Taxation I I. Is it Income? A.

Prof. Ting, Jan

Fall 2011

IRC § 61(a): Gross Income = all income from whatever source defined. 1. "undeniable accession to wealth, clearly realized, and over which taxpayer has complete dominion" - Glenshaw Glass a) "undeniable accession to wealth" 1. any increase in net worth, regardless of source, is income - Glenshaw b) "clearly realized over which taxpayer has complete dominion" 1. Capital invested in property is not income until it is realized, i.e.: taxpayer gets separate benefit - Eisner v. Macomber 2. Receipt of Financial Benefit a) § 61's broad all inclusive language was meant for Congress to exert the full measure of their taxing power under 16th Amendment - Cesarini 1. treasure trove constitutes taxable income - Reg. § 1.61-14, Cesarini 2. Vesting ordinarily determined by reference to property law in the state - Cesarini b) In the case of compensation for services rendered, the form of payment makes no difference. - Old Colony Trust c) punitive damages awarded still are considered an undeniable accession to wealth, clearly realized, over which the taxpayer has complete dominion. - Glenshaw Glass 1. Congress intended to tax all gains except those specifically exempted d) Loans are non taxable. - § 61 - James v. US

e) Illegal Appropriation is considered income.

f) Frequent flyer miles? When do they become income? 1. discount: offered to everyone vs. income: specifically given to you - Charley 3. Imputed Income 1

Taxation I

Prof. Ting, Jan

Fall 2011

a) Rental value of building owned by taxpayer does not constitute income - Helvering b) If services are paid for other than in money, fmv of property must be included in income. If services are rendered at a stipulated price, it will be presumed to be fmv of compensation received. - Rev. Ruling 79-24 c) You can't avoid taxes by placing property in a corp. if you are in control of it. As long as you still have complete and absolute dominion over it, it is gross income. - Dean v. Commissioner 4. Summary of Gross Income a) not a mere return of capital, and b) not accompanied by a contemporaneously acknowledged obligation to repay, and c) not excluded by a specific statutory provision (§ 61) B. IRC § 102(a): Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance 1. § 102(b): Subsection (a) shall not exclude from gross income a) income from any property; or b) where under terms of gift, bequest, devise, or inheritance is of income from property, the amount of such income. - See Irwin v. Gavit 2. Gift : "proceeds from a detached and disinterested generosity, out of affection, admiration, charity or like impulses. The critical consideration is the intention with which payment, however voluntary, has been made." - Duberstein a) mere absence of legal or moral obligation does not make it a gift b) if payment proceeds primarily from constraining force of any moral or legal duty or from anticipated benefit of an economic nature it is not a gift. c) where payment is in return for services rendered, it is irrelevant that donor derives no economic benefit from it d) donor's characterization of his action is not determinative

2

Taxation I

Prof. Ting, Jan

Fall 2011

e) Courts are to "rely on their experience with the mainsprings of human conduct" (base factors on their own experience) 1. destroys uniformity btw. the courts - Frankfurter, J., dissenting 3. Property received from estate of decedent in compromise of his claim is still considered a gift by bequest. This is because he would've never been able to have a claim if he was not considered an heir by statute. - Lyeth v. Hoey 4. IRC § 102(c): Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee. a) 102(c)(2) : Employee achievement awards and de minimis fringes b) See also Bequeaths of property in exchange for services are not considered gifts under 102(a) and rather are income under 61(a). Substance over Form - Wolder v. Commissioner c) Proposed Reg. § 1.102-1(f) 1. does not apply to prizes and awards. 2. if employee can show transfer not made in recognition of employee's employment, transfers btw. related parties if purpose can be substantially attributed to familial relationship of parties and not circumstances of employment = excludable as gross income. C. IRC § 132: Certain Fringe Benefits 1. (a) gross income shall not include any fringe benefit which qualifies as a 1. no additional cost service = § 132(b) a) § 132(b)(2): must be in the same line of business 2. qualified employee discount = § 132(c) a) § 132(c): also incorp. "line of business" in which employer is b) § 1.132-4(a)(1)(iv): performance of services that directly benefit more than one line of business : an employee who performs substantial services for both is treated as performing in all lines of business. 3. working condition fringe = 132(d) 3

Taxation I

Prof. Ting, Jan 4. de minimis fringe = 132(e) 5. qualified transportation fringe = 132(f) 6. qualified moving expense reimbursement = 132(g) 7. qualified retirement planning services = 132(m) 2. 132(h) = individuals treated as employees for subsection (a)(1) and (a)(2) 3. 132(i) = reciprocal agreements 4. 132(j)(1): non discrimination - only applies to (a)(1) + (a)(2)

Fall 2011

a) According to Reg. § 1.132-8 highly paid employees receiving benefits under (a)(1) + (a)(2) cannot exclude any from gross income 5. 132(m): non discrimination - applies to (a)(7) D. Other Exclusions from Gross Income 1. § 79 excludes group term life insurance premiums for up to a max. of $50,000 2. § 112 excludes compensation received by military personnel for service in a combat zone and compensation for periods during which the person is hospitalized as a result of wounds, disease, or injury incurred while serving in a combat zone. 3. § 129 excludes amounts paid by an employer for "dependent care assistance" up to a maximum annual amount of 5,000 (2500 for married individual filing separately) 4. § 137 excludes employer payments of qualified adoption expenses under an adoption assistance program 5. § 134 excludes some additional military benefits 6. § 125 provides for establishment of "cafeteria plans," which allow employees to chose fringe benefits they would like from an umber of fringe benefits w/out loss of exclusion from gross income. E. IRC § 119(a): Meals & Lodging 1. Meals and lodging furnished to employee, spouse, dependents are excluded from gross income only if : a) (1): meals are furnished on business premises of employer, or 4

Taxation I

Prof. Ting, Jan

Fall 2011

1. Jack B. Lindeman: Right across the street considered on premises 2. Commissioner v. Kowalski: Groceries may be meals, but CASH reimbursements are definitely not meals b) (2): employee required to accept such lodging on business premises of his employer as a condition of employment 1. Look to the nature of the business: how many hours employee will have to work and be at the office - how do other businesses in the same trade operate? - Hatt 2. IRC § 119(b) a) (1): Provisions of employment contract or state statute not to be determinative b) (2): fact that a charge is made for meals, and employee may accept or decline such meals shall not be taken into account c) (3): Certain fixed charges for meals d) (4): Meals furnished to employees on business premises where meals of most employees are otherwise excludable 1. more than half of employees to whom such meals are furnished must be furnished for the convenience of the employer 3. 119(d) : Lodging Furnished by certain Educational Institutions to Employees 4. 107 : Rental Value of Parsonages F. IRC § 1001(a) 1. A. AR AB ---------------------G B. AB AR ---------------------L

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Taxation I 2. § 1011 Adj. Basis:

Prof. Ting, Jan

Fall 2011

a) § 1012: Basis of Property is Cost b) § 1016: Adjustments to Basis 3. What is Cost? a) Purchases: 1. Cost is value of property received at the time of of transaction. - Philadelphia Park a) if you don't know value of property received, then as fallback you go with value of property given b) if neither is available, you look to the original cost of the property given b) Gifts: § 1015(a) 1. gifts made after Dec. 31, 1920: a) basis shall be the same as in the hands of the donor, except that if basis is greater than fmv of property at time of gift, then basis shall be fmv. = carryover basis b) See Taft v. Bowers c) Marital rights are considered compensation for gifts, and are subject to purchase-basis for income purposes bargained for exchange - Farid-Es-Sultaneh v. Commissioner d) if it could go either way depending on whether you use donor's basis or basis at the time it is given to donee - See Reg. § 1015-1(a)(2) Example - you basically have to compute both the gain and the loss - it often ends out as a wash c) Part Gift Part Sale 1. 2 Views: a) take the basis and subtract it from the gain 6

Taxation I

Prof. Ting, Jan

Fall 2011

b) divide the value into shares (%) and then make a calculation for each share : both the share he gave away and the share he sold c) Reg. § 1.1015-4: Unadjusted Basis is whichever of the following is greater: 1. amount paid by transferee, or 2. transferor's adjusted basis at time of transfer, and 3. amount of increase if any, in basis for gift tax paid. d) Spouses: § 1041: no gain or loss for transfers to spouse or a former spouse if transfer is incident to divorce 1. the transfer is seen as a gift and has carryover basis e) Inheritance: § 1014 1. basis of inherited property is fmv at date of decedent's death 4. What is Amount Realized? a) IRC § 1001(b) : amount realized is sum of money received plus fmv of property b) fmv of stock considered to be amount realized. Bonuses in any form are in exchange for services of employees. Therefore company held to have gain of the fmv of stock given to employees. - International Freighting Corp, Inc. c) taxpayer who sold property encumbered by non-recourse mortgage must include unpaid balance of mortgage in amount realized. - Crane d) Crane is now going to be applied in situations where fmv is less than amount of debt; notwithstanding the fact you probably weren't going to pay the debt off. - Tufts e) Net Gifts: when donor transfers property to a donee on condition that donee pay amount of gift tax. 1. this is a bargained for exchange: a) donor has a gain of gift tax paid

7

Taxation I

Prof. Ting, Jan

Fall 2011

b) donee has gain of gift (AR) minus gift tax (Cost/Basis) - Diedrich 5. Life Insurance Policies IRC § 101 a) if you die early, beneficiary collects life ins 1. no tax consequence for life ins disbursement b) § 101(a)(2): you can't exclude any more money from a life ins policy than you paid for - to discourage trading life ins policies c) § 101(a)(2)(A)+(B): you can sell life ins policies as long as there is a basis or method of calculation for determining a basis to determine gain or it is to a partner of the insured or corp. 6. Annuities: IRC § 72 a) 3 Common Classes: 1. single life annuity a) fixed money payments to annuitant for life after which all rights under contract cease 2. self and survivor annuity a) fixed payments to annuitant for life and then continued to another after death 3. joint and survivor annuity a) pays jointly to 2 annuitants while both are living, then payments continue to survivor b) § 72(a) : amounts received as an annuity is includable in gross income minus c) § 72(b)(1) : investment ------------------expected return

= % of payments excluded

d) § 72(b)(2) : everything will be taxed after life expectancy date has past e) § 72(b)(3)(A)(ii) : amount of unrecovered investment in excess of payments not included in gross income

8

Taxation I

Prof. Ting, Jan 7. Discharge of Indebtedness: 61(a)(12) a) discharge of indebtedness is income - Kirby Lumber

Fall 2011

b) 108(d): indebtedness of taxpayer means indebtedness: 1. (A): for which taxpayer is liable, or 2. (B): subject to which taxpayer holds property c) If taxpayer in good faith disputes amount of debt, settlement of debt is treated as the amount of that debt. 1. gambling chips have no value outside of the casino - therefore the debt amount was in dispute - Zarin v. Commissioner (controversial) d) discharge of indebtedness by bankruptcy is not income 108(a)(1)(A) e) " if debtor is insolvent 108(a)(1)(B) f) discharge of student loan is not income 108(f)(1) 8. Damages a) Damages for Lost Profits = income Damages to Make you Whole Again (repair) = not Income - In Lieu of Rule, Raytheon

b) Health Insurance: 1. § 104(a) : income does not include: a) 1: amounts received under workmen's comp b) 2: amounts received (other than punitive dmgs) by suit or settlement on account of personal injuries/sickness 1. Govt. will accept as long as settlement is truly adversarial and at arms length a) "in lieu of prosecution" - Rev. Ruling 79-313 c) 3: amounts received thru accident or health insurance for personal injuries or sickness d) 4: amounts received by pension or annuity for personal injury/sickness 9

Taxation I

Prof. Ting, Jan

Fall 2011

e) 5: disability income attributable to injuries incurred as direct result of terrorist or military action 2. § 105 : benefits received by health care policy should be income, but not if they are for health care 3. § 106: employer provided health insurance under accident or health plan is not included as gross income 4. 104(c): if something is excluded by state statute, it's not taxable 5. if you take an offer of structured settlement, and have ins. holding it in trust for you, it's tax free, whereas if you have full control of it and put it into an annuity, you are taxed on the interest - Rev. 79-313

9. Separation and Divorce a) § 71(a): gross income includes alimony or separate maintenance payments b) § 71(b): payments must be made in cash c) 6 71(b)(1)(A): payment received by or on behalf of spouse under divorce or separation instrument d) § 71(b)(1)(C): payee spouse and payor spouse must not be members of the same household when payments are made e) § 71(b)(1)(D): if there is any post-death liability to make payments, not alimony f) Frontloading a) definition: giving one time lump sum payment/property settlement 1. this is more like a settlement than for support b) § 71(f) : in year 3, if we notice this was a one time transaction (frontloading), it is going to be included as income for payor (no deduction) and payee will receive a deduction 1. only concerned w/ years 1 and 2, any excess after that doesn't matter 10

Taxation I e) Indirect Payments

Prof. Ting, Jan

Fall 2011

1. If payments are on behalf of the spouse, in this case in the form of paying ins premiums, it will count as alimony for tax purposes as well - IT 4001 f) Property Settlements 1. § 1041: if it is incidental to divorce, no tax consequence but carry over basis as if it was a gift g) Child Support : § 71(c): non taxable (also has priority status of funds) G. Exclusions 1. § 121 : Exclusion of gain from sale of principle residence a) trying to encourage homeownership b) caveat: you can't take a loss on a personal residence - considered personal consumption 2. Ex-patriots living in a foreign country a) § 911: compromise; most of their income is taxable, but they can exclude a part of it 3. Savings bonds used to fund higher education 4. Proceeds of Roth IRAs (however any gains you receive are taxable) 5. Interest of State and Local Bonds - § 103 a) Is this a good idea? It benefits both state and local govts. and investors but it also really only benefits the rich H. Assignment of Income 1. One of the consequences of the bracket system of taxation is that it causes people to want to shift their assets to another person in a lower tax bracket 2. Because of progressive tax structure, you can often reduce your taxable income by dividing it into 2 individuals : 2 pots rule - See Lucas v. Earl 3. you can't shift your income to someone else for tax avoidance a) whoever earns it, is taxed on it - Lucas v. Earl b) Note: this case has sort of been reversed: joint return, allows husband and 11

Taxation I

Prof. Ting, Jan

Fall 2011

wife to combine their income and have it taxed at a lower income bracket 1. this is only if there is only one wage earner spouse 4. Giannini did not accept 5% of company profits as per contact. He was President and Director of the Board of the company. Company decided to to donate the money to charity. Court says any participation in the decision was only in his corp. capacity. Because he had no control or dominion over this compensation he waived his right to it and it was not taxable. - Giannini a) Is this case creating a charitable exception? 1. Giannini voided the contract of receiving a percentage of profits before he earned anything for the upcoming year --> timing 2. because it was based on a percentage of company profits rather than wage, it was kind of like money earned by the company rather than Giannini himself ---> who earned it? 3. This exception Requires: taxpayer to disclaim income both prior to earning it and without naming any recipient 5. Executor waived his right to statutory fees. - Rev. 66-167

a) Test: does waiver present evidence of an intent to render a gratuitous service? 1. limitation: you can waive your fee in the first 6 mos. if you meet the test 6. Clinical fees that Professors had to remit back to the law school are non-taxable a) obviously trying to shift income, but Service says it's ok. - Rev. 74-581 5. Income From Property a) Fruit from the Tree Metaphor : whoever owns the tree, owns the fruit; being able to pick and choose who you're going to give the fruit to, is the same as cashing them yourself. 1. Father had a bunch of bond coupons, gave them to Son w/out cashing them - Father has to pay tax - Helvering v. Horst 2. You can assign your beneficial interest to a Trust to someone else and have them pay the interest - this works becomes the income has not been 12

Taxation I earned yet

Prof. Ting, Jan - Blair

Fall 2011

3. Distinction btw. Helvering v. Horst and Blair : In Helvering, only gave away fruit of the tree, in Blair, the entire tree was transferred 4. Taxpayer sold rights to future dividends from his stock to son @ discount. Court holds these are exchanges of valuable consideration. - Estate of Stranahan 5. Can't use a transfer of property to assign income after there has been an agreement to sell or receipt of a bid. - Susie Salvatore 6. Taxpayer sold life ins. contract to charitable org. right before it matured = "over=ripened fruit" and taxpayer responsible - Rev. 69-102 7. Transfer of calves to charity, then charity sold calves when they matured = transfer of the tree - gain goes w/ tree and attributable to charity - Campbell v. Prothro 8. Landlord transfers right to share crop rent to charity, then charity sells it = over ripened fruit, and landlord is taxed. - Tatum

I.

Entities 1. Corp. are taxed as entities a) dividend income from corp. is income to shareholder b) "double tax regime": taxed once to the corp. and then when it is distributed to the shareholder it is taxed again 2. Partnerships don't pay tax a) considered pass thru entities b) serves as a conduit for gain/income or losses 3. LLCs: you get the benefits of corp., but taxed like a partnership 4. Trusts & Estates a) income that is distributed is taxed to the beneficiary b) any income retained is taxed as a taxpayer

II.

Deductions 1. 162(a): Trade or Business Deductions

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Taxation I

Prof. Ting, Jan

Fall 2011

a) There shall be allowed as a deduction all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including 1. reasonable allowance for salaries 2. traveling expenses, other than amounts which are lavish or extravagant, while away from home in pursuit of trade or business 3. rentals or other payments for purposes of trade or business on property to which taxpayer has not taken or is not taking title or in which he has no equity b) Business deductions are to be eval. on a necessary and ordinary standard 1. necessary: it is "appropriate and helpful" - See McCulloch v. Maryland 2. ordinary: as to "life in all its fullness" 3. it is extraordinary to pay off liability for another company to a creditor - Welsh v. Helvering 2. 263(a): Capital Expenditures a) 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. This paragraph shall not apply to : <see statute> 2. Capital expenditures are profitable in the long run because they increase your basis 3. all of the costs of building a building should be treated as capital expenses even though by themselves, they seem like expenses. a) otherwise, you are getting a deduction for building a building as opposed to buying one - Idaho Power 4. Ordinary does not mean repetition, it means "how would others act in this circumstance?" Repairs are not designed to improve, but rather to fix things back to what they were before - therefore they are not considered a capital improvement. - Midland Empire

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Taxation I

Prof. Ting, Jan

Fall 2011

5. If a company forgets to put in a necessary feature into a building, then later decides to build or install that feature, it is not considered a repair - it is a capital expenditure - Mt. Morris Drive-In 6. Deductions are to be narrowly construed and the burden of proof is always on the taxpayer. a) although future benefit is not a controlling factor, courts may use it b) fact specific inquiry - INDOPCO 7. Taxpayer must capitalize amount paid to outside services facilitate an acquisition, but compensation paid to employees who are helping you acquire the asset do not have to be capitalized - Regs a) Regs have left window open as to whether employees helping you build the building is a capital expenditure or expense 3. 262(a): no deduction shall be allowed for personal, living, or family expenses a) you can only get a deduction if you are carrying on in a business - you can't deduct the costs of trying to find one - Morton Frank 4. 195: as long as it's under 55,000, you can get a deduction for start up costs a) this is to encourage small businesses 5. Treasury will not allow deductions for expenses incurred by individuals who have employed for for such a long time there is a substantial lack of continuity btw. employment. a) however, an employee's expenses in seeking employment elsewhere but in the same trade are deductible whether or not they are successful - Rev. 75-120 6. "Reasonable Salaries" - 162(a)(1) a) 162(m): Certain Excessive Employee Renumeration (1): no deduction for employee enumeration if it exceeds $1,000,000 b) 280G: no deduction shall be allowed under this chapter for any excess parachute payment

15

Taxation I

Prof. Ting, Jan 1. <see statute, probably won't come up - hopefully!> c) 7 factor test for reasonable compensation (majority view): 1. type and extent of services rendered 2. scarcity of qualified employees 3. qualifications and prior earning capacity of employee 4. contributions of employee to business venture 5. net earnings of employer 6. prevailing compensation paid to employees w/ comparable jobs 7. peculiar characteristics of employer's business - See Exacto d) Posner's test for reasonable compensation (minority view):

Fall 2011

1. if shareholders receive a huge return in relation to what they expected, the salary is considered reasonable a) go look at comparable companies to find out - Exacto Spring Corp.

e) Reg. § 1.1.162-7(b)(2): the form or method of fixing compensation is not decisive as to deductibility. Payments in any form of contingent compensation do invite scrutiny, but they are not to be treated as fundamentally different then compensation at a flat rate. 1. if compensation is paid pursuant to a free bargain before services are rendered, it should be allowed as a deduction 2. The degree of control that the taxpayer has over the company is relevant to deciding as to whether there was a free bargain; while the son's owned the company and were adults, the father dominated the sons in the business therefore it was not a free bargain - Harold's Club 7. Travel Expenses - 162(a)(2) a) 162(a): (2nd to last sentence) : taxpayer shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year. b) 274(n)(1): Only 50% of meal and entertainment expenses allowed as deduction: 1. (A) any expense for food or beverages 2. (B): any item considered to be entertainment or facility used w/ this activity c) 274(c): foreign travel d) 274(h): attendance at conventions, etc. 16

Taxation I

Prof. Ting, Jan e) 274(m): additional limitations on travel expenses: 1. luxury water transportation - no deduction 2. travel as form of education - no deduction 3. travel expenses of spouse, dependent, or others - no deduction f) traveling expenses cannot be deducted unless you have a home - Rosenspan

Fall 2011

1. Commuting to work is not deductible, because you can choose where you want to live a) 3 factors for whether travel expenses can be deducted: 1.reasonable and necessary 2. away from home 3. in the course of business - Flowers g) Temporary employment travel expenses are deductible (as long as they are under one year - Peurifoy; See § 162(a) h) If you have no permanent home, you cannot ever be away from home - Stidger - Rosenspan i) If you own multiple houses, only one can be considered your home, the other is temporary - this is not constrained by the amount of time in which taxpayer is there - Andrews j) Transportation costs to a temporary assignment are deductible - Rev. 99-7; 162(a) k) "overnight rule" : can't deduct your meals if you don't stay overnight 8. Necessary Rental and Similar Payments - 162(a)(3) a) Substance over form of contract: if rent is paid to eventually get title it is treated as an exchange rather than rent (several payments bunched up front for sprinkler system) - Starr's Estate 9. Expenses for Education - 1.162-5(a) a) (1) maintains or improves skills req'd by in his employment or other trade or business b) (2) meets express reqs of employer or applicable law or regulations - Corell

17

Taxation I

Prof. Ting, Jan c) Nondeductible Educational Expenditures (b): 1. minimum educational requirements for his job 2. qualification for new trade or business

Fall 2011

10.

Miscellaneous Business Deductions a) § 274(a): Disallowance of Certain Entertainment, Etc. Expenses b) Business meals may be deductible under 162: 1. Under Cohan v. Commissioner, you can claim deductions w/out keeping records, however a) § 274(d): you have to substantiate your records now b) 274(e)(2): expenses for food and bev. furnished on business premises are deductible c) 274(e)(3): reimbursed expenses d) 274(e)(4) recreational etc. expenses for employees e) 274(n)(1): only 50% allowed deduction allowed for meal and entertainment expenses 1. as long as they are directly related to trade or business c) Uniforms: a) if you can wear it for any occasion, it is not deductible, BUT b) if it is specific to work, it may be deductible d) Advertising Expenses a) Generally the cost of advertising in magazines, TV, and sports programs is currently deductible. But billboards are not (capital expenditure) e) Dues 1. in general dues paid to org. directly related to one's business is deductible. 2. dues for entertainment purposes are not - 274(a)(3) 18

Taxation I f) Lobbying

Prof. Ting, Jan

Fall 2011

a) you cannot use funds for lobbying (pretty much at all, except for local legis.) ; however there are some monetary limits - 162(e) 11. Business Losses - § 165 1. trade or business losses 2. loss incurred in transaction entered into for profit 3. casualty loss ((c)(3): if loss of property not connected w/ trade or business or transaction entered into for profit - 165(h) applies) 12. Depreciation - § 167(a); See Tables : pg. XV a) (1) property used in the trade of business, or (2) property held for the production of income 1. See 1.167(a)-2 (tangible property) 2. § 611 : depletion (natural resources) b) a way to amoritize loss (from wear and tear) c) How to figure out depreciation deductions: 1. start w/ adjusted basis 2. each depreciation deduction further adjusts the basis - 1016(a)(2) 3. you stop getting the deductions when your basis is depleted d) § 168 - Accelerated Cost Recovery System: 1. Requirements: a) must be property that will be consumed, or will wear out, or will become obsolete, or will otherwise become useless to the taxpayer, and b) must be property that has an identifiable useful life to the taxpayer, and c) must be property used in trade or business or d) for the production of income 2. 168(b)(4): salvage value is treated as zero 3. Method/Rate of Depreciation: 19

Taxation I

Prof. Ting, Jan a) straight line : divide basis by class life b) 200% declining balance

Fall 2011

1. 200% of [basis divided by class life], then for subsequent year, subtract depreciation deduction from previous adj. basis. New adj. basis is then divided by class life again, and you get 200% of that...and so on 2. you switch to straight-line under that rate when it would be more than you would get by declining balance method c) Useful Life or Appropriate Recovery Period 1. applicable convention: Half Year Convention - 168(d) a) when you dispose of property, half life convention comes in - otherwise you just hold on to property - and you get full depreciation deduction 2. Applicable Recovery period - 168(c) a) to figure this out, you must first look at the class tables under 168(e) d) What do you we do about partial years? 1. mid quarter convention 168(d)(3) 4. § 168(k) : Special Allowance for Certain Property Acq. after Dec. 31, 2007 and before Jan. 1 2013 a) first see if this deduction applies - adjusts your basis b) a taxpayer may elect out of this option 5. § 179 Bonus Depreciation (also adjusts your basis) a) allows for cost of 179 business property as expense NOT chargeable to capital AND allowed as a deduction for year property was placed in service b) 179 property - 179(d)(1) 1. tangible property to which 168 applies - (A)(ii) 20

Taxation I

Prof. Ting, Jan 2. computer software 3. section 1245 property c) Limitations based on year:

Fall 2011

1. 179(b)(1): dollar limitation : aggregate cost taken into account 2. Reduction in limitation : 179(b)(2) 3. can elect to apply 179 on an item by item basis, BUT 4. amounts listed under 179(b)(2) take all of the property you could have applied to 179 into account, not just the property you do apply 179 to 5. (b)(3): limitation based on income from trade or business 6. luxury automobiles in course of business - § 280F 6. Intangible Property - § 197 13. Deductions for Profit Making Nonbusiness Activities a) § 212: for individuals, there shall be allowed as a deduction for all ordinary and necessary expenses 1. for production or collection of income (not for collection of property though) See 1.121-1(k) a) Cf. Higgins (stock and real estate portfolio expenses not deductible as trade or business expenses 2. for the management, conservation, or maintenance of property held for production of income; or a) Origin of the Claim Test - used to determine whether legal fees are a personal expense or really for collection of income or management, conservation, etc. of property (only § 212(2)) - Fleischman 3. in connection w/ the determination, collection, or refund of any tax b) 1.212-1(d): Expenses, must be "ordinary and necessary." Thus they must be reasonable in amount and much bear a reasonable and proximate relation to the 21

Taxation I

Prof. Ting, Jan

Fall 2011

production or collection of income or management, etc. of property held for production of income. - See Rev. 64-236; but see Surasky (payments made to Board of Directors of company in which he owned stock deductible) 14. Deductions Not Limited to Business or Profit-Seeking Activities a) HUD credit basically subsidizes the higher bracket tax payers and doesn't give any subsidy to lowest tax bracket (those that don't pay income tax) 1. this doesn't make sense, if w eare going to have a housing subsidy, it makes much more sense to deny the high tax bracket and only give it to the low tax brackets - Stanley Surrey's Essay b) § 163(a): there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness c) § 163(h): disallowance of deduction of personal interest d) 280 : no deduction for use of a dwelling unit used a residence 1. (d)(1): taxpayer uses dwelling unit during taxable year as residence if he uses it for personal purposes for a number of days which exceeds the greater of 14 days or 10 percent of days during the year which the united is rented e) § 7872(a): Loans w/ below Market Interest Rates a) borrower gives interest to lender (constructive) b) lender giving free interest to borrower c) Both are getting income d) not all interest is deductible so both are taxed e) 7872(c)(1)(B) : between employer and employee : both are clearly getting income f) Parent to Child : 1. parent would not get deduction for a gift 2. child is probably getting a gift a) may get deduction from paying constructive interest and parent may recognize income g) de minimis exception of $10,000 f) deductibility of taxes: § 164 1. Taxpayer can deduct real estate taxes on property he owns, but cannot deduct real estate taxes he's paying off on property owned by another 22

Taxation I - Cramer 15. Restrictions on Deductions:

Prof. Ting, Jan

Fall 2011

a) Deductions Limited to Amount at Risk § 465 1. 465(d) : definition of loss a) the property must be at risk for you to get a deduction (there basically needs to be money put in - in the form of loan or capital See 465(b) : amounts considered at risk b) Activities not Engaged in For Profit (Hobby Loss) 1. § 183 (as opposed to 212 : activity engaged in for a profit) a) remember there is a special rule for breeding, training, showing or racing of horses - See Engdahl c) Passive Activity Loss Rule - § 469 1. shut down traditional tax shelters in '86 2. See 1.469-5T in regards to "material participation 3. 465(h)(5) participation by spouse treated as taxpayer's participation d) Illegal Activities 1. Income gained through illegal means is income, but what about deductions? a) see James v. United States 2. 162(c): Bribes or kickbacks are not deductible 3. 162(f): fines are not deductible 4. 165(d): Gambling losses: you can only use the losses to offset your gains from gambling 5. 280(E): all income from drug dealing is taxable but no deduction or credit

23

Taxation I III. AGI

Prof. Ting, Jan

Fall 2011

1. G.I. Some Ded. (above the line) ----------------------------------------------------A.G.I. Other Ded. ---> This could mean S.D. + P.E. § 63(b) or you can elect to itemize under § 63(e) (as defined under 63(d)) ----------------------------------------------------T.I. 2. § 62: Adjusted Gross Income (shows above the line deductions) 3. § 217 : Moving Expenses 4. § 151: Personal Exemption 5. § 152: Dependents 6. § 63(c): Standard Deduction a) extra deduction for elderly § 63(f)(1) b) extra deduction for the blind § 63(f)(2) c) 63(f)(3): unmarried blind or elderly get an even bigger deduction 7. § 63(d): definition of Itemized Deductions a) § 67 : 2 percent floor on Misc. itemized deductions 1. (b): Misc. Itemized Deductions 2. Note: This will determine whether you want to go w/ Itemized or Standard Deduction IV. Timing/Methods of Accounting 1. 441 : period for computation of taxable income 2. 442: if taxpayer changes annual account period, new accounting period shall become taxable year only if change approved by Secretary. 3. 461(a): amount of deduction shall be taken taxable year which is proper under method of accounting 4. 446: General Rule for Methods of Accounting a) 446(c): Most Basic Methods of Accounting 24

Taxation I 1. cash method

Prof. Ting, Jan

Fall 2011

a) most individual taxpayers b) § 451: cash receipts : it is reported as income in the year you receive it c) § 1.1451-2(a): Constructive Receipt of Income 1. income is constructively received when it is credited to his account, set aside for him, or otherwise made available for him to do with whatever he wants 2. For constructive receipt it has to be in your control - or ready for you to just come and take it - Hornung 3. Checks are like cash, you have income when you receive it not when you cash it - Kahler 4. Deductions for Insurance premiums are deductible as if they are a capital expense (allocatable pro-rata over the life of the asset) - Boylston Market Ass'n; See 461(g) (relating to interest) 5. Mail Rule: a check is received when it is placed in the mail - Rev. 54-465 6. There is no doctrine of constructive deduction : you can only deduct when the check is actually cashed! - Vander Poel 2. accrual method a) most businesses b) matches deductions to income c) § 1.446-1(c)(1)(ii)(A): 1. Income: a) when all events have occurred that fix the right to receive income b) the amount of income can be determined w/ 25

Taxation I

Prof. Ting, Jan reasonable accuracy 2. Deductions:

Fall 2011

a) taxable year in which all the events have occurred that establish the fact of the liability b) amount of liability can be determined with reasonable accuracy c) economic performance has occurred with respect to the liability d) when the right to receive becomes fixed : income accrues. When you delivered the goods, that is when income is to be reported. - Spring Foundry e) In cases of pending actions in court for dmgs; all of the events have not occurred until all of the appeals have been dismissed (if applicable) - Rev. 70-51 f) Claim of Right Doctrine: even if all of the event's haven't occurred; if you actually get the money and say it's yours; it is yours and you have to include it as income in the taxable year - N. American Oil g) Prepaid income (e.g.: advance rent payment) is reported in the year in which you receive and get your hands on it - New Capital Hotel, Inc. h) Prepaid Income is not always going to be reported as income in the year of receipt - exception for baseball season tickets because all of the games are going to be played in the subsequent year. - Artnell; Tampa Bay Devilrays 1. Deferred Income a) § 455: deferred income for magazine subscriptions b) § 456: auto club dues allowed deferred income c) Otherwise, (unless possibly w/ sports games season tickets); income is when you receive it 2. Rev. Proc. 2004-34: 1 year deferral only and only for services rendered

26

Taxation I

Prof. Ting, Jan

Fall 2011

a) explicitly inapplicable to prepaid interest or rent i) Deduction on interest when it accrues; that is when the liability accrues - Rev. 57-463 j) § 461(h): no deduction for future performance; deduction happens when the service is performed! Cf. Schuessler k) § 267(a)(2): matching deduction and income btw. related taxpayers: 1. deduction by payor allowed no earlier than when corresponding income recognized by payee. l) § 467: Certain payments for the use of Property or Services 1. forces both parties to a § 467 rental agreement to be use accrual method of accounting for the transaction 2. § 467(d)(2): does not apply to payments that do not exceed $250,000 5. § 1341: Computation of Tax Where Taxpayer Restores Substantial Amount held Under Claim of Right ; if it appeared you had an unrestricted right to such item and you later find out you don't, entitled to the lesser of a) you either get a deduction b) or a credit for the excess tax paid in the previous year Cf. United States v. Lewis (under claim of right doctrine : if you say it is your income then it is treated as such, however, you can take a deduction when you realize that it really wasn't yours) 1. if taxpayer is in a higher tax bracket, it is more beneficial to take the deduction, if the item was taxed at a higher rate, then it is better to get the tax credit c) If taxpayer had an unrestricted right to an item of gross income and in a subsequent year he is no longer entitled to that income, then § 1341 applies - Van Cleave 6. § 111 : Normal Rule: if you are merely getting your own property back - you are not entitled to a deduction

27

Taxation I

Prof. Ting, Jan

Fall 2011

a) exception: if you did get a deduction for it, it must be treated as income 1. exception to exception: "tax benefit rule" § 111: a) did you get a benefit from the deduction? 1. if so, taxable 2. if not, it's not 3. doesn't matter extent of your benefit - Alice Phelan Sullivan a) if taxpayer elects to use the standard deduction, there is no benefit to getting ur property back - Rev. 79-15 7. Income Averaging a) Do it Yourself Averaging : does it work? 1. it is fine if you do it before you have full control over the money, but if you put the money in an escrow account that is constructive receipt 2. giving it to another person or company to set it aside is also constructive receipt 3. Qualified Plans: a) conceptually what you are doing with retirement plans (in which you get a deduction) is deferring recognition of the tax until some year in the future, hopefully u'll be in a lower tax bracket 1. Roth IRA (taxed on contribution, deduction for distribution) vs. Traditional IRA/401(k) (taxed on distribution - deduction for contribution) 8. § 172: Carrybacks and Carryovers a) carrybacks of deductions for 2 preceding years

28

Taxation I

Prof. Ting, Jan b) carryovers of deductions for subsequent 20 years

Fall 2011

V.

Capital Gains/Losses 1. People who get income from labor actually pay more taxes than people who get income from capital gain a) Policy: 1. income from investments are not guaranteed 2. but is money from labor guaranteed? 3. incentivizes people to make more money so they can get their money from capital rather than labor 4. trickle-down theory : it's good for everybody b) Real Justifications: 1. when someone gets money from a capital gain, it goes back into the market; it is still invested = "left pocket to right pocket theory" 2. to tax gain that is due to inflation, that is not fair 3. Bunching: to tax them on a bunch of income that accrued at one time (when capital is sold) when they really attained the income over a long time is unfair 4. Lock in: all of us want money invested in the highest and bess use a) if the gain is taxed as ORD, it deters people from being able to freely deploy their capital most efficiently for the benefit of everyone. 2. § 1 : Rates of Taxation: a) § 1(h): Taxation of Capital Gains 1. taxable income minus capital gain then capital gain is taxed a) generally = 15% b) collectibles gain = 28% 29

Taxation I

Prof. Ting, Jan c) unrecaptured § 1250 gain = 25%

Fall 2011

3. § 1222 : Net Capital Gain a) STCG STCL NSTCG or NSTCL b) LTCG LTCL NLTCG or NLTCL

------------------------

------------------------

b) 1(h)(11): dividends taxed as net capital gain 4. § 165(c): limitation on losses of individuals a) § 165(f): capital losses = losses from sale or exchanges of capital assets shall be allowed only to the extent allowed in sections 1211 and 1212 1. § 1211: Limitation on Capital Losses a) corps: only allowed capital losses to offset capital gains b) individuals: losses shall be allowed only to the extent of gains or (if such losses are greater than gains), the lower of 3,000 or excess of such losses over gains (offsets some of your other income as well) c) 1212: capital loss carrybacks and carryovers 2. § 1222(10) : definition of net capital loss a) Offset NLTCG and NLTCL and NSTCL and NSTCG b) Offset whatever is left c) Determine whether you have 3000 (max) or less NCL d) Offset against income e) whatever is left is carried over for the next year 1. remember STCL is to be used up first

30

Taxation I 5. § 1221 : Capital Asset Defined

Prof. Ting, Jan

Fall 2011

a) profits received in ordinary course of trade are business are treated as ORD not as capital gains. In this case, taxpayer never actually stopped selling the lots and a substantial part of his income came from these lot sales. - Mauldin b) substantial purpose is no longer the standard - it now is: "what was it primarily used for?" It must have been of FIRST importance as a capital asset to be considered as one - Malat v. Riddel c) Given a choice, you probably would prefer STCL to LTCL because STCG is potentially going to be taxed at a higher rate than LTCG d) Hedging transactions are now excluded from capital gain status by § 1221(a)(7) - Arkansas Best 6. Best of Both Worlds: § 1231 : Property Used in Trade or Business and Involuntary Conversions (big hotchpot - BHP) (a)(1): if gains exceed losses, it is all treated as LTCG (a)(2): if losses exceed the gains, they are all treated as ORD b) 1231(a)(3): who can use it : people who own property used in trade or business 1. business owners! c) 1231(b): definition of property used in trade or business d) 1231(a)(4)(C): casualty losses 1. if losses and gains from casualty loss (separate hotchpot - SHP) a) losses exceed gains - treated separately from big hotchpot of the rest of 1231 1. still can turn into ORD although it's in a separate hotchpot

31

Taxation I

Prof. Ting, Jan b) gains exceed losses - pours over into big hotchpot e) 1231(c): Recapture of Net Ordinary Losses

Fall 2011

a) when you take losses before the gains, the aggregate amount of losses you took for the preceding 5 years is going to offset the LTCG of 1231 income and that is going to turn into ORD as long as the gain does not exceed the losses f) 1223: Holding Period Rules 7. § 1245: Gains from Dispositions of Certain Depreciable Property a) when you take a bunch of depreciation deductions from a piece of property and then sell it at a gain: some of those depreciation deductions are going to come back 1. (a)(1): the lesser of a) recomputed basis or b) amount realized c) in another disposition, fmv over adj. basis d) OVER adjusted basis e) is treated as ORD income 2. (a)(2): recomputed basis: a) adjusted basis by adding b) all adjustments on account of deductions allowed or allowable to any person for depreciation or amortization 3. a conversion of vehicle from business to personal use is not a disposition for purposes of § 1245 a) but if you later sell it, after depreciation, and you get a gain, it is still subject to § 1245 - Rev. 69-487; see 1245(a)(3) 4. 1245(b) Limitations:

32

Taxation I

Prof. Ting, Jan a) 1245(b)(2): 1245 effect goes away @ death

Fall 2011

b) See also § 1014: transfers btw. married persons (stepped up basis depreciation reflected) c) Note; with family members, depreciation is also reflected in the basis 8. § 1250: Gain from Dispositions of Certain Depreciable Realty a) only applies to property held for less than a year and/or property that was held a long time ago (before '86) and they took ADR or ACRS b) however, this is going to be taxed at 25% because it is 1250 unrecaptured gain § 1(h)(D)(1) 9. § 1202 gain, and collectibles are at 28% bracket a) 1202(a): only taxed on 50% of the gain from qualified small business stock held for more than 5 years 1. Qualified Small Business - 1202(d): a) gross assets of less than $50,000,000

33

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