Pearsons Federal Taxation 2018

Comprehensive 31st Edition Rupert

Solutions Manual
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 Chapter I:6

Deductions and Losses

Discussion Questions

I:6-1 Deductions for AGI reduce the taxpayer's gross income by the full amount of the deduction even
if the standard deduction is used. Deductions from AGI are not beneficial unless their sum exceeds
the standard deduction, in which case these deductions will be included as itemized deductions. Also,
many deductions from AGI are decreased by a percentage of AGI (e.g., 10% for medical expenses,
10% for casualty losses, and 2% for miscellaneous itemized deductions). pp. I:6-3 and I:6-4.

I:6-2 Expenses incurred in producing rental income are deductions for AGI. p. I:6-3.

I:6-3 A deduction for a loss incurred on the sale of a capital asset held for investment is a
deduction for AGI. p. I:6-3

I:6-4 Joe’s AGI is $104,000, computed as follows:

Gross Income from Business $200,000

Business Deductions ( 60,000) $ 140,000
Alimony ( 30,000)
Self-employed health insurance premiums ( 6,000)
AGI $ 104,000

The $4,000 mortgage interest on his personal home and the $2,000 for medicine and doctors that
Joe paid during the year are deductions from AGI. pp. I:6-3 and I: 6-4.

I:6-5 a. If the expenses are deductions for AGI, Mario's taxable income for 2017 is:

Income $55,000
Deductions for AGI ( 9,000)
AGI $46,000
Standard deduction ( 6,350)
Personal exemption ( 4,050)
Taxable income $35,600
b. If the expenses are deductions from AGI, Mario's taxable income is:

Income $55,000
Deductions for AGI ( 0)
AGI $55,000
Deductions from AGI ( 7,900)a
Personal exemption (4,050)
Taxable income $43,050

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a
$9,000 - ($55,000 x .02) = $7,900. Note that the taxpayer loses the benefit of the standard
deduction if the expenses are deductions from AGI. p. I:6-4.

I:6-6 a. Factors used to determine whether an activity is profit- motivated include:

1. Whether the activity is conducted in a business-like manner,

2. The expertise of the taxpayer or his advisor,

3. The time and effort expended by the taxpayer in carrying on the activity,

4. Whether the assets used are expected to appreciate in value,

5. The taxpayer's success in carrying on other similar activities,

6. The history of income or losses with respect to the activity,

7. The amount of occasional profits,

8. The financial status of the taxpayer, and

9. Any elements of personal pleasure or recreation, which the activity might

involve.

b. Whether an activity is profit-motivated or not depends upon the intent of the

taxpayer. These factors provide an objective way of determining a taxpayer's intent. Expenses
incurred in a profit-motivated activity are deductible, whereas expenses incurred in a personal
activity generally are not deductible (with certain exceptions). Thus, external indications of a
taxpayer’s motive or intent are extremely important in determining the deductibility of an
expenditure. pp. I:6-29 and I:6-30.

I:6-7 No, it is not automatically deemed a hobby. The other factors mentioned in the
Regulations can be relied upon to determine that the activity is, in fact, a business. The burden
to prove it is not a hobby is generally on the taxpayer. However, meeting the 3 out of 5 year test
shifts the burden of proof to the IRS. pp I:6-29 and I:6-30.

I:6-8 It is important to determine whether the activity is a business or an investment because

different tax consequences may result depending on the type of activity. For example,
deductions incurred in a business are generally for AGI whereas investment expenses generally
are from AGI deductions subject to various limitations. Losses incurred on business property are
ordinary, whereas losses on investment property generally are capital losses and are subject to
limitation. pp. I:6-5 and I:6-6.

I:6-9 An ordinary expense is an expense that bears a reasonable and proximate relationship to
the income-producing activity or property. It must be customary or usual to the particular
activity. Also, ordinary expenses are currently deductible as opposed to expenditures that must
be capitalized.

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 Necessary is defined as appropriate or helpful. However, an expense need not be
indispensable in order to be necessary. The test here is whether a reasonable business person
would have incurred the same expenditure.

A reasonable expense is one that is reasonable in amount. It must not be excessive or

unusual when compared to similar expenses made by similar businesses. pp. I:6-7 through I:6-9.

I:6-10 Capital expenditures:

Pursuant to the new tangible property regulations, capital expenditures are amounts paid for:

1. New buildings

2. Permanent improvement or betterments that increase the value of any property, or

3. Restoring property to its normal usage.

A deductible expenditure generally keeps a business asset in a normal operating condition.

p. I:6-10.

I:6-11 The disallowance for expenses related to tax-exempt income prevents the taxpayer from
enjoying a double tax benefit. If expenses related to tax-exempt income were deductible, the
taxpayer would benefit by not paying tax on the income and at the same time would be able to
deduct the expenses related to that income. p. I:6-12.

I:6-12 A bribe or kickback that is illegal under state law may be deducted by the taxpayer if the
state law is not generally enforced. pp. I:6-12 and I:6-13.

I:6-13 a. The entire $400 is deductible under Sec. 212 because it is incurred in the
determination of a tax. However, all $400 is a miscellaneous itemized deduction (a from AGI
deduction). Miscellaneous itemized deductions are only deductible to the extent they exceed 2%
of AGI, and then only if the taxpayer itemizes deductions rather than taking the standard
deduction.
b. Because $250 of the fee is attributable to Michelle's business, this amount is a for
AGI deduction. The remaining $150 is a miscellaneous itemized deduction, subject to the
limitation explained in part a. pp. I:6-6 and I:6-7.

I:6-14 a. Although Otter Corporation’s lobbying expenses relate to its business, they are
not deductible because they are not incurred in an attempt to influence local legislation.
b. Yes. Now since the lobbying expenses relate to its business and are incurred in an
attempt to influence local legislation, they are deductible.
c. Yes. These are in-house expenditures that do not exceed $2,000 for the year.
Thus, under the de minimis exception they are deductible. pp. I:6-14 and I:6-15.

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I:6-15 a. Tommy’s Inc. has incurred these expenses in the regular course of its business.
Tommy’s Inc. can deduct the expenses in the year incurred (last year).
b. Because Tommy’s Inc. is not in the restaurant business when these expenses are
incurred, they are not deductible as business expenses. However, they do qualify for
amortization as start-up costs, beginning in the month Tommy’s begins its restaurant business. If
Tommy’s makes an election, it can take a current deduction for $5,000 of the expenses, and
amortize the remaining $1,800 over a 180-month period. Thus, this year Tommy’s may deduct
$5,110 [$5,000 plus $1,800 remaining expenses amortized over 180 months equals $10 per
month, multiplied by 11 months].
c. Because Tommy’s is not in the restaurant business when these expenses are incurred,
they are not deductible as business expenses. Furthermore, since it did not enter the restaurant
business, they also cannot be amortized and deducted under Sec. 195. pp. I:6-15 and I:6-16.

I:6-16 For travel or entertainment expenses to be deductible, documentation such as account

books, logs, receipts, statements of witnesses, etc., must exist. The documentation must
substantiate the amount, the time and place, the business purpose, and the business relationship
with the person entertained. pp. I:6-17 and I:6-18.

I:6-17 Generally, under the cash method of accounting the prepayment of expenses will not
result in a current deduction if the expenditure creates an asset with a useful life which extends
substantially beyond the close of the taxable year. However, prepaid interest paid in the form of
points charged in connection with the improvement of the taxpayer's principal residence may be
deducted in the year paid if (1) the loan is secured by the residence, (2) the payment of points is
an established business practice, and (3) the amount of the prepayment does not exceed the
amount generally charged. If the points are paid to purchase (as opposed to improve) the
taxpayer's residence, two additional requirements are that (1) the closing agreement must clearly
designate the amounts as points (e.g., a loan origination fee), and (2) the amount must be
computed as a percentage of the amount of the loan. pp. I:6-19 and I:6-20.

I:6-18 Except for certain taxpayers in certain industries with annual gross receipts of $10 million
or less (or taxpayers with annual gross receipts of $1 million or less), inventories must be
accounted for using the accrual method. As a result, a cash method taxpayer who has inventory
may use both methods of accounting. This constitutes a hybrid method. p. I:6-18.

I:6-19 a. Economic performance occurs as the taxpayer actually provides the property or
services.
b. Economic performance occurs when the property or services are actually provided
to the taxpayer.
c. For recurring liabilities, economic performance can be treated as having occurred
in the year of accrual if all of the following tests are met:

1. The all-events test is met during the year.

2. Economic performance occurs within the shorter of (a) 8 ½ months after the close
of the tax year, or (b) a reasonable period after the close of the tax year.

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 3. The expense is recurring and the taxpayer consistently treats the item as incurred
in the tax year.

4. Either (a) the item is not material or (b) the accrual of the item in the tax year
results in a more proper matching against income than accruing the item in the tax year in
which economic performance occurs.

The recurring liability exception applies only to the following transactions:

1. Another person provides the taxpayer with property or services.

2. The taxpayer uses property.

3. The taxpayer must provide property or services to another person.

4. The taxpayer must make payments to another for rebates, refunds, awards or
prizes, insurance or service contracts, or taxes.

pp. I:6-21 through I:6-23.

I:6-20 Congress enacted the "wash sale" provisions to prevent taxpayers from generating
artificial tax losses in situations where taxpayers do not intend to reduce their holdings in the
stock or securities that are sold. pp. I:6-23 and I:6-24.

I:6-21 Judicial and administrative rulings have held that preferred stock of a corporation is not
considered substantially identical to common stock of the same corporation. However, bonds of
the same corporation that have maturity dates within a few months of each other have been held
to be substantially identical. pp. I:6-24 and I:6-25.

I:6-22 a. An individual's spouse, brothers and sisters, ancestors, and lineal descendants are
considered members of the taxpayer's family for purposes of Sec. 267.
b. The term "related parties" under Sec. 267(b) includes (1) an individual and a
corporation in which the individual owns more than 50% of the value of the outstanding stock,
(2) various relationships between grantors, beneficiaries, and fiduciaries of a trust, a corporation and
a partnership if the same persons own more than 50% in value of the stock of the corporation and
more than 50% of the partnership, and two corporations if the same persons own more than 50% in
value of both corporations and at least one of the corporations is an S corporation. These
relationships are included because the taxpayer may be able to exert control or influence which may
keep transactions between the parties from being completely at arm's length. pp. I:6-26 and I:6-27.

I:6-23 Congress has imposed the concept of constructive ownership to prevent taxpayers from
attempting to circumvent the related party rules by dispersing ownership of a corporation among
family members or related entities while at the same time retaining economic control. p. I:6-26.

I:6-24 On a subsequent sale of the property, the related purchaser may reduce a gain the
purchaser realized by the amount of the disallowed loss. However, the disallowed loss is
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allowable only to the extent of the gain recognized on the subsequent sale by the related
purchaser. p. I:6-28.

I:6-25 The $1,000 income from the hobby is included in Jill's gross income. Since hobby
expenses are deductible up to the amount of the income from the hobby, $1,000 of the hobby
expenses are potentially deductible. However, they are deductible as from AGI miscellaneous
itemized deductions subject to the 2% of AGI limit. Thus, unfortunately none of the expenses of
the hobby are deductible since they do not exceed this limit ($71,000 x .02 = $1,420). pp. I:6-29
and I:6-30.

I:6-26 Under Section 280A, a day of personal use of the vacation home includes any day that the
property is used for personal purposes, (1) by the taxpayer or his/her family, (2) by any
individual under a reciprocal-use arrangement, and (3) by an individual not paying a fair rental
for the property. p. I:6-32.

I:6-27 According to the IRS, expenses are allocated to the rental use of a vacation home by the
following formula:

rental use number of rental days total expense

= x
expenses total number of days used for year

However, the Tax Court and the 9th and 10th circuit courts of appeal have held that the
allocation of interest and taxes to the rental use may be done by taking into account all the days
in the year. Thus, the denominator in the allocation fraction for interest and taxes would be 365 if
this approach is used.
The expenses allocated to rental use are deducted in the same order as expenses under the
hobby loss rules:

1. Expenses that the taxpayer may deduct even if not incurred in a trade or business
or investment activity,

2. Other expenses that could be deducted if incurred in a business or investment

activity but which do not reduce the tax basis of the vacation home,

3. Expenses of the vacation home that could have been deducted if incurred in a
trade or business or investment activity that do reduce the tax basis in the asset.
pp. I:6-32 and I:6-33.

I:6-28 Pursuant to Sec. 280A(g), the taxpayer will not have to report any rental income or rental
expenses from the vacation home if two tests are met. These tests are, (1) the taxpayer uses the
vacation home as a residence for the taxable year, and (2) the taxpayer actually rents the vacation
home for less than 15 days during the taxable year. In order for the vacation home to qualify as a
residence of the taxpayer, the taxpayer must use the vacation home for personal purposes for
more than the greater of (a) 14 days or 10% of the total rental days for the taxable year. Thus, in
this case since the taxpayer has rented the property for only 12 days during the year, if
the taxpayer personally uses the vacation home for more than 14 days during the taxable year

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(the greater of 14 days or 10% of the total rental days), the taxpayer won’t have to report any of
the rental income or rental expenses from the vacation home. Additionally, if the vacation home
qualifies as a residence of the taxpayer (the taxpayer’s personal use exceeds the greater of
14 days or 10% of the total rental days), the taxpayer can still deduct the interest and property
taxes attributable to the vacation home as itemized from AGI deductions. If the taxpayer does
not have enough personal-use days to qualify the property as a residence, the property may be
considered either (1) a hobby or (2) an investment or business. pp. I:6-33 and I: 6-34.

Issue Identification Questions

I:6-29 The primary tax issue is whether the exercise equipment qualifies as a trade or business
expense, an unreimbursed employee expense, or is a nondeductible personal expense.
A secondary issue is whether the cost of the equipment would be capitalized and depreciated or
whether Sec. 179 would apply to permit an immediate write-off of the cost of the equipment
(assuming that the equipment is business or employment-related). The facts in this question are
similar to those in David A. Kelly, 1991 PH T.C. Memo ¶ 91,605, 62 TCM 1406 where the
taxpayer, an employee of Arthur Young & Co., before the purchase of the equipment belonged to
two health clubs. Because of his long hours of work; the facilities were often closed by the time
he got off work. The court held that, despite his need to maintain a rigorous work schedule, the
health benefits were inherently personal in nature. The Tax Court compared the equipment with
eye-glasses and business suits, stating that these too are necessary for business, but due to their
personal nature, are not deductible. p. I:6-2.

I:6-30 The primary tax issue is whether Gus may deduct the $50,000 payment to his
ex-girlfriend as an ordinary and necessary business expense. To be deductible under Sec. 162(a),
an expense must be ordinary and necessary, and incurred in carrying on the taxpayer's trade or
business. To be deductible under Sec. 212(1), an expense must be ordinary, necessary, and paid
for the production of income. The facts in this question are similar to a tax court case Michael
Harden, 1991 PH T.C. Memo ¶ 91,454, 62 TCM 756 in which the court held that the potential
charges were personal in nature, rather than of a business nature. Thus, the payment was
nondeductible. The threat of termination is a consequence of the personal matter. The taxpayer
argued that he would never have paid the amount if the team had not threatened to fire him.
However, the tax court held that the reason for the payment was of no consequence. pp. I:6-7
and I:6-8.
I:6-31 The primary tax issue is whether the payment of the mortgage interest by Kathleen is
deductible as an itemized deduction. The facts in this question are similar to Kathleen M.
Emmons, 1961 PH T.C. Memo ¶ 61,290, 20 TCM 1513 where the tax court did not allow
Kathleen an interest expense deduction because the indebtedness was not hers. The fact that
Molly was Kathleen's dependent was irrelevant to the issue. pp. I:6-9 and I:6-10.

I:6-32 The primary tax issue is whether the activity is a business or a hobby. If the activity is
deemed to be a business, the classification of the income and expenses and the deductibility of
the losses need to be considered. If the activity is deemed to be a hobby, the application of the
hobby loss limitation rules needs to be considered. The facts in this situation appear similar to
Mark A. Stephens, 1991 PH T.C. Memo ¶ 91,383 62 TCM 430 where the Tax Court ruled that
the activity was a business. However, this situation is different from the Stephens case in a few
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respects. Most importantly, there is no evidence that Katie and Alan conduct the activity like a
business, that they maintain an accounting system, or that they promote the activity. However,
Katie and Alan might still be found to have a business because Alan acquired training and advice
from professionals and they take patrons out during the times of demand. Katie and Alan could
elect to keep the tax year open to take advantage of the presumptive rule. But, if their company
goes out of business because of inability to obtain liability insurance, like the Stephens’ did, the
presumptive rule will not help Katie and Alan. pp. I:6-5, I:6-29, I:6-30 and I:6-37.

Problems
I:6-33 a. Because Roberta is not reimbursed for any of these employee business expenses,
she must report them as miscellaneous itemized deductions from AGI. All of the expenses
qualify for deductibility. However, Roberta must reduce the potentially deductible amount of the
client meals by $200 (50% of the total $400 meals and entertainment expenses). Thus, the total
of Roberta’s unreimbursed employee business expenses that are potentially deductible is $1,225
($1,425 - $200). Roberta must then add this amount to her other miscellaneous itemized
deductions to determine if the total exceeds 2% of Roberta’s AGI. If so, Roberta adds the
amount in excess of the 2% of AGI to the rest of her itemized deductions to determine if the total
of all her itemized deductions exceeds the standard deduction. Itemized deductions are discussed
in more detail in Chapter 7.
b. Reimbursed employee business expenses generally are deductions for AGI. In
this case, Roberta won’t have to report either (1) the reimbursement as income or (2) the
reimbursed employee business expenses because the expenses are accounted for and reimbursed
under a plan where Roberta must report the expenses to her employer in order to be reimbursed.
Thus, the reimbursement and the expenses cancel each other out. Under this situation, the 50%
reduction of the deduction for the client meals and entertainment applies to the employer.
(See Chapter 9 for a discussion of the treatment of employee business expenses).
c. All of the expenses qualify as for AGI deductions because Roberta incurred them
in her own business. Thus, Roberta will report them as deductible business expenses on her
Schedule C. Here again, however, Roberta can only report $1,225 ($1,425) as deductions
because she can only deduct 50% of the client meals and entertainment. pp. I: 6-3 and I: 6-4.

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I:6-34
Kent’s taxable income is $122,600, calculated as follows:
Income:
Salary $150,000
Dividends 800
Interest 1,500
Rental income $8,000
Minus: For AGI deductions
Maintenance $ 500
Property taxes 1,000
Utilities 2,400
Depreciation 1,700
Insurance 800 (6,400) 1,600
Loss on sale of stock ( 2,000)
Alimony ( 10,000)
AGI $141,900
Minus: Itemized deductions:
Medical $6,000
Minus: .1 x $141,900 (14,190) -0-
Taxes 4,300
Contributions 4,000
Interest 7,000
Casualty loss 6,100
Minus: ( 100)
Minus: 0.10 x $141,900 (14,190) -0-
Miscellaneous itemized deductions 1,200
Minus: 0.02 x $141,900 (2,838) -0-
Itemized deductions 15,300 ( 15,300)
Personal exemption ( 4,050)

Taxable income $122,550

pp. I:6-3 and I:6-4.

I:6-35 1. Replacement of roof - capitalize and depreciate.

2. Repainting of interior - deduct as an expense.

3. Repair of door handles and installation of locks - deduct as an expense.

4. Replacement of broken windows - deduct as an expense.

5. Replacement of crumbling sidewalks and stairs - capitalize and depreciate.

Note that the Treasury has recently issued new regulations that have very detailed
instructions and examples regarding how to determine whether an expenditure is to be
capitalized or deducted.

pp. I:6-10 and I:6-11.

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I:6-36 a. Eljay, LLP may only deduct the $150 expended for the presentation to the county
council since these expenses were incurred in direct connection with an appearance before a
local council which was dealing with legislation that was of direct interest to Eljay's business.
The other expenditures are all nondeductible. Furthermore, they exceed the $2,000 de minimis
exception.
b. Eljay may deduct all $2,100. As explained in (a), the $150 expended for the
presentation to the county council is deductible under the local legislation exception.
Furthermore, since the total of the other expenditures does not exceed $2,000 ($900 + $700 +
$300 + $50 = $1,950) they are all deductible under the de minimis exception. pp. I:6-14 and
I:6-15.

I:6-37 a. Not deductible. The title search should be capitalized as part of the cost of the
building.
b. Deduction for AGI. This is an ordinary and necessary business expense.
c. $400 is a deduction for AGI and $100 is a miscellaneous itemized deduction.
d. Not deductible. This represents a personal expenditure.
e. Deduction for AGI. This is an ordinary and necessary business expense.
pp. I:6-6 and I:6-7.

I:6-38 Damian Corp.’s taxable income from this illegal business activity is $355,500, computed
as follows:
a. Sales $750,000
Minus: Cost of goods sold (270,000)
Gross income $480,000
Minus: Salaries $75,000
Freight 22,500
Lease Payments 15,000
Interest 12,000
Total (124,500)
Taxable income $355,500

The bribes of $30,000 are not deductible. pp. I:6-12 through I:6-14.

b. Taxable income is $480,000 ($750,000 - $270,000). Under Sec. 280E, expenses

incurred in the illegal trafficking of a controlled substance are not deductible. Cost of goods sold
is not a deduction but is used to compute gross income. pp. I:6-12 through I:6-14.

I:6-39 a. The payment is not deductible because it is an illegal bribe paid to a government
employee. Note that the Department of Veterans Affairs is an agency of the federal government.
b. Not deductible if it is unlawful under the Foreign Corrupt Practices Act of 1977.
c. Not deductible if the state law making the payment illegal is generally enforced.
pp. I:6-12 through I:6-14.

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I:6-40 a. The expenses are currently deductible because Big Bang, LLP is already in the
business of operating entertainment galleries.
b. The expenses are currently deductible because Big Bang, LLP is already in the
business of operating entertainment galleries. pp. I:6-15 and I:6-16.

I:6-41 a. The expenses are not deductible because Big Bang, LLP is not engaged in the
entertainment business and it did not enter the new business.
b. $6,600 current year deduction. Big Bang, LLC may deduct $5,000 in the current
year under Sec. 195, which permits a deduction in the year the business starts up to the lesser of
(1) the amount of start-up expenditures or (2) $5,000. The remaining $36,000 must be amortized
over 180 months starting in May. Thus, this year Big Bang may also deduct an additional $1,600
($36,000/180 x 8 months) of the remaining costs for a total deduction of $6,600 in the current
year. pp. I:6-15 and I:6-16.

I:6-42 Timing of Expense Recognition.

a. 1. Solutions may deduct only $4,000 in the current year. The all-events test
requires that (1) the existence of liability is established, and (2) the amount of
the liability is determined with reasonable accuracy. Although a liability to
the contractor is established, the amount of the liability is uncertain. Because
the amount of the liability can be accurately established only with respect to
$4,000, Solutions Corporation can only deduct that amount on its current-year
tax return. The economic performance test is met because the contractor
performed the remodeling service before the year-end of December 31.

2. Solutions Corporation may deduct $11,500 on its current-year tax return for
the amounts actually paid to service the warranties during the current year. It
cannot take a deduction for its estimated liability for next year because it fails
both the all-events test and the economic performance test. First, the liability
is not certain in existence or amount. Second, the corporation did not perform
work related to the estimated liability.

3. As of December 31, Solutions reports the following related to the trade seminars:
Expenses paid in current year: Expenses to be paid in the following year:

Rent $1,250 Rent $2,500

Seminar Teacher Compensation 1,800 Seminar Teacher Compensation 3,600
Printer 700 Printer 1,400
Total $3,750 Total $7,500

Solutions can definitely deduct the $3,750 paid in the current year. These
expenses meet both the all-events test and the economic performance test.
The expenses to be paid in the following year meet the all-events test because
they are certain in existence and amount. However, the expenses do not meet
the general economic performance test because the services to which they
relate are not performed in the current year. However, Solutions Corporation
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 can deduct the entire $7,500 liability in the current year under the exception to
the economic performance test for recurring liabilities, because:
i. The all-events test is met in the current year,
ii. Economic performance will occur before August 15 of next year,
which is within 8 ½ months of the close of next year,
iii. The expense is recurring and the taxpayer (we assume)
consistently treats the item as incurred in the tax year; and
iv. The accrual of the item in the tax year results in a more proper
matching against income than accruing the item in the tax year in
which economic performance occurs.

b. 1. If Solutions Corporation were a cash-method taxpayer, it could not deduct any

amount of the liability in the current year. It can deduct the remodeling
expense in the period in which it pays the bill, which will likely be the
following year.

2. If Solutions Corporation were a cash-method taxpayer, it could deduct the

$11,500 actually paid to service the warranties.

3. If Solutions Corporation were a cash-method taxpayer, it could only deduct

the amount actually paid in the current year, $3,750.

pp. I:6-18 through I:6-23.

I:6-43 a. $2,000 ($12,000 x 2/12)*. The $5,000 deposit is not deductible.

b. $500 ($18,000 x 1/36)
c. $5,000
d. The $700 worth of stationery and office supplies is not currently deductible
because Pamello uses the cash method of accounting and Pamello didn’t pay for the supplies
during the current year.
e. $1,000

*Note: Following the Zaninovich case cited on p. I:6-19 of the text a taxpayer could deduct the
full $12,000. Perhaps this is also possible in other jurisdictions.
pp. I:6-18 through I:6-20.

I:6-44 a. Total deductions in the current year are $16,200 ($12,000 mortgage interest +
$4,200 in points which represent interest). The points of $4,200 are computed as follows:
$280,000 x .015.
b. The other closing costs (appraisal fee and the title search) are added to the cost
basis of the home. pp. I:6-19 and I:6-20.

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I:6-45 a. Although Broward has a realized loss of $5,000 (selling price of $5,000 – basis of
$10,000) on its sale of the Silver Fox common stock, because of the wash sale provisions it can
recognize only $3,333 of the total realized loss. The wash sale provisions apply in this case
because Broward purchased 250 shares of Silver Fox common stock within 30 days after the sale
of the stock. Thus, $1,667 (250/750 x $5,000) is disallowed. The wash sale rules do not apply to
Broward’s purchase of the Silver Fox preferred stock because the Silver Fox preferred stock is
not considered substantially equivalent to the Silver Fox common stock. Although Broward may
recognize $3,333 of the realized loss, because it is a capital loss Broward may only deduct these
losses against the capital gains it realizes during the year.

b. Broward’s basis in the 250 shares of Silver Fox common stock is $3,417 ($1,750
purchase price plus the $1,667 disallowed loss). The holding period for the newly purchased 250
shares begins on April 17, 2011. Broward’s basis in the preferred stock is its cost of $1,000.
Broward’s holding period in the preferred stock begins on January 2, 2017. pp, I: 6-23 through
I: 6-25.

I:6-46

Transactions
Date in Western Common Stock Amount
March 8, 2011 Purchases 1,000 shares $12,000
October 3, 2017 Purchases 300 shares 3,000
October 12, 2017 Sells original 1,000 shares 8,500
November 1, 2017 Purchases 500 shares 4,000

a. Cougar realizes a total loss of $3,500 ($8,500 - $12,000). However, Cougar can
only recognize $700 ($3,500 x .2) of the total loss. Under the wash sale rules, the remaining
$2,800 of the realized loss is disallowed because Cougar repurchased 80% of the common stock
sold [(300 + 500)/1,000) = 80%] within the 61 day period beginning 30 days before the date of
sale and ending 30 days after the date sale. Because the $700 recognized loss is a capital loss,
Cougar can only deduct it against any capital gains it realizes during the year.

b. The basis in the 300 shares purchased October 3, 2017 is $4,050. [$3,000
purchase price + $1,050 (3/8 x $2,800 disallowed loss)]. The basis in the 500 shares purchased
November 1, 2017 is $5,750. [($4,000 purchase price + $1,750 (5/8 x $2,800 disallowed loss))].
The holding period for both of these blocks of stock starts on March 8, 2011.

c. The recognized loss would be $3,500. Nonvoting, nonconvertible preferred stock

is not substantially identical to common stock in the same corporation. Thus, the wash sale rules
do not apply to the purchase of the preferred stock. Cougar’s basis in the preferred stock would
be the cost of the stock ($3,000 for the October 3rd purchase and $4,000 for the November 1st
purchase) and the holding periods would begin on the respective dates of purchase. pp. I: 6-23
through I: 6-25.

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I:6-13
I:6-47 Constructive Ownership

a. Troy is deemed to own 30% in Berry Corporation (see diagram) because he is

treated as owning the stock owned by his family which, under Sec. 267 includes his wife, Angie,
and his son, Tom. Note that Troy is not deemed to own the stock owned by Jimmy (Troy’s cousin)
or Jimmy’s father (Troy’s uncle), because cousins and uncles are not considered family under Sec.
267. Also note that Troy and Jimmy are partners in TJ partnership. In general, under Sec. 267 a
partner is considered as owning the stock that his/her partner owns. However, this attribution from
a partner doesn’t apply if the only stock the individual is treated as owning is stock owned by
his/her family. Because the only stock Troy is treated as owning is the stock owned by his wife,
Angie, and his son, Tom, he doesn’t own the stock owned by his partner, Jimmy.

Percentage Troy’s
Owner Ownership constructive ownership
Tom (Troy’s son) 20% 20%
Jimmy (Troy’s cousin) 15% 0%
Jimmy’s Father (Troy’s uncle) 30% 0%
Angie (Troy’s wife) 10% 10%
Nicole (Angie’s sister) 25% 0%
100% 30%

Troy Tom
Jimmy Angie
50%
Jimmy’s 50%
Father Nicole
TJ
15%

20% 10%

30%
25%
Berry
Corporation

b. Troy may recognize the entire $5,000 loss because he and Berry Corporation are
not related parties under Sec. 267. Because this loss is a capital loss, Troy can only deduct the
recognized capital loss against his capital gains for the year, plus an additional $3,000 of capital
losses in excess of his capital gains.
Copyright © 2018 Pearson Education, Inc.
I:6-14
 c. Troy cannot recognize the $5,000 loss. Troy is deemed to own 70% in Berry
Corporation. Thus, he and the corporation are related parties and he cannot recognize the $5,000
loss. He is attributed 10%, from Angie, his wife, and 20% from Tom, his son, because they are
family members under Section 267. He is attributed 12.5% from the partnership, because
partners own their proportionate share of what the partnership owns. Thus, because of this
constructive ownership from the partnership, Troy is treated as owning stock in Berry, Inc. in a
way other than just from his family (Angie and Tom). He is also attributed the 15% that Jimmy
(his partner) directly owns and the 12.5% that Jimmy is deemed to own through the partnership,
because a taxpayer is attributed everything his partner owns except stock that is attributed to the
partner through family attribution (the 30% owned by Jimmy’s father.)
Percentage Troy’s
Owner Ownership constructive ownership
Tom (Troy’s son) 20% 20%
Jimmy (Troy’s cousin) 15% 15%
Jimmy’s Father (Troy’s uncle) 30% 0%
Angie (Troy’s wife) 10% 10%
TJ Partnership 25% 25%

100% 70%

Troy is attributed stock from TJ Partnership, Jimmy, Angie, and Tom.

Troy

Jimmy 50% 50% Tom

TJ

Jimmy’s Angie
15% 20%
Father
25%
30% 10%
Berry
Corporation

pp. I:6-26 through I:6-29.

Copyright © 2018 Pearson Education, Inc.

I:6-15
I:6-48 a. Ralph may recognize the loss of $10,000 on the sale of the land to Burnham, Inc.
Of course, this loss is a capital loss and is first offset against his other capital gains. Any capital
loss in excess of his other capital gains is only deductible up to $3,000 per year. Any excess
must be carried over to subsequent years. In order to determine if the loss disallowance rules of
Sec. 267 apply, we must determine Ralph’s actual and constructive ownership in Burnham, Inc.
This ownership is determined as follows:

Actual Ownership 10%

Through Thann (Ralph’s brother)
Thann’s actual ownership 10
Thann’s ownership through PIB (.4 x .7) 28 38%
Total 48%

Because under Sec. 267, Ralph doesn’t own over 50% in Burnham, Inc., he may
recognize the loss.

b. Thann’s entire loss is disallowed. Under Sec. 267, Thann is treated as owning
100% of Burnham, Inc., computed as follows:

Actual Ownership 10%

Through Ralph (Thann’s brother) 10%
Through PIB to himself (.7 x .4) 28%
Through PIB to his partners (.7 x .6) 42% 70%
Through Sara, his partner 10%

Total 100%

Note that since Thann owns stock in Burnham, Inc. other than through a family
member, he is treated as owning the stock actually and constructively owned by his partners.
Thus, the loss is disallowed. However, when Burnham, Inc. subsequently sells the land for a
gain, it may offset up to $10,000 of the gain it recognizes. If it subsequently sells the land at a
loss, Thann’s disallowed $10,000 loss is completely lost.

c. Thann can recognize the loss and offset it against his other capital gains. Any
capital loss in excess of his other capital gains is deductible up to $3,000 in the
current year. The remainder is carried over to subsequent years. Thann is treated
as owning only the 40% that Ralph owns. Because the only stock he is
considered as owning is attributed to him from a family member, he is not treated
as owning the stock in Burnham, Inc. that his partner, Sara owns.

pp. I:6-26 through I:6-29.

Copyright © 2018 Pearson Education, Inc.

I:6-16
I:6-49 Since Sally is considered a related party to Sage Corporation (she constructively owns
60% of the corporation through her brother and grandmother), the corporation may only deduct
the payment in the year that Sally reports the payment as income. Thus, each alternative
situation is taxed as follows:

a. 1. Sally must report the income in 2016.

2. Sage Corporation must deduct the expense in its tax year ending January 31,
2017.
b. 1. Sally must report the income in the year ending December 31, 2017.
2. Sage Corporation must deduct the expense in its tax year ending January 31,
2017.
c. 1. Sally must report the income in the year ending December 31, 2017.
2. Sage must deduct the expense in its tax year ending January 31, 2018.

pp. I:6-28 and I:6-29.

I:6-50 a. Since CVI Corporation and Sandi are related parties under Sec. 267, the $23,000
loss is disallowed.
b. 1. Sandi will recognize no gain or loss. The $10,000 subsequent gain
($85,000 - $75,000) is reduced by the $23,000 disallowed loss. The entire disallowed loss
cannot be used to create a loss on the subsequent sale.
2. There are no tax consequences to CVI Corporation upon the subsequent
sale by Sandi. The remaining $13,000 loss is completely lost.
c. Sandi will recognize a loss of $5,000 ($70,000 - $75,000 basis). The $23,000
previously disallowed loss is completely lost.
d. Sandi will recognize a gain of $7,000 ($105,000 - $75,000 = $30,000 gain,
reduced by the $23,000 disallowed loss). pp. I:6-25 through I:6-28.

I:6-51 Rachel may make an election to keep 2016 open for possible audit with respect to her
bath product sales until the end of 2019 is past so that the presumptive test may be applied. If
she has income from her sales in 2017, 2018, and 2019, the burden of proof will shift to the IRS.
The IRS will have to prove that her bath product business is a hobby in order to disallow the loss
from 2016. pp. I:6-29 and I:6-30.

I:6-52 Emily cannot make the election to keep the year open. The election allows the year in
question to remain open with respect to the activity until sufficient years have passed so that the
presumptive test may be applied. The election must be made within 3 years after the due date for
the year in which the taxpayer first engages in the activity. In this situation, Emily has had losses
four out of six years and the profits test is not met during those years. pp. I:6-29 and I:6-30.

Copyright © 2018 Pearson Education, Inc.

I:6-17
I:6-53 a. Since this activity is a hobby, Chuck can potentially deduct a total of $1,100 of
the expenses related to the hobby activity. This amount is limited to the income Chuck realizes
from the hobby, and is calculated as follows:

Gross income ($800 + $300) $1,100

Minus: Property Taxes ( 200)
900
Minus: feed and veterinary fees (limited to remaining income) ( 900)
Net $ -0-

b. All of the expenses are deductions from AGI since the activity is a hobby. If
Chuck itemizes his deductions, all of the property taxes may be deducted and all but $200 of the
feed and veterinary expenses may be deductible subject to the 2% of AGI limit on miscellaneous
itemized deductions. No depreciation is allowed. These expenses, of course, are deductible only
if the sum of Chuck’s itemized deductions exceeds the standard deduction.
c. -0-. None of the depreciation was deducted so the basis of the hutches is not
reduced. pp. I:6-29 through I:6-31.

I:6-54 a. Since this activity is a hobby, Chuck can potentially deduct a total of $1,500 of
the expenses related to the hobby activity. This amount is limited to the income Chuck realizes
from the hobby ($1,200 + $300), and is calculated as follows:

Gross income ($1,200 + $300) $1,500

Minus: Property Taxes ( 200)
1,300
Minus: feed and veterinary fees ( 1,100)
Minus: Depreciation (limited to remaining income) ( 200)
Net $ -0-

b. All of the expenses are deductions from AGI since the activity is a hobby. All of
the property taxes and all the feed and veterinary expenses are deductible. However, the
deduction for depreciation is limited to $200. The deduction for the feed, veterinary fees and
depreciation are miscellaneous itemized deductions subject to the 2% of AGI limitation.
c. $200 The cost basis in the rabbit hutches is reduced only by the amount of the
depreciation that is deducted. pp. I:6-29 through I:6-31.

Copyright © 2018 Pearson Education, Inc.

I:6-18
I:6-55 a. Kim may take a $9,000 deduction for AGI and a $1,000 deduction from AGI, as
follows:
Interest and taxes of $3,000 (60/80 x $4,000) are for AGI deductions.*
The remaining taxes of $250 and interest of $750 (if the interest is qualified
residence interest) are deductions from AGI.
Insurance (60/80 x $500) = $375 for AGI deduction.
Repairs and Maintenance (60/80 x $700) = $525 for AGI deduction.
Utilities (60/80 x $800) = $600 for AGI deduction.
Depreciation of $4,500 for AGI deduction (60/80 x $8,000 = $6,000; but limited
to $4,500 remaining income).
The nondeductible part of the depreciation allocated to the rental ($1,500) may be
carried over to the next year.
b. Basis is reduced by $4,500.

*Note, however, that if the approach sanctioned in the Bolton case (see the discussion on page
I:6-32 and 33 and footnote I6-52 in the text) is used, $658 (60/365 x $4,000) of interest and taxes
would be allocated to the rental portion leaving more of the second and third tier expenses to be
deductible.
pp. I:6-31 through I:6-34.

I:6-56 Since Kim used the condominium over 14 days during the year for personal purposes, it
qualifies as a residence. The condo was rented out for less than 15 days during the year. Thus,
Kim will report no income or deductions from the property. However, Kim may deduct the
property taxes from AGI, and if Kim chooses the condominium as her second personal residence,
she also can deduct the interest from AGI. pp. I:6-31 through I:6-34.

Copyright © 2018 Pearson Education, Inc.

I:6-19
Comprehensive Problems
I:6-57 1. Bryce’s taxable income is $87,700 computed as follows:

Salary $100,000
Net capital gain (3,000 + 5,000 – 2,000) 6,000
Hobby income 2,500
AGI $108,500
Itemized deductions:
Property taxes $125
Misc. itemized deductions:
Other 5,000
Hobby Expenses:
(2,900 + 270 + 200 = 3,370)
Limited to remaining income (2,500 – 125) 2,375 7,375
2% of AGI ($108,500 x 0.02) (2,170) 5,205
Total (less than standard deduction) $5,330
Standard deduction (12,700)
Personal exemptions (2 x 4,050) (8,100)
$87,700

Because the building lot was sold to Bryce's brother, the $7,000 loss is
disallowed. Bryce realized a $3,000 ($8,000 - $5,000) gain on the sale of Gold Corporation
stock, a $4,000 loss ($5,400 - $9,400) on the sale of the Silver stock, and a $5,000 gain ($12,000
- $7,000) on the sale of the United stock. All $8,000 of the gain is recognized. However,
because Bryce purchased 100 shares of Silver Corporation stock within 30 days before the sale
of the Silver Corporation stock, one-half of the loss is disallowed. Thus, only $2,000 (0.50 x
$4,000) of the loss is recognized. Assuming Bryce’s fly-tying activities are a hobby, the
deductible expenses are limited to the gross income generated from the activity. Furthermore,
they are all deductions from AGI.
2. Bryce's basis in the Silver stock is $4,800 ($2,800 + $2,000 disallowed loss).

pp. I:6-29 through I:6-31.

I:6-58 1. Jaron qualifies as a surviving spouse because his wife died just two years ago.
Jaron receives three personal exemptions at $4,050 each for a total of $12,150 (one for himself
and one each for his two youngest children). His son Danny doesn’t qualify as a dependent
because Danny is neither a qualifying child (he is over 19 and is not a full-time student) nor a
qualifying relative (Danny’s gross income exceeds the exemption amount of $4,050). Laura
doesn’t qualify because she is filing a joint return with her husband, Chad.
2. Jaron is not allowed a home office deduction for the expenses allocable to his
home office because Jaron’s use of the office in his home doesn’t meet any of the following
requirements: (1) the home office is not his principal place of business, (2) Jaron doesn’t meet
with clients in the home office, and (3) Jaron has another office where he conducts the
administrative and managerial activities of the business. The property taxes on Jaron’s home are
Copyright © 2018 Pearson Education, Inc.
I:6-20
deductible as a “from” AGI deduction if the sum of all itemized deductions exceeds the standard
deduction of $12,700. In this case, the sum is less than the standard deduction, so Jaron receives
no deduction for the payment of the property taxes on his personal residence.
3. Laura and Chad’s use of the rental apartment is considered personal use of the
apartment. However, Jaron’s personal use of the rental apartment is less than 10% of the number
of days the apartment was rented out (270 x .1 or 27 days) so the condominium is not considered
Jaron’s resident and the provisions of §280A do not apply. The net income from the rental is
calculated as:
a. Rental income $18,000
b. Interest (3,150) x (270/294)= ( 2,893)
c. Taxes (1,700) x (270/294)= ( 1,561)
d. Other expenses (6,000) x (270/294)= ( 5,510)
e. Depreciation (7,090) x (270/294)= ( 6,511)
f. Total $ 1,525

Note that the allocation formula used for interest and taxes is based on the total number of days
used rather than the modified allocation formula allowed by the courts (which would have
allocated the interest and taxes using a ratio of 270/365. Use of this ratio allocates more interest
and taxes to the rental use of the condominium, which allows Jaron to claim more overall
deductions. Since the condo does not qualify as Jaron’s residence, the interest allocated to the
personal use is not deductible. Furthermore, although the taxes of $139 allocated to the personal
use ($1,700 - $1,561) generally would be deductible as a “from” AGI deduction, the total of
Jaron’s itemized deductions does not exceed the standard deduction.

4. Jaron’s land transaction has the following tax consequence:

LTCG on land: ($75,000 - $70,000) $ 5,000
Brother’s disallowed loss (related party) (4,000)
$1,000
5. Jaron’s stock transaction has the following tax consequence:
STCL on Genomics: (8,000 - $10,000) ($2,000)

With the $1,000 LTCG on the land and the $2,000 STCL on the Genomics stock, Jaron
will have a net STCL of $1,000, all of which is deductible (up to $3,000).

6. Jaron reports $98,500 net income from his consulting business on Schedule C,
calculated as follows:

a. Consulting fees received $185,000

b. Wages expense ( 47,400)
c. Rent expense ( 20,000)
d. Depreciation ( 2,100)
e. Other expenses ( 17,000)
f. Net income $ 98,500

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I:6-21
 7. Jaron’s 2017 income tax liability, ignoring any available credits and self-
employment taxes is $10,194, calculated as follows:

Income: Net Business income (Sch. C) $98,500

Capital gain or (loss) (Sch. D) $1,000
(2,000) ( 1,000)
Net rental income (from Sch. E) 1,525

AGI: $99,025
Standard deduction (12,700)
Personal & dependency exemptions (3 x $4,050) (12,150)

Taxable Income $74,175

Tax Liability (based on surviving spouse status) $10,194

pp. I:6-31 through I:6-34.

Tax Strategy Problems

I:6-59 The business is currently facing a $200 loss for 2017. If the loss is reported on Danielle’s
Schedule C, it will be the third loss reported in the past five years. Therefore, the activity will
not meet the safe-harbor rule (ie. if a business activity generates a profit in three out of five
consecutive years, the burden of proof shifts to the IRS, and the activity will not likely be subject
to hobby loss rules).

If the business can generate a profit for 2017, it will meet the safe-harbor rule. To do so,
Danielle must accelerate income recognition and defer payment of expenses.

First, she can accelerate the recognition of income. Danielle should not wait until the end
of the month to bill the Springville Orchestra, but should hand-deliver a bill immediately. The
orchestra will likely pay the bill within ten days, before December 31. As soon as the orchestra
mails the check, Danielle can recognize the income. By including this item of income, the
business reports a profit of $800.

If Danielle continues her practice of paying bills right away, she will incur $1,000 in
additional expenses. If she also claims a $75 deduction for meal costs, she will net a $275 loss.
So, she should delay paying her bills until January 1, even if the delay requires her to hand-
deliver payment at that time. She should still take the meal deductions, as that expense will be
lost if she does not claim it on her 2017 return. The final result is as follows:

Copyright © 2018 Pearson Education, Inc.

I:6-22
2017 Schedule C

Income received before 12/12/2017: $9,000

Payment from Springville Orchestra: 1,000
GROSS INCOME $10,000
General Expenses 9,200
Meals (150 x 50%) 75
Total Expenses 9,275
Net Income Reported on Schedule C $ 725

Deductions in 2018 when paid:

Refurbishing repair/maintenance expense 300
Newspaper advertisement expense 200
Printer advertisement expense 500
$1,000

The tax practitioner should strongly advise the client to distinguish her performing
activities from personal activities by maintaining a separate bank account, account books and
records, and perhaps dedicating an area of her home to performing managerial and administrative
duties relating to the business.

pp. I:6-29 through I:6-31.

I:6-60 TO: Peter Baumann

FROM: Student, CPA
DATE: October 12, 2017
SUBJECT: Sale of printing press

I have looked over your transaction, and it appears that selling your printing press to
Chamberlain Corporation will produce some unfavorable tax consequences.

You are not allowed to deduct any loss on a sale of property to a related party. Under the
definition of related parties in Sec. 267 of the Internal Revenue Code, you are considered
owning 75% of Chamberlain Corporation. (12.5% through the Coxmann Partnership,
30% through Emily Cox (Emily is considered as owning 12.5% through Coxmann
Partnership and 17.5% through Chloe, International, Inc.) 7.5% through your sister,
Susan, and 25% through your brother, Brian.) This means that you are considered related
to Chamberlain Corporation, and you will not be able to deduct the $40,000 loss if you
sell the press to Chamberlain. Chamberlain will have a basis of $50,000 in the press. If
Chamberlain sells the press at a gain later, it will be able to offset the gain to the extent of
your disallowed loss.

Copyright © 2018 Pearson Education, Inc.

I:6-23
 I recommend that you sell the printing press to an unrelated third party. That way, you
will be able to deduct your $40,000 loss. Chamberlain Corporation may then buy a
comparable press from an unrelated party.

If you have any questions, please give me a call. Thank you.

Sincerely,

Student, CPA

pp. I:6-26 through I:6-28.

Tax Form/Return Preparation Problems

I:6-61 (See Instructor’s Resource Manual)

I:6-62 (See Instructor’s Resource Manual)

I:6-63 (See Instructor’s Resource Manual)

Case Study Problem

I:6-64 FACTS:

1. John left his employment in 2010 and in 2011 created a fishing charter service.

2. John was an avid fisherman and Kathy, a CPA, assisted John in creating a
business plan. They also opened a bank account for the charter service,
developed a bookkeeping system, and acquired insurance to cover the boat and
passengers.

3. John completed the requirements to acquire the necessary licenses. He advertised

the charter service in local newspaper and magazines.

4. The activity was unprofitable in 2 of 4 years from 2011 through 2014.

5. In 2015, John started full-time employment with an insurance company and

continued to take paying and non-paying parties each weekend throughout the
fishing season. John's costs increased unexpectedly and the activity lost $8,000 in
2015.

Copyright © 2018 Pearson Education, Inc.

I:6-24
 ISSUES:
Are the Browns engaged in the activity for profit, which would allow all expenses
related to the activity to be deducted under Sec. 162 or is the activity a hobby with expenses
deductible only to the extent of gross income under Sec. 183?

DISCUSSION:
Reg. Sec. 1.183-2(b) provides a list of factors to assist in determining whether an
activity is engaged in for profit. The list is as follows:

1. Whether the taxpayer conducts the activity in a businesslike manner.

2. The expertise of the taxpayer or his advisors.
3. The time and effort expended by the taxpayer in carrying on the activity.
4. Whether the assets in the business are expected to appreciate.
5. The taxpayer's success in carrying on other similar activities.
6. The taxpayer's history of income or losses with respect to the activity.
7. The amount of occasional profits, if any, that are earned.
8. The taxpayer's financial status.
9. Any elements of personal pleasure or recreation which the activity might involve.

For the following reasons the charter activity might be determined to be engaged in for
profit:

1. The activity was carried on in a businesslike manner. This is evidenced by the

business plan, an established bookkeeping system, insurance, licenses,
advertising, and the restructuring.

2. The Browns’ expertise. John is an avid fisherman with many years of experience.
Kathy is a practicing CPA and she assisted John in the business portion of the
activity.

3. The time and effort expended in the activity. Even though John was employed
full-time, he devoted substantial amounts of time to the activity.

4. The element of pleasure which is involved. Although John enjoys fishing, almost
all of his trips were either with paying parties or promotional non-paying parties.
The fact that Kathy would rarely accompany John is an additional indicator that
the activity was an attempt to produce income and not done for recreation.

Copyright © 2018 Pearson Education, Inc.

I:6-25
 The activity might be classified as a hobby for the following reasons:

1. The assets John uses are not expected to appreciate.

2. John’s history of income and profits indicate the activity was a hobby. He
incurred a loss in three of the five years of operation.

3. When a profit was made, the amount of profit was relatively small.

4. John’s financial status also might indicate the activity was a hobby. He was
employed in a full-time job during 2015.

The factor dealing with the taxpayer's success in carrying on other similar activities does
not apply to the Brown's situation. They had never tried a similar venture.

Using the regulation as a research source, a student may be able to establish a strong
argument for both sides in this case. However, the weight of the evidence probably leans
towards a determination that John is engaged in a business. See John R. Zwicky, 1984 PH T.C.
Memo ¶84,471, 48 TCM 1026.

p. I:6-36.

Tax Research Problems

I:6-65 FACTS:

1. Richard Penn is the president and part owner of an architecture consulting firm.

2. He also owns 25% of a corporation which is now bankrupt.

3. Many unsecured creditors of the corporation were unable to collect on the debts.

4. Some of the bankrupt corporation's creditors are also clients of Richard's firm.

5. Richard was not obligated to pay off the corporation's debts. However, he did pay
the debts because he felt that it was necessary to improve his business reputation
with the customers of his architecture firm.

Copyright © 2018 Pearson Education, Inc.

I:6-26
ISSUES:
1. Can Richard deduct the amount he paid on behalf of the bankrupt corporation?

CONCLUSIONS:
1. Richard may deduct, under Sec. 162, the amount paid to those who are also
customers of his consulting firm.
2. Richard may not deduct the amount paid to the other creditors of the corporation.

DISCUSSION:
Sec. 162 allows a deduction for business expenses that are incurred for a business motive,
and are ordinary and necessary.

Many times the determination of whether a payment is ordinary and necessary is

extremely difficult. A landmark case in this area is Welch v. Helvering, 12 AFTR 1456,
3 USTC 1164 (USSC, 1953). In the case, the Supreme Court decided that when a
taxpayer paid the debts of his former corporation because he dealt with many of the same
customers in his new job, the payments were not deductible. The Court stated that the
payments were made to build goodwill in his new employment, instead of preserving his
existing business reputation. See also Earl E. Cloud, 1976 PH T.C. Memo ¶76,027, 35
TCM 95. and Justice Steel, Inc., 1980 PH T.C. Memo 80,466, 41 TCM 209.

The determination of whether a necessary business motive is present can also be difficult.
In Paul L. Dunmire, 1981 T.C. Memo ¶81,372, 42 TCM 438 the taxpayer owned 99% of
a furniture corporation; however, he did not actively participate in the operations of the
corporation. The taxpayer pledged stock owned in another corporation to obtain the
furniture corporation's loans. When the furniture corporation wasn't able to pay its
creditors, he made direct payments to the corporation's creditors so that he would not lose
his stock and maintain his business reputation. The court decided that a business motive
did not exist.

The courts have decided that payments made to maintain a present professional
reputation are deductible. In William A. Thompson, 1983 PH T.C. Memo ¶83,487, 46
TCM 1109, the taxpayer owned 51% of a coal mine, which eventually liquidated. The
taxpayer stated he felt morally bound to repay the corporation's creditors and later repaid
all the debts of the liquidated mine. The court allowed a deduction for the payments
made to creditors who were also clients of Thompson's engineering firm. See also
Warren Young v. US, 56 AFTR 2d 85-5196, 85-2 USTC 9643 (D.C. No. Dist. of Okla.)
and Harold L. Jenkins, 1983 PH T.C. Memo ¶83,667, 47 TCM 238.

From the court cases cited, Richard can make a strong argument for deducting the
payments he made to the creditors who were also clients of his architecture firm.

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I:6-27
I:6-66 FACTS:
1. Paul Wilde owns a large portfolio of stocks and securities which he manages
himself.
2. His investing philosophy is to purchase and hold stocks for the dividends and
long-term growth.
3. Although he buys and sells stock regularly during the year, most of the stocks he
sells have been held over one year.
4. This year he has rented a suite of offices and has hired two investment assistants
and four secretaries. He has also purchased some new computer equipment and
office furniture for the offices.

ISSUES:
1. Do Paul’s activities constitute a trade or business, or are they an investment
activity?
2. What is the tax treatment of his expenses? Specifically, are they deductions “for”
or “from” AGI?

CONCLUSIONS:
1. Paul’s activities are not considered a business. Instead, Paul is involved in an
investment activity.
2. The expenses are deductions “from” AGI. Additionally, they are deductible only
to the extent they exceed two percent of Paul’s AGI.
3. Paul cannot deduct the purchase of the computers and office furniture under Sec.
179 because they are not used in a business. Instead, they must be capitalized and
depreciated.

DISCUSSION:
In Higgins v. CIR, 25 AFTR 1160, 41-1 USTC §9233 (USSC, 1941), the Supreme Court
held that a taxpayer who merely kept records and collected interest and dividends from
his securities was not involved in a trade or business. This was the case, despite the size
of the taxpayer’s holding. Subsequent cases also indicate that a taxpayer who buys and
sells stocks and securities for the dividends and long-term growth and who is not
involved in short-term trading is not engaged in a trade or business. See also Estate of
Louis Yaeger, Deceased, Judith Winters, Ralph Meisels, Abraham J. Weber and the Bank
of New York, 889 F2d 29, 89-2 USTC ¶9633 (CA-2), Frederick R. Mayer and Jan Perry
Mayer, 67 TCM 2949 (1994), and Rudolph W. and Abbie A Steffler, 69 TCM 2940
(1995). In each of these cases, the taxpayer was more interested in the long-term
investing potential rather than merely trading based upon short term market fluctuations.
Furthermore, the taxpayers were not involved in selling stocks and securities to others in
the capacity of a broker.

Since Paul is deemed to be engaged in an investment activity rather than in a business,

the expenses are deductions “from” AGI. Furthermore, they are deductible only to the
extent that they exceed 2% of Paul’s AGI.

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I:6-28
 Since Paul is not considered engaged in a trade or business, Paul must capitalize and
depreciate the computers and office equipment and cannot take a current section 179
deduction.

“What Would You Do In This Situation?” Solution

Ch. I:6, p. I: 6-36

The determination of whether an activity is truly a business or merely a hobby is always a hot
topic for the IRS because so many taxpayers try to deduct the expenses associated with the
activity even though their intent and purpose of engaging in the activity is really for personal
pleasure rather an attempt to make money. Because you have a long term relationship with
Mr. Gerbeuses, you should feel comfortable initiating a serious and detailed discussion with him.
In this discussion you should address the factors that the IRS uses to determine whether an
activity is a business or a hobby. A partial list of these factors include:

1. Whether the taxpayer conducts the activity in a businesslike manner

2. The taxpayer’s expertise as well as advice he/she receives from advisors
3. The time and effort expended by the taxpayer in the activity
4. Whether the assets used in the activity are expected to appreciate in value
5. The taxpayer’s financial status.
In this discussion, you should also help him identify how to establish the facts that will
demonstrate these factors, including making sure he can document a strong business plan and he
develops proper strategic planning, management and bookkeeping processes. In order to do so
he should document marketing studies, etc.

You should also help him understand the differences in the tax consequences if the activity is a
hobby instead of a business. In this discussion, using actual analytical data could help him
understand the importance of making the right decision and then properly following and
documenting the plan.

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I:6-29