Part I: What is Income?
What are the sources of Federal Tax Law?
-Internal Revenue Code (of 1986), IRC S 132(f)(5)(B)(ii)(l)
-Regulation (26 CFR) Reg. S 1.61-21(a)(4)(ii)
-Administrative Rulings & Chief Counsel Legal Advice
-Revenue Rulings 2002-19 (Rev. Rul.)
-Revenue Procedures (Rev. Proc.)
-Announcements (Ann.)
-Notices (Notice)
-Private Letter Rulings 200521029 (PLR)
-Technical Advice Memos (TAM)
-General Counsel Memos (GCM)
-Chief Counsel Advice (CCA)
-Court cases
*Remember - Congress has the final word, not the courts
What is the tax structure?
Gross income
(Minus) "Above the line Deductions
(Equals) Adjusted Gross Income (AGI)
(Minus) Personal Exemption(s)
(Minus) Standard or Itemized Deductions
(Equals) Taxable Income
(Times) Tax Rates
(Equals) Tax Owed
(Minus) Tax Credits
(Equals) Amount to be paid
What is income?
Section 61. Gross income defined
(a)General definition. Except as otherwise provided in this subtitle, gross income
means all income from whatever source derived, including (but not limited to) the
following items
Commissioner v Glenshaw Glass Co. (still the controlling case - undeniable accessions to
wealth)
-D received a judgment that included $250K in punitive damages for antitrust violations
-The Tax Court and the COA agreed with the taxpayers in both cases that the damages
were not taxable
-The SC held that it was income, because of the broad definition of income in Section 61
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*Precedent was Eisner which stated that "income may be defined as the gain derived
from capital, from labor, or from both combined…"
"Here we have instances of undeniable accessions to wealth, clearly realized, and over
which the taxpayers have complete dominion."
Realized - when you actually have the money
How are gifts computed in income?
Section 102(a). General rule.
No income to recipient; no deduction to giver
Commissioner v Duberstein (90)
-B gave D a Cadillac because B had given him useful business information. B's company
deducted the Cadillac as a business expense.
-Tax Court held that it was not a gift and SCOTUS agreed stating that the Tax Court's
decision was not "clearly erroneous".
-"A gift in the statutory sense, on the other hand, proceeds from a detached and
disinterested generosity, out of affection, respect, admiration, charity or like impulses."
Section 102(c): Employee gifts.
(1) In general. Subsection (a) shall not exclude from gross income any amount
transferred by or for an employer to, or for the benefit of, an employee.
Section 274(b) Gifts.
(1) Limitation.--No deduction shall be allowed under section 162 or section 212 for
any expense for gifts made directly or indirectly to any individual to the extent that
such expense, when added to prior expenses of the taxpayer for gifts made to such
individual during the same taxable year, exceeds $25.
Section 74(a) Prizes and Awards
(a) General rule.--Except as otherwise provided in this section or in section 117
(relating to qualified scholarships), gross income includes amounts received as prizes
and awards.
(Unless, if you didn't try to get the prize, you can give it to charity and it is not
accounted for on your income.)
Section 117. Qualified scholarships
(a) General rule.-- Gross income does not include any amount received as a qualified
scholarship by an individual who is a candidate for a degree at an educational
organization
(b) Qualified scholarship
(1) any amount used for qualified tuition and related expenses (tuition and
fees, books, supplies, equipment required for courses.
(c) Limitation.
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(1) shall not apply to any amount received with represents payment for
teaching, research, or other services by the student required as a condition for
receiving the qualified scholarship
What are non-cash/fringe benefits?
Benaglia v Commissioner (54)
-Manager of hotel occupied a suite of rooms in his hotel and received meals at his hotel
which were not included in income.
-Commissioner added to his income the market value of the rooms but the court held that
this should not have been included because he would not have been able to do his job
properly if he had not been there (it was for the convenience of the employer).
*The IRS accepted the "convenience of employer" test after this until Section 119 adopted
a specific version.
Section 79 - Group Term Life Insurance
-Included in income to the extent that such cost exceeds $50,000 of such insurance (this is
allocable)
Section 119 - Meals or Lodging Furnished for the Convenience of the Employer
(a)There shall be excluded from gross income of an employee the value of any meals or
lodging furnished to him, his spouse, or any of his dependents by or on behalf of his
employer for the convenience of the employer, but only if(1) in the case of meals, the meals are furnished on the business premises of the
employer
(2) in the case of lodging, the employee is required to accept such lodging on the
business premises of his employer as a condition of his employment.
(d)Lodging furnished by certain educational institutions to employees:
(1) gross income shall not include the value of qualified campus lodging furnished to
such employee during the taxable year.
Section 125(d) - Cafeteria Plan Defined
(1) The term "cafeteria plan" means a written plan under which
(A) all participants are employees, and
(B) the participants may choose among 2 or more benefits consisting of cash (which
is taxable) and qualified benefits (nontaxable)
*An employee may, in effect elect to reduce his or her taxable salary and take noncash
benefits instead
Examples in text - childcare services (65): Group-term life insurance, dependent care
assistance, adoption assistance, excludable accident and health benefits, elective
contributions under a qualified case or deferred arrangement under section 401(k)
Section 125(f) - Qualified Benefits Defined
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Section 132 - Certain Fringe Benefits
(a) Exclusion from gross income - Gross income shall not include any fringe benefit which
qualifies as a
(1) no-additional-cost service - ordinary course of business of employer at no
substantial additional cost (hotel rooms, plane seats)
(2) qualified employee discount (employee can give up their profit, but not go under
cost) (for services, they can be 20% off)
(3) working condition fringe - primary interest is to benefit the employer, not the
employee (it would be deductible as part of the job)
(4) de minimis fringe - so small as to make accounting for it unreasonable
(5) qualified transportation fringe - includes car to and from work, any transit pass,
qualified parking, or bike commuting reimbursement
-may not exceed $100 a month or $175 per month in the case of qualified
parking
(6) qualified moving expense reimbursement - would be deductible as a moving
expense
(7) qualified retirement planning services
(h) Certain Individuals Treated as Employees
-Includes retired employees, widows of employees who died while employed,
spouse, and dependent child
Treas. Reg. Section 1.61-2(d)(1) - (page 1025)
Compensation paid other than in cash:
-if services are paid for in property, the fair market value of the property taken
in payment must be included in income as compensation
-if services are paid for in exchange for other services, the fair market value of
such other services taken in payment must be included in income as
compensation.
What is imputed income?
Imputed Income -self-provided goods or services that do not arise from observable
market transactions (something you do for yourself)
Examples of imputed income:
Ex: Living in a home that you own, preparing your own meals
Ex: A & B both make $50,000 salary and inherit $100,000. A invests the money in
bonds and makes $8,000 in interest income whereas B buys a house identical to
where A is living and paying rent. A has to pay taxes on his income (interest) but B
doesn't have to pay taxes on his imputed income (money saved in rent).
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-The effect of this difference shifts people from renting to buying which
increases the demand for houses which decreases the value of the house you
can get for $100,000.
Gross Income
A
B
$58,000
$50,000
Ex: C earns $58,000 per year and borrows $100,000 to buy the house. C gets to
deduct the interest rate of $8,000 a year. C is taxed on an income of $50,000 per
year.
*This mortgage interest deduction encourages people to purchase homes, but
discourages people from making other investments (such as purchasing stock or
starting your own business)
Ex: A nurse can earn $20 per hour. However, he is taxed at 35%, so his take home
pay is only $13 per hour. A housepainter charges $15 per hour. Nurse would paint it
himself because the cost would be lower. (self = 10*13 = $130. painter = 10*15 =
150)
-Taxes have changed the choice. Absent taxes you should hire a person, taking
taxes into account you should do it yourself.
Ex: A is a couple where one makes $40,000 and the other stays at home. B is a
couple that works one make 40K the other makes 10K and they spend 8K per year
on housekeeping. A is taxed at 40K, B is taxed at 50K and both are at a tax rate of
25%.
-A ends up with 30K. (40K-10K). B ends up with 29.5K (50K - 8K - 12.5K).
-We could fix this by creating a deduction for housekeeping (however, this
would favor hiring housekeepers by dropping the cost)
Why don't we tax imputed income?
-practicality, valuation, privacy, tracking, public outrage, liquidity
Possible sources of imputed income?
-buying a car (yes), buying a tuxedo (yes), renting a tuxedo (no), buying a washing
machine (yes), repairing one's own car (yes), enjoyment of leisure (not really
imputed income)
Income effect: when taxes go up, people will work more because they have a certain
amount of money they want to keep
Substitution effect: when taxes go up, people will work less because it has become no
longer worth it to work the same amount of time
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Bartering: Revenue Ruling 79-24
Situation 1: In return for personal legal services performed by a lawyer for a
housepainter, the housepainter painted the lawyer's personal residence. Both are
members of a barter club.
-The FMV of the services received by both the painter and the lawyer are
includible in gross income
Situation 2: An individual who owned an apartment building received a work of art
created by a professional artist in return for the rent-free use of an apartment for six
months by the artist.
-The FMV of the work of art and the six months of rental value of the
apartment are includible in the gross incomes
What are damages and how are they taxed?
-Recoveries for personal or business injuries
-"origin of the claim test" - if the amount received would have been excluded anyhow, it
doesn't have to be included in income
IRC Section 104. Compensation for injuries or sickness
(a) In General... gross income does not include-(1) amounts received under workmen's compensation acts as compensation for
personal injuries or sickness
(2) the amount of any damages (other than punitive damages) received (whether as
lump sums or periodic payments) on account of personal physical injuries or physical
sickness; (this doesn't say whose physical injuries)
(3) amounts received through accident or health insurance for personal injuries or
sickness
For purposes of paragraph (2), emotional distress shall not be treated as a physical
injury or physical sickness. The preceding sentence shall not apply to an amount of
damages not in excess of the amount paid for medical care…attributable to
emotional distress
*Rationale for not taxing lost wages - because you can get multiple years of income in the
same year which would put you in a higher tax rate
*This rule is critical when you are structuring your settlement agreement, if you are the P
- don't call it punitive damages!
How are payments for medical expenses taxed?
-Where an employer pays the premiums on the employee's medical insurance, the
amount is deductible by the employer but is not included in the employee's income. This
exclusion extends to an employee's spouse or dependents.
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-Self-employed people are allowed to deduct part of their health insurance outlays (100
percent deductible in 2007).
Section 106. Contributions by employer to accident and health plans
(a) General rule. Except as otherwise provided in this section, gross income of an
employee does not include employer-provided coverage under an accident or health plan.
Section 104. Compensation for injuries or sickness
(a) In General. Except…gross income does not include
(3) amounts received through accident or health insurance…for personal injuries or
sickness (other than amount received by an employee, to the extent such amounts
(A) are attributable to contributions by the employer which were not includible in
the gross income of the employee, or (B) are paid by the employer)
Section 105. Amounts received under accident and health plans
(a) Amounts attributable to employer contributions...
(b) Amounts expended for medical care. Except…gross income does not include amounts
referred to in subsection (a) if such amounts are paid…to the taxpayer to reimburse the
taxpayer for expenses incurred by him
How is debt treated?
1. Loan Proceeds Are Not Income
-Debt is generally excluded from income (the loan does not increase net worth).
-Nonrecourse loan - lender cannot go after the taxpayer's other assets
-Ex from book: But what if a taxpayer has a $50,000 nonrecourse loan secured
by property worth $40,000 and an expectation that he will surrender the lean
property instead of repaying the loan? (General rule is that it is not enough to
make it income, however you could argue that the substance of the
transaction is actually a sale of the property for $50,000.)
*There could be an alternative rule where loan proceeds are included in income and
repayment is deductible. However, this would make borrowing much more
expensive.
2. True Discharge of Indebtedness
-Although the repayment of a loan generally has no tax consequences, if a loan is
discharged for less than the amount owed, the borrower must include in income the
amount of the discount (the amount owed less the amount paid to discharge the
debt)
United States v Kirby (161) - leading case
-Kirby issued 12.1 million in bonds in exchange for cash. In the same year, Kirby
repurchased some of the same bonds at $138,000 less than their face value. The
COC agreed with the taxpayer that the $138,000 was excluded from income.
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-The Supreme Court reversed holding that "the taxpayer has realized within the year
an accession to income….the excess of the issuing price or face value over the
purchase price is gain or income for the taxable year."
*All that matters is that you got the money, it doesn't matters what you did with it.
Section 108. Income From Discharge of Indebtedness
(f) Student loan.-(1)In general.--In the case of an individual, gross income does not include any
amount which would be includible in gross income by reason of the discharge
of any student loan…
(h) Special rules relating to principal residence indebtedness
Mortgage forgiveness provides relief for taxpayers who would otherwise
recognize the income from the discharge of indebtedness when mortgage
lenders foreclose on the taxpayer's principal residence.
Zarin v Commissioner (165) - this has been limited almost to its facts (gambling)
-Zarin "borrowed" $3.4 million from Resorts to purchase chips he lost playing craps.
Resorts filed suit and settled for $500,000. Resorts' extension of credit was illegal
and so unenforceable under NJ law.
-The Tax Court agreed with the IRS that the 2.9 million difference should be included
in Z's income but the COA reversed stating that this was a contested liability and
therefore, the payment he owed was equal to the settlement rather than the
disputed sum.
How is illegal income treated for tax purposes?
-It doesn't matter what you did to get the income, it is income.
IRS Publication 525:
-Illegal activities. Income from illegal activities, such as money from dealing illegal drugs,
must be included in you income on Form 1040.
Gilbert v Commissioner (196)
-President of a company makes an unauthorized withdrawal from his company of $2
million in an attempt to merge with another company.
-He told the directors about this and signed notes stating that he owed them the money
but the board did not approve his actions.
-Tax Court agreed with the IRS that the withdrawals are included in Gilbert's income as
illegal income.
-COA stated that this was not a typical embezzlement case because there was a
reasonableness that he could have paid this back and, therefore, it did not constitute
income.
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How is the interest on state and local bonds treated for tax purposes?
§103. Interest on State and local bonds.
-Exempts from taxation the interest on certain state, municipal, and other such bonds.
-"Putative tax" - bond holders get less pre-tax dollars since it is not subject to federal
income tax
-Exemption continues to be available without limit, for bonds whose proceeds are used
for traditional governmental purposes such as financing schools, roads, and sewers.
However, Congress has imposed limitations on states using tax-exempt financing for
private purposes.
Ex: Taxable bonds earn 10% interest. Tax-exempt bonds 8% interest. Each investor is
investing $1,000.
Tax rate
Taxable bonds
Tax-exempt
A
30%
$700
$800
B
20%
$800
$800
C
10%
$900
$800
Summary: What is (Gross) Income?
Gross Income
includes: (IRC §61; Reg. §1.61-1)
▪compensation, etc. (IRC §61(a) list)
▪punitive damages & other “windfalls” (Glenshaw Glass)
▪prizes and awards (IRC §74)
▪noncash benefits generally (Treas. Reg. §1.61-2(d)(1))
▪bartered goods & services generally (Rev. Rul. 79-24)
▪damages generally (but see origin of the claim test)
▪discharge of indebtedness generally (IRC §61(a)(12); Kirby Lumber)
▪illegal income (but see Gilbert)
excluded by practice:
▪imputed income
▪loan proceeds
excluded by statute:
▪gifts (IRC §102; Duberstein) & certain scholarships (IRC §117)
▪certain fringe benefits (IRC §§79, 105-106, 119, 125,132; also IRC §§107, 127,
129; Benaglia)
▪certain damages (IRC §104; origin of the claim test)
▪certain discharges of indebtedness (IRC §108; Zarin)
▪interest from state and municipal bonds (IRC §103)
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Part II – When is it income?
What is annual accounting?
-For purposes of this class, we will assume a typical calendar year, but a fiscal year does
not have to be a calendar year.
Ex:
2010
($50,000)
2011
$100,000
*Problem with this is that she has only actually made $50,000 in the two years, but she is
taxed on $100,000.
Why is the transactional system impractical?
-It affords reason for postponing the assessment of tax until the end of a lifetime to
ascertain more precisely whether the final outcome will be a gain or loss. It would present
the practical problem of separating out the costs of and returns from separate
transactions. (allocating overhead costs)
Burnet v Sanford (138 - annual as opposed to transactional accounting)
-Court held that a company had to recognize $192,577.39 as income in the year it was
received even though the transaction as a whole did not produce any income under the
16th Amendment
-Transactional tax system would postpone taxes indefinitely
What are Net Operating Losses? Carryover and Carrybacks:
Section 172:
-Losses that occur primarily in the trade or business may be carried over 20 years or
carried back 2 years to offset prior or future income
-Attempts to mitigate the harshness of annual accounting
What are the 4 major timing doctrines?
-claim of right doctrine
-tax benefit rule
-constructive receipt (Amend)
-economic benefit (Pulsifer)
What is a claim of right? How is it treated for tax purposes?
-Under the claim of right doctrine, the taxpayer who has possession of the income is taxes
on the income despite the dispute. If this taxpayer later is forced to give up this income,
an adjustment is his tax liability will be needed. The adjustment takes the form of a
deduction in the year in which the income is repaid.
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North American Oil v Burnet (143) - when must be included in income
-The govt. filed suit seeking land claimed by North American. In 1916, the receiver made
$172,000 which the District Court ordered to be paid to the P in 1917. The argument was
in litigation until 1922. However, the Court held that the money was taxable to the P in
1916.
-"If a taxpayer receives earnings under a claim of right and without restriction as to its
disposition, he has received income which he is required to return.
*If it wasn't taxable until the end of litigation, it would encourage the parties to extend
the litigation process.
Illinois Power Co. v Commissioner (146) - when it can be excluded from income
-"the taxpayer is allowed to exclude from his income money received under an
unequivocal contractual, statutory, or regulatory duty to repay it, so that he really is just
the custodian of the money."
United States v Lewis (147)
-Based on claim of right, the Supreme Court held that excess bonus received "under
mistake of fact" was income in the year it was originally given, and did not give a refund
based on recalculation. However, he can take a deduction in the year when he has to give
it back (the problem with this solution is that it doesn't take into account different tax
rates)
Section 1341 (changes law from Lewis)
-If a mistaken amount is overclaimed in a prior year, the taxpayer can claim a credit in the
year of repayment for the tax that would have been saved by excluding the item in the
earlier year. (this is the same as allowing the taxpayer to reopen the earlier year, except
for the interest on the overpayment.)
-The change must be more than $3,000 for this section to apply.
*This is narrowly construed by the IRS. Mere errors such as arithmetic do not qualify.
What happens if a prior charitable donation is given back to a
taxpayer?
-Ex: Man donates a building to charity only if it is used for religious or educational
purposes. Ten years later, the charity does not want to use it for this purpose anymore
and gives it back to the donor.
Section 111:
-If a deduction did not reduce the taxpayer's tax liability for any year and any loss
carryovers resulting from it have expired without being used, the recovery of the amount
deducted need not be included in income.
-However, if it saved even $1 in a prior year, it must be included in income for the current
year.
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-This differs from 1341 because you don't get to choose your taxable year, so the taxpayer
is not protected against adverse marginal rate changes.
What are the constructive receipt and economic benefit doctrines?
Constructive receipt - taxpayer has current access to the funds
Economic benefit - funds have been set aside for the taxpayer to receive at a later date
Amend v Commissioner (277) - not constructive receipt
-Mr. A sells and delivers wheat in 1944 and is paid for it in 1945. The govt. asserts that
under the doctrine of constructive receipt, the payment was income in 1944.
-Court holds in favor of Mr. A stating the constructive receipt depends solely upon the
existence of a situation where the income is fully available to him. Mr. A had no legal right
to demand and receive his money from the sale of his 1944 wheat until 1945. Just
because he could have set the deal up to receive the money in 1944, doesn't mean it
should constitute income in 1944.
Pulsifer v Commissioner (281) - constructive receipt
-In 1969, Mr. P won $48,000 and the children's share was placed into a court controlled
account until they reached 21 or until an application for the funds was made on their
behalf.
-Court held that this was taxable to the children in 1969 because they had "an absolute,
non-forfeitable right to their winnings on deposit with the Irish court." (The court referred
to this as economic-benefit theory, but it really is constructive receipt. Economic benefit
would be if they had an absolute right to the winnings, but they could not get it until they
were 21.)
Constructive Receipt v Economic Benefit
-Burrus says (in 1944) come in anytime after delivery and we'll cut you a check.
(constructive receipt - taxable income in 1944)
-Burrus puts the money into a bank account in Amend's name in August 1944 but with
instruction to not permit any withdrawals until Jan 1, 1945. (Economic benefit - taxable in
1944)
-Burrus signs a written, notarized contract in August 1944 promising payment on January
1, 1945. (contract - taxable income in 1945)
What are the different accounting methods used by taxpayers?
-Cash - reporting the money when you receive it (easy to use)
-Accrual - report income when it is earned, report expenses when they are incurred
Georgia School-Book Dep. v. Commissioner (333)
-Dep. sold books to the state of Georgia and received an 8 percent commission for its
services. (They used the accrual method)
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-In 1938 and 1939, Georgia did not pay the amount owed in full because of a shortfall in
funding. The Dep. only included in income the amount it received during those years.Dep.
first tried to argue that they hadn't completed their services yet, which the court rejected.
Next they argued that there was a reasonable expectancy that the claim would ever be
paid.
-The court held that because there was no intervening legal right, and Georgia was not
insolvent making payment improbable, it must be included in income.
American Auto. Association v US (337)
-AAA used the accrual method. It received prepaid annual membership dues and allocated
those dues across two years based on the demand for services form members. AAA
allocated its membership costs across the two years in the same fashion.
-The COC and the Supreme Court held that dues had to be accrued in the year received.
Year 1
Year 2
AAA
36
24
S. Ct.
60
0
-The dissent stated that under the method held by the majority, the result will be a
distortion of normal fluctuations in the taxpayer's net income.
-In the aftermath of this case, Congress did adopted Section 456 which allows prepaid
dues to be included in gross income in the years during which the related liability exists
(subject to a 36 month prepaid period limit)
Westpac Pacific Food v Commissioner (344)
-W negotiated contracts with vendors under which it agreed to buy a certain volume of
merchandise during a certain time period in exchange for a volume discount paid as "cash
up front". W properly accounted for the up front cash as a liability when received, that it
applied to reduce the cost of the goods it purchased pursuant to these contracts.
-Court holds that the amount received was not income "because the taxpayer here has to
pay the money back if the volume commitments are not met, it is not an 'accession to
wealth'…Rather, it was merely an advance against an obligation, repayable if the
obligation was not performed."
Other Accounting Method Code Sections:
IRC Section 446: Grants taxpayers permission to use their chosen accounting method for
tax purposes unless doing so would not clearly reflect income
IRC Section 448: Requires most large-scale firms to use the accrual method
IRC Section 451: Items of income are included in gross income in the year received unless
the chosen accounting method provides differently.
IRC 461(h): Includes "economic performance" in the "all events" test for taking a
deduction. (You must actually get the services you are paying for to deduct them)
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How are investments in property taxed?
Section 61(a)(3): gross income includes "gains derived from dealings in property"
IRC Section 1001:
(a) defines "gain for the sale or other disposition of property" as "the excess of the
amount realized over the adjusted basis"
(b) defines the "amount realized" as generally the amount of money received + the fair
market value of other property received
(c) provides that generally any gain or loss on the sale or other disposition of property will
be "recognized"
IRC Section 1012: defines "basis" generally as cost
IRC Section 1001: defines "adjusted basis" as basis adjusted as provided in IRC Section
1016
*Gains only come from the sale or other disposition of property!
*There has to be excess
Inaja Land v. Commissioner (120)
-I bought 1,236 acres for $61,000. LA paid I $49,000 for an easement and to release and
forever discharge the city from liability for water diversion.
-I wanted to defer taxation until the land was sold. The govt. wanted the $49,000 to be
income in the year it was received.
-Court rules for the taxpayer. They rejected the apportionment argument because it was
impracticable to apportion the land.
*This case has basically been limited to its facts
Example 1:
1/1/11 - Buy house for $100,000.
-Basis = $100,000
1/2/11 - Add garage for $10,000
-Adjusted basis = $100,000 + $10,000 = $110,000.00
12/31/11 - Deduct depreciation of $11,000 (10% total cost)
-Adjusted basis = $110,000-$11,000 = $99,000.00
12/31/12 - Deduct depreciation of $11,000
-Adjusted basis = $99,000-$11,000 = $88,000.00
1/1/13 - Sell house for $120,000 (amount realized)
-Gain = $120,000 - $88,000 = $32,000.00
-Gain recognized = $32,000
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How is life insurance treated for tax purposes?
Section 101: Amounts received from life insurance are excluded from gross income.
Types:
-Term Life Insurance: e.g. pay $100 for a single-year $100,000 policy
-Single Premium Life Insurance: e.g., pay $25,000 for lifetime $100,000 policy
-Multiple-year fixed premium term policy
-Annual premium "whole life" policy
Mortality gains and losses:
Ex 1 -Pay $100 for a single-year $100,000 policy.
-If you do not die during the year, mortality loss of $100 (cost of the policy)
-If you die during the year, mortality gain of $99,900 (payout less policy cost).
Ex 2 - Pay $10,000 for an entire-life $100,000 policy
-When you die, you have a mortality gain of $90,000 less the investments
earnings you could have had from the $10,000
-The insurance company does not have a loss because it can invest your
$10,000 tax free and so will presumably, on average, get a return of at least
$90,000 (ignoring its costs and profits)
Why does Congress allow this to happen?
-Because they don't want to have to be the person that voted to tax widows
How is deferred compensation treated?
Minor v United States (284)
-Minor contracted with S for deferral of a portion of his income for future services. S
established a trust, of which it was the beneficiary and Minor was one of the trustees, to
purchase annuities to provide for the payments owed under the deferred compensation
plan. District Court found no currently taxable income for Minor. Govt. attempts to argue
that Minor received an economic benefit, and therefore, this should constitute income.
-The Court rejects this because it is unsecured from S's creditors and therefore incapable
of valuation. (Because S is the beneficiary, not Minor, there is a substantial risk of
forfeiture)
Section 83. Property transferred in connection with performance of services
(a) General rule. --If, in connection with the performance of services, property is
transferred…, the excess of-(1) the fair market value of such property…over
(2) the amount (if any) paid for such property, shall be included in the gross income
of the person who performed such services in the first taxable year in which the
rights of the person having the beneficial interest in such property are transferable
or are not subject to a substantial risk of forfeiture
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Section 409A. Inclusion in gross income of deferred compensation under nonqualified
deferred compensation plans
-Imposes certain procedural requirements relating to distributions, acceleration of
benefits and permitted elections by beneficiaries
-Failure to meet these requirements makes all deferred income, including income
deferred in previous years, immediately includable in income
-Beneficiary also has to pay interest and a 20 percent additional tax
How are Qualified Employee Plans 401(k)s treated?
When payouts are made:
-Pension Plans: aimed at retirement
-Other Plans: when you leave company, after 20 years of service, etc.
How payouts are determined:
-Defined Benefit Plans: employer agrees to provide fixed retirement benefits to
each employee based on factors such as the employee's pre-retirement salary and
number of years of employment
-Defined Contribution Plans: employer's annual contribution to the plan, rather
than the amount of ultimate benefit, is fixed by a formula, and the amount a retiree
ultimately gets depends on the investment return that was earned on the
contributions.
How contributions are determined:
-Money-Purchase Plans
-Profit-Sharing Plans
-Stock Bonus Plans
Tax Treatment of Qualified Employee Plans:
Employee:
Contributions: current exclusion
Earnings: current exclusion
Distributions: included
Employer:
Deduct contributions when made
Restrictions on Qualified Plans:
-nondiscrimination
-must comply with ERISA - designed to ensure the safety of investment by the plan
-dollar limits - you can only put in so much into these plans per year
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How are employee stock options treated?
Commissioner v LoBue (296)
-Supreme Court held that employee stock options were taxable (upon exercise)
Three main approaches to the taxation of an employee stock option:
1. Income upon receipt of the option: If Section 83 is available
When received: FMV of option is taxable in Y1 as ordinary income (deductible to
employer)
When exercised: amount paid for stock is added to the FMV of option to determine
basis
When sold: (Selling price - basis) = capital gain
Section 83:
(a) Mandatory includability - When a stock option is issued to an employee, if it has
a "readily ascertainable fair market value" its value must be included in the income
of the employee
*It is not includable, however, if the option is (a) non-transferable and (b)
subject to a "substantial risk of forfeiture"
(b) Elective includability - Even if taxation of an employee is not required at the time
of issuance based on non-transferability or risk of forfeiture, the employee is
allowed to elect taxation. In that event, the fair market value is determined without
regard to any restrictions.
*Congress allows this because they get income now, and if it turns out to not
be valuable, he doesn't get his money back
(e) The option is never immediately taxable if it "lacks a readily ascertainable fair
market value"
*Income when the option becomes nonforfeitable or transferable - Where the
employee could have made the election in (b) above but did not, the option is
included in income (and deductible to the employer) when it either ceases to be
nontransferable or ceases to be subject to substantial risk of forfeiture. (Section
83a)
2. Income upon exercise of the option: default rule (LoBue standard - If Section 83 and
422 are not available)
When received: no income, no deduction
When exercised: (stock value - exercise price) = ordinary income (deduction for
employer)
When sold: (selling price - stock value when exercised) = capital gain
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*Income upon exercise of the option - An option that lacked a "readily ascertainable
FMV" when granted is not taxed until exercised, even if the value becomes
ascertainable after it is granted but before it is exercised.
3. Gain recognized upon sale of the stock: If Section 422 applies
When received: no income, no deduction
When exercised: no income, no deduction
When sold: (selling price - exercise price) = capital gain (no deduction for employer)
Incentive Stock Options (ISOs) - Section 422
-Applies the third approach to taxpayers who meet specified statutory requirements
*requires the employee to retain the stock for at least 2 years after the grant of
option and one year after receiving stock under the option
*option price must be no less than fair market value of the stock at the time the
option is granted
*for each individual, there is a $100,000 ceiling
*value of the stock is determined as of the time the option is granted
Cramer v Commissioner (302)
-In 1978 and 1979, Taxpayers received stock options that were very questionable
regarding whether they could be readily ascertained upon grant (necessary for Section 83)
-Although the accountant advised them that the IRS might take a different opinion, the
taxpayers filed Section 83(b) recognizing $0 in income for the stock options. (they were
attempting to recognize zero ordinary income, so they could recognize capital income
later upon exercising)
-The issue was whether, at the time of the original transfer, the options had a "readily
ascertainable fair market value," within the meaning of 83.
-Taxpayers argued that the Treasury Regulation was an invalid interpretation of Section
83. (This is a Hail Mary pass)
-Taxpayers lost and were also penalized for intentional disregard of rules and regulations
and substantial understatement of tax
What penalties do taxpayers face for failing to file returns/incorrect
returns?
IRC 6651 (a)(1): late filing of return - 5 percent per month up to 25 percent
IRC 6651(a)(2): late payment of tax - 0.5 percent per month up to 25 percent
IRC 6662: negligence and other accuracy-related penalties - 20 percent
IRC 6663: fraud - 75 percent (ignorance of the law is an excuse)
IRC 7201: tax evasion - up to five years and/or fine
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How are transfers incident to marriage and divorce taxed?
United States v Davis (311) - Prior to Section 1041
-Mr and Mrs. D entered into a voluntary property settlement and separation agreement.
Under the agreement, Mr. D. transferred 1000 shares of duPont stock to Mrs. Davis. He
also agreed to make support payments. Mrs. Davis agreed to accept the shares in full
settlement and satisfaction of her claims and rights against Mr. D. Delaware was not a
community property state.
-Two issues: (1) Is it a taxable event? (2) If so, how much taxable gain resulted therefrom?
-Court held that it was a taxable event to the husband (if it was a community property
state, it would not have been a taxable event) The Court calculated the taxable gain as the
market value of the property which was transferred by the husband.
*This was altered by Section 1041.
IRS Section 1041. Transfers of property between spouses or incident to divorce
(a) General rule.--No gain or loss shall be recognized on a transfer of property from
an individual to…
(1) a spouse, or
(2) a former spouse, but only if the transfer is incident to the divorce
(b) Transfer treated as gift; transferee has transferor's basis
(2) the basis of the transferee in the property shall be the adjusted basis of the
transferor
(c) Incident to divorce…occurs within 1 year after the date on which the marriage
ceases, or is related to cessation of the marriage.
Farid-Es-Sultaneh (316)
-Mr. K transferred 800K worth of stock to F in contemplation of marriage. Mr. K entered
into an antenuptal agreement with F in which she agreed to release all her marital rights
in exchange for the stock. Mr. Ks basis in the stock was .015 per share. The stock was
worth $10 per share on the date of transfer. F sold some of the shares for $19/share.
-Commissioner wanted this to be treated as a gift (basis would be 0.15/share). F wanted
to treat this as a sale (so the basis would be $10/share)
-Court held that this was a sale of her marital rights, and therefore, is was a basis of
$10/share
Alimony: Certain payments received by the payee spouse are taxable to him/her under
Section 71(a) and those payments become deductible by the payor spouse under Section
215.
Section 71. Alimony and separate maintenance payments
(a)General rule. Gross income includes amounts received as alimony…
(b)Alimony defined…
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Seven requirements for alimony:
1. The payment must be in cash
2. The payment must be received under an "instrument" or divorce or separate
maintenance
3. The parties must not have agreed that the payment will be nontaxable to
the payee and nondeductible to the payor.
4. The parties must not be members of the same household.
5. The payment cannot continue after the death of the payee spouse
6. The payments must not be for child support
7. Only payments that are substantially equal for the first 3 years will be
treated as alimony
Diez-Arguelles (325)
-Woman tries to take bad business debt deduction because her husband failed to pay the
child support he was supposed to.
-Court did not allow this because she didn't have a basis in it (because she didn't lend him
any money)
How are annuities taxed?
-Traditionally, an annuity was a contract requiring the payment of a specified amount at
specified regular intervals
-In the current era, the term "annuity" is widely used to refer to a contract with an
insurance company under which the annuitant makes a current payment in return for the
promise of a single larger payment by the insurance company in the future
*You put the money aside so that you are guaranteed income when you get to an age and
retire (they pay annual payments as long as you live)
Example (129)
-Year one: Taxpayer, age 50, pays $100,000 premium to insurance company
-Year one to twelve: insurance company invests premium, which grows to $200,000
-Year twelve: insurance company begins paying the taxpayer, now 62 and with life
expectancy of 20 years, $18,000 per year for the rest of her life.
Section 72:
-Requires the calculation of an "exclusion ratio" to account for income under an annuity
-The ratio is simply the investment in contract divided by the expected return. This ratio is
applied to each payment received.
Ex: Investment = $100,000 and expected return is $180,000. The ratio of 55.55 percent is
applied to each payment received. Thus of each $9,000 payment, 55.55 percent, or $5,000
would be treated as a nontaxable recovery of investment and the remaining $4,000 would
be income.
20
*If you outlived your life expectancy (and exceed your expected return), it is all
taxable.
*If you die before you recover the entire amount of your investment, you are
entitled in your final income tax return to a deduction for the portion of your
investment not recovered.
How are gambling losses treated?
Section 165:
(d) Wagering losses: Losses from wagering transactions shall be allowed only to the extent
of the gains from such transactions
*An example of "basketing" grouping related items of income and expense together.
When is income realized for tax purposes?
Eisner v Macomber (213 - 1920) - stock split
-Mrs. M owned 2,200 shares of Standard Oil, Standard Oil Co. declared a 50% stock
dividend. Mrs. M received an additional 1,100 shares as a result of the dividend. The share
price before the dividend was $360 to $382 per share. The share price after the dividend
was $234 to $268 per share.
-The govt. argues that the stock dividend embodies the accumulated earnings of the
company (over the time she has held the stock)
-Issues with this: liquidity, uncertainty issues
-Court held that this was not recognition of income. Mrs. M's position had not changed
*Here we have taxes only on transactions, not on ascensions of wealth
What potential difficulties does this decision help to avoid?
-liquidity, uncertainty, valuation, practicality
Mark-to-market - securities exchange exception to valuation
Section 305:
(a) General rule: Gross income does not include the amount of any distribution of stock of
a corporation made by such corporation to its shareholders with respect to its stock
(b) Exceptions:
(1) Distributions in lieu of money - if the distribution is, at the election of any of the
shareholders, payable either
(A) in its stock, or
(B) in property
*This is similar to constructive receipt
(2) Disproportionate distributions
*if certain shareholders gain a disproportionate amount of ownership in the
company
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Section 307:
-You reallocate her basis in her old shares to that with her new shares. Her basis in the
stock does not change.
Helvering v Bruun (226) - improved property
-B leases land to tenant for 99 years. Tenant builds new building on land. Tenant defaults
on lease and B gains possession of land and building. Gain in building of $51,434.
Options of gain recognition:
When:
Amount:
When built
PV of building at termination
Lease termination
Gain in value
Sale of the land
Gain in value
Over the term of the lease
Value at termination
-Court held that the gain was income to taxpayer when the lease was terminated.
*However, this is not the current rule.
Section 109. Improvements by lessee on lessor's property: (Overturned Bruun)
-Gross income does not include income (other than rent) derived by a lessor of real
property on the termination of a lease, representing the value of such property
attributable to buildings erected or other improvements made by the lessee.
Section 1019. Property on which lessee has made improvements
-Neither the basis nor the adjusted basis of any portion of real property shall, in the case
of the lessor of such property, be increased or diminished on account of income derived
by the lessor in respect of such property and excludable from gross income under section
109
Leased Property Examples:
In each situation assume a 10-year lease:
-Cash rent paid annually - rent is income when received by landlord
-Cash rent paid annually; new $10k shed in Year 5 that only lasts 5 years - no
additional income
-Same, except economy crashed in year 6, tenant defaults on lease and land (and
shed still worth 10K) - income upon sale if still valuable
-No cash rent; tenant agrees to build a 20-year building worth 400K initially and
200K at the end of the lease. (included as rent over lease)
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Cottage Savings Association v Commissioner (235) - How sensitive is the trigger to
realization?
-CS sold 90% participation in 252 mortgages and simultaneously purchased 90%
participation interest in 305 mortgages. CS claimed it had realized a $2.4 million loss as a
result of the transactions. The FHLBB had previously ruled that the exchange of
substantially identical mortgages did not require the reporting of losses for its purposes.
IRS argued that their economic position was no different, so they should not be able to
trigger the losses
-Issue: whether the realization principle in Section 1001(a) incorporates a "material
difference requirement". If it does, we must further decide what that requirement
amounts to and how it applies in this case.
-Court held that Section 1001(a) did incorporate a "material difference requirement"
because it was a reasonable interpretation of the statute. It stated that they were
"materially different" because they were different legal entitlements - different homes,
different lenders, etc.
*The govt. responded to this case by creating a regulation defining "materially different"
as a "significant modification".
*Section 1001 gives you the formula to calculate the loss, Section 165 tells you when a
loss can be deducted
How is a gain on the sale of a home treated for tax purposes?
Section 121:
-Excludes from income certain gain on the sale or exchange of a home.
-The taxpayer must have owned the home and used it as a principal residence for periods
aggregating at least 2 years over the 5-year period ending on the date the taxpayer sold it.
*The amount of gain that Section 121 excludes is generally limited to $250K for a single
taxpayer and $500K for married taxpayers filing jointly.
*The $500K level is also available for surviving spouses, provided that the sale takes place
within 2 years of the date of death of the deceased spouse.
*Congress puts a limitation on the gain because they lose money by allowing the
exclusion
Limitations:
-Section 121 generally cannot apply to any taxpayer more than once every 2 years.
-However, this limitation is called off if the sale or exchange was "by reason of a change in
employment, health, or to extent provided in regulations, unforeseen circumstances.
-The same grounds also permit exclusion up to a reduced dollar ceiling for taxpayers who
failed to meet the two-year use requirement.
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When do gains and losses go unrecognized?
1.Like-kind Exchanges:
Section 1031
(a)No gain or loss shall be recognized on the exchange of property held for productive use
in a trade or business of for investment if such property is exchanged solely for property
of like kind which is to be held either for productive use in a trade or business or for
investment.
*no cash, both properties held for productive use/investment, some exceptions,
mortgages aren't covered by 1031
(b) Gain for exchanges not solely in kind. If an exchange would be within the provision of
subsection (a)… if it were not for the fact that the property received in exchange consists
not only of property permitted…to be received without the recognition of gain, but also of
other property or money, then the gain, if any, to the recipient shall be recognized, but in
am amount not in excess of the sum of such money and the fair market value of such
other property
*Boot - refers to money, and property other than money, that is transferred as part
of a like-kind exchange but is not like-kind property.
*Under 1031(b), the amount of the gain recognized is the lesser of the amount of
gain realized or the amount of the boot. If there is no gain to be recognized, the
boot is not taxable.
(c) Loss from exchanges not solely in kind. If…, then no loss from the exchange shall be
recognized
Calculating the basis:
-Under section 1031(d) the basis for the property received in a like-kind exchange will be
the same as the basis of the property relinquished.
-When gain is recognized because of a boot, basis must be increased in the amount
recognized so that that gain will not be taxed again
-Of the total basis calculated, a portion equal to the FMV of the boot must be allocated to
that boot, with the remainder being allocated to the like-kind property received
-If boot is paid, rather than received, the amount of the FMV of boot is added to the basis
Reasons for 1031:
(1) practicality: no cash = no recognition, hard to measure gain/loss = no recognition (2)
fairness: same nature = no recognition (3) economic considerations: capital mobility = no
recognition
What is like-kind?
PLR 200203033:
-Taxpayers provide Perpetual Conservation Easement on Old Ranch in exchange for
CongOrg providing New Ranch with a PCE
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-Court held that it was a like-kind exchange.
-Treas. Reg. Section 1.1031(a)-1(b)
Section 1033. Involuntary conversions:
(a) General rule. If property (as a result of its destruction in whole or in part, theft, seizure,
or requisition or condemnation or threat or imminence thereof) is compulsorily or
involuntarily converted
(1) Conversion into similar property. No gain shall be recognized
*In order for this section to apply, taxpayer must reinvest in similar property in 2
years
Multi-Party Transactions:
-S owns Farm 1 with a basis of $10,000. B offers S $1million for Farm 1. S refuses because
S does not want to recognize gain. B finds Farm 2. O owns Farm 2. S agrees with B to
exchange Farm 1 for Farm 2. B buys Farm 2 from O for $1million and exchanges Farm 2
with S for Farm 1.
STUDY HANDOUT 15!!!
How are gifts taxed?
Section 1015. Basis of property acquired by gifts and transfers in trust.
(a) Gifts after 12/31/1920 - If the property was acquired by gift after 12.31.1920, the basis
shall be the same as it would be in the hands of the donor or the last preceding owner by
who it was not acquired by gift, except that if such basis is greater than the FMV of the
property at the time of the gift, then for the purpose of determining loss the basis shall be
such FMV
*In effect, Congress is saying that you can't transfer built in losses
Taft v Bowers (112)
-A buys stock for $1,000. A gives the stock to B when the stock has a FMV or $2,000. B
sells the stock for $5,000.
-Issue: Does B recognize the gain accumulated while A owned the stock?
-Court held that the taxpayer must recognize the gain based on the donor's basis (the
$1,000).
*Reasons for transferred basis: valuation (practical),liquidity (donee has the funds not the
donor), disincentive to give property
Section 1014. Basis of property acquired from a decedent
(a) In general. Except as otherwise provided in this section, the basis of property in
the hands of a person acquiring the property from a decedent or to whom the
property passed from a decedent shall, if not sold, exchange, or otherwise disposed
of before the decedent's death by such person, be
(1) the FMV of the property at the date of the decedent's death
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*Ex: Walmart heirs were able to inherit the stock based on the FMV at the time of
death saving millions
*This is effectively an exclusion rule (and promotes lock-in)
Caution: 1014(f) is subject to a sunsent provision and does not apply to estates of
decedents dying after 12.31.2010 unless legislation to the contrary is enacted.
Estate tax:
-Taxes estates above a certain amount
-For 2009, the threshold amount was $3.5 million. For 2011, the threshold amount is $1
million
-The estate tax is repealed for 2010 only
Gift tax:
-Taxes donors on gifts above certain amounts
-Annual exclusion per recipient. For 2010, the annual exclusion is $13,000
-Lifetime exclusion of $1 million
*Still in effect in 2010
Diedrich v Commissioner (174)
-Ds gave stock to their children. D's basis in the stock is $51,073. Gift is conditioned on
children paying any applicable taxes. Children paid $62,992 in gift taxes. Issue: Did the
discharge of tax constitute income to the parents?
-Court held that, yes, this discharge of indebtedness did constitute income. Tax was
charged based on the adjusted basis of all of the stock.
How is property transferred with debt treated?
Crane v Commissioner (180)
-1932: Mrs. C inherits land and building with a FMV of $262K and subject to a $262K
nonrecourse mortgage
-1932 - 1938: Mrs. C claims depreciation deductions of $25,500
-1938: Mr. C sells the property for $2500, still subject to the mortgage which now was
$255,000.
-Court holds that the amount Mrs. C realized was ($2500 cash + $255,000 debt relief)
*This makes sense because she was using the basis in order to get depreciation
deductions so she should also have to take it into account when she sells it. Also, Court
holds that 1001 applies to property rather than equity
Commissioner v Tufts (188)
-The amount of the debt is more than the value of the property
-1970: Partnership borrows on a nonrecourse basis $1.85 million to build an apartment
complex
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-1971 - 1972: Partners deduct losses and depreciation of $440K reducing the complex's
basis to $1.45 million
-1972: Partners sell partnership interests to a 3rd party. The complex is worth $1.4 mil on
the date of sale and is still subject to the $1.85 million loan
-The Court held that amount realized was the full debt relief ($1.85 million)
-In concurrence, O'Connor states that it would make more sense to have a cash amount
and the debt relief as two separate transactions
Woodsan Assoc. v Comm'r (232)
-1922: Ms. W buys the property for $296K in part with mortgage debt for which she is
personally liable
-1931: Ms. W refinances and increases the amount of the debt to $400K. It is now
nonrecourse
-1934: Ms. W transfers the property to Woodsman Assoc
-1943: Bank forcloses on the property. The debt principal is $381K.
*Court held that the refinancing transaction is a non-event for tax purposes and doesn't
result in the owner recognizing a gain.
Recourse v. Nonrecourse Loans
If owner surrenders property when encumbered by nonrecourse debt or in exchange for
assumption of recourse debt, then:
if nonrecourse debt (Tufts rule)
• sale, with amount realized = mortgage
• so (capital) gain (if any) = mortgage –adjusted basis
if recourse debt
•discharge of indebtedness = mortgage –FMV of property
•§108 may exclude DOI (ordinary) income
•(capital) gain (if any) = FMV of property –adjusted basis
What are constructive sales and how are they treated?
The Problem (p 261)
-E owns 1,000 shares of ABC stock worth 90K with a basis of 10K
-E was 90K not but does not want to realize (and recognize) any gain until next year
-E borrows 1,000 shares of ABC stock for one year from her broker, and then sells
those shares for $90K. No gain realized
-One year later Eileen transfers her initial 1,000 shares of ABC stock to her broker.
She realizes and recognizes her gain in those shares based on their then market
value.
-E therefore delayed her gain for one year without having to worry that ABC stock
lose value.
27
*Congress did not like this because it allowed E to get money and to get rid of the
uncertainty of the price dropping
Section 1259. Constructive sales treatment for appreciated financial positions.
(a) In general.--If there is a constructive sale of an appreciated financial position(1)the taxpayer shall recognize gain as if such position were sold, assigned, or
otherwise terminated at its FMV on the date of such constructive sales…
(c) Constructive sale.
(1) In general. A taxpayer
Still a problem? (p 262)
-A owns X stock worth $500 million, basis $10,000 in 2010.
-A wants to minimize his risk from holding X stock but does not want to realize and
recognize gain until 2015.
-A sells to a third party an option to purchase his X stock for $510 million on
12/31/15
-A buys an option from a third party to sell his X stock for $490 million of 12/31/15
-If on 12/31/15 his X stock is worth more than $510 million, the first option holder
buys his shares for $510 million
-If on 12/31/15 his X stock is worth less than $490 million, he will sell his shares to
the second option seller for $490 million
-A has therefore effectively limited his risk form holding X stock to a +/- $10 million
range while delaying recognition of his X stock gain until 2015. (This is risky. The IRS
might claim that you have a gain in 2010 and you will lose.)
Zero interest Example:
Your parents loan you $500K to buy a new home at zero interest
-In this scenario, if your parents loaned you money, it is inferred that you are
paying interest and they are gifting it back to you.
-Therefore, your parents are getting interest income in this scenario.
Burnet v Logan (270)
-Ms. L owned shares of A&H with a basis of $180K. She sold the shares to Y for
$120K plus future payments based on the amount of ore to be mined. The amount
of ore was uncertain. The govt. estimated the present value of those payments as
$100K. Ms. L argued that this was an "open transaction" and that she should not
have to recognize income until her entire basis was met. Govt. argued that this was
a closed transaction and that the estimated payment of $100K should be included
making her income $40K at the time.
-Court holds that this is an open transaction and that the taxpayer doesn't recognize
any income until the $180K basis is met
*This could also have been considered under the installment method.
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Section 453. Installment Sale (nullified Burnet)
(a) General rule. Except as otherwise provided in this section, income from an
installment sale shall be taken into account for purposes of this title under the
installment method.
(b)Installment sale defined.
(1) In general. The term installment sale means a disposition of property where
at least 1 payment is to be received after the close of the taxable year in which
the disposition occurs.
Installment Sale Method Application:
Threshold Requirements:
-sale of "property"
-at least one payment received after year of sale
-election out generally leads to all gain/loss being realized and recognized in
year of transaction
What property is covered?
-most real and person property
-partnership interests
-not certain types (no publicly traded stock, inventory)
-if a business is sold, sale price must be allocated among assets sold and each
treated separately
Example: Suppose a taxpayer sells property with a basis of $100,000 in return for a
stated amount of $300,000 in the form of payments to be received at the end of
each of the subsequent five years. Since the basis is $100,000 and the total to be
received is $300,000, two-thirds of each payment received is treated as gain; the
other one-third is a recovery of basis.
Year
Amount Received Gain Recognized Basis Used
Basis Remaining
1
30,000
20,000
10,000
90,000
2
60,000
40,000
20,000
70,000
3
30,000
20,000
10,000
60,000
4
60,000
40,000
20,000
40,000
5
120,000
80,000
40,000
0
300,000
200,000
100,000
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Part III: What reduces income?
What is the formula from gross income?
Gross Income:
(MINUS) "Above the Line Deduction" (Section 62(a))
(EQUALS) Adjusted Gross Income
(MINUS) Personal Exemptions
(MINUS) Standard or Itemized Deductions
(EQUALS) Taxable Income (Section 63)
(TIMES) Tax Rate
(EQUALS) Tax Owed
What are deductions?
-Expenses can you apply against your income
-"Above the Line Deduction" (Section 62(a))
What is the standard deduction amount?
Section 63(c). 2010 Amounts:
3,000 per individual ($6,000 filing jointly)
$4,400 Head of Household
*Cannot take the standard deduction if you itemize
Are there any limitations on itemized deductions?
Section 68. Overall limitation on itemized deductions (NOT IN 2010)
(a)General rule - In the case of an individual whose AGI exceeds the applicable amount,
the amount of the itemized deductions otherwise allowable for the taxable year shall be
reduced by the lesser of
(1) 3 percent of the excess of AGI over the applicable amount
(2) 80 percent of the amount of itemized deductions otherwise allowable for such
taxable year.
(b) the term "applicable amount" means $100,000
What are casualty losses?
Section 165. Losses
(c) Limitation on loses of individuals. In the case of an individual, the deduction under
subsection (a) shall be limited to
(1) losses incurred in a trade or business
(2) losses incurred in any transaction entered into for profit, through not connected
with a trade or business; and
(3) except as…losses arise from fire, storm, shipwreck, or other casualty, or from
theft.
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(h) Limatations
(1) $100 limitation per casualty- Any loss…shall be allowed only to the extent that
the amount of the loss…arising from each casualty, or from each theft, exceeds $100
(2) Net casualty loss allowed only to the extent it exceeds 10 percent of adjusted
gross income
(A) personal casualty losses shall be allowed for the taxable year only to the
extent of the sum of
(i) the amount of the personal casualty gains for the taxable year, plus
(ii)so much of such excess as exceeds 10 percent of the adjusted gross
income of the individual
Casualty Gain Example
Year one: you buy a garage for $5,000
Year five: Tornado destroys the garage and insurance company gives you $10,000
*Casualty gain = $5,000
Dyer v Commissioner (356) - other casualty
-Siamese cat had a fit and broke one of a pair of vases. Insurance company refuses to pay
and taxpayer tries to deduct the loss of the vase.
-Can this constitute an "other casualty" under the statute to allow the deduction? (NO)
Chamales v Commissioner (358)
-1994: Couple commits to buy a quiet home in OJ's neighborhood but after the murders it
gets crazy with media and tourists. The C's claimed a 30 percent loss from their $2.85
million purchase price. Court held this was not a casualty loss under 165.
Casualty Loss Example
-Gary and Ginger buy Hawaii property for $2 million and a hurricane damages it. Repair
costs was $250K and insurer paid $100K. Their neighbors choose not to repair their
property, reducing the value to $1 million. Their AGI for the year of the hurricane is
$500K.
250K (repair costs)
-100K (insurance proceeds)
-100 (statute)
-50K (10% of AGI limit)
$99,900 (casualty loss deductible - this reduces the basis of the property)
Blackman v Commissioner (366)
-Taxpayer burns his own house down after getting angry at his wife and putting her
clothes in the stove. He tries to take a casualty deduction.
-Court held that his was his gross negligence and, therefore, he could not take this as
a deduction
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To what extent are medical expenses deductible?
Section 213(a):
-Medical expenses are deductible to the extent that they exceed 7.5% of AGI.
-There shall be allowed as a deduction the expenses paid during the taxable year, not
compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse,
or a dependent…, to the extent that such expenses exceed 7.5 percent of AGI.
Section 213 (d)(1) The term "medical care" means amounts paid
(A) for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the
purpose of affecting any structure or function of the body
Taylor v Commissioner (372)
-P's doctor instructed him not to mow the lawn due to his allergies. He paid $178 for his
lawn to be mowed and deducted it as a medical expense. Court held that it was not a
legitimate medical expense. He did not prove that other family members could not have
mowed and that he would not have paid others to do it anyway.
Henderson v Commissioner (372)
-P's bought and modified a van specifically to transport their child. They tried to
depreciate the cost of their van over 5 years.
-Issue: Whether depreciation is deductible as a medical expense under Section 213.
-Court held that depreciation was not deductible under Section 213 because it was not
"expenses paid during the taxable year".
Ochs v Commissioner (374)
-P's wife is ill and the doctor recommends that she not be around the kids. The P ships the
kids to boarding school and deducts the tuition as a medical expense. Majority holds that
the cost of the boarding school is nondeductible as a medical expense.
*The rule the courts use is the typical medical rule. Cosmetic surgery is not included
unless it is necessary
How is interest treated for the purposes of taxable income?
Section 163. Interest.
(a) There shall be allowed as a deduction all interest paid or accrued within the taxable
year on indebtedness.
(h) Disallowance of deduction for personal interest
(1) In the case of a taxpayer other than a corporation, no deduction shall be allowed
under this chapter for personal interest paid or accrued during the taxable year.
Interest that is deductible under Section 163:
-Business or investment interest: interest incurred in a trade or business or for the
production of income has always been allowed as a deduction
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-Personal interest is deductible only if it is "qualified residence interest" within the
meaning of 162 (h)(3)
-Two categories of "qualified residence interest": Acquisition indebtedness, home equity
indebtedness
1. Acquisition indebtedness: debt incurred to buy, build, or improve a personal
residence, and which is secured by the residence.
*There is a limit of $1 million on such debt
2. Home equity indebtedness: any debt (without limitation as to the use of
proceeds) secured by a personal residence.
*Limited to the lesser of $100,000 or the fair market value of the residence
minus the amount of any outstanding acquisition indebtedness.
*To clear up, this is not an annual deduction, it is a total. Also, the totals are on the
principal of what you take out, not on the loan repayment.
Tracing: Suppose that business property is used to secure a loan that is used for personal
purposes
-Interest generally is allocated according to the use of the loan proceeds.
Section 221. Interest of Education loans
-Allows a deduction for interest on indebtedness used to pay higher education expenses
of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer.
*This is an itemized deduction which is good but there are limits on it. The maximum
deduction is $2,500.
*It is also phased out for taxpayers with modified adjusted gross income in excess of
$50,000 ($100,000 in the case of a joint return)
Are any other taxes paid deductible when computing federal income
tax?
Section 164. Taxes
-A taxpayer may claim a deduction for certain taxes paid to state, local, and foreign
governments.
*This deduction for SALT is an itemized deduction and is not available to those who
choose to claim the standard deduction (with the exception of property taxes in
2008 and 2009). In the past few years, in states with no income tax you could deduct
sales tax (but not this year).
How do charitable contributions affect taxes?
Section 170. Charitable, etc. contributions and gifts
-The Code allows individuals and corporations to claim as itemized deductions any
"charitable contribution…payment of which is made within the taxable year.
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Eligible donees include:
-the United States and any political subdivision of it or any of the states,
-organizations that are "organized and operated exclusively for religious, charitable,
scientific, literary, or educational purposes,", and
-certain other enumerated donees, including veterans organizations, fraternal-lodge
organizations, and cemetery companies
*In general, these organizations must operate on a non profit basis
Ottawa Silica Co. v United States (383)
-O donates a 50 acre site for a school to be built and claimed a deduction of $415K.
Because the school was going to have to build access roads which would greatly
benefit O's land held for housing development, the Commissioner held that O
received a substantial benefit and should not be allowed a deduction. There were
memos which stated that O was expecting to get their land advanced by the school
coming in. The Court denied plaintiff a charitable contributions stating "It is thus
quite apparent that O conveyed the land to the school fully expecting that as a
consequence of the construction of public access roads through its property it would
receive substantial benefits in return."
Limitations on deductions:
-Charitable contribution deductions are subject to the following limitations:
Cash & Non-Capital Gain Property:
-50% of AGI - gifts made to churches, educational organizations, medical
institutions, and certain publicly supported organizations
-30% of AGI - gifts made to private foundations, eligible entities other than
charities and governmental units, and "for the use of"
Capital Gain Property:
-30% of AGI
-20% of AGI to private foundations, eligible entities other than charities and
governmental uses, and "for the use of"
*You can carry these over for 5 years if you can't deduct all in the year of
contribution
Gain Property Limits
Gain Property:
-short term (held for less than a year) is not deductible
-long-term capital gain stock deductible if
-publicly traded stock
-other intangible property (except IP), as long as not to a private
foundation; or
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-tangible personal property
-if not to a private foundation and
-used to further religious, charitable, etc. purpose
*inventory can only be deducted at cost (without gains)
*for self-generated materials, you can only deduct the basis
*The benefit of donating gained property is that you never have to pay taxes
on the appreciated value
(Ex: Donate stock with a basis of $1,000 and a FMV of $5,000. You only pay
taxes on the $1,000 and you take a deduction on the full $5,000.)
Paperwork requirements
"Quid Pro Quo" Donations:
-Donation of more than $75 and return benefit provided
-Written receipt required
All donations:
-bank record or written receipt from charity required (2007)
-for $250 or more, written receipt from charity required
Property Donations (other than publicly traded securities)
-if deduction claimed of more than $5,000
-qualified appraisal required
-appraisal summary attached to return
-if $500K or more full appraisal attached to return
What are personal exemptions?
Section 151. Allowance of deductions for personal exemptions
(a) Allowance of deductions -- In the case of an individual, the exemptions provided
by this section shall be allowed as deduction in computing taxable income
(b) Taxpayer and spouse
(c) Additional exemption for dependents
2010 Personal Exemption Amount = $2,000/person (not subject to phaseout in 2010)
Section 152. Dependent defined
(a) In General -- the term "dependent" means
(1) a qualifying child
-a child, a child's descendant, or a sibling of the taxpayer
-is less than 19 years old or, if a student, less than 24 years old
-has not provided more than half of his or her own support; and
-has the same principal place of abode as the taxpayer for more than
one-half of the taxable year
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(2) a qualifying relative
-child or a child's descendant, parent or parent's ancestor, sibling, aunt,
uncle, cousin, or in-law, or "has the same principal place of abode as the
taxpayer and is a member of the taxpayer's household
-has gross income less than the exemption amount
-receives more than half of his or her support from the taxpayer; and
-is not a qualifying child of the taxpyer
King v Commissioner (408)
-In 1998 and 1999, two parents were both claiming the child as a dependant. Mrs. K
executed an IRS form in 1987 and "all years thereafter" releasing the dependency
exemption deduction to Mr. L
-Court held that because Mrs. K executed the letter in 1987, she had released her
exemption to Mr. L in that year and he was entitled to deduction even though the child
lived with her for those years.
What are business/investment expenses and how are they different
from personal expenses?
Section 262(a): "Except as otherwise expressly provided…no deduction shall be allowed
for personal, living, or family expenses.
Section 162(a): "There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred…in carrying on any trade or business
Section 212: Permits a deduction by individuals for "ordinary and necessary" expenses for
production of income (other than from a trade or business).
*Business expenses are preferable deductions because they are above the line with no
limits
What is ordinary and necessary?
Welch v Helvering (545)
-Mr. W was a secretary of the W Company, a grain business. The W Company had a
discharge from its debts in bankruptcy. Mr. W continued to work in the grain
business and determined that it would further his business interest to repay the
debts. He used a substantial portion of his commissions over five years to repay the
debts. Court held against the taxpayer stating "There is need to determine whether
they are both necessary and ordinary…Men do at time pay the debts of others
without legal obligation…but they do not do so ordinarily.
Gilliam v Commissioner (550)
-Artist is heavily medicated on a plane, traveling to give a lecture at an art
conference, and he flips out and assaults another passenger. He tries to deduct his
legal fees and the amount of his settlement as "ordinary and necessary expenses of
carrying on a trade or business."
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-The court agreed with the Commissioner that this was not an appropriate
deduction. Court held that "we do not believe it is ordinary for people in such trades
or businesses to be involved in altercations of the sort here involved in the course of
any such travel. The travel was not itself the conduct of Gilliam's trades or
businesses."
How are illegal or unethical expenses treated?
Section 162(c): Denies a deduction for bribes or kickbacks to
-Government employees, if illegal
-Foreign government employees, if illegal
-Other persons, if illegal and law generally enforced
-Medicare/Medicaid providers
Section 162(f): Denies a deduction "for any fine or similar penalty paid to a
government for the violation of any law."
Section 162(g): Denies a deduction for the punitive 2/3 proportion of damages paid
for certain antitrust criminal violations
Section 280E: Denies a deduction for expenses of drug trafficking. A cost of goods
sold deduction is still permitted.
Stephens v Commissioner (561)
-S was convicted of defrauding R. The court sentenced him to 10 year prison term
and also fined him $16K. Five years of his prison term was suspended on the
condition that he make restitution to R in the amount of $1 million. He paid $530K
of the restitution in 1984. He had included this same amount in his income in 1976
and had paid tax on it. In 1984, he attempted to deduct this amount and the
Commissioner disallowed it stating that because S made the restitution payment in
lieu of punishment, the deduction should be disallowed.
-The court held that the deduction would not "severely and immediately frustrate
public policy" under Section 165 and was not deductible under Section 162. They
used 162 to interpret 165 stating that because this wasn't specifically mentioned in
162, it must not have been intended in 165.
How is compensation treated?
Section 162(a) - Includes as an ordinary and necessary business expense "a
reasonable allowance for salaries or other compensation for personal services
actually rendered."
Section 162(m) - Denies a deduction by a publicly held corporation for compensation
paid to the chief executive officer or any of the four highest compensation officers
other than the CEO in excess of $1 million.
*Limit does not apply to certain performance-based compensation (therefore, this
limitation serves almost no purpose)
*Disincentive to pay top executives too much money
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Limitation on Miscellaneous Itemized Deductions:
Section 67: 2% floor on miscellaneous itemized deductions
(a) General rule. In the case of an individual, the miscellaneous itemized deductions
for any taxable year shall be allowed only to the extent that the aggregate of such
deduction exceeds 2 percent of AGI
*This is a practicality concession - if there is no 2 percent limit, employees will
deduct everything
The following expenses miscellaneous itemized deductions:
-employee expenses (if you are self-employed, this doesn't apply)
-investment expenses
The following expenses are not relevant to this deduction:
-deductions relating to interest, taxes, casualty and theft loss, charitable
contributions and gifts, medical expenses
How is "trade or business" limited?
Hobby Losses:
-The question is not: Is this a hobby? The question is: Is there a profit motive?
-If hobby loss, can't offset every gain but only gains from hobbies
Nickerson v Commissioner (423) - trade or business?
-Mr. N was concerned that his career in advertising had a limited life and so explored
other sources of income. He and his wife purchased a rundown dairy farm, which
they began to fix up. He visited the farm frequently and also began to refamiliarize
himself with farming. They did not expect to make a profit for approximately 10
years and had significant losses in the years at issue in the case.
-Issue: Does this constitute a trade or business?
-Appellate court reverses Tax Court and states that this constitutes a trade or
business."It is sufficient if the taxpayer has a bona fide expectation of realization of
profit, regardless of the reasonableness of such expectation."
In order to determine if taxpayer had expectation of profit, tax court must
consider:
1. manner in which taxpayer carries on the activity
2. the expertise of the taxpayer or his advisors
3. the time and effort expanded by the taxpayer in carrying on the activity
4. expectation that assets used in activity may appreciate in value
5. the success of the taxpayer in carrying on other similar and dissimilar
activities
6. the taxpayer's history of income or losses with respect to the activity
7. the amount of occasional profits, if any, which are earned
8. the financial status of the taxpayer
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9. elements of personal pleasure or recreation
Section 183. Activities not engaged in for profit
-Allows income generated by a hobby venture to be offset by the expenses of that
venture (after reduction of the income by the amount of any deductions, such as for
interest and taxes, allowed without regard to profit-seeking motive)
-Only to the extent that those expenses, plus other miscellaneous expenses, exceed
2 percent of AGI
Home Offices:
-When a person does in fact use part of his home exclusively, or even primarily, for
business, the costs of that part of the home (including a pro rata share of utility bills and
depreciation on that part) might property be regarded as a deductible business expense
Popov v Commissioner (434)
-Ms. P is a professional violinist who uses her living room as her practice area for 4
or 5 hours a day. She also performed in a variety of professional orchestras for 120
to 140 hours a year. The living room was off-limits to her 4 year old daughter.
-Was this a "principle place of business"?
-Two prong test: (1)"relative importance" (2) time spent
-Court held that this did constitute a principal place of business because P spent
significantly more time practicing the violin at home than she did performing or
recording.
Section 280A - Disallowance of certain expenses in connection with business use of
home, rental of vacation home, etc.
(a) General rule. No deduction shall be allowed
(b) Exceptions for interest, taxes, casualty losses
(c) Exceptions for certain business or rental use
(1) Certain business use - portion of dwelling unit which is exclusively
used
(A) as the principal place of business
(B) as a place of business which is used by patients, clients, or
customers
(C) in the case of a separate structure which is not attached to the
dwelling unit, in connection with the taxpayer’s trade or business.
(if employee, the (C) shall apply only if the exclusive if for the
convenience of his employer)
For vacation homes: 280A covers any "dwelling unit" used by the taxpayer for
"more than the greater of 14 days or 10 percent of the number of days during
the year for which the unit is rented at fair rental.
*Weekend exception: If you get paid rent for less than 15 days, you don't
have to report any rental income.
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Income Unconnected to a Trade or Business:
Moller v United States (439)
-Taxpayers make a living managing their investments on a day-to-day business and
deducted their homes offices as a trade or business expense
-Court held that this was not a trade or business expense.
-It distinguished between "traders" who are considered to be engaged in a trade or
business, and "investors" who are not. In order to be considered a trader, "a
taxpayer's activities must be directed to short-term trading, not the long-term
holding of investments, and income must be principally derived from the sale of
securities rather than from dividends and interest paid on those securities."
How are travel and entertainment expenses treated?
Standard for Travel and Entertainment Expenses:
-"primary purpose"
-"sufficient" business justification
-Employer provides: excluded from employee's gross income as a working condition fringe
benefit if employee could deduct it as an ordinary and necessary business expense
-Employer reimburses: excluded from gross income and not listed as a deduction if
ordinary and necessary business expense
Rudolph v United States (453)
-An insurance company provided a trip from Dallas to NY for agents that met a certain
quota. The Commissioner assessed its value to them as taxable income. SCOTUS affirmed
the District Courts holding that the trip was "in the nature of a bonus, reward, and
compensation for a job well done," and was therefore income to Rudolph. Therefore, the
costs were personal and nondeductible. Dissent stated that these were "isolated
engagements of the kind here in question have no rational connection with compensation
'for services' rendered."
Section 274:
-Disallowance not deduction
-Scope: meals, entertainment, travel expenses
-Tests:
-"directly related to" business OR
-"associated with" business and directly preceding/following a "substantial and bona
fide business discussion"
-Substantiation Required
-Special Rules
-meals and entertainment deduction limited to 50%
-spousal travel expenses (no deduction is allowed unless the spouse is an employee,
had a bona fide business purpose for being on the trip, and the additional expenses
would otherwise be deductible
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-sports and entertainment tickets (face value limit)
-skyboxes
-foreign travel and conventions - disallowed unless it is reasonable for the meeting
to be held outside of North America
-cruises
-expense treated as additional compensation
Moss v Commissioner (460)
-Mr. M was a partner at a small trial firm. The attorneys met everyday at Café for lunch,
that being the most convenient time given court schedules. They discussed the assigned
cases over lunch. Mr. M deducted the $1,000 annual costs as an ordinary and necessary
business expense.
-119 didn't apply because the café was not the employer's premises
-162 didn't apply because he was not "while away from home"
*This is a know it when you see it opinion - who knows where the line is - complete
mess
Danville v United States (464)
-D hosted a Super Bowl trip, inviting two reps from each significant current or potential
customer. Most trip materials did not indicate a business purpose. D employees
informally met with the customer representatives throughout the weekend. D displayed
its products in the hotel.
-Court held that the expenses must be both "an ordinary and necessary business expense"
under 162 and the expense must be "directly related to" or "associated with" the active
conduct of the taxpayer's business under 274.
Churchill Downs v Commissioner (471)
-C owned and operated various race tracks, including the one that hosts the Kentucky
Derby. In connection with the races, C hosts various events, including galas, meals, and
parties. It sought to deduct 100% of the costs of these events. The Commissioner was
seeking the other 50% under Section 274. C attempted to argue that this was a necessary
business expense to promote the event to customers rather than an entertainment
expense.
-Court held that because it wasn't attended by the primary customers (instead celebrities)
and also it was a social event rather than an event with their business.
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How are child-care, commuting, and moving expenses treated?
Child-Care Expenses:
Smith v United States (477) - changed by Section 21
-Smiths were both employed. They hired nanny and sought to deduct the costs.
Court held that the expenses are not deductible. "There results no taxable income
from the performance of this service and the correlative expenditure is personal and
not susceptible of deduction."
*Court is comparing two-earner couple with children to two-earner couple without
children. (It was a personal choice to have children)
Section 21. Expenses for household and dependent care services necessary for
gainful employment.
(a) Allowance of credit.
(1) In general. In the case of an individual for which there are 1 or more
qualifying individuals…there shall be allowed as a credit…an amount
equal to the applicable percentage of the employment-related
expenses…paid by such individual during the taxable year
(2) Applicable percentage defined. 35% reduced (but not below 20%) by
1 percentage point for each $2,000 (or fraction thereof) by which the
taxpayers adjusted gross income for the taxable year exceeds $15,000
(c) Dollar limit on amount creditable - The amount of the employment related
expenses shall not exceed
(1) $3,000 if there is 1 qualifying individual…, or
(2) $6,000 if there are 2 or more qualifying individuals
*This is a non-refundable credit. So you can only apply it against the tax you
owe.
*Minimum for a wealthy family is $600 (20% of $3,000)
Section 129. Dependent care assistance programs
(a) Exclusion
(1) In general. Gross income of an employee does not include amounts
paid or incurred by the employer for dependent care assistance provided
to such employee
(2) Limitation of exclusion
(A) In general. The amount which may be excluded under paragraph
(1) for dependent care assistance with respect to dependent care
services provided during a taxable year shall not exceed $5,000
($2,500 in the case of a separate return by a married individual)
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Traveling Expenses:
Section 162(a)(2) - ordinary and necessary business expense includes: traveling
expenses (including amounts expended for meals and lodging other than amounts
which are lavish or extravagant under the circumstances) while away from home in
the pursuit of a trade or business;
-"temporarily away from home" only if
-away one year or less
-taxpayer realistically expects to be away for one year or less; and
-taxpayer plans to return in one year or less
-"away" only if taxpayer stays overnight
-traveling salesmen have no "home" and so can never be "away"
Commissioner v Flowers (481)
-Mr. F was an attorney in Jackson, MS and was offered a position in Mobile, AL. He
did not want to move, so they arranged that he would pay his own traveling
expenses between Jackson and Mobile. Mr. F sought to deduct his traveling
expenses of $900 and &1620.
-Court did not allow this deduction because the expense was no incurred in pursuit
of business (it was therefore a personal expense)
Three conditions that must be satisfied before a traveling expense deduction
may be made:
(1) The expense must be a reasonable and necessary traveling expense
(2) The expense must be incurred "while away from home."
(3) The expense must be incurred in pursuit of business.
Hantzis v Commissioner (487)
-Ms. H was a 2L at Harvard. Unable to find a summer job in Boston, she took a
position in NY. She spent over $3K on traveling to NY and renting a small apartment
in NY. Her husband remained working in Boston, and they continued to keep their
home in Boston.
-Section 162(a)(2) - "traveling expenses (including amounts expended for meals and
lodging) while away from home in the pursuit of a trade or business". Court held
that she could not deduct her traveling expenses because she was not away from
home.
Moving Expenses:
Section 217. Moving Expenses
-There shall be allowed as a deduction moving expenses in connection with the
commencement of work…at a new principal place of work.
- "Moving expenses" means only (1) the reasonable expenses of moving
household goods and personal effects and (2) of traveling (including lodging).
Such term shall not include any expenses for meals
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-Conditions for allowance - No deduction…unless: (1) 50 mile away
requirement and (2) full-time employee requirement
*If your employer pays for more than is allowed as a deduction, the excess is
treated as income
*This is an above the line deduction
What are the above-the-line deductions?
-Above the line deductions are the deductions subtracted from gross income to calculate
adjusted gross income (AGI)
-They are not subject to limitation and are listed under Section 62(a)
Section 62(a)
-Trade and business deductions
-Certain trade and business expenses of employees (includes reimbursed expenses
of employees, certain expenses of elementary teachers)
-Losses from sale or exchange of property
-Retirement savings
-Alimony
-Moving Expenses
-Interest on Education Loans
-Higher Education Expenses
-Health Savings Accounts
How are Clothing, Legal, and Education Expenses Treated?
Clothing:
-This is a miscellaneous itemized deduction which is subject to the 2% AGI floor
-Uniforms are deductible generally
Pevsner v Commissioner (497)
-Ms P was the manager of the S in Dallas, TX. She was required by her employer to
wear S clothing while at work and related events. She purchased the clothing herself
at an employee discount. She lived a simply life, and did not wear the clothes
outside of work.
-Court looked at three factors to determine if the costs could be deducted: (1)
condition of employment (2) adaptable for general usage (3) general usage. Taking
an objective view, the court held that because the clothes were adaptable to
general usage as ordinary clothing, they were not deductible.
Legal:
United States v Gilmore (500) - origin of the claim rather than consequences to the
taxpayer
-Mr. G was the President and controlling shareholder of several GM dealerships. Ms.
G filed for divorce and sought a majority of Mr. G's property under California's
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community property laws. Mr. G, desiring to protect his ownership and the
continued operation of dealerships, successfully contested Ms. G's claims and
sought to deduct his $40K legal fees under Section 212.
-Section 212(2) "conservation of property" was held by the Court not to cover this
situation, making the fees nondeductible.
Standard: depends on whether or not the claim arises in connection with the
taxpayer's profit-seeking activities. It does not depend on the consequences that
might result to a taxpayer's income-producing property from failure to defeat the
claim.
*However, in a later case they allowed him to add to his basis the legal expenses (in
effect, just changing the timing of the deduction)
Education:
Carrol v Commissioner (506)
-Detective C was part of the Chicago PD. The Department had an official policy of
encouraging policemen to obtain higher education. Detective C took courses at
DePaul toward a philosophy degree with an eye to eventually attending law school.
Standard - taxpayer justify the education as maintaining or improving skills required
by him in his employment
Regulation 1.162-5 Expenses for education
(a) General rule. Expenditures made by an individual for education…are deductible
as ordinary and necessary business expenses…if the education
(1) Maintains or improves skills required by the individual in his employment or
other trade or business, or
(2) Meets the express requirements of the individual's employer, or the
requirements of applicable law or regulations, imposed as a condition to the
retention by the individual of an established employment relationship, status,
or rate of compensation.
*If you are at your current established job, and you are told you need to get more
education, it is okay.
*If you need the requirements to get in the door, not deductible.
*If your employer pays for your education and it would be deductible if you paid for
it, it is a working fringe benefit and not included as income
Section 222. Qualified tuition and related expenses
*This was terminated after December 31, 2009.
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What are capital expenditures?
Capitalization vs Current:
Current Expenses:
-May deduct the expense when it is paid (or accrued)
Capital Expenditures:
1. added to the basis
2. depreciated over a period of years (which reduces basis)
3. sell property (gain/loss = amount realized - adjusted basis)
Capital Expenditure vs. Current Expense Example:
-Client is in the apartment rental business
-Bought land for $100K in January 2010:
*No current deduction, capitalize basis
-Bought apartment building for $100K in 1/10:
-Rent collected offset by operating costs
-Building loses 3% of value to normal wear and tear in 2010
*Taxpayer gets current deduction for reduced value
-Rent apartment building for $10K in 2010:
-Subleases the apartments to individual tenants
*Current deduction
Section 263: "No deduction shall be allowed for any amount paid out for new buildings or
for permanent improvements or betterments made to increase the value of any property
or estate."
*This language of the statute was not intended to be read literally (it meant any long-term
asset). The court does not read it literally.
Encyclopedia Britannica v Commissioner (512) - capital asset
-EB hired DS to research and draft the Dictionary of Natural Sciences. EB agreed to pay DS
advances against the royalties that it expected to receive from the book. EB attempted to
deduct this advance in its entirety as a business expense in the year it was made. IRS
disallowed the deductions.
-Govt. argued that this was an asset which would produce income for years, and therefore
the expenses should be matched over years when the income from the book comes in.
-Court holds that this is a long-term asset and should be capitalized over a period of years.
It distinguished between in-house and outside work and held that if it had been created
in-house, it would have been currently deductible based on administrative and practicality
issues.
*Because in-house employees have such a wide range of responsibilities, it would be hard
for them to determine how much time was allocated to creating this specific dictionary
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Section 263A. Capitalization and inclusion in inventory costs (Biggest change - the
distinction between in-house and outside is gone)
-Standard: in the case of property which is inventory in the hands of the taxpayer, shall be
included in inventory costs (special case of capitalization), and in the case of any other
property, shall be capitalized
-Applicable costs: The costs described in this paragraph with respect to any property are
(A) the direct costs of such property, and (B) such property's proper share of those
indirect costs (including taxes) part or all of which are allocable to such property
-Applicable property: (1) Property produced by taxpayer and (2) Property acquired for
resale
*Congress limited the scope of 263A somewhat by excluding from its ambit retailers and
wholesalers with annual gross receipts of less than $10 million. *CEO's salary, advertising
and marketing expenses - currently deductible
INDOPCO, Inc. v Commissioner (520) - mergers and capitalization
-I merged with another company. The merger produced long-term benefits for I, including
access to the resources of the other company, etc. I incurred legal and investment
banking fees incident to the merger.
-Court held that the costs must be capitalized stating "the realization of benefits beyond
the year in which the expenditure is incurred is undeniably important in determining
whether the appropriate tax treatment is immediate deduction or capitalization."
*This was theoretically correct, but practically a nightmare.
How are repair and maintenance expenses treated?
Midland Empire Packing Co. v Commissioner (522) - repair ordinary expense
-ME used the basement of its plant for meat storage and curing. The basement had been
satisfactory for these purposes. ME added concrete to the plant to oil proof it against an
oil nuisance created by a neighboring refinery and deducted the entire cost in that year as
an ordinary and necessary expense. Govt. disallowed, arguing that it was not an
"ordinary" expense in ME's business.
Section 1.1624 - Repairs
-The cost of incidental repairs which neither materially add value of the property nor
appreciably prolong its life, but keep it in an ordinarily efficient operating condition,
may be deducted as an expense.
*However, the gain or loss cannot be increased by the amount of such expenditures.
-Court held in favor of the taxpayer, stating "after the expenditures were made, the plant
did not operate on a changed or larger scale, nor was it thereafter suitable for new or
additional uses." It served only to permit ME to continue its normal operations.
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Revenue Ruling 94-38 - repair ordinary expense
-X owns and operates a manufacturing plant. The plant's operation has contaminated the
land and groundwater. X remediates the soil by disposing of the contaminated soil and
replacing it with clean soil. X constructs a groundwater treatment and monitoring facility
that X expects will operate for more than 10 years. The effect is to return the eland to
essentially the same physical condition that existed before contamination.
-The facilities have a useful life beyond the taxable year and must be capitalized.
-The expenses incurred by X for soil remediation and ongoing water treatment do not
constitute capital expenditures.
Norwest Corp. v Commissioner (531) - repair capital expense
-N decided to remodel a bank building. N determined that it would be necessary to
remove asbestos that would be disturbed by the remodeling. N also decided to removed
asbestos from a lower level parking garage at the same time. Remodeling cost $5 million
and asbestos removal cost $1.9 million.
-The General Plan of Rehabilitation Doctrine states that expenses incurred as part of a
plan of rehabilitation or improvement must be capitalized even though the same
expenses if incurred separately would be deductible as ordinary and necessary.
-Citing this doctrine, the court held that the asbestos removal must be capitalized with the
rest of the expenses.
*Problem with this doctrine is that it does not promote efficiency.
How are inventory, rent, and goodwill treated for tax purposes?
Inventory:
-Any item the taxpayer plans to re-sell (can be purchased or produced)
COGS: Beginning Inventory + Purchases - Ending Inventory
Inventory Valued at Cost:
-When inventory is on hand at the beginning of the year, cost is the amount at which
it was included in closing inventory of prior year
-For merchandise purchased after beginning of year, cost is inventory price plus
transportation and other acquisition charges less certain trade discounts
-For merchandise produced during the year, cost is the total of direct costs and
indirect costs.
FIFO: First-in-First-Out (general rule)
-Assumes that good first acquired are sold first and therefore the goods in closing
inventory are those most recently purchased
-Either method of valuing inventory - cost or cost or market, whichever is lower may
be used with FIFO.
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-In a falling market, lower of cost or market tends to reduce income; the value
of the closing inventory is recued to market, creating a higher costs of goods
sold, resulting in a lower gross income.
LIFO: Last-in-First-Out (Section 472)
-Items purchased last are considered sold first so closing inventory is valued as if
composed of the earliest purchases.
-Inventory must be valued at cost (lower of cost or market is unavailable)
-Generally produces the best tax results in a period of rising prices; tax liability is
deferred on inventory gains as long as firm maintains inventory
*472(c) - LIFO must be used to report to investors if used for tax purposes
*After choosing LIFO or FIFO, you cannot change without permission from the IRS
Rent Payment vs. Installment Purchase
Rental:
-Lessee pays rent for 99 years to lessor
-Lessee deducts the rent as a current expenditure
-Lessor includes the rent in gross income
-Lessor cannot deduct the cost of the land
*This makes a difference if the lessee has a higher marginal tax rate than the lessor
(Ex: Notre Dame is tax exempt)
Purchase:
-Buyer pays installment payments for 99 years
-Buyer cannot deduct the principal
-Buyer deducts the interest as a current expenditure
-Seller includes gain (not basis) in gross income
-Seller includes interest in gross income
Starr's Estate v Commissioner (541)
-Taxpayer "leased" sprinkler system for a five year term at $1240 a year. Renewable
at election of taxpayer for additional 5 years a $32/year. If no renewal, sprinkler
company had six months to remove the system. If renewal, status of system in year
11 unclear. Normal purchase price for system was $4,960. Sprinkler systems are
tailor-made for properties and so have negligible salvage value.
-Court held that the practical effect was a sale (substance over form) and it
constituted a sale. It also says it isn't worth litigating in future because taxpayer can
deduct interest and depreciation so the actual tax difference is minimal.
Goodwill
Section 197: Amortization of goodwill and certain other intangibles
-Taxpayer can deduct ratably over the 15-year period
-Depreciation (real or tangible property), Amortization (intangible property)
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-This can only be applied if the intangible property is acquired and is within the
conduct of a trade or business activity
(A) goodwill
(B) going concern value
(C) any of the following:
-workforce in place
-business books and records
-any patent, copyright, formula, design, process, pattern, knowhow,
format, or other similar item
-any customer-based intangible
-any supplier-based intangible
-any other similar item
(D) any license, permit, or other right granted by a governmental unit or an
agency
(E) covenant not to compete
(F) any franchise, trademark, or trade name
How is depreciation treated for tax purposes?
Section 167. Depreciation
(a) General rule. There shall be allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear (including reasonable allowance for
obsolescence)-(1) of property used in the trade or business, or
(2) of property held for the production of income
Variables:
-cost
-salvage value
-useful life
-formula for allocating depreciation deduction
Ways to increase depreciation deductions:
-You can frontload the depreciation deduction to take the deduction sooner
-You can reduce the salvage value (to zero)
-You can shorten the useful life
-You can inflate cost (example: you can deduct 1.5 the amount of the cost)
*Policy reason for this is that it stimulates investment
Example:
GM pays $100K for a robot in Jan. 1 of Year 1. The robot has a useful life of 10 years.
The robot has a salvage value of $10K. A depreciation deduction of an equal amount
for each year of useful life is permitted ("straight line" depreciation).
*To begin with, this goes into the basis
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*$100K - $10K = 90K/10 = 9K per year in depreciation
*You cannot deduct beyond the salvage value
*Tangible assets placed in service after 1980 are depreciated under the rules of
Section 168.
Section 168. Accelerated cost recovery system
-For personal property there are now recovery periods for six different classes of
property: 3 year, 5 year, 7 year, 10 year, 15 year, 20 year
(1, 2) Applicable depreciation method:
-Prescribed method for declining balance: 200% (for 3,5,7,10 year property);
150% (for 15, 20 year property)
-Switching to the straight line method for the 1st taxable year for which using
the straight line method with respect to the adjusted basis as of the beginning
of such year will yield a larger allowance.
(3) Property to which straight line method applies
(4) Salvage value shall be treated as zero.
-Half-year convention: for the 1st year the rate is half of what it would be for a full
year,
-Unless 40% place in last quarter then mid-quarter convention
*Cost of recovery begins not when property is acquired but when it is "placed
into service"
What are tax shelters?
What is not a tax shelter:
-Taking advantage of a tax provision as was intended by Congress (example: tax-exempt
bonds)
-Taking advantage of a tax provision in a manner clearly permitted by the terms of the
provision, if not squarely within Congress' intent (ex: choosing to make a charitable
contribution by contributing appreciated property)
-Taking an aggressive position in a gray area of the law (ex: the Chamales' (from OJ case)
casualty loss)
-Run-of-the-mill tax evasion ("forgetting" to report income; counting personal expenses as
business deductions)
What is a tax shelter:
-Any plan or arrangement a significant purpose of which is the avoidance or evasion of
Federal income tax. IRC Section 6662(d)(2)(C)(ii)
-A transaction lacking "economic substance" and entered into for a tax benefit.
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*Not every tax shelters are illegal. There is a difference between tax shelters and abusive
tax shelters.
Knetsch v United States (579)
-Pays $140K in interest on a $4 million loan. The annuity increases by $100,000 which he
borrows nonrecourse leaving him losing $40,000 on the year.
-However, the $100K borrowed and the increase in value of the annuity is not income and
he gets to deduct the $140k in interest.
-He saves $110K in taxes, therefore the net effect of this was to make $70K.
*Court ruled against the taxpayer because there was no economic substance other than
him paying a fee for tax benefits. Although the taxpayers argued that they were just
following the statute before the 1954 amendment, the Court held that the 1954 provision
just expanded the application of the policy already in effect. Dissent argues that this was a
legislative remedy and that Congress should be responsible for changing the rule to
prevent loopholes.
Goldstein v Commissioner (584)
-Ms. G wins $140K in the Irish Sweepstakes. Ms. G borrows $465K at 4%. She pays $465K
for US Treasury notes with a $500K face value and 1.5% interest. She prepays $52K in
interest on the loan. Total economic loss was $18.5K. This was different from Knetsch in
that the loan was real and from a different source. Court holds against taxpayer again
because her sole motive was tax purposes.
What Lawyers are used for Tax Shelters:
-Marketing tool: Provides an "opinion letter" that reassures participants that the tax
shelter transaction is not, in fact, "too good to be true."
-Penalty Protector: Provides an opinion letter that protects participating taxpayers from
the imposition of penalties even if the tax shelter ultimately fails.
Levels of Confidence in Opinion Letters:
-Reasonable basis - A reasoned argument that provides a 15-30% chance of success.
-Substantial authority - An argument based on the reasonable interpretation or
application of precedential authority although there may be contrary authority (30-50%)
-More likely than not - States unambiguously that there is a greater than 50% likelihood
that the tax treatment will be upheld if challenged by the IRS
*This is required to take the deduction
-Should - States unambiguously that the legal conclusion should be correct based on
available authority, although there is nothing directly on point (70)
-Will - States unambiguously that the legal conclusion are correct. Often required for
business transactions. (100%)
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Part IV: Whose income is it?
Whose income?
-Important because there is a huge incentive to transfer taxable income because of the major
difference in tax brackets
Definitions:
Marginal tax rate: The rate at which the next dollar you earn will be taxed at
Progressive tax: As you earn more income you are taxed at a higher percentage
Average tax rate: What is the average tax rate paid on all of your income.
Kiddie Tax:
-Children who have not attained the age of 18 are subject to this
-Applies if either parent of the child is alive at the close of the taxable year
-The child cannot file a joint return for this subsection to apply
What if the kids tax rate is higher?
-The higher rate applies
How to figure out the tax:
-On kids earned income - that is tax that they earned (kids are taxed on earned
income just like anyone else on earned income)
-But on investment income - you apply the parent's marginal tax rate (So its as if the
parents had earned that income)
Tax Rate Categories:
-Married individuals filing joint returns and surviving spouses (Best Schedule)
-Widows or widowers over the past 2 years who have a dependent child from
deceased
-Heads of households (Mostly single parents)
-Unmarried Individuals (Single people)
-Married individuals filing separate returns (This is the worst schedule)
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What is the AMT? (Alternative Minimum Tax)
-AMT imposes a tax at a reduced rate on a broader base. (The resulting tax is only payable
to the extent that it exceeds the normal tax)
Denial or Reduction of Deductions & Other Items:
-No personal exemptions or standard deduction
-No miscellaneous itemized deductions
-No state and local taxes deduction
-No home equity loan interest deduction
-Increased floor (10%) for medical expenses
-Certain tax-exempt bond interest taxable
-ISOs taxed on exercise
To calculate AMT:
-You get AMTI then subtract the exemption amount and multiply that number by
the tax rate.
-Tax Rate (26% first $175,000; 28% thereafter)
Exemption Amount
-$45,000/$33,750 for 2010 (unless new legislation)
-Phased out above $150,000/$112,500
Klaassen v Commissioner (614)
-Family with 10 children were forced to pay an extra $1,085 in taxes due to the AMT (they
lost their personal exemptions, floor in medical expenses changed, and they were taxed at
a higher rate). They argued that it was not the intention of Congress to have lower income
families pay extra taxes under AMT. They also made constitutional arguments. Court held
that the tax laws were neutral so no constitutional argument. They also lost on the
congressional intent argument because the language of the statute was plainly written
and there was no ambiguity.
Prosman v Commissioner (617)
-Taxpayer argues that he should not be subject to AMT because if his employer had
treated some of the money he was paid as per diem, rather than AGI, he would not have
been affected by the AMT. They also argue that this was against the Congressional intent.
-Court holds that, while they may sympathize, under the plain meaning of the statute the
taxpayer was subject to the AMT.
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What is the attribution of income?
Why shift income to another taxpayer?
-To shift income to a lower marginal tax rate
-To avoid alternative minimum tax
Lucas v Earl (623) - controlling case, income must be taxable to who earned it
-Taxpayers file two separate returns dividing the income earned by E in half based
on contract entered into with wife to divide all income.
-Court holds that the taxpayers must file one return because E "was the only party to
the contracts by which the salary and fees were earned." Court stated that "the tax
could not be escaped by anticipatory arrangements and contracts however skillfully
devised…"
*If the Court had not ruled this way, it would have encouraged people with large
incomes to split in multiple ways to start at the bottom as many times as possible
Poe v Seaborn (626) - community property state, sharing required by law
-Taxpayers were married in a community property state and filed 2 separate returns
each with 1/2 of the community income and expenses. Commissioner argued that all
of the income should have been reported on the husband's return.
-Court held in favor of taxpayers stating that "the law's investiture of the husband
with broad powers, by no means negatives the wife's present interest as a co-owner.
They distinguished this from Earl stating, "here, by law, the earnings are never the
property of the husband, but that of the community." After this decision, couples in
community property states enjoyed a significant tax advantage.
"Marriage bonus" - in 1948 all married couples in all states were allowed to file joint
returns and compute the total tax by first computing a tax on half of the total and
then doubling the amount (thereby providing 2 starts at the bottom).
Chief Counsel Advisory (630)
-Whether a domestic partner in California is required to include in gross income all
of his or her earned income or one-half of the combined income earned by the
individual and his or her domestic partner?
-Domestic partner must report all of his or her income earned from the performance
of his or her personal services. (The relationship between registered domestic
partners under the California Act is not marriage under California law).
*The Chief Counsel provided an advisory after this stating that they could assign
income but not file jointly.
"Marriage penalty" (634) - occurs in families with two wage earners with substantial
incomes.
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-Congress helped to eliminate the singles penalty in 1969 which caused an marriage
penalty since the two starts from the bottom they enjoyed while single would no
longer be available to them when married.
*Exists because of the different rate schedules, when you get up high enough the
trigger point is less than double of a single individual.
*Congress has worked really hard in recent years to limit the marriage penalty
Armantrout v Commissioner (637)
-Mr. A and other petitioners were employees of H. H provided a plan to help its key
employees pay college costs for their children. The benefit was up to $10K per
employee and $4K per child, with the employee deciding how to allocate the
available funds among his or her children. Benefits ceased upon end of employment.
Hamlin used the plan to help recruit and retain key employees. College education
plans provided by employer were held as deferred compensation to employees, and
therefore, includible in their gross income.
Transfers of Property and Income from Property
-Key Question: Did the donor give a gift of property (income from property not taxable to
donor) or did he give a gift of income from property (income from property taxable to
donor)?
Blair v Commissioner (646)
-The taxpayer had a limited interest (a life estate) but gave away a portion for its
entire duration
-Not taxable to donor, taxable to donee
Horst (648)
-The taxpayer owned the entire property (a bond) and gave away a limited interest
(the interest income for a brief period of time)
-Taxable to donor
Services Transformed into Property
Helvering v Eubank (654) - ineffective transfer
-Mr. E was a retired insurance agent. Mr. E had a right to renewal commissions on
insurance policies he had previously sold. Mr. E assigned the renewal commissions
to a corporate trustee for the benefit of other individuals.
-Citing Horst, the Court held that the commissions were taxable as income to the
assignor (Mr. E) when paid.
*Court states that this is about a deferral of services which goes back to Lucas v Earl
and therefore it can't effectively be transferred
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Heim v Fitzpatrick (655) - effective transfer
-Mr. H assigned an invention and related patents to the H company in exchange for
royalties and certain rights. Mr. H assigned a portion of his contract rights to his wife
and children. Mr. H and his relatives owned the H company.
-Court held that the rights retained by P and assigned to his wife and children were
sufficient substantial to justify the view that they were given income-producing
property. Therefore, the contract rights assigned to wife and children were taxable
to them, and not Mr. H.
Options to define property:
-Define "property" narrowly as the original source of the income - only transfer of all
rights will be effective
-Define "property" broadly as any not yet realized item of value - transfer of any
such item will be effective
-Define "property" as all rights owned - even if not all rights relating to the property
(Example: Blair)
Attribution of Income Relating to Trusts:
Three types:
1. Grantor Trust - if the income from the trust is, or may be, used for the
benefit of the grantor, the grantor is still treated as owning the property for tax
purposes
2. Simple Trust - those that are required to distribute all income currently,
that have made no distributions of corpus, and that claim no charitable
deduction during the taxable year. All income paid each year to the
beneficiary, the beneficiaries are taxed on the income
3. Complex Trust - any trust that is not a grantor trust or a simple trust. The
trust and the beneficiary might pay taxes on the trust. If the money is left in
the trust, it is taxable to the trust and the beneficiary later gets a credit for the
amount paid by the trust.
Trust Example (666 and 667)
-Trust Characteristics: G funds trust with $300K; B, G's brother, is the trustee. For
benefit of G's children. Distributions for comfort, support, education, etc. Trustee
has discretion over distributions and investments. Terminates in 10 years;
distribution to children then.
-Tax Results: Generally shifts income to trust and/or G's children, but support issue.
If power to change income or corpus among possible additional beneficiaries, need
"independent" trustee (not B).
Attribution of Income Relating to Corporations and Partnerships:
Two types of relevant corporations:
S Corporations
-limited number and type of shareholders
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-elected "small business corporation" status
-taxed generally like partnerships
C Corporations
-all other corporations
-taxed as separate entities
Section 482. Allocation of income and deductions among taxpayers
-In any case of two or more organizations, trades, or businesses…owned or
controlled directly or indirectly by the same interests, the Secretary may distribute,
apportion, or allocate gross income, deductions, credits, allowances between or
among such organizations, trades, or businesses, if he determines that such
distribution, apportionment, or allocation is necessary in order to prevent evasion
of taxes or clearly to reflect the income of any of such organizations, trades, or
businesses…
Foglesong v Commissioner (677) - vast majority - taxpayer transferring business into
corp. will work for income attribution purposes
-Mr. F was a successful steel salesman. He created a corporation to obtain limited
liability protection and provide a vehicle for new business ventures. The new
business ventures did not materialize, but the corporation paid all his sales
expenses, employed a secretary, and complied with all corporate formalities. The
corporation paid $32,000 in dividends to the preferred stock owners over four years.
(Mr. F => C Corp => Kids)
-The Tax Court held that the income was taxable to the taxpayer and not to the
Corp. However, the COA reversed holding that this was valid.
*There is a strong legal respect for the separate entity of the corporation. Mr.
F contracted with steel sellers with the C Corporation (the formalities matter).
*There were not 2 separate businesses under 482 because it was just the
individual and his corporation (this is a disputed issue between circuits)
United States v Basye (685) - partnerships taxed on services
-PMG was a partnership with 200 partners and numerous employees. It contracted
with K to provide medical care to plan members. In exchange, K paid compensation
to the partnership and funded a pension trust for the benefit of P's partners and
employees.
-P's partners paid no taxes on the funded pension trust for the benefits of its
partners and employees. SCOTUS held that the pension trust was income to the
partners and that they should pay taxes on it. (This was not about who benefitted
from the trust, it was that the money going into the trust was compensation to the
partnership for the services it provided.)
*It doesn't matter that none of the partners are actually seeing the money
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Part V: What type of income is it?
What is a capital asset?
Section 1221 - Defines "capital asset" as meaning property held by a taxpayer but not
including:
(1) Stock in trade or inventory of a business, and property held primarily for sale to
customers in the ordinary course of a trade or business
(2) Real or depreciable property used in a trade or business
(3) Copyrights or similar property held by their creators
(4) Accounts receivable acquired in the ordinary course of a trade or business
(5) U.S. government publications received free or at reduced costs.
Section 1231 - Exception for real and depreciable property used in a trade or business and
held for more than one year. Classifies all gains from such property as long-term capital
gains and all losses as ordinary income losses.
General Rule:
-Capital gain tax rates generally apply to capital gain recognized on property that has been
owned for more than one year (Long-term capital gain)
-Capital gain recognized on property that has been owned for a year or less is taxed as
ordinary income (Short-term capital gain)
Lower Tax Rates on Capital Assets:
-0%: gain that would be subject to a 15% or lower rate if treated as ordinary income
-15%: gain that would be subject to a more than 15% rate if treated as ordinary income
-25%/28%: special rates for certain property
-lower rates only apply to long-term capital gains and to qualified dividend income (see
Handout #35)
Net Capital Gain – the excess of the net long-term capital gain for the taxable year over
the net short-term capital loss for such year.
Capital Loss Limitation
-Capital losses can reduce capital gains but only $3,000 of capital loss can be used to
offset ordinary income. IRC Section 1221(b), 1212(b)
What are the reasons for distinguishing between capital and ordinary income?
-Bunching - taxation of multi-year appreciation in a single year
-Lock-in - incentive to not sell appreciated assets even more favorable investments
(Prevent by: no tax realized on rollover, mark-to-market)
-Inflation - some appreciation not "real"
-General Incentives for Savings
-Incentive for New Industries
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-Unrealized Gains - equalizing treatment with
-Double-Tax on Corporate Earnings
Bielfeldt v Commissioner (706) - trader does not equal ordinary loss
-Mr. B traded US Treasury notes and bonds in large volumes based on a "glut" theory he
had developed. It was successful for a few years but then he lost tens of millions of dollars
in years at issue. Mr. B argued that this was an ordinary loss and therefore should be fully
offset against ordinary income. Court held that it was a capital loss because he was a
speculator and not a dealer. Therefore, it did not meet 1221(a) of stock or trade held
primarily for sale to customers in the ordinary course of a trade or business.
Biedenharn Realty Co (710) - leading case in development of land
-Company bought the real estate in the 1930s for investment purposes. Company
subdivided and improved the land through the addition of streets, drainage and utilities.
Company hired brokers to advertise the subdivided residential lots. Company sold
hundreds of lots over many years.
-Court held that this was ordinary income, rather than capital income, and had to be taxes
at the higher tax rates.
-In making this determination the court looked at multiple factors: (1) the nature and
purpose of the acquisition of the property and the duration of the ownership; (2) the
extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent,
continuity and substantiality of the sales; (4) the extent of subdividing, developing, and
advertising to increase sales; (5) the use of a business office for the sale of the property;
(6) the character and degree of supervision or control exercised by the taxpayer over any
representative selling the property (7) the time and effort the taxpayer habitually denoted
toe the sales.
-The Court also discussed the intent at the time of the sale, as opposed to the original
acquisition, unless the investors were forced to abandon prior purposes for reasons
beyond their control.
How has the court limited taxpayers from classifying gains as capital?
-As reflected in the cases below, the courts have made an effort to narrow the concept of
"capital asset"
Corn Products (721)
-Taxpayer wanted to treat the income made from the corn futures as capital gains, but IRS
held that they were ordinary gains. SCOTUS held that the gain from the sale of corn
futures treated as ordinary (rather than capital) income.
-"Admittedly, P's corn futures do not come within the literal language of the exclusions set
out in this section…Congress intended that profits and losses arising from the everyday
operation of a business be considered as ordinary income.
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Arkansas Best (724) - Limited Corn Products - list of exceptions is exhaustive
-Petitioner sold Bank stock resulting in a capital loss of $9.9 million dollars. P claimed this
as an ordinary loss but Court held that it was a capital loss.
*Limited Corn as involving only a broad reading of the inventory exception "hedging
transactions that are an integral part of a business' inventory-purchase system fall within
the inventory exclusion of Section 1221.
*Motivation in purchasing an asset is irrelevant, the list of 5 exceptions to ordinary
gains/losses is exhaustive
Hedging Transactions:
-A "hedging transaction" is any transaction entered into in the normal course of the
taxpayer's trade or business primarily "to manage risk of price changes or currency
fluctuations with respect to ordinary property" or borrowings."
-IRC Section 1221(a)(7) now excludes from the definition of capital asset "any hedging
transaction which is clearly identified as such before the close of the day on which it was
acquired, originated, or entered into."
Section 64. Ordinary income defined -The term "ordinary income" includes any gain from
the sale or exchange of property which is neither a capital asset nor property described in
Section 1231(b).
Section 65. Ordinary loss defined -The term "ordinary loss" includes any loss from the sale
of exchange of property which is not a capital asset.
Hort v Commissioner (731) - Payment for Cancellation of a Lease
-Money paid to petitioner to cancel a lease was held to be ordinary income. Taxpayer
attempted to treat the money he was to be paid under the original lease as his adjusted
basis and therefore he realized a loss. The problem was, at the end of the day, he still
owned the building (similar to Horst.)
-"The amount received by petitioner for cancellation of the lease must be included in his
gross income in its entirety…Simply because the lease was "property" the amount
received for its cancellation was not a return of capital. (Because lease payments would
have been ordinary income)
Get capital gain slide from online
Womack v Commissioner (736) - Future Income from Lottery Tickets
-Proceeds from the sale of the rights to future installment payments from lottery winnings
held as ordinary income.
-"Congress did not intend for taxpayers to circumvent ordinary income tax treatment by
packaging ordinary income payments and selling them to a third party…when a lottery
winner sells Lottery Rights, he transfers a right to income that is already earned, not a
right to earn income in the future."
*It was a clear case of a substitute for ordinary income (Court made this up)
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McAllister v Commissioner (740) - sale of interest in a trust = capital asset
-RS's will established a trust. Income paid to J for life. The paid to Ms. M for life.
Remainder in widow and RJ. RJ paid $55K to Ms. M to release her life interest in the trust.
Ms. M reported a capital loss on the transaction of $8,970.
-The key here is: What does property mean? If it is property, it is a capital asset. If it is not
property, 1221 does not apply.
-Court cites the Blair case, stating that because she was giving up her interest forever, this
was the transfer of property under 1221.
*This is great for taxpayers because they can sell their life estate to take a lump sum at
capital gains (converting stream of ordinary income into lump sum at capital gains)
*The court made a mistake here by giving her a basis in the property. Under current law,
she would have recognized a gain of $55K.
Commissioner v PG Lake (745) - applying Blair/Horst distinction to 1221 context
-L owed its President $600K. L had interest in two oil leases. The President cancelled the
debt in exchange for $600K plus 3% interest to be paid out of the oil income attributable
to Lake under the leases. The amount owed was paid in a little more than 3 years.
-Court concluded that the consideration received for oil payment rights was taxable as
ordinary income (to the company). Court held that the consideration was paid for the
right to receive future income, not for an increase in the value of the income-producing
property.
Example: Assume L's oil leases gave it a right to $100K barrels of oil worth $1 million.
-L sells the leases for $1 million. (capital gain)
-L sells a 60% interest in the leases for $600K (capital gain)
-L sells a right to $600K plus 3% interest payable out of its oil lease income. (ordinary
gain)
*Key distinctions: In the first case, they have sold the entire interest and will never
see the lease again. In the second case, they will never get back any of the 60%
interest. However, in the 3rd scenario, after the $600K is made, L gets the lease back
so it is not a capital gain. (L retains risk)
Commissioner v Brown (748)
-C owned CB, a sawmill and lumber company. The CI bought the company in 1952 for $1.3
million payable over 10 years. The CI liquidated the company and leased its assets to F
owned by the attorneys for C, for 80% of operating profits. The CI paid 90% of the
payments it received from CB. The CI sold the assets for $300K in 1957. Total payments by
the CI to Brown were $900K over the five years involved. (This is a tax shelter!)
-Court held that this was not a sham transaction. It also held that it was a sale. Therefore,
they gave it capital gains treatment.
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Examples of Distinctions:
Securities (dealer v trader) (Bielfeldt)
Real estate (developer v investor) (Biednenharn)
Leases (vertical v horizontal interest) (Hort, PG Lake)
Life interests (vertical v horizontal interest) (McAllister)
Lottery winnings (Womack)
Business Assets (Brown)
Baker v Commissioner (759 - termination payments)
-Mr. B retired from being a State Farm agent. Issue: whether the termination payment
received by Mr. B upon retirement is taxable gain or ordinary income.
-Mr. B argued that he assigned his policies to a successor agent, the successor hired two
of Mr. B's employees and assumed his phone number, and the successor worked with Mr.
B prior to his retirement.
-Court held that the termination payment is taxable as ordinary income for multiple
reasons including: the assets were owned by SF and not taxpayer, there was no
agreement for transfer, there were no employment contracts (and you can't sell people)
**To switch to capital gain treatment: give title to agents (with right of first refusal)
Commissioner v Ferrer (768 - theatrical production rights)
-Author Contract: Ferrer and LaMure - Gave F exclusive right to produce play. Gave F right
to prevent movie or broadcast for a limited time. Gave F percentage of proceeds from
movie or broadcast. Gave L advances and royalties.
-Movie Contract: Ferrer and Huston - F agreed to act in the movie. Paid F a salary, both
up-front and from receipt. Paid F a percentage of net profits. F terminated the Author
Contract when he entered into the Movie Contract.
-Court held that F's surrendering his lease of the play and his incidental power to prevent
disposition of the motion picture were capital gains
-However, the surrender of his opportunity to receive 40% of the proceeds were ordinary
income because F never owned any motion picture rights - just the income stream.
*To make it less complicated - make one clause for acting, one clause for giving up rights
*He should have tried this under the Blair/Horst principles because he gave up all of his
rights
Miller v Commissioner (776)
-GM died in 1944. In 1952, Universal Pictures agreed to pay Ms. M a share of movie
income in exchange for the right to produce "The Glenn Miller Story." State law at best
unsettled on whether Ms. M owned this right. In 1954, Ms. M received $409K under this
contract.
-Court held that this was ordinary, rather than capital, income. It stated that the
beneficiaries of the deceased did not receive a capitalizable "property" in his name.
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Patents and Copyrights: 1221(a)(3) and 1235
Section 1221(a)(3) - capital asset does not include a copyright, a literary, musical, or
artistic composition, a letter or memorandum, or similar property, held by - (A) a
taxpayer whose personal efforts created such property, (B) in the case of a letter,
memorandum, or similar property, a taxpayer for whom such property was prepared
or produced
*This does not apply to a person who buys a capital asset, it also does not
apply to musical compositions
*This does not include a patent, or an invention, or a design which may be
protected only under the patent law and not under the copyright law.
Section 1235 - ensures that income from the transfer of patents will be taxed as
long-term capital gain even if received by a professional inventor.
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Tax Credits:
Dependent Care Services Credit
-Section 21
-$3,000 for 1 qualifying, maximum of $6,000 for 2 or more qualifying children
-Subject to limitations (see page 42 of outline)
-Minimum for wealthy family is $600
Earned Income Tax Credit (415)
-Section 32
Credit for Elderly and Permanently and Totally Disabled (416)
-Section 22
Child Tax Credit (417)
-Section 24
-$1,000 credit for each dependent “child” under age 17
-reduced as income rises above threshold amounts
HOPE Scholarship Credit (509)
-Section 25A(a)(1)
-$1,500 credit only usable in first two years
Life-time learning credit (509)
-Section 25A(a)(2)
-20% of $10,000 ($2,000)
-You can’t take this if you take Hope
Adoption Expenses
-Section 23
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Floors, Limits, and Phaseouts:
*Personal exemption phaseout and 3% reduction on itemized deductions are not applicable in
2010 .
Section 170. Charitable contributions limitations
-see page 34 of outline (substantiation required)
Section 221. Interest on Student loans
-limited to $2,500
-phased out as AGI is above $50,000
Section 274. Meals and entertainment
-limited to 50% (substantiation required)
Section 162. Qualified Residence Interest Deduction
-only applies if more than $1 million in debt was incurred, you can borrow another
$100,000 of home equity debt
Section 79. Group-Term Life Insurance
-included in income to the extent that such cost exceeds $50,000 of such insurance
Section 1341. Where taxpayer restores substantial amount held under claim of right
-amount overclaimed in prior year must be more than $3,000
-if it is not, then Lewis applies (you can still deduct)
Section 165. Losses
-gambling losses limited to gains for gambling income
-casualty losses:
-$100 limitation per casualty
-net casualty allowed only to the extent that it exceeds 10% of AGI
Section 213(a). Medical Expenses
-deductible to the extent they exceed 7.5% of AGI
Section 67. 2% Floor on Miscellaneous Itemized Deductions
Section 183. Activities not engaged in for profit
-limited to the extent that those expenses, plus other miscellaneous expenses, exceed
2% of AGI. Then still basketed.
Section 129. Dependent care assistance programs
-shall not exceed $5,000 ($2,500 if individual return)
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