Personal Income Tax
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PERSONAL INCOME TAX SPRING 2005 Professor Howard Chapman
CHAPTER 1
Total Receipts -Exclusions = Gross Income
- ADJ = AGI
- Itemiz or STD -Exem = TI
* Rate =Tax before credits
- Credits = Tax
Phase out- as income reaches certain level, benefits are phased out by AGI
Total Receipts- FMV of all money, property, services Exclusions- gifts, scholarships, inheritances, damage awards for personal physical injury Gross Income- Total receipts minus exclusions Deductions- taxpayer expenditures (business expenses, charity) and freebies and adjustments adjustments- business expenses, alimony. above the line deductions. (agi is the line) everyone entitled whether they itemize or not AGI- Itemized- mortgage interest, real estate, charity. below line. must own home or condo OR Standard- 5150 and 10300 Exemptions-3300 for each tax payer, spouse, dependent under 105,500. as AGI rises, exemption amount decreases by 2%. Taxable Income is amt on which tax is computed. Credits subtracted from tax
Indexing-
Laffer curve- 1981 wont raise more money after 50%
1939, 1954 irc
1986
1. new tax law will extend capital gain 1 2. alternative minimum tax- disallows deductions, not indexed, more middle income end up paying kiddie tax- children under 13 with interest in dividends taxed at parents rate raised to age 17 ------function of tax- raise revenue, implement economic policy, tool of social policy depreciation incentive not extended tax brackets- tax lawyers do tax planning. plan transactions for best tax result, represent in disputes w/IRS corporate tax, estate planning, pension source of tax law- appx 1. IRCode passed by congress. nothing is indexed for inflation legislative history, passes code regulations by treasury dept ex branch. explain and interpret. presumed valid revenue rulings issued by IRS, their interpretation of law case law- judicial. all three branches involved tax evasion- illegal, not reporting income or bogus deductions. ex. not reporting cash. "poor man's tax shelter" tax avoidance is legal. paying minimum that you legally can. ex. not billing in nov.
1998 irs restructuring act. audits taxpayer compliance measurement program audit- justify everything on return. account for every deposit, receipts for every expenditure, corporate minute books tax procedure- 3 yr statute of limitations for irs to look at return or to amend. if fraud, no statute if do something bad either pay and sue for refund- district ct. trial by jury, if win, get refund and interest or dont pay, go to tax court and sue for redetermination. no jury. if lose, pay plus interest appeal to 7th circuit
A. HISTORY OF FEDERAL INCOME TAX (P.4)
AUTHORITY:
1. 16th Amendment: “Congress shall have the power to lay and collect tax on incomes, from whatever source derived, without apportionment among the several states and without regard to any census or enumeration” 2. 1913 Tax Act – imposed a low rate of taxes, given the high exemption levels, only a small portion of the American public paid income taxes (the very wealthy) 1940s more were taxed b/c of the war effort Collection difficulties 3. Modern Tax Withholding System – required employers to withhold from their employees’ compensation a sum determined by reference to a specially formulated schedule Purposes Served by the Tax System: (1) Revenues to operate the government (2) Allocation – richer pay more; “Progressive” (3) Social Policy – allow deductions for things we want people to do, e.g. buy houses = mortgage deduction
2 (4) Economic Policy – allows businesses to depreciate certain tangible property rapidly, thereby encourages business to invest in new equipment
B. RESOLUTION OF TAX ISSUES THROUGH THE JUDICIAL PROCESS (P.6)
1. Trial Courts – three courts have original jurisdiction in federal tax cases:
a. Tax Court [Constitutional Status under Article I, §8[9]]– taxpayers can bring claims (1) without first paying the asserted deficiency, and (2) tried by one judge, no jury, who submits an opinion to the chief judge for consideration Chief judge either (1) allows decision to stand, or (2) refers it to the full court for review [Reviewed Opinions are accorded greater weight – know its reviewed if its published]
b. Federal District Courts – taxpayers can bring claims here (1) in the district where the taxpayer resides (or a corporations principal place of business), and (2) they pay the alleged deficiency, (3) may be tried before juries
c. United States Court of Federal Claims – jurisdiction over all tax suits against the United States regardless of amount where the taxpayer has paid the deficiency; jury trials may be allowed
2. Appeals – appeals from the Tax Court are heard here – Jurisdiction is in the court for the circuit in which the taxpayer resides
C. UNDERSTANDING THE BIG PICTURE (E.2) Income Tax – everything of value that comes in, excluding certain amounts such as gifts, inheritance, fringe benefits [Income – Exclusions and Deductions = Taxable Income – Credits]
Refer to Handout #4 Total Receipts: the fair market value of all money, property and services received during the year
Minus exclusions: receipts that the Code excludes from taxation, such as gifts, inheritances, and damage awards for personal physical injuries
Equals gross income
Minus adjustments (“above the line” deductions) deductions such as business expenses and alimony that are subtracted from gross income to arrive at adjusted gross income
Equals Adjusted Gross Income – AGI determines how various other deductions and credits are treated for tax purposes
Minus the Greater of:
(a) Itemized Deductions (“below the line” deductions) Deductions such as real estate taxes, mortgage interest and charitable contributions
(b) the Standard Deduction ($5,000 on single returns; $10,000 on joint returns)
Minus Exemptions ($3,200 deduction for every taxpayer and qualified dependent)
3 Equals Taxable Income: the amount used to calculate the tax – the tax is determined by using the tax rate schedules on Handout #1
Subtract Credits from the tax (child tax credit, dependent care credit, the Hope and Lifetime Learning credits, and amounts already paid, such as withholding tax)
To arrive at the Tax Due or Refund
CHAPTER 2
1. GROSS INCOME = CASH, PROPERTY, or SERVICES to determine whether something is gross income look to (1) Code §61; (2) Regulation §1.61-1(a), etc.; and (3) Case Law – Glenshaw Glass, etc.
§61(a): “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:” (1) Compensation for services, including fees, commissions, fringe benefits, and similar terms; (2) Gross income derived from Business (3) Gains derived from dealings in Property (4) Interest (5) Rents (6) Royalties (7) Dividends (8) Alimony and separate maintenance payments (9) Annuities (10) Income from Life Insurance and Endowment Contracts (11) Pensions (12) Income from Discharge of Indebtedness (13) Distributive share of Partnership gross income (14) Income in respect of a Decedent (15) Income from an interest in an Estate or Trust
REGULATIONS: §1.61-1(a) Gross Income. Cross references (p.892) §1.61-14 Miscellaneous Items of Gross Income: (p.898) (1) Punitive Damages (such as treble damages = 3 times the damages) (2) Exemplary Damages for fraud (3) Another person’s payment of the taxpayer’s income taxes (4) Illegal Gains (5) Treasure Trove
§1.61-2 Compensation for services including fees, commissions, and similar items (p.893) (a) In general – Wages, salaries, commissions paid to salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses (including Christmas bonuses), termination or severance pay, rewards, jury fees, marriage fees and other contribution received by a clergyman for services, pay of persons in the military or naval forces of the United States, retired pay of employees, pensions, and retirement allowances are income to the recipients unless excluded by law (d) Compensation paid other than in cash – FMV (1) In general – paid for in property or paid for in exchange for other services = FMV, unless stipulated price then that price is presumed to be FMV (2) Property Transferred (i) If property transferred to employee or independent contractor as compensation for services for an amount less than FMV, the difference between the amount paid for the property and the amount of its FMV at the time of transfer is compensation and shall be included in the 4 gross income of the employee/IC Gain or loss computation: Basis shall be the amount paid for the property increased by the amount of the difference (ii) (a) Cost of Live Insurance on the life of the employee. Generally, life insurance premiums paid by employer on life of employee where proceeds are payable to beneficiaries = gross income to employee (4) Stock and notes transferred to employee/IC – if employer transfers stock to employee/IC as compensation for services, the FMV at the time of the transfer shall be included in gross income of employee/IC; Notes constitute income in the amount of their FMV at time of transfer… (6) Property transferred, Premiums paid, and Contributions made in connection with the performance of services after June 30, 1969
Case Law defining Income
Glenshaw Glass – Income – Treble damages (3 times the damages) under antitrust law and exemplary damages for fraud are included in recipient’s gross income because according to the Court, “Undeniable accessions to wealth, clearly realized and over which the taxpayers have complete dominion” are includable in gross income Overturned Eisner v. Macomber defining income as “gain derived from capital, from labor or from both combined”
Cesarini – Income – Husband and wife found $5000 inside an old piano they had purchased – must they include it as income? – YES; Reg. 1.61-14(a) requires taxpayers finding treasure to include it in gross income when reduced to undisputed possession for the year it is found
Old Colony Trust – Income –Employer agreed to pay the income taxes of employee – income to employee? – YES; Satisfaction of a taxpayer’s obligation by another person constitutes economic benefit to him, resulting in income to the taxpayer
Revenue Ruling 79-24 – Income – lawyer performs legal services for taxpayer, who in turn paints the lawyer’s house [Barter Transaction] – Income to both? – YES; both have income as a result of the transaction in an amount equal to the FMV of the services each received (presumed to be an equal amount of each because no additional payments are made)
McCann – Income – salesman wins all expense paid vacation for high sales that is mostly play but with must attend seminars –income? – YES; it’s additional compensation to the employee [Distinguish: Not Income when employee is sent on business, not for top sales, and play is incidental to his business trip Convenience of Employer Doctrine] Employee receives something of value from Employer, like property = Income is FMV Business Travel Airline Miles Not Income (administratively impossible)
Imputed Income – self-services are not income Grow Vegetables to Eat – Not Income Grow Vegetables to Sell – Income
CHAPTER 3: EFFECT OF AN OBLIGATION TO REPAY
1. Loan – Not Income – no accession to wealth because there is an obligation to repay accordingly, repayment is not deductible
Exception: Third Party Repays = Income, unless it’s a gift
5 2. Claim of Right Doctrine – Income – get a check for more than you’re supposed to income when you receive it; deduction if you are required to refund the money that was overpaid to you
Example: Y1 = $25k (Income) but you were overpaid by $5,000 Y2 = Repay $5,000 Deduction of $5k
3. Illegal Income – Income – like claim of right, its income when you get it and a deduction if repaid. Exception is controlled substances. No deduction.
4. Security Deposit (rent) – if applied as rent, it’s income; but if not applied to rent and tenant has a right to demand repayment = obligation to repay = not income
CHAPTER 4: GAINS DERIVED FROM DEALINGS IN PROPERTY
§ 61(a)(3) – Gross income includes “gains derived from dealings in property” liabilities incurred by taxpayer in acquisition of property are included in taxpayer's basis in that property. ex. 100,000 loan for land, still counted as taxpayer's basis since has to be repaid recourse liabilities of a seller, assumed by a purchaser, are included in the seller's amount realized. ex. mortgage on house included in realized amt. economic gain should equal tax gain commissioner argues for lower basis, taxpayer for higher basis basis also called unrecovered cost (adjusted basis)- what you can take out tax free philly park amusement rule- basis for property exchanged is its fair market value basis includes cash given plus debt incurred in acquiring property- crane/k- tax shelter
“Gain” is the Excess of the amount realized over the unrecovered cost (§1001(a) adjusted basis) or other basis for the property sold or exchanged [Reg. § 1.61-6(a)] Want taxpayers to recover their investment tax-free Formula: Amount Realized over Adjusted Basis = Excess [Recovery of Capital Theory] § 1016 (a) Expenditures = Adjustments that increase basis; (b) Exhaustion, Wear & Tear = Depreciation in basis
“Amount Realized” – FMV of property, services received or debt being paid on your behalf [§ 1001(b)]
“Basis” = Cost; “Adjusted Basis” – reflects the impact event occurring subsequent to one’s acquisition of property may have on the amount of one’s investment in the property (i.e. additional investments or losses – adding on a room, or having something destroyed in a storm)
*Dividends = Gross Income because they are Realized Gains however, dividends do not affect the basis – investor is still able to recover is investment basis tax-free
6 A. Tax Cost Basis – get a car with FMV of $5,000 in return for $5,000 of services = $5,000 basis taxpayer turns around and sells the car for $5,500, then he has a gain of $500 Total income from receipt and sale of the car is $5,500, just as though taxpayer received the first $5000 in cash, purchased the care for that amount, then sold it for $5,500
B. Basis of Property Acquired in Taxable Exchanges – Philadelphia Park Amusement – acquirer’s basis is: Price Paid + Debt Incurred to Acquire the Property
CHAPTER 5: GIFTS AND INHERITANCES
A. Overview
§ 102 – Gifts & Inheritances – excludes from gross income of the recipient the value of cash or property received by gift or inheritance, regardless of amount devise- gift in will for land bequest- gift in will for personal property inheritance- if no will
De takes Dr basis if gain. Use FMV if loss.
Intent is Critical – motive of the donor Duberstein says a gift in the statutory sense means “proceeds from a detached and disinterested generosity . . . out of affection, respect, admiration, charity or like impulses” donor must intend that it be a gift (expect nothing in return) Compensation for Services is Not a Gift – Transfers made to compensate another for services rendered or in expectation of services to be rendered are not gifts Intrafamilial Transfers – rebuttably presumed to be gifts – look to facts/circumstances surrounding the transfer if there is an expectation of receiving economic value, the transfer will not be considered a gift, even if it is made from one family member to another
EXCEPTIONS: 1. § 102(b) – the Exclusion does not apply to Income from the Property Received by Gift (e.g. Connie’s mother gives her a rental property While Connie may exclude the value of the property from her gross income, she must include the rental income during her ownership § 102(b)(1) – Stock (not tax) but any income derived from the stock will be taxed – to determine gain or loss look at difference between donor’s basis and what donee sells it for § 102(b)(2) – Life Estate – income it generates is [taxed?]
2. § 102(c)(1) – Exclusion does not apply to amounts (including property) Transferred by an Employer to, or for the benefit of, an employee Can deduct, but not exclude But, no deduction for gifts to individuals over $25 can exclude, but not deduct
Gift and Estate Tax –
Estate Tax- Value of property owned at time of death Taxed at 45%.
Gift Tax – tax on donor to protect estate tax because people were giving things away just before they died to avoid the estate tax
Individual may give $12,000/yr in gifts tax free (Husband & Wife = $24,000/yr). lifetime exclusion for gifts and estates at 2M/ per
7 inc. pension, homes, life insurance, stocks
2010 estate tax will be repealed for one year
B. BASIS of Property Received by Gift, Bequest or Inheritance
1. Gifts of Appreciated Property
§ 1015 – “Transferred or Carryover Basis” – in accepting a gift, recipient takes donor’s basis (e.g. stock), thus appreciation is ultimately taxed to the recipient/donee
Taft v. Bowers – court rejected taxpayer’s argument that she should only be taxed on appreciation that occurred subsequent to her receiving the gift Court reasoned that based on the statute she knew in accepting the gift that it was dripping with tax liabilities
2. Gifts of Depreciated Property – PROHIBITS attempts for someone in a lower tax bracket to give a gift that has depreciated to someone in a higher tax bracket, because deducting the loss will mean more to the person in the higher tax bracket [E.g. Claude has a basis of $200 and took a $100 loss; he is in the 10% tax bracket 10% x $100 = $10 deduction for a loss to Claude VS. Clause give the stock to Mary, who is in the 30% tax bracket, then her deduction is worth $30]
§ 1015(a) – Shifting Loss – shifting of losses is prohibited where depreciated gifts are given, recipient still takes donor’s basis, but the loss will never be realized because the loss disappears upon sale (realization) no one can claim it as a deduction once transferred
SUMMARY: Can give away appreciation, but not depreciation - **Should just sell it, take the loss, and give away the proceeds**
**TRANSFERRING GAIN/LOSS PROBLEM ALWAYS ON EXAM**
3. Stepped Up (or stepped down) Basis
§ 1014 – “Stepped-Up (or down) Basis” – basis of property acquired from a decedent = FMV at the time of decedent’s death (i.e. appreciation from basis not taxed)
Only appreciation that occurs AFTER decedent’s death will be subject to tax
Applies to property transferred by decedent’s will, intestate succession laws, property acquired through joint tenancy or community property
§ 1022(a) – Windfall Profit Tax Act - significantly changes basis rules for property of decedents dying after 2009. The general rule then is that the basis of property acquired from a decedent shall be the lesser of FMV or Decedent’s Basis.
§ 1022 (b), (c) –However, up to $1,300,000 of basis increase is allowed with respect to the decedent’s property, plus up to an additional $3,000,000 of basis increase for property acquired by the surviving spouse
Estate Planning Note: § 1022 will only be active in the year 2010 it will be repealed in 2011
§ 1014(e) – if you give property to a donor who dies within 1 year and you inherit the property back, you basis shall be the adjusted basis of the decedent just before death (Donor takes Donee’s Basis)
8 Example: Son buys stock for $20,000, but today the FMV is $500,000 Father is very ill, so the son gifts the appreciated stock to his dying father Father then puts in his will that the son will inherit that same stock upon the father’s death (loophole – trying to get § 1014(a) to apply) NO, Congress plugged this loophole with § 1014(e)
4. Part-Gift, Part-Sale – sale of property for less than FMV
§ 1.1001-1(e) – Seller’s Gain/Loss – the seller-donor has a gain to the extent that the amount realized exceeds the adjusted basis of the property; no loss is recognized on such transaction
Example: Sally seller’s property has: (1) Adjusted Basis = $5,000; (2) FMV = $10,000; (3) Sold to niece Erin = $2,500 Sally seller has no gain or loss (amount realized is only $2,500 which does not exceed her adjusted basis of $5,000)
§ 1.1015-4 – Recipient’s Gain/Loss – donee’s basis will be the greater of the amount the donee paid for the property OR the adjusted basis of the donor + donee’s basis is limited to the FMV at the time of transfer
Example: Erin’s basis in the lot will be $5,000 the greater of the amount she paid Sally ($2,500) or Sally’s adjusted basis ($5,000)
Liabilities – Property sold at less than FMV, but with liabilities attached Suppose Sally’s lot was subject to $2,500 liability, and Erin, in lieu of paying Sally $2,500 in cash, assumes the $2,500 liability. The same result obtains: the transaction is still part-gift, part-sale the amount realized by Sally, on account of the assumption of the liability, is still $2,500 and neither a gain nor loss is recognized on the transaction and Erin takes a $5,000 basis in the lot just as before (p.97)
CASES – refer to Emmanuel
CHAPTER 6: SALE OF A PRINCIPAL RESIDENCE
§ 1034 – “Bought Up” – enabled taxpayers to avoid recognition of the gain (deduction) on the sale of their home so long as the home was their principal residence at the time of sale + they “bought up,” i.e. purchased a home costing at least as much as the sale price of the old home then they could deduct the gain on the sale
Problem: Older individuals who determine they no longer need the family home or cannot maintain a larger home sell it and purchase a smaller, less expensive home No Deduction under § 1034
Old § 121 – Remedy to § 1034 – enabled older taxpayers to exclude a portion of the gain realized on the sale of their home + they did not have to purchase a new principal residence and, if they did, the gain excluded did not serve to reduce the basis of their new principal residence
Requirements to Get the Exclusion: 1. 55 years of age or older 2. Ownership and Use Requirements – taxpayer had to own and use the property as her principal residence for periods aggregating three years or more during the five year period ending on the date of sale or exchange
Maximum Exclusion: $125,000 on the sale or exchange of property used as principal residence
Limitation: Once-in-a-Lifetime Benefit – once a taxpayer (or his/her spouse – “tainted spouse rule”) has taken advantage of the exclusion, it was never available again 9 Current § 121 (1997 Taxpayer Relief Act repealed § 1034 and dramatically amended old § 121)
1. Ownership and Use Requirements - § 121(a) – (Statutory) – p. 114 a. Maximum Exclusion – $250,000 ($500,000 with respect to certain joint returns) see below b. Aggregated Use Requirement – taxpayer must have owned and used the property as a principal residence “for periods aggregating for two years or more during the five year period” Does Not have to be taxpayers principal residence at the time of sale
Ownership and use requirements may be satisfied during nonconcurrent periods so long as the taxpayer satisfies each of them within the five year period ending on the date of the sale or exchange Examples:
1. Rent/Own – renting and later buying allows § 121 to apply so long as you satisfy the (2) Requirements: that is own for two years out of the five and use as principal residence for two years out of five (use a principal residence while renting, but not while owning is fine)
2. Short Temporary Absences – still counted as periods of use (i.e. going away to school for the summer still counts VS going to live there for a year would not count because it isn’t a short temporary absence) – short temporary absences are counted even if the residence is rented during the time the owner is away
3. Joint Returns – § 121(d)(1) – married couples can reap the benefits of § 121(a) if either spouse meets the ownership and use requirements
4. Death of Spouse – § 121(d)(2) – if an unmarried individual sells or exchanges property subsequent to the death of his or her spouse (i.e. marries later), the individual’s use and ownership periods for purposes of § 121(a) will include the period the deceased spouse owned and used the property
E.g. Martha owned and used a house as her principal residence since July 1, 1987 Marries Bill on July 1, 2001 and they use Martha’s home as their principal residence Martha dies on August 15, 2003 and bill inherits house and continues using it as his principal residence Sells home on June 1, 2004 Even though Bill owned the home himself for less than two years, he still satisfies the ownership requirements of § 121 since Bill’s period ownership includes the period that Martha owned and used the property before her death
5. Transfer of Property Between Spouses (§ 1041) – § 121(d)(3)(A) – where one spouse transfers property to another spouse, the recipient spouses’ ownership period for purposes of § 121(a) will include the ownership period of the transferor
6. Divorce Situations – § 121(d)(3)(B) – if an individual continues to have ownership interest in a residence but is not living in the residence because the individual’s spouse or former spouse is granted use of the residence under a divorce or separation instrument, the individual will nonetheless be deemed to use the property during the period her spouse or former spouse is granted the use of the property
7. Physical/Mental Incapability – § 121(d)(7) – if the individual owns and uses the residence for one year in the five year period, the individual will be treated as using the property for any period during the five year period in which the individual, while owning the property, resides in a facility satisfying certain requirements
2. Amounts Excludable 1. $250,000 – exception where filing a joint return 2. Applies to only one sale or exchange every two years – § 121(b)(3)
10 3. Exception – § 121(c) – if taxpayers file a joint return, the taxpayers may exclude up to $500,000 if certain Requirements of § 121(b)(2) are met: a. One of the spouses must satisfy the ownership requirement b. Both spouses must satisfy the use requirement (even if not married, but married when they file jointly) c. Neither spouse has used the exclusion within the last two years
EXCEPTIONS that allow married couples to claim exclusions up to $500,000 Satisfying the § 121(b)(2) Requirements: 1. Husband and Wife each owned their own home before marriage and sold both homes after they married if the other requirements of § 121 are satisfied, the H and W will each be entitled to exclude up to $250,000 of the gain from their sale (Note: the use of the exclusion by one spouse within the past two years will not prevent the other spouse from claiming the maximum exclusion on the sale of her principal residence)
2. Husband and Wife working in different parts of the country and having separate principal residences would be entitled to exclude up to $250,000 on the sale of each of the residences (each person’s exclusions are treated separately, but jointly report the gain)
In other words: On a joint return, if they are married, each of their exclusions are added together 400k gain on a joint return; she excludes 250k and he excludes 125k = 375, pay tax on 125k Joint return, profit is joint, add up exclusions
3. Jointly Own, but Not Married – each are eligible to exclude up to $250,000assuming all other requirements of § 121 are satisfied + Gain is split equally (e.g. tenants-in-common)
4. Sale or exchange occurs because of Change in Place of Employment, Health or Certain Unforeseen Circumstances Causes taxpayer to fail to meet the ownership and use requirements of § 121(a) OR the once the once-every-two-year rule § 121(c) provides that some or all of the gain may still be excluded Applies to Marriage and Joint Tenancy, i.e. move in with some one but don’t meet § 121 requirements, you are still entitled to a reduced exclusion Change in Co-Owner’s Place of Employment (Tenant in Common) – Reg. § 1.121-3T(c) – sale will be treated as a sale by reason of change in place of employment IF the primary reason for the sale is the change in the location of a “qualified” individual’s employment a “qualified individual” includes the co-owner of a taxpayer’s residence
Proportional Exclusion CALCULATE according to § 121(c):
Supposed to be there for 2yrs, but moved after 6mo. lived there for ¼ of the time, so entitled to ¼ the exclusion
Numerator – period of time you owned it, used it, or since you sold it; Denominator = 24 (2yrs); multiply that by the exclusion $250,000 = PROPORTIONAL EXCLUSION
Unforeseen Circumstances – Reg. § 1.121-3T(e)(2) –
5. Depreciated Deductions – § 121(d)(6) – exclusion shall not apply to the gain realized on a sale of one’s principal residence to the extent that the taxpayer claimed depreciation deductions with respect to that residence at any time after May 6, 1997
11 Example: Sale of Home Office – assume after May 6, 1997 taxpayer properly claimed $15,000 in depreciation deductions with respect to her home office – taxpayer sold the home an recognized a $75,000 gain only $60,000 of that is subject to the exclusion under § 121(a) Thus, the depreciation deduction will reduce the Section 121 exclusion by the amount that was deducted for depreciation
3. Principal Residence
Alternating Residences – Reg. § 1.121-1(a)(2) – where a taxpayer alternates between residences, the residence the taxpayer uses a majority of the time during the year will be considered his principal residence
Factors to Identify a Property as Taxpayer’s Principal Residence (Reg. § 1.121-1(a)(2)) Applied in Guinan v. United States 1. Taxpayers Place of Employment 2. Principal place of abode of Family Members 3. Address listed on tax returns, driver’s license, vehicle registration, voter registration 4. Mailing Address for bills and correspondence 5. Location of taxpayers Banks 6. Location of Religious Organizations and Recreational Clubs that taxpayer is affiliated with
Vacation Homes – tempted to convert a vacation home to a primary residence for two years to get the exclusion Reg. § 1.121-1(b)(2)
Conclusion: § 121 is now a major benefit to homeowners E.g. Married couple sells home for a $900,000 gain, they can take a $500,000 exclusion upon the sale OR hold the property until their deaths where their devisees will reap the benefit of a stepped-up basis under § 1014
CHAPTER 7: SCHOLARSHIPS AND PRIZES
Exclusions – amounts received that are excluded from gross income
A. PRIZES AND AWARDS
§ 74 – Prizes and Awards are gross income (must report FMV) Exception for awards based on “religious, charitable, scientific, educational, artistic, literary or civic achievement,” IF (1) Recipient was selected, and did not enter the contest; and (2) is not required to render substantial future services [§74(b)(1), (2)]
1986 Addition §74(b)(3) “Meritorious Achievement” Award exception applies only if the recipient gives up the prize – to apply the exception recipient must: 1. Meet pre-1986 requirements “religious, charitable . . .” 2. Designate a governmental unit or qualifying charity Note: Designation must be timely [Reg. §§ 1.74-1(c)(1), (d), (e)(2)] 3. Transfer the prize or award to the designee
Summary: To Avoid Gross Income: 1. Reject the prize or award 2. Designate and Transfer
§ 74(c) Employment Achievement Awards – something that is a deduction for the employer and an exclusion for the employee
12 Qualified Plan Award – employee achievement award under a written plan that does not discriminate in favor of highly compensated employees + average annual cost per employee cannot exceed $400 i. If the employer can fully deduct the award, the employee can exclude it from income ii. If the employer cannot fully deduct, the employee must report the amount that exceeds the deduction limit
B. QUALIFIED SHOLARSHIPS [Refer to H/o #23]
§ 117 – 1986 amendments limited exclusions for scholarships to: (1) Qualified scholarships received by Qualified Scholarship – limited to that portion of a scholarship or fellowship used for tuition and course- related expenses, but no actual “tracing” of funds is required – no non-qualifying purposes such as room and board (2) Degree-seeking students at Candidate for a Degree – includes students attending a primary or secondary school, and undergraduate or graduate students pursuing an academic or professional degree at a college or university (3) Qualifying educational institutions
C. EMPLOYER-EMPLOYEE SCHOLARSHIPS – usually seen as “quid pro quo” and is taxable as compensation
EXCEPTIONS: (1) Qualified Tuition Reduction; and (2) Educational Assistance Programs
§ 117(d) Qualified Tuition Reduction [only for educational employees] –
Universities have tuition reduction plans that enable employees, their spouses and dependents to attend classes tuition-free Excludes the tuition for undergraduate courses
§ 127 Educational Assistance Programs
When am employer reimburses an employee for tuition, the reimbursement is additional compensation to the employee unless a Code section excludes it. Section 127 excludes up to $5,250 of tuition reimbursement received from an employer for both undergraduate and graduate courses; and the exclusion applies whether or not the education is related to the employee’s work Note on Graduate Teaching and Research Assistants – lose if they are found to be teaching, rather than studying
§ 132(d) Working Condition Fringe Benefit
Excludes some tuition reimbursements as “working conditions” fringe benefits amounts the employer reimburses the employee that employee could have deducted as a business expense under § 162 if she had paid them herself An employee may deduct the cost of tuition as a business expense provided: (a) education maintains or improves her skills in her employment, and (b) the education does not prepare the employee for a new trade or profession
CASE LAW McCoy v. Commissioner Facts: Δ Company sponsored annual sales contest; Π won a 1957 Lincoln then he drove it from FL to TN and traded it in for $1000 and a Ford station wagon Δ paid $4,452.54 and excluded on their return as additional compensation to employee; Π reported $3600
Law: §74 the inclusion in gross income of amounts received as prizes and awards
13 § 1.74-1(a)(2) – if the award is not made in money but is made in goods or services then the FMV of such goods or services is the amount to be included in income
Π argues: $3600 represents amount of car once he got it and the amount realized upon trade-in Δ argues: Car depreciated when Π drove it home from FL to TN
Held: Neither the price paid by employer nor price received by petitioner is FMV – court guesses in middle
Bingler v. Johnson Held: Amounts received were taxable “compensation” rather than excludable “scholarships” – based on quid pro quo argument that there was an employer-employee relationship, benefits, classes were on topic of work – plus they were required to return to work after completion of leave for classes = future services
Casebook Problems: Problem #3: YES – § 117(c) – no indication that it’s a condition to receiving the scholarship – probably the Full Amount is Excluded, unless there is a quid pro quo (condition) then it is not excludable
Problem #4: Room and Board = Taxable; Value of the scholarship is Excluded – but why are sports scholarships excludable when it appears to be a condition that you play the sport – because once you are awarded a scholarship, you get it whether you play or not, despite the fact that it will not be renewed
Problem #5: NO – excluded, unless she had to accept the job to get the scholarship, then it’s quid pro quo and is therefore taxable
CHAPTER 8: LIFE INSURANCE AND ANNUNITIES
Life Insurance Proceeds are Excluded (not Taxable) Requires an “Insurable Interest” – must have an insurable interest to take out a life insurance policy means financial interest (creditor takes out policy) or personal relationship (family member takes out policy)
§ 101(a)(1) “Mortality Gain” Life insurance proceeds paid “by reason of the death of the insured” are excluded from gross income [Mortality Gain = Insurance Proceeds – Premium Paid] Two Types of Insurance Term Insurance – pay a premium for one year, then have to renew premium will go up because statistically your chances of dying go up each year Whole Life Insurance – pay a fixed amount o Premium if Fixed – doesn’t go up as you get older o Cash Surrender Value – value of policy builds up – chart after 12yrs = 12,335 Interest is never taxed (tax-free buildup) you’re basically making an investment + at any time you can borrow out the cash surrender value tax-free and never have to pay it back – have income to the extent the amount you get exceeds your basis o Those are the tax advantages of whole life insurance b/c you can build it up tax-free, but as the cash surrender value builds up, so does the death penalty o Policies are losing popularity b/c tax laws have changed to make investments less expensive, e.g. stocks are taxed at a max of 15% so investing outside of a tax-sheltered vehicle has become cheaper
§ 262 Mortality Loss – premiums paid in each year, are Not deductible 14 exception: where employer pays the premium on employee’s life insurance as a form of compensation
Notes on § 101 Exclusion: the exclusion applies to proceeds of “life insurance contracts” as defined by §7702 AND it is necessary proceeds be payable “by reason of the death of the insured” *usually not a problem except: By reason of unpaid debt – where the seller of property takes out insurance on the life of the purchaser in an amount equal to the unpaid balance of the purchase price – Not Excludable;
Elaboration: 1. Insured is Not required to be the owner of the policy 2. Insured can also be a beneficiary of insurance on the life of another
Special Rules and Exceptions: (1) “Living or Accelerated Death benefits” [§ 101(g)] – proceeds excluded from income even though they are not by reason of death paid prior to death in recognition of substantial medical and other expenses associated with terminal illness –Excludable
(2) Life Insurance Policy for its Cash Value [§ 72(e)] – proceeds are taxable to the extent they exceed the total consideration paid for the policy § 101 does not apply because its not payable by reason of death
(3) Life Insurance Proceeds in Lump-sum or Installments [§ 101(a)(1)] – applies to both, but the exclusion is Not meant to cover post-death earnings on the proceeds i. Lump Sum § 101 All Excluded ii. Interest payments [§ 101(c)] – interest payments on amounts withheld by the insurer under an agreement to pay interest are taxable iii. Installments – Interest built into installments [§ 101(d)] – principal portion of each installment is tax-free, and the interest portion is taxable iv. Pro-ration [§ 101(d)(1)] – excess of the prorated portions are taxable [Handout #26]
(4) Transfer for Valuable Consideration [§ 101(a)(2)] – the exclusion does not apply to those who receive proceeds by purchasing a life insurance contract for valuable consideration unless an exception applies, the exclusion will be limited to the purchase price of the contract (basis); amounts in excess of the basis must be included in gross income, Exceptions: 1. § 101(a)(2)(A) proceeds will be excluded if you purchase the policy for less than its worth in a part-gift part-sale transaction, then your basis is the greater of what you paid v. what dad paid (e.g. dad sells life insurance policy to son for less than the cash surrender value son can exclude full proceeds)
2. § 101(a)(2)(B) proceeds will be fully excluded if the transferor is an insured or a member of a partnership
3. § 101(g)(2)(A) The transfer of a policy to allow payment for long-term care for a terminally or chronically ill insured is not considered assignment of the death benefit
(5) Group-term Insurance Provided by Employers [§ 79] – Group term life insurance (means employer is buying it and employees are part of the group) - §79 excluded the premiums employer pays on the first $50k of coverage assume salary of $75k, then a portion of the premium attributable to the extra $25k will be excluded?
Casebook Problems (p.139): Problem #1: Mortgage paid off by reason of death – proceeds are excluded – he gets home tax-free (both questions)
15 Problem #4: 101a2B – john bought policy a transfer for valuable consideration will proceeds be fully excluded – YES Part 2: Sold policy to John’s son – only exclude his basis plus any later premiums he paid
ANNUITIES
§ 72 Annuity – is an investment contract between taxpayer and an annuity company You contribute money to this annuity (any amount) – start earning income on day 1 and the earnings are not taxed reinvested money grows a lot faster “Annuity” = series of equal payments – once you start taking it out OR you can take a lump sum Function of Annuity – to increase retirement income because you can’t take it out before age 59 ½ and if you do = 10% penalty tax; vs. 401k where the amount you can contribute is limited
Return on your Investment Basis (what you paid for the annuity) is Tax-free
Profit (anything above your initial investment/basis) is Taxable § 72(b)(1) Exclusion Ratio Mechanism: 40% of each payment is non-taxable; 60% is taxable
Amount Received x Investment in the = Amount Excluded as Annuity Contract ------Expected Return (Mortality Table) p923 for get life expectancy
Mortality Gain – if taxpayer lives longer than expected, monthly payments keep coming w/same amount excluded Mortality Loss § 72(b)(2) – once initial investment (basis) is fully recovered, further payments are fully taxable § 72(b)(3) – if taxpayer dies before recovering initial investment (basis), the unrecovered investment is deductible
Two-Life Joint and Survivor Annuities – payable for the life of the survivor of two persons [Table VI] Reg. §1.72-9 for Tables (p.911)
Refund Feature § 72(c)(2)(A) – presence of a refund feature requires that the “investment in the contract” be decreased decreasing the exclusion ration fraction reduces the amount of each annuity payment excluded from income
Deferred Payment Annuities § 72(e)(2), (3) and (4) – premiums are paid in for a number of years before payment commences during those years premiums are earning investment income free of tax, and the earnings are not taxed until the annuity starting date [seen as abuse of the system] NOW withdrawals (including loans) are taxable to the extent of earnings on the investment Pre-mature Distributions – 10% penalty tax
Corporations § 72(u) – investment earnings are subject to tax on a current basis if the annuity contract is held by a corporation rather than a natural person
Note: § 72 Applies to Commercial and Private Insurers
Brokerage Account v. Annuity Tax Advantages of Annuity = deferring tax until when you take it out Used to be very popular, but less so since the tax structure has changed
Example: $1M in brokerage account v. annuity
16 Annuity – no tax is paid on gain disadvantage is when you take it out it is taxed as ordinary income, i.e. whatever your current tax bracket is Advantage: Can’t outlive your income No more defined benefits pension plans in private companies (where you get a percentage of your income for life) and replaced with 401K, but when you take it out, it’s ordinary income
Brokerage Account – disadvantage is that income earned is taxed currently, and therefore not available for reinvestment; but there are funds that don’t generate much income on a yearly basis, such as index funds, however when you finally sell it, your rate is only 15%
Compare being taxed at 15% v. the “ordinary rate” which currently goes as high as 35% + brokerage allows you to take money out when you want with no penalties
Life Insurance v. Annuity Life Insurance – if you die before receiving investment = too bad; but live longer than expected = continue to exclude Annuities if you die before recovering your investment tax free, then estate gets a deduction for the amount you didn’t receive tax-free; if you live beyond life expectancy and after you’ve recovered full investment, the balance if fully taxed (sucks for old people because it’s not taxed for so long and then taxed when they are really old = they get less)
CHAPTER 9: DISCHARGE OF INDEBTEDNESS
§ 61(a)(12) Discharge of Indebtedness – income from discharge of indebtedness constitutes gross income except as provided in § 108, there is no insolvency exception
Specific Rules Governing Exclusion 1. Insolvency
Exception to § 61(a)(12) § 108 – discharge of indebtedness will not constitute gross income if “the discharge occurs in a Title 11 Bankruptcy case OR if the discharge occurs when the taxpayer is Insolvent
*Note: Discharge of a Debt with Property = Gain
§ 108(d)(3) – Limits the Insolvency Exclusion to the “amount by which the taxpayer is insolvent” “Insolvency” – means excess of liabilities over the FMV of assets (Net Income = Assets – Debts)
Insolvency Exception – discharge indebtedness, then only tax to the extent the person is solvent AFTER the cancellation of debt income
§ 108(b)(2)(E) – certain tax attributes are subject to reduction this section requires reduction in the basis of property
2. Disputed or Contested Debt – if the amount of debt is disputed, the settlement of the amount does NOT constitute a discharge of indebtedness [Preslar] – thus, if a taxpayer disputes the original amount of debt in good faith, a subsequent settlement of that dispute is “treated as the amount of debt available for tax purposes” Taxable Income on Settlements = Difference between Original Amount and Reduced Amount Liquidated Debt – certain agreed upon amount of debt Unliquidated Debt – disputed amount
Zarin – Contested Liability Doctrine –
17 3. § 108(e)(5) Purchase-Money Debt Reduction for Solvent Debtors – taxpayer purchases property, but later refuses to pay the entire balance of the purchase price because of irregularities associated with the sale or because of defects in the property where seller agrees to reduction of purchase price taxpayer’s Basis in Property is correspondingly Reduced [Only applies to Property]
4. § 108(e)(4) Acquisition of Indebtedness by Person Related to Debtor – where a person related to the debtor acquires the indebtedness, the acquisition shall be treated as an acquisition by the debtor Debtor has Discharge of Indebtedness Income (taxable)
5. § 108(e)(2) Discharge of Deductible Debt – forgiveness of a debt does not constitute income if the payment of the debt would have been deductible
Discharge of Indebtedness as Gift, Compensation, Etc.
§ 102(a) Discharge of indebtedness as a Gift may be excluded, but requires intent of gift
Subsequently, Commissioner v. Jacobs holds that gift exclusions are not applicable where a debtor purchased his own obligations at a discount – In light of Jacobs, it is doubtful that any taxpayer will be successful arguing discharge of indebtedness as a gift in the commercial context
Problems: Refer to Class Notes
CHAPTER 10: COMPENSATION FOR INJURY AND SICKNESS
Overview: § 104 and § 105 exclude from gross income certain amounts received on account of personal physical injury and sickness
§ 106(a) excludes from gross income employer-provided coverage under health and accident plans
A. Damages
1. Business or Property Damages – unless there is a specific rule to the contrary a. Damages awarded on account of lost profits are taxable; b. Recovery for property damage is measured against the basis of the property to determine taxpayers realized gain or loss c. Raytheon – antitrust damages are not necessarily taxable; only where they represent compensation for loss of profits Test: “In lieu of what were damages awarded?” Example: A buys Blackacre for $5,000. It appreciates in value to $50,000. B tortiously destroys it by fire. A sues and recovers $50,000 in damages. Although no gain was derived by A from the suit, his prior gain due to the appreciation in value of Blackacre is realized when it is turned into cash by the money damages
2. Damages Received on Account of Personal Physical Injury or Sickness a. § 104(a)(2) excludes from income any damages received, whether by suit or agreement, as a lump-sum or periodic payment, on account of personal physical injuries or sickness (does not apply to business or property damages) – separate physical and non-physical injury U.S. v. Garber – no exclusion for personal injury sustained donating blood plasma, i.e. payments received constituting damages - requires a tort claim against the payor
History: 18 b. Threlkeld – extremely broad reading of § 104(a)(2) excluded damages awarded based on “any invasion of rights” (both physical and non-physical injuries), e.g. 1st Amendment
Supreme Court
c. Burke – [limitations based on remedial damages scheme] damages awarded for sex discrimination were excluded Supreme Court reviewed and held that the test was “whether the injury complained of was a tort-type personal injury” Concluded that sexual discrimination is not tort-like Based on remedies available under Title VII (backpay and injunctive relief) the court held that the amounts received by taxpayer were not “damages received on account of personal injury” within § 104(a)(2)
d. Schleier – awards of backpay and liquidated damages under ADEA claim Court reviewed it and indicated that damages are “on account of” personal injuries for § 104(a)(2) if they bear a close nexus to personal injury, i.e. damages are intended to compensate taxpayer for the personal injury held liquidated damages were intended to punish wrongdoer and backpay was lost wages – neither were compensation for the personal injury
1996 Congressional Amendments
e. Damages excludable on account of “Physical” Injuries or Sickness only No definition of “physical” Look to Letter Ruling and Legislative History Letter Ruling – “direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding are personal physical injuries under § 104(a)(2) Legislative History – suggests Schleier approach
f. Emotional Distress – only medical expenses resulting from emotional distress may be deducted, damages awarded based on emotional distress are included in gross income – the exclusion only applies to damages received from emotional distress attributable to physical injury/sickness Origin of the Claim – if an action has its origin in a physical injury or physical sickness then all damages that flow from it are excludable, e.g. physical injury loss of consortium = excludable Exclusion does not apply to damages received (other than medical expenses) based on employment discrimination claims or defamation claims accompanied by claims of emotional distress
3. Punitive Damages - § 104(a)(2) exclusion does not apply to punitive
4. Allocation of Awards – Π will try to get all or most of their damages allocated under “personal injury” to avoid taxation Unclear as to what extent Π can get away with this (mixed decisions) a. Robinson – Tax Court emphasized that it could make its own determination of the proper allocation of settlement proceeds b. Bagley – court agreed the Service should not be bound by a settlement agreement “screwing them out of a lot of $$$” c. McKay – Tax Court respected an allocation of ¾ to personal injury and ¼ to contract
5. Periodic Payments – excludable, even though the entire amount will include interest income vs. taking a lump sum and putting it into an annuity (exclude lump sum, but report a portion of each years annuity payment as gross income)
6. Alternative Minimum Tax and § 67
Alternative Minimum Tax + Statute Included in Handouts
If you win a lawsuit you will have to pay an attorney’s fee Assume you win a physical personal injury suit for $1M and attorneys fees is 1/3 104(8)(2) says physical personal injury awards are excluded 19 § 212(1) – deduction for the production or collection of income means to the extent you have taxable income you should be able to deduct the expenses
Assume it was $1M for defamation (not a physical tort) $1M is Included in Income and the 400k of attorneys fees are deductible under § 212(1)
Handout 28A
How should it be deducted under § 212 Two possibilities: 1. Deducted from Adjusted Income; OR 2. Itemized Deduction
Go to § 62 – lists all deductions that are Adjustments in Code Section order - § 212 is NOT listed, thus deduction under § 212 are Itemized
Itemized deductions are further classified . . . §212 can only be deducted up to 2% that it exceeds gross income
Itemized deductions are phased out once AGI reaches a certain amount
Alternative Minimum (paying tax on income he didn’t get – paying tax on what he paid the attorneys) – begin with the regular tax computation, then add back several items that were deductible for regular + 2%MIDS Attorney’s fee is NOT deductive for purpose of Alternative Minimum Tax Exemptions
End amount is what he pays final tax on Taxpayer pays the GREATER OF tax figured the regular way and figured the alternative minimum way
AMT was Unfair Congress enacted a section saying: Section 62(a) lists deductions amendment § 62(a)(20) adjustment strictly for attorneys fees described in the bill (discrimination cases – now not deductible as itemized, but only as adjusted) – attorneys fees are no longer taxed to plaintiff, just lawyers b/c they are the ones getting it
**Exemptions are added back in for AMT purposes** Unfair, but Congress didn’t fix it for so long because it generates so much income – still not corrected and controversial today
Attorney’s Fees:
§ 212 – shall be deductible expenses incurred for collection of taxable income – doesn’t tell you how to deduct it
§ 62 – tells you how it’s deductible – lists all of the deductions that are deductible as adjustments - § 212 expenses are not deductible under § 62 with the exception of § 62(20) which says legal fees incurred in discrimination suits are deductible as adjustments
If it’s not deductible as an adjustment, then by default, it’s an Itemized Deduction
§ 67 – after you determine it’s not an adjustment, and is therefore Itemized then if its listed in §`67 it is NOT a 2%
§ 212 attorney’s fees are not listed = 2% miscellaneous itemized deductions
2% miscellaneous itemized deductions are NOT deductible at all
B. Accident and Health Insurance – must consider § 104(a)(3) and § 105 together 20 1. § 104(a)(3) Self-financed Insurance is Excludable – payments received through accident or health insurance policies are excludable from gross income IF the taxpayer finances his own insurance with after- tax dollars a. Employer-financed insurance payments are taxable Go to § 105 b. If the policy is financed by both taxpayer and employer – the taxpayers self-financed portion is excludable
2. § 105 Employer-financed Insurance is Taxable a. § 105(a) – generally, payments from insurance policies financed by the Employer are taxable for taxpayer, spouse and dependents, i.e. included in employee’s gross income (and not excluded under 104(a)(3))
Exceptions:
b. § 105(b) & (c)– medical expense reimbursements and certain payments for permanent bodily injury or disfigurement are excludable – limited to actual medical expenses incurred Example: Sick pay or wage continuation payments are taxable under employer-financed insurance; not taxable under self-financed plan
c. § 105(c) – payments under employer-financed plans are excluded to the extent they compensate for permanent bodily injury or disfigurement of the taxpayer, spouse, or dependents, provided the payments are computed with reference to the nature of the injury and not the period of absence from work
3. § 106(a) – permits employer contributions to accident and health plans to be made tax-free to the employee, but § 105(a) makes payments under such employer-financed plans taxable, unless §§ 105(b) or (c) applies
C. Previously Deducted Medical Expenses – amounts attributable to previously deducted medical expenses are not excluded. §§ 104(a) and 105(b) not going to allow an expenditure to be deducted and then the reimbursement of the expense be excluded because it would = double tax benefit a. Reimbursement for non-deductible medical expenses are Excludable
D. Worker’s Compensation
1. § 104(a)(1) – amounts received under workers’ compensation acts as compensation for personal injuries or sickness are excluded a. Extends to payments under a statute in the nature of WC b. Not extend to retirement, even where retirement is caused by occupational injury or illness c. Not extended to non-occupational injury, even when label of WC is placed upon the payment
E. Disability Pensions
1. § 104(a)(4) – military disability pensions and certain other government disability pensions are excluded a. Limited by § 104(b) to person receiving compensation for combat-related injuries and those who would (on application) receive disability compensation from the Veterans’ Administration b. § 104(a)(5) – exclusion for disability caused by Terrorist Attacks to a U.S. employee engaged in performance of official duties
CHAPTER 11: FRINGE BENEFITS
A. Meals and Lodging - § 119
21 1. § 119 Convenience of Employer Doctrine – meals and lodging are excluded for employee, spouse and dependants if it is: a. On the Business Premises – where the business is ran from is considered the premises b. Condition of Employment – where employee is required to accept lodging to enable him to perform the duties of employment i. Required to be available for duty at all times (nurse/hotel manager Benaglia); and ii. Could not perform the services required unless furnished w/lodging
Van Rosen – the element of gain to the employee is secondary and incidental to the ends of the employer’s business
Caratan – it was enough for taxpayer to establish he was required to be available for duty at all times; not necessary to show that the duties would be impossible to perform without such lodging being available
Kowalski – cash payments (for meals) are not excludable
2. § 132(a)(4) De Minimis Fringe Benefit – some benefits that are not usually excludable (such as cash payments) can be excluded under this section if they are only “occasional,” and not regularly paid (Gotcher)
B. Fringe Benefits and Section 132 – Seven (7) Categories
1. No-Additional Cost Service – where businesses, such as airlines, RR or hotels have excess capacity which will remain unused for lack of paying customers, make this excess capacity available free of charge to employees
Limitations: 1. § 132(b)(1) the service must be on offered for sale to customers in the ordinary course of business (can’t give something to employee in advance of attempted sale)
2. § 132(b)(1) the service must be offered in the line of business of the employer in which the employee is performing services a. Two Separate Lines of Business is not Excluded – owning two different businesses, e.g. airline and hotel and giving free hotel stays to airline worker is not excluded
b. Performance of substantial services directly benefiting more than one line of business is treated as the performance of substantial services in all such lines of businesses [Reg. § 1.132-4(a)(1) (iv)]
3. § 132(b)(2) employer may not incur substantial additional cost (including foregone revenue) a. “Substantial” Additional Cost – if the cost of services is “merely incidental” to the primary services rendered, they are substantial
b. Foregone Revenue – the employee would not have purchased the service unless it were available to the employee at the actual the actual price charged to the employee (e.g. airline employee flies for free and receives extra seats for free foregone revenue thus, employees receiving free flights do not get the no-additional cost exclusion)
c. Employee payment does not serve to transfer an employer-provided service into a “no- additional cost” service
d. Services that do not satisfy the no-additional cost rule may still be excluded as a qualified employee discount
22 4. Nondiscrimination – prohibits discrimination in favor of highly compensated employees (defined in § 414(q) to include officers and owners) – § 132(j)(1) a. If the non-discrimination rule is violated, only members of the highly compensated group, not all employees receiving benefits, will be taxed
b. § 132(i) Reciprocal Agreements –agreements between employers in the same line of business enabling the employers to provide tax-free benefits to one another’s employees Requires: (1) Writing and (2) Employers cannot incur Substantial Additional Costs (including foregone revenue)
c. Charley – taxpayer could not covert his frequent flyer miles to cash while traveling on business with his flights paid by his employer and then exclude it as no additional cost to employer under §132(a)(1) – amounts constituted personal income to taxpayer/employee
2. Qualified Employee Discount – employee discounts are excluded (difference b/w price charged to regular customers and the employee discount)- so the other money is income?
Limitations: “qualified property or services” – contains same “for sale to customers” and “in the line of business” requirements
Exclusion for employee discounts on services is limited to 20% of the price at which the services are being offered by the employer to customers
Exclusion for employee discounts on property is limited to the employer’s gross profit percentage Gross Profit Percentage – excess of the aggregate sales price for the property sold by the employer over the aggregate cost of such property to the employer, divided by the aggregate sales price Total Sales = $1,000,000; Employer’s Cost for merchandise = $600,000 [1,000,000 minus 600,000 = 400,000 which is 40% of 1,000,000] Thus, an employee discount with respect to such merchandise is excluded to the extent it does not exceed 40% of the selling price of the merchandise to non- employee customers
Policy: Benefits to Employer 1. Increases overall sales/profits b/c selling at discount = stimulates sales to a customer group who might not otherwise buy as much of the company’s merchandise 2. Employee Education – using the products they are selling makes employees more effective sales persons, gives them higher morale, and makes them more loyal advocates 3. Advertising – seeing sales persons wear the apparel/accessories may encourage customers to buy thinking it will look at good on them 4. Multiplier Effect – employees being accompanied on shopping trips by others who become customers as a result of the trip
3. Working Condition Fringe Benefits – property and services that are so closely connected to job performance that were the employee, rather than the employer pay for them, the employee would be entitled to deduct their cost as a business expense (e.g. transportation, subscriptions to current literature, tools, office space, supplies, etc.)- excludable to ee, deductible to er
p.216 – look to regs Cash Payments – Not a working condition fringe benefit, UNLESS employee is required to use the payments for expenses incurred in specific or pre-arranged qualified activity
Vehicle Usage (both company and personal)
Consumer Product Testing 23 Outplacement Services
Townsend Industries – company paid for fishing trip that took place after two-day meeting was excluded because (1) nearly all employees felt obligated to go; and (2) for company benefit because it’s a small company and interpersonal interactions build concrete future benefits/loyalty
4. De Minimus Fringe Benefits – § 132(e)(1) – excludable where goods/services to the employee are in value so small that taxing him would be unreasonable
Frequency Matters – can’t be regular
Employer-Employee relationship between provider and recipient Not necessary
Regulations provide Special Rules for Excluding De Minimus Fringe Benefits: (p. 217)
5. Qualified Transportation Fringe
(1) employer-provided transit passes; “transit pass” – (refer to §132f5)
(2) transportation in commuter highway vehicle in connection w/travel between employee’s residence and work; “commuter highway vehicle” – 132f5
(3) qualified parking near work premises; “qualified parking” – 132f
Cash reimbursements for (1)-(3) are Excludable, subject to specified dollar limitations adjusted for inflation (132f2,6)
6. Qualified Moving Expense Reimbursement – amount paid to employee for expenses that would be deductible as moving expenses under § 217 are excludable
7. Qualified Retirement Planning
8. On-Premises Gyms and Other Athletic Facilities –§ 132(l) – excludable where use is limited to employees, their spouses, and dependent children
Requirements: On business premises of employer Operated by employer Used mostly by employees
Note: § 132 expressly does not apply to any fringe provided for in another Code section
Policy Implications of § 132– inequity and economic inefficiency caused by exempting fringe benefits from tax a. Donald C. Lubick at Committee Task Force on Fringe Benefits Hearing i. Employees –Inequality among Employees of Equal and Unequal Income – with equal income should be treated equally, but when fringe benefits are exempted, taxpayers w/equal incomes pay unequal taxes; Fringe benefits exempted from tax is of greater value to high-income taxpayer ii. Employers – Inequality Among Employers – those able to provide fringe benefits have a competitive advantage over those that are not iii. Market – Distortion in demand and labor markets incentive to provide fringe benefits instead of cash
President – Personal Use of Government Aircraft by the President’s Family and Friends (p. 226) Analysis: Is transportation by President’s family and friends subject to federal income tax? – YES 24 (1) Employer-Employee Relationship; and (2) Corporation-Shareholder Relationship
Doctrine of Constructive Receipt – if a taxpayer entertains or benefits his friends by use of his employer’s property, the use is income to the taxpayer Gotcher – taxpayer held to have realized income where supplier’s paid for his wife’s travel expenses on a trip to tour the supplier’s plant because the supplier’s payment relieved him of financial responsibility for the wife’s expense
Held: President’s family and friends need to fly government because of elevated security precautions but for these considerations the family and friends could have traveled on commercial airlines President’s economic benefit is the cost of first class commercial fares for the trips provided by Government aircraft, rather than the charter rates
Future Argument: By nature of the office, President must be available at all times
C. Miscellaneous
1. Tax Exempt Interest – interest on state and local bonds is excluded under § 103(a)
Whether one should invest in a tax-exempt bond look at the tax bracket of the taxpayer and the rate of return on comparable taxable investments (p.229)
Example: Corporate Bond paying 10% taxable interest v. Municipal Bond paying 8% tax-free interest 15% tax bracket, the after-tax return on the corporate bond exceed 8% and is preferable 20% or higher tax bracket, the after-tax return is less than 8% and the municipal bond is a better choice Exclusion is worth more to those in the higher tax bracket
2. Adoption Expenses – § 23 – employer can provide tax-free assistance up to $10,000 per child with respect to an employee’s “qualified adoption expenses” pursuant tot an employer’s written adoption expenses program. This exclusion is phased out for em0ployees with ADI between $150,000 and $190,000
“Qualified Adoption Expenses” – include reasonable expenses directly related to the adoption of an “eligible child” (other than the child of a taxpayers spouse), meaning and individual under 18 or who is physically or mentally incapable of caring for himself
Adoption of a non-U.S. citizen – credit is available upon finalization of adoption
3. Government Welfare – excluded as charitable gifts based on the lack of nexus to compensation
Payments made on non-governmental entities are not considered payments for the general welfare and are not excluded (may still be excluded as gifts)
4. Disaster Relief Payments – § 139 – excludes any amounts received by an individual as a qualified disaster relief payment “Qualified disaster relief” means any amount paid to an individual; (1) to reimburse or pay reasonable necessary personal, family, living or funeral expenses incurred as a result of a qualified disaster; (2) to reimburse or pay reasonable expenses incurred for repair or rehabilitation of a personal residence or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement, or replacement is attributable to a qualified disaster 25 (3) by a Federal, State or local government or agency or instrumentality thereof, in connection nwith a qualified disaster in order to promote the general welfare
“Qualified disaster” means: (1) a disaster resulting from terroristic or military action (defined in §692c2) (2) Presidentially declared disaster (defined in §1033h3) (3) Disaster resulting from any event that the Secretary determines to be of catastrophic nature (4) Disaster that warrants assistance from Federal, State, or local government or instrumentality . . .
5. Education Savings Bonds –§ 135 – excludes interest on “qualified U.S. savings bonds” used to pay higher education expenses of the taxpayer, spouse or dependent – subject to inflation adjusted phase-out based on taxpayers modified AGI
Qualifying Education Expenses include: tuition and required fees at eligible institutions reduced by certain scholarships and benefits received with respect to the student
Limitation: Higher Education Expenses – where redemption proceeds for the year from qualifying bonds exceed the higher education expenses paid during the year – the amount excluded cannot exceed interest income from the bonds redeemed during the year
6. Flexible Spending Arrangement (H/o 26-7)
CHAPTER 37: TAX CONSEQUENCES OF DIVORCE
Assignment of Income 3 Types 1. Alimony – deductible and income 2. Child Support – not deductible; not income 3. Property Settlements – not deductible; not income (W takes H’s basis)
A. Alimony Requirements (§ 71): Income with respect to § 61(a)(8)
1. Cash - § 71(b)(1) – payment must be in cash; payments by property or services are not alimony
2. Payment must be received by “or on behalf of” the spouse (or former spouse)§ 71(b)(1)(A) – may pay recipient spouse directly or pay a third party on behalf of former spouse (e.g. mortgage payments) i.e. husband pays mortgage = alimony = income
3. Payment must be made “under a divorce or written separation instrument” - § 71(b)(2)(A) – requires writing + mutual consent
Payments made under oral agreements do not qualify (Ewell)
Mutual Assent is required (Leventhal) – letters that do not show a meeting of the minds are not a written separation agreement, but letters will work if you show meeting of minds
4. Divorce/Separation Instrument must not designate the cash payment as one that is excludable from the gross income of the recipient and nondeductible to the payor - § 71(b)(1)(B) – the parties can determine which spouse will pay tax on the alimony income generally the payor will want the deduction b/c he is in a higher tax bracket than recipient – if payors tax bracket is lower, parties should specify in the decree that the payment is nondeductible to payor and non-includable to recipient
26 5. Legally Separated, Must not be Members of Same Household at time payment is made - § 71(b)(1)(C) – Not legally separated, payments under a written separation agreement or support decree may constitute alimony even though the parties are members of the same household –
6. No Payment After Recipient Dies - § 71(b)(1)(D) – its support for the recipient spouse; she no longer needs support after she dies – even if agree to transfer property after death in lieu of a support payment while recipient is still alive, it does not qualify as alimony to determine, courts have a two-part inquiry: (1) Look for an unambiguous condition terminating payments (in divorce decree or by operation of law); and (2) where there is no unambiguous condition, courts will independently evaluate the language of the decree to determine whether payments in question satisfy 71b1D
Hoover – where the divorce decree contained no provision for payments to terminate upon death, and where applicable state law did not clearly provide for such termination not alimony
Webb – Look to the agreement
7. Cash payment must not be classified as child support - § 71(c)
B. Child Support Payments – not exclusion or deduction (except § 151) – the payment “fixed” (in the agreement) as child support by the divorce or separation instrument is not alimony
Child support is excluded from income of the custodial spouse - § 71(c)(1) – thus in order to qualify as alimony, the payment must not be a payment for the support of a child of the payor – the “fixed” amount is not alimony
§ 71(c)(2)(A)(B) – reductions relating to certain contingencies involving the child specified in the instrument (dying, attaining age of majority, etc.) OR where the reduction can be clearly associated with a contingency of a kind as specified in part (A), then that reduction amount will count as child support as if in the agreement as such from day 1 – thus not deductible as alimony
Regulation p. 908 [H/o# 37]
Situation 1: if the child turns 18 within 6 months (before or after) a reduction, then the reduction amount is counted as child support from day 1
Situation 2: If reductions are made within 24 months and 1 day (check to be sure) of more than one child turning a certain age (and kids are between age 18 and 24), then the reduction is counted as child support from day 1
Rebuttable Presumptions: Both Situation 1 & 2 are presumptions – both can be rebutted by (1) agreement was slated to end, but then kid turns 18 within 6 months of the end date; or (2) taxpayer can prove that the contingent dates and reductions were coincidental
C. Alimony Recapture- Excess Front-Loading (getting higher payments at the beginning and having them decrease over time) – § 71(f) – cash payments not fixed as child support and which comply with the requirements of alimony constitute alimony, includable in payee’s income and deductible to payor
§ 71(f) said “excess alimony payments” having been included by the payee and deducted by the payor in a prior year, are “recaptured” in the subsequent year tax treatment is REVERSED: excess amount is deductible by the payee and includable by the payor (payor is forced to “give back” the excess deduction (i.e. payor spouse is giving back in a later year the benefit from a prior year)
27 Only allowed in “3rd post-separation year” (§ 71(f)(6)) recapture cannot occur in any other year look at years 1 and 2 to determine if recapture should occur in year 3
For Excess Front-Loading rules to occur there must be a variance among the payments due during the three- year period of more than $15,000 (irrelevant because will have to calculate on exam) in order for the front-end loading rules to apply
Refer to H/o #29
Calculation: Step 1: Calculate the excess alimony payment for the 2nd post separation year Alimony Y2 – (Alimony Y3 + $15,000) = excess payment for 2nd post-sep yr
Step 2: Calculate the excess alimony payment for the 1st post-separation year
(Alimony Y2 – Excess Payment Y2) + Alimony Y3 Alimony Y1 – ------+ $15,000 = 2
= excess payment for the 1st post-separation year
Step 3: Calculate the excess alimony payment: sum of steps 1 and 2 Step 4: Determine the consequences to payor and recipient in 3rd post-separation year: Deduction to recipient in the amount of excess alimony payment Inclusion to payor in the amount of excess alimony payment
§ 71(f) – to determine whether a deduction is also an adjustment (§ 215 – if wife includes it under § 71, then husband can deduct it under § 215 – but 215 doesn’t say how to deduct it look to § 62 and it says alimony is a deduction]
But § 71f1 tells you how to deduct it: (A) & (B) – saying alimony is deductible as an Adjustment
§ 71f5 Exceptions: Recapture – means you’ve deducted it here, and now we’re recapturing the deduction back by making you report it and pay it back in the 3rd year
Exceptions to Recapture: 1. Where payments cease by death or . . . 2. Fluctuating payments not under control of payor (tied to another source of income that he can’t control – usually self owned businesses)
D. Alimony Trusts § 682 – wife doesn’t want to have to chase husband every year for the money have taxpayer to put money in alimony trust so wife is guaranteed money thus alimony rules don’t apply, instead normal trust rules do (he gets no deduction and she gets income) that’s how it would end up anyway since he is giving up the money
E. Dependency Exemption – § 152(e) – the “custodial parent” (having custody of the child for the greater part of the year) is entitle to the dependency exemption where the parents were entitled to the exemption when they were together
One of the § 151(c) general income, age or status tests must be satisfied before the custodial parent is entitled to exemption
28 Non-custodial parent receives the exemption only where the custodial parent has released the claim to the exemption in writing – can be permanent or cover one or more years + a copy must be attached to the non- custodial parent’s tax return for each year the exemption is sought
In absence of agreement – goes to custodial parent b/c it assumes he pays more than half the child support
Step-parent support is treated as parental support
F. Filing Status matters . . .
G. Property Transfers - §1041 – no gain or loss is recognized on a property transfer between spouses or incident to divorce transfer is treated as a gift, with the transferee taking the transferor’s basis
“ Incident to Divorce” means either: (1) One-year rule – transfer of property occurs within one year after the date the marriage is terminated [§ 1041(c)(1)]; or
(2) Cessation of Marriage – transfer is contemplated by the divorce decree and occurs within six months of the dissolution or thereafter if there is a good reason for delay [§ 1041(c)(2)]
Applies to any transfer of property between spouses, not only divorce situations – all nontaxable because Congress believed transfers within a single economic unit should not be taxed – unintrusive
Tax Consequences still apply – since neither gain nor loss is recognized in the transfer, the parties effectively determine who bears the future tax burden in appreciated property and who receives the future tax benefit on property with value less than its basis when they decide how to divvy up things
Example – Spousal Transfer: Maria and Bob are married. Bob sells an office building with a basis of $50,000 to Maria. Maria pays him $100,000, the buildings FMV. Because this is a transfer between spouses, Bob does not recognize the $50,000 gain on the transfer, and has no income as a result of his receipt of $100,000. Moreover, Maria takes a basis of only $50,000 in the office building, even though she paid $100,000 for it.
Example – Divorce Transfer: Consider the facts of Davis, under current law. Mr. Davis transfers stock with a basis of $100 and a FMV of $1,000 to Mrs. Davis in full settlement of their divorce. Under current law, Mr. Davis would not recognize the $900 gain and Mrs. Davis would not include the $1000 FMV of the stock in her gross income, and would instead take the stock with a basis of $100 (the basis prior to transfer).
Old Rule in Davis (still applies to non-martial situations): Mr. Davis transferred 1,000 shares of stock to Mrs. Davis is satisfaction of all marital rights. The transfer was a sale, resulting in a gain to Mrs. Davis of the difference between the FMV of the shares and his basis in them [Transfer = Sale, thus taxable in recognition of gain or loss to transferor]
Limitations: 1. Transfer of services between spouses is taxable [Temp. Reg. § 1.1041-1T(a)]
2. Assignment of income: (1) Revenue Ruling 2002-22 (reversed Davis): Enacted to determine whether during an assignment of income during divorce was governed by assignment of income principles or § 1041 Ruling concluded that § 1041 is applicable and therefore the taxpayer did not have any income (excluded) when the stock options and deferred compensation were transferred but taxpayer’s former spouse would be taxable upon the exercise of the stock options or receipt of the deferred compensation ***Only applies to transfers of property in connection with divorce***
29 3. Inapplicable to nonresident alien transfers
H. Personal Residence § 121 – additions to § 121 transfers that also fall within § 1041 (p.843)
I. Legal Expenses Incurred During Divorce – not deductible (Gilmore)
Gilmore – wife filed for divorce and husband cross-claimed to protect his assets from wife husband won and filed for a refund for expenses spent on legal fees since he was successful and was therefore only defending his assets Held: Expense of resisting claim to assets is a nondeductible as a “personal” or “family” expense Lykes – litigation expenses for business are deductible; personal are not to be a business expense deduction under § 212, the claim must arise in connection with the taxpayer’s profit-seeking activities Here, Gilmore was defending against his wife getting to his business assets, thus the claim stemmed entirely from the marital relationship, not profit-seeking business activities – not deductible
DEDUCTIONS
CHAPTER 12: BUSINESS AND PROFIT SEEKING EXPENSES
- § 162 – taxes net income while allowing a deduction for the expenses incurred to make the income (costs) Gross Income = Profit – Costs
3 Categories of Income-Producing Activity: 1. Trade or Business - § 162 2. Activity for the Production of Income - § 212 deduction 3. Sporadic Activity, entertainment or amusement – later § (only deductible up to the income that was generated)
§ 162(a) Requirements for the Deduction of Costs Associated with Business (2) Cost must be an “expense”; (3) The expense must be “ordinary; (4) It must be “necessary”; (5) It must be “paid or incurred during the taxable year”; and (6) It must be paid or incurred in “carrying on” a “trade or business”
1. Expense must be “Ordinary and Necessary”
a. Ordinary Expense
Welch – “ordinary” requires that a cost be customary or expected in the life of a business life in all its fullness must supply the answer
Jenkins – Conway Twitty was allowed a business deduction for the money he refunded to investors when his restaurant failed to protect his reputation as a musician (business expense as a musician)
Deputy – Type of Business / Kind of Transaction – “ordinary” is normal, usual or customary the transaction that gives rise to it must be a common or frequent occurrence in the type of business involved (so something that is common and ordinary, and therefore deductible in one type of business, may not be in another type of business) Look to Time, Place and Circumstances – look at the kind of transaction from which to obligation arose and determine whether its normalcy in a particular business was crucial and controlling Godel – No Deduction – NY securities company took out life insurance policy on the life of the President to protect itself from loss because stock prices fall when a president dies No 30 deduction allowed under § 162 because even businesses accustomed to buying insurance in connection with their business would use fund to purchase a policy of that nature [Not Normal]
Gilliam – No Deduction – allowed for artist who created a disturbance on a commercial flight (injuring others) while he was traveling on business to give a lecture because: (1) artists and teachers do not generally engage in conduct like that while traveling on business; (2) costs were not incurred as part of transportation; (3) his actions did not seek to further trade or business
Dancer – Deduction – allowed for negligence costs associated with a car accident while traveling on business because: (1) automobile travel was an integral part of this business (2) accidents while traveling in cars are common (inseparable incident of driving a car)
***Distinguish from Gilliam where criminal actions are not “inseparable incidents” of air travel*** b. Is the Expense “Necessary?”
Welch – “necessary” means “appropriate and helpful” + indicated that the business person would be given the benefit of the doubt that this requirement is satisfied most of the time
Palo Alto – Necessary – 9th Circuit overturned the Tax Court holding that maintaining and airplane on standby basis to get Palo Alto personnel back home from their business trips was “appropriate and helpful to the business and was a response it would expect a business in taxpayers’ circumstances to make”
Henry – Not Necessary – taxpayer/accountant flew a flag on his yacht with “1040” on it and claimed it would be used to attract business from the yachting community no because it went to “further ends that were primarily personal” + expenses, when considered in relation to the fees which petitioner attributes to yachting, are inordinate and do not indicate the requisite proximate relationship between his sporting activities and his business
Dobbe – Not Necessary – landscaping business tried to deduct costs for landscaping around personal residence No, “When a corporation makes an expenditure that primarily benefits the corporation’s shareholders and only tangentially benefits the corporation’s business, the amount of the expenditure may be taxed to the shareholder as a constructive dividend and is not deductible under § 162” [Incidental Benefit to the corporation does Not trump primarily personal benefit]
Reasonable Salaries – § 162(a) – only reasonable salaries may be deducted (reasonableness is inherent in “ordinary and necessary”) – to avoid the temptation to disguise dividends as deductible wages
Corporations will pay tax on their income; Dividends are not deductible for corporations (it’s a distribution of their earnings) Dividend is taxed at ordinary income rates + taxed to the shareholders when they receive it = Double Taxation of Corporations
Since dividends are not deductible, that’s why Reasonable Salaries becomes an issue – what for them trying to hide dividends in padded salaries
Tests for Reasonableness (in casebook):
1. Hypothetical Independent Investor Test – whether an inactive, independent investor would be willing to compensate the employee as he was compensated
31 2. Factor Test – position held by employee, hours worked and duties performed, employee’s importance to the success of the business, comparison of past duties and salary to current duties and compensation, comparison of employee’s salary to that of those performing similar services, size/complexity of the company, existence of a potentially exploited relationship, bonus system that distributes all or nearly all pre-tax earnings of the company
3. Indirect Market Test – someone being compensated to make the company do better in the long run more money he generates for the company, the higher salary he can demand
Enactment of § 162(m) – disallowing the deduction of certain employee compensation in excess of $1,000,000
Clothing – where clothing is so business-related that it warrants a deduction, e.g. uniform acquisition of police, firemen, letter carriers, nurses, bus drivers, railway personnel, etc. [Revenue Ruling 70-474] + Equipment related to members of the armed forces [§ 1.262(b)(8)]
Pevsner – (clothing store manager not allowed to deduct amounts paid for stores’ clothing she was required to purchase and wear to work)
Deductibility of Clothing as a Business Expense applies if: (1) the clothing is of a type specifically required as a condition of employment, (2) it is not adaptable to general usage as ordinary clothing, (3) it is not so worn
*General usage is Objective (generally accepted as ordinary street wear), not subjective according to lifestyle If it can be worn outside of work, it’s a personal expenditure, regardless of whether or not you wear it or want to wear it
Public Policy – no deduction where the deduction would frustrate national or state policies
Tank Truck Rentals – disallowed deduction of fines paid for violation of state weight limits Commission v. Sullivan – allowed deduction for rent and wages incurred in operating an illegal bookmaking establishment – didn’t want to make gambling enterprises taxable on gross receipts while other businesses were taxable on net income
Test of Nondeductibility – “Severity and Immediacy” of the frustration resulting from the allowance of the deduction
Is it ordinary and necessary? – fines for violation are considered ordinary and necessary Is it legitimate? – (no deduction for illegal expenses)
§ 162 (c), (g), & (f) – amended adding provisions disallowing deductions for certain fines, penalties, bribes and antitrust payments
§ 162(f) – if paid to the government § 162(g) –
Lobbying Expenses – § 162(e) – disallows any deduction for amounts paid or incurred in connection with: (1) influencing legislation, or (2) any direct communication with a covered executive branch official in an attempt to influence official actions or positions of the official 32 “Influencing Legislation” means – any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of legislation [§ 162 (e)(A)(4)]
Does NOT apply to “legislation of any local council or similar governing body,” e.g. county commissioners, city councils, and tribal councils
***Only lobbying at the federal level are prohibited***
2. “Carry On a Trade or Business”
a. What Constitutes a “Trade or a Business”? – case-by-case basis some guidelines . . .
Higgins – (Investment is Not a trade or business) salaries and other expenses incident to looking after one’s own investments in bonds and stocks were NOT DEDUCTIBLE Trader – is considered to be involved in a trade or business because his activities are directed toward short-term trading w/income being derived from the sale of securities rather than from the dividends and interest which investors typically seek Investor – seek income from their own investments (dividends and interest)
Groetzinger – (gambler got deductions) taxpayer must be involved in activity with continuity and regularity + primary purpose for engaging in the activity must be for income or profit sporadic activity, diversion or an amusement does not qualify
b. “Carrying On” Requirement – expenses incurred while investigating a buying a business/or searching for location or those expenses incurred in preparation for opening once the business has been purchased are not deductible under § 162 because they are not “carry on” business
Frank – No Deduction – trips to investigate possible purchases travel expenses and legal fees no deduction because he was not engaged in any trade or business at the time
Richmond – No Deduction – pre-operating expenses are “capital expenditures,” not costs incurred once the carrying on has begun
3. Application of the “Carrying On” Requirement to Employees – taxpayer may still get the § 162 deduction by being in the trade or business of being an employee (Primuth) Employee can have more than one trade or business
No Deduction – Expenses incurred in an effort to commence a new trade or business are like pre-operating expenses and are treated as capital expenditures, thus no deduction under § 162
Deduction – Expenses incurred by an employee finding work in the same trade or business = “carrying on” are therefore the costs are deductible
A. Scope of the “Carrying On” Requirement:
Primuth – Deduction – secretary-treasurer was able to deduct fee paid to an employment agency because he was carrying on the trade or business of being a “corporate executive” same trade, different corporate employer Compare positions before and after the change of employment to see if they are the same
33 Cremona – Deduction – job counseling incurred to improve his job opportunities in that business were deductible even though taxpayer did not succeed in obtaining new employment (distinguish pre- operating/operating notion from seeking/securing standard)
Vs.
Rockefeller – No Deduction – for expenses incurred while running for VP, even though he had been in the trade or business of being an executive in federal and state governments Tax Court held that it’s not the same as those associated with other positions he had held
Revenue Ruling 75-120: Expenses incurred in seeking new employment in the same trade or business is deductible under § 162 if directly connected with such trade or business as determined by all the objectives, facts and circumstances No Deduction for expenses seeking employment in a new trade or business (there cannot be a lack of continuity between the old and new position or to someone seeking first time employment) Traveling to a destination and then looking for new employment in his present trade or business expenses are deductible only to the extent the trip if primarily for seeking employment, not primarily personal o Expenses while at the destination that are properly allocable to seeking new employment are deductible, even if traveling expenses to and from are not
Unemployment Still in the Trade or Business – standard is 1-year
Furner – Deduction – obtaining master’s in education educational expenses were deductible as carrying on the trade/business of teaching Rule: It is possible for an employee to retain, at least temporarily, his status of carrying on his own trade or business independent of receiving any compensation from a particular employer
4. Section 212 Deductions – allows a deduction for the “ordinary and necessary” expenses of producing or collecting income, maintaining property held for the production of income, or determining, collecting or refunding any tax
E.g. Investor can deduct expenses for secretarial assistance, accountants, etc. even though he would not be deemed to carry on a trade or business
E.g. Tax Preparation = above the line deduction; other expense
5. § 195 and Amortization of Certain Pre-Operational / Start-up Costs - § 195 was introduced because of the controversy between pre-operating and operating expenses
Amendment to § 195(b): Should a taxpayer elect to deduct start-up expenditures he shall be allowed a deduction for the taxable year in which the active trade or business begins in an amount equal to the LESSER OF
(i) the amount of start-up expenditures; OR (ii) $5,000 reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000
Remaining expenditures shall be deducted ratably over the next 15 years Calculate: Remaining Start-up Expenditures ÷ 15 = Amount Deductible Per Year
CHAPTER 13: CAPTIAL EXPENDITURES 34 § 263 Capital Expenditures – denies a deduction for the cost of new buildings or for permanent improvement or betterments increasing the value of property, and for restoration costs for which an allowance is made Thus, if an expenditure constitutes a capital expenditure, the amount expended is capitalized and added to the basis of the asset
Regulations Clarify:
Reg. § 1.263(a) -1(b) – disallowance applies to expenditures that “add to value, or substantially prolong the useful life” of property, OR “adapt property to a new and different use,” but not to “incidental repairs and maintenance”
A. DISTINGUISH: Deductible Expense v. Capital Expenditure: (1) Capital Expenditure – the cost of acquisition of property “having a useful life substantially beyond the taxable year” (2) Deduction – incidental materials and supplies purchased during the year, where no records were kept and where taxable income is clearly reflected [Reg. § 1.162-3] (3) Deduction – for professional expenses for amounts paid for books, furniture, professional instruments and equipment, “the useful life of which is short” [Reg. § 1.162-6]
B. Defining Capital Expenditure in the Case Law
Generally 1. Acquiring Assets – costs incurred in acquiring or disposing of assets are capital expenditures Includes the price of the asset and expenses of acquiring property
What is an Asset?
Regulations examples: Cost of assets such as buildings, machinery and equipment, furniture and fixtures, and “similarly property having a useful life substantially beyond the taxable year” (Tangible or Intangible)
Trickier when businesses expand into new ventures not obvious what parts, if any, are capital E’s
Lincoln Savings & Loan – Separate Asset Test – when a separate asset is created, the amounts expended in doing so are capital expenditures
Exploring a New Venture = CE (researching, investigating and considering acquiring a new venture)
[New Undertakings = Not Deductible; Expansion of Existing Business = Deductible]
2. Future Benefits
Indopco – Future Benefits Test – Unilever sought to acquire National Starch (later renamed Indopco) in a friendly takeover. National incurred a variety of expenses in connection with the transactions, including $2.2 million in investment banker’s fees and $500,000 in legal fees Were the costs associated with the acquisition capital expenditures or deductible? Capital Expenditures, because the creation of a separate asset is a sufficient, but not necessary, element to test whether certain expenditures are capital expenditures
[R]If an expenditure creates a more than insignificant future benefit (continuing + long-term) to the taxpayer, the expenditure is a capital asset, even if no separate asset is created Here, benefits motivating the acquisition were to last for many years = significant future benefit = CE
Selected Categories of Capital Expenditures
35 1. Cost of Acquisition and Costs Incurred in Perfecting Title
Acquisition Costs are Capital Expenditures – when taxpayer purchases Tangible Property (building, machine or vehicle) or Intangible Property (a copyright or patent or interest in a corporation or a partnership) Continuing + Long-term Benefit that must be capitalized Woodward [Reg. § 1.263(a)-2(c), 1.212-1(k)] – costs incurred in defending or perfecting title = CE appraisal and litigation costs incurred in determining the price of stock taxpayers were required to purchase from dissenting shareholders = CE + Costs of Disposing of an asset = CE [Reg. § 1.263(a)-2(e)] – on the disposition of an asset, the gain is reduced or the loss is increased by treating the disposition costs as a Reduction in the amount realized
Retired/Discarded Assets – [Revenue Ruling 2000-7] = Deduction
Stegar – retiring lawyer purchased nonpracticing malpractice insurance to cover him for any malpractice he may have committed while in the trade that could resurface during his retirement = Deductible [Must be purchased in the year the business ceased]
Georator – legal fees resulting from efforts to cancel a trademark = CE; Medco Products – legal fees incurred in trademark infringement action = CE
Idaho Power – payments for the acquisition of an asset = CE (Encyclopedia cannot deduct expenses it pays on company to produce a manuscript that Encyclopedia plans to sell for profit; similarly, if you hire a carpenter to build a tree house you plan to rent, the cost of acquiring the rental property are CE) incorporated by Congress:
§ 263A – requires capitalization of direct and indirect costs – including certain interest costs – incurred by taxpayers who manufacture, construct, or produce real or tangible personal property, or who acquire or hold inventory property for resale [Regulations followed]
2. Repair or Improvement – [Reg. § 1.162-4 and § 1.263(a)-1(b)] provide that expenditures for repairs or maintenance, which do not materially add to value or appreciably prolong useful life, are Deductible; replacements or improvements, on the contrary, are Not.
Note: Despite the fact that amounts paid or incurred for incidental repairs may have future benefit, INDOPCO “does not affect the treatment of those costs as business expenses which are generally deductible under § 162 of the Code”
Series of Repairs that Improvement (Wehrli):
a. One-Year Rule of Thumb – if the expenditures bring about the acquisition of an asset having a period of useful life in excess of one year OR if it secures a like advantage to the taxpayer which has a life of more than one year = CE (guidepost, not absolute rule)
b. General Plan of Rehabilitation – when a repair is made as part of an overall plan of rehabilitation = CE (look to see whether the plan exists and whether the repair was actually a part of it)
Cleaning/Treating Groundwater (Environmental) :
a. Revenue Ruling 94-38 – costs of excavating soil, transporting it and backfilling are Deductible because that are classified as “restoration,” but the building of treatment facilities are CE
b. § 198 – environmental clean-up costs paid or incurred, prior to 2004, to control hazardous substances at a “qualified contamination site,” and which would otherwise have to be capitalized are Deductible 36 Employee Training
Revenue Ruling 96-62 – training costs are Deductible, despite some future benefits
Examples include: cost of trainers, updating manuals, training to operate equipment, training new employees of an ongoing business **Only those costs incurred while carrying on the business; does Not apply to start-up costs**
3. Intangible Assets [Reg. § 1.263(a)-4(b)(1)] – requires the capitalization of amounts paid to acquire or create an intangible, to “facilitate” the acquisition or creation of an intangible, or to create or enhance a separate and distinct asset + {Refer to H/o #52A}
“Acquired Intangibles” – ownership interests in corporations, partnerships or other entities; debt instruments; options to provide or acquire property; leases; patents or copyrights; or franchises or trademarks [Reg. § 1.263(a)-4(c)(1)]
“Created Intangibles” – financial interests (which in turn include ownership interests, debt instruments; and options to provide or acquire property); prepaid expenses; certain membership fees; amounts paid to create or terminate certain contracts for property; amounts paid to defend title to intangible property [Reg. § 1.263(a)- 4(d)]
Boylston Market Ass’n – prepaid expenses include advanced rentals, payment of bonuses for cancellation or acquisition of leases, commissions for negotiating leases are CE because they are all payments that are amortized over the life of the lease + same as Prepaid Insurance at issue here
“Facilitate the Acquisition or Creation of Intangibles” – includes amounts paid to facilitate, investigate or otherwise pursue transactions or to facilitate the acquisition of a trade or business or to change the business’ capital structure –
Does Not Include: employee compensation, overhead, de minimis costs, or (12-month rule) amounts paid for a right or benefit that does not extend either (1) 12 months from the first realizing the right or benefit, or (2) the end of the tax year following the year payment
4. Expansion Costs – Deductible
Briarcliff – taxpayer’s cost in establishing a “franchise” division = Deductible expenditures for the protection of an income from loss or diminution
Colorado – costs incurred by bank in creating credit card services for customers = Deductible bank had no property interest in the credit card procedures
Revenue Ruling 2000-4 [effect of INDOPCO, future benefit] – Deductible – reaffirmed Briarcliff stating that the mere ability to sell in new markets and to new customers, without more, does not result in significant future benefits
5. Advertising Expenses [after INDOPCO, future benefits] – Deductible – Revenue Ruling 92-80
Only capitalized in unusual circumstances where advertising is directed at obtaining future benefits beyond those traditionally associated with advertising
Other Examples Purchase Price of Land = Capital Expenditure
37 Commission paid on the purchase of corporate shares = capital expenditure (and is added to the price of shares in determining their basis) Legal expenses in perfecting or defending title to real property = capital expenditure (added to basis of the property) Depreciation and other expenses associated with equipment used to build an asset = capital expenditure
CHAPTER 14: DEPRECIATION
Depreciation Deduction – §167 – is a reasonable allowance for the exhaustion, wear and tear (1) of property used in the trade or business or for investment, or (2) of property held for the production of income
***REFER TO HANDOUTS***
CHAPTER 15: LOSSES AND BAD DEBTS – deductions allowed for losses and bad debts
LOSSES – § 165 – authorizes a deduction for any uncompensated loss during the year, but the loss deduction is limited for individuals to trade or business losses, losses in profit-seeking transactions, and casualty or theft losses
1. Trade or Business Losses [§ 165(c)(1) and (c)(2)] – losses must be incurred in a business (above the line) or profit-seeking transaction (below the line) if they are to be deductible
“Trade or Business” requirement set out in § 162 – same activities qualify as such here
“Profit-Seeking Transactions” – includes stock investor, but not homeowner selling residence however, Personal-Use Property may be converted into income-producing property to qualify as a 162(c) (2) deduction, e.g. offer to rent, or sale where property was held for the production of income
Cowels – No Deduction where personal was offered to rent, but never rented, prior to sale
Newcombe – No §167 and §212 Deduction where residence was offered for sale, not rent [R] To get the deduction, taxpayer must show that he was seeking to realize “Postconversion Appreciation” – conversely, where the profit sought by the taxpayer represents only the appreciation that took place during the period when the taxpayer occupied the property, the property will not be deemed to have been “held for the production of income” Taxpayers Primary Purpose will be controlling (unlikely profit-motive will be considered dominant where taxpayer is making personal use of residential property)
Gevirtz – No Deduction – Abandoned Original Profit Motive – taxpayer bought land intending to build an apt complex, changed her mind and built a residence that could be converted into apt, but lived there for several years; after unsuccessfully renting or selling she claimed a loss deduction
Multi-Use (Both Personal and Profit-Seeking) Allocation of loss between the (nondeductible) personal used and (deductible) business for profit-seeking use is allowable
“LESSER OF” – basis is limited, for loss purposes, to the lesser of value or basis at the time of conversion adjusted for items, e.g. depreciation, for the period subsequent to the conversion of property to income producing purposes – Personal loss remained nondeductible
Computing Depreciation in terms of Loss Deductions 38 Personal-Use Property converted to Income Producing – requires that taxpayer’s basis for computing loss on that property, as determined under the “lesser of” rule, be adjusted for items such as depreciation for the period following the conversion [Reg. § 1.165-9(a)(2)]
Business Property converted to Personal Use – FMV on the date of conversion, if less than the adjusted basis of the property at that time, is the basis for computing depreciation [Reg. § 1.167(g)-1]
2. When is a Loss Sustained? – loss must be evidenced by closed and completed transactions, fixed by identifiable events (e.g. sale or exchange of property usually “fixes” the loss)
Mere decline in value is not a loss sustained, just as mere appreciation does not constitute gross income – must be fixed/recognized
Securities – § 165(g)(2) – are a loss when they become Worthless (extensive shrinkage is not enough) regulations 3. Amount of Deduction - § 165(b) – loss deduction is limited to the adjusted basis of the property in question
Insurance money received deduction is reduced. § 165(a) Loss in Year 1; Insurance money received in Year 2 – regulations note that the loss is not treated as sustained until reimbursement is determined
BAD DEBTS – § 166 – allows a deduction for debts that become worthless during the taxable year in the amount of the debt’s adjusted basis
Note: § 166 does not apply to debt evidence by a “security” § 165 governs
Bona Fide Debt Requirement – must be a debtor-creditor relationship based on a valid, enforceable obligation to pay a fixed or determinable sum of money Gifts are not debt family transactions are highly scrutinized – presumed gift No Deduction Forgiveness or Cancellation of a debt = Gift = No Deduction
Worthlessness – 7 year statute of limitations for refund claims so, if you mistakenly determined the year of worthlessness, there is usually time to file a refund claim for the proper year
Guarantees – losses arising from loan guarantees are classified as business or nonbusiness debts based on their connection with the taxpayer’s trade or business
2 Types of Bad Debts:
1. Business Debts – § 166(a)(1) – the business motive must be dominant in order the debt to be characterized as a business debt Deductible as Ordinary Losses in the year they become wholly worthless
Partially Worthless Business Debts – § 166(a)(2) – deductible up to the amount charged off within the year
2. Non-Business Debts – § 166(d)(2) – a debt other than one created or acquired in connection with the taxpayer's business is deductible only upon becoming wholly worthless as Short-Term Capital Losses (not ordinary losses), e.g. unrepaid loan to a friend or relative Capital losses are disadvantageous b/c under § 1211, the deduction of capital losses is limited to capital gain plus $3k 39 Buchanan – No Deduction if even a modest fraction of the [nonbusiness] debt can be recovered because then the debt is not wholly worthless no bifurcating debt into recoverable and nonrecoverable portions
Shareholder Loans Higgins – ownership of stock is not a trade or business thus, loans made to corporations by stockholders are usually nonbusiness debts because they are not connected to trade or business
Whipple – NonBusiness Debt where shareholder-employee had unrepaid advances to a closely held corporation
Employee Loans Dominant Motive is Key – if the dominant motivation for the loan is to protect the employment relationship Business Debt
CHAPTER 16: TRAVEL EXPENSES
Only expenses which are predominantly business in nature are deductible when they are ordinary/necessary + Substantiation
A. Commuting Costs - § 162 – Not Deductible – where to live is a personal choice and if you chose to do so, you could live closer to work and avoid costs associated with your daily commute
§ 162(a)(2) –Travel Expense Must Satisfy (3) Elements: (Flowers) 1. Reasonable and Necessary 2. Incurred Away from Home 3. Incurred in Pursuit of Business – must be a direct connection between the expenditure and the carrying on of the taxpayer or his employer
Domestic Travel – ask is it primarily business or primarily personal Out of Area Travel – same question, then prorate business (6 out of 10 days are business days = 60% is deductible and 50% of meals and lodging on business days only)
“Reasonable and Necessary/In Pursuit of Business”
Flowers – No Deduction – taxpayer lived in Jackson, MS and his principal place of business (RR) was in Mobile, AL Expenses were not incurred in pursuit of the business since Jackson was his regular home + added cost was unnecessary and inappropriate to the development of the RR’s business (he chose to live in Jackson, otherwise his work was in Mobile – the RR gained nothing from him living in Jackson)
RULE: The exigencies of business rather than the personal conveniences and necessities of the traveler must be the motivating factors
Sanders – No Deduction – for commuting expenses for those who worked on an Air Force Base and lived in the nearest surrounding community that civilians could live (civilians banned from living in the 10 mile radius surrounding the base) Reasoning: No difference between Petitioner’s and those who couldn’t find suitable housing closer to their urban employment and must make the daily commute to work
Other Commuting Deductions: 40 1. Working in 2 Different Locations on the Same Day for the Same Employer – Deduction for the cost of traveling from one work location to the other But if he goes directly home from the second location (Nondeductible) where those expenses do not exceed the transportation expenses from his headquartered office to his home
2. Working in 2 Different Locations within the Same City on the Same Day for 2 Separate Employers – No Deduction for going from first to second place of employment (not a duty for either job or carrying on business for either employer) Deduction since local transportation expenses in getting from one place to another constitute ordinary and necessary expenses incurred in carrying on his combined trade or business and in discharging his duties during the same day
3. Performing Work-Related Tasks while Traveling from Home to Work – Deduction Maintenance and Operating Costs where you are “on duty” during the travel time
Pollei – police officers considered “on duty” when they drove their personal vehicles to and from police headquarters (PD installed equipment in private vehicles so they could be used as unmarked vehicles + Officers were required to notify dispatchers upon leaving and arriving home + respond to calls = public service/safety component)
No Deduction for making cell phone calls or using dictaphone because most employees perform these tasks voluntarily or for their convenience
Revenue Ruling 99-7 – in general, daily transportation expenses between taxpayer’s residence and work location are nondeductible
Exceptions 1. Transportation costs going between residence and temporary work location outside of the metropolitan area where he normally lives and works (temp location within = no deduction) 2. Has one or more work locations away from his residence, he can deduct expenses going between residence and a temporary work location in the same trade or business 3. Deduct expenses going from residence another work location in the same trade or business where residence is the principal place of business
B. Other Transportation Expenses Fly to take a deposition or argue a case Deduction – Ordinary and Necessary/Solely Business- related Taxi/Drive to see a client during the workday Deduction Principal Place of Business is home Deduction for traveling from home to meet clients Travel on Business, but stay extra days to visit Primary Purpose – Business (deduct expenses that are business related) – Personal (separate; deduct only business expenses) Luxury Water Travel – § 274(m)(1) – take a cruise ship Limited Deduction, since meals and entertainment may be included Travel as a Form of Education – § 274(m)(2) – Not Deductible
C. Expenses for Meals and Lodging while Traveling - § 162(a)(2) – meal and lodging expenses to be deducted when taxpayer is “away from home” – limited to 50% by § 274
(1) Requirement to Deduct for any (lodging, meals, away from home)
Overnight Rule – where employees have been authorized to stop performing their regular duties to get substantial sleep or rest prior to returning to their home terminals they may deduct cost of meals and lodging
41 Correll – absence need not be an entire 24-hour period, but it must be of such duration that the taxpayer cannot reasonably be expected to complete the round trip without stopping to sleep/rest
No Deduction for Stopping to eat (but not to obtain substantial sleep or rest) on trips completed within one day
“Lodging” – Deduction where a taxpayer on a business trip incurs duplicate expenses in maintaining an apartment or home at his principal place of work and incurring additional expense in securing lodging in some other city while on business
Taxpayer Works in More than One Place, but Doesn’t Incur Duplicate Lodging Expenses – No Deduction – Glazer – where employee worked six months in Albany, vacated his apartment and moved to NYC for the next six months
“Meals” – meals are deductible under § 162(a) when they are an ordinary and necessary business expense (provided they are substantiated as required by § 274) – eating alone, not with client in a personal expenditure No Deduction getting lunch at work; Deduction for lunches while out of town if there is an overnight stay (day trip, then no deduction for lunch)
“Away from Home” – Home – principal place of business (§ 162(a)(2)) – Not where personal residence is located OR where a person spends most of his working time
More than one employer OR Works in more than one location – Principal Place of Business is a Factual Determination – Robertson – objective test 1. amount of time spent in a location + 2. amount of business activity generated + 3. amount of taxpayer’s income derived from a location
Exception to “Away from Home”
Henderson –No Deduction – traveling jewelry had no “home” to be “away from home”
Temporary Jobs – Deduction – considered in “travel status” and travel expenses paid or incurred in connection with the temporary assignment away from home are deductible One-Year Presumption – assignments away from home of one year or less are considered temporary o Exception where Employment expected to last less than one year turns into more e.g. expect it to last 8 months, then asked to stay for 7 more = 8 months treated as temporary and 7 months treated as indefinite
Seasonal Employment – temporary, unless employee regularly returns year after year, then permanent Major Post of Duty v. Minor Post of Duty o Two Different Seasonal Jobs – temporary if the taxpayers home does not shift with the seasonal jobs (if it changes, then it’s considered abandoning one permanent job for another permanent job)
Andrews – Deduction – taxpayer engaged in a seasonal business in Boston, and bred/raced horses in Florida during the off-season – owned homes in both places and worked approximately 6 months in both locations – wanted to deduct travel expenses (including meals and lodging) for the FL residence Factual Determination which home was his “tax home” Taxpayer is expected to reasonably locate his home, for tax purposes, at his ‘major post of duty’ so as to minimize the amount of business travel away from home 42 D. Travel Expenses of Spouse - § 274(m)(3) – where a spouse or dependant accompanies taxpayer on a business trip, a taxpayer may not deduct such expenses unless: 1. Bona Fide Employee – the spouse, dependant or other individual accompanying the taxpayer is a bona fide employee of the taxpayer; 2. Bona Fide Business Purposes – the travel of the spouse, dependant or other individual is for a bona fide business purposes; 3. Expense is otherwise deductible – the spouse, dependant or other individual could otherwise deduct the expense
Employer-paid expenses for spousal travel may be deducted by the employer as compensation to the employee [§ 274(e)(2)]
If not deducted here it is presumably a fringe benefit § 132
E. Reimbursed Employee Expenses - § 162 – employee may claim a deduction for ordinary and necessary business expenses Above-the-Line – only if they are reimbursed expenses satisfying § 62(c) Below-the-Line – unreimbursed employee expenses OR reimbursed expenses not satisfying § 62(c) 2% MIDS rule of § 67, and useful only for taxpayers who itemize rather than take the standard deduction [Deductible Employee Expenses are always 2% MIDS]
Accountable Plans (§ 62c - qualified reimbursement arrangements) – amounts paid to employees under theses plans are Excluded from Gross Income [Non-accountable plans are included in gross income]
Requirements: 1. Business Connection – reimbursement arrangement must provide reimbursements, advances or allowances only for deductible business expenses 2. Expense must be Properly Substantiated (information to substantiate amount, time, place and business purpose) – but per diem or mileage expenses are satisfactory without such info 3. Return Excess Amount of the Substantiated Expenses (failure to return = non-accountable expense = included in gross income)
G. Business-Related Meals - § 162(a) – with client – Deductible as ordinary and necessary business expenses § 274 imposes stiff limitations taxpayer must be present + limited to 50% of its cost (more in Ch. 17)
H. Limitations on Foreign Travel – § 274(h) – subject to same standards as domestic travel Must be primarily related to business
Foreign Travel for Conventions – § 274(h)(1) – factors to see whether the convention is reasonable – No Deduction unless taxpayer establishes the meeting is directly connected to his trade or business No Deduction for convention on cruise ships with ports of call outside the US $2,000/yr limit for conventions held on cruise ships that meet the §274(h)(2) requirements Definition of North America § 274(h)(3)(A)
I. Relationship to Section 212 – allows Deductions for travel expenses and meal expenses incurred in an income-producing activity but do not rise to the level of a trade or business No Deduction for conventions, seminars or similar meetings Deduction for property held for the production of income (e.g. rental property) as 2% MIDS (except rents and royalties = adjustments)
HANDOUT # 70
43 CHAPTER 17: ENTERTAINMENT AND BUSINESS MEALS
*First assume it’s deductible as an ordinary, necessary business expense under § 162 or § 212 then look for limits
§ 274 – LIMITATION on 162 Deductions – 50% Deduction (meals and entertainment, not lodging) – Unless an employee pays out of his own pocket and is reimbursed by his employer, he gets 100% and the employer is subject to the 50%
“Entertainment” – § 274(a) – amusement or recreation – No Deduction Unless the item was directly related to or associated with a substantial or bona fide business
“Directly Related to or Associated With” – means the business discussion took place during the entertainment or directly preceding or directly following the event with a clear business purpose for the expenditure, but an intent to maintain business goodwill or obtain new business satisfies this requirement Client to a Sporting Event – not the event, but it’s deductible if there is a meal where a discussion takes place immediately before or immediately after then the event too is deductible Reasonably anticipate some income or specific business from the expense – no goodwill outings
Does Not Require that more time be spent on business than entertainment or that business and entertainment occur on the same day Business Meals – § 274(k) – with client (Alone = ONLY deductible when Away from Home)
Deduction if not lavish or extravagant If a $150 meal is extravagant to the extent of $50 50% deduction off the $100 = $50D (Not used often by courts)
Taxes and tips are included as part of the cost and are subject to the 50% deduction
§ 119 excludes from income meals furnished for the convenience of the employer, but only if they are on the employer’s premises
§ 132 excludes occasional supper money from income
To what extent is the cost of taxpayer’s own meal deductible? – cannot deduct more than he would normally spend on himself (R.R. 63-144) (Moss) – but is mostly overruled where client requests an extravagant meal “can’t eat a PB&J while he has Caviar” Deduct full cost of your meal Meals involving only co-workers, partners are highly questionable o Not too often is usually okay o Just because lunch is the most convenient time to get together and discuss firm business does Not make it a necessary business expense – matters if they are made to eat lunch somewhere more or less expensive than normal, but if they choose it’s usually not deductible o Show evidence that the firm’s conference room was otherwise occupied and they had to meet for lunch – deductible argument
Case Law
Walliser Case - P went on a trip that was for business, but including a tour of various cities and he said that he did not enjoy the trip?(1) Ask whether they were ordinary and necessary business expenses under 162? YES (2) Does § 274 (an activity that is entertainment, amusement, or recreation) apply? – court said that this does not apply at all b/c this was business travel. Court disagreed. Section 274 did apply, b/c this type of travel was entertainment TEST: "Directly-Related To" Test - travel must be directly related to the active conduct of the trade or business. This standard prohibits deductions aimed merely at promoting 44 goodwill. TEST(2): "Associated With" the active conduct of the trade or business and was directly preceded or followed by a substantial and bona fide business discussion. HELD - that this trip was totally not deductible b/c it was deemed entertainment.
Churchill Downs – 50% deduction because part of it was for entertainment expenses that had nothing to do with the business of racing (entertaining customers)
Are casino expenses on high rollers deductible? –Yes because it’s in connection with their business to get the high rollers in (distinguish between entertainment on and off premises) – off premises is only 50% deductible; On premises is a deductible business expense
Entertainment Facilities – § 274(a)(1)(B) – no deduction (e.g. hunting lodges, swimming pools, airplanes and vacation homes; entire facilities, not parts like a skybox to a stadium)
Exception: Where facility is used “primarily” for business purposes (more than 50% of business use) – never a deduction for club dues, regardless of primary use
Entertainment expenses not denied by their association with the facility – go hunting and lodge is included, deductible vs. employer owned a hunting lodge that he used to entertain, no deduction for lease payments
Substantiation Requirements – § 274(d) – taxpayer must substantiate either by “adequate records” OR “by sufficient evidence corroborating his own statements” the following: 1. Amount of the Expense 2. Time and Place it was incurred 3. Business Purpose for the expense 4. Business Relationship to the taxpayer of the persons entertained
If substantiation requirements are not met, the deduction is disallowed even if it is otherwise okay
“Adequate Records” – maintaining an account book, diary or similar records with entries made at or near the time of the expense, together with documentary evidence (bills or receipts) in support of the entries Documentary evidence not required for expense less than $75 Per Diem or Mileage allowances do not have to be substantiated
CHAPTER 18: EDUCATION EXPENSES (Handout 71-73)
Eligibility of certain Educational Costs for Deduction as Business Expenses
§ 162 3 Types of Educational Expenses 1. Purely Personal – Nondeductible – taking gourmet cooking class 2. Business-Related – Deductible – restaurant owner takes cooking class to maintain skills 3. Business-Related/Capital in Nature – Nondeductible – taking classes b/c want to change careers
Requirements: An individual may deduct educational expenses that either (1) Maintain or Improve skills required in his employment, trade or business; OR (2) Meet the express requirements of his employer, or applicable law, necessary to retain his established employment relationship, status or rate of compensation (Reg. § 1.162-5(a))
An Expense is Nondeductible under § 162 if it either: (1) Meets the minimum educational requirements for qualification in the taxpayer’s employment or trade or business; OR (2) Qualifies the taxpayer for a new trade or business
45 Thus, taxpayer must avoid the latter two tests while at the same time satisfying one of the two former tests
Skill Maintenance Test – includes refresher courses, courses dealing with current developments, academic or vocational courses + must be germane to the taxpayers job
Taxpayer must be established in a trade or business before expenses for the job are deductible
Factors Include: 1. Period of Time of Employment – short-term looks like hiatus 2. Abandon Trade or Business upon Return to School – if yes, probably no D; but suspension of employment for school for a year or less is considered temporary (2 years temp in business) – basically a facts and circumstances thing
Employer Requirement Test – expenses that meet employer’s express requirements or applicable law imposed as a condition to retention of his established employment relationship, status or rate of compensation
Requirements must be imposed for a bona fide business purpose, e.g. continuing education requirements
Minimal Educational Requirements – no deduction for educational expenses required to meet the minimum educational requirements to qualify for employment, trade or business
Expenses to satisfy subsequent change in those requirements = Deductible
No Deduction for educational expenses incurred as part of a program of study which will lead to qualifying him in a new trade or business (If the education qualifies you in a new trade or business at all, then No Deduction, even if it also improves current skills) o Warren – minister took classes (mostly geared toward ministry) and earned a bachelor’s degree bachelor’s degree qualifies him for a new trade or business o Law Degree New Trade or Business, even if you plan to continue in nonlegal
Change of Duties – Deduction – same job, different duties
Examples: Dentistry, Psychologist Psychiatrist; lawyer tax lawyer Not: Practicing law in a different state; Accountant CPA = New Trade/Business
Questions to Ask: 1. Did he work long enough to be considered in the trade or profession (1 yr)? 2. Did he abandon the trade or profession? 3. New T or P vs. Change of Duties
TRAVEL – § 274(m)(2) – ND for travel as a form of education D to obtain education Look at Facts and Circumstances to determine the “Primary Purpose” of the trip Can separate personal from educational (D for educational)
TAX INCENTIVES FOR EDUCATION – CREDITS
3 deductions that depend on the amount of AGI – each of these D’s are Adjustments §221 – Interest §222 – Education §429 – Passive Losses
Each Section defines what AGI is for purposes of the other sections – Handouts Later 46 §221b2C – determine AGI for interest purposes before you determine §222
§ 222b2C – determine AGI after application of § 221 1. Hope Scholarship Credit – § 25A(b) – credit up to $1500 per student for a maximum of 2 years for qualified tuition and related expenses for higher education (100% on the first $1000 of qualifying expenses and 50% on the next $1000) – for taxpayer, spouse, or dependents
Limitations 1. Eligible Student – enrolled at least half-time during the first 2 years of postsecondary education + in a program leading to a degree, certificate, other recognized credential 2. Phased Out for taxpayers with modified gross incomes $40,000 and $50,000 (between 80 and 100 on joint returns) 2. Lifetime Learning Credit – §25(c)(1) – credit up to $2000 per taxpayer for the qualified tuition and related expenses of higher education (same phase out rules as Hope)
**Student cannot take both the Hope and Lifetime Credit in the Same Year**
Differences from HOPE 1. Not limited to a maximum number of years or to the first two years (e.g. Graduate level applies) 2. No half-time enrollment basis or degree-granting program requirement 3. Calculated on a per taxpayer basis rather than per student basis (1 time credit per taxpayer, whether he gives it to his spouse or dependent is irrelevant)
3. Coverdell Education Savings Accounts – trust accounts created for kids under 18 for the purpose of paying qualified higher education expenses or qualified elementary and secondary education expenses
4. Deduction for Qualified Higher Education Expenses – § 222 – above-the-line
1. $3,000 (2002, 2003); $4,000 (2004, 2005) then expires; 2. Available to taxpayers whose AGI does not exceed specific amounts; 3. Cannot be taken in the same year for the same student for whom HOPE or LLC is claimed
5. Interest Deduction for Interest on Qualified Education Loans – § 221(a) – above-the-line
1. Maximum deduction is $2,500 2. Phased out for taxpayers with modified AGI between $50,000 and $65,000 3. For taxpayer, spouse or dependent who is enrolled at least half-time in a degree-seeking program
6. § 529 Qualified Tuition Plans – not limited to taxpayers w/AGI within certain amounts (p.427)
7. Educational Assistance Programs –
8. § 135 Excludes Income Interest on “Qualified U.S. Savings Bonds” used to pay higher education expenses of taxpayer, spouse or dependents
**Class Notes Summary**
State Tuition Pre-Paid Plans
§ 529 Plan – can put amount into the plan (no limit, but worry about gift tax – first year you can put in 50k and have it excluded) accumulates tax free and when it’s taken out to be used for education its tax-free Negative: Have to choose between investment plans (not flexible) 47 Coverdell Savings Plan – maximum of 2000 (phased out) – idea is you can put in 2K/year (the amount is ND) but it accumulates tax free and is tax free when you take it out and use it for education
Education Incentives 1. § 25A – HOPE – during first 2yrs of undergrad – max is $1500 per child 2. § 222 – Lifetime learning credit – after second yr of undergrad – max is $10,000 qualified expenses times 20% per family
Handout #70 § 25A(b) – tells you how to compute HOPE credit No HOPE credit if child has been convicted of a drug offense
§ 25A(c) – Lifetime Learning Credit
***ONLY do § 222 OR § 25A – NOT BOTH
***HANDOUTS # 71 – 75***
CHAPTER 19:
CHILD CARE Credit – § 21 – Deduction allowed for child care so that parents can work allowed only where there is an “employment-related expense” and one or more “qualifying individuals”
“Employment-Related Expense” – expenses for household services and for the care of a qualifying individual, incurred to enable the taxpayer to be gainfully employed where there are one or more qualifying individuals with respect to the taxpayer
“ Qualifying Individual” 1. Dependent of the taxpayer under age 13 for whom taxpayer is eligible to claim as a dependent 2. Dependent of the taxpayer who is physically OR mentally incapable of caring for himself 3. Spouse of taxpayer who is physically OR mentally incapable of caring for himself
Deduction is limited to $3,000 for one dependent; $6,000 for two or more
§ 129 Excludes from the gross income of an employee amounts paid or incurred by employer pursuant to a dependent care assistance program
Exclusion cannot exceed $5,000
Amounts that are excluded here must be subtracted from the employment-related expense D
LEGAL EXPENSES – to distinguish between D and ND legal expenses use the “Origin-of-Claim” Test Origin-of-Claim Test
If the origin of the litigated claim is Personal = ND
If the origin of the litigated claim is a Business or Profit-Seeking Transaction = D, so long as the claim arises in connection with the taxpayers profit-seeking activities (consequences are irrelevant)
Legal Expenses- To be deductible, a legal test must meet one of two tests: (1) it must either be a business expense that is ordinary and necessary to the conduct of the taxpayer's trade or business [Origin-of-the-Claim test- if the origin of the claim litigated lies in a personal as opposed to a business or profit-seeking transaction, the expenses are nondeductible]; or (2) a nonbusiness expense incurred in: 48 a. collecting or producing income; b. managing, conserving, or maintaining income-producing property; or c. the determination, collection, or refund of any tax.
CHAPTER 20: HOBBY LOSSES
Hobby Losses – § 183 – losses incurred through personal hobbies “activity not engaged in for profit” are Not Deductible, i.e. activities not deductible under §§ 162 or 212
The first inquiry- Is the activity engaged in for a profit? Must have a profit objective, not an expectation of profit Factors
Each Activity must be tested according to Factors to determine whether it is “for profit”: 1. Manner in which the taxpayer carries on the activity 2. Expertise of taxpayer of his advisors 3. Time and Effort expended by taxpayer in carrying on the activity 4. Expectation that assets used in the activity may appreciate in value 5. Success of taxpayer in carrying on other similar or dissimilar activities 6. History of Income or Losses with respect to the activity 7. Amount of Occasional Profits, if any, earned 8. Financial Status of taxpayer 9. Elements of personal Pleasure or Recreation
Weigh all facts and circumstances giving greater weight to objective facts
Presumption that the activity was engaged in for business, with respect to a given year, if the activity was profitable for 3 years in the 5 year period ending the year in question (Rebuttable)
Application: § 183 applies to Individuals, S corporations, Estates and Trusts § 183 does not apply to any dwelling unit for any year to which § 280A applies § 183 does not apply where §§ 162 and 212 apply
The next inquiry is what can be deducted?
There are three categories of deductions:
1. Category 1 deductions are those, such as home mortgage interest and state and local property taxes which are allowed to a taxpayer whether or not an activity is engaged in for profit. 2. Category 2 deductions are those that would have been allowed if the activity were engaged in as a trade or business; garden-variety 162 or 212 expenses 3. Category 3 deductions are those, such as depreciation, that result in basis adjustments and that would be allowed if the activity were engaged in for profit.
Deductions allowable- In the case of an activity not engaged into for profit to which subsection (a) applies, there shall be allowed under 183(b) -
1. the deductions which would be allowable under this chapter for the taxable year with regard to whether or not such activity is engaged in for profit, and
49 2. a deduction equal to the amount of the deductions which would be allowable under this chapter for the taxable year only if such activity were engaged in for profit, but only to the extent that the gross income derived from such activity for the taxable year exceeds the deductions allowable by reason of paragraph 3.
CHAPTER 21: HOME OFFICE DEDUCTION
§ 280A – D where taxpayer uses his residence exclusively and regularly as his principal place of business
First Inquiry: Does a place qualify as a home office?
“Principal Place of Business” is determined by (Solimon): 1. Relative Importance of the activities performed at each business location; and 2. Time Spent at each place (greater weighted given to the place where the services are performed)
Amendment (Reversed Soliman) – home office deduction is appropriate for a place of business used for “administrative or management activities, if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities Not where he could conduct it, but where he does conduct it For plumbers, electricians and other laborers who perform services in other people’s homes and there is no other fixed place of business
Employees seeking to D home office expenses must also satisfy the “convenience of the employer” standard
Weissman – college professor allowed to D where he was sharing an office with several other professors and chose to work at home, and did 80% of his work there necessity negates the claim that the home office was a personal convenience + employer provided no suitable space + spared the employer the cost of providing a suitable space
Limitation – § 280A(c)(5): Even if the taxpayer satisfies the business use requirement, the amount of the D allowed is limited GI from the use of the residence for trade or business purposes is the ceiling for D’s
Reduced by (1) D’s the taxpayer could claim regardless of whether the home office were used for T or B purposes (real estate taxes, mortgage interest allocable to home office); and (2) D’s attributable to T or B activity but that are not allocable to the dwelling itself (secretarial expenses, supplies, business telephone) (3) Expenditures not related to the use of the dwelling unit for business purposes (lawn care) are not taken into account in computing D’s allowable under § 280A
Typical Office Expenses include: Rent, Depreciation, Insurance, Mortgage Interest, Property Taxes, Utilities
Second Inquiry: If it does qualify as a home office, how much is the deduction (allocate)
Computation of the Home Office Deduction-
1. Expenses directly related to the business space (painting the room or the cost of draperies) are deductible in full. 2. Expenses that relate to the entire home must be allocated between the business portion and the personal portion of the home. 3. Mortgage interest and real estate taxes are "always allowable (a/a)" deductions. 4. Those allocated to the business space are adjustments and those allocated to the personal space are itemized deductions.
50 5. Maintenance and depreciation are deductible to the extent they are allocated to the business portion of the home; the rest are non-deductible personal expenses. 6. Section 280A(c)(5) limits the deductibility of maintenance and depreciation expenses to the amount of income remaining after the direct business expenses and are "always allocable" expenses are deducted. In other words, maintenance and depreciation expenses of a home office cannot generate a tax loss. Deductible maintenance and depreciation expenses which exceed the income limitation are carried forward to next year. Maintenance expenses, which do not reduce the basis of the home, are deducted before depreciation.
Example:
GI from consulting services = $1,900 Reduced by (a) expenses not allocable to the unit
Expenses for Secretary = $500 Business Telephone = $150 Supplies = $200 Total = $850
(b) always allowable Ds Total Allocable to Office Mortgage Interest = $5,000 $500 Real Estate Taxes = $2,000 $200 Total = $700
Sum of (a) and (b) ………………………….. $1,500
§ 280A(c)(5) Limit Gross Income of $1,900, less $1,550………………$350
Thus, only $350 of Clare’s other expenses may be D under § 280A
Assume the share of other expenses allocable to her home office was as follows:
Total Allocable to Office Insurance $600 $60 Utilities $900 $90 Lawn Care $500 0 Depreciation $3,200 $320 Total allocable to office………………………………….. $470
The amount of other Ds allocable to the unit exceeds the $350 limit.
Ordering Rule for Claiming Ds Ds which do not cause an adjustment must be claimed First (insurance and utilities totaling $150 – leaving $200 of depreciation which may be deducted) The $120 of depreciation allocable to the use of the unit which may not be D may be carried over to the succeeding tax year
Cases: Popov (musician) – no D for practicing at home
CHAPTER 44: LIMITATION ON TAX SHELTERS
At Risk and Passive Loss
D cannot exceed one’s Basis in property
51 Big Picture: Tax Shelter is a business activity that is structured to generated huge losses at the beginning of a business –usually structured as limited partnerships because partnerships do not pay tax any gains and losses flow through to partners
Prior to 1974 – 4 Partners A invests $10k + Partnership borrowed on his behalf $90,000 (Crane case – partner’s basis is: Cash Paid + Debt incurred to acquire the property) A is a limited partner (only responsible for $10k) Partnership enters into activity that sustains big loss A gets a letter saying loss in the amount of $70,000 $49,000 back *Business were just set up to generate losses tax shelter made money anyway
Basis is reduced from 100k to 30k – eventually his basis reaches zero – when he is relieved of the debt that’s an amount realized he accomplished Deferral (got the money now – five years later he’ll buy another tax shelter to pay off the one before – and so the game goes on)
1974 Congress passed the At Risk Rules – if you put in $10,000 in cash and have $90,000 in debt you cannot D more than you have at risk only D $10,000 Got around it by making partners legally liable people did it for the return
1986 Passive Loss Rules – loss in an activity in which you do not actively participate (e.g. limited partner – other investors)
***HANDOUTS #89 – 90*** KNOW FOR EXAM
At Risk Rules – § 465 – only allows D of the amount of taxpayer’s initial amount at risk, which is the sum of (1) cash contribution to the activity; (2) adjusted basis of the other property contributed by the taxpayer to the activity; and (3) amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged property as security
“ Amount at Risk” does not include: Property already put up in relation to the activity; Amounts borrowed from those with an interest in the activity; Any amounts otherwise protected against loss through nonrecourse financing, guarantees, etc.
Amount at risk is increased by:
a. cash or property contributed by the taxpayer (including personal cash used to pay a liability of the business); b. recourse debt (debt on which the taxpayer has personal liability); c. qualified nonrecourse financing in a real estate activity; d. income of the activity (whether or not the taxpayer withdraws any cash).
Amount at risk is decreased by:
a. withdrawals or distributions of cash or property; b. activity losses.
52 Limitation on Passive Activity Losses – § 469 REFER to Handout # 92-95
CHAPTER 22: THE INTEREST DEDUCTION
Interest – § 163 – lender has no interest income; borrower may D when incurred in connection with a trade or business activity; Personal interest (credit cards) is limited to interest on mortgages on one’s personal residence
Interest – compensation for used of borrowed funds (not for services provided by lender – those are charged separately) – rate in “points” varies according to time and duration
Personal Mortgage Interest D – 2 Categories 1. Acquisition Debt (fully deductible) 2. Home Equity Loans (deductible up to $10,000)
Section 163(h) Disallowance of deduction for personal interest, except interest allocable to trade or business, investment interest, and qualified residence interest (a,b,d)
1. In general.- In the case of a taxpayer other than a corporation, no deduction shall be allowed for personal interest paid or accrued during the taxable year.
2. Personal Interest.- For purposes of this subsection, the term "personal interest" means any interest allowable as a deduction under this chapter other than-
A. interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee), B. any investment interest, C. any interest which in taken into account under § 469 in computing income or loss from a passive activity of the taxpayer, D. any qualified residence interest, and E. any interest payable under section 6601 on any unpaid portion of the tax imposed by section 2001 for the period during which an extension of time for payment of such tax is in effect under § 6163.
Qualified Residence Interest – § 163(h)(3) Refer to Handouts # 104-106
Student Loan Interest – § 221 – authorizes above-the-line deduction for interest paid by a taxpayer on any qualified education loan for taxpayer, spouse, or dependents at higher-education institutions while enrolled at least half-time in a program leading to a degree or recognized education credential
Maximum Deduction: $2,500
Phased Out when MAGI is between $50,000 and $65,000 ($100,000 and $130,000 for Joint Returns)
221(d) – Qualified Education Loan Defined
Determining AGI – Refer to Handout # 110 – 111
CHAPTER 23: DEDUCTION FOR TAXES
§ 164 – D for some State and Local taxes for Federal Income Tax Purposes – basically to allow a D for certain taxes paid or accrued outside of a trade or business or other income-producing activity Always D taxes
53 incurred as a trade or business expense (162) and transactions entered into for profit (212), thus some expenses that cannot be D under § 213 may be under 162 or 212 if they are business expenses
Deductions Allowed: 1. State, local, and foreign real property taxes; 2. State and local personal property taxes; 3. State and local, and foreign, income, war profits, and excess profit taxes. ND for Personal and Family Living Expenses (even if they fall into an above category)
Who May Claim the Deduction? – Only the person upon whom they are imposed
ND for gratuitously paying the tax liabilities of others
Exception: Real Property Tax Tenants-in-Common
Test of whether or not a real property tax is D by the person who paid such tax is whether that person satisfied some personal liability OR protected some personal right OR beneficial interest in property
Powell – she was a tenant in common with five others (one-sixth), but she paid all of the property tax and wanted to D it okay because tenants in common have a right to occupy the whole property, thus by paying all the tax, tenant was protecting her personal right/beneficial interest in the property
Assessments (§ 162c) Paid to Local Governments by Property Owners – mostly NO May be Added to the Basis of Property
Water and Sewer = fees paid for services = ND
Local benefits that Increase the Value of Property = ND, Except to the extent they are allocable to Maintenance or Interest Charges
Streets, Sidewalks, and other like improvements = ND
Where the assessment represents the cost of improvements in the nature of capital expenditures, the assessment may be added to the basis of the property subject to the assessment
Apportionment of Real Property Taxes Between Buyer and Seller – § 164(d) – when real property is sold, the portion of taxes allocable to that part of the “real property tax year” (determined by local law) ending the day before the sale is imposed on the SELLER; the portion allocable to that part of the real property tax year beginning on the day of the sale is imposed on the PURCHASHER
Example: The real property tax year is a calendar year. Real property taxes for a given property for the real property tax year are $3,650. The real property is sold by Smith to Brown on March 1. $590 of the tax, i.e. 59/365 is treated as imposed on Smith and the remaining $3,060, i.e. 306/365 is treated as imposed on Brown
Apportionment cannot be reallocated by agreement between the buyer and seller (§ 164c2)
Can only D taxes paid since you were the purchaser – paying past property taxes are not D, even if the taxpayer is liable for those taxes
Class Example: 2003 tax bill comes in October of 2004 = $5,000 (paid $2,500) February gets the other half of the bill = paid the installment of 2004 taxes based on 2003 taxes
54 Sell your home on July 1, 2005 – seller has to pay the buyer at the closing for all the taxes that will be payable up to June 30, 2005 Seller deducts the taxes up to the period of time he sold and moved out o So seller has to pay buyer for all 2004 taxes + 6 months of 2005 taxes – (minus) the installment that has already been paid (i.e. seller must pay buyer all real estate taxes up until the day he moved out) – Seller can D what he paid the buyer o Only seller can D (not buyer until he is the owner) o Problem – RE taxes go up every year – last known tax bill is $5000 – broker isn’t going to tell the buyer that if we base his payment on the 5000 figure, but taxes go up substantially then buyer gets screwed want to build in extra percentage so you don’t have to chase the seller o September 2005 Buyer gets a tax bill – how much can he D? – None; he didn’t live there (bill is from 2004 tax) o September 2006 ($8,000) – how much can buyer D – 6 months worth – bill is from 2005 and buyer only lived there for 6 months of 2005
Sales Tax Table – H/O # 113 D Sales Tax (use table or keep your receipts) or Income Tax, whichever is higher
Read Handout # 115
CHAPTER 25: MEDICAL EXPENSES
§ 213 – D for uncompensated medical expenses of the taxpayer and taxpayer’s spouse and dependents to the extent the expenses exceed 7.5% of the AGI
Only allowed for expenses “Actually Paid” during the year
§ 213(b) – ND for nonprescription drugs; D for nonprescription equipment and supplies, such as crutches if they otherwise constitute medical care expenses
Medical Expense v. ND Personal Expense
“ Medical Care”/Expenditure – § 213(d)(1)(A) – includes amounts paid for (1) diagnosis, (2) cure, (3) medication, (4) treatment, or (5) prevention of disease, or (6) for the purpose of affecting any structure or function of the body + medically related transportation costs, qualified long-term care services, and medical insurance (213d1B,C,D) + certain lodging costs away from home form medical care (213d2)
However, D shall be Limited to expenses incurred “primarily” to prevent or alleviate physical or mental defects or illness, and will not extend to expenses that are “merely beneficial to . . . general health”
Is the services rendered, not the qualification of the practitioner services must be medical in nature as opposed to household or personal
D includes expenses for Elective Procedures such as cosmetic surgery (face-lift; hair removal) on the theory that the operation affects a structure or function of the body
§ 213(d)(9) – Limits on Cosmetic Surgery – amounts expended for insurance to cover cosmetic surgery of the nature described in § 213(d)(9) are ND + No Reimbursement for costs under an employer-provided health plan, no exclusion
Related to Disease v. Improve Appearance
55 D = Breast Reconstruction following mastectomy OR Vision Correction surgery = medical expenses deformity directly related to disease
ND for Teeth Whitening designed to improve appearance
Capital Expenditures – D medical expense where the primary purpose of the expenditure is medical care of the taxpayer, spouse or dependent (e.g. wheelchairs) – (sometimes D for swimming pools and special equipment, but where it constitutes and improvement to the property, the D is limited to the amount by which the cost of the improvement exceeds the increase in value) – No need to factor in Depreciation, just D
Henderson – modifications made to van to transport handicapped child – no depreciation D because it did not qualify as an amount “paid” for medical care as required by § 213(a) – Modifications would be D for the year they were made
Food and Beverage Generally, outside the institutional setting (hospital or special school) expenses for food and beverage, including special diets are ND because they are personal expenses
However, the cost of special foods taken as a substitute for a normal diet may be D to the extent it exceeds the cost of a normal diet
Legal Only ND for Illegal Operations or Tx, including Medical Marijuana
Transportation – D under § 213(d)(2) if incurred “primarily for or essential to” medical care
ND – Moving to Florida for the winter season, per doctor’s orders, to alleviate heart and lung ailments
Divorced Parents Special rule for child of divorced parents – child shall be treated as a dependent of BOTH parents for purposes of medical expense D
Handout # 114-115 – don’t have to know these Fee paid to donor for medical expenses = D Expenses paid for surrogate mothers medical expenses = ND
Handout # 116 and Problems on # 117
CHAPTER 26: charitable contributions
Section 170(a)(1)- Allowance of deduction. General Rule- There shall be allowed as a deduction any charitable contribution (as defined in subsection(c)) payment of which is made within the taxable year. A charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary. 170(c)(2)- Charitable Contribution defined.- For purposes of this section, the term "charitable contribution" means a contribution or gift to or for the use of-
A corporation, trust, or community chest, fund or foundation.
a. created or organized in the U.S.; b. organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster amateur sports, or for the prevention f cruelty to children or animals;
56 c. no part of the net earnings of which insures to the benefit of any private shareholder or individual; d. which is not disqualified for tax exemption.
Section 170(f)(8)(A)- Substantiation requirement- General rule.- No deduction shall be allowed under subsection (a) for any contribution of $250 or more unless the taxpayer substantiates the contribution by a written acknowledgement of the contribution by the donee organization.
This is an other itemized deduction- not subject to the 2% miscellaneous floor. Must have "donated intent"- not supposed to get anything in return. There are limits: if cash contribution exceeds 50% of AGI balance must be carried over for 5 years. Most large donations are appreciated property- limited to 30% of AGI. If donation exceeds $5,000- must attach an appraisal. Must be in cash, not services. Can only deduct the basis if it is ordinary property. Can deduct the FMV if it is a Long term capital gain.
Handout # 118
Allows D to help subsidize charities
D Cash and Property Contributions, not basis
To “Qualified Recipients” (501c3)
Charity to Alma Mater to get tickets – ND
D for old clothes – get FMV that the IRS thinks is acceptable
Contributions are D in the year paid
Use the Mail Box Rule – payment is maid when dropped in box on Dec. 31, 2005
Never D more than the FMV; only D basis if held for 12 months or less
Deduction Limits: 1. Donate Cash – limited to 50% of AGI 2. Donate Appreciated property cannot D more than 30% of AGI
Substantiation – if the Donation is over $250 of non-cash profit, the charity must send you receipts acknowledging any benefit you received for the contribution (dinner, religious benefit) Subtract amount of what you got from the donation amount
Donating Cars to Charity – people were D bluebook value regardless of what condition it was in (abuse) Congress changed the rule as of January 1 of this year – charity must report how much they sell the car for and that’s how much you can D
Stock or Other Items of Value Need an Appraiser (Handout # 119 and 120)
Carryover is okay
57 CHAPTER 31: capital gains and losses
1. Introduction- The tax treatment of gains and losses on the sale of capital assets depends on the type of asset, the length of the holding period and the tax bracket of the taxpayer. The long-term holding period is 12 months.
Problem: Assets held for a few year that appreciated where only taxed when realized (sold or exchanged) then they were taxed during one year even though the appreciate occurred over several years bunching problem
Three Requirements for LTCG:
(1) Sale or Exchange of a
(2) Capital Asset (prop held by tax payer ex. Whats listed in 1221. not included- stock or trade (inventory), depreciable personal property and all real property in trade or business, copyright, literary, musical, art, letter held by taxpayer whose personal efforts created property (musical composition changed a few weeks ago, treated as capital asset), or taxpayer who gives to son as gift and takes creator’s basis, whatever, not on exam
(3) Held for more than one year
2. CAPITAL GAINS RATES
a. Long-term Capital Gains Realized before 1986 - Short-term capital gains (STCG) have always been taxed at the regular tax rates. Prior to the Tax Reform Act of 1986, taxpayers could deduct 60% of realized long-term capital gains (LTCG). The maximum tax rate on regular income was 50%. The 60% deduction reduced the maximum tax on long-term capital gains to 20% as shown in the following example:
Grant purchased Intel stock in 1983 for $5,000 and sold it in 1985 for $9,000, resulting in a $4,000 LTCG. She was entitled to a capital gain deduction of $2,400 ($4,000 x 60%), deductible as an adjustment, which left $1,600 of the gain in her taxable income. Grant was in the 50% tax bracket, the highest bracket prior to the Tax Reform Act of 1986. She paid $800 of tax on the $1,600 of capital gain that was subject to tax ($1,600 x 50%). Grant paid $800 of tax on the $4,000 LTCG, which equals 20% of the gain.
b. Long-term Gains Realized Between 1986 and 1997- Congress repealed the capital gain deduction in 1986 when it lowered the maximum tax rate from 50% to 28%. Without any special tax treatment, the maximum tax on all income, including long-term capital gains, was 28%. However, Congress recognized the maximum tax rate was likely to increase beyond 28% in future years, so the 1986 act provided that if the maximum tax rate was increased, LTCG would still be taxed at a maximum rate of 28%. Sure enough, the top rate was increased to 31% in 1990 and to 39.6% in 1993, but the maximum tax on LTCG remained at 28% from 1986 until Tax Reform Act 1997 reduced the rate to 20%. A taxpayer in a bracket higher than 28% had to make a special computation to determine the tax on LTCGs. c. Rates on Capital Gains After January 1, 1998- Gains and losses from capital assets held one-year or less are STCG or STCL. STCG are taxed at the taxpayer's regular rate. Gains and losses from capital assets held more than one-year are long-term. There are three groups of long-term assets, which are taxed at different maximum rates as indicated.
Groups of Long-term Assets:
58 1. The 20% group consists of gains and losses from most capital assets held for more than one-year. The maximum tax rate on these gains is 20%, but the rate is only 10% for gains that would be in the 15% bracket. 2. The 25% group consists of recapture gain on the disposition of real property held for business or investment, to the extent of depreciation deductions. The maximum tax rate on this gain is 25%.
(3) COMPUTATION OF TAX ON CAPITAL GAINS Refer to Handout
CHAPTER 31: Casualty losses
§ 165(c)(3) – D for uncompensated casualty or theft losses that are unconnected with a trade for business or with a transaction entered into for profit limited by § 165(h) $100 ND Floor After the $100 floor, net casualty loss for the year is allowed only to the extent it exceeds 10% of the taxpayers AGI
Fire, Storm, Shipwreck ( and Other Casualty – identifiable event of a sudden, unexpected and unusual nature (e.g. diamond lost from ring when door slammed on hand; denied when rings were accidentally flushed down toilet)
Damage resulting from taxpayer’s “Willful Act or Willful Negligence” will not be allowed
Foreseeability or Negligence will not take an occurrence outside the ambit of “other casualty”
E.g. Meteorological forecast (foreseeable) and Automobile Accidents (negligence) are D losses
Termite Damage Generally, denied because it lacks the “sudden” element D for damage caused up to 15 months after filtration
Lottery- win, sell for lump sum, not property selling, selling income, treated as income
Lawyer buys 25k Picasso on office 50,000 profit when sells few years later Capital gain- painting is not depreciable (no art is)
59