services
a. The service must be one offered for sale to customers in the ordinary course of business
b. The service must be in the line of business that the employee is working
c. The employer incurs no substantial additional cost
d. No discrimination in favor of highly compensated employees
i. Ex: airline employee gets a free airline ticket if employee flies standby/ theater tickets
2. Qualified employee discount
a. Services limited to 20% of the price at which the services are being offered by the employer to
customers
b. Property limited to the gross profit percentage. Generally not less than the purchase cost of goods to
the employer.
3. Working condition fringe
a. If the employee can deduct if she paid the expense herself, then this qualifies here
i. Ex: chapman pays Doti’s bar fees, but he would be able to normally deduct that
4. De minimus fringe
a. Non cash benefit (under $100) is so small that to keep track of it would be administratively
impracticable
5. Qualified transportation fringe
a. Parking on company premises, carpooling, etc
Meals Fringe
1. Condition of employment
2. For the benefit of the employer
3. On the premises
Lodging Benefits
1. For the benefit of the employer
2. A condition of employment
3. On the premises
9
Case:
1. J. Grant Farms Inc. v. Commissioner – the Grants made a corporation for their farm and lived in the house that
was on the farm
a. Section 119 states that the value of lodging is excluded as gross income if it is on the premises of the
business for the convenience of the employer, and it was a condition of the employment.
b. Issue: was the lodging a condition of the Grant’s employment?
c. Holding: yes, the court held that living on the premises was an implied condition of the employment, the
farm requires constant, if not continuous, monitoring and work.
Life Insurance
1. Section 101 states that in general, gross income does not include amounts received under a life insurance
contract, if such amounts are paid by reason of the death of the insured.
Exclusion of Gain on Sale of Principal Residence
Exclusion of Gain from Sale of Principal Residence:
1. Section 121 states: The Taxpayer can exclude up to $250,000 (or $500,000 if married and filing joint tax return)
of gain realized on the sale of a principle residence.
Requirements:
1. Applies to only one principle residence
2. The taxpayer must have owned the residence for at least two out of previous five years before the sale
a. Only one spouse has to be on the title
b. Time ends upon the close of the sale
3. The taxpayer must have used the residence for at least two out of previous five years before the sale
a. Both spouses have to satisfy the use requirement (meaning both have to live there for two out of the 5
years
b. Does not have to be continuous
c. Military leaves are okay
4. The exclusion must not have been previously claimed within two years preceding the sale.
a. This is to prevent people who are in the business of flipping houses from avoiding tax
§121(d) Special Rules for divorced and deceased spouses
1. A taxpayer who receives property from a deceased spouse is treated as owning and using the property for the
period the deceased spouse owned and used the property before death
a. The full $500,000 exclusion applies if the surviving spouse sells the home within two years after the
death of the predeceased spouse
2. A taxpayer who obtains property from a spouse or former spouse by gift or in a divorce is treated as owning the
property for the period the transferor spouse owned the property
a. A taxpayer whose spouse or former spouse is granted sole use of the property pursuant to divorce is
treated as using the property, if the occupying spouse so uses the property
Exceptions:
1. A reduced maximum exclusion applies to taxpayers who sell a principle residence, but fail to satisfy the
ownership and use requirement or the one-sale-every-two-years rule if:
10
a.
b.
c.
d.
A change in employment over 50 miles
Health reasons
Unforeseen circumstances
The proportion is determined by the following formula:
i. The period owned/24 months x normal exclusion = reduced maximum exclusion
Cases:
1. Guinan v US – taxpayers own homes in Wisconsin, Arizona, and Georgia
a. The taxpayers did not have a principle resident because they although they spent the most amount of
days as compared to their other residence individually, it was not over 50% of the total days
b. The court found the major factors was the days, but also important:
i. Where you file your taxes
ii. Where you vote/have your DL
iii. Where your banks are
iv. Church
Home Office Deduction
Section 280 In order to deduct part of your home for conducting business activities a taxpayer must use that part of the
home: (1) exclusively and (2) regularly as
1. A taxpayers principle place of business for conducting any trade or business or
2. A place where the taxpayer meets or deals with clients, or customers in the normal course of the taxpayers
trade or business
Note:
1. If you have the ability to have an office (like your employer offers you a place to work at the firm) then you
cannot take this home office deduction
How to calculate
1. If you qualify for a deduction, it is limited based on the percentage of the home used for business:
a. Divide the square footage of the home office by the square footage of the total home.
Cases:
1. Papov v. Commissioner – violinist practices at home claimed a portion of her living room for a home office
a. This court said Popov was entitled to a home office deduction because the IRS allows for a home office
deduction if it is used exclusively as the principle place of business for any trade or business of the
taxpayer.
b. The court will use facts and circumstances test with two primary considerations
i. The point where goods/services are delivered must be given great weight
ii. The time spent at each place
11
Assignment of Income
FORM OVER SUBSTANCE HERE
There are two categories of Assignment of Income:
1. Assignment of Earned Income
a. Rule: The Supreme Court held in Lucas v. Earl that income is taxes to the person who earned it. No
assignment, however skillfully drafted, will be effective.
b. Exception:
i. If the Taxpayer abandons the income before he earned it and did not assign the income
(although you can merely suggest the payor to give it to charity)
ii. Two elements must be met!
1. The taxpayer must not have yet carried out the act to earn the future income
2. The payor is not contractually obligated to pay the income to the assignee
2. Assignment of Income from Property
a. Rule: Income from property is taxed to the owner of the property. If an owner assigns the income from
the property they still are taxable on the income, but if they assign the property that produces income
the assignee is liable for the taxes on the income it produces.
b. Exceptions:
i. “income to son for life, reversion to father”
ii. “50% of income to son for life, reversion to father”
The Incentives to assign Income:
1. Progressive tax rate structure:
a. Income tax rate increases based on income, there is a tax advantage in shifting income from a higher
bracket taxpayer to a lower bracket taxpayer, like a child (see below for details)
2. Accelerating Income:
a. If income will be taxed at a higher rate in subsequent years, there is an incentive to find a way to
accelerate future income into the present tax period or vice versa.
§7701 Economic Substance Doctrine
1. Justice Learned Hand: “anyone may so arrange his affairs to pay the least amount of tax…there is not even a
patriotic duty to pay the most taxes.”
a. This means a taxpayer is free to arrange his financial affairs to reduce their tax liability
i. Factors:
1. Economically realistic
2. Valid and valuable consideration
3. Risk of ownership
4. Made a profit
Cases:
1. Lucas v. Earl
a. Facts:
12
i. Taxpayer entered into a valid contract with his wife to the effect that income earned or property
received by either shall be held and owned as joint tenants. So they each reported half of the
total income on the respective tax returns
b. Issue:
i. should the taxpayer pay tax on his entire earnings
c. Rule:
i. Income is taxed to the person who earns it. No assignment, however skillfully drafted, will be
effective.
d. Notes:
i. This was a valid contract to avoid probate, not to avoid taxes
ii. The court had to rule this way, or else they would have emasculated the income tax and make it
worthless – tis was about public policy
iii. This is the fruits and the tree! You cannot assign the fruits without transferring the tree or past
of it.
2. Strahan v. Commissioner – accelerating income
a. Facts:
i. Taxpayer, to accelerate his income, assigned to his son anticipated cash dividends from common
stock. He did this because his income that year was not high enough to fully absorb his interest
deduction. The father had too much itemized deductions – and he would not be able to take
advantage of them.
b. Issue:
i. In which year is the father taxable?
c. Rule:
i. A cash basis taxpayer ordinarily includes income in the year of receipt, rather than the year
when earned.
ii. A taxpayer who assigns the right to future income from consideration in a bona fide commercial
transaction will ordinarily realize income in the year of receipt
iii. This was NOT an assignment of income. The taxpayer was not trying to make someone else pay
the taxes; instead, he was trying to pay taxes sooner
d. Notes:
i. Here, it was find because the son mad a profit – meaning there was economic substance. If the
son did not make anything, then likely no good.
ii. This is the economic substance + tax motivation
3. Salvatore v. Commissioner – progressive tax rate structure
a. Facts: Taxpayer-mother inherited ownership of a gas service station from her husband. The mothers
three sons and daughters operated the gas station. Mother started negotiating with Texaco to sell the
station in early summer 1963. Mother on July 24 accepted Texeco’s offer to buy the station by executing
an agreement to sell to Texaco. On August 28 mother transfers by deed ownership one half interest in
the station to her five children. The mother and children reported their gain on the sale in accord with
their respective ownership shares. The children were in a lower tax bracket than the mother so they
would pay less in taxes then mother would. IRS said the mother was responsible for the entire gain.
b. Issue: was mothers transfer to the children effective for income tax purposes? (substance over form)
c. Rule:
i. The taxpayer was taxable on the entire gain, because she held full ownership on the fate of sale
to Texaco (when they shook hands, that was when it was too late) the title transfer to the
13
children came too late. Court applied the substance over form doctrine. This was done solely to
avoid taxes, no other economic basis.
ii. If she would have transferred title to the children before the negotiations then she would have
only had to pay taxes on her share
1. Holding: we don’t care when the contract was signed! We care when they had a deal.
d. Notes:
i. How to solve this problem?
1. Have the mother transfer the interest before the negotiations with Texaco start.
2. If you already have an offer, reject it, then do the transfer, then go back to the
negotiating table.
3. Because SCOTUS says that the sale of property is when the parties have a tacit
agreement (implied without being stated) so the fact that the mother shook hands
means that they had a deal and it was too late to transfer the money.
§1(g) Kiddie Tax
1. Applies to any child under the age of 18 and to full-time students ages 19-23
2. Applies to unearned income such as interest and dividends received in excess of a base amount.
3. Regular standard deduction in excess of base amount and personal exemption allowance do not apply to the
child’s unearned income
4. Income over the base amount is taxed to child at the parents rate or the child’s rate, whichever is higher
a. If parents are divorced, apply the tax bracket of the parents highest rate that has custody.
b. Does not apply if the parents are dead
Uniform Trust Account for Minors Act (UTMA)
1. This is a custodial account for minors under which the minor cannot withdrawal money from the account until
he reaches majority. The custodian (usually a parent) manages the account. Earning on the account (interest,
dividends, etc.) are taxed to the child.
“Totten” Trust Bank Account
1. The parents solely owns a typical bank account
2. When the parents dies, the account passes to the child or other person named as beneficiary
3. Child has no rights while the parent is alive, the parent can revoke account and change the beneficiary
4. The parents is responsible for income tax on the account
5. This does not shift income, and does avoid probate!
Business and Profit Seeking Expenses
Expense v. Capital Outlay
1. Expense:
a. Benefit to the business within one year period
2. Capital:
a. Benefit to the business goes beyond one year
3. Post 1993:
a. Amortization (deduction) of goodwill and most other purchased intangibles is over 15 years
14
§162 Business Deductions
1. Requires:
a. Expense (not capital) that is
b. Ordinary
i. Customary or expected in the life of a business.
c. Necessary
i. Means appropriate and helpful!
ii. There must be a causal connection between the expense and the business
1. There have been two cases in which the IRS said expenditure was not ordinary and
necessary
a. CEO was into astrology, and to him it was a science and useful for making
decisions. CEO hired astrologist to help him make decisions, he even had an
office next to the CEO. Astrologist got paid $60,000. IRS said not ordinary or
necessary
b. Guy was into Christian science and hired a Christian Science advisor to help him
make decisions. Court said religion is like astrology – not proven. This is not
appropriate or helpful.
d. Paid or incurred during the taxable years
e. Paid or incurred in carrying on a trade or business, and
f. No deductions for fines, bribes, etc.
Cases:
1. Welch v. Helvering
a. Facts:
i. Taxpayer paid off the bankruptcy debts of his former employer to establish good business
relations with his customers.
b. Issue:
i. Was the payment of the debts of another an ordinary and necessary expense of the business?
c. Holding:
i. No. Necessary means “appropriate and helpful”
1. Here, there was a causal relationship between expense and business BUT the payment
would have benefited the taxpayer for more than one year, so this was more of a capital
outlay.
2. Thus, NOT an expense but instead a capital expenditure.
2. Jenkins v. Commissioner
a. Facts:
i. Petitioner, Conway Twitty, is a well-known country music entertainer. Conway and several of his
friends decided to form a chain of fast food restaurants and incorporated Twitty Burger. During
that time, approximately 75 of petitioner’s friends and business associates invested money in
Twitty Burger. Twitty Burger was experiencing financial difficulties and shortly thereafter it was
decided that Twitty Burger be shut down. Subsequently, Conway Twitty decided that the
investors should be repaid the amount of their investments in the failed corporation. Because
Twitty burger had no assets, so Conway Twitty decided to repay the investors from his future
earnings.
b. Issue:
15
i. Can Conway Twitty deduct the payments that he made to investors as ordinary and necessary
business expenses?
c. Holding:
i. Yes. The court held that there was a causal connection to his music career. Thus, there can be a
different business involved that you are trying to protect. (This expense was NOT to help Twitty
Burger but his music career and rep.)
1. The difference between Jenkins and Welch is that Twitty was already in the music
business and his payments were to keep his reputation
2. Where Welch payments were to establish a new business reputation (which is a capital
expenditure)
Capital Expenditures
1. Capital Expenditures
a. Costs related to the acquisition of property
i. Purchase price, including delivery charge and sales tax,
ii. Defending or perfecting title,
iii. Making asset suitable for its intended use, or
iv. Other costs associated with acquiring an asset.
b. Outlays for the permanent improvement or betterment of existing property
i. Add substantially to the value of existing property
ii. Appreciably prolong its life, or
iii. Adapt the property to a new and different use!
2. Depreciation!
a. Residential Reality = 27.5 years
b. All other commercial reality = 39 years
i. LAND IS NOT DEPRECIABLE!
3. Non-real property purchased
a. Any equipment and similar purchases are deductible in the year they were acquired as long as it is under
$1,000,000.
4. Incidental Repairs
a. The exception to the general rule of having to capitalize any benefit to the business exceeding one year
i. If the repair is intended to keep the capital asset in good operating condition then its fully
deductible in the year the cost was incurred.
Notes:
1. Doti’s test for Capital Expenditure v. Business Expense:
a. Is it new and different?
i. Repair is only a bit new – but not different – does it keep the business status quo???
ii. Did it change the size, extend the life, enhance the value?
iii. Changing something so you can start a business = capital expenditure (this adds to your basis)
iv. Why did they make the changes and look at what you had vs. what you have now
Cases:
1. Midland Empire Packing Company
a. Facts
16
i. Taxpayer added a concrete lining in the basement of his meat packing plant to oil proof it
against seepage caused by a neighboring refinery. This was to repair a crack.
b. Issue
i. Is the repair deductible as an ordinary and necessary expense or is it a capital outlay?
c. Rule
i. A repair is an expense for the purpose of keeping the property the “status quo”
ii. For income tax purposes a repair does not add substantially to the value of the property, nor
does it prolong its life.
d. Holding
i. This was a repair/fix and not an improvement
ii. This repair merely served to keep the property in an operating condition over its probable useful
life for the purpose for which it is used
2. Morris Drive-In Theatre Co
a. Facts
i. Taxpayer purchased farm land and proceeded to construct a drive-in outdoor theater. The
adjacent property owner complained that the altered slop of the land caused an acceleration
and concentration of the flow of water after it rains. The neighbor sued for damages and they
settled by agreeing the taxpayer would construct a drainage system to remedy the problem
b. Issue
i. Is the drainage system cost a repair or capital outlay?
c. Holding
i. Capital Outlay. This was done to fix a problem but it was new and different. The taxpayer knew
the property’s drainage system was inadequate. This was not merely the repair of an existing
faulty system.
d. How is this different from Midland Empire?
i. The foundational crack in midland was deterioration of the building through the course of
normal use. The drainage ditch was something then needed from the beginning to drain the
slope.
1. The drainage system is also new, and the repair in the crack of the wall is not.
Tax Shelters
IRC §469
Passive Activities
1. A passive activity involves the conduct of any trade or business in which the taxpayer does not materially
participate
a. Material participation:
i. More than 500 hours per year involvement in the business constitutes material
2. Loss is deductible only against other passive income in the same year. Unused loss has to be carried over to
subsequent years.
3. If a taxpayer disposes her entire interest in a passive activity, then any carry over losses are deductible against
non-passive income in the tax year sold.
Non-passive Activities
17
1. A non-passive activity involves conduct of any trade or business in which the taxpayer does materially
participate
a. Spends more than 500 hours per year involvement in the business
2. Loss is fully deductible against all other income
Rental Real Estate
1. Non-real estate professionals
a. Two requirements to get this deduction
i. At least 10% ownership in the real estate
ii. Actively participates
1. Easily satisfied (just meet with clients)
b. If income is less than $100,000
i. May deduct up to $25,000 against all other income
c. If income is between $100,000-$150,000
i. Formula: $25,000 – ½(AGI – 100,000)
d. If income is over $150,000
i. NO DEDUCTION!
2. Real estate professionals
a. Two requirements to be a real estate professional
i. More than 50% of your time is spent on real estate activities
ii. More than 750 hours per year is spend on real estate activities
b. No limit on deduction of loss!
3. Note:
a. Motels/hotels are not residential real estate!
i. Must deduct loss through passive/non-passive activities
Interest Expense Limitations
The loan MUST be used for the purchase or improvement of a home
We first must determine why the taxpayer incurred the interest expense.
1. If trade or business of the taxpayer with material participation
a. Fully deductible under 162
2. Qualified principle home and one second home
a. Fully deductible up to an overall cap of $750,000 in secured loans on principle and one second home
(cannot be a rental home! Must be a vacation home that you spend at least 2 weeks a year in)
i. this is only if the loan is a secured loan (loans from parents do not count)
3. Consumer debt
a. Not deductible
i. No auto loans or credit card loans
4. Investment portfolio related property making activities without customers (vacant land) are not subject to
passive loss rule
a. Interest is deductible only to extent of net investment income with lifetime carryover
5. Interest expense
18
a. Pass loss activity is subject to pass loss rules and interest expense is treated the same as any other
business expense.
Lenders
1. While you are allowed to take out a second mortgage on the equity of your home, the first lender may have put
something in the contract preventing the homeowner from getting a second loan
a. The first lender may be hostile
b. And the second lender may charge a very high interest rate because of the risk (the 1st lender gets
priority)
Mortgage points
1. Lenders charge points (1 point = 1%)
2. This is charged above the loan interest
a. $750,000 loan plus one point = $7500 has to be paid upfront! This is deductible! It is treated as the
general interest of the mortgage.
b. This is only for the lender, if an mortgage agent or mortgage broker charges you points, that is not
deductible
Formula to determine how much is deductible
1. 1st home = $300,000
a. Fully deductible
nd
2. 2 home = $800,000
a. Only $450,000 deductible
3. 450,000/800,000 = 56.25%
a. 56.25% x the interest rate of the second home = deductible amount
Notes:
1. Each person is eligible to take this deduction
a. Have a couple who doesn’t want to get married! Perfect, have them each take out a loan for $750,000
and then they can purchase a $1.5 million home and have it be fully deductible
Capital Gains and Losses
What is a capital gain?
1. Sale or exchange of property
a. Gain or loss on the sale of an asset held for investment purposes
i. Stocks, bonds, and land
b. Goodwill of business and patents
2. Trade or business
a. Depreciable property used in a business
i. Capital gain if sold at a gain, and ordinary loss if sold at a loss
3. Personal used assets
a. Auto, clothes
i. Capital gain if gold at gain, but no tax implications if sold as loss
19
The rates for a capital gain:
JOINT RETURN AMOUNT
Ordinary income + net capital gain
Up to $77,200
FAVORABLE RATE ON NET CAPITAL GAIN
$77,201-$452,400
15%
$452,401
20% plus 3.8% for health care act add on tax
Zero
Notes:
1. There is an overall $3,000 cap per year on all net capital losses against ordinary income with a lifetime carryover.
2. Losses carried over can be applied against capital gains in subsequent years & $3,000 offset against ordinary
income.
TYPE OF INCOME
INCOME TAX TREATMENT
Salary and interest received
Ordinary income
Business profit or loss
Ordinary income or loss
1. Performance of services
* keep in mind passive loss rules
2. Sale of inventory
3. Sale of intellectual property by its creator or done
of the creator
Dividend on corporate stock
Sale or exchange of investment property
1. Stocks, bonds, and land held for investment
2. Goodwill of a business
3. Patent and a music work sold by its creator
Capital gain
Capital gain or loss
Property used in a trade or business
Business property which can be depreciated
Capital gain or loss
Capital gain or ordinary loss if sold at loss
Personal asset used
Capital gain if sold for gain, and no tax implication if sold
for a loss
Like Kind Exchanges
1. Exchanges of real property held for productive use in business (but not if held primarily for sale) or for
investment purposes qualify for tax deferred treatment. DOES NOT APPLY TO PERSONALTY
a. Personal assets such as a home or vacation home DO NO COUNT
i. You need to rent out the home for it to be considered a business property,
20
2. Gains and losses from exchanges are deferred
3. “like kind” generally means any type of business or investment real property exchanged for any other kind of
business or investment real property
4. For delayed exchanges, taxpayer has 45 days to locate replacement property and 180 days to close on the
replacement property after the date of closing of the sale of the relinquished property
a. This generally comes up where A has a buyer, but he has not found the right replacement property. C
does not want to wait to purchase A’s property. So, the Code allows C to pay $5 million to escrow. The
escrow company conveys a deed to C from A. From this date, A has 45 days to find a replacement
property from B. Then he must close within 180 days.
b. If A is trying to find C, then A will take out a “bridge loan” to pay off B, and then he has 45 days to find C
to pay off the loan.
5. THIS IS ONE OF THE FEW AREAS OF THE LAW THAT REQUIRES FORM OVER SUBSTANCE!
Cases:
1. Decleene v. Commissioner – tried to do a LKE without an escrow agent
a. Facts:
i. Taxpayer owned and operated a trucking repair business on improved real property in Green
Bay, Wisconsin. (McDonald drive). To expand his business, taxpayer acquired by purchase
unimproved real property on which a new building for his business would be constructed.
(Lawrence drive)
ii. Taxpayer found a buyer for the original property. To facilitate a like-kind exchange, the taxpayer
convinced the buyer to formally purchase the new property from him and then exchange it with
the taxpayer for the old property.
iii. The IRS challenged the reverse exchange because taxpayer did not use a third party exchange
facilitator as required by the IRS regulations.
b. Issue:
i. Was this a like-kind exchange?
c. Holding:
i. No. The court ruled against the taxpayer because he first purchased the new property a year or
more before he was ready to relinquish the old property. The court ruled that a taxpayer
cannot engage in an exchange with himself. A tax deferred §1031 exchange requires “a
reciprocal transfer of property, as distinguished from a transfer for a money consideration.” The
buyer of the exchange did not have beneficial ownership of the replacement property.
d. Reasoning:
i. Form over substance
ii. No use of a third party or escrow agent
Charity
Charity donation is a Personal Expense that is allowed as a deduction
Notes:
1. Cash:
a. Max 60% of AGI allowed to be deducted
2. Gifts of appreciated property
21
a. Max 30% of AGI allowed to be deducted
b. Can deduct the full Fair Market Value of the thing being donated
3. BOTH GET 5 YEAR CARRYOVER
Example:
1. Husband and wife own stock in apple worth $1,000,000 that they bought for $200,000. They donate the stock to
Chapman. How much is deductible for charity? $1,000,000 can be deducted, and they get taxed on nothing.
2. Alum of Notre Dame wants to go to a football game so he donates $10,000 and in return the school gives the
Alum front row tickets. This is no longer allowed! Taxpayers may no longer deduct these deductions to
university football games.
Overall Deduction Analysis
This is a two-step process:
1. Frist, classify the type of deduction
a. Personal, or
i. Only deductions allowed
1. Medical (in excess of 7.5% AGI)
2. State/Local Taxes up to $10,000
3. Interest deduction up to $750,000
4. Charitable contributions
a. See above for max deduction allowed
b. Business.
2. Second, determine if the business expense is capital or expenditure
i. Capital Expenditure
1. Benefits the business for more than 1 year
2. Depreciated over either 39 (commercial real estate) or 27.5 years (rental real estate)
ii. Expense
1. Benefits the business for less than 1 year
2. Ordinary and necessary
3. Made in carrying on a trade or business
iii. Illegal bribes, lobbying expenses, fines and penalties (such as EPA penalties) are NOT
DEDUCTIBLE
22
Fed Tax Rule Statements
Theory
Substance over form
Economic Substance
Section 7701, the codified economic substances doctrine, states that any transaction shall be treated as having
economic substance if (1) the transaction changes the taxpayer’s economic position in a meaningful way and (2) the
taxpayer has a substantial purpose for entering into such transaction.
Judge Learned Hand – Arranging Taxes
Judge Learned Hand said in the case of Gregory v. Helvering “anyone may so arrange his affairs to pay the least amount
of taxes…there is not even a patriotic duty to pay the most taxes.”
Home
Gains Derived from Dealings in Property
Section 61(a)(3) of the Internal Revenue Code states that gross income includes gains derived from dealings in property.
A gain from the sale or other disposition of property is the amount realized over adjusted basis. Adjusted basis is
determined by how the property was initially acquired and the amount the taxpayer has invested in a tax sense into the
property.
Interest Expense Limitations
The IRC allows taxpayers to deduct the interest on one principle home and one second home up to a combined
$750,000. The taxpayer must live in the second up for at least 2 weeks during the year, and the loan must be for the
purchase or improvement of the home.
Exclusions of Gain on Sale of Principal Residence
Section 121 of the Internal Revenue Code states that a Taxpayer can exclude up to $250,000 (or $500,000 if married and
filing joint tax return) of gain realized on the sale of a principle residence. In order to take advantage of this deduction
the taxpayer must have owned and used the residence for at least two out of previous five years before the sale and the
exclusion must not have been previously claimed within two years preceding the sale.
A taxpayer may qualified for a reduced exclusion if the taxpayer fails to satisfy the ownership and use requirement or
the one-sale-every-two-years rule if there is: a change in employment over 50 miles, health reasons, or unforeseen
circumstances. The formula to determine the reduced exclusion is: the period owned/24 months x normal exclusion =
reduced maximum exclusion.
Home Office Deductions (ALSO FOR BUSINESS)
Section 280 of the Internal Revenue Code allows taxpayers to deduct part of their home expenses for conducting
business activities inside their home as long as the taxpayer uses that part of their home (1) exclusively and (2) regularly
as the taxpayers principle place of business or a place where the taxpayer meets with clients in the normal course of
the taxpayers business.
23
Rental Real Estate (ALSO FOR BUSINESS)
Section 469 of the Internal Revenue Code allows non-real estate professionals who own at least 10% of the rental real
estate and actively participates is allowed an annual $25,000 deduction against all other income, as long as AGI is below
$100,000. The active participation is relatively easy to satisfy.
Section 469 of the Internal Revenue Code allows taxpayers who are real estate professionals, meaning more than 50% of
their time and more than 750 hours during the year is spent on real estate activities, to have no cap on the amount of
loss deducted from all income.
Business
Qualified Business Deductions
Recently, Congress has passed a law that allows for taxpayers to take an automatic 20% deduction from their adjusted
gross income of the taxpayers income from a trade or business. This deduction will be phased out, meaning you will be
unable to take the deduction, if you’re your income exceeds $157,500 if single and $315,000 if married. Additionally, this
deduction will only last until the year 2025.
Like Kind Exchanges
Section 1031 of the Internal Revenue Code states that exchanges of property held for productive use in business or for
investment purposes qualify for tax deferred treatment, meaning any gain or loss on the exchange of like kind assets are
deferred. Like-kind generally means any type of business or investment real property exchanged for any other kind of
business or investment property. For delayed exchanges the taxpayer has 45 days to locate the replacement property
and 180 days to close in the replacement after the date of closing on the relinquished property. For this exchange to be
nontaxable, the taxpayer needs to be sure that he does not take possession or control any money, but instead uses an
intermediary such as an escrow agent to facilitate the transfer.
I should advice you not to buy the replacement property because then you will not be able to defer the gain and will be
taxed on the sale. This occurred in a case called Decleene. In that case, the taxpayer bought the replacement property
(R) while still owning property M. He then persuaded the potential buyer of property M to buy property R and then he
engaged in a swap. The court found that this was an invalid 1031 exchange because a 3rd party facilitator was not used.
Thus, I urge you to contact a third party facilitator, such as an escrow company, before moving forward.
Business and Profit Seeking Expenses
Section 162 of the Internal Revenue Code allows taxpayers to deduct from their income ordinary and necessary business
expenses paid during the taxable year in carrying on a trade or business. Expenses will be considered a business expense
if the expense benefits the business for less than a year or is considered repair or maintenance. Ordinary means costs
that are customary or expected for the business. Necessary means an expense that is appropriate and helpful to the
business. This section allows a taxpayer to deduct any equipment or similar purchase that costs under $1,000,000 in the
taxable year without worrying about depreciation.
Capital Expenditure
A capital expenditure is an expense that benefits a business for more than one year, and such expenses cannot be
deducted all at one but must be depreciated of a specific amount of years. The two categories of capital expenditures
include costs related to the acquisition of property and the costs for permanent improvement. Section 263 of the
24
Internal Revenue Code allows taxpayers to depreciate the costs related to the acquisition of [commercial reality over 39
years/residential rental reality over 27.5 years]. However, the land which the building sits on is not depreciable.
Additionally, permanent improvements which either adds substantially to the value of the existing property or adapts
the property to a new or different use is including in the depreciation scale. Incidental repairs and maintenance are
exceptions to this general rule and are deducted in the year which the expense is incurred.
Tax Shelters
Section 469 of the Internal Revenue Code forces taxpayers who receive income from businesses in which they do not
materially participate (passive activities) to deduct losses from that business only against other passive income in the
same year, and any unused loss has to be carried over to subsequent years. A passive activity is one in which the
taxpayer spends less than 500 hours a year involved in the business. However, if a taxpayer materially participates,
meaning they exceed 500 hours in a year in participation then the loss is fully deductible against all other income in the
same year the loss is earned. Any excess is carried over to subsequent years for the life of the taxpayer.
If a taxpayer disposes her entire interest in a passive activity, then any carry over losses are deductible against nonpassive income in the tax year sold.
Interest Expense Limitations
If a taxpayer incurred interest expenses in the course of a business in which the taxpayer material participates, then that
interest will be fully deductible in the taxable year it was incurred.
Personal
Gross Income
The court in Glenshaw Glass ruled that gross income is any income from whatever source derived, subject to the Internal
Revenue Code’s exclusions. Income is an increase in wealth plus, in the case of property, a realization event, such as a
sale, exchange or lucky find.
Taxable v. Non-taxable Finds
In the terms of found property, we must assess whether the find is taxable or nontaxable by determining when the
property was reduced to the undisputed ownership to the taxpayer, which would require looking at state property law.
This rule is laid out in Cessarini, in which the taxpayer bought a piano at a garage sale and then found money in the back
of the piano years later. The court held that the money was taxable to the taxpayers in the year it was found in the back
of the piano because under property law that is when they acquired ownership to the money. However, if the found
item is inherently connected to the previous sale or exchange made by the taxpayer, then the item will not be taxed
until it is sold (this is the oil in the ground example).
Gifts/Inheritance
Section 102 of the Internal Revenue Code states that gifts and inheritances are excluded from gross income. In order to
determine if a transfer is a gift we need to assess the transferor’s intent. A gift needs to come from a detached and
disinterested generosity. The presence of these factors show that the transfer was a gift: (1) no strings attached – from
the goodness of the heart, (2) family or other non-commercial relationships, (3) no obligation to make the transfer, (4)
made out of love and affection. The presence of the following factors tend to show that the transfer was not a gift: (1)
strings attached – expecting something in return, (2) business/commercial relationship, (3) obligatory, (4) compensation
for past or future services.
25
This issue of gift took center stage in Duberstein where the taxpayer received a fancy car from a business friend as
payment for providing business referrals to the business friend. The court noted that the intent of the transferor is the
most critical consideration in determining if the transfer is a gift. In this case, the Duberstein court noted that the intent
of the transferor, the business friend, was to compensate the taxpayer for past referrals and to induce future referrals as
well, thus the transfer was not a gift.
Personal Physical Injury Awards
Section 104(a)(2) of the internal revenue code states that gross income does not include the amount of any damages
(excluding punitive damages) received by settlement or suit on account of personal physical injury or physical sickness.
When analyzing if the damages are excluded under 104(a) we need to determine if there was (1) compensation, other
than punitive damages, (2) by settlement or agreement, (3) for a tort or tort like claim, (4) because of physical injury or
physical sickness. If all 4 elements are present, all compensatory damages will be excluded from gross income. There
also must be a causal connection between the tort and physical injury. However, pure emotional distress, such as
stomachaches, insomnia, and headaches are not considered physical injury or physical sickness.
The court in Amos determined that there just needs to be a good faith claim that there was personal physical injury or
physical sickness to qualify.
Personal Physical Injury settlements
While all damages that flow from the tort should be tax free, there have been cases, such as Amos, where the court has
(arbitrarily) chosen how much of the settlement was on account of the physical injury. In order to avoid the courts
arbitrary allocation, the settlement should clearly state the exact amount of the damage for the physical injury, and the
exact amounts for any other parts of the settlements (such as nondisclosure agreements).
Tax Consequences of Divorce
During a divorce, there are three possible ways to treat payments from one spouse to another as a part of a divorce: (1),
property transfers (2) alimony, or (3) child support.
Section 1041 of the Internal Revenue Code states that there is no gain or loss on a property transfer between spouses
incident to divorce. The transfer is treated as a gift (meaning there are no tax implications) for income tax purposes,
with the transferee takes the transferor’s basis. A transfer of property between spouses will be considered incident to
divorce if it occurs within one year of the date of the end of the marriage, or it is happens within six years of the end of
the marriage and the transfer is related to the divorce.
Starting in 2019, alimony will be considered a property transfer and will thus have no tax implications. Before 2019,
alimony may be taxable to the payee and deductible to the payor if: (1) the payments are in cash, (2) the payments are
received by a spouse or someone on behalf of the spouse, (3) the payment is made under a divorce or separation
agreement, (4) the instrument must not designate that the payments are excludable from gross income and
nondeductible to the payer, (5) the payor and payee cannot be members of the same household, and (6) the payer must
have no obligations to make a payment after the payees death.
Child Support payments reflects a pre-existing parental support obligation for which there is no deduction allowed,
these payments are treated as a gift and thus have no tax implications. The payments are not considered income to the
children, and the payments are not deductible by the payor.
26
Discharge of Indebtedness
Section 108 of the Internal Revenue Code states that the discharge of indebtedness is included in income. However,
exceptions apply if the discharge is on account of the taxpayer’s bankruptcy or if the taxpayer is insolvent (owes more
than his current assets).
Life Insurance
Section 101 of the Internal Revenue Code states that gross income does not include amounts received under a life
insurance contract, if such amounts are paid by reason of the death of the insured.
Assignment of Income
There are two types of income that can be assigned: (1) assignment of earned income and (2) assignment of income
from property. The Supreme Court held in Lucas v. Earl that earned income is taxes to the person who earned it. No
assignment, however skillfully drafted, will be effective. However, if the taxpayer abandons the income before he has
earned it, and he did not assign that income, then that income will likely not be taxed to the taxpayer. Additionally,
income from property is taxed to the owner of the property. If an owner assigns the income from the property the
owner is still taxable on the income, but if the owner assigns the property that produces income the assignee is liable for
the taxes on the income it produces.
Capital Gains
Capital assets include vacant land and stocks and bonds and qualified cash dividends on corporate stocks. The favorable
capital gains rate applies on the sale or exchange of these capital asset if held for more than one year. However, the
losses from a capital gain held for more than one year can only be deducted at a max of 3,000 against ordinary income,
with lifetime carryover. Although, the loss is fully deductible about long term capital gains.
27