Federal Income Tax 1
FEDERAL INCOME TAX- SPRING 2012 BROWN
Calculation of Tax Liability
1. Gross Income [§ 61 – defines; § 1 – imposes a tax on GI]
- “Above the line” deductions [§ 62(a) – list of eligible deductions]
Adjusted Gross Income
- Personal Exemption(s) [§ 151] (subject to any phase out)
- Standard Deduction [§ 63(b), (c)] OR
- Itemized Deductions [§ 63(a), (d)]
Limitations on Itemized Deductions
§ 67(b) – ID other than the ones listed in 67(b) are allowed only to the extent they exceed 2% of TP AGI
§ 68 – Overall limitation on IDs for TPs w/ AGI in excess of the “applicable amount,” defined in § 68(b)
Taxable Income (- Net capital gains [15%] – (unrecaptured §1250 gains [25%] + collectible gains [28%]))
* Tax Rate
Gross Tax Liability
- Tax Credits
Net Tax Liability OR Tax Refund
Introduction
1. Tax Policy
a. Fed Income Tax is progressive, not proportionate (flat tax)
b. Federal Insurance Comprehensive Act Tax (FICA – payroll tax) is a flat tax.
c. Ideal Income Base - Haig-Simons Definition
i. Two components
1. Value of rights exercised in personal consumption
a. Current-year receipts minus business & investment deductions.
2. Change in property value over X period
ii. We adhere to Part I, but not Part II, b/c we have a realization requirement that you have to sell the
property before you include it in the base. For admin reasons, it would be very hard for IRS to
monitor all increases in value
iii. Tax expenditures (spending by congress but through the tax code) are departures from ideal base
2. Inflation & Income Tax
a. Hellerman v. Comm’r (SCOTUS 1981)
i. Issue: whether gain from sale of property due to inflation is income?
ii. Say should be taxed only on economic gain, not nominal gain
iii. Holding: income is based on the meaning a layperson would give it, which means the “extra dollars”
paid to them even in nominal gain does not equal their real gain in an economic sense
3. Compliance & Enforcement
a. Tax Return Preparation: ABA Formal Ethics Opinion 85-352 (1985)
i. Used to be a reasonable basis, now lawyer must have a good faith belief
ii. § 6662 – penalty for substantial understatement of tax liability which can be avoided if the facts are
adequately disclosed or if there is or was substantial authority for position taken
iii. If there is substantial authority for their position, then okay, but if there is not, att’y must inform client
about penalty
b. Tax Shelters
i. Special disclosure and penalty rules apply b/c of the special threat tax shelters & audit lottery
ii. Listed transactions and reportable transactions have strict liability penalties attached for understating
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The Scope of Gross Income
1. Cash Receipts: Does Source Matter? Generally, no.
a. Windfalls and Recovery of Capital
i. Windfalls [§ 61]
1. “GI means all income from whatever source derived…” – 61(a)
2. TP must include in income any windfalls they receive. All we need is an accession of wealth
that is realized and subject to the TP’s dominion. If it is not out, it is in
a. Comm’r v. Glenshaw Glass (SCOTUS 1955)
i. Two actions re: antitrust violations
1. $324K of $800K settlement was in punitive damages (Glenshaw)
a. Argued that did nothing intentional
2. $125K of $375K was loss of profits, rest punitive b/c treble damages
(William Goldman Theatres)
ii. Issue: whether $ rec’d as exemplary damages for fraud or as punitive 2/3s
portion of a treble-damage antitrust recovery must be reported as GI?
iii. Holding: Punitive damages are “undeniable accessions to wealth, clearly
realized & over which TPs have complete dominion.” Punitive damages
must be included in GI
1. Limits Eisner v. Macomber to dividends, distinguishing “gain” from
“capital”
a. Defined income as being derived from labor or capital
2. This case is ltd to its facts
b. SOURCE IS ALWAYS IRRELEVANT FOR INCLUDING IN GI
i. “except as otherwise provided”
3. Cesarini v. US (N.D. Ohio 1969)
a. Found $4,467 in old piano
b. Report on tax returns, but then file amended return asking for refund of taxes on that
amount b/c it was (1) found; (2) income from the yr piano was bought and SOL
blocks it now; and (3) entitled to capital gains treatment
c. Holding: State law applies. Under OH law, $ not disputed until discovered so not
barred by SOL
i. “treasure trove regulation”: Reg § 1.61-14(a) “The finder of treasure trove is
in receipt of TI, for FIT purposes, to the extent of its value in US currency,
for the TP in which it is reduced to undisputed possession”
ii. If a physical item, can defer reporting income until sell item; if cash, report
the year in which it was found
1. IRS ignores reporting in year found for things like caught baseballs
iii. BUT law says that you need to declare value when find it, and then
declare appreciation when sell it
1. Recorded as ordinary income in this case
4. What if you buy something for a small value and it is worth a lot more than expected?
a. Accession to wealth
b. Ignore this in a stranger situation (would need to report if employer-employee
relationship – Reg. § 1.61-2(d)(2)(i))
c. Becomes unrealized appreciation, must report when sold
d. What about rebates?
i. 1979 Rev. Rul.: ignore accession of wealth in an arms-length transaction
5. What about self-created, imputed income, i.e., catching a baseball? Deferral of tax until sell
baseball, then it is a LTCG
6. GI includes income realized in any form, whether in money, property, or services. §1.61-1(a)
[$10K bracelet found in piano – horizontal equity]
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ii. Recovery of Capital [§ 1001; § 1012]
1. § 1001(a) - Computation of Gain or Loss defines the gain on the sale of property as the
excess of the “amount realized” on the sale over the “adjusted basis” of the property
2. § 1001(b) - Amount Realized - Defines a TP’s amount realized on a sale as the cash received
by the TP plus the FMV of any non-cash property received
3. § 1012 - Basis of Property - Cost - Defines a TP’s basis in an asset as “the cost of such
property”
4. § 1016 provides for certain adjustments in moving from §1012 basis to “adjusted basis”
b. Gift and Bequests
i. Statutes [§102; §1.102-1(f)(2)]
1. GI does not include the value of property acquired by gift, bequest, devise, or inheritance
[§102(a)]
2. Donor does not receive a deduction. A shift to the donee
3. Gains can be transferred, but not losses §1015(a)
4. Exclusion does not extend to the income earned on property given as a gift [§102(b)]
5. Business gifts generally are deductible only up to $25 per year per recipient [§274(b)]
ii. Standard Inquiry [Duberstein is binding; Goodwin is not]
1. Comm’r v. Duberstein (SCOTUS 1960)
a. D receives Cadillac from Mohawk as a “gift” for giving M a list of potential
customers
b. D did not intend to be compensated for the info
c. M deducts the value of the car as a business expense
d. D did not include in GI seeing car as a gift
2. Stanton v. US (Same opinion)
a. S worked at church, decided to go into business for himself
b. Church directors all liked him & wanted to give him a gift of $20K, instead of
pension & retirement benefits
c. S did not include in GI
d. Issue: What is a gift in context w/ a business overtone?
e. Holding: Focus on the objective intent of the transferor – was it from a “detached
and disinterested generosity,” “out of affection, respect, admiration, charity or
like impulses”?
i. Car not a gift b/c seeking to encourage a business relationship
ii. Must evaluate the facts of each case
iii. Congress meant “gift” to be interpreted in the “colloquial sense”
iv. Must be an objective inquiry into transferor’s intent
1. Factual Q
2. Deference to the trier of fact
f. When the recipient has performed some service for the transferor, the receipt is
generally not a gift
g. Payment of a business nature when:
i. Thing of value given by employer to employee upon termination of
employment
ii. Payments in a business relationship, occasioned by the performance of some
service
Value of Car After-tax Cost to Mohawk
After-tax Benefit to Duberstein
$30K ($50K reduced by $20K
$30K ($50K value of car,
M’s ltr indicates car is not a gift $50K
tax savings from deduction)
reduced by $20K tax liability)
$30K
$30K (no deduction allowed by $30K (car treated as gift)
M’s ltr indicates car is a gift
§ 274(b))
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iii.
iv.
v.
vi.
vii.
h. Post-Duberstein Amendments to Tax Code:
i. § 274(b) denies transferor a business expense deduction for any business gift
ii. § 102(c) says that § 102(a) gift/inheritance deductions cannot apply to “any
amount transferred by or for an employer to, or for the benefit of, an
employee”
Gifts v. Compensation: Goodwin v. United States (8th Cir. 1995)
1. Goodwins denied refund for taxes paid on payments rec’d from members of Rev. Goodwin’s
congregation
2. Church did not consider these “gifts” as income when setting Rev.’s annual compensation
3. Issue: is the money a gift under the Duberstein std?
4. Holding: TI b/c the special occasion gift was a regular, sizable payment made by person
whom Rev. provides services, thus, a form of compensation
a. Gathered by congregation leaders
b. In a regular program, o/b/o congregation
Tips – § 6053
1. Employees who receive tips must include them in GI. Tips are required for services
rendered. However, there is a reporting problem b/c they are receiving cash.
2. Jt Committee on Taxation, 1982
a. Must report all tips to employer for a month before the 10th day of next month
b. Large food and beverage establishments required to report to IRS (1) gross receipts
of the establishment from food & beverage sales, (2) the amount of aggregate charge
receipts, (3) the aggregate amount of tips shown on such charge receipts, and (4)
reported tip income
c. No tip allocations need to be made if tipped employees voluntarily report tips
aggregating 8 percent or more of gross receipts
Property as a Gift § 1015(a)
1. “Basis shall be the same as it would be in the hands of the donor”
2. Example: Mom gives house to son
a. Bought in 2009 for $100K
b. Give to son in Feb. 2011, FMV $110K
c. Son sells in Jan. 2012 for $135K
d. Mom:
i. AB $100,000
(pays tax when bought property)
ii. No tax on transfer b/c not a “sale or other disposition” § 1001(a)
iii. But subject to transfer tax of amount over $13,000 based on FMV
e. When Mark sells it:
i. AB: $100K (same as donor)
ii. AR: $135K
iii. Realized gain included in GI: $35K
1. LTCG b/c donor’s holding period added to donee’s § 1223(2)
f. However, Su Lin would still be subject to the transfer tax over $13,000 if exceeded
lifetime exemption
Employer/Employee Gifts
1. There cannot be a gift between employer & employee unless it can be proven the gift was not
given in recognition of the employee’s employment (relatives or birthday) §102(c)
Prizes and Awards
1. Not defined in code; something given to you in recognition for an
accomplishment/achievement
2. §74(a) - Except as otherwise provided in this section or in §117 (relating to qualified
scholarships), GI includes amounts received as prizes and awards
3. Rev. Rul. 57-374: FMV of trip not included in GI where refuse an all-expense pd trip
a. Need an ascension of wealth
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c. Personal Injury Damages [104(a)(2); 213(a)]
i. Statute
1. §104(a)(2) excludes from GI “any damages (other than punitive damages) received (whether
by suit or agreement and whether as lump sums or as periodic payments) o/a/o personal
physical injuries or physical sickness” – includes lost wages, pain & suffering, IIED, loss of
consortium resulting from physical injuries
2. Physical manifestations, such as physical indications of emotional distress, of nonphysical
injuries do not constitute a personal physical injury or sickness
3. However, last sentence of §104(a) says this does not apply if you go to a doctor to treat IIED,
even if the expenses arise not from physical injuries, to that extent they will be excluded
4. Wages are excluded b/c of attorney’s fees – might not be able to deduct it (in the case of
physical injury) § 162
a. Whistleblower/employment case: att’y’s fees treated as an above the line deduction §
62(a)(20) – but must include settlement in GI
ii. Standard
1. Whether the settlement payment is excludable from GI under §104(a)(2) depends on the
nature and character of the claim asserted, and not upon the validity of that claim. Look
first to the settlement agreement language (lump sum jury verdict) and then to the payor’s
intent
2. Amos v. Comm’r (TCM 2003)
a.  is a photographer, who Dennis Rodman kicked in groin during Chicago Bulls game
b. Had a preexisting back condition
c. Settled w/ Rodman – confidential agmt was part of consideration for payment
d. Issue: whether $200K settlement from 1997 is excludable?
e. Holding: $120K is, but $80K is not. Where damages rec’d in settlement, nature of the
claim that was actual basis for settlement controls whether such damages are
excludable
i. Two requirements TP must meet to exclude under § 104(a)(2) (Comm’r v.
Schleier)
1. TP must demonstrate that the underlying COA give rise to recover
based upon tort
2. TP must show damages were rec’d o/a/o personal injuries or sickness
ii. Portion of settlement was to prevent  from disclosing, publicizing the facts,
or assisting a criminal prosecution against Rodman
2. Is It Taxable If It Isn’t Cash? Generally, Yes, As far as §61 is Concerned
a. Goods & Services
i. GI includes income realized in any form, whether in money, property, or services. §1.61-1(a)
ii. §61(a) requires an obj. measure (retail value) of FMV
1. Rooner v. Comm’r (TC 1987)
a. Partners in acct’g firm, received goods & services in exchange for payment for acct’g
services provided
i. “cross-acct’g” w/ 4 clients
b. Became dissatisfied w/ cross acct’g, goods overpriced, services not satisfactorily
performed – discounted those goods and services against what was owed to
partnership
c. Clients not informed of adjustments
d. Issue: can they discount the retail prices of foods & services rec’d in exchange for
acct’g services using subjective determination of value?
i. GI includes FMV of goods & services rec’d by them
e. Holding: § 61 requires objective measure of FMV – cannot adjust acknowledged
retail price
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iii. If services are paid for in exchange for other services, the FMV of such other services taken in
payment must be included in income as compensation §1.61-2(d)(1)
iv. Meals & Lodging - §119(a), §1.119-1(a)
1. §119(a) - Exclusion from GI the value of meals & lodging furnished by an employer to an
employee (her spouse, or dependents). Factual inquiry - substantial non-compensatory
purpose, ex. waiters & firefighters Reg. § 1.119-1
a. (1) For Meals to be excluded:
i. For convenience of the employer; and
1. = substantial noncompensatory purpose
ii. The meals are furnished on the business premises
b. (2) For lodging to be excluded (§1.119-1(b))
i. Furnished on business premises of employer;
ii. Furnished for convenience of the employer; and
iii. Employee is req. to accept such lodging as a condition of his employment
c. Excludes rental value of employer-providing housing if:
i. (1) housing is located on business premises of employer
ii. (2) employee must accept the housing as a condition of employment
iii. (3) housing is furnished “for the convenience of the employer”
2. §119(d) - Lodging for Certain Educational Institutions
a. (1) Employees of educ. institutions are often provided nearby housing at belowmarket rent. The value of such lodging is excluded from GI of the employee
provided that the employee pays rent for such lodging in an amount that equals or
exceeds 5% of the FMV of the lodging
b. (2)(A) If the employee does not pay rent of at least 5% of the appraised value, TP
receives TI in the amount of the difference between the rent paid, & the lesser of i. 5% of the FMV of the lodging, or
ii. AVG rental paid by individuals not affiliated w/ the institution for lodging
provided by the institution that is comparable to that provided to employee
c. (3) The term qualified lodging means lodging to which subsection (a) does not apply,
and which is located or in the proximity of a campus of the education institution
3. Employer gets a deduction under § 162 for transfer of real property to an employee
b. Imputed Income and Unrealized Appreciation
i. Imputed Income
1. Non-cash benefits you create for yourself, in the absence of an exchange are not taxable
a. Performing a service in exchange for a service is to be included in GI (Rooney)
2. Imputed income from owner-used property is excluded from the scope of §61
a. Home mortgage interest deduction preserves the benefit of the imputed income
exclusion for homeowners w/ mortgages
b. Loser is the renter – owner gets deductions, not person renting
3. Public Policy - Privacy & Liberty Problems - You don’t want to force people in the market
place if they don’t want to go in. Encourages specialization of labor & efficiency. There are
also reporting, administration, valuation, and liquidity problems
ii. Unrealized Appreciation
1. As long as you do not sell (or otherwise dispose of) your shares, income tax will continue to
disregard any increases or decreases in the value of the stock. However, Congress can
change that and has the power to tax unrealized appreciation to the extent it sees fit
2. Results only in deferral of tax, taxed under §1001 for gain realized once you sell it
3. Public Policy - Valuation and liquidity
a. Valuation – Can look at the current price of the shares
b. Liquidity – However, TP could easily sell (or borrow against) some of the shares in
order to pay a tax on the appreciation
4. But stepped up to FMV upon death § 1014
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c. Employer-Provided Benefits
i. Employer-Provided Health Insurance [§106] [§105] [§125]
1. §106(a) excludes from the GI of an employee the value of employer-provided health
insurance coverage to TP, spouse or his dependents (Reg. § 1.106-1)
2. §105(b) excludes from GI the value of benefits received under employer-provided health
insurance, to the extent the benefits constitute reimbursement of medical expenses
3. Removes both premiums & benefits from income tax base
4. Same Sex Marriage If an employer provides health insurance coverage for unmarried
partners of its employees, the value of the partner coverage cannot be excluded from GI
under DOMA (except if partner qualifies as a dependent of the employee under §152)
ii. Cafeteria Plan [non discrimination applied]
1. Under §125, a TP who is offered a choice between cash & health insurance coverage, and
who chooses insurance, will not be taxed under the doctrine of constructive receipt
2. Qualified benefits mean any benefit that is not includible in the GI of the employee by reason
of an express provision of this chapter (§106, §105) §125(f)
3. One drawback of the cafeteria plans is that you have to estimate how much you put in. If you
don’t spend it you may lose it
iii. No Employee Health Care
1. §213(a) allows TP who do not have health insurance through their employers to claim their
medical expenses as itemized deductions (only to the extent they exceed 7.5% of AGI)
iv. Self-Employed Health Coverage
1. §162(l) self-employed people who provide their own health insurance coverage have an
above the line deduction. Does not apply if you are an employee
v. Group-Term Life Insurance
1. §79(a) allows employees to exclude the value of group-term life insurance provided by their
employers, for up to $50,000 of insurance. Employers may not discriminate
2. Amount over $50K is counted in GI
vi. Certain Fringe Benefits
1. §132(a)- GI shall not include any fringe benefit which qualifies as a a. No-additional-cost service [§132(a)(1), §132(b), §1.132-2]
i. A service regularly provided to the public by the employer, which the
employer can provide to the employee w/out incurring significant additional
cost (incidental to primary service being provided by employer)
ii. Non-discrimination rule applied [§1.132-8]
1. § 132(j)(1) nondiscrimination on exclusions for no-additional-cost
services & qualified employee discounts
2. § 117(d)(3) nondiscrimination on exclusion for qualified tuition
reductions
iii. Air Transportation - Any use of air transportation by a parent of an
employee shall be treated as use by the employee. §132(h)(3). Supports
certain expectations of the parties
iv. Inflight services of a flight attendant & the cost of inflight meals are
incidental costs
b. Qualified employee discount [§132(a)(2), §132(c)], [Non-discrimination rule]
i. To apply, it must be “qualified property or service” to get an employee
discount
ii. For that to occur, it must be “any property or services which are offered for
sale to customers in the ordinary course of the line of business of the
employer in which the employee performs substantial services” §132(c)(4)
iii. Qualified property does not include real property & personal property of a
kind commonly held for investment (sec., commodities, currency, & real
estate) §1.132-3(a)(2)(ii)
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iv. A transfer of property (gift) by an employee w/out consideration is treated as
use by the employee for purposes of this section §1.132.3(b)(1)(ii)
v. Limitation on Discount [price determined at time of sale]
1. (c)(1)(A) - Discounts to property may not exceed GP Percentage
2. (c)(1)(B) - Discounts to services may not exceed 20% of retail price
a. Ex - Free flight on reserved basis. $1K ticket is discounted
20% and $800 is included in GI. GI would be reported when
you actually take the flight §1.132-3(e)
c. Working condition fringe [§132(a)(3), §132(d)]
i. A benefit provided to the employee that, if he had paid for it personally,
would have generated a business deduction as a T/B expense under §162 or
as depreciation under §167. Don’t have to worry about the 50%. 274(n).
1. §162 – Allows TP to deduct all the “ordinary and necessary”
expenses paid or incurred during the TY in carrying on any T/B
2. §167 – Allows TP to take depreciation deductions on P used in a T/B
or held for the production of income
d. De minimis fringe [§132(a)(4), §132(e), §1.132-6] [nondiscrimination DNA]
i. §132(e) - This is the provision of goods or services to the employee w/ a
value so small as to make accounting for it unreasonable or administratively
impracticable. A cash payment cannot be a de minimis fringe
1. Frequency is determined by reference to the frequency w/ which the
employer provides the fringes to each individual employee
2. Maybe it is frequent w/ one employee, but for the entire population it
might not be frequent. Otherwise, take a look at how often it is
provided to the entire workforce
ii. Examples - §1.132-6(e)
1. Traditional birthday or holiday gifts of P (not cash) w/a low FMV,
occasional theater/sporting tickets; coffee, doughnuts, soft drinks
2. Included in GI: Gift cards from AmEx or Target. However, some
may qualify as a working condition fringe- §1.132-6(c)
iii. Occasional Meal Money [§1.132-6(d)(2)] [three requirements]
1. Occasional basis – Availability of the benefit and the regularity w/
which the benefit is provided by the employer to the employee
2. Overtime – This condition does not fail to be satisfied merely b/c the
circumstances giving rise to the need for overtime work are
reasonably foreseeable
3. Meal Money – Meal or meal money provided to enable the employee
to work overtime
iv. Employer Provided Transportation [§1.132-6(d)(2)(ii)]
1. Only if an unusual circumstances (factual inquiry) (working from
1am – 8am) and it is unsafe (history of crime)
2. Exclude the excess of $1.50 one-way commute
v. You don’t have to be an employee. §1.132-1 Reference to athletic
scholarship that has transportation and massages. Part of the value that she
gets from the school is incidental
e. Qualified transportation fringe [§132(a)(5), §132(f)]
i. The monthly limitation under §132(f)(2)(A) for transit passes/commuter
highway vehicle is $125 and under §132(f)(2)(B) for qualified parking near
or on the premises is $240. Cash reimbursements included §132(f)(3)
ii. Constructive Receipts – No amount shall be included in GI of an employee
solely b/c the employee may choose between any qualified transport fringe &
compensation which would otherwise be includible in GI of employee. If you
choose salary it’s in GI. If you take reimbursement it is excluded
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1. Doctrine of constructive receipt: TP who has the right to receive a
taxable payment, but turns his back on the payment, is taxed just as if
he had actually rec’d the payment, i.e., taxed for parking if could
have had cash  eliminated by § 132(f)(4)
iii. Policy – Fairness issue. Expectation of TP
f. Qualified moving expense reimbursement [§132(a)(6), §132(g)]
i. Amounts rec’d by an individual from an employer as payment for expenses
that would be deductible by the employee as moving expenses under §217 if
paid by the employee
g. Qualified retirement planning services [§132(a)(7), §132(h)]
i. Any planning advice or info provided to an employee by an employer
maintaining a qualified employer plan
h. Qualified military base realignment and closure fringe [§132(a)(8), §132(i)]
d. Restricted Property and Stock Options [§83]
i. Basic Rule
1. (a) Elements:
a. Property is transferred to TP in connection w/ services
b. Subject to a substantial risk of forfeiture
c. Not disposed of in an arm’s length transaction before the property becomes
transferable or the risk of forfeiture is removed
d. Generally, taxed on the FMV of the property at the time of the transfer (reduced by
any amount she paid for the property)
e. Example – If Jane is allowed to buy $10,000 of her employer’s stock for only $4,000,
she will have $6,000 of GI under §83(a)
2. (e)(3) - This section does not apply to stock options w/o a readily ascertainable FMV
3. Transferred property is not taxable to person performing services if her rights in property are
not substantially vested (subject to a substantial risk of forfeiture & are transferable)
a. If substantially nonvested property later becomes vested, tax is imposed at time of
vesting
4. (h) - Employer is allowed a deduction under §162 (T/B) for the TY when the employee
includes the amount in GI [FMV - Amount Paid]
5. General Rule for Qualified Stock Options:
a. No GI until sale of shares, when do sell  LTCG
b. Employer gets NO deduction under § 162
c. Need SH approval from corp’n to give options to employees
d. Hold for 2 yrs after grant of option; 1 yr after exercise option before can sell
e. Annual amount of options granted an employee cannot exceed $100K
f. Must be “in the money” meaning option price = FMV at time of grant of option
g. When exercise option, if value goes above market price, must put difference in GI
ii. Earner is Taxed
1. (a) Earned income must be taxed to the earner, even if the earner arranges for the income to
be received by a family member, friend, or controlled entity
iii. Accelerate Inclusion (w/in 30 days of receiving stock - §83(b)(2))
1. (b) Permits a TP who receives substantially nonvested property to elect to pay tax on the
value of the property (determined w/out regard to restrictions) in the year she receives the
property
a. (1) no tax consequences to employee for electing option
b. (2) taxed when exercise option if stock is substantially vested
2. (b)(1) If election is made, subsection (a) does not apply
a. Should only take the election if two things:
i. Confident there will be no forfeiture; and
ii. Confident the value will continue to increase
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b. If property is subsequently forfeited, no deduction is allowed
c. TP should make this election when it will trigger no current income tax liability b/c
TP purchased the property for its FMV
i. Alves v. Comm’r (9th Cir. 1984)
1. Joined company as VP, got stock to try to raise capital for initial
operations
2. Splits into 3 categories: (1) repurchase if left in 4 years; (2)
repurchase if left in 5 years; (3) unrestricted
3. Arguing that paying FMV does not mean in connection w/
performance b/c not compensation
4. Issue: Does § 83 apply even when paid FMV for stock?
5. Holding: Yes. Applicable to all restricted property, transferred to
any person in connection w/ services, not just as compensation
a. Must make election in year stock acquired to avoid treatment
of appreciation as ordinary income § 83(b)
d. Treasury Reg. 1978: fact that the transferee has paid full value for the property
transferred, realizing no bargain element in the transaction, does not preclude the use
of the electing to include in GI under § 83(a)
iv. Incentive Stock Option (ISO) [§ 422]
1. Elements:
a. (1) grant of option is not a taxable event
b. (2) when exercise option, excess of value of stock over option price is not a taxable
event § 421(a)
2. Not taxable event even if substantially vested, basis in stock ltd to price pd
3. Exercise of option will be taxed if sell stock, then taxed as a capital gain
a. Not included in GI when exercise option, only when sell stock
4. Negatives:
a. No business expense deduction for employer § 421(a)(2)
b. Significant restrictions on ISO qualifications § 422(b)
i. Option cannot be outstanding for > 10 yrs after granted
ii. Cannot be granted to a person who owns > 10% of corp’n
iii. Cannot be “in the money” (not lower than trading price) at time it is granted
5. Cannot be granted more than $100K in ISOs each year § 422(d)
e. Scholarships [§117]
i. General Rule
1. Any amount received as a qualified scholarship by an individual who is a candidate for a
degree at a college or university (regular faculty & curriculum & has a regularly enrolled
body of students) §170(b)(1)(A)(ii)) §117(a), §1.117-6(c), (d)
2. Doesn’t need to be called scholarship
3. Applies to both cash & in-kind (free or reduced tuition) scholarships §117(b)(1)
4. Source of scholarship irrelevant
5. Exclusion limited to tuition & fees, cost of course-related books, supplies, & equipment that
must be required of all students in the particular course instruction §117(b)(2)
a. Incidental are not included - Room-and-board, travel, meals and other expenses that
are not required for either enrollment or attendance is not eligible §117(b)(2)
b. Athletic Scholarships - It is not conditional on performance of athlete
6. Not excluded from GI: Amounts received that represents payment for teaching, research, or
other services by the student required as a condition for receiving the qualified scholarship
§117(c)
a. If only a portion of the scholarship/fellowship grant represents payment for services,
must determine amount of the scholarship to be allocated to payment for services
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Federal Income Tax 11
b. This includes employees who receive scholarships from employers for higher level
degrees (cannot exclude)
c. Does not deny exclusion for services performed by the student’s parent
ii. Qualified Tuition Reduction
1. §127 provides an exclusion for an employee whose tuition is paid by his employer under an
“educational assistance program.” Can exclude up to $5,250 and subject to
nondiscrimination.
2. §117(d)(3) - A college/university can provide its employees w/ tax-free “qualified tuition
reductions.” May be provided to the employee or to the employee’s dependent child or
employee’s spouse. Reduction must not discriminate in favor of highly compensated
3. Income Inclusions as Mistake-Correcting Devices
a. Annual Accounting Period
i. The annual accounting system serves the gov’t need for closure wrt tax liabilities
ii. It cannot leave tax consequences open pending later developments, but closure requirement (that is
the need to determine tax liability in each year) is not violated by tax rules that look back to earlier
years to determine the tax consequences of this year’s receipts
1. § 1001: calculates gain to loss realized on a sale in the current yr by subtracting adjusted basis
iii. Limit of 3 years to amend tax returns
b. Interest
i. GI includes income from interest §61(a)(4)
ii. In general, all interest paid or accrued is deductible §163(a)
1. But cannot take a personal deduction for a personal interest paid or accrued on indebtedness
unless it is allocable to a trade § 163(h)(2)(A)
c. Loans and Cancellation of Indebtedness
i. Loans - Borrowed money is excluded from GI b/c of an offsetting liability to repay the loan
1. There needs to be a consensual recognition of a repayment obligation
ii. Income from discharge of Indebtedness [§108]
1. GI includes income from discharge of indebtedness [§61(a)(12)] unless, the TP falls under an
exception:
a. (a)(1)(A) - Title 11 (bankruptcy) case
b. (a)(1)(B) - TP is Insolvent - Exclusion limited to the amount of TP’s insolvency
(a)(3) (excess of liabilities over FMV of assets) otherwise report it- §108(d)(3).
c. Example
i. Facts: Jorge owned P worth $750K but owed debts, including the one
ultimately discharged, totaling $900K. Discharged debt is $50K.
ii. Answer: $150,000 is TP’s insolvency. The full $50,000 is excluded.
2. US v. Kirby (1931)
a. Issued bonds for par value, bought same bonds on open mkt later that yr at less than
par value
b. Issue: is this reported as a taxable gain or loss in GI for the yr?
c. Holding: It should be reported as a gain b/c buying the bonds was still an accession
of wealth § 61(a)(12) (“income from discharge of indebtedness”)
3. If you find out there is an inconsistent event, that’s when the GI is reported
4. Although TP does not have to include in GI, they have to take the amount they are not
including in GI, & deduct that amount from any losses listed under §108 (b)(2) – in the order
listed below. The effect is to increase the TP’s future tax bills.
a. (A) NOL
b. (B) General business credit
c. (C) Minimum tax credit
d. (D) Capital loss carryovers
e. (E) Basis reduction
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Federal Income Tax 12
iii.
iv.
v.
vi.
5. Borrowing & Repayment
a. Borrowed $ is not included in borrower’s GI b/c receipt of funds is offset by
obligation to repay, but is also entitled to no deduction when make principal
payments
b. However, must report on amounts borrowed that will never be repaid once “mistake”
becomes known (Kirby)
c. Include in yr when becomes apparent that loan will not be fully repaid BUT must
correct in earlier yr if mistake was based on info known or knowable during the
earlier yr
Net Operating Loss Deduction [above the line deduction]
1. A NOL may be used to offset net income in the two years preceding the loss, & in the 20
years following the loss year [§172]. This is only for business losses [§172(d)]
2. Carrying debt forwards keeps SOL open during that 20 yr limit for purpose of amending tax
returns
Bad Debts
1. A debt only becomes worthless when a "legal action would not result in satisfaction because
there is not a possibility of repayment" §1.166-2(b)
2. Business Bad Debt - §166(a)
a. §166(a)(1) – Wholly worthless debts: Deductible
b. §166(a)(2) – Partially worthless debts: Non-recoverable part is deductible
c. §166(b) - The amount of deduction is determined by the AB provided in §1011 for
determining the loss from the sale or other disposition of property
3. Non-business debts §166(d)
a. Definition: Debts other than those created in connection w/ TP’s T/B, or a debt
where the loss from worthlessness is incurred by the TP’s T/B. §166(d)(2)(A), (B)
b. Loss sustained on the worthlessness of a non-business debt is treated as a STCL, and
is therefore available only as an offset against STCG capital gains and $3,000 of
capital gain income per year §166(d)(1)(B), 1211(b)
c. Such debts must become wholly worthless, partial worthlessness is not allowed.
4. Gift - If a lender cancels the debt at a discount as a gift to the borrower, the borrower does
not have to include the discount in income §102(a)
5. Student Loans [§108(f)]
a. (1) GI does not include any discharge of a student loan if the discharge occurs b/c the
student works for a certain period of time for a nonprofit or gov’t organization
b. Example: If a law school agrees to discharge a law student’s loan and the discharge is
contingent on the student working in public interest law, the student may be able to
exclude the discharged debt from income §108(f)(2)(D)(ii)
Disputed Liabilities
1. If a lender & borrower disagree about the amount owed & the borrower ultimately pays the
lender less than the amount that the lender said was owed, the difference does not have to be
included in income
2. Example – Mary buys a used car on credit w/ note of $10K, which she believes to be the
FMV. Later, she finds out that the odometer has been rolled back. She complains and the
dealer tears up the $10K note and replaces it w/ a $7K note. The $3K is not included in GI
Purchase Price Adjustment [§108(e)(5)] [Ref. 108(c) - 3P debt can be a PP adjustment]
1. A discharge of debt will be treated as a PP adjustment (which has no tax consequences,
instead, AB is lowered by the amount) if:
a. It is seller financed (not to a financing 3rd party, such as a bank), and
b. Reduction does not occur in a Title 11 case or when purchaser is insolvent
2. Ex: Mary buys a car for $10K on credit. Interest rates rise & the seller-creditor agrees to
accept $9K cash in cancellation of the debt. $1K of debt cancelled is not GI
a. Related to buyer-seller, not related to borrowing $ from a 3d party
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Federal Income Tax 13
vii. Embezzlement and Other Illegal Income
1. A TP has received income when she “acquires earnings, lawfully or unlawfully, w/out the
consensual recognition, express or implied, of an obligation to repay and w/out restriction as
to their disposition”
2. Collins v. Comm’r (1993)
a. Worked as a ticket vendor at horse race track, bet himself despite not having any $
b. Lost for the day, turned himself in to his mgr who called the police
i. Gambled $80,280, but won back $42,175, in debt of $38,105
c. Did not report his illegal earnings on tax return
d. Issue: did the unpaid bets constitute theft or embezzlement income?
e. Holding: yes, b/c he had opportunity to derive gratification + economic gain from
stolen tickets, TI is $38,105. Larceny of any kind resulting in an unrestricted gain of
moneys to a wrongdoer is TI
i. Test:
1. Whether realized economic value (Realizable value test)
2. Whether had sufficient control over stolen property (control test)
ii. Normally GI does not includes loans b/c they do not result in realized gains
as any increase in net worth is offset by corresponding obligation to repay
f. Reference to Gilbert v. Comm’r (2d Cir. 1977), which held that there was a
consensual recognition of obligation to repay despite absence of loan agmt b/c (1)
intended to repay, (2) believed w/drawals would be approved by BOD for merger,
and (3) made prompt assignments of assets sufficient to secure amount owed
i. Here- no way employer would ratify and amount was 3x his annual income
g. Reference to Zarin v. Comm’r (3d Cir. 1939)- Disputed Liability Doctrine
i. Applies when a TP incurs a debt in order to acquire property, dispute arises
concerning value of property, and dispute is settled by reducing amount of
the acquisition indebtedness
ii. No correction needed on tax return b/c mutual mistake in value of property
h. Although the bets gave rise to gambling losses, the TP gained from the
misappropriation of his employer’s property w/o its knowledge or permission. The
gambling loss is not relevant to & does not offset Collins’ gain in the form of
opportunities to gamble that he obtained by virtue of his embezzlement
i. Must report all ILLEGAL income
i. TP may ordinarily claim a tax deduction for payments she makes in restitution. Such
a deduction is available for the TY in which the repayments are made §165(c)
d. Debt Relief Associated w/ Disposition of Property [§7701(g)]
i. Introduction
1. Types of Transactions
a. Save money and pay in cash
i. §1011(a) - Adjusted Basis for Determining Gain or Loss
ii. §1012 - Basis of Property - Cost
iii. §1001(a) - Computation of Gain or Loss (AR - AB = Gain)
b. Seller-Finance
i. Financing provided by the owner/seller of real estate, who takes back a
secured note. Debtor really doesn’t own property so no basis in property
c. Debt
i. Nonrecourse Debt
1. Secured obligation which debtor is not personally liable.
2. The lender’s only remedy on default is foreclosure on the property
security (i.e., the asset securing the debt is the sole source of
payment)
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Federal Income Tax 14
3. Risk of decline in value of the property below principal amount of
nonrecourse mortgage is borne by the creditor, not debtor
ii. Recourse Debt
1. Debt for which debtor personally liable, whether or not secured by
property, the lender can proceed against the debtor and garnish his
wages, impose liens on his property, etc
d. Tax Shelter
i. Can take depreciation deductions [§167 & §168] and can offset them against
ordinary income. So no cash outlay, and get this deduction based on
schedules set forth for various categories of depreciable assets
ii. Effect of Debt on Basis
1. TP’s purchase debt is included in basis from purchase of property, regardless of whether
recourse or non-recourse, creditor is 3rd-party or seller, or incurred debt is new or preexisting. Borrowed funds, that is the unpaid balance of a mortgage, are included in
computing the basis of property acquired in a nonrecourse debt (Crane v. Comm’r)
2. Post-acquisition debt that happens to be secured by a piece of property does not increase the
basis of that property (except to the extent that the debt proceeds are used to permanently
improve the property, which causes a basis increase under the general rule of §1016(a)(1))
iii. Effect of Debt on Amount Realized when Debt Relief is Greater than Property Value
1. Comm’r v. Tufts (SCOTUS 1983)
a. $1.8M loan financed completed for apt complex on a nonrecourse basis
b. Contributions and deductions of partners in partnership led to adjusted basis of
$1.45M in property
c. Layoffs in area so rental income less than expected, unable to make mortgage
payments
d. Each partner sold interest in property to Bayle, FMV at time was $1.4M
e. Each partner reported the sale as a loss, but IRS said there was a capital gain
f. Issue: must a TP include the unpaid amount of a nonrecourse mortgage when it
exceeds the FMV of the property sold?
g. Holding: same rule that applied in Crane applies when the unpaid amount of the
nonrecourse mortgage exceeds the value of the property transferred; associated
extinguishment of the mortgagor’s obligation to repay is acct-d for in the
computation of the amount realized and thus must include in amount realized the
amount of nonrecourse mortgage assumed by the purchaser even when FMV falls
below obligation Reg. § 1.1001-2(b)
i. Gain = adjusted basis – amount realized
ii. Amount realized = sum of any $ rec’d + FMV of property
iii. TP must acct for proceeds of obligations he has rec’d tax free and included in
basis b/c mistaken assumption that TP would repay loan
h. O’Connor, concurring: wants to separate the two aspects of the event – (1)
ownership and sale of property, & (2) the arrangement and retirement of the loan
i. Benefit rec’d by TP for selling property is cancellation of mortgage that is
worth no more than FMV of property, recognizing a loss in the property
ii. Restores continuity in system by making TP-seller’s proceeds on the
disposition of property equal to the purchaser’s basis in the property
2. NON-RECOURSE ANALYSIS
a. Tax symmetry. Full amount of the loan must be included in amount realized b/c the
TP was allowed to include the full loan in basis on the assumption that the TP would
eventually repay the loan
b. Amount realized from a sale or other disposition of property includes the amount of
liabilities from which the transferor is discharged as a result of the sale or disposition
c. Capital gain = Non-recourse debt – AB
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Federal Income Tax 15
3. Problem Example
a. Facts
i. Tom has a nonrecourse note = $3,000,000
ii. FMV of the building has declined to $2.75 million
iii. Stranger buys building subject to $3 million indebtedness (none paid)
iv. Tom claimed depreciation deductions = $400,000
b. Answer - Tom’s
i. Amount Realized - §1001(b)
1. = $3 million
ii. Adjusted Basis - §1016(a)
1. = $2.6 million ($3 million - $400,000)
iii. Realized Gain - §1001(a)
1. = $400,000 capital gain (may be eligible for the preferential rate)
c. Answer - Purchaser
i. Amount Realized - §1001(b)
1. = $2.75 million (FMV)
a. On sale, the only applicable principle is one of taxsymmetry, and for this purpose value is irrelevant.
b. §1.1001-2(a)(3)- Discharge of Liabilities. This § does not
apply to the extent that such liability wasn’t taken into
account in determining the transferor’s basis for such
property
ii. Adjusted Basis - §1016(a)
1. = $2.75 million (FMV)
a. At acquisition, the Q is whether the nonrecourse obligation
is or is not true debt, and for this purpose value matters
b. No one would be willing to pay more for property, or borrow
more to buy it, than the property was actually worth
4. RECOURSE ANALYSIS [Bifurcated Approach (Rev Rule 90-16) – Tufts O’Connor]
a. Discharge of indebtedness ordinary income: Recourse debt – FMV = X
i. §61(a)(12) - GI includes discharge of indebtedness
1. Better to have debt cancellation income if the debt cancellation
income qualifies for the §108(a)(1)(B) insolvency exception
a. § 108(a)(1)(B): GI does not include any amount that would
otherwise be included in GI by reason of discharge of
indebtedness of TP if the discharge occurs when TP is
insolvent
2. Consider if they are insolvent/bankrupt/qualified principle
residence indebtedness exclusion
b. Disposition of property capital gain/loss: FMV – AB = X
i. §61(a)(3) - GI includes gains derived from dealings in property
1. Better to have capital gain if the K gain is taxed at a special low rate
since the cancellation of indebtedness income does not qualify for
exclusion under §108
2. If there is a loss, no deduction allowed under 165(c)
c. Reg § 1.1001-2(a)(2) and (3): amount realized from a sale or other disposition of
property includes the amount of liabilities from which the transferor is discharged as
a result of the sale
d. Under bifurcations the FMV is crucial in determining both the amount of Kirby
(DOI) income and the amount of gain or loss from the property transaction
5. Problem Example
a. Facts
i. Naomi buys a building paying $100K + recourse debt of $1.9 million
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Federal Income Tax 16
ii. Naomi’s AB in the building is $1,700,000 and FMV was $1.85 million,
iii. Bank-lender accepted building in full satisfaction of the outstanding
indebtedness which remained $1.9 million
iv. X had paid none of the principal amount of the debt
b. Answer [Bifurcate]
i. Adjusted Basis - §1016(a)
1. = $1.7 million
ii. Realized Gain
1. Discharge of indebtedness ordinary income
a. = Recourse debt – FMV = X
b. = $1.9 million - $1.85 million = $50,000
2. Disposition of property capital gain
a. = FMV – AB = X
b. = $1.85 - $1.7 million = $150,000
c. Extra
i. Land is purchased for $100K. Value goes up to FMV $500,000 & you to
borrow $250K (recourse or non-recourse) against this property
ii. Now the land is encumbered by a debt (recourse) of 250K. There is no
disposition, you are just borrowing. When you sell, amount realized is
$250K cash plus the debt that is encumbered in the property. Amount
realized is $500K - basis of $100, so you get a $400K gain
e. If nonrecourse indebtedness is discharged, but there is no disposition of property
i. Problem Example
1. Facts
a. D purchases a $10 million building entirely for nonrecourse debt (financed by a 3rd P
purchaser other than the seller). After some years, building FMV drops to $7
million. Holder of the note agrees to reduce debt to $7 million (market decline). D
continues to own the building –no disposition of the property
2. Answer
a. Note:
i. Falls under §108(c), not §108(e) because this is not seller financed. Better to
fall under (e) because it reduces your basis & defers gain
ii. Old Rev Rule 91-31 would include $3 million of discharge of indebtedness
income, and that would side-step Tufts
iii. So Congress enacted §108(c) as a remedy for 91-31 situation: rehabilitation
provision for realtors in distress
iv. Brings result under §108(e)(5) to TP who otherwise wouldn’t qualify.
b. Exclude from GI, and reduce his AB
i. (c)(2) - Limitation - Can only reduce AB to extent amt. of debt exceeds
FMV
1. CASE: AB = Donald would reduce AB to $7 million, which is $10
million (current AB) - $3 million (amount discharged)
2. Limitation: $10 million - $7 million = $3 million. So D may only
reduce AB by $3 million, which he is able to do here
f.
Qualified Principal Residence Indebtedness
i. GI does not include any amount which would be includible in GI by reason of the discharge of
indebtedness of the TP if the indebtedness discharged is qualified principal residence indebtedness
§108(a)(1)(E)
ii. QPRI means acquisition indebtedness that is less than $2M (married) and $1M (single) to acquire a
principal residence §108(h)(1)(2)
iii. Does not apply to non-acquisition indebtedness, i.e., home equity loan, or to cancellation of any
indebtedness secured by a secondary residence
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Federal Income Tax 17
iv. If you are holding onto the property, you reduce basis in property by amount excluded from GI
§108(h)(1)(1)
v. No GI inclusion results from cancellation of QPRI if in response to either – § 108(h)(1)(3)
1. Decline in the value of the resident securing the debt
2. Precarious financial condition of TP
vi. Problem Example
1. Facts
a. M&K purchased a home in late 2006 for a FMV of $750,000. They paid $10,000
down and borrowed $740,000 on a recourse basis. Due to the burst of the housing
bubble the home is now worth only $600,000. The outstanding balance on the
mortgage was $730,000. The bank agreed to accept conveyance of the home in full
satisfaction of the outstanding mortgage obligation
2. Answer
a. Amount Realized
i. = $600,000 (FMV)
b. Adjusted Basis
i. = $750,000 ($740,000 + $10,000)
ii. = $730,000 (amount they owe)
c. Excluded Loss
i. = $130,000 [what happens if they sell the property? Just a loss? No]
ii. Not a deductible loss. §165(c)(1) & (2) only allowed for a T/B or for profit
transaction. It’s a personal asset. No deduction for personal expenses.
Property Transactions
g. Introduction
i. §1001(a). Addresses recognition of gain or loss on sale or disposition of property. Again, AR – AB
1. (b). Addresses calculating AR
2. (c). States §1001 is subject to all others in the Code and determines recognized gain
ii. §1011 & §1012
1. Address calculating AB
2. §1016. Improvements increase AB and depreciation deductions decrease AB.
h. The Realization Doctrine
i. Background
1. The realization req. departs from the Haig-Simons ideal tax base, which would include
unrealized appreciation in the tax base. We don’t do that in our system because of valuation
and liquidity problems
2. Eisner v. Macomber (SCOTUS 1920)
a. Std Oil issued additional shares sufficient to constitute a stock dividend of 50% of
outstanding shares
b. ’s 2200 shares became 1100 shares and was called upon to pay tax on new shares
c. Issue: whether Congress has power to tax income of SH and w/o apportionment, a
stock dividend?
d. Holding: Stock dividends are not taxable as income when they are not cash, but a
cash dividend is taxable
i. “derived from” = profit, something of exchangeable value proceeding from
the property
ii. In dicta stated that capital can be considered income, but all income must be
realized before it can be taxed. Defined income in terms of sources: defined
as gain derived from capital, labor, or both, so long as includes profit
gained from sale or conversion
iii. Unrealized appreciation is not income w/in the meaning of the 16th amend. &
stock dividends are a form of unrealized appreciation
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Federal Income Tax 18
iv. Pro rata stock distribution  interest changes, but there is no sale or
disposition coming from capital or labor
1. Those who receive a cash dividend can choose to do w/ it what they
want, whereas a stock dividend just gives more stock, so there is no
choice
e. Eisner is a narrow holding confined to its facts
f. Dissent - Stock dividends are actually the equivalent of cash dividends & are
therefore properly taxable
ii. Stock Dividends [§305; §307]
1. Pro rata stock dividends are not GI until disposition since there is no realization event. % of
each SH’s share remains same, but overall # of shares increases (more, but smaller pieces of
the same pie)
a. For policy reasons we don’t tax unrealized appreciation. We do tax cash
b. A stock dividend may be somewhere in between. It really looks like unrealized
appreciation. But it’s not like cash since it is not as disposable. The same may be
said for exchanges since nothing is really severed
c. Pro rata stock distribution:
i. Interest changes
1. No sale or disposition b/c there was not income derived by capital or
labor
2. Distributions of Stock and Stock Rights - §305(a) - Except as otherwise provided, no GI
recognized when you receive the stock dividend. Codifies narrow holding of Macomber
3. Basis of Stock and Stock Rights Acquired in Distribution - §307(a) - SH basis for the
dividend shares is a proportionate part of the cost of the original lot
a. Example:
i. One stock of 40 FMV (old). One stock of 60 FMV (new). Old basis = $40
b. Answer:
i. Basis of old stock = $40 (basis) * (40/100) = $16
ii. Basis of new stock = $40 (basis) * (60/100) = $24
4. Holding Period - §1023 - You treat new shares like old shares wrt holding period
iii. Loss Deduction [§165(a), (c)]
1. There shall be allowed as a deduction any loss sustained during the TY and not compensated
for by insurance or otherwise §165(a)
2. Limitation (only for individuals) - May only deduct loss if:
a. §165(c) (1). Incurred in a T/B; or [above the line - §62(a)(1)]
b. §165(c) (2). Incurred in any transaction entered into for profit, though not connected
w/ a T/B. [above the line - §62(a)(3)]
c. §165(c) (3). Losses of property not connected w/a T/B or a transaction entered for
profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft
3. Loss is not allowed wrt amounts on which the TP has never been taxed
a. Example: Bought shares for $1000, increased in value to $5000, but decreased in
value to $500 at time of selling  Realize only a $500 loss
4. Loss generally is not allowed in connection w/ a transaction not entered into for profit §
165(c) - can only deduct if loss incurred in a T/B or nonbusiness transaction for profit
5. § 1211: capital losses are allowed up to the amount of capitals gains in the same year plus
$3000 for noncorporate TPs
iv. Problem Example
1. Facts: X Corp has 3 SH, Anna, Barack, and Carrie. Each owns 100 shares of the common
stock which they have held for more than 5 years. Each has an AB of $60 in their shares. X
Corp returns some of the profits to the SH. At that time each share was valued at $200. In
lieu of distributing cash of $100 per share to each SH, X Corp decides to issue one additional
share for each stock held. It thus distributes 100 shares each to A, B, and C. Each share is
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Federal Income Tax 19
i.
worth $100. Must they include an amount in GI as a result of the distribution? What is their
basis in the stock held? See §§307(a); 305(a); §1.307-1(a)
2. Answer:
a. There was no realization event so they do not need to include amount in GI
b. Basis of their stock = $60 [old basis] *(100/200) = $30 [307(a)]
v. Problem [Wash Sale]
1. Facts: Marta owns 50 shares of ABC Corp stock. She purchased the stock 3 years ago for
$60,000. On 3/1/2009, she sells those shares for $35,000, which is their FMV at the time.
On 3/31/2009, she purchases 50 shares of ABC stock for $35,000
2. Answer:
a. What is her realized loss as a result of the sale?
i. $60K - $35K = $25K - Losses incurred in any transaction entered into for
profit, though not connected w/ a T/B §165(c)(2)
b. How much is allowed as a deduction?
i. No deduction is allowed. If a TP realizes a loss on the sale of stock, no loss
deduction is allowed if the TP purchases “substantially identical” stock
w/in a period beginning 30 days before the date of such sale or disposition
and ending 30 days after such date” §1091(a) [Loss from Wash Sales of
Stock or Securities]
c. What is her basis in the new shares purchased?
i. Basis shall be the basis of the stock or securities sold or disposed of,
increased or decreased, by the difference, if any, between the price at which
the property was acquired §1091(d)
ii. There is no difference between purchased stock & sold stock. Basis in new
stock will be $60,000. If sale price was $40K instead of $35, we would
increase the basis to $65,000. For decreases, you subtract the basis
vi. Manipulation of Realization Rules
1. The Substance of Continued Ownership w/ Realization of Loss
2. Cottage Savings Association v. Comm’r (SCOTUS 1991)
a. Cottage Savings exchanged participation interests in various mortgages w/ another
lender pursuant to Federal Home Loan Bank Board’s Memorandum R-49 in order to
realize tax-deductible losses sustained as a result of holding long-term, low-interest
loans when interest rates surged
b. Took deductions representing the adjusted difference b/w the face value of the
participation interest that it traded and the FMV of the participation interest that it
rec’d
c. Issue: does a financial institution realize tax-deductible losses when it exchanges
interest in one group of residential mortgage loans for another lender’s interest in a
differ group or residential mortgage loans?
d. Holding: Cottage Savings realized a loss under § 1001(a) as the mortgages had
different mortgagors, & because they were secured by different properties, the loans
were materially different w/ legally distinct entitlements
e. Dissent: Mortgages were substantially identical, not materially differ so were not
recognizable for income tax purposes
Non-Recognition [§1031]
i. Nonrecognition transactions: transactions in which gain or loss is realized by the TP engaging in the
transaction, but will not be recognized for tax purposes
ii. §1001(c) provides that realized gains & losses are recognized unless otherwise provided in the Code
1. §121 allows TPS to avoid taxes of up to $250K on gain on the sale of a personal residence
under certain conditions
2. In divorce, transferee spouse must take a basis in the property that is equal to the transferor’s
adjusted basis at the time of the transfer (“transferred basis”)
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Federal Income Tax 20
iii. Involuntarily converted – defer taxation of gains on property if property condemned or physically
destroyed, if proceeds have been reinvested in other similar property § 1033
iv. Like-Kind Exchanges - If a TP can fall under it w/ a like-kind exchange, they will not have to
recognize any gain in their property exchange. Payback is a deferral, not a total exclusion. §1031
1. Public Policy: Provides incentive for reinvestment in property that is held for productive use
This section is not elective, it auto applies b/c still holding onto the same property essentially
2. Only allowed when difficulty of valuation, lack of liquidity and continuation of the basis
nature of the investment are present
3. (a)(1) General Rule
a. No gain or loss recognized on the exchange of property held for productive use in a
T/B or for investment if such property is exchanged “solely for property of like
kind” which is to be held for productive use either in a T/B or for investment.
b. §1.1031(a)-2 “Nature and character” of the property, not the “grade/quality” is the
focus of the inquiry for determining property of like kind. Ex. Improved real estate
for unimproved real estate is a like kind exchange
i. Real Property: Extremely easy to qualify. Even if TP exchanges a vacant
land for land w/ building, it is like kind
ii. Personal Property: Have to be exchanges in the same asset class. A car for a
truck would not w/in the same class
4. (a)(2) Exceptions
a. (A) Stock in trade or other property held primarily for sale,
b. (B) Stocks, bonds, or notes,
c. (C) Other securities or evidence of indebtedness or interest,
d. (D) Interest in partnership,
e. (E) Certificates of trust or beneficial interests, or
5. (b) Not Solely in Kind: when receives consideration both in form of qualified and nonqualified property
a. Address gains from not solely in kind. The recognized will be the amount of the nonlike kind boot. Gain Analysis:
i. Gain Realized = FMV received + boot received (or – boot paid) – old AB
ii. Recognized gain = Recognized up to the value of boot (non-qualified
property or cash) received
6. (c) Losses from not Solely in kind
a. Complete non-recognition in loss cases. Most TPs w/ losses on assets that they are
disposing of will prefer not to qualify under §1031
7. (d) Basis of Acquired Property
a. TP keeps their old AB & adjusts it w/ any recognized gain/loss. Gain/loss deferred.
i. Decreased by the amount of any money received by TP in transaction;
ii. Increased by the amount of any gain recognized by TP in transaction;
iii. decreased by the amount of any loss recognized by TP in transaction
b. AB Analysis:
i. If received boot:
1. = Old AB - (FMV of the cash or other boot received) + recognized
gain (or loss)
a. AB will actually only change if the lessor amount is the
realized gain and not the boot
ii. If gave boot:
1. = Old AB + boot paid + recognized gain (or - recognized loss)
c. When additional consideration is given, the basis of the transferred property is
increase by the amount of the additional consideration
v. Problem 1
1. Facts: Mike owns vacant waterfront land w/ AB of $100K. June owns a commercial building
w/ AB of $500K. FMV of both properties = $1,000,000, they exchange their property
20
Federal Income Tax 21
2. Answer:
a. Mike [No recognition]
i. AB = $100,000 * basis retained*
Gain Realized = $900,000
b. June [No recognition]
i. AB = $500,000 *basis retained*
Gain Realized = $500,000
vi. Problem 2
1. Facts - Mike’s land is worth $1,100,000 and, as a result, June transfers $100K cash in
addition to her building. Consequences? Alternative, if Mike’s AB in his land is
$1,050,000?
2. Answer:
a. Mike
i. Gain Realized = 1,000,000 (FMV received) + 100,000 (boot received) 100,000 (old AB) = $1,000,000.
1. Recognized Gain = $100,000 (boot) ($900K of future gain to be
recognized)
ii. AB = $100,000 (Old AB) - $100,000 (FMV of the cash or other boot
received) + $100,000 (recognized gain)= $100,000
b. Mike Alternative
i. Gain Realized = 1,000,000 (FMV received) + 100,000 (boot received) 1,050,000 (old AB) = $50,000.
1. Recognized Gain = $50,000 (all of which is recognized because he
receives a $100,000 boot) ($900K of future gain to be recognized)
ii. AB = $1,050,000 - $100,000 (FMV of the cash or other boot received) +
$50,000 (recognized gain)= $1,000,000
c. June
i. Gain Realized = 1,100,000 (FMV received) - 100,000 (boot paid) - 500,000
(old AB) = $500,000
1. Recognized Gain = $0 (Nothing recognized b/c all like-kind)
ii. AB = $500,000 (Old AB) + $100,000 (boot paid) + 0 (recognized gain) =
$600,000
vii. Problem 3
1. Facts: Suppose that in #2, June transfers a truck worth $100K which she used in her business.
What is the difference in result? W/ non-like kind exchanges of property, we will recognize
gain in the amount of the FMV of the other property
a. Mike
i. Gain Realized = $1,000,000 (FMV received) + $100,000 (boot received) $100,000 (old AB) = $1,000,000
1. Recognized Gain = $100,000 (boot) ($900K recognized in future)
ii. AB of House = $100,000 (Old AB) - $100,000 (lessor of boot received or
realized gain) + $100,000 (recognized gain)= $100,000
iii. AB of Truck = $100,000
b. June
i. House
1. Gain Realized = 1,000,000 (FMV received) - 500,000 (old AB) + 0
(lessor of realized gain or boot received) = $500,000
a. Recognized Gain = $0 (boot) ($500K of future gain to be
recognized). All like-kind
2. AB = $500,000 (Old AB) + $100,000 (boot paid) + 0 (recognized
gain) = $600,000
ii. Truck (not like kind exchange)
1. Gain Realized = $100,000 (FMV received) - 60,000 (old AB) + 0
(lessor of realized gain or boot received) = $40,000
a. Recognized Gain = $40,000 (boot)
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Federal Income Tax 22
j.
Exclusion of Gain on Sale of Personal Residence [§121]
i. House Report 105-148 (1997)
1. Change law to exclude gain realized on the sale or exchange of a principal residence up to
$250K (from $125K), instead of rolling over the gain to defer recognition of gain reducing
basis in new home
2. Must have owned and occupied it for at least the two of the 5 years prior to sale
3. Can still only take advantage of this once every two years
ii. §121(a) - If a TP sells their principle residence, the gain is not recognized if they have lived in the
residence for periods aggregating two years (or more) out of the five years preceding the sale
1. Two limitations:
a. (b)(1) May only exclude up to $250,000 if single
b. (b)(2)(A) May exclude $500,000 for JR if they meet 3 requirements:
i. At least one of the spouses owns;
ii. Both spouses meet the use req.; and
iii. Neither of the spouses has used this section in the past two years
c. (b)(3)(A) May only take once every two years.
2. Example 1
a. Facts: Lorna purchased her sole residence on 7/1/2003, for $300K. She lives in her
home until 11/1/2009 when she sells it to James for $675K
b. Answer: Recognized Gain = $125,000 [K asset LT] [$250,000 is excluded
§121(b)(1)]
i. Adjusted Basis = $300,000 - §1012 Amount Realized = $675,000 - §1001(b)
ii. Gain Realized = $375,000 - §1001(a)
3. Example 2
a. Facts: Sergio and Liz (married) purchased their home on 5/1/2004 for $450K. They
live in their home until 6/1/2009, when they sell their home to Tyler for $900K
Answer: Recognized Gain = 0 [falls below $500K exclusion - §121(b)(2)(A)
i. Adjusted Basis = $450,000
Amount Realized = $900,000
ii. Realized Gain = $450K
iii. §121(c) - A TP who has not occupied the residence for requisite two sequential years, or who has
taken a §121 exclusion w/in the preceding two years, may qualify for a reduced exclusion.
1. (c)(2)(B) - Reduced exclusion is available if TP had to move b/c of a change of place of
employment, health, or other unforeseen circumstances
a. If TP cannot satisfy the occupancy req.:
i. TP can exclude $250K (or $500K), multiplied by period of time (in the five
years before the sale or exchange) during which the TP owned and used the
residence as a principal residence divided by two years
b. If the TP has excluded gain under §121 w/in the two preceding years:
i. $250K (or $500K) x period of time b/t the sale/exchange of the previous
principal residence (for which the §121 exclusion was claimed) & the
sale/exchange of the most recent principal residence divided by 2 years
2. Example 3
a. Facts: Assume that Sergio and Liz in #2, purchased the home on 6/1/08. Does your
answer change? Suppose the reason for the move is that Sergio has become ill and
the couple needs to move to a home on one level?
b. Answer: Yes. Sergio and Liz will qualify for a reduced exclusion
i. Must pro-rate the dollar limitation if they have not lived there for two years
In this case, Sergio and Liz have lived there for 1year
ii. Thus, the $500,000 limitation must be multiplied by 1/2 = $250,000
iii. Amount of gain recognized will be $450,000 (RG) - $250,000 = $200,000
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Federal Income Tax 23
iv. §121(b)(4)[(5)] - Subsection (a) does not apply to gain from the sale/exchange of property allocated
to “periods of nonqualified use” - any period (after 1.1.2009) during which the property is not used as
the principal residence of the TP or the TP’s spouse or former spouse
1. (b) - Calculation = (i) Total period of nonqualified use / (ii) period such property was owned
by TP
2. Example
a. Facts: Sergio & Liz, in #2, lived in their home from 5/1/04 until 5/1/05. They rented
the home to third parties from 5/1/05, to 5/1/08. They move back into their home on
5/1/08, and sell it to Tyler for $900K on 5/1/09. Assume basis was reduced by
$35,000 to reflect depreciation deductions from the rental of the home
b. Answer:
i. AB = $450,000, AR = $900,000, depreciation gain recognized = $35,000
ii. Of the remaining $450K of gain 3/5 ($270K) is allocate to nonqualified use
& not eligible for the exclusion. Since the remaining gain of $180K is less
than the max gain of $500K that may be excluded, gain of $180Kis excluded
from GI
v. Losses are deductible under § 165(c) only if they are incurred in a T/B so no loss is allowed for
personal residential property loss
k. Property Transferred by Gift, Bequest, or Devise
i. Property Transferred by Gift [§1015]
1. The donee takes property w/ a transferred basis. (a). It permits the shifting of a particular
type of income to a lower bracket TP & you are able to tack on her holding period for capital
gain
2. Gift of appreciated property does not constitute a realization event, resembling like-kind
exchanges—except transferred basis not exchanged basis
3. (a) - However, if the donee’s AB > FMV of the property at the time of the gift, then for the
purpose of determining loss the basis shall be the FMV. Loss not transferred
4. (d)(1)(A) - Basis shall be increased by the amount of gift tax paid wrt such gift (but not
above the FMV of the property at the time of the gift)
ii. Losses w/ respect to transactions between related TPs [§267]
1. General - No deduction allowed in respect of any loss from the sale/exchange of property b/w
persons in subsection between related parties. (a)(1). Persons referred to in (a) are: members
of a family (b)(1)
2. Amount of Gain Where Loss Previously Disallowed - Where a TP loss sustained by the
transferor is not allowable to the transferor as a deduction & the TP then sells or otherwise
disposes of such property at a gain, then such gain is recognized only to the extent that it
exceeds loss that was not recognized by the transferor (d)(1),(2)
iii. Problem
1. Facts: Mara purchased vacant land on 3/1/06, for $120K. On 3/1/09, when the property was
worth $200K, she transferred the land to her daughter, Jane, who paid nothing for the
property. What are the FIT consequences? In the alternative, Mara’s AB in the land was
$225K or $155K
2. Answer:
a. Mara- Gifts are not dispositions, so there is no gain recognition. The gain is built in
and transferred to Karen. No deduction permitted for gifts.
b. Jane (AB $120K)
i. The donee takes property w/ a transferred basis. §1015(a). Therefore, Jane
will take a transferred basis of $120,000. Gifts not included in GI. §102(a).
$80,000, no recognition. Steps into her mom’s shoes
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Federal Income Tax 24
c. Jane (AB $225K)
i. AB is equal to $200K (FMV). If the AB ($225K) > FMV ($200K) of the P at
the time of the gift, then for the purpose of determining loss the basis shall
be the FMV. No deduction for losses allowed on the part of Mara §267(a)(1)
ii. But if Jane can sell the P for $250K, then the basis will be $225K for
purposes of determining gain. So she will have realized gain of $25K
iii. Any amount between $225K and $200K, for loss, the basis will be $200K
d. Jane (AB $155K)
i. Jane will take a transferred basis of $155K. Gifts not included in GI. §102(a).
$35,000, no recognition. Steps into her mom’s shoes
iv. Problem
1. Facts: What if Mara sold the land to Jane (family) when the property was worth $75,000 &
Mara’s basis was $125K. What results if Jane then sells property to a stranger two years
later for $120K?
2. Answer:
a. Mara
i. AR - AB = $75K - $125K = - $50K loss not recognized between related
parties §267(a)(1)
b. Jane
i. AB = $75K (FMV). If the AB ($125K) > FMV ($75K) of the P at the time of
the gift, then for the purpose of determining loss the basis shall be the FMV
c. If Jane sells P to a stranger for $120K
i. AR - AB = $120K - $75K equals $45K gain. However, recognized realized
gain of $45K only to the extent that it exceeds the loss that was not
recognized by the mother. §267(d)(1), (2). In this case, no recognized gain
v. Treatment of Loans w/Below-Market Interest Rates [§7872]
1. Policy:
a. Policy concern is that parents could shift interest income from themselves to their
children. Higher bracket parents to lower bracket children. The gift tax still applies
2. §7872 applies if:
a. The loan is a below-market loan,
i. (e)(1) - A loan is a below-market loan if it is interest-free or provides for
interest at less than the Applicable Federal Rate
1. (f) - Demand Loan - Loan payable on demand of the creditor. Each
year compute from the same principal amount
2. (f) - Term Loan - Payable on a certain date fixed or determinable by
the loan instrument. You would need to re-compute the principal
b. The loan is one of the types of loans w/in the scope of §7872(c), and
i. (1)(A) - Gift loan
1. Below market loan in the nature of a gift (f)(3)
ii. (1)(B) - Compensation related loans
1. Loan between employer & employee or corp. and SH (c)(1)(B)
iii. (1)(C) - Corporation-SH Loans
1. Any below-market loan directly or indirectly between a corporation
and any shareholder of such corporation
c. None of the exceptions of §7872 apply
i. In the case of a gift loan, (c)(2) provides a $10,000 de minimis exception for
gift loans between individuals. Gift tax still applie.
ii. (d)(1) - If the total amount of gift loans between two related parties does not
exceed $100,000, the amount recast as interest income to the lender is
limited to the investment income of the borrower. If it is above $100,000,
there is no limit for the lender
iii. If you have less than $1,000 net investment income, no retransfer.
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Federal Income Tax 25
iv. This limitation only applies to GI; the gift tax is still applicable
3. Analysis:
a. (a)(1)(A),(B) - Foregone interest (AFR - (e)(2)) on gift loans & demand loans is
treated as transferred from the lender to the borrower, & re-transferred from borrower
to the lender on the last day of the year. Sets up a fictional transfer
b. The net effect is to leave the generally high bracket lender w/ interest income and,
depending on the nature of the borrower’s investment, to possibly give the generally
low bracket borrower a corresponding interest deduction
4. Problem:
a. Facts: Michael loans $100,000 to sister w/ 0% interest on January 1, 2003. It is a
demand loan because his sister Andrea only has to pay it back when requested by
Michael and falls under gift loan under (c)(1)(A). She pays back on January 1, 2008.
For 2003, federal interest rate is 4% compounded semi-annually
b. Answer:
i. Compounding
1. First Half of Year: 100,000 * 2% = $2,000
2. Second Half of Year: 102,000 * 2% = $2,040
3. Thus, 2003 interest = 4,040
ii. Analysis
1. A fictional transfer b/c the interest is transferred and retransferred on
the last calendar day of the year
2. Andrea
a. Under §102, may exclude the interest from GI because it is
treated as a gift
b. She may deduct the $4,040 if she uses the loan for a
business/investment even though she does not have to
recognize the interest as income because of §102
c. Under §163(d), deduction for investment interest is limited
to net investment income
3. Michael
a. Under §61(a), must include $4,040 interest in GI as interest
income
b. B/c it is a gift, Michael must also pay gift transfer tax on the
$4,040 if he cannot exclude it under yearly exclusion or
lifetime exclusion
vi. Property Transferred by Bequest
1. A transfer at death is not treated as a realization event, and the transferee receives a basis
equal to the property’s FMV as of the decedent’s death §1014(a)(1)
2. § 1014(c) exception to tax free increases in basis at death: no basis increase allowed for
“property which constitutes a right to receive an item of income in respect of a decedent
[IRD] under § 691”
a. IRD = amounts that had been taxed to decedent during lifetime if on accrual rather
than cash method
i. Ex: compensation pd for work done before death, but pd after death
3. Problem 1
a. Facts: Ms. Z died March 2012 leaving to her niece, Barbara: $3M cash; A Corp stock
worth $1M (Ms. Z’s AB = $1.5M); C Corp Stock worth $2M (Ms. Z’s AB = $1M).
b. Answer: Barbara excludes all of it from GI b/c death is not a realization event. She
takes the FMV at the time of death as her AB in the property. She does not take her
aunt’s AB in the property
i. Estate will have to pay $308,000 in estate taxes on the $880,000 that is over
the $51.2M limit
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Federal Income Tax 26
vii. Gift Tax and Estate Tax
1. Estate Tax § 2001
a. Applicable when addressing transfer upon death
b. The top graduated rate is 45%. Flat 35% for 2011 and 2012
c. Exemption amount for 2009 is $3.5 million
i. 2011: $5M
ii. 2012: S5,120,00
d. Per Tax Reform Act, in 2010, there will be no estate tax
e. Expected to decline to $1M for 2013 and later, but doubtful Congress will
2. Gift Tax § 2501
a. A parallel to the estate tax and has a top rate is 45%
b. When the gift tax is paid, the donee may increase her basis. §1015(d)(1)(A).
c. In 2010 the gift tax remains w/ the same exemption amount. The rate would go back
up to 55% + 5% rate
d. Exclusions: Lifetime = $5.12 million
Yearly exclusion = $13,000
e. Exceptions that do not have gift tax: spousal gifts; charitable contributions; general
support obligations (i.e., to children)
Personal Deductions
1. Introduction
a. Adjusted Gross Income [GI minus “above the line” deductions listed under §62(a)]
i. (a)(1). Trade and business deductions
1. Does not consist of performance of services by the TP as an employee
ii. (a)(2). Trade and business deductions of employees
1. (A) Reimbursed expenses of employees above the line, otherwise below the line
iii. (a)(3). Losses from sale or exchange of property [not for personal use]
iv. (a)(7). Retirement savings
v. (a)(9). Penalties forfeited b/c of premature w/drawal of funds from time saving accounts/depots
vi. (a)(10). Alimony payments (§71, §215)
vii. (a)(15). Moving expenses
viii. (a)(17). Higher education interest payments [§221]
ix. (a)(18). Higher education expenses [§222]
x. (a)(20). Costs involving discrimination suits (attorney fees and court costs)
b. Taxable Income
i. TI is AGI less §151 personal and dependent deductions and less the greater of SD or aggregate
allowable itemized deductions §63(a),(b)
ii. Itemized deductions = those allowable deductions other than (1) those allowable in calculating
AGI and (2) those reflecting personal exemptions of the TPs & dependents
iii. Except as otherwise expressly provided in this chapter, no deduction is allowed for “personal,
living, or family expenses” §262(a)
c. Standard Deduction - 63(c)
Filing Status
Married Individuals Filing JT &
Surviving Spouses
Head of Households
Unmarried individuals
Married individuals filing separate
returns
26
Standard
Deduction
$11,900
$8,700
$5,950
$5,950
Federal Income Tax 27
d. Personal Exemptions
i. §151(d) - $3800 for 2012
1. (a) TP gets one
2. (b) Spouse gets one
3. (c) Other qualifying dependents (same sex partner)
ii. (e) Special Rule for Divorced Parents
1. (1)(B) Custodial parent who has the children more than half of the year gets the personal
exemption. This can be bargained away via contract §152(e)(2)
2. You want to consider if it may be more advantageous to have one parent over the other if
one parent’s income is so high that it will be phased out
e. Dependent Defined
i. §152(a)(1) - Qualifying child is a person who - §152(c):
1. Is the TP’s child or sibling, or the descendent of the TP’s child or sibling;
2. Is 18 or younger (or 23 or younger if the person is a student);
3. Has the “same principal place of abode” as the TP for more than half the year;
4. Has not provided more than half of his own support for the year
ii. §152(a)(2) - Qualifying relative is a person who - §152(d):
1. Who either (A) is the TP’s child or child’s descendant, parent or parent’s ancestor,
sibling, aunt, uncle, niece, nephew, cousin, or in-law, or (B) has the “same principal place
of abode as the TP and is a member of the TP’s household”
2. Whose GI for the year is less than the §151 personal exemption amount;
3. Who receives more than half of her support from the TP, and
4. Who is not a qualifying child of the TP?
2. Itemized Deductions
a. Limitations on Itemized Deductions
i. Miscellaneous Itemized Deductions [those not listed under §67(b)]
1. Miscellaneous itemized deductions means itemized deductions other than:
1. (1) Deduction under 163 (relating interest),
2. (2) Deduction under 164 (relating to taxes - state and local),
3. (3) *Deduction under 165(a) for casualty/theft losses
4. (4) Deduction under 170 (relating to charitable),
5. (5) Deduction under 213 (relating to medical, dental, etc., expenses),
6. (6) Deduction allowable for impairment-related work expense
7. (9) Deduction allowable for 1341 (claim of right)
2. Typical examples:
1. Expenses associated w/ investment activities, such as investment advice, safedeposit boxes, and the like;
2. Expenses associated w/ preparing tax returns and defending them, if necessary, in
administrative or judicial proceedings; and
3. Unreimbursed employee business expenses, such as attorney fees, subscription
journals, professional society membership fees, and so on
ii. 2% Floor Limitation on Miscellaneous Itemized Deductions - §67
1. Take AGI * 2%.
2. Aggregate all itemized deductions that are not excluded from limitation under §67(b).
3. Third, may only take the itemized deductions that exceed the 2% of AGI.
b. Charitable Contributions [§170]
i. General Rule
1. (a)(1) Authorizes deductions for charitable contributions made w/in TY. No deduction is
allowed for a contribution of services §1.170A-1(g)
2. (c) Charitable contribution is for use of:
1. (1) Fed, State, Local gov’t for public use
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Federal Income Tax 28
2. (2) Corp., trust, or community chest, fund, or foundation 1. (A) Must be domestic (no foreign gov’t)
2. (B) Religious, charitable, scientific, literary, or educational organizations
3. (C) No private SH or individuals (Univ. pres. has to disclose his salary)
4. (D) Cannot be for political campaign
3. (3) War veteran orgs.
4. (4) Fraternal-lodge societies
5. (5) Cemetery companies
3. Rolfs v. Comm’r (TC 2010) [Quid Pro Quo]
1. Owes $19,940 in taxes, but says entitled to a larger charitable contribution for a
house donated to a local volunteer fire dep’t, meaning they overpaid
2. 1996: pd $600K for lakefront property in Wisconsin
3. Old house, losing value, either demolish for $10-15K or donate to a fire dep’t
looking for houses to practice techniques on
4. Donated house, getting necessary approval for fire dep’t’s burn exercises using
house
5. Expected that house would be used and destroyed by fire
6. K-d after exercise to have a new house built
7. Deducted $76,000 related to lake house contribution
8. Comm’r says rec’d substantial benefit (demolition); TPs say incidental benefit
9. Issue: are they entitled to deduction and is $200K+ contribution amount correct?
10. Holding: transferred only house, not land w/ house so can only deduct if value of
house exceeded the benefit they rec’d of demolition & severance from the land &
restriction to training (no resid’l use) rendered the lake house virtually worthless
1. Charitable contribution = unrequited payments to qualified recipients;
cannot expect a substantial benefit in return
2. Test for determining when part of a dual payment is deductible (US v.
Am. Bar Endowment):
1. Deductible only if and to the extent it exceeds the mkt value of
the benefit rec’d
2. Excess payment must be made w/ intention of making a gift
3. Scharf: whether the value of the public benefit of the donation exceeded
the value of the benefit rec’d by the donor
1. No longer applied
ii. Case & Reg.
1. Must be made w/ (1) donative intent, & (2) w/o adequate consideration Rev. R. 84-132.
2. A charitable contribution (gift) cannot be quid pro quo
1. Hernandez v. Comm’r (TC 1989)
1. Church of Scientology believes that any time a person receives
something he must pay something back to maintain “inflow” and
“outflow” of the spirit in order to avoid spiritual decline
2. Issue: can the payments for the sessions be deducted?
3. Holding: payments made to the Church of Scientology in order to
receive services known as “auditing” and “training” are not deductible
4. Dissent: Charitable contribution of the amount paid that is more than the
benefit rec’d
1. Problem is that the “going rate” includes the contribution
2. Rev. Ruling 93-73 makes this decision “obsolete”
3. § 170(f)(8) did so in a way as well b/c it made “intangible
religious benefits” still count as a contribution
3. If the value received is less than the amount given to the charity, then only the difference
is deductible
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Federal Income Tax 29
1. Skylar v. Comm’r (2002)
1. Not allowed to deduct part of child’s tuition payment to religious
schools as charitable contributions
2. Issue: did the new changes to the code since Hernandez now allow a
deduction?
3. Holding: not similarly situated to the training or auditing rec’d by
members of the Church of Scientology, but regardless, the tuition
payments have not been shown to constitute a partially deductible “dual
payment”
1. Larson v. Valente UnCON-al Denominational Preference Test
a. (1) whether the law facially discriminates amongst
religions
b. (2) if yes, under strict scrutiny, is the discrimination
justified for a compelling gov’tal interest
2. Must establish that the dual payment exceeds the mkt value of
the goods rec’d in return
4. Example: If an individual purchases a ticket to a United Way dinner, only the portion of
the ticket cost that exceeds the value of the dinner received in return is a “contribution or
gift”
iii. Percentage Limitations
1. (b)(1) Deduction to qualified organizations listed in §170(b)(1)(A) limited to 50% of the
TP’s “contribution base” (AGI w/out adding NOL carryback). Generally schools,
churches, gov’t entities, medical or hospital care & other publicly supported
organizations
1. A 30% limit to gifts to private foundations
2. A 30% limit applies to gifts of appreciated property
3. A 20% limit to gifts of appreciated property if made to private foundations
2. (b)(2) Corp. TP may deduct up to 10% of their TI, computed w/out regard to their
charitable gifts, their dividends-received deduction, & any carrybacks for K or op. losses
3. (d) Excess over GI may be carried over & used in same fashion for the next 5 years, or
until disposed of
iv. Appreciated Property
1. Donors of appreciated property deduct the value of property they contribute, despite the
fact that neither the TP nor the exempt org. will ever pay tax on the appreciation in the
property
2. Limitations (Congress realized how much it was giving away):
1. The gain would have been LTCG had the TP sold the property;
2. In the case of a contribution of tangible personal property, the use of the property
by the charity is related to the charity’s tax-exempt purpose, and
3. The property is not given to a “private foundation,” defined in §170(e)
3. (f)(11)(c) Requires a TP to obtain an appraisal for donated P w/ a claimed value of more
than $5,000
4. Lary v. Comm’r (11th Cir. 1986)
1. Were disallowed deductions for blood donated b/c performance of a service, not
a charitable contribution under the regulation
2. Issue: is it disallowed as a service or for other reasons?
3. Holding: no deduction b/c can only take a deduction for a charitable contribution
if the amount of such shall be reduced by the amount of gain which would not
have been LTCG if the property contributed had been sold by the TP at its FMV
at time of contribution
1. No basis in the donated blood or that the holding period for blood is
more than 6 months [law now says 12 months]
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Federal Income Tax 30
v. Private or Church School
1. No deduction is allowed w/ respect to tuition fees or fixed donations made by a TP to a
private or church school. Such amounts are not gifts to the school, but are consideration
between the parties
2. The denial of the deduction has been upheld even though a significant element of the
church school curriculum is religious education
vi. Religious Benefits
1. Fixed payments to churches or synagogues for pew rents, dues, or to attend specific
services are deductible despite the fact that the contributions would appear to confer a
specific benefit on the donor Rev. R. 70-47
1. However, paying a “donation” in return for educational religious courses is not
deductible b/c it exceeds the FMV of the benefits and privileges rec’d by the TP
Rev. R.78-189
vii. Athletic Contribution
1. If a contribution by an individual receives the right to purchase tickets to an athletic event
for the contribution, then 80% of the amount donated will be deductible §170(l)
c. Personal Interest Expense [§163(a), (d), (h); §221; §62(a)(17); §7872]
i. General Rule
1. §163(a) – all interest paid or accrued on indebtedness is deductible
2. §163(h)(1) - Personal interest deductions are not allowed during the TY (2) except for:
1. (h)(2)(A) Interest properly allocable to T/B (even if it results in a net loss from
the activity in any particular TY) (Redlark - Tax deficiency);
2. (h)(2)(B) Investment interest;
3. (h)(2)(C) Passive (investment) activity interest;
4. (h)(2)(D) Qualified residence interest: Interest paid w/ respect to acquisition
indebtedness or home-equity indebtedness;
5. (h)(2)(E) Interest payable on unpaid portion of tax;
6. (h)(2)(F) Educational loans (§62(a)(17), §221)
3. Disallowed to deduct interest pd on loans used to produce tax-exempt income:
1. § 265 municipal bond purchases
2. § 264 life insurance and annuity Ks
ii. Investment Interest Limitation [163(d); §469(e)(1)]
1. (d)(1) GENERAL - For TPs other than corp., deduction for investment interest is limited
to the net investment income
1. Net investment income is the excess (if any) of investment income over
investment expenses - (d)(4)(A) of the TP for the year
2. (d)(2) - CARRYFORWARD OF DISALLOWED INTEREST - If this limitation prevents
the deduction of an amount of interest, the disallowed portion is carried forward &
treated as incurred by the TP in the next year. There is no time restriction on the carryforward
3. (d)(3) - INVESTMENT INTEREST
1. (A) General - Investment interest is interest on a debt the proceeds of which are
used to acquire “property held for investment”
1. (d)(5)(A) property held for investment includes interest, dividends,
annuities, or royalties not derived in the ordinary course of a T or B.
§469(e)(1)
2. (B) Exceptions - Investment interest shall not include:
1. (i) Any qualified residence interest.
2. (ii) Any interest which is taken into account under §469 in computing
income or loss from a passive activity of the TP
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Federal Income Tax 31
iii. Qualified Residence Interest [§163(h)(3)]
1. §163(h)(3) - Qualified interest is interest paid on either “acquisition indebtedness” or
“home equity indebtedness” wrt a “qualified residence” of TP
2. The higher the tax bracket, the more the mortgage interest deduction helps them!
3. Qualified residence Definition
1. TP’s principal residence (§121) & 1 other residence of the TP. Married couples
who file separately are allowed only 1 residence each §164(h)(4)(A)(ii)
4. Acquisition indebtedness
1. Two requirements §163(h)(3)(B)(i):
1. (I) Indebtedness incurred in acquiring, constructing, or substantially
improving any qualified residence of the TP, and
2. (II) Secured by such residence
2. Limitation §163(h)(3)(B)(ii):
1. A TP’s aggregate amount of acquisition indebtedness cannot exceed $1
million ($500K for married individual filing a separately)
5. Home equity indebtedness
1. (C)(i) Any debt secured by a residence that is not acquisition indebtedness. Do
not have to use the loan to improve a home. It can be used for whatever reason.
1. Exception to general rule that interest is categorized according to the use
of the loan proceeds
2. Limitations:
1. Total of (I) home equity indebtedness plus (II) acquisition indebtedness
cannot exceed the FMV of the qualified residence.
2. (C)(ii) Aggregate amount treated as home equity indebtedness for any
period cannot exceed $100K ($50K for married filing a separate return)
6. Pau v. Comm’r (1997)
1. Purchased Condo in 1989, used as primary residence, but reclassified as rental
property when bought a home that same year, which use as primary residence
2. IRS said interest could only be deducted up to $1M, not the $1.1M that they had
based interest deducted on
3. Issue: can deduct $1M acquisition indebtedness AND $100K home equity
indebtedness?
4. Holding: Yes, but did not demonstrate that any of the debt was not acquisition
indebtedness, that is, incurred in acquiring the residences
7. Rev. Rul. 2010-25
1. Does away w/ Pau, allowing a TP to deduct up to $1.1M of qualified interest
indebtedness
2. Anything over § 1.1M is nondeductible personal interest
3. Acquisition indebtedness can constitute home equity indebtedness to the extent it
exceeds $1M
d. Medical Expenses [§213; §105(a),(b); §106; §125]
i. §213(a) - If you don’t have insurance and pay for medical expenses you can receive a deduction
to the extent that such expenses exceed 7.5% of AGI
1. Increases to 10% in 2013
2. Deduction for expenses when PAID during a TY, not when services rendered
3. Reimbursements subtracted & net amount of medical expenses compared to 7.5% of AGI
4. Most itemizers cannot take deductions due to floor
ii. §213(d)(1) Medical care means:
1. (A) “Amounts paid for the diagnosis, cure, mitigation, or prevention of disease, or for the
purpose of affecting any structure or function of the body”
1. §213(d)(2) - Travel expenses (food and lodging) are deducted as medical
expenses only if the care for which the travel is incurred is provided “by a
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Federal Income Tax 32
physician, in a licensed hospital” & only if the travel involves “no significant
element of personal pleasure.” Limit of $50 deductible per night
2. §213(d)(9) - No deduction allowed for cosmetic surgery unless it is “necessary to
ameliorate a deformity”
3. Rev. Rul. 2002-19 - Weight loss program undertaken as a treatment for a
specific disease can be deductible
4. Rev. Rul. 99-28 - Smoking cessation costs are deductible because nicotine
causes disease and is addictive
5. The cost of maintaining or improving general health or fitness (e.g., gym
memberships) does not qualify §1.213-1(e)(1)(ii)
6. Capital improvements to property for qualifying medical purposes are deductible
to the extent that the cost of the improvements exceeds the value that
improvements add to the home §1.213-1(e)(1)(iii)
2. (B) Transportation primarily for and essential to medical care
3. (C) Certain long-term care services
4. (D) Medical insurance costs
iii. Comm’r v. Bilder (SCOTUS 1962)
1. TP tried to deduct rent for living in FL, ordered to live there during winter by Dr.
2. TP died at 43, had suffered 4 heart attacks before Dr. issued order
3. TP, wife & daughter moved for 3 winter months
4. Disallowed 2/3 of rent deduction, attributing to accommodations for wife + daughter, but
COA rev’d saying deductible medical expenses
5. Issue: Is the rent deductible in this situation?
6. Holding: cannot deduct, can deduct “travel primarily for and essential to the prevention
or alleviation of a physical or mental defect or illness” but not costs of living expenses
1. Can only deduct meals and lodging during the course of travel or while receiving
treatment, not because need to change environment for general improvement of
health
iv. Publication 17
1. Expenses you can deduct:
1. Birth control pills
2. Fertility enhancement treatments
3. Guide dog costs
4. Lead paint removal costs
5. Legal abortions
6. Laser eye surgery
2. CANNOT deduct:
1. Nutritional supplements
2. Nonprescription drugs
3. Household help (even if recommended by dr)
4. Herbal remedies
v. O’Donnabhain v. Comm’r (Tax Court 2010)
1. Diagnosed w/ GID
2. Comm’r agrees GID is a disease but it does not fall under § 213 b/c it does not reflect an
abnormal structure or function of the body
3. Issue: Can he deduct medical expenses for hormone therapy, breast augmentation, and
sex reassignment surgery due to a “mental defect”?
4. Holding: GID is a disease under the meaning of § 213; the sex reassignment and hormone
therapy were treatments and “it is sufficient if the circumstances justify a reasonable
belief that the tre
has failed to show that the breast
augmentation was a treatment for GID rather than cosmetic surgery
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Federal Income Tax 33
1. Under § 213 must show:
1. Present existence or imminent probability of a disease, defect or
illness – mental or physical
2. Payment for goods or services directly or proximately related to the
diagnosis, cure, mitigation, treatment, or prevention of the disease or
illness
2. Where the expenditures are not wholly medical in nature and may serve a
personal as well as medical purpose, they must bass a but for test  TP must
prove both that the expenditures were an essential element of the treatment and
that they would not have otherwise been incurred for nonmedical reasons
3. Disease is not limited to those w/ organic origins, a finding of a disease is based
on:
1. A determination by a mental health professional that the condition
created a significant impairment to normal functioning, warranting
treatment OR
2. A listing of the condition if a medical reference text
vi. Health Savings Accts and Health Flexible Spending Arrangements
1. § 223 above the line deduction for contributions to a Health Savings Acct
1. TP must be covered under a high deductible health plan of at least 1,200/yr for an
individual or 2,400 for a family
2. Max deduction is 3,100 individual or 6,250 for a family
3. Amount in account rolls over each yr
2. § 125 cafeteria plan – agree to a salary reduction at beginning of year in exchange for
employer’s agmt to contribute an equal amount of reduction to employee’s health flexible
spending arrangement
1. Use it or lose it rule if don’t use the amount during the TY
2. Not taxed for choosing the insurance over cash
3. Credits [deduct from actual tax bill instead of taxable income]
a. Child Tax Credit [§24]
i. General
1. (a) Allows a $1,000 credit for each “qualifying child,” defined under §152(c) & who has
not attained age 17
ii. Limitation
1. (b)(1) The amount of the credit allowable is reduced (but not below zero) by $50 for each
$1,000 (or fraction thereof) by which the TP’s AGI exceeds the threshold amount - (b)(2)
Filing Status
Threshold
Amount
Joint Return
$110,000
Individual who is not married
$75,000
Married individual filing a separate
$55,000
return
b. Child Care Credit [§21]
i. General
1. Purpose of the household care credit is to enable the TP to be gainfully employed
2. (a)(1)
1. A TP who maintains a HH w/ one or more “qualifying individuals” is entitled to
a credit equal to the “applicable percentage” of the TP’s “employment-related
expenses” for the year
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Federal Income Tax 34
ii.
iii.
iv.
v.
3. (a)(2)
1. “Applicable percentage” starts at 35%, but is reduced by one percentage point for
each $2,000 (or fraction thereof) by which the TP’s AGI > $15,000. It never is
reduced below 20%
2. Any AGI greater than $45,000 gets 20% applicable percentage
Qualifying Individual
1. (b)(1)(A) - “Qualifying individual” includes any dependent of the TP who is under the
age of 13, and w/ respect to whom the TP is entitled to claim an exemption.
Employment-Related Expenses
1. (b)(2) - “Employment-related expenses” amounts paid for the care of a qualifying
individual, if “incurred to enable the TP to be gainfully employed”
Dollar Limit
1. (c) - No more than $6,000 of expenses can be taken into account in computing the credit
(or $3,000 for TPs w/ only one qualifying individual)
Earned Income Limitation
1. No more than the earned income of the lowest earning spouse (or own income if single)
2. Stay-at-home moms have $0 in income and thus those families cannot take a child care
credit
Business Expense Deductions
1. Ordinary & Necessary Expenses / T/B [162(a)-(c), (f),(g); 212; 165(c)(1),(2)]
a. General Rule - §162(a)
i. “Above the line” deduction under §62(a)(1) is allowed for “ordinary and necessary” expenses
paid or incurred in carrying on any T/B by an employer
1. (1) Salaries or other compensation for personal services actually rendered;
2. (2) Traveling expenses in pursuit of T or B; and
3. (3) Rentals paid for the use of business property
ii. Reg. §1.162-1(a): The full amount of the allowable deduction is allowed even though such
expenses exceed the GI derived during the TY from such business
iii. §62(a)(1) - If the expenses are incurred by an employee & are not reimbursed by the employer,
the expenses are “below the line” itemized deduction subject to the 2% floor (§67)
1. Example - Lester pays $1,000 (un-reimbursed) for a CLE relating to his job as an
accountant. This also includes legal fees
iv. §62(a)(2) - Reimbursed employee business expenses are treated like non-employee business
expenses and are “above the line” deductions
v. §132(d) - Reference to working condition fringe income exclusion under
b. Requirements
i. Ordinary
1. Not Extraordinary
a. Something that is “normal, usual, or customary” in the T/B in which the TP is
engaged. Deputy v. Dupont, 1940
2. Not a capital expenditure (depreciation)
a. Something that does not provide continuing value, but is rather used up in the
production of income in the current TY. You didn’t buy a building or something
that will last you for longer than a year
3. Comm’r v. Heininger (SCOTUS 1943)
a. Dentist accused of fraud wrt ads for selling false teeth
b. Attorneys fee and legal expenses incurred to fight fraud claims made by gov’t
that froze all of his mail
c. Issue: are the attorney fees deductible from GI as a business expense?
d. Holding: for him to employ a lawyer to defend his business from threatened
destruction was “normal”; it was the response ordinarily to be expected and no
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Federal Income Tax 35
suggestions that it was in bad faith or that fees were unreasonable means the
court can assume the expenses were appropriate and helpful
i. Irrelevant whether or not he is actually found guilty of committing fraud
ii. Necessary
1. The expense is “appropriate and helpful” in “the development of the TP’s business”
2. Palo Alto Town & Country Village, Inc. v. Comm’r (9th Cir. 1978)
a. Commander Aviation owned a plane
b. TPs pd a fee in return for Commander to make the plan available on a standby
basis
c. Comm’r only allowed them to deduct the $125/hr fee for actual flying time, not
payments to operate the plane on a 24 hr standby basis
d. Saved TPs more money by having plane on standby for business emergencies
e. Issue: was keeping plane on standby an ordinary and necessary expense?
f. Holding: incurring the expense of maintaining Commander’s plane on a standby
basis was appropriate and helpful to the business, and it was a response one
would normally expect a business in TPs’ circumstance to make
iii. In T/B
1. Comm’r v. Groetzinger (SCOTUS 1987)
a. Full-time gambler who made $70K making wagers solely on his own account
b. He had no other profession or type of employment
c. Issue: was this engaging in a T/B, subject to business deductions?
d. Holding: To be engaged in a T/B, a TP must be involved in an activity w/
continuity and regularity and must have the primary or substantial purpose of
creating income or profit rather than merely engaging in a hobby – thus gambling
pursued full time, in good faith, and w/ regularity, to the production of income
for a livelihood is a T/B
i. Court rejects Frankfurther’s “gloss” from Deputy v. Du Pont, which
stated that a TP’s activities as to whether a T/B was open to
determination for suspicion that almost every activity would satisfy the
gloss
2. Resolution of the issue “req. an examination of the facts in each case” Higgins
3. Self-employment is subject to 15.3% tax on income up to 94,200 and 2.9% over that
a. Managing an investment does not generate self-employment tax liabilities
c. Special Rules
i. Expenses for Production of Income
1. §212, allows a deduction for all non-business profit-seeking, ordinary & necessary
expenses incurred during TY for:
a. (1) The production or collection of income,
b. (2) The management or holding of property that produces income (but not in a
T/B), &
c. (3) The collection or computation of tax
2. Reg. §1.212-1(b): §212 expenses are deductible even if the property is not currently
productive and there is no likelihood that the property will be sold for profit
3. Notes:
a. This covers businesses that are not regular, continuous, and substantial.
i. Reversed Higgins & states that a deduction is okay for expenses incurred
in the production or collection of income.
ii. Example - This section permits an individual w/ investment income from
stocks and bonds to deduct her brokerage fees and the cost of a
subscription to WSJ
b. These are generally “below the line” deductions subject to the §67 limitation
(2% floor)
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Federal Income Tax 36
ii.
iii.
iv.
v.
vi.
vii.
i. However, there are some §212 deductions that are “above the line” such
as §62(a)(4), relating to deductions attributable to rents & royalties
Illegal Bribes, Kickbacks, or Other Payments
1. §162(c) - No deduction is allowed for illegal payments to any gov’t employee (domestic
or foreign) or illegal bribes or kickbacks to other persons
Lobbying and Political Expenditures
1. §162(e) - No deduction for any amount connected to influencing leg. or political
campaigning
Fines
1. §162(f) - No deduction for any fine or similar penalty paid to the gov’t
Treble Damage Payments under the Antitrust Laws
1. §162(g) - No deduction is allowed for 2/3 of any amount paid or incurred
Excessive Employee Remuneration
1. §162(m) - No deduction for excessive remuneration over $1 million
Losses (above the line)
1. Although §165(a) confers a deduction for “any loss sustained during the TY and not
compensated for by insurance or otherwise,” this is limited by 165(c):
2. In the case of an individual, §165(a) losses are limited to:
a. (1) Losses incurred in a T/B;
b. (2) Losses incurred in any transaction entered into for profit, though not
connected w/ a T/B; and
c. (3) Losses not connected to either of the above, if arising from fire, storm,
shipwreck, or other casualty, or theft. Claimed in the year you discover
2. Travel [§162(a)(2)]
a. Deduction allowed for traveling expenses (including meals & lodging) only if it is:
i. Travel expenses are ordinary and necessary - §162(a)
ii. The expenses are incurred while the TP is away from home (temporary), and - §162(a)(2)
1. Temporary - Reasonably expected to last one year or less (deduction allowed)
2. Must be away from general vicinity of home AND satisfy the “overnight” rule, i.e., trip
involves a substantial rest period of 8 hours (or a night’s sleep)
iii. Must be “directly connected w/ or pertaining to the TP’s T/B” Reg. 1.162-2(b)(1).
1. Two Categories:
a. Business to business; and
i. No commuting deduction allowed (of which parking is a subset). §1.1622(e)
b. Away from home (meaning, TP lives in MA, but works in CA).
i. Deductible if three Flower requirements met:
1. Reasonable and necessary travel expense;
2. Incurred “while away from home”; and
a. Purpose is to mitigate the burden of the TP who, b/c of
the exigencies of his T or B, must maintain two places of
abode & thereby incur additional and duplicate living
expenses. Factual inquiry
b. If a TP maintains two residences for personal reasons,
the duplicate expenses incurred at the work location are
not deductible
3. Incurred in the pursuit of business
ii. Hantziz v. Comm’r (1st Cir. 1981)
1. Law student deducted expenses for summer employment
2. Lived in Boston w/ husband, worked summer in NY
3. Deducted housing, meals & transportation in NY
4. Issue: Is this deductible?
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Federal Income Tax 37
5. Holding: No. She was living in NY at the time of working, and
thus NY was her home for tax purposes at the time of incurring
those expenses—she was not away from home
3. Entertainment [274(a), (c), (d), (e), (k), (l), (m), (n)]
a. §274 operates as a limitation on §162(a) and, to a lesser degree §212
i. Cohan v. Comm’r (2d Cir. 1930)
1. Theatrical mngr and producer of Yankee Doodle Dandy, kept no acct of “free-handed”
entertainment expenses
2. Issue: can he deduct expenses even though it is impossible to know exactly how much he
spent?
3. Holding: absolute certainty is impossible in most circumstances; should make as close an
approximation as possible
4. § 274(d) requires TPs to document travel and entertainment expenses
b. (a) General Requirements
i. (1)(A) If an activity is “of a type generally considered to constitute entertainment, amusement, or
recreation,” its expenses may be deducted only if:
1. The activity is “directly related” to the TP’s business [more stringent std.], or
a. There has to be business transacted in the meeting
b. Only if the entertainment is of a sort conducive to a business discussion.
c. Expenditures made in a clear business setting, such as a “hospitality room” at a
convention, will be considered directly related to the active conduct of the TP’s
T/B [Reg. 1.274-2(c)(4)]
d. Certain expenditures generally will not be considered directly related, such as
expenditures for entertainment when the TP was not present, & for entertainment
offering substantial distractions (such as at sporting events, nightclubs, and
cocktail parties) [Reg. 1.274-2(c)(7)] unless there was substantial business
discussion before or after
2. The activity is “associated w/” the conduct of the TP’s business and it immediately
precedes or follows a “substantial business discussion” [Less stringent std]
a. Associated w/
i. The TP must show that he or she had a clear business purpose in making
the expenditure, such as to obtain new business or encourage the
continuation of an existing business relationship [Reg. 1.274-2(d)(2)]
b. Substantial and bona fide business discussion before or after
i. Whether a discussion, negotiation, or meeting constitutes a substantial
and bona fide business discussion depends on all of the facts and
circumstances of the situation [Reg. 1.274-2(d)(3)(i)(a)]
ii. The discussion must be substantial in relation to the entertainment, but it
is not necessary that more time be spent of business than on
entertainment
ii. (3) Denial of deductions for club dues (principal function is to entertain its members).
c. (e) Exceptions to Application of (a)
i. There are nine categories of expenses that are subject to the business connection tests. These are
assumed to have the requisite business connection.
1. (1) For food/beverages for employees in a cafeteria or other business setting;
2. (2) That are treated as compensation;
3. (3) That are reimbursed (business meal);
4. (4) For recreation of employees, such as at the annual company picnic;
5. (5) For employee, stockholder, or other “bona fide” business meetings;
6. (6) For meetings of business leagues (conventions);
7. (7) For food/entertainment generally available to the public, as in hot dogs and soda
available at a sidewalk sale;
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Federal Income Tax 38
d.
e.
f.
g.
h.
i.
j.
8. (8) Which constitute entertainment sold to customers;
9. (9) For prizes and awards for non-employees
(d) Substantiation requirement
i. Imposes significant substantiation requirements on TPs seeking to deduct expenses:
1. Applies to §162 or §212 for traveling expenses (meals & lodging while away from home)
2. The TP must keep adequate books and records to support:
a. (A) The amount of any expense;
b. (B) The time and place that the expense was incurred;
c. (C) The business purpose of the expense; and
d. (D) The business relationship to the TP of the person receiving the gift
(n) 50% Deductibility Rule for Meals and Entertainment Expenses
i. (1) Deductions for meal & entertainment expenses are limited to 50% of the amount spent.
Enacted to address the free martini lunch. Assumption that at least 50% of the meal is
attributable to personal enjoyment. Does not apply to airfare or hotel rooms
ii. (2) Exceptions
1. (A) If an employer reimburses an employee for such expenses, the employee may deduct
the full expense (which, in effect, permits the TP to exclude the reimbursement, which
would otherwise have to be included in income - §132(d)), but the employer may deduct
only 50% of the expense
2. The 50% limitation does not apply to expenses for food and beverages that would be
excludable by the recipient as a de minimis fringe benefit under §132(e)
(b) Gifts
i. (1) No deduction is allowed for the cost of business gifts in excess of $25 per recipient per year
(c) Certain Foreign Travel
i. If a bus trip outside US is purely for bus purposes, expenses for travel will be fully deductible
ii. However, if a portion of the trip is for personal purposes, an allocation must be made b/w the
business and personal portions, & only the bus portions will generate deductible expenses. If,
however, the total travel time does not exceed 1 week, or personal portion is less than 25% of the
trip, no allocation will be required, & the expenses of travel will be fully deductible [Reg. 1.2744(a)]
(k) Business Meals
i. (1) For meals, any amount that is “lavish” or “extravagant” or is incurred while the TP (or a
representative of the TP) is not present is nondeductible
ii. The Service doesn’t usually quibble w/ lavishness.
(l) Limitation on Entertainment Tickets
i. (1) Entertainment Tickets
1. (A) Only the face value is deductible: Extra fees, whether imposed by legitimate ticket
agents or scalpers, are not deductible
2. (B) An exception is provided for charity sporting events, where the face amount of the
ticket includes a donation
ii. (2) Skyboxes
1. Amount deductible shall not exceed the sum of the face value of non-luxury box seats
(m) Additional Limitations on Travel Expenses
i. (1) Luxury Water Transportation
1. A TP may not take a deduction in excess of $2,000 for conventions or meetings on cruise
ships in one calendar year
ii. (2) Travel as Form of Education
1. No deduction for travel as a form of education
iii. (3) Travel Expenses of Spouse, Dependent, or Others
1. No deductions are allowed for travel expenses incurred for a spouse, dependent, or other
individual accompanying the TP on business travel, unless a. (A) That person is an employee of the TP,
b. (B) The travel of that person is for a bona fide business purpose, and
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Federal Income Tax 39
c. (C) Such expenses would otherwise be deductible by that individual [274(m)(3)]
4. Problems 1
a. Facts: Reimbursement of $7,000 for first-class airfare for flight from LA to HK (and hotel lodging for
five nights totaling $4,000) for trip to meet potential suppliers of the company
b. Answer:
i. Complete cost of First-class airfare and hotel lodging is deductible. Deductible under §162(a)(2).
IRS does not care about lavishness. There is a substantiation requirement under §274(d)
ii. Wrt the reimbursement, there are two approaches.
1. First approach is to include $7,000 as GI and then taken an above the line deduction of
$7,000 under §162(a)(2)
2. Second approach would be to not include anything as a working condition fringe under
§132(d)
5. Problem 2
a. Facts: Reimbursement for 4 client dinners totaling $2K each. At the dinners Myrna entertained clients
and their spouses or partners. Total in attendance at each dinner: 10, including Myrna. $200 a head
b. Answer:
i. If they discussed business employer deducts 50%. 274(n). Since it appears that there was no talk
of business, no deduction allowed. Also, it appears that the meal is pretty lavish. $200 a head §
274(k)
ii. Will the reimbursement be excluded from Myrna’s GI? If there is a business purpose, she
excludes $8,000 under §132(d). Firm gets to deduct only 50%
6. Problem 3
a. Facts: Reimbursement for $50,000 expense of hosting birthday party for Myrna’s partner, Sam. Myrna
invited several important clients and company employees under her immediate direction. Total guests:
100. $500 a head
b. Answer:
i. GI of $50K will be included. This is a personal expense. It is not associated w/ or directly related
to the TP’s business
7. Problem 4
a. Facts: Reimbursement of airfare of $800 from Los Angeles to San Francisco to spend the weekend w/ her
partner, Sam, who lived in San Francisco
b. Answer: No deduction. This is personal. No business purpose. Under 162(a)(2). She’s away from home
but not for business purposes
i. Say she goes to LA for temp employment. Say she also has a business connection not that she is
not giving up, she can deduct those travel expenses (incidental expenses included). Limited to one
year - temp assignment can’t last longer than a year
Patrolling Business- Personal Borders
1. Education Expenses [25A; 222; 162(a)] [Reg. §1.162-5]
a. General
i. §1.162-5(a) - An individual is allowed to deduct educational expenses if the education either:
1. (1) Maintains or improves skills required by individual in his employment or T/B; or
a. Examples: Refresher courses or courses dealing w/ current developments as well
as academic or vocational courses (c)(1)
b. Allemeier v. Comm’r (TC 2005)
i. Worked for Selane Products before, during and after getting MBA,
remaining in the same profession
ii. Issue: Whether petitioner may deduct expenses incurred to earn a MBA
iii. Holding: Yes. The MBA improved preexisting skills that petitioner used
before enrolling in the problem; may deduct education-related expenses
but not parking
c. Remember that if it is unreimbursed & they are an employee it falls under §67
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Federal Income Tax 40
2. (2) Meets express requirements of the individual’s employer or applicable licensing
regulations imposed as a condition to the retention of the individual’s status
3. They can deduct it under §162(a) or exclude reimbursement as a working condition
fringe under §132(d)
ii. §1.162-5(b)(1) - It must not be education for either of two other sorts (even if it meets one or both
of the requirements above):
1. (2) The education must not meet minimum entry-level requirements for qualification in
the particular T/B the TP is entering;
2. (3) The education must not qualify the TP for a new T/B
a. Namrow v. Comm’r (4th Cir. 1960)
i. Psychiatrists attended a psychoanalytic training program—personal
analysis and services of supervising analysts were deducted
ii. Issue: Whether expenditures made by two psychiatrists in order to
qualify themselves to practice psychoanalysis are not deductible in
computing their TI?
iii. Holding: Yes. The expenditures were made to acquire a skill not
possessed by ordinary psychiatrists and thus are not allowed
1. Only allowed if not to meet min entry level requirements—
institute training was necessary to practice psychoanalysis
3. Problem: A lawyer, not working in tax area, pays $30,000 in tuition to obtain an LL.M.
in Taxation. Her firm reimburses the cost. $30,000 is included in GI
b. Education Credits
i. Qualified education expenses that qualify for both credits are first allocated to the HOPE credit,
and only then to the Lifetime Learning Credit [25A(c)(2)(A)]
ii. Qualified tuition and related expenses include “tuition, fees, and course materials.”
iii. Non-academic fees are not covered (sports, athletic fees, insurance) 25A(f)(C)
iv. Hope Scholarship Credit [25A(b)] [per student basis]
1. (1) General
a. (A) Refundable 100% credit on the first $2,000 of “qualified tuition and related
fees” and a (B) 25% credit on the next $2,000 of such expenses.
b. Maximum allowable for TY beginning in 2009 is $2,500
2. (2) Limitations
a. (A) Credit allowable for 4 TYs
b. (B) Student must be enrolled at least half-time at a qualified institution
c. (C) Credit allowed only for 4 years of postsecondary education
d. (D) Denial of credit if student convicted of a felony drug offense
3. (6) Portion of Credit Refundable
a. If TP has no income for that year, you are allowed a refund of 40% of the credit
v. Lifetime Learning Credit [25A(c)] [per TP basis]
1. (1) Credit equal to 20% of qualified expenses of up to $10,000 (max $2,000)
2. (2) Special Rules for Determining Expenses
a. Allowed for any course of instruction at an eligible educational institution to
acquire or improve job skills of the individual
b. Available for graduate and undergraduate tuition and fees
c. For attorneys, CLE are included
vi. Limitations Based on Modified AGI [25A(d)]
1. Both credits are subject to phase-outs as AGI increases
2. Hope Credit - Complete Phase-out for AGI above $80K single ($160K for married)
3. Lifetime - Complete Phaseout for AGI above $52K single ($104K for married)
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Federal Income Tax 41
Step 1: Determine the otherwise available credit (OAC) HOPE: 100% of the first $2K + 25% of the next $4K
Step 2: Calculate the reduction amount
OAC x (AGI – Initial phase-out amount)
$10,000 (single) or $20,000 (married jointly)
Step 3: Determine the available credit
OAC – Reduction Amount = Available Credit
Initial phase-out amounts =
$80,000 (single)
$160,000 (married jointly)
Step 1: Determine the otherwise available credit (OAC) Life Learn: 20% x Allowable Expenses (up to $10K)
Step 2: Calculate the reduction amount
OAC x (AGI – Initial phase-out amount)
$10,000 (single) or $20,000 (married jointly)
Step 3: Determine the available credit
OAC – Reduction Amount = Available Credit
Initial phase-out amounts =
$52,000 (single)
$104,000 (married jointly)
vii. Problem
1. Facts: Lester (unmarried) has two children ages 18 and 20. He pays for college tuition,
fees, and course materials for each child in the sum of $8,000 in 2009. The 18 year old is
a freshman in college and the 21 year old is a senior. Both are enrolled full-time for a
degree and neither has been convicted of a felony drug offense. Lester pays $1,000 (unreimbursed) for a continuing education course relating to his job as an accountant. Lester
pays no other deductible expenses in 2009. He receives salary in the sum of $80,000 in
2009
2. Answer:
a. Total Credits = $5,000
i. Hope [25(b)]
1. $2500 * 2 = $5,000 credit for the two
ii. Lifetime [25(c)]
1. $200 credit for Lester
2. Phaseout
a. $80,000 - $50,000 / 10,000 = 3 * $200 = $600.
b. That means it is phased out entirely
c. Qualified Tuition and Related Expenses [§222][enacted for people who have too much AGI]
i. §222 (extended through 2009) permits a deduction for certain qualified education expenses paid
during the TY for educ. of the TP, his spouse, or dependents
1. A TP cannot take a §222 deduction and a Hope Scholarship Credit or Lifetime Learning
Credit in the same year §222(c)(2)(A)
2. Qualified education expenses include tuition, fees and course material at an eligible
educational institution. Reference to 25A. Non-academic fees do not qualify
ii. The maximum deduction is $4,000. This deduction is subject to the following phase-out rules:
AGI
Single
Married
Filing
Jointly
AGI <= $65,000
$65,000 <= AGI <=
$80,000
AGI > $80,000
AGI <=$130,000
$130,000 < AGI <=
$160,000
AGI > $160,000
41
Deduction
(2002/03)
$3,000
$0
De duction
(2004/05)
$4,000
$2,000
$0
$3,000
$0
$0
$4,000
$2,000
$0
$0
Federal Income Tax 42
iii. Problem
1. Facts: Ezra, unmarried, graduated from law school in May, 2009. He paid his final tuition
of $15,000 in January, 2009. He begins employment in the fall of 2009, earning $60,000
(his only GI for the year). He makes no other deductible payments in 2009
2. Ruling: $4,000 qualified tuition deduction. Does not qualify for Lifetime b/c AGI too
high
d. Higher education interest payments [§221]
i. §221(d) - Defines higher education and covers tuition, room and board
ii. §221(b)(1) - Deduction shall not exceed $2,500 (2001 and after)
iii. §221(b)(2)
1. Limitation
a. If AGI exceeds $75K ($150K for joint returns), then no deduction is permitted
2. Phase Out
a. Fraction = (AGI – $60,000 ($120K if joint return)) / $15K ($30K in the case of a
joint return)
b. Take result & multiply by $2,500 & that’s the deduction permitted
c. Problem 6.6.5
i. Facts: Sherry graduated from medical school in 2009. She pays interest on her medical school
loans of $10,000 in 2009. She earned salary of $60,000 in 2009 from her hospital residency
program. She had no other GI and paid no other deductible expenses in 2009. See §221
ii. Answer: $2,500 higher education interest deduction permitted
Capitalization and Cost Recovery
1. Capitalization and Depreciation: The Basics [162(a); 212; 1016; 179]
a. Current Expenses versus Capital Expenditures
i. Current Expense - Immediate deduction in the year in which they are incurred
1. Hostile takeover expenses you can deduct them immediately since they are like repair
ii. Capitalize - No immediate deduction. Cost covered over time through depreciation.
1. Items not depreciable include land, corporate stock, or works of art
2. Capitalize cost when the expenditure has a significant future benefit
3. The idea behind this is matching your deduction w/ your income
b. Depreciation [§167; §263]
i. General rule
1. Once a TP has a capital expenditure under §263, he is going to want to depreciate
a. 263(a)(1) - No Immediate Deduction for Capital Expenditures
2. §167(a) give authorization to depreciate. All depreciation is an above-the-line deduction.
A depreciation deduction for the exhaustion, wear and tear is allowed for:
a. Depreciable asset (finite life)
b. (1) Property used in the T/B (not for personal use asset), or
c. (2) Property held for the production of income
3. §167(c) The basis for depreciation is the cost
c. **Election to Expense Certain Depreciable Business Assets [§179]
i. General Rule
1. (d)(1) Permits a TP to elect to deduct the cost of “Section 179 Property” in the year in
which the P is placed in service
a. (A) Tangible property to which §168 applies (or computer software),
b. (B) Section 1245 property, and
i. Personal property (not real property)
ii. Other tangible property (not including a building or its structural
components)
c. (C) Acquired for the purchase for use in the active conduct of a T or B
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Federal Income Tax 43
ii. Limitation
1. (b)(1) Dollar Limitation
a. $250,000 immediate deduction. Reduces the TP’s depreciable basis in the
property by the amount deducted. Extended through 2009. 2010 look at revenue
update
2. (b)(2) Phaseout in Limitation
a. If equipment purchased is over $800,000, then each dollar over $800K must be
deducted from the $250K immediate deduction permitted
3. (b)(3) Limitation based on Income from T/B
a. The depreciation deduction under this section may only be used to offset GI, it
cannot create a loss. Any excess deduction is carried over to the next year
d. **Special Allowance for Certain Property [§168(k)]
i. Only applies to qualified property covered by §168 and has a recovery period of 20 years or less
ii. If new property and placed in use after December 31, 2007, then 50% of the AB of the qualified
property is deducted immediately. Deduct that amount from the basis
e. Modified Accelerated Cost Recovery System (MACRS) [§168]
i. After applying the special bonus sections, go through MARCS, the method by which TPs claim K
recovery for tangible assets used in a T/B or held for the production of income Two functions:
1. Deduction
a. MACRS deduction is a deduction from GI in computing AGI [§167(a)]
2. Basis reduction
a. Amount of MACRS deduction reduces the basis of the asset [§1016(a)]
i. (1) Adjustments for expenditures properly chargeable to K account
ii. (2) Exhaustion, wear & tear, obsolescence, amortization, & depletion
3. Recapture Rules
a. §1245 - Gain is going to be treated not as capital but ordinary income if you
deducted more than the actual value of the property – this is depreciation
recapture
i. If sell property for more than pd for it, § 1245 does not apply to that gain
b. § 1250 does not require depreciation recapture for buildings unless there is
“additional depreciation” (i.e., depreciation allowances in excess of straight line
depreciation)
c. If understate actual decline, can deduct under § 1231 an ordinary loss (not
capital) as long as § 1231 gains do not exceed losses
ii. Cost recovery schedule depends on:
1. Total amount of cost to be recovered
2. # of years over which the cost is to be recovered
3. Rate at which the cost is to be recovered over those years
iii. (a) General Rule
1. The depreciation deduction provided by §167(a) shall be determined by using:
a. (1) the applicable depreciation method (b),
b. (2) the applicable recovery period (c), and
c. (3) the applicable convention (d)
iv. *(b) Applicable Depreciation Methods
1. (3) Straight Line Method
a. MACRS deduction is taken on a pro rata basis over the recovery period for the
property
b. Cost of property is divided by the recovery period to determine annual deduction.
c. The following types of property use the straight-line method:
i. (A) Nonresidential real property
ii. (B) Residential rental property
iii. (C) Any railroad grading or tunnel bore
iv. (D) Property which TP elects to use straight-line under (b)(5)
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Federal Income Tax 44
v. (E) Property described in (e)(3)(D)(ii)
vi. (F) Water utility property described in (e)(5)
vii. (G) Qualified leasehold improvement property described in (e)(6)
viii. (H) Qualified restaurant property described in (e)(7)
2. (2) 150% Declining Method [applies (b)(2)(A),(B),(C)]
a. MACRS deduction is AB of the property multiplied by 150% of the straight-line
%
b. In the year in which the method would produce a lower MACRS deduction than
the straight-line rate, the TP reverts to straight-line
3. (1) Double Declining Balance Method
a. Unless otherwise provided, this is the default method
b. (A) MACRS deduction is the AB of the property multiplied by 200% of the
straight-line percentage
c. (B) In the year in which the method would produce a lower MACRS deduction
than the straight-line rate, the TP reverts to straight-line
4. (4) Salvage value treated as zero
5. (5) Offers an irrevocable election to apply either the:
a. Straight-line, or
b. 150% declining balance methods
c. To 1 or more classes of property in any TY
d. Irrevocable once the election is made
v. *(c) Applicable recovery period
1. Recovery period of an asset might have no relation to the actual life of the asset, but is
nevertheless mandatory in computing MACRS deductions
2. Various statutory rec. periods include 3/5/7/10/20/25 years, & the ones listed below:
a. 5 years – cars and light trucks
i. Starts accelerated, switches to straight line depreciation in year 4
b. 25 Years - Water utility property
c. 27.5 Years - Residential rental property
d. 39 Years - Nonresidential real property
e. 50 Years - Any railroad grading or tunnel bore
3. Other specific classifications of property can be found in §168(e)(3)
vi. *(d) Applicable Convention
1. Recovery begins when the property is “placed in service,” i.e., when it is dedicated to use
in a T/B [Reg. 1.168(d)-1(a)]
a. Conventions deem a property to be placed in service at a specific time during the
month/quarter/year, regardless of when it is actually placed in service
2. Half-year convention
a. 168(d)(4)(A) - For tangible property other than real property, a purchase or sale
is deemed to be made at the middle of the year, regardless of when during the
year the transaction actually occurs
3. Mid-month convention
a. §168(d)(4)(B) - TPs buying or selling nonresidential real property are deemed to
make the purchase or sale on the 15th day of the month in which the transaction
occurs. Same convention applies to residential rental property & any railroad
grading or tunnel bore
4. Mid-quarter convention
a. §168(d)(4)(C) - If the aggregate bases of properties placed in service during the
last quarter of the year exceed 40% of the aggregate bases of all properties placed
in service during the year, the half-year convention does not apply. Instead, the
mid-quarter convention deems the property placed in service at the middle of the
quarter in which they were actually placed in service
44
Federal Income Tax 45
f.
vii. Depreciation Tables
1. General Depreciation System - xv
2. Nonresidential Real Property Table - xvii
viii. Problem 1
1. Facts: Jamal purchased a semi-conductor mnf. eqp. for his business. The equipment
had a class life of 9.5 years. It is 5-year P (§168(e)(3)(B)). DOP was 5/1/09. Jamal paid
$450K for the equipment. Jamal had TI from the business of $400K. What depreciation
deductions are allowed Jamal 2K9? If Jamal sells equipment in 2015 for $2K?
2. Ruling:
a. Apply §179 deduction (he qualifies) - Deduct $250K immediately
b. Apply §168(k) deduction (he qualifies) - Deduct 50% = $100K immediately
c. Applicable depreciation method = Assume double declining
d. Applicable recovery period = 5 year
e. Applicable convention = mid-year
f. Calculation - Table xv (other half year is tacked on to end of recovery period)
i. TY - 2009 [100,000 * 2/5] x ½ = 20,000
ii. TY - 2010 [80,000 x 2/5] = 32,000
iii. TY - 2011 [48,000 x 2/5] = 19,200
iv. TY - 2012 [28,800 x 2/5] = 11,520 * switch to straight line*
v. TY - 2013 [17,280 x 1/1.5] = 11,520
vi. TY 2014 [5,700 (1/2 x 11,520)] = 5,700
vii. (OR USE AMOUNTS IN CHART)
g. $2,000 realized gain for GI (applied as ordinary income, not K gains)
ix. Problem 2
1. Facts: Latika purchased a commercial building (nonresidential real property) on October
1, 2009 for use in her business. She paid $3,000,000 for the building
2. Ruling:
a. Because nonresidential real property, is not eligible for two bonus provisions.
i. Applicable depreciation method = straight line
ii. Applicable recovery period = 39 year
iii. Applicable convention = mid-month
b. Use Chart xvii because non-residential real property
i. 2009 = [3,000,000 * 1/39] * 5/24 = $16,025.64 (mid-month applied)
ii. 2010 = $76,920
iii. Year 40 = [3,000,000 * 1/39] * 19/24 = (mid-month applied) she will
recover the balance of her deduction. She will get her 9.5/12 for the
amount left to get down to a zero basis
Start-Up Expenditures [§195] [above the line]
i. (a) Capitalization of Expenditures
1. Except otherwise provided in this section, no deduction for start-up costs are allowed
2. Expenses that would be deductible under §162 [T/B expenses] but for the “carrying on”
req. (i.e., start-up expenditures) may be deductible if TP properly elects to take advantage
of §195(a)
ii. (c) Definitions
1. (1)(A) The costs were paid or incurred in connection w/; and
a. (i) Investigating the creation or acquisition of an active T/B;
b. (ii) Creating an active T/B; or
c. (iii) Any activity before the day on which the active T/B begins
2. (1)(B) Costs would have been deductible under §162, if T/B was already up & running
a. Thus, true K expenditures (i.e., the costs of business assets and other items that
would be capital expenditures even if incurred by an ongoing business) must be
capitalized in the usual fashion
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Federal Income Tax 46
iii. (b) Election to Deduct
1. (1)(A) TP is allowed a deduction for TY in which active T or B begins in amount equal
to the lesser of:
a. (i) The amount of start-up expenditures w/ respect to the active T or B, or
b. (ii) $5,000 reduced by amount the total pre-opening expenses exceeds $50K
2. (1)(B) Any remaining amount must be amortized over 180 months (15 years) beginning
w/ the month in which the active T/B begins using the straight line
iv. (b)(2) Failure
1. (2) If the attempted creation of a business or acquisition fails or is abandoned before
the end of the period to which paragraph (1) applies, immediate deduction is permitted to
the extent allowable under §165 (Losses)
v. Problem
1. Facts: Malcolm has decided to start a new bus. He spends $12K on travel expenses
related to visiting possible locations & meeting w/ prospective sellers. He selects a
business & pays his attorney $20K to prepare the acquisition documents relating to the
transaction. The above expenses were paid from February to 6/09. On 6/1/09, Malcolm
acquires the building & begins operations a week later. Are any of the above amounts
deductible under §195. Suppose instead the deal falls through & Malcolm abandons the
project. May he claim a D for any of the above costs under §165(c)?
2. Answer:
a. $12,000 on Travel
i. Deductible since it is investigating under §195(c)(1)(A)(i)and it would
have been deductible under §162, if T or B was already up & running
ii. $5,000 deduction allowed immediately under §195(b)(1)(A)(i).
iii. The remainder $7,000 is allowed as a deduction spread over 180 months
(15 years). It would begin w/ the month that the act or trade business
begins. That would give her about a $39 deduction per month
b. $20,000 on Attorney Fees
i. Doesn’t meet §195(c)(1)(B) req.; thus, must be capitalized w/building.
Add to the basis of asset that the expenses were used to help acquire
c. Abandons Project
i. §195 does not apply since the business never starts and it applies only
when the act of T/B begins
ii. Look to §195(b)(2) for reference to §165(c). This is a below the line
itemized deduction. There is no business connection so it doesn’t fit
§162
iii. Attorney fees are for profit transaction fees not for a bus. §165(c)(2)
iv. Travel expenses would be lost & not deductible. There was no
transaction and was contemplating targeting a transaction
g. Amortization of Goodwill and Certain Other Intangibles [§197]
i. (a) General Rule
1. A TP may claim a deduction for any amortizable §197 intangible equal to the AB of the
intangible divided by 15 years (straight line). Above the line deduction
2. TP may begin to claim this deduction in month of acquisition of the intangible. Pro rate
3. Such an amortization deduction reduces the basis of the asset in question [§1016(a)(2)]
ii. (c) Amortizable 197 Intangible
1. (1) Amortizable intangible includes intangibles that are held in connection w/TP’s T/B
2. (2) This term does not include “self-created” intangibles (unless it is created in
connection w/a transaction involving the acquisition of assets constituting a T/B or
substantial portion thereof)
3. No deduction for depreciation is allowed wrt goodwill Reg. §1.167(a)-3(a)
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Federal Income Tax 47
iii.
(d) Intangible
1. Intangibles include goodwill, going-concern value, covenants not to compete patents,
copyrights, customer based, formulas or processes, and various other intangibles
a. Goodwill is defined as the likelihood that customers will return to the old place
of business, the tendency of an established business to continue
b. Going concern value is the value of an operational bus, as compared w/ the cost
of acquiring all of the components of the business & getting them going
iv. (e) Exceptions
1. Excludes financial interests, interests in land, readily available computer software, and
leases of tangible property [197(c)(2),(e)(2),(3),(5)]
h. Problem 1
i. Facts:
1. $7 million patent purchased w/ a remaining legal life of 7 years. Does it matter whether
the TP buys the patent as part of the purchase of a business, or buys the patent alone?
ii. Answer:
1. Patent is an intangible under §197(d)(1)(C)(iii). Amortized using straight line over 15 Ys
2. There is a difference if the intangible is purchased as part of the purchase or alone
a. If the patent was purchased alone, it would not be a §197 intangible §197(e)(4)
b. Go back to §167, intangibles are allowed to be amortized under §1.167(a)-3, p.
1148. You must know the useful life. §1.167(a)-14, provides amortization of
certain intangibles excluded from §197 (separately acquired patents and such).
Both regulations provide that you can recover the cost over its useful life in the
TP’s T/B
3. As a result, it has a rec. period of 7 years under the straight line method (pro rate) under
§168
i. Problem 2
i. Facts:
1. Co. buys a customer based intangible for $3 million. It has a 15 year amortization life
span. Each year, Media spends $200K on advertising which is expensed immediately. At
the end of 15 years, the customer list is still worth $3 million. How much will Media
have been allowed to deduct w/ respect to the list?
ii. Answer:
1. Media will be able to deduct all of it and the basis will be zero. This seems overly
generous since advertising expense seems to have a significant future benefit to the co.
Maybe it should be capitalized
2. What Costs must be Capitalized [§263(a)] [§263A]
a. Definition
i. Any amount paid out for new buildings or property or for permanent improvements or
betterments made to increase value of any property or estate when related to T/B must be
capitalized, even if no separate asset is created §263(a)(1)
ii. If the useful life extends substantially beyond the year in question, it may not be immediately
deductible under §162(a). It must be capitalized
1. §1.263(a)-2 - Examples
a. (a) Cost of acquisition, construction, or erection of buildings, machinery &
equip., furniture & fixtures, & similar property having a useful life substantially
past TY
b. (b) Securing a copyright
c. (c) Defending or perfecting title to property
d. (d) The amount expended for architect’s services
e. (e) Commissions paid in purchasing securities
2. Includes wages paid in connection w/ the construction or acquisition of a K asset
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Federal Income Tax 48
b. Repairs v. Improvement
i. Repair (expense) [§1.162-4]
1. Keeps property in an ordinarily efficient operating condition
ii. Improvement (capitalized and depreciated separately)
1. Materially add to the value of the P or appreciably prolong its life
c. Exceptions
i. Advertising and other selling expenses are deductible as business expenses §1.162-1(a)
ii. Expenditures for institutional or goodwill advertising which keeps the TP’s name before the
public are ordinary and necessary business expenses §1.162-20(a)(2)
iii. Employee compensation and overhead costs that do not facilitate the acquisition, creation or
enhancement of an intangible asset (regardless of the % of the employee’s time that is allocable
to capital transactions). This includes an employee of the TP who works full time on merger
transactions 67 Fed. Reg. 77701 (2002)
d. Cases & Rev. Rul.
i. Comm’r v. Indiana Power Co. (SCOTUS 1974)
1. In business of transmission, distribution and sale of electric energy
2. Used its own employees and equipment to make improvements in facility over the years
3. Capitalized the construction-related depreciation to vehicles and equipment used, but for
tax purposes, claimed the depreciation as a deduction under § 167(a)
4. § 263(a)(1) disallows a deduction for an amount “paid out for new bldgs or for permanent
improvements or betterments” according to Comm’r
5. Issue: are you entitled a deduction for depreciation on equipment owned and used in the
construction of own capital facilities—over the short life of the equipment or over the
longer life of the capital facilities?
6. Holding: the cost of depreciation, although presently incurred is related to the future and
is appropriately allocated as part of the cost of acquiring income-producing capital – thus
the equipment depreciation is to be consider capital
a. Construction related depreciation on the equipment is not an expense to the TP of
day to day business and should be recognized as a capital cost
7. § 263A is the Uniform Capitalization Rule (Unicap) applying this case’s principle
ii. INDOPCO v. Comm’r (SCOTUS 1992) [lost some of its power through Rev. Rulings]
1. Unilever expressed interest in acquiring National Starch
2. Greenwalls who owned largest share indicated would transfer shares if tax free, using a
reverse subsidiary cash merger
3. National Starch deducted the fee charged by Morgan Stanley to conduct a fairness
opinion of takeover, but not for legal expenses rendered
4. Comm’r disallowed deduction, Tax Ct found expenses to be capital in nature.
5. Issue: whether certain expenses incurred by a target co. in course of a friendly takeover
are deductible as ordinary and necessary business expenses?
6. Holding: certain legal & professional fees incurred by a target corp. to facilitate a friendly
acquisition were capital expenditures – benefits of accrual exceeded TY
a. Creation of a separate and distinct asset well may be a sufficient, but not
necessary, condition to a classification as a capital expenditure – about the
duration and extent of benefits realized more than a separate asset
iii. Rev. Rul. 92-80 (1992) (in response…)
1. Are advertising costs still business expenses under § 162 (not capital expenditures)?
2. INDOPCO does not affect advertising costs, they are still deductible
3. Only not in unusual circumstances where advertising is directed towards obtaining future
benefits significantly beyond those traditionally associated w/ product advertising
iv. Treasury Guidance (2002)
1. Intangible asset =
a. Any intangible acquired from another person in a purchase or similar transaction
b. Certain rights, privileges, or benefits that are created or originated by TP
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Federal Income Tax 49
c. Separate and distinct intangible asset
i. Whether expenditure creates a distinct and recognized property interest
subject to protection of fed or state law
ii. Whether it creates anything transferable or salable
iii. Whether it creates anything w/ an ascertainable and measurable value in
money’s worth
d. Future benefit
i. Employee compensation and overhead costs do NOT facilitate the
acquisition, creation or enhancement of an intangible asset
v. Rev. Rul. 2001-4 [aircraft airframe maintenance]
1. The heavy maintenance visit did not involve replacement, alterations, improvements, or
additions to the airframe that appreciably prolonged its useful life, materially increased
its value, or adapted it to new or different use
2. Instead, maintenance was used merely to keep airframe in ordinarily efficient operating
condition over its anticipated useful life for the uses for which the property was acquired
vi. Where expenditure is made as part of a general plan of rehabilitation, modernization, and
improvement of the property, the expenditure must be capitalized, even though, standing alone,
the item may be classified as one of repair or maintenance
e. §263A - Capitalization and Inclusion in Inventory costs of Certain Expenses
i. §263A denies a TP an immediate deduction for the costs of producing property that the TP will
either use in its business or sell as inventory
f. Exceptions
i. §263(a)(1) Does not apply to expenditures for:
1. (A) The development of mines or deposits [616];
2. (B) Research and experimental expenditures [174];
3. (C) Soil and water conservation expenditures [175];
4. (D) Farmers for fertilizer, etc. [180];
5. (E) Removal of architectural & transportation barriers to handicapped & elderly [190];
6. (F) Tertiary injectants [193];
7. (G) - (L) which deductions are allowed under 179, 179A-E
g. Problem 1
i. Facts:
1. Vicki owns a commercial building for her business. She purchased the building in 2007
(paying $1 million). In 2009, it became apparent that (despite an inspection prior to sale)
the roof on the building would not last the expected useful life & would have to be
replaced. Vicki paid $150K to replace the roof. In 2009, she also paid a cleaning service
$20,000 for weekly cleaning of the floors & windows (when necessary)
2. Additional costs of painting all of the offices in the building a new shade in 2009
ii. Answer:
1. Replacement of $150K Room
a. Will probably need to be capitalized. This would substantially prolong the useful
the life of the building. You would assume that she expects the building to be
useful for 39 years. She could try to analogize it to Rev. Rul. 2001-4 (aircraft
maintenance)
b. Separately depreciate the cost using §168. The roof is a new separately
depreciable asset from the building (non-residential real property) starting in
2009
c. Vicky had already been depreciating the building. Now she has a replacement of
the room. So it’s a new asset
d. You can have a number of different improvements. They would be on their
separate depreciation schedule
2. Cleaning Services of $20K
a. Deductible under §162 (T/B expense). This is maintenance
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Federal Income Tax 50
3. Painting all of the offices
a. It comes down to if this is considered a repair (immediately deductible) or an
improvement. Normally, just keeping each of the offices & rooms painted just
keeps it in its normal efficient operating condition
b. If you want to freshen, that probably won’t materially add to the value.
c. Painting would most likely to have to be coupled w/ something else to be a
rehabilitation
h. Problem 2
i. Facts:
1. In connection w/ the purchase of the building, Vicki paid her attorney $15K to prepare
the closing documents. Was a deduction for those fees allowable in 2007? How should
she handle architectural fees for construction of a new building?
ii. Answer:
1. 15K Attorney Fees & Architecture Fees
a. Expenditures are intimately connected w/ the cost of acquisition of the asset, so it
must be capitalized. Add $15,000 to the basis of the $1 million commercial
building. Architecture fees are also added to the basis §1.263(a)-2(e)
3. Business Reputation & Job Hunting
a. Business Reputation
i. Welch v. Helbering (SCOTUS 1933)
1. After corp. for which TP was secretary was adjudged bankrupt, petitioner sought to
reestablish his relations w/customers & to solidify his credit & standing by paying a
portion of corp.’s discharged debts
2. Over 5 successive years, petitioner made substantial payments to creditors & deducted
payments from his income
3. Issue: whether payments by TP as agent are allowable deductions in computation of
income if made to creditors of a bankrupt corp’n in endeavor to strengthen his own
standing & credit
4. Holding: payments were not deductible from income as ordinary and necessary expenses,
but rather, were in the nature of capital expenditures, an outlay for the development of
reputation and good will
a. Although Welch’s payments were necessary b/c they were appropriate & helpful
to the continuation of his business, his payments of another's debts w/no legal
obligation to do so were not ordinary b/c they were not the common & accepted
means of heightening his reputation for generosity & opulence.
b. Mr. Welch most likely lost any deduction (current or capital expenditure)
i. Not allowed to deduct payments made to generate good will
ii. Jenkins v. Comm’r (1983)
1. Country singer paid off investors the lost value of a failed attempt to start a burger
restaurant
2. Issue: are payments made to investors ordinary and necessary business expenses?
3. Ruling: There was a proximate relationship between the payments made to the holders of
Twitty Burger debentures and Conway Twitty’s T/B as a country music entertainer. The
primary motive was to protect his personal business reputation.
a. Twitty’s expenses are more analogous to deductible repair expenses for physical
assets, while Mr. Welch’s expenses were not—Twitty’s reputation was only
slightly damages, whereas Mr. Welch was trying to establish a new business, not
repair a current one
b. Job Hunting Expenses
i. Job hunting expenses are currently deductible if the TP is “seeking new employment in the same
T/B which he is currently employed. Rev. Rule 75-120. Rev. Rul. 78-93
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Federal Income Tax 51
ii. Job hunting expenses are unreimbursed employee business expenses, and thus are among the
“miscellaneous itemized deductions” subject to the 2 percent of AGI floor of §67
iii. Where TP is seeking his first job or employment in a new T/B - no current deduction is allowed
c. Problem
i. Facts:
1. Can a law student deduct the expenses of her search for a job as an attorney? Would
reimbursement of interview travel expenses be excludible from GI? See §132(d)
ii. Answer:
1. No deduction is allowed for job hunting expenses. You are not in T/B
2. Travel reimbursements are excluded from GI under CL
3. We don’t have a code provision. §132 regulations do not allow an exclusion if the person
is not an employee. But if you are consulting, it does work. But that doesn’t fit here for
§132(d)
Income Tax Treatment of Families and Marriages
1. Income Tax Treatment of Couples (Married and Partnered)
a. Tax Benefits to Parents
i. § 21: credit for a ltd amount of child care while a parent is at work (see above under business
expense)
ii. § 129: exclusion from GI of benefits rec’d from an employer through a “dependent care
assistance program”
iii. § 151: dependency exemption
iv. § 24: child credit (see above under business expense)
b. Dependent Care Assistance Exclusion [§ 129]
i. $5,000 ceiling regardless of number of children
ii. Employees who participate have income reduced by an amount (up to $5,000) to participate in
DCAP for following year
iii. As employee incurs and pays child care expenses, submits receipts to employer who reimburses
up to amount of salary reduction
iv. Amounts rec’d through DCAP are tax-free
v. Expenditure used to support an exclusion under § 129 cannot be used as basis of § 21 credit
c. Tax Consequences of Marriage
i. Lucas v. Earl (SCOTUS 1930)
1. Made a K in 1901 w/ wife that everything they own or acquire from that point forward
will be owned as jt tenants
2. Declared can only be taxed on half of his income b/c other half is wife’s
3. Issue: whether taxed on total income or only half pursuant to K made w/ wife?
4. Holding: should be taxed on all earned income even if he didn’t “beneficially receive” all
of it
5. * this was at the time when tax system treated married couple as two separate TPs
ii. Poe v. Searborn (SCOTUS 1930)
1. Separate income tax returns b/w husband and wife, real estate only in his name, his
income comprised his salary, interest, dividends, and profits on real and personal
property sales
2. Tax comm’r said all this income should have been reported in husband’s name
3. Issue: b/c the property is community property b/w husband and wife, is tax split?
4. Holding: clear that under Washington’s law of community property, husband and wife
own it equally even if his name is the only one on the deed – each entitled to one half of
the “community” income
5. *no longer that relevant once Congress enacted splitting of married couple income when
filing separately
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Federal Income Tax 52
d. Tax Consequences of Divorce
i. Payments meeting the definition of alimony are taxable to the payee (§61(a)(8), §71(a)) and are
deductible above the line (§62(a)(10)) by the payor (§215(a))
ii. Support benefits do not fall w/in the §102(a) gift exclusion b/c they are not gratuitous (using the
language of Duberstein)
1. Alimony and Separate Maintenance Payments [§71]
a. (a) GI includes amount received as alimony.
b. (b) Alimony means any payment in cash or check (no stock, bonds, etc.) if:
i. (A) Made under a divorce or separation agreement;
ii. (B) Divorce decree or separation instrument must not designate the
payment as nondeductible/non-includible;
iii. (C) Payor and payee must live in separate households; and
iv. (D) No obligation to pay the payee after the death of the payee
c. (c) Child support payments are not deductible by payor or includible by
payee
i. (1) Can’t affix sum as payable for the support of children
ii. (2)(A) Payments that end when a child dies, marries, leaves school or
reaches a certain age (such as attaining majority) will be characterized as
child support payments even if it is called and otherwise qualifies as
alimony Regs. §1.71-1T(c)
d. (f) Recomputation where excess front-loading of alimony payments
i. Applies when all req. of (b) are met (alimony) & there is a front loading
of payments (payments in the first 3 years are more than 15K apart)
1. Does not cover backloaded payments
2. Tax liability shifted in property settlements of ongoing
diversions of income streams, but not for one time divisions of
assets (tax liability shifts to person receiving property not giving)
3. If pd $100K in year 1, but nothing in year 2 and 3, only $15K in
year one counted as alimony for tax purposes—the extra $85K is
treated as a property settlement
4. Purpose is to ferret out disguised property settlements, mitigating
the benefit of the deduction to the payor & the detriment of the
inclusion to payee
5. We also don’t care after the 3Y. But a divorced spouse may not
wish to wait until year 4 to get the P settlement in the form of
cash [it might not be around when year 4 comes along!]
ii. (1) In General - If alimony payments are front-end loaded, IRC requires
an adjustment in the third TY.
1. (A) Payor includes the “excess alimony payments” in GI, and
2. (B) Payee is entitled to an above the line deduction Y3. If she
has insufficient income (remember to include alimony payment
from Y3) in Y3 to use entire deduction, too bad
iii. (3), (4) Calculating Excess Alimony Payments
1. Determine the excess payments for the second year
a. = AP in the 2Y - ($15K + AP in Y3)
2. Determine the excess payments for the first year
a. = AP in 1Y - ($15K + AVG alimony payment made in
2Y and 3Y(which is computed after reducing the 2Y
payment by any portion of that payment treated as an
excess payment under (f)(4)))
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Federal Income Tax 53
e. Transfers of Property between Spouses and Former Spouses [§1041]
i. (a) There is no loss or gain realized (recognized) on the transfer if married, or incident to a
divorced (w/in 6 years after the date on which the marriage ceases). However, unrecognized
gain/loss doesn’t disappear. It is a deferral till transferee disposes of the property
ii. (b) The property transfer is treated as a gift. Thus, no GI, & the transferee takes AB of transferor
iii. (e) Transfers in Trust where Liability Exceeds Basis
1. Will not take transferor’s basis
iv. Problem
1. Ted and Selena own a personal residence (FMV $750K, Basis = $400K & unimproved
land #1 (worth $700K, Basis = $680K). Ted also individually owns some stock worth
$250K, basis = $50K and unimproved land #2 worth $500K, basis = 100K, encumbered
by nonrecourse indebtedness of $300K. Two agree that Ted will trade his interest in the
personal residence to Selena & that she transfer her interest in the unimproved land #1 to
him. He also proposes that Selena accept the transfer of either the stock or land #2
2. Answer: Selena Land Basis [FMV = $500, Encumbered debt = $300K, Basis = $100K]
a. W/out §1041, he would have realized $400K of gain on the transaction. Is there
any difference since they are encumbered w/ debt? No §1041 exception to this
b. Rule doesn’t change. She will take AB = $100K encumbered w/ a debt. If she
were to sell the property, she will include $200K & $300K debt relief (Crane),
even though she didn’t get the borrowed money. Total recognized gain = $400K
c. Reference to Tufts case
f. Tax Issues Relating to Unmarried Couples
i. Reynolds v. Comm’r (Tax Memo 1999)
1. Couple maintained a close personal relationship for 24 years, resembling that of a
husband & wife
2. Mr. Kent gave clothing & jewelry to the petitioner, then broke off the relationship &
asked petitioner to return certain property
3. A settlement agreement was entered into in which petitioner received $22K
4. Issue: Whether the $22K amount is includable in petitioner’s 1994 GI
5. Holding: Petitioner had no gain to recognize upon receipt of the disputed payment. Her
basis equaled or exceeded her total amount realized. Not included in her GI b/c it was
paid for her to surrender all rights in property purchased during the relationship
a. The items she got from the relationship over the years were gifts akin to those
b/w a husband and wife and not compensation for services
ii. Income splitting for domestic partnerships
1. In CA, earned income is community property. Should they split 50-50 on fed tax forms?
Yes, split 50-50
2. Gift tax exemption does not apply to domestic partnership (not spouses under the law)
g. Problem
i. You want to marry someone who is wealthier than you. She proposes to transfer corp. stock
worth $2 million (Basis = $50K) in exchange for prenuptial to relinquish all of your marital
rights. Would you be better off requesting cash of $2 million (or $1,950,000) in lieu of the stock?
ii. Answer:
1. After Marriage [§1041 applies]
a. Transferor - No recognition
b. Transferee - You will prefer to get the cash b/c you could use the $2 million to
buy the stock in $2 million. You wouldn’t have that built in gain. W/ the $2
million in stock, you will take a basis of $50,000. Therefore, $1.95 million will
be taxed at 15% (LTCG)
2. Before Marriage
a. Transferor - Is this a gift since it’s a personal relationship? But it doesn’t look
like a gift here (quid pro quo). You are disposing of the stock in exchange of the
relinquishment of rights. Will have to recognize gain in order to give stock
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Federal Income Tax 54
b. Transferee - It won’t matter if you receive cash or stock since you will have a
basis equal to what is received. Reynolds. Bending over backwards for recipient
Capital Gains and Losses
1. Mechanics
a. Must have a capital asset [§1221]
i. Generally considered investments - stocks, bonds, real estate, interests in partnerships or other
unincorporated businesses. Definition by exclusion
ii. If the owner does anything to develop his property, he is likely to find that the property has lost
capital asset status
iii. §1221(a) Property held by the TP (whether or not T/B) except:
1. (1) Inventory (sale to customers in the ord. course of business)
2. (2) PP used in T/B subject to depreciation or real P used in T/B,
3. (3) Copyright, a literary, musical, or artistic composition,
4. (4) Accounts or notes receivable,
5. (6) Any commodities derivative financial instrument,
6. (7) Any hedging transaction
7. (8) Supplies regularly consumed by TP in the ordinary course of a T/B
b. That is sold or exchanged
c. Holding Period Property of +1 year [§1223]
i. The period of time during which the TP holds an asset is the holding period
ii. The holding period usually begins when the TP acquires the asset by purchase
iii. If a TP receives property in an exchange that is totally or partially tax-deferred, the holding
period of the property received in exchange will include
1. The ownership period of the property received, plus
2. The ownership period of the property given in exchange [1223(1)]
a. This only applies if the property exchanged was a capital asset/1231 property
3. If a TP receives property in a transaction in which his basis is determined by reference to
another person’s basis in that same property, the holding period includes the period of
time during which both TP held the property [1223(2)]
d. Do we have a capital gain or loss? [§1222] §1222 defines terms relating to K gains & losses
i. Long-term
1. (3) Gain - §1001(a) realized property gain, unless there is a non-recognition provision in
(c) so that will be included in GI for the LTCG
2. (4) Loss - §165(c)(2) - Loss for any transaction for a profit but not connected w/ a T/B
ii. Short-term
1. (1) Gain - K asset, sale or exchange, but not held for more than a year. Gain needs to be
taken into account. We know under 1001(a) this is taken into account so it is a STCG.
2. (2) Loss - §165(c)(2) - Loss for any transaction for a profit but not connected w/ a T/B
e. Pick One Capital Gains Rate [§1(h)]
i. All long-term (not short-term) K gain and loss must be placed into one of three categories
1. 28% capital gain and loss
a. Made up of mostly gain & loss on the sale of “collectibles,” such as coins,
stamps, art, antiques, guns, gems, etc.
2. 25% capital gain (not losses)
a. Applies to dispositions of depreciable real property, recaptures only the excess of
depreciation claimed over the allowable straight-line depreciation
3. *15/5% capital gain and loss*
a. Residual category, i.e., it includes all K gain and loss not included in other 2 cat.
i. The 5% rate applies to TPs whose regular rate is 10 or 15%
ii. The 15% rate applies to all other TPs in higher brackets
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Federal Income Tax 55
2. Process
a. §61(a)(3)
i. All capital gains (short term and long term) are added to arrive at GI
b. §165(c)(2), (f)
i. (c)(2) All K losses (short term & long term) are deducted to arrive at AGI (above the line)
ii. (f) Losses from sale/exchange of K assets are allowed to the extent allowed in §1211 & §1212
1. Limitation on Deductions of K Losses [§1211(b)]
a. Individuals may deduct capital losses only to the extent of K gains plus,
i. The lesser of
1. $3,000, or
2. The excess of capital losses over capital gains.
b. This is to prevent cherry picking losses
2. Capital Loss Carrybacks and Carryovers [§1212(b)]
a. Losses that cannot be claimed b/c of this limitation are called “net capital losses,”
and carry forward indefinitely to later TYs
b. In each succeeding year, capital losses may be deducted to the extent of capital
gain recognized in that year
c. Take below-the-line itemized deductions or SD, & personal exemptions to arrive at TI
d. §1222(11)
i. Take out net K gains from TI to tax at preferential rate, & put remaining TI in tax table
ii. Net capital gain = Net LTCG – Net STCL (if there is one); or
1. (LTCG – LTCL) – (STCL – STCG) (if there is one)
2. §1(h)(11). Qualified dividends are added to LTCG once calculated and treated at
preferential rate
iii. Apply applicable rate
e. Problem 1 - When Gains Exceed Losses
i. Halle, 40 & unmarried, received salary in the sum of $200K in 2009. She sold the following
stock:
1. 100 shares ABC stock: $15,000 LTCG
2. 100 shares XYZ stock: $20,000 STCG
3. 100 shares TNT stock: -5,000 LTCL
4. 100 shares CCC stock: -25,000 STCL
ii. Answer:
1. GI = 200,000 (salary) + 20,000 (STCG) + $15,000 (LTCG) = $235,000
2. AGI = 235,000 (GI) – 25,000 (STCL) – 5,000 (LTCL) = 205,000
3. TI = 205,000 (AGI) – 5,700 – 3,261(PE reduced) = $196,033
a. Net Capital Gain = (15,000 – 5,000) – (25,000 + 20,000) = 5,000
b. Thus, ordinary TI becomes 191,033
1. And, net capital gain becomes $5,000 (taxed at preferential rate of 15% because ordinary
TI is not taxed at a marginal rate below 25%)
f. Problem 2 - When Losses Exceed Gains
i. If instead of the above, Halle sold the ABC stock as indicated in #1 & the TNT stock in #1 for
$35K in 2009, but made no other stock sales, what are her GI, TI, and AGI for 2009? See
§1212(b)
ii. Answer:
1. GI = 200,000 (salary) + $15,000 (LTCG) = $215,000
2. AGI = 215,000 (GI) - 18,000 (LTCL) = $197,000
a. Individuals may deduct capital losses only to the extent of K gains plus $3,000.
b. $15,000 (LTCG) + $3,000 = $18,000 allowed as a deduction. $2,000 carryover.
3. TI = 197,000 (AGI) – 5,700 – 3,334 (PE reduced) = $187,966.
a. She has no net capital gain (Net LTCG - Net STCL) here so there is no
preferential rate. This income is taxed all at the ordinary rate.
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Federal Income Tax 56
Earned Income Tax Credit § 32
1. Refundable credit
2. Childless EITC – available to TPs at least 25 yrs but no older than 64
a. Only if income less than $13,980
3. For three children or more, increased to 45%
Qualifying Children
1
2
3+
None
Earned Income Amount
9,320
13,090
13,090
6,210
Max. Amount of Credit
3,169
5,236
5,891
475
Threshold Phaseout (S or HOH)
17,090
17,090
17,090
7,770
Complete Phaseout (S or HOH)
36,920
41,952
45,060
13,980
Threshold Phaseout (married)
22,300
22,300
22,300
12,980
Complete Phaseout (married)
$42,130
$47,162
$50,270
$19,190
4. § 32(c): refundable credit – can get a refund even if no tax liability
5. Comm’r v. Banks/Comm’r v. Banaitis (2005)
a. Banks: Civil suit against employer, fired for discrimination, settled after trial, on contingency fee
b. Banaitis: Suit for interference w/ employment K, attempting to induce him to breach fiduciary duties,
settled on contingency fee
c. Issue: wh
d. Holding: General rule – when a litigant’s recovery constitutes income, the litigant’s income includes the
portion of the recovery paid to the att’y as a contingent fee
i. Deduction issue: could have deducted legal expenses except for alternative minimum tax
requirements which do not allow misc. itemized deductions
ii. Client retains ultimate dominion and control over the underlying claim – att’y is just an agent
obligation to act o/b/o and for the exclusive benefit of the client
1. Thus it is appropriate to treat the full amount of recovery as income to the principal
e. Example: can exclude “income” from performing at a charity event; but must include (and can deduct) if
designate that all the proceeds of a particular performance will benefit X charity
56