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ACCT 3410


Federal Income Tax


Lecture Outlines

Kent N. Schneider

East Tennessee State University

Fall 2010

This material is for educational use in the above course

by students, faculty, and staff of East Tennessee State University.
How to Succeed in Accounting Classes

Reading the Textbook

Read to understand “why.” • Try to explain each new topic in your own words.
Work problems to understand “how.” • To be sure that you understand “how” as well as “why,”
work through the examples in the text.
Consolidate and review. • Go back to previous chapters and bring yourself up to
date. See how this chapter builds on the previous ones.
• Rework one problem each week from a previous
chapter. Rework problems that were difficult.
Relate the topics to your experiences. • You will understand the material better and retain it
longer if you can relate it to things you already know —
places you have worked or other courses you have had.
Prepare specific questions to ask. • Pinpoint the thing that you do not understand.
• Keep a notebook of points you find difficult.

Working Homework Problems

Work the problem without • Try to do the problem on you own before looking back
“page-flipping.” at the chapter.
• “Page flipping” wastes time and does not help you to
learn the material.
Be neat and orderly. • Sloppy calculations, messy papers, and general
carelessness cause most errors.
Keep up with your class. • Check your problem against the solution presented in
Prepare specific questions to ask. • Note the part of the problem with which you have
difficulty and ask questions during class.

Make Best Use of Class Time

Come to class prepared. • Classes are interesting when you take part.
Pay attention during class. • Ask questions if you do not understand.

Preparing for Exams

Concentrate on the important topics. • Note the topics that the instructor emphasizes.
Don’t stop with just “getting the idea.” • Be sure you can work problems without using the text.
Every exam has an element of speed. • Have your “how’s” and “why’s” at your fingertips.
• If you are slow, you probably need to study more.
Be sure you can apply the rules that • Exam problems will not be a carbon copy of the
you have learned. homework problems. They will approach the material
from a different angle to test your ability to analyze and
understand, rather than your ability to memorize.
• Practice by working old CPA exam questions.

Taking the Exam

Avoid the exam pitfalls. • Read the problems carefully, underlining key words.
• Show your calculations in a neat and orderly manner.
Use the “one-check, two-check” system • Attempt the first question. If you can answer it quickly
and easily, work the problem completely and move on.
• If a question seems “impossible,” place 2 checks next to
the question number in the exam booklet and move on.
• If you are in the midst of a question that seems to be
taking too much time, or if you immediately spot that a
question is answerable but time-consuming, place one
check next to the question number in the exam booklet
and move on.
• After attempting all the problems in this manner, return
first to the single-check questions and work them.
• Once all the single-check questions have been answered,
return to the “impossible” double-check questions.
When you return to these questions, they often will not
seem “impossible.”

Improve Your Learning Skills

People learn in many different ways:

Visual learners Like drawing diagrams, pictures, and charts.

Visual/verbal learners Like to read the written word. They like books and instructional material with
clearly written text.
Auditory learners Like to hear new information through spoken explanations, commentaries,
and tapes. They benefit from reading key passages aloud and making tapes.
Physical learners Like hands-on learning where they can immediately try things for themselves.
They like to do as they learn. (E.g., writing, underlining, doodling,

Improve your learning effectiveness by combining these learning styles.

Read and visualize the material You have seen it.

Read key points out loud, make up questions and answer them. You have heard it.
Write out the answer to your question and circle the major point. You have done it.

Retain more of what you learn by systematic review:

• 1 hour later • 1 week later

• 1 day later • 1 month later

Chapter 3

Chapter 3
Taxable Entities, Tax Formula, and
Introduction to Property Transactions

I. Introduction
A. Taxable Entities — There are only three types of entities
subject to tax under the Federal income tax:

1. Individuals;

2. Corporations; and

3. Fiduciary Taxpayers (estates and trusts)

B. Several other entities are either tax-exempt or their income is

taxed directly to their owners.

II. The Taxable Entities

A. Individuals

1. Citizens and residents of the United States are subject to the

Fed. income tax under §1 of the Code.

a) They are subject to tax on all forms of taxable income,

regardless of source.

2. A sole proprietor's business transactions are reflected in his or

her taxable income.

a) The income and expenses from the business are treated

similarly to other forms of taxable income and deductible

b) These items are reported on Schedule C of the sole

proprietor's Form 1040.

Chapter 3

3. A U.S. citizen or resident is taxed on worldwide income.

a) To mitigate possible double taxation, a credit is allowed by

the U.S. for taxes paid to the foreign government.

4. Nonresident aliens pay U.S. income tax only on their U.S.

source income.

B. Corporations

1. Domestic corporations are subject to tax on their world-wide

income under I.R.C. §11.

2. The tax treatment of corporations is similar to that of

individuals. However, several important differences do exist.

3. The corporation pays tax on its taxable income.

a) If a portion of that profit is distributed, that distribution

generally is taxed to the shareholder.

b) This results in double taxation of corporate profits.

C. Fiduciary Taxpayers (Estates and Trusts)

1. The person charged with overseeing the activities of an estate

or trust is called a fiduciary, since he or she acts in a fiduciary

a) The fiduciary of an estate is the executor(trix) or


b) The fiduciary of a trust is the trustee.

2. The taxable income or loss of an estate or trust is calculated in

a way similar to that for an individual.

a) However, when distributions are made during a year, the

taxable income of the trust or estate generally is reduced
by the amount of the distributions.

b) Thus, if distributed, the income of the estate or trust is

taxed to the beneficiary who receives the distribution.

3. Since the trust or estate reduces its taxable income by the

amount taxed to the beneficiary or heir, it generally only pays
tax on the undistributed income.

Chapter 3

D. Partnerships, S Corporations, and Limited Liability Companies


1. Unlike C Corporations, estates and trusts, partnerships, S

corporations, and LLC’s are PURE CONDUITS for Federal
income tax purposes.

2. All items of partnership income, expense, gain or loss pass

through the partnership and are taxed to the individual
partners or shareholders.

3. Partnerships do file an annual return, Form 1065, with the


a) This return reports the results of the partnership

transactions and how the partnership items are divided
among the partners.

b) Because the partner pays taxes on his or her share of the

partnership income AS IT IS EARNED, distributions
made by the partnership to the partner generally are not

4. S corporations file an annual return, Form 1120S.

a) This return reports the tax items of the corporation and

how they are allocated, based on the number of shares
held, to the shareholders.

b) To be eligible to elect S status, the corporation must have

100 or fewer shareholders and must meet several other

c) With an S corporation, unlike a partnership, an owner

(shareholder) also can be an employee.

Do Problem #31

Chapter 3

III. Tax Formula

A. The tax formula for individuals illustrates the relationships of
the various items of income, deduction, gain, loss, and credit
in the determination of the individual income tax.

1. This formula appears on the back inside cover of the text.

B. Gross Income

1. Gross income is income from whatever source derived,

reduced by those items of income which are specifically
excluded from income.

a) "Income from whatever source derived" includes any

permanent increase in the taxpayer's net wealth. (Very
broad definition.)

2. The exclusions from gross income are allowed for various

social, political, and technical reasons.

C. Deductions for AGI

1. The deductions for AGI are certain deductions specified in the

Code which are allowed regardless of whether the taxpayer
itemizes his or her other deductions.

2. Unless a deduction is included in the list on p. 3-20, it is an

itemized deduction.

3. Some of the more common deductions for AGI include:

a) Most trade or business expenses of a sole proprietor;
b) Moving expenses;
c) Rental expenses;
d) Alimony;
e) Qualifying IRA contributions

Chapter 3

D. Adjusted Gross Income (AGI)

1. AGI = Gross income - Deductions for AGI

2. AGI serves as the basis for determining the amount of certain

deductions, such as:

a) Medical expenses — deductible only to the extent they

exceed 7.5% of AGI.

b) Charitable contributions — deduction is limited to 50% of


c) Casualty losses — deductible only to the extent it exceeds

$100 plus 10% of AGI.

3. The amount of a taxpayer's AGI also can affect:

a) Exclusions from gross income

b) Itemized deductions

c) Personal and dependency exemption deductions

d) Tax credits

E. Itemized Deductions

1. All deductions for individuals, other than deductions for AGI,

are deductions from AGI or "Itemized deductions." (See
partial list on p. 3-24)

2. The most common itemized deductions are:

a) Medical expenses
b) Interest on home mortgages
c) State and local income taxes
d) State and local property taxes
e) Charitable contributions
f) Casualty and theft losses
g) UNREIMBURSED employee business expenses

Chapter 3

F. Standard Deduction

1. In general, the Standard Deduction is subtracted from AGI if

the Standard Deduction exceeds the taxpayer's total itemized

a) Thus, a taxpayer would not "itemize" deductions if total

itemized deductions did not exceed the Standard
Deduction amount.

2. The amount of the Standard Deduction depends upon the

taxpayer's filing status.

a) 5,700 — Single

b) 8,400 — Head of household

c) 11,400 — Married filing jointly

d) 11,400 — Surviving spouse

e) 5,700 — Married filing separate

3. Additional Standard Deduction for the Blind and Elderly.

a) Single taxpayers

(1) Single taxpayers who are either blind or age 65 are

entitled to an additional standard deduction amount
of $1,400 in 2010.

(2) If both blind and age 65 or older, the additional

Standard Deduction is $2,800 in 2010.

b) Married taxpayers (including Surviving spouses)

(1) Married taxpayers who are either blind or age 65

are entitled to an additional standard deduction
amount of $1,100.

(2) If both spouses were blind and age 65, the

additional Standard Deduction amount would be
$1,100 x 4 or $4,400.

Chapter 3

4. Restrictions on the use of the Standard Deduction

a) The standard deduction is limited for an individual who is

eligible to be claimed as a dependent by another taxpayer.

b) No standard deduction is allowed for:

(1) A married person filing separately if his or her

spouse is itemizing deductions.

(2) A nonresident alien.

(3) An individual filing a return for a short year caused

by a change of accounting period.

G. Exemptions

1. The personal and dependency exemptions are deductions

based on the size and make-up of a taxpayer's family. They
are allowed for the taxpayer and any qualifying dependents.

2. Generally, every taxpayer is entitled to claim a PERSONAL

EXEMPTION on their own return.

a) Exception: Taxpayers are not allowed a personal

exemption if they can be claimed as a dependent on
another's tax return.

3. In contrast, DEPENDENCY EXEMPTIONS are claimed for

qualifying individuals who are supported by the taxpayer.

4. The amount of each exemption deduction is $3,650 for 2010

Do Problem #39

Chapter 3

H. Taxable Income and Tax Rates

1. The income tax is based on taxable income, which is

determined by subtracting personal and dependency
exemption deductions, along with the greater of the standard
deduction or itemized deductions, from AGI.

2. The actual tax due is calculated by applying the appropriate

tax rates to the taxable income figure.

3. The rates differ depending on the taxpayer's filing status.

4. Actually, the TAX RATES are the same for all taxpayers:
10%, 15%, 25%, 28%, 33%, and 35%

a) What distinguishes the various schedules is where these

brackets begin and end.

I. Credits and Prepayments

1. Credits are amounts provided in the Code which directly

reduce the tax.

a) Various credits are allowed for several economic and

social reasons (e.g., the child and dependent care credit).

2. Any prepayments of tax made by the taxpayer are also

subtracted from the gross tax in arriving at the tax due.

a) Prepayments most commonly occur in the form of:

(1) Withholding of Federal income taxes from salaries

and wages, and

(2) Quarterly estimated tax payments made by

taxpayers expecting to owe more than $1,000 of
tax in excess of their withholding.

J. Other Taxes

1. F.I.C.A. (social security) tax

2. Self-employment tax
3. Alternative minimum tax
4. Gift tax;
5. Estate tax.

Chapter 3

IV. Introduction to Property Transactions

A. The Federal tax system requires that most gains be
considered in the calculation of taxable income. In addition,
certain losses may be deducted.

1. Gain or loss is REALIZED any time a taxpayer sells or

otherwise disposes of property.

2. A simple formula for calculating gain or loss realized is as

follows: (See exhibits on pp. 3-31 and 3-32.)

Amount of money received (net)

+ FMV of other property received
Amount realized
- Adjusted basis in property given-up
Gain (or loss) realized

3. The adjusted basis of the property transferred is generally its

cost of acquisition minus depreciation claimed.

a) It is similar to the financial accounting concept of "book


4. The gain or loss realized is generally RECOGNIZED in the

year of disposition.

a) This means that it is currently taken into account for tax


(1) Gains being taxed, and

(2) Losses being deductible.

Do Problem #46

Do Problem #47

Chapter 3

B. Losses

1. The only losses which are deductible for tax purposes by

individual taxpayers are:

a) Losses incurred in carrying on a trade or business;

b) Losses incurred in transactions entered into for profit;


c) Casualty and theft losses of personal use property.

2. Losses on other dispositions of personal use property are


C. Character of Gain or Loss

1. Generally, gains and losses are either ordinary or capital in

nature. Capital gains and losses are those incurred upon the
sale or exchange of capital assets.

3. Capital assets include all assets EXCEPT those falling into five
specified groups of nonqualifying assets. (See p. 3-34.)

a) The excluded assets are:

(1) Inventory;

(2) Depreciable property and land used in a trade or


(3) Trade accounts and notes receivable; and

(4) Copyrights, compositions, and letters held by the

creator, government publications, etc.

b) Capital assets, therefore, include most investment

properties and most personal use assets of the taxpayer.

Chapter 3

4. Tax Treatment of Capital Gains and Losses

a) The exact treatment of gains and losses on the sale or

exchange of capital assets can be determined only after
an involved netting process.

(1) First, gains and losses are classified according to

holding period.

(a) A gain or loss is long-term if the asset has

been held more than 12 months.

(b) A gain or loss is short-term if the asset has

been held 12 months or less.

(2) Next, long-term gains and losses are netted

together to arrive at the net long-term capital gain
or loss.

(a) Similarly, the short-term gains are netted

against the short-term losses to compute
the net short-term capital gain or loss.

(3) Third, the results are combined, and the

appropriate treatment is determined.

(a) This final netting of transactions is possible

only if there is a net LTCG and a net STCL
or vice versa.

Do Problem #48

b) Tax treatment of capital gains

(1) Net capital gains, long-term or short-term, are fully

included in gross income.

(2) Net STCGs are treated as ordinary income.

(3) Net LTCGs are subject to a maximum tax rate of

5% for 10% and 15% bracket taxpayers and
15% for all other taxpayers.

(4) For now, don’t worry about gains on collectibles,

qualified small business stock, and real estate.

Chapter 3

c) Tax treatment of capital losses

(1) LTCLs and STCLs are treated identically.

(2) A taxpayer may use net capital losses to offset up

to $3,000 of ordinary income annually.

(a) Capital losses in excess of the $3,000 limit

are carried forward and deducted in future

Do Problem #49

Do Problem #53

Chapter 4

Chapter 4
Personal and Dependency Exemptions; Filing Status;
Determination of Tax; Filing Requirements

I. Personal and Dependency Exemptions

A. Exemption Amount

1. The exemption amount is adjusted annually to reflect changes

in the Consumer Price Index.

a) 2010: $3,650
b) 2009: $3,650

B. Personal Exemptions

1. General Rule: Each taxpayer is allowed a personal exemption.

2. Married filing jointly

a) Since a joint return by a husband and wife is a return by

two taxpayers, at least two exemptions will be allowable
on that return.

3. Married filing separately

a) General rule: A married person filing separately is not

entitled to an exemption for a spouse (since the spouse
typically is also filing a return).

b) However, a married person can claim an exemption for a

spouse, provided:

(1) The spouse has no gross income, and

(2) The spouse is not claimed as a dependent by any

other taxpayer.

4. Return filed by Dependent

a) If one is eligible to be claimed as a dependent on

another's return, he will NOT be allowed to claim a
personal exemption on his own return.

Chapter 4

C. Dependency Exemptions

1. A dependent must be either a “qualifying child” or a

“qualifying relative.”

2. Qualifying child

a) There are 6 requirements that must be satisfied to be

classified as a “qualifying child”:

(1) Relationship test (see p. 4-3)

(a) Child, stepchild, adopted child

(b) Brothers, sisters
(c) Grandchildren, nieces, nephews

(2) Residence test

(a) Child must live in the same principal

residence with the taxpayer for more than
one-half of the taxable year.

(b) Temporary absences for school, vacation,

etc. are permissible.

(3) Age test

(a) Under age 19,

(b) Full-time student under age 24, or

(c) Permanently and totally disabled,

regardless of age

(4) Joint return test

(a) Child cannot file a joint return with spouse.

(5) Citizenship or residency test

(a) U.S. citizen, resident, or national

(b) Resident of Canada or Mexico

(6) Not self-supporting test

(a) Child must not have provided more than

50% of his total support.

(b) Scholarships are not considered support


Chapter 4

b) Tie-breaker rules used when individual is “qualified

child” of multiple taxpayers:

(1) Parent prevails over non-parent

(2) Custodial parent prevails over non-custodial parent

(3) Parent with the higher AGI prevails.

(4) If none of the taxpayers is the child’s parent, the

taxpayer with the highest AGI prevails.

3. Qualifying relative (5 requirements)

a) Support test

(1) The taxpayer must provide more than 50% of the

dependent's total support.

b) Gross income test

(1) Dependent's gross income must be less than the

exemption amount for the current year.

(2) Exception: This requirement is waived for

taxpayer's child or stepchild who is either:

(a) Under age 19, or

(b) A full-time student under age 24.

c) Relationship test

(1) In general, the test is met by family members,

including both blood and in-law relationships.
[See list on p. 4-9.]

(2) Test also is met by a member of the taxpayer's

household during the ENTIRE taxable year.

d) Joint return test

(1) Dependent cannot file a joint return with spouse.

e) Citizenship or residency test

(1) U.S. citizen, resident, or national

(2) Resident of Canada or Mexico

Do Problem #35

Chapter 4

4. Support

a) The support tests refer to the amounts actually spent

toward the support of the taxpayer.

b) Support includes basic necessities, plus other common

expenditures, including those for toys, entertainment,
gifts, and education. {See Exhibit on p. 4-6.)

(1) Support does not include the amount of a


(2) Support does include Social Security benefits and

welfare benefits spent on the dependent's support.

c) Multiple Support Agreements

(1) A dependency exemption may be assigned to a

taxpayer under a multiple support agreement if all
of the following tests are met:

(a) No individual contributed over half the

support of the individual

(b) Over half the support was provided by a

group, each member of which is a qualifying
relative of the individual.

(c) The prospective dependent meets all of the

other requirements for qualifying as a
dependent. (i.e. Citizenship, joint return,
gross income.)

(2) The dependency exemption is assigned to a group

member who contributed more than 10% of the
total support.

(3) The multiple support agreement must be signed by

every member of the group contributing more than
10% of the support.

Do Problem #39

Chapter 4

d) Children of Divorced or Separated Parents

(1) If the mother and father of a child are separated,

but together have CUSTODY more than one-half of
the year and provide more than one-half of the
SUPPORT for the child, the following special rules

(2) General Rule: The custodial parent (the parent

with custody for greater portion of the year) is
entitled to the dependency exemption.

(3) Exceptions:

(a) The custodial parent signs a written

statement stating that he/she will not claim
the exemption, and the statement is
attached to the noncustodial parent's return.

(b) Multiple support agreements may be used

to supersede other agreements.

(4) These rules apply to parents who are:

(a) Divorced or legally separated under decree

of divorce or separate maintenance;

(b) Separated under written separation

agreement; or

(c) Live apart at all times during the last 6

months of the year.

Do Problem #40

D. Phase-out of Exemption Deduction

1. Expired in 2009.

Chapter 4

E. Child Tax Credit

1. Taxpayers receive a tax credit of $1,000 per "qualifying child"

who is:
a) Under age 17, and
b) A U.S. citizen

2. Tentative credit = $1,000 x # of qualifying children

3. Limits on Refundability of the Child Tax Credit

a) The refundable portion of the Child Tax Credit =

10% (Earned income – 10,000).

(1) The refundable portion of a tax credit is paid to the

taxpayer even if his tax liability is zero.

b) If a taxpayer has 3 or more qualifying children, the

refundable portion of the Child Tax Credit includes a
portion of the taxpayer's social security tax liability.

4. Phase-out of Child Tax Credit

a) The Child Tax Credit is phased out using the following


AGI -Threshold Factor

———————— = (round up) x $50 = Reduction of credit
$1,000 (or $500)

b) Phase-out Thresholds

(1) $75,000 — Unmarried taxpayers

(2) $110,000 — Married filing jointly
(3) $55,000 — Married filing separately

Chapter 4

II. Filing Status

A. There are four separate rate schedules used for calculating tax
liability. One's filing status determines the appropriate rate
schedule to be used.

B. Married

1. Marital status is determined on the last day of the taxable year.

Only if a married taxpayer is legally separated will he/she be
treated as unmarried for tax purposes.

2. A married couple may elect to file a JOINT income tax return.

a) The advantage of the joint return is that their combined

incomes are effectively averaged, and average tax rates
are applied.

b) Once a joint return is filed, separated returns may not be

filed for the same year. However, if separate returns are
filed initially, a joint return may be subsequently filed
within the normal time limitations.

c) Consequences of filing jointly:

(1) In general, a husband and wife filing a joint return

are jointly and severally liable for the tax on the

(2) However, the Innocent Spouse Rule states that

joint and several liability will not be imposed if:

(a) There has been a material omission of

gross income attributable to one spouse,

(b) The innocent spouse did not know or have

reason to know of the omission, and

(c) The innocent spouse did not benefit

significantly from the unreported income.

(3) In addition, the Innocent Spouse Rule protects an

individual from liability for the portion of taxes
attributable to a former spouse.

Chapter 4

3. Married taxpayers typically elect to file a joint return because

few married taxpayers will benefit from using the rates for
married persons filing separately.

a) Some may choose to file separately anyway:

(1) To avoid joint and several liability, or

(2) To ensure that the parent of one or both spouses

will get the dependency exemption.

b) Married persons are required to file separately if:

(1) The spouses have different taxable years, or

(2) Either spouse is a nonresident alien at any time

during the year.

4. For a deceased taxpayer, marital status is determined on the

date of death. The survivor therefore may file a joint return
with the decedent for the year of death.

C. Surviving Spouse

1. The surviving spouse rules allow a widow or widower to use

the married filing jointly rates (Sch. Y-1) if two requirements
are met.

2. Requirements:

a) The spouse must have died within the 2 taxable years

preceding the current taxable year; and

b) The taxpayer must provide over half the cost of

maintaining a home in which the surviving spouse and a
dependent child or stepchild live for more than half of the
tax year.

Chapter 4

D. Head of Household

1. Requirements:

a) Taxpayer is UNMARRIED on the last day of the tax year

or qualifies as an "abandoned spouse," and

b) Taxpayer provides over one-half of the cost of

maintaining a home in which a "qualifying child" or a
“dependent familial relative” lives for more than half of
the taxable year.

2. “Qualifying child” (same as for dependency exemption)

a) Relationship test
b) Residence test
c) Age test
d) Joint return test
e) Citizenship test
f) Not self-supporting test

3. “Dependent familial relative”

a) Includes most “qualifying relatives” (for purposes of a

dependency exemption).

b) Does not include dependents who are unrelated members

of the household for the entire year.

c) Special rules:

(1) A dependent parent need not live in the taxpayer's

home. (E.g., a nursing home.)

(2) An UNMARRIED “qualifying child” who lives with

the taxpayer need not be a dependent.

(a) E.g., parents and child living with great-


Chapter 4

4. Abandoned Spouse

a) A married individual may file as head of household, if

he/she qualifies as an abandoned spouse.

b) Requirements:

(1) The taxpayer must provide over half the cost of a

home in which he/she and a dependent child or
stepchild live for more than half of the taxable year.

(2) The taxpayer's spouse must not live in the home at

any time during the last 6 months of the taxable

E. Single: A taxpayer who does not qualify for any of the other filing
classifications will use the tax rates for single taxpayers.

Do Problem #41

III. Tax Determination

A. Tax Tables (See excerpt on p. 4-24.)

1. A taxpayer who qualifies MUST calculate tax using the Tax


2. Thus, taxpayers with taxable income up to $100,000 generally

must use the Tax Tables.

B. Tax Schedules

1. The following taxpayers must use the tax rate schedules:

a) Taxpayers with taxable income greater than $100,000;


b) Taxpayers who have a taxable year of less than one year

due to a change of accounting period.

2. See p. 4-26 or the inside front cover for tax rate schedules.

Do Problem #48

Chapter 4

C. Special Computation Rules

1. Personal Exemption is not available to dependents.

2. Standard Deduction for dependents is limited.

a) If an individual may be claimed as an dependent of

another taxpayer, the MINIMUM standard deduction is
equal to the GREATER of:

(1) $850 (plus any extra standard deduction for age or

blindness); or

(2) The individual's earned income plus $300.

Do Problem #43

3. The Kiddie Tax Rules

a) The Kiddie Tax potentially applies to children who:

(1) Have not filed a joint return;

(2) Have at least one living parent or foster parent; and

b) Other requirements depending upon the age of the child:

(1) Under 18 — no other requirements.

(2) Age 18 — earned income < 50% of support
(3) Ages 19 to 23
(a) Earned income < 50% of support and
(b) Full-time student.

c) In most cases, Net Unearned Income is simply the child's

unearned income in excess of $1,900.

d) The effect of the Kiddie Tax (assuming the child has no

EARNED income) is as follows:

(1) The first $950 of unearned income is offset by the

child's standard deduction.

(2) The second $950 of unearned income is taxed at

the child's rates.

(3) The remaining unearned income is taxed to the

child at the parent's tax rates.

Do Problem #49

Chapter 4

e) Computation of the Child's Tax

(1) Step 1: Compute net unearned income of all


(2) Step 2: Compute the tax on the child's income

EXCLUDING net unearned income (NUI).

(3) Step 3: Compute parental tax

Tax on parent including NUI of all children

-Tax on parent computed in normal manner
Parental tax

(a) A child’s net unearned income is not

considered when computing any of the
parent's deductions or credits, but is
included when computing tax liability.

(b) The parental tax must be computed using

the net unearned income of all children and
then allocated pro rata based on each
child's relative contribution to total net
unearned income as follows:

Child's NUI Child's

---------------------- x Parental = share
All children's NUI tax of tax

(4) Step 4: Compute child's total tax.

Tax on child excluding NUI (Step 2)

+ Parental tax (Step 3)
Child's total tax

Do Problem #50

Chapter 4

IV. Filing Requirements

A. Most individuals are required to file a tax return whether they
owe a tax or not. However, some low-income persons are not
required to file.

1. In general, the amount of a taxpayer's gross income determines

whether a person must file.

B. A person generally is required to file if gross income exceeds

the sum of his/her standard deduction plus personal
exemptions: (See p. 4-34.)

C. Special Rules

1. An individual who is eligible to be claimed as a dependent of

another taxpayer must file if:

a) Gross income exceeds the standard deduction applicable

to such individual (the greater of $950 or earned income
plus $300); or

b) Unearned income exceeds $950

2. If married filing separately, a spouse must file if his/her gross

income exceeds the exemption amount:

a) 2010: $3,650

b) 2009: $3,650

3. Any taxpayer who has self-employment income of $400 or

more must file.

4. Any taxpayer who receives advance payments of the earned

income credit.

Chapter 4

D. Due Date

1. An individual's tax return is due on the 15th day of the 4th

month following the close of the taxable year.

a) April 15 for calendar year taxpayers.

2. Extensions of time to file the return may be granted, but they

do not extend the time for payment of the tax.

a) If the taxpayer fails to pay the tax owed by the due date of
the return, interest is charged at a rate 3% higher than
the Federal short term rate

3. Penalties

a) Failure-to-pay penalty

(1) 0.5% per month (or fraction thereof), up to a

maximum of 25%, of the tax due.

(2) No penalty is assessed if:

(a) Reasonable cause for late payment, or

(b) Taxpayer obtained an extension of time to

file, and the tax due is less than 10% of the
total tax shown on return.

b) Failure-to-file penalty

(1) 5% per month (or fraction thereof), up to a

maximum of 25%, of the tax due.

(2) The minimum penalty if a return is not filed within

60 days of the due date is the LESSER of:

(a) $100, or

(b) Total tax

Chapter 4

E. Estimated Tax Payments

1. A taxpayer with an estimated tax due in excess of any

withholding deducted from his salary or wages during the year
must make quarterly estimated tax payments.

2. Generally, to avoid a penalty for underpayment of estimated

tax, an individual is required to make estimated payments
totaling either:

a) 90% of the current year's gross tax before any


b) 100% of last year's tax before any prepayments;

(1) 110%, if last year's AGI > $150,000.

c) The amount required under the annualized income

installment method. (Example 35, p. 4-42).

3. No estimated payments are required (and no penalty will be

assessed) if a taxpayer's estimated tax due is less than $1000.

F. Statute of Limitations

1. General rule: 3 years from date of filing or due date,

whichever is later.

2. Exceptions:

a) Substantial omission of income: 6 years

b) No return is filed: No limit

c) False or fraudulent return: No limit

Do Problem #59
(use Form 1040 and
Schedules A and B)

1040 Department of the Treasury—Internal Revenue Service

U.S. Individual Income Tax Return 2010 (99) IRS Use Only—Do not write or staple in this space.

For the year Jan. 1–Dec. 31, 2010, or other tax year beginning , 2010, ending , 20 OMB No. 1545-0074
Label L Your first name and initial Last name Your social security number
(See A

instructions B
on page 14.) E If a joint return, spouse’s first name and initial Last name Spouse’s social security number

Use the IRS
label. H Home address (number and street). If you have a P.O. box, see page 14. Apt. no.
Make sure the SSN(s) above
Otherwise, E c

and on line 6c are correct.
please print
or type. E City, town or post office, state, and ZIP code. If you have a foreign address, see page 14. Checking a box below will not

a 0
change your tax or refund.

Election Campaign a Check here if you, or your spouse if filing jointly, want $3 to go to this fund (see page 14) a You Spouse

Filing Status 1

a f 01
Married filing jointly (even if only one had income)
4 Head of household (with qualifying person). (See page 15.) If the
qualifying person is a child but not your dependent, enter this

Check only one child’s name here. a

3 Married filing separately. Enter spouse’s SSN above

box. and full name here. a 5 Qualifying widow(er) with dependent child (see page 16)

D /30
6a Yourself. If someone can claim you as a dependent, do not check box 6a . . . . . Boxes checked
Exemptions on 6a and 6b
b Spouse . . . . . . . . . . . . . . . . . . . . . . . . No. of children
c Dependents: (2) Dependent’s (3) Dependent’s (4)  if qualifying on 6c who:
child for child tax • lived with you
(1) First name Last name social security number relationship to you
credit (see page 17) • did not live with

you due to divorce
or separation
If more than four

(see page 18)
dependents, see Dependents on 6c
page 17 and not entered above
check here a Add numbers on
d Total number of exemptions claimed . . . . . . . . . . . . . . . . . lines above a
7 Wages, salaries, tips, etc. Attach Form(s) W-2 . . . . . . . . . . . . 7
8a Taxable interest. Attach Schedule B if required . . . . . . . . . . . . 8a
b Tax-exempt interest. Do not include on line 8a . . . 8b
Attach Form(s)
9a Ordinary dividends. Attach Schedule B if required . . . . . . . . . . . 9a
W-2 here. Also
attach Forms b Qualified dividends (see page 22) . . . . . . . 9b
W-2G and 10 Taxable refunds, credits, or offsets of state and local income taxes (see page 23) . . 10
1099-R if tax 11 Alimony received . . . . . . . . . . . . . . . . . . . . . 11
was withheld.
12 Business income or (loss). Attach Schedule C or C-EZ . . . . . . . . . . 12
13 Capital gain or (loss). Attach Schedule D if required. If not required, check here a 13
If you did not 14 Other gains or (losses). Attach Form 4797 . . . . . . . . . . . . . . 14
get a W-2,
see page 22. 15a IRA distributions . 15a b Taxable amount (see page 24) 15b
16a Pensions and annuities 16a b Taxable amount (see page 25) 16b
17 Rental real estate, royalties, partnerships, S corporations, trusts, etc. Attach Schedule E 17
Enclose, but do 18 Farm income or (loss). Attach Schedule F . . . . . . . . . . . . . . 18
not attach, any
payment. Also, 19 Unemployment compensation (see page 27) . . . . . . . . . . . . . 19
please use 20a Social security benefits 20a b Taxable amount (see page 27) 20b
Form 1040-V. 21 Other income. List type and amount (see page 29) 21
22 Combine the amounts in the far right column for lines 7 through 21. This is your total income a 22
23 RESERVED (see page 29) . . . . . . . . 23
Adjusted 24 Certain business expenses of reservists, performing artists, and
Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24
Income 25 Health savings account deduction. Attach Form 8889 . 25
26 Moving expenses. Attach Form 3903 . . . . . . 26
27 One-half of self-employment tax. Attach Schedule SE . 27
28 Self-employed SEP, SIMPLE, and qualified plans . . 28
29 Self-employed health insurance deduction (see page 30) 29
30 Penalty on early withdrawal of savings . . . . . . 30
31a Alimony paid b Recipient’s SSN a 31a
32 IRA deduction (see page 31) . . . . . . . . 32
33 Student loan interest deduction (see page 34) . . . 33
34 RESERVED (see page 35) . . . . . . . . . 34
35 Domestic production activities deduction. Attach Form 8903 35
36 Add lines 23 through 31a and 32 through 35 . . . . . . . . . . . . . 36
37 Subtract line 36 from line 22. This is your adjusted gross income . . . . . a 37
For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 97. Cat. No. 11320B Form 1040 (2010)
Form 1040 (2010) Page 2
38 Amount from line 37 (adjusted gross income) . . . . . . . . . . . . . . 38
Tax and
39a Check
{ You were born before January 2, 1946,
Spouse was born before January 2, 1946,
Blind. Total boxes
Blind. checked a 39a
b If your spouse itemizes on a separate return or you were a dual-status alien, see page 35 and check here a 39b
Subtract line 40 from line 38

o f
Itemized deductions (from Schedule A) or your standard deduction (see page 35) .
. . . . . . . . . . . . . . . . .
Exemptions. Multiply $3,650 by the number on line 6d . . . . . . . . . . .

43 Taxable income. Subtract line 42 from line 41. If line 42 is more than line 41, enter -0- . . 43
44 Tax (see page 37). Check if any tax is from: a Form(s) 8814 b Form 4972 . 44

f t a 1 0
Alternative minimum tax (see page 40). Attach Form 6251 . . .
Add lines 44 and 45 . . . . . . . . . . . . . . .
Foreign tax credit. Attach Form 1116 if required . . . . 47
. .
. .
. . . . .
. . . . a

a 0
48 Credit for child and dependent care expenses. Attach Form 2441 48

r 2
49 Education credits from Form 8863, line 23 . . . . . 49

50 Retirement savings contributions credit. Attach Form 8880 50

D /30
51 Child tax credit (see page 42) . . . . . . . . . 51
52 Residential energy credits. Attach Form 5695 . . . . . . 52
53 Other credits from Form: a 3800 b 8801 c 53
54 Add lines 47 through 53. These are your total credits . . . . . . . . . . . . 54

55 Subtract line 54 from line 46. If line 54 is more than line 46, enter -0- . . . . . . a 55

Other 56 Self-employment tax. Attach Schedule SE . . . . . . . . . . . . . . . 56
57 Unreported social security and Medicare tax from Form: a 4137 b 8919 . . 57
Taxes 58 Additional tax on IRAs, other qualified retirement plans, etc. Attach Form 5329 if required . . 58
59 a Form(s) W-2, box 9 b Schedule H, line 27 c Form 5405, line 16 . . . . 59
60 Add lines 55 through 59. This is your total tax . . . . . . . . . . . . . a 60
Payments 61 Federal income tax withheld from Forms W-2 and 1099 . . 61
62 2010 estimated tax payments and amount applied from 2009 return 62
63 Making work pay credit. Attach Schedule M . . . . . . . 63
If you have a 64a Earned income credit (EIC) . . . . . . . . . . 64a
child, attach b Nontaxable combat pay election 64b
Schedule EIC. 65 Additional child tax credit. Attach Form 8812 . . . . . . 65
66 American opportunity credit from Form 8863, line 14 . . . 66
67 First-time homebuyer credit from Form 5405, line 10 . . . 67
68 Amount paid with request for extension to file (see page 72) . 68
69 Excess social security and tier 1 RRTA tax withheld (see page 72) 69
70 Credit for federal tax on fuels. Attach Form 4136 . . . . 70
71 Credits from Form: a 2439 b 8839 c 8801 d 8885 71
72 Add lines 61, 62, 63, 64a, and 65 through 71. These are your total payments . . . . a 72
Refund 73 If line 72 is more than line 60, subtract line 60 from line 72. This is the amount you overpaid 73
Direct deposit? 74a Amount of line 73 you want refunded to you. If Form 8888 is attached, check here . a 74a
See page 73 a b
and fill in 74b,
Routing number a c Type: Checking Savings
74c, and 74d, a d Account number
or Form 8888. 75 Amount of line 73 you want applied to your 2011 estimated tax a 75
Amount 76 Amount you owe. Subtract line 72 from line 60. For details on how to pay, see page 74 . a 76
You Owe 77 Estimated tax penalty (see page 74) . . . . . . . . 77
Do you want to allow another person to discuss this return with the IRS (see page 75)? Yes. Complete the following. No
Third Party
Designee Designee’s Phone Personal identification
name a no. a number (PIN) a

Sign Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief,
they are true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.
Joint return? Your signature Date Your occupation Daytime phone number

See page 15.

Keep a copy
for your Spouse’s signature. If a joint return, both must sign. Date Spouse’s occupation
Print/Type preparer’s name Preparer’s signature Date PTIN
Paid Check if
Firm’s name a Firm's EIN a
Use Only
Firm’s address a Phone no.
Form 1040 (2010)
SCHEDULE A Itemized Deductions OMB No. 1545-0074
(Form 1040)
Department of the Treasury a Attach to Form 1040. a See Instructions for Schedule A (Form 1040).
Internal Revenue Service (99) Sequence No. 07
Name(s) shown on Form 1040 Your social security number

and 1

o f
Caution. Do not include expenses reimbursed or paid by others.
Medical and dental expenses (see page A-1) . . . . . . 1

2Enter amount from Form 1040, line 38 2
3Multiply line 2 by 7.5% (.075) . . . . . . . . . . . 3


4Subtract line 3 from line 1. If line 3 is more than line 1, enter -0- . . . . . . . . 4

Taxes You 5State and local income taxes . . . . . . . . . . . 5

a f 01
Real estate taxes (see page A-3) . . . . . . . . . .
New motor vehicle taxes from line 11 of the worksheet on
back (for certain vehicles purchased in 2009) . . . . . .

r 2
page A-2.) 7

8 Other taxes. List type and amount a

D /29
9 Add lines 5 through 8 . . . . . . . . . . . . . . . . . . . . . . 9
Interest 10 Home mortgage interest and points reported to you on Form 1098 10
You Paid 11 Home mortgage interest not reported to you on Form 1098. If
page A-4.)

Your mortgage
deduction may
0 6
paid to the person from whom you bought the home, see page
A-4 and show that person’s name, identifying no., and address a

12 Points not reported to you on Form 1098. See page A-4

special rules . . . . . . . . . . . . . . . .
. 12

be limited (see 13 Mortgage insurance premiums (see page A-4) . . . . . . 13

page A-4).
14 Investment interest. Attach Form 4952 if required. (See page A-5.) . 14
15 Add lines 10 through 14 . . . . . . . . . . . . . . . . . . . . . 15
Gifts to 16 Gifts by cash or check. If you made any gift of $250 or more,
Charity see page A-6 . . . . . . . . . . . . . . . . 16
If you made a 17 Other than by cash or check. If any gift of $250 or more, see
gift and got a page A-6. You must attach Form 8283 if over $500 . . . . 17
benefit for it, 18 Carryover from prior year . . . . . . . . . . . . 18
see page A-6. 19 Add lines 16 through 18 . . . . . . . . . . . . . . . . . . . . . 19
Casualty and
Theft Losses 20 Casualty or theft loss(es). Attach Form 4684. (See page A-7.) . . . . . . . . . 20
Job Expenses 21 Unreimbursed employee expenses—job travel, union dues,
and Certain job education, etc. Attach Form 2106 or 2106-EZ if required.
Miscellaneous (See page A-7.) a 21
Deductions 22 Tax preparation fees . . . . . . . . . . . . . 22
(See 23 Other expenses—investment, safe deposit box, etc. List type
page A-7.) and amount a
24 Add lines 21 through 23 . . . . . . . . . . . . 24
25 Enter amount from Form 1040, line 38 25
26 Multiply line 25 by 2% (.02) . . . . . . . . . . . 26
27 Subtract line 26 from line 24. If line 26 is more than line 24, enter -0- . . . . . . 27
Other 28 Other—from list on page A-8. List type and amount a
Deductions 28
Total 29 Add the amounts in the far right column for lines 4 through 28. Also, enter this amount
Itemized on Form 1040, line 40 . . . . . . . . . . . . . . . . . . . . . 29
Deductions 30 If you elect to itemize deductions even though they are less than your standard
deduction, check here . . . . . . . . . . . . . . . . . . . a

For Paperwork Reduction Act Notice, see Form 1040 instructions. Cat. No. 17145C Schedule A (Form 1040) 2010
Schedule A (Form 1040) 2010 Page 2

Worksheet Before you begin:  You cannot take this deduction if the amount on Form 1040, line 38, is equal to or greater than
for Line 7— $135,000 ($260,000 if married filing jointly).
New motor  See the instructions for line 7 on page A-3.

o f
1 Enter the state and local sales and excise taxes you paid in
2010 for the purchase of any new motor vehicle(s) after
February 16, 2009, and before January 1, 2010 (see
page A-3) . . . . . . . . . . . . . . . . . .


Use this

worksheet to 2 Enter the purchase price (before taxes) of the new motor vehicle(s) 2

figure the
amount to enter
on line 7.

f 1
3 Is the amount on line 2 more than $49,500?

Enter the amount from line 1.

a } 2
Yes. Figure the portion of the tax from

(Attach to Form
r /
line 1 that is attributable to the first
$49,500 of the purchase price of

D /29
each new motor vehicle and enter it
here (see page A-3).
4 Enter the amount from Form 1040, line 38 . . . .



. .

. . . . . . 3

0 }
5 Enter the total of any—
• Amounts from Form 2555, lines 45 and 50;
Form 2555-EZ, line 18; and Form 4563, line 15,
• Exclusion of income from Puerto Rico
. . . 5

6 Add lines 4 and 5 . . . . . . . . . . . . . . . 6

7 Enter $125,000 ($250,000 if married filing jointly) . . . . . 7

8 Is the amount on line 6 more than the amount on line 7?

No. Enter the amount from line 3 above on Schedule A,
line 7. Do not complete the rest of this worksheet.

Yes. Subtract line 7 from line 6 . . . . . . . . 8

9 Divide the amount on line 8 by $10,000. Enter the result as a

decimal (rounded to at least three places). If the result is 1.000
or more, enter 1.000 . . . . . . . . . . . . . . 9 .

10 Multiply line 3 by line 9 . . . . . . . . . . . . . . . . . . . . . 10

11 Deduction for new motor vehicle taxes. Subtract line 10 from line 3. Enter the result
here and on Schedule A, line 7 . . . . . . . . . . . . . . . . . . . 11
Schedule A (Form 1040) 2010
SCHEDULE B OMB No. 1545-0074
(Form 1040A or 1040) Interest and Ordinary Dividends
Department of the Treasury a Attach to Form 1040A or 1040. a See instructions on back.
Internal Revenue Service (99) Sequence No. 08
Name(s) shown on return Your social security number

Part I

o f
List name of payer. If any interest is from a seller-financed mortgage and the
buyer used the property as a personal residence, see instructions on back and list

this interest first. Also, show that buyer’s social security number and address a

(See instructions
on back and the
instructions for

f t a 1 0
Form 1040A, or
Form 1040,
line 8a.)

r a / 2 0 1

D /15
Note. If you
received a Form
1099-INT, Form
1099-OID, or

statement from

a brokerage firm,
list the firm’s
name as the 2 Add the amounts on line 1 . . . . . . . . . . . . . . . . . . 2
payer and enter
the total interest
3 Excludable interest on series EE and I U.S. savings bonds issued after 1989.
shown on that Attach Form 8815 . . . . . . . . . . . . . . . . . . . . . 3
form. 4 Subtract line 3 from line 2. Enter the result here and on Form 1040A, or Form
1040, line 8a . . . . . . . . . . . . . . . . . . . . . . a 4
Note. If line 4 is over $1,500, you must complete Part III. Amount
Part II 5 List name of payer a

(See instructions
on back and the
instructions for
Form 1040A, or
Form 1040, 5
line 9a.)

Note. If you
received a Form
1099-DIV or
statement from
a brokerage firm,
list the firm’s
name as the
payer and enter
the ordinary
dividends shown 6 Add the amounts on line 5. Enter the total here and on Form 1040A, or Form
on that form. 1040, line 9a . . . . . . . . . . . . . . . . . . . . . . a 6
Note. If line 6 is over $1,500, you must complete Part III.
Part III You must complete this part if you (a) had over $1,500 of taxable interest or ordinary dividends; (b) had a
foreign account; or (c) received a distribution from, or were a grantor of, or a transferor to, a foreign trust. Yes No
Foreign 7a At any time during 2010, did you have an interest in or a signature or other authority over a financial
Accounts account in a foreign country, such as a bank account, securities account, or other financial account?
and Trusts See instructions on back for exceptions and filing requirements for Form TD F 90-22.1 . . . . .
(See b If “Yes,” enter the name of the foreign country a
instructions on 8 During 2010, did you receive a distribution from, or were you the grantor of, or transferor to, a
back.) foreign trust? If “Yes,” you may have to file Form 3520. See instructions on back . . . . . .
For Paperwork Reduction Act Notice, see your tax return instructions. Cat. No. 17146N Schedule B (Form 1040A or 1040) 2010
Chapter 5

Chapter 5
Gross Income

I. Objectives of the Chapter

A. WHAT constitutes income?

B. WHEN income is to be reported?

C. WHO must report income?

II. What Constitutes Income?

A. §61(a) provides the general rule:

1. "Except as otherwise provided ... gross income means all

income from whatever source derived ...."

a) The term "except" refers to the numerous provisions in

the Code (between 30 and 40) that specifically exempt
certain items from taxation.

2. Although "gross income" is defined in the Code, the term

"income" is not!

B. Form-of-Benefit Principle

1. "Gross income includes income realized in any form, whether

in money, property or services."

2. Without this rule, taxpayers could escape tax through barter.

C. Return of Capital Doctrine

1. Income results only after the taxpayer has recovered his

capital investment.

2. In other words, a taxpayer is allowed a tax-free return of

capital before gain is realized.

Chapter 5

3. This doctrine permits the deduction of the costs of doing


a) For example, COGS, depreciation, interest, taxes, and

other business expenses are deductible under this

III. Reporting Income

A. Accounting Periods

1. Two types of taxable years:

a) Calendar year

(1) The most convenient accounting period for

individual taxpayers.

b) Fiscal year

(1) Usually, it is any period of 12 months ending on the

last day of any month other than December.

(2) 52-53 week year:

(a) The taxpayer picks a particular DAY (e.g.

the last Saturday in June), rather than a
particular DATE, on which to end the
taxable year.

2. Taxable year and reporting income from conduit entities

a) Income from partnerships and S corporations is taxed to

the taxpayer as of the last day of the entity’s taxable year.

b) Income from a trust is taxable to the beneficiary as of the

end of the calendar year.

c) These rules allow partners and S corporation

shareholders to defer income.

Chapter 5

B. Limitations on Fiscal Years

1. General rule: To eliminate deferral possibilities, partnerships,

S corporations, and personal service corporations (PSC) are
required to use the calendar year.

2. Exception: §444

a) Under §444, a partnership, S corporation, or PSC that

normally would be required to use the calendar year may
elect to use a fiscal year.

b) In order to elect a fiscal year, a partnership or S

corporation must pay the tax that is deferred —computed
at the highest individual rate — plus a toll charge of 1
percent by May 15.

c) Thus, §444 permits the use of fiscal years, but removes

the tax incentive.

C. Accounting Methods in General

1. Accounting methods available:

a) Cash

b) Accrual

c) Special methods

(1) E.g., Installment method, Completed contract

method, etc.

d) Any combination of these three methods.

Chapter 5

D. Cash Method

1. According to Treas. Reg. §1.446-1(c)(i):

a) The cash method requires that "all items which constitute

gross income (whether in the form of cash, property, or
services) are to be included in income in the taxable year
in which they are actually or constructively received."

2. Although less accurate than the accrual method, the cash

method is approved by I.R.C. §446.

a) The cash method is subject to the IRS power to require

another method of accounting to be used to ensure that
income is clearly reflected.

(1) For example, inventories must be accounted for

using the accrual method.

3. Cash equivalent doctrine

a) Income is income whether received in the form of cash,

property, or services.

b) The cash basis taxpayer reports income when the

equivalent of cash is received.

4. Constructive Receipt Doctrine

a) The purpose of the constructive receipt doctrine is to

prevent manipulation by limiting the cash basis taxpayer's
control over the timing of income recognition.

(1) Income available to the taxpayer, but not actually

reduced to his possession, is treated as if it had
been received.

(2) Classic examples

(a) Taxpayer receives salary or dividend check

in December, but waits until January to cash

(b) Taxpayer waits until the most favorable tax

period to present his passbook to have
interest credited to his account.

Chapter 5

b) Requirements for application

(1) Taxpayer has control over the amount without

substantial limitations and restrictions.

(a) E.g., stock received which cannot be sold

until a specific date.

(2) The amount has been set aside or credited to the

taxpayer's account.

(a) E.g., interest on savings.

(3) The funds are available for payment.

(a) Obligor is ready, willing, and able to pay.

c) Special situations

(1) Demand payments — Debts owed to taxpayer

where the debtor is ready, willing, and able to pay
on demand ARE constructively received.

(2) Payment date fixed by contract

(a) If payments are to be made on a due date

fixed by an agreement between the obligor
and the taxpayer, the due date normally

(b) The constructive receipt doctrine does NOT

apply because, after the contract has been
made, the taxpayer has no right to receive
the income early.

(c) Note that the taxpayer receives nothing

more than a promise to pay and assumes
the risk that payment may never be made.

Do Problem #31

Chapter 5

5. Limitations on the Use of the Cash Method

a) General Rule: To prevent abuses, certain types of taxable

entities are prohibited from using the cash method.

(1) Regular C corporations,

(2) Most partnerships that have a regular C corporation

as a partner, and

(3) Tax shelters.

b) Exceptions: Entities permitted to use the cash method

(1) Corporations and partnerships with annual gross

receipts not exceeding $5 million;

(2) Farming businesses; and

(3) Personal service corporations where 95% of the

stock is owned by the employees.

6. Accounting for Inventory

a) General rule:

Taxpayers must use the ACCRUAL method to

report both Sales and COGS if inventories are a
significant income-producing factor.

b) Exceptions:

(1) The rules are relaxed for the following categories of


(a) Taxpayer has average annual gross

receipts of $1 million or less.

(b) Service business with average annual gross

receipts of less than $10 million.

Chapter 5

E. Accrual Method

1. Gen. Rule: The "All Events Test"

a) Income must be reported by an ACCRUAL method

taxpayer when:

(1) All the events have occurred which fix the

taxpayer's right to the income, AND

(2) The amount can be determined with reasonable


b) The same test is used for determining the timing of


2. Exceptions: For tax purposes, the accrual basis taxpayer often

must use the cash basis:

a) Dividends are reported when received, rather than the

date of record.

b) Prepaid income.

c) Amounts received under a “claim of right.”

Chapter 5

3. Prepaid Income

a) General Rule: Accrual method taxpayers must report

prepaid income items in the year of RECEIPT.

b) Exceptions:

(1) Prepaid service income (Rev. Proc. 2004-34)

(a) In the year of receipt, the taxpayer includes

the prepayment in gross income to the
same extent that the prepayment is included
in income for financial accounting purposes.

(b) In the following tax year, the rest of the

prepayment is included in gross income.

Do Problem #39

(2) Advance Payments for Goods

(a) Report the income as it accrues if:

(i) Accounting method for tax is same as

for financial accounting;

(ii) Goods are not in stock on the last day of

the year; and

(iii) Seller has not received payments

exceeding his or her cost.

(b) If the goods are on hand at the end of year

and receipts exceed cost, income is
reported at the earlier of:

(i) Period reported for financial accounting,


(ii) The second taxable year after the tax

year in which the receipts exceeded

(3) Prepaid dues and subscription income

(a) Use of the accrual method is permitted.

Chapter 5

(4) Advance Payments relating to LT Contracts

(a) In general, a long-term contract is defined

as any contract for the manufacture,
building, installation, or construction of
property that is not completed within the
same tax year in which it was entered into.

(b) The percentage of completion method must

be used for all long-term contracts, except:

(i) Contracts of small businesses (ave.

gross receipts for past 3 years < $10
million) can use completed contract

(ii) Home construction contracts can use

completed contract method.

(iii) A 70% percentage of completion

method may be used for certain
residential construction.

(c) Under the percentage completion method,

the taxpayer includes in gross income a
portion of the total contract price calculated
as follows:

Direct and allocable indirect

Total costs incurred this period
Contract x ----------------------------------------
Price Total estimated costs of contract

(d) Once the contract is completed, the annual

income is recomputed based on FINAL
COSTS rather than estimated costs.

(i) Interest is paid to the taxpayer if there

was an overstatement of income.

(ii) But, the taxpayer must pay interest if

income was understated.

Chapter 5

4. Claim of Right Doctrine

a) If a taxpayer receives income under dispute and claims it

as his own, that amount must be included in gross
income, even though the amount may have to be refunded
if the claim is later denied.

b) Examples

(1) Embezzled funds

(2) Contingent legal fees that must be returned if the

client loses on appeal.

(3) Commissions that were improperly calculated and

had to be repaid.

c) Deposits

(1) Deposits are not income since the taxpayer

recognizes an obligation to repay.

(2) Instead of requiring payment of the last month's

rent, landlords should recharacterize the amount as
a deposit.

Do Problem #38

F. Changes in Accounting Methods

1. Once an accounting method has been adopted by the taxpayer,

it may not be changed without the consent of the IRS.

a) Applications to change methods must be filed within 180

days of the beginning of the tax year when the change is
to become effective.

b) Permission to change is granted only if the taxpayer

agrees to make any adjustments required by the IRS.

(1) These adjustments are required to prevent the

omission of income or the double-counting of

Chapter 5

2. Accounting for the Adjustment

a) General rule: Adjustments are reported and any

additional tax is due in the year of change.

b) Changing from a Category A (clearly erroneous) method

to a correct method:

(1) If the taxpayer voluntarily changes:

(a) Positive adjustments are spread over 4 tax


(b) Negative adjustments under $25,000 are

reported in the year of change.

(2) If the change is required by the IRS as part of an

audit, the entire adjustment is reported in the year
of change.

c) Changing from a Category B (permissible) method to

another permissible method:

(1) Generally, the adjustment is spread over 6 years.

Do Problem #33

Chapter 5

IV. Interest Income

A. Sale or purchase of interest-bearing investments between
interest payment dates:

1. Seller includes, as interest income, the amount of interest

accrued to the date of sale, regardless of whether a cash or
accrual basis taxpayer.

a) The sales price is reduced accordingly.

b) Example: Seller sells bond for $10,100, including $100 of

interest accrued to the date of sale. Seller treats $100 as
interest income and reduces the sales price to $10,000.

2. Buyer treats the subsequent payment of interest (which was

accrued by the seller) as a nontaxable return of capital and
reduces the basis of the instrument accordingly.

a) Example: Same as above. Buyer treats receipt of $100

accrued interest as a nontaxable return of basis. Buyer's
basis in the bond is now 10,000.

3. By assuming that the sales price includes interest accrued to

the date of sale, the opportunity for converting ordinary
income into capital gain is eliminated.

B. Original Issue Discount

1. General rule

a) Taxpayers must amortize the discount and report interest

income as it accrues, even if the taxpayer is on the cash

b) Zero coupon bonds

(1) Generate taxable interest income, but

(2) Provide no cash flow until the bond is redeemed.

Chapter 5

2. Series EE and Series I (adjusted for inflation) savings bonds

a) These bonds are non-interest-bearing instruments.

(1) They are issued at a discount; and

(2) The amount for which the bond may be redeemed

increases the longer it is held.

b) The increase in redemption value may be reported either

annually or deferred until the bond is redeemed.

(1) This rule applies to cash and accrual basis


3. Treasury Bills

a) Like EE bonds:

(1) Short-term (maturing in one year or less)

government obligations are issued as a discount
and redeemed at face value when they mature.

(2) The "gain" must be reported as interest income.

b) Unlike EE bonds, the taxpayer does not have a choice as

to when the interest is reported.

(1) Cash basis taxpayers report all the interest income

at redemption when the interest is paid.

(2) Accrual method taxpayers must accrue the interest

(amortize the discount) on a daily basis and report
it when earned.

Chapter 5

V. Identification of the Taxpayer

A. Income from Personal Services

1. Income is taxed to the one who actually earned the income

since he or she controls the source.

2. Income earned by a child is included in the child's gross

income, and not the parent's.

B. Income from Property

1. Income from property is taxed to the owner of the property.

2. Transferring income-producing property by gift

a) Interest-bearing obligations

(1) Interest accrues on a daily basis.

(2) The donor and donee report their appropriate share

when the donee collects the interest.

b) Stocks—the date of declaration controls.

(1) Gift BEFORE declaration date: Donee taxed

(2) Gift AFTER declaration date: Donor taxed

Chapter 5

C. Interest-free and below-market loans

1. Pre-1984 tax consequences

a) The interest-free use of money loaned on demand by

employers to employees, corporations to shareholders, etc.
did not constitute income to the borrower.

(1) Thus, interest-free loans were being used as a form

of tax-free compensation.

b) Interest-free use of money loaned on demand was not

treated as a taxable gift and, thus, could be used to shift
income to lower bracket taxpayers.

(1) Example

(a) B, in the 50% bracket, loaned his daughter,

D, $100,000 interest-free.

(b) D would then invest the $100,000, and the

income earned on the investment was taxed
at D's lower tax bracket.

2. 1984 Changes

a) To prevent these abuses:

(1) The borrower is treated as if he had paid the lender

interest on the loan at the statutory rate; and

(2) The lender then is considered to have transferred

an equal amount back to the borrower.

b) Results:

(1) The borrower is entitled (possibly) to a deduction

for the interest hypothetically paid to the lender.

(2) The lender reports the hypothetical payment as

interest income.

(3) The lender treats the hypothetical payment to the

borrower as either compensation, a dividend, or a
gift, depending upon the relationship between the
borrower and the lender.

(4) Similarly, the borrower treats the payment as either

compensation, a dividend, or a gift, as the case
may be.

Chapter 5

3. Exception for loans not exceeding $10,000

a) General Rule:

(1) There are no income or gift tax consequences as

long as loans outstanding between borrower and
lender never exceed $10,000.

b) However, the $10,000 de minimus exception will not apply


(1) Gift loans — if the borrower uses the loan proceeds

to purchase or carry income-producing assets.

(2) Non-gift loans — if one of the purposes is tax


4. Cap on interest income for gift loans between individuals not

exceeding $100,000

a) If the aggregate amount of outstanding loans does not

exceed $100,000 on any day during the year:

(1) The lender is treated as having made a gift, as

determined above.

(2) However, the borrower's hypothetical interest

payment is limited to his net investment income.

(a) If the borrower's net investment income is

less than $1,000, it is considered to be -0-.

(b) In such a case, the lender does not have

any interest income — only a gift that may
be subject to the gift tax.

b) This rule permits loans such as those by parents to

children to enable them to buy homes, attend college, etc.
without concern for interest income . . . but still a
potential gift tax.

Do Problem #45

Do Problem #46

Chapter 6

Chapter 6
Gross Income: Inclusions and Exclusions

I. Investment Income
A. Corporate Distributions

1. Dividend distributions from a corporation's E&P.

a) Cash and property distributions from a corporation's

current or accumulated E&P are classified as dividends.

b) Currently, dividends are taxed the same as LTCGs:

(1) 5% for taxpayers in the 10% and 15% brackets.
(2) 15% for all other taxpayers.

c) Note: the reduced tax rates on dividend income are not

available to taxpayers who:

(1) Owned the stock (on which the dividends were

paid) for fewer than 60 days, or

(2) Purchased the stock with borrowed funds, while

deducting the interest on the loan.

2. Distributions that are not from the corporation's current or

accumulated E&P are a return of capital.

a) Such distributions are excludable to the extent of the

taxpayer's basis in the stock.

b) Amounts received in excess of the taxpayer's basis are

capital gains.

Corporate Effect on Effect on Basis

Distribution Taxable Income in Stock
1. E&P Included No change
2. Basis Excluded Reduced
3. Capital gain Included No change

Chapter 6

3. Stock Dividends

a) Distributions of common stock to common shareholders.

(1) The dividend is fully excludable.

(2) Shareholders increase the number of shares held,

and their original basis is divided equally among all
shares of common.

Original Adj. Basis New basis per share

------------------------ = for ALL shares
Total shares

(3) The holding period for the new shares is the same
as the holding period of the original shares.

b) Distributions of nonconvertible preferred stock to

common shareholders.

(1) The dividend is fully excludable.

(2) The shareholder now owns both common stock and

preferred stock.

(3) The basis of the original holdings of common stock

is allocated between the common and preferred
shares based on relative FMV:

FMV of old Original Adj. Basis

---------------------------- x basis = of OLD shares
FMV old + FMV new

FMV of new Original Adj. Basis

---------------------------- x basis = of NEW shares
FMV old + FMV new

(4) Again, the holding period for the new shares is the
same as the holding period of the original shares.

Chapter 6

c) Stock dividends distributed to preferred shareholders.

(1) The distribution is treated as a cash dividend.

(2) The basis of the stock received by the preferred

shareholders is equal to the FMV of the stock

4. When shareholders can choose to receive dividends in cash or

in additional shares of stock, they are deemed to have received
income under the Constructive Receipt Doctrine.

Do Problem #19

Do Problem #18

B. Interest

1. General rule: Include in gross income

2. Exclusions:

a) Interest on state and local bonds

(1) Interest is excluded.

(2) Gains on sale of these bonds are included.

b) Interest on Education Savings bonds

(1) Omit.

Chapter 6

C. Annuities

1. An annuity is an investment contract that requires a fixed

amount of money to be paid to the owner at specific intervals
for either a specific period of time or for life.

2. Annuities may be purchased either by an individual or for an

employee by his/her employer.

a) When an annuity is purchased by an individual, the

interest earned is tax-deferred.

b) Thus, the interest is includable in gross income when the

annuitant receives cash payments.

3. Early withdrawals — withdrawing funds before annuity

benefits are scheduled to begin.

a) Annuity contracts issued after Aug. 13, 1982.

(1) Early withdrawals are treated as being a distribution

of the interest income earned on the contract.

(a) Only after all of the deferred income has

been received by the taxpayer will any
funds be considered a nontaxable return of

(b) A 10% penalty is assessed against all

withdrawals of deferred income earned on
funds invested after August 13, 1982.

(c) This penalty is waived under certain


b) Annuity contracts issued before Aug. 14, 1982

(1) Early withdrawals are treated as a tax-free return of

capital, provided distributions are from funds
invested prior to Aug. 14, 1982.

Chapter 6

4. Taxation of regular annuity payments

a) Annuitants receive the principal plus accrued interest in


(1) The individual has includable gross income equal to

the amount of interest received.

b) The formula for determining the portion that is a

nontaxable return of capital for the period is:

Investment Amount Return

—————— x received = of
Expected return currently capital

(1) The includable portion is the amount received

currently less the portion that is a return of capital.

(2) When the annuity is to be received over a

stipulated number of years, the expected return is:

Amount to be received each year

x Number of years' payments are to be rec'd
Expected return

(3) When the annuity is to be received over the life of

the annuitant, the expected return is:

Amount to be received each year

x Multiple corresponding to annuitant's age*
Expected return

* See Exhibit 6-3, p. 6-14.

Do Problem #23

Chapter 6

5. Simplified Safe Harbor Method

a) A simplified method for computing the excludable portion

of each annuity payment MUST be used if the annuity

(1) Start after November 18, 1996,

(2) Are Single life annuities or Joint and survivor


(3) Are made from a qualified retirement plan, and

(4) Start when the recipient is under age 75 or, if older,

there are less than 5 years of guaranteed payments

b) The portion of each monthly payment that is excluded is

determined using this formula:

Investment in the contract

————————————— = Exclusion
Number of monthly payments

c) The number of monthly payments to be used in the

denominator is found in the Monthly Payments Table on
p. 6-15.

Do Problem #24

Chapter 6

D. 529 College Savings Plans

1. Income tax treatment

a) Distributions are nontaxable, provided the money is used

to pay qualified higher education expenses (not room and

b) Unused balances in a 529 plan can be rolled over, without

penalty, to an account for another family member.

2. Estate and gift tax treatment

a) 529 plan contributions up to $12,000 per year will not be

subject to gift tax.

(1) Taxpayers can contribute $60,000 to a 529 plan

and treat it as though contributed evenly over the
next 5 years, escaping gift tax.

b) Note: tuition paid directly to an education institution for

another person is not subject to gift tax, either.

II. Employee compensation and other benefits

A. Employee compensation is includable in gross income
whether it is:

1. Salary

2. Commissions or bonuses

3. Tips

4. Vacation pay

5. Severance pay

Chapter 6

B. Employer Awards to Employees

1. General rule: Employee awards are compensation.

2. Exceptions: The following awards are excludable by the

employee and deductible by the employer:

a) Awards for length of service or safety achievement

($400/employee limit)

b) Awards under a nondiscriminatory qualified award plan

($1,600/employee limit)

C. Social Security Taxes and Benefits

1. Gross wages, including Social Security withheld, are taxable,

but individuals are not allowed either an exclusion or a
deduction for FICA taxes withheld.

a) The amount withheld from employees represents half the

Social Security tax on wages, with the other half being
paid by the employer.

b) The employer's portion of the FICA taxes is not gross

income to the employee.

2. In general, Social Security benefits received are excludable

from gross income. However, high income bracket taxpayers
are required to include in gross income a portion of the Social
Security benefits received.

a) Calculate the taxpayer's "Modified AGI."

+ Tax-exempt interest
+ 50% of Social Security benefits received
+ Foreign earned income exclusion
Modified AGI

Chapter 6

b) Tier 1: If the "Modified AGI" is LESS THAN or

EQUAL to $34,000 (single) or $44,000 (married filing
jointly), the social security benefits included in gross
income is the LESSER of:

(1) 50% of the benefits received; or

(2) The result of the following formula:

Modified AGI
- Base amount ($32,000; 0; or $25,000)
x 50%
Includable benefits (Tier 1)

c) Tier 2 : If the "modified AGI" is GREATER than

$34,000 (single) or $44,000 (married filing jointly), the
social security benefits included in gross income is the

(1) 85% of the benefits received; or

(2) The result of the following formula:

Modified AGI
- ADJ. base amt. ($44,000; 0; or $34,000)
x 85%
+ The LESSER of:
(1) The Tier 1 inclusion, or
(2) $4,500 (single); $6,000 (joint)
Includable benefits (Tier 2)

Do Problem #28

Chapter 6

D. Federal and State Unemployment Taxes

1. Only employers are subject to Federal and State

unemployment taxes.

a) These taxes are deductible business expenses for the


b) However, they are not gross income for the employee.

2. ALL unemployment compensation is taxable.

E. Life Insurance

1. Employer-paid life insurance premiums are excludable by an

employee but only for the first $50,000 of group term life
insurance protection.

a) Premiums paid by an employer for any other type of life

insurance is fully includable.

2. When group-term life insurance protection exceeds $50,000,

the employee will include in gross income a portion of the
employer-paid premiums.

a) The amount included in gross income is determined by

referring to the Regulations and is based on the
employee's age as of the last day of his/her tax year.

b) See Exhibit 6-6, p. 6-25.

Chapter 6

3. Life insurance proceeds received by a beneficiary on the death

of the insured.

a) Generally, such amounts are excludable from gross


b) Exceptions:

(1) If life insurance is used to protect a creditor against

a bad debt loss on the death of the insured.

(2) If a policy is transferred to another party in

exchange for valuable consideration, any gain from
the proceeds on the insured’s death is includable.

F. Health insurance benefits

1. All medical insurance reimbursements are excludable income

regardless of who pays the premium.

2. Any reimbursement of medical costs reduces the amount of

medical expenses that can be deducted as itemized deductions.

3. When medical expenses are paid in one year, but

reimbursements are received in a later year:

a) Taxpayers can anticipate the reimbursement and not

deduct any reimbursable expenses; or

b) They can itemize all medical costs paid during the year,
even though reimbursement is expected.

(1) In this case, the reimbursement is includable in

gross income when received to the extent a tax
benefit was obtained from the prior year’s medical
expense deduction.

c) If employer-provided medical insurance reimburses the

employee in excess of medical expenses he/she incurred,
the over-reimbursement is includable in the employee’s
gross income.

Chapter 6

G. Qualified Long-term Care Benefits

1. Employer-paid premiums for long-term care insurance are

excluded from the employee’s gross income.

2. In general, benefits (up to $260 per day) paid for the care of a
patient also are excluded from gross income.

H. Accident or disability plans

1. Employer-provided plans

a) General rule: Amounts received under an employer-

provided accident or disability plan are includable.

b) Exception: Payments are excludable if made for

permanent loss or use of function or member of the body.

2. Employee-provided plans

a) All disability income is excludable if the taxpayer if the

taxpayer paid for the disability coverage.

Do Problem #35

Chapter 6

I. Employer-Provided Meals and Lodging

1. The value of meals and lodging provided by an employer to an

EMPLOYEE and the employee's spouse and dependents is
excluded from gross income, if:

a) Meals and lodging are provided for the employer's


b) Meals and lodging are provided on the employer's

business premises; and

c) In the case of lodging, the employee is required (as a

condition of employment) to occupy the quarters in order
to perform employment duties.

2. If all requirements are met, the value of meals and lodging is

excludable for all employees, even those who are major

a) Note: This provision does NOT apply to owners who do

not qualify as employees (e.g., partners).

J. Employer-provided child care

1. The employee can exclude the value of this benefit, and the
employer can deduct the cost of providing the service.

2. The employee's exclusion is limited to the LESSER of:

a) Earned income of lesser earning spouse, or

b) $5,000

K. Adoption Assistance Programs

1. Employees can exclude up to $11,390 (per child) of qualified

adoption expenses paid by his or her employer.

2. The exclusion phases out for employees with AGI between

$170,820 and $210,820.

Chapter 6

L. Educational Assistance Plans

1. Employer-provided educational assistance up to $5,250 for

undergraduate and graduate education will be excluded from
gross income.

M. Section 132 Fringe Benefits

1. Working condition fringe benefits

a) Working condition fringe benefits are excludable to the

extent that employees could deduct the cost had they paid
the cost themselves.

b) Items qualifying include:

(1) Company-owned autos;

(2) Professional dues and subscriptions; and

(3) Free or low-cost parking.

2. See Exhibit 6-7 on p. 6-32 for a summary of the §132 fringe


Do Problem #50

Chapter 6

III. Personal Transfers between Individuals

A. Transfers by Gift or Inheritance

1. The value of property received as a gift, bequest, devise or

inheritance is specifically excluded from gross income by §102.

a) However, this exclusion does not apply to income earned

on the property.

2. Generally, the source of assets received as a gift or inheritance

is not relevant, with two exceptions:

a) The exclusion does not apply to a gift or assignment of


b) A gift or bequest of a specific sum of money to be paid

from a trust or estate in more than three installments is
includable income to the extent that it is paid from the
income (DNI) of the trust or estate.

B. Alimony and Separate Maintenance

1. Alimony or separate maintenance payments are deductible for

AGI by the payer and includable in gross income of the payee.

2. Payments qualify as alimony only if all six of the requirements

listed on p. 6-39 are met:

a) They are made in cash;

b) They are made as a result of a divorce or separation

under a written decree of separation;

c) They are required under a decree or written instrument

incident to a divorce;

d) They are not designated as child support;

e) The husband and wife do not live together or file a joint

return; and

f) The payments cease with the death of the recipient.

Chapter 6

3. If the divorce agreement states that payments are not alimony

for income tax purposes, they are not treated as alimony, even
if all the previously mentioned requirements are met.

4. Transfers of property between spouses incident to a divorce

are nontaxable.

5. Limitations on front-loading of alimony

a) Prevents taxpayers from disguising property settlements

as alimony.

C. Child Support

1. Amounts that qualify as child support are:

a) Not deductible by the payer; and

b) Excluded from gross income of the recipient.

2. Funds qualify as child support if: (p. 6-42)

a) Fixed or is contingent on the child's status,

b) Paid solely for the support of minor children, and

c) Payable by decree, written instrument, or agreement.

3. If any of these three requirements are not met, the payments

are treated as alimony with no part considered as child

Do Problem #45

Do Problem #47

Chapter 6

IV. Transfers by Unrelated Parties

A. Life Insurance Proceeds

1. General rule: Exclude from gross income of recipient

2. Cashing in policy before death

a) General rule: recognize gain, but not loss.

b) Exception: A terminally-ill or chronically-ill individual

may exclude from gross income accelerated death benefits

3. Substitute for Taxable Income

a) If the proceeds for a life insurance policy replace a

taxable income stream, the proceeds are includible in
gross income.

4. Transfer for Valuable Consideration

a) If a taxpayer purchases another’s life insurance policy,

treat the transaction as an ordinary investment.

b) This rule doesn’t apply if the purchaser is:

(1) A partner of the insured;

(2) A partnership in which the insured is a partner;

(3) A corporation in which the insured is a shareholder

or officer; or

(4) The insured.

Chapter 6

B. Prizes and Awards

1. Generally, prizes and awards are includible in gross income.

2. Awards for Scientific, Charitable, etc. Achievement

a) An individual who is granted and ACCEPTS a prize or

award in recognition of religious, charitable, scientific,
educational, artistic, literary, or civic achievement is no
longer entitled to exclude the award from income.

b) However, if the award is TRANSFERRED by the payor to

a tax-exempt charity designated by the award winner, the
award winner can exclude the amount from gross income
and will not be allowed a charitable contribution

c) To qualify for this exclusion:

(1) The recipient must have been selected without any

action on his part to enter the contest; and

(2) The recipient must not be required to render

substantial future services.

C. Scholarships and Fellowships

1. The exclusion for scholarships and fellowships is limited to the

amount that is required to be used (and is actually used) for:

a) Tuition and fees required for enrollment; and

b) Books, supplies, and equipment required for a course.

2. Scholarships granted with the expectation of present or future

services are includable in gross income.

3. Scholarship amounts used for room and board are taxable.

a) These amounts are considered “earned income” for

purposes of determining the standard deduction of the
dependent student.

Chapter 6

D. Government Transfer Payments

1. In general, all state and federal welfare or public assistance

payments are excluded from gross income.

2. Government payments to farmers, on the other hand, are

generally included in gross income.

V. Business Gross Income

A. Agreements Not to Compete and Goodwill

1. Payments received pursuant to a Covenant not to Compete are

ordinary income.

2. Payments received for Goodwill are capital gains.

B. Damages Awarded

1. Punitive damages — includable in gross income.

2. Compensatory damages:

a) Reimbursement of litigation expenses

(1) Tax-free return of capital

b) Compensation for loss of goodwill or other assets

(1) Tax-free return of capital

c) Reimbursement for lost profits

(1) Ordinary income

C. Lease Cancellation Payments

1. Received by Lessor:

a) Always considered to be ordinary income

2. Received by Lessee:

a) Amounts received by lessee are considered to be proceeds

from the sale of the lease.

(1) Thus, the gain is includable in gross income.

Chapter 6

D. Leasehold Improvements

1. If the improvements are made by the tenant in lieu of rent,

they are includable in the landlord's gross income.

2. If the improvements are not in lieu of rent, the landlord never

will include them in gross income.

a) However, if the property is sold, the improvements

presumably will cause the gain realized by the
landlord/seller to be larger.

VI. Miscellaneous Items

A. Asset Discovery

1. Cash or other assets found by a taxpayer are taxable income.

2. Example: Cash found in a used piano purchased by taxpayer.

B. Income Tax Refunds

1. Federal income tax refunds — excludable

2. State and local tax refunds

a) Included in gross income to the extent of any TAX

BENEFIT realized in the prior year.

C. Damages Awarded to Individuals

1. Compensation for personal injury

a) Generally, the damage awards are excludable.

b) However, if the award is for reimbursement of medical

expenses deducted in a prior year, they are includable in
gross income to the extent the taxpayer received a TAX
BENEFIT for them.

2. Compensation for lost income generally is includable.

3. All punitive damages are includible.

Chapter 7

Chapter 7
Overview of Deductions and Losses

I. Introduction
A. General Requirements for Deductions and Losses

1. Deductions are a matter of legislative grace.

2. Nothing is deductible unless allowed by the Code

a) Deductions do not necessarily need to be specifically

identified in the Code (e.g., rent expense) before a
deduction is allowed.

b) Items need only meet general criteria which cover a broad

array of expenses (e.g., expenses incurred in carrying on
a trade or business).

B. Timing of Deductions

1. The time value of money suggests the acceleration of all


2. The year of deduction depends on accounting method (cash or


C. Distinguishing between Deductions FOR AGI and Itemized


D. Substantiating Deductions

1. The taxpayer must prove his right to a deduction, as well as the

amount spent or the loss incurred.

Chapter 7

II. General Requirements for Deduction of Expenses

A. §§162 and 212

1. §162(a) allows the deduction of "all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying
on a trade or business."

2. §212 allows a taxpayer to deduct all the ordinary and

necessary expenses paid or incurred during the taxable year:

a) For the production or collection of income;

b) For the management, conservation, or maintenance of

property held for the production of income; or

c) In connection with the determination, collection, or

refund of any tax.

3. Under both §§162 and 212, deductions are allowed only if the
expense is:

a) Sufficiently related to carrying on a trade or business or

income producing activity;

b) Ordinary and necessary;

c) Reasonable; and

d) Paid or incurred during the taxable year.

B. Activity and Relationship

1. The Activity

a) Profit motive

(1) To be deductible either as a trade or business

expense or an expense related to an income-
producing activity, the activity must be entered into
for profit.

(2) If there is no profit motive, the "hobby loss" rules of

§183 will apply.

b) Sufficient taxpayer involvement

(1) Taxpayer involvement is what distinguishes a trade

or business from an income-producing activity.

Chapter 7

(2) To be considered a trade or business:

(a) The taxpayer must devote a major portion of

time to the activities, or

(b) Activities must be regular or continuous.

2. Distinguishing Between §§162 and 212

a) Trade or business

(1) Most §162 expenses are deductible FOR AGI.

(2) BUSINESS bad debts result in ordinary loss.

b) Production of income

(1) With the exception of expenses related to rents and

royalties, §212 expenses are usually deductible

(2) NONBUSINESS bad debts are always given STCL


3. The Relationship

a) Business expenses must be directly connected with or

must pertain to the taxpayer's trade or business.

b) Production of income expenses must bear a reasonable

and proximate relationship to the income producing

4. The thrust of the requirement that an expense be sufficiently

related to a trade or business or an income producing activity
is to allow expenses incurred in seeking a profit and disallow
personal expenses.

Chapter 7

C. Ordinary and Necessary

1. Ordinary

a) Typically, the "ordinary" condition has been used by

courts to deny deductions which were highly unusual in
nature or were capital expenditures.

b) One court denied a stock broker's deduction of premiums

paid on life insurance on the life of the President of the
U.S. where he believed the death would disrupt the stock

2. Necessary

a) Necessary implies that the expenses merely must be

"appropriate and helpful."

D. Reasonable in Amount

1. This requirement is applied to regulate expenses between

related parties.

2. The most common application is to deny a corporation's

compensation deduction for payments which are really
nondeductible dividends paid to the employee/shareholder.

E. Paid or Incurred During the Taxable Year

1. Cash Basis Taxpayers

a) General rule: Expenses are deductible in the tax year

when they are actually paid.

b) Exceptions:

(1) Cash basis taxpayer must use the accrual method

for computing sales and COGS if inventories are an
income-producing factor.

(2) Expenditures for assets with useful lives extending

substantially beyond the close of the taxable year
must be capitalized.

(a) In addition to fixed assets, this rule also

applies to prepayments for rent and
insurance that will not accrue within one
year of payment.

Chapter 7

(3) Prepaid interest must be capitalized and amortized

over the term of the loan.

(a) However, "points" paid when buying your

principal residence are currently deductible.

(4) Cash basis tax shelters cannot deduct

prepayments unless economic performance occurs
within 90 days after the close of the tax year.

c) When is payment "actually" made?

(1) Neither a promise to pay nor a promissory note is

considered payment.

(2) Payments made with borrowed funds are

deductible when paid.

(3) Expenses paid by credit card are deductible when

the charge is actually made and not when the bank
actually pays.

(4) When the taxpayer pays through the mail, payment

is usually considered made when the mailing

2. Accrual Basis Taxpayers

a) An accrual basis taxpayer deducts expenses when:

(1) The all events test is satisfied, and

(2) Economic performance has occurred.

b) The "all events test" requirements:

(1) All events establishing the existence of a liability

must have occurred, and

(2) The amount of the liability can be determined with

reasonable accuracy.

Chapter 7

c) Economic performance test

(1) This test is designed to prevent premature


(a) E.g., strip miners accruing the future cost of

restoring the land.

(2) When does economic performance occur?

(a) Liability to provide goods or services —

when goods or services are actually

(b) Liability to pay for services, goods, or the

use of property — when the taxpayer
receives services, goods, or uses the

(c) For certain liabilities, economic performance

occurs only when the liability is paid (i.e.,
cash basis is required):

(i) Refunds and rebates

(ii) Awards, prizes, and jackpots
(iii) Insurance premiums
(iv) Taxes

(3) Economic performance is not required for certain

recurring items. (See p. 7-16.)

d) Even accrual basis taxpayers must use the cash basis for
the following expenses:

(1) Charity contributions (except corporations)

(2) Medical expenses

F. Employee business expenses

1. An employee is in the trade or business of being an employee.

2. §162 applies to most employee business expenses.

Chapter 7

III. Deduction for Losses

A. §165 allows the deduction of losses:

1. Trade or business losses — Deduction FOR AGI

2. Income-producing activity losses — Deduction FOR AGI

3. Personal losses are deductible FROM AGI if caused by:

a) Fire

b) Storm

c) Shipwreck

d) Theft

e) "Other casualty"

Chapter 7

IV. Classification of Expenses

A. For or From AGI

1. Deductibility must be determined first.

2. §62 only indicates the proper classification of the item.

B. Importance of Distinction

1. Itemized deductions are deductible only if they exceed the

standard deduction.

2. The amount of other deductions is tied to AGI:

a) Miscellaneous itemized deductions are deductible only to

the extent they exceed 2% of AGI.

b) Medical expenses must exceed 7.5% of AGI.

c) Casualty losses must exceed 10% of AGI.

C. Deductions for AGI (pp. 7-21 and 7-22)

1. Trade or business expenses of the self-employed

2. Reimbursed employee business expenses

3. Losses from sales or exchanges of business or income-

producing property

4. Deductions attributable to rents or royalties

5. IRA or Keogh contributions

6. Alimony

7. Moving expenses

8. 50% of self-employment tax

9. 100% of medical insurance premiums

Chapter 7

D. Itemized Deductions (p. 7-22)

1. Medical expenses
2. Charitable contributions
3. Interest expense
4. Taxes
5. Casualty losses
6. Miscellaneous itemized deductions

E. Miscellaneous Itemized Deductions (pp. 7-22 and 7-23)

1. Unreimbursed employee business expenses

2. Investment expenses
3. Tax preparation and tax advice fees

F. Self-employed v. Employee

1. Test: Right to control performance of the job.

a) See list of factors on p. 7-25.

2. Tax consequence of classification:

a) If self-employed, all expenses of the trade or business are

deductible FOR AGI.

b) If an employee, only reimbursed expenses are deductible


(1) Most unreimbursed expenses are Miscellaneous

Itemized Deductions.

Do Problem #40

Chapter 7

V. Limitations on Deductions
A. Hobby Loss Rule

1. Overview

a) §183 provides that hobby expenses are deductible only to

the extent of hobby income.

b) However, §183 can be overcome if the taxpayer shows

conclusively that the activity is not a hobby.

2. Profit Motive

a) To prove an activity is not a hobby, the taxpayer must

show a bonafide intent to make a profit.

b) Factors to be considered in determining whether an

activity is a hobby are found in the regulations.
(See p. 7-26.)

3. Presumptive Rule

a) The burden of proof in hobby loss cases is shifted to the

IRS if the taxpayer's activity shows a profit in at least 3
out of 5 (2 out of 7 for horses) consecutive years.

4. Deduction Limitation

a) If the activity is considered to be a hobby, the treatment of

hobby expenses involves a three-step approach:

Gross hobby income

(Step 1) - "Otherwise allowable" deductions
Gross income limit
(Step 2) - Other expenses (except depr.)
Gross income limit
(Step 3) - Depreciation
Net income (cannot be < 0)

Chapter 7


deductions that are fully deductible as itemized
deductions, such as property taxes.


depreciation and amortization) are deductible as
miscellaneous itemized deductions, subject to the 2% of
AGI floor.

d) Depreciation and amortization, if allowable under the

hobby loss rules, are also deductible as miscellaneous
itemized deductions.
Do Problem #34

B. Personal Living Expenses

1. General rule: Income-producing expenses are deductible;

personal expenses are not.

2. Exceptions: The Code specifically allows the deduction of

some personal expenses, such as medical expenses, charitable
contributions, home mortgage interest, and property taxes.

C. Legal Expenses

1. Such expenses are NOT deductible if they arise because of a

PERSONAL matter.

a) The key is the ORIGIN of the dispute.

b) E.g., the legal costs of getting a divorce are typically

nondeductible except to the extent they are attributable to
tax advice.

2. Some legal fees may be CAPITAL expenditures.

a) E.g., costs of obtaining clear title to land.

Chapter 7

D. Capital Expenditures

1. Although an expenditure may be ordinary and necessary, it

cannot be deducted if it is a capital expenditure.

2. The obvious difference between capital expenditures and

normal business expenses is the timing of the deduction.

a) Business expenses are deducted immediately.

b) Capital expenditures are written off over time in the form

of depreciation, amortization, or depletion deductions.

3. The INDOPCO decision by the Supreme Court requires

taxpayers to capitalize expenditures that could produce “long-
term benefits” for the taxpayer.

E. Business Investigation Expenses

1. If taxpayer is in same trade or business: Deduct all expenses

2. If the taxpayer is investigating a new trade or business, the tax

treatment depends on whether the taxpayer enters the

a) Does not enter the business: Not deductible.

b) Enters the business:

(1) Deduct the first $5,000 of qualifying business start-

up expenses immediately, and amortize the excess
over a period of 180 months.

(2) If start-up expenses exceed $50,000, the initial year

$5,000 deduction is reduced, dollar-for-dollar, of
excess start-up expenses incurred.

(a) Thus, if start-up expenses exceed $55,000,

then the entire amount must be amortized
over 180 months.

3. Job seeking expenses in the same profession are deductible.

Chapter 7

F. Public Policy Restrictions

1. Fines and penalties paid for the violation of any law are not

2. Illegal kickbacks, bribes, etc. are not deductible.

3. Expenses of an illegal business occasionally are denied on

public policy grounds.

G. Lobbying Expenses and Political Contributions

1. Deductions are allowed for expenses of appearing before local

governmental units on legislative matters of direct interest to
the taxpayer's business.

2. Expenses incurred in connection with state and national

legislation are nondeductible.

3. Political contributions, whether direct or indirect, are


H. Expenses related to Tax-Exempt Income

1. Expenses related to exempt income other than interest

a) Deductions are disallowed.

b) E.g., education expenses paid with tax-free scholarship

funds are not deductible.

2. Interest income

a) Interest expense incurred to purchase or carry exempt

obligations is not deductible.

b) Investment-related expenses are not deductible when they

relate to tax-exempt interest.

Chapter 7

I. Related Party Transactions

1. Losses on sales between related parties

a) Loss is disallowed.

b) On subsequent disposition of the property, the previously

disallowed loss may be used to reduce any gain realized
on the transaction.
Do Problem #49

2. Unpaid expenses and interest to a related party

a) Where an accrual basis taxpayer makes a payment to a

related party who is on the cash basis, the expense is
deductible only when it is actually paid.

b) In effect, all accrual basis taxpayers are on the cash basis

for payments to related parties.
Do Problem #50

J. Payment of Another's Obligation

1. General rule: A taxpayer is not permitted to deduct the

payment of a deductible expense of another taxpayer.

2. Exception: Medical expenses of a dependent

a) For this purpose, the individual is treated as a dependent

even if the gross income test and t(e joint return test are
not satisfied.

K. Substantiation

1. Normally, documentary evidence (invoice, canceled check, etc.)

is required to prove the amount spent.

2. §274 imposes strict recordkeeping requirements for travel and

Do Problem #56

Chapter 8

Chapter 8
Employee Business Expenses

I. Introduction
A. Examine specific provisions governing certain deductions
common to employees and self-employed persons.

B. Topics considered

1. Education expenses

2. Moving expenses

3. Home office expenses

4. Transportation, travel, and entertainment expenses

II. Education Expenses

A. An individual must be employed or engaged in a trade or
business in order to deduct education expenses.

1. In order for education expenses to be deductible, the education

must be:

a) Required by the employer or by law, or

b) To maintain and/or improve existing skills.

2. Education expenses will not be deductible, however, if the


a) Is necessary to meet the minimum requirements of the

taxpayer's trade or business, or

b) Qualifies the taxpayer for a new trade or business.

Chapter 8

3. Classification of education expenses:

a) Deductions FOR AGI

(1) Only reimbursed expenses incurred by an

employee are deductible FOR AGI.

(2) All education expenses of a self-employed taxpayer

are deductible FOR AGI.

b) Deductions FROM AGI

(1) All unreimbursed education expenses, including

travel and transportation, are deductible FROM

(2) Since these expenses are classified as

are subject to the 2% of AGI floor.

c) The cost of meals incurred in connection with deductible

education expenses (whether deductible for or from AGI)
are only 50% deductible.
Do Problem #24

B. Deduction of Qualified Tuition

1. Qualified tuition and related expenses are deductible FOR


a) Only expenses paid to the educational institution as a

condition of enrollment are eligible for deduction.

2. Deduction amount is based on AGI:

a) $4,000 deduction
(1) MFJ: 0 — 130,000
(2) Single/Head of household: 0 — 65,000

b) $2,000 deduction
(1) MFJ: 130,001 — 160,000
(2) Single/Head of household: 65,001 — 80,000

c) No deduction
(1) MFJ: over 160,000
(2) Single/Head of household: over 80,000
(3) MFS over -0-

Chapter 8

3. No “double-dipping” allowed.

a) Expenses used to claim a Hope or Lifetime Learning

Credit cannot be deducted.

(1) Hope Credit

(a) Available only for the first 2 years of post-

secondary education

(b) Credit = 100% of the first $2,000 and 25%

of the next $2,000 of qualifying educational

(2) Lifetime Learning Credit

(a) Available in any tax year in which the Hope

Credit is NOT claimed.

(b) Credit: 20% of the first $10,000 of qualifying

educational expenses.

b) Expenses paid from tax-free sources, such as

scholarships, Coverdale (educational savings) accounts,
and §529 qualified tuition plans, are not deductible.

Chapter 8

III. Moving Expenses

A. Rationale for allowing a moving expense deduction as a

1. Encourage the mobility of labor.

2. If taxpayer moves to take a higher-paying job, this will result

in increased revenue for the government.

B. To deduct moving expenses, the taxpayer must be either a:

1. New employee;
2. Transferred employee; or
3. Self-employed person

C. Moving Expenses

1. Moving expenses will be deductible FOR AGI.

2. Moving Expense Tests:

a) Distance test:

Distance from Distance from

to NEW JOB plus 50 miles

b) Time test:

(1) EMPLOYEE must work full-time 39 weeks out of

first 52 weeks.

(2) SELF-EMPLOYED PERSON must work full-time:

(a) 39 weeks out of first 52 weeks, and

(b) 78 weeks in 2 years.

Chapter 8

3. Moving Expense Computation

a) Only DIRECT moving expenses will be deductible:

(1) Moving household and personal belongings

(a) Must be reasonable in amount.

(2) Travel to new residence

(a) Actual expenses, or

(b) 16.5 cents/mile (for 2010)

b) Meal expenses incurred during a move will NOT be

Do Problem #25

Chapter 8

IV. Home Office Expenses

A. Office in home expenses cannot be deducted unless the office
is used EXCLUSIVELY and REGULARLY for one of three
business purposes: (See p. 8-14)

1. As the principal place of business for any business of the


a) The Soliman test:

(1) To satisfy this test, the home office must be the

MOST IMPORTANT place of business.

(2) Factors to be considered:

(a) The relative importance of the functions

performed at each of the business locations,

(b) The amount of time spent at each location.

b) The 1997 amendment:

(1) Office must be used to conduct administrative and

management activities of a trade or business, and

(2) There is no other fixed location of the trade or

business where the taxpayer conducts substantial
administrative and management activities of the
trade or business.

2. As a place of business which is used regularly by patients, etc.

in meeting or dealing with the taxpayer in the normal course of
his trade or business, OR

3. In connection with the taxpayer's trade or business if the office

is located in a separate structure.

B. In addition, employees must also show that the use of the

office in the home is for the convenience of the employer.

Chapter 8

C. Daycare and Storage Use of Home

1. The exclusive use test is not applied when a portion of the

taxpayer's home is used:
a) To provide daycare services, or
b) To store inventory and product samples.

D. If office in home expenses meet the test described above and

are therefore deductible, the deductions are limited to the
income generated by the business.

1. Home office expenses are offset against home office income in

the following order:

a) Offset allocable portion of "expenses otherwise

deductible," such as property taxes, interest, and direct
business expenses (e.g., depreciation, supplies)

(1) If self-employed, these expenses are deductible on

Schedule C.

(2) If an employee:

(a) Property taxes and mortgage interest are

deductible in full as itemized deductions.

(b) Direct business expenses are classified as

miscellaneous itemized deductions.

b) Offset allocable portion of all other home office expenses.

(1) If self-employed, these expenses are deductible on

Schedule C.

(2) If an employee, these expenses are miscellaneous

itemized deductions subject to the 2% of AGI floor.

c) Offset depreciation on the portion of the home that

qualifies as a home office.

2. Remember home office expense deductions cannot exceed

gross income from the business activity.

Chapter 8

E. Carryover of unused deductions.

1. Any home office expenses that are not deducted because of the
gross income limitation can be carried forward and offset
against home office income in future years.
Do Problem #26

Do Problem #28

V. Transportation Expenses
A. Distinction between Transportation and Travel

1. Transportation expenses — transportation in the course of

business while NOT in TRAVEL STATUS.

2. Travel expenses — transportation, meals, lodging, laundry,

telephone, etc. while AWAY FROM HOME OVERNIGHT in
the course of business.

B. Transportation v. Commuting

1. General rule: Commuting expenses are not deductible,

because they are the result of a personal decision as to where
one wishes to reside.

2. Exceptions:

a) Commuting with Tools, Etc.

(1) Only the ADDITIONAL expenses attributable to

carrying the tools are deductible.

(2) IRS uses the "same mode" test to determine

whether any additional expenses are incurred:

Cost of commuting by one mode with tools

- Cost of commuting by same mode w/o tools
Additional, deductible costs

b) Commuting between Two Jobs

(1) The cost of commuting directly from one job to

another is deductible.

Chapter 8

c) Commuting to a Temporary Assignment

(1) The taxpayer may deduct transportation costs from

home to a business location and back home again,
provided 2 requirements are met.

(2) Requirements:

(a) Must be a temporary assignment.

(i) Taxpayer anticipates termination; job

duration not indefinite.

(ii) IRS: Not temporary if job is expected to

last more than 1 year.

(b) Job site must be beyond the general area of

the taxpayer's tax home.

d) Transportation between job sites

(1) Transportation between the taxpayer’s home and

his first and last job sites is non-deductible

(2) But, once the taxpayer arrives at the first job site,
subsequent transportation costs are deductible.

Chapter 8

C. Computing Car Expenses

1. Actual Expenses

a) Deduction = Actual expenditures x business use %

b) Expenditures include gas, oil, repairs, insurance, taxes,

depreciation (subject to limits), licenses, etc.

2. Standard Mileage Rate

a) The standard mileage rate approximates the costs for gas,

oil, repairs, insurance, and depreciation.

b) The business portion of expenses for taxes, parking, and

tolls also are deductible.

c) 2010 Rate: 50 cents per mile for all business miles.

3. Switching Methods

a) Use of the Actual Expenses method in the first year

prevents the taxpayer from ever using the Standard
Mileage Rate on that car.

b) The taxpayer can switch from the Automatic Mileage

method to the Actual Expenses method.

(1) However, the car cannot be depreciated using

MACRS rules.

(2) Instead, depreciation must be determined using the

"facts and circumstances" method (i.e., the method
used in financial accounting.)

Do Problem #36

Chapter 8

VI. Travel Expenses

A. Treatment of Travel Expenses

1. Deductible FOR AGI

a) Trade or business travel

b) REIMBURSED employee business travel
c) Travel related to production of rents and royalties

2. Deductible FROM AGI (Misc. Item. Ded. — 2% of AGI)

a) Unreimbursed employee travel

b) Travel related to income-producing activities, other than

rents and royalties

B. The "Away from Home" Test

1. For travel expenses to be deductible, the taxpayer must be

away from his TAX HOME; and

2. The taxpayer must be away from home OVERNIGHT.

C. Combined Business and Pleasure Travel

1. Domestic Travel


the travel expenses are fully deductible.

b) If the trip is primarily for personal purposes, only those

travel expenses directly related to business upon arrival at
the destination are deductible.

2. Travel Expense of Spouses and Dependents are not deductible


a) The individual is an employee of the person paying the

travel expenses;

b) The individual has a bonafide business purpose for

making the trip; and

c) The expenses are otherwise deductible.

Chapter 8

3. Foreign Travel — omit.

Do Problem #35 (Use
Form 2106 for part a.)

VII. Entertainment Expenses

A. All entertainment expenses, including business meals, must
be either:

1. Directly-Related Expenses — those which are incurred in an

actual meeting or discussion in a clear business setting; or

2. Associated-With Expenses—those which are incurred

immediately BEFORE or immediately AFTER a bonafide
business discussion and serve a specific business purpose, such
as obtaining new business or maintaining goodwill.

B. Deduction Limitation on Meals and Entertainment

1. General rule: The deduction for meals and entertainment is

limited to 50% of the total, qualifying expenditures.

2. Exceptions:

a) Reimbursed expenses

(1) When the taxpayer is reimbursed for meals or

entertainment, the limitation is imposed on the party
making the reimbursement, not the taxpayer
receiving the reimbursement.

b) Excludable fringe benefit

(1) The 50% rule does not apply when the food or
beverage provided is excludable as a de minimus
employee fringe benefit (e.g., holiday turkeys given
to employees or subsidized cafeterias).

Chapter 8

c) §274(e) exceptions

(1) Food and drink furnished on the business premises

primarily for employees (e.g., costs of a holiday
office party).

(2) Recreational or social activities, including facilities

primarily for employees (e.g., a summer golf outing
or a company health club).

(3) Entertainment and meals that the employee reports

as compensation (e.g., a company-provided

(4) Entertainment and meals at business meetings of

employees, stockholders, and directors (e.g.,
refreshments at a staff meeting).

(5) Costs of items made available to the general public

(e.g., soft drinks at a grand opening).

(6) Costs of entertainment and meals sold to the


d) Meals provided to employees on the employer’s premises

for the convenience of the employer (§119 exclusion) are
fully deductible.

C. Business Gifts

1. General rule:

a) Deduction is limited to $25 per year per person

b) It’s unclear whether the 50% rule applies to gifts.

2. Exceptions — the $25 limit does not apply to:

a) Advertising giveaways valued at less than $4 where name

is imprinted.

b) Point of purchase advertising (e.g., signs and promotional

material used at the recipient’s place of business).

Chapter 8

D. Entertainment Facilities

1. General rule

a) No deduction for expenses related to any property you

own, rent, or use for entertainment.

b) E.g., rent, maintenance, utilities, or depreciation of yacht,

hunting lodge, or swimming pool; or dues paid to a social
or athletic club.

2. Exception:

a) The cost of entertainment facilities provided primarily for

employees is fully deductible.

(1) E.g., the employee facilities at Eastman.

Do Problem #38

VIII. Travel and Entertainment Recordkeeping Requirements

A. General rules:

1. "No deduction is allowable unless the taxpayer substantiates

by adequate records or by sufficient evidence corroborating his
own statement."

2. "No deduction allowed on the basis of approximation or

taxpayer's unsupported testimony, no matter how reasonable
or credible."

B. Elements to be substantiated

1. Receipt for lodging and other expenses of $75 or more

2. Time

3. Place

4. Business purpose (unless evident from surrounding facts)

5. Business relationship (for entertainment only)

Chapter 8

IX. Reporting Requirements for Reimbursed Employee

A. Accountable and Nonaccountable Plans (see p. 8-49)

1. Employee business expenses are considered to be reimbursed

only if the reimbursement or allowance system qualifies as an

2. To be an accountable plan, the employee must substantiate

expenses to the employer and, in the case of advances and
allowances, must return to the employer any amount in excess
of that which is substantiated.

a) An employee whose reimbursement is based on a fixed

allowance (e.g., a per diem for meals and lodging or a
mileage allowance) is deemed to have substantiated the
amount of his expenses up to the amount set by the IRS
for per diem, mileage, or other expense allowances.

b) Due to this rule, employees who receive allowances within

the IRS guidelines will have no reimbursements in excess
of their substantiated expenses, and, therefore, will not
have any excess to return.

3. If the arrangement does not meet the accountable plan

requirements, it is considered to be a nonaccountable plan.

B. Reimbursements Made Under Accountable Plans

1. Excluded from gross income.

2. Not reported on the employee’s Form W-2.

3. Exempt from employment taxes (e.g., FICA and

unemployment taxes)

4. Since the reimbursement is excluded from gross income, the

expense does not need to be reported. The expenses are
effectively deducted FOR AGI.

Chapter 8

C. Reimbursements Made Under Nonaccountable Plans

1. Must be reported in the employee’s gross income.

2. Must be included on Form W-2.

3. Subject to employment taxes.

4. The expenses are reported and deducted as miscellaneous

itemized deductions.

D. Form 2106

1. Under either plan, employee business expenses to be reported

are summarized on Form 2106.

2. When this form is properly completed, the unreimbursed

employee business expenses flow to Schedule A and are
deducted as miscellaneous itemized deductions.

E. Partial Reimbursements

1. If reimbursement does not cover all deductible business

expenses, the reimbursement must be allocated between the
expenses subject to the 50% limit and all other employee
business expenses.

2. Formula for allocating reimbursement to meals and

entertainment expenses:

Meals & entertainment expenses

—————————————— x Reimbursement
Total employee expenses

3. Example:

a) Problem: Employee incurs $3,000 of meal and

entertainment expenses and $7,000 of other expenses.
The employee receives only $8,000 in reimbursement of
these expenses.

b) Solution: $2,400 of the reimbursement is allocable to the

meals and entertainment, and the remaining $5,600 of
reimbursement is allocated to the other employee business

Form 2106 Employee Business Expenses
OMB No. 1545-0074

See separate instructions.
Department of the Treasury Attachment
Internal Revenue Service (99) a Attach to Form 1040 or Form 1040NR. Sequence No. 129
Your name Occupation in which you incurred expenses Social security number

Part I

o f
Employee Business Expenses and Reimbursements

Column A Column B
Step 1 Enter Your Expenses Other Than Meals Meals and

a 0
and Entertainment Entertainment

a f t 0 1
1 Vehicle expense from line 22 or line 29. (Rural mail carriers: See
instructions.) . . . . . . . . . . . . . . . . . . 1

r 2
2 Parking fees, tolls, and transportation, including train, bus, etc., that

did not involve overnight travel or commuting to and from work . 2

D /16
3 Travel expense while away from home overnight, including lodging,
airplane, car rental, etc. Do not include meals and entertainment . 3
4 Business expenses not included on lines 1 through 3. Do not include
meals and entertainment . . . . . . . . . . . . . . 4

0 6
5 Meals and entertainment expenses (see instructions) . . . . .
6 Total expenses. In Column A, add lines 1 through 4 and enter the
result. In Column B, enter the amount from line 5 . . . . . .

Note: If you were not reimbursed for any expenses in Step 1, skip line 7 and enter the amount from line 6 on line 8.

Step 2 Enter Reimbursements Received From Your Employer for Expenses Listed in Step 1

7 Enter reimbursements received from your employer that were not

reported to you in box 1 of Form W-2. Include any reimbursements
reported under code “L” in box 12 of your Form W-2 (see
instructions) . . . . . . . . . . . . . . . . . . . 7

Step 3 Figure Expenses To Deduct on Schedule A (Form 1040 or Form 1040NR)

8 Subtract line 7 from line 6. If zero or less, enter -0-. However, if line 7
is greater than line 6 in Column A, report the excess as income on
Form 1040, line 7 (or on Form 1040NR, line 8) . . . . . . . 8

Note: If both columns of line 8 are zero, you cannot deduct

employee business expenses. Stop here and attach Form 2106 to
your return.

9 In Column A, enter the amount from line 8. In Column B, multiply line

8 by 50% (.50). (Employees subject to Department of Transportation
(DOT) hours of service limits: Multiply meal expenses incurred while
away from home on business by 80% (.80) instead of 50%. For
details, see instructions.) . . . . . . . . . . . . . . 9
10 Add the amounts on line 9 of both columns and enter the total here. Also, enter the total on
Schedule A (Form 1040), line 21 (or on Schedule A (Form 1040NR), line 9). (Armed Forces
reservists, qualified performing artists, fee-basis state or local government officials, and individuals
with disabilities: See the instructions for special rules on where to enter the total.) . . . . . a
For Paperwork Reduction Act Notice, see instructions. Cat. No. 11700N Form 2106 (2010)
Form 2106 (2010) Page 2
Part II Vehicle Expenses
Section A—General Information (You must complete this section if you
(a) Vehicle 1 (b) Vehicle 2
are claiming vehicle expenses.)
11 Enter the date the vehicle was placed in service . . . . . . . . . 11 / / / /
Total miles the vehicle was driven during 2010

o f . . . . . . . .
Business miles included on line 12 . . . . . . . . . . . .
Percent of business use. Divide line 13 by line 12 . . . . . . . .

15 Average daily roundtrip commuting distance . . . . . . . . . . 15 miles miles
16 Commuting miles included on line 12 . . . . . . . . . . . . . 16 miles miles

f t a 1 0
Other miles. Add lines 13 and 16 and subtract the total from line 12
Was your vehicle available for personal use during off-duty hours? . .

Do you (or your spouse) have another vehicle available for personal use?
. . .
. . .

20 Do you have evidence to support your deduction? . . . . . . . . . . . . . . . . . . Yes No

r a /2
If “Yes,” is the evidence written? . . . . . . . . . . . . . . . . . . . . . . . .
Section B—Standard Mileage Rate (See the instructions for Part II to find out whether to complete this section or Section C.)
Yes No

D /16
22 Multiply line 13 by 50¢ (.50). Enter the result here and on line 1 . . . . . . . . . . . . 22
Section C—Actual Expenses (a) Vehicle 1 (b) Vehicle 2
23 Gasoline, oil, repairs, vehicle
insurance, etc. . . . . . . 23

24a Vehicle rentals . . . . . . 24a

b Inclusion amount (see instructions) . 24b
c Subtract line 24b from line 24a . 24c
25 Value of employer-provided vehicle
(applies only if 100% of annual
lease value was included on Form
W-2—see instructions) . . . . 25
26 Add lines 23, 24c, and 25. . . 26
27 Multiply line 26 by the percentage
on line 14 . . . . . . . . 27
28 Depreciation (see instructions) . 28
29 Add lines 27 and 28. Enter total
here and on line 1 . . . . . 29
Section D—Depreciation of Vehicles (Use this section only if you owned the vehicle and are completing Section C for the vehicle.)
(a) Vehicle 1 (b) Vehicle 2
30 Enter cost or other basis (see
instructions) . . . . . . . 30
31 Enter section 179 deduction (see
instructions) . . . . . . . 31
32 Multiply line 30 by line 14 (see
instructions if you claimed the
section 179 deduction or special
allowance). . . . . . . . 32
33 Enter depreciation method and
percentage (see instructions) . 33
34 Multiply line 32 by the percentage
on line 33 (see instructions) . . 34
35 Add lines 31 and 34 . . . . 35
36 Enter the applicable limit explained
in the line 36 instructions . . . 36
37 Multiply line 36 by the percentage
on line 14 . . . . . . . . 37
38 Enter the smaller of line 35 or line
37. If you skipped lines 36 and 37,
enter the amount from line 35.
Also enter this amount on line 28
above . . . . . . . . .
Form 2106 (2010)
Chapter 9

Chapter 9
Capital Recovery

I. Introduction
A. Concept of Capital Recovery

1. Income doesn't occur until the taxpayer recovers the cost of

producing income.

2. Matching concept: the cost of assets providing indirect

benefits, such as equipment, is allocated to the periods

B. Cost Allocation Methods

1. Depreciation — tangible assets

2. Amortization — intangible assets

3. Depletion — natural resources

II. Depreciation and Amortization for Tax Purposes

A. General Rules for Depreciation Deductions

1. Requirements

a) Property must be used in a trade or business or be held

for the production of income to qualify for depreciation or
cost recovery.

b) When a single asset is used for both profit seeking

purposes and personal purposes, only the portion
attributable to business or income-producing activities
may be depreciated.

c) Property that has no determinable life may not be

depreciated or amortized (e.g., land)

Chapter 9

2. Conversion of Personal Use Property to Business Use

a) When personal use property is converted to business or

production of income use, the basis for depreciation is the

(1) FMV at date of conversion, or

(2) Adjusted basis at date of conversion.

3. Adjustment to Basis

a) Depreciation or cost recovery reduces an asset's basis by

the amount ALLOWED or ALLOWABLE.
Do Problem #27

III. Modified Accelerated Cost Recovery System (MACRS)

A. Background

1. The original ACRS system was in effect from 1981-1986.

a) Property placed into service during those years continue

to be depreciated using the ACRS rules in effect at that

2. The TRA 86 radically changed the cost recovery rules for

property placed into effect after 1986.

a) To distinguish the two cost recovery systems, practitioners

often refer to the new rules as MACRS (Modified ACRS).

Chapter 9

B. Property subject to MACRS

1. All TANGIBLE property that is depreciable and placed into

service after 1986 is recovery property.

2. Property not eligible for MACRS treatment:

a) Property owned or used by the taxpayer or a related party

before 1987.

b) Intangible property such as copyrights or patents.

c) Property not depreciated in terms of years.

(1) E.g., units-of-production method.

(2) If the taxpayer has used the automatic mileage

method, he cannot use MACRS for that vehicle.

3. MACRS is mandatory for all qualifying property.

C. Classification of Property and Recovery Percentages

1. See Exhibits on pp. 9-8 and 9-9.

2. Personal property

a) In general, personal property will fall into one of 6

(1) 3-year property
(2) 5-year property
(3) 7-year property
(4) 10-year property
(5) 15-year property
(6) 20-year property

b) As the chart indicates, an asset's MACRS classification is

described in Rev. Proc. 87-56.

(1) There are a few assets that are specifically

assigned to a particular class, such as cars and
light trucks which are assigned to the 5-year class.

Chapter 9

3. Real Property

a) In contrast to the variety of property classes for personal

property, real property (buildings) will fall into one of
three classes:

(1) Residential rental property has a 27.5 year

recovery period.

(2) Nonresidential property placed in service before

May 13, 1993 has a 31.5 year recovery period.

(3) Nonresidential property placed into service on or

after May 13, 1993 has a 39 year recovery period.

b) All real property will be depreciated using the straight-

line method.

D. Calculating Depreciation

1. The computation of MACRS deductions requires the

knowledge of three factors:
a) Recovery period
b) Depreciation method, and
c) Accounting convention

2. Recovery Period

a) As previously discussed, the recovery period of an asset

usually is based on its class life.

b) See examples on p. 9-10.

3. Depreciation Methods

a) Personal property

(1) MACRS provides for either 200% DB or 150% DB

for personal property.

(2) However, the taxpayer also has the option of

depreciating such assets using straight-line depr.

b) Real property — only the S/L method is used.

Chapter 9

4. Accounting Conventions

a) Personal property

(1) Half-year convention

(a) When the half-year convention is in effect,

the taxpayer receives one-half year's
depreciation in the year of acquisition

(b) Similarly, one-half year's depreciation also

is permitted in the year of sale or other

(2) Mid-quarter convention

(a) If more than 40% of the aggregate bases of

all personal property placed into service
during the last 3 months of the year, the
MID-QUARTER rules will apply.

(b) When the mid-quarter convention applies,

the depreciation deductions for the year of
acquisition and the year of sale or other
disposition will be calculated in a special

(i) Year of Acquisition

(a) Depreciate beginning at the

middle of the calendar quarter
during which the asset was
placed into service and ending
on the last day of the tax year.

(ii) Year of Disposition

(a) If an asset uses the mid-quarter

convention, the convention must
be used in year of disposition,

(b) Depreciate the asset beginning

at the start of the taxable year
and ending at the middle of the
calendar quarter during which
the asset was sold.

Chapter 9

b) Real property

(1) Mid-month convention

(a) As the name implies, the mid-month

convention allows the taxpayer to deduct
one-half month's depreciation for the month
during which the asset was placed into

(b) It also permits one-half month's depreciation

for the month of sale or other disposition.

5. MACRS Tables

a) In Appendix C, the author has provided official tables

which implement the three necessary factors: Recovery
period, Depreciation method, and Accounting convention.

b) Personal Property

(1) Half-year convention

(2) Mid-quarter convention

c) Real Property

(1) Mid-month convention

d) These tables are very easy to use. The amounts in the

columns represent percentages of the original cost
recovery basis of an asset.

(1) In most cases, the depreciation computation

involves multiplying the cost of an asset by the
appropriate percentage for each recovery year.

(2) Of course, if the asset is sold before it is fully

depreciated, an adjustment based on the
appropriate accounting convention will be required
for the final depreciation amount.

Do Problem #28

Chapter 9

E. Straight-Line Methods

1. If a taxpayer does not wish to use the accelerated depreciation

methods previously discussed for depreciating personal
property, the taxpayer may elect to use either the MACRS
Straight-line method or the Alternative Depreciation System
for newly-acquired assets.

2. MACRS Straight-Line

a) If elected, the MACRS straight-line method permits the

deduction of straight-line depreciation over the asset's
regular recovery period.

b) The election, which is available each tax year, applies to


(1) In other words, the straight-line election is available

annually on a class-by-class basis.

c) The applicable accounting convention (half-year or mid-

quarter) must be implemented even though the straight-
line method is used.

Do Problem #30

3. Alternative Depreciation System

a) The ADS is very similar to the MACRS Straight-line

method. The only significant difference, as illustrated on
p. 9-20, is that the recovery period usually is much longer
than under MACRS.

b) This method is not likely to be elected by many taxpayers

because the depreciation method is so slow.

c) The ADS is not elective in certain situations, such as the

alternative minimum tax computation. In those special
situations, the ADS is the ONLY method permitted.

Do Problem #31

Chapter 9

F. Limited Expensing Election

1. To provide the small business with some relief from tedious

depreciation records, Congress enacted §179 which gives
taxpayers the choice of expensing the cost of qualifying property in
the year of acquisition, rather than capitalizing and depreciating the
cost of the asset.

2. General Rule:

a) §179 expense is limited to $250,000 for 2010.

b) This limit is adjusted annually for inflation.

3. Limits:

a) The $800,000 limit

(1) If the total cost of qualifying property acquired by a

taxpayer exceeds $800,000, the $125,000 limit is
reduced on a dollar-for-dollar basis.

(2) Thus, if $1,050,000 of qualifying assets are

acquired during a tax year, the §179 expensing
election is not available.

b) The taxable income limit

(1) The amount of a taxpayer's §179 expense

deduction cannot exceed the combined amounts of
taxable income from ALL TRADES OR
BUSINESSES actively conducted by the taxpayer
during the current tax year.

(2) Any §179 expense that is disallowed by the taxable

income limitation may be carried forward and
treated as a qualifying §179 acquisition in a
subsequent year.

c) The SUV limit

(1) The §179 expense deduction for SUVs (between

6,000 and 14,000 pounds) is limited to $25,000.

Chapter 9

4. If a portion of the cost of an asset is deducted under §179, that

asset's cost recovery basis (adjusted basis) is reduced by the
amount expensed.

a) Only the remaining basis in the asset is eligible for

regular MACRS depreciation.

5. Under §179, "Eligible Property" must be:

a) Recovery property,
b) Must not be a building,
c) Used in a trade or business, and
d) Must not be acquired from a "related party."

e) Note: property held for the production of income is NOT

eligible for §179 treatment.

6. Recapture of §179 expense

a) If property that has been expensed under §179 is

converted to nonbusiness use AT ANY TIME, the
taxpayer must recapture the §179 expense to which he is
not entitled.

b) The amount to be recaptured (ie., taken into income) is

the excess of the §179 and MACRS deductions actually
taken over the amount of MACRS deductions that would
have been allowed for the asset.

Do Problem #34

Do Problem #35
(use Form 4562)

G. Bonus Depreciation – omit

Chapter 9

H. Limitations for Automobiles

1. For passenger autos placed into service in 2010:

a) The maximum depreciation (including §179 expense)

deduction available is:

(1) 3,060 — First year

(2) 4,900 — Second year
(3) 2,950 — Third year
(4) 1,775 — Subsequent years

b) Furthermore, since these limits include amounts deducted

under §179, the use of the §179 election is virtually
useless for all but the cheapest autos.

2. These limits are adjusted for inflation. See p. 9-29 for prior
year limits.
Do Problem #12

Do Problem #37

I. Automobile Leasing

1. Lease payments for an automobile used in business or in an

income-producing activity are deductible.

2. However, to prevent the use of leases to circumvent the limits

on auto depreciation, the taxpayer who deducts lease payments
also must include in income an amount based on:

a) The car’s FMV (see the table on p. 9-32),

b) The portion of the tax year the lease was in effect, and

c) The percentage of business and investment use.

3. See Example 22, p. 9-31.

Chapter 9

J. Limitations for Personal Use

1. If "listed property" is not used more than 50% of the time for
Trade or Business purposes in the year of acquisition, several
tax benefits are lost or restricted:

a) No §179 expense election

b) Depreciation must be calculated using the Alternative

Depreciation System.

c) See flowchart on p. 9-35.

2. Listed Property (See pp. 9-34 and 9-35)

a) Passenger autos

b) Other vehicles used for transportation

c) Entertainment property

d) Computers and peripherals, unless used exclusively at a

regular business establishment.

e) Cell phones

3. Qualified Business Use

a) Only TRADE OR BUSINESS use is considered in

determining whether the "listed property" is used
PREDOMINATELY for business.

b) Employee use of listed property is not considered business

use, unless it is:

(1) For the convenience of the employer, and

(2) Required as a condition of employment.

c) Once it has been determined whether or not "listed

property" has been put to a "qualified business use,"
ALL USAGE for the production of income AND for trade
or business purposes is included in determining the
percentage of the asset which may be depreciated.

Chapter 9

4. Employer-Provided Cars

a) When an employee uses an automobile, the EMPLOYER

can depreciate the ENTIRE cost of the automobile (i.e.,
qualify for 100% business use) in any of the following

(1) Full Inclusion Method — The employee's actual use

is disregarded, and the employee must include
100% of the value of the car's use in income.

(a) Employee can deduct any substantiated

business use as a miscellaneous itemized

(2) Partial Inclusion Method — Only the employee's

personal use of the company car is included in

(a) Employer must be able to substantiate the

employee's business use.

(b) Employee can deduct any substantiated

business use as a miscellaneous itemized

(3) Rental Reimbursement Method — Employee

reimburses the employer for personal use.

b) Five Percent Owner Rule

(1) If the car is used by an employee who is also a 5%

owner of the business, the business must compute
depreciation based on the employee-owner's actual
business use.

c) Methods of Valuing the Car's Use

(1) Facts and circumstances method

(2) Lease value table in Regulations ) Safe

) Harbors
(3) Standard mileage allowance )

Chapter 9

5. §179 Recapture Provisions

a) If the 50% test is satisfied in the first year of an asset's

use but is failed in a subsequent year before fully
depreciated, the taxpayer must recompute depreciation for
the prior years using ADS.

b) The excess of the MACRS deductions claimed, over those

available using ADS, are included in income in the tax
year during which the 50% test is failed.

c) Depreciation in future years is computed using ADS.

6. Recordkeeping Requirements for Listed Property

a) The substantiation rules for travel and entertainment also

apply to the use of listed property.

b) Items to be substantiated:

(1) The cost of acquisition, maintenance, and repair.

(2) The date of the use of the property.

(3) The amount of each business or investment usage,

along with total usage.

(4) The purpose of the use of the property.

Chapter 9

IV. Amortization
A. General rules

1. Not recovery property

2. Must have limited life

3. Amortized using the straight-line method over the estimated

useful life

B. Goodwill and Covenants Not to Compete

1. General Rules:

a) Goodwill cannot be amortized.

b) Covenants can be amortized on a straight-line basis over

the life of the covenant.

2. Exception: Goodwill and Covenants acquired after August 10,

1993 can be amortized over 15 years.

C. Leasehold Improvements

1. For leasehold improvements made after 1986, the tenant must

depreciate the improvements using the regular MACRS rules.

2. The lease term is no longer relevant to the computation.

Chapter 9

V. Depletion
A. Compute the depletion using either cost or percentage
depletion method and deduct the higher amount.

B. Cost Depletion

1. Taxpayer is allowed to deduct a portion of his adjusted basis in

the property as each unit is sold.

2. Formula:

Annual Unrecovered basis Units

cost = ——————————— x SOLD
depletion Estimated recoverable units in yr

3. Using cost depletion, the total depletion deductions never will

exceed the taxpayer's basis.

C. Percentage Depletion

1. To compute percentage depletion, a statutory percentage (see

p. 9-45) is multiplied by the GROSS INCOME earned from the

a) Formula:

Statutory % x gross income = % depletion

b) The percentage depletion deduction is limited to:

(1) 50% of the taxpayer's taxable income from mineral

properties (e.g., coal mines), or

(2) 100% of the taxpayer's taxable income from oil and

gas properties.

2. Since percentage depletion is computed without reference to

the taxpayer's adjusted basis, it is possible for a taxpayer's
depletion deductions using percentage depletion to exceed the
taxpayer's adjusted basis in the property.

Do Problem #41

OMB No. 1545-0172
Form 4562 Depreciation and Amortization
(Including Information on Listed Property) 2010
Department of the Treasury Attachment
Internal Revenue Service (99) a See separate instructions. a Attach to your tax return. Sequence No. 67
Name(s) shown on return Business or activity to which this form relates Identifying number

Part I

o f
Election To Expense Certain Property Under Section 179
Note: If you have any listed property, complete Part V before you complete Part I.

1 Maximum amount. See the instructions for a higher limit for certain businesses . . . . . . . . 1 $250,000
2 Total cost of section 179 property placed in service (see instructions) . . . . . . . . . . . 2

t a 0
Threshold cost of section 179 property before reduction in limitation (see instructions) .
Reduction in limitation. Subtract line 3 from line 2. If zero or less, enter -0- . . . . .

f 1
Dollar limitation for tax year. Subtract line 4 from line 1. If zero or less, enter -0-. If
. . .
. . .
. .
. .

separately, see instructions . . . . . . . . . . . . . . . . . . . . . . . . . 5

r a
(a) Description of property

(b) Cost (business use only) (c) Elected cost

D /21
7 Listed property. Enter the amount from line 29 . . . . . . . . .
8 Total elected cost of section 179 property. Add amounts in column (c), lines 6 and 7
9 Tentative deduction. Enter the smaller of line 5 or line 8

. . . . . . . . . . . . . . .
. . . . . . 8

10 Carryover of disallowed deduction from line 13 of your 2009 Form 4562 . . . . . . . . . . . 10

11 Business income limitation. Enter the smaller of business income (not less than zero) or line 5 (see instructions) 11
12 Section 179 expense deduction. Add lines 9 and 10, but do not enter more than line 11 . . . . . 12
13 Carryover of disallowed deduction to 2011. Add lines 9 and 10, less line 12 a 13
Note: Do not use Part II or Part III below for listed property. Instead, use Part V.
Part II Special Depreciation Allowance and Other Depreciation (Do not include listed property.) (See instructions.)
14 Special depreciation allowance for qualified property (other than listed property) placed in service
during the tax year (see instructions) . . . . . . . . . . . . . . . . . . . . . . 14
15 Property subject to section 168(f)(1) election . . . . . . . . . . . . . . . . . . . . 15
16 Other depreciation (including ACRS) . . . . . . . . . . . . . . . . . . . . . . 16
Part III MACRS Depreciation (Do not include listed property.) (See instructions.)
Section A
17 MACRS deductions for assets placed in service in tax years beginning before 2010 . . . . . . . 17
18 If you are electing to group any assets placed in service during the tax year into one or more general
asset accounts, check here . . . . . . . . . . . . . . . . . . . . a
Section B—Assets Placed in Service During 2010 Tax Year Using the General Depreciation System
(b) Month and year (c) Basis for depreciation
(d) Recovery
(a) Classification of property placed in (business/investment use (e) Convention (f) Method (g) Depreciation deduction
service only—see instructions)
19a 3-year property
b 5-year property
c 7-year property
d 10-year property
e 15-year property
f 20-year property
g 25-year property 25 yrs. S/L
h Residential rental 27.5 yrs. MM S/L
property 27.5 yrs. MM S/L
i Nonresidential real 39 yrs. MM S/L
property MM S/L
Section C—Assets Placed in Service During 2010 Tax Year Using the Alternative Depreciation System
20a Class life S/L
b 12-year 12 yrs. S/L
c 40-year 40 yrs. MM S/L
Part IV Summary (See instructions.)
21 Listed property. Enter amount from line 28 . . . . . . . . . . . . . . . . . . . . 21
22 Total. Add amounts from line 12, lines 14 through 17, lines 19 and 20 in column (g), and line 21. Enter here
and on the appropriate lines of your return. Partnerships and S corporations—see instructions . . . . . 22
23 For assets shown above and placed in service during the current year, enter the
portion of the basis attributable to section 263A costs . . . . . . . 23
For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 12906N Form 4562 (2010)
Form 4562 (2010) Page 2
Part V Listed Property (Include automobiles, certain other vehicles, cellular telephones, certain computers, and
property used for entertainment, recreation, or amusement.)
Note: For any vehicle for which you are using the standard mileage rate or deducting lease expense, complete only 24a,
24b, columns (a) through (c) of Section A, all of Section B, and Section C if applicable.

(a) (b)

(d) f
Section A—Depreciation and Other Information (Caution: See the instructions for limits for passenger automobiles.)
24a Do you have evidence to support the business/investment use claimed? Yes No 24b If “Yes,” is the evidence written?
Basis for depreciation
(g) (h) (i)

Type of property (list Date placed Recovery Method/ Depreciation Elected section 179
investment use Cost or other basis (business/investment
vehicles first) in service period Convention deduction cost
percentage use only)

a 0
25 Special depreciation allowance for qualified listed property placed in service during

the tax year and used more than 50% in a qualified business use (see instructions) .

26 Property used more than 50% in a qualified business use:



r a /2
D /21
27 Property used 50% or less in a qualified business use:
% S/L –
% S/L –
% S/L –

28 Add amounts in column (h), lines 25 through 27. Enter here and on line 21, page 1 . 28

29 Add amounts in column (i), line 26. Enter here and on line 7, page 1 . . . . . . . . . . . . 29
Section B—Information on Use of Vehicles
Complete this section for vehicles used by a sole proprietor, partner, or other “more than 5% owner,” or related person. If you provided vehicles
to your employees, first answer the questions in Section C to see if you meet an exception to completing this section for those vehicles.
(a) (b) (c) (d) (e) (f)
Vehicle 1 Vehicle 2 Vehicle 3 Vehicle 4 Vehicle 5 Vehicle 6
30 Total business/investment miles driven during
the year (do not include commuting miles) .
31 Total commuting miles driven during the year
32 Total other personal (noncommuting) miles
driven . . . . . . . . . . . .
33 Total miles driven during the year. Add lines
30 through 32 . . . . . . . . .
34 Was the vehicle available for personal use Yes No Yes No Yes No Yes No Yes No Yes No
during off-duty hours? . . . . . . .
35 Was the vehicle used primarily by a more
than 5% owner or related person? . . .
36 Is another vehicle available for personal use?
Section C—Questions for Employers Who Provide Vehicles for Use by Their Employees
Answer these questions to determine if you meet an exception to completing Section B for vehicles used by employees who are not
more than 5% owners or related persons (see instructions).
37 Do you maintain a written policy statement that prohibits all personal use of vehicles, including commuting, by Yes No
your employees? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
38 Do you maintain a written policy statement that prohibits personal use of vehicles, except commuting, by your
employees? See the instructions for vehicles used by corporate officers, directors, or 1% or more owners . . . .
39 Do you treat all use of vehicles by employees as personal use? . . . . . . . . . . . . . . . .
40 Do you provide more than five vehicles to your employees, obtain information from your employees about the
use of the vehicles, and retain the information received? . . . . . . . . . . . . . . . . . . .
41 Do you meet the requirements concerning qualified automobile demonstration use? (See instructions.) . . .
Note: If your answer to 37, 38, 39, 40, or 41 is “Yes,” do not complete Section B for the covered vehicles.
Part VI Amortization
(a) (c) (d) Amortization (f)
Date amortization
Description of costs Amortizable amount Code section period or Amortization for this year
42 Amortization of costs that begins during your 2010 tax year (see instructions):

43 Amortization of costs that began before your 2010 tax year . . . . . . . . . . . . . 43

44 Total. Add amounts in column (f). See the instructions for where to report . . . . . . . . 44
Form 4562 (2010)
Chapter 10

Chapter 10
Certain Business Deductions and Losses

I. Bad Debts
A. General Requirements

1. Bona Fide Debt

a) There must be a valid debtor-creditor relationship.

b) If a "bad debt" was really a gift, the loss is not deductible.

(1) E.g., a parent "loans" money to his/her child for to

buy a car, never intending to be repaid.

2. Basis

a) The taxpayer must have a basis in the debt in order to

deduct it when it goes bad.

b) Consequently, a cash basis taxpayer cannot deduct

uncollectible accounts receivable since such sales have
not been included in income.

(1) The net effect is to exclude both the income and

the bad debt deduction.

3. Worthlessness

a) Worthlessness depends upon the facts

b) A taxpayer does not have to take legal action to enforce

payment, but must make some reasonable attempt to

c) A bad debt can be deducted only in the year of


Chapter 10

B. Business v. Nonbusiness Bad Debts

1. Business Bad Debts

a) Must be created or acquired in connection with the

taxpayer's TRADE or BUSINESS.

b) Business Bad Debts are deductible without limitation in

the year it becomes worthless or partially worthless.

2. Nonbusiness Bad Debts

a) All bad debts other than Business Bad Debts are

Nonbusiness Bad Debts.

b) Tax treatment:

(1) Nonbusiness Bad Debts are always treated as

Short-term Capital Losses.

(a) Consequently, the nonbusiness bad debts

may offset ordinary income, subject to the
annual $3000 limitation.

(2) Nonbusiness bad debts must be TOTALLY

worthless to be deductible.

(a) The taxpayer cannot deduct a partially

worthless debt until he determines that no
further collections will be made.

Do Problem #12

Chapter 10

II. Casualty and Theft Losses

A. General Rules

1. As we learned in the last chapter, §165 permits the deduction

of all losses incurred in connection with a trade or business or
an income-producing activity.

2. In contrast, losses on personal use property are deductible only

if they qualify as “casualty or theft losses.”

B. Casualty and Theft Defined

1. Casualties

a) Rev. Rul. 72-592 states that a casualty is the complete or

partial destruction of property resulting from an
identifiable event of a sudden, unexpected, and unusual

(1) Sudden — event must be swift, not gradual.

(2) Unexpected — unanticipated and occurs without

the intent of the one who suffers the loss.

(3) Unusual — event does not commonly occur.

2. Thefts — broadly defined

Do Problem #7

C. Loss Computation

1. Gen. rule: The amount of the loss is computed in the manner

shown below:

The LESSER of:

Decline in FMV, or
Adjusted basis
Less: Any reimbursement
Amount of casualty or theft loss

Chapter 10

2. Exceptions:

a) If property used in a trade or business or in an income-

producing activity is stolen or COMPLETELY destroyed,
the measure of the loss is:

Adjusted Basis - Insurance reimbursement

b) For personal casualty and theft losses, the amount of the

loss is further reduced by:

(1) A $100 floor, for EACH casualty, and

(2) An additional 10% of AGI floor, which is applied to

the total of the losses after reduction by the $100
floor for each loss.

3. No deduction will be permitted for insured losses, unless a

timely insurance claim is filed.
Do Problem #18 (use
Form 4684 for part a).

D. Year Deductible

1. Gen. rule: Losses are deductible in the year in which they


2. Exceptions:

a) Theft losses are deductible in the year of discovery.

b) Casualty losses sustained in a federal disaster area may

be deducted in the taxable year immediately preceding the
year of loss.

(1) This election has the advantage of accelerating the

deduction — thereby providing some relief to
disaster victims.

Chapter 10

III. Net Operating Losses

A. Carryback and Carryforward Years

1. General rule:

a) NOLs are carried back 2 years and then forward 20 years.

2. NOL's are carried back 3 years and then forward 15 years in

the following situations:

a) NOLs in tax years beginning before Aug. 5, 1997;

b) NOLs arising from casualty losses of individuals;

c) NOLs of farmers; and

d) NOLs of small businesses attributable to losses incurred

in Presidentially declared disaster areas.

3. Alternatively, a taxpayer may make an irrevocable election to

simply carry the NOL forward only.

B. Net Operating Loss Computation

1. Formula:
Business income ———————————————————> +

Business deductions —————————————————> —

Personal casualty loss —————————————————> —

Nonbusiness income ——— + ————————————> +

Nonbusiness deductions —-- — ———
+ ——
Nonbusiness capital gains — + ———
Nonbusiness capital losses — — STOP
+ ——> +
Business capital gains ——- — ————————
Business capital losses —— + ————————————> +

Chapter 10

2. Rationale:

a) The NOL is allowed only for losses ACTUALLY

REALIZED by the taxpayer. (True economic loss)

b) CAPITAL LOSSES have their own carryover rules.

Thus, they cannot be used to increase a NOL.


reduce taxable income, but do not represent an economic
loss to the taxpayer.

d) Since the NOL provisions deal only with losses in

operating a trade or business and casualty and theft
not permitted to create or to increase a NOL.

e) NOL's from other tax years cannot be allowed to create or

to increase a NOL for the current year. Otherwise, there
would be an indefinite carryforward of NOL's. The 20
year limit would be meaningless.
Do Problem #19

Do Problem #22

Form 4684 Casualties and Thefts
See separate instructions.
OMB No. 1545-0177

Department of theTreasury © Attach
to your tax return. Attachment
Internal Revenue Service © Use a separate Form 4684 for each casualty or theft. Sequence No. 26
Name(s) shown on tax return Identifying number

SECTION A—Personal Use Property (Use this section to report casualties and thefts of property not used in a trade
or business or for income-producing purposes.)
1 Description of properties (show type, location, and date acquired for each property). Use a separate line for each property lost or damaged from
the same casualty or theft.
Property A
Property B
Property C
Property D
2 Cost or other basis of each property . . . . . . 2
3 Insurance or other reimbursement (whether or not you
filed a claim) (see instructions) . . . . . . . . 3
Note: If line 2 is more than line 3, skip line 4.
4 Gain from casualty or theft. If line 3 is more than line 2,
enter the difference here and skip lines 5 through 9 for that
column. See instructions if line 3 includes insurance or other
reimbursement you did not claim, or you received payment
for your loss in a later tax year . . . . . . . . 4
5 Fair market value before casualty or theft . . . . 5
6 Fair market value after casualty or theft . . . . . 6
7 Subtract line 6 from line 5 . . . . . . . . . 7
8 Enter the smaller of line 2 or line 7 . . . . . . 8
9 Subtract line 3 from line 8. If zero or less, enter -0- . . 9
10 Casualty or theft loss. Add the amounts on line 9 in columns A through D . . . . . . . . . . . . . 10
11 Enter the smaller of line 10 or $500 . . . . . . . . . . . . . . . . . . . . . . . . 11
12 Subtract line 11 from line 10 . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Caution: Use only one Form 4684 for lines 13 through 22.
13 Add the amounts on line 12 of all Forms 4684 . . . . . . . . . . . . . . . . . . . . . 13
14 Add the amounts on line 4 of all Forms 4684. . . . . . . . . . . . . . . . . . . . . . 14

15 ● If line 14 is more than line 13, enter the difference here and on Schedule D. Do not
complete the rest of this section (see instructions). . . . . . . .
● If line 14 is less than line 13, enter -0- here and go to line 16.
● If line 14 is equal to line 13, enter -0- here. Do not complete the rest of this section.
16 If line 14 is less than line 13, enter the difference . . . . . . . . . . . . . . . . . . . . 16
17 Add the amounts on line 12 of all Forms 4684 on which you entered a disaster loss (see instructions) . . . . . . 17
18 Is line 17 more than line 14?
Yes. Enter the difference. If you are filing Schedule A (Form 1040), go to line 19. Otherwise, enter this amount
on line 6 of Schedule L (Form 1040A or 1040). Do not complete the rest of Section A. Form 1040NR filers, see
No. Enter -0-. If you claim the standard deduction, do not complete the rest of Section A. . . . . . . 18
19 Subtract line 18 from line 16 . . . . . . . . . . . . . . . . . . . . . . . . . . 19
20 Enter 10% of your adjusted gross income from Form 1040, line 38, or Form 1040NR, line 36. Estates and trusts, see instructions 20
21 Subtract line 20 from line 19. If zero or less, enter -0- . . . . . . . . . . . . . . . . . . . 21
22 Add lines 18 and 21. Also enter the result on Schedule A (Form 1040), line 20, or Form 1040NR, Schedule A, line 8.
Estates and trusts, enter the result on the "Other deductions" line of your tax return . . . . . . . . . . 22
For Paperwork Reduction Act Notice, see page 5 of the instructions. Cat. No. 12997O Form 4684 (2009)
Form 4684 (2009) Attachment Sequence No. 26 Page 2
Name(s) shown on tax return. Do not enter name and identifying number if shown on other side. Identifying number

SECTION B—Business and Income-Producing Property

Part I Casualty or Theft Gain or Loss (Use a separate Part l for each casualty or theft.)
23 Description of properties (show type, location, and date acquired for each property). Use a separate line for each property lost or damaged
from the same casualty or theft.
Property A
Property B
Property C
Property D
24 Cost or adjusted basis of each property . . . . . 24
25 Insurance or other reimbursement (whether or not you
filed a claim). See the instructions for line 3 . . . . 25
Note: If line 24 is more than line 25, skip line 26.
26 Gain from casualty or theft. If line 25 is more than line 24, enter
the difference here and on line 33 or line 38, column (c), except as
provided in the instructions for line 37. Also, skip lines 27 through
31 for that column. See the instructions for line 4 if line 25 includes
insurance or other reimbursement you did not claim, or you
received payment for your loss in a later tax year. . . . . 26
27 Fair market value before casualty or theft . . . . 27
28 Fair market value after casualty or theft . . . . . 28
29 Subtract line 28 from line 27 . . . . . . . . 29
30 Enter the smaller of line 24 or line 29 . . . . . 30
Note: If the property was totally destroyed by casualty or lost
from theft, enter on line 30 the amount from line 24.
31 Subtract line 25 from line 30. If zero or less, enter -0- 31
32 Casualty or theft loss. Add the amounts on line 31. Enter the total here and on line 33 or line 38 (see instructions) . . 32
Part II Summary of Gains and Losses (from separate Parts l) (b) Losses from casualties or thefts
(c) Gains from
(i) Trade, business, (ii) Income- casualties or thefts
(a) Identify casualty or theft rental or royalty producing and includible in income
property employee property
Casualty or Theft of Property Held One Year or Less
33 ( ) ( )
( ) ( )
34 Totals. Add the amounts on line 33 . . . . . . . . . . . . 34 ( ) ( )
35 Combine line 34, columns (b)(i) and (c). Enter the net gain or (loss) here and on Form 4797, line 14. If Form 4797 is
not otherwise required, see instructions . . . . . . . . . . . . . . . . . . . . . . . 35
36 Enter the amount from line 34, column (b)(ii) here. Individuals, enter the amount from income-producing property on Schedule A (Form
1040), line 28, or Form 1040NR, Schedule A, line 16, and enter the amount from property used as an employee on Schedule A (Form
1040), line 23, or Form 1040NR, Schedule A, line 11. Estates and trusts, partnerships, and S corporations, see instructions . . . . 36
Casualty or Theft of Property Held More Than One Year
37 Casualty or theft gains from Form 4797, line 32 . . . . . . . . . . . . . . . . . . . . . . . . . 37
38 ( ) ( )
( ) ( )
39 Total losses. Add amounts on line 38, columns (b)(i) and (b)(ii) . . . . . 39 ( ) ( )
40 Total gains. Add lines 37 and 38, column (c) . . . . . . . . . . . . . . . . . . . . . . 40
41 Add amounts on line 39, columns (b)(i) and (b)(ii) . . . . . . . . . . . . . . . . . . . . 41
42 If the loss on line 41 is more than the gain on line 40:
a Combine line 39, column (b)(i) and line 40, and enter the net gain or (loss) here. Partnerships (except electing large
partnerships) and S corporations, see the note below. All others, enter this amount on Form 4797, line 14. If Form
4797 is not otherwise required, see instructions . . . . . . . . . . . . . . . . . . . . . 42a
b Enter the amount from line 39, column (b)(ii) here. Individuals, enter the amount from income-producing property on
Schedule A (Form 1040), line 28, or Form 1040NR, Schedule A, line 16, and enter the amount from property used as
an employee on Schedule A (Form 1040), line 23, or Form 1040NR, Schedule A, line 11. Estates and trusts, enter on
the “Other deductions” line of your tax return. Partnerships (except electing large partnerships) and
S corporations, see the note below. Electing large partnerships, enter on Form 1065-B, Part II, line 11 . . . . . 42b
43 If the loss on line 41 is less than or equal to the gain on line 40, combine lines 40 and 41 and enter here. Partnerships
(except electing large partnerships), see the note below. All others, enter this amount on Form 4797, line 3 . . . . 43
Note: Partnerships, enter the amount from line 42a, 42b, or line 43 on Form 1065, Schedule K, line 11.
S corporations, enter the amount from line 42a or 42b on Form 1120S, Schedule K, line 10.
Form 4684 (2009)
Chapter 11

Chapter 11
Personal Itemized Deductions

I. Medical Expenses
A. What is Deductible?

1. Amounts PAID for the diagnosis, cure, relief, treatment, or

prevention of a disease of the taxpayer, his or her spouse, and

a) The status of the person as the taxpayer's spouse or

dependent must exist either:

(1) When the medical services are rendered, or

(2) At the time the expenses are paid.

b) Both the "gross income" test and the "joint return" test
are waived for purposes of determining dependency

c) Medical expenses for children of divorced parents are

deductible by the parent who pays for the expenses—
regardless of who gets the exemption.

2. Deductions for medicines and drugs are limited to

expenditures for PRESCRIBED drugs.

3. Capital expenditures for the permanent improvement of the

taxpayer's property (e.g., elevator, wheelchair ramps) are
deductible in the year made.

a) Deduction is limited to the amount by which the payment

exceeds the increase in value of the property improved.

b) A reasonableness standard is applied to capital

expenditures made for medical purposes.

Chapter 11

4. Nursing homes

a) If the principal reason for placing an individual in a

nursing home is the availability of medical care, the entire
cost of the institutional care is a deductible medical

b) If an individual's medical condition is NOT the principal

reason for being in an institution, then only those costs
directly related to medical care are deductible.

5. Long-term care costs

a) Amounts paid for long-term care of a chronically-ill

individual are deductible.

b) Premiums for long-term care insurance are deductible,

subject to limits based on the insured’s age. (See p. 11-8.)

6. Medical transportation costs qualify as deductions.

a) Transportation costs include amounts actually paid for

bus, taxi, etc. and the out-of-pocket costs if the taxpayer
uses his own car.

b) Rather than keep track of out-of-pocket costs, the

taxpayer can deduct 16.5 cents a mile (2010), plus
parking fees and tolls.

7. Travel costs include ONLY transportation and lodging.

a) Travel must be beyond the taxpayer's locale.

b) Meal cost en route are not deductible. Only meals

provided by the hospital as a necessary part of medical
care qualify as medical deductions.

c) Lodging costs are limited to $50 per night for each


(1) If the individual requiring medical treatment cannot

travel alone, the lodging cost of a companion also
will be deductible.

8. Medical insurance premiums, including amounts withheld by

an employer, qualify as medical expenses.

9. Unnecessary cosmetic surgery does not qualify.

Chapter 11

B. When Deductible?

1. Medical expenses are deductible only in the year they are


2. Prepayments are not allowed as deductions unless the taxpayer

is required to prepay.

C. Amount Deductible?

1. Medical expenses, less any insurance reimbursements, are

deductible to the extent they exceed 7.5% of AGI.

2. Insurance reimbursements must be accounted for in the year

of receipt.

a) Reimbursement for prior years' deductions are subject to

the tax benefit rule.

b) The tax benefit rule requires the taxpayer to include in

gross income the SMALLEST of:

(1) The amount of the reimbursement,

(2) Prior year medical expenses in excess of 7.5% of

AGI, or

(3) Itemized deductions in excess of the Standard

deduction for the prior year.

Do Problem #27

Chapter 11

D. Health Savings Accounts (HSA)

1. Certain employees may exclude employer contributions to

HSAs, and self-employed taxpayers may deduct contributions
to HSAs as deductions for AGI.

a) The HSA must be used in connection with High

Deductible Health Plans (HDHP).

b) HDHP limits for 2010:

(1) Individual coverage

(a) Minimum Deductible: 1,200

(b) Maximum out-of-pocket: 5,950

(2) Family coverage

(a) Minimum Deductible: 2,400

(b) Maximum out-of-pocket: 11,900

2. Eligible taxpayers

a) Must have a High Deductible Health Plans (HDHP).

b) Not covered by other health plans (some exceptions exist).
c) Not eligible for Medicare (under age 65).
d) Not claimed as a dependent of another taxpayer.

3. Deductible Contributions

a) Under age 55:

(1) Individual coverage — $3,050

(2) Family coverage — $6,150

b) Ages 55 to 64:

(1) Individual coverage — $4,050

(2) Family coverage — $7,150

Chapter 11

4. HSA distributions

a) Non-taxable — if used by the recipient to pay for medical

expenses not covered by a high deductible plan.

b) Taxed but not penalized — if distribution is made by

reason of death, disability, or after the beneficiary
becomes eligible for Medicare.

c) Taxable and subject to 10% penalty — if used for other

purposes before age 65, death, or disability.

E. Health Insurance Costs of Self-employed Taxpayers

1. General rule:

a) Self-employed individuals are permitted to deduct 100%

of the premiums paid for health insurance coverage for
themselves and their spouses and dependents as a
deduction FOR AGI.

2. Restrictions:

a) This deduction is not permitted UNLESS the self-

employed individual provides similar coverage for all of
his or her employees.

b) This deduction cannot exceed the taxpayer's NET


c) This deduction is not allowed if the self-employed

individual or spouse is eligible to participate in an
employer's insurance plan.

Chapter 11

II. Taxes
A. General requirements for Deductibility

1. A tax is deductible only if it is:

a) Imposed on the taxpayer's income or property, and

b) Paid or incurred by the taxpayer in the taxable year for

which a deduction is claimed.

B. Income Taxes

1. Cash basis taxpayers are allowed to deduct STATE and

LOCAL income taxes:

a) Withheld from salary by an employer,

b) Estimated taxes paid during the year, and

c) Payments made in the current year on a prior year's

income tax liability.

2. If a cash basis taxpayer receives a refund of state, local, or

foreign taxes in the current year, the taxpayer must include in
income the LESSER of:

a) The amount of the refund received, or

b) The amount by which total itemized deductions exceeded

the standard deduction when the taxes were originally

Do Problem #28

Chapter 11

C. Sales Taxes

1. From 2004 through 2009, taxpayers could deduct state and

local sales taxes, instead of state and local income taxes.

a) This provision expired at the end of 2009, but Congress is

considering an extension of this rule

2. Computation:

a) Actual sales tax payments substantiated by receipts, or

b) Optional sales tax tables (see p. 11-18).

D. Property Taxes

1. Personal property taxes are deductible only if they are imposed

on the VALUE of the property (ad valorem taxes).

2. Real property taxes imposed on property bought or sold

during the year must be apportioned between the buyer and
seller according to the number of days the property was held
by each.

3. Special assessments for sidewalks, street paving, etc., are not

deductible as real property taxes.

a) These costs are added to the basis of the land.

Do Problem #30

Chapter 11

III. Interest Expense

A. When Deductible?

1. Generally, in the year paid or incurred.

2. Cash basis taxpayers, generally, are denied deductions for

PREPAID interest.

a) Exception: "Points" paid by the buyer in connection with

debt incurred to purchase or improve the taxpayer's
principal residence are deductible when paid.

b) Similarly, "points" paid to re-finance the taxpayer's

principal residence must be amortized over the term of the
new loan.

B. Limitations and Disallowance Possibilities

1. Classification of Interest Expense

a) Nondeductible personal (consumer) interest

b) Trade or business interest

c) Investment interest

d) Interest from a passive activity

e) Qualified residence interest

2. Personal interest

a) Personal interest, which is interest expense that does not

fall into any of the other categories, is not deductible.

b) Examples: Credit card interest; interest on a car loan.

(See list on pp. 11-22 and 11-23)

Chapter 11

3. Qualified residence interest

a) QRI is interest paid on a liability secured by the

taxpayer's primary or secondary home.

(1) Fully deductible as an itemized deduction.

b) Qualified residence interest includes interest (subject to

limitations) on:

(1) Acquisition indebtedness, and

(2) Home Equity indebtedness

c) Acquisition indebtedness

(1) Includes:

(a) Debt incurred in acquiring, constructing, or

substantially improving any qualified
residence of the taxpayer, which is secured
by the residence,

(b) Debt incurred by refinancing previously

existing acquisition indebtedness, and

(c) All debt incurred on or before October 13,

1987, which is secured by a qualified

(2) $1,000,000 Limitation

(a) The total amount treated as acquisition

indebtedness cannot exceed $1 million.

(b) The pre-October 13, 1987 indebtedness is

not subject to the $1 million limit.

(i) However, such pre-existing debt does

reduce the $1 million limit on acquisition
indebtedness incurred after October 13,

Chapter 11

d) Home Equity Indebtedness

(1) Home equity indebtedness is any indebtedness

(other than acquisition indebtedness) secured by a
qualified residence.

(2) HEI is limited to the LESSER of:

(a) The FMV of the qualified residence in

excess of any acquisition debt on the
residence, or

(b) $100,000.

e) Any interest on mortgage debt in excess of the limits for

Acquisition indebtedness or Home equity indebtedness is
classified as personal interest.

4. Investment interest

a) Investment interest is generally any interest expense on

debt used to finance property held for investment.

b) The deduction for investment interest expense is limited to

the taxpayer's NET INVESTMENT INCOME for the

(1) Any investment interest expense in excess of the

annual limit may be carried forward indefinitely.

(2) Net investment income — investment income less

investment expenses, other than interest.

(a) Dividend income and Capital Gains from the

sale of investment property are NOT
included in the computation of investment
income UNLESS the taxpayer elects to tax
these items as ordinary income (instead of
taxing the income at the preferential
5%/15% rates.).

(b) Investment expenses include all deductions

(except interest) that are directly connected
with the production of income.

Do Problem #32

Do Problem #31

Chapter 11

5. Trade or business interest

a) Interest expense incurred in connection with a self-

employed individual's trade or business is fully deductible

b) In contrast, interest expense incurred in connection with

an employee's trade or business is classified as personal

6. Student Loan Interest

a) Qualifying student loan interest is deductible FOR AGI

up to $2,500 per year.

b) Requirements:

(1) Loan incurred to pay qualified educational

expenses of the taxpayer, spouse, or dependents.

(2) Student must be enrolled at least half-time in a

degree program.

(3) Taxpayer cannot be claimed as a dependent in the

year the student loan interest deduction is claimed.

(4) Married taxpayer must file jointly in the year the

student loan interest deduction is claimed.

c) Deduction Phase-out:

(1) Single or Head of household:

Modified AGI – 60,000 Student

——————————— x loan
15,000 interest

(1) Married filing jointly:

Modified AGI – 120,000 Student

———————————— x loan
30,000 interest

Chapter 11

IV. Charitable Contributions

A. Deduction Requirements

1. To be deductible, the contribution must be:

a) Made to a qualifying donee, and

b) Completed before the close of the tax year.

2. Disallowance Possibilities

a) Direct contributions to needy or worthy individuals are

not deductible.

b) Similarly, contributions made to qualifying organizations,

but restricted to the use by a specific person, generally are
not deductible.

3. Substantiation Requirements

a) No deduction is allowed for any charitable contribution of

$250 or more, unless:

(1) The taxpayer substantiates the contribution by a

contemporaneous written acknowledgment from
the charity; or

(2) If the charity files a return with the IRS reporting the
information that is required to be included in the
written acknowledgment to substantiate the amount
of the deductible contribution.

b) An acknowledgment is required to include:

(1) The amount of cash and a description, but not the

value, of any non-cash property contributed.

(2) Whether the charity provided any goods or services

in exchange for any property contributed.

(3) A description and good-faith estimate of the value

of any goods and services provided by the charity.

Chapter 11

B. Limitations on Deductions

1. Rules applicable to ALL contributions

a) Contributions of all property other than LTCG property

are valued at the LESSER of the property's:

(1) Adjusted basis, or

(2) FMV on the date of contribution.

b) Contributions of Services:

(1) No deduction is allowed for a contribution of


(2) However, unreimbursed expenses related to the

services are deductible. (E.g., 14 cents/mile)

c) Contributions in excess of the AGI limits (see below) can

be carried forward for 5 years.

(1) Contribution carryovers are considered after current

year contributions.

(2) Contribution carryovers remain subject to the same

percentage-of-AGI limits.


FOUNDATIONS (50% organizations)

a) Deduction Limitation: 50% of AGI (in most cases)

b) General Rule: For contributions of LTCG property, the

taxpayer has a choice:

(1) Choice 1: The amount of the contribution is the

property's FMV, but the deduction is limited to 30%
of AGI, or

(2) Choice 2: The amount of the contribution is the

property's adjusted basis, and the deduction is
limited to 50% of AGI.

Chapter 11

c) Exception: Contributions of TANGIBLE, PERSONAL,

LTCG property used by the charity in a manner
UNRELATED to its exempt function.

(1) The amount of the charitable contribution is the

property's adjusted basis.

(2) The deduction limit remains at 50% of AGI.

3. Private NONOPERATING Foundations

a) Contribution of Cash or Ordinary Income property:

(1) The deduction limitation is 30% of AGI.

b) Contribution of LTCG property:

(1) General rule:

(a) The amount of the contribution is the

taxpayer's adjusted basis in the property.

(b) The deduction limitation is 20% of AGI.

c) The deduction for contributions to private nonoperating

foundations is limited to the LESSER of:

(1) 20% of AGI (for LTCG property) and 30% of AGI

(for cash and ordinary income property), or

(2) 50% of AGI, minus any contributions made during

the taxable year to 50% organizations.

4. The overall deduction limit on TOTAL charitable

contributions is 50% of AGI.

Do Problem #35

Do Problem #38

Chapter 11

V. Miscellaneous Itemized Deductions

A. Deductible unreimbursed expenses relating to an employee's
trade or business include:

1. Qualified education expenses.

2. Union or professional dues.

3. Subscriptions to trade magazines.

4. Special clothing and equipment, including the costs for

maintenance and repairs (e.g., laundry costs for uniform).

B. Other miscellaneous personal itemized deductions include:

1. Safe deposit box rental if investment property or related

documents are stored in it.

2. Fees for investment advice.

3. Fees for the preparation of the individual's income tax return.

4. All reimbursed expenses, if the employee is overreimbursed

and is allowed to keep the overreimbursement.

C. Amount deductible?

1. Only to the extent the miscellaneous deductions exceed 2% of


2. An employee's unreimbursed costs for business meals and

entertainment must first be reduced by the 50% disallowance
before being subjected to the 2 percent floor limitation.

Do Problem #40

Chapter 14

Chapter 14
Property Transactions:
Basis Determination, Recognition of Gain or Loss

I. Realization v. Recognition
A. Realization

1. Gain or loss is REALIZED when an asset is disposed of,

whether by sale, exchange, or retirement.

2. Realized gain or loss is determined by comparing the


B. Recognition

1. Recognition of a gain or loss means that it will be reported on

the taxpayer's income tax return and affect taxable income.

2. Most realized gains and losses are recognized, as well.

However, certain realized gains and losses are not recognized:

a) Postponed gains

(1) Involuntary conversions

b) Postponed gains and losses

(1) Like-kind exchanges

c) Postponed losses

(1) Related party transactions

(2) Wash sale losses

d) Tax-free gain

(1) Sale of principal residence

e) Disallowed losses

(1) Losses on the sale of personal use property.

Chapter 14

II. Gain or Loss Realized

A. Computing Amount Realized

1. See exhibit on p. 14-5.

B. Determination of Adjusted Basis

1. Original Basis (See chart p. 14-12)

a) Purchase: Cost of acquisition

b) Gift:

(1) Gain basis:

(a) Donor's basis + gift tax paid on post-1976


(b) See p. 14-7 for the formula.

(2) Loss basis is the LESSER of:

(a) Gain basis, or

(b) FMV on date of gift

Do Problem #25

Do Problem #26

Chapter 14

c) Inheritance:

(1) General rule: Stepped-up basis

(a) FMV on date of death or

(b) The alternate valuation date, if elected for

estate tax purposes.

(2) Exceptions:

(a) Income in respect of decedent — income

earned by the decedent but not included on
his or her final tax return — is taxed to the

(b) The gift/bequest rule — Property given to

the decedent within a year of death, which
is bequeathed back to the donor, does not
receive a stepped-up basis.

Do Problem #27

Do Problem #28

d) Personal Use Property Converted to Business Use:

(1) Gain basis: Original adjusted basis

(2) Loss basis is the lesser of:

(a) Original adjusted basis, or

(b) FMV on date of conversion.

e) Nontaxable exchange:

(1) FMV less any postponed gain or

(2) FMV plus any deferred loss.

Chapter 14

2. Basis Adjustments

a) Depreciation or Cost recovery

b) §179 expense

c) Capital improvements and betterments

C. Effect of Liabilities on Amount Realized

1. Amount Realized is INCREASED by those liabilities which the

BUYER either assumes or takes subject to.

2. Amount Realized in DECREASED by those liabilities which

the SELLER either assumes or takes subject to.

3. In contrast, BASIS includes the amount of liabilities secured

by the property itself or assumed by the party receiving the
Do Problem #22.

III. Concepts Related to Realization and Recognition

A. Sale or Other Disposition

1. Convertible Securities

a) Generally, when a taxpayer exchanges securities for other

securities, it results in a taxable transfer.

b) However, no gain is recognized when a taxpayer

exchanges stocks or bonds, under a conversion privilege,
for other securities.

2. Transfers in Satisfaction of Debt

a) Granting a mortgage on property in order to secure a debt

is not a disposition of the property.

b) However, transfers in satisfaction of a debt (e.g.,

foreclosures) ARE taxable dispositions.

Chapter 14

3. Abandonment

a) Abandonment of income-producing property or business

property is a taxable disposition.

b) Taxpayer's loss is equal to the property's adjusted basis.

4. Demolition

a) No loss deduction is allowed for:

(1) The excess of the demolished building's adjusted

basis over its salvage value, or

(2) Expenses of demolition.

b) The cost of demolition and the disallowed loss are added

to the basis of the land.

5. Spousal Transfers

a) Transfers of property between spouses during marriage,

or within one year after divorce, is NOT a taxable event.

b) Similarly, transfers made more than one year after

divorce are also nontaxable, provided they are made
pursuant to the divorce decree.

c) The recipient's basis in the transferred property is the

same as the transferor's basis.

6. Liabilities in Excess of Basis

a) When a taxpayer transfers property and liabilities to a

buyer and the liabilities assumed by the buyer exceed the
property's adjusted basis, the taxpayer will recognized
gain equal to the excess of the liabilities assumed over the
property's adjusted basis.

Chapter 14

7. Transfers to Charity

a) Generally, transfers to charity are not treated as a sale or

exchange. Thus, no gain or loss is recognized.

b) However, if there is a BARGAIN SALE to CHARITY:

(1) The adjusted basis of the transferred property is

allocated between the sale portion and the donated

Sale price Adjusted Adjusted basis

———— x basis = for Gain
FMV computation

(2) Gain resulting from the sale portion of the

transaction is recognized.

(3) In addition, the transferor also gets a charity

contribution deduction:

FMV of the donated property

- Sales price (or liability assumed by charity)
FMV of charity contribution

Do Problem #30

B. Allocations of Purchase Price and Basis

1. Sale of a Sole Proprietorship is considered to be a sale of the

business assets for a lump-sum.

a) As illustrated in Example 38 (p. 14-18), the purchase

price must be allocated among the business assets.

b) Then, gain or loss is calculated on the sale of each asset


Chapter 14

c) Finally, the tax treatment for each gain or loss is


(1) E.g., gain on the sale of Inventory is ordinary

income; gain from the sale of goodwill is capital

2. Sales of stock or partnership interests generally are NOT

treated as sales of the business assets. Thus, no allocation is

IV. Installment Sale Method

A. General Rules

1. An installment sale occurs any time the seller is to receive at

least one payment after the taxable year during which the sale
took place.

2. Installment Sale Method cannot be used for sales of:

a) Inventory,

b) Property subject to depreciation recapture, or

c) Stocks and securities

3. If an eligible Installment Sale has occurred, the gain MUST be

reported using the Installment Method, unless the taxpayer
ELECTS OUT by reporting the entire gain in the year of sale.

B. Gain Reported under the Installment Method

1. Determine Gross Profit on Sale

a) The gross profit is simply the TOTAL GAIN (excluding

interest) to be reported over the years of the installment

b) Gross profit = Amount realized - Adjusted basis

Chapter 14

2. Determine the Total Contract Price

a) Generally, the total contract price is determined as

Amount realized
- Liabilities assumed by buyer
Total contract price

b) An exception exists when the liability assumed by the

buyer is greater than the seller's adjusted basis in the

(1) The excess is treated as a DEEMED CASH

PAYMENT received in the year of sale.

(2) Thus, the excess is added to the total contract


3. Determining Gain Reported (p. 14-21)

Gross profit Payments

———————— x received in = Recognized Gain
Total contract price current year

Do Problem #31

(use Form 6252

for parts a, b, & c)

Chapter 14

C. Limitations on Certain Installment Sales

1. Imputed Interest Rules

a) Deferred payment sales of property for more than $3,000

must provide a REASONABLE interest rate.

b) If a deferred payment sale does not provide a reasonable

interest rate:

(1) The selling price is RESTATED to equal the

payments received on the date of sale, PLUS the
discounted present value of the future payments.

(2) The excess of the FACE VALUE of the future

payments over the DISCOUNTED PRESENT
VALUE of the future payments is reported as
interest income under the accrual method,
regardless of the taxpayer's accounting method.

Do Problem #32

2. Related-Party Installment Sales

a) If the related party buyer resells the property before

making all the payments on the original installment sale:

(1) The related party seller is treated as receiving any

payments actually collected by the related party

(2) This rule does not apply if the second sale occurs:

(a) More than 2 years after first sale, or

(b) After the death of the related party seller.

Chapter 14

b) The installment method generally cannot be used for

sales of depreciable property between related parties.

(1) Exception: the installment method CAN be used IF

the related party seller can prove tax avoidance
was NOT a principal motive of the transaction.

3. Dispositions of Installment Obligations

a) Generally, if an installment note is transferred before all

of the payments are collected, the seller is required to
report gain or loss on the disposition.

b) If the note is sold or exchanged:

Amount realized
- Adjusted basis of note
Gain or loss

c) If the transfer of the installment note is not by sale or

exchange (e.g., by gift):

FMV of the note

- Adjusted basis of note
Gain or loss

Chapter 14

V. Disallowed Losses
A. Wash Sales

1. A wash sale occurs if a taxpayer sells or exchanges stock or

securities and, within 30 days before or after the date of such
sale, acquires "substantially identical" stocks or securities.

2. The basis of the replacement stock or securities is:

Cost of the replacement stock or securities

+ Amount of the disallowed loss
Basis of replacement stock or securities

Do Problem #33

B. Sales Between Related Parties

1. §267: Loss transactions

a) Losses realized by the seller in a related party transaction

are not recognized.

b) If the buyer in a related party transaction later sells the

property for a gain, the unrecognized loss realized by the
seller can be used by the buyer to offset the gain realized
upon the later sale of the property.

2. §1239: Gain transactions

a) Recognized gains on the sale of depreciable property

between related parties are taxed as ORDINARY
INCOME, rather than as a capital gain.

Form 6252 Installment Sale Income
a Attach to your tax return.
OMB No. 1545-0228

Department of the Treasury a Use a separate form for each sale or other disposition of Attachment
Internal Revenue Service property on the installment method. Sequence No. 79
Name(s) shown on return Identifying number

Description of property a
Date acquired (mm/dd/yyyy) a

o f b Date sold (mm/dd/yyyy) a

3 Was the property sold to a related party (see instructions) after May 14, 1980? If “No,” skip line 4 . . . . Yes No
4 Was the property you sold to a related party a marketable security? If “Yes,” complete Part III. If “No,”

a 0
complete Part III for the year of sale and the 2 years after the year of sale . . . . . . . . . . . . Yes No

Part I Gross Profit and Contract Price. Complete this part for the year of sale only.

a f 0 1
Selling price including mortgages and other debts. Do not include interest whether stated or unstated
Mortgages, debts, and other liabilities the buyer assumed or took the
property subject to (see instructions) . . . . . . . . . . .

r 2

7 Subtract line 6 from line 5. . . . . . . . . . . . . . . 7

D /23
8 Cost or other basis of property sold . . . . . . . . . . . 8
9 Depreciation allowed or allowable . . . . . . . . . . . . 9
10 Adjusted basis. Subtract line 9 from line 8 . . . . . . . . . 10
11 Commissions and other expenses of sale . . . . . . . . . 11

12 Income recapture from Form 4797, Part III (see instructions) . . . 12

13 Add lines 10, 11, and 12 . . . . . . . . . . . . . . . . . . . . . . . . . 13
14 Subtract line 13 from line 5. If zero or less, do not complete the rest of this form (see instructions) 14
15 If the property described on line 1 above was your main home, enter the amount of your excluded
gain (see instructions). Otherwise, enter -0- . . . . . . . . . . . . . . . . . . . 15
16 Gross profit. Subtract line 15 from line 14 . . . . . . . . . . . . . . . . . . . 16
17 Subtract line 13 from line 6. If zero or less, enter -0- . . . . . . . . . . . . . . . . 17
18 Contract price. Add line 7 and line 17 . . . . . . . . . . . . . . . . . . . . 18
Part II Installment Sale Income. Complete this part for the year of sale and any year you receive a payment or have
certain debts you must treat as a payment on installment obligations.
19 Gross profit percentage (expressed as a decimal amount). Divide line 16 by line 18. For years after
the year of sale, see instructions . . . . . . . . . . . . . . . . . . . . . . 19
20 If this is the year of sale, enter the amount from line 17. Otherwise, enter -0- . . . . . . . . 20
21 Payments received during year (see instructions). Do not include interest, whether stated or unstated 21
22 Add lines 20 and 21 . . . . . . . . . . . . . . . . . . . . . . . . . . 22
23 Payments received in prior years (see instructions). Do not include
interest, whether stated or unstated . . . . . . . . . . . 23
24 Installment sale income. Multiply line 22 by line 19 . . . . . . . . . . . . . . . . 24
25 Enter the part of line 24 that is ordinary income under the recapture rules (see instructions) . . . 25
26 Subtract line 25 from line 24. Enter here and on Schedule D or Form 4797 (see instructions) . . . 26
Part III Related Party Installment Sale Income. Do not complete if you received the final payment this tax year.
27 Name, address, and taxpayer identifying number of related party

28 Did the related party resell or dispose of the property (“second disposition”) during this tax year? . . . . . Yes No
29 If the answer to question 28 is “Yes,” complete lines 30 through 37 below unless one of the following conditions is met. Check the box that applies.
a The second disposition was more than 2 years after the first disposition (other than dispositions of
marketable securities). If this box is checked, enter the date of disposition (mm/dd/yyyy) . . . . . a
b The first disposition was a sale or exchange of stock to the issuing corporation.
c The second disposition was an involuntary conversion and the threat of conversion occurred after the first disposition.
d The second disposition occurred after the death of the original seller or buyer.
e It can be established to the satisfaction of the Internal Revenue Service that tax avoidance was not a principal purpose for
either of the dispositions. If this box is checked, attach an explanation (see instructions).
30 Selling price of property sold by related party (see instructions) . . . . . . . . . . . . 30
31 Enter contract price from line 18 for year of first sale . . . . . . . . . . . . . . . . 31
32 Enter the smaller of line 30 or line 31 . . . . . . . . . . . . . . . . . . . . . 32
33 Total payments received by the end of your 2010 tax year (see instructions) . . . . . . . . 33
34 Subtract line 33 from line 32. If zero or less, enter -0- . . . . . . . . . . . . . . . 34
35 Multiply line 34 by the gross profit percentage on line 19 for year of first sale . . . . . . . . 35
36 Enter the part of line 35 that is ordinary income under the recapture rules (see instructions) . . . 36
37 Subtract line 36 from line 35. Enter here and on Schedule D or Form 4797 (see instructions) . . . 37
For Paperwork Reduction Act Notice, see page 4. Cat. No. 13601R Form 6252 (2010)
Chapter 17

Chapter 17
Property Transactions:
Dispositions of Trade or Business Property

I. Section 1231 Treatment

A. Definition of §1231 Assets

1. In general, §1231 assets are property held for more than 12

months and used in a trade or business.

a) They are ordinary assets until they have been held for
more than 12 months.

b) See p. 17-4 for list of other §1231 assets.

B. See p. 17-8 for Flowchart on the §1231 netting process.

1. Note that PERSONAL casualty and theft losses are not


2. All other casualty and theft losses involving §1231 assets or

capital assets (excluding personal use assets and assets not held
for more than 12 months) are netted together.

a) Typically, a net loss results. Thus, these items are treated


b) If, however, a net gain results, it is combined with all

other §1231 transactions.

3. Before the 1984 Act, once the §1231 netting process was
complete, the treatment was as follows:

a) Net §1231 Loss: Ordinary loss

b) Net §1231 Gain: LTCG

Chapter 17

4. Now, the treatment of Net §1231 Gains has changed:

a) If the taxpayer deducted any §1231 losses in any of the

preceding 5 taxable years, then all or a portion of those
§1231 losses will be "recaptured."

(1) Recapture causes all or a part of the Net §1231

Gain to be treated as ORDINARY INCOME,
offsetting the ordinary loss treatment granted to the
§1231 losses incurred during the preceding 5
taxable years.

(2) The amount to be recaptured is the LESSER of:

(a) The unrecaptured §1231 losses deducted

during any of the 5 preceding taxable years,

(b) The current year's Net §1231 gain.

Do Problem #46

II. Depreciation Recapture

A. §1245 Recapture — "Full Recapture"

1. §1245 is the most straightforward of the recapture provisions:

a) §1245 recaptures ALL DEPRECIATION taken after

1961, to the extent of the recognized gain.

b) If the property is disposed of at a LOSS, the loss is a

§1231 loss. §1245 is inapplicable to loss situations.

2. Definition of §1245 property

a) The bulk of the §1245 assets in practice are depreciable

business equipment.

b) In general, §1245 property is depreciable personal (as

opposed to "real property") property.

Chapter 17

c) §1245 property also includes:

(1) Property expensed under §179.

(2) Nonresidential real property depreciated under the

ACRS accelerated percentage method. (Pre-1987

3. Rationale behind §1245

a) The taxpayer has enjoyed an ORDINARY deduction due

to depreciation or cost recovery.

b) Unless the §1245 assets is subsequently sold for MORE

than it originally cost, the existence and amount of any
realized gain is due to the depreciation deductions
claimed in prior periods.

c) Since the gain was caused, at least in part, by the

claiming of ordinary deductions, the gain should be taxed
as ordinary income.

d) Compare: Depreciation recapture with the tax benefit


4. Since §1245 depreciation recapture potential is all post-1961

depreciation claimed, the only way to recognize a §1231 gain
on the sale of §1245 property is to sell the property for more
than it's original basis.

Do Problem #34
(use Form 4797)

Do Problem #40

Chapter 17

B. §1250 Recapture — "Partial Recapture"

1. In general, §1250 recaptures only depreciation claimed in

excess of STRAIGHT-LINE.

a) However, nonresidential real property depreciated using

the ACRS statutory percentage method is subject to
§1245, and all depreciation is recaptured.

2. §1250 property

a) In general, §1250 property is depreciable REAL property.

b) §1250 property includes nonresidential real property

depreciated using the optional straight-line method.

3. Unrecaptured §1250 Gain

a) Unrecaptured depreciation from the sale of §1250

property with a long-term holding period is taxed at a
maximum rate of 25%.

b) Thus, even though §1250 does not cause the gain caused
by deducting straight-line depreciation to be classified as
ordinary gain, this rule prevents that portion of the gain
from enjoying the same treatment as LTCGs.

4. Formula:

Amount Realized
- Adjusted Basis
Realized Gain
- §1250 Gain (the lesser of:)
• Realized gain, or
• Total depreciation - S/L depreciation
Remaining gain
- Unrecaptured §1250 Gain (the lesser of:)
• Remaining Gain, or
• S/L depreciation
§1231 Gain

Do Problem #44

Chapter 17

C. §291 — "Additional Recapture"

1. §§1245 and 1250 apply equally to individuals and corporations.

2. Corporations, however, have an additional recapture under


a) §291 requires that the corporation recapture, in addition

to §1250 recapture, 20% of the LESSER of:

(1) S/L depreciation, or

(2) Realized gain - §1250 recapture potential

b) Contrast: Example 21 on p. 17-34.

D. Considerations Common to §§1245 and 1250

1. Exceptions to the Recapture Rules:

a) Generally, these exceptions result in a

POSTPONEMENT, rather than an elimination, of the
depreciation recapture:

(1) Gifts

(2) Certain tax-free transactions involving the creation

or restructuring of corporations

(3) Like-kind exchanges and Involuntary conversions

b) In contrast, a transfer by reason of death eliminates ALL

recapture potential.

2. Installment Sales

a) For installment sales after 6-6-84, depreciation recapture

income is fully recognized in the year of an installment
sale of depreciable property—even if no payments are
made in that year.

Form 4797 Sales of Business Property OMB No. 1545-0184

Department of the Treasury

(Also Involuntary Conversions and Recapture Amounts
Under Sections 179 and 280F(b)(2)) 2010
a Attach to your tax return. a See separate instructions.
Internal Revenue Service (99) Sequence No. 27
Name(s) shown on return Identifying number

o f
Enter the gross proceeds from sales or exchanges reported to you for 2010 on Form(s) 1099-B or 1099-S (or
substitute statement) that you are including on line 2, 10, or 20 (see instructions) . . . . . . . . 1

Part I Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other
Than Casualty or Theft—Most Property Held More Than 1 Year (see instructions)
2 (a) Description
of property

f t a
(b) Date acquired
(mo., day, yr.)

1 0 (c) Date sold

(mo., day, yr.)
(d) Gross
sales price
(e) Depreciation
allowed or
allowable since
(f) Cost or other
basis, plus
improvements and
expense of sale
(g) Gain or (loss)
Subtract (f) from the
sum of (d) and (e)

r a / 2 0
5 D /23
Gain, if any, from Form 4684, line 42 . . . . . . . . . . .
Section 1231 gain from installment sales from Form 6252, line 26 or 37 .
Section 1231 gain or (loss) from like-kind exchanges from Form 8824 .

6 Gain, if any, from line 32, from other than casualty or theft. . . . . . . . . . . . . . . . . . 6

7 Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows: . . . . . . . 7
Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following the
instructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below.
Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from
line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section 1231
losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on the
Schedule D filed with your return and skip lines 8, 9, 11, and 12 below.
8 Nonrecaptured net section 1231 losses from prior years (see instructions) . . . . . . . . . . . . . 8
9 Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If line
9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as a long-term
capital gain on the Schedule D filed with your return (see instructions) . . . . . . . . . . . . . . 9
Part II Ordinary Gains and Losses (see instructions)
10 Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less):

11 Loss, if any, from line 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 ( )

12 Gain, if any, from line 7 or amount from line 8, if applicable . . . . . . . . . . . . . . . . . 12
13 Gain, if any, from line 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
14 Net gain or (loss) from Form 4684, lines 34 and 41a . . . . . . . . . . . . . . . . . . . 14
15 Ordinary gain from installment sales from Form 6252, line 25 or 36 . . . . . . . . . . . . . . . 15
16 Ordinary gain or (loss) from like-kind exchanges from Form 8824. . . . . . . . . . . . . . . . 16
17 Combine lines 10 through 16 . . . . . . . . . . . . . . . . . . . . . . . . . . 17
18 For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a
and b below. For individual returns, complete lines a and b below:
a If the loss on line 11 includes a loss from Form 4684, line 38, column (b)(ii), enter that part of the loss here. Enter the part
of the loss from income-producing property on Schedule A (Form 1040), line 28, and the part of the loss from property
used as an employee on Schedule A (Form 1040), line 23. Identify as from “Form 4797, line 18a.” See instructions . . 18a
b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040, line 14 18b
For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 13086I Form 4797 (2010)
Form 4797 (2010) Page 2
Part III Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255
(see instructions)
(b) Date acquired (c) Date sold (mo.,
19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property: (mo., day, yr.) day, yr.)


o f

Property A Property B Property C Property D

These columns relate to the properties on lines 19A through 19D. a

20 Gross sales price (Note: See line 1 before completing.) . 20

a f
Cost or other basis plus expense of sale . . . .
Depreciation (or depletion) allowed or allowable . .

01 .

r 2
23 Adjusted basis. Subtract line 22 from line 21. . . . 23

25 If section 1245 property:

D /23
Total gain. Subtract line 23 from line 20 .

a Depreciation allowed or allowable from line 22 .

b Enter the smaller of line 24 or 25a . . . .
/. . .




If section 1250 property: If straight line depreciation was used,

enter -0- on line 26g, except for a corporation subject to section 291.
a Additional depreciation after 1975 (see instructions) .
b Applicable percentage multiplied by the smaller of line
24 or line 26a (see instructions) . . . . . . .

c Subtract line 26a from line 24. If residential rental property
or line 24 is not more than line 26a, skip lines 26d and 26e 26c
d Additional depreciation after 1969 and before 1976. . 26d
e Enter the smaller of line 26c or 26d . . . . . . 26e
f Section 291 amount (corporations only) . . . . . 26f
g Add lines 26b, 26e, and 26f. . . . . . . . . 26g
27 If section 1252 property: Skip this section if you did not
dispose of farmland or if this form is being completed for a
partnership (other than an electing large partnership).
a Soil, water, and land clearing expenses . . . . . 27a
b Line 27a multiplied by applicable percentage (see instructions) 27b
c Enter the smaller of line 24 or 27b . . . . . . 27c
28 If section 1254 property:
a Intangible drilling and development costs, expenditures
for development of mines and other natural deposits,
mining exploration costs, and depletion (see
instructions) . . . . . . . . . . . . . 28a
b Enter the smaller of line 24 or 28a . . . . . . 28b
29 If section 1255 property:
a Applicable percentage of payments excluded from
income under section 126 (see instructions) . . . . 29a
b Enter the smaller of line 24 or 29a (see instructions) . 29b
Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30.

30 Total gains for all properties. Add property columns A through D, line 24 . . . . . . . . . . . . . 30
31 Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13 . . . . . . 31
32 Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 36. Enter the portion from
other than casualty or theft on Form 4797, line 6 . . . . . . . . . . . . . . . . . . . . 32
Part IV Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less
(see instructions)
(a) Section (b) Section
179 280F(b)(2)
33 Section 179 expense deduction or depreciation allowable in prior years. . . . . . . . 33
34 Recomputed depreciation (see instructions) . . . . . . . . . . . . . . . . 34
35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report . . 35
Form 4797 (2010)
Chapter 15

Chapter 15
Nontaxable Exchanges

I. Sale of Principal Residence

A. §121 Exclusion

1. Taxpayers can exclude up to $250,000 ($500,000 on joint

returns) of gain on the sale of their principal residence.

2. Ownership and Use Tests

a) To qualify for the exclusion, the taxpayer must have

owned and occupied the home as his principal residence
for at least 2 of the last 5 years prior to the sale.

b) If the taxpayer fails to meet the 2 of 5 year test due to

unforeseen circumstances, he is can exclude a portion of
the $250,000/$500,000 limit.

(1) The exclusion is calculated by multiplying the §121

limit amount by the ratio of the actual ownership
and use months divided by 24 months.

3. One Sale Every Two Years

a) The exclusion is available only if the taxpayer has not

sold another home during the 2 years prior to the sale.

4. Amount of Exclusion

a) The exclusion for most taxpayers is limited to $250,000.

b) Joint filers can exclude up to $500,000, provided:

(1) At least one spouse meets the ownership test;

(2) Both spouses meet the use test; and

(3) Neither spouse has sold a residence within the last

2 years.

Chapter 15

5. Depreciation Recapture

a) Any gain realized on the sale of the home must be

recognized to the extent of any depreciation deducted on
the home.

Do Problems #28, 31, 34

II. Involuntary Conversions

A. Definition

1. An involuntary conversion is the result of the destruction

(partial or complete), theft, seizure, condemnation, or the sale
or exchange under threat of condemnation of the taxpayer's

2. A DIRECT involuntary conversion occurs when the

involuntarily converted property is converted directly into the
replacement property.

3. An INDIRECT involuntary conversion occurs when the

taxpayer receives money or other nonqualifying property
which is then used to purchase the replacement property.

B. Replacement Property

1. The Functional Use Test

a) This test for determining qualified replacement property

is used when the owner of the involuntarily converted
property also USED the property.

b) Under the Functional Use test, the taxpayer's use of the

replacement property and the involuntarily converted
property must be the same.

(1) For example, an office building used in a trade or

business cannot be replaced with a factory building.

Chapter 15

2. The Taxpayer Use Test

a) This more lenient test is used when rental properties have

been involuntarily converted.

b) Under this test, the replacement property must be used as

rental property regardless of the lessee's use.

3. The "Like-Kind" Test

a) This test, the most lenient of the three, is used where there
is a condemnation of real property which is used in the
taxpayer's trade or business or held for the production of

b) The "like-kind" exchange test for real property is very

broad. Essentially, the condemned real property must be
replaced with other real property—regardless of use.

4. Acquisition of replacement property from a related party will

not qualify for involuntary conversion treatment.

a) This rule does not apply if the realized gain is $100,000 or


C. Replacement Time Period

1. General Rule: The taxpayer has 2 years from the END of the
taxable year in which the gain was first realized.

2. Exception: If the involuntary conversion is a condemnation of

real property which is used in the taxpayer's trade or business
or held for investment, the taxpayer has 3 years from the END
of the taxable year in which the gain was first realized.

3. The earliest date for replacement also depends on the form of

the involuntary conversion.

a) Condemnation: The earliest date for replacement is the

date of the threat of condemnation of the property.

b) Other forms of Involuntary Conversion: The earliest date

for replacement is the date of the involuntary conversion.

Chapter 15

D. Nonrecognition Rules

1. Realized losses

a) Involuntary conversion of business or income producing


(1) The loss is recognized.

(2) This treatment is MANDATORY.

b) Involuntary conversion of personal use property:

(1) If caused by CONDEMNATION, the realized loss is

NOT recognized.

(2) If caused by a CASUALTY OR THEFT, the realized

loss is recognized, subject to the $100 and 10% of
AGI floors.

2. Realized gains

a) A realized gain in a DIRECT involuntary conversion is


b) A realized gain in an INDIRECT involuntary conversion

is recognized, unless the taxpayer ELECTS to postpone
the gain.

(1) The amount of gain to be recognized if the taxpayer

elects postponement is the LESSER of:

(a) The realized gain, or

(b) The amount realized that is not reinvested

in replacement property.

E. Basis of Property Received

1. The basis of boot received is the FMV of the boot.

2. The basis of the qualifying property received is reduced by the

amount of the postponed gain.

Chapter 15

F. Holding period of Replacement Property

1. If the involuntarily converted property was a capital asset or a

§1231 asset, the holding period of the replacement property
includes the holding period of the involuntarily converted

2. If the involuntarily converted property was neither a capital

asset nor a §1231 asset, the holding period is not "tacked."
Do Problem #37

Chapter 15

Postponement of Gain on
Involuntary Conversions

Proceeds Proceeds
- Adjusted basis - Cost of Replacement Property
--------------------- ---------------------------------------
Realized gain Amount Not Reinvested
============ ======================

the LESSER of:

Recognized Gain

Realized gain Cost of Replacement Property

- Recognized gain - Postponed gain
----------------------- -----------------------------------------
Postponed gain Basis of Replacement
============= =======================

Chapter 15

III. Like-Kind Exchanges

A. Requirements for Nonrecognition

1. The property transferred in a like-kind exchange must be held

for productive use in a trade or business or for investment.

a) Personal use property does NOT qualify.

b) Also excluded from like-kind treatment are:

(1) Inventory
(2) Stocks and bonds
(3) Notes
(4) And other similar items.

2. The property must be "like-kind" property.

a) Real property — Any exchange of real property for real

property meets the like-kind test.

b) Tangible, depreciable personal property — must be within

the same:

(1) General asset class (p. 15-27), or

(2) Property class as defined in the Commerce

Department’s Standard Industrial Classification

3. The property received must be held for productive use or for


a) Taxpayer exchanged a ranch or another ranch. He

contemplated (but had no definite plans at the time of the
exchange) eventually making a gift of it to his children.

(1) After holding the ranch for a period of 9 months for

productive use in a trade or business or for
investment, the taxpayer gave the ranch to his

(2) The Tax Court held that the exchange qualified as

a "like-kind" exchange.

Chapter 15

b) Taxpayer exchanged her farm for two residential

properties. On the same day, taxpayer's two children,
who had selected the residences, occupied the two houses
as their principal residences.

(1) Seven months later, the taxpayer made a gift of the

two residences to the children.

(2) The Tax Court held that the property received was
not held for productive use or for investment, and,
therefore, it was a taxable exchange.

4. The form of the exchange can involve more than 3 parties.

E.g., a "triangular like-kind exchange."

5. The exchange of like-kind property does not have to be

simultaneous. However, to qualify for nonrecognition
treatment, the property to be received must be:

a) Identified within 45 days of the initial transfer, and

b) Received within 180 days of the transfer, but no later than

the due date of the return for the year of transfer.

6. §1031 postponement of recognition is MANDATORY.

a) If the taxpayer wants to avoid nontaxable exchange

treatment, it is necessary to structure the transaction so
the "like-kind" exchange requirements will not be met.

b) Reasons for avoiding "like-kind" exchange treatment:

(1) The taxpayer may wish to recognize a realized loss

on the exchange.

(2) The taxpayer may be able to recognize capital gain

on the exchange. As a result, the basis for
depreciation (which yields ordinary deductions) of
the replacement asset will be higher.

Chapter 15

B. Effect of Boot

1. Boot is property which is not like-kind property.

2. The RECEIPT of boot will trigger recognition ONLY if there

is realized gain.

a) The amount of gain recognized is the LESSER of:

(1) Boot received, or

(2) Realized gain.

b) If boot is received and a LOSS is realized, no recognition

will occur.

3. The GIVING of boot normally does not trigger recognition.

a) However, if the adjusted basis of the boot is not equal to

its FMV, then recognition of gain or loss will occur.

b) In this situation, gain recognized could exceed the

realized gain on the exchange of the "like-kind property.

C. Basis of Property Received

1. Basis of boot received is the FMV of the property.

2. Alternative methods of computing the basis of like-kind

property received are shown on p. 15-31.

D. Holding period of Property Received

1. If the like-kind property transferred was a capital asset or a

§1231 asset, the holding period of the replacement property
includes the holding period of the like-kind property

2. If the like-kind property was neither a capital asset nor a

§1231 asset (e.g., "ordinary property"), the holding period is
not "tacked."
Do Problems #44 and #45

Chapter 15

Postponement of Gain on
Like-Kind Exchanges

FMV of Like-kind prop. rec'd Liabilities discharged

+ Liabilities discharged - Liabilities assumed
- Liabilities assumed --------------------------
+ Other boot received Net Liab. discharged*
- Other boot given
---------------------------------------- + Other boot received
Amount realized - Other boot given
- Adjusted basis ---------------------------
----------------------------------------- Net Other boot rec’d*
Realized Gain ---------------------------
======================= Net boot received

the LESSER of:

Recognized Gain

Realized gain FMV of new property

- Recognized gain - Postponed gain
------------------------ ------------------------------
Postponed gain Basis of new property
============= ==================

* If the result is a negative number, use zero as the result.