This action might not be possible to undo. Are you sure you want to continue?
COMPUTING TAX LIABILITY......................................................................................................................................1 WHAT IS INCOME?..........................................................................................................................................................2 COMPENSATION FOR SERVICES ...........................................................................................................................................2 FRINGE BENEFITS............................................................................................................................................................2 Work-related fringe benefits -- This is found in §132 – These are fringe benefits not covered by other specific exclusion sections. ..................................................................................................................................................3 Meals and Lodging -- §119 (To be excluded from income).....................................................................................5 Section 83 – Property Transferred for Performance of Services.............................................................................6 INTEREST-FREE LOANS -- §7872......................................................................................................................................8 IMPUTED INCOME.............................................................................................................................................................9 DO YOU HAVE TO WORK FOR YOUR INCOME?.................................................................................................................10 Gifts and Bequests.................................................................................................................................................10 Government Transfer Payments............................................................................................................................12 Prizes, Awards Scholarships.................................................................................................................................12 CAPITAL APPRECIATION AND RECOVERY OF CAPITAL.........................................................................................................12 Present Value Computations.................................................................................................................................12 Capital Recovery and Basis...................................................................................................................................13 Realization.............................................................................................................................................................15 ANNUITIES -- §72.........................................................................................................................................................17 LIFE INSURANCE............................................................................................................................................................18 TREATMENT OF DEBT.....................................................................................................................................................19 Illegal Income........................................................................................................................................................19 HOW LOANS ARE TAXED...................................................................................................................................20 Discharge of Indebtedness.....................................................................................................................................20 FREEING OF ASSETS THEORY..................................................................................................................................22 Borrowing and Basis.............................................................................................................................................23 DAMAGES AND SICK PAY...............................................................................................................................................26 Damages to Business Interests..............................................................................................................................27 Damages for Personal Injury and Sick Pay...........................................................................................................28 TAX-EXEMPT INTEREST..................................................................................................................................................29 ARBITRAGE...................................................................................................................................................................30 DEDUCTIONS AND CREDITS......................................................................................................................................30 BUSINESS EXPENSES (ABOVE THE LINE DEDUCTIONS)........................................................................................................30 Ordinary and Necessary........................................................................................................................................31 PUBLIC POLICY LIMITATIONS..........................................................................................................................................32 LOBBYING EXPENSES.....................................................................................................................................................33 REASONABLE ALLOWANCES FOR SALARY..........................................................................................................................33 EMPLOYEE BUSINESS EXPENSES AND THE 2% FLOOR.........................................................................................................34 The 2% Floor........................................................................................................................................................35 DISTINGUISHING BUSINESS AND PERSONAL EXPENSES.........................................................................................................35 Hobby Losses....................................................................................................................................................36 Travel Away from Home........................................................................................................................................36 Transportation...................................................................................................................................................36 Food and Lodging.............................................................................................................................................37 Limitations........................................................................................................................................................38 Meals and Entertainment.......................................................................................................................................38 Home Office Expenses...........................................................................................................................................39 CURRENT VERSUS CAPITAL EXPENSES..............................................................................................................................41
Tax Fall 2001
Why do we care?...................................................................................................................................................41 Two Ways to Skin a Cat: Old and New IRA’s................................................................................................41 Acquisition and disposition of assets.....................................................................................................................42 Nonrecurring expenditures and expenditures that provide benefits beyond the current year................................44 Corporate Reorganizations/BUSINESS INTANGIBLES................................................................................45 Expenses of an Ongoing Business....................................................................................................................47 Expenses with Respect to a New Business – Start up costs..............................................................................47 Deductible Repairs s. Nondeductible Rehabilitation or Improvements............................................................48 Job Search and Education Expenses.....................................................................................................................48 Depreciation and Amortization: Recovery of Capital Expenditures.....................................................................50 Depletion...............................................................................................................................................................52 INTEREST......................................................................................................................................................................52 In General and Arbitrage......................................................................................................................................52 Sham Transaction and No Economic Purpose Doctrines......................................................................................55 What is Interest? ..................................................................................................................................................56 Problems of Inflation ............................................................................................................................................56 LOSSES........................................................................................................................................................................57 Business vs. Non-business profit Seeking Losses...................................................................................................57 Personal versus Business or Profit-Seeking Losses...............................................................................................58 Casualty Losses.....................................................................................................................................................58 Loss Limitations....................................................................................................................................................58 Property Losses.................................................................................................................................................58 Tax Shelters.......................................................................................................................................................60 PERSONAL DEDUCTIONS.................................................................................................................................................62 Standard Deduction...............................................................................................................................................62 Personal Exemptions -- §151.................................................................................................................................63 Phaseouts of Exemptions and Itemized Deductions...............................................................................................63 Credits vs. Deductions...........................................................................................................................................64 Taxes – SEE NEW §154 IN PACKET....................................................................................................................65 WHOSE INCOME?...........................................................................................................................................................68 TAXATION OF THE FAMILY...............................................................................................................................................68 Treatment of Couples............................................................................................................................................68 Treatment of children (“kiddie tax”).....................................................................................................................69 Treatment of Divorce.............................................................................................................................................70 ASSIGNMENT OF INCOME................................................................................................................................................71 Income from Services............................................................................................................................................71 Income from Property............................................................................................................................................71 Income from Property or Services: Which is it?...................................................................................................72 CAPITAL GAINS AND LOSSES....................................................................................................................................72 HISTORIC TREATMENT OF CAPITAL GAINS........................................................................................................................73 MECHANICS OF CAPITAL GAINS – SEE TEXT P. 530............................................................................................................73 POLICY OF PREFERENTIAL TREATMENT OF CAPITAL GAINS (SEE PAGES 546-551 FOR THIS)....................................................75 DEFINITION OF A CAPITAL ASSET -- §1221.....................................................................................................................75 DEPRECIABLE PROPERTY AND RECAPTURE.........................................................................................................................78 DERIVATIVES AND HEDGING............................................................................................................................................80 NONRECOGNITION OF GAIN OR LOSS: LIKE-KIND TRANSACTIONS.......................................................81
Tax Fall 2001
Federal Income Tax – Key Provisions Code Section §61 §61, 7189
Gross Income Defined – all income from whatever source derived Items Specifically Included in Gross Income (not a comprehensive list) • §71 – Alimony • §72 – Annuities • §74 – Prizes and Awards • §79 – Group term life insurance purchased for employees • §82 – reimbursement for moving expense • §83 – Property Transferred in Connection with Performance of Services • §85 – Unemployment Compensation • §86 – Social Security and Tier 1 railroad retirement benefits Items Specifically Excluded from Gross Income (not a comprehensive list) • §101 – Certain Death Benefits • §102 – Gifts and Inheritances • §103 – Interest on State and Local Bonds • §104 – Compensation for injuries or sickness • §104 – Amounts received under accident and health plans • §106 – Contributions by employer to accident and health plans • §108 – Income from discharge of indebtedness • §117 – Qualified Scholarships • §119 – Meals and Lodging furnished for the convenience of the employer • §121 – exclusion of gain from sale of principal residence • §125 – cafeteria plans • §127 – educational assistance programs • §129 – dependent care assistance programs • §132 – certain fringe benefits • §135 – Income from United States Savings Bonds used to pay higher education tuition and fees Adjusted Gross Income Defined – look here for above the line deductions • 62(a)(1) – Trade and business deductions • 62(a)(2) (A) – Reimbursed Employee expenses • 62(a)(3) – Losses from sale or exchange of property • 62(a)(4) – Deductions attributable to rents and royalties • 62(a)(6) – pension plans of self-employed • 62(a)(7) – retirement savings • 62(a)(10) – alimony • 62(a)(15) – Moving expenses • 62(a)(16) – medical savings accounts • 62(a)(17) – interest on education loans Taxable Income defined – look here for below the line deductions • 63(c) – Standard deduction – for non itemizers
Tax Fall 2001
63(d) –Itemized deductions • 63(e) – election to itemize Allowance of Deductions for Personal Exemptions • In 2001 – personal exemption is $2900, in 2000, was $2000 • §151(d)3 – personal exemption gets phased out once reach certain income level (about 200,000) • §151(d)4, companion provision, inflation adjustment -- in the case of any taxable year, the dollar amount shall be increased based on the cost of living adjustment Dependent Defined – taxpayers also entitled to exemption for each dependent (includes children, grandchildren, parents and other relatives, and unrelated members of taxpayer’s household, more than ½ of whose support for taxable yr provided by taxpayer); Trade or Business Expenses – there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . . • deduction may be above the line or below the line Interest – There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness • deduction is limited • may be above the line or below the line Expenses for Production of Income – In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year • for the production or collection of income • for the management, conservation or maintenance of property held for the production of income or • in connection with the determination collection or refund of any tax • deduction may be above the line or below the line 2% Floor on Miscellaneous Itemized Deductions – In the case of an individual, the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2% of any adjusted gross income. • If your expense is not on the list in §67, by default it is a miscellaneous itemized deduction and thus subject to the floor. • Deductions not subject to the floor include (not comprehensive): o interest - § 163 o casualty losses -- §165(a) o taxes - § 164 (state, local, and property) o charitable contributions -- §170, §642(c) o medical expenses - § 213 o moving expenses - § 217 o annuity mortality losses - § 72(b)(3) Ordinary income defined – any gain from the sale or exchange of property which is neither a capital asset nor property used in a trade or business. Ordinary loss defined – any loss from the sale or exchange of property which is not a capital asset.
Tax Fall 2001
With § 162. in 2000. Meredith Huston 1 Tax Fall 2001 . • At this point. disability and old age (§ 22). companion provision.$5000 for joint (see code for other categories) or Itemized Deductions (§ 63(d)) -.§ 164 (state. income from an interest in an estate or trust.000) §151(d)4. you may subtract any allowed Tax Credits in order to figure Tax Liability.2% floor of adjusted gross income.in the case of any taxable year.§ 62(b) losses from sale or exchange of property . 212. including: • Non-Miscellaneous Itemized Deductions . trade or business expenses) from Gross Income in order to compute Adjusted Gross Income.§ 215.§ 163 o casualty losses -.subject to §67 -. o If it is included in gross income. Includes compensation. inflation adjustment -.§ 217 o annuity mortality losses . royalties. o Does not include excluded categories which are found in §101-134 of the code • Next take above the line deductions (§62). dividends.§ 161 + § 62(a)(3) alimony by payor . tax withheld (§ 31). pensions.§ 1. and 163 it depends. and earned income in the case of low-income taxpayers (§ 32). • Next take below the line deductions (= the sum of personal exemptions and either (1) itemized deductions OR (2) standard deduction in order to get Taxable Income (§ 63).§ 162 reimbursed business expenses . annuities. local.§ 67(b) o interest . child care credit (§21(a)).§170.§ 72(b)(3) • Finally. was $2000 §151(d)3 – personal exemption gets phased out once reach certain income level (about 200. will be found in §61. §642(c) o medical expenses .§165(a) o taxes . o The deductions include: ordinary and necessary business expenses . ) • Below the line deductions are: o (1) Allowance of Deductions for Personal Exemptions (§ 151) – deductions for taxpayer and spouse and for dependents (§152) In 2001 – personal exemption is $2900. and property) o charitable contributions -. the dollar amount shall be increased based on the cost of living adjustment o (2) AND either Standard Deduction (§ 63(c)) -. 71-89 of the code. fringe benefits. apply the taxable income to the tax tables in order to find tax .§ 62(a) expenses of performing artists . Allowable expenses (ie.§ 213 o moving expenses . discharge of indebtedness income.Federal Income Tax Professor Shuldiner – Fall 2001 COMPUTING TAX LIABILITY • Determine Gross Income (§61) – statute lists a non-inclusive list of sources of $ included in gross income. o It’s above the line if in § 62. income from insurance. o Credits include Hope and Lifetime Learning (§25A).
If have radically different fringe benefits. there could be wide disparities. Without taxation. its in the tax base per GLENSHAW GLASS. don’t want to double tax – once for compensation and a second time for income on sale. Court found payment of the tax by the employer was compensation for labor and as such was includible in employee’s income. Meredith Huston 2 Tax Fall 2001 .) • OLD COLONY TRUST – o Company agreed to pay employee’s taxes for 2 years. whether traceable to labor. (Includes property. in-kind compensation from employer. • Any fringe benefit not qualifying for statutory exclusion (§132(a)) is expressly includible in gross income (§61(a)(1) and subject to employment taxes.Supreme Court. All gains are taxable. • Included in gross income -. o Fair market value of property will be included in income. 71-89 • Excluded from gross income -. Form of payment doesn’t matter.WHAT IS INCOME? • Haig Simons definition – algebraic sume of (1) the market value of rights exercised in consumption and (2) the change in value of store of property rights between beginning and end of period in question. • Reg. Wages. the rich would get richer while the poor would have a greater % of their income taxed. then get FMV of property when given as compensation. 1. the difference between the price paid and the fair market value is considered to be salary o Compensation = difference between FMV and amount employee paid for property o Basis = amount paid + any amount included in compensation. without taxation. capital or good fortune. • Rationale for taxation: o Taxes serve as a proxy for ability to pay. Fringe benefits are a part of one’s ability to pay because they free up money which would otherwise be spent on supplied benefit. The code also specifically provides that certain items are to be included or excluded from gross income. If its accession to wealth. §61 is source-blind. The situation here is the same as where the company is paying the employee a higher income and the employee uses the money to pay the tax himself. • A first try: In MACOMBER (1920) – the court said income was everything from capital or labor (the question is…what about prizes. Would tax imputed income and unrealized appreciation. o Recognition of Congressional intent to tax all income broadly under §61 – all income from whatever source derived o The issue is now simple enrichment. fees.§61. • Could not be excluded as a gift under §102 because §102(c) says that gifts from an employer are includible income. it is still income. o If purchase property from employer at less than FMV. o Vertical Equity – better jobs usually have more fringe benefits. salaries. FRINGE BENEFITS • DEFINITION: Non-cash. o If you sell property. o Horizontal equity – similar jobs should be taxed similarly. scholarships etc?) • GLENSHAW GLASS -. 1955 – narrows definition of income – all accessions to wealth clearly realized and over which taxpayers have complete dominion. amount of income would be FMV.§§101-134 COMPENSATION FOR SERVICES §61 says compensation for services is included in income. commissions. fringe benefits are income. o Same rules follow when services are provided as compensation.61-2(d): if extra compensation is in the form of property.
If employer’s motive is to compensate. o 2 part test to determine if something was includible as income under §61 • economic gain? • Gain must primarily benefit taxpayer. Work-related fringe benefits -. dealership.) Under §132(h)(2)(A). Rationale for exclusion o Administrative burden of accounting is not worth the overall benefit to the system o Want to encourage people to buy certain goods (health care) o Political/Historical reasons – certain fringes were initially de minimis and voters take it for granted that are excludable. Court will look at the level of control of the employee and the primary purpose of the expense. Beneficiaries of fringe benefits exclusion include employee’s spouse. dependent child. Volkswagen hoped Gotcher would open a U. o Critical inquiry was what was the dominant purpose of the trip? If the payment of expenses serves no legitimate corporate purpose. As for his wife. and thus not deductible from income taxes. fringe benefits which don’t qualify for exclusion are now includable in gross income under §61 unless excluded by some other Code provision. Look to whether taxpayer had control over the expenses. the trip was primarily a vacation. then will be included in income. regardless of whether employee uses it for business or personal expense because either way it is a business expense to the employer. Fringes are partly non-compensatory as employer derives a benefit from them. Change would not be worth the potential political costs. would lead employees to take compensation in forms that they don’t want because it would be cheaper than cash at higher tax rates. o Difficult to estimate the value of a fringe to an employee and FMV may not be fair measure of income. now required to allocate expenses between business and personal when trip is outside the U. Meredith Huston 3 Tax Fall 2001 . or retired/disabled former employee. • GOTCHER (1968) (108) o Gotcher and his wife went on a 12 day all expense paid trip to Germany to tour Volkswagen factory. Don’t want to distort consumption decisions. however. Gross income shall not include any fringe benefit if it qualifies as one of the following: (Otherwise. it constituted income and was not deductible. the economic benefit will be taxable to the recipient.• • • o Efficiency –. EXCLUDING COST OF FRINGE: Purpose business or compensation? Employee can exclude cost of fringe from income if the primary purpose of the fringe is business.This is found in §132 – These are fringe benefits not covered by other specific exclusion sections. • §274(c) – explicit rule for foreign travel. The concept of tax expenditures: we can use the tax treatment of fringe benefits to incentivize certain behavior. the spouse/dependent children of employees and retired/surviving spouses of employees are treated as employees for No Additional Cost Service and Qualified Employee Discount.if didn’t tax fringes. rich people in a higher tax bracket are getting more of a benefit. o The district court held the cost of the trip was not income to D husband.S. as to D wife. But when we do that. Employer can always deduct whole cost of fringe. Did he have to take the trip? o The personal benefits Gotcher received were incidental to the dominant purpose of marketing and cultivating investors.S. See Gotcher below. employee.
o Example: sales of merchandise to store employees at cost. o §274(d) If employer uses fringe for both personal and business use. §132(g) Other excludable fringe benefits: o Meals and lodging. o Includes free standby flights to airline employees…the seat would go empty.132-2 – zero-marginal cost service provided to employee. security guard protection. o Discounts on property held for investments (as well as discounts on real property) are not excludable from income under §132(c)(4).g. Used to be that parking was excluded. o This does not include any amount that would be deductible under a trade or business other than that of working for this employer. personal letter typed by secretary.§132(f) -o Any qualified transportation benefit including a carpool (“commuter highway vehicle”) with at least 6 people. Like an empty seat on an airplane or an empty hotel room if they are residual spaces. etc. o Same line of business requirement as above. or highly compensated employees. o Must meet nondiscrimination requirements §132(h). but not mass transportation Qualified Moving Expense Reimbursement -. o (Line of business requirement keeps employees of huge conglomerates for getting a wide range of tax free services). can’t discriminate in favor of employees who are officers.§132(d) – property or services provided to an employee which would be deductible as trade or business expenses under §162 or as depreciation expenses under §167 if he paid for them out of his own pocket. 1. o §132(j)(1) – not excludable if only offered to highly compensated employees. use of copy machine) o Eating facilities: Employer provided eating facility is de minimus if located on or near business premises and revenue exceeds or equals operating costs. Working Condition Fringe -. o 1.132-1. Service offered must be offered for sale to customers in the ordinary course of line of business for the employer. use of a vehicle to get home if outside of working hours. (That’s the same as you can offer employees a % discount up to your gross profit percentage). will not qualify as a no-additional cost service because revenue will be foregone. §119 o Group-term health insurance.§132(c) – savings by employee is not taxable – Employees can get up to 20% of retail price (services) or employer’s wholesale cost (goods) tax free. If employees are allowed to reserve in place of paying customers.132-6: Include things like meals required to allow employees to work overtime. o Up to S100/month – including transit pass.§132(e) – Exclude if value considering frequency is so small as to make accounting unreasonable or administratively impractical (e. Qualified Employee Discount -.§132(b) and 1. §79 o Legal services. owners. It has to be a service of the same type ordinarily sold to the public. o Note: no discrimination clause for working condition fringes o Examples: parking facilities. they just take it…there’s no additional cost to the airline.• • • • • • • No Additional Cost Service -.§132(a)(6). $175/month in the case of qualified parking. then employee must substantiate what % used for business and only exclude that portion of the cost. De Minimis Fringe -. §120 4 Tax Fall 2001 Meredith Huston . Company picnics etc. o Reciprocal agreements among employers operating similar businesses: can qualify under §132(i). Qualified Transportation fringe -. trade journal provided by employer.
Health services.§119 (To be excluded from income) • Main issue is that it is difficult to draw the line between business and personal benefit. it is much easier to see how much personal benefit goes to the employee (and may be less likely to be excluded from income).this excludes employer contributions to accident and health plans from the gross income of employees. if deductible. ALTERNATE ROUTE TO DEDUCTIBILITY: If not excluded under §119. Court didn’t buy argument that for state trooper business premises consisted of entire state. o Troopers had to eat anyway and weren’t forced to eat in a particular place and were given $ whether or not they actually ate. If it: o (1) employer furnishes meals. Meredith Huston 5 Tax Fall 2001 . (Inconsistent with regulation. applies only if the employee must pay whether or not meals are consumed – SIBLA – firefighter case. then will be a working condition fringe under §132(d) §274(n) – deduction denied for ½ all meals to employer because is hard to determine whether purpose of meal is business or personal (more on this later). CASINO EXCEPTION . under §119(b)(3). When cash reimbursements are used.§119(b)(4) .Also known as the 50% rule. but the statute wins) COMMISSIONER V. §129 (phaseouts) o Meals and Lodging -. o Qualified education expenses – tuition reimbursement as a fringe benefit. where if over half the employees are getting meals for non-compensatory purposes. will be excluded under §132(e)(2). o If excluded from income under §119.119) Even if there is a part compensatory purpose. (2) the meals are provided for the convenience of the employer. o The issue was whether the payments were meals furnished for the convenience of the employer. The meals were not consumed on business premises. §117 o Transportation. Cash reimbursements aren’t excludable under §119. • Lodging – Counts if (1) it’s furnished on the business premises by the employer and (2) its provided for the convenience of the employer. • Meals furnished to employee. §132(e)(2) meals in a company cafeteria are de minimis fringe. If employee must pay fixed charge for meal. KOWALSKI (1977) (113) o Cash meal allowances for a NJ state trooper were found to be taxable. Convenience of employer met where there is a substantial noncompensatory purpose (Reg 1. dependent or spouse for convenience of employer and served on business premises are excluded from income. Court found that reimbursements were undeniably accessions to wealth. especially for employees of universities. §106. then they’re all deductible. May still be able to deduct expenses under §162(a) business expense provisions (50% limitation under that rule). allowed to exclude from income an amount equal to the fixed charge. (3) the meals are provided on business premises of employer. the noncompensatory purpose will trump it. The court held that § 119 did not cover cash payments of any kind. and (3) employee is required to accept lodging as a condition of employment. clearly realized. and over which respondent had complete control. §132(f) o Day care. consider deductibility under §162 (trade or business expenses).
that’s income. • If the house is close to the business premises. then will not be taxed. it can qualify (across the street). o §119 codifies the results of Benaglia.) Meredith Huston 6 Tax Fall 2001 . the outcome would likely have been different. • Must have a reasonable noncompensatory purpose to qualify as a fringe. §83 must apply (stock options must have a readily ascertainable fair market value. Manager was constantly on-call. o All or nothing approach – assume value is zero until it vests o Cannot value “possibility” of earning $ later • § 83(b) also contains an election. they pay tax on the difference.. BUT… • If a person receives property in return for performance of services and if property is non-transferable and subject to substantial risk of forfeiture (§83(c)(1)) at time of transfer. §119(a)(2).. Strange result o So the election is a bad deal if you are not sure property will vest or if you would prefer to minimize the capital gains you pay later on. • BENAGLIA V. Court rules it was part of the business premises. This reflects that Congress thought these benefits would be worth less to employees than market value. o When is it “substantial risk of forfeiture”? When full enjoyment of the property is conditioned upon future performance of substantial services by an individual. Expense was excludable because it was for the convenience of his employer. and for the convenience of the employer. Lodging must be a condition of employment to be exempted. o The election is a good deal if you are sure property will vest and you want to pay lower capital gains. Section 83 – Property Transferred for Performance of Services Basic rule: if you get property in exchange for services.why are these benefits any different? Focus on compulsion element. • Once the property vests (and forfeiture risk is removed) the taxpayer must include the basis of the property in his income. Basis = FMV at time of vesting minus any amount paid for the property. The taxpayer can elect to count the property as income upon receipt. That way. that’s income (its like another form of salary). which under GOTCHER is not income. See ADAMS where big house in Tokyo had become associated with company and was used for business entertaining. it is on the business premises. §119 was intended for situations where employees feel restrained in their choice of eating places. • Rule of thumb is that if business benefit is large enough relative to cost. Had to live there – suggests lack of control. COMMISSIONER (1937)(Handout) o Hawaiian hotel manager given luxury suite and meals in hotel.o If troopers had been given vouchers for their meals. o If the property never vests because leave employer (like lose stock options) code does not permit a loss (although would have thought it would). o If you still get the dividend from this stock. o Is this decision wrong? Salaries are paid so someone can exploit an employees services. o In order to make the election. Lodging excluded from income if employee is required to accept as a condition of employment. then property is treated as still owned by transferor and no income is realized by the transferee. so they solve the measurement problem by putting the benefit received at 0. any appreciation in value will be taxed as capital gain at realization rather than as income when the property vests. When a taxpayer is allowed to buy something at below market value in exchange for services. o Presence of compensatory element does not change the answer if it is outweighed by noncompensatory factors like the convenience of the employer. The employees are compelled to use the stuff.
Interest Free Loans Used to be a type of income-shifting from high-income taxpayers to low-bracket family members. (Interest rate is below the Applicable Federal Rate. • Employer Health Insurance -. Employer received deduction for premiums. low bracket person gets interest deduction. Term loans go by the rates listed. One important exception is §7872(c)(2). Result: high bracket lender gets interest income. • (2) the loan is one of the types of loans in the scope of §7872. employee must include in income portion of compensation received that is attributable to employer’s donation. although these payments might be included in gross income. They are gift loans. • Amounts received under Accident and Health plans -.Tax Expenditure Fringes • Preference in Code which provides a subsidy to certain types of expenditures or transactions. the statute applies 3 fictions: • Loan bears a market rate of interest • Lender gives borrower sufficient funds to enable borrower to pay lender market interest • Borrower pays lender a market rate of interest on loan. Way for government to encourage private expenditures in these areas. the short-term rate applies. • Educational benefits • Cafeteria Plans . If employer paid for some or all of insurance.employer payments to group term life insurance excludable from income so long as costs less than $50K. they may be deductible as §213 itemized medical expenses. benefit must be provided to all employees on nondiscriminatory basis. o Designed to allow the choice of cash or tax-free benefits o Availability of cafeteria plans = greatly expanded utility of tax provisions • Life Insurance – §79 -.payments made by employer for employee’s dependent care excludable from employee’s income up to $5000/yr ($2500 for married individuals filing separately). different for different length loans). $ received from accident or health insurance if insurance paid for by employee.when employees can choose from a variety of benefits. compensation loans. damages received on account of personal injuries or sickness (other than punitive damages). Check and see if an exception applies.500 of foregone interest is deemed transferred as a gift Meredith Huston 7 Tax Fall 2001 . §7872 applies to a loan if: • (1) the loan is a below-market loan. which excludes from §7872 auspices loans between individuals less than $10. corp-shareholder loans. AFR = 10%. Annual interest on loan is $20.000. tax-avoidance loans.§125 -. At the end of the first year.§129 -. they can still get their exclusions (provided that written and include in the choices cash and qualified benefits and that the benefits are non-discriminatory). • (3) None of the exceptions to §7872 apply. compounded semiannually. Full Example: Amy gift loans Bob $200. These are listed in §7872(c). If the loan is a demand loan. (Exception doesn’t apply to loans to buy income-producing assets).500. • Compensation and Insurance for Injuries and Sickness – §104(a)(3) – excludes from gross income workers compensation. $20. Assuming a loan is covered by §7872.§106 – excludes from employee’s gross income employer provided medical coverage and health benefits.§105 – includes in gross income all payments received from health insurance plans to reimburse taxpayer for expenses incurred for medical care to the extent that insurance plan (not including §105(b) medical expenses) was paid for by employer and was not included in gross income buy §106 • Dependent Care .000 at 0% interest.
unless one of the primary purposes of the loan is tax avoidance.500 will be taxed at normal rates as interest income. Use short term rate and recalculate that rate annually according to federal rates. Structured in this way. dividend. • Interest free loans are treated as if borrower was required to pay back to the lender the market rate of interest. A loans $10. o Demand loan – cannot necessarily know what counts as income because don’t know when loan will be called in. • §7872(b) – applies to all below-market rate loans. No money changes hands. A has income of 1K. o Instead. There is a $100K limit (aggregate of loans cannot exceed this) • To determine applicable interest rates. A will have no income and no gift tax. then retransferred from Bob to Amy as a interest payment. Bob will get a $20. if this is the case. A “gives” B gift/refund equal to interest paid by B (1K). amount of interest imputed as repayment to lender is limited to the borrower’s net investment income. • General rule is that loans at the market rate are not treated as income because liability to repay offsets the receipt. A also will incur $1000 of gift tax. or long term rate applies. must then decide if short. contribution to capital. or compensation. • Foregone interest is a transfer from the lender to the borrower and interest retransfer from the borrower to the lender. However. will not be excludable. The court will look to the economic realities to determine the principal purpose of the loan. mid-. §7872 says can’t get around tax consequences by dropping interest rate to zero. Amy’s $20. The foregone interest is then treated as a gift. depending on the circumstances. • Example: o A gives a 10K loan to B at market interest rate – 10%). must decide if loan is a term loan or a demand loan. so if borrower has a net investment income of $0.§7872 Shift taxes from lender to borrower. Will treat the cash flows in second scenario in the same way as in the first although they will not be characterized in the same way.from Amy to Bob. Is loan a gift loan? Yes No 8 Tax Fall 2001 Meredith Huston . (That’s what she would have made investing in treasury bonds). B “pays” interest to A of 1K. subject to “investment interest” restrictions. o Term loan – calculate amount of interest by going to applicable federal rate (AFR) (§1274).000 to B at zero% interest. not just interest-free loans • §7872(c) – treat reimbursement from lender to borrower as: o dividend – if corporation to shareholder loan o compensation – if employer to employee o income – if sole purpose is tax avoidance o gift – if gift loan §7872(d) – in case of gift loan. INTEREST-FREE LOANS -. lender does not have to treat would-be interest payment as income for taxation.500 interest deduction. to avoid tax consequences. • Loans of less than $10K are generally excluded if interest is a gift and if loan proceeds are not used for business or investment purposes.
No tax abuse going on. Alleviates efficiency concerns which arise when move away from non-cash economy. while other people have to earn more wages (and be taxed on those wages) in order to pay for the same services.g. How should imputed income be taxed: o Property tax can be viewed as payment for local services OR as income tax on value of home ownership. we should not tax one who chooses more leisure less than one who chose to apply their ability to do income-producing work (which benefits the economy) (e. Limits amount of “income” it to amount of net investment income. IMPUTED INCOME DEFINED: Income derived from the use of household durables such as a personal residence. or television set. o Example: paying cash for a house and then living there tax free. Service providing spouses) are better off because don’t have to pay for their services. car. • Imputed income is excluded from income under §61. o Deny deduction for mortgage interest paid out each year. o Valuation Problems. yet you’re not taxed on it. 7872(d) Limitation – if gift loan is $100k or less see 7872(d) Limits Deemed Income (B) above for tax purposes. and income from the performance of services for one’s own or one’s family’s benefit (plumber fixes his own pipes) This includes the income from homemakers. we’ll treat it. That would bring renters and owners much closer together. Imputed Income is divided into (1) imputed income from capital • You put money into a capital good that you use for personal purposes. You still get a flow of value out of the use of that money.Use 7872(a) Is it a demand loan? No Yes Use 7872(a) Use 7872(b) • Purpose is to avoid high income taxpayers from shifting cash to low income taxpayers to invest and then pay lower tax rate on investment returns. want to encourage home-ownership). why bother to treat it as interest. • Reasons why imputed income should be taxed: o Equity – people with tax free imputed income (eg. • Efficiency – if two people have the same ability to pay. o Allows for administrative efficiency. o Privacy intrusion for IRS to determine value of your services/how much you value things. Exception in barter exchanges – income is imputed and included in income so there is no incentive for people to engage in non-cash exchanges in order to avoid taxes. If a loan is more than $10k there’s no diminimus exception but for purposes of income tax. • Reasons for excluding imputed income: o Conceptual difficulty with taxing imputed income. Line drawing problems. Meredith Huston 9 Tax Fall 2001 . (A woman who worked and then had to pay for child care wouldn’t get deductions for this.
In some cases the taxes could encourage you to not do your own work (like fix your own sink). for determining loss on a subsequent sale of the property by the donee. Why tax gift giver? Consider gift giving to be a form of consumption. The selection of the donee as the taxable person favors wealthy people who give from higher tax brackets. No deduction should be allowed for consumption. This would be a huge implicit-subsidy for giftgiving. • So on gifts of appreciated property. the FMV of the property is equal to or greater than the basis of the property in the hands of the donor. at the time of transfer.§1015(a) (1) If. would give the donor a chance for a tax-dodge by ensuring $ will be taxed at donee’s (presumably) lower rate. Gifts (made during donor’s lifetime) §102 – donee excludes gifts from income. • You write your own will. • Ways we could tax gift income: Donor No deduction (taxed) No deduction (taxed) Exclude from income (no tax) Exclude from income (no tax) • Donee Exclude gift from income (no tax) Taxed on gift as income (taxed) Taxed on gift as income (taxed) Exclude gift from income (no tax) Analysis Law for most gifts. Less fear of fraud in the alimony circumstance. Don’t do this because would be 2 full levels of tax Law for Alimony. (2) What if the property has declined in value in the hands of the donor so that FMV of the property at the time of transfer is less than the donor’s basis in the property? • For purposes of determining gain on the sale of property acquired by gift. could make reciprocal gifts and evade tax. the donee’s basis is the same as the basis of the donor. no tax. It is hard to imagine taxing this. Gifts of Appreciated/Depreciated Property – What is the Basis? Two scenarios . which is why tax on donee is allowed there. If were to tax the donee.(2) imputed income from labor. Therefore the donee is responsible for any appreciation in value that took place while the donee owned the property. the donee takes the donor’s basis. Meredith Huston 10 Tax Fall 2001 . but someone else should pay tax. as well as the appreciation between the gift and the sale of the property. DO YOU HAVE TO WORK FOR YOUR INCOME? Gifts and Bequests • §102 – excludes value of property acquired by gift/bequest • Donor is taxed instead of donee. Our system because donor is more likely to be in a higher tax bracket. Gave the $. This is the deal with charitable gifts. §1015(a) carries over the donor’s basis to the donee. • However. the donee takes a basis equal to the FMV of the property at time of transfer.
Bequests §102 – beneficiary excludes gift from gross income. 1.61-2(a)(1)) • COMMISSIONER V.If it is not possible to establish donor’s basis. (Reg 1. • This means appreciation of property during the decedent’s life will never be taxed • Encourages individuals to retain appreciated property until their death. §691(a) – Bequests – Bequest is included in gross income of estate or beneficiary. • Tips that constitute compensation for services are income. Reg. admiration. o Court looks to the totality of the facts and disregards common law definition of a gift (as a voluntary transfer--that’s not enough here) – said too broad • Under common law def. Example: Donor gives stock worth $2000 that cost the donor $1000. See reg 1. If the stock is then sold for: $5000 Then the gain is $4000 $1750 The gain is $750 $600 The loss is $400 (because the basis is just $1000. Duberstein would clearly have been gift. Meredith Huston 11 Tax Fall 2001 . B has no loss or gain on the sale. DUBERSTEIN (1960)(138) – The Cadillac case. You look at the donor’s intent. o Duberstein suggested customers to car dealer. (Stepped up or stepped down). o You get a business deduction for the first $25 of untaxed gifts made to a client. Another example: A gives B property worth $10. If she sells the property for $15. 102(c) will not apply id transfer of money is “substantially attributable” to family relationship and not to employment relationship. it is not a gift (Shuldiner says do not take this at face value. out of affection. When is something a gift? • §274(b) – Employers can’t deduct more than $25 in any year for gifts to employees. with a basis of $20. respect. o Court defines “gift” as something given from detached and disinterested generosity. o Problem with DUBERSTEIN: allows some room for donee to exclude gift from income and for donor to deduct gift from income (Congress passes § 274(b) and § 102(c) to try to close this gap) o Court says if payment proceeds from constraining force of moral duty or from the expectation of future benefit. Basis is determined by §1014.102-1(f)(2) – if familial relationship. never greater than FMV at time of transfer. For the purposes of determining loss. o The taxpayer’s argument that something is a gift will be a lot stronger if the business giving to them doesn’t deduct them as a business expense. the lower of the donee’s basis/FMV at time of gift. who gave him a Cadillac in return. basis will be FMV at date property acquired by donor. whoever receives it. • § 102(c): gifts transferred by employer to or for benefit of employee cannot be excluded from gross income (require context of employment relationship). charity or like impulses.1015-4 provides that initial basis of transferee is greater of amount paid by transferee for property or transferor’s basis under §1015(d)/ For determining loss. but to sell before death anything that’s declined in value. For the purpose of gain the basis is $20 so he has no gain. B has a basis of $10 so he has no loss. board voted him a gift of $25. Property acquired by reason of death takes a basis in the hands of the beneficiary equal to its fair market value on the date of the decendent’s death. Stanton acted as church manager and comptroller.000 when he retired.
See §86. o But certain prizes are excludable if they are not retained by recipient.probably wouldn’t apply to a gift to your grandmother out of moral duty clearly there’s this core idea of familial gifts that is excluded from “detached and disinterested”) o Govt. • §74(c) – exception – employee achievement awards (like for length of service to safety). not included in gross income if less than $400. like room and board. • §127 – allows any employer to give education assistance tax free to employees up to $5250 (see also §25A for Hope Scholarships and Lifetime Learning Credit. like teaching or researching. and t is number of years) 12 Tax Fall 2001 . look at estate and gift tax (but say can’t analogize to that – don’t tell us why there would be different definitions of gift for gift tax and income tax.§85. • Unemployment is generally taxable . wants clear test – personal property distinguished from business reasons. o §117(c) – exclusion don’t apply for scholarships that are compensation for services. (This is because its supposed to take the place of wages. can avoid certain taxes if you win prize and give it to charity. common law definition (voluntary transfer).) • Social security benefits are taxable according to an income schedule. Has to be in recognition of merit (see list). Government Transfer Payments • Support provided by family members. not from legal/moral requirement). Prizes. as possible so can tax it under income since it would be deductible want definition to be as narrow as possible. in certain cases. • Welfare payments aren’t taxable. Awards Scholarships • §74 – prizes and awards are income. and award has to go to charity. award can’t require future services. like intra-family gifts. not included in gross income.) CAPITAL APPRECIATION AND RECOVERY OF CAPITAL • need to decide when to tax gain from capital o realization doctrine—wait until realization of gain • how to figure out how much gain? o Basis – device tax law uses to keep track of cost Present Value Computations • • Meredith Huston Present va lue = Future payment (1 + rate of return ) number of years deferral Future value = x (1 + r)t (where R is the interest rate/rate of return. o §117(d) allows universities to give free education to employees. Athletic scholarships are a gray area. • §117 – Scholarships are excludable only if the are “qualified scholarships” o A scholarship is qualified only to the extent that it covers tuition and required fees/books/supplies. §117(c) would seem to apply if scholarship is conditioned on playing a sport. for gift tax want as broad def. recipient didn’t enter contest. govt. • Other possible tests: intent of donor (detached and disinterested generosity. §117(b) o Students must include in income scholarships that cover other expenses.
determination of amount and recognition of gain or loss o (a) gain = excess of amount realized minus the adjusted basis. IRS will always argue for the third. no worse off than you were the day before. Expensing sets the basis at $0 so that at the time of sale of property. Code generally only taxes realized gains. Dividend income received while stock held is taxed in full without any offset of capital invested. cost or basis taken into account only when stock is sold or exchanged. Depreciation is amount of decreased basis. Determination of Basis of Property o §1012 -. cab driver taking depreciations for car). Allowing this would essentially turn income tax into a consumption tax. Since depreciation is treated like cost. there may be timing issues associated with taxes that make this preferable. now have car.The basis of property is its cost. However. • Recovery of Capital/Ways to account for Cost: o Immediately deductible expense – costs said to be expensed. tax-free recovery of such income-producing expense is immediate. o Capitalized – Purchase price or cost taken into account only when asset is sold or exchanged. No better. all income from sale taxed. o Amount realized = sum of $ received plus value of property received. Loss = excess of adjusted basis minus amount realized. o Depreciated – periodic deductions are allowed for asset’s cost (e.Best to deduct now and pay tax later (defer income) because $ today is worth more than $ tomorrow. In case of stock. except as otherwise provided. If enough income to offset deductions.g. When asset must be capitalized. This generally does not make sense because all you have done is to exchange asset forms. Immediately Expense Gross Income Deduction Net Income Depreciation Gross Income Deduction Net Income Capitalized Gross Income Deduction Net Income • • Year 1 3K 10K (7K) 3K 2K 1K 3K 0 3K Year 2 3K 0 3K 3K 2K 1K 3K 0 3K Year 3 3K 0 3K 3K 2K 1 3K 0 3K Year 4 3K 0 3K 3K 2K 1k 3K 0 3K Year 5 3K 0 3K 3K 2K 1K 3K 0 (7K) Taxpayers will always prefer the first option – delay of income recognition and acceleration of deductions. • Capital Recovery and Basis • § 1001 -. Had cash. basis is adjusted by a set % each year. tax liability on other income is offset by amount of depreciation taken o Example: Buy an asset for $10K that will produce $3K of income. Cost – depreciation + capital investments = Basis Meredith Huston 13 Tax Fall 2001 .
below) • Hort inherited building. he was relieved of the duty to pay income tax. can allocate basis if give up interest in residual and income stream (e. profits. or gains or profits and income derived from any source whatever. Allocation of Basis (when there is a part sale of property) Could apply amount realized against basis for entire property and not report any gain until aggregate amount realized exceeds entire basis. Allocation is in proportion to FMV of portions at time property purchased. Would have included prepayment of discounted value of unmatured rental Meredith Huston 14 Tax Fall 2001 . o Where bargain purchase is in substance a substitute for salary. Bank canceled lease when became no longer profitable. o §1016 – Adjusted Basis – reflects capitalized expenditures. Another random exception: A court let a taxpayer treat the entire proceeds of a partial sale as tax-free recovery of capital when someone damaged his riverfront property. Hort claimed canceled lease as a loss (difference between present value of future rental payments and the lump sum settlement received for letting out to bank) and did not claim $ in consideration for cancellation of income. depreciation. then can allocate basis when give away some of that income stream. income and basis would be $100). HORT V. the exchange is usually viewed as a realization event and any gain/loss will be recognized. Court was influenced by (1) basis allocation would have been difficult and (2) the sale was involuntary. • Reg. o §22(a)—expressly defines gross income to include gains. and certain losses.Simple rule: Where the taxpayer receives property in exchange for cash or services. If own income stream and underlying residual.61-6 requires basis allocation rather than upfront recognition of the basis with the first sale or deferral until final sale. buy 4 acres land for $1K and sell 1 acre for $500 minus $250 of basis. Court held $ received in consideration was a substitute for rent and was taxable income. Could allocate basis of whole between part sold and part retained in some reasonable manner and compare amount realized with portion of total basis allocated to part sold. plus amount included in income as salary (e. COMMISSIONER (1941) (140) (compare with HORST. It is as if the employee had received compensation in cash and had used the cash to purchase the property. not at favorable capital gains rate. But to that extent. employee permitted to purchase $100 stock for $80. (Reg. Taxed as ordinary income. May also allocate basis to figure out depreciation. Rented out to Bank. Cost is generally the value of the property received. purchaser takes cost basis and is not taxed on gain until disposes of property at FMV. Cost basis of asset would be recharacterized purchase price.). Had to report entire amount received for lease without regard to claimed disparity between that amount and difference between present value of unmatured rental payments and fair rental value of property for unexpected period of lease. §1. the basis is the fair market value of the property received. o Cannot claim loss for canceled lease because undoubtedly diminished amount of gross income expected to realize.g. untaxed receipts. amount of price reduction should be included in income and purchaser should be treated as acquiring asset for FMV. Allocate basis according to FMV of each part and amount realized applies only to basis of part sold. If property purchased at less than FMV.61-2(d)(2)(i).g. 1. and income from rent. o Where taxpayer acquires property in exchange for property. taxed on $20. Hort received $ in consideration of canceling lease. So if you own only income stream. amount paid. Reaches rent prior to cancellation. • Can only allocate basis if give up a portion of all that you have.
Shuldiner proposes this case was really about whether Hort had a realization event. will constitute gross income for the taxable year in which it is reduced to undisputed possession. Basis remains with the principal. then he would have basis and this decision would not apply. Court held that taxpayer must point to a specific statute to show an exception to gross income or the cash will be included in income under §61. carver out interest not a capital asset and cannot have basis. however.g. basis in property unchanged and income is taxable. • §1091 – disallows realization of loss in a “wash sale” – (e. not the year of purchase. lease is carved out of ownership in land). was somehow not a property transaction.S. Currency. 1. Would have extended to proceeds of suit to recover damages from breached lease.1000-1: Gain or loss is realized only when exchange of property for other property that is materially different in kind or extent (e. • CESARINI V. land is exchanged for cash). don’t account for intermediary gains/losses. Cash is income for the year found.61-14 : in addition to the terms enumerated in §61(a). Meredith Huston 15 Tax Fall 2001 . found $4467 inside the piano. Rental stream not a separate capital asset with allocable basis. and buy 100 shares at a lower price within 30 days). §1221(4) and 167(c) – cannot have basis in lease payments or in any right of future stream of income arising out of a larger estate (e. only gains/losses upon realization.” o Reg. etc. there are many other kinds of gross income.g buy 100 shares of stock. o Administrative burden of annual reporting o Difficulty and cost of determining asset values annually o Potential hardship of obtaining funds to pay taxes on accrued but unrealized gains. merely creates ordinary income If have property that produces stream of income and sell that stream. o Reg. but there could have been some plausible argument that the expected value of the lease was embedded in the basis of the sasset he received from his father. o This supplies possibility of significant abuse and much of the tax code is concerned with limiting the ability to “cherry-pick” from assets in terms of realization timing. Includes “treasure trove” to the extent of its value in U. Realization • Gains and losses in the value of property are generally only reflected in taxable income when “realized.o o o o o o payments whether received at inception of lease or any time thereafter. This. it is unrealized gain. sell at a loss. US (1970)(144) – Taxpayer bought a piano for $15 in 1957. • The realization requirement provides taxpayers with flexibility in the timing of taxation of gains and losses. In 1964. o Note: Contrast from treasure trove: If you buy property (like a painting) and find out immediately that it has a greater value than expected. Realization events include sales. would the cancellation be a realization event? Moral – cannot divide basis intertemporally. Note that if Hort’s asset consisted solely of the lease. Court is implicitly saying that his basis = 0. the increased value is not income. 1.g. • Realization requirement is necessary because periodic taxation of accrued gains and losses would cause three problems. Shuldiner says Hort should have been arguing that he had basis = value of the lease. changes to terms/legal entitlements. Therefore $ received for carved out interest or right to future payment included in income with no adjustment to basis. If lease were an asset.
but good to understand. Receipt of books was an accession to wealth and must be included in income. taking deduction shows exercise of dominion and control. o Haverly was trying to get a double tax benefit – no tax and get charitable deduction. taxable. This is an old standard. loans were different enough. Issued stock dividends. no limit where there is fraud/misrepresentation. improvements were charged as income. no longer good law. With charitable donations. 1. Question then is whether different sets of loans are materially different. Macomber still applies to stock dividends. Coupon -. (e. COTTAGE SAVINGS (1991)(154) – S&L sitting on huge losses. Income must be derived from capital and not just increase in wealth to be taxable under 16th amendment. If cash option. This was a realization event. generally 3 years if overstate depreciations. want to take them as a tax loss. then not taxable. If taxpayer receives stock dividend. FHLBB). Realization is fundamentally arbitrary. Loans were materially different because holders had different legal entitlements in kind/extent. there is no need to wait for a realization event in order to include it in income. 6 years if understate income. crucially. (Issued shares of stock as a dividend rather than cash). no income. o Respective possessors of properties must enjoy legal entitlements in different kind/extent to qualify for a realization event. Frequent flier miles – consensus seems to be that for business they are income (because have deducted the cost of the frequent flier miles as a business expense). So they created a clever device by which they swapped losses with another S&L (actually. for personal use they are not (purchase price reduction). Exchanged mortgages would qualify as a change in legal entitlement. If the found asset had been something less liquid. general rule is that don’t have to realize/recognize gain where donate property which has appreciated in value. so losses were allowable. Eisner v. just saying that Haverly’s donation of books made it clear that he considered them to be income.income? No is merely a purchase price reduction. US (1975)(146) – School principal received unsolicited textbooks from publishers. But see §109 – improvements to farm are not income. o Court is not saying that donations to charity are realization events. The gain is considered to be built into the property. o Statute of limitations regarding taxes.g. MACOMBER (1920)(149) – Corporation had a lot of $ gains. then have income.• • • • • • o The underlying logic here is that since cash has no basis. when owner got farm back.001-1 – for there to be a realization event. o No realization. HAVERLY V. o Cash dividends are taxable whereas stock dividends are not taxable until stocks are sold and cash gain is realized (now codified in §305(a)). and. then could have argued were a working condituion fringe under §132.) o IRS argued that exchanges of substantially similar pools of mortgage loans was not a realization event. has no option to choose cash. Selling loans means putting losses on books which creates insolvency issues and might require that S&L be shut down under other laws. then donated them to school library and claimed a deduction. tenant made improvements. but cannot do so without a realization event and therefore want to sell mortgage loans. o If employer had given books to him. o Reg. Court disagreed. must be an exchange of materially different sorts of assets. would have been taxed when sold or converted to cash. Cases since have held the opposite – BRUUN (159)– farm leased. 16 Tax Fall 2001 Meredith Huston . Where there is an intent to exercise complete dominion when received. o If employer gave it to you might be income (although de minimis) EISNER V. Here principal exercised dominion over books by donating them and trying to deduct and here.
34 94. the banks emerged with legally distinct entitlements. all additional payments count as income. Here you were assumed to have an annual income of 3% of your purchase price. Investment in annuity is in effect the “basis” recovered when payments are received. Allows for significant deferral of income. Several approaches. not their value. This ratio remains constant through the life of the loan.§72 • Annuitant has income to the extent receives more than paid for annuity.30 Ending Balance 183.67 New Balance 283. materially different.00 94.34 267.34 100. New standard permits change in debt instrument without triggering a sale/exchange. Set an interest rate of return (IRR).96 89.34 0.63 Life annuity = Classic annuity 17 Tax Fall 2001 Meredith Huston .00 Withdrawal 100 100 100 300 267.04 11.34 194.30 237. for 5 years want $1000/month. o 3% rule – this was prior statutory approach. • Term Annuity – i.66 32. o Basis recovery first – this was the old way to do it. So the annual payment would consist of $3570 (5/7) of capital recovery and $1430 of taxable interest. • This accelerates the recognition of income. Don’t begin recognizing income until your basis in the annuity’s purchase price is paid off.34 Interest 16. (§72(b)).o Ex. Taxpayer prefers this deferred taxation. then the portion of each payment = AIP*IRR is income. but perhaps not if exchange wheat futures. o Exclusion ratio – this is the law – what §72 says to do – Set an exclusion ratio where the numerator is the investment in the contract and the denominator is the expected return. This creates an exclusion factor of 5/7 (100000/1400000). Once your basis has been recovered. Here. Tremendously taxpayer friendly. • IRS probably gives preferential treatment to annuities (by using exclusion ratio calculus rather than bank deposit treatment) because want to encourage retirement planning. Reg. You are treated as if you deposited your investment in the contract in the bank account and withdraw the fixed amount of the annuity from the bank each year.30 183.94 94.001-3 – makes easier to renegotiate instrument. and for every payment.70 29.e. if exchange stocks.00 5. ANNUITIES -. 1.000 for a life annuity that is expected to give you 28 $5000 payments (for a total of $140. Year 1 2 3 Total PDV • Starting Balance 267. Look at characteristics of things exchanged. o Bank Account Treatment – this is what Shuldiner likes. For example: if you pay $100. since the earlier balances are necessarily larger. Deferred annuities have most preferential treatment. The bank is assumed to pay a certain rate of interest (market rate?) Basically have a self-amortizing loan which = the present value of all annuity payments. redefined materiality. payment * exclusion ratio is the recovery of capital.00 Principal Withdrawn 83. and payment * (1-exclusion ratio) is taxable income. It is necessary to determine what portion of each payment is treated as tax-free recovery of basis and what portion is taxable return of investment.000). Remainder is recovery of capital.
annuity will kick in and pay $100/year for 3 years. your estate) get a deduction at death for all of the basis that you did not get to exclude. under annuity rule.TWO SCENARIOS – HOW LONG WILL YOU LIVE? • If you live longer than expected.Note contract requires real life insurance component for tax-free policy to apply. get the $. o Shuldiner argues that on average. Involves gamble that insured will live through term/period covered by insurance. when turn a certain age. no income if your beneficiary collect or loss if it expires. Interest is taxed to annuitant as receives payment -. interest is taxed first. o No deduction for premium. must use present value. o §1275(a)(1) & Reg. If annuitant lives to life expectancy. Basically nets out. expect $83 to grow to $184 (if you put $ in bank at 6%). §72(c) – often look to tables on life expectancies to calculate out life annuities. 28) (where does 300 come from? -.§72(b). o §7702(a) -. to get value. LIFE ANNUITY . §72(q) imposes penalty on amounts withdrawn before retirement. 1. o Preferential tax treatment – when compared to other forms of savings. this is more harmful to taxpayer than if transactions were actually taxed. $83 now (if rate is 6%). Mortality gains are not taxed. Now you will pay $267 for future privilege. then you (actually. • Ex. when you get income. • Term insurance – premium in return for which a specified sum will be paid to insured’s survivors in event of death. Difference represents interest. you cannot exclude from income more than your basis in the annuity K and therefore you must take all $ coming in from that time (the time you were supposed to die) forward as income and therefore taxable. Deferred annuity – put aside $ now. When taxpayer wants payments to be in the future. gross income does not include amounts received under a life insurance contract. if such amounts are paid by reason of the death (or terminal or chronic illness) of the insured. therefore.o Give insurance company $. • Rules do a bad job of recognizing the difference between a deferred annuity and a term annuity. then take $72 into income each year for three years in which you get $ and $28/year counted as repayment of basis. since if insurance companies are doing their job. interest accrues between time of initial purchase and time of first payment. annuity payments will exceed annuity cost. This defines what gets this favored treatment. and therefore outlive these allocations. but now are aggregated. LIFE INSURANCE • §101 – except as otherwise provided. Insurance contract against living too long and outliving your assets. Actuarial tables used to be gender bifurcated. o Shuldiner’s theory is that this is a way to take back from the women who are now getting lower averaged life exclusion ratios. their exclusion ratio used to be lower and had to pay a higher tax. pay no tax until get payment. policy expires. Since women live longer than men. Need present value of $267 in 20 years. significantly more policies will expire (for which they can’t collect a loss) than pay out (for which they are not taxed on the gain). Meredith Huston 18 Tax Fall 2001 . they say will give you $1000/month for life o Opposite of life insurance.$100 for 3 years). calculate exclusion ratio ($83/300 = .72-9 (table ages). 20 years from now. • If you die early. o Uncertain what the final calue will be. Thus when cash is withdrawn. • §72(e) – treats cash withdrawals before starting date of annuity as income to extent cash value of K exceeds owner’s investment. Survivors do not get return if insured survives.
Meredith Huston 19 Tax Fall 2001 . would not be allowed to deduct term payments from your income.• • • • • o Alternatively wouldn’t make much difference. Overcharged when you’re young. and the savings portion. Since gain = amount realized – basis. §101(g) – lets those who are terminally ill cash in policy and treat it as life insurance or can sell policy and treat it as if life insurance and thereby get tax benefits. which would be taxed. Ordinary Life Insurance – Whole life. • Makes sense because nobody’s net worth is changing. Total policy costs consist of the cost of the pure insurance protection enjoyed up to surrender date. offset that interest against the costs associated with the policy. §101(c) – have to include interest payments made on insurance proceeds that have not been fully distributed to beneficiary. This is a tax favored form of investment. undercharged when you’re old. even if the taxpayer/criminal is required to return the money. if withdraw. then taxing gains would have no effect. Basis is what you put in/spent on plan. Illegal Income • General rule – illegal income is included in income/taxable under §61. o Two elements: “pure term insurance” and “savings” component (building up cash value of policy) o Can borrow against this $ and can withdraw (surrender) $. But its made interest. this is clearly tax-preferential treatment. are taxed. TREATMENT OF DEBT A borrower doesn’t realize income upon receipt of a loan. in other words. Pays out at death. Result is to let you deduct term premiums. and every month they subtract your “premium” from the account. uniform annual payments. Just buy n/(1-tax rate) to put yourself in the same position as a no-tax world. not the company. that interest must be included in income. Twist is that insured can deduct money from his account at any time (after some minimum number of years). If benefits taxed and premiums deductible. account bears some interest. Reflects investor’s decide to increase savings element of insurance component. Amount realized (what have in account) = everything you put in (whole life premium) + interest – term premiums. not after death. o Even if you cash out via surrender. the loading fee. Universal Life Insurance – huge lump sum payment up front. There is also no deduction when he makes principal payments on the loan. Essentially treats non-term life insurance like an annuity. $ paid out by plan at death. If amounts excluded are held under agreement to pay interest. Except you can. then gain = interest – term premium. or his beneficiaries receive balance in account on his death. Variable Life Insurance – savings: paid premiums invested in equity market. Presumably buyer of plan is taxed on gain from $ paid out v. Company invests the sum. • Not fair to tax people who make legal $ but not those who make illegal $. Under normal tax rules. Idea is that terminally ill need $ at end of lives. Smoothes out the effect of increasing premiums as you get older and more actuarially risky. in effect. if policy is paid out and beneficiary does not get all $ and instead someone else holds $ in exchange for interest. o Interest build-up in savings portion is not taxed. Essentially are building up a savings reserve in your insurance account with the too-high payments early on. Insurance company invests this reserve and the interest or gain earned helps to pay out later. those payments are taxed. regardless of how loan proceeds are used. whenever that occurs. Returns will vary and insured bears the risk. you are taxed on the savings component only to the extent that it exceeds the value of the policy. Allows you to exclude income life insurance payments before death.
lender can obtain satisfaction of obligation only from property securing debt. • Court saw issuing bonds at one date and then repurchasing them at another day as a good investment. Once repayment is discharged. • Interest on loan – Debtor may deduct interest payments. o When taxpayer makes restitution for illegal gains. must account for original loan in income. • Non-Recourse debt – Borrower is not personally liable for repayment of debt. Avoid purchase price redux theory that court in Zarin could have done. Courts have held though that people act as if they have to repay and so treat non-recourse debt in the same way as recourse. With illegal income (e. 175) – corporation sold bond (borrowed) for $12.15M in income. buy inventory . so it is taxable. Gain measured based on FMV at time of receipt. What’s a better approach to base the decision on? Typically businesses make deductible outlays with borrowed funds (pay employee salaries. Less clear. Repayment is recovery of capital.• • Distinguished from loans: with loans there is an understanding that the borrower will repay. Lender does not have deductible loss upon making loan and does not realize income on repayment of loan principal. Collins derived a benefit from illegal income. Merely exchanging your future repayment for cash today. lender can look not only to any asset securing the debt.§162 ordinary business expenses). so could argue that this should be recognized as income. Upon default. COMMISSIONER – (1993) (167) – taxpayer made illegal bets by embezzling $ from off-track betting by punching up $80K in betting tickets for himself. no simultaneously occurring liability giving rise to a net increase in wealth. embezzlement) there is no repayment expectation (i. Rationale: 1) Net gain in wealth and therefore should be taxed.g. bought back for 12M. and the resulting gain was taxable like any other profit from speculative activity. and 2) Original loan was not taxed as income on assumption that it was later to be paid back. but also to borrower’s other assets for repayment. Lost $38K. So people are allowed to Meredith Huston 20 Tax Fall 2001 .15 M. Creditor must include interest payments as income. Clear that recourse debt is not income when issued. o Court rejects argument that in Zarin (3rd cir. Not a taxable event. There is no deduction when makes principal payments on loan. Discharge of Indebtedness • §61(a)(12) – Gross income includes income from discharge of indebtedness (where debt is cancelled for less than face value). Entered into legally-enforceable promise to repay. KIRBY LUMBER (1931)(see p. Congress passed §108 to provide some relief for this provision. Court treated this as forgiveness of indebtedness and therefore taxable as income. o JAMES – Court requires a consensual recognition of an obligation to repay.) tickets have no economic value and should be excluded under §108(d). regardless of how loan proceeds are used because is offsetting obligation to repay. Not obliged to repay. he can deduct the amount of those payments from his gross income.e. “found” $. COLLINS V. • Recourse debt – Borrower is personally liable for repayment of debt. Results are appropriate because there is no change in the net worth of either party. • HOWEVER. HOW LOANS ARE TAXED • Principal of loan – Borrower does not realize income upon receipt of loan. Cannot deduct gambling loss because can only deduct against winnings §165(d).
could not have income from discharge of indebtedness. o Does the court say that exception 108e5 can’t apply to intangible property? No. • Lawyer argues that loan was non-recourse so he is no better off legally than he was before the loan was forgiven. taxpayer not liable for debt because chips are not property. J. the Court should have made him reduce (1) or (2). o Alternatively. prices go up). Is amount forgiven taxable? • IRS’ theory – there is a discharge of indebtedness so he has income under §61(a)(12) of $3M.5M. but rather are a medium of exchange. Why could they buy back bonds at less than face value? Interest rates go up. but this case doesn’t fall under what Congress intended to be included. but didn’t he – e. there is no purchase price reduction because chips had specific face value and statute didn’t intend adjustments for that. 3M cancellation of indebtedness income. happiness at the table] o If yes. Under NJ law. his net worth did not increase. Result to lender is income. Didn’t arise from a purchase of property. • §165(d) – can only deduct gambling losses against gambling gains (attempt to discourage gambling). Also. it was a contested liability and income doesn’t arise under settlement of a contested liability.g. and you’re screwing the Treasury unless they tax that muthafucka. • Counterargument – but why should we only go after net losers and not net winners? Imputed income argument – should person who chooses work they like be charged for it? • Tax court said no. you’re not doing (3).e. (2) get deductions for outlays of funds. • Economics perspective – had 3. ZARIN V.5M loss. amount that’s important). Meredith Huston 21 Tax Fall 2001 . [Consumption + Δwealth = -500k argue he didn’t consume anything. Tax perspective – we don’t allowed gambling loss for taxable purposes so has 0 income. selling at low rate) and then re-lending $ at higher interest rate.5M gambling loss. Alternative: Kirby Lumber looks like a worse credit risk now than when loan made.o (1) exclude the borrowed money from income. argues that he didn’t see chip income as debt because he didn’t think he was going to have to pay it back. That’s how the Treasury makes it back. lender may make $ by letting borrower pay back less than full amount owed (i. but they didn’t have a statute for that. Property isn’t chips themselves but opportunity to gamble the chips. he now has to give back either (1) or (2). Really. Can buy back bond at a cheaper rate now than before. and so has loss of 3M. Rue’s theory in dissent (maj. ASSUMING (3) the company will subsequently repay the amount borrowed out of after-tax income. taxpayer received value of opportunity to gamble from casino. so they did the next best thing and include it in gross income. said it may apply to some types of intangibles. If you get a discharge of indebtedness. Having reduced his repayment. SO net has . • Circuit court overruled tax court and found since the loan was unenforceable under New Jersey law (adopt Jacobs argument). rejects): Exceptions to principle of indebtedness – 108(e)(5) – reductions in purchase price shouldn’t be counted as income (it’s new amount not orig. so prices go down (if go down. Settled for $500K. Jacobs. If the interest rate on debt is lower than current market interest rate. why should we just tax losers and not winners? Consumption Argument – there is some consumption in gambling and so shouldn’t be able to deduct it. COMMISIONER (1989)(175) – Debtor gambled on credit and defaulted to casino for $3. 3 COI income.
not income 108f – loan forgiveness for students doesn’t count as income. Use the amount of debt forgiven in insolvency to reduce the basis in other assets. Exceptions to Cancellation of Indebtedness rule . As if took deduction [for business expense] and gave it back. Taxpayer has income of $10 because insolvency exception only covers amount to extent of insolvency. would have to pay more tax on the sale. Ultimately. Except for §108(e)(5). discharge of a liability doesn’t result in discharge of indebtedness income to the extent that liability would have been deductible had it been paid. Fair market value is 1. and annual accounting system – was no gain until 1981. o §108(e)(5) – Purchase price Reduction – reduction in price owed to seller for purchase of property (not services) not treated as a discharge of indebtedness (which is includible in income).Freeing of assets theory Counterargument – but if debt was never enforceable.g. HYPO – parents lend you money for tuition for law school and then say forget it.g.§108 o §108(a): A cancellation of debt is not taxable where the taxpayer bankrupt (108(a)(1)(a)) or is insolvent (108(a)(1)(b)).” it happens only in the next year when he settles. if didn’t sell would bear higher cost of depreciation (couldn’t deduct). Building worth 2M.5M. Qualified real property exception: For example. • Court responds: o No. liability is $100. all the theories revolve around the question of value. Has to be debt that was incurred to buy the building (not for other purposes). So he’s at -$60. E.8M. See debt as much more real. Could I use purchase price redux theory – NO because money is from bank NOT seller. debt reduction would otherwise have resulted in discharge of indebtedness. even if we can see “chip income. theory than under insolvency argument? • Under insolvency it’s not a free ride – would have to reduce “tax attributes” (other deductions). Reduction does not affect income. Looks at moment before debt was forgiven to moment after debt was forgiven and sees – you are better off. see debt as outstanding until it was settled in 1981. debt of 1. Have to respect 165. $70 forgiven.5M. o §108(e)(2) – Lost deductions – excludes from income discharge of debt if its payment would have given rise to a deduction (e. then canceling of debt didn’t free up any assets. For reduction in amount of debt to be treated as a purchase price reduction. Assets are $40. (Why should 108(e)(5) only apply to property? Why not to services?) Meredith Huston 22 Tax Fall 2001 . Can’t use insolvency exception – though within scope of the deal. it’s a gift.) (Might have to itemize for this provision to apply) o In other words. would lose bases in those properties – if sold. Why is Zarin better under 3rd Cir. if bank forgives interest on mortgage. must show: debt is of purchaser of property (not a 3rd party) to seller which arose out of purchase of that property (does not apply if debt transferred to 3rd party) taxpayer must be solvent and not in bankruptcy when debt reduction occurs. He’s developer. might not be insolvent overall. lender agrees to mark down debt to 1.
• S1001 – determination of amount and recognition of gain or loss o (a) gain = excess of amount realized over the adjusted basis. Example: Borrow $200. the lender reduces principal to $150.000. or it may be a nontaxable gift. • SMALL EXCEPTION – Reduction of principal of an undersecured nonrecourse debt by the holder of the debt (not the seller) results in discharge income. should be reduced by a third if we are going to take them away. but poorly. • §1017 – Rules for adjusting basis where there is a discharge of indebtedness • Other discharge exceptions: If a lender cancels the debt at a discount as a gift to the borrower.000 – adjusted basis (§1016) = $120.g.000 o Sell property → 140. Loan amount is initially included in basis under the assumption that you will later pay it back.§1016(a)(2) and improvements o You need to adjust your basis for depreciation even if you declined to take depreciation deduction. o NOTE: whatever they settle on as the adjustment.000 cash to pay debt.g. so would count as income. • Ex. o Treatment as a gift may only apply to loans extended in noncommercial setting -. except as otherwise provided. So since credits are worth 3x more. could decide when to take deduction and code does not generally allow you to elect when deductions are taken. Seems to be comparable so should be covered but isn’t b/c 108e5 JUST talks about property. • Discharge of indebtedness in a commercial setting cannot be considered a gift. 40.: 100. • §1011 – allows for adjustments to basis • §1016 – allows for adjustments to basis including depreciation -. 50. Loss = excess of adjusted basis over amount realized. o §108(e)(6) – Corporate debt to stockholder – if stockholder forgives debt owed by corporation. If could decide to defer depreciation. so the corporation has no discharge of indebtedness income. parent forgives loan – or may be treated as compensation. That’s $50. so renegotiate the price – not covered by 108(e)(5). it may be income under OLD COLONY TRUST.000 o Depreciate → 30. Borrowing and Basis • Basis is not difficult to determine when asset is purchased with cash. will save a $1.Example: Like house painted.000 recourse debt.000 cash. When no longer have to pay it back (e. Need to know basis to calculate gains/losses when property sold and to calculate depreciation over the life of the property (§1016).g. it is more complicated. o §108(f)(1)—Student loan – where school forgives part of a loan because go into a certain line of work. that’s the borrower’s new basis in the property. • Generally allowed to include amount of a loan in basis and then to take deductions on that basis. buyer buys property and assumes loan). the Code treats it as if corporation satisfied debt with amount of $ equal to stockholder’s basis in debt.000 in pocket → gain of 20. will save 33 cents. public service forgiveness programs) • If a debtor does not pay back a loan and someone else pays it back.000. need to account for discharge of loan.000 (even though net loss = 10. If tax rate is 1/3 and have a $1 deduction. If have a $1 credit.000 to buy building. not included in income (e. When asset is acquired for debt.e. • §1012 – The basis of property is its cost.000. basis = 150.000 in discharge income.000 cash – this is because of the deduction for depreciation) Meredith Huston 23 Tax Fall 2001 . • §108(b)(3)(b) – reductions in B C and G shall be 33 1/3 cents for each dollar o Why? All credits – if a credit rather than a reduction is 33 1/3 cents. buy building for $150.000 100. it doesn’t have to include the discount in income per §102. When building is worth $150.
1. but made no payments on the mortgage principal. owes money – own building and owe money cancel each other – leaves with put option. • Equity not zero because has the right to hold on to property until price increases – and does not have to risk capital to do so. 1. Commissioner (in Tufts -. 24 Tax Fall 2001 Meredith Huston . undiminished by mortgages. 50. o Economic benefit theory? o Consistency theory? Count on one. debt = $260K. She has no downside risk. Have to include amount discharged in amount realized.000 o Does not change the facts – get this result from Crane o Crane tells us non-recourse debt is the same as a recourse debt Reg. equity = $0. o She is confusing her basis in the building with her equity in the building. • Court says is neither. o Reg. holding that the nonrecourse debt should be included in the amount realized and that Crane obtained an economic benefit from the purchaser’s assumption of the mortgage identical to the benefit conferred by the cancellation of personal debt. If building goes down in value. (260 – depreciation).000.10. basis = 150.000 net Ex.000 . buy building for $150." not its equity.001-2(4)(i) – sale of property that secures non-recourse debt discharges transferor from liability. FMV = $260K. basis = 150.000. 3: 100. Crane v. She included the full amount of the mortgage debt when she computed her basis in the property for depreciation deductions. "Amount realized" from "the sale of property" is "the sum of any money received plus the fair market value of the property.000 recourse debt secured by a mortgage.• • • • • 20.001-2(4)(ii) – if property subject to recourse debt is sold and buyer agrees to pay debt. In this view: she owns building. o Reg. taking deductions for depreciation.000 secured non . o Case establishes principle that recourse and non-recourse loans are treated equally. adjusted for depreciation. she reasoned that her basis was zero (despite her earlier depreciation deductions) and that the amount she received from the sale was simply the cash she received. So amount realized = net cash received + amount of outstanding mortgage. plus owns put option.000 cash. o Commissioner argued that her basis was the property’s FMV at the time of her husband’s death. 50. so cannot depreciate property. The purchaser took over the mortgage liability.000 Gain – 30. She operated the property for a few years. Basis was the FMV at time of husband’s death (§1014 – inherited property) adjusted for depreciation in the interim. and that the amount realized was the cash received plus the amount of the outstanding mortgage received by the buyer. In claiming her amount realized.recourse debt. seller discharged of debt and must include it in gains regardless of whether or not bank holds seller personally liable for debt.000 cash.187) –Taxpayer received property through bequest. buy building for $150. can walk away without a loss because non-recourse • Contrast with put option – right to sell to the lender at a 260. 1.000 Depreciation = . Either type of loan is included in the basis of the asset it finances and relief from a non-recourse loan is used in determining the amount realized on disposition. FMV Equity = Has a call option = not owner of property. 2: 100.000 o Does not change the facts Ex. count on the other.001-2: Discharge of liabilities – amount realized from sale of property includes amounts of liabilities from which transferor discharged as a result. o Sold property encumbered by non-recourse mortgage. o Court agreed with the commissioner. Only lender who suffers from decrease in value of property.
Commissioner (1976)(196) – Doctors formed a partnership to by inn for $1. Doctors took interest deductions on debt and depreciation deductions on $1.You Using Property Using Property 1. Difference between outstanding value on property and the FMV is considered discharge of indebtedness or ordinary income (§108). o To permit taxpayer to limit realization to FMV would be to recognize tax loss without economic loss.85M. but took the building subject to the mortgage.85M non-recourse for apartments. Losses used to offset gains made as doctors. Unable to operate building profitably. Tufts (1983) (187) – taxpayers (partnership) borrowed $1. Transaction was really the purchase of an option.200. Buyer -. Cannot use mortgage value in assessing basis and then leave it out of assessing amount realized. o Nonrecourse and recourse debt are not treated completely the same because lead to the same total income. but by including it. Taxpayers argued no more than $1. Note this is how recourse loans are treated. Liability would be the same if left mortgage out of basis and amount realized.4M) to satisfy taxpayers debt of $1.2M under Crane. Estate of Franklin v.4 FMV and (2) use of constructive proceeds ($1. which reduced basis to $1.4M adjusted basis. No cash flow in this transaction rent (income) = Interest (deduction) in every year so no net +/.000 loan Rent Get property back at end of 10 years o Could have been a valid sale allowing depreciation.200. and having repaid none of loan principal. Shuldiner says O’Connor fails because different transaction. Sale price must include the amount of debt forgiven or assumed for less than face value. so sale would generate no taxable gain.4M. Took out $450K in depreciation deductions. Meredith Huston 25 Tax Fall 2001 . Court found taxpayers had realized full unpaid balance of mortgage debt and must recognize $450K gain because understanding of obligation to pay the full amount. but recourse may be cancellation of indebtedness taxed as ordinary income and subject to §108 restrictions. realized value under §1001(b). but taxpayers failed to demonstrate that purchase price was = to FMV of property.2M nonrecourse debt. When obligation relieved.Me Buy Property Lease property 1. not to sell. but debt repayment would be cancellation of indebtedness (this would be ordinary gain.4M should be included in their amount realized and so had no recognizable gain. o Symmetry here.000 Price Interest Seller -. Paid $75K in prepaid interest and leased back to sellers who paid all expenses for upkeep/ownership and paid rent to doctors equal to interest payments doctors made. At the time. o The Crane rule applies when the non-recourse mortgage exceeds the FMV of the property. forfeiting their interest payment.• • Commissioner v. can take advantage of the time value of depreciation deductions. Incentive is to walk away. majority view would be capital gain (lower rate)).effect. o O’Connor concurrence – suggests that transfer of excessively mortgaged property might be viewed as twofold event of (1) sale of asset itself (apartment building) for $1. sold property to another investor who paid them $0. but no economic benefit. FMV not greater than $1. Option for Doctors to walk away in 10 years.
Where it is not close. Nonrecourse like Tufts. mortgage not included in basis and not included in amt realized upon disposition. Basis in property cannot include debt. o Shuldiner thinks better result would be no sale. Exception -. civil rights awards don’t count). will ignore subjective test. 1. o Test – look at objective reality at beginning of transaction and see if buyer really intends to buy. in Tufts. $900 princ. Tax rule changes: get rid of tax rule for prepaid interest… Change limited installment sales treatment (so that Romney would have declare $ upfront) Charge penalties [this actually happened] o Taxpayers could have artificially inflated basis (i. must allocate for time where interest would have accrued.1001-2(a)(3) – Taxpayer’s amount received reflects debt relief only to extent that basis is included in debt. Prepaid interest – cannot deduct for prepaid interest (§461(g)) – no real difference between borrowing $1000 and prepaying $100 and borrowing $900. + $100 int. where act as if investment will pay back). so can only deduct interest over period for which it was allocated. even if amt of debt then exceeds FMV DAMAGES AND SICK PAY Personal Injury Awards (Generally) Damage awards for personal injury (from individuals and workman’s comp) are excluded from gross income under §104(a).o Sellers lose depreciation deductions by selling. a tax shelter was created here – this is now illegal – see At Risk Rules (§465 – can get basis for nonrecourse debt. (Defamation.e. Have to pay $900 one year from now – BUT you have $900 in pocket. where value of security exceeded debt initially. tack on another zero) to claim larger depreciation deductions.$100 prepay 11% What’s the liability you owe? Same as if borrowed $900 and owe $1000. apply Tufts reasoning. In effect. taxpayers get depreciation o Reconciling Tufts and Franklin: Tufts should be understood as holding only that taxpayer must treat nonrecourse mortgage consistently when accts for basis and amt realized. and there may reasonably have been a bad bargain.§461(g)(2) does allow for deduction on mortgage points (form of prepaid interest). $900 one year from now is worth less than what you would pay now (future value) so no deduction allowed. will not treat as real debt (opposed to Crane and Tufts. If value of property drops so that is less than mortgage. will still use a subjective test. which would be taxable). Where there is no equity. This is not allowed. Punitive damages are taxed. o Reg. §104(a)(2) Commercial Damage Awards (Generally) Meredith Huston 26 Tax Fall 2001 . Analogy to term insurance (though this is to replace lost wages in part. so there is no cancellation of indebtedness. where it is close. If you prepay interest. This applies only to physical injuries or sickness. generally foreclosure. where amt of mortgage exceeds FMV of property securing it when debt first incurred. HYPO Situation 1 Situation 2 $1000 loan $900 loan 10% . Passive Loss rules (§469) below. thus in Franklin situation. but will not be able to take out debt in excess of what you invest in deal – either b/c you put money in or because you took out actual debt). debt will be included in basis and amt realized upon foreclosure. is possible that building was already fully depreciated so this could have been a way to get fresh depreciation.
Otherwise even if got value of building back. (E. COMMISSIONER (204) – Antitrust suit damages are taxable income. Payment resulting from negotiated settlement of a canceled lease was taxable because payment was a substitute for rent reserved in the lease. you realize value of gain at sale. • If property destroyed is converted into money then get a gain • If property destroyed is converted into a new building.allows you to replace stolen or converted property and elect to have income = damages received – cost of replacement. then no gain. because then if you sold. Though its unfair to tax someone on appreciation on an asset they didn’t intend to dispose of. Damages were recovery for loss of goodwill because unable to show basis in goodwill. Unavailable for things like business goodwill. RAYTHEON V. this section lets him exclude the gain that would otherwise be recognized. In settlement for damages.Damage recoveries arise out of involuntary transactions.000 (Basis = 400. it could be thought of as no basis in lost profits).000 income. But if were forced to sell building and then had to rebuild. yet taxpayer cannot attribute to capital amount in excess of adjusted basis of asset involved.000). Damages to Business Interests If building burn down – can be paid damages for: • value of factory taxed in same manner as if sold factory (AR – basis) o Doesn’t matter if AR is different than FMV – even if would have made more if sold. • lost profits taxed as ordinary income • punitive Substitution theory: What are the damages a substitute for? • Basic rule comes from HORT. Meredith Huston 27 Tax Fall 2001 . Where taxpayer receives amount to compensate for lost profits.g. no basis/fully taxable. need to allocate $ to recovery for lost profits and recovery for property damage. o So §1033 says if a taxpayer reinvests the proceeds of an involuntary conversion in business property of a similar character.000. §1033 – Involuntary conversion -. o Punitive damages are not a substitute for anything – they are therefore not excluded from taxation. (A forced realization). Where taxpayer receives amount to compensate for loss of property that has adjusted basis. If a taxpayer’s recovery exceeds property’s basis. (Also. amount is recovery of basis. still only get AR b/c would’ve been taxed on that additional amount anyway. Originally would be treated as if sold the building – 600. o When settlement is for loss of capital. Lost profits are a substitute for profits which are ordinarily taxed. Fully taxable. o Assume Building is destroyed –Value of Building – 1. which is established through expensed items and has no basis. would still have to pay taxes on gain and then have less money to reinvest. Also applies to insurance proceeds received as result of destruction. amount of income is extent to which amount received exceeds adjusted basis. goodwill is loss of capital. should not have to pay taxes to replace property – resolved by §1033. but no basis in goodwill) • GLENSHAW GLASS (205) – Court held that $ received as exemplary damages for fraud or as punitive 2/3 of treble damage recovery must be included in gross income under §61 – accession to wealth with complete dominion. RAYTHEON. Only works where basis = $0. the excess is taxable just as it would be through sale.
Emotional distress – only exclude recovery for emotional distress if the distress is the byproduct of other physical injury or sickness. Congress then amended §104 provision to allow for full range of damages 28 Tax Fall 2001 Meredith Huston . But normally subjective feelings are ignored (still are taxed if hate the job which pays you income).§104(a) (2) taxable – under current law (any damages (other than punitive damages). so should not Extensive litigation on this issue. Become whole again with damages. Pain And Maybe exclude. now being made whole. “on account of personal physical Suffering Made worse off by pain and suffering. maybe include. . o Interest earned when the payment of damages is periodic rather than a lump sum (§104(a) (2)).Congress feels bad for the injured. IRS originally (casebook is wrong . then they changed their position. Damages paid out over time – entire recovery is excluded from income. used to not be specifically excluded. becomes zero when damaged. Medical Expenses Maybe we should exclude. Although the supplement says that interest is not received “on account of personal injuries or sickness. Here is non-voluntary.5% of AGI (adjusted gross income). If had basis Damages in property before. even if the payments in the future implicate interest as compensation for the delay. . ) found that punitive damages were not income because were “on account of” .” With lump sum. have income from these damages. injuries” are excluded under 104(a)(2). Normally (§213 – itemize) deduction limited to 7. . but interest is taxable. . • Assume car accident – in the absence of §104. Property Treat as if sold property. so no income. principal is not taxed. (Incentive to use structured settlements). how should these be treated? Lost Wages Punitive Damages No §104 Taxable Taxable With §104 for personal injury excluded -.Damages for Personal Injury and Sick Pay • § 104 excludes: o Amount of any damages received on account of personal injuries or sickness.Under BURKE could only get lost wages. Excluded -. • What Injury constitutes a personal injury? o Personal injury means Tort-like damages o Sex discrimination case (206) -. odd disparity if we treat people more favorably if they recover from their accident.
Courts have been unsympathetic to that position SCHLIER– clear age discrimination case – court said damages were not on account of personal injuries. so here.g. the only risk involved is the risk associated with the revenue of the underlying projects. tax-exempt yield at 5%. In a normal case. excluded under §104(a)(3) (amounts received through accident or health insurance) o TAX-EXEMPT INTEREST §103 – interest from state and local government bonds is not taxable. (Excludes§ 141 private activity bond and arbitrage bond (where buy in one market and sell in another). With revenue bonds.• • Age discrimination cases (p. and therefore impaired exercise of sovereign powers. and that severance pay in settlement of that claim and should be excluded. so will have to pay out a higher interest rate to bondholder. The more general obligation bonds a municipality issues. o If tax rate is 50%. Break even taxpayer = 1. made borrowing more expensive. municipality would use this to avoid the problem of compiling risks which is endemic to general obligation bonds. tax exempt = 3.) • General Obligation Bond – bond secured by full faith and credit of municipality or state.6%. o Ex. exemption remains as a federal subsidy to the states for their activities. Allows state and local governments to pay lower rates of interest on their debt then that paid on taxable corporate bonds. court upheld provision that taxes interest on state and local bonds unless bonds issued in registered form. If MM mutual = 5. BAKER (212). Constitutional implications: SOUTH CAROLINA V. if bonds sell at 7% “leakage” goes to high income purchaser. • Original constitutional justifications for tax-exemption having been eliminated. bond for turnpike will be paid out of tolls collected).000 per arm – excluded under 105(c) o §106 – Contributions by employer to accident and health plans Employer buys insurance – excluded under §106 You buy disability insurance – not excluded under §105.63%. Government employees and while working abroad o does not apply to victims of domestic terrorism Employer Payments -.§105(a) Medical expenses – excluded under 105(b) (would be included under 105(a)) 10. Meredith Huston 29 Tax Fall 2001 . • Who is the break even taxpayer? o Rate exempt = Rate tax x (1-tax rate).71%.(R exempt/R tax) = 36. the greater risk they will default. • Back pay received on account of age discrimination was not on account of personal injury (although injury may have been suffered) 104(a)(5) – Amounts received to victims of violent attacks determined to be terrorist attacks by Secretary of State not included in income o only helps U. Rejected argument that statute interfered with state’s right to borrow. and when not registered form. These bonds are capped by §146(B). any taxpayer in a higher bracket is being subsidized. • Revenue Bond – bonds paid out of proceeds of underlying project (e. have a personal injury. 206) – workers took position that would have had an age discrimination claim.S. because of that have lost wages.Treatment? o §105 – Amounts received Under Accident and Health Plans Lost wages while sick (sick leave) – Taxable -. • Conversion formula: o Tax yield (for taxable bonds) x (1-tax rate) = tax-exempt yield o Problem is that exemption has different value to different taxpayer at different rates.
ANOTHER EXAMPLE: So let’s say 7% is what the municipality has to pay. state could offer 5. Arbitrage bonds are basically where municipality borrows at preferential rates to buy assets at retail.1% interest since they are paying 50% tax on interest received for corporate bonds. not enough people in A group to sell all of tax exempt bonds. would have to pay 7. o Assume C wants to borrow at 6%. o §103(b)(1) – allows exemptions for certain qualified private activity bonds (§141(e) -§146(a) puts a volume cap on these bonds. completely subvert taxable bond market if allowed too often. cannot shift its gain to private business. etc. $ funneled to private and not government purpose. effective after-tax interest rate they receive is 5% To get B to prefer state bonds. locks in a 2% gain. C: 10% bracket To get highest bracket (A) to prefer state bonds to corporate bonds. o Taxpayers may not deduct interest from borrowing to purchase tax exempt bonds -. Thus the rich get a 2% subsidy and state only gets a 3% subsidy. The federal government loses 8% here (from the 10% bonds they would have gotten on one 50% and 30% taxpayer). The municipality gains only 6% however. • Arbitrage by holders of municipal bonds. Like Private Activity Bonds.1%. Meredith Huston 30 Tax Fall 2001 . • Courts use an objective standard to distinguish between the two. Roughly → trying to tax profits. Don’t want to allow this because municipality uses $ for roads. Too attractive.1% interest rate. • Arbitrage bonds – not tax exempt (§103(b)(2)). we only want to tax net income. so allow deductions for costs tied to producing income. because city have had to offer 10% if not for the tax-free status. Get government to borrow $ and lend it to me.These bonds are especially attractive to higher bracket taxpayers because may not need to borrow to take advantage of these. because bondholders only get 7% after tax rate on corporate bonds If all bonds could be bought by A. so they’re saving 3% on each of two bonds.§265(a) (2).1% bond and all of subsidy would go to state. As an empirical matter. B: 30% bracket.§141 exception. If borrowed at 10% to by 7% bonds. not 10%. Only government municipal bonds are exempt. schools. this is tax arbitrage. are taxable under alternative minimum tax. o Ex. which equals 6%. state has to attract B group of investors by giving them a 7. not revenues. Philadelphia issues 7% bonds to invest in fed bonds at 10%. o Assume corporate bonds paying 10% interest and there are three classes of people – A: 50% bracket. BUSINESS EXPENSES (ABOVE THE LINE DEDUCTIONS) Often people try to say personal expenses are business deductions. DEDUCTIONS AND CREDITS • Theory. • ARBITRAGE • Problems when have a piece of the market taxed differently from the rest. so to sell the entire issue. and in 50% bracket. municipal bonds would have to pay 5. Let’s say they issue bonds to 50% and 30% taxpayers. • Private activity bonds -.
so if you take deduction above the lie will have lower AGI and so can qualify for these things. • Examine – could he depreciate. obviously don’t deduct for this] • This is a response for HIGGINS No the case that all 162 deductions are above and all 212 are below the line. Shuldiner argues “ordinary” means non-capital expenditure. That’s what this case is about.. To reestablish relationship with customers in industry. This distinguishes provision from nondeductible personal expenses (under §212) o GROETZINGER – professional gambler engages in a trade or business if involved in activity with continuity and regularity and with primary purpose of earning income or a profit. Could deduct under §162. [If take standardized deduction. HELVERING (217) – taxpayer worked for company that went bankrupt. now good will you purchase is. have to examine §62 and see if the item is on that list. etc. and actively engaged in. o • • • WELCH V. reputation and goodwill not deductible (capital asset not ordinary) Shuldiner asks – what if you come up with an original idea for your business. B/c of phase outs in the code – where say “we said you could get this but you’re too rich” – these benefits are based on adjusted gross income. investment activity). o Good will in the past was not depreciable.g. managing portfolio. Investment income is below the line. Not necessarily requirement of regularity. [That’s a subjective std. if take below the line will have to wait and apply to qualify. not deductible under §162. Tried to claim a deduction for paying off debts. [clearly here was capital expenditure]. Meredith Huston 31 Tax Fall 2001 . taxpayer decided to pay off as many creditors as could even though not legally obligated to do so. §212 deductions are below the line. o Why is above the line deduction better? B/c if not itemized you’d lose it. Paid/incurred – included to allow for both cash-basis (individual) and accrual (corporations) taxpayers. §62(a)(4) – includes rents and royalties – clearly above the line.Ordinary and Necessary §162 – deductions allowed for all ordinary and necessary expenses in carrying out trade or business paid in cash or incurred during taxable year (includes reasonable allowances for salaries. Lawsuit is deductible (capital asset. HIGGINS provides no readily helpful standard [just says that you aren’t in trade/business if managing your own investment] §212 – (for contrast) permits individuals to deduct ordinary and necessary expenses stemming from income producing activities that do not qualify as trade or business (e. Court said expense was not ordinary and necessary. but habitual). o Necessary – if taxpayer thought were appropriate and helpful.§162(a)). regular and continuous. whether this should be immediately expensed or capitalized. and rentals -. not implicitly mentioned. good will you get yourself may not be. traveling expenses. Taxpayer need not be actively engaged. even if no sale of good or services involved. amortize. miscellaneous itemized deductions. subject to the 2% floor. Not unusual. • What is trade/business? Trade/business has to be an activity entered into for the purpose of making a profit. easy to meet] o Ordinary – common and accepted means.
GILMORE (222) – taxpayer sought to deduct legal expenses incurred in contesting divorce property settlement. apply normal ordinary and necessary test to see if expense was incurred in carrying on trade/business. meals. Could also argue that the repayments of debts were to protect something he already possessed. If the origin of the claim was a business activity. • §162(f) – can’t deduct fines paid to government in violation of law • §162(c) – can’t deduct bribes to public officials • §162(g) – can’t deduct 2/3 treble damages paid when convicted of antitrust violations • §280(e) – can’t deduct any expenses related to drug activity • §165 – limit on deductibility of losses that would frustrate sharply defined national or state policies proscribing particular types of conduct. Legal Expenses as ordinary and necessary • GILLIAM V.o Rationale: amounts paid by taxpayer had to be capitalized rather than expensed under §162 because repayment of discharged debts produced benefits (in form of goodwill) to taxpayer that extended beyond year in which payments were made. congress specifically stated that deduction not allowed for pursuit of certain kind of business. “Origin of the claim” test used to distinguish deductible from nondeductible litigation expenses. 1-162-1(a): deduction for expense which would otherwise be allowable under §162 shall not be denied on grounds that allowance of such deduction would frustrate sharply defined public policy. One argument: Not Meredith Huston 32 Tax Fall 2001 . litigation expenses were deductible because travel was ordinary and necessary to business of traveling salesman. but altercation/lawsuit were not in furtherance of business.g. so were nondeductible. Court held defense of lawsuit was not ordinary and necessary. Does not have to be a legal business cost – like securities fraud. Looked at plane. o Court here looks at the origin of the claim to determine whether expense is ordinary. Max Sobel case – can’t deduct kickbacks but can include in costs of goods sold. TELLIER – question of whether expenses incurred by taxpayer in unsuccessful defense of criminal prosecution may qualify for deduction under §162(a) – ordinary and necessary expenses. • TANK TRUCK (234) -. o According to Shuldiner. • Court should hesitate to read in public policy exception to allow for a deduction unless Congress has specifically declared such exception. Not deductible under §162.) See below for specific exceptions. o US V. They were to shore up his goodwill. he flipped out and caused damage. o DANCER V. so these could be called deductible repairs to an existing capital asset. PUBLIC POLICY LIMITATIONS • COMMISSIONER V. Stemmed from personal marital relationship. Taxpayer tries to deduct cost of legal defense. • Reg.Allowance of deduction for fines incurred by overweight trucks driving through PA would undermine PA weight limit policy. COMMISSIONER (220) – taxpayer was artist flying to Memphis on a business trip. While on plane. a reputation in the grain trade. can deduct expenses incurred in carrying on illegal activities (bookies can deduct rent). COMMISH – where lawsuit arose out of car accident on a business trip. payments that would not pass muster under §162 should not be deductible under §165 PA bookie case. then the litigation costs are deductible. travel may be ordinary and necessary to business. no deduction allowed. Contrast with Gilliam – where flying not ordinary part of being artist. hotel – all could be looked at as paid in furtherance of business. (E.
Deductions are a matter of grace. o What about deduction of legal fees for challenging the fines? Under Tellier. Denies deduction for executive compensation over $1M in publicly traded corporations. • Attempts to influence executive and judicial branch do not constitute influencing legislation for deductibility purposes. • §162(m) – another limitation on salaries.really a fine. 6) prevailing contribution paid to employees with comparable jobs. 7) peculiar character of employer’s business. 5) net earnings of employer. Overcompensation of employees: Don’t want to pay more than deserve/more than the work justifies/cannot pay unreasonable salary to siphon off dividends • Don’t want people overpaying family members to shift income. COMMISH (223) – Independent Investor Test – How to tell if a salary is unreasonable. o Limits on lobbying by non profit orgs. o Limit to reasonable allowances because of 2 concerns: Nomenclature: Don’t want to be able to deduct things that are not what they say they are (i. 2) scarcity of qualified employees. Does not result in an Equal protection violation. • In order for expense to be deductible.e. o Tax court cited 7 factors: 1) type/extent of services rendered. LOBBYING EXPENSES • §162(e) – Lobbying is generally not deductible.<$2000 also deductible o Lobbying for public initiatives and referenda is not deductible.162-7 – unreasonable compensation paid to an employee is not deductible. If a toll. Worried about paying too much – non-tax concern of protecting stockholder from rapacious CEOs? • EXACTO SPRINGS V. o §1. 3) goals/prior earning capacity of employee. 4) contributions of employee to business venture. Meredith Huston 33 Tax Fall 2001 . The savings to the corporation overwhelms this cost. certain exceptions: at state or local level o De Minimis -. why not deduct? But the court wouldn’t look at this in this way. just a way for PA to collect $. not of right. say salary (because deductible for corporation) even though something else/really dividends (not deductible for corporation)) • Does it matter to the employee whether income is a dividend or salary? o There will be a tax cost to the individual if paid in salary because of social security and Medicare taxes. REASONABLE ALLOWANCES FOR SALARY • Note: some salaries are non deductible – where there is a salaried employee for personal use. need to have a trade or business and legislation must be of direct interest to that business. • No constitutional problems with limiting deductions. Are not allowed to penalize organizations in exercising free speech. • §162(a)(1) – reasonable allowances for salaries and other compensation for personal services are deductible as ordinary and necessary. but do not have to subsidize them. like a license fee or a toll. Also ensures complete hands-off policy on part of government – protects first amendment rights. o This is read as a limitation on the amount allowable (salaries would already be deductible under ordinary/necessary business expenses). would be permissible to deduct them. • Difficult to draw the line between deductible institutional or goodwill advertising and nondeductible efforts to influence the public on legislative issues of significance.
this is somewhat limited. even if employee cannot deduct. • §62(a)(2)(B). Parachute is excessive if present value of payment is greater than three times employee’s average salary for past five years. Rebuttable presumption that salary is reasonable. higher rate of return for company = more salary manager can demand. o Miscellaneous deductions are subject to a 2% floor and it is easier for total expenses to exceed 2% AGI if lowered by above the line deductions which are not subject to the 2% floor o Child care credit greater if AGI lower o Some below the line deductions are phased out at a rate of 3% of excess of AGI over particular threshold. Since only 30% of taxpayers itemize. Re-imbursement versus not-reimbursed §62(a)(2)(A): If employee is reimbursed. Meredith Huston 34 Tax Fall 2001 . which is decreased by above the line deductions because many below the line deductions shave floor set by % AGI (e. it is more likely to be a legitimate business expense. (These fall under miscellaneous deductions.• Posner says even using these factors should be in favor of taxpayer or neutral. no above-the-line deduction. Can only deduct above the line if reimbursed. Independent investor test – reasonable rate of return to be gotten by investor. Prefer above the line because o if are not an itemizer. • When firm pays expense directly → working condition fringe. IRS figures that if your employer is parting with money. must itemize to get. • All unreimbursed expenses are below the line and deductible only if employee itemizes deductions. whether business expenses are taken above or below the line depends on whether are reimbursed.162-2(c)—requires that reimbursement plans be accountable or won’t be sufficient for deduction. Uses indirect market test: see corporation as having K with manager for services. business can deduct as a business expense. employee can deduct above the line even if take a standard deduction. because by definition independent investors. Higher AGI → greater phaseout. cannot take advantage of below the line deductions. Essentially using corporations to substantiate legitimacy of expenses. o • Generally. medical expenses are only deductible if rise to 7% AGI). o EMPLOYEE BUSINESS EXPENSES AND THE 2% FLOOR • §162 -. Excess over 3x of average is not deductible.Expenses incurred by employee in connection with trade or business are deductible. 1. subject to 2% floor see below) o Rule inapplicable to artists whose employee business expenses are deductible in computing AGI. Ultimately allows deduction – not a problem with publicly traded corporations. §62(a)(2): can only deduct expense if normally deductible under §§ 161-193 • Reg. then no reason to think siphoned off salary. • Why a special treatment for reimbursed expenses? May be that employer is a gatekeeper in the system. o taxpayers want a low adjusted gross income.g. o Raises frequent question of whether expenses are personal and whether identical employee expenses are subject to disparate treatment. Golden parachutes : §280(g) – limit to deduction taken for payments to key employees when ownership of corporation changes. Feels judges are not qualified to determine reasonableness. that factors are vague and not properly weighted against each other. not included in income • When not reimbursed → employee claims deduction §63(d).
it is a miscellaneous itemized deduction and subject to the 2% floor (unless a moving expense. explicitly excluded). (3) §165 losses. (6) §1341 computation of taxes where tax returns $ held under claim of right. but for business/investment motive) o Expenditures are reasonable even if clearly profit oriented o Sometimes only for additional expenses due to need of taxpayer’s business or income producing activities. If your expense is not on this list.g. • TREBILCOCK—employed minister to give business advice with strong spiritual slant. (7) §72 annuity pmts. (So only deduct on amounts over 2%. • §67(b)– tells you what is not a miscellaneous itemized deduction. because if employer had purchased clothing would not be deductible under §162 o Suit not deductible even if have business need for one. Rul. but not deductible despite business benefit because not ordinary for business. haircut) • §262 – no deduction for personal expenses o §262(b) – for individual. o If employer provides free clothing. Has attempted to limit “mixed motive” expenses to raise revenue. not both.g. List includes: o (1) §163 interest. is probably income and not a working condition fringe (§132). o Sometimes allocated between business and personal o Inherently personal – nondeductible even if shown to enhance profit-making activity (e. (4) §170 charitable contributions. also provides some simplification. for first phone line. travel and entertainment. Meredith Huston 35 Tax Fall 2001 . o Primary purpose in incurring expense was profit-seeking (in some cases.The 2% Floor • §67(a) – taxpayer can deduct miscellanueous itemized deductions only to extent that on aggregage exceed 2% of taxpayer’s AGI for the year. TP wants to deduct. would induce misallocation of resources. o Rev. Would be very tedious for taxpayer and for IRS to audit without the floor because of tons of insignificant expenses. that 2% is lost $) o Why have the floor? To raise revenue. 70-474: Uniforms are usually deductible. regardless of business use. any charge for basic phone service. • Congress has recently responded to abuses by imposing restrictions on or disallowing certain deductions – e. and vertical inequity – because taxpayers with higher incomes often have more opportunities to obtain these deductions than lower. • PEVSNER – Woman expected to wear designer clothing for boutique. Second line. (2) §164 taxes. by default. (8) §171 amortizable bond premium The two big categories of miscellaneous deductions are employee business expenses (§162) and §212 expenses. • A mixed motive (personal and business) must be treated as either personal or business. (5) §213 medical expenses. • Tests applied by IRS: o Appropriate and helpful to taxpayer’s business or income producing activity. personal. Court used objective test: 1) is the clothing specifically required for employment? 2) Is the clothing adaptable for general usage as ordinary clothing? 3) Does taxpayer wear the fashion as ordinary clothing? Taxpayer lost. deductible. DISTINGUISHING BUSINESS AND PERSONAL EXPENSES • need to distinguish between personal and business expenses because if allowed business deduction for personal consumption would create horizontal inequity – taxpayers with similar income have different abilities to obtain deductions depending on occupations.
(Best you can do is break even – you’re not going to produce losses for these activities) Can’t shield other income with hobby losses. then start looking to 162. 7) amount of occasional profits earned. • §162(a)(2): allows deduction for (ordinary and necessary) travel expenses incurred (1) while away from home (overnight. • Activity must be engaged in for profit in order to claim loss deductions.• Why the distinction? No personal value from McD’s uniform. 212 for deductions. Meredith Huston 36 Tax Fall 2001 . but you could wear Armani suit to other events. Travel Away from Home Travel/entertainment expenses associated with a business have an inherent element of personal consumption and have been subject to substantial taxpayer abuse…§162(a)(2) and 274 put restrictions on deductibility of such expenses. 5) success of taxpayer in carrying on similar/dissimilar activities. • COMMISH V. not whether it was likely to make a profit (reality). If there is a demonstrable profit motive. allows to take deductions otherwise would not be able to take. Was allowed a deduction for truck pulling expenses. see CORRELL) (2) in pursuit of trade or business (motivated by exigencies of taxpayer’s business) and (3) reasonable/appropriate. can still get deduction for things that would have been deductible if were doing for profit. Despite §1. §183(b)(2): if hobby not for profit. Standard is completely subjective – did taxpayer engage in the activity with the actual and honest objective of making a profit? That someone derives pleasure from an activity does not. 8) financial status of taxpayer.162-2(e). on its face. COMMISH (1982)(254) – Taxpayer is a NY police officer who must travel around NJ to commute to work because cannot carry his weapon there legally (and must carry it in NY for job). as long as gross income derived is greater than deductions allowed under this section. 4) expectation that assets used may appreciate. o Shuldiner claims it is an allowance provision.183-2(a) that says greater weight is given to objective facts than to the taxpayer’s statement of intention.This turns on whether the taxpayer meant to make a profit (sincerity). o NICKERSON . even if not engaged in for profit. • McCABE V.. • §183: test whether activity engaged in for profit. Hobby Losses Distinguishes between activities that are engaged in “not for profit” and those that are engaged in for profit. COMMISH (1984) (371) – taxpayer not allowed to deduct for mud racing hobby because profit potential was too slim. 3) time and effort expended by taxpayer. consider 1) manner activitiy carried out. disallow deduction. FLOWERS (255) – commuting expenses not deductible because it is a personal choice to live away from work. PLUNKETT V. Transportation • Commuting – costs of commuting from home to work are nondeductible personal expenses (unless qualified transportation fringe under §132(f). • §183(b)(1): doesn’t prevent you from taking deduction from some other aspect of code. • • • • §183(d): rebuttable presumption that enterprise is a profit-making venture if is profitable 3 years out of 5 Reg. 9) whether elements of personal pleasure or recreation involved. Reg.183-2(b): Factors in considering a for-profit operation. can’t use losses from here to offset other gains. 1. 6) taxpayer’s history of income/loss with regard to activity. 2) expertise of taxpayer/advisors. 1. can basically take deduction up to amt earned on activity. Where you live is a personal choice..
but if going between residence and temporary place of business. o If you go from house in Philadelphia to work at courthouse (skip the office) -. o If you go from house in Philadelphia to work at Liberty Place and then to Courthouse – can deduct cost from liberty place to courthouse – because is a business expense. o Shuldiner says should be deducted as a trade/business expense. (You may be able to deduct her extra commuting costs that are attributable to transporting the tools). B. Taxpayer must still have business reason for maintaining old home (i. meals. See §274(n) and below.e. Court held he couldn’t deduct excess expenses because he chose where to live (personal consumption). or C.FAUSNER – additional expenses may at times be incurred for transporting required tools and materials to and from work. only 50% of their cost is deductible. then deductible. therefore commuting expenses allocable to that time were deductible. Meredith Huston 37 Tax Fall 2001 . Food and Lodging • §162(a) – temporary employment doctrine: taxpayers can deduct transportation. o Is §162(a)(2) necessary? Shuldiner seems to think not really. • Transportation costs while on the job are generally deductible. Argument not as strong here as for lodging. o POLLEI – court ruled that police officers who began active patrol when they left their homes were engaged in their jobs while driving to and from station.Will be a deductible expense – temporary workplace -. every worksite is a temporary workplace. see CORRELL) (2) in pursuit of trade or business (motivated by exigencies of taxpayer’s business) and (3) reasonable/appropriate. • §162(a)(2): allows deduction for (ordinary and necessary) travel expenses incurred (1) while away from home (overnight. §1.162-2 Revenue ruling 90-23 – transportation expenses in going between residence and regular place of business are nondeductible. plan to return to work there). Is this a reasonable outcome? Not necessarily. Argument is that there is a duplicative expense incurred. meals away = more expensive. o Reimbursed travel expenses are deductible from gross income under §62(a)(2)(A) and are not subject to 2% floor o In the case of food or beverages. allocation of personal and business costs may be feasible.• • Commute is made much more expensive. Examples o If you go from your house to Philadelphia Construction site A. o unreimbursed travel expenses are deductible as miscellaneous itemized deduction and are subject to 2% AGI floor of §67. o Maybe would be a different decision if he had only tried to deduct the additional costs of his commute – he tried to deduct them all. so is always a commute. o Small exception .as long as in the same trade or business as normal employment – See. cannot deduct costs o If you go from your house to NY construction site D. • Meals would be inherently personal and not deductible. Rev Rul 99-7 Justification: Why would we want a rule that requires people to go to the office when they don’t need to? How is this distinguishable from construction example? In construction. and lodging expenses when assigned to work in a place away from home for less than one year. can deduct costs.
not that you be performing the same work in temporary site or that the temporary business necessarily be constant and ongoing. CORRELL (259) – Requirement of sleep and rest – Taxpayer is traveling salesman and wants to deduct meals eaten on the road. daily nature of meal makes it inherently personal. generally not deductible. Don’t get full value out of this meal. Sibla is here – how posner distinguishes from Moss. o So if you do maintain two residences for personal reasons. • Limitations • §280F: limits deductions for luxury car expenses • §274(c): certain foreign travel. Under §162 may be ordinary and necessary because of business benefit. Even if it slips through §274. (m): additional travel limitations. Business did not require her to maintain the residence there (her spouse did). Court found that in order to get a deduction for expenses incurred while “away from home” must have an overnight stay/sleep and rest. wouldn’t be what you usually eat. temporary. o Shuldiner thinks that the important factor is the temporariness of the work. 3) motivated by exigencies of business. • And then if its meal/entertainment. HANTZIS (1981)(260) – Harvard law student spent summer in NYC. Need a business reason for both homes in order to deduct the extra one. o Three part test – 1) reasonable and necessary.MOSS (269) – partners from law firm meet in restaurant for working lunch every day. Court says she cannot deduct because Boston was not her home for tax purposes as she had no place of business there. (k): extravagant meals nondeductible.• • Lodging = inherently personal. Meredith Huston 38 Tax Fall 2001 . Great Meal – Posner says if is really expensive meal. it’s a 50% deduction (see below). Taxpayer’s home for purposes of §162(a)(2) is the taxpayer’s regular or principal place of business. She deducts her expenses for the summer. business in another. But lodging = duplicative expense incurred only because traveling for business • Certain transportation expenses are deductible even without this provision.. Court says nondeductible. Costs of business entertainment and meals may be deducted only if (§274(a)(1)) (1) item was directly related to the active conduct of taxpayer’s trade (as opposed to creation of goodwill) OR (2) the item preceded or followed a substantial and bona fide business discussion and was associated with the taxpayer’s trade or business. (h): attendance at conventions nondeductible if out of continent. IRS is trying to make sure you’re not double-counting for home in one area. but employer is subject to 50/50 restriction. o Posner argues: Bad Meal – exclude – don’t get full value. 162 might get it . (d): substantiation requirement. 2) incurred while away from home. (e): misc. Anti-discrimination – trying to integrate firehouses. No exclusion. §162 is the bar to deduction here. Can exclude. (n) only 50% of business meals and business entertainment are deductible Meals and Entertainment Business meals and entertainment expenses are reimbursed by an individual’s employer are fully excludable by employee. forced mess = to force them to eat together. claims Boston is home and that stay in NYC was business related. and away from home. Lawyers argue that are compelled to eat there. create social lubrication Normal Meal – Moss is here. might have had different outcome if meal was not every day.
SUTTER (Tax Ct. 1953)(pg. Employer may still only deduct 50% §274(n)(B) – when employer pays.• • • • o The firm ended up hiring their favorite waiter and opening a small dining room in the firm. then §274 (n) doesn’t apply. and 132(e) is exempted from 274 by 274(n)(2)(B). • §274(k) – extravagant meals non deductible Home Office Expenses • §280A—Deduction for “qualified” home office expenses. • (3) principal reason for expense was active conduct of taxpayer’s trade or business Rev Ruling 63-144 argues that should only be able to deduct in excess of what would have had • §274(d): imposes substantiation rules. o Rule overruled COHAN rule. or whether they could be excluded under § 132 (fringe benefits) or § 119 (meals and lodging for the convenience of the employer). o Under §132. o §119(a) – Employee may exclude the value of meals provided for the convenience of the employer on the business premises. see fn. taxpayer must demonstrate it was different or in excess of that which would have been made for taxpayer’s personal purposes §274(n) – 50% limitation on employer’s deduction for employee meals. disallowance applies to employer because not reimbursed expense o expenses subject not only to 50% exclusion but also to the 2% floor under §67. • (2) taxpayer engaged in business discussions during or directly before/after meal or entertainment. • Cafeterias. executive dining room. generally⇒ Fifty-percent exclusion under 274(n) does not apply to cafeterias because of 274(n)(2)(B). 100% deductible for employee. Meredith Huston 39 Tax Fall 2001 . 270. • §274(l)—limits entertainment deduction. requiring taxpayer to retain adequate documentation (receipts).) • no deduction is permitted for membership dues in any club organized for business or pleasure or recreation. §119 cases are deemed to be §132(e) cases. Country clubs etc – can’t deduct unless the club is used primarily for business purposes. which had allowed approximations of the amount of expenditures when there was evidence of a deductible expenditure in some amount. §274(n)(A) – if employer reimburses employee. cost of client’s meal deductible under §274(a) if directly related or associated w/active conduct of trade or business: • if (1) taxpayer has more than general expectation of deriving income or specific business benefit. COHAN still applies to expenses outside of §274(d). (Need to establish more than 50% of the days were for business use. Excludable from income under §119 o If Moss were an associate rather than a partner. the issue would be whether or not the lunches constituted compensation (274(e)(2). This is intended to approximate the personal component of meals.): if personal living expense is to qualify under §162. Space must be exclusively used for business on a regular basis. o Consider §132(e)(2) as alternative means of providing employer-subsidized meals – de minimis fringe defined – treatment of certain eating facilities o §274(e) – food and drinks served on the premises are an exception §274(a): If take client out to lunch. Cafeteria.
Note stricter requirement where taxpayer is an employee. Must take expenses that exist apart from the business first – mortgage. Exclusive use -. principal place of business was hospital. still gets deduction. Look at second if first is not definitive. subject to continuing application of gross income limit. New rule very generous for home offices at least in non-employee context. In effect. Court found that these were not met.Space must be principal place of business (SOLIMAN) or used to meet clients (telephone meetings not included – GREEN) or a separate structure o Qualify as home office under §280A(c) only where the taxpayer uses the home office exclusively on a regular basis (1) as the principal place of business for any trade/business of taxpayer. Ruling 94-24 – principal place of business is location at which greatest number of hours are spent. Office furniture and salary of assistant are business expenses which would be deductible above the line under §62. Wants to deduct room in home where works on paperwork although he sees patients at the hospital. • If employer has provided adequate office space. would not give him dining room which he exclusively used during business day. OR (2) as a place of business that is used by clients. even if does these activities in his truck during the day. only then apply expenses that exist solely because of the business 40 Tax Fall 2001 Meredith Huston . can only use home office deduction if use of home office is for convenience of employer. Home office expenses are limited to gross income from the use of home office less deductions associated with residence that are allowable regardless of use and other deductible expenses attributable to rental by employee of all or part of home to employer if employee uses rented portion to perform services of employee. First part of test is more important. Convenience of employer = if employer doesn’t provide employee with office or employer has not provided adequate office space in which employee can effectively carry out duties. patients or customer is meeting or dealing with taxpayer in his business.Resolution of SOLIMAN problem: a home office can be the principal place of business if the taxpayer uses to office to conduct administrative or management activities and there is no other fixed location of the business where the taxpayer conducts substantial administrative or management activities • SOLIMAN still applies if taxpayer is arguing that home office is principal place of business and office isn’t used for substantial administrative/management activities.g. Principal Place of Business – SOLIMAN (277) –Taxpayer is a doctor who doesn’t have office at hospital. taxes. etc. home office expenses cannot exceed net income from that activity. o Focal point test.• • • • • • §280A(c) -. Court gave him the living room. 2) time spent at each place. that’s for the convenience of the employee. Trying to make sure guy who reads office papers in his la-z-boy doesn’t take deduction for his den. o Flush language in §280A(c)(1) -. real property taxes. even if home office is only used for business. (§280A(c)(5)(B)(i)). casualty losses). §280A(c)(5) –Disallowed deductions may be carried forward. which principally considers point where services are rendered or goods delivered. mortgage interest. OR (3) in connection with the taxpayer’s business if the office in a separate structure not attached to taxpayer’s home. o If it’s an employee. but was used to eat some meals in (“time slice” case) §280A(b) – Section does not take away deductions that are already entitled to (e. Court holds not deductible. o Primary considerations: 1) relative importance of activities performed at each business location.SENGPIEL (270) – lawyer used 51 percent of home for business. o Rev.
Two Ways to Skin a Cat: Old and New IRA’s If tax rates are consistent. Pay for machinery out of savings and allowed deduction for savings.§219 -Expense (deduct) investment -No tax during life Meredith Huston Roth IRA -. taxes on income are $33 – net yield is $67 (6. All have left is increase in consumption. • Ex. rather than income. annual income = $100.7% after-tax return). o Capitalization requirement results from wanting to accurately reflect the taxpayer’s true income for each year by matching an expense with the income it creates. • Equivalence. Cost savings that occurs when cost of investment is deducted but income taxed equals tax savings. asset is $1K. cost $1K. taxes on income = $33. office assistant). o Allowing immediate expensing of capital expenditures basically eliminates all taxes on capital. income = consumption + savings. will not be mortgage interest and taxes. so if permit people to expense purchase of capital assets. interest. return on asset is $110. Assumes tax. o Consumption tax – Haig-Simons definition. Deduction is disallowed initially (must capitalize) but income on investment is exempt. Conventional IRA -. So if any expenses cannot be matched. Equivalent to: o Interest free loan—accelerated deductions allow $ now and pay it back later in reduced basis. of immediate deduction of capital investment to exemption from tax of income from investment.§408A -No deduction -No tax during life 41 Tax Fall 2001 . May be used for any business so long as meets requirements. converts income tax into consumption tax. the two IRA forms are generally economically equivalent. • • Current expenses – immediately deductible Capital expenses – not immediately deductible Why do we care? • If all expenditures made for business or investment were immediately deductible. under certain conditions. o If allowed to fully expense in year purchased. the same nominal amount of tax will be paid.• (furniture. tax savings from expense = $333. CURRENT VERSUS CAPITAL EXPENSES §263 capital assets – disallows deductions for the cost of acquiring property whose useful life extends substantially beyond the close of the taxable year. • Tax deferral – don’t want people to immediately deduct capital expenses because it delays their actual payment of tax for a few years. asset with 10% annual return. Home office need not be used for principal business. savings arise because income from other sources offset by immediately deductible $1K expense. in the end. net yield = $67/667 = 10% yield – eliminates all tax on capital. o Tax free return on amount invested – immediate deduction yields exemption equivalence. tax would be imposed on consumption. Capital assets produce income for a while. assume 33% tax rate. the ability to front-load deductions and back load income is very helpful to taxpayers. Understanding that. Out of pocket cost of asset $667. Permitting immediate deduction. and investment yields are constant. not taxing yield.
000 next year. then $5000.000 in Conventional.000 in Roth. assuming are in a 50% tax bracket. lose tax free status if withdraw (may have worse consequences. If predict lower rates later (decrease in rates). people over 50 get extra 500 then extra 1. will prefer this. but are exceptions – like if withdraw for first time home purchase) -Covers people with income up to $150K income If going to be in a 15% bracket now and a 35% bracket later. then $5000. Meredith Huston 42 Tax Fall 2001 .000 next year. If the outlay in question has a useful life over 1 year. 1. o To invest 2. (high low) Decision will also depend on income tax rates.000 -Can withdraw at age 59 ½ if remove prematurely. • • • §263—disallows deduction for capital expenditures. What is tricky is the identification of the cost of purchasing an asset and determining whether an asset has actually been purchased. Roth may cost government $ because of shifting tax brackets. 10% penalty -Covers people not in employer retirement account or those who are in employer retirement accounts but with lower income (50-80K range) If going to be in 35% tax bracket now and a 28% bracket later. Revenue perspective (5 year window used by gov’t to estimate revenue) o Conventional IRA loses a lot of up front revenue for government because people will deduct right away Revenue window of only 5 years tends to overstate cost to federal government Doesn’t include benefit of getting that $ later o Roth IRA – loses no up-front revenue for government. need to invest $4. etc.000 -Can withdraw at age 59 ½ if remove prematurely. Reg. then you have to capitalize it. immediate revenue raiser (why the income limit is higher – want to encourage more people to use this) Loses the money later If believe equivalencies. o In conventional are sharing the cap with the government – they get 50% of the deal o Structurally the Roth is a better deal if can predict tax rates. • -No tax at end -Cap = $2. will prefer this. but can’t there is a cap.000 3. people over 50 get extra 500 then extra 1. incentives.263(a) –2(a): Costs incurred in acquisition of asset must be capitalized. 10% penalty. nothing actually happens to value of investment when choose Roth over conventional IRA.000 3. Acquisition and disposition of assets Whether an outlay should be treated as an expense under §162 or capital expenditure under §263 boils down to a question of timing. but from revenue perspective gov’t wins lots of money when people choose Roth IRA or convert their IRAs o In actuality.-Full taxation when you withdraw -Cap = $2. specifically new buildings and improvements to real estate. Conventional preferred. (low high) Higher income tax rates later (increase in rates) = Roth IRA preferred • • Want to invest maximum in account.
Recover asset’s cost over the term of its useful life. o Depreciation – recognized each period as capital asset earns income. just part of cost of acquiring the asset. o Construction costs – costs of constructing capital asset (Wages.263(a)-2. Simpler argument.) must be capitalized Why? Parity argument. §263A – Uniform capitalization rule -. IDAHO POWER (293)(294) – Big crane spends ½ time working on building and other ½ in garage.212-1(k) §263(a)(1): disallows deduction for any amount paid out of new buildings or for permanent improvements or betterments made to increase value of property/estate.• • • • General rule: Want to match time period during which get benefit from an asset with its cost. 1. Must capitalize interest incurred during production period. Expenditure capitalized. §167 – Depreciation – transfer basis from one asset to another WOODWARD (290) – taxpayer claimed deductions for attorney’s accountant’s and appraiser’s fees for services rendered in connection with appraisal litigation which occurred to resolve price of stock taxpayer purchased. o Cost incurred in acquisition or disposition of capital assets treated as capital expenditures – falls under §212 and §162 o Court looked to origin of the claim (GILMORE)– in connection with what type of transaction did these expenses arise? o Which result is preferable? Historically taxpayers would have preferred not to capitalize. 1. below the line deductions (note everything is below the line unless there is a specific provision making it above the line) o Expenses incurred in defense of or perfection of title or property cannot be deducted as current expenses. • Taxpayers that produce property (real/tangible) are subject to the §263(A) UNICAP rules. less tax cost Shuldiner thinks that for most taxpayers today. No deduction was allowed. actually prefer capitalization because don’t get the ordinary deduction (this has something to do with the 2% floor and above the line vs. Need to treat people who buy equipment to build and people who hire people with equipment to build in the same way. Buy a cab – good for 5 years. must capitalize all direct and indirect costs incurred in acquisition of capital assets. remaining interest expense carried forward and get to deduct any leftover expenses when sell asset. depreciate and recover rest upon sale. will likely have to capitalize the expense and depreciate over time. Indirectly taxes imputed income. Capitalize ½ normal depreciation into project’s basis and recognize depreciation as usual for other ½ corresponding to time spent idle. If benefit received from asset exceeds one year. recover cost when sell or receive future dividends. but must be capitalized and added to property’s basis – follows Reg. 43 Tax Fall 2001 Meredith Huston . Recover purchase price of a tractor through depreciation. • §263A(f) – Special rules for allocation of interest to property produced by the taxpayer. supplies. even if it is a one time cost.capitalization and inclusion in inventory costs of certain expenses. Added to basis in stock. etc. If borrow $ to buy stock and have to pay interest under §163(d) (limitation on investment interest). o Broker’s commission – not immediately deductible. Court upheld commissioner’s position that under §263. depreciation deduction should be disallowed and disallowed amounts added to taxpayer’s adjusted basis in capital facilities to be depreciated over useful life. can only deduct interest on loan to extent paid out in dividends. insofar as equipment was used for construction of capital facilities. Court said expenditure was capital expenditure connected with acquisition of stock.
263A-1(e)(2)(i). Dog pays $5K to build milkbone machine. and photographers. • Direct costs – cost of materials. certain taxes. and the portion of indirect costs allocable to goods sold. What is capitalized -$5K cost of machine. Ex. indirect labor costs. If dog owns bulldozer as part of construction.if something appears to be ordinary and necessary expense. (2) • Indirect costs include costs of repair of repair/maintenance of equipment/facilities. o part of cost of acquiring land suitable for building is to get rid of old structure. can’t take interest deductions and must capitalize interest into cost. and thus deductible under §162. §174 – research and development can usually be expensed. EXCEPTION – UNICAP rules (§263A) don’t apply to businesses that are in the business of buying/making property that have under $10 million in gross receipts. Capitalize cost of construction.• • • • • §263A(f)(2)(A)(ii)—assigns interest on other debts to be included in basis of property to extent that those interest payments could have been reduced if taxpayer didn’t build property o ONLY Applies to property with a long useful life (real property) or property for which the production period is long (jet aircraft. Any appreciation will be taxed even though imputed income (§263A(f)). advertising and general business/financial planning don’t have to be capitalized. so if borrow for construction. • Key questions o Internal/External? o Direct/Indirect? o Ordinary(Recurring)/Nonrecurring Expenses? Must capitalize all expenditures that produce or acquire assets or produce value to taxpayer for period beyond one year. wages to employees who produce/sell goods §1. (g) (1). then the expense must be capitalized. depreciation on equipment or facilities. $ paid in wages and supplies. artists. Note that §263 Capitalization requirement trumps §162 -. 44 Tax Fall 2001 • • Meredith Huston . rent on equipment. §263A(h) – exception for writers. costs of tools/equipment. o Nonrecurring expenditures and expenditures that provide benefits beyond the current year If §263(A) applies.) o Provision is limited in scope. do not have to capitalize costs of making property. if dog spent $4. o See §161 for statutory support for this. it requires the taxpayer to recover the expenses of producing/selling goods when the goods are sold. o Default assumption is that expenses should be capitalized. The UNICAP rules apply to the direct costs of producing and selling goods.5 on wages and supplies and new machine must be aged before can produce. entitled to depreciation to extent not using as part of construction. Have to look to §263 (see if expense is explicitly included) and then 162 (to see if ordinary and necessary) before deciding whether to deduct. Creating or enhancing distinct asset sufficient but not necessary condition to force expenditure to be capitalized. then worth $5K. o R&D can be expensed. Want to encourage this activity. facilities or land. indirect material costs. etc. but it is included under §263. utility costs. Depreciation deduction won’t be allowed until machine placed in service. §280B—disallows deduction of any expenses for demolition of structures and requires that such expenses be added to the basis of the land on which demolished structures are located (not into the new building). more limited than rest of 263A Ex. o Marketing. costs of certain admin or support departments.
on ground that they were ordinary and necessary. Seems odd. would have required they capitalize it. so did not want to capitalize it. arguably buying book here and therefore must capitalize that cost just as would have to capitalize cost of consulting services bought as cost of building asset. not the furnace. Fall River was required to continue to amortize the installation charge over the period of time the equipment would have remained under the lease.• One year rule – where an expenditure is expected to produce income over a period of time rather than only in the current year. capitalization. • INDOPCO (296) – taxpayer wanted to deduct legal and consulting fees spent engaged in friendly takeover bid where they were target. Court held taxpayer’s realization of benefit beyond year in which expenditure is incurred is undeniably important in determining whether appropriate tax treatment is immediate deduction or capitalization. Said deductions are exception and burden is on taxpayer to show entitlement to deduction. Shuldiner not certain this is what Court meant. Taxpayer said had no future benefit and no separate asset (since they were target). Recurring/Non-recurring -. had it existed then. Here taxpayer 45 Tax Fall 2001 Meredith Huston . still can recover cost over time through amortization If equipment was pulled out of customer’s home early. court says capital expense. Court says future benefit is not controlling. Even though no asset. if own employee wrote book. Posner suggests that nonrecurring nature of expense is significant Purpose – to match up expenditures with income If really take seriously concept of capital expenditure as anything that yields income. result will be to force capitalization of virtually every business expense o LINCOLN SAVINGS (in case. 297): Asset non-transferable and earned no return. accompanied by a recovery of capital as the income earned. §263A. no future benefit (court seems to accept this). there will be a greater chance that they will be considered capital expenses. Ignores reality but creates parity. Arguably there is no asset here – cost of installation. o ENCYCLOPEDIA BRITTANICA (310) Company sent work out instead of doing it in house.Ordinariness of costs. is thought to reflect each year’s income more accurately than immediate deduction of the expenditure o FALL RIVER GAS (1965): Court required taxpayer to capitalize cost of installing gas appliances that leased to customers b/c expenditure made in anticipation of continuing economic benefit over period of years– indicative of a capital expense. but court reasoned that equipment remaining longer than expected provided a windfall to company that cwould not be matched by a corresponding drawback unless they were forced to recognize installation charges for all units over expected life. does not mean only expenditures that create/enhance separate assets capitalized under §263 • Corporate Reorganizations/BUSINESS INTANGIBLES Requirement that long-lived assets must be capitalized applies to intangible assets from which the taxpayer expects to realize economic benefits in future years. • Case stands for proposition that expenditures that serve to create or enhance separate asset should be capitalized under §263. would not have to capitalize it. Taxpayers argued that this means you only have to capitalize if separate asset. What is controlling is that it enhances a separate or distinct additional asset. If expenses are extraordinary and non recurring.
thereby resulting in a more accurate calculation of net income. o The court determined that the legal and investigatory expenses that were incurred prior to the subsidiary's "final decision" regarding the acquisition were fully deductible. Court applied rule saying costs incurred to defend a business are deductible. which provided the long-term benefit. would be impossible to argue this expense should be capitalized)). Do we want this outcome? o Court quotes INDOPCO standard. If had paid inside lawyers. Does not add much clarity to the direct/indirect relation question. Commissioner disallowed deductions.D attempted to deduct salaries paid to officers of a subsidiary for services performed in merging companies. Argument for not capitalizing investigatory costs: Here the benefit is really in the future. On appeal. No current benefit. o Costs at issue here are internal. o Advertising -. o Case basically stands for the idea that tax law is trying to match current expenses with current benefits. Still generally deductible. Case makes extreme distinction between external and internal costs. Rev. but the remaining legal and investigatory expenses were incurred after the "final decision" and therefore had to be capitalized. o Argument that salary costs did not have to be capitalized -. o Employee training costs – treatment not changed by INDOPCO. STANLEY (298) -. • Implications of INDOPCO o Hostile takeovers – probably would have been able to expense if hostile takeover because neither creates new asset nor adds future value (although success might help to scare off future takeovers (but administratively. Match expense with benefit and must capitalize expense. Meredith Huston 46 Tax Fall 2001 . but Shuldiner thinks they misuse the standard. but consummation should be capitalized because of new asset. so capitalized expenditure only recovered if corp is sold/dissolved. 96-62. Investigatory expenses • WELLS FARGO (2000) (299) -. cost had to be capitalized.what could be more ordinary than deducting employees’ salaries? But does this ignore INDOPCO question of whether there should be some matching going on? o When paid outside lawyers to do work. Through §162 and §263. o Investigatory costs v. acquisition costs.spent $ because of perceived benefit of being acquired. The court determined that the officers' salaries were fully deductible because there was only an indirect relation between the salaries and the acquisition. o Norm is to capitalize expenses – burden on taxpayer to show why their costs should be expensed. Rul. A. Service issued Revenue ruling 92-80 after INDOPCO – clarified that case does not change basic rule of deductibility for advertising.E. D also sought to deduct legal/investigatory expenses. Fees to protect existing structure.has always been deductible (§162). the court reversed in part and affirmed in part. code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable.Permitted taxpayer to deduct fees in unsuccessfully fighting a hostile takeover. costs would not have had to be capitalized. salaries and legal expenses were not ordinary and had to be capitalized. o NOTE: Merger transaction (which was capitalized) benefits continue as long as merged entity continues in being (no useful life)…so they can’t take depreciation/amortization. indirect.
o Accounting and tax accounting standards are different. Expenses with Respect to a New Business – Start up costs • Question of whether expense was incurred to maintain existing business or change/expand new business. • Costs of a new business →Creation of new asset. it’s all future oriented • INDOPCO. o IRS apparently viewed INDOPCO (green light to seek/presumption of capitalization) as a reason to pursue capitalization of the costs that SFAS 91 requires to be deferred (loan fee income and costs deferred and recognized over the life of the loan (amortized)) o Case stands for the proposition that routine costs do not have to be capitalized even if they go into creating long-lived assets. not capitalized over the life of the loan (§263). the court did not faithfully follow the rule of the case but an extraordinarily narrow reading of INDOPCO. but didn’t. Required company in business of acquiring automobile installment loans from automobile dealers to capitalize the costs of acquisition of the loans. these are the costs of creating the loan. Circuit court disagreed – said tax court reading of what could create assets was overbroad. tax accounting goal to collect income. even though with §212 you’re not in a trade or business. cannot support tax court analysis that there is a future benefit.Expenses of an Ongoing Business IRS is more willing to allow deduction of costs of expanding an existing business. obtained operating license from FCC. financial accounting conservative view of what is income. which mostly paid for checks of the creditworthiness of the borrowers. must be capitalized (cannot deduct expenses of a trade or business before you are in the trade or business). incidental future income is important. o This applies to §212. Contrast with FALL RIVER. o Future benefits -. not clear why not o Creation of asset (LINCOLN SAVINGS)– relevant asset here is the loan. origination of loan doesn’t really have a future benefit. including employee’s salaries. deductible. • RICHMOND – Court required capitalization of job training and related expenses incurred before co. Because there is no separate and distinct asset. Shuldiner thinks court’s view is too narrow. “Separate and distinct” asset does not mean any identifiable asset. Cases are mixed. Loan origination fees • PNC BANKCORP (2000)(302) –Loan origination charges (external 3rd party payments and internal salaries of loan officers) should be expensed immediately as ordinary business expenses (§162). Clear future benefit. • But here.IRS: upfront. ct held not carrying on trade or business until licensed Meredith Huston 47 Tax Fall 2001 . • Eg. • Problematic – bank opens new branch – expansion of existing business or new business? Courts have not required capitalization of existing business expansion. TP should argue the cost is related to the fee income.Future benefit analysis in INDOPCO is not meant as a bright line test. Burger seller current income and future income (good will) (incidental. if the latter. o Matching -. Unsettled area of the law. not bound by the rules of financial accounting. Have different purposes. Tax court accepted this argument. If the former. But future benefits do not depend on the creation of an asset. ignored) all considered current. Right thing is to match current expense to future income • §195 – recognition of startup costs over a 180 month period o Includes investigatory expenses. o LYCHUCK (308) Here clearly don’t follow PNC.
o Rebuilding old building would be making good on previously taken depreciation. Job Search and Education Expenses • Job search o Revenue Ruling 75-120 (320) – job seeking expenses in same trade or business are deductible under §162 if directly connected with such trade or business as determined by all objective facts and circumstances below the line deduction). Not deductible for individual seeking employment for the first time. only applies to expenses incurred with respect to an existing profit seeking endeavor not qualifying as a trade or business. • • • RR 94-12.My land. polluted. FMV = 1 million. which are large in comparison to the asset. If have to capitalize. basis = 1.Deductible Repairs s. o Government wants to encourage clean-up. If unemployed. • But expenses made to restore property damage are generally deductible. 1. rehabilitation capitalized. trade or business consists of services performed for past employer unless there is a substantial lack of continuity since time of past employment Not allowed if seeking employment in new trade/business . Expenditures that substantially increase the useful life of an asset. basis = 2 million. but government’s basic provision is really not a subsidy for cleanup. Buyers perspective is purely future benefit. should be capitalized. o Note that this approach only right for original owner—subsequent purchaser who comes in to clean up should capitalize.162-4. Improvements. o Basis = zero because property is worth nothing cleaned up. if don’t then probably can’t fly. o Incidental repairs are of small and recurring nature. Right answer should be that can expense clean up costs. o Regs say that subsequent expenditures that alter the property’s capacity or function or extend useful life.looks to depreciable life schedule to gauge whether you are prolonging or maintaining. o MCDONALD (321): Court held state judge could not deduct assessments that had to be paid to political party organization for election campaign. Nondeductible Rehabilitation or Improvements • Repairs expensed under §162(a). Seller gets their loss when they sell property for reduced cost. FMV = 1 million o Parallel to demolition cases – have to take into account cost of demolition. Aircraft have to redo/heavy maintenance. repairs still deductible following INDOPCO. is clearly a future benefit if I clean it up. Also see 1.263(a)-2—improvements are example of capital expenditure. Part of costs of past goods produced (not of future goods). (323) -. Had been fear that INDOPCO might affect this. and whether they add to the asset’s basis. or are part of an overall plan of remodeling/rehabilitation are probably capital outlays. Looks at 4 cases Environmental clean-up costs -. take into account/recognize costs of polluting when go to sell. b/c repair has future benefit Rev Rule 2001-4. million. • These are also not deductible under §212(1) – below the line deduction. seeking office expenses nondeductible Meredith Huston 48 Tax Fall 2001 . But what are the tax consequences of cleanup? o Matching argument – For past 20 years have been overstating profits because were not calculating costs of cleaning up production. If can expense. • Test is whether the improvements prolong the asset’s life beyond its initial assessed life. every 8 yrsexpense this.
he would not have been able to deduct the LLM (even though it was not a minimum educational requirement) because he would not have been in the trade or business yet. teachers.• o What happens to the expense of a bar review course when employer pays for it? Not within the trade or business until pass the bar Why for lawyers. $5250 max exclusion Meredith Huston 49 Tax Fall 2001 . just modified to include state and private tuition plans. • Education that qualifies taxpayer for a new trade/business not deductible even if taxpayer never intended/never entered new business. See also §274(m)(2) Educational IRA/Savings §530(a) – education IRA account shall be exempt from taxation. IRS argues that 3L year is disqualified under §1. • Cost of acquiring new skills is usually denied unless taxpayer can show intent is merely to enhance the skills already possessed. Because are not yet in the trade or business for which education is a cost.162-5(d): travel as education is not deductible unless you take classes or something. §25A(d) Lifetime Learning Credit is 20% of $5K ($1K) • Scholarships and Employer Provided Assistance o §117: gross income does not include qualified scholarship by individual who is candidate for degree at educational organization in §170(b) o §127: gross income does not include amts paid or expenses incurred by employer for educational assistance to employee if assistance is furnished pursuant to (b). Also wants to deduct costs of LLM degree. Wealthy phased out of Hope. like $1. Question is fact specific – what determines base level depends on occupation. This means most standard degree programs like JD. §135 – savings bonds for education §529 – qualified state tuition programs. etc.162-5: education expenses deductible as ordinary/necessary if: 1) maintain or improve skill in present trade/business or 2) meet express requirements of employer. 100% for first $1K.162-5(c) but only because he had worked as a lawyer prior to the LLM degree. but subject to taxes imposed by §511 (relating to imposition of tax on unrelated business income of charitable organizations). Education Credits • §25A – Hope and lifetime learning credits Hope Credit allows credit for first 2 yrs of college. Don’t want the taking in culture along the Seine excuse. increases marginal rate. Basically says that cannot deduct expenses for a base level of education.162-5(b)(2) – minimum educational requirements. 1. Had he not worked. excluded from income when take out $ for education. like Roth IRA.5K scholarship designed more for middle class. 50% for second $2K. Wants to deduct costs of 3L year as additional education. MBA etc are not deductible. changing states may be considered new trade/business Is it a working condition fringe under §132? No because could not be deducted under §162 Education Expenses o REUHMANN (322) – Law Student passed GA bar after his 2nd year. LLM degree was deductible under 1. o BUT an accountant couldn’t go to law school to be better at accounting 1.
§168(b)(5)) o Real estate—straight line may be used (§168(b)(3)) o Salvage value is not taken into account in any of these (§168(b)(4)) Meredith Huston 50 Tax Fall 2001 .7. 3.§168(d) • this is the date on which the depreciable property is deemed to be placed into service. and not if its perpetual or indefinite.• Student Loan Interest o §221: in case of individual.§168(c) and (e) (3) the applicable convention . the code does not use economic depreciation. o Deduction designed to allow taxpayers to treat as expense in determining taxable income in allocable part of cost of business or investment assets that have limited life. Simply measures true decline in the value of an asset over the course of a year. determine cost of asset. o Double Declining balance method (Accelerated depreciation)– allocates a larger portion of the cost to the earlier years and a lesser portion to the later years.§168 (2) the applicable recovery period . subtract salvage value which will receive at the end and divide that amount by the useful life. wear and tear (including reasonable allowance for obsolescence) of assets used in trade/business and held for the production of income. To actually compute depreciation: Easy way: Refer to depreciation tables (page xv of code book). See §168 (e) for classification. However. but it is applied each year to the amount remaining after the depreciation of previous years has been charged off Inflation problems can justify using accelerated depreciation because if inflation after year of purchase. like land. Would be administratively infeasible. Alternative depreciation strategies: o Economic depreciation – this is the ideal.5. Estimate useful life of asset. Once figure out what kind of property it is. neutral as to asset choice. 20 year classes: depreciated using 150% declining balance method. deduction allowed for taxable year amt equal to interest paid by taxpayer during taxable year on any qualified education loan o §62(a)(17): deduction on interest on education loans Depreciation and Amortization: Recovery of Capital Expenditures Steps to solve a depreciation problem: (under §168) (1) the applicable depreciation method . o §167 applies to property if its useful life is definite and predictable. o Depreciation allowance is limited to cost. because it is too difficult to figure out the true decline in value each year. Prescribes one of three depreciation methods for each class. A constant percentage is used. • • • • §167 – permits as depreciation deduction a reasonable allowance for exhaustion. should be easy to apply depreciation table Current System: Modified Accelerated Cost Recovery System (MACRS) o Depreciable assets are assigned to one of eight recovery classes with lives of 3-39 years. o Straight line method – cost of an asset is allocated in equal amounts over its useful life. No depreciation allowance is provided for assets acquired for personal use.10 year classes: depreciated using 200% Declining Balance method with appropriate switch to straight line method to maximize deductions (§168(b)(1)) 15. value of depreciation deduction will decline over time. with appropriate switch to straight line to maximize deductions (§168(b)(2)) o May elect to use straight line for any class (§168(b)(3)(c).
g. not depreciable under Reg 1. But.• • • • • Applicable Convention – Because property is seldom purchased on the first day of the year and disposed of on the last day. Meredith Huston 51 Tax Fall 2001 . when land and bldg bought together. Huge effort to carve off intangibles (e.167(a)-3 – If an intangible asset is known from experience to be of use for a limited period that can be estimated w/reasonable accuracy.5K of cost of tangible business property where annual total investment in qualified property $200K or less. §179 – Election to expense certain depreciable business assets – generally applies to small businesses.Don’t depreciate it – not expected to decline in value. o §197 -. Taxpayers won the case. purchase price must be allocated b/w land and bldg in proportion to respective FMV Intangibles . adopt rules to determine depreciation allowance when property is not used for entire year. The adjusted basis of the property is reduced by the amount of the deduction before computing the amount otherwise allowable as depreciation deduction under this chapter for such taxable year and any subsequent taxable year.167(a)-2. get three months of depreciation. Big issue with intangibles in takeovers of businesses. You get an additional allowance of 30% of the adjusted basis of the property for the taxable year the property is put into service. you can get a depreciation allowance. trained workforce in place) which were distinct from goodwill o HOUSTON CHRONICLE (1973) was able to demonstrate that old subscriber list had value apart from goodwill. was an argument that customer list had become less valuable. Because newspaper was defunct. does not apply to any intangible created by taxpayer unless created in connection w/acquisition of trade/business. won’t wear out . patents. the property will be considered to be owned by the person leasing it back (Safe harbor leasing lasts about 1 year). In theory. B gets depreciation deduction. customer list. Permits taxpayer to elect to deduct immediately up to $17. passed after NEWARK. . 2001 and before January 1. default convention is ½ year convention -. A sells to B. This was ESTATE OF FRANKLIN. EX. Tax code responds by saying that if there are insufficient attributes of ownership. §1245 and §1250 provide that certain amounts previously deducted as depreciation will be recaptured as ordinary income rather than capital gain when depreciable property sold. B leases to A.Amortization of intangibles: most intangibles. including goodwill. 2005.Supreme Court said could depreciate these types of assets as long as could be valued and had a limited useful life. and that value decayed over time. copyrights. will go to a mid-month or mid-quarter convention Land -. . Any additional property subject to usual depreciation rules. if bought car three months into year.§168(d) • Administrative convenience leads to ½ default. effect is to permit many small businesses to deduct cost of business assets rather than capitalize Recapture – Happens when depreciation is too rapid and go to sell depreciated property. put issue to rest o §1. Creates an incentive to “place property in service (§168(a))” in the second half of the year In certain situations. o September 11 Exception -§168(k) – Property acquired after September 10. o NEWARK MORNING LEDGER (1993)-. Safe harbor leasing—Transfer depreciation deductions to higher bracket taxpayer or to taxpayer who can use it against their gains. More on this below.§168 only applies to tangible property. amortized on straight line basis over 15 yr period.
the tax code does not always tax assets correctly and if liabilities (interest) are taxed correctly. It remains deductible even after the basis (capital actually invested) has been recovered.000 barrels of average daily production at a 15% rate o Calculated with respect to gross income from the property. but only amount received from extraction o Must have a “economic interest” in the minerals to get a depletion deduction (includes owners. §163(a) o SEE §263A(f) – special rules in for capitalizing interest in making of long-production property. interest is deductible. there are practical reasons why we want to know whether money paid is actually interest. but not licensees) INTEREST In General and Arbitrage • In a broad sense. the rest of § 163 whittles down the scope of deductible interest (i. investment interest. interest should be deductible. • Cost depletion – estimates the total amount of natural resource in the property and allows deduction of its cost in proportion to each year’s extractions o Has been allowed for water • Percentage depletion – allows the deduction of a specified percentage of the gross income from the property year after year without regard to the recovery of cost.g.e. o For example. and home mortgage interest are deductible. Shuldiner thinks we should look at indebtedness like a negative asset • However.generally.” • Depletion allowances are used in situations where it is difficult to determine what portion of property has been removed from the ground and sold and what has been retained – generally applies to mineral or oil and gas exploration and development. as it represents a reduction in your net worth without corresponding consumption. the door is left open for tax arbitrage. business interest. not the amount attributable processing or manufacturing minerals. it provides a subsidy for the activities to which it applies and a stimulus to natural resource exploration and development. lessees. o Limited to 50% of the taxable income from the property for minerals other than oil and gas o Because Percentage depletion permits a taxpayer to deduct more than actual cost. • § 163 (a) -. it might be difficult to distinguish between interest and principal components in an installment loan payment plan. Is not necessarily better than cost depletion. • Business Interest: interest on indebtedness used to operate trade/business is cost to taxpayer of doing business and thus is deductible like any other business expense except when the interest is required to be capitalized (e. §163(d) Meredith Huston 52 Tax Fall 2001 . when allocable to asset that taxpayer is constructing). personal interest is not deductible. 1975 – percentage depletion was repealed for oil and gas wells of major oil companies. Independent domestic oil and gas producers may use percentage depletion for 1. o Also.Depletion • §611 provides for a “reasonable allowance for depletion according to the peculiar conditions in each case. • Investment interest: deduction of interest on debt incurred by individuals to purchase or carry investment property is limited to net investment income (with indefinite carry-forward of interest disallowed under this provision. passive interest may or may not be deductible or deductible to the extent that it offsets passive gains). while assets are not. o However. but historically has been the case.
b) investment interest. Could treat all as ordinary income with $10 gain at ordinary rate or get capital gains on $10 or try to claim $90 in capital gains and $80 in ordinary losses. $1.2K and carry forward $1. you don’t really care because the rate is not that much better. If only short-term capital gains. o Interest incurred in connection with passive activity is not treated as investment interest. Defined by omission to include any interest otherwise deductible under §163 that is not a) interest paid or incurred in connection with trade or business (not including for this purpose trade/business of performing services as employee).§163(d)(4)(B)(ii): net investment income here is excess of net gain on disposition – capital gain + (dividend – deduction) • Capital gains are not generally included in net investment income. e) interest on certain deferred estate tax payments o Historically personal interest was fully deductible.§163(h)—personal non-business interest is not deductible. o RENT ISN’T INVESTMENT INCOME o §163(d)(3)(A): links debt with activity so properly allocable to property held for investment. have 100 in net investment income –80 from capital gains and 20 from dividend --> $100 interest deduction. • Personal Interest -. If buy a bond for $1K and hold for one year in which earn $90 Interest. Another option is to claim $90 in capital gains and no loss -. look at all investment activities and can carry forward. o §163(d)(4)(B)(ii): gives you the option to recharacterize capital gains as ordinary investment income. The best you can do is have no tax on your investment income.8K o Ex. but is instead subject to the rules of §469 which limit deductibility of passive losses. o Ex. Only a difficult question if dealing with long-term capital gains. $0 loss. Pro: allows you to increase the amount of investment income against which you can match investment interest.2 investment income. $3K Investment expense. d) qualified residence interest (as defined in §163(h)(3)).So if you borrowed to finance investments but your portfolio did poorly. got $20 dividend and had to pay $100 interest for $ borrowed to buy bond. c) interest that would be deductible in connection with §469 passive activity. o §163(d)(4): Net investment income is total investment income less investment expenses. • Downside is that you lose favorable capital gains treatment on the 80 included in net investment income (becomes ordinary). Con: cannot then claim preferential capital gains tax rate on the amount elected. So take $1. • If you make no election. you cannot generate a loss using interest. and $80 carried forward on interest. $4K capital gains. • Could elect to include $80 in capital gain as an offset to investment income expense (90-90+80=80). §10 in capital gains (left from 90-80). therefore you can take advantage of all this in one year if you are willing to give up some capital gains benefit. 3rd Option is the most attractive because more gains are taxed as capital gains/lower rate and creates ordinary losses that can be used to offset salary and other ordinary gains. o §265(a)(2) – can’t deduct interest used to buy tax-exempt municipal bonds. $0 in ordinary income and $0 in carry-forward. end up with $90 capital gains. deduction eliminated in 1986 (see home mortgage exception) 53 Tax Fall 2001 Meredith Huston .
like gasoline. I’m a traveling salesman and borrow money to buy a car that I use only for business purposes. o §221 allows deduction for interest on student loans. Home Mortgage Interest – Major exception to disallowance of personal interest. would be seen as employer’s income. as long as debt does not exceed FMV of home.• Things like interest on a personal auto loan.Reg 1. (§221 does not use tracing rules. Above or below the line? Below the line. If gas reimbursed. debt must be secured by the home (can’t take out loan on 1st home to buy 2nd – 2nd home must secure 2nd loan). o §163(h)(1) interest on income tax deficiency is personal interest. §163(h) (3)(B) o Home equity indebtedness: interest may be deductible on home mortgage equity indebtedness up to $100K. o Restrictions: Tracing required Refinancing is OK – still home mortgage interest after refinance. credit card interest. because an employee.Reg 1. gas. Can’t deduct if reimbursed either (harsh rule) What if employer buys the car – provides as an interest free loan – not deductible under §7872 Employer buys car and lets me use it – is payment of interest by employer imputed income to me? No. must be secured by residence.163-10T(n): definition of qualified residence interest Are tracing rules good? Tracing rules are manipulable (such as through commingled funds) Are there alternatives? Alternative = security rules (don’t know what these are) Refinancing rule – new loan has the same character as the original loan o Ex. Gas – deductible? Yes. now all considered an additional cost of the items purchased. Interest – no -. Interest would not be seen as my interest. Cannot deduct points on refinancing though.§163(h)(2)(3) – interest paid not deductible if in the trade or business of performing services as an employee. no correct way to determine w/certainty purpose for which funds borrowed Temp. o 54 Tax Fall 2001 Meredith Huston . Allows for two types of deduction: o Acquisition indebtedness: interest deductible on up to $1M of debt used to acquire. regardless of purpose or use of loan. limit reduced as principal is repaid on loan and refinancing does not increase. construct or substantially improve either principal residence (sale of principal residence = no tax on gain under §121) or second home (sale = tax on gain under §121). I then pay interest. use of car would be income (imputed rental income)– but protected under §132 – Working condition fringe. Loan may be taken out to pay down personal credit cards and would still be deductible. Tolls – deductible.163-8T: tracing principles for allocation of loan proceeds to specific purposes Temp. passive or investment interest? Need to trace funds to their source. since $ is fungible. will be above the line. trade or business expense under §162. Variety of interest provisions limit interest deductions based on purpose of loan. presumption loan used for educational expenses – pro-taxpayer rule) o How do I know whether interest is personal interest? How can I see if it is business. Congress allowed this deduction to encourage homeownership (preference over renters). §163(h)(3)(C). and tolls for the car.
Court found there was no sham. transaction will not be upheld.• Qualified residence may be vacation home. Only up to $1M of acquisition debt. 356) – Taxpayer prepaid interest in year where won sweepstakes and tried to deduct prepayment. • GOLDSTEIN (Note. Prepays interest on loan and takes deductions. Read into language of §163 a business purpose requirement. o §264(a) – if borrow to buy annuities. Was a flaw in the tax system. but the Supreme Court focused on whether what was done was what the statute intended (more objective than subjective). • §264 – says cannot deduct interest used to purchase single premium annuity contract.1M -. So under §163. o How do we tell there is no purposive reason other than a deduction? – rejected idea that she had a profit motive. but must choose one home to get the deduction. o If the only purpose is to get tax deductions.) (like FRANKLIN). Does the transaction really represent a loss Meredith Huston 55 Tax Fall 2001 . because defer income on annuities and keep loan interest current because is deductible when paid. don’t get benefit of claiming interest deductions. Problem of matching income and interest. motive of tax avoidance is not permissible. Not a clear motive test. o District court looked to motive (subjective test). negative rate of tax achieved when taxpayer can obtain both interest deduction and equivalent of 0% tax rate on income from asset purchased w/debt o Interest disallowance provisions permit wealthy taxpayers to obtain relatively greater benefits from tax-favored assets b/c can acquire tax-favored assets by liquidating existing assets o Deduction of interest expended to earn tax-exempt or tax-preferred investment income has long been controversial. funded by loan from company that sold to him. but disallowed the interest deduction on the grounds that there was no purposive reason for the prepayment other than to secure a deduction. Never built up any equity in annuity. plus another $100K in home equity indebtedness --> max $1. out of pocket is ok. limited deductions in several contexts: §264: forbids deduction of interest on borrowing with regards to certain life insurance or annuity Ks §265(a)(2): prohibits deduction of interest on indebtedness to purchase or hold bonds that yield tax-exempt interest §§1277 and 1282 defer deduction of interest on indebtedness to purchase or hold certain bonds purchased at discount until interest income from bond taxed at maturity or upon disposition §163(d): limits deduction of investment interest to investment income §461(g): deductions of prepayments of interest restricted §263A(f): interest incurred in connection w/construction of certain types of real property and tangible personal property must be capitalized and amortized Sham Transaction and No Economic Purpose Doctrines • KNETSCH (1960)(352) – Created tax shelter with annuities.§163(h)(3)(B)(ii) Tax Arbitrage o Arises when assets eligible for favored tax treatment are acquired w/debt. o Should you be able to deduct prepaid interest as interest? – Historically tax law respected form of deduction and allowed you to deduct it. Bought single premium deferred annuity. Kills loophole Knetsch tried to exploit. although it remains a factor. Taxpayer does not get deduction because there was nothing of substance to be realized by Knetsch beyond a tax deduction (no tax on a deferred annuity until it is paid out.
you pay me back 110 in 1 year.000. §216 allows tenant-s/h in coop bldg to deduct pro rata share of interest.00 principal. 10.000 interest If left up to parties. o Ex. must allocate for time that interest would have accrued. (e. §§1271-1278 o Ex. 10% interest rate. lender can suffer real loss later when time for payback and $ not worth same as it was Meredith Huston 56 Tax Fall 2001 . Sometimes it is difficult to see whether or not we have interest . What is Interest? • Money is fungible – can’t look at a dollar and tell what it is. 5 interest 80 principal. 3 years = 100. 53. I lend you 100. Problems of Inflation • Inflation: causes problems for income tax.000 interest • would be able to manipulate tax result. taxed each year as if were accruing interest at equal rate. generally assume 780 is interest and rest is principal. • 123. converted large amts of equity capital into debt through financial transactions/ leveraged buyouts and leveraged recapitalizations • Assuming there is debt. o Ex. so can only deduct interest over period for which allocated). I’ll pay you 133. making this distinction became increasingly important in ‘80s b/c cos.g no real difference b/w borrowing $1000 and prepaying $100 and borrowing $900.000 in 3 years Bought property for 100. • Is there equity or is there debt – use substance over form analysis to decide.000 interest • 80. o Ex.o of income? No. could structure many ways. 10 interest 105 principal. 30 interest indefinite number of characterizations. but Treasury has never issued final regulations under §385. §163(b) allows interest deduction under certain circumstances where carrying charges are imposed even though actual amount of interest cannot be determined. Interest or principal? If in 1st month $780 interest has accrued.000 plus 33.000. §7872 recharacterizes as interest amounts designated otherwise on variety of nointerest/below-market interest transaction.000 paid back over 30 years Someone pays 32.000. Mortgage – bank lends 1. I pay back 800 per month for 30 years. Property transaction – instead of paying me now. Zero Coupon Bond – 100. Congress has enacted provisions to take inflation into account but none deals directly w/assets and liabilities. o Distinguishing Debt from Equity: §385 authorizes Treasury to prescribe by regulation how to ascertain whether interest in corporation is stock or debt. §461(g) – now makes prepaid interest non-deductible.000 principal. The only exception to this rule is the deductibility of mortgage points (§461(g)(2). Labyrinth of rules which tell us correct characterization: Original Issue Discount Rules. if you prepay.000 back – value accrues each year with interest rate. In mortgages pay mostly interest in beginning. 100 principal. what part of debt is interest? What is principal? o Distinguishing Interest from Principal: important because interest deductible but principal is not.
people make out from overstatement of deductions Does the government lose out on this? Usual assumption is that this is what happens. • Then there’s §162(c)(2) losses. Casualty is a realization event. Actual loss sustained is a rule laid down by the courts and not replacement value. When do losses occur? o Tax consequences only when realized. §162(c)(2) losses must be itemized below the line. people tend to hold debt in tax-preferred forms. exchanged. May no longer be the case – inflation is not as high as it was. However. in form of net operating loss carry-forwards (20 years) or carry-backs (2 years) as provided by §172 than do investment or transaction for-profit losses under §165(c)(2) o Have a car used in business activity. Government not in a hurry to change because might be politically unpopular. and casualty losses. accident.Amount of loss deduction: – loss is adjusted basis of property. §62(a)(2).§165(c) limits deduction to losses incurred in a trade or business or in connection with any transaction entered into for profit. o Many non-business losses are capital losses. Non-business profit Seeking Losses Trade or business losses are deductible from gross income rather than from AGI. which can only be deducted above the line (computing AGI) if they result from a sale/exchange of property or are attributable to property that produces rent or royalties. can’t take a loss o Property Loss – When you buy an asset at one price and then sell it at a lower price. • Individual taxpayers . generally. §165(b) -. • Business losses under §165(c)(1) generally receive more favorable tax treatment over time. and therefore can be taken even if the TP doesn’t itemize.• • We overstate interest income and we overstate interest deductions to deal with this problem. allows deductions for losses incurred in connection with trade or business transaction entered into for profit. o Courts tend to fix the time of a loss by looking to definitive or identifiable event or to conduct indicating a closed transaction or no reasonable prospect of recovery. consistent with §162 and §212. Two types of losses: o Operating losses – run a business and lose money Have already dealt with these in several areas: §183 – hobby losses. or otherwise disposed of. Other losses are personal and non deductible (exceptions for casualty and theft losses). with limited deductibility. taxpayer may dispose of property without actually suffering economic loss where sells to related party or under obligation to repurchase. Business vs. -. • • • • §165 permits deductions for certain losses not compensated for by insurance. LOSSES §165(a) authorizes a deduction for any loss realized during a taxable year which isn’t compensated by insurance or otherwise. Time of realization is clear when property is sold. Also not clear when property becomes worthless. §280A – home office. • OTHERWISE.Above the line loss – 62(a)(1) deductible from gross income rather than adjusted gross income (below the line) and therefore can be taken even if the taxpayer does not itemize (§62(a)(2)) 57 Tax Fall 2001 Meredith Huston . Better solution would be to index basis or index interest to inflation. Look to realism and practicality.
Painting destroyed was purchased at $30K. usually come from insurance payments that exceed basis of property damaged • Argument for casualty loss provision is that does not recognize personal consumption. Personal versus Business or Profit-Seeking Losses • §165 denies deduction for personal losses other than theft/casualty. Deductible loss is $30K. otherwise are itemized. $45K was untaxed appreciation. • Casualty gain: recognized gain from any involuntary conversion of property. It is not subject to the 2% floor § 67 (b)(3) • Reg. Casualty Losses • Casualty loss: attributable to fire. and then can only take losses to the extent that the uninsured losses exceed 10% AGI. Loss Limitations Property Losses • FENDER (381) – Taxpayer sets up trusts for kids. trusts repurchased bonds for value plus accrued interest. Deductible loss = $8K. not a trade or business. losses from sale of property can be allocated between different uses. car worth $8K. Owned by trusts. §165(c)(2) losses deducted in computing adjusted gross income only if result from a sale/exchange of property or are attributable to property that produces rent/royalties §62(a)(3) &(4). At time of accident. • See information on §183 and Hobby losses (Plunkett) above. Paid $20K for car. 42 days later. o This is a big limitation – must have a very big loss. even though consistent with wash sale rules. • §165(h) -.165-7 – amount of deduction on personal property is limited to lesser of FMV prior to the casualty minus the FMV after casualty or the property’s adjusted basis.• Have a car used in a for-profit activity. To offset gains. Corresponds to §262 denying deductions for personal expenses. or the same property is used at different times for different purposes. Had large capital gains from sale of stock. Meredith Huston 58 Tax Fall 2001 . Circumstances suggest there was no realization event. Lose ability to pay taxes when lose value of property. • When part of property is used for one purpose and part for another. o Casualty loss is an itemized deduction. • Ex. Recognized tax loss. Trust then sold bonds to bank over which he had significant control (owned 40%. storm. single largest block). co-trustee attempted to sell bonds that had substantially declined in value. • Ex. 1. o Disallow loss deduction for unrealized gains to prevent double benefit because gain never taken into income. appreciated in value to $75K. Empirically this provision is of little significance. $12K considered to be already consumed. is stolen. • Deduction allowed where inherited property sold at loss without ever having been used as a residence by taxpayer. Court held that because of the structure of the transaction. and thus taken below the line. Get the first $100 of loss. the taxpayer retained sufficient domain over bonds to ensure that he could recapture them and not suffer economic loss. Personal casualty loss where property not used for business/investment.Casualty losses are subject to a 10% floor. shipwreck or theft (not sale/exchange). Taxpayer’s car completely destroyed. No sale or exchange of property 62(a)(3) – so this is not an above the line loss o Sale or exchange language is key. Deduction allowed in proportion to business or income producing use in the same way basis in property is allocated between personal and business uses when calculate depreciation.
basis of stock purchased is that of stock sold. not lost. applies to certain commodity future Ks and stock and stock option transactions where offsetting positions are held in similar/related properties o how to determine if two positions are offsetting? 1092(c)(2) o before this was enacted. if ultimately sells property for gain. by individuals only to extent of capital gains plus $3K ordinary income • §1212: any capital losses not allowed in current year may be carried forward indefinitely by individuals Straddles: where taxpayer retains related assets w/unrealized gains. not all assets. regardless of effect on overall economic position or economic substance of transaction. so losses are deferred. 30 days after) o really requires that securities be identical to be caught in the wash sale provision. duration. between certain related people. only to losses o Defers loss rather than eliminating in by adding loss to basis of stock purchased. if a different issuer. Even worse if agree on a set price. seller’s loss generally lost permanently under this provision b/c purchaser’s basis for computing loss when sells property is his cost. can obtain deferral and conversion • To obtain deferral. limits deduction of losses from straddles to amt by which losses exceed unrecognized gains on offsetting positions. whether direct or indirect. o If there is an explicit agreement to sell back. purchaser’s cost basis is increased by seller’s disallowed loss §1091 -. Could switch for an identical yield. Straddle • Typical straddle. §267: disallows deductions for losses from sales or exchanges of property. credit rating. service would litigate these as not-for-profit transactions where no loss is allowed (but this was messy) o presumptions when something has a substantial diminution in risk – 1092(c)(3) Meredith Huston 59 Tax Fall 2001 . 30 days before. but still be o. will have very high basis. while retaining gain until next year (accelerate loss and defer gain) • One form of tax shelter • §1092: enacted to address this problem. sell loss leg in current tax year. similar rules apply to short sales. o Only covers securities. §1091 requires that the security repurchases take the basis of the security sold. So when that stock is sold. taxpayer acquires offsetting positions in commodity futures Ks (ie. etc. does not apply to gains nor if securities are not substantially identical In other words. then clearly are disallowing loss realization. any changes will offset each other. • §165(f) – only allows you to take losses as permitted by §1211 and §1212 §1211: capital losses deductible by corporations up to capital gains. so that the loss deduction is postponed until a bona fide disposition is made. o covers a 61 day period (day of sale.k. such as family members or corporations and majority (>50%) shareholders. plus any additional amount paid on repurchase.disallows loss from sale preceded or followed by purchase of substantially identical securities (including options) within 30 day period (look up/back 30 days). Found neither §267 (transfer to related party) nor §1091 (wash sale) applied. to buy and sell wheat).ie. o Does not apply to gains. Insufficient for allowing deduction.Found taxpayers motivated by tax avoidance. can use tax losses to obtain optimum tax treatment. generate smaller gains.
such as wages. so investors are still entitled to include such third-party debt for the purposes of calculating deductible losses. don’t take inflation into account (mismeasure income). Meredith Huston 60 Tax Fall 2001 . §465(b) • But if it’s inside financing (loans made by promoter of property). interest. o §465 limits the deductions from a trade or business activity to the amount of taxpayer’s at risk investment as well. o Penalty rules o All of these helped some. nonrecourse loans from outside lenders continue to be free of at risk. $ came from nonrecourse loan from seller. • BRANNEN (406): paid $1. but did not really work. use §183 to determine profit motive o Fix procedural rules • “Tax matters” partner – can sue one partner and decision will apply to all partners.or abusive.§1256: requires certain stock and commodities be marked to market at end of year. o With real estate. • May either be legitimate – sometimes intentional on the part of congress (accelerated deductions for real estate to encourage real estate investment) -. • The at risk is only with respect to the cash/property he has actually drawn from his own resources. or dividends that were neither produced by nor related to income produced by investment. accelerated depreciation (mismeasure income). • §465 – At-Risk Rule -. get basis. but not going to let you take deductions beyond where they exceed how much you are at risk (i. gain/loss fully recognized. Tax Shelters • Aim to generate losses that can offset or shelter other income. • How to attack shelters: o Fix stupid rules like prepaid interest.e. • What produces shelters? Bad tax rules – mismeasurement of income.5M for movie. Brannen never at risk of having to pay back $. §465(b) o Restricts the amount of deductible loss from the ownership of depreciable property (other than real estate) to the TOTAL AMOUNT OF TP’S INVESTMENT. If allow deduction for prepaid interest (mismeasure income). Nonrecourse debt is not considered $ that puts you at risk unless is for real estate and then puts you at risk so long as borrow from someone other than the seller of the property. ct did not find honest profit motive. Provision has been expanded over time. Problem because was difficult to prove there was no profit motive. own $ on the line). each such K taxpayer holds treated as if sold at year end. o Fix depreciation rules (didn’t want to) o Index debt for inflation (didn’t want to) o Abandon realization requirement (didn’t want to) o Use “common law-like” doctrines like fact that need a profit motive. THE AMOUNT AT RISK. whether or not taxpayer holds offsetting positions.somewhat successful – RESTRICTS THE AMOUNT OF DEDUCTIBLE LOSS FROM OWNERSHIP OF DEPRECIABLE PROPERTY TO TOTAL AMOUNT THAT TP HAS AT RISK. • Often passive investments. and often structured as limited partnerships to provide investors both the benefits of limited liability and conduit taxation (whereby income and losses of partnership are passed through to partners). the debt only counts as at risk if the investors are personally liable for it. • Problem w/using §183 to attack tax shelters is that highly fact sensitive analysis.
000 net deduction -. (p. • §469 – Passive Loss rule -. pool activities together. o Congress said we’ll divide the trade/business world into passive and active (and investment) • Loss from passive business cannot offset active business • Loss from active business can offset passive business • Allow only $3000 capital losses a year from investment. 408): o > 500 hours/taxable year o performs substantially all of activities involved with activity o > 100 hours /year where that equals or exceeds participation of any other individual o “significant participation” with respect to this activity (more than 100 hours.Could I take entire deduction? Yes. 50K down. o You can carry over the losses to offset any income from the depreciable asset the next year. 6 factors to show material participation (p. In 1986. continuous and substantial basis. continuous and substantial basis. but were still allowed most non-recourse debt.Ex. there is 61 Tax Fall 2001 Meredith Huston . – o When people engage in tax shelter activities. had a very limited scope. may show material participation by “Facts and circumstances” that demonstrate that she participates in the activity on a regular. Effective in shutting down real estate rules? Don’t know because this was the same year as passive loss rules were enacted. 411) o 469(g) – dispositions of entire interest in passive activity – A lot of tax shelter activities are timing gains. 125.000 interest year 1. Can I take it? Yes • Year 3. o §469 -. But allow active losses to offset investment income. there is no timing gain. loss is allowed. 1.000 non recourse. but less than that required for material participation) and her combined participation in all such activities exceeds 500 hours o she materially participated in the activity for any 5 of the last 10 prior taxable years o she materially participated in a “personal service” activity in any one of the three prior taxable years (a trade or business in which capital is not an income producing factor) • Alternatively. Certainly did not apply to real estate. Uses basket approach – divides income into certain categories or baskets and limits deductions against that income to expenses related in some manner to the production or receipt of that income. 125.000 income year 1 o Deductions? • Year 1. Assume 100.very successful -. Assume 100. their involvement is basically passive. • §469(h)(1) -.basically shut down the tax shelter industry. because is lower than at risk amount of 250K (down payment + recourse debt) • Year 2.000. (see 465(c)). can’t use losses from passive activities to offset gains from business or investment income) o What is a passive activity? – • 469(c)(1) conducted in trade/business that taxpayer does not materially participate in. if fully dispose of activity. can’t take deduction because no longer have anything at risk o When rules originally enacted.material participation = regular.e.If engaged in a passive activity can only deduct losses from those activities to the extent that there is a gain from those activities (i. expanded to include real estate.000 deduction. 200K recourse debt. • Is this determined on an activity-by-activity basis? No.
or when partially worthless.800 (1/2 joint filing) o Married filing jointly – 7. GENERES – The proper measure to determine if a bad debt has a proximate relation to the taxpayer’s trade or business is dominant motivation. to U.600 Married filing jointly is less than 2x Single • Creates both marriage penalty and marriage bonus. up to $25. • §63(c) – defines standard deduction. o No income. Note there is an exception for home mortgage interest -.S. For 2001 – o Single = 4550 o Married filing separately – 3. He said he loaned it to protect his job. If were an active participant in rental real estate. • §469(c)(7) – Real estate professionals –must perform 750 hours of work in area and this must constitute more than ½ of his services. For individuals for small scale rental activities who actively manage them. not his investment.000 losses can be used against nonpassive income. Standard Deduction • Standard deduction taken below the line in lieu of itemizing. married marriage penalty • §167 – will eliminate marriage penalty. effectively acts as floor for itemized deductions (get regardless of expenditures) • Itemized deductions other than those listed in §67(b) are allowed only to the extent they exceed 2 percent of the taxpayer’s AGI. but only until 2010 • Note that certain taxpayers are required to itemize even if their deductions are less than the standard deduction – not available to married taxpayers filing separate returns where either spouse itemizes. would not trigger suspended losses. possessions. o All major itemized deductions are listed in §67(b) and not subject to 2% floor. PERSONAL DEDUCTIONS These are largely unrelated to the costs of earning income.Rental real estate – exception in the code when enacted. Says 67(a). and to estates. Corp fails. Less fear of fraud when are getting out of an investment. o §166(d) – loss sustained on the worthlessness of a nonbusiness debt is treated as a short-term capital loss. • Non-business debts – profit-seeking activity or in personal setting – must be wholly worthless.000 BAD DEBTS Debts which become worthless during the taxable year are deductible from gross income under §166. • Business debts – deducted when it becomes wholly worthless.o o no tax shelter anymore –not a taxable gain. Has phaseout provision.$100. married income marriage bonus o Two incomes. Applies to any real property (not just rental). They reflect differences in ability to pay. 469(c) (2) rental activities – no matter what are included in the passive loss world. to nonresident aliens. • Why have a standard deduction? (two arguments) Meredith Huston 62 Tax Fall 2001 . • Exceptions • §469(i) -. citizens with income from U. increase marriage bonus o phases in beginning in 2004.S. only available to offset capital gains plus $3000 of ordinary income. trusts. common trust funds or partnerships.000 to a corporation he was president of and owed 44%. Guy loaned $300. different rates depending on filing status (determined by §7703).
adds to progressivity o Administrative simplification -. So on a joint return. you get it o If a member of family (great grandparent. o Used to be that everyone got them (now don’t unless pass the support test). • §152 – Taxpayers entitled to exemptions for dependents. but lose it on the 1st dollar. SEE NEW §152 IN PACKET Child credit .viewed as adjustment of tax rate schedules. you can no longer take the personal exemption for yourself if someone else can claim you as a dependent on their return. Now don’t have to.000 indexed $199.$150. Person who actually pays support should claim the deduction. o Anyone else. Subject to phaseouts.§24 – get a tax credit for each child. you can get it.viewed as substitute for itemized deductions for those taxpayers whose itemized deductions would be relatively small amts o Choice of argument will effect position on other issues Like is it fair that non-itemizers (generally poorer) cannot deduct charitable deductions? • More than fair – have included amount in standardized deduction (if chose simplification argument) • Efficiency problem – not encouraging standard deduction people to give to charity Dependents -. §63(c)(5) o Personal Exemptions -. so really is 49 * $2500 Meredith Huston 63 Tax Fall 2001 . deduction for exemption is reduced when income reaches $199.) and very low income (income under exemption amount). if they are a member of your household and they are very low income. o If child 18 or under or 23 and under and a student. had to file a return. there is a cap – standard deduction is maximum greater of $750 or earned income+$250 (didn’t used to add this unearned income – meant if kid had $1 interest.450 Phase out: Lose 2% per $2500 increment in income over the threshold amt.§151 • §151 – for tax years beginning in 2001. nephew. the personal exemption amount under §151(d) is $2. if pass support test – need to provide greater than 50% support.Used to be that children were treated as separate deductions.• Zero bracket amount -.After 1986.) if you can be claimed as a dependant on someone else’s return. Now. • §152(e) – dependency exception in the event of divorce/separation allocated to parent with custody unless they waive that right. Then.900 (indexed for inflation). uncle. reflects view that no tax should be paid for incomes below certain amt since std deduction + personal exemption nullifies such income (creates $0 tax bracket) – floor under which people don’t pay tax or file returns. (PEP) o Phaseout based on AGI o Threshold -.950 • Looks like it would take about 50 * $2500 to be phased out. • §151(d)(2) -. Phaseouts of Exemptions and Itemized Deductions PERSONAL EXEMPTION PHASEOUT – Applies to personal and dependent exemptions • §151(d) – personal exemption phased out for income above a threshold amount. Taxpayers are allowed to exempt this for themselves. etc.450 and completely eliminated when income reaches $321.
so that have a 10% reduction in personal exemptions.000 (married filing jointly or single) indexed 132. 2/3 in 2010. (certain protected deductions not phased out. (Phaseout faster and faster every year because of inflation). o Reduction of itemized deductions? If we want to look at influence of this on people’s behavior. e. so itemized deductions would be reduced by $600.5K not indexed. Same value to higher income people as lower income people. if $10. or a desire to increase tax revenues over time. Why didn’t they index? Carelessness. • Marginal tax rate effectively goes up as a result of phaseouts. Deductions • Credits = $1 credit is equal to $1 tax. o Note: phaseout is not properly indexed. Why some high income people now take standard deduction (5% high income taxpayers). so lose 8% of exemption (assuming $2. 1/3 phaseout disappears in 2008. $2. too complicated. medical expenses. the 3% rule is the operative rule.g. For most people (96% over the threshold). avoided unpopular politics). take excess $20K. investment interest. but $2. need to look at rule which applies. .5K/$10K is 4 *2% = 8. (§151 was about ½% surcharge) Would only use 80% rule if high income and few itemized deductions (rare). Really would have a 33% rate. o 2001 Act phases out phaseouts in 2006 and 2007. multiply by 3% = $600.001. . but this didn’t raise enough revenue. o Marriage penalty is more severe for §68 than for other sections because married filing jointly has the same income level phaseout as single taxpayers and married filing separately gets only ½ of what single filer would get. if have AGI of $120K. Lose the lesser of: 3% of AGI over the threshold ((AGI minus threshold)* 3%) or 80% of itemized deductions. decided to get rid of bubble. then 5 increments above 2%. casualty losses) o Example: assuming threshold $100K. decided would add phaseouts instead to get the $ needed. 2009. (And if he asks us to do this . How did they do this? With a “bubble” (???? no idea what this means) o In 1991. effectively repealed Shuldiner argues repeal is a hidden way to cut taxes for high income taxpayers. o Phaseout effectively raises the marginal rates on high income taxpayers because the phaseout applies progressively to higher incomes. o Phaseout cannot reduce itemized deduction below level of standard deduction because would always elect standard deduction rather than itemize. o ITEMIZED DEDUCTION PHASEOUT • §68 – claims to tell you your itemized deduction has been phased out (PEAS) o §68—Threshold is 100. !) • Why phase out? o In 1986. decided to go with top income tax rate of 28%.950. • For most people §68 imposes a 1% surcharge on income over the threshold – did this rather than raise tax rates (sub rosa way to raise taxes. but would pretend was 28%.Example: $10K income above the threshold amount. Threshold element is indexed for inflation. • Deductions = higher value to higher income people? • Personal credits include Meredith Huston 64 Tax Fall 2001 . Credits vs.5K threshold).
o Earned Income Tax Credit – §32 – refundable credit Provides credit to low income individuals who have earnings (really seen as a subsidy for low income wage earners. o Very important where credit is aimed at low income people Taxes – SEE NEW §154 IN PACKET • §164 -. way to assure minimum standard of living for working poor). Over time has expanded: • For people with no qualifying children – 7. Foreign income taxes subject to some limitations. have no ability to pay. • §275 – federal income tax. Originally built in to offset cost of social security tax for low-income wage earners. $75K single.§21 o Child credit – §24 -.§25A – Hope and lifetime learning credits o Credit for the Elderly and Disabled -. Serious marriage penalty issues with this.• o Education credit -. Consumption expenditure. and local levels are not deductible regardless of whether are personal or profit-seeking. but can also take a credit. • Business taxes – sales tax on business activity is deductible. • Sales taxes – no longer deductible for non-business activities. Meredith Huston 65 Tax Fall 2001 .phased out– taxpayer gets credit of $700 in 2005 for each qualifying child (not indexed for inflation). is part of cost of acquisition. Range starts at $100K for married/joint. file tax return simply for cash payment. gift taxes imposed at federal. state. Phaseout based on AGI. Social Security Taxes. State sales tax/income tax election – you can deduct the state and local sales taxes instead of state/local income taxes (useful for residents of states without income taxes). rather than just to zero. Only available to itemizers (not subject to 2% floor -. Were deductible prior to 1986. • Foreign income taxes treated differently under §164 o Can take deduction if you want. Reduces tax liability to negative numbers.§22(a) o Child care credit -. may be allowed as a credit against domestic income tax liability instead of a deduction. • Taxes incurred in business activity or in connection with the production of income are deductible under §162 or §212 in the calculation of AGI. Would capitalize and depreciate along with rest of cost. Alleviated to some extent in 2001 act. Phaseout = $50 for each $1K of modified AGI exceeding threshold amount. can’t deduct. o If were buying tractor for farm and there was a sales tax. estate. but permitted because want to subsidize state and local activities. Is it a refundable credit or a non-refundable credit? o Refundable = even people with no tax liabilities can receive credit.65% = burden of social security tax but • 34% with one child • 40% with two or more children complex provision in many ways congress has backed off.§67(b)(2)) o Why? Two theories: If pay tax. Qualifying child must be under 17 and dependent under §151. inheritance.permits a deduction for state and local income and property taxes. Equivalent to increase in marginal rate by 5% for people w/kids in phaseout range.
(jump to Q4) (3) Is it marketable securities (Corporate stock)? (look at 170(e)(5)) • YES – you get the FMV • NO – You get basis as a deduction. Couldn’t say this outright . • Why have deduction? o If I gave it away. like red cross. • Gifts of Property o §170(e): taxpayer who gives appreciated property to charity doesn’t realize gain. Gets around §178. I can’t consume it o Subsidy to giving o Why deduction rather than credit? Why only available to itemizers? One answer -. art museum • Private Foundations – get support from smaller group of individuals. charitable contributions to public charities of appreciated securities or real estate therefore are deductible in full if would produce long-term capital gain if sold Contribution of any property other than marketable securities to private foundation gives rise to deduction generally limited to basis o To determine amount of deduction: Questions to ask here (VIA §170(e): (1) Is it going to be long term capital gain? • YES (jump to Q2) • NO – (short term capital gain or ordinary income property) You get to deduct basis. lack public monitoring function of public charities. Matching program perspective – if you’re poor. Carnegie foundation. • Why? Because if there could be a valuation problem Meredith Huston 66 Tax Fall 2001 . we don’t trust the way you give. will not be income. applies to all contributions of property that would produce ordinary income or shortterm capital gain if sold and to contributions of property that would produce longterm capital gain if sold where donee is private foundation or where contributed property is tangible personal property unrelated to exempt function of charity. . • Public Charity – gets support from public. (Like a museum)). should only get an $85 deduction. o Substantiation requirement -. thus untaxed gain (effectively subsidy for donations of appreciated property). o 30% AGI restriction on deductible giving for private foundations – we don’t trust them as much.to prevent people from understating quid pro quo and overstating a deduction.limitation on deduction – for most is a limit of 50% of AGI (congress does not want elimination of tax liability) • §170(b)(2) – corporation’s charitable deduction limited to 10% of taxable income. Huston Foundation. • Is it a real donation? o Requirement of detached and disinterested generosity (Duberstein) – the quid pro quo problem o $100 to public radio and get a $15 umbrella. (2) Is it private? • YES – we’re a little more suspicious. • §74—prizes and awards. .Charitable Deductions • §170(a)– get a deduction for cash or FMV of property you donate to a charity (must itemize) • §170(b) -.More cost effective to give to rich. if all given to charity. (jump to Q3) • NO – Public charity – (charity where you have to go to the public for your funds. so we won’t match it. but can deduct full FMV of appreciated property.
(4) Is it tangible personal property? (You can feel it…that’s tangible. you have to allocate the basis to the part sold and part given. but if tangible property that will not be used by donee in charitable function.) • YES – jump to Q5 • NO – (Intangibles or real property) – you get FMV. • NO – basis. $10K rental pmts and 50% tax rate.amt of gain that would not have been long-term capital gain. If you make a capital expenditure that would otherwise qualify as being for medical care. o HERNANDEZ – Fixed payments to churches and synagogues for pew rents or to attend certain services are deductible. deduction for painting donated to museum. even though you get a benefit. • Contribution of property to public charity generally FMV. Tax Exempt Organizations Skipped by me. don’t get deduction of painting donated to Greenpeace) o Limitation: to extent would have been ordinary income. You get FMV. do not get deduction (e. if donate. which the Service has held is an expenditure incurred for the primary purpose of medical care. Medical Expenses Medical benefits provided by an employer are fully excludable from an employee’s income . to the extent the expenditure exceeds the increase in value of the taxpayer’s property. Meredith Huston 67 Tax Fall 2001 . would probably sell it to get deduction and then donate the $ Gifts of Services o Taxpayer cannot deduct the value of services rendered to charitable institutions. If you’re installing a swimming pool. 170(e)(2) and 1011(b) if you do a part sell part gift. §213 – a taxpayer can deduct amounts spent on medical care (not compensated by insurance or otherwise) for the taxpayer and taxpayer’s spouse and dependents to the extent that the medical expenses exceed 7.§105(b) and §106. Person may deduct unreimbursed out-of pocket expenses incurred in connection with donating services to a charitable organization. for instance. book used for a library.g. IRS wins. it’s deductible. can only take deduction of $5K and not full rental amt since would have been ordinary income) o §170(b)(1)(d): amt of deduction for appreciated property w/long-term capital gain limited to 30% of donor’s AGI o If property had loss. (5) Is it using it for related use? • YES – (This means that art is being displayed at a museum). you can’t deduct those additional costs as being for medical care. Court here says fees paid to Scientology for training and auditing are a quid pro quo and he doesn’t get the benefit. then says later that it will allow deductions to Scientology. FMV reduced by full appreciation (e.5% of AGI. any additional expenditure that is attributable to personal motivation does not have medical care as its primary purpose and is not related to the medical care for purposes of §213.g. So if you make your pool pretty.
divide by 2. 0.? • It is impossible to simultaneously address all these problems and retain a progressive income tax. What happens when both earners individually fall in highest bracket? o Marriage penalty remains from the standard deduction?? o 1986 – bubble – for mid-high income earners – 33%. no change in tax when marry. Eliminates many questions or extra steps. single bonus. o Creates a marriage penalty for spouses who earn similar incomes. o If both earning 50K. See table: Even 100. But brings in lots of complications: Who gets deductions for kids. Singles began to get upset. so in 1948.0 = 200+0 Single Married • < = • 2nd earner deduction – allowed deductions of 10% income of lower earning spouse up to $3K.000 must be greater than the total tax on two single people each earning 100. Congress adopted special rate for singles – not as good as joint filing. compute tax and multiply by 2. but justified with imputed income argument. congress implemented joint filing. o Common law states v.000 if we are to have a progressive tax structure. • If allow for marrieds to both file as single – creates inequality across couples. so penalty decreased. Seaborn 1930) Matters because we have a progressive tax. had effect of reducing maximum marriage penalty to about $3K. much greater tax liability Community property – 50. gives couple equality. o If one earns 100K and one none. people above and below = 33% what does this do???? 68 Tax Fall 2001 Meredith Huston . 100 = 100+100 Split 200. Huge single penalty relative to marriage bonus • In 1969. but penalty not as steep – maximum 20% more takes rather than 40%. investment interest. Add incomes. • Joint filing has administrative arguments in favor. but rates were flattened. 50. States also allowed people to elect into community property regime (courts said had to be mandatory community property regime) o Community property = in effect joint filing. • Joint filing. Began to break down. o The tax on a single person earning 200. etc. community property states (allowed spouses to split income – Poe v. repealed. • Mandatory separate filing would eliminate marriage penalty. Common law – 100. lower tax liability States began to adopt community property laws to avoid tax problems.WHOSE INCOME? TAXATION OF THE FAMILY Treatment of Couples • Should we treat a married couple differently than two individuals? • Pre 1948 – separate taxpayers. Did away with geographic and cross-couple differences. there was a huge bonus when got married. But can argue that don’t care about this. o 1986.
o Unearned income of children under 14 = taxed at parents top marginal rate regardless of source Unearned income includes dividend and interest income. kid does not get to ride up tax brackets b/c not independent from parents o Now have option to elect to report child’s full income on parents’ return if child’s income if less than 10X standard deduction (less than $7500K) but not attractive option most of time b/c lose capital gains treatment on kid’s income b/c added to parents’ AGI Earned income is taxed 69 Tax Fall 2001 Meredith Huston . Final amt $2001-$3000 taxed at parents’ rate. court held rules do not significantly interfere w/decisions to marry/did not deprive constitutional right.even if parent is phased out or chooses not to take it.• • • • §68 – threshold = same for married and single – huge marriage penalty. and unearned gains o Child’s income actually added to the parents’ taxable income. then first $1-$750 taxed at 0% b/c covered by standard deduction. not AGI. dividends. dependant has lower standard deduction o §63(c)(5)(a) – standard deduction shall not exceed greater of $500 or the sum of $250 and such individual’s earned income. taxes place little obstacle on getting married Treatment of children (“kiddie tax”) • Children used to be treated as separate. the amount of itemized deductions directly connected to production of unearned income --> so basically $1500) o unearned income above 2X standard deduction. but still there.unearned income above $1.467): taxpayers are married couple each w/earned income. DRUCKER (2ndCir. Got one standard deduction. 2001 act o Standard deduction – 2 times single o 15% bracket – 2 times single.Kiddie tax. Earned income is taxed like that of an adult. • Concern that the rich would hide their income with their lower bracket kids. which is important b/c it won’t affect the phase-outs. o net unearned income= unearned income minus ($750 (standard deduction for dependent under §63(c)(5)(A). • §1(g) -. LOOK AT 433 E&E FOR THIS IF HE ASKS. • Parent takes standard deduction. covers interest. child cannot -. challenged marriage penalty by filing married w/separate return applying rate of unmarried individuals under §1(c) instead of §1(d). Schedule 0-750 751-1500? 1500-2000? 2001+ % 0 10% 15% ???? parents’ marginal • Example: if kid has $3K unearned income. indexed for inflation) plus the greater of $750 (indexed amt. integrated children more into family. personal exemption. next amt $751-$1500.) or if kid itemizes. therefore.4K. • Parent takes exemption (§151). is taxed at 10% (§1(i) and then 1500 –2000 is taxed at ???. §151 – less of a marriage penalty.1982) (pg. so in 1986.
Can you get around 1041 by gifting to spouse? No. property generally held for a while. There may be excess alimony in 1st and 2nd post-separation year. (4) no liability for any payment after death of payee. Excess for year one is therefore 37. but must be under written agreement of divorce/separation (above the line deduction under §62(a)(10)) • Tax treatment is actually more favorable for divorced couples • A and B get divorced. Not deductible to payor. • ex. Transferee’s basis is carryover basis regardless of value of transferred property (can transfer loss – unlike with a gift). but will be included in income for third year. Applies regardless of whether transfer was of community property of separately owned property or whether was for consideration (divorce is not a realization event). Excess alimony in year 2 is 10K (25K-(0+15K)).5K ((25K-10K + 0)/2). -. and (5) payments do not constitute child support • §215: alimony deductible by donor. Any transfer between spouses is a non-recognition event. if there is a loss. Incentive from payor’s point of view to recharacterize alimony as child support. W pays H 40K in Year 1. Can’t do this.Treatment of Divorce • §71: permits payments (whether in discharge of alimony or support obligations or property rights) to be treated as deductible alimony so long as: (1) payments are in cash rather than property or services. Rare. • Also. A pays: o $100/month to B as alimony. Recipient takes carryover basis in property equal to adjusted basis of transferor (effectively treated as a gift). • Excess 2nd year = excess of 2nd year payments minus 3rd year plus 15K • Excess 1st year = excess year 1 minus average 2nd and 3rd year plus 15K. • “Recapture” does not apply if annual alimony is less then $15K o $800/month to B as child support – Not income (not taxable) to payee. Is §1041 pro or anti-taxpayer as opposed to realization regime (which existed before 1041)? • A pro-taxpayer rule – suspect that on average taxpayers substantially win out.§1041 provides that no gain or loss is to be recognized on any transfer of property between spouses or on transfer incident to divorce between former spouses.5K +15K)) which she reports as gross income. Meredith Huston 70 Tax Fall 2001 . see §1041 – not quite same basis rule as for gifts (§1015) because can transfer a loss with gifts. H has a deduction of 37. A Transfers $40. you can sell it and take loss. Average alimony for 2 and 3 is 7. carryover basis.Income to payee under §71.5K (50K-(7.5K that year too. 25K in year 2 and zero in year 3. Not deduction. Note: §71(f) – cannot front load alimony (make larger payments in early years). no gain/loss. (3) parties do not live in same household if already legally divorced or separated. (2) parties do not earmark payments as nondeductible to payor and nontaxable to payee. deduction to payor under §215 parties may elect to treat alimony payments as nondeductible to the payor and nontaxable to the payee so that two parties will pay lowest total tax §71(b)(1)(B) – allows lower bracket TP to make payments to higher bracket recipient. Ex. so IRS loses time value of $ and then again when an asset is ultimately taxed because then taxed at transferee’s rate and transferee rate is generally lower.000 in stock to B -.Not income. • Under divorce. o Property settlements -.
ct says income is taxable immediately to partners when paid to trust in BASYE no substantial risk of forfeiture (to the partnership). o Court rules amounts paid by employer to trust for education of kids was additional income to the employees. considered income to kids. Court concludes valid.250 of compensation. siphoning wages of employers. ASSIGNMENT OF INCOME Key principles: (1) earned income is taxable to the person who earns it. Sticks with you. IRS wanted to call this compensation. o Could this be set up in a tax-free way under current law? §127 – educational assistance program – up to §5. o Contrast with BASYE: when partnerships shift their income into trust held until retirement that trust is taxable. income to parents when paid from trust to children. fruits must be attributed to tree from which grew (don’t want people just assigning income to lower bracket) • ARMANATROUT (1978)(481) -. Primary residences not taxed for the most part. • LUCAS V. relevant entity in ARMANTROUT is employer. as partners are considered to own income. Scholarship cannot be a quid pro quo. lots of uncertainties – when will sell. leaves job. EARL (1930)(479) -. taxpayer prevented from assigning earned income to those whose services did not produce the income. occurred in 1901. get deferral until compensation “vests. assigned $9K in interest (entire property interest) during his life to his children. not taxable immediately b/c until paid out to kids. results were that she was taxed at lower rate. (2) income from property is taxable to the owner of the property. Principle helps preserve the progressive tax system. employer gets benefit of deferral. • Transferee would prefer it to be pre §1041 because there their ex-spouse would have had to pay the tax under the old regime and now they do • Of course couple could take the implicit tax liability into account into their bargaining – but this could be hard to do. not to student. and here seems $ is exchange for services. though employees said was not.” o In ARMANTROUT.taxpayer entered into agreement prior to marriage to split income w/wife. o So basically the company is paying a third-party (the kids) for the employees services. Men (traditional transferor) vs. etc. income from services cannot be assigned to another entity.corporation set up Educo trust fund which paid for employers’ children for education purposes.) • §83: No realization of income where there is a substantial risk of forfeiture. before tax code in 1918. there is a risk of forfeiture if kids don’t go to college. o Why not a tax-free scholarship? Because $ goes to parent. Income from Services • Earned income is taxed to the person who earned it. Meredith Huston 71 Tax Fall 2001 . so not for tax avoidance purposes. so cannot be income right away to employees. • In general. women (transferee) (on average) – • Transferor rather no gain under 1041 than gain before 1041. – But only works for employee?? Not clear (Shuldiner doesn’t know. can’t do anticipatory arrangements to avoid taxation. relevant entity here is trust Income from Property • BLAIR (1937)(487): Blair has life interest in trust created by father. what tax rate will be. substantial risk of forfeiture.
stock may be a capital asset. assignee becomes beneficiary entitled to all rights. he will be taxed on that income. o Must look at whether coupon was mature or unmature. • Problem in distinguishing the two arises often in copyright and patent cases. – Value of residual will increase over time. he is owner of corpus. June 1. he retains corpus. only gave away interest income (fruit. must have a sale or exchange under §1222 Ex. not tree). HELVERING V. Is a good transfer because has nothing else. essentially here gave up corpus (tree) o Key is that he is assigning fractions of what he owns. o The assignment in this case was in a permanent interest in the donor’s property—once given away the donees’ fractional interests could never revest in the donor. • Heim (495) – assignment of royalties is income from property when assignor retains ownership interest in income producing property. Is this a sensible scheme? Yes and no. What happens to interest already earned between Jan 1 and June 1? – where there is interest already earned. HORST (1940)(489): Horst has coupon bond and gives to child. How are we going to tax increase in value? Income from Property or Services: Which is it? • If transferor retains power and control over assigned income. o Particular holding obviated by §1286. so he is taxed He could have distributed the later year coupons to himself or anybody else. kept principal. so is not a capital gain • §1211 and §1212 penalize capital losses o §1211 – losses from sale or exchange of a capital asset. If I have stock and get a dividend. but the rest is transferable. o If I transfer principal to daughter and interest to son? Tax on son’s income to daughter? Problem is similar to problem in Hort (lease cancellation). 31.• • so long as assignable and has been assigned w/o reservation.not just streams of income. transfers entire bond. Meredith Huston 72 Tax Fall 2001 . but no sale or exchange. CAPITAL GAINS AND LOSSES • §1001 – taxes you on gain and loss from sale or disposition of an asset (both capital and ordinary) (broad language) • For capital gain. and is taxpayer on that income.gain from sale or exchange of assets held for longer than one year. o Corpus = bond. Valid assigment of income? Not quite. transfer of property will not be respected. taxable to Horst o The court taxed Horst on the income from the property. o §1(h) – net capital gain requirement o §1222(11) – defines net capital gain o §1222 provisions require sale or exchange o So to get preferential rate under §1h. need a sale or exchange of a capital asset. cannot transfer. To the extent you have accrued income in some sense. So no transfer of this interest. and then viewed the son (who actually collected the income) as the receiver of the gift. he has transferred a share of all that he has -. o Bond payable semi-annually on June 30 and Dec. This practice would make the progressive rates hard to enforce. o §1212 – capital loss carrybacks and carryovers • Holding period – important o §1h requires net capital gain o §1222 – net capital gain defined in essence as net long term capital gain long term -.
but can count my 9 months in his total – he has 1 year.Assets held for more than 5 years if otherwise taxable at 15% o 14% -.Greater than 5 years held Holding period beginning after 12/31/00 (Will really become a long time before this really becomes effective – why???) o 25% -. However.6% brackets o but look to §1(i)(2) for actual tax rates Year 2001 2002-3 2004-5 2006 and beyond • 28%. Was recently 6 months o §1223 – holding period of property – provides a set of tacking rules whereby can add holding periods across assets or people give property to my son after 9 months.Shuldiner doesn’t get this one o 18% -. but as marginal rates crept up it remained there. Shuldiner thinks it is actually 5%) o 8% -. 15% or 10% o No special rates for these guys Special Rates o 7. At the time that was the top marginal rate. Note that this rate cap is of no use to low-bracket TP (contrast with exclusion) • 1997 – decision to reintroduce capital gains rate → current §1(h) – extraordinarily complex provision. 31%. Means of giving preference has fluctuated. he holds for three months. MECHANICS OF CAPITAL GAINS – SEE TEXT P.§1202 (small business) stock – subject to a 50% exclusion if otherwise taxable at 15% (not significant category. 36% Brackets Subtract ½% Subtract 1% Subtract 2% Subtract 3% 39.Basic preferential capital gains rate = o 28%. and preference increased. so no preference. Basically happens in carryover type provisions – where basis is carried over §1221–capital asset defined – see below HISTORIC TREATMENT OF CAPITAL GAINS • Historically there has been a preference for capital gains (with brief hiatuses).6% Bracket Subtract 1% Subtract 1% Subtract 2% Subtract 4.6% • 10% capital gains rate = Low income TP o §1(i)(1) -. so is effectively 14% o 15% -.low income defined –income to be taxed at a rate of less than 25%.5% -. capped capital gains rate at 28% (effective rate was 33%).• • Holding period requirement fluctuates. 530 • 20% -. o Was percentage exclusion until 86—got ordinary rate on 40% of your capital gains. 39. 36%. capital gains exclusion was good for everyone (contrast with rate cap). o 1986—took off preferential treatment as trade to get marginal rates low.§1202 (small business) stock – old preference of 28% on ½ gain.gain to the extent of depreciation on real estate held for more than one year (unrecaptured §1250 gain) 73 Tax Fall 2001 Meredith Huston . 31%.
• Long term is gain/loss from sale/exchange of capital assets held for over 1 year. the excess loss is offset against $3000 of ordinary income. o Short-term gains must be netted against short-term losses. How to compute capital gains – Jeff example (1) §1222 divides capital gains and losses into two classes…long term and short term. with unlimited carryforward. o Net long-term gains taxed at preferential rates. o Net short term gains are taxed at normal rates. If short-term losses are greater. so then the net losses are combined and can offset up to $3000 of ordinary income with unlimited carryforward. o (2) §1222 netting procedure. and the latter is subject to the favorable rate. the excess short-term gain is taxable in full as ordinary income. • Having combined the two categories. Congress does not want to provide same incentive for collectibles Collectible defined in §408(m) • Implicit in this are all sorts of netting rules which we will not focus on. o There’s an excess of long term gain over short term loss. see p. o There’s an excess of short term gain over long term loss. (Long term loss can offset short term gain. • In general capital losses can be offset only against capital gains. there is a net short-term gain. • §1211 permits individual taxpayers to offset capital losses (long or short term) against ordinary income up to $3000 annually. there is a net short-term loss. Losses carried forward keep their character • Short term losses are deemed to offset ordinary income before long term losses. If short-term gains exceed shortterm losses. o Netting of long-term gains and losses produces either a net long-term gain or net long-term loss. 533 to work through this. • Short term gain/loss is sale of capital assets held for 1 year or less.Gain on collectibles held for more than one year.§1222 – 4 categories. the excess (“net capital gain) is taxed at the preferential capital gains rate. • Any excess not allowed in one year is carried forward indefinitely.28% -. • If both categories have net gains. the excess is long term gain taxed preferentially. o If net short-term capital gains exceed net long-term capital losses. o In either case. the former is taxed in full as ordinary income. • Basic netting rules -. • Net losses in both categories. and vice versa). o Short-term gain or loss is then netted against long-term gain or loss. o When taxpayer has both net short-term gain and net long-term gain. Taxpayer nets the gains and losses in each category (long term and short term) separately. while net long term is treated preferentially in §1(h). then short term is taxed at ordinary rates. (3) Apply the tax rates. Unused capital losses can be carried over indefinitely. If one category shows a net loss and the other a net gain. o If the net long-term capital gain exceeds the net short-term capital loss. §1212(b)(2). 74 Tax Fall 2001 Meredith Huston . the excess is a short term gain taxed at ordinary rates. then the net loss and net gain are netted against each other.
Repealed in 1986 when rates became flatter – in interest of simplicity and revenue. Asset really cost 1200. If really wanted to solve problem. 2001 act eliminates this – will this change lock in effect?? Unknown. may be in your interest not to buy a more productive asset and to hold on to this asset. can I get capital gains for this? Yes. When reduced tax on gain. §1212(b) (2). Ordinary gain.§1221 §1221: defines capital asset broadly to include all property held by taxpayers (whether or not connected with his trade or business w/certain exceptions: (THESE ARE NOT CAPITAL ASSETS) o §1221(a)(1): inventory. Incentive – want incentive for capital formation. Also need to take into account benefits of deferral when calculating what preferential rate should be. Ordinary gain. Losses carried forward keep their character POLICY OF PREFERENTIAL TREATMENT OF CAPITAL GAINS (SEE PAGES 546-551 FOR THIS) Bunching—progressive rate structure. will be taxed on $500 gain. so preferential tax rate should apply. lessen lock in. Ex. If we look at you only in this year you look like a fat cat. Problem with annual accounting. Don’t give preference to interest. Cost of asset should be adjusted for inflation. dealer can say will bought stock for investment where have a gain and bought for business where have a Meredith Huston 75 Tax Fall 2001 . Capital Gain. Can sell asset now and pay tax on gain. For you there is no bunching problem because you recognize capital gains every year. o Problem – solution we use doesn’t get it right.o Where losses exceed gains. Taxed under §475 (marked to market – taxed without regard to realization) o Investment portfolio.000 ordinary income each taxable year. Own home. To make up for this o Overbroad: What if you are a fat cat and you always were one. But you’re not. o Right solution is to index basis for inflation (don’t do this) Can argue don’t need indexing because have given people benefit of deferral. or hold on to it an defer gain forever. Causes problems. excess capital loss offsets up to $3. why give incentive to old investments. CVS – Sell Toothpaste. Even if expect a less than optimal gain. o Incorrect solution where there really is bunching. but in one year have a big gain. Ex. Person normally in 25% bracket. Trade/business. not new ones. Also. Used to have one. Inflation – if you bought an asset for 1000 and there is now 20% inflation and you sell for 1500. • Dealer in Stock – in it for dealer markup. But we don’t do this. dividends. Lock in—if you hold an asset on which you have already had substantial gain. o Alternative approach – tax without regard to realization (mark to market system). held for investment. so argument is a bit odd. Any excess not allowed in one year is carried forward indefinitely. not long term gain. would use an averaging scheme. so proper gain is 300. Very crude expensive incentive. but this is not correct. o Biggest lock in provision is step up at death – way to avoid tax altogether. DEFINITION OF A CAPITAL ASSET -. You get a great preference. or property held primarily for sale to customers in ordinary course of trade or business Ex. to average income over period of time (say 5 years) and level out the gain. Hold stock.
says sales are secondary purpose and rental is still primary purpose. but have no customers. The latter is capital. and look at time of sale to see what purpose was at that time CONTINENTAL CAN (545) -. For all but a few taxpayers.have to show #1 purpose. IRS wants it to mean substantial purpose. would have been capital under §1221(a).playing fast and loose w/language of statute. not capital. Looking for short term swings. Issue is Meredith Huston 76 Tax Fall 2001 . IRS says primary purpose to sell machines and co. so ordinary income. its classification then depends on whether it is used in the taxpayer’s business…as a warehouse or factory for instance…or is merely held for investment.found not enough. Active traders – may be so active that rise to level of trade or business. §475 has this rule. turns on meaning of primary taxpayer’s primary motivation is key in determining whether should get preferential rate. Capital Gain. later sold rest of it and claimed capital b/c claimed primary purpose was to hold for investment in apt bldg. Partnership bought land –> sell land to corporation. taxed at ordinary rate. Once identified as investment. INTERNATIONAL SHOE (1974)(545): co. not liquidation sales • Construes Malat to say that primary purpose pivots on ordinary course of business motivation. ct uses semantic trick and makes primary modify ordinary business purpose and not purpose • Import limited greatly. Capital Gain.• • loss. or liquidation motivation. ct holds machinery was inventory. is held for sale to customers – ordinary. securities are capital assets. Even though yesterday was not held for sale. o See also §1236 Investor – not in trade/business because they have no customers. ct says that these sales were ordinary and predictable end. selling remainder of land terminates joint venture so not in ordinary course of business. can’t change your mind. selling machines is ordinary course of business. the former. How do we solve this? Must identify asset at purchase in order to get capital gain. rents out shoe-making equipment. Court said because are selling today. Corporation develops the land. Problematic areas: o Rental/Sales MALAT (1966)(554): Mixed motive case – in mixed motive case must look at primary motivation to determine whether is held for sale to customers. capital loss. but plans changed and sold off some parcels. look to see whether investment or personal consumption If a taxpayer’s real estate or other property is not regarded as stock in trade. Courts say are in a trade or business. forced to sell some of machines. Taxpayer bought land and was going to build apt bldg to rent. • This means the gain/loss will be treated by the favorable rules of §1231. Court disagrees.made can processing machinery. it is excluded from capital asset status by §1221(2). Ways courts get around Malat • Changed motive • Bifurcation of business • Ordinary course? Or exceptional or liquidation sale? o Real estate – holding for investment or for sale? BRAMBLETT (546) – Partnership and corporation have same members. Had been rented out for 20 years and now had to sell something. it says “primary” means principally or “of first importance .
gov’t publication §1221(a)(6): any commodities derivative financial instrument §1221(a)(7): any hedging transaction which is clearly identified as such on date on which acquired §1221(a)(8): supplies of type regularly used or consumed by taxpayer in ordinary course of trade or business Meredith Huston 77 Tax Fall 2001 . Shuldiner says there is no reason. Justification here is desire for limited liability for development activities. which is entitled to depreciation under §167 or is real property §1221(a)(3): copyright.S. 554) Partnership made only one substantial sale and four insubstantial sales over three years. must answer yes to all three of these questions. artistic composition. Partnership wins – so have capital gains. court says not enough to make partnership directly in the business of selling land. literary. developing. corporation must be acting like an agent – get agent’s fee. and if so. used in trade or business. what business? • Was the taxpayer holding the property primarily for sale in that business? • Were the sales ordinary in the course of that business? o In order to be ordinary. • Also considered – relative income (not in case) (p. continuity and substantiality of the sales o Most important factor. have legal authority to bind the partnership. letter or memo held by taxpayer who created it. Court won’t say this is a sham. Taxpayers position is that should have ordinary income for development by corporation and capital gain for sale of land by partnership. or taxpayer in whose hands basis is determined §1221(a)(4): accts or notes receivable from ordinary course of trade or business §1221(a)(5): U. whether partnership held land as a capital or ordinary asset. Corporation merely acting as agent of partnership? Court says will not assume agency simply because there is control. Third question is what about form over substance? When does form control over substance? Frank Lyon – when the structure has genuine economic substance. extent. Second question is what happens when you integrate partnership with corporation. • Extent of subdividing. taxpayer for whom created if letter or memo. duration of the ownership • Extent and nature of the taxpayer’s efforts to sell the property (depends on nature of the market) • Number. Seven factors • Nature and purposes of the acquisition. musical. is compelled or encouraged by business or regulatory reality. and is not shaped by solely tax avoidance motives. According to court. • Could look at the question in the other way to ask why the partnership makes sense here. and advertising to increase sales • Use of a business office for sale of property • Character and degree of supervision or control exercised by the taxpayer over any representative selling the property • Time and effort the taxpayer habitually devoted to the sales. Test: • Was the taxpayer engaged in a trade or business. THE REST OF THE THINGS THAT AREN’T CAPITAL ASSETS §1221(a)(2): property.
DEPRECIABLE PROPERTY AND RECAPTURE Under §1221(a)(2) real or depreciable property used in a trade or business is excluded from the category of capital assets. • §1231 -- allows real and depreciable property used in trade/business to yield capital gain when disposed of at gain (held at least one yr) and ordinary loss when disposed of at loss (best of both worlds) • What property qualifies? – property used in a trade or business, of a character that can be depreciated according to §167, held for one year or more. - §1231(b) o §1231 basically—Each year, gain or loss on any item of §1231 property is netted against gain or loss on other items of §1231 property. If, in a given year, a taxpayer has a net gain on §1231 sales or exchanges, the §1231 gains and losses are capital. (Subject to §1245 recapture rules) If in the year, the taxpayer has a net loss on §1231 sales/exchanges, the §1231 gains and losses are ordinary. EXCEPTION §1231(c) - If, in a given year, a taxpayer recognizes a net §1231 gain, but has taken an ordinary deduction for a net §1231 loss in the last five years, the prior ordinary loss deduction is recaptured by recharacterizing that portion of the net §1231 gain in the current year as ordinary. • Example – In one year, guy recognizes a $10k gain on a truck, and a loss of $50k on a building. This results in a net $40k §1231 loss, so the gain and loss will both be ordinary. o Now say he sells the truck in year one, the building in year two. Can he take a 10k capital gain year one, and a 50k ordinary loss in year two? Oh HELL no. §1231(c) says that the 10k as ordinary, so the guy would recognize net 40k ordinary loss, the same result as if he sold them in the same year. 3 types of dispositions may give rise to §1231 treatment: (1) gain/loss from sales and exchanges of property used in trade or business; (2) gain or loss arising from condemnations and involuntary conversions (ie. casualty or theft losses) of property used in trade or business; and (3) gain or loss from condemnations or involuntary conversions of capital assets held in connection w/trade or business or in profit seeking activity that falls short of trade or business o §1231 requires 2-stage netting process: (1) taxpayer nets gains from casualty and theft losses (e.g. insurance) against losses from such involuntary conversions; if losses exceed gains, §1231 does not apply either to losses or gains (deemed no sale or exchange); if gains exceed losses, both gains and losses carried over to second stage of netting process; (2) taxpayer compares total gains w/total losses from involuntary conversions carried over from first stage “firepot,” and condemnations and sales/exchanges of business property; if losses exceed gains, gains includible in ordinary income and losses deductible from ordinary income; if gains exceed losses, gains treated as long-term capital gains and losses treated as long-term capital losses; carried over to tax return combined w/long-term capital gains and long-term capital losses from other sources If net gain for all §1231 property, gains and losses are capital If net loss for all §1232 property, gains and losses are ordinary o Favorable regime for casualty losses. Recapture provisions o
Tax Fall 2001
§1245 recharacterizes capital gain from the sale of a depreciable asset (other than real property) as ordinary income equal to the lesser of • (1) the gain recognized on the sale of the asset OR • (2) prior depreciation taken on the asset sold. Property is §1245 property if (1) depreciation is allowed on the property under §167, and (2) the property is one of the types of property specified in §1245(a)(3), including personal and tangible property. (also includes amortized property like patents). EXAMPLE – Guy buys truck for $10,000. Under §167/§168, he can depreciate it over 5 years. This is a business expense. After the truck is fully depreciated, he sells it for $2000. Thus the depreciation allowance was too generous by $2000. • If there was no recapture provisions, Max would have a $2000 capital gain (assuming he didn’t sell other §1231 property that year). • Under §1245, gain to the extent of the prior depreciation (here he took $10,000 in depreciation) is characterized as ordinary income. So here Max includes the $2000 as ordinary income. • If he sold the car for $13,000, $10,000 of the gain would be ordinary to make up for the depreciation, and the remaining $3000 would be capital under §1231. §1250 – real property depreciation recapture – says that any depreciation over straight line has to be recaptured, but you can’t use anything but straightline on real property since 1986, so generally there’s no depreciation in excess of straightline and no portion of the gain is subject to §1250 recapture.
§1245 – enacted to prohibit conversion of ordinary income into capital gain on sale of depreciable property by requiring recapture of previously deducted depreciation as ordinary income; ordinary gain reported pays back excess depreciation, although taxpayer has enjoyed time value of earlier depreciation deductions; if any depreciable property is sold for more than adjusted basis, any gain not exceeding total depreciation allowed is taxed as ordinary income Example: Truck bought for 100K for use in business for more than 1 year, took $15K depreciation, new basis is $85K. Truck is depreciable property used in trade/business, so excluded under §1221(a)(2) FMV Gain/Loss Case 1 $75K ($10K) Ordinary Loss-§1231 Case 2 $90K $5K Ordinary Gain-§1245 Case 3 $105K $20K $15K ordinary, $5K capital -- §1245
Example: S has 2 trucks, each purchased for $10K and each depreciated $2K. Truck 1 sold for $9K (gain of $1K) and 2 for $7.5K (Loss of $500). Under §1221(a) (2), $1K ordinary gain and $500 ordinary loss. • §1231 – 1 is capital gain and 2 is ordinary loss, would be great, but not how it works, under §1231, must net, here there is a gain of $500 • §1245 – 1 capital gain and 2 capital loss, but wrong, apply §1245 before §1231, then §1245 would take 1 out and only apply §1231 to 2. 2 would get ordinary loss because 1 is one with the recapture. Takes recapture gain out of the situation. Shuldiner says the regulations imply that you should do §1245 first and then §1231 (first take out any gains from netting which are made ordinary by §1245)
Tax Fall 2001
If 1 sold for $11K, then $3K gain, $2K gain is ordinary, $1K subject to §1231 as gain , 2 still $500 of §1231 loss, net $1K against $500, $500 gain under §1231, net gain is capital, net loss is ordinary. §1250 – only recapture extent to which have taken accelerated depreciation. kind of circular—only recapture gain over straight-line, but have to depreciate real property straightline, so rarely any overage for 1250. More common under 1245 b/c of accelerated depreciation. Ordinary (unrecaptured gain) taxed at 25% for 1250. In the code because we used to allow accelerated depreciation. Has now been effectively written out of the code. However – still a Partial recapture scheme. Gain up to the amount of depreciation allowed on real property held for more than 12 months is taxed at a special capital gains rate of 25%. This is more advantageous than taxing gain at ordinary rates, which can be as high as 39.1%, but is not as beneficial as usual capital gains rate of 20%.
DERIVATIVES AND HEDGING • Businesses use hedges to reduce risk of price fluctuation or selling right to buy fixed amts of underlying product at fixed price on certain date; hedging legitimate form of business insurance • Example: farmer buys 10K bushels corn @ $2/bushel; price could change by time K becomes due; o could be $1.8/bushel or $2.35/bushel; enter into forward K now to sell 10K bushels for $2.35/bushel; then when K due, can either perform or sell corn and close out K for value; if corn then is $1.8/bushel, would have loss of $.2 on books; but K has value of $2.35$1.8=$.55 gain; if net gain and loss- $.55-$.35=$.2; o on other hand, if at time K due, corn is at $2.5, then sell for $2.5; profit of $.5 and loss of $.15 on K (for canceling K); Successfully locked in profit of $.35 either way • 1936 – IRS said true hedges are common trade practices generally regarded as insurance. As such the costs thereof are an ordinary and necessary expense. Proceeds thereof should be reflected in net income. Why does this become an issue in Corn Products 20 years later o taxpayer has gains, not losses and is hoping to get out of hedging treatment o What is excuse for saying GCM does not apply – (what is GCM??? I have no idea) GCM referred to true hedges – caselaw regarding what true hedges are. Also had to really lock in profit for hedge. Was Corn Products really doing this? No, look at facts of case, if prices dropped, corn products would lose money. This is not a perfect hedge. • Corn Products v. Commissioner (562) – Company wanted to assure themselves a supply of corn at a given price. Issue was what should character of hedges be? Company argued were capital asset transactions. o 2 arguments: Narrow hedge, not a true hedge, or were just legitimate capitalists – if were speculators, hedging doctrine would not apply. o Court says gain is ordinary. To hold otherwise, would permit those engaged in hedging transactions to transmute ordinary income into capital gain at will. If a sale of the future created a capital transaction while delivery of the commodity under the same future did not, a loophole in the statute would be created and purpose of Congress is frustrated. o Gains and losses from the sales of the futures contracts were an integral part of the taxpayer’s business. Test is what company’s motive was when bought/sold asset. Here, was to maintain operations of company (e.g. to ensure they could buy corn to make corn syrup). Where an integral part of business will not get capital treatment o Broadens inventory exception because future is just substitute for actual corn (inventory). o Unclear what grounds and scope of holding were – Arkansas Best resolves this.
Tax Fall 2001
Arkansas Best (565)—buys stock in a bank, bank starts to go bad, buy more stock in bank to try to preserve its reputation. Original purchases of stock had been for investment purposes; claim is that later purchases were business necessity; therefore wanted original purchases to be capital and later ones ordinary. Courts look at statute and determine “integral part of the business test” of Corn Products is wrong/misinterpretation; said business purpose/motive irrelevant. o If there was a general exception for things integral to business, why would there be the exceptions in §1221(a)? Exceptions would be redundant, so this couldn’t be what congress wanted. o Court did not overrule Corn Products; still good law; expansive reading of inventory exception, expanded to include surrogates to inventory and therefore motive is only relevant when bears on something surrogate for inventory. Corn Products does not extend to assets other than futures purchased for inventory hedging purposes. o Here did not narrowly apply definition, instead broadly applied exclusion o Simple application of the substitution doctrine (See Hort) o FN 3 (667): in Hort narrowly construe property. Does not apply here? o Income right is ordinary gain Hedging o Long hedge? Ok, capital o Short position? Position to sell, not buy, so doesn’t fit, so is ordinary? o Debt hedge? Debt is ordinary. Are debt hedges ordinary or capital? o If you are hedging an item that is ordinary, it will generate ordinary gain, not capital gain. o How are you going to account for the hedge? When will I realize gain or loss under hedge – normally when I would go out and sell. But they said no, we’re abolishing realization requirement for hedges. IRS regulations said have to match income – gain/loss on hedge with income gain/loss on item being hedged and must do so up front, not after the fact. Congress then codified regulations. Now have 1221(a)(7) o What if you are an airline and you have jet fuel? Want to hedge jet fuel costs. Are they ordinary? Under corn products they were because were part of trade or business Problem is if sold fuel, would not be ordinary, because not depreciable property or held for sale to customers – would get capital gain. SO put in 1221(a)(8) do deal with things like jet fuel. o Hedging is alive and well. If designed to manage risk on assets or debt (present or future) and you identify it, it will be an ordinary transaction. o Business purpose test is gone. Stock – can stock be ordinary? o Circle K --Ct. ruled that, yes, purchase of interest in a gas company was inventory. IRS settled rather than let this ruling muck things up any more.
NONRECOGNITION OF GAIN OR LOSS: LIKE-KIND TRANSACTIONS • §1001 – determination of amount and recognition of gain or loss • General Rule: §1001(c) and §1002: gains and losses must be realized and recognized (taxed); realization of gain/loss is taxed when recognized • §1031-§1042 = nonrecognition events. • §1031 -- when taxpayer exchanges property of like kind held for investment, trade/business, no gain or loss recognized; property must be held for productive uses o Applies primarily to land. All real estate considered like kind
Tax Fall 2001
What is basis? Ex.000 Here will recognize 20. in addition to like-kind property. rest to property.000 property of like kind.000 Swap Whiteacre FMV = 100.boot. but look at §1031(b). and have a like kind exchange. . cash and a car §1031(a) says exchange solely for worth 10. (4) partnership interests. (2) certificates of trust. . cannot recognize loss. preserve gain in property Blackacre FMV = 100. get property which is not similar.000 Like – kind exchange Used for pleasure FMV = 100.000 Like kind exchange? Not car or cash Throw in 10. (3) other securities.000 Basis = 10. 3 Cash Car Property FMV 10 10 80 Blackacre still gets like-kind exchange.realized gain is recognized to extent boot (transferred basis in new property decreased by any $ received and increased by any gain recognized) o boot = cash or nonqualifying property §1031(d): Basis of property disposed of becomes property acquired and is decreased by any $ received and increased by any gain recognized o Old basis –Cash+Gain-Loss = new basis Is it merely a deferral provision? Both a deferral and nonexclusion provision? o Meant to be a deferral and not an exclusion provision Why particularly generous here? For valuation issues? Not clear.000 Meredith Huston Swap Whiteacre Basis = 70.000 Basis = 60. §1031(b): Boot -.000 for property.000 Basis = 10. will exchange for cash and get the loss. (5) inventory.000 Basis after swap = 10. (6) other property held primarily for sale o If you have a loss. Continuity of business activity? But would only apply to business.• • • • • Limitations: §1031(a)(2): like-kind exchanges disallowed for: (1) stocks/bonds. Example: o Blackacre FMV = 100. won’t swap.000 82 o What is amount Tax Fall 2001 . only care about what B would use land for.000 of gain (gain recognized up to amount of cash and nonqualified property). If you have a loss.000 Gain = 90. Whiteacre does not get like-kind exchange FMV = 80. Basis 10K 10K 10K Gain 0 0 70 o Old basis –Cash+Gain-Loss o 10-10+20-0 = 20K basis .if in exchange. 10 basis to car.
Meredith Huston 83 Tax Fall 2001 .000 and also has 30.000 Equity = 70.000 Basis = 10. In Carlton. One of the issues you get here is that most of the time people do not want to swap property – so have deferred exchanges and third party exchanges.000 Gain = 90.000 realized? Debt assumer counts as amount realized (Tufts and Crane) So amount realized = 100.Basis = 10. Complicated situations.000 • o There are some exceptions to this rule in the regulations What if swap where FMV = 100. Do not recognize a gain.000 debt – can offset debt with your debt. taxpayers didn’t make the arrangement carefully and got caught.000 Debt = 30.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue reading from where you left off, or restart the preview.