Kratzke FedIncTax Fall 2010

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INCOME TAX OUTLINE
KRATZKE
FALL 2010 TEXT: MALMAN, INDIV TAX BASE 2ND
Kratzkes Three Rules of Income Taxation in the American Tax Code #1: We tax income once and only once (generally speaking*)Scream.4.2011.Cam.DivX-NoGRP #2: If there are exceptions, you better find them in the code- there are no C/L exceptions #3: If you find an exception, treat the income as if it had been taxed
I. INTRODUCTION
A. History & Constitutional Framework
1. IT as we know it today first implemented in 1913 2. Imposed on all taxable income of US residents & citizens 3. Constitutional Basis a. Art I, 8, Cl 1 Congress shall have power to lay & collect taxes, duties, b. Art I, 2 & 9 allows direct Fed tax only if apportioned among states according to population (direct tax not used b/c not practical) i. 16A allows Congress to tax any income w/o apportionment (upheld by SCOTUS)
B. Sources of Fed IT Law

1. Legislative materials (Code & legislation) 2. Administrative materials Treasury regs (depts interpretation of Code), Revenue Rulings (opinion of Commissioner) & procedures, private letter rulings, technical advice
C. Tax Procedure
1. If deficiency found & TP disagrees, can appeal to Regional Office of IRS 2. If no agreement reached, IRS issues Notice of Deficiency & TP can either: a. File petition in Tax Court w/in 90 days or b. Pay deficiency & file administrative claim for refund i. If claim denied/inaction, TP can sue in Ct of Fed Claims or Dist. Ct. 3. Judicial Procedure a. Tax Court no pay, no jury, tax expertise, appealable to Court of Appeals i. IRS may nonacquies b. District Court pay, option of jury, appealable to Court of Appeals c. Fed Claims pay, no jury, appealable to Court of Appeals for Fed Circuit
D. Tax Policy
1. Primary Goal: REVENUE 2. Rationales for Determining Whom to Tax a. Equity i. Distributive Justice I. Dominant Standards A. Ability to pay (IT tries to do this) B. Standard of living (justifies consumption tax) II. Dominant Theories A. Utilitarianism (greatest good for greatest number, declining marginal utility of income justifies progressive taxation) B. Redistribution (Rawls) C. Libertarianism (Nozick) III. Dominant Rate Structures A. Progressive rates (rate of tax increases w/ income) B. Proportionate tax (rate constant as base varies)
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C. Regressive tax (rate decreases as base increases) ii. Vertical and Horizontal Equity I. Vertical = people in different economic situation should be taxed differently II. Horizontal = people in same economic situations should be taxed same b. Efficiency i. Facilitate pursuit of self-interest, wealth maximization ii. Neutrality I. Ideal efficient tax would be neutral (wouldnt affect behavior), but only tax thats neutral is head tax (lump-sum) which doesnt measure ability to pay II. Elasticity A. Neutrality depends on elasticity of response (if highly elastic, small tax could = change in behavior) III. Substitution/Income Effect A. Substitution Effect: people will substitute non-taxed leisure for work B. Income Effect: work more to make up for taxation iii. Incidence (def) who bears burden of tax I. Real incidence: falls on person who bears burden II. Nominal incidence: falls on person who pays bill iv. Capitalization: how market responds to differing tax treatment of economically identical transactions I. Full capitalization: cost of item fully accounts for tax liability v. Deadweight Loss: when TPs change behavior to avoid tax & both TP & govt suffer (if revenue is goal of IT, should minimize deadweight loss) c. Simplicity i. Rationale: Code easier/cheaper to enforce (efficiency), TP can better understand, promotes transparency (equity) ii. BUT complexity may be necessary to have fairer tax which computes ability to pay 3. Questions p. 15/ E. Tax Terms & Concepts
1. Gross Income (GI) (def) ( 61):all income from whatever source, not limited to items listed a. Inclusions ( 71-90) = items specifically included in income b. Exclusions ( 101-138) = items specifically excluded from income c. Realization & Recognition Requirement: economic appreciation not necessarily recognized as GI until realized (i.e., sold) 2. Basis ( 1012): $ that have already been taxed or is treated as having been taxed (i.e., cost of property) a. Basis is returned without being taxed, is taxed when earned originally before being used for consumption/capital tax free return of invested capital b. Adjusted Basis (AB): original basis + additions/subtractions 3. Gains/Losses a. Gain/Loss on Sale ( 1001(a)): [Amount realized Adjusted basis] b. Amount Realized (AR) ( 1001(b)): Money Received + FMV of Property Received c. Recognized Gain/Loss: amount of realized gain/loss included in GI in current year (generally recognize all unless postponed under some non-recognition provision) d. Character of Gain/Loss: based on nature of asset, holding period, whether sold/exchanged i. Capital: lower rate for gain purposes, but limited deductibility for loss purposes I. Applies to assets held for more than one year ii. Ordinary
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4. Deductions = Things that youre allowed to claim reduce your GI a. Generally only allowed for business expenses + some limited personal expenses b. But also include personal exemption c. Subtracted from base (Value = Quantity of Deduction Marginal Tax Rate) d. Limited to enumerated items in statute 5. Adjusted Gross Income (AGI) ( 62(a)) a. = (GI) ( 62/above the line deductions) (which are ALWAYS taken) 6. Taxable Income ( 63) a. = AGI (greater of itemized deductions OR standard deduction) personal exemptions ( 151) b. Itemized Deductions i. Must look to I. 67(a) (deduct only > 2% GI) A. can only deduct amount of miscellaneous deductions above 2% floor, then subject to 68 II. 68(a)-(b) A. deduct 3% of the excess of AGI over the applicable amount (100,000) B. OR 80% of the amount of itemized deductions otherwise allowable for the year C. Policy: increase incentives to take the simplified standard deduction route, phase out deduction for high income TPs c. Standard Deduction ( 63) i. With the Personal Exemption, creates a 0% tax bracket ii. Furthers simplicity no need for majority of taxpayers to keep receipt iii. Married couple takes twice standard deductions of single filer I. Without straightforward doubling, this would aggravate marriage penalty d. Personal Exemptions ( 151) i. One per TP (so two for joint filers) ii. 151(d)(3) has phase-out for higher income taxpayers 7. Tax Liability a. (TI Applicable Marginal Rate(s)) Credits b. Tax rates graduated first dollars taxed at lowest bracket & last dollars taxed highest bracket i. Average rate = rate applied to aggregate taxable income (tax liability/taxable income) ii. Marginal rate = rate applied to last dollar c. Credits = dollar-for-dollar reduction of tax liability; direct benefits i. Cong. uses to implement social policy (education, childcare, etc.) ii. BUT effect may be same as deduction Determining Tax Liability on Income (Problem, p. 22)
61 Gross Income 62 Deductions (Above the Line) _____________________________ =Adjusted Gross Income or itemized deductions 63(d) (Below the Line subject to 67, 68)
- standard deduction 63(c)
-personal exemption deduction 151 _____________________________ = taxable income x calculations page ix

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John and Jane, married. Receipts --His Salary 65k, hers 23k. --1,800k proceeds from stock bought 2 years before for 1k --12k recd damages for personal injury --6k car loan --300 interest bank savings acct Expenditures --32k apartment rent, food, clothing, entertainment --300 interest on old student loans --420 interest on car loan --7,500 fed income taxes withheld from wages --2,100 state and local income taxes paid
o Ascertain gross income, defined extremely broadly under 61

Both salaries = 88k 1,800 stock sale 1k cost (basis) = 800 gain 300 interest = 89,100 Gross Income (12k personal injury award is excluded 104) Ascertain Adjusted Gross Income: Subtract above the line (ATL) deductions, under 62 AGI Generally business deductions, costs of generating income ATL deductions worth more than BTL automatically get to take full value In hypo: 300 student loan is deductible per 221 So AGI = 89,100 300 = 88,800 Compute taxable income by making further deductions from AGI more personal deductions Subtract itemized deductions and personal deductions (left side) Miscellaneous deductions can be itemized and deducted if they exceed 2% of AGI, subject to limitations - 67 and 68 Will only count if BTL itemized deductions save more than the standard OR subtract standard deduction and personal deductions - 63 (right side) Standard deduction (p xi Code) = 11,400 married filing jointly Personal exemptions (p xi Code) = 3,650 each x 2 = 7,300 Apply deduction phase-outs, limitations calculated deduction amount may not be entirely deductible TI = 88,800 AGI 11,400 std deduction married/jointly 7300 pers exemptions = 70,100 Remove from TI any amounts that are taxed differently, e.g. long-term capital gains TI 70,100 800 cap gains = 69,300 (tentative) Apply appropriate tax rates, under tax rate tables p ix considering/separating different kinds of income Make sure capital income is taxed at capital rates 69,300 TI tentative per table p ix: 9362.50 +325.00 (25% of (69,300 68,000 = 1300)) +120 (800 cap gains x 15%) = 9807.50 tentative tax liability
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o o
o Apply tax credits, if applicable

9807.50 7500 paid thru withholding = 2307.50 due
F. Time Value of Money

1. General Principle: Timing of payments/deductions affects present/actual value of tax imposed. TPs will generally want to defer payments and accelerate deductions. 2. Money is more valuable today than in future b/c can grow if invested 3. Present value = value of future investment today 4. Compound interest = interest on principal + interest on previously earned interest 5. Paying IT later is better; try to get deductions earlier deferral of tax liability is characterized as an interest free loan from the government 6. Value of Deferrals minimizes the present value of the tax paid 7. Invest a smaller amount to generate needed amount for tax later 8. Problems p. 26/
II. INCOME & DEDUCTIONS

A. IT vs. Consumption Tax
1. Income Tax: The Haig-Simons definition a. Income = (Personal) Consumption + Wealth b. Would ideally include unrealized gains on property/investments (but IT only recognizes realized gains ( 1001(a))) 2. Consumption Tax (based on standard of living) = tax levied on use of funds for personal reasons a. Consumption = Income Wealth b. Excludes savings 3. Main Difference: Treatment of Savings a. If you spend all income, consumption & IT tax base SAME b. BUT, consumption tax defers taxation of savings until money spent i. Present value of future tax is lower, whereas IT taxes savings when earned ii. Note: deferral of taxation on savings could benefit wealthy ppl who dont have to spend 4. Elements of consumption tax in IT a. E.g., retirement savings accounts (deduct contributions & no tax until paid out) 5. Questions p. 30/
B. Employers & Employees

1. Symmetry a. Employee includes compensation in income ( 61) and employer deducts compensation expenses ( 162) b. But symmetry may not be achieved if employer and employee in different tax brackets c. Capitalization requirements are major source of timing asymmetry 2. Compensation as Gross Income under 61 a. Section 61 is VERY inclusive Gross inc = __1___ b. 1 X (where X is the marginal tax rate) c. Old Colony Trust (U.S. 1929) i. Holding: Payment of debt in consideration of services = income to employee; Therefore, payment of employees IT is inclusion in employees GI (even though indirect pmt) d. Applicable Regulations i. GI = income realized in any form, including property (Reg. 1.61-1(a)) ii. Items counting as compensation generally (Reg. 1.61-2(a)(1))
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I.
Wages, salaries, commissions, bonuses, etc.
iii. GI from property/services in exchange for services is FMV of property/services

(Reg. 1.61-2(d)(1)) iv. Reg. 1.61-2(d)(2)(i) IF employer transfers property to employee at below FMV, THEN GI = FMV Amount Employee Paid Employees basis when sold = Amount Employee Paid + GI amount per above v. GI for manufacturing/merchandising = total sales cost of goods sold ( 1.61-3(a)) e. GI doesnt include gifts/inheritance ( 102) 3. Trade or Business Deductions under 162 a. Main Rule TP may deduct above the line all ordinary & necessary business expenses i. Ordinary Two Senses I. Ordinary vs. Capital A. Expenses that are currently deductible, as against capital expenditures II. Ordinary vs. Nonrecurring/Extraordinary A. A cost that other similarly situated businesspeople pay B. Commissioner v. Tellier (U.S. 1966) 1. Holding: TP can deduct expense of unsuccessful defense of criminal prosecution arising out of business 2. NOTE: No public policy limitation on deductions ( 1.162-1(a)) ii. Necessary I. Expense must be appropriate and helpful for development of TPs trade or business II. Voluntary Expenses A. Main Rule: Cant deduct voluntary expenses unless prove they were paid to protect/promote business 1. Friedman v. Delaney (1st Cir. 1948) a. Holding: payments to court on behalf of client not ordinary & necessary business expense b/c voluntary (compelled by moral obligation) 2. But see Pepper v. Commissioner (1961) a. Holding: lawyer allowed to deduct repayment of loans furnished by other clients for one clients business which turned out to be fraud b/c payments enhanced practice B. See also Tellier iii. Specifically Disallowed Business Deductions I. 162(c) illegal bribes/payments to govt officials (162(c)(1)) or anyone (162(c)(2)) II. 162(f) fines/penalties to govt for legal violations III. 162(g) 2/3 of treble damages paid under antitrust laws IV. 162(m) excessive performance-based compensation to CEO in publicly held corporation (over $1 million), but doesnt include compensation not for services performed (e.g., commissions, attainment of performance goals BUT) 162(m)(4)(c) gives roadmap how can deduct A. 162(m)(5) Companies involved in TARP V. 280E amount paid/incurred in carrying on business trafficking drugs iv. Employees I. Can deduct ordinary & necessary business expenses under 162, but only above the line if subject to reimbursement plan ( 62(a)(2)(A)) v. Questions p. 44
b. Salaries or Other Compensation ( 162(a)(1))

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i.
Main Rule IF compensation deductible under 162(a)(1), THEN it is I. Reasonable, AND II. Given purely for services ii. Reasonableness Requirement ( 162(a)(1)) I. Rationale: Combating avoidance devices (i.e., disguising non-deductible dividend payments as salary) II. Traditional, Multi-Factor Test A. Test 1. Employees role in corporation (position, hours worked, duties performed) 2. What similar companies pay 3. Character & condition of company (size, net income, capital) 4. Conflict of interest between company and employee 5. Internal consistency B. Harolds Club (9th Cir. 1965) 2 sons run gambling business & enter contract w/ dad (gaming wiz) for fixed salary + contingent bonus (20% of profits) 1. Reg. 1.162-7(b)(2) [applicable to contingent compensation] look at reasonableness of contingent comp when contract made and whether it resulted from free bargain w/o undue influence 2. Entire salary NOT deductible b/c contract not freely bargained (father dominated sons) III. Independent Investor Test A. Main Rule IF investors obtaining a far higher return than reasonably expected, THEN employees compensation presumptively reasonable AND presumption rebuttable if high return not due to CEO exertions B. Rationale: Trust the companys judgment; courts not competent here C. See Exacto Spring (7th Cir. 1999 (Posner, J.)) iii. Purely for Services Requirement (Reg. 1.162-7(a)) I. Compensation may not be a disguised dividend iv. Treatment of Excessive Compensation (Reg. 1.162-8) 4. Individual Deductions for Income Producing Expenses ( 212) a. Ordinary & necessary expenses paid/incurred by individual during taxable year for i. (1) Production or collection of income I. Unreimbursed employee expenses, investment & profit-making activities ii. (2) Management, conservation, maintenance of income-producing property iii. (3) Figuring out tax liability is deductible b. 212 deductions are below the line (unless from rents/royalties) 5. Questions and Problems p 58-59/
C. Fringe Benefits
1. General Rule a. Fringe benefits included in compensation (GI) ( 61(a)(1)) b. Rationale i. Equity want to treat people earning same value the same (fringe = value) ii. Efficiency dont want job choices to be affected by fringe benefits
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c. General Principles: Non-cash (in-kind), non-compensatory benefits that merely enable an employee
to perform a job satisfactorily. i. Although prob covered by 61, FBs do not constitute, should be excluded from income ii. Employee may get them tax free such benefits are not really compensation iii. Benefits really need to be tied to doing the job, incidental to business. If too personal wont be excluded. I. Fringe benefits that are too tangential, are actually compensation are income iv. But employer should still be able to take immediate deduction for costs v. Who gets excludable fringe benefits? Employees, certain relatives I. Who gets taxed? Employee benefits being extended because of employment relationship. Up to employee to allow benefit to run to others, but employee is TP associated with benefit. Also simpler administratively (Nixons tax returns) 2. Exception: Certain fringe benefits excluded from GI ( 132) a. Excluded Fringe Benefits i. No additional cost service ii. Qualified employee discount iii. Working condition fringe iv. De minimis fringe v. Qualified transportation fringe b. Limitations i. Nondiscrimination provision ( 132(j)(1)) I. Exclusion for highly compensated employees for no-add-cost service & qualified employee discounts permissible only if A. fringe available on substantially same terms B. to each member of C. a group of employees defined under a reasonable classification set up by employer which does not discriminate in favor of highly compensated employees II. Cant have the effect of favoring highly compensated employees (like officers) c. Use by spouse or dependent children ( 132(h)) I. Use by spouse or dependent children is treated as use by employee (plus special exception for parents of airline employees)
d. No-additional-cost service ( 132(b))

i. IF no-additional cost service, THEN I. Service is provided to employer is offered for sale to customers, AND II. Employer incurs no substantial additional cost in providing to employee ii. E.g., airline employee flying for free; have to fly standby, wait to make sure seat isnt bought by customer to be excluded
e. Qualified employee discount ( 132(c)) i. Discount on qualified property/services that doesnt exceed:
(for property) gross profit % of price offered to customers or (for services) 20% of price offered to customers I. Gross Profit % = Sale Price - Cost Sale Price II. Qualified Property doesnt include real property or investment property (i.e., stocks)
f. Working condition fringe ( 132(d)) i. Business expense that employee could deduct if he paid for it (under 162 or 167 (depreciation
of business/income producing property))
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g. De minimis fringe ( 132(e))

i. Property or service whose value is so small and frequency so high as to make accounting for it unreasonable or administratively impracticable I. E.g., occasional theater tickets, free limited use of copy machine ii. Includes meals excluded under 119 iii. Generally cash is not a de minimis fringe
h. Qualified transportation fringe (132(f))

i. Transportation in a commuter highway vehicle between home and work ii. Transit passes iii. Qualified parking 3. Problems p. 73 4. GI Inclusions from Property Transfers in connection w/ performance of services ( 83) a. Amount of GI Included ( 83(a)) Service provider who receives property from employer has inclusion in GI of FMV(at time of trigger) Price He Paid b. Character of Income from 83 Transfer: Ordinary Income (not Capital Gain) c. When Triggered i. Default Rule Wait and See ( 83(a)) I. Income triggered when property is Transferable OR Not subject to substantial risk of forfeiture II. Substantial risk of forfeiture ( 83(c)(2)) IF Full enjoyment of property conditional on future performance of services, THEN property subject to substantial risk of forfeiture III. Transferable ( 83(c)(1)) Property transferable ONLY IF transferee receives property w/o substantial risk of forfeiture ii. Optional Inclusion in Year of Transfer ( 83(b)) I. TP may include [(FMV) (Price Paid)] in GI in year property transferred II. Upside greater capital gains later (lower tax) on stock held for over 1 year A. Example 1. TP pays $1500 for $2000 stock; believes stock will increase in value to $4500 by yr 5 2. Under 83(a), say becomes vested in year 4 at value of $3500; include $2000 of ordinary income at that point ($3500-$1500); sell in year 5 w/ basis of $3500 ($1000 in cap gains) 3. Under 83(b), include $500 in GI now; sell in year 5 w/ basis of $2000 ($2500 in cap gains) III. Downside no deduction allowed if value of stock decreases or property forfeited d. Applicability to Stocks i. Section 83 applies to stock purchased at discount from employer (b/c stock not under 132)
e. Timing of Employers Deduction 83(h) i. Employer deducts same amount at same time as employee
5. Meals/lodging furnished at convenience of employer ( 119) a. Main Rule
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b. Meals/lodging furnished to employer, spouse or children are excluded from GI if certain conditions
met (employees degree of control is key) c. Lodging (Reg. 1.119-1(b)) i. Must be required to accept lodging as condition of employment ii. Must be furnished for convenience of employer (no mere formality) iii. Must be on business premises of employer I. Adams v. US (C.Cl. 1978) Condition met b/c (1) premises built & owned by employer, (2) designed in part to accommodate employers business activities, (3) employee required to live at residence, (4) employee performed business activities in home, (5) residence served important business function of employer d. Meals (Reg. 1.119-1) i. Only applies to meals in kind, not cash reimbursements (Commr v. Kowalski (U.S. 1977)) ii. Must be taken on business premises e. Problems p. 86
D. Gifts
1. Definition of a Gift a. Definition Detached, disinterested generosity, out of affection, respect, admiration, charity or like impulses i. Focus primarily on donors intention ii. Also consider overall context I. Generally gifts made by employers/corp. entity not gifts iii. Review of lower court decisions is for reasonableness/clear error b. Duberstein (U.S. 1960) i. Facts: President of company A sent president of company B a car as gift for sending names of potential customers ii. Holding I. Car not a gift b/c looks like compensation for past services or inducement to provide more names in future (not detached/disinterested) II. Court rejects proposed test that gifts be defined as transfers of property for personal as distinguished from business reasons 2. Treatment Gifts in General a. Main Rules ( 102) i. Donee can exclude value of gift from GI ii. Donor cannot deduct cost of gifts to donee b. Under Haig-Simons, could tax both donor/donee (or either) b/c i. Donor consumes enjoyment of giving (so no deduction) ii. Donee consumes gift itself / has wealth (so inclusion) c. Rationale for Current system i. Treatment more administratively convenient ii. Donee generally less wealthy & less in control iii. Treats donor and done as one taxable unit (e.g., same family) d. Problems p. 98 3. Treatment of Business Gifts and Employee Achievement Awards a. Business Gifts ( 274(b)) i. Employer may deduct business gift (under 162 or 212) ONLY IF I. Gift expense, plus sum of all other gift expenses made for donee during year, do not exceed $25 II. Item is a gift under 102 III. Cost of item to employer doesn't exceed $4
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IV. Item display employers name & one of a number of identical items distributed by employer
A. E.g., law firm giving away mugs w/ name of firm NOT a gift b. Employee Achievement Awards (EAA) ( 274(j) i. Default Rule TP must include prizes/awards in GI ( 74(a) ii. Exceptions 74(c) I. IF cost to employer of EAA does not exceed amount allowable as deduction to employer, THEN employee can exclude EAA from GI II. IF cost to employer of EAA does exceed amount allowable as deduction to employer, THEN employees GI only includes greater of: A. Total cost of EAA Cost of EAA allowable as deduction to employer (but this amount cannot be greater than FMV of award), OR B. FMV of EAA Cost allowable as deduction to employer III. EAA (def) ( 274(j)(3)(A)) A. item of tangible property B. transferred by employer to employee for length of service or safety achievement C. awarded in meaningful presentation D. isnt likely disguised compensation IV. Dollar Limitations on EAAs A. Qualified Plan Award Can deduct up to $1600 for each employee under qualified plan award (which is an established written program that doesnt discriminate in favor of highly compensated employees) B. Not Qualified Plan Award Can deduct up to $400 for each employee if not a qualified plan award (which is anything else) iii. Problem p. 100
III.
REFINING THE CONCEPT OF INCOME

1. Whether included in GI definition of income a. Glenshaw Glass (U.S. 1955) (Generally) i. Gross Income 61 includes all accessions to wealth, clearly realized & over which taxpayers have complete dominion & control ii. Holding: Punitive damages must be included in income I. Reg. 1.61-14: punitive damages included in GI II. See also Murphy (D.C. Cir. 2007) A. Compensatory damages for non-physical injury included in GI b/c not damages for personal physical injuries (which is what is excluded under 104(a)(2)) & implicitly included under 61) B. Note: court takes non-traditional approach to 61 by looking at legislative history to determine whether to include damages for non-physical injuries; traditionally, 61 includes any item that falls w/in definition of income
A. Which Benefits are Included in GI?
b. Rev Rule 80-52 (Bartering of Services)

i.
ii. iii.
iv. v.
Main Rule Receipt of services in exchange for services is included in GI Facts: A&B both perform services for each other worth $200 & receive 200 barter points to use in the barter club Holding: A & B each have income; otherwise people could use bartering to get around taxation Difference between someone who barters & someone who performed services themselves is difference in leisure time Questions p. 115
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c. Gotcher (5th Cir. 1968) (Receipt of in-kind consumption (outside gift and compensation contexts))
I. Income under 61 must be 1) economic gain & 2) must primarily benefit taxpayer personally II. Holding A. Expenses from paid trip excludable from GI if dominant purpose of trip is business (all or nothing standard) B. Employee & wife receive trip paid for by employer in efforts to get employee to open US Volkswagen dealership trip is income to wife but not employee b/c trip was primarily business & primarily benefited employer (not employee) C. Note: case decided before fringe benefits rules passed D. Were assuming husband/wife file joint return, but if they filed separately could argue income is his & he made a gift to her III. Questions p 120
d. Market bargains do not result in GI (Palmer v. Commr (U.S. 1937))

2. Realization: A When and Whether GI Question a. Realization = an event (usually sale) of property which triggers recognition of income from appreciation of property b. 1001 recognition of gain/loss i. 1001(a) Gain from Sale of Property = Amount Realized Adjusted Basis ii. 1001(b) AR = Cash Received + FMV of any Property Received iii. 1001(c) Unless there is an exception, entire amount of gain/loss is recognized
c. Eisner v. Macomber (1920) (Severance Requirement)

i. Severance Requirement Income from capital requires something for TPs separate use, benefit, and disposal that is derived and severed from the property I. Rationale TP is no richer than before, doesnt have anything new ii. Holding I. Mere increase in value of capital investment (via issuance of stock dividend) doesnt give rise to GI b/c of severance requirement II. Court says realization is a constitutional requirement under 16th Am iii. Later cases clarify that realization is not a constitutional issue & Congress can tax unrealized gains I. See Helvering v. Bruun (1940) lessor has income from building that tenant erected when land reverted back to lessor at termination of lease A. Eroded severability requirement building not actually severable from land II. LM: think of severability as having something different enough from what you had before
d. Cesarini v. US (N.D. Oh. 1969) (Windfall Rule)

i. Windfall Rule Windfalls give rise to immediate inclusion under 61 I. Windfall (def) A. When taxpayer gains something different and new besides property B. Must be distinguished from appreciation (GI deferred) and market bargains (no GI) ii. Holding I. Money found in piano is taxable, b/c windfall
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II. Money found is taxable in year found, b/c state law applies, state law was English common
law rule, and TPs gained superior title only once they found the money III. 1.61-14 treasure trove = GI (= value in US currency) for taxable year in which its reduced to undisputed possession e. Questions/Problems p 132-33 3. Imputed Income a. Main Rule Imputed income does not count as GI b. Rationale: administrability & compliance problems, liquidity issue, valuation absent FMV, public perception of tax law/personal liberty c. Imputed Income (def) Enjoyment/value taxpayer receives from her own services or property outside the ordinary processes of the market i. E.g., attorney preparing her own tax returns, farmer eats some of his produce (imputed income = profit foregone) ii. But see Commr v. Daehler (5th Cir. 1960) real estate salesmans commission paid him b/c of sale to himself counts as GI, b/c market transaction d. Horizontal Equity Problem i. If imputed income not taxed, people who choose to perform their own services taxed differently (and less) than others in same economic situation ii. E.g., Services for housekeeping I. When spouse 1 stays home, only taxed on spouse 2s income plus have clean house; when spouse 1&2 work, taxed on both then have to pay housekeeper (see p.138) iii. High income earners benefit most from exclusion e. Questions/Problems 137-38
B. Loans
1. Primary Rules a. Borrower does not include loan in GI i. Rationale: offsetting obligation (no net accession to wealth) ii. Time Value Advantage: Get money today, get taxed on it later b. Lender does not deduct loan from GI 2. Definition of Loan a. Borrowers Side i. Loan = $ received with consensual recognition, express or implied, of obligation to repay and without restrictions on disposition I. Other considerations: intent to repay, ability to repay ii. James v. US (1961) I. Holding: embezzled funds (and all unlawful proceeds) are GI II. 165(a) & (c)(2) Repayment of stolen funds can be deducted in year of repayment iii. Other Cases I. US v. Rochelle (5th Cir. 1967) swindler who was lent money under false pretenses realized GI even though money was technically a loan II. Gilbert v. Commissioner (2d Cir 1977) [taking = loan based on intent] corporate president took funds from corp. w/o authorization to use for good of corp. & signed promissory notes secured by his own assets; even though corp. was unable to recover $ later, court held taking was loan based on intent of president b. Lenders Side i. Payments are not advances/loans when no binding obligation to repay
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ii. Boccardo v. Commissioner (9th Cir 1995)

Holding A. Contingency fee arrangement under which law firm incurred costs of litigation & would receive nothing if there was no recovery (no explicit obligation to repay costs) was not loan B. Therefore, firm can deduct costs as ord/nec business expenses c. Problems p 148 3. Cancellation of Indebtedness (COI) a. Primary Rules i. Borrower includes in GI the amount of COI ( 61(a)(12)) ii. Lender deducts loss from COI ( 166) b. Borrowers Side i. Whether there is COI IF COI, THEN I. Borrower pays back loan at lesser amount II. Not a disputed debt ii. Amount of COI: US v. Kirby Lumber (1931) Inclusion in GI from COI = Amount Originally Borrowed Amount Paid Back I. Rationale: assets were made available A. Note: Kirbys assets made available rationale doesnt work in all cases, because sometimes amount of indebtedness exceeds borrowers assets B. Therefore, also use rationale that borrower didnt report income b/c promised to pay it back, so failure to repay is inconsistent w/ original reason to exclude & adjust income accordingly iii. When to Include Income from COI I. Include in year debt cancelled (doesnt change tax consequences in year 1 when debt incurred) iv. Zarin v. Commissioner (T.C. 1989) cancellation of consumption deby I. Zarin gambled on credit/markers in debt for 3.4 million casino sued for full amount settled for 500,000; incurred a consumption debt II. Holding A. Inclusion in GI from COI = Gambling debt (IOUs for chips) settlement amount III. Z Arg: Unenforceable Debt A. TC: Nonenforceability not dispositive look at how parties treated transaction; Z didnt include credit as income, but as loan IV. Z Arg: Disputed Debt Settlement No Income A. TC: Not a disputed debt, b/c there was agreement as to what he owed, and much of it was simply liquidated V. Z Arg: 165(d) Losses from wagering transactions allowed as deduction to extent of gains from such transaction s A. TC: Doesnt apply b/c (1) Regulation requires they occur in the same year, and gambling losses & gain from settlement occurred in different years and (2) gains werent from wagering transactions, but from cancellation of debt VI. Z Arg: 108(e)(5) Purchased Money Debt Reduction A. TC: Doesnt apply b/c Z acquired the opportunity to gamble, which is not property under 108(e)(5) VII. Dissents A. Tannenwald Dissent
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I.
1. The debt was not enforceable, and that is dispositive, because there was no freeing
up of assets under Kirby Lumber 2. And there was a genuine disputed debt B. Jacobs Dissent 1. Says chips equaled income to Z, since no enforceable debt, and would apply 165(d) to allow P to deduct gambling losses to extent of chip income C. Ruwe Dissent 1. Z did receive property in gambling chips, therefore apply 108(e)(5) VIII. Arguments for Zarin: A. Chips werent equivalent of cash & all he acquired was opportunity to gamble & they bargained out to actual value of what he received B. He received compensation for incentivizing people to gamble IX. BUT, Reversal A. 3rd Cir. later reversed and held no cancellation of indebtedness income b/c obligation was a disputed debt (nonenforceable) under 108(d)(1) B. Need actual liability to have COI income, and settlement eliminated that liability debt disputed until settlement amount decided and fulfilled it C. Also found no property subject to debt chips didnt count D. Problems with their reasoning: E. But 108 focuses on the exclusions, didnt really look to 61 inclusions first F. Enforceability of debts shouldnt necessarily be determinative X. Question p 160 v. Exclusion of COI from GI I. Indebtedness (def) 108(d)(1): Debt for which taxpayer is A. Liable or B. Subject to which taxpayer holds property II. Main Rule COI income excluded from GI if: A. COI is a gift B. Student loan forgiveness C. COI occurs in title 11 case D. COI occurs when TP insolvent E. Indebtedness is qualified farm indebtedness (see 108(g)(2)) F. Indebtedness is qualified real property business indebtedness G. Indebtedness is qualified principal residence indebtedness which is discharged before January 1, 2010 III. Gifts A. COI income excluded from GI if COI is gift (Autenreith v. Commr (3d Cir. 1940) B. 108(b) Excluded COI is applied to reduce tax attributes of TP IV. Taxpayer Insolvency A. COI income excluded on basis of TP insolvency cant exceed amount by which TP is insolvent ( 108(a)(3)) V. Qualified Real Property Business Indebtedness ( 108(c)(3)) A. COI income on basis of qualified real property business indebtedness are applied to reduce the basis of TPs depreciable real property VI. Qualified Principal Residence Indebtedness A. Exclusions of COI on basis of principal residence indebtedness are applied to reduce (not below zero) basis of TPs principal residence ( 108(h)(1)) VII. General rules for COI ( 108(e))
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A. No general insolvency exception from rule that indebtedness discharge = GI

B. No GI realized from COI if payment of liability would have been deductible 1. Ex: if TP pledges to give church donation but then has to reduce pledge, no cancellation of indebtedness b/c donation would have been deductible C. Amount must be adjusted for unamortized premium & discount w/r/t indebtedness discharged D. Purchase Money Debt Reduction (Lemon rule) 1. Debt reduction is treated as purchase price reduction (not cancellation of debt) if a. debt of purchaser of tangible property, b. to seller of property, c. w/r/t such property, d. is reduced in manner that would otherwise be indebtedness discharge e. not in title 11 case or when purchaser is insolvent E. General Reduction of TPs Tax Attributes ( 108(b)(2)) vi. Satisfaction of Debt vs. COI I. IF COI, THEN A. Lack of consideration from borrower to lender 1. US v. Centennial Savings Bank (1991) early withdrawal penalties paid by depositors to bank not discharge of indebtedness b/c payment was just fixed amount required to close account AND B. Borrowers failure to satisfy debt 1. if debt is paid by services, property, or any money, its satisfied & not discharged II. In Kind Satisfaction of Debt A. IF debt satisfied in kind, THEN satisfaction transaction is analyzed as taxable exchange 1. Services: Analyze as if a. Borrower performed services for lender b. Lender paid borrower for services (thus gets deduction) c. Borrower pays lender to satisfy loan 2. Property: a. Taxable Transaction under 1001 b. Analyze as if Borrower gave lender property Lender paid cash to borrower for property Borrower paid cash to lender to satisfy loan 3. Release of Claim (Rev Rule 84-176) a. Debt forgiven by seller in exchange for payment of amount of debt + release of breach of contract claim is not income from COI b. Analyze as if Lender paid borrower damages (1/2 of debt) Borrower paid full amount of debt as cash
c. COI: Lenders Side Bad Debts ( 166) i. If COI, Lender can deduct wholly or partially worthless debt which becomes worthless
within taxable year d. Problems p. 165-67 e. Treatment of loans under Consumption Tax
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i. Consumption = Income Wealth ii. One Approach I. Amount Borrowed = GI (b/c cash inflow) II. Deduction = Principal and Interest paid on loan A. Rationale: Dont tax twice (proceeds would be paid with after-tax $) iii. Another (Economically Equivalent) Approach I. Amount Borrowed = Excluded from GI II. No Deduction for Principal and Interest paid on loan iv. Effect on Borrowing: Would discourage borrowing to consume (consistent w/ encouraging savings) v. Treatment of Interest I. Interest is part of loan, because it is included in future value of principal vi. Deduction for Loan Proceeds Invested
IV.
DEDUCTIONS & CREDITS: BUSINESS EXPENSES VS. PERSONAL EXPENSES

1. Allow taxpayers to deduct cost of business b/c: a. Conceptual: Costs of producing income are not themselves income b. Efficient: Dont want to disincentivize business that costs a lot to run (dont want to skew choices): c. Equitable: Want people w/ same profit to pay same tax (ability to pay)
A. Introduction
B. Above the Line Deductions vs. Below the Line Deductions

1. Above the Line Deductions ( 62(a)) a. Trade/business Deductions ( 62(a)(1)) i. Expenses attributable to trade/business carried on by taxpayer ii. Exception: Expenses incurred in trade/business that is performance of services by TP as employee b. Specified trade/business deductions of employees ( 62(a)(2)) i. Reimbursed expenses under reimbursement or other expense allowance arrangement as per 1.62-2(c)(5) c. Losses from sale/exchange of property ( 161 et seq.) d. Rents/royalties (deductions attributable to) ( 161, 212, 611) e. Deductions of life tenants/income beneficiaries of property f. Pension/profit-sharing/annuity plans of self-employed individuals g. Retirement savings ( 219) h. Alimony ( 215) i. Moving expenses ( 217) j. Interest on higher ed loans ( 221) k. Higher ed expenses ( 222) l. Health savings accounts ( 223) m. Costs of discrimination suits 2. Below the Line Deductions a. Generally, mixed business & personal expenses (only taken if TP itemizes) b. Limitations on i. The 2% Rule ( 67(a)) I. Amount of Deduction allowed for miscellaneous itemized deductions (MIDs) = (Sum of all MIDs) (2% of AGI) II. Miscellaneous Itemized Deductions ( 67(b)): A. All below the line deductions EXCEPT
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1. Interest Deduction ( 163) 2. Taxes Deduction ( 164) 3. Various Losses Deduction ( 165(a), (d)) 4. Charitable Contributions ( 170) 5. See others III. Rationale: simplicity for taxpayers; makes them have less incentive to calculate itemized deductions ii. The Rich Person 3% / 80% Rule ( 68(a)) I. IF AGI exceeds $100,000, THEN Amount of Itemized Deductions allowed = (Itemized Deductions allowed after 67(a)) Lesser of 3% (AGI $100,000) OR 80% (Itemized Deductions allowed after 67(a)) II. Deductions Not Subject to 3% / 80 % Rule (68(c)) A. Medical, etc. expenses ( 213) B. Investment Interest Deductions ( 163(d)) C. Various Losses Deduction ( 165(a), (d)) 3. Reimbursement: What is an Accountable Plan? (1.62-2(d)-(f)) a. Accountable Plan i. Business Connection (d): Expenses must be business expenses paid/incurred by employee in connection w/ performance of services ii. Substantiation (e): Plan must require employee to make adequate accounting to employer iii. Excess Returned(f): Plan must require employee to return amounts paid in excess of actual expenses
b. IF Employee Reimbursed for Expenses under Accountable Plan i. Employee may exclude reimbursements from GI (1.62-2(c)(4)) IF I. Employee makes adequate accounting to employer ( 1.162-17, 1.274-5T)
II. Employee doesnt claim excess reimbursements over expenses
ii. Employer subject to any 50% Limitation under 274(n)(2)(A) (see below) c. IF Employee Reimbursed for Expenses under Nonaccountable Plan i. Employee must report reimbursements as GI ( 1.62-2(c)(5))
ii. Reimbursements may be taken as below the line deductions subject to 274(n), then 67 & 68, as long as employee makes adequate accounting of expenses 4. Example: options for structuring payment of employee expenditures which are deductible a. Employer can pay expenses that employee incurs on job i. Employer gets above the line deduction under 62(a)(1) ii. Employee gets exclusion from GI under 132 b. Employee can pay expenses upfront & receive reimbursement from employer i. Under Accountable Plan I. Employer gets above the line deduction under 62(a)(1) II. Employee gets either? A. above the line deduction under 62(a)(2), OR B. exclusion from GI under 1.62-2(c)(2) ii. Under Nonaccountable Plan I. Employer gets above the line deduction under 62(a)(1) II. Employee gets inclusion in GI, and may get below the line deduction under 1.62-2(c)(5), subject to 67-68 limitations
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c. Employee can pay expenses upfront & not be reimbursed at all

i. Employer has no result ii. Employee can get below the line deduction under 212, subject to 67-68 limitations iii. Bad deal for employee
C. Mixed Business & Personal Expenses

1. Primary Rules a. Trade/business expenses generally deductible ( 162) b. Personal expenses generally not deductible ( 262) 2. Travel & Lodging a. Commuting Costs (Rev Rule 99-7) i. Travel between two business locations is deductible ii. Traveling between work and home I. General Rule: Travel between work and home not deductible A. Rationale: Cost stems from personal choice about where to live Commuting Rules II. Exceptions: A. Commuting expenses for daily travel to temporary work location outside TPs metro area 1. Temporary (def) a. Expected to last for less than 1 year (no longer temporary as soon as its apparent that it will last for more than 1 year) b. Does last for less than 1 year B. If TP has one or more regular work locations, commuting expenses for daily travel to temporary work location in same trade /business, regardless of distance 1. E.g., travel from home to clients office on the way to taxpayers office C. Home Office Exception 1. If TPs principal place of business is his home (as defined in 280A(c)(1)(A)), commuting expenses for daily travel from home to other work locations in same trade/business D. Tool Exception 1. If taxpayer incurs addl expenses in transporting tools between home and work, TP can deduct cost of commuting (not clear whether all, or only incremental, may be deducted) b. Traveling Expenses While Away From Home ( 162(a)(2)) i. Traveling Expenses (def) ( 1.162-2(a)) I. Fares, meals (but see below for additional meal limitations), lodging & expenses incident to travel ii. Traveling expenses deductible ONLY IF: I. Ordinary/reasonable ( 1.162-2(a)) & necessary II. Not lavish or extravagant under the circumstances III. Incurred while away from home IV. Incurred in the pursuit of trade/business iii. Away From Home Requirement I. Home General region in which TP lives and works (different from commuting) A. Therefore, Traveling away from home TP has business connection with home B. Rationale: 162(a)(2) is concerned w/ duplication of living expenses necessitated by business C. Hantzis v. Commissioner (1st Cir 1981) 1. Facts: couple lives in Boston and wife (Harvard law student) takes summer job in NY (husband stays in Boston) & tries to deduct transportation expenses to/from NY & meals/lodging in NY
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2. Holding: 162(a)(2) deduction disallowed, b/c expenditures were not incurred away
from home, b/c Hantzis had no business connection to Boston, therefore NY was home for tax purposes D. Daly v. Commissioner (4th Cir 1981) 1. Facts: Salesman w/ residence in Virginia who regularly traveled to other states for selling purposes 2. Holding: Tax home = area served as traveling salesman (even though he prepared reports in his Virginia residence); therefore, expenses to tax home not deductible, b/c Virginia residence maintained for personal reasons II. 2 Abodes & TP has Business Connection w/ Each A. The home that is away from home is the minor post of duty B. The tax home is the major post of duty C. To determine which location is major post, look at length of time spent D. See Andrews v. Commissioner (1st Cir 1991) 6 months MA & 6 months FL III. Home Office When No Other Fixed Locations( 280A(c)(1)) A. Principal place of business includes place used for admin or management activities of trade/business IF there is no other fixed location where such work is conducted iv. Trade or business Requirement I. Primarily Test ( 1.162-2(b)) A. If trip is primarily for business, can deduct travel expenses B. If primarily for pleasure, 1. Cant deduct travel, meal, or lodging expenses 2. Can deduct expenses related to business incurred while on trip II. No Need for Business to be Pre-Existing A. Trade or business doesnt need to be pre-existing (see Hantzis) B. Question is whether expense incurred as cost of producing income c. Questions p. 185 3. Meals & Entertainment a. Meals incurred through travel away from home ( 162(a)(2)) i. See additional requirements above ii. Away From Home Requirement I. See additional requirements above II. Overnight Rule A. Deduction for Meals away from home Overnight Stay B. US v. Correll (U.S. 1967) meal eaten alone can only be deducted if satisfies 3 requirements of 162(a)(2) III. note: a meal eaten w/ client at restaurant out of town may be deductible under 162
b. Local Meals / Meals Not Otherwise Deductible Under 162(a)(2) i. Local Meals / Non- 162(a)(2) meals deductible only if they are
ordinary and necessary business expenses I. Ordinary and Necessary Requirement A. Necessity: Frequency, importance to the business B. Moss v. Commissioner (7th Cir 1985) (Posner, J.) 1. Court disallows deduction for meal under 162 when partners in small firm met at restaurant for lunch every day 2. Fact that they met every day looks personal; if they only met once a month it would probably be deductible 3. Meals were ordinary but not necessary 4. NOTE: 274 not discussed b/c didnt pass under 162
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II. Three Types must meet 162 AND THEN 274 A. Entertaining clients and customers B. Entertaining co-workers C. Solo attendance at professional meetings III. Amount of Deduction A. Entire cost of valid business meal deductible under 162(a) (subject to 274 limits) B. Rationale: Administratively burdensome to disallow personal element ii. Questions p 195 c. Limits on Deductibility of Meals/Entertainment ( 274) i. Substantiation Requirement ( 274(d)) I. No deduction allowed for travel, meals or entertainment unless substantiated by adequate records ii. Threshold Requirement ( 274(a)) (in addition to under 162) I. Deduction allowed for entertainment, amusement or recreation (including meals) ONLY IF activity was A. directly related to conduct of business ( 1.274-2(c) & (d)) OR B. associated w/ conduct of business (only) if activity directly precedes or follows substantial & bona fide business discussion II. Entertainment A. Objective Definition ( 1.274-2(b)) III. Directly Related Test 1. Requires greater degree of proximate relationship between expense and trade/business than required by 162 2. Expenses meant to promote company goodwill in social setting do not count IV. Associated With Test A. Directly preceding or following is interpreted restrictively, esp. w/r/t expenses to promote goodwill V. See Walliser v. Commissioner (T.C. 1979) A. Holding: Cost of tour taken by bank loan manager for ppl in building industry to meet potential clients & foster good will not deductible under 274 1. Entertainment; doesnt matter that Ps said they didnt enjoy the trip 2. 162 ord/necessary requirements satisfied, but still need to satisfy 274 3. Fostering goodwill/future business doesnt meet directly related test or associated with test VI. Exceptions to 274(a) ( 274(e)) (important to look at) iii. 50 % Limitation ( 274(n)) I. Only 50% of entire meal or entertainment cost is deductible (whether away from home or not) II. Exceptions to ( 274(n)(2)) iv. Limitation on Deductibility of Business Gifts (274(b)) I. See Above v. Additional Business Meal Limitation ( 274(k)) I. No deduction allowed for business meal unless expense is A. Not lavish/extravagant, and B. TP present at meal II. Exceptions ( 274(k)(2)) vi. Limitation for Entertainment Tickets ( 274(l)) I. Deduction for entertainment tickets cannot exceed face value of non-luxury ticket (unless for charity)
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vii. Filter process for entertainment/meals: Start with 162, then 274(a), then 274(d) substantiation,
then 274(k) not lavish or extravagant. If meet a and k, still limited to 50%. THEN, 67(a) 2% floor if itemizing, then 68 phasedown if itemize enough. viii.Questions/Problems p 202-203 4. Child Care a. Deductibility / Imputed Income Status i. Child care not deductible as business expense under 162 or 212 I. Smith v. Commissioner (T.C. 1939) A. child care costs not deductible as business expense under 162 b/c relationship to business too tenuous (child care is a personal expense) B. wanted but for test (but for care, wife couldnt work & make income) but court rejected as slippery slope C. NOTE: Opposite but for test 1. But for work, wouldnt need child care a. Would have helped b. Wouldnt apply to other personal costs like meals ii. Child care performed by TP not taxed b/c imputed income iii. Equity Problem I. Overall, structure makes it not worth it for women to work sometimes II. Could be rectified by taxing imputed income or allowing deduction for child care b. Child Care Credit ( 21) i. Rationale: Congress now sees child care as mixed business/personal expense limited to payments related to employment but less than full cost of childcare included ii. IF TP has I. Expenses for household & dependent care services II. That are incurred to enable TP to be gainfully employed THEN TP may claim credit equal to (Applicable %) (Sum of Child Care Expenses) iii. Applicable % I. 35%, but II. Reduced by 1% for every $2,000 (or fraction thereof) earned over AGI of $15,000 III. BUT, never reduced below 20% iv. Limitation on Sum of Child Care Expenses ( 21(c)) I. Absolute Max of $3,000 for 1 dependent II. Absolute Max of $6,000 for 2 or more dependents III. Sum of Expenses cannot exceed TPs earned income ( 21(d)) v. E.g. TP w/ $100,000 AGI, $20,000 of childcare expenses & 1 child: I. Credit = 20% of $3,000 = $600 II. Max amount of credit (assuming v. low income w/ lots of kids) = 35% of $6,000 vi. Refundability I. Credit is not refundable, so no assistance to low-income taxpayers who pay no IT c. Dependent Care Assistance Program (129) i. Exclusion from GI for compensation from employer-provided dependent care programs (usually through salary reduction agreements) ii. TP may exclude from GI income employer pays TP for dependent care assistance pursuant to dependent care assistance program (129(d)) iii. Limitation on Exclusion I. Absolute max of $5,000 ($2,500 if separate return by married individual) ( 129(a)(2)(A)) II. Exclusion cannot exceed TPs earned income ( 129(b)(1)(A))
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iv. Value of Exclusion I. (Sum of exclusion) (TPs marginal rate) II. Therefore, works same as above line deduction v. Relation to Child Care Credit of 21 I. Receipt of 129 exclusion disallows receipt 21 credit unless total exclusion doesnt exceed max in 21(c) in which case TP can get credit under 21 for difference vi. Credit for employers ( 45F) I. Employers can claim credit up to $150,000 for 25% of qualified employee child care expenses & 10% of qualified child-care resource referral expenses d. Child Tax Credit ( 24) i. Child Credit of $1,000 per dependent age 16 and younger ( 24(a)) ii. Rationale: Supporting childrearing w/o regard for costs of child care iii. AGI Limitation I. Total Credit Per Dependent = $1,000 reduced by $50 for each $1,000 (or fraction thereof) in AGI over threshold amount II. Threshold Amount of AGI ( 24(b)(2)) A. Joint Return: $110,000 B. Unmarried individual: $75,000 C. Married individual filing separately: $55,000 iv. Refundable ( 24(d)) e. Questions p 209 5. Education a. Rationale for Codes Treatment of Education i. Accurate Measurement of Income I. Generally, education considered personal expense (so not deductible), but can be mixed business/personal II. Education could also be seen as capital b/c investing in future earning A. Wouldnt allow deductions B. But to extent that Code doesnt permit amortization of education costs, various benefits provided may counterbalance this disallowance ii. Promotion of Progressivity (Ability to Pay) I. To extent deductions are conceptually appropriate for education, lack thereof is an indirect tax on educated people, who are higher earners iii. Promotion of Education I. Investment in economic growth, personal enrichment, etc. b. Exclusions i. Employer Education Assistance Programs ( 127) I. TP may exclude from GI income employer pays TP for educational assistance pursuant to educational assistance program (127(b)) II. Limitation on Exclusion A. Absolute max of $5,250 ( 129(a)(2)) B. Exclusion cannot exceed TPs earned income ( 129(b)(1)(A)) ii. Scholarship Exclusion ( 117) I. TP may exclude from GI Amount received as qualified scholarship/qualified tuition reduction Unless compensatory ( 117(c)(1)) c. Deductions
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i. Work-related Education Expenses ( 162(a)) I. TP may deduct below the line work-related education expenses
ONLY IF ordinary and necessary
II. Ordinary and Necessary Educational expenses (Reg. 1.162-5) A. Deductible:

1. Education in order to: a. Maintain/improve skills needed in TPs present job or employment b. Meet requirements of employer or applicable law/regulations for retaining present job/rate of compensation E.g., state changes education requirements once youre already in profession 2. Travel Expenses while away from home primarily for engaging in independently deductible work-related education (Reg. 1.162-5(e)) B. Not Deductible: Education in order to 1. Meet minimum educational requirements of TPs chosen trade/business a. E.g, JD b. E.g., Wassenaaar v. Commr (T.C. 1979): Tax LLM cannot deduct cost of degree when he enrolled right after law school 2. Qualify for new trade/business ii. Interest on Education Loans ( 221) I. TP may deduct above the line interest on qualified education loans ( 221(d)(1)) II. Limitations A. Dependents Not Eligible ( 221(c)) 1. TP may not take 221 deduction if claimed as dependent by another TP under 151 B. On Amount of Deduction 1. Absolute max of $2500 ( 221(b)(1))
2. IF AGI exceeds $50,000 AND filing singly,

Deduction reduced by X, where ________X________ = (AGI $50,000) Deduction Otherwise $15,000 3. IF AGI exceeds $100,000 AND filing jointly, Deduction reduced by X, where ________X________ Deduction Otherwise = (AGI $100,000) $30,000
iii. Qualified Tuition & Related Expenses ( 222) I. TP may deduct above the line qualified tuition & related expenses II. Qualified Tuition & Related Expenses (def) ( 25A(f)(1)) A. See Hope & Lifetime Learning Credits, below III. Limitations A. Limitations on Amount of Deduction 1. If TPs AGI =< $65,000 ($130,000 for joint) max is $4,000 2. If $65,000 < TPs AGI =< $80,000 ($130,000 < TPs AGI =< $160,000 for joint) max is $2,000 3. If TPs AGI > $80,000 ($160,000 for joint)
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no deduction B. No double benefit 1. Other Deductions: No deduction under 222 for expense for which deduction taken elsewhere 2. 25A Credits: No deduction under 222 if TP elects credits under 25A 3. Qualified tuition & related expenses reduced by amount of exclusions taken under 135, 529(c)(1) and 530(d)(2) d. Credits i. Hope & Lifetime Learning Credits ( 25A) I. How they work together A. TP allowed total credit equal to Hope Credit + Lifetime Learning Credit B. Limitations 1. Reduction for Scholarship ( 25A(g)(2)) a. Amount of qualified tuition & related expenses must be reduced by amount of any scholarships 2. Precluded by Taking of Deduction ( 25A(g)(5)) a. Cant get credit for an expense if youve taken deduction for it (ex: 162 workrelated education deduction) 3. Not for Same Student in Same Year ( 1.25A-1(b)) a. Cant take both Hope & Lifetime Learning credits for same student/expenses in same year 4. Taxpayer / Student Limitations a. TP entitled to credits only if student is TP, spouse or dependent b. If student is a dependent, credit goes to taxpayer claiming dependent (even if student pays own tuition) ( 25A(g)(3))
II. Qualified Tuition & Related Expenses (def) ( 25A(f)(1)) (as amended) A. Includes: Tuition, fees, and course materials
at eligible educational institution for courses of instruction required for enrollment of 1. TP 2. TPs spouse 3. TPs dependent (def in 152) B. Excludes 1. Sports expenses ( 25A(f)(1)(B)) 2. Nonacademic fees ( 25A(f)(1)(C)) III. Hope Credit ( 25A(b) (as amended)) A. Per student for only and each of first four years of college, and only if student at least time: Credit allowed of up to $2,000 of qualified tuition & related expenses AND Up to 25% of such expenses over $2,000 but under $4,000 (therefore, max credit is $2,500) B. Reduction ( 25A(i) (as amended)) Example: AGI $165,000 with $5,000 expenses = $2500 max credit otherwise
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1. If filing singly,
$2,500 x ($90,000 $165,000) = credit $10,000
2. If filing jointly,
($180,000 $165,000) = $1,875 credit $20,000 3. Thus, credit phases out for individual AGI > $80,000, gone at $90k upper limit and joint AGI > $160,000, gone at $180k upper limit C. Refundability ( 25A(i) (as amended)) 1. 40% of Hope Credit ($1,000) is refundable $2,500 x
IV. Lifetime Learning Credit ( 25A(c))

A. Per TP, Credit allowed of (20%) (Sum of qualified tuition & related expenses) B. Max sum of qualified tuition & related expenses 1. $10,000 2. Therefore, max credit is $2,000 C. Reduction ( 25A(d)) Same formula as Hope Credit above
1. If filing singly, substitute $60,000 in formula 2. If filing jointly, substitute $120,000 in formula 3. Thus, credit phases out for individual AGI > $50,000, gone at $60k upper limit
and joint AGI > $100,000, gone at $120k upper limit e. Education Savings Vehicles i. In General I. After-tax dollars contributed to these accounts grow tax-free II. Rationale: Encouraging savings for education III. Example of consumption tax treatment of investments in IT ii. Qualified Tuition Programs (QTP) ( 529) I. QTPs are exempt from taxation ( 529(a)) II. QTP (def) ( 529(b)) A. Must be established by state or eligible educational institution & taxpayer can contribute for designated beneficiary B. Contributor may purchase tuition credits or make contributions (cash only) III. Qualified Higher Education Expenses ( 529(e)(3)) A. Basics 1. Tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a beneficiary at an eligible education institution B. Special Needs 1. Expenses for special needs services for a special needs beneficiary C. Room & Board 1. For students who are at least time, room and board up to limitation under 529(e) (3)(B)(ii) IV. Contributions A. Limitations:
26
1. Cannot be excess of what is necessary to provide for beneficiarys higher education

expenses ( 529(b)(6)) 2. AGI Limitation: None V. Distributions ( 529(c)) A. Distributions that dont exceed higher education expenses are excluded from GI B. Distributions that do exceed higher education expenses are includible under 72 C. Limitations 1. Reductions required by a. Amount of scholarships received ( 529(c)(3)(B)(v)(I)) b. Amount of qualified higher education expenses used to calculate Hope &/or Lifetime Learning Credits under 25A 2. Interaction with 530 a. Can contribute to both accounts, but cant contribute more than each allows & cant contribute more than you will ultimately need for education expenses iii. Coverdell Education Savings Accounts / Education IRAs ( 530) I. EIRAs are exempt from taxation, except to extent required by 511 ( 530(a)) II. EIRAs (def) ( 530(b)) A. Must be trust created or organized in U.S. for paying qualified education expenses of an individual III. Qualified Education Expenses ( 530(b)(2)) A. Includes Qualified Higher Education Expenses under 529(e)(3) B. Includes Qualified Elementary & Secondary Education Expenses under 530(b)(3) 1. Expenses for tuition, fees, academic tutoring, special needs services, books, supplies, other equipment which are incurred in connection w/ enrollment or attendance at public, private, or religious school 2. Expenses for room & board, uniforms, transportation, and supplementary items and services 3. Expenses for purchase of computer technology or equipment IV. Contributions A. Limitations 1. Only in cash ( 530(b)(1)(A)(i)) 2. Beneficiary cannot be older than 18 ( 530(b)(1)(A)(ii)) 3. Absolute Max: $2,000/yr. 4. AGI Limitation a. If filing singly, amount of contribution reduced by X, where __ X__ = (AGI $95,000) $2,000 $15,000 b. If filing jointly, amount of contribution reduced by X, where __ X__ = (AGI $190,000) $2,000 $30,000 Sum of Distributions B. Other Limitations 1. Reductions required by a. Amount of scholarships received ( 529(c)(3)(B)(v)(I)) b. Amount of qualified higher education expenses used to calculate Hope &/or Lifetime Learning Credits under 25A 2. No Deduction, Exclusion, or Credit for Same Expense ( 530(d)(2)(D)) 3. Interaction with Qualified Tuition Programs ( 530(d)(2)(C)(ii)) Questions p 220
f.
6. Losses
27
a. Main Rule: i. To affect TPs income, losses must be I. Realized II. Recognized III. Allowed ( 165) A. also establishes limits on the amount that can actually be deducted IV. Not Disallowed ( 267 among others) b. Deduction for Losses ( 165) i. ITP may deduct below the line (but not subject to 67-68) losses sustained during taxable year AND not otherwise compensated (e.g., by insurance) I. Exception for Losses from Sale or Exchange of Property ( 62(a)(3)) A. TP may deduct above the line losses from sale or exchange of property ii. Timing of Deduction (Reg. 1.165-1(a)-(b)) I. Losses must be clearly and actually sustained in year deduction claimed iii. Amount of Deduction ( 165(b)) I. For determining amount of loss, TPs basis in property at time of loss is AB under 1011 II. Absolute Max: Basis in property at time of loss iv. Limitations on Deductible Losses of Individuals (165(c)): I. Losses must be A. Incurred in trade/business B. Incurred in transaction entered into for profit (not trade/business) C. Incurred in fire, storm, shipwreck, other casualty or theft II. Theft/Casualty Losses A. General Restrictions 1. Other Casualty (def): Sudden, unexpected unusual event 2. Willful Negligence: Loss deduction denied if taxpayers inaction amounting to willful negligence caused loss 3. $100 Limitation Per Casualty ( 165(h)(1)) a. Deduction for particular casualty/theft loss allowed only to extent it exceeds $100 4. Amount Exceeding 10% of AGI Limitation ( 165(h)(2)) 5. Amount of Casualty/Theft Loss a. (Reg. 1.165-7(b)(1)) Lesser of (FMV of property immediately before casualty) (FMV after casualty) OR amount of AB b. Special Rule for Totally Destroyed Business/Investment Property IF casualty involves business/investment property which is totally destroyed AND AB > FMV before the casualty, THEN loss allowed as deduction is AB III. Wagering Losses ( 165(d)) A. Only allowed to extent of gains IV. Capital Losses (165(f)) A. Losses from sale or exchange of capital assets allowed only to extent allowed in 1211-1212 c. Other Limitations (Disallowances) i. Related Parties ( 267)
28
I. Main Rule: No deduction allowed for losses on property sales or exchanges between related
parties (but can recognize gains) II. Related Parties (def) ( 267(b)) A. Family members or economically related individuals (individual & corp more than 50% owned, etc.) III. Constructive Ownership of Stock ( 267I) A. You own the stock owned by your family (spouse, brother/sister, ancestors & lineal descendants), partner, shareholders, etc. IV. Amount of Gain on Resale Where Loss Previously Disallowed ( 267(d)) A. When property is re-sold, gain recognized to extent of: (Gain on Property) (Previously Disallowed Loss) ( 267(d)) B. If there is loss from such a resale, it is not reduced or enlarged by disallowed loss C. Example: 1. Mom (M) sells $25,000 property to daughter (D) for $10,000 (basis = $10,000) 2. D sells to unrelated party for $30,000 3. Disallowed loss of $15,000 offsets Ds gain of $20,000 & only $5,000 gain is recognized ii. Hobby Losses ( 183) I. No deductions on activity not engaged in for profit II. 183(b)(2) can deduct costs of hobbies up to income earned (below the line itemized deduction) III. This section is no longer v. important b/c addressed mostly by 469 IV. Smith v. Commissioner (T.C. 1947) losses from operation of farm are deductible b/c the farm was operated as a business (even though there was a loss) A. To determine whether activity was business or hobby, look at taxpayers intention (need to find objective of making profit) iii. Passive Activity Limitation ( 469) I. 3 Classes Income in Code 1. Ordinary (working at trade or business, employee) a. Exoebses Wall some can go between 2. Portfolio (individual) a. May be taxed less (e.g. capital gains) Impenetrable wall 3. Passive neither of the above a. Trade or business in which TP does not materially participate (i.e. silent partner) b. Enough depreciation deductions to wipe out any income c. If end up with a MINUS, no overall loss. d. Offset may be applied to future year
d. Bad Debts ( 166)

Bad Business Debts I. TP may deduct worthless or partially worthless debts II. Amount of Deduction A. TPs basis for determining amount of deduction is AB under 1011 ii. Bad Nonbusiness Debts ( 166(d)) I. Non-business debts treated as short term capital gain ( 166(d)(1)(B)) e. Questions/Problems p 234-235 i.
29
D. Tax-Favored Personal Expenses 1. General Principles Certain personal expenses are deductible, despite 262
a. Why? Encourage TP to incur that expense, alleviate tax burden on TPs who do, make up for other overtaxation i. Use the tax code as a source/tool of social policy 2. Tax Expenditures can provide targeted benefits, shape social policy by reducing the tax bill a. Official definition revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax or a deferral of liability b. Govt spends through the tax code by providing exclusions, deductions, deferrals or credits to TPs who incur certain expenses, engage in certain behavior i. Indirect subsidies cutting tax liability rather than writing checks ii. Perhaps better way to do it forces the subsidy to be spent on the selected activity, by reimbursing amounts spent on that activity iii. Criticism allows the code to veer too far from revenue raising function, allows too much revenue to go uncollected, costs the govt a lot of money I. Response ideal income base and revenue collection arent the only goals of the tax system, and if not, this is a good way to implement fed policy c. Provisions listed in tax expenditure budget list of provisions that deviate by the ideal comprehensive income base i. These are expenses that are not deducted in order to define income, but because the govt said they could be deducted ii. Lobbying for an expenditure argue it is actually consistent with normative income tax base, dont actually argue its an expenditure d. Evaluating expenditures as implementation of federal policy i. Subsidies in this way do encourage certain behaviors ii. But need to make sure that the real costs are fully evaluated I. Should be analyzed as direct govt expenditures not as tax deductions II. Upside down subsidies deductions help those in higher brackets, provisions wont even affect those at the very bottom who dont pay taxes III. End up providing funds indirectly in ways/to groups we would never fund directly iii. Why most expenditures have limits, phaseouts, caps to try to limit upside-down effects e. Questions p. 243
V. TIMING
OF
INCOME & DEDUCTIONS
A. Annual Accounting Concept

1. Primary Rule: taxable income is determined for a 12-month period; no transactional approach a. Burnet v. Sanford & Brooks (U.S. 1931) i. Facts I. TPs expenses performing dredging services exceeded payments by $176,000; TP sued payor for $176,000 & recovered the money; taxpayer claimed recovered $ wasnt income b/c transaction as whole didnt produce profits ii. Holding I. Taxpayer must report $ as income in year recovered even though transaction as whole didnt produce income iii. Congress alleviated this problem by adding 172 allows 2-year carry-back & carry forward of net operating losses from trade/business for businesses (not individuals); tax attribute under 108(b) 2. Issues: mistakes that need correction, rate changes, distortions, gaming the system, statute of limitations
B. Claim of Right Doctrine

1. Primary Rule:
30
2. 3.
4.
5.
6.
If TP receives earnings under claim of right & w/o restrictions as to disposition, then must include earnings in GI in year of receipt (irrespective of accounting method) Allowance for Deduction: a. TP can deduct any income that must be repaid in the year of repayment Distinguishing from Loan a. Obligation to repay loan is definite b. No definite obligation to return money if claim of right; obligation to return may arise only b/c of subsequent events North American Oil v. Burnet (U.S. 1932) a. Facts i. TP was beneficial owner of oil-producing land & govt had legal title to land; govt sued to oust TP from land & receiver appointed in 1916 to hold income from land; govt lost suit at district level in 1917 & money paid to TP; govt lost final appeal in 1922 b. Holding i. TP had to report income from oil produced by land in 1917 b/c government lost suit and money paid to taxpayer ii. TP under claim of right w/o restriction even though govt may have won 1922 appeal Treatment of Receipts Later Returned US v. Lewis (U.S. 1951) a. Facts: i. TP returned part of bonus he had already included in income b. Holding i. Under claim of right, had income, and could only deduct in year returned under tax rate of that year Section 1341 Modifying the Lewis Result a. IF i. TP included item in GI in prior taxable year b/c of claim of right, AND ii. TP entitled to deduction b/c in current year b/c now no right to item, AND iii. Amount of deduction > $3,000 THEN TPs tax liability for current year is lesser of (see p. 281 text) Tax liability computed w/ deduction ( 1341(a)(4)) E.g. [($200K current income) ($100K repayment)] x [15% current marginal tax rate] = current tax liability OR Tax liability computed w/o deduction ( 1341(a)(5) E.g. [($200K current income) x (15% current marginal tax rate )] [previous deduction of (100K) (30%)] i.e. (Amount of item)(TPs Tax % for prior taxable year)] b. Question/Problems p. 282
C. Tax Benefit Concept ( 111)

1. Inclusionary Component IF a. TP parted w/ property/money in a previous taxable year, AND b. TP recd tax benefit from (= took deduction on account of expense), AND c. (Three Overlapping Options) i. Property/money returned to TP, OR ii. Event subsequently occurs that is fundamentally inconsistent w/ premise on which deduction taken, OR iii. Original transaction unwound THEN
(1) TP has inclusion in GI in current taxable year of:

Value of property/money recd
31
AND (2) Incremental Tax Liability = (Value of property/money recd) (TPs Current Year Tax %) (see Alice Phelan Sullivan Corp. v. U.S. (Ct. Cl. 1967 for this rule) 2. Exclusionary Component IF a. TP parted w/ property/money in a previous taxable year, AND b. TP did not receive tax benefit from so parting, AND c. Any of Three Overlapping Options Above THEN no inclusion in GI from return of property/money, receipts from sale, etc. 3. Tax Benefit / Taking the Deduction ((b) above) a. Dobson v. Commr (U.S. 1943) i. Facts I. TP sustained loss on sale of stock, but did not deduct losses b/c had no taxable income to deduct from. Later recovered loss through damages for fraud. ii. Holding I. No inclusion in year of recovery, b/c TP derived no tax benefit from losses 4. Fundamental Inconsistency ((c) above) a. Bliss Dairy (U.S. 1983) i. Facts I. TP deducted cost of cattle feed as income producing. Later distributed unused feed in liquidation. Rule was that liquidating distributions did not itself trigger income. ii. Holding I. Value recd from distributed cattle feed included in income, b/c its sale in liquidation fundamentally inconsistent w/ taking of deduction earlier b. Byrd, Transferee v. Commr (T.C. 1986) i. Facts I. TP deducted cost of young plants as income producing. Later distributed plants in liquidation. ii. Holding I. Value recd from distributed plants included in income, b/c had been converted to nonbusiness use which does not produce income, which was fundamentally inconsistent w/ taking of deduction earlier c. Schwarz Rojas v. Commr (T.C. 1988) i. Facts I. TP deducted costs of crop cultivation, b/c income producing. Later distributed crops in liquidation. ii. Holding I. Value recd from crops excluded from income, b/c deduction premised on consumption of crop cultivation items, and these were consumed, so no fundamental inconsistency. 5. Return of Donated Property a. Basis in Property When Returned: Only what basis was when TP donated it b. IT General Approach (see 885 Investment Co. v. Commr (T.C. 1990)) IF donated property returned, TP has inclusion in GI of lesser of Deduction taken initially OR FMV of property at time of return c. Fundamental Inconsistency / Unwinding Approach IF donated property returned, TP has inclusion in GI of deduction taken initially 6. Questions/Problems p 288-289
32
D. Methods of Accounting
1. In General a. Financial & Tax Accounting i. Financial Accounting I. Goal to provide info about TPs financial well-being II. Errs on side of conservatism so income not overstated, ii. Tax Accounting I. Goal to raise revenues on annual basis and provide view of TPs wealth iii. Which Trumps if They Conflict I. If treatment of an item differs among two methods, tax method wins iv. Finance & Tax Symmetry Requirement ( 446(a)) I. TP generally must use same timing convention for tax purposes as for financial books/records b. Default Timing Rules i. Inclusions ( 451(a)) I. Include income in year received unless different under method of accounting ii. Deductions ( 461(a)) I. Deductions allowed in year set by method of accounting 2. Cash Method used by most wage earners/employees/personal service & small businesses w/ limited inventory. Follow the money. a. Income i. Main Rule: I. Cash method TP must include income on earlier of A. actual receipt, including 1. receipt of economic benefit 2. receipt of cash equivalent B. constructive receipt ii. Constructive Receipt ( 1.451-2) I. Income received when delivery subject solely to control/volition of TP (no substantial limitations or restrictions) A. Aldrich Ames v. Commissioner (T.C. 1999) 1. Holding a. TP didnt have constructive receipt the year KGB said they had set aside money for him b/c there were conditions and steps required to get the money B. Hornung v. Commissioner (T.C. 1967) 1. Facts a. Car awarded to football player Dec 31st at 4:30pm; TP in Green Bay & car in NY, & person who announced award had neither keys nor title 2. Holding a. Car not constructively received in year 1 when awarded, b/c delivery not dependent solely on volition of TP C. Requirement of Notice 1. Tax Courts View: YES (Davis v. Commr (T.C. 1978)) 2. Services View: NO (1.451-2(a)) II. Treatment of Checks A. Main Rule: Receipt of checks = receipt of cash (even if bank closed) 1. See Lavery v. Commr (7th Cir. 1946); Kahler v. Commr (T.C. 1952) B. Bad Credit Exception 1. If payor has bad credit, whether or not included depends on Cowden test
33
(see Cash Equivalents, below)
iii. Economic Benefit

Income received when Money or property irrevocably set aside for TP subject only to time A. Sproull v. Commr (T.C. 1951) pre- 83 1. Holding a. Money put in trust for TP by employer is taxable in year entrusted (not in years paid out) b/c was irrevocably paid out for Ts sole benefit (no one else had interest or control over money) B. See also Reg. 1.83-3(e) (codifying Economic Benefit Rule) 1. Property includes beneficial interest in assets transferred or set aside from claims of creditors of transferor 2. Thus, trust/escrow = current income II. Amount Received: FMV of the money or property iv. Cash Equivalent I. Income received when TP receives debt obligation that is a cash equivalent, requiring: A. Promise to pay by solvent obligor B. Unconditional and assignable C. Not subject to set-offs D. Of a kind frequently transferred to lenders/investors E. At discount not substantially below face value F. More than a mere promise to pay G. Cowden v. Commr (5th Cir. 1961) 1. Form of the debt obligation is irrelevant; a debt is the equivalent of cash if above II. Amount Received: FMV of debt obligation III. Rev Rul 60-31: (p. 298 text) A mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method. v. Deferral of Income I. Rules relating to Constructive Receipt A. LIMITED APPLICABILITY 1. 409A applies only to compensation plans for employees & directors B. Plan Failure ( 409A(a)(1)) 1. IF a plan fails to meet requirements of 409A, THEN inclusion in GI during taxable year of all compensation deferred under the plan for the taxable year and all preceding taxable years to extent compensation (1) not subject to substantial risk of forfeiture, AND (2) not previously included 2. Interest & Penalties ( 409A(a)(1)(B)) C. Distributions ( 409A(a)(2)) 1. May not be made earlier than a. Separation from service b. Disability c. Death d. Specified time or fixed schedule e. Change in ownership of corporate payor f. Unforeseeable emergency D. Accelerations: Prohibited ( 409A(a)(3))
34
I.
E. Elections of Deferral ( 409A(a)(4)) 1. Election to defer must be made before close of taxable year before the year in which compensation paid II. Rules relating to Funding A. Offshore Trusts ( 409A(b)(1)) 1. Trust assets set aside for deferred compensation located or transferred out of U.S. treated as property in exchange for services under 83 III. Rules relating to Economic Benefit
A. If money in trust is subject to claims of employers general creditors, no income until distribution (e.g., rabbi trust) vi. Timing of Employers Deduction ( 404(a)(5)) I. Employers deduction for deferred comp. deferred until year employee has income
b. Deductions for Cash Method i. Main Rule I. Cash method TP allowed deduction upon actual payment, limited to delivery of A. Cash B. Check (including mailing of check), OR C. Property II. NO Doctrine of Constructive Payment ii. Cash Method & Prepayment of Expenses I. Cash method TP must generally capitalize prepaid expenses ( 1.263(a)-4(d)(3)) II. General Rule IF expense is a capital expenditure, THEN cannot deduct full amount of expense in year of payment, AND capitalization (pro-rata allowance) required under 263 III. Boylston Market (1st Cir. 1942) A. Holding 1. Prepaid insurance = capital expenditure that must be deducted based on pro rata portion each year 2. Rationale: allowing TP to take dull deduction in year of pre-payment would distort income IV. One Year Rule ( 1.263(a)-4(f)) TP need not capitalize amount that is paid to create or facilitate creation of any right or benefit that does not extend beyond earlier of (1) 12 months after first date on which TP realizes right or benefit, OR (2) End of tax year following tax year in which payment made
Lease Prepaid Lease Begins
Lease Ends
End of 2nd Tax year
_____________________________________________________ 1/1/09 3/1/09 3/1/10 12/31/10
c. Questions p 308-309 3. Accrual Method Follow the Obligation

35
a. Goal match expenses against related revenue b. Some people argue this is more accurate than cash method, but it doesnt take into account time value of money c. Income i. Main Rule: The All Events Test ( 1.446-1(c)(1)(ii)(A)) I. Accrual method TP must include income when A. All events have occurred which fix right to receive income AND B. Amount of income may be determined w/ reasonable accuracy II. Fixed Fact of Liability Requirement A. Consistency Creates Flexibility 1. Pacific Grape Prods. (9th Cir. 1955) a. Facts: TP followed consistent practice of accruing income and billing customers for goods to be delivered during subsequent year b. Holding: TPs method OK, b/c TP consistently followed the practice B. Inconsistency Prevents Flexibility 1. TP cannot accrue on delivery in one year, and shipment in another III. Reasonable Accuracy Requirement ( 1.451-1(a)) A. Sufficiency of Info on TPs Books 1. Requirement satisfied if TP can calculate w/ reasonable accuracy amount of income with the info currently available to him 2. Continental Tie & Lumber Co (U.S. 1931) a. Facts: Govt took over TPs RR & was supposed to pay compensation b. Holding: TP had to report income earlier than actual receipt b/c was possible to compute income based on TPs books/records B. Adjusting for Over/Underpayment ( 1.451-1(a) & 1.461-1(a)(2)(i)-(ii)) 1. In subsequent year, upon full information: TP may deduct overpayments TP must include underpayments C. Issue: Is it a debate about amount or fact of liability? ii. Accrual Method & Debt I. Amount of Inclusion for Debt Instruments: Face Value A. BUT, Doubts about Collectibility of Debt (Spring City Foundry (U.S. 1934)) B. Mere Doubt: Must accrue, can take worthless business debt deduction later ( 166) C. Uncollectibility or Substantial Uncertainty: Need not accrue iii. Prepaid Income & Accrual Method ( 455) I. Main Rule Despite non-satisfaction of all-events test, TP must report prepaid income for future services in year received A. Rationale: TP is getting unrestricted use of cash B. RCA v. US (2d Cir. 1981) 1. Facts: RCA receives prepayments for future services, doesnt include prepayments in income b/c unsure of how much itll make on contracts 2. Holding a. RCA must include prepayments when received (cant defer as earned)
b. Though RCAs method sensible for financial accounting, tax accounting needs to raise revenue & cant deal w/ uncertainty
II. Permitted Deferral A. Time & Extent of Performance Certain
36
1. TP may be able to defer reporting advance payments when date/extent of performance of future service is certain 2. Artnell v. Commr (7th Cir. 1968): a. Baseball team could defer inclusion of income from tickets sold in year 1 when games in year 2 b/c set schedule 3. E.g.: payments for caps/gowns can be reported when apparel used (i.e., date of graduation) b/c timing certain B. Certain Prepaid Subscription Income ( 455) 1. Claim income when the newspapers/mags go out C. Prepaid Dues by Certain Membership Organizations ( 456) 1. Might overrule AAA D. Payment for Services (Rev Rule 2004-33) 1. Service provider can either a. report prepayments in year received, OR b. report what is earned in year 1 & report all remaining earnings in year 2; cannot defer past end of year 2 iv. Distinguishing Security Deposits from Prepaid Income I. General Difference A. Advance payments = inclusion in GI B. Security Deposits = loans (not GI) II. Main Rule to Distinguish A. Look at parties rights & obligations at time of payment, specifically: 1. IF money kept by seller as long as he performs Advance Payment 2. IF seller has no control over whether he keeps money Security Deposit B. Indianapolis Power & Light (U.S. 1990) 1. Facts: Utility required deposits from all non-creditworthy customers which could later be refunded or applied to bills; deposits were co-mingled w/ utilitys general funds 2. Holding: Deposits not advance payments (not taxable income) b/c utility doesnt have complete control & customer has choice to get refund d. Deductions under Accrual Method i. Main Rule I. Accrual method TP allowed deduction for liability upon A. Satisfaction of All Events Test AND B. Economic Performance ii. All Events Test ( 461(h)(4)) I. All events occurred which determine fact of liability II. Amount of liability can be determined w/ reasonable accuracy iii. Economic Performance (EP) ( 461(h)(1)) I. Rationale: addresses time value issue w/ deductions for future expenses under accrual method by delaying deduction until much closer to time of payment II. Services & Property Provided TO TP ( 461(h)(2)(A)) A. Provision of Services to TP 1. EP occurs as Services Provided a. 1.461-4(d)(6)(ii) T paying for services can satisfy economic performance if reasonably expects prop/service w/in 3.5 mos B. Provision of Property to TP 1. EP occurs as Property Provided C. Use of Property by TP ( 1.461-4(d)(3) 1. EP occurs ratably as TP uses Property (e.g., rent)
37
III. Services & Property Provided BY TP

A. EP occurs as TP Provides Services or Property 1. 1.461-4(d)(4)(i) if T is providing services/prop, economic performance can occur when T incurs costs to satisfy the liability IV. Workers Compensation & Tort Liabilities A. IF liability 1. requires payment to another person, AND 2. arises out of workers comp. OR any tort, THEN EP occurs as payments are made V. Other Sources of Liability A. Breach of Contract ( 1.461-4(g)(2)) B. Violation of Law ( 1.461-4(g)(2)) C. Awards, Prizes, & Jackpots ( 1.461-4(g)(4)) D. Anything Else ( 1.461-4(g)(7))
VI. Recurring Item Exception ( 461(h)(3)(A)) A. IF, re: a liability 1. All events test satisfied, AND
2. EP occurs on or before earlier of a. When TP files timely return for taxable year OR b. 8.5 months after end of taxable year, AND 3. Liability is recurring in nature, AND 4. Either a. Amount of liability not material, OR b. Accrual in taxable year results in better matching of liability & related income THEN TP may take deduction for liability in current taxable year iv. Matching Accrual TP Deductions to Cash TP Inclusions I. Problem: Accrual method TP otherwise allowed to deduct earlier than CP can include II. Solutions A. For Related Parties ( 267(a)(2)) 1. Postpones accrual method TPs deductions for related parties to year in which cash method TP reports income B. For Deferred Compensation Plans ( 404(a)(5)) 1. Postpones accrual method TPs deduction for deferred compensation until year cash method TP reports income v. Accrual of Contested Liabilities I. Main Rule (U.S. v. Con Ed. (U.S. 1961)) A. Accrual Method TP may not deduct a liability that is contested until final determination of TPs liability, pending dispute outcome II. Exception ( 461(f)) A. Accrual Method TP may deduct a liability that is contested ONLY IF 1. All Events Test satisfied 2. EP Satisfied 3. Money placed beyond TPs control in fund 4. Bona fide dispute as to liability B. Refunds to TP once dispute settled Tax Benefit Income C. Timing of Deduction: Year in which money transferred to fund 4. Choice of Accounting Methods a. Maintenance of Inventories ( 1.446-1(c)(2))
38
i.
TPs maintains inventories TP must use accrual method I.
ii. BUT, IRS rule

TP w/ gross receipts of $10 million or less dont have to maintain inventories or be on accrual method b. TP can use one method for one trade/business and another for a different trade/business c. TP doesnt have to use same method for personal and trade/business affairs 5. Questions/Problems p 330
VI.
DIVORCE: ALIMONY, PROP SETTLEMENTS,
AND
C. S. TRANSACTIONS
A. Alimony/Separate Maintenance
1. Gross Income for recipient 71(a) 2. Deduction for payor 215(a) 3. Cash (not services or property) 71(b)(1) a. Can be paid directly to third party for payees rent, mortgage, taxes, or tuition 4. Pursuant to written divorce or separation instrument 5. Written instrument must not designate payments as not includable in GI and not deductible 6. Spouses must not live in same household at time of payments 7. Liability for payments must cease at death of payee 8. Payments cannot be fixed as child support 9. Payments must not be front-loaded 71(f) a. If payments front-loaded first two years, GI to payor and deduction for payee b. Yr 2 post-separation: Amt pd MINUS (Amt recd yr 3 + 15k Code amt) = frontloading for 2nd yr c. Yr 1 post-separation: (Amt pd yr 1) MINUS (average of: pmt yr 2 the frontloading from yr 2 + Yr 3 amt) + 15,000 code amt = excess d. Payor counts the excess as GI in Tax yr 3, Payee takes the amount as deduction; undoing a property settlement tried to treat as alimony e. Purpose: avoid disguised property settlements where payor gets no deduction f. Rule of thumb: alimony decreases 7.5k or more yr 1 to yr 2, and 15k or more from yr 2 to yr 3 problem! Property Settlements 1. Property transfers pursuant to divorce are treated as non-taxable gifts 1041 a. Not taxable event, no recognition of gain or loss b. Transferee takes transferors basis and holding period c. Unrealized losses assigned to transferee spouse Child Support Payments 1. Not income, not deductible 71(c) 2. Must be fixed in an operating instrument 3. If reduced or eliminated on contingent event with a child (e.g. turning 18) 4. Planning opportunity: Treat as taxable alimony if payee spouse in much lower tax bracket than payor, payor could pay larger amount due to the resulting deduction (meet in middle approach) Legal Expenses a. Generally: Not deductible 262; Reg. 1.262-1(b)(7) b. But: Attorney fees paid by payee spouse to collect income are deductible Reg. 1.262-1(b)(7) c. Tax advise incident to divorce deductible 212(3) Questions/Problems p 580
B.
C.
D.
E.
VII. WHEN ARE PROPERTY TRANSACTIONS TAXED?

A. Realization Event
1. 1001(a) Gains and losses for property are accounted for upon the sale or other disposition 2. See Helvering v. Bruun (1940) lessor has income from building that tenant had erected when land reverted back to lessor at termination of lease
39
3.
4. 5. 6.
a. Eroded severability requirement building not actually severable from land b. Gain is a portion of the value of property received by TP c. Think of severability as having something different enough from what you had before 109 reverses Bruun a. Excludes from income of the lessor of real property on the termination of a lease the value of the leasehold improvement made by the lessee, unless the improvements constitute a payment in kind of lease rentals. Cottage Savings (1991): S&L exchanged set of mortgages with another S&L, claimed a loss. a. Rule: exchanged properties are materially different if they embody legally distinct entitlements, and thus are a realization event for gains/losses. 1091 wash sale rule: sell and re-buy same number shares of stock in same company within 60 days, do not realize a loss (may adjust original basis by the difference in the transaction costs) Problems, p 393-394
B. Basis
1. In General a. Rationale: Want to give TP credit for dollars already taxed, in order to avoid double-taxation b. Definition i. 1012, 1.1012-1(a) I. Basis of property = cost, which is amount paid for property in cash or other property with money that has already been taxed ii. Conceptual I. Basis of property = dollars already included in GI that are invested in the property A. Exception: debt-financed transactions (assumption of future inclusion) c. Basis & Consumption Tax i. No Basis in Consumption Tax I. In cash flow consumption tax, there would be no basis ii. Treatment of Business/Investment Property I. Purchase of business/investment property would trigger deduction for full amount II. Sale/disposition of business/investment property would be fully included in GI iii. Treatment of Personal Property I. Income on purchase, and not deductible, b/c consumption iv. Treatment of Mixed Investment-Consumption Property I. Could either (1) treat purchase price as present value of future consumption, and disallow deduction, or (2) allow full deduction at purchase and tax annual consumption value 2. Basis in Arms-Length Exchanges of Property (Bartering) a. Main Rule In arms-length exchange of property, TPs new basis = FMV of property received b. Valuation Issues i. Presume value of properties exchanged are equal; Therefore, A. If FMV of property received is unclear, look to FMV of property given
B. If FMV of properties received AND property given are unclear,

Then look to TPs undepreciated cost of property given c. Philadelphia Park v. U.S. (Ct. Cl. 1954) i. Facts: TP gave bridge to city in exchange for 10 year extended franchise ii. Holding: TPs basis in franchise = FMV of what received d. Exception: Property Exchanges for Productive Use or Investment ( 1031) i. Main Rules ( 1031(a)(1)) I. Gain/Loss IF property exchanged solely for property A. Of like kind, AND
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B. To be held either for productive use in trade/business or for investment THEN no gain or loss from exchange II. Basis TPs basis from such an exchange is basis in property given A. Minus any money TP receives B. Plus/minus amount of gain/loss recognized on exchange ii. Exceptions( 1031(a)(1)) I. Stock in trade or other property held primarily for sale II. Stocks, bonds, or notes III. See others 3. Allocating Basis a. Capital included in basis & no gain until capital returned b. Burnet v. Logan (U.S. 1931) sale of stock in exchange for cash (less than value of stock) + promise to pay annual sums doesnt give rise to income until capital (value of stock) returned & profit made i. Basis = value of stock received, so no gain until receive more than that value ii. Modern approach: Regs. 15A.453-1(c), 1.1275-4 c. Hort v. Commissioner (U.S. 1941) T must include as ordinary income full amount of consideration for cancellation of lease (cant offset w/ value of cancelled lease) i. Amount received for cancellation was not return of capital, it was essentially substitute for rental payments which are GI 4. Basis in Non-Arms Length Property Exchanges a. Buyers Basis is FMV of Property Received b. Losses Between Related Parties ( 267) i. Related Parties ( 267) I. Main Rule: No deduction allowed for losses on property sales or exchanges between related parties (but can recognize gains) II. Related Parties (def) ( 267(b)) A. Family members or economically related individuals (individual & corp more than 50% owned, etc.)
III. Constructive Ownership of Stock ( 267(c))

A. You own the stock owned by your family (spouse, brother/sister, ancestors & lineal descendants), partner, shareholders, etc. IV. Amount of Gain on Resale Where Loss Previously Disallowed ( 267(d)) A. When property is re-sold, gain recognized to extent of: (Gain on Property) (Previously Disallowed Loss) ( 267(d)) B. If there is loss from such a resale, it is not reduced or enlarged by disallowed loss C. Example: 1. Mom (M) sells $25,000 property to daughter (D) for $10,000 (basis = $10,000) 2. D sells to unrelated party for $30,000 3. Disallowed loss of $15,000 offsets Ds gain of $20,000 & only $5,000 gain is recognized 5. Basis in Property Gifts a. Main Rules i. FMV > Donors Basis IF, at time of gift, FMV > donors AB, THEN donees AB in gifted property is donors AB ii. FMV < Donors Basis (Prohibition on Loss Transfer) ( 1015(a))
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IF, at time of gift, FMV < donors AB, THEN I. Gain Rule IF calculating whether donee has GAIN, THEN donees AB in gifted property is donors AB II. Loss Rule IF calculating whether donee has LOSS, THEN donees AB in gifted property is FMV of property at time of transfer III. Example A. Donors AB: 300 B. FMV at Gift Transfer: 220 C. FMV at New Transfer: 250 D. Gain on New Transfer = AR:250 AB:300 = -50 = No Gain E. Loss on New Transfer = AR: 250 AB:220 = 30 = No Loss b. Exception for Transfer of Property Between Spouses ( 1041) i. Treated as Gifts ( 1041(a)) I. Transfers of property between spouses while married or incident to divorce are gifts; therefore, no inclusion for done and no deduction for donor ii. Donee Spouse takes Donor Spouses Basis ( 1041(a)) IF transfer between spouses while married or incident to divorce, THEN transferee always takes transferors basis (allows transfer of loss) c. Exception for Inherited Property ( 1014(a)) i. Death is not a Realization Event ii. Main Rule Donees AB in inherited property = FMV of property on date of decedents death d. Questions p 407-408
C. Capitalization
1. In General a. General Rule IF an amount expended is a capital expenditure (that is, if it generates future income), THEN it cannot be currently deducted in full (regardless of accounting method) AND may either be deducted through depreciation or not at all i. Welch v. Helvering (U.S. 1933) I. Facts: A. TP was personally paying companys debts to preserve reputation II. Holding: A. TPs payments of companys debt are capital expenditures b/c not ordinary (in ordinary/non-extraordinary sense) under 162 ii. Encyclopaedia Brittanica v. Commr (7th Cir. 1982) (Posner, J.) I. Facts: A. TP diverted from normal business and paid outside company to develop manuscript for science encyclopedia for ownership by TP II. Holding: A. TPs payments for manuscript must be capitalized, because (1) produce income over time, and (2) amounts expended were not ordinary in their business in sense of recurring III. Rationale: Providing accurate picture of TPs income by matching it with appropriate deductions b. Capitalization & Basis
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i.
Main Rule Capitalized expenditures are added to basis of property I. E.g., lawyers fees related to acquisition of land included in cost of land
c. When and Whether i. Generally a question of when to deduct (if ascertainable useful life), but sometimes a question of whether (if no ascertainable useful life) ii. Example: I. Land & Stocks: deduct at sale II. Machinery: deduct through depreciation III. Cost of education: never deduct 2. Expenditures Relating to Tangible Assets a. Capital Expenditures i. Amounts expended for new buildings ( 263) I. Examples A. Architects services ii. Non-Inventory Real or Tangible Personal Property for Business Use ( 263A) I. Includes A. Real or tangible personal property produced by TP for Business Use ( 263A(b)(1)) B. Real or tangible property acquired by TP for resale ( 263A(b)(2)) II. Examples A. Cost of buying, constructing or erecting building/machinery/equipment w/ useful life substantially beyond taxable year iii. Amounts expended for permanent improvements or betterments made to increase the value of any property or estate ( 263, Reg. 1.263-1) iv. Amounts expended to restore property (Reg. 1.263-2) v. Amounts expended in connection with sale of property (Prop. Reg. 1.263(a)-1 vi. Amounts expended to facilitate the acquisition of property (Prop. Reg. 1.263(a)-2(d)(3)) I. Cost of environmental cleanup up after acquisition vii. Exceptions I. Mines & deposits expenditures ( 616) II. Research & experimental expenditures ( 174) III. Soil & water conservation expenditures IV. Farmer expenditures for fertilizer ( 175) V. Expenditures for removal of architectural & transportation barrier to handicapped/elderly ( 190) b. Ordinary Expenses i. Amounts expended to repair or maintain property (Reg. 1.162-4) ii. Property which is inventory for TPs business ( 263A(a)(1)) iii. Professional Expenses I. Examples A. Office supplies c. Distinguishing Repairs from Improvements i. Relevant Unit of Property I. Old Approach A. FedEx Corp v. U.S. (W.D. Tenn. 2003) 1. Holding: Costs of airplane engine inspections and maintenance currently deductible as repairs, b/c unit of property at issue was jet plane 2. Factors
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a. TP and industrys treatment of component as part of larger unit for regulatory, market, management, accounting purposes b. Coextension of economic useful life of component with larger unit c. Functional interdependence of component and larger unit d. Maintenance of component while affixed to larger unit II. Proposed Regulations (Prop. Reg. 1.263(a)-3(d)(2)) A. Buildings 1. Building & structural components treated as single unit of property B. Non-Buildings 1. In general, single unit of property includes all functionally interdependent components 2. Special rules for plant property and network assets ii. Improvement I. Old Approach A. Midland Empire Packing Co. (T.C. 1950) 1. Holding: Costs of adding concrete lining to basement currently deductible as repairs, b/c allowed TP to continue to use basement as it previously had B. Mt. Morris Drive-In Theatre (T.C. 1955) 1. Holding: Costs of installing drainage system not currently deductible as repairs, b/c foreseeable need for it in preparing land for use as drive-in theater II. Proposed Regulations A. Betterment of a Unit of Property (Prop. Reg. 1.263(a)-3(f)(1)(iii)) IF amount paid 1. Ameliorates material condition or material defect that existed prior to acquisition or arose during production of property, 2. Results in material addition to unit of property (including physical enlargement, expansion, or extension, OR 3. Results in material increase in capacity, productivity, efficiency, or quality of unit of property or its output THEN amount paid is a Betterment, and must be capitalized B. Restoration of a Unit of Property (Prop. Reg. 1.263(a)-3(g)(1) IF amount paid 1. For replacing property that TP has deducted as a loss, 2. For replacing property where TP has taken account of basis of such property in computing gain or loss on a sale or exchange or in damages from a casualty, 3. To return a unit of property to its ordinarily efficient operating condition, if it has deteriorated to a state of disrepair and can no longer function for its intended purpose, OR 4. To rebuild unit of property to like-new condition after end of propertys economic useful life THEN amount paid is a Restoration, and must be capitalized C. New or Different Use IF amount paid adopts unit of property to new or different use, THEN amount paid must be capitalized D. Safe Harbor for Routine Maintenance (Prop. Reg. 1.263-3(e)(1)) 1. Main Rule IF amount paid is for routine maintenance on unit of property, THEN amount paid is not an Improvement, but a Repair 2. Routine Maintenance (def): Recurring activities TP expects to perform as result of TPs use of unit of property to keep it in its ordinarily efficient, operating condition E. Safe Harbor for Regulatory Compliance (Prop. Reg. 1.263(a)-3(d)2), (e)(5) Ex. 7) d. Amounts Paid in connection with Sale of Property (Prop. Reg. 1.263(a)-1(d))
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Exceptions I. Advertising Expenses e. Amounts Paid to Facilitate Acquisition of Property (Prop. Reg. 1.263(a)-2(d)(3)) i. Examples I. Amounts paid to broker to find new office building for TPs offices II. Amounts paid to interior decorator to find new desk for TPs office ii. Exceptions I. Salaries to employees (Prop. Reg. 1.263(a)-2(d)(3)(ii)(D)) II. Costs incurred to investigate real property acquisitions (e.g., marketing study) 3. Expenditures Relating to Intangible Assets a. Capital Expenditures i. Old Approach IF amount expended creates a significant future benefit, THEN amount must be capitalized I. Indopco v. Commissioner (U.S. 1992) A. Facts 1. TP, corporation being acquired in a friendly takeover, incurs investment banking & legal fees in connection with it B. Holding 1. Fees must be capitalized b/c relate to enhancement of significant future benefit, not determinative, but a taxpayers realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization. II. AE Staley v. Commissioner (7th Cir. 1997) A. Facts 1. TP incurred fees defend against threat of hostile takeover B. Holding 1. Fees are currently deductible b/c seek to preserve status quo, not produce future benefits III. PNC Bancorp. v. Commissioner (3d Cir. 2000) A. Facts 1. TP bank incurred costs for marketing, researching, and originating loans B. Holding 1. Loan origination costs are currently deductible (both internal & paid to 3rd parties) b/c they are ordinary (recurring) IV. Wells Fargo & Co. v. Commr (8th Cir. 2000) A. Facts 1. TP paid $150K of salaries to corporate officers involved in corporate restructuring B. Holding 1. Salaries are currently deductible b/c employees not hired specifically to render services in transaction ii. Modern Approach (Reg. 1.263(a)-4) I. Capital Expenditures related to Intangible Assets include: A. Amounts expended to acquire an intangible B. Amounts paid to create an intangible C. Amounts paid to create or enhance a separate and distinct intangible asset D. Amounts paid to create or enhance a future benefit (irrelevant) E. Amounts paid to facilitate acquisition or creation of an intangible (transaction costs) II. Amounts expended to acquire an intangible (Reg. 1.263(a)-4(c)) A. See examples in rule III. Amounts paid to create an intangible (Reg. 1.263(a)-4(d))
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i.
A. Financial Interests B. Prepaid Expenses C. Memberships and Privileges D. Rights obtained from govt agency E. Contract rights 1. Includes advance lease payments (Reg. 1.263(a)-4(d)(6)(i)(A), -(vii) Ex.1) 2. De minimis exception for amounts under $5,000 (-4(d)(6)(v)) F. Contract terminations G. Benefits related to real property provision, production, or improvement IV. Amounts paid to create or enhance a separate and distinct intangible asset ( 1.263(a)4(b)(3)) A. See general definition B. Create or terminate contract rights C. Amounts paid in performing services D. Creation of computer software E. Creation of package design V. Transaction Costs (( 1.263(a)-4(e)(1)) A. See examples in rule b. Ordinary Expenses i. Advertising, promotional, training, and similar costs (Rev. Rul. 92-80) ii. Acquisition of leasehold iii. Costs associated w/ expanding business I. E.g., deciding whether or which property to buy (but once honed in on property, costs associated w/ purchasing are capitalized) iv. Compensation to TPs employees (Prop. Reg. 1.263(a)-2(d)(3)(ii)(D)) I. BUT, payment to outside personnel in creation of capital asset always capitalized v. Amount paid to create intangible right/benefit that passes one year rule I. Earlier of 12 months after first date T realizes benefit, or end of taxable year following year payment made ( 1.263(a)-4(f)) II. BUT, here TPs accounting method will also matter, esp. if accrual TP vi. Professional Expenses I. Rent, dues to professional society & subscription to professional journal (BUT not prepayment of subscription), etc. c. Start-up Exception ( 195) i. Main Rule During year of start-up, TP may elect to currently deduct amount equal to Lesser of Amount of start-up expenditures, OR ($5,000) [(Amount of start-up expenditures) ($50,000)] ii. Start-up Expenditures ( 195(c)) I. Deductibility under 195 Deductibility under 162 if business were existing (FMR Corp. v. Commr (T.C.) d. Exception for Certain Depreciable Business Assets ( 179) i. Main Rule IF property is Section 179 Property, THEN TP may currently deduct up to $250,000 for costs of Section 197 Property ii. Section 179 Property ( 179(d)(1)) I. Includes A. Tangible property to which 168 applies (and computer software) B. That is acquired by purchase for use in active conduct of a trade/business
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iii. Max Amount ( 179(b)(2)-(3)) Amount of deduction cannot exceed lesser of I. (Amount Otherwise Deductible) [(Costs of Section 197 Property) ($800,000)] OR II. TPs Taxable Income from active conduct by TP of trade or business during year iv. Carryover ( 179(b)(3)(B)) TP can, indefinitely, and subject to normal the max amount above carry over to following years previously disallowed deductions due either to $800,000 limitation or Taxable Income limitation
D. Depreciation
1. In General a. Rationale: Allocates cost of an asset over time that it produces income b. Business/Investment Assets w/ & w/o Ascertainable Useful Life i. Assets w/ ascertainable useful life: depreciated over time ii. Assets w/o ascertainable useful life: recovered on disposition (e.g., land, stocks) 2. Depreciation & Basis (1016(a)(2)) Deductions for depreciation reduce TPs basis in depreciated property 3. General Authorization ( 167) Depreciation deduction allowed for a. Property used in trade or business (above the line) b. Property held for production of income (below the line) 4. Tangible Property ( 168) a. Modified Accelerated Cost Recovery System (MACRS) i. Asset recovered over statutorily prescribed recovery period & salvage value ignored b. 50% Bonus Depreciation Deduction ( 168(k)) IF (generally) property has a recovery period of 20 years or less, THEN before computing deduction otherwise allowable under 168 (see below) TP allowed deduction of 50% of AB of property c. Main Rule Annual depreciation deductions on tangible property are a function of i. Propertys Basis ii. Applicable Recovery Period iii. Applicable Depreciation Period iv. Applicable Convention
d. Applicable Recovery Period ( 168(c), (e))

i. Determine Classification ( 168(e))
ii. Determine Applicable Recovery Period ( 168(c))
iii. Determine Depreciation Schedule per Tables xv - xvii e. Applicable Depreciation Method ( 168(b))
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i. 150 % or 200% Declining Balance

I. Application: For 3 20 year properties II. How to Use A. Determine Category/Recovery Period B. Tables xv ii. Straight Line Method I. Application: For nonresidential real & residential rental property II. How to Use Per year, Depreciation Deduction = _____AB______ # of Years OR Tables xvi - xvii iii. Election to Use 150% Method ( 168(b)(5)) I. TP can elect to recover cost of property using straight line method ( 168(b)(5))
f. Applicable Convention ( 168(d))

i. Half-Year Convention I. Application: Unless otherwise specified II. Main Rule IF asset placed in service or disposed of during year, THEN event deemed to have occurred in middle of first year Therefore, you get half-year depreciation in first & last years ii. Mid-Month Convention I. Application A. Nonresidential real property B. Residential rental property C. Railroad grading or tunnel bore II. Main Rule IF one of above assets placed in service or disposed of during month, THEN event deemed to have occurred in middle of month Therefore, you get half-month depreciation in first & last months iii. Mid-Quarter Convention I. Application ONLY IF A. Property otherwise eligible for half-year convention B. More than 40% of all of TPs depreciable personal property placed in service during last three months of taxable year II. Main Rule IF property placed in service or disposed of during quarter, THEN event deemed to have occurred in middle of quarter Therefore, you get half-quarter depreciation in first & last quarter 5. Intangible Property ( 197 & 167) a. Main Rule IF property is an Amortizable Section 197 Intangible, THEN property may be amortized using the straight-line method over 15 years i. NOTE: Generally, AB for purposes of 15 year amortization will equal (Value of All a Business Assets) (Value of Business Tangible Assets) b. Amortizable Section 197 Intangible (def) ( 197(c)) i. Includes I. Property held in connection with trade/business of a 212 activity ii. Excludes
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I. Anything not a Section 197 Intangible II. Property created by the TP c. Section 197 Intangible ( 197(d)) i. Includes I. Goodwill II. Going concern value III. Workforce in place, business books, patents, customer-based intangible, etc. IV. License, permits, or other rights V. Covenants not to compete VI. Franchise, trademark, or trade names ii. Excludes I. Financial interests II. Land III. Computer software (see 167(f)(1)) IV. Interests in film & other media, right to receive tangible property or services, patent/copyrights V. Interests under leases & debt instruments VI. Mortgage servicing rights (see 167(f)(3)) 6. Land, Art & Antiques a. Not depreciable: i. Land, stock, inventory items, artworks (no determinable useful life) b. Antiques i. Service: not depreciable ii. 3d Circuit: depreciable (b/c wear & tear requires allocation of purchase costs) 7. Deducting vs. Capitalizing Depreciation a. Main Rule ( 263A) IF TP uses capital asset to produce another capital asset, THEN i. TP must capitalize depreciation of first capital asset over life of second capital asset, AND ii. Depreciation of first capital asset added to basis in second capital asset b. Rationale i. Use of the capital asset in such a case is a capital expenditure, and depreciation of the asset represents costs of that expenditure, b/c those costs are allocated over the assets useful life c. Idaho Power (U.S. 1974) i. Facts I. Power company TP used construction equipment it purchased to construct new buildings. TP also used that equipment for its normal course of business. ii. Holding I. TP must capitalize percentage of depreciation on equipment that is allocable to assets use in construction of capital facilities II. Codified in 8. Capitalizing Interest a. Main Rule ( 263A) Interest on loan taken to produce capital asset must be capitalized into assets basis Present Value of an Investment Tables text p. 24 Future Value of an Investment Tables text p. 24
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Problems p. 442
E. The Impact of Liabilities

1. In General a. Mortgages & Securities i. Mortgage (def): Security interest in property given by borrower to creditor to obtain loan ii. Secured (def): Creditor has lien on asset and takes it in event of default iii. Self-Amortizing Loan (def): Loan repayable in equal installments, including principal and interest iv. Purchase Money Mortgage (def): Seller of property is also lender b. Recourse & Nonrecourse Loans i. Recourse Loan (def): Loan in which borrower personally liable for repayment of debt (lender can go after personal assets) ii. Nonrecourse Loan (def): Loan in which borrower not personally liable for debt (lender can only get proceeds of foreclosure sale) 2. Rule Applicable for All Debt Types (1.1001-2(a)(3)) IF liability incurred b/c of acquisition is not included in basis, THEN liability not included in amount realized 3. Recourse Debt a. Primary Rules i. Basis I. Recourse debt used to acquire property is always included in TPs basis ii. Amount Realized ( 1.1001-2(a)(2)) I. IF FMV at Disposition > Amount of Recourse Debt, THEN AR is FMV at Disposition II. IF FMV at Disposition < Amount of Recourse Debt, THEN (bifurcation approach) A. AR is FMV at Disposition AND B. Any Recourse Debt Discharged by Lender is COI income 1. Possible 108 Exclusion, Subject to Basis Reductions a. Subject to basis reductions in depreciable real property ( 108(c)(1)(A)), or residence ( 108(h)(1)) III. When Transferee is Lender A. Bad Debt Deduction ( 166) b. Rationale: Purchaser is actually liable for amount 4. Nonrecourse Debt a. Basis i. IF FMV at Acquisition > Amount of Nonrecourse Debt, THEN nonrecourse debt used to acquire property is included in TPs basis (no matter the identity of the lender) b. Amount Realized ( 1.1001-2(a)(1))
i. IF FMV at Disposition > Amount of Nonrecourse Debt

THEN nonrecourse debt of which TP is relieved at disposition is included in AR I. See Crane (economic benefit rationale)
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ii. IF FMV at Disposition < Amount of Nonrecourse Debt THEN same result as above I. See Tufts (symmetry of treatment rationale) iii. When Transferee is Lender Transfer of property to lender is taxable event under 1001
iv. Tufts (U.S. 1983) I. Facts: Mortgagor sold property to 3d party, FMV less than amount of his outstanding
mortgage debt II. Holding: Mortgagors amount realized is the amount of his outstanding debt assumed by buyer III. Rejection of Bifurcation Approach A. No COI b/c no modification of terms between borrower & lender B. Note: also wouldnt be COD if property transferred to lender b/c want to treat all nonrecourse debt the same
F. Capital Gains governed by 1(h)

1. If gain is capital, and long term capital gain (held for over 1 year) which results in a net capital gain taxed at a reduced rate 2. Individuals only 3. Steps: 1. 1h (a) - (e) for the income baskets. Take taxable income, then 2. take out the net cap gain and tax it at ord rates (at front book), THEN 3. ord income taxed at less than 25% (i.e. in the 15% or 10% brackets) and have net cap gain, its taxed at 0 zero rate 4. if ord rate gain in 2. was 25% or more OR in 2. was < 25% but had enough to top it up to top 15% bracket, then REST OF ADJ CAP GAIN TAXED 15% 5. unrecaptured 1250 gain (just know it exists depreciation on a bldg, i.e. real prop depreciation) its taxed at max 25% (or at 10 or 15 % if in those brackets0 6. 28% rate gain apply 28% MAX (b/c if 28% more than pd under a, only pay whatever pd under a) 4. If all capital gains/losses for individual add up to net loss, individual can use capital loss to reduce ordinary income by up to 3k. Any loss > 3k carries over to next year. 1211(b) 5. Do not tax capital gains more than tax ordinary income of a TP; if max ord rate for TP is 10%, then cap gains taxed 10% 6. 28% - Collectibles i. Coins, rugs, wine, art 7. Short term capital gains taxed at ordinary rates 8. Holding period capital assets must be held over a year to qualify for capital gains treatment a. When capital assets are gifted, donnee steps into donors shoes and tacks on holding period b. Works for losses too 1.1223-1(b)
G. Capital Losses parallel to capital gains

1. May be used to fully offset capital gains 2. Excess loss can be applied against up to $3000 of other income 3. Losses can be carried forward but not back Problems p. 484
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Kratzke FedIncTax Fall 2010

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INCOME TAX OUTLINE

FALL 2010 TEXT: MALMAN, INDIV TAX BASE 2ND

B. Sources of Fed IT Law

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- standard deduction 63(c)

-personal exemption deduction 151 _____________________________ = taxable income x calculations page ix

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o Ascertain gross income, defined extremely broadly under 61

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o Apply tax credits, if applicable

F. Time Value of Money

II. INCOME & DEDUCTIONS

B. Employers & Employees

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Wages, salaries, commissions, bonuses, etc.

iii. GI from property/services in exchange for services is FMV of property/services

b. Salaries or Other Compensation ( 162(a)(1))

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d. No-additional-cost service ( 132(b))

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g. De minimis fringe ( 132(e))

h. Qualified transportation fringe (132(f))

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REFINING THE CONCEPT OF INCOME

A. Which Benefits are Included in GI?

b. Rev Rule 80-52 (Bartering of Services)

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d. Market bargains do not result in GI (Palmer v. Commr (U.S. 1937))

c. Eisner v. Macomber (1920) (Severance Requirement)

d. Cesarini v. US (N.D. Oh. 1969) (Windfall Rule)

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ii. Boccardo v. Commissioner (9th Cir 1995)

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A. No general insolvency exception from rule that indebtedness discharge = GI

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DEDUCTIONS & CREDITS: BUSINESS EXPENSES VS. PERSONAL EXPENSES

B. Above the Line Deductions vs. Below the Line Deductions

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c. Employee can pay expenses upfront & not be reimbursed at all

C. Mixed Business & Personal Expenses

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II. Ordinary and Necessary Educational expenses (Reg. 1.162-5) A. Deductible:

2. IF AGI exceeds $50,000 AND filing singly,

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IV. Lifetime Learning Credit ( 25A(c))

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1. Cannot be excess of what is necessary to provide for beneficiarys higher education