Federal Income Tax



Federal Income Tax-Morrison

❖ Chapter 1: Introduction

➢ The Constitution and the Income Tax

▪ Art. I, § 8 of US Constitution allows Congress to “lay and collect Taxes, Duties, Imposts, and Excises…”

▪ Limited in 3 ways:

• “direct” taxes must be apportioned

• Bills for raising revenue must originate in the House of Representatives

• Taxes must be uniform throughout the united states

▪ Apportionment of Direct Tax

▪ The Origination Clause

▪ The Uniformity Clause

• Does not prohibit a progressive tax or a tax that distinguishes between different sources or uses of income. Uniformity required is that taxes be geographically uniform in the sense that whatever plan or method congress adopts for laying the tax in question, the same plan and the same method must be made operative throughout the United States

➢ The Internal Revenue Service

▪ Besides seeing that taxes are collected, an important IRS function involves providing interpretation and guidance for taxpayers and Service personnel.

▪ Lawyers read letter rulings only to gain insight into the Service’s thinking; in practice, many lawyers treat these ruling in much the same way as if they were authoritative and argue them in court-and sometimes courts listen

▪ Service will not rule on some issues:

• Many involve factual questions;

• Will not rule on matter being litigated;

• Questions arising under legislative regulations

▪ Service will rule on proposed transactions, but not on hypothetical ones.

▪ Service imposes fees for these rulings

➢ Tax Controversies

▪ Most disputes which arise at the audit level are settled by agreement between the taxpayer and the revenue agent representing the service.

▪ If agreement is not reached, the Service will normally send the taxpayer a “30-day letter” explaining the determination. The taxpayer who wishes to pursue the matter further without paying the tax has thirty days to file a protest and appeal the proposed determination. If the taxpayer takes no action within thirty day, or if agreement is not reached on appeal, the taxpayer will be sent a deficiency notice, or “90-day letter.” The taxpayer then has 90 days to pay the tax or to challenge the alleged deficiency by filing a petition with the Tax Court. If the taxpayer does neither, the Service will assess the tax and demand payment by a specific date; if the taxpayer still does not pay, the Service will commence collection activity.

▪ The service may assess a tax within 3 years of the due date or the actual filing date of a return, whichever is later; § 6501(a) & (b).

▪ If a return omits an item of gross income greater in amount than 25% of the gross income shown on the return, the service has 6 years, in which to assess the tax (§ 6501(e))

▪ If the taxpayer files no return or files one that is false or fraudulent with intent to evade tax, there is no statute of limitations on assessment (§ 6501(c))

▪ If tax was paid and taxpayer is seeking a refund, the settlement procedure begins with the taxpayer’s filing a claim for refund. SOL for filing is the latest of: (1) three years from the date on which the return was filed; (2) three years from the due date for that return; or (3) two years from the date on which the tax pas paid (§§ 6511(a), 6513)

▪ Income-tax disputes not settled can be litigated in the Tax Court (if the tax has not been paid) or by a suit for a refund in a federal district court or the Court of Federal Claims.

▪ 1998 Act shifted the burden of proof to the government if the taxpayer presents credible evidence and (1) complies with the substantiation and recordkeeping requirements of the Code and regulations; (2) exhausts administrative remedies within the service and cooperates in satisfying reasonable requests by the government for witnesses and information; and (3) meets certain net-worth requirements (§ 7491)

▪ Golsen Rule: tax court has adopted a practice of following decisions of a court of appeals to which the case before it is appealable.

▪ § 7430 provides for the award of attorneys’ fees, expert witness fees, and the costs of studies, engineering reports, and analyses to taxpayers who ‘substantially prevail’ with respect to either the amount in controversy or ‘the most significant issue or set of issues presented.’ In order to recover under this section the taxpayer must have exhausted administrative remedies. If the government establishes that its position was ‘substantially justified,’ the taxpayer will not be treated as having substantially prevailed. Awards under 7430 cannot be made to individuals whose net worth exceeds $2 million, or to corporations with more than 500 employees and a net worth of over $7 million.

▪ Although the govt cannot recover attorneys’ fees, Tax Court petitioners who institute proceedings ‘primarily for delay,’ whose positions are ‘frivolous or groundless,’ or who have ‘unreasonably failed to pursue available administrative remedies’ are subject to paying a penalty up to $25,000 (§ 6673(a)). Other courts may sanction litigants financially; when they do so in tax cases, the penalties may be collected as if they were taxes 9§ 6673(b)).

▪ Summation:

• Tax Controversies: Taxpayers are required to file returns and pay the taxes due. If there is a controversy w/ reportable income, the following procedure is implemented:

□ Action by the IRS: Most are settled by agreement b/t the taxpayer and Revenue Agent. If not, the IRS will send a 30-day letter explaining its determination/position.

➢ If no action is taken w/in 30 days by the taxpayer (a written protest or payment), a deficiency notice, or 90-day letter will be sent.

➢ Taxpayer now has 90 days to pay up or file a petition w/ tax court. If neither is done, the IRS will assess the tax and demand payment by certain date, and then seize assets if that order is not complied with.

□ Action by the Taxpayer: Possible avenues for the taxpayer in a dispute. Taxpayer should, depending on sum of the dispute, do research to determine the best possible course of action and/or venue.

➢ Contest liability in tax court (cannot be availed if taxpayer has paid the tax in full, b/c tax court is Art. I court, only having deficiency jxd) No jury, tax-court judge. Appeal would go to the circuit court of appeals, then to SC, which rarely grants cert. in tax cases.

➢ If you have money, pay it, then sue for refund in the federal district court. Probably good if you are weak on the Code. You will get jury.

➢ Pay money, sue for a refund in court of fed. claims, appeal to the federal circuit in D.C.

➢ Taxpayers and Tax Rates

▪ The Progressive Rate System

• Progressive Rate System: Income-tax rates for individuals and corps have almost always been progressive—i.e., tax on a high income is a larger percentage of the income than the tax on a lower income.

□ Proportional (not used): A tax on the same percentage of all income, i.e., 20% of all income. (A-100K, B-20K, after tax A would have 80K, while B would have 16K, A still has 5X the amount of income as B)

□ Regressive (not used): A tax on the larger percentage of lower income than of higher incomes, i.e., a tax of 20% of the first 100K, plus 10% of the amount of income over 100K.

• *After the progressive rate system is implemented, as a general rule, if A’s before tax income is higher than B’s before tax income, A’s after tax income will also be higher than B’s.

▪ Tax-Rate System: The tax-rate schedules of § 1 apply to the taxpayer’s taxable income. Taxable income is computed by subtracting from the taxpayer’s gross income (See § 61) from any allowable deductions.

• §61 Gross Income Defined—encompasses only the gross amount of wages, dividends, interest, rent, etc…received by the taxpayer undiminished by any deductions attributable to such income

• HYPO: (Progressive Structure) A, single male, has $100K of taxable income.

□ Rate schedule—Over $53,500 but not over $115, 000…is taxed at $12,107, plus 31% of the excess over $53,500.

➢ $12,107 is automatic

➢ With 100K, A is $46,500 over $53,500. This amount is taxed at 31% (46,500 x .31) and equals $14,415 of additional tax.

➢ Tax Liability of A: $26,522 ($12,107 + $14,415)

➢ A’s marginal tax rate is 31%

➢ A’s average tax rate is 26.522% (divided by 100K)

• HYPO: A earns $50K a year, for ten years. B earns nothing in yrs. 1, 3, 5, 7 and 9 and 100K in yrs 2, 4, 6, 8.

□ Rate Schedule—0% of the first $25K a year of income plus 10% of the amount by which the taxpayer’s income exceeds $25K

➢ A, each year is taxed $2500. $25K for ten years

➢ B, is taxed nothing in 1,3,5,7,9. But in years 2,4,6,8,10 is taxed at a rate of 10% on the $75K. $7500 per year, or $37,500K total for years 2,4,6,8,10

➢ Interest and Penalties

▪ Interest

• Under § 6621, those who pay their taxes after due date must pay interest at rates determined by formula

▪ Criminal Penalties

• Tax evasion, a felony (§ 7201)

• Willful failure to collect, account for, or pay a tax, a felony (§ 7202)

• Willful failure to file returns, to keep required records, or to pay a tax, a misdemeanor (§ 7203)

• Willful filing a false or fraudulent document, a misdemeanor (§ 7207)

❖ Chapter 2: The Concept of Income

➢ Basic Tax Computations

▪ Gross Income (§ 61(a)): “all income from whatever source is derived,” including the 15 types of income set forth in § 61(a)(1)–(15)

• List is not exhaustive

• Inclusionary rules are in §§ 71-90

• Exclusionary rules are found in 101-139A

▪ *Taxable Income: Calculated by subtracting the taxpayer’s deductions from gross income. (If gross income is 200K, and deductions are 50K, taxable income equals 150K)

• Individual Taxpayers: Calculations of taxable income involves two steps

□ Deductions (from § 62—above-the-line deductions) are subtracted from gross income, yielding a figure called adjusted gross income (AGI)

➢ *§62 encompasses all business expenses (except most employee business expenses), investment expenses pertaining to rents.

➢ Next, the taxpayer subtracts deductions for personal exemptions (not tied to actual outlays) and either (i) itemized deductions or (ii) standard deduction from AGI to determine taxable income. (If your itemized exceeds your standard, you deduct the itemized. If your itemized is less than the standard, you deduct the standard)

• All taxpayers will deduct their above-the-line deductions and their personal exemptions.

• *Itemized deduction (§63d): deductions other than above-the-line deductions, personal exemptions and the standard deductions, i.e., charitable contributions, home mortgage interest, state and local income taxes, property taxes

• *Standard deductions: Statutory Amount (usually 6K for married couple, 3K for individual)

▪ Child Tax Credits (§24) : Low and middle income parents are allowed, as well as their personal exemptions, credits for their US citizen children under the age of seventeen, living w/ taxpayer

• $1,000 for each qualifying child

• Phased out if income exceeds $110K (married filing joint return) or $75K (individual). For each 1K over the statutory amount, the total credit is reduced by $50.

• Hypo: 2 qualifying kids, income is less than $110K, $2,000 credit

• If their income is 115,200, their credit is reduced by $1,100, to $900.

▪ HYPO: Married couple w/ two dependent children has $60K gross income and the following deductions:

• $2K loss on the sale of business property

• $8K mortgage interest on principal residence

• $1K charitable contribution

• $4K state and local income taxes

• $2K property taxes on principal residence

• *(1) is the only above the line deduction (§§ 62(a)(1) & (3), which totals 2K, therefore their AGI is $58K. They will next subtract itemized deductions and personal exemptions

• *(2)—(5) are itemized deductions totaling $15K. (58-15=45)

• *Personal deductions of 2K each for themselves and kids, totaling $8K. (45-8=35)

• TAXABLE INCOME: $35K.

□ *Rates: $1,400 plus 15% in excess of $12K. Excess $21K at 15% equals $3150

• TAX LIABILITY: $4550 ($1400 + $3150) From this amount the couple subtracts their $960 credit for child-care expenses and a $2,000 child tax credit, yielding a tax of $1,590

□ (An above the line deduction will be worth more to many taxpayers than an identical itemized deduction would be worth. b/c only those whom total itemized deduction exceed their standard deductions will claim itemized deductions on their returns. You always claim above the line deductions).

▪ HYPO (page 38): A, age 67, is single and not a head of household nor a surviving spouse, has 40K gross income, 4K of deductions from rental property, 1K of property taxes on her home, and $2650 of state income taxes.

• AGI: {§ 62} $36K (Above the line deductions-$4K subtracted from gross income-$40K)

□ Itemized Deductions: $3650

□ Standardized Deductions: $5750 ($3K + $2K + $750)

➢ Standard Deduction of $3000 (see §63(c)(2)(C)) for an individual who is not married and who is not a surviving spouse or head of household

➢ Over 65 add-on of $750 (see §63(f)(3) this is only for standard deduction) for person whom is not married and is not a surviving spouse. You get $750 instead of $600.

➢ Personal Exemption: $2000 (see §151(d)(1))

• Taxable Income: $30,250 (Gross income, $36K, minus deductions allowed by §63, $5750.) Taxable Income defined in §63.

➢ “Accessions to Wealth”

▪ In general

• No single conclusive criterion has been found to determine in all situations what is a sufficient gain to support the imposition of an income tax.

• Commissioner v. Glenshaw Glass Co.

□ I: Does $ received as punitive damage count as gross income under §61 which must be reported? Glenshaw didn’t report $324K punitive portion of settlement as income

□ H: Yes. Taxable income. Undeniable accessions to wealth.

□ R: Court gives a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains (“accessions to wealth”) except those specifically exempted by statute of regulation. (This is a broad statement that probably shouldn’t be taken to an extreme.)

• Notes:

□ Other windfall cases. Taxpayers bought a second-hand piano for $15. Seven years later they found $4,467 in cash hidden in the piano. The court, relying on Glenshaw Glass, held that the windfall was income.

□ Book reviewers and teachers are sent free books by publishers, who hope that the books will be reviewed or adopted for class use. The Service’s position is that the value of the book is not income, except to recipients who display unseemly greed by giving books to charity and taking a deduction for their value.

• Eisner v. Macomber

□ I: Does the distribution of a corporate stock dividend (as opposed to a cash dividend, which is obviously income) constitute a realized gain to the shareholder

□ H: Distributions is not a taxable event, this tax statute violates 16th Amend.

□ R: Taxpayer received nothing out of the company’s assets for his separate use and benefit. Ms. Macomber never realized any income. In order to realize, Ms. Macomber would have had to sell. Court describes income as the gain derived from capital, from labor, or from both combined.

• **T. Reg. § 1.61—14 provides that treasure trove (property found by the T) is income in the year when it is reduced to undisputed possession….(find $20 in hallway, cash in a piano)

• **What if C had found a valuable object rather than cash? If C had found the piano is worth $500K, it is not income until it is realized/sold. $10 basis in a $500K piano—gain would be the difference ($499,990)

• Treas. Reg. § 1.61-14(a) has generally been read as requiring inclusion in income of the value of the found property.

• §161-1(a)—Gross Income—means all income from whatever source derived, unless excluded by law. Includes income realized in any form, whether money, property, or services. Income, therefore, may be realized in the form of services, meals, accommodations, stock, or other property, as well as in cash.

• §161-14(a)—Misc. items of gross income—indicates that in addition to §61(a), there are many other kinds of gross income. Illegal gains, treasure trove, punitive damages, etc…

□ Realization: Before any increase in net worth becomes taxable, a realization must occur. This means that a crystallizing event must have taken place which makes it reasonable and convenient to compute gain or loss. See Code § 1001 (“sale or disposition of property”)

• HYPO: A taxpayer who finds a gold coin worth $100 has realized that amount of income under Treas. Reg. §161-14(a), but a taxpayer who buys a gold coin for $50 has no income when the coin increases in value to $150 (unless he sells or exchanges it for something else). In each case, wealth has increased, but in the second, the gain in question has not been realized

• HYPO: T owes X $1K. T transfers property worth $1K, but on which T’s basis (cost) was only $400. There is realization of a $600 gain to T.

• HYPO: T discovers a valuable natural gas below house—You must have undisputed possession. If you extract and sell, then you have realized b/c you have undisputed possession.

• HYPO: Tenant erected a bldg. on leased land and then defaulted on lease payment. On regaining possession, the landlord was held to have realized income equal to the value of the bldg.

□ Read: Realization must occur before an increase in net worth becomes taxable. An event must occur that it is appropriate to tax the increase now.

▪ Gross Income from Sales

• Appreciation: The tax system usually does not tax appreciation (or allow a deduction for losses) until the taxpayer disposes of the property. (Until the property is disposed of appreciation or depreciation are “unrealized”)

□ Difficult to make annual appraisals to ascertain how much appreciation has occurred.

□ Thus b/c “unrealized appreciation” is not taxed, people will prefer investing in assets that will appreciate to those assets that will produce realized gains. To wit: You would prefer to invest in stock that will increase in value, as opposed to the stock that pays increases in dividends and remains the same price.

□ HYPO: L buys land for $100K. One year later, oil is struck next door, and her land shoots up in value to $500K. Oil is never found, but there is that potential. Lucy does not have to pay any tax right away, only when she sells for 500K, 40 yrs. later.

□ HYPO: Taxpayer buys stock for $1000 on June 15, by the end of the year, the stock has increased in value to $1500. Not taxable until property is disposed of.

□ §1001(a) Computation of gain or loss: A taxpayer’s realized “gain” on the disposition of property is the excess of the amount realized over the “adjusted basis.” In the previous hypos, amount realized is simply the amount of cash for which the taxpayer sells the property, and the property’s basis is its $1000 cost.

□ §1001(b) Amount Realized: The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property received

□ §1001(c) Recognition of gain or loss: Gain or loss realized on the sale or exchange of an asset is recognized (taxed) unless another provision of law provides otherwise.

□ §1012 Basis of Property—Cost: The basis of property shall be the cost of such property. The cost of real property shall not include any amount in respect of real property taxes which are treated under §164(d) as imposed on the taxpayer. (In some instances, treated elsewhere in the code, a property’s “basis” must be adjusted and “basis” may be something other than the cost of the property)

➢ Basis must be known both for computation of gain or loss and also computing depreciation

□ §1011(a) Adjusted basis for determining gain or loss: The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (see § 1012, i.e., cost), adjusted upward for expenditures, receipts, losses, or other items properly chargeable to the capital account, and adjusted down for depreciation, amortization and depletion as provided in §1016

□ HYPO: A finds and keeps a gold statute worth $10K. If in a later year she sells the statute for 12K, how much gain does she realize upon the sale?

➢ $2K gain on the sale (she must pay initial tax on the 10K she realizes)

□ HYPO: B buys a statute from an antique dealer for $4K, actual value is $14K. Later, B sells for $16K. What is B’s gain on the sale?

➢ $12K (4K basis—no gain until sold).

□ HYPO: Client comes to M for will preparation. Gives M a chicken for preparation, says it is worth $25.

➢ $25 worth of income is realized, both have income

➢ If M sells the chicken to his law partner for $30—•M has a gain of $5, and is taxed only on that gain

□ HYPO: M buys a car for 20K, W buys the same car of 17K.

➢ Wife does not have income. Just bargaining b/t parties.

□ HYPO: W, as the 10,000 buyer gets a check for $10K from the dealership.

➢ Windfall, not related to the transaction. INCOME.

□ HYPO: M renders services to widow, and never charges her. M, with intention of moving to St. Louis, meets w/ widow, whom gives him $300.

➢ As no payment for services was ever discussed, M will argue that it is a gift or windfall, not tied to any particular service rendered. The IRS will say compensation for services.

□ HYPO: C receives a $500 Fed. income-tax refund. Not includable in gross income.

• Realization and Recognition: A realized gain is includable in gross income only if it is also recognized. Except as provided in the Code, the entire amount of any realized gain or loss on the sale or exchange of property is recognized for tax purposes. (Read: If not recognized, not taxable)

□ Congress has provided for non-recognition of gain (or loss) in some situations § 1001(c). The rationale being that a taxpayer who has engaged in this class of transactions has not changed the nature of his investment sufficiently to warrant a tax being imposes on his realized gain.

□ An example of a non-recognition provision is §1031, under which gain from the exchange of business/investment property for other business or investment property of “like kind” is not recognized), corporate mergers.

• Bargain Purchases; Employee Discounts: When a taxpayer purchases property at arm’s length for less than it is worth, he is ordinarily not taxed on the fruits of his astute dealing. Since the property’s basis is its cost, however, the profit on the advantageous purchase may enter into gain on a later sale of the property.

□ In contrast, the bargain element may be taxed immediately if a bargain purchase for less than FMV is not an independent arm’s length transaction, but reflects an extraneous objective, such as the seller’s desire to confer an economic advantage on the buyer.

• HYPO: House is for sale: $75K. House is appraised at $100K. Not income per §61 to the buyer.

• HYPO: M gives S $10K after bad legal advice which cost her $10K.

□ Not income to S. S is just being returned to original position. (This payment served only to restore S’s impaired capital—see Tax Free Recovery of Capital)

▪ Compensation for Services: In General

• Old Colony Trust Co. v. Commissioner

□ F: Wood, President of American Woolen, was paid salary and commission of $1M in 1918. Company agreed to pay Wood’s fed. income tax of $680K. (Amendment goal was to make sure that tax paid was at the highest progressive rates).

□ I: Did the payment by the employer of the income taxes assessable against Wood constitute additional taxable income to Wood?

□ H: Payment by employer constituted income to employee, and Wood (employee) is taxable on the $680K.

□ R: Voluntary payment was irrelevant, and this was not a gift. Wood’s debt was discharged, making him wealthier. The transaction was in the nature of compensation for services, which is explicitly taxable under §61(a)(1)

□ Wood’s argument that the $ was never paid to him, it was paid to the IRS directly, was rejected. (Still income although you don’t receive cash in hand)

➢ Other argument was that there would be no resolution, the company would keep paying the tax on paying the tax for the employee (never ending cycle).

□ *OLD COLONY PRINCIPLES:

➢ Form of Income does not matter

➢ Income may include discharge of obligation to 3rd party (A’s payment of B’s obligation is tantamount to a payment from A to B)

➢ In employment context, gift argument is last-ditch effort, that probably won’t work. B/c it is still based on something he is still doing for the company (performance).

• HYPO: C transfers property w/ an adjusted basis of $40 and a value of $100 to D in exchange for $70 cash and D’s payment of C’s $30 debt to E. What result to C and D?

□ C sold property, $60 taxable gain

□ D basis (what paid + tax liability)=$100

• HYPO: E is employed by X corp in a state which has no income tax. Last year, E accepted a temp. assignment for X in an adjoining state which imposes a 5% income-tax on compensation earned w/in the state. E agreed to serve at his regular salary if X would pay any state income tax liability incurred by E at the temporary post. E earned $10K while on assignment. X paid the resulting $500 tax liability. Must E include the $500 in Fed. gross income? Does it matter whether the $500 is included? Consider §164(a)(3) ASK MORRISON—He says income

• Payments by Liability Insurers: When damages resulting from a taxpayer’s tortious behavior are paid by an insurance company, as in the case of an automobile accident caused by the taxpayer’s negligence, the payment is not taxed as income to the T. This is probably a corollary of the denial of a loss deduction for premiums paid by an insured who sustains no reimbursable loss.

• Obligation of Payor: In Old Colony, the employee was the beneficiary of the employer’s payments (since he would have been required to pay the taxes from his own resources if the Co. had not.)

□ However, Old Colony does not apply to payments satisfying obligations of the payor, e/t the employee derives some benefit as a by-product of the payment (e.g., corporate obligation—imposed by state law—to pay s/h legal fees in derivative action; employer’s payment of business expenses charged to an employee’s account)

• Transfer of property as Compensation for Services: §83

□ Commissioner v. LoBue (decided before §83)

➢ F: LoBue was a manager of Michigan Chemical Corp. Co. had a stock option plan making 10K shares of its common stock available for distribution to key employees at $5 per share. Ultimately, LoBue exercised these $5 per share options, paying the company only $1700 for stock having a market value of $9,930. ($29/share)(known as dilution). LoBue gave promissory notes when stock was $20/share (§83—if you pay for stock w/note (secured by the stock itself) and no personal obligation, it is really still just an option.)

➢ Tax Court held for LoBue, finding options not to be compensation, but a proprietary interest in the business.

➢ H: Rev’d. This is compensation for personal service w/in meaning of §61.

➢ R: 1) This is not a gift, so it seems impossible to say that it is not compensation. No exemption exists which allows deductions for “proprietary interests.” When assets are transferred by an employer to an employee to secure better service they are plainly compensation, regardless if it is stock or money, 2) LoBue realized taxable gain when he purchased the stock, 3) When should the gain on the shares be measured? (This is remanded to the tax court) When Lobue paid the cash and the market value was higher or when the options were granted or when the promissory notes were given and the market value of the shares was lower?

▪ LoBue exercises options at some point and at that point he has income.

▪ LoBue’s argument is that he was simply given an interest in the company. They wanted to encourage his efforts.

▪ Court has no sympathy, it is income.

▪ Next argument, LoBue paid for the stock with an I owe you in order to receive stock. Value went way up from when he gave the I owe you notes to when he paid off the notes. Therefore he would have had to pay more tax. So, he argues that he should pay tax on the amount when he gave the I owe you (note).

➢ What would you want to find out if you were tax court?

▪ Get a copy of his financial statement, can he pay off this note?

▪ Go to his company and find out if anyone has ever enforced the note.

▪ If arguing his side you want to argue he was financially stable to pay off.

➢ $5 (Option-granted)—No tax is payable on the option

➢ $20 (x340 shares)—Did he have a real obligation? Basis would be $20. If he sells, the difference is capital gain

➢ $29 (340 shares)—Lobue would not want to be taxed here, as it would be the most costly.

• IRC § 83—Property transferred in connection with the performance of services (this § does not only apply to employees, but also a lawyer who gets stock)

□ Basic Rule(s):

➢ As to timing, an employee generally must include in income the value of property received as compensation at the earlier of the property’s (1) ceasing to be subject to a substantial risk of forfeiture or (2) becoming transferable (§ 83(a))

➢ If you buy stock from employer (or anything e.g. car), for less than it is worth, the spread is income, if there are no restrictions.

➢ Option—No income at that point. It becomes so when you exercise the option, and there is no restrictions (substantial risk of forfeiture)

➢ Basis—Dollars spent and amount taxed.

• §83 deals with:

□ Non-Qualified Stock Options: Stock transferred to an employee for a bargain price and subject to restrictions (Not transferable, subject to forfeiture)

➢ *If the stock is transferred for a bargain price and not subject to restrictions, the result would be immediate compensation income of the bargain element.

▪ Restrictions: If there are restrictions, then the employee does not have to include the bargain element of the transaction in his income until the substantial risks of forfeiture are lifted.

▪ *Not very marketable

▪ *When restrictions are lifted, the employee includes as ordinary income the value of the stock at the time the restrictions are lifted—not the value at the time of the transfer. *This amount is reduced by the employee’s purchase price.

□ Deferred Compensation Arrangements—defer receipt of some of my income to when marginal rates are (hopefully) lower.

□ §1.83-1: Generally such property is not taxable until it has been transferred (as defined in §1.83-3(a)) and becomes substantially vested (as defined in §1.83-3(b)). The fair market value of such property over the amount paid for such property shall be included as compensation in the gross income of such employee for the taxable year in which the property becomes substantially vested.

□ §1.83-3(a)—Transfer: A transfer of property occurs when a person acquires a beneficial ownership interest in such property

□ §1.83-3(a)(2)—Option: The grant of an option to purchase certain property does not constitute a transfer of such property.

□ §1.83-3(b)—Substantially Vested and Non-Vested Property: Property is substantially non-vested when it is subject to a substantial risk of forfeiture, and is nontransferable . Property is substantially vested for such purposes when it is either transferable or not subject to a substantial risk of forfeiture.

• HYPO: On 11/1/78, X corp sells to E, an employee, 100 shares of X corp stock at $10/share, when fair market value is $100/share. Terms: Each share is subject to substantial risk of forfeiture (not lapsing until 11/1/88) and is nontransferable.

□ Since E’s stock is substantially non-vested, E does not include any such amount in his gross income as compensation in 1978

□ On 11/1/88 fair market value is $250/share, and the stock becomes substantially vested. E must include $24K (100 shares of stock x $250 fair market value per share less $10 paid by E for each share).

□ (E paid $1K for stock, fair market value is $25K)

• §83(b)—Election to include in gross income in year of transfer

□ Tax payer can say hello IRS, I’m going to elect to pay tax on this right now. Can be some risk to pick up the tax.

□ Purpose is if you expect stock price to sky rocket. For example pay tax on $10 immediately. Then down the road if you sell for $40 dollars more than can realize as gain and only pay 15% tax.

□ Risk – betting stock is going to go up and that you are going to last however many years or whatever terms are specified in the option.

• §83(c)(1)—Substantial Risk of Forfeiture: The rights of a person in property are subject to a substantial risk of forfeiture is such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.

□ §1.83-4(b)—Basis: If property to which §83 apply is acquired by any person while such property is still substantially non-vested, such person’s basis for the property shall reflect any amount paid for such property and any amount includible in the gross income of the person who performed the services.

• §83(h) allows the employer to deduct the excess of the value of the stock over the exercise price of a Non-Qualified Stock Option. The excess is called the spread.

□ §1.83-6(a)—Deduction by Employer: The amount of the deduction is equal to the amount included as compensation in the gross income of the service provider (employee). The deduction is allowed only for the taxable year of that person in which or with which ends taxable year of the service provider in which the amount is included in compensation.

• (a) Options: Agreement to buy property at the election of the person to whom the option is given. Ordinarily an option must be exercised before a specified date a specified price.

□ Per §83(e)(3), §83 does not apply to the transfer of an option w/out a readily ascertainable fair market value.

□ Option terminology: an option is a contractual right to purchase or sell specified property at a given price (the exercise price) within a specified time (the option term). If the option is not exercise before its term expires, the option lapses. The excess of the value of the property at the time of exercise price is the spread.

• INCOME AND BASIS (when property is received for services)

• §1012: Basis of property is its cost; you only pay tax on gain over the basis, which is realized

• HYPO: If A does some work for B and receives a $30K car as compensation, §83(a) requires A to include $30K in gross income. (This is the equivalent of A being paid $30K in cash and using the cash to buy the car).

• HYPO: A sells the car to C for $30K.

□ Per §1001(b), A’s amount realized is $30k (the amount of cash received)

□ Whether A realizes a gain depends upon A’s basis for the car. See §1012—property basis is its cost.

□ A’s gain on selling the car to C must be zero, thus A’s basis for the car must have been $30K, even though he did not pay cash for it

□ A’s cost basis has to be the 30K of income A recognized on receiving the car, not the amount of money (zero) paid for the car. (A is treated as having received $30K of cash as compensation and using it to purchase the car, thus obtaining a $30K basis).

□ A’s basis for property received as compensation does not arise b/c he “invested” $30K of his labor in earning the property. (Cost basis of §1012 can’t include the value of the taxpayer’s labor, which economists refer to as “opportunity cost”)

□ See problems on page 61

• Accounting Methods: Consider a taxpayer who in 2003 becomes entitled to receive a 10K payment for services and who receives the payment in 2004. Whether the payment is includable in the taxpayer’s ‘03 or ’04 income depends upon his accounting method.

□ Accrual-Method: Taxpayer reports income upon acquiring a right to the payment

➢ *Becomes entitled to a deduction upon incurring liability; not when actually paid.

□ Cash-Method: Taxpayer reports income when cash (property or check) is received.

➢ *Most employees use the cash-method to report compensation for services

➢ *Normally take-out deductions when they pay out money

▪ Deferred Compensation: An Introduction to the Time-Value of Money

• *Taxpayers can often take advantage of the time-value of money by arranging their affairs so as to postpone tax liability.

□ Goal: The objective of tax planning based on deferral is usually to delay taxes w/out delaying economic gains.

• Tax-Favored Savings: Because an income tax applies to both a taxpayer’s earnings from working and to his investment returns, it is sometimes said that the income tax imposes a double tax on those who save some of the money they earn. Consider the following:

□ HYPO (No Tax) W, saved $2k of his salary, and invests it for 20yrs at a return of 10%, compounded annually would yield 13,455

□ HYPO (TAX-30% on initial earnings and annual investment return) Same facts, 30% of $2K earnings leaves $1400 to be invested. Annual return of 10% is also taxed at 30%, so the annual after tax return is 7%. An investment of $1400 at 7% for 20yrs will grow to $5418. Almost 60% of what taxpayer could have accumulated w/ no tax is…. gone.

□ To encourage savings, Congress has enacted a wide variety of programs, basically with two forms of benefit:

➢ the earnings of the plan are not taxed at all, or

➢ the money contributed to the plan is not taxed when it is earned and the return on the plan’s investments is not taxed as it accrues, but the original investment and all accumulated savings are taxed when they are w/drawn from the plan.

□ Roth IRA: The amount of contribution is limited to the taxpayer’s earned income not over 95k (150K for married filing jointly). 4K contribution limit is phased out for taxpayer’s whose modified AGI exceed the statutory threshold. When put money in; not take deduction right away; builds up tax free; can take out tax free.

*Better choice for younger workers

➢ *4K (5K if married)

➢ *Contributions are not deductible, but if the taxpayer takes only qualified distributions from the plan, the earnings of the plan (which grow tax free) are never taxed.

➢ *Distributions after 5-year period from first contribution are qualified if they are made after the taxpayer reaches age 59½.

➢ HYPO: Same facts as above, 30% taxpayer, if he invests by contributing $1400 ($2000 less $600 in tax) to a Roth IRA, the investment will grow to (at 10%) $9418 in 20yrs.

▪ At that time, if the taxpayer is over 59½ or is otherwise eligible for a qualified distribution, the entire amount can be withdrawn without tax.

▪ Without the Roth IRA’s tax exemption, the taxpayer would have accumulated only $5418 (after tax) by the end of 20yr. period.

□ Traditional IRA: Two exceptions from the similar eligibility rules and withdrawals to the Roth IRA—

➢ Withdrawals from the traditional IRA can be made w/out losing tax benefits for a wider variety of purposes (medical expenses, educational costs, etc…)

➢ not important

➢ *$4K (5K if married)

*You deduct amount of contributions; when you take out—you are taxed—must take out when you are 70 ½

➢ *Because contributions to and earning of a traditional IRA are eventually subject to income tax, while earnings of a Roth IRA are never taxed, traditional IRA may seem at first glance to be inferior. It is an illusion, though

➢ HYPO: 30% taxpayer who earned $2K and plans to invest whatever is left after tax at 10% for 20yrs. In traditional IRA, taxpayer’s initial investment will be $2K (as the investment is deductible, nothing need to be kept back for tax).

▪ 20yrs at 10% = $13,455.

▪ If entire amount is w/drawn, the amount will be subject to 30% tax as income, leaving $9418 (the same amount as the Roth)

▪ Traditional IRA’s deferral of taxes on both the initial contributions and the annual earnings on contributions yields the same benefit as the Roth’s forgiveness of taxes on the earnings, with no benefit on the initial contributions.

• Other Tax favored Savings Plans: The real action ($) involves plans having much higher contribution limits.

□ Qualified (deferred compensation) Plans: Meet a variety of explicit rules relating to employee participation and benefits. Governed by §§401-404 (See 401K—w/ higher contributions limits)

➢ *The earnings are not subject to tax when they are contributed or when they accumulate, but only when distributed/taken out. (build up is tax free)

➢ 401(K): Employee can contribute up to 15% of salary; not taxed when contributed or while it builds, only when taken out.

□ Tax Credit for IRA contributions and other retirement plans: §25(b) gives many low-income tax payers a non-refundable tax credit for contributions. For married couples, filing joint, the credit can be as much as half of the first 2K a year contribution if the couples modified AGI is 30K or less.

➢ No credit is allowed couples w/ modified AGI over 50K

➢ AGI limits for most unmarried taxpayers are half those for couples.

□ Tax Free “Roll-overs”: When employee is fired, quits or retires, the employee may want to withdraw the funds from the employee plan (i.e., 401k), so that he can direct future investments. Ordinarily, distribution would trigger an income tax on the entire amount, and if under 59½, a 10% penalty tax on premature distributions may apply.

➢ Rollover would allow funds to be transferred to a traditional IRA, or other qualified plan, within 60 days and avoid tax on the distribution.

➢ Rule calls for the funds to be rolled over directly to the receiving plan, rather than being distributed to the taxpayer, then transferring. (A 20% withholding tax may be assessed--§3405(c).)

➢ If taxed per §3405, employee must come up with some other source of income to avoid being taxed on part of the distribution.

➢ HYPO: $1M, is employee’s distribution, if it is paid to the employee, who then transfers to the IRA, the withholding tax will take $200K, so the employee will receive only $800K. Because a completely tax-free rollover must consist of the entire amount of the distribution, the employee will have to come up with $200K, to reinvest the full $1M

□ Qualified Domestic Relations Order: Divorcing couples cannot simply assign rights to benefits under pension or profit sharing plans by agreement. The state court must enter a decree that is a “QDRO” in order to transfer interest

➢ Non-Qualified, Contractual (deferred compensation) Plans: Setting aside of money for deferred taxation, which does not have to meet broad requirements w/ respect to employee participation, benefits and funding.

▪ Employer generally must be willing to undergo a tax disadvantage to confer unusual benefits on the object of its bounty. Employer is subsidizing the employee’s tax deferral—employer must still pay taxes on the money.

*The number of nonqualified deferral plans has exploded b/c of the increased restrictions enacted w/ respect to qualified plans—see ERISA, limiting the amount how much executives could save in qualified plans

➢ HYPO: On 12/30/01, E tells employer to not give him the 10k at this point. Wait till next year b/c I had a real good year this year, and I might need it next year

▪ Per §1.451-2, he constructively received it on 12-30.

▪ Solution: If at the beginning of the year you tell employer not pay you 10k of your 100k salary, instead paying you the 10k in 10yrs--it is not “constructively received” (even if employer puts into a bank account) if:

▪ The money is not subject to you taking it; you have no right to demand it.

▪ The money is subject to the creditors of the employer

▪ Illegal Gains

• T.Reg. §1.614(a) gross income includes illegal gains, and a deduction is allowed if and when the wrongdoer reimburses the victim for the loss per §§ 165(a) and 165(c)(2) as a transaction entered into for profit.

• James v. United States

□ trying to get him for first not reporting

□ Secondly, they are trying to show there was wilfullness in not reporting (which would bring in a felony)

➢ Cannot get him on wilfullnes b/c of the chance that he may have read Wilcox and depended on it, actually believing he didn’t have to pay tax.

□ F: Union official embezzled in excess of $738K in 3yrs., and did not report these amounts in gross income. Convicted of tax evasion.

I: Are embezzled funds to be included in gross income of the embezzler in the year in which the funds are misappropriated

□ H: 1) Overruled Wilcox, illegal income is taxable despite the recipient’s legal obligation to make restitution. Court uses language similar to Glenshaw Glass, i.e., it is an accession to wealth. 2)The prosecution of the taxpayer for tax fraud, however, is overruled. Fraud requires willfulness and b/c of Wilcox being on the books at the time the alleged crime was committed, this could not have been considered willful.

(James paints with a broad brush—all illegal income is taxable)

➢ In Rutkin, what is the lawyer’s argument for not including in income? It is not income b/c you have to give it back to the person they took it from. They phrase it as a loan.

➢ However certainly not the case here. No intention to pay it back.

• Loans: Loans are generally not income. If they were income, repayments would be deductions and be very complicated. In James, there was no consensual obligation to re-pay, therefore, this could not be considered a loan.

□ If you are caught embezzling, you could not simply say, I’ll repay you, this is just a loan.

□ Furthermore, if the T “purports” to borrow funds for a legitimate business purpose, but is actually swindling the lenders, if the intent to cheat is dominant, the funds are taxable fruits of larceny or embezzlement. (If the investment façade is given credence, the receipts are nontaxable borrowed funds).

• The tax law and non-tax criminals: Rutkin and James gives the federal government power to punish local crimes such as embezzlement and extortion (by including illegal gains as income—subject to 1040 reporting).

• HYPO: T is trustee of a family trust which is not subject to court supervision. T, in breach of trust, sells to himself for $4K a trust asset worth $10K. What result to T.

□ 6k gain is taxable. Basis is now $10K

□ This is not a bargain purchase or a windfall. You treat people differently by the way they act.

➢ Recovery of Capital

▪ Measuring “income” the sense of “gain” or “profit” requires making an allowance for the costs of earning income. The following material will highlight that not all “receipts” are “gains.”

▪ Sales

• Sales: In the case of a sale, the taxpayer’s recovery of capital takes place at the stage of calculating gross income. This is the simplest form of capital recovery.

• HYPO: E buys corporate stock for $3k and sells it for $3700. E’s gross income is $700. His cost basis is $3k, which is not taxable, b/c it is a recovery of capital.

▪ Dividends, Interest and Rent

• Dividends, Interest and Rent: These are taxable, w/out regard to any “cost basis.”

• HYPO: T spends $100K to buy a tract of farm land, which he then leases for $8K per year. The $8K rent is includable in the taxpayer’s gross income each year. The taxpayer’s $100K investment—his basis—does not enter into the calculation of either the gross income from the property or taxable income, until he sells the land.

• HYPO: T buys corporate stock for 100K. He cannot use any of the stock’s 100K basis to offset the receipt of cash dividends; as the previous hypo indicates, the use of basis must await the disposition of the stock

□ Dividends are taxed at 15%

□ When sell stock you record the gain in your stock as capital gain in your gross income.

▪ Depreciation

• Depreciation: Largest amount of deductions, next to salary. §167 permits the taxpayer to recover (tax-free) the cost of property that is exhausted in the process of generating business income. Property may not be depreciated unless the T’s investment will be consumed, in part or whole, by the effects of exhaustion, wear and tear, or obsolescence.

□ Concept: Assets used in business become less valuable as time goes by. Thus a taxpayer owning the asset deducts annually an arbitrary percentage of the cost of the asset. (If the asset is an intangible asset, such as a copyright, the deduction is known as amortization)

*Depreciation is most often utilized as the tool for which government re-formulates economic policy.

□ Straight-Line Depreciation: Depreciate by taking deduction each year for % decreased.

□ Wasting Investment Requirement: Depreciation is denied for assets that are not adversely affected by the passage of time or by use in the T’s business, such as works of art, antiques, and raw land.

➢ However, courts have held that depreciation is allowed for property having value as a work of art if the property sustains wear and tear in its use in the T’s trade or business. (See Simon v. Comm’n, allowing violins to be depreciated, b/c their use subjected them to wear and tear. The court rejected the argument that proof of a determinable useful life is an essential precondition to the depreciation deduction. They said that §168’s purpose was to relieve T’s of the burden of establishing useful life. This was allowed e/t the violins apparently appreciated in value as the T’s used them.)

□ IRC §167(a)—General Rule: There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear & tear (including reasonable allowance for obsolescence—

➢ (1) of property used in the trade or business, or

➢ (2) of property held for the production of income

▪ Thus, a machine or computer would be the type of property subject to depreciation, but not a raw piece of land.

▪ Your own personal car, computer, or house will not qualify unless used in a trade or business and for production of income. The basic legislative policy permits deduction for the cost of making a living, but not the cost of living.

• Basis for Depreciation

□ (1) In general—the basis on which exhaustion, wear and tear are to be allowed in respect of any property shall be the adjusted basis provided in §§1011, 1016(a)(2) for the purpose of determining the gain on the sale or other disposition of such property.

• Murphy- compensation for non-physical personal injury is not income bc not from lost earnings or wages

• Hampton Pontiac v. United States:

□ F: P entered into an agreement w/ King Pontiac’s controlling S/H (Matthews) that King Pontiac would surrender its franchise, and Matthews would receive money. The money paid to Matthews was deducted by P as a salary expense on its federal tax return. The deduction was disallowed, P paid the disallowed deduction and now requests a refund.

□ H:

□ R: 1) The payments were capital investments, not deductible as “ordinary and necessary business expenses.” The contract w/ Matthews was an integral part of P’s expense in acquiring its Pontiac Franchise. Payments were includible in P’s invested capital.

□ The capital investments are not “amortizable” (under §167 of the IRC, which allows intangible assets to be depreciated if the useful life of the asset is of limited duration, capable from experience of being “estimated w/ reasonable accuracy”) over the initial fixed term of the franchise agreement (i.e., five years). The P has failed to bear the burden of establishing the amortizable character of his payment on the basis of the fixed life of the franchise. Giving due weight to the actual record of non-renewals of GM franchises, it cannot be said that the enjoyment of this franchise “may with reason be expected to end” in five years. Quite contrary, the franchise was reasonably certain of renewal. Safeguards were in place—review by former SC Justice.

□ But such payments may be amortized over the life expectancy of Samuel W. Jones, as computed by the mortality tables issued under the Treasury Reg. It is clear from the records that the death of the participating owner will normally occasion the termination of the franchise

□ To sum pup:

➢ The payments by the taxpayer to Matthews must be capitalized and may not be expensed

➢ Such payments may not be amortized over the initial fixed term of the franchise agreements but,

➢ Such payments may be amortized over the life expectancy of Samuel W. Jones, Sr., as computed by the mortality tables issued under the Treasury Regulation

• Notes on Depreciation:

□ HYPO: Taxpayer buys a truck for $10K, takes a straight line depreciation of $4K, and sells the truck for $7K.

➢ T’s basis is reduced to $6K, sold for $7K, thus he has a $1K gain.

□ Depreciation accounts for the largest amount of deduction, next to salary.

▪ Annuities

• Annuities: Contract providing for regular payments (after you pay a single or series of premiums) from an insurance Co., to the annuitant, with an interest element, which begin at retirement or other fixed date and continue for a term of years or for the life of one or more individuals. (Essentially assuring the recipient of a lifetime source of funds)

□ Deal is that they have to pay me that amount for as long as I live.

□ Old annuity form is that lets say I pay you 100K for the agreement today and tomorrow I die, they get to keep the 100K – HUGE Risk

□ Today there are different forms of annuities.

➢ Make payments for at least 5, 10, 15, etc. years.

➢ Or make payments until you or your estate recovers 100K you paid in

➢ Or pay the annuity for as long as you and someone else (spouse) lives

➢ Or we will pay 100% of what we promised to pay while both alive but when one of beneficiaries dies we will cut down to 2/3s

□ Why do people buy them? B/c you get the payments forever. Also there is a buildup in there that is tax free.

□ How do they get taxed? LOOK AT HANDOUT

• Charitable gift annuities – typically the charity will offer a little bit less than a typical annuity will offer, but b/c there is a little bit less payout there is a charitable deduction. So when purchase you get an immediate charitable deduction.

□ Only caution – there are a lot of charities that offer them. Make sure they can actually pay.

• Private annuities

□ Insurance Co. could go bankrupt / inflation could get bad

□ Insurance Co. is willing to bet that they make more on your premiums than they will have to pay you back in interest.

□ What you are paid back depends upon what interest rate the Co. is willing to assume.

□ What you are getting back is not just interest, but part of your principle (invested capital) you put in plus the interest. Thus the question becomes—what are you taxed on?

• IRC §72(b): Gross income does not include that part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract, i.e., the portion of return which represents your premiums is after tax dollars, which is not taxed again (Only taxed on the interest you receive) Thus we need to determine your exclusion ratio, which you will not be taxed on.

□ Exclusion Ratio: This ratio is determined by dividing the investment in the K as found under §1.72-6 by the expected return under such K as found under §1.72-5.

□ Exclusion Ration= Investment in K/Expected Return

□ PROBLEMS: Pg. 101

➢ The exclusion ratio for the particular K is then applied to the total amount received as an annuity during the taxable year by each recipient. Any excess of the total amount received (during the taxable year) over the amount determined to be the exclusion ratio, shall be included in the gross income of the recipient for the taxable year of receipt.

➢ HYPO: Taxpayer A purchased an annuity K providing payments of $100 per month for consideration of $12,650. Assume the expected return is $16,000. The exclusion ratio to be used by A is $12,650/$16,000; or 79.1 percent.

▪ If 12 such monthly payments are received by A during his taxable year, the total he may exclude from gross income in such year is $949.20 ($1200 x 79.1) The balance ($1,200-$949.20) $250.80 is gross income.

• Expected Return: (If a K to which §72 applies provides that one annuitant is to receive a fixed monthly income for life) the expected return is determined by multiplying the total of the annuity payments to be received annually by the multiple shown in Table I or V of §1.72-9 under the age (as of the annuity starting date) and, if applicable, sex of the measuring life (usually the annuitant’s)

□ HYPO: Male, 66, purchases a K prior to July 1, 1986, providing for annuity of $100/month for his life.

➢ Monthly payment of 100 x 12 months equals annual payment of…….$1200

➢ Multiple shown in Table I male, age 66………………………………14.4

➢ Expected return (1,200 x 14.4)………………………………………….$17,280

□ HYPO (a): A, who is 65 on 1/1/01 pays an insurance company $144K for an annuity of $1000 a month for A’s lifetime, payments to begin on 1/31/01.

➢ How much is income?

▪ Investment: $144,000

▪ Expected Return: 240,000 (12,000 x 20.0)

▪ Exclusion Ratio: 60% (144,000/240,000)

▪ 12,000 x 60%=$7,200

▪ 12,000-7200=$4,800 Include as income

• Mortality Loss: The annuitant dies before life expectancy

□ Estate will actually get to make this deduction.

• Mortality Gain: The annuitant outlives his life expectancy / HYPO: If the reverse happens, and the guy lives much past 20yrs., then everything after his life expectancy is taxable. All must be included as income.

▪ Business Expenses

• One point worth knowing is that the costs of making sales—such as the costs of shipping or of operating delivery trucks—are treated as business expenses, not as part of the costs of the goods that have been sold.

• Dixie Dairies Corp. v. Commissioner

□ Commissioner says what this is an expense. You have 200 GI

□ They both come to the same amount of taxable income.

□ What is the fuss?

➢ Commissioner claims the payment is illegal.

➢ 162(c) – illegal bribes cannot be a deduction

➢ Commissioner argues this is a business expense and cannot deduct under gross income.

➢ Dixie Dairies would argue that nobody enforces this so it should be a deduction

➢ The second argument the commissioner makes is they didn’t have to make these payments, they were optional.

➢ LESSON: where the deduction falls (above or below) matters

□ Court sides with Dairies

• EXCLUSIONS

□ Section 101 – if someone receives the proceeds of a life insurance policy, it is not income

□ Section 102 – gifts and inheritances

□ Section 103 – interest on state and local bonds

➢ Allows gov to put interest rate lower than what can get out on market

□ Section 104 – Compensation for injuries or sickness

□ Section 105 – Amounts received under accident and health plans

□ Section 108 – Discharge of evidence

□ Section 117 – Qualified scholarship

□ Section 121 – When sell principle residence, can exclude from GI up to 1 million of gain

➢ Cancellation of Indebtedness

▪ As a general rule, borrowing does not give rise to income to the borrower and repaying the debt does not gives rise to a deduction. As for the lender, he does not have a deduction when making the loan, and does not have income on repayment.

• Borrowing creates an immediate offsetting obligation to repay and therefore the borrower is not wealthier than he was before borrowing,

• The better explanation of why there is no income is that the amount realized is the amount of the loan, and his basis is also the amount of the loan. Thus there is no gain realized, since amount realized equals basis.

• This indicates that an increase in wealth is not necessarily the touchstone of taxation.

▪ United States v. Kirby Lumber Co.

• LOOK TO HANDOUT

• Kirby bought bonds at a discounted rate, however value of bonds went down.

• Value of these bonds can fluctuate with the amount of risk the bonds have.

• Holmes’s theory of income?

□ On balance sheet (handout), he sells $12,126,800 worth of bonds. When sell bonds does that impact net worth of company?

□ When lumber company bought bonds at discount the cash decreased by $940,779 and the liabilities decreased by $1,078,300 and the difference was a little of 100K. Holmes said that they have income because “assets were freed up b/c of this transaction.” The liability side went down more than the cash put out. To the extent that they freed up assets, they have income.

□ Kerbaugh-Empire was distinguished here by saying the transaction as a whole was a loss.

• When you borrow money, you don’t have to pay any tax on those borrowed funds, b/c at the same time you have an obligation to pay it back. If there is some forgiveness on that debt, then you should realize taxable income on the amount forgiven.

• Kirby Principle: When discharge of indebtedness, have income at that time.

▪ Discharge of Indebtedness: When a person debt is cancelled or reduced, his net worth is increased, and the amount reduced or cancelled is treated as income, unless if falls w/in several possible exceptions.

• See IRC §61(a)(12): Income from discharge of indebtedness.

▪ Insolvency Exception: The Courts have created a doctrine under which cancellation-of-indebtedness income is taxed only to the extent that the taxpayer is solvent after the cancellation.

• IRC §108(a)(1): Gross income does not include any amount…by reason of discharge of indebtedness of the taxpayer if

□ 108(a)(1)(A) Discharge occurs in a bankruptcy case

□ 108(a)(1)(B) Discharge occurs when the taxpayer is insolvent

□ (Note that the bankruptcy exception goes further than the insolvency exception by excluding cancellations of debt in bankruptcy in full, even if the debtor becomes solvent as a result of the proceedings)

• Per 108(a)(3): The amount excluded shall not exceed the amount by which you are insolvent. Thus, if you are 10k insolvent, and 20k in debt—you can only exclude 10k

□ Who is Insolvent?

➢ §108(d)(3): The term insolvent means the excess of liabilities over the fair market value of “assets,” without qualifying

➢ Carlson v. Comm’n: Held that “assets” as defined in §108(d)(3) includes all of the taxpayer’s assets, not just non-exempt assets

▪ HYPO: T owes $100K in debts and has two assets, each worth $75K. One of the assets is exempt from the claims of creditors; the other is not. In determining if T is insolvent, 108(d)(3) seems to indicate that T has assets of 150K (by including the exempt asset)

• PAGE 122 problems – answers on handout

• Reduction of basis following exclusion of cancellation of indebtedness

□ §108(b) requires that the taxpayer apply the exclusions under §108 (a) by reducing the tax attributes of the taxpayer in the order so provided in §108(b)

➢ One tax attribute is the basis of the property held by the taxpayer

➢ However, the basis of exempt property (under the Bankruptcy Act) will not be reduced

➢ §1017 contains directions for calculating basis reduction (made at the beginning of the taxable year following the taxable year in which the discharge occurs)

➢ Another tax attribute is net-operating carryover: a loss from an earlier year which, b/c of its deduction in that year would provide no benefit, can be carried over to future years and deducted against those years’ incomes

▪ HYPO: Before a debt cancellation, T’s assets are worth $1000, and her liabilities total $1600. T is insolvent. One of her debts, in the amount of $900 is canceled upon payment of $100. (Ordinarily this would result in debt cancellation income of $800). However, T is insolvent (b/c the discharge occurred when T was insolvent) to the extent of $600, and so $600 of the income is not taxed.

• Consequently, T’s income is only $200

• T must reduce tax benefits by the remaining $600 per §108(b).

• T must go down the list of 108(b) until she finds tax attributes sufficient to absorb the entire amount of untaxed income.

▪ Liabilities giving rise to Deductions:

• Per §108(e)(2) No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.

• HYPO: F, cash method lawyer, owes G $500 for services G has performed for F. F would be entitled to a $500 deduction upon paying for these services. G cancels $300 of the debt.

□ $300 is not income to F b/c the payment of the liability would have given rise to a deduction.

▪ RAIL-JOINT PRINCIPLE: Several courts have held that cancellation of a debt gives rise to income only if incurring the debt gave the taxpayer money, property, or services.

• Commissioner v. Rail Joint: Company distributed its own bonds to its S/H as a dividend, then bought back some of the bonds for less than face value. Held, Corp., having received nothing when it issued the bonds, (i.e., when it incurred debt they did not get $, property, services) had no income when it bought them back for less than face value. The Rail Joint court distinguish Kirby Lumber by saying that Kirby’s assets were increased by the cash received for the bonds

▪ Reduction of Purchase Price: (PROBLEMS PG 124 – answers on handout)

•See §108(e)(5) 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, such reduction does not occur in a bankruptcy case or when the purchaser is insolvent.

• Statutory reduction of purchase price rule applies only in the case of a debt owed to the seller of property.

□ Only applies b/t a creditor and purchaser

➢ Hirsch v. Comm’n: T bought property for 29K (paying 10K down, assuming 19K mortgage debt) Several years later, the value of the property fell to 8K. The mortgagee agreed to take 8K in full satisfaction. Held, the $7K that was cancelled was a reduction in the purchase price and not income.

▪ HYPO: Buck Gray car purchase, you paid 10k, find out some things are wrong, Buck says I’ll give it to you for 7k. This is only an adjustment of the purchase price. ONLY works between buyer and seller, no successor to buyer and seller.

▪ HYPO: A owes B 50K and is insolvent. A owns some land with a basis of 20K and a FMV of 30K. B says I will accept that land in full satisfaction of the debt. What Result? Any income?

• It’s as if A had gone and sold that property, he would have realized 10K of gain. Then he would have took that 30K and gave it to B. The principle doesn’t override the fact that he realized gain when he used that appreciated property to clear the debt.

• A has income of 10K.

▪ Qualified Real Property Business Indebtedness: An exclusion is created under §108(a)(1)(D), for taxpayers, other than C corp’s, and applies only to the extent that the amount of the debt before cancellation exceeds the value of the property which secures the debt.

• You must have depreciable property. To wit:

▪ HYPO: T incurs a debt of 200K to buy a building used in a trade, and the value of the bldg. falls to $180K. A cancellation of 30K, will produce only 10K of income. (§108(a)(1)(D) only applies to the amount the debt exceeds the value, i.e., 20K.) The basis of the property must be reduced by the amount of debt-cancellation income excluded, i.e., 20K. (see 108(c)(1)(A), which provides that the basis of depreciable real property must be reduced by the amount excluded from gross income.

▪ Revenue Ruling 84-176

• F: Corp. (buyer) entered into K w/ seller, under which buyer agreed to purchase various quantities of goods. Seller shipped some goods, but refused to ship the rest. Buyer refuses to pay ($1K) for the goods already received and files a counterclaim. Settlement—buyer agreed to pay $500, remaining 500 was forgiven, in return of buyer dropping counterclaim. Seller excluded $500 from income per §108 and reduced the basis of its assets by that amount as req’d by §107.

• H: This amount that the seller waived, is to be treated as payment for lost profits rather than a discharge of indebtedness.

• R: Debt discharge that is only a medium for some other form of payment, such as a gift or salary, is treated as that form of payment rather than under the debt discharge rules

• (Not every indebtedness that is cancelled results in gross income being realized by the debtor “by reason of” discharge of indebtedness. If a cancellation of indebtedness is simply the medium for payment of some other form of income)

▪ PROBLEM ON 127

• 1. No income, gift.

• 2. Yes, personal services income.

□ **If not w/in a 108 exclusion, it is income.

➢ Damages and Social Welfare Payments

▪ Damages, In General

• Damages in General: §104—if payment does not arise out of physical injury or physical sickness (ex-medical expenses, lost wages, pain + suffering), utilize “in lieu of test.” / Punitive = not excludable

□ Thus, Age and Sex discrimination, libel, slander, etc… are all includable in income.

□ Attorney’s Fees: Money you expend to produce taxable income is normally deductible

• Sager Glove Corp. v. Comm’n

□ F: Sager sued Bausch & Lomb Optical for violation of Antitrust violations (refusing to supply it w/ lenses for safety goggles), which forced Sager to cancel a K w/ General Motors, lose customers, etc… Case settled for $478K. 132K was paid as reimbursement for atty. fees, to which constituted ordinary and necessary business expense—which is deductible. Both parties agreed 132K was income. Why would Sager Glove not care about that? B/c they will be able to deduct it as a Business Expense.

□ Sager claim – Sager argued that it was a capital gain. He said that it was a loss of goodwill (they were forced out of the goggle business so he claims this was replacing the money invested in the business which is called goodwill)

➢ However they never offered any proof of whatever basis they had, so it will be taxable income.

□ Commissioner claim – Commissioner claimed that it was a lost profit and since they would have paid tax anyway, it will be taxable here.

□ H: Taxable as ordinary income, as it looks like compensation for lost profits

□ R: If the recovery represents damages for lost profits, it is taxable as ordinary income. However, if it represents a replacement of capital destroyed or injured, the money received, to the extent it does not exceed the basis, is return of capital and not taxable.

□ Business and Personal Injuries: Damages for the destruction of property (personal or business) which exceed the basis of the property are income.

HYPO: Vacation home has basis of 20K, and is destroyed. Taxpayer receives 30K in damages from tortfeasor or insurance payments. T has 10K of income.

➢ Where did they go wrong in complaint?

▪ They alleged in the complaint that it was lost profits, therefore switching gears in the middle of the case will get you in a lot of trouble. Also Mr. Sager testified that it was lost profits. Now he is trying to switch gears in the 7th Circuit.

▪ Was there any allocation in the settlement agreement? NONE

▪ When they get to trial we find out:

• Mr. Sager was not present at the settlement meeting; and

• They did not provide any witnesses to stay how they allocated the settlement amount

□ 104 doesn’t apply here, only I is: Is it going to be a return of capital or ordinary income as it is here?

▪ Damages Under Section 104

• Pre-1996 §104: Under 104(a)(2): all of the compensatory damages—lost wages and pain and suffering—were excludable.

• CANNOT USE EMOTIONAL TRAUMA TO SPRINGBOARD INTO PHYSICAL INJURY, if try will be taxed.

• Present day §104: In General—except in the case of amount attributable to (and not in excess of) deductions allowed under §213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—…

□ Worker’s Compensation

□ Damages (other than punitives) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness….

➢ For purposes of para. (2), emotional distress shall not be treated as a physical injury or physical sickness.

➢ If not a physical injury, go back to the “in lieu of test.”

➢ Injury must come from outside agency, not self-inflicted

▪ i.e., a doctor jumping of bridge b/c of libel

▪ i.e., a headache, anxiety—“tough rocks”

• Mental/Psychological Injury is not included w/in §104 unless it is the result of a physical injury

• HYPO: Son of M, almost gets hit by a car, and now has headaches, etc…No physical injury to the son.

• HYPO: If car hit Son, causing physical injury (i.e., contusions, bruises) and M recovers, this is excludable, b/c event which gave rise to award was physical injury.

• HYPO: M is accused of sexual harassment by S. S sues M and wins. This is not excludable b/c there was not physical injury.

• Two Fundamental kinds of damages: Damage to the person and to the business.

□ Damages from Personal Injuries

➢ Compensatory damages received on account of personal physical injuries or physical sickness are generally excluded. See §104(2)(a)

➢ Punitive damages are always included.

➢ Emotional distress is not a physical injury or physical sickness, though recoveries for medical expenses in emotional distress cases remain excludable. See § 104(c)

□ Damages from Injury to Business

• Annuity Payments (Structured Settlements): An accident victim who receives 100K from an insurance Co. and uses the 100K to buy an annuity, includes the interest portion of the annuity in income under §72. However, if the settlement takes the economically identical form of an annuity (periodic) payment to the victim at an increased %, the victim can exclude all of the annuity payment.

□ Must be labeled as an interest component of an annuity received as personal injury damages, not as interest in substance.

• HYPO: 300k settlement (right now) or 360k spread over a period of time? If you took the 300k up front and bought an annuity, part of it is taxable. However, if you took the 360k, none of it is includable in income, e/t there is an interest element.

• Amos v. Commissioner

□ After Rodman kicked Mr. Amos in groin, Rodman settles for 200K

□ Settlement agreement

➢ Amos agrees to not say anything about Rodman, refuses to cooperate with police

➢ Also a liquidation clause saying if Mr. Amos violates any of the provisions, then he must pay Rodman 200K (exact amount of settlement)

□ Mr. Amos records 80K as taxable income, excludes 120K

□ Is this a 104 case? (physical injury)

➢ Commissioner is claiming it is not by bifurcating. He is saying the amount attributable to physical injuries is under 104 and should be excluded. But the other provisions in the agreement have nothing to do with the physical injuries and they should be separated (not under 104).

➢ Commissioner wants to put $1 to physical injuries.

□ Court comes up with allocation, what is it?

➢ Court just picks a number.

□ LESSON OF CASE – they should have allocated in the settlement agreement the amount of damages to physical injuries. If you were representing Mr. Amos you should have argued to soften that language all about what Mr. Amos had to do in settlement. Sure should have put in something about, “We allocate XXX number of dollars to physical injuries.”

▪ Social Welfare Payments

• Revenue Ruling 85-39

□ Issue: are dividend payments made by the State of Alaska includable in gross income under § 61 of the IRC?

□ Court notes that certain payments made under legislatively provided social benefit programs for promotion of the general welfare are not includible in a recipient’s gross income, bonus payments received under the Alaska Longevity Bonus Act are includible in the recipient’s gross income.

• Notes

□ Most Social Security benefits are partially includable in the incomes of upper and middle income recipients under § 86.

□ Unemployment benefits are taxable under § 85 b/c unemployment benefits replace taxable wages and b/c exclusion of unemployment benefits creates an incentive for unemployment.

❖ Chapter 3: Some Exclusions, Deductions, and Credits

➢ Tax-Exempt Interest

▪ In Pollock v. Farmers’ Loan & Trust Co., the Supreme Court held the Income Tax Act of 1894 unconstitutional in taxing the interest on state and municipal bonds b/c it was in effect, a tax on a state’s power to borrow.

▪ Supreme Court overruled Pollock in South Carolina v. Baker

▪ Although Congress now has the power to tax interest on state and local bonds, Congress has shown no sign of wanting to exercise that power in a sweeping way.

▪ § 103, which provides that gross income does not include interest on any “state or local bond,” is seen today as a form of revenue sharing. By giving up the taxes it could collect on state and local bond interest, the federal government enables states and cities to borrow more cheaply than they could if that interest were taxed. In effect, the federal government pays part of the states’ borrowing costs.

➢ Tax Expenditures

▪ Tax expenditure: those revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability

➢ Gifts and Bequests

▪ Gifts: Ever since 1913, gifts and inheritances have been excluded from income. This exclusion raises some puzzling theoretical questions. One who receives a gift or inheritance has certainly enjoyed an increase in wealth (See Glenshaw), but is nonetheless exempt.

• *§102: Gross Income does not include the value of property acquired by gift, bequest, devise, or inheritance

• *Donors get no deductions for gifts and donees have no income: If A earns a salary or collects interest on a bond and then gives some of the salary or interest to B, A has income (per §61) and B does not (via § 102).

• What qualifies as a gift?

□ The most critical consideration is the transferor’s intention.

□ The donor’s characterization of his action is not determinative.

□ Mere absence of a legal or moral obligation to make a payment does not establish that it is a gift. See Old Colony

□ A gift in the statutory sense, proceeds from a detached and disinterested generosity. See Lobue

□ Per Duberstein, the reach of the concept of income is pretty broad when gratuitous transfers are made in a business setting.

□ Comm’n v. Duberstein

➢ F: 1) Duberstein, pres. of Duberstein Iron & Metal Co., referred customers to Berman, pres. of Mohawk Metal Co., in the course of doing business. In 1951, Berman gave Duberstein a present of a Cadillac b/c the info Duberstein had given was so helpful. No obligation, just decided to. Mohawk deducted the Caddy as a business expense.

➢ 2) Stanton: Employee gave payment to retiring employee. He received 20K. Some people weren’t totally on board with doing it but ultimately it was a decision that was made with his resignation.

▪ Was this payment for any sort of resolution from a conflict btwn employees?

➢ H: 1)Tax Court was not clearly erroneous in finding Caddy not to be a gift, b/c no intention of gift, but a remuneration for services provided or inducement of future services. 2) Remanded, b/c Dist. Court’s conclusion was a general finding that it was a gift, w/ no concrete indication of the legal standard utilized.

➢ R: Transferor’s intention is of paramount significance; what is the dominant reason that explains his action in making the transaction. The test under Duberstein is the Donor’s intent, not what the donee may have thought.

▪ Taxing statute does not make non-deductibility by the transferor a condition on the gift exclusion

▪ Decision as to whether it is a gift must be based on trier-of-fact’s review of totality of facts in each specific case. Give deference to the trier of fact.

• Gov’t wanted to come up with a new test for if it is a gift, however court rejected the proposal.

➢ Court noted that a gift in the statutory sense, on the other hand, proceeds from a ‘detached and disinterested generosity,’ ‘out of affection, respect, admiration, charity or like impulses.’ And in this regard, the most critical consideration, as the court was agreed in the leading case here , is the transferor’s ‘intention.’ ‘What controls is the intention with which payment, however voluntary, has been made

□ PROBLEM PG 186 – Most likely T has the income, with a gift from T to D. Question is what kind of value is given for income.

□ HYPO: M gives 10k to his smoking daughter. Income? No. Probably a gift, as this is not really compensation for services. Per Duberstein, look into M’s head. Did he intend gift?

□ HYPO: M, thinking that P is underpaid, gives P (local priest) $50. M is augmenting P’s income. The more the priest starts thinking this payment to be an augmentation of services, and expects it—the more clearly it becomes income.

➢ *The family relationship in hypo #1 provides the distinction from hypo #2.

□ TIPS? Income. If restaurants don’t keep accurate records than keep 8% as tips.

□ United States v. Harris

➢ F: K, deceased, was a wealthy widower, whom gave two broads each more than half a million dollars over the course of several years. Is this income to the two ladies?

➢ H: Remand w/ instructions to reverse indictments against the two ladies.

➢ R: How do you ascertain the intent of the dead guy?

• Gifts to Employees: §102(c), enacted in 1986, provides a conclusive presumption of income. In general, there shall not be excluded from income any amount transferred by an employer to an employee; except for de minimis gifts under § 132, and some non-cash achievement awards under § 74(c).

□ Overrules Stanton: A gift to employees for long and loyal service, constitutes income.

□ But see proposed T.Reg. §1.102-1, which proposes that §102(c) should not be applied to amount transferred b/c related parties (e.g., father & son) if the purpose of the transfer can be substantially attributed to the familial relationship (natural object of bounty)of the parties and not the circumstances of employment.

□ HYPO: Notify firm that getting married and they give you weekend off. Monday morning a tiffanys box shows up on doorstep from firm, technically under 102(c) it is income.

• Gifts of Income from Property: Instead of an outright gift of property, the donor may confer the income from property as a gift. In such an event, the income from the property is taxable to the donee, notwithstanding that the transaction is indisputably a gift. See §102(b) (including income from any property)

□ *If the gift takes the form of periodic payments from specified property, it is taxable to the recipient to the extent the payments are out of income from the property and excludable to the extent the payments must be made from principal. See §102(b)

• Bequests/Inheritances: Like gifts, bequests, devises, inheritances are excluded from income by § 102. Comes to you through trust, intestate succession, b/c someone took a statutory share permitting spouse to do that, money from a will contest

□ A spouse’s statutory share is not income, even if decedent tried to disinherit

□ BASIS: The basis of inherited property is the property’s value at the date of the decedent’s death. § 1014—no tax on the amount inherited, but you get a stepped-up basis

➢ Fine area between a transfer that is made b/c the person is the normal object of that persons beneficial attitudes and those transfers that are made to take care of some legal obligation.

➢ Problems sometimes run into.

▪ 102(c) sometimes gets in the way

▪ Pg. 187

• Problem 1: Who really is the employer? The Corporation.

• Problem 2: Literally 102(c) would say it is income. He disagrees, says that is not really what 102(c) was meant for.

• Problem 3: Literal wording of 102(c) would say yes, but looking at regulation 1.102-1(f)(2) holds that it is not.

• Basis of Gifts & Bequests

□ Gifts: §1015 applies to transfers by gift.

➢ General Rule is “Carryover Basis”—the donee takes the donor’s basis for determining gain or loss

▪ HYPO: A transfers stock to B as a gift

• Basis of Donor (A)—$10K

• FMV—$15K

• Donee’s (B) basis—$10K

• If B then transfers to C, and the FMV is $20K, C’s basis (as long as it is a §102 transfer) would be $10K

• When this stock is sold, gain will be taxed (low basis, but higher FMV).

▪ HYPO: If A sold for its FMV (15K), he would pay tax upon the

• $5k gain, then give it to B (whom would have a $15k basis—although basis isn’t usually talked about in terms of cash)

□ Exception: If FMV is less than basis at time of gift, for purposes of determining loss, basis shall be FMV.

▪ HYPO:

• Basis of Donor—$10K

• FMV—$8K

• Sale by Donee—$9K (No gain or loss)

• Sale by Donee—$11K ($1K gain)

• Sale by Donee—$6K ($2K loss)

▪ Bequests: §1014 applies to property acquired from decedent

• General Rule is “Stepped-up Basis”—the person acquiring the property takes, as their basis, the FMV of the property at the date of death or some other valuation date.

□ This could produce a ‘step-down’ if FMV was less than decedent’s basis.

□ HYPO: A has 250K property, and takes 200K in depreciation deductions, thus basis is now 50K. When A dies, the FMV of his property is 450K. The property is willed to B, B basis in the property is 450K. If B takes 200K in deductions, his new basis is 250K.

□ HYPO: Old man Swygert buys Lake Michigan house for 28K in 1930. Today it is worth $1.2M. Old man says he is going to give it to Mike Swygert. Mike says Dad, don’t give the property to me now, as a gift, b/c my basis will be $28K Rather transfer it to me at death, and then my basis will be $1.2M

➢ Life-Insurance Proceeds

▪ As a broad general rule, proceeds from life insurance contracts are taxable, however, proceeds paid under an insurance contract, by reason of the death of the insured, are excluded from gross income [ No deduction shall be allowed for premiums on any life insurance policy, or annuity contract if taxpayer is directly or indirectly a beneficiary under the policy or K]

• NOT DEDUCTIBLE

▪ Two major (huge) advantages of life insurance

• All proceeds are tax-free

• Investment element builds up tax-free (similar to Roth IRA) (Life insurance companies bring important long term investment strategies to the capital markets)

▪ Basic Concepts:

• Premiums depend upon your insurability (age, disease, etc…)

• Owner of policy (whom may cancel coverage, change beneficiary, etc…) may be the insured or somebody else

• Life insurance company wants you to live forever so that you pay more in premiums than you receive from death benefits. Pure gamble that insured will live long—if the insured dies young the Co. loses.

□ (Compare an annuity, where they want you to die right away)

▪ Term Insurance: No investment feature, simply provides death benefits if the insured dies w/in the coverage period— usually for a set “term,” usually 5-10 yrs.

• Most simple type – simply death protection

• Renewability: Allows you to purchase for another term (at a higher rate b/c you are older) w/out going through insurability process, i.e., taking a physical exam.

• Convertability: Some term-insurance policies may be converted by the insured to a more-elaborate kind of policy.

• Decreasing:

▪ Whole Life Insurance: Premium you pay—$1000. $100 goes to the mortality coverage (term), and $900 goes into an investment account. Mortality factor and investment factor.

• Systematic plan

• As $900 grows, none of the build-up is taxable.

□ Insurance/Investment: §7702 requires that if you have a life insurance policy that produces investment, it must have a significant insurance element. (Not a very restrictive test)

➢ What if decide to cash in? Assume 100K policy and paid in 20K in premiums and policy now has cash value of 30K. So you cash in policy for the 30K, now you have a 10K gain which is taxable.

□ Cash Value: Life insurance policies combining term and investment components, provide ways in which the insured can w/draw the accumulated investment

➢ A common use of the return on the investment component of life insurance is to pay some of the premiums on the policy—resulting in a complete tax exemption for the investment return ( cash value) b/c §72(e)(4)(b) provides that “dividends” on insurance policies are tax free if retained by the insurer as premiums. (Contrast someone who buys term ins., and pays the premiums w/ interest earned on a bank account).

➢ As a rule, lump-sum payments to an insured (amount not received as annuity) are tax free until the total amount of the payments to the insured exceeds the total amount of premiums paid by the insured. (By contrast, early w/drawl from annuity K’ are taxed under §72(e)(2)).

▪ The proceeds of loans against insurance policies are tax free b/c loan proceeds are not income.

• Section 79 – concerning group term life insurance policies. Section states that up to $50K of that insurance can be provided by your employer tax free. If over 50K then must include in income.

• 101(g) – people who have terminal illness or chronically ill, they can go to companies that specialize in purchasing life insurance policies from people in those situations

• For families, these cash value policies are often a poor deal, b/c the commissions are usually high. But employers can negotiate low commissions and it makes sense for them to round up cash they might have lying around (on which they’re earning taxable returns, and blow it into a life-insurance policy where the returns aren’t taxed

➢ Scholarships and Prizes

▪ Scholarships

▪ Prizes

• Prizes and Awards are included in income under § 74(a).

□ Exceptions:

➢ (a) Charitable Transfer: A prize is not taxable if (i) it was received for scientific, educational, or similar achievements and (ii) the recipient orders that it be transferred to a charity. See § 74(b) (recipient would also not be entitled to a charitable deduction for the transfer)

➢ (b) Employee Achievement Awards: An award to an employee for length of service or safety achievement is not taxable unless it cost the employee more than $400. See §§ 74(c), 274(j)

• HYPO: T, a professional football player, received an automobile from a sports magazine after he was named the MVP in the championship game. Held to be a taxable accession to wealth under Glenshaw. This was not a tax-free gift under §102, nor was it an award for noteworthy service under §102.

• Turner v. Commissioner

□ Person selected by chance from a telephone book and won a radio contest. Petitioners reported $520 on their return, but the commissioner increased the source to $2,200 (the retail price of the tickets)

□ Court concluded that a majority of the retail value should be taxed, but not all of it b/c the tickets were non-transferable and non-salable

➢ Charitable Contributions and Tax-Exempt Organizations

▪ Any charitable contribution, as defined in § 170(c), actually paid during the taxable year, is allowable as a deduction in computing taxable income irrespective of the method of accounting employed

• I.R.C. §170(c) “a contribution or gift to or for the use of—(basically) the government or any entity organized and operated predominantly for charitable, religious, scientific, literary, or educational purposes.

□ *Contributions do not qualify under §170(c) merely b/c the recipient is tax-exempt, i.e., social welfare org., chamber of commerce, and social clubs are tax-exempt, but gifts to them are not deductible under §170 (although they may so be under §162—business expense).

□ *Gifts to needy individuals are not deductible under §170, even if a charitable organization plays a role in delivering the gift.

▪ In General: To be deducted under §170 a charitable transfer must:

• (1) Be paid to or for the use of a qualified recipient

□ the latter phrase encompasses gifts in trust

□ Expenditures made for the use of, but not “to” do not qualify for the 50% limitation of 170(b)(1)(A), but only for the 30% of 170(b)(1)(B).

• (2) Constitute a gift or contribution rather than a payment for goods or service

□ “detached and disinterested generosity” of Dubserstein?

□ This standard may be tough, as very few whom donate cloak themselves in anonymity to avoid the plaudits of the public gratitude

➢ Under §170(l), if a payment to a college or university would be a deductible charitable gift but for the fact that it entitles the taxpayer “to purchase seating at an athletic event in an athletic stadium of such institution,” 80% of the payment is considered a charitable contribution. The actual cost of the tickets is non-deductible.

▪ HYPO: T donated 2k to the University Athletic Fund (Donors of $1500 or more can purchase tickets which entitle the holder to preferred seats at basketball games)

• 80% of the $1500 is deductible, as $1500 entitles the taxpayer to the purchase.

• 100% of the $500 is deductible

▪ Consist of Cash or qualified property

▪ You may deduct unreimbursed out of pocket expenses incurred in performing services for a charity (including uniforms, transportation, meals, lodging) which are considered gifts to the charity; but not time spent performing services for charitable organizations.

▪ Not exceed a specified percent of taxpayer’s AGI in the year of payment

• Most contributions: 50%

• Contributions to private organization; gifts of appreciated property: 30%

▪ Meet Certain other standards

▪ Taxpayer must itemize deduction under 63(e) to claim the deduction.

• Substantiation Requirements for All Contributions: §170(f)(8) disallows a deduction for any contribution of $250 or more, unless the T obtains “substantiation” of the contribution by means of written acknowledgement of by the donee organization.

□ Limitation on Amount Deductible: The charitable contribution deduction for a payment of a taxpayer makes, partly in consideration for goods or services from the donee, must be reduced by the fair market value of the goods or services the organization/donee provides.

➢ The taxpayer may rely upon donee’s representation of the FMV.

➢ EXCEPTION: Certain goods that have insubstantial value (small items of token value) are disregarded.

▪ Annual membership benefits are ignored if the annual membership fee is not more than $75 and the benefits consist of only rights exercised in conjunction w/ being a member (free parking, discounted admission, preferred access to goods)

□ Value of a contribution in Property: If charitable contribution is made in property other than money, the amount of the contribution (which may be deducted) is the fair market value of the property at the time of the contribution—basis is disregarded.

➢ If hold property for less than one year, you can only deduct your basis in that property. Therefore, hold it for longer than 1 year

□ Gifts of tangible personal property

➢ Ex: Painting – bought for 1K and is now worth 5K. You decide to give it away. If give to Brower museum of art then can deduct 5K but if give to Red Cross you can only deduct 1K (your basis). This is b/c you must give it to an organization that will use it in its function. Theory is that you know that Red Cross would sell it.

➢ also if only have it for less than 1 years than only basis regardless.

▪ HYPO: T plans to sell appreciated stock, and give the proceeds to a charity. T is dumb and would better off to contribute the stock itself—giving rise to the same deduction as the donation of the proceeds, and the gift of the stock is not an event which requires T to recognize the gain (contrast § 84).

▪ Contribution of Services: No deduction is allowable under § 170 for a contribution of services. However, unreimbursed expenditures made incident to the rendition of services to an organization, contributions to which are deductible, may constitute a deductible contribution, i.e., the cost of a uniform which is required to be worn in performing donated services is deductible.

▪ Percentage Limitations:

• Individual (See § 170(b)(1)—In the case of an individual, any charitable contribution shall be allowed to the extent that the aggregate of such contributions does not exceed 50% of the taxpayer’s contribution base for the taxable year.

□ (Individ. are entitled to deduct up to 50% of their AGI for most charitable gifts)

□ HYPO: If AGI is 100k, T could deduct 50k of a 70k charitable contribution. 20k would be deductible the next year.

• Corporation In the case of a corporation, the total deductions shall not exceed 10% of the taxpayer’s taxable income computed. See § 170(b)(2).

▪ Haverly v. United States

• F: T, a Principal of Elementary School, received unsolicited samples of text books, with a FMV of $400. T could do whatever he wanted w/ the books, and chose to donate them to the Library. T then took a charitable deduction of $400, under §170. IRS assessed a deficiency against T representing income taxes on the value of the books received. T paid tax, now seeks refund - § 170 deduction

• Problem: didn’t claim income yet claimed deduction

• H: When a tax deduction is taken for the donation of unsolicited samples the value of the samples received must be included in the taxpayer’s gross income – he exercised dominion over them when gave them to library

• R: The receipt of textbooks is clearly an “accession to wealth.” The act of claiming a charitable deduction manifests the intent to accept the property as one’s own.

• Held: Not income b/c he didn’t ask for them. However, if he decides to deduct them, then he must record them as income for tax purposes.

• Until you start trying to take advantage, won’t go after you.

▪ Problem p. 214 #4

➢ State, Local, and Foreign Taxes

▪ Taxes deductible: §164 (a): Except as otherwise provided, the following taxes shall be allowed as a deduction for the taxable year w/in which paid or accrued:

• State and local and foreign real property taxes

• State and local personal property taxes

• State and local and foreign income, war profits, and excess profits taxes

□ Tax on stuff for business is added to the basis for depreciation reasons

▪ 164(f) Self-Employment Taxes—

• As a partner or self-employed individual, you must pay all of this tax. This § says you may deduct portion (above the line) that employer would normally pay.

▪ Problem Page 228-29 #2

➢ Personal Exemptions and Filing Status

▪ Personal and Dependency Exemptions

• Personal Exemption: §151 allows a deduction in a fixed dollar amount ($3,300 for 2006 adjusted for inflation) for each taxpayer regardless of age, income, marital status; deducted from AGI in determining taxable income—in other words, below the line deduction

□ This exemption amount is phased out (reduced) as the taxpayer’s AGI increases beyond specified levels, depending upon filing status. See §151(d)

□ §151(d)(2) denies a deduction to a person (regardless of age) for whom a dependency exemption is allowable to another.

□ When a joint return is filed, two personal exemptions are allowed b/c both spouses are taxpayers.

• Dependency Exemption: allows a taxpayer to take a dependency exemption (deducting amount from AGI) for each individual whom:

□ is related to the taxpayer in a manner specified by §152, which is broadly defined and easy to be considered a dependent.

□ receives more than one half of his support (food, shelter, clothing, education, etc.) from the taxpayer or satisfies a special support requirement; and

□ does not have gross income exceeding the exemption amount or is a child of the taxpayer who is either below the age of 19 or a student under the age of 24 (See §151(c)(1)(A)

➢ General rule is that in order to claim dependency exemption, dependent may not have gross income over exemption amount; unless kid falls w/in §151(c)(1)(B)

➢ The taxpayer’s spouse can never be the taxpayer’s dependent. See §152(a)(9)

➢ If you are married and file a joint return w/ spouse, your parents could not claim you as a dependent.

• Divorced Parents: Who gets to claim the dependency exemption, where a kid gets over half of his support from his two parents?

□ Custodial Parent: Largely to simplify things, §152(e) was enacted, under which children are dependents of the custodial parent (the one who had custody for the greater portion of the year) unless the parents agree to transfer the exemption to the noncustodial parent.

□ Requirements: For §152(e) to apply, the following must be met:

➢ more than one half of the child’s support for the year is provided by his or her parents

➢ the parents are divorced, separated under a decree, or live apart for last 6mo. of the year.

➢ the child is in custody of one or both of the parents for more than one half of the year.

□ Thus §152(e) does not apply if a grandparent or other 3rd person supplies more than one half of the child’s support or has custody for more than one half of the calendar year

□ If a spouse remarries, support by a subsequent spouse of either parent is deemed to be provided by that parent. See §152(e)(5)

▪ Filing Status

• The taxpayer’s filing status determines the rates that apply to the taxpayer’s income

□ Married Couples: If a couple is married at the end of the year, they can either file separately or combine their income and deductions on a joint return under §6013. If one spouse has substantially higher income than the other, they can usually reduce their taxes by filing jointly.

➢ Filing a joint return makes both spouses liable for the tax.

□ Single Persons: Singles must usually calculate their tax under §1(c), unless they are either a surviving spouse or head of household

□ Surviving Spouse: Although single, the surviving spouse gets the benefits of the joint-return.

□ Head of Household: A head of household is taxed more lightly than a single person, but not as lightly as a surviving spouse

• Problems 234-35

➢ Alimony and Related Issues

▪ Until 1942, alimony was not income to the spouse who received it and was not deductible by the payor.

• Current tax consequences: If divorced related payments to a spouse are alimony or separate maintenance (as defined in §71) the recipient includes the payments in income and (per §§ 215, 62(a)(10)) the payor gets an “above the line” deduction, i.e., payor gets to deduct payment in computing AGI. §71 intentionally gives lawyers latitude to allow (family law) agreements to achieve favorable tax treatment. Payment has to end at death or re-marriage but doesn’t have to go til then. (In order to get deduction, someone must be taxed)

□ Compare Child Support and Division of Property, which does not invoke §71

➢ Child Support: Payor will pay 1k per month for as long as ex-lives. When kid is 21, payment reduces to $750. $250 thus represents child support—not subject to §71—thus the tax burden is on the payor. Why? It is not income to the payee, and the payor gets no deduction for making the payment.)

➢ Division of Property: You get house, and 100K, I get benzo and vacation home. This is not alimony.

• If amount is not treated as alimony, it is typically treated as a division of property, not w/in the scope of §71. (Davis- if property is transferred bc of divorce = no gain or loss to either)

• Professor continuously noted that spouses could “opt-out” of §71. See §71(b)(1)(B), noting that the instrument may designate that otherwise taxable and deductible payments will not be taxable and deductible. Flexibility to the spouses in negotiating treatment.

□ Economics of Divorce: Usually the higher-income spouse makes payments to the lower-income spouse. What is usually desired by both parties therefore, is that the payments be deductible to the payor and income to the payee. (If the payments are deductible to the higher-bracket payor, that saves the estranged couple more in taxes than it costs to have the payments income to the lower-bracket payee.) This leads to more after tax income to divide.

➢ Basic Requirements For Taxable and Deductible Alimony

▪ Payment is received by, or on behalf of, a spouse under a divorce or separation instrument. §71(b)(1)(A)

▪ Payment is in cash or equivalent.

▪ The divorce or separation instrument does not designate the payment as a non-alimony payment. §71(b)(1)(B)

▪ The payment is not for child support or property division.

▪ In the case of a decree or legal separation or of divorce, the parties are not members of the same household at the time the payment is made. §71(b)(1)(C)

▪ There can be no liability to make the payment in cash or in property after the death of the payee-spouse. §71(b)(1)(D)

▪ The spouses may not file a joint return

➢ Basis in Alimony Property: See rule §1041, which essentially operates in the same fashion as the basis for a gift (§1015), i.e., recipient will take the basis of the transferor. “Carry-over”, not a stepped-up basis.

□ If H makes mortgage payments on a house owned by W, the payments may be alimony. You could not make payments on an asset that you own

➢ Often, both spouses have an ownership interest, and both may be liable on the mortgage.

▪ Okerson- post-death payments fail to qualify as alimony for Fed. Income tax purposes

• Had to pay alimony payments to wife. How were they set up

□ 113 monthly payments totaling 117,000, terminating upon her death, but would still be required to continue making the monthly payments towards the education of the couple’s children until they completed 4 yrs. of college

• Also had to pay 33,500 to her attorney, upon her death the payments would continue being paid

• Is this alimony?

□ Intent of parties does not matter. Code has set out a bright line objective test. So doesn’t matter that parties intended it to be alimony.

➢ What doomed these payments (not alimony)? The payments were to continue after her death.

➢ What does this begin to look like? It looks like a lump sum property settlement.

➢ How could you fix the problem here?

▪ As long as Ms. Okerson is alive, you could have Mr. Okerson pay the premiums on a life insurance policy owned by Ms. Okerson and for the benefit of the kids. This would likely qualify as alimony.

▪ Kean- where support payments are unallocated, the entire amt. is attributable to the payee spouse’s income

• Mr. Kean required by ct. to pay 6K a month into a joint checking account and the wife was to use this for herself, her children, and the household expenses.

• Here the tax court says it is alimony, however, the wife claims it is not alimony.

• Why doesn’t she want it to be alimony? She doesn’t want to claim it as income.

• What are her arguments?

□ She never received money.

➢ Court shoots it down b/c she has unfettered discretion to use the money.

□ There was nothing in the order that required that the payments terminate upon her death.

□ Court handles by looking to New Jersey law which show that if it is silent to whether payments terminate on death, then it is presumed that they do.

• “Whipsawed”

□ What is gov’t worried about? Not getting their taxes, so they went after Mr. Kean as well just in case they lost to Ms. Kean.

• Pg. 246

□ (1) These payments are child support so 30K is going to be non-deductible.

□ (2) None of it would be alimony and none of it would be income.

□ (3) Okerson. Only 10K would be deductible.

➢ Personal Tax Credits

▪ The Child Tax Credit

• § 24 allows a low-or middle-income taxpayer a $1000 credit for each qualifying child of the taxpayer who is under age 17. The credit is phased out at the rate of $50 for each $1000 by which the taxpayer’s modified AGI exceeds $75k (for unmarried) or $110k (for married).

▪ The Credit for Household and Dependent Care Services

• §21 allows a credit for amounts paid for child care and household services if the taxpayer has at least one child under the age of 13 or an incapacitated dependent; and the amounts are paid in order to enable the taxpayer to be gainfully employed.

□ Status of taxpayer: To be entitled to credit under §21, the taxpayer must “maintain a household” that includes one or more qualifying individuals (see above)

• Leverage – use other peoples borrowed money to leverage transactions so that if things go well it can produce a lot of good things, but if they go bad it can be really bad

□ Ex: 400K that you are ready to invest in real estate.

□ Options for buying apartments to rent:

➢ Can buy 1 complex and put 400k down and owe 600K

➢ Can buy 2 complexes and put 200K down and owe 800K on each

➢ Can buy 4 complexes and put 100K down and owe 900K on each

□ What do you need to know? How many tenants are you going to have, how consistent, basically what is cash flow in?

• Problems 250-51

• Summer camp and § 21: can the cost of sending children to summer camp while their parents work qualify as employment-related expenses under § 21?

□ Tax court allowed the credit, finding that the taxpayer’s ‘principal purpose in sending her child away to camp was to provide for his well-being and protection’ and noting that the summer camp was ‘virtually as inexpensive as’ alternative forms of care.’

▪ The Earned-Income Credit

• § 32 is intended to supplement the incomes of low-income working people, especially those who support minor children it is intended to make work more attractive to low-income taxpayers, who, though not subject to heavy income taxation, have to pay social security and medicare taxes, which contain not exemptions for the poor.

• This credit differs from most other credits b/c it is refundable-i.e., the amount by which the credit exceeds the taxpayer’s tax liability before applying the credit is paid to the taxpayer. Thus if tax liability would be $1500 without the credit, and if the amount of the credit is $1700, the taxpayer owes no tax and receives a $200 payment from the government.

▪ Education Credits

• Hope Scholarship Credit of §25A(b) is a tax credit equal to the first $1000 and half of the next $2000 of qualified tuition and academic fees (but not room and board) paid to an academic institution for the education of a student during the first two years of post-secondary education. The credit is phase out of upper-income taxpayers: the phase out begins at a modified ADI of $40,000 ($80,000 for joint returns) and is completed when modified AGI reaches $50,000 ($100,000 for joint returns)

• Problem p. 254

▪ Other Personal Credits

❖ Chapter 4: Business and Investment Expenses

➢ Depreciation and Related Matters (MUST KNOW, not gonna ask questions of how to calculate, rather the principles of how it fits in)

▪ Depreciation, or Cost Recovery: In principle, depreciation refers to the systematic allocation of an asset’s cost over its useful life, i.e., the period over which the asset may reasonably be expected to be useful to the taxpayer in his business or investment activity. Has nothing to do with actual wear and tear of property.

▪ Depreciation deductions allow taxpayer to recover these costs over time, included in AGI

▪ IRC § 167 Depreciation: 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 used in the trade or business, or

• of property held for the production of income

▪ Straight-Line Method: The cost (or other basis) of the asset (less its estimated salvage value) is deductible in equal amounts over its useful life. T.Reg §1.167(b)-1(a)

• Most real property must be depreciate w/ this method, can always elect to use this.

• HYPO: Purchase for 10K, useful like of 5 years – get 2K a year

□ Declining-balance Method: Accelerated method of depreciation, producing deductions in excess of those allowable under the straight line method in the early year’s of the asset’s life

➢ (Thus, b/c of the time value of money, taxpayer’s will generally prefer to deduct depreciation—and thus reduce taxes—sooner rather than later and will therefore prefer this method when possible)

▪ (i) Depreciation and Basis: §1016(a)(2(A) & (B) requires that proper adjustment to the basis of property be made for (among other things) the amount allowed as a depreciation if that amount reduced the taxpayer’s income. Essentially, every deduction you take is subtracted from your basis, and thus reduces your basis. When you sell the property, you are producing capital gain.

➢ MACRS: In order to compute depreciation deductions, one needs to know:

▪ (1) the property’s recovery period:

• These periods range from 3 to 39 years

▪ (2) the method of depreciation to be used:

• Property in the 3, 5, 7, and 10yr classes will ordinarily depreciated under a double-declining (200%) balance method, and switching to straight-line when that method would give a larger deduction

□ Most real property is depreciated on straight line

▪ (3) the convention for determining when property is treated as having been placed in service.

• §168: This section contains the depreciation schedule for most tangible assets. Salvage value is not taken into account in this §, so the entire basis of the property may be deducted if the property is held for the “recovery period.”

□ so when buy a truck that is going to be used in your trade or business would it make sense for me to be able to deduct the 20K in the first year, b/c going to use it over the next 5 years?

□ Depreciation is simply a method to measure costs recovered

• 5 Steps to Depreciation

□ Is this asset depreciable? Land is not.

□ What is the assets basis? Look to sections 1011 and 1012

□ What is the assets useful life? Look to regulation. Ex: Residential Real Estate is 27.5 years and non-residential real estate is 29 years.

□ What method of depreciation do you use? Most 3 – 10 yr we use double declining balance. 15 – 20 uses 150% declining balance. Real estate you have to use straight line. Anytime you want to you can use straight line.

• For tax purposes you want to get rid of profit in a company as fast as you can so you depreciate. So you keep 2 sets of books, those for shareholders which show the profits and those for tax purposes which show depreciation.

• Depreciation of Improvements: §168(i)(6) requires that depreciation on improvements of or additions to property be taken as if the property had been placed in service at the time of the improvement or addition.

• HYPO: Residential rental real estate is assigned a recovery period of 27.5 years (most other buildings is 39 years). T has had 10 years of making depreciation deduction, 27.5 left to go, and then builds an addition to the bldg. The addition must be deducted over a period of 27.5 years. You may not add cost to the basis of original.

□ Intangible Property: §197 deals w/ intangibles that diminish over time, i.e., patents, licenses, goodwill, permits, etc… (§168 deals w/ tangibles)

➢ deductible (amortized) over 15 yrs.

• Expensing in Lieu of Depreciation: The code (§179) provides that you may elect to treat the cost of certain qualifying property—tangible personal depreciable property for use in the active conduct of a trade or business—as an expense (deducting it all completely, currently) as opposed to depreciation.

□ Shall not exceed 25k and amount cannot exceed the taxpayer’s taxable income from the active trade or business

➢ This flies-in-the-face of the concept of gradual depreciation deductions

▪ WHY? Just to promote business, economic stimulus.

• Organizational Expenditures: The organization expenditures of a corporation (articles of incorporation, fees for by-law and minute prep.) may, at the election of the corp., be allowed as a deduction over 5 yrs.

□ You may elect out of the 60 month amortization. Why? You may plan to operate at a loss.

▪ Simon v. Commissioner (Morrisson doesn’t really like this case)

• Ds were musicians who purchased these special collectible bows for playing the violin.

• Question was whether they could depreciate these bows.

□ Issue: After being appraised, they were worth more than when they were bought.

□ Even though they are using the bows, they are still appreciating.

□ Nobody argued that they were worth more than when they bought them.

□ Commissioner argues that even though we know depreciation may not reflect the exact depreciation each period, at least one way of looking at it is we are giving you the money to replace the value of something that wears out through use. These don’t wear out.

➢ Was there a useful life? These people couldn’t prove what it was.

□ However court says it doesn’t matter that they cannot figure out the useful life.

□ Legislative History states that must be able to determine useful life (section 167).

□ 168 is the mechanic section, stating this is how you figure it.

▪ Crane v. Commissioner

• F: Mr. C transferred to Mrs. C property w/ FMV of $262k, and (coincidentally) subject to $262k mortgage. Mrs. C operated property for 7 yrs. collecting rent and taking depreciation deductions of $25,500, and now sells property subject to the non-recourse mortgage for $2500 cash.

• I: What is her gain? T argues $2500. To figure out, we must know:

□ What is her basis? $262k (Basis is determined by the value of the physical property—not equity—undiminished by the mortgage.)

□ It was appropriate to take depreciation deductions, which would cause the basis to decline by same amount deducted. 262k – 25,500 = $236,500 basis

□ What is amount realized? T received only $2500 cash, but she was relieved of the mortgage, which is thus part of the amount realized. (2500 + 262k= $264,500)

• H: Amount of a non-recourse liability is included in the amount realized on sale of the property. Thus if the mortgage was still $262k at the time of sale, Ms. Crane’s realized amount was $262k + $2500. Her adjusted basis would be 262k less the $25,500 depreciation she took

• Gain: 28,000 (264,500 – 236,500)

• This allows you to milk your depreciation, sell property, then start over b/c mortgage is included.

➢ Capital Expenditures

▪ Some business or investment costs, “called capital expenditures” are not deducted immediately (as in §§162, 212); instead they are included in the basis of an asset (i.e., capitalized) and are normally recovered either through depreciation or by reducing gain when the taxpayer disposes of the asset.

• Capital expenditures may be thought of as the costs of acquiring or improving assets expected to last substantially beyond the end of the taxable year in which the costs were incurred.

• Some capital expenditures cannot be recovered through depreciation. For example, the cost of land purchased for a business use, must be capitalized. But, b/c the land is not expected to suffer a decline in value b/c purchase and disposition, the land is not depreciable.

▪ Capital Expenditure: Expenditures made for assets with useful life of more than one year. This includes any amount paid out for new buildings (acquisition or construction) or for permanent improvements or betterments made to increase the value of any property or estate.

▪ Basis Principle: §263 reflects the basic principle that a capital expenditure may not be deducted from current income in the year that they are made. Such expenditures are capitalized.

• Section 263 – when do I deduct and when do I capitalize (add to basis and recover it later)?

□ EX: suppose buy an empty lot to run a business. Suppose after buy you realize that there is an easement that you have to get rid of b/c you know you can’t get financed with out it. So you spend 10K in legal fees to get easement cleaned up. Question – can you deduct these expenses are do you have to add those expenses to your property’s basis? MUST add it to your basis, cannot deduct it.

▪ PLAINFIELD-UNION TEST

• Plainfield-Union v. Comm’n:

□ Utitlity company started using river water instead of well water which caused their pipes to become clogged. They then cleaned and lined them with cement. This action was the issue of whether it was deductible or had to be capitalized.

□ H: Repair to water-line pipes (after river water wrecked havoc) was currently deductible

□ R: An expenditure which returns property to the state it was in before the situation prompting an expenditure arose, and which does not make the relevant property more valuable, more useful, or longer-lived, is usually deemed a deductible repair. On the other hand, a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property.

□ Any properly performed repair can be said to add value to an asset, however, the proper test is whether the expenditure materially enhances the value, use, expectancy, strength, or capacity as compared w/ the status of the asset prior to the condition necessitating the expenditure. Here the useful life was not increased, the capacity not enhanced. Just returned to the original position.

□ Court held – value of pipe was not increased.

□ If the court said cannot depreciate it then what would they have done? Add its cost to the basis of the water pipe and depreciate its cost over the assets useful life

➢ The cost of keeping property “in an ordinary efficient operating condition may be deducted as an expense.”

□ [If this would have been capitalized, they would have added cost to the basis of the pipes, depreciated over time]

▪ Cases within Plainfield

• Midland v. Empire: Oil seepage in meat packing plant, T lined walls and floors w/ concrete to restore normal operating condition. This was a deductible expense. Repairs did not increase the useful life or value when compared to the pre-seepage period.

□ If they would have provided for seepage in construction, easily includable in the capital investment per §262

• Illinois Merchants Trust Co.: Some wooden pilings were exposed, they replaced with concrete supports and they held this was deductible

• Regenstein v. Edwards: floor of 3rd story of landlord’s bldg sagged. Steel columns and steel crossbeams were installed in order to permanently cure the defect. Entire expenditure was for the sole purpose of restoring the property to its former condition and allowed the deduction.

□ Professor disagrees: life expectancy was extended.

• Mt. Morris Drive-In Theatre Co (note 1 on pg. 282): Construction of drive-in theatre caused rain water to drain onto neighbor’s land, T now constructs a drainage system. Tax Court held cost of drainage system to be a capital expenditure, b/c need for drain should have been foreseen when theatre was built. The fact that you did it later is irrelevant. Premised upon foreseeability;

▪ Comm’n v. Idaho Power: - see handout

• F: Idaho Power uses their trucks in trade/business, thus entitled to §162 (depreciation deduction)

• I: Since these trucks were used in process of constructing their own facilities, do they get to deduct depreciation over scheduled life of trucks or do they have to take same amount of depreciation and capitalize it, making it part of cost of bldg. (This case is not about whether they can take a depreciation deduction, but rather what do they do with it? Do they deduct 20% this year, or do they capitalize)

• H: Construction-related depreciation on equipment not an expense to the taxpayer of its day to day business is appropriately recognized as a part of the taxpayer’s cost or investment in the capital asset. Expenses, whatever their character, must be capitalized if they are incurred in creating a capital asset.

• When the asset is used to further the taxpayer’s day to day business operations, the periods of benefit usually correlate w/ the production of income. Thus, to the extent that equipment is used in such operations, a current depreciation deduction is an appropriate offset to gross income currently produced. However, different principles are implicated when the consumption of the asset takes place in the construction of other assets that, in the future, will produce income themselves. In the latter, the cost represented by depreciation does not correlate w/ production of current income. Rather, the cost (although presently incurred) is related to the future.

• Commissioner’s claim – if use assets to create the capital asset, the depreciation must be capitalized. Therefore the amount would factor into the basis of the capital asset. So the 20K gets recovered over the 25 years (useful life). Also the basis of the vehicle would go down as depreciate.

□ Wages: The Idaho Power Court indicates that wages paid in the carrying on of a trade or business qualify as a deduction from gross income. §162(a)(1). BUT, when wages are paid in connection w/ the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired.

□ Office v. House Hypo: If you replaced the roofs on these two buildings, what arguments would you advance for each?

➢ House: You would argue that it was a capital expenditure, which you may add to your basis, which results in less taxable gain when you sell

➢ Office: You would argue that this is a repair—an ordinary necessary expense. But you will lose says Morrison

▪ Pg. 289 Problem – bought for 100K, took 40K for depreciation, sold for 70K. What result? Gain of 10K.

▪ INDOPCO v. Comm’n

• Friendly take-over transaction – Unilever wants to buy National Starch.

• While they are structuring this deal they have some legal fees (around half a million). They also pay 2 million to Morgan Stanley for an opinion on the deal.

• Greenwalls (majority shareholders) said they aren’t voting for this deal unless we get a tax-free deal (when you have a stock for stock deal you recognize no capital gain, so the Greenwalls transferred their National Starch stock to the preferred stock they got in Unilever and did not have to pay tax on it)

• While they found out through the opinion from Morgan Stanley that the Greenwalls wouldn’t have to pay tax, the issue is that they wanted to deduct the expenses including mainly the expense of getting an opinion from Morgan Stanley.

• Lincoln Savings – everyone thought this meant that they may deduct expenses in a situation like this as long as a new asset isn’t created. However court held this was a bad reading of that case. Therefore they couldn’t deduct.

• Where did these costs go? Added to the bottom line (basis).

• I: Are professional expenses (1.2M) incurred by a target corporation in the course of a “friendly” takeover deductible business. Taxpayer argues that based on Lincoln Savings, the test for capital expenditures is whether an asset was created or enhanced; and no asset was created or enhanced.

• H: Capital Expenditure. (Comm’n now seeks to capitalize intangibles).

• R: While an expenditure that creates or enhances a separate and distinct asset should be capitalized, it does not follow that only expenditures that create or enhance separate and distinct assets are to be capitalized under §262. While the presence of a future benefit is not controlling, it is undeniably important in deciding if an expenditure is capital. The expenses of planning this merger created substantial future benefits for INDOPCO (access to buyer’s technology, synergy w/ buyer’s products, convenience of having one S/H rather than 3500). (Burden to show a right to deduction is on the Taxpayer).

▪ Staley – if incur these types (INDOPCO) of fees in pushing off a hostile takeover, you can deduct those immediately. However if fail the fight and end up going along with takeover, now the costs of the actual takeover cannot be deducted immediately.

▪ What about advertising? Benefit likely last more than one year, deduct or capitalize? Deduct, but nobody knows why (also packaging costs).

▪ Inventories: Inventory refers to goods purchased or manufactured by a firm and held for sale as part of the firm’s ordinary business operation. Do you get deduction for goods going to sell, no, you get deduction when sell them.

• Fifo v. Lifo- when inventory price is rising, sell most expensive inventory (tax price falling), cheapest when inventory price is falling (handout)

□ when buy something you can’t sell, you deduct as a loss

➢ Business, Investment, and Personal Expenses

▪ Introduction

• Three general provisions (Sections 162, 167, and 212) allow business and investment expenses to be deducted:

• §162: Trade or Business Expenses: Deduction (usually above-the-line) is available for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business (earning a profit)

• Comm’n v. Groetzinger: Trade or Business is a subjective determination. You do not have to sell goods, have a secretary, have a hanging sign, etc…In finding dog gambling (for this specific T) to be a trade or business, Court said that T must be involved in activity w/ continuity and regularity and primary purpose must be for income/profit. A hobby, sporadic activity, or an amusement diversion does not qualify – only if get income

□ Groetzinger establishes:

➢ one must be involved in the activity with continuity and regularity if the activity is to be a trade or business

➢ the code normally focuses on a common-sense concept of what is a trade or business

➢ one need not hold one’s self out as offering goods or services to others to be engaged in a trade or business (this was the principal issue)

➢ the fact that one’s livelihood derives from an activity is some indication that the activity is a trade or business

□ Employee Business Expenses: Working as an employee is a trade or business, and so an employee’s business expenses are deductible under §162(a), i.e., Union dues and subscriptions to professional journals (below the line). Employee expenses reimbursed by the employer and the expenses of one who is a ‘qualified performing artist’ are above-the-line deductions.

➢ Most employee business expenses are itemized deductions and are also “misc. itemized deductions” for purposes of the 2% floor of §67. (Can deduct misc. itemized deductions and itemized deductions- they are separate things)

• §212: Expenses for Production of Income: In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—

➢ For the production or collection of income;

➢ For the management, conservation, or maintenance of property held for the production of income; or

➢ in connection w/ the determination, collection, or refund of any tax (state or fed), i.e, fees relating to preparing tax returns, tax planning, legal advice relating to tax consequences of divorce, etc…, etc

□ This § embraces an individual when he is a seeker of profit, by allowing him to deduct $ incurred in that search. §212 enlarges the type of category of income (not just trade or business) to which expenses are deductible.

• Higgins see handout

• Morrisson- when used for estate tax , put on receipt about part of service was for the tax planning, so it was deductible for the client

• §262: Personal, living, and family expenses: Unless otherwise indicated, no deduction shall be allowed for personal, living, or family expenses.

□ i.e., premiums paid on life insurance, insurance for house you live in, expenses maintaining your household (rent, water, utilities)

□ Expenses incurred in traveling away from home (transportation, meals, lodging) are not deductible, unless they qualify under §§162, 212

□ Costs of commuting to work are personal and thus not deductible.

• §263: Capital Expenditures: No deduction (as of right now)—for any amount paid out for new bldgs, or for permanent improvements or betterments made to increase the value of any property or estate.

□ Trade Or Business: If an activity is a “trade or business,” depreciation on assets used in the activity can be deducted under §167(a)(1); and other “ordinary and necessary” expenses are deductible under §162(a).

➢ Many business expenses (§162 is the workhorse) are above-the line deductions b/c of 62(a)(1), and thus not subject to the limits of §67 (see below)

□ Production of Income: If property is held for “the production of income,” §167(a)(2) authorizes depreciation, and expenses of managing, conserving, and maintaining the property are deductible under §212(2). Costs incurred for the production or collection of income are deductible under §212(1).

➢ Expenses deductible under §212 are ordinarily “miscellaneous itemized deductions.” The (negative) impact of such a designation is that §67 allows deductions for misc. itemized deductions only to the extent that the total of these deductions exceeds 2% of an individuals AGI.

• Kenseth v. Commissioner

□ F: Firm deducted 40% for attorney’s fees after T won an age discrimination suit against his former employer.

□ H: This 40% is income, and you may deduct it per §212, but you are now subjected to the following:

➢ 2% floor is triggered per §67

➢ Alternative Minimum Tax implications

➢ Total limit of §68

□ Taxpayer’s argument: I assigned the money to the law firm. Court rejected this and indicated that an assignment is ineffective to shift tax liability.

□ HYPO: M assigns 50% of income to his son. Tax liability is not shifted. (You could assign 10% to A, 15% to B, 25% to C, and so on, until there is no tax liability on your income.)

▪ Connecting Expenses to Activities

• The Role of Motive:

□ United States v. Gilmore

➢ F: Gilmore owns 3 car dealerships, and is involved in a divorce. Wife is claiming that she should get share of property (which is stock in GM).

➢ I: The pivotal issue in this case becomes: was this part of respondents’ litigation costs as ‘business’ rather than a ‘personal’ or ‘family’ expense?

➢ H: Not deductible per §262 (personal expenses are not to be deducted)

➢ R: 1) §212 is subject to the same limitations and restrictions that are applicable to those allowable under §162—namely §262 renders non-deductible personal or family expenses. 2) Characterization as business or personal must derive from the “claim of origin” test of the litigation cost (which are sought to be deducted). The litigation cost arose from the marital relationship—clearly personal or familiar relate.

▪ Claim of the Origin Test:

• HYPO: Costs of defending a criminal prosecution arising out of business activities are deductible

• HYPO: W suing H in a divorce obtains court order restricting activity of corp. all of whose stock is owned by H. The corp’s costs of seeking a relaxation or clarification of the order have both a “business origin” in the sense that they are incurred b/c of business necessity, but yet they have a personal origin (§262) in that the dispute arose b/c of the divorce. Court allowed deduction under §162.

• HYPO: Lawyer retires, buys a boat which is his only asset. A client locates the lawyer and sues him for malpractice. Origin of the claim is business not personal

• (GILMORE II—allowed the taxpayer to include his legal fees in the basis of the property he kept his wife from getting) See page 314

□ Wild v. Comm’n

➢ F: T gets alimony, which is taxable per §71. T expends 6k in legal fees to secure alimony payments.

➢ I: Are these fees deductible under §212(1) or prevented by §212

➢ H: Deductible under §212(1). For the production or collection of income

➢ R: T.R. §1.262-1 indicates that attorney fees which are paid in connection w/ a divorce or decree for support, which are properly attributable to the production or collection of amounts includible in gross income under §71 are deductible by the wife under §212.

➢ Gilmore (claim of the origin) interprets §212(2), this is a different section—§212(1). IRS has not changed the reg. so it stands.

□ Pevsner v. Comm’n: (5th Circuit)

➢ F: Employer req’d T to wear YSL(expensive) clothes to work and to some work related conferences. T could (if she wanted) also wear the YSL clothes outside of work, but she claimed that she did not and would not b/c it conflicted w/ her simple life style and would never have purchased this ordinarily

➢ I: May T deduct cost of clothing and upkeep of clothing per §162 or does §262 prevent?

➢ H: Rev’d. No deduction, as this is not a business expense. Test for deductibility of clothing is if it is of a type specifically required as a condition of employment and whether it is not adaptable to general usage as ordinary clothing. OBJECTIVE APPROACH must be utilized (individualized approach of tax court is too difficult), and this stuff is adaptable to general usage as ordinary clothing.

□ Deductible –laughter test---Morrisson

➢ Inherently Personal Expenses: Army man’s cost of required haircuts over what he would have normally spent were inherently personal in nature and thus non-deductible.

➢ HYPO: M is professional musician. This year he spent $1k for formal clothing, which he wore only during concert appearances. Deductible per the Objective test.

➢ HYPO: Painters—bibs are not deductible

➢ HYPO: Steel Workers: steel toes and goggles are deductible.

• Ordinary and Necessary

□ Welch v. Helvering:

➢ F: Company (in grain business) goes bankrupt and is discharged from all debts. T was the secretary of the Co. when it went broke. T now owns his own grain business, and cuts a deal w/ Kellogg to purchase grain on commission. T (voluntarily) pays off the debts of his old company to improve his chances of success and re-establish relations.

➢ I: Are T’s payments to the creditors deductible as “ordinary and necessary” business expenses per §162?

➢ H: Not deductible. Capitalize and add to your basis, as this is going to produce good will—income over a long period of time

▪ (1) Necessary? Yes. Necessary for the development of the business

▪ (2) Ordinary? No. Voluntariness of the actions are irrelevant, this simply is not ordinarily done—in fact—it is extraordinary. Court will not expand what is ordinary.

□ Deputy v. Dupont: “An expense may be ‘Ordinary’ though it happens but once in the Taxpayer’s lifetime, if the transaction which gives rise to it is a common or frequent occurrence in the type of business involved.” Thus, the same expense may be ordinary for one business, while not necessarily so for another business.

➢ Normalcy in the particular business/industry is crucial and controlling.

▪ “A Reasonable Allowance for Salaries”

• Salary v. Dividend: One cost of doing business that is not deductible is a corporation’s payment of dividends to S/H. Since dividends and salaries are ordinary income to the recipient, but dividends are not deductible by the corporation, the owners of a closely held corp have every incentive to pay high salaries and low dividends, or no dividends at all.

• §162(a): Trade or Business Expenses:

□ A reasonable allowance for salaries or other compensation for personal services actually rendered.

□ Per T.R. §1.162-7(a): The amount of compensation must be reasonable and the payments must in fact be purely for services.

➢ any amount paid in the form of compensation but not in fact for services, is not deductible.

➢ Bonuses to employees will constitute allowable deductions from gross income when made in good faith as additional compensation for services actually rendered—provided such payments (when added to fixed salary) do not exceed reasonableness.

➢ Cannot deduct campaign contributions

• Elliotts, Inc. v. Commissioner

□ F: T, company in the business of selling John Deere equipment, claimed deductions of $181k and $191k in consecutive years for the total compensation to its CEO and sole shareholder, Edward G. Elliott. The Comm’n found these to be in excess of the amount T properly could deduct as reasonable salary under §162(a)(1). Tax Court agreed, saying that 120k and 125k were reasonable salary, and assessed deficiencies.

□ I: Deductibility by corporation of payments made as compensation for services to an employee who is also a S/H. Salary (deductible per §162) vs. dividends (not deductible)

□ H: TC is rev’d.

□ R: 1) Automatic Dividend Rule (presuming disguised dividends if corp is profitable) is rejected—as no statute requires profitable corporations to pay dividends and not all s/h demand dividends. 2) Court focuses on reasonableness of compensation when there is no other evidence of an intent to hide dividends into compensation payments.

➢ REASONABLENESS

▪ Nature and Quality of services; scarcity of qualified employees

▪ Effect of those services on investment returns

▪ Look at other people in circumstances

▪ How important is individual

▪ M wants to know why the marketplace doesn’t just decide what is reasonable

□ Tax Court failed to consider Elliott’s “extreme personal dedication and devotion to work,” i.e., 80 hours per week. TC failed to consider the reasonableness on an overall basis.

• Automatic Dividend Rule: Although Elliotts expressly rejected this rule, it has resurfaced in the 9th Cir. and the IRS indicates that failure to pay more than an insubstantial portion of earnings as dividends on stock is a “very significant factor” in determining the deductibility of compensation

□ HYPO: M’s daughter doesn’t do anything to justify her salary of 30k.

➢ 1) If not reasonable compensation—does she still pay tax. YES (Probably). Some may say gift

➢ 2) M (sole s/h), Comm’n would say that this is a constructive dividend (to you) described as salary.

□ HYPO: M rents bldg. to his Co. for 50k per year. FMV is 25k per year. RESULT: Rental payments are deductible, but Co. is likely to be denied 25k (over FMV) in deduction. M still has income.

▪ Travel and Entertainment

• The issue that is involved here is paying for something and trying to deduct it, although it is really §262 (personal stuff). Are these expenses brought upon by business or personal? Because these expenses have significant personal expense elements, the decisions try to insure that only expenses that are predominantly business in nature are deductible.

*SEE HANDOUT 3/24, 3/25

• Commuting and Lunching Expenses

□ (1) Commuting: Basic rule is that commuting expenses are not considered business expenses, and thus, they are not deductible

➢ Exceptions:

▪ When additional expenses are incurred for transporting job required tools and an allocation b/t personal and business expense is feasible.

▪ Taxpayer whom is on duty while Commuting: Pollei v. Comm’n allowed police captains to deduct costs of commuting to work in their personally owned unmarked cars, a regularly scheduled activity..

▪ Costs of commuting to a distant, temporary job are deductible as travel expenses

▪ Costs of travel b/t one job site and another are not commuting expenses and thus deductible (as when a lawyer takes a cab from the office to the courthouse)

➢ If you go away overnight, you may deduct—travel, lodging, meals.

□ REVENUE RULING 99-7

➢ I: Under what circumstances are daily transportation expenses incurred by a T in going b/t the T’s residence and a work location deductible under §162(a).

➢ H: In general daily transportation expenses incurred in going b/t a T’s residence and a work location are non-deductible commuting expenses. However, such expenses are deductible under the following circumstances:

▪ T may deduct daily transportation expenses incurred in going b/t the T’s residence and a temporary work locale outside the metropolitan area where the T lives and normally works

▪ If T has one or more regular work locations ways from his residence, the T may deduct daily transportation expenses incurred in going b/t the T’s residence and a temporary work location in the same trade/business, regardless of distance.

▪ If a T’s residence is his principle place of business (exclusively used on a regular basis) the T may deduct daily transportation expenses incurred in going b/t the residence and another work location in the same trade/business, regardless of whether the other work location is regular or temporary and regardless of distance.

• Working Couples: Suppose that H&W work in cities 300 miles apart—heaving commuting expenses for at least one. It seems artificial to say that the expenses derive from a personal choice about where to live—yet not exception for this kind of case has yet been created.

• Moss v. Comm’n

□ F: T, lawyer, appeals decision of the TC disallowing deductions of a little more than 1k in two years, representing his share of his law firm’s lunch expense. There is no suggestion that the lawyers dawdled over lunch, as they were extremely busy w/ much litigation.

□ The IRS concedes that meals are deductible under 162 when an “ordinary and necessary” business expense.

□ H: No deduction—daily lunches is too often

□ R: §162 is not in play. (T is not an employee, but rather a partner—self-employed.) Court assumed that it was necessary for Moss’s firm to meet daily to coordinate work of the firm (and lunch was the most convenient time) But it does not follow that the expense of the lunch was a necessary business expense. The restaurant they went to was not luxurious, it may be different if they went to a place that was too expensive for their personal tastes, so they would have gotten less value than the cash equivalent.

□ To allow a deduction for all business-related meals would confer a windfall on people who can arrange their work schedules so they do some of their work at lunch. The difference in this case is that all the participants in the lunch knew each other—they don’t need the social lubrication that a meal w/ an outsider provides—at least don’t need it daily.

□ Matter of degree: If they met once a month, they could probably deduct. But they tried to take advantage of the system and do it too much. Matter of degree and circumstance—daily is too often.

□ If T (Moss) was an employee, rather than a self-employed taxpayer (partner) the issue would have been whether the cost of the meals was includible in gross income

➢ When one T pays for a business meal which another T eats, issues of both deductibility and includability arise: The person who eats the meal (an employee, for example) needs to determine if the meal can be excluded under §119 or as a de minimis fringe benefit; the person who furnishes (employer) will usually treat the cost of the meal as a business expense under §162(a).

□ If the lunch was held in the conference room, catered by Café Angelo, this would be deductible per §119 (meals are furnished on premises)

• “Away from Home:” §162(a)(2) allows a deduction for travel, meals and lodging while away from home in pursuit of a trade or business. Must stay overnight to deduct meals. (50% according to §274)

□ The IRS has reasoned that the T’s “home” for purposes of §162(a)(2) is the T’s principal place of business

□ HYPO: T, on a 3-day business trip to another city, can deduct meals and lodging.

□ HYPO: A T who takes a permanent job 500 mi. from home cannot deduct meals and lodging at the job site even if this is away from home in a literal sense.

□ Robertson v. Comm’n

➢ F: Justice Robertson is a judge in Jackson, MS and lives and teaches law in Oxford, MS. Judge got reimbursed for some of his travel, meals and lodging incurred in attending court sessions in Jackson, and tried to deduct what was not reimbursed, saying that he was away from home.

➢ H: No deduction. Tax home is Jackson, as his trade/business is being on the Supreme Court. Thus the traveling expenses were not incurred while “away from home”

□ Hantzis v. Comm’n

➢ F: T goes to law school in Boston, lives in Boston—works in NYC for summer. T seeks to deduct travel expenses, apartment that was rented, and meals under §162.

➢ H: Not deductible.

➢ R: T’s home for purposes of §162(a)(2) was her place of employment and the cost of traveling to and living in NY was not incurred while “away from home.”

➢ Court will ultimately assess the reason for the T’s maintenance of two homes. If the reason is perceived to be personal, the T’s home will generally be held to be his place of employment, rather than his residence, and the deduction will be denied. T’s trade or business did not require that she maintain a home in Boston as well as in NYC. (Compare situation where T lives and works for a firm in Boston, and business exigency requires that she temporarily live in NYC to serve a client)

▪ Temporary Business: You may deduct expenses if away from home on a temporary basis

▪ §162(a)(2) provides that the taxpayer shall not be treated as being “temporarily away from home during any period of employment if such period exceeds one year.”

➢ Fatal to her argument was that she had no business in Boston. Her tax home was N.Y. therefore she can’t deduct.

➢ HYPO: Visiting law professor for 9 months (school year) may deduct lodging meals, travel, etc…

➢ HYPO: If the dean asks the visiting professor to stay on for another year—the expenses are deductible until the time you make the decision to extend your stay past one year.

➢ HYPO: If the visiting professor had signed on for 18mo., but then quit after 9mo., none of this is deductible—b/c the expectation was that the employment was to last for more than one year.

• Entertainment

□ Moore v. United States

➢ Moores hosted an annual party in December for a few hundred business associates. At some time during the party, Mr. Moore would typically address the attendees—the overwhelming majority of whom were real estate agents who had sold at least two homes constructed by the Moores during the calendar year—to thank them for their efforts to sell houses his company had constructed during the last year and to encourage them to sell houses his company would construct in the coming year. On their annual tax returns, the Moores made it their practice to deduct the costs associated with these parties as business-related entertainment expenses.

➢ Court addresses whether there is a ‘clear business setting’

➢ A business entertainment expense qualifies as ‘directly related’ and therefore deductible if an active business discussion occurred during the entertainment activity or if the entertainment activity took place in a clear business setting.

➢ A taxpayer can show that entertainment occurred in a clear business setting by ‘clearly establishing that any recipient of the entertainment would have reasonably known that the taxpayer had no significant motive, in incurring the expenditure, other than directly furthering his trade or business.’

➢ Moores satisfied the clear business setting in two ways:

▪ They established that any attendee at the 1989 party would have reasonably known that the expense of the party was incurred only to further the Moore’s business (2 witnesses testified to such)

▪ Moores incurred theexpense specifically to reward the real estate agents who had sold at least 2 of their homes during the current fiscal year and encouraging those agents to sell at least 2 additional homes to be built by the Moores in the succeeding fiscal year. Additionally, since hosting this party, sales have tripled

□ § 274(a)(1)(B) disallows deductions for any item with respect to a facility used in connection with the entertainment and other activities listed in § 274(a)(1)(A). Lakefront property example.

▪ The “Carrying on” Requirement

• Start up and expansion costs: Some costs—called pre-opening expenses—are non-deductible under § 162 b/c no business is being “carried on.” These non-capital business start up expenses may be written off over a five year period, if the trade or business is an active one.

• Costs of seeking employment: It is now settled that an employee who incurs expenses in seeking a new job in the same field can deduct those expenses under § 162.

□ However, a law student who fly’s to CA to look for a job does not get deduction.

• Moving Expenses: § 217 allows an above the line deduction for some of the costs of moving to take on a new job position (over 50mi. away) even in the case of an employee or self-employed person who had no job before the move.

□ lodging, mileage, Uhaul. BUT not meals

• **just looking for a job doesn’t count. Neither does a job where you travel all the time and have no real permanent residence.

• **looking for a new job (getting worms) isn’t deductible unless it is in the same field

• Frank v. Commissioner

□ After discharge from Navy, Frank and his wife began a trip through the U.S. to investigate and, if possible, acquire a newspaper or radio enterprise to operate.

□ Issue: whether the petitioners may deduct $5,965 in the determination of their net income for the year 1946 as ordinary and necessary business expenses or as losses.

□ Evidence reasonably establishes that petitioners expended the amount of expenses in traveling, telephone, telegraph, and legal expenses in the search for and investigation of newspaper and radio properties.

□ § 162 cannot be used b/c they were not engaged in any trade or business at the time the expenses were incurred. The expenses of investigating and looking for a new business and trips preparatory to entering a business are not deductible as an ordinary and necessary business expense incurred in carrying on a trade or business. The § presupposed an existing business with which petitioner is connected

▪ Educational Expenditures

• Cost of a college education is generally nondeductible bc courts consider the cost to be a personal expenditure. Yet, they are allowed to deduct if education 1) maintains or improves skills required be the ind. in his trade or business, 2) meets express requirements of his employer, or applicable law, necessary to retain his or her established employment relationship, status, or rate of compensation. Education expenses to meet the minimum educational requirements of a new trade or business are nondeductible.

• Sharon v. Commissioner

□ Law students expenses both for tuition, bar review, and bar application fees.

□ Issue: whether the petitioner may amortize the cost of obtaining his license to practice law in New York.

□ Court found no merit b/c his college and law school expenses provided him with a general education which will be beneficial to him in a wide variety of ways. The costs and responsibility for obtaining such education are personal.

• Allemeier v. Commissioner

□ Issue: Whether petitioner may deduct expenses incurred to earn a master’s degree in business administration.

□ Educational expenses, specifically, are deductible if the education maintains or improves skills required by the individual in his or her employment or other trade or business or meets the express requirements of the individual’s employer

□ No deduction is allowed, however, if the taxpayer’s expense is for education that enables him or her to meet the minimum educational requirements for qualification in his or her employment or if the education leads to qualifying the taxpayer for a new trade or business.

□ Court declined to find that a minimum education requirement existed merely b/c petitioner’s promotions happened to coincide with his enrollment in the MBA program

□ Whether an education qualifies a taxpayer for a new trade or business depends upon the tasks and activities he or she was qualified to perform before the education and those that he or she was qualified to perform afterwards. The court has repeatedly disallowed education expenses where the education qualifies the taxpayer to perform ‘significantly’ different tasks and activities. The relevant inquiry is whether the taxpayer is objectively qualified in a new trade or business.

❖ Chapter 5: Interest Income and Deductions

➢ Some Forms of Interest

▪ Interest is includable in the lender’s income under §61(a)(4) unless §103 applies. §163 seems to say that all interest can be deducted, however, several Code provisions limit or deny altogether the deductibility of many kinds of interest.

• The simplest form of interest is an explicit annual charge of a percentage loan for the period in which the loan remains outstanding. But other ways of charging are common:

• Points: Banks often charge loan processing fees or points to borrowers. The IRS treats points as interest unless they are paid for such “services” as preparing and reviewing documents, doing the paper work required for FHA and VA mortgage loans, and appraising the property that secures the loan.

□ EX- pay interest on 10K and only get $9,500 / EX- pay $500 on closing cost

➢ Most points on loans can be deducted.

➢ Deductible and Nondeductible Interest

▪ Introduction

• See handout:

□ Interest: The cost of obtaining current cash, borrowing (and incurring interest) to buy a particular asset

□ §163(a): There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. But this general rule is limited by a number of Code provisions which deny deductibility to many kinds of interest:

• EXCEPTIONS TO GENERAL RULE OF DEDUCTIBILITY:

□ Interest on indebtedness “incurred or continued to purchase or carry” tax exempt bonds cannot be deducted; §265(a)(2)

□ Passive Activity: Interest which is treated as an expense of passive activity (such as renting property) is deductible only against income from passive activities if the taxpayer is an individual; §469

□ Interest on Indebtedness: “incurred or continued to purchase or carry” certain life-insurance and annuity K’s cannot be deducted; §264

□ Investment Interest: As defined in §163(d)(3), can be deducted by a non-corporate taxpayer only to the extent of the taxpayer’s “net investment income” for the year.

□ Construction of Real Property or other Property with a long useful life: Must be capitalized if the property has an “estimated period” of more than two years or if the estimated production is more than one year and the property costs more than $1M; §263A(f)

□ Personal Interest: Personal interest incurred by a non-corporate taxpayer is not deductible. §163(h) defines personal interest as all interest other than interest listed in §§163(h)(2)(A)—(F)

• Mortgage deduction- you can deduct interest on mortgage that you use to acquire this appreciating asset (up to 1mil) – see handout

□ Can deduct what you pay to your investment advisor (212)

▪ Section 265(a)(2)

• Wisconsin Cheesemen-

□ Question for resolution is whether the taxpayer may deduct from its gross income it paid on its mortgage and some of its short-term loans

□ interest on some short term loans are not deductible but mortgage interest is / interest on municipal bonds is non-taxable????

▪ Investment Interest

• § 163(d) limits deductions for ‘investment interest’ to the amount of the taxpayer’s net investment income for the year

• Interest on amts. borrowed in connection with a trade or business (business interest) and on amts. borrowed for investment purposes (investment interest) generally are deductible in calculating net income, subject to certain limitations to prevent tax avoidance. You can deduct interest on loans to acquire investment to the extent that you have investment income.

• Yeager- you may deduct investment interest to the extent of your income. You can carry it forward to later years if you can’t deduct it that year.

▪ Personal Interest

• In the case of a taxpayer other than a corporation, §163(h)(1) disallows deductions for “personal interest,” which is defined as all interest other than the six kinds of interest listed in § 163(h)(2), i.e.,

□ interest paid or accrued on indebtedness properly allocable to a trade or business (T has a store, borrowing $ for inventory, etc…)

□ any investment interest (but only to the extent of the income—Yeager)

□ any interest taken into account under §469 in computing income or loss from a passive activity of taxpayer

□ any qualified residence interest (most home-mortgage interest)

➢ consists of interest on “acquisition indebtedness” and on home equity indebtedness.

□ any interest allowable as a deduction under §221 (relating to interest on educational loans) (these are above the line per §221.

❖ Chapter 7: Who is the Taxpayer?

➢ Personal Service Income

▪ Lucas v. Earl

• F: Husband and Wife enter into a K in 1901 which stipulates that all property they get (salary, gifts, inheritance, etc…) is to be held in joint tenancy with right of survivorship.

• I: Should husband be taxed for the whole of the salary and attorney’s fees received by him in 1920 & 1921, or should he be taxed only half of that, b/c of the arrangement w/ his wife.

• H: Although this is a valid agreement, H is taxed on the whole

• R: H earned the money and a gratuitous assignment will not be effective, regardless if the K is valid. Income tax cannot be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.

▪ HYPO: M&J have a partnership. Profits are 300k. 250k is attributable to J’s hard work. 50k to M’s occasional work (done on golf course). You cannot assign income—thus metaphor does not always work. This inequity should be addressed by the Partnership.

▪ HYPO: Law Professor works in Clinic, and is sometimes entitled to $, which is turned over to the school. Income to the Professor? NO. Acting as an agent of the organization. (School will probably not pay tax as it is a tax-free institution.)

▪ HYPO: W is named in H’s will as executor, and per law is entitled to a fee. W waives the fee, to avoid income. NOT TAXABLE.

▪ HYPO: M says to BOD, I don’t want any more salary (1.2M). BOD gives it to UCLA, to establish research fund. M not taxed, as he had nothing to do where it went. (If he suggested that it go to UCLA, then it is different.) GIANNINI CASE

▪ Poe v. Seaborn

• H: Husband and Wife are entitled to file separate returns, each treating one-half of the community income as his or her respective incomes.

• Under Washington (State) law, the entire property and income of the community can no more be said to be that of the husband, than it could rightly be termed that of the wife.

• Earl was distinguished, b/c here, by law, the earnings are never the property of the husband, but that of the community. This is income derived from investing selling community property (not the salary of the husband). Ownership counts, not control

➢ Marriage and the Income Tax

▪ Revenue Act of 1948 allowed married couples to ‘split’ their incomes if they elected to file joint returns.

➢ Income from Property

▪ In General

• Blair v. Commissioner

□ F: Father (life income beneficiary of his father’s will) assigned to his child fixed annual dollar amounts of income to be paid from his life interest in a trust.

□ I: Who is taxed? Father or Sons

□ H: Valid assignment of property, and the child, rather than the father are taxed on the assigned income as it is received. Earl is not applicable, but rather Poe is b/c the income is arising from the property.

□ R: The one who is to receive the income as the owner of the beneficial interest is to pay the tax. The interest that the father had was present property alienable like any other in the absence of a valid restraint upon alienation. The beneficiary (father may thus transfer a part of his interest as well as the whole.

➢ Father’s life interest in the trust income is the tree—the underlying property. The father in effect chopped down some of his fruit and some of his tree and gave some of his fruit and some of his tree to his children. This was effective to shift tax liability. If you only give away the fruit—this is an assignment of income, which will not shift tax liability.

• Helvering v. Horst

□ F: (Coupons were attached to bonds, when date arrived, you clipped and turned into bank) Owner of negotiable bonds detached from them negotiable interest coupons shortly before their due date and delivered them as a gift to his son who in the same year collected them at maturity.

□ I: Is the realization of income taxable to the donor--father.

□ H: Yes. The exercise of the power to dispose of income (procuring payment to another) is the enjoyment and hence realization of the income.

□ R: The enjoyment of the economic benefit accruing to donor by virtue of his acquisition of the coupons is realized as completely as it would have been if he had collected the interest in dollars.

□ This is not like Blair v. Comm’n. In Blair, the right to the income from the trust property was derived from a gift of ownership of the income producing property. (Since the gift was held to be the income of the owner of the property the income from it was held to be the owner of the property)

□ Here, the donor (owner) is retaining control of the property and thus the income is taxable to him although paid to the donee

➢ The donor had given only the fruit—the coupon—rather than the tree—a bond, thus this is a “Carved-Out Income Interest.”

➢ If he had devised ½ bond + interest, this looks like Blair (tree and fruit)

➢ TEST: Identify the tree—the property that is held—does the donor still have rights to the tree, or has he parted w/ some of the tree? (You don’t need to part completely w/ the tree)

• § 1286 appears to overturn Horst. § 1286(b) provides that a person who strips one or more coupons from a bond and then ‘disposes of the bond or such coupon’ has income in the amount of interest accrued on the bond up to the time of disposition. This implies that one who strips the coupon and disposes of it would not be taxable on the income accruing after the date of disposition.

• Commissioner v. Banks

□ § 62(a)(20) appears to reverse this case

□ Issue: whether the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingent-fee agreement is income to the plaintiff under the IRC.

□ Court held as a general rule: when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.

• Problem 494-495

❖ Chapter 8: Income from Dealings in Property-General Considerations

➢ Introduction

▪ Eisner v. Macomber held that the 16th Amendment did not authorize the taxing of unrealized gains (few today would believe Macomber is good law today). Still today, Congress has generally chosen not to take unrealized gain into account b/c of the administrative and compliance difficulties that would result.

▪ HYPO: Purchase stock for $40, at the end of the year it is worth $100. Wealth is increased by $60, but T does not include the increment in income b/c the stock has not been disposed of, i.e., not realized.

▪ Analysis of a Property Transaction:

• Has a sale, exchange, or other taxable event (“realization event) occurred?

• If so, determine the amount of realized gain or loss (1001(b) and 1011)

• Even if realized, should this gain (or loss) be recognized (deductible)? Although § 1001(c) generally requires that realized gains/losses be recognized, Congress has provided for “non-recognition.”

□ (Recognized Loss is deductible only to the extent that it is allowable.

□ §165(a) generally allowed deductions for losses sustained during the year, but §165(c) prohibits non-corporate taxpayers from deducting losses other than those (1) incurred in trade or business, (2) those incurred in a transaction entered into for profit, and (3) certain casualty losses w/ respect to personal-use property)

• If it should be recognized (hence includable in gross income if a gain, or deductible if a loss), you must determine the character of the gain or loss as “ordinary” or “capital.” If capital it may need to be treated specially in making the computation.

➢ The Taxable Event

▪ A Gift of Property is non-taxable

▪ Bequests are non-taxable

▪ Exchanges of similar property are not taxed

▪ HYPO: M goes to get a $15 haircut at the barber. Pays with stock which has a FMV of $15, basis of $5. RESULT: M has $10 gain, as there has been a realizing event. (It is as if he went to a broker and cashed stock in, received $15, and gave it to the barber). The barber has $15 of income; basis of $15.

▪ International Freighting Corp., Inc. v. Comm’n

• F: Bonuses were given in the form of common stock of the duPont Company. During 1936, T paid over 150 shares of common stock of duPont, whose cost to T at the date of delivery was $16k, and whose market value was then $24k. T took a deduction for $24k in its return. Comm’n argues that if T took 24k deduction, it should have included 8k as taxable profit (realized gain)

• H: Taxable gain equal to the difference b/t the cost of the shares and the current market value, although they get a deduction per §162. Employees are taxed on the property received for services, per §83

▪ HYPO: T, cash-method, owes an employee, E, $10k for services rendered in T’s business. T satisfies the obligation by transferring to E property w/ an adjusted basis of $4k, and a FMV of $10k. RESULT: T has 6k of capital gain, and a 10k deduction per §162. E has 10k gain/basis

▪ Problem page 522

➢ Computation of Realized Gain or Loss

▪ The Basis of Property Acquired by Purchase or Taxable Exchange

• Philadelphia Amusement Park- conveyed bridge to city in exchange for extension on franchise

□ Court determined that when property is exchanged for property in a taxable exchange the taxpayer is taxed on the difference between the adjusted basis of the property given in exchange and the fair market value of the property received in exchange.

□ What is their basis? Let’s say bridge costs 10k

□ What is the value of the extension? FMV let’s say 100k

➢ their basis will be 100k (10k for bridge plus 90k of gain)

• Notes:

□ Basis of property acquired by exercise of an option: suppose a taxpayer pays $10,000 for an option to buy business real estate for $100,000 at any time during the next two years. When the taxpayer acquires the option, the property is worth $95,000. The taxpayer exercises the option at the end of the second year when the property is worth $115,000. The taxpayer recognizes no gain on the exercise of the option and obtains a basis of $110,000 for the property.

• Problems p. 528

• Basis of Property acquired by exercising an option: Suppose T (in 2001) pays 10k for an option to buy business real estate for $100k, within the next two years. (When owner gets 10k option, she does NOT have income at this point) Currently, property is worth $95k.

□ In 2003, T exercises option when property is worth $115k. RESULT: T recognizes no gain, and obtains a basis of $110k (10k option + 100k purchase price) (Owner would now have income of $110k)

➢ If the option expires with no deal going through—the owner now has 10k of “ordinary income.” (Professor questions why basis isn’t simply just reduced)

➢ If 3rd party wants to buy T’s option, and T sells it for $15k, T has $5k of gain income.

• Allocation of Basis: Consider a T who buys a 200 acre farm for 100k, and later sells 50 acres for 40k, retaining the rest of the farm. The T’s amount realized is 40k, but what is the basis of the property sold?

□ Gain realized on sale or exchange of property is included in income--generally gain is the excess of the amount realized over the unrecovered cost or other basis for the property sold

□ HYPO: B purchases for 25k property consisting of a used car lot (10k) and adjoining filling station (15k). Five years later, B sells the filling station for 20k, at a time when 2k has been allowed as depreciation thereon. RESULT: B’s gain on the sale is 7k, as basis in the filling station was reduced to 13k via depreciation, sold for 20k.

▪ Transactions Involving Mortgaged Property

• Crane

□ You include amt. of borrowed funds for mortgage in basis

• Parker v. Delaney

□ F: Parker acquired 4 apartment houses from banks. He paid no money for the properties and took them subject to mortgage liens totaling $273k. In 1945 the mortgages were in default, and Parker conveyed the properties to the banks. Parker reported 31k as gain from the sale, but sued for a refund, claiming that his amount realized was zero. The adjusted basis in 1945 was $273k less $45,280 (of depreciation deductions), or $227,719.

□ I: Was gain realized (in excess of the adjusted basis) from this taking over of the mortgage debt?

□ H: Paying down the debt doesn’t change your basis. P purchased the property for $0. He paid $13,989 on mortgage debt, and took depreciation deductions in the amount of 45,280. 45,280-13,989 = 31,291, which is his gain. The amount of the mortgages was $31k in excess of the adjusted basis. When a mortgage is used to finance the purchase of property, that mortgage goes into the basis of the property. Then on subsequent foreclosure on the property (treated as a sale) the mortgage goes into the amount realized. Thus the gain is calculated by the amount realized minus the basis (which will be reduced by an depreciation taken). AMT of unpaid mortage is included in amt. realized.

• Revenue Ruling 90-16

□ F: X was the owner and developer of a residential subdivision, obtaining a loan from an unrelated bank, unconditionally liable for repayment of the debt. The debt was secured by a mortgage on the subdivision. X became insolvent and defaulted. An agreement was reached whereby the subdivision was transferred to the bank and the bank released X from all liability for the amounts due on the debt.

➢ FMV: $10k -X’s adjusted basis: $8k -Amount due on debt: $12k

□ I: Is this transfer (to the bank) a sale or disposition resulting in the realization and recognition of gain by the T under §§ 1001(c) and 61(a)(3)?

□ H: This is not a non-recourse loan. Basis of 8k, sells for 10k. Has 2k of income.

□ R: To the extent of the FMV of the property transferred to the creditor, the transfer of the subdivision is treated as a sale or disposition upon which gain is recognized under §1001(c), thus X realizes and recognizes $2k gain.

• Subject to the application of § 108, to the extent that the amount of debt exceeds the FMV of the subdivision, X would also realize income from the discharge of indebtedness. Yet, does not have to pay bc he is insolvent.

• Amt realized=cash plus amt. of unpaid mortgage (see handout from old test)

• Adjusted basis= amt. paid for plus assumed mortgage

• Notes

□ Chief Judge Magruder’s suggestion that the cost basis of purchased property should not include the amount of a mortgage has never been followed. It is well established that the principal amount of a purchase-money debt, even without personal liability, is included in the property’s basis. This rule is subject to two qualifications:

➢ A purchase-money mortgage so greatly in excess of the property’s value that the buyer is unlikely to pay it off is almost certainly not included in basis

➢ Contingent and indefinite obligations of the buyer are not included in the property’s depreciable basis

➢ Tax Shelters

▪ Tax shelters: investments which are intended to generate deductible tax losses in excess of economic losses, with the tax losses being used to reduce (“shelter”) the taxpayer’s other income

▪ How Tax Shelters Work

▪ Tax-Shelter Legislation

➢ The Basis of Property Acquired by Gift

▪ In General

• As we saw in Chapter 3, the recipient of a gift can exclude the gift from income under §102(a). A donor, who transfers the property by gift usually recognizes no gain or loss on the transfer.

□ Per §1015(a), the donee generally assumes the donor’s basis for the property (“carry-over”). Thus this § may result in taxing the donee on gain attributable to appreciation that occurred while the donor held the property.

□ “Lower-of-basis-or-value:” If at the time of the gift the value of the property is less than the donor’s adjusted basis (basis is greater than FMV), the donee must use the FMV (rather than the donor’s basis) in computing the amount of loss realized on a disposition of the property.

□ §1223(2): If you get property, you must carry over basis and use holding period of the donor, i.e., if Donor had property for 6mo., and gave it to Donee, donee has holding period of 6mo.

• Problem- p 564 (handout)

▪ Transfers in Connection with Marriage and Divorce

• Davis case and §1041:

□ US v. Davis: T transferred appreciated stock to his former wife under a divorce property-settlement agreement. The court required T to recognize the gain to the extent that the value of the stock exceeded its basis. The T’s ex-wife obtained a cost basis equal to the value of the stock received. In essence, the transaction was viewed as if the transferor (husband) had paid cash to his ex-wife, who had then used the cash to purchase the property

□ §1041: In overturning Davis, §1041 instructs that gain or loss is not recognized upon the transfer of property to the taxpayer’s spouse or, in the case of transfers “incident to” divorce, to a former spouse.

➢ The exclusion for transfers incident to divorce covers all transfers w/in one year of the cessation of the marriage, as well as transfers “related to” that cessation.

➢ §1041 treats the property (for income-tax purposes) as having been acquired by the transferee by gift.

➢ Although a gift, the basis of such property is not governed by §1015(a), but rather §1041(b)(2). See §1015(e), which instructs marital property transfers to §1041.

➢ Under §1041(b)(2), the transferee assumes the transferor’s basis—the only practical difference is that this § does not contain the lower-of-basis-or value limitation, which is discussed above.

• Young- Young supposed to transfer 59-acre tract of land. His basis was $130,000 in that piece of real estate. He transfers that to his ex-wife but, it was subject to an option for $2.2mil. Wife sold property.

□ Issue- whether she has to report capital gains from the sale.

□ Holding- Yes, she must take his $130,000 basis and get the gain from his $2.2mil

• REVENUE RULING 2002 – 22

□ Divorce decree said you are going to give part of your non-qualified stock options to you ex-spouse and you are going to give a portion of your nonqualified deferred compensation to your ex-spouse

□ Issue – when stock options exercised or deferred comp paid, is there income that must be recorded.

□ Deferred comp is theoretically compensation for services already performed, going to be tax when received.

□ Stock options going to be taxed when exercised.  After divorce the wife exercises the stock options, who is it income to?  Wife, she could exercise whenever she wanted.

□ LESSON:  if dealing with something similar to these types of programs in co, must execute a ???

□ What about the deferred compensation?  

➢ As a lawyer you should put a trigger in: “whatever the average retirement age is is when this will be paid.”  Otherwise could work rest of life just to screw wife.

➢ The Basis of Property Acquired by Bequest or Inheritance

▪ In General

• Present Law: § 1014—the basis of inherited property is usually the value of the property at the date of the decedent’s death. Since the decedent is not required to recognize gain on the transfer of the property at death, any appreciation that occurred during the decedent’s life is exempted from tax. (“Stepped-Up” basis)

• HYPO: Basis in stock $100, FMV $10,000. M’s brother in law is ill, gives him stock. Brother in law takes basis of $100 (gift). B-I-L, then bequests the stock back to M, who will get the stepped up basis. RESULT: 1040(e) prevents such bush-league tactics.

• HYPO: $100 basis stock now has a FMV of $1M. Huge gain is up, how can you avoid? Go to bank and borrow $990,000 (as 1M stock as security). You get this money tax free, as it is borrowed money. If T dies in an accident. His heirs get the 1M (stepped-up) basis, and get a deduction for the 990k loan, based upon the Fed. Estate Tax.

• Problem p. 556

• Problem p 599

❖ Chapter 9: Non-Recognition Transactions and (Dis)allowance of Losses

➢ Introduction

▪ A realized gain is includable in gross income only to the extent that it is recognized.

▪ Similarly, a realized loss cannot be deducted unless it is recognized.

• Non-Recognition Rules: Congress has decided (for policy reasons) that immediate recognition of the realized gain or loss is inappropriate. These rules act to postpone the tax reckoning for certain types of transaction.

□ Non-recognition usually results in a deferral of the gain or loss rather than a permanent exclusion of the gain or loss from the tax base

▪ Two types of non-recognition rules:

• Tax-free exchanges, in which one item of property is exchanged for qualifying non-recognition property

• Tax-free rollovers, in which property is sold and qualifying replacement property is purchased by the taxpayer within some prescribed period of time

➢ Tax-Free Exchanges

▪ Introduction

• No gain or loss is recognized if property is exchanged for qualifying property

• One item of property is exchanged for qualifying non-recognition property

□ The basis of the property given up is usually transferred to the property acquired.

□ If the taxpayer receives cash or non-qualifying property (“boot”) in the exchange, any realized gain usually must be recognized to the extent of the boot received.

□ Even though boot is received, the taxpayer generally is not permitted to recognize loss. If the rule were otherwise, the taxpayer could recognize loss of an otherwise non-taxable exchange by having the transferee pay a small amount of boot.

▪ Like-Kind Exchanges Under Section 1031

• §1031 generally provides for non-recognition of gain or loss if property is held for productive use in a trade or business or for investment is exchanged solely for property of “like-kind,” to be held either for productive use in a trade or business or for investment.

□ 1031—

➢ (a)(1): No gain/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.

➢ (a)(2)—does not apply to stock, bonds, notes, interests in partnership, etc…

➢ (b)—Not Solely in Kind: if a like kind exchange takes place, along with other property being received, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the FMV of such other property.

➢ (d)—Basis: If property was acquired on an exchange described in this §, then the basis shall be the same as that of the property exchanged, decreased in the amount by any money received by the T and increased by the amount of gain or decreased in the amount of loss to the T that was recognized on such exchange.

▪ (i) “Like-Kind” Property

• T.Reg. § 1.1031(a)-1(b): Indicates that “like-kind” is a reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class.

□ Livestock of different sexes are not like kind. §1031(e)

□ Foreign real property is not of like kind w/ real property located in US

□ Personal property used predominantly in US is not of like kind w/ personal property used outside US

▪ (ii) Depreciation of like-kind exchanges:

• The property received is to be depreciated over the remaining recovery period of the property exchanged using the same convention and depreciation method as was used for the property exchanged.

• However, if the new basis exceeds the old, any increase of the new property’s basis (over the old) is treated as a newly purchased property.

• HYPO: T exchanges truck (basis 20k) and 15k cash for a new truck. The basis of the new truck would be 35k (20k basis of old truck plus 15k additional cash invested). As to the 20k, T would compute depreciation using the method, convention and remaining recovery period of the old truck. The remaining 15k would be depreciated as if a new truck had been purchased.

▪ Other Exchange-Type Non-Recognition Rules

➢ Tax-Free Rollovers

▪ Introduction

• Under a rollover-type non-recognition rule, no gain or loss is recognized if the taxpayer disposes of property and, within prescribed time limits, purchases qualifying replacement property.

• Property is old and qualifying replacement property is purchased by the T within some prescribed period of time.

• **The basis is the cost of the new property minus the gain not recognized

• **the realized gain is recognized to the extent that the amt. realized exceeds cost of the new property

▪ Involuntary Conversions under Section 1033

• The operation of the rollover type non-recognition rules is exemplified by § 1033(a)(2).

• § 1033(a) provides that if

□ (1) the taxpayer’s property is involuntarily converted into money, and

□ (2) within prescribed time limits the taxpayer purchases replacement property that is (generally) similar or related in service or use to the property involuntarily converted, then (at the taxpayer’s election) the gain realized on the involuntary conversion is recognized only to the extent that the amount realized exceeds the cost of the replacement property

• The basis of the replacement property is its cost, less the amount of unrecognized gain on the involuntary conversion; § 1033(b).

▪ Sale of a Principal Residence Under Section 121

• § 121 excludes from gross income the first $250,000 ($500,000 on a joint return) of gain on the sale of the taxpayer’s principal residence; §121(a) & (b).

• The exclusion applies regardless of whether the taxpayer purchases a replacement residence and regardless of the taxpayer’s age

• To qualify for the exclusion, the taxpayer must have owned the property (and used it as his principal residence) for at least two of the five years ending on the date of the sale; § 121(a).

• In general, the taxpayer can use the exclusion for only one sale in any two-year period; § 121(b)(3).

• If the sale is occasioned by a change in place of employment or health, a proportionate part of the exemption can be used even though the taxpayer does not satisfy the two-year-ownership-and-use test or the once-every-two-years requirement; §121(c)

• Realized gain in excess of the amount excluded must be recognized even if the taxpayer purchases a replacement residence

▪ Wash Sales Under Section 1091

• § 1091 purports to ‘disallow’ the deduction of a loss on a sale of stock or securities if, within 30 days preceding or following the sale, the taxpayer purchased stock or securities substantially identical to those sold.

• For example, the taxpayer purchased a share of stock for $50 in January, sells it for the $30 in November and, within 30 days, repurchases a share of the same stock for $35. The $20 loss realized on the November sale is not recognized. The basis of the replacement share is $55—its cost increased by the amount of unrecognized loss. If the new share is later sold for $45, the taxpayer recognizes loss of $10—a result that makes sense, as the taxpayer invested a total of $85 and received a total of $75.

➢ Allowance of Losses

▪ In General

• A recognized loss is deductible only if it is allowable.

• A disallowed loss is permanently barred from deductibility. Examples are losses disallowed by §§ 165(c) and 267.

• Sometimes, however, a loss is ‘disallowed’ in one year may only be held in abeyance until a future year—usually a year in which the taxpayer has sufficient income of a specified character to match against the loss. See §§ 1211 and 469.

• To determine the allowability of a recognized loss, begin with § 165. If the loss is not allowed by § 165, proceed no further; a deduction is permanently barred. If the loss is allowable under § 165, then consider whether it is permanently disallowed by some other provision, such as § 267. If the loss still appears to be allowable, it must usually be characterized as ordinary or capital. Finally, if the loss is subject to some additional limit, apply the additional limit.

• § 165(a) generally allows a deduction any loss sustained during the taxable year. For individual taxpayers, however, § 165(c) limits this general rule by restricting deductibility to:

□ (1) losses incurred in a trade or business,

□ (2) losses incurred in any transaction entered into for profit (investment losses), and

□ (3) certain casualty losses to personal use property

• The limits of § 1659c) do not apply to corporate taxpayers.

• Notes:

□ § 165(f) does not authorize a deduction for capital losses; it serves only as a cross reference to § 1211, which limits the deductibility of capital losses deductible under § 165. Therefore, an individual’s loss from the sale or exchange of a capital asset not used in a trade or business or in an investment activity—a taxpayer’s personal house or car, for example—cannot be deducted, even against capital gains b/c the loss is not described in § 165.

▪ Conversion of Property from Personal to Business or Investment Use

• McAuley v. Commissioner

□ Issues:

➢ Whether petitioners are entitled to a deduction of a loss in the amount of 3,588 or any part thereof resulting from the sale of a house which they used as a personal residence until Sept. 1, 1970

➢ If petitioners are not entitled to the claimed loss deduction are they entitled to any deduction for the cost of maintenance and depreciation on the house in 1971

□ Court held that petitioners were not entitled to any deduction under § 165 for loss on the sale of the house, but are entitled to deduct the depreciation for the period from 1971 to the date of the sale of the house in 1971, and the maintenance and insurance expenses they paid with respect to the house in 1971 under § 167(a)(2) and § 212

▪ Losses on Transactions Between Related Parties

• § 267(a)(1) disallows deductions for losses on the sale or exchange of property to a related person.

• The transferee acquires a cost basis for the property under § 1012. As a result, the transferee’s basis for computing realized gain or loss on a subsequent disposition of the property is computed without regard to the loss previously disallowed to the transferor.

• A loss that has been disallowed to the transferor under § 267 cannot be deducted by the transferor even when the transferee sells the property to an unrelated party.

• In general, therefore, both the transferor and the transferee are denied any benefit from a loss disallowed by § 267. But if the transferee subsequently disposes of the property at a gain, § 267(d) limits the recognized gain to the amount in excess of the loss previously disallowed.

• McWilliams v. Commissioner

□ Purpose of buying stock was to establish tax losses. Petitioners filed separate income tax returns for these years, and claimed the losses which he or she sustained on the sales as deductions from gross income.

❖ Chapter 10: Capital Gains and Losses

➢ The Significance of Characterization

▪ Whenever a gain is recognized, it must be characterized as ordinary or capital

▪ Capital Gains must be fully included in gross income.

▪ Long-term capital gains are generally taxed at a lower rate than ordinary gain.

▪ Capital losses are generally less attractive than ordinary losses: ordinary losses generally are fully deductible against ordinary income on a dollar-for-dollar basis, but only $3000 of ordinary income can be offset by capital loss in each year.

▪ 1. Capital Gains/Losses: §1222 defines capital gains/losses as gains and losses from the (a) sale or exchange of, (b) capital assets. (both must be present)

• The term “capital asset” is defined in § 1221, means property held by the taxpayer (whether or not connected with his trade or business, other than that excluded by §§ 1221 (a)

□ Inventory

□ depreciable or real property used in trade or business

□ certain copyrights and artistic compositions

□ accounts or notes receivable from inventory or in the ordinary course of trade or business.

• Some classic examples of capital assets are:

□ *stocks, bonds, securities held by a taxpayer (in his/her personal account) who is not a professional dealer in stocks/securities

□ *undeveloped land held as an investment by the T

□ *paintings or other artifacts—gold, silver, stamps, coins, gems, etc…provided that they are not held for sale by a dealer

□ *T’s home (note that if the home were sold at a loss, a deduction for the loss would not be allowed, thus the question of capital loss treatment would not arise. Any gain on the sale of the home (beyond the allowed exemption) would be a capital gain)

□ *Household furnishings

□ *A car used for pleasure or commuting

□ *Investment property

• Some classic examples of non-capital assets are:

□ *property held mainly for sale to customers or property that will physically become a part of the merchandise that is for sale to customers

□ *Supplies regularly used in ordinary course of trade or business

▪ 2. Long Term/Short Term: Depends upon the T’s holding period. The holding period is significant b/c only long-term gains get the benefit of the capital gains preference.

• A gain or loss is long-term if the asset was held for more than one year before being sold/exchanged; §§ 1222(3)(4)

▪ 3. Mechanics of Gain/Loss: If T has both capital gain and loss, the gains are not netted against the losses in computing gross income; instead the losses are deducted in computing AGI; § 62(a)(3)

• Net Capital Gain (NCG) is subjected to the favorable capital gains tax rates.

• NCG is computed by taking NLTCG and subtracting NSTCL.

□ If the LTCG exceeds the LTCL (the excess is NLTCG), one next nets all the short term transactions. Any excess of STCL over STCG (that is, any NSTCL) is then subtracted from the NLTCG to arrive at the NCG.

▪ HYPO p. 639:

• STCG = $5,000

• STCL = $7,000

• LTCG = $14,000

• LTCL = $4,000

• NSTCL: 2,000 (7,000-5,000)

• NLTCG: 10,000 (14,000-4,000)

• NCG: 8,000 (10,000-2,000) (This is what is taxed favorably)

▪ Any excess of short-term capital gain (NSTCG) over NLTCL is taxed at ordinary income tax rates up to $3,000 then carried forward after that.

• HYPO:

□ LTCG = $10,000

□ LTCL = $5,000

□ STCG = $10,000

□ STCL = $12,000

□ NLTCG: $5,000

□ NSTCL: $(2,000) = 10,000-12,000

□ NCG: $3,000

□ If NSTCL was ($10,000), it would wipe out all of the NLTCG (5k), and still leave a NLTCL of $5,000.

➢ Thus, 3,000 would be deductible and 2,000 carried forward as a STCL to offset capital gains of later years.

• ***From the T’s point of view, the first prize is to obtain a net capital gain for the year. The consolidation prize is a capital loss that can be used to offset up to 3,000 of ordinary income. The 3,000 offset only occurs if there is a deductible capital loss left over after offsetting capital gains.

• If long term loss is more than short term gain= the loss applies against ordinary income (see handout)

• If long term gain more than short term loss= you deduct to offset (see handout)

▪ 4. Capital Losses: Losses from sales or exchanges of capital assets shall be allowed only to the extent allowed in §§ 1211 and 1212

• a) § 1211: Corporate taxpayers may deduct capital losses only to the extent of capital gains, with excess capital losses carried over to other years.

• b) § 1212:

➢ The Sale-or-Exchange Requirement

▪ §1222 limits capital gains and losses to those from the “sale or exchange” of capital assets. (compare § 1001(a)—sale or other disposition of property)

• Thus some courts have held that some taxable dispositions are not sales or exchanges and therefore do not result in capital gain or loss even if the property disposed of is a capital asset.

▪ Nahey v. Comm’n

• Company acquired the Wehr Corp., whom had a pending claim against Xerox. Company acquires right to lawsuit and ends up getting a 6M settlement from Xerox.

• H: Not a capital gain, as the settlement of the lawsuit b/t the companies does not constitute a sale or exchange

• The receipt of payment by a creditor is not traditionally viewed as a sale or exchange b/c the obligation was extinguished by the payment. Basis = 0. This is ordinary income.

➢ Capital Assets

▪ Section 1221(a)(1) and 1231(b)(1)(A) & (B)

• Business and Purpose under § 1221(a)(1): This § excludes inventory from the definition “capital asset.” (Property that is held by the T primarily for sale to customers in the ordinary course of his trade or business.) The issue becomes then, does the T have a trade or business? The T’s whose activities are so frequent or intensive that he is held to be in business is said to be a “dealer” in the property sold. If he is not a dealer, gains and losses will be capital.

• Kemon v. Comm’n

□ I: Were securities are held primarily for sale to customers in the ordinary course of business?

□ H: No.

□ R: In determining whether a seller of securities sells primarily to “customers,” the seller must be comparable to a merchant, in that they purchase their stock in trade (here securities) with the expectation of reselling at a profit, not b/c of a rise in value, but merely b/c they hope to find a market of buyers who will purchase from them at this price. This is a “dealer.” Contrast that with a trader—sellers depending upon a rise in value or an advantageous purchase to enable them to sell at a price in excess of cost.

□ Here, the activity of T with regard to the securities conformed to the customary activity of a trader rather than a dealer holding securities primarily for sale to customers. T frequently refused to sell securities which it was accumulating despite the fact that the bid price would have resulted in profit. T never advertised itself or held itself out to the public as having on hand securities for sale.

□ A trader is someone who buys and sells securities on a large scale but whose gains and losses are capital b/c the sales are not “to customers”

• §351- T who contributes property to corp. recognize no gain or loss on the gain or loss on the transfer. Basis is usually 50k for Corp. and 50k for T.

▪ Non-capital Assets Other than Inventory

➢ Quasi-Capital Gains and Losses Under Section 1231

▪ § 1231 determines the character of gain/loss on three kinds of taxable dispositions of property:

• Sales or exchanges of “1231 assets” that is property used in the trade or business, which is excluded from the status as a capital asset per 1221(a)(2).

• Condemnations of §1231 assets and long-term capital assets held in connection w/ business or investment activity.

• Involuntary conversions by destruction or theft of §1231 assets and long-term capital assets held in connection w/ business or investment activity.(casualty transactions)

▪ Process of §1231: It provides for property used in trade or business or held for investment.

• The Casualty “Fire” Pot: The gains and losses on all casualty transactions are netted together.

□ If that net result is a loss, then none of these individual casualty transaction enter further into the workings of §1231. If the net result on all the casualties is to break even or is a gain, then all of the casualties—gains and losses—involved in this netting process pass into consideration in the “Main Pot”

• The “Main Pot:” The following transactions are netted in the “Main Pot”

□ All casualties, if they have netted to break even or a gain in the Casualty Pot

□ Sales or exchanges of capital assets or depreciable property and real property used in the trade or business, held for more than one year

□ Condemnation of depreciable property and real property used in the trade/business, held for more than one year.

□ If the transactions in the Main Pot net out to a gain, then each transaction in the Main Pot will be considered long-term capital gain. These §1231 (quasi) capital gains/losses are then combined with the taxpayer’s other capital gains and losses arising from a sale or exchange of capital assets. The combined gains/losses are subject to the normal treatment

□ If all the transactions in the Main Pot net out to break even or a loss, then each transaction in the Main Pot is considered an ordinary gain or loss. (very beneficial to T on both ends)

➢ Depreciation Recapture and Related Matters

▪ The basic theory of recapture is that the gain on the sale of depreciable property which is attributable to previously taken depreciation is deemed to be ordinary gain

▪ Sections 1245 and 1250

• (a) § 1245 Gain from dispositions of certain depreciable property: Overrides §§ 1222 and 1231 to recapture as ordinary income the make-up gain (does not apply to losses) on § 1245 property which is defined as “any property which is or has been property of a character subject to the allowance for depreciation provided in § 167, and is either—

□ personal property

□ other property

□ This § is said to apply to personal property such as machinery, equipment, vehicles

• When you take depreciation deduction and you sell property, any depreciation that is recaptured in sale will be taxed at a higher rate than just capital gain.

• HYPO: T pays 10k for a truck, properly deducts 6k in depreciation while using the truck in a business, and then sells the truck for $5500. The T’s gain on the sale is $1500 ($5500 less $4000 adjusted basis). This $1500 is not a real economic gain, but a make-up gain that just compensates for the excess depreciation deductions taken. (An economic gain results where property is sold for more than its cost.) §1245 treats this as ordinary gain.

• HYPO: T pays 100k for a machine, and depreciates for 6 years (10k per, 60k total) leaving basis of 40k. T then sells the machine for 130k. RESULT: T realizes and recognizes $90k. Under §1245, 60k is ordinary income (not involved in the netting process of §1231) b/c of the 90k gain, 60k was due to previously taken depreciation. 30k is put into the “Main Pot” where it may turn out to be ordinary income or capital gain in the 20% group.

• HYPO: Jones buys a machine for his trade or business for 16k. J took depreciation deductions totaling 6k, rendering his basis 10k. J then sold the machine for 20k. RESULT: Realized gain is 10k. 6k is ordinary income, 4k goes into the §1231 Main Pot

• HYPO: Same facts, except that the machine was sold for 12k. RESULT: 2k gain (of ordinary income). Nothing passes into the Main Pot. The only reason this gain came about was b/c of the depreciation deduction.

• Sale of a business- see handout

□ you have a capital gain/loss when you sell your business.

• Lottery winnings are ordinary income

▪ Section 1239

▪ Section 1231 Reconsidered

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