This is a code class based on the Internal Revenue Code
We focus on the provisions related to individual income tax
Each Code Section has a corresponding Regulation
The intent of a regulation is to interpret the code. Congress puts forth the code section and the Treasury Department (IRS) further explains the code section
Regulations are binding on the Courts unless they are found to be unreasonable
Step 1: Go to the code
Step 2: Go to the regulation
Step 3: If there is a dispute, a court will interpret the regulations and revenue code statutes
Concepts carry over from provision to provision meaning, concepts repeat themselves and build on each other. Keep up on the rules.
Revenue Rulings
Revenue Rulings are not binding by the courts. After submitting a particular set of facts to the IRS, the IRS will give an interpretation of the particular set of facts in the form of a Revenue Ruling. A regulation is the interpretation of the law. A revenue ruling is the interpretation of a set of facts. Revenue rulings are not bound by the court; however, as a taxpayer you can rely on a revenue ruling because the IRS is bound by the Revenue Ruling – the IRS cannot take a position contrary to a revenue ruling. The catch: your fact pattern or situation has to be identical to the Revenue Ruling’s fact pattern or situation.
Disputes of Interpretations
Options:
The Tax Court (the “poor-man’s court”): Only available if you didn’t pay your understatement of tax. If you get a Notice of Deficiency you can dispute it without having to pay the IRS first.
The Federal Claims Court and the
ONE OF FIVE ISSUES/MAJOR TOPICS
1. What is gross income?
2. Whose gross income is it?
3. What can be deducted?
4. When must the income be reported and when can a deduction be taken?
5. When there is a disposition of property at a gain, should a special tax rate apply?
CHAPTER 2: THE EFFECT OF AN OBLIGATION TO REPAY
COMPUTING TAX LIABILITY
What is gross income? You are taxed on gross income, minus deductions. Any accession to wealth is usually income.
Accession to Wealth: Any increase in net worth.
Gross Income: Any accession to wealth, clearly realized over which the taxpayer has dominion and control. If someone pays you for services with property, use of property or services, you have gross income.
Gross Income
Less Deductions
= Taxable Income
Times Tax Rate
= Gross Tax Liability
§ 61. Gross Income Defined –
(a) General definition – 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 items;
(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; and
(15) Income from an interest in an estate or trust.
Commissioner v. Glenshaw Glass Co. (Supreme Court) (1955)
Rule: Money received as punitive damages must be included as gross income. The court considered it a “windfall” as it was a result of the third party’s bad conduct and not from labor. 1. The concept of gross income is very broad;
2. Punitive damages are gross income;
3. Working definition of gross income for those items not specifically included
Exam: If I state that compensation for services is listed as income – it is gross income and no need for a Glenshaw Glass analysis. Use Glenshaw Glass for those items not listed in § 61.
Fn.8: The long history of departmental rulings holding personal injury recoveries nontaxable on the theory that they roughly correspond to a return of capital cannot support exemption of punitive damages following injury to property….Damages for personal injury are by definition compensatory only. Punitive damages on the other hand, cannot be considered a restoration of capital for taxation purposes.
Cesarini v.
Facts: The Cesarini’s, after finding money in a piano and declaring it on their taxes, filed an amended tax return which removed the funds in question from gross income.
Rule: Unless expressly excluded by law, gross income includes all income from whatever source derived. The burden is on the taxpayer to find an exemption within the code that excludes something from gross income.
The taxpayer is arguing pursuant to § 74 (prizes and awards) that there is no specific listing for treasure trove for gross income. They also argue that if it is gross income, it should have been included in the year they bought the piano and the SOL would have run. The taxpayer loses on that argument because the money wasn’t realized or found until last year, well within the SOL (3 years)
Gifts
Gifts are an accession to wealth however there is a code provision that excludes gifts from income – Code 102.
Even though the Cesarini’s argue that this is a treasure trove, there is a regulation that specifically states treasure trove is income.
Form
What if the Cesarini’s had discovered a Rolex instead of cash? Is that gross income? Yes, you have to include the FMV as income. Form does not matter.
If you catch a potentially lucrative baseball and you give it back, it’s not income (you can refuse prizes). The Cesarini’s had a clearly realized accession to wealth at the time in which they found the cash.
Realization
If you exchange items for services you must report as income. Unrealized gain is not taxed. Week 1 Problem Handout: If Martha Stewart’s tether increases in value, you do not have to declare appreciation of value after you take ownership as income. The receipt of property itself results in gross income whether its cash, services, or intangible property. If it increases in value there is no realization or less until you dispose of it (not necessarily a sale – if it’s destroyed in a fire, insurance will pay for that asset – losing ownership is a more accurate description of dispose). Putting assets up for collateral is not disposing of assets – you still own it. Assets used to pay off a liability would be realized as it is an increase of wealth.
If the Handout were an exam question, start out by saying that compensation for services is gross income. Then ask, does the fact that he received a tether and not cash impact that compensation for services analysis? You can cite to Revenue Code 79-24
Rule: (1) Gross income includes the FMV of property or services received in exchange for services, even if received as part of a barter transaction (Rev. Rule. 79-24). Loss of income as a deduction isn’t realized until you’ve disposed of the asset. Unrealized gains do not result in gross income until you dispose of that asset. (2) Appreciation in the value of property must be realized before it is included in gross income (Glenshaw Glass).
Pigs get fed, hogs get slaughtered
If you are aggressive, you’ve got a chance. If you are a complete hog about it, you’re going to get slaughtered and lose.
Loans
Loans are not income because there is no accession to wealth – it is a liability; however, If someone pays your debts in exchange for your services, you have gross income.
Old Colony Trust Co. v. Commissioner (1929)
Facts: The Commissioner (P) sought to tax, as additional income to the employee, the amount of his federal income taxes which were paid on his behalf by his employer.
Rule: The payment by an employer of the income taxes assessed against his employee constitute additional taxable income to the employee. There is economic benefit to a taxpayer even when someone else pays the obligation.
Rule per Shaeffer: Gross income includes the payment of any debt, liability, or other obligation by a third party in exchange for services.
McCann v.
Facts: The McCanns (P) received an all-expense-paid trip as a reward for Mrs. McCann's job performance, but they did not include the value of the trip in their gross income calculation on their joint income tax returns.
Rule: When services are paid for in a form other than money, the fair market value of the thing received must be included in gross income.
Rule per Shaeffer: Gross income includes any economic or financial benefit conferred as compensation, regardless of the form the compensation takes § 61(a)(1). Ask: Who is the intended beneficiary? If the trip were required for business, then the value of the trip would not be included in gross income.
Not Included in Gross Income
Unrealized Gain: A mere appreciation in your assets does not create income.
Bargain Purchase
If you purchase an item for less than its fair market value (a bargain purchase), you do not have gross income. The discount is not included in gross income. Policy: it would be a nightmare to prove that there even was a discount (buying a can of beans for less than FMV, a used car, etc.)
Substance Controls Over Form: Get a desk at a discounted price from an employer. Was it for services? We look at the transaction’s substance, not its form. When you buy a desk from your employer for less than FMV, the form is a bargain purchase. If your employer sells you a desk under FMV for a job well done, it now looks like compensation for services (substance). As long as it is truly a bargain purchase and not for services, it will be excluded from income. (Akin to a gift – a true gift is excluded from income).
Pellar v. Commissioner (US Tax Court) (1955)
Facts: The Pellars (P) paid $55,000 for a house fairly valued at $70,000, but paid no taxes on the $15,000 difference which they realized.
Rule: The purchase of property for less than its fair market value does not, of itself, give rise to the realization of taxable income.
This was not a disguised distribution of earnings. There is no employment relationship so there is no disguised compensation. The government could not prove that this wasn’t a bargain purchase. If it’s gross income to anyone it’s the father because he has a relationship with the contractor.
Note on Bargain Purchases: If an employee/employer relationship exists, we should be skeptical whether or not it is a bargain purchase or compensation for services. We look to the substance, not the form. If we have a bargain purchase in form but its substance is really compensation for services, the employee’s gross income inclusion is the difference in FMV value and amount paid.
CHAPTER 3: THE EFFECT OF AN OBLIGATION TO PAY
Loans
A loan does not represent an “accession to wealth” or increase the taxpayer’s net worth because the loan proceeds are accompanied by an equal and offsetting liability: the borrower has an obligation to repay the loan, and it is this repayment obligation that negates treatment of a loan as income.
A return of your investment (not on your investment) is not considered gross income. Interest paid is included as gross income.
Illegal Income
Illegal income is gross income even if you have to repay it. A taxpayer has an accession to wealth when he receives earnings through illegal means. If you have to repay the money then you can use that as a deduction for the amount you paid.
Claim of Right Doctrine
The fact pattern to look for in a claim of right issue is someone receiving income (a will?) and there is a possibility that someone out there may get it.
What happens when you receive income, whether it be treasure trove or by other means, and someone else claims an interest or has a potential claim against it? The issue becomes, when you find the property do you have to report it then or wait until the contingency is removed?
North American Oil v. Burnet (US Supreme Court) (1932)
Facts: Income earned in 1916 from property in the hands of a receiver was not reported or given to North American Oil (P) until 1917.
1916: Land put in receivership by a judge
1917: Court decides in favor of North American, income earned turned over
1922: Government lost Appeal, North American can keep proceeds
Issue: Should funds impounded by a Receiver who is in control of only a portion of a corporation's property be taxed to the corporation when it finally has an unqualified right to receive them?
Rule: “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income.”
In other words, when you receive disputed income, you include it at the time of receipt rather than wait until a legal dispute is resolved.
To Receive Under A Claim of Right: Without restriction of use. If the money is tied up in escrow, you have no control over it. A self imposed restriction is not a restriction for the claim of right. Under the claim of right doctrine we do not await the resolution of a contingency to decide whether or not the receipt of the money was income. Money received under a claim of right, without restriction as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan.
Elements:
1. Receipt,
2. under a claim of right,
3. without restrictions,
4. is income
CHAPTER 3 CONTINUED
Deposits vs. Advance Payments
Security deposits are not gross income as long as they truly are a deposit rather than an advance payment which is included in income.
Advance Payment Example: Paying first month’s rent before you move in. Look to see if the lessee has control over whether the lessor can get the deposit back or not. If the property owner gets to keep the deposit then it’s an advance payment.
Commissioner v.
Rule: A taxpayer receives income if he acquires earnings without an express or implied obligation to repay and has complete dominion over their disposition.
Shaeffer: The court will look at whether the customer or the company controls the ultimate disposition of a deposit. Here, IPL consistently treated the deposits as belonging to the customers, both by listing them as current liabilities for accounting purposes and by paying interest; therefore, it’s a deposit and the recipient doesn’t have to include it as income. If the customer controls the ultimate disposition, it’s a deposit. If the taxpayer controls, it’s an advance payment.
In determining whether a taxpayer enjoys “complete dominion” over a given sum, the crucial point is not whether his use of the funds is unconstrained during some interim period. The key is whether the taxpayer has some guarantee that he will be allowed to keep the money. P 71
Problem 3 P 55:
Argument for taxpayer: IPL asks us to see who’s in control of the funds. Under the contract the tenants control – if they don’t trash the place and they pay their last month’s rent they get their money back. The issue is whether or not they can get their money back.
Argument for the IRS: The majority of the time the deposit is being used for rent. If the taxpayer controls then it’s an advance payment to be included in gross income.
Exam: Argue both sides. Shaeffer isn’t looking for the right answer, he’s looking for analysis.
Coupons and Rebates
Coupons and rebates are a reduction in purchase price (bargain purchase) and therefore no gross income.
Westpac Pacific Food v. Commissioner (2006)
Shaeffer: I don’t like the holding in the case because it is not inclusive enough. You could go several different directions with these facts. The court’s analysis isn’t that complete – it’s open to dispute.
1. You could simply say this was a rebate (reduction in purchase price) and rebates are not gross income. Distinction: If you return the spices, you lose your rebate.
2. What the court chose to do instead was follow IPL – is this more of a deposit or more of a loan? This is akin to a deposit because the taxpayer is not sure whether he could keep it depending on volume discounts. So until they meet their target, no gross income. IPL said more than that – if you control whether you can keep those funds, it is gross income. You could argue that Westpac is really in control of the money when they meet their target and therefore the discounts should be considered income.
3. Argue pursuant to North American Oil that this is really a receipt of earnings under claim of right; therefore they have a gross income inclusion that if they have to pay it back at a later date they get a deduction (just increase purchase price then if you have to pay it back).
Holding: Because the taxpayer here has to pay the money back if the volume commitments are not met, it is not an accession to wealth as required by Glenshaw Glass.
Advance on Royalties
Problem 4: § 61(a)(6) Royalties are gross income. An advance payment of a royalty is gross income. If a taxpayer wants to escape tax liability, he is going to argue against the form – even though the form is an advance payment it’s really not that in substance.
Argument:
1. Rely on Westpac to say that this isn’t income. Westpac received some funds up front but was uncertain whether the company could keep the funds based on sales. If Kevin doesn’t buy a certain amount of books, he essentially has to give the money back.
2. North American Oil says if you receive earnings or claim of right without restrictions it is gross income, deduct at a later date. If this is an advance payment for his royalty stream he can hold it with no restrictions and do whatever he wants with the money at the present time without anticipation of giving the money back it would be gross income under NAO. If he has to give it back then he gets a deduction. Shaeffer: If it were up to me, North American Oil controls – wait until the contingency is removed or report it upfront.
Exam: Talk about both sides: Westpac and North American Oil. Remember: A circuit court will most likely favor the taxpayer. A tax court will favor the IRS.
CHAPTER 4: GAINS DERIVED FROM DEALINGS IN PROPERTY
Reg. §1.61-6(a): In general – Gain realized on the sale or exchange of property is included in gross income, unless excluded by law. For this purpose property includes tangible items, such as a building, and intangible items, such as goodwill. Generally, the gain is the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged.
AR minus AB = Gain
Amount Realized
- Adjusted Basis
____________________
Gain
§ 1001(b): Amount Realized – The amount realized from the sale or other disposition of property shall be the sum of any money received plus the FMV of the property (other than money) received.
The Amount Realized is what you sold the property for – 1001(b) the cash you received for the FMV for the property, or if you received property you include both.
Amount Realized is:
- Any cash received
- FMV of property received
- FMV for services received
- Debt relief received
Whatever you sold your property for is your amount realized and it could be from any of the above examples. Anything you receive in exchange for your property goes into your amount realized.
§ 1011. Adjusted basis for determining gain or loss
(a) General rule – The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis.
The starting point for our adjusted basis is our cost.
§ 1012 Basis of property – cost –
The basis of property shall be the cost of such property. It doesn’t measure fluxuations in value but rather measures your investment. If you increase your investment, your basis goes up.
ADJUSTED BASIS
Example:
Basis/Cost: Paid $200,000 for house in
Increase Basis: Paid $40,000 to build greenhouse attached to house
_____________
Basis: $240,000
Decrease Basis (recovered
some of your investment): Received $9,000 for lightning damage to house from insurance
______________________
Adjusted Basis: $191,000
You blow half of the $9,000 in
Basis does not measure FMV, it measures costs. You are only taxed on increase in value when realized. The Vegas money has no impact on basis. Gain is triggered when you sell.
TAX COST BASIS
Week 1 Problem
Amount Realized: $150,000 Ted sells the tether
Tax Cost Basis (Adjusted
Basis): $96,000
Gain: $54,000
$0 is an option because he didn’t pay for it. He would then have $150,000 in Gain but be taxed twice. He was taxed at the $96,000 the first time. To make sure he is taxed once, give an adjusted basis.
Tax Cost Basis: gross income inclusion plus anything you paid for it as a result of the receipt of property.
AR = $150,000
- AB = $96,000
______________________
Gain = $54,000
Desk Example
As a result for performance of services, employer sold desk with a FMV of $4,000 to employee for $100. Since this is not a bargain purchase, employee must include $3,900 as income.
One year later employee sells desk for $6,000.
AR = $6000
AB = $3900 + $100 Cost of desk or actual investment. (Gross income inclusion or tax cost basis plus costs or anything you paid for it)
Total AB = $4,000
_______________
Gain = $2,000
$3,900 is compensation for services already taxed on. We adjust the basis on the $3900 because it was already included in gross income the year it was received.
Debt
If you assume a liability or borrow money to purchase property, that becomes part of your basis. Adjusted Basis includes any debt you used to acquire property. Loan incurred in acquiring property are part of your basis, but no basis when you repay the loan (the principal) because that happened upfront.
Debt Relief
If you sell property and you have debt relieved as part of that sale, the debt relief is part of your amount realized.
Example: If you buy a piece of property for $100,000, it increases in value to $200,000, you refinance your mortgage and take out $200,000 – you have a piece of property worth $200,000 but $200,000 in debt. If some one buys the property and assumes the entire debt, the amount realized is the debt relief.
Property for property exchange
Facts: Philadelphia Park Amusement Co. (P) deeded its interest in a bridge to the city in exchange for a ten-year extension on a franchise.
Rule: Where a taxable exchange of property occurs, gain or loss should be recognized in establishing the basis for the property on the date of the transfer.
Issue: What is the basis or cost of the franchise costs? Is the basis the FMV of the bridge (the property given up) or is the basis in a property for property exchange equal to the value of the item received?
Holding: The basis in a property for property exchange is equal to the value of the property received and is established as of the date of a taxable transfer.
If you don’t know the value of one of the items in the exchange, you can assume it’s the value of the other item being exchanged. If the bridge is worth $10,000, we are going to assume the franchise rights are worth $10,000 in an arms-length exchange.
General Rules:
1. In a property for property exchange, the basis for property received is equal to its FMV at the time of the exchange.
2. In a property for property exchange, if we don’t know the value of one of the items, we will assume it’s the same value of the other item exchanged.
Analysis: The amount paid for an asset is its basis. If the property is later sold for more than its original price, the taxpayer has made a taxable gain. If the taxpayer depreciates the asset over a period of time, his basis is reduced to the extent of the depreciation deductions. If the property is exchange for other than cash, the adjusted basis is the value of the property received, plus any gain which was taxed to the taxpayer as a result of the transaction. If a loss was taken, the adjusted basis is the value of the property received.
Problems P 79
2.
(a) Maggie’s basis in the summer home is $500,000. We get credit up front for the amount borrowed.
(b) Loan payments will not cause the investment to go up because she already got credit for that up front.
3. Revenue Ruling 79-24: If you provide services at a stipulated price, we are going to assume that property received is equal in value to that stipulated price (similar to
Claire Liz
Year 1 AR: $5,500 (Debt relief or compensation for services) Gross Income: $5,500
AB: $100 (costs, not the value of your services)
Year 5 Sells painting (AR minus AB = gain)
AR: $10,000
AB: $5,500
Gain: $4,500 (appreciation in value)
4.
(a)
Katie Patrick
FMV $450,000 FMV: $450,000
AB $150,000 AB: $50,000
AR: $450,000 (what she received) AR: $450,000 (what he received)
AB: $150,000 AB: $50,000
Gain: $300,000 Gain: 400,000
(b) When you dispose of multiple assets, figure out gain or loss on each asset individually because (1) there is a potential that if you sell multiple assets, some of those assets to have losses and some will have gains. If we commingle or combine our basis and amount realized, we are allowing the losses to be absorbed against the gains and not all losses are deductible. (2) There are limitations on the amount of losses we can take.
Example: You buy three items at the grocery store totaling $10 – 1 item worth $5, 1 item worth $3, and 1 item worth $2. You didn’t pay $10 for any particular item; you paid $10 for all three. We split the items based on the value we gave up (see below). Figure out your gain or asset on each item individually.
K P
FMV AZ land $500,000 FMV NV land $450,000
AB $150,000 AB $50,000
Cash FMV $50,000
AR $450,000 + cash $50,000 = $500,000 AR $450,000 + $50,000
AB $150,000 cash = $500,000
AR $50,000
Gain $350,000 AB $50,000
Gain $0 Gain $400,000
We allocate $50,000 to the AR for the cash, and the other $450,000 is our AR in the land. We take our AB for each one – $0 gain for cash and P’s AB in the land was $450,000, therefore $400,000 of gain in his land.
Exam: You cannot combine altogether because there may be losses built into the combination that are not deductible.
P’s basis in K’s property is $500,000 – the FMV (Philadelphia Park).
Week 2 Handout
When you receive a piece of property and it’s subject to a debt, minus the FMV from the debt to get net value.
LIFE INSURANCE
§ 101. Certain Death Benefits
(1) General rule – Except as otherwise provided in paragraph (2), subsection (d), and subsection (f), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. (no distinction between term or universal life policies).
Term Life: pure insurance.
Universal Life: investment component.
Policy: Encourage people to provide for their loved ones and it’s a poor time to be taxing someone.
Cashing Out the Policy
If you cash out a policy, it is not a result of the death of the insured; therefore taxable as gross income.
§ 72: Take the proceeds minus the total consideration for the policy which is all of your premium payments. (Amount Realized minus Basis).
Example: Cash in policy and receive $10,000 of proceeds but paid $8,000 in premiums – report $2,000 of gain.
§ 101(g) Treatment of certain accelerated death benefits –
(1) In general – For purposes of this section, the following amounts shall be treated as an amount paid by reason of death of an insured:
Terminally ill (requires doctor certification); or
Chronically ill (cannot perform certain life functions).
Payments on the life insurance policy as a result of being terminally or chronically ill is treated as payments made as a result of the death of the insured.
Transfer-for-value Rules
When terminally or chronically ill, you can sell your policy to a third party and not report the income as a gain or loss (they normally don’t pay the full amount). However, the third party (or purchaser for value) has to pay taxes on the proceeds from the life insurance policy. § 101(2) provides transfer-for-value rules. Take the amount received in the policy minus total consideration for the policy (purchase price plus any premium payments) and determine loss or gain.
Substance Over Form (a reoccurring theme in this course)
Insurance Example: someone sells a business and buyer makes payments over time. Seller may get nervous if buyer dies so seller may require buyer to get an insurance policy to cover unpaid purchase price. If buyer dies, the policy pays the seller. In form it’s a death benefit, but in substance it’s not – it’s part of your purchase price. (AR minus Base to get Gain). Using insurance proceeds to pay for property, wages, etc. is taxable as income.
Any Earnings on the Death Benefit Have to be Reported
Example: Insurance company tells beneficiary to wait an extra year and pays $1.2 million instead of $1 million, tax the $200,000 and exclude the $1 million.
If death benefits are paid out over time, use the Annuity Formula to figure out what portion of the payment is a death benefit and what portion is earnings.
Problems P 145
2. No tax consequences.
3. No tax on death benefit but a tax on earnings
ANNUITIES
· “A payment over time” or “an investment”
· A return on just the investment is tax free, earnings however are subject to tax.
How to Calculate Earnings – Exclusion Ratio
We pro rate our investment over the payment period. This is done with Exclusion Ratio
Exclusion Ratio
Payment X Investment = amount excluded
Expected Return
X_______________ = amount excluded
Problems P 152
Problem 1:
$1,000 (payment) X $5,000 (investment) = $500 (amount excluded)
$1,000 X 10 years = $10,000
We can exclude $500 because that is his return of his investment. We tax the other $500 as earnings on gross income.
Problem 2: – Use chart on page 526 of code book
$1,000 for rest of life (28.6 years) X $10,000 = $349.00 (349% of $1,000)
$1,000 X 28.6 = $28,600
Problem 3: If you have an annuity policy based on your life and you die prior to life expectancy being reached, you can deduct the un-recovered investment. Here, $349.00 was the only part of a return of investment. The other $651.00 is taxable gain ($349.00 + $651.00 = $1,000). $349.00 X 3 = $1,047 can be excluded.
Problem 4: After 28.6 he has fully recaptured his investment, everything after that is fully included in gross income.
Problem 5: Use handout chart – 33.6 years
GIFTS
Fn. 6 P 105: A gift is a transfer of property made for personal as distinguished from business reasons.
Oprah handout Week 3
§ 102. Gifts and Inheritances –
(a) General rule – Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
§ 102(b)(1) The income on the gift is not excludable. In other words, if you give stock as a gift, you can exclude that from income; however any dividends are taxable gain. If you sell the gift any gain received is not excludable.
§ 102(b)(2) A gift of income is not excludable.
The Supreme Court said that we look to the donor’s intent. A trier of fact is supposed to look at the human conduct. Here, the intent of the trip was a gift. We are to look to see if it’s detached and disinterested from any moral or legal obligation or intent to benefit in the future.
Oprah is “buying” goodwill and promoting her brand, show, etc. Oprah’s gifts are more akin to prizes and awards. The recipients have to include the FMV of the items received as gross income.
Commissioner v. Duberstein (Supreme Court) (1960)
FACT SUMMARY: Duberstein (P) was given a car by a business associate but did not declare the car as taxable income, deeming it a gift.
· Berman declared the Caddy as a deduction
· We are less likely to find gifts in a business setting
RULE OF LAW The determination as to whether transferred property constitutes a gift requires an analysis by the trier of fact of all relevant factors.
A gift in the statutory sense proceeds from a “detached and disinterested generosity, out of affection, respect, admiration, charity, or like impulses.”
· Look to the intent of the donor
·
Wolder v. Commissioner (1974)
FACT SUMMARY: Wolder (P) agreed to render legal services to a client without billing for them in exchange for money and stocks bequeathed to him in her will.
RULE OF LAW: While gross income will generally not include property acquired by gift, devise, or bequest, where such property is received for the purpose of payment for services performed, it becomes taxable income.
· The intent was compensation for services
Olk v. Commissioner (1976)
FACT SUMMARY: Olk (P), a craps dealer, claimed that monies known as "tokes" given to him by players at the casino were nontaxable gifts.
RULE OF LAW: Receipts by taxpayers who are engaged in rendering services that are contributed by those with whom the taxpayers have some personal or functional contact are taxable income when in conformity with the practices of the area and easily valued.
Goodwin v.
FACT SUMMARY: The Reverend and Mrs. Lloyd L. Goodwin (P) contended that "special occasion gifts" made to them by members of their congregation were nontaxable gifts.
· The intent was to be detached, out of generosity, etc. but it doesn’t carry the day
· The gifts were regular and habitual which hurt positions of gifts
· The taxpayer provided services
· The amount given every year for birthday was $15,000
· No bright-line rule that people you provide services to can’t give you gifts
RULE OF LAW: Regular, sizable payments made by persons to whom the taxpayer provides services are customarily regarded as a form of compensation and may be included as taxable income.
§ 102(c) Employee gifts –
(1) In general – Shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.
Gifts (continued)
§ 102 provides that gifts are excludable from gross income. We are not deducting it, rather we are not including it in income in our return. If we receive $100,000 as a gift, we simply do not report it.
Test For Gifts
Gifts come form detached and disinterested generosity out of admiration, respect, and similar impulses. To be detached and disinterested means you don’t expect anything in return. Duberstein said we look at the intent of the donor at the time of the gift to see if it is detached and disinterested and the trier of fact makes that determination. In Duberstein, the tax court said it was not a gift and the Supreme Court said it was not going to overturn the findings of the trier of fact (Tax Court) unless it was clearly erroneous.
Intent of the donor is examined objectively based on all the facts and circumstances.
In the Wolder case (inheritance case), the court looked at substance over form. Clearly the deceased was making the transfer out of some legal obligation; therefore, not detached or disinterested. In substance it was compensation for services and in form it was inheritance and substance controls.
Basis Rules
If you are a recipient of a gift, what is your basis?
We care what our basis in a gift is because we might sell it someday. 102(b)(1): income on a gift is not excludable from gross income. If you sell at a gain, that gain must be reported. We need to know what our adjusted basis is.
Inheritance
Our basis rule for inheritance is FMV at the time of death – IRC § 1014(a).
Appreciated Property Example: Someone is going to want to transfer a piece of property before he or she dies. Someone bought the family farm in 1919 for $2,000 and now it’s worth $1M and the purchaser wants to give the property away. When you give property away the recipient’s basis is equal to the transferor’s basis – in this case $2,000. If it’s transferred in a will, the basis is $1M – the value at the time of death. Death wipes out gain and is never reported. If we have appreciated property we are better off passing it off in our will.
Loss: If the land was purchased for $1M and is now worth $500,000, the recipient’s basis is $500,000. The FMV rule also wipes out losses.
What should we do if we are in that situation?
Sell the property and give the person the proceeds. Trigger the loss before you die by the sale and give the proceeds away.
Gifts
Rule: If you receive a gift, your basis in that gift is what Donor paid for it – transfer basis. The donor’s basis transfers to the donee. In a gift setting, the donee takes the basis equal to the donor’s basis in the property.
Example: Grandma has a family farm that she paid $2,000 for, and now is worth $1M. If she makes a gift of that property to you, your basis is $2,000. The gain goes to the donee. It shifts any built-in gain from the donor to the donee. If the donee sells the property with a basis of $2,000, the donee is going to trigger all that gain. The transfer of gain from one taxpayer to another is recognized by Congress as long as someone picks up that gain.
Losses
Special Rule for purposes of determining loss:
· Donee’s basis - if donor’s basis is greater than FMV at time of gift, the donee’s basis shall be FMV at time of gift.
· Under the exception for determining the donee’s basis, can unrealized losses be shifted from the transferor to the transferee?
Policy: to prevent the shifting of loss to another taxpayer. You cannot shift the loss to someone else so that he or she can utilize the loss on his or her tax return.
Shifting of Losses: This is an exception to the general transfer basis rule when the FMV of the property is less than the donor’s adjusted basis. We determine the donee’s loss as the FMV at the time of gift. Two conditions must be met:
1. The donee has to sell the loss. If the donee sells at a gain, FMV does not apply, we use carry-over or transfer basis rule.
2. There has to be a loss. The FMV of the property at the time of gift must be less than the donor’s adjusted basis at the time of the gift.
Donor Donee Donee Sold
100 80 70 AR 70
AB FMV <10> not 30 - 80
- 10AB
We denied $20 of loss. We allow for the deduction of the loss during donee’s ownership – in this case, $10. No deduction for the $20 of loss that occurred during the donor’s ownership.
Donor Donee Donee Sold
100 Loss 70 105 less 100 = 5 gain
AB FMV AR
When the exception produces a gain (there is still a transferred loss between donor and donee) when the donee sells the property, and there is a gain under the exception, you report no gain, no loss. The exception isn’t there to create bigger gains; it’s there to prevent the shifting of losses. You never get the donor’s loss.
For the exception we use the FMV.
Part-Sale, Part-Gift
1.1001-1(e)
· Donor has gain to the extent the AR exceeds AB
· No loss is recognized
· 1-1015-4 Donee’s basis is the greater of the amount donee paid for property or the AB of the donor.
Usually occurs when there is a sale of property for less than FMV and is a common transaction between family members and close friends. The difference between FMV and the amount you sold it for is a gift. Courts will look to see if donor was actually intending the discount to be a gift.
What are the tax consequences? Loss – no deduction. Gain – gross income
The seller does not take a loss deduction; however, if donee sells property for more than he or she paid for it, donee will have to report the gain. The seller cannot take a loss deduction when intentionally sold at a loss.
How do we determine donee’s basis?
It’s the greater of the donor’s adjusted basis (gift basis rule) or the cost (purchase price basis rule). You benefit either the donor’s basis or your cost, whichever is higher.
Problems P 93
1. Carol – legal assistant
Lucille – attorney
§ 102. Gifts and inheritances –
(a) General rule – Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
§ 102(c) Employee gifts –
(1) In general – Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of an employee.
Any property you receive from your employer under § 102 is not excludable from gross income. If there are other parties involved, we need to know what their objective intent is.
2. The form is clearly compensation for services. As far as a gift is concerned, the most we could get is the $15,000.
3. B R
AB AB
60 60
Ask your client to get an appraisal at the time of the gift.
Not adjusted for inflation
4. § 1015 when we have employee-employer relationship which are also family relationship, we can have an excludable gift as long as we can show that was the intent.
5. Donor Donee Donee Sold for 30
60 45 30 -15 Get to deduct
AB FMV AR AB
Donor Donee Donee sold for 55
60 45 55 10
AB FMV AR AB No gain, no loss rule
6. Part sale, part gift. If the seller has a gain, must report as income.
8. FMV at the time of death. The $90,000 in gain is washed away – the government never gets a piece of it.
Prizes and Awards
§ 74 – General rule – an award is included in gross income
Exceptions:
· Transfer to Charity 74(b)
· Employee achievement awards 74(c)
§ 74(b) Exception for certain prizes and awards transferred to charities – Gross income does not include amounts received as prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, but only if:
1. You took no action to receive the reward;
2. No obligation to provide future services as a result of receiving the award;
3. The award must be received for one of the listed items (religious, charitable, scientific, educational, artistic, literary, or civic achievement);
4. The award must be transferred to a designated charity or government agency before the recipient gets use of the property.
§ 74(c) – Exception for certain Employee and Achievement Awards
Must be based on:
1. Safety or length of service record;
2. Has to be tangible property (not cash);
3. Can only exclude up to $400;
4. Must be part of a meaningful presentation.
Scholarships
§ 117 General rule – Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization.
Qualified tuition: (required tuition, fees, books, and equipment for required course of study).
What is not included: room and board. If the scholarship is an exchange for past, present, or future services, it is not excludable under §117
Problems P 131
1. Joan: She must include FMV of property in gross income. Realization (loss or gain) is only an issue after you take ownership and sell it. $1,600 is the AB for both Joan and Ted.
Ted: $1,600 AB, $1,200 AR – loss of $400. The AB is the tax-cost basis for awards of property.
4. $10,000 is income because it is room and board. You could argue that the scholarship is based upon future performance therefore making it gross income; however, Revenue Ruling 77-262 basically provides that scholarships are excludable from gross income under §117.
5. If the scholarship is not dependent upon her taking the job then it’s excludible from gross income. If the scholarship is dependent upon her taking the job, it’s included in gross income.
Debt relief is included as income because the benefit we receive is our net worth goes up.
The reasoning in Kirby Lumber has been called the “freeing-of-assets” theory. Under this theory, a taxpayer realized gain when a debt is discharged because after the discharge the taxpayer has fewer liabilities to offset his or her assets.
Exceptions
Insolvency § 108
Insolvency – We our insolvent when the extent of our liabilities exceeds the FMV of our assets. If you receive debt relief while insolvent, you can exclude the debt from income. Discharge of indebtedness will not generate gross income if the discharge occurs when the taxpayer is insolvent. However, the exclusion for insolvency is limited to the amount in which the taxpayer is insolvent. The insolvency exception only applies when we are insolvent. Any amount not included in insolvency has to be reported as income.
Bankruptcy § 108
Bankruptcy – Discharge of indebtedness does not result in gross income if the discharge occurs in a title 11 case (bankruptcy proceeding). No insolvency test – insolvency and bankruptcy are two separate exceptions.
Disputed Liabilities
Disputed Liabilities – Settlement of a disputed liability does not result in debt discharge income.
Disputed Legal Fees Example: discharge of liability or reduction does not result in gross income
Purchase-Money Debt Reduction § 108(e)(5)
· Debt reduction by the seller of property owed by the purchaser does not result in gross income if the debt arose out of the purchase of such property.
· Does not apply to bankruptcy or insolvency.
A purchaser who buys property from the seller and the seller also serves as the lender. If the debt associated with the property is reduced, it is treated as a reduction in purchase price rather than debt discharge which means no gross income.
Reducing purchase price will reduce your basis. This will cause your basis to go down which may have consequences when you sell it.
Substance over Form
If we are insolvent we can exclude debt relief from gross income; however, compensation for services while we are insolvent, we must include the compensation in gross income. Same with bankruptcy.
Example: Bob borrows $40,000 from his parents to go to law school. His parents forgive the debt to Bob as a graduation gift. Does Bob have gross income? The intent of the gift governs.
Debt Discharge as a Medium for another form of payment – Revenue Ruling 84-176
ISSUE: Is the amount owed by a taxpayer, that is forgiven by a seller in return for a release of a contract counterclaim, income from discharge of indebtedness and thereby subject to exclusion?
RULE: “Debt discharge that is only a medium for another form of payment (such as a gift or compensation for services) is treated as that form of payment rather than under the debt discharge rules.”
Gehl v. Commissioner (1995)
FACT SUMMARY: Gehl (P) conveyed farmland by deed in lieu of foreclosure. The court found that the taxpayers received a gain includable as gross income from the transfers of the farmland.
RULE OF LAW A transfer of property by deed in lieu of foreclosure constitutes a "sale or exchange" for federal income tax purposes.
HOLDING AND DECISION: (Bogue, J.) Yes. The Gehls' (P) transfers by deeds in lieu of foreclosure of their land to PCA in partial satisfaction of the recourse debt were properly considered sales or exchanges for purposes of Section 1001. Even though a taxpayer does not receive any cash proceeds from the land transfers, it does not mean there was no amount realized. The Gehls (P) were given credit toward an outstanding loan through the land transfer. The tax court's bifurcation of the issues was appropriate. While section 108, which grants an exclusion to insolvent taxpayers only as to income from discharge of indebtedness, clearly applies to the forgiven remaining balance of the loan ($29,412), the land transfers are not within the scope of I.R.C. Section 108 and were properly treated independently. Affirmed.
Shaeffer: The debt discharge in Gehl was being used as a medium for another from of payment. The Gehls had to report gain and it was irrelevant that they were insolvent with respect to the property.
Problems P 163
1. From Bank: debt relief.
From Employer: compensation for services
From Brother: a gift
Debt Discharge Review
§ 61(a)(12) – Debt Relief is included in gross income as it is an accession to wealth or there was a wealth increase.
Exceptions:
Bankruptcy
Insolvency: The extent to which your liabilities exceed the FMV of your assets. In other words, you have more liabilities than assets. The amount of debt relief is excluded to the extent of your insolvency.
Disputed Liabilities
The sum of disputed liabilities does not result in gross income.
Purchase Money Debt Relief
Purchase Money Relief: A buyer of property who incurs debt in acquiring property from the seller (seller is the lender), the reduction of that debt does not result in debt relief income, and instead it’s treated as a reduction in purchase price. The reduction in purchase price is not without consequences because your purchase price is your basis and the lower your basis, you will create more gain.
Debt Relief as some other form of Payment
Parents forgiving debt: Not debt relief because it was used as a medium as a gift. The gift rules would apply.
Problems P 163
2.
(a) If you have a judgment against you, it still can be a disputed liability – as long as all the options to appeal are over. It is still a disputed liability; therefore, not gross income.
(b) No exception apply therefore the debt relief is income.
(c) K owes 3rd party $19,000, K’s parents buy the note for $10,000 ($9,000 less). §108(e)(4): If a person related to the debtor acquires the debt, it’s treated the same as the original debtor. If mom and dad buy K’s debt for $10,000, K will have to include the debt relief as income. When they forgive the debt to K, it’s a gift.
4. Irrelevant that he’s insolvent. He’s getting paid for his services. There is no insolvency exception for compensation for services.
Business or Property Damages
We ask, “in lieu of what were the damages awarded.” If the damages were lost profits, profits are income; therefore, we must include the damages received as income. We look to what the damages are replacing.
Example: I smash into your car. I pay you $30,000 for damages to car. The $30,000 is in lieu of the car. We look at AR – AB.
I smash into car, cause $2,000 worth of damage. I pay $2,000 to fix car but instead you keep money instead. The amount received does not exceed basis; therefore, do not report gain, you are recovering some of your investment and it is reflected in the basis.
Personal Physical Injuries or Sickness
§ 104(a)(2) excludes from income any damages received, whether by suit or agreement, as a lump-sum or periodic payment, on account of:
1. Personal physical injuries or physical sickness; and
2. The damages are received through prosecution or settlement of “tort or tort type rights.”
Lost Wages
Commissioner v. Schleier: As long as the damages are a direct result of those personal physical injuries and a tort claim, we can exclude even lost wages. If you miss work as a result of that injury on tort claim, you can exclude lost wages as income.
If you fail one of those elements, you lose and § 104(a)(2) doesn’t apply and you will have to include damages as gross income.
Emotional Distress
Amounts received under emotional distress on their own do not result in an excludable payment. The only time payments for emotional distress are excludable are when they arise out of personal physical injury of a tort claim.
Punitive Damages
The statute itself says it does not cover punitive damages. Even if related to physical injury of a tort claim, must be included in gross income.
You want to allocate your damages to compensatory damages; however, the court doesn’t have to respect your allocation. The court will look to the facts. Try not to be overly greedy.
Accident and Health Insurance
Two types:
1. Purchased by the employer; and
2. Purchased by employee.
Employer-provided Accident Insurance - § 106
Do not have to include the value of employer provided insurance in gross income because there is a code section that excludes it. The employer gets a deduction.
When the insurance provides you benefits § 105(a) provides that amounts provided shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includable in the gross income of the employee, or (2) are paid by the employer.
Exceptions:
§ 105(b): if payment is for medical expenses or reimbursement of medical expenses, we can exclude those amounts
§ 105(c): if payment is for loss of bodily function, loss of member or permanent disfigurement, we can exclude those amounts also. Any amounts in excess have to be reported under the general rule. Any amounts for loss wages are included in gross income.
If you purchase your own health insurance, all amounts received under that policy are excluded from gross income even lost wages.
Problems P 181
1. $150,000 of lost profits is taxable; therefore, included in gross income. $350,000 in lieu of AR 350,000-AB 200,000=$150,000 gain.
2. See book
3. $500,000 is taxable income as it did not derive from a physical injury and a tort
Rule of Deductions: we only get a deduction for those expenses in which a code provision specifically authorizes each deduction we take.
Generalizations
1. Most personal expenses are not deductible, i.e., rent, utilities, etc. We get to deduct losses incurred in a trade or business.
2. Generally only get deductions for expenses we use up during the year. Example: buy a truck for trade or business – it’s going to last more than a year; therefore cannot deduct expense all at once but rather deduct over time.
Welch v. Helvering: payments made merely out of a sense of moral obligation are not deductible from gross income. Goodwill purchased over time is not a necessary expense. It was not customary or expected for someone in the grain business to pay a third party.
Jenkins v. Commissioner: expenditures to a third party are deductible under § 162 if the payments were made primarily with a business motive and if there is sufficient connection between the payments and the taxpayer’s trade or business.
Deductions that are allowed – § 162
Business Expenses § 162: Elements (ONE PIA)
· Ordinary (customary and expected in that line of business) and
· Necessary (appropriate and helpful to that business – court relies on the judgment of business person unless the expense seems personal in nature)
· Expense (life less than one year – has to use up in one tax year)
· Paid or incurred during the taxable year (timing)
· In carrying on (business must be operational – your doors are open for business)
· A trade or business (continuous and regular activity that is not a hobby)
If you pay to promote your business and it’s an ordinary and necessary expense of that business, we can deduct those expenses.
Reasonable Salary
Only reasonable salaries may be deducted. For salary: what an independent investor would pay in the same or similar circumstances. Would a similar employee receive a similar wage, similar education, etc?
Clothing
Test for clothing to be deductible:
1. Required to wear distinctive clothing;
2. The attire must not be suitable for ordinary wear outside of work; and
3. Must not wear attire outside of work.
The deduction is designed for nurses, police officers, firefighters, etc.
Carrying On
Expenses incurred while not operational are not deductible under § 162; however, § 195 allows you to deduct start up costs. These are expenses that would normally be deducted under § 162 except for they carrying on element is not met. It still has to be ordinary, necessary expense paid during the taxable year.
§ 195 allows you to take a deduction for the first year you open your business equal to the lesser of your costs, start up costs, or $5,000. That means if your start up costs is $5,000 or less, you can deduct it all in the first year under § 195. If your start up costs are $3,000, you get an immediate deduction. Once your start up costs exceeds $5,000, the excess over $5,000 have to be spread out over 180 months. If your start up costs exceeds $50,000 you have to reduce your $5,000 deduction to the extent those costs exceed $50,000 (the excess).
Higgins v. Commissioner (Supreme Court) (1931)
FACT SUMMARY: Higgins (P), who employed individuals and incurred substantial expenses incident to managing his properties and investments, sought a business deduction for salaries and expenses.
ISSUE: If an individual hires employees to aide in the management of properties and personal assets, are those salaries and related expenses deductible as business expenses?
RULE OF LAW: While the determination of what constitutes "carrying on a business" requires case-by-case factual analysis, salaries and other expenses incurred in the management of personal assets are not deductible as business expenses.
ANALYSIS: (Casenotes): Surprisingly, there is nothing in the Code or the regulations that defines or sets guidelines for identifying what is and is not a trade or business. Given that there are no guidelines, it is also surprising to find that cases that must define trade or business are very rare. The useful reach of this particular case may, however, be limited; it most likely stands only for the proposition that management of personal assets is not a trade or business, even if done with a substantial investment of time.
Denied under § 162. After Higgins the court adopted § 212: Expenses for production of income which allows an individual to deduct all the oridinary and necessary expenses paid or incurred during the taxable year –
1. For the production and collection of income;
2. For the management, conservation, or maintenance of property held for the production of income; or
3. in connection with the determination, collection, or refund of any tax.
Engaged in a trade or business
Commissioner v. Groetzinger
Rule: An activity in which the taxpayer is involved with continuity and regularity and for which the taxpayer’s primary purpose for engaging in the activity is for income or profit.
Q & A Starting Week 8 from 1:00 to 2:00
Review
· Gross income minus deductions brings us to our taxable income
· The more deductions, the lower taxable income
· Deductions are a matter of legislative grace, meaning we need a code section to authorize and tax deduction we take.
· Deductions are covered under three major topics:
1. Expenses
2. Appreciation
3. Losses
· Generally, personal expenditures are not deductible (gas, rent, movies, etc.)
· Most expenditure deductions relate to trade or business activity or investment activity
Example: The 1040 flag on the yacht in line with the attorney’s tax business. He deducts the costs of the yacht as a business expense. The court held that it looks like a personal expense therefore requiring him to justify his expense as appropriate and helpful, necessary, etc. – the elements of § 162. Since the flag was not necessary he failed one of the elements; therefore, no deduction. Must meet all elements of § 162 in order to deduct.
Carrying On
The business is operational and your doors are open for business.
Expenses for start up costs (training, advertising, etc.) do not apply under § 162; however, § 195 may apply to those expenses.
In a Trade or Business
It has to be a continuous and regular activity, which is not a hobby, for the purpose of generating income for profit.
Higgins case: In order to get a § 162 deduction, the court is going to look at all the facts and circumstances to determine whether or not you are in a trade or business. Managing your own investments is never a trade or business. After Higgins, Congress adopted § 212 which allows deductions for managing investments business expenses.
Groetzinger case: Losses due to betting on dog races were trade and business expenses. The court said that in order for it to be a trade or business, you need a continuous and regular activity for profit or income and it cannot be a mere hobby. The court found that Groetzinger’s activity is so regular and so continuous that he was engaged in a trade or business.
Sheaffer: If I were the judge I would call this an addiction; however, the Court recognizes professional gambling as trade or business. Seven days a week at the dog track does seem like a little more than a hobby. He had no other source of income so it must be the intent to make income for profit even though he wasn’t very good at it. Hobby Loss Rule: If you generate a loss for five years running, the presumption is that you are engaged in a hobby and not in a trade or business.
§ 212
If we fail the trade or business requirement (not continuous and regular), but we still have an intent to make a profit (like an investor) we will look to § 212.
§ 212. Expenses for production of income –
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year –
1. For the production of income;
2. For the management, conservation, or maintenance of property held for the production of income; or
3. In connection with the determination, collection, or refund of any tax
Property owner Example: Paying someone to mow the lawn is a cost associated with production of income. Trade magazines, advertising, bulletins, etc. are typical § 212 expenses.
§ 195
Carry-on Element
§ 195. Start-up Expenditures
Start-up Expenditures Definition: Any amount, paid in connection with investigating the creation or acquisition of an active trade or business, or creating an active trade or business or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.
If we meet all the elements of §162 except for the carrying on element, § 195 allows us to elect to take a deduction for the first year and spread the rest of the costs over time.
We can deduct all the start-up costs up to $5,000.
See § 195 Handout.
§ 195(b)(1)(A)
(i) $53,000 or
(ii) $5,000
If your start up costs exceeds $50,000, you have to reduce by $5,000. This phases out your $5,000 deduction. In order to qualify for a “small business”, you have to spend less than $50,000 for start up costs. If you spend over $50,000 you are no longer a small business and therefore must phase out $5,000.
$53,000 (start-up costs)
- $50,000 (amount allowed)
$3,000 (excess – costs exceed $50,000 by $3,000)
Since there is an excess, we reduce our deduction by the excess amount ($3,000).
$5,000
- $3,000 (excess)
$2,000 deduction under (b)(1)(A)
Al can deduct $2,000 for start-up costs for his ice cream store.
If the start-up costs were $55,000, your $5,000 deduction would be totally phased out. Congress doesn’t think you are a small business person at that point and they don’t want to help you anymore.
§ 195(b)(1)(B)
Under (b)(1)(A) the amount un-deducted was $51,000 ($53,000 - $2,000 deduction)
Take the remainder ($51,000) and spread it out over 180 months (15 years).
$51,000 / 180 = $283 (amount per month we can deduct for the remaining 180 months)
$283 X 5 months (Al started in August) = $1,416.66 (deduction for first year)
Total deduction is $3,416.00 ($2,000 + $1,416.66)
If start-up costs are over $55,000, you are stuck with dividing the whole amount over 180 months.
Problems P 241
1.
(a) Daughter gets bigger bonus. Salaries are § 162(a)(1): reasonable salaries generally are a business expense. The IRS will look to see if amount is the same a third party would receive. The extra $10,000 in bonus would have to be tied to her performance. If we can’t show that the IRS is likely to re-characterize the $10,000 in a substance over form analysis that it actually is a gift.
(b) Corporations are separate legal entities. People try to disguise dividends as compensation.
2.
(a) Moral obligation argument vs. promotion and protection of business argument. Welch case vs. Jenkins case. If you pay the loss of someone else to protect or promote your own business, then it is ordinary and necessary – customary and expected in that line of business. (Jenkins or Twitty case).
(b) Run thru § 162 analysis:
Is it Ordinary: Is it customary and expected? Are transportation costs ordinary and expected?
Is it Necessary: Is it appropriate and helpful? Normally rely on business judgment rule (
4. It is not distinctive attire. To qualify, it cannot be suitable for outside wear and cannot wear it outside of work. This is for uniforms for such people as nurses, police officers, firefighters, etc. and the farther you get away from those professions the harder it is to deduct the expenses. These are personal expenses in maintaining your wardrobe (Pevsner case – the court will look objectively. The court held that dress clothes are not distinctive enough even though you lead a simple life.
5. $5,000 advertising
$5,000 rent
$6,000 wages
$3,000 training
Total: $19,000
Cannot deduct under § 162 because he is not carrying on yet, he is in the start up phase. In order to take a deduction under § 162 his doors need to be open for business. Under § 195(b)(1)(A) he would be able to make the deduction if he meets all the requirements of § 162 except for the carrying on requirement. The purchase of the franchise of $500,000 will not be a § 162 expense because it is not an expense – it provides a benefit longer than one year. He would be allowed to deduct the start up costs under § 195(b)(1)(A) for the first $5,000. Under § 195(b)(1)(B) he would divide the remaining $14,000 ($19,000 - $5,000) over 180 months or $77 each month.
6. § 162 would not work here as this is not a trade or business (Higgins); however, he could take a deduction under § 212 for the production of income, or for tax preparation and advice. He can deduct the WSJ if he is using it for his production of income activity. Caveat to § 212: The expense has to be incurred for taxable income. Tax free bonds = no deduction.
Business Interest
This is interest that you pay. If the interest is incurred under your trade or business activity, or your investment activity, the interest is deductible.
Example: take out a line of credit for payroll, the interest expense is deductible. Borrow money to make an investment, the interest on that loan is deductible.
Personal Interest
Interest on credit cards is generally not deductible. An auto loan for personal use is not deductible.
Exceptions:
Interest on student loans is deductible to a certain extent
§ 163(h)(3) Qualified Residence Interest
Interest that arises from a debt on a loan that is secured by your residence – Two types:
1. Acquisition indebtedness: Debt incurred in acquiring, constructing, or substantially improving a qualified residence that is also secured by such residence (the house is secured by the mortgage). The interest on that loan is deductible. You can have up to two qualified residences – your residence and a vacation home. Limit: You can only deduct the interest on debt up to $1M.
2. Home equity indebtedness: Any other debt secured by the qualified residence. Limitation: The aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000. If your debt exceeds the value of your house, it’s not really secured by your house then.
Problems P 511
1.
(a) Deductible
(b) Not deductible – personal. However, if you borrow using a home equity loan – deductible
Charitable deductions are really personal expenses, but what Congress allows us to do is subsidize those causes which we think are worthy to donate to as long as it is a qualified recipient and a gift.
Requirements
1. Contribution (a detached or disinterested gift)
2. Qualified recipient (see below)
3. Actual payment
4. Subject to certain limitations.
Qualified Recipient
·
· States or political subdivisions
· Religious, charitable, scientific, literary, education organization
· Cannot be an individual (
Brother-in-law’s painting example: If you get something in return for your charitable donation, it is not a gift; therefore, no deduction unless it is de minimis in nature.
Hypo: If pay more than the value of what we receive, the excess may be a charitable contribution (Revenue Rule 83-104). Paying $1,000 for something that is worth $50 as a donation – look to the Duberstein standard – look at intent of donor. If the intent that the excess be a donation or a gift, then it is deductible but you must satisfy the intent requirement. You cannot expect a quid pro quo.
Special Rules
· No deduction for services (but can deduct costs associated with providing your services)
· If property would generate ordinary income, can only deduct the basis
· If property would generate Long Term Capital Gain and will not be used by organization for exempt purposes, can only deduct the basis
RULE: Taxpayers may claim deductions for charitable contributions only if the money goes directly to the organization or to trusts or foundations.
Shaeffer: The Court is trying to prevent misuse of charitable deductions as a slippery-slope argument because the
Capital Asset/Expenditure
· Significant benefit beyond one year
· Acquisition costs
· Defending or perfecting title
· Cost of constructing an asset
· Replacement or improvement (v. repair)
· Entering a new line of business (v. expansion)
· Billboards, signs, etc. (v. other advertising)
· A separate and distinct asset that has a life beyond one year (Lincoln Savings case)
· A expenditure that produces significant benefits that extend beyond the tax year in question (INDOPCO case)
Congress has denied a deduction for capital expenditures.
INDOPCO v. Commissioner (1992)
FACT SUMMARY: The Court affirmed that consulting and legal fees incurred by a company in deciding whether to accept another company’s friendly takeover bid provided a long-term benefit and therefore had to be capitalized.
Shaeffer: INDOPCO is really just a guidepost. Certain expenditures, even though they provide a benefit beyond a given tax year, are currently deductible. Example: employee training costs. Hopefully you incur that cost just once. If the employee provides the service for a number of years, then the benefit is beyond a given tax year. If we strictly applied INDOPCO, that training would have to be capitalized (nondeductible).
Acquisition Costs
Example: Purchase of a building is a capital expenditure (it provides a benefit beyond the current tax year).
What about the fees and costs associated with acquiring that building? Rule: costs incurred while acquiring a capital expenditure also are capitalized (can’t be deducted and become part of the basis of the asset). Example: Building costs $100,000. Realtor expenses are $6,000. Total basis: $106,000.
· If you dispose (sell) a capital expenditure, those costs are also capitalized (added to your basis)
· If we increase our basis we reduce our gain which is just as good as a tax deduction
· Legal fees associated with title have to be capitalized
· Discarding a capital expenditure can be deducted right away (can deduct the cost of the service for removing an old sign)
Repair and Improvements
Example: Hole in roof and you fix four shingles. Under INDOPCO, we should capitalize it. However, we throw out the INDOPCO test because almost every maintenance project will benefit for over one year. We use four factors (see below) to determine whether something is an improvement or maintaining the property.
Midland Empire Packing Company v. Commissioner (1950)
NATURE OF CASE: Appeal from Commissioner's (D) decision holding that the oil-proofing of a basement was a capital improvement.
FACT SUMMARY:
RULE OF LAW A structural change which does not increase the useful life or use of a building and which is the normal method of dealing with a given problem is a "repair" for tax purposes.
ISSUE: Should a structural change which does not add to the life or use of a building, and is the normal manner of dealing with a specific situation, be capitalized or immediately deduct it?
HOLDING AND DECISION: (Arundell, J.) No. A repair merely serves to keep property in an operating condition over the probable life of the property and for the purpose for which it was used. It adds nothing of value to the property, merely maintains it. Section 162 permits deductions for ordinary and necessary business expenses. While the Commissioner (D) concedes that the oil-proofing was necessary, he claimed that it was not an ordinary expense. Ordinary does not mean that an expense must be habitual. It merely requires that, based on experience, the expense would be a common and accepted means of combating a given problem. Here, neither the life nor use of the basement was changed. Certainly oil-proofing is the normal means of combating oil seepage. The fact that the problem did not exist for 25 years is not determinative. Once it occurred, Midland (P) dealt with it in a normal and acceptable manner. The oil-proofing was a repair rather than a capital improvement. The Commissioner's (D) decision is overturned.
Shaeffer: If the Court says it’s a repair, then it’s a deductible expense. If the Court says that it’s an improvement, then we have to capitalize it. If you maintain the building for normal operations, that will be treated as a repair. An improvement will fall into one of the four categories:
1. Adds substantial value to the property
2. Prolongs the useable life
3. Adapt the property to a new or different use
4. Be part of a general rehabilitation project
Mt. Morris Drive-In Theatre Co. v. Commissioner (1955)
NATURE OF CASE: Appeal from disallowance of a business expense deduction.
FACT SUMMARY: The way in which the land was cleared in building the Mt. Morris Drive-In Theatre (P) caused an increase in drainage, so a drainage system was installed under threat of litigation from a neighbor.
RULE OF LAW: In determining if something was a business expense or a capital expenditure, the decisive test is the character of the transaction that gave rise to the expense.
FACTS: Knowing the land on which it was building sloped toward one particular corner of the neighboring land owned by Nickolas,
ISSUE: Does the character of the transaction that gave rise to an expense determine whether it constitutes a deductible business expense or a capital expenditure?
HOLDING AND DECISION: (Kern, J.) Yes. The decisive test in determining if something constitutes a business expense or a capital expenditure is the character of the transaction that gave rise to the expense. Here, it was obvious from the beginning that a drainage system would be required and that until this was accomplished, the capital investment was incomplete. The cost of its construction was really a part of the process of completing the initial investment in the land for its intended use, so the transaction was a capital expenditure and gave rise to no business deduction. Decision entered for the Respondent.
CONCURRENCE: (Raum, J.) This expenditure for drainage would clearly have been capital in character if made when the theater was initially built, and that does not change simply because it was made later.
DISSENT: (Rice, J.) This expenditure did not improve, better, extend, increase, or prolong the property's useful life nor cure the geological defect. It merely dealt with that defect's immediate consequences. Thus, I cannot agree that the expenditure was capital in nature.
ANALYSIS: In a number of cases, an undetected geological defect caused problems the taxpayer had to remedy. Courts have allowed such expenditures to be treated as business expenses. The main difference in this case is that the problem was foreseeable when construction began.
Intangible Assets
12-month Rule P 291
If you purchase a right or benefit that doesn’t last longer than 12 months and the benefit expires by the end of the subsequent tax year following payment, we’ll treat that as an expense even though the benefit may last longer than the current tax year.
Capitalization is not required for amounts paid for a right or benefit that does not extend;
· Beyond 12 months from first realizing the right or benefit, and
· The end of the tax year following year of payment.
Example: You rent property from August 2007 to August 2008 – that benefit will last beyond the given tax year. The IRS will allow you to deduct that expense as long as it meets the requirements.
Expansion Cost
Example: Advertise new ice cream store in a new location. Expansion costs are not start up costs. Expansion costs are currently deductible as long as they meet the requirements of § 162. You have to currently be entered into that type of business.
If I buy a new building I cannot deduct those expansion costs because it is an asset.
Problems P 277
1.
(a) Repair vs. Improvement analysis. The IRS has said that Painting the interior or exterior of a building is a deductible expense and not an improvement.
(b) The IRS has held that fixing a few shingles is a repair. Under these facts, this is merely a repair because the roof is “new” and taxpayer is simply restoring the condition. Do the improvement analysis: Did the $12,000 add to the value of the property? No. Did it substantially improve the life of the building? No, it had a new roof before and a new roof after. Did it change its use? No. Was it part of a rehabilitation project? No. If the roof was 25 years old we would get a different answer.
(c) All of the costs (even the paint) have to be capitalized because it is part of a rehabilitation project.
(e) The maintenance agreement is an expense under the 12 month rule.
(f)
YR 1 YR 2 YR 3
Dec Feb Jan 31
Payment Benefit starts End of benefit
Cannot take a deduction in year one for fire insurance. The benefit does not end by the following year after payment; therefore the 12 month rule doesn’t apply.
Review
There are several exceptions to the INDOPCO rule:
Acquisition or Construction costs: If you purchase a building, those costs (realtor) incurred have to be capitalized. Same as if you build it.
Like acquisition or construction costs. If you purchase a building and incur costs, those costs will be capitalized.
Repair vs. improvement.
Repair=expense, improvement=capitalize. Improvement prolongs useful life, or changes use of property, or adds to renovation or rehabilitation project. and therefore the capitalization has to be expenditure.
Advertising costs are treated as expenses which are deductible are treated as expenditures.
Employee training is treated as an expense. Intangible costs that has a benefit longer than a year must be capitalized. 12 month rule, where a purchase a right or benefit and that benefit doesn’t last longer 12 months, we treat that as an expense.
Ex. Reg 55 of treasury dept. Freightway case. you had to have license to operate truck. The license was for a year but went through 2 tax years. IRS says it lasts beyond tax years although they are technically right the court didn’t allow it.
Problems P 277
g) 2 years of cleaning supplies is it an expenditure or capital expense? The starting point is INDOPCO if its a benefit lasts longer than current year then it is capitalized. P.281: Authorizing the deduction of “incidental” materials and supplies purchased during the year where no records of consumption or inventories are kept and where taxable income is clearly reflected. This is saying that if you purchase supplies and materials and it goes into the following year we are going to treat it as a deductible expense if you are not tracking those items. If we are buying supplies for 2 years then this won’t apply to us. Because there is an intentional buying of supplies for 2 years we must capitalize. If it was 1 year of supplies and the supplies carried over then the regulation would apply.
h) 6k in legal fees in successfully defending lawsuit. It is capital because if we incur legal fees associated with the title of property, it has to be capitalized. Attorney fees become part of the basis in the property/partnership. What if he is claiming quarter interest in profits not as owner but as an employee? Clearly legal fees associated with title of property have to be capitalized. What if he is claiming interest as employee? It should be deductible because it is not associated with title debts.
2. Is fee deductible? If it is ordinary, necessary, it’s an expense in carrying on trade or business – expansion costs are good enough to be deductible expenses. There is no issue with the carrying on element because she is already engaged in business. Would your answer be different if instead of owning restaurant she opened a health and fitness center and hires consultant for that? She doesn’t meet the carrying on element with respect to the health industry. What relief does she have though? She can elect to use § 195 for start-up costs.
CHAPTER 14: DEPRECIATION
3 different depreciation methodologies:
1. §168- depreciation for tangible property (MACRS)
2. §197- depreciation of intangibles
3. §167- catch-all
Capital Asset
Does the asset wear out over time?
No – expenditure not recovered against gross income
Yes – expenditure recovered through depreciation/amortization
Depreciation – groups
· Tangible personal property (i.e., ovens, desks, trucks, tractors)
· Real property (i.e., buildings)
· Intangible property (i.e., goodwill, going concern value, customer lists)
· All other depreciable/amortizable assets
§ 168 – Accelerated cost recovery system
Depreciation for tangible property
· Tangible property
· Subject to exhaustion, wear and tear,
· Placed in service after 1980,
· Used in trade of business or held for production of income
Simon v. Commissioner (1995)
FACTS: Violinist who wants to depreciate bows. What form of deduction are they taking here? Depreciation. We have a capital expenditure and we couldn’t deduct the cost but the capital expenditure wears over time depreciation is supposed to reflect the depletion in value of a capital expenditure. As you are using this thing and it is wearing out, you are to deduct depletion in value. Depreciation allows you to spread the lost value over a period of time.
What happened to the value of the bows? Since they were being used they were being worn out, but the bows have an independent value as a collector’s item so the value is going up.
RULE: The availability of a deduction for depreciation on tangible property depends on whether the asset falls within the meaning of "recovery property." Property is "recovery property" under the Economic Recovery Tax Act of 1981 § 168 (ERTA) if it is: "(1)Tangible, (2) placed in service after 1980, (3) of a character subject to the allowance for depreciation, and (4) used in the trade or business, or held for the production of income."
The IRS wants the TP to show a useful life of the item so you can depreciate accordingly. The IRS and TPs were always arguing over what the useful life was. So what Congress did was they adopted ACRS and then MACRS to determine useful life. The useful life, according to these charts, is pre-determined. You then use these charts regardless if it is a new or used asset. The court held the bows were a proper depreciation deduction. The court disregarded the useful life concept and used § 168.
The elements for § 168 are:
1. tangible property,
2. placed in service after 1980 (assume everything in this class is post-1980),
3. of a character subject to allowance (subject to wear and tear) for depreciation,
4. used in trade or business or held for production of income.
· No depreciation for personal expenditures
· We are looking for a capital expenditure that is being worn out
What are some things that are not depreciable? Land, inventory, and stocks. The rationale behind inventory not being deductible is that it is not being used or worn out as part of your trade or business. In essence, they can sit and collect dust for years and never be in service. Stuff you’re holding for sale is inventory.
The mechanics of §168 are the mechanics of depreciation in general. We are always looking for a capital expenditure being worn out as part of your trade or business or investment activity. If that is the case, we should be able to find a provision that allows us to deduct it.
Mechanics of §168
MACRS says we use a half-year convention for tangible property other than real property.
Definition of half-year convention: Regardless of when you put the property in service, you get a half-year depreciation in the year you acquired the property and also the year you sell it you get a half-year depreciation.
1. Basis (distributing your basis over time)
2. Depreciation Period (3 year property, 5 year property, etc.)
3. Methodology (straight-line: take a period of time and spread the cost out equally, double-declining balance method: twice the straight-line method – switch to whichever is more)
4. Convention when property was placed in service.
- We have 2 different types of conventions:
i. Tangible property other than real property- regardless of when you put property in use it is assumed that it was in use for half a year. As you take your depreciation deductions, your basis will go down to year by year till it reaches zero.
ii. Real property
Revenue Procedure 87-57 P 344
Each column adds up to 100% meaning, if you hold the property for its entire life, you will get 100% of your basis in the form of deductions over that period. As you take the depreciation deductions, your basis goes down by the amount of depreciate you’ve taken.
What happens if you sell your property before you fully recover your basis?
You have to use the AB that reflects the depreciation deductions, in other words, you get half-year convention in the year of sale. IRS knows what a half-year amount is in year of purchase, but they don’t know when you will sell the property. What you have to do in the year of sale is in order to figure out the half-year depreciation is to calculate a full-year depreciation and divide it by half.
Example: if we sold it in year 2 we could do it one of two ways:
1. Take our basis and multiply it by 32% and divide that full-year depreciation in half; or
2. We could simply divide our depreciation rate in half, take 16% depreciation rather than 32%
If you’re smart you make your purchases in December; however, if 40% of your costs of § 168 property (tangible property other than real property) comes in the fourth quarter (last three months of the year), we must use the Mid-quarter Convention for the Fourth Quarter. P 348
The mid-quarter table treats you as if you put the property in use at the mid-quarter of the quarter in which you purchased the property. Example:
Quarter:
1 2 3 4
$1000 $1000 $1000 $7000
Total: $10,000. 70% of total came in 4th quarter – must use Mid-quarter Tables
We generally use the half-year convention/table unless greater than 40% of our purchases cam in 4th quarter. So, we use the mid-quarter table.
We will use the first quarter mid-quarter table for first $1000, second quarter mid-quarter table for the second $1000, third quarter mid-quarter table for the third $1000, and the fourth quarter mid-quarter table for the fourth purchase of $7000. You figure out depreciation on each asset individually not collectively.
You only use the Mid-quarter tables if greater than 40% of your purchases came in the fourth quarter!
· Policy: to prevent people from making purchases at the end of the year and deducting the depreciation.
· Once you start with a table, you stick with that table for the remainder of the asset’s life. Otherwise, your column will not add up to 100%.
Problems P 309
1.
(a) Land is not depreciable
(b) Fences and sidewalks wear out, they are tangible property, are used in the trade or business, after 1980; therefore, depreciable.
(c) Same as above.
(d) Valuable antiques are subject to depreciation, used in business, can depreciate.
(e) Valuable works of are generally not depreciable; however, in a hotel, it is being used up and not clearly valuable works of art – argue both side.
2.
(a) Using the half-year table, depreciation is 20% for year one. That gives us a depreciation deduction of $40,000.
AB Depreciation
Year 1: $200,000 20% of $200,000 = $40,000
- $40,000
Year 2: $160,000 32% of $200,000 = $64,000
- $64,000
Year 3: $96,000 19.2% of $200,000 = $38,400
- $19,200
Even though the basis goes down, use the original or unadjusted basis to calculate depreciation. Policy: The IRS is simplifying the depreciation tables.
After seven years the depreciation will be $0.
(b) Once you start with a half-year convention you stick with it. If item was sold in year three, figure out depreciation for a full year and divide by half. The year the item is sold you get a half-year depreciation.
Example: Sold in year 3 – depreciation is 19.2% of $200,000 or $38,400. Then divide by 2 = $19,200. Minus $19,200 from the depreciated amount of the year in which it was sold ($96,000) to get basis at the time of sale or in this case $76,800
(c) Use Mid-quarter fourth quarter table, 5-year property P 348
(d) (1) The §179 deduction is $125,000 (the max); (2) use the deduction to reduce your basis – $125,000 - $200,000 = $75,000; (3) use any §168 deductions after your §179 deductions. In other words, use §168 to depreciate the $75,000 basis.
Using the half-year table, 5-year recovery period, 20% of $75,000 is $15,000. The taxpayer gets a total deduction in year 1 with respect to the property is $140,000. The taxpayer’s basis at the start of year 2 is $60,000. To depreciate year 2 we’ll take 32% of $75,000 (stick with the §168 basis).
4. Use the Residential Table on P 349. Depreciable amount is $1M, March is 3rd month, 2.879%
§ 179 – Election to expense certain depreciable business assets
Adopted to help small businesses
Requirements
· Tangible personal property, not real property
· Subject to depreciation
· Acquired by purchase for use in Trade or business
When we have depreciable property, we deduct over time. But § 179 was created to help small business people. It is elective. Rather than depreciating your property, you can deduct the entire cost during the first year. You can disregard depreciation. It applies to tangible personal property other than real property. In order to use § 179, it has to be tangible property that wears out and has to be acquired by purchase. For § 179 to apply you actually have to buy the property and it only to applies to property for trade or business.
Limitations
Sounds too good to be true? Well, it is.
1. Maximum amount of deduction under § 179 is capped at $125,000. Should your costs exceed $125,000, you have to depreciate the excess.
2. There is a phase-out provision here (similar to $5,000 deduction under § 195) to make sure the big companies aren’t profiting from this. The phase out starts when you purchase $500,000 of § 179 property. You have to reduce your $125,000 deduction by the amount which your § 179 property purchases for the year exceed $500,000. At what point is your deduction totally phased out? $625,000.
3. Your § 179 deduction cannot exceed your taxable income from your trade or business activity. Example: Your taxable income is $30,000. Your maximum §179 deduction is $30,000
§ 197 – Amortization of goodwill and certain other intangibles
· Acquired intangible
· 197 intangible (includes customer list, going concern value and goodwill)
· Held in Trade or Business or production of income activity
§ 197 applies to intangible property. It has to be an acquired intangible. It has to be used in your trade or business or your investment activity. If you purchase goodwill, you can depreciate it. There is a whole list of 179 intangibles.
Methodology: Straight line
Period in which you get a depreciation deduction: 180 months or 15 years. The first date of the month you acquire the intangible is where you start.
Handout Problem 3(c):
When you buy a business you pay for more than just the assets, you are also paying for its value as a going concern.
Amortization: Same as depreciation except it’s for intangible items.
Analysis
Step 1: Divide costs by 180
Step 2: Start amortization in the month acquired, multiply Step 1’s amount by number of months left in the year
Step 3: Multiply number by 12 for remaining years.
Step 4: If Step 1 was done in a month other than January, the last year will include however many months left over. Example: Purchase made in February, last year will have one extra month to calculate.
§ 167 – Depreciation
· Subject to exhaustion, wear and tear
· Spread the costs over the useful life
· Used in trade of business or for production of income
· Is a catch-all for those items that escape §§168 and 197
We are taking items that we would normally treat as an expense and we buy a multi-year supply of it. Example: fire insurance, 5-year supply of paper, etc.
Property used in trade or business subject to allowance for depreciation and you can determine the useful life of the asset and you spread your cost over the useful life. We are taking items that are used as an expense and making it a capital expenditure and using the straight-line depreciation. If you buy 5 years of paper then you are making a capital expenditure.
CHAPTER 15 – LOSSES AND BAD DEBTS
§ 165 – Losses
The only loss that can be deducted for personal type assets are casualty losses, i.e., fire, storm, shipwreck, or other casualty, or from theft.
Personal Losses
Individuals may take deductions for losses incurred in:
· Trade or business;
· Transaction entered into for profit; or
· As a result of fire, storm, shipwreck or other casualty, or from theft.
IRC §165(c)
What does it mean to have a loss?
AR minus AB. If your AB exceeds your AR, you have a loss. In other words, if you sell something for less than what you bought it for, you have a loss.
Cowles v. Commissioner (1970)
Can we convert personal property into business property?
RULE: Mere offers to rent as well as sell a personal residence are insufficient to provide the necessary foundation for the deduction of a loss incurred in a transaction entered into for profit, as required by § 165(c)(2).
He bought his residence originally to live in. He gets a job transfer and re-locates. He puts a rent sign up and the offers don’t add up and he doesn’t rent but ultimately sells for a loss. The question is was this loss deductible?
Shaeffer: The court says that merely putting up property for rent doesn’t convert personal property into for profit or trade or business property.
What did he actually have to do to convert it to investment?
In order to qualify, he actually had to rent it – the “For Rent” wasn’t good enough. The IRS conceded in this case that offers to rent furnish a sufficient basis to entitle petitioners to certain deductions with respect to “property held for the production of income” under §§ 212 and 167. In other words, if you put the property up for rent, that is sufficient to depreciate the property and take deductions associated with maintaining the property (§212). Putting property up for rent is not sufficient for for-profit property under §165.
Hypo: Let’s say we successfully convert personal property into investment property. How do Congress and the Treasury Department prevent this?
Example: Let’s say you buy a house for $100,000 but it drops in value to $70,000. Congress does not want you to take the $30,000 loss that occurred during personal ownership.
Let’s say you rent the house out and convert it into property held for profit. You decide to sell the house for $40,000. AR is $40,000 and your AB is $70,000. Congress makes you use the lesser of your AB or the FMV at time of conversion (with any depreciation reflected in it) for purposes for calculating loss. The first loss of $30,000 that occurred during personal ownership is denied. You must take the difference of AR ($70,000) minus the FMV at the time of conversion ($40,000), or $30,000. This is a lot like the rules associated with gifts. In this hypo the FMV was less than the AB of 100,000.
Example 2: What if when sold the FMV was $70,000 therefore producing a gain of $10,000? § 165 does not apply to gains.
CHAPTER 27 – LIMITATIONS ON DEDUCTIONS
§ 267 – Limitations on Losses
· Taxpayer cannot recognize a loss on the sale/exchange of property to a related party
Related Parties
· Family members;
· An individual and a corporation more than 50% percent in value of the outstanding stock of which is owned by such individual (controlling interest);
· A grantor or fiduciary of any trust.
When a related-party purchaser sells to a third party, they only recognize gain to the extent the gain exceeds the original related party seller’s disallowed loss.
Example: Mom sells stock to her son at a loss. Mom’s AB: $100, AR to son: $70 – Mom has $30 of Realized Loss. § 267 says mom cannot recognize the $30 of loss. Son sells the stock – AR: $110. Son’s AB is $70; therefore, $40 of gain. § 267 provides that when a related-party purchaser sells the asset, they only have to recognize gain to the extent that said gain exceeds the original seller’s (mom) disallowed loss. Mom had a disallowed loss of $30; therefore, son only has to report $10 of gain ($40 - $30 = $10).
If son sells at a loss – AR: $60, AB: $70, he has a $10 loss; however, mom’s disallowed loss never gets utilized. It is only used to offset gain.
Review
§ 165 allows losses from:
§ 165(c)(1) your trade or business;
§ 165(c)(2) transactions for profit not connected with a trade or business;
§ 165(c)(3) casualty losses.
What it doesn’t allow is for personal losses.
Bad Debts
Only applies to bona fide debt. This is only an issue when the borrower and lender are related. The IRS may think it’s a gift. Look for:
· A Promissory Note in place?
· Reasonable rate of Interest charged?
· Was there intent to create a loan obligation?
Bad Debt Analysis:
· Is there a bona fide debt?
· Is it a bad debt?
· Business vs. Non-business debt?
· What is the taxpayer’s basis in the debt? (bad debt deductions limited to basis)
(§ 166)
Is it a bad debt?
· Is the debt collectible or is it worthless?
· Was the debt paid off in a different form?
We can only claim a bad debt when it is uncollectible/worthless. Look for:
· Insolvency
· Bankruptcy
· Borrower skipped town
· Assets seized by creditors
Example: Loan money to brother, place the note with a sister, you charge interest, and your intent was this is a loan and not a gift. Your brother goes bankrupt. You can deduct debt that arises from a personal relationship as long as it is a bona fide debt.
P 360-362
What type of bad debt is it?
Non-business bad debts can include: (1) personal loans; or (2) investment loans, and are treated as short-term capital losses (maximum deduction is $3,000 per year unless you have capital gains to offset it).
Non-business Business
Short Term Capital Loss Ordinary Deduction
Can only deduct $3,000 per year but carry
the rest forward the following year
Non-business bad debt Example: Loan someone $100,000, he pays $20,000 in principal for an outstanding loan of $80,000. Borrower falls behind on payments but he only has $5,000 to pay you. If you can collect that over time, your debt is not totally worthless. You have to show that the whole amount is non-collectible to get a bad debt deduction. You can only take a deduction if you can show outstanding debt is totally worthless.
Business bad debt Example: $80,000 outstanding but we can collect $5,000. The difference: We can deduct the remaining $75,000 right away – we do not have to wait for the entire debt to become worthless. We are taking a partial bad debt deduction for that portion that is worthless. It is not treated as a short-term capital loss – it is an ordinary deduction.
Dominant Motive
Look at relationship of loss to taxpayer’s trade or business:
- Was loan needed to keep job?
- Was loan otherwise related to maintaining trade or business as an employee?
- Is it the dominant motive?
ISSUE: Is this a business or a non-business debt? Is it proximately related to his trade or business?
RULE: A taxpayer, attempting to deduct funds lent to a corporation as a business bad debt, must establish that the dominant motivation for the original transaction involved a business purpose.
SHAEFFER: His trade or business is that of an employee. The IRS claims this loan was made to protect his investment and therefore falls into the non-business category. The Court ultimately decides that a proximate relationship means that dominant motivation for making the loan must be tied to your business. The taxpayer must show that a loan is tied to the business as an employee of the company. The Court quickly decides that his dominant motivation was not tied to the business as an employee because his salary was $12,000 per year. Would anyone in his or her right mind put $300,000 at risk to protect a $12,000 salary? The dominant motivation was to protect his investment and since his investment activity was non-trade or business, therefore, it is treated as a short-term capital loss.
Amount of Your Deduction
The amount that can be deducted is limited to basis.
The amount of your deduction is your basis. If you loan $100,000, and you get paid back $20,000, you’ve collected some of your basis, and your basis is only $80,000.
What if you don’t loan someone cash but instead provide them with services?
The only time services result in basis is when you include the value of those services in gross income. Whether you include the value of those services in gross income will depend upon whether you are cash basis taxpayer or an accrual basis taxpayer.
Cash Basis Taxpayer Rule: Taxpayer has a gross income inclusion when he or she gets paid (receives the money). If you’ve received it, then you’ve collected your debt; therefore, it’s not worthless.
Accrual Basis Taxpayer Rule: Taxpayer has a gross income inclusion from an amount owed to him or her for their services upon the completion of the services when the amount is owed. So, even if he or she is not paid, they may have a gross income inclusion. If they have a gross income inclusion, then they have basis. If you have basis and your debt goes worthless, now you have a tax deduction.
Cash Basis Attorney Example: A client owes you $30,000 (outstanding debt). If you are a cash basis taxpayer you include that in gross income when you receive it. If client goes BK and the amount is discharged, you have a gross income of $0 – you never got paid. The taxpayer’s AB in this obligation that went worthless is $0 – never included in gross income. Even though the debt is worthless, his deduction is $0. No gross income, no deduction.
Accrual Basis Attorney Example: A client owes you $30,000. You have to include the amount in gross income even though you haven’t received the funds. Once you include it in gross income, you have an AB in that income obligation of $30,000. When client goes BK, you get a bad debt deduction equal to the basis $30,000.
With respect to bad debt deductions, the Accrual Basis taxpayer is worse off because he has essentially loaned the government money for a full year.
Problems P 352
4.
(a) Does not qualify for § 212 – Property held for profit. She has been trying to sell the property since the day she moved out, not holding the property for appreciation in value; therefore, no deduction.
b. AR $200,000
- AB $235,000
<$35,000>
Depreciation reduces your AB by either the amount you took or the amount you are allowed, whichever is greater. In the -$35,000 there is $25,000 of loss (the home went down in value during personal ownership). If we sell at a loss we apply the lesser of rule – the lesser of AB or our FMV AB with depreciation deductions. If we have a gain the lesser of rule does not apply.
FMV at time of conversion: $225,000
Adjusted for depreciation:
AR $200,000
- AB $210,000
<10,000>
The $25,000 of loss that occurred during ownership is denied. If she sells for $200,000, she gets a $10,000 loss. She bought the property for $250,000. She recovered part of the purchase price through depreciation bringing her basis down to $235,000. If she sells for $225,000, economically she has lost $10,000 in which she is denied a tax deduction. The IRS will not make her report a gain because there really is not gain – no gain, no loss. We report nothing.
Sell at $240,000 Example:
Use the general rule first to determine whether or not you have a loss or gain. If you have a gain, don’t worry about the lesser of rule.
AR: $240,000
AB: $235,000 ($250,000 – depreciation)
$5,000 gain
Casualty Losses
Losses – sec. 165(c) Fire, shipwreck, and storm
· Trade or business
· Transaction entered into for profit
· Casualty loss
Determine loss by taking your AR minus your AB but a casualty loss has additional limitation.
Casualty Losses applies to personal losses
· Is it a casualty or theft loss?
· In what year did it occur?
· How much can be deducted?
Revenue Rule 75-592 (White v. Commissioner)
· Must be an identifiable event that is sudden, unexpected, and unusual
· Those events analogous to fire, storm, shipwreck
· Most jurisdictions require physical damage
· Termites: cannot deduct because it happened over time.
SHAEFFER: Sudden means that it must be swift and not gradual or progressive. Unexpected means an event ordinarily unanticipated that occurs without intent of the one who suffers the loss. Unusual means extraordinary and nonrecurring. We can apply the sudden, unexpected or unusual test, but not everyone will agree on what that means. The test does not apply to a fire or a shipwreck. The test only applies to other casualties. Most jurisdictions require that there be some physical damage.
Theft
The burden is on the taxpayer to show theft in order to deduct the loss. A mysterious disappearance doesn’t necessarily mean the property was stolen.
Chamales v. Commissioner (
RULE: Casualty Losses. A casualty loss arises when the nature of the occurrence precipitating the damage to the property qualifies as a casualty and the nature of the damage sustained is such that is deductible for purposes of § 165. Only physical damage to or permanent abandonment of property will be recognized as deductible under § 165. The court will not permit deductions based upon a temporary decline in market value.
SHAEFFER: Homeowners wanted to deduct the declining value of their home on their taxes. The property dropped in value because it was a noisy neighborhood. The court said that they didn’t have the type of damage that would allow for a casualty loss – no physical damage, not sudden, unexpected or unusual. Taxpayers denied deduction – this is a mere fluxuation in value.
Timing
· Theft – take the deduction the year you discovered a theft has taken place
· Others – year of occurrence
Amount of Loss (see handout for week 7)
Limitations:
· Loss reduced by insurance received
· Only to the extent it exceeds $100 per casualty or theft
· Only to the extent all casualty losses exceed 10 percent of AGI
Step 1:
Lesser of:*
· Basis or
· Decrease in value (value before – value after)
* If asset used for investment or in trade or business and totally destroyed, then loss = AB
Rationale: If your property is worth $100,000, but you only paid $10,000 for it, the IRS is only going to give you a deduction of $10,000 (your basis). If your damages are less than your basis, you only get to deduct your damages. You do not get a deduction for the amount you are reimbursed. If your reimbursement exceeds your AB, no casualty loss but a gain.
Step 2:
If you choose not to file a claim because you don’t want your insurance rates to go up, you have to reduce your deduction by the amount you could have received had you filed a claim.
Step 3:
For each casualty you have to reduce your deduction by $100. If you have $99 worth of damages – no deduction (no de minimis deductions)
Step 4:
Aggregate all your casualties together and reduce them by 10% of your adjusted gross income (AGI). Example: If your AGI is $100,000, you will only get a casualty-loss deduction to the extent your losses exceed $10,000 (after reduced for reimbursements, $100 per casualty).
Problems P 542
2.
(d) There is a reasonable inference that there was a theft. Shaeffer: I would take the deduction and argue it in an audit. P 545: If we are negligent (not locking the car door), we still can take a deduction. If we are grossly negligent (leaving the diamond on top of the car), then we cannot take a deduction.
Suppose she paid $10,000 for the brooch with $5,000 decline in value.
Step 1:
$5,000
0 (reimbursements)
Step 2: (no insurance in this hypo but normally reduce in this step)
Step 3:
$5,000
-$100 (reduce by $100 per the code)
Total: $4,900
Step 4:
Suppose her AGI is $30,000
$4,900
-$3,000 (10% of AGI)
Casualty loss deduction: $1,900
If her AGI was $50,000 – no deduction
2.
(a) A storm on a coast is foreseeable, but it’s not gross negligence. The erosion happened slowly. You would argue that the storm caused the erosion
§ 121 – Exclusion of gain from sale of principal residence
No gain shall be reported from the sale or exchange of property if the property has been owned and used by the taxpayer as the principal residence (where you spend the majority of your time) for at least 2 years or more (live there and own property 2 out of 5 years prior to the sale).
Single – maximum exclusion: $250,000
Married – maximum exclusion: $500,000 (must file a joint return, be married at the time of sale, only one had to own property and use for the 2 out of 5, can’t have used exclusion prior).
Like-Kind Exchanges – § 1031
§ 1031/non-recognition of gains or losses
If we have a loss on our principal residence…if we have a 1031 transaction, where a loss occurred deny a taxpayer from taking a loss.
Two Holding Requirements:
1. The property you give up must be used in your trade or business or investment activity
2. The property that you receive must be used in your trade, business or investment activity
The property that you give up must be in like kind to the property you receive.
1031(a)(2)
Like Kind Requirement
Real property for real property is like kind. Real property for …is not like kind.
Exceptions:
The property cannot be:
· Inventory
· Stocks, bonds or notes
· Other securities
· Interests in a partnership
· Certificates of trusts
· Choses in action (having a right to possession)
It has to be similar nature or character. The exchange of an SUV for a car is like kind.
Rationale behind 1031: It is really a continuation of your investment and it’s deferring your gain or loss.
Equalizing The Transaction
If you receive property that is not like kind (boot), you have to report your gain.
Example: Bought an asset for $90 sold it for $100 = $10 gain. In this transaction we received property with a FMV of $50 and cash of $50.
AR: $100 ($50 property, $50 cash)
AB: $90
Gain: $10
Your realized gain is the maximum that you will report. If you have a gain, only report the gain to the extent that you received boot.
Boot Received (Gain) Calculation
Cash received
+ FMV of non-like kind property received
+ net-positive debt relief (treated as boot. Amount of mortgage relief less amount of mortgage assumed)*
- Cash and FMV of non-like kind property
Total boot received*
*can’t be less than zero
Unrecognized Gain
Total gain realized
- recognized gain
Unrecognized gain
Basis:
Non like kind property
Apply regular rules:
Basis = cost = FMV
Basis:
Like kind property
FMV (new property)
- unrecognized gain
basis
FMV (new property)
+unrecognized loss
basis
Holding Period
The holding period of the like-kind property exchanged tacks onto the holding period of the like-kind property received.
Review
Gain has to be reported to the extent of our boot.
Even if you exceed your realized gain, the max amount of gain you ever report is your realized gain.
There are only 3 questions I could ask you that pertain to the calculation of gain and the basis of property:
1. What is your realized gain on each asset?
2. Of that realized gain, how much do you have to report?
3. What basis does the taxpayer take in the property received?
When we have a property for property exchange, Philadelphia Park tells us we use its FMV.
For like-kind property, your basis or starting point is the FMV of the property received; however, we need to make adjustments to that FMV basis because § 1031 is a deferral – it defers gain or defers loss. Any unrecognized gain or unrecognized loss on the property that we gave up that was like kind, is reflected in the adjusted basis of that new like-kind property received. We make an adjustment to the like-kind property received to reflect any unrecognized gain or loss.
If we have gain that went unrecognized, we decrease the basis of that like-kind property received by the unrecognized gain. We dispose of that property in taxable exchange that unrecognized gain is triggered. If we have an unrecognized loss, we increase our AB for later on.
If you meet requirements of §1031 that gain or loss goes unreported.
REALIZED GAIN = AR-AB.
RECOGNIZED GAIN= REPORTED GAIN OR LOSS.
*Gains are always reported unless there is a code saying otherwise.*
*Losses are generally deductible and they meet the requirements of 165 (c)(3)(Trade or business, investment, or casualty).*
§1031
1. exchange of property for property (does not include stocks, bonds, bonds, and promissory notes).
- must be trade or business or investment
- property taxpayer receives must be for trade or business.
*Each taxpayer can qualify for 1031 without regard for how other person uses the property.*
Example: if you give up property you held for investment purposes and get a home for personal residence, what is relevant is how you use that home for investment purposes.
2. Like-Kind requirement
a. based on facts and circumstances- look at nature & character of property (not grade or quality)
b. same asset class
c. same product classification
Boot- the amount made up to equal out the exchange (Generally non-like-kind property like car, cash, stocks, etc.)
*Even if your boot exceeds your realized gain, you only report the realized gain which is the maximum. Boot can’t be more than realized gain.*
The 3 questions asked in a Like-Kind exchange problem are:
- What is the realized gain?
- What is the amount recognized?
- What is the AB in the new property?
Remember the basis in non-like kind property is the PHI park rule: it is assumed to be the FMV.
Problems p. 919
1(a)
K A
AB: 100k
FMV: 500k FMV: 500k
Is it a like kind exchange? Yes, it is real property and it is used for trade or carrying on a business.
First do holding requirements, then proceed to step 1.
Step 1: AR-AB= realized gain
AR = 500k (property received from A), AB = 100k (what he paid for his farm) = 400k realized gain (this is the maximum amount of gain you will report to the extent of your boot). Remember 1031 is a deferral provision. The gain is reflecting the appreciation in value since you took ownership that now is fixed through your sale.
Your reportable gain never exceeds your realized gain.
We also care about step 1 because we need to know how much deferred gain he produced in this transaction.
Step 2: Does each asset qualify for like kind treatment? Here, it does because it is for business so, YES. For every YES we move on. We are saying that for property which meets our 1031 requirement that we have a gain on, we must report our gain to the extent we receive boot. In other words, we are trying to see if our boot exception applies.
Step 3: BOOT calculation: Of that realized gain of $400K, does K have to report any of that? He received no cash, no non like-kind property received, no net positive debt relief and he did not pay any cash or give a non like-kind property. So this step produces a boot number of 0. A Boot of $0 tells us we have no gain to report. What is the exception for gain? Gain is only recognized or reported to the extent we receive boot. Of the $400K of gain in Step 1, K reports none of it.
Basis of Property Received:
Step 4: First step in determining basis in property received. This step tells us how much gain is deferred. We had 400k of recognized gain – 0 (from step 3) = 400k unrecognized or deferred gain. The deferred gain will be reflected in the basis of the property received.
Step 5: Final step in determining basis in property received. K’s basis in like-kind property is FMV of $500k, subtract $400k unrecognized gain (or we add unrecognized loss) (remember you can only have one: either a gain or loss). K will have an AB in A’s farm of $100K.
So when he sells A’ farm for FMV, the unrecognized gain of $400K will be triggered. So congress wants the gain when you sell the property.
(c)
Step 1: what is realized gain?
A
Real 400k
Cash 100k
Kevin received land (400k) + cash (100)= 500k. – 100k (Kevin’s AB)= 400k realized gain.
Step 2: does it qualify for like kind treatment? YES
Step 3: boot calculation
100k cash
0 DR
0 non-like kind property
- no cash or non-like property paid
=
100k boot (recognized gain)
Step 4-
400k realized gain- 100k recognized= 300k unrecognized gain which is built into basis of property K received.
Step 5- K’s AB?
He received cash which = non-like kind property= fmv (100k)
Like kind property=fmv= 400k-300k unrecognized gain= 100kAB.
1ci-
Step 1: AR 100k + 400k
AB 420k
Gain is 80k
Step 2. YES
Step 3 boot calculation
100k cash
+ 0 non like kind
0 DR
-0 cash paid or non like kind
=
100k. since our realized gain is less than the boot, we must report or recognize 80k. our recognized gain cannot exceed our realized gain. What happens to the other 20k? the unreported boot is a return of his unadjusted basis.
Step 4 unrecognized gain
Amount realized (80k) – recognized gain (80k)= 0 unrecognized gain. 1031 did not have an impact on K.
Step 5
Like kind property=fmv=400k increase or decrease by 0
400k-0=400k.
1ciii
Step 1- realized loss
100k + 400k – 600AB= <100k>
Step 2 YES
Step 3
No loss is recognized under 1031. is step 3 relevant? No, because boot is telling us of our gain this is how much we must recognize. Since we have no gain, this step is irrelevant when you have a loss.
Step 4- how much unrecognized gain you have?
We don’t have a gain so this step is irrelevant
Step 5-
K received cash which is non-like kind his basis in the cash= 100k
Like kind property is FMV.
Fmv= 400k and we add the unrecognized loss which is 100k. the AB is 500k.
If K sells the property the loss is built in. as a tax planner is it good to enter into like kind exchange when loss happens? No. we generally do not want to defer losses.
§ 1031
Practice Problem II (week 9 handout)
Bill
Step 1: What is Bill’s Realized Gain or Loss?
AR: $800 (Tomi’s land minus her mortgage) + $800 (DR – his mortgage going to Tomi) = $1600
We then figure out gain or loss on each asset separately. We split up the $1600 between the two assets sold – the boat and the land.
Of the $1600, $400 of it is for the boat and $1200 of it is for the land.
Boat – AR: $400
AB: $200
Realized Gain: $200
Land – AR: $1200
AB: $400
Realized Gain: $800
Step 2: What is Bill’s Recognized Gain or Loss?
Ask: Does each asset that Bill transferred qualify for § 1031 treatment?
Boat: No, it does not qualify under § 1031. We have a boat that was transferred that was not like-kind. If the answer is no, that means you cannot defer the gain and you have to report it.
Bill’s Recognized Gain on the boat is $200.
Land: Yes, it does qualify under § 1031; therefore, § 1031 rules apply: No loss shall be recognized and no gain shall be recognized except for the extent of boot.
Bill’s Recognized Gain on the Land will be determined in Step 3 to determine Boot.
Step 3: Did Bill Receive any Boot?
Ask: Did he receive any cash? No. Did he receive any non like-kind property? No (if he had, use FMV). Any net positive debt relief? Yes. Bill started out with a $800 mortgage and ended up with a $400 mortgage; therefore, his net positive debt relief is $400.
Bill gave up a non like-kind property in the form of a boat and its FMV was $400. Bill has $0 boot. That means Bill does not recognize any gain. The boot calculation only applies to like-kind property.
+ $0 Cash
+ $0 Non like-kind property
+ $400 Net positive debt relief
- $400 Cash and/or FMV of non like-kind paid by Bill
Boot = $0
Bill’s Recognized Gain on the land is $0. So Bill does not have to report the $800 of gain on the land.
Step 4: How much gain did § 1031 defer?
Ask: How much unrecognized gain that Bill had on his like-kind asset that § 1031 deferred.
Take realized gain on the like-kind asset: $800
Subtract recognized gain of: $0
$800
Bill has $800 of unrecognized gain or deferred gain under § 1031.
Step 5: Basis of the asset Bill received
Bill received 1 asset – Tomi’s property with a FMV of $1200. Minus unrecognized gain from Step 4 of $800, which gives Bill an AB of $400.
$1200
- $800
AB: $400
Bill’s basis in the property that he received from Tomi is $400.
Tomi
Step 1:
AR: $400 (land) + $400 (DR) + $400 (Boat) = $1200 (this makes sense because this is the value that she gave up)
- AB: $1000 (she only had one asset)
Realized Gain: $200
Step 2:
Ask whether or not the property she gave up qualifies for § 1031. Answer: yes, therefore 1031 applies. She meets the holding requirement and it was property for property.
Tomi only has to recognize gain to the extent she received boot.
Step 3: Boot Determination
Ask: Did Tomi receive any cash? No. Did she receive any non like-kind property? Yes, the boat valued at $400. Did she receive any net positive debt relief? No, she is in a worse position. She has negative debt relief (-$400), but we cannot put anything less than $0. If one person has positive debt relief, the other person has negative debt relief.
+ $0 Cash
+ $400 Non like-kind property
+ $0 Net positive debt relief
- $0 Cash and/or FMV of non like-kind property paid by Tomi
Boot = $400
Realized gain from Step 1: $200.
Therefore, we cannot report gain in excess of our realized gain. So even though our boot is $400, we are only reporting or recognizing $200 of that. Your recognized gain cannot exceed your realized gain.
Recognized gain: $200
The other $200 of boot is attributable to a return of the basis.
Step 4: How much gain is deferred under § 1031?
The basis she receives in Bill’s property.
For the like-kind property we need to know whether there is unrecognized gain or unrecognized loss.
Realized gain: $200
Recognized gain: $200
§ 1031 had no impact – no gain deferred under § 1031. If Tomi would have sold this item for cash she would have received the same answer.
Step 5:
Ask: What is Tomi’s basis in each asset she received?
She received a non like-kind boat – her AB is the FMV or $400.
The land was like kind. The FMV is $1200. Subtract from that unrecognized gain or loss. The AB in the land is $1200. Here there was no unrecognized gain or unrecognized loss under § 1031.
Tips:
· The AB in non like-kind property is the asset’s FMV.
· The AB in the like-kind property is the asset’s FMV reduced by unrecognized gain OR increased by unrecognized loss.
· When you come up with your boot number, always go back to Step 1 and make sure your boot doesn’t exceed your realized gain.
· The boot number is telling you, of your unrealized gain, this is how much you have to report.
· If boot exceeds your realized gain, then you recognize your realized gain.
§ 1033 – Involuntary Conversions (applies to gains)
An involuntary conversion is an event where property, as a result of its destruction in whole or in part by theft, seizure or requisition or condemnation or threat or imminent threat thereof, is compulsory or involuntarily converted.
EXAM: In a fact pattern, if there is something that is burning down, how do you know if it is involuntary conversion or casualty loss? Look to see whether there is loss or gain. If there is a loss then the casualty loss provision applies (§ 165). Involuntary conversions apply to avoiding recognized gain.
With involuntary conversion it does not have to be sudden like the disasters in casualty loss because there can be a seizure in an involuntary conversion. § 1033 applies when you are being reimbursed an amount that exceeds your AB.
§ 1033 has two types of conversions – mandatory provision and an elective provision.
Mandatory Provision: The mandatory provision only applies when your property is destroyed and the party reimbursing you gives you property back that’s similarly related in service or use. Example: If your barn burns down and the insurance company gives you a new barn (rare).
Elective Provision: If you receive property back that is not similarly related in service or use, you can elect not to recognize gain. In order to not elect recognized gain, the TP must replace the property with property that is similarly related in service or use within the required time period which generally is 2 years. Most cases will be the elective provision. Even if you make this election, you could partially be required to recognize gain (see below).
There is no requirement that the property that has been destroyed be held for business, trade, or investment. Also, there is no requirement that the property you receive be used in your trade or business or investment. Unlike § 1031, the involuntary conversion can and does apply to personal gains.
Liant Record, Inc. v. Commissioner (1962) P 969
Definition of similarly related in service or use
RULE: Involuntary Conversions. In determining whether replacement property acquired by an investor is similar in use to involuntarily converted property, a comparison of the service or use that the properties have to the taxpayer-owner is critical.
ISSUE: Whether the proceeds from the condemnation of an office building were reinvested in property which was similar or related in service or use.
SHAEFFER: The TP elected to not recognize gain. The issue becomes, did TP replace the property with property that is similar in use and service of the old property? The government is using the functional test. This test looks at how the property is physically being used. We must look at how the first tenants were using the property and how the new tenants were using the property. Here, the physical use of the property is different.
The court said that when the property is rented out we don’t look at tenant’s physical use; we look at the TP’s physical use.
“In applying such a test to a lessor, a court must compare, inter alia, (among other things) the extent and type of the lessor’s management activity, the amount and kind of services rendered by him to the tenants, and the nature of his business risks connected with the properties.”
The functional test has two different applications depending on the owner’s use of the property:
1. If the owner is using the property, we look to see if the property is similarly related in service or use by looking at the owner’s physical use.
2. If the owner is using the property as investment property (renting it out), we are going to compare the owner’s management activities – the services he provides the tenants, and his investment risk in the old property and the new property to see if it is similarly related in service or use.
Similar in service or use is narrower than like-kind exchanges. Example: if you exchange a grocery store for an apartment building, that is like kind (real property for real property), but it may not be similar in service or use.
Regulation 1.1033 P 964 tells us what will not be similar use. If your barge is destroyed, you’d better buy a new barge.
Recognizing Gain
You are required to recognize gain to the extent that your AR exceeds the cost of your replacement property.
You can avoid the recognition of gain by spending your entire amount realized.
Similar to like-kind exchanges, there could be a situation where you calculate AR minus the cost of replacement property which produces a number greater than the calculation of AR minus AB (realized gain)
Do you think under 1033 your recognized gain should ever exceed your realized gain?
For example: You buy property for 100 (AB). The property is destroyed and it is worth 120 (FMV). Insurance co. gives you 120 and you have 20 of realized gain. But you replace the property within the required time with property that is similar in use and the cost of the replacement property is 90. Here your AR is 120 and your cost is 90 which is supposed to be a recognized gain. If the calculation produces a gain, the max you report is 20 – your realized gain. This is the same concept as 1031. Similar to 1031, 1033 is a deferral of unrecognized gain provision. In 1031 we reduce basis by unrecognized gain and we increased it by unrecognized loss. If we have a loss we should talk about casualty.
Problems P 959
1
(a) Step 1: Is the physical use the same? Yes. How is the new property being used? Same. So it qualifies under 1033. Apply the functional test. The TP qualifies. There is nothing to prevent your from increasing or decreasing he size of your store as long as the property is similarly related to service or use. If you decrease the size of your store, this could lead to gain as you are not using all the money.
Step 2: Calculate the gain or loss realized
AR: 500k
AB: 150k
350k gain
(1) We care about this number because it is the max amount of gain TP will report; and (2) We will use this number again to help us figure out unrecognized gain into the basis of the new property.
Step 3: Did TP invest is qualified replacement property within appropriate time frame? Yes
Step 4: Determine amount of recognized gain
AR: 500k
Cost: 750k
0 recognized gain
The cost of the new property exceeds the AR. Of the 350k realized gain, TP reports none of it.
Step 5: Any realized gain that is not recognized is unrecognized gain
Realized gain: 350k, recognizing or reporting 0.
-Unrecognized (deferred) gain of 350k =
Unrecognized gain: 350k
Step 6: Determine basis received in the transaction
Cost of replacement property (750k) – unrecognized gain (350k) = 400k is the basis in the new property.
If you are a builder or general contractor, the cost of the replacement property could be less than the FMV. In that case, you will be given the cost to replace the property instead of the FMV (getting gypped!)
2
(a) This deals with a situation where your personal residence is destroyed. You can use § 121. 121 is different from 1031 and 1033 in that 121 is not a deferral provision. It completely avoids the gain. We can use 1031 and 1033 together.
§ 121 – Involuntary Conversion of Principal Residence
§ 121 excludes up to $250,000 or $500,000 of the gain on the sale or exchange of a principal residence. § 121 generally provides that an involuntary conversion will be treated as a sale for purposes of § 121. Thus, the possibility exists that a TP whose principal residence is involuntarily converted could take advantage of § 121 to exclude some or all of the realized gain; any realized gain not excluded under § 121 could be deferred under § 1033 if the requirements of that provision were satisfied.
How much gain if he takes advantage of §121 and §1033? First step is to apply 121. Then we are told to take AR for purposes of involuntary conversion and reduce it by the amount you excluded under 121.
Is it his principal residence? Yes. Did he live there 2/5 years as personal residence? Yes. Did he own it for 2/5 years? Yes he did. You must have not used §121 in the past 2 years. He did not.
How much gain did he have? AR - 600 (FMV) - AB 200= 400k gain. Of that gain how much can he exclude under 121? 250 excluded. Of the 400k we can exclude 250k and it never gets reported. This leaves 150 out there that may still be reported. But this gets interpreted under 150.
Now we go to § 1033. we want to make sure the 150 never gets reported. 121d5b says we have to reduce our AR by the 250k that we will exclude.
§1033
AR 600k - 250k exclusion = 350k. Our AR is 350k for purposes of § 1033. We are making sure that the 350 doesn’t get reported either.
Step 1 How much can you defer?
AR-AB (he had an adjusted basis of 200k in the property) (350k-200k) = 150k realized gain
Step 2 Reduce your AR by that amount
- does the exchange qualify for like-kind treatment? YES
Step 3 take the new amt realized an apply it to those steps for 1033
- boot calculation? No ifs, ands or BOOTs about it.
Step 4- recognized gain?
Step 5- unrecognized gain
Realized 150k- 0 recognized gain= 150k unrecognized gain
Step 6- AB?
Cost of replacement property- unrecognized gain (500k -150k)=350k AB.
Review
Like-kind Exchange
§ 1031 provides that no gain or loss shall be recognized (reported). If there is a loss on § 1031 property the loss isn’t recognized period. If there is a gain, it only has to be recognized to the extent taxpayer received boot. Any gain or loss that goes unrecognized under like-kind property will be built into the basis of that like-kind property the taxpayer received.
Start out with the rule in
EXAM: I could test § 1031 as an essay question. I would be testing you to see if this was a like-kind exchange or not.
Involuntary Conversion
EXAM: Involuntary conversion on the essay – I give a fact pattern where someone’s property is being destroyed. People instantly want to talk about casualty loss. You have to determine whether, this destruction of property a result of a casualty loss (AR is less than the AB), or is this creating a gain situation where you’ve been compensated more that you paid for the property. If it’s a gain, talk about involuntary conversion where we can defer that gain. We have the elective provision under § 1033 which allows us to avoid recognition of gain. That applies in situations where TP receives property that is not similarly related in service or use from the property that was destroyed. If that’s the case we recognize gain.
Holding Period
The holding period of the converted property tacks onto the holding period of the replacement property.
Hybrid between § 121 and § 1033
Step 1: Apply § 121. This allows for an exclusion of either $250,000 of $500,000. If you have less than $250,000 of gain (if single), that’s all you have to do as § 121 will completely void that gain. If your gain exceeds any § 121 amount, then you apply § 1033
Step 2: If there is additional gain, reduce AR by that gain that goes unrecognized under § 121.
Step 3: Apply § 1033 based on reduced AR. By reducing the AR by § 121 you are recognizing the fact that § 121 is a pertinent exclusion (never picked up). Any gain under § 1033 is just that – deferred.
Will not be on exam
Tax shelter: a transaction entered into tax purposes as its primary motivation rather than business purposes. It is entered into solely for the tax results.
§ 465
· Recourse debt: Personally liable.
· Non-recourse debt: No personal liability. You can walk away from it and your assets are safe.
· § 465 is designed to prevent people from taking losses created by non-recourse debt. Paying too much for something and creating a loss thru depreciation purchased with non-recourse debt.
· Congress is only allowing deductions from your activities to the extent you have an amount at risk.
At-risk Rules
Taxpayer may not deduct losses generated by certain activities in excess of the amount the taxpayer is “at-risk.”
At-Risk “Loss”
income from activity
- operating expenses
= loss
Initial Amount At-Risk
cash contributions to activity
+ AB of property contributed to activity
+ borrowed amounts personally liable for
+ pledged prop other than prop used in activity
amount at risk
If the activity is holding real property, the amount at risk also includes qualified non-recourse financing.
At Risk
+ Cash
+ AB Property
+ Loans (recourse)
+ Pledged property
Amount at risk
+ $1,000 cash
+ 1000 AB property
+ 0 loans
+ 0 pledged property
Amt at risk: $2,000
Hypo: Hotel generates an operational loss of $7,000. § 465 says your loss deduction cannot exceed your amount at risk. Your deduction is the amount at risk – $2,000
Every year you have to adjust your amount at risk. If you make an additional investment in year 2, your amount could go up. Any losses can be carried forward and used later on.
§ 469
Similar to § 465 in that it is preventing losses, however it is broader. § 469 denies losses even on depreciation from recourse debt. § 469 makes you break your income and loss items into passive and non-passive gains and losses.
Rule: You can only take passive losses as a deduction against passive gains. Having passive gains is a good thing because you can use your passive losses. Having passive losses is a bad thing because you are limited in your use – you cannot use them against your non-passive. The key is determining which activities are passive and non-passive activities. In order to be non-passive, you need material participation (regular and continuous substantial activity)
Passive Activity – Defined
A passive activity is any trade or business in which the taxpayer does not materially participate.
Material Participation
· regular, continuous, and substantial participation
· regulations provide 7 tests
Safe Harbors
500 hours towards an activity in any particular year means you’ve materially participated; therefore, any losses from that activity can be put in the non-passive category.
Example: Ownership of a racehorse – keeping books, feeding, etc. for 500 hours.
Activities Per Se Passive
· limited partners (some exceptions)
· rental property, except
· taxpayer in the business
· taxpayer who actively participates in real estate activity; may use $25,000 of passive losses against other (non-passive) income
Per se passive: Ownership in a limited partnership – no participation and rental activities. Can deduct up to $25,000 of passive losses against rental properties; however, there is an income phase out – once you reach $100,000, no deduction.
Active Participation
· Own at least 10% interest
· Participate in a significant and bona fide sense in making management decisions, etc.
Computation of Passive Activity Loss
· Compute gains and losses from each activity.
· Add net profits/losses from all activities.
· - if net gain, report gain
-if net loss, do not report; carry forward
P 737
If we are talking about capital gains, we are talking about the rate of tax. Generally we are subject to a graduated rate of tax. As your rate of income goes up, your rate of tax goes up. For long-term capital assets (held for a long period of time), we get a preferred flat rate of tax that is not based on income level. Congress is giving us this preferred flat rate of tax so that it encourages people to sell the asset – the damage is not as severe.
So, what is this all about?
Determining those categories of assets where the gain should be taxed at a lower rate. Ask: Do we have a capital asset? We must first determine what type of asset it is. If gain or loss is recognized determine the characterization:
· Capital
· 1231 – hotchpot
· Ordinary
§ 1221(a): Capital asset means property held by the taxpayer except:
1. Inventory
2.
3. Depreciation property (trade or business)
4. Real property (trade or business – if held for more than 1 year, § 1231 property)
5. Supplies (using on a daily basis in trade or business, close to inventory)
6. Accounts receivable (may not be capital)
7. Davis & Hort cases
If it’s capital it has the potential for the preferred rate of tax.
Section 1231 – hotchpot
· Depreciable property used in a trade or business and held more than one year;
· Real property (land) used in a trade or business and held more than one year.
Ordinary
Anything that does not fit into one of the other categories
Capital 1231 (best of both worlds) Ordinary
Gain + if +, gets moved to capital Gain – (could lead to a higher rate of tax)
If -, gets moved to ordinary
Loss - Loss + (there are no restrictions on ordinary losses)
§ 1231 is a holding pattern and it has to move by the end of the year. If you add 1231 up at the end of the year and it’s a positive number, your entire 1231 column moves over to capital. If negative, 1231 moves to ordinary. That’s a good thing because there are no restrictions on your ordinary losses.
When do we have a capital asset?
Bynum v. Tax Court
RULE: Capital gains treatment of real estate gains is available only to passive investors.
SHAEFFER: The Bynums had a hard time paying their bills. The original bank seemed to accept that idea. A new bank bought the original bank and became more aggressive about paying their bills. The bank suggested that the Bynums sell some of their property before the bank foreclosed on it.
A developer told the Bynums that if they broke up the land into sub lots they might make more money. They sell 37 of 160 right off the bat. The issue becomes whether or not this gain is capital gain so that they get the preferred rate of tax. The IRS said that they were holding the lots primarily for sale to customers as part of their trade or business (refer to items on the 1221(a) list). The taxpayer is trying to argue that we are passive investors – we are farmers. The IRS counters with the Bynums have two trades or businesses. The court agreed and said the second trade or business is selling lots to customers. The facts indicated that the Bynums made a bunch of improvements (streets, sewer lines, etc.) and in essence it is inventory; therefore not a capital asset.
When we have the sale of real property and the issue is whether or not it is held for sale to customers as part of a trade or business, we look to 4 factors (is it a capital asset or excluded?)
1. Volume and frequency of sale (the most important factor);
2. Improvements (passive investors generally do not improve the land);
3. Level of advertising and solicitation engaged in; and
4. Whether or not you used a real estate agent.
Hort v. Commissioner
RULE: Where the unexpired portion of a lease is settled for cash, the payment received by the taxpayer is merely a substitute for rent and must be reported as ordinary income.
SHAEFFER: The taxpayer received land through his father’s will. One of the tenants wanted to get out of his lease early. The TP negotiated a deal where the tenant gives a lump-sum amount for being let out of the lease. The TP claims a loss by letting the renter out. Your gain or loss is determined by taking your AR minus your AB. Here there was no basis so TP clearly had gain. The question becomes, is that gain capital, 1231, or ordinary? The court said that the sale is replacing rent. Rent is always going to be ordinary. The replacement for that rent will also be ordinary. If you are selling your right to rent, that payment for that receivable rent or income stream will also be ordinary.
RULE: Amounts received by a taxpayer in exchange for the assignment of their right to receive a portion of certain future annual lottery payments are ordinary income.
SHAEFFER:
How do we determine the tax consequences?
Capital Gains
2 different types of capital gains and capital losses
1. Short term; and
2. Long term
Long term capital gains get a preferred rate of tax. A LTCG is from the sale of a long-term capital asset. It is long term if it’s an asset held for more than 1 year. If it’s a LTCA that generates a gain, it becomes a LTCG.
Short term capital assets that generate gain are taxed as ordinary income.
Net capital gain is your LTCG after you've deducted your long term capital losses against it and reduced further by any net short term capital loss.
Refer to Week 10 Handout
§ 1211(b) – you can deduct your capital losses to the extent of your capital gains
The maximum of your capital losses is $3,000 per year
Step 1: break up long and short term
Step 2: deduct long term losses against long term gains. Deduct short term losses against short term gains.
Step 3: if your long term has a net loss and your short term has a net gain, you can deduct that loss against the gain. You can deduct the loss in one category from a gain in another category. If they are both losses and both are gains, we do not commingle.
Step 4: determine tax consequences.
Collectibles: 28% long term capital rate
Un-recaptured 1250 gain: 25%
Qualified Dividend
The corporation generates a profit and the profit is distributed to stockholders. Historically dividends were treated as ordinary income meaning they are subject to the graduated rate system. President Bush had issue with corporations taxed twice. Congress compromised with dividends are now treated as net capital long-term gain at the 15% rate. It has to be a qualified dividend (from a domestic corp. or some foreign corps with a comprehensive bi-lateral tax treaty with the
Problems P 737
1.
(a) Inventory – not a capital asset
(b) Depreciable property used in trade or business is excluded from our definition of capital asset. It’s § 1231 property as long as it’s held for more than 1 year.
(c) Capital asset – § 1221
(d) Land used in trade or business is not a capital asset.
Note: These notes go to week 10 or so - I ran out of gas.
