The Fronks Case: Narrative Solution
Table of Contents:
Course Design Contributors:
Technology Tips:
Enlightened Auditors:
 Fix double exclusion for Health Insurance reimbursements, Katherine, 500
points
 Tom's municipal and State of Idaho bond interest should be excluded,
Tonya and Robyn, 500 points
Useful Commentary/Questions:
The Issues:
Expertise Issues From Case 1:
Issue E1-1:
Tax Formula (MOM: Jana, 450 points; PR: Andy A., 225 points)
Issue E2-1:
Filing Status (MOM: Katherine, 225 points; PR: -----, 113 points)
Issue E3-1:
Accounting Method (MOM: Tonya, 169; PR: Terra, 84 points)
Issue E4-1:
The Fronks' Exemption Status (MOM: Charity, 450 points; PR:
Robyn , 225 points)
Issue E5-1:
The Fronks' Standard Deduction (MOM: Katherine, 113 points;
PR: Jill, 56 points)
Issue E6-1:
Do the Fronks have to File? (MOM: Jill, 225 points; PR: Jana,
113 points)
Issue E7-1:
When Do the Fronks Have to File? (MOM: Terra, 113 points;
PR: Garit, 56 points)
Issue E8-1:
Dividends (MOM: Garit, 113 points; PR: Terra, 56 points)
Issue E9-1:
Casualty Loss (MOM: Andy A., 338 points; PR: Tonya, 169
points)
Issue E10-1:
Charitable Contributions (MOM: Nate, 338 points; PR: Frank,
169 points)
Issue E11-1:
Prizes (MOM: Andy B., 225 points; PR: Tonya, 113 points)
Issue E12-1:
Wages (MOM: Robyn, 113 points; PR: Rebecca, 56 points)
Issue E13-1:
Meals with a Twist (MOM: Akiko, 169 points; PR: -----, 84
points)
Issue E14-1:
Sale of Stock (MOM: Kevin, 844 points; PR: Andy B., 422
points)
Issue E15-1:
Loan Proceeds (MOM: Rebecca, 338 points; PR: Robyn, 169
points)
Issue E16-1:
Scholarships (MOM: Frank, 450 points; PR: Katie, 225 points)
Issue E17-1:
Losses on Personal Loan to ex-Friend (MOM: Jana, 281 points;
PR: Kevin, 141 points)
Issue E18-1:
Gifts (MOM: Katie, 113 points; PR: Nate, 56 points)
Issue E19-1:
IRA's (MOM: Amanda, 338 points; PR: Robyn, 169 points)
Issue E20-1:
Grants (MOM: Tonya, 225 points; PR: Jill, 113 points)
Issue E21-1:
Interest Income (MOM: Charity, 113 points; PR: Akiko, 56
points)
Issue E22-1:
Personal Interest Expense (MOM: Emily, 113 points; PR: Kevin,
56 points)
Issue E23-1:
Earned Income Credit (MOM: Garit, 338 points, PR: Terra, 169
points)
Issue E24-1:
State Tax Refund (MOM: Terra, 225 points; PR: Rebecca, 113
points)
Issue E25-1:
Federal Tax Refund (MOM: Andy A., 113 points; PR: Frank, 56
points)
Issue E26-1:
Personal Expenditures (MOM: Katherine, 113 points; PR:
Emily, 56 points)
Issue E27-1:
Forms (MOM: Nate, 338 points; PR: Katie, 169 points)
Issue E28-1:
Federal Income Tax Withholdings (MOM: Jill, 141 points; PR:
Andy A., 71 points)
Issue E29-1:
Hope and Lifetime Learning Credits (MOM: Robyn, 675 points;
PR: Katherine, 338 points)
Issue E30-1:
Underwithholding Penalty (MOM: Garit, 563 points; PR:
Charity, 281 points)
Issue E31-1:
Tax Liability (MOM: Andy B., 169 points; PR: -----, 84 points)
Issue E32-1:
State Income Tax Withholdings (MOM: Akiko, 113 points; PR:
Tonya, 56 points)
Issue E33-1:
FICA Taxes (MOM: Kevin, 338 points; PR: Garit, 169 points)
Issue E34-1:
Medical Expenses (MOM: Rebecca, 169 points; PR: Amanda, 84
points)
Issue E35-1:
Order of Credit Usage (MOM: Frank, 281 points; PR: Jana, 141
points)
Issue E36-1:
Guaranteed Student Loan Interest (MOM: Emily, 225 points;
PR: Andy A., 113 points)
Expertise Issues From Case 2:
Issue E1-2:
Sales Tax (MOM: Katie, 150 points; PR: Charity, 75 points)
Issue E2-2:
Clothing Deductions (MOM: Amanda, 300 points; PR: Garit,
150 points)
Issue E3-2:
Cancellation of Debt (MOM: Jill, 450 points; PR: -----, 225
points)
Issue E4-2:
Employer Provided Childcare Payments (MOM: Tonya, 300
points; PR: Robyn, 150 points)
Issue E5-2:
Mortgage Interest (MOM: Katherine, 300 points; PR: Charity,
150 points)
Issue E6-2:
Life Insurance Proceeds (MOM: Charity, 225; PR: Rebecca, 113
points)
Issue E7-2:
Personal Property Tax – Ad Valorem (MOM: Jana, 300; PR:
Emily, 150 points)
Issue E8-2:
Moving Expenses (MOM: Terra, 600 points; PR: Jana, 300
points)
Issue E9-2:
Health and Accidental Insurance (MOM: Jill, 225 points; PR: ----, 113 points)
Issue E10-2:
Childcare Credit (MOM: Andy A., 450 points; PR: Katherine,
225 points)
Issue E11-2:
Monica’s IACPA Items Paid by CHE (MOM: Nate, 375 points;
PR: Terra, 188 points)
Issue E12-2:
Cafeteria Benefit Plans in General – Receipt of Cash Payment
(MOM: Garit, 225 points; PR: Andy B., 113 points)
Issue E13-2:
Group-Term Life Insurance (MOM: Akiko, 375 points; PR:
Nate, 188 points)
Issue E14-2:
Flexible Spending Plan (MOM: Kevin, 300 points; PR: Akiko,
150 points)
Issue E15-2:
Employer's Payment of Educational Expenses (MOM: Frank,
300 points; PR: Robyn, 150 points)
Issue E16-2:
Employer Paid Athletic Membership (MOM: Andy B., 300
points; PR: Frank, 150 points)
Issue E17-2:
Presidential Election Campaign Fund Designation (MOM:
Robyn, 225 points; PR: Katie, 113 points)
Issue E18-2:
Children's Tuition Payments: Personal Expense or Charitable
Contribution (MOM: Rebecca, 300 points; PR Amanda, 150
points)
Issue E19-2:
Home Equity Loan Interest (MOM: Amanda, 300 points; PR:
Kevin, 150 points)
Issue E20-2:
Automobile Rebate (Katie, 300, points; PR: Andy B., 150 points)
Issue E21-2:
Apportionment of Property Tax upon Sale (MOM: Emily, 450
points; PR: Jill, 225 points)
Issue E22-2:
Condemnation of Property (MOM: Jana, 450 points; PR:
Katherine, 225 points)
Issue E23-2:
Sale of Personal-Use Portion of Rocky Mountain Home (MOM:
Tonya, 600 points; PR: Emily, 300 points)
Issue E24-2:
Sale of Home – Business Portion of Rocky Mountain Home
(MOM: Garit, (1,500 - 750) points; PR: Tonya, 750 points)
Issue E25-2:
Inherited Property (MOM: Charity, 225 points; PR: Nate, 113
points)
Issue E26-2:
Taxation of Sole Proprietorship (MOM: Katherine, 300; PR:
Akiko, 150 points)
Issue E27-2:
Business (Sole-Proprietorship) Income (MOM: Andy A., 375
points; PR: Charity, 188 points)
Issue E28-2:
Business Expenses (MOM: Terra, 375 points; PR: Katie, 188
points)
Issue E29-2:
Cost Recovery (MOM: Jill, 1,500 points; PR: Terra, 750)
Issue E30-2:
Home Business Expense Deductions (MOM: Nate, 750 points;
PR: -----, 375 points)
Issue E31-2:
Points (MOM: Garit, 300 points; PR: Frank, 150 points)
Issue E32-2:
Interest on State and Municipal Bonds (MOM: Andy B., 150
points; PR: Rebecca, 75 points)
Issue E33-2:
Self-Employment Tax (MOM: Robyn, 750 points; PR Andy A.,
375 points)
Issue E34-2:
Keogh-Plan Contributions (MOM: Akiko, 750 points; PR: Garit,
375 points)
Issue E35-2:
Child Tax Credit (MOM: Frank, 450 points; PR: Jana, 225
points)
Issue E36-2:
401(k) Plans - Employee Contributions (MOM: Rebecca, 300
points; PR: Terra, 150 points)
Issue E37-2:
401(k) Plans - Employer Contributions (MOM: Amanda, 300
points; PR: Robyn, 150points)
Issue E38-2:
Phaseout of Itemized Deductions (MOM: Emily, 450 points; PR:
Kevin, 225 points)
Issue E39-2:
Interest on Educational Savings Bonds (MOM: Katie, 375; PR: Tonya, 188 points)
Issue E40-2:
Signing Bonus (MOM: Jana, 450 points; PR: Akiko 225 points)
Issue E41-2:
Accident and Health Insurance Benefits (MOM: Tonya, 300
points; PR: Katherine, 150 points)
Issue E42-2:
Basis of New Home (MOM: Karrie, 300 points; PR: Rebecca, 150
points)
Issue E43-2:
Alternative Minimum Tax (MOM: Charity, 1500 points; PR:
Katie, 750)
New Issues from Case 3:
Issue N1:
Child Support Payments (MOM: Katie, 200 points; AUD: Jill, 100
points; PR: Nate, 100 points)
Issue N2:
Alimony Payments (MOM: Katie, 800 points; AUD: Jill, 400 points;
PR: Garit, 400 points)
Issue N3:
Travel Expenses (MOM: Jill, 600 points; AUD: Jana, 300 points; PR:
Karrie, 300 points)
Issue N4:
Monica's Mileage (MOM: Tonya, 400 points; AUD: Jana, 200
points; PR: Jill, 200 points)
Issue N5:
Gambling Winnings and Losses (MOM: Jill, 400 points; AUD:
Tonya, Amanda, 200 points; PR: Andy B., 200 points)
Issue N6:
Safe Deposit Box Expenses (MOM: Andy A., (400 - 200) points;
AUD: Amanda, (200 - 100); PR: Terra, 200 points)
Issue N7:
Taxation of Partnerships in General (MOM: Katie, 500 points;
AUD: Rebecca, Katherine, Karrie, 250 points; PR: Amanda, 250
points)
Issue N8:
Limited Partnership Interests and the Passive Loss Provisions
MOM: Katie, 1000 points; AUD: Rebecca 500 points; PR: Emily, 500
points)
Issue N9:
Service Fees - Dentistry (MOM: Jill, 500 points; AUD: Tonya, 250
points; PR: Katie, 250 points)
Issue N10: Monthly rental payments (MOM: Tonya, 200 points; AUD: Andy
B., 100 points; PR: Andy A., 100 points)
Issue N11: Prepayment of final month’s rent (MOM: Tonya, 200 points;
AUD: Andy B., 100 points; PR: Frank, 100 points)
Issue N12: Security Deposit for rental property (MOM: Tonya, 200 points;
AUD: Andy B., 100 points; PR: Robyn, 100 points)
Issue N13: Rental Expenses (MOM: Tonya, 200 points; AUD: Andy B., 100
points; PR: Jana, 100 points)
Issue N14: Prepaid Insurance (MOM: Tonya, (300 - 150) points; AUD: Andy
B., (150 - 75) points; PR: Katie, 150 points)
Issue N15: Depreciation of Residential Rental Property (MOM: Tonya, 600
points; AUD: Andy B., 300 points; PR: Akiko, 300 points)
Issue N16: Passive Losses and Rental Real Estate Activity (MOM: Tonya, 500
points; AUD: Andy B., 250 points; PR: Emily, 250 points)
Issue N17: Worthless Small Business Stock (MOM: Andy B., (400 - 100)
points; AUD: Jill, Karie, (200 - 50) points; PR: Andy A., 200 points)
Issue N18: Wash Sale -- Reacquisition of BioGen Corporation stock (MOM:
Katherine, 500 points; AUD: Karrie, 250 points; PR: Terra, 250
points)
Issue N19: Legal Fees - Will (MOM: Robyn, 300; AUD: Amanda, Frank, 150
points; PR: Jill, 150 points)
Issue N20: Health Insurance - Self-employed Individuals (MOM: Jill, 400
points; AUD: Jana, Garit, 200 points; PR: Amanda, 200 points)
Issue N21: Amy and James’ Dependency Exemptions (MOM: Katherine, 800
points; AUD: Karrie, 400 points; PR: Kevin, 400 points)
Issue N22: Charitable Contribution -- Sole Proprietorship (MOM: Tonya,
400 points; AUD: Frank, 200 points; PR: Andy B., 200 points)
Issue N23: Employment Related Expenses (MOM: Kevin, 300 points; AUD:
Nate, Akiko, 150 points; PR: Rebecca, 150 points)
Issue N24: Business Bad Debts of a Cash Basis Taxpayer (MOM: Jana, 500
points; AUD: Jill, 250 points; PR: Frank, 250 points)
Issue N25: Monica's Computer - Employment Related Expenses (MOM:
Garit, (500 - 200) points; AUD: Andy B., (250 - 100) points; PR:
Karrie, 250 points)
Issue N26: Melinda and Bonnie’s braces (MOM: Andy A., 300 points; AUD:
Garit, 150 points; PR: Jana, 150 points)
Issue N27: Gift loans (MOM: Robyn, 600 points; AUD: Katherine, Karrie, 300
points; PR: Charity, 300 points)
Issue N28: Special Assessments (MOM: Garit, 400 points; AUD: Jana, 200
points; PR: Robyn, 200 points)
Issue N29: Divorced Parents and the Dependency Exemption (MOM:
Jennifer, 400 points; AUD: Andy A., 200; PR: Tonya, 200 points)
Issue N30: Monica's Retirement Plan (MOM: Amanda, (300 - 200) points;
AUD: Andy A., (150 - 100) points; PR: Garit, 150 points)
Issue N31: Investor’s Counsel Fees (MOM: Terra, 300 points; AUD: Frank, 150
points; PR: Nate, 150 points)
Issue N32: Basis of like-kind assets (MOM: Jill, 600 points; AUD: Tonya, 300
points; PR: Katherine, 300 points)
Issue N33: Land Improvement Depreciation (MOM: Garit, (700 - 100) points;
AUD: Robyn, (350 - 50) points; PR: Katie, 350 points)
Issue N34: Vacation Rental Home (MOM: Andy B., 1,000 points; AUD: Tonya,
500 points; PR: Jana, 500 points)
Issue N35: Llamas - Hobby Activity (MOM: Frank, 1000 points; AUD:
Amanda, 500 points; PR: Terra, 500 points)
Issue N36: Class Life of Dental Equipment (MOM: KSB, 500 points; KSB, 250
points; PR: Jill, 250 points)
Issue N37: Sale of Section 1245 Property -- Dental Chair (MOM: Amanda,
(800 - 200) points; AUD: Frank, (400 - 100) points; PR: Andy A., 400
points)
Issue N38: Related-Party Sale -- Bell Corp. Stock (MOM: KSB, 600 points;
AUD: KSB, 300 points; PR: Kevin, 300 points)
Issue N39: Monica's Complimentary Textbook (MOM: KSB, 400 points;
AUD: KSB, 200 points; PR: Jana, 200 points)
Issue N40: Dividends - Life Insurance Policy (MOM: KSB, 300 points; AUD:
KSB, 150 points; PR: Robyn, 150 points)
§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§§
Expertise Issues from Case 1:
Issue E1-1:
Path:
Tax Formula (MOM: Jana, 450 points; PR: -----, 225 points)
CCH Network; USMTG; Spine, Tax Tables--Features,
Computation of Taxable Income; ¶61, Individuals
Narrative Solution:
The computation of an individual's taxable income involves several steps. Items that constitute
income for tax purposes must be sifted from items that do not constitute income. Similarly,
expenses that are deductible must be sifted from expenses that are not deductible. In addition,
deductible expenses must be divided into expenses that are deductible from gross income and
those that are deductible as itemized deductions.
The following outline summarizes the computation of taxable income by an individual and
highlights those items that often enter into this computation.
Numerical Implication Statement:
This documentation suggests the following tax formula as modified to accommodate exclusions
such as gifts:
Income Broadly Conceived
- Exclusions
= Gross Income
- Deductions from Gross Income
= Adjusted Gross Income
- Maximum(Standard Deductions; Itemized Deductions)
- Personal and Dependency Exemptions
= Taxable Income
Tax Liability
- Credits
= Tax Due (Refund)
Issue E2-1:
Path:
Path:
Path:
Path:
(MOM: Karrie, 225 points; PR: -----, 113 points)
RIA Checkpoint, Federal Tax Handbook; Single; Single
Individuals
Path: CCH Online; USMTG; Spine: Individuals, Computing the
Tax; Taxable Income and Rates
CCH Network; USMTG; Keyword: Single; GUIDEBOOK,
2001USMTG ¶173, Who Is a Head of Household?
RIA Checkpoint; FTH; Spine, Chapter 1 Tax Rates & TablesSingle; ¶ 1101. Income tax rates for individuals, & ¶ 1102. Single
individuals.
Narrative Solution:
¶ 1101. Income tax rates for individuals.
Different rates apply to:
... single taxpayers ( ¶ 1102 );
... married persons filing joint returns and qualified widows and widowers ( ¶
1103);
... married persons filing separate returns ( ¶ 1104 );
... heads of households ( ¶ 1105 ).
¶ 1102. Single individuals.
Taxpayers who aren't married at year's end and who don't qualify as surviving spouses or heads
of household, and certain married taxpayers living apart compute their tax under the following
tax rates for single persons if they can't use the tax tables
The rates for 2000 are:
--------------------If taxable income is:
The tax is:
----------------------------Not over $26,250....
15% of taxable income
Over $26,250 but not
over $63,550......
Over $63,550 but not
$3,937.50 plus 28% of the
excess over $26,250
$14,381.50 plus 31% of the
over $132,600.....
Over $132,600 but not
over $288,350.....
Over $288,350.......
excess over $63,550
$35,787.00 plus 36% of
the excess over $132,600
$91,857.00 plus 39.6% of
the excess over $288,350
¶173 Who Is a Head of Household?
In order to qualify for head of household status, a taxpayer must not be married or a surviving
spouse (¶175 ) at the close of the tax year. In addition, the taxpayer must maintain as his home a
household which, for more than one-half of the tax year, is the principal place of abode of one or
more of the following:
(1) A son or daughter, grandchild, or stepchild. If one of the above is married at the close of
the taxpayer's tax year, the taxpayer must be able to claim the person as a dependent (but not
merely by virtue of a multiple support agreement (¶147 )). For purposes of this requirement, an
adopted child or a foster child that has been a member of the taxpayer's household for the entire
year shall be treated as the taxpayer's child by blood. A taxpayer qualified for "head of a
household" status, even though his daughter filed a joint return with her deceased husband,
because all parties had lived with the taxpayer during the entire tax year.[ 2001FED ¶3340.12 ]
(2) Any other person (see (3)(a)-(i) at ¶137 ) eligible to be claimed as a dependent, except for
those eligible to be claimed under a multiple support agreement (¶147 ). A dependent satisfying
the member of taxpayer's household test (see (3)(j) at ¶137 ) is not sufficient to qualify a
taxpayer for head of household status.
Numerical Implication Statement:
Our documentation suggests that there are five basic filing statuses, married filing jointly,
surviving spouse, married filing separately, head of household, and single. It is extremely likely
that the Fronks will use the status of married filing jointly. This generally provides for the
lowest tax liability. However, there is a very slight possibility that they may want to file married
filing separately. This fact should be kept in mind as the return is being prepared and other tax
issues are being resolved. The Fronks' filing status is an important consideration in determining
if the they have to file and in determining their standard deduction amount.
Issue E3-1:
Path:
Path:
Accounting Method (MOM: Tonya, 169; PR: -----, 84 points)
CCH Network; USMTG; Spine, GUIDEBOOK, 2001USMTG
¶1515, Cash v. Accrual Basis
RIA Checkpoint; FTH; Spine, Chapter 11 Tax Accounting-Inventories¶ 2820. Limits on choice of accounting methods.
Narrative Solution:
Taxable income must be computed not only on the basis of a fixed accounting period but
also in accordance with a method of accounting regularly employed in keeping the taxpayer's
books. A "method of accounting" includes the overall method of accounting for income and
expenses and the method of accounting for special items such as depreciation (Reg. §1.446-1(a)
).[ 2001FED ¶20,607 ] There are two common overall methods of accounting for income: (1) the
cash basis and (2) the accrual basis.
The cash basis (cash receipts and disbursements) is the method of accounting
used by most individuals. Income is generally reported in the year that it is actually or
constructively received in the form of cash or its equivalent or other property. Deductions or
credits are generally taken for the year in which the related expenditures were actually paid,
unless they should be taken in a different period to more clearly reflect income (examples would
include depreciation allowances and prepaid expenses). When no books are kept, an individual
not engaged in business must report income on the cash basis.
[ 2001FED ¶20,620.0254 ] In other cases, the accounting method used must clearly reflect
income. An approved standard method of accounting (such as the cash basis or the accrual basis)
ordinarily is regarded as clearly reflecting income.
Under the accrual method, income is accounted for when the right to receive it comes
into being--i.e., when all the events that determine the right have occurred. It is not the actual
receipt but the right to receive that governs. Expenses are deductible on the accrual basis in the
year incurred--i.e., when all the events have occurred that fix the amount of the item and
determine the liability of the taxpayer to pay it. See ¶1539 for a discussion of this "all-events
test" as it relates to economic performance.
As a general rule, a taxpayer may not change his method of accounting without obtaining
advance permission from the IRS (Code Sec. 446(e) ; Reg. §1.446-1(e) ).[ 2001FED ¶20,606 ,
2001FED ¶20,607 ]
Application for permission to change the method of accounting must generally be
filed on Form 3115 during the tax year in which the taxpayer desires to make the proposed
change (Reg. §1.446-1(e)(3)(i) ).[ 2001FED ¶20,608 ]
Numerical Implication Statement:
The cash basis (cash receipts and disbursements) is the method of accounting used by most
individuals. Since the Fronks have no unique considerations that would suggest otherwise, they
need to use the cash-basis accounting method.
Issue E4-1:
The Fronks' Exemption Status (MOM: Charity, 450 points; PR:
-----, 225 points)
Narrative Solution:
Path: CCH Internet; 2001 USMTG, Individuals; Personal Exemption; GUIDEBOOK,
2001USMTG ¶133, Exemption Amount
The amount of a personal exemption (for taxpayer and his spouse) and of a dependency
exemption (for taxpayer's dependents) is $2,800 for 2000. This amount is adjusted
annually to reflect the inflation rate. For 2001, the exemption amount is unofficially
projected by CCH to be $2,900. For tax returns due on or after September 19, 1996, the
exemption is denied to claimants who fail to provide the dependent's correct taxpayer
identification number on the return claiming the exemption.
The deduction for exemptions may be reduced or eliminated for higher-income taxpayers
The exemption for a taxpayer whose adjusted gross income exceeds the set threshold
amount, based on filing status is reduced by 2% for each $2,500 ($1,250 for a married
person filing separately) or fraction thereof by which AGI exceeds the threshold amount.
The 2000 threshold amounts are: (1) $193,400 for joint returns or a surviving spouse; (2)
$161,150 for a head of household; (3) $128,950 for single taxpayers; and (4) $96,700 for
married persons filing separately. Phase out thresholds for 2001, as unofficially projected
by CCH, will increase to $199,450 (joint return or surviving spouse), $166,200 (head of
household), $132,950 (single taxpayer), and $99,725 (married filing separately).
Path: RIA: 2000 RIA Federal Tax Handbook; Exemption Amount; ¶ 3114 Deduction for
personal exemptions.
Each taxpayer may be entitled to an exemption for himself and spouse and may
qualify for an additional exemption for each dependent.
The exemption amount is $2,800 for 2000, and $2,900 for 2001. However, an
individual (e.g., a child) who can be claimed as a dependent by another (e.g., the
child's parent) can't claim a personal exemption for himself.
Path: RIA Checkpoint; Federal Tax Coordinator d2; Support Requirements for Dependents; A3700 Support Requirements for Dependents
As explained at paragraph 3600 et seq., the support test is one of five tests which a
taxpayer must meet before the taxpayer is allowed an exemption deduction for a
dependent. Under the support test, a taxpayer, either alone or together with others, must
provide over half of the support of the person claimed as a dependent for the calendar
year in which taxpayer's tax year begins. 1 Here is how the support test works:
(1) If a person actually provides more than half of his or her own support for the
calendar year, no one can meet the support test and therefore no one can claim
that person as a dependent.
Path: RIA; 2000 RIA Federal Tax Handbook; Dependent Expemption; Chapter 13
Individual's Tax Computation – Kiddie Tax – Self-Employment Tax – Estimated
Tax; ¶ 3100 How Income Tax on Individuals is Computed; ¶ 3118 Exemption for
dependents.
A taxpayer is entitled to a deduction equal to the exemption amount for each
person who qualifies as his “dependent.” A person qualifies as taxpayer's
dependent only if all of these tests are met:
(1) The person is related to the taxpayer or is a member of the taxpayer's
household.
(2) The person's gross income doesn't equal or exceed the exemption amount
(except for certain children).
(3) The taxpayer provides certain support to the person.
(4) The person doesn't file a joint return under certain conditions.
(5) The person meets tests concerning citizenship or is a resident of the U.S.,
Canada or Mexico.
However, no exemption is allowed for any individual unless the individual's TIN is
included on the return claiming it.
Issue: Amy’s Dependency Exemption
Path: CCH;Fed Tax Guide; keyword=dependent earnings;¶147, Support of Dependent
A taxpayer must furnish more than one-half of the total support provided during the calendar
year before claiming an exemption for a dependent. If more than half of the support is provided
by two or more people, the dependency exemption is not necessarily lost. A person can be
treated, for purposes of the exemption, as having provided more than half of an individual's
support if: (1) no one person provided over half of the support; (2) over half of the support was
received from persons who each would have been entitled to claim the exemption had they
contributed more than half of the support; (3) over 10 percent of the support was provided by the
person claiming the exemption; and (4) each person who contributed more than 10 percent of the
support signs a written declaration (Form 2120 ) stating that they will not claim the exemption,
which is attached to the return of the taxpayer claiming the exemption
"Total" support is determined on a yearly basis and is the sum of (1) the fair rental value of
lodging furnished to a dependent, (2) the costs of all items of expense paid out directly by or for
the benefit of the dependent, such as clothing, education, medical and dental care, gifts,
transportation, church contributions, and entertainment and recreation, and (3) a proportionate
share of the expenses incurred in supporting the whole household that cannot be directly
attributed to each individual, such as food. Item (3) does not include items that represent the
cost of maintaining a house, such as heat, electricity, repairs, taxes, etc., because these costs are
accounted for in the fair rental value of the lodging furnished the dependent. Medical care
includes the premiums paid on a medical care policy, but not the benefits provided by the policy.
Medicare benefits, both basic and supplementary, as well as Medicaid, are also disregarded in
determining support.
Some capital expenditures qualify as items of support, such as the cost of an automobile
purchased for a dependent and the cost of furniture and appliances provided to the dependent.
However, the following have been held or ruled not to be items of support: (1) income and social
security taxes paid by a dependent child from his own income; (2) funeral expenses of a
dependent; (3) costs incurred by a parent in exercising
visitation rights; and (4) life insurance premium costs.
In determining whether a taxpayer furnished more than one-half of a dependent's total
support, the support provided by the taxpayer, by the dependent, and by third parties must be
taken into account. In addition, only the amount of the cash actually expended for items of
support is taken into account. However, the source and tax status of money used to provide
support is, generally, not controlling. It may come from taxable income, tax-exempt receipts, and
loans. Furthermore, the year in which the support is received, and not the year of payment of the
indebtedness incurred, is controlling in determining whether over one-half of the support is
furnished by the taxpayer, regardless of his method of tax accounting.
In the case of the taxpayer's child or stepchild who is a student, any amounts received as
scholarships (including the value of accommodations furnished to a student nurse) do not have to
be taken into account. Educational benefits received under the United States Navy's educational
assistance program are not considered to be scholarships.
…But a taxpayer's child who has not attained age 19 or who was under age 24 and was a fulltime student at a regular educational institution or as pursuing a full-time, accredited, on-farm
training course during each of five calendar months in 2000 may be claimed as a dependent (if
the taxpayer satisfies the support test), regardless of the amount of the child's income.
Gifts and bequests of income, and the income from property that is received as a gift or bequest,
are taxable to the recipient, whether paid periodically or in a lump sum
But a taxpayer's child (¶137 ) who has not attained age 19 or who was under age 24 and was a
full-time student at a regular educational institution or was pursuing a full-time, accredited, onfarm training course during each of five calendar months in 2000 may be claimed as a dependent
(if the taxpayer satisfies the support test), regardless of the amount of the child's income. The
five calendar months need not be consecutive. In fixing the $2,800 income ceiling, any income
excludable from the claimed dependent's gross income (such as exempt interest, disability, or
social security) is disregarded. This income, however (except a student's scholarship), if used to
any extent for support of the dependent, must be taken into account (to the extent that it was so
used) to determine whether the taxpayer has furnished more than one-half of the claimed
dependent's support.
Numerical Implication Statement:
This documentation makes it clear that Tom and Monica each get an exemption amount. A
dependency exemption is available for each dependent that satisfies the citizenship, joint-return,
relationship, support, and gross-income test. In general, the support test is satisfied if over 50
percent of the dependent's support comes from the taxpayers and the gross-income test is
satisfied when the dependent's income is less than the $2,800 exemption amount. James clearly
meets all of those tests. Scott's case is not so clear. The gross income test is not a problem
because he's a student less than 24 years of age and thus can earn all he wants. The support test
at first appears problematic. However, scholarships do not count towards the support test nor
those amounts not spent (specifically, the unspent internship income). Thus, Scott's support of
$6,111 is less than that provided by his parents, $6,500. Exemptions are subject to a phaseout
that begins at $193,400 for married-filing joint couples. The excess is measured in $2,500
increments each (or part thereof) of which results in 2 percent reduction in the total exemptions.
Melinda's situation is an interesting one. The only dependency test at issue for Melinda is the
support test. With dividend proceeds of $25,000, bank account interest of $240 (a $6,000
average balance), and an interest rate of 4 percent, it appears that Melinda contributed $19,000 to
her own support (she has title to the portfolio) and Tom contributed $7,653 (see issue NXX) via
the imputed interest provisions on gift loans. Thus, its clear that Tom fails the support test and
looses Melinda's dependency exemption.
Owing to some unique consideration, Amy and James Casselmens' case is considered
under separate disclosure as a new issue.
Issue E5-1:
Path:
Path:
The Fronks' Standard Deduction (MOM: Katherine, 113 points;
PR: -----, 56 points)
CCH Network; USMTG; Spine, GUIDEBOOK, 2001USMTG
¶126, Taxable Income and Rates
RIA Checkpoint; FTH; Spine, RIA Federal Tax Handbook Chapter
13 Individual's Tax Computation ¶ 3111 Standard deduction.
Narrative Solution:
The amount of the standard deduction varies according to the taxpayer's filing status.
This deduction, together with the taxpayer's personal and dependency exemptions, applies to
reduce adjusted gross income in arriving at taxable income. Listed below are the standard
deduction amounts available in 2000 to individuals other than those who are age 65 or older or
who are blind:
Filing status
Married filing jointly and surviving spouses
Married filing separately
Head of household filers
Single filers
2000 standard
deduction amount
$7,350
$3,675
$6,450
$4,400
A special rule applies to an individual for whom a dependency exemption is allowable to
another taxpayer. Such individual's basic standard deduction may not exceed the greater of $700
(to increase to $750 in 2001) or the sum of $250 and the individual's earned income, up to the
applicable standard deduction amount ($4,400 for single taxpayers) (Code Sec. 63(c)(5) ).[
2001FED ¶6020 ] Thus, a child who may be claimed as a dependent by his parents and who has
no earned income and $700 of interest or dividend income will have a $700 standard deduction.
A scholarship or fellowship grant that is not excludable from the dependent's income (see ¶879 )
is considered earned income for standard deduction purposes.[ 2001FED ¶7170.06 ]
¶126, Taxable Income and Rates
Individuals who do not itemize their deductions are entitled to a standard deduction amount
which varies according to filing status.
A special rule applies to an individual for whom a dependency exemption is allowable to
another taxpayer. Such individual's basic standard deduction may not exceed the greater of $700
(to increase to $ 750 in 2001) or the sum of $250 and the individual's earned income, up to the
applicable standard deduction amount ($4,400 for single taxpayers) (Code Sec. 63(c)(5)).[
2001FED ¶6020 ] Thus, a child who may be claimed as a dependent by his parents and who has
no earned income and $700 of interest or dividend income will have a $700 standard deduction.
A scholarship or fellowship grant that is not excludable from the dependent's income (see ¶879)
is considered earned income for standard deduction purposes.[ 2001FED ¶7170.06 ]
Numerical Implication Statement:
Given the Fronks are going to file married filing jointly, their standard deduction is $7,350. The
standard deduction is an important consideration in resolving whether the Fronks have to file and
itemize. In terms of the tax formula, the standard deduction shows up as a contender along side
itemized deductions.
Issue E6-1:
Path:
Path:
Do the Fronks have to File? (MOM: Jill, 225 points; PR: -----,
113 points)
CCH Network; USMTG; Spine, Individuals (Chapter 1), ¶109,
Citizens and Residents
RIA Checkpoint; FTH; Spine, Chapter 13 Individuals Tax
Compensation – Kiddie Tax – Self Employment Tax – Estimated
Tax; ¶3111 How Income Tax on Individuals is Computed
Narrative Solution:
For each tax year, a return must be made by a U.S. citizen or a resident alien who has at least a
specified minimum amount of gross income. The income levels at which individuals must file
income tax returns for 2000 (even though no tax is owed) are generally as follows (Code Sec.
6012 ): [ 2001FED ¶35,142 ,
2001FED ¶35,150.21 ]
Single individual (also individuals treated as unmarried
for tax purposes; see ¶173 ) ......................………………….. $ 7,200
Single individual, 65 or older .........................…………........... 8,300
Married individual, separate return .................……….............. 2,800
Married couple, joint return ...............................…………...... 12,950
Married couple, joint return, one spouse 65 or older ............... 13,800
Married couple, joint return, both spouses 65 or older ............ 14,650
Head of household .....................................……………........... 9,250
Head of household, 65 or older .................…………................ 10,350
Qualifying widow(er) ................................……………............ 10,150
Qualifying widow(er), 65 or older ..............……….................. 11,000
Numerical Implication Statement:
This table shows that amounts at which the applicable taxpayers must file a tax return. The
amounts appearing in that table are the sum of the applicable individual'(s)' standard deduction
amount and the available exemption amount(s). Because the Fronks' income gross minimum
income is over 12,950 (the threshold for filing married - joint return) they will need to file a tax
return.
Issue E7-1:
Path:
Path:
When Do the Fronks Have to File? (MOM: Terra, 113 points;
PR: -----, 56 points)
CCH Network; USMTG; Spine, Individuals (Chapter 1), Date;
¶118 Due Date
RIA Checkpoint; FTH; Federal Editorial Materials, RIA Federal
Tax Handbook; ¶1000 Tax Calendar-2001 due dates
Narrative Solution:
¶118, Due Date
The individual income tax return is due on or before the 15th day of the 4th month following the
close of the tax year (April 15 in the case of a calendar-year taxpayer) (Reg. §1.6072-1(a) ).[
2001FED ¶36,721 ] If the due date falls on a Saturday, Sunday, or legal holiday, the return may
be filed on the next succeeding day that is not a Saturday, Sunday, or legal holiday (Reg.
§301.7503-1 ).[ 2001FED ¶42,631 ]
Numerical Implication Statement:
Individuals must file their returns by April 15th in the year following the close of the tax year. If
the 15th falls on a holiday or weekend, there is an automatic extension to the succeeding day that
is not a weekend day or a holiday. This issue does not have an explicit tax formula impact.
Issue E8-1:
Path:
Dividends (MOM: Garit, 113 points; PR: -----, 56 points)
CCH Network; USMTG, Search, Dividends; Guidebook
2001USMTG ¶733, Dividends.
CCH Network; USMTG; Spine, Special Corporate Status (Chapter
23), Dividends; ¶2303, Distribution to Shareholders
Path:
RIA Checkpoint, FT Handbook; Spine, Contents, Federal Library,
Federal Editorial Materials, RIA Federal Tax Handbook,
Dividends ¶1200 Gross Income.
Narrative Solution:
Dividends are fully includible in gross income. For income tax purposes, the term "dividend"
means any distribution made by a corporation to its shareholders, whether in money or other
property, out of its earnings and profits accumulated after February 28, 1913, or out of earnings
and profits of the tax year (Code Sec. 316(a) ; Reg. §1.316-1 ).[ 2001FED ¶15,702 , 2001FED
¶15,703 ] See ¶747 .
Gross income consists of all income, from all sources, such as compensation for services,
business income, interest, rents, dividends and gains from the sale of property. Only items
specifically exempt may be excluded.
When a corporation distributes its earnings to its shareholders, the distribution is usually a
dividend, taxable to them as ordinary income. But not all corporate distributions are dividends.
And some transactions that don't appear to be dividends may be taxed as constructive dividends.
The shareholder is then taxed on the distributions. (¶237 ) (Code Sec. 854(b) ).[ 2001FED
¶26,460 ]
Numerical Implication Statement:
Tom's $40,000 and Monica's $18,000, as reported on 1099-DIV, must be included in gross
income. As a practical tax-formula matter, those dividends must be reported in income broadly
conceived.
Issue E9-1:
Path:
Path:
Casualty Loss (MOM: Andy A., 338 points; PR: -----, 169 points)
CCH Network; USMTG; Spine, GUIDEBOOK, 2001USMTG
¶1131, Amount of Casualty Loss
RIA Federal Tax Handbook; FTH; Spine, Chapter 4 Interest
Expense--Taxes--Losses--Bad Debts ¶ 1794 Casualty losses--Form
4684. 1
Narrative Solution:
¶ 1794. Casualty losses-Form 4684.
A deduction is allowed for losses arising from a casualty (¶ 1795) where taxpayer actually
sustains a loss and the loss is on property. (Code Sec. 165(c)(3)) The property must suffer
physical damage and not just a decline in value, even if that decline results from being in or near
an area where casualties have occurred and might occur again. FTC ¶ M-1601; USTR ¶
1654.300 et seq.; Tax Desk ¶ 36,604 Casualty losses and theft losses are reported on Form 4684.
FTC ¶ M-1600; FTC ¶ M-2132; USTR ¶1654.370; Tax Desk ¶ 36,600
¶1131, Amount of Casualty Loss
The amount of a casualty loss (business or nonbusiness) is the lesser of (1) the difference between the fair market
value of the property immediately before the casualty and its FMV immediately thereafter or (2) the adjusted basis
of the property immediately before the casualty.[ 2001FED ¶10,004 ] The amount of a theft loss is (1) the amount of
money stolen or (2) the lesser of the value of the property other than money or its adjusted basis.[ 2001FED ¶10,100
, 2001FED ¶10,101.113 ] A business casualty loss is fully deductible. A personal casualty loss is subject to a $100
floor and to a 10%-of-AGI limitation (see ¶1134 and 1137 ). When there is damage to different kinds of business
property, loss must be computed separately for each single, identifiable property damaged or destroyed. This rule
does not apply to nonbusiness property. Thus, if a tree is blown down in the front yard of a taxpayer's residence, the
loss is the difference in the FMV of the taxpayer's whole property before and after damage to the tree (Reg. §1.1657(b) ).[ 2001FED ¶10,004 ]
Numerical Implication Statement:
A business casualty loss is fully deductible. Personal casualty losses are deductible as itemized
deductions. The amount of their loss is determined as follows: (minimum(FMV before - FMV
after; adjusted basis) - insurance proceeds - $100 deductible per casualty. The net loss resulting
from offsetting casualty gains against casualty losses is deductible only to the extent that it
exceeds 10% of AGI. The Fronks had a decline in the fair market value of their vacation rental
home of $25,000. Their adjusted basis was $17,000. Thus, the applicable loss before insurance
recovery and itemized deduction adjustments is $17,000. Taking into account the insurance
recovery, the Fronks' loss is $7,000. Of that amount, 120 / 366 or $2,295, is allocable to rental
activity and the remainder, $4,705, is personal. Given there are no casualty gains, the Fronks
personal deductible casualty loss becomes $4,662 - $100 - ($BIG AGI * .10)) = $0. The Fronks
also have a loss from the business-use portion of the Rocky Mountain home. In that case, their
loss is the minimum(20,000; 15,400) - 14,400 = 1,000. The casualties related to the businesses
are in essence deductions from gross income. Those losses are reported on Form 4684.
Issue E10-1:
Path:
Path:
Charitable Contributions (MOM: Nate, 338 points; PR: -----, 169
points)
CCH Network; USMTG; Spine, Deductions (Chapter 9-12),
Charity; ¶1061, Contributions that are deductible.
RIA Checkpoint; FTH; Spine, Chapter 6 Charitable Contributions;
¶ 2100 Charitable Contribution Deduction.
Narrative Solution:
¶1061, Contributions that are deductible
A contribution is deductible only if made to, or for the use of, the following qualified
organization:
A corporation, trust, or community chest, fund, or foundation, created or organized in the
United States or in any possession or under the law of the United States, any state, the District of
Columbia, or any possession of the United States, organized and operated exclusively for
religious, charitable, scientific, literary or educational purposes, or to foster national or
international amateur sports competition, or for the prevention of cruelty to children or animals,
no part of the net earnings of which inures to the benefit of any private shareholder or individual
(e.g., nonprofit hospitals and churches and synagogues). Also, the organization must not be
disqualified for tax exemption under Code Sec. 501(c)(3) by attempting to influence legislation.
¶ 2138 Substantiating Charitable Contributions--$250, $500 and $5,000 Rules.
Taxpayers (donors) must substantiate their charitable deductions, and supply appraisals and other
information for certain property contributions. No charitable deduction is allowed for a
contribution of $250 or more unless taxpayer substantiates it by a contemporaneous written
acknowledgement from the donee.
¶ 2139. Charitable contributions must be substantiated; donee's receipt.
A charitable deduction isn't allowed unless the taxpayer can prove his right to it. ( Code Sec.
170(a)(1) ) FTC ¶ K-3901 et seq.; USTR ¶ 1704.50 , Tax Desk ¶ 33,401
For cash contributions, the taxpayer must keep either a cancelled check, receipt or other reliable
evidence. ( Reg § 1.170A-13(a)(1) ) FTC ¶ K-3919 ; USTR ¶ 1704.50 ; Tax Desk ¶ 33,409 For
contributions of property (other than cash), the taxpayer must have a receipt from the donee and
keep records showing the donee's name and describing the gift. ( Reg § 1.170A-13(b)(1) ) FTC ¶
K-3926 , FTC ¶ K-3927 ; USTR ¶ 1704.50 ; Tax Desk ¶ 33,413
For additional substantiation required for contributions of $250 or more, see ¶ 2140 , over $500
but not more than $5,000, see ¶ 2141 , or over $5,000, see ¶ 2142 .
¶ 2140. Substantiation requirement for contributions of $250 or more.
No charitable deduction is allowed for any (cash or property) contribution of $250 or more
unless taxpayer substantiates it by a contemporaneous written acknowledgement (but not just a
cancelled check) from the donee organization.
In general, the written acknowledgment must state: (1) the amount of cash and a description (but
not the value) of any property other than cash contributed; (2) whether the donee provided any
goods or services in consideration for the contribution; (3) a description and good-faith estimate
of the value of those goods or services; and (4) if the goods or services consist entirely of
intangible religious benefits (e.g., admission to a religious ceremony), a statement to that effect. (
Code Sec. 170(f)(8)(B)(i) ; Reg § 1.170A-13(f)(2) ) Special requirements apply for the
contemporaneous written acknowledgment of a charitable transfer to a pooled income fund ( ¶
2121 ). ( Reg § 1.170A-13(f)(13) ) FTC ¶ K-3933 et seq.; USTR ¶ 1704.50 ; Tax Desk ¶ 33,417
et seq.
Separate payments are generally treated as separate contributions and aren't aggregated ( Reg §
1.170A-13(f)(1) ), but IRS is expected to issue anti-abuse rules. FTC ¶ K-3934 ; USTR ¶
1704.50 ; Tax Desk ¶ 33,418
¶ 2100 Charitable Contribution Deduction.
An individual who itemizes can deduct charitable contributions up to 50%, 30% or 20% of his
adjusted gross income, depending on the type of property contributed and the type of donee. A
corporation can deduct charitable contributions up to 10% of its taxable income. Amounts that
exceed the ceilings can be carried forward for five years. The deduction allowed for property
contributions is usually the property's fair market value, but the deduction is reduced for gifts of
certain types of property.
For individuals, charitable contributions are deductible only as an itemized deduction on
Schedule A (Form 1040). ( Reg § 1.170A-1(a) ) FTC ¶ A-2701 ; USTR ¶ 1704.01 ; Tax Desk ¶
33,021. For the charity's requirement to disclose the deductibility of contributions to it, see ¶
4115
¶ 2127. Charitable deduction ceilings for individuals.
There's a ceiling on the amount an individual may deduct each year as a charitable contribution,
based both on the type of property contributed and the type of charity to which the contribution
is made. The ceilings (below) for any tax year are a percentage of taxpayer's “contribution base”
(below) for the year, subject to an overall 50% ceiling for all charitable gifts. ( Code Sec.
170(b)(1) ) FTC ¶ K-3670 ; USTR ¶ 1704.05 ; Tax Desk ¶ 33,301 For carryover of excess
contributions, see ¶ 2133 .
If the contributions are all to “50% charities” (listed at ¶ 2128 ), the year's ceiling is 50% of
taxpayer's contribution base for the year, except for contributions of appreciated capital gain
property ( ¶ 2130 ). ( Code Sec. 170(b)(1)(A) ) FTC ¶ K-3671 ; USTR ¶ 1704.05 ; Tax Desk ¶
33,304
If the contributions are all to “30% charities” ( ¶ 2129 ), or are “for the use” of any charities, the
ceiling is 30% of taxpayer's contribution base (except for contributions of appreciated capital
gain property, see ¶ 2130 ) or, if less, 50% of his contribution base minus his contributions to
50% charities. ( Code Sec. 170(b)(1)(B) ; Reg § 1.170A-8(c) ) FTC ¶ K-3671 , FTC ¶ K-3674 ,
FTC ¶ K-3684 et seq. ; USTR ¶ 1704.05 , USTR ¶ 1704.10 et seq. ; Tax Desk ¶ 33,309
An individual's “contribution base” for a year is his adjusted gross income (AGI) for the year,
but without deducting any NOL carryback to that year. ( Code Sec. 170(b)(1)(F) ) FTC ¶ K-3672
; USTR ¶ 1704.05 ; Tax Desk ¶ 33,302
For spouses filing joint returns, these ceilings apply to the couple's combined contributions and
their combined contribution base. ( Reg § 1.170A-2(a)(1) , Reg § 1.170A-8(a)(1) ) FTC ¶ K3673 ; USTR ¶ 1704.06 ; Tax Desk ¶ 33,303
¶ 2128. 50% charities.
For purposes of the deduction ceilings for individuals ( ¶ 2127 ), “50% charities” are:
(1) churches (or church conventions or associations);
(2) tax-exempt educational organizations;
(3) tax-exempt hospitals and certain medical research organizations;
(4) certain organizations holding property for state and local colleges and universities;
(5) a U.S. state or possession, or any political subdivision of any of these, or the U.S. or the
District of Columbia, if the contribution is for exclusively public purposes;
(6) an organization organized and operated exclusively for charitable, religious, educational,
scientific or literary purposes, or for the prevention of cruelty to children or animals, or to foster
national or international amateur sports competition if it normally gets a substantial part of its
support from the government or general public;
(7) certain private foundations;
(8) certain membership organizations more than one-third of whose support comes from the
public. ( Code Sec. 170(b)(1)(A) ) FTC ¶ K-3720 et seq.; USTR ¶ 1704.08 ; Tax Desk ¶ 33,305
¶ 2129. 30% charities.
For purposes of the ceilings on an individual's charitable deduction ( ¶ 2127 ), “30% charities”
are qualifying charitable organizations ( ¶ 2102 ), that aren't 50% charities ( ¶ 2128 ), e.g., war
veterans' organizations, fraternal orders, cemetery companies, and certain private nonoperating
foundations. ( Code Sec. 170(b)(1)(B) ; Reg § 1.170A-8(c) ) FTC ¶ K-3684 et seq.; USTR ¶
1704.05 , USTR ¶ 1704.10 et seq. ; Tax Desk ¶ 33,310
¶ 2132. Gifts of appreciated capital gain property to 30% charities—20% ceiling.
An individual's deduction ceiling for gifts of appreciated long-term capital gain property to 30%
charities is 20% of his contribution base ( ¶ 2127 ) (and there's no election like the one for gifts
to 50% charities, see ¶ 2131 ). ( Code Sec. 170(b)(1)(D) ) FTC ¶ K-3700 ; USTR ¶ 1704.11 ; Tax
Desk ¶ 33,316
Numerical Implication Statement:
Contributions made to a qualified organization such as a church qualify as an itemized deduction
whose deductibility is limited, in the case of a cash gift, to 50 percent of adjusted gross income
(i.e., the contribution base). In this case, the Fronks' $29,490 contribution would appear as an
itemized deduction and be limited to no more than 50 percent of AGI. This ceiling limitation is
unlikely to restrict the deductibility of the Fronks' contribution. Thus, the only real impediment
to deductibility is their standard deduction, which in this case is easily thwarted.
Issue E11-1:
Path:
Path:
Prizes (MOM: Andy B., 225 points; PR: -----, 113 points)
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable and
Exempt; ¶ 1384. Prizes and awards
CCH Network; USMTG; Spine, Income (Chapter 7), Contests;
¶785, Taxed with One Exception.
Narrative Solution:
¶ 1384. Prizes and awards.
All prizes and awards (with certain exceptions, see ¶ 1385 ) are includible in gross income (
Code Sec. 74(a) ; Reg § 1.74-1(b) ) unless: the prize is primarily for religious, charitable,
scientific, educational, artistic, literary, etc., achievement; the recipient was selected without any
action on his part, and thus isn't required to render substantial future services; and it's transferred
by the payor to a governmental unit or charity the recipient designated ( Code Sec. 74(b) ) FTC ¶
J-1201 et seq. ; USTR ¶ 744 ; Tax Desk ¶ 19,401 before getting any benefit from it. FTC ¶ J1208 ; USTR ¶ 744.01 ; Tax Desk ¶ 19,406 IRS specifies the requirements of the designation
(including model language). FTC ¶ J-1210 ; USTR ¶ 744.01 ; Tax Desk ¶ 19,408 For employee
awards, see ¶ 1255 .
For a prize paid in property or services, the taxable amount is the prize's current fair market
(resale) value. ( Reg § 1.74-1(a)(2) ) FTC ¶ J-1223 ; USTR ¶ 744.04 ; Tax Desk ¶ 19,420
Under the principle of constructive receipt ( ¶ 2825 ), the winner of a contest (e.g., a lottery,
jackpot) who is given the option of receiving either a lump sum or an annuity has to include the
value of the award in gross income, even if he or she takes the annuity. However, in the case of a
cash basis individual, a “qualified prize option” (to choose either cash or an annuity not later
than 60 days after becoming entitled to the prize) is disregarded in determining the tax year for
which any portion of a “qualified prize” (one payable over at least 10 years and that meets other
requirements) is included in income. ( Code Sec. 451(h) ) That is, the individual doesn't have to
include the value of the prize in income immediately merely by having had the option to choose
cash. FTC ¶ G-2424.2 ; USTR ¶ 4514.043 ; Tax Desk ¶ 44,112
Numerical Implication Statement:
On 12/31/2000, Tom won a $21,000 Volkswagon Beetle as a door prize at party. The prize is not
for religious, charitable, scientific, educational, artistic, literary, etc., achievement nor was the
prize given immediately to a qualified organization. Since the prize was not received for
acceptable undertakings nor appropriately given away thereafter, it is not excludable. Tom must
report the $21,000 Beetle at its full market value of $21,000. Since it is includible in gross
income, it must as a practical matter be included in income broadly conceived.
Issue E12-1:
Path:
Wages (MOM: Robyn, 113 points; PR: -----, 56 points)
CCH Network; USMTG; Spine, Income (Chapter 7), Salaries,
Wages and Benefits; ¶713, Compensation Is Income
Path:
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable and
Exempt; ¶ 1207 Compensation Income.
Narrative Solution:
¶713, Compensation Is Income
All compensation for personal services, no matter what the form of payment, must be included in
gross income. [ 2001FED ¶5507.01 ] Wages, salaries, commissions, bonuses, fringe benefits that
do not qualify for statutory exclusions, tips, payments based on a percentage of profits, directors'
fees, jury fees, election officials' fees, retirement pay and pensions, and other forms of
compensation are income in the year received, and not in the year earned, unless the taxpayer
reports income on the accrual basis.
Numerical Implication Statement:
Wages must be included in gross income. From a tax formula perspective, since gross income is
an artifact or derived from the relationship of tax-formula elements, i.e., gross income = income
broadly conceived - exclusion), wages must be included in income broadly conceived. In
particular, Monica's 2000 wages totaling $80,845 must be included in income broadly conceived.
Issue E13-1:
Meals with a Twist (MOM: Akiko, 169 points; PR: -----, 84
points)
Narrative Statement:
Path: CCH Network; USMTG; keyword: meals; ¶873, Food and Lodging Provided by
Employer
Effective for tax years beginning after December 31, 1997, meals that are excluded from an
employee's income under Code Sec. 119 are considered a de minimis fringe benefit under Code
Sec. 132 .[ 2001FED ¶7420 ] The IRS Restructuring and Reform Act of 1998 provided that if
more than one-half of the employees are furnished meals for the convenience of the employer, all
meals provided on the premises are treated as furnished for the convenience of the employer.
Therefore, the meals will be fully deductible by the employer, instead of possibly being subject
to the 50-percent limit on business meal deductions, and excludable by the employees. The
value of meals and lodging furnished by an employer to an employee, a spouse, or dependents
for the employer's convenience is not includible in the employee's gross income if, in the case of
meals, they are furnished on the employer's business premises
Path: CCH Network; Federal Tax Service; keyword: employer operated eating facilities;
§B:10.142, Employer-Operated Eating Facilities
Meals received in an employer-operated eating facility are de minimis fringes if the facility is
located on or near the employer's business premises and revenue from the facility equals or
exceeds the facility's direct operating costs.30 See §B:10.142[2] for discussion of the amount
excludable. This exclusion is available to highly compensated employees only if the access to the
facility is available on substantially the same terms to each member of a group of employees that
is defined under a reasonable classification of employees that does not discriminate in favor of
highly compensated employees.31 See §B:10.142[1] for discussion of these nondiscrimination
rules.
30 Code Sec. 132(e)(2); Reg. § 1.132-7(a)(1)(i).
31 Reg. § 1.132-7(a)(1)(ii).
Employer-operated eating facilities are facilities that are owned or leased by the employer,
operated by the employer, located on or near the business premises of the employer, and at which
the meals furnished are provided during or immediately before or after the employee's work
day.32 An employer is considered to operate a facility if it contracts with another to provide an
eating facility.33 Meals for this purpose include food, beverages, and related services provided at
the facility.34
32 Reg. § 1.132-7(a)(2) .
33 Reg. § 1.132-7(a)(3) .
34 Reg. § 1.132-7(a)(2) (ii).
COMMENT:
Subsidized eating facilities are provided by employers for a variety of reasons, including the
unavailability of adequate eating establishments near the employer's premises, the desire to
encourage employees to remain on the business premises and the desire to provide employees
low-cost meals.
The employer may apply the requirement that the revenue from an eating facility exceeds its
direct cost either separately for each dining room or cafeteria, or with respect to all eating
facilities it operates.35
35 Reg. § 1.132-7(b) .
The direct operating costs of an eating facility are the cost of food and beverages and the cost of
labor for personnel whose services relating to the facility are performed primarily on the
premises of the facility.36 The direct operating costs of an eating facility operated for an
employer by another are the direct operating costs incurred by the employer and the amount paid
to the operator of the facility to the extent it is attributable to what would be direct operating
costs if the employer operated the facility.37
36 Reg. § 1.132-7(b)(1).
37 Reg. § 1.132-7(b)(3).
The cost of labor for personnel whose services are not performed primarily on the premises is
not part of the direct operating cost. If an employee performs services relating to the facility both
on and off the premises, only the portion of the total labor cost attributable to the services
performed on the premises can be included in direct operating costs.38 Labor costs for this
purpose include all compensation included on the employee's Form W-2, Wage and Tax
Statement.39
38 Id.
39 Id.
In determining whether the revenue from an eating facility exceeds its direct cost, an employer
can exclude revenue and costs attributable to meals that are excludable from employees' income
because they are furnished for the convenience of the employer if the employer can reasonably
determine the number of meals that are so excludable.40 See §B:10.220 for discussion of this
exclusion. A hospital can also exclude costs and revenues attributable to meals furnished to
volunteers who receive food and beverages, if it can reasonably determine the number of meals
they receive.41
40 Reg. § 1.132-7(a)(2).
41 Id.
An employee who receives a meal that is excludable from income because it is provided for the
convenience of the employer 43 (see §B:10.220 ) is treated as having paid an amount for that
meal equal to the direct operating costs of the facility attributable to that meal.44 Thus, a meal
provided for the convenience of the employer is treated as a de minimis fringe benefit that is
wholly deductible by the employer.45 See §B:10.228 for discussion of the deductibility of
employer-provided meals.
43 See Code Sec. 119.
44 Code Sec. 132(e)(2) .
45 Id; see HR Rep. No. 220, 105th Cong., 1st Sess. (1997).
An employer that charges nonemployees a greater amount than it charges employees must
exclude all costs and revenues attributable to meals furnished to nonemployees in determining
whether the revenue from an eating facility exceeds its direct cost.46
46 Reg. § 1.132-7(a)(2).
Path: CCH Network; Federal Tax Service; keyword: employer operated eating facility;
§G:8.264, De Minimis Fringe Benefits
The percentage limitation on meal expenses does not apply to food and beverage expenses that
are excludable from gross income of the recipient as de minimis fringe benefits.31 In general,
meals provided in an employer operated facility are de minimis fringe benefits if the facility is
located on or near the employer's place of business32 and the revenue from the facility equals or
exceeds the facility's direct operating costs.33 See §B:10.142. Meals furnished at such facilities
for the convenience of the employer that are excluded from the employee's gross income,34 need
not meet the operating cost criteria.35 See §B:10.220 for discussion of the requirements for
exclusion of employer-provided meals.
31 Code Sec. 274(n)(2)(B); Code Sec. 132(e).
32 Code Sec. 132(e)(2)(A).
33 Code Sec. 132(e)(2)(B).
34 Code Sec. 119(a)(1) .
35 Code Sec. 132(e)(2)
For tax years beginning before January 1, 1998, the Code did not specifically provide that meals
furnished for the convenience of the employer could be de minimis fringes without regard to the
operating criteria.36 The Ninth Circuit has held, however, that an employer could deduct 100
percent of costs of meals furnished for the convenience of employer, without regard to the
revenue operating costs tests. Thus, a hotel and casino operator was allowed a 100-percent
deduction for meals provided to employees who were required to stay on the premises for
security and logistic purposes, thereby satisfying the convenience of the employer test.37 Due to
that decision, the IRS has withdrawn a settlement program proposing compromise percentage
reductions to employer-provided meal deductions taken by hotel, casino and similar operators
prior to January 1, 1998.38 See §B.10.228 for discussion of employer-provided meal deductions.
36 Code Sec. 132(e), prior to amendment by the Tax Relief Act of 1997, P.L. 105-34 , Act
§970(a) (August 5, 1997).
37 Boyd Gaming Corp. v Commr, CA-9, 99-1 USTC ¶50,530, 177 F3d 1096 (Acq.).
38 Announcement 99-77, 1999-32 I.R.B. 243; Announcement 98-78, 1998-34 I.R.B. 30.
For food and beverages provided in situations other than an employer operated eating facility,
the exception applies if the value is so small as to make accounting for it unreasonable or
administratively impracticable.39 This determination is generally based on the frequency with
which the employer provides similar benefits. See §B:10.140. For example, de minimis food and
beverages exempted from the percentage limitation include occasional cocktail parties, group
meals or picnics for employees.40 This de minimis exception to the percentage limitation may
apply to food and beverages provided to either independent contractors or employees and other
recipients.41
39 Code Sec. 132(e)(1) .
40 Reg. § 1.132-6(e)(1).
41 Reg. § 1.132-1(b)(4) ; IRS Letter Ruling 200030001, April 6, 2000.
The de minimis exception also applies to the transfer for business purposes off a packaged food
or beverage item, such as a holiday turkey or bottle of wine.42
42 Senate Committee Report to P.L. 99-514 (1986), S. Rep. No. 99-313.
Path: CCH Network; Federal Tax Service; keyword: employer operated eating facility;
§B:10.20, Overview--Statutory Fringe Benefits
Employees are taxed on fringe benefits unless benefits are specifically excluded from income by
statute. No-additional-cost services, employee discounts, working condition fringe benefits, de
minimis fringe benefits, qualified moving expense reimbursements, and qualified transportation
fringe benefits are specifically excludable from gross income. Nondiscrimination rules apply to
no-additional-cost services and qualified employee discounts. Meals and lodging furnished for
convenience of employer for substantial noncompensatory business reasons are excludable.
Benefits paid under adoption assistance programs are excludable from income. Employer
contributions to and benefits from dependent care assistance programs are excluded from
income. Benefits provided by an educational assistance program are excluded from gross
income before January 1, 2002.
Many employers provide their employees fringe benefits in addition to cash compensation.
Compensation for services is taxable. See §B:1.60 . However, fringe benefits may be excluded
from the employees' income if they satisfy statutory requirements as no-additional-cost services,
employee discounts, working condition fringe benefits, de minimis fringe benefits, qualified
moving expense reimbursements, or qualified transportation fringe benefits. Fringe benefits not
falling into these six categories are generally taxable. See §B:9.20 for discussion of other fringe
benefits and §B:1.40 for discussion of what constitutes compensation for services.
If an employer can provide a service that it regularly sells to the public to employees at no
substantial additional cost, the value of that service is not taxed to the employee. See §B:10.40 .
Similarly, employers can sell goods or services to their employees at a discount from the price
charged to the general public without causing the employees to be taxed. The discount on goods
may not exceed the employer's profit percentage and the discount on services is limited to 20
percent. See §B:10.60 .
No-additional-cost services and qualified employee discounts must be available to employees on
a nondiscriminatory basis. The benefits must be available on substantially the same terms to all
employees or to each member of a reasonable classification of employees that does not
discriminate in favor of highly compensated employees. If a plan fails the nondiscrimination test,
only employees who are not highly compensated may exclude the value of the benefit. See
§B:10.100. An employer engaged in more than one line of business must treat each line of
business separately in applying the discrimination test. See §B:10.80.
Working condition fringe benefits are excluded from an employee's gross income. They are
benefits the employee would have been entitled to deduct as a deductible business expense had
he paid for them himself; for example, an employer-provided automobile used for business
purposes. See §B:10.120 .
A fringe benefit may be excludable from an employee's income as a de minimis fringe benefit if
its value is so small that accounting for it would be administratively impractical. See §B:10.140.
Qualified transportation fringe benefits, including van pooling, transit passes and qualified
parking, are not taxed to employees to the extent they do not exceed dollar limitations. For
earlier years, transit passes were excludable as de minimis fringe benefits and qualified parking
was excludable as a working condition fringe benefit. See §B:10.160.
Amounts paid or reimbursed by an employer for deductible moving expenses of an employee in
years after 1993 are excluded from the gross income of the employee. See §B:10.180.
Reimbursements are subject to substantiation requirements and prohibitions against retention of
excess reimbursements.
If an employer provides a restaurant or cafeteria for its employees on its business premises, the
employees' use of the facility is not taxed if the employer charges the employees enough to cover
its direct operating costs. The nondiscrimination rules do not apply to working condition, de
minimis, qualified transportation fringe benefits, or moving expenses, but they do apply to
employer-provided eating facilities. See §B:10.142.
An on-premises athletic facility owned and operated by the employer for the use of its employees
is a fringe benefit not included in the employees' gross income. See §B:10.200.
Employees may also exclude from income the value of meals or lodging furnished in kind for the
convenience of the employer on the business premises of the employer for a substantial
noncompensatory reason. The employee must be required to accept excludable lodging as a
condition of his employment. See §B:10.220.
Employer contributions to qualifying dependent care assistance programs are excluded from an
employee's income if the plan meets statutory requirements. See §B:10.260. An exclusion is
allowed for contributions to qualifying educational assistance programs in tax years beginning
before January 1, 2002. Employer-provided educational assistance that is not otherwise
excludable from gross income can be excluded if it is a working condition fringe benefit. See
§B:10.240.
Amounts paid or expenses incurred by an employer for an employee's qualified adoption
expenses under an adoption assistance program are excluded from the employee's income in
years before 2002. See §B:10.280 .
Employers and employees generally must comply with reporting requirements with respect to
fringe benefits. See §B:10.300 .
Path: CCH Network; USMTG; keyword: subsidized meals, ¶55, Checklist for Items of
Income, link: 2001FED ¶7222.01; ¶7222.01, Meals and Lodging Furnished by Employer:
Synopsis - meals and lodging for the convenience of the employer.-The value of meals furnished to an employee, the employee's spouse or dependents by or on
behalf of the employer is excludable from the employee's gross income if: (1) the meals are
furnished on the business premises of the employer; and (2) the meals are furnished for the
convenience of the employer.
The exclusion covers only meals furnished by an employer and not cash reimbursements for
meals (R.J. Kowalski, SCt, 77-1 USTC ¶9748 , ¶7222.59 ).
The convenience of the employer. Meals furnished by an employer without charge to an
employee are regarded as furnished for the convenience of the employer if the meals are
furnished for a substantial noncompensatory business reason of the employer, rather than as a
means of providing additional compensation to the employee. This is determined by an
examination of all the surrounding facts and circumstances (Reg. §1.119-1(a)(2) (i); see the
examples at Reg. §1.119-1(a)(2) (ii)).
Numerical Implication Statement:
The value of meals furnished to an employee, the employee's spouse or dependents by or on
behalf of the employer is excludable from the employee's gross income if: (1) the meals are
furnished on the business premises of the employer; and (2) the meals are furnished for the
convenience of the employer. Meals that are excluded from an employee's income under Code
Sec. 119 are considered a de minimis fringe benefit under Code Sec. 132 .[ 2001FED ¶7420 ]. A
subsidized cafeteria located on the employer's premises satisfies each of the exclusion tests. In
addition, a subsidized cafteria must also generate sufficient revenue to cover its direct operating
costs. In this case, employee meals obtained as an intimate component of employment are not
relevant.
Issue E14-1:
Path:
Path:
Path:
Path:
Path:
Path:
Path:
Path:
Path:
Path:
Sale of Stock (MOM: Kevin, 844 points; PR: -----, 422 points)
CCH Network; USMTG; Spine, Basis for Gain or Loss (Chapter
16) Property Acquired by Gift/Bequest, ¶1630, Property Acquired
by Gift
CCH Network; CCH Explanations and Analysis – USMTG;
Sales -- Exchanges -- Capital Gains (Chapter 17) - ¶1735,
Characterization of Gain or Loss
CCH Network;CCH Explanations and Analysis – USMTG;
Sales -- Exchanges -- Capital Gains (Chapter 17) ¶1777, Rules on
Determination of Holding Period
CCH Network - CCH Explanations and Analysis – USMTG;
Tax Guide - Sales -- Exchanges -- Capital Gains (Chapter 17)
Treatment of Capital Gain or Loss ,¶1736 Tax on Capital Gains-Individual, Estate, Trust-Post-May 6,1997CCH Network; USMTG; Spine, Select All; Guidebook, 2001
USMTG ¶849, Gift
CCH Network; USMTG; Spine, Select All; Guidebook 2001 ¶55,
Checklists Items for Income; Gifts-2001 FED ¶6553.03
RIA Checkpoint; FTH; Spine, Chapter 9 Capital Gains and LossesSection 1231, Stock; ¶2600 Capital Gains and Losses
CCH Online; USMTG; "capital asset; ¶1741, Capital Asset
CCH Online; USMTG; netting w/par capital; ¶1739, Netting of
Gains and Losses
CCH Online; USMTG; short-term loss; ¶1752, Limitation on
Capital Loss
Narrative Solution:
¶849, Gift
The value of a gift is excludable from gross income, but any income from the gift, including
profit upon sale, is taxable (Code Sec. 102(b) ). A gift of income from the property of an estate
or trust is not exempt except in the case of a gift of a specific sum or of specific property paid or
credited all at once or in not more than three installments.
¶6553.03, Gifts and Bequests
To be considered a gift the payment must proceed from a detached and disinterested generosity;
out of affection, respect, admiration, charity or similar impulse. The intention of the transferor is
controlling (see M. Duberstein, 60-2 UIn addition to the intention of the transferor the essential
elements of a gift are: (1) a donor competent to make the gift (see D.L. Zips, Dec. 25,806 , at
¶6553.375 ); (2) a donee capable of accepting the gift and acceptance of the gift by the donee
(see A. Weil, 36-1 USTC ¶9183 , at ¶6553.305 ); (3) a clear and unmistakable intention on the
part of the donor to absolutely and irrevocably divest himself of the title, dominion and control
of the subject matter of the gift (see ¶6553.31 ); (4) the irrevocable transfer of the present legal
title and of the dominion and control of the entire gift to the donee, so the donor can exercise
no further act of dominion or control over it (see J.S. Gullborg, 5 BTA 628, Dec. 1941 ;
¶1630, Property Acquired by Gift
If property was acquired by gift after 1920, the basis to the donee is the same as it would be in
the hands of the donor or the last preceding owner by whom it was not acquired by gift (Code
Sec. 1015(a) ; Reg. §1.1015-1 ).[ 2001FED ¶29,390 , 2001FED ¶29,391 ] The basis for loss is
the basis so determined (adjusted for the period prior to the date of the gift as provided in ¶1611 -¶1617 ) or the fair market value of the property at the time of the gift, whichever is lower.
¶1735, Characterization of Gain or Loss
The characterization of income as capital or ordinary and the differentiation between long-term
and short-term capital gains and losses is necessary for income tax reporting purposes.
Gain or loss from the sale or exchange of a capital asset is characterized as either short-term or
long-term depending on how long the asset was held by the taxpayer (¶1777 ). If a taxpayer has
both long-term and short-term transactions during the year, each type is reported separately and
gains and losses from each type are netted separately. The net long-term capital gain or loss for
the year is then combined with the net short-term capital gain or loss for the year to arrive at an
overall (net) capital gain or loss. When capital gains exceed capital losses, the overall gain is
included with the taxpayer's other income but is generally subject to a maximum tax rate of 20%
for sales of long-term capital assets and 35% for corporations (see ¶1736 , ¶1737 and ¶1739 ).
When capital losses exceed capital gains, the deductible loss may be limited (see ¶1752 and
¶1757 ).
¶1741, Capital Asset
A capital gain or loss arises from the sale or exchange of a capital asset, or an asset given
this effect under the Code (see ¶1747 ). The term “capital asset” means property (whether or not
connected with a trade or business) except the following:
(1) an inventoriable asset;
(2) property held primarily for sale to customers in the ordinary course of the taxpayer’s
trade or business (according to the Supreme Court, “primarily” means “of first importance”
or “principally,” and not merely “substantially”); [ 2001FED ¶30,422.022, 2001FED
¶30,575.021]
(3) a note or account receivable acquired in the ordinary course of trade or business for
services rendered or from the sale of stock in trade or property held for sale in the ordinary
course of business;
(4) depreciable business property;
(5) real property used in taxpayer’s trade or business;
(6) a copyright, a literary, musical or artistic composition, a letter or memorandum, or
similar property (but not a patent or invention) held by the taxpayer who created it, or by
one whose basis in the property is determined by reference to the basis of the one who
created it, or in the case of a letter, memorandum or similar property, a taxpayer for whom
such property was prepared or produced; and
(7) a U.S. government publication (including the Congressional Record) held by a
taxpayer who received it (or by another taxpayer in whose hands the publication would have
a basis determined in whole or in part by reference to the taxpayer’s basis) other than by
purchase at the price at which the publication is offered to the public (Code Sec. 1221; Reg.
§1.1221-1).[ 2001FED ¶30,420, 2001FED ¶30,421]
Reporting: In most situations, individuals use Schedule D (Capital Gains and Losses) of Form
1040 to report the sale or exchange of a capital asset. However, starting with 2000 tax returns,
some individuals may be able to report their capital gains on Form 1040A. A Form 1040A may
be used when the individual's only capital gains are from mutual fund distributions.
¶1777, Rules on Determination of Holding Period
The holding period for a capital asset is the length of time that the taxpayer owned the property
before disposing of it through sale or exchange. Determining whether the holding period was
"short-term" or "long-term" will determine the tax treatment of any recognized gain or loss
(Code Secs. 1222 and 1223 ).[2001FED ¶30,440 , 2001FED ¶30,460 ] After December 31, 1997,
the lowest long-term capital gain tax rate is generally available when a capital asset has been
held more than 12 months. Generally, for sales and exchanges after July 28, 1997, and before
January 1, 1998, the long-term capital gains rates only applied if the taxpayer held the asset more
than 18 months. Special low rates for assets held more than five years go intoeffect after
December 31, 2000 (Code Sec. 1(h) ).[ 2001FED ¶3260 ] See ¶1736 for a discussion
concerningthe taxation of capital gains.
Calculating the Holding Period. In most situations when determining how long an asset was held,
the taxpayer begins counting on the date after the day the property was acquired. The same date
of each following month is the beginning of a new month regardless of the number of days in the
preceding month (Rev. Rul. 66-7).[ 2001FED ¶30,463.3997 ] For example, if property was
acquired on February 1, 2000, the taxpayer's holding period began on February 2, 2000. The date
the asset is disposed of is part of the holding period. However, there are special rules that must
be applied when determining the holding period of assets acquired by gift, inheritance, exchange,
etc. See "Special Holding Periods," below.
Gift. The holding period of property acquired by gift or transfer in trust (see ¶1630 and ¶1678 )
includes the time the property was held by both the donor and the donee, if the donee is required
to use as his basis the basis of the donor (Code Sec. 1223(2) ).[ 2001FED ¶30,460 ] When the
fair market value at the time of the gift is used to determine the loss and such fair market value is
greater than the donor's basis in the property, the holding period of the donor may not be used.[
2001FED ¶30,461 ]
Inherited. For property acquired from a decedent, the long-term holding period requirement is
generally considered to be met (Code Sec. 1223(11)).[ 2001FED ¶30,460]
Generally, for sales of long-term capital assets after May 6, 1997, the maximum capital gains
rate is 20% (10% for individuals in the 15% tax bracket). A special lower rate of 18% (8% for
individuals in the 15%tax bracket) applies to transactions after December 31, 2000, when the
asset was held more than five years (Code Sec. 1(h) ).[ 2001FED ¶3260 ] These rules are
discussed in detail below.
These capital gains rates apply to individuals, estates and trusts.
Netting of Gains and Losses
In order to determine their recognized capital gain or loss for the tax year, noncorporate
taxpayers have to follow specific netting procedures (Code Sec. 1(h)(1)).[ 2001FED ¶3260]
The basic netting procedure provides that within each tax rate group (e.g., 20% group),
gains and losses are netted in order to arrive at a net gain or loss for the group. After this basic
process has been completed, the following netting and ordering rules must be applied (Notice 9759):[ 2001FED ¶3285.55]
(1) Short-term capital gains and losses. Short-term capital losses (including short-term loss
carryovers from a prior year) are applied first to reduce short-term capital gains, if any, that
would otherwise be taxable at ordinary income tax rates. A net short-term loss is used first to
reduce any net long-term capital gain from the 28% group (Code Sec. 1(h)(5)(A)(III)).[
2001FED ¶3260] Any remaining short-term loss is then used to reduce gain from the 25% group
and then the 20% group (Code Sec. 1(h)(1)).[ 2001FED ¶3260]
(2) Long-term capital gains and losses. A net loss from the 28% group (including long-term
capital loss carryovers) is used first to reduce gain from the 25% group, then to reduce net gain
from the 20% group. A net loss from the 20% group is used first to reduce net gain from the 28%
group, and then to reduce gain from the 25% group.
Any resulting net capital gain that is attributable to a particular rate group is taxed at that
group’s marginal tax rate.
Example. At the end of 2000, Ralph Helm had a short-term capital loss of $35,000. He also had
long-term capital gains in the following amounts and tax rate groups: $28,000 (25% groupunrecaptured Section 1250 gain), $5,000 (28% group-collectibles gain), and $10,000 (20%
group). Helm would first apply $5,000 of his short-term loss against his 28% collectibles gain.
Next he would apply $28,000 of his short-term loss against the 25% unrecaptured Section 1250
gain. His remaining $2,000 of short-term loss would then be applied against his $10,000 gain in
the 20% group. The result of this netting and ordering procedure is that he has $8,000 of longterm gain subject to a 20% capital gains tax.
Limitation on Capital Loss
To determine the deductibility of capital losses, all capital gains and losses (without
distinction between long-term and short-term) incurred during the year must be totaled. Any
capital losses are deductible only to the extent of any capital gains plus, in the case of
noncorporate taxpayers, ordinary income of up to $3,000 (Code Sec. 1211).[ 2001FED ¶30,390]
Thus, both net long-term capital losses and net short-term capital losses may be used to offset up
to $3,000 of an individual’s ordinary income. Special rules for married persons, whether filing
joint or separate returns, are at ¶1757 .
Example. For 2000, Janet Green had $30,000 of ordinary income, a net short-term capital loss of
$500 and a net long-term capital loss of $300. Green’s total capital loss deduction is $800.
Numerical Implication Statement:
Monica has a gain from the sale of her inherited stock. Because she received the stock as an
inheritance, it's deemed held for a long-term period, thus qualifying for a 20 percent tax rate.
From a netting perspective, Monica's gain is netted against long-term capital losses. Any
resulting net long-term capital gain is netted against any net short-term capital loss. A net shortterm capital loss is first netted against 28 percent gains, then 25 percent gains, and finally 20
percent gains. Any remaining short-term capital loss is reported at the rate of $3,000 per year.
From a tax formula perspective, Monica must include her gain in income broadly conceived.
Care must also be exercised to ensure that capital gains are separated from taxable income and
taxed at appropriate rates. As a practical matter, we recall the $2,500 short-term capital loss
from Tom's non-business bad debt (see issue E17-1). That loss will most likely be used to offset
the 25% long-term capital gain arising from the business-use portion of the home (see Issue E24-
2). We also note that while it appears that other capital asset sales are introduced as new issues
in this case, this general framework is robust enough to accommodate the general considerations
(i.e., character, netting, holding period, etc.) arising therefrom.
Issue E15-1:
Path:
Loan Proceeds (MOM: Rebecca, 338 points; PR: -----, 169 points)
CCH Online; Federal Tax Service; keyword: loans and offsetting
liabilities; §A:5.45, Loans and Offsetting Liabilities
Narrative Solution:
Generally, if a taxpayer receives property or money and he is obligated to repay the money or
return the property, the value of that property or money is not included in gross income. There is
no accession to wealth because of the offsetting liability; there is no increase in the taxpayer's net
worth. Thus, the proceeds of a loan made to a taxpayer are not income at the time the loan is
made. The source of the funds ultimately used to repay the loan is immaterial. Thus, for example,
a taxpayer who used misappropriated funds to repay cash advances from credit cards was not
required to include in gross income the amount of the cash advances, although the
misappropriated funds were included in gross income. In another case, the Tax Court held that a
loan from an employer to an employee-stockbroker that was evidenced by a promissory note was
a valid indebtedness and not compensation for future services. Subsequent year-end bonuses
from the employer to the employee in the exact repayment amount due on the loan were
includable in the employee's income in the year received. However, if the loan is subsequently
forgiven by the lender, or the lender's claim against the taxpayer becomes unenforceable because
of the running of the statute of limitations, the taxpayer may have gross income at that time in
the nature of income from the discharge of indebtedness. Collection of a loan is unenforceable if
the borrower, rather than the lender, controls whether the loan must be repaid. Thus, for example,
when a professional sports team received an advance which was to be repaid out of the proceeds
from the rental of skyboxes, but was not actually required to build or rent skyboxes, the team,
rather than the purported lender, controlled whether the advance would ever have to be repaid.
Therefore, the team had taxable income equal to the amount of the advance at the time the
advance was made.
A taxpayer does not realize gross income from the cancellation of some student loans made by
governmental agencies, charitable organizations or educational institutions. Generally, the
taxpayer must perform public service in exchange for the cancellation of the loan.45 See
§A:20.42[2] . 45 Code Sec. 108(f); Your Federal Income Tax, IRS Publication 17, 88 (1998).
Numerical Implication Statement:
Generally, if a taxpayer receives property or money and he is obligated to repay the money or
return the property, the value of that property or money is not included in gross income. There is
no accession to wealth because of the offsetting liability; there is no increase in the taxpayer's net
worth. Thus, the proceeds of a loan made to a taxpayer are not income at the time the loan is
made. This analysis suggests that the Fronks mortgage proceeds should be included in gross
income. Thus, as a practical matter, those proceeds (i.e., approximately $420,000 (i.e., 12,241 /
.07 * 12 / 5)) should be included in income broadly conceived and then excluded as an exclusion.
Issue E16-1:
Path:
Path:
Path:
Scholarships (MOM: Frank, 450 points; PR: -----, 225 points)
CCH Network; USMTG; Spine, Exclusions from Income (Chapter
8), Scholarships; ¶879, Scholarship or Fellowship Grant Is Not
Income
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable &
Exempt; ¶ 1385 Scholarships and fellowships.
CCH Network; Federal Tax Service and Standard Federal Income
Tax Reporter; Spine, Qualified Scholarships; PROP-REG,
2001FED ¶7182, §1.117-6, Qualified scholarships, LR-3-87,
6/9/88.
Narrative Solution:
¶879, Scholarship or Fellowship Grant Is Not Income
Any amount received as a qualified scholarship by an individual who is a candidate for a
degree at a qualified educational organization, which normally maintains a regular faculty and
curriculum and normally has a regularly enrolled body of students in attendance where its
educational activities are regularly carried on, is excluded from that individual's gross income
(Code Sec. 117 ; Reg. §1.117-1 ).[ 2001FED ¶7170 , 2001FED ¶7172 ] A qualified scholarship
includes any amount received by an individual as a scholarship or fellowship grant so long as the
amount was used for qualified tuition and related expenses such as fees, books, supplies, and
equipment required for courses of instruction at a qualified educational organization.
¶ 1385, Scholarships and fellowships.
A scholarship or fellowship isn't taxable, to the extent it's a “qualified scholarship” granted to a
degree candidate at an educational organization and isn't a stipend ( ¶ 1387 ). ( Code Sec. 117(a)
, Code Sec. (c) ) FTC ¶ J-1230 ; USTR ¶ 1174.01 ; Tax Desk ¶ 19,351
A “qualified scholarship” is any amount received as a scholarship and used for tuition and fees
required for enrollment at an educational organization, and for required fees, books, supplies and
equipment. ( Code Sec. 117(b)(2) ) FTC ¶ J-1232 , FTC ¶ J-1233 ; USTR ¶ 1174.01 ; Tax Desk ¶
19,352 An “educational organization” is one that normally maintains a regular faculty,
curriculum and regularly enrolled student body in attendance. ( Code Sec. 117(b)(2)(A) ) FTC ¶
J-1244 ; USTR ¶ 1174.01 ; Tax Desk ¶ 19,359
Timing Matters:
PROP-REG, 2001FED ¶7182, §1.117-6, Qualified scholarships, LR-3-87, 6/9/88.
(2) If the amount of a scholarship or fellowship grant eligible to be excluded as a
qualified scholarship under this paragraph cannot be determined when the grant is received
because expenditures for qualified tuition and related expenses have not yet been incurred, then
that portion of any amount received as a scholarship or fellowship grant that is not used for
qualified tuition and related expenses within the academic period to which the scholarship or
fellowship grant applies must be included in the gross income of the recipient for the taxable
year in which such academic period ends.
Numerical Implication Statement:
Scholarships are excluded from gross income so long as they spent of qualified expenses.
Qualified expenses include tuition and related expenses such as fees, books, supplies, and
equipment required for courses of instruction at a qualified educational organization. When a
scholarship covers an academic year and thus extends across portions of two calendar years, the
scholarship recipient can defer the reporting of those scholarship proceeds until the last year in
which the academic scholarship ends. In the Fronk's case, only Scott has scholarship income.
As noted in E4-1, scholarships are not counted for purposes of the support test. In addition, the
scholarship will affect the amount of the education credit that can be taken by the Fronks. Since
he is not the taxpayer, it no longer makes sense to consider this issue from the perspective of an
exclusion
Issue E17-1:
Path:
Path:
Losses on Personal Loan to ex-Friend (MOM: Jana, 281 points;
PR: -----, 141 points)
CCH Network; USMTG; Spine, Sales—Exchanges—Capital
Gains (Chapter 17), Loss; ¶1752, Limitation on Capital Loss
RIA Checkpoint; FTH; Spine, Chapter 4 Interest Expense—
Taxes—Losses—Bad Debts; ¶ 1852 Deduction for Bad Debts,
¶1858 Business and Nonbusiness debts defined and
¶ 2609 Netting rules where taxpayer has capital losses
Narrative Solution:
¶ 1852 Deduction for Bad Debts
Bad debts are deductible whether or not connected with taxpayer's business. Deduction is
allowed for total worthlessness and, in some cases, for partial worthlessness.
Business bad debts are deductible as ordinary deductions. They are deductible if partly worthless
as well as when wholly worthless. Nonbusiness bad debts are deducted only as short-term capital
losses, and only when wholly worthless (¶ 1857). FTC ¶ M-2800 et seq. FTC ¶, M-2900 et seq.;
USTR ¶ 1664; Tax Desk ¶ 32,050
An item can't be deductible both as a bad debt and as a loss. If it could be treated as either, it
must be treated as a bad debt. FTC ¶ M-2503; USTR ¶ 1654.040; Tax Desk ¶ 32,058
¶ 1858 Business and nonbusiness debts defined
A business debt is either:
... a debt created or acquired in the course of taxpayer's trade or business (whether or not it
was related to that business when it became worthless); or
... a debt the loss from whose worthlessness is incurred in taxpayer's trade or business. This
applies if the loss is proximately related to taxpayer's business when the debt becomes worthless.
A bad debt is proximately related to business if business is the dominant motivation for the debt.
( Reg §1.166-5(b) ) FTC ¶ M-2902 ; USTR ¶ 1664.301 ; Tax Desk ¶ 32,303
A nonbusiness debt is a debt other than a business debt. ( Code Sec. 166(d)(2) ; Reg § 1.1665(b) , (d)) FTC ¶M-2902 ; USTR ¶ 1664.301 ; Tax Desk ¶ 32,303
¶ 2609 Netting rules where taxpayer has capital losses
The following netting and ordering rules apply where the taxpayer has capital losses:
(1) Short-term capital losses are applied first to reduce short-term capital gains, if any,
otherwise taxable at ordinary income rates. If there's a net short-term capital loss, it reduces any
net long-term gain from the 28% group, then gain from the 25% group, and finally reduces net
gain from the 20% group.
(2) Long-term capital losses are handled as follows:
... A net loss from the 28% group (including long-term capital loss carryovers) is used first
to reduce gain from the 25% group, then to reduce net gain from the 20% group.
... A net loss from the 20% group is used first to reduce net gain from the 28% group, then
to reduce gain from the 25% group.
¶1752, Limitation on Capital Loss
To determine the deductibility of capital losses, all capital gains and losses (without distinction
between long-term and short-term) incurred during the year must be totaled. Any capital losses
are deductible only to the extent of any capital gains plus, in the case of noncorporate taxpayers,
ordinary income of up to $3,000 (Code Sec. 1211 ).[ 2001FED ¶30,390 ] Thus, both net longterm capital losses and net short-term capital losses may be used to offset up to $3,000 of an
individual's ordinary income. Special rules for married persons, whether filing joint or separate
returns, are at ¶1757 .
Numerical Implication Statement:
Nonbusiness bad debts are characterized as short-term capital losses and are deductible only in
the year in which they become fully worthless. That short-term capital loss is then used to offset
short-term capital gains. Any excess loss is then used to offset 28% long-term capital gains first,
then 25% long-term capital gains, and then 20 % long-term capital gains. In this case, on
2/14/99, the Fronks loaned a now ex-friend $2,500 to get a business started. The loan was to be
repaid on 3/1/00 along with 10% interest. By the end of 2000, the Fronks were certain of never
being repaid. The $2,500 loan is treated as a short-term capital loss to be deducted on Schedule
D. The Fronks would first use the loss to offset the 25% gain arising from the sale of the
business-use portion of the Rocky Mountain home.
Issue E18-1:
Path:
Path:
Gifts (MOM: Katie, 113 points; PR: -----, 56 points)
CCH Network; USMTG; Search, Gifts; – 2001 U.S. Master Tax
Guide - Exclusions from Income (Chapter 8) ¶849 Gift
RIA Checkpoint; FTH; Spine, Chapter 2 Income Taxable and
Exempt; ¶1379 Gifts and Inheritances.
Narrative Solution:
¶ 849 Gift
The value of a gift is excludable from gross income, but any income from the gift,
including profit upon sale, is taxable (Code Sec. 102(b) ). A gift of income from the property of
an estate or trust is not exempt except in the case of a gift of a specific sum or of specific
property paid or credited all at once or in not more than three installments. See ¶847 . For a
donee's basis for gift property, see ¶1630 .
Tips are not gifts, and they are taxable (see, further, ¶717 ).[ 2001FED ¶5507.4651 ]
Food, clothing and rent payments furnished as strike benefits by a labor union to a needy worker
participating in a strike may be considered gifts; [ 2001FED ¶6553.46 ] in determining whether a
gift was made, the fact that benefits are paid only to union members is not controlling.[ 2001FED
¶6553.46 ]
The exclusion from gross income applicable to the value of property acquired by gift
does not apply to any amount transferred by or for an employer to, or for the benefit of, an
employee (Code Sec. 102(c) ).[ 2001FED ¶6550 ] Certain employee achievement awards are
excludable, however (see ¶785 ), and certain fringe benefits provided by employers are also
excludable (see ¶863 ).
Numerical Implication Statement:
The Fronks can exclude the full value of any gifts that they receive from taxation. As a practical
matter, this means that they will include their gifts in income broadly conceived and then exclude
them back out again. Thus, Tom's $30,000 maternal gift is included in income broadly
conceived and then excluded as an exclusion.
Issue E19-1:
Path:
IRA's (MOM: Amanda, 338 points; PR: -----, 169 points)
RIA Checkpoint; Code, Committee Reports, Regulations, Tax
Treaties; IRA; Code;§219 retirement savings
Narrative Solution:
Path:
CCH Online; USMTG; Spine, Retirement Plans; ¶2168, Introduction
Individuals who receive compensation (“earned income” in the case of a self-employed
individual) that is includible in gross income and who are not age 701/2 or older during the tax
year may make contributions to traditional individual retirement accounts (IRAs) (Code Sec. 219
and Code Sec. 408).[ 2000FED ¶18,902] Individuals may also have access to Roth IRAs (see
¶2180 ) and Education IRAs (see ¶2182 ). Amounts earned in a traditional IRA are not taxed
until distributions are made (Code Sec. 408(e)(1)).[ 2000FED ¶18,902] In addition, contributions
to a traditional IRA may be deducted, subject to limitations in the case of persons who are active
participants in employer-maintained retirement plans (Code Sec. 219(g)).[ 2000FED ¶12,650]
Subject to limitations, contributions in excess of the amount deductible may be made to a
traditional IRA (Code Sec. 408(o)).[ 2000FED ¶18,902] The primary focus of the following
material is on traditional IRAs. Roth IRAs are discussed at ¶2180 and Education IRAs are
covered at ¶2182 .
The term “compensation” includes alimony. It does not include pensions, annuities or other
forms of deferred compensation. The IRS will accept as compensation the amount properly
shown on the Form W-2 box 1 for wages, tips, and other compensation less any amount properly
shown in box 11 for nonqualified plans.[ 2000FED ¶18,922.042] The compensation of a selfemployed person is the individual’s “earned income,” as defined at ¶2113 (Code Sec.
219(f)(1)).[ 2000FED ¶12,650]
Path:
CCH Online; USMTG; Spine, Retirement Plans; ¶2168, Introduction; ¶2171,
Deduction Limitations for Single Persons and Married Persons Filing Separate
Returns
For a single individual, head of household, or a married individual who files a separate
return, contributions to IRAs in any tax year are deductible to the extent that they do not exceed
the lesser of (1) $2,000 or (2) the individual’s compensation for that year that is includible in
gross income (“includible compensation”) (Code Sec. 219(b)(1)).[ 2001FED ¶18,922.023]
However, the $2,000 limitation is reduced if the individual is an active participant in an
employer maintained retirement plan (Code Sec. 219(g)).[ 2001FED ¶18,922.023] The reduction
is in an amount that bears the same ratio to $2,000 as the individual’s adjusted gross income in
excess of the “applicable dollar amount” bears to $10,000. For 2000, the applicable dollar
amount for a single individual or head of household is $32,000. For such a taxpayer, the
deduction limit becomes zero when adjusted gross income is $42,000 or more. The applicable
dollar amount for a married person filing separately is $0. Thus, for such a taxpayer, the
deduction limit becomes zero when adjusted gross income is $10,000 or more. See ¶2172 for the
deduction limits imposed on married persons filing joint returns.
Adjusted Gross Income. For purposes of the reduction in the dollar limitation, AGI is
modified by taking into consideration Code Sec. 86 (relating to the inclusion in income of social
security and railroad retirement benefits) and Code Sec. 469 (relating to disallowance of passive
activity losses), and by not taking into consideration Code Sec. 135 (exclusion of interest on
educational U.S. Savings Bonds), Code Sec. 137 (exclusion of employer paid adoption
assistance), Code Sec. 221 (deduction for student loan interest), Code Sec. 911 (foreign earned
income and housing exclusion), and the deduction for contributions to IRAs (Code Sec.
219(g)(3)(A)).[ 2001FED ¶12,650]
Future AGI Limits for Single Individuals. The AGI limits for single individuals and heads of
households is being gradually increased over a number of years. For example, for 2001, the AGI
phaseout range will be from $33,000 to $43,000. For 2005 and thereafter, the maximum range
will be from $50,000 to $60,000 (Code Sec. 219(g)(2)(A)(ii)).
Path:
CCH Online; USMTG; Spine, Retirement Plans; ¶2180, Roth IRA
Contributions to a Roth IRA are never deductible (Code Sec. 408A(c)(1) ).[ 2001FED ¶18,925 ]
The advantage of the Roth IRA is that the buildup within the IRA (e.g., interest, dividends and/or
price appreciation) may be free from federal income tax when the individual withdraws money
from the account. To be treated as a Roth IRA, the account must be designated as such when it is
established. A Roth IRA is treated like a traditional IRA (see ¶2168 ) except for the special rules
described below.
Contribution Limits. The maximum total yearly contribution that can be made by an individual
to all IRAs (traditional and Roth) is $2,000, not counting rollover contributions (Reg. §1.408A-3
, Q & A-3(c)).[ 2001FED ¶18,927 ] Unlike traditional IRAs, individuals are allowed to make
contributions to a Roth IRA even after age 701/2 (Code Sec. 408(c)(4) ).[ 2001FED ¶18,925 ]
Income Limits. Contributions to Roth IRAs are subject to income limits. The maximum yearly
contribution that can be made to a Roth IRA is phased out for a single individual with an AGI
between $95,000 and $110,000, for joint filers with AGI between $150,000 and $160,000, and
for married filing separately with AGI between $0 and $10,000 (Reg. §1.408A-3 , Q & A3(b)).[
2001FED ¶18,927 ]
Path:
CCH Online; USMTG; Spine, Retirement Plans; ¶2168A, Time When
Contribution Considered Made
Individuals have until the due date of their tax returns to make contributions to their IRAs (e.g.,
April 15). Filing extensions are not taken into account. If the contribution is made by the due
date, it will be treated as having been made on the last day of the tax year for which the return is
filed (Code Sec. 219(f)(3)).[ 2001FED ¶18,922.0227 ] A deduction may be claimed for a
contribution even though the contribution had not yet been made when the return is filed,
provided that it is in fact made before the due date for filing the return
Numerical Implication Statement:
When an individual has wages or earned income that is included in gross income he or she can
contribute up to the maximum of their compensation or $2000 to either a Roth IRA or a regular
IRA. Since Monica is participating in an employer provided retirement plan, her ability to
contribute to a traditional IRA phases out if the Fronks adjusted gross income were between
$55,000 and $62,000 (which it easily exceeds). Monica's loss of the traditional IRA deduction
doesn't prevent Tom from participating so long as their AGI is less than $160,000 (phaseout runs
from $150,000 to $160,000). It's highly likely that their AGI will be greater than $160,000. So,
there will be no traditional IRA deduction for Tom. If a couple is filing jointly, their ability to
contribute to a Roth IRA is phased out for AGI between $150,000 and $160,000. A regular IRA
contribution is deductible from gross income up to the $2000 limit. Roth IRA contributions are
not deductible. Regular IRA’s are taxable upon distribution while Roth IRA’s are tax free at
distribution. The Fronks have until April 16th to decide to fund their IRA. Since it's highly
likely that the Fronks will have AGI in excess of $160,000, they will not be able to particpate in
the Roth IRA either. Frankly, they're just too damn Republican rich.
Issue E20-1:
Path:
Path:
Grants (MOM: Tonya, 225 points; PR: -----, 113 points)
CCH Network; IRS Publications; Search, Pell Grant, 2001, IRS
Publication No. 4, Taxable Scholarships and Fellowships Pell
Grants, Supplemental Educational Opportunity Grants, and Grants
to States for State Student Incentives; No. 17, Rules That Apply to
Both Credits Adjustments to qualified expenses.
RIA Checkpoint; FTH; Contents, Federal Library, Federal
Editorial Materials, RIA Federal Tax Handbook, Chapter 2 Income
– Taxable and Exempt; ¶ 1383 Prizes, Scholarships, Etc.
Narrative Solution:
IRS-PUB, 2001, IRS Publication No. 4, Taxable Scholarships and Fellowships
Pell Grants, Supplemental Educational Opportunity Grants, and Grants to States for State
Student Incentives. These grants are nontaxable scholarships to the extent used for tuition and
course-related expenses during the grant period.
IRS-PUB, 2001, IRS Publication No. 17, Rules That Apply to Both Credits
Adjustments to qualified expenses. If you pay higher education expenses with certain tax-free
funds, you cannot claim a credit for those amounts. You must reduce the qualified expenses by
the amount of any tax-free educational assistance you received. Tax-free educational assistance
could include:
 Scholarships, Pell grants,
Do not include expenses paid with any of the following funds.
 Tax-free distributions from an education IRA.
 Tax-free scholarships, such as a Pell grant.
Numerical Implication Statement:
Like scholarships, Pell Grants, Supplemental Educational Opportunity Grants, and Grants to
States for State Student Incentives are nontaxable scholarships to the extent used for tuition and
course-related expenses during the grant period. In general, qualified tuition and related expenses
are tuition and fees required for enrollment or attendance at an eligible educational institution.
Student-activity fees and fees for course-related books, supplies, and equipment are included in
qualified tuition and related expenses only if the fees must be paid to the institution as a
condition of enrollment or attendance. In the Fronk case, there are no Pell grants. Thus, our
analysis of this issue ends here.
Issue E21-1:
Interest Income (MOM: Charity, 113 points; PR: -----, 56 points)
Path:
CCH Network; USMTG; Spine, Income (Chapter 7), Interest;
¶724, Interest Income
Path:
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable and
Exempt; ¶ 1306 Interest Income.
Narrative Solution:
Regardless of the name given to the amounts or the form of the transaction, the receipt or
accrual of interest received or accrued is taxable as ordinary income, unless specifically
exempt.
All interest received or accrued is fully taxable (Reg. §1.61-7 ) [ 2001FED ¶5702 ] except
interest on (1) tax-exempt state or municipal bonds, including interest on registered warrants
issued by the state of California since July 1, 1992, as a result of its fiscal crisis,[ 2001FED
¶6602.469 ] and (2) certain ESOP loans (¶725 ). A cash-basis taxpayer is taxed on interest
when received. Interest on bank deposits, coupons payable on bonds, etc., is considered
available and taxed to a cash-basis taxpayer under the doctrine of constructive receipt and is
taxed when credited or due
Numerical Implication Statement:
The Fronks received Form 1099-INT from Tom's and Monica's portfolios of $10,000 and
$8,000, respectively. The interest, unless excluded in connection with state and municipal
bonds, is included in gross income. Thus, as a practical matter, it must be included in income
broadly conceived. It is reportable on Schedule B of the 1040 tax form.
Issue E22-1:
Path:
Path:
Personal Interest Expense (MOM: Emily, 113 points; PR: -----,
56 points)
CCH Network; USMTG; Spine, Deductions (Chapters 9 –12),
Interest on Car Loan, ¶948, Interest on Car Loans
RIA Checkpoint; FTC 2d; Chapter K deductions-Taxes, Interest,
Charitable, Medical, Others; K-5510 No Deduction for Personal
Interest
Narrative Solution:
Interest on Car Loans
Interest paid by an employee on a car loan is nondeductible personal interest. See ¶1045. A
self-employed taxpayer may claim the interest paid on the business portion of a car as a business
expense. The remaining nonbusiness portion is nondeductible personal interest (Code Sec.
163(a) ).[ 2001FED ¶9102 ]
Numerical Implication Statement:
In general, personal interest expense is not deductible. We can identify personal interest by what
it is not. It is not interest paid for indebtedness allocable to a business. It is not investment
interest. It is not qualified interest on a residence. It is not interest on the unpaid portion of an
estate tax. It is not interest on an educational loan. The Fronks made interest payments in
connection with their car loans totaling $9,555. The loan was used to purchase a car for their
personal use. In general, personal interest, such as that arising from the car loan, is not
deductible. Thus, none of The Fronks' car loan interest is deductible. We also note that these
concepts apply to the $2,530 of interest on the VISA card.
Issue E23-1:
Path:
Path:
Earned Income Credit (MOM: Karrie, 338 points, PR: -----, 169
points)
CCH Network; USMTG; Spine, Tax Credits (Chapter 13),
Earned Income Credit; 2001USMTG ¶1375, Earned Income
Credit
RIA Checkpoint; FTH; Spine, Chapter 7 Tax Credits – Earned
Income; ¶ 2340-42 Earned Income Overview, ¶ 2345
Disqualified Income and ¶ 2344 Eligible individual defined
Narrative Solution:
¶1375, Earned Income Credit
A refundable earned income credit is available to certain low-income individuals who have
earned income, meet modified adjusted gross income thresholds, and do not have more than a
certain amount of disqualified income for purposes of individuals having excess investment
income (Code Sec. 32(a) and Code Sec. 32(i)). [2001FED ¶4080] The disqualified income limit
for 2000 is $2,400 (to be $2,450 in 2001).
¶ 2342, Earned income defined
Earned income includes wages, salaries, tips, other employee compensation and an
individual's net earnings from self-employment less one-half of the self-employment tax under
Code Sec. 164(f) (¶ 1758). (Code Sec. 32(c)(2)(A)) It also includes certain compensation that is
excluded from gross income, such as disability benefits attributable to employer-paid premiums,
the rental value of a parsonage, and the value of meals and lodging furnished for the convenience
of the employer. Earned income also is reduced by any net loss in earnings from selfemployment (Rag §1.32-2(c)(2)) and doesn't include any amount received as a pension or an
annuity, any amount subject to the 30% withholding tax on U.S. income (not connected with
U.S. business) of nonresident alien individuals (Code Sec. 32(c)(2)(B)), unemployment
compensation, worker's compensation (Rag § 1.32-2(c)(2)), amounts earned while an inmate in a
penal institution, or amounts received for “workfare” services to the extent subsidized by a state
program. (Code Sec. 32(c)(2)(B)(iv)) Earned income is determined without regard to any
community property laws. (Code Sec. 32(c)(2)) FTC ¶ A-4216; USTR ¶ 324.05; Tax Desk ¶
56,907
¶ 2345, Disqualified Income
A taxpayer with “disqualified income” over $2,400 (in 2000, $2,450 in 2001, as indexed for
inflation) for the year cannot claim the credit. (Code Sec. 32((i)(1)) FTC ¶ A-4204; USTR
¶324.02; Tax Desk ¶ 56,904.1 Disqualified income means:
(1) interest or dividends to the extent includible in gross income for the tax year
( Code
Sec. 32(i)(2)(A) );
(2) tax exempt interest received or accrued during the tax year. ( Code Sec. 32(i)(2)(B) Tax
exempt interest is defined by reference to the rules requiring disclosure of the amount of
tax exempt interest on the return;
(3) the excess (if any) of gross income from nonbusiness rents or royalties ( Code Sec.
32(i)(2)(C)(i) ) over the sum of (a) the noninterest deductions that are clearly and
directly allocable to that gross income ( Code Sec. 32(i)(2)(C)(ii)(I) ) and (b) the interest
deductions properly allocable to the gross income; ( Code Sec.32(i)(2)(C)(ii)(II) ) FTC ¶
A-4205 ; USTR ¶ 324.02 ; Tax Desk ¶ 56,904.1
(4) the taxpayer's capital gain net income for the year ( Code Sec. 32(i)(2)(D) (but gain that
is treated as long-term capital gain under Code Sec. 1231(a)(1) ( ¶ 2681 et seq.) is not
disqualified income); FTC ¶ A-4204.1 ; USTR ¶ 324.02 ; Tax Desk ¶ 56,904.1 and
(5) the excess, if any, of the aggregate income from all passive activities for the year
(determined without regard to any amount otherwise included in earned income, or the
other disqualified income described above) over the aggregate losses from all passive
activities for the tax year (as so determined). ( Code Sec. 32(i)(2)(E) ) FTC ¶ A-4204
;USTR ¶ 324.02 ; Tax Desk ¶ 56,904.1
¶ 2344. Eligible individual defined.
Any individual who has a “qualifying child” ( ¶ 2346 ) for the tax year is an eligible
individual. ( Code Sec. 32(c)(1)(A)(i) ) An individual who doesn't have a qualifying child for the
tax year is also an eligible individual if:
... the individual's principal place of abode is in the U.S. for more than half the tax year
(U.S. Armed Forces personnel are considered to have their personal abode in the U.S. for the
time they are stationed outside the U.S. on extended active duty),
... either the individual or the individual's spouse (if any) is older than 24 but younger than
65 before the end of the tax year,
... the individual can't be claimed as the dependent of another taxpayer for any tax year
beginning in the same calendar year as the individual's tax year ( Code Sec. 32(c)(1)(A)(ii) ), and
... the individual isn't a nonresident alien for any part of the tax year, or has elected under
Code Sec. 6013(g) or Code Sec. 6013(h) to be treated as a U.S. resident. ( Code Sec.32(c)(1)(E) )
FTC ¶ A-4206 , FTC ¶ A-4213 ; USTR ¶ 324.02 ; Tax Desk ¶ 56,911
¶ 2341. Earned income credit—overview—Schedule EIC.
An eligible individual (¶ 2344) is allowed a credit equal to the credit percentage times the
amount of the individual's earned income for the tax year that doesn't exceed the statutory earned
income amount. (Code Sec. 32(a)(1)) However, the EIC for a tax year can't be more than the
excess (if any) of (1) the credit percentage of the earned income amount, over (2) the phaseout
percentage of so much of the modified adjusted gross income (¶ 2343 ) (or if greater, earned
income) of the individual for the tax year as exceeds the phaseout amount. (Code Sec. 32(a)(2))
These amounts are determined as follows: FTC ¶ A-4201 et seq.; USTR ¶ 324 et seq.; Tax Desk
¶56,901
In the case
of eligible
The Credit Maximum The Phaseout Phaseout
individual with:
% is:
Credit Base
% is:
Begins at:
----------------------- ---------------- -------------No qualifying
children ..........
1 qualifying
child .............
2 or more qualifying children ....
7.65%
$4,610
7.65%
$5,770
34%
$6,920
15.98%
$12,690
40%
$9,720
21.06%
$12,690
Thus, the maximum credit for 2000 is $353 (no qualifying children), $2,353 (one qualifying
child), or $3,888 (two or more qualifying children). FTC ¶ A-4201; USTR ¶ 324 et seq.; Tax
Desk ¶56,901 The EIC for 2000 is completely phased out at the following amounts of earned
income (or AGI, whichever is greater): FTC ¶ A-4202
... $10,380 for an eligible individual with no qualifying children.
... $27,413 for an eligible individual with one qualifying child, and
... $31,152 for an eligible individual with two or more qualifying children.
Numerical Implication Statement:
The earned income credit is available for two general classes of financial challenged individuals,
those with children and those without children. Since the Fronks have only one qualifying child
(qualifying children are children, step-, adopted-, or foster children of the taxpayer that lived
with the taxpayer over half the year and are less than 19 (24 if full-time student), we focus on the
one-child logic domain. The credit base is $6,920. The rate is 34 percent and yields a credit of
$2,353. The phaseout begins at $12,690 and uses a rate of 15.98 percent. The earned income
credit is disallowed if the Fronks have disqualified income (e.g., dividends and interest and longterm capital gains) in excess of $2,400. This is sufficient to eliminate that credit for the Fronks
who have disqualified income of at least $76,000. In addition, the credit phaseout is complete
when AGI is $27,415. With AGI of at least eight times that, the Fronks will get no earned
income credit.
Issue E24-1:
State Tax Refund (MOM: Terra, 225 points; PR: -----, 113 points)
Path:
Path:
CCH Network; USMTG; Spine, Returns – Payment of Tax
(Chapter 25); Guidebook 2001USMTG; ¶1092, Expenses
Connected with the Determination of Tax.
RIA Checkpoint; FTH; Contents, Federal Library, Federal
Editorial Materials, RIA Federal Tax Handbook, Chapter 6 –
Charitable Contributions – Medical Expenses – Alimony – Other
Nonbusiness Deductions; ¶2171, Tax Determination Costs.
Narrative Solution:
Expenses Connected with the Determination of Tax
Any ordinary and necessary expense incurred in connection with the determination,
collection, or refund of any tax is deductible as an itemized deduction on Schedule A of Form
1040, subject to the 2% floor (¶1011 ) (Code Sec. 212(3) ).[ 2001FED ¶12,520 ] This includes
tax return preparation fees allocable to an individual’s Form 1040 and Schedules A and B.
However, Form 1040 expenses attributable to a trade or business, Schedule C and C-EZ, and
those incurred for Schedules E and F are deductible from gross income and are not itemized
deductions.[ 2001FED ¶6005.109 ] See ¶973 .
This provision applies to estate and gift tax contests as well as to income tax contests. It also
applies to state and local taxes as well as federal taxes and includes property taxes and state or
city income taxes. Legal expenses incurred in determining tax liability include legal fees paid for
obtaining a ruling on a tax question[ 2001FED ¶12,523.421 ] and defending against a criminal
indictment for tax evasion.[ 2001FED ¶12,523.3264 ] An allocation between tax and nontax
matters should be made.
The recovery of an amount deducted or credited in an earlier tax year is included in a taxpayer's
income in the current (recovery) year, except to the extent the deduction or credit didn't reduce
federal income tax (or alternative minimum tax, but not the accumulated earnings or personal
holding company “penalty” taxes ( Code Sec. 111(d)(1) ) FTC ¶ J-5526 , FTC ¶ J-5527 ; USTR ¶
1114 ; Tax Desk ¶ 18,104) imposed in the earlier year. ( Code Sec. 111(a) ) FTC ¶ J-5500 et seq.
; USTR ¶ 1114 et seq.; Tax Desk ¶ 18,101
The receipt of an amount that was part of an earlier deduction or credit is considered a recovery
and generally must be included, partially or totally, in income in the year of receipt (Code Sec.
111 ).[ 2001FED ¶7060 , 2001FED ¶7061 , 2001FED ¶7062.01 ] Common types of recoveries
are refunds, reimbursements or rebates. Interest on amounts recovered is income in the year of
the recovery.
Numerical Implication Statement:
It's highly likely that the Fronks itemized deductions in the prior year. They seem to have the
amount of activity to deduce this hypothesis. If they did itemize, then the state income tax
refund reduced the amount of federal tax liability in the year that it was taken out and should be
included in their income broadly conceived in the year in which it is received. Thus, the $3,017
state tax refund is included in income broadly conceived.
Issue E25: Federal Tax Refund (MOM: Robyn, 150 points; PR: Matt, 75 points)
Path:
CCH; 2001 Master Tax Guide; Income (Chapter 7); Recoveries
Path:
RIA checkpoint; Chapter 2 Income - Taxable & Exempt; ¶1205
Narrative Solution:
Recoveries
The receipt of an amount that was part of an earlier deduction or credit is considered a recovery
and generally must be included, partially or totally, in income in the year of receipt. Common
types of recoveries are refunds, reimbursements or rebates. Interest on amounts recovered is
income in the year of the recovery.
When the refund or other recovery is for amounts that were paid in separate years, the recovery
must be allocated between these years.
Example 1. Marcia VanNauker paid her 1999 estimated state income tax liability of $4,000 in
four equal installments in April, June, and September of 1999 and in January of 2000. In May of
2000, she received a $400 refund based upon her 1999 state income tax return. (Refunds of
federal income taxes are never included in income, because they are never allowed as a
deduction from income.) Because the tax liability was paid in two years, the amount recovered
must be allocated pro rata between the years in which the liability was paid. Because 75% of the
liability was paid in 1999, 75% of the $400 refund (or $300) is for amounts paid in 1999 and is a
recovery item in 2000 when received. The remaining $100 is offset against the otherwise
deductible state tax payments made in 2000.
Numerical Implication Statement:
The Fronks' federal tax refund of $1,779 is not included in gross income because it was never
allowed as a deduction. As a practical matter, this means that their federal tax refund should be
included in income broadly conceived and then excluded out again.
Issue E26-1:
Path:
Path:
Personal Expenditures (MOM: Katherine, 113 points; PR: -----,
56 points)
CCH ; USMTG; Spine, Nonbusiness Expenses (Chapter 10),
Expenses; ¶1003, Personal Expenses
RIA Checkpoint; FTH; Chapter 6-Charitable Contributions—
Medical Expenses—Alimony—Other Nonbusiness Deductions;
¶2169, Nonbusiness expenses
Narrative Solution:
A personal, living or family expense is not deductible unless the Code specifically provides
otherwise (Reg. §1.262-1 ).[ 2001FED ¶13,601 ] Nondeductible expenses include insurance
premiums paid on taxpayer's own dwelling, life insurance premiums paid by the insured, and
payments for house rent, food, clothing, domestic help, most education, and upkeep of an
automobile.
Numerical Implication Statement:
Unless the Code provides otherwise, personal expenditures are not deductible. Thus, the vast
majority of the Fronks' living expenses (food, lodging, entertainment, clothing, car insurance and
payments, etc.) are nondeductible expenses.
Issue E27-1:
Path:
Path:
Forms (MOM: Nate, 338 points; PR: -----, 169 points)
CCH Network; USMTG; Spine, Chapter 1- Individuals, The
Return Form, ¶124 Forms in Use for 2000
RIA Checkpoint; FTH; Spine, Chapter 24 Returns and Payment Of
Tax ¶ 4700 Returns and Payment of Tax ¶4702 Individual Income
Tax Return Forms
Narrative Solution:
¶124, Forms in Use for 2000
Three principal forms are available for use by the majority of individuals for 2000. These forms
include Form 1040 and a shorter return form, Form 1040A . In addition, certain taxpayers with
no dependents may use Form 1040EZ , which is substantially shorter and easier to fill out than
either of the other 1040 forms. If the applicable filing conditions are met, any of the forms in the
1040 series may serve as a separate return or as a joint return. However, if a married person files
Form 1040 as a separate return and itemizes deductions, a spouse can either file Form 1040 and
itemize deductions or file Form 1040A and claim a standard deduction of zero. These rules do
not apply to a spouse who is eligible to file as unmarried or as head of household (see¶173 ).
Form 1040EZ . For the 2000 tax year, the simplified income tax return, Form 1040EZ , may be
used by taxpayers who: (1) have single or joint filing status (if you are a nonresident alien at any
time in 2000, your filing status can only be married filing jointly); (2) claim no dependents; (3)
do not claim a student loan interest deduction or an educational credit; (4) are under age 65 on
January 1, 2001 and are not blind at the end of
2000; (5) have taxable income of less than $50,000; (6) have income from only wages, salaries,
tips, unemployment compensation, taxable scholarships and fellowships, Alaska Permanent Fund
dividends, and taxable interest income not exceeding $400; (7) have received no advance earned
income credit payments; and (8) owe no household employment taxes on wages paid to a
household employee. If you do not meet all eight requirements, you must use either Form 1040
or Form 1040A . If social security tax is owing on tip income, the taxpayer must use Forms 1040
and 4137. No tax credits (other than the earned income credit), itemized deductions, or
adjustments to income may be taken on Form 1040EZ . The "Single" or "Married Filing Jointly"
column of the Tax Table (¶25 ) must be used to find the amount of income tax, which is entered
on the appropriate line of Form 1040EZ .
An individual who has no qualifying children and who received less than a total of $10,380 in
taxable and nontaxable earned income may be able to take the earned income credit on Form
1040-EZ if the taxpayer or his spouse was at least age 25 at the end of 2000. The IRS will
calculate the EIC for taxpayers who indicate that they desire such a computation on the
appropriate line of the form.
Form 1040A . Form 1040A is a two-page form accompanied by four Schedules. It is to be used
by an individual, a married couple filing jointly or separately, a head of household, or a
qualifying widow(er) with a dependent child (¶175 ) who does not itemize personal deductions,
whose gross income consists only of wages, salaries, tips, taxable scholarship and fellowship
grants, IRA distributions, pensions or annuities,
taxable social security or railroad retirement benefits, unemployment compensation, dividends,
interest, and Alaska Permanent Fund dividends, and whose taxable income is less than $50,000.
If the taxpayer receives more than $400 of either taxable interest income or dividend income,
claims the exclusion of interest from series EE U.S. savings bonds issued after 1989 (¶730 ),
receives interest or dividends as a nominee, receives interest from a seller-financed mortgage
where the buyer used the property as a personal residence (¶726 ), claims the credit for child and
dependent care expenses (¶1301 ), receives employer-provided dependent care benefits (¶869 ),
claims the credit for the elderly or the disabled (¶1304 ), or is eligible for the earned income
credit (¶1375 ), the respective parts of Schedules 1 through 3 or Schedule EIC for Form 1040A
must be completed. To claim the adoption credit (¶1306 ), Form 8839 must be attached. To claim
the education credit (¶1303 ), Form 8863 must be attached. The child tax credit (¶1302 ) is
figured on the child tax credit worksheet and is entered on the appropriate line of Form 1040A .
To claim the additional child tax credit, Form 8812 must be attached. The IRA deduction (¶2170
), nondeductible IRA contributions (¶2173 ), alternative minimum tax liability (¶1400 and
following), and advance EIC payments may also be claimed on
Form 1040A . A taxpayer who made estimated tax payments (¶2679 and following) and wishes
to apply any part of the refund to 2001 estimated tax, or who is subject to an underpayment of
estimated tax penalty determined on Form 2210 , can reflect these items on Form 1040A .
However, Form 1040A may not be used by an individual who is required to file any of the
schedules necessary to support Form 1040 (other than the information contained in the Schedules
to Form 1040A ), has taxable income of $50,000 or more, or if any of the following applies to
the taxpayer:
(1) itemizes deductions;
(2) claims any credit against tax (see the discussion of Form 1040 , below) other than
the credits allowable for child and dependent care (¶1301 ), for earned income (¶1375 ),
for the elderly or the disabled (¶1304 ), for the adoption credit (¶1306 ), for the education
credit (¶1303 ), or for the child tax credit (¶1302 );
(3) realizes taxable gain on the sale of a personal residence (¶1705 and following);
(4) claims any adjustments to income (other than the deduction for certain
contributions made to an IRA (¶2168 ) or the deduction for student loan interest
(¶1082 );
(5) receives in any month tips of $20 or more that are not reported fully to the
employer, Form W-2shows allocated tips that must be reported in income, owes social
security and Medicare tax on tips not reported to the employer, or has a Form W-2 which
shows any uncollected social security, Medicare, or RRTA tax on tips or on group-term
life insurance;
(6) is a nonresident alien at any time during the year and does not file a joint return or is
married at the end of the year to a nonresident alien or dual-status alien who has U.S.source income and who has not elected to be treated as a resident alien (however, such
a married taxpayer may use Form 1040A if considered unmarried and eligible to use
the head of household tax rate);
(7) owes or claims any of the items set out as "Other Taxes" in the discussion of Form
1040 , below, with the exception of advance earned income credit payments and
alternative minimum tax;
(8) receives income from (a) self-employment (net earnings of at least $400) (¶2667 ),
(b) rents and royalties (¶762 and ¶763 ), (c) taxable state and local income tax
refunds, (d) alimony received (¶771 ), (e) capital gains (¶1735 ), (f) business
income (¶759 ), or (g) farm income (¶767 );
(9) is the grantor of, or transferor to, a foreign trust;
(10) can exclude either foreign earned income received as a U.S. citizen (¶2402 ) or
resident alien or certain income received from sources in a U.S. possession while a
resident of American Samoa for all of 2000 (2410 );
(11) receives or pays accrued interest on securities transferred between interest
payment dates;
(12) earns wages of $108.28 or more from a church or church-controlled organization
that is exempt from employer social security taxes;
(13) receives any nontaxable dividends or capital gain distributions;
(14) is reporting original issue discount in an amount more or less than that shown on
Form 1099-0ID ;
(15) receives income as a partner (¶415 , ¶431 ), an S corporation shareholder (¶309 ),
or a beneficiary of an estate or trust; or
(16) has financial accounts in foreign countries (exceptions apply if the combined
value of the accounts was $10,000 or less during all of 2000 or if the accounts
were with a U.S. military banking facility operated by a U.S. financial institution).
An individual otherwise eligible to use Form 1040A should use Form 1040 if allowable
itemized deductions exceed the appropriate standard deduction amount. See ¶126 .
Form 1040 . The basic Form 1040 is a single-sheet, two-page form. To it are added any
necessary supporting schedules, depending upon the particular circumstances of the individual
taxpayer. The chart that appears at ¶61 illustrates an individual's computation of taxable income
on Form 1040 . Items listed on the chart are explained at the paragraphs indicated.
The Tax Table (¶25 ) is used to determine the amount of tax if taxable income is less than
$100,000 (see ¶128 ). If taxable income is $100,000 or more, the appropriate Tax Rate Schedule
(¶11 -¶17 ) must be used to compute the tax (see ¶130 ). Further, taxpayers who realized a net
capital gain may owe less tax if they calculate their liability using Schedule D, Part IV (see ¶126
).
Generally, Form 8615 must be used to calculate the tax for any child who was under age 14 on
January 1, 2001, and who had more than $1,400 of investment income (see ¶126 ). However,
taxpayers who elect to be taxed on the unearned income of their children who are under age 14
(see ¶114 ) must add to the amount of tax for Form 1040 the tax calculated on Form 8814 . They
do not file Form 8615 . The Form 8814 amount must be entered in the space provided on Form
1040 . Also included in the total is any tax from Form 4972 (Tax on Lump-Sum Distributions)
(see ¶2153 ), Form 5329 (Additional Taxes Attributable to IRAs, Other Qualified Retirement
Plans, Annuities, Modified Endowment Contracts, and MSAs) (see ¶2157 ), and Schedule J
(Farm Income Averaging) (see ¶767 ).
Credits. A number of credits whose excess over tax liability is not refundable in the current year
are subtracted from the resulting tax in the following order: (1) credit for child and dependent
care expenses (¶1301 ); (2) credit for the elderly or for the permanently and totally disabled
(¶1304 ); (3) education credits (¶1301 ); (4) child tax credit (¶1302 ); (5) adoption credit (¶1306
); (6) mortgage interest credit (¶1308 ); (7)
first-time homebuyer credit for District of Columbia (¶1310 ); (8) foreign tax credit (¶2475 ); (9)
general business credit (¶1323 ), which consists of (a) investment tax credit, to the extent
available (¶1345 and following), (b) work opportunity credit (formerly, the targeted jobs credit)
(¶1342 ), (c) welfare-to-work credit for individuals who begin work for the employer after
December 31, 1997 (¶1343 ), (d) alcohol fuels credit (¶1326
), (e) research credit (¶1330 ), (f) low-income housing credit (¶1334 ), (g) disabled access credit
(¶1338 ), (h) enhanced oil recovery credit (¶1336 ), (i) renewable electricity production credit
(¶1339 ), (j) Indian employment credit (¶1340 ), (k) credit for employer-paid FICA and Medicare
taxes on employee cash tips (¶1341 ), (l) credit for contributions to selected community
development corporations (¶1325 ), and (m) orphan
drug credit (¶1344 ); (10) empowerment zone employment credit (¶1339A ); (11) credit for prior
year alternative minimum tax (¶1370 ); (12) qualified electric vehicle credit (¶1321 ); and (13)
credit for fuel from a nonconventional source (¶1319 ).
Taxpayers who have qualifying children under age 17 are entitled to the child credit for tax years
beginning after December 31, 1997. The amount of the credit is $500 per child (¶1302 ).
Taxpayers may also claim the Hope scholarship credit for qualifying tuition and related expenses
paid after December 31, 1997, for education furnished in academic periods beginning after that
date and the lifetime learning credit for qualifying tuition and related expenses paid after June
30, 1998, for education furnished in academic periods after that date (¶1303 ).
Other Taxes. The following taxes are then added: (1) self-employment tax (¶2664 ); (2)
alternative minimum tax (¶1401 ); (3) recapture of any investment tax credit (¶1364 ), lowincome housing credit (¶1334 ), federal mortgage subsidy (¶1308 ), or qualified electric vehicle
credit (¶1321 ); (4) FICA, Medicare, and/or RRTA tax owing on tip income not reported to the
employer, and employee FICA, Medicare, and/or RRTA tax on tips where the employer did not
withhold proper amounts (¶2639 ); (5) excess contribution, excess distribution, and premature
distribution taxes for IRAs and qualified pension or annuity plans, excess accumulations in
qualified pension plans (including IRAs) and MSAs, or early distribution tax for a modified
endowment contract entered into after June 20, 1988 (¶2157 , ¶2174 , ¶2179 ); (6) advance
earned income credit payments received (¶1375 ); (7) household employment taxes (¶2650 ); (8)
the "Section 72(m)(5) excess benefits tax" imposed on a 5% owner of a business who receives a
distribution of excess benefits from a qualified pension or annuity plan; (9) uncollected FICA,
Medicare, and/or RRTA tax on tips with respect to employees who received wages that were
insufficient to cover the FICA, Medicare, and RRTA tax due on tips reported to their employers;
(10) uncollected FICA, Medicare, and/or RRTA tax on group-term life insurance; (11) any
excise tax due on "golden parachute" payments (¶2609 ); and (12) tax on accumulated
distribution of trusts (¶907 ).
Payments. To arrive at final tax due or refund owed, the taxpayer subtracts from the above
balance the following: (1) federal income tax withheld (¶2601 et seq.); (2) 2000 estimated tax
payments and amounts applied from 1999 returns (¶2679 et seq.); (3) earned income credit
(¶1375 ); (4) amounts paid with applications for automatic filing extensions (¶2509 ); (5) excess
social security tax withheld from individuals paid more than a total of $76,200 in wages by two
or more employers and/or excess RRTA tax withheld from individuals paid more than a total of
$56,700 by two or more employers (¶2648 ); (6) credit for excise tax on gasoline and special
fuels used in business and credit on certain diesel-powered vehicles (¶1379 ); and (7) a
shareholder's share of capital gains tax paid by a regulated investment company (¶2309 ).
The following schedules and forms are added to the basic Form 1040 as needed:
(1) Schedule A for itemizing deductions; (2) Schedule B for reporting (a) more than $400 of
dividend income and/or other stock distributions, (b) more than $400 of taxable interest income
or claiming the exclusion of interest from series EE U.S. savings bonds issued after 1989 used
for higher educational expenses, and (c) declaring any interests in foreign accounts and trusts; (3)
Schedule C or Schedule C-EZ for claiming profit or loss from a sole proprietorship; (4) Schedule
D for reporting capital gains and losses; (5) Schedule E for reporting income or loss from (a)
rents and royalties, (b) partnerships and S corporations (see ¶301 ), (c) estates and trusts, and (d)
real estate mortgage investment conduits (REMICs); (6) Schedule EIC for providing information
regarding the earned income credit; (7) Schedule F for computing income and expenses from
farming; (8) Schedule H for reporting employment taxes for domestic workers paid $1,200 or
more during 2000; (9) Schedule J for reporting farm income averaging; (10) Schedule R for
claiming the tax credit for the elderly or the disabled; (11) Schedule SE for computing the tax
due on income from self-employment; (12) Form 4797 for reporting gains and losses from sales
of business assets or from involuntary conversions other than casualty or theft losses (reported on
Form 4684 ); (13) Form 6251 for computing the alternative minimum tax; (14) Form 4562 for
reporting depreciation and amortization; (15) Form 2106 or 2106-EZ for computing employee
business expenses; (16) Form 8582 for computing the amount of passive activity loss; (17) Form
3903 for calculating moving expenses; (18) Form 4835 for reporting farm rental income and
expenses; (19) Form 8283 for claiming a deduction for a noncash charitable contribution where
the total claimed value of the contributed property exceeds $500; (20) Form 8606 for reporting
nondeductible IRA contributions, for figuring the basis of an IRA, and for calculating nontaxable
distributions; (21) Form 8615 for computing the tax for children under age 14 who have
investment income in excess of $1,400 in 2000; and(22) Form 8829 for figuring allowable
expenses for business use of a home.
Te following forms are for computing and claiming credits: (1) Form 4136 to claim the credit for
federal tax on gasoline and special fuels (¶1379 ); (2) Form 3468 to claim the investment credit,
to the extent available (¶1345 ); (3) Form 5884 to calculate the work opportunity credit; (4) Form
2441 to figure the child and dependent care credit; (5) Form 1116 to compute the foreign tax
credit; (6) Form 2439 , Copy B, to support the regulated investment company tax credit; (7)
Form 6478 to compute the alcohol fuels credit; (8) Form 6765 to compute the credit for
increasing research activities; (9) Form 3800 if more than one of the components of the general
business credit are claimed; (10) Form 4255 to compute the recapture of investment credit for
regular and energy property; (11) Form 8830 to claim the enhanced oil recovery credit; (12)
Form 8396 to figure the mortgage interest credit and any carryforwards; (13) Forms 8586 and
8609 and Schedule A for Form 8609 to compute the low-income housing credit available for
buildings placed in service during 2000; (14) Form 8611 to compute the recapture of the lowincome housing credit; (15) Form 8801 to compute the credit for prior year alternative minimum
tax; (16) Form 8812 to claim the Additional Child Tax Credit; (17) Form 8826 to claim the
disabled access credit; (18) Form 8828 to compute the recapture of a federal mortgage subsidy;
(19) Form 8835 to claim the renewable electricity production credit; (20) Form 8834 to
determine eligibility for the qualified electric vehicle credit; (21) Form 8845 to claim the Indian
employment credit; (22) Form 8846 to claim the credit for employer-paid FICA and Medicare
taxes on employee cash tips; (23) Form 8847 to claim the
credit for contributions to selected community development corporations; (24) Form 8844 to
claim the empowerment zone employment credit; (25) Form 8839 to claim the adoption credit;
and (26) Form 8863 to claim the education credits.
In addition, Form 4137 is used to compute social security (FICA) and Medicare tax on tip
income that is not reported to an employer, and Form 5329 is used to compute the various
penalty taxes applicable to retirement arrangements and plans.
Adjustments to Income. Adjustments to income (on page 1 of Form 1040 ) are principally those
deductions that may be taken whether or not the standard deduction is employed. They include
deductions for contributions to self-employed retirement plans or individual retirement
arrangements (¶2113 ,¶2168 ), student loan interest (¶1005 , ¶1082 ), medical savings accounts
(¶860 , ¶1020 ), moving expenses (¶1073 ), one-half of self-employment tax (¶2664 ), the
forfeited interest penalty for premature withdrawals from a time savings account (¶1120 ),
alimony paid (¶771 ), expenses of qualified performing artists (¶941A ), jury duty pay given to
an employer (¶941 , ¶1010 ), forestation or reforestation amortization (¶1287 ), repayment of
supplemental unemployment benefits (¶1009 ), contributions to Code Sec. 501(c)(18) pension
plans (¶601 ), employee business expenses of fee-basis state or local government officials (Code
Sec. 62(a)(2)(C) ) (¶941 ), the deduction for a clean-fuel vehicle placed in service in 2000 (¶1286
), and deductible expenses incurred with respect to the rental of personal property (¶1085 ).
The self-employed health insurance deduction is 60% for 2000. The deduction is claimed in the
Adjusted Gross Income section of Form 1040 . The self-employed health insurance deduction
remains at 60% through 2001, increasing to 70% in 2002 and 100% in 2003 and later years
(Code Sec. 162(l) ).
IRS Computation of Tax. Any taxpayer who files an individual tax return by the due date, April
16, 2001, can have the IRS compute the tax under certain conditions. These returns must be
signed and dated. The inclusion of a daytime telephone number will speed processing should any
questions arise. Lines 1-7 (1-8 if the IRS is also to figure the earned income credit) on Form
1040EZ or Lines 1-25, 27, 28, 29, 30, 34, and 36 through 38b on Form 1040A , as well as any
schedules or forms asked for on those lines, should be completed if applicable. Taxpayers
claiming the credit for the elderly or disabled should attach Schedule 3 to their returns, write
"CFE" next to line 28 on Form 1040A , check the box on Schedule 3 for filing status and age,
and complete Part II and lines 11 and 13 of Part III if necessary. To enable the IRS to calculate
the earned income credit, "EIC" must be written next to line 38b, the amount of nontaxable
earned income received must be indicated below that line, and Schedule EIC must be attached to
Form 1040A . When a joint return is filed, the taxable income of each spouse must be separately
listed in the margin next to the line for taxable income. The IRS will not figure the tax for
taxpayers who are required to file Form 8615 (see ¶126 ).
The IRS will figure the tax for a taxpayer using Form 1040 who (1) files a signed and dated
return by April 16, 2001 (inclusion of a daytime telephone number will speed up processing
should any questions arise), (2) does not itemize deductions, (3) does not receive foreign earned
income or claim a deduction or exclusion in connection with working abroad (Form 2555 or
2555-EZ), (4) does not request application of a refund to next year's tax, (5) has taxable income
that (a) is less than $100,000 and (b) consists only of wages, salaries, tips, dividends, interest,
taxable social security benefits, unemployment compensation, IRA distributions, pensions,
and/or annuities, (6) does not elect to report a child's interest and dividends (Form 8814 ), (7)
owes no social security or Medicare tax on unreported tip income (Form 4137 ), (8) did not
receive an accumulation distribution made by a trust (Form 4970 ), (9) did not receive a lumpsum distribution from a qualified retirement plan (Form 4972 ), (10) did not realize profit or loss
from an at-risk activity (Form 6198 ), (11) is not liable for alternative minimum tax (Form 6251
), (12) is not required to file Form 8615 (see ¶126 ), does not claim a credit for adoption
expenses (Form 8839 ), and does not claim a deduction for contributions to a MSA or long-term
care insurance contract (Form 8853 ). Lines 1-39 and 41-64 are to be completed if applicable
(the "Total" lines should not be computed), along with any related forms or schedules. Line 58,
indicating income tax withheld, must be filled in. If eligible for the earned income credit, the
taxpayer should write "EIC" and enter the amount and type of any nontaxable income on the
dotted line next to Line 60a and, if he has a qualifying child, should fill in Schedule EIC and
attach it to the return. If eligible for the tax credit for the elderly or for the permanently and
totally disabled, the taxpayer should write "CFE" on the dotted line next to Line 45 and attach
Schedule R with the necessary information completed. The box on Schedule R for filing status
and age must be checked, and Part II and lines 11 and 13 of Part III, if applicable, must be filled
in. If a joint return is being filed, the taxable income of each spouse must be separately listed
under the words "Adjustments to Income" on the front of Form 1040 . Finally, all necessary
forms and schedules must be attached to the return.
Loss ¶1735, Characterization of Gain or Loss
The characterization of income as capital or ordinary and the differentiation between long-term
and short-term capital gains and losses is necessary for income tax reporting purposes.
Gain or loss from the sale or exchange of a capital asset is characterized as either short-term or
long-term depending on how long the asset was held by the taxpayer (¶1777 ). If a taxpayer has
both long-term and short-term transactions during the year, each type is reported separately and
gains and losses from each type are netted separately. The net long-term capital gain or loss for
the year is then combined with the net short-term capital gain or loss for the year to arrive at an
overall (net) capital gain or loss. When capital gains exceed capital losses, the overall gain is
included with the taxpayer's other income but is generally subject to a maximum tax rate of 20%
for sales of long-term capital assets and 35% for corporations (see ¶1736 , ¶1737 and ¶1739 ).
When capital losses exceed capital gains, the deductible loss may be limited (see ¶1752 and
¶1757 ).
Losses from the sale of stock in a small business investment company (¶2392 ) or in a small
business corporation (i.e., Code Sec. 1244 stock) (¶2395 ) may be considered ordinary rather
than capital if certain requirements are satisfied.
Reporting. In most situations, individuals use Schedule D (Capital Gains and Losses) of Form
1040 to report the sale or exchange of a capital asset. However, starting with 2000 tax returns,
some individuals may be able to report their capital gains on Form 1040A. A Form 1040A may
be used when the individual's only capital gains are from mutual fund distributions.
Numerical Implication Statement:
The Fronks should use Form 1040 and include with it the following forms and schedules (this is
our best guess at this early point in time): 1) Schedule A for itemizing deductions; 2) Schedule
B for reporting (a) more than $400 of dividend and/or interest income; 3) Schedule C for selfemployment activity; 4) Schedule D for reporting capital gains and losses; 5) Schedule SE for
computing the self-employment tax; 6) Schedule E; 7) Probably Form 2106 for employmentrelated expenses; 7) Maybe Form 2210 to compute under-withholding penalty; 8) Form 2441 for
childcare credit; 9) Maybe Form 3903 for moving expense; 10) Form 4562 for depreciation; 11)
Form 4684 for personal and business casualties; 12) Form 4797 for sale of business assets; 13)
maybe Form 8606 for IRA contribution; 14) Form 8829 for business use of home, and 15) Form
8863 for education credits.
Issue E28-1:
Path:
Path:
Federal Income Tax Withholdings (MOM: Jill, 141 points; PR: ----, 71 points)
CCH; Withholding(Chap 26); Withholding; Methods of
Withholding; ¶2614 CCH; Withholding(Chap 26); Withholding;
Withholding on Wages; ¶2601
RIA; Chapter 7; ¶2300; ¶2340; ¶2348
Narrative Solution:
A credit against the employee's income tax liability is granted for income taxes withheld from his
salary or wages and for social security taxes overwithheld on the wages of a taxpayer with more
than one employer
Withholding of income tax by an employer is required only on an employee's "wages."
Generally, the term "wages" includes all remuneration (other than fees paid to a public official)
for services performed by an employee for an employer, including the cash value of all
remuneration (including benefits) paid in any medium other than cash. Salaries, fees, bonuses,
commissions on sales or on insurance premiums, taxable fringe benefits, pensions and retirement
pay (unless taxed as an annuity) are, if paid as compensation for services, subject to withholding.
The term "employer" includes not only individuals and organizations engaged in trade or
business, but also organizations exempt from income, social security and unemployment taxes.
Withholding also applies to wages and salaries of employees, corporate officers, or elected
officials of federal, state, and local government units.
The term "employee" must be distinguished from an "independent contractor" for purposes of
employment tax obligations
The law provides two methods of computing the tax to be withheld: (1) the "percentage" method
and (2) the "wage bracket" method.
Regardless of which method is used, the amount of withholding will depend upon the amount of
wages paid, the number of exemptions claimed by the employee on the withholding exemption
certificate, the employee's marital status, and the "payroll period" of the employee.
Numerical Implication Statement:
The Cooks' Federal Income Tax Withholdings are applied as credits against their tax liability
and, given issue E35, are refundable if the withholding amount is larger than their tax liability.
Issue E29-1:
Path:
Path:
Hope and Lifetime Learning Credits (MOM: Robyn, 675 points;
PR: -----, 338 points)
CCH Network; USMTG; Spine, Tax Credits (Chapter 13), Hope
and Lifetime Learning Credits; IRC, 2001FED ¶3820, Sec. 25A,
HOPE AND LIFETIME LEARNING CREDITS, and
2001USMTG ¶1303, Credits for Higher Education Tuition
RIA Checkpoint; FTH; Spine, Chapter 7 – Tax Credits; ¶2340,
Personal (Refundable and Nonrefundable) Credits, ¶2361, Hope
Scholarship Credit, and ¶2362, Lifetime Learning Credit
Narrative Solution:
For any tax year, a taxpayer is permitted to elect only one of the following with respect to one
student: (1) the Hope credit, (2) the lifetime learning credit, or (3) the exclusion for distributions
from an education IRA used to pay higher education costs (Code Sec. 530).
Personal (Refundable and Nonrefundable) Credits-- The nonrefundable credits are: the hope
scholarship and lifetime learning credits, see ¶ 2361 and ¶ 2362 ;
A taxpayer can claim the Hope scholarship or the lifetime learning credit for qualified expenses
he pays for education for himself, his spouse or an individual he claims as a dependent on his tax
return for the tax year in which the credit is claimed.
Based on the requirements in section 25A(b)(2) and (3), the regulations define an eligible student
for purposes of the Hope Scholarship Credit as a student who meets all of the following
requirements: (1) for at least one academic period during the taxable year, the student enrolls at
an eligible educational institution in a program leading toward a postsecondary degree,
certificate, or other recognized postsecondary educational credential (degree requirement); (2)
for at least one academic period during the taxable year, the student enrolls for at least half of the
normal full-time work load for the course of study the student is pursuing (work load
requirement); (3) as of the beginning of the taxable year, the student has not completed the first
two years of postsecondary education at an eligible educational institution (year of study
requirement); and (4) the student has not been convicted of a federal or state felony offense for
the possession or distribution of a controlled substance as of the end of the taxable for which the
credit is claimed (felony drug conviction restriction). The Hope credit may be elected for a
student's expenses only for two tax years.
There is no limit to the number of years for which a taxpayer may claim a lifetime learning credit
(Proposed Reg. §1.25A-4(b)). The credit may be claimed for degree and non-degree courses. If
the course is not part of a postsecondary degree program, it will be allowed if it is taken by a
student to acquire or improve job skills (Proposed Reg. §1.25A-4(c)).
An eligible educational institution is a college, university, vocational school, or other
postsecondary educational institution that is described in section 481 of the Higher Education
Act of 1965 (20 U.S.C. 1088) and, therefore, is eligible to participate in the student aid programs
administered by the Department of Education. This category includes virtually all accredited
public, nonprofit, and proprietary postsecondary institutions.
The regulations provide that, in general, the test for determining whether a fee is treated as a
qualified tuition and related expense is whether the fee is required to be paid to the eligible
educational institution by students as a condition of the students' enrollment or attendance at the
institution. The regulations specifically provide that qualified tuition and related expenses
include fees for books, supplies, and equipment used in a course of study only if the fees must be
paid to the eligible educational institution for the enrollment or attendance of the student at the
institution. Similarly, the regulations provide that, in general, qualified tuition and related
expenses include nonacademic fees (fees charged by an eligible educational institution that are
not used directly for, or allocated to, an academic course of study) only if the fees must be paid
to the eligible educational institution for the enrollment or attendance of the student at the
institution.
Appalachian State University requires the following fees to be paid before enrollment; Ed &
Tech Fee, Athletic Fee, Health Services, Student Activity Fee, Retirement of Debt, Book Rental
Fee, and Transportation Fee.
The regulations provide that the amount of otherwise allowable qualified tuition and related
expenses paid during a taxable year must be reduced by the following amounts paid to, or on
behalf of, a student during the taxable year: (1) a qualified scholarship that is excludable from
gross income under section 117. The regulations provide that a scholarship or fellowship grant is
treated as a qualified scholarship excludable from income under section 117 (and thereby
reduces the amount of qualified tuition and related expenses that a taxpayer may otherwise
include in claiming an education credit) A qualified scholarship is any amount received by an
individual as a scholarship or fellowship grant to the extent the recipient establishes that, in
accordance with the conditions of the grant, it was used for qualified tuition and related
expenses.
The regulations provide that for taxable years beginning before 2002 the maximum Hope
Scholarship Credit amount is $1,500 (100 percent of the first $1,000 of the qualified tuition and
related expenses paid during the taxable year for education furnished to an eligible student
during any academic period beginning in the taxable year or treated as beginning in the taxable
year, plus 50 percent of the next $1,000 of such expenses paid with respect to that student).
The Lifetime Learning Credit for any taxpayer for any taxable year is an amount equal to 20
percent of so much of the qualified tuition and related expenses paid by the taxpayer during the
taxable year (for education furnished during any academic period beginning in such taxable year)
as does not exceed $10,000 ($5,000 in the case of taxable years beginning before January 1,
2003).
The allowable amount of the credits is reduced for taxpayers who have modified adjusted gross
income above certain amounts. Modified adjusted gross income is adjusted gross income
increased by income earned outside the United States (amounts otherwise excluded from income
under Code Sec. 911, 931 , and 933 ). Income earned in Puerto Rico and U.S. possessions is
considered to be earned abroad. The phaseout of the credits begins for most taxpayers when
modified AGI reaches $40,000; the credits are completely phased out when modified AGI
reaches $50,000. For joint filers the phaseout range is $80,000 to $100,000 (Code Sec. 25A(d)).
The Hope credit and the lifetime learning credit are not available to married taxpayers who file
separate returns (Code Sec. 25A(g)).
Numerical Implication Statement:
The Hope Scholarship and Lifetime Learning Credits are nonrefundable credits available to
individuals who incur education related expenses for themselves, their spouse, or an individual
who they claim as a dependent. The Hope Credit is available to those individuals who are
pursuing a postsecondary degree at an eligible institution and have not yet completed two years
at the institution as of the beginning of the taxable year. The Lifetime Learning Credit has no
degree or year of study requirement. Qualified expenses for purposes of education credits are
limited to expenses that must be paid as a condition of a student’s enrollment or attendance. As
a practical matter, qualified expenses for purposes of education credits do not include
expenditures for books and supplies. Qualified expenses are netted against scholarship and grant
proceeds. Excess qualified expenses are then used to create education credits at the rate one
dollar on the dollar for the Hope credit and 20 cents on the dollar for the Lifetime credit. The
Hope Credit is reduced by modified adjusted gross income above certain amounts as determined
through a phase out. For a married-filing-jointly couple, the phase out begins when modified
AGI reaches $80,000 and ends at $100,000, the point at which the credits are completely phased
out. In total, the Hope Credit may not exceed $1,500, and the Lifetime Learning Credit may not
exceed $5,000.
The Fronks' children either appear to have sufficient scholarships to cover their qualified
expenses or don't satisfy one or more of the dependency tests. Thus, there is no qualified
expense base from which to derive a lifetime learning credit. And, even if there were, the
Fronks' AGI is well in excess of $100,000, thus completely phasing out any education credit that
might arise.
Issue E30-1:
Path:
Path:
Underwithholding Penalty (MOM: Garit, 563 points; PR: -----,
281 points)
CCH Network; USMTG; Spine, Deficiencies—Refunds—
Penalties (Chapter 13), Underpayment; ¶ 4865 Interest rate on
underpayments.
RIA Checkpoint; FTH; Spine, Chapter 25 Deficiencies—
Refunds—Penalties; ¶ 3151 Individual Estimated Tax.
Narrative Solution:
¶ 3151 Individual Estimated Tax
An individual must pay 25% of a “required annual payment” by Apr. 15, June 15, Sept. 15 and
Jan. 15, to avoid an underpayment penalty. The required annual payment for most taxpayers is
the lower of 90% of the tax shown on the current year's return or 100% of the tax shown on the
prior year's return. (For making 2000 estimates, however, taxpayers whose adjusted gross
income on their '99 return is over $150,000 (over $75,000 if married filing separately) must
pay the lower of 90% of their 2000 tax or 108.6% of their '99 tax.) There's no underpayment
penalty if the tax shown on the return (after withholding) is less than $1,000. There's also no
penalty if other specified exceptions or waivers apply.
To avoid the underpayment penalty, an individual must either: (1) pay each “required
installment” ( ¶ 3152 ) by the due date of that installment ( ¶ 3155 ), (2) meet one of more of the
exceptions to the penalty ( ¶ 3159 ), or (3) get a waiver of the penalty ( ¶ 3160 ). FTC ¶ S-5200 ;
USTR ¶ 66,544 et seq.; Tax Desk ¶ 57,130
¶ 3158. Penalty for underpayment of estimated tax.
The penalty for underpayment equals the product of the interest rate (using simple interest) (
Code Sec. 6622(b) ) on deficiencies ( ¶ 4865 ), times the amount of the underpayment (below)
for the period of the underpayment (below). ( Code Sec. 6654(a) ) FTC ¶ S-5260 ; USTR ¶
66,544.02 ; Tax Desk ¶ 57,180
The amount of the underpayment is the excess of the “required installment” ( ¶ 3152 ) over any
amount paid on or before the due date of the installment. ( Code Sec. 6654(b)(1) )
The period of underpayment runs from that due date to the earlier of: (1) Apr. 15 following the
close of the tax year, or (2) the date the underpayment is paid. ( Code Sec. 6654(b)(2) ) For
purposes of (2), above, a payment is credited against unpaid installments in the order the
installments are required to be paid. ( Code Sec. 6654(b)(3) ) FTC ¶ S-5261 et seq. ; USTR ¶
66,544.02 ; Tax Desk ¶ 57,182
Form 2210 (Form 2210F for farmers and fishermen) may be used to compute the penalty, FTC ¶
S-5265 ; Tax Desk ¶ 57,185 or IRS will figure the penalty and send a bill. FTC ¶ S-5260
¶ 3159. Exceptions to underpayment penalty.
The underpayment penalty doesn't apply:
(1) if the tax shown on the return (or the tax due if no return is filed) is less than $1,000 after
reduction for withholding tax paid, ( Code Sec. 6654(e)(1) ) FTC ¶ S-5266 ;Tax Desk ¶ 57,186
or
(2) if the individual was a U.S. citizen or resident for the entire preceding tax year, that tax year
was 12 months, and the individual had no tax liability for that year, ( Code Sec. 6654(e)(2) ) FTC
¶ S-5267 ; USTR ¶ 66,544.05 ; Tax Desk ¶ 57,187 or
(3) for the fourth installment, if the individual (who isn't a farmer or fisherman, ¶ 3156 ) files his
return by the end of the first month after the tax year (Jan. 31 for calendar year taxpayers), and
pays in full the tax computed on the return, ( Code Sec. 6654(h) ) FTC ¶ S-5268 ; USTR ¶
66,544.02 ; Tax Desk ¶ 57,188 or
(4) under certain circumstances with respect to a period during which a Title 11 bankruptcy case
is pending. ( Code Sec. 6658(a) ) FTC ¶ S-5269 ; USTR ¶ 66,584 ; Tax Desk ¶ 57,189
¶ 3154. Withholding as payment of estimated tax.
Any withholding is treated as a payment of estimated tax. An equal part of the withheld tax is
considered paid on each installment date unless the individual establishes the dates the amounts
were actually withheld. ( Code Sec. 6654(g)(1) ) FTC ¶ S-5248 ; USTR ¶ 66,544 ; Tax Desk ¶
57,169
¶ 4865. Interest rate on underpayments.
The rate of interest on tax underpayments and penalties is keyed to the short-term federal rate for
the previous calendar quarter, ( Code Sec. 6621(a)(2) ) and is compounded daily. FTC ¶ V-1101 ,
FTC ¶ V-1104 ; USTR ¶ 66,214 ; Tax Desk ¶ 85,101 The rates (applicable federal rate (AFR)
plus three percentage points) are: FTC ¶ V-1102 ; USTR ¶ 66,214 ; Tax Desk ¶ 85,101
9% (Apr. 1, 2000 —Dec. 31, 2000)
8% (Apr. 1, '99 —Mar. 31, 2000)
7% (Jan. 1, '99 —Mar. 31, '99)
8% (Apr. 1, '98 —Dec. 31, '98)
9% (July 1, '96—Mar. 31, '98)
8% (Apr. 1, '96 —June 30, '96)
9% (July 1, '95—Mar. 31, '96)
10% (Apr. 1, '95—June 30, '95)
9% (Oct. 1, '94—Mar. 31, '95)
¶2838, Interest on Underpayment of Tax
Interest on underpayments of tax is imposed at the federal short-term rate plus three percentage
points (Code Sec. 6621(a)(2) ). The interest rates, which are adjusted quarterly, are determined
during the first month of a calendar quarter and become effective for the following quarter.
Interest accrues from the date the payment was due (determined without regard to any extensions
of time) until it is received by the IRS. Interest is to be compounded daily, except for additions to
tax for underpayment of estimated tax by individuals and corporations (Code Sec. 6601 ).[
2001FED ¶39,410 , 2001FED ¶39,412 , 2001FED ¶39,415.01 , 2001FED ¶39,450 , 2001FED
¶39,455.01 , 2001FED ¶39,460 , 2001FED ¶39,560.01 ] The interest rate on underpayments for
the first quarter of 2000 is 8%; and the interest rate on underpayments for the second through
fourth quarters of 2000 is 9%.[ 2001FED ¶39,455.021 ]
15.3. Code Sec. 1274(d)(1)(C)(ii)
IRS issues tables showing rates for a particular month on or about the 20th day of the preceding
month. 15.4 IRS has issued tables, shown below, giving the one-month applicable federal shortterm (obligations not exceeding three years), mid-term (over three years but not over nine years),
and long-term (over nine years) rates (in percentages) based on annual, semiannual, quarterly
and monthly compounding assumptions:
AFR
110% AFR
120% AFR
130% AFR
AFR
110% AFR
120% AFR
130% AFR
October 2000 n16.3
Short-Term
6.30%
6.20%
6.15%
6.12%
6.94%
6.82%
6.76%
6.73%
7.58%
7.44%
7.37%
7.33%
8.22%
8.06%
7.98%
7.93%
January 2001 n15.12
Short-Term
5.90%
5.82%
5.78%
5.75%
6.50%
6.40%
6.35%
6.32%
7.10%
6.98%
6.92%
6.88%
7.71%
7.57%
7.50%
7.45%
¶ 4864. Interest on underpayments.
Interest is generally payable whenever any tax or civil penalty isn't paid when due ( Code Sec.
6601(a) ), even if the taxpayer has been granted an extension of time to pay the tax. ( Code Sec.
6601(b)(1) ; Reg § 301.6601-1(a) ) There's no interest on late payments of estimated tax ( Code
Sec. 6601(h) ) (but for comparable penalty computations, see ¶ 3158 (individuals) and ¶ 3355
(corporations)) or unemployment tax. ( Code Sec. 6601(i) ) FTC ¶ V-1000 et seq.; USTR ¶
66,014 ; Tax Desk ¶ 85,201
Interest is payable on an erroneous refund or credit. ( Code Sec. 6602 ) FTC ¶ T-9108 ; USTR ¶
66,024 ; Tax Desk ¶ 85,207
¶ 4827. Assessment of interest and penalties.
Interest may be assessed when the underlying tax is collectible. ( Code Sec. 6601(g) ) FTC ¶ T3646 ; USTR ¶ 66,014.01 ; Tax Desk ¶ 83,611
For income, estate, gift and certain excise taxes, the negligence and fraud penalties are assessed
like deficiencies ( ¶ 4826 ). So are the delinquency penalties ( ¶ 4872 , ¶ 4873 ), but only if
attributable to a deficiency and not if measured by the tax shown on the return. The penalty for
estimated tax underpayments ( ¶ 3117 , ¶ 3355 ) is assessed as a deficiency only if no return is
filed. ( Code Sec. 6665(b) ; Reg § 301.6659-1(c) ) FTC ¶ T-3638 et seq.; USTR ¶ 66,654 ; Tax
Desk ¶ 83,612
The normal assessment and collection rules don't apply to the penalties for promoting an abusive
tax shelter ( ¶ 4887 ), or for aiding and abetting a tax understatement ( ¶ 4883 ). A taxpayer may
delay collection of these penalties by paying at least 15% of the penalty and filing a claim for
refund of it, within 30 days of notice and demand for payment. If IRS denies the claim, the
taxpayer has 30 days to sue for refund in a district court (where IRS may counterclaim for the
unpaid penalty amount). The normal procedures also don't apply to the penalty for filing a
frivolous return ( ¶ 4891 ). ( Code Sec. 6703(b) , (c)) FTC ¶ V-5650 ; USTR ¶ 67,034
Numerical Implication Statement:
The under withholding penalty is triggered when a taxpayer's current federal income tax
withholdings are less than the minimum of 100 percent of last year's tax liability or 90 percent of
this year's tax liability. In the Fronks' case, it's highly likely that they had AGI in excess of
$150,000, suggesting that they actually need to pay in the minimum of 108.6 percent of last
year's tax or 90 percent of this year's tax. A safe harbor moderates this penalty logic, i.e., if the
under-withheld amount is less than $1,000, no penalty applies. The Fronks paid $109,337 in
taxes last year and have withholdings this year of $163,000. Since this year's withholdings are
more than 108.6 percent of last year's tax payments (i.e., 109,337 * 1.086 = $118,740), there is
no under-withholding penalty for the Fronks. Had there been a penalty, the following general
computational framework would have been relevant:
15-Apr
15-Jun
15-Sep
15-Jan
Minimum
Payment
$
32.25
$
32.25
$
32.25
$
32.25
Actually
Withheld
$ 28.75
$ 28.75
$ 28.75
$ 28.75
Pay Prior
Shortage
$
$
3.50
$
7.00
$ 10.50
Net Qrtly
Payment
$ 28.75
$ 25.25
$ 21.75
$ 18.25
Shortage Int* Time
$ 3.50
9% 61/365
$ 7.00
9% 92/365
$ 10.50
9% 122/365
$ 14.00
9% 90/368
Penalty
Amount
$ 0.05
$ 0.16
$ 0.32
$ 0.31
$ 0.84
1) Melinda’s tax liability for the current year is $1,721. Since she had $115 of federal
withholding for 2000 and a Hope credit of $449, her under-withholding is $1,157. This is above
the $1,000 safe harbor, which means under this assumption only she has a penalty. 2) In order to
avoid penalty, the required annual payment for Melinda is the lower of 90% of her 2000 tax
liability or 100% of the tax shown on her 1999 tax return. Last year Melinda’s tax liability was
$129 and 90% of this year's current liability is $1,549 ($1,721*.9). The lesser of these two is
$129. Therefore the minimum they should have paid $32.25 (129/4) per quarter and they only
paid $28.25 ($115/4) per quarter. Under this assumption, she will owe a penalty.
* Interest on underpayments of tax is imposed at the federal short-term rate plus three
percentage points. The interest rates, which are adjusted quarterly, are determined during the first
month of a calendar quarter and become effective for the following quarter. Consult charts in
Narrative Solution and you will see the tax rate for all four installments is 9%. From a tax
formula perspective, Melinda will be penalized $1.00 (.84 rounded) for under-withholding. This
will either increase tax due or reduce her refund.
Issue E31-1:
Path:
Path:
Tax Liability (MOM: Andy B., 169 points; PR: -----, 84 points)
CCH Online; USMTG; Tax Tables-Features; ¶25, Taxable income
tables at least $5,000 to $14,000, ¶128, Tax Table Simplifies
Computation
RIA Checkpoint; FTH; Spine, Chapter 1-Tax Rates and Tables; ¶
1102 Single individuals.
Narrative Solution:
A table prepared by the IRS (reproduced at ¶25 ) simplifies determination of the tax. The
table is based on taxable income and applies to taxpayers who file Form 1040 and have taxable
income of less than $100,000. A similar tax table (ending at $50,000 rather than $100,000) must
be used by filers of Forms 1040A and 1040EZ.
Taxpayers may not use the table if they have taxable income of $100,000 or more or if they
file short-period returns because of a change in their annual accounting periods (¶1507 and
¶1509 ). Also, estates and nongrantor trusts may not use the table; instead, they must use the Tax
Rate Schedule at ¶19 .
Path:
CCH Online; USMTG; Spine Search, Tax Tables, Tax Rates, Tax
Rate Schedules for 2000 and 2001; ¶13, SCHEDULE Y-1: Married
Filing Jointly and Surviving Spouses
Click on the calculator to look up the tax for the year, filing status, and income amount you
specify.
Individual Income Tax
2000
--------------------------------------------------Taxable Income
of the
But Not
% on
amount
Over
Over
Pay
+
Excess over---------------------------------------------------$
0-- $ 43,850 $
0
15%
$
0
43,850-- 105,950
6,577.50
28
43,850
105,950-- 161,450 23,965.50
31
105,950
161,450-- 288,350 41,170.50
36
161,450
288,350-- ........ 86,854.50
39.6
288,350
Numerical Implication Statement:
Because their taxable income is greater than $100,000, the Fronks are too wealthy to use the tax
table. Given their taxable income, the Fronks appear to be in the 31 percent marginal tax rate.
Of course, in the Fronks' case, long-term capital gains are taxed at a maximum rate of 20 percent.
As a practical matter, once the long-term gain is subtracted out, the Fronks drop back into the 28
percent bracket. Thus, their tax is ?????.
Issue E32-1:
Path:
Path:
State Income Tax Withholdings (MOM: Akiko, 113 points; PR: ----, 56 points)
CCH; 2001 USMTG; Search “itemized deductions”;Chapters 912—Deductions; Chapter 10-Nonbusiness Expenses; ¶1012, Floor
on Miscellaneous Itemized Deductions; ¶1021, Deductible Taxes;
¶924, Federal and State Income Taxes
RIA Checkpoint; FTH; Keyword Search “itemized deductions”;
Chapter 12 – Withholding Tax on Wages and Other Income
Payments; ¶ 3017, Additional withholding allowances; ¶ 3108,
Itemized Deductions
Narrative Solution:
Deductible Taxes
Taxes not directly connected with a trade or business or with property held for production
of rents or royalties may be deducted only as an itemized deduction on Schedule A of Form
1040. Following is a list of such taxes (Code Sec. 164(a) ):[ 2001FED ¶9500 ]
(1) State, local or foreign real property tax. (However, see ¶1026 .)
(2) State or local personal property tax. Payment for registration and licensing of a car
may be deductible as a personal property tax if it is imposed annually and assessed in
proportion to the value of the car (Reg. §1.164-3(c) )[ 2001FED ¶9506 ] (¶1022 ).
(3) State, local or foreign income, war profits, or excess profits tax (¶1023 and ¶2475).
(4) Generation-skipping transfer tax imposed on income distributions (¶2942 ).
Itemized Deductions Not Subject to the Two-Percent Floor
The following itemized deductions (reported on Schedule A of Form 1040 ) are not subject to the
two-percent floor discussed at ¶1011 (Code Sec. 67(b) ):[ 2001FED ¶6060 ]
(1) Interest (see ¶1043 et seq.),
(2) Taxes (see ¶1021 and ¶1028 et seq.),
(3) Casualty, theft, and wagering losses (see ¶1101 et seq.),
(4) Charitable deductions (see ¶1058 et seq.),
(5) Medical and dental expenses (see ¶1015 et seq.),
(6) Deductions for impairment-related work expenses (see ¶1013 ),
(7) Deductions for estate tax in the case of income in respect of a decedent (see ¶191 ),
(8) Deductions allowable in connection with personal property used in a short sale
(¶1944 ),
(9) Deductions relating to computation of tax when the taxpayer restores an amount in
excess of $3,000 held under claim of right (see ¶1543
(10) Deductions where annuity payments cease before an investment is
recovered pursuant to Code Sec. 72(b)(3) ,
(11)
Amortizable bond premiums (see ¶1967 ), and
(12) Deductions of taxes, interest, and business depreciation by cooperative housing
corporation tenant-stockholder (¶1040 ).
State income taxes that are based on net business income may only be deducted by selfemployed individuals on Schedule A of Form 1040 as an itemized deduction. However, if the
state income tax is based on gross business income, the tax may be deducted as a business
expense (Temporary Reg. §1.62-1T(d) ).[ 2001FED ¶6003 ].
RIA caution: A taxpayer who has too little tax withheld because he has claimed too many
withholding allowances may have to pay a penalty for underpayment of estimated tax, see ¶ 3158
.
Numerical Implication Statement:
Monica's $7,000, and given E26-2, Tom's $18,800 in state income withholdings of qualify as an
itemized deduction and are ultimately deductible to the extent that the Fronks' total itemized
deductions exceed their $7,350 standard deduction.
Issue E33-1:
Path:
Path:
Path:
Path:
FICA Taxes (MOM: Kevin, 338 points; PR: -----, 169 points)
CCH Network; USMTG; Spine, Credits, Refundable ¶1372, Credit
for Taxes Withheld on Wages
CCH Online; USMTG; Spine, FICA tax credit, Deductions,
Business Expenses-Taxes; ¶923, Social Security Tax
CCH Network; USMTG; Spine, Withholding – Estimated Tax
(Chapter 26), GUIDEBOOK, 2001USMTG ¶2648, FICA Tax
Rates
CCH Network; USMTG; Spine, Exclusions from Income –
Chapter 8, Employee Benefits, ¶863, Fringe Benefits, ¶873, Food
and Lodging Provided by Employer
Path:
Path:
CCH Network; USMTG; Spine, Exclusions from Income –
Chapter 8, Scholarships or Fellowship Grant, ¶879, Scholarship or
Fellowship Grant Is Not Income
RIA Checkpoint; FTH; Spine, Withholding Tax on Wages and
Other Income Payments (Chapter 12), FICA, ¶1107, FICA (Social
Security and Medicare) Tax
Narrative Solution:
¶1372, Credit for Taxes Withheld on Wages
A credit against the employee's income tax liability is granted for income taxes withheld from his
salary or wages and for social security taxes overwithheld on the wages of a taxpayer with more
than one employer (Code Sec. 31 ).[ 2001FED ¶4060 ] For 2000, if a single employer withheld
more than the maximum $4,724.40 of social security tax (6.2% tax rate on wage base of
$76,200), the employee should request a refund from the employer. Overwithholding for this tax
cannot be claimed as a refund on the employee's return. All wages are subject to the 1.45%
Medicare tax. See ¶2648 .
However, if a person has more than one employer and the employers' combined amounts
withheld exceed the maximum, a credit for the excess social security tax may be claimed on
Form 1040 . If the employee is not required to file an income tax return, he may file a special
refund claim (Reg. §31.6413(c)-1 ).[2001FED ¶38,754 ] See ¶2449 as to credits for tax withheld
from nonresident aliens.
¶923, Social Security Tax
The federal social security tax on an employer is deductible by the employer as a business
expense. The contribution of an employer on wages paid to a domestic worker is not deductible
unless it is classified as a business expense.[ 2001FED ¶9502.30 ]
The tax imposed on employees by the Social Security Act is not deductible by the employee. If
the employer pays the tax without deduction from the employee’s wages under an agreement
with the employee, the amount is deductible by the employer and is income to the employee
(Rev. Rul. 86-14 ).[ 2001FED ¶5508.0146 ]
A self-employed individual may deduct from gross income 50% of the self-employment tax
imposed for the same tax year (Code Sec. 164(f) ).[ 2001FED ¶9500 ] See, also, ¶2670 .
¶2648, FICA Tax Rates
Under the Federal Insurance Contributions Act, an employer is required to withhold social
security taxes (including hospital insurance tax) from wages paid to an employee during the year
and must also match the tax withheld from the employee's wages. For 2000, the combined tax
rate is 7.65 percent, which consists of a 6.2 percent component for old-age, survivors, and
disability insurance (OASDI) and a 1.45 percent component for hospital insurance (Medicare).
The OASDI rate applies only to wages paid within an OASDI wage base ($76,200 for 2000 and
$80,400 in 2001). There is no cap on wages subject to the Medicare tax (Code Sec. 3101 , Code
Sec. 3111 and Code Sec. 3121(a) ).[ 2001FED ¶114 ]
¶863, Fringe Benefits
The following noncash benefits qualify for exclusion from an employee's gross income: (1) noadditional-cost services (e.g., free stand-by flights by airlines to their employees); (2) qualified
employee discounts (e.g., reduced sales prices of products and services sold by the employer);
(3) working condition fringe benefits (e.g., use of company car for business purposes); (4) de
minimis fringe benefits (e.g., use of copying machine for personal purposes); (5) qualified
transportation fringe benefits (e.g., transportation in a "commuter highway vehicle," transit
passes, and qualified parking); and (6) qualified moving expense reimbursements (Code Sec.
132(a) ; Reg. §1.132-1 ). Also, the value of any on-premises athletic facilities provided and
operated by the employer is a nontaxable fringe benefit (Code Sec. 132(j)(4) ).[ 2001FED ¶7420]
The above benefits may be extended to retired and disabled former employees, to widows and
widowers of deceased employees, and to spouses and dependent children of employees.
Applicable nondiscrimination conditions must be met (Code Sec. 132(h) ).[ 2001FED ¶7420 ]
Denial of a deduction to an employer for its payment of travel expenses of a spouse, dependent,
or other individual accompanying an employee on business travel does not preclude those items
from qualifying as working condition fringe benefits (Reg. §1.132-5).
The above benefits that are excluded from an employee's gross income also are excludable from
the wage base for purposes of income tax, FICA, FUTA, and RRTA withholding purposes. In
the case of taxable noncash fringe benefits in the form of the personal use of an employerprovided vehicle, income tax withholding may be avoided if the employer elects not to withhold
and notifies the employee of such election (social
security and railroad retirement taxes must be withheld). However, the value of the benefit must
be included on the employee's Form W-2 (Code Sec. 3402(s) ).[ 2001FED ¶33,542 , 2001FED
¶33,591 ] The IRS has issued detailed regulations governing the exclusion of fringe benefits
from an employee's income.[ 2001FED ¶5510 , 2001FED ¶7430 , 2001FED ¶7421 ]
¶873, Food and Lodging Provided by Employer
Effective for tax years beginning after December 31, 1997, meals that are excluded from an
employee's income under Code Sec. 119 are considered a de minimis fringe benefit under Code
Sec. 132 .[ 2001FED¶7420 ] The IRS Restructuring and Reform Act of 1998 provided that if
more than one-half of the employees are furnished meals for the convenience of the employer, all
meals provided on the premises are treated as furnished for the convenience of the employer
(Code Sec. 119(b)(4) ). This provision became effective for tax years beginning before, on, or
after July 22, 1998. Therefore, the meals will be fully deductible by the employer, instead of
possibly being subject to the 50-percent limit on business meal deductions, and excludable by the
employees.
The value of meals and lodging furnished by an employer to an employee, a spouse, or
dependents for the employer's convenience is not includible in the employee's gross income if, in
the case of meals, they are furnished on the employer's business premises and if, in the case of
lodging, the employee is required to accept the lodging on the employer's business premises as a
condition of employment (Code Sec. 119 ; Reg.
§1.119-1 ).[ 2001FED ¶7220 , 2001FED ¶7221 ] The fact that the employer imposes a partial
charge for meals or that the employee may accept or decline meals does not affect the exclusion
if all other conditions are met, but cash reimbursements of the employee's meal expenses are
included in gross income (Code Sec.119(b) ).[ 2001FED ¶7220 , 2001FED ¶7222.59 ] If meals
are furnished for the convenience of the employer,
they must be furnished for substantial noncompensatory business reasons (such as having the
employee oncall) rather than as additional compensation (Reg. §1.119-1(a)(2) ).[ 2001FED
¶7221 ] See also Boyd Gaming Inc., 99-1 USTC ¶50,530.[ 2001FED ¶7222.29 ] The term
"business premises of the employer" generally means the place of employment of the employee.
It can include a camp located in a foreign country if an employee is furnished lodging.
¶879, Scholarship or Fellowship Grant Is Not Income
Any amount received as a qualified scholarship by an individual who is a candidate for a degree
at a qualified educational organization, which normally maintains a regular faculty and
curriculum and normally has a regularly enrolled body of students in attendance where its
educational activities are regularly carried on, is excluded from that individual's gross income
(Code Sec. 117 ; Reg. §1.117-1 ).[ 2001FED ¶7170 , 2001FED ¶7172 ] A qualified scholarship
includes any amount received by an individual as a scholarship or fellowship grant so long as the
amount was used for qualified tuition and related expenses such as fees, books, supplies, and
equipment required for courses of instruction at a qualified educational organization.
Tuition Reduction. The amount of any qualified tuition reduction to employees of educational
institutions is, similarly, excluded from gross income (Code Sec. 117(d) ).[ 2001FED ¶7170 ]
The tuition reduction must be provided to an employee of a qualified educational organization
(described above). The reduction can be for education provided by the employer or by another
qualified educational organization. Moreover, it can be for education provided to the employee,
the employee's spouse, dependent child, or other
person treated as an employee under Code Sec. 132(h) . However, it can only be used for
education below the graduate level unless it is for the education of an employee who is a
graduate student and who is engaged in teaching or research activities for the employer (Code
Sec. 117(d)(5) [4]).[ 2001FED ¶7170 ] Any qualified tuition reduction may be excluded only if it
does not discriminate in favor of highly compensated employees (Code Sec. 117(d)(3) ).[
2001FED ¶7170 ]
The exclusions for qualified scholarships and qualified tuition reductions will not apply to
amounts representing payments for teaching, research, or other services performed by the student
that are required as a condition for receiving the qualified scholarship or qualified tuition
reduction (Code Sec. 117(c) ).[ 2001FED ¶7170 ] Presumably, athletic scholarships awarded to
students who are expected, but not required, to participate in sports would, as they have in the
past, qualify for exclusion.[ 2001FED ¶7183.22 ]
Numerical Implication Statement:
This documentation reveals that a taxpayer's social security tax payments are not deductible and
that a credit for those payments is available only when over withholding arises from multipleemployers withholding on the seemingly same tax-base dollars. Because Monica's employer
withheld the appropriate FICA taxes and Tom is self-employed, one can conclude that neither
Tom nor Monica can take a deduction or credit for excess FICA withholdings.
Issue E34-1:
Path:
Path:
Medical Expenses (MOM: Rebecca, 169 points; PR: -----, 84
points)
RIA Checkpoint; Code; Medical Expense; Medical, Dental, Etc.
expenses
CCH; USMTG; Spine, Deductions, Non-business deductions;
Medical expenses;
Narrative Solution:
¶1016, What Are Medical Expenses?
Medical expenses include amounts paid for the diagnosis, cure, mitigation, treatment, or
prevention of disease or for the purpose of affecting any structure or function of the body;
transportation cost of a trip primarily for and essential to medical care; qualified long-term care
service; and for medical insurance (including premiums paid under the Social Security Act,
relating to supplementary medical insurance for the aged or for any qualified long-term care
insurance contracts that do not exceed certain limits) (Code Sec. 213(d) ).[ 2001FED ¶12,540 ] A
medical expense deduction is allowed for lodging, but not meals, while away from home
primarily for and essential to medical care. This lodging deduction is limited to amounts that are
not lavish or extravagant and cannot exceed $50 per night for each individual (Code Sec.
213(d)(2) ).[ 2001FED ¶12,540 ] The deduction may also be claimed for a person who must
accompany the individual seeking medical care.[ 2001FED ¶12,543.82 ]
The costs of birth control pills prescribed by a physician, a legal abortion or a vasectomy
are deductible.[ 2001FED ¶12,543.115 ] Amounts for psychiatric treatment of sexual inadequacy
are a medical expenditure, but marriage counseling fees are not.[ 2001FED ¶12,543.775 ,
2001FED ¶12,543.7055 ]
¶1015, Medical and Dental Expenses
An individual is entitled to an itemized deduction for expenses paid during the tax year for the
medical care of the individual, the individual's spouse, or a dependent to the extent that such
expenses exceed 7.5% of adjusted gross income (Code Sec. 213(a) ).[ 2001FED ¶12,540 ] These
expenses are reported on Schedule A of Form 1040 . On a joint return, the percentage limitation
is based on the total adjusted gross income of both husband and wife. The deduction may be
taken for any person who was a dependent or spouse either at the time the services were rendered
or at the time the expenses were paid (Reg. §1.213-1(e)(3) ).[ 2001FED ¶12,541 ] For purposes
of this deduction, "dependent" is defined at Code Sec. 152 (see ¶137 ), except (1) the amount of
the dependent's gross income is not considered (Reg. §1.213-1(a)(3) ),[ 2001FED ¶12,541 ] and
(2) a child of divorced parents is treated as the dependent of both parents for purposes of the
medical expense deduction (Code Sec. 213(d)(5) ).[ 2001FED ¶12,540 ] The deduction,
however, is limited to unreimbursed medical expenses (Code Sec. 213(a) ).[ 2001FED ¶12,540 ]
Reimbursement received for expenses deducted in a previous tax year is includible in gross
income in the year received to the extent previously deducted. Reimbursement for an earlier tax
year in which no deduction was claimed is excludable when received (Reg. §1.213-1(g) ).[
2001FED ¶12,541 ]
Numerical Implication Statement:
Medical expenses are amounts paid for the diagnosis, cure, mitigation, treatment, or prevention
of disease or for the purpose of affecting any structure or function of the body. They qualify as
an itemized deduction whose ultimate deductibility is subject to a 7.5% floor. The Fronks paid
for $24,250 (i.e., anticipating the legitimacy of orthodontia as a medical expense and selfemployed health insurance that is not deductible as a deduction from gross income) of medical
expenses during 2000. They received reimbursements from their accident and health care plan
of $6,600 and $1,200 from their health care flexible spending account. Once those amounts are
subtracted from the$24,250 in medical expenses, the Fronks have $16,450 of medical expenses
that are then subjected to the 7.5 percent floor. Regrettably, the 7.5-percent AGI floor eliminates
the deductibility of those remaining medical expenses.
Issue E35-1:
Path:
Path:
Order of Credit Usage (MOM: Frank, 281 points; PR: -----, 141
points)
CCH Network; USMTG; Spine, Tax Credits (Chapter 13),
Refundable and Nonrefundable Credits; GUIDEBOOK,
2001USMTG ¶1371, Credit Limits and IRC, 2001FED ¶4060,
Sec. 31, TAX WITHHELD ON WAGES
RIA Checkpoint; FTH; Spine, Chapter 7 Tax Credits – ¶2340
Personal (Refundable and Nonrefundable) Credits
Narrative Solution:
¶ 2340 Personal (Refundable and Nonrefundable) Credits.
Taxpayers, whether or not in business, may qualify for one or more personal credits. Some of
these credits are refundable, i.e., the excess of the credit over taxpayer's tax liability is refunded
to the taxpayer; others are not.
The nonrefundable credits are:
... the credit for the elderly and the permanently and totally disabled, see ¶ 2350 ;
... the credit for household and dependent care expenses, see ¶ 2351 et seq.;
... the credit for adoption expenses, see ¶ 2357 ;
... the regular child tax credit, see ¶ 2358 ;
... the mortgage credit, see ¶ 2363 ;
... the hope scholarship and lifetime learning credits, see ¶ 2361 and ¶ 2362 ;
... the credit for electric vehicles, see ¶ 2364 ;
... the first-time DC homebuyer credit, see ¶ 2365 ;
... the minimum tax credit, see ¶ 2367 .
The refundable credits are the credits:
... for earned income by certain taxpayers, see ¶ 2341 et seq.;
... for additional child credit for families with three or more children, see ¶ 2359 ;
... for tax withheld, see ¶ 2348 ;
... for excess social security tax withheld, see ¶ 2349 ; and
... for excise tax for certain nontaxable uses of fuels.
¶1371 Credit Limits
The nonrefundable credits are claimed in the following order: (1) the sum of the personal credits
are claimed first: (a) Child and Dependent Care Credit (¶1301), (b) Credit for the Elderly and
Permanently or the Permanently and Totally Disabled (¶1304 ), (c) the
Educational Credits (¶1303 ), (d) the Child Tax Credit (¶1302 ), (e) the Adoption Credit (¶1306
), and (f) the Credit for Interest on Certain Home Mortgages (¶1308 ) (note: the sum of the
personal credits may be claimed only to the extent that they do not exceed the excess of the
regular tax liability over the tentative minimum tax, as determined without regard to the
alternative minimum tax foreign tax credit; however, in 2000 and 2001 the credits may be taken
against both the regular tax liability and the alternative tax liability (Code Sec. 26(a), as amended
by Tax Relief Extension Act of 1999, P.L. 106-170)); (2) Foreign Tax Credit (¶1311 ); (3)
Alternative Fuels Credit (¶1319 ); (4) the Qualified Electric Vehicles Credit (Code Sec. 30 )
(¶1321 ); and (5) the General Business Credit (¶1323 ) (note: the general business credit is
claimed not only after the above listed credits but also after the refundable credits discussed at
¶1372 et seq.).
¶4060, Sec. 31, Tax Withheld On Wages
WAGE WITHHOLDING FOR INCOME TAX PURPOSES-- The amount withheld as tax under
chapter 24 shall be allowed to the recipient of the income as a credit against the tax imposed by
this subtitle.
Numerical Implication Statement:
This documentation makes it clear that there are two classes of credits, nonrefundable and
refundable. In addition, we can see that there is a usage order for nonrefundable credits.
Although somewhat subtle, this documentation also establishes that in general, with the
exception of the general business credit, nonrefundable credits are used before refundable
credits. That subtle notion is established in the wording of the last phrase, "…the general
business credit is claimed not only after the above listed credits but also after the
refundable credits".
Issue E36-1:
Path:
Guaranteed Student Loan Interest (MOM: Emily, 225 points;
PR: -----, 113 points)
RIA Checkpoint; FTH; keyword: Student Loan; ¶ 1727 Qualified
education loan interest (up to $2,000 in 2000) deductible abovethe-line.
Narrative Solution:
Student loan interest generally is treated as personal interest and thus isn't deductible. However,
individuals can deduct a maximum of $2,000 for 2000 ($2,500 for 2001 and thereafter) for
interest paid on qualified higher education loans. (Code Sec. 221) FTC ¶ K-5500 et seq.; USTR ¶
2214. Tax Desk ¶ 31,410 et seq. The deduction is claimed as an adjustment to gross income to
arrive at adjusted gross income. (Code Sec. 62(a)(17)) FTC ¶ K-5501; USTR ¶ 2214 Only
interest paid during the first 60 months in which interest payments are required (whether or not
consecutive) is deductible. FTC ¶ K-5501.1; USTR ¶ 2214; Tax Desk ¶ 31,411.1 For this
purpose, a loan and any refinancings are treated as one loan. (Code Sec. 221(d)) The 60-month
period for consolidated loans or collapsed loans generally begins on the latest date on which any
of the underlying loans entered repayment status. (Prop Reg § 1.221-1(h)(1) [taxpayers may
rely]) FTC ¶ K-5501.4; USTR ¶ 2214
The 60-month period continues to elapse whether or not payments are actually made, unless the
repayment period is suspended for a period of deferment or forbearance (including postponement
in anticipation of cancellation). But the 60-month period isn't suspended if interest continues to
accrue while the loan is in deferment or forbearance, and the taxpayer has the option of
requesting that the interest be capitalized during the deferment but elects to make current interest
payments. (Prop Reg § 1.221-1(e)(3) [Taxpayers may rely]) FTC ¶ K-5501.4; USTR ¶ 2214 No
deduction is allowed for interest due within the 60-month period that is paid after its expiration.
(Prop Reg § 1.221-1(e)(4) [Taxpayers may rely]) FTC ¶ K-5501.1 et seq.; USTR ¶ 2214; Tax
Desk ¶ 31,411.1
RIA observation: The 60-month rule means that interest payments on loans taken out years ago
may still be deductible. For example, if payment on a qualifying loan started in Jan., '97, the
taxpayer will be able to deduct a full 12 months of interest for 2000 and a full 12 months of
interest for 2001 before the 60-month period runs out.
No deduction is allowed under the higher-education loan provision for any amount for which a
deduction is allowable under any other provision of the Code (e.g., home equity loan; see ¶
1737). (Code Sec. 221(f)(1)) FTC ¶ K-5503.1; USTR ¶ 2214.02; Tax Desk ¶ 31,414.2
The deduction phases out ratably for taxpayers with modified AGI between $40,000 and $55,000
($60,000 and $75,000 on joint returns). Modified AGI is AGI figured without regard to the
deduction for qualified education loan interest, and without regard to the exclusions for foreign,
possession, and Puerto Rico income. (Code Sec. 221(b)(2)(C)(i)) The $40,000 and $60,000
phase-out thresholds will be indexed for inflation after 2002. FTC ¶ K-5502; USTR ¶ 2214.01;
Tax Desk ¶ 31,412
A person who is claimed as a dependent on another's return can't claim the education interest
deduction. (Code Sec. 221(c)) FTC ¶ K-5503 The deduction may be claimed only by a person
legally obligated to make the interest payments. (Prop Reg § 1.221-1(b) [Taxpayers may rely])
FTC ¶ K-5502.2 And married couples must file joint returns to take the deduction. (Code Sec.
221(f)(2)) FTC ¶ K-5503.2
Path: RIA Checkpoint; FTH; keyword: Student Loan; ¶ 1728 Qualified education loan defined.
A qualified higher education loan is any debt incurred by the taxpayer solely to pay qualified
higher education expenses that are:
... incurred on behalf of the taxpayer, the taxpayer's spouse, or any dependent of the
taxpayer as of the time the debt was incurred, ... paid or incurred within a reasonable period of
time before or after the debt is incurred, and ... attributable to education furnished during a
period when the recipient was an eligible student (as defined for Hope credit purposes, i.e., at
least a half-time student, see ¶ 2361). (Code Sec. 221(e)(1))
Any education loan issued as part of a federal postsecondary education loan program
automatically meets the reasonable-period requirement. Also, qualified higher education
expenses are considered paid within a reasonable time if they relate to a particular academic
period and the loan proceeds are disbursed within 60 days before the start and 60 days after the
end of that academic period. (Prop Reg § 1.221-1(f)(3)(ii) [Taxpayers may rely])
Revolving lines of credit generally aren't qualified education loans unless the borrower agreed to
use the line of credit to pay only qualifying higher education expenses.
A qualified education loan includes debt used to refinance debt that qualifies as a qualified
education loan, but doesn't include:
... debt owed to a related person as defined by Code Sec. 267(b) (¶ 2450) or Code Sec.
707(b)(1) (¶ 3730)
... or debt owed by reason of (a) a loan under a qualified employer plan or (b) certain
amounts treated as a loan under a qualified employer plan. (Code Sec. 221(e)(1))
Loans do not have to be made or guaranteed under a federal education loan program to be
qualified education loans. (Prop Reg § 1.221-1(f)(3)(iv) [Taxpayers may rely]) FTC ¶ K-5504;
USTR ¶ 2214.02; Tax Desk ¶ 31,414
Qualified higher education expenses are the costs of attendance at an eligible educational
institution, which is generally a post-secondary educational institution eligible to participate in
the federal student loan program. An eligible educational institution also includes one
conducting an internship or residency program leading to a degree or certificate awarded by an
institution of higher education, a hospital, or a health care facility that offers postgraduate
training. (Code Sec. 221(e)(2)) FTC ¶ K-5504.2 Qualified higher education expenses include
tuition, fees, room and board, and related expenses, but must be reduced by the amount excluded
by reason of such expenses under the rules for employer-provided educational assistance benefits
(¶ 1259), income from U.S. Savings Bonds used to pay higher education expenses (¶ 1340),
distributions from an education IRA (¶ 4385), and scholarship or fellowship grants (¶ 1385).
(Code Sec. 221(e)(2)) They also must be reduced by veterans' and armed forces' educational
assistance allowances and any other educational assistance excludable from the student's gross
income (other than as a gift, bequest, devise or inheritance). (Prop Reg § 1.221-1(f)(2)
[Taxpayers may rely]) FTC ¶ K-5503.1
Path: CCH Online; USMTG; Spine, Individuals, keyword: student loan, Forms in Use for
2000, Adjustments to Income, Education and Related Expenses; ¶1082, Education and
Related Expenses
Interest on Education Loans. Individuals are allowed to deduct interest paid during the tax year
on any qualified education loan from gross income in arriving at adjusted gross income on Form
1040 . The debt must be incurred by the taxpayer solely to pay qualified higher education
expenses (Code Sec. 221(e)(1) ). The deduction is limited to interest paid during the first 60
months in which such payments are required. The original loan and all refinancings of the loan
are treated as one loan for this purpose (Code Sec. 221(d)). The maximum deductible amounts of
interest are as follows: $2,000 for tax years beginning in 2000; and $2,500 for tax years
beginning in 2001 and thereafter (Code Sec. 221(b)(1) ).[ 2001FED ¶12,692 ] In computing the
deductible amount, the deduction that would otherwise be allowed (taking into account the above
dollar limitation) is reduced by an amount that equals the otherwise allowable deduction times a
fraction, the numerator being the excess of AGI over $40,000 ($60,000 if married filing jointly)
and the denominator being $15,000. The deductible amount cannot be reduced below zero (Code
Sec. 221(b)(1)(B)).
Numerical Implication Statement:
Interest on education loans is deductible from gross income up to $2,000 in 2000 and $2,500 for
years thereafter. The deduction is available for the first five years that payments are required. A
deduction phaseout begins at adjusted gross income of $60,000 and is complete at $75,000 (for
married-filing-jointly individuals). While the Fronks have no education-loan interest, if they
had, it would have been phased out.
Expertise Issues From Case 2:
Issue E1-2:
Path:
Sales Tax (MOM: Katie, 150 points; PR: -----, 75 points)
RIA Checkpoint; FTH; Spine, RIA Federal Tax Handbook
Chapter 4 Interest Expense--Taxes--Losses--Bad Debts ¶ 1757
Deduction for Taxes.¶ 1758 Which taxes are deductible?
Narrative Solution:
¶ 1758. Which taxes are deductible?
Deductible state, local and foreign taxes are:
... state, local and foreign income, war profits and excess profits taxes;
... state, local and foreign real property taxes;
... state and local personal property taxes;
... other state, local and foreign taxes (e.g., occupational taxes) paid or accrued in business
or for the production of income unless incurred in connection with an acquisition or disposition
of property. ( Code Sec. 164(a)(1) , (3))
State or local sales or use taxes paid or incurred in connection with the acquisition or
disposition of property aren't deductible (buyer treats them as part of the cost, seller as a
reduction in the amount realized). Other sales taxes are deductible only if paid or incurred in a
trade or business or for the production of income. ( Code Sec. 164(a) ) FTC ¶ L-2352.1 ; USTR ¶
1644.09 ; Tax Desk ¶ 32,701 For state unemployment and disability taxes, see ¶ 1759 .
Numerical Implication Statement:
The Fronks paid state sales taxes of $3,002. These taxes are not deductible.
Issue E2-2:
Path:
Path:
Clothing Deductions (MOM: Amanda, 300 points; PR: Garit,
150 points)
CCH Network; USMTG; Spine, Non-business expenses (Chapter
10), Clothing expenses; ¶1083, Uniforms and Special Clothing
RIA Checkpoint; FTH; Spine, Chapter 3- Expenses of a Business;
¶ 1627 Uniforms and special work clothes.
Narrative Solution:
¶ 1627. Uniforms and special work clothes.
Deduction for the cost and maintenance of clothing is allowed if:
... the employee's occupation is one that specifically requires special apparel or equipment as a
condition of employment, and
... the special apparel or equipment isn't adaptable to general or continued usage so as to take the
place of ordinary clothing.
Thus, protective clothing, such as safety shoes, helmets, fishermen's boots, work gloves, oil
clothes, etc., are deductible if required for the job. But work clothing and standard work shoes
aren't deductible even if the worker's union requires them. FTC ¶ L-3801 ; USTR ¶ 1624.067 ;
Tax Desk ¶ 35,101 Clothes ruined on the job aren't deductible unless the above tests are met.
FTC ¶ L-3805 ; USTR ¶ 1624.067 ; Tax Desk ¶ 35,105
Uniforms and Special Clothing
The cost and upkeep of a uniform, including laundering and cleaning, are deductible only if the
uniform is required as a condition of employment and is not adaptable to general wear. If the
employee is reimbursed for uniform expenses under an accountable plan (¶943 ), reimbursement
is not reported on the employee's Form W-2 ; therefore, it need not be accounted for on the
employee's tax return (Reg. §1.62-2(c)(4) ).[ 2001FED ¶6004 , 2001FED ¶6006 , 2001FED
¶6006.15 ] If the cost exceeds the reimbursement, any excess is deductible as an itemized
deduction, subject to the 2% floor (¶1011 ). Reimbursement made under a nonaccountable plan
(¶943 ) must be included in income, but may be deducted as an itemized deduction on Schedule
A of Form 1040 , subject to the 2% floor and limitations (Reg. §1.62-2(c)(5) ).[ 2001FED ¶6004
, 2001FED ¶6006.0334 ] Armed Forces reservists may deduct the unreimbursed cost (less
nontaxable uniform allowance) of a uniform required when in attendance at drills or other
functions if prohibited from wearing it for regular use.[ 2001FED ¶8524.265 ]
A deduction is allowed for special items required in the employee's work that do not replace
items of ordinary clothing, such as work shoes and special gloves for a railroad fireman, shop
caps, high-top shoes, and leather-palm gloves used by a railroad car repairman, gloves used by a
railroad brakeman, and boots required of a telephone company lineman.[ 2001FED ¶8524.265 ,
2001FED ¶8524.2658 ]
¶1003, Personal Expense
A personal, living or family expense is not deductible unless the Code specifically provides
otherwise (Reg. §1.262-1 ).[ 2001FED ¶13,601 ] Nondeductible expenses include insurance
premiums paid on taxpayer's own dwelling, life insurance premiums paid by the insured, and
payments for house rent, food, clothing, domestic help, most education, and upkeep of an
automobile.
¶1011, Two-Percent Floor on Itemized Deductions
An individual is allowed itemized deductions, other than the ones listed at ¶1012 , only to the
extent that the aggregate of such deductions exceeds two percent of the individual's adjusted
gross income for the tax year (Code Sec. 67(a) ).[ 2001FED ¶6060 ] These deductions are
reported on Schedule A of Form 1040 . Indirect deductions from pass-through entities (including
nonpublicly offered mutual funds) that would not be allowed if paid or incurred directly by an
individual are denied. However, such pass-through entities do not include estates, certain trusts,
cooperatives, certain publicly offered mutual funds (RICs), and real estate investment trusts
(REITs) (Code Sec. 67(c) ).[ 2001FED ¶6060 ] Estates and trusts are generally treated as
individuals. See ¶528 .
Any limitation or restriction placed upon an itemized deduction, such as the 50% reduction for
meals, generally applies prior to the two-percent floor (Reg. §1.67-1T(a)(2) ).[ 2001FED ¶6061 ]
A statutory employee, such as a full-time life insurance salesperson, is not treated as an
employee for purposes of deducting expenses incurred in his business. Thus, such expenses may
be claimed as trade or business expenses on Form 1040 , Schedule C, and are not treated as
miscellaneous itemized deductions (see ¶941B ).[ 2001FED ¶6006.107 ]
Numerical Implication Statement:
Monica and Tom had clothing expenses of $3,129 and $4,800, respectively. The tests to see if
the uniform and laundry expenses are deductible are (1) is the uniform required as a condition of
employment and (2) is it not adaptable to general wear. Monica and Tom clothing expenses
probably fail the first requirement and definitely fail the second requirement. Thus, they cannot
deduct any of their clothing expenses. Had they been able to do so, Monica's clothing expenses
would have been a miscellaneous itemized deduction subject to the 2% of AGI limit (only the
portion of total miscellaneous expenses exceeding 2% of AGI can be deducted) and Tom's would
have been deductible as a business expense since he's self-employed
Issue E3-2:
Path:
Path:
Path:
Path:
Path:
Cancellation of Debt (MOM: Jill, 450 points; PR: -----, 225
points)
CCH Network, Spine, Cancellation of Debt, - Standard Federal
Income Tax Reporter - Income and exclusions--Secs. 61-150 Gross income defined (compensation, business and farm income,
dealings in property, pensions, discharge of indebtedness, illegal
gains, devices to escape taxation)--Sec. 61 - CCH-EXP,
Cancellation of Indebtedness, 2001FED ¶5802.021, Cancellation
of Indebtedness: Discharge-of-debt income
CCH Network; USMTG; Spine, Exclusions from Income (Chapter
8), ¶885 Income from Discharge of Debt
CCH Network; USMTG; Spine, Income (Chapter 7), ¶791 Debt
Cancelled
CCH Online; Federal Tax Service; Keyword: loans; §A:5.45,
Loans and Offsetting Liabilities
CCH Online; Federal Tax Service; Keyword: loans; §A:9.61, Gifts
Narrative Solution:
2001FED ¶5802.021, Cancellation of Indebtedness: Discharge-of-debt income
Cancellation of Indebtedness: Discharge-of-debt income.-Generally, a taxpayer realizes income from a creditor's nongratuitous discharge of all or a portion
of the taxpayer's debt (Code Sec. 61(a)(12) ; Reg. §1.61-12(a) ). Included within the meaning of
a debt is any indebtedness for which a taxpayer is liable or any debt that attaches to property held
by the taxpayer (IRS Pub. 525 "Taxable and Nontaxable Income" (for 1998 returns)). For
example, if a creditor discharges a taxpayer's debt because the taxpayer performed certain
services for the creditor, the taxpayer will realize income in the amount of the debt (Reg. §1.6112(a) ).
Gratuitous discharge of debt. If a creditor intends for a discharge of debt to be a gift, the debtor
does not realize income. The important factor is the creditor's donative intent and not the
voluntary or involuntary nature of the cancellation of the debt. Thus, the mere fact that
cancellation of a debt is voluntary does not establish that it was a gift. It is important to note that
cancellation of debt in the business context ordinarily will not be treated as
gratuitous because businesses generally do not intend to make gifts to each other.
¶885, Income from Discharge of Debt
Generally, a taxpayer realizes income to the extent his debts are forgiven (Code Sec. 61(a)(12) ).
However, a taxpayer need not recognize income from the discharge of debts in bankruptcy
proceedings under title 11 of the U.S. Code or when the taxpayer is insolvent outside bankruptcy
(Code Sec. 108(a)(1)(A) and (B) ). See ¶791 . Certain taxpayers may also exclude from gross
income amounts realized from the discharge of qualified real property business indebtedness and
qualified farm indebtedness (Code Sec. 108(c) and Code Sec. 108(g) ). See ¶791 . For the
cancellation of certain student loans, also see ¶791 .
¶791, Debt Canceled
Income from the discharge of indebtedness is includible in gross income unless it is excludable
under Code Sec. 108 . Four types of exclusions are provided in the following priority order: [
2001FED ¶7002 ] (1) a debt discharge in a bankruptcy action under Title 11 of the U.S. Code in
which the taxpayer is under the jurisdiction of the court and the discharge is either granted by or
is under a plan approved by the court; (2) a discharge when the taxpayer is insolvent outside
bankruptcy; (3) a discharge of qualified farm indebtedness; and (4) a discharge of qualified real
property business indebtedness.
The taxpayer's insolvent amount includes the amount by which a nonrecourse debt exceeds the
fair market value of the property securing the debt, but only to the extent that the excess
nonrecourse debt is discharged.[ 2001FED ¶7010.38 ] Form 982 is filed with a
debtor's income tax return to report excluded income from the discharge of indebtedness.
When an amount is excluded from gross income as the result of a discharge of indebtedness in a
Title 11 case, a discharge of indebtedness during insolvency, or a discharge of qualified farm
indebtedness, a taxpayer is required to reduce its tax attributes. The reduction in the foreign tax
credit, minimum tax credit, passive activity credit, and general business credit carryovers is to be
made at a rate of 331/3 cents per dollar of excluded income (Code Sec. 108(b)(3)(B) ).[
2001FED ¶7002 ]
A corporation that satisfies a debt by transferring corporate stock to its creditor is treated as if it
has paid the creditor with money equal to the fair market value of the stock. The corporation will
thus have income from discharge of indebtedness to the extent that the principal of the debt
exceeds the value of the stock (and any other property transferred) (Code Sec. 108(e)(8) ).[
2001FED ¶7002 ] A similar rule applies to debtors (corporate or noncorporate) issuing debt
instruments in satisfaction of indebtedness (Code Sec. 108(e)(10) ).
Nonrecourse Debt. Discharge of indebtedness can result even if the canceled debt is nonrecourse
(i.e., no person is personally liable for repayment of the debt). Thus, where property securing a
nonrecourse debt is transferred in exchange for cancellation of the debt (such as a foreclosure
sale), the amount realized from the sale or exchange includes the principal amount of the debt
discharged.[ 2001FED ¶5802.34 ] The IRS has ruled
that the "writedown" of the principal amount of a nonrecourse note by a holder who was not the
seller of the property results in the realization of discharge of indebtedness income, even if there
is no disposition of the property (Rev. Rul. 91-31 ).[ 2001FED ¶5802.34 ]
Farmers. Income arising from the discharge of qualified farm indebtedness owed to an unrelated
lender, including a federal, state, or local government or agency, or instrumentality thereof, may
be excluded from a taxpayer's income if certain requirements are met. The debt must be incurred
directly in connection with
the operation by the taxpayer of the trade or business of farming. Also, this relief applies only if
at least 50% of the taxpayer's aggregate gross receipts for the three tax years preceding the tax
year in which the discharge of indebtedness occurs is attributable to the trade or business of
farming. The discharge of indebtedness income is excluded only to the extent absorbed by tax
attributes (credits are reduced at a rate of 331/3 cents per dollar of excluded income) and the
adjusted bases of qualified property (any property held or used in a trade or business or for the
production of income) (Code Sec. 108(g) ).[ 2001FED ¶7002 ]
Basis reduction occurs first with respect to depreciable property, then with respect to land used
in the business of farming, and finally with respect to other qualified property (Code Sec.
1017(b)(4) ).
Qualified Real Property Business Indebtedness. A taxpayer other than a C corporation may elect
to exclude from gross income amounts realized from the discharge of debt incurred or assumed
in connection with real property used in a trade or business and secured by that property (Code
Secs. 108(a)(1)(D) and 108(c)).[2001FED ¶7002 ] The debt must be incurred or assumed before
1993, or, if incurred or assumed after 1992, it
must be incurred or assumed to acquire, construct, reconstruct, or substantially improve the real
property. The excludable amount is limited to the excess of the outstanding principal amount of
the debt over the fair market value of the business real property (reduced by the outstanding
principal amount of any other qualified business
indebtedness secured by the property). Also, the exclusion may not exceed the aggregate
adjusted bases of depreciable real property held by the taxpayer immediately before discharge.
The excluded amount reduces the basis of depreciable real property.
The election to treat debt as qualified real property business indebtedness must be filed with the
taxpayer's timely income tax return (including extensions) for the tax year in which the discharge
occurs (Reg. §1.108(c)-5 ). The election, which is revocable with the consent of the IRS
Commissioner, is made on Form 982 . A taxpayer who fails to make a timely election must
request consent to file a late election under (Reg. §301.9100-3 ).
Student Loans. A special income exclusion applies to the discharge of all or part of a student
loan if, pursuant to the loan agreement, the discharge is made because the individual works for a
specified period of time in certain professions for any of a broad class of employers (e.g., as a
doctor or nurse in a rural area) (Code Sec. 108(f) ).[ 2001FED ¶7002 ] The loan must be made by
(1) a federal, state, or local government (or
instrumentality, agency, or subdivision, thereof); (2) a tax-exempt public benefit corporation that
has assumed control of a public hospital with public employees; or (3) an educational institution
if (a) it received funds to loan from an entity described in (1) or (2) above, or (b) the student
serves, pursuant to a program of the institution, in an occupation or area with unmet needs under
the direction of a governmental unit or a tax-exempt section 501(c)(3) organization (e.g.,
charitable, religious, educational, scientific organization). Loans refinanced through such a
program by the institution (or certain tax-exempt organizations) also qualify for the exclusion.
§A:5.45, Loans and Offsetting Liabilities
Generally, if a taxpayer receives property or money and he is obligated to repay the money or
return the property, the value of that property or money is not included in gross income. There is
no accession to wealth because of the offsetting liability; there is no increase in the taxpayer's net
worth. Thus, the proceeds of a loan made to a taxpayer are not income at the time the loan is
made.36 The source of the funds ultimately used to repay the loan is immaterial. Thus, for
example, a taxpayer who used misappropriated funds to repay cash advances from credit cards
was not required to include in gross income the amount of the cash advances, although the
misappropriated funds were included in gross income.37 In another case, the Tax Court held that
a loan from an employer to an employee-stockbroker that was evidenced by a promissory note
was a valid indebtedness and not compensation for future services. Subsequent year-end bonuses
from the employer to the employee in the exact repayment amount due on the loan were
includable in the employee's income in the year received.38 However, if the loan is subsequently
forgiven by the lender, or the lender's claim against the taxpayer becomes unenforceable because
of the running of the statute of limitations, the taxpayer may have gross income at that time in
the nature of income from the discharge of indebtedness.39 Collection of a loan is unenforceable
if the borrower, rather than the lender, controls whether the loan must be repaid. Thus, for
example, when a professional sports team received an advance which was to be repaid out of the
proceeds from the rental of skyboxes, but was not actually required to build or rent skyboxes, the
team, rather than the purported lender, controlled whether the advance would ever have to be
repaid. Therefore, the team had taxable income equal to the amount of the advance at the time
the advance was made.40
For a taxpayer to realize income as a result of the forgiveness of indebtedness, the debt must be
one for which the taxpayer is liable or subject to which the taxpayer holds property.44 See
§E:4.60.
An amount transferred without expectation of repayment, even if evidenced by an IOU, is
considered a gift rather than a loan.42 The taxpayer bears the burden of proving that a transfer is
a loan. Thus, purported loans received by a taxpayer who was the president of a corporation were
included in the taxpayer's gross income when there was no corporate authorization for the loans,
no written evidence of indebtedness, and no repayment of principal or interest.43
§A:9.61, Gifts
Gifts are not included in income.1 Although a gift for tax purposes may differ from a commonlaw gift,2 in most situations the requirements are the same. These requirements include the
following:
1
Code Sec. 102(a).
2
See Edson v Lucas, 40 F2d 398 (8th Cir 1930).
 a competent donor;
 a donee capable of accepting the gift;
 a clear intention of the donor to divest himself of the title to and dominion and control of
the property absolutely and irrevocably;
 donative intent, as opposed to business or investment motives;
 an actual irrevocable transfer of the legal title to and dominion and control of the property
to the donee (see §A:9.61[3]);
 delivery of the property to the donee; and
 acceptance by the donee.3
Numerical Implication Statement:
This documentation suggests that the discharge of indebtedness is generally included in gross
income. However, it appears that the cancellation of debt is not income if that cancellation is
intended as a gift. Since the Fronk's did not have any discharge of indebtedness, the analysis of
this issue ends here.
Issue E4-2:
Path:
Employer Provided Childcare Payments (MOM: Tonya, 300
points; PR: -----, 150 points)
CCH Network; USMTG; Spine, Childcare (Chapter 8) Exclusions
from Income; ¶869, Employer-Provided Child or Dependent Care
Services
Narrative Solution:
¶869, Employer-Provided Child or Dependent Care Services
The value of child or dependent care services provided by an employer pursuant to a written plan
generally is not includible in the employee's gross income (Code Sec. 129 ).[ 2001FED ¶7380 ]
To qualify for dependent care assistance, the dependent must be (1) under 13 years old, (2)
physically or mentally incapable of caring for himself, or (3) a spouse who is physically or
mentally incapable of self-care (Code Sec. 21(b)(1) ). The plan generally must not discriminate
in favor of employees who are highly compensated. However, if a plan would qualify as a
dependent care assistance program except for the fact that it fails to meet discrimination,
eligibility, or other requirements of Code Sec. 129(d) , then despite the failure the plan may still
be treated as a dependent care assistance program in the case of employees who are not highly
compensated. The amount excludable from gross income cannot exceed $5,000 ($2,500 in the
case of a separate return by a married individual). The amount of any payment exceeding these
limits is includible in gross income for the tax year in which the dependent care services were
provided, even if payment for the services is received in a subsequent tax year (Code Sec.
129(a)(2)(B) ).[ 2001FED ¶7380 ] The exclusion cannot exceed the earned income of an
unmarried employee or the earned income of the lower-earning spouse of married employees.
The exclusion does not apply unless the name, address, and taxpayer identification number of the
person performing the child or dependent care services are included on the return of the
employee benefiting from the exclusion (Code Sec. 129(e)(9) ). However, the exclusion may be
claimed even though the information is not provided if it can be shown that the taxpayer
exercised due diligence in attempting to provide this information. See ¶1301 for child and
dependent care credits.
Numerical Implication Statement:
Payments by an employer for dependent care assistance under a written plan are excluded from
an employee's gross income up to $5,000 and to the extent of the earned income of the lower
earning spouse. Since the Fronks did not receive childcare, our analysis of this issue ends here.
Issue N5:
Path:
Path:
Path:
Mortgage Interest (MOM: Jana, 400 points; AUD: Amanda, 200,
points; PR: -----, 200 points)
RIA Checkpoint; FTH; Spine, Chapter 4 Interest Expense—Taxes—
Losses—Bad Debts; ¶ 1733 Qualified Residence Interest.
CCH Network; USMTG; Mortgage Interest; ¶1045, Personal Interest
CCH Network; USMTG; Mortgage Interest; ¶1047, "Qualified
Residence Interest" Defined
Narrative Solution:
¶ 1700 Deduction for Interest.
Interest is deductible if it's incurred with respect to a valid debt and is actually paid or accrued
during the tax year. But there's no deduction for interest incurred in most personal transactions
and on certain kinds of debt. To be deductible, the charge for interest need not be reasonable,
FTC ¶ K-5001 ; USTR ¶ 1634 ; Tax Desk ¶
31,102 and may even be usurious. FTC ¶ K-5002 ; USTR ¶ 1634.021 ; Tax Desk ¶ 31,102 But it
must be definitely ascertainable, FTC ¶ K-5024 ; USTR ¶ 1634.025 and be paid with respect to a
valid debt. FTC ¶ K-5060 et seq.; USTR ¶ 1634 ; Tax Desk ¶ 31,152
The deduction for interest is subject to various limits (for investment interest, see ¶ 1729 et seq.;
for qualified residence interest, see ¶ 1733 et seq.; for qualified education loan interest, see ¶
1726 ), and some interest may not be deducted at all ( ¶ 1715 et seq.). For limits on the deduction
of interest incurred in a passive activity, see ¶ 1812 et seq. For interest expenses that must be
included in inventory or capitalized, see ¶ 1654 et seq.
¶ 1753. When to deduct “unstated interest.”
The unstated interest allocated to a payment in a deferred payment sale ( ¶ 1708 ) is deducted by
cash method buyers in the year the payment is made, and by accrual method buyers in the year
the payment is due. ( Reg § 1.483-2(a)(1)(ii) ) FTC ¶ K-5283 ; USTR ¶ 1634 ; Tax Desk ¶
31,953
¶ 1733 Qualified Residence Interest.
Qualified Residence Interest.
Taxpayers may claim itemized deductions for “qualified residence interest”—i.e., interest on (1)
up to $1,000,000 of acquisition debt and (2) up to $100,000 of home-equity debt. The debt must
be secured by taxpayer's “qualified residence.”
¶ 1734. Deduction of “qualified residence interest.”
“Qualified residence interest” ( ¶ 1735 ) is specifically excluded from the bars or limits on
deducting:
personal interest ( ¶ 1715 ) ( Code Sec. 163(h)(2)(D) ; Reg § 1.163-10T(b) );
investment interest ( ¶ 1731 ) ( Code Sec. 163(d)(3)(B)(i) ; Reg § 1.163-10T(b) ); or
passive activity interest ( ¶ 1817 ). ( Code Sec. 469(j)(7) ; Reg § 1.163-10T(b) ) FTC ¶ K5473 ; USTR ¶ 1634.052 ; Tax Desk ¶ 31,451
But qualified residence interest is subject to the bars and limits for:
... interest in connection with single premium insurance ( ¶ 1719 );
... interest relating to tax-exempt income ( ¶ 1723 );
... interest on related-party transactions ( ¶ 2838 );
... interest under the “at-risk” rules ( ¶ 1805 et seq.);
... accrued market discount ( ¶ 1716 ); and
... certain straddle interest ( ¶ 2652 et seq.). ( Reg § 1.163-10T(b) ) FTC ¶ K-5473 et
seq.; Tax Desk ¶ 31,451
For how the interest allocation rules apply to qualified residence interest, see ¶ 1744 .
RIA caution: For the treatment of residence interest for alternative minimum tax purposes, see ¶
3209 .
¶ 1735. What is “qualified residence interest”?
“Qualified residence interest” is any interest paid or accrued during the tax year on acquisition
indebtedness ( ¶ 1736 ) or home equity indebtedness ( ¶ 1737 ) with respect to any property that,
at the time the interest is accrued, is taxpayer's qualified residence ( ¶ 1738 ). ( Code Sec.
163(h)(3)(A) ) For a cash basis taxpayer, it also includes certain “points” paid on debt incurred in
connection with his principal residence. ( Reg §1.163-10T(j)(2)(i) ) FTC ¶ K-5471 ; USTR ¶
1634.052 ; Tax Desk ¶ 31,452. A debt may be part acquisition indebtedness and part home
equity indebtedness. FTC ¶ K-5491 ; Tax Desk ¶31,470
¶ 1736. Acquisition indebtedness.
Acquisition indebtedness is debt that: (1) meets the dollar limitation described below; (2) is
incurred in acquiring, constructing or substantially improving taxpayer's “qualified residence” ( ¶
1738 ) (or adjoining land) and (3) is secured by the residence. FTC ¶ K-5484 ; USTR ¶ 1634.052
; Tax Desk ¶ 31,464 New debt a taxpayer incurs to refinance his acquisition indebtedness also
qualifies, but only up to the amount of the refinanced debt. ( Code Sec. 163(h)(3)(B)(i) ) FTC ¶
K-5488 ; USTR ¶ 1634.052 ; Tax Desk ¶ 31,468 Debt is treated as incurred in acquiring, etc., a
residence if the debt proceeds can be traced to payment of the costs of the acquisition, etc. FTC ¶
K-5487 ; Tax Desk ¶ 31,801
The aggregate amount of debt that may be treated as acquisition indebtedness for any period (i.e.,
interest on such debt deductible as “qualified residence interest,” see ¶ 1733 ) can't exceed
$1,000,000 ($500,000 for a married individual filing a separate return). ( Code Sec.
163(h)(3)(B)(ii) ) These dollar amounts are reduced (not below zero) by the aggregate amount of
outstanding (including refinanced) “pre-Oct. 13, '87 indebtedness.” ( Code Sec. 163(h)(3)(D) )
FTC ¶ K-5485 , FTC ¶ K-5489 ; USTR ¶ 1634.052 ; Tax Desk ¶ 31,465 For where debt exceeds
these limits, see ¶ 1744 .
¶ 1737. Home equity indebtedness.
Home equity indebtedness is any debt (other than acquisition indebtedness, see ¶ 1736 ) secured
by taxpayer's qualified residence ( ¶ 1738 ), to the extent the aggregate amount of the
indebtedness doesn't exceed the fair market value of the residence (as reduced by the amount of
acquisition indebtedness on it). Unlike acquisition debt ( ¶ 1736 ), home equity debt generally
may be used for any purpose without affecting its deductibility; see ¶ 1744 . The aggregate
amount treated as home equity indebtedness (i.e., interest on such debt deductible as “qualified
residence interest,” see ¶ 1733 ) for any period may not exceed $100,000 ($50,000 for a married
individual filing a separate return). ( Code Sec. 163(h)(3)(C) ) FTC ¶ K-5490 ; USTR ¶1634.052
; Tax Desk ¶ 31,469 For debt that exceeds these limits, see ¶ 1744 .
RIA observation: In other words, home equity indebtedness is limited to the taxpayer's net equity
in the residence, with a $100,000 ($50,000) ceiling.
RIA caution: For treatment for alternative minimum tax purposes, see ¶ 3209 .
¶ 1738. Qualified residence.
A qualified residence is: (1) taxpayer's principal residence (i.e., one that would qualify for
exclusion of gain under Code Sec. 121 ( ¶ 2444 ) ( Code Sec. 163(h)(4)(A)(i)(I) ) and/or (2) any
other residence (second residence) taxpayer properly elects to treat as qualified for the tax year,
even if he didn't use it as a residence that year. But a second residence that taxpayer rents out to
others during the year can't qualify unless he also
uses it as a residence (i.e., uses it for personal purposes during the year for more than the greater
of 14 days or 10% of the number of days it is rented out for a fair rental). ( Code Sec.
163(h)(4)(A)(i)(II) , (iii); Reg §1.163-10T(p)(3)(iii) ) A taxpayer who has more than one
residence that meets these tests may elect each year which to treat as the second (qualified)
residence. ( Code Sec. 163(h)(4)(A)(i) ; Reg §1.163-10T(p)(3)(iv) ) FTC ¶ K-5474 et seq.; USTR
¶ 1634.052 ; Tax Desk ¶ 31,454
A residence for this purpose includes a condominium or cooperative housing corporation (coop). Any indebtedness secured by stock in a co-op is treated as secured by the house or
apartment taxpayer is entitled to occupy. Even if local restrictions prohibit using the stock as
security, it will be treated as securing the debt if taxpayer can show the debt was incurred to
acquire the stock. ( Code Sec. 163(h)(4)(B) ; Reg §1.163-10T(p)(3) ) FTC ¶ K-5481 ; USTR ¶
1634.052 ; Tax Desk ¶ 31,461 A time-share can also qualify if it
satisfies the above tests for rental property. ( Reg § 1.163-10T(p)(6) ) FTC ¶ K-5482 ; Tax Desk
¶ 31,462
A residence under construction may be treated as a qualified residence for a period of up to 24
months, but only if it otherwise qualifies as of the time it's ready for occupancy. ( Reg § 1.16310T(p)(5) ) FTC ¶ K-5483 ; Tax Desk ¶ 31,463
For married taxpayers filing jointly, the second residence may be owned and/or used by either
spouse. For spouses filing separately, each may have only one qualified residence (unless the
other spouse gives written consent otherwise). ( Code Sec. 163(h)(4)(A) ) FTC ¶ K-5480 ; USTR
¶ 1634.052 ; Tax Desk ¶ 31,460
¶ 1741. How interest is allocated.
Interest expense is allocated the same way as the debt with respect to which the interest accrues,
by tracing disbursements of the debt proceeds to specific expenditures. ( Reg § 1.163-8T(a)(3) ,
(c)(1)) Except for qualified residence interest ( ¶ 1735 ), the nature of any property securing the
debt isn't relevant. ( Reg § 1.163-8T(c)(1) ) FTC ¶ K-5231 ; USTR ¶ 1634.055 ; Tax Desk ¶
31,801
1744. Qualified residence interest as “allocable” interest.
Qualified residence interest ( ¶ 1733 et seq.) is deductible without regard to how that interest
expense (or the underlying debt) is allocated. ( Reg § 1.163-8T(m)(3) ) FTC ¶ K-5238 ; USTR ¶
1634.055 ; Tax Desk ¶31,805
Illustration: E borrows $20,000. The loan is secured by a residence. E uses the loan proceeds to
buy a car strictly for personal use. The debt and the interest are allocable to personal
expenditures, so the interest would normally be subject to the personal interest limits ( ¶ 1715).
However, if the interest is qualified residence interest (i.e., home equity debt, see ¶1735), it's not
personal interest and would be fully deductible. ( Reg § 1.163-8T(m)(3) ) FTC ¶K-5238 ; USTR
¶ 1634.055 ; Tax Desk ¶ 31,805 However, where the debt exceeds the qualified residence
interest limits ( ¶ 1736 , ¶ 1737 ), allocation is required for the “excess.” ( Reg § 1.163-10T(e) )
FTC ¶ K-5499 ; Tax Desk ¶ 31,479
Federal Taxes - CCH Explanations and Analysis - 2001 U.S. Master Tax Guide - Deductions
(Chapters 9--12) - GUIDEBOOK, Nonbusiness Expenses (Chapter 10) - GUIDEBOOK, Interest
GUIDEBOOK, 2001USMTG ¶1045, Personal Interest
Personal Interest
Personal interest is not deductible. Personal interest is any interest incurred by an individual
other than:
(1) interest paid or accrued on indebtedness properly allocable to a trade or business (other than
services as an employee) (see ¶937);
(2) investment interest (see ¶1094);
(3) interest taken into account in computing income or loss from a passive activity of the
taxpayer (see ¶2053);
(4) qualified residence interest (see ¶1047);
(5) interest on the unpaid portion of the estate tax for the period during which there is an
extension of time for payment of the tax on the value of a reversionary or remainder interest in
property or when an estate consists largely of an interest in a closely held business; and
(6) interest on qualified education loans (see ¶1082) (Code Sec. 163(h)(2)). [2001FED ¶9102]
GUIDEBOOK, 2001USMTG ¶1047, "Qualified Residence Interest" Defined
Qualified residence interest is interest that is paid or accrued during the tax year on acquisition or
home equity indebtedness with respect to any qualified residence. A qualified residence includes
the principal residence of the taxpayer and one other residence (i.e., vacation home) that is used
by the taxpayer for a number of days exceeding the greater of 14 days or 10 percent of the
number of days during the tax year that it is rented out at a fair rental value. However, if a
dwelling unit is not rented at any time during the tax year, such unit may be treated as a qualified
residence regardless of personal use. Interest on a loan secured by a qualified residence in a state
where the security instrument is otherwise restricted by a debtor protection law is qualified
residence interest if it otherwise qualifies. Interest paid or accrued by a trust or estate on
indebtedness secured by a beneficiary's qualified residence is qualified residence interest if the
residence would be a qualified residence if owned by the beneficiary. Married taxpayers who file
separate returns are treated as one taxpayer, with each entitled to take into account one residence
unless both consent in writing to having only one taxpayer take into account both residences
(Code Sec. 163(h)(3)). [2001FED ¶9102]
The receipt of mortgage interest is generally reported by the lender on Form 1098 (¶2565). In the
case of seller-provided financing, taxpayers claiming a deduction for qualified residence interest
must include on their returns the name, address and TIN of the person to whom interest is paid or
accrued (Code Sec. 6109(h)). [2001FED ¶36,960]
Numerical Implication Statement:
The Fronkss mortgage interest payments are deductible because the homes on which they were
paid were “qualified residences" and the indebtedness from which the interest emanated was less
than $1,000,000. Taxpayers can deduct interest on mortgage indebtedness up to $1,000,000 if
that indebtedness was taken out to buy, build, or improve a home. The Fronks have paid off the
on the old Boone, thus it yields no deductible interest. The mortgage on the new home generated
$12,241 in deductible interest. In light of the 10 percent business use of the home, the Fronks
will deduct only 90 percent of the mortgage interest as an itemized deduction.
Issue E6-2:
Path:
Path:
Life Insurance Proceeds (MOM: Charity, 225; PR: -----, 113
points)
CCH Network, USMTG, Spine, Life Insurance Proceeds,
Exclusions from Income (Chapter 8), ¶803, General Rule
RIA Checkpoint; FTH; Spine, Life Insurance, Chapter 2 Income–
Taxable and Exempt; ¶ 1354 Life Insurance Proceeds.
Narrative Solution:
¶803, General Rule
Amounts received under a life insurance contract paid by reason of the death of the insured are
generally excluded from gross income. Generally, all amounts payable on the death of the
insured are excluded, whether these amounts represent the return of premiums paid, the
increased value of the policy due to investment, or the death benefit feature (that is, the policy
proceeds exceeding the value of the contract immediately prior to the death of the insured).
It is immaterial whether the proceeds are received in a single sum or otherwise. However, if the
proceeds are left with the insurer under an agreement to pay interest, any interest earned and paid
is income to the recipient (Code Sec. 101 ; Reg. §§1.101-1(a) and 1.101-3 ).[ 2001FED ¶6502 ,
2001FED ¶6503 , 2001FED ¶6508 ]
A contract must qualify as a life insurance contract under applicable state or foreign law and
meet either a cash value accumulation test or a guideline premium/cash value corridor test (Code
Sec. 7702 ).[2001FED ¶43,150 ] If a contract does not satisfy at least one of these tests, it will be
treated as a combination of term insurance and a currently taxable deposit fund, and the
policyholder must treat income on the contract as ordinary income in any year paid or accrued
(Code Sec. 7702(g) ).[ 2001FED ¶43,150 ]
Amounts received after December 31, 1996, under a life insurance contract on the life of an
insured, terminally or chronically ill individual may be excluded from gross income. Similarly, if
a portion of a life insurance contract is assigned or sold to a viatical settlement provider, amounts
received are excludable (Code Sec. 101(g) ).
¶ 1354 Life Insurance Proceeds.
Life insurance proceeds payable by reason of the insured's death are fully excludable or, if paid
later than death under an interest option or in installments, partially excludable, from the
recipient's gross income. All or part of the exclusion may be lost if the contract is transferred
during the insured's life. Certain accelerated death benefits received by terminally or chronically
ill insureds are excluded from gross income.
¶ 1355. How life insurance proceeds are taxed.
Amounts received under a “life insurance contract” ( ¶ 1356 ), that are paid by reason of the
insured's death aren't included in the gross income of the recipient (i.e., beneficiary) ( Code Sec.
101(a) ) (unless the policy was transferred for value, see ¶ 1361 ). The exclusion applies to lump
sum payments made at the time of the insured's death, and to amounts paid later to the extent the
payment doesn't exceed the amount payable at the time of death. ( Reg § 1.101-1(a)(1) ) FTC ¶ J4700 et seq.; USTR ¶ 1014 ; Tax Desk ¶ 14,851 For dividends and other lifetime payments, see ¶
1359 . For accelerated death benefits, see ¶ 1360 .
For life insurance contracts that don't qualify, the exclusion is limited to the excess of the death
benefits over the contract's net surrender value (i.e., value on surrender). ( Code Sec. 7702(g)(2) )
The net surrender value is treated as an annuity payment ( ¶ 1362 et seq.). Also, the owner of the
contract is taxed (in the year it fails to qualify) on the income earned on it during the insured's
lifetime. This income equals the excess, for the year, of: (1) the sum of the net surrender value
increase plus the cost of life insurance protection provided, over (2) premiums paid. ( Code Sec.
7702(g)(1)(B) ) FTC ¶ J-4900 et seq. ; USTR ¶ 1014 , USTR ¶ 77,024.07 ; Tax Desk ¶ 14,854
¶ 1356. Life insurance contract defined.
To qualify as a life insurance contract, a contract must be a life insurance (or endowment)
contract under local law and satisfy either (a) a cash value accumulation test, or (b) a combined
guideline premium requirement/cash value corridor test. ( Code Sec. 101(f) , Code Sec. 7702(a) ,
(h)) FTC ¶ J-4800 et seq. ; USTR ¶ 1014 , USTR ¶ 77,024 ; Tax Desk ¶ 14,901 Pre-'85 contracts
must entail risk shifting and risk distribution. FTC ¶ J-4950 et seq. ; USTR ¶ 1014 ; Tax Desk ¶
14,901
¶ 1357. Proceeds paid in installments.
If the life insurance proceeds payable on the insured's death are paid in installments or for life,
only part (below) of each payment is excluded. Any amount that exceeds the excluded portion is
taxable when received. But if the amount of the total anticipated payments can't exceed the total
amount payable at the insured's death, then each payment is fully excludable, whenever it's
made. ( Code Sec. 101(d)(1) ; Reg § 1.101-4(a)(1)(i) ) FTC ¶ J-4718 ; USTR ¶ 1014.04 ; Tax
Desk ¶ 14,855
The excludable portion of each payment is: (1) the excludable amount held by the insurer with
respect to the particular beneficiary, divided by (2) the number of payments to be made or, if
payments are for life, the number of payments anticipated over the life expectancy of the
beneficiary. This same prorated amount of each payment is excludable, regardless of how many
payments are made ( Reg § 1.101-4 ) (i.e., even if the beneficiary exceeds his anticipated life
expectancy). FTC ¶ J-4720 ; USTR ¶ 1014.04 ; Tax Desk ¶ 14,855
A beneficiary who is the spouse of an insured who died before Oct. 23, '86, may exclude an
additional $1,000 each year of amounts received by reason of the insured's death. FTC ¶ J-4719 ;
USTR ¶ 1014.05 ; Tax Desk ¶ 14,855
¶ 1358. Proceeds left at interest.
Where excludable life insurance proceeds are held by the insurer under an agreement to pay
interest, the interest is taxable to the recipient, whether the interest option was chosen by the
insured or by his beneficiaries or estate. No part of this interest may be excluded under the
proration rules ( ¶ 1357 ). ( Code Sec. 101(c) ; Reg § 1.101-3(a) ) FTC ¶ J-4717 ; USTR ¶
1014.03 ; Tax Desk ¶ 14,853
Numerical Implication Statement:
The life insurance proceeds that Robinette received, $250,000, on account of her mother's death
are fully excludable from gross income. As a practical matter, this means that those proceeds
will be included in income broadly conceived and then excluded.
Issue E7-2:
Path:
Path:
Personal Property Tax – Ad Valorem (MOM: Jana, 300; PR: ----, 150 points)
CCH Network; USMTG; Spine, GUIDEBOOK, Nonbusiness
Expenses (Chapter 10) Deductions (Chapter 9-12), Personal
Property Tax ¶1021, Deductible Taxes, ¶9507.021 Definitions-Deductible State Taxes: Property Taxes
RIA Checkpoint; FTH; Spine, RIA Federal Tax Handbook
Chapter 4 Interest Expense--Taxes--Losses--Bad Debts, Ad
Valorem ¶ 1757 Deduction for Taxes. ¶ 1774 Personal property
taxes
Narrative Solution:
¶1021, Deductible Taxes
Taxes not directly connected with a trade or business or with property held for production of
rents or royalties may be deducted only as an itemized deduction on Schedule A of Form 1040 .
Following is a list of such taxes (Code Sec. 164(a) ):[ 2001FED ¶9500 ]
(1) State, local or foreign real property tax. (However, see ¶1026 .)
(2) State or local personal property tax. Payment for registration and licensing of a car may
be deductible as a personal property tax if it is imposed annually and assessed in proportion
to the valueof the car (Reg. §1.164-3(c) )[ 2001FED ¶9506 ] (¶1022 ).
(3) State, local or foreign income, war profits, or excess profits tax (¶1023 and ¶2475).
(4) Generation-skipping transfer tax imposed on income distributions (¶2942 ).
¶9507.021 Definitions--Deductible State Taxes: Property Taxes
Reg. §1.164-3 and Reg. §1.164-4 provide special definitions with regard to property taxes:
Real property taxes. Real property taxes include those imposed on interests in real property
and levied for the general public welfare. This does not include assessments for local benefits
(see Reg. §1.164-4 , at ¶9508 ).
Personal property taxes. To qualify for deduction as personal property taxes, the tax must be-(1) an ad valorem tax--one assessed in proportion to the value of the property;
(2) an annual tax--one imposed on an annual basis (even though it is collected more or less
often than once a year); and
(3) a tax imposed on personal property (even though in form it may be imposed on the
exercise of a privilege).
License fees paid for the registration of a motor vehicle are deductible by business taxpayers
as personal property taxes, therefore, if they meet these three qualifications. Meeting the ad
valorem requirement is the most difficult. A motor vehicle tax based on weight, model year, and
horsepower, or any of these characteristics, is not an ad valorem tax (Reg. §1.164-3(c) , at ¶9506
). But a tax based partly on value and partly on other criteria can qualify in part.
Example: State X imposes a motor vehicle registration tax of 2 percent of the value of the
vehicle plus 30 cents per hundredweight. A, a resident of X, owns a car having a value of $2,000
and weighing 3,100 pounds. A pays an annual registration fee of $49.30. Of this amount, $40 (2
percent of $2,000) would be deductible as a personal property tax. The remaining $9.30, based
on the weight of the car, would not be deductible.
Numerical Implication Statement:
Property taxes levied on personal property are deductible as an itemized deduction on Schedule
A if they are imposed as a function of the property's value, imposed annually, and levied on
personal property. Thus, the ad valorem property taxes that the Fronks paid for their cars,
$2,779, are deductible as itemized deductions.
Issue E8-2:
Path:
Path:
Moving Expenses (MOM: Terra, 600 points; PR: -----, 300
points)
CCH Network; USMTG; Spine, Non Business Expenses (Chapter
10), Moving Expenses ¶713, Compensation Is Income
RIA Checkpoint; FTH; Spine, Chapter 3 Deductions – Expenses of
a business; ¶ 1646 Moving Expenses.
Narrative Solution:
¶1075, Eligibility for Deduction
A taxpayer must meet a distance test, a length-of-employment test and a commencement-ofwork test.
The new principal place of work must be at least 50 miles farther from the taxpayer's old
residence than the old residence was from the taxpayer's old place of work. If there was no old
place of work, the new place of work must be at least 50 miles from the old residence (Code Sec.
217(c) ).[ 2001FED ¶12,620 ]
During the 12-month period immediately following the move, the taxpayer must be employed
full time for at least 39 weeks. A self-employed taxpayer must be employed or performing
services full time for at least 78 weeks of the 24-month period immediately following the move
and at least 39 weeks during the first 12 months. The full-time work requirement is waived,
however, if death, disability, involuntary separation from work (other than for willful
misconduct), or transfer to another location for the benefit of the employer occurs (Code Sec.
217(c) and Code Sec. 217(d) ).[ 2001FED ¶12,620 ]
In general, the move must have been in connection with the commencement of work at the new
location and the moving expenses must be incurred within one year from the time the taxpayer
first reports to the new job or business. If the move is not made within one year, the expenses
ordinarily will not be deductible unless it can be shown that circumstances existed to prevent
incurring the expenses within that period (Reg. §1.217-2(a)(3) ).[ 2001FED ¶12,622 ]
An eligible taxpayer is permitted to deduct moving expenses even though the 39- or 78-week
residence requirement has not been satisfied by the time prescribed for filing the return
(including extensions) for the tax year in which the moving expenses were incurred and paid.
However, a taxpayer who fails to meet the requirements must either file an amended return or
include as gross income on the next year's return the amount previously claimed as expenses
(Code Sec. 217(d) ; Reg. §1.217-2(d)(3) ).[ 2001FED ¶12,620 , 2001FED ¶12,622 ]
An individual who retires from an overseas job and returns to the U.S. or a survivor (spouse or
dependent) of any decedent who worked outside the U.S. at the time of death is also eligible to
deduct moving expenses if, within six months of the decedent's death, the survivor moves to the
U.S. from a foreign residence that had been shared with the decedent (Code Sec. 217(i) ).[
2001FED ¶12,620 ]
¶1073, Moving Expense Deduction
An employee or self-employed individual may deduct as an adjustment to gross income the
expenses of moving himself and his family from one location to another if the move is related to
starting work in a new location and the amount is reasonable (Code Sec. 217 ).[ 2001FED
¶12,620 ] The deduction is computed on Form 3903 and reported on Form 1040 .
Deductible moving expenses are limited to the cost of (1) transportation of household goods and
personal effects and (2) travel (including lodging but not meals) to the new residence (Code Sec.
217(b) ).[ 2001FED ¶12,620 ]
Where an automobile is used in making the move, a taxpayer may deduct either (1) the actual
out-of-pocket expenses incurred (gasoline and oil, but not repairs, depreciation, etc.) or (2) a
standard mileage allowance of ten cents per mile in 2000 (Rev. Proc. 99-38 ).[ 2001FED
¶12,623.11 ]
GUIDEBOOK, 2001USMTG ¶1076, Reimbursement by Employer
Reimbursement by Employer
Gross income does not include qualified moving expense reimbursements. These are amounts
received from an employer as a payment for or reimbursement of expenses that would be
deductible as a moving expense if directly paid or incurred by the employee (Code Sec.
132(a)(6) and (g) ).[ 2001FED ¶7420 ] See ¶863 .
Any amount other than a qualified reimbursement received or accrued, directly or indirectly, by a
taxpayer from the taxpayer's employer as a payment for or reimbursement of moving expenses
must be included in the taxpayer's gross income as compensation for services (Code Sec. 82 ).[
2001FED ¶6374 ] Such reimbursement or payment to or on behalf of a taxpayer by his employer
is considered wages subject to the withholding (Code Sec. 3401(a)(15) ; Reg. §31.3401(a)(15)-1
).[ 2001FED ¶33,502 , 2001FED ¶33,528 ]
Qualified Moving Expense Reimbursement. A qualified moving expense reimbursement is an
excludable fringe benefit. This is an amount received (directly or indirectly) by an individual
from an employer as a payment for (or a reimbursement of) expenses that would be deductible as
moving expenses under Code Sec. 217 if directly paid or incurred by the individual. The term
does not include a payment for (or a reimbursement of) an expens actually deducted by an
individual in a prior tax year (Code Sec. 132(g) ). See ¶1073 .
GUIDEBOOK, 2001USMTG ¶953, Code Sec. 274 Substantiation Requirements
Code Sec. 274 Substantiation Requirements
In order to claim any deduction, a taxpayer must be able to prove that the expenses were in fact
paid or incurred. The following expenses, which are deemed particularly susceptible to abuse,
must generally be substantiated by adequate records or sufficient evidence corroborating the
taxpayer's own statement: expenses with respect to travel away from home (including meals and
lodging), entertainment expenses, business gifts, and expenses in connection with the use of
"listed property" (such as cars and computers--see ¶1211 ). The expenses must be substantiated
as to (1) amount, (2) time and place, and (3) business purpose. For entertainment and gift
expenses, the business relationship of the person being entertained or receiving the gift must also
be substantiated (Temporary Reg. §1.274-5T(a) -(c) ).[ 2001FED ¶14,410 ]
Employee's Substantiation of Reimbursed Expenses. An employee's expenses are substantiated,
for purposes of the accountable plan requirements (¶943 ), if the employee provides an adequate
accounting of the expenses to the employer in the form of adequate records (Temporary Reg.
§1.274-5T(f)(4) ).[ 2001FED ¶14,410 ] The adequate accounting requirement can be satisfied as
to the amount of lodging and/or meals and incidental expenses by using the per diem allowances
discussed at ¶954 -¶954B .
Substantiation by Adequate Records. A contemporaneous log is not required, but a record of the
elements of the expense or use of the listed property made at or near the time of the expenditure
or use, supported by sufficient documentary evidence, has a high degree of credibility. Adequate
accounting generally requires the submission of an account book, expense diary or log, or similar
record maintained by the employee and recorded at or near the time of incurrence of the expense.
Documentary evidence, such as receipts or paid bills, is not generally required for expenses that
are less than $75. Documentary evidence for lodging expenses is required (Temporary Reg.
§1.274-5T(c)(2)(iii) ).[ 2001FED ¶14,410 ] The employee should also maintain a record of any
amounts charged to the employer.
The Cohan rule, which may be used by the courts to estimate the amount of a taxpayer's
expenses when adequate records do not exist, may not be used to estimate the expenses covered
by Code Sec. 274 (Temporary Reg. §1.274-5T(a)(1) ).[ 2001FED ¶14,410 ] However, if a
taxpayer has established that the records have been lost due to circumstances beyond the
taxpayer's control, such as destruction by fire or flood, then the taxpayer has a right to
substantiate claimed deductions by a reasonable construction of the expenditures or use
(Temporary Reg. §1.274-5T(c)(5) ).[ 2001FED ¶14,410 ]
Employees of the executive and judicial branches and certain employees of the legislative branch
of the federal government may substantiate their requests for reimbursement of ordinary and
necessary business expenses with an account book or expense log instead of submitting
documentary evidence (e.g., receipts or bills) (Rev. Proc. 97-45 ).
¶1005, Deductions Allowed
Adjusted gross income,[ 2001FED ¶6002 ] an intermediate figure between gross income and
taxable income, is the starting point for computing deductions that are based on, or limited by,
percentage of income (Reg. §1.62-1T ).[ 2001FED ¶6003 ]
"Adjusted gross income" means gross income minus deductions (Code Sec. 62 ):[ 2001FED
¶6002 ]
(1) on account of a trade or business carried on by the taxpayer (except for services as an
employee) (¶1006 ),
(2) for trade or business expenses paid or incurred by a qualified performing artist for services in
the performing arts as an employee (¶941A ),
(3) allowed as losses from the sale or exchange of property (see ¶1007 , ¶1701 et seq.),
(4) for expenses paid or incurred in connection with the performance of services as an employee
under a reimbursement or other expense allowance arrangement with the employer or third party
(¶942 ),
(5) attributable to rental or royalty property (¶1089 ),
(6) for depreciation or depletion allowed to a life tenant of property or to an income beneficiary
of property held in trust, or to an heir, legatee, or devisee of an estate (¶1090 ),
(7) for contributions by self-employed persons to pension, profit-sharing, and annuity plans
(¶2113 ),
(8) allowed for cash payments to individual retirement accounts (IRAs) and deductions allowed
for cash payments to retirement savings plans of certain married individuals to cover a
nonworking spouse (¶2170 , ¶2172 ),
(9) for the ordinary income portion of a lump-sum distribution to the extent included in gross
income (repealed effective for tax years beginning after December 31, 1999) (¶2153 ),
(10) for interest forfeited to a bank, savings association, etc., on premature withdrawals from
time savings accounts or deposits (¶1120 ),
(11) for alimony payments (¶1008 ),
(12) for the amortization of reforestation expenses (¶1287 ),
(13) for certain repayments of supplemental unemployment compensation benefits to a trust
described in Code Sec. 501(c)(9) or (17) , required because of receipt of trade readjustment
allowances (¶1009 ),
(14) for jury duty pay remitted to employer (¶1010 ),
(15) for moving expenses (¶1073 ),
(16) for the purchase of clean-fuel vehicle and refueling property (¶1286 ),
(17) for interest on education loans incurred on, before, or after August 5, 1997, with respect to
loan interest payment due and paid after December 31, 1997 (Code Sec. 62(a)(17) ) (¶1082 ),
(18) for contributions to a medical savings account allowed by Code Sec. 220 (Code Sec.
62(a)(16) ) (¶1020 ), and
(19) for expenses paid or incurred by a fee-basis state or local government official for services
performed (¶941 ).
Employee expenses at (4), above, that are not reimbursed under an accountable plan are not
deductible from gross income. See ¶942 , ¶943 .
SEC. 217. MOVING EXPENSES.
217(a) DEDUCTION ALLOWED.-There shall be allowed as a deduction moving expenses paid or incurred during the taxable year
in connection with the commencement of work by the taxpayer as an employee or as a selfemployed individual at a new principal place of work.
217(b) DEFINITION OF MOVING EXPENSES.-217(b)(1) IN GENERAL.--For purposes of this section, the term "moving expenses" means only
the reasonable expenses-217(b)(1)(A) of moving household goods and personal effects from the former residence to the
new residence, and
217(b)(1)(B) of traveling (including lodging) from the former residence to the new place of
residence.
Such term shall not include any expenses for meals.
Numerical Implication Statement:
In order to deduct moving expenses from gross income the taxpayer must pass three test. These
three test are: the distance test (distance from old residence to new work place must be 50 miles
more that the distance from the old residence to the old work place), a length-of-employment test
(39 weeks if an employee; 78 weeks if self-employed) and a commencement-of-work test.
Qualified moving expenses are the reasonable expenses of: (1) moving household goods and
personal effects from the former residence to the new residence, and (2) traveling (including
lodging) from the former residence to the new place of residence and must be incurred within
one-year of the commencement of work. This does not include any expenses for meals. Where
an automobile is used in making the move, a taxpayer may deduct either (1) the actual out-ofpocket expenses incurred (gasoline and oil, but not repairs, depreciation, etc.) or (2) a standard
mileage allowance of ten cents per mile in 2000. In this case since we do not know actual
expenses they can deduct .10 per mile.
In order to qualify for the moving expense deduction, the Fronks must have moved to start work
in a new location, meet the distance test (moved more than 50 miles), and a length-ofemployment test (78 weeks if self-employed, 39 if an employee. Unfortunately, the Fronks
clearly fail two of those tests (i.e., the distance test and new-work place test). Thus, the $2,350
spent by the Fronks is a personal expense and not deductible.
Issue E9-2:
Health and Accidental Insurance (MOM: Jill, 225 points; PR: ----, 113 points)
Path:
CCH Network; USMTG; Spine, CCH Analysis, Health Insurance;
¶6803.01, Employer Contributions to Health and Accidental
Health Plans
Narrative Solution:
¶ 6803.01, Employer Contributions to Health and Accidental Health Plans
Contributions by an employer to accident and health plans, to provide coverage for employees in
the event of personal injury or sickness to the employee, his spouse or his dependents, are not
taxable to the employees (Reg. §1.106-1 ). Special rules apply to contributions to medical
savings accounts (Code Sec. 106(b) ; see ¶6803.021 ). The exclusion is applicable whether the
employer's contribution is made by payment of insurance premiums or by some other means,
such as a contribution to an
independent fund, and whether retired as well as active employees are covered (Rev. Rul. 62-199
; ¶6803.39 ). If health and accident insurance is purchased, the exclusion will apply regardless of
whether or not a group policy or an individual policy is involved. However, if the policy
purchased provides other benefits besides health and accident benefits, then only that portion of
the employer's contribution allocable to the accident and health benefits is excludable under
Code Sec. 106 .
Gross income does include long-term care benefits provided through flexible spending
arrangements (Code Sec. 106(c) ; see ¶6803.03 ).
Numerical Implication Statement:
The payment of premiums by an employer is not included in the taxpayer’s gross income.
Therefore the $1,848 provided by U of I for Monica’s health and accident insurance is included
in Income Broadly Conceived, but it is taken out as an exclusion and therefore is not taxable.
Issue E10-2:
Path:
Childcare Credit (MOM: Andy A., 450 points; PR: -----, 225
points)
CCH Network; USMTG; Spine, Tax Credits (Chapter13), Child
Care; ¶1301, Child and Dependent Care Credit
Narrative Solution:
A nonrefundable credit is allowed for a portion of qualifying child or dependent care expenses
paid for the purpose of allowing the taxpayer to be gainfully employed (Code Sec. 21 ).[
2001FED ¶3502 ] The credit is computed on Form 2441 ,"Child and Dependent Care Expenses,"
or Schedule 2 of Form 1040A , whichever is applicable. To be eligible for the credit, the
taxpayer must maintain a household for one of the following individuals:
(1) A dependent under age 13 for whom a dependency exemption may be claimed.
(2) Any other person who is physically or mentally incapable of caring for himself. In this case,
the taxpayer must either (a) be able to claim the person as a dependent or (b) be able to claim the
person as a dependent except for the fact that the person had income exceeding the exemption
amount.
(3) The taxpayer's spouse who is physically or mentally incapable of self-care.
(4) Certain dependent children of divorced parents (see below).
Qualifying expenses include expenses paid for household services and for the care of a
qualifying individual. Services outside the home qualify if they involve the care of a qualified
child or a disabled spouse or dependent who regularly spends at least eight hours a day in the
taxpayer's home. Payments to a relative also qualify for the credit unless the taxpayer claims a
dependency exemption for the relative or if the relative is the taxpayer's child and is under age
19. However, no credit is allowed for expenses incurred to send a child or other dependent to an
overnight camp.
Amount of Credit. The maximum amount of employment-related expenses to which the credit
may be applied is $2,400 if one qualifying child or dependent is involved or $4,800 if two or
more are involved less excludable employer dependent care assistance program payments. The
credit is equal to 30% of employment-related expenses for taxpayers with adjusted gross income
of $10,000 or less. For taxpayers with adjusted gross income over $10,000, the credit is reduced
by one percentage point for each $2,000 of adjusted gross income (or fraction thereof) over
$10,000. For taxpayers with AGIs of over $28,000, the credit is 20%.
Qualifying employment-related expenses are considered in determining the credit only to the
extent of earned income--wages, salary, remuneration for personal services, net self-employment
income, etc. For married taxpayers, expenses are limited to the earned income of the lowerearning spouse. Generally, if one spouse is not working, no credit is allowed. However, if the
nonworking spouse is physically or mentally incapable of caring for himself or is a full-time
student at an educational organization for at least five calendar months during the year, the law
assumes an earned income--for each month of disability or school attendance--of $200 if there is
one qualifying child or dependent or of $400 if there are two or more.
Numerical Implication Statement:
A nonrefundable credit is allowed for a portion of qualifying child or dependent care expenses
paid for the purpose of allowing the taxpayer to be gainfully employed. The credit base is
obtained as follows: minimum(minimum(Tom's net self-employment earnings, Monica's earned
income); 2,400 for one child; amount spent) - amount excludable from gross income under the
dependent care assistance exclusion. Since their AGI is going to be well over $28,000, the base
amount is then multiplied by the applicable credit rate of 20 percent. The Fronks spent $6,100
on childcare and received qualified childcare assistance totaling $0. Therefore, the eligible
childcare expenses are $2,400. Thus, the logic becomes, (minimum (minimum (Big Number;
80,450); 2,400; 6,100) - 0) * .20 = 480. The credit is computed on Form 2441, "Child and
Dependent Care Expenses." The dependents Tax ID Number and that of the caregiver must
appear as part of the documentation on Form 2441.
Issue E11-2:
Path:
Monica’s IACPA Items Paid by CHE (MOM: Nate, 375 points;
PR: -----, 188 points)
CCH; 2001USMTG; keyword= fringe benefits; ¶863, Fringe
Benefits
Narrative Solution:
The following noncash benefits qualify for exclusion from an employee's gross income: (1) noadditional-cost services (e.g., free stand-by flights by airlines to their employees); (2) qualified
employee discounts (e.g., reduced sales prices of products and services sold by the employer);
(3) working condition fringe benefits (e.g., use of company car for business purposes); (4) de
minimis fringe benefits (e.g., use of copying machine for personal purposes); (5) qualified
transportation fringe benefits (e.g., transportation in a
"commuter highway vehicle," transit passes, and qualified parking); and (6) qualified moving
expense reimbursements
132(d) WORKING CONDITION FRINGE DEFINED.-For purposes of this section, the term "working condition fringe" means any property or
services provided to an employee of the employer to the extent that, if the employee paid for
such property or services, such payment would be allowable as a deduction under section 162 or
167 .
Path: Federal Taxes –SEARCH “business expenses paid by employee” CCH Explanations and
Analysis - 2001 U.S. Master Tax Guide - Deductions (Chapters 9--12) - GUIDEBOOK,
Business Expenses (Chapter 9) - GUIDEBOOK, 2001USMTG 981, Professional Person
Professional Person
Expenses incurred for operating a car used in making professional calls, dues to
professional organizations, rent paid for office space, and other ordinary and necessary business
expenses are deductible by a professional person. Amounts for books and equipment may be
deducted if the useful life of the item is not more than one year (Reg. §1.162-6 ).[ 2001FED
8633 ]
No deduction is allowed for dues paid to any club organized for business, pleasure,
recreation, or other social purposes (Code Sec. 274(a)(3) ).[ 2001FED 14,402 ] However, this
disallowance does not extend to professional organizations (e.g., bar and accounting
associations) or public service organizations (e.g., Kiwanis and Rotary clubs) (Reg.§1.2742(a)(2)(iii)(b) ).[ 2001FED 14,405 ] See, also, 913 .
A professional who performs services as an employee and who incurs unreimbursed
related expenses may deduct such expenses only as itemized deductions subject to the 2% floor.
See 941 and 1011 .
Information Services. Amounts paid for subscriptions to professional journals, and the cost
of information services such as Federal or State Tax Reporters, Unemployment Reporters, Labor
Law or Trade Regulation Reporters, Estate Tax Reporters, and other law reporters that have a
useful life of one year or less are deductible by a lawyer, accountant or an employee who buys a
service in connection with the performance of his duties.[ 2001FED 8634.02 ] The cost of a
professional library having a more permanent value should be capitalized.
Other Expenses. A deduction is allowed to members of the clergy, lawyers, merchants,
professors, and physicians for expenses incurred in attending business conventions (959 ).[
2001FED 8527 ] (For foreign conventions, see 960 .) A member of the medical profession is
allowed a deduction for business entertainment, subject to the rules discussed at 910 , so long as
there is a direct relationship between the expense and the development or expansion of a medical
practice.[ 2001FED 8523.2717 ] A doctor's staff privilege fee paid to a hospital is a capital
expenditure.[ 2001FED 8634.043 ] For other deductions, see the Checklist at 57 .
Numerical Implication Statement:
The value of working-condition-fringe benefits is excluded from gross income. A working
condition fringe is has two components: 1) An expense, that if paid by the employee would have
been deductible, and 2) the payment of that expense by the employer. Employment-related
expenses such as Monica's $1,775 in IACPA items would have been deductible as miscellaneous
itemized deductions subject to a two-percent AGI floor had Monica paid for them. Payment of
those expenses by U of I qualifies those payments as working-condition fringe benefits. Thus,
the value of the IACPA items is included in income broadly conceived and then excluded as an
exclusion.
Issue E12-2:
Path:
Cafeteria Benefit Plans in General – Receipt of Cash Payment
(MOM: Garit, 225 points; PR: -----, 113 points)
CCH Network; USMTG; Spine, Income (Chapter 7), Bonus; ¶713
Compensation Is Income CCH Network; USMTG; Spine, Income
(Chapter 7), Cafeteria Plans; ¶861Cafeteria Plans
Narrative Solution:
All compensation for personal services, no matter what the form of payment, must be included in
gross income.[ 2001FED ¶5507.01 ] Wages, salaries, commissions, bonuses, fringe benefits that
do not qualify for statutory exclusions, tips, payments based on a percentage of profits, directors'
fees, jury fees, election officials' fees, retirement pay and pensions, and other forms of
compensation are income in the year received, and not in the year earned, unless the taxpayer
reports income on the accrual basis.
Cafeteria Plans. Employer contributions under written "cafeteria" plans are excludable from the
income of participants to the extent that they choose qualified benefits. See ¶861.
Cafeteria plans are employer-sponsored benefit packages that offer employees a choice between
taking cash and receiving qualified benefits, such as accident and health coverage, group-term
life insurance coverage, or coverage under a dependent care program (Code Sec. 125 ; Proposed
Reg. §1.125-1 ).[ 2001FED ¶7320 , 2001FED ¶7321 ] No amount is included in the income of a
cafeteria plan participant who chooses among the benefits of the plan; however, if a participant
chooses cash, it is includible in gross income as compensation. If qualified benefits are chosen,
they are excludable to the extent allowed by law.
Numerical Implication Statement:
Cafeteria plans offer employees the option of taking benefits or their cash equivalents. If
employees opt for the benefits, their value is in general excluded from gross income. Cash
equivalents are included in gross income. Monica opted for cafeteria plan benefits (she paid for
them instead of taking cash in the form of additional take-home salary) consisting of the health
insurance premiums for spouse and children coverage, $3,323, and the flexible spending account,
$1,200. She didn't opt for any cash.
Issue E13-2:
Path:
Group-Term Life Insurance (MOM: Akiko, 375 points; PR: ----, 188 points)
CCH Network; USMTG; "group-term life insurance"; ¶721,
Group-Term and Split-Dollar Life Insurance
Narrative Solution:
An employee must include in income the cost (based on the IRS uniform premium cost tables,
reproduced below) of more than $50,000 of group-term life insurance provided by his employer.
An employee's age is determined as of the last day of the employee's tax year.
Example 1. X Corp. pays the premiums on a $70,000 group-term insurance policy on the
life of its president, Dan Fox, with Fox's wife as beneficiary. Fox is 51 years old at the end of
2000. The IRS-established uniform cost for $1,000 of group-term coverage for twelve months in
2000 is $2.76 ($0.23 x 12) The cost of the policy includible in Fox's gross income is computed as
follows:
Total insurance coverage ....................................... $70,000.00
"Tax-free" insurance ......................................... 50,000.00
---------Insurance coverage subject to tax .............................. $20,000.00
---------Taxable cost of policy includible in Fox's gross income ($2.76 x
20) ............................................................ $55.20
==========
The $50,000 limit relates to the group-term life insurance coverage which the employee
receives during any part of the tax year.
Any amount paid by the employee toward the purchase of group-term life insurance coverage
on the employee's life during the tax year reduces the amount includible in gross income. If a
discriminatory group-term insurance plan exists, the cost of the life insurance paid by the
employer for the tax year is includible in the gross income of key employees and certain former
key employees.
Table 1--For Post-June 30, 1999 Coverage
Cost Per $1,000 of Protection for One-Month Period
Age
Cost
Under 25 ...................................................... 5 cents
25 through 29 ................................................. 6 cents
30 through 34 ................................................. 8 cents
35 through 39 ................................................. 9 cents
40 through 44 ................................................. 10 cents
45 through 49 ................................................. 15 cents
50 through 54 ................................................. 23 cents
55 through 59 ................................................. 43 cents
60 through 64 ................................................. 66 cents
65 through 69 ................................................. $1.27
70 and above .................................................. $2.06
Numerical Implication Statement:
The cost of $50,000 of insurance coverage is excluded from gross income. The cost of amounts
beyond $50,000 must be included in gross income. The amount included in gross income is
determined by dividing the excess by $1,000 and multiplying the resulting amount by the cost
per 1,000 (taken from the IRS table). Since neither Tom nor Monica received this benefit, our
analysis of this issue ends here.
Issue E14-2:
Path:
Flexible Spending Plan (MOM: Kevin, 300 points; PR: -----, 150
points)
CCH Online; Federal Tax Service; flexible spending arrangement;
CCH-EXP §B:15.100, Flexible Spending Arrangements
Narrative Solution:
Flexible spending arrangements provide tax-free reimbursement to employees of health care
or dependent care expenses.
The term flexible spending arrangement (FSA) or reimbursement account commonly refers to
an arrangement under which an amount is credited to an account from which an employee may
be reimbursed for health care, dependent care or other expenses that are excludable from gross
income if paid by an employer. The account may be funded by employer contributions or by a
salary reduction agreement. See § B:15.61[2].
An FSA can be a cafeteria plan if it is funded by a salary reduction agreement or otherwise
allows employees to choose to receive cash instead of a qualified benefit. It is not a cafeteria plan
if employees are not given this choice.1
EXAMPLE: Charter Co. agrees to reimburse each of its employees for up to $2,000 of medical
or dependent care expenses incurred during the calendar year if the employee agrees to a
reduction in his salary of an equal amount. Neither medical nor dependent care reimbursement
under this plan is excludable from gross income because the same amount may be used to
reimburse different types of expenses. Reimbursement would be excludable if the employee
were required to specify in advance the portion of the employer's contribution that would be
usable to reimburse medical expenses and the portion that would be usable to reimburse
dependent care expenses.7
Numerical Implication Statement:
Flexible spending arrangements provide employees tax-free reimbursements. Thus,
reimbursements are included in income broadly conceived and then excluded. Reimbursements
must be used to reduce the deductibility of reimbursed expenses. When offered as a component
of a cafeteria plan, payments to the flexible spending account results are also excluded from
income broadly conceived. Thus, Monica's $1,200 in flexible spending account reimbursements
are include in income broadly conceived, then excluded, and finally used as an offset to reduce
deductible medical expenses.
Issue E15-2:
Path:
Employer's Payment of Educational Expenses (MOM: Frank,
300 points; PR: -----, 150 points)
CCH Network; USMTG; educational assistance; ¶871, Employer
Payment of Employee’s Educational Expenses
Narrative Solution:
Payments received by an employee for tuition, fees, books, supplies, etc., under an employer’s
educational assistance program may be excluded from gross income up to $5,250 (Code Sec.
127; Reg. §1.127-1).[ 2001FED ¶7350, 2001FED ¶7351] This rule does not apply, however, to
graduate teaching or research assistants who receive tuition reduction under Code Sec. 117(d).
Excludable assistance payments may not cover tools or supplies that the employee retains after
completion of the course or the cost of meals, lodging, or transportation. Although the courses
covered by the plan need not be job-related, courses involving sports, games, or hobbies may be
covered if they involve the employer’s business or are required as part of a degree program (Reg.
§1.127-2(c)).[ 2001FED ¶7352] The exclusion applies with respect to undergraduate courses
beginning before January 1, 2002 (Tax Relief Extension Act of 1999, P.L. 106-170). It does not
apply to graduate level courses.
Numerical Implication Statement:
This is a tricky issue because it ultimately requires some inference to resolve. An employer's
payment of education-related expenses are excluded from gross income up to $5,250 if the
payment was with respect to an undergraduate class. In the case of a Master's class, the
exclusion can be salvage as a working condition fringe (see E11-2) if the taxpayer can show that
the class meets a professional requirement. A working condition fringe benefit occurs when an
employer pays for an item that would have been deductible as a 2-percent miscellaneous
itemized deduction had the employee paid for it. In this case, neither Monica nor Tom
encountered such items. Thus, our analysis ends here.
Issue E16-2:
Path:
Employer Paid Athletic Membership (MOM: Andy B., 300
points; PR: -----, 150 points)
CCH Network; USMTG; CCH-EXP, 2001FED ¶9051.01,
Compensation Deduction for Fringe Benefits
Narrative Solution:
CCH-EXP, 2001FED ¶9051.01, Compensation Deduction for Fringe Benefits
.01 Synopsis - noncash fringe benefits.--While employee compensation in the form of fringe
benefits is generally includible in income under Code Sec. 61 (¶5507.032 ) certain fringe benefits
are excluded from gross income under Code Sec. 132 . See ¶7438 . Although employers may not
deduct the value of a noncash fringe benefit that is includible in an employee's income as
compensation, Temporary Reg. §1.162-25T states that the costs incurred in providing the benefit
to the employee are deductible.--CCH.
Path:
CCH Network; USMTG; Exclusions from Income
(Chapter 8) - GUIDEBOOK, Employee Benefits -
GUIDEBOOK, 2001USMTG ¶863, Fringe Benefits
The following noncash benefits qualify for exclusion from an employee's gross income: (1)
no-additional-cost services (e.g., free stand-by flights by airlines to their employees); (2)
qualified employee discounts (e.g., reduced sales prices of products and services sold by the
employer); (3) working condition fringe benefits (e.g., use of company car for business
purposes); (4) de minimis fringe benefits (e.g., use of copying machine for personal purposes);
(5) qualified transportation fringe benefits (e.g.,
transportation in a "commuter highway vehicle," transit passes, and qualified parking); and (6)
qualified moving expense reimbursements (Code Sec. 132(a) ; Reg. §1.132-1 ). Also, the value
of any on-premises athletic facilities provided and operated by the employer is a nontaxable
fringe benefit (Code Sec. 132(j)(4) ).[2001FED ¶7420 ]
The above benefits may be extended to retired and disabled former employees, to widows
and widowers of deceased employees, and to spouses and dependent children of employees.
Applicable nondiscrimination conditions must be met (Code Sec. 132(h) ).[ 2001FED ¶7420 ]
Denial of a deduction to an employer for its payment of travel expenses of a spouse,
dependent, or other individual accompanying an employee on business travel does not preclude
those items from qualifying as working condition fringe benefits (Reg. §1.132-5 ).
The above benefits that are excluded from an employee's gross income also are excludable
from the wage base for purposes of income tax, FICA, FUTA, and RRTA withholding purposes.
In the case of taxable noncash fringe benefits in the form of the personal use of an employerprovided vehicle, income tax withholding may be avoided if the employer elects not to withhold
and notifies the employee of such election (social security and railroad retirement taxes must be
withheld). However, the value of the benefit must be included on the employee's Form W-2
(Code Sec. 3402(s) ).[ 2001FED ¶33,542 , 2001FED ¶33,591 ] The IRS has issued detailed
regulations governing the exclusion of fringe benefits from an employee's income.[2001FED
¶5510 , 2001FED ¶7430 , 2001FED ¶7421 ]
Numerical Implication Statement:
The value of employer-subsidized access to athletic facilities is treated as an exclusion if the
athletic facility in on the employer's premise, operated by the employer, and used substantially
by employees, their spouses and dependent children. Since U of I is subsidizing an athletic
facility that is on its premises, and operated by the U of I, and used substantially by U of I's
employees, the $825 value of this benefit must be included in income broadly and then excluded.
Issue E17-2:
Path:
Presidential Election Campaign Fund Designation (MOM:
Robyn, 225 points; PR: -----, 113 points)
CCH Online; Spine, Federal Taxes, Presidential w/par Election
w/par Campaign; ¶36,820, sec. 6096 Designation by Individuals;
Narrative Solution:
[b] Presidential Election Campaign Fund Designations.
Every individual, other than a
nonresident alien, whose income tax liability for the tax year is at least $3 may designate that $3
be paid to the Presidential Election Campaign Fund. On a joint return showing a liability of $6 or
more, each spouse may separately designate that $3 be paid to the fund. For these purposes,
income tax liability is the amount of income tax imposed on an individual for the tax year
reduced by the sum of all nonrefundable credits.8
7 Code Sec. 6096(a) ; Reg. § 301.6096-1(a).
8 Code Sec. 6096(b) .
A designation to pay $3 to the fund can be made on either the first page of the return or on
the page with the taxpayer's signature. The designation can also be made on an amended
individual income tax return filed on Form 1040X, Amended U.S. Individual Income Tax
Return, within 201/2 months after the original due date of the return. Once a designation is made
it cannot be revoked.
Numerical Implication Statement:
In order to contribute to the presidential election campaign fund, the taxpayers must have a tax
liability equal to the amount of the elected amount ($3 per taxpayer). Given the necessity of
having a minimum tax liability to contribute to the fund, it's apparent that the fund designation
does not alter the tax liability. The designation is made on the first page of the tax return and
once designated cannot be revoked. The IRS simply acts as a collection agent for the
designations of these funds. Though they have ample tax liability, the Cooks have opted not to
participate.
Issue E18-2:
Path:
Children's Tuition Payments: Personal Expense or Charitable
Contribution (MOM: Rebecca, 300 points; PR -----, 150 points)
CCH Network; CCH Explanations and Analysis CCH-ANNO,
2001FED ¶11,620.518, Charitable Contributions: Benefits to
Donor: Tuition and Educational Payments.
Narrative Solution:
Charitable Contributions: Benefits to Donor: Tuition and educational payments.-In each of the situations described below, the donee organization operates a private school and
is an organization described in section 170(c) of the Code. In each situation a taxpayer who is a
parent of a child who attends the school makes a payment to the organization. In each situation,
the cost of educating a child in the school is not less than the payments made by the parent to the
organization.
Situation 1. Organization S, which operates a private school, requests the taxpayer to
contribute $400x for each child enrolled in the school. Parents who do not make the $400x
contribution are required to pay $400x tuition for each child enrolled in the school. Parents who
neither make the contribution nor pay tuition cannot enroll their children in the school. The
taxpayer paid $400x to S.
Situation 2. Organization T, which operates a private school, solicits contributions from
parents of applicants for admission to the school during the period of the school's solicitation for
enrollment of students or while the applications are pending. The solicitation materials are part
of the application materials or are presented in a form indicating that parents of applicants have
been singled out as a class for solicitation. With the exception of a few parents, every parent who
is financially able makes a contribution or pledges to make a contribution to T. No tuition is
charged. The taxpayer paid $400x to T, which amount was suggested by T.
Situation 3. Organization U, which operates a private school, admits or readmits a
significantly larger percentage of applicants whose parents have made contributions to U than
applicants whose parents have not made contributions. The taxpayer paid $400x to U.
Situation 4. Organization V, a society for religious instruction, has as its sole function the
operation of a private school providing secular and religious education to the children of its
members. No tuition is charged for attending the school, which is funded through V's general
account. Contributions to the account are solicited from all society members, as well as from
local churches and nonmembers. Persons other than parents of children attending the school do
not contribute a significant portion of the school's support. Funds normally come to V from
parents on a regular, established schedule. At times, parents are personally solicited by the
school treasurer to contribute funds according to their financial ability. No student is refused
admittance to the school because of the failure of his or her parents to contribute to the school.
The taxpayer paid $40x to V.
Situation 5. Organization W, operates a private school that charges a tuition of $300x per
student. In addition, it solicits contributions from parents of students during periods other than
the period of the school's solicitation for student enrollments or the period when applications to
the school are pending. Solicitation materials indicate that parents of students have been singled
out as a class for solicitation and the solicitation materials include a report of W's cost per
student to operate the school. Suggested amounts of contributions based on an individual's ability
to pay are provided. No unusual pressure to contribute is placed upon individuals with children
in the school, and many parents do not contribute. In addition, W receives contributions from
many former students, parents of former students, and other individuals. The taxpayer paid
$100x to W in addition to the tuition payment.
Situation 6. Church X operates a school providing secular and religious education that is
attended both by children of parents who are members of X and by children of nonmembers. X
receives contributions from all of its members. These contributions are placed in X's general
operating fund and are expended when needed to support all church activities. A substantial
portion of the other activities is unrelated to the school. Most members of X do not have children
in the school, and a major portion of X's expenses are attributable to its nonschool functions. The
methods of soliciting contributions to X from church members with children in the school are the
same as the methods of soliciting contributions from members without children in the school.
X has full control over the use of the contributions that it receives. Members who have children
enrolled in the school are not required to pay tuition for their children, but tuition is charged for
the children of nonmembers. Taxpayer, a member of X and whose child attends X's school,
contributed $200x to X during the year for X's general purposes.
Section 170(a) of the Code provides, subject to certain limitations, for the allowance of a
deduction for charitable contributions or gifts to or for the use of organizations described in
section 170(c), payment of which is made during the taxable year.
A contribution for purposes of section 170 of the Code is a voluntary transfer of money or
property that is made with no expectation of procuring a financial benefit commensurate with the
amount of the transfer. (See section 1.170A-1(c)(5) of the Income Tax Regulations and H.R.
Rep. No. 1337, 83rd Cong., 2d Sess. A44 (1954).) Tuition expenditures by a taxpayer to an
educational institution are therefore not deductible as charitable contributions to the institution
because they are required payments for which the taxpayer receives benefits presumably equal in
value to the amount paid. (See Channing v. United States, 4 FSupp 33 (D.Mass.), aff'd per
curiam 67 F2d 986 (1st Cir. 1933), cert. denied, 291 US 686 (1934).) Similarly, payments made
by a taxpayer on behalf of children attending parochial or other church-sponsored schools are not
allowable deductions as contributions either to the school or to the religious organization
operating the school if the payments are earmarked for such children. (See Rev. Rul. 54-580 ,
1954-2 CB 97.) However, the fact that the payments are not earmarked does not necessarily
mean that the payments are deductible. On the other hand, a charitable deduction for a payment
to an organization that operates a school will not be denied solely because the payment was, to
any substantial extent, offset by the fair market value of the services rendered to the taxpayer in
the nature of tuition.
Whether a transfer of money by a parent to an organization that operates a school is a
voluntary transfer that is made with no expectation of obtaining a commensurate benefit depends
upon whether a reasonable person, taking all the facts and circumstances of the case into
account, would conclude that enrollment in the school was in no manner contingent upon making
the payment, that the payment was not made pursuant to a plan (whether express or implied) to
convert nondeductible tuition into charitable contributions, and that receipt of the benefit was not
otherwise dependent upon the making of the payment.
In determining this issue, the presence of one or more of the following factors creates a
presumption that the payment is not a charitable contribution: the existence of a contract under
which a taxpayer agrees to make a "contribution" and which contains provisions ensuring the
admission of the taxpayer's child; a plan allowing tax payers either to pay tuition or to make
"contributions" in exchange for schooling; the earmarking of a contribution for the direct benefit
of a particular individual; or the otherwise-unexplained denial of admission or readmission to a
school of children of taxpayers who are financially able, but who do not contribute.
In other cases, although no single factor may be determinative, a combination of several
factors may indicate that a payment is not a charitable contribution. In these cases, both
economic and noneconomic pressures placed upon parents must be taken into account. The
factors that the Service ordinarily will take into consideration, but will not limit itself to, are the
following: (1) the absence of a significant tuition charge; (2) substantial or unusual pressure to
contribute applied to parents of children attending a school; (3) contribution appeals made as part
of the admissions or enrollment process; (4) the absence of significant potential sources of
revenue for operating the school other than contributions by parents of children attending the
school; (5) and other factors suggesting that a contribution policy has been created as a means of
avoiding the characterization of payments as tuition.
However, if a combination of such factors is not present, payments by a parent will normally
constitute deductible contributions, even if the actual cost of educating the child exceeds the
amount of any tuition charged for the child's education.
Situation 1.
The taxpayer is not entitled to a charitable contribution deduction for the payment to
Organization S. Because the taxpayer must either make the contribution or pay the tuition charge
in order for his or her child to attend S's school, admission is contingent upon making a payment
of $400x. The taxpayer's payment is not voluntary and no deduction is allowed.
Situation 2.
The taxpayer is not entitled to a charitable contribution deduction for the payment to
Organization T. Because of the time and manner of the solicitation of contributions by T, and the
fact that no tuition is charged, it is not reasonable to expect that a parent can obtain the admission
of his or her child to T's school without making the suggested payments. Under these
circumstances, the payments made by the taxpayer are in the nature of tuition, not voluntary
contributions.
Situation 3.
The taxpayer is not entitled to a charitable contribution deduction for contributions to
Organization U. The Service will ordinarily conclude that the parents of applicants are aware of
the preference given to applicants whose parents have made contributions. The Service will
therefore ordinarily conclude that the parent could not reasonably expect to obtain the admission
of his or her child to the school without making the transfer, regardless of the manner or timing
of the solicitation by U. The Service will not so conclude, however, if the preference given to
children of contributors is principally due to some other reason.
Situation 4.
Under these circumstances, the Service will generally conclude that the payment to
Organization V is nondeductible. Unless contributions from sources other than parents are of
such magnitude that V's school is not economically dependent upon parents' contributions,
parents would ordinarily not be certain that V's school could provide educational benefits
without their payments. This conclusion is further evidenced by the fact that parents contribute
on a regular, established schedule. In addition, the pressure placed on parents throughout the
personal solicitation of contributions by V's school treasurer further indicates that their payments
were not voluntary.
Situation 5.
Under these circumstances, the Service will generally conclude that the taxpayer is entitled to
claim a charitable contribution deduction of $100x to Organization W. Because a charitable
organization normally solicits contributions from those known to have the greatest interest in the
organization, the fact that parents are singled out for a solicitation will not in itself create an
inference that future admissions or any other benefits depend on a contribution from the parent.
Situation 6.
The Service will ordinarily conclude that the taxpayer is allowed a charitable contribution
deduction of $200x to Organization X. Because the facts indicate that X's school is supported by
the church, that most contributors to the church are not parents of children enrolled in the school,
and that contributions from parent members are solicited in the same manner as contributions
from other members, the taxpayer's contributions will be considered charitable contributions, and
not payments of tuition, unless there is a showing that the contributions by members with
children in X's school are significantly larger than those of other members. The absence of a
tuition charge is not determinative in view of these facts.
Rev. Rul. 83-104 , 1983-2 CB 46.
The taxpayers were disallowed a deduction for amounts given to an education fund established
and maintained by their church and used to support schools in which the taxpayers' children were
enrolled. The payments were made to insure that a school where their children would be
educated by people who shared their religious belief would be available. The payments were
more in the nature of tuition payments than a charitable contribution.
Numerical Implication Statement:
Tuition to religious schools is not considered a contribution because of the benefit received
doctrine; therefore, the amount is not deductible. The $7,000 in tuition paid to the Moscow
Catholic School is a personal expense, so it is not deductible. Thus, there is no explicit tax
formula impact.
Issue E19-2:
Path:
Path:
Home Equity Loan Interest (MOM: Amanda, 300 points; PR: ----, 150 points)
CCH Network; USMTG; Spine; Non Business Deductions
(Chapter 10); Home equity; ¶1048, Acquisition and Home Equity
Indebtedness
RIA Checkpoint; USMTG; Spine, Chapter 4 Interest Expense—
Taxes—Losses—Bad Debt; ¶ 1737. Home equity indebtedness.
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶1048, Acquisition and Home Equity Indebtedness
Acquisition and Home Equity Indebtedness
Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially
improving a qualified residence and secured by such residence. Any such debt that is refinanced
is treated as acquisition debt to the extent that it does not exceed the principal amount of
acquisition debt immediately before refinancing.
Home equity indebtedness is all debt (other than acquisition debt) that is secured by a
qualified residence to the extent it does not exceed the fair market value of the residence reduced
by any acquisition indebtedness. Interest on such debt is deductible even if the proceeds are used
for personal expenditures.[ 2001FED ¶9102 ]
GUIDEBOOK, 2001USMTG ¶1048A, Limits on Acquisition and Home Equity
Indebtedness
Limits on Acquisition and Home Equity Indebtedness
Only a limited amount of interest paid or accrued is deductible as qualified residence interest.
The aggregate amount of acquisition indebtedness may not exceed $1 million and the aggregate
amount of home equity indebtedness may not exceed $100,000. These amounts are halved for a
married individual filing a separate return. Interest attributable to the amount of debt equal to or
under the above limits is fully deductible, while interest attributable to debt over such limits is
nondeductible personal interest (¶1045 ). See ¶1048B for rules applicable to debt incurred on or
before October 13, 1987.
GUIDEBOOK, 2001USMTG ¶1047, "Qualified Residence Interest" Defined
"Qualified Residence Interest" Defined
Qualified residence interest is interest that is paid or accrued during the tax year on acquisition
or home equity indebtedness with respect to any qualified residence. A qualified residence
includes the principal residence of the taxpayer and one other residence (i.e., vacation home) that
is used by the taxpayer for a number of days exceeding the greater of 14 days or 10 percent of
the number of days during the tax year that it is rented out at a fair rental value. However, if a
dwelling unit is not rented at any time during the tax year, such unit may be treated as a qualified
residence regardless of personal use. Interest on a loan secured by a qualified residence in a state
where the security instrument is otherwise restricted by a debtor protection law is qualified
residence interest if it otherwise qualifies. Interest paid or accrued by a trust or estate on
indebtedness secured by a beneficiary's qualified residence is qualified residence interest if the
residence would be a qualified residence if owned by the beneficiary. Married taxpayers who file
separate returns are treated as one taxpayer, with each entitled to take into account one residence
unless both consent in writing to having only one taxpayer
take into account both residences (Code Sec. 163(h)(3) ).[ 2001FED ¶9102 ]
¶ 1744. Qualified residence interest as “allocable” interest.
Qualified residence interest ( ¶ 1733 et seq.) is deductible without regard to how that interest
expense (or the underlying debt) is allocated. ( Reg § 1.163-8T(m)(3) ) FTC ¶ K-5238 ; USTR ¶
1634.055 ; Tax Desk ¶ 31,805
Illustration: E borrows $20,000. The loan is secured by a residence. E uses the loan proceeds to
buy a car strictly for personal use. The debt and the interest are allocable to personal
expenditures, so the interest would normally be subject to the personal interest limits ( ¶ 1715 ).
However, if the interest is qualified residence interest (i.e., home equity debt, see ¶1735), it's not
personal interest and would be fully deductible. ( Reg § 1.163-8T(m)(3) ) FTC ¶ K-5238 ; USTR
¶ 1634.055 ; Tax Desk ¶ 31,805
Numerical Implication Statement:
The Fronks may deduct the interest from their home equity loan as part of their itemized
deductions. Interest associated with the maximum(100,000; equity (i.e., FMV - indebtedness))
qualifies for deductibility. The lender would report this interest on the form 1098. Due to the 10
percent business-use of the old Boone home, 90 percent or $3,669 (4,077 * .90) of the home
equity loan interest is deducted as an itemized deduction and the remaining 10 percent or $408 is
deductible as a home office expense.
Issue E20-2:
Path:
Automobile Rebate (Katie, 300, points; PR: -----, 150 points)
CCH; USMTG; Spine, Rebate; What Is Included in Gross Income:
Reimbursement of Expenses: Rebates.
Narrative Solution:
Rebates received in 1937 on purchases made and accrued as expense on the books in
1933 and 1935 were not income in 1937.
Western Adjustment & Inspection Co., 45 BTA 721, Dec. 12,170 (Nonacq.).
The Commissioner's determination that taxpayer realized additional income in the form of a
purchase rebate from a lumber company was sustained in the absence of evidence to the
contrary.
Mulder Bros., Inc., 26 TCM 217, Dec. 28,366(M) , TC Memo. 1967-43.
A corporation overstated its cost of goods sold by the amount of rebates paid by a third party to
its president on petroleum purchases and was required to include such amount in its income.
X-L Service, Inc., 32 TCM 701, Dec. 32,041(M) , TC Memo. 1973-148.
Rebates received by taxpayers as ordinary retail customers from automobile
manufacturers upon the purchase of a new automobile are not considered income for tax
purposes.
IR-1451, January 24, 1975, 759 CCH ¶6373 .
The taxpayer was entitled to reduce the gain on the sale of his business and inventory by $4,500
because this amount was a rebate to the purchaser of the inventory.
R.A. Eaton, 38 TCM 1233, Dec. 36,247(M) , TC Memo. 1979-320.
If a customer of an electric utility company participates in an energy conservation program for
which the customer receives a rate reduction or nonrefundable credit on the customer's electric
bill, the amount of the rate reduction or nonrefundable credit is not includible in the customer's
gross income.
Rev. Rul. 91-36 , 1992-2 CB 17.
A membership organization that developed computer applications did not recognize income with
regard to nonrefundable credits that it granted to some of its members. When the group lost its
exempt qualification and accepted new members, it offered the original members nonrefundable
credits equal to the amount of dues they had contributed, which could be offset only against their
liabilities to the group for licensing fees. Pursuant to Rev. Rul. 91-36 , 1991-2 CB 17, the credits
represented a reduction in the licensing fee charged to a member. Accordingly, the group did not
realize income upon its grant or the credits or members' use of them, and it had to report as
income only the amount collected in satisfaction of the reduced licensing fees.
Path: CCH Online; Standard Federal Income Tax Reporter; rebate w/par automobile;
¶8590.033, Automobile Expenses: Depreciation: “Tax cost” of a car.-The business basis of a car on which depreciation is computed is its purchase price multiplied by
the business use percentage. The purchase price is the full price charged by a car dealer to the
taxpayer and ordinarily includes any carrying charges that are not identifiable as interest or
insurance. The purchase price is reduced by the amount of any rebate paid to the customer. See
Rev. Rul. 76-96 , ¶8858.607 .
Reduction of basis. Before the recovery percentage (under MACRS) can be applied to the cost
basis of a new car, that basis must be reduced by amounts currently expensed under a Code Sec.
179 election.
Straight-line depreciation. Under the alternative MACRS straight-line method of depreciation,
the depreciable business cost basis of a car is determined by multiplying the purchase price
(estimated salvage value is zero) by the business use percentage.
Computing cost basis. There are three rules that can affect the computation of a car’s tax cost
or basis. First, if a taxpayer receives a rebate from a manufacturer, the amount of the rebate is
subtracted from the purchase price to arrive at the car’s tax cost. The rebate does not represent
taxable income to the purchaser. See Rev. Rul. 76-96 ,
Second, the basis of a car must be reduced by the amount of the gas guzzler tax when a
taxpayer acquires a car that is subject to this tax and use of the automobile begins not more than
one year after the first sale to a consumer. See Code Sec. 1016(d) and ¶29,412.0255 for
complete details.
Third, the sales tax paid on a car used in a trade or business is added to the cost of the car for
depreciation purposes. See Code Sec. 164(a) and ¶9502.01 .
Numerical Implication Statement:
Rebates are included in income broadly conceived and then excluded as an exclusion. They are
also subtracted from the cost basis of the automobile. Since the Fronks received no rebate the
analysis of this issue ends here.
Issue E21-2:
Path:
Apportionment of Property Tax upon Sale (MOM: Emily, 450
points; PR: -----, 225 points)
CCH Online; USMTG; "property taxes"; ¶1032, Apportionment of
Real Property Tax Upon Sale
Narrative Solution:
The real property tax deduction must be apportioned between the seller and the buyer according
to the number of days in the real property tax year (¶1033 ) that each holds the property. Where
property is sold during any real property tax year, the taxes are considered as imposed upon the
seller up to, but not including, the date of sale. The taxes are treated as imposed on the buyer
beginning with the date of sale. Proration is required whether or not the seller and purchaser
actually apportion the tax (Reg. §1.164-6(a) and Reg. §1.164-6(b)(1)).[ 2001FED ¶9603]
However, when property is sold subsequent or prior to the real property tax year, see ¶1038 .
Example 1. A sells his farm to B on August 1, 2000. Both use the cash- and calendar-year basis
of accounting. Taxes for the real property tax year, April 1, 2000, to March 31, 2001, become
due and payable on May 15, 2001. B pays the real estate taxes when they fall due. Regardless of
any agreement between the parties, for federal income tax purposes 122/365 of the real estate
taxes are treated as imposed upon A and are deductible by him.
Example 2. Assume the same facts as in Example 1, except that A uses the accrual basis of
accounting. If he has not elected to accrue the real property taxes ratably, he will be treated as
having accrued 122/365 of the taxes on the date of sale. The balance is deductible by B when he
pays the taxes, if he is on the cash basis, unless the rule at ¶1035 applies because the seller (A) is
personally liable for payment of the taxes. If he is on the accrual basis, he follows the rules
explained at ¶1031.
Path: CCH Online; Federal Tax Service; "apportionment of property taxes"; §A:15.140,
Apportionment of Real Property Taxes Between Seller and Purchaser
When a taxpayer deducts an amount of real property tax in the tax year before the year of sale
that is greater than the amount of tax treated as imposed on him under the apportionment rule,
the excess deduction is includable in his income in the year of sale to the extent that he receives a
tax benefit from the deduction in the earlier year. See §A:15.150 . When real property is sold, the
amount realized includes real property taxes that are treated as imposed on the seller if the
purchaser agrees to pay the accrued taxes. Therefore, taxes allocated to the seller under the
apportionment rule, but paid by the purchaser, increase the seller's gain or reduce his loss. See
§A:15.151[1]. When a seller elects to capitalize real property taxes and, in a tax year before the
year of sale, pays the real property taxes that are treated as imposed on the purchaser, the seller
treats any reimbursement received for the payment as part of the purchase price. See
§A:15.151[2] . A purchaser of real property at a foreclosure tax sale is entitled to deduct only the
real property taxes attributable to that part of the real property tax year in which he owns the
property. See §A:15.153.
Path: CCH Online; Federal Tax Service §F:1.41[2], Spine, Real Estate, Acquisition and
Ownership of Real Estate, Acquisition Costs, Purchase; Apportionment of Property
Taxes
To the extent that any payment to a seller includes an amount treated as property taxes
imposed on the buyer under these rules, this amount cannot be included in the buyer's basis of
the acquired property.55 If a buyer pays more in taxes than allowable to the buyer as a deduction,
the excess is added to the basis of the acquired real estate.56
55
Reg. § 1.1001-1(b)(2), (4), Ex (1).
56
Reg. § 1.1001-1(b); see Reg. § 1.1001-1(b)(4) , Ex (2).
Path: CCH Online; USMTG; real property taxes; ¶1021, Deductible Taxes
Taxes not directly connected with a trade or business or with property held for production of
rents or royalties may be deducted only as an itemized deduction on Schedule A of Form 1040.
Following is a list of such taxes (Code Sec. 164(a)):[ 2001FED ¶9500]
(1) State, local or foreign real property tax. (However, see ¶1026 .)
(2) State or local personal property tax. Payment for registration and licensing of a car
may be deductible as a personal property tax if it is imposed annually and assessed in
proportion to the value of the car (Reg. §1.164-3(c))[ 2001FED ¶9506] (¶1022).
(3) State, local or foreign income, war profits, or excess profits tax (¶1023 and ¶2475 ).
(4) Generation-skipping transfer tax imposed on income distributions (¶2942 ).
Numerical Implication Statement:
When a buyer pays for all of the property taxes associated with a newly purchased home, the
seller's legal share of the taxes are added to the basis of the buyer's new home and to the seller's
sale proceeds and are deductible by the seller as an itemized deduction. The day a sale is
counted as the buyer's day (i.e., the one who holds title at the days end). The Fronks sold their
Long View home on July 25, 2000 and are thus allocated property taxes through July 24, 2000.
Thus, $2,808 (i.e., $5,000* 205 / 365) in property taxes is allocated to the Fronks. With regard
to the Rocky Mountain home, the situation is reversed. That is, the Fronks have paid for
someone else's share of the property taxes in addition to their own. The Fronks closed on the
Rocky Mountain home on August 1, 2000. Thus, $3,353 (i.e., 8,000 * 153 / 365) in property
taxes is allocated to the Fronk. Finally, having to pay someone else's property taxes results in an
economic decrement to the Cooks that is alleviated by adding the amount of taxes paid in behalf
of another to the basis of the Rocky Mountain home, thus eventually reducing the amount of
future gain on the home sale or increasing the depreciation deduction on the home-office use
portion of the home.
Issue E22-2:
Path:
Condemnation of Property (MOM: Jana, 450 points; PR: -----,
225 points)
CCH Online; USMTG; keyword=condemnation; ¶1713, ¶1716
Narrative Solution:
An involuntary conversion occurs when property is destroyed, stolen, condemned, or disposed of
under the threat of condemnation and the taxpayer receives other property or money in payment
(e.g., insurance proceeds or a condemnation award). When the taxpayer's property is converted
involuntarily or by compulsion into other property similar or related in service or use to the
converted property, recognition of gain can be deferred. In addition, any money received on the
conversion need not be recognized if an equal amount is spent to acquire property similar or
related in service or use to the converted property
Loss from an involuntary conversion is deductible only if the converted property is used in
a trade or business or for the production of income. However,casualty or theft losses on personal
property may be deductible
When an individual's principal residence has been involuntarily converted, the individual
may exclude any realized gain, up to the $250,000/$500,000 maximum, as if the home had been
sold If the total realized gain is more than the maximum exclusion, the individual may postpone
recognizing the gain if replacement property is purchased. The sale of land within a reasonable
period of time following the destruction of a principal residence qualified as part of the
involuntary conversion of the residence on the date it was destroyed
Reporting Requirements. Form 4797 (Sales of Business Property) is used to report the
involuntary conversion, other than from casualty or theft, of business property, capital assets
used in a business or held for rent or royalty income. Form 4684 (Casualties and Thefts) is used
to report involuntary conversions from casualties and thefts. Schedule D (Capital Gains and
Losses) is used to report gains from involuntary conversions, other than from casualty of theft, of
capital assets not held for business or profit.
If only a portion of a tract of land is appropriated by a condemning authority, the condemnation
award may have two components: (1) compensation for the converted portion and (2) severance
damages for the retained portion. In this situation, the entire award is considered compensation
for the condemned property unless it is established that a specific portion was for damage to
retained property
For purposes of determining gain or loss, compensation for the converted property and
severance damages is treated separately. Thus, the owner's legal and other expenses and the basis
of the property must be apportioned between the compensation for the part of the property taken
and the severance damages for the part retained. If severance damages are for damage to only a
portion of the retained property, only that part of the basis of the retained property properly
allocable to the damaged portion can be taken into account. Severance damages reduce the basis
of the retained property. Any excess of severance damages over such basis (plus allocated
expenses) is gain.
Numerical Implication Statement:
The Fronks received a check in the amount of $3,400 due to the condemnation of their land for
road expansion. The Fronks paid a lawyer $3,000 to contest the condemnation and ultimately
received $10,000 in severance damages. There are two parts to this issue, the condemnation
award and the severance award. The condemnation award is dealt with like a disposal or sale.
Severance awards reduce the basis of the remaining property. Focusing first on the
condemnation, the basis of the land is 10% of the $200,000 that the Fronks paid for the land and
house. Thus, the basis in the land is $20,000. The part of the land that was condemned was 5%
of the total land or $1,000 (i.e., 20,000 * .05). Therefore, the award minus the basis in the
property yields a long-term capital gain of $2,400 (i.e., $3,400 – 1,000). This long-term capital
gain would have been recognized on Schedule D in the condemnation year and thus has no
impact on the 2000 tax return. The original basis in the property minus the 5% portion of the
land basis allocated to the condemnation leaves a basis in the remaining property of $199,000
(i.e., $180,000 + (20,000 - 1,000)). With regard to the severance, the net severance damage
award is $7,000 (i.e., 10,000 - 3,000 legal fees). Since the severance award is to compensate the
Fronks for decrements in the value of the remaining property, it stands to reason that the basis
recovery should be applied proportionately (i.e., probably 10 percent to the land and 90 percent
to the home). Thus, the basis in the remaining property is $192,000 (i.e., 199,000 - 7,000). This
general analysis ignores the fact that 10 percent of the Fronks' home is being depreciated for its
business use. This general analysis, as supplemented by the cost recovery wrinkle, is also
relevant to determining the gain or loss on the sale of this property.
Issue E23-2:
Path:
Path:
Path:
Sale of Personal-Use Portion of Rocky Mountain Home (MOM:
Tonya, 600 points; PR: ---, 300 points)
CCH; USMTG; Spine, Sales-Exchanges-Capital Gains (Chapter
17), Sale of Home; ¶1705, Exclusion of Gain-Post-May 6, 1997
CCH; USMTG; Spine, Select All, Property Taxes; ¶1032,
Apportionment of Real Property Tax Upon Sale
CCH; USMTG; Spine, Select All, Property Taxes; ¶1604,
Adjusted Basis of Property
Narrative Solution:
¶1705, Exclusion of Gain-Post-May 6, 1997
An individual may exclude from income up to $250,000 of gain ($500,000 on a joint return in
most situations) realized on the sale or exchange of a residence. The individual must have owned
and occupied the residences for an aggregate of at least two of the five years before the sale or
exchange. The exclusion may not be used more frequently than once every two years. For
purposes of the two-year rule, sales
prior to May 7, 1997, are not taken into account (Code Sec. 121(b)(3) ).[ 2001FED ¶7260
¶1604, Adjusted Basis for Property
To determine the gain or loss from a sale or other disposition of property, the amount realized
must be compared with the basis of the property to the taxpayer--generally measured by the
original capital investment, adjusted to the date of sale. In most situations, the basis of property
is its cost to the taxpayer.
Numerical Implication Statement:
In general, a married-filing joint couple can exclude up to $500,000 in gain from the sale of the
non-business-use portion of their home if both taxpayers owned the home and used it as their
principal residence in two out of the last five years. In this case, the Fronks can only take a
$250,000 exclusion because Monica fails both two-year requirements. Sale proceeds include
cash received, the assumption of liabilities, and, as we discovered in issue E21-2, property taxes
paid by the buyer in behalf of the seller. The basis of the home that was sold must reflect all
basis-adjusting items such as the condemnation discussed in Issue E22-2, and special
assessments (see Issue NXX). The computation is as follows:
Computational Details:
Sales Proceeds:
 Contract price
 Property taxes paid in behalf of seller (see Issue E21-2)
 Total proceeds
Proceeds allocated to non-business-use of home (90 percent)
Less basis:
 Purchase price
 1986 Special Assessment (see Issue NXX)
 Condemnation recovery (see Issue E22-2)
 Severance recovery (see Issue E22-2)
 1995 Special Assessment (see Issue NXX)
Un-recovered cost
Basis allocated to non-business-use of home (90 percent)
Gain on non-business-use of home
$500,000
2,808
$502,808
$452,527
$200,000
5,000
(1,000)
(7,000)
6,000
$203,000
182,700
$269,827
This gain should be included in income broadly conceived and then excluded only up to
$250,000.
Issue E24-2:
Path:
Sale of Home – Business Portion of Rocky Mountain Home
(MOM: Karrie, 1,500 points; PR: -----, 750 points)
CCH Online; FTH; Spine Sales – Exchanges – Capital Gains
(Chapter 17) Capital Gains; ¶1747, Property Used in Trade or
Business; ¶1701, Gain from Sale or Exchange of Property; ¶1611,
Additions to Basis of Property; ¶1617, Reductions in Basis; ¶1716,
Condemnation Award; ¶1779, Depreciation Recapture Rules;
¶1786, Code Sec. 1250 Property; ¶1780, Depreciation Subject to
Recapture; ¶1736, Tax on Capital Gains--Individual, Estate, Trust-Post-May 6, 1997
Numerical Solution:
¶1747, Property Used in Trade or Business
Property Used in Trade or Business
Business real estate or any depreciable business property is excluded from the definition of
“capital assets” (¶1741). However, if the business property qualifies as Code Sec. 1231 property
and gains from dealings in such property exceed any losses, then each gain or loss is treated as
though it were derived from the sale of a long-term capital asset (Code Sec. 1231(a)).[ 2001FED
¶30,572 ] If the losses exceed the gains, all gains and losses are treated as though they were
ordinary gains and losses.
Taxpayers use Form 4797 (Sales of Business Property) to report Code Sec. 1231
transactions.
(1) Property used in the trade or business, subject to depreciation and held for the long-term
holding period (¶1777 ) (but excluding property includible in inventory; property held primarily
for sale to customers; a copyright; a literary, musical or artistic composition; a letter,
memorandum or similar property (see item (6), ¶1741 ); and government publications (see item
(7), ¶1741 )).
¶1701, Gain from Sale or Exchange of Property
Gain from Sale or Exchange of Property
Gains from sales or exchanges of property are generally recognized for income tax purposes
(Code Sec. 1001(c) ).[ 2001FED ¶29,220 ] The gain from a sale or exchange of property is the
excess of the amount realized from the sale or exchange (¶1703 ) over the property’s adjusted
basis (Code Sec. 1001(a) ).[ 2001FED ¶29,220 ] The adjusted basis of an asset is generally the
taxpayer’s original cost plus the cost of any capital improvements and less any depreciation or
depletion (Code Secs. 1011 , 1012 and 1016 ) [ 2001FED ¶29,310 , 2001FED ¶29,330 ,
2001FED ¶29,410 ] (¶1604 et seq.). Some types of exchanges of property may be partially or
totally tax free (see ¶1719 et seq.).
¶1611, Additions to Basis of Property
Additions to Basis of Property
In computing gain or loss on sale of property, the cost or other basis must be adjusted for any
expenditure, receipt, loss, or other item properly chargeable to the capital account (Code
Sec.1016(a)(1) ; Reg. §1.1016-1 --Reg. §1.1016-9 ).[ 2001FED ¶29,410 --2001FED ¶29,426 ]
This necessitates an addition for improvements made to the property since its acquisition.[
2001FED ¶29,412.021 ] Other capital charges are added to the cost (for example, brokers'
commissions, lawyers' fees, etc.) incurred in buying real estate. Generally, expenditures incurred
in defending or perfecting title to property are also a part of the cost of the property.[ 2001FED
¶8526.038 ] Estimates of costs for future improvements to real property required by law or by
contract may be added to the basis of the property sold if permission is obtained from the IRS.
Otherwise, such costs are not taken into account until economic performance relating to the costs
occurs (Code Sec. 461(h)).[ 2001FED ¶21,802 , 2001FED ¶29,313.576 ] See ¶1539 . See
checklist at ¶57 to determine whether an expense is deductible or must be capitalized and added
to basis.
¶1617, Reductions in Basis
Reductions in Basis
In order to determine the amount of gain or loss on the sale or other disposition of property, or
the basis of property acquired in an exchange, and the basis for depreciation or depletion, the
unadjusted basis (usually its cost, but in some cases the transferor's basis) of the property must be
decreased by any items that represent a return of capital for the period during which the property
has been held. These include the expense deduction for certain depreciable business assets, the
investment credit (50% of the credit for energy and reforestation credits), tax-free dividends,
recognized losses on involuntary exchanges, casualty losses, deductions previously allowed or
allowable for amortization, depreciation, obsolescence or depletion, and unrecognized gains on
tax-free exchanges.[ 2001FED ¶29,410 ]
¶1716, Condemnation Award
If only a portion of a tract of land is appropriated by a condemning authority, the
condemnation award may have two components: (1) compensation for the converted portion and
(2) severance damages for the retained portion. In this situation, the entire award is considered
compensation for the condemned property unless it is established that a specific portion was for
damage to retained property (Rev. Rul. 59-173 ).[ 2001FED ¶29,650.504 ]
For purposes of determining gain or loss, compensation for the converted property and
severance damages are treated separately. Thus, the owner's legal and other expenses and the
basis of the property must be apportioned between the compensation for the part of the property
taken and the severance damages for the part retained. If severance damages are for damage to
only a portion of the retained property, only that part of the basis of the retained property
properly allocable to the damaged portion can be taken into account (Rev. Rul. 68-37 ).[
2001FED ¶29,650.504 ] Severance damages reduce the basis of the retained property. Any
excess of severance damages over such basis (plus allocated expenses) is gain.
¶1779, Depreciation Recapture Rules
Code Sec. 1250 Property. Depreciable real property, other than that included within the
definition of Code Sec. 1245 property, is subject to depreciation recapture under Code Sec. 1250
. (Code Sec. 1250 property is defined at ¶1786 .) Gain on the sale or other disposition of Code
Sec. 1250 property is treated as ordinary income, rather than capital gain, to the extent of the
excess of post-1969 depreciation allowances over the depreciation that would have been
available under the straight-line method. See ¶1780 . However, if Code Sec. 1250 property is
held for one year or less, all depreciation (and not just the excess over straight-line depreciation)
is recaptured (Code Sec. 1250(b)(1) ).[ 2001FED ¶31,000 ] See ¶1736 for capital gains
treatment of “unrecaptured Section 1250 gain.”
¶1786, Code Sec. 1250 Property
Code Sec. 1250 property is any real property that is or has been depreciable under Code
Sec. 167 but is not subject to recapture under Code Sec. 1245 . This includes all intangible real
property (such as leases of land or Code Sec. 1250 property), buildings and their structural
components, and all tangible real property except Code Sec. 1245 property (Code Sec. 1250(c)
).[ 2001FED ¶31,000 ] For real property covered by Code Sec. 1245 rather than Code Sec. 1250
, see ¶1785 .
¶1780, Depreciation Subject to Recapture
Depreciation Subject to Recapture
In general, depreciation on tangible property placed in service after 1986 is determined
under the Modified Accelerated Cost Recovery System (MACRS). Property placed in service
after 1980 and before 1987 is covered under the Accelerated Cost Recovery System (ACRS).
See ¶1216 and following.
MACRS. Gain on the disposition of tangible personal property is treated as ordinary income
to the extent of previously allowed MACRS deductions. If property from a general asset account
is disposed of, the full amount of proceeds realized on the disposition is treated as ordinary
income to the extent the unadjusted depreciable basis of the account (increased by amounts
allowed as deductions under Code Secs. 179 and 190 for assets in the account) exceeds
previously recognized ordinary income from prior dispositions (Prop. Reg. §1.168(i)-1(e) ).[
2001FED ¶11,275B ]
Residential rental property and nonresidential real property that is placed in service after 1986
and is subject to the MACRS rules must be depreciated under the straight-line MACRS method.
Therefore, recapture of depreciation on such property is not required, because no depreciation in
excess of straight-line depreciation could have been taken.
¶1736, Tax on Capital Gains--Individual, Estate, Trust--Post-May 6, 1997
Depreciable Real Estate. A maximum 25% rate is imposed on long-term capital gain
attributable to certain prior depreciation that had been claimed on real property. This
depreciation is referred to as “unrecaptured Section 1250 gain.” Unrecaptured Section 1250
gain is defined as the excess of (Code Sec. 1(h)(7)(A) ):[ 2001FED ¶3260 ]
(1) the amount of long-term capital gain (not otherwise treated as ordinary income) that
would be treated as ordinary income if Code Sec. 1250(b)(1) included all depreciation and the
applicable percentage that applied under Code Sec. 1250(a) were 100%, over
(2) the excess of 28%-rate loss over 28%-rate gain.
Even under these capital gains rules, Code Sec. 1250 will continue to treat some prior
claimed depreciation (i.e., usually the amount claimed in excess of the amount allowable under
the straight-line method) as ordinary income.
Example 6. On December 7, 1999, William Drake sold a building for $1,000,000.
The building had originally cost $700,000 and, over the years, Drake had claimed
$300,000 in depreciation. Upon the sale of the building, Drake recognizes a total gain of
$600,000. Of the $300,000 in claimed depreciation, $100,000 was in excess of that
allowed under the straight-line method. Under the capital gains rules (Code Sec.
1(h)(7)(A) ), $200,000 of the total claimed depreciation is classified as unrecaptured
Section 1250 gain. This is because if Section 1250 had applied to all depreciation, and
not only additional depreciation, $300,000 of Drake’s long-term capital gain would have
been treated as ordinary income. Based on these facts, the $100,000 in excess
depreciation would be taxed as ordinary income, the $200,000 in unrecaptured Section
1250 gain would be subject to a maximum capital gains rate of 25%, and the remaining
$300,000 of gain would be subject to a maximum capital gains rate of 20%.
Under MACRS, all depreciation on real property must be computed under the straight-line
method. As a result, any gain on the sale of MACRS real property that was held more than 12
months and that is due to claimed deprecation will be classified as “unrecaptured Section 1250
gain.”
Numerical Implication Statement:
Depreciable business property is not defined as a “capital asset.” However, for purposes of the
sale of business property, Section 1231 provides that any gains in excess of losses are treated as
though derived from the sale of a long-term capital asset. If the losses exceed the gains, all gains
and losses are treated as though they were ordinary gains and losses. In addition, depreciable
real property is subject to depreciation recapture under Code Sec. 1250. Gain on the sale or
other disposition of property, including buildings, is treated as ordinary income, rather than
capital gain, to the extent of the excess of post-1969 depreciation allowances over the
depreciation that would have been available under the straight-line method. If no depreciation
exists in excess of straight-line, the long-term gain attributable to unrecaptured depreciation is
taxed at a maximum rate of 25%; any remaining gain is taxed at 20%. The gain from a sale of
property is determined as the excess of the amount realized from the sale over the property’s
adjusted basis. The basis of property, usually defined as original cost, is adjusted by reductions
to the basis by any items that represent a return of capital for the period during which the
property has been held. In the Fronk case, such items include severance damages from the
receipt of a condemnation award (see Issue N22), special assessments, and depreciation. The
computation of gain on the sale of the business portion of their Long-View home is as follows:
In the sale of a home with a business-use portion, gain related to that business-use portion must
be reported. The business use portion of the home qualifies for Section 1231, or long-term
capital-gain treatment, to the extent that there is no depreciation recapture. Depreciation
recapture for depreciable real property is governed by Section 1250. Section 1250 defines
depreciation recapture as depreciation in excess of straight-line depreciation. Since 18-year real
property is depreciated using 175% DDB with a switch to straight line, we must determine if
there is excess depreciation as of July 25, 2000. Referring to the logic presented in Issue E29-2
for computing depreciation for the Long View home and substituting the straight-line multipliers
featured in the 18-year straight-line Table appearing in the Issue E29-2 documentation, we have
the following straight-line cost recovery:
Long View Home:
In order to compute the current year's depreciation, the relevant depreciable cost must be
identified. We first note the June 1, 1986 special assessment assets are added to the basis of the
land and are not depreciable. With regard to the June 1, 1995 condemnation and severance,
Issue E12-2 notes that severance proceeds are used to reduce the basis of the remaining property,
part of which is the home. To carry out this computation, we assume that the old Long-View
homestead retains the same proportionate value of land and building that it had when purchased.
Thus, $6,300 (i.e., ((10,000 - 3,000) * .90)) is allocated to the home.
Computational Details:
Sales Proceeds:
 Contract price
 Property taxes paid in behalf of seller (see Issue N21)
 Total proceeds
$500,000
2,808
$502,808
Proceeds allocated to non-business-use of home (90 percent)
Less basis:
 Purchase price
 1986 Special Assessment (see Issue N30)
 Condemnation recovery (see Issue E12-2)
 Severance recovery (see Issue E12-2)
 1995 Special Assessment (see Issue N30)
Un-recovered cost
Basis allocated to non-business-use of home (90 percent)
Gain on non-business-use of home
$452,527
$200,000
5,000
(1,000)
(7,000)
6,000
$203,000
182,700
$269,827
This gain should be included in income broadly conceived and then excluded as an exclusion.
Proceeds allocated to business-use portion of sale
Less basis:
 Land (10 percent)
 1986 Special assessment (see Issue N30)
 Condemnation (see Issue E12-2)
 Severance (see Issues E12-2, E29-2)
 1995 Special assessment (see Issue N30)
 Home (10 percent)
 Depreciation - pre-severance (see Issue E29-2)*
$ 50,281
$ 2,000
$
500
(100)
(70)
600
$12,795
930
$18,000
2,930
 Severance (see Issue E12-2)
 Depreciation - post severance (see issue E29-2)^
Section 1231 gain
630
3,336
16,761
1,239
$ 46,112
*((((.06 + .09 + .08 + (.07 * 2) + (.06 * 2) + (.05 * 4) + (.05 * 5 / 12)) * 18,000)) = 12,795
^($4,575 * ((.05 * 7/12) + (.04 * 4) + (.04 * (6.5 / 12)) * 3.4582132**) =
"(18,000 - 12,795 - 630)
** 0.7108333 of the asset's life has passed, implying .2891667 remains. The reciprocal of
.2891667 is 3.4582132
In order to evaluate Section 1250 recapture, we must contemplate straight-line recovery of the
business-portion of the Long-View home. The basis of the depreciable portion of the home
immediately following the severance award is (see E29-2 for cost recovery multipliers): $5,834
(i.e., 18,000- (.03 + (.06 * 9) + .05 + (.05 * 5 / 12)) * 18,000)) - 630)). Since the new
depreciable cost must be allocated over the remaining life of the home's original 18-year life and
64.088333 (i.e., (.03 + (.06 * 9) + .05 + (.05 * 5 / 12)) percent of that life has passed, each costrecovery multiplier must be adjust to reflect the remaining 35.911667 percent life. The
reciprocal of 35.911667 percent is 2.784610. The straight-line cost recovery through the
remainder of the Fronks' presence in the Long-View home totaled $4,162 (i.e., ($5,834 * (.05 *
(7 / 12)) + (.05 * 4) + (.05 * 6.5 / 12)) * 2.784610). The (6.5 / 12) portion of that computation
reflects the mid-month convention for the disposition year. The total straight-line depreciation
was $15,698 ($11,536 + $4,162).
Since the accelerated depreciation, $16,131, exceeds straight-line depreciation, $15,698, by
$433, the Section 1250 recapture is $433. Thus, of the $46,112 Section 1231 gain, $433 is recharacterized as ordinary income, $15,698 is taxed as a 25 percent long-term capital gain and the
remaining $29,981 is taxed as a 20-percent long-term capital gain. The business-use portion of
this sale should be reported on Form 4794. It is very important to note that the sale of the
business-use portion of the home is not reported on Schedule C, thus escaping the selfemployment tax and being excluded from the Keogh base. Issue E34-2, contains documentation
that explicitly excludes gains from the sale of business assets from the self-employment tax.
Issue E25-2:
Path:
Inherited Property (MOM: Charity, 225 points; PR: -----, 113
points)
CCH Network; USMTG; Spine, Exclusions from Income (Chapter
8); Inheritance; ¶847, Bequest
Narrative Solution:
The value of property acquired by bequest, devise or inheritance is excluded from gross
income (Code Sec. 102 ; Reg. §1.102-1 ).[ 2001FED ¶6550 , 2001FED ¶6551 ] But the income
flowing from the property is not exempt, as, for example, that received as investment income
from the property or as profit from a sale of the property. For the basis of inherited property, see
¶1633 -¶1639 .
The exclusion also does not apply if the bequest consists not of property but of income from
property. Thus, a bequest of annual rent from the testator's property for 10 years is taxable
income to the beneficiary.
A bequest of a specific sum or of specific property from an estate or trust may be exempt
from tax if it is paid or credited all at once or in not more than three installments (Code Sec.
663(a)(1) ; Reg. §1.663(a)-1 ).[ 2001FED ¶24,440 , 2001FED ¶24,441 ] An amount which is
paid from the estate or trust income may qualify as a bequest for this purpose if the amount could
have been paid from either income or principal; however, an amount that can only be paid from
the estate or trust income will not be treated as bequest and, thus, will not be exempt even when
paid in less than four installments.
Numerical Implication Statement:
The value of inherited property is excluded from taxation. Thus, the $200,000 stock portfolio
received by Monica is included in income broadly conceived and then excluded as an exclusion.
Issue E26-2:
Path:
Taxation of Sole Proprietorship (MOM: Katherine, 300; PR: ----,
150 points)
CCH Online, Federal Taxes, USMT, Corporations (Chapter 2),
Organizations Taxed as Corporations, How Organizations Are
Taxed
Narrative Solution:
A corporation, like any business other than a sole proprietorship or a single-member
limited liability corporation (in states where permitted), is formed by business associates to
conduct a business venture and divide profits among investors (Reg. §301.7701-2 ).[ 2001FED
¶43,080 ] A corporation files a charter or articles of incorporation in a state, in a U.S. possession,
or with the U.S. government. It prepares by-laws, has its business affairs overseen by a board of
directors, and issues stock. Under the "check-the-box" regulations, entities formed under a
corporation statute are automatically classified as corporations. Further, other entities with more
than one member are allowed to elect corporate status on Form 8832 , "Entity Classification
Election." Thus, an entity that is a partnership under the laws of the state in which it is formed
may elect to be taxed as a C corporation or an S corporation under the Code (Reg. §301.7701-3
).[ 2001FED ¶43,080 , 2001FED ¶43,083 ] However, an entity organized under a state's
corporation statute cannot elect to be taxed as a partnership.
For tax purposes, the predominant forms of business enterprise are C corporations, S
corporations, partnerships, limited liability companies (LLCs), and sole proprietorships. To
choose among these is to choose among significant differences in federal income tax treatment.
Although many of the Code's provisions apply to all of these entities, some areas of the law are
specially tailored for each type. The classification of an entity will have a lingering tax impact
throughout the entity's existence.
Of the types of business organization, C corporations are subject to the toughest tax bite.
Their earnings are taxed twice. First, a corporate income tax is imposed against its net earnings
and then, after the earnings are distributed to shareholders as dividends, each shareholder must
pay taxes separately on his or her share of the dividends (Code Sec. 11 and Code Sec. 301(c) ).[
2001FED ¶3365 , 2001FED ¶15,302 ] Since no tax deduction may be claimed by a corporation
for its distribution of dividends, there is no chance of lessening the overall tax drain. However,
for example, if the corporation is family owned, the corporation can reduce or even eliminate its
federal income tax liability by distributing its income as salary to shareholder-employees who
actually perform valuable services to the corporation. Nevertheless, those who receive
distributions from a corporation in exchange for services are subject to tax on the distributions
(Reg.
§1.351-1(a)(1)(i) ).[ 2001FED ¶16,403 ]
This scheme of taxation differs radically from that applied to S corporations, partnerships,
limited liability companies, and sole proprietorships. These entities do not pay an entity-level tax
on their earnings. There is no partnership income tax (Code Sec. 701 ).[ 2001FED ¶25,060 ] Nor
(in most cases) is there an S corporation income tax, limited liability company income tax, or
sole proprietorship income tax (Code Sec. 1363 ).[ 2001FED ¶32,060 ] Only the owners or
members of these entities are taxed on their share of the entity's earnings.
For more on S corporations, see ¶301 . Partnerships are discussed at ¶401 , while LLCs are
discussed at ¶402B . Foreign corporations are discussed at ¶2425 . Sole proprietorships, which
are really no more than the alter egos of individuals, are discussed throughout this book as part of
the material on individual income taxation.
Path: CCH Online; Federal, USMTG, Individuals, Taxation of a Sole Proprietorship, ¶124,
Forms in Use for 2000
…
The following schedules and forms are added to the basic Form 1040 as needed:
(1) Schedule A for itemizing deductions; (2) Schedule B for reporting (a) more than $400
of dividend income and/or other stock distributions, (b) more than $400 of taxable interest
income or claiming the exclusion of interest from series EE U.S. savings bonds issued after 1989
used for higher educational expenses, and (c) declaring any interests in foreign accounts and
trusts; (3) Schedule C or Schedule C-EZ for claiming profit or loss from a sole proprietorship;
Numerical Implication Statement:
The taxation of Tom's sole proprietorships is no different than the taxation of an individual. That
is the sole proprietorship is the individual. There is no sole proprietorship tax, the owner is the
one taxed on the entity's earnings.
Issue E27-2:
Path:
Business (Sole-Proprietorship) Income (MOM: Andy A., 375
points; PR: -----, 188 points)
CCH Network; USMTG; Spine, Withholding—Estimated Tax
(Chapter 26), Withholding; ¶2670, Self-Employment Income
Narrative Solution:
¶2670, Self-Employment Income
“Net earnings from self-employment” consist of: (1) the gross income derived from any trade or
business, less allowable deductions attributable to the trade or business, and (2) the taxpayer’s
distributive share of the ordinary income or loss of a partnership engaged in a trade or business
(Reg. §1.1402(a)-1 ).[ 2001FED ¶32,561 ] The term “trade or business” does not include services
performed as an employee other than services relating to certain: (1) newspaper and magazine
sales; (2) sharing of crops; (3) foreign organizations; and (4) sharing of fishing catches (Code
Sec. 1402(c)(2) ).[ 2001FED ¶32,560 ]
There are special rules for computing net earnings from self-employment (including a special
optional method of computing net earnings from non-farm self-employment) (Code Sec. 1402(a)
).[ 2001FED ¶32,560 ] Rents from real estate and from personal property leased with the real
estate, and the attributable deductions, are excluded unless received by the individual in the
course of his business as a real estate dealer.
Dividends and interest from any bond, debenture, note, certificate or other evidence of
indebtedness issued with interest coupons or in registered form by any corporation are excluded
from net earnings from self-employment income unless received by a dealer in stocks and
securities in the course of his business. Other interest received in the course of any trade or
business is not excluded. Gain or loss from the sale or exchange of property that is not stock in
trade or held primarily for sale is excluded, as is gain or loss from the sale or exchange of a
capital asset.
Numerical Implication Statement:
The portfolio interest and dividend income generated by Tom's antique firearms business, $1,500
and $1,200, respectively, and his dentistry business, $9,000 and $16,000, respectively, is
excluded from net earnings from self-employment. This implies that that income is not reported
on Schedule C and thus subjected to the self-employment tax. It follows then that the logic
relevant to non-business related interest and dividends (see Issues E8-1 and E21-1) applies, thus
suggesting that that business-related portfolio interest and dividends is reported on the Fronks'
Schedule B. This conclusion is furthered strengthened by the incidence of sole-proprietorship
taxation issue (see Issue E26-2). This documentation suggests that because the checking account
interest is earned in the normal course of business, it will be included in net earnings from selfemployment and reported on schedule C. It also suggest that net earnings do not include gain or
loss from the sale or exchange of property that is not stock in trade or held primarily for sale is
excluded, as is gain or loss from the sale or exchange of a capital asset.
Issue N28:
Path:
Path:
Path:
Path:
Business Expenses (MOM: Terra, 375 points; PR: -----, 188
points)
RIA Checkpoint; FTH; Spine, Chapter 3-Deductions; ¶1506
Ordinary and Necessary Business Expenses.
RIA Checkpoint; FTH; Spine, Chapter L – Deductions; ¶L-4216.
Getting and renewing business licenses.
CCH Network; Standard Federal Income Tax Reporter; Spine,
Deductions Secs. 161-291, Advertising Expenses; ¶8951, §1.16220, Expenditures attributable to lobbying, political campaigns,
attempts to influence legislation, etc., and certain advertising.-IRC, 2001-CODE-VOL, SEC. 162. TRADE OR BUSINESS
EXPENSES.
Narrative Solution:
¶1506 Ordinary and Necessary Business Expenses.
Individuals, corporations and other taxpayers can deduct ordinary and necessary expenses paid
or incurred during the tax year in carrying on any trade or business.
162(a) IN GENERAL.-There shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business, including-162(a)(1) a reasonable allowance for salaries or other compensation for personal services
actually rendered;
162(a)(2) traveling expenses (including amounts expended for meals and lodging other than
amounts which are lavish or extravagant under the circumstances) while away from home in
the pursuit of a trade or business; and
162(a)(3) rentals or other payments required to be made as a condition to the continued use
or possession, for purposes of the trade or business, of property to which the taxpayer has not
taken or is not taking title or in which he has no equity.
¶L-4216. Getting and renewing business licenses
Annual license fees are deductible, even though included as part of the initial cost. 13 If
taxpayer buys an existing liquor license and pays more than the amount of the annual fee,
the excess is a nondeductible capital expenditure, while the amount equal to the annual
fee is deductible as an expense. 14
¶8951, §1.162-20, Expenditures attributable to lobbying, political campaigns, attempts to
influence legislation, etc., and certain advertising.--
(2) Institutional or "good will" advertising. Expenditures for institutional or "good will"
advertising which keeps the taxpayer's name before the public are generally deductible as
ordinary and necessary business expenses provided the expenditures are related to the
patronage the taxpayer might reasonably expect in the future. For example, a deduction will
ordinarily be allowed for the cost of advertising which keeps the taxpayer's name before the
public in connection with encouraging contributions to such organizations as the Red Cross, the
purchase of United States Savings Bonds, or participation in similar causes. In like fashion,
expenditures for advertising which presents views on economic, financial, social, or other
subjects of a general nature, but which does not involve any of the activities specified in
paragraph (b) or (c) of this section for which a deduction is not allowable, are deductible if they
otherwise meet the requirements of the regulations under section 162.
(b) Taxable years beginning before January 1, 1963--(1) In general.--(i) For taxable years
beginning before January 1, 1963, expenditures for lobbying purposes, for the promotion or
defeat of legislation, for political campaign purposes (including the support of or opposition to
any candidate for public office), or for carrying on propaganda (including advertising) related to
any of the foregoing purposes are not deductible from gross income. For example, the cost of
advertising to promote or defeat legislation or to influence the public with respect to the
desirability or undesirability of proposed legislation is not deductible as a business expense, even
though the legislation may directly affect the taxpayer's business.
Path:
CCH-EXP, 2001FED ¶8610.01, Cost of Materials
¶8610.01 Synopsis - cost of incidental materials.--A business expense deduction is not
allowed for items that are used by the taxpayer to compute the cost of property included in
inventory or to determine the gain or loss basis of its plant, equipment or other property. The cost
of goods sold is in effect excluded from gross income when it is subtracted from gross receipts
for purposes of determining gross income. The rule applies in the case of a merchandising,
manufacturing or mining business (Reg. §1.61-3(a) and Reg. §1.162-1(a) ). Taxpayers carrying
materials and supplies on hand may, however, deduct as expenses the cost of materials and
supplies actually consumed in their operations. (Reg. §1.162-3 ).
Ordinarily, costs of materials and supplies are deductible only to the extent they are actually
consumed and used in business operations during the tax year. The consumption limit will not
apply, however, if there are incidental materials and supplies for which no inventories or records
of use are kept. Under this incidental materials and supplies exception, the deduction can be
based on amounts purchased, as long as the method does not distort taxable income.
Uniform capitalization rules. Where the uniform capitalization rules apply, the cost of
materials and supplies described in Reg. §1.162-3 is considered an indirect material cost subject
to capitalization (Reg. §1.263A-1(e)(3) (ii)(E)).--CCH.
Numerical Implication Statement:
Expenses related to a business activity are deductible from gross income.
In addition to cost recovery, which is dealt with in Issue E29-2, these cash disbursements listed
for the antique firearms business the advertising, business license, gas, and the telephone
expenses can be deducted from the gross income of the business. These expenses can be
deducted because they are ordinary and necessary expenses. The cost of goods sold is deductible
from gross receipts. Therefore, the antique firearms business can deduct cost of antique firearms
sold of $12,500 from gross receipts and $3,820 (i.e., Advertising, $600, Business License, $500,
Gas, $2,000, and Telephone, $720) of other business expenses from the resulting gross income.
There is a deduction allowed for the business use of the home the treatment of which will be
dealt with separately in issue E30-2.
In addition to cost recovery, which is again considered in issue E29-2, the dentistry has the
following business expenses that total $432,509:

















Advertising
Business license
Contribution to Employees’ Qualified Defined Contribution
Keogh Plan
Custodial services
Dental Supplies
Health Insurance Plan for Employees
Insurance (general and malpractice)
Interest ($300,000 SBA loan)
Magazine and newspaper subscriptions
Office supplies
Payroll Taxes
Professional Dues
Professional Fees
Professional Journals
Utilities (electricity and sewage and water)
Telephone
Wages
Issue E29-2:
Path:
$ 6,000
1,000
27,500
10,000
75,500
20,976
32,400
21,000
780
3,000
18,186
3,700
7,300
2,700
8,900
2,567
191,000
Cost Recovery (MOM: Jill, 1,500 points; PR: -----, 750)
GUIDEBOOK, 2001USMTG ¶1201, Property Subject to
Depreciation Property Subject to Depreciation
Narrative Solution:
Capital Assets must be Depreciated:
Path: CHH Internet; 2001USMTG;Business Expenses; Guidebook, 2001USMTG ¶903, Capital
Expenditures.
An expense that adds to the value or useful life of property is considered a capital expense.
Generally, capital expenses must be deducted by means of depreciation, amortization or
depletion. If the expense is not subject to depreciation, amortization or depletion, it is added to
the cost basis of the property. Capital expenses include those for buildings, improvements or
betterments of a long-term nature, machinery, architect's fees, and costs of defending or
perfecting title to property.
Expenses that keep property in an ordinarily efficient operating condition and do not add to its
value or appreciably prolong its useful life are generally deductible as repairs. Repairs include
repainting, tuck-pointing, mending leaks, plastering, and conditioning gutters on buildings.
However, the costs of installing a new roof and bricking up windows to strengthen a wall are
capital expenditures.
A taxpayer who buys or acquires an item of a capital nature, such as a building, a machine or
equipment, is not permitted to deduct the total cost of the item in the tax year of acquisition.
Instead, the cost of such an item must be written off and deducted over a period of tax years that
begins generally with the year of acquisition.
The Current Cost Recovery Regime:
Path: CHH Internet; 2001USMTG;Business Expenses; Guidebook, 2001USMTG ¶1201,
Property Subject to Depreciation
Modified accelerated cost recovery system (MACRS) rules apply to property placed in
service after 1986.
Property is depreciable if it (1) is used for business or held for the production of income. (2) has
a determinable useful life exceeding one year; and (3) wears out, decays, becomes obsolete, or
loses value from natural causes.
Ownership of a capital interest in depreciable property is a prerequisite to deducting
depreciation. Depreciation may not be claimed until the property is placed in service for either
the production of income or use in a trade or business.
Taxpayers may deduct a reasonable allowance for the exhaustion, wear and tear of property used
in a trade or business, or of property held for the production of income. Depreciation is not
allowable for property used for personal purposes, such as a residence or a car used solely for
pleasure.
Depreciation is allowed for tangible property, but not for inventories, stock in trade, land apart
from its improvements, or a depletable natural resource.
Methods. The methods of depreciation are dependent on when the property was placed in
service. The Modified Accelerated Cost Recovery System applies to tangible property
generally placed in service after 1986 and the Accelerated Cost Recovery System applies to
property placed in service after 1980 and before 1987. Under MACRS and ACRS, the cost or
other basis of an asset is generally recovered over a specific recovery period. For assets placed in
service before 1981 and assets that are excluded from MACRS and ACRS, the depreciation
allowance for any tax year is limited to such ratable amount as is necessary to recover the
remaining cost or other basis, less salvage value, during the remaining useful life of the property
(class life ADR is to be used when it was elected). In no event may an asset that is not subject to
MACRS or ACRS be depreciated below a reasonable salvage value.
Depreciation based on a useful life is to be calculated over the estimated useful life of the asset
while actually used by the taxpayer and not over the longer period of the asset's physical life.
Property Classes:
Path: CHH Internet; 2001USMTG;Business Expenses; Guidebook, 2001USMTG ¶1240,
Classes of Depreciable Property
The classes of depreciable property are defined in terms of property and the class life as of
January 1, 1986. The class life (or assigned class life) of an asset affects its recovery period, the
method of depreciation used, and the applicable convention. Under MACRS, assets are classified
according to their present class life as follows:
Three-Year Property. Three-year property includes property with a class life of four years or less.
Any race horse over two years old or any other horse over 12 years old at the time it is placed in
service is also classified as three-year property. For property placed in service after August 5,
1997, certain "rent-to-own" consumer durable property (e.g., televisions and furniture) is
considered as three-year property.
Five-Year Property. Five-year property generally includes property with a class life of more
than four years and less than 10 years. This property includes: (1) cars, (2) light and heavy
general-purpose trucks, (3) qualified technological equipment, (4) computer-based telephone
central office switching equipment, (5) research and experimentation property that is property,
(6) semi-conductor manufacturing equipment, (7) geothermal, solar and wind energy properties,
(8) certain biomass properties that are small power production facilities, (9) computers and
peripheral equipment, and (10) office machinery (typewriters, calculators, etc.).
Seven-Year Property. Seven-year property includes property with a class life of 10 years or
more but less than 16 years. This property includes any office furniture and fixtures, railroad
track and property that does not have a class life and is not otherwise classified.
Nonresidential Real Property. Nonresidential real property is real property that is not (1)
residential rental property or (2) property with a class life of less than 27.5 years. It includes
property that either has no class life or whose class life is 27.5 years or more, including elevators
and escalators. The cost of nonresidential real property generally placed in service after
May 12, 1993, is recovered over 39 years. For property placed in service after 1986 and
before May 13, 1993, cost is recovered over 31.5 years.
GUIDEBOOK, 2001USMTG ¶1261, Real Property
Real Property
Under ACRS, the unadjusted basis of real property is recovered over a period of 19 years
for real property placed in service after May 8, 1985, and before 1987. For real property placed
in service after March 15, 1984, and before May 9, 1985, unadjusted basis is recovered over a
period of 18 years. A 15-year recovery period applies to real property placed in service after
1980 and before March 16, 1984, and to low-income housing.[ 2001FED ¶11,258.025]
In computing the ACRS deduction, a full-month convention is used for real recovery
property placed in service before March 16, 1984, and for low-income housing, and a mid-month
convention is used for real recovery property (other than low-income housing) placed in service
after March 15, 1984. Under the full-month convention, real property placed in service at any
time during a particular month is treated as placed in service on the first day of such month,
thereby permitting a full month’s cost recovery for the month the property is placed in service.
For a disposition at any time during a particular month before the end of a recovery period, no
cost recovery is permitted for such month of disposition. Under the mid-month convention, real
property placed in service at any time during a particular month is treated as placed in service in
the middle of such month, thereby permitting one-half month’s cost recovery for the month the
property is placed in service. For a disposition of real property during a month before the end of
a recovery period, one-half month’s cost recovery is allowed for the month of disposition.
In using the following tables, there are separate rate schedules depending upon the month in the
first tax year that the property is placed in service. Further, where real property is sold before the
end of the recovery period, the ACRS deduction for the year of disposition is to reflect only the
months of the year during which the property was in service. For a short tax year, appropriate
adjustments must also be made to the table amounts. A special rule applies where there is a
disposition of real recovery property in the first recovery year.
GUIDEBOOK, 2001USMTG ¶1240, Classes of Depreciable Property
Additions and Improvements. Additions and improvements to a property are depreciated under
MACRS in the same way that the property would be depreciated if it were placed in service at
the same time as the addition or improvement (Code Sec. 168(i)(6)). For example, a roof
replaced on a commercial building in 2000 is treated as 39-year MACRS nonresidential real
property even if the building is depreciated under ACRS or a pre-ACRS method.
Depreciation Methods:
Path: CHH Internet; 2001USMTG; Recovery Methods; Guidebook, 2001USMTG ¶1243,
Recovery Methods
Under MACRS, the cost of depreciable property is recovered using (1) the applicable
depreciation method, (2) the applicable recovery period, and (3) the applicable convention.
Instead of the applicable depreciation method, taxpayers may irrevocably elect to claim straightline MACRS deductions over the regular recovery period. The election applies to all property in
the MACRS class for which the election is made that is placed in service during the tax year and
is made on the return for the year such property is first placed in service.
The cost of property in the 3-, 5-, 7-, and 10-year classes is recovered using the 200% decliningbalance method over three, five, seven, and ten years, respectively, and the half-year convention,
with a switch to the straight-line method in order to maximize the deduction. The cost of 15- and
20-year property is recovered using the 150% declining-balance method over 15 and 20 years,
respectively, and the half-year convention, with a switch to the straight-line method at a time to
maximize the deduction The cost of residential rental and nonresidential real property is
recovered using the straight-line method and the mid-month convention.
An election may be made to recover the cost of 3-, 5-, 7-, and 10-year property using the 150%
declining-balance method over the regular recovery periods (the ADS recovery period for
property placed in service before 1999). This election, like the straight-line election described
above, is made separately for each property class. Generally, 3-, 5-, 7-, and 10-year property
used in the trade or business of farming must be depreciated under the 150% declining balance
method unless an election was made to deduct preproductive period expenditures, in which case
the alternative MACRS method must be used.
The MACRS deduction is computed by first determining the rate of depreciation (dividing the
number one by the recovery period). This basic rate is multiplied by the percentage allowed for
the class of property being depreciated (1.5 or 2 for the 150% or 200% declining-balance
method, as applicable). The adjusted basis of the property is multiplied by the declining-balance
rate and the half-year convention is applied in computing depreciation for the first year. The
depreciation claimed in the first year is subtracted from the adjusted basis before applying the
declining-balance rate in determining the depreciation deduction for the second year.
The depreciation rate (in percentage terms) may also be determined by dividing the specified
declining-balance percentage (150% or 200%) by the applicable recovery period. The decliningbalance rate is constant for each tax year in which the declining-balance method is used and is
applied to the unrecovered basis of the property in conjunction with the appropriate convention.
Under the MACRS straight-line method, a new applicable depreciation rate is determined for
each tax year in the applicable recovery period. For any tax year, the applicable depreciation rate
(in percentage terms) is determined by dividing one by the length of the applicable recovery
period remaining as of the beginning of such tax year. The rate is applied to the unrecovered
basis of such property in conjunction with the appropriate convention. If as of the beginning of
any tax year the remaining recovery period is less than one year, the applicable depreciation rate
under the straight-line method for that year is 100%.
MACRS depreciation tables which contain the annual percentage depreciation rates to be applied
to the unadjusted basis of property in each tax year, may be used to compute depreciation instead
of the above rules. The tables incorporate the appropriate convention and a switch from the
declining-balance method to the straight-line method in the year that the latter provides a
depreciation allowance equal to, or larger than, the former. The tables may be used for any item
of property (that otherwise qualifies for MACRS) placed in service in a tax year.
If a table is used to compute the annual depreciation allowance for any item of property, it
must be used throughout the entire recovery period of such property. However, a taxpayer may
not continue to use a table if there are any adjustments to the basis of the property for reasons
other than (1) depreciation allowances or (2) an addition or improvement to such property that is
subject to depreciation as a separate item of property.
Averaging Conventions:
Path: CHH Internet; 2001USMTG; Conventions; ¶1245, Averaging Conventions
The following averaging conventions apply to depreciation computations made under the
regular MACRS method, the straight-line MACRS method, and the MACRS alternative
depreciation system (ADS) (Code Sec. 168(d)).[ 2001FED ¶11,250] The recovery period begins
on the date on which the property is placed in service under the applicable convention.
Half-Year Convention. Under the half-year convention, applicable to property other than
residential rental property and nonresidential real property, property is treated as placed in
service or disposed of in the middle of the tax year. Thus, one-half of the depreciation for the
first year of the recovery period is allowed in the tax year in which the property is placed in
service, regardless of when the property is placed in service during the year.
If property is held for the entire recovery period, a half-year of depreciation is allowable in
the tax year in which the recovery period ends.
Generally, a half-year of depreciation is allowed in the tax year of disposition if there is a
disposition of property before the end of the recovery period.[ 2001FED ¶11,279.037]
Mid-Month Convention. A mid-month convention applies to residential rental property,
including low-income housing, and nonresidential real property. Property is deemed placed in
service or disposed of during the middle of the month. The deduction is based on the number of
months the property was in service. Thus, one-half month’s cost recovery is allowed for the
month the property is placed in service and for the month of disposition if there is a disposition
of property before the end of the recovery period.
Mid-Quarter Convention. A mid-quarter convention applies to all property, other than
nonresidential real property and residential rental property, if more than 40% of the aggregate
bases of such property is placed in service during the last three months of the tax year. Under the
mid-quarter convention, all property placed in service, or disposed of, during any quarter of a tax
year is treated as placed in service at the midpoint of such quarter (Code Sec. 168(d)(3)).[
2001FED ¶11,250] Property placed in service and disposed of within the same tax year is
disregarded for purposes of the 40% test.
In determining whether the mid-quarter convention is applicable, the aggregate basis of
property placed in service in the last three months of the tax year must be computed regardless of
the length of the tax year. Thus, if a short tax year consists of three months or less, the midquarter convention applies regardless of when the depreciable property is placed in service
during the tax year.
The cost of Sec. 179 property purchased during the last three months of the year that is
properly expensed is excluded from the aggregate basis of property placed in service in
determining whether the mid-quarter convention applies.
For purposes of the 40% test, depreciable basis does not include adjustments resulting from
transfers of property between members of the same affiliated group filing a consolidated return.
The MACRS deduction for the first year for property subject to the mid-quarter convention is
computed by first determining the depreciation for the full tax year and then multiplying it by the
following percentages for the quarter of the tax year the property is placed in service: first
quarter, 87.5%; second quarter, 62.5%; third quarter, 37.5%; and fourth quarter, 12.5%.
Depreciation may also be determined under Tables 2-5, above.
Election to Expense Certain Depreciable Business Assets:
Path: CHH Internet; 2001USMTG; Election to Expense; Guidebook, 2001USMTG ¶1208,
Election to Expense Certain Depreciable Business Assets
An expense deduction is provided for taxpayers (other than estates, trusts or certain
noncorporate lessors) who elect to treat the cost of qualifying property, called sec .179 property,
as an expense rather than a capital expenditure. The election, which is generally made on Form
4562 , is attached to the taxpayer's original return (including a late-filed original return) or on an
amended return filed by the due date of the original return (including extensions) for the year the
property is placed in service and may not be revoked without IRS consent. Employees may make
the election on Form 2106 .
The maximum Code Sec. 179 deduction is $20,000 for tax years beginning in 2000 and
$24,000 for tax years beginning in 2001 and 2002. Thereafter, the deduction is $25,000 per year.
The maximum amount is reduced by a dollar for each dollar of the cost of qualified property
placed in service during the tax year over $200,000.
The total cost of property that may be expensed for any tax year cannot exceed the total
amount of taxable income derived from the active conduct of any trade or business during the tax
year, including salaries and wages. A deduction disallowed under this rule is carried forward an
unlimited number of years subject to the ceiling amount for each year. To qualify as Code Sec.
179 property, the property must be tangible Code Sec. 1245 property, depreciable Code Sec. 168,
and acquired by purchase for use in the active conduct of a trade or business. Property and air
conditioning or heating units do not qualify as property.
Path: CCH Online; Federal Tax Service; Spine, ACRS and MACRS, Election to Expense
Depreciable Property; §G:19.20, Overview—Election to Expense Depreciable Business
Property
Married taxpayers and controlled groups of corporations are treated as one taxpayer for
purposes of the annual dollar cap and $200,000 limitations. The limitation applies to both the
partnership and each partner and to an S corporation and each shareholder. In addition, the
aggregate cost of qualifying property that may be deducted during a tax year is limited to the
amount of taxable income generated by the taxpayer's active trade or business. Taxpayers may,
however, carry over qualifying deductions that are limited by this restriction to subsequent tax
years. See §G:19.60.
Path: CCH Network; Federal Tax Service; section 179; §G:19.62, Annual Dollar Limitation
Taxpayers may elect to expense, instead of depreciate, up to the following amount for the first
year property is placed in service:6
6
Code Sec. 179(b)(1) .
Tax Years
Beginning in:
1999
2000
2001
2002
2003 or thereafter
Deduction Allowed
19,000
20,000
24,000
24,000
25,000
For property placed in service in 1998, a taxpayer's maximum expense election was $18,500. For
1997, it was $18,000.7
Path: CHH Internet; 2001USMTG; Section 1245; ¶1785, Code Sec. 1245 Property
Code Sec. 1245 property is property that is or has been depreciable (or subject to amortization
under Code Sec. 197) and that is either (1) personal property (tangible and intangible) or (2)
other tangible property (not including a building or its structural components) used as an integral
part of (a) manufacturing, (b) production, (c) extraction, or (d) the furnishing of transportation,
communications, electrical energy, gas, water, or sewage disposal services (Reg. §1.1245-3).[
2001FED ¶30,905] The term “other tangible property” includes research facilities or facilities for
the bulk storage of fungible commodities used in connection with the activities in (a)-(d). A
leasehold of Code Sec. 1245 property is also treated as Code Sec. 1245 property (Reg. §1.12453).[ 2001FED ¶30,905]
Livestock is considered Code Sec. 1245 property, and depreciation on purchased draft,
breeding, dairy and sporting livestock is recaptured as ordinary income when sold. Raised
livestock generally has no basis for depreciation, but to the extent that it does have a basis and is
depreciated, it would be subject to recapture.[ 2001FED ¶30,909.021]
Code Sec. 1245 property also includes so much of any real property (except “other property”
described at (2) above) that has an adjusted basis reflecting adjustments for amortization of
pollution control facilities, child care facilities, or railroad grading and tunnel bores; expenditures
for removal of architectural and transportation barriers to the handicapped and elderly,
reforestation, or tertiary injectants; and amounts expensed under Code Sec. 179. Code Sec. 1245
property also includes single purpose agricultural and horticultural structures and storage
facilities used in connection with the distribution of petroleum products (Code Sec. 1245(a)(3)).[
2001FED ¶30,902]
Depreciation Tables:
Path: CHH Internet; 2001USMTG; depreciation tables; ¶1243, Recovery Methods
Depreciation computed without the use of the IRS tables is determined as follows: the decliningbalance depreciation rate is determined and compared with the straight-line rate. A switch is
made to the straight-line rate in the year depreciation equals or exceeds that determined under the
declining-balance method. The applicable rate is applied to the unrecovered basis. The 200%
declining-balance depreciation rate is 40% (1 divided by 5 (recovery period) times 2). The
straight-line rate (which changes each year) is 1 divided by the length of the applicable recovery
period remaining as of the beginning of each tax year (after considering the applicable
convention for purposes of determining how much of the applicable recovery period remains as
of the beginning of the year). For year four, the straight-line rate is .40 (1 divided by 2.5). For
year five, the straight-line rate is .6667 (1 divided by 1.5). For year six, the straight-line rate is
100% because the remaining recovery period is less than one year.
Table 1.
General Depreciation System
Applicable Depreciation Method: 200 or 150 Percent
Declining Balance Switching to Straight Line
Applicable Recovery Periods: 3, 5, 7, 10,15, 20 years
Applicable Convention: Half-year
If the
Recovery
Year is:
and the Recovery Period is:
3-year 5-year 7-year 10-year 15-year 20-year
the Depreciation Rate is:
1 ..... 33.33 20.00 14.29
10.00
5.00
2 ..... 44.45 32.00 24.49
18.00
9.50
3 ..... 14.81 19.20 17.49
14.40
8.55
4 ...... 7.41 11.52 12.49
11.52
7.70
5 ............ 11.52
8.93
9.22
6.93
6 ............. 5.76
8.92
7.37
6.23
7 .................... 8.93
6.55
5.90
8 .................... 4.46
6.55
5.90
9 ............................ 6.56
5.91
10 ........................... 6.55
5.90
11 ........................... 3.28
5.91
12 ................................... 5.90
13 ................................... 5.91
14 ................................... 5.90
15 ................................... 5.91
16 ................................... 2.95
17 ..........................................
18 ..........................................
19 ..........................................
20 ..........................................
21 ..........................................
3.750
7.219
6.677
6.177
5.713
5.285
4.888
4.522
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
2.231
GUIDEBOOK, 2001USMTG ¶1243, Recovery Methods
Table 5.
General Depreciation System
Applicable Depreciation Method: 200 or 150
Percent Declining Balance Switching to Straight Line
Applicable Recovery Periods: 3, 5, 7, 10,
15, 20 years Applicable Convention: Mid-quarter (property
placed in service in fourth quarter)
If the
Recovery
Year is:
and the Recovery Period is:
3-year 5-year 7-year 10-year 15-year 20-year
the Depreciation Rate is:
1 ...... 8.33
5.00
3.57
2.50
1.25
2 ..... 61.11 38.00 27.55
19.50
9.88
3 ..... 20.37 22.80 19.68
15.60
8.89
4 ..... 10.19 13.68 14.06
12.48
8.00
5 ............ 10.94 10.04
9.98
7.20
6 ............. 9.58
8.73
7.99
6.48
7 .................... 8.73
6.55
5.90
8 .................... 7.64
6.55
5.90
9 ............................ 6.56
5.90
10 ........................... 6.55
5.91
11 ........................... 5.74
5.90
12 ................................... 5.91
13 ................................... 5.90
14 ................................... 5.91
15 ................................... 5.90
16 ................................... 5.17
17 ..........................................
18 ..........................................
19 ..........................................
20 ..........................................
21 ..........................................
0.938
7.430
6.872
6.357
5.880
5.439
5.031
4.654
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.459
4.458
4.459
3.901
GUIDEBOOK, 2001USMTG ¶1261, Real Property
Table V
18-Year Real Property
(placed in service after March 15 and before June 23, 1984)
----------------------------------------------------------------------------Year
Month Placed in Service
-------------------------------------------------------------------
1
2
3
4
5
6
7
8
9
10-11 12
----------------------------------------------------------------------------1st
10%
9%
8%
7%
6%
6%
5%
4%
3%
2%
1%
2nd
9%
9%
9%
9%
9%
9%
9%
9%
9%
10%
10%
3rd
8%
8%
8%
8%
8%
8%
8%
8%
9%
9%
9%
4th
7%
7%
7%
7%
7%
7%
8%
8%
8%
8%
8%
5th
6%
7%
7%
7%
7%
7%
7%
7%
7%
7%
7%
6th
6%
6%
6%
6%
6%
6%
6%
6%
6%
6%
6%
7th
5%
5%
5%
5%
6%
6%
6%
6%
6%
6%
6%
8-12th
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
13th
4%
4%
4%
5%
5%
4%
4%
5%
4%
4%
4%
14-18th
4%
4%
4%
4%
4%
4%
4%
4%
4%
4%
4%
19th
1%
1%
1%
2%
2%
2%
3%
3%
4%
------------------------------------------------------------------------CCH-EXP, 2001FED ¶11,258.031
(Straight Line Method Over an 18-Year Period)
(Assuming Mid-Month Convention)
Month Placed in Service
-----------------------------Year
1-2 3-4 5-7 8-9 10-11 12
-------------------------------------------------------------1 ............................. 5%
4%
3%
2%
1%
0.2%
2-10 .......................... 6
6
6
6
6
6
11 ............................ 5
5
5
5
5
5.8
12-18 ......................... 5
5
5
5
5
5
19 ............................ 1
2
3
4
5
5
-------------------------------------------------------------Table 7.
General Depreciation System
Applicable Depreciation Method: Straight Line
Applicable Recovery Period: 31.5 years
Applicable Convention: Mid-month
If the
Recovery
Year is:
1
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
3.042
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
1.720
0.000
2
2.778
3.175
3.175
3.175
3.175
3.175
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
1.984
0.000
Table 7A.
If the
Recovery
And the Month in the First Recovery Year
the Property is Placed in Service is:
3
4
5
6
7
8
9
the Depreciation Rate is:
2.513 2.249 1.984 1.720 1.455 1.190 0.926
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.175 3.175 3.175 3.175 3.175 3.175
3.175 3.174 3.175 3.174 3.175 3.175 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
3.175 3.174 3.175 3.174 3.175 3.174 3.175
3.174 3.175 3.174 3.175 3.174 3.175 3.174
2.249 2.513 2.778 3.042 3.175 3.174 3.175
0.000 0.000 0.000 0.000 0.132 0.397 0.661
10
11
12
0.661
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
0.926
0.397
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
1.190
0.132
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
3.175
3.174
1.455
General Depreciation System
Applicable Depreciation Method: Straight-Line
Applicable Recovery Period: 39 years
Applicable Convention: Mid-month--taken from the
IRS Pub. 946 --CCH.
And the Month in the First Recovery Year
Year is:
the Property is Placed in Service
3
4
5
6
7
8
the Depreciaiton Rate is:
2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963
2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564
0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605
1
1
2--39
40
2
is:
9
10
11
12
0.749 0.535 0.321 0.107
2.564 2.564 2.564 2.564
1.819 2.033 2.247 2.461
Are the special assessment assets depreciable?
Path: CCH Online; Standard Federal Tax Reporter; depreciation w/par street; ¶11,007.52,
Depreciable Property: Sidewalks and streets.-No depreciation is allowable on the cost of construction of sidewalks, curbs, paved streets,
sewers, and water mains borne by taxpayer in connection with construction of its housing units
where, upon completion of the construction, the maintenance of the public facilities was taken
over by the local government units and they became part of the street systems for public use and
convenience.
Numerical Implication Statement:
An Overview:
Capital expenditures typically cannot be expensed immediately but must instead be capitalized as
assets and then depreciated. With the exception of the old Boone home, which was acquired
during the ACRS regime, all of the assets featured in this case were acquired during the MACRS
(i.e., modified accelerated cost recovery system) regime, applicable to post-1986 acquisitions.
Under the MACRS regime, the relevant cost recovery table and its accompanying annual cost
recovery multipliers is a function of an asset's property class, averaging convention, depreciation
method, and whether or not the Section 179 expensing election is applicable. An averaging
convention controls how much depreciation can be taken in the period of acquisition and
disposition. The Section 179 election allows the acquisition cost of tangible personalty (as
opposed to realty) to be expensed immediately up to a certain amount (e.g., $20,000 in 2000,
$19,000 in 1999, $18,500 in 1998, and $18,000 in 1997). The election amount is reduced dollar
for dollar for qualified assets in excess of $200,000 and cannot exceed trade or business income,
including wages and salaries. For purposes of the annual amount and limit provisions, married
taxpayers and multiple sole-proprietorships of a given taxpayer are all treated as a single
taxpayer.
The business assets of the antique firearms business:
Tom's assets consist of a $4,300 computer (1999), $3,400 of fixtures (1998), $51,000 of
electrical tools (including $1,000 for special wiring, 1998), a $5,500 climate control system
(includes $500 for special wiring; 2000), and 10 percent of the old and new Boone homes. The
computer belongs to the 5-year property class while the fixtures and probably the electrical tools
belong to the 7-year property. The half-year convention, which allows half-a-year's cost
recovery in the acquisition and disposition years and the 200 declining-balance depreciation
method with a switch to straight-line is applicable to all but the climate control system and the
Boone homes. Since only one Section 179 amount is available for the Fronks each year
regardless of the number of sole proprietorships operating under their auspices, it makes sense to
allocate the Section 179 amounts to the slowest depreciating qualifying assets. Both the
dentistry and the firearms businesses had qualifying 7-year property in 1999. Unfortunately,
$259,000 of qualifying Section 179 was placed into service. Thus, the over-consumption
provision is applicable. For each dollar in excess of $200,000, the Section 179 amount of
$19,000 is reduced dollar for dollar. Since the applicable excess is $59,000, the Section 179
amount is phased out for 1999. Thus, no Section 179 amount would have been available for the
firearms business' computer that means that the 2000 cost recovery for the computer system
equals $1,376 (i.e., $4,300 * .32). In 1998, it appears that the dentistry did not acquire new
Section179 assets. Thus, we assume that the $18,500 Section 179 amount was first used to
expense the $3,400 of fixtures and that the remainder was used to expense a portion of the 7-year
equipment. Thus, 2000's cost recovery for the equipment is $6,279 (i.e., (((50,000+1,000)(18,500-3400)) * .1749)). The climate control system and special wiring, which seem like
structural components of the home and somewhat like an air-condition system, thus not
qualifying as Section 179 property. The applicable year 2000 cost recovery is $53 (i.e., $5,500 *
.00963). The special wiring required to bring the electrical equipment to its intended use in
2000, though in one sense a structural component of the home, probably qualifies for Section
179 treatment. That is, the asset served by the special wiring probably controls whether it
qualifies for Section 179 treatment. Since it's related to a 7-year asset, it makes sense to allocate
$1,500 of the $20,000 Section 179 amount to the wiring. The 10-percent business-use portion of
the old Boone home and the new Boone home are nonresidential real properties. The old Boone
home was placed in service on June 1, 1984 and is thus an 18-year ACRS asset while the new
Boone home is 39- year MACRS asset. The mid-month averaging convention and straight-line
depreciation method are relevant to the cost recovery of those assets. Section 179 is in general
not available for real property.
Depreciation Computation Summary:
$1,376
$
$6,279
$ 53
$1,500
1999 Computer -- no Section 179 used (phased out); $4,300 * .32
1998 Fixtures -- $4,300 expensed in 1998 (18,500 could be expensed in 1998)
1998 Equipment -- ((50,000 + 1,000) - (18,500 - 4,300)) * .1749
2000 Climate Control System (5,500 * .00963)
Electrical Tools, Special Wiring (up to 20,000 can be expenses in 2000)
Long View Home:
In order to compute the current year's depreciation, the relevant depreciable cost must be
identified. We first note the June 1, 1986 special assessment assets are added to the basis of
the land and are not depreciable. With regard to the June 1, 1995 condemnation and
severance, Issue E12-2 notes that severance proceeds are used to reduce the basis of the
remaining property, part of which is the home. To carry out this computation, we assume
that the old Boone homestead retains the same proportionate value of land and building that
it had when purchased. Thus, $6,300 (i.e., ((10,000 - 3,000) * .90)) is allocated to the home.
The basis of the depreciable portion of the home immediately following the severance award
is: $4,575 (i.e., 18,000- ((((.06 + .09 + .08 + (.07 * 2) + (.06 * 2) + (.05 * 4) + (.05 * 5 / 12))
* 18,000) ) - 630)). Since the new depreciable cost must be allocated over the remaining life
of the home's original 18-year life and 71.08333 (i.e., (.06 + .09 + .08 + (.07 * 2) + (.06 * 2)
+ (.05 * 4) + (.05 * 5 / 12))) percent of that life has passed, each cost-recovery multiplier
must be adjust to reflect the remaining 28.91667 percent life. Thus, for 2000, the cost
recovery for the Long View home is $343 (i.e., ($4,575 * (.04 / .2891667) * (6.5 / 12)).
The (6.5 / 12) portion of that computation reflects the mid-month convention for a
disposition year.
Rocky Mountain Home:
From Issue E22-2 we recall that the basis of the new home $876,647, thus the cost recovery
is $760 (i.e., $876,647 * .90 * 00963 * .10).
The business assets of the Dentistry business:
Since greater than 40 percent of the Dentistry's tangible personalty assets were purchased in the
last quarter of the year, the mid-quarter convention applies to these assets placed in service in
1999:
$24,700
$55,100
$12,398
$ 5,928
Computer system, basis $65,000 (see Issue N16), no Sec. (phased out), * .38
Dental equip., basis $145,000 (see Issue N16), no Sec. 179 (phased out), * .38
Furniture & fixtures (1999), basis $45,000, no Sec. 179 (phased out), * .2755
Paving & sidewalk, basis $60,000, not a Sec. 179 asset, * .0988
In 1999, the clinic was also placed in service:
$ 8,974
Clinic, basis $350,000, not Sec. 179 asset, * .02564
The half-year convention applies to those assets that were placed in service in 2000:
$15,000
$ 1,000
Furniture & fixtures, basis $15,000, expensed via Sec. 179
Landscaping, basis $20,000, not Sec. 179 asset, * .05
Issue N30: Home Business Expense Deductions (MOM: Akiko, 1000 points;
AUD: Rebecca, Katie, 500 points; PR: -----, 500 points)
Path:
CCH Internet; 2001 USMTG; Business Use of the Home; Deductions
(Chapters 9—12), GUIDEBOOK, 2001USMTG ¶961, Business Use
of Home
Narrative Solution:
Taxpayers are not entitled to deduct any expenses for using their homes for business
purposes unless the expenses are attributable to a portion of the home (or separate structure) used
exclusively on a regular basis (1) as the principal place of any business carried on by the
taxpayer, (2) as a place of business that is used by patients, clients, or customers in meeting or
dealing with the taxpayer in the normal course of business, or (3) in connection with the
taxpayer's business if the taxpayer is using a separate structure that is appurtenant to, but not
attached to, the home. If the taxpayer is an employee, the business use of the home must also be
for the convenience of the employer. The allowable deduction is computed on Form 8829
(Expenses for Business Use of Your Home).
Generally, a specific portion of the taxpayer's home must be used solely for the purpose of
carrying on a trade or business in order to satisfy the exclusive use test. This requirement is not
met if the portion is used for both business and personal purposes. However, an exception is
provided for a wholesale or retail seller whose dwelling unit is the sole fixed location of the trade
or business. In this situation, the ordinary and necessary expenses allocable to space within the
dwelling unit that is used as a storage unit for inventory or product samples are deductible
provided that the space is used on a regular basis and is a separately identifiable space suitable
for storage.
Tax Years Beginning After 1998. The phrase "principal place of business" includes a place
of business that is used by the taxpayer for the administrative or management activities of any
trade or business of the taxpayer if there is no other fixed location of such trade or business
where the taxpayer conducts substantial administrative or management activities of the trade or
business.
Taxpayers who perform administrative or management activities for their trade or business
at places other than the home office are not automatically prohibited from taking the deduction
based on failure to meet the principal place of business requirement. According to the House
Committee Report to P.L. 105-34, the following taxpayers are not prevented from taking a home
office deduction under the new definition.
(1) taxpayers who do not conduct substantial administrative or management activities at a
fixed location other than the home office, even if administrative or management activities (e.g.,
billing activities) are performed by other people at other locations;
(2) taxpayers who carry out administrative and management activities at sites that are not
fixed locations of the business (e.g., cars or hotel rooms) in addition to performing the activities
at the home office;
(3) taxpayers who conduct an insubstantial amount of administrative and management
activities at a fixed location other than the home office (e.g., occasionally doing minimal
paperwork at another fixed location); and
(4) taxpayers who conduct substantial nonadministrative and nonmanagement business
activities at a fixed location other than the home office (e.g., meeting with, or providing services
to customers, clients or patients at a fixed location other than the home office).
Tax Years Beginning Before 1999. The Supreme Court's decision in Soliman established
the test that was previously used to determine whether a particular location was the taxpayer's
principal business location. Under this test only the most important, consequential, or influential
location could be the principal location. The Court said that while the ultimate determination
depends upon the facts of each situation, two primary steps were to be followed in making the
determination: (1) the relative importance of the functions performed at each business location
must be analyzed, and (2) if (1) did not result in a definitive answer, the amount of time spent in
the home business location was compared to the time spent in each of the other places where
business was conducted. In some situations, after applying the two steps, the conclusion may be
reached that the individual had no principal place of business. As mentioned above, after 1998,
the definition of a "principal place of business" has been expanded to cover home offices used to
conduct administrative or management activities.
Residential Telephone. An individual is denied a business deduction for basic
local telephone service charges on the first line in the residence. Additional
charges for long-distance calls, equipment, optional services (e.g., call waiting),
or additional telephone lines may be deductible
The home office deduction is limited to the gross income from the activity, reduced by
expenses that are deductible without regard to business use (such as home mortgage interest) and
all other deductible expenses attributable to the activity but not allocable to the use of the unit
itself. Thus, a deduction is not allowed to the extent that it creates or increases a net loss from the
business activity to which it relates. Any disallowed deduction may be carried over, subject to
the same limit in carryover years.
Example. A teacher operates a retail sales business, in which she makes a qualified
business use of a home office. Assume that 25% of the general expenses for the dwelling unit are
allocable to the home office. The taxpayer's gross income and expenses from the retail sales
business are:
Gross income ....................................................... $25,000
Home Office Expenses
Total
Interest and property taxes --------------------------$8,000
Insurance, maintenance, utilities--------------------2,000
Depreciation ------------------------------------------6,000
Total home office expenses --------------------------Expenses allocable to retail sales business, but not allocable to
home office use (e.g., supplies, wages paid)---------$24,000
=======
Total expenses ----------------------------------------------$28,000
Allocable to
Office
$2,000
500
1,500
$ 4,000
The teacher must apply both the deductions allocable to her retail sales business and the
deductions for taxes and interest allocable to the business use of the home ($26,000) against the
gross income from the activity ($25,000) in order to determine the limitation on her deduction.
Because the limitation amount (negative $1,000) is zero or less, the teacher cannot deduct
expenses for depreciation, insurance, maintenance, and utilities, which would otherwise qualify.
For the tax year, the teacher has a business loss of $1,000, and may carry forward the unused
$2,000 of expenses to a succeeding year, again subject to the limitation.
Numerical Implication Statement:
The expenses attributable to the business use of a home are deductible from gross income as
business expenses to the extent of net direct business income. In this case, those expenses
consist of:
Home Office Expenses:
Interest:
Mortgage - LongView
Home Equity
Mortgage - Rocky Mountain
Points - Rocky Mountain
Property Taxes:
LongView
Rocky Mountain
Insurance:
LongView
Rocky Mountain
Utilities:
LongView
Rocky Mountain
Maintenance:
LongView
Rocky Mountain
Cost Recovery:
LongView
Rocky Mountain
Limited to Net Direct Business Income (E30-2)
$
408
1,224
420
$2,052
$ 281
335
616
$
70
240
310
$ 238
400
638
$ 500
200
700
$ 343
760
1,103
$5,419
9,961
A total of $5,419 can be expensed and deducted from Tom's gunsmith business income as long
as it does not create or increase a net loss. The deductions for expenses are limited to the amount
of net direct business income. In Tom's case, that is $9,961. Therefore, he can deduct the entire
home use amount. Had there been excess home office expenses, they could have been carried
forward to future periods and again subjected to these same rules.
Issue E31-2:
Path:
Points (MOM: Garit, 300 points; PR: -----, 150 points)
CCH Online; USMTG; keyword: points; ¶1055, Deductibility of
Prepaid Interest by Cash-Basis Taxpayers
Narrative Solution:
Points on a home mortgage loan for the purchase or improvement of, and secured by, a principal
residence are deductible in the year paid to the extent that, under regulations, the payment of
points is an established practice in the area involved and the amount of the payment does not
exceed that generally charged in the area for a home loan (Code Sec. 461(g)(2) ).[ 2001FED
¶21,802 ] As a matter of administrative practice, the IRS treats as deductible in the year paid any
points paid by a cash-basis taxpayer with respect to a home mortgage that meets the following
requirements (Rev. Proc. 94-27 ):[ 2001FED ¶9402.65 ]
(1) They must be designated as points on the RESPA settlement statement (Form HUD-1), for
example, as "loan origination fees" (including amounts so designated on VA and FHA loans),
"loan discount," "discount points," or "points";
(2) They must be calculated as a percentage of the principal loan amount;
(3) They must be paid to acquire the taxpayer's principal residence, and the loan must be secured
by that residence;
(4) They must be paid directly by the taxpayer (which may include earnest money, an escrow
deposit, or down payment applied at closing) and may not be derived from loan proceeds. Points
paid by a seller (including points charged to the seller) are considered directly paid by the
taxpayer from funds not derived from loan proceeds if they are subtracted by the taxpayer from
the purchase price of the residence in computing its basis; and
(5) They must conform to an established business practice of charging points for loans for the
acquisition of personal residences in the area in which the residence is located, and the amount of
points may not exceed the amount generally charged in that area. In this connection, the IRS
emphasizes that no part of the amounts paid may be in lieu of appraisal, inspection, title, and
attorney fees, property taxes, or other amounts that are ordinarily stated separately on the
settlement statement.
The above safe harbor does not apply to the extent that the points exceed the limit on acquisition
indebtedness discussed at ¶1048A . Nor does it apply to points paid on home improvement loans,
second or vacation home loans, refinancing or home equity loans, or lines of credit. The fact that
a taxpayer cannot satisfy the requirements of the safe harbor does not necessarily mean that
points are not currently deductible; it does mean that the IRS will not automatically consider
them to be currently deductible. In a recent letter ruling, the IRS allowed a couple to amortize
home-purchase loan points over the life of the loan in a situation where the applicable standard
deduction in the year the points were paid was greater than the couple's itemized deductions
(including the total points paid) (IRS Letter Ruling 199905033 , November 10, 1998).[ 2001FED
¶9402.04 ]
Points paid to refinance a home mortgage are not deductible in full in the year paid but must be
deducted ratably over the period of the loan because such points are for repaying the taxpayer's
existing indebtedness and are not paid in connection with the purchase or improvement of the
home. However, the U.S. Court of Appeals for the Eighth Circuit, reversing the Tax Court, has
allowed full deduction in the year paid for points on a long-term home mortgage loan refinancing
a short-term balloon loan used to acquire the home.[ 2001FED ¶9402.62 ] Also, if part of the
refinancing proceeds is used for improvements, a portion of the points may be deducted in the
year paid.[ 2001FED ¶9402.60 ]
A loan discount (where a lender delivers to an individual borrower an amount smaller than the
face amount of the loan and the difference is the agreed charge for the use of borrowed money) is
interest.[ 2001FED ¶9104.586]
Points. Points may also be deductible as interest. Points are charges paid by a borrower to obtain
a home mortgage and include certain charges paid by the seller to a lender for the buyer's
mortgage. Other names used for deductible points are loan origination fees, loan discounts,
discount points and maximum loan charges. While a fairly broad rule permits the deduction of
home mortgage interest, the rule governing the deduction of points is narrower and has a number
of attendant restrictions.
Points, like other pre-paid interest that represents a charge for the use of money, must generally
be amortized over the life of the mortgage. However, points may be deducted in full in the year
paid if:
(1) the loan is used to purchase or improve the individual's principal residence;
(2) the loan was secured by the residence;
(3) the points did not exceed the points usually charged in the area where the loan was made; and
(4) the points were computed as a percentage of the amount of the loan.
If the loan was used to buy the taxpayer's home, the individual must have provided funds (e.g.,
down payment, escrow deposit or earnest money), at least equal to the points charged. If the loan
was used to improve the home, the taxpayer must have paid the points with funds other than the
those obtained from the lender.
The IRS announced in 1994 that it will permit buyers to deduct points paid by sellers when
buyers purchase their principal residences. This allowance is retroactive to homes purchased
after 1990. If the home was purchased after April 3, 1994, seller-paid points reduce the buyer's
basis even if the taxpayer does not claim the deduction. If the home was purchased before April
4, 1994, the seller-paid points reduced the buyer's basis only if the taxpayer claimed the
deduction. The seller may not deduct the points paid for the buyer; they are treated as a sales
expense.
Applicable forms. To deduct home mortgage interest and points, a taxpayer must file Form 1040
and itemize deductions on Schedule A; the deduction is not permitted on Form 1040EZ.
Numerical Implication Statement:
Points on a home mortgage loan for the purchase or improvement of, and secured by, a
principal residence are deductible in the year paid to the extent that, under regulations, the
payment of points is an established practice in the area involved and the amount of the payment
does not exceed that generally charged in the area for a home loan. Points paid to refinance a
home mortgage are not deductible in full in the year paid but must be deducted ratably over the
period of the loan because such points are for repaying the taxpayer's existing indebtedness and
are not paid in connection with the purchase or improvement of the home. To deduct home
mortgage interest and points, a taxpayer must file Form 1040 and itemize deductions on
Schedule A; the deduction is not permitted on Form 1040EZ.
The points that the Fronks paid, $4,200, are treated as interest and are deductible as an itemized
deduction as long as they are not used as a charge for a service (i.e., – inspection, appraisal).
Issue E32-2:
Interest on State and Municipal Bonds (MOM: Andy B., 150
points; PR: -----, 75 points)
Path:
CCH Network; USMTG; Spine, Income (Chapter 7), Interest;
¶724, Interest
Narrative Solution:
¶724, Interest
All interest received or accrued is fully taxable (Reg. §1.61-7 ) [ 2001FED ¶5702 ] except
interest on (1) tax-exempt state or municipal bonds, including interest on registered warrants
issued by the state of California since July 1, 1992, as a result of its fiscal crisis,[ 2001FED
¶6602.469 ] and (2) certain ESOP loans (¶725 ). A cash-basis taxpayer is taxed on interest when
received. Interest on bank deposits, coupons payable on bonds, etc., is considered available and
taxed to a cash-basis taxpayer under the doctrine of constructive receipt and is taxed when
credited or due.
Interest earned on corporate obligations is generally taxed when actually received by, or credited
to, a cash-basis taxpayer (Reg. §1.61-7(a) ). The same rule applies to interest on certificates of
deposit, time obligations, and similar deposit arrangements on which interest is credited
periodically and can be withdrawn without penalty even though the principal cannot be
withdrawn without penalty prior to maturity. However, interest on a six-month certificate that is
not credited or made available to the holder without penalty before maturity is not includible in
the holder's income until the certificate is redeemed or matures.[ 2001FED¶21,009.3247 ]
Increments in value on growth savings certificates are taxable in the year that the increase
occurs.[2001FED ¶5704.023 ] Any increment in the value of life insurance or annuity prepaid
premiums or premium deposits is income when made available to the policyholder for
withdrawal or when credited against premiums payable.[ 2001FED ¶5504.023 ] Interest on a
judgment is taxable, even if the underlying award is
nontaxable.[ 2001FED ¶6662.043 ]
When a bond with defaulted interest coupons is bought "flat" (that is, the price covers both
principal and unpaid interest), any interest received that was in default on the date of purchase is
not taxable but is a return of capital. If the bond is sold, this amount must be applied to reduce
the basis, in turn increasing the gain or reducing the loss. If interest is received for a period
which follows the date of purchase, it is taxable in full.[ 2001FED ¶5704.046 , 2001FED
¶5704.3062
Numerical Implication Statement:
Interest earned on bonds or other debt obligations issued by states or political subdivisions of
states (local governments) generally is excluded from gross income. However, interest on bonds
issued by state and local governments can be taxed when the proceeds of the bonds are not used
for traditional governmental purposes. Bonds used for nontraditional governmental purposes
include among other uses: (1) private activity bonds that primarily benefit private individuals,
groups, or companies, (2) arbitrage bonds when the proceeds are reinvested at a higher interest
rate or used to replace funds used to purchase higher-yielding investments, and (3) bonds that are
not issued in registered form. According to the definitions of these three bonds, the state of
Idaho bonds that the Fronks have is not one of these. The interest from the state of Idaho bonds
is tax-exempt. Thus, 30% of the Gunsmith's interest (i.e., $1,500 * .30 = $450) and 40% of
Monica's (i.e., $8,000 * .40 = $3,200) is included in income broadly conceived and then
excluded from gross income. In addition, Tom's municipal and State of Idaho Bond interest,
$2,500 and $2,500, respectively are also tax-exempt and must be excluded.
Issue E33-2:
Self-Employment Tax (MOM: Robyn, 750 points; PR -----, 375
points)
Narrative Solution:
Path: CCH Online; USMTG; Self employment tax; Self employment Income
The self-employment tax is 15.3 percent and consists of two taxes--an OASDI (i.e., social
security) tax of 12.4 percent and a Medicare tax of 2.9 percent. The tax is based on "selfemployment income," which is defined as "net earnings from self-employment." For 2000, the
OASDI base has been increased to $76,200 ($80,400 for 2001). There is no longer a cap for the
Medicare component. However, if wages subject to social security or railroad retirement tax are
received during the tax year, the maximum is reduced by the amount of wages on which these
taxes were paid (Code Sec. 1402(b) ).[ 2001FED ¶32,560 ] If net earnings from self-employment
are less than $400, no self-employment tax is payable.
"Net earnings from self-employment" consist of: (1) the gross income derived from any
trade or business, less allowable deductions attributable to the trade or business, and (2) the
taxpayer's distributive share of the ordinary income or loss of a partnership engaged in a trade or
business. The term "trade or business" does not include services performed as an employee other
than services relating to certain: (1) newspaper and magazine sales; (2) sharing of crops; (3)
foreign organizations; and (4) sharing of fishing catches (Code Sec. 1402(c)(2) ).[ 2001FED
¶32,560 ]
There are special rules for computing net earnings from self-employment (including a
special optional method of computing net earnings from nonfarm self-employment) Rents from
real estate and from personal property leased with the real estate, and the attributable deductions,
are excluded unless received by the individual in the course of his business as a real estate dealer.
Dividends and interest from any bond, debenture, note, certificate or other evidence of
indebtedness issued with interest coupons or in registered form by any corporation are excluded
from net earnings from self-employment income unless received by a dealer in stocks and
securities in the course of his business. Other interest received in the course of any trade or
business is not excluded. Gain or loss from the sale or exchange of property that is not stock
in trade or held primarily for sale is excluded, as is gain or loss from the sale or exchange of a
capital asset.
Termination payments received by former insurance salespersons are excludable from selfemployment tax under certain circumstances specified under Code Sec. 1402(k) .[ 2001FED
¶32,560 ]
Even though the rental value of a parsonage (or a parsonage rental allowance) and the value
of meals and lodging furnished for the convenience of the employer are not included in a
minister's gross income for income tax purposes they are taken into account in calculating net
earnings from self-employment The same is true of amounts excluded from gross income as
foreign earned income (see ¶2401 ). However, self-employment
income does not include a minister's retirement benefits received from a church plan or the rental
value of a parsonage allowance, as long as each was furnished after the date of retirement.[
2001FED ¶32,599.58 ]
One business deduction that cannot be taken in calculating net earnings from selfemployment for the tax year is the deduction allowed for 50 percent of the self-employment tax
for the same tax year However, the law provides a substitute for that deduction. This is an
amount determined by multiplying net earnings from self-employment (calculated without regard
to the substitute deduction) by one-half of the self-employment tax rate for the year For 2000,
this is 7.65 percent of the net earnings from self-employment.
Example. Aileen Smith, a self-employed individual, has $40,000 of net earnings from selfemployment in 2000 (determined without regard to the substitute deduction). Her selfemployment tax for 2000 would be computed as follows:
Self-employment net earnings ..................................... $40,000
Less: $40,000 x 7.65% ............................................ 3,060
--------Reduced self-employment net earnings ............................. $36,940
Tax rate on self-employment income ............................... x15.3%
--------Self-employment tax for 2000 ..................................... $ 5,652
Path: CCH Online; USMTG; Self Employment Tax; Social Security Taxes
Narrative Solution:
The federal social security tax on an employer is deductible by the employer as a business
expense. The contribution of an employer on wages paid to a domestic worker is not deductible
unless it is classified as a business expense
The tax imposed on employees by the Social Security Act is not deductible by the
employee. If the employer pays the tax without deduction from the employee's wages under an
agreement with the employee, the amount is deductible by the employer and is income to the
employee.
A self-employed individual may deduct from gross income 50% of the self-employment
tax imposed for the same tax year
Numerical Implication Statement:
The self-employment tax is levied upon net earnings from self-employment which consist of
gross income derived from any trade or business, less allowable deductions attributable to the
trade or business, and the taxpayer's distributive share of the ordinary income or loss of a
partnership engaged in a trade or business. Net earnings do not include gain or loss from the sale
or exchange of a non-inventory business asset and dividends and interest from any bond,
debenture, note, certificate or other evidence of indebtedness issued with interest coupons or in
registered form by any corporation. Net earnings include interest received in the course of any
trade or business. If net earnings are less than $400, no self-employment tax has to be paid.
The self-employment tax is composed of a 12.4 percent OASDI tax on the first $76,200 of net
earnings and a 2.9 percent Medicare component on all net earnings. The tax is computed by first
taking net earning and subtracting 7.65 percent of net earning from net earnings. Tom's selfemployment tax is computed as follows:
Self-employment net earnings - Firearms:
Revenues:
Checking interest
Instrument Sales
Expenses:
Cost of Instruments Sold
Advertising
Business License
Cost Recovery:
Computer system
Fixtures - 1998
Equipment
Climate control system
Wiring - 2000
Gas
Telephone
Home Office Expenses:
Interest:
Mortgage - LV
Home Equity
Mortgage - RM
Points - RM
Property Taxes:
LV
RM
Insurance:
LV
RM
$
489
35,0000
$ 12,500
600
500
$1,376
6,279
53
1,500
$
408
1,224
420
281
335
70
240
9,208
2,000
720
$35,489
Utilities:
LV
RM
Maintenance:
LV
RM
Cost Recovery:
LV
RM
Net Earnings
238
400
500
200
343
760
5,419
30,947
$ 4,542
Self-employment net earnings - Dentistry:
Income (E41-2):
Interest from Checking (E25-2), (E41-2)
Service Fees (E34-2), (E41-2)
Expenses
Advertising
Business license
Employees’ Keogh Plan
Cost Recovery (E29-2):
Computer System (E29-2)
$24,700
Dental Equipment (E29-2)
55,100
Furniture and Fixtures - 1999
12,398
Furniture & Fixtures - 2000,
15,000
Clinic (E29-2)
8,974
Paving and Sidewalk (E29-2)
5,928
Lanscaping (E29-2)
1,000
Custodial services
Dental Supplies
Health Insurance Plan for Employees
Insurance (general and malpractice)
Interest ($300,000 SBA loan)
Magazine and newspaper subscriptions
Office supplies
Payroll Taxes
Professional Dues
Professional Fees ((i.e., accountants))
Professional Journals
Utilities (electricity and sewage and water)
Telephone
Wages
Net Earnings
Combined net earnings
Less: $199,719 x 7.65%
$
567
753,625
$754,192
$ 6,000
1,000
27,500
123,100
10,000
75,500
20,976
32,400
21,000
780
3,000
18,186
3,700
7,300
2,700
8,900
2,567
191,000
559,076
$195,177
$199,719
15,279
Reduced self-employment net earnings
Social Security (76,200 * .124)
Medicare (184,440* .029)
Self-employment tax for 2000
$184,440
$ 9,449
5,349
$ 14,798
Tom can deduct from gross income 50% of the self-employment tax imposed for the same tax
year. Thus, the Fronks can deduct $7,399 from gross income.
Issue E34-2:
Path:
Keogh-Plan Contributions (MOM: Akiko, 750 points; PR: -----,
375 points)
CCH Online; FTS; Spine; Chapter 3- Retirement Plans; §C:20.00,
Scope—Retirement Plans for the Self-Employed
Narrative Solution:
CCH-EXP, CCH Federal Tax Service §C:20.41, Self-Employed Individuals
Self-Employed Individuals —
Only employees are eligible to participate in qualified plans.1 See §C:20.41[2] for discussion of
who is the employer. However, proprietors, partners and other individuals who are selfemployed individuals (see §C:20.41[1] ) are treated as employees for qualified plan purposes and
are eligible to participate in such plans.2 A self-employed individual is covered under a qualified
plan during the period beginning with the date a contribution is first made on his behalf and
ending when there are no longer funds under the plan that can be used to provide the individual
or his beneficiaries with benefits.3
CCH-EXP, CCH Federal Tax Service §C:20.00, Scope—Retirement Plans for the SelfEmployed
Scope—Retirement Plans for the Self-Employed
The self-employed are permitted to establish self-funded retirement plans. These plans are
sometimes known as Keogh plans. They generally are covered by the qualification requirements
applicable to other plans. However, contributions and deductions are
based on the self-employed individual's earned income, rather than his compensation from an
employer. In addition, special rules apply to plans maintained for the benefit of owneremployees.
CCH-EXP, CCH Federal Tax Service §C:20.40, Persons Eligible
Persons Eligible—
Self-employed individuals are deemed employees for tax-qualified plan purposes and thus are
eligible to participate in Keogh plans. Sole proprietors and partnerships may sponsor Keogh
plans. If self-employed individual is engaged in more than one trade or business, each trade or
business is separate employer. Common-law employees may not establish Keogh plan.
Self-employed individuals include proprietors and partners. See §C:20.41 for definition of selfemployed individuals. They do not include common-law employees. See §C:20.44.
Self-employed individuals are deemed to be employees for purposes of participating in qualified
plans. However, a self-employed individual engaged in more than one trade or business is
considered an employee only of those from which he has earned income. See §C:20.43 . In
addition, if the self-employed individual is an owner-employee, special rules apply. See
§C:20.42 for definition of owner-employee.
CCH-EXP, CCH Federal Tax Service §C:20.60, Earned Income Requirement
Earned Income Requirement—
In general, earned income means net earnings from self-employment in trade or business in
which personal services actually rendered by individual are material income-producing factor.
Income from disposition of certain types of property is also deemed earned income.
Self-employed individuals must have earned income to make contributions to Keogh plans.
Earned income generally means net earnings from self-employment in a trade or business. See
§C:20.61 . It does not include passive income. See §C:20.62.
Net earnings are computed as for purposes of self-employment tax, with modifications. See
§C:20.63.
CCH-EXP, CCH Federal Tax Service §C:13.20, Overview—Limitations on Benefits and
Contributions
The total amount of contributions for, and benefits payable to, participants in qualified retirement
plans is limited by statute. The annual benefit for qualified defined benefit plan participants
cannot exceed the lesser of $90,000, adjusted for inflation, or 100
percent of the participant's average compensation during the three consecutive years in which he
received the greatest aggregate compensation from the employer. The annual additions to a
defined contribution plan participant's account cannot exceed the
lesser of $30,000, adjusted for inflation, or 25 percent of the participant's compensation for the
year. A plan that does not comply with this requirement is disqualified. In addition, employer
deductions are not allowed for contributions exceeding these limits. See §C:13.40 .
CCH-EXP, CCH Federal Tax Service §C:20.101, Deduction for Contributions to Keogh Plan
Contributions to a Keogh plan are deductible only if they are ordinary and necessary business
expenses and do not exceed the prescribed limitations for deductions for contributions to
qualified plans.2
However, contributions to a Keogh plan that are not allocated to the purchase of life, accident,
health, or other insurance are deemed to be ordinary and necessary to the extent they do not
exceed the earned income of the individual derived from the trade or business with respect to
which the plan is established. Earned income for this purpose is computed without taking into
account the contributions deduction.4
CCH-EXP, CCH Federal Tax Service §C:20.102, Limitations on Contributions and Benefits
Contributions and benefits under Keogh plans are subject to the general limitations on
contributions and benefits under qualified plans. See §C:13.20 for discussion of limitations on
contributions and benefits. Thus, the annual addition to a participant's account under a defined
contribution Keogh plan cannot exceed the lesser of:
(l) an amount equal to the normal cost of the plan; or
(2) 25 percent of compensation.14
The annual benefit provided to any participant under a defined benefit Keogh plan cannot exceed
the lesser of:
(1) $90,000, adjusted for inflation; or
(2) 100 percent of the participant's average compensation for his high three years.15
CCH-EXP, CCH Federal Tax Service §C:20.107, Reporting of Deduction
Reporting of Deduction —
An employer is allowed a deduction for contributions to Keogh plans on behalf of employees.34
See §C:20.101 for the amount of this deduction.
34 Code Sec. 404(a).
An individual who owns the entire interest in an unincorporated trade or business is treated as his
own employer for this purpose.35 Thus, he is entitled to a deduction for contributions made on
his own behalf. The deduction is taken on the self-employed individual's Form 1040, U.S.
Individual Income Tax Return, and is a deduction from gross income.36 The individual is also
entitled to a deduction for contributions on behalf of his employees.37
§C:20.101, Deduction for Contributions to Keogh Plan
6 Code Secs. 401(c)(2), 415(c)(3)(B).
Compensation for a self-employed individual is earned income, and this takes into account the
deduction for plan contributions. Thus, while contributions to a profit-sharing plan on behalf of
employees can be deducted up to 15 percent of compensation, a
smaller percentage must be used in computing the deduction for contributions on behalf of the
self-employed persons if earned income unreduced by the contribution is used in determining the
contribution for self-employed individuals, which is often the case.
The maximum amount a self-employed individual can contribute is further reduced because
earned income is determined by reducing net earnings from self-employment (see §C:20.61) by
the 50-percent deduction for employment taxes imposed on
self-employed individuals. See §A:15.63 for discussion of the income tax deduction and
§A:23.40 for discussion of the self-employment tax deduction. The amount of the deduction can
be determined as follows:7
7 Retirement Plans for the Self-Employed, IRS Publication 560 (2000).
(1)Determine
the
self-employed
person's
rate,
using
the
following
table: ____
If the plan
contribution rate is:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
The rate is:
0.009901
0.019608
0.029126
0.038462
0.047619
0.056604
0.065421
0.074074
0.082569
0.090909
0.099099
0.107143
0.115044
0.122807
0.130435
0.137931
0.145299
0.152542
0.159664
0.166667
0.173554
0.180328
0.186992
24
25
0.193548
0.200000
If the plan's contribution rate is not a whole number, the self-employed person's rate can be
determined using this worksheet:
(a) Plan contribution rate, as a
decimal
_________
(b) Rate in (a) plus 1
_________
(c) Divide (b) by (a).
_________
(2) Subtract the deduction for
self-employment tax from net
earnings.
(3) Multiply the rate determined in
(1) by the amount determined in
(2).
(4) Multiply the $170,000 limitation
on compensation that applies in
year 2000 and 2001, (see
§C:13.160), by the plan's
contribution rate. Enter the
lesser of $30,000 or the result.
(5) The lesser of the amount in (3) or
(4) is the deductible
contribution.
Numerical Implication Statement:
Only employees are eligible to participate in qualified plans. However, proprietors, partners and
other individuals who are self-employed individuals are treated as employees for qualified plan
purposes and are eligible to participate in such plans. Self-employed individuals are deemed
employees for tax-qualified plan purposes and thus are eligible to participate in Keogh plans.
Self-employed individuals must have earned income to make contributions to Keogh plans. The
annual addition to a participant's account under a defined contribution Keogh plan cannot exceed
the lesser of: (l) an amount equal to the normal cost of the plan; or (2) 25 percent of
compensation. Contributions to a Keogh plan are deductible only if they are ordinary and
necessary business expenses and do not exceed the prescribed limitations for deductions for
contributions to qualified plans. Contributions to a Keogh plan that are not allocated to the
purchase of life, accident, health, or other insurance are deemed to be ordinary and necessary to
the extent they do not exceed the earned income of the individual derived from the trade or
business with respect to which the plan is established. The amount of the deduction can be
determined as follows: determine the self-employed person's rate (in this case Bill’s rate will be
20% because this is a money purchase plan), subtract the deduction for self-employment tax
from net earnings, multiply the 20% by the number determined from subtracting the deduction
for self-employment tax from net earnings, then multiply 170,000 (the limitation on
compensation that applies to 2000) by 20% and enter this number or $30,000 whichever is less,
finally take the lesser of the last two computations. This will be the amount of the Cook’s
contribution that is deductible. As a practical matter, we note:
Keogh Plan Deduction = Net self-employment income - (.50 * self employment tax) Minimum((170,000 * .20); 30,000; .25 * Net self-employment income).
Which simplifies to:
Keogh Plan Deduction = (Net self-employment income - (.50 * self employment tax)) * .20
Referencing Issue E33-2, we see that net earnings from self-employment total $199,719 and that
the self-employment tax is $14,887. Thus, the formula becomes KPD = (minimum((199,719 (.5 * 14,798))*.20); (170,000 * .25); 30,000) = $30,000.
The Keogh contribution is deductible as a deduction from gross income.
Issue E35-2:
Path:
Child Tax Credit (MOM: Frank, 450 points; PR: -----, 225 points)
CCH Network; USMTG; Spine, Chapter 13, Tax Credits; ¶1302,
Child Tax Credit
Narrative Solution:
1302, Child Tax Credit
Taxpayers who have qualifying children, i.e., a child, descendant, stepchild, or eligible foster
child who is a U.S. citizen and for whom the taxpayer may claim a dependency exemption and
who is less than 17 years old as of the close of the tax year, are entitled to the child tax credit
(Code Sec. 24).[ 2001FED ¶3760 ] The amount of the credit is $500 per child. The credit is
allowed only for tax years consisting of 12 months.
Limitation of Credit Based on AGI. The child tax credit begins to phase out when
modified adjusted gross income (AGI) reaches $110,000 for joint filers, $55,000 for married
taxpayers filing separately, and $75,000 for single taxpayers. The credit is reduced by $50 for
each $1,000, or fraction thereof, of modified AGI above the threshold (Code Sec. 24(b) ).
Refundable Amount of Child Credit. Taxpayers who qualify for the child tax credit may
qualify for a refundable credit known as the supplemental credit. Taxpayers who have three or
more qualifying children may also be entitled to an additional credit.
Amount of Supplemental Credit. A technical correction clarifies that the amount of the
supplemental child credit is equal to the lesser of: (1) the amount by which the taxpayer's total
nonrefundable personal credits (as limited by Code Sec. 26(a) ) are increased by reason of the
child credit or (2) the excess of (a) the taxpayer's total tax credits (including the EIC, but not the
supplemental child credit or credits for excess social security tax withheld, tax withheld on
nonresident aliens and foreign corporations, or excise taxes on gasoline and certain fuels used in
farming and other qualified purposes) over (b) the sum of the taxpayer's regular income taxes
and social security taxes. The nonrefundable child tax credit is reduced by the amount of the
refundable supplemental child credit (Code Sec. 32(n)(2) ).
Amount of Child Credit for Three or More Children. A technical correction clarifies the
application of the Code Sec. 26(a) income tax liability limitation to the refundable portion of the
child tax credit for families with three or more children. The additional credit for families with
three or more children ("additional credit") is treated in the same way as other refundable credits
and is calculated on Form 8812 . After all the other credits are applied according to the stacking
rules to reduce the taxpayer's tax liability for the year, then the refundable credits are applied.
The refundable credits first reduce the taxpayer's tax liability for the year, and any remaining
credit in excess of the tax liability for the year is payable to the taxpayer.
Specifically, for families with three or more children, the additional credit is equal to the lesser
of: the child tax credit that would be allowed if computed without regard to the refundable
additional credit and the Code Sec. 26(a) tax liability limitation, or the amount that the total
nonrefundable personal credits (including the child tax credit but without regard to the
refundable additional credit) would increase if the Code Sec. 26(a) tax liability limitation were
increased by the excess of (a) the taxpayer's social security taxes for the tax year over (b) the
earned income credit determined without regard to the supplemental child credit for the tax year.
The amount of the additional credit reduces the amount of the nonrefundable child credit
otherwise allowable without regard to the Code Sec. 26(a) tax liability limitation. For taxpayers
subject to the AMT, the additional credit is reduced by the excess of (1) the taxpayer's AMT for
the tax year over (2) the amount of the reduction of the EIC with respect to the taxpayer for the
tax year.
However, the Code has been amended to allow the credit against both regular tax liability
and alternative minimum tax liability in 2000 and 2001 (Code Sec. 24(d)(2) as amended by Tax
Relief Extension Act of 1999, P.L. 106-170). It should be noted that by legislation the AMTbased reduction did not apply in 1998 or 1999.¶
Narrative Solution:
The Fronks have one child under 17 as of the end of tax year 2000, James. Thus, it would appear
that the Fronks are entitled to a $500 per child nonrefundable tax credit. The tax credit has
phaseout that begins at $110,000 for joint filers like the Fronks, with a $50 phaseout for every
$1000 of modified AGI above $110,000. Thus, if the Fronks have AGI above $120,000, the tax
credit of $500 will be lost in its entirety.
Issue E36-2:
Path:
401(k) Plans (MOM: Rebecca, 300 points; PR: -----, 150 points)
RIA Checkpoint; FTH; Spine, Chapter 21 Pension and ProfitSharing Plans—401(k) Plans—IRAs—Roth IRAs—SEPs—
SIMPLE Plans; ¶ 4318. 401(k) plans—$10,500 elective deferral
for 2000.
Narrative Solution:
¶ 4318. 401(k) plans—$10,500 elective deferral for 2000.
Cash or deferred arrangements (CODAs), popularly known as “401(k)” plans (from Code Sec.
401(k) ) allow an employee to choose whether the employer should pay a certain amount directly
to the employee in cash, or should instead pay that amount on the employee's behalf to a
qualified trust under a profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase plan
or a rural cooperative defined contribution pension plan. ( Code Sec. 401(k) ) FTC ¶H-8950 et
seq.; USTR ¶ 4014.17 ; Tax Desk ¶ 28,066 For salary-reduction arrangements similar to 401(k)
plans under SIMPLE retirement plans, SEPs established before '97, and tax-sheltered annuities,
see ¶ 4379 , ¶ 4378 , and ¶4389 .
However, an employee may elect to defer no more than $10,500, as indexed for 2000, tax-free
under a 401(k) plan or Code Sec. 403(b) tax-sheltered annuity (¶ 4389 ) for a tax year. ( Code
Sec. 402(g)(1) , (5)) Excess deferrals must be either corrected (i.e., distributed) by Apr. 15 of the
following tax year ( Reg §1.402(g)-1(e)(2)(ii) ), or included in the employee's gross income. (
Reg §1.402(g)-1(a) ) FTC ¶ H-9151 et seq.; USTR ¶ 4014.17 , USTR ¶ 4154.015 ; Tax Desk ¶
28,420 et seq.
¶2111, 401(k) Plans
Special Qualification Requirements. A 401(k) plan must satisfy the following special
requirements (Code Sec. 401(k)(2) and (4) ): [ 2001FED ¶17,502 ]
(1) It must give the participant the option of having the employer contribute amounts to the
plan or receiving those amounts in cash.
(2) It must prohibit distributions of amounts attributable to elective contributions earlier
than one of the following events: (a) separation from service, death or disability; (b) termination
of the plan without establishment of a successor plan; (c) attainment of age 591/2; (d) a corporate
employer's disposition of substantially all of its assets or its interest in a subsidiary if the
participant continues in the service of the purchaser or subsidiary; or (e) hardship. Distributions
at age 591/2 or for hardship are not permitted in the case of a money purchase pension plan.
(3) It must provide that the participant's right to the value of the account that is attributable
to elective contributions be fully vested at all times.
(4) It must not require as a condition of participation that an employee complete more than
one year
of service with the employer.
(5) It must not condition benefits under the 401(k) plan or any other benefit upon an
employee's election to make contributions to the 401(k) plan. However, this prohibition does not
apply to an employer's matching contributions.
Hardship Distribution. A hardship distribution is one that (1) is made because of the
distributee's immediate and heavy financial need and (2) does not exceed the amount necessary
to satisfy that need (Reg. §1.401(k)-1(d)(2)(i) ).[ 2001FED ¶18,110 ] Types of expenses that
satisfy the requirement of immediate and heavy financial need are: (a) medical expenses of the
employee, spouse and dependents; (b) expenditures (excluding mortgage payments) to purchase
a principal residence for the employee; (c) post-secondary tuition for the employee, spouse,
children or dependents; and (d) expenditures to stave off eviction or foreclosure with respect to
the employee's principal residence (Reg. §1.401(k)-1(d)(2)(iii)(A) and (iv)(A) ).
Numerical Implication:
A 401(k) plan is a cash-or-deferred arrangement option that allows employees to opt for cash
payments or a deferral of income and thus taxation. A qualified plan satisfies several special
qualification requirements and is nondiscriminatory. Since Tom is self-employed and Monica is
a state employee whose retirement vehicle is not a 401(k), our analysis of this issue stops here.
Issue N37: 401(k) Employer Contribution (MOM: Karrie, 400 points; AUD:
Katherine, 200 points; PR: -----, 200 points)
Path:
CCH Network; USMTG; Spine, Retirement Plans (Chapter 21);
401(k); ¶2111, 401(k) Plans
Narrative Solution:
Under a "401(k) plan," employer contributions to the plan will not be included in the income of a
participant because the employee has the option of taking the contribution in cash or having it
paid to the plan (an "elective contribution") or because the contribution coincides with a salary
reduction arrangement (Code Secs. 401(k) and 402(e)(3); Reg. §§1.401(k)-1 and 1.402(a)-1(d)).
[2001FED ¶17,502, 2001FED ¶18,110, 2001FED ¶18,202, 2001FED ¶18,203] These types of
plans are sometimes referred to as "cash or deferred arrangements" (CODAs).
A 401(k) plan must generally be part of a profit-sharing or stock bonus plan that, in
addition to meeting the general requirements of a qualified plan, must meet the special
requirements summarized below.
Limit on Deferrals. Elective deferrals under all CODAs in which an individual participates
are subject to an annual limitation (Code Sec. 402(g)(3)). [2001FED ¶18,202] There is not a
separate limitation for each employer's CODA. For 2000, the limit is $10,500.
Example. In 2000, Tony defers $8,000 under the 401(k) plan of Employer A and
$5,000 under the plan of Employer B. Tony has made an excess deferral in 2000 of $2,500
($13,000 in deferrals - $10,500 deferral allowable).
The maximum dollar limit may be increased for 15-year employees of schools, hospitals,
home health service agencies, health and welfare service agencies, churches, and conventions or
associations of churches (or associated organizations) (Code Sec. 402(g)(8)). [2001FED
¶18,202]
Amounts in excess of the limit are included in the participant's income. If the excess
remains in the plan or plans, it is not treated as a part of the participant's investment in the plan
and, therefore, is taxed again when distributed. However, the participant is entitled--before April
15 of the tax year following the year in which the excess is included in income--to withdraw the
excess without tax consequences. The income attributable to the excess must also be withdrawn
and is includible in the gross income of the participant for the tax year in which it is distributed.
If the employee participates in more than one CODA, then that employee can designate the
amount of the excess that is to be withdrawn from each plan (Code Sec. 402(g)(2)(A)(i)).
[2001FED ¶18,202]
Matching Contributions from Employers. As a general rule, matching contributions made to
a 401(k) plan by the employer are not treated as elective contributions and are, therefore, not
subject to the annual limit (e.g., $10,500 for 2000). Matching contributions made to 401(k) plans
for self-employed persons are not treated as part of the individual's elective contributions (Code
Sec. 402(g)(9)). [2001FED ¶18,202]
Special Qualification Requirements. A 401(k) plan must satisfy the following special
requirements (Code Sec. 401(k)(2) and (4)): [2001FED ¶17,502]
(1) It must give the participant the option of having the employer contribute amounts to the
plan or receiving those amounts in cash.
(2) It must prohibit distributions of amounts attributable to elective contributions earlier
than one of the following events: (a) separation from service, death or disability; (b) termination
of the plan without establishment of a successor plan; (c) attainment of age 591/2; (d) a corporate
employer's disposition of substantially all of its assets or its interest in a subsidiary if the
participant continues in the service of the purchaser or subsidiary; or (e) hardship. Distributions
at age 591/2 or for hardship are not permitted in the case of a money purchase pension plan.
(3) It must provide that the participant's right to the value of the account that is attributable
to elective contributions be fully vested at all times.
(4) It must not require as a condition of participation that an employee complete more than
one year of service with the employer.
(5) It must not condition benefits under the 401(k) plan or any other benefit upon an
employee's election to make contributions to the 401(k) plan. However, this prohibition does not
apply to an employer's matching contributions.
Hardship Distribution. A hardship distribution is one that (1) is made because of the
distributee's immediate and heavy financial need and (2) does not exceed the amount necessary
to satisfy that need (Reg. §1.401(k)-1(d)(2)(i)). [2001FED ¶18,110] Types of expenses that
satisfy the requirement of immediate and heavy financial need are: (a) medical expenses of the
employee, spouse and dependents; (b) expenditures (excluding mortgage payments) to purchase
a principal residence for the employee; (c) post-secondary tuition for the employee, spouse,
children or dependents; and (d) expenditures to stave off eviction or foreclosure with respect to
the employee's principal residence (Reg. §1.401(k)-1(d)(2)(iii)(A) and (iv)(A)).
To satisfy the requirement that the funds are needed to satisfy an immediate and heavy
financial need, the participant must first have exhausted all distributions and nontaxable loans
available under all plans of the employer. A distribution will not qualify as a hardship
distribution unless its receipt triggers the suspension of elective contributions and other
employee contributions on behalf of the employee for at least 12 months. Nor will a distribution
qualify unless, by the terms of the plan, the applicable dollar limit on the employee's elective
contributions for the employer's tax year following the tax year of the distribution is reduced by
the elective contributions made by the employee for the tax year of the hardship distribution
(Reg.§1.401(k)-1(d)(2)(iv)(B)(4)).
An immediate and heavy financial need also includes any amounts necessary to pay any
income taxes or penalties reasonably anticipated to result from the distribution (Reg. §1.401(k)1(d)(2)(iii)(B) and (iv)(B)). [2001FED ¶18,110]
Special Nondiscrimination Rules. Unless the employer establishes a SIMPLE 401(k) (see
¶2112) or satisfies one of the alternative tests mentioned below, a qualified 401(k) must meet a
special annual nondiscrimination test. The first step in the test is to determine the actual deferral
ratio (ADR) (expressed as a percentage) of each highly compensated employee's elective
contribution for the year being tested to his or her compensation for the same year. The next step
is to determine the average of those individual ratios (expressed as a percentage). The average
ADR for highly compensated individuals is then compared against the preceding plan year
average ADR for rank and file employees. The average ratio (referred to as the actual deferral
percentage (ADP)) of the highly compensated group may not exceed:
(a) 125% of the ADP of the rank and file group if the ADP of that group is 8% or more;
(b) 200% of the ADP of the rank and file group if the ADP of that group is 2% or less; or
(c) the ADP of the rank and file group plus two percentage points if the ADP of that group is
between 2% and 8% (Code Sec. 401(k)(3)(A)(ii)). [2001FED ¶17,502]
Election to Use Current Year ADP. The employer may elect to calculate the ADP for rank and
file employees with reference to data for the current year. If made, this election may not be
revoked without permission of the IRS. If the test year is the first year of the plan, and if the
employer does not make this election, the ADP of rank and file employees for the preceding plan
year is deemed to be 3% or, if the employer so elects, the ADP calculated on the basis of rank
and file employees for the first plan year (Code Sec. 401(k)(3)(A)(ii) and (k)(3)(E)). [2001FED
¶17,502]
For purposes of applying the nondiscrimination rule, the employer may elect to treat
matching contributions and nonelective contributions as elective contributions if they satisfy the
distribution and vesting rules (items (2) and (3) of the special qualification requirements
discussed above) (Code Sec. 401(k)(3)(D)(ii)
). [2001FED ¶17,502]
The ADP test will be deemed satisfied if the employer establishes a SIMPLE 401(k). In
addition, for plan years beginning after 1998, the ADP test will be deemed satisfied if the plan
satisfies either one of the following alternatives:
(1) The employer must make matching contributions on behalf of each rank and file
employee in an amount equal to (a) 100% of the employee's elective contributions not exceeding
3% of the employee's compensation and (b) 50% of the employee's elective contributions in
excess of 3% but not in excess of 5% of the employee's compensation (Code Sec.
401(k)(12)(B)(i)). [2001FED ¶17,502] Also, at any rate of elective contribution, the matching
rate for any highly compensated employee must not be greater than the matching rate for any
rank and file employee (Code Sec. 401(k)(12)(b)(ii)). [2001FED ¶17,502] Even though the rate
of matching contribution with respect to any rate of elective contribution is not equal to the
percentage required by the 100/50 match rule, the plan will be treated as having satisfied that
rule if the design of the plan is such that (a) the rate of an employer's matching contribution does
not increase as an employee's rate of elective contributions increases and (b) the aggregate
amount of matching contributions at the rate of elective contribution is at least equal to the
aggregate amount of matching contributions that would have been made if matching
contributions satisfied the 100/50 match rule (Code Sec. 401(k)(12)(B)(iii) ).[ 2001FED ¶17,502
]
(2) The employer must contribute to a defined contribution plan at least 3% of
compensation on behalf of each rank and file employee eligible to participate in the plan. The
contribution must be made whether or not the employee makes an elective contribution or an
after-tax contribution (Code Sec. 401(k)(12)(C)). [
2001FED ¶17,502]
Satisfaction of either alternative test by the same plan that includes the CODA being tested
is not necessarily required. If the test is satisfied for each employee eligible to participate in the
401(k) plan by any plan maintained by the employer, the 401(k) qualifies (Code Sec.
401(k)(12)(F)). [2001FED ¶17,502]
Correction of Excess Contributions. A plan is not disqualified because elective
contributions on behalf of highly compensated employees exceed those permitted under the
special nondiscrimination rule, provided that the excess is (1) recharacterized as an employee
contribution or (2) distributed to the highly compensated employees. A distribution must include
any income allocable to the excess contribution (Code Sec. 401(k)(8); Reg. §1.401(k)-1(f)(1)).
[2001FED ¶17,502, 2001FED ¶18,110]
Penalty on Excess Contributions. There is a 10% penalty on excess contributions. The
penalty will not apply if the excess is recharacterized or distributed within the 21/2-month period
following the plan year in which the excess contribution arose (Code Sec. 4979(f); Reg.
§1.401(k)-1(f)(6)(i) and Reg. §54.4979-1(c)). [2001FED ¶18,110, 2001FED ¶34,520, 2001FED
¶34,522]
Highly Compensated Employees. A highly compensated employee is any employee who
was:
(1) a 5% or more owner of the employer during the plan year or the preceding year, or
(2) an employee who had compensation for the preceding year in excess of $85,000 for 2000
and, if the employer elects, was among the top 20% of employees by compensation for the
preceding year (Code Sec. 414(q)(1)). [2001FED ¶19,150]
Numerical Implication Statement:
Employers contributions to 401(k) plans are excluded from gross income. In addition, there is
no limitation on the amount that employers can contribute to those plans. Since Tom is selfemployed and Monica is a state employee whose retirement vehicle is not a 401(k), our analysis
of this issue stops here.
Issue E38-2:
Path:
Phaseout of Itemized Deductions (MOM: Emily, 450 points; PR:
-----, 225 points)
CCH Online; USMTG; spine search, Deductions, Nonbusiness
Expenses, Phaseout of Itemized Deductions; ¶1014, When AGI
Exceeds Inflation-Adjusted Dollar Amount
Narrative Solution:
An individual whose adjusted gross income exceeds a threshold amount is required to
reduce the amount of allowable itemized deductions by three percent of the excess over the
threshold amount (Code Sec. 68 ).[ 2001FED ¶6080 ] No reduction is required, however, in the
case of deductions for medical expenses, investment interest, and casualty, theft or wagering
losses. The 2000 threshold amount is $128,950 ($64,475 for married filing separately) (Rev.
Proc. 99-42 ). The 2001 thresholds, are $132,950 and $66,475, respectively (Rev. Proc. 2001-13
). However, the reduction may never be more than 80 percent of allowable deductions, excluding
deductions for medical expenses, investment interest, and casualty, theft or wagering losses.
Thus, for example, if otherwise allowable itemized deductions are $10,000, the reduction amount
cannot exceed $8,000.
This limitation is applied after any disallowance of miscellaneous itemized deductions subject to
the two-percent floor (¶1011 ) has been taken into account (Code Sec. 68(d) ) and the reduced
amount is reported on Schedule A of Form 1040 .[ 2001FED ¶6080 ]
Numerical Implication Statement:
A phaseout of itemized deductions is required if the Fronks AGI exceeds $128,950. Since it
does, the relevant logic is Min(((AGI - $128,950) * .03); (.80 * allowable deductions)). Since
all of the Fronks' itemized deductions are allowable, the logic becomes Min(((493,337 - 128,950)
* .03); (.80 * 89,081)) = Min(10,932; 71,265), or $10,932.
Issue E39-2:
Path:
Interest on Educational Savings Bonds (MOM: Katie, 375; PR: ----, 188 points)
CCH Online; Standard Federal Tax Reporter; educational savings
bonds; ¶7551.50, U.S. Savings Bonds Used to Finance Higher
Education: Guidance on bond interest exclusion.
Narrative Solution:
Amount Excludable. The amount of interest on qualified United States savings bonds
excludable under section 135 of the Code is limited by the amount of redemption proceeds
(interest and principal) used to pay qualified higher education expenses during the same tax year
as the redemption. If the amount of the qualified United States savings bond redemption
proceeds exceeds the amount of the qualified higher education expenses paid in the tax year of
redemption, the amount of excludable interest will be limited. For example, if two-thirds of the
total bond redemption proceeds are used to pay qualified higher education expenses during the
same tax year as the redemption, only two-thirds of the interest portion of the qualified United
States savings bonds redemption proceeds is excludable.
In addition, the interest exclusion is phased out for joint filers with modified adjusted gross
incomes between $60,000 and $90,000. Married individuals need to file joint returns to claim
any interest exclusion. For single filers and heads of households, the phase-out range is between
$40,000 and $55,000. After 1990, these limits will be indexed for inflation and then rounded to
the nearest multiple of $50.00. Modified adjusted gross income is adjusted gross income
modified by adding back certain exclusions for income from foreign sources, certain United
States possessions, and Puerto Rico, and after taking into account taxable social security benefits,
the IRA deduction, and the passive activity loss limitation.
Numerical Implication Statement:
This documentation focuses on the exclusion of interest income associated with the redemption
proceeds of an education bond. This redemption orientation implies that during the bond's life,
the recognition of interest income is deferred. This means that the $48 dollars of interest income
associated with those bonds is deferred until redemption. At the time of redemption, the interest
income can escape taxation altogether if it is spent on qualified educational expenses. This
ultimate exclusion potential is phased out at fairly low AGI levels and thus primarily appears to
be designed to help the middle class educate their kids. As a practical matter, this means the $48
appears in income broadly conceived and is then excluded.
Issue E40-2:
Path:
Signing Bonus (MOM: Jana, 450 points; PR: Andy A-----, 225
points)
CCH Online; Federal Tax Service; keyword: signing bonus;
§B:2.41[1], Signing Bonuses
Narrative Solution:
A signing bonus is sometimes paid, especially to athletes, before the performance of any services
as an inducement to employment. Because the bonus is awarded before the performance of any
services, its deductibility as compensation cannot be justified on the basis of the employee's past
contributions to the business. See § B:2.64. Courts have treated these payments as compensation
without reaching the issue of the actual rendering of services.14 The bonus must meet the
reasonableness standard. The most important factor in the determination of whether the payment
is reasonable is the consistency of the bonus with industry practice.15
14
Est of Boyd v Commr, 76 TC 646 (1981) aff'd, per curiam, CA-3 69-2 USTC ¶9443, 410 F2d
298; Allen v Commr, 50 TC 466 (1968).
15
Hundley, Jr v Commr, 48 TC 339 (1967).
Path: CCH Network; Federal Tax Service, Spine, C--RETIREMENT PLANS, keyword:
compensation defined; §C:13.60, Compensation Defined
Compensation Defined-Compensation of employee is compensation from employer for year. Compensation of
self-employed individual is participant's earned income, determined without regard to exclusions
available for U.S. citizens or residents living abroad.
Compensation of a participant who is an employee for purposes of applying the
limitations on contributions and benefits is the participant's compensation from the
employer maintaining the plan for the year.1 See §C:13.61. However, if a defined
contribution plan provides for the continuation of contributions on behalf of all totally and
permanently disabled participants for a fixed or determinable period, the compensation of a
participant in the plan in limitation years beginning after 1996 who is permanently and totally
disabled is the amount of compensation that would have been received by the participant for the
year if he or she was paid at the rate of compensation in effect immediately before the onset of
the disability. No election is required and highly compensated employees are not excluded. If the
plan does not provide for the continuation of contributions for a fixed or determinable period, the
pre-1997 requirements apply.2 In limitation years beginning before 1997, this rule applies only if
the employer elects and only if contributions made with respect to the amounts treated as
compensation are nonforfeitable when made. In addition, in years before 1997, highly
compensated employees are excluded from the application of this rule.3
Path: CCH Network; Federal Tax Service; Link from previous citation; §C:13.61[1], Basic
Definition of Compensation—Post-1997 Limitation Years
Basic Definition of Compensation—Post-1997 Limitation Years
Compensation from the employer for the purposes of the limitations on contributions and
benefits in limitation years beginning after 1997 includes but is not limited to:
(1) wages, salaries, fees for professional services and other amounts received for personal
services actually rendered in the course of employment with the employer, including
commissions paid to salesmen, compensation on the basis of a percentage of profits,
commissions on insurance premiums, tips, bonuses, fringe benefits and reimbursements
or other expense allowances under a nonaccountable plan22 (see §G:8.382), to the extent
includable in income or excludable only on account of the exclusion for foreign earned
income or for income from sources within American Samoa, Guam, the Northern
Mariana Islands or Puerto Rico for residents of these areas (see §M:7.60 and §M:15.20
for discussion of these exclusions);23
22
See Reg. § 1.62-2(c).
23
Code Secs. 911, 931, 933 .
(2) amounts paid for injury or sickness, or under an accident or health plan to the extent
includable in income;
(3) amounts reimbursed by the employer for moving expenses to the extent that at the
time of the payment it is reasonable to believe that these amounts are not deductible by
the employee;
(4) the value of nonqualified stock options includable in gross income for the tax year in
which granted; and
(5) the amount includable in gross income of an employee who makes an election to
include the value of property received in connection with the performance of services
over any amount paid for the property24 in income;25 and
24
See Code Sec. 83(b).
25
Reg. § 1.415-2(d)(2).
(6) elective contributions, even if otherwise excludable from the employee's gross
income, made under:
(a) a qualified cash or deferred arrangement,
(b) a simplified employee pension salary reduction arrangement,
(c) a tax-sheltered annuity salary reduction arrangement,
(d) an eligible deferred compensation plan of a state or local government or
private tax-exempt organization (a Section 457 plan),
(e) a cafeteria plan, or
(f) a plan allowing an election to reduce cash compensation in exchange for
qualified transportation fringe benefits.26
26
Code Sec. 415(c)(3)(D) , as amended by the Community Renewal Tax Relief Act of 2000,
P.L. 106-554, Act §314(e) (December 21, 2000).
Compensation does not include items such as:
 employer contributions to deferred compensation plans, other than the plans listed in
item (6), above, to the extent that they would be excludable from the employee's gross
income in the tax year in which contributed without the application of the dollar
limitations on contributions and benefits;
 amounts received from the exercise of a nonqualified stock option, or when restricted
stock either becomes freely transferable or is no longer subject to a substantial risk of
forfeiture;
 amounts realized from the sale, exchange or other distribution of stock acquired under
a qualified stock option;
 other amounts that receive special tax benefits, such as premiums for group-term life
insurance not includable in the gross income of the employee, or contributions towards
the purchase of a tax-deferred annuity; or
 distributions from a qualified plan.27
27
Reg. § 1.415-2(d)(3).
A plan that defines compensation to include and exclude only these items is automatically
considered to be using a definition of compensation meeting the requirements.28
28
Reg. § 1.415-2(d)(10) .
Numerical Implication Statement:
A signing bonus is sometimes paid, especially to athletes, before the performance of any services
as an inducement to employment. Because the bonus is awarded before the performance of any
services, its deductibility as compensation cannot be justified on the basis of the employee's past
contributions to the business. See § B:2.64. Courts have treated these payments as compensation
without reaching the issue of the actual rendering of services. Compensation is included in the
employee's income, unless it is specifically excluded. Of particular interest to this issue is
whether a bonus can be considered compensation for purposes of making contributions to a
401(k) plan. Compensation in that sense seems to be linked to the providing of services, though
that notion is weakened by items such as moving expense reimbursements and accident and
health insurance reimbursements included in income. That notion is further weakened by the
nature of the items that are explicitly not included as compensation (e.g., employer contributions
to deferred compensation plans, amounts received from the exercise of a nonqualified stock
option, amounts realized from the sale, exchange or other distribution of stock acquired under a
qualified stock option, other amounts that receive special tax benefits, and distributions from a
qualified plan). Those not-included-items seem materially different from the signing bonus. The
inclusion of signing bonuses in gross income seems to strengthen the likelihood that they qualify
as compensation for 401(k) contribution purposes. Since the Fronks have no signing bonuses,
our analysis of this issue ends here.
Issue E41-2:
Accident and Health Insurance Benefits (MOM: Tonya, 300
points; PR: ------, 150 points)
Narrative Solution:
Path: RIA Checkpoint; FTH; keyword: health and accident insurance; ¶ 1388. Accident and
Health Insurance Benefits.
Benefits received from accident and health insurance are excluded from gross income, unless the
benefits compensate for medical expense deductions from an earlier year. Benefits from longterm care insurance policies are subject to special rules.
Path: RIA Checkpoint; FTH; keyword: health and accident insurance; ¶ 1260. Employee's
medical expenses reimbursed or insured by employer.
An employee can exclude from gross income amounts received from his employer, directly or
indirectly, as reimbursement for expenses for the medical care of himself, his spouse, and his
dependents. (These amounts are excludable even where a sole proprietor employer is the
employee's spouse, and the amounts received are for the employer-spouse's medical care.) FTC ¶
H-1110; Tax Desk ¶ 13,336 However, reimbursement is includible in the employee's income to
the extent it exceeds medical expenses or it's attributable to medical expense deductions he took
in a previous year. (Code Sec. 105(b); Reg § 1.105-2 ) FTC ¶ H-1110 et seq.; USTR ¶ 1054.01;
Tax Desk ¶ 13,336
An employee also excludes from gross income the cost (i.e., premiums paid) of employerprovided coverage under an accident or health plan. (Code Sec. 106) FTC ¶ H-1102; USTR ¶
1064; Tax Desk ¶ 13,332 However, if the employer-provided policy, trust, etc., provides other
benefits, only the portion of the employer contributions for the accident and health coverage is
excludable. (Reg § 1.106-1) FTC ¶ H-1106 ; USTR ¶ 1064; Tax Desk ¶ 13,334
Insurance premiums paid for partners and more-than-2% S corporation shareholders (who are
treated as partners) are not excludable. FTC ¶ H-1126; USTR ¶ 1064 ; Tax Desk ¶ 13,326
Highly compensated individuals who benefit from an employer's “self-insured” medical
reimbursement plan that discriminates in favor of “highly compensated employees” (defined in ¶
4326) must include “excess reimbursements” (reimbursements for benefits not available to other
plan participants) in income. (Code Sec. 105(h) ) FTC ¶ H-1138 et seq.; USTR ¶1054.05 ; Tax
Desk ¶ 13,313
Numerical Implication Statement:
Benefits received from an accident and health insurance plan are excluded from gross income.
This means that the $6,600 in plan benefits is excluded from gross income. Thus, benefits are
included in income broadly conceived and then excluded as exclusions.
Issue E42-2:
Path:
Basis of New Home (MOM: Karrie, 300 points; PR: -----, 150
points)
CCH Network; USMTG; property basis; ¶1611, Additions to Basis
of Property
Narrative Solution:
In computing gain or loss on sale of property, the cost or other basis must be adjusted for any
expenditure, receipt, loss, or other item properly chargeable to the capital account (Code Sec.
1016(a)(1); Reg. §1.1016-1--Reg. §1.1016-9).[ 2001FED ¶29,410--2001FED ¶29,426] This
necessitates an addition for improvements made to the property since its acquisition.[ 2001FED
¶29,412.021] Other capital charges are added to the cost (for example, brokers’ commissions,
lawyers’ fees, etc.) incurred in buying real estate. Generally, expenditures incurred in defending
or perfecting title to property are also a part of the cost of the property.[ 2001FED ¶8526.038]
Estimates of costs for future improvements to real property required by law or by contract may
be added to the basis of the property sold if permission is obtained from the IRS. Otherwise, such
costs are not taken into account until economic performance relating to the costs occurs (Code
Sec. 461(h)).[ 2001FED ¶21,802, 2001FED ¶29,313.576] See ¶1539 . See checklist at ¶57 to
determine whether an expense is deductible or must be capitalized and added to basis.
Numerical Implication Statement:
The basis of the new Boone home is equal to its purchase price plus (closing costs minus
property taxes) plus the property taxes that the Fronks paid in behalf of the seller*. As a
practical matter then, the basis is equal to $800,000 + (80,000 - 8000) + 4,647 = $876,647.
Other than influencing the cost recovery computation, the basis has no immediate impact on the
tax formula.
*See Issue E21-2 for supporting logic and computations.
Issue E43-2:
Path:
Alternative Minimum Tax (MOM: -----, 1125 points; PR: -----,
563)
CCH Network; 2001USMTG; ¶1401, 1435
Narrative Solution:
Alternative minimum tax rules have been devised to ensure that at least a minimum amount of
income tax is paid by high-income corporate and noncorporate taxpayers (including estates and
trusts) who reap large tax savings by making generous use of certain tax deductions and
exemptions. Without the alternative minimum tax, some of these taxpayers might be able to
escape income taxation entirely. In essence, the AMT functions as a recapture mechanism,
reclaiming some of the tax breaks primarily available to high-income taxpayers, and represents
an attempt to maintain tax equity.
Alternative Minimum Taxable Income. AMTI is the heart of minimum taxation. It is through this
figure that excessive tax savings are recaptured. The base for computing AMTI is regular taxable
income (including unrelated business taxable income, real estate investment trust taxable
income, life insurance company taxable income, or any other income base, other than the alcohol
fuels credit gross income of Code Sec. 87 , used to calculate regular tax liability). This amount is
then increased by a body of tax items, known as tax preference items (TPIs), which are the
ultimate target of the minimum tax recapture apparatus. These items make up only a portion of
the Code's available tax benefits but have been identified as a potential source of inordinate tax
savings.
There are two ways in which TPIs are used to compute AMTI. In the first approach, all or a
portion of the deductions or exclusions that have been claimed in computing regular taxation are
directly added back to the regular taxable income base that makes up AMTI. For example, the
excess of a depletion deduction for an interest in a mineral deposit over the adjusted basis of the
interest must be added to the regular taxable income base. In the second form of recapture, the
method used to compute a deduction for regular taxation is changed for minimum taxation. A
change in methods will often, but not always, reduce the amount of a deduction originally
claimed in regular taxation (or increase the amount of income originally subject to regular
taxation) and thereby increase the taxable income base used in AMTI. For example, a
corporation that uses the MACRS 200-percent declining balance method to compute a property's
depreciation deduction for regular tax purposes may have to use the 150-percent declining
balance method to compute AMTI. In the early years of that property's life, the regular tax
MACRS deduction will exceed the deduction allowed for purposes of AMTI. For a given tax
year, the excess of MACRS deductions over AMT deductions, if any, must be added back to the
AMTI base.
Taxpayers with low levels of tax benefits are exempt from alternative minimum taxation under a
schedule of exemptions that also serves to prevent taxpayers with an exceptionally high amount
of tax benefits from claiming an exemption. The alternative minimum taxable income
exemption amount for married persons filing a joint return, as well as for surviving spouses, is
$45,000. It must be reduced by 25% of the amount by which AMTI exceeds $150,000 (i.e.,
$45,000 - 25% (AMTI - $150,000)), causing the exemption amount to be completely phased out
when AMTI is $330,000 or more. Single individuals and heads of household are granted a
$33,750 exemption, while estates, trusts (other than electing small business trusts, see below)
and married persons who file separate returns are allowed a $22,500 exemption. Corporations
receive a $40,000 exemption. Under the exemption phaseout for single individuals and heads of
households, the exemption amount is reduced by 25% of the amount by which AMTI exceeds
$112,500, resulting in an elimination of the exemption amount for individuals who have AMTI
of $247,500 or more. As for estates, trusts, and married persons who file separate returns, the
exemption amount must be reduced by 25% of the amount by which AMTI exceeds $75,000 and
is phased out at $165,000. Married persons who file separate returns not only lose their
exemptions when AMTI reaches $165,000 but must increase AMTI by 25% of the amount by
which it exceeds $165,000, up to an overall increase of $22,500. This makes them subject to a
$45,000 exemption phaseout, the same phaseout amount faced by married persons who file
jointly.
Among the tax items that have been singled out as potential sources of extraordinary tax savings
are tax preference items (TPIs). Because these items are instrumental in generating tax savings
by reducing a taxpayer's taxable income, they must be added back to the taxable income of either
corporate or noncorporate taxpayers in computing AMTI so that unreasonably high tax breaks
may be recaptured. The following is a complete list of TPIs:
(1) The amount by which the depletion deduction claimed by a taxpayer (other than an
independent oil and gas producer) for an interest in a property exceeds the adjusted basis of the
interest at the end of a tax year;
(2) The amount by which an integrated oil company's excess intangible drilling costs (i.e., the
excess of the IDC deduction over the deduction that would have been allowed if the costs had
been capitalized and ratably amortized over a 120-month period) is greater than 65% of the
taxpayer's net income from oil, gas, and geothermal properties. Independent producers are not
subject to this preference in tax years beginning after 1992. Their AMTI, however, may not be
reduced by more than 40% (in tax years beginning after 1993) of the AMTI that would
otherwise be determined if the taxpayer were subject to this intangible drilling cost preference
and did not compute an alternative tax net operating loss deduction;
(3) The excess of a financial institution's deduction for reasonable bad debt reserves over the
deduction that would have been allowed had the institution maintained a reserve for all tax years
on the basis of actual experience;
(4) Tax-exempt interest (less any related expenses) on specified private activity bonds, which
generally are issued after August 7, 1986;
(5) For most property placed in service prior to 1987, the excess of accelerated depreciation
on nonrecovery real property over straight-line depreciation;
(6) For most property placed in service by noncorporate taxpayers and personal holding
companies prior to 1987, the excess of accelerated depreciation on leased personal property over
straight-line depreciation;
(7) For most property placed in service prior to 1987, the excess of rapid amortization of
pollution control facilities under Code Sec.169 over the depreciation that would be allowed
under Code Sec. 167 ;
(8) For most property placed in service by noncorporate taxpayers and personal holding
companies prior to 1987, the excess of the ACRS deduction for leased recovery property (other
than 19-year real property and low-income housing) over the straight-line depreciation deduction
that would have been allowed if a half-year convention had been used, salvage value had been
disregarded, and the following recovery periods had been used:
In the case of:
The recovery
period is:
3-year property ............................................ 5 years
5-year property ............................................ 8 years
10-year property ........................................... 15 years
15-year public utility property ............................ 22 years
(9) For most property placed in service by taxpayers prior to 1987, the excess of the ACRS
deduction for 19-year real property or low-income housing over the deduction that would have
been allowed if straight-line depreciation, with a 19-year recovery period for real property and a
15-year recovery period for low-income housing, had been used and computed without
considering salvage value; and
(10) 42 percent of the amount of gain excluded from the sale or disposition of qualified small
business stock (28 percent is substituted for 42 percent, in the case of stock, the holding period of
which begins after December 31, 2000).
Noncorporate taxpayers must make the following adjustments when computing AMTI:
Alternative Tax Itemized Deductions. Some of the itemized deductions that a noncorporate
taxpayer has claimed for regular tax purposes may not be claimed for AMTI purposes. These
deductions and the tax savings they generate have been targeted for recapture by the AMTI.
They include miscellaneous itemized deductions that are subject to the 2% AGI floor under Code
Sec. 67 . This means that miscellaneous itemized deductions claimed in the computation of
regular taxation must be added back to AMTI. State, local, or foreign tax payments are not
deductible, and refunds of these taxes need not be included in AMTI.
Deductions may be claimed for medical expenses, but the expenses must exceed AGI by 10%
rather than 7.5%. Investment interest expenses are limited to the size of a taxpayer's net
investment income. Tax-exempt interest on private activity bonds is included in investment
income for this purpose, and interest expended to carry the bonds is included in investment
interest expenses.
The limitation on itemized deductions of high-income taxpayers that applies for regular tax
purposes does not apply for AMTI purposes
Among the itemized interest deductions that may be claimed against AMTI is qualified
housing interest, which is similar to the qualified residence interest deduction that may be
claimed against regular tax. Qualified housing interest is interest paid on a loan used to
purchase, build, or substantially improve (1) a taxpayer's principal residence and (2) another
dwelling (i.e., a house, apartment, condominium, or mobile home that is not used on a transient
basis) personally used by the taxpayer during a tax year for the greater of (a) 14 days or (b) 10%
of the number of days during which the dwelling is leased. It is not subject to the limitation on
investment interest deductions. Interest on a refinanced loan is also deductible if the loan does
not exceed the balance remaining on the original loan.
Personal Exemptions and the Standard Deduction. No deduction for or in lieu of personal
exemptions may be claimed against alternative minimum taxable income, and the standard
deduction may not be claimed for AMTI purposes
Circulation and Research and Experimental Expenditures. Circulation expenditures (i.e., the
costs (deductible under Code Sec.173 ) of establishing, maintaining, or increasing a newspaper's,
magazine's, or other periodical's circulation), which are expensed for regular tax calculations,
must be capitalized for AMTI calculations and ratably amortized over a three-year period, which
starts with the tax year in which the expenditures are made research and experimental
expenditures (Code Sec.174 ) must be ratably amortized over a 10-year period. These
adjustments, in effect, treat the excess of expense deductions over amortization deductions as a
tax preference. Besides noncorporate taxpayers, personal holding companies must also
recompute circulation costs for AMTI. No recomputation of research and experimental costs is
required if a taxpayer has materially participated in the activity that generated the costs. If a loss
is sustained on property that generated these research and experimental deductions or circulation
expenditures, a deduction is allowed equal to the lesser of (1) the unamortized expenditures or
(2) the amount that would be allowed as a loss had the expenditures remained capitalized. The
adjusted basis of such property must be computed under the alternative minimum tax rules in
order to determine the gain or loss from the sale for alternative minimum tax purposes. The
difference between the regular tax gain or loss and the recomputed alternative minimum tax gain
or loss is a tax preference adjustment in the year of sale.
Incentive Stock Options. AMTI must be increased by the amount by which the price
actually paid by an individual for an incentive stock option is exceeded by the option's fair
market value at the time his rights to the stock are freely transferable or are not subject to a
substantial risk of forfeiture
Passive Farm Tax Shelter Losses. Noncorporate taxpayers (including personal service
corporations who are not material participants in a farming business but use a farming tax shelter
to avoid regular tax liability may not deduct passive farming losses in computing AMTI. Farm
tax shelters are farm syndicates or passive farm activities in which the taxpayer (or his spouse) is
not a material participant. The amount of denied losses must be reduced by the amount of a
taxpayer's insolvency during a tax year. Insolvency is defined as the excess of a taxpayer's
liabilities over the fair market value of his assets. Taxpayers may not net income and losses from
various farming tax shelters to determine an overall loss or gain. Each tax shelter must be
regarded separately. Thus, a taxpayer who suffers a $1,000 loss from one tax shelter, but
has a $1,000 gain from another, must include a $1,000 gain in AMTI calculations. Also, tax
preferences included in losses must be adjusted so that their preference is eliminated.
Farm losses that have been disallowed as deductions from AMTI in one tax year may be
claimed as deductions from farm income from that activity in the succeeding tax year. Taxpayers
who dispose of their interest in a farm tax shelter are allowed to claim their losses against AMTI.
Other Passive Business Activity Losses. With some modifications, the regular tax rules
limiting the deductibility of losses from passive, nonfarm business activities must be followed in
finding the minimum tax liability of individuals, trusts, estates, closely held C corporations, and
personal service corporations. Thus, deductions for passive losses may be claimed only against
passive income. One modification requires a taxpayer to reduce the amount of denied losses by
the amount of his insolvency during a tax year. Furthermore, the passive activity loss is
determined without regard to any qualified housing interest. Finally, passive losses must be
adjusted, as they would be under other minimum tax rules, to eliminate tax preferences.
Path: CCH Online; USMTG; AMT w/par real property; GUIDEBOOK, 2001USMTG ¶1430,
Adjustments Affecting Corporate and Noncorporate Taxpayers
In addition to TPIs, the AMT is aimed at recovering some of the tax savings generated by a
variety of other deductions and methods for computing tax liability. This is achieved by
requiring taxpayers to recompute certain regular tax deductions in a different, less preferential
manner. Adjustments are usually required in order to eliminate “time value” tax savings that
result from tax laws allowing the acceleration of deductions (e.g., the MACRS depreciation) or
the deferral of income (e.g., the completed-contract method of determining income from longterm contracts). Thus, the recomputation of the items for AMT purposes usually results in an
initial increase to AMTI.
Some adjustments have to be made solely by noncorporate taxpayers (see ¶1435 ), while
others have to be made solely by corporate taxpayers (see ¶1440 ). All taxpayers, whether
corporate or noncorporate, must make the following adjustments when determining AMTI:
Depreciation. For property placed in service after 1998 if the 200 percent declining balance
method is used for regular tax purposes for 3-, 5-, 7-, or 10-year property, then the 150-percent
declining balance method and regular tax depreciation period must be used for AMT purposes
(Code Sec. 56(a)(1)).[ 2001FED ¶5200] For all other property placed in service after 1998, no
AMT adjustment is required, as AMT and regular tax depreciation are identical.
For property placed in service after 1986 and before 1999, if the 200-percent declining
balance method is used for regular tax purposes for 3-, 5-, 7-, or 10-year property, then the 150percent declining balance method and the ADS recovery period must be used for AMT purposes
(Code Sec. 56(a)(1), prior to amendment by P.L. 105-34). If the 150-percent declining balance
method is used for 15- or 20-year property then the 150-percent declining balance method and
the ADS recovery period is used for AMT purposes. If the 150-percent declining balance method
election is in effect for regular tax purposes for 3-, 5-, 7-, 10-, 15-, or 20-year property, then no
adjustment is required for AMT purposes, as the AMT and regular tax depreciation are computed
the same way (i.e., using the 150-percent declining balance method over the ADS recovery
period). In the case of 27.5-year residential real property, or in the case of 31.5- or 39-year real
property, AMT depreciation is computed using the straight-line method and ADS recovery
period (40 years). If the straight-line election is in effect for regular tax purposes for 3-, 5-, 7-,
10-, 15-, or 20-year property, then for AMT purposes the straight-line method and ADS recovery
period must be used. If the MACRS ADS method (elective or nonelective) is used for regular tax
purposes, then no adjustment is required for AMT purposes, as AMT and regular tax
depreciation are computed the same way on real and personal property subject to such method.
Adjusting depreciation deductions, rather than treating them as TPIs, may provide taxpayers
with some major benefits as they compute AMTI in the later years of a property’s use. Although
MACRS deductions will exceed AMT deductions in the early years of a property’s use
(assuming that AMT and MACRS deductions are not computed in the same manner), the reverse
will be true in the later years. Thus, the higher deductions produced under the applicable AMT
method in later years may be used to reduce AMTI and, therefore, reduce the potential for
alternative minimum taxation. Another benefit from the adjustment approach to depreciation is
that depreciation for all property is combined in calculating AMTI, allowing for the netting of
excess MACRS deductions with excess alternative deductions. Consequently, a taxpayer who
has excess MACRS deductions on a new piece of property may be able to avoid paying an AMT
on the excess deductions by offsetting them with excess alternative deductions generated by an
older piece of property.
No AMT adjustments have to be made to depreciation claimed for property which has been
expensed under Code Sec. 179; motion pictures, video tapes, and public utility property for
which the normalization method of accounting is not used; and property which is depreciated
under the units of production method or under a depreciation method which is not based on a
term of years (other than the retirement-replacement-betterment method or similar method).
When property that generated depreciation deductions is sold, its adjusted basis must be
computed under the alternative minimum tax rules in order to determine the gain or loss from the
sale for alternative minimum tax purposes (Code Sec. 56(a)(7)).[ 2001FED ¶5200] The
difference between the regular tax gain or loss and the recomputed alternative minimum tax gain
or loss is a tax preference adjustment in the year of sale.
Example 1. A taxpayer has purchased a piece of property for $100,000 and, over several tax
years, has claimed a total of $25,000 of depreciation deductions in regular tax calculations. In
AMTI calculations made during the same tax years, he has claimed adjusted depreciation
deductions totaling $10,000. He sells the property in the current tax year for $150,000. The
adjusted basis of the property in regular tax calculations is $75,000 ($100,000 - $25,000), leaving
him with a regular tax gain of $75,000. However, the amount of gain that must be included in his
AMTI calculations is only $60,000 ($150,000 - $90,000), since the adjusted basis of the property
must reflect only adjusted depreciation deductions.
GUIDEBOOK, 2001USMTG ¶1243, Recovery Methods
Table 8.
General and Alternative Depreciation Systems
Applicable Depreciation Method: Straight Line
Applicable Recovery Periods: 2.5 -- 50 years
Applicable Convention: Half-year
GUIDEBOOK, 2001USMTG ¶1243, Recovery Methods
If the
Recovery
Year is:
Recovery Period is:
40.0
1 ....... 1.250
2 ....... 2.500
3 ....... 2.500
4 ....... 2.500
5 ....... 2.500
6 ....... 2.500
7 ....... 2.500
8 ....... 2.500
9 ....... 2.500
10 ...... 2.500
11 ...... 2.500
12 ...... 2.500
REV-PROC, Accelerated cost recovery: Recovery classes: Class lives: Recovery periods.--, Revenue Procedure
87-56, (Jan. 01, 1987)
Recovery Periods
(in years)
AlterGeneral
native
DepreAsset
Class Life
ciation
ciation
class
Description of assets included
(in years)
System
System
SPECIFIC DEPRECIABLE ASSETS USED IN ALL BUSINESS ACTIVITIES,
EXCEPT AS NOTED:
00.11
Office Furniture, Fixtures, and Equipment:
Includes furniture and fixtures that are
not a structural component of a building.
Includes such assets as desks, files,
safes, and communications equipment. Does
not include communications equipment that
is included in other classes.............. 10
7
10
00.12 Information Systems:
Includes computers and their peripheral
equipment used in administering normal
business transactions and the maintenance
of business records, their retrieval and
analysis. Information systems are defined
as:
1) Computers: A computer is a programmable
electronically activated device capable of
accepting information, applying prescribed
processes to the information, and supplying
the results of these processes with or
without human intervention. It usually
consists of a central processing unit
containing extensive storage, logic,
arithmetic, and control capabilities.
Excluded from this category are adding
machines, electronic desk calculators,
etc., and other equipment described in
class 00.13.
2) Peripheral equipment consists of the
auxiliary machines which are designed to
be placed under control of the central
processing unit. Nonlimiting examples are:
Card readers, card punches, magnetic tape
feeds, high speed printers, optical
character readers, tape cassettes, mass
storage units, paper tape equipment,
keypunches, data entry devices,
teleprinters, terminals, tape drives,
disc drives, disc files, disc packs,
visual image projector tubes, card sorters,
plotters, and collators. Peripheral
equipment may be used on-line or off-line.
Does not include equipment that is an
integral part of other capital equipment
that is included in other classes of
economic activity, i.e., computers used
primarily for process or production
control, switching, channeling, and
automating distributive trades and services
such as point of sale (POS) computer
systems. Also, does not include equipment
of a kind used primarily for amusement or
entertainment of the user.................. 6
5 *
5 *
* Property described in asset class 00.12 which is qualified technological
equipment as defined in section 168(i)(2) is assigned a recovery period of
5 years notwithstanding its class life. See section 3 of the revenue
procedure.
00.3
Land Improvements:
Includes improvements directly to or added
to land, whether such improvements are
section 1245 property or section 1250
property, provided such improvements are
depreciable. Examples of such assets might
include sidewalks, roads, canals,
waterways, drainage facilities, sewers (not
including municipal sewers in Class 51),
wharves and docks, bridges, fences,
landscaping, shrubbery, or radio and
television transmitting towers. Does not
include land improvements that are
explicitly included in any other class,
and buildings and structural components as
defined in section 1.48-1(e) of the
regulations. Excludes public utility
initial clearing and grading land
improvements as specified in Rev. Rul.
72-403, 1972-2 C.B. 102................... 20
15
20
CCH-EXP, 2001FED ¶164.01, MACRS Depreciation Tables PART 02 OF 02.
TABLE 18
Alternative Minimum Tax (see section 7 of this
revenue procedure)
Applicable Depreciation Method: 150 Percent Declining
Balance Switching to Straight Line
Applicable Recovery Periods: 2.5-50 years
Applicable Convention: Mid-quarter (property placed
in service in fourth quarter)
and the Recovery Period is:
If the
Recovery
Year is:
1
2
3
4
5
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
2.88
22.41
17.24
13.26
13.10
2.68
20.85
16.39
12.87
12.18
the Depreciation Rate is:
...... 7.50
6.25
5.36
..... 55.50 46.88 40.56
..... 26.91 25.00 23.18
..... 10.09 21.87 22.47
.................... 8.43
4.69
35.74
22.34
19.86
17.37
4.17
31.94
21.30
17.93
17.93
3.75
28.88
20.21
16.40
16.41
3.41
26.34
19.16
15.14
15.14
3.13
24.22
18.16
14.06
14.06
11.5
12.0
12.5
13.0
13.5
1.39
10.96
9.74
8.66
7.69
…
If the
Recovery
Year is:
1
2
3
4
5
10.0
...... 1.88
..... 14.72
..... 12.51
..... 10.63
...... 9.04
If the
17.5
Recovery
10.5
11.0
the Depreciation Rate is:
1.79
14.03
12.03
10.31
8.83
1.70
13.40
11.58
10.00
8.63
1.63
12.83
11.16
9.70
8.44
1.56
12.31
10.77
9.42
8.24
1.50
11.82
10.40
9.15
8.06
1.44
11.37
10.06
8.90
7.87
18.0
18.5
19.0
19.5
20.0
20.5
Year is:
1
2
3
4
5
......
......
......
......
......
the Depreciation Rate is:
1.07
8.48
7.75
7.09
6.48
1.04
8.25
7.56
6.93
6.35
1.01
8.03
7.38
6.78
6.23
0.99
7.82
7.20
6.63
6.11
0.96
7.62
7.03
6.49
5.99
0.938
7.430
6.872
6.357
5.880
0.915
7.250
6.720
6.228
5.772
CCH-EXP, 2001FED ¶164.01, MACRS Depreciation Tables PART 01 OF 02.
TABLE 14
Alternative Minimum Tax (see section 7 of this
revenue procedure)
Applicable Depreciation Method: 150 Percent Declining Balance
Switching to Straight Line
Applicable Recovery Periods: 2.5 -- 50 years
Applicable Convention: Half-year
CCH-EXP, 2001FED ¶164.01, MACRS Depreciation Tables PART 01 OF 02.
and the Recovery Period is:
If the
Recovery
Year is:
1
2
3
4
5
2.5
..... 30.00 25.00 21.43
..... 42.00 37.50 33.67
..... 28.00 25.00 22.45
............ 12.50 22.45
..........................
...... 7.50
..... 13.88
..... 11.79
..... 10.02
...... 8.74
If the
17.5
Recovery
Year is:
1
2
3
4
5
3.5
......
......
......
......
......
4.0
4.5
5.0
5.5
6.0
6.5
11.54
20.41
15.70
13.09
13.09
the Depreciation Rate is:
If the
10.0
Recovery
Year is:
1
2
3
4
5
3.0
4.29
8.20
7.50
6.86
6.27
10.5
11.0
18.75
30.47
20.31
20.31
10.16
16.67
27.78
18.52
18.52
18.51
15.00
25.50
17.85
16.66
16.66
13.64
23.55
17.13
15.23
15.23
12.50
21.88
16.41
14.06
14.06
11.5
12.0
12.5
13.0
13.5
the Depreciation Rate is:
7.14
13.27
11.37
9.75
8.35
6.82
12.71
10.97
9.48
8.18
6.52
12.19
10.60
9.22
8.02
6.25
11.72
10.25
8.97
7.85
6.00
11.28
9.93
8.73
7.69
5.77
10.87
9.62
8.51
7.53
5.56
10.49
9.33
8.29
7.37
18.0
18.5
19.0
19.5
20.0
20.5
21.0
the Depreciation Rate is:
4.17
7.99
7.32
6.71
6.15
4.05
7.78
7.15
6.57
6.04
3.95
7.58
6.98
6.43
5.93
Numerical Implication Statement:
3.85
7.40
6.83
6.30
5.82
3.750
7.219
6.677
6.177
5.713
3.659
7.049
6.534
6.055
5.612
3.571
6.888
6.396
5.939
5.515
The Alternative Minimum Tax regime is designed to ensure that taxpayers that are in a position
to use many tax provisions to substantial lower or eliminate their tax liability pay some minimal
tax.
The Alternative Minimum Tax is characterized as:
Taxable Income
+/- Adjustments
+ Preferences
= Alternative Minimum Tax Base
- Exemption (subject to phaseout)
= Alternative Minimum Taxable Income
Tentative Minimum Tax
Regular Tax
Alternative Minimum Tax (if positive)
In general, the Alternative Minimum Tax regime allows less depreciation in the early years of
assets lives. This results positive adjustments in the early years and a negative adjustments in the
later years of assets lives. However, no adjustment is required for Section 179 amounts (i.e.,
both the regular tax regime and the AMT regime view Section 179 amounts in the same way).
*Referencing the cost recovery context set forth in E29-2, the conventions (i.e., the mid-quarter
and half-year conventions) and the Section 179 retain their relevance to AMT recovery. For
purposes of AMT recovery, the applicable depreciation method is 150 declining balance rather
than 200 declining balance. The AMT usually requires a longer life than does the regular tax. In
particular, 7-year becomes 10-year property. The 5-year property remains 5-year property.
According to E34-2, no adjustment is required for property with a class life greater than 10 years
if it was placed in service after 1998 (this provision is relevant to the paving and sidewalk,
landscaping and clinic). Thus, for purposes of these activities:
Gunsmith:
Asset
RT Life
AMT Life
Convention
Multiplier
Computer
Equipment
Long View Home
Rocky Mountain Home
5
5
Half-year
7
10
Half-year
31.5
40
Mid-month
No adjustment required
.2550
.1388
.0250
Asset
RT Life
Multiplier
Computer
Dental Equipment
Furniture & Fixtures - 1999
Paving & Sidewalk
5
5
Mid-qtr, 4th
5
5
Mid-qtr, 4th
7
10
Mid-qtr, 4th
No adjustment required
Dentistry:
AMT Life
Convention
.2888
.2888
.1472
Landscaping
Clinic
No adjustment required
No adjustment required
Since the Fronks sold depreciable property, the gain on the sale must be computed for both
regular and AMT purposes. Recalling that the gain on the business-use portion of the home is
computed as follows:
Proceeds allocated to business-use portion of sale
Less basis:
 Land (10 percent)
 1986 Special assessment (see Issue N30)
 Condemnation (see Issue E12-2)
 Severance (see Issues E12-2, E29-2)
 1995 Special assessment (see Issue N30)
 Home (10 percent)
 Depreciation - pre-severance (see Issue E29-2)*
 Severance (see Issue E12-2)
 Depreciation - post severance (see issue E29-2)^
Section 1231 gain
$ 50,281
$ 2,000
$
500
(100)
(70)
600
$12,795
630
3,336
930
$18,000
2,930
16,761
1,239
$ 46,112
*((((.06 + .09 + .08 + (.07 * 2) + (.06 * 2) + (.05 * 4) + (.05 * 5 / 12)) * 18,000)) = 12,795
^($4,575 * ((.05 * 7/12) + (.04 * 4) + (.04 * (6.5 / 12)) / .2891667) =
"(18,000 - 12,795 - 630)
The AMT counterpart is:
Proceeds allocated to business-use portion of sale
Less basis:
 Land (10 percent)
 1986 Special assessment (see Issue N30)
 Condemnation (see Issue E12-2)
 Severance (see Issues E12-2, E29-2)
 1995 Special assessment (see Issue N30)
 Home (10 percent)
 Depreciation - pre-severance (see Issue E29-2)*
 Severance (see Issue E12-2)
 Depreciation - post severance (see issue E29-2)^
Section 1231 gain
$ 50,281
$ 2,000
$
500
(100)
(70)
600
$4,912
630
2,202
930
$18,000
2,930
7,744
10,256
$ 37,095
*((.01250 + (.025 * 10) + (.0250 * 5 / 12)) * 18,000) = 4,912
^(12,458" * ((.0250 * 7 / 12) + (.025 * 4) + (.025 * 6.5 / 12)) / .725) = 2,202
"(18,000 - 4,912 - 630)
The AMT gain is smaller than the regular tax gain, thus resulting in negative adjustment of
$9,017
According to that documentation the Fronks' deduction for state income taxes, property taxes,
miscellaneous itemized deductions in excess of the 2 percent floor and home equity loan interest
and their personal and dependency exemptions are not allowed for AMT purposes, thus giving
rise to several positive adjustments. Furthermore, the documentation also implies that the Fronks
can take a negative adjustment for their state income tax refund and their itemized deduction and
exemptions phaseouts.
The Fronks have no preference items.
The Fronks have a $45,000 exemption amount that can be used to reduce their AMT base. The
exemption amount is phased at the rate of 25 percent of any excess of the AMT income over
$150,000. Since their AMT base is much greater than 150,000, all of the Fronks' exemption will
be phased out.
The specific numerical details for the non-cost recovery portion of this issue have been relegated
to the master numerical solution.
New Issues from Case 3:
Issue N1:
Path:
Child Support Payments (MOM: Katie, 200 points; AUD: Jill, 100
points; PR: 100 points)
CCH; 2001USMTG; keyword=”child support payments”; ¶776,
Child Support
Narrative Solution:
Payments made under post-1984 instruments that fix an amount of money or part of the
payment as child support are treated as child support for tax purposes and are not deductible. If
any amount specified in the instrument is to be reduced based on a contingency set out in the
instrument relating to a child--such as attaining a specified age, dying, leaving school, or
marrying--the amount of the specified reduction is treated as child support from the outset. The
same rule applies if the reduction called for by the instrument is to occur at a time that can
clearly be associated with such contingency. Thus, unlike the situation under pre-1985 law,
payments that vary with the status of a child are not deductible.
Numerical Implication Statement:
Tom’s child-support payments of $500 per month ($6000 total) are not a qualified deduction
from income.
Issue N2:
Path:
Alimony payments Alimony Payments (MOM: Katie, 800 points;
AUD: Jill, 400 points; PR: -----, 400 points)
CCH Online; USMTG; Spine, Chapters (9-12) Deductions, Alimony;
¶773, Year of Taxability or Deductibility; ¶771, Classification; ¶774,
Three-Year Recapture of Excess Alimony Payments; ¶776, Child
Support
Narrative Solution:
¶773, Year of Taxability or Deductibility
Alimony payments are generally includible in income in the year received (Code Sec. 71(a);
Reg. §1.71-1) [2001FED ¶6090, 2001FED ¶6091] and are deductible in the year paid (Code Sec.
215; Reg. §1.215-1), [2001FED ¶12,570, 2001FED ¶12,571] regardless of whether the taxpayer
employs the cash or the accrual method of accounting. A recapture rule prevents “front-loading”
of alimony payments; see below.
¶771, Classification
Alimony and separate maintenance payments are income to the recipient and are deductible by
the payor if certain requirements are met (Code Sec. 62(a)(10) ; Code Sec. 71 ; Code Sec. 215 ).[
2001FED ¶6002 , 2001FED ¶6090 , 2001FED ¶12,570 ] However, different rules apply to
payments made under post-1984 divorce or separation instruments (see ¶772 -¶776 ) and to
payments made under pre-1985 instruments (¶777 ). However, if a pre-1985 instrument is
expressly modified to so provide, the rules for post-1984 instruments will apply to subsequent
payments under that instrument.
Alimony payments are taken as a deduction from gross income in arriving at adjusted gross
income and thus may be claimed by taxpayers who do not itemize.
¶773, Year of Taxability or Deductibility
Payments made under a post-1984 divorce or separation instrument are includible in the gross
income of the recipient and deductible by the payor if the following requirements are met: (1) the
payment is in cash or its equivalent, (2) the payment is received by or on behalf of a spouse
under a divorce or separation instrument, (3) such instrument does not designate the payment as
one which is not includible in gross income and not allowable as a deduction under Code Sec.
215, (4) in the case of an individual who is legally separated from his or her spouse under a
divorce decree or a separate maintenance decree, the payee spouse and the payor spouse must not
be members of the same household at the time such payment is made, (5) there is no liability to
make any payment for any period after the death of the payee spouse or to make any payment
(either in cash or property) as a substitute for such payments after the death of the payee spouse,
and (6) the spouses must not file joint returns with each other (Code Sec. 71(a) ; Code Sec. 71(b)
; Code Sec. 71(e) ).[ 2001FED ¶6090 ]
A divorce or separation instrument is defined as (1) a divorce or separate maintenance decree or
a written instrument incident to such a decree, (2) a written separation agreement, or (3) a decree
that is not a divorce decree or separate maintenance decree but that requires a spouse to make
payments for the support or maintenance of the other spouse (Code Sec. 71(b)(2)). [2001FED
¶6090]
¶774, Three-Year Recapture of Excess Alimony Payments
A special recapture rule applies to “excess” alimony payments (Code Sec. 71(f)). [2001FED
¶6090] Its purpose is to prevent property settlement payments from qualifying for alimony
treatment. The rule requires the recapture of excess amounts that have been treated as alimony
either during the calendar year in which payments began (the “first post-separation year”) or in
the next succeeding calendar year (the “second post-separation year”). Excess alimony is to be
recaptured in the payor spouse’s tax year beginning in the second calendar year following the
calendar year in which payments began (the “third post-separation year”) by requiring that
individual to include the excess in income. The payee, who previously included the payments in
income as alimony, is entitled to deduct the amount recaptured from gross income in his or her
tax year beginning in the third post-separation year.
Excess alimony, the amount that must be recaptured in the third post-separation year, is defined
as the sum of the excess payments made in the first post-separation year plus the excess
payments made in the second post-separation year.
The amount of excess payments in the first and second post-separation years is determined
under a statutory formula. For the first recapture year, the excess payment amount is the excess
(if any) of the total alimony paid in the first post-separation year over the sum of $15,000 and the
average of the amount of alimony paid in the second post-separation year (minus excess
payments for that year) and the amount of alimony paid in the third post-separation year. Thus,
for the first post-separation year, the following formula would be used:
alimony excess
alimony
[ ( paid in - payments ) + paid in ]
2nd year in 2nd year
3rd year
alimony
excess
paid in
payments = 1st - ( $15,000 + ------------------------------------------- )
year
2
To determine the excess payments in the first year it is necessary to determine the excess
payments in the second year. The amount of excess payments in the second year is the excess (if
any) of the amount of alimony paid during the second year over the sum of the amount of
alimony paid in the third year plus $15,000.
alimony paid alimony paid
excess payments = in 2nd year - ( in 3rd year
+ $15,000 )
Once the excess payments for both the first and second post-separation years have been
determined, the results are added together to determine the amount that must be recaptured in the
third post-separation year.
Example 1. In 2000, Mr. Black makes payments totaling $50,000 to his ex-wife. He
makes no payments in either 2001 or 2002. Assuming none of the exceptions (set forth
below) apply, $35,000 will be recaptured in 2002. Mr. Black will have to report an
additional $35,000 in income, while his ex-wife will be entitled to a $35,000 reduction in
income.
Example 2. In 2000, Ms. Gold makes payments totaling $50,000 to her ex-husband.
In 2001, she makes $20,000 in payments, but in 2002 she makes no payments. Assuming
that none of the exceptions apply, the total amount that must be recaptured in the third
year is $32,500. This represents $5,000 from the second year ($20,000 minus $15,000)
and $27,500 from the first year. The amount recaptured from the first year equals the
excess of $50,000 (the payments made) over the sum of $15,000 plus $7,500. The $7,500
is the average of the payments for years two and three after reducing the payments by the
$5,000 recaptured for year two ($15,000 ($20,000 payment in year two plus $0 payment
in year three minus the $5,000 that was required to be recaptured) divided by two equals
$7,500).
Exceptions to Recapture Rule. The recapture of excess payments is not required if the alimony
payments terminate because either party dies or the payee-spouse remarries before the end of the
third post-separation year. The rules also do not apply to temporary support payments received
under an instrument described in Code Sec. 71(b)(2)(C) . In addition, they do not apply where
the payments fluctuate because of a continuing liability to pay--for at least three years--a fixed
portion of income from the earnings of a business or property or from compensation from
employment or self-employment (Code Sec. 71(f)(5)(C) ).[ 2001FED ¶6090 ]
¶776, Child Support
Payments made under post-1984 instruments that fix an amount of money or part of the
payment as child support are treated as child support for tax purposes and are not deductible
(Code Sec. 71(c) ).[ 2001FED ¶6090 ] If any amount specified in the instrument is to be reduced
based on a contingency set out in the instrument relating to a child--such as attaining a specified
age, dying, leaving school, or marrying--the amount of the specified reduction is treated as child
support from the outset. The same rule applies if the reduction called for by the instrument is to
occur at a time that can
clearly be associated with such contingency. Thus, unlike the situation under pre-1985 law,
payments that vary with the status of a child are not deductible.
Example. A 2000 divorce instrument provides that alimony payments will be reduced
by$100 per month when a child reaches age 18. Under these circumstances, $100 of each
payment is treated as child support.
Numerical Solution:
The recapture of “excess” alimony payments is required to prevent property settlement
payments from qualifying for alimony treatment. Excess is defined as the sum of the excess
payments made in the first post-separation year plus the excess payments made in the second
post-separation year. In this case, excess alimony is to be recaptured in Tom’s 2000 tax year (the
“third post-separation year”) through the inclusion of excess payments in his gross income.
Karla, who previously included the payments in income as alimony, is entitled to deduct the
amount recaptured from gross income in her tax year beginning in the third post-separation year.
Child-support payments, in general, are not deductible, and therefore must be subtracted from the
amount of alimony paid each year before calculating excess. Calculation of excess payments as
follows:
Excess payments = (160,000-6,000) – [(50,000-6,000) + 15,000] = $ 95,000
(Second year)
Excess payments = (200,000-6,000) – (15,000 + [((160,000-6,000) – 95,000) + (50,000-6,000))/2])
= $ 127,500 (First year)
Thus, Tom must include excess alimony payments of $222,500 (95,000+127,500) in his gross
income for the 2000 tax year. However, under the post-1984 provision, $44,000 (50,000-6,000)
in alimony payments for this year will be deductible from his gross income.
Issue N3:
Path:
Travel Expenses (MOM: Jill, 600 points; AUD: Jana, 300 points; PR:
-----, 300 points)
RIA Checkpoint; FTH; Spine; Chapter 3 Deductions--Expenses of a
Business; ¶ 1541 Travel Expenses
Narrative Solution:
¶ 1541 Travel Expenses
Travel Expenses.
The costs of away-from-home business travel can qualify as deductible expenses.
¶ 1552. Travel expense deduction for a companion.
No deduction is allowed (other than under Code Sec. 217 , moving expenses) for travel expenses
paid or incurred for a spouse, dependent, or other individual accompanying the taxpayer (or an
officer or employee of the taxpayer) unless ( Code Sec. 274(m)(3) ):
... the spouse, etc., is an employee of the taxpayer,
... the travel of the spouse, etc., is for a bona fide business purpose, and
... the expenses would otherwise be deductible by the spouse, etc. FTC ¶ L-1739 ; USTR ¶
2744.035 ; Tax Desk ¶ 29,123
The limits on deductions for travel companions don't apply to a companion who (1) is a business
associate ( ¶ 1563 ), (2) comes along for a bona-fide business purpose, and (3) could otherwise
deduct the expense if he incurred it. ( Reg § 1.274-2(g) )
If a wife accompanies her husband on a business trip and her expenses aren't deductible, the
deductible expense for transportation and lodging is the single rate cost of similar
accommodations for the husband. But the full rental for a car in which both spouses travel is
deductible, since no part of the expense is attributable to the “extra” spouse.
¶ 1581. Substantiation by use of optional meal allowance.
Employees and self-employeds who are away from home on business travel may use standard
per diem amounts to compute meal expense deductions instead of keeping records to substantiate
the actual amount of the expense. FTC ¶ L-4632 ; USTR ¶ 2744.10 ; Tax Desk ¶ 29,452
Employees or self-employeds whose work directly involves moving people or goods (e.g., by
plane, bus, truck, ship) and regularly involves travel to different localities with different meal
and incidental expense (M&IE) rates may for 2000 and the first nine months of 2001 treat $38 as
the federal M&IE (meals and incidental expenses) rate for any locality in the continental U.S.
and $42 as the M&IE rate for any nonforeign locality outside the continental U.S. This method
also can be used by payors of a per diem allowance only for M&IE away-from-home expenses to
an employee in the transportation industry, if the payment qualifies as a regular meals-only
allowance under the rules below. FTC ¶ L-4721 ; USTR ¶ 2744.17 ; Tax Desk ¶ 29,626
If a payor (employer, its agent, or third party) pays a per diem allowance only for meals and
incidental expenses in lieu of reimbursing these actual expenses incurred for travel away from
home, the amount that's deemed substantiated is the lesser of the per diem allowance or the
amount computed at the federal M&IE rate ( ¶ 1575 ) for the locality of travel for each calendar
day (or part of a day) the employee is away from home. FTC ¶ L-4632 , FTC ¶ L-4717 ; USTR ¶
2744.10 ; Tax Desk ¶ 29,620
Using standard per diem amounts only releases the taxpayer from the duty of substantiating the
actual amount. Time, place and business purpose must still be substantiated.
An employee may deduct an amount computed under this method only as an itemized deduction
(subject to the percentage limit on meal and entertainment expenses, ¶ 1570 , and then to the 2%of-AGI floor on miscellaneous itemized deductions, ¶ 3109 ). A self-employed individual
deducts the amount in determining adjusted gross income. This deduction is subject to the
percentage limit on meal and entertainment expenses. FTC ¶ L-4632 ; USTR ¶ 2744.18 ; Tax
Desk ¶ 29,452
¶ 1580. Proving travel and transportation expenses.
The taxpayer must prove all of the following elements by adequate records or by a sufficiently
corroborated statement:
(1) The amount of each separate expenditure for traveling away from home, such as the cost of
transportation or lodging. The daily cost of breakfast, lunch, and dinner and other incidental
travel elements may be aggregated if they are set forth in reasonable categories, such as for
meals, oil and gas, taxi fares, etc.
(2) The dates of the departure and return home for each trip, and the number of days spent on
business away from home.
(3) The destinations or locality of the travel.
(4) The business reason for the travel or the nature of the business benefit derived or expected to
be derived as a result of the travel. ( Reg § 1.274-5T(b)(2) ) FTC ¶ L-4630 ; USTR ¶ 2744.10 ;
Tax Desk ¶ 29,553
Incidental travel expenses, e.g., tips, aren't subject to these rules. Where records are incomplete
and documentary proof is unavailable, the taxpayer may establish the amount of incidental travel
expenses by reasonable approximations. ( Reg § 1.162-17(d)(3) ) FTC ¶ L-4633 ; Tax Desk ¶
29,555
¶ 1542. Deduction for travel costs.
Ordinary and necessary expenses incurred while traveling “away from home” in pursuit of a
trade or business are deductible. Those expenses include amounts (other than amounts that are
lavish or extravagant) paid for meals (subject to a percentage limit, see ¶ 1570 ) and lodging. (
Code Sec. 162(a)(2) ) FTC ¶ L-1701 ; USTR ¶ 1624.114 ; Tax Desk ¶ 29,102
Deductible business travel expenses include baggage charges, air, rail and bus fares, cost of
transporting sample cases or display materials, expenses for sample rooms, cost of maintaining
or operating a car, house trailer or airplane, telephone and telegraph expenses, laundry and dry
cleaning costs, taxi fares, etc., from the airport or station to the hotel and back, from one
customer to another, transportation from where meals and lodging are obtained to the temporary
work assignment, and reasonable tips incident to any of the above expenses. ( Reg § 1.162-2(a) )
FTC ¶ L-1705 ; USTR ¶ 1624.114 ; Tax Desk ¶ 29,105
Travel expenses don't include expenses of the taxpayer's own entertainment. FTC ¶ L-1713 ;
USTR ¶ 1624.114 ; Tax Desk ¶ 29,107
¶ 1570. Meal and entertainment deduction limits—the 50% rule.
The amount of an otherwise allowable deduction for meal or entertainment expenses (including
meals while on business travel status, ¶ 1541 ) is reduced by 50%. This reduction applies to any
expense for food or beverages, and any item with respect to entertainment, amusement, or
recreation, or for a facility used for such an activity. ( Code Sec. 274(n)(1) )
The 50% limit doesn't apply to:
... Expenses treated as compensation paid to an employee or otherwise included in the gross
income of the recipient of the meal or entertainment. ( Code Sec. 274(n)(2)(A) )
... Meals and entertainment expenses that are reimbursed. ( Code Sec. 274(n)(2)(A) ) Instead, the
percentage limit applies to the person making the reimbursement.
... Traditional recreational expenses for employees. ( Code Sec. 274(n)(2)(A) )
... Services and facilities made available by the taxpayer to the general public. ( Code Sec.
274(n)(2)(A) )
... Expenses of goods, services, or use of facilities, sold by the taxpayer in a bona fide transaction
(entertainment sold to customers). ( Code Sec. 274(n)(2)(A) )
... Food or beverage expenses that are excludable from the gross income of the recipient under
the de minimis fringe benefit rules. ( Code Sec. 274(n)(2)(B) )
... An expense that is part of a package that includes a ticket to attend certain charitable sporting
events. ( Code Sec. 274(n)(2)(C) ) The event must: (1) be organized for the primary purpose of
benefiting a tax-exempt charitable organization, (2) contribute 100% of the net proceeds to the
charity, and (3) use volunteers for substantially all work performed in carrying out the event. (
Code Sec. 274(l)(1)(B) )
... Food or beverage expenses of crews of certain drilling rigs and crews of certain commercial
vessels. ( Code Sec. 274(n)(2)(E) ) FTC ¶ L-2138 et seq.; USTR ¶ 2744.01 ; Tax Desk ¶ 29,458
et seq.
Where an employee's deduction of unreimbursed employee business expenses is subject to the
2%-of-AGI floor discussed at ¶ 3109 , the 50% limit is applied before the 2% floor. FTC ¶ L2135 ; USTR ¶ 2744.01 ; Tax Desk ¶ 29,456
The deductible percentage of meals consumed by certain transport workers (e.g., air transport
employees, truck and bus drivers, railroad employees) while away from home during or incident
to the period of duty subject to the hours of service limitations of the Department of
Transportation is: 60% for 2000 or 2001; 65% for 2002 or 2003; 70% for 2004 or 2005; 75% for
2006 or 2007; and 80% for 2008 or later years. ( Code Sec. 274(n)(3) ) FTC ¶ L-2145.1 ; USTR
¶ 2744.01
¶ 1510. Right to deduction—Cohan rule.
Where a taxpayer's records or other proof aren't adequate to substantiate expense deductions, the
taxpayer may be allowed to deduct an estimated amount under the Cohan rule. But the deduction
may be for much less than he spent, since the court in making an estimate may bear heavily upon
a taxpayer whose inexactitude is of his own making. FTC ¶ L-4509 et seq.; USTR ¶ 1624.014 ;
Tax Desk ¶ 25,707
The Cohan rule doesn't apply to travel or entertainment expenses, listed property, or business
gifts, see ¶ 1579 et seq
¶ 1547. U.S. travel for business and pleasure.
Transportation costs to and from the destination are deductible only if the trip is related primarily
to the taxpayer's business. Expenses at the destination that are allocable to the taxpayer's business
are deductible even if the expenses of getting to and from the destination are disallowed because
the trip was primarily a pleasure trip. FTC ¶ L-1702 , FTC ¶ L-2135 ; USTR ¶ 1624.119 ; Tax
Desk ¶ 29,104 If the trip is primarily for business, but the taxpayer extends his stay for personal
reasons, makes side trips, or engages in other nonbusiness activities, he may deduct only the
expenses, such as lodging and 50% of the cost of meals, that he would have incurred if the trip
had been totally for business. But no allocation is required for transportation costs to and from
the business destination.
Employee Business Expenses.
Employees are engaged in the trade or business of being employees and thus can deduct certain
ordinary and necessary expenses, within limits.
Employees may deduct their employment-connected business expenses such as travel expenses,
union dues, work clothes, etc., as described in the following paragraphs.
Unreimbursed employee business expenses are generally deductible only as miscellaneous
itemized deductions subject to the 2%-of-AGI floor, see ¶ 3109 . ( Reg § 1.67-1T(a)(1)(i) ) FTC
¶ L-3900 et seq. ; USTR ¶ 1624.067 ; Tax Desk ¶ 56,163 For unreimbursed moving expenses,
see ¶ 1646 et seq.
¶ 1546. Overnight trip required.
A travel expense deduction for meals and lodging isn't allowed unless the trip takes the taxpayer
away from home overnight , or at least long enough to require rest or sleep. FTC ¶ L-1710 ;
USTR ¶ 1624.147 ; The individual need not be away from his tax home for an entire 24-hour day
or throughout the hours from dusk to dawn if his relief from duty is long enough to get necessary
sleep. A layover sufficient only for a short rest and to get a meal isn't “overnight.” FTC ¶ L-1710
; USTR ¶ 1624.147 ;
Numerical Implication Statement:
Travel expenses are the costs of away-from-home business travel and can qualify as deductible
expenses. Deductible expenses include amounts (other than amounts that are lavish or
extravagant) paid for meals, air, rail and bus fares, expenses for sample rooms, taxi fares, etc.,
from the airport or station to the hotel and back, from one customer to another, transportation
from where meals and lodging are obtained to the temporary work assignment. If the trip is
primarily for business, but the taxpayer extends his stay for personal reasons, makes side trips, or
engages in other nonbusiness activities, he may deduct only the expenses, such as lodging and
50% of the cost of meals, that he would have incurred if the trip had been totally for business.
But no allocation is required for transportation costs to and from the business destination. A
travel expense deduction for meals and lodging isn't allowed unless the trip takes the taxpayer
away from home overnight, or at least long enough to require rest or sleep. Un-reimbursed
employee business expenses are generally deductible only as miscellaneous itemized deductions
subject to the 2%-of-AGI floor. Transportation costs to and from the destination are deductible
only if the trip is related primarily to the taxpayer's business. The amount of an otherwise
allowable deduction for meal or entertainment expenses (including meals while on business
travel status, is reduced by 50%. This reduction applies to any expense for food or beverages.
The taxpayer must prove all of the following elements by adequate records or by a
sufficiently corroborated statement:
(1) The amount of each separate expenditure for traveling away from home, such as the cost of
transportation or lodging. The daily cost of breakfast, lunch, and dinner and other incidental
travel elements may be aggregated if they are set forth in reasonable categories, such as for
meals, oil and gas, taxi fares, etc.
(2) The dates of the departure and return home for each trip, and the number of days spent on
business away from home.
(3) The destinations or locality of the travel.
(4) The business reason for the travel or the nature of the business benefit derived or expected to
be derived as a result of the travel.
No deduction is allowed for travel expenses paid or incurred for a spouse, dependent, or other
individual accompanying the taxpayer unless:
... the spouse, etc., is an employee of the taxpayer,
... the travel of the spouse, etc., is for a bona fide business purpose, and
... the expenses would otherwise be deductible by the spouse, etc.
But the full rental for a car in which both spouses travel is deductible, since no part of the
expense is attributable to the “extra” spouse. Therefore, the deductible expenses the Fronks
incurred in Las Vegas are:
50% of the airfare:
($375)
Motel:
($312)
Food and Beverages:
($90)
Transportation:
($150)
Total deductible amount:
($927)
From a tax formula perspective, the Fronks gross income will be reduced by $927 to reflect the
travel expenses of the business.
Issue N4:
Path:
Monica's Mileage (MOM: Tonya, 400 points; AUD: Jana, 200
points; PR: -----, 200 points)
CCH Network; USMTG; Spine, Deductions – Chapters 9-12;
¶946, Car Expense, ¶945, Local Transportation Expenses, ¶981,
Professional Person, ¶947, Substantiation of Car Expenses
Narrative Solution:
¶946, Car Expense
Expenses for gasoline, oil, tires, repairs, insurance, depreciation, parking fees and tolls, licenses,
and garage rent incurred for cars used in a trade or business are deductible. The deduction is
allowed only for that part of the expenses that is attributable to business.[ 2001FED ¶8501 ]
Generally, an employee's unreimbursed expenses can be deducted only as a miscellaneous
itemized deduction subject to the 2% floor (Code Sec. 67 ).[ 2001FED ¶6060 ] See ¶941 . See
¶1214 concerning depreciation of a car.
¶945, Local Transportation Expenses
Local transportation expenses are generally those incurred for the business use of a car.
However, they also include the cost of travel by rail, bus, or taxi. Businesses (including selfemployed persons and statutory employees) may deduct ordinary and necessary local
transportation expenses from gross income (Reg.§1.162-1(a) ).[ 2001FED ¶8501 ] The manner
of an employee's deduction for transportation expenses generally depends on whether the
employee is reimbursed under an accountable plan. See ¶943 .
Commuting Expenses. Commuting expenses between a taxpayer's residence and a business
location within the area of the taxpayer's tax home generally are not deductible.[ 2001FED
¶8550.069 ] However, a deduction is allowed for expenses incurred in excess of ordinary
commuting expenses for transporting job-related tools and materials.[ 2001FED ¶8590.25 ] An
individual who works at two or more different places in a day may deduct the costs of getting
from one place to the other.[ 2001FED ¶8570.175 ]
There is an exception to the general rule that commuting expenses are not deductible. If a
taxpayer has at least one regular place of business away from home, then daily transportation
expenses for commuting between the taxpayer's residence and a temporary work location in the
same trade or business can be deducted (Rev. Rul. 99-7 ).[ 2001FED ¶8570.146 ] For this
purpose, a temporary work location is defined using a one-year standard. If employment at a
work location is realistically expected to last (and does in fact last) for one year or less, the
employment is temporary, absent facts and circumstances to the contrary. Employment at a
work location is not temporary, regardless of whether or not it lasts for more than one year, if it
is realistically expected to last more than one year or there is no realistic expectation that
employment will last for one year or less. A taxpayer may at first realistically expect that
employment at a work location will last one year or less, but at a later date, realistically expect
that the work will last for more than one year. In this situation, the taxpayer's realistic
expectation changes and will be treated as not temporary after that date (unless facts and
circumstances indicate otherwise).
Prior to Rev. Rul. 99-7 , the term "temporary work location" was defined as a work location
where the taxpayer performed services on an irregular or short-term basis (Rev. Rul. 90-23 ).
For the rules concerning deductions while on a temporary assignment "away from home," see
¶951 .
Travel from a Home Office. Individuals who use their homes as their principal place of business
(¶961 ) are permitted to deduct transportation expenses between their homes and another work
location in the same trade or business (Rev. Rul. 99-7 ).[ 2001FED ¶8570.012 ] This rule applies
regardless of whether the work location is temporary or regular and regardless of the distance. A
Tax Court decision permitted an individual to deduct daily transportation costs incurred in
traveling between his home and numerous temporary work sites because the home was the
individual's "regular place of business."[ 2001FED ¶8570.146 ] However, the IRS has ruled that
it will not follow the Tax Court's decision in such a situation unless the residence is also the
taxpayer's principal place of business (Rev. Rul. 94-47 ).[ 2001FED ¶8590.0414 ] See ¶961 for a
discussion of home office expenses.
¶981, Professional Person
Expenses incurred for operating a car used in making professional calls, dues to professional
organizations, rent paid for office space, and other ordinary and necessary business expenses are
deductible by a professional person. Amounts for books and equipment may be deducted if the
useful life of the item is not more than one year (Reg. §1.162-6 ).[ 2001FED ¶8633 ]
No deduction is allowed for dues paid to any club organized for business, pleasure, recreation, or
other social purposes (Code Sec. 274(a)(3) ).[ 2001FED ¶14,402 ] However, this disallowance
does not extend to professional organizations (e.g., bar and accounting associations) or public
service organizations (e.g., Kiwanis and Rotary clubs) (Reg.§1.274-2(a)(2)(iii)(b) ).[ 2001FED
¶14,405 ] See, also, ¶913 .
A professional who performs services as an employee and who incurs unreimbursed related
expenses may deduct such expenses only as itemized deductions subject to the 2% floor. See
¶941 and ¶1011 .
Information Services. Amounts paid for subscriptions to professional journals, and the cost of
information services such as Federal or State Tax Reporters, Unemployment Reporters, Labor
Law or Trade Regulation Reporters, Estate Tax Reporters, and other law reporters that have a
useful life of one year or less are deductible by a lawyer, accountant or an employee who buys a
service in connection with the performance
of his duties.[ 2001FED ¶8634.02 ] The cost of a professional library having a more permanent
value should be capitalized.
Other Expenses. A deduction is allowed to members of the clergy, lawyers, merchants,
professors,and physicians for expenses incurred in attending business conventions (¶959 ).[
2001FED ¶8527 ] (For foreign conventions, see ¶960 .) A member of the medical profession is
allowed a deduction for business entertainment, subject to the rules discussed at ¶910 , so long as
there is a direct relationship between the
expense and the development or expansion of a medical practice.[ 2001FED ¶8523.2717 ] A
doctor's staff privilege fee paid to a hospital is a capital expenditure.[ 2001FED ¶8634.043 ] For
other deductions, see the Checklist at ¶57 .
Automobile expenses are deductible if the automobile is used in connection with a trade or
business or in connection with an income-producing activity. A deduction is allowable only for
that portion of the use attributable to business or income-producing activities. The portion
attributable to personal use is nondeductible. For rules on substantiation of automobile expenses,
see ¶14,417.01 et seq.
Unreimbursed automobile expenses incurred by employees must generally be taken as itemized
deductions subject to the two-percent floor on itemized deductions (¶6064.01 ). However, certain
employees may deduct their unreimbursed business expenses from gross income (¶8524 ).
Business use test. Automobiles must be predominantly used in business in order for a taxpayer to
claim accelerated MACRS deductions for the cost of the automobile. The requirement is met if
the taxpayer's business use of the property exceeds 50 percent under Code Sec. 280A(f)(2)(b)
(¶15,100 ).
Expenses for a car that an employee uses in connection with employment are eligible for the
business expense deduction only if the car is used for the convenience of the employer and as a
condition of employment (¶8524.025 ).
Commuting expenses. As a general rule, expenses incurred in traveling between the individual's
home and a business location are not deductible. However, some important exceptions to this
general rule exist (see discussion at ¶8570.026 ).
Reporting expenses. The deduction for automobile expenses of an employee is generally
computed on Form 2106, Employee Business Expenses. However, certain "statutory employees"
claim their car expenses on Schedule C or C-EZ (¶8524.01 ). A self-employed person claims
automobile expense on Schedule C, Schedule C-EZ or Schedule F of Form 1040. See ¶8590.075.
¶947, Substantiation of Car Expenses
A taxpayer can substantiate car expenses by keeping an exact record of the amount paid for
gasoline, insurance, and other costs. However, the standard mileage rate method is a simplified
method available to both employees and self-employed persons in computing deductions for car
expenses in lieu of calculating the operating and fixed costs allocable to business purposes (Rev.
Proc. 99-38 ).[ 2001FED ¶8590.55 ]
Standard Mileage Rate. Under the standard mileage method, the taxpayer determines the
amount of the allowable deduction by multiplying all the business miles driven during the year
by the standard mileage rate. The standard mileage rate is 32.5 cents a mile for all miles driven in
2000 (Rev. Proc. 99-38 ).[2001FED ¶8590.55 ] From January 1, 1999 through March 31, 1999
the rate was 32.5 cents. From April 1, 1999 through December 31, 1999, the business standard
mileage rate was 31 cents per mile. The business portion of parking fees and tolls may be
deducted in addition to the standard mileage rate (Rev. Proc. 99-38 ).
Rural mail carriers who receive a qualified reimbursement for expenses incurred for the use of
their vehicles for performing the collection and delivery of mail in a rural route are allowed a
deduction for an amount equal to the qualified reimbursements received (Code Sec. 162(o) ).[
2001FED ¶8500 ]
The standard mileage rate method may be utilized by self-employed individuals or employees
who own or lease a car and operate only one car at a time for business purposes (Rev. Proc. 9938 ; Temporary Reg. §1.274(d)-1T ). The standard mileage rate is not available for cars used for
hire (taxicabs) or two or more cars used simultaneously (fleet). Use of the standard mileage rate
in the first year of business use is considered an election to exclude the car from MACRS
depreciation (Rev. Proc. 99-38 ) (¶1236 ).
Fixed and Variable Rate (FAVR) Method. An employee's car expenses will be deemed
substantiated if the payor (usually the employer) reimburses the employee's expenses with a
mileage allowance using a flat rate or a stated schedule that combines periodic fixed and variable
payments. At least five employees must be covered by such an arrangement at all times during
the calendar year, but at no time can the majority of covered employees be management
employees. There are additional requirements that
must be met (Rev. Proc. 99-38 ).
Numerical Implication Statement:
Monica can treat the business related portion (10,800)of her miles driven as an itemized
deduction. The 1,500 miles she commuted to work are not deductible. To calculate the itemized
deduction, she would take the standard business rate of 32.5 cents per mile and multiply by the
10,800 miles. This equals $3,510 that may be an itemized deduction. However, this amount is
subject to the 2% floor (must exceed 2% of AGI). It appears at this point that it will not exceed
2% of the Fronks AGI.
Issue N5:
Path:
Gambling Winnings and Losses (MOM: Jill, 400 points; AUD:
Tonya, Amanda, 200 points; PR: -----, 200 points)
CCH Network; USMTG; Spine; Losses- Bad Debts (Chapter 11);
¶1121, Wagering Loss
Narrative Solution:
¶1121, Wagering Loss
Losses from wagering are deductible to the extent of the gains from wagering, regardless of the
legality of the activity under local law (Code Sec. 165(d) ).[ 2001FED ¶9802 ] A professional
gambler may deduct his losses directly from his gambling income. The nonprofessional must
include all gambling income in his gross income but can claim the losses only as an itemized
deduction.[ 2001FED ¶10,105.01 ]
¶787, Gambling and Other Gains
Gain arising from gambling, betting and lotteries is includible in gross income. A gain from an
illegal transaction, such as bootlegging, extortion, embezzlement or fraud, is also includible
¶788, Gambling Losses
The law permits the deduction of wagering losses only to the extent of the taxpayer's gains from
similar transactions (Code Sec. 165(d) ; Reg. §1.165-10 ).[ 2001FED ¶9802 , 2001FED ¶10,104
] They are nonbusiness losses and are deductible only if itemized on Schedule A of Form 1040 .
If gambling is conducted as a business, the losses are deductible as business losses, but only to
the extent of gains.[ 2001FED ¶10,105.01
¶1014, When AGI Exceeds Inflation-Adjusted Dollar Amount
An individual whose adjusted gross income exceeds a threshold amount is required to reduce the
amount of allowable itemized deductions by three percent of the excess over the threshold
amount (Code Sec. 68 ).[ 2001FED ¶6080 ] No reduction is required, however, in the case of
deductions for medical expenses, investment interest, and casualty, theft or wagering losses. The
2000 threshold amount is $128,950 ($64,475 for married filing separately) (Rev. Proc. 99-42 ).
The 2001 thresholds, are $132,950 and $66,475, respectively (Rev. Proc. 2001-13 ). However,
the reduction may never be more than 80 percent of allowable deductions, excluding deductions
for medical expenses, investment interest, and casualty, theft or wagering losses. Thus, for
example, if otherwise allowable itemized deductions are $10,000, the reduction amount cannot
exceed $8,000.
This limitation is applied after any disallowance of miscellaneous itemized deductions subject to
the two-percent floor (¶1011 ) has been taken into account (Code Sec. 68(d) ) and the reduced
amount is reported on Schedule A of Form 1040 .[
¶1012, Itemized Deductions Not Subject to the Two-Percent Floor
The following itemized deductions (reported on Schedule A of Form 1040 ) are not subject to the
two-percent floor discussed at ¶1011 (Code Sec. 67(b) ):[ 2001FED ¶6060 ]
(1) Interest (see ¶1043 et seq.),
(2) Taxes (see ¶1021 and ¶1028 et seq.),
(3) Casualty, theft, and wagering losses (see ¶1101 et seq.),
(4) Charitable deductions (see ¶1058 et seq.),
(5) Medical and dental expenses (see ¶1015 et seq.),
(6) Deductions for impairment-related work expenses (see ¶1013 ),
(7) Deductions for estate tax in the case of income in respect of a decedent (see ¶191 ),
(8) Deductions allowable in connection with personal property used in a short sale (¶1944 ),
(9) Deductions relating to computation of tax when the taxpayer restores an amount in excess of
$3,000 held under claim of right (see ¶1543 ),
(10) Deductions where annuity payments cease before an investment is recovered pursuant to
Code Sec. 72(b)(3) ,
(11) Amortizable bond premiums (see ¶1967 ), and
(12) Deductions of taxes, interest, and business depreciation by cooperative housing corporation
tenant-stockholder (¶1040 ).
Numerical Implication Statement:
Losses from wagering are deductible to the extent of the gains from wagering, regardless of the
legality of the activity under local law. A nonprofessional gambler must include all gambling
income in his gross income but can claim the losses only as an itemized deduction. In the
Fronk’s case, Monica’s winnings totaled $900 while Tom’s gambling losses total $1,700. From
a tax formula perspective, this means that all $900 of Monica’s winnings must be included in
income broadly conceived and are not taken out as an exclusion, which means they will show up
in gross income. The $1,700 loss of Tom’s can be included on Schedule A as an itemized
deduction up to the amount of the winnings; in this case $900 which is not subject to a 2% floor.
Issue N6:
Path:
Safe Deposit Box Expenses (MOM: Andy A., (400 - 200) points;
AUD: Amanda, (200 - 100); PR: -----, 200 points)
TEMP-REG, 2001FED ¶6061, §1.67-1T, 2-percent floor on
miscellaneous itemized deductions
Narrative Solution:
Expenses for Production of Income: Investor's Expenses: Safe deposit box rent.-Deduction allowed for rental of safe deposit box used to store stock certificates determined.
Amounts spent for rental of safe deposit box, Securities Exchange registration fees, and postage
paid on sale of securities were deductible nonbusiness expenses.
The storage of records at an unrented home office which was ostensibly held for rent did not
entitle taxpayer, who did not rent a safe deposit box, to deduct a calculated $1 per day storage
fee.
Taxpayer's expenditures for bookkeeping supplies, payment for services of certified public
accountant in auditing books of trusts, expenditures for services rendered by bookkeeper in
keeping personal books and rent of a safe deposit box for personal securities were held
deductible.
(a) Type of expenses subject to the floor--(1) In general. With respect to individuals, section 67
disallows deductions for miscellaneous itemized deductions (as defined in paragraph (b) of this
section) in computing taxable income (i.e., so-called "below-the-line" deductions) to the extent
that such otherwise allowable deductions do not exceed 2 percent of the individual's adjusted
gross income (as defined in section 62 and the regulations thereunder). Examples of expenses
that, if otherwise deductible, are subject to
the 2-percent floor include but are not limited to-(i) Unreimbursed employee expenses, such as expenses for transportation, travel fares and
lodging while away from home, business meals and entertainment, continuing education courses,
subscriptions to professional journals, union or professional dues, professional uniforms, job
hunting, and the business use of the employee's home,
(ii) Expenses for the production or collection of income for which a deduction is otherwise
allowable under section 212(1) and (2), such as investment advisory fees, subscriptions to
investment advisory publications, certain attorneys' fees, and the cost of safe deposit boxes,
(1) The implementation of records management practices is a business decision that is solely
within the discretion of the taxpayer. Recommended records management practices include the
labeling of records, providing a secure storage environment, creating back-up copies, selecting
an offsite storage location, and testing to confirm records integrity.
Section 212 of the Internal Revenue Code of 1954 provides for the deduction, in the case of an
individual, or all the ordinary and necessary expenses paid or incurred during the taxable year for
the production or collection of income or for the management, conservation, or maintenance of
property held for the production of income.
Section 1.212-1(d) of the Federal income tax regulations provides that such expenses must be
reasonable in amount and must bear a reasonable and proximate relation to the production or
collection of taxable income or to the management, conservation, or maintenance of property
held for the production of income.
Inasmuch as the expenses incurred by the partnership during the taxable year for postage,
stationery, safe deposit box rentals, bank charges, fees for accounting and investment services,
rent, and utility charges, are of the nature described in section 212 of the Code, are reasonable in
amount and bear a proximate relationship to investment activities of the partnership, the
expenses qualify as deductions under section 212 of the Code.
Numerical Implication Statement:
The Fronks may deduct the business portion of the safe deposit box ($200) as an ordinary
business expense on Tom’s Schedule C. The remaining $400 allocable to storing their portfolio
instruments are a miscellaneous deduction subject to the 2% floor reported on Schedule A.
Issue N7:
Path:
Taxation of Partnerships in General (MOM: Katie, 500 points;
AUD: Rebecca, Katherine, Karrie, 250 points; PR: -----, 250 points)
CCH Network; USMTG; Spine, Chapter 20 Passive Losses,
Partnership; ¶404, Partners, Not Partnership, Subject to Tax
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶404, Partners, Not Partnership, Subject to Tax
Partners, Not Partnership, Subject to Tax
A partnership does not pay federal income tax; rather, income or loss “flows through” to the
partners who are taxable in their individual capacities on their distributive shares of partnership
taxable income. However, the partnership is a tax-reporting entity that must file an annual
partnership return (see ¶406 ). In determining federal income tax, a partner must take into
account separately his distributive share of certain items (listed at ¶431 ) of partnership income,
gain, loss, deduction or credit. A partner’s distributive share of partnership items is includible on
his individual income tax return (or corporate income tax return for corporate partners) for his
tax year in which the partnership tax year ends (Code Sec. 706(a) ).[ 2001FED ¶25,160 ] A
partner is generally not taxed on distributions of cash or property received from the partnership,
except to the extent that any money distributed exceeds the partner’s adjusted basis in his
partnership interest immediately before the distribution (see ¶453 ). Taxable gain can also result
from distributions of property that was contributed to a partnership with a “built-in gain” (where
property has a fair market value in excess of its adjusted basis) and from property distributions
that are characterized as sales and exchanges (see ¶432).
Numerical Implication Statement:
In determining his federal income tax, Tom, a limited partner in Crown Enterprises, must take
into account separately his distributive share of certain items of partnership income, gain, loss,
deduction or credit. In this case, Tom’s 2000 K-1 reported ordinary income $45,000, interest of
$1,001, dividends of $597, a §179 expense deduction of $200, and a Form 6251 depreciation
adjustment of $2,761. Tax formula implications are as follows: 1) The interest and dividends are
includable in income broadly conceived, will flow through to taxable income, and are reported
on Schedule E and flow into Schedule B; 2) The §179 expense deduction of $200 will be
subtracted from Crown Enterprise's ordinary income and, since each tax return is afforded only
one Section 179 amount, combined with the $15,000 furniture and fixture expense relating to
Tom’s dentistry. To this amount, $4,800 of Monica’s computer system will be added to equal a
total expense deduction of $20,000 (the maximum allowable for 2000). This amount will be
included in the tax formula as a deduction from gross income. The Section 179 amount is
reported on schedule E; 3) The depreciation adjustment of $2,761 relates to AMT and will be
treated as a positive adjustment, and 4) The analysis of the ordinary income appears in Issue N8.
Issue N8:
Path:
Limited Partnership Interests and the Passive Loss Provisions
MOM: Katie, 1000 points; AUD: Rebecca 500 points; PR: -----, 500
points)
CCH Network; USMTG; Spine, Chapter 20 Passive Losses, ¶2059,
Passive Activity Defined; ¶427, Partnerships and the Passive Activity
Loss Rules; ¶2053, General Rules; ¶2045, Limit of Losses to Amount
at Risk
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶2059, Passive Activity Defined
Passive Activity Defined
A passive activity is one that involves the conduct of any trade or business in which the
taxpayer does not materially participate (Code Sec. 469(c)).[ 2001FED ¶21,960 ] Any rental
activity is a passive activity whether or not the taxpayer materially participates. However, there
are special rules for real estate rental activities (see ¶2063 ) and real estate professionals (see
¶2064 ).
Generally, to be considered as materially participating in an activity during a tax year an
individual must satisfy any one of the following tests: (1) he participates more than 500 hours;
(2) his participation constitutes substantially all of the participation in the activity; (3) he
participates for more than 100 hours and this participation is not less than the participation of any
other individual; (4) the activity is a "significant participation activity" (see below) and his
participation in all such activities exceeds 500 hours; (5) he materially participated in the activity
for any five years of the 10 years that preceded the year in question; (6) the activity is a "personal
service activity" (see below) and he materially participated in the activity for any three years
preceding the tax year in question; or (7) he satisfies a facts and circumstances test that requires
him to show that he participated on a regular,
continuous, and substantial basis (Temporary Reg. §1.469-5T(a) ).[ 2001FED ¶21,965 ] Special
rules are also provided for determining the material participation of limited partners (Temporary
Reg. §1.469-5T(e)(2) ),[ 2001FED ¶21,965 ] certain retired or disabled farmers (Temporary Reg.
§1.469-5T(h)(2) ),[ 2001FED ¶21,965 ] and personal service and closely held corporations
(Temporary Reg. §1.469-1T(g)(2) and Temporary Reg. §1.469-1T(g)(3)(i) ).[ 2001FED ¶21,962
]
Significant Participation Activity. A significant participation activity is one in which the
taxpayer participates more than 100 hours during the tax year but does not materially participate
under any of the other six tests set forth above (Temporary Reg. §1.469-5T(c) ).[ 2001FED
¶21,965 ]
Personal Service Activity. A personal service activity involves the performance of personal
service in (1) the fields of health, engineering, architecture, accounting, actuarial services, the
performing arts, or consulting or (2) any other trade or business in which capital is not a material
income-producing factor (Temporary Reg. §1.469-5T(d) ).[ 2001FED ¶21,965 ]
GUIDEBOOK, 2001USMTG ¶427, Partnerships and the Passive Activity Loss Rules
Partnerships and the Passive Activity Loss Rules
The passive activity loss limitations (see ¶2053 ) apply at the partner level to each partner’s
share of any loss or credit attributable to a passive activity of the partnership (Code Sec. 469 ).[
2001FED ¶21,960 ] A partnership may engage in both passive and nonpassive activities. For
example, a partnership may engage in business that is a passive activity of its limited partners
(who normally do not participate in the management of a limited partnership), and it also may
have investment assets that produce portfolio income (not a passive activity). Thus a partner who
disposes of his interest in a partnership must allocate any gain or loss among the various
activities of the partnership in order to determine the amount that is passive gain or loss and the
amount that is nonpassive gain or loss. In general, the allocation is made in accordance with the
relative value of the partnership’s assets.
To allow a partner to make these calculations, a partnership must report separately a
partner’s share of income or losses and credits from each (1) trade or business activity, (2) rental
real estate activity, and (3) rental activity other than rental real estate. A partnership’s portfolio
income, which is excluded from passive income, must also be separately reported (Code Sec.
703 ).[ 2001FED ¶25,100 ]
Generally, a passive activity of a partner is (1) a trade or business activity in which the
partner does not materially participate or (2) any rental activity. Except as provided (Temporary
Reg. §1.469-5T(e)(2) ),[ 2001FED ¶21,965 ] an interest in an activity as a limited partner in a
limited partnership is not one in which the partner materially participates. If a partnership reports
amounts from more than one activity on a partner’s Schedule K-1 and one or more of the
activities is passive to the partner, the partnership must attach a statement detailing the income,
losses, deductions, and credits from each passive activity and the line of Schedule K-1 on which
that amount is included.
GUIDEBOOK, 2001USMTG ¶2053, General Rules
General Rules
Generally, losses from passive activities may not be deducted from other types of income
(for example, wages, interest, or dividends) (Code Sec. 469 ).[ 2001FED ¶21,960 ] Similarly, tax
credits from passive activities are generally limited to the tax allocable to those activities. In
determining a taxpayer’s allowable loss, the at-risk rules discussed at ¶2045 are applied before
the passive activity loss rules.
Generally, to the extent that the total deductions from passive activities exceed the total
income from these activities for the tax year, the excess (the passive activity loss) is not allowed
as a deduction for that year. A disallowed loss is suspended and carried forward as a deduction
from the passive activity in the next succeeding tax year (Reg. §1.469-1(f)(4) ).[ 2001FED
¶21,961B ] Any unused suspended losses are allowed in full when the taxpayer disposes of his
entire interest in the activity in a fully taxable transaction (Code Sec. 469(g) ) (see ¶2076 ).[
2001FED ¶21,960 ]
Most taxpayers use Forms 8582 and 8582-CR to calculate their allowable passive losses
and credits. Form 8810 is used by personal service corporations and closely held C corporations.
Form 8825 is used by partnerships and S corporations to report income and deductible expenses
from rented real estate activities.
GUIDEBOOK, 2001USMTG ¶2045, Limit of Losses to Amount at Risk
Limit of Losses to Amount at Risk
Code Sec. 465 generally limits a taxpayer's deductible loss to the amount that the taxpayer has
at risk with respect to an activity.[ 2001FED ¶21,850 ] The rules, which apply to individuals and
certain closely held corporations, are designed to prevent taxpayers from offsetting trade,
business, or professional income by losses from investments in activities that are largely financed
by nonrecourse loans for which they are not personally liable. Even if it has been determined that
the loss is deductible under the at-risk rules, the loss may still be limited by the passive activity
loss rules (see ¶2053 ).
Under the at-risk rules, loss deductions are limited to the amount of the taxpayer's cash
contribution and the adjusted basis of other property which he contributes to the activity, plus
any amounts borrowed for use in the activity if the taxpayer has personal liability for the
borrowed amounts or has pledged assets not used in the activity as security for the borrowed
amounts. The taxpayer will not be considered at risk with respect to amounts protected against
loss through nonrecourse financing, guarantees, stop-loss agreements, or similar arrangements
(Code Sec. 465(b) ).[ 2001FED ¶21,850 ] Also, amounts are not at risk if they are borrowed from
(1) a creditor who has an interest other than as a creditor (which has been defined as a capital or
net profits interest) or (2) a person related to a person with such an interest (Code Sec. 465(b)(3)
).[ 2001FED ¶21,850 ]
Form 6198 is used to compute the deductible loss, if any, under the at-risk rules.
Numerical Implication Solution:
Tom's limited involvement in Crown Enterprises Tom renders that activity a passive activity.
Losses from a passive activity are limited in two ways, the at-risk rules and the passive loss
rules. The at-risks rules limit the available passive loss to the taxpayers at-risk amount in a given
activity. The at-risk amount is equal to the taxpayers investment in the activity and any debt for
which the taxpayer is personally liable. If there is an insufficient at-risk amount, the passive
losses are suspended under the at-risk rules. The passive loss rules limit the deductibility of an
available passive loss to any passive income that that loss can offset. If there is insufficient
passive income, the passive losses are suspended under the passive loss rules. Any suspended
passive losses are freed up when the passive activity is sold.
Tom's initial at-risk amount is $50,000. That amount is sufficient to render 1998's and 1999's
$20,000 and $10,000 losses available for passive-loss rules consideration. As of the end of 1999,
the at-risk amount is $20,000. In 1998 and 1999, there wasn't any passive income, thus the entire
$30,000 in passive losses was suspended under the passive loss rules until passive income is
available. The $45,000 in passive income in 2000 frees up the $30,000 of passive losses
suspended under the passive loss rules. Thus, only $15,000 of the $45,000 of passive income is
taxable. Schedule E and Forms 6198, 8582, and 8582-CR are needed to report this activity.
Issue N9:
Service Fees - Dentistry (MOM: Jill, 500 points; AUD: Tonya, 250
points; PR: -----, 250 points)
Narrative Solution:
This issue is resolved via an application of common "accounting" sense. We proceed by
introducing a "T" account for accounts receivable and solving for the cash collection unknown.
BB
Billings
NSF check
EB
Accounts Receivable
15,800 1900
741,540 1200
1900 753,440
2,700
Right off NSF
Right off dead patient
Cash Collection
Numerical Implication Solution:
Given the "T" account analysis, the Dentistry generated $753,440 in cash receipts in 2000. Those
receipts should be included in income broadly conceived.
Issue N10: Monthly rental payments (MOM: Tonya, 200 points; AUD: Andy
B., 100 points; PR: -----, 100 points)
Path:
CCH Network; USMTG; Spine, Income – (Chapter 7), Rental
Income, ¶762, Rents
Narrative Solution:
Amounts received or accrued as rents in payment for the use of property must be included in
gross income. As a general rule, the payment by a lessee of any expenses of a lessor is additional
rental income of the lessor. Consideration received by the lessor for cancellation of a lease is in
substitution for rental payments and, thus, not a return of capital. Any reduction in the value of
property due to cancellation of a lease is a deductible loss only when fixed by a closed
transaction.
Numerical Implication Statement:
The monthly rental payments of $60,000 received by the Fronks are considered income and thus
included in income broadly conceived and are reported on Schedule E
Issue N11: Prepayment of final month’s rent (MOM: Tonya, 200 points;
AUD: Andy B., 100 points; PR: -----, 100 points)
Path:
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable and
Exempt; ¶ 1349, Advance rentals and security deposits.
Narrative Solution:
¶5705,
§1.61-8, Rents and royalties
(a) In general. Gross income includes rentals received or accrued for the occupancy of real
estate or the use of personal property. For the inclusion of rents in income for the purpose of the
retirement income credit, see section 37 and the regulations thereunder. Gross income includes
royalties. Royalties may be received from books, stories, plays, copyrights, trademarks,
formulas, patents, and from the exploitation of natural resources, such as coal, gas, oil, copper, or
timber. Payments received as a result of the transfer of patent rights may under some
circumstances constitute capital gain instead of ordinary income. See section 1235 and the
regulations thereunder. For special rules for certain income from natural resources, see
subchapter I (611 and following), chapter 1 of the Code, and the regulations thereunder.
(b) Advance rentals; cancellation payments. Except as provided in section 467 and the
regulations thereunder, gross income includes advance rentals, which must be included in
income for the year of receipt regardless of the period covered or the method of accounting
employed by the taxpayer. An amount received by a lessor from a lessee for cancelling a lease
constitutes gross income for the year in which it is received, since it is essentially a substitute for
rental payments. As to amounts received by a lessee for the cancellation of a lease, see section
1241 and the regulations thereunder.
Numerical Implication Statement:
The $2,400 of prepaid rent is includable in the Fronks rental income and thus included in
included in income broadly conceived and on Schedule E.
Issue N12: Security Deposit for rental property (MOM: Tonya, 200 points;
AUD: Andy B., 100 points; PR: -----, 100 points)
Path:
RIA Checkpoint; FTH; Spine, Chapter 2 Income – Taxable and
Exempt; ¶ 1349, Advance rentals and security deposits.
Narrative Solution:
¶ 1349, Advance rentals and security deposits.
An advance rental is currently taxable ( Reg § 1.61-8(b) ), even if it's refundable or can be
applied against the property's purchase price. FTC ¶ J-2218 ; USTR ¶ 4514.193 ; Tax Desk
¶12,103 But a security deposit ( ¶ 1206 ) isn't taxable rent. FTC ¶ J-2277 ; USTR ¶ 4514.194 ;
Tax Desk ¶ 12,108
Numerical Implication Statement:
The security deposits of $1,800 are not considered income to the Fronks as they are to be
returned to the tenants after the leases terminate. Such deposits are only income if the Fronks
retain a portion of the security deposit to cover a default in the lease (e.g., such as non-payment
of rent or damages).
Issue N13: Rental Expenses (MOM: Tonya, 200 points; AUD: Andy B., 100
points; PR: -----, 100 points)
Path:
CCH Network; USMTG; Deductions (Chapters 9--12), ¶1089,
Deductions Attributable to Rental or Royalty Property
Path:
CCH Explanations and Analysis - Standard Federal Income Tax
Reporter – Deductions--Secs. 161-291 - Expenses for production of
income--Secs. 211, 212 – §1.212-1 Nontrade or nonbusiness
expenses.
Narrative Solution:
¶1089, Deductions Attributable to Rental or Royalty Property
Ordinary and necessary expenses attributable to property held for the production of rents or
royalties may be deducted in determining adjusted gross income (Reg. §1.62-1T(c) ).[ 2001FED
¶6003 ] These deductions include interest, taxes, depreciation, depletion, losses, etc. (Reg.
§1.212-1 ).[ 2001FED ¶12,521 ] The property does not have to be actually producing income if it
is held for the production of rents or royalties.[2001FED ¶6005.03 , 2001FED ¶12,523.035 ]
Property held for the production of royalties includes intangible as well as tangible property.
Therefore, depreciation on a patent or copyright may be deducted. Similarly, an operating owner,
lessee, sublessor or sublessee, or purchaser of royalty interests can deduct his share of a
depletion allowance on natural resources. See ¶1201 and ¶1289 , respectively.
Where a property is devoted to rental purposes for part of a year and to personal use for the other
part, a proration of expenses is required. See the example on proration at ¶963 . See, also, ¶966
for special rules governing the deduction of expenses of rental vacation homes. For the
applicability of the at-risk and passive activity rules, see ¶2045 and ¶2053.
§1.212-1, Nontrade or nonbusiness expenses.
(a) An expense may be deducted under section 212 only if-(1) It has been paid or incurred by the taxpayer during the taxable year (i) for the production
or collectionof income which, if and when realized, will be required to be included in income for
Federal income tax purposes, or (ii) for the management, conservation, or maintenance of
property held for the production of such income, or (iii) in connection with the determination,
collection, or refund of any tax; and (2) It is an ordinary and necessary expense for any of the
purposes stated in subparagraph (1) of this
paragraph.
(b) The term "income" for the purpose of section 212 includes not merely income of the
taxable year but also income which the taxpayer has realized in a prior taxable year or may
realize in subsequent taxable years; and is not confined to recurring income but applies as well to
gains from the disposition of property. For example, if defaulted bonds, the interest from which
if received would be includible in income, are purchased with the expectation of realizing capital
gain on their resale, even though no current yield thereon is anticipated, ordinary and necessary
expenses thereafter paid or incurred in connection with such bonds are deductible. Similarly,
ordinary and necessary expenses paid or incurred in the management, conservation, or
maintenance of a building devoted to rental purposes are deductible notwithstanding that there is
actually no income therefrom in the taxable year, and regardless of the manner in which or the
purpose for which the property in question was acquired. Expenses paid or incurred in managing,
conserving, or maintaining property held for investment may be deductible under section 212
even though the property is not currently productive and there is no likelihood that the property
will be sold at a profit or will otherwise be productive of income and even though the property is
held merely to minimize a loss with respect thereto.
(c) In the case of taxable years beginning before January 1, 1970, expenses of carrying on
transactions which do not constitute a trade or business of the taxpayer and are not carried on for
the production or collection of income or for the management, conservation, or maintenance of
property held for the production of income, but which are carried on primarily as a sport, hobby,
or recreation are not allowable as nontrade or nonbusiness expenses. The question whether or not
a transaction is carried on primarily for the production of income or for the management,
conservation, or maintenance of property held for the production or collection of income, rather
than primarily as a sport, hobby, or recreation, is not to be determined solely from the intention
of the taxpayer but rather from all the circumstances of the case. For example, consideration will
be given to the record of prior gain or loss of the taxpayer in the activity, the relation between the
type of activity and the principal occupation of the taxpayer, and the uses to which the property
or what it produces is put by the taxpayer. For provisions relating to activities not engaged in for
profit applicable to taxable years beginning after December 31, 1969, see section 183 and the
regulations thereunder.
(d) Expenses, to be deductible under section 212, must be "ordinary and necessary". Thus,
such expenses must be reasonable in amount and must bear a reasonable and proximate relation
to the production or collection of taxable income or to the management, conservation, or
maintenance of property held for the production of income.
(e) A deduction under section 212 is subject to the restrictions and limitations in part IX
(section 261 and following), subchapter B, chapter 1 of the Code, relating to items not
deductible. Thus, no deduction is allowable under section 212 for any amount allocable to the
production or collection of one or more classes of income which are not includible in gross
income, or for any amount allocable to the management, conservation, or maintenance of
property held for the production of income which is not included in gross income. See section
265. Nor does section 212 allow the deduction of any expenses which are disallowed by any of
the provisions of subtitle A of the Code, even though such expenses may be paid or incurred for
one of the purposes specified in section 212.
(f) Among expenditures not allowable as deductions under section 212 are the following:
Commuter's expenses; expenses of taking special courses or training; expenses for improving
personal appearance; the cost of rental of a safe-deposit box for storing jewelry and other
personal effects; expenses such as those paid or incurred in seeking employment or in placing
oneself in a position to begin rendering personal services for compensation, campaign expenses
of a candidate for public office, bar examination fees and other expenses paid or incurred in
securing admission to the bar, and corresponding fees and expenses paid or incurred by
physicians, dentists, accountants, and other taxpayers for securing the right to practice their
respectiveprofessions. See, however, section 162 and the regulations thereunder.
(g) Fees for services of investment counsel, custodial fees, clerical help, office rent, and
similar expenses paid or incurred by a taxpayer in connection with investments held by him are
deductible under section 212 only if (1) they are paid or incurred by the taxpayer for the
production or collection of income or for the management, conservation, or maintenance of
investments held by him for the production of income; and (2) they are ordinary and necessary
under all the circumstances, having regard to the type of investment and to the relation of the
taxpayer to such investment.
(h) Ordinary and necessary expenses paid or incurred in connection with the management,
conservation, or maintenance of property held for use as a residence by the taxpayer are not
deductible. However, ordinary and necessary expenses paid or incurred in connection with the
management, conservation, or maintenance of property held by the taxpayer as rental property
are deductible even though such property was formerly held by the taxpayer for use as a home.
(i) Reasonable amounts paid or incurred by the fiduciary of an estate or trust on account of
administration expenses, including fiduciaries' fees and expenses of litigation, which are ordinary
and necessary in connection with the performance of the duties of administration are deductible
under section 212 notwithstanding that the estate or trust is not engaged in a trade or business,
except to the extent that such expenses are allocable to the production or collection of taxexempt income. But see section 642(g) and the regulations thereunder for is allowance of such
deductions to an estate where such items are allowed as adeduction under section 2053 or 2054
in computing the net estate subject to the estate tax.
(j) Reasonable amounts paid or incurred for the services of a guardian or committee for a ward
or minor,and other expenses of guardians and committees which are ordinary and necessary, in
connection with the production or collection of income inuring to the ward or minor, or in
connection with the management, conservation, or maintenance of property, held for the
production of income, belonging to the ward or minor, are deductible.
(k) Expenses paid or incurred in defending or perfecting title to property, in recovering
property (other than investment property and amounts of income which, if and when recovered,
must be included in gross income), or in developing or improving property, constitute a part of
the cost of the property and are not deductible expenses. Attorneys' fees paid in a suit to quiet
title to lands are not deductible; but if the suit is also to collect accrued rents thereon, that portion
of such fees is deductible which is properly allocable to the services rendered in collecting such
rents. Expenses paid or incurred in protecting or asserting one's rights to property of a decedent
as heir or legatee, or as beneficiary under a testamentary trust, are not deductible.
(l) Expenses paid or incurred by an individual in connection with the determination,
collection, or refund of any tax, whether the taxing authority be Federal, State, or municipal, and
whether the tax be income, estate, gift, property, or any other tax, are deductible. Thus, expenses
paid or incurred by a taxpayer for tax counsel or expenses paid or incurred in connection with the
preparation of his tax returns or in connection with any proceedings involved in determining the
extent of tax liability or in contesting his tax liability are deductible.
(m) An expense (not otherwise deductible) paid or incurred by an individual in determining or
contesting a liability asserted against him does not become deductible by reason of the fact that
property held by him for the production of income may be required to be used or sold for the
purpose of satisfying such liability.
Numerical Implication Statement:
Rental property expenses of $24,647 (interest expense), $7,500 (property taxes), $10,000
(R&M), $8,194 (Utilities), and $1,730 (Miscellaneous) are deductible from gross rental income
and on Schedule E
Issue N14: Prepaid Insurance (MOM: Tonya, (300 - 150) points; AUD: Andy
B., (150 - 75) points; PR: -----, 150 points)
Path:
CCH; Primary Sources; keyword=prepaid insurance; Pub No. 535,
When Can I Deduct an Expense?
Narrative Solution:
When you deduct an expense depends on your accounting method. An accounting method is a
set of rules used to determine when and how income and expenses are reported. The two basic
methods are the cash method and an accrual method.
Cash method. Under the cash method of accounting, you deduct business expenses in the tax
year you actually paid them, even if you incur them in an earlier year.
Accrual method. Under an accrual method of accounting, you generally deduct business
expenses when you become liable for them, whether or not you pay them in the same year. All
events that set the amount of the liability must have happened, and you must be able to figure the
amount of the expense with reasonable accuracy.
Economic performance rule. Under an accrual method, you generally cannot deduct or
capitalize business expenses until economic performance occurs. If your expense is for property
or services provided to you, or your use of property, economic performance occurs as the
property or services are provided, or the property is used. If your expense is for property or
services you provide to others, economic performance occurs as you provide the property or
services.
Example. Your tax year is the calendar year. In December 2000, the Field Plumbing Company
did some repair work at your place of business and sent you a bill for $150. You paid it by check
in January 2001. If you use an accrual method of accounting, deduct the $150 on your tax return
for 2000 because all events occurred to fix the fact of liability and economic performance
occurred in that year. If you use the cash method of accounting, you can deduct the expense on
your 2001 return.
Prepayment. You cannot deduct expenses in advance, even if you pay them in advance. This
rule applies to both the cash and accrual methods. It applies to prepaid interest, prepaid insurance
premiums, and any other expense paid far enough in advance to, in effect, create an asset with a
useful life extending substantially beyond the end of the current tax year.
Example. In 2000, you sign a 10-year lease and immediately pay your rent for the first 3 years.
Even though you paid the rent for 2000, 2001, and 2002, you can deduct only the rent for 2000
on your current tax return. You can deduct on your 2001 and 2002 tax returns the rent for those
years.
Contested liability. Under the cash method, you can deduct a contested liability only in the year
you pay the liability. Under an accrual method, you can deduct contested liabilities, such as taxes
(except foreign or U.S. possession income, war profits, and excess profits taxes), in the tax year
you pay the liability (or transfer money or other property to satisfy the obligation) or in the tax
year you settle the contest. However, to take the deduction in the year of payment or transfer,
you must meet certain conditions. See Contested Liability in Publication 538 for more
information.
Related person. Under an accrual method of accounting, you generally deduct expenses when
you incur them, even if you have not paid them. However, if you and the person you owe are
related and the person uses the cash method of accounting, you must pay the expense before you
can deduct it. The deduction by an accrual method payer is allowed when the corresponding
amount is includible in income by the related cash method payee. See Related Persons in
Publication 538.
Numerical Implication Statement:
Since you cannot deduct expenses in advance, even if you pay them in advance, the Fronks must
allocate the prepaid insurance on a monthly basis. The Fronks paid $4,561 for insurance on
3/1/1998. Thus, the monthly premium is $126.70. For 1998, the insurance deduction would be
$1267.00, 1999 is $1520.40, 2000 is $1520.40. The remaining balance of $253.20 would be
deducted in 2001.
Issue N15: Depreciation of Residential Rental Property (MOM: Tonya, 600
points; AUD: Andy B., 300 points; PR: -----, 300 points)
Path:
CCH Network; USMTG; Deductions (Chapters 9--12), ¶1089,
Deductions Attributable to Rental or Royalty Property, ¶1240, Classes
of Depreciable Property, ¶1243, Recovery Methods
Narrative Solution:
¶1240, Classes of Depreciable Property
The classes of depreciable property are defined in terms of Code Secs. 1245 and 1250 property
and the class life as of January 1, 1986.[ 2001FED ¶163.01 ] For purposes of the post-1986 rules,
Code Sec.1245 and Code Sec. 1250 property are defined under Code Sec. 1245(a)(3) and Code
Sec. 1250(c) , respectively (see ¶1785 and 1786 ), for purposes of determining gain. The class
life (or assigned class life) of an asset affects its recovery period, the method of depreciation
used, and the applicable convention. Under
MACRS, assets are classified according to their present class life as follows:
Three-Year Property. Three-year property includes property with a class life of four years or less.
Any race horse over two years old or any other horse over 12 years old at the time it is placed in
service is also classified as three-year property (Code Sec. 168(e)(1) and (3)).[ 2001FED ¶11,250
] For property placed in service after August 5, 1997, certain "rent-to-own" consumer durable
property (e.g., televisions and furniture) is
considered as three-year property (Code Sec. 168(e)(3)(iii) ). [ 2001FED ¶11,250 ]
Five-Year Property. Five-year property generally includes property with a class life of more
than four years and less than 10 years. This property includes: (1) cars, (2) light and heavy
general-purpose trucks, (3) qualified technological equipment, (4) computer-based telephone
central office switching equipment, (5) research and experimentation property that is Sec. 1245
property, (6) semi-conductor manufacturing equipment, (7) geothermal, solar and wind energy
properties, (8) certain biomass properties that are small power production facilities, (9)
computers and peripheral equipment, and (10) office machinery (typewriters, calculators, etc.)
(Code Sec. 168(e)(1) and (3)).[ 2001FED ¶11,250 ]
Furniture, appliances, and carpeting used in residential rental property is five-year property
(Announcement 99-82 ). Property used in wholesale or retail trade or in the provision of personal
and professional services for which a specific recovery period is not otherwise provided is fiveyear property (Asset Class 57.0 of Rev. Proc. 87-56 ).
Seven-Year Property. Seven-year property includes property with a class life of 10 years or more
but less than 16 years. This property includes any office furniture and fixtures, railroad track and
property that does not have a class life and is not otherwise classified (Code Sec. 168(e)(1) and
(3) ).[ 2001FED ¶11,250 ]
10-Year Property. Ten-year property is property with a class life of 16 years or more and less
than 20 years (e.g., vessels, barges, tugs, and single-purpose agricultural or horticultural
structures) (Code Sec. 168(e)(1) ).[ 2001FED ¶11,250 ] MACRS deductions for trees or vines
bearing fruit or nuts that are placed in service after 1988 are determined under the straight-line
method over a 10-year recovery period (Code Sec.
168(b)(1) ).[ 2001FED ¶11,250 ]
15-Year Property. Included within 15-year property is property with a class life of 20 years or
more but less than 25 years. It includes municipal wastewater treatment plants and telephone
distribution plants and other comparable equipment used for the two-way exchange of voice,
data communications, and retail motor fuels outlets (Code Sec. 168(e)(1) and (3) ).[ 2001FED
¶11,250 ]
20-Year Property. Twenty-year property includes property with a class life of 25 years and more,
other than Code Sec. 1250 real property with a class life of 27.5 years or more. Water utility
property and municipal sewers placed in service before June 13, 1996, and farm buildings are
included within this class (Code Sec. 168(e)(1) and (3) ).[ 2001FED ¶11,250 ]
25-Year Property. Water utility property and municipal sewers placed in service after June 12,
1996 are included in this class (Code Sec. 168(c) and (e)(5) ). The straight-line depreciation
method is mandatory for 25-year property (Code Sec. 168(b)(3)(F) ).
27.5-Year Residential Rental Property. Residential rental property (Code Sec. 168(e)(2)(A) )
[2001FED ¶11,250 ] includes buildings or structures with respect to which 80% or more of the
gross rental income is from dwelling units. It also includes manufactured homes that are
residential rental property and elevators and escalators.
¶1243, Recovery Methods
Under MACRS, the cost of depreciable property is recovered using (1) the applicable
depreciation method, (2) the applicable recovery period, and (3) the applicable convention (Code
Sec. 168(a) ). Instead of the applicable depreciation method, taxpayers may irrevocably elect to
claim straight-line MACRS deductions over the regular recovery period. The election applies to
all property in the MACRS class for which the election
is made that is placed in service during the tax year and is made on the return for the year such
property is firstplaced in service.
The cost of property in the 3-, 5-, 7-, and 10-year classes is recovered using the 200%
declining-balance method over three, five, seven, and ten years, respectively, and the half-year
convention, with a switch to the straight-line method in order to maximize the deduction (Code
Sec. 168(b)(1) ).[ 2001FED ¶11,250 ] The cost of 15- and 20-year property is recovered using
the 150% declining-balance method over 15 and 20 years, respectively, and the half-year
convention, with a switch to the straight-line method at a time to maximize the deduction (Code
Sec. 168(b)(2) ).[ 2001FED ¶11,250 ] The cost of residential rental and nonresidential real
property is recovered using the straight-line method and the mid-month convention (Code Sec.
168(b)(3) ).[ 2001FED ¶11,250 ]
Table 6. General Depreciation System
Applicable Depreciation Method: Straight Line
Applicable Recovery Period: 27.5 years
Applicable Convention: Mid-month
If the
Recovery
Year is:
1
And the Month in the First Recovery Year
the Property is Placed in Service is:
2
3
4
5
6
7
8
9
10
11
1.667
3.636
3.636
3.636
3.636
3.636
3.636
3.636
1.364
3.636
3.636
3.636
3.636
3.636
3.636
3.636
12
the Depreciation Rate is:
1
2
3
4
5
6
7
8
3.485
3.636
3.636
3.636
3.636
3.636
3.636
3.636
3.182
3.636
3.636
3.636
3.636
3.636
3.636
3.636
2.879
3.636
3.636
3.636
3.636
3.636
3.636
3.636
2.576
3.636
3.636
3.636
3.636
3.636
3.636
3.636
2.273
3.636
3.636
3.636
3.636
3.636
3.636
3.636
1.970
3.636
3.636
3.636
3.636
3.636
3.636
3.636
1.061
3.636
3.636
3.636
3.636
3.636
3.636
3.636
0.758
3.636
3.636
3.636
3.636
3.636
3.636
3.636
0.455
3.636
3.636
3.636
3.636
3.636
3.636
3.636
0.152
3.636
3.636
3.636
3.636
3.636
3.636
3.636
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636
0.000 0.000 0.000 0.000 0.000 0.000 0.152 0.455 0.758 1.061 1.364 1.667
Numerical Implication Statement:
Given the general cost recovery framework established in E29-2, the Fronks own and manage a
4-unit apartment building acquired on May 22, 1996 for $400,000. The basis for depreciation is
$320,000 (80% of $400,000). The Fronks must depreciate the rental property over 27.5 years
using the mid-month convention. In 1996, the depreciation percentage was 2.273%. In 2000,
the depreciation is 3.636%. Thus, the depreciation expense for 2000 is $11,635.20 ($320,000 X
3.636%). As noted in Issue N13, cost recovery is a deduction from gross income.
Issue N16: Passive Losses and Rental Real Estate Activity (MOM: Tonya, 500
points; AUD: Andy B., 250 points; PR: -----, 250 points)
Path:
CCH Network; USMTG - Tax Shelters -- At-Risk Rules -Passive Losses (Chapter 20) - USMTG ¶2053, General Rules,
¶2063, Active Participation in Rental Real Estate Activity
Narrative Solution:
USMTG ¶2053, General Rules
Generally, losses from passive activities may not be deducted from other types of income (for
example,wages, interest, or dividends) (Code Sec. 469 ).[ 2001FED ¶21,960 ] Similarly, tax
credits from passive activities are generally limited to the tax allocable to those activities. In
determining a taxpayer's allowable loss, the at-risk rules discussed at ¶2045 are applied before
the passive activity loss rules.
Generally, to the extent that the total deductions from passive activities exceed the total income
from these activities for the tax year, the excess (the passive activity loss) is not allowed as a
deduction for that year. A disallowed loss is suspended and carried forward as a deduction from
the passive activity in the next succeeding tax year (Reg. §1.469-1(f)(4) ).[ 2001FED ¶21,961B ]
Any unused suspended losses are allowed in full when the taxpayer disposes of his entire interest
in the activity in a fully taxable transaction (CodeSec. 469(g) ) (see ¶2076 ).[ 2001FED ¶21,960 ]
Special rules apply to rental real estate activities in which a taxpayer actively participates (see
¶2063 ). Losses and credits that are attributable to limited partnership interests are generally
treated as arising from a passive activity (Code Sec. 469(h)(2) ).[ 2001FED ¶21,960 ] Losses
from working interests in oil and gas property are not subject to the limitation (Code Sec.
469(c)(3) ).[ 2001FED ¶21,960 ]
The passive loss rules do not apply to a rental of a taxpayer's residence if the residence is
covered by the rules pertaining to vacation home rentals and home office deductions (Reg.
§1.469-2(d)(2)(xii) )[ 2001FED ¶21,962B ] (see ¶961 ).
Most taxpayers use Forms 8582 and 8582-CR to calculate their allowable passive losses and
credits. Form 8810 is used by personal service corporations and closely held C corporations.
Form 8825 is used by partnerships and S corporations to report income and deductible expenses
from rented real estate activities.
¶2063, Active Participation in Rental Real Estate Activity
There is a limited exception to the passive loss rules in the case of losses from rental real estate
in which the taxpayer actively participates (Code Sec. 469(i) ).[ 2001FED ¶21,960 ] The
exception is available only to individual taxpayers or their estates for tax years ending less than
two years after the date of death. An individual may meet the active participation requirement if
he participates in the making of management decisions (for example, deciding on rental terms) or
arranges for others to provide services (for example, repairs) in a significant and bona fide
sense.[ 2001FED ¶21,966.0353 ] The requirement for active participation applies in the year in
which the loss arose as well as the year in which the loss is allowed under the $25,000 allowance
rule. (However, real estate professionals may be able to treat rental property activities as
nonpassive activities (¶2064 ).)
Under this exception, up to $25,000 of passive losses and the deduction equivalent of tax credits
that are attributable to rental real estate may be used as an offset against income from nonpassive
sources (forexample, dividends and wages) each year. To be eligible for this exception, the
individual must own at least a 10% interest (Code Sec. 469(i)(6) ).[ 2001FED ¶21,960 ] This
$25,000 maximum amount is reduced, but not below zero, by 50% of the amount by which the
individual's adjusted gross income exceeds $100,000.
"Adjusted gross income," for purposes of this exception, disregards adjustments to income for
social security benefits, qualified U.S. savings bonds, adoption assistance programs, qualified
retirement contributions and passive activity losses (Code Sec. 469(i)(3)(E) ).[ 2001FED ¶21,960
] The $25,000 is completely phased out when adjusted gross income reaches $150,000 (Code
Sec. 469(i)(3) ).[ 2001FED ¶21,960 ] For married
taxpayers who file separate returns and live apart, up to $12,500 of passive losses may be used to
offset income. This amount is reduced by 50% of the amount by which the taxpayer's adjusted
gross income exceeds $50,000 (Code Sec. 469(i)(5) ).[ 2001FED ¶21,960 ]
For the rehabilitation tax credit (see ¶1347 ), the phaseout range for offsetting tax on up to
$25,000 of nonpassive income is between $200,000 and $250,000 of adjusted gross income; no
AGI limitation applies to the low-income housing credit (¶1334 ) (Code Sec. 469(i)(3) ).[
2001FED ¶21,960 ] The individual need not actively participate in the activity to which the
credits relate (Code Sec. 469(i)(6)(B) ).[ 2001FED ¶21,960 ]
Numerical Implication Statement:
Rental activity is a passive activity by definition. Thus, the passive loss framework set forth in
Issue N8 is relevant. In addition, that logic is moderated by the rental real estate exception.
Expenses related to producing the income are deductions from gross income to the extent that
they do not exceed the income. Up to $25,000 of passive losses may be used to offset other
income such as wages if the taxpayer’s AGI does not exceed $100,000. The $25,000 is
completely phased out when adjusted gross income reaches $150,000, therefore the Fronks
cannot use any passive losses to offset other income. Fortunately, there is sufficient passive
income from Crown Enterprises and the vacation rental home to easily absorb the excess
deductions associated with the apartment complex.
Issue N17: Worthless Small Business Stock (MOM: Andy B., (400 - 100)
points; AUD: Jill, Karie, (200 - 50) points; PR: -----, 200 points)
Path:
CCH Online; USMTG; "small business stock" w/par loss; ¶2395,
Code Sec. 1244 Stock
Narrative Solution:
An individual may deduct, as an ordinary loss, a loss from sale or exchange, or from
worthlessness, of “small business stock” (more commonly called “Code Sec. 1244 stock”) issued
by a qualifying small business corporation. A corporation qualifies if the amount of money and
other property it receives as a contribution to capital, and as paid-in surplus, does not exceed $1
million (Code Sec. 1244(c)(3)). This determination is to be made at the time the stock is issued
and must take into account amounts received for such stock and for all stock previously issued.
Property (other than money) is taken into account at its adjusted basis to the corporation for
figuring gain, less any liabilities to which the property was subject or that were assumed by the
corporation.[ 2001FED ¶30,790] In addition to satisfying many statutory requirements, including
one stipulating a percentage of gross receipts from nonpassive sources, the corporation must be
“largely an operating company.” [ 2001FED ¶30,800] However, the stock must have been issued
to the taxpayer or to the taxpayer’s partnership. The maximum amount deductible as an ordinary
loss in any one year is $50,000 ($100,000 on a joint return) (Code Sec. 1244(b)). The ordinary
loss allowed on this stock is a business loss for the purpose of determining a net operating loss
deduction (Code Sec. 1244(d)(3)).[ 2001FED ¶30,790]
Numerical Implication Statement:
Small business stock, i.e. stock in a company whose paid-in surplus does not exceed $1,000,000,
that becomes worthless results in an ordinary loss to the extent of unrecaptured capital but not to
exceed $100,000 for married filing jointly couples. The Fronks' $75,000 loss is reported in
income broadly conceived as an ordinary loss.
Issue N18: Wash Sale -- Reacquisition of BioGen Corporation stock (MOM:
Katherine, 500 points; AUD: Karrie, 250 points; PR: -----, 250 points)
Path:
CCH Network; Guidebook, 2001 USMTG ¶1935, Wash Sale Losses
Denied; IRC, 2001-CODE-VOL, SEC. 1091. LOSS FROM WASH
SALES OF STOCK OR SECURITIES.
Narrative Solution:
¶1935, Wash Sale Losses Denied
A loss sustained upon a sale or other disposition of stock or securities is not allowed if,
within a period beginning 30 days before the date of the sale or disposition and ending 30 days
after that date, the taxpayer has acquired, or has entered into a contract or option to acquire,
substantially identical stock or securities (Code Sec. 1091(a) ; Reg. §1.1091-1 ).[ 2001FED
¶30,180 , 2001FED ¶30,181 ] Similarly, a loss realized on the closing of a short sale of stock or
securities is disallowed if within 30 days before or after the closing substantially identical stock
or securities are sold or another short sale of substantially identical stock or securities is entered
into (Code Sec. 1091(e) ).[ 2001FED ¶30,180 ] The term “stock or securities” includes contracts
or options to acquire or sell stock or securities (except as provided in regulations).
An acquisition by gift, bequest, inheritance, or tax-free exchange that is made within the 61day period does not bring the wash sale rule into play. The proscribed period is not cut off by the
end of a tax year. Also, nonrecognition of loss cannot be avoided by arranging for delivery
outside the 61-day period since the contract date fixes the date of loss if the obligation to deliver
becomes fixed on that date.[ 2001FED ¶30,183.104 ] See, also, the discussion on short sales at
¶1944 .
The wash sale rule applies to all classes of taxpayers, including corporations, except that it
does not apply to stock or securities dealers for losses sustained in a transaction in the course of
business.
Where shares of the same corporation are purchased in separate lots, sold at the same time,
and then reacquired within the prohibited time period, a loss on one lot may not be claimed to
reduce the gain from the other shares.[ 2001FED ¶30,183.11 ] The U.S. Supreme Court has
disallowed deduction of a loss incurred when identical securities were purchased by a taxpayer’s
spouse.[ 2001FED ¶30,183.109 ]
For application of the wash sale rules to commodity futures contracts involving tax straddle
positions, see ¶1948 .
1091(a) DISALLOWANCE OF LOSS DEDUCTION.-In the case of any loss claimed to have been sustained from any sale or other disposition of
shares of stock or securities where it appears that, within a period beginning 30 days before the
date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by
purchase or by an exchange on which the entire amount of gain or loss was recognized by law),
or has entered into a contract or option so to acquire, substantially identical stock or securities,
then no deduction shall be allowed under section 165 unless the taxpayer is a dealer in stock or
securities and the loss is sustained in a transaction made in the ordinary course of such business.
For purposes of this section, the term “stock or securities” shall, except as provided in
regulations, include contracts or options to acquire or sell stock or securities.
1091(d) UNADJUSTED BASIS IN CASE OF WASH SALE OF STOCK.-If the property consists of stock or securities the acquisition of which (or the contract or
option to acquire which) resulted in the nondeductibility (under this section or corresponding
provisions of prior internal revenue laws) of the loss from the sale or other disposition of
substantially identical stock or securities, then the basis shall be the basis of the stock or
securities so sold or disposed of, increased or decreased, as the case may be, by the difference, if
any, between the price at which the property was acquired and the price at which such
substantially identical stock or securities were sold or otherwise disposed of.
Numerical Implication:
A wash sale occurs when identical stock is acquired within plus or minus 30 days of the sale of
the old stock. A loss from such a sale is disallowed. The basis of the new BioGen stock is
$23,000. That is, the basis of the new stock is equal to the basis of the old securities, $22,000,
increased by the difference between the selling price of the old stock, $9,000, minus the purchase
price of the new, $8,000. Thus, the sell of the new stock results in a long-term capital gain of
$9,000 ($32,000 - 23,000). As noted in issue E14-1, the sale will appear in income broadly
conceived and the resulting gain will be taxed at a maximum rate of 20 percent.
Issue N19: Legal Fees - Will (MOM: Robyn, 300; AUD: Amanda, Frank, 150
points; PR: -----, 150 points)
Path:
CCH Network; USMTG; Spine, Deductions (Chapters 9--12),
Nonbusiness Expenses (Chapter 10), Legal Fees; ¶1093, Legal
Expenses
CCH; USMTG; Word Search – “Legal Fees to Update Wills”, ¶57,
Checklist for Deductions
Narrative Solution:
Legal expenses are deductible, as miscellaneous itemized deductions on Schedule A of Form
1040 , subject to the 2% floor (¶1011 ), if they are paid or incurred for the production of income
or for the management, conservation, or maintenance of income-producing property.[ 2001FED
¶12,521 ] Legal expenses paid or incurred in recovering investment property and amounts of
income includible in gross income are deductible (Reg. §1.212-1(k) ).[ 2001FED ¶12,521 ]
However, legal expenses incurred in defending or perfecting title to property, in the acquisition
or disposition of property, or in developing or improving property must be capitalized.
Generally, legal expenses paid by one spouse in resisting the other's monetary demands in
divorce are nondeductible personal expenses. However, legal expenses for collecting alimony
under a divorce decree are deductible, as a miscellaneous itemized deduction, subject to the 2%
floor (¶1011 ).[ 2001FED ¶12,523.3273 ]
GUIDEBOOK, 2001USMTG ¶57, Checklist for Deductions
The Internal Revenue Code permits a number of wide-ranging deductions that may be taken into
account in arriving at taxable income. However, the Code contains a number of rules and
restrictions concerning the expenses that qualify as deductions and the taxpayers who may claim
them. Although deductions generally reduce taxable income, deductions from gross income,
available to all qualifying taxpayers, must be distinguished from deductions from adjusted gross
income, available only to those taxpayers who itemize. Certain miscellaneous itemized
deductions, including unreimbursed employee business expenses and investment expenses, are
deductible by an individual only if the aggregate amount of such deductions exceeds two percent
of adjusted gross income (see 2001FED ¶6064.01 of the STANDARD FEDERAL TAX
REPORTER). In addition, deductions that can be taken currently must be distinguished from
those that can be taken over a number of tax years through depreciation or amortization.
The chart below lists a number of expenses that a taxpayer might incur. The chart indicates for
each expense a symbol(s) representing the possible availability of a deduction, its timing, and
whether it is deductible from gross income or adjusted gross income. Many deductions have
special rules. The chart also provides the STANDARD FEDERAL TAX REPORTER paragraph
number where further information on the deduction may be found.
The following symbols are used:
D/GI = Deductible from gross income
D/AGI = Deductible from adjusted gross income
D/Am = Deductible over a period of time
ND = Nondeductible
Attorney's fees
. accounting suit by former partner, defense of ... D/GI, 2001FED ¶13,603.243
. acquisition of corporate control ... ND, 2001FED ¶8526.4213
. business debts, collection of ... D/GI, 2001FED ¶8526.429
. condemnation proceeding, defense of ... ND, 2001FED ¶8526.4198
. disbarment proceedings ... D/GI, 2001FED ¶8526.032
. divorce, 2001FED ¶13,603.223
. . obtaining alimony ... D/GI, 2001FED ¶13,603.223
. . proceedings ... ND, 2001FED ¶13,603.223
. . property settlement ... ND, 2001FED ¶13,603.223
. personal affairs ... ND, 2001FED ¶13,603.01
. slander prosecution (personal) ... ND, 2001FED ¶13,603.253
. tax advice on investments ... D/AGI, 2001FED ¶12,523.346
. title clearance
. . land ... ND, 2001FED ¶8526.469
. . stock ... ND, 2001FED ¶13,709.93
. will preparation ... ND, 2001FED ¶13,603.259
CCH-ANNO, 2001FED ¶13,603.259, Personal, Living, and Family Expenses: Will drafting. --
Numerical Implication Solution:
For the legal fees that were incurred in the amount of $1,320 for updating their wills are not
deductible because they are personal expenses. Fees paid by an individual for general personal
legal services, including preparation of a will, are not deductible. Therefore there is no effect on
the tax formula
Issue N20: Health Insurance - Self-employed Individuals (MOM: Jill, 400
points; AUD: Jana, Garit, 200 points; PR: -----, 200 points)
Path:
CCH Network; USMTG; Spine; Business Expenses (Chapter 9);
Health Insurance Plan; ¶908, Disability Payments; Contributions for
Employee
Narrative Solutions:
¶908, Disability Payments; Contributions for Employee
An employer's deduction for contributions to a funded welfare benefit plan for sickness,
accident, hospitalization or medical benefits is governed by Code Sec. 419 (Temporary Reg.
§1.162-10T ).[ 2001FED ¶8751 ] See ¶2198 and ¶2199 . Although amounts that are added to a
self-insurance reserve account are not currently deductible, actual losses charged to the account
are deductible.[ 2001FED ¶8522.3947 ]
Group health plans that fail to provide continuing coverage to qualified beneficiaries
may subject employers to an excise tax (Code Sec. 4980B ).[ 2001FED ¶34,600 ]
Self-Employed Persons. For 2000, self-employed persons may deduct from gross
income 60% of amounts paid during the year for health insurance for themselves, spouses, and
dependents from gross income (Code Sec. 162(l)(1)(B) ).[ 2001FED ¶8500 ] The deduction is
limited to the taxpayer's net earned income derived from the trade or business for which the
insurance plan was established, minus the deductions for 50% of the self-employment tax and/or
the deduction for contributions to Keogh, self-employed SEP or SIMPLE plans. The selfemployed health insurance deduction remains at 60% for 2001, and then increases to 70% in
2002, and 100% in 2003 and thereafter (Code Sec. 162(l)(1) ). Amounts eligible for the
deduction do not include amounts paid during any month, or part of a month, that the selfemployed individuals were able to participate in a subsidized health plan maintained by their
employers or their spouses' employers (Code Sec. 162(l)(2)(A) ).
¶1019, Health and Accident Insurance Premiums
Health and Accident Insurance Premiums
A medical expense deduction is allowed for premiums paid for medical care insurance
(including contact lens insurance),[ 2001FED ¶12,543.77 ] subject to the 7.5% limitation (¶1015
). If an amount is payable under an insurance contract for other than medical care (such as
indemnity for loss of income or life, limb, or sight), no amount paid for the insurance is
deductible unless the medical care charge is stated separately in the contract or furnished in a
separate statement. Premiums paid by a taxpayer before age 65 for medical care insurance for the
taxpayer, the taxpayer's spouse, or a dependent, effective after age 65, are considered to be
medical expenses in the year paid if the premiums are payable (on a level payment basis) under
the contract (1) for a period of 10 years or more or (2) until the year the taxpayer reaches age 65
(but in no case for a period of less than five years) (Reg. §1.213-1(e) ).[ 2001FED ¶12,541 ]
The premiums for long-term care insurance contracts was added to the definition of
"medical care" for tax years beginning after December 31, 1996. The premiums eligible for the
medical deduction are those paid during the year for a qualified long-term care insurance
contract. The amount of the premium that is deductible is limited by the age of the individual at
the close of the tax year. The inflation-adjusted maximum deductible amount for 2000 is: age 40
or less, $220; age 40 through 49, $410; age 50 through 59, $820; age 60 through 69, $2,200; and
age 70 or older, $2,750. The amounts for 2001 are $230, $430, $860, $2,290, and $2,860,
respectively (Code Sec. 312(d)(10), Rev. Proc. 99-42 , Rev. Proc. 2001-13 ).
Amounts paid as self-employment tax (¶2664 ) or as employee tax (¶2648 ) for hospital
insurance under the Medicare program are not medical expenses. Similarly, the basic cost of
Medicare insurance (Medicare A) is not deductible, unless voluntarily paid by the taxpayer for
coverage. However, the cost of extra Medicare (Medicare B) is deductible.[ 2001FED
¶12,543.49 ] Self-employed persons can deduct from gross income 60% of amounts paid for
health insurance coverage in 2000 and 2001, 70% in 2002, and 100% in 2003 and thereafter. For
details, see ¶908 .
Narrative Implication Statement:
The Fronks made a $5000 contribution to a health insurance plan for themselves. This is
deductible up to 60%, however; self-employed individuals are not eligible for the deduction if
the amounts paid were paid during any month, or part of a month, that the self-employed
individuals were able to participate in a subsidized health plan maintained by their employers or
their spouses' employers. Since Monica has a plan through the state that covers Tom and the
children, none of the $5000 contribution is deductible from gross income. However, the
contribution will be deductible as medical expenses through an itemized deduction subject to a
7.5% AGI floor, but the Fronks will probably not benefit from this because their AGI is too high.
Issue N21: Amy and James’ Dependency Exemptions (MOM: Katherine, (900
- 800) points; AUD: Karrie, (720 - 640) points; PR: 450 points)
Narrative Solution:
Gross Income Test:
Community Property:
Path: CCH Online; USMTG; Idaho; ¶710, Community Property Income.
In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico,
Texas, and Washington (under the provisions of the Wisconsin Marital Property Reform Act, the
rights of spouses in Wisconsin may also be considered community property rights [98FED
¶2350.01])), the property acquired by a husband and wife after their marriage is generally
regarded as owned by them in community, and income from such property is community income
divisible equally between them. Although each state has exceptions in classifying income as
separate or community property, the general rule is that salaries, wages, and other compensation
for the services of either or both the husband and wife are community income. But it does not
follow in every state that income from separate property is separate income. The states also differ
in their treatment of property acquired by inheritance or intestate succession. However, the IRS
can disallow the benefits of any community property law to a spouse for any income that the
spouse treats as his or hers alone if that spouse fails to notify the other spouse of the nature and
amount of income (Code Sec. 66(b)) [98FED ¶6050].
Tuition Waivers
Path: CCH-ANNO, 2001FED ¶7183.65, Scholarships and Fellowship Grants: Spouse of
employee.-Tuition waivers granted to the wife of a medical school employee to attend the medical school
were disinterested scholarships rather than additional compensation for services because the
employee was not required to perform services in exchange for the waivers beyond his usual,
fully compensated services. Although the waivers were received after the enactment of Code
Sec. 117(d) , which eliminated the exclusion for graduate level studies, they were excludable
from gross income as scholarships under a transitional rule provided by the Tax Reform Act of
1986.
Path: Linked to Sec. 117(d):
IRC, 2001-CODE-VOL, SEC. 117. QUALIFIED SCHOLARSHIPS.
117(d) QUALIFIED TUITION REDUCTION.--
117(d)(1) IN GENERAL.--Gross income shall not include any qualified tuition reduction.
117(d)(2) QUALIFIED TUITION REDUCTION.--For purposes of this subsection, the term
“qualified tuition reduction” means the amount of any reduction in tuition provided to an
employee of an organization described in section 170(b)(1)(A)(ii) for the education (below
the graduate level) at such organization (or another organization described in section
170(b)(1)(A)(ii) ) of-117(d)(2)(A) such employee, or
117(d)(2)(B) any person treated as an employee (or whose use is treated as an employee
use) under the rules of section 132(h) .
117(d)(3) REDUCTION MUST NOT DISCRIMINATE IN FAVOR OF HIGHLY COMPENSATED, ETC.-Paragraph (1) shall apply with respect to any qualified tuition reduction provided with respect
to any highly compensated employee only if such reduction is available on substantially the
same terms to each member of a group of employees which is defined under a reasonable
classification set up by the employer which does not discriminate in favor of highly
compensated employees (within the meaning of section 414(q) ). For purposes of this
paragraph, the term “highly compensated employee” has the meaning given such term by
section 414(q) .
117(d)(5)[4] SPECIAL RULES FOR TEACHING AND RESEARCH ASSISTANTS.--In the case of the
education of an individual who is a graduate student at an educational organization described in
section 170(b)(1)(A)(ii) and who is engaged in teaching or research activities for such
organization, paragraph (2) shall be applied as if it did not contain the phrase “(below the
graduate level)”.
Support
Tuition waivers not included (given immediately preceding paragraph and support analysis in
Issue E4-1).
Joint return
Path: CCH Online; USMTG; "joint return" w/par "married child"; ¶145, Exemption for
Married Child.
Generally, a parent may claim a married child as a dependent only if the child does not file a
joint return and otherwise qualifies as a dependent. If the support test is met, a parent may
claim a married child and his or her spouse as dependents, even though they file a joint return, if
neither is required to file a return for the year (the filing being merely for the purpose of
claiming a refund) [98FED ¶8005.11].
Path: CCH Online; Federal Taxes; "dependency exemption" w/par "joint return"; TC, [CCH
Dec. 35,607] , WILLIAM J. AND LORETTA C. MARTINO, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT, [Credits and
exemptions: Dependency exemption: Daughter-in-law: Dependent filing joint return.]--,
(Dec. 28, 1978)
[Appealable, barring stipulation to the contrary, to CA-2.--CCH]
[Code Sec. 152 ]
[Credits and exemptions: Dependency exemption: Daughter-in-law: Dependent filing joint
return.]--Petitioners’ daughter-in-law had no income during the taxable year 1975. Over half of
her support was furnished by petitioners during the year 1975. The daughter-in-law signed a
joint return for 1975 with her husband which reported all the husband’s earnings in 1975 and
claimed a refund for all income tax withheld from those earnings. The total income of the
daughter-in-law and her husband was not sufficient to require the filing of a return by the
daughter-in-law and her husband since they were entitled to file a joint return. No tax liability
would exist for either the daughter-in-law or her husband for 1975 on the basis of a married
individual filing a separate return. Petitioners claimed a dependency exemption for their son and
their daughter-in-law.Held: (1) Petitioners are not entitled to a dependency exemption
deduction for their son for 1975 since they have failed to show that they contributed over onehalf of his support in that year; and (2) the joint return filed by petitioners’ daughter-in-law with
her husband for the year 1975 constituted a claim for refund and therefore, under Rev. Rul. 54567 , 1954-2 C.B. 108 and Rev. Rul. 65-34 , 1965-1 C.B. 86 which we approve, petitioners are
entitled to a dependency exemption deduction for their daughter-in-law for 1975.
Numerical Implication Statement:
Given the general dependency exemption framework noted in Issue E4-1, we now consider
specific wrinkles to several of those tests. With regard to the gross income test, since James and
Amy live in a community property state, they will each be deemed to have income of $5,517.50
(i.e., ($4,000 + $7,000 + $35) * .50)). Notice that those computations did not include Amy's
tuition waivers because they are scholarships used to cover qualified expenses (i.e., tuition).
With $5,517.50 each, the gross income test is failed in a general sense. However, the gross
income test has an exception for students. Children of the taxpayers can earn an unlimited
amount of income so long as the child student is under the age of 24 and attends a qualified
educational institution for at least part of 5 months during the year. This exception is sufficient
to preserve Amy's exemption but not James because he is not a child of the taxpayers. From a
support perspective, Amy's tuition waiver is not counted because of its scholarship like character.
With only $10,500 in support versus the $11,035 of Amy and James, it appears that the Fronks
failed the support test. However, if Amy and James earned $35 in interest income during the
year and the interest rate is 3.5 percent, Amy and James must have had an average balance or
$1,000 in their bank account. Since any unspent income is not counted towards the support test
(see Issue E4-1) and Amy and James appear to have had $1,000 of such income, their support is
just $10,035. Thus, the Fronks squeak by on the support test. Amy and James' filing of a joint
return appears fatal to the joint-return test. However, if they Amy and James satisfy three
conditions, the filing of the joint return is not fatal, 1) the Fronks meet the support test, 2) Amy
and James didn't have to file, and 2) they had no tax liability had they filed married filing
separately. For purposes of evaluating if Amy and James had to file, the Martino case seems to
suggest that we evaluate the filing and the married-filing separate requirements independent of
the possibility that Casselmans’ exemptions are claimed on another taxpayer’s return. The
Casselmans $11,035 of income is less than the $12,950 (see Issue E6-1) that triggers the need to
file. Furthermore, on separate returns (again assuming for the moment that they get their
exemption amounts), Amy and James wouldn't have a liability unless they had over $6,475 in
gross income. They don't. Thus, it appears that all of the tests were satisfied for Amy and all but
one test was satisfied for James.
Issue N22: Charitable Contribution -- Sole Proprietorship (MOM: Tonya,
400 points; AUD: Frank, 200 points; PR: -----, 200 points)
Path:
CCH Online; Standard Federal Tax Reporter; "charitable
contribution" w/par "business deduction"; CCH-EXP, 2001FED
¶8853.021, Contributions and Dues as Business Expenses: Business
expense v. charitable contribution.-Narrative Solution:
Business expense deductions are not allowed for charitable contributions or gifts that are
deductible under Code Sec. 170 (Code Sec. 162(b) and Reg. §1.162-15(a) ). In some situations,
however, a payment to a charitable organization may be deductible as a business expense, rather
than as a charitable contribution. A business expense deduction may be preferable because the
limitations of Code Sec. 170 would not apply.
The limitation of Reg. §1.162-15(a) , with respect to transfer of property to charitable
organizations, applies only to transfers that are in fact gifts or contributions (Reg. §1.16215(a)(2) ).
Transfers of property to a charitable organization that bear a direct relationship to the
taxpayer’s business and that are made with a reasonable expectation of financial return
commensurate with the amount of the transfer may constitute allowable deductions as
trade or business expenses rather than as charitable contributions (Reg. §1.170A-1(c)(5) ).
Thus, when a taxpayer engaged in a trade or business makes such a transfer of property, the
transfer is deductible as an ordinary and necessary business expense. Conversely, when a
taxpayer engaged in a trade or business makes a voluntary contribution of property
without a reasonable expectation of a financial return to the trade or business, the
deductibility of the transfer is to be determined under rules that apply to deductions for
charitable contributions (Code Sec. 170 ), and no business deduction is allowed with respect
to the transfer. These rules apply regardless of whether the recipient is an organization
described in Code Sec. 170 (Reg. §1.162-15(b) ). Whether a particular transfer was made with a
reasonable expectation of a financial return, commensurate with the amount of the transfer, is a
question of fact (Rev. Rul. 73-113 , ¶8853.1554 ).
Path: CCH Online; Standard Federal Tax Reporter; "charitable contribution" w/par partnership;
CCH-EXP, 2001FED ¶880.03, Comparison Chart for Choosing Form of Business
FACTOR
PARTNERSHIP CORPORATION S
MULTICORPORATION MEMBER LLC*
Charitable Contributions
Under Code
Sec. 702,
charitable
contributio
are not
deductible
by the
partnership
but are
deductible
by the
partners
subject to
their
individual
limitations
Deductible
by the
corporation
Limited to
10% of
taxable
income,
before
contributio
Excess may
be carried
over five
years.
Code Sec.
Same as
1366
partnership
applies in
the same
manner as
the rules
for a
partnership
and
partner.
Numerical Implication Statement:
This documentation suggests that the Dentistry's charitable contribution will flow through to the
owner of sole proprietorship and will be subjected to the usual charitable contribution logic (see
E10-1).
Issue N23: Employment Related Expenses (MOM: Kevin, 300 points;
AUD: Nate, Akiko, 150 points; PR: -----, 150 points)
Path:
Employment related expenses RIA Checkpoint; 2001 FTH;
Deductible Expenses; ¶ 3109 Miscellaneous itemized
deductions – 2%-of-AGI floor.
Narrative Solution:
Miscellaneous itemized deductions include unreimbursed employee business expenses,
including union and professional dues and home office expenses; expenses related to
investment income or property, such as investment counsel or advisory fees; tax return
preparation costs and related expenses; appraisal fees paid to determine the amount of a
casualty loss or a charitable contribution of property; and hobby expenses to the extent of
hobby income.
If an expense relates to both a trade or business activity (not subject to the 2% floor) and
a production of income or tax preparation activity (subject to the 2% floor) the taxpayer
must allocate it between the activities on a reasonable basis.
Path: RIA Checkpoint; 2001 FTH; Deductible Expenses; ¶ 1624 Employee Business
Expenses.
Employees are engaged in the trade or business of being employees and thus can deduct
certain ordinary and necessary expenses within limits.
Employees may deduct their employment-connected business expenses such as travel
expenses, union dues, work clothes, etc., as described in the following paragraphs.
Unreimbursed employee business expenses are generally deductible only as miscellaneous
itemized deductions subject to the 2%-of-AGI floor.
Numerical Implication Statement:
Monica's employment related expenses are deductible as miscellaneous itemized deductions
subject to a 2 percent AGI floor. Thus, Monica's $1,140 in subscriptions, dues, and journals is
deductible.
Issue N24: Business Bad Debts of a Cash Basis Taxpayer (MOM: Jana, 500
points; AUD: Jill, 250 points; PR: -----, 250 points)
Path:
CCH Network; USMTG; Spine, Write-off (Chapter 9-12),
Deductions; ¶1104, When Is a Loss Sustained?
¶1104, When Is a Loss Sustained?
Generally a loss is deductible only for the tax year in which it is sustained (but see ¶1141 ), i.e.,
the tax year in which its occurrence is evidenced by closed and completed transactions and is
fixed by identifiable events occurring in such tax year (Reg. §1.165-1(d)(1) ).[ 2001FED ¶9803 ]
No deduction may be claimed in the year of loss for any portion of the loss for which there
remains a reasonable prospect of recovery. A deduction may be taken in the year in which it
becomes reasonably certain that there will be no recovery (Reg. §1.165-1(d)(2) ).[ 2001FED
¶9803 ]
No deduction is available for a partial loss resulting from the shrinkage in value of property,
except as reflected in an inventory.[ 2001FED ¶9805.01 ] An exception to this rule is the
chargeoff of the worthless part of a business debt (see ¶1145 ). See ¶1157 regarding changes in
the deduction of an addition to a reserve for bad debts. According to the Tax Court, where life
insurance on the life of one partner is intended to compensate the surviving partner for the loss of
his investment in the partnership caused by the death, no deductible loss is incurred.[ 2001FED
¶9804.33 ]
CCH-EXP, 2001FED ¶10,650.021, Bad Debts: Business v. nonbusiness bad debts.-Nonbusiness bad debts are deductible by taxpayers other than corporations only as short-term
capital losses (Code Sec. 166(d) ), are subject to the limitations on deductions for capital losses,
and are reported on Schedule D (Form 1040). In addition, an S corporation that has a
nonbusiness bad debt must separately state the debt as a short-term capital loss (Rev. Rul. 93-36 ,
1993-1 CB 187; see ¶10,700.66 ). No deduction may be claimed for a partially worthless
nonbusiness bad debt (see ¶10,700.021 ; see, also, ¶30,392.01 et seq.).
A business bad debt is deductible by both corporate and noncorporate taxpayers to the full extent
of its worthlessness, without limitation. If accounts receivable, notes receivable, or both are
created or acquired in connection with a trade or business and become worthless, they are
business bad debts.
Corporate debts are business debts. Debts of corporations are business debts. With respect to
other taxpayers, a debt is a business debt only if it is created or acquired in connection with a
trade or business of the taxpayer claiming the deduction, or if the loss from worthlessness of the
debt is incurred in his trade or business.
For a discussion of the distinction between business and nonbusiness bad debts, see ¶10,700.03 .
Decisions on the question of whether loans result in business or nonbusiness bad debts are
annotated following ¶10,700.10 .
¶1145, Business Bad Debts
Business bad debts, which arise from the taxpayer's trade or business, differ from nonbusiness
bad debts (see ¶1169 ) in that they can be deducted to the extent of their worthlessness at any
time when they become partly or totally worthless and they can, generally, be deducted from
gross income. A "business debt" is a debt (1) created or acquired in connection with the trade or
business of the taxpayer who is claiming the deduction or (2) the worthlessness of which has
been incurred in the taxpayer's trade or business (Reg. §1.166-5(b) ).[ 2001FED ¶10,691 ] A
business bad debt deduction, however, is not available to shareholders who have advanced
money to a corporation as a contribution to capital [ 2001FED ¶10,650.7301 ] or to creditors
who hold a debt that is evidenced by a bond, debenture, note, or other evidence of indebtedness
that is issued by a corporation or by a governmental unit, with interest coupons or in registered
form (Code Sec. 165(g)(2)(C) ).[ 2001FED ¶9802 ] Nonbusiness bad debts are treated as shortterm capital losses, subject to a $3,000 ($1,500 for married individuals filing separate returns)
(see ¶1752 and 1757 ) per year deduction limitation, and are deductible only when totally
worthless.
A noncorporate taxpayer who incurs a loss arising from his guaranty of a loan is entitled to
deduct the loss only if the guaranty arose out of his trade or business or in a transaction entered
into for profit. If the guaranty was connected with a trade or business, the resulting loss is an
ordinary loss (business bad debt). If the guaranty was not connected with a true trade or business
but was profit-inspired, the resulting loss is a short-term capital loss (nonbusiness bad debt). No
deduction is available if the guaranty payment does not fall within the above categories, if there
is no legal obligation on the taxpayer to make the guaranty payment, or if the guaranty was
entered into after the debt became worthless.[ 2001FED ¶10,800.01 ]
Since the tax treatment accorded business bad debts and nonbusiness bad debts differs, the
taxpayer must show that his dominant motivation in making the payment was business-related in
order to obtain the more favorable tax treatment.[ 2001FED ¶10,700.03 ]
¶1148, Time of Deduction
A cash-basis taxpayer can deduct a bad debt only if an actual cash loss has been sustained or if
the amount deducted was included in income. Nearly all accrual-basis taxpayers must use the
specific chargeoff method to deduct business bad debts; the reserve method for computing and
deducting bad debts on receivables may be used only by small banks and thrift institutions.
Specific chargeoff is based on actual worthlessness and is not applicable merely because the
taxpayer gives up attempts to collect (see ¶1157 ). A worthless debt arising from unpaid rent,
interest, or a similar item is not deductible unless the income that such item represents has been
reported for income tax purposes by a taxpayer on the accrual basis.[ 2001FED ¶10,650.023 ]
¶1157, Reserve for Bad Debts
The reserve method for computing and deducting bad debts on receivables may be used only by
small banks.[ 2001FED ¶10,690.01 , 2001FED ¶23,650 ] Consequently, nearly all accrual-basis
taxpayers must use the specific charge-off method for receivables that become uncollectible in
whole or in part. Thrift institutions that qualify as small banks can use the experience method of
accounting. Thrift institutions that are treated as large banks are required to use the specific
charge-off method (Code Sec. 593(f) and Code Sec. 593(g) ).
Path:
RIA Checkpoint; FTH; Spine, Chapter 4 – Interest Expense – Losses – Bad Debt;
¶ 1855. Amount of bad debt deduction
¶ 1852 Deduction for Bad Debts.
Bad debts are deductible whether or not connected with taxpayer's business. Deduction is
allowed for total worthlessness and, in some cases, for partial worthlessness.
Business bad debts are deductible as ordinary deductions. They are deductible if partly worthless
as well as when wholly worthless. Nonbusiness bad debts are deducted only as short-term capital
losses, and only when wholly worthless ( ¶ 1857 ). FTC ¶ M-2800 et seq. FTC ¶ ,M-2900 et seq.
; USTR ¶ 1664 ; Tax Desk ¶ 32,050
An item can't be deductible both as a bad debt and as a loss. If it could be treated as either, it
must be treated as a bad debt. FTC ¶ M-2503 ; USTR ¶ 1654.040 ; Tax Desk ¶ 32,058
However, a worthless debt that is evidenced by a security, and is owed by a corporation or a
government, is a loss, and not a bad debt, unless owed to a bank. ( Code Sec. 165(g) , Code Sec.
166(e) , Code Sec. 582(a) ) FTC ¶ M-3301 , FTC ¶ M-3309 ; USTR ¶ 1664.160 ; Tax Desk ¶
32,051
¶ 1857. Effect of classification as business or nonbusiness bad debt.
The need to determine whether a debt is a business or nonbusiness debt ( ¶ 1858 ) arises only for
noncorporate taxpayers, because a corporation's debts are always business debts. ( Code Sec.
166(d) ) FTC ¶ M-2800 ; USTR ¶ 1664 , USTR ¶ 1664.300 ; Tax Desk ¶ 32,301
Business bad debts are fully deductible against income ( Code Sec. 166(a) ), while nonbusiness
bad debts are short-term capital losses of limited deductibility. ( Code Sec. 166(d)(1)(B) ) FTC ¶
M-2401 ; FTC ¶ M-2901 ; USTR ¶ 1664 , USTR ¶ 1664.300 ; Tax Desk ¶ 32,051
Business and nonbusiness debts are deductible when wholly worthless, but only business debts
are deductible when partly worthless. ( Code Sec. 166(a) , (d)(1)(A)) FTC ¶ M-2401 ; FTC ¶ M2800 ; USTR ¶ 1664.210 , USTR ¶ 1664.270 , USTR ¶ 1664.300 ; Tax Desk ¶ 32,251
¶ 1858. Business and nonbusiness debts defined.
A business debt is either:
... a debt created or acquired in the course of taxpayer's trade or business (whether or not it was
related to that business when it became worthless); or
... a debt the loss from whose worthlessness is incurred in taxpayer's trade or business. This
applies if the loss is proximately related to taxpayer's business when the debt becomes worthless.
A bad debt is proximately related to business if business is the dominant motivation for the debt.
( Reg § 1.166-5(b) ) FTC ¶ M-2902 ; USTR ¶ 1664.301 ; Tax Desk ¶ 32,303
A nonbusiness debt is a debt other than a business debt. ( Code Sec. 166(d)(2) ; Reg § 1.166-5(b)
, (d)) FTC ¶ M-2902 ; USTR ¶ 1664.301 ; Tax Desk ¶ 32,303
¶ 1855. Amount of bad debt deduction.
The amount deductible for a wholly worthless debt is its adjusted basis for determining loss on a
sale or exchange ( ¶ 2400 et seq.), regardless of its face value. ( Code Sec. 166(b) ; Reg § 1.1661(d) ) FTC ¶ M-2402 ; USTR ¶ 1664.210 ; Tax Desk ¶ 32,052 The adjustments used to figure
adjusted basis are generally the debtor's payments on the debt. But a deduction allowed for a
debt's partial worthlessness reduces the debt's basis to that extent, whether or not taxpayer got a
tax benefit from his deduction. FTC ¶ M-2406 ; FTC ¶ M-2407 ; Tax Desk ¶ 32,054
If the creditor (taxpayer) has no basis in the debt. there's no deduction. FTC ¶ M-2404 ; USTR ¶
1664.210 ; Tax Desk ¶ 32,052 So there's no deduction for wages, rents, alimony, etc., that were
never received, unless these items were included in income. ( Reg § 1.166-1(e) ) FTC ¶ M-2506 ;
USTR ¶ 1664.210 ; Tax Desk ¶ 32,053 Where taxpayer reports receivables at fair market value
(FMV) rather than face, the deduction can't exceed FMV. ( Reg § 1.166-1(d)(2) ) FTC ¶ M-2402
; Tax Desk ¶ 32,052
Where taxpayer fails to prove a debt's exact basis, it may be estimated by a court if taxpayer
proves his right to some deduction. FTC ¶ M-2405 ; Tax Desk ¶ 32,052
If a debt is compromised because of inability to pay the full amount, taxpayer deducts the debt's
adjusted basis minus any cash and the value of any property received. If the debt is compromised
for some other reason, taxpayer doesn't have a bad debt (but may have a loss). FTC ¶ M-2408 ;
Tax Desk ¶ 32,054
Numerical Implication Statement:
Happy Teeth’s operates on a cash basis meaning that income is recognized when cash is received
and expenses are recognized only when cash is paid. Happy Teeth had two wholly worthless
accounts within their accounts receivable in 2000. However, since it operates under a cash basis
only the $1900 is deductible. This amount is deductible because the cash was received and
counted as income and then became worthless through a bad check. The $1200 wholly worthless
account is not allowed as a deduction because the cash was never received and therefore never
counted as income. From a tax formula perspective, this will decrease net earnings and therefore
decrease taxable income.
Issue N25: Monica's Computer - Employment Related Expenses
(MOM: Garit, (500 - 200) points; AUD: Andy B., (250 - 100)
points; PR: -----, 250 points)
Path:
CCH Online; Federal Taxes; computer w/par professor and
section 179; TCM, [CCH Dec. 45,856(M)] , Thomas C.
Cadwallader and Judy C. Douglas v. Commissioner, Expenses-trade or business: Home office: Principal place of business:
Teachers.--, (July 24, 1989)
Narrative Solution:
Docket No. 32130-87., TC Memo. 1989-356, 57 TCM 1030, Filed July 24, 1989
[Appealable, barring stipulation to the contrary, to CA-7.--CCH.]
[Code Sec. 280 ]
Expenses--trade or business: Home office: Principal place of business: Teachers.--A college
professor who maintained necessary research materials and conducted research at his home
office was denied a deduction for home office costs. Under the focal point test, a home office is
not a teacher’s principal place of business. Also, the taxpayer here failed to demonstrate that the
dominant portion of his work was performed at his home office.
[Code Sec. 280 ]
Expenses--trade or business: Computers: Used at home.--A college professor and his wife, a
transportation planner, who both used a computer in their home in order to properly perform the
duties of their employment, were allowed to deduct the cost of their computer equipment. Use of
a computer was required in order for the taxpayers to properly perform the duties of their
employment. Also, their purchase of a computer spared their employers the cost of providing
them with suitable ones with which to perform their job duties.--CCH.
Thomas C. Cadwallader, pro se. David R. Reed, for the respondent.
Memorandum Findings of Fact and Opinion
CLAPP, Judge:
Respondent determined deficiencies in petitioners’ Federal income taxes as follows:
Year
Sec.6651(a)(1)
1
Deficiency
1982 ...................................... $ 315
1983 ......................................
345
1984 ...................................... 1,626
$78.75
After concessions, the issues are (1) whether section 280A allows petitioner Cadwallader to
take a deduction in 1982 and both petitioners to take deductions in 1983 and 1984 with respect to
Cadwallader’s home office; and (2) whether section 280F prevents petitioners from deducting
under section 179 the cost of computer equipment they purchased in 1984.
Findings of Fact
Some of the facts are stipulated and are so found. The stipulation of facts and attached exhibits
are incorporated herein by this reference. Petitioners are husband and wife. At the time the
petition was filed, they were residents of Champaign, Illinois.
During the years at issue, Cadwallader was a tenured psychology professor at Indiana State
University (the university) in Terre Haute, Indiana, where he teaches psychology classes each
semester. During the years in issue, the university class schedules showed petitioner as teaching
an average of 13 hours per semester. Some of these classes were taught by both petitioner and
another faculty member.
A tenured professor such as Cadwallader is expected to conduct research as a part of his job.
Cadwallader conducts his research in the history of psychology. As a result of this research,
Cadwallader has accumulated over the years an extensive amount of historical reference
materials. Most of these materials are not available in the university library. Cadwallader could
not conduct his research if he did not have access to his reference materials.
The university provides Cadwallader with three different private rooms on campus with a total
square footage of approximately 330 square feet. One room is Cadwallader’s office and contains
a desk, telephone, typewriter, and some of his reference materials. He meets students, maintains
his professor-student relationships, and does much of his classroom preparation in this campus
office. The other campus rooms also contain his reference materials. These materials are so
extensive that Cadwallader cannot house all of them in the three rooms assigned to him by the
university. Consequently, he stores much of them at his home, using his study and parts of the
living and dining rooms. He does much or all of his research at home. Cadwallader has written a
number of articles in his field of specialty.
In September 1984, petitioners purchased a personal computer. Cadwallader uses the
computer for storing information and for word processing in his academic research. He has given
seminars on computer use. During the years in issue he did not have access to a computer at the
university.
Douglas used the computer in connection with her job at the West Central Indiana Economic
Development District, where she was promoted to chief transportation planner in the spring of
1984. Her employer did not have a computer of its own and did not explicitly require her to
purchase the computer as a condition of her employment.
Opinion
After concessions, the issues are (1) whether section 280A allows petitioner Cadwallader to
take a deduction in 1982 and both petitioners to take deductions in 1983 and 1984 with respect to
Cadwallader’s home office, and (2) whether section 280F prevents petitioners from deducting
under section 179 the cost of the computer equipment they purchased in 1984. Petitioners bear
the burden of proof on both issues. Rule 142(a).
The first issue involves the home office. Section 280A(a) provides that no deduction is
allowed to a taxpayer with respect to a dwelling unit that he also uses as a residence. Section
280A(c)(1) , however, establishes certain exceptions to this general rule of nondeductibility.
Petitioner relies upon the exception in section 280A(c)(1)(A) , which provides that the general
rule of nondeductibility shall not apply to “any item to the extent such item is allocable to a
portion of the dwelling unit which is exclusively used on a regular basis as the principal place of
business for any trade or business of the taxpayer. * * * In the case of an employee, the * * *
exclusive use * * * [must be] for the convenience of his employer.”
The legislative history and the section 280A income tax regulations offer little guidance as to
the scope of the “principal place of business” concept. See Baie v. Commissioner [Dec. 36,907 ],
74 T.C. 105, 109 (1980). It is established, however, that a taxpayer can have only one principal
place of business for each business in which he is engaged. Curphey v. Commissioner [Dec.
36,753 ], 73 T.C. 766 (1980). “We therefore take it that what Congress had in mind was the focal
point of a taxpayer’s activities.” Baie v. Commissioner, supra at 109. See also Jackson v.
Commissioner [Dec. 37,875 ], 76 T.C. 696, 700 (1981). This “focal point” is the location which
is most essential to carrying on the taxpayer’s business. Williams v. Commissioner [Dec.
43,996(M) ], T.C. Memo. 1987-308; Cristo v. Commissioner [Dec. 39,326(M) ], T.C. Memo.
1982-514; Eastman v. Commissioner [Dec. 45,771(M) ], T.C. Memo. 1989-288.
This Court consistently has held that the focal point of a college professor’s activities is the
campus, campus office, or classroom rather than the home office. See Renner v. Commissioner
[Dec. 41,275(M) ], T.C. Memo. 1984-303; Bilenas v. Commissioner [Dec. 40,576(M) ], T.C.
Memo. 1983-661; Harris v. Commissioner [Dec. 40,369(M) ], T.C. Memo. 1983-494; Moskovit
v. Commissioner [Dec. 39,275(M) ], T.C. Memo. 1982-472, affd. by unreported decision (10th
Cir., October 19, 1983). This applies to teachers whose job responsibilities do not extend to
research. Wilhelm v. Commissioner [Dec. 40,126(M) ], T.C. Memo. 1983-274. It also applies to
professors who are expected to do research and who spend more time at their home office than
on campus. See Storzer v. Commissioner [Dec. 39,099(M) ], T.C. Memo. 1982-328; Moskovit v.
Commissioner, supra. In addition, it applies even if the employer provides inadequate office
space. See Storzer v. Commissioner, supra; Weightman v. Commissioner [Dec. 37,986(M) ],
T.C. Memo. 1981-301. If we were to follow these cases, petitioners’ home office deduction must
be disallowed.
However, we have been reversed on three occasions by Courts of Appeals which have
criticized the focal point test on which the above cases are based. Meiers v. Commissioner [86-1
USTC ¶9180 ], 782 F.2d 75 (7th Cir. 1986), revg. a Memorandum Opinion of this Court [Dec.
41,621(M) ]; Weissman v. Commissioner [85-1 USTC ¶9106 ], 751 F.2d 512 (2d Cir. 1984), revg.
and remanding a Memorandum Opinion of this Court [Dec. 40,645(M) ]; Drucker v.
Commissioner [83-2 USTC ¶9550 ], 715 F.2d 67 (2d Cir. 1983), revg. and remanding [Dec.
39,392 ] 79 T.C. 605 (1982). Petitioners rely heavily upon these three cases. Drucker v.
Commissioner, supra, involved musicians who were employed by the Metropolitan Opera
Association, but who practiced at home. The musicians spent less than half of their working time
at the Met’s headquarters at Lincoln Center. “The place of performance was immaterial so long
as the musicians were prepared, and most of the preparation occurred at home. The home
practice areas were appellant’s principal places of business within the meaning of section 280A
.” Drucker v. Commissioner, 715 F.2d at 69.
In Weissman v. Commissioner, supra, a professor’s home office was held to be his principal
place of business. The professor spent 80 percent of his working hours at his home office
because his campus office was inadequate. The court allowed the deduction, in part because the
dominant portion of the professor’s work was performed at home.
In Meiers v. Commissioner, 782 F.2d at 75, self-employed individuals “made a legitimate
business decision not to create office space at * * * [their] laundromat.” A “major consideration”
in the Court’s allowance of the home office deduction was the amount of time spent in the home
office. Other factors that “may from time to time weigh in the balance, such as the importance of
the business functions performed * * * in the home office; the business necessity of maintaining
a home office; and the expenditures of the taxpayer to establish a home office.” Meiers v.
Commissioner, supra at 79.
All three of these cases shift emphasis from the focal point of the taxpayer’s work, or the place
where the taxpayer’s work is most visible, to the place where the taxpayer accomplishes the
dominant portion of his work. Petitioners, however, have not demonstrated that the dominant
portion of Cadwallader’s work was performed at the home office. Petitioners called Donald A.
Nelson, the chairperson of the psychology department at the university, who testified about
Cadwallader’s three offices on campus. Nelson also testified that the university library lacks the
materials needed by Cadwallader for his research. According to Nelson, Cadwallader could not
write his scholarly papers without the reference materials he had accumulated over the years.
Douglas testified that Cadwallader had extensive reference materials in his home office.
Cadwallader testified that his research extensively draws on his reference materials, and that his
campus offices do not have adequate space to store those materials. He also testified that the
materials at his home filled “a complete room called my study. It has overflowed into our living
room. It has overflowed into our dining room.” Petitioners have not shown that Cadwallader
spends more than half of his time at his home office.
Each “home office” case must stand on its own facts. The three Courts of Appeals decisions
relied on by petitioner found that the dominant portion of the taxpayers’ work was done at the
home office. After a review of the evidence before us in this case, we conclude that the dominant
portion of Cadwallader’s work took place on the campus where he taught classes, conducted his
student related activities, and maintained substantial research materials. Thus, under either the
focal point test or the dominant portion test, Cadwallader’s home office does not qualify as his
principal place of business within the meaning of section 280A(c)(1)(A) . Accordingly
petitioners are not allowed a home office deduction.
The second issue facing us involves the computer equipment. Section 280F(d)(4)(A)(iv)
provides that “any computer or peripheral equipment” is “listed property.” “Employee use of
listed property shall not be treated as use in a trade or business for purposes” of expensing under
section 179 unless “such use is for the convenience of the employer and required as a condition
of employment.” Section 280F(d)(3)(A) ; sec. 1.280F-6T(a)(1) , Temp. Income Tax Regs., 49
Fed. Reg. 4271 3 (Oct. 24, 1984).
In order for the “condition of employment” requirement to be satisfied, petitioners’ employers
need not explicitly require them to use a computer. Sec. 1.280F-6T(a)(2) (ii) and (a)(4) Ex. (2),
Temp. Income Tax Regs. Instead, it is only necessary that petitioners’ use of the computer be
required in order for them to properly perform the duties of their employment. Sec. 1.280F-6T(a)
(2)(ii), Temp. Income Tax Regs. We conclude that this requirement is satisfied. Cadwallader’s
duties of employment included historical research that involved massive amounts of data and
writing. This research was substantially aided by a computer. Under the instant facts, the
computer was required in order for Cadwallader to properly perform the duties of his
employment. Similarly, Douglas testified that her office was required to do planning which
involved extensive number crunching. Much of this work previously had been done on a
mainframe computer owned by the state, but the state eliminated access to this computer. The
previous chief transportation planner had purchased a personal computer in order to be able to do
his work. Her office lacked the funds to purchase a computer of its own. Thus, the computer was
required in order for Douglas to properly perform the duties of her employment.
We also conclude that the “convenience of employer” requirement is satisfied. Here the
computer purchase spared petitioners’ employers the cost of providing them with suitable
computer equipment with which to engage in their job responsibilities. See Weissman v.
Commissioner, 751 F.2d at 517.
Thus, section 280F does not prevent petitioners from deducting the cost of their computer
equipment under section 179 .
Decision will be entered under Rule 155.
Numerical Implication Statement:
The Cadwallader case reveals that Monica's computer acquisition was for the convenience of the
employer and is thus deductible as a miscellaneous itemized deduction under the usual
provisions for a capital asset. Since $16,700 of 2000's $20,000 Section 179 amount has been
used ($15,000 -- Dentistry's furniture & fixtures, $1,500 -- Gunsmith's wiring for electrical
equipment -- $200 -- Crown Enterprises, $3,300 remains to be used for the computer system.
This leaves a $2,200 basis. Given the framework presented in Issue E29-2, the applicable cost
recovery multiplier is .20. Thus, regular cost recovery is $440. All of those deductions are
miscellaneous itemized deductions subject to 2% of the AGI floor.
Issue N26: Melinda and Bonnie’s braces (MOM: Andy A., 300 points; AUD:
Garit, 150 points; PR: -----, 150 points)
Path:
RIA Checkpoint; FTH; Spine, Orthodontia, ¶59, Checklist for
Medical Expenses
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶59, Checklist for Medical Expenses
Checklist for Medical Expenses
Generally, a medical expense deduction is allowed for expenses incurred in the diagnosis,
cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure
or function of the body for the individual or for the individual's spouse or dependents. The
deduction covers expenses that have not been reimbursed by medical insurance or other sources.
Despite the broad scope of medical expenses, not every expense incurred for medical care is
deductible. Also, there is a 7.5-percent floor on the medical expense deduction. The chart, below,
lists specific types of expenses that the IRS or federal courts have allowed as a deduction. The
user can easily check whether an official determination has been made as to the deductibility of a
particular type of expense.
Orthodontia
1(e)(1)(ii)
Yes
Reg. §1.213-
Numerical Implication Statement:
The Fronks can deduct orthodontia expenses, subject to a 7.5% floor. This would be considered
an itemized deduction. The Fronks AGI will exceed the 133,334 dollar limit so no deduction will
be applicable.
Issue N27: Gift loans (MOM: Robyn, 600 points; AUD: Katherine, Karrie, 300
points; PR: -----, 300 points)
Path:
CCH Network; USMTG; Spine, ¶83 Applicable Federal Rates
CCH Network; USMTG; Spine, ¶795 Imputed Interest on BelowMarket Interest Loans Imputed Interest on Below-Market Interest
Loans
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶83, Applicable Federal Rates
Applicable Federal Rates
Following are the monthly applicable federal interest rates for January 2000 through February
2001, published by the IRS for purposes of testing imputed interest in below-market interest
loans (¶795 ) and debt-for-property transactions (¶1954 ). The rates are also relevant under the
golden parachute rules (¶907 ) and for testing interest in connection with deferred payments for
the use of property (¶1859 ).
In the case of below-market interest loans that are demand or gift loans, an amount deemed the
“foregone” interest is treated as transferred from the lender to the borrower and retransferred by
the borrower to the lender as interest. In order to simplify the computation of such foregone
interest, the IRS prescribes a “blended annual
rate,” which is 6.24% on loans from January 1, 2000 through December 31, 2000.
GUIDEBOOK, 2001USMTG ¶795, Imputed Interest on Below-Market Interest Loans
Imputed Interest on Below-Market Interest Loans
Under Code Sec. 7872 ,[ 2001FED ¶43,956 ] loans that carry little or no interest are generally
recharacterized as arm’s-length transactions in which the lender is treated as having made a loan
to the borrower bearing the statutory federal rate of interest. Concurrently, there is deemed to be
a transfer in the form of gift, dividend,
contribution to capital, compensation, or other manner of payment (depending upon the nature of
the loan) from the lender to the borrower which, in turn, is retransferred by the borrower to the
lender to satisfy the accruing interest (Code Sec. 7872(a)(1) ). This rule applies to (1) gift loans,
(2) corporation-shareholder loans, (3) compensation loans between employer and employee or
between independent contractor and client, (4)
tax-avoidance loans, (5) any below-market interest loans in which the interest arrangement has a
significant effect on either the lender’s or borrower’s tax liability, and (6) loans to any qualified
continuing care facility not exempt under Code Sec. 7872(g) .
In the case of a demand loan or a gift loan, the imputed interest amount is deemed to be
transferred from the lender to the borrower on the last day of the calendar year of the loan. As for
a term loan (other than a gift loan), there is an imputed transfer from the lender to the borrower,
in an amount equal to the excess of the amount loaned over the present value of all payments
required under the loan, which is deemed to have taken place on the date the loan was made.
Exceptions. A $10,000 de minimis exception applies to gift loans between individuals if the loan
is not directly attributable to the purchase or carrying of income-producing assets (Code Sec.
7872(c) ). There is also a $10,000 de minimis exception for compensation-related or corporationshareholder loans that do not have tax avoidance as a principal purpose. Further, in the case of
gift loans between individuals where the total amount
outstanding does not exceed $100,000, the amount deemed transferred from the borrower to the
lender at the end of the year will be imputed to the lender only to the extent of the borrower’s
annual net investment income (Code Sec. 7872(d) ). If such income is less than $1,000, no
imputed interest is deemed transferred to the lender.
Rules exempt certain below-market interest loans by individuals to continuing care facilities
made pursuant to a continuing care contract (Code Sec. 7872(g) ).[ 2001FED ¶43,956 , 2001FED
¶43,960.04 ] Also, in the case of an employer loan to an employee made in connection with the
purchase of a principal residence at a new place of
work, the applicable statutory federal rate for testing the loan is the rate as of the date the written
contract to purchase the residence was entered into (Code Sec. 7872(f)(11) ).[ 2001FED ¶43,956]
Numerical Implication Statement:
Tom’s gift loan of $250,000 in stock to Melinda is recharacterized as an arm's-length transaction
in which Tom (the lender) is treated as having made a loan to Melinda (the borrower) bearing the
statutory federal rate of interest and receiving interest income. The "deemed" income is
computed as follows: $250,000*213/366*.0624 = $9078.68 (ie., the days that Melinda had the
gift loan divided by the number of days in the year, then multiply that by the applicable federal
rate). The amount would go into income broadly conceived and reported on schedule B.
Issue N28: Special Assessments (MOM: Garit, 400 points; AUD: Jana, 200
points; PR: -----, 200 points)
Path:
CCH Network; USMTG; Spine, GUIDEBOOK, 2001USMTG ¶1626,
Basis of Residential or Converted Property
Path:
CCH Network; USMTG; Spine, CCH Federal Tax Service §A:15.20,
Overview—Deductible Taxes
Narrative Solution:
Basis of Residential or Converted Property
Where property has been occupied by the taxpayer as a residence continually since its
acquisition, no adjustment of the basis is made for depreciation, since none is allowable. The cost
of permanent improvements to the property is added to the basis, as are special assessments paid
for local benefits that improve the property.[ 2001FED ¶9508 , 2001FED ¶29,410 , 2001FED
¶29,412.021 ] Recoveries against a builder for defective construction reduce the basis.[ 2001FED
¶29,412.9968 ]
Overview—Deductible Taxes
Certain federal, foreign, state and local taxes are specifically nondeductible, while others are
nondeductible because no specific deduction exists for them. Taxes that are specifically
nondeductible cannot be deducted even if they are paid or incurred for business or investment
purposes. Taxes assessed against local benefits that tend to increase the value of the property
assessed are not deductible as taxes except to the extent they are properly allocable to
maintenance or interest charges. See §A:15.80 .
Numerical Implication Statement:
Special Assessment liens are given by the local and federal governments to permanently
improve property. This cost is added back to the cost basis of the house. In the case of the
Fronks, the special assessment of $5,000 in 1986 and $6,000 in 1995 for the long view
home is added to the basis of that home. The 6,000 is calculated as (10,000 * .6 (portion
allocated for road extension))= 6,000. The excess $4,000 was an itemized deduction in
1995 because it is for “maintenance” of property.
Issue N29: Divorced Parents and the Dependency Exemption (MOM:
Jennifer, 400 points; AUD: Andy A., 200; PR: -----, 200 points)
Path:
CCH Network; USMTG; Spine; Chapter 1 Individuals; ¶139
Exemptions for Children of Divorced Parents
Narrative Solution:
GUIDEBOOK, 2001USMTG ¶139, Exemptions for Children of Divorced Parents
Exemptions for Children of Divorced Parents
Generally, the dependency exemption for children of divorced taxpayers will go to the parent
who has custody of the child for the greater part of the calendar year. This rule applies only if the
child receives over one-half of his or her support from parents who are divorced, legally
separated, or have lived apart for the last six months of the calendar year. In addition, the child
must have been in the custody of one or both parents for
more than one-half of the calendar year (Code Sec. 152(e) ).[ 2001FED ¶8007 ]
There are three exceptions to the rule that a custodial parent is entitled to the dependency
exemption.[ 2001FED ¶8007 , 2001FED ¶8200 ] The first exception arises when there is a
multiple support agreement that allows the child to be claimed as a dependent by a taxpayer
other than the custodial parent (see ¶147 ). The second exception is when the custodial parent
releases his or her right to the child's dependency exemption to the noncustodial parent. This
release must be executed in writing (Form 8332 or similar release) and attached to the
noncustodial parent's tax return for each year the exemption is released. The final exception is
when a pre-1985 divorce decree or separation agreement between the parents grants the
exemption to the noncustodial parent and the noncustodial parent provides at least $600 for the
support of the child for the year in question.
When a parent has remarried, support received from the parent's spouse is treated as
received from the parent (Code Sec. 152(e)(5) ).[ 2001FED ¶8007 ]
Numerical Implication Statement:
Since Tom’s child support payments in Bonnie’s behalf easily satisfy the support test, it is not
clear if Tom will claim Bonnie as a dependent. In most cases children of divorced parents are
claimed by the custodial parent, however, there are exceptions. One exception would allow Tom
to claim Bonnie as a dependent if Karla released her right to Bonnie’s dependency exemption to
Tom. This would have to be done in writing and attached to Tom’s tax return. Since there is no
indication of any such agreement between Karla and Tom, we assume that Tom cannot claim
Bonnie as a dependent, and therefore gets no exemption for her.
Issue N30: Monica's Retirement Plan (MOM: Amanda, (300 - 200) points;
AUD: Andy A., (150 - 100) points; PR: -----, 150 points)
Path:
CCH Online; Standard Federal Tax Reporter; Citation search, Section
401(a); CCH-EXP, 2001FED ¶17,507.023, Qualified Pension, ProfitSharing, Stock Bonus and Annuity Plans: Advantages of
Qualification: Employer contributions not currently taxed to
employees.--
Narrative Solution:
The contributions of an employer to a pension, profit-sharing or other qualified plan are in the
nature of compensation to the employees. If the contributions are made to a nonqualified plan,
they are includible in the income of the employee at the time when they are no longer subject to
a substantial risk of forfeiture (Code Sec. 83 and Code Sec. 402(b) ). If the contributions are
made to a qualified plan, on the other hand, employer contributions generally are not taxed to the
employee until they are actually distributed to him. The same, of course, is true with respect to
the employee’s share of the earnings of the fund maintained by a qualified plan (see ¶17,507.021
) (Code Sec. 402(a) and Code Sec. 403(a)(1) ).
Numerical Implication Statement:
This documentation suggests that the tax implications of participating in a University sponsored
retirement plan are identical to those encountered under the Section 401(k). The taxation of
employee contributions is deferred until withdrawn during retirement. Employer contributions
are deductible. From an employee's perspective, the taxation of employer contributions is also
deferred until withdrawn. As a practical matter, the employer's contributions will appear in
income broadly conceived and then excluded. Monica's contributions will appear as an
exclusion.
Issue N31: Investor’s Counsel Fees (MOM: Terra, 300 points; AUD: Frank, 150
points; PR: -----, 150 points)
Path:
Path:
CCH Network; USMTG; Spine, Deductions (Chapter 9-12),
Nonbusiness Expenses; ¶1086 Investor’s Expenses
CCH Network; USMTG; Spine, FINAL-REG, 2001FED
¶12,521, §1.212-1, Nontrade or nonbusiness expenses.--
Narrative Solution:
Investment counsel fees, custodian fees, fees for clerical help, office rent, state and local transfer
taxes, and similar expenses paid or incurred by an individual in connection with investments held
by the individual are deductible as an itemized deduction on Schedule A of Form 1040 , subject
to the 2% floor (¶1011 ) (Reg. §1.212-1(g) ),[ 2001FED ¶12,521 ] except where they relate to
rents and royalties (¶1089 ). A dealer or trader in securities is not an investor and may deduct
these items as business expenses (subject to the uniform capitalization rules; see ¶990 et seq.).[
2001FED ¶8521.04 , 2001FED ¶8521.1475 ]
§1.212-1 Nontrade or nonbusiness expenses.-(a) An expense may be deducted under section 212 only if-(g) Fees for services of investment counsel, custodial fees, clerical help, office rent, and
similar expenses paid or incurred by a taxpayer in connection with investments held by him are
deductible under section 212 only if (1) they are paid or incurred by the taxpayer for the
production or collection of income or for the management, conservation, or maintenance of
investments held by him for the production of income; and (2) they are ordinary and necessary
under all the circumstances, having regard to the type of investment and to the relation of the
taxpayer to such investment.
Numerical Solution:
The $1100 in investment council fees made by the Fronk’s is deductible on schedule A, and is
included in the itemized deductions within the tax formula. It is subject to a 2% floor of their
adjusted gross income. As long as the fees are paid or incurred by the taxpayer for the
production or collection of income or for the management, conservation, or maintenance of
investments held by him for the production of income; and (2) they are ordinary and necessary
under all the circumstances, having regard to the type of investment and to the relation of the
taxpayer to such investment they can be deducted as an itemized deduction. For this case, we
will assume that the criteria has been met.
Issue N32: Basis of like-kind assets (MOM: Jill, 600 points; AUD: Tonya, 300
points; PR: -----, 300 points)
Path:
CCH Online; USMTG; Spine; (Chapter 16); Like-kind property;
¶1651, Tax-Free Exchange Generally
Narrative Solution:
¶1651, Tax-Free Exchange Generally
If property is acquired in an exchange on which no gain or loss is recognized, the basis of the
property is the same as that for the property exchanged (Code Sec. 1031(d) ; Reg. §1.1031(d)-1
).[ 2001FED ¶29,602 , 2001FED ¶29,612 ] This basis is known as a “substituted basis.” See
¶1607 . It applies to: (1) exchanges of property held for
productive use or investment solely for property of like kind (¶1721 ); (2) some exchanges of
stock for stock of the same corporation (¶1728 ); (3) exchanges of property solely for stock or
securities of a “controlled” corporation (¶1731 ); and (4) exchanges of stock or securities solely
for stock or securities in a reorganization (¶2229 ).
¶1657, Exchange Tax Free in Part
In an exchange, money or other property, which is not permitted to be received without the
recognition of gain or loss (see ¶1723 ), may be received together with securities or property that
is permitted to be received without the recognition of gain or loss. In such exchanges, the cost or
other applicable basis of the property acquired is the same as that of the property exchanged,
decreased by the amount of any money received by the
taxpayer in the transaction and increased by the amount of gain or decreased by the amount of
loss recognized in the exchange. If such “other property” is received in an exchange that is tax
free in part, the cost or other basis of the property disposed of must be allocated between the
property received tax free and such “other property,” assigning to the “other property” an amount
equivalent to its fair market value (Code Sec. 1031(d) ).[ 2001FED ¶29,602 ]
GUIDEBOOK, 2001USMTG ¶1721, Like-Kind Exchanges
Like-Kind Exchanges
No gain or loss is recognized upon the exchange of property held for productive use in a trade or
business or for investment if the property received is of a like kind and is held either for
productive use in a business or for investment. This rule does not cover stock in trade or other
property held primarily for sale, stocks, bonds, notes, certificates of trust, beneficial interests,
partnership interests, securities or evidences of indebtedness or nterest (Code Sec. 1031 ; Reg.
§1.1031(a)-1 ).[ 2001FED ¶29,602 , 2001FED ¶29,603 ] It does cover “trade-in” allowances (see
¶1654 ). Nonrecognition treatment does not apply if one of the exchanged properties is real
property located outside the United States (Code Sec. 1031(h) ).[ 2001FED ¶29,602 , 2001FED
¶29,608.05 ]
If property received in a like-kind exchange between related persons (as defined at ¶1717 ) is
disposed of within two years after the date of the last transfer that was part of the like-kind
exchange, the original exchange will not qualify for nonrecognition treatment (Code Sec. 1031(f)
).[ 2001FED ¶29,602 , 2001FED ¶29,608.04 ] Any gain or loss that was not recognized by the
taxpayer on the original exchange must be recognized as of the date that the like-kind property is
disposed of by either the taxpayer or the related party. The running of the two-year period may
be suspended when the holder of the exchanged property has substantially diminished the risk of
loss by the use of a put, short sale, holding by another person of a right to acquire such property,
or any other transaction (Code Sec. 1031(g) ).[ 2001FED ¶29,602 ] A disposition that would
otherwise require recognition of the original exchange is excepted from the related-person rule if
(1) neither the original exchange nor the disposition had as one of its principal purposes the
avoidance of federal income tax, (2) the disposition was due to the death of either related party,
or (3) the disposition was due to the compulsory or involuntary conversion of the property (see
¶1713 ).
For the basis of property received in a like-kind exchange, see ¶1651 .
Reporting. Form 8824 (Like-Kind Exchanges) is used to report the like-kind exchange.
Like-Kind Property Defined. Property is of like kind if it is of the same nature or character. Most
exchanges of real properties qualify as like-kind exchanges (Reg. §1.1031(a)-1(b) and (c) ).[
2001FED ¶29,603 ] However, real property located in the U.S. and real property located outside
the U.S. are not like-kind property (Code Sec.
1031(h)(1) ).[ 2001FED ¶29,602 ]
Personal properties are like kind if they are of a like kind or class. Depreciable tangible personal
properties are of a like class if they fall within the same general asset class or the same product
class. For depreciable tangible personal property, asset classes follow those used for depreciation
purposes (see Rev. Proc. 87-56 , which appears at ¶163.01 of the 2001 Standard Federal Tax
Reporter and at ¶74 of the 2001 U.S. Master Tax Guide--Loose-Leaf Edition). Product classes
are determined by reference to the four-digit product classes in Division D of the Standard
Industrial Classification (SIC) codes, as set forth in the SIC Manual (Reg. §1.1031(a)-2(b) ).[
2001FED ¶29,606 ]
Personal property predominantly used in the U.S. and personal property predominantly used
outside of the U.S. are not “like-kind” property (Code Sec. 1031(h)(2) ).[ 2001FED ¶29,602 ]
Exchanges involving intangible personal property or nondepreciable tangible personal property
may qualify for like-kind exchange treatment only if the properties are like kind. Goodwill and
going concern value are not like-kind property (Reg. §1.1031(a)-2(c) ).[ 2001FED ¶29,602 ,
Numerical Implication Statement:
If property is acquired in an exchange on which no gain or loss is recognized, the basis of the
property is the same as that for the property exchanged. In an exchange, money or other
property, which is not permitted to be received without the recognition of gain or loss, may be
received together with securities or property that is permitted to be received without the
recognition of gain or loss. In such exchanges, the cost or other applicable basis of the property
acquired is the same as that of the property exchanged, decreased by the amount of any money
received by the taxpayer in the transaction and increased by the amount of gain or decreased by
the amount of loss recognized in the exchange. In the Fronks case, there was an exchange of old
assets for new assets.
Computer System:
FMV new system: 60,000
Old system BV: 15,000
Cash paid in exchange: 50,000
Loss: 5,000
Increase in basis: 5,000
Adjusted Basis: 60,000 + 5,000 = 65,000
Dental Equipment:
FMV of new equipment: 170,000
Old equipment BV: 5,000
Cash paid in exchange: 140,000
Gain: 25,000
Decrease in Basis: 25,000
Adjusted Basis: 170,000-25,000 = 145,000
Issue N33: Land Improvement Depreciation (MOM: Garit, (700 - 100) points;
AUD: Robyn, (350 - 50) points; PR: -----, 350 points)
Path:
RIA Checkpoint; FTH; Spine, Chapter 3 Deductions--Expenses of a
Business ¶1500 Start-Up Expenditures ¶1505 Expanding an existing
business ¶1507. “Ordinary and necessary” requirement
Narrative Solution:
¶ 1505. Expanding an existing business.
A taxpayer can deduct expenditures made to expand an existing business. The taxpayer must
show:
... that the business contemplated and the one already conducted are closely related or
“intramural,” and
... that the expenditures are ordinary and necessary expenses of the business conducted
when the expenses were incurred, and not capital expenditures.
Expansion costs must be capitalized if they provide the taxpayer with long-term benefits, or
create separate and distinct assets, or relate to a change in the nature of the taxpayer's activities
(e.g., wholesaler opening retail outlet). FTC ¶ L-5101 ; USTR ¶ 1624 et seq. Tax Desk ¶ 30,116
¶ 1507. “Ordinary and necessary” requirement.
A deductible business expense must be both ordinary and necessary in relation to the
taxpayer's industry. (Code Sec. 162(a) ) FTC ¶ L-1200 et seq. ; USTR ¶ 1624.012 ; Tax Desk ¶
25,562
An expense is ordinary if it's customary or usual in the taxpayer's business. FTC ¶ L-1201 ;
USTR ¶ 1624.012 ;Tax Desk ¶ 25,562 But an unusual expense may be ordinary if it's reasonably
related to the taxpayer's trade or business. FTC ¶ L-1201 , FTC ¶ L-1209 ; USTR ¶ 1624.012 ;
Tax Desk ¶ 25,562
A necessary expense is one that's appropriate and helpful in developing and maintaining the
taxpayer's business. It need not be essential or indispensable. Usually the taxpayer's judgment as
to what's necessary will be accepted. FTC ¶ L-1201 ; USTR ¶ 1624.012 ; Tax Desk ¶ 25,562
Some courts have held that to be deductible under Code Sec. 162 , an expense must not only
be ordinary and necessary, but also reasonable in amount and reasonable in relation to its
purpose. FTC ¶ L-1202 ; USTR ¶ 1624.013 ; Tax Desk ¶ 25,563 It has been held that
depreciation deductions are not to be considered in assessing whether business expenses are
reasonable under Code Sec. 162 . FTC ¶ L-1208
Expenditures are deductible as ordinary and necessary even though they turn out to have been
unwise. FTC ¶ L-1210 ; Tax Desk ¶ 25,572
GUIDEBOOK, 2001USMTG ¶903, Capital Expenditures
Capital Expenditures
An expense that adds to the value or useful life of property is considered a capital expense
(Reg. §1.263(a)-1 ).[ 2001FED ¶13,701 ]Generally, capital expenses must be deducted by means
of depreciation, amortization or depletion. If the expense is not subject to depreciation,
amortization or depletion, it is added to the cost basis of the property. Capital expenses include
those for buildings, improvements or betterments of a long-term nature, machinery, architect's
fees, and costs of defending or perfecting title to property (Reg. §1.263(a)-2 ).[ 2001FED
¶13,703 ] See Checklist at ¶57 .
Expenses that keep property in an ordinarily efficient operating condition and do not add to
its value or appreciably prolong its useful life are generally deductible as repairs (Reg. §1.162-4
).[ 2001FED ¶8620 ] Repairs include repainting, tuck-pointing,[ 2001FED ¶8620 ] mending
leaks, plastering, and conditioning gutters on buildings.[ 2001FED ¶8620 ] However, the costs of
installing a new roof [ 2001FED ¶13,701 ] and bricking up windows to strengthen a wall [
2001FED ¶13,701 ] are capital expenditures
GUIDEBOOK, 2001USMTG ¶1026, Improvement Tax
Improvement Tax
Any tax that is in reality an assessment for local benefits such as street, sidewalk, and other
like improvements is not deductible by a property owner, except where it is levied for the
purpose of maintenance and repair or of meeting interest charges on local benefits. It is the
taxpayer's burden to show the allocation of amounts assessed to the different purposes (Code
Sec. 164(c)(1) ; Reg. §1.164-4 ).[ 2001FED ¶9500 , 2001FED ¶9508 ]
CCH-EXP, 2001FED ¶11,007.031, Depreciable Property: Land and landscaping.-[IRC] [Regulations] [Current Developments] [CCH Annotations]
Depreciable Property: Land and landscaping.--
IRS-PUB, 2001, IRS Publication No. 527, Depreciation
Table 3. MACRS Recovery Periods for Property Used in Rental
Activities
MACRS Recovery Period To Use
Type of Property
Computers and their peripheral equipment
Office machinery, such as:
Typewriters
Calculators
Copiers
Automobiles
Light trucks
Appliances, such as:
Stoves
Refrigerators
Carpets
Furniture used in rental property
General
Depreciation
System
Alternative
Depreciation
System
5 years
5 years
5 years
5 years
5 years
6 years
5 years
5 years
5 years
5 years
5 years
9 years
9 years
9 years
Office furniture and equipment, such as:
Desks
Files
Any property that does not have a class life and that
has not been designated by law as being in
any other class
7 years
10 years
7 years
12 years
Roads
Shrubbery
Fences
15 years
15 years
15 years
20 years
20 years
20 years
Land is not a depreciable asset. The cost of landscaping, including the planting of trees, grass
and shrubbery, is a capital expenditure and cannot be deducted currently as a business expense
(Alabama-Georgia Syrup Co., Dec. 24,957 , at ¶11,007.1958 ). Although earlier decisions of the
Tax Court held that landscaping items were nondepreciable because they were more closely
associated with the land than with depreciable buildings (Algernon Blair, Inc., Dec. 22,906 and
H. Shainberg, Dec. 23,838 (Acq.), at ¶11,007.1958 ), it changed its position in a later case and
held that shrubbery planted around a recreation lodge was depreciable over a 10-year period
(Alabama-Georgia Syrup Co., Dec. 24,957 , at ¶11,007.1958 ).
GUIDEBOOK, 2001USMTG ¶1245, Averaging Conventions
Averaging Conventions
The following averaging conventions apply to depreciation computations made under the regular
MACRS method, the straight-line MACRS method, and the MACRS alternative depreciation
system (ADS) (Code Sec. 168(d) ).[ 2001FED ¶11,250 ] The recovery period begins on the date
on which the property is placed in service under the applicable convention.
Half-Year Convention. Under the half-year convention, applicable to property other than
residential rental property and nonresidential real property, property is treated as placed in
service or disposed of in the middle of the tax year. Thus, one-half of the depreciation for the
first year of the recovery period is allowed in the tax year in which the property is placed in
service, regardless of when the property is placed in service during the year.
If property is held for the entire recovery period, a half-year of depreciation is allowable in the
tax year in which the recovery period ends.
Generally, a half-year of depreciation is allowed in the tax year of disposition if there is a
disposition of property before the end of the recovery period.[ 2001FED ¶11,279.037 ]
Mid-Month Convention. A mid-month convention applies to residential rental property,
including low-income housing, and nonresidential real property. Property is deemed placed in
service or disposed of during the middle of the month. The deduction is based on the number of
months the property was in service. Thus, one-half month’s cost recovery is allowed for the
month the property is placed in service and for the month of disposition if there is a disposition
of property before the end of the recovery period.
Mid-Quarter Convention. A mid-quarter convention applies to all property, other than
nonresidential real property and residential rental property, if more than 40% of the aggregate
bases of such property is placed in service during the last three months of the tax year. Under the
mid-quarter convention, all property placed in service, or disposed of, during any quarter of a tax
year is treated as placed in service at the midpoint of such quarter (Code Sec. 168(d)(3) ).[
2001FED ¶11,250 ] Property placed in service and disposed of within the same tax year is
disregarded for purposes of the 40% test.
In determining whether the mid-quarter convention is applicable, the aggregate basis of property
placed in service in the last three months of the tax year must be computed regardless of the
length of the tax year. Thus, if a short tax year consists of three months or less, the mid-quarter
convention applies regardless of when the depreciable property is placed in service during the tax
year.
GUIDEBOOK, 2001USMTG ¶1208, Election to Expense Certain Depreciable Business
Assets
An expense deduction is provided for taxpayers (other than estates, trusts or certain
noncorporate lessors) who elect to treat the cost of qualifying property, called Sec. 179 property,
as an expense rather than a capital expenditure. The election, which is generally made on Form
4562, is attached to the taxpayer’s original return (including a late-filed original return) or on an
amended return filed by the due date of the original return (including extensions) for the year the
property is placed in service and may not be revoked without IRS consent.[ 2001FED ¶12,120]
Employees may make the election on Form 2106.
The maximum Code Sec. 179 deduction is $20,000 for tax years beginning in 2000 and
$24,000 for tax years beginning in 2001 and 2002. Thereafter, the deduction is $25,000 per year.
The maximum amount is reduced by a dollar for each dollar of the cost of qualified property
placed in service during the tax year over $200,000.
The total cost of property that may be expensed for any tax year cannot exceed the total
amount of taxable income derived from the active conduct of any trade or business during the tax
year, including salaries and wages. A deduction disallowed under this rule is carried forward an
unlimited number of years subject to the ceiling amount for each year. To qualify as Code Sec.
179 property, the property must be tangible Code Sec. 1245 property, depreciable under Code
Sec. 168, and acquired by purchase for use in the active conduct of a trade or business (Code
Sec. 179(d)).[ 2001FED ¶12,120] Code Sec. 50(b) property and air conditioning or heating units
do not qualify as Code Sec. 179 property.
Special rules apply to an enterprise zone business (Code Sec. 1397A).[ 2001FED ¶32,397,
2001FED ¶32,399]
GUIDEBOOK, 2001USMTG ¶1785, Code Sec. 1245 Property
Code Sec. 1245 Property
Code Sec. 1245 property is property that is or has been depreciable (or subject to
amortization under Code Sec. 197) and that is either (1) personal property (tangible and
intangible) or (2) other tangible property (not including a building or its structural components)
used as an integral part of (a) manufacturing, (b) production, (c) extraction, or (d) the furnishing
of transportation, communications, electrical energy, gas, water, or sewage disposal services
(Reg. §1.1245-3).[ 2001FED ¶30,905] The term “other tangible property” includes research
facilities or facilities for the bulk storage of fungible commodities used in connection with the
activities in (a)-(d). A leasehold of Code Sec. 1245 property is also treated as Code Sec. 1245
property (Reg. §1.1245-3).[ 2001FED ¶30,905]
Livestock is considered Code Sec. 1245 property, and depreciation on purchased draft,
breeding, dairy and sporting livestock is recaptured as ordinary income when sold. Raised
livestock generally has no basis for depreciation, but to the extent that it does have a basis and is
depreciated, it would be subject to recapture.[ 2001FED ¶30,909.021]
Code Sec. 1245 property also includes so much of any real property (except “other
property” described at (2) above) that has an adjusted basis reflecting adjustments for
amortization of pollution control facilities, child care facilities, or railroad grading and tunnel
bores; expenditures for removal of architectural and transportation barriers to the handicapped
and elderly, reforestation, or tertiary injectants; and amounts expensed under Code Sec. 179.
Code Sec. 1245 property also includes single purpose agricultural and horticultural structures
and storage facilities used in connection with the distribution of petroleum products (Code Sec.
1245(a)(3)).[ 2001FED ¶30,902]
GUIDEBOOK, 2001USMTG ¶1240, Classes of Depreciable Property
Nonresidential Real Property.
Nonresidential real property is Code Sec. 1250 real property (see ¶1786 ) that is not (1)
residential rental property or (2) property with a class life of less than 27.5 years. It includes
property that either has no class life or whose class life is 27.5 years
or more, including elevators and escalators (Code Sec. 168(e)(2)(B) ).[ 2001FED ¶11,250 ] The
cost of nonresidential real property generally placed in service after May 12, 1993, is recovered
over 39 years. For property placed in service after 1986 and before May 13, 1993, cost is
recovered over 31.5 years.
CCH-EXP, 2001FED ¶11,279.023, Modified Accelerated Cost Recovery System: General
MACRS property classes.—
15-year property. Included in 15-year property is property with an ADR class life of 20 years or
more but less than 25 years. Such property includes municipal wastewater treatment plants (asset
class 50) and telephone distribution plants and other comparable equipment, certain depreciable
land improvements (such as sidewalks, roads, docks, bridges, fences and landscaping shrubbery),
assets used in producing cement
(but not cement products), water carrier assets not qualifying as 10-year property, pipelines and
service station buildings. See, below for special rules relating to service station buildings.
1.
General Depreciation System
Applicable Depreciation Method: 200 or 150
Percent
Declining Balance Switching to Straight Line
Applicable Recovery Periods: 3, 5, 7, 10,
15, 20 years
Applicable Convention: Half-year
If the
Recovery
Year is:
and the Recovery Period is:
3-year 5-year 7-year 10-year 15-year 20-year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
the Depreciation Rate is:
. 33.33 20.00 14.29
10.00
5.00
. 44.45 32.00 24.49
18.00
9.50
. 14.81 19.20 17.49
14.40
8.55
.. 7.41 11.52 12.49
11.52
7.70
........ 11.52
8.93
9.22
6.93
......... 5.76
8.92
7.37
6.23
................ 8.93
6.55
5.90
................ 4.46
6.55
5.90
........................ 6.56
5.91
........................ 6.55
5.90
........................ 3.28
5.91
................................ 5.90
................................ 5.91
................................ 5.90
................................ 5.91
................................ 2.95
.......................................
.......................................
.......................................
.......................................
.......................................
3.750
7.219
6.677
6.177
5.713
5.285
4.888
4.522
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
4.462
4.461
2.231
5.
General Depreciation System
Applicable Depreciation Method: 200 or 150
Percent
Declining Balance Switching to Straight Line
Applicable Recovery Periods: 3, 5, 7, 10,
15, 20 years
Applicable Convention: Mid-quarter (property
placed in
service in fourth quarter)
If the
Recovery
Year is:
and the Recovery Period is:
3-year 5-year 7-year 10-year 15-year 20-year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
the Depreciation Rate is:
.. 8.33
5.00
3.57
2.50
1.25
. 61.11 38.00 27.55
19.50
9.88
. 20.37 22.80 19.68
15.60
8.89
. 10.19 13.68 14.06
12.48
8.00
........ 10.94 10.04
9.98
7.20
......... 9.58
8.73
7.99
6.48
................ 8.73
6.55
5.90
................ 7.64
6.55
5.90
........................ 6.56
5.90
........................ 6.55
5.91
........................ 5.74
5.90
................................ 5.91
................................ 5.90
................................ 5.91
................................ 5.90
................................ 5.17
.......................................
.......................................
.......................................
.......................................
.......................................
0.938
7.430
6.872
6.357
5.880
5.439
5.031
4.654
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.458
4.459
4.458
4.459
3.901
Numerical Implication Statement:
The Fronks are able to deduct the amounts of landscaping and paving as a matter of a
depreciable asset that is associated with the business. Landscaping and Paving, 60,000 dollars, fit
into the category of a 20 ADR (asset depreciation range), which is a 15-year MACRS class. The
mid-quarter is applicable to assets that are not residential rental property and nonresidential real
property and thus reaches the paving and sidewalks because more than 40 % of the assets
reached by the mid-quarter convention were placed into service in the last quarter of the year.
The half-year method is used for the 20,000 of landscaping. Finally, Section 179 is not available
for landscaping, sidewalks, and paving because those assets are not Section 1245 assets.
The calculation is:
Sidewalks and Paving
60,000 * .0988 = 5,928
Landscaping
20,000 * .05 = 1,000
The depreciation is deduction from gross income.
Issue N34: Vacation Rental Home (MOM: Andy B., 1,000 points; AUD: Tonya,
500 points; PR: -----, 500 points)
Path:
CCH Network; USMTG; Spine; Rental Income; 2001USMTG ¶966,
Deductions on Rental Residence or Vacation Home
Narrative Solution:
Deductions on Rental Residence or Vacation Home
Special rules limit the amount of deductions that may be taken by an individual or an S
corporation in connection with the rental of a residence or vacation home, or a portion thereof,
that is also used as the taxpayer's residence (Code Sec. 280A ).[ 2001FED ¶14,850 ]
Minimum Rental Use. If the property is rented for less than 15 days during the year, no
deductions attributable to such rental are allowable and no rental income is includible in gross
income. Deductions allowed without regard to whether or not the home is used for business or
the production of income (e.g., mortgage interest, property taxes, or a casualty loss) may still be
deducted.
Minimum Personal Use. If the home is not used by the taxpayer for personal purposes for
the greater of (a) more than 14 days during the tax year or (b) more than 10% of the number of
days during the year for which the home is rented at a fair market rental, the limitations in Code
Sec. 280A do not apply. However, the deductibility of expenses still may be subject to the hobby
loss rules of Code Sec. 183 if the rental of the residence is not engaged in for profit. See ¶1195 .
Deduction Limitations. If the property is rented for 15 or more days during the tax year and
it is used by the taxpayer for personal purposes for the greater of (a) more than 14 days or (b)
more than 10% of the number of days during the year for which the home is rented, the rental
deductions are limited. Under this limitation the amount of the rental activity deductions may not
exceed the amount by which the gross income derived from such activity exceeds the deductions
otherwise allowable for the property, such as interest and taxes. According to the IRS, expenses
attributable to the use of the rental unit are limited in the same manner as that prescribed under
the hobby loss rules at ¶1195 (i.e., the total deductions may not exceed the gross rental income
and the expenses are further limited to a percentage that represents the total days rented divided
by the total days used). However, the Tax Court has rejected this formula (the decision has been
affirmed on appeal by both the Ninth and Tenth Circuit Courts of Appeals).[ 2001FED
¶14,854.30 , 2001FED ¶14,854.58 ] It is the Tax Court's position that mortgage interest and real
estate taxes are not subject to the same percentage limitations as are other expenses because they
are assessed on an annual basis without regard to the number of days that the property is used.
As a result, the formula employed by the Tax Court computes the percentage limitation for
interest and taxes by dividing the total days rented by the total days in the year. The following
example illustrates the operation of the two methods for allocating rental unit expenses.
Example. During the year an individual rents out his vacation home for 91 days and
uses the home for personal purposes for 30 days. The gross rental income from the unit is
$2,700 for the year. He pays $621 of real property taxes and $2,854 of mortgage interest
on the property for the year. The additional expenses for maintenance, repair and utilities
total $2,693.
The IRS allocation of all expenses would be based on 75% (91 days rented ÷ 121
days used). In contrast, the Tax Court would allocate taxes and interest based on 25% (91
days rented ÷ 365 days) and use the 75% limitation for the additional expenses for
maintenance, repair, etc.
IRS
Tax Court
1. Gross rental income....................... $ 2,700 $ 2,700
2. Less: Interest ($2,854) ................... - 2,141
- 714
Property tax ($621) ..........................
- 466
- 155
---------- ---------3. Remaining available income ................ $
93 $ 1,831
4. Utilities, maintenance, etc. ..............
- 93 - 1,831
---------- ---------5. Net income ................................ 0
0
========== ---------6. Unused expense allowable as itemized
deductions:
Interest ..................................... $
713 $ 2,140
Property tax .................................
155
466
========== ---------7. Total allowable deductions ................ $ 3,568 $ 5,306
A vacation home is deemed to have been used by the taxpayer for personal purposes if for
any part of the day the home is used (Code Sec. 280A(d)(2) ):
(1) for personal purposes by the taxpayer, any other person who owns an interest in the
home, or the relatives (spouses, brothers, sisters, ancestors, lineal descendants, and spouses of
lineal descendants) of either;
(2) by any individual who uses the home under a reciprocal arrangement, whether or not a
rental is charged; and
(3) by any other individual who uses the home unless a fair rental is charged.
If the taxpayer rents the home at a fair rental value to any person (including a relative listed
above), for use as that person's principal residence, the use by that person is not considered
personal use by the taxpayer. This exception applies to a person who owns an interest in the
home only if the rental is under a shared equity financing agreement.
The term "vacation home" means a dwelling unit, including a house, apartment,
condominium, house trailer, boat, or similar property (Code Sec. 280A(f)(1) ).
Bed and Breakfast Inns. The special restrictions on deductions related to a residence used
for business and personal purposes do not apply to the portion of the residence used as a bed and
breakfast inn (IRS Letter Ruling 8732002 ).[ 2001FED ¶14,854.585 ]
Path: CCH Network; USMTG; Spine; Rental Income; 2001USMTG ¶1195,
Hobby Expenses and Losses
Hobby Expenses and Losses
Losses incurred by individuals, S corporations, partnerships, and estates and trusts that are
attributable to an activity not engaged in for profit--so-called hobby losses--are generally
deductible only to the extent of income produced by the activity (Code Sec. 183 ; Reg. §1.183-1
--Reg. §1.183-4 ).[ 2001FED ¶12,170 , 2001FED ¶12,171 --2001FED ¶12,176 , 2001FED
¶12,177.025 ] Some expenses that are deductible whether or not they are incurred in connection
with a hobby, such as taxes, interest, and casualty losses, are deductible even if they exceed
hobby income. These expenses, however, reduce the amount of hobby income against which
hobby expenses can be offset (Code Sec. 183(b)(1) ).[ 2001FED ¶12,170 , 2001FED ¶12,177.01
] The hobby expenses then offset the reduced income, in the following order: (1) operating
expenses other than amounts resulting in a basis adjustment and (2) depreciation and other basis
adjustment items.[ 2001FED ¶12,177.035 ] The itemized deduction for hobby expenses to the
extent of income derived from the activity is subject to the 2% floor on miscellaneous itemized
deductions (see ¶1011 ).
An activity is presumed not to be a hobby if profits result in any three of five consecutive
tax years ending with the tax year in question, unless the IRS proves otherwise (Code Sec.
183(d) ).[ 2001FED ¶12,170 ] An activity involving the breeding, training, showing, or racing of
horses is presumed not to be a hobby if profits result in two out of seven consecutive years. A
special election on Form 5213 permits suspension of the presumption until there are five (or
seven) years in existence from the time the taxpayer first engages in the activity. A taxpayer need
not waive the statute of limitations for unrelated items on his return in order to take advantage of
the presumption (Code Sec. 183(e)(4) ).[ 2001FED ¶12,170 ]
Numerical Implication Statement:
The tax treatment of a vacation rental home depends upon whether its usage is primarily
personal, rental, or a hybrid of the two. Usage is primarily personal when the property is rented
less than 15 days. Usage is primarily rental when the property is used for personal purposes no
more than 14 days or 10 percent of the rented days. Usage is of a hybrid variety when the
property is rented more than 15 days and personal usage more than 14 days or 10 percent of
rented days.
In the event of primarily personal usage, no rental income is reported nor are rental expenses
deductible (mortgage interest, property taxes, casualty losses are deductible as usual). In the
event of primarily rental usage, rental income is reported and rental expenses are allocate
between personal use and rental use days. In the event of hybrid usage, rental income is reported
and rental expenses are deductible in a hierarchy. First, expenses that are deductible anyway
(mortgage interest, property taxes, etc.); second, otherwise non-deductible expenses other than
depreciation, and depreciation. Expenses from the second and third category are deductible only
if there is sufficient income to absorb them. That is, in no case can hybrid usage result in a loss.
Taxpayers can use either the IRS or Tax Court method to allocate expenses in the first category
between rental and personal usage. The IRS method allocates those expenses based on the total
number of personal and rental use days. The Court method allocates those expenses based on the
total days in the year. All remaining expenses are allocable based on the total personal and rental
days (i.e., the IRS method).
For purposes of the Sawtooth Valley home, given the Tax Court method, these computations are
relevant:
Rental:
Personal:
Rental Income
Category 1 Expenses:
Real Estate Taxes (2,000 * 120 / 366)
Mortgage Interest (11,779 * 120 / 366)
Casualty Loss (7,000 * 120 / 366)
Income to cover category 2 expenses
Category 2 Expenses:
Utilities & Main. (14,000 * 120 / 150)
Income to cover category 3 expenses
Category 3 Expenses:
Depr.^^ (180,000 * .03636 * 120 / 150)
Net income from vacation rental home
^^Logic drawn from Issue E29-2 and N-3
30,000
656
3,861
2,295
23,188
1,342 (itemized deduction)
7,906 (itemized deduction)
4,699 (itemized deduction)
11,200
11,988
2,800 (non deductible)
5,236
6,752
1,309 (non deductible)
The excess vacation rental income that appears in the tax formula, $9,047, is obtained by adding
the $6,752 plus the casualty loss of $2,295. The casualty loss is a disposition of assets and as
such will not be reported on Schedule E (it's routed through Form 4684). This treatment of the
disposition is exactly the same as what one encounters with a Schedule C business.
Issue N35: Llamas - Hobby Activity (MOM: Frank, 1000 points; AUD:
Amanda, 500 points; PR: -----, 500 points)
Path:
CCH Network; USMTG; Word Search-Hobbies, GUIDEBOOK,
2001USMTG ¶1195, Hobby Expenses and Losses Hobby Expenses
and Losses
Path:
RIA Checkpoint; FTH; Chapter 13 Individual's Tax Computation-Kiddie Tax--Self-Employment Tax--Estimated Tax 1
Path:
RIA Checkpoint; FTH; Chapter 4 Interest Expense--Taxes--Losses-Bad Debts 1 ¶ 1775 Deduction for Losses.
Narrative Solution:
Losses incurred by individuals, S corporations, partnerships, and estates and trusts that are
attributable to an activity not engaged in for profit--so-called hobby losses--are generally
deductible only to the extent of income produced by the activity (Code Sec. 183 ; Reg. §1.183-1-Reg. §1.183-4 ).[ 2001FED ¶12,170 , 2001FED ¶12,171 --2001FED ¶12,176 , 2001FED
¶12,177.025 ] Some expenses that are deductible whether or not they are incurred in connection
with a hobby, such as taxes, interest, and casualty losses, are deductible even if they exceed
hobby income. These expenses, however, reduce the amount of hobby income against which
hobby expenses can be offset (Code Sec. 183(b)(1) ).[ 2001FED ¶12,170 , 2001FED ¶12,177.01
] The hobby expenses then offset the reduced income, in the following order: (1) operating
expenses other than amounts resulting in a basis adjustment and (2) depreciation and other basis
adjustment items.[ 2001FED ¶12,177.035 ] The itemized deduction for hobby expenses to the
extent of income derived from the activity is subject to the 2% floor on miscellaneous itemized
deductions (see ¶1011 ).
An activity is presumed not to be a hobby if profits result in any three of five
consecutive tax years ending with the tax year in question, unless the IRS proves otherwise
(Code Sec. 183(d) ).[ 2001FED ¶12,170 ] An activity involving the breeding, training, showing,
or racing of horses is presumed not to be a hobby if profits result in two out of seven consecutive
years. A special election on Form 5213 permits suspension of the presumption until there are five
(or seven) years in existence from the time the taxpayer first engages in the activity. A taxpayer
need not waive the statute of limitations for unrelated items on his return in order to take
advantage of the presumption (Code Sec. 183(e)(4) ).[ 2001FED ¶12,170 ]
¶ 1780. Hobby (not-for-profit) losses.
For individuals, partnerships, estates, trusts and S corporation deductions attributable to an
activity not engaged in for profit (Code Sec. 183(a) ) FTC ¶ M-5800 , FTC ¶ M-5802 ; USTR ¶
1834 et seq.; Tax Desk ¶ 42,201 are allowed only as follows:
(1) The full amount of deductions (e.g., state and local property
taxes) otherwise allowable for the tax year without regard to
whether the activity is engaged in for profit. ( Code Sec.
183(b)(1) ; Reg § 1.183-1(b)(1)(i) )
(2) Amounts allowable as deductions only if the activity were
engaged in for profit, but only if the allowance doesn't result in a
basis adjustment, and only to the extent the gross income from
the activity exceeds the deductions in (1), above. ( Code Sec.
183(b)(2) ; Reg § 1.183-1(b)(1)(ii) )
(3) Amounts allowable as deductions only if the activity were
engaged in for profit, that if allowed would result in a basis
adjustment (e.g., depreciation), but only to the extent the gross
income from the activity exceeds deductions allowed or
allowable under (1) and (2). ( Code Sec. 183(b)(2) ; Reg §
1.183-1(b)(1)(iii) , (b)(3)) FTC ¶ M-5804 et seq.; USTR ¶
1834 ; Tax Desk ¶ 42,201
In other words, deductions attributable to the “not for profit” activity are allowed to the extent
of income from it, or for the full amount of related deductions allowable regardless of profitseeking, whichever is larger. FTC ¶ M-5804 ; USTR ¶ 1834 ; Tax Desk ¶ 42,201
However, the deductions allowable under these rules are subject to the 2%-of-AGI floor ( ¶
3109 ) on miscellaneous itemized deductions. ( Reg § 1.67-1T(a)(1)(iv) ) FTC ¶ A-2710 ; USTR
¶ 674 ; Tax Desk ¶ 42,203
¶ 3109. Miscellaneous itemized
deductions—2%-of-AGI floor.
Miscellaneous itemized deductions are allowed only to the extent that they, in the aggregate,
exceed 2% of adjusted gross income. (Code Sec. 67(a) ) FTC ¶ A-2711 et seq. ; USTR ¶ 674 ;
Tax Desk ¶56,161 To the extent any other limit or restriction is placed on a miscellaneous
itemized deduction, that other limit applies before the 2% floor. For example, the 2% floor is
applied after the percentage limit for business meals and entertainment ( ¶ 1570 ). (Reg § 1.671T(a)(2) ) FTC ¶ A-2711 ; USTR ¶ 674 ; Tax Desk ¶ 56,161
RIA observation: Miscellaneous itemized
deductions that don't exceed 2% of AGI are lost. There's
no carryover.
Miscellaneous itemized deductions are itemized deductions other
than deductions for:
... medical expenses;
... taxes;
... interest;
... charitable contributions;
... casualty and theft losses;
... gambling losses (of non-professional gamblers);
... impairment-related work expenses;
... estate tax on income in respect of a decedent;
... personal property used in a short sale;
... restored amounts held under a claim of right;
... annuity payments that cease before investment is recovered;
... amortizable bond premium;
... payments by tenant-stockholders in connection with co-op
housing corporations. ( Code Sec. 67(b) )
Miscellaneous itemized deductions include unreimbursed employee business expenses,
including union and professional dues and home office expenses; expenses related to investment
income or property, such as investment counsel or advisory fees; tax return preparation costs and
related expenses (for deduction of tax determination costs as business expenses, see ¶ 1513 );
appraisal fees paid to determine the amount of a casualty loss or a charitable contribution of
property; and hobby expenses to the extent of hobby income. ( Reg § 1.67-1T(a)(1) ) FTC ¶ A2722 et seq. ; USTR ¶ 674 ; Tax Desk ¶ 56,163
If an expense relates to both a trade or business activity (not subject to the 2% floor) and a
production of income or tax preparation activity (subject to the 2% floor) the taxpayer must
allocate it between the activities on a reasonable basis. ( Reg §1.67-1T(c) ) FTC ¶ A-2722 et
seq.; USTR ¶ 674 ; Tax Desk ¶ 56,163.
Numerical Implication Statement:
Tom's llama activity clearly has the feel of a hobby activity. In no event is a loss allowed for a
hobby activity. In addition, expenses associated with the hobby are deductible according to the
following hierarchy: 1) Expenses that are deductible anyway (e.g., property taxes): 2) Expenses
other than depreciation, and 3) Depreciation. Income from the hobby activity is included in
income broadly conceived. Category 2 and 3 activities are characterized as miscellaneous
itemized deductions subject to a 2 % AGI floor. These computations are relevant:
Sales of Llamas
Less: Property Taxes
Income for Category 2 Expenses
Feed for Llamas
Medicine & Vet
Remaining Income
$25,000
2,100
22,900
13,000
9,900
-
itemized deduction
item. ded. s.t. 2 % AGI floor
item. ded. s.t. 2 % AGI floor
Since all of the income is used up, the remaining $2,100 in medicine and vet expenses as well as
all of the depreciation is not deductible. The entire $22,900 in deductible category 2 expenses is
miscellaneous itemized deductions subject to a 2 percent AGI floor. The property taxes are
itemized deductions as usual.
Issue N36: Class Life of Dental Equipment (MOM: KSB, 500 points; KSB, 250
points; PR: -----, 250 points)
Path:
CCH Online; Federal Taxes; technological equipment; REV-PROC,
87FED ¶6729, Revenue Procedure 87-57, 1987-2 CB 687, (Jan. 01,
1987)
Narrative Solution:
(b) 5-year property recovery class: Any automobile or light general purpose truck, any semiconductor manufacturing equipment, any computer-based telephone central office switching
equipment, any qualified technological equipment (as defined in section 168(i)(2)), any property
used in connection with research and experimentation, and certain energy property described in
section 168(e)(3)(B)(vi).
Path: CCH Online; Internal Revenue Code; citation search "168(i)(2)"; IRC, 2001-CODEVOL, SEC. 168. ACCELERATED COST RECOVERY SYSTEM.
168(i)(2) QUALIFIED TECHNOLOGICAL EQUIPMENT.-168(i)(2)(A) IN GENERAL.--The term “qualified technological equipment” means-168(i)(2)(A)(i) any computer or peripheral equipment,
168(i)(2)(A)(ii) any high technology telephone station equipment installed on the
customer’s premises, and
168(i)(2)(A)(iii) any high technology medical equipment.
…
168(i)(2)(C) HIGH TECHNOLOGY MEDICAL EQUIPMENT.--For purposes of this paragraph, the term
“high technology medical equipment” means any electronic, electromechanical, or computerbased high technology equipment used in the screening, monitoring, observation, diagnosis, or
treatment of patients in a laboratory, medical, or hospital environment.
Numerical Implication Statement:
Equipment is typically 7-year class property. However, this documentation affords a more
generous class life if equipment is high tech medical equipment. It is highly likely that the
Dentistry equipment qualifies for the 5-year class life. Thus, given the general cost recovery
context set forth in Issue E29-2 and the basis logic set forth in Issue N16, the medical equipment
has a $145,000 basis, 5-year life, mid-quarter convention, a .38 cost recovery multiplier, and cost
recovery of $55,100.
Issue N37: Sale of Section 1245 Property -- Dental Chair (MOM: Amanda,
(800 - 200) points; AUD: Frank, (400 - 100) points; PR: -----, 400
points)
Path:
CCH Online; USMTG; section 1245;l ¶1747, Property Used in Trade
or Business
Narrative Solution:
Business real estate or any depreciable business property is excluded from the definition of
“capital assets” (¶1741 ). However, if the business property qualifies as Code Sec. 1231 property
and gains from dealings in such property exceed any losses, then each gain or loss is treated as
though it were derived from the sale of a long-term capital asset (Code Sec. 1231(a) ).[ 2001FED
¶30,572 ] If the losses exceed the gains, all gains and losses are treated as though they were
ordinary gains and losses.
Taxpayers use Form 4797 (Sales of Business Property) to report Code Sec. 1231
transactions.
Code Sec. 1231 property includes (Code Sec. 1231(b) ; Reg. §§1.1231-1 and 1.1231-2 ): [
2001FED ¶30,572 , 2001FED ¶30,573 , 2001FED ¶30,574 ]
(1) Property used in the trade or business, subject to depreciation and held for the longterm holding period (¶1777 ) (but excluding property includible in inventory; property held
primarily for sale to customers; a copyright; a literary, musical or artistic composition; a
letter, memorandum or similar property (see item (6), ¶1741 ); and government publications
(see item (7), ¶1741 )).
(2) Real property used in the trade or business and held for the long-term holding period
(¶1777 ) (but excluding property includible in inventory or held primarily for sale to
customers).
(3) Trade or business property (items (1) and (2), above) held for the long-term holding
period (¶1777 ) and involuntarily converted.
(4) Capital assets held for the long-term holding period (¶1777 ) and involuntarily
converted (for rules, see ¶1748 ).
(5) A crop sold with the land, where the land has been held for the long-term holding
period (¶1777 ).
(6) Livestock, as explained at ¶1750 .
(7) Timber, domestic iron ore, or coal under conditions described at ¶1772 .
When Code Sec. 1231 property is also property subject to depreciation recapture under
Code Sec. 1245 or 1250 or mining property with unrecaptured mining exploration expenditures
under Code Sec. 617 , the amount of the Code Sec. 1231 gain on sales or exchanges is the
amount by which the total gain exceeds amounts recaptured at ordinary income rates under Code
Sec. 1245 , 1250 or 617(d)(1) (see ¶1779 and following). The farmland expenditure recapture
rules may also cause reductions in Code Sec. 1231 gain (see ¶1797 ).
A loss that is disallowed by other provisions of the law (e.g., a sale between family
members) is not taken into account in comparing Code Sec. 1231 gains and losses.
Recapture of Net Section 1231 Losses. A taxpayer who has a net section 1231 gain (i.e.,
excess of section 1231 gains over section 1231 losses) for the tax year must review the five
preceding tax years for possible recapture of net section 1231 losses for the prior years. If there
were any net section 1231 losses during such period, the taxpayer must treat the current year’s
net section 1231 gain as ordinary income to the extent of the amount of unrecaptured net section
1231 losses for that past period (Code Sec. 1231(c) ).[ 2001FED ¶30,572 ] The losses are to be
recaptured on a first-in, first-out (FIFO) basis.
Example. A business taxpayer incurred a net section 1231 gain of $23,000 for
2000. The taxpayer had a net section 1231 loss of $12,000 in 1998 and a net section
1231 loss of $15,000 in 1999. The taxpayer must include the total 2000 $23,000 net
section 1231 gain as ordinary income (i.e., recapture the $12,000 net section 1231 loss
for 1998 and $11,000 of the $15,000 net section 1231 loss for 1999). The $4,000 balance
of the net section 1231 loss for 1999 remains outstanding, to be recaptured should the
taxpayer realize any net section 1231 gain during 2001-2004.
Path: CCH Online; USMTG; section 1245; ¶1779, Depreciation Recapture Rules
Code Sec. 1245 Property. A gain on the sale or other disposition of Code Sec. 1245
property (¶1785 ) is taxed as ordinary income to the extent of all depreciation or amortization
deductions previously claimed on the property. Amounts expensed under Code Sec. 179 (¶1208
), Code Sec. 190 , for the removal of architectural and transportation barriers (¶1287 ), and Code
Sec. 193 , for tertiary injectant costs, are considered amortization deductions (Code Sec. 1245(a)
).[ 2001FED ¶30,902 ]
The amount treated as ordinary income is the excess of the lower of (1) the property’s
recomputed basis or (2) the amount realized or fair market value over the adjusted basis of the
Code Sec. 1245 property. The recomputed basis is the property’s adjusted basis plus previously
allowed or allowable depreciation or amortization reflected in the adjusted basis.
A disposition of Code Sec. 1245 property includes a sale in a sale-and-leaseback transaction and
a transfer upon the foreclosure of a security interest but does not include a mere transfer of title
to a creditor upon creation of a security interest or to a debtor upon termination of a security
interest (Reg. §1.1245-1 ).[ 2001FED ¶30,903 ]
Numerical Implication Statement:
The sale of the dental chair results in a $10,000 gain (i.e., $10,000 sales proceeds - $0 adjusted
basis). Since the chair was a depreciable asset used in the Dentistry business and was held for a
long-term holding period, it is a Section 1231 asset and thus transforming the character of the
gain to long-term capital gain. Section 1245 applies to depreciable personalty used in a business.
Section 1245 requires depreciation recapture for all depreciation taken. The recapture changes
the character of the Section 1231 long-term capital gain back to ordinary income to the extent of
previously taken depreciation. Thus, of the $10,000, $1,000 is ordinary income and $9,000 is
long-term capital gain. This activity is reported on Form 4797 (i.e., it does not show up on
Schedule C and is thus not subject to the self-employment tax). As a practical matter, the sale
will appear in income broadly conceived and the taxation of the proceeds adjusted to ensure that
$9,000 is taxed as a long-term capital gain.
Issue N38: Related-Party Sale -- Bell Corp. Stock (MOM: KSB, 600 points;
AUD: KSB, 300 points; PR: -----, 300 points)
Path:
CCH Online; USMTG; family stock; Losses not allowed
Narrative Solution:
In most situations, a loss from the sale or exchange of property is not allowed when the sale or
exchange is between (Code Sec. 267 ; Reg. §1.267(b)-1 ):[ 2001FED ¶14,150 , 2001FED
¶14,153 ]
(1) Members of a family (brother, sister, spouse, ancestor, or lineal descendant);
(2) An individual and a corporation if the individual owns (directly or indirectly) more than 50%
in value of the outstanding stock;
(3) Two corporations that are members of a controlled group (at least 50% owned) of
corporations;
(4) A grantor and a fiduciary of any trust;
(5) A fiduciary of one trust and a fiduciary of another trust, if the same person is grantor of both
trusts;
(6) A fiduciary of a trust and any beneficiary of such trust;
(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both
trusts;
(8) A fiduciary of a trust and a corporation more than 50% in value of the outstanding stock of
which is directly or indirectly owned by or for the trust or a grantor of the trust;
(9) A person and an exempt charitable or educational organization controlled by the person or, if
the "person" is an individual, by the individual or his family;
(10) A corporation and a partnership if the same persons own (a) more than 50% in value of the
outstanding stock of the corporation and (b) more than 50% of the capital interest or profits
interest in the partnership;
(11) An S corporation and another S corporation if the same persons own more than 50% in
value of the outstanding stock of each corporation; or
(12) An S corporation and a C corporation if the same persons own more than 50% in value of
the outstanding stock of each corporation.
In determining stock ownership: (a) stock held by a corporation, partnership, estate, or trust is
considered owned proportionately by its shareholders, partners, or beneficiaries; (b) individuals
are considered to own stock owned by their families, as defined above; and (c) stock owned by
an individual's partner is considered owned by the individual if the individual also owns stock in
the corporation (Code Sec. 267(c) ).[ 2001FED ¶14,150 ]
When the rule results in a denial of a loss deduction to the transferor of property, gain is taxable
to the original transferee upon disposition of the property to an outsider only to the extent that it
exceeds the transferor's loss allocable to the property. This rule benefits only the original
transferee (Reg. §1.267(d)-1 ).[ 2001FED ¶14,155 ]
Example. A father sells business property with a $15,000 basis to his son for $5,000. The father's
$10,000 realized loss is not deductible. Later, the son sells the property for $18,000 to an
unrelated person. His realized gain is $18,000 minus $5,000, or $13,000, but only $3,000
($13,000 minus the father's $10,000 disallowed loss) is recognized.
Numerical Implication Statement:
A loss from the sale or exchange of property is not allowed when family members are involved.
Such is the case with Mike and Tom. Since Mike purchased the stock for $18,000 and sold it to
Tom for $13,000, Mike’s loss of $5,000 is not deductible. When Tom sells the stock for
$20,000, he realizes a gain of $7,000, however, only $2,000 ($7000 - $5,000) is recognized since
a gain is taxable only to the extent it exceeds the original transferor’s loss. The remaining gain
is a long-term capital that is included in income broadly conceived and taxed at a maximum rate
of 20 percent (see Issue E14-1). This sale is reported in Schedule D.
Issue N39: Monica's Complimentary Textbook (MOM: KSB, 400 points;
AUD: KSB, 200 points; PR: -----, 200 points)
Path:
CCH Online; USMTG; business gifts; ¶918, Business Gifts
Narrative Solution:
Deductions for business gifts, whether made directly or indirectly, are limited to $25 per
recipient per year. Items clearly of an advertising nature that cost $4 or less and signs, display
racks, or other promotional materials given for use on business premises are not gifts (Code Sec.
274(b)(1) and Reg. §1.274-3 ).[ 2001FED ¶14,402 , 2001FED ¶14,406 ]
Numerical Implication Statement:
Businesses are allowed to deduct gifts at a maximum of $25 per customer. Thus, it appears that
Monica received a gift of $25. The remaining $100 appears to be income.
Issue N40: Dividends - Life Insurance Policy (MOM: KSB, 300 points; AUD:
KSB, 150 points; PR: -----, 150 points)
Path:
CCH Network; USMTG; keyword: dividends on insurance policy;
¶1533, Cash Basis and Constructive Receipt
Narrative Solution:
It is not always necessary that money or property representing income actually be in the
taxpayer's possession before it is considered received. Income that is constructively received is
taxed to the cash-basis taxpayer as though it had been actually received.
There is constructive receipt when income is credited without restriction and made available
to the taxpayer. There must be no substantial limitation or condition on the taxpayer's right to
bring the funds within his control. An insubstantial forfeiture provision, a notice requirement, or
the loss of bonus interest for deposits or accounts in certain financial institutions is not a
substantial limitation (Reg. §1.451-2(a) ).[ 2001FED ¶21,007 ]
Common examples of constructive receipt include matured and payable interest coupons,
interest credited on savings bank deposits, and dividends unqualifiedly made subject to a
stockholder's demand. However, if a dividend is declared payable on December 31 and the
corporation follows a practice of paying the dividend by checks mailed so that the shareholders
will not receive them until January of the following year, the dividend is not considered to be
constructively received by the stockholders in December.[ 2001FED ¶21,007 , 2001FED
¶21,009.1235 ] For the time of receipt by shareholders of certain mutual fund dividends, see
¶2303 . Accrued interest on an unwithdrawn insurance policy dividend is gross income to the
taxpayer for the first tax year during which the interest may be withdrawn.[ 2001FED ¶21,007 ]
Salaries credited on corporate books are taxable to an officer in the year when the officer
may withdraw the compensation at will if the corporation has funds available to pay the salaries
without causing financial difficulties. Bonuses that are based on yearly sales and that are
otherwise not available to an officer are taxable in the year of receipt.[ 2001FED ¶21,007 ,
2001FED ¶21,009.17 , 2001FED ¶21,009.14 ]
Accrued interest on a deposit that may not be withdrawn at the close of an individual's tax
year because of an institution's actual or threatened bankruptcy or insolvency is not includible in
the depositor's income until the year in which such interest is withdrawable (Code Sec. 451(g) ).[
2001FED ¶21,002 ]
Any option to accelerate the receipt of any payment under a production flexibility contract
(between certain eligible owners and producers and the Secretary of Agriculture) which is
payable under the Federal Agriculture Improvement and Reform Act of 1996 (the FAIR Act) is
to be disregarded in determining the taxable year in which such payment is properly included in
gross income (Tax Relief Extension Act of 1999, P.L. 106-170, Act Sec. 525).
Path: CCH Online; Federal Tax Service; keyword: life insurance dividends, life insurance
dividend income; §A:8.147, Insurance Dividends
Dividends paid under insurance contracts are taxed under the provisions dealing with
annuities. See § A:8.60. The policyholder excludes the dividends from his gross income unless
total dividends received exceed total premiums paid; the excess is immediately taxable in full.116
For the exception to this rule for modified endowment contracts, see § A:8.61[4]. However, if
proceeds are received before death, the cost of the policy is reduced by the dividends received in
computing any gain.
116
Code Sec. 72(e).
Otherwise nontaxable dividends under a life insurance policy are not taxable merely because
they are left with the insurance company as interest; however, the interest credited to the
dividends is taxable.117
117
Code Sec. 72(j); Reg. § 1.451-2; T.H. Cohen v Commr, 39 TC 1055, Dec. 26,031 (1963)
(Acq.).
Dividends used to purchase additional paid-up insurance are not constructively received by the
policyholder and thus are not taxable at that time.118
118
A. Nesbitt, II v Commr, 43 TC 629, Dec. 27,239 (1965).
Dividends under a single-premium or paid-up policy are exempt if they are received before the
policy matures,119 but taxable if they are received after maturity.120
119
G.T. Helvering v E.E. Meredith, 1 TCM 847, Dec. 13,097(M), aff'd, CA-8, 44-1 USTC ¶9244
, 140 F2d 973.
120
F.M. Shelley v Commr, 10 TC 44, Dec. 16,209 (1948).
Cash dividends received by an employer who took a deduction for premiums paid on group
insurance policies are taxable.121
121
Harris Hardwood Co., Inc. v Commr, 8 TC 874, Dec. 15,737 (1947); Commr v O. Liquidating
Corp., CA-3, 61-2 USTC ¶9508, 292 F2d 225, cert. denied, 368 US 898.
Dividends received on a group credit life insurance policy by a farm production credit
association were not taxable because the policy premiums were not deducted and the association
was acting as an agent for its members.122
122
Rev. Rul. 74-321, 1974-2 CB 16.
Path: CCH Online; Federal Tax Service; keyword: life insurance dividends, life insurance
dividend income; Service §I:5.163, Dividends From Life Insurance Companies
Distributions by life insurance companies are taxed as dividends to the extent they are made to
shareholders in their capacities as shareholders. See §I:5.40. Dividends credited or paid to
policyholders that are a partial refund of their insurance premium are not treated as dividends.33
Similarly, dividends on policies of workmen's compensation insurance are not dividends.34
These amounts are treated as rebates, and are not included in the income of the recipients, unless
they exceed the amount paid for the policy.35 See §I:5.143[2] for discussion of rebates versus
dividends.
33
Code Sec. 316(b)(1).
34
Houston Chronicle Publishing Co. v Commr, 3 TC 1233, Dec. 14,101 (1944).
35
SM 5680, V-1 CB 32 (1926).
Numerical Implication Statement:
Dividends paid under insurance contracts are taxed under the provisions dealing with
annuities. See § A:8.60. The policyholder excludes the dividends from their gross income unless
total dividends received exceed total premiums paid; the excess is immediately taxable in full.
However, if proceeds are received before death, the cost of the policy is reduced by the dividends
received in computing any gain. Therefore, the $500 dividend the Fronks received on their life
insurance policy is excluded from their gross income.