FEDERAL INCOME TAX

Professor Abrams Fall 2009
I. Introduction to Tax and Tax Policy
a. Determining Taxable Income: Concepts i. What is a Taxpayer’s Tax Liability? 1. Multiply INCOME by the appropriate TAX RATE (ex: Income of $100 x 40% = $40 income tax liability) Tax Liability: INCOME x TAX RATE 2. Must ask: a. How do we determine income? b. How do we determine the appropriate rate? i. § 1 A: Rates that apply to individuals 1. Note: the first dollar for everyone is taxed at the lowest rate ii. Ensuring Taxpayers are Taxed Alike 1. Horizontal Equity a. Taxpayers that are virtually alike should be taxed the same i. Ex: If TP A and TP B seem to be in the same economic position, then they should pay the same tax. If A buys a share of stock for $100 and sells it for $150, and B buys a share of stock for $200 and sells it for $250 A and B may receive different amounts but they each made a profit of $50 and should be taxed the same. 2. Vertical Equity a. Taxpayers that are fundamentally different should be taxed differently iii. Terminology 1. Gross Income: What comes in 2. Taxable Income: What we want a. Corporations i. Taxable Income = Gross Income – Allowable Deductions b. Individuals i. Taxable Income = Gross Income – Some Deductions = Adjusted Gross Income – Rest of Deductions 1. Some Deductions = Business Deductions = Above the Line Deductions (subtracted before AGI) 2. Rest of Deductions = Personal Deductions = Below the Line Deductions (subtracted after AGI)

Taxable Income for Corporations and Individuals:  CORPORATIONS: Gross Income – Allowable Deductions  INDIVIDUALS: Gross Income – Business Deductions = AGI – Personal Deductions 3. Deductions: What we do not pay tax on a. What is a Deduction Worth? i. A deduction is worth the amount of the deduction times your tax rate = marginal tax rate

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ii. If you are a HIGH TP = Deductions are Worth MORE iii. If you are a LOW TP = Deductions are Worth LESS
b. Tax Subsidies i. When we get interest deductions, this represents a partial government subsidy 1. Tax subsidies reduce the price, but the seller still gets the selling amount—the only person who loses money is the TP ii. Why are they Relevant? 1. Congress is required to put forth a tax expenditure budget each year b. The Tax Base i. Generally 1. Society-wide concept that constitutes those items which together constitute gross income (ex: wages, rents, gains, etc.) 2. To raise tax revenue, Congress raises rates or broadens the tax base a. The greater the tax base, the greater the amount of revenue that will be raised with a fixed set of rates ii. The Income Tax vs. The Consumption Tax 1. Income Tax: tax on your consumption AND saving a. Based on ability to pay 2. Consumption Tax: a tax only on what you consume a. Based on actual ability to consume b. Amount consumed = Gross income – Savings c. Hides labor income d. Can be implemented by: i. Allow an immediate deduction for the cost of investments OR ii. Do not allow such a deductions but exclude investment returns from the tax base c. The Tax Rate and Definitions i. Progressive Rates: tax rates increase as the amount of taxable income increases 1. First dollars are taxed at the LOWEST rates for all taxpayers ii. Marginal Rate: the rate at which the next dollar will be taxed iii. Average Rate: total tax liability / total income iv. Relationship: marginal rate is greater than or equal to average rate d. Cost, Recovery, Depreciation, & Basis: The Widget Problem i. Basis First = TP takes all deductions now and pay taxes later (TP wants this) 1. Allowing immediate deductions is equivalent to exempting the periodic investment return ii. Basis Last = TP pays taxes last (government wants this) iii. Ratable = Proportion 1. Statute will tell us which method to use

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II.

What is Income: § 61
a. Gross Income Defined: § 61(a)

Section 61(a): Except as otherwise provided, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, etc (2) Gross income derived from business (3) Gains derived from dealings and property (4) Interest (5) Rents (6) Royalties (7) Dividends (8) Alimony and separate maintenance payments (9) Annuities (10) Income from life insurance and endowment contracts (11) Pensions (12) Income from discharge of indebtedness (13) Distributive share of partnership gross income (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust  Note: under this provision, if nothing in the code says otherwise, it is income; this includes appreciation in property value. However, appreciation is not a realization event so it does not qualify as taxable income, but does qualify as economic income. b. Glenshaw Glass Income i. “Income from whatever source derived” in § 61 requires that there be: 1. Accession to wealth 2. Clearly realized (or sufficiently at hand) 3. Over which the taxpayer has complete dominion

III.

What does “Clearly Realized” Mean?

a. Determination of Gain or Loss i. § 1001 1. § 1001(a): Computation of gain or loss a. Gain = Amount realized – Adjusted Basis (in § 1011) Must have a b. Loss = Adjusted Basis – Amount Realized disposition to 2. § 1001(b): Amount Realized determine a. Amount realized = sum of any money received + FMV of the property gain or loss! (other than money) received 3. § 1001(c): Recognition of Gain or Loss a. The entire amount of the gain or loss on the sale or exchange of property shall be recognized (except as otherwise provided) ii. Basis 1. Definition: basis = cost, or the amount you get tax-free (tells us what we have been taxed on) a. Basis = amount of your investment in some profit-generating activity or asset less amounts already used to offset receipts initial basis = cost b. As you allocate some of that cost to offset receipts, you must reduce your basis adjusted basis (§ 1011) 2. If you recognize income, your adjusted basis is higher

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defrauded. In our system. A disposition of property should not produce an accession to wealth unless one party to an exchange is deceived. Cash Dividends: TAXABLE 1. If the distribution is of the corporation’s own stock. or incompetent equal values should be traded 2. California: Proposition 13 real estate values cannot change until you sell the house) c. including trading) 2.3. Side-bar: Mark-to-Market System 1. What is it? a. Realization: when a taxpayer disposes of appreciated property (think: the selling or disposing of property. must “mark” everything at its market value i. sometimes not 1. A high basis is good because you can get more money without getting taxed Summary: WHAT IS YOUR BASIS?  Basis is your cost  Basis of cash = face value  Basis based on method of acquisition:  Acquire normally = cost  Acquire by gift = carryover basis (basis of donor) unless determining loss (see below)  Acquire by devise = FMV at time of death (or 6 months later if estate so elects)  Acquire by divorce = carryover basis  Non-recognition (transfers of property) = see below b. There is taxable income even though there is no “gain”—gain is not the only kind of income! 2. Stock Dividend: Sometimes taxable. Caveats 1. The proper comparison is the BASIS of what is being given up with the VALUE of what is received iii. it is taxable and added to “net capital gain” to the extent of the earnings and profits of the corporation iii. Realization vs. Generally 1. IT IS RECOGNIZED UNLESS THE CODE SAYS OTHERWISE ii. Recognition 1. The Realization Doctrine i. If the payment is in the form of cash or property. An individual who is a stockholder of a corporation may receive a dividend payment in the form of cash (or other property) or in the form of the corporation’s stock ii. appreciation is not a taxable event 2. Dividends i. sometimes they are taxable and sometimes they are not 4 . Real-life example: property taxes except for CA a. Recognition: if realized gain must be included on the taxpayer’s return IF REALIZED. § 61(a)(7): provides that gross income includes income from dividends a. At the end of each year.

ask:  What is the gain or loss realized? o Gain/loss realized = Amount realized (amount of cash + amount of property you receive) – adjusted basis (cost of any property you are giving away)  What is the gain or loss recognized? o Recognize gain to the extent of the value of the boot (cash + other property) received o If the boot value is lower than gain recognized. Stock in trade or other property held primarily for sale. Boot: § 1031(b) i. The requirements of § 1031(a)(1): 1. LIKE KIND: Two pieces of property have to be of “like kind” (note: not defined use in a T or B in statutes. Choses in action b. 1031 (hence. Replacement property must be held for productive use in trade or business or held for investment § 1031(a)(1): c. which will also be developed and sold to customers this is not of like-kind ii.e. or vi. or notes. § 1001 applies § 1031(a)(1): “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” ii. Real estate is of “like kind” to real estate. Generally i. then gain recognized = $0 o Only recognize losses upon disposition if boot is received. then the disposition of property is NOT TAXABLE and thus NOT RECOGNIZED otherwise. Relinquished property must be held for productive use in trade or business or held for investment b.IV. etc. iii. Foreign for foreign. Other securities or evidences of indebtedness or interest. which were held for development and sale to customers. PRODUCTIVE USE + INVESTMENT a. distinction between personal property and real estate in the or held for regulations) investment a. 1. v. If you fall under §1031(a)(1). the difference is gain deferred o If no boot is received. for unimproved oceanfront property in Oregon. Certificates of trust or beneficial interest. All domestic real estate is of like kind to all domestic real estate under i. iv. Ex: a real estate developer exchanges unimproved lots in Santa Barbara. Interests in a partnership. even if wildly different (i. NO EXCEPTIONS: Cannot fall under 1031(a)(2) (“exceptions”) 1031(a)(2) a. bonds. Held for Productive Use or Investment: § 1031 a. Stocks.  Productive 2. Does not have to be trade for trade.  Of Like Kind dirt is of “like kind” to an office building)  Cannot fall b. but not domestic for foreign exceptions of § 3. non-recognition) does not apply to any exchange of: i. Calculation Steps: Whenever you have an exchange that meets § 1031 and there is boot. loss recognized = $0 o NOTE: debt liability = cash received = boot  What is the basis? o New Basis = Old basis – money received (cash/debt liability) + gain recognized – loss recognized 5 o This is equal to the FMV of the property received minus any gain deferred .

A is deemed to have received a $2000 portion of the acquired real estate in exchange for the stock. If boot was received in addition to the property (excluding any cash received). SELLER  QI  BUYER property to BUYER i. What is it? 1. Boot basis = FMV at the time of the exchange b. since $2000 is the FMV of the stock at the time of the exchange. liability taken on by someone else = money received for the TP 2. Allocation Values a. The transaction is bifurcated into a 1031 exchange of real estate and 1001 exchange of boot given up (latter exchange is taxable) 2.000. Allocation of Non-Cash Property 1. The real estate transferred has an adjusted basis of $10. Real estate basis = New basis value – Boot basis iii. c. the basis must be allocated between the new property and the boot (think diamonds) 2.000 and a FMV of $11. QI pays cash replacement property within the earlier of 180 days after the to SELLER of transfer of the relinquished property or the due date of the replacement property  TP now has title to 6 replacement property . The basis of the real estate acquired by A: Adjusted bases ($10K + $4K) = $14K – Loss recognized ($2k) = $12K. The TP must receive the 45/180. TP is deemed to have received in exchange for such other property an amount = to FMV i. Thus. Deferred Like Kind Exchanges: § 1031(a)(3) i. Once again. No gain or loss is recognized on the exchange of the real estate since the property received is of the type permitted to be received without recognition of gain or loss. If TP Gives Away Debt: Constructive Boot 1. The basis of the property for TP = total basis of the properties given away (includes cash. This is the most common way to equalize value: the person with more FMV simply borrows against it and keeps the money (equity for equity) 3.ii. his adjusted basis will include the value of any debt taken on. and THE STEPS: then goes to the Buyer TP  relinquished a. If TP Gives up BOOT 1. The stock transferred has an adjusted basis of $4. iv. The property given up is first transferred to a qualified intermediary (QI).000 and a FMV of $2000. if the TP gives up boot: a. ALL property) b. The real estate acquired as a FMV of $13. we treat this debt as if it is money received: this is constructive boot (release of debt boot) a.000. A $2000 loss is recognized on the exchange of stock for real estate. The QI holds the cash in escrow while ID’s replacement the TP identifies replacement properties within 45 days of the property  after transfer of the relinquished property. TP basis in the property acquired = FMV of the property received less any gain deferred Example: A exchanges real estate held for investment plus stock for real estate to be held for investment. If the taxpayer gives away debt. THE SCENARIO: The TP sells the relinquished property to  cash to QI (holds Buyer and the Buyer puts the cash goes into escrow with the in escrow while TP Qualified Intermediary. NOTE: If another TP who receives the debt-ridden property. Thus.

acquires the relinquished property from the TP. IF the boot = 100% of the value of the relinquished property received prior to the receipt of any qualifying property. The due date of the taxpayer’s return (including extensions) 2. Any actual or constructive receipt of disqualifying property will cause the transaction to be taxable b. The taxpayer must receive the replacement property within the earlier of: a. and thus the transaction is taxable 2. he would have been taxed on entire property—therefore. thereby disqualifying the transaction 7 . Occurs if the taxpayer has an unrestricted right to obtain property. Identification of Replacement Properties 1. the property is NOT of a like-kind. The maximum number of replacement properties that the TP may ID is: a. Reverse-exchange: QI acquires the replacement property BEFORE acquiring the relinquished property—QI has to make sure not to get stuck with the replacement property 2. The 95-Percent Rule: the 200% rule may be bypassed if at least 95% of the identified properties acquired by the TP within the 180 period d. Notables 1. Constructive Receipt i. Receipt of the Replacement Property 1. the total FMV of the properties identified may not exceed 200% of the net sales proceeds from the relinquished property c. NOTE: If some boot is received as part of the deferred exchange. If Buyer had just given TP cash. Exception: property actually received during the ID period or exchange period will be treated as properly identified even if the taxpayer violates these rules—like kind exchange will be allowed iii. Actual and Constructive Receipt of Boot a. then receipt of cash by the QI would be treated as receipt by the taxpayer. the transaction is taxed under § 1031(b). transfers the relinquished property. TP uses a QI to hold the money so he doesn’t have it way to defer gain recognition ii. b. Qualified intermediary: is not the TP and enters into a written agreement. acquires the replacement property.taxpayer’s return. and transfers the replacement to the TP 2. Avoiding the Timing Requirements a. 180 days after the transfer of the relinquished property OR b. the transaction will be treated as a fully taxable sale even if some like-kind property ultimately is received iv. The 3-Property Rule: up to 3 properties can be identified without regard to FMV b. If a QI were treated as an agent of the taxpayer. The QI pays cash to the Seller (of the replacement property) so the TP acquires title to the replacement property. Why do we have deferred like-kind exchanges? a. The transferor must ID potential replacement properties within 45 days of the transfer of the relinquished property: if this is not done. The 200-Percent Rule: if more than 3 properties are identified. even if the taxpayer does not ultimately exercise that right ii.

The insurance company will have the use of $100. Involuntary Conversions: § 1033 a. iii. for example. Cottage did not have to report the loss on the mortgage pool given up in exchange because the mortgage pools were “substantially identical” within the meaning of federal bank regulations. but can exclude certain amounts of such payments under § 72(b)(1) 8 . SO. Under § 1033. Cottage claimed that the loss was realized on the exchange of the mortgage pools—interests exchanged were materially different because the underlying loans were secured by different properties.000. The difference between the cost and the expected return represents interest. Here. Any proceeds not reinvested are treated as boot b. ending upon the death of the purchaser.V.1001-1(a): gain or loss is realized when property is exchanged for cash or other property “differing materially either in kind or in extent” b. Significance: As long as the property entitlements are not identical. recognize the LESSER of your realized gain or your un-reinvested money c. at the time of purchase. storms. can take cash proceeds and reinvest them in property “similar or related in service or use” to the converted property and thereby avoid gain recognition (deferral of gain) on the transaction so long as all of the proceeds are reinvested in the similar property 1. Regulation § 1. Calculating Basis of Replacement Property: § 1033(b)(b) i. When is Gain/Loss Realized?: The Limits of § 1001(a) a.000 in return for annual payments of $10. Generally i. For bank regulation purposes. iii. Basis = FMV of replacement property – Gain Deferred VI. so that the individual is expected to receive $150. Often purchased to ensure sufficient funds for a financially stable retirement 1. VII. a TP whose property is involuntarily converted (ex: condemnation. the obligors on the mortgages varied between the 2 pools) and the exchange was thus a realization event. Commissioner (1991): When is Gain/Loss Realized? i. Assume that. etc). Cottage Savings Association v. § 72(a) provides that gross income includes annuity payments. An annuity is a K that provides for a series of payments in return for a fixed sum ii. Issue: Whether an exchange of one group of mortgage loans for another group is a disposition of property within § 1001(a). Generally i.000 for many years.000. the individual is expected to live 15 years and that the payments begin immediately after purchase. the exchange falls under § 1001(a). the exchanged mortgage pools embodied legally distinct entitlements (since. Holding: Exchanged properties are “materially different” if they embody “legally distinct entitlements” 1. Generally i. iv. Ex: An individual may pay an insurance company $100. Annuities a. ii. The gain shall be recognized ONLY to the extent that the amount realized upon the conversion exceeds the cost of such other property or stock 1. Calculating Gain: § 1033(a)(2)(A) i. Facts: Cottage exchanged a group (or “pool”) of residential mortgages that had declined in value for another pool of residential mortgages.

These are treated by using the exclusion ratio as well once payments are made ii. At one time. Historical Tax Avoidance Schemes a. The annuity provider is a TP as well: the annuity provider is able to pay the TP his deferred return only out of the annuity provider’s after-tax income 3. like insurance companies. Tax Avoidance and Inside Build-up a. are permitted to set aside expected payments (“reserve account”) and are NOT taxed on the inside build-up no one is taxed on the growth of the investment until the money goes to the taxpayer i. The government receives tax on the investment return (interest) by the annuity provider: inside build-up b. some annuity providers. she will recover exactly what she invested in the contract and have to include any excess of the total amount received over the basis  If a taxpayer OUTLIVES her life expectancy. Exclusion Ratio: Cost of the annuity K / expected return on the annuity K a. What is a Deferred Annuity? 1. If the annuity provider is NOT an insurance company. What are the Tax Consequences? 1. § 72(b): a taxpayer may exclude from each annuity payment the product of the payment multiplied by the exclusion ratio 1. all of each subsequent annuity payment must be included in income (§ 72(b)(2)) because there is no further basis to recover  If a taxpayer dies “early. Deferred Annuities i. Exclusion ratio: Cost of annuity / (payment per term x length of annuity) b. To figure out how much to include each year: Payment per year – Excluded Amount = Includable amount What happens If…  If a taxpayer lives exactly for her life expectancy.b. § 72(e): Borrowing Against the Annuity 1. What is excluded from each payment: Exclusion ratio x annuity payment 2. This is a way to defer tax liability: TP is not taxed under § 72 until the TP starts receiving payments 2.” her estate will be able to deduct the difference between the aggregate amount excluded from income under § 72(b) and the cost of the K can deduct any un-recovered basis (§ 72(b)(3)) as a loss (TOTAL BASIS – TOTAL $ RECEIVED = AMT OF LOSS DEDUCTION) c. The beneficiary of a deferred annuity pays NO TAX on the interest of the annuity until the receipt of the annuity payments a. However. This exclusion ratio is multiplied by each annuity payment to determine what is excluded from income—the remainder is treated as gain and included as income under § 72(a) a. there is no tax-free build-up unless the annuity provider is somehow taxexempt iii. Exclusion Ratio: § 72(b)(1) i. individuals could use annuities to build up interest income 9 . Deferred annuity: type of annuity that does not provide payments for many years (ex: may begin at retirement) 2.

and the beneficiary gets the final paycheck) b. Amounts Borrowed on a Loan Secured by an Annuity Policy are TAXABLE INCOME: § 72(e)(4) a. We have taxation every time there is productive activity—every cycle of consumption/production = cycle of taxation—with gifts. then the beneficiary is taxed equivalently: income with respect to decedent c. Yes. The purchaser may treat only the amounts actually paid by the purchaser as investments in the K for computing the exclusion ratio under § 72(a) 2. they can sell the annuity to a company like JG Wentworth ii. NOTE: Can still borrow against the actual investment in the annuity taxfree. Changed by Congress 2. Gifts a. If a beneficiary receives funds that would have been taxed to the decedent had they survived. If someone dies. devise or inheritance a. Tax Penalty with DEFERRED ANNUITIES: § 72(q) a. Example: Qualified Retirement Funds i. Looking at ONE UNIT 10 . whichever is longer. Buying Annuities i. If you borrow against the appreciation of the annuity. bequest. Policy: Should Gifts be EXCLUDED from Income? 1. they may have unreported income because it is not time to report it yet (ex: die in the middle of the month. and the income portion is includible (income first allocation) c. the purchaser does not step into the shoes of the annuitant VIII. The beneficiary is taxed like B. If B dies after 2 years. Thus. PUNISHES deferral reduction d. the transferor forsakes consumption in favor of the transferee’s. How is the Beneficiary Taxed? i. § 102(a): Gifts or Inheritances 1. there is only 1 cycle of consumption and production a. this is treated as a distribution and is now taxable b. IX. Any distribution (including loans) received before the annuitant is age 59 ½ is subject to a 10% penalty b. to avoid multiple taxation 2. If the annuitant wants to accelerate receipt. Death and Income with Respect to Decedent: § 691 a. General rule: Gross income does NOT include the value of property acquired by gift. this provision speaks only to borrowing against the untaxed growth in the value of the annuity 3. A gift is not includable for the donee. 8 more payments will go to the beneficiary.tax-free and borrow the increase in value in the policy—loan was made by the annuity company and secured by the annuity (no tax on receipt of loan proceeds) b. §72(e)(4)(A): Loan proceeds are treated as “amounts not received as an annuity” such amounts must be allocated between return of capital and income. The Tax Consequences of Buying an Annuity: § 72(g) 1. B puts money away so that it will pay an annuity for B’s life or 10 years. and the donor receives no deduction ii. Generally i.

charity.00 on t expenses > which the TP is clearly and permanently imprinted and which is one of a $25 number of identical items distributed generally by the TP is NOT a gift  Cost of less (ex: Barbri pen) than $4 with TP 4. Bowers (1929): Taxing Gifts the donor’s basis will be carried over to the donee. then to determine loss.b. In a Trade or Business: §274(b)(1)(a) family) a. awards. the basis = FMV a. meaning that the donee will pay taxes on the appreciation that occurred during the donor’s ownership (because the gift is not treated as a recognition event) a. one’s life and something one would not have made an expenditure for awards. scholarships or fellowships name (Barbri) a. Have to point to the fact that the gift was not made in What is NOT a recognition of the employee’s employment was due to Gift: familial relationship  Tipping in c. What is NOT a Gift 1. Thus. use carry-over basis for every calculation except LOSS 2. §1015(a): for gifts received after 12/31/1920. Covers transactions from EMPLOYER to EMPLOYEE ii. or like impulses” ii. Basis Calculations: § 1015(a) i. scholarships. because it is in exchange for services 2. This is something received which is not needed in the ordinary course of  Prizes. §1015(a) lets you get a gift tax-free! 11 . the basis shall be the same as it would be in the hands of the donor or last preceding owner by whom it was NOT acquired by gift. Detached and Disinterested Generosity 1. GIFT: employer does not get a deduction and employee has no  Employer to income employee gifts ii. Tax Consequences restaurants i. Employee Gifts: § 102(c) a. An employee can give a gift to his employer b. Commissioner v. A donee can be taxed on appreciation that accrued prior to a gift b. EXCEPT if such basis is GREATER than FMV at the time of gift. What is a Gift? LOOK TO THE TRANSFEROR i. and thus not deductible there are no gifts from employer to employee i.102-1(2)): i. Taft v. § 102(c): gifts from employer to employee are income and taxable. NO GIFT: employer gets a deduction and employee has income (unless for 3. Rule: Gift for the purposes of § 102 is a transfer made out of a “detached and disinterested generosity” or out of “affection. § 1. Transfer can be attributed to a familial relationship 1. admiration. No deductions are allowed for gifts in excess of $25 Entertainmen b. Tipping in Restaurants a. NOT a gift.102-1(a) b. SO: NOT a gift unless (Reg. Carry-Over Basis 1. §274(b)(1)(a): an item having a cost to the TP not in excess of $4. NOT gifts under Reg. Duberstein (1960): What is a Gift? a. Prizes. § 1. or c.

B sells the filling station for $20. $22. 5 years later.000 property consisting of a used car lot and adjoining filling station. the cost or other basis of the entire property is equally apportioned (relative FMV) among the several parts and the gain realized/loss sustained on the part of the entire property sold is the difference between the selling price and cost or other basis Allocate basis in allocated to such part. At the time.000. RULE: Sales proceeds will only be included in gross income to the extent that they exceed the TP’s basis in the property— reduce the TP basis by AR. Under § 1014.000 . B’s gain on this sale is $7000. the City of LA each part began dumping waste in a steam that ran through the TP’s land.000 = $7000) ii.000 x 3/5 = $15. Temporally 1. Geographically 1. The TP sued the City and settled for a payment of $50K for past damage and for giving the City the right to continue dumping (easement). Thereafter. then Donee’s Basis = Donor’s Basis o If Donor’s Basis > FMV at time of the gift. Issue: Is any part of the $50K settlement taxable? c.$15.ii. v. since $7000 is the amount by which the selling price of the filling station exceeds the portion of the cost equitably allocable to the filling station at the time of purchase reduced by depreciation.000 at a time when $2000 has been properly allowed as depreciation thereon (ADD BACK DEPRECIATION). Court does not do usual calculation of apportioning basis: going to give enough basis to offset amount realized no income and no loss (no reason for this) ii. Example: B purchases for $25. The sale of each part is treated as a separate transaction proportion to and gain or loss is computed separately on each part FMV values at a. the basis of property acquired from a decedent = FMV at the date of the death of the decedent 12 .000. b. Holding: No portion of the payment is income—treat the full amount as return of capital and apply in reducing the cost basis i. ($25. Division of Property Geographically and Temporally i. Inaja Land Co. Summary of § 1015(a)  Basis Determinations o If Donor’s Basis < FMV at time of the gift. then  GAIN: Donee’s Basis = Donor’s Basis  LOSS: Donee’s Basis = FMV at the time of gift • To determine gain/loss calculation compare FMVs o If Donee’s AMOUNT REALIZED (FMV at sale) is BETWEEN Donor’s Basis and FMV at the time of gift. the FMV of the filling station is $15. Facts: The TP purchased land for $61K. NO LOSS OR GAIN o REMEMBER: Gain = AR – AB (if negative number = loss!) d. Transfers at Death: § 1014 a. Commissioner (1947): When Impossible/Impractical to --Gain or loss Allocate Basis. The Entirety of Net Amount Received Will be Recovered from treated That Basis separately for a. SO: Allocate basis in proportion to FMV values at time of acquisition time of acquisition 2.61-6(a): When property is divided geography for sale.000 and the FMV of the used car lot is $10. Regulation § 1.

The basis of property acquired from a decedent = FMV at the date of the death of the decedent i. device. Tax benefit = a reduction in tax liability b.  Getting Around § 102(b)(2) and Irwin v. Gavit --Ex: I am a taxpayer and I am going to die soon with $100. Abrams thinks SCOTUS got this wrong—exploitation when you have an income interest in a charitable organization and the remainder to grandchild. d. The kid will only get taxed upon a disposition of property (i. When Does it Apply? a. bequest. only to find later than the money or property is returned i. e. Example: A loan previously deducted as a bad debt may in fact be paid in a later year. Generally 1.e. Will you write me the will that does that? --You have a proposal: put the property in the trust—income for the charity for 9 years. the amount of such income. and B will get the remainder after the expiration of a term of years (9 years).000. and the remainder for the nephew. Gavit (1925): Taxing Divided Interest in a Bequest a. b. The kid will get 9 years of interest and never pay tax on it: devise is worth $50. EFFECT: over-tax the income beneficiary and under-tax the remainderman (gets the entire §100K). or amortization (Reg. sell LOSS property and hold on to GAIN property and no one will pay taxes (because you have higher basis) c.000. The property is put in trust: income to A.000 but they will not pay tax at all because they are a charity. § 1. A will get the income interest for a fixed period of time.111-1) ii. he sells the property). ii.000 and will never get taxed based on Irwin v. under the theory that an income interest is not “property” under § 1014 or under § 102(b)(1). The charity will get $50. depletion. Exceptions: deductions with respect to depreciation. or inheritance is of income from property. or an amount deducted for medical expenses may be reimbursed by insurance in a later year should this later recovery be treated as income? 1. then the recovery is viewed as income to the full extent of the deduction 13 . Codified in § 102(b)(2): subsection(a) shall not exclude from gross income where the gift. Income that has been EARNED by a decedent prior to death will not be excluded under § 1014—IRD is earned income of a decedent that was not includible to the decedent prior to death 2. SO: If on death bed. i. Gavit. When a taxpayer takes a deduction for expenses paid. THE RULE: The returned item may be excluded from income to the extent that the initial use as a deduction did not actually provide a tax saving. giving rise to a tax saving. Facts: TP dies owning $100K in value.000 in value when you die—they will pay tax on $72. Any unrealized appreciation by the decedent just simply goes away ii. remainder to B. Holding: TP had a zero basis in the income interest. Issue: How should A be taxed? c. If full use of a deduction was made. Tax Benefit Rule i. Unrealized gain or loss is LOST at death! b. Income in Respect of a Decedent i. I have a nephew and a charity that I am fond of: I want to leave both $50. Irwin v.

The Inclusionary and Exclusionary Aspects of the Tax Benefit Rule 1.previously allowed (Alice Phelan Sullivan). Take a standard deduction (instead of an itemized deduction) b. or from both combined—HE JUST GOT HIS cash. then a later recovery of the item will be excluded from income. he only BASIS RETURNED got his basis 2. Holding: Tax-free no deduction when it comes out. when a separate return would have given them $19K less in tax. then the later recovery will be taxed (Alice Phelan Sullivan) 2. and then getting the money back and getting 14 . Facts: TP made a charitable contribution of 2 parcels of realty and the parcels were returned over 15 years later. Clark v. and at which rate: the rate at the time the deductions were taken or the rate at the time of recovery? 3. ii. then treat as income a. AMOUNT TO BE TAXED: The full extent of the deduction previously taken b. If TP recovers property for which he did NOT get a tax benefit: NO income is recognized 3. Think: paying taxes in Year 1 where you don’t enjoy the cash) benefit. b. Since he was 1. Inclusionary Aspect a. He was reimbursed for the amount. 2. The advisor had advised them to file a joint return. Do not realize any income TAX BENEFIT RULE: THE RECOVERY OF A PREVIOUSLY DEDUCTIBLE ITEM GIVES RISE TO INCOME ONLY TO THE EXTENT THE PREVIOUS DEDUCTION PRODUCED A TAX BENEFIT. The reimbursement was not derived from capital. Issue: How is this taxed? iii. from reimbursed in labor. If a deduction in an earlier year generated no tax benefit (because there would have been no taxable income even without the deduction). Issue: What amount is included in taxable income: the reduction in tax liability the TP received OR the amount of deductions taken by TP. RATE: The rate at the time of recovery iii. Alice Phelan Sullivan (1967): The Inclusionary Aspect of the Tax Benefit Rule 1. Exclusionary Aspect a. 2. Facts: TP hired a tax advisor to get tax advice. no inclusion when it comes back. Commissioner (1939): Exclusionary Aspect of Tax Benefit Rule i. If a deduction in an earlier year generated a tax benefit. ii. How does a TP NOT get a tax benefit on a deduction? a. This is an example of the exclusionary aspect of the tax returned (the benefit rule amount of 3. § 111(a): Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in a prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter a. If TP got a tax benefit because of a deduction and subsequently recovered property: TP recognizes gross income to the extent of the recovery b. TP made an election on the tax return that turned out to be the wrong one— the election was irrevocable and could not be corrected. Holding: A transaction which returns to a TP his own property cannot be said to give rise to income—but if treated as a deduction.

Rental or other payments required to be made as a condition to the continued use or possession for purposes of the T or B. In general. Trade or Business Expenses: § 162(a) 1. NOTE: Net Operating Loss (NOL) § 172 a. NOTE: NOL only arises in operation of a business X. collection. To the extent a prior deduction gave rise to a NOL that has not yet expired. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year— a. Traveling expenses (including amounts for meals and lodging other than lavish or extravagant amounts under the circumstances). but neglect to claim it and then recover—it is UNCLEAR as to whether this gets the exclusionary aspect of the TB rule 3. of property which the TP has no equity ii. or family expenses General Definitions to Note  Ordinary: current. or refund of any tax Captures all remaining profit-seeking activity that is not in a trade or business  NOTE: § 262: No deduction for personal.benefit of exclusion  Note: if entitled to a deduction.e. What Can be DEDUCTED in a Trade or Business? i. and c. including— a. Get to carry over losses through the year you have income government allows you to move your losses forward so you can carry over NOL when you do have income and claim deduction that year i. then the cost is capitalized and will produce a long-term benefit and you cannot deduct the cost now 15 . A reasonable allowance for salaries. legal fees for tax advice) b. living. deductions arising out of profit-seeking activity can give rise to an NOL while personal deductions (such as charitable deductions) do not. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Expenses for the Production of Income: § 212 1. the deduction is treated as having given rise to a tax benefit. (SEE BELOW) b. renting property) or c. For the production or collection of income (i. or other compensation for personal services actually rendered b. while away from home in pursuit of a trade or business (but not for more than a year. short-term  Necessary: not intended for personal benefit  Trade or business: think profit-seeking activity  Capitalize: if an expenditure is NOT ordinary. the tax benefit rule applies and you are taxed on that benefit ii. or maintenance of property held for the production of income (i. For the management. Capitalization and Trade or Business Expenses a. conservation. To the extent that you get something back akin to Alice Phelan and you haven’t exercised NOL. In connection with the determination.e.

or otherwise. No deduction shall be allowed any amount paid out for new buildings or for permanent improvement or betterments made to increase the value of any property or estate b. expenditures producing assets whose useful lives will NOT extend SUBSTANTIALLY beyond the close of the taxable year can be deducted in full iii. Soil and water conservation expenditures deductible under section 175 d. Research and experimental expenditures deductible under section 174 c. Issue: Can a business that purchases a 1-year fire insurance policy on < 2 years: July 1 deduct the entire cost of the policy? expense b. Expenditures for which a deduction is allowed under section 179 (2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. who were also shareholders. § 1.263(a)-1) § 263: No deduction shall be allowed for (1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. cost of goods sold. Capital Improvements: § 263(a) 1. b. Exacto Spring Corp. v.. No deduction shall be allowed for personal. Issue: Should part of it be considered a dividend. NOTE: Capital expenditures are subsequently recovered through depreciation. CIR (1999): Salaries CAN BE Deductible a. deductible! b. ADJUST BASIS/DEDUCT AT DISPOSITION (Reg. the cost should be recovered in part in the current capitalize year and in part in the next taxable year because the policy will have value in each of the two taxable years ii. Living or Family Expenses: § 262 1. Facts: Paid the officers. Expenditures by farmers for fertilizer. Conceptually. so as not to be deductible? c. e. Expenditures for removal of architectural and transportation barriers to the handicapped and elderly which the taxpayer elects to deduct under section 190. BUT. the cost of the asset is an expense thus. Held: DEDUCTION 2. This paragraph shall now apply to a. at such time as the property to which the amount relates is disposed of by TP SO INCLUDE COST AT CAPITALIZATION. living. f. etc. T OR B EXPENSES: What Can be DEDUCTED as an ORDINARY and NECESSARY EXPENSES in a T or B? 1. deductible under section 180. Generally a. Commissioner v. Expenditures for the development of mines or deposits deductible under section 616.iii. amortization. Personal. as an adjustment to basis. a really high salary b. 16 . Holding: YES > 2 years: i. So long as the asset will fully waste during the current or next taxable year. Boylston Market Ass’n: Assets that do NOT EXTEND SUBSTANTIALLY into the Taxable Year are Deductible a. or family expenses ii. CAPITAL EXPENSES: What CANNOT BE DEDUCTED? i.

The cost of goodwill in connection with the acquisition of assets of a going concern d. but can deduct ordinary and necessary business expenses: conceptually. b. 17 . Examples of Capitalization: Reg.263(a)-2 i. or erection of buildings. even if the benefits are intangible and the expenses do not create a separate and distinct asset. Other Case-Specific Examples of CAPITALIZATION 1. An expenditure MUST be capitalized if it provides a long-term benefit without regard to whether that benefit attaches to a particular. Note: failed business doctrine allows for expense CAPITALIZE. Facts: Business tried to deduct fees associated with merger. Expenses in constructing a building or machinery (Idaho Power) e. identifiable asset ii. which remain the property of the person making the payment SHORT TERM iii. are you spending money to make money in the current year. or equipment. The cost of defending or perfecting title to property (add to basis = EXPENSE of land) get the benefit of the land for more than 1 year iv. Expenses in production of a book (EB) iv. Merger costs that give long-term benefit (INDOPCO) ii. § 1. Other Case Specific Examples of Capitalization: see next section i. The amount expended for architect’s services (add to cost of building) v. machinery. THE TEST: Does the expense i. or the future year? b. UNDER INDOPCO: An expenditure MUST be capitalized if it provides a long-term benefit without regard to whether that benefit attaches to a particular. Amount expended for securing a copyright and plates. Holding: Investment banking fees incident to a merger must be capitalized—the benefit of the merger will last indefinitely i. § 263A and Inventory Costs iii. What is a Capital Expenditure? Reg. § 1. Expenses to secure business reputation (Welch) iii. Create an asset with a useful life substantially beyond the taxable year OR ii. Substantially prolong the useful life of the property OR iv. INDOPCO (1992): Costs Associated with a Corporate Acquisition a. and similar property having a useful life substantially beyond the taxable year LONG TERM = 1.2. The test: the capitalization requirement also applies to expenses that produce significant future benefits. Add to the value of the property OR iii. (deduction) ii. identifiable asset (See below) c. The cost of acquisition. Adapts the property to a new use Must capitalize those things that will produce betterments to any property or estate. construction.263(a)-(1)(b) a. Costs incurred by the target corporation in a friendly takeover.

Facts: EB hired a publishing company to do all the preparation and editing for a book—EB gave them royalties in advance. Idaho Power (1974): Expenses In Constructing a Building or Machinery a. EB treated these advances as ordinary and necessary business expenses and deducted them. Commissioner (1992): Smaller Costs as Part of a Larger Renovation are Capitalizable a. Facts: A power company had to capitalize expenses for wages and depreciation on trucks used to construct a capital facility with a 30-year useful life. Holding: NO DEDUCTION the cost must be capitalized because from the publisher’s standpoint. Encyclopedia Britannica v. Welch v. and just as expenditures that are put into a building to put it into shape must be capitalized. the contractor will depreciate the asset for the useful life of the asset. IRS argued that the asbestos removal expenditures must also be capitalized. b. not the shorter useful life of the trucks. 5. Because the removal was part of a larger. Facts: P paid off creditors of a bankrupt corporation.Costs Associated with a Corporate Acquisition  Acquiring corporation’s expenditures in a successful acquisition: capitalized as the cost of the stock acquired or as part of the assets acquired (note: goodwill allocation. Helvering (1933): Expenses to secure one’s business reputation are NOT deductible a. which he was secretary of. Facts: As part of a general building remodeling costing approximately $7 million. The effect was that the TP was required to recover the cost of the trucks over the 30-year-life of the facility.  EX: You own a power plant and hire a contractor to build something for you. § 197)  Acquiring corporation’s expenditures in an unsuccessful acquisition: expense like costs invested in other failed business ventures  Target corporation’s expenditures in a failed acquisition: case-by-case capitalize on the theory they were incurred to attract a more valuable suitor or were incurred to increase the value of the stock OR look to failed business doctrine if failed as a result of regulatory difficulty (or some other reason) 2. b. Commissioner (1982): Expenses in Production of a Book a. you will depreciate the asset for the life of the power plant. If you hire a carpenter to build a rental property. to strengthen his own standing and credits. Norwest Corporation v. admittedly capitalizable renovation. the TP discovered asbestos material in the walls and paid almost $ 2 million for its removal. and claimed the expense as a business deduction. whereas you will depreciate for the life of the power plant. Holding: Capitalize! i. This is MATCHING the income to the EXPENSE. If you build the building yourself. Commissioner v. Holding: NO DEDUCTION this is an extraordinary expense because most secretaries who worked for a now bankrupt corporation would not pay off creditors of the corporation 3. so must expenditures to create a book i. b. The remodeling expenses were capitalized by the TP the costs of asbestos removing were deducted. it should be capitalized 18 . a book is just another rental property. the cost of the carpenter is capitalized into the cost of the rental unit 4.

Holding: Environmental remediation costs are subject to capitalization under § 263A. whereby the costs of producing selfcreated assets. Repairs that do not materially add to the value of the property or appreciably prolong its life are generally allowed as deductions iii.Subdividing Mass Assets: Fixing the Elevator in a Building --When some major component has a useful life significantly shorter than the overall asset (e. THIS DOES NOT APPLY TO TAXPAYERS WITH GROSS RECEIPTS OF $10 million or less 3. there is no question that you must capitalize (ex: buy a house knowing the roof has a hole it in—if you later fix the roof. the term “produce” includes construct. Repairs. All the costs of the manufacture of the inventory of goods to be sold. develop. Sets out the uniform capitalization rules. Capitalization and Inclusion of Inventory Costs: § 263A 1.. In the tax 19 . including such items as the cost of insurance on the manufacturing plant. the elevator in a building. § 263A(g)(1): provides that for the purposes of § 263A. Midland Empire Packing v. manufacture. If you fall under § 263A. but not the furniture in the building) --Asset segregation—unclear how far this extends Summary:  Expenditures that produce a benefit that does not extend beyond the year in which the expenses were incurred (and the year after) do not have to be capitalized  Expenses that produce a benefit that has a useful life that extends beyond a year in which the expenses were incurred (and the year after) must be capitalized o MAKING MONEY IN THE PAST = EXPENSE o MAKING MONEY IN THE FUTURE = CAPITALIZE iv.g. build. A mere repair is deductible. install. must be added to the cost of the inventory and deducted at the time the inventory is sold b. 1. do not get the benefit of other rulings XI. MUST BE capitalized—extends to ALL manufacturers a. NOTE: If it is something that you know you will have to do when you acquire the asset. Facts: TP used the basement of its meat packing plant to store and cure meats. you will have to capitalize that cost!) b. Improvements. Examples of § 263A in Application a. Issue: Are costs incurred to clean up land that a TP contaminated with hazardous waste by operation of the TP’s plan includible in inventory costs under § 263A? ii. Generally i. or improve 2. Treatment of Environmental Remediation Expenses Revenue Ruling 2004-18: Capitalize Environmental Remediation Costs under 263A i. such as the in-house production of a manuscript. Commissioner (1950): Look to Long-Term Benefits to Determine Capitalization or Expense i. but an improvement that extends the asset (or improves the asset) has to be capitalized ii. & Maintenance a.

or from theft 2. Revenue Ruling 94-38 (1994): Look to When Profits are Being Enjoyed i. storm. X’s operations discharge hazardous waste—to comply with federal regulations. X decided to remediate the soil/groundwater. Holding: 1. Facts: X owns and operates a plant (no contamination when purchased). then it would not be deductible XII. this is limited to: i. if you have an unexpected diminution in value and you put it into its state that it was before. creating a health hazard that caused federal meat inspectors to threatened to shut down the plant. Note: even though the benefits are long-term. Small Repairs as Part of Big Repairs (see above) i. TPs must “use inventories” for tax purposes if use of inventories is necessary to clearly reflect the taxpayer’s income: § 471 1. Norwest Corporation (1992): if you do something relatively small that would be deductible as part of something big. Issue: Repair? iii.year at issue. the cost to expand cannot plausibly be described as a repair. Inventory Accounting a. the CONRETE is now part of the improvement and capitalization must occur e. 1. Daily monitoring = ongoing a. ii. There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for insurance or otherwise: a. Losses of property not connected with a trade or business or a transaction into for profit. not a capital improvement—adding the wall merely permitted the TP to keep doing what it had been doing for 25 years before the oil seepage occurred. If TP decided to expand and then pour concrete. then the small becomes part of something big THUS. still deduct 2. Losses incurred in a trade or business ii. oil from a newly constructed refinery began to seep through the walls of the plant basement. Note: the other option instead of repairing the building is to claim a § 165 loss c. Losses incurred in any transaction entered into for profit (though not connected with a trade or business) iii. In order to avoid a plant shutdown. Sudden. Thus. Treatment facilities = capitalize useful life beyond taxable year 3. or other casualty. Issue: Business expense or capitalize (263)? iii. the TP paid about $5000 to line the basement walls with concrete. In the case of an individual. ii. Look to when the profits are enjoyed d. A TP who keeps an inventory of goods for sale must capitalize the costs of supplies and materials instead of immediately deducting them the costs are added to the taxpayer’s inventory costs and deducted when the inventory is sold ii. Holding: Addition of the concrete wall was a repair. shipwreck. and constructed groundwater treatment facilities: restored X’s land to same physical condition prior to contamination. if losses arise from fire. Soil/groundwater/daily monitoring= deductible  merely restoring to prior condition 2. Want to match income with the expense of producing that income 20 . Unexpected Losses See Casualty Losses i. Generally: § 165 1. ii. Generally i. this is DEDUCTIBLE under Midland if it is part of a bigger improvement.

Have to use cost/market method look to the lower of the MOST RECENT PURCHASE or the MARKET PRICE ii. FIFO v. most TPs use FIFO because if you elect LIFO. purchase. or sells merchandise AND b. The production. d. TP argued this was a rental and wanted to deduct rental payment of $1240. then you have to use it for financial accounting purposes—and TPs want high gross income ii. Lease? i. or sale of such merchandise is an incomeproducing factor b. The taxpayer produces. ii.2. The lease on system was for 5 years with annual rental costs of $1240—had to rent for 5 years or renew/removal. Calculating Taxable Income i. Ex: what shoppers are doing—buying the newest milk from the bank. NOTE: FIFO applies unless a TP makes an election to apply LIFO. § 472(c). Excessive rental payments clearly amounted to a purchase on an installment basis —deal was structured as a lease only to generate deductions 2. putting new tires on top b. can agree as to whether it is a lease and a purchase 21 . Issue: Capitalize or Expense? iii. 1959): Purchase vs. Taxable Income = Gross Receipts from Sales – Cost of Goods 1. Assumes that the items sold during the year were the earliest items purchased. then the value is negligible 3. Commissioner (9th Cir. Government argued purchase and capitalization on an installment basis ($6200 = $1240 x 5) = recover the $6200 over time. It is obvious that the nominal rental payments after 5 years were just a service charge for inspection a. FIFO (First-in-First-out): 1. NOTE: § 467 parties are allowed to come up with a written allocation process in leases. purchases. THIS IS what we want—want the deduction to be big. Most sprinkler systems have to be tailor-made for a specific piece of property and if you have to remove them. LIFO: Determining Cost of Unsold Inventory i. Regulation § 1. Assumes that the items sold were the most recently purchased items and the items in closing inventory (unsold) were the earliest items purchased have to use OLDEST PURCHASE VALUE seller made to buy inventory to determine unsold inventory a. Cost of Goods Sold = Cost of Starting Inventory (Into the Current Year) + Cost Incurred in Current Year – Cost of Unsold Inventory GROSS RECEIPTS FROM SALES – [COST OF STARTING INVENTORY + COST INCURRED IN THE CURRENT YEAR – COST OF UNSOLD INVENTORY] = TAXABLE INCOME c. so we want the cost of unsold inventory to be small because this gives you the biggest deduction LIFO increases costs of good sols and reduces TP liability i. LIFO (Last-in-First-out): 1. and that the items left in closing inventory (unsold) at the end of the year are the most recently purchased items a. Ex: grocery store and milk (old milk in the front) b. NOTE: Obama has proposed to eliminate this 2. Facts: Fire sprinkler system installed at TP plant. Holding: Capitalize 1.471-1: requires a TP to use inventories if: a. A TP who elects LIFO must also use it for financial reporting purposes. However. Starr’s Estate v.

Consist with realization doctrine: assumes that there is no change until disposition 2. and should ONLY be taxed to the extent his income deduction exceeds his cost of investment ii. is wearing out and that deterioration is a cost of doing business which is appropriately We should allow reflected on the TP’s return the inevitable i. securities. etc) 2. § 1. wear. Depreciation Deductions: § 167(a) a. Personal Residence c. depreciation deductions are not allowed for property that does not wear out over time or through use (ex: gold. undeveloped land. Depreciation of Capital Expenditures a. Kinds of Depreciation 1. Land (apart from improvements or physical developments on it) 4. faster rate of depreciation in the earlier years than in the later years 22 . Generally i. The rationale of the depreciation deduction is that the property the TP is using in his trade or business or profit-seeking activity. What is Depreciation Deduction? 1. On amounts representing a mere deduction in market value (Reg. § 1. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion. Assumption that depreciation is the same each year: allocates the total cost of the asset ratably to each year of the useful life of the property i. 20% of the cost could be deducted each year b. Inventories capital asset! 2. Mandatory for ALL tangible personal property: § 168(b)(3) c.167(a) – 2) asset is not a 1.XIII. On the following: (Reg. Automobiles (personal) 6. Natural resources 5. Can elect not to take into account salvage value and apply the mid-year convention: § 168(g) d. Ex: If the useful life of the asset were 5 years. Gross income is REDUCED ii. Basis is REDUCED adjusted basis declines as you claim more deductions ii. Is used in a trade or business OR ii. and tear (including a reasonable allowance for obsolescence) of property that i. The deduction for depreciation is simply a way of reflecting the decrease in value fact that the TP is always entitled to a deduction for a return on to be reflected in a his capital. Is held for the production of income b.167(a) – 1(a)) A depreciable ii. TPs are entitled to take a depreciation deduction with respect to certain property used in the trade or business or for the production of income b. Stock in trade 3. What does a depreciation deduction do? i. Generally: Why do we have depreciation deductions? a. Straight-line depreciation: ratable depreciation (“amortization”) a. When is a depreciation deduction NOT allowed? i. Accelerated depreciation: faster than straight-line. Thus.

permitting deduction of the entire cost of the property b. Depreciation Deductions under § 168 and § 197 i. We have 3. Essentially. Other Assets i. accelerated depreciation allows the owner to take larger write-offs for the depreciation of selected goods and properties early on. residential rental property. The applicable recovery method and (§ 168(c)) iii.a. Almost everything is 5 or 7 year property 4. with the understanding that the same goods and properties will not be eligible for the same level of depreciation in later years. Under § 168.7. Assets that are hard to value: 15 years (ex: goodwill assets) ii. Assumes the salvage value of the property = 0.15. Uses recovery periods that are substantially shorter than the actual useful lives of the property. b. all assets have been allocated to specific class lives 1. § 168(a)  § 168(c) a. Generally a.10. § 168(c): Applicable Recovery Period Property Shall be Treated As: The Applicable Recovery Period Is: 23 . The applicable depreciation method (§ 168(b)) ii. The Applicable Convention  § 168(e) 2. Under the provision.5. Applicable depreciation method ii. Allows the use of accelerated depreciation methods. Scrap value: when assets are no longer useful as they kind of assets they are but can be used for other purposes (ex: metal from a computer)  assume 0 iii. and 20-year property. § 168: Tangible Property Modified Accelerated Cost Recovery System (MACRS) 1. and iii. the annual depreciation deductions are determined using: i. water utility property. the depreciation deduction  § 168(b) provided by section 167(a) for any tangible property shall be determined  § 168(d) by using: i. § 168(e): Classification of Property a. The applicable convention (§ 168(d)) 3. and any railroad grading or tunnel bore Property Shall be Treated As: 3-year property 5-year property 7-year property 10-year property 15-year property 20-year property If such property has a class life: 4 or less More than 4 but less than 10 10 or more but less than 16 16 or more but less than 20 20 or more but less than 25 25 or more b. Except as otherwise provided in this section. Today. Applicable recovery method and The Steps: iii. ACRS accelerates deductions in 3 ways: i. ii. No longer have “useful life” or ask how the asset is used in your business 2. non-residential real property. Useful Life and Class Lives i.

Thus:  If TOO MUCH in last 3 1. 200% Declining Balance Method: a method by which your rate of depreciation declines over years—get the most in the early years and the least in the later years (in the first year. assume it is in service mid-Feb (think 15th of the month) 2. residential. This produces only ½ the expected cost-recovery deduction in  REAL PROPERTY: the first year Mid-Month iii. can elect straight line (can always pick a worst method) c. assume that ALL property is placed in service MID-YEAR i. This is the best method iii. you get exactly twice straight line) i. get 2/10 in the first year ii. 150% Declining Balance Method: in the first year.5 years 39 years 50 years  IF REAL PROPERTY: must use straight line  IF NOT REAL PROPERTY: --15-year or 20-year property: 150% --Any other type: 200% (unless TP elects the 150%) 5. 7-year property is recoverable over 8 years b. If the property’s useful life is less than 15-years (3. Ex: If you put something in service in February. railroad. Real Estate and the Mid-Month Convention: § 168(d)(2) i.3-year property 5-year property 7-year property 10-year property 15-year property 20-year property Water utility property Residential rental property Non-residential real property Any railroad grading or tunnel bore 3 years 5 years 7 years 10 years 15 years 20 years 25 years 27. 3-year property is recoverable over 4 years months: 2. Mid-Year ii. 5-year property is recoverable over 6 years Mid-Quarter 3. The very longest property gets the SLOWEST method 6. This applies to 15 or 20-year property. For real property (non-residential. rather than claiming 150%. and Mid-Quarter Convention a. If 10-year property. Except as otherwise provided. Big dollar assets want more accuracy—why mid-month applies to real estate 24 .7. conclusively assume it Summary: When is Property was put in service in the middle of 2009: you get ½ of the first Put INTO SERVICE? year’s depreciation on your 2009 return. Ex: If something is put in service in 2009. Always applies to residential real property. Mid-Month. § 168(b): Rate of Depreciation a. get 2/7 in the first year and will decline over time. Ex: if 7-year property. or 10year property) then you can use the 200%--but.5. § 168(d): The Mid-Year. if you want. BUT if you want. This is the worst method ii. get the  NOT REAL PROPERTY second half of the first-year depreciation. and railroad or tunnel bore): use the MID-MONTH 1. can elect 150% or straight line b. etc iii. Straight line i. get 150% i. For 2010. This is the second-best method ii.

can expense everything in the first year if you are a SMALL TAXPAYER (think small businesses) i. He places the van in service in September of Year 1.000. The van is 5-year property and has a 5-year recovery period. This is an elected provision: making the election reduces the than $625K. TP’s depreciable basis in the property by the amount deducted you lose this under § 179 provision 1. The maximum deduction allowed under § 179(b)(1) is reduced 1 dollar for each dollar of “section 179 property” in excess of a threshold amount provided in § 179(b)(2)  SO: Up to $125. “Section 179 property”  depreciable.  If your property was worth $600. Under the straight-line method. 7. depreciable property (excluding real estate) and is phased out as the amount of such property purchased by the TP during the year exceeds $500. October to December If you paid $12K with a 10% depreciation deduction per year:  Half-year: $1200  Mid-month: $1150  Mid-quarter: $600 EXAMPLE:  YEAR ONE: Suppose that Tom pays $20K for a delivery van that he will use in his business. b. § 179: Election to Expense Certain Depreciable Business Assets a. January to March 2. Quarters: 1. The half-year convention also applies. the deduction would be 200% of 20% or 40% of the $20K cost of the van. if you expense everything.000—would be limited to deduction of $25. If the aggregate basis of property (everything other than land and buildings) during the last 3 months (October. November. the depreciation deduction would be 20% (1/5) each year for five years. July to September/October 4. NOTE: Once the mid-quarter convention is triggered.c. so the deduction = $8K.000. cannot use the mid-year convention and get LESS depreciation iii. So. then the mid-quarter convention applies 1. In lieu of the above depreciation rules. Under the 200% method. This advantage applies only to tangible. A TP can elect to currently deduct the cost of “section 179 property” in the year in which the property is placed in service If your ii. This reduces Tom’s adjusted basis of the van to $16. or December) exceeds 40% of the aggregate bases of property. with a depreciation for every 25 . The property is deemed to have been placed in service on the date that is halfway through the quarter in which the property is actually placed in service 2. April to June 3. basis = $0 be careful. it is used for ALL property in the year! iv. so Tom’s Year 1 depreciation deduction is $4000. Every piece of property accumulated during the year now gets mid-quarter ii. § 179(b)(1) caps the aggregate annual cost that is currently deductible however under § 179—also subject to a phaseout based on the aggregate amount of § 179 property placed in service i.000.000 of the cost of depreciable non-real estate can be expensed in lieu of MACRS. Special rule for excess backloading—if you put too much of your non-real estate depreciable property to go in the end of the year. tangible personal property is property (does not include intangible property or real estate) worth more iii. Everything Other than Real Estate 168(d)(3): Mid-Quarter Convention i.

i. Going concern value c. the cost of a covenant not to compete is recovered --Business books and over 15 years even if it lasts for only 2 or 3 years. and other information base. Goodwill b. Authorizes straight-line cost recovery for “amortizable section 197 --Goodwill intangibles” over a 15-year statutory life (15 years applies even if the --Patents. SELF CREATED ASSET A self-created asset is only amortizable if acquired in connection with the acquisition of a T or B—not required that TP acquire ALL the assets of transferor. just the one in which the self-created § 197 intangible is used. useful life is fixed and shorter) --Licenses. For determining the depreciation deduction for depreciable deductibles NOT described in 197. records c. § 197(c)(1): “Amortizable” means acquired after the appropriate date and in connection with a trade or business of a profit-seeking activity. NOTE: The term “amortization” rather than depreciation. permit. formula. Ex: Suppose a TP purchases a copyright with 8 years remaining. § 197: Intangible Property 1. Any supplier-based intangible vi.else. Generally 1. 2. copyright. ii. iii. § 197(a): TP shall be entitled to an amortization deduction with respect to any amortizable § 197 intangible. Any other similar item d. compete Similarly. know how. or other right granted by a governmental unit or an 26 . Business books and records. § 179(b)(3)(A): the TP’s § 179 deduction cannot exceed the taxable income from the TP’s business in the year in which the property was placed in service: CANNOT EXPENSE MORE THAN INCOME ii. operating systems. --Covenants not to The cost of that copyright is recovered ratable over 15 years. permits i. typically is used to describe deductions for the cost of intangible property. Any customer-based intangible v. cannot be for personal use i. process. depreciable property = amortizable) § 197 Intangibles: b. Any license. Workforce in place including its composition and terms and conditions of its employment. Amortization of Intangibles: § 197 i. should act as if the § 167 provisions were not repealed OLD 167 is still the law for a small number of assets (can claim accelerated depreciation except with respect to intangibles) c. § 197(f)(7): Any amortizable section 197 intangible shall be treated as property which is of a character subject to the allowance for depreciation provided in section 167 (thus. or other similar item iv. format. Any patent. The amount of such deduction shall be determined by amortizing the adjusted basis of such intangible RATABLY over 15-year period beginning with the month in which such intangible was acquired a. etc. pattern. § 197(d): The following are § 197 intangibles: a. ii. Any of the following intangible items: i. design.

iii. Appropriate adjustments to the adjusted bases of such retained intangibles shall be made for any loss not recognized 2. Land 3. § 197(f)(2)(A): STEP-IN-THE-SHOES RULE In the case of any section 197 intangible transferred in a transaction described in subparagraph (B). No loss shall be recognized by reason of such disposition (or such worthlessness) and. NOTE: INDOPCO Court Since you cannot amortize or deduct the costs incurred. Exceptions: § 197(e) The following are NOT amortizable 1. Any franchise. Loss Disallowance for Partial Dispositions: § 197(f)(1) 1. § 168 Property iii. the incremental increase in the adjusted basis is treated as a new section 197 intangible in the hands of the transferee (ex: contribute assets to a corporation that you control and it has debt. if a TP acquires multiple amortizable § 197 intangibles and some are disposed of while others are retained. or trade name. Any covenant not to compete…of an interest in a trade or business or substantial portion thereof. Ex: mortgage service industry. This occurs in 3 contexts: i. Under § 197. Certain kinds of software: special and off-the-shelf 4. cigarette booths in bars b. This applies to professional services as well. NO LOSS on the DISPOSITION is PERMITTED: TP’s adjusted basis disposed of is added to adjusted basis of intangibles retained a. You own 100 cigarette booths. you lose 5 booths. debt is treated as a new § 197 intangible)   Summary: AMORTIZATION OF INTANGIBLES Intangibles can be amortized ratably over a 15-year period regardless of their actual useful lives Intangibles that are created by the TP (rather than purchased) cannot be amortized—unless they are created 27 in connection with a transaction or series involving the acquisition of assets constituting a trade or business or a substantial portion of a trade or business. the transferee shall be treated as the transferor for purposes of applying this section with respect to so much of the adjusted basis in the hands of the transferee as does not exceed the adjusted basis in the hands of the transferor a. f. Treatment of Certain Transfers: § 197(f)(2) 1. iv. Mortgage servicing 5. trademark. Certain transaction costs (ex: investment advice) a. Continue the schedule of the transferor: the depreciation schedule does NOT change b. 3. can amortize the cost over 15 years (you get 1/15 each year) ii. Your basis for the disposed of 5 booths is added to the remaining 95 booths. § 197(f)(2)(B): If in a transaction listed in § 197(f)(2)(B) the transferee somehow takes an adjusted basis in the transferred intangible GREATER than that of the transferor. can only recover your costs upon disposition (getting out of the business). b. Capital improvements ii. If there is a disposition of any amortizable section 197 intangible acquired in a transaction or series of related transactions (or any such intangible becomes worthless) and one or more other amortizable section 198 intangibles acquired in such transaction or series of related transactions are retained: a. Amortization Time Limits a. THUS. Transfers of § 197 property 2. Financial interests (stocks and bonds) 2. . In Year 3.agency of instrumentality thereof e.

He and his father were the shareholders of the company.XIV.  Personal expenses are NOT deductible 28 . c. Arguments 1. classroom teacher to guidance counselor. Education. Issue: Is TP’s payments of debts deductible to TP as “ordinary and necessary” business expenses? 3. Facts: TP was the secretary of a company in the grain business. he decided to try to pay off many of the debts of the bankrupt company as he was able. The TP made a K with the Kellogg Company to purchase grain for it on commission. § 1. Deductible: expenditure is like deductible advertising designed to maintain the good reputation of a business b. & Other Expenses a.162-5) Education is Deductible If (1) Maintain or improve skills used in the TP’s current trade or business. Generally i. Welch v. classroom teacher to principal. Education i. Government: payments are NOT deductible but were capital expenditures for GOODWILL 2. Goodwill i. OR (2) Meet express requirements imposed on the TP for continuing in his current trade or business (should not qualify for new T or B)  NOTE: An employer’s willingness to reimburse the employee for the costs of certain education does NOT establish that the education maintained or improved skills used by the TP in his current trade or business  Mandatory CLE is deductible  Must be IN the T or B to get the deduction Education is Not Deductible If (1) The education simply meets the minimum educational requirements for the TP’s current trade or business (ex: schooling to get a license for a trade) (2) The education qualifies the TP for a new trade or business—a change of duties that involves the same general type of work is not a new trade or business (all teaching)  Examples of changes in duties that are NOT a new trade or business: elementary to secondary school teacher. Helvering (SCOTUS 1933): Goodwill is Capitalizable 1. capital asset: Welch: expenditure is designed to purchase goodwill and that goodwill is a non-deductible capital asset 2. The payments were capital expenditures establishing goodwill the amounts paid by the TP had to be capitalized because repayment of the discharged debts produced benefits to the TP that extended beyond the year in which the payments were made. Non-deductible. Over 5 years. Goodwill. Courts are split as to the treatment of “goodwill” payments ii. Holding: NOT DEDUCTIBLE: a. Payments were necessary but not “ordinary” b. The company went bankrupt and was released from its debts. the TP earned $118K on commission and paid of $43K in debts of the former bankrupt company. a. etc. In order to re-establish relations with customers that he had worked with in his previous capacity (and thus improve his reputation). Generally: When is Education Deductible? (Reg.

The expenditures made by A in attending law school are non-deductible because this course of study qualifies him for a new trade or business. Today. Why an LLM is deductible if you are already a lawyer and not deductible if you are not a lawyer already XV. then you can amortize the expense during the first year of your T or B 3.) at night. or any activity engaged in for profit and 3. a self-employed individual practicing engineering. Abrams argues that 1. etc. then no deduction is allowed iii.162-5 is INVALID because if you can make an election under § 195. Investigating the creation or acquisition of an active trade or business. and 2. The amount of start-up expenditures with respect to the active trade or business OR b. Creating an active trade or business. The TP shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the lesser of: a. reduced (but not below zero) by the amount by which such startup expenditures exceed $50. 2. Old Colony Trust Company v. § 195(a): Except as otherwise provided. takes a 2-week course reviewing new developments in several specialized fields of medicine.Example: B. legal education is deductible if you are a lawyer. The remainder of such start-up expenditures shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the active trade or business begins 3. 1969): No Deduction for New T or B 1. If the education will qualify you for a new T or B. B’s expenses for the course are deductible because the course maintains or improves skills required by him in his T or B and does not qualify him for a new T or B. If a TP elects the application of this subsection with respect to any start-up expenditures: 1. attends law school at night and after completing his law school at night he receives a degree in law. but not deductible if you are NOT a lawyer 2. Example: A. Facts: A PO took general college courses (philosophy.000. Other Kinds of Income a. no deduction shall be allowed for start-up expenditures i. § 195(c)(1): “Start-up expenditures” means any amount paid or incurred in connection with: 1. Holding: NO—his courses were personal and unrelated to his duties as a PO a. He listed the expenses as a deduction: an expense relative to improving job skills to maintain his position as a detective. § 195(b)(1): Election to Deduct AMORTIZING START-UP EXPENDITURES i. Commissioner (SCOTUS 1929): Gross Income under § 61 Results Anytime a 3rd Party Pays a TP’s Obligation 29 . Issue: Are the expenses deductible? 3. or 2. Commissioner (7th Cir. Carroll v. NOTE: The TP may choose to forgo the election by clearly electing to capitalize its start-up expenditures on a return XVI. $5000. a general practitioner of medicine. consistent with police policies. b. English. history. ii. For the production of income before the date on which the active trade or business begins. in anticipation of such activity becoming an active trade or business…. Compensation i. Start-Up Expenses: § 195 a. Abrams Argument 1.

may avoid making the payment of the tax 3. NOTE: A third party paying off debt is ALWAYS INCOME to the TP. Ex: If the employer donates $1000 to a charity on the behalf of the employee. 30 . Commissioner v. depending on why the third party is You are taxed paying off the debt (for instance. Commissioner: Judges Have Discretion in Valuating Non-Cash Benefits 1. The government asserted the TP had income of $2200. Windfalls & Gifts i. Issue: whether a TP. Legal representation offered to a non-descript company employee is more clearly income because the company gets no benefit other than as it benefits from all forms of compensation provided to its employees b. clearly realized. There are undeniable accessions to wealth. but it may be excluded from taxation or deductible. which means he does not have to pay them ii. Holding: INCOME (“gains or a. but if a gift. Facts: TP won 2 first-class airline tickets to Brazil and exchanged them for 4 round-trip coach tickets. This was NOT a gift because the payment was compensatory 4. The TP has become richer even though he did not directly receive the payment. and over profits derived which the TPs had complete dominion from ANY b. NOTE: Damages are not income. The payment of the tax by the employers was in consideration of the services rendered by the employee and was a GAIN derived by the employee from his labor: the form of payment makes no difference i. legal fees are included in Ronald’s income failure to turn down the lawyer suggests that he enjoys the benefit of a lawyer (WINDFALL) i. case says that 2. except for punitive damages (§ 104(a) (2)) ii. Turner v. Facts: TP worked for the American Woolen Company—resolved to pay the income taxes of its officers. Thus. Ex: If Ronald McDonalds is charged with assault of a minor and you receive McDonalds hire a lawyer to defend him.1. then on the taxable. The cost to purchase 2 transferable first-class tickets was $2200. then not taxable) windfalls that a. the TP argued for a valuation of $520. because the debt is being paid on his behalf. but to someone else. 2. probably no income to employee UNLESS TP agrees in advance to the contribution (much tougher) b. Issue: whether the money received as exemplary damages (punitive damages) for anything that fraud or as the punitive portion of antitrust recovery must be reported as gross can be taxed income is taxed 3. this case stands for the proposition that: when a payment is directed NOT to the person who has earned it. Facts: Both the Glenshaw Company and William Goldman Theaters received punitive damages as part of a settlement. There mere fact that the payments were extracted from the wrongdoers SOURCE as punishment for unlawful conduct cannot detract from their character WHATEVER) as taxable income to the recipients c. having induced a third party to pay his income tax. Glenshaw Glass (SCOTUS 1955): An Accession to Wealth = Income 1. the cost to purchase 2 non-transferable first-class tickets was $1900. Holding: NO payment constituted income to the employee a. if payment is in exchange for services. we will impute it to the person who has earned it b. but only reported a portion of the § 61—this settlement as income for the tax year involved.

CAN EXCLUDE if it doesn’t cost the employer much to give it to you b. Permission to attend Emory classes given to Emory employees 2. Airline employees that get a free ride (unless he bumps someone off) 1.2. telephone services iii. judges have leeway to decide c. Issue: how to valuate? 3. If PROPERTY gross profit percentage* of the price at which aggregate sales price) the property is being offered by the employer to customers 31 . Reg. In which the employee is providing services. Qualified Employee Discount: § 132(a)(2) a. Employee discount means the difference between the price at Price of property to which the property or service is offered to an employee and the customers X * price at which such property or services are being offered to ( [excess of aggregate sales customers price sold to customers and employees – employer’s b. Hotel accommodations. Holding: Income of $1400—average of the two values a. Statutory Fringe Benefits: § 132 Section 132: Gross income shall not include any fringe benefit which qualifies as a 1) No additional-cost service 2) Qualified employee discount 3) Working condition fringe 4) De minimis fringe 5) Qualified transportation fringe 6) Qualified moving expense reimbursement 7) Qualified retirement planning services 1. Fringe Benefits i. Limitations: Discount cannot exceed § 132(c)(1) aggregate cost of property] / i. NON-CASH compensation that is EXCLUDABLE from income 2. THUS. What are Fringe Benefits? a. How do we VALUE Fringe Benefits if they are to be included? a. No-Additional Cost Service: § 132(a)(1) a. and iii. Service is in the employer’s ordinary line of business ii. Definition: § 132(b): Any service provided by an employer to an employee if: i. Generally. Note: if reserved seats.61-21(b): the taxable fringe benefits to be included should be the FAIR MARKET VALUE ii. Definition: § 132(c)(3) § 132(c)(1) for Property: i. § 1. valuation of non-cash benefits—although non-cash benefits are judged at FMV. Examples i. Ex: employer gives you a car to use  question becomes to what extent you have income in the form of this compensation b. Employer incurs no substantial additional cost in providing such service (determined without regard to any amount paid by the employee for such service) 1. Generally 1. Any compensation for services not paid in the form of wages OR i. then 80% of the FMV of tickets is includible ii.

A 32 . Definition: § 132(d): i. Example: Reg. Working Condition Fringe: § 132(a)(3) If the TP could have expensed the property or services. you get it for free) ii. any use of air transportation by a PARENT of an employee will be treated as use by the employee 3. Assume further than during the prior taxable year of the employer. § 1. Non-Discrimination Provisions for Qualified Employee Discounts and No-Additional Cost Services: § 132(j)  Requires the benefit to be made available to a wide-cross section of employees. it would have been deductible (hence. and 3) Any widow or widower of an individual who died while employed by the employer in the line of business in the line of business by reason of retirement or disability 4) Any spouse or dependent child (see Reg) of the employee = employee 5) Any partner who performs services for a partnership is considered employed by the partnership 6) For no-cost additional service. including non-highly compensated employees o Cannot just make a benefit available to highly compensated employees  Who is a Highly Compensated Employee? § 132(j)(6) and Reg. For purposes of this paragraph. air conditioning. § 1.132-1] 1) Any individual who is currently employed by the employer in the line of business 2) Any individual who was formerly employed by the employer in the line of business and who separated from service with the employer in the line of business by reason of retirement or disability. this is a working condition fringe  a.000 and is one of the employer’s top wage earners OR o Paid more than 150% of amount specified in § 415(c)(1)(A)  ALL OTHER TYPES OF FRINGE BENEFITS CAN BE LIMITED TO THE HIGHLY NOTE: Who is an Employee Under (a)(1) and (a)(2)? § 132(h) [Reg. Property or services provided to the employee by the employer that would have been deductible as ordinary and necessary business expenses under § 162/§ 67 if the employee had paid for the property or services b. Assume that a wholesale employer offers property for sale to 2 discrete customer groups at differing prices.132-3(b) i. § 1.132-8(f)(1) o Employee owns 5% or more of the employer o Paid a salary of more than $75. Note: property does not include real property or personal property held for investment (securities) ii. Assume that unrelated to company X’s trade or business and unrelated to employee A’s T or B of being an employee of X. 70% of the employer’s gross sales are made at 15% discount and 30% at no discount. the current undiscounted price at which the property or service is being offered by the employer for sale to customers may be reduced by the 15% discount. Examples: i. When your employer gives you a chair. If SERVICES 20% of the price at which the services are being offered by the employer to the customers (have to include anything above the discount) Any discount that exceeds the employer’s costs is includible income! c. use of the elevators—if you had to pay for it yourself. ii.000 o Paid a salary of more than $50.1.

if you take the car service home every night. that eliminates the tax benefit 2. it would have be included in gross income d. The employer is indifferent because they get a deduction deadweight loss 33 . probably not de minimis b. Qualified Parking parking provided to an employee on or near the business premises of the employer iv. As soon as you get an option of cash. c. Qualified Transportation Fringe: § 132(a)(5) a. Limitation: § 132(f)(2): Amount of these benefits cannot exceed i. Examples: 1. A may NOT exclude the amount unless it meets 162. De Minimis Fringe: § 132(a)(4) a. Revenue derived from the facility normally equals or exceeds the direct operating costs of such facility 5.is a member of the BOD of Y. Ex: So if an Emory professor gets a choice between cash and parking. NOTE: Choices Between Cash and Benefits 1. you get taxed and employers don’t cafeteria plans— give a choice eliminates 3. Any qualified bike commuting reimbursement b. Working late at a law firm and they bring in dinner or a car service home 2. THERE IS NO 67(a) 2% limitation for AGI unless it qualifies under § 162—then 67(a) applies! ii. Definition: § 132(f)(1) i. Any transit pass iii. and ii. if the employee had chosen the compensation. Constructive Receipt: § 132(f)(4) i. Limitations i. Eating Facilities are INCLUDED IF § 132(e)(2): i. Still get exclusion if employee has a choice between qualified parking and compensation—HOWEVER. § 132(e): Benefits that are very small and very widespread. $ 175/month for qualified parking c. Transportation in a commuter highway vehicle if connection with travel between employee’s residence and place of employment ii. and chooses parking—then he has to include the parking on his income This is why we have  Either way. $ 100/month for commuter highway vehicle and transit pass transportation ii. value as to make of such property or fringe is so small as to make accounting for it accounting for it unreasonable or administratively impracticable unreasonable or 1. Definition: Value is so small i. NOTE: premised on the proposition that there is no difference on an inclusion and a deduction + exclusion 4. BUT. Facility is located on or near the business premises of the employer. Must take into account the frequency at which similar administratively fringes are provided by the employer to the employees impracticable ii. X provide A with air transportation to company Y BOD meeting.

and F’s spouse decide to spend their annual vacation in Europe. Free parking Giving an Emory professor parking for free when he would walk otherwise 3. may take a number of personal flights annually for a nominal charge. Can I exclude that under § 132? deduction doesn’t apply to de  § 119: can exclude meals if it is for the minimis or qualified moving convenience of the employer—but cannot prove expense reimbursement it is for the convenience  § 132(l): only applies to a TYPE provided for. and FOOD is included in § 119 f. a flight attendant in the employ of A. This section shall not apply to any fringe benefits of a type the tax treatment of which is expressly provided for in any other section of this chapter Think preemption 1.61-2(b)] 2) P is the president of C. § 1. § 1. an airline company. Examples income because 119 speaks to 1. P is planning a week-long business trip to LA and will fly there and back on C’s corporate jet.  For P exclude because it is not a benefit or it is a working condition fringe benefit  For wife include because she is not performing services—but value might be zero under Reg. Examples: 1. F and F’s spouse take advantage of this policy and fly to and from Europe. accident and health insurance. Cafeteria Plans: § 125 i. P’s spouse intends to accompany P on the round-trip flight for personal reasons. in the latter. iii. on a standby basis. I work in a restaurant that lets me eat meals there and I this but doesn’t allow get a 20% discount. Any money remaining in the employee’s account at the end of the year must be forfeited: § 125(d)(2)(A)  Ex: An employer plays a salary of $35K in cash to one employee and $30K in cash and $5K in child care to another. a corporation that has its executive offices in NYC. HYPOS on Fringe Benefits: 1) F. and dependent care) ii. the employee is not treated as receiving that $5K as income and the employer may deduct the $5K as § 162(a) salary. Permits an employer to establish a “cafeteria plan” in which an employee may elect to receive taxable cash or among a variety of excludable benefits (ex: group-term life insurance up to $50K.61-2(g)(1) 34 .  If standby EXCLUDE as no-additional cost service [§ 132(b)]  If reserved seats 80% of FMV of tickets is includable [Reg. This section excludes (e) and (g) (de minimis fringe provision  benefit and qualified transportation fringe benefit) thus.ii. along with members of their immediate families. Mandatory health insurance people who can afford health insurance and do not buy it—making Emory give them health insurance creates a deadweight loss because you are giving people something they do not care to buy 2. can always exclude the de minimis benefit or qualified moving expense reimbursement even if it is of the type excluded by another section 2. A has a policy whereby any of its employees. This reduces dead-weight loss because it allows people to choose what they value most highly. THIS IS WHY WE HAVE CAFETERIA PLANS e. Unclear how far this section extends! 132(l) says this is taxed as ii. Section NOT to apply fringe benefits expressly provided for elements: § 132(l) i.

except that the discount is available only to S and other officers of D. For the convenience of his employer i.  Exclude as a qualified transportation fringe [§ 132(f)(1)(C)]—partners are treated as employees 9) The facts are the same as in Question 8. an attorney in the employ of C. a senior partner of L. Benaglia v. approximately covers D’s costs. associates.  Exclude as qualified employee discount § 132(c) (note: average costs approach) 5) The facts are the same as in Question 4. THE RULE: Meals or lodging furnished to the employee.  Might qualify as a working condition fringe benefit. This benefit is provided by L to all partners. an assistant manager in the employ of D. joins a prestigious country club. D pays for the actual cost of the evening meal pursuant to company policy. C provides personalized financial planning services to all of its officers without charge. C maintains an on-site gymnasium that is available to all employees during normal business hours. a department store. an associate at L. and employees at L a choice of whether to accept parking of $75 and A accepts the parking. works at C’s national headquarters. except that D’s profit margin on ticketed items is only 10%. For years. and that L offers all partners. D has a policy whereby employees are entitled to a 20% discount from the ticketed sales price of any item sold by the store so long as the resulting sales price. Facts: TP was employed as a manager of several hotels.  Excludible under § 132(j)(4): deduction for on premises athletic facilities if located on the premises of the employer. on average.  If elect parking: exclude [§ 132(f)(4)]  If cash: include 10) The facts are the same as in Question 9 except that L offers no cash option and provides parking ONLY to partners and associates of the law firm. and other employees.  Excludible as de minimis (anti-discrimination does not apply) 8) S. OR c. a prominent law firm located in a large city. Meals & Lodging: § 119 1. The parking privilege is valued at $75 per month. § 1. his Valuating salary was fixed without reference to his meals and lodging—which the non-cash benefits: FMV of property or 35 services . his spouse. A uses the gym each working day.132-3(c)] 6) The facts are the same as in Question 4. MEALS: the meals are furnished on the business premises of the employer.  Exclusion because anti-discrimination does not apply 11) A is an associate in the employ of L. except that it now pertains to A. 7) A.3) B is an officer in the employ of C. associates. L pays its associate membership fees for various local clubs and organizations. a manufacturing company.  Income unless de minimis under § 132(a)(4) 4) S. is occasionally required to work overtime to help mark down merchandise for special sales. operated by the employer.  Excess of the employee discount (20%) over the permissible discount (10%) is includable [Reg. Note: business premise means the “place of employment of the employee” (Reg. Note: tied to whether the meals are given for a “substantial noncompensatory business reason” Reg.119-1(a)(2)(i) b.  Inclusion because of the anti-discrimination rule in § 132(j)(1). On those occasional instances. LODGING: the employee is required to accept such lodging on the business premises of his employer as a condition of his employment i. a corporation. a retail department store. § 1. and dependents are excluded ONLY IF: a. In order to encourage participation in community activities and local society. is provided free parking by the law firm. so the resultant sales price does not cover D’s costs. § 1. a senior VP of D. A. dependent on the precise nature of the clubs—most likely includable 12) A. Commissioner (1937): Exclude Meals and Lodging if For the Convenience of the Employer a. purchases a fridge from D’s appliance department.119-2(c)) 2. taking advantage of this policy. and all the use is by employees (or spouses/dependents) iii. a law firm.

Facts: TP. Discharge of Indebtedness: i. holding the value as the FMV of the rooms and meals furnished by the employer. § 1. US v. A loan is not gross income. not for personal convenience. Valuating non-cash benefits (both for property and services): Include the price as FMV (Reg. NOTE: If the TP lacks sufficient tax attributes to cover the KL excluded income. Kirby Lumber Income 36 .e. His residence at the hotel was not by way of compensation for his services. issued $12 million of bonds in exchange for its outstanding preferred stock on which there were dividend arrearages. Borrowed funds are NOT taxable because you have no accession to wealth: the receipt of funds is offset by the obligation to repay 2. gross income can include income from discharge of indebtedness § 61(a)(12) (see below) KL Income 1. the effect of § 108 is to provide a permanent exclusion ii. Why? i. Kirby Lumber (SCOTUS 1931): Repurchase of Debt at Less than Face Value = Income 1. the TP has income to the extent there is no longer an TAXABLE GAIN obligation (i. TP then purchased million of these bonds for $862K. when the corresponding obligation to repay Income: the is reduced. Holding: The re-acquisition of debt for LESS than what was borrowed is taxable income to the borrower. NOTE: Bond Proceeds = Loan Proceeds. because there is an you receive when accession to wealth) you pay debt back ii. bond holders give the for less than what bond issuers cash and in exchange. Indebtedness: any indebtedness for which (1) the TP is liable or (2) subject to which the TP holds property (§ 108(d)(1)) b. the bond issuer promises to was borrowed pay the holder the amount back plus interest b. comfort or pleasure: solely because he could not otherwise perform the services required of him (had to be available at a moment’s notice) ii.. Generally i. BUT. Commissioner and judges’ discretion XVII. What TP received was for the “need and convenience” of the employer iii. Borrowed Funds and Discharge of Indebtedness a. Issue: is this income? If so. the amount of the reduction. because it has the corresponding Kirby Lumber obligation to repay.hotel paid. NOTE: In response to this case. Congress enacted § 119 1. Loan proceeds are NOT income and are NOT taxable 1. b. Holding: NOT income i. Commissioner added an additional amount to TP’s income as compensation received. a. Kirby Lumber. how much? c. § 108 provides exemptions or deferral by allowing the insolvent debtor to exclude KL income in exchange for reducing certain tax attributes a. 2. Thus.61-(2) (d)) Note: Turner v. the TP bought the bonds back for $138K less than the price at which they were issued. Codified in § 61(a)(12): A TP may realize income by payment or purchase of his obligations at less than their face value c.

but not investment/vacation home) a. 2013 (ex: discharges helps TP who loses his home. § 108(a)(1): When Gross Income is NOT Realized Gross income does not include any amount which (but for this subsection) would be includable in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if: 1. QUALIFIED REAL PROPERTY INDEBTEDNESS In the case of a taxpayer other than a C corporation. the indebtedness is qualified real property business  Discharge if indebtedness OR deductible if paid 5. tort judgment discharged in bankruptcy KL Income requires taxii. if more liabilities >  Seller of assets = insolvent property takes 3. B has $15K of KL income. Examples: If B borrows $100K from L and then pays off the debt of $85K. QUALIFIED FARM INDEBTEDNESS The indebtedness discharged is back debt and qualified farm indebtedness. The amount excluded from gross income shall be applied to reduce the tax attributions of the TP as provided a. unless the intention wasn’t to make it a gift (like in a business setting where kids are starting a new business). Amount excluded shall not exceeded the amount to which the TP is insolvent  Insolvent b. parents discharges a child’s debt. excluding income under § 108(a) requires a TP to postpone his or her tax liability by decreasing dollar-for-dollar certain “tax attributes” that would otherwise be available to offset future income 37 . When do we have it? TODAY Interest rates shoot up and people are in financial difficulty c. for example. No recognition of 2. 3. QUALIFIED RESIDENCE INDEBTEDNESS The indebtedness discharged is  Student loan qualified residence indebtedness which is discharged before January 1. Rules for Discharge of Indebtedness: § 108 i. TITLE 11 CASE The discharge occurs in a title 11 case (in a bankruptcy case —discharge that occurs by reason of the bankruptcy action). Other examples: corporation acquiring for less than face value its own bonds previously distributed as a dividend. A tort judgment is discharged in bankruptcy iii. GIFT: If. there conditioned on an is no tax-free receipt of funds and/or obligation to repay obligation to repay 1. The GAIN of paying the debt back for less than what was borrowed is taxable to the borrower 2.i. it is considered a gift under § 102. later reduces purchaser’s debt 4.  Debt forgiveness is excludable as a gift under § 102 only when you have detached and disinterested generosity that FULLY releases from the debt (Duberstein) 2. What is it? 1. A corporation acquires for less than its face value its own bonds previously distributed as a dividend 3. TP IS INSOLVENT The discharge occurs when the taxpayer is insolvent KL income if: (working out bankruptcy problems outside bankruptcy court)  Bankrupt a. Thus. Exceptions: KL Income requires tax-free receipt of funds free receipt of funds conditioned on an obligation to repay in these examples. § 108(b): Reduction of Tax Attributes IF YOU FALL UNDER 108(A) 1. NOTE: this is not applicable if the debt is paid! (Remember Old Colony Trust) ii. Insolvent = Excess of liabilities – FMV of assets.

When you pay for the parts. paying $1000. you do not have KL income but should have to pay for it with tax attributes (i. capital loss carryover. Rationale i. i. Mistaken Discharge of Indebtedness: Gifts of Property Encumbered by Debt Part Sale. etc. you borrow $1000. basis is reduced! ii. Rationale i. reducing tax attributes. You unfortunately can only pay $600 after 90 days (you owe $1000). You then see an ad for Sears.b. it is treated as $800- obviously. minimum tax credits. the cost is deductible under § 162 (ordinary and necessary business expense is deductible).33 per dollar of exclusion so when you sell the property. you do not have income if the debt is discharged a. you do NOT have INCOME money from the seller of the good. Example: You go to Best Buy and see a TV for $1000. Rather than not have KL income. Best Buy reduces it to $800. If Best Buy reduces the price. you have a higher income! a. effectively defers income rather than permanently excluding it 2.e. A reduction in purchase price should NOT produce KL income since there would have been no income had the original price been lower. You would have KL income of $400. § 108(e): General Rules for Discharge of Indebtedness 1. if made in full. basis.  Thus. would be deductible. There is NO KL income when the plumber pays in plumbing services: this is compensation and no different as payment. The discharge of a deductible liability should NOT produce any net income because the KL income is offset by the deduction should be taxed no worse than if you had received the amount of KL income in cash. § 108(b)(5): can elect to reduce basis in property over the other tax attributes iii. whatever they may be. If the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced (buy by putting cash down and signing a note and the note is forgiven not because of If you borrow insolvency or bankruptcy). § 108(e)(5): Downward purchase price adjustments DO NOT INCUR INCOME a. Part Gift Transactions 38 . If you do not see the Sears ad and want to instead return the TV and Best Buy lets you pay $800. b. offering the TV for $800. you do b. NOTE: Applies only to purchase price reductions of PROPERTY and then ask for a (but at least one court has been willing to extend to services purchase price received) reduction. you do not have any income because the payment. d. Example: I write a will for a plumber and the plumber agrees to pay $800 —but then agrees to pay with his services. Tax attributes include: net operating losses. d. § 108(e)(2): If payment of the debt would be deductible. Because of § 108(e)(2). § 108(b)(3): basis reductions are made DOLLAR for DOLLAR while credit reductions are made $0. reduce basis by $ 200) c. Example: You are in a plumbing business and your supplier of parts lets you take the parts you need and you have to pay within 90 days. followed by complete repayment 2. KL Income? i.

Recognition of Gain i. Even though the transaction was treated as part gift and part sale. TP: “net gift” in the amount by which the FMV > gift tax paid thus. KL does not apply! i. The relative has no income by reason of § 102 (devise 39 . A transaction that otherwise would be a gift ends up being treated as a part gift. 2. they have no income. The donors’ gain from the sale portion of the transfer equalized their AR as a result of the debt relief less their entire basis in all of the assets transferred.000 computed by an AR = $60K gift tax minus B=$50K b. Commissioner (SCOTUS 1982): Assuming Family Member’s Gift Tax Liability Counts as Part Sale and Part Gift 1. but since he demanded that action on her part in exchange for the stock. the donors were not required to allocate their basis between sale and gift portions of the transfer c. he in effect SOLD the stock to her for the amount of the gift tax liability = $60K. An employee’s debt to his employer is canceled in exchange for services rendered: the employee has compensation income and the employer has a business reduction ii. The TP basis in the stock at the time of the transfer was $51. The donee has a basis in the stock of $60K. iii. Diedrich v. that would otherwise not be a tax-triggering event. Holding: The transaction is a part sale. the amount of the gift is simply reduced by the gift tax paid by the children. A child’s debt to a parent is forgiven out of detached and disinterred generosity. part gift the donees assumed the donors’ gift tax liability a. Issue: Do the Diedrichs have income to the extent that the gift tax paid by the children exceeds their basis in the stock? a. the gift tax paid by the children was $62. d.i. Commissioner: Diedrichs have income of $10. The TP did not have his gift tax liability discharged for less than face value: all that happened was that the payment check was physically written by the daughter. the AR = $60K.073. A decedent provides in his will that a relative’s debt is to be forgiven. Gifts Of Property Encumbered by Debt 1. Since the donor’s liability by the donee = direct payment to the donor ($60K). and the AB = $51K. giving a gain of $9K. the donor should recognize gain on the transaction (AR > AB). The child has no income as a result of § 102(a). part sale because the code insists on treating debt relief as consideration in a property transfer 2. becomes one if there is debt transfer involved 3. ii. b.000 shares of stock to their 3 children on the condition that their children pay the resulting gift taxes. 2. The Donee’s Basis i. Commissioner: Court treated gift as a discharge of indebtedness but allowed the TP to use the whole basis of the property to offset the transfer. Diedrich v. In this case.992. 1. This means that a gift. NOTE: Other Examples of Diedrich Like Situations (“Medium of Payment” Cases) i. 3. Facts: TP (Diedrichs) transferred 85.

Reg.000 paid by the donee is payment for the donor’s basis in the stock. Transfer of Property Subject to Debt: Tax Consequences for the TP Who is Relieved of Debt i. defer the appreciation but that doesn’t work because the charity doesn’t get taxed—so donor gets taxed on the gain as much as possible  APPROACH TO § 1011(b): Bifurcate the transfer into SALE (§ 1001) and GIFT (§ 1015) BASED ON PAYMENT / FMV AT TIME OF GIFT/SALE e. In effect. Non-Recourse Debt: debt secured by collateral for which the debtor is NOT personally liable The seller of a b. Basis Calculation: Transfers in Part a Gift and in Part a Sale 1. The transferor’s adjusted basis for the property at the time of the transfer The donee’s basis in property received in a part sale/part gift transaction. 2. i. If a TP is relieved of non-recourse liability in connection with the property subject to disposition of encumbered property: non-recourse debt i. when the donee is a charity. General Rule: Where a transfer of property is in part a sale and in part a gift. the unadjusted basis of the property in the hands of the transferee is the sum of whichever the following is GREATER: i. The amount paid by the transferee for the property. The debt relief is included in the TP’s AR because the debt is included in TP’s basis when TP acquired the property (Crane v. Recourse debt: debt that is not backed by collateral from the borrower. etc. the appreciation in the property. If a deduction is allowable under § 170 (relating to charitable contributions) by reason of a sale. assuming the donor was taxed like Diedrich. § 1. then the adjusted basis for determining the gain from such sale shall be that portion of the adjusted basis which bears the same ratio to the adjusted basis as the AR bears to the FMV of the property. Commissioner) 40 . allows the lender to collect from the debtor and the debtor’s assets in the case of default Face PERSONAL LIABILITY ii. Non-Recourse Debt 1. Generally a. AR includes the amount of debt outstanding at the time purchaser of disposition ii.000—the donor would recognize no gain and the donee would take a carry-over basis of $51.  NOTE: IF the gift tax liability had been only $45. iii. This means that the recognition of gain increases basis pro tanto. Generally: Debt Taken on At Acquisition of Property a. Exception: § 1011(b)—Bargain Sale to a Charitable Organization a. equals the donor’s carryover basis plus any gain recognized by the donor on the transaction. Recourse Debt 1.000 under § 1015. OR ii. SO. MUST be taxed to the donor ii. the first $51.1015-4 a. The debt relief is INCLUDED in the TP’s AR AND AB for the realizes an amount purpose of computing gain or loss realized in the property that INCLUDES the transaction debt assumed by the 1.exclusion). Usually.

Facts: TP inherited a building for which FMV was = to outstanding mortgage of $262K.851. TP asserted that her gain was the $2500. claiming that her basis in the property was 0 because she inherited the property when it NOTE: had no equity. Commissioner (SCOTUS 1947): Include Debt in Basis Regardless of How the Property is Financed a.iii. She then sold the property subject to the mortgage back to the original owner. NOTE: The debt assumed goes into the basis! 4. Partial Payment of Debt a. 41 .$28K) deductions b. Adjusted basis is reduced by ii. The debt was also included in the AR since the debt was assumed (it amounted to debt relief). i. FOR PARTIAL PAYMENTS OF DEBT: AR includes the amount of debt outstanding at the time of disposition.000. Government: basis included the amount of debt owed on the any property. She rented it for several years. The government insisted instead that they actually realized a gain of $400K: the difference between the principal amount of the debt and their basis. then the value of any outstanding debt is treated:  NON-RECOURSE: Part of Amount Realized  RECOURSE: Only FMV of the property is treated as AR o Any excess of indebtedness over FMV = Income 2. d. Tufts) Recourse v. Issue: Is the amount of a debt used to finance a property included in the basis of the property even though the amount of debt is greater than the amount of the equity? c. they sold it for no consideration other than the assumption of the NR liability. so they claimed a loss of $55. Non-Recourse Transfers: Tax Consequences When Transferred Back to Creditor  TRANSFERRED TO SOMEONE ELSE: If encumbered property is transferred to anyone other than the creditor. while AB includes the original amount of debt when the property was first bought 3. depreciation giving her a gain of $24K ($257K – ($262K . and basis had been reduced by depreciation deduction. Debt was included in the basis regardless of whether the property was financed with debt or equity.400. she had made a GAIN to the extent of those deductions. Holding: YES i. there is no different between recourse and non-recourse debt  TRANSFERRED TO CREDITOR: But if the encumbered property is transferred to the creditor in complete satisfaction of the debt. AR includes the debt relief EVEN IF the encumbered property is worth less than the amount of debt at the time the TP disposes of the property (Commissioner v. ii.455. and was paid $2500 net of expenses. Her AR = $257K ($2500 + outstanding balance on the mortgage). Tufts (SCOTUS 1983): AR Includes the Outstanding Balance of Any NR Loan Encumbering a Property a.500 on NR basis to build an apartment complex. When their basis in the property was $1.740. took a depreciation deduction each year ($28K).750. Since the TP had used the FMV of the property to determine the depreciation deductions. Commissioner v. Crane v. Facts: TP’s borrowed $1. The FMV of the property at the time of sale was $1.

Mrs. While holding Blackacre. This was a tax shelter because the TP borrowed on a nonrecourse basis against appreciated property in excess of TP’s adjusted basis in the property—locked in and monetized gain without paying tax THIS IS A TAX SHELTER Example:  M buys Whiteacre. Borrowing Against Appreciation 1. Wood for TPs selling $101. Wood was and AR not personally liable on the mortgage. undeveloped land. Then Mrs. Only Adds to Amount Realized NR Borrowing > Basis a. Ex: X buys stock for $10K. realizing event adds to AR i. Answer: YES Since X spent $10K and ended up with $50K. under the new structure. This property had initially been purchased by Mrs. The FMV of the property is irrelevant EX: T purchased Blackacre for $100. Holding: The mortgaging of already-held property non-recourse is not a increase basis. after acquisition b. Issue: What is Mrs. T then transfers the property to U. T claims $20 in depreciation and reduces the mortgage by $30. acquisition debt Wood obtained an additional mortgage to the property. M gets the $50K to pay Herbert by putting 42 . Commissioner: Debt Taken On After Acquisition Does Not Increase Basis. is given to X’s daughter. Finally. The stock. ii. Wood subsequently refinanced the property and took it subject to In Crane: $432K mortgage (she was personally liable on the mortgage). Debt Taken on AFTER Acquisition 1. paying $20 in cash and singing a non-recourse note for $80. However. from Herbert. Wood transferred the In Woodsam (NR property to the TP in a tax-free exchange. iv. bringing the total increases basis mortgage to $400K. What is T’s gain or loss on the transfer to U?  AR = $65 + outstanding debt of $50 = $115  AB = $100 (entire basis) – depreciation deduction of $20 = $80  Gain: $115 . The amount of NR liability (mortgage debt) is to be included in calculating both the basis and the AR in property on disposition. Facts: Woodsam was a corporation owning property transferred to it by Woods.$80 = $35 iii. Issue: What is the TP’s AR in this situation? c. When the stock is worth $100K.b. preventing the potential problem of a mortgagor receiving untaxed income unaccounted for by an increased basis in property. X recognizes a gain of $40K under Diedrich. Mortgaging property subsequent to its acquisition does NOT increase basis executing the second mortgage did not count as a taxable disposition of the land under § 1001 because TP still controlled the property in the same manner as before ii. Mrs. Should X recognize gain on the gift? a.400 in cash and a pair of mortgages worth $195K ($296K total). receiving cash of $65 from U. property w/ debt: Mrs. X borrows $50K on a non-recourse basis. Wood’s gain in Year 10? does NOT c. Holding: TP realized a GAIN of $400K with an AR = the debt The AR includes the debt relief EVEN if the encumbered property is worth less than the amount of debt at the time the TP disposes of the property i. The mortgage still had a > DEBT): debt remaining balance of $381K when it was foreclosed upon. securing the debt only by the stock. Woodsam Associates v. subject to the debt. for $50K.

What is her gain or loss?  AR = $65K ($30K + $35K of debt) + $10K = $75K  Basis = $50K  Gain = AR – AB = $75K . her basis is still $50K  2 years later. her basis is still $50K  Over the next 2 years. Thus. Transfers of Property Subject to Debt: Tax Consequences for TP Who Takes On Debt at Acquisition when NR Indebtedness > FMV i. She has paid off no further principal on the mortgages. After 5 years.down $10K of her own money and borrowing the other $40K on a non-recourse basis from the Bank. 1976): If You Deliberately Overpay. Facts: Involved a sale of a motel to a limited partnership followed by a leaseback of the property to the original owner. Approach #1: Crane Rule for Basis a. Holding: Such an arrangement involving non-recourse debt could be a valid sale > FMV of a. plus a balloon payment at the end.$50K = $25K f. basis or AR i. Pleasant Summit Land Corp v. the partnership purported to own the property for purposes of depreciation and interest deductions. The purchase price was to be paid in installments over 10 years. Approach #3: Pleasant Summit Land Corp. If seller-financed non-recourse indebtedness substantially until PAID exceeds the value of the purchased property. At this time. the property drops in value from $100K to $85K.  The partial pay-off of the mortgage has no impact on her basis in Whiteacre: it is still $50K  At this time. v. You Do Not Get the Benefit of Crane TRANSFEREE 1. which issues a check to be used for payment at closing. Debt only goes into basis on the assumption that it will likely be paid off 3. M sells the property. debt does not go into basis until paid b.  M’s basis in Whiteacre: $50K  Time passes. no money was changing hands over the 10-year period—yet. for which the partnership had no personal liability. Whiteacre has appreciated to a value of $100K. Debt outstanding + cash for property 2. The transaction goes smoothly. so the remaining mortgage is now $30K. Tax Consequences for TP Receiving Property With Acquisition Debt BASIS CONSIDERATIONS 1. Estate of Franklin v. the debt will not support deductions for NO debt into depreciation of interest. it is not depreciated so we don’t have to worry about the basis changing on account of that. M has paid off $10K of the mortgage.  Impact on M’s basis of the drop in value of the property: nothing. Since Whiteacre is undeveloped real estate. This could be an anti-abuse rule limited in its application to abusive borrowings upon payment. NOTE: Resolves the question left open by Crane as to what would happen if non-recourse mortgage debt were used to buy property with a FMV less than debt c. Approach #2: Estate of Franklin Rule--Only Include Debt Likely to Be Paid Off a. all debt adds into basis ii. Commissioner (3d Cir. M borrows another $35K on Whiteacre on a non-recourse basis  Impact of the after-acquired mortgage on M’s basis: nothing. The annual rental payments on the leaseback just equaled the amount of the installment obligations. Where the non-recourse mortgage debt is of an amount GREATER than property the FMV of the property. If NR indebtedness 2. 1988): The 43 . Commissioner a. Commissioner (9th Cir. Basis only includes FMV at time of disposition: lender has an incentive to write-down the debt b. She gets $10K at the closing and the buyer takes the property subject to the mortgages.

Because of the at-risk risk rules. This amount is reduced by any money distributed by the activity to the An individual in TP and by the amount of losses that are allowed under § 465 based on a T or B cannot the TP’s at-risk amount deduct losses c. basis for Transferee TP:  Crane: debt outstanding + cash for property OR  Estate of Franklin: only include debt likely to be paid off  Pleasant Summit: basis includes FMV at time of disposition g. the basis of property contributed by the TP to the activity. Income obtained illegally is taxable 44 . took on debt by third-party lender. The At-Risk Limitation of § 465: Deductions Limited to Amount of Risk i. Holding: Court permitted non-recourse debt that exceeded the value of the property to be included in basis to the extent of such FMV at the time of acquisition 1. Generally i. buys a motion picture for $500K. Facts: When TP acquired property. In the first “at risk year of distribution. Defended its departure from Franklin by noting the possibility that TP might end up agreeing with the lender to settle the debt for this amount iii. NOTE: Subsequent cases have either rejected Pleasant Summit in favor of Estate of Franklin OR reconciled the 2 in that Pleasant Summit applies in non-abusive situations (pre-existing or third-party financing. Professor likes this rule the best! When TP acquires property with NR Debt > FMV. S is not at risk for the $450K loan because it is non-recourse.Basis Can be Included—Opposite of Franklin i. the movie loses $80K. What are the tax consequences? investment” in a. The $30K disallowed loss may be carried forward to the next year to offset any income from the movie in that year. What is basis? ii. Example: S. The at-risk amount is increased by income from the activity that the TP from an includes but does not withdraw from the activity investment in 2. Illegal Income in a T or B: § 162 a. XVIII. Does not include non-recourse loans unless borrowed in connection with real estate b. S may ONLY deduct losses from the the activity activity to the extent of his financial stake in the deal. and debt for which the TP is personally liable or that is secured by assets of the TP (§465(b)). At-risk amount: includes cash contributed by the TP to the activity. rather than seller financing and leaseback as in Franklin) iv. or the amount that he is personally at risk of losing. i. Therefore. § 465(a)(1): Limits the deduction of losses from a T or B to the amount of the TP’s atrisk investment NOTE: § 465(a)(2): losses disallowed under § 465 are carried forward to the next year 1. a prominent movie critic. S may only deduct $50K of the first-year’s loss. He puts excess of her up $50K of his own money and $450K from a non-recourse loan.

Gilbert v. Issue: Did Gilbert realize income? iii. Commissioner (2d Cir. The punitive damages portion of criminal antitrust violations a. He was forced to pay a $18K fine—incurred $22K in legal expenses in defending himself and claimed a deduction on those expenses. Most bribes and kickbacks (§ 162(c)(1)). 2. there is preclusion from assessing the tax by judgment creditors  There is a special provision however: JEOPARDY ASSESSMENT Commissioner may assess taxes even if delay will jeopardize collection in his discretion (ex: risk of flight) c. a.ii. where he believes that his withdrawals will be approved by the corporation. courts will almost always find income in the year in occurs and if there is re-payment. he sold many of the Celotex shares and executed an interest-bearing promissory note to Bruce to get an assignment of most of his property. NOTE: This case is an ANOMOLY (TPs like Gilbert almost always lose). he was found guilty of mail fraud and violating Securities Act of 1933. another company and brought about the merger. but where there is an indictment and prosecution. There was no accession to wealth because there was an immediate. and where he makes a prompt assignment of assets sufficient to secure the amount owed. consensual obligation to repay iv. To recoup much of Bruce’s outlay. IRS then filed tax liens against Gilbert—he claimed a loss deduction. Other illegal payments (§ 162(c)(2)) under any law 3. Commissioner v. § 162: the following expenses CANNOT BE deducted for payments MADE in a T or B for: 1. Facts: Gilbert was the president and principal stockholder of Bruce Company—acquired on borrowed money substantial ownership of stock in Celotex. and 4. Tellier (SCOTUS 1966): Business Related Costs of Defending Oneself are Deductible Under § 162(a)—Conviction is Irrelevant i. However. Holding: NO 1. Facts: T was an UW. Fines and penalties (§ 162(f)). Commissioner disallowed the deduction. he does NOT realize income on the withdrawals. ii. If you file a petition 90 days after receiving this notice. 1977): No Realization of Income on Illegal Withdrawals from Corporation If TP Has Reasonable Certainty of Repayment ANOMALY i. ii. The stock market declined and Gilbert had to furnish additional funds for the Celotex shares purchased by him—he used corporate funds to supply the margin: intended to repay the money and claimed to be acting in corporation’s best interests (told other Bruce officers). No deduction or credit allowed for any amount paid or incurred during the taxable year in carrying on any T or B if such T or B consist of trafficking controlled substances b. Issue: whether expenses incurred in the unsuccessful defense of a criminal prosecution 45 . the expenses of illegal activities are deductible UNLESS § 162 explicitly provides that the expenses are non-deductible iii. RULE: Where a TP withdraws funds from a corporation which he fully intends to repay and which he expects with reasonably certainty he will repay. § 280E: Expenditures in connection with the illegal sale of drugs 1. they will give a deduction SIDE-BAR: Statutory Notices of Deficiency  A statutory notice of deficiency is a legal document that provides the taxpayer with no more than 90 days to file a petition with the US Tax Court to contest a proposed deficiency.

Government: this violates PP. The TP brought several thousand dollars to be copied but was robbed by masked gunmen during the copying.000 fine = not deductible under 162(f) XIX. Since Stephens had already paid taxes on the embezzled funds. Facts: Stephens was indicted for participating in a scheme to defraud Raytheon—was allowed to make restitution and a 5-year prison term (paid $1 million). Facts: TP was shown a black box that apparently copied a real $20 bill onto a blank piece of paper. Holding: No deduction allowable e. unless used in business.000 for the lawyer. Of these expenses. 1. 1990): Deductions Allowed When To Do Otherwise Would Overstate the TP’s Total Income—Deductions Allowed for Repayment i. So. Stephens was taxed on his receipt of $530K of embezzled funds—turned over to Raytheon the $530K fund and executed a $470K promissory note. which expenses are deductible? 1) $25. and $15. Only where deductions would “frustrate sharply” national or state policies have they been disallowed—the illegality should play not rule 2. The hitman incurs the following expenses: $400 for the gun. Commissioner (2d Cir. then it IS deductible! HYPO: Husband hires a hitman to kills his wife—he pays $25K to the hitman for the job. representing the interest. No serious PP is offended when a man faced with a serious criminal charge employs a lawyer to help in his defense d.000 lawyer’s fee = deductible (but unclear) not clear relation to profit-seeking activity per se 6) $15. $500 for ammunition. disallowing the deduction for repaying the funds is a DOUBLE sting 2. then capitalizable 3) $500 for ammunition = seems clearly deductible  but may seem to close to the actual act itself (PP) 4) $2 bus fare = deductible (Sullivan case) Business expense 5) $15.000 for the fine after conviction. Mazzei v. Generally 1. The TP eventually figured out that the robbers were confederates of the alleged counterfeiters. the deduction should not be allowed because it would take the sting out of his punishment ii. because Stephens made restitution in lieu of punishment. $2 for the bus fare. Interest on State and Local Bonds i. nonetheless.can fall as a deduction under § 162(a) as an ordinary and necessary business expense iii. allowing them to borrow more cheaply No tax on state and a. Holding: Deduction allowed 1. and the TP then sought a theft loss. Stephens v. Holding: YES can deduct expenses in defense of a criminal prosecution 1. $15. Issue: whether a deduction for Stephens’ restitution payment of embezzled funds to Raytheon so sharply and immediately frustrates a governmentally declared public policy hat the deduction should be allowed iii. Exempt Income and Expense a. TPs may exclude the interest they receive on certain state/local local bonds except: bonds tax-exempt bonds bear a lower rate of interest than taxable  Private activity bonds. people invest in tax-exempt bonds because the bond interest on them is not taxed  Arbitrage bond 2. NOTE: If income comes in and goes out. Stephens claimed as a deduction the $530K restitution payment. gross income does (note issues)  Bond not in 46 registered form . ii. Commissioner (TC 1974): Breaking the Law is Enough to Disallow Deductions i.000 payment = income (accession to wealth) 2) $400 for the gun should be deductible. EXCEPTIONS § 103(a): Except as otherwise provided. The federal government does NOT tax interest on state and local bonds indirect way to help state/local governments.

you cannot deduct the interest on your borrowing ii.NOT include interest on a state or local bond except for: a. The TP would be willing to buy a GA bond as low as 6%. 64 of Abrams notes --Acts as a subsidy which allows governments to compete in the market—but it is a leaky subsidy. The benefit is passed to the private entity because it now has a building which is essentially financed at a rate less than market rate ii. Costs to produce exempt income are NOT deductible (ex: safety deposit box)  § 103 as a LEAKY SUBSIDY pg. This includes costs associated with obtaining such recovery (such as legal fees) are deductible as well b. § 103(b)(1) exempts private activity bonds b. § 265(a)(2): No deduction allowed for money borrowed to purchase a tax-exempt security i. --EX: An investor in a 40% bracket can buy a GA bond for 8% or a GM bond for 10%. Thus. Arbitrage Bond: § 103(b)(3) i. NOTE: CAN NO LONGER DO THIS § 103(b)(1)— later no longer tax exempt c. Should you acquire higher yield investments be able to deduct the cost of ii. then leases the building (loans proceeds) to a private entity for an amount which is enough to cover the principal and amortization 2. if you borrow money to buy § 103 bonds. An arbitrage bond: any bond issued in which the proceeds of such issue are reasonably expected (at the time of the issuance of the bond) to be used directly or If you buy a bunch of 103 indirectly to acquire higher yield investments or to bonds and you put them in a replace funds which are used directly/indirectly to safe-deposit box. XX. as it benefits investors whether an investor will choose a government bond over a private bond will depend on the investor’s tax bracket. Amounts received on account of injury are taxable under the general rule that accessions to wealth are includible within “gross income” under § 61 1. State issues bonds to construct building. The state could sell its tax-exempt bond at 9% and the license: no deduction proceeds from these sales would be used to buy federal  If you put a federal bond: bonds paying 10%--thus. What is it? 1. High-bracket TP reap a windfall when state gives lower interest rates. but receives a BENEFIT because he is receiving an 8% return. Bond not in registered form d. § 104(a)(2): Gross income shall not include the amount of any damages (other than § 104(a)(2):  “For physical injury”  Excludes punitive damages 47 . Personal and Business Injuries a. Personal Injuries i. could no deduction act as a conduit for treasury  If you put only a marriage 2. What is it? 1. Generally i. Problems the safe-deposit box? NO 1. Private activity bond which is not a qualified bond: § 103(b)(1) i. States were getting money and then buying treasury  If you put only state bonds: bonds—with exemptions for the treasury bonds. the state would pocket the deduction (not tax exempt) spread without doing anything  If all three: deal with this 3.

Child support is NOT deductible by the payor and is not taxed to the payee ii. NOTE: Structured Settlements 1. If any portion of the death benefit under a life insurance K on the life of an insured is sold or assigned to a viatical settlement provider. § 101(g)(2): Treatment of Viatical Settlements a. the payor is not taxed. but payments over time 2. If we are given a structured settlement. the following amounts shall be treated as an amount paid by reason of the death of an insured: any amount received under a life insurance K on the life of an insured who is a terminally or chronically ill individual 2. or a settlement this language was just removed! 2. What are they? a. NOTE: If you sell the insurance. gross income does NOT include amounts received if such income results from amounts paid by reason of the death of the insured a. Emotional distress is included as income EXCEPT with regards to medical care which is based on physical injury/sickness attributable to emotional distress (§ 104(a)(5)) i. Leak in the System 1. This way. § 1. Commissioner (TC 1984): The Method of Accounting Determines the Deduction 48 . How are they taxed? a. Businesses can buy a modest amount of insurance and deduct—includable on the recipient and purchaser side 2. § 101(a)(1) and (2): In general. the purchaser is taxed because this is an investment ii. Generally 1. Life insurance benefits are excludable from taxation 2. Child Support Obligations in Default i. Emotional Distress a. Deduction without any inclusion d.punitive damages) received on account of personal physical injuries or physical sickness 1. Structured Settlements: payments not in lump sum. § 101(g)(1): For purposes on this section. Reg. the statute lets you exclude the entire structured settlement. Generally: § 101(a)(1) and (2) 1.104-1(c): The term “damages received” means an amount received through prosecution of a legal suit or action based upon tort or tort-type rights. and the insurance company does not pay tax c. A Leak in the System a. the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance K by reason of death of such insured iii. § 101(g): Viatical Settlements (ex: AIDS cases) 1. the payor will be taxed on it as if they invested 3. The way structured settlements are done: PAYOR gives immediate payment to INSURANCE COMPANY who makes payments over time b. Life Insurance: § 101 i. the payee is not taxed. Note: K claims are taxable—unless physical injury + K ii. Diez-Arguelles v.

2. in computing taxable income. Facts: F agreed to pay TP (cash-method) child support and was in arrears. Notion that she ought not to have a deduction for the failure to receive exempt income is wrong—losing a deduction based on method of accounting seems fundamentally wrong XXI. Accrual Method i. Tax Accounting: do not want people to escape taxation. Alternative set of tax rules with fewer deductions—every one is required to compute their regular tax liability and AMT. or i. Generally i. General Rules for Tax Accounting § 446: General Rules for Methods of Accounting o (a) Taxable income shall be computed under the method of accounting on the basis of which the TP regularly computes his income in keeping his books. income Income under actually not received but within your right of control Cash Method ii. inherently conservative b. Legal right to get the money/property at your discretion. Tax Accounting a. Holding: NO a. Thus. if you have a legal right to payment but elect not to receive WHEN: it. you can still be taxed focuses on when you COULD have  Actually received something. o (b) Clear Reflection of Income: if the Secretary thinks that the books do not clearly reflect income. Court does not agree that TP is “out of pocket” because of F’s failure to pay—she has no basis because she did not actually receive the payment b. inherently liberal ii. Income: included when a. Alternative Minimum Tax (AMT) 1. must get consent from the Secretary 1. On her return. a. Actually received: getting the money/property right now b. Financial Accounting: used to allow investors to make appropriate choices.1. NOTE: § 166(d): a non-corporate TP may deduct non-business bad debts as a short-term capital loss in the year such debts become completely worthless—only deductible to the extent of the TP’s basis in the debts. even though you might choose to receive it received  Constructively 49 received  Economic benefit  . Cash Method: Focuses on when you get paid 1. Methods of Tax Accounting: Cash v. Issue: Can the deductions be made? 3. can order another method to be used that does clearly reflect income o (c) Permissible Methods  The Cash Receipts and Disbursements Method  An Accrual Method  Any other allowed  Any combination of the foregoing o (d) A TP engaged in more than one trade or business may. and must pay whichever is greater b. Differences Between Tax and Financial Accounting a. use a different method of accounting for each T or B o (e) In order to change the method of accounting. TP treated the amount in arrears due from F as a non-business bad debt and deducted the amount for their gross income as a short-term capital loss. These deductions were not allowed. Professor finds this to be a dreadful opinion i. Constructively received (right to demand property).

A customer gets its meter read mid-month: when the meter is read. NOTE: Reg. Consider the Dec-Jan period. Commissioner) c. Promise of payment in 1 year: Income in 1 year ii. If the K you sign gives you NO right to ask for payment. a bill is created that allows  CASH the customer to pay. There is income immediately to the TP if the TP has the payor transfer the money to a third party so it is not subject to the reach of the transferor’s creditors absolute right to income in the form of a fund which has been irrevocably set aside for him in a trust that is beyond the reach of the payor’s creditors 1. Deductions: All Events Test focuses on a. Accrual Method: Focuses on when you earn income 1.e. WHEN SERVICES ARE RENDERED.later iii. even if you do not have it in your hands (ex: trusts/accounts established for someone’s benefit) ii. Both: Income Now 2. All events have occurred and b. Deductions: deduct when actually made ii. economic performance occurs as the person provides such services. Example of Reasonable Accuracy: You are a public utility that has to read meters for customers. METHOD 1. Since the meter is being read once a month. § 1. NOT PREPAYMENT ii. Cash or property now: Income now iii. item allowable for a deduction. Note: the mere transfer of money on behalf of the TP is enough (Pulsifer) d. or otherwise made available so that he may draw upon it at any time or so that he could have drawn upon it during the taxable year if notice had been given 1. Economic benefit: i. Amount of liability can be determined with reasonable accuracy earn income c. or expense) of the TP arises from the provision of services. cost.451-2(a): In the taxable year during which income is credited to TP’s account. If the liability (i. Examples: i. you do not have income until actually paid (Amend v. 1. Income: included when a. set apart for him. There is NO income until January because of the  ACCRUAL requirement of reasonable accuracy METHOD 2. Economic Performance (§ 461(h)(2)) i. Amount can be determined with reasonable accuracy i. the company focuses on doesn’t know how much gas they have sold to the WHEN you customer until January get paid 2. All the events have occurred WHEN you b. Focuses on whether you have a benefit of something. Income is NOT constructively received if the TP’s control of it is subject to substantial limitations or restricted 2. Example: If the TP has agreed to pay $100K worth of services to 50 .

LATER: In one year (Amend v. iii. Commissioner) 3) What if R would have agreed to pay T earlier? a. you have to hire a certain amount of postproduction editors for 8 weeks. and 3) Economic performance has occurred with respect to the liability Deductions Expenditures are to be deducted for the taxable year in which actually made (ex: check mailed or credit card charged) Limitations 1) No one who uses inventory can use the cash method 2) Almost all corporations are precluded from this method 3) In a partnership. because you have done the work Cash Method Income Reg. or services) are to be included in the taxable year in which actually or constructively received or economic benefit Accrual Method Reg. if the partner cannot use the cash method because they are a corporation. Example: You work for someone. LATER: When they get paid (Amend v. Under union rules. § 1. the entire partnership cannot HYPOS: Assume for these hypotheticals that T is a cash-method taxpayer. You cannot deduct as soon as you start filming have to wait to deduct the salaries of the workers until they actual perform the service. When does T have income? a. Commissioner) (later) 2) T agrees to dig a swimming pool for R. the TP can only accrue $20K (1/5) of the deduction iii.446-1(c)(i) Items which constitute gross income (whether in the form of cash. Accrual Method: An Example 1. with T to be paid $20. 1) T agrees to dig a swimming pool for R: do they have income when they get paid or when they do the work? a.446-1(c)(ii) Income is to be included in the taxable year when: 1) All the events have occurred that fix the right to receive the income AND 2) The amount of the income can be determined with reasonable accuracy ALL EVENTS TEST: Liability is incurred in the taxable year in which: 1) All the events have occurred that established the fact of the liability 2) The amount of the liability can be determined with reasonable accuracy. When do you have income? a. § 1. Example: You are in charge of a motion picture production. property. and they will pay you after 30 days. Cash Method: Income after 30 days b. LATER: When they get paid 51 .be performed over the next 5 years. Cash v. Accrual Method: You have income NOW. in the first year.000 in 1 year.

When does T have income? a. Office Depot is paid immediately by the issuing bank and the taxpayer becomes a debtor of the issuing bank. Always determine if it is income FIRST! i. Scenario #1: When the taxpayer used the MasterCard. you can deduct when you take the goods home. Scenario #2: When the taxpayer used the Office Depot card.000 in 1 year— you have no right now) and the bank will give you $22. Congress passed a special provision for lottery winners who choose installment payments because they would all file bankruptcy because they couldn’t pay the bill. they give you $22. NOW You have income immediately and it is the FMV of the property: $20. R gives T a certificate of deposit from the bank (gives T the right to $20. a cash payer taxpayer that buys a house cannot deduct it because it is a capital expense 13) Suppose that I am a cash method taxpayer and I do work but my employer refuses to pay me. Under #2. You can only deduct when you actually pay them. You go to Office Depot and there are 2 options: 1) pay with MasterCard. So. bill comes 1 month later. No deduction 11) You buy a lottery ticket and you win. NOTE: For deductions with cash TP—look to actual payment b. NOW Pulsifer case: economic benefit doctrine—if a cash basis taxpayer has the payor transfer the money to a third party so it is no subject to the reach of the transferor’s creditors. If no right to ask under K: income until actual payment 5) Suppose that T does some work and gets paid right at the end of the year. When do you have income: now or in a year? a. NO INCOME b. a. Do I have come? a. You could either get the $4 million lump sum or get $6 million later ($1 million a year for 6 years).4) Suppose T could get paid any time T wanted. there is no deduction.000 in a year—but they give you nothing at all (as opposed to a CD you could sell. now you have nothing). What is the difference? a. Does T have income now? a. you can deduct when you take the goods later. no full economic performance 14) Suppose I do get paid but I get robbed after 4 minutes. When you get paid in property. Do I have income? a. IMMEDIATELY b. and then using the borrowed funds to pay Office Depot c. Constructive: I could have asked if I wanted to—so NO Constructive receipt. but you chose not to (does not preclude income recognition) 6) T digs the swimming pool. Essentially has been transferred to the agent. Under #1. 2) you pay with your Office Depot card. This is illegal. There is no difference between using your MasterCard. NOW. When do you have income? a. and you pay the bill. and it will be worth $22. Thus. and you pay the bill. 104(a)(2) excludes DAMAGES from INCOME c. You have income immediately and it is the FMV of the property 8) You do the work. borrowing $100. Office Depot is not getting paid yet—you are promising to pay them. When do you have income? a. If you have a right to ask: income now ii.000 in an interest-bearing account. 12) You have an automobile accident and you get damages: either $ 4 million now or $6 million in installment payments. bill comes 1 month later. It is an account that you cannot borrow against. NOW: Immediately i. YES—cannot say you do not have income because it disappears 52 . BUT. even though you do not have income immediately 9) You are a lawyer in a private practice and you need to supplies. you have income immediately 7) Suppose you agree to do the work and they agree to give you a car. then it is income immediately to the taxpayer i. When you tell the bank and say that you want to pay the interest later.000 (with interest) in 1 year. NEVER—trick question! b. When is there income? a. the taxpayer has paid immediately with borrowed funds and can DEDUCT NOW! i. 10) You have a home mortgage and want to deduct the interest of the mortgage. When do you get the income? a. Lump sum: tax bill of $4 million TODAY—constructive receipt of $4 million because you had the ability to demand it c. but it is a busy time and T takes the check and deposit it in January. T just has to ask—T does not ask for a year. NOW: ImmediatelyWhen you got the check because you COULD have negotiated the instrument. cannot sell it.000 (what it is worth now minus the interest) b.

GA was several years behind in its payment—at issue is whether the TP had recognized income when the books were delivered or when they were sold. YES: All the events have occurred that give you the legal right: the lack of payment does not matter i. No deferral based on statistical measures 4. Commissioner (SCOTUS 1963): Considered the includability of prepaid income upon receipt A dancing school was taxable in the year of receipt on amounts paid by students for lessons to be provided in the future. 2. US (SCOTUS 1961): Have to Show EXACTLY When Money is Earned 1. Do you have income? a. Issue: Did the TP recognize income when the books were delivered or when they were sold? 3. Facts: AAA received annual membership fees obligating it to provide towing and related services on demand. Delay in the receipt of cash in the absence of doubt about ultimate payment is not enough to prevent accrual of income b. later is WORSE (defer deduction) -No obvious advantage between cash or accrual  NOTE: If your method of accounting DEFERS income and ACCELERATES deduction. Commissioner (TC 1943): Not Getting Paid in the Absence of Doubt About Payment IS Not Enough To Prevent Accrual of Income 1. Accrual Accounting: No Obvious Advantage Income Deductions Cash Later: when they get paid Later: when you write the check Accrual Earlier: have to include it Earlier: when they owe the when they DO the service money  Is it good or bad to be later? -On the income side. Georgia School-Book Depository v. TP collected the costs of the books from the state and remitted all but a percentage to the publisher with the retained percentage being the TP’s commission. Accrual makes better sense: the fact of payment is irrelevant. At issue was the proper accrual of the fees. Cases on Accrual Method Accounting i. Legal technicalities will not prevent the accrual method ii. Cash v. TP could not show when they were going to earn the money—earn money when it sends out a tow truck. Holding: Accrual at the TIME of receipt—government wins a. Facts: TP (accrual method) was a book broker. Holding: TP loses (when the books were delivered)—commissions on all the books purchased by the state should have been accrued and returned as income a. it is the RIGHT to get paid c. Accrual accounting turns on when you do the work—there was no reasonable expectancy that TP would not ever be paid i. selling textbooks for publishers to the state of GA. AAA v. TP argued that it was earned upon payment and since there was no reasonable expectancy that the payment would be made then the commissions involved were not properly accruable (all events had not occurred). when someone joins cannot prove WHEN they are going to use the service b. it is better to be LATER (defer) -On deduction side.15) What if you are an accrual method taxpayer and your employer stiffs you. Issue: In what year are the prepaid fees taxable as income? 3. it is a good method 53 . 2. NOTE: Schlude v.

reporting income when services were performed is OK iv. Annual Accounting i. succeeded in avoiding inclusion upon receipt of advance payments that it demanded from customers whose credit it determined was suspect. or when the payment was collected. Indianapolis Power and Light (SCOTUS 1990): If Analogous to a Loan. This is like a loan: you will earn it as you place the orders—if you do not place the orders. Schlude) d. Holding: Held for TP—payments were analogous to loans by the customers rather than advance payments like in AAA. 2006): Cash Advances in Exchange for Volume Purchase Commitments are NOT Income 1. v. There is no income when you get a security deposit because loans are not taxable events. are NOT income when received a. As goods were sold. and other times was paid before performing services.iii. Government sought to require that the income be reported when the services were performed. Government: argues the cash advances were income because TP had complete dominion over the money and could spend the money as it wanted 2. just like a loan. Holding: NO cash advances in exchange for volume purchase commitments. 2. Customers could demand repayment of the deposits if service was terminated or upon establishing good credit b. the TP treated the up-front cash discount as a liability when it was received. Generally 54 . Boise Cascade v. a. an electrical utility. Facts: TP had performed engineering services. Then No Inclusion Upon Receipt 1. whichever came first. a. Issue: Whether cash paid in advance by a wholesaler to a retailer. TP followed a consistent practice of reporting the income when services were performed. in exchange for a volume commitment. Government is only entitled to a fair method of accounting b. Facts: TP. these payments usually ended up being credited against the customers’ monthly electrical bills. Using accrual accounting. Westpac Pacific Food v. you will have to pay it back Summary:  IF LIKE A LOAN: no inclusion upon receipt of payment (IPL. is “gross income” under § 61 3. 2. Commissioner v. subject to pro rata payment if the volume commitments are not met. the TP applied the discount pro rata to the full purchase price— net effect is that it reduced the cost of goods sold and increased reported profit. Westpac)  IF A PREPAID ADVANCE: inclusion upon receipt of payment (AAA. Facts: TP promised to buy a lot of items and received cash as advance as its discount on its future purchases. Commissioner (9th Cir. TP’s services were fixed and definite (as opposed to AAA and Shlude) and dependent solely upon the demand or request of the client—thus. Holding: Disagreed with government—inconsistency is too strident a. Customers earned interest against the payments—TP did not place the deposits in a separate account and could use the money without restriction. United States (SCOTUS 1976): Government is Only Entitled to a Fair Method of Accounting 1. In practice. TP sometimes performed services before being paid.

when you have money under a claim of right. TP is taxed. When it got paid. the deductions are treated as a tax benefit—when the money is returned. he has received income which he is required to report  Thus. the taxable year is the calendar year: Jan 1 – Dec 31 3. The income tax is based on annual accounting: § 441 2.1. Issue: whether the gain or profit which is the subject of the tax can be ascertained on the basis of fixed accounting periods OR it can be net profit ascertained on the basis of particular transactions of the TP when they are brought to conclusion c. If a TP receives earnings under a claim of right and without restrictions as to its disposition. Net operating losses can be carried back for 2 years (REFUND) and can be carried forward as many as 20 years (REDUCING TAX LIABILITY IN THE FUTURE)  If the TP prefers. the annual accounting convention would require the company to pay tax on its second year of income of $100K even though the company has broken even for the first 2 years. Burnet v. 2. only business deductions (excluding charitable contributions) can control to an NOL carryover: § 172(d)(4)  RELATION TO TAX BENEFIT RULE: Net operating losses arise when allowable tax deductions are greater than taxable income. you must include it get the money. For individuals. For nearly all individuals. NOTE: The transaction produces NO benefit. and you claim it is yours--that is enough to establish a claim. Potential Problems a. Ex: A newly formed company might lose $100K in its first year of operation and earn $100K in the following year. Claim of Right Doctrine a. resulting in negative taxable income (more expenses than revenue). If you have income and loss in the same year. The company can take advantage of: § 172 (net operating loss provisions) ii. North American Oil Consolidated v. Burnet (SCOTUS 1932): The TP 55 . b. can forgo the loss carryback and simply carry the loss forward 3. Holding: Compute on annual fixed method—government wins! i. they NET in that year 2. b. The TP who has possession of the income is taxed on the income despite any dispute ii. its deduction in those years produced no tax benefit. Strictly applied. The Claim of Right Doctrine i. the government wanted to tax this as income. Congress responded with § 172: NET OPERATING LOSSES 1. To the extent the deductions made the income be negative. Problems of Annual Accounting 1. Sanford & Brooks (SCOTUS 1931): Annual Accounting Is Constitutional a. yet the TP still has to pay taxes ii. Facts: The TP expended money working on a K in which it had no income—as a result. while the TP argued that it was not taxable income because it had lost money overall on the K.

the government argued that the work was done badly and refused to pay. Because the TP and in Year 2.Who Has Possession of the Income is Taxed On the Income Despite Any Dispute i. cannot defer income past receipt for accrual basis TP § 461(f): The Flipside of North American Oil  If the TP contests an asserted liability. In Year 4. 2. United States v. Facts: TP received a bonus of $22K as an employee in Year 1 annual accounting can hurt (cash basis TP). When there is a dispute. Lewis (SCOTUS 1951): An Adjustment for Tax Liability Under Claim of Right Takes the Form of a Deduction in The Year in Which the Income is Repaid This is an example of how i. In Year 2. the TC holds for TP and TP gets paid. Contested Liability a. the government’s appeal is dismissed (so the TP gets to keep the money and the TC judgment is final). a deduction would be allowed for the taxable year of the transfer determined after application of subsection (h). so it would have been in Year the deduction meant more to him in Year 1 ii. If a TP fits § 1341. Bonus was held by TP under a claim of right—nothing in the holding of North American permits an exception just because a TP is mistaken in his belief as to claim of right iv. In Year 3. However. Congress responded with § 1341 1. went to a higher bracket in 1. Facts: In Year 1. If an accrual basis TP: have income when “all the events an accrual method TP have occurred that establish your right to be paid and the becomes “cash right can be determined with reasonable accuracy” method” TP  TP: money is taxable in Year 1 when money was made  Government: all events have NOT occurred iii. TP: wanted a deduction in Year 1 rather than Year 2 Year 2 was LESS than what  NOTE: TP was in a higher bracket in Year 1. If a cash basis TP: no actual receipt until Year 3 or economic benefit or constructive receipt For disputed claims. the work is done by North American Oil. the contest with respect to the asserted liability exists after the time of the transfer. Holding: Include income in the year of receipt (year 3) under the “claim of right” theory 1. then the deduction SHALL BE ALLOWED for the taxable year of the transfer. he was compelled to return $11K to his employer. Issue: Should the TP take the deduction for the repaid $11K in 1946 or 1944? iii. the TP transfers money or other property to provide for the satisfaction of the asserted liability. ii. Holding: amount is deductible in Year 2—TP LOSES 1. Government: wanted to put $11K deduction in Year 1 Year 2.  The CONTEST does not preclude the deduction  NOTE: Include income under tax benefit rule 3. TP used money during the taxable year thinking the TP due to progressive he was entitled to it—there was litigation regarding his bonus. Issue: In what year is income included when you are an accrual basis TP? 1. the TP will reduce tax liability in the 56 . tax rates. the TP sues to get paid. and but for the fact that the asserted liability is contested. his tax benefit in 2.

Open v. a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the TP did not have an unrestricted right to such item or to portion of such item. the repayment of an amount mistakenly included in income can produce either a current deduction of the amount repaid or. despite the fact the TP only paid $5K of tax on the $20K inclusion in Year 1. If the TP had instead been in the 25% bracket in Year 1 and 35% bracket in Year 2. SO—A reduction in tax liability will occur if:  In a prior year. In Year 2. pays $7K of the tax on that amount. Thus § 1341 effectively gives the TP a choice of 2 positions litigated in Lewis. is forced to return the disputed funds. Generally i. Closed Transactions i. the TP who is now in the 25% bracket. § 1341 allows the TP to reduce her Year 2 tax liability by $7K. it’s been established that the TP did NOT have such a right  The amount of the deduction exceeds $3000K CREDIT OR  THEN. a TP includes $20K in year 1. all income now 2. The deduction.  Note: embezzlers do not have the right to this provision (no unrestricted right)  EXAMPLE: Suppose that under the claim of right doctrine. Closed Transaction: a. Generally: How Do We Look at Installment Sales? 1. would not make the TP whole for the $7K of the tax the TP paid in Year 1.year of repayment by the reduction in tax that would have occurred in the year in which the income was included had the TP not included the amount  Under § 1341. it appeared that TP had an unrestricted right to an item  Now. What is an installment sale? 1. which is the reduction in tax that would have occurred in Year 1 (the year in which the income was included) had the TP not included that amount. 2. Installment Sales a. § 1341 would allow the TP to deduct the $20K in Year 2 for a tax savings of $7K. which would save the TP $5K in Year 2. The TP is allowed a deduction in Year 2 for the $20K repaid in that year. All events have occurred so as to allow the transaction to be subject to tax. A sale of property in which the seller receives a series of payments to be made in the future b. a tax credit equal to the amount of taxes imposed on the prior overpayment. at the TP’s election. who is in the 35% bracket. XXII. Events have not occurred to allow the transaction to be subject to tax 57 . Open Transaction: BASIS FIRST a. The TP. the tax for the year will be the LESSER DEDUCTION of: tax for the taxable year computed with the deduction OR an amount equal to the tax computed without the deduction minus the decrease in tax for the prior year § 1341: Computation of tax where TP restores substantial amount held under claim of right  If an item was included in gross income for a prior taxable year (or years) because it appeared that the TP had an unrestricted right to such item. and the amount of such deduction exceeds $3000K—then the tax imposed SHALL BE THE LESSER OF: TAX COMPUTED WITH DEDUCTION OR AN AMOUNT OR AN AMOUNT EQUAL TO TAX FOR THE TAXABLE YEAR WITHOUT DEDUCTION – DECREASE IN TAX UNDER THIS CHAPTER FOR THE PRIOR TAXABLE YEAR.

B does not have to pay the $500K immediately—instead he is required to pay $100K a year for 5 years. § 453(b): An installment sale is a disposition of property where at least 1 payment is made after the close of the taxable year 4. No income until you exceed your basis Example: TP owns property with a basis of $100K and a FMV of $500K. then include all amounts received after she had recovered her basis. taxation of options. TP was permitted to recover all of her basis first. a. Installment Sales Reporting: § 453 i. TP sells the property to B for $500K. 3. He must make annual payments of interest as well. Burnet v. Since the amount to be received in the future was not ascertainable. Example: Inaja land. should exclude all receipts until basis is recovered b. closely held business and sole stockholder sells his shares for $100K in cash plus 10% of profits for each 5 years SUMMARY:  FOR RARE AND UNUSUAL CIRCUMSTANCES: Open transaction treatment  WHEN PAYOUT PERIOD IS FIXED AND MAXIMUM AMT PAID IS UNCERTAIN: basis recovery is ratable over payout period (closed transaction treatment) c. i. TPs may elect out of § 453 and recognize the entire gain in the year of the sale: § 453(d)  will really only happen if TP is in a lower tax bracket in the year of the sale 2. AFTER THE CASE: § 453(j)(2) and Regulations only in rare and unusual circumstances will property be treated as NOT having an ascertainable value a. Facts: TP sold stock in a mining company in exchange for cash and payments that were based on the amount mined in the future. § 453(a): Income from an installment sale shall be taken into account under the installment method (note: no limit by character/method of accounting) 3. Sellers receiving contingent payments must apply § 453 in the year of the sale and preclude open transaction reporting except in extraordinary cases. the remaining payments are taxable in full (ex: nothing year 1. Generally 1. Logan (SCOTUS 1931): If the FMV is Not Ascertainable. in the first year. Thus. Government: wanted to treat it like an annuity 2. Does not apply to sales of personal property by TPs who regularly sell personal property on the installment plan b. Holding: For TP this is an open transaction so no FMV to be determined a. Under the terms of the sales K.b. TP receives $100K of the $500K sales price owed her. § 453(c): Installment Method 58 . on the unpaid balance of the installments. Open Transaction Treatment 1. and taxed later) ii. When does it apply? a. TP: argued it was an open transaction—since the total AR cannot be determined. § 453 applies automatically to a sale of property if the seller realizes a gain on the sale and at least 1 payment for the property will be received by the seller after the close of the taxable year i. at a market rate.  Closed transaction: tax TP on the full gain in the year of the sale—even though she receives only a quarter of that amount (ex: $500K)  Open Transaction: TP would not recognize any gain until TP recovers the basis.

000 as a down payment and then other payments each year for 5 years.000 = 45 % x $20. If any person disposes of property to a related person (“first disposition”) and before the person making the first disposition receives all payments with respect to such disposition. the related person disposes of the property (“second disposition”). or disposition 2.000 -$45.000 -Gross profit = $45. 3.000 = $9000 -Include $9000 5 times (which is $45. transmitted. Selling to Loved Ones Who Re-Sell Immediately: § 453(e) 1. Selling the Installment Obligation: § 453B SELLER AS LARGE TP 1. iv. sold or otherwise disposed of. your tax obligation is triggered at the time when your loved one sells to X. transmission. He agrees to sell his property for $100K. SO: If you sell to a loved one who then sells to person X. 59 . He pays $20. Gross profit = Gain Realized = AR – AB HYPO: Our taxpayer owns property with an adjusted basis of $55 K. include $9K and exclude the rest ii. but only if all such obligations exceed $ 5 million in the taxable year. How much income is on the down payment? -Total K price = $100. OBLIGATIONS MUST EXCEED $5 MILLION: This applies to outstanding obligations as well.000 / $100. The deferred payments will include appropriate interest. the AMOUNT REALIZED with respect to the second disposition will be treated as received at the time of the second disposition by the person making the first disposition SELLING WITHIN 2 YEARS a.000) -Of the $20.a. FORMULA: Payments in current year x (Gross Profit / Total K Price) i. SALES PRICE MUST EXCEED $150K: Only applies to obligations which arise from a disposition of any property under the installment method but ONLY if the sales price of the property exceeds $150K b.000 down payment. interest payments shall be paid on the deferred tax liability with respect to such obligation in the manner provided 2. Total K price = AR ii. gain or loss shall result to the extent of the difference between the basis of the obligation and the amount realized or the fair market obligation of the obligation at the time of distribution. you have to pay interest on the value of the deferral that installment reporting gives you—but only if you fall under the $150 K or $5 million limitation. SO: To the extent you are avoiding paying taxes when you get something. Basis of the obligation § 453(B)(b): excess of the face value subtracted by an amount equal to income which would be returnable (includable) were the obligation satisfied in full FORMULA: Basis = Amt you don’t have to pay – (GP/TK)(Amt you don’t have to pay) Gain = Amt sold obligation for – Basis iii. Income recognized for any taxable year from a disposition is a proportion of payments received in the current year b. To fall under this provision: a. If an installment obligation is satisfied other than face value or distributed. Interest Payments on Installment Sales: § 453A 1. In the case of an installment obligation.

as payment on the note received) USE FORMULA XXIII. but not the obligation to buy property i. Call options: gives you the right. will wait to see if it rises) (or “out of the money”) --Long a particular asset: will make money if the asset goes up (CALL) --Short an asset: will make money if the asset goes down (PUT) iii. If the TP wishes to shift the benefits and burdens of ownership of the asset to someone. For the put option: the price I receive = strike price b. Option price: the price paid for the option JARGON: --In the money: strike price is below the fair market value at which the underlying asset is selling for call option. strike price is above the fair market value at which the underlying asset is selling for put option --Deep in the money: strike price is not even close to the value at which the underlying asset is selling—just a description that the option is certainly going to be exercised --Under water: strike price is ABOVE the current value of the asset (will not exercise an under water option. economically indifferent to the transaction 3. Economic Indifference a. The Collar 1. Collar: the simultaneous purchase of a put option and the selling of a call option 2. to sell the property 2. Definitions a. borrowing against the asset will not suffice. Generally: Deferring Taxation on Unrealized Appreciation i. recognition of the boot will occur under the installment method (that is. Selling an option to purchase the asset at a fixed price (“call option”) will transfer most of the benefits of the ownership to the option holder while paying someone for a put option (an option to sell the property for a fixed price) will transfer most of the risk of value of the property to the seller of the put option ii. For the call option: the price I pay = strike price ii. Borrowing against an appreciated asset allows the TP to defer taxation on the unrealized appreciation (as opposed to income from investment of the loan proceeds that has to service the debt). Installment Sales and Boot from a § 1031 Exchange: § 453(f)(6) 1. Example: If the put option has a strike price of $85 while the call option has a strike price of $110—the TP will enjoy the first $10 of appreciation 60 . 3. If you buy a put option and sell a call option for the same price. Put options: gives you the right. A TP who owns an appreciated asset can convert that appreciation into cash by borrowing against the asset. When Collars Are NOT Immediate Sales a. Options 1. Strike price: the price at which the underlying asset will sell under the terms of the option i.v. Deferring Income a. OPTIONS!  TRANSFER BENEFITS OR RISKS OF OWNERSHIP a. Think: gives you benefit of ownership b. 2. Why Buy Options? 1. but not the obligation. The Two Kinds a. If the boot in a like-kind exchange includes an installment note.

No tax consequences when options are created. When is an Option Worth the Most? 1. Employee Taxed When Money Paid by Employer to Employer 1. Ex: If the asset is selling for $100 and your strike price is $101—look to historic volatility of the asset c. Determining the Price of an Option  The three determinants of determining the price of an option: 1) Relationship of the current strike price to FMV 2) Duration of the option 3) Historic volatility of the option i. Options are largely treated as open transactions (basis first) i. If I let it lapse. The seller gets open transaction treatment as well—seller gets gain on what they receive if the option is exercised 3. 1985): When Money is in Escrow. my basis is $105. Facts: TP entered into agreement in which he would render medical services to subscribers of prepaid medical plan in exchange for fees to be paid by organization in charge of plan. TP agreed he would be paid 50% of the fees. Revenue Ruling 60-31: A cash-basis employee is NOT taxable on the unsecured promise by the employer of compensation to be paid in the future ii. Using Options to Deter Financial Risks i. United States (9th Cir. To get this money: can sell a call option d. An option will be more valuable if its strike price is close to or below the current value of the asset (FMV) a. I simply have a loss with a deduction. Put options: spending money NOW to ensure that you do not lose money in the future 2. To avoid price changes that cause the price of an asset to go higher: 1. Thus. Buy an option that gives you a right to by the asset at TODAY’s value—using a financial instrument to hedge a business risk to make money (derivatives0 iii. Compensatory Options to Get Deferral i. or when there is too tight of a collar b.in the property and will suffer the first $15 of decline in value. b. Can buy an option to exchange for a set rate of US dollars 2. Ex: If I buy a call option. Minor v. To monetize exposure to future risk and lock in gain 1. this collar will NOT be treated as an immediate sale because the TP retains a significant economic interest in the value of the property iv. Open Transaction Treatment when exercised a. The fees were paid in a deferred compensation plan: TP who deferred compensation entered into agreement in which TP and org would agree that future services of TP would be paid according to a designated percentage of the fee he/she would receive under the fee schedule if not participating in the plan: balance in a deferred compensation fund. only when exercised 2. Can use a forward K: can sell the foreign currency to have no possible gain or loss ii. org established a trust with TP as trustee and org 61 . An option will be more valuable if its duration is longer 2. NOTE: If an option is “too deep in the money. If I pay $2 for the call option and buy the asset for $103. To avoid a currency fluctuation risk: 1. Tax Consequences of Options 1. it is “open” until we determine whether I exercise it or let it lax.” going to assume the option will be exercised.

TP only included 10% of the fees ACTUALLY received. Employer-Sponsored Plans 1. Thus. NOTE: Back-dated options: options with prices below the FMV of the “currently stock on the date the option was granted TAXABLE taxable”) 3. In Some Circumstances. If You Do the Minor Scheme. out of the control of the employer.e. c. Requires the employer to make contributions sufficient to The employer deducts now and the employee only has 62 income when he/she withdraws . Provides that upon a deterioration of the employer’s financial health. a. and the EMPLOYEE ONLY HAS INCOME WHEN HE/SHE WITHDRAWS b. the tax benefit of a “qualified” pension plan is that the employer can DEDUCT contributions to the plan when made even though the employees need not report the income until they receive distributions from the plan (ex: retirement!) i. This provision accelerates taxation of deferred compensation a. Accelerate benefits OR Anything that b. Defined Benefit Plans (§ 401(l)(3)): benefits upon retirement i. Where money is set aside in a trust or escrow account for the benefit of the employee. Holding: TP’s benefits are NOT property under § 83 a. employee is not taxed: no accession to wealth as a trustee. SO: THE EMPLOYER DEDUCTS NOW.as beneficiary. NOTE: Plans must be non-discriminatory and cannot discriminate in favor of the highly compensated 2. TP does not have any right. Thus. The assets are held in a pension trust that is TAX EXEMPT so that the contribution of the employer will increase tax-free until distributions are made c. Types a. and get well secured compensation that is not taxed. Unforeseen emergency v. You will Be TAXED NOW: § 409A 1. for a 2. TP: participants in the plan have no right to compel org to execute trust agreement—no right to title 2. What Is Not Currently Taxable Under 409A a. Disability iv. Applies in all situations where the employee has a binding right to  409A sets received deferred compensation out reqs. Generally a. not taxed as a beneficiary. title. fails to meet assets are shielded from outside creditors reqs is TAXED (i. Death iii. § 409A: Amounts payable in the future are taxable when bargained for if the plan NOT to plan allows employees to: be taxed. Government: TP should have included his gross income for that portion of fees that the organization placed in a trust for his future benefit (economic benefit) b. Payments triggered by: i. or interest in the trust—TP’s only involvement is as a trustee b. the EMPLOYEE is taxed at the time when the money is paid by the employer to the employee iii. a. In general. Corporate take-over e. Firing ii. Qualified Deferred Compensation Plans i. the remaining 90% went into the trust.

Usually allow employees to put in money as well iii. Under these types of options. Defined Contribution Plans (§ 401(l)(2)) i. Requires the employer to make specific contributions into the pension trust and then the employees will receive benefits based on the actual returns of the pension investments employees bear all the risks that the pension assets will under perform ii. Think: No benefit now. Think: upfront benefit. Does not promise a specific benefit at retirement—employee and employer contribute money to individual account and the funds are invested on the employee’s behalf ii. the gain is taxable as capital gain ii. The IRA trust is an exempt entity deductible when made. complete inclusion 1. At that time. Any money taken out of a Roth-IRA is treated as compensation income 3. Incentive Stock Options: § 422 ( Typically Used by Start-Ups!) 1. the employee is permitted to contribute up to $2000 per year to an “individualized retirement account” (IRA) b. Generally a. Defines specific monthly benefits to be received at retirement ii. Contributions are non-deductible but subsequent distributions from the Roth-IRA are tax-free to the recipient 1. there is NO INCOME and NO INCOME on the RETURN 2. Generally 63 . This is very favorable to the employee 2. but no taxation on the back-end ii. Largely limited to state and local governments—historically under-funded b. taxed when received 2. Roth-IRA i. Grows tax-free iii. Better for extraordinary returns and high bracket TPs iii. Generally a. § 422(b)(4): Strike price cannot be below the value of the stock on the date of issue c. § 422 Requirements a. Traditional IRA i. employees are given stock options in connection with their work employees are ONLY taxed when they SELL the stock but employer never gets a deduction i. Traditional IRA and Roth IRA a. provide the express benefits provided to the employees 1. Grows tax-free b.f. § 422(a)(1): No disposition of the option can be made within 2 years of granting the option nor within 1 year of the transfer of the share to him b.000 per year Non-Qualified Compensation Plans i. § 422(d): Cannot exceed $100. If a TP who has compensation income is NOT able to participate in an employer-sponsored pension plan. When you take money out from the Roth-IRA. harsh taxation ii. Upfront deduction. Employee-Plans 1.

The § 83(b) Election a. Generally a. Ex: If you get restricted stock. § 83 applies to transfers of property in connection with the performance of services i. The TP prefers immediate taxation despite the lack of alienability and risk of forfeiture § 83(b) Election: Can 2. § 83(a) a. DOES NOT include money or unfunded. Non-qualified compensation plans are pension plans that do NOT qualify for preferential tax treatment a. A type of matching provision: employer DEDUCTS when the employee INCLUDES 4. Use an § 83(b) election when: 1. There is no limit on the amount of current compensation that can be deferred to and become taxable in future years 3. Transferrable OR ii. Basis: value of the property at the time of inclusion NOTE: If the property is NOT currently taxable under § 83(a). then the TP will be taxed when the property FIRST becomes alienable or the risk of forfeiture is removed  Qualified plans: employer and employee wins  Non-qualified plans: either employer or employee wins 3. NO longer subject to a substantial risk of forfeiture (i. PROPERTY under § 83: includes real or personal property or a beneficial interest in assets transferred to a trust or escrow account if the assets are beyond the reach of the transferor’s creditors 1. The Amount Included: Value of property at time it vests– Amount TP Paid 1. FORMULA: Value of property at the time of transfer – Amount TP Paid ii. an employee TP must include income from the transfer in the first year in which the transferred property “vests” this means it is either: i. § 83(a) does not apply if an employee makes an election under § 83(b) b. These plans are generally used for senior corporate executives ii.1. rights in the property are not conditioned on the future performance of The employer deducts substantial services by the employee) the compensation 1. you can ELECT to be taxed immediately on the value of what you get minus what you paid (file § 83(b) election within 30 days) i. § 83(b): If you get property in connection with performance or services. Compensation receipt is deferred to a future taxable year under these plans 2. it is compensation iii. unsecured promises to pay money in the future 2. Property Transferred in Connection with Performance or Services: § 83 1. Property is worth relatively little when received but will elect to be taxed increase substantially prior to sale OR immediately on VALUE OF PROPERTY – 64 AMOUNT TP PAID . Under § 83(a).e. SO: Include in income the VALUE of the property ONLY when the when there is NO RISK OF FORFEITURE employee includes it! 2. you have income when the risk of forfeiture disappears—gives you open transaction treatment so long as there is a substantial risk of forfeiture to you or your transferee—upon inclusion.

In some partnerships.e.3. through managers). NOTE: If the partnership’s business consists of selling capital assets (i. Commissioner (TC 1966): When the Buyer Receives the 65 . the contribution of services to a partnership in exchange for partnership interest is not a taxable event—despite receiving partnership interest. the sale of property accompanied by the reservation of a right of occupancy did not result in the transfer of ONLY a future interest because the seller’s right of occupancy was in the nature of a leasehold interest. The Partnership Carried Interest Controversy: Deferred Compensation and Conversion into Capital Gain 1. The property will become very valuable while held by the TP and will be taxable under § 83(a) but the TP intends to hold the property well beyond that time so that the election trades some taxation now for an increased benefit from the realization doctrine 4. The Rule of Alstores 1. the income eventually reported by the partner will be capital gain and the interest the managers have with the partnership is “carry interest” g. Since this is considered as a return of investment. because the purchaser acquired the benefits and burdens of ownership of property ii. Deferred Sales i. The Carry Interest Controversy a. a share of the partnership profits is paid to the manager as a form of compensation for services rendered (“carry interest”) b. In Alstores (below). Proposal: partner would not be immediately taxable in receipt of a partnership interest in exchange for services but all income reported by the service partner would be taxable as ordinary income—treats partner like in § 83(a) 3. there is no income as compensation for services rendered (unlike a corporation) 2. Under the existing administrative guidance. This typically occurs when the partnership is a private equity or hedge fund d. MOST stock options are not property upon receipt (think: no income because you do not have property) i. Alstores Realty Corporation v. STOCK OPTIONS: § 83(e): a. HOWEVER: the TP will be taxed upon exercise the stock option Summary: Open Transaction Treatment Burnett v. A stock option gives the employee the right to buy stock of the employer at a specified price (strike price) b. the manager receives capital gain treatment—instead of ordinary income treatment i. nor can an § 83(b) election be filed c. Logan: only in rare and unusual circumstances will property be treated as having an unascertainable value and thus open transaction treatment Most stock options receive open transaction treatment Other property subject to risk of forfeiture and/or non-transferrable    iii. TPs are generally not taxed on the receipt of a stock option. This allows HIGH bracket TPs to get taxed at LOWER rates c.

NOTE: This case follows Irwin v. Ex: X owns a 3-story building and it burns down. Generally: What is a Casualty Loss? 1. Rights of the seller were limited to those of a lessee—could not alter/improve the building c. For a family of 4. What is a Personal Deduction? 1. basis to a. the Buyer Receives More than Just a Future Interest 1. Reg. and rebuilds to a 2-story building—this is a not a disposition of property. There shall be a deduction for a debt that becomes worthless within the taxable 2. The terms of the agreement provided for an immediate payment of $750K.5 years—this was income of $250K.165-1(b): A loss must be evidenced by closed and completed transactions fixed by identifiable events i. Facts: TP agreed to purchase a warehouse with a current FMV of $ 1 million. The Zero Bracket Amount 1. the abandonment of property. Allowable for certain expenses incurred without regard to whether the expenses were for the production of income ii. § 1. Gavit: can avoid interest tax by pre-payment— give all the basis to the remainderman XXIV. Generally i. § 151: Each taxpayer gets a deduction for personal exemption 2. but a loss within § 165 ii. “Risk of ownership” had been fully transferred to the TP: assumed the control of the premises and benefits of ownership (supply utilities. Issue: what is the correct value of the basis: $750K or $1 million? 3.) b. and the worthlessness of 66 . This is pre-paid rent! 4.000 3. Closed and Completed Transactions a. The partial destruction of property by fire or other natural disaster. Casualty Losses i.5 years) for $750K. bore risk of damage. Argument of constructive receipt of $250K 2. seller to remain for 2.5 years. § 165(a): There shall be allowed as a deduction ANY loss sustained during the taxable year and not compensated for by insurance or otherwise a. TP (Buyer): purchased the remainder (2. Buyer received upfront $250K and allowed the in Irwin v. Government: TP should be treated as having paid $1 million for the man like warehouse (cost basis).Benefits and Burdens of Ownership of Property. and Giving the the seller would retain possession for 2. etc. this = $26. Gavit! i. Personal Deductions a. basis of the $750K with no further tax consequences remainder b. § 166: Bad Debts 1. NOTE: broader than § 1001(a) as there is no requirement that there be a disposition of property i. a. NOTE: approximately 60% of US taxpayers do not have gross income in excess of the zero bracket amount b. Holding: Government wins the case—the rental income is taxable and the basis is $ 1 million. Every TP gets a standard deduction: a certain amount of income that will NOT be taxed 2.

§ 165(h) SUBSTANTIAL LOSSES i. or other casualty. 3. § 165(b): The amount of a loss deduction is limited to a TP’s adjusted diminution in value of 67 the property  Adjust basis down for any loss claimed . OR ii. The Avoidance of Small Losses a. it must appear that the fire. but by its  Profit-seeking activity extraordinary behavior in the course of having its first fit. Limitations of the Casualty Loss Deduction 1.000 in wages (tantamount to AGI) and you have 2 casualty losses $6000 and $5000 in the taxable year. Ordinary Losses i.000 = $800 = Deduction amount Amount of Loss Deduction:  Business Property: 3. storm. or other casualty. For a loss to be deductible. shipwreck. NOTE: Allowed a deduction for ANY loss occurred from a profit-seeking activity c. Amount of Loss and Basis Calculations TP adjusted basis The maximum loss you can claim is basis (Reg. unexpected losses that cannot be described as “life choices” b. The breakage of ordinary household equipment such as or B) china or glassware through negligence of handling or by a family pet is not a casualty loss SUDDEN.800  Subtract AGI: $10. Dyer v. The sudden loss of consumption ought to be a deduction unless it could fairly be described as consumption itself  MUST distinguish between everyday occurrences and sudden. § 1.property (without a disposition) have given rise to loss deductions ii. the deduction is limited to a. Facts: TPs claimed a casualty loss deduction for $100 for Casualty losses are damages to a vase broken by their household pet—claimed it limited to: was not occasioned by the cat’s ordinary behavior. c. if such losses arise from fire. Congress enacted § 165(h)(1) UNEXPECTED. through not connected with a T or B. Losses incurred in a T or B b. MUST BE SUDDEN 2. § 165(h)(1): For each casualty loss sustained by an individual. fire. Except as provided in subsection (h).800 . or casualty was of similar character to a store. Gross Income – Business Deductions  NOTE: AGI = wages Example: You have $10. As a result of this case. § 165(c): In the case of an individual. or from theft i. What can you deduct?  For each loss. must reduce the casualty by $ 100 IF LOSS NOT RELATED TO PROFIT-SEEKING ACTIVITY (limited to § 165(c)(3)) ii. storm. shipwreck. Holding: NOT a casualty loss  Losses that arise from 1. and i.$10. Losses incurred in any transaction entered into for profit. or from shipwreck theft (if not connected to T 2. § 165(h)(2): Add up all allowable casualties and reduce the amount by 10% of AGI 1.165-1(c))  Non-Business Property: LESSER of adjusted basis or a. Commissioner (1961): Will Not Recognize Small. subtract $100: $5900 and $4900  Add each value up: $10. losses of property not connected with a T or B or a transaction entered into for profit.

Ordinary negligence is NOT a bar on allowance of a casualty loss deduction—but gross negligence is (conduct here was grossly negligent or worse) 2. Ring slips off finger into lake: no casualty loss because there was no “intervention of any sudden. ii. To allow the deduction would frustrate PP 3. For determining the FMV value of property after the casualty for a building/ornamental trees used in a T or B. A loss incurred in a T or B in any transaction entered into profit shall be determined by reference to the single. Holding: NO 1. A complete destruction of the property giving rise to a loss deduction = TP’s adjusted basis in the property ii. Specific Losses under § 165: What Qualifies as a Casualty Loss? 1. the improvements to the property if property NOT used damaged or destroyed shall be considered as an integral part of in a T or B the property no separate basis 2. allowing the deduction would frustrate PP ii. Husband flushes ring down toilet: no casualty loss 1. § 1.165-7(b)(1))  Diminution in value of the property OR  Adjusted basis b. Government: since he intentionally set fire in violation of PP. In the case of a non-business property. Wife cleans ring. Diamond Rings: An Uncertain Standard i. identifiable property damaged or destroyed. Commissioner (1987): Gross Negligence is a Bar on Casualty Loss Deductions i. Abrams: if you can get an abandonment loss. He then deducted $97K attributable to the destruction of his residence and its contents. the decrease in value shall be measured by taking the building/trees into account separately and calculating SEPARATE losses (allocate basis)  Separate bases if b.basis in the property i. LOSS OF PROPERTY NOT USED IN A TRADE OR BUSINESS property used in a T i. Issue: whether a TP is allowed to deduct the loss resulting from the fire started by him iii. Loss to Real Estate and Improvements: Reg. the amount of loss is the LESSER of: (Reg. Negligence and Intentional Acts that Cause Loss a.165-7(b)(2) a. Basis must be adjusted DOWNWARD to the extent of any casualty loss claimed: § 1016(a)(1) iii. § 1. destructive force” ii. NON-BUSINESS PROPERTY: 1. Facts: A TP and his W were in a domestic dispute and he set her clothes on fire. husband washes the ring down the sink: casualty loss allowed 68 . Blackman v. In determining the casualty loss involving real property and or B improvements thereon not used in a T or B or in any transaction  No separate basis entered into for profit. burning down his house. Basis Adjustment i. BUT. why not an arson loss? b. BUSINESS PROPERTY (including investment property): 1. 1. LOSS OF PROPERTY USED IN TRADE OR BUSINESS i.

Property Covered by Insurance. They claimed that their house lost value due to the large crowds that gathered outside of his home. § 165(h)(4)(e): Any loss of an individual described in subsection (c)(3) (non-business) to the extent covered by insurance shall be taken into account under this section ONLY if the individual files a timely insurance claim with respect to such loss i. infestation is fast c. Disease by Bugs and Trees a. the standard in property will not the 9th Circuit is “loss suffered as a result of physical result in a casualty damage to property” loss—even if damage ii. Beatle infestation: i. A casualty loss should require some kind of accidental damage to the TP property b. THUS: Personal property with insurance—to get loss. 6 months to kill tree: no casualty loss ii. Chamales v. but left your property intact—can you get a loss if your business remains standing? 1. Losses and Repairs claim BOTH a a. Husband slams door on ring: casualty loss 3. right around the time of his murder trial. storm. Termite infestation: no casualty loss i. Mere change in value does not result in a casualty loss ii. Dry rot: no casualty loss 5. even though change is permanent only a change in value You cannot 6. Fixing the loss is considered capitalization of the repair 69 . Decline in Property Value: Beyond a Mere Change in Value a. EX: If you own a business and the neighborhood around you is damaged. Termite damage is not deductible because scientific data establishes that it does not occur with suddenness comparable to that caused by fire. Government: public attention is not the type of “sudden value of one’s and unexpected event” that will qualify. This does not reflect the type of permanent devaluation —have to show physical damage 2. must timely file and if NOT. Most JDs would NOT give a loss. 18 months to kill tree: casualty loss iii. You cannot claim BOTH a casualty loss and a deduction under § loss and a deduction 162 cannot claim something is a loss under § 165(a) AND a mere repair i. Unexpected Event that Qualifies as a Casualty Loss i. TP used decline in value for house as casualty loss.iii. A mere change in 1. Facts: TPs bought a house near OJ Simpson’s. EX: If there was a flood and it took out the 2 properties next to you. Think: disease is inherently slow. then no loss 4. But No Insurance Claim Filed: NO LOSS a. Disease of trees: casualty loss allowed b. Commissioner (2000): Public Attention is not a Sudden. So: either repair OR claim loss + capitalize repair b. Neighborhood Damage i. Holding: This does not qualify as a casualty loss is permanent 1. you cannot claim a casualty loss—no injury to property 1. or shipwreck d.

§ 165(g): Worthless securities c. Amounts paid for operations or treatments affecting any portion of the body are therefore paid medical care.iv. The 7.5% of AGI. Illegal Medical Care if something is medical care but ILLEGAL. § 1-213.5% deduction ii. § 165(d): Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions 2. mitigation.5% of the TP’s AGI 2. What is NOT Deductible Medical Care: a. cure. (§ 213(d)(1)(A)) i. Other Provisions of § 165 1. ii.  Expenditures seeing eye dog. An expenditure that is merely helpful to the general health of the TP is not deductible medical care i. Examples: hospital services.1-(e) 1. Makes the medical expense deduction available to only a small portion of taxpayers b. treatment. may be deductible only to the extent expenditures that the cost of the improvement exceeds the increase in the value of the property 1. What is Deductible Medical Care: a. for medical care of the TP. The term medical care includes the diagnosis. Generally: Are not deductible. BUT NOTE: A capital expenditure for permanent improvement general health or betterment of property which would NOT ordinarily be for the  Capital purpose of medical care. or a dependent to the extent that such expenses exceed 7. etc. but when the theft is discovered 3. really for extraordinary medical expenses c. Ex: If a doctor tells a patient who is showing signs of stress to Deductible Medical take a vacation. Capital Expenditures  Illegal Medical i.) merely helpful to TP’s ii. § 165(e): Theft losses—timing of the theft loss is NOT when the theft occurs.5% Limitation a. Thus. § 213(a): There shall be allowed as a deduction the expenses paid during the taxable year. Ex: If you were required to put in a whirlpool tub and it 70 . The Medical Care Deduction: § 213(a) 1. Capital expenditures where the primary purpose is medical care to TP and it does not increase the value of the property may be deductible (see below) 2. laser surgery b. or prevention of disease. but MAY qualify if its primary Care purpose is medical care to TP and dependents (ex: eye glasses. his spouse. it is not allowable (even if the government does not enforce the illegality— medical marihuana) b. the cost of the vacation is not a deductible Care DOES NOT medical expense even if it improves the patient’s health Include: c. a. not compensated for by insurance or otherwise. SO: Can deduct amounts spent on medical care for the TP and others to the extent medical expenses EXCEED 7. surgical/dental. Medical Care Expenses i. NOTE: insurance premiums subject to 7. Expenses paid for medical care shall include those paid for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care. nursing services. What is Medical Care? § 213(d) and Reg. air conditioner.

medical costs i. Largely. TP: total cost of the van is deductible and depreciable over 5 years as a medical expense under § 213 ii. the TP medical care deduction is limited to 10K. They deducted the cost of the van and also took amortization of a depreciation deduction for the years following. Mitigation is also included in the definition of medical care d. Depreciation is not a deductible medical expense and is not an “expense paid” within the statute 3. Holding: NO i. you have to send your kids to school 2. How Courts Have Interpreted What is Deductible Medical Care 1. you are not allowed to choose your own method of treatment ii. TP then sent children to boarding school and deducted the sum as a medical expense. Holding: NO deductions allowed i. she would not improve and her nervousness and irritation might cause the cancer to return. Government argues this is a non-deductible personal expense under § 262. No showing why other family members could not do this and whether he would have paid others to do it without the doctor tell him not to mow his lawn 2.does not increase the value of your house. Issue: Is this a deductible medical expense? c. Holding: NO i. Wife’s doctor told him that if kids were not separated from the wife. b. He paid $178 to have lawn mowed and claimed it is a medical expense deduction. Commissioner (1987): Deduct only Expenses Required for Medical Care a. Henderson v. While mowing the lawn is a choice. Commissioner (2000): No Deduction for Depreciation of Medical Expenses a. Ochs v. iii. b. Facts: TPs purchased a van for son who was in wheelchair—had There is no statutory modifications with lift. Government: can expense the van with the lift as deductible in the year it was paid—but no depreciation deduction b. she would not have been able to deduct the apartment as a medical expense because IRS would have said she should have sent the kids away 71 . Taylor v. the entire cost of the tub IS deductible  BUT If a TP installs the tub for $50K and it adds $40K to the value of the home. Facts: Doctor instructed TP not to mow lawn due to allergy. Issue: Does this qualify as a deductible medical expense? c. Expenditures made on behalf of some family members of a family unit frequently benefit others in the family—expenses here were made by necessity because of the loss of the wife’s services ii. 1952): No Deduction for Sending Kids to Boarding School When Wife has Cancer a. Commissioner (2d Cir. Facts: TP’s wife had cancer. Comments: i. NOTE: Arguments for Finding a Deduction 1. If she had moved to a small apartment.

a state government. Generally: a. or foundation if the order organization is operated exclusively for religious. charitable. “Charitable” based on how profits are made 1. Educational Purposes Limitations of i. not where the money goes! . WITH A PUBLIC PURPOSE: The US government. sororities) ii. or educational purposes.d.  No part of the scientific. § 170(c)(4) d. An itemized deduction for charitable contributions is permitted under § 170(a) Charitable (1). § 501(c)(3): For Religious. fund. or foundation. Generally: What is a Charitable Contribution? 1. to foster national or international sports competition. LIMITATIONS: No Benefit To the Donor! NO QUID PRO QUO a. testing for public safety.  War veterans literary. Corporations. or for the prevention of cruelty to can be propaganda children or animals  No lobbying ii. Charitable organizations: organizations to which contributions are deductible to the donor (§ 501(c)(3)) b. contributions 2. Contributions to an organization are not deductible. §§ 170(c)(3). § 501(c)(3) and § 501(c)(4): List of Exempt Organizations a. 3. § 170(c)(2) c. TO A FRATERNAL ORDER: A fraternal order or lodge. Ex: A gas station created to give 100% of its profits to children is not a § 501(c)(3) organization because it does not operate as a charitable organization 2. ii. but only if the gift is to be used exclusively for charitable purposes. however. and any community chest. or for the prevention of cruelty to children or animals. or educational purposes. Non-profit corporation: not-for-profit State standard i. no private inurement (ex: Emory University. § 501(c)(3): organized and operated exclusively for religious. trust. scientific. Limitations:  Must be formed in 1. but it means that you will NOT give it to shareholders. Charitable contributions are defined in § 170(c) as contributions to or for the use may be given of certain listed non-profit enterprises that are given for: to: a. including local Religious/cha governments and US territories if the contribution is made for ritable/educatio exclusively public purposes. Exempt organizations federal standard (§ 501). community chest. (5). TO WAR VETERANS: An organization of war veterans. § 170(c)(1) n b. FOR RELIGIOUS/CHARITABLE/EDUCATION: A charitable  Fraternal corporation. Charitable. fund. “Not-for-profit” means NOT that you will make money. or to earnings can benefit foster national or international amateur sports competition (but the donor only if no part of its activities involve the provision of athletic  No substantial part facilities or equipment). The Deduction for Charitable Contributions i.  Public purpose or any other political subdivisions of the US. Statutes are concerned with HOW the organization makes its money. No part of the net earnings can benefit the donor US  Concerned with 72 OPERATIONS. or a non-profit cemetery company or corporation. Terminology i. not WHAT it does with its money 2. organization that will not have to pay federal income tax 1. Who Can You Donate To: What is a Charitable Organization? 1. charitable. if any part of the net earnings of the donee organization BENEFIT any private shareholder or individual § 170(c)(2)(C).

Property: the value of the property contributed (deduct basis for any property that has gone down in value) 3. schools. or intervene. hospitals. Significant limits on private foundations: must distribute 5% of annual income 2. A TP can contribute cash. property. or recreational purposes 1. Include: churches. in part. but unreimbursed expenses incurred in rendering those services are deductible (ex: driving to a charitable function) 73 . and the net earnings of which are devoted exclusively to charitable. or local associations of employees. the Code creates 2 types: those to whom the TP may contribute up to 50% of his AGI and those to whom the TP may contribute up to only 30% of his charitable contribution base i. organizations receiving a substantial part of their support from the state or federal government ii. No substantial part of the activities of which is carrying on propaganda OR 3. Services: no deduction allowed. on the TYPE of contribution made by the donor ii. colleges. § 501(c)(4): Civil Leagues and Organizations i. Otherwise attempting to influence legislation and which does not participate in. Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare. or services to a § 170 (c) charity the tax consequences of the contribution of the donor under § 170 turn.2. § 501 and Limitations of the Charitable Deduction 1. What is the Amount of the Charitable Contribution? i. the deduction is limited to if the donor gives: 1. Cash: the amount of cash 2. 30% Charities Private Foundations 1. With respect to types of charities. 50% Charities Public Charities 1. any political campaign on behalf of any candidate for public office almost an absolute prohibition against charitable organizations getting involved in the political process at all  NOTE: A charitable organization formed OUTSIDE of the US will not be a 501(c)(3) organization b. Percentage Limitations: § 170(b) a. NOTE: absence of lobbying prohibition iii. educational. medical schools. Thus. Those organizations qualified to receive deductible charitable contributions but do not qualify as 50% charities  Think: private foundations under § 501(c)(3): organization that has received ALL or a bulk of its funds from 1 or a small number of individuals (ex: Gates Foundation) 2. Amount of the Charitable Contribution a. the membership of which is limited to the employees of a designated person or persons in a particular municipality.

donor’s adjusted basis in the property if: personal property and use  The contributed property is tangible personal of property is unrelated to property and the donee’s charity’s use of the organization’s charitable property is UNRELATED to the organization’s purpose charitable purpose  The property is donated to certain private foundations OR  The contributed property is a patent or certain other intellectual property. plus 20 acres the full amount for right-of-way for 2 access roads—these roads were to the benefit of contributed is allowed ONLY if the donor receives NO substantial benefit from the contribution. C’s painting had appreciated in value to $30K. because the painting is tangible property and the use of the painting by the church is not related to its charitable purpose. § 170(e)(1)(A): If the property contributed would have If short-term gain produced ordinary income or short-term capital gain had ONLY then deduct it been sold (because the property is not a capital asset or only adjusted has not been held by the donor for at least 1 year).If you give… Cash Property Services Ancillary expenses incurred with charitable function (ex: driving to charitable function) Short term property Long term property used by charity for furtherance of charitable function Deduction Is: Amount of cash Value of property contributed** Zero Expenses incurred (adjusted basis) Basis See below b. because the painting would have produced ordinary income if L. NOTE: no real estate. that he bought for $3K and donates the painting to an art museum. had sold it. she contributes her painting to her church. C’s 10-year § 170 deduction is limited to $10K. an art dealer. Limitations of § 170(e) 1. What is a Charitable Contribution? 1. his § 170 deduction will be limited to $3K. NOTE: if C had instead given the property to an art museum. Facts: TP donated 50 acres of its land to a school district. i. 74 . Ottawa Silica v. United States (Fed. his basis in the painting. a professional actress. TM. In year 10. etc. Cir. § 170(e)(1)(B): Even if the sale of the contributed Even if long-term. 1983): Donor Cannot Receive a Substantial Benefit for Deduction A § 170 deduction for a. including specific types of copyrights and software. the donor’s § 170 deduction is limited to the adjusted basis if tangible. bought a painting for $10K in year one. property by the donor would have produced long-term Deduction limited to capital gain. stocks/bonds Ex: C. Reducing the Basis of Appreciated Property: § 170(e) i. this is limited by § 170(e) ii. iv. trade names. owns a painting worth $20K. 2. her basis in the painting. despite the fact that neither the TP nor the exempt organization will ever pay tax on the appreciation of the property but. By year 10. Donors of appreciated property deduct the VALUE of the property they contribute. a dealer in art. the basis donor can ONLY deduct her adjusted basis in the property Ex: If L. when C had AGI of $800K. the § 170(e)(1)(B) limitation does not apply because the charity’s use of the painting is related to its exempt purpose.

and gets the ability to advertise for his homes near an elementary school.) 1. Advertising Benefits i. Thus: indirect benefits may be allowable deductions f. you can deduct the expense. Religious Organizations taking Stances on Political Issues i. Challenges under the First Amendment 1. this is punishment. The contribution of the land may be deductible unless it is overnegotiated (such that you have to build by a certain type. i. Other Examples a. and you cannot go to the dinner unless you pay. Issues Arising with Charitable Contributions and the First Amendment a. Settlement as Charitable Deduction May be Deductible i.TP. Receiving Goods for Donation is Not Deductible i. EX: In TM infringement case. If you could get in without paying the $%. for purposes of § 170 the donor’s contribution is reduced by the benefit received. so no deduction b. EX: Someone comes by and says that they represent the disadvantaged—they manufacture light bulbs and you get 4 light bulbs for $20. A contribution made to a charity is not made for exclusively public purposes if the donor receives and/or anticipates receiving a substantial benefit in return—here. Government: received substantial benefit. etc. To the extent that you overpay for the benefit. Ex: Catholic Church’s stance on abortion—argument that it could not be recognized as a § 501(c)(3) (no definitive statement on this issue) b. EX: Tickets to the High Holy Days are deductible—you do not tax religious benefits. Holding: No: If the donor receives a substantial benefit as a result of the contribution. EX: A developer donates the land to a school. The limitation that charities cannot lobby in favor of issues that are important to them is problematic ii. TP: received no benefits in return for its contribution and should get a § 170 deduction ii. not a contribution. Exercising Constitutional Rights: Is this Punishment? i. You cannot deduct the $20 unless the light bulbs do not work because this is a purchase. d. Overpayment for a Good/Service May Be Deductible i. Disney settled case with $50K as a charitable deduction—may be deductible v. b. TP then claimed a charitable deduction for the value of the property contributed. ii. you cannot deduct the $5. EX: A charitable organization requires $100 to go to a dinner. Issue: Can a charitable deduction be allowed? c. c. Lobbying the government is protected by the First Amendment —argument that by losing § 501(c)(3) status for lobbying the government. i. e. then you can deduct. Government: being tax exempt is a subsidy and there is no obligation to provide this 75 . EX: If you go to a museum and they charge $5 to enter. Pure Religious Benefits Are Deductible i. TP knew that the contribution would benefit them 2. Having a Choice in Payment May Be Deductible i.

§ 501(i) and Social Clubs i. this is quid pro quo iii. allowed EP argument 3. Religious Issues a. 1. Facts: Bob Jones is a school dedicated to Christian beliefs— denies admission to applicants engaged in an interracial marriage Bob Jones has never or known to advocate interracial marriage or dating. Interest on indebtedness used to purchase or carry tax-exempt securities is non-deductible: § 265(a)(2) b. Limitations a. Government: no deduction. § 163(a): All interested paid or accrued within the taxable year on personal interest unless 76 qualified residence interest . Racial Discrimination a. Bob Jones University v. the charter. It is inconsistent with US history to allow an basis of race? organization to get the benefit of § 501(c)(3) organization and discriminate on the basis of race iv. educational ii. bylaws. Facts: Church of Scientology received payments for auditing and training with the Church. Commissioner (SCOTUS 1989): Payments for Religious Auditing and Training Do Not Qualify under § 170 i. THIS PROVISION DOES NOT PRECLUDE ACTUAL DISCRIMINATION 1. Only says the discrimination cannot be writing: discrimination could be verbal! e. NOTE: Abrams wants to abolish § 170 for this reason: why should the government be able to use § 170 to regulate speech? 2. An organization (private club) shall not be exempt from taxation if at any time during the taxable year. Investment interest is limited to net investment income: § 163(d) ii. TPs tried to deduct payments. Generally: personal interest is non-deductible (§ 163(h)1) No deduction 2. NOTE: Powell v. can qualify as a tax-exempt organization under § 501(c) precluded to ANY (3) organization that iii. NOTE: This case has never been applied BEYOND educational institutions—unclear if Bob Jones precludes 501(c)(3) status to ANY organization that discriminates on the basis of race b. These are Church services integral to membership in the Church: allowed you to move up in your standing with the Church. IRS gave it been applied beyond tax-exempt status and then took it away. Interest Paid i. a non-profit school that enforces racially institutions: can § discriminatory admissions standards on the basis of religious 501(c)(3) status be doctrine. or religion ii. color.iii. Hernandez v. § 163: Interest allowed for a. Church: EP argument (but raised too late in SCOTUS) ii. or other governing instruments of such organization contains a provision which provides for discrimination against any person on the basis of race. quid pro quo 2. Generally: business and investment interest is deductible 2. Issue: whether TP. 1991): Church of Scientology is a § 501(c)(3) organization. United States (SCOTUS 1983) i. Personal Interest 1. Holding: NO discriminates on the 1. Commissioner (11th Cir. Holding: No deduction. Business and Investment Interest: § 163(a) 1.

Qualified Residence Interest and Limitations a. § 163(h)(3)(B): Acquisition Indebtedness OR Interest can be 1. Limitation: only allowed $1 million TOTAL ii. Any indebtedness that is incurred in acquiring. the amount allowed as a deduction for investment interest for any taxable year shall not exceed the net investment income of the TP for the taxable year d. Such term includes any indebtedness secured by such residence resulting from the refinancing of indebtedness  Home equity meeting the requirements but ONLY to the extent that it indebtedness does not exceed the amount of refinancing 3. § 163(h)(3)(C): Home Equity Indebtedness: 1. Personal interest: interest OTHER than from T or B or investment interest (so: in connection with a profit-seeking activity would still be deductible) ii. Interest on a loan used for any purpose is deductible IF the loan is secured by the TP’s personal residence but only to the extent that such loan does not exceed $100K. EXAMPLE: A deduction is allowed for interest on a loan used to purchase or improve the TP’s personal residence up to $1 million. b. Any indebtedness other than acquisition indebtedness secured by a qualified residence to the extent that the aggregate amount of such indebtedness does NOT exceed the FMV of such qualified residence reduced by the amount of acquisition indebtedness with respect to such residence ANY OTHER PURPOSE—DOES NOT HAVE TO BE RELATED TO RESIDENCE 2.indebtedness is deductible b. or substantially improving any qualified residence and is SECURED by such residence  Acquisition indebtedness OR 2. What is a qualified residence and is it deductible? i. § 1. Limitation: CANNOT exceed $100K 3. § 163(b): If an installment purchase does not separately agree for interest.163: must trace how funds are used b. Note: Confusing Area of the Law  If you borrow money towards acquiring and 77 . § 163(d)(1): In the case of a TP other than a corporation. Limitation on Interest Deduction: § 163(h) a. You can have 1 principal residence and 1 other indebtedness up residence (for both acquisition indebtedness and home to $ 1 million equity) (per TP and per 2. deductible for: constructing. Reg. You reside in it or it is primarily your residence designated by Can only deduct you acquisition 1. § 163(d)(2): The amount not allowed as a deduction for any taxable year shall be treated as investment interest paid or accrued by the TP in the next taxable year carry-forward 3. interest is 6% c. § 163(h)(1): No deduction allowed for personal interest (unless a corporation) i. § 163(h)(3): Qualified residence interest means any interest that is paid or accrued during the taxable year on: i. This is PER TAXPAYER and PER RESIDENCE residence) ii. § 163(h)(2): Can deduct qualified residence interest 4.

Unclear outcome if the TP would voluntarily pay what the state charges in taxes for the services XXV. but when accrued b. Hobby Losses and Activities Not Engaged for Profit i. § 461(g)(1): Prepaid interest cannot be deducted when paid. Funds are unavailable for consumption: deductible 2. (AMT OF REFINANCING + HOME EQUITY) / TOTAL NEW AMT BORROWED = % x INTEREST PAYMENT = DEDUCTIBLE AMOUNT 6. TP need only prove that their current actions were motivated by the for pursuit of T or B or for a 78 profit . State and taxes are deductible only to the extent: 1. This must be acquisition indebtedness on your principal home f. BUT NOTE: § 461(g)(2) i. If the taxes pay for services provided to TP: part of consumption iii. Facts: TP bought a farm for his retirement. Points on a acquisition indebtedness are deductible 1. If you refinance your mortgage. POINTS: Amounts a lender requires a borrower to pay usually on closing of a loan. 1983): If Activity is Profit-Seeking. and it exceeds the $ 1 million limitation on acquisition indebtedness— it is UNCLEAR whether the rest of the money can be used as home equity indebtedness 5. Only the TP obligated to the taxing authority can deduct taxes paid (if they have actually paid them) ii. Nickerson v. only allowed deduction to the extent the refinancing replaces acquisition indebtedness at the time of refinancing b. TP hired a farmer to convert the land into more profitable crop and tried to fix up the place. Prepaid Interest: § 461 a. TP claimed a § 162 deduction—was not allowed because it was argued that the primary goal in operating the farm was not to make a profit and thus was not deductible Qualify under § (personal). Holding: Held for TP PURPOSE is a. Commissioner (7th Cir. or acquisition indebtedness on a second home 1. in lieu of charging the borrower a higher interest amount  This is an exception to the rule for points paid on indebtedness secured by the TP principal residence and incurred to purchase/improve the principal residence ii. Generally 1. the mortgage is worth $135K. TP borrows $140K--$5K of home equity and $135K of acquisition indebtedness. This does NOT apply to refinancing. home equity loans. to the extent of the gross income of that activity ii. The Special Case of Refinancing a. Can Deduct under § 162 1. § 183 allows deductions for expenses attributable to activities not engaged in for profit. Taxes Paid i. 162 or § 212 if the PRIMARY 2. Ex: At time of refinancing. Deductions with Personal and Business Components a.improving your residence.

No significant enjoyment came from the activity iii. only get a deduction to the extent the gross income is greater than permitted deductions b. in the case of a TP who is an individual extent the portion or an S corporation. NOTE: Do § 183(d) first. then you get the benefit if you turn a profit of 2 out of 7 years b. § 280A(a): Except as otherwise provided. Home Offices A deduction is i. no deduction otherwise allowable under this chapter shall be of the dwelling allowed with respect to the use of a dwelling unit which is used by the TP during unit is: the taxable year as a residence  Exclusively 2.expectation that they would later reap a profit—here. there is a presumed profitmotive and the government has to prove the other way i. § 183(b): In the case of an activity not engaged in for profit. Generally: § 280A allowed to the 1. If for 3 out of 5 years you made a profit. Ex: the accidental hobbyist who makes money for profit. § 280A(c): Subsection(a) shall NOT apply to any item to the extent such item is for any T or B allocable to a portion of the dwelling unit which is EXCLUSIVELY USED on a  Used in normal regular basis: course of T or B 79  If in connection with T or B if separate . Turning the business into profit-seeking enterprise ii. then the burden is on the government to prove that deductions that you DO not have a profit-motive PRESUMPTION OF BEING IN AN are permitted ACTIVITY FOR PROFIT (REBUTTABLE) a. but only to the extent that the gross income derived from If an activity is such activity of the taxable year exceeds the deductions allowable not engaged in i. § 183(b)(1): Deductions which would be allowable for the taxable year without regard to whether or not such activity in engaged in for profit. § 280A(b): Can get all those things that would be deductible used as the PPB 3. § 183(d): If the gross income from an activity for 3 or more of the prior 5 exceeds the years exceeded the deduction. then look to Nickerson/Regulation factors (ex: bookkeeping. § 183: Activities NOT Engaged In For Profit 1. etc.) SUMMARY of § 183(b):  Permitted deductions: Will get the deduction if you would have gotten it anyways (ex: property taxes)  Other deductions: For anything else. § 183(b)(2): A deduction equal to the amount that would be allowable under this chapter for the taxable year only if such activity were engaged in for profit. § 183(c): “Not engaged in for profit” no T or B or investment activity from the activity 3. there shall be allowed: a. NOTE: expenses incurred in producing hobby income are ONLY to the deductible under this provision—but cannot exceed income from extent that the the hobby gross income 2. This provision prevents TPs from using hobby losses to shield expenses are other income deductible iii. and i. NOTE HORSE RACING: IF you are in the business of horse racing. they were renovating the farm and laying the ground work for a career switch b. these ii. The activity was PROFIT-SEEKING i. NOTE: All the personal mortgages that do not turn on profitmotives are allowed under this provision: provision does not disallow any deductions without regard to profit motive b.

$1050 = $3950 = MAX DEDUCTION UNDER § 280E iii. IRS disallowed the deductions: it seemed inconceivable that the living room’s sole purpose was the practice of music. Facts: TP is a musician who contracts with various studios to record music and performs regularly. Using Solimon: Look to the TP’s PPB Test to determine PPB i. ex: paper you type on) 1. or customers in meeting or dealing with the TP in the normal course of his T or B OR i. Commissioner (9th Cir. Claimed a home office deduction for the living room and deducted 40% of the annual rent and 20% of the electricity bill.a. As the principal place of business for any T or B of the TP OR i. but has no office. Can deduct depreciation for the home office in the house (but cannot deduct rest of personal residence) ii. Issue: Can a professional musician get a home office deduction for practicing in her living room? 3. clients. If the separate structure is NOT physically attached to the dwelling. She uses her living room to practice 4 to 5 hours a day. Must be used ONLY for the T or B—cannot have multiple uses b. 2. then it will be DEEMED to be apart of the dwelling and you LOSE 4. but mortgage interest allocable is $800. The deductions allowed under this chapter for the taxable year by reason of being attributed to such use SHALL not exceed the excess of: a. The sum of: i. taxes is $100 and you have T or B costs of $150. Requires a face-to-face meeting (web-cam doesn’t work) c. Depreciation Deductions a. in connection with the TP’s T or B i. and ii. 2001): Following the Soliman 2-Part Test 1. The Limitation on Deductions: § 280A(c)(5) 1. NOTE: This provision basically means that NO ONE CAN get a deduction for a home office! GROSS INCOME FROM SUCH USE – (PERSONAL DEDUCTIONS ALLOCABLE TO BUSINESS USE OF DWELLING + § 162 DEDUCTIONS NOT ALLOCABLE TO DWELLING) = PROFIT YOU GET = MAX DEDUCTION Ex: You sell $5000 worth of mysteries. but is part of the curtilage nearby. As a place of business which is used by patients. The deductions allocable to the T or B (or rental activity) in which such use occurs (but which are not allocable to such use) for such taxable year (§ 162 deductions. In the case of a separate structure which is not attached to the dwelling unit. The deductions allocable to such use which are allowable under this chapter for the taxable year whether or not such unit (or portion thereof) was used (personal deductions). Holding: YES A professional musician is entitled to deduct the expenses from the portion of her home used EXCLUSIVELY for music practice The Soliman 2-Part a. $5000 . Relative importance of the activities performed at each location:  Relative unable to determine here importance of the ii. Relative amount of time: TP spent more time practicing the activities performed at violin at home than other activities each location  Relative amount of 80 time spent at each location = Deduction Allowed? . The gross income derived from such use of the taxable year over b. What is YOUR PPB?_--> Popov v.

b. Traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under circumstances) while away form home in the pursuit of a T or B are DEDUCTIBLE b. A dwelling unit is deemed used for personal purposes if it is occupied by the TP. certain relatives. but at the various hospitals. Soliman’s 2 Part-Test i. Soliman (SCOTUS 1993): Anesthesiologist did all the work at the hospital but had no office—he used his home to do his bookkeeping. then things that are normally NOT deductible are deductible iv. ii. 1983): Mere Management of Investment Is Not a T or B a. Moller v. or by any person who does not pay a fair rental 81 . Merely because the TPs spent much time managing their own sizable investments does not mean they were engaged in a T or B c. § 280A and Rental Homes 1. Generally 1. NOTE Differences: 1. and interest a. practice takes more time than performing 4. Anesthesiologist does most of his work at the hospital. utilities. However. Facts: TPs devoted their full time to investment activities (spent about 40 hours a week determining what to invest in). Issue: Whether the TP’s investment activity was a T or B so as to fall under the exception for 280A (exception to general disallowance for home offices if it is the PPB for any T or B of the TP) c. if the TP’s property is RENTED for part of the year and used by the TP for part of the year. They deducted expenses attributable to maintaining their 2 home offices and IRS did not allow. the TP is entitled to deduct all expenses associated with the property. Solimon talked about the delivery of goods and services. NOTE: Commissioner v. while being a professional musician is NOT a service industry 2. United States (Fed. Cir. allowing the TP to deduct the expenses of the rental property creates potential for abuse § 280A ii. If you do not have a fixed place of employment. Applies only if the TP uses the rental property for “personal purposes” during the year a. SCOTUS rejected this argument: PPB is not at home. NOTE: § 162(a)(2) Away from Home Expenses a. If a TP owns rental property that is NOT used by the TP for personal purposes at any time during the taxable year. This is not a T or B because investment is categorically NOT a T or B trading stock for one’s own account can’t ever give rise to a T or B ii. Commission v. Holding: NO DEDUCTION for the offices under § 280A i. Rental Homes i. repairs. They make about 98% of their gross income from interest and dividend income (note: they didn’t really buy or sell anything—make a lot of money by holding and collecting dividends).b. Income Unconnected to a T or B: T or B or Mere Investment 1. He argued that the PPB is the central location where you travel from. property taxes. including depreciation. A TP who merely manages his investments seeking long-term gain like here is NOT carrying on a T or B iii. whereas here.

Ex: Many people have a house they rent out but do not use— when the Olympics come to town and they rent for a high amount this rule says NO DEDUCTION but EXCLUDE INCOME! ii. Unlike a wager or a bet. These are subject to the 2% limitation. meals. On his return. Thus. medical expenses. Facts: TP won 3 games on Wheel of Fortune—received money and a car (winnings must be included). § 67(b): Lists non-miscellaneous itemized deductions: i. Miscellaneous. § 212 Deductions 1. Interest. Itemized Deductions: § 67 i. § 280A(d)(1): de minimis personal use is IGNORED a. THUS: can exclude rental income if rented less than 15 days 4. TP incurred expenses in exchange for specific goods and services 82 . if you rented for 100 days. subject (greater of 2 weeks or 10%): personal use is entirely ignored and to § 280A(c)(5) not subject to § 280A at all 3. charitable contribution deductions. Ex: buying WSJ as an employee in T or B iii.If de minimis. can use it as many as 14 days minimis. miscellaneous itemized deductions are not allowed ii. claim of right deduction… b. TP sues § 165(d): losses from wagering transactions shall be allowed only to the extent of the gains from such transactions. § 280(g): The Olympics Rule a. Un-Reimbursed Employee Expenses 1. § 67(a): Limits a TP’s itemized deductions to aggregate deductible expenses in excess of 2% of AGI (only expenses greater than 2% of AGI can be deducted!) a. taxes. § 280A(c)(5) applies make sure to take into account TP days of rental d. § 212 deductions 2. and lodging) that may be offset from his “gambling winnings” on the program. Holding: Deduct under § 67. estate tax. iv. not § 165(d) a. 2. Generally 1. Commissioner (TC 1995): Losses Incurred in Playing a TV Show Are Not Gambling Losses 1. A TP uses a dwelling unit during the taxable unit as a residence if he uses such unit for personal purposes for a number of days that exceeds the GREATER of A) 14 days OR B) 10% of the number of days during such year for which such unit is rented at fair rental If not de i. This 2% floor eliminates the business expense deduction for most employee TPs b. Employee business expenses that are NOT reimbursed by the employer are subject to § 67 and the 2% floor a. THIS LEAVES AS DEDUCTIBLE: i. casualty and theft losses. NOTE: Under the AMT. can deduct entire amount 2. Whitten v. but can exclude the income i. Ex: This section permits an individual with investment income from stocks and bonds to deduct her brokerage fees and the cost of a subscription to the Wall Street Journal. you get NO deductions for the business use. If the rental use is very small. deducted portion of winnings as “gambling losses” (transportation. Un-reimbursed employee expenses ii. Issue: proper characterization of expenses incurred by TP in attending and participating in a TV game show—are these wagering losses under § 165(d)? 3.

Commissioner (TC 1983): Purchases Bought For One’s Office Are Not Deductible 1.b. such as  Cell delivery vehicles. Issue: Can the deduction be allowed? 3. Home computers computers b. and a parking space for her office—IRS did not allow the deduction. Her employer gave her all the necessary furnishings she needed—no evidence was presented to prove that the presence of the print/plant in her office were either necessary or helpful in performing her required services i. Listed property is defined in § 280F(d)(4)(A) to include:  Home a. NOTE: A working condition fringe benefit exists under § 132(d) when employers provide a plan/print/etc. STRAIGHT LINE DEPRECIATION if the qualified business use is less than 50%  EX: If the qualified business use = 40% of total use and other business use = 25% of total use. ACCELERATED DEPRECIATION if the qualified business use exceeds 50% a. live plant. the TP’s depreciation deduction. entertainment recreation. Facts: TP took a deduction for the purchase of a framed print. Henderson v. 4. and cars used to transport Phones passengers (ex: limo service): § 280F(d)(4)  Things c. is NOT eligible for accelerated depreciation TP limited to straight line depreciation 2. Listed Property: § 280(F) i. but if you provide it for yourself—then NOT DEDUCTIBLE! f. or amusement” ii. 2. The Amounts paid for the print/plant were expended to improve the appearance of the TP’s office: a personal expense that aided her in the performance of her duties as an employee b. Any use of listed property by an employee (rather than a self-employed individual) is not treated as use in a T or B (and thus is not eligible for any depreciation) UNLESS such use is: 83 . iii. If a TP does not use listed property for business purposes more than 50% of the time. NOTE: This case would not come up today because of the 2% limitation. Cannot deduct certain types of cars and vehicles. NOTE: Even if a TP is in a profit-seeking activity (§ 212 would have let him deduct here). Automobiles: limits deduction to a modest compact car  Cars i. Cell phones and used for d. Holding: NO—expenses are non-deductible personal expenses under § 262 a. Generally: What is Listed Property? 1. Not in the T or B of gambling: did not incur losses in excess of his winnings c. Office Decorations and Relation to Fringe Benefits i. for the portion of the cost of the property allocable to the business use of the property. for your office. § 280(F) imposes additional limitations on a TP’s business deductions for certain Listed listed property that is especially subject to abuse Property: 2. ONLY GET TO THE EXTENT IT IS BUSINESS USE. this does not give rise to deductions for his family e. the TP must use show depreciation with respect to 65% of the cost of the item. moving vans. “Any property of a type generally used for purposes of entertainment. What Kind of Depreciation Deduction is Allowed? 1. § 280F(d)(3): Use of a Listed Property By an Employee 1.

the TP actively engaged in business meeting. discussion. the TP must have actively engaged in business discussion  The principle character of the activity was the active conduct of a T or B  The expenditure was allocable to the prospective client 3. no deduction  Directly related to T is allowed for things considered to be for amusement. Generally 1. Can F deducts the costs of the hunting trip? NO  The TP had to have more than a general expectation of deriving a benefit  During the activity.274-2(c): What is directly related? 1. § 274(a)(1): Thus. then the employee gets compensation b. or or B entertainment UNLESS:  Before or after a a. negotiation. For the convenience of the employer and b. or recreation expenses unless the TP substantiates the expense be adequate records. Required as a condition of employment 2. Exception: reimbursed employee expenses and expenses under $75 4. This applies for travel away from home or anything considered entertainment or listed property must corroborate statements. TP had more than a general expectation of deriving income at the time the TP made the expenditure (goodwill fails) 2. No deduction or credit is permitted for traveling. or any other BF transaction 3. business purpose and business relationship b. Person had to be involved in TP’s T or B b. Reg. The item was “directly related to” the active conduct of the TP’s T or B discussion/association (as opposed to the creation of goodwill) OR with T or B i. the customer places an order with F. Travel and Entertainment Expenses: § 274 i. The item preceded or followed a substantial and bona fide business discussion and was associated with the TP’s T or B EX: F takes a business associate on a hunting trip. If the employee does not meet § 274. expenses only allowed they have been subject to substantial TP abuse if: 2. Between shots and without any prior discussion. Ex: If you buy a laptop for work. recreation. § 1. preferably made at or near the time of the expenditure i. Like any form of compensation. The principal character of the business entertainment was the active conduct of the TP’s T or B AND 4. During the time period. entertainment. If Employee Doesn’t Get § 274… a.a. TPs are allowed to deduct the ordinary and necessary expenses incurred in carrying on a business under § 162(a) since travel and entertainment expenses Deductions for travel associated with a business have an inherent element of personal consumption. Substantiation: § 274(d) a. even if you have a deduction under §162/§212. you cannot deduct this! g. the employer can deduct the compensation as a business related expenses  § 274(e) EXCEPTIONS: Deductions are allowed for:  Food and beverages provided by employer on business premises for employee 84 .

Meals and Entertainment Expenses § 274(n): Deductions for meals and entertainment expense are limited to 50% of the amount spent a. THUS. This does NOT apply to expenses for food and beverages that would be excludable by the recipient as a de minimis fringe benefit under § 132(e) (or working condition fringe benefit) 2. if 25% or more of the travel! total time is spent on personal activities then ALL costs of the trip must be allocated between the personal and business components c. § 274(c)(3): Travel outside the US does not include any travel from 1 point in the US to another point in the US ii. Employer: § 274(n) b. the employee may deduct the FULL EXPENSE (which. Foreign Travel for domestic i. Food and Beverage Limitations 1. Domestic Travel: Begins and Ends in the US (PR and Guam OK) i. but the employer may only deduct 50% of the expense. so long as employee is accountable Expenses for recreational. then the entire amount of the trip may be deducted except for any additional costs associated No with the personal component allocation b. Assuming the primary purpose for the trip was business. ALLOCATE between foreign and domestic travel Examples of Foreign and Domestic Expenditures and Allocation Rules  Ex: I go from ATL to LA on business lasting 1 week and remain for a 2nd week on vacation. Assuming the primary purpose for the trip was business. THE TOUCHDOWN RULE i. Meals. PRIMARY PURPOSE TEST: If the primary purpose of domestic travel is business-related. Such expense is NOT lavish or extravagant under the circumstances AND ii. social or similar activities for employees or shareholders Expenses in relation to business meetings Meetings related to business leagues Items made available to the public by TP Entertainment sold by TP Expenses includible in come of persons who are NOT employees for compensation of services or as an award ii. § 274(c): For travel exceeding 1 week. what percentage of the airfare is deductible? 50% 85 .       Reimbursed expenses. No deduction is allowed for the expense of any food and beverage UNLESS: i. in effect. Domestic Travel and Foreign Travel a. If an employer reimburses an employee for such expenses. TP is PRESENT at the furnishing of the food or beverages iii. permits the TP to exclude the reimbursement which would otherwise be included as income). Entertainment. Employee: § 274(e)(3) ii. what percentage of the airfare is deductible? 100%  Ex: I go from ATL to Japan on business lasting 2 weeks and remain an additional 2 weeks on vacation. Travel Expenses 1. Food or Beverage Requirements: § 274(k) a. i.

Costs of sending customers 1. 1990): If Entertainment is the Central Focus. Abrams: can treat this as a bonus or non-deductible  If the employees are to deduct the trip. has to meet the direct relation standard of § 274 2. Commissioner rejected this and said they were only entitled to deduct 50% of the expenses because they qualified as “entertainment” 86 . The travel expenses of the person accompanying the TP are otherwise deductible iv. Ex: I go from ATL to Japan via Hawaii on business lasting 2 weeks and remain in Japan an additional 2 weeks on vacation. 2002): Generating Goodwill Does Not Give Rise to a Deduction Under § 274 a. Entertaining Customers 1. and customer wives and children. Cannot Deduct a. Cannot deduct the costs of spouses unless they are in fact employees of the company and engaged in TP’s business 2.” not appropriate and helpful ii. NOTE: Court is treating “ordinary and necessary” as “essential. Facts: TP claimed deductions for a weekend trip of 120 persons to the Super Bowl: employees and spouses. dependent. Churchill Downs v. Danville Plywood Corporation (8th Cir. Holding: NO—not an “ordinary and necessary” business expense under § 162(a) i. however iii. The person accompanying the TP is an employee of the TP (or the TP’s employer) ii. There is no business begin conducted on the trip. or other person accompanies the TP on business travel. Cost of sending the employees 1. The person accompanying the TP is traveling for a bona fide purpose and iii. Travel as a Form of Education is NOT Allowed: § 274(m)(2) a. Assuming the primary purpose was business. Ex: Social Studies teachers who vacation in Europe in the summer claimed it was making them better teachers—Court disallowed the deduction because “travel as a form of education” is not deductible 3. Commissioner (6th Cir. what percentage of the airfare is deductible? 100% of the airfare between ATL and Hawaii and 50% of the airfare between Hawaii and Japan. the travel expenses of the person accompanying the TP are not deductible unless: i. Issue: Deductible? c. TP argued that the expense of both customer and employee tickets should be deducted because the trip made is possible for TP employees to pitch products to TP customers b. If a spouse. Travel on Business with Relatives: § 274(m)(3) a. Court: Entertainment was the central focus of the excursion with all the other activities running a distant second in importance 2. 2. Facts: Churchill Downs deducted the full amount of the expenses of brunches/dinners/galas associated with the Kentucky Derby and Breeder’s Cup as “ordinary and necessary business expenses” under § 162(a). Costs of sending the employee’s spouses 1.

a lawyer. TP: argues that the expenses are not entertainment expenses because they showcased entertainment product—generated publicity and media attention to introduce races to public b. Overnight Rule: you are not “away from home” unless you are required to spend 1 night away from home iii. not by the business—railroad did not require him choice of where to to live in Mobile live and not by business. AL—condition of his employment was that he would live in Jackson and the railroad would pay his traveling expenses. TP is just trying to generate goodwill—this does not rise to a deduction under § 274 3. Facts: TP. The only public transportation was by bus and the bus went through NJ—NJ forbid anyone but a NJ police officer from carry a gun. Can deduct traveling expenses including meals and lodging while “away from home” in pursuit of a T or B if the following requirements are met: i. Flowers (SCOTUS 1945): No Deduction for Traveling Expenses When Expenses Incurred As a Result of Personal Choice a. Generally: § 162(a)(2) a. Commuting Expenses 1.for purposes of § 274. Police officer 87 . Commissioner v. EXCEPTION: If a person with heavy tools required the use of a DEDUCTION is personal car to transport them. Technical Advice Memorandum 584428: Free Sample Analogy a. brunches. 1982): The Personal Choice of Where to Live from home” as a Does Not Result in Away-From-Home Deductions result of personal a. NO ii. The expenses are incurred while the TP is “away from home” 1. McCabe v. might deduct the cost of the allowed car this seems inconsistent with Flowers  Not “away 3. Commissioner disallowed the deductions. He represented a railroad whose main office was in Mobile. MS. Holding: Costs associated with a theater critic going to a theater are deductible (akin to free samples). not the TP’s personal preferences 2. PO wanted to deduct the cost of driving to work in excess of the cost of taking public transportation. Issue: Deduction allowed? Flowers: c. Holding: NO only way a deduction would have been allowed is if the  If traveling employer’s business forced the TP to travel and live in some place other expenses to work than Mobile are necessitated i. Commissioner (2d Cir. These expenses were necessitated by the personal choice of by the personal where to live. The expenses are motivated by the exigencies of the TP’s business. etc. TP then deducted the traveling expenses and expenditures for meals and hotel when in Mobile under § 162(a)(2). The law applicable at the choice time for NY police officers—were required by law to carry the weapon back and forth from work. The Rule of b. Given that the events at issue are mainly dinners. Holding: NO the 50% limitation applies i. The travel expenses are reasonable and appropriate ii. i. Other Expenses: Commuting and Legal Expenses i. it seems likely that a significant portion of the expenses for which TP seeks a deduction are for food and beverages: thus 50% limitation applies ii. Issue: Deductible? c. h. Facts: Police officer lived and worked in NY. resided and worked in Jackson.

TAX HOME = POB

wanted to deduct the marginal cost of taking his car to work. b. Issue: Deduction allowed? c. Holding: NO i. Police officer did not have to live where he was living—invokes Flowers ii. You are not “away from home” for business reasons 4. Hantzis v. Commissioner (1st Cir. 1981): Your Home is Not Where You Attend Law School a. Facts: TP, a law student, tried to deduct the costs of living in NYC during a 10-week summer law firm clerkship since she lived in Boston. b. Issue: Was the TP “away from home” for tax purposes? c. Holding: NO i. TP was not engaged in a T or B in Boston, where she lived and attended law school, but was engaged in a T or B in NYC, where she worked—her “home,” for purposes of § 162(a)(2) was NY ii. TP did not meet the “exigencies of business” test because she chose to live in Boston for personal reasons, not business reasons iii. Being in school is not a business!

What is a Taxpayer’s Home: Rev. Ruling 93-86  A TP’s “home” for purposes of § 162(a)(2) is generally considered to be located at (1) the TP’s regular or principal (if more than 1 regular) place of business, or (2) if the TP has no regular place of business, then at the TP’s regular place of abode in a real and substantial sense (note: Courts have disagreed with this  If a TP comes within neither category (1) or (2), the TP is considered to be an itinerant whose “home” is wherever the TP happens to work. 5. Specific Examples: What Constitutes “Away from Home” Under § 162(a)(2)? a. Place of Business in State X, Residence in State Y: No Deduction i. Rule of Flowers: If the expense is motivated by the TP’s personal preferences, no deduction for expenses incurred in commuting from State X to State Y b. Multiple Places of Business and One Residence: Deduction i. If you have a “home” in the conventional sense and no place of business, your home for tax purposes is where you live and when you are “away from home” this is deductible ii. You are “away from home” at all business locations c. Multiple Places of Business and Multiple Residences: No Deduction i. “Home” is wherever you are working and you cannot deduct anything d. The Triangle Rule: 2 Places of Businesses in State X and State Y, and a Residence in State X i. If you go to your office in State X, then go to a client’s office in State Y, and come home to State Z can deduct the commute from State X to State Y Business to business 1. Business to business travel is deductible, while leaving travel within the same home is not T or B is deductible ii. Limitations under Revenue Ruling 99-7: Must be in Same T or B 1. If you have more than 1 regular PPB and at least 1 is away from residence, all costs going between residence and temporary work locations in the same T or B are

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deductible regardless of distance  Ex: grocery store owner commuting between grocery stores gets a deduction, but a mystery Temporary v. writer/lawyer would not Permanent: 2. If residence is principal place of business within § 280A  If you accept a can deduct the costs of travel between residence and any temporary job, convert work location in same T or B, regardless of distance or to permanent. permanence of worksite  If you go with an 3. Thus, costs between going from residence to work can expectation of lasting be deducted IF: more than a year, job is  Work location is temporary (ex: 3 month never temporary. project)  Temporary = < 1 year  Work location is temporary and 1 more location away from residence in a T or B (ex: working in ATL and going to client’s office)  If TP’s residence is her PPB and the work location is in the same T or B (note: if 1 home office, has to be in the same T or B) e. In Furtherance of Education i. If In the Business First, then Get LLM 1. Cost of tuition is deduction, as are meals and lodging under 50% limitation ii. If NOT in the Business First, then Get LLM 1. No deduction allowed SUMMARY: POB in State X, Residence in State Y: No deduction Multiple POB, Residence in State Y: Always deduct Multiple POB, Multiple Residences: No deduction Triangle Rule and Revenue Ruling 99-7: Deduct for daily transportation expenses if -Work location is temporary and away from home -Work location is temporary, more than 1 regular work location away -TP’s residence is PPB and work location is in same T or B --Furthering Education: If you do legal work before going to get LLM, can deduct!     ii. Legal Expenses 1. Generally a. Business Legal Fees are Deductible: TP may deduct legal expenses that are incurred in a T or B or related to the production of income, under § 162 or § 212 b. Personal Legal Fees are NOT Deductible c. Legal Fees with Personal and Business Components: Origin of the Claim i. The deductibility of such legal fees depends on the origin of the claim, not the potential consequences of the claim ii. If the origin of the claim is personal, legal fees are nondeductible even if they also protect the TP’s business or investment interests (note US v. Gilmore) The Origin of the Claim  If the origin of claim is the protection of or ownership of property, the legal fees are not deductible (Gilmore)  If the origin of the claim is personal, the legal fees are not deductible (ex: Matt Damon being sued for

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palimony by former ex-roommate)  If the origin of the claim stems from a T or B or profit-seeking activity, legal fees are deductible (ex: PR firm protecting Matt Damon’s reputation)

2. United States v. Gilmore (SCOTUS 1963): The Origin of the Claim Test a. Facts: Legal expenses were incurred by TP in protecting assets from W.
She wanted earnings accumulated by his position in 3 corporations. In fighting off claims, TP incurred legal fees: argues deductible under § 212 as an expense “incurred for the conservation of property held for the production of income.” TP argued he would have suffered damage to his business reputation if W had succeeded. b. Issue: Were these expenses business expenses and thus deductible? c. Holding: No deduction allowed under § 212—the claims arose solely from the marital relationship and not from income-producing activity i. Origin of the Claim 1. The characterization as “business” or “personal” of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the TP’s profit-seeking activities does not depend on the consequences that might result to a TP’s incomeproducing property from a failure to defeat the claim ii. Here, the property didn’t exist but for the marital relationship thus, none of the expenditures can be considered “business” expenses 3. The Loophole of Gilmore: The Addition of Basis to Reduce Gain a. FOLLOWING THE CASE: In a subsequent year, Gilmore sold some of the stock that had been contested in the divorce action. He added Remember: suits disallowed attorney’s fees to the basis of his stock as capitalized costs of to quiet title of defending title. Prior cases had allowed the addition of such costs to property are basis. capital expenses i. Government argued: Gilmore should be applied to basis —add to basis questions and reduce ii. DC held: for TP costs of defending title are capital expenses gain! (suit to quiet title) whether arising in suits of primarily business or personal in character. 1. THUS, Gilmore was able to find a loophole and decrease his gain! 2. Legal expenses may not be added to basis in some personal suits because “as a factual matter, the expenses would not have been primarily to defend title” 4. The Asymmetry of Alimony Suits a. If a TP wants an increase in alimony, legal fees are deductible b. If a TP resists an increase in alimony, legal fees are NOT deductible

XXVI.

Divorce and Alimony

a. Generally i. Under § 1041, no gain or loss is recognized on transfers of property to a spouse or a former spouse, provided that the transfer is incident to divorce 1. PROPERTY = TANGIBLE and INTANGIBLE can be property or cash ii. The basis under this section is always carryover b. Transfers Incident to Divorce and Marriage

90

§ 1041(c): A transfer of property is incident to the divorce if such transfer a. 1947): Transfer of Marriage Rights for Consideration is Not a Gift a. TP asserts that the present disposition is comparable to a non-taxable division of property between 2 co-owners. Thus. had surrendered BETWEEN all marital property rights in the husband’s estate. if you are married. Is related to the cessation of the marriage THUS: §1041 provides that a transfer of property between spouses or former spouses where the transfer is incident to divorce are treated as gifts with carry-over basis! ii. 2. TP agreed to transfer to his W 10000 shares of stock in a company in exchange for a release of legal obligations. a.  DAVIS MAY b.i. THIS IS LARGELY MOOT TODAY BECAUSE OF § 1041(a) today. TRANSFERS INCIDENT TO DIVORCE: United States v. IN ANTICIPATION OF MARRIAGE: Farid-Es-Sultaneh v. The exchange of property for freedom from marriage was similar to the exchange of property for services or other non-like-kind property and is TAXABLE i. Facts: TP-wife sold certain shares of stock which she has previously received from her husband pursuant to a pre-nuptial agreement. it found that the TP’s basis for the PRENUPS—BUT shares was $10: FMV on the date transferred and reduced her gain. Government: contended that the TP’s basis in the shares was the A GIFT same as her husbands (15 cents/share) because the shares had been received by her as a gift. 1041(a) makes Farid c. in consideration for the shares. Occurs within 1 year after the date on which the marriage ceases. thus making it taxable. Facts: Pursuant to a divorce. § 1041(a): No gain or loss shall be recognized on a transfer of property from an individual to a spouse or to a former spouse a. The stock had a basis SPOUSES AND in the husband’s hands of 15 cents per share. Holding: NOT A GIFT: transfer from H to W was not a gift for income APPLY TO tax purposes but an exchange of valuable property interests—stock for marital property rights. BUT NOTE: Davis may still apply to transfers of property in anticipation of marriage or to transfers of property between partners in a same-sex committed relationship 4. there is no gain: treated as a gift. OVERRULED by § 1041 i. while the Government argues that it resembles a transfer of property in exchange for the release of an independent legal obligation. Holding: The stock transfer was a taxable event and the AR received by the H will be the tax basis for the W. with basis as carryover 2. The W has no interest over the management of the property b. Cost basis for the property in the hands of the W based on AR by the H c. but a FMV of $10/share FORMER SPOUSES when transferred to the TP. Davis (SCOTUS 1962): A Transfer of Appreciated Property Incident to a Divorce Is a Realization Event to the Transferor § 1041 OVERRULES—THIS IS A GIFT 1. the TP. moot 91 . § 1041(b)(2): Basis of the transferee is the AB of the transferor (carry-over basis) TREATED AS A GIFT 3. how much gain? 3. Commissioner (2d Cir. Under TRANSFERS that agreement. = TREATED LIKE i. As a result. § 1041: Transfers of Property Between Spouses or Incident to Divorce 1. Issues: 1) Was the stock transfer a taxable event? 2) If so. or b.

transfers of property in satisfaction of K obligations.most property transferred pursuant to a pre-nuptial agreement would be contingent and follow the marriage ceremony. CANNOT LIVE IN SAME HOUSE: in GIVE the case of an individual legally separated.  THUS: §1041 provides that a transfer of property between spouses or former spouses where the transfer is incident to divorce are treated as gifts with carry-over basis! c. and deductible to the PAYOR 2. family wealth is being divided between H and W in both instances and it is THIS circumstance —rather than the presence of “consideration” in Farid or arms-length dealing in Davis. Alimony Payments: § 71 i. must not be living in same EQUAL house BASIS e. If payable beyond the death of the payee. And if transfers from deceased husbands to surviving widows are viewed as non-realization events even though the marital relationship comes to an end. Generally. Quite obviously. fixed or disputed. IN WRITING: received by a spouse under a divorce or separation instrument PAYMENTS c. IN CASH: any payment in cash if such payment is b. To be included as ALIMONY: a. NOTE: this happened before the marriage. so she was not a “spouse” under § 1041 WHY WAS § 1041 ENACTED?  The Davis and Farid decisions are undoubtedly defensible in terms of realization criterion: in general. YEAR 3: The excess alimony paid in years 1 and 2 is recaptured 92 . it is difficult to see why transfers which are prompted by the formation (or dissolution) of the marital unit should be treated differently. Includible to the RECIPIENT. ALL PAYMENTS are NOT alimony f. that ought to govern the tax outcome. through it otherwise justifies the finding of taxable event.  The presence of a K obligation. payments are treated as alimony only to the extent they are substantially equal in the first three years in which alimony payments are made b. NO LIABILITY BEYOND PAYEE DEATH: No liability to make any payment on the death of the payee spouse and no liability as a substitute for such payments after death of payee—can continue beyond payor i. seems insufficient on the whole to remove pre-marital and post-marital property arrangements from the ambit of the gift provisions. § 71(f): Computing Alimony Payments a. it is hard to see why a realization should be deemed to occur when the marriage is terminated through divorce. so that the transferee would be the “spouse” as defined i. CAN’T SPECIFY PAYMENT IS NON-DEDUCTIBLE: the divorce or SHOULD separation instrument does not designate such payment as a payment BE EQUAL which is not includible in gross income (can elect out). Payments that are “front loaded” in this 3-year period are recharacterized as property settlements provision requires recapture of any disproportionately high amount of alimony paid in the first 2 years i. are taxable events  but the cases are MISGUIDED  If property transfers between spouses are “gifts” when they take place during the marriage. IF LEGALLY SEPARATED. Generally 1. It is not alimony if it continues past the death of the recipient ii. AND THUS d. NOTE: Any payments that end when a child dies or reaches a certain age (ex: 18) will be characterized as child support payments 3.

Note: if payments are $15K or less. Married couples with only 1 income earner pay less tax than they would have if they were not married and each spouse were taxed individually 2. A Note on the Marriage Penalty and Bonus: The Joint Return i. For those couples composed of 1 TP who has little or no income of his or her own 93 . Married couples with 2 income earners pay MORE tax than they would have if they were not married and each spouse were taxed individually because each of the 2 earners would have benefited from the progressiveness of the tax rates 2. this will disappear d. The Divorce Penalty a. The added tax owed by 2 income earners who marry = marriage penalty ii. the spouse who receives the alimony deducts the same amount from gross income in year 3 1. Marriage Bonus 1. Marriage Penalty 1. THIS IS RECAPTURE OF INCOME ii.by requiring the payor spouse to include it in income in year 3.

Assignment of Income a. Via Contract 1. To report over multiple years. If the assignment is not effective: the transferor still pays tax on the income/interest iii. The oil is removed by another foreign company Y. The incidence of earned income cannot be shifted by anticipatory assignment (“however skillfully devised”) of the right to receive the income 2. dividing the income between the 2 TPs would have transactions reduced the overall tax liability. Y. Athletes try to get their income spread out over time because they make a great deal of money in a short period of time ii. X starts a company in a foreign JD with a lot of oil. Facts: Earl and his W entered into an agreement in which any property Want arms(including salaries) would be jointly earned. Z owns the foreign subsidiary. In order for assignment to be effective. Why Do TPs Assign Income? 1. Personal service income cannot be shifted (Lucas) except by the performance of gratuitous services OR by statute (Poe) 2. if the employee does all the work? ii. Loan Out Issue i. NOT have already earned the income/interest being taxed 2. Holding: NO The income must be reported by the party who earned it i. This case pre-dates the joint length return—here. Earl (SCOTUS 1930): The Income Must be Reported By the Party Who Earned it a. b. Income splitting and the progressive tax rate structure create a system where the same amount of income earned by 1 person is taxed at a higher rate than the aggregate amount of the same income earned by several persons ii. Whether the income that is in dispute is to be reported in part by H and in part by W or rather reported entirely by H (what government wants) c. GENERAL RULES TO REMEMBER 1. Income from Labor i. Income from property can be shifted provided there is a complete transfer (Blair) of the income-producing property. A question arises as to how much is taxed to Z and to the foreign subsidiary 94 . NOT retain control over the income producing asset AND b. The Lucas Doctrine and Other Examples a. Lucas v. When Is Assignment of Income Effective and Not Effective? 1. One company loans companies out—who is taxed on the extra income. Could be income splitting. US Company Z to be sold in the US. Athletes: Income Splitting with YOURSELF i. the transferor must: a. Issue: whether Earl could be taxed entirely on the salary and attorney’s fees that he earned as a lawyer in view of the K i. refined by another company. and the donee does not retain an interest in the property (Horst) b. if the companies are related c.XXVII. allows the sports franchise to pay an off-shore entity to pay the athlete over time cannot do this! b. Generally i. Transfer Pricing Issues i.

and other personal property. Commissioner v. Poe v.” ii. NOTE: Aramco Case NOTE: If assignment contract is an arm’s length arrangement. Sanborn (SCOTUS 1930): In a Community Property State. IRS determined that allowed ALL the income should have been reported in the H’s return. This represents a transfer-pricing issue: the price that is charged between the subsidiary and the parent tells us how much will remain off-shore and how much will remain off-shore and how much will get taxed ii. the income of the community can no more Splitting be said to be that of the H’s than that of the W’s income by ii. Government: the husband is essentially the owner of the community property—the income is the H’s (H has management and control of the community property) b. i. US only gets what is taxed to Z 2. and accident insurance business generated by the bank.1. Seaborn Does Not Apply Outside the Context of H and W 95 . Facts: TP earned sales commissions equal to 45-50% of the premiums CONTRACT paid by its borrowers on credit life. Chief Counsel Advisory Opinion 2006080308: Poe v. the operation of earnings are never property of the H. Holding: YES i. Arms-length bargaining to figure out if price was appropriate 3. are H and W entitled to divide the community property in half on their return? c. rather than the bank. the courts will allow it – say in a partnership agreement ii. First Security Bank (SCOTUS 1972): Following Poe v. but that of the community law when you cannot do it 2. Holding: Court held in favor of the bank i. bonds. H and W each income returned ½ of the total community income as gross income and each splitting is deducted ½ of expenses to arrive at net income. The real estate stood in H’s Nonname but everything else was community property and neither owned consensual any separate property or had any separate income. Issue: In a community property state. TP: income of the community property is owned by the community and the H and W have each a present vested ½ interest ii. by law. health. i. which it owned and received the fees that had been previously received by the TP bank. Via Statute 1. Government: sought to tax the profits of the subsidiary to the bank b. Under the law of WA. by operation Seaborn of a. After being advised by counsel that it could not lawfully earn such commissions. stocks. This case is distinguished from Earl because HERE. Facts: Seaborn and his W accumulated property comprising real estate. Income Splitting Allowed by Statute a. the bank set up another corporation. This new arrangement was lawful because the subsidiary was a separate entity and viewed as the seller of the policies. “We know of no decision of this Court wherein a person has been found to have taxable income for which he did not receive and was PROHIBITED from receiving.

Holding: The daughter should be taxed because she became part owner of the trust and income from property should be taxed to the owner of the property a. A spouse who files separately must include the gross income of ½ of the combined earning income of both spouses. or client 2. He presented it to the issuer and received the interest payment. When it comes to services performed by charities. Holding: An individual who is a registered domestic partner in CA must report ALL of his or her income earned from the performance of his or personal services i. Facts: TP made a gift of a bond interest coupon just prior to the coupon’s maturity. is the assignor STILL TAXABLE on the income of $9K? 3. Distinguishing Blair i. From the trust. Blair v. gave away ALL property rights—but in Horst. the rules are more generous to TPs than the rules related to service performed for an employer. Issue: the question of the tax liability of a beneficiary of a testamentary trust for a tax upon the income which is assigned to his children after these assignments. RULE: Income from property cannot be assigned where the donor retains the underlying property and thereby the right to make future gifts from the income of that property ii.a. Issue: Is a CA individual who is a registered domestic partner required to include in gross income all of his or her earned income OR ½ of the combined income earned by the individual and his/her domestic partner? c. In 1999. Holding: No income shifting—TP is taxed when the coupon is cashed a. Earl apply to income shifting to charities? c. 2. Gratuitous Performance of Services 1. 2. Income from property is taxed to the owner of the property iii. There is NO Shifting of Income 1. Commissioner (SCOTUS 1937): Income from Property is Taxed to the Owner of the Property 1. Helvering v. Facts: TP’s father created a trust based on his will. Generally 1. Generally. income from property is treated as owned by the owner of that property and taxed to that person 2. Horst (SCOTUS 1940): If a TP Merely Assigns the Income and Keeps the Property. Poe v. and $9K for each year after in net income. customer.16-2(c): provides that no income arises where services were rendered directly to the charitable organization and this includes services rendered to a charity as a promoter of public entertainment 3. TP assigned to his daughter. Facts: CA is a community property state—all property acquired by marriage is community property and they are equal interest. Does Lucas v. Seaborn does not apply outside the context of H and W— the rights afforded to domestic partners in CA are NOT made an incident of marriage by the policy of the State iii. In Blair. she gave only 1 coupon with the right to receive more coupons 96 . interest of $6K for the remainder of that calendar year. Allowed domestic partners to file joint tax returns for state tax purposes b. § 1. CA extended certain rights of married couples to domestic partners who register their partnership with the CA Secretary of State: Domestic partners are given the same rights as married couples. Issue: Who is taxed on the interest that the son received? 3. Reg. Income from Property: GRATUITOUS TRANSFERS i.

GAVIT:  Whereas in Irwin. iv. do NOT shift the tax levied upon that income from the service provider. Mere power to collect commissions (right the assignee received LIKE LUCAS V. in Horst. she is taxed because she owns the property 1. since she kept the property and merely assigned the income of the property. from the assignor) was insufficient to shift the income to the EARL assignee ii. he is very obviously much in it and the arrangement is one that he created  However. whereas the Court chose to tax the income beneficiary (son) rather than remainderman (TP)—son would be viewed as being the income beneficiary with the TP as the remainderman.ii. Helvering v. Thus. Horst: gift of income from property (income does not shift) iii. Issue: Does the income shift? c.e. this is similar to Irwin. The renewal commissions were taxable to the assignor himself in the year received by the assignee because the assignee ONLY had a “mere power to collect” (i. like assignments of personal service income attributable to future services. b. income from property is taxed to the owner of property —In Horst. In Blair. Holding: NO the assignor is taxed on the contingent renewal payments when received by the assignee THIS IS JUST i. the right to earned income cannot be called property) iii. if son was taxed entirely with TP never being taxed (opposite of Horst). 97 . NOTE: Court cites HORST which is a PROPERTY CASE  NOTE: SCOTUS has held that assignments of personal service income attributable to past services. in Blair: gift of property (income shifts) vs. Facts: TP assigned to a family trust of commissions to be received in the future for services rendered in the past by the TP. Vertical Slice: Part of the income from the property for as long as the property exists (Blair) income shifts Horizontal slice = Horst TIME Vertical slice = Blair = Income shifts RELATION TO IRWIN V. Income from Services Transformed Into Property 1. Vertical Slices 1. the donor is out of the picture. Horizontal Slice: all of the income from the property for a fixed amount of time (Horst) income does not shift 2. Horizontal vs. Eubank (SCOTUS 1940): The Right to Earned Income Cannot Be Called Property and Does Not Shift Income a.

income 98 . Facts: TP is a life insurance agent who purchases from other insurance agents their rights to renewal commissions on life insurance policies (just like Eubank. 1955): Arms-Length Assignments Tax the Assignor Only to the Extent of Consideration Received 1. which decedent reported as ordinary income. a TP cannot escape taxation by legally assigning or giving away a portion of the income derived from income-producing property retained by the TP. can argue Eubank is WRONG—a little part of the income in Eubank should be taxed to the daughter just like a little bit of the dividend can be taxed to the son. 2. This is true whether the services are to be rendered in the future (Earl) OR have already been completed at the time the designation is made (Eubank) note: statutory exceptions (Poe. 2. rather—the son was 4. Where there is an arms-length assignment (rather than between father and son) of income rights for valuable consideration. Non-Gratuitous Assignments of Income i. Thus. Issue: What are the tax consequences of this assignment? 3. Commisisoner (2d Cir. Issue: Whether the TP is taxable on the receipt or the purchaser 3. TC argued that the assignment of future dividends in exchange for cash value of those dividends was really a loan masquerading as a sale. Holding: Puchasor is taxable on the amount of consideration received both TP and purchasor are taxed (split) a. Commissioner (6th Cir. Facts: The decedent’s income wasn’t going to be high enough to take full advantage of a large interest deduction. the fact that valuable consideration was an integral part of the transaction distinguishes this case such that the decedent TP was not taxable on the income. 1973): Is Eubank Wrong? 1. TP did not report income on the assigned renewal commissions. a. Cotlow v. Arms-Length Assignment i. The decedent’s estate reported no income from the dividends. and got the interest deduction.d. Holding: No assignment of income and son was appropriately taxed on the dividend amount of $7K and father received taxable income of $115K. the son paid consideration of $115K to receive future income from stock dividends worth of $122K. While ordinarily. First Commissioner)  GIFTS FROM INCOME PRODUCING PROPERTY: Gifts from income-producing property are effective to shift the future income to the donee (Blair—vertical slice) o Exception: the donor remains taxable if he retains property rights—ex: gift of a limited number of income-payments drawn from a larger series (Horst—horizontal slice)—this is ineffective to shift income o THUS: If all the income from the property for a fixed amount of time is given: Horst. Estate of Stranahan v. the assignor is TAXED—realizes only the amount of consideration received and is taxable for receipts in excess of that amount b. when the market draws the line. the court will follow it ii. SUMMARY:  GIFTS FROM INCOME FROM PERSONAL SERVICES: Income from personal services is taxable to the person who does the work. except the insurance agent SOLD rather than gifted his right to future commissions). Courts will not draw the line between the earned and unearned component of a future income stream—however. no matter whom he designates to receive the pay envelope. Drawing the Line i. NOTE: Based on this case. so he assigned anticipated stock dividends to his son in exchange for $115K.

Accounts or notes receivable acquired in the ordinary course of T or B for services rendered or from sale of property 5. capital gain has been taxed at lower rates then ordinary income 1. a literary. or artistic composition. Stock or securities held by a TP who is not a professional dealer in stocks or securities 2. Bottom LINE: Capital Asset = Personal Property i. Taxation of Capital Gains and Losses i. Under § 1(h). Receivables acquired in exchange for such inventory also fail to qualify as capital assets 2. FOR CAPITAL GAINS THING: GAINS ON INVESTMENT b. What Is a Capital Asset? § 1221(a) i. NOTE: may qualify for more favorable tax treatment under § 1231 3. A TP in whose hands the basis of such property is determined in whole or party by reference to the basis of such property in the hands of a TP described in “a” or “b” i. Must ask: is it inventory when you sell it in the ordinary course of T or B? SCOTUS took to purpose at time of sale b. A publication of the US government a. Undeveloped land as held as an investment by the TP c. Classic Examples: 1. BUT DOES NOT INCLUDE 1. Generally i. The Maximum Rate of Net Capital Gain: § 1(h) 99 . or similar property. Inventory (inventory stock in trade of the TP) and property held for sale to customers in the ordinary course of business a. NOTE: A patent is a capital asset 4. buyer taxed on time value of money (Stranahan. does not shift if part of the income from property is given for as long as property exists: Blair. § 1221(a): Property held by the TP (whether or not connected with his T or B). NOTE: capital gain recognized by corporations does not receive favorable treatment § 1201 2. A copyright. Depreciable or real property used in T or B a. The flip side of favorable treatment for capital gains is unfavorable treatment of capital losses iii. A TP for whom such property was prepared or produced or c. a TP pays taxes at the ordinary rate in § 1(a) on all income other than “net capital gain” plus a reduced rate of tax on net capital gain ii. EX: A TP who received the work as a gift from the creator of the work or a person for whom the property was prepared ii. Capital Gain 1. Property held for investment and ONLY occasionally sold is not inventory (Biedenharn Realty v. a letter or memo. Cotlow) XXVIII. held by: a. musical. US) c. Historically. A TP whose personal effects created such property b. income does shift NON-GRATUITOUS TRANSFERS: o Selling the right to receive future income from property/services: owner is taxed on income when he sells the right to receive income to another. Capital Gains and Losses a.

a. The maximum rates: 15. stamps. then 0% rate applies b. § 1223: Holding Period in an Asset a. AB > AR or AR <AB 3. Company goes out of business and shares get canceled = disposition. the TP is permitted to “tack” an additional holding period to the current holding period b. 25. then 28% tax rate i. ii. you have ORDINARY income. § 1250: if you sell depreciated real estate. wines. 28% rate = have capital gains from the exchange or sale of collectibles: if you sell a collectible like artwork for gain. You are able to sell for $115. 15% rate = usual rate for 33% TP. (1) You can tack from 1 period to another: this is the § 1031—can tack the property given up for property I get 100 . § 1222: Other Terms Relating to Capital Gains and Losses Subject to § 1211 a. not sale or exchange ii. not sale or exchange iii. NOTE: If less than 33% TP. not sale or exchange ii. Collectibles = artwork. financial assets and investment real estate. Generally i. Bond being paid off = disposition. Sale or Exchange. but $40K taxed at 25% 2. other than depreciation recovery c. and coins d. you do not have a capital gain/loss 1. then the $2K is § 1250 gain  The additional $15K is taxed at 15%. sale/exchange + held asset for longer than 1 year. Long-term capital gain/loss: held asset longer than 1 year i. Thus. Since you are selling it for $115K and you have a basis of $60K. In some circumstances. from any gain relating to accelerated depreciation  If straight line makes basis $60 K and accelerated makes it $58K. AB > AR or AR < AB b. Thus. Un-recaptured § 1250 gain is the $40K of depreciation: only applies to real estate because § 1250 applies to real estate 1. Short-term capital gain/loss: the term means gain/loss from the sale or exchange of a capital asset held for not more than 1 year. rugs. if and to the extent such gain is taken into account i. Not Disposition  The following DO NOT COUNT as Sales or Exchanges i. gems. not capital gain. and 28% i. sale/exchange + held asset for less than 1 year. antiques. 25% rate = applies to un-recaptured § 1250 gain i. EX: You buy real estate for $100K and depreciate it to $60K using straight-line depreciation. A TP’s holding period starts when the asset is acquired ii. metal. The disposition of a capital asset does not necessarily give rise to a capital gain/loss if you have a disposition that is not a sale or exchange. then you have a gain of $55K. Abandonment of property = disposition.

Thus. like all other losses. If you have capital gains for next year. § 1211 101 . Capital losses. other carryover basis) Move holding periods across property i. just disappears b. Both corporate and non-corporate TP can deduct the capital losses they recognize during a given year to the extent of the capital gains they recognize during that year 3. If you have no capital gains for 9 years. but no carryback Corporate TP Not allowed to deduct their capital losses in excess of their capital gains –but can carry the excess capital loss back 3 years and forward 5 years Non-Corporate TP Non-corporate TPs are allowed to deduct up to $3000 of their capital losses in excess of their capital gains in a given year and carry forward indefinitely the excess capital losses disallowed  NOTE: Ex: If a TP recognizes a $900K capital loss and no capital gain the current or future years. Would clearly apply to § 1031 exchange (as well as § 1031(b)) iii. i. are non-deductible unless some provision affirmatively grants a deduction: Think “disallowance provision” i. Only applies when the property you get has the same basis in whole or in part ii. with just a capital losses from sales or exchanges of capital assets shall be allowed only to loss and no capital the extent of the gains from such sales or exchanges plus the lower of gain! $3000 or the excess of such losses over such gains.i. losses from sales or exchanges of capital assets shall be allowed only to the extent of gains It is VERY BAD from such sales or exchanges to be a corporation b. 1223(2) doesn’t apply because it is not carryover basis d. then the capital losses can be claimed next year for 5 years ii. Capital Loss Limitations 1. Move holding period from 1 property to another for the same TP c. if you get the basis under 1014. § 1211: Limitation on Capital Losses a. (2) Can include property for which the same property was held for someone else if your basis is held in reference to someone else (ex: gifts. everyday business income falls outside the category of capital gain or loss 2. The usual provision is § 165: losses incurred in profit-seeking activity ii. CORPORATIONS: In the case of a corporation. When you die. § 1212: Capital Loss Carrybacks and Carryovers a. and if someone dies get long term capital gain ii. (9) If someone applies property from decedent. INDIVIDUALS: There is an indefinite carry forward. from one TP to another for same period. can tack the holding periods SUMMARY: from self to self across period. NON-CORPORATE TP: In the case of a TP other than a corporation. CORPORATIONS: Can carry the loss back 3 years and forward 5 years i. Generally a.

Net Long Term Capital Gain: Long Term Capital Gain – Long Term Capital Loss b. it would take 300 years for the TP to deduct the full $900K iii. How to Calculate: THE MECHANICS: STEP ONE: DIVIDE GAINS AND LOSSES INTO 4 CATEGORIES 1) Short-term capital gain: gains from the sale/exchange of capital asset held for 1 year or less 2) Short-term capital loss: loss from the sale/exchange of capital asset held for 1 year or less 3) Long-term capital gain: loss from the sale/exchange of capital asset held for more than 1 year 4) Long-term capital loss: loss from the sale/exchange for capital asset held for more than 1 year STEP TWO: CALCULATE THE NET SHORT TERM AND NET LONG TERM GAINS OR LOSSES 1) Net Short Term Gain or Loss: a. § 1222 divides capital gains and losses into 2 classes: long-term (held > 1 year) and short term b. a TP recognizes both capital gains and losses. but only at a rate of $3000K a year—at this rate. Calculation of short-term and long-term capital gains carried out through the “netting” procedure of § 1222 c. If in a single year. that long-term loss may offset short-term gain 2. The Steps Generally: i. Distinguish long-term and short-term capital gains and losses by reference to the 1-year holding period ii. the TP must net the capital gains and losses as provided in § 1222 a. Net Short Term Capital Loss: Short Term Capital Loss – Short Term Capital Gain 2) Net Long Term Gain or Loss a. or. Capital Loss and Capital Gain: § 1222 Net Capital Gain 1. Net Long Term Capital Loss: Long Term Capital Loss – Long Term Capital Gain STEP THREE: DETERMINE TAXABLE TREATMENT What is TP Position? Position Net Long Term Capital Gain Only Net Long Term Capital Gain & Net Short Term Capital Gain Net Short Term Capital Gain Only Net Long Term Capital Gain & Net Short Term Capital Loss Possibility Include in Net Capital Gain Include Net Long Term Capital Gain in Net Capital Gain Include Short Term Capital Gain in ORDINARY INCOME Include as Ordinary Income  If Net Long Term Capital Gain > Net Short Term Capital Loss: Net Long Term Capital Gain – Net Short Term Capital Loss = Include in Net Capital Gain  If Net Long Term Capital Gain < Net Short Term Capital Loss: Net Loss = Net Short Term Capital Loss – Net Long Term Capital Gain deduct up to $3K of net losses and the rest is carried forward to the next year Net Loss = Net Long Term Capital Loss deduct up to $3K and the rest is Net Long Term Capital Loss Only 102 . Net Short Term Capital Gain: Short Term Capital Gain – Short Term Capital Loss b. This means that short-term loss may offset long-term gain. Net the gains and losses in for long-term and short-term separately: if one category shows a net loss and the other a net gain.allows the TP to deduct the entire $900K. the net loss and net gain are netted against each other 1.

ii. remaining: taxed at 15% d. At the end of the year. This includes gains from the involuntary conversion of long-term capital assets (ex: TP’s car is wrecked. applying to depreciable property OTHER than real estate. the Code has LIMITED the ability of property-owners to combine ordinary deprecation deductions with capital gain by requiring RECAPTURE of all or a portion of the depreciation when the property is sold. If the value of the property at a given date exceeds adjusted basis—if. the provision creates a special problem in respect to the depreciation allowance a. and insurance proceeds exceed the TP’s basis in the car) 3. To limit this problem. § 1231 applies to the sale and exchange of assets described in § 1221(2): depreciable property and real estate used by the TP in a T or B b. Under § 1245. then Net Gain = Net Short Term Capital Gain – Net Long Term Capital Loss include in ordinary income iv. This means that the prior deductions from ordinary income will be transmuted into capital gain through sale 2. the depreciation allowed for tax purposes has been greater than the actual decline in the property’s value—then a sale of the property will produce a gain. annual depreciation is a deduction from ordinary income. Long-Term Capital Gain: Depreciation Deduction: taxed at 25%. 103 . § 1231 Gains and Losses a. Since § 1231 permits capital treatment for gains from sales of depreciable property. THUS: § 1231 property get the benefit of capital gain without the detriment of the loss side ii. and the amount deducted is subtracted from the TP property basis. Thus. and the gain under § 1231 will be all capital c. b. Assets Taxable Under § 1231 1. Generally a. Determining the Taxable Rate a. This problem has been rendered acute by the adoption of accelerated depreciation rules. all § 1231 gains and losses are netted together to produce a single § 1231 gain or loss 2.Net Long Term Capital Loss & Net Short Term Capital Loss Net Short Term Capital Loss Only If Net Long Term Capital Loss > Net Short Term Capital Gain Net Long Term Capital Loss & Net Short Term Capital Gain carried forward to the next year Net Loss = Net Long Term Capital Loss + Net Short Term Capital Loss deduct up to $3K and the rest is carried forward to the next year Net Loss = Net Short Term Capital Loss deduct up to $3K and the rest is carried forward to the next year Net Loss = Net Long Term Capital Loss – Net Short Term Capital Gain deduct up to $3K and the rest is carried forward to the next year  If Net Long Term Capital Loss > Net Short Term Capital Gain above  If Net Long Term Capital Loss < Net Short Term Capital Gain. The Provisions of § 1245 1. Generally: Background to the RECAPTURE RULES 1. If a loss = ordinary loss i. If a gain = long-term capital gain b. in effect. Generally a. Depreciation Recapture Under § 1245 and § 1250 i.

Since real estate usually can be depreciated ONLY using the straight line method. patents. To the extent § 1245 applies to a particular transaction. Other property: used in manufacturing. 1. Exceptions under § 1245(b) a. Property amortizable under § 179 b. In general. and the remaining gain of $1K would be capital gain under § 1231. If the same property were sold for $11K. TP includes ordinary income equal to the LESSER OF i. 2. etc. BUT NOTE: Congress has provided for some accelerated depreciation § 1250 is of real estate to encourage rebuilding in designated areas (ex: Hurricane basically moot except in these 104 . it overrules all other statutory provisions ii. Whenever an asset is sold and not all the gain realized is recognized at ordinary rates. b. The gain recognized on the sale of the asset OR ii. Preemption under § 1245(d) a. it does so without regard to any other provision b. Applies to depreciable real estate. Exceptions: § 1250(d) gifts. Does not apply to gifts or devices b. Can apply to non-recognition transactions ONLY to the extent that boot is received and gain would be recognized even in the absence of depreciation recapture iii. trucks. Property is § 1245 property if:  Depreciation is allowed on the property under § 167. this means there will not be ANY recapture under § 1250 c. whereas § 1245 extends to recapture to all depreciation previously allowed 2. including personal and tangible property i. certain tax-free transactions.a TP’s gain on the sale of his property is taxed as ordinary income to the FULL EXTENT of his prior deductions i. § 1250 only recaptures so much of the claimed depreciation as exceeds straight-line depreciation (§ 1250(b)(1)) b. computers. iii. must consider § 1245 and § 1250 3. copyright. § 1250 recaptures ONLY the excess of depreciation actually taken over the depreciation that would have been allowed under straight-line depreciation recapture under § 1250 thus applies to the EXCESS of accelerated over SL depreciation. devises. equipment. research. etc. Generally a. § 1245 Property: all depreciable tangible property—autos. such as buildings and other structures i. machinery. and then sold for $9K. THUS: all depreciation is recaptured when § 1245 property is disposed of EXAMPLE: If an asset purchased for $10K were depreciated to $6K. Generally described. the first $4K of gain would again be ordinary under § 1245. Personal property under § 167 ii. § 1250(h): like § 1245. and  The property is one of the types specified in § 1245(a)(3). Prior depreciation taken on the asset sold 1. The Provisions of § 1250 1. Recapturing Depreciation a. the gain of $3K would be “recaptured” as ordinary income. etc.

She paid $50K for the equipment. it will be taxed at a 25% rate (rather than 15%) EXAMPLES OF § 1231. gain on the sale of tangible physical property such as machinery is subject to recapture in the amount of the lesser of the gain recognized on the sale OR the prior depreciation taken on the property sold under § 1245. all the gain is recaptured as ordinary income. Her AB in the equipment at time of sale is zero.  Jim sells a copyright for $55K. He bought the copyright form the person (not related to Jim) who created the copyrighted property in exchange for $50K. ($50K basis less $10K “depreciation” taken on the property). Under § 1250.  Of the $60K capital gain. However. This is treated as capital gain ii. Here. ($50K basis less $50K depreciation taken on equipment). Bielfeldt v. The lesser is $50K thus. prior depreciation was $50K. Jim’s AB for the property at the time of sale is $40K. SL depreciation from depreciable real estate is not re-characterized as ordinary income under § 1250: this is called UNRECAPTURED § 1250 GAIN i. Here. Facts: TP is a large trader in US Treasury notes and bonds—wants to overturn a decision by the TC denying him the right to offset immense trading losses that he incurred against all but $3K of his income. AND § 1250  Jan sells the Shady Acres Apartment Building for $320K. Her AB in the property at the time of sale is $260K ($300K basis less $40K of depreciation taken on building). § 1245.  John recognizes $50K of gain. which is capital under § 1231. so no portion of the gain is subject to § 1250 recapture. None of this gain is subject to depreciation recapture so Jan includes no ordinary income on the sale. Holders of a copyright can deduct this form of decline through amortization. Section 1245 applies to intangible property that has been amortized as well as tangible property that has been depreciated. The remaining $20K of capital gain is taxed at a capital gain rate of 15% or less. Commissioner (7th Cir. Jan purchased the property in Year 1 for $300K. the only way to depreciate real property is by SL. so $50K of gain is ordinary income.  Jan recognizes $60K of gain.Katrina. Here. The value of the copyright thus declines (to zero) as it reaches its expiration date. He claims he is a dealer and the 105 . However. so that $40K of the gain is subject to the 25% capital gain rate. 9/11) § 1250 will apply to disposition of property qualifying for such accelerated depreciation 3. e. If it rises to net capital gain. gain is recaptured as ordinary income to the extent of prior depreciation. $10K of the $15K gain—the portion of the gain equal to prior amortization—is recaptured as ordinary income. which is capital under § 1231. which is capital under § 1231.  Copyrights do not have an indefinite life but are valid for a fixed number of years. $40K is attributable to SL depreciation deductions that Jan has taken on the property. His AB in the property at the time of sale is $100K ($400K basis less $300K of depreciation taken on machinery). the total gain recognized is $50K and the prior depreciation is $300K. 2000): The Difference Between a Securities Trader and a Securities Dealer 1. Property Held “Primarily for Sale to Customers” i.  Jen sells equipment used in her auto repair shop business for $60K.  Jen recognizes $60K of gain. capital gain on real property is subject to recapture ONLY to the extent that the depreciation on the property exceeds SL depreciation— however.  John sells machinery used in the business to build widgets for $150K. Un-recaptured § 1250 Gain a. The remaining $10K of gain is capital gain. John bought the equipment in Year 1 for $400K.

The TP reported its gains on this basis. 1976): Once an Investment Does Not Mean Always An Investment 1. Biedenhard Realty v. § 170(e)(1) Reductions 1. claiming they were capital. Issue: Is he allowed deductions for the ordinary income? 3. the donor can deduct ONLY adjusted basis in the property i. Holding: Ordinary Gain a. If a dealer: can deduct ALL losses as ordinary from income b. § 170(e)(1)(A): The charitable contribution under § 170(a) is reduced to the extent that gain from sale of the contributed property the extent it would be shortSHORT TERM term capital gain or ordinary income a. The property is donated to certain private foundations OR c.losses incurred in the sale of the Treasury securities were losses connected with his “stock in trade”—these are ordinary rather than capital losses. Substitutes for Ordinary Income 106 . Generally 1. TPs can take deductions for charitable contributions—equals the FMV of the property contributed 2. The contributed property is a patent or certain other intellectual property d. Did the sales from the subdivision constitute property held by the TP primarily for sale to customers in the ordinary course of its T or B? 3. The contributed property is tangible personal property (ex: works of art. and brokers’ activities all point towards ordinary gain in T or B 4. solicitation and advertising efforts. § 170(e)(1)(B): Even if a sale of the contributed property by the donor would have produced long-term capital gain. the donor’s § 170 deduction is limited to the donor’s AB in the property if: a. This deduction is reduced by § 170(e)(1) ii. NOTE: THIS NEVER APPLIES TO CONTRIBUTIONS OF REAL ESTATE OR INTANGIBLE PROPERTY SUCH AS STOCKS AND BONDS g. Dealer: compensated for services rendered ii. he did not maintain an inventory. NOTE: IMPROVEMENT + REZONING INTO SUBDIVISIONS = FATAL f. Court looks to a variety of factors: substantiality and frequency of sales. Under § 170(a). US (5th Cir. etc) AND the donee’s use of the property is unrelated to the organization’s charitable purpose b. Trader: profits from swings in value and reports gains and losses as capital b. but IRS asserted a deficiency: all gains were ordinary income and the TP filed for a refund. LONG TERM antiques. Issue: Were the gains ordinary or capital? a. a. Government had agreed that 60% of the gain would be reported as ordinary income and 40$ as capital gain. Holding: NO—he was merely a speculator. Facts: TP held lots of real estate for investment and turned one property into a subdivision. he was out of the market as many as 200 days per year. § 170(e)(1) Re-Examined: Reduction of Charitable Contribution Deductions  SEE ABOVE i. Ex: reduction for any recapture amount under § 1245 2. If not a dealer: can only deduct up to $3K 2. etc. a. THUS: if the property contributed would have produced ordinary income or short-term capital gain had it been sold (because the property is not a capital asset or has not been held by the donor for at least a year). 2. improvements.

The TP reported a loss from the transaction of $21K Tax Court said it was ordinary income of $140K. Commissioner (11th Cir. the bank notified the TP that it wished to terminate its occupancy. when the lease still had some 13 years to run. TP still has an interest in the property. Note Chirelstein argument: capital gain should arise from relative changes in value rather than from the passage in time iii. Issue: Is the right to the remainder of the payments property. Generally 1. 2007): Assignment of Lottery Rights is Not A Capital Asset Under the Substitute for Ordinary Income Doctrine 1. TP reported the amount received from the financial company as proceeds from the sale of a long term capital asset. After he received some of the payments. Hort v. TP did not make an underlying investment in the payments and there was no change in the value of the right to receive payments over time—not a capital asset 1. A capital transaction only exists if the sale/exchange of an asset results in 1. A return in capital investment AND 2. he assigned his rights to the remainder of the payment to a financial company. i. Holding: NO a. THUS: Sale of a carved out interest in property cannot qualify for capital gain treatment and do not absorb any of the TP’s property basis. Womack v. 2. which was to be paid in annual payments. the TP agreed to cancel the lease in consideration of a cash payment by the bank of $140K. unaccompanied by a disposition of the underlying property.i. When a lump-sum payment is received in exchange for payments that would otherwise be received at a future time as ordinary income. No capital gain treatment and an offsetting basis to one who carved out disposes of a right to future income which has been carved out of a larger estate: the sale of an income right. Facts: TP won the lottery. Lottery rights involve no underlying investment of capital—any gain from their sale reflects no change in 107 . Realized gain/loss which accrues to the investment over a period of time ii. This is Not a Capital Asset i. Commissioner (SCOTUS 1941): When a TP Only Sells the Right to Receive Rental Income For a Period of Years. of which the main floor had been leased to a bank for a period of 15 years at an annual rent of $25. This is merely a substitute for ordinary income—a substitute for future rent payments If landlord i. Issue: Can the TP offset the value of the lease canceled against the consideration received by him to compute a gain or loss? 3. Here. b. After negotiations. Facts: TP inherited a building. so that the amount TP received was capital gain? 3. 2. Holding: NO this is a substitute for ordinary income a. the TP has Not Transferred Property for Purposes of § 1221 1. not for an increase in the value of income-producing property ii. results in ordinary income to the seller equal in amount to the entire proceeds of the sale.000. because the consideration was paid for the right to receive future income. Subsequently. as he can rent it to pays tenant. capital gain treatment of the lump sum is inappropriate. someone else no longer ii.

T might pay $ 780 for the bond after 1 year (when it is worth $750). they will divide the OID for that year between them (so: T and L divide $75) ii. The acquisition premium would be $30. If the sale from the first purchaser to the purchasee takes place during the second year. The unpaid. 108 . if any.the value of the asset 2. she must include $75 for the second year (redemption price = $825). If a purchaser of a bond sells the bond at the beginning of a year. When lottery winner sells lottery rights. her OID = $320 (if she keeps it for 4 years). if any of the redemption price over the issue price  Ex: If L pays $680 (issue price) for a $1000 bond (redemption price). with an OID = $70. the issuer of the OID in the obligation has to pay the 6% interest annually plus 3% at early years maturity and more in b. of the amount paid for a bond over the sum of its issue price plus accrued OID (§ 1272(a)(7)) a. T must include the $75 OID. Similarly. the purchasee includes the OID for that year (so: T includes $75) b. Thus. A borrower must pay a lender interest on principal borrowed in order to compensate the lender for the borrower’s use of the lender’s funds while the loan is outstanding i. For example. accrued interest increases the principal owed ii. Example: If a subsequent purchaser pays more for the bond than the sum of the issue price plus accrued OID to date. the OID. The OID is determined only once per bond and is defined in reference to what the first purchaser paid. NOTE:  OID is the same for all holders  Acquisition and market must be determined anew for each holder Date of Issue 1 Year Later 2 Years Later 3 Years Later Redemption Total 2. plus 6% interest annually may have to be sold at $97 because the 6% interest is inadequate—the extra $3. If L pays $680 and holds the bond for only 1 year. Acquisition Premium: excess. What is the Original Issue Discount? 1. Generally a. Value $680 $750 $825 $910 $1000 Change in Value --$70 $75 $85 90 $320 Selling the Bond a. Original issue discount (OID): term for unstated interest on debt. a note which will be paid $100 at maturity. if L sold the bond to T at the beginning of the second year. not a right to earn income in the future h. she redeems it for $750. the later years determined at the time the debt is issued i. If she continues to hold the bond throughout the second year. he transfers a right to income that is already earned. § 1272(a)(1): anyone who holds a bond with OID must include the OID on the bond for the period held ii. is economically There is less the same as interest: for use of the $97. OID is defined as the excess. Original Issue Discount and Related Rules i. Acquisition Premium PAYING MORE FOR THE BOND 1.

that gain qualifies as capital gain i. This is appropriate because the increase in value of the bond ABOVE and beyond the accrued OID reflects a change in market values. The excess. is determined anew for each holder of the bond. so the AB for the first purchaser is $750. b. b. if you hold it for 3 years. under § 1276(b)(1) 1. If you hold it until redemption. out of the 5 remaining years.  Depending on how long you hold the bond. that percentage of the gain is ordinary. like acquisition premium. increases AB in the bond by the OID includible 3. Market discount. T. includes: OID for that year -.fraction of OID ii. not the time value of money FORMULA for Inclusions with Acquisition Premiums: OID for Year X – [OID for Year X x [(Price Actually Paid by T – Issue Price in Year of Purchase by T) / (Redemption Price for Total Years of Bond – Issue Price for Year of Purchase by Current Holder] iii. Subsequent Holder Number Two (U) a. of the issue price plus accrued OID over the purchase price b. The same formula applies 4. a TP who purchases a bond with a market discount will have some of the dispositional gain characterized as ordinary income ii. When he sold it to T for $780. Thus. NOTE: Subsequent purchaser. there is a gain of $30. What is a Market Discount? a. Market Discount PAYING LESS FOR THE BOND 1. So much of the gain as does not exceed the accrued market discount will be taxed as ordinary income under § 1276(a)(1). A subsequent holder who pays an acquisition premium is entitled to REDUCE the includible OID by the acquisition premium. where market discount is assumed to accrue ratably. Assuming the bond is not held in inventory. Subsequent Holder Number One (T) a. Rather. if any. there is a gain of $ 30 under § 1001(a)  Purchaser paid $680 for the bond and included OID of $70. This does NOT affect the amount of OID a bondholder reports i. The rest is capital. To figure out what the subsequent purchaser. then 3/5 of your gain times the amount of the market discount is ordinary. then all of your gain is ordinary. T. Subsequent holders after T will use the same acquisition premium as T (ex: $30). THUS: The implicit interest represented by market discount is deferred until disposition of the bond. When the first purchaser sells the bond to T. The First Purchaser a. OID accruing after the purchase = Redemption Price for Total Years of Bond – Issue Price for that Year b. 109 .2. Fraction of OID = Acquisition Premium / OID accruing after the purchase giving rise to the acquisition premium 1. where the acquisition premium accrues at the same rate as the OID i.

However. the retained portion and the portion that is disposed of is treated as a NEW BOND that is purchased at a discount and is payable at a fixed amount on a future date. § 1286 SUBJECTS THE STRIPPED BOND AND THE DETACHED INTEREST COUPONS TO THE OID RULES i. Must allocate a basis to each of the retained coupons and 110 . In general. Example: Suppose T purchases the bond after year 1 for $735. T will include OID of $75 and increase his basis to $810. Of that $40 gain. i. A TP who purchases a stripped bond or 1 or more stripped coupons is treated as holding a NEW bond that is issued on the purchased date with OID in an amount that is equal to the excess of the stated redemption price at maturity (or in the case of a coupon. 2. or $5 per year. b. If T then sells the bond for $850. i. b. and that gain can qualify as capital under § 1271(a)(1).2. ii. NEW OID = Redemption price at maturity – Proportion of FMV on purchase date of coupon/bond ii. Special rules are provided with respect to the purchaser and “stripper” of stripped bonds. Example: If T holds the bond until redemption for the 4 years. If the holder of the bond separates any of the coupons prior to maturity and then sells one or more of the coupons or the corpus. the amount payable on the due date) OVER the ratable share of the purchase price of the stripped bond/coupon. all of that gain will be re-characterized as ordinary income under § 1276(a)(1) because there was $15 of market discount and all of it has accrued at redemption. Thus. the holder is treated as if he sold the remaining parts of the bond to himself on that date for fair market value. Coupon Stripping and Stripped Bonds 1. there is a gain of $15 on the redemption. § 1286 treats both the stripped bond and the detached interest coupons as individual bonds that are newly issued with the OID on the date of disposition THUS. ii. Calculating the Includible Amount a. If T holds the bond for 1 year. Separating Bonds Prior to Maturity i. Generally a. there will be a gain of $40. T will include a total price of $250 of OID and will increase his AB in the bond to $985. iv. Stripped bond: a debt instrument in which there has been separation in ownership between the underlying debt instrument and any interest coupon that has not yet become payable. $5 is taxed as ordinary income because there was $15 of market discount to accrue over 3 remaining years of the bond. § 1286 a. The OID is includible in gross income under the general rules b. There is $15 of market discount because T’s purchase price of $735 is $15 below the issue price of $680 plus accrued OID ($70) = $750. upon the disposition of either the stripped bond or the detached interest coupons. determined on the basis of the respective FMV of the stripped bond/coupon on the purchase date.

The seller follows a similar pattern with respect to coupons 1 and 2 as well as with respect to the corpus.53 in the second year.41 in coupon 3 and will treat the difference between that price and the redemption amount of $120. Ex: GIFTS 1286(b) seems to apply. 1286(a) refers to the strippee/transferee this is triggered by a purchase 1. Thus. he will include OID of $109. If you strip in year 2.14 in the third year. Effect of 1286 i.48 in the second year. Then. the purchaser will include OID of $10.75 in the first year.41.Horst looked at the coupons and bond as 2 separate pieces of property—here. 1286(b) refers to the disposer this is triggered by a disposition ii. the sold items also are treated as separate zero coupon bonds subject to the OID rules. OID of $108.  Example: Suppose the holder of the bond sells coupon 3 immediately for its fair market value of $85. 2. Rather than treating the coupons as income and the bond as property they treat the whole thing as property iii. each of these retained items is treated as a separate zero-coupon bond subject to the OID rules individually. 1.00 as OID. but 1286(a) seems not to as well.86 in the third year. Further. we have to go back to year 1 and include the OID you would have paid. they look at the entire thing as property! corpus (if retained) equal to fair market value. IF YOU DO SEPARATE WE DIVIDE THE INTEREST BETWEEN EACH THING 3.25 in the first year. and OID of $12. 4. §1286(a)-(b). OID of $11. 111 . Amounts realized from the sale of stripped bonds/coupons constitute income to the TP only to the extent that such amounts exceed the basis allocated to the stripped coupons or bond § 1286 and the Overruling of Horst?  1286 incorporates precisely the analysis that Abrams proposed under Stranahan—however: IT ONLY APPLIES TO STRIPPED BONDS  If you keep both the bonds and the coupons: 1286 doesn't apply c. Thus. and OID of $107. The buyer takes a cost basis of $85.

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