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FEDERAL PERSONAL INCOME TAX OUTLINE

TABLE OF CONTENTS:

I. Introduction [1-36]

II. Characteristics of income [p. 37-42 Notes; §61; Reg. §1.61-1 (a), Reg. §1.61-2(a)(1), (d)(1)]

• noncash benefits

o food and lodging [p. 42-48; §119(a), (b)(1), (2), (4); Reg. §1.119-1(a)(1) and (2), (b), (c), (f)]

o Other fringe benefits [p. 49-56, 59-63; §79(a), §106(a), §125(a), (d)(1), (f), §129(a). (b), §132(a)-(f)(5), (gH)(U (j)(4)]

o imputed income [p. 63-70]

• windfalls and gifts

o punitive damages [p. 70-73]

o gifts [p. 73-83, 91-95, questions; §85, §102(a), (c), §274(b)]

o intervivos transfers of unrealized gain by gift [p. 95-99 (skip note 6); §1001(a)-(c), §1011(a), §1012, §1015(a)]

o transfers at death [p. 99-101 (only note 1), §1014(a), (b)(1)-(4)]

o gifts of divided interests [p. 103-105]

• recovery of capital

o capital gains [p. 25]

o basis [p. 105-109, Reg. §1.61-6(a)]

o annuities and pensions [p. 115-119; §72(a), (b)(1)-(3)(A), (c)(1), (3), (4)]

o gains and losses from gambling [p. 120-121]

o recovery of loss [p. 20-21 (re-read carryover paragraph), 121-126; §165(a), (b), (c)(3)]

• recoveries for personal & business injuries [Raytheon, Murphy v. U.S.; p. 141-45; §104(a), §105(b)-(c); Reg. §1.104-1(c)]

• transactions involving loans and discharge from indebtedness

o loan proceeds [p. 145-146]

o true discharge of indebtedness [p. 146-149; §61(a)(12)]

o relief provisions [p. 149-150; §108(a)(1), (d)(1)-(3), (e)(5)]

o misconceived discharge theory [pp. 150-163, §1011(b); Reg. §1.1001-1(e)]

o transfer of property subject to debt [p. 28-29; p. 163-180; Reg. §1.1001-2(a)]

• Illegal Income [p. 180-185]

III. Problems of timing

• gains and losses from investment in property

o realization requirement [p. 27-28, 193-194, 213-224; §109, §165(a); Reg. §1.61-8(c), §1.165-1(a)]

o express nonrecognition provisions [p. 190-91, 224-26, 231; §121(a)-(c), §1031(a)-(d), §1033(a)(1),(2)(A),(B); Reg. §1.1031(a)-1]

o boot and basis [p. 231-233]

• recognition of losses[p. 237-241]

• annual accounting and its consequences

o The use of hindsight [p. 126-131; §172(a), (b(1)(A), (2), (3), (c), (d)(1)-(4), §441(a)-(e); Reg. §1.165-1(d))]

o claim or right [p. 131-138; §1341(a), (b)(1)]

o tax benefit rule [p. 138-141; §111(a), (c)]

• constructive receipt and related doctrines

o introduction to accounting methods [p. 25-27; §446(a)-(d); Reg. §1.446-1(c)(1)(i), (ii)]

o constructive receipt and economic benefit [p. 253-59; §451 (a); Reg. §1.451-1(a), Reg. §1.451-2]

o deferred compensation [p. 268-274; §83(a)-(e)]

o qualified employee plans [p. 282-286]

o stock options, restricted property, and other employee compensation [p. 286-301; §422; Reg. §1.83-7(b)]

IV. Income Splitting and the Taxation of the Family

• Income from services [p. 599-610]

• transfers of property and income from property [p. 618-626]

• transfers incident to marriage [p. 301-307; §1041]

• alimony, child support, and property settlements [p. 311-318; §71, §166, §215(a), (b)]

V. Personal Deductions

• introduction [p. 22-24, 339-342; §67(a), (b), §68(a)-(d), §162(a), §262(a)]

• casualty losses [p. 342-345, 352-355; §165(c)(3), (h)(1)-{3); Reg. §1.165-7(a)(1), (2), (b)(1)]

• extraordinary medical expenses [p. 356-365; §213(a), (b), (d)(1)]

• charitable contributions [p. 366-368, 372-383; §170(a)(1), (c)(1), (2)]

VI. Deductions for Mixed Business and personal expenses [p. 401-403]

• hobby losses [p. 403-411, §183(b)(2)]

• home offices and vacation homes [p. 411-419; §280A]

• income unconnected to a trade or business [p. 419- 429]

• travel and entertainment [p. 431-439, §274(a), (d), (e), (k)-(n)(2)(B)]

• business lunches [p. 440-443, Questions a-f, p. 443]

• childcare expenses [p. 456-459; §21 (a)-(d)]

• commuting and moving expenses [p. 459-75; §162(a)(2), §217(a),(b)(1),(c); Reg. §1.162-2(e)]

• legal expenses [p. 478-484]

VII. Deductions for the cost of earning income

• distinguishing current expenses from capital expenditures [p. 491-498, 500-502; §174(a)(1), §263(a); §1.263(a)-1]

• repair and maintenance expenses [p. 502-506; Reg. §1.162-4]

• ordinary and necessary; extraordinary behavior [p. 530-536]

• reasonable compensation ; costs of illegal or unethical activities [p. 537-544]

Federal Personal Income Tax OUTLINE

I. Introduction [1-36]

• Tax Rate Schedules:

o (1) married people

▪ permitted to file a “joint return” (i.e. a return on which they aggregate their income and deductions so that it does not matter who earned what

▪ also available for “surviving spouses” but not for single-sex couples

o (2) heads of households

▪ less favorable than married couples

▪ unmarried person with a dependent living w/him/her

▪ idea is that the head of household has financial burdens similar to a married couple

o (3) unmarried individuals - “single people”

▪ less favorable than heads of households

o (4) married people filing separate returns

▪ least favorable of all

▪ special rate → generally results in increased aggregate taxes and only rarely will result in reduced aggregate taxes

• “Marriage Penalty” –added tax paid by 2 people who have roughly the same earnings & are married

o the secondary worker in a married couple is subject to tax rates determined by the income of the primary worker

• Penalties

o TP must pay a penalty equal to 20% of the amount of any underpayment due to negligence

o substantial understatement = one that exceeds the greater of 10% of the proper tax or $5,000 ($10K for a corporation)

o error attributable to fraud

▪ civil penalty only imposed in cases of “highly flagrant behavior”

▪ criminal fraud, aka “willful attempt to evade or defeat any tax imposed by this title or the payment thereof” is a felony carrying a penalty of not more than $100K ($500K corporations) or 5 years in prison, or both

• Tax Mistakes:

o Adjustment - if taxpayer later finds a mistake, make an adjustment in year the true facts appear

o Amended Return - if, however, the mistake was plainly an error at the time of reporting, then the remedy is to file an amended return

o 3 year SOL for claims for refunds of overpayments, made by amended return or otherwise

• IF the taxpayer & the IRS cannot reach agreement, IRS will order the taxpayer to pay the deficiency, plus interest and any applicable penalties, and the taxpayer must either do so or go to court

o 3 options for judicial review

▪ (1) decline to pay the tax and file a petition for review a/the Tax Court

• available only if the tax has not been paid as of the date of the petition

▪ (2) pay the tax and sue for a refund in federal district court where the taxpayer resides

• judge not likely to be tax expert, however jury trial available

▪ (3) pay the tax and sue for a refund in the US Court of Federal Claims

• decisions reviewable by the US Court of Appeals for the Federal Circuit

• if an issue is 1st litigated by a TP who obtains a favorable legal ruling in the Claims Court, & that ruling is upheld on appeal, all other taxpayers may then take their cases to that court & foreclose the possibility of a conflict among circuits

• Process: calculate the following in the following order…

o (1) Gross Income §61 - “all income from whatever source derived, including…”

o (2) Adjusted Gross Income (AGI) §62

▪ calculate after the TP’s gross income has been determined

▪ AGI is arrived at by deducting from gross income a set of items listed in §62

o (3) Taxable Income §63

▪ calculate after calculating AGI

▪ involves deducting (a) the amount of the personal exemptions of the TP and their dependents, if any, plus either (i) the standard deduction OR (ii) itemized deductions

o (4) Offsets – offset the tax with any credits that may be available and determine whether a minimum tax must be paid

▪ Credit = direct offset to the tax (see §21-41)

▪ Deduction = reduces taxable income and thereby reduces the tax payable by the amount of the deduction multiplied by the relevant rate of tax

• Alternative Minimum Tax (AMT) for individuals - §55

o tax imposed on a special base at a rate of 26% of the first $175K and 28% on amounts above that

• Realization & Recognition

o Realization – a gain or loss is realized when there has been some change in circumstances such that the gain/loss might be taken into account for tax purposes [note: recognition not necessary]

o Recognition – a gain or loss is recognized when the change in circumstances is such that a gain or loss is taken into account [note: there must have been a realization event]

• Entities

o Sole proprietor - all items of income and expenses of the business are treated for tax purposes as items of income and expenses of the sole proprietor

o Partnership – pass through taxation

o Trust – generally pass through taxation to the beneficiary

o Corporation – treated as separate taxpaying entities

• Tax Deferral

o Advantages – a tax liability deferred from the present to the future gives the TP the use in the interim of the amount that would otherwise have been paid presently in taxes

o Discounting to Present Value – the process of calculating present value of a future amount

o “The Rule of 72” – roughly an amount doubles within the number of years determined by dividing 72 by the interest rate

II. Characteristics of Income [p. 37-42; §61; Reg. §1.61-1, Reg. §1.61-2]

• Income Defined:

o Eisner v. Macomber – “the gain derived from capital, labor, or both” (narrow)

o Haig-Simmons - “the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in value of the store of property rights between the beginning and end of the period in question” (broad)

• Noncash Benefits

o Gross Income §61: includes income realized in any form (money, property, services, etc…)

▪ “if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation”

o Taking noncash benefits raises problems of administrative feasibility & may make enforcement difficult

o Food and Lodging [p. 42-48; §119; Reg. §1.119-1]

▪ Benaglia – if food & lodging for the convenience of the employer → not taxable income

▪ §119 – Definitions

• Meals [groceries maybe, some even include TP, soap, etc…]

• Furnished [meal allowance to CHP not ‘furnished’, but fireman cash that could be for meals or whatever was ‘furnished’]

• Convenience of the Employer [business reasons other than tax advantages, provisions of employment K not determinative, usually shown by proof that employee is ‘on-call’ outside of business hours]

• Business Premises [some say roads/highways, usually official gov’t residences]

• Employee [doesn’t include self-employed persons]

o Other Fringe Benefits [p. 49-56; p. 59-63; §79, §106, §125, §129, §132]

▪ Ex: life insurance, medical insurance, discounts, parking, company cars, airline travel, club memberships, and tuition remissions

▪ problems of valuation and enforcement

▪ §132 – Statutory Exclusions for well-established taxpayer practices

• no additional cost services & qualified employee discounts

o restriction: must work in line of business of employer in which the item is ordinarily offered for sale & employer can’t discriminate for highly compensated employees

• working condition fringes

• de minimis fringe

• qualified transportation fringe

• moving expense

• retirement planning services

• gyms and athletic facilities

▪ Cafeteria Plans §125

• employee may choose among variety of noncash nontaxable benefits or may choose to take the cash

• ex: childcare payments

• includes nondiscrimination rule and is limited to (group life insurance, dependent care assistance, adoption, accident/health benefits, 401K)

• Use-it-or-Lose-it Rule

▪ Frequent flyer credits

• credits earned by business travel – clearly income but problems w/valuation

o → IRS says it IS income, but you are not required to report it

• credits earned by personal travel – not income

▪ Valuation

• items tend to be either wholly excludable or included at their FMV without regard to any argument they were worth less than to the taxpayer

• Turner – 1st class steamship tickets∏ turned into 4 coach tickets

o determined amount be included in income because the tickets gave them the opportunity to enjoy a luxury (subjective valuation though)

• Home Run Ball – IRS says fan does not have taxable income from ball, but may if he decides to sell it (also commercial fisherman, big game hunters, prospectors, miners, and treasure hunters → until they turn bounty into cash)

o Imputed Income [p. 63-70]

▪ imputed income is NOT taxed

▪ Home ownership: the person who borrows to invest in a personal residence relies on a combination of two tax rules

• (1) the non-taxation of imputed income; and

• (2) the deductibility of the interest payment

• = benefit to taxpayer when they borrow money to invest in tax-favored investments

▪ Services: the benefit of the services that one performs for oneself is imputed income

• Homemakers – effect may induce secondary workers to stay home and provide services to the household/children rather than take a job where services are more valuable to society

o §21 – credit for childcare

o §129 – allowing taxfree employer reimbursement for childcare expenses

o §125 – allowing employers to offer employees a choice between a tax free benefits and cash

• Marital dissolution – value of services one performs for oneself in creating human capital

▪ “Barter club”

• legal services in exchange for house painting – includible in gross income §61

• artwork for 6 months free rent – includible in gross income §61

o Psychic Income & Leisure – cost of achieving happiness is NOT taxed

• Windfalls and Gifts

o Punitive Damages [p. 70-73]

▪ Glenshaw Glass – punitive damages taxable under §22 “gains or profits and income derived from any source whatever”

o Gifts [p. 73-83, 91-95; §85, §102, §274]

▪ Gifts are NOT taxable income to the recipient (§102) but income from gifts IS

• no income to the donee & no income to the recipient

• but note: gifts in excess of $10,000 per year by the same donee may be

▪ Duberstein – donor’s characterization of his action is not determinative of whether something is a gift → there must be an objective inquiry as to whether it really is a gift

• led to the adoption of §83

▪ From employer to employee – NOT treated as a gift

▪ Business gift - §274(b) allows deduction of the first $25 of the gift as an ordinary & necessary business expense

• If business motivation strong enough → not a gift → transferee required to treat value of item received as an addition to AGI

▪ Application:

• ordinary tips – includable as income (payable for services rendered)

• surviving spouses – payments by corporations, limited by $25 gift deduction

• prizes, awards, scholarships - limited exclusion for that portion of the scholarship that is required to be used for tuition, fees, books, and supplies and the equipment required of the courses

• Bequest – the act of giving property by will is excluded from income and not taxable (§102)

• Welfare – traditional welfare payments not taxable §61

• Unemployment – not taxable §85

• Social Security – depends on TP’s AGI

• Alimony –are deductible by the payor and taxable to the recipient

• Child Support & Property Settlement – not deductible by the payor and not income to the payee

o Intervivos Transfers of Unrealized Gain By Gift [p. 95-99; §1001, §1011, §1012, §1015]

▪ Concept of Basis: Amount Realized – Basis = Gain (Loss)

• Basis = the amount that the TP has invested in the property already; what the taxpayer paid – taxed dollars

o this way, when the property is transferred we have some way of determining the portion of it that is income

• Amount Realized = what TP gets in the transaction; FMV of all stuff received

• Income = the gain (or loss)

▪ Taft v. Bowers – gifts given during life (intervivos) = income to the donee

o Transfers At Death [p. 99-101, §1014]

▪ AKA Inherited Property

▪ The basis of property acquired by reason of death is the FMV on date of death §1014

• [or optional valuation date 6 months after death §2032]

• effect = basis is “stepped up” or “stepped down” from decedent’s basis to the value at the time of death

▪ §1014 encourages people to hold on to appreciated property (can also borrow against the appreciation & loans are NOT recognized as a gain)

o Gifts Of Divided Interests [p. 103-105]

▪ Irwin v. Gavit – income consequences of transfers made under a trust = all basis goes to the principal and none is allocated to the interest

• when interest is split from the gift itself, the basis goes w/the property (whoever is getting the property can exclude that from income)

• the person getting the interest must include w/income

• Recovery Of Capital

o Capital Gains [p. 25]

▪ Capital Gain – gain from the sale or exchange of a “capital asset” [i.e. property, other than inventory]

• generally asset held at least in part for its appreciation in value

• ex: stock, real estate, collectibles

• Normally taxed lower than other forms of income

• short term – gain on the sale of a capital asset held for 1 year or less

• long term – gain from the sale of an asset held for more than 1 year

• ex: most forms of dividend income treated as capital gain

▪ Capital Losses – loss from the sale or exchange of a capital asset

• can be used only to set off capital gain (except individuals may use up to $3000 to offset ordinary income)

o Basis [p. 105-109, Reg. §1.61-6(a)]

▪ Inaja Land – apportionment of easement land is impossible ϖ all of the capital is recovered and there is no income

▪ Today: we need to allocate basis adequately – TP has to figure out how to allocate

o Annuities and Pensions [p. 115-119; §72]

▪ traditional annuity = K requiring payment of a specified amount at specified regular intervals, often for the lifetime of the person entitled to the payments (annuitant)

▪ three possible payment schemes

• (1) investment first – treat each payment as a tax free recovery of capital until the entire investment is recovered, then treat all payments as income

o today: allowed only for unsecured promises by individuals to pay

• (2) income first – all payments could be treated as income to the extent of any income set aside for the policyholder by the insurance company in its reserves

o thus, early payments would be largely income → as time passed → more and more of each payment would be a recovery of capital

• (3) §72 – requires calculation of “exclusion ratio” (the investment in the K divided by the expected return)

o this ratio is applied to every payment received

▪ Deferred Annuities – favorable to taxpayers b/c the value of the annuities investment increases each year as the payment dates approach, but tax on that increase is deferred until the payments are received

▪ Pensions – same as annuities except the exclusion for one’s investment (basis) is determined by a simplified method under which the investment in the K is divided by the # of anticipated payments

• amounts contributed toward the pension by the employer are not treated at the time of the contribution as income of the employee for purposes of §72(b) exclusion ration

▪ Variable Annuities – payments to the annuitant depend on the investment experience of a segregated assets account held by the company for such policyholders

o Gains and Losses from Gambling [p. 120-121]

▪ ALL gains are taxable BUT losses (both professional and amateur) are deductible only to the extent of gains from the same taxable year §165(d)

• no carryover provision for losses

▪ Policy: personal consumption – this is not a purely financial transaction, it is a form of entertainment

o Recovery of Loss [p. 20-21, 121-126; §165]

▪ Clark - Clark goes to a tax lawyer who tells them to file joint return for 1932.

• IRS finds deficiency of $34,000 (if they had not followed advice and filed separately, would have saved $19K)

• Lawyer gives them that amount to make up for his error & they don’t report it on their tax return

• Court holds that the payment was NOT income b/c it was a payment to make him whole

• Recoveries for Personal and Business Injuries [Raytheon , Murphy; p. 141-45; §104, §105; Reg. §1.104-1]

o Basic Rule:

▪ Company – damage awards for lost profits are taxed in the year received

• punitive damages are also taxed

▪ Individual – awards are tax free if attributed to personal injury

• but does not extent to punitive damages

• §1033 allows TP to defer tax provided the amount is reinvested in similar use

o Raytheon – antitrust suit against RCA for making radio set repair licensees buy their tubing

▪ recovery of lost profits IS income

▪ Recovery of injury to goodwill is NOT income [recovery is return of capital]

• BUT compensation for loss of goodwill in excess of its cost is income

o Murphy v. U.S. – damages received for personal injury lawsuit are income

▪ Non-physical personal injuries – settlement payments for damages suffered (sexual harassment in this case) should not be taxable & are excludable from income under §104(a)(2)

▪ Income under §61 does not include the amount of any damages received (other than punitive), on account of personal physical injuries or physical sickness (also, emotional isn’t physical)

• Transactions Involving Loans and Discharge From Indebtedness

o Loan Proceeds [pp. 145-146]

▪ loan proceeds are NOT income

• because loans are not an accession to wealth based on the assumption that the loan will be repaid (just an exchange of assets)

• this is true no matter what the use of the loan, and whether it is recourse or nonrecourse

▪ recourse vs. nonrecourse loans

• only affect taxpayer behavior

• recourse = personal liability

• nonrecourse = no personal liability

o security, only thing pledged to the property is security; the only property is typically the loan proceeds

o True Discharge of Indebtedness [pp. 146-149; §61(a)(12)]

▪ Rule: Income results from the discharge of indebtedness b/c the TP has received more than is paid back [Kirby Lumber]

▪ Kirby Lumber – Kirby issues 12M in corporate bonds, borrow money from bond holders and purchase back 1M in face value of bonds for less than the face value b/c concern of nonpayment/interest rate went up

• Court holds that the difference between the amount they originally borrowed and the amount they actually had to pay back equaled income from the discharge of indebtedness

o Relief Provisions [pp. 149-150; §108]

▪ A person is not required to report all of discharge of debt because of insolvency (§108)

• This will come into play later, however, when they are no longer insolvent.

• → It is a deferral provision rather than an excusal provision

▪ Solvent Farmers – relief under §108 for insolvent debtors is also available when debt is incurred by operation of farm during 3 proceeding years, and they derived more than 50% of annual gross receipts from farming

▪ Purchase money debt – the reduction of debt incurred to purchase property and owed to the seller is treated as a reduction in sale price, rather than income to the purchaser

▪ Student Loan Forgiveness – excludes from income any cancelation or repayment of a student loan, provided they are contingent upon work for a charitable or educational institution

o Misconceived Discharge Theory [pp. 150-163, §1011(b); Reg. §1.1001-1(e)]

▪ Zarin – held that settlement of gambling debt by casino was taxable (not a discharge of indebtedness b/c the taxpayer wasn’t liable and gambling chips aren’t property)

• Note: if gambling chips were property, this would have been discharge of indebtedness under §108(e)(5)

▪ Diedrich - ∏s had kids pay the tax on gift given to them = discharge of indebtedness

• Court holds that a donor who makes a gift of property on condition that the donee pay the resulting gift taxes realizes taxable income to the extent that the gift taxes paid by the donee exceed the donor’s adjusted basis in the property

o Transfer of Property Subject to Debt [p. 28-29, 163-180; Reg. §1.1001-2(a)]

▪ Depreciation = deduction to account for the expected decline in value of a wasting asset used to generate income

• wasting asset = due to wear and tear or obsolescence

• only permitted on asset used to generate income, for business or investment

▪ Crane – TP inherits property subject to mortgage that was the same amount of the property’s FMV at the time → TP owns property for 6 years and takes the $25.5K deductions → ultimately sells for $2,500 with assumption of the loan

• Court holds that TP’s basis was not zero b/c she was taking deductions

• Rule: Loan proceeds are treated the same as cash for purposes of determining basis

▪ Tufts – nonrecourse debt in excess of the property’s FMV

• hold that the TP must recognize income upon the disposition of the building

• Note: O’Connor’s concurrence

o bifurcation approach = separate into two separate events (1) a sale of property and (2) a discharge of debt

• Illegal Income [pp. 180-185]

o Illegal income IS taxable income

o Business Expenses related to illegal operation/professions are deductible

▪ exceptions: expenses related to distribution of illegal drugs & payments such as bribes or kickbacks are not deductible

o Gilbert - embezzled funds can constitute taxable income to the embezzler, but if you repay the money in the taxable year you won’t be taxed on it

III. Problems of Timing

• Timing: why do you want to defer your payments?

o time value of money – want to put your money to work (invest) and spend it later

▪ if you invest “before tax” dollars you have more money to invest

o deferrals, such as deferred compensation/401K’s are attractive b/c earnings on before-tax dollars are not immediately taxed

• Gains and Losses From Investment in Property

o Realization Requirement [p. 27-28, 193-94, 213-224; §109, §165(a); Reg. §1.61-8(c), §1.165-1(a)]

▪ 3 Steps to include a gain from property in income

• (1) there has to be income in an economic sense

• (2) there generally must be a realization

• (3) the item can’t qualify for non-recognition

▪ Cottage Savings & Loan

• Issue: whether a financial services institution realizes a tax-deductible loss when it exchanges its interests in one group of residential mortgages for another group

• Test for realization: to realize a gain or loss in the value of property, the taxpayer must engage in a “sale or other disposition of the property”

o → an exchange of property gives rise to realization if the properties exchanged are “materially different” [i.e. when their respective possessors enjoy legal entitlements that = different in kind of extent]

• Hold – the mortgage swap does give rise to realized losses

▪ Reg. 1.1001-d - whether a “significant modification” has occurred in yield, timing, or amounts of payment, the obligor, or the nature of the instrument”

• a significant modification results in an exchange for both the debtor and holder of the debt

▪ Exception: depreciation allowance for expected decline in value of an asset that’s used in a trade or business

o Gain on the Sale of a Home [p. 190-191] (start here – insert above “express nonrecognition provisions”)

▪ §121 excludes from income certain gain on the sale or exchange of a home

• Requirement: TP must have owned the home & used it as a principal residence for at least 2 years over the 5-year period ending on the date the TP sold it

• Restriction: Only allowed to do this 1x every 2 years

o Exception: if change = by reason of change in place of employment, health, or unforeseen circumstances [§121(c)(2)(B)]

• Benefit: can generally exclude $250K from income ($500K for married TP’s)

▪ → rule designed to help empty nesters who sold homes and bought smaller ones

o Express Nonrecognition Provisions [p. 224-26, 231; §121, §1031, §1033; Reg. 1.1031(a)-1]

▪ §1031 – applies to exchanges of certain business or investment property (but not stocks or bonds) that are held to be of “like kind”

• Rule: no gain is recognized on like-kind exchanges (includes when TP receives like-kind property and boot)

▪ Creates an unintended tax incentive for TP’s to sell assets that are worth less than the assets basis [see Cottage Savings]

• creates a “lock-in” or tax disincentive to sell → makes no sense economically

▪ Effect of not being recognized is basically the same as not being realized

• → the underlying gain or loss remains subject to taxation in the future upon the occurrence of a realization event

▪ Involuntary Conversions §1033

• §1033 – provides for nonrecognition where property is compulsorily or involuntarily converted (i.e. theft, destruction, condemnation) and is replaced with property that is “similar or related in service or use”

• nonrecognition of gain is mandatory when there is a direct conversion

• nonrecognition is optional when TP receives cash & buys replacement property

• note: replacement must generally occur w/in 2 years

▪ Other nonrecognition provisions found in §§1036-1042, §721

o Boot and Basis [p. 231-233]

▪ Boot = money and property other than money that, under provisions like §1031, is transferred as part of the like-kind exchange but is not like-kind property

• A transfer of boot will affect basis & may result in recognition of gain

• Ex: A farmer exchanges one farm for another farm and receives cash and a tractor “to boot”

o the amount of money + the value of the tractor = the boot

o the amount of gain recognized is the lesser of the amount of gain realized (farm) or the amount of the boot [§1031(c)]

▪ if there is no gain, the boot is not taxable and the gain is recognized to the extent of the boot

▪ Basis:

• Basis of property received in a like-kind exchange (§1031) = a “substituted basis” [i.e. basis of property received will be the same as the basis of the property relinquished]

▪ Calculation of basis when there is a boot:

• (1) Follow directions set forth in §1031(d) mechanically; or

• (2) Follow these steps…

o 1. IF simple exchange of like-kind properties (no boot)

▪ → the property first received must take on the basis of the property relinquished

▪ → When the property is ultimately disposed of, any previously unrealized gain or loss will be recognized

o 2. IF gain is recognized b/c of boot

▪ → basis must be increased in the amount recognized so the gain will not be taxed again

▪ → the basis of the like-kind property received + the basis of the boot must = the basis of the original property + the amount of gain recognized

o 3. Of the total basis calculated, a portion equal to the FMV of the boot must be allocated to that boot, w/the remainder being allocated to the like-kind property received

o 4. IF boot is paid rather than received → the amount of the boot is added to basis

▪ Formula: A + B = C

• A = original basis

• B = amount of gain recognized

• C = total basis (to be allocated between the like-kind property received and the boot)

▪ Formula: C – D = E

• D = (FMV of the boot)

• E = the new or substituted basis of the like-kind property received

▪ IF there is no boot

• → the like-kind property received will have the same basis as the property surrendered (E=A)

▪ IF there is boot

• → 1st, increase the original basis by the amount of gain recognized to determine the total basis to be allocated (A+B=C)

• → 2nd, the boot receives a basis equal to its FMV (D)

o The basis left for the like-kind property received (E) is equal to (C – total basis) reduced by (D - the basis allocated to the boot) ( E = C - D

▪ IF gain recognized = the amount of the boot (i.e. if B=D)

• → Then the basis of the like-kind property received is the basis of the like-kind property surrendered

• Recognition of Losses [p. 237-241]

o Note: when costs are capitalized, there is no current deduction for those costs and instead the TP keeps track of them in a capital account

▪ here, the capitalized cost (i.e. basis) is taken into account only on disposition

o Rev. Rul. 84-145

▪ Issue: whether domestic commercial air carrier sustained a deductible loss under §165(a) because of a devaluation of its route authorities

▪ Law:

• §165(a) – provides that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated otherwise

• Reg. 1.165-1(d) – provides that to be allowable as a deduction under §165(a) the loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained during the taxable year (i.e. only a bona fide loss is allowed)

▪ Analysis:

• Although the value of its routes were substantially reduced under the Deregulation Act, the mere diminution in value of the operating rights does not constitute the elimination or abandonment of a completely worthless asset

• Also, there was no closed and completed transaction fixed by identifiable events b/c the taxpayer’s operating rights remained unchanged even though more competition was introduced

▪ Holding: TP did not sustain a deductible loss of its capitalized cost under §165(a) because of the devaluation of its route

o Constructive sales/Short sales

▪ “short” the stock = a TP who borrows stock and then sells the borrowed stock

▪ “short against the box” = a TP holds stock and then borrows and sells the identical stock

▪ §1259 – sale of borrowed stock treated as sale

• applies specifically to short sales against the box

• a TP who holds an appreciated financial position and then substantially eliminates all risk of future gain or loss w/respect to the property is treated as if she had sold the property

• Annual Accounting and its Consequences

o Annual accounting principle – income measured on an annual basis

▪ for most TPs it’s the calendar year, but doesn’t have to be

o The Use of Hindsight [p. 126-131; §172, §441; Reg. §1.165-1(d)]

▪ Burnet v. Sanford & Brooks – S&B dredging the DE River for 3 years and suffered negative income (losses) – sued the gov’t to recover and received $176 settlement

• IRS said they had to include this in their income, but S&B argued it was unfair because it was not income, but recovering from losses in prior years

• Court said annual accounting principle prevails, no matter how unfair it may seem to the TP therefore the $176K settlement was income in the year received

• Aftermath: Congress enacted §172 (for Net Operating Loss carryovers) which mitigates the harshness of annual accounting

o the losses that may be carried over (forward or back) to another year are primarily losses incurred in a trade or business

o Claim Of Right [p. 131-138; §1341]

▪ General Rule: TP includes something in income in an earlier year and then has an offsetting deduction (note: more valuable than a credit under §1341) in a later year when the income is lost

▪ North American Oil v. Burnet – if TP receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to report on his tax returns, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent

▪ US v. Lewis – TP given larger bonus than he was supposed to receive, paid taxes on that larger amount, and then has to return portion of the bonus

• Court concludes that income taxes must be paid on income received, there is no exception just because the TP was mistaken – no refund allowed

▪ §1341 enacted in reaction

• provides that if the deduction exceeds $3K the tax is the lesser of the amount determined by claiming a deduction in the ordinary manner or by forgoing a deduction and claiming a credit in the year of repayment for the tax that would have been saved by excluding the item in the earlier year

• If the TP’s tax bracket is lower in the year of inclusion than in the year of repayment, §1341 allows the TP to deduct the amount repaid in the year of repayment, despite the fact that the deduction saves the TP more than he paid in tax

• IRS has ruled that restorations do not qualify under §1341 if based on “mere errors” such as arithmetic errors or on ‘subsequent events’ such as a refund pursuant to a contract right

▪ Note: Amended Returns

• used to claim refunds of overpayments in earlier years

• such returns may be filed only to correct mistakes about facts that were or reasonably should have been known before the end of the earlier year

o Tax Benefit Rule [p. 138-141; §111]

▪ Involves situations in which the TP claims a deduction in an earlier year, and then in a later year the deducted amount is in some sense recovered or regained

▪ Inclusionary Rule:

• requires the TP to include an item in income

• triggers an inclusion whenever an event occurs that is fundamentally inconsistent with a tax benefit recognized in an earlier year

• ex: Alice Phelan Sullivan Corp – 20 years later, the charity decided not to us the property and returned it to the TP → recovery was held to generate taxable income in the amount of the earlier deduction

▪ Exclusionary Rule:

• permits the TP to exclude an item that would otherwise be included in income under the inclusionary rule

• §111(a) permits a TP to exclude the recovered item in the later year to the extent that it did not reduce the TP’s liability in the earlier year

• Constructive Receipt and related doctrines

o Introduction To Accounting Methods [p. 25-27; §446; Reg. §1.446-1(c)(1)]

▪ Cash Method – amounts are treated as income when received in cash (or cash equivalent) and are deductible when paid

• Capital Costs – limitation on the cash method

o the costs of capital investments may not be deducted when the cash outlay is made, but only as the asset is used or when it is sold, exchanged, or abandoned

o a portion is deducted each year – annual deduction = depreciation of ACRS (accelerated cost recovery system)

• Constructive Receipt – another limitation

o a right to payment is treated as if received when the TP had an unrestricted right to receive cash, even if cash was not in fact taken

• Cash Equivalence & Economic Benefit – another limitation

o people are treated as if they had received cash when they receive valuable property or rights

o ex: computer = cash equivalent or economic benefit

▪ Accrual Method – items included in gross income when earned, regardless of whether payment has been received (used by most businesses)

▪ Annual Accounting – tax liabilities computed on an annual basis

• each year must be closed out for tax accounting purposes at the end of theyear on the basis of the information available at that time

▪ §446 – if not method of accounting has been regularly used by the TP, or if the method used does not clearly reflect his income, the computation of taxable income shall be made under such methods as does correctly reflect his income

o Constructive Receipt and Economic Benefit [p. 253-259; §451; Reg. 1.451-1(a), Reg. 1.451-2]

▪ Constructive Receipt results in taxation of amounts that are set aside or available

• i.e. amounts to which the TP has a legal claim → not amounts which would have been available if the TP had made some other deal

• Amend – K for sale of wheat produced/harvested in 1944 & sold for 1945

o Rule: income is received or realized when it is made subject to the will and control of the TP and can be reduced to actual possession

▪ a cash basis TP cannot be deemed to have realized income at the time promise to pay in the future is made

o Thus, constructive receipt doesn’t apply & TP reports income in 1945

▪ Economic Benefit Theory – an individual on the cash receipts and disbursements method of accounting is currently taxable on the economic and financial benefit derived from the absolute right of income in the form of a fund which has been irrevocably set aside for him in trust and is beyond the reach of the payor’s creditors

• Pulsifer – court rules that petitioners had an absolute, nonforfeitable right to their winnings on deposit w/the Irish court and all that was needed to receive it was for their legal representative to apply for the funds, which he did

o Hold that the Economic benefit theory applies and they recognized the prize money when the Irish court created the account

o Deferred Compensation [p. 268-274; §83]

▪ Rule: contributions to a deferred compensation are not currently taxable

▪ Nonqualified plans – essentially no limit on the amount of current compensation that can be deferred to and become taxable in future years

• generally used for senior corporate executives and high-income individuals

▪ Qualified plans – generally must be made available to all employees and are limited to the amounts that can be deferred

▪ Employer’s mere “promise to pay” some amount of compensation in the future….

• employee is not taxed currently by virtue of this promise

▪ Where money is set aside in a trust/escrow account for the benefit of the employee, out of control of the employer…

• the employee is taxed at the time when the money is paid by the employer

▪ Minor – physician’s deferred compensation plan

• Court concludes that the trust arrangement was an unfunded plan that does not confer a present taxable economic benefit

o additionally, the plan was unsecured and subject to a risk of forfeiture

o therefore there was no constructive receipt

▪ Note: the attractiveness of the deferred comp plan is limited by the fact that the employer will not receive a deduction for the amount to be paid in the future until the year in which the employee recognizes income

• if parties in same tax bracket – disadvantage to employer

• if employer in lower tax bracket – can be advantageous

▪ Professional Sports teams

• employees of this kind of organization may find it advantageous to defer unlimited amounts of income, so long as the deferred agreement meets the guidelines of Minor

▪ §409A – codifies rules re: deferred compensation

• provides that amounts payable in the future are taxable, when bargained for, IF the plan allows employers financial health or provides that upon deterioration of the employer’s financial health, assets are shielded from outside creditors

• applies to grants of restricted stock and stock options

• does not apply to qualified deferred compensation plans

o Qualified Employee Plans [p. 282-286]

▪ (1) Defined Benefit plans – employer provides fixed retirement benefits to employee

▪ (2) Defined Contribution plans – employer’s contribution is fixed by a formula, amt employee gets depends on investment return earned by the contribution

▪ Tax planning – Two choices

• (1) Nonqualified plans (those not covered by special statutory rules)

o Taxable to employees under:

▪ §83

▪ Doctrine of constructive receipt

▪ Economic benefit

o Employer’s deduction is not allowed until benefit is taxable to the employee (§83(h))

• (2) Qualified pension, profit-sharing, or stock bonus plans (Better choice for taxpayer)

o Amts paid into the plan are NOT taxed to employees who are entitled to future benefits

▪ Taxed only when they actually receive payments on retirement

▪ Under 401(k), employees are not taxable on amts up to $11K/yr set aside for retirement (rising to $15K in 2006) even if they had the option to take cash

o Employers get an immediate deduction for amts paid into the plan

o Earnings on funds paid into the plan and invested by it are NOT taxed

o Employers are allowed to provide Roth 401(k) plans

▪ The employee is taxed on amts paid into the retirement fund by the employer, but distributions are tax free

▪ Antidiscrimination rules - prohibit discrim in favor of highly paid employees (

• Requires that qualified plans must provide reasonably comparable benefits to all employees

▪ Individuals

• Self-employed may set up qualified plan ( IRA

o Income earned is NOT taxed as long as it is accumulated

o Amts paid in are deductible

o Amts ultimately w/drawn as retirements benefits = included in income

• Roth IRA

o Individuals filing a joint return w/ income less than $150K (§408A)

o Nondeductible but no annual tax on income earned and “qualified distributions” = tax free

▪ “qualified distribution” – distribution that takes place more than 5yrs after the yr of contribution and made after age 59.5, after contributor becomes disabled or dies, or is made for higher education or first time home buyer expenses up to $10K

o More advantageous than IRA for taxpayers who wish to save for college or first time home purchases, or who are in a lower tax bracket

o §530 - tax exempt education IRAs

▪ contributions = nondeductible, cannot be more than $500/yr. and must be made before beneficiary reaches 18

▪ Penalty for early w/draw - Amts w/drawn before age 59.5 = 10% penalty + includible in gross income (§72(t))

• Does not apply is employer has retired after age 55, had died or become disabled, or if distrib = 1 of a series of periodic payments, or does not exceed deductible medical expenses, etc

• Does not apply for educational expenses

• Does not apply up to $10K of first time home purchases

▪ Mandatory distributions - Qualified plans are subject to rules specifying min distributions. Generally must begin in the yr employee reaches age 70.5

▪ Limitations on contributions and benefits - Max benefit may not exceed $160K (§415)

o Stock Options, Restricted Property, & Other Employee Comp. [p. 286-301; §422; Reg. 1.83-7(b)]

▪ “Compensatory” or “Employee” stock options - A stock option gives the employee the right to buy stock of the employer at a specified price

▪ Employee IS taxed on employee stock options received (Commissioner v. LoBue (1956)) where LoBue received a substantial econ and financial benefit from his employer…‘compensation for personal service’ under §61(a))

▪ Taxation of employee stock options - 3 main approaches (the IRS utilizes all 3 in different circumstances)

• (1) Income upon receipt of the option

• (2) Income upon exercise of the option

• (3) Gain recognized upon sale of the stock

▪ Statutory rules for determining tax treatment of employee stock options

• §422 – “incentive stock option” (ISOs) an employee stock option that meets specified reqs set forth in §422

o Applies the 3rd approach (capital gain upon sale of stock)

• §83 – tax treatment of the grant and exercise of a stock option depends on whether the option has a readily ascertainable fmv

o applies 1st and 2nd approach

▪ Nonstatutory Stock Options – those that fail to meet the terms of §422

• Under §83, if property is transferred to a person as compensation for services ( tax consequences:

o (1) Income upon receipt of the option

▪ (a) Mandatory includability – if the option has a “readily ascertainable fmv” it must be included in the income of the employee (and may be deducted by the employer) §83(a)

• The fmv is not includable if the option is (a) nontransferable and (b) subject to a “substantial risk of forfeiture” §83(a)(2)

▪ (b) Elective includability §83(b)

▪ (c) Prereq to both mandatory and elective includability §83(e)(3)

• §83 applies to the grant of an option w/ a readily ascertainable fmv, but does not apply to the grant of an option that does not have a readily ascertainable fmv

o (2) Income subsequent to receipt of the option

▪ (a) income when the option becomes nonforfeitable or transferable

▪ (b) income upon exercise of the option

▪ Cramer -

• Issue: Whether, at the time of the original transfer, the options had a “readily ascertainable fmv,” w/in the meaning of §83(e)(3)

• Rule: Reg. 1.83-7 provides that the value of an option is generally not ascertainable unless the option is actively traded on an established securities market. An option not traded on the market does not have a “readily ascertainable fmv” when granted, unless the taxpayer can show that all of the following conditions exist:

o i. option is transferable by the optionee;

o ii. Option is exercisable immediately in full by the optionee;

o iii. Option or property subject to the option is not subject tot any restriction or condition…which has a significant effect upon the fmv; and

o iv. Fmv of the option is readily ascertainable in accordance w/ (b)(3)

IV. Income Splitting and the Taxation of the Family

• Income from Services [p. 599-610] – attempt to shift personal service income

o Rule: Personal service income is taxed to the person who performs the service and cannot be shifted to a lower bracket taxpayer

▪ Lucas v. Earl – assignment to taxpayer’s wife of ½ of the taxpayer’s income did not shift that income to his wife

• Fruit and tree metaphor: “No distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew”

o Personal service income cannot be shifted except by the performance of gratuitous services

▪ Gratuitous performance of services for charities - Donated services to charitable and political orgs are treated as untaxed imputed income even if the org sells the services to the public and the value of the services is easy to ascertain

o Diversion by Operation of Law

▪ Poe v. Seaborn - H and W were entitled to file separate tax returns, each treating ½ of the community income as his or her respective income (community property state).

• Transfers of Property and Income From Property [p. 618-626]

o Rule: Income from property can be shifted provided there is a complete transfer of the income-producing property, and the donee does not receive a carved-out right

▪ Horizontal interest – an interest in property that is coterminous (extends as far) in time w/ donor’s interest

• Blair – taxpayer had a limited interest (a life estate) but gave away a portion for its entire duration (i.e. part of the income for his life), a gift of a horizontal interest in property, shifts the income from that interest to the donee.

▪ Carved-out right – a gift of property that is not coterminous, but reverts back to the donor

• Helvering v. Horst - Taxpayer owned the entire property (a bond), and gave away a limited interest (the interest income for a brief period of time); he gave away what has come to be called a “carved out” income interest, which does not shift income to the donee.

• Transfers Incident To Marriage [p. 301-307; §1041]

o Property Settlements

▪ U.S. v. Davis – the Supreme Court held that a transfer of appreciated property incident to a divorce was a realization event to the transferor.

• Does not apply to a transfer between divorcing spouses of property held as community property

• Overturned by statute

o §1041 – no gain or loss is recognized by either party on the transfer of property to (i) a spouse or (ii) a former spouse, provided that the transfer is incident to divorce

▪ transferee assumes transferor’s basis in the property

• May still apply to transfers of property in anticipation of marriage

• Applies to transfers of property between partners of same-sex partnerships

• Alimony, Child Support, and Property Settlements [p. 311-318; §71, §166, §215]

o Alimony (and separate maintenance) payments are taxable to the payee and deductible to the payor. (Above-the line deduction). §71

▪ (1) the payment must be in cash §71(a)

• §1041 – no gain or loss is recognized on certain transfers of property between spouse and former spouses

▪ (2) the payment must be received under an “instrument” of divorce or separate maintenance §§71(b)(1)(A), 71(b)(2)

• oral agreements not allowed

• unmarried coupled are not covered

▪ (3) parties must not have agreed that the payment will be nontaxable to the payee and nondeductible by the payor

▪ (4) parties must not be members of the same household §71(b)(1)(C)

▪ (5) payments cannot continue after the death of the payee spouse §71(d)(1)(D)

▪ (6) payments must not be for child support

▪ (7) only payments that are substantially equal for the first 3 yrs will be treated as alimony

• “Property settlements” - Payments that are “front loaded” (unequal, w/ larger amts in the 1st or 2nd yr.) re-characterized as property settlements

o Payments are initially treated as alimony but the excess amts are “recaptured” in the 3rd yr. “Recaptured” means that the payor must include the excess in income.

▪ Not taxable to the payee and is not deductible to the payor

o Child support is not taxable to the payee and is not deductible to the payor. §166

▪ Diez-Arguelles - Diez was divorced from her former husband, who failed to make full payment of his child support obligation. Diez treated the money owed as a non-business bad debt and deducted the amt from her gross income as a short-term capital loss.

• Rule: Under §166(d) a non-corporate taxpayer may deduct non-business bad debts as a short term capital loss in the year such debts become completely worthless

• Holding: The amts due Diez by Baxter for child support are not deductible under §166 as non-business bad debts is sustained.

V. Personal Deductions

• Introduction [p. 22-24, 339-342; §67, §68(a)-(d), §162(a), §262(a)]

o Personal deductions are those that have nothing to do w/ the production of income

o Personal deductions are subtracted from AGI in determining taxable income

▪ A taxpayer may take either:

• (i) Itemized personal deductions - §67(b):

o Casualty losses

o Medical expenses

o Charitable donations

o Interest (e.g. Home mortgage interest)

o State and local taxes

o Alimony

o Note: Itemized deductions, other than the ones listed in §67(b), are allowed only to the extent they exceed 2% of AGI

o §68 imposes an overall limitation for taxpayers w/ AGI above a certain threshold amt

▪ Deductions will be reduced by 3% of the excess of adjusted gross income over the threshold amt

• The loss cannot exceed 80% of the otherwise allowable itemized deductions

• (ii) Standard deduction - §63(b)”

o Amts are adjusted annually for inflation

o Generates a larger deduction than would itemized deductions

• Casualty Losses [p. 342-345, 352-355; §165; Reg. §1.165-7]

o §165(c)(3) – deduction for losses of “property not connected with a trade or transaction entered into for profit” from “fire, storm, shipwreck, or other casualty, or from theft.”

▪ Taxpayer may deduct casualty losses to the extent that the aggregate losses during the taxable yr > 10% of AGI, after reducing each loss by $100. §165(h)

▪ Casualty loss deduction is permitted only to the extent that the loss is not reimbursed by insurance or otherwise. §165(a)

▪ The deduction is permitted in the taxable yr in which the loss occurs or, in the case of theft, in the taxable yr. in which the taxpayer discovers the loss. §165(e)

o IRS definition = only an event that is “sudden, unexpected, and unusual” qualifies as a casualty. Rev. Rul. 63-232

▪ Dyer – taxpayers claimed a casualty loss deduction of $100 for damages to a vase broken by their cat. Court denied the deduction b/c breakage of a household good by a family pet is noo unexpected.

▪ The IRS has ruled that termite damage is not deductible b/c scientific data establishes that is does not occur “w/ the suddenness comparable to that caused by fire, storm or shipwreck.” Rev. Rul. 63-232

• Similarly, a deduction has been denied for dry rot

o A taxpayer may take a casualty loss deduction for property destroyed due to a taxpayer’s negligence. A casualty loss is not allowed if the loss is caused by gross negligence or a willful act by the taxpayer

▪ Blackman – taxpayer was denied a casualty loss deduction for his destroyed home b/c his gross negligence in failing to put out the fire he started

• Extraordinary Medical Expenses [p. 356-365; §213]

o §213(a) – medical expenses are deductible to the extent that they exceed 7.5% of AGI

▪ Note: Medical benefits provided by an employer are fully excluded from an employee’s income §§105 and 106

o What is medical care? §213(d)

▪ Amts paid for the “diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purposes of affecting any structure or function of the body.”

• Taylor – Taxpayer was unable to carry his burden of proof est. that lawn care expenses incurred due to an allergy and Dr.’s instructions not to mow the lawn was a medical expense.

o Amts spent on property investments for medical purposes are deductible only to the extent that the cost of the improvement exceeds the increase in value of the property – Ex. Taxpayer, on the advice of his Dr. installs a pool for $50K that adds $40K to value of his home ( taxpayer’s medical expense deduction = $10K (Note: if taxpayer has access to nearby pool deduction will not be allowed or if pool built is extravagant, can only deduct average cost of home pool from average increase in value)

▪ Note: Certain improvements made to accommodate a sick/impaired member of the household do not improve the value of the residence, e.g. ramps, etc.

o Deductible medical expense also include the costs of medical insurance, hospital lodging, and transportation incurred “primarily for and essential to medical care.”

o Deductions for cosmetic surgery are now limited under §213(d)(9)

o Depreciation IS NOT deductible as a medical expense under §213

▪ Henderson – Taxpayers’ son was confined to a wheel chair and purchased a van and installed a lift to transport son. Depreciated the cost of the van and lift. Depreciation is not an “expense paid” or “amount paid” w/in the meaning of §213.

o Ochs – taxpayer’s wife diagnosed w/ cancer. Placed children in boarding school so wife could improve. Taxpayer deducted the cost of boarding school as a medical expense.

▪ The expenses incurred by the taxpayer were nondeductible family expenses under §262 rather than medical expenses. However, dissent felt that this man’s expense fell w/in the category of “mitigation, treatment, or prevention of disease” and the deduction should have been allowed.

• Charitable Contributions [p. 366-368, 372-383; §170]

o Individuals and corporations may claim, as an itemized deduction, any “charitable contribution…payment of which is made w/in the taxable year.” §170(a)(1)

▪ Allowable deductions for individuals for gifts made to churches, educational orgs, medical institutions, and certain publicly supported orgs, as list in (b)(1), are limited to 50% of the taxpayer’s “contribution base” (generally AGI)

▪ Contributions to other orgs, the allowable deductions for individuals are limited to a max 30% of AGI

o Charitable contribution defined under §170(c): Includes U.S. and any political subdivisions, orgs that are “org and operated exclusively for religious, charitable, scientific, literary, or educational purposes.”

o Deduction for full amt contributed is allowed only if the donor receives no substantial benefit from the contribution

▪ If the donor receives a substantial benefit, the donor’s contribution is reduced by the benefit received. (e.g. fundraiser dinner tickets for $300, value of dinner = $50, deduction = $250)

o Collegiate Athletics

▪ §170(l) – where a donor makes a contribution to a college or university and the contribution gives the donor the right to buy preferred seating tickets for athletic events at school, the donor’s deduction is limited to 80% of the contribution

o Religious Benefits and Services

▪ “pew rents, building fund assessments, and periodic dues paid to a church…are all methods of making contributions to the church, and such payments are deductible as charitable contributions...”

VI. Deductions for Mixed Business and Personal Expenses [p. 401-403]

• Two ways to claim deductions for expenses that may be thought of as the cost of generating income:

o (1) §162(a) – the deduction for the “ordinary and necessary expenses paid or incurred…in carrying on any trade or business.”

o (2) §212 – covers the expenses of generating income from sources other than a trade of business

• Limitations

o §262 - “no deduction shall be allowed for personal, living, or family expenses.”

o §67 - certain so called “itemized” deductions are allowable only to the extent that in the aggregate they exceed 2% of AGI

• Hobby Losses [p. 403-411, §183(b)(2)]

o §183 - Losses generated by such “hobby” businesses: Distinguishes between activities that are “not engaged for profit,” and activities that are:

▪ §183(c) - An activity not engaged in for profit is any activity other than one w/ respect to which deductions are allowable under §162 (ordinary and necessary business expenses) or under §212 (expenses related to the production income)

• Nickerson – The court concluded, after weighing factors, that taxpayer’s farming activity was engaged in for profit. Taxpayers “need only prove their sincerity rather than their realism” in making a profit (intent)

o Factors from Nickerson case (not dispositive) Reg. §1.183-2(b)

▪ Manner in which taxpayer carries on the activity

▪ Expertise of the taxpayer

▪ Time and effort expended by the taxpayer in carrying on the activity

▪ Expectation that assets may appreciate

▪ Success of taxpayer carrying on similar activities

▪ History of income or losses

• §183(d) – presumption that if your gross income exceeds the deductions in last 3/5 years then you are presumed to have engaged in it for profit

o Burden is w/the taxpayer

▪ Amount of occasional profits

▪ Financial status of the taxpayer

▪ Elements of personal pleasure or recreation

• Home Offices and Vacation Homes [p. 411-419; §280A]

o §280A (a) An individual is not allowed a deduction for any use of a home for business purposes unless an exception under 280A applies

o Vacation Homes

▪ §280A applied to any “dwelling unit” used by the taxpayer for more than a specified amt of time - “14 days or 10% of the # of days during the yr. for which the unit is rented at a fmv.” (d)(1)

▪ If the unit is not used by the taxpayer for personal purposes at any time during the year, the taxpayer may deduct all expenses associated w/ the property, including depreciation, repairs, utilities, prop taxes, and interest.

▪ If the unit is used for personal purposes for more than the specified amt of time, but is rented our for less than 15 days, then the owner excludes the rental income and may not claim a deduction other than for interest and taxes (deductible under §163(h))

▪ If the unit is used for personal purposes for less than the specified amt of time, then §280A does not apply, but the deduction other than for taxes is allowed on a pro rate basis (comparing personal use and rental use)

• If a profit motive is lacking, the interest becomes “personal interest” which is not deductible

▪ If the unit is used for personal purposes for more than the specified amt of time, then expenses other than interest and taxes must still prorated, but the deduction cannot exceed the rent received, reduced by an allocable share of the interest and taxes

o Home Offices

▪ §280A(c)(1) allows a deduction for an office in the taxpayer’s home only where the taxpayer uses the home office exclusively on a regular basis:

• (A) as the principal place of business for any trade or business of the taxpayer;

• (B) as a place of business that is used by patients, clients or customers in meeting or dealing w/ the taxpayer in his business; or

• (C) in connection w/ the taxpayer’s business if the office is a separate structure not attached to the taxpayer’s home.

▪ If the taxpayer is an employee (opposed to being self-employed), he is allowed a home office deduction only if his use of the home office if for the “convenience of the employer” (

• If the employer does not provide the employee w/ an office at all or has not provided adequate office space in which the employee can effectively carry out employment duties

▪ Principal Place of Business

• Popov – a professional violinist who practiced in the living room of her apartment. The court reversed the tax court’s denial of a home office deduction

o Soliman Tests – standard for determining whether a home office is a “principal place of business” when taxpayer does not use the office for admin or managerial activities

▪ (1) Relative Importance of activities performed

▪ (2) Amt of time spent

• §280A(c)(1) provides that the term principal place of business includes the taxpayer’s home office if it is exclusively and regularly used to conduce substantial administrative or management activities for a trade or business of the taxpayer and the taxpayer does not conduce substantial admin or mgmt activities elsewhere.

• Income Unconnected to a Trade or Business [p. 419- 429]

o Must be engaged in a “trade or business” under §280A

▪ Moller – taxpayers deducted the expenses of the home office in which they worked full-time managing their investments. In determining whether taxpayers were engaged in a trade or business, court distinguished between “investing” and “trading”

• Trading = trade or business; Investing does not ( The court concluded that the Mollers were investors and thus were not engaged in a trade or business and could not deduct the expenses of their home office.

▪ Whitten - Issue: Proper characterization of expenses incurred by taxpayer in attending and participating in a game show

• Holding: Expenses were deductible as miscellaneous itemized deductions under §67

• Taxpayer could have argued: Trade/business – if he went to these shows all the time, bet on all sorts of things, and studied a lot for the show [i.e. professional game show player]

• Travel and Entertainment [p. 431-439, §274]

o §162(a) - Taxpayers are allowed to deduct the ordinary and necessary expenses incurred in carrying on a trade or business.

▪ §162(a)(2) allows a taxpayer to deduct travel expenses, including the costs of meals and lodging, if:

• (i) the travel expenses are reasonable and appropriate;

• (ii) the expenses are incurred while the taxpayer is away from home; and

• (iii) the expenses are motivated by the exigencies of the taxpayer’s business, not the taxpayer’s personal preferences

▪ Rudolph v. U.S. – taxpayer’s employer provided a trip to it employees and their wives. The IRS assessed the value of the trip as taxable income.

• Issue: Whether the purpose of the trip was related primarily to business or waa rather primarily personal in nature.

• Holding: Pleasure trip in nature of a vacation. Taxable to employee.

o Note: May deduct expenses for spouse if bona fide business purpose for the trip

o §274 - Entertainment expenses

▪ Allows taxpayers to deduct any cost of “any activity which is of a type generally considered to constitute entertainment, amusement , or recreation” only if the activity is “directly related” to business. §274(a)(1)(A)

• No deductions for entertainment intended to merely establish goodwill

▪ 50% limitation on meal/entertainment deduction - nondeductible personal expense §274(n)

▪ Expenses for the spouse - No deduction unless: §274 (m)(3)

• spouse is employee, and

• bona fide business purpose for the trip, and

• expenses otherwise deductible

▪ Substantiation requirements §274(d)

▪ Exceptions §274(e)

▪ Foreign Travel §274(c)

▪ Cruise/Foreign conventions §274(h)

▪ Deduction for entertainment tickets are limited to the face value of the tickets

• Deductions for luxury skyboxes generally are limited to the cost of seats in non-luxury boxes

▪ Dues paid to athletic, sporting or social clubs generally are not deductible

• Unless used primarily for the furtherance of the taxpayer’s trade or business, but no deduction may be taken for membership dues “in any club organized for business, pleasure, recreation, or other social purpose.”

• Business Lunches [p. 440-443]

o If a business meal deduction is not limited by §274, the deduction is limited under §162 if the expense of the meal does not appear to be an ordinary and necessary business expense

▪ Moss – a partner in a law firm was denied a §162 deduction for the expense of daily lunches at a restaurant where the taxpayer and other partners met to discuss/coordinate work.

o Remember: 50% limitation on meal/entertainment deduction - nondeductible personal expense §274(n)

▪ If employer reimburses an employee for such an expense, the employee may deduct the full expense, but the employer may deduct only 50% of the expense

▪ Does not include food expense that would be excludable as a de minimus fringe benefit under §132(e)

• Childcare Expenses [p. 456-459; §21]

o Smith – child-care costs of a two-earner couple were not deductible b/c child care expenses were inherently personal.

o Now, §21 – A taxpayer is allowed a credit for certain household and dependent care services incurred to enable the taxpayer to work.

▪ (a) if the taxpayer’s household included one or more “qualifying individuals,” the taxpayer is allowed a credit in the amt equal to the “applicable %” of the “employment-related expenses” the taxpayer paid during the taxable yr.

• “Qualifying individual” = dependent under age 13 or who is physically or mentally incapable of caring for himself

• “Employment related expense” = expenses incurred to enable the taxpayer to work

o Credit limited to: % of the amt spent for household services, up to $2,400 for one child and $4,800 for two+ children

▪ Declines as income rises

o §21(c)(2)(A) provides that “employment expenses” do not include costs of “a camp where the child stays overnight.”

o §129 – dependent care assistance

▪ allows employers to provide programs as part of one’s compensation, on a pre tax basis, for dependent care

▪ dependant care is reimbursed

▪ $5,000 may be applied on a pre tax basis

• Commuting and Moving Expenses [p. 459-475; §162, §217; Reg. §1.162-2(e)]

o Commuting Costs

▪ Thought to result for the taxpayer’s personal choice of where to live and are generally treated as nondeductible personal expenditures. Reg. §1.162-2(e)

• Flowers – taxpayer’s commuting expenses were incurred solely as a result of the taxpayer’s desire to maintain a home in Jackson while working in Mobile, a factor irrelevant to the maintenance and prosecution of the railroad’s business

▪ §162(a)(2) – Allows a deduction for income tax purposes of “traveling expenses (including the entire amt expended for meals and lodging) while away from home in pursuit of a trade or business.”

• 3 conditions must be satisfied before a traveling expense deduction may be made:

o (1) The expense must be a reasonable and necessary traveling expense

o (2) The expense must be incurred “while away from home”

o (3) The expense must be incurred in pursuit of business

▪ If a taxpayer has a regular work location but takes a temporary assignment at a different location, the taxpayer can deduct his costs of traveling to and from the temp job location (§162(a) deduction)

▪ The taxpayer is “away from home” w/in the meaning of §162(a)(2)

• Hantzis – taxpayer found a job as a legal assistant w/ a law firm in NYC for 10 weeks during the summer while her husband remained in Boston at the couple’s home. Deducted cost of transportation, meals and small apt. in NYC under §162(a)(2). Court held that the expenses were not incurred “while away from home.”

o Must establish his business connection both to the location he calls “home” and the place where he is temporarily working.

▪ Daily Transportation Costs - While on the job are generally deductible even though the costs of travel between the taxpayer’s home and principal place of business are not deductible. Reg. §1.162-2.

o Moving expenses: §217 – allows a deduction for the moving expenses of a taxpayer who takes a new job, if, the new job would add at least 50 miles to his or her commute, and in the yr following the move the taxpayer works at least 39 weeks at the new job.

▪ Deductions under §217 are not subject to the 2% threshold in §67

• Legal Expenses [p. 478-484]

o In individual may deduct legal fees that are incurred in a trade or business (§162) or related to the production of income (§212).

▪ Legal fees incurred in a business context must be capitalized in they are incurred in connection w/ the acquisition of property w/ an extended useful life

▪ Personal legal fees are non-deductible personal expenses

• Depend on “origin” of the claim

o If person – legal fees are non-deductible

o U.S. v. Gilmore – taxpayer w/ family business was denied a deduction for legal fees he incurred, during his divorce, to defend his wife’s claim on his controlling interest in the business. Court held that the origin of the divorce claim was personal and that the litigation costs were not deductible.

VII. Deductions for the cost of earning income

• Distinguishing Current Expenses from Capital Expenditures [p. 491-98, 500-02; §174, §263; §1.263(a)-1]

o Current business expenses are deductible in the yr. in which they are incurred

o The cost of a business asset w/ a useful life that extends beyond the yr. in which the expense is incurred must be capitalized

▪ Capitalized expense = deducted over a period of time, i.e. over 10 yrs

o §263 requires capitalization of amts paid to acquire, produce or improve:

▪ (i) real or personal property, including land, buildings, machinery, and equipment; or

▪ (ii) intangibles

• Expenses must be capitalized if they create, or facilitate the creation of, a “separate and distinct intangble”

o Encyclopedia Britannica – Britannica hired a publishing co to create a manuscript for the dictionary. The manuscript acquired by an outside contractor was income producing for a number of years and must be capitalized

o INDOPCO – Taxpayer took a deduction for investment banking and legal fees incurred w/ a takeover. The takeover produced long-term benefits. Supreme Court held that fees incident to a merger must be capitalized.

• Repair and Maintenance Expenses [p. 502-506; Reg. §1.162-4]

o Repairs (deductible) vs. capital improvement (capitalized over a period of time)

▪ Reg. §1.162-4: Helps distinguish between an expenditure to be classified as a repair and one to be treated as a capital outlay:

• To repair is to restore to a sound state or to mend, while a replacement connotes a substitution

o A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition

▪ Does not add to value of property

▪ Keeps property in an operating condition

• Replacements, alterations, improvements or additions prolong the life of the property, increase its value or make it adaptable to a different use

▪ Midland Empire – taxpayer used the basement of its meat packing plant to store and cure meat. In the taxable yr. at issue, oil from a new refinery began to seep thru the walls. Taxpayer paid $5K to line the basement walls w/ concrete. The Tax court held that this was a repair, not a capital improvement, and deductible as a necessary and ordinary business expense.

▪ Mt. Morris Drive In – taxpayer’s actions in building a drive in theater caused substantial water drainage onto an adjacent landowner’s property, installed a correction drainage system under threat of litigation. Held: The cost of the drainage system had to be capitalized since the need for it was foreseeable and was part of the process of completing the taxpayer’s initial investment for its original intended use.

• Ordinary and Necessary; Extraordinary Behavior [p. 530-536]

o Business expenses are deductible under §162 and §212 only if they are “ordinary and necessary”

▪ In some limited circumstances, the expenses will not be deductible b/e they are thought to be personal in nature.

• Gilliam – taxpayer, an artist who suffered from a mental condition, was denied a deduction for expenses incurred to settle lawsuits arising out of a business trip. The court held that the costs incurred in connection w/ the altercation were not ordinary expenses of the taxpayer’s trade or business.

• Reasonable Compensation; Costs of Illegal or Unethical Activities [p. 537-544]

o Reasonable Compensation

▪ §162(a)(1) provides expressly for the deduction of a “reasonable allowance for salaries or other compensation for personal services actually rendered.”

• “unreasonable” compensation paid to an employee is not deductible.

o Compensation is unreasonable and nondeductible only if the compensation arrangement between the employee and employer involves tax avoidance.

o Costs of Illegal or Unethical Activities

▪ Income obtained illegally IS taxable

• Expenses of illegal activities are deductible unless §162 explicitly provides that the expenses are nondeductible (

o §162 explicitly provides that the following expenses cannot be deducted:

▪ bribes and kickbacks

▪ fines and penalties paid to the gov’t

▪ punitive damages portion of criminal antitrust violations

▪ Courts have also used a frustration of public policy test to determine whether the expenses of illegal activity were deductible.

• Courts allowed a deduction unless the deduction would frustrate a clearly defined state or national public policy.

▪ Stephens – Taxpayer embezzled, ordered to pay restitution in the amt of embezzled funds. Stephens’ restitution payment was a remedial measure to compensate another party, not a “fine or similar penalty” under §162, not paid to the gov’t.

• Holding: Neither the public policy exception, precluding a deduction when it would severely and immediately frustrate public policy to allow it, nor the exception to deductibility of expenses under §162, bars deduction of Stephens’ restitution payment. Deduction for restitution allowed.

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