FEDERAL INCOME TAX

Professor Abrams Fall 2009

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

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

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

II.

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

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

III.

What does Clearly Realized Mean?

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

3. A high basis is good because you can get more money without getting taxed
Summary: WHAT IS YOUR BASIS? Basis is your cost Basis of cash = face value Basis based on method of acquisition: Acquire normally = cost Acquire by gift = carryover basis (basis of donor) unless determining loss (see below) Acquire by devise = FMV at time of death (or 6 months later if estate so elects) Acquire by divorce = carryover basis Non-recognition (transfers of property) = see below b. The Realization Doctrine i. Realization vs. Recognition 1. Realization: when a taxpayer disposes of appreciated property (think: the selling or disposing of property, including trading) 2. Recognition: if realized gain must be included on the taxpayers return IF REALIZED, IT IS RECOGNIZED UNLESS THE CODE SAYS OTHERWISE ii. Caveats

1. A disposition of property should not produce an accession to wealth unless one

party to an exchange is deceived, defrauded, or incompetent equal values should be traded 2. The proper comparison is the BASIS of what is being given up with the VALUE of what is received iii. Side-bar: Mark-to-Market System 1. What is it? a. At the end of each year, must mark everything at its market value i. In our system, appreciation is not a taxable event 2. Real-life example: property taxes except for CA a. California: Proposition 13 real estate values cannot change until you sell the house) c. Dividends i. Generally 1. 61(a)(7): provides that gross income includes income from dividends a. There is taxable income even though there is no gaingain is not the only kind of income! 2. An individual who is a stockholder of a corporation may receive a dividend payment in the form of cash (or other property) or in the form of the corporations stock ii. Cash Dividends: TAXABLE 1. If the payment is in the form of cash or property, it is taxable and added to net capital gain to the extent of the earnings and profits of the corporation iii. Stock Dividend: Sometimes taxable, sometimes not 1. If the distribution is of the corporations own stock, sometimes they are taxable and sometimes they are not

IV.

Held for Productive Use or Investment: 1031

a. Generally i. If you fall under 1031(a)(1), then the disposition of property is NOT TAXABLE and thus NOT RECOGNIZED otherwise, 1001 applies

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

ii. Allocation of Non-Cash Property 1. If boot was received in addition to the property (excluding any cash received), the basis must be allocated between the new property and the boot (think diamonds) 2. Allocation Values a. Boot basis = FMV at the time of the exchange b. Real estate basis = New basis value Boot basis iii. If TP Gives up BOOT 1. The transaction is bifurcated into a 1031 exchange of real estate and 1001 exchange of boot given up (latter exchange is taxable) 2. Thus, if the TP gives up boot: a. The basis of the property for TP = total basis of the properties given away (includes cash, ALL property) b. TP is deemed to have received in exchange for such other property an amount = to FMV i. Once again, TP basis in the property acquired = FMV of the property received less any gain deferred Example: A exchanges real estate held for investment plus stock for real estate to be held for investment. The real estate transferred has an adjusted basis of $10,000 and a FMV of $11,000. The stock transferred has an adjusted basis of $4,000 and a FMV of $2000. The real estate acquired as a FMV of $13,000. A is deemed to have received a $2000 portion of the acquired real estate in exchange for the stock, since $2000 is the FMV of the stock at the time of the exchange. A $2000 loss is recognized on the exchange of stock for real estate. No gain or loss is recognized on the exchange of the real estate since the property received is of the type permitted to be received without recognition of gain or loss. The basis of the real estate acquired by A: Adjusted bases ($10K + $4K) = $14K Loss recognized ($2k) = $12K. iv. If TP Gives Away Debt: Constructive Boot 1. If the taxpayer gives away debt, we treat this debt as if it is money received: this is constructive boot (release of debt boot) a. Thus, liability taken on by someone else = money received for the TP 2. This is the most common way to equalize value: the person with more FMV simply borrows against it and keeps the money (equity for equity) 3. NOTE: If another TP who receives the debt-ridden property, his adjusted basis will include the value of any debt taken on.

c. Deferred Like Kind Exchanges: 1031(a)(3)

i. What is it? 1. The property given up is first transferred to a qualified intermediary (QI), and THE STEPS: then goes to the Buyer TP relinquished a. SELLER QI BUYER property to BUYER i. THE SCENARIO: The TP sells the relinquished property to cash to QI (holds Buyer and the Buyer puts the cash goes into escrow with the in escrow while TP Qualified Intermediary. The QI holds the cash in escrow while IDs replacement the TP identifies replacement properties within 45 days of the property after transfer of the relinquished property. The TP must receive the 45/180, QI pays cash replacement property within the earlier of 180 days after the to SELLER of transfer of the relinquished property or the due date of the replacement property TP now has title to 6 replacement property

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

V.

Involuntary Conversions: 1033

a. Generally i. Under 1033, a TP whose property is involuntarily converted (ex: condemnation, storms, etc), can take cash proceeds and reinvest them in property similar or related in service or use to the converted property and thereby avoid gain recognition (deferral of gain) on the transaction so long as all of the proceeds are reinvested in the similar property 1. Any proceeds not reinvested are treated as boot b. Calculating Gain: 1033(a)(2)(A) i. The gain shall be recognized ONLY to the extent that the amount realized upon the conversion exceeds the cost of such other property or stock 1. SO, recognize the LESSER of your realized gain or your un-reinvested money c. Calculating Basis of Replacement Property: 1033(b)(b) i. Basis = FMV of replacement property Gain Deferred

VI.

When is Gain/Loss Realized?: The Limits of 1001(a)

a. Generally i. Regulation 1.1001-1(a): gain or loss is realized when property is exchanged for cash or other property differing materially either in kind or in extent b. Cottage Savings Association v. Commissioner (1991): When is Gain/Loss Realized? i. Facts: Cottage exchanged a group (or pool) of residential mortgages that had declined in value for another pool of residential mortgages. For bank regulation purposes, Cottage did not have to report the loss on the mortgage pool given up in exchange because the mortgage pools were substantially identical within the meaning of federal bank regulations. Cottage claimed that the loss was realized on the exchange of the mortgage poolsinterests exchanged were materially different because the underlying loans were secured by different properties. ii. Issue: Whether an exchange of one group of mortgage loans for another group is a disposition of property within 1001(a). iii. Holding: Exchanged properties are materially different if they embody legally distinct entitlements 1. Here, the exchanged mortgage pools embodied legally distinct entitlements (since, for example, the obligors on the mortgages varied between the 2 pools) and the exchange was thus a realization event. iv. Significance: As long as the property entitlements are not identical, the exchange falls under 1001(a).

VII. Annuities
a. Generally i. An annuity is a K that provides for a series of payments in return for a fixed sum ii. Often purchased to ensure sufficient funds for a financially stable retirement 1. Ex: An individual may pay an insurance company $100,000 in return for annual payments of $10,000, ending upon the death of the purchaser. Assume that, at the time of purchase, the individual is expected to live 15 years and that the payments begin immediately after purchase, so that the individual is expected to receive $150,000. The difference between the cost and the expected return represents interest. The insurance company will have the use of $100,000 for many years. iii. 72(a) provides that gross income includes annuity payments, but can exclude certain amounts of such payments under 72(b)(1)

b. Exclusion Ratio: 72(b)(1) i. 72(b): a taxpayer may exclude from each annuity payment the product of the payment multiplied by the exclusion ratio 1. Exclusion Ratio: Cost of the annuity K / expected return on the annuity K a. Exclusion ratio: Cost of annuity / (payment per term x length of annuity) b. What is excluded from each payment: Exclusion ratio x annuity payment 2. This exclusion ratio is multiplied by each annuity payment to determine what is excluded from incomethe remainder is treated as gain and included as income under 72(a) a. To figure out how much to include each year: Payment per year Excluded Amount = Includable amount

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

tax-free and borrow the increase in value in the policyloan was made by the annuity company and secured by the annuity (no tax on receipt of loan proceeds) b. Changed by Congress 2. Amounts Borrowed on a Loan Secured by an Annuity Policy are TAXABLE INCOME: 72(e)(4) a. If you borrow against the appreciation of the annuity, this is treated as a distribution and is now taxable b. 72(e)(4)(A): Loan proceeds are treated as amounts not received as an annuity such amounts must be allocated between return of capital and income, and the income portion is includible (income first allocation) c. NOTE: Can still borrow against the actual investment in the annuity taxfree; this provision speaks only to borrowing against the untaxed growth in the value of the annuity 3. Tax Penalty with DEFERRED ANNUITIES: 72(q) a. Any distribution (including loans) received before the annuitant is age 59 is subject to a 10% penalty b. PUNISHES deferral reduction d. Buying Annuities i. If the annuitant wants to accelerate receipt, they can sell the annuity to a company like JG Wentworth ii. The Tax Consequences of Buying an Annuity: 72(g) 1. The purchaser may treat only the amounts actually paid by the purchaser as investments in the K for computing the exclusion ratio under 72(a) 2. Thus, the purchaser does not step into the shoes of the annuitant

VIII.

Death and Income with Respect to Decedent: 691

a. If someone dies, they may have unreported income because it is not time to report it yet (ex: die in the middle of the month, and the beneficiary gets the final paycheck) b. How is the Beneficiary Taxed? i. If a beneficiary receives funds that would have been taxed to the decedent had they survived, then the beneficiary is taxed equivalently: income with respect to decedent c. Example: Qualified Retirement Funds i. B puts money away so that it will pay an annuity for Bs life or 10 years, whichever is longer. If B dies after 2 years, 8 more payments will go to the beneficiary. The beneficiary is taxed like B.

IX.

Gifts
a. Generally i. 102(a): Gifts or Inheritances 1. General rule: Gross income does NOT include the value of property acquired by gift, bequest, devise or inheritance a. A gift is not includable for the donee, and the donor receives no deduction ii. Policy: Should Gifts be EXCLUDED from Income? 1. Yes, to avoid multiple taxation 2. We have taxation every time there is productive activityevery cycle of consumption/production = cycle of taxationwith gifts, the transferor forsakes consumption in favor of the transferees, there is only 1 cycle of consumption and production a. Looking at ONE UNIT

10

b. What is a Gift? LOOK TO THE TRANSFEROR i. Detached and Disinterested Generosity 1. Commissioner v. Duberstein (1960): What is a Gift? a. Rule: Gift for the purposes of 102 is a transfer made out of a detached and disinterested generosity or out of affection, admiration, charity, or like impulses ii. What is NOT a Gift 1. Tipping in Restaurants a. NOT a gift, because it is in exchange for services 2. Employee Gifts: 102(c) a. 102(c): gifts from employer to employee are income and taxable, and thus not deductible there are no gifts from employer to employee i. Covers transactions from EMPLOYER to EMPLOYEE ii. An employee can give a gift to his employer b. SO: NOT a gift unless (Reg. 1.102-1(2)): i. Transfer can be attributed to a familial relationship 1. Have to point to the fact that the gift was not made in What is NOT a recognition of the employees employment was due to Gift: familial relationship Tipping in c. Tax Consequences restaurants i. GIFT: employer does not get a deduction and employee has no Employer to income employee gifts ii. NO GIFT: employer gets a deduction and employee has income (unless for 3. In a Trade or Business: 274(b)(1)(a) family) a. No deductions are allowed for gifts in excess of $25 Entertainmen b. 274(b)(1)(a): an item having a cost to the TP not in excess of $4.00 on t expenses > which the TP is clearly and permanently imprinted and which is one of a $25 number of identical items distributed generally by the TP is NOT a gift Cost of less (ex: Barbri pen) than $4 with TP 4. Prizes, awards, scholarships or fellowships name (Barbri) a. NOT gifts under Reg. 1.102-1(a) b. This is something received which is not needed in the ordinary course of Prizes, ones life and something one would not have made an expenditure for awards, scholarships, or c. Basis Calculations: 1015(a) i. Carry-Over Basis 1. 1015(a): for gifts received after 12/31/1920, the basis shall be the same as it would be in the hands of the donor or last preceding owner by whom it was NOT acquired by gift, EXCEPT if such basis is GREATER than FMV at the time of gift, then to determine loss, the basis = FMV a. Thus, use carry-over basis for every calculation except LOSS 2. Taft v. Bowers (1929): Taxing Gifts the donors basis will be carried over to the donee, meaning that the donee will pay taxes on the appreciation that occurred during the donors ownership (because the gift is not treated as a recognition event) a. A donee can be taxed on appreciation that accrued prior to a gift b. 1015(a) lets you get a gift tax-free!

11

ii. Summary of 1015(a)

Basis Determinations o If Donors Basis < FMV at time of the gift, then Donees Basis = Donors Basis o If Donors Basis > FMV at time of the gift, then GAIN: Donees Basis = Donors Basis LOSS: Donees Basis = FMV at the time of gift To determine gain/loss calculation compare FMVs o If Donees AMOUNT REALIZED (FMV at sale) is BETWEEN Donors Basis and FMV at the time of gift, NO LOSS OR GAIN o REMEMBER: Gain = AR AB (if negative number = loss!)

d. Division of Property Geographically and Temporally i. Geographically 1. Regulation 1.61-6(a): When property is divided geography for sale, the cost or other basis of the entire property is equally apportioned (relative FMV) among the several parts and the gain realized/loss sustained on the part of the entire property sold is the difference between the selling price and cost or other basis Allocate basis in allocated to such part. The sale of each part is treated as a separate transaction proportion to and gain or loss is computed separately on each part FMV values at a. SO: Allocate basis in proportion to FMV values at time of acquisition time of acquisition 2. Inaja Land Co. v. Commissioner (1947): When Impossible/Impractical to --Gain or loss Allocate Basis, The Entirety of Net Amount Received Will be Recovered from treated That Basis separately for a. Facts: The TP purchased land for $61K. Thereafter, the City of LA each part began dumping waste in a steam that ran through the TPs land. The TP sued the City and settled for a payment of $50K for past damage and for giving the City the right to continue dumping (easement). b. Issue: Is any part of the $50K settlement taxable? c. Holding: No portion of the payment is incometreat the full amount as return of capital and apply in reducing the cost basis i. Court does not do usual calculation of apportioning basis: going to give enough basis to offset amount realized no income and no loss (no reason for this) ii. RULE: Sales proceeds will only be included in gross income to the extent that they exceed the TPs basis in the property reduce the TP basis by AR. Example: B purchases for $25,000 property consisting of a used car lot and adjoining filling station. At the time, the FMV of the filling station is $15,000 and the FMV of the used car lot is $10,000. 5 years later, B sells the filling station for $20,000 at a time when $2000 has been properly allowed as depreciation thereon (ADD BACK DEPRECIATION). Bs gain on this sale is $7000, since $7000 is the amount by which the selling price of the filling station exceeds the portion of the cost equitably allocable to the filling station at the time of purchase reduced by depreciation. ($25,000 x 3/5 = $15,000; $22,000 - $15,000 = $7000) ii. Temporally 1. Transfers at Death: 1014 a. Under 1014, the basis of property acquired from a decedent = FMV at the date of the death of the decedent

12

The basis of property acquired from a decedent = FMV at the date of the death of the decedent

i. Any unrealized appreciation by the decedent just simply goes away ii. Unrealized gain or loss is LOST at death! b. SO: If on death bed, sell LOSS property and hold on to GAIN property and no one will pay taxes (because you have higher basis) c. Income in Respect of a Decedent i. Income that has been EARNED by a decedent prior to death will not be excluded under 1014IRD is earned income of a decedent that was not includible to the decedent prior to death

2. Irwin v. Gavit (1925): Taxing Divided Interest in a Bequest a. Facts: TP dies owning $100K in value. The property is put in trust:
income to A, remainder to B. A will get the income interest for a fixed period of time, and B will get the remainder after the expiration of a term of years (9 years). b. Issue: How should A be taxed? c. Holding: TP had a zero basis in the income interest, under the theory that an income interest is not property under 1014 or under 102(b)(1). i. EFFECT: over-tax the income beneficiary and under-tax the remainderman (gets the entire 100K). ii. Codified in 102(b)(2): subsection(a) shall not exclude from gross income where the gift, bequest, device, or inheritance is of income from property, the amount of such income. d. Abrams thinks SCOTUS got this wrongexploitation when you have an income interest in a charitable organization and the remainder to grandchild. Getting Around 102(b)(2) and Irwin v. Gavit --Ex: I am a taxpayer and I am going to die soon with $100,000. I have a nephew and a charity that I am fond of: I want to leave both $50,000. Will you write me the will that does that? --You have a proposal: put the property in the trustincome for the charity for 9 years, and the remainder for the nephew. The charity will get $50,000 in value when you diethey will pay tax on $72,000 but they will not pay tax at all because they are a charity. The kid will get 9 years of interest and never pay tax on it: devise is worth $50,000 and will never get taxed based on Irwin v. Gavit. The kid will only get taxed upon a disposition of property (i.e. he sells the property). e. Tax Benefit Rule i. Generally 1. When Does it Apply? a. When a taxpayer takes a deduction for expenses paid, only to find later than the money or property is returned i. Example: A loan previously deducted as a bad debt may in fact be paid in a later year, or an amount deducted for medical expenses may be reimbursed by insurance in a later year should this later recovery be treated as income? 1. Exceptions: deductions with respect to depreciation, depletion, or amortization (Reg. 1.111-1) ii. Tax benefit = a reduction in tax liability b. THE RULE: The returned item may be excluded from income to the extent that the initial use as a deduction did not actually provide a tax saving. If full use of a deduction was made, giving rise to a tax saving, then the recovery is viewed as income to the full extent of the deduction

13

previously allowed (Alice Phelan Sullivan). 2. 111(a): Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in a prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter a. If TP got a tax benefit because of a deduction and subsequently recovered property: TP recognizes gross income to the extent of the recovery b. If TP recovers property for which he did NOT get a tax benefit: NO income is recognized 3. How does a TP NOT get a tax benefit on a deduction? a. Take a standard deduction (instead of an itemized deduction) b. Do not realize any income TAX BENEFIT RULE: THE RECOVERY OF A PREVIOUSLY DEDUCTIBLE ITEM GIVES RISE TO INCOME ONLY TO THE EXTENT THE PREVIOUS DEDUCTION PRODUCED A TAX BENEFIT.

ii. Alice Phelan Sullivan (1967): The Inclusionary Aspect of the Tax Benefit Rule 1. Facts: TP made a charitable contribution of 2 parcels of realty and the parcels
were returned over 15 years later.

2. Issue: What amount is included in taxable income: the reduction in tax liability
the TP received OR the amount of deductions taken by TP, and at which rate: the rate at the time the deductions were taken or the rate at the time of recovery? 3. Holding: A transaction which returns to a TP his own property cannot be said to give rise to incomebut if treated as a deduction, then treat as income a. AMOUNT TO BE TAXED: The full extent of the deduction previously taken b. RATE: The rate at the time of recovery iii. The Inclusionary and Exclusionary Aspects of the Tax Benefit Rule 1. Inclusionary Aspect a. If a deduction in an earlier year generated a tax benefit, then the later recovery will be taxed (Alice Phelan Sullivan) 2. Exclusionary Aspect a. If a deduction in an earlier year generated no tax benefit (because there would have been no taxable income even without the deduction), then a later recovery of the item will be excluded from income. b. Clark v. Commissioner (1939): Exclusionary Aspect of Tax Benefit Rule i. Facts: TP hired a tax advisor to get tax advice. TP made an election on the tax return that turned out to be the wrong one the election was irrevocable and could not be corrected. The advisor had advised them to file a joint return, when a separate return would have given them $19K less in tax. He was reimbursed for the amount. ii. Issue: How is this taxed? iii. Holding: Tax-free no deduction when it comes out; no inclusion when it comes back. Since he was 1. The reimbursement was not derived from capital, from reimbursed in labor, or from both combinedHE JUST GOT HIS cash, he only BASIS RETURNED got his basis 2. This is an example of the exclusionary aspect of the tax returned (the benefit rule amount of 3. Think: paying taxes in Year 1 where you dont enjoy the cash) benefit, and then getting the money back and getting

14

benefit of exclusion

Note: if entitled to a deduction, but neglect to claim it and then recoverit is UNCLEAR as to whether this gets the exclusionary aspect of the TB rule

3. NOTE: Net Operating Loss (NOL) 172

a. To the extent a prior deduction gave rise to a NOL that has not yet expired, the deduction is treated as having given rise to a tax benefit. In general, deductions arising out of profit-seeking activity can give rise to an NOL while personal deductions (such as charitable deductions) do not. (SEE BELOW) b. Get to carry over losses through the year you have income government allows you to move your losses forward so you can carry over NOL when you do have income and claim deduction that year i. To the extent that you get something back akin to Alice Phelan and you havent exercised NOL, the tax benefit rule applies and you are taxed on that benefit ii. NOTE: NOL only arises in operation of a business

X.

Capitalization and Trade or Business Expenses

a. What Can be DEDUCTED in a Trade or Business? i. Trade or Business Expenses: 162(a) 1. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including a. A reasonable allowance for salaries, or other compensation for personal services actually rendered b. Traveling expenses (including amounts for meals and lodging other than lavish or extravagant amounts under the circumstances), while away from home in pursuit of a trade or business (but not for more than a year; and c. Rental or other payments required to be made as a condition to the continued use or possession for purposes of the T or B, of property which the TP has no equity ii. Expenses for the Production of Income: 212 1. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year a. For the production or collection of income (i.e. legal fees for tax advice) b. For the management, conservation, or maintenance of property held for the production of income (i.e. renting property) or c. In connection with the determination, collection, or refund of any tax Captures all remaining profit-seeking activity that is not in a trade or business

NOTE: 262: No deduction for personal, living, or family expenses

General Definitions to Note Ordinary: current, short-term Necessary: not intended for personal benefit Trade or business: think profit-seeking activity Capitalize: if an expenditure is NOT ordinary, then the cost is capitalized and will produce a long-term benefit and you cannot deduct the cost now

15

iii. T OR B EXPENSES: What Can be DEDUCTED as an ORDINARY and NECESSARY

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

16

2. What is a Capital Expenditure? Reg. 1.263(a)-(1)(b)

a. THE TEST: Does the expense i. Create an asset with a useful life substantially beyond the taxable year OR ii. Add to the value of the property OR iii. Substantially prolong the useful life of the property OR iv. Adapts the property to a new use

Must capitalize those things that will produce betterments to any property or estate, but can deduct ordinary and necessary business expenses: conceptually, are you spending money to make money in the current year, or the future year?
b. UNDER INDOPCO: An expenditure MUST be capitalized if it provides
a long-term benefit without regard to whether that benefit attaches to a particular, identifiable asset (See below) c. Examples of Capitalization: Reg. 1.263(a)-2 i. The cost of acquisition, construction, or erection of buildings, machinery, or equipment, and similar property having a useful life substantially beyond the taxable year LONG TERM = 1. Note: failed business doctrine allows for expense CAPITALIZE; (deduction) ii. Amount expended for securing a copyright and plates, which remain the property of the person making the payment SHORT TERM iii. The cost of defending or perfecting title to property (add to basis = EXPENSE of land) get the benefit of the land for more than 1 year iv. The amount expended for architects services (add to cost of building) v. The cost of goodwill in connection with the acquisition of assets of a going concern d. Other Case Specific Examples of Capitalization: see next section i. Merger costs that give long-term benefit (INDOPCO) ii. Expenses to secure business reputation (Welch) iii. Expenses in production of a book (EB) iv. Expenses in constructing a building or machinery (Idaho Power) e. 263A and Inventory Costs iii. Other Case-Specific Examples of CAPITALIZATION 1. INDOPCO (1992): Costs Associated with a Corporate Acquisition a. Facts: Business tried to deduct fees associated with merger. Costs incurred by the target corporation in a friendly takeover. b. Holding: Investment banking fees incident to a merger must be capitalizedthe benefit of the merger will last indefinitely i. An expenditure MUST be capitalized if it provides a long-term benefit without regard to whether that benefit attaches to a particular, identifiable asset ii. The test: the capitalization requirement also applies to expenses that produce significant future benefits, even if the benefits are intangible and the expenses do not create a separate and distinct asset.

17

Costs Associated with a Corporate Acquisition Acquiring corporations expenditures in a successful acquisition: capitalized as the cost of the stock acquired or as part of the assets acquired (note: goodwill allocation; 197) Acquiring corporations expenditures in an unsuccessful acquisition: expense like costs invested in other failed business ventures Target corporations expenditures in a failed acquisition: case-by-case capitalize on the theory they were incurred to attract a more valuable suitor or were incurred to increase the value of the stock OR look to failed business doctrine if failed as a result of regulatory difficulty (or some other reason)

2. Welch v. Helvering (1933): Expenses to secure ones business reputation are

NOT deductible a. Facts: P paid off creditors of a bankrupt corporation, which he was secretary of, to strengthen his own standing and credits, and claimed the expense as a business deduction. b. Holding: NO DEDUCTION this is an extraordinary expense because most secretaries who worked for a now bankrupt corporation would not pay off creditors of the corporation 3. Encyclopedia Britannica v. Commissioner (1982): Expenses in Production of a Book a. Facts: EB hired a publishing company to do all the preparation and editing for a bookEB gave them royalties in advance. EB treated these advances as ordinary and necessary business expenses and deducted them. b. Holding: NO DEDUCTION the cost must be capitalized because from the publishers standpoint, a book is just another rental property, and just as expenditures that are put into a building to put it into shape must be capitalized, so must expenditures to create a book i. If you hire a carpenter to build a rental property, the cost of the carpenter is capitalized into the cost of the rental unit 4. Commissioner v. Idaho Power (1974): Expenses In Constructing a Building or Machinery a. Facts: A power company had to capitalize expenses for wages and depreciation on trucks used to construct a capital facility with a 30-year useful life. The effect was that the TP was required to recover the cost of the trucks over the 30-year-life of the facility, not the shorter useful life of the trucks. EX: You own a power plant and hire a contractor to build something for you, the contractor will depreciate the asset for the useful life of the asset, whereas you will depreciate for the life of the power plant. This is MATCHING the income to the EXPENSE. If you build the building yourself, you will depreciate the asset for the life of the power plant. 5. Norwest Corporation v. Commissioner (1992): Smaller Costs as Part of a Larger Renovation are Capitalizable a. Facts: As part of a general building remodeling costing approximately $7 million, the TP discovered asbestos material in the walls and paid almost $ 2 million for its removal. The remodeling expenses were capitalized by the TP the costs of asbestos removing were deducted. IRS argued that the asbestos removal expenditures must also be capitalized. b. Holding: Capitalize! i. Because the removal was part of a larger, admittedly capitalizable renovation, it should be capitalized

18

Subdividing Mass Assets: Fixing the Elevator in a Building --When some major component has a useful life significantly shorter than the overall asset (e.g., the elevator in a building, but not the furniture in the building) --Asset segregationunclear how far this extends Summary: Expenditures that produce a benefit that does not extend beyond the year in which the expenses were incurred (and the year after) do not have to be capitalized Expenses that produce a benefit that has a useful life that extends beyond a year in which the expenses were incurred (and the year after) must be capitalized o MAKING MONEY IN THE PAST = EXPENSE o MAKING MONEY IN THE FUTURE = CAPITALIZE

iv. Capitalization and Inclusion of Inventory Costs: 263A

1. Sets out the uniform capitalization rules, whereby the costs of producing selfcreated assets, such as the in-house production of a manuscript, MUST BE capitalizedextends to ALL manufacturers a. All the costs of the manufacture of the inventory of goods to be sold, including such items as the cost of insurance on the manufacturing plant, must be added to the cost of the inventory and deducted at the time the inventory is sold b. 263A(g)(1): provides that for the purposes of 263A, the term produce includes construct, build, install, manufacture, develop, or improve 2. THIS DOES NOT APPLY TO TAXPAYERS WITH GROSS RECEIPTS OF $10 million or less 3. Examples of 263A in Application a. Treatment of Environmental Remediation Expenses Revenue Ruling 2004-18: Capitalize Environmental Remediation Costs under 263A i. Issue: Are costs incurred to clean up land that a TP contaminated with hazardous waste by operation of the TPs plan includible in inventory costs under 263A? ii. Holding: Environmental remediation costs are subject to capitalization under 263A. 1. If you fall under 263A, do not get the benefit of other rulings

XI.

Repairs, Improvements, & Maintenance

a. Generally i. A mere repair is deductible, but an improvement that extends the asset (or improves the asset) has to be capitalized ii. Repairs that do not materially add to the value of the property or appreciably prolong its life are generally allowed as deductions iii. NOTE: If it is something that you know you will have to do when you acquire the asset, there is no question that you must capitalize (ex: buy a house knowing the roof has a hole it inif you later fix the roof, you will have to capitalize that cost!) b. Midland Empire Packing v. Commissioner (1950): Look to Long-Term Benefits to Determine Capitalization or Expense i. Facts: TP used the basement of its meat packing plant to store and cure meats. In the tax

19

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

XII. Inventory Accounting

a. Generally i. A TP who keeps an inventory of goods for sale must capitalize the costs of supplies and materials instead of immediately deducting them the costs are added to the taxpayers inventory costs and deducted when the inventory is sold ii. TPs must use inventories for tax purposes if use of inventories is necessary to clearly reflect the taxpayers income: 471 1. Want to match income with the expense of producing that income

20

2. Regulation 1.471-1: requires a TP to use inventories if:

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

21

XIII. Depreciation of Capital Expenditures

a. Generally i. What is Depreciation Deduction? 1. Generally: Why do we have depreciation deductions? a. TPs are entitled to take a depreciation deduction with respect to certain property used in the trade or business or for the production of income b. The rationale of the depreciation deduction is that the property the TP is using in his trade or business or profit-seeking activity, is wearing out and that deterioration is a cost of doing business which is appropriately We should allow reflected on the TPs return the inevitable i. The deduction for depreciation is simply a way of reflecting the decrease in value fact that the TP is always entitled to a deduction for a return on to be reflected in a his capital, and should ONLY be taxed to the extent his income deduction exceeds his cost of investment ii. Thus, depreciation deductions are not allowed for property that does not wear out over time or through use (ex: gold, undeveloped land, securities, etc) 2. Depreciation Deductions: 167(a) a. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear, and tear (including a reasonable allowance for obsolescence) of property that i. Is used in a trade or business OR ii. Is held for the production of income b. When is a depreciation deduction NOT allowed? i. On amounts representing a mere deduction in market value (Reg. 1.167(a) 1(a)) A depreciable ii. On the following: (Reg. 1.167(a) 2) asset is not a 1. Inventories capital asset! 2. Stock in trade 3. Land (apart from improvements or physical developments on it) 4. Natural resources 5. Automobiles (personal) 6. Personal Residence c. What does a depreciation deduction do? i. Gross income is REDUCED ii. Basis is REDUCED adjusted basis declines as you claim more deductions ii. Kinds of Depreciation 1. Straight-line depreciation: ratable depreciation (amortization) a. Assumption that depreciation is the same each year: allocates the total cost of the asset ratably to each year of the useful life of the property i. Ex: If the useful life of the asset were 5 years, 20% of the cost could be deducted each year b. Mandatory for ALL tangible personal property: 168(b)(3) c. Can elect not to take into account salvage value and apply the mid-year convention: 168(g) d. Consist with realization doctrine: assumes that there is no change until disposition 2. Accelerated depreciation: faster than straight-line; faster rate of depreciation in the earlier years than in the later years

22

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

4. 168(c): Applicable Recovery Period

Property Shall be Treated As: The Applicable Recovery Period Is:

23

3-year property 5-year property 7-year property 10-year property 15-year property 20-year property Water utility property Residential rental property Non-residential real property Any railroad grading or tunnel bore

3 years 5 years 7 years 10 years 15 years 20 years 25 years 27.5 years 39 years 50 years

IF REAL PROPERTY: must use straight line IF NOT REAL PROPERTY: --15-year or 20-year property: 150% --Any other type: 200% (unless TP elects the 150%)

5. 168(b): Rate of Depreciation a. 200% Declining Balance Method: a method by which your rate of

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

24

c. Everything Other than Real Estate 168(d)(3): Mid-Quarter

Convention i. If the aggregate basis of property (everything other than land and buildings) during the last 3 months (October, November, or December) exceeds 40% of the aggregate bases of property, then the mid-quarter convention applies 1. The property is deemed to have been placed in service on the date that is halfway through the quarter in which the property is actually placed in service 2. Every piece of property accumulated during the year now gets mid-quarter ii. Special rule for excess backloadingif you put too much of your non-real estate depreciable property to go in the end of the year, cannot use the mid-year convention and get LESS depreciation iii. NOTE: Once the mid-quarter convention is triggered, it is used for ALL property in the year! iv. Quarters: 1. January to March 2. April to June 3. July to September/October 4. October to December

If you paid $12K with a 10% depreciation deduction per year: Half-year: $1200 Mid-month: $1150 Mid-quarter: $600

EXAMPLE: YEAR ONE: Suppose that Tom pays $20K for a delivery van that he will use in his business. He places the van in service in September of Year 1. The van is 5-year property and has a 5-year recovery period. Under the straight-line method, the depreciation deduction would be 20% (1/5) each year for five years. Under the 200% method, the deduction would be 200% of 20% or 40% of the $20K cost of the van, so the deduction = $8K. The half-year convention also applies, so Toms Year 1 depreciation deduction is $4000. This reduces Toms adjusted basis of the van to $16,000. 7. 179: Election to Expense Certain Depreciable Business Assets a. In lieu of the above depreciation rules, can expense everything in the first year if you are a SMALL TAXPAYER (think small businesses) i. A TP can elect to currently deduct the cost of section 179 property in the year in which the property is placed in service If your ii. Section 179 property depreciable, tangible personal property is property (does not include intangible property or real estate) worth more iii. This is an elected provision: making the election reduces the than $625K, TPs depreciable basis in the property by the amount deducted you lose this under 179 provision 1. So, if you expense everything, basis = $0 be careful, b. 179(b)(1) caps the aggregate annual cost that is currently deductible however under 179also subject to a phaseout based on the aggregate amount of 179 property placed in service i. The maximum deduction allowed under 179(b)(1) is reduced 1 dollar for each dollar of section 179 property in excess of a threshold amount provided in 179(b)(2) SO: Up to $125,000 of the cost of depreciable non-real estate can be expensed in lieu of MACRS. This advantage applies only to tangible, depreciable property (excluding real estate) and is phased out as the amount of such property purchased by the TP during the year exceeds $500,000. If your property was worth $600,000would be limited to deduction of $25,000, with a depreciation for every

25

else.

ii. 179(b)(3)(A): the TPs 179 deduction cannot exceed the

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

26

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

XIV. Goodwill, Education, & Other Expenses

a. Generally i. Courts are split as to the treatment of goodwill payments ii. Arguments 1. Non-deductible, capital asset: Welch: expenditure is designed to purchase goodwill and that goodwill is a non-deductible capital asset 2. Deductible: expenditure is like deductible advertising designed to maintain the good reputation of a business b. Goodwill i. Welch v. Helvering (SCOTUS 1933): Goodwill is Capitalizable 1. Facts: TP was the secretary of a company in the grain business. He and his father were the shareholders of the company. The company went bankrupt and was released from its debts. The TP made a K with the Kellogg Company to purchase grain for it on commission. In order to re-establish relations with customers that he had worked with in his previous capacity (and thus improve his reputation), he decided to try to pay off many of the debts of the bankrupt company as he was able. Over 5 years, the TP earned $118K on commission and paid of $43K in debts of the former bankrupt company. a. Government: payments are NOT deductible but were capital expenditures for GOODWILL 2. Issue: Is TPs payments of debts deductible to TP as ordinary and necessary business expenses? 3. Holding: NOT DEDUCTIBLE: a. Payments were necessary but not ordinary b. The payments were capital expenditures establishing goodwill the amounts paid by the TP had to be capitalized because repayment of the discharged debts produced benefits to the TP that extended beyond the year in which the payments were made. c. Education i. Generally: When is Education Deductible? (Reg. 1.162-5) Education is Deductible If (1) Maintain or improve skills used in the TPs current trade or business; OR (2) Meet express requirements imposed on the TP for continuing in his current trade or business (should not qualify for new T or B) NOTE: An employers willingness to reimburse the employee for the costs of certain education does NOT establish that the education maintained or improved skills used by the TP in his current trade or business Mandatory CLE is deductible Must be IN the T or B to get the deduction Education is Not Deductible If (1) The education simply meets the minimum educational requirements for the TPs current trade or business (ex: schooling to get a license for a trade) (2) The education qualifies the TP for a new trade or businessa change of duties that involves the same general type of work is not a new trade or business (all teaching) Examples of changes in duties that are NOT a new trade or business: elementary to secondary school teacher, classroom teacher to principal, classroom teacher to guidance counselor, etc. Personal expenses are NOT deductible

28

Example: B, a general practitioner of medicine, takes a 2-week course reviewing new developments in several specialized fields of medicine. Bs expenses for the course are deductible because the course maintains or improves skills required by him in his T or B and does not qualify him for a new T or B.

Example: A, a self-employed individual practicing engineering, attends law school at night and after completing his law school at night he receives a degree in law. The expenditures made by A in attending law school are non-deductible because this course of study qualifies him for a new trade or business.

ii. Carroll v. Commissioner (7th Cir. 1969): No Deduction for New T or B 1. Facts: A PO took general college courses (philosophy, English, history, etc.) at
night, consistent with police policies. He listed the expenses as a deduction: an expense relative to improving job skills to maintain his position as a detective. 2. Issue: Are the expenses deductible? 3. Holding: NOhis courses were personal and unrelated to his duties as a PO a. If the education will qualify you for a new T or B, then no deduction is allowed iii. Abrams Argument 1. Today, legal education is deductible if you are a lawyer, but not deductible if you are NOT a lawyer 2. Abrams argues that 1.162-5 is INVALID because if you can make an election under 195, then you can amortize the expense during the first year of your T or B 3. Why an LLM is deductible if you are already a lawyer and not deductible if you are not a lawyer already

XV. Start-Up Expenses: 195

a. 195(a): Except as otherwise provided, no deduction shall be allowed for start-up expenditures i. 195(c)(1): Start-up expenditures means any amount paid or incurred in connection with: 1. Investigating the creation or acquisition of an active trade or business, or 2. Creating an active trade or business, or any activity engaged in for profit and 3. For the production of income before the date on which the active trade or business begins, in anticipation of such activity becoming an active trade or business. b. 195(b)(1): Election to Deduct AMORTIZING START-UP EXPENDITURES i. If a TP elects the application of this subsection with respect to any start-up expenditures: 1. The TP shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the lesser of: a. The amount of start-up expenditures with respect to the active trade or business OR b. $5000, reduced (but not below zero) by the amount by which such startup expenditures exceed $50,000, and 2. The remainder of such start-up expenditures shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the active trade or business begins 3. NOTE: The TP may choose to forgo the election by clearly electing to capitalize its start-up expenditures on a return

XVI. Other Kinds of Income

a. Compensation i. Old Colony Trust Company v. Commissioner (SCOTUS 1929): Gross Income under 61 Results Anytime a 3rd Party Pays a TPs Obligation

29

1. Facts: TP worked for the American Woolen Companyresolved to pay the

income taxes of its officers.

2. Issue: whether a TP, having induced a third party to pay his income tax, may
avoid making the payment of the tax

3. Holding: NO payment constituted income to the employee

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

30

2. Issue: how to valuate? 3. Holding: Income of $1400average of the two values a. Generally, valuation of non-cash benefitsalthough non-cash benefits
are judged at FMV, judges have leeway to decide c. Fringe Benefits i. Generally 1. What are Fringe Benefits? a. Any compensation for services not paid in the form of wages OR i. Ex: employer gives you a car to use question becomes to what extent you have income in the form of this compensation b. NON-CASH compensation that is EXCLUDABLE from income 2. How do we VALUE Fringe Benefits if they are to be included? a. Reg. 1.61-21(b): the taxable fringe benefits to be included should be the FAIR MARKET VALUE ii. Statutory Fringe Benefits: 132 Section 132: Gross income shall not include any fringe benefit which qualifies as a 1) No additional-cost service 2) Qualified employee discount 3) Working condition fringe 4) De minimis fringe 5) Qualified transportation fringe 6) Qualified moving expense reimbursement 7) Qualified retirement planning services

1. No-Additional Cost Service: 132(a)(1)

a. Definition: 132(b): Any service provided by an employer to an employee if: i. Service is in the employers ordinary line of business ii. In which the employee is providing services, and iii. Employer incurs no substantial additional cost in providing such service (determined without regard to any amount paid by the employee for such service) 1. THUS, CAN EXCLUDE if it doesnt cost the employer much to give it to you b. Examples i. Airline employees that get a free ride (unless he bumps someone off) 1. Note: if reserved seats, then 80% of the FMV of tickets is includible ii. Hotel accommodations, telephone services iii. Permission to attend Emory classes given to Emory employees 2. Qualified Employee Discount: 132(a)(2) a. Definition: 132(c)(3) 132(c)(1) for Property: i. Employee discount means the difference between the price at Price of property to which the property or service is offered to an employee and the customers X * price at which such property or services are being offered to ( [excess of aggregate sales customers price sold to customers and employees employers b. Limitations: Discount cannot exceed 132(c)(1) aggregate cost of property] / i. If PROPERTY gross profit percentage* of the price at which aggregate sales price) the property is being offered by the employer to customers

31

1. Note: property does not include real property or personal

property held for investment (securities)

ii. If SERVICES 20% of the price at which the services are being
offered by the employer to the customers (have to include anything above the discount) Any discount that exceeds the employers costs is includible income! c. Example: Reg. 1.132-3(b) i. Assume that a wholesale employer offers property for sale to 2 discrete customer groups at differing prices. Assume further than during the prior taxable year of the employer, 70% of the employers gross sales are made at 15% discount and 30% at no discount. ii. For purposes of this paragraph, the current undiscounted price at which the property or service is being offered by the employer for sale to customers may be reduced by the 15% discount.

Non-Discrimination Provisions for Qualified Employee Discounts and No-Additional Cost Services: 132(j) Requires the benefit to be made available to a wide-cross section of employees, including non-highly compensated employees o Cannot just make a benefit available to highly compensated employees Who is a Highly Compensated Employee? 132(j)(6) and Reg. 1.132-8(f)(1) o Employee owns 5% or more of the employer o Paid a salary of more than $75,000 o Paid a salary of more than $50,000 and is one of the employers top wage earners OR o Paid more than 150% of amount specified in 415(c)(1)(A) ALL OTHER TYPES OF FRINGE BENEFITS CAN BE LIMITED TO THE HIGHLY NOTE: Who is an Employee Under (a)(1) and (a)(2)? 132(h) [Reg. 1.132-1] 1) Any individual who is currently employed by the employer in the line of business 2) Any individual who was formerly employed by the employer in the line of business and who separated from service with the employer in the line of business by reason of retirement or disability, and 3) Any widow or widower of an individual who died while employed by the employer in the line of business in the line of business by reason of retirement or disability 4) Any spouse or dependent child (see Reg) of the employee = employee 5) Any partner who performs services for a partnership is considered employed by the partnership 6) For no-cost additional service, any use of air transportation by a PARENT of an employee will be treated as use by the employee

3. Working Condition Fringe: 132(a)(3)

If the TP could have expensed the property or services, this is a working condition fringe a. Definition: 132(d): i. Property or services provided to the employee by the employer that would have been deductible as ordinary and necessary business expenses under 162/ 67 if the employee had paid for the property or services b. Examples: i. When your employer gives you a chair, air conditioning, use of the elevatorsif you had to pay for it yourself, it would have been deductible (hence, you get it for free) ii. Assume that unrelated to company Xs trade or business and unrelated to employee As T or B of being an employee of X, A

32

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

33

ii. Examples: 1. Mandatory health insurance people who can afford health insurance and do not buy itmaking Emory give them health insurance creates a deadweight loss because you are giving people something they do not care to buy 2. Free parking Giving an Emory professor parking for free when he would walk otherwise 3. THIS IS WHY WE HAVE CAFETERIA PLANS e. Section NOT to apply fringe benefits expressly provided for elements: 132(l) i. This section shall not apply to any fringe benefits of a type the tax treatment of which is expressly provided for in any other section of this chapter Think preemption 1. This section excludes (e) and (g) (de minimis fringe provision benefit and qualified transportation fringe benefit) thus, can always exclude the de minimis benefit or qualified moving expense reimbursement even if it is of the type excluded by another section 2. Unclear how far this section extends! 132(l) says this is taxed as ii. Examples income because 119 speaks to 1. I work in a restaurant that lets me eat meals there and I this but doesnt allow get a 20% discount. Can I exclude that under 132? deduction doesnt apply to de 119: can exclude meals if it is for the minimis or qualified moving convenience of the employerbut cannot prove expense reimbursement it is for the convenience 132(l): only applies to a TYPE provided for, and FOOD is included in 119 f. Cafeteria Plans: 125 i. Permits an employer to establish a cafeteria plan in which an employee may elect to receive taxable cash or among a variety of excludable benefits (ex: group-term life insurance up to $50K, accident and health insurance, and dependent care) ii. Any money remaining in the employees account at the end of the year must be forfeited: 125(d)(2)(A) Ex: An employer plays a salary of $35K in cash to one employee and $30K in cash and $5K in child care to another, in the latter, the employee is not treated as receiving that $5K as income and the employer may deduct the $5K as 162(a) salary. iii. This reduces dead-weight loss because it allows people to choose what they value most highly. HYPOS on Fringe Benefits:
1) F, a flight attendant in the employ of A, an airline company, and Fs spouse decide to spend their annual vacation in Europe. A has a policy whereby any of its employees, along with members of their immediate families, may take a number of personal flights annually for a nominal charge, on a standby basis. F and Fs spouse take advantage of this policy and fly to and from Europe.

If standby EXCLUDE as no-additional cost service [ 132(b)] If reserved seats 80% of FMV of tickets is includable [Reg. 1.61-2(b)]
2) P is the president of C, a corporation that has its executive offices in NYC. P is planning a week-long business trip to LA and will fly there and back on Cs corporate jet. Ps spouse intends to accompany P on the round-trip flight for personal reasons.

For P exclude because it is not a benefit or it is a working condition fringe benefit For wife include because she is not performing servicesbut value might be zero under Reg. 1.61-2(g)(1)

34

3) B is an officer in the employ of C, a manufacturing company. C provides personalized financial planning services to all of its officers without charge.

Income unless de minimis under 132(a)(4)

4) S, a senior VP of D, a retail department store, purchases a fridge from Ds appliance department. D has a policy whereby employees are entitled to a 20% discount from the ticketed sales price of any item sold by the store so long as the resulting sales price, on average, approximately covers Ds costs.

Exclude as qualified employee discount 132(c) (note: average costs approach)

5) The facts are the same as in Question 4, except that Ds profit margin on ticketed items is only 10%, so the resultant sales price does not cover Ds costs.

Excess of the employee discount (20%) over the permissible discount (10%) is includable [Reg. 1.132-3(c)]
6) The facts are the same as in Question 4, except that the discount is available only to S and other officers of D.

Inclusion because of the anti-discrimination rule in 132(j)(1).

7) A, an assistant manager in the employ of D, a department store, is occasionally required to work overtime to help mark down merchandise for special sales. On those occasional instances, D pays for the actual cost of the evening meal pursuant to company policy.

Excludible as de minimis (anti-discrimination does not apply)

8) S, a senior partner of L, a law firm, is provided free parking by the law firm. This benefit is provided by L to all partners, associates, and other employees. The parking privilege is valued at $75 per month.

Exclude as a qualified transportation fringe [ 132(f)(1)(C)]partners are treated as employees

9) The facts are the same as in Question 8, except that it now pertains to A, an associate at L, and that L offers all partners, associates, and employees at L a choice of whether to accept parking of $75 and A accepts the parking.

If elect parking: exclude [ 132(f)(4)] If cash: include

10) The facts are the same as in Question 9 except that L offers no cash option and provides parking ONLY to partners and associates of the law firm.

Exclusion because anti-discrimination does not apply

11) A is an associate in the employ of L, a prominent law firm located in a large city. In order to encourage participation in community activities and local society, L pays its associate membership fees for various local clubs and organizations. A, taking advantage of this policy, joins a prestigious country club.

Might qualify as a working condition fringe benefit, dependent on the precise nature of the clubsmost likely includable
12) A, an attorney in the employ of C, a corporation, works at Cs national headquarters. C maintains an on-site gymnasium that is available to all employees during normal business hours. A uses the gym each working day.

Excludible under 132(j)(4): deduction for on premises athletic facilities if located on the premises of the employer, operated by the employer, and all the use is by employees (or spouses/dependents)

iii. Meals & Lodging: 119 1. THE RULE: Meals or lodging furnished to the employee, his spouse, and
dependents are excluded ONLY IF: a. For the convenience of his employer i. Note: tied to whether the meals are given for a substantial noncompensatory business reason Reg. 1.119-1(a)(2)(i) b. MEALS: the meals are furnished on the business premises of the employer; OR c. LODGING: the employee is required to accept such lodging on the business premises of his employer as a condition of his employment i. Note: business premise means the place of employment of the employee (Reg. 1.119-2(c)) 2. Benaglia v. Commissioner (1937): Exclude Meals and Lodging if For the Convenience of the Employer a. Facts: TP was employed as a manager of several hotels. For years, his Valuating salary was fixed without reference to his meals and lodgingwhich the non-cash benefits: FMV of property or 35 services

hotel paid. Commissioner added an additional amount to TPs income as compensation received, holding the value as the FMV of the rooms and meals furnished by the employer. b. Issue: is this income? If so, how much? c. Holding: NOT income i. His residence at the hotel was not by way of compensation for his services, not for personal convenience, comfort or pleasure: solely because he could not otherwise perform the services required of him (had to be available at a moments notice) ii. What TP received was for the need and convenience of the employer iii. NOTE: In response to this case, Congress enacted 119 1. Valuating non-cash benefits (both for property and services): Include the price as FMV (Reg. 1.61-(2) (d)) Note: Turner v. Commissioner and judges discretion

XVII. Borrowed Funds and Discharge of Indebtedness

a. Generally i. Loan proceeds are NOT income and are NOT taxable 1. Borrowed funds are NOT taxable because you have no accession to wealth: the receipt of funds is offset by the obligation to repay 2. 108 provides exemptions or deferral by allowing the insolvent debtor to exclude KL income in exchange for reducing certain tax attributes a. NOTE: If the TP lacks sufficient tax attributes to cover the KL excluded income, the effect of 108 is to provide a permanent exclusion ii. BUT, gross income can include income from discharge of indebtedness 61(a)(12) (see below) KL Income 1. Indebtedness: any indebtedness for which (1) the TP is liable or (2) subject to which the TP holds property ( 108(d)(1)) b. Discharge of Indebtedness: i. US v. Kirby Lumber (SCOTUS 1931): Repurchase of Debt at Less than Face Value = Income 1. Facts: TP, Kirby Lumber, issued $12 million of bonds in exchange for its outstanding preferred stock on which there were dividend arrearages. TP then purchased million of these bonds for $862K. Thus, the TP bought the bonds back for $138K less than the price at which they were issued. 2. Holding: The re-acquisition of debt for LESS than what was borrowed is taxable income to the borrower. a. Why? i. A loan is not gross income, because it has the corresponding Kirby Lumber obligation to repay; when the corresponding obligation to repay Income: the is reduced, the TP has income to the extent there is no longer an TAXABLE GAIN obligation (i.e., the amount of the reduction, because there is an you receive when accession to wealth) you pay debt back ii. NOTE: Bond Proceeds = Loan Proceeds; bond holders give the for less than what bond issuers cash and in exchange, the bond issuer promises to was borrowed pay the holder the amount back plus interest b. Codified in 61(a)(12): A TP may realize income by payment or purchase of his obligations at less than their face value c. Kirby Lumber Income

36

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

37

b. Tax attributes include: net operating losses, capital loss carryover, minimum tax credits, basis, etc. Thus, reducing tax attributes, whatever they may be, effectively defers income rather than permanently excluding it 2. 108(b)(3): basis reductions are made DOLLAR for DOLLAR while credit reductions are made $0.33 per dollar of exclusion so when you sell the property, you have a higher income! a. 108(b)(5): can elect to reduce basis in property over the other tax attributes iii. 108(e): General Rules for Discharge of Indebtedness 1. 108(e)(2): If payment of the debt would be deductible, you do not have income if the debt is discharged a. Example: You are in a plumbing business and your supplier of parts lets you take the parts you need and you have to pay within 90 days. When you pay for the parts, the cost is deductible under 162 (ordinary and necessary business expense is deductible). You unfortunately can only pay $600 after 90 days (you owe $1000). You would have KL income of $400. Because of 108(e)(2), you do not have any income because the payment, if made in full, would be deductible. b. Rationale i. The discharge of a deductible liability should NOT produce any net income because the KL income is offset by the deduction should be taxed no worse than if you had received the amount of KL income in cash, followed by complete repayment 2. 108(e)(5): Downward purchase price adjustments DO NOT INCUR INCOME a. If the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced (buy by putting cash down and signing a note and the note is forgiven not because of If you borrow insolvency or bankruptcy), you do NOT have INCOME money from the seller of the good, i. NOTE: Applies only to purchase price reductions of PROPERTY and then ask for a (but at least one court has been willing to extend to services purchase price received) reduction, you do b. Example: You go to Best Buy and see a TV for $1000. Rather than not have KL income. paying $1000, you borrow $1000. You then see an ad for Sears, offering the TV for $800. Best Buy reduces it to $800. KL Income? i. If Best Buy reduces the price, it is treated as $800- obviously, basis is reduced! ii. If you do not see the Sears ad and want to instead return the TV and Best Buy lets you pay $800, you do not have KL income but should have to pay for it with tax attributes (i.e. reduce basis by $ 200) c. Example: I write a will for a plumber and the plumber agrees to pay $800 but then agrees to pay with his services. There is NO KL income when the plumber pays in plumbing services: this is compensation and no different as payment. d. Rationale i. A reduction in purchase price should NOT produce KL income since there would have been no income had the original price been lower.

d. Mistaken Discharge of Indebtedness: Gifts of Property Encumbered by Debt Part Sale, Part
Gift Transactions

38

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

39

exclusion). NOTE: IF the gift tax liability had been only $45,000the donor would recognize no gain and the donee would take a carry-over basis of $51,000 under 1015. In effect, the first $51,000 paid by the donee is payment for the donors basis in the stock. iii. Basis Calculation: Transfers in Part a Gift and in Part a Sale 1. Reg. 1.1015-4 a. General Rule: Where a transfer of property is in part a sale and in part a gift, the unadjusted basis of the property in the hands of the transferee is the sum of whichever the following is GREATER: i. The amount paid by the transferee for the property, OR ii. The transferors adjusted basis for the property at the time of the transfer The donees basis in property received in a part sale/part gift transaction, assuming the donor was taxed like Diedrich, equals the donors carryover basis plus any gain recognized by the donor on the transaction. This means that the recognition of gain increases basis pro tanto.

2. Exception: 1011(b)Bargain Sale to a Charitable Organization

a. If a deduction is allowable under 170 (relating to charitable contributions) by reason of a sale, then the adjusted basis for determining the gain from such sale shall be that portion of the adjusted basis which bears the same ratio to the adjusted basis as the AR bears to the FMV of the property. i. SO, when the donee is a charity, the appreciation in the property, etc. MUST be taxed to the donor ii. Usually, defer the appreciation but that doesnt work because the charity doesnt get taxedso donor gets taxed on the gain as much as possible APPROACH TO 1011(b): Bifurcate the transfer into SALE ( 1001) and GIFT ( 1015) BASED ON PAYMENT / FMV AT TIME OF GIFT/SALE

e. Transfer of Property Subject to Debt: Tax Consequences for the TP Who is Relieved of Debt
i. Recourse Debt 1. Generally a. Recourse debt: debt that is not backed by collateral from the borrower; allows the lender to collect from the debtor and the debtors assets in the case of default Face PERSONAL LIABILITY ii. Non-Recourse Debt 1. Generally: Debt Taken on At Acquisition of Property a. Non-Recourse Debt: debt secured by collateral for which the debtor is NOT personally liable The seller of a b. If a TP is relieved of non-recourse liability in connection with the property subject to disposition of encumbered property: non-recourse debt i. The debt relief is INCLUDED in the TPs AR AND AB for the realizes an amount purpose of computing gain or loss realized in the property that INCLUDES the transaction debt assumed by the 1. AR includes the amount of debt outstanding at the time purchaser of disposition ii. The debt relief is included in the TPs AR because the debt is included in TPs basis when TP acquired the property (Crane v. Commissioner)

40

iii. AR includes the debt relief EVEN IF the encumbered property is

worth less than the amount of debt at the time the TP disposes of the property (Commissioner v. Tufts) Recourse v. Non-Recourse Transfers: Tax Consequences When Transferred Back to Creditor TRANSFERRED TO SOMEONE ELSE: If encumbered property is transferred to anyone other than the creditor, there is no different between recourse and non-recourse debt TRANSFERRED TO CREDITOR: But if the encumbered property is transferred to the creditor in complete satisfaction of the debt, then the value of any outstanding debt is treated: NON-RECOURSE: Part of Amount Realized RECOURSE: Only FMV of the property is treated as AR o Any excess of indebtedness over FMV = Income

2. Partial Payment of Debt a. FOR PARTIAL PAYMENTS OF DEBT: AR includes the amount of debt outstanding at the time of disposition, while AB includes the original amount of debt when the property was first bought 3. Crane v. Commissioner (SCOTUS 1947): Include Debt in Basis Regardless of How the Property is Financed a. Facts: TP inherited a building for which FMV was = to outstanding mortgage of $262K. She rented it for several years, took a depreciation deduction each year ($28K). She then sold the property subject to the mortgage back to the original owner, and was paid $2500 net of expenses. Her AR = $257K ($2500 + outstanding balance on the mortgage). i. TP asserted that her gain was the $2500, claiming that her basis in the property was 0 because she inherited the property when it NOTE: had no equity. Adjusted basis is reduced by ii. Government: basis included the amount of debt owed on the any property, and basis had been reduced by depreciation deduction, depreciation giving her a gain of $24K ($257K ($262K - $28K) deductions b. Issue: Is the amount of a debt used to finance a property included in the basis of the property even though the amount of debt is greater than the amount of the equity? c. Holding: YES i. Debt was included in the basis regardless of whether the property was financed with debt or equity. ii. Since the TP had used the FMV of the property to determine the depreciation deductions, she had made a GAIN to the extent of those deductions. The debt was also included in the AR since the debt was assumed (it amounted to debt relief). d. NOTE: The debt assumed goes into the basis! 4. Commissioner v. Tufts (SCOTUS 1983): AR Includes the Outstanding Balance of Any NR Loan Encumbering a Property a. Facts: TPs borrowed $1,851,500 on NR basis to build an apartment complex. When their basis in the property was $1,455,750, they sold it for no consideration other than the assumption of the NR liability. The FMV of the property at the time of sale was $1,400,000, so they claimed a loss of $55,740. The government insisted instead that they actually realized a gain of $400K: the difference between the principal amount of the debt and their basis.

41

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

42

down $10K of her own money and borrowing the other $40K on a non-recourse basis from the Bank, which issues a check to be used for payment at closing. The transaction goes smoothly. Ms basis in Whiteacre: $50K Time passes. Since Whiteacre is undeveloped real estate, it is not depreciated so we dont have to worry about the basis changing on account of that. After 5 years, Whiteacre has appreciated to a value of $100K. At this time, M has paid off $10K of the mortgage, so the remaining mortgage is now $30K. The partial pay-off of the mortgage has no impact on her basis in Whiteacre: it is still $50K At this time, M borrows another $35K on Whiteacre on a non-recourse basis Impact of the after-acquired mortgage on Ms basis: nothing; her basis is still $50K Over the next 2 years, the property drops in value from $100K to $85K. Impact on Ms basis of the drop in value of the property: nothing; her basis is still $50K 2 years later, M sells the property. She has paid off no further principal on the mortgages. She gets $10K at the closing and the buyer takes the property subject to the mortgages. What is her gain or loss? AR = $65K ($30K + $35K of debt) + $10K = $75K Basis = $50K Gain = AR AB = $75K - $50K = $25K

f. Transfers of Property Subject to Debt: Tax Consequences for TP Who Takes On Debt at
Acquisition when NR Indebtedness > FMV i. Estate of Franklin v. Commissioner (9th Cir. 1976): If You Deliberately Overpay, You Do Not Get the Benefit of Crane TRANSFEREE 1. Facts: Involved a sale of a motel to a limited partnership followed by a leaseback of the property to the original owner. The purchase price was to be paid in installments over 10 years, plus a balloon payment at the end, for which the partnership had no personal liability. The annual rental payments on the leaseback just equaled the amount of the installment obligations. Thus, no money was changing hands over the 10-year periodyet, the partnership purported to own the property for purposes of depreciation and interest deductions. If NR indebtedness 2. Holding: Such an arrangement involving non-recourse debt could be a valid sale > FMV of a. Where the non-recourse mortgage debt is of an amount GREATER than property the FMV of the property, the debt will not support deductions for NO debt into depreciation of interest. basis or AR i. If seller-financed non-recourse indebtedness substantially until PAID exceeds the value of the purchased property, debt does not go into basis until paid b. NOTE: Resolves the question left open by Crane as to what would happen if non-recourse mortgage debt were used to buy property with a FMV less than debt c. This could be an anti-abuse rule limited in its application to abusive borrowings upon payment, all debt adds into basis ii. Tax Consequences for TP Receiving Property With Acquisition Debt BASIS CONSIDERATIONS 1. Approach #1: Crane Rule for Basis a. Debt outstanding + cash for property 2. Approach #2: Estate of Franklin Rule--Only Include Debt Likely to Be Paid Off a. Debt only goes into basis on the assumption that it will likely be paid off 3. Approach #3: Pleasant Summit Land Corp. v. Commissioner a. Basis only includes FMV at time of disposition: lender has an incentive to write-down the debt b. Pleasant Summit Land Corp v. Commissioner (3d Cir. 1988): The

43

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

XVIII.

Illegal Income in a T or B: 162

a. Generally i. Income obtained illegally is taxable

44

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

c. Commissioner v. Tellier (SCOTUS 1966): Business Related Costs of Defending Oneself are
Deductible Under 162(a)Conviction is Irrelevant i. Facts: T was an UW, he was found guilty of mail fraud and violating Securities Act of 1933. He was forced to pay a $18K fineincurred $22K in legal expenses in defending himself and claimed a deduction on those expenses. Commissioner disallowed the deduction. ii. Issue: whether expenses incurred in the unsuccessful defense of a criminal prosecution

45

can fall as a deduction under 162(a) as an ordinary and necessary business expense iii. Holding: YES can deduct expenses in defense of a criminal prosecution 1. Only where deductions would frustrate sharply national or state policies have they been disallowedthe illegality should play not rule 2. No serious PP is offended when a man faced with a serious criminal charge employs a lawyer to help in his defense d. Mazzei v. Commissioner (TC 1974): Breaking the Law is Enough to Disallow Deductions i. Facts: TP was shown a black box that apparently copied a real $20 bill onto a blank piece of paper. The TP brought several thousand dollars to be copied but was robbed by masked gunmen during the copying. The TP eventually figured out that the robbers were confederates of the alleged counterfeiters, and the TP then sought a theft loss. ii. Holding: No deduction allowable e. Stephens v. Commissioner (2d Cir. 1990): Deductions Allowed When To Do Otherwise Would Overstate the TPs Total IncomeDeductions Allowed for Repayment i. Facts: Stephens was indicted for participating in a scheme to defraud Raytheonwas allowed to make restitution and a 5-year prison term (paid $1 million). Stephens was taxed on his receipt of $530K of embezzled fundsturned over to Raytheon the $530K fund and executed a $470K promissory note, representing the interest. Stephens claimed as a deduction the $530K restitution payment. 1. Government: this violates PP; because Stephens made restitution in lieu of punishment, the deduction should not be allowed because it would take the sting out of his punishment ii. Issue: whether a deduction for Stephens restitution payment of embezzled funds to Raytheon so sharply and immediately frustrates a governmentally declared public policy hat the deduction should be allowed iii. Holding: Deduction allowed 1. Since Stephens had already paid taxes on the embezzled funds, disallowing the deduction for repaying the funds is a DOUBLE sting 2. NOTE: If income comes in and goes out, then it IS deductible! HYPO: Husband hires a hitman to kills his wifehe pays $25K to the hitman for the job. The hitman incurs the following expenses: $400 for the gun, $500 for ammunition, $2 for the bus fare, $15,000 for the lawyer, and $15,000 for the fine after conviction. Of these expenses, which expenses are deductible? 1) $25,000 payment = income (accession to wealth) 2) $400 for the gun should be deductible, unless used in business, then capitalizable 3) $500 for ammunition = seems clearly deductible but may seem to close to the actual act itself (PP) 4) $2 bus fare = deductible (Sullivan case) Business expense 5) $15,000 lawyers fee = deductible (but unclear) not clear relation to profit-seeking activity per se 6) $15,000 fine = not deductible under 162(f)

XIX. Exempt Income and Expense

a. Interest on State and Local Bonds i. Generally 1. The federal government does NOT tax interest on state and local bonds indirect way to help state/local governments, allowing them to borrow more cheaply No tax on state and a. So, TPs may exclude the interest they receive on certain state/local local bonds except: bonds tax-exempt bonds bear a lower rate of interest than taxable Private activity bonds; nonetheless, people invest in tax-exempt bonds because the bond interest on them is not taxed Arbitrage bond 2. EXCEPTIONS 103(a): Except as otherwise provided, gross income does (note issues) Bond not in 46 registered form

NOT include interest on a state or local bond except for: a. Private activity bond which is not a qualified bond: 103(b)(1) i. What is it? 1. State issues bonds to construct building, then leases the building (loans proceeds) to a private entity for an amount which is enough to cover the principal and amortization 2. The benefit is passed to the private entity because it now has a building which is essentially financed at a rate less than market rate ii. 103(b)(1) exempts private activity bonds b. Arbitrage Bond: 103(b)(3) i. What is it? 1. An arbitrage bond: any bond issued in which the proceeds of such issue are reasonably expected (at the time of the issuance of the bond) to be used directly or If you buy a bunch of 103 indirectly to acquire higher yield investments or to bonds and you put them in a replace funds which are used directly/indirectly to safe-deposit box. Should you acquire higher yield investments be able to deduct the cost of ii. Problems the safe-deposit box? NO 1. States were getting money and then buying treasury If you put only state bonds: bondswith exemptions for the treasury bonds, could no deduction act as a conduit for treasury If you put only a marriage 2. The state could sell its tax-exempt bond at 9% and the license: no deduction proceeds from these sales would be used to buy federal If you put a federal bond: bonds paying 10%--thus, the state would pocket the deduction (not tax exempt) spread without doing anything If all three: deal with this 3. NOTE: CAN NO LONGER DO THIS 103(b)(1) later no longer tax exempt c. Bond not in registered form d. 265(a)(2): No deduction allowed for money borrowed to purchase a tax-exempt security i. Thus, if you borrow money to buy 103 bonds, you cannot deduct the interest on your borrowing ii. Costs to produce exempt income are NOT deductible (ex: safety deposit box)

103 as a LEAKY SUBSIDY pg. 64 of Abrams notes --Acts as a subsidy which allows governments to compete in the marketbut it is a leaky subsidy, as it benefits investors whether an investor will choose a government bond over a private bond will depend on the investors tax bracket. High-bracket TP reap a windfall when state gives lower interest rates. --EX: An investor in a 40% bracket can buy a GA bond for 8% or a GM bond for 10%. The TP would be willing to buy a GA bond as low as 6%, but receives a BENEFIT because he is receiving an 8% return.

XX. Personal and Business Injuries

a. Generally i. Amounts received on account of injury are taxable under the general rule that accessions to wealth are includible within gross income under 61 1. This includes costs associated with obtaining such recovery (such as legal fees) are deductible as well b. Personal Injuries i. 104(a)(2): Gross income shall not include the amount of any damages (other than 104(a)(2): For physical injury Excludes punitive damages

47

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

48

1. Facts: F agreed to pay TP (cash-method) child support and was in arrears. On

her return, TP treated the amount in arrears due from F as a non-business bad debt and deducted the amount for their gross income as a short-term capital loss. These deductions were not allowed. a. NOTE: 166(d): a non-corporate TP may deduct non-business bad debts as a short-term capital loss in the year such debts become completely worthlessonly deductible to the extent of the TPs basis in the debts. 2. Issue: Can the deductions be made? 3. Holding: NO a. Court does not agree that TP is out of pocket because of Fs failure to payshe has no basis because she did not actually receive the payment b. Professor finds this to be a dreadful opinion i. Notion that she ought not to have a deduction for the failure to receive exempt income is wronglosing a deduction based on method of accounting seems fundamentally wrong

XXI. Tax Accounting

a. Generally i. General Rules for Tax Accounting 446: General Rules for Methods of Accounting o (a) Taxable income shall be computed under the method of accounting on the basis of which the TP regularly computes his income in keeping his books. o (b) Clear Reflection of Income: if the Secretary thinks that the books do not clearly reflect income, can order another method to be used that does clearly reflect income o (c) Permissible Methods The Cash Receipts and Disbursements Method An Accrual Method Any other allowed Any combination of the foregoing o (d) A TP engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each T or B o (e) In order to change the method of accounting, must get consent from the Secretary 1. Differences Between Tax and Financial Accounting a. Financial Accounting: used to allow investors to make appropriate choices; inherently conservative b. Tax Accounting: do not want people to escape taxation; inherently liberal ii. Alternative Minimum Tax (AMT) 1. Alternative set of tax rules with fewer deductionsevery one is required to compute their regular tax liability and AMT, and must pay whichever is greater b. Methods of Tax Accounting: Cash v. Accrual Method i. Cash Method: Focuses on when you get paid 1. Income: included when a. Actually received: getting the money/property right now b. Constructively received (right to demand property), or i. Legal right to get the money/property at your discretion; income Income under actually not received but within your right of control Cash Method ii. Thus, if you have a legal right to payment but elect not to receive WHEN: it, you can still be taxed focuses on when you COULD have Actually received something, even though you might choose to receive it received Constructively 49 received Economic benefit

later iii. NOTE: Reg. 1.451-2(a): In the taxable year during which income is credited to TPs account, set apart for him, or otherwise made available so that he may draw upon it at any time or so that he could have drawn upon it during the taxable year if notice had been given 1. Income is NOT constructively received if the TPs control of it is subject to substantial limitations or restricted 2. If the K you sign gives you NO right to ask for payment, you do not have income until actually paid (Amend v. Commissioner) c. Economic benefit: i. Focuses on whether you have a benefit of something, even if you do not have it in your hands (ex: trusts/accounts established for someones benefit) ii. There is income immediately to the TP if the TP has the payor transfer the money to a third party so it is not subject to the reach of the transferors creditors absolute right to income in the form of a fund which has been irrevocably set aside for him in a trust that is beyond the reach of the payors creditors 1. Note: the mere transfer of money on behalf of the TP is enough (Pulsifer) d. Examples: i. Promise of payment in 1 year: Income in 1 year ii. Cash or property now: Income now iii. Both: Income Now 2. Deductions: deduct when actually made ii. Accrual Method: Focuses on when you earn income 1. Income: included when a. All events have occurred and b. Amount can be determined with reasonable accuracy i. Example of Reasonable Accuracy: You are a public utility that has to read meters for customers. A customer gets its meter read mid-month: when the meter is read, a bill is created that allows CASH the customer to pay. Consider the Dec-Jan period. METHOD 1. Since the meter is being read once a month, the company focuses on doesnt know how much gas they have sold to the WHEN you customer until January get paid 2. There is NO income until January because of the ACCRUAL requirement of reasonable accuracy METHOD 2. Deductions: All Events Test focuses on a. All the events have occurred WHEN you b. Amount of liability can be determined with reasonable accuracy earn income c. Economic Performance ( 461(h)(2)) i. If the liability (i.e. item allowable for a deduction, cost, or expense) of the TP arises from the provision of services, economic performance occurs as the person provides such services. 1. WHEN SERVICES ARE RENDERED, NOT PREPAYMENT ii. Example: If the TP has agreed to pay $100K worth of services to

50

be performed over the next 5 years, in the first year, the TP can only accrue $20K (1/5) of the deduction iii. Example: You are in charge of a motion picture production. Under union rules, you have to hire a certain amount of postproduction editors for 8 weeks. You cannot deduct as soon as you start filming have to wait to deduct the salaries of the workers until they actual perform the service. iii. Cash v. Accrual Method: An Example 1. Example: You work for someone, and they will pay you after 30 days. When do you have income? a. Cash Method: Income after 30 days b. Accrual Method: You have income NOW, because you have done the work

Cash Method
Income Reg. 1.446-1(c)(i) Items which constitute gross income (whether in the form of cash, property, or services) are to be included in the taxable year in which actually or constructively received or economic benefit

Accrual Method
Reg. 1.446-1(c)(ii) Income is to be included in the taxable year when: 1) All the events have occurred that fix the right to receive the income AND 2) The amount of the income can be determined with reasonable accuracy ALL EVENTS TEST: Liability is incurred in the taxable year in which: 1) All the events have occurred that established the fact of the liability 2) The amount of the liability can be determined with reasonable accuracy; and 3) Economic performance has occurred with respect to the liability

Deductions

Expenditures are to be deducted for the taxable year in which actually made (ex: check mailed or credit card charged)

Limitations

1) No one who uses inventory can use the cash method 2) Almost all corporations are precluded from this method 3) In a partnership, if the partner cannot use the cash method because they are a corporation, the entire partnership cannot

HYPOS: Assume for these hypotheticals that T is a cash-method taxpayer. 1) T agrees to dig a swimming pool for R: do they have income when they get paid or when they do the work? a. LATER: When they get paid (Amend v. Commissioner) (later) 2) T agrees to dig a swimming pool for R, with T to be paid $20,000 in 1 year. When does T have income? a. LATER: In one year (Amend v. Commissioner) 3) What if R would have agreed to pay T earlier? a. LATER: When they get paid

51

4) Suppose T could get paid any time T wanted, T just has to askT does not ask for a year. When is there income? a. NOW: Immediately i. If you have a right to ask: income now ii. If no right to ask under K: income until actual payment 5) Suppose that T does some work and gets paid right at the end of the year, but it is a busy time and T takes the check and deposit it in January. When does T have income? a. NOW: ImmediatelyWhen you got the check because you COULD have negotiated the instrument, but you chose not to (does not preclude income recognition) 6) T digs the swimming pool, R gives T a certificate of deposit from the bank (gives T the right to $20,000 in 1 year you have no right now) and the bank will give you $22,000 (with interest) in 1 year. Does T have income now? a. NOW You have income immediately and it is the FMV of the property: $20,000 (what it is worth now minus the interest) b. When you get paid in property, you have income immediately 7) Suppose you agree to do the work and they agree to give you a car. When do you get the income? a. NOW; You have income immediately and it is the FMV of the property 8) You do the work, they give you $22,000 in an interest-bearing account. It is an account that you cannot borrow against, cannot sell it, and it will be worth $22,000 in a yearbut they give you nothing at all (as opposed to a CD you could sell, now you have nothing). When do you have income: now or in a year? a. NOW Pulsifer case: economic benefit doctrineif a cash basis taxpayer has the payor transfer the money to a third party so it is no subject to the reach of the transferors creditors, then it is income immediately to the taxpayer i. Essentially has been transferred to the agent, even though you do not have income immediately 9) You are a lawyer in a private practice and you need to supplies. You go to Office Depot and there are 2 options: 1) pay with MasterCard, bill comes 1 month later, and you pay the bill; 2) you pay with your Office Depot card, bill comes 1 month later, and you pay the bill. Under #1, you can deduct when you take the goods home. Under #2, you can deduct when you take the goods later. What is the difference? a. NOTE: For deductions with cash TPlook to actual payment b. Scenario #1: When the taxpayer used the MasterCard, Office Depot is paid immediately by the issuing bank and the taxpayer becomes a debtor of the issuing bank. Thus, the taxpayer has paid immediately with borrowed funds and can DEDUCT NOW! i. There is no difference between using your MasterCard, borrowing $100, and then using the borrowed funds to pay Office Depot c. Scenario #2: When the taxpayer used the Office Depot card, Office Depot is not getting paid yetyou are promising to pay them. You can only deduct when you actually pay them. 10) You have a home mortgage and want to deduct the interest of the mortgage. When you tell the bank and say that you want to pay the interest later, there is no deduction. a. No deduction 11) You buy a lottery ticket and you win. You could either get the $4 million lump sum or get $6 million later ($1 million a year for 6 years). When do you have income? a. IMMEDIATELY b. Lump sum: tax bill of $4 million TODAYconstructive receipt of $4 million because you had the ability to demand it c. BUT, Congress passed a special provision for lottery winners who choose installment payments because they would all file bankruptcy because they couldnt pay the bill. 12) You have an automobile accident and you get damages: either $ 4 million now or $6 million in installment payments. When do you have income? a. NEVERtrick question! b. 104(a)(2) excludes DAMAGES from INCOME c. Always determine if it is income FIRST! i. So, a cash payer taxpayer that buys a house cannot deduct it because it is a capital expense 13) Suppose that I am a cash method taxpayer and I do work but my employer refuses to pay me. This is illegal. Do I have income? a. NO INCOME b. Constructive: I could have asked if I wanted toso NO Constructive receipt; no full economic performance 14) Suppose I do get paid but I get robbed after 4 minutes. Do I have come? a. YEScannot say you do not have income because it disappears

52

15) What if you are an accrual method taxpayer and your employer stiffs you. Do you have income?
a. YES: All the events have occurred that give you the legal right: the lack of payment does not matter i. Accrual makes better sense: the fact of payment is irrelevant, it is the RIGHT to get paid

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

53

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

Summary: IF LIKE A LOAN: no inclusion upon receipt of payment (IPL, Westpac) IF A PREPAID ADVANCE: inclusion upon receipt of payment (AAA, Schlude)
d. Annual Accounting i. Generally

54

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

55

Who Has Possession of the Income is Taxed On the Income Despite Any Dispute i. Facts: In Year 1, the work is done by North American Oil. However, the government argued that the work was done badly and refused to pay. In Year 2, the TP sues to get paid. In Year 3, the TC holds for TP and TP gets paid. In Year 4, the governments appeal is dismissed (so the TP gets to keep the money and the TC judgment is final). ii. Issue: In what year is income included when you are an accrual basis TP? 1. If a cash basis TP: no actual receipt until Year 3 or economic benefit or constructive receipt For disputed claims, 2. If an accrual basis TP: have income when all the events an accrual method TP have occurred that establish your right to be paid and the becomes cash right can be determined with reasonable accuracy method TP TP: money is taxable in Year 1 when money was made Government: all events have NOT occurred iii. Holding: Include income in the year of receipt (year 3) under the claim of right theory 1. When there is a dispute, cannot defer income past receipt for accrual basis TP 461(f): The Flipside of North American Oil If the TP contests an asserted liability, the TP transfers money or other property to provide for the satisfaction of the asserted liability, the contest with respect to the asserted liability exists after the time of the transfer, and but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer determined after application of subsection (h), then the deduction SHALL BE ALLOWED for the taxable year of the transfer. The CONTEST does not preclude the deduction NOTE: Include income under tax benefit rule 3. Contested Liability a. United States v. Lewis (SCOTUS 1951): An Adjustment for Tax Liability Under Claim of Right Takes the Form of a Deduction in The Year in Which the Income is Repaid This is an example of how i. Facts: TP received a bonus of $22K as an employee in Year 1 annual accounting can hurt (cash basis TP). TP used money during the taxable year thinking the TP due to progressive he was entitled to itthere was litigation regarding his bonus, tax rates. Because the TP and in Year 2, he was compelled to return $11K to his employer. went to a higher bracket in 1. Government: wanted to put $11K deduction in Year 1 Year 2, his tax benefit in 2. TP: wanted a deduction in Year 1 rather than Year 2 Year 2 was LESS than what NOTE: TP was in a higher bracket in Year 1, so it would have been in Year the deduction meant more to him in Year 1 ii. Issue: Should the TP take the deduction for the repaid $11K in 1946 or 1944? iii. Holding: amount is deductible in Year 2TP LOSES 1. Bonus was held by TP under a claim of rightnothing in the holding of North American permits an exception just because a TP is mistaken in his belief as to claim of right iv. Congress responded with 1341 1. If a TP fits 1341, the TP will reduce tax liability in the

56

year of repayment by the reduction in tax that would have occurred in the year in which the income was included had the TP not included the amount Under 1341, the repayment of an amount mistakenly included in income can produce either a current deduction of the amount repaid or, at the TPs election, a tax credit equal to the amount of taxes imposed on the prior overpayment. Thus 1341 effectively gives the TP a choice of 2 positions litigated in Lewis. 2. SOA reduction in tax liability will occur if: In a prior year, it appeared that TP had an unrestricted right to an item Now, its been established that the TP did NOT have such a right The amount of the deduction exceeds $3000K CREDIT OR THEN, the tax for the year will be the LESSER DEDUCTION of: tax for the taxable year computed with the deduction OR an amount equal to the tax computed without the deduction minus the decrease in tax for the prior year 1341: Computation of tax where TP restores substantial amount held under claim of right If an item was included in gross income for a prior taxable year (or years) because it appeared that the TP had an unrestricted right to such item, a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the TP did not have an unrestricted right to such item or to portion of such item; and the amount of such deduction exceeds $3000Kthen the tax imposed SHALL BE THE LESSER OF: TAX COMPUTED WITH DEDUCTION OR AN AMOUNT OR AN AMOUNT EQUAL TO TAX FOR THE TAXABLE YEAR WITHOUT DEDUCTION DECREASE IN TAX UNDER THIS CHAPTER FOR THE PRIOR TAXABLE YEAR. Note: embezzlers do not have the right to this provision (no unrestricted right) EXAMPLE: Suppose that under the claim of right doctrine, a TP includes $20K in year 1. The TP, who is in the 35% bracket, pays $7K of the tax on that amount. In Year 2, the TP who is now in the 25% bracket, is forced to return the disputed funds. The TP is allowed a deduction in Year 2 for the $20K repaid in that year. The deduction, which would save the TP $5K in Year 2, would not make the TP whole for the $7K of the tax the TP paid in Year 1. 1341 allows the TP to reduce her Year 2 tax liability by $7K, which is the reduction in tax that would have occurred in Year 1 (the year in which the income was included) had the TP not included that amount. If the TP had instead been in the 25% bracket in Year 1 and 35% bracket in Year 2, 1341 would allow the TP to deduct the $20K in Year 2 for a tax savings of $7K, despite the fact the TP only paid $5K of tax on the $20K inclusion in Year 1.

XXII. Installment Sales

a. Generally i. What is an installment sale? 1. A sale of property in which the seller receives a series of payments to be made in the future b. Open v. Closed Transactions i. Generally: How Do We Look at Installment Sales? 1. Closed Transaction: a. All events have occurred so as to allow the transaction to be subject to tax; all income now 2. Open Transaction: BASIS FIRST a. Events have not occurred to allow the transaction to be subject to tax

57

b. No income until you exceed your basis Example: TP owns property with a basis of $100K and a FMV of $500K. TP sells the property to B for $500K. Under the terms of the sales K, B does not have to pay the $500K immediatelyinstead he is required to pay $100K a year for 5 years. He must make annual payments of interest as well, at a market rate, on the unpaid balance of the installments. Thus, in the first year, TP receives $100K of the $500K sales price owed her. Closed transaction: tax TP on the full gain in the year of the saleeven though she receives only a quarter of that amount (ex: $500K) Open Transaction: TP would not recognize any gain until TP recovers the basis; the remaining payments are taxable in full (ex: nothing year 1, and taxed later)

ii. Burnet v. Logan (SCOTUS 1931): If the FMV is Not Ascertainable, Open Transaction
Treatment 1. Facts: TP sold stock in a mining company in exchange for cash and payments that were based on the amount mined in the future. a. TP: argued it was an open transactionsince the total AR cannot be determined, should exclude all receipts until basis is recovered b. Government: wanted to treat it like an annuity 2. Holding: For TP this is an open transaction so no FMV to be determined a. Since the amount to be received in the future was not ascertainable, TP was permitted to recover all of her basis first, then include all amounts received after she had recovered her basis. 3. AFTER THE CASE: 453(j)(2) and Regulations only in rare and unusual circumstances will property be treated as NOT having an ascertainable value a. Sellers receiving contingent payments must apply 453 in the year of the sale and preclude open transaction reporting except in extraordinary cases. i. Example: Inaja land; taxation of options; closely held business and sole stockholder sells his shares for $100K in cash plus 10% of profits for each 5 years SUMMARY: FOR RARE AND UNUSUAL CIRCUMSTANCES: Open transaction treatment WHEN PAYOUT PERIOD IS FIXED AND MAXIMUM AMT PAID IS UNCERTAIN: basis recovery is ratable over payout period (closed transaction treatment) c. Installment Sales Reporting: 453 i. Generally 1. When does it apply? a. 453 applies automatically to a sale of property if the seller realizes a gain on the sale and at least 1 payment for the property will be received by the seller after the close of the taxable year i. Does not apply to sales of personal property by TPs who regularly sell personal property on the installment plan b. TPs may elect out of 453 and recognize the entire gain in the year of the sale: 453(d) will really only happen if TP is in a lower tax bracket in the year of the sale 2. 453(a): Income from an installment sale shall be taken into account under the installment method (note: no limit by character/method of accounting) 3. 453(b): An installment sale is a disposition of property where at least 1 payment is made after the close of the taxable year 4. 453(c): Installment Method

58

a. Income recognized for any taxable year from a disposition is a proportion of payments received in the current year b. FORMULA: Payments in current year x (Gross Profit / Total K Price) i. Total K price = AR ii. Gross profit = Gain Realized = AR AB HYPO: Our taxpayer owns property with an adjusted basis of $55 K. He agrees to sell his property for $100K. He pays $20,000 as a down payment and then other payments each year for 5 years. The deferred payments will include appropriate interest. How much income is on the down payment? -Total K price = $100,000 -Gross profit = $45,000 -$45,000 / $100,000 = 45 % x $20,000 = $9000 -Include $9000 5 times (which is $45,000) -Of the $20,000 down payment, include $9K and exclude the rest

ii. Selling the Installment Obligation: 453B SELLER AS LARGE TP

1. If an installment obligation is satisfied other than face value or distributed, transmitted, sold or otherwise disposed of, gain or loss shall result to the extent of the difference between the basis of the obligation and the amount realized or the fair market obligation of the obligation at the time of distribution, transmission, or disposition 2. Basis of the obligation 453(B)(b): excess of the face value subtracted by an amount equal to income which would be returnable (includable) were the obligation satisfied in full FORMULA: Basis = Amt you dont have to pay (GP/TK)(Amt you dont have to pay) Gain = Amt sold obligation for Basis

iii. Interest Payments on Installment Sales: 453A

1. In the case of an installment obligation, interest payments shall be paid on the deferred tax liability with respect to such obligation in the manner provided 2. To fall under this provision: a. SALES PRICE MUST EXCEED $150K: Only applies to obligations which arise from a disposition of any property under the installment method but ONLY if the sales price of the property exceeds $150K b. OBLIGATIONS MUST EXCEED $5 MILLION: This applies to outstanding obligations as well, but only if all such obligations exceed $ 5 million in the taxable year. 3. SO: To the extent you are avoiding paying taxes when you get something, you have to pay interest on the value of the deferral that installment reporting gives youbut only if you fall under the $150 K or $5 million limitation. iv. Selling to Loved Ones Who Re-Sell Immediately: 453(e) 1. If any person disposes of property to a related person (first disposition) and before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (second disposition), the AMOUNT REALIZED with respect to the second disposition will be treated as received at the time of the second disposition by the person making the first disposition SELLING WITHIN 2 YEARS a. SO: If you sell to a loved one who then sells to person X, your tax obligation is triggered at the time when your loved one sells to X.

59

v. Installment Sales and Boot from a 1031 Exchange: 453(f)(6) 1. If the boot in a like-kind exchange includes an installment note, recognition of
the boot will occur under the installment method (that is, as payment on the note received) USE FORMULA

XXIII.

Deferring Income

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

60

in the property and will suffer the first $15 of decline in value. Thus, this collar will NOT be treated as an immediate sale because the TP retains a significant economic interest in the value of the property iv. Tax Consequences of Options 1. No tax consequences when options are created, only when exercised 2. Open Transaction Treatment when exercised a. Options are largely treated as open transactions (basis first) i. Ex: If I buy a call option, it is open until we determine whether I exercise it or let it lax. If I pay $2 for the call option and buy the asset for $103, my basis is $105. If I let it lapse, I simply have a loss with a deduction. b. The seller gets open transaction treatment as wellseller gets gain on what they receive if the option is exercised 3. NOTE: If an option is too deep in the money, going to assume the option will be exercised, or when there is too tight of a collar b. Determining the Price of an Option

The three determinants of determining the price of an option: 1) Relationship of the current strike price to FMV 2) Duration of the option 3) Historic volatility of the option
i. When is an Option Worth the Most? 1. An option will be more valuable if its duration is longer 2. An option will be more valuable if its strike price is close to or below the current value of the asset (FMV) a. Ex: If the asset is selling for $100 and your strike price is $101look to historic volatility of the asset c. Using Options to Deter Financial Risks i. To avoid a currency fluctuation risk: 1. Can buy an option to exchange for a set rate of US dollars 2. Can use a forward K: can sell the foreign currency to have no possible gain or loss ii. To avoid price changes that cause the price of an asset to go higher: 1. Buy an option that gives you a right to by the asset at TODAYs valueusing a financial instrument to hedge a business risk to make money (derivatives0 iii. To monetize exposure to future risk and lock in gain 1. Put options: spending money NOW to ensure that you do not lose money in the future 2. To get this money: can sell a call option d. Compensatory Options to Get Deferral i. Revenue Ruling 60-31: A cash-basis employee is NOT taxable on the unsecured promise by the employer of compensation to be paid in the future ii. Minor v. United States (9th Cir. 1985): When Money is in Escrow, Employee Taxed When Money Paid by Employer to Employer 1. Facts: TP entered into agreement in which he would render medical services to subscribers of prepaid medical plan in exchange for fees to be paid by organization in charge of plan. The fees were paid in a deferred compensation plan: TP who deferred compensation entered into agreement in which TP and org would agree that future services of TP would be paid according to a designated percentage of the fee he/she would receive under the fee schedule if not participating in the plan: balance in a deferred compensation fund. TP agreed he would be paid 50% of the fees; org established a trust with TP as trustee and org

61

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

f.

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

63

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

3. The property will become very valuable while held by the TP and will be taxable under 83(a) but the TP intends to hold the property well beyond that time so that the election trades some taxation now for an increased benefit from the realization doctrine 4. STOCK OPTIONS: 83(e): a. A stock option gives the employee the right to buy stock of the employer at a specified price (strike price) b. MOST stock options are not property upon receipt (think: no income because you do not have property) i. TPs are generally not taxed on the receipt of a stock option, nor can an 83(b) election be filed c. HOWEVER: the TP will be taxed upon exercise the stock option Summary: Open Transaction Treatment Burnett v. Logan: only in rare and unusual circumstances will property be treated as having an unascertainable value and thus open transaction treatment Most stock options receive open transaction treatment Other property subject to risk of forfeiture and/or non-transferrable

iii. The Partnership Carried Interest Controversy: Deferred Compensation and Conversion into Capital Gain 1. Under the existing administrative guidance, the contribution of services to a partnership in exchange for partnership interest is not a taxable eventdespite receiving partnership interest, there is no income as compensation for services rendered (unlike a corporation) 2. Proposal: partner would not be immediately taxable in receipt of a partnership interest in exchange for services but all income reported by the service partner would be taxable as ordinary incometreats partner like in 83(a) 3. The Carry Interest Controversy a. In some partnerships, a share of the partnership profits is paid to the manager as a form of compensation for services rendered (carry interest) b. Since this is considered as a return of investment, the manager receives capital gain treatmentinstead of ordinary income treatment i. This allows HIGH bracket TPs to get taxed at LOWER rates c. This typically occurs when the partnership is a private equity or hedge fund d. NOTE: If the partnerships business consists of selling capital assets (i.e. through managers), the income eventually reported by the partner will be capital gain and the interest the managers have with the partnership is carry interest

g. Deferred Sales
i. The Rule of Alstores 1. In Alstores (below), the sale of property accompanied by the reservation of a right of occupancy did not result in the transfer of ONLY a future interest because the sellers right of occupancy was in the nature of a leasehold interest, because the purchaser acquired the benefits and burdens of ownership of property ii. Alstores Realty Corporation v. Commissioner (TC 1966): When the Buyer Receives the

65

Benefits and Burdens of Ownership of Property, the Buyer Receives More than Just a Future Interest 1. Facts: TP agreed to purchase a warehouse with a current FMV of $ 1 million. The terms of the agreement provided for an immediate payment of $750K, and Giving the the seller would retain possession for 2.5 years. basis to a. TP (Buyer): purchased the remainder (2.5 years) for $750K; basis of the $750K with no further tax consequences remainder b. Government: TP should be treated as having paid $1 million for the man like warehouse (cost basis). Buyer received upfront $250K and allowed the in Irwin v. seller to remain for 2.5 yearsthis was income of $250K. Gavit! i. Argument of constructive receipt of $250K 2. Issue: what is the correct value of the basis: $750K or $1 million? 3. Holding: Government wins the casethe rental income is taxable and the basis is $ 1 million. a. Risk of ownership had been fully transferred to the TP: assumed the control of the premises and benefits of ownership (supply utilities, bore risk of damage, etc.) b. Rights of the seller were limited to those of a lesseecould not alter/improve the building c. This is pre-paid rent! 4. NOTE: This case follows Irwin v. Gavit: can avoid interest tax by pre-payment give all the basis to the remainderman

XXIV.

Personal Deductions

a. Generally i. What is a Personal Deduction? 1. 151: Each taxpayer gets a deduction for personal exemption 2. Allowable for certain expenses incurred without regard to whether the expenses were for the production of income ii. The Zero Bracket Amount 1. Every TP gets a standard deduction: a certain amount of income that will NOT be taxed 2. For a family of 4, this = $26,000 3. NOTE: approximately 60% of US taxpayers do not have gross income in excess of the zero bracket amount b. Casualty Losses i. Generally: What is a Casualty Loss? 1. 165(a): There shall be allowed as a deduction ANY loss sustained during the taxable year and not compensated for by insurance or otherwise a. NOTE: broader than 1001(a) as there is no requirement that there be a disposition of property i. Ex: X owns a 3-story building and it burns down, and rebuilds to a 2-story buildingthis is a not a disposition of property, but a loss within 165 ii. 166: Bad Debts 1. There shall be a deduction for a debt that becomes worthless within the taxable 2. Closed and Completed Transactions a. Reg. 1.165-1(b): A loss must be evidenced by closed and completed transactions fixed by identifiable events i. The partial destruction of property by fire or other natural disaster, the abandonment of property, and the worthlessness of

66

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

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

68

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

69

iv. Other Provisions of 165 1. 165(d): Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions 2. 165(e): Theft lossestiming of the theft loss is NOT when the theft occurs, but when the theft is discovered 3. 165(g): Worthless securities c. Medical Care Expenses i. The Medical Care Deduction: 213(a) 1. 213(a): There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the TP, his spouse, or a dependent to the extent that such expenses exceed 7.5% of AGI. a. SO: Can deduct amounts spent on medical care for the TP and others to the extent medical expenses EXCEED 7.5% of the TPs AGI 2. The 7.5% Limitation a. Makes the medical expense deduction available to only a small portion of taxpayers b. Thus, really for extraordinary medical expenses c. NOTE: insurance premiums subject to 7.5% deduction ii. What is Medical Care? 213(d) and Reg. 1-213.1-(e) 1. What is Deductible Medical Care: a. The term medical care includes the diagnosis, cure, mitigation, treatment, or prevention of disease. Expenses paid for medical care shall include those paid for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care. ( 213(d)(1)(A)) i. Amounts paid for operations or treatments affecting any portion of the body are therefore paid medical care. ii. Examples: hospital services, nursing services, surgical/dental, laser surgery b. Capital expenditures where the primary purpose is medical care to TP and it does not increase the value of the property may be deductible (see below) 2. What is NOT Deductible Medical Care: a. Illegal Medical Care if something is medical care but ILLEGAL, it is not allowable (even if the government does not enforce the illegality medical marihuana) b. An expenditure that is merely helpful to the general health of the TP is not deductible medical care i. Ex: If a doctor tells a patient who is showing signs of stress to Deductible Medical take a vacation, the cost of the vacation is not a deductible Care DOES NOT medical expense even if it improves the patients health Include: c. Capital Expenditures Illegal Medical i. Generally: Are not deductible, but MAY qualify if its primary Care purpose is medical care to TP and dependents (ex: eye glasses, Expenditures seeing eye dog, air conditioner, etc.) merely helpful to TPs ii. BUT NOTE: A capital expenditure for permanent improvement general health or betterment of property which would NOT ordinarily be for the Capital purpose of medical care, may be deductible only to the extent expenditures that the cost of the improvement exceeds the increase in the value of the property 1. Ex: If you were required to put in a whirlpool tub and it

70

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

71

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

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

73

If you give Cash Property Services Ancillary expenses incurred with charitable function (ex: driving to charitable function) Short term property Long term property used by charity for furtherance of charitable function

Deduction Is: Amount of cash Value of property contributed** Zero Expenses incurred (adjusted basis) Basis See below

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

74

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

75

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

indebtedness is deductible b. 163(b): If an installment purchase does not separately agree for interest, interest is 6% c. 163(d)(1): In the case of a TP other than a corporation, the amount allowed as a deduction for investment interest for any taxable year shall not exceed the net investment income of the TP for the taxable year d. 163(d)(2): The amount not allowed as a deduction for any taxable year shall be treated as investment interest paid or accrued by the TP in the next taxable year carry-forward 3. Limitation on Interest Deduction: 163(h) a. 163(h)(1): No deduction allowed for personal interest (unless a corporation) i. Personal interest: interest OTHER than from T or B or investment interest (so: in connection with a profit-seeking activity would still be deductible) ii. Reg. 1.163: must trace how funds are used b. 163(h)(2): Can deduct qualified residence interest 4. Qualified Residence Interest and Limitations a. What is a qualified residence and is it deductible? i. You reside in it or it is primarily your residence designated by Can only deduct you acquisition 1. You can have 1 principal residence and 1 other indebtedness up residence (for both acquisition indebtedness and home to $ 1 million equity) (per TP and per 2. This is PER TAXPAYER and PER RESIDENCE residence) ii. EXAMPLE: A deduction is allowed for interest on a loan used to purchase or improve the TPs personal residence up to $1 million. Interest on a loan used for any purpose is deductible IF the loan is secured by the TPs personal residence but only to the extent that such loan does not exceed $100K. b. 163(h)(3): Qualified residence interest means any interest that is paid or accrued during the taxable year on: i. 163(h)(3)(B): Acquisition Indebtedness OR Interest can be 1. Any indebtedness that is incurred in acquiring, deductible for: constructing, or substantially improving any qualified residence and is SECURED by such residence Acquisition indebtedness OR 2. Such term includes any indebtedness secured by such residence resulting from the refinancing of indebtedness Home equity meeting the requirements but ONLY to the extent that it indebtedness does not exceed the amount of refinancing 3. Limitation: only allowed $1 million TOTAL ii. 163(h)(3)(C): Home Equity Indebtedness: 1. Any indebtedness other than acquisition indebtedness secured by a qualified residence to the extent that the aggregate amount of such indebtedness does NOT exceed the FMV of such qualified residence reduced by the amount of acquisition indebtedness with respect to such residence ANY OTHER PURPOSEDOES NOT HAVE TO BE RELATED TO RESIDENCE 2. Limitation: CANNOT exceed $100K 3. Note: Confusing Area of the Law If you borrow money towards acquiring and

77

improving your residence, and it exceeds the $ 1 million limitation on acquisition indebtedness it is UNCLEAR whether the rest of the money can be used as home equity indebtedness 5. The Special Case of Refinancing a. If you refinance your mortgage, only allowed deduction to the extent the refinancing replaces acquisition indebtedness at the time of refinancing b. Ex: At time of refinancing, the mortgage is worth $135K. TP borrows $140K--$5K of home equity and $135K of acquisition indebtedness. (AMT OF REFINANCING + HOME EQUITY) / TOTAL NEW AMT BORROWED = % x INTEREST PAYMENT = DEDUCTIBLE AMOUNT 6. Prepaid Interest: 461 a. 461(g)(1): Prepaid interest cannot be deducted when paid, but when accrued b. BUT NOTE: 461(g)(2) i. Points on a acquisition indebtedness are deductible 1. POINTS: Amounts a lender requires a borrower to pay usually on closing of a loan, in lieu of charging the borrower a higher interest amount This is an exception to the rule for points paid on indebtedness secured by the TP principal residence and incurred to purchase/improve the principal residence ii. This does NOT apply to refinancing, home equity loans, or acquisition indebtedness on a second home 1. This must be acquisition indebtedness on your principal home f. Taxes Paid i. Only the TP obligated to the taxing authority can deduct taxes paid (if they have actually paid them) ii. State and taxes are deductible only to the extent: 1. Funds are unavailable for consumption: deductible 2. If the taxes pay for services provided to TP: part of consumption iii. Unclear outcome if the TP would voluntarily pay what the state charges in taxes for the services

XXV. Deductions with Personal and Business Components

a. Hobby Losses and Activities Not Engaged for Profit i. Generally 1. 183 allows deductions for expenses attributable to activities not engaged in for profit, to the extent of the gross income of that activity ii. Nickerson v. Commissioner (7th Cir. 1983): If Activity is Profit-Seeking, Can Deduct under 162 1. Facts: TP bought a farm for his retirement. TP hired a farmer to convert the land into more profitable crop and tried to fix up the place. TP claimed a 162 deductionwas not allowed because it was argued that the primary goal in operating the farm was not to make a profit and thus was not deductible Qualify under (personal). 162 or 212 if the PRIMARY 2. Holding: Held for TP PURPOSE is a. TP need only prove that their current actions were motivated by the for pursuit of T or B or for a 78 profit

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

a. As the principal place of business for any T or B of the TP OR

i. Must be used ONLY for the T or Bcannot have multiple uses

b. As a place of business which is used by patients, clients, or customers in

meeting or dealing with the TP in the normal course of his T or B OR i. Requires a face-to-face meeting (web-cam doesnt work) c. In the case of a separate structure which is not attached to the dwelling unit, in connection with the TPs T or B i. If the separate structure is NOT physically attached to the dwelling, but is part of the curtilage nearby, then it will be DEEMED to be apart of the dwelling and you LOSE 4. Depreciation Deductions a. Can deduct depreciation for the home office in the house (but cannot deduct rest of personal residence) ii. The Limitation on Deductions: 280A(c)(5) 1. The deductions allowed under this chapter for the taxable year by reason of being attributed to such use SHALL not exceed the excess of: a. The gross income derived from such use of the taxable year over b. The sum of: i. The deductions allocable to such use which are allowable under this chapter for the taxable year whether or not such unit (or portion thereof) was used (personal deductions), and ii. The deductions allocable to the T or B (or rental activity) in which such use occurs (but which are not allocable to such use) for such taxable year ( 162 deductions, ex: paper you type on) 1. NOTE: This provision basically means that NO ONE CAN get a deduction for a home office!

GROSS INCOME FROM SUCH USE (PERSONAL DEDUCTIONS ALLOCABLE TO BUSINESS USE OF DWELLING + 162 DEDUCTIONS NOT ALLOCABLE TO DWELLING) = PROFIT YOU GET = MAX DEDUCTION
Ex: You sell $5000 worth of mysteries, but mortgage interest allocable is $800, taxes is $100 and you have T or B costs of $150. $5000 - $1050 = $3950 = MAX DEDUCTION UNDER 280E

iii. What is YOUR PPB?_--> Popov v. Commissioner (9th Cir. 2001): Following the
Soliman 2-Part Test 1. Facts: TP is a musician who contracts with various studios to record music and performs regularly, but has no office. She uses her living room to practice 4 to 5 hours a day. Claimed a home office deduction for the living room and deducted 40% of the annual rent and 20% of the electricity bill. IRS disallowed the deductions: it seemed inconceivable that the living rooms sole purpose was the practice of music. 2. Issue: Can a professional musician get a home office deduction for practicing in her living room? 3. Holding: YES A professional musician is entitled to deduct the expenses from the portion of her home used EXCLUSIVELY for music practice The Soliman 2-Part a. Using Solimon: Look to the TPs PPB Test to determine PPB i. Relative importance of the activities performed at each location: Relative unable to determine here importance of the ii. Relative amount of time: TP spent more time practicing the activities performed at violin at home than other activities each location Relative amount of 80 time spent at each location = Deduction Allowed?

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

81

If de minimis, can deduct entire amount

2. 280A(d)(1): de minimis personal use is IGNORED

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

82

b. Not in the T or B of gambling: did not incur losses in excess of his winnings c. NOTE: Even if a TP is in a profit-seeking activity ( 212 would have let him deduct here), this does not give rise to deductions for his family e. Office Decorations and Relation to Fringe Benefits i. Henderson v. Commissioner (TC 1983): Purchases Bought For Ones Office Are Not Deductible 1. Facts: TP took a deduction for the purchase of a framed print, live plant, and a parking space for her officeIRS did not allow the deduction. 2. Issue: Can the deduction be allowed? 3. Holding: NOexpenses are non-deductible personal expenses under 262 a. The Amounts paid for the print/plant were expended to improve the appearance of the TPs office: a personal expense that aided her in the performance of her duties as an employee b. Her employer gave her all the necessary furnishings she neededno evidence was presented to prove that the presence of the print/plant in her office were either necessary or helpful in performing her required services i. NOTE: This case would not come up today because of the 2% limitation. 4. NOTE: A working condition fringe benefit exists under 132(d) when employers provide a plan/print/etc. for your office, but if you provide it for yourselfthen NOT DEDUCTIBLE! f. Listed Property: 280(F) i. Generally: What is Listed Property? 1. 280(F) imposes additional limitations on a TPs business deductions for certain Listed listed property that is especially subject to abuse Property: 2. Listed property is defined in 280F(d)(4)(A) to include: Home a. Home computers computers b. Automobiles: limits deduction to a modest compact car Cars i. Cannot deduct certain types of cars and vehicles, such as Cell delivery vehicles, moving vans, and cars used to transport Phones passengers (ex: limo service): 280F(d)(4) Things c. Cell phones and used for d. Any property of a type generally used for purposes of entertainment, entertainment recreation, or amusement ii. What Kind of Depreciation Deduction is Allowed? 1. ACCELERATED DEPRECIATION if the qualified business use exceeds 50% a. If a TP does not use listed property for business purposes more than 50% of the time, the TPs depreciation deduction, for the portion of the cost of the property allocable to the business use of the property, is NOT eligible for accelerated depreciation TP limited to straight line depreciation 2. STRAIGHT LINE DEPRECIATION if the qualified business use is less than 50% EX: If the qualified business use = 40% of total use and other business use = 25% of total use, the TP must use show depreciation with respect to 65% of the cost of the item. ONLY GET TO THE EXTENT IT IS BUSINESS USE.

iii. 280F(d)(3): Use of a Listed Property By an Employee

1. Any use of listed property by an employee (rather than a self-employed individual) is not treated as use in a T or B (and thus is not eligible for any depreciation) UNLESS such use is:

83

a. For the convenience of the employer and b. Required as a condition of employment 2. Ex: If you buy a laptop for work, you cannot deduct this! g. Travel and Entertainment Expenses: 274 i. Generally 1. TPs are allowed to deduct the ordinary and necessary expenses incurred in carrying on a business under 162(a) since travel and entertainment expenses Deductions for travel associated with a business have an inherent element of personal consumption, expenses only allowed they have been subject to substantial TP abuse if: 2. 274(a)(1): Thus, even if you have a deduction under 162/212, no deduction Directly related to T is allowed for things considered to be for amusement, recreation, or or B entertainment UNLESS: Before or after a a. The item was directly related to the active conduct of the TPs T or B discussion/association (as opposed to the creation of goodwill) OR with T or B i. Reg. 1.274-2(c): What is directly related? 1. TP had more than a general expectation of deriving income at the time the TP made the expenditure (goodwill fails) 2. During the time period, the TP actively engaged in business meeting, negotiation, discussion, or any other BF transaction 3. The principal character of the business entertainment was the active conduct of the TPs T or B AND 4. Person had to be involved in TPs T or B b. The item preceded or followed a substantial and bona fide business discussion and was associated with the TPs T or B EX: F takes a business associate on a hunting trip. Between shots and without any prior discussion, the customer places an order with F. Can F deducts the costs of the hunting trip? NO The TP had to have more than a general expectation of deriving a benefit During the activity, the TP must have actively engaged in business discussion The principle character of the activity was the active conduct of a T or B The expenditure was allocable to the prospective client 3. Substantiation: 274(d) a. No deduction or credit is permitted for traveling, entertainment, or recreation expenses unless the TP substantiates the expense be adequate records, preferably made at or near the time of the expenditure i. This applies for travel away from home or anything considered entertainment or listed property must corroborate statements, business purpose and business relationship b. Exception: reimbursed employee expenses and expenses under $75 4. If Employee Doesnt Get 274 a. If the employee does not meet 274, then the employee gets compensation b. Like any form of compensation, the employer can deduct the compensation as a business related expenses 274(e) EXCEPTIONS: Deductions are allowed for: Food and beverages provided by employer on business premises for employee

84

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

Examples of Foreign and Domestic Expenditures and Allocation Rules Ex: I go from ATL to LA on business lasting 1 week and remain for a 2nd week on vacation. Assuming the primary purpose for the trip was business, what percentage of the airfare is deductible? 100%

Ex: I go from ATL to Japan on business lasting 2 weeks and remain an additional 2 weeks on vacation. Assuming the primary purpose for the trip was business, what percentage of the airfare is deductible? 50%

85

 Ex: I go from ATL to Japan via Hawaii on business lasting 2 weeks and remain in Japan an additional 2 weeks on vacation. Assuming the primary purpose was business, what percentage of the airfare is deductible? 100% of the airfare between ATL and Hawaii and 50% of the airfare between Hawaii and Japan.

2. Travel as a Form of Education is NOT Allowed: 274(m)(2)

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

86

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

87

TAX HOME = POB

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

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

88

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

89

palimony by former ex-roommate) If the origin of the claim stems from a T or B or profit-seeking activity, legal fees are deductible (ex: PR firm protecting Matt Damons reputation)

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

XXVI.

Divorce and Alimony

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

90

i. 1041: Transfers of Property Between Spouses or Incident to Divorce 1. 1041(a): No gain or loss shall be recognized on a transfer of property from an individual to a spouse or to a former spouse a. Thus, if you are married, there is no gain: treated as a gift, with basis as carryover 2. 1041(b)(2): Basis of the transferee is the AB of the transferor (carry-over basis) TREATED AS A GIFT 3. 1041(c): A transfer of property is incident to the divorce if such transfer a. Occurs within 1 year after the date on which the marriage ceases, or b. Is related to the cessation of the marriage THUS: 1041 provides that a transfer of property between spouses or former spouses where the transfer is incident to divorce are treated as gifts with carry-over basis!

ii. TRANSFERS INCIDENT TO DIVORCE: United States v. Davis (SCOTUS 1962): A

Transfer of Appreciated Property Incident to a Divorce Is a Realization Event to the Transferor 1041 OVERRULESTHIS IS A GIFT 1. Facts: Pursuant to a divorce, TP agreed to transfer to his W 10000 shares of stock in a company in exchange for a release of legal obligations. TP asserts that the present disposition is comparable to a non-taxable division of property between 2 co-owners, while the Government argues that it resembles a transfer of property in exchange for the release of an independent legal obligation, thus making it taxable. 2. Issues: 1) Was the stock transfer a taxable event? 2) If so, how much gain? 3. Holding: The stock transfer was a taxable event and the AR received by the H will be the tax basis for the W. a. The exchange of property for freedom from marriage was similar to the exchange of property for services or other non-like-kind property and is TAXABLE i. The W has no interest over the management of the property b. Cost basis for the property in the hands of the W based on AR by the H c. OVERRULED by 1041 i. BUT NOTE: Davis may still apply to transfers of property in anticipation of marriage or to transfers of property between partners in a same-sex committed relationship 4. IN ANTICIPATION OF MARRIAGE: Farid-Es-Sultaneh v. Commissioner (2d Cir. 1947): Transfer of Marriage Rights for Consideration is Not a Gift a. Facts: TP-wife sold certain shares of stock which she has previously received from her husband pursuant to a pre-nuptial agreement. Under TRANSFERS that agreement, the TP, in consideration for the shares, had surrendered BETWEEN all marital property rights in the husbands estate. The stock had a basis SPOUSES AND in the husbands hands of 15 cents per share, but a FMV of $10/share FORMER SPOUSES when transferred to the TP. = TREATED LIKE i. Government: contended that the TPs basis in the shares was the A GIFT same as her husbands (15 cents/share) because the shares had been received by her as a gift. DAVIS MAY b. Holding: NOT A GIFT: transfer from H to W was not a gift for income APPLY TO tax purposes but an exchange of valuable property interestsstock for marital property rights. As a result, it found that the TPs basis for the PRENUPSBUT shares was $10: FMV on the date transferred and reduced her gain. 1041(a) makes Farid c. THIS IS LARGELY MOOT TODAY BECAUSE OF 1041(a) today, moot

91

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

92

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

93

XXVII. Assignment of Income

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

94

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

95

a. Facts: CA is a community property stateall property acquired by

marriage is community property and they are equal interest. A spouse who files separately must include the gross income of of the combined earning income of both spouses. In 1999, CA extended certain rights of married couples to domestic partners who register their partnership with the CA Secretary of State: Domestic partners are given the same rights as married couples. Allowed domestic partners to file joint tax returns for state tax purposes b. Issue: Is a CA individual who is a registered domestic partner required to include in gross income all of his or her earned income OR of the combined income earned by the individual and his/her domestic partner? c. Holding: An individual who is a registered domestic partner in CA must report ALL of his or her income earned from the performance of his or personal services i. Poe v. Seaborn does not apply outside the context of H and W the rights afforded to domestic partners in CA are NOT made an incident of marriage by the policy of the State iii. Gratuitous Performance of Services 1. When it comes to services performed by charities, the rules are more generous to TPs than the rules related to service performed for an employer, customer, or client 2. Reg. 1.16-2(c): provides that no income arises where services were rendered directly to the charitable organization and this includes services rendered to a charity as a promoter of public entertainment 3. Does Lucas v. Earl apply to income shifting to charities? c. Income from Property: GRATUITOUS TRANSFERS i. Generally 1. Generally, income from property is treated as owned by the owner of that property and taxed to that person 2. RULE: Income from property cannot be assigned where the donor retains the underlying property and thereby the right to make future gifts from the income of that property ii. Blair v. Commissioner (SCOTUS 1937): Income from Property is Taxed to the Owner of the Property 1. Facts: TPs father created a trust based on his will. From the trust, TP assigned to his daughter, interest of $6K for the remainder of that calendar year, and $9K for each year after in net income. 2. Issue: the question of the tax liability of a beneficiary of a testamentary trust for a tax upon the income which is assigned to his children after these assignments, is the assignor STILL TAXABLE on the income of $9K? 3. Holding: The daughter should be taxed because she became part owner of the trust and income from property should be taxed to the owner of the property a. Income from property is taxed to the owner of the property iii. Helvering v. Horst (SCOTUS 1940): If a TP Merely Assigns the Income and Keeps the Property, There is NO Shifting of Income 1. Facts: TP made a gift of a bond interest coupon just prior to the coupons maturity. He presented it to the issuer and received the interest payment. 2. Issue: Who is taxed on the interest that the son received? 3. Holding: No income shiftingTP is taxed when the coupon is cashed a. Distinguishing Blair i. In Blair, gave away ALL property rightsbut in Horst, she gave only 1 coupon with the right to receive more coupons

96

ii. In Blair, income from property is taxed to the owner of property

In Horst, since she kept the property and merely assigned the income of the property, she is taxed because she owns the property 1. Thus, in Blair: gift of property (income shifts) vs. Horst: gift of income from property (income does not shift) iii. Horizontal vs. Vertical Slices 1. Horizontal Slice: all of the income from the property for a fixed amount of time (Horst) income does not shift 2. Vertical Slice: Part of the income from the property for as long as the property exists (Blair) income shifts Horizontal slice = Horst TIME

Vertical slice = Blair = Income shifts

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

97

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

98

does not shift if part of the income from property is given for as long as property exists: Blair; income does shift NON-GRATUITOUS TRANSFERS: o Selling the right to receive future income from property/services: owner is taxed on income when he sells the right to receive income to another; buyer taxed on time value of money (Stranahan. Cotlow)

XXVIII. Capital Gains and Losses

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

99

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

100

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

101

allows the TP to deduct the entire $900K, but only at a rate of $3000K a yearat this rate, it would take 300 years for the TP to deduct the full $900K

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

Net Long Term Capital Loss Only

102

Net Long Term Capital Loss & Net Short Term Capital Loss Net Short Term Capital Loss Only If Net Long Term Capital Loss > Net Short Term Capital Gain Net Long Term Capital Loss & Net Short Term Capital Gain

carried forward to the next year Net Loss = Net Long Term Capital Loss + Net Short Term Capital Loss deduct up to $3K and the rest is carried forward to the next year Net Loss = Net Short Term Capital Loss deduct up to $3K and the rest is carried forward to the next year Net Loss = Net Long Term Capital Loss Net Short Term Capital Gain deduct up to $3K and the rest is carried forward to the next year If Net Long Term Capital Loss > Net Short Term Capital Gain above If Net Long Term Capital Loss < Net Short Term Capital Gain, then Net Gain = Net Short Term Capital Gain Net Long Term Capital Loss include in ordinary income

iv. Assets Taxable Under 1231 1. Generally a. 1231 applies to the sale and exchange of assets described in 1221(2): depreciable property and real estate used by the TP in a T or B b. At the end of the year, all 1231 gains and losses are netted together to produce a single 1231 gain or loss 2. 1231 Gains and Losses a. If a gain = long-term capital gain b. If a loss = ordinary loss i. THUS: 1231 property get the benefit of capital gain without the detriment of the loss side ii. This includes gains from the involuntary conversion of long-term capital assets (ex: TPs car is wrecked, and insurance proceeds exceed the TPs basis in the car) 3. Determining the Taxable Rate a. Long-Term Capital Gain: Depreciation Deduction: taxed at 25%; remaining: taxed at 15% d. Depreciation Recapture Under 1245 and 1250 i. Generally: Background to the RECAPTURE RULES 1. Since 1231 permits capital treatment for gains from sales of depreciable property, the provision creates a special problem in respect to the depreciation allowance a. This problem has been rendered acute by the adoption of accelerated depreciation rules. Thus, annual depreciation is a deduction from ordinary income, and the amount deducted is subtracted from the TP property basis. b. If the value of the property at a given date exceeds adjusted basisif, in effect, the depreciation allowed for tax purposes has been greater than the actual decline in the propertys valuethen a sale of the property will produce a gain, and the gain under 1231 will be all capital c. This means that the prior deductions from ordinary income will be transmuted into capital gain through sale 2. To limit this problem, the Code has LIMITED the ability of property-owners to combine ordinary deprecation deductions with capital gain by requiring RECAPTURE of all or a portion of the depreciation when the property is sold. ii. The Provisions of 1245 1. Generally a. Under 1245, applying to depreciable property OTHER than real estate,

103

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

104

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

105

losses incurred in the sale of the Treasury securities were losses connected with his stock in tradethese are ordinary rather than capital losses. a. If a dealer: can deduct ALL losses as ordinary from income b. If not a dealer: can only deduct up to $3K 2. Issue: Is he allowed deductions for the ordinary income? 3. Holding: NOhe was merely a speculator; he did not maintain an inventory, he was out of the market as many as 200 days per year, etc. a. Trader: profits from swings in value and reports gains and losses as capital b. Dealer: compensated for services rendered ii. Biedenhard Realty v. US (5th Cir. 1976): Once an Investment Does Not Mean Always An Investment 1. Facts: TP held lots of real estate for investment and turned one property into a subdivision. Government had agreed that 60% of the gain would be reported as ordinary income and 40$ as capital gain. The TP reported its gains on this basis, but IRS asserted a deficiency: all gains were ordinary income and the TP filed for a refund, claiming they were capital. 2. Issue: Were the gains ordinary or capital? a. Did the sales from the subdivision constitute property held by the TP primarily for sale to customers in the ordinary course of its T or B? 3. Holding: Ordinary Gain a. Court looks to a variety of factors: substantiality and frequency of sales, improvements, solicitation and advertising efforts, and brokers activities all point towards ordinary gain in T or B 4. NOTE: IMPROVEMENT + REZONING INTO SUBDIVISIONS = FATAL

f. 170(e)(1) Re-Examined: Reduction of Charitable Contribution Deductions SEE ABOVE

i. Generally 1. Under 170(a), TPs can take deductions for charitable contributionsequals the FMV of the property contributed 2. This deduction is reduced by 170(e)(1) ii. 170(e)(1) Reductions 1. 170(e)(1)(A): The charitable contribution under 170(a) is reduced to the extent that gain from sale of the contributed property the extent it would be shortSHORT TERM term capital gain or ordinary income a. THUS: if the property contributed would have produced ordinary income or short-term capital gain had it been sold (because the property is not a capital asset or has not been held by the donor for at least a year), the donor can deduct ONLY adjusted basis in the property i. Ex: reduction for any recapture amount under 1245 2. 170(e)(1)(B): Even if a sale of the contributed property by the donor would have produced long-term capital gain, the donors 170 deduction is limited to the donors AB in the property if: a. The contributed property is tangible personal property (ex: works of art, LONG TERM antiques, etc) AND the donees use of the property is unrelated to the organizations charitable purpose b. The property is donated to certain private foundations OR c. The contributed property is a patent or certain other intellectual property d. NOTE: THIS NEVER APPLIES TO CONTRIBUTIONS OF REAL ESTATE OR INTANGIBLE PROPERTY SUCH AS STOCKS AND BONDS g. Substitutes for Ordinary Income

106

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

107

the value of the asset 2. When lottery winner sells lottery rights, he transfers a right to income that is already earned, not a right to earn income in the future h. Original Issue Discount and Related Rules i. What is the Original Issue Discount? 1. Generally a. A borrower must pay a lender interest on principal borrowed in order to compensate the lender for the borrowers use of the lenders funds while the loan is outstanding i. The unpaid, accrued interest increases the principal owed ii. Thus, a note which will be paid $100 at maturity, plus 6% interest annually may have to be sold at $97 because the 6% interest is inadequatethe extra $3, the OID, is economically There is less the same as interest: for use of the $97, the issuer of the OID in the obligation has to pay the 6% interest annually plus 3% at early years maturity and more in b. Original issue discount (OID): term for unstated interest on debt, the later years determined at the time the debt is issued i. 1272(a)(1): anyone who holds a bond with OID must include the OID on the bond for the period held ii. OID is defined as the excess, if any of the redemption price over the issue price Ex: If L pays $680 (issue price) for a $1000 bond (redemption price), her OID = $320 (if she keeps it for 4 years). The OID is determined only once per bond and is defined in reference to what the first purchaser paid. If L pays $680 and holds the bond for only 1 year, she redeems it for $750, with an OID = $70. If she continues to hold the bond throughout the second year, she must include $75 for the second year (redemption price = $825). Similarly, if L sold the bond to T at the beginning of the second year, T must include the $75 OID.

NOTE:
OID is the same for all holders Acquisition and market must be determined anew for each holder Date of Issue 1 Year Later 2 Years Later 3 Years Later Redemption Total 2.

Value $680 $750 $825 $910 $1000

Change in Value --$70 $75 $85 90 $320

Selling the Bond a. If a purchaser of a bond sells the bond at the beginning of a year, the purchasee includes the OID for that year (so: T includes $75) b. If the sale from the first purchaser to the purchasee takes place during the second year, they will divide the OID for that year between them (so: T and L divide $75)

ii. Acquisition Premium PAYING MORE FOR THE BOND 1. Acquisition Premium: excess, if any, of the amount paid for a bond over the
sum of its issue price plus accrued OID ( 1272(a)(7)) a. Example: If a subsequent purchaser pays more for the bond than the sum of the issue price plus accrued OID to date. For example, T might pay $ 780 for the bond after 1 year (when it is worth $750). The acquisition premium would be $30.

108

2. Subsequent Holder Number One (T) a. A subsequent holder who pays an acquisition premium is entitled to REDUCE the includible OID by the acquisition premium, where the acquisition premium accrues at the same rate as the OID i. To figure out what the subsequent purchaser, T, includes: OID for that year -- fraction of OID ii. Fraction of OID = Acquisition Premium / OID accruing after the purchase giving rise to the acquisition premium 1. OID accruing after the purchase = Redemption Price for Total Years of Bond Issue Price for that Year b. NOTE: Subsequent purchaser, T, increases AB in the bond by the OID includible 3. Subsequent Holder Number Two (U) a. Subsequent holders after T will use the same acquisition premium as T (ex: $30). b. The same formula applies 4. The First Purchaser a. When the first purchaser sells the bond to T, there is a gain of $ 30 under 1001(a) Purchaser paid $680 for the bond and included OID of $70, so the AB for the first purchaser is $750. When he sold it to T for $780, there is a gain of $30. b. Assuming the bond is not held in inventory, that gain qualifies as capital gain i. This is appropriate because the increase in value of the bond ABOVE and beyond the accrued OID reflects a change in market values, not the time value of money FORMULA for Inclusions with Acquisition Premiums: OID for Year X [OID for Year X x [(Price Actually Paid by T Issue Price in Year of Purchase by T) / (Redemption Price for Total Years of Bond Issue Price for Year of Purchase by Current Holder]

iii. Market Discount PAYING LESS FOR THE BOND

1. What is a Market Discount? a. The excess, if any, of the issue price plus accrued OID over the purchase price b. This does NOT affect the amount of OID a bondholder reports i. Rather, a TP who purchases a bond with a market discount will have some of the dispositional gain characterized as ordinary income ii. So much of the gain as does not exceed the accrued market discount will be taxed as ordinary income under 1276(a)(1), where market discount is assumed to accrue ratably, under 1276(b)(1) 1. THUS: The implicit interest represented by market discount is deferred until disposition of the bond. Market discount, like acquisition premium, is determined anew for each holder of the bond. Depending on how long you hold the bond, that percentage of the gain is ordinary. Thus, if you hold it for 3 years, out of the 5 remaining years, then 3/5 of your gain times the amount of the market discount is ordinary. The rest is capital. If you hold it until redemption, then all of your gain is ordinary.

109

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

110

Horst looked at the coupons and bond as 2 separate pieces of propertyhere, they look at the entire thing as property!

corpus (if retained) equal to fair market value. 1. Then, each of these retained items is treated as a separate zero-coupon bond subject to the OID rules individually. Further, the sold items also are treated as separate zero coupon bonds subject to the OID rules. 1286(a)-(b). 2. IF YOU DO SEPARATE WE DIVIDE THE INTEREST BETWEEN EACH THING 3. If you strip in year 2, we have to go back to year 1 and include the OID you would have paid. 4. Rather than treating the coupons as income and the bond as property they treat the whole thing as property iii. Amounts realized from the sale of stripped bonds/coupons constitute income to the TP only to the extent that such amounts exceed the basis allocated to the stripped coupons or bond

1286 and the Overruling of Horst? 1286 incorporates precisely the analysis that Abrams proposed under Stranahanhowever: IT ONLY APPLIES TO STRIPPED BONDS If you keep both the bonds and the coupons: 1286 doesn't apply c. Effect of 1286 i. 1286(b) refers to the disposer this is triggered by a disposition ii. 1286(a) refers to the strippee/transferee this is triggered by a purchase 1. Ex: GIFTS 1286(b) seems to apply, but 1286(a) seems not to as well. Example: Suppose the holder of the bond sells coupon 3 immediately for its fair market value of $85.41. The buyer takes a cost basis of $85.41 in coupon 3 and will treat the difference between that price and the redemption amount of $120.00 as OID. Thus, the purchaser will include OID of $10.25 in the first year, OID of $11.48 in the second year, and OID of $12.86 in the third year. The seller follows a similar pattern with respect to coupons 1 and 2 as well as with respect to the corpus. Thus, he will include OID of $109.75 in the first year, OID of $108.53 in the second year, and OID of $107.14 in the third year.

111