FEDERAL INCOME TAX Five basic questions: 1. Is it income? 3. Is it deductible? 5. To whom is it income? I.
2. When is it income? 4. When is it deductible?
INTRODUCTION Gross Income (§ 61) − Above the Line Deductions (§ 62(a)) - - - - - Adjusted Gross Income (AGI) (§ 62) - - - - - - - - - - - - - - - - - - - - - - − Below the Line deductions (standard, § 63(c), OR itemized, § 63(d)) − Deduction for Personal Exemptions (§ 151) Taxable Income (§ 63)
II.
INCOME § 61. Gross income defined. (p. 60) (a) General definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived . . . .
A. Income In-Kind (Noncash Benefits). 1. The pay payment of tax for employee is taxable income – 1Old Colony Trust Co. v. Comm’r (U.S. 1929): a. It is compensation for services rendered. b. The form of compensation is immaterial. c. Discharge of indebtedness income. 2. Meals and lodging provided to employees: a. Not taxed when supplied merely as a convenience to the employer and noncompensatory – 2Benaglia v. Comm’r (TC 1937) (T lived in hotel he managed). b. Superseded by statute: § 119 § 119. Meals or lodging furnished for the convenience of the employer. (p. 116) (a) Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to employment. There shall be excluded from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer, but only if-(1) in the case of meals, the meals are furnished on the business premises of the employer, or (2) in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.
c. Tres. Reg. § 1.119–1(a)(2): to escape tax, must have a “substantial noncompensatory business reason.” 3. Fringe Benefits: § 132, an exclusionary provision. § 132. Certain fringe benefits. (p. 128) (a) Exclusion from gross income.—Gross income shall not include any fringe benefit which qualifies as a— (1) no-additional-cost service, offered to customers in ord. course of line of business (2) qualified employee discount, cannot be more than the normal markup, sell at cost (3) working condition fringe, ordinary & necessary expenses deductible under §§ 162 or 167 (4) de minimis fringe, trivial, copies, personal phone calls (5) qualified transportation fringe, (6) qualified moving expense reimbursement, (7) qualified retirement planning services . . . . (j) Special rules. nondiscrimination rule, (1), (2), (7) excluded if only highly-compensated employees are eligible.
1
4. Other fringe benefit provisions: a. § 117(d) – qualified tuition reduction b. § 129 – dependent care assistance program c. § 125. Cafeteria Plans. (p. 122) (1) Employees can choose from among from of a variety of benefits (nontaxable) or take cash (taxable). (2) A nondiscrimination rule applies. 5. Valuation. a. §§ 119 and 132 are all-or-nothing in including income. b. Other approach: 3Turner v. Comm’r (TC 1954) – value of ship tickets won as a prize not taxed at retail value, but not taxed at nothing either – court arbitrarily split the difference? B. Imputed Income. Economic benefits derived from non-market transactions—like owning your own home, taking care of your own children, leisure and “psychic income”—and not taxed. C. Windfalls and Gifts. 1. Punitive damages— a. are taxable. 4Comm’r v. Glenshaw Glass Co. (U.S. 1955). b. The Court abandoned the previous constitutional approach to income (from 19Eisner v. Macomber), and holds that the statute grants “the full measure of taxing power.” c. We impose tax on “undeniable accessions to wealth.” 2. § 74. Prizes and awards. Are generally included in income. (p. 89) 3. Gifts § 102. Gifts and inheritances. (p. 99) (a) General rule. Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. (b) Income. Subsection (a) shall not exclude from gross income— (1) the income from any property referred to in subsection (a); or (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income.
a. Taxable to the donor, not the donee. b. (§ 102 is distinct from the Gift tax, which is the donor’s obligation, but has a $1 million exemption.) c. Gifts in the commercial context – 5Comm’r v. Duberstein (U.S. 1960) – tax consequences depend on the intent of the donor. (1) To be a gift under the statute, gift must come from “detached and disinterested generosity” usually out of “affection, respect, admiration, or charity.” (2) But no hard and fast rules, courts must consider all the factors using the “mainsprings of human conduct and the totality of the facts.” d. In response to Duberstein, Congress added § 274(b) – Cannot deduct as a business expense any “gift” of more than $25. e. 6United States v. Harris (7th Cir. 1991) – mistresses convicted of tax evasion for not reporting “gifts” – a criminal case is not the place for novel interpretations of the tax code. 4. Inter Vivos Gifts of Unrealized Gain a. 7Taft v. Bowers (U.S. 1929) – stock transferred, the donee acquires the donor’s basis. b. Codified by § 1015— (1) When gain is realized by donee, donee’s basis is the donor’s basis. (2) When loss is realized by donee, donee’s basis is the lower of donor’s basis or FMV at the date of gift (3) See Regs. §1.1015–1 for example (p. 1515) 2
5. Transfers at Death § 1014. Basis of property acquired from a decedent. (a) In general.—Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent's death by such person, be— (1) the fair market value of the property at the date of the decedent's death . . . .
(or under § 2032, FMV at 6 months after date of death)
a. It can be very advantageous to die—tax on unrealized gain disappears—heirs get a “stepped-up” basis. b. Make sure to sell your loss property before death, otherwise your heirs will get a “stepped-down” basis and can deduct less. c. § 1014 results in the lock-in phenomena—people tend to hang on to property until death D. Recovery of Capital 1. Income does not include recovery of one’s capital (i.e. basis not included in income when gain is realized). 2. 8Inaja Land Co. v. Comm’r (T.C. 1947) – T received settlement money from L.A. for an easement. Court found that it was impossible to determine how much the easement lowered T’s property value, so rather than taxing the settlement money as income, subtract it from basis and wait until gain or loss realized. 3. Life Insurance a. Many products, but boil down into two things: (1) pure insurance protects against untimely death, and (2) a saving component b. § 101(a) – gross income does not include payments from life insurance by reason of the death of the insured. (Despite being an accession to wealth.) c. § 101(a)(2) – can acquire someone else’s life insurance for consideration. The amount you paid for policy is basis, taxed on income above that. (Terminally ill often sell their insurance. They are treated as if income came from death. § 101(g).) 4. Annuities and Pensions a. The inverse of insurance. Lump sum payment up front in return for income for life. b. How are annuities taxed? § 72 (p. 71) (1) Exclusion ratio: each of the payments is considered part income, part return of capital. (2) May exclude percentage of the payments equal to (investment in contract/expected return). (3) The expected return is calculated by actuarial tables. (4) If there is unrecovered investment at death (i.e. die before life expectancy table predicted), the unrecovered amount is deducted in the final taxable year. (You have to have enough income in final year to absorb the deduction, otherwise it is lost.) § 72(b)(3) (5) Once investment is fully recovered (i.e. live longer than expectancy table predicted), all payments are income. c. Pensions (“qualified employer plans”) are treated essentially the same as annuities. 5. Gains and Loss from Gambling – all gains are taxable; losses are only deductible to the extent of gambling gains in the same tax year (“basketing” approach). § 165(d) 6. Recovery of Loss – 9Clark v. Comm’r (T.C. 1939) – T received bad tax advice and had to pay more than T would have if received proper advice. Tax counsel paid the difference. Not income, but compensation for a loss (like compensatory damages in other cases).
3
E. Annual Accounting and Its Consequences 1. Principles of Accounting in Tax a. § 441 – period for computation of taxable income. b. § 441(g) – if no books kept, taxable year is calendar year. If keep books may use a fiscal year. c. § 446 – general rule for methods of accounting. Permissible methods: (1) cash receipts and disbursements – report income when received; report losses when paid (2) accrual method – report income when have an uncontested claim of right; report losses when obligation to pay is incurred 10 2. Burnet v. Sanford & Brooks Co. (U.S. 1931) – T received judgment for breach of contract by the United States. Entire judgment taxable in the year received. Harsh ruling because had big losses in previous years with no income to offset. In response, Congress enacted § 172— 3. Exception to annual accounting: § 172. Net operating loss deduction (p. 208) a. Can carryback loss previous 2 years or carryover next 20 years. b. Carryback to the first possible year and go in order until loss is exhausted. 4. Claim of Right – a. 11N. Am. Oil Consol. v. Burnet (U.S. 1932) – income is taxable in the year in which the money is received under claim of right—when you have legal and unrestricted use of it. In this case, income under receivership was taxable when court awarded it to T. b. 12United States v. Lewis (U.S. 1951) – T paid tax on a bonus, but later had to return bonus to employer. T wanted a credit for the tax paid. Court said no except to annual accounting rule. Instead T could take a loss in the year he had to repay. c. In response to Lewis issue, Congress added § 1341 – (1) T has an option: either take the deduction in the current year OR get credit for what T overpaid in original year. (2) IRS has said § 1341 does not apply to “mere errors” such as arithmetic. 5. The Tax Benefit Rule § 111. Recovery of tax benefit items. (p. 114) (a) Deductions. Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.
a. Opposite of Lewis and § 1341—have a loss and take a deduction, but then all or part of the loss is restored/recovered. Has two parts: b. Inclusionary aspect – if you took a deduction and received a tax benefit, you must include the recovery in income. c. Exclusionary aspect – to the extent that you did not receive a tax benefit, you do not include it in income. d. Example: Bliss Dairy – dairy farm bought feed and took a deduction for the cost of the feed. Farm was liquidated. Although not really a recovery, the deduction was “fundamentally inconsistent” with a later occurrence. Inclusion required.
4
F. Recoveries for Personal and Business Injuries § 104. Compensation for injuries or sickness. (a) In general.—Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include— (1) amounts received under workman’s compensation . . . (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness . . . .
1. § 104 was amended in 1996 to add the word “physical.” 2. So: emotional injuries, slander, libel, violation of civil rights are not excludable. G. Transactions Involving Loans and Income from “Discharge of Indebtedness” 1. Loan proceeds are not income. 2. Discharge from indebtedness is taxed – § 61(a)(12) a. 13United States v. Kirbey Lumber Co. (U.S. 1931) – T (corporation) issued bonds, interest rates went up, T repurchased bonds at a discount, the difference was includable in income as discharge from indebtedness. b. Exceptions: § 108. Income from discharge of indebtedness. (a) Exclusion from gross income. (1) In general.—Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if— (A) the discharge occurs in a title 11 case, bankruptcy (B) the discharge occurs when the taxpayer is insolvent . . .
BUT, you have to give up a whole bunch of tax “goodies”: (b) Reduction of tax attributes. must reduce any carryover-able net operating losses
c. If discharge of indebtedness brings you from negative net worth to –0–, courts have said no income. AND if discharge of indebtedness brings you from negative net worth into positive net worth, then it is income to the extent it went above –0–. d. 14Zarin v. Comm’r (3d Cir. 1990) – T lost $3.5 million gambling. Settled with the casino for $500,000. IRS said discharge of indebtedness income of $3 million. BUT the court said it was not a debt, but a contested liability (it was probably not enforceable under N.J. law), therefore, no discharge of indebtedness income. e. 15Diedrich v. Comm’r (U.S. 1982) – T gave stock to children with the condition that they pay the resulting gift tax. Old Colony controls, T has been relieved of an obligation and therefore must pay the resulting tax. 3. Transfer of property subject to debt a. 16Crane v. Comm’r (U.S. 1947) – T inherited building subject to nonrecourse mortgage. T took depreciation deductions. T transferred the building and loan for nominal sum. IRS said that amount realized included the loan, so T received income equal to the depreciation deductions plus boot. Treat nonrecourse mortgages as if T were personally liable. b. Pyrrhic victory – a result of Crane was the creation of the real estate tax shelter. Could acquire rental property at no risk (nonrecourse loan) and offset income from other sources with large depreciation deductions – this was foreclosed by § 469 which disallowed passive activity losses. But you can carry losses forward and subtract them when gain realized from sale (but only to the extent of the gain). c. 17Comm’r v. Tufts (U.S. 1983) – answered an unresolved question from Crane: how to treat an underwater nonrecourse loan. Apply the same rule as Crane: treat it as a regular loan, i.e. cancellation of indebtedness applies when nonrecourse mortgage assumed by someone else.
5
H. Illegal Income 1. Embezzled funds are income (even if T is forced to return the funds later) – so often government can get a tax lien, then if any money is left, the corporation can get it back. 2. 18Gilbert v. Comm’r (2d Cir. 1977) – T illegally withdrew corporate funds, but since T fully intended to repay, expected he would be able to repay, believed the withdrawal would be ratified, and made a prompt assignment of assets to cover the withdrawal—it was not income. I. Interest on State and Local Bonds § 103. Interest on State and local bonds (a) Exclusion.—Except as provided in subsection (b), gross income does not include interest on any State or local bond. (b) Exceptions.—Subsection (a) shall not apply to— (1) Non-qualified private activity bonds (§ 141), but exempt facility bonds are excludable (§ 142). (pp. 138–39) (2) Arbitrage bond. (§ 148) (3) Bonds not in registered form (§ 149).
J. Gain on the Sale of a Home 1. Gain from the sale of one’s principal residence is excluded from income – § 121. 2. Limitations: a. Up to $250,000 is excluded ($500,000 if married). b. Must have used the home as a principal residence for 2 of the prior 5 years – § 121(a). c. Applicable to only 1 sale or exchange every 2 years. 3. Losses on homes are not deductible. K. Special rate for dividends – § 1(h)(11) – qualified dividends are taxed at the capital gains rate (domestic corporations only, no mutual funds). III. TIMING A. Gains and Losses from Investment in Property 1. The Historical Basis of Realization Doctrine a. 19Eisner v. Macomber (U.S. 1920) – realization is a constitutional requirement (this holding has been abrogated). b. Realization is now a doctrine of administrative convenience (not required by the Constitution). c. 20Helvering v. Bruun (U.S. 1940) – Tenant improved T’s building. T repossessed the building and was taxed on the value of the improvements. d. Bruun has been superseded by statute: § 109 – value of a lessee’s improvements is not included in gross income of lessor. § 1019 – neither the basis nor adjusted basis is changed when tenant leaves improved property to landlord. e. 21Woodsam Assocs., Inc. v. Comm’r (2d Cir. 1952) – Basis is not increased when T receives a loan (secured by a nonrecourse mortgage). Borrowing is not a realization event, T never disposed of the property, and therefore basis is unchanged. (1) Crane mortgage – basis includes loan as part of purchase prince (purpose of loan is to acquire the property). (2) Woodsam mortgage – basis not increased when money is borrowed out of increased property value (mortgage subsequent to acquisition).
6
2. The Contemporary Realization Doctrine § 1001. Determination of amount of and recognition of gain or loss (p. 593) (a) Computation of gain or loss.—The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
a. § 1001 – “sale or other disposition” b. 22Cottage Savings Assoc. v. Comm’r (U.S. 1991) – T (savings & loan) swapped “substantially identical” yet “materially different” loans with another S&L in order to recognize a loss for taxation purposes, but not for accounting purposes. Court allowed this. c. Treas. Reg. § 1001–1(a): gain or loss is realized “from the exchange of property for other property differing materially either in kind or in extent.” – Court’s gloss on this interpreted it broadly (“hair trigger” realization). B. Statutory Nonrecognition Provisions 1. These provisions allow taxpayers to defer, not permanently exclude, income. 2. Like-Kind Exchanges (tax-free § 1031 exchanges) § 1031(a). Exchange of property held for productive use or investment (p.603) (a) Nonrecognition of gain or loss from exchanges solely in kind.— (1) In general.—No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (2) Exception.—This subsection shall not apply to any exchange of— (A) stock in trade or other property held primarily for sale, (inventory) (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.
a. Treas. Reg. § 1.1031(a)–1(b) – “like kind” means nature or character, not grade or quality. b. Treas. Reg. § 1.1031(a)–2(b) – depreciable tangible property must be in the same “General Asset Class” (p. 1520). c. § 1031(b) – if taxpayer receives boot in a § 1031 exchange, gain is recognized up to the amount of boot received. d. § 1031(c) – if taxpayer receives boot, no loss is recognized. e. § 1031(d) – calculating basis: (adjusted basis in old property) – (money involved “boot”) + (gain recognized) = (adjusted basis in new property) Calculating basis example (from § 1.1031(d)–1 on p. 1522): Z exchanges Truck A for Truck B and $200 boot. Truck A— A/B = $2,500 exchanged for Truck B— FMV = $2,400 + $200 cash boot Z recognizes $100 in gain. $2,500 − 200 + 100 = $2,400 (Z’s basis in Truck B)
f. 3-corner transaction – artificial transaction, but has been upheld by the courts. (1) Example 1: B wants to buy S’s farm, but S doesn’t want to recognize gain, so B buys O’s farm for cash, then B executes a tax-free exchange with S. (2) Example 2: S swaps with O, and then O sells to B for cash.
7
3. § 1033. Involuntary conversion— if property destroyed, T gets insurance money, and T invests the money (within limited time frame) in property that is “similar or related in use or service” then gain is not recognized. (narrowly construed) 4. Nonrecognition Rules for Certain Corporate Transactions a. § 351. Transfer to corporation controlled by transferor No gain or loss recognized if property is transferred to a corporation by one or more persons solely in exchange for stock and immediately after the transaction the transferors are in control (have 80% of voting power). (1) The corporation assumes the transferor’s basis. (2) Gain is recognized to the extent of boot received. (3) May be unfair to people contributing services, not property to the corporation. b. § 357. Assumption of liability – Transfer to corporation property subject to debt, gain is recognized to the extent that liabilities exceed FMV. c. § 368. Tax-free reorganization – no gain or loss recognized from a statutory merger. C. Deemed Realization—Constructive Sales 1. § 1259 – the IRS will treat certain activities as a “constructive sale.” 2. For example, a “short against the box”—T shorts stock that T already owns. The effects are that (1) T gets the proceeds of the short sale now, and because already has the stock to cover it, (2) there is no longer any risk. Under § 1259, this is a constructive sale and gain is recognized immediately. (An ordinary short sale is taxed when it is closed out.) D. Original Issue Discount and Related Rules 1. Original Issue Discount (OID) refers to unstated interest. See §§ 1272–75. 2. For example a bond with an issue price of $600,000 and redemption value of $1,000,000 in 5 years. The $400,000 (unstated interest) will be taxed as regular income over each of the 5 years (not straight-line; treated as compounding interest). 3. This is more complicated with property where there is no readily determinable issue price. 4. OID is applied to rent – § 467. Suppose T leases property to Lessee for 3 years in return for a single $1 million payment at the end of the term. T will be taxed on a “constant rental amount” (1/3 of the present value of $1 million in three years = $301,389) each year, plus interest in the second and third years. Equalizes cash and accrual based taxpayers. E. Open Transactions and Installment Sales 1. Open Transaction Doctrine a. 23Burnet v. Logan (U.S. 1931) – T sold stock for $120,000 plus future mining royalties. T argued, and court accepted, that this should be an “open transaction” because it was impossible to determine the present value of the future payments. b. See Treas. Reg. § 1.1001–1(a) – only in rare and extraordinary cases will property be considered to have no FMV—so it is very unusual to have an open transaction. Today the Logan case would likely apply the installment method. 2. Installment Method a. § 453 – when at least one payment is in a year other than the sale year, the payments are split into taxable gain and recovered basis (ratio of gain over the total contract price). b. § 453(d) – the taxpayer may opt out of the installment method, in which case the entire gain is taxable in the year the disposition occurs.
8
F. Constructive Receipt and Economic Benefit 1. Constructive receipt – Cash-method taxpayers are taxable when there is an “unqualified right” to income. When the money could be reduced to actual possession but for action or inaction on the part of the taxpayer. Property must have an
ascertainable market value to be constructively received. 2. 24Amend v. Comm’r (T.C. 1949) – T, farmer, contracted to deliver wheat in August for
consideration paid the following January. This was not constructive receipt in August, because T had no legal right to the money before January. 3. Economic benefit – 25Pulsifer v. Comm’r (T.C. 1975) – Children betting on Irish horses. T had an absolute, non-forfeitable right to money deposited in a bank, could retrieve it at any time. This was an “economic benefit” and taxable to T when deposited. 4. Nonqualified Deferred Compensation a. 26Minor v. United States (9th Cir. 1985) – Physician was a member of a P.C. Compensation was paid 10% in cash and 90% placed in a deferred compensation fund. The deferred compensation was not income because of restrictions placed on the funds (money was lost if T competed). No constructive receipt or economic benefit because the substantial risk of forfeiture made the funds incapable of valuation. b. Downside of nonqualified deferred compensation plans is risk that employer might not be able to pay in the future, so some plans were designed to limit this by accelerating payments if the financial outlook of the company deteriorated. This was eliminated by § 409A, which makes benefits taxed when bargained for if the plan allows for acceleration of payments. 5. Qualified Employee Plans a. Qualified plans (must cover a class of employee and not discriminate—governed by IRC and ERISA) are clearly an economic benefit to employees, but are not income to the employee (until withdrawals made at retirement) AND the employer gets to deduct from tax immediately. b. §§ 401–09 6. § 451(h) qualified prize option – if win an annuity in lottery but can take a single lump sum payment, this is ignored for the purposes of constructive receipt. G. Transfers Incident to Marriage and Divorce 1. Property Settlements (Historically) a. 27United States v. Davis (U.S. 1962) – husband transferred property to wife as part of divorce settlement, husband pays tax on gain at transfer, wife’s basis is FMV at time of transfer. SUPERSEDED BY STATUTE b. 28Farid-Es-Sultaneh v. Comm’r (2d Cir. 1947) – premarital transfers: basis is FMV at time of transfer (presumably this is still good law). 2. Property Settlements (Current) – § 1041 – no gain or loss is recognized from transfers of property between spouses/ex-spouses incident to divorce. It is treated as a gift. (Transferee has transferor’s basis.) 3. Alimony, Child Support, and Property Settlements a. Alimony is included in gross income – § 61(8) b. 71(a) – alimony is included in income of the payee and deductible by the payer. c. Alimony is § 71(b)(1): (1) Payment in cash received under a divorce or separation instrument. (A) (2) Opt-out allowed: (B) – private ordering (potential bargaining chip). (3) Payer and payee can’t live together. (C) (4) (D) – payments must cease upon death of payee spouse. 9
d. Child support is not alimony— (1) tax-free to payee; not deductible by payer (2) § 71(c)(2) – can’t hide child support in alimony (no contingencies involving children in the instrument). e. § 71(f) recomputation where excess front-loading of alimony payments— (1) If early payments are too large it is not really alimony, but a property settlement, and should not be deductible by the payer. (2) Income will be recaptured in the third year if payments in the first year exceed the average of the second/third year plus $15,000 (see p. 70). f. 29Diez-Arguelle v. Comm’r (T.C. 1984) – T was supposed to receive child support, but did not and deducted the amount she should have received as a bad debt under § 166. Court said T was not “out of pocket”—so no basis in the debt and not deductible. H. Cash Receipts and Payments of Accrual Method Taxpayers 1. Delay in Receipt of Cash – 30Geo. Sch. Book Depository v. Comm’r (T.C. 1943) – income taxable to T when T had right to receive them, not when actually paid (unless there is a reasonable expectancy that the claim will never be paid). 2. Prepaid Income a. 31Am. Auto. Assoc. v. United States (U.S. 1961) – prepaid dues taxable in year paid. SUPERSEDED BY STATUTE b. § 456 – allows membership organization apportion prepaid dues income ratably over the period of time the organization is liable to render services. 3. Deposits Versus Advance Payments a. Security deposit is not rent (LL needs to return it)—not income, but advance payments are income. b. 32Westpac Pacific Food v. Comm’r (9th Cir. 2006) – T received a cash advance in return for exclusive agreement and minimum sale requirement. If minimum not met, T had to repay advance on a pro-rata basis. Court found this cash advance was not income (not an accession to wealth), more like a security deposit. 4. Current Deduction of Future Expenses a. All Events Test – a future obligation is not deductible unless (1) the fact of liability is firmly established AND (2) the amount of the liability can be determined with reasonable accuracy. b. § 461(h) – economic performance test – cannot take a deduction before economic performance has occurred (adds third requirement to the All Events Test). IV.
PERSONAL DEDUCTIONS, EXEMPTIONS, AND CREDITS
Gross Income (§ 61) − Above the Line Deductions (§ 62(a)) Ordinary and necessary business expenses (§ 162) Alimony (§ 71) - - - - - Adjusted Gross Income (AGI) (§ 62) - - - - - - - - - - - - - - - - - - - - - - - (the line) − Below the Line deductions Personal deductions Charitable contributions (§ 170) – limited to a maximum of 50% of AGI Medical expenses (§ 213) – in excess of 7.5% of AGI Casualty losses (§ 165(c)) – in excess of 10% of AGI Home mortgage interest (§ 163(h)(3)) Miscellaneous itemized deductions – 2% of AGI floor − Deduction for Personal Exemptions (§ 151) Taxable Income (§ 63)
10
A. § 63(c) – standard deduction OR § 63(d) – itemized deduction B. Casualty Losses 1. § 165(a) – deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. 2. § 165(c) Losses of individuals a. § 165(c)(1) – losses incurred in a trade or business b. § 165(c)(2) – losses incurred in any transaction entered into for profit, though not connected to a trade or business c. § 165(c)(3) – losses from “fire, storm, shipwreck, or other casualty, or from theft.” 3. Threshold – deductions limited to those that exceed 10% of AGI, § 165(h)(2), and a $100 “deductible,” § 165(h)(1). a. Example: you have $100,000 AGI and suffer a $50,000 casualty loss. Subtract 10% of AGI and $100. You may deduct $39,900. b. The $100 is on a per casualty basis, so if the same casualty destroyed two cars, only take one $100 deduction. 4. “Other casualty” does not include your sick cat breaking a vase. 33Dyer v. Comm’r. 5. “Suddenness” requirement— a. Termite damage not deductible because it is not sudden, unlike the named casualties. b. Losing or breaking rings—courts have gone both ways. 6. Physical damage rule a. 33Chamales v. Comm’r (T.C. 2000) – T lived near O.J. Simpson. Value of their house decreased after crowds started showing up. Casualty loss deduction disallowed— (1) there was no physical damage and (2) there was evidence that the value was recovering (not permanent). b. Circuit split— 9th Cir. – there must be physical damage 11th Cir. – need not be physical damage 7. Casual that is the result of taxpayer’s negligence a. Negligence is generally not a bar to casualty loss deduction— Treas. Reg. § 1.165–7(a)(3)b – damage to a car resulting from the faulty driving of the taxpayer is a casualty loss as long as it was not a willful act or willful negligence. b. But gross negligence will bar deduction— 34Blackman v. Comm’r (T.C. 1987) – T set fire to his own house in the course of a domestic dispute (he was burning his wife’s clothes on the stove). No casualty loss deduction because (1) this was gross negligence or worse and (2) allowing deduction would frustrate Maryland public policy against arson and domestic abuse. C. Extraordinary Medical Expenses 1. § 213(a) – medical expenses are only deductible to the extent they exceed 7.5% of AGI. 2. What is a medical expense? a. Regs. say – diagnosis, cure, mitigation, treatment, or prevention of disease. b. Deductible— birth control pills, vasectomies, dentist fees, physical therapy, psychotherapy, and abortion. c. Not deductible— maternity clothes, tooth paste, fitness club fees, and scientology. 3. 34Taylor v. Comm’r (T.C. 1987) – T’s doctor told him not to mow the grass due to a severe allergy. T deducted cost of hiring someone else as a medical expense—NOPE. 4. 35Henderson v. Comm’r (T.C. 2000) – T bought a van to transport son with spina bifida. Depreciation of van not allowed under § 213, but cost of installing a wheelchair lift is. 11
5.
36Ochs
v. Comm’r (2d Cir. 1953) – T’s wife recovering from cancer. Costs paid to send
children to boarding school to give wife peace of mind were allowed as a § 213 deduction. (unique case) D. Charitable Contributions 1. § 170(a)(1) – may deduct any “charitable contribution . . . payment of which is made within the taxable year.” 2. How do you define charity? § 170(c) a. A State or the United States, or any of their political subdivisions. b. A corporation, trust, or community chest, fund, or foundation—organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international sports competition, or for the prevention of cruelty to children or animals. c. Special rules: no revenue to any individual; not disqualified under § 501(c)(3) for political intervention. d. IRS publishes a list of approved charities. 3. § 170(b) – percentage limitations a. Donations to “Large A” organizations capped at 50% of AGI. Large A orgs: (1) church or association of churches (2) educational organization with faculty and enrolled students (3) hospital with medical research (4) government supported organization (5) governmental unit (6) other government-supported orgs. (7) private foundation (8) public charities b. Donations to other types of charities are limited to 30% of AGI. c. Donations to Large A can be carried over to next year, but not non-A orgs. 4. Gifts of property a. When you give property that would result in capital gain income, capital gain is not recognized, and the deduction is equal to FMV at time of gift. b. If give some property that is not long-term gain property, have to reduce the amount of the contribution by that amount (1) If not long term, can only deduct basis. (2) Can get around this by waiting a year. c. Gifts of tangible personal property shall be reduced to basis if unrelated to charity’s exempt function, § 170(e)(1)(B) – example: could give a painting to a museum and deduct FMV, but not to soup kitchen. d. Inventory can be donated when directly related to charity’s exempt function (grocery store donating canned food to soup kitchen), but only basis is deductible – § 170(e)(3). e. There is no deduction for the value of services donated. 5. Gifts with Private Objectives or Benefits a. 36Ottawa Silica Co. v. United States (Fed. Cir. 1983) – T, corporation, donated land for the building of a school, but a main reason was that the school would build access roads. The charitable deduction was disallowed because T inured a “significant benefit”—more than what the general public got—such to make it quid pro quo. b. Gifts with incidental benefits do not cause deduction to be disallowed. Ottawa. 12
6. Congress intended that tax-exempt charities must serve public purpose and not be contrary to public policy. Therefore, Bob Jones University’s tax-exempt status was revoked for its policy forbidding interracial dating. 37Bob Jones Univ. v. United States (U.S. 1983). 7. Life interests a. If you give tangible property but retain a life-interest, you have not made a charitable contribution (until all interests have terminated). b. Charitable Trusts – income for life, § 170(f) permits you to take a deduction NOW. (1) CRAT – Charitable Remainder Annuity Trust – intangible property (2) CRUT – Charitable Remainder Uni-Trust E. Interest 1. § 163(d) – investment interest (interest paid in the course of earning investment income, example: buying stock on margin) is deductible, but only to the extent of investment income. 2. § 163(h) – personal interest is generally disallowed. 3. § 163(h)(3)(c) – home mortgage interest deduction (costs the treasury $95 billion per year). 4. Arbitrage problem – Borrow $1,000,000 @ 10% interest Buy Muni bond $1,000,000 @ 8% return if interest deductible in 40% bracket
($100,000) interest cost $80,000 interest income $40,000 tax savings $20,000 net return
Can’t do this—§ 265(a)(2)! 5. Tracing rules (very complicated), BUT trace to the use of the proceeds of loan. Treas. Reg. § 1.163–8T 6. Buy insurance with borrowed funds? NO DEDUCTION – § 264. F. Taxes— 1. § 164 – deduction for State and Local Taxes (SALT). 2. Applies to property taxes – another reason why most homeowners itemize. G. Personal and Dependency Exemptions 1. § 151 – personal exemption is a below the line deduction indexed to inflation. 2. Can take the deduction for each taxpayer and any dependents, defined in § 152. 3. For 2011, personal exemption is $3700. 4. 38King v. Comm’r (T.C. 2003) – Both never-married parents claimed dependency exemption for child. Usually goes to the parent who provided over one-half of support for a given year, but in this case that parent had signed a release giving up those rights. Court found against her, even though she provided most of the support. SUPERSEDED BY STATUTE – now the statute only applies to divorced parents. H. Earned Income Tax Credit – § 32, a tax credit or kind of “negative income tax” for wage earners (primarily those with children). It phases in and phases out (CB 415).
13
V.
ALLOWANCES FOR MIXED BUSINESS AND PERSONAL OUTLAYS A. The conflict: 1. § 262 – no deduction for personal living or family expenses. 2. § 162 – allows deduction for ordinary and necessary expenses incurred in carrying on any trade or business. a. There could be expenses for income generating activities that do not rise to the level of a trade or business. b. BUT— § 212 – deduction for ordinary and necessary expenses incurred— (1) for the production of income. (2) for the management, conservation, or maintenance of property held for the production of income. (3) in connection with the determination, collection, or refund of any tax. c. HOWEVER, § 212 is a miscellaneous itemized expense (§ 67), which can only be deducted to the extent they exceed 2% of AGI. d. ON THE OTHER HAND, § 162 is an above-the-line deduction. e. HENCE, a lot of litigation over what is a trade or business. 3. Questions that arise: a. Is something a personal expense or necessary and ordinary business expense? b. Family or non-family? c. Capital expense or ordinary expense? d. § 162 versus § 212. B. Controlling the Abuse of Business Deductions 1. Hobby Losses a. § 183. Activities not engaged in for profit— (1) No deductions except (mortgage interest), real estate taxes, and ordinary and necessary business expenses (up to the amount of income). (2) No losses (offsetting other income) allowed. b. Presumption § 183(d) – if activity generated profit in 3 out of last 5 years, then presumed for profit (or if a horse breeder, 2 out of last 7 years). c. 39Nickerson v. Comm’r (7th Cir. 1983) – primary purpose test and what is the reasonableness of the expectation of profit? T bought farm and was losing money, but it was a lot of individual effort—not done just for fun—so it must be for profit. d. Treas. Reg. § 1.183–2(b) – list of 9 factors (p. 1049–50). 2. Home Offices a. § 280A – in general no business-related expenses may be deducted for one’s place of residence. b. Exception: deduction allowed if part of the residence is used exclusively and on a regular basis as the taxpayer’s principal place of business or to meet patients, clients, or customers. c. The Soliman principal place of business test: (1) relative importance of each location (where are services delivered?) (2) relative amount of time in each location d. In Soliman, doctor worked at hospital, but did reading and record-keeping at home. Deduction disallowed because he delivered services at hospital and spent significantly more time at hospital. (Statute altered—now may take a deduction if home used for administrative purposes and there is no other place to do so. § 280A(c)(1)(C).)
14
e. In 40Popov v. Comm’r (9th Cir. 2001) home office deduction allowed for violinist. Spent more time practicing at home and court stretched the rule because music does not fit into a strict “delivery of services” context.
3. Income Unconnected to a Trade or Business a. 41Moller v. United States (Fed. Cir. 1983) – T took deductions under § 162 as a “trade or business” for their investment business. Should it have been under § 212 for the production of income instead? YES. Traders—get income through short-term gains and swings in the market—are in a trade or business. Investors—get income from interest and dividends and long-term holdings—are not in a trade or business (no matter how many hours they spend working on it). T was an investor. b. 42Whitten v. Comm’r (T.C. 1995) – T won prizes on Wheel of Fortune, tried to take deductions for travel and lodging as “gambling losses” under § 165—NOPE. Travel expenses are not tantamount to a wager. 4. Office Decoration a. Only deductible if an ordinary and necessary expense—such as for a law firm that hosts clients. b. 43Henderson v. Comm’r (T.C. 1983) – office decoration deduction my assistant state attorney general disallowed—only tangentially connected to employment duties. 5. Certain items (like home computers, cars, cell phones) are only deductible if used “for the convenience of the employer and required as a condition of employment.” BUT the employer cannot just say something is required—employ an “objective” test. C. Travel and Entertainment Expenses 1. Main question: what is the primary purpose of the trip? a. Business purpose: deductible (§ 162); not taxed to employee (§ 132(d)). b. Personal: not deductible; if paid by employer included in income. c. Mixed: generally all or nothing (typically deduction allowed if there is a sufficient business purpose). But meals and entertainment are deductible at 50%. 2. 44Rudolph v. United States (U.S. 1962) – trip to N.Y.C. was a reward for selling a certain amount of insurance. There was a business meeting, but primary purpose was pleasure—akin to a vacation. Included in income. 3. § 274. Disallowance of certain entertainment expenses— a. No deduction unless taxpayer establishes that the entertainment was directly related to (or if preceding or following a business discussion, that it was associated with) the active conduct of T’s trade or business. b. Establishment of goodwill is not deductible (so meeting has to be with a current client, not a potential client). c. § 274(d) – substantiation required (have to keep records). This applies to travel expense deductions under §§ 162 and 212 as well. d. § 274(h) – conventions “outside the North American area” are not deductible. e. § 274(m)(3) – business travel deductions for spouses not allowed. f. § 274(n) – meal and entertainment expenses deductible only at 50%. 4. 45Moss v. Comm’r (7th Cir. 1985) – business lunches not deductible when not necessary (and you do it every day). 5. 46Danville Plywood Corp. v. United States (8th Cir. 1990) – trip to the Super Bowl was not really a business expense—even though clients were invited, that was clearly not the primary purpose, but rather a “bootstrapping afterthought.” 6. 47Churchill Downs, Inc. v. Comm’r (6th Cir. 2002) – entertainment is entertainment (and therefore subject to the 50% limitation), unless entertainment is your business (for example, a fashion show, which would be deductible under § 162). 15
D. Child-Care Expenses 1. 48Smith v. Comm’r (T.C. 1938) – child care not deductible. SUPERSEDED BY STATUTE. 2. § 21 – childcare tax credit (phased out as income rises). 3. § 129 – employer can give employees up to $5,000 tax-free through a dependent care assistance program. (But any DCAP payments directly reduce § 21 credit—usually better to take the credit.) E. Commuting Expenses 1. Regular travel from home–work or work–home is not deductible. (Everybody has to do this, and you get to choose where you want to live.) 2. But travel while at work (work–work) is a deductible business expense. 3. Travel while away from home is deductible – § 162(a)(2). Must sleep and rest away
from home.
4. Temporary assignment away from home is deductible for the worker (but not for the worker’s family). 5. 49Comm’r v. Flowers (U.S. 1945) – T lived in Jackson, Miss. but worked in Mobile, Ala. Travel expenses not deductible. Requirements: (1) expenses are reasonable and necessary; (2) expenses incurred “away from home”; (3) expenses incurred “in pursuit of business.” 1 is fine, 2 court declined to answer, 3 failed. 6. 50Hantzis v. Comm’r (1st Cir. 1981) – Boston law student with summer job in N.Y.C. Costs of living in N.Y.C. are not deductible. T’s trade or business did not require travel between the cities or that T maintain two homes. F. Clothing Expenses 1. Clothing is deductible only if: (1) specifically required as a condition of work, (2) not adaptable to general usage as ordinary clothing, (3) not so worn. 2. 51Pevsner v. Comm’r (5th Cir. 1980) – T worked at boutique clothing store, would have worn less expensive clothes if she didn’t have to work there. Not deductible—clothing could be worn for general usage. Objective test—no reference to T’s lifestyle or personal taste. G. Legal Expenses 1. Legal expenses are deductible under § 162 or § 212. 2. Origin of the claim doctrine. 3. 52United States v. Gilmore (U.S. 1963) – T had legal fees in a divorce. Deducted them because if he lost the divorce case, his business would have been negatively affected. Disallowed—it is the origins, not the consequences, of the legal action that matter. The action arose from T’s personal life, not business. 4. Accardo v. Comm’r (7th Cir. 1991) – T was acquitted of racketeering. No deduction for legal fees because T was not in the business of racketeering. (But some co-defendants who were convicted were allowed a deduction.) H. Education Expenses 1. Education is deductible if (1) it maintains or improves the skills required by the individual in employment or trade or business or (2) meets requirements of employer or law imposed as a condition of employment. Treas. Reg. § 1.162–5. 2. 53Carroll v. Comm’r (7th Cir. 1969) – police officer’s education expenses for a philosophy degree (he wanted to attend law school) were not deductible because “generally and basically unrelated to this duties.”
16
VI.
DEDUCTIONS FOR THE COSTS OF EARNING INCOME A. Current Expenses Versus Capital Expenditures 1. § 162 (expenses deducted in current year) versus § 263 (expenses must be capitalized)
§ 263. Capital expenditures (a) General rule. No deduction shall be allowed for— (1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
2. Exceptions to § 263: development of mines, research and development, soil & water conservation, and some expenditures by farmers. Also, IRS has never required advertising to be capitalized. 3. § 263A. Capitalization and inclusion in inventory costs of certain expenses (UNICAP) a. Direct and indirect costs must be allocated to capital property and inventory. b. Inventory costs recovered when sold. (1) If inventory turns over quickly, it does not matter that much. (2) But long-term inventory does matter—time value of money. c. § 263A(b) – section applies to: (1) real or tangible personal property produced by the taxpayer, or (2) property (inventory) acquired for resale (if taxpayer has more than $10,000,000 in sales.) d. Self-created assets: (1) Idaho Power Co. – T built its own power transmission lines with useful life of 40 years. All the costs (salaries, equipment, supplies, etc.) must be capitalized over the life of the asset. (2) 54Encyclopaedia Britannica v. Comm’r (7th Cir. 1982) – T outsourced writing of book. Wanted to deduct costs as § 162 expense. Disallowed: must capitalize it because the asset will produce income over a period of years. The cost was not an “ordinary and necessary” reoccurring expense. (NOW, under § 263A all costs— direct or indirect—must be capitalized.) e. Intangibles – INDOPCO case: Court said that realization of intangible benefits beyond year of expense required capitalization. This was very broad, but IRS has issued regulations to limit its power and create more certainty. (CB 520) B. Repair and Maintenance Expenses 1. Repairs are deductible as an ordinary and necessary business expense, BUT 2. Replacements, alterations, or additions are capital investments. 3. 55Midland Empire Packing Co. v. Comm’r (T.C. 1950) – T installed concrete floor in basement to fix an oil seepage problem. This was a repair because it did not add to the value of the property or prolong its life. It merely permitted T to operate in the same manner it had before the seepage started. Did not operate on a changed or larger scale. 4. 57Norwest Corp. & Subsidiaries v. Comm’r (T.C. 1997) – T remodeled its building and removed asbestos. The asbestos removal alone might have been deductible, BUT the removal and the remodeling were one intertwined project. Cost of both must be capitalized. C. Inventory Accounting 1. The idea is to match costs with revenues. 2. Generally use first-in-first-out accounting (FIFO), but may elect last-in-first-out (LIFO) under § 472. 3. LIFO will result lower income in a rising market, which is good for tax purpose, but companies want to show high profits. § 472(c) requires you to use the same accounting method for reports to investors and creditors as for tax purposes. 17
D. Rent Payment Versus Installment Purchase 1. People say they are renting when really they aren’t (because rent is deductible and asset purchases must be capitalized). 2. 58Starr’s Estate v. Comm’r (9th Cir. 1959) – T claimed it was leasing a sprinkler system, but it was re-characterized as an installment purchase with interest by the court. The IRS can disregard form for substance. (See also Knetch case: gave sham transaction no substance.) E. “Ordinary and Necessary” Requirement of § 162 1. 59Welch v. Helvering (U.S. 1933) – T had debts discharged in bankruptcy, but paid them anyway to increase goodwill. This was not “ordinary”—paying debts not legally owed is highly extraordinary. 2. 60Gilliam v. Comm’r (T.C. 1986) – crazy artist was arrested for a disturbance on a plane. Expenses not an ordinary and necessary business expense because “beyond the norm.” 3. Dancer – T driving car for business hit a child. Legal expenses were deductible. 4. Illegal or Unethical Activities— a. Tank Truck Rentals (U.S. 1958) – intentionally running trucks overweight. Fines not deductible because contrary to public policy. b. BUT, legal expenses of illegal businesses deductible – Comm’r v. Sullivan (U.S. 1958): rent for illegal bookmaking business is deductible. c. Statutory exceptions in § 162 (1) § 162(c) – no deduction for illegal bribes and kickbacks (2) § 162(f) – no deductions for fines and penalties (3) § 162(g) – no deduction for the 2/3 punitive damages under Clayton antitrust act (4) These exceptions do not apply to losses under § 165, so restitution of embezzled funds is deductible – Stephens v. Comm’r (2d Cir. 1990). F. Depreciation 1. § 167. Depreciation deduction allowed a. for property used in trade or business b. for property held for the production of income c. Applies to both tangible and intangible assets (but see § 197). d. basis is cost 2. § 168. Accelerated cost recovery system (ACRS, now MACRS) a. applies to tangible property b. Tangible assets are in one of 6 property classes. (1) This does not have much of anything to do with economic depreciation. (2) Example: Trucks and computers are 5-year property. c. Use the 200% declining balance method, but switch to the straight line method when it would yield a higher deduction. Example: $25,000 asset with 5 year useful life Year 1 Year 2 Year 3 ...
Straight line $25,000 − 5,000 = $20,000 $20,000 − 5,000 = $15,000 $15,000 − 5,000 = $10,000 ... ... ...
Double declining balance $25,000 − 10,000 = $15,000 (10/25 = 0.4) $15,000 − 6,000 = $11,000 (0.4 × 15 = 6) $11,000 − 5,000 = $ 6,000 (at this point, switch to straight line)
(Or, even better, sell this asset and get a new one)
d. 15- and 20-year property uses a 150% declining balance recovery. e. Real property uses straight-line depreciation: (1) Residential rental property has a recovery period of 27.5 years. (2) Nonresidential rental property has a recovery period of 39 years. 18
G.
H.
I.
J.
K.
L.
f. Example: $50,000 machine, depreciated to $40,000 and sold for $45,000 results in $5,000 ordinary gain (recapture of depreciation) – but watch out for §§ 1231 and 1245 § 1231. Property used in the trade or business (section 1231 assets) 1. held for more than 1 year 2. Not inventory, sold in ordinary course of business, not literary 3. If 1231 gains exceed 1231 loss, treat as long-term capital gain. 4. If a loss, treat as ordinary loss and deduct it from income. § 1245. Gain from dispositions of certain depreciable property – overlaps with § 1231, but recapture depreciation first. 1. Section 1245 property is property subject to § 167 depreciation deductions and is personal property or other tangible property (not buildings) 2. When you sell a section 1245 asset, gain is ordinary gain to the extent of depreciation deductions, otherwise subject to § 1231 capital gain. 3. But § 1245 does not apply to real property, so . . . § 1250. Gain from dispositions of certain depreciable realty 1. Only applies to buildings (because land is not depreciable). 2. Does not apply to property purchased after 1986. 3. This Section is DEAD. 4. ESSENTIALLY: no recapture of depreciation on buildings Intangible assets 1. § 197. Amortization of goodwill and certain other intangibles a. Applies to: (1) intangibles that are purchased and held for business (2) Examples: goodwill, going concern value, workforce in place, patent, copyright, licenses, covenants not to compete, franchise, trademark, trade name. b. Does not apply to self-created intangible assets (except if the intangible is created in connection with a transaction) – § 197(c)(2)(B). c. Amortized: ratable recovery over 15 years (always straight-line). 2. Intangible property with a determinable useful life can be amortized outside of § 197. When no gain or loss is recognized for income, then NOT a §§ 1231 or 1245 exchange. 1. Examples: a. Gifts b. Like-kind exchanges (§ 1031) c. Transfers at death (§1014) d. Certain tax-free transactions (§351 exchange solely for stock) e. involuntary conversions 2. Don’t want to have a lot of depreciation to recapture in these situations. § 179. Election to expense certain depreciable business assets 1. § 179 property (which normally would have to be capitalized) can be expensed and deducted in the current year. 2. Limits: currently limited to $500,000 per year (scheduled to decrease in future years, but Gabinet guaranteed Congress will change it.) 3. Definition of § 179 property – tangible property subject to § 168 (MACRS) and computer software.
19
VII. SPLITTING INCOME A. Diversion of Service Income by Private Agreement 1. 62Lucas v. Earl (U.S. 1930) – Husband and wife executed agreement to split property 50/50. But “fruits cannot be attributed to a different tree from that on which they grew.” Income should be attributed to the husband for tax. 2. But if the agreement is not gratuitous it may be allowed. Hundley v. Comm’r – son, a baseball player, assigned a percentage of his income to his father, who acted as his coach and agent. 3. § 83. Property transferred in connection with performance of services – are taxed to the worker—cannot be deflected 4. 64Armantraut v. Comm’r (T.C. 1977) – employer program set up college tuition trust. The money was distributed to the children of key employees. This was treated as deferred compensation—income to the employee. B. Diversion of Service Income by Operation of Law 1. 63Poe v. Seaborn (U.S. 1930) – in community property state (Washington), husband and wife each have present ½ interest in all community property. Income can be split between husband and wife for tax purposes. (Created an advantage for couples in community property states—many states changed their laws. In 1948 Congress amended the code to allow for married couples to split income.) 2. IRS does not allow for splitting of income between registered domestic partners in a community property state. Poe only applies to community property law in the context of husband and wife. C. Marriage Penalty – the tax tables for married couples are not quite a doubling of the single tables, so for 2 wage earners with similar income, filing jointly can lead to a “marriage penalty.” D. Transfers of Property and Income from Property 1. 65Blair v. Comm’r (U.S. 1937) – T assigned income from a life-estate trust to his children. The income was taxable to the children. 2. 66Helvering v. Horst (U.S. 1940) – T gave children coupons from a coupon bond. Income taxable to T. 3. 66Helvering v. Eubank (U.S. 1940) – T assigned to third party some income from commissions from renewal of life insurance. Income taxable to T. 4. If interest transferred was coterminous with T’s interest (vertical slice), then transferee is taxed; if interest transferred was something less than the entire right owned by T (horizontal slice), then T is taxed. 5. § 482 – IRS may allocate income and deductions among taxpayers if necessary to prevent evasion of taxes. 6. § 704(e). Family partnerships – can’t just assign partnership profits—must give a capital interest. E. Trusts 1. Established by a grantor, run by a trustee, and pays income to a beneficiary. 2. Simple trust – all income must be distributed currently. 3. Complex trust – some income may be retained. 4. Irrevocable trust a. A trust is a taxable entity, but gets a deduction for income distributed, so (for a simple trust) –0– income. b. Beneficiary pays tax on income. 5. But a short term trust with reversion to grantor is taxed to the grantor – § 673. 20
6. § 676 – if grantor has power to revoke the trust, then taxed to the grantor (also called a “grantor’s trust”). VIII. CAPITAL GAINS AND LOSSES A. Long Term Capital Gains 1. § 1(h) – preferential treatment (long term net gains taxed at 15%). 2. Sale or exchange of capital asset held for more than one year. 3. What is a capital asset? § 1221. Capital asset defined a. All property EXCEPT: (1) stock in trade; inventory; property held for sale; (2) property subject to depreciation deduction or real property used for trade or business; (3) copyright; works of art; musical compositions; intellectual property (in the hands of the creator or the person for whom it was created). b. What does this LEAVE? Investment-type property. (1) stocks (2) real property held for investment (3) patents (see also § 1235) c. Personal residence is a capital asset (but remember exclusion—§ 121). B. Calculating Long- and Short- Term Capital Gains and Losses – § 1222. 1. Long term capital gains and losses are the gain or loss from sale or exchange of capital asset held for more than one year. 2. Short term capital gains and losses are the gain or loss from sale or exchange of capital asset held for less than one year. 3. No preferential tax rate for short term capital gains—treated as ordinary income. 4. For an individual (not corporations), a net capital loss is deducted from income (up to $3,000) – § 1211. 5. If capital losses exceed $3,000, you can carry over to year 2 – § 1212 6. Net short against short; net long against long; net net short against net long. C. Transactions Related to the Taxpayer’s Regular Business 1. Corn Products Case: to hedge against future prince increases, T bought corn futures contracts. Are these contracts a capital asset or ordinary income? In an individual’s hands it would be an investment—hence capital gain. Service said they were integrally related to ordinary business, so must be ordinary income. 2. For 3 decades Corn Products appeared to create a new class of “integrally related” assets. But in Arkansas Best (U.S. 1988), the Court said everyone is misinterpreting Corn Products—it was really decided because the futures were a substitute for inventory.
21
I.
INTRODUCTION ........................................................ 1
F. Clothing Expenses ............................................. 16
II.
INCOME.................................................................... 1
G. Legal Expenses .................................................. 16
A. Income In-Kind (Noncash Benefits). ................... 1
H. Education Expenses .......................................... 16
B. Imputed Income ................................................... 2 C. Windfalls and Gifts .............................................. 2 D. Recovery of Capital .............................................. 3 E. Annual Accounting and Its Consequences ......... 4 5. The Tax Benefit Rule ........................................... 4 F. Recoveries for Personal and Business Injuries .. 5 G. Transactions Involving Loans and Income from “Discharge of Indebtedness” ................................ 5 H. Illegal Income ....................................................... 6 I. Interest on State and Local Bonds ...................... 6 J. Gain on the Sale of a Home ................................. 6 K. Special rate for dividends. ................................... 6 III. TIMING..................................................................... 6
A. Current Expenses Versus Capital Expenditures 17 B. Repair and Maintenance Expenses .................. 17 C. Inventory Accounting ........................................ 17 D. Rent Payment Versus Installment Purchase .. 18 E. “Ordinary and Necessary” Requirement of § 162 18 F. Depreciation ....................................................... 18 G. § 1231. Property used in the trade or business 19 H. § 1245. Gain from dispositions of certain depreciable property. ......................................... 19
A. Gains and Losses from Investment in Property 6
I. § 1250. Gain from dispositions of certain depreciable realty .............................................. 19
B. Statutory Nonrecognition Provisions ................. 7
J. Intangible assets ................................................ 19
C. Deemed Realization—Constructive Sales .......... 8
K. When no gain or loss is recognized for income, then NOT a §§ 1231 or 1245 exchange. ............ 19
D. Original Issue Discount ....................................... 8 E. Open Transactions & Installment Sales ............ 8
L. § 179. Election to expense certain depreciable business assets ................................................... 19
F. Constructive Receipt and Economic Benefit ...... 9
VII. SPLITTING INCOME ............................................... 20
G. Transfers Incident to Marriage and Divorce ...... 9
A. Diversion of Service Income by Private Agreement .......................................................... 20
H. Cash Receipts and Payments of Accrual Method Taxpayers ........................................................... 10 IV. PERSONAL DEDUCTIONS, EXEMPTIONS, AND CREDITS................................................................. 10
B. Diversion of Service Income by Operation of Law ..................................................................... 20 C. Marriage Penalty ............................................... 20
A. § 63(c) – standard deduction OR § 63(d) – itemized deduction ............................................. 11
D. Transfers of Property and Income from Property 20
B. Casualty Losses .................................................. 11
E. Trusts ................................................................. 20
C. Extraordinary Medical Expenses ...................... 11
VIII. CAPITAL GAINS AND LOSSES ................................ 21
D. Charitable Contributions................................... 12
A. Long Term Capital Gains .................................. 21
E. Interest ............................................................... 13
B. Calculating Long- and Short- Term Capital Gains and Losses – § 1222. ............................... 21
F. Taxes ................................................................... 13 G. Personal and Dependency Exemptions ............ 13 H. Earned Income Tax Credit ................................ 13 V.
VI. DEDUCTIONS FOR THE COSTS OF EARNING INCOME 17
ALLOWANCES FOR MIXED BUSINESS AND PERSONAL OUTLAYS................................................................ 14 A. The conflict: ........................................................ 14 B. Controlling the Abuse of Business Deductions 14 C. Travel and Entertainment Expenses ................ 15 D. Child-Care Expenses ......................................... 16 E. Commuting Expenses ........................................ 16
C. Transactions Related to the Taxpayer’s Regular Business ............................................................. 21
