Federal Income Tax Outline

Income Tax Outline

Introduction

            Income Tax and the US Constitution

                        Art. 1, Sect 8, clause one provides Congress the power to tax: “power to lay

and collect taxes, duties, imposts and excises”

However, Congress must impose direct taxes by the rule of apportionment, and

indirect taxes by the rule of uniformity

            Direct tax: a tax demanded from the very person who is intended to pay

it

Indirect tax: a tax paid primarily by a person who can shift the burden of the tax to someone else or who at least is under no legal compulsion to pay the tax (ex. sales tax)

                        Because of apportionment problems, Congress does not enact direct taxes

The 16^th Amendment provides that income taxes shall not be subject to the rule of apportionment regardless of the sources from which the taxed income is derived

The rule of uniformity requires that all federal income taxation must be geographically uniform throughout the US: Whenever some manner or mode of taxation is used somewhere in the U.S., the same manner or mode must be used everywhere throughout the US

As a practical matter, Unless the Supreme Ct has spoken on the issue, different regions of the US will sometimes apply different tax principles depending on the law as determined by the controlling Ct of Appeals

Note: Requiring a taxpayer to file an income tax return does not violate his 5^th amendment privilege against self-incrimination

            The Tax Practitioners Tools

In any federal tax question the statutory law must be found and the proper meaning must be ascribed to such law

The law is the Internal Revenue Code of 1986 (I.R.C. § ____ )

Look to the Code first then to the regulations

Revenue rulings are used to discover the IRS’s position on a subject

There are three trial courts for Tax cases: Tax Ct, Federal Claims Court, and the US Dist Ct.

In the Tax Ct. the taxpayer can file suit to challenge the deficiency w/o paying (provided he responded to the 30 and 90-day letters sent by the IRS)

In the other two courts, the person must pay the entire deficiency and then file suit for a refund

NOTE: Most cases go to the tax court who have better qualified judges, the D. Ct. is the only place you can get a jury trial for tax matters

COMPUTATIONS

Classification of Taxpayers and Rates

            Currently, § 1 of the Code taxes individuals at five rates: 15, 28, 31, 36, and 39.6 %

            Individual taxpayers are grouped into four classifications:

1.      Married Individuals Filing Joint Returns and Surviving Spouses;

2.      Heads of Households

3.      Unmarried Individuals (not falling within the first two classifications as surviving spouses or heads of households)

4.      Married Individuals Filing Separate Returns

For each of the classifications there is a corresponding rate schedule

Tax tables provide a simple method for computing taxes

Note: If you live just one day, you are deemed to have lived the whole year

§6012 requires most persons to file an income tax return. Persons with zero taxable income are not required to file (ex. if an individual made $8000 and he automatically gets a $5000 standard deduction and $3000 in personal exemptions he does not have to file) However, if had had money withheld and wants to get it back, he must file.

Marriage penalty: Previously there were only three rates (MFS, H of H, and MFJ) but singles complained to Congress and a new category was added (Single) So now there is a marriage penalty. Married couples filing a joint return will pay more tax than two single person with the same total income (rationale is that the couples living expenses are likely to be less than those of two single persons and therefore the couples tax should be higher than that of two single persons)

Kiddie tax: net unearned income of a child under the age of 14 is taxed at the higher of the child’s regular rate or the rate at which it would be taxed to the parents if added to their other income (applies to unearned income)

Dependents income is taxed to the taxpayer that earns it, so child is taxed, not the parents

            §1(g) Rate

§151(d) no personal exemption, a person who can be claimed as a dependent gets no personal exemption

§63(c)(5) standard deduction ($700)

If the dependent is 14 or older then the Kiddie tax does not apply but the standard deduction is only $700, unless he has earned income (in which case he could deduct the earned income plus $250 up to $4400)

So if he is 15 and has $5000 unearned income, he gets a $700 deduction and is taxed at a rate of 15%

If he is 13 and has $5000 unearned income, he gets a $700 deduction, and the excess of the $5000 over $700 plus $700 (unless he is itemizing), which is 3600, is taxed at the parents rate while the remaining $700 is taxed at 15%

If he is 13 and has unearned income and earned income, he will get the earned income standard deduction (earned income plus $250 not to exceed $4400) but the portion of the unearned income that exceeds $700 plus $700 (unless he is itemizing) will still be taxable at his parents rate.

Note: One is not a statutory “surviving spouse” for the year of the spouse’s death

* * * See Problems at p. 936

Credits Against Tax

A credit of a certain dollar amount is more advantageous to the taxpayer than a deduction because it reduces tax liability dollar for dollar whereas a deduction reduces only taxable income with a corresponding but smaller reduction in tax liability

The code assigns the credit provisions top five groups (four nonrefundable and one refundable):

The four “nonrefundable” (even if they exceed the amount of tax computed, they do not generate a refund):

1.      personal credits (§21, 22, 23, 24, and 25)

2.      general business credits (§38, 40-46, 49, 1396)

3.      certain miscellaneous credits (§ 27, 29, 30)

4.      minimum tax credit (§53a)

The fifth group of credits is refundable (§31-35)

Included in this group is the Earned Income Credit, which gives low income workers a credit against their income tax liability. The amount of the credit is based on a percentage of their earned income, and it is phased out as their income increase. This constitutes a negative income tax, in that it provides such taxpayers with an additional source of financial support.

Note: It is best that refundable credits be consumed last as this will maximize the amount of the refund

Determination of Tax Liability

Who Must File

Individuals who have the following gross income (2000):

Single—in excess of $7,200 ($2,800 personal exemption plus $4,400 standard deduction); [$8,300 if 65 or older ($2,800 personal exemption, basic standard deduction of $4,400 and additional standard deduction of $1,100)]

Married Filing Jointly—$12,950 ($5,600 personal exemptions plus $7,350 standard deduction); [$13,800 if one spouse 65 or older ($5,600 personal exemptions, basic standard deduction of $7,350 and additional standard deduction of $850); $14,650 if both spouses 65 or older]

Head of Household—$9,250 ($2,800 personal exemption plus $6,450 standard deduction) [$10,350 if 65 or older (include $1,100 additional standard deduction)]

Single dependent—$4,400 if no unearned income; $700 if unearned income and no earned income; greater of (a) $700 or (b) earned income + $250 (maximum of $4,400)

Self-employed individuals—$400 of self-employed income

Corporations

Estates and Trusts

Partnerships (Information Return only)

Tax Formula

            Individuals

Income (except exclusions) (§61)

­                      Deductions for Adjusted Gross Income (§ 62)

=          Adjusted Gross Income (§ 62)

­                      Greater of: Itemized Deductions (§63) or Standard Deduction (§ 63(c)) and Personal and Dependency Exemptions (§ 151 and 152)

=          Taxable Income

Tax Liability:

Tax Table or Tax Rate Schedule (§ 1)

­                      Tax Withheld and Estimated Tax Paid

­                      Tax Credits

=          Tax Due or Refund

Corporations

Gross Income

­                      Deductions

=          Taxable Income

Tax Liability—Rate Schedule (§ 11)

Estates and Trusts

Gross Income

­                      Deductions

­                      Distribution to Beneficiaries or Heirs

­                      Exemption ($300 or $100 for Trust; $600 for Estate)

=          Taxable Income

Tax Liability: Rate Schedule (§ 1(e))

Children under 14 are taxed at parents’ highest marginal tax rate for net unearned income over $1,400 (for 2000).  Section 1(g)(4) provides that “net unearned income” is the child’s unearned income in excess of the amount set out in §63(c)(5)(A) plus the greater of that amount or any itemized deductions directly attributable to the production of the unearned income.  (The amount set out in §63(c)(5)(A) is the lowest standard deduction for a dependent.  The Code sets out $500—this amount has been increased to $700 for cost of living increases.  Thus, the amount is $700 plus $700 (if there are no itemized deductions attributable to production of unearned income that exceeded $700)).

Individual Taxpayers        

STANDARD DEDUCTION (§63(c))

            Basic

                                                                        1998                1999                2000

            Single                                                   $4,250             $4,300             $4,400

            Married, filing jointly                           $7,100             $7,200             $7,350

            Surviving spouse                                 $7,100             $7,200             $7,350

            Head of household                              $6,250             $6,350             $6,450

            Married, filing separately                     $3,550             $3,600             $3,675

            Additional

Taxpayer and spouse (only) age 65 or over or blind:

            Single                                       $1,100

            Married, filing jointly                    850

            Surviving Spouse                          850

            Head of Household                    1,100

            Married, filing separately              850

Dependents—Standard Deduction is limited to the greater of $700 or the dependent’s earned income for the year plus $250 but not to exceed $4,400 [§63(c)(5) ]

PERSONAL AND DEPENDENCY EXEMPTION (§151)

$2,800 per taxpayer and dependent (2000)

            Phase-out of exemption (§151(d)(3))

                        Begins at threshold adjusted gross income and is

Joint returns/ Surviving Spouse                          193,000 – 315,900

Head of Household                             161,1500 – 283,650

Single                                                     128,950 – 251,450

Married, filing separately                         96,700 – 157,950

Phase-out by 2% for each $2,500 by which adjusted gross income exceeds amounts above. (divide exceeded amount by 2,500, round up, then multiply by 2, subtract from 100 = % of exemption you get)

            Dependent must meet five tests:

(1)   Support (§152)

                                    Taxpayer must furnish over one-half of dependent’s support

Multiple Support Agreement (several adult children supporting elderly parent)

Person must contribute more than 10% of support per §152(c);

                                                No one person provides more than 50% of support; and

                                                All persons together provide more than 50% of support

                        (2) Income Test (§151(c))

Dependent’s Gross Income must be less than Exemption Amount ($2,800 in 2000) or

Child under 19 or full-time student under 24

                        (3) Relationship (§152(a))

Relative as set out in §152(a) or

Member or Taxpayer’s Household

                        (4) Joint Return (§151(b))

Dependent may not file joint return unless

No tax liability for either spouse on joint return and

Neither spouse is required to file return

                        (5) Citizenship (§152(b)(3))

Must be U.S. citizen, U.S. resident, or resident of Canada or

Mexico

OVERALL LIMITATION ON ITEMIZED DEDUCTIONS

§68 (b)(1) limits itemized deductions to lessor of (1) 3% of excess of adjusted gross income over threshold amount ($128,950 in 2000) of (2) 80% of otherwise allowable itemized deductions

FILING STATUS

HEAD OF HOUSEHOLD (§2(b))

1.                  Taxpayer pays more than half the cost of maintaining home in which dependent relative or unmarried child lives over half the year, or

2.                  Taxpayer maintains separate home for parent or parents if at least one parent qualifies as a dependent

3.                  Abandoned spouse may file as head of household if

1.                  Taxpayer does not file joint return

2.                  Taxpayer paid more than half the cost of maintaining home that was principal residence for taxpayer’s dependent child for more than half year (§§2(c) & 7703(b)) (must not live w/ spouse for six months)

SURVIVING SPOUSE (files using rates for married, filing jointly [§2(a)])

Applies for two years following death of spouse IF

                        Taxpayer maintains household for dependent child.

Tax Rate Tables. For tax years beginning in 2000, the tax rate tables under § 1 are as follows:

TABLE 1  MARRIED INDIVIDUALS FILING JOINT RETURNS AND
SURVIVING SPOUSES

If Taxable Income Is:                                       The Tax Is:
Not Over $43,850 ………………………..      15% of the taxable income
Over $43,850 but not over ……………….    $6,577.50 plus 28% of the excess over
    $105,950                                                               $43,850
Over $105,950 but not over……………….   $23,965.50 plus 31% of the excess over
    $161,450                                                               $105,950
Over $161,450 but not over ……………….  $41,170.50 plus 36% of the excess over
    $288,350                                                               $161,450
Over $288,350 …………………………….   $86,854.50 plus 39.6% of the excess over
                                                                            $288,350

TABLE 2  -- HEADS OF HOUSEHOLDS

If Taxable Income Is:                                       The Tax Is:
Not Over $35,150 …………………………   15% of the taxable income
Over $35,150 but not over                $90,800 ………  $5,272.50 plus 28% of the excess over
                                                                              $35,150
Over $90,800 but not over ………………… $20,854.50 plus 31% of the excess
    $147,050                                                               over$90,800
Over $147,050 but not over ……………….  $38,292 plus 36% of the excess over $147,050
    $288,350
Over $288,350……………………………… $89,160 plus 39.6% of the excess over
                                                                             $288,350

TABLE 3  -- UNMARRIED INDIVIDUALS (OTHER THAN SURVIVING SPOUSES
AND HEADS OF HOUSE HOLDS)

If Taxable Income Is:                                       The Tax Is:
Not Over $26,250 …………………………   15% of the taxable income
Over $26,250 but not over $63,550 ………  $3,937.50 plus 28% of the excess over
                                                                             $26,250
Over $63,550 but not over ………………..   $14,381.50 plus 31% of the excess over
     $132,600                                                               $63,550
Over $132,600 but not over ………………   $35,787 plus 36% of the excess over $132,600
     $288,350
Over $288,350…………………………….    $91,857 plus 39.6% of the excess over
                                                                             $288,350

TABLE 4 - Section 1(d). -- MARRIED INDIVIDUALS FILING SEPARATE RETURNS

If Taxable Income Is:                                       The Tax Is:
Not Over $21,925…………………………    15% of the taxable income
Over $21,925 but not over $52,975……….  $3,288.75 plus 28% of the excess over
                                                                             $21,925
Over $52,975 but not over $80,725 ………. $11,982.75 plus 31% of the excess over
                                                                             $52,975
Over $80,725 but not over ………………… $20,585.25 plus 36% of the excess over
     $144,175                                                               $80,725
Over $144,175……………………………… $43,427.25 plus 39.6% of the excess over
                                                                             $144,175

 

Gross Income

Gross income is broadly defined in §61 of the IRC as “income from whatever source derived.”  Income for tax purposes includes receipts that are derived from labor or capital and other receipts that are accessions to wealth.  A return of capital or money borrowed is NOT income (no accession to wealth).

The following items are specifically included in income for tax purposes.  (§§71-90)

1. Alimony (§71)

2. Annuities (§72)

That portion representing a return of investment is NOT taxed.  Formula is:

Annual Receipts X Investment/Expected Return = Amt. Excluded

3. Services of a Child (§73) Treated as income of the child

4. Prizes and Awards (§74)

Taxed unless:

(1)               received in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement;

(2)               no action on part of recipient to receive award;

(3)               recipient not required to render substantial future services as condition to receiving award; and

(4)               award transferred to charitable organization or governmental unit.

5. Group-Term Life Insurance purchased by Employer (§79)

Cost of premiums taxed to extent premiums exceed cost of first $50,000 of insurance.

6. Reimbursement of Moving Expenses (§82)

Taxed to employee to extent not for qualified moving expenses under §217.

7. Property transferred in Consideration of Services Rendered (§83)

Taxed to extent of FMV of property year in which interest is transferable or not subject to substantial risk of forfeiture.

8. Unemployment Compensation (§85)

Full amount is taxed.

The following are specifically excluded from income for tax purposes (§§101-132)

(1) Proceeds from life insurance policy received “by reason of death” if no valuable consideration paid for policy.  (Valuable consideration can be paid by partnership in which insured is a partner or by corporation in which insured is officer or shareholder.) (§101)

            (2) Gifts and Inheritances (§102)

No exclusion for gift from employer to employee (§102(c)(3)).  For gifts in business context, payor may only deduct $25.  (§274(b))

1.                  For gifts, basis to donee is basis to donor unless FMV on date of gift is less than donor’s basis and donee sells property at a loss (§1015)

2.                  For bequests, basis to heir is FMV on date of decedent’s death unless executor elects alternative date for valuing property for estate tax purposes.  (§1014)

            (3) Interest on State and Local Governmental Bonds (§103)

Interest is taxed if from

(1)               Private activity bond that is not a qualified bond

(2)               Arbitrage bonds

(3)               Bonds not in registered form

            (4) Compensation for Personal Injuries (§104)

Punitive damages are taxed unless awarded in a wrongful death case and state law only provides for punitive damages in such cases. Exclusion includes lump sum payment or periodic payments. Structured settlements permit plaintiff to exclude earnings on damage award

            (5) Amounts received under Accident and Health Plans (§104)

If from policy purchased by employer and premiums were not taxed to employee under §106, exclusion is limited to amount expended for medical and recovery for loss of member or function of body.

(6) Cost of Premiums for Accident and Health Plans paid for Employee by Employer (§106)

            (7) Worker’s Compensation (§104)

(8) Rental Value of Parsonages and Living Allowances to Minister of Gospel (§107)

            (9) Meals and lodging furnished to employee by employer if

                        * furnished on business premises of employer,

                        * for convenience of employer, and

* for lodging, as a condition of employment. (119)

(10) Scholarships and fellowships, but only to a candidate for a degree and only as to tuition and required books, fees, and equipment for courses (§117).  Not excluded if in nature of compensation for services rendered or to be rendered.

(11) Tuition reduction by school or college for employee’s family, but only if non-discriminatory and only for undergraduate degree (§117(d)).

(12) Employer’s cost of premiums for first $50,000 of group term life insurance for employee (§79).

(13) Other employee fringe benefits (§132)

1. No additional cost fringe (§132(a)(1) and §132(b))

Employee receives service rather than property.

Must be in same line of business of employee.

Can be reciprocal agreements with other businesses (§132(I).

Discrimination clause applies (§132(j))

2. Employee Discounts (§132(a)(2) and §132(c))

Not available of real property or for property held for investment.

Limited to gross profit percentage for property and 20% for services.

Must be in same line of business.

Discrimination clause applies.

3. Working Condition Fringe (§132(a)(3) and §132(d))

Not income if employee could deduct cost of item if employee paid for it.

4. De minimus fringe (§132(a)(4) and §132(e))

So small as to make accounting unreasonable

Includes eating facility for employees and on-premises gym and athletic facilities.

5. Transportation and Parking (§132(a)(5) and §132(f))

Limited to $155 per month for qualified parking and $60 per month for transportation fringes.

6. Qualified moving expense reimbursement (§132(a)(6) and §132(g))

Amount received that would be deductible if paid by employee.

7.      Use by member of family deemed use by employee (§132(h))

Includes spouse and dependent children and parents if air transportation.

(14)           Discharge of Indebtedness (§108)

Not income if discharge occurs in bankruptcy, taxpayer is insolvent (to extent of amount by which taxpayer is insolvent), qualified business indebtedness, and qualified farm indebtedness.

Qualified business indebtedness—exclusion limited to amount indebtedness exceeds FMV of real property used in a trade or business and secured by debt.

Qualified farm indebtedness—limited to adjusted basis of property used in trade or business or for production of income and tax attributes of taxpayer.

Must reduce tax attributes first and then basis of property.  May elect to reduce basis of property.

Purchase money reduction by seller of property is treated as price reduction.

Not discharge of indebtedness income if discharge is a gift.

Not discharge of indebtedness income if taxpayer would have had a tax deduction had taxpayer paid liability.

            (15) Improvements by Lessee on Lessor’s Property (§109)

Not income unless made in lieu of rent.

            (16) Recovery of Tax Benefit Items (§111)

Taxed to extent of tax benefit from deduction of item in a previous year.

            (17) Income of Governmental Entities (§115)

            (18) Gain on Sale of Personal Residence

Gain up to 250,000 (500,000 for certain joint returns) is excluded

Taxpayers must have owned and used the home as a personal residence for two years or more during a five year period

Taxpayers may exclude gain up to $500,000 if one of the spouses satisfy the ownership requirements and both spouses satisfy the use requirements. Neither spouse may have used the exclusion within the past two years.

If a sale or exchange occurs because of change in pace of employment, health, or other unforeseen circumstances and taxpayer fails to meet ownership and use requirements, some gain still may be excludable.

Excludable amount is fraction of 250,000 ( or 500,000) , numerator of which is length of time taxpayer owned and used home and denominator is 24 months.

GROSS INCOME: The Scope of § 61

Federal income tax is imposed annually on a net figure known as “taxable income”

“Taxable income” is “gross income” less certain authorized deductions

§61 defines gross income as: “all income from whatever source derived” and includes a list (however income is not limited to that list)

Part III (starting at §101) contains the item specifically excluded from gross income

            Equivocal Receipt of Financial Benefit

In Cesarini v. US, the plaintiffs discovered (in ’64) some money in a piano they purchased in 1957. The P’s claim that they money found in the piano is not includable as gross income. (They further argue that since they bought the piano in ’57 but did not find the money until ’64, the SOL had run ). The court holds that the money found was properly taxable as income. The court reasons that income from all sources is taxed unless the taxpayer can point to an express exemption. Moreover, there was a IRS revenue ruling on point which stated that “the finder of a treasure trove is in receipt of taxable income”. (Treasure trove is taxable income.)

In Old Colony Trust Co. v. Commissioner, the company adopted a resolution whereby it would pay the officers tax liability. The IRS argued that the payment by the employer of the income taxes assessable against the employee constituted additional taxable income to the employee. The S.Ct. agreed and held that the payment constituted income to the employees. The court reasoned that the payment was in consideration of the services rendered by the employee and was a gain derived by the employee from his labor and therefore subject to income tax.

In Commissioner v. Glenshaw Glass Co., the issue was whether money received as exemplary damages for fraud or as punitive damages must be reported by a taxpayer as gross income. The court indicates some criteria for gross income “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion”, and concludes that such monies are taxable income. The court reiterates that the broad phraseology of §61 will be given a liberal construction.

In Charley v. Commissioner, the court holds that travel credits converted to cash in a personal travel account established by an employer constitute gross income to the employee. (the employee was billing client for first class tickets, then buying coach tickets, upgrading to first class and pocketing the difference)

            Note: Illegal gains are taxable

            Assets – Liabilities = Net Worth

Anything that increases your net worth is income

Increases in net worth can occur either by an increase in assets or a decrease in liabilities

If someone pays a liability for you that is income

            Income w/o Receipt of Cash or Property

The rental value of a building owned and occupied by the taxpayer does not constitute income within the meaning of the 16^th Amendment. Helvering V. Independent Life Ins. Co.

If you set up a corporation to own your house, and you live in it rent free, you will be charged the rental value as gross income and taxed accordingly (as a corp is a separate legal entity)

Barter Clubs: If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. So if a housepainter paints a lawyers house in return for legal services, the fair market value of the services received by the housepainter and the lawyer are includable in their gross incomes.

Crops/Gardens: If you grow your crop and consume it = no income. If you sell it or barter it = income.

GAIN FROM DEALSINGS IN PROPERTY

Return-of-capital concept: if T lends B money and later pays it back no one would suppose that T has gross income upon the mere repayment of the principal amount of the loan. This is because the repayment constitutes a mere return of capital

Basis: generally the cost of something or if gained by other than purchase then its market value

Gain on the disposition of property §1001(a): the excess of the “amount realized” over the “adjusted basis”

Amount realized: the amount of money received and the fair market value of the property (other than money) received on the disposition

            §1001 Formula:                       The amount realized    (what you sell it for)

                                                -                      adjusted basis

                                                =          the taxable gain or loss

If you cannot determine the FMV of the property you acquired, then look to the FMV of what you gave in exchange to determine the cost basis. Philadelphia Park

§109 if the lessee make improvements to the property being leased there is no income to the lessor unless the improvements are made in lieu of rent

            Property Acquired by Gift

§ 1015 the basis of property acquired by gift is the same as it would be in the hands of the donor, however, if such basis is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be fair market value (see problems on p.128)

The above rule works to the detriment of the taxpayer as it makes the claimable loss less

If the property is sold between the Basis and the FMV, then there is neither a gain or loss (see p.128 (b)(3))

On a gift the basis is a carryover basis, i.e. the donors basis

            Property Acquired Between Spouses or Incident to Divorce

§1041 general rule: no gain or loss shall be recognized on a transfer of property from an individual to a spouse or a former spouse (if transfer is incident to divorce)

            Property Acquired From a Decedent

The property acquired receives a basis equal to its fair market value on the date on which it was valued for federal estate tax purposes, so the heirs starts with a new basis. Plus a surviving spouse gets a stepped up basis

            Amount Realized

The amount realized includes: cash, FMV of the property received or any mortgages

Rule: when you acquire property and there is a mortgage on it, your basis includes the mortgage (and preexisting tax liens are like mortgages are also included in the basis)

When you take depreciation it will lower your basis

Phantom gain: occurs when a person takes over a mortgage, pays nothing on it, takes depreciation deductions, and then gets rid of the property, she will still experience a gain because the cost basis has decreased (due to deduction) and the mortgage has not decreased

A mortgage is part of the amount realized

If there is a mortgage, the amount realized must be at least the amount of the mortgage see §7701(g)

However, the basis only includes a mortgage that is part of the acquisition indebtedness. Later mortgages do not increase the basis unless it is a capitol expenditure to improve the land

Note: If you receive property as a gift you are entitled to add part of the gift tax to your basis in the property, §1015(d)(6) sets out the ratio on how to compute the amount of the gift tax you can add, Basically the ratio is:

The tax amount (TA) x the Net appreciation to donor (NA) divided by the value of the gift (FMV)

TA  =   NA 

            FMV

So if donors basis is $20,000 and FMV is $30,000, net appreciation to donor is $10,000. And donee’s adjusted basis would be $22,000

                                    $10,000

            $6000  x          _______          =     $6000 x 1/3      =   $2000

                                    $30,000

Include more on nonrecourse loans

THE EXCLUSION OF GIFTS AND INHERITANCES

            Gifts

The question of whether a transfer of money or property constitutes a gift within the exclusion of §102(a) is an issue of fact to be determined by the trial court trier of fact

A gift in the statutory sense proceeds from a detached and disinterested generosity out of affection, respect, admiration, charity or like impulses. The most critical consideration is the transferors intention.

However, §274(b) place limitations on deductions for gifts. In a business context, if a business intends it to be a gift, it can only take a $25 deductions

Under §102(c) gifts to employees are income

            Bequests, Devises, and Inheritances

§102 exempts the value of property acquired by gift, bequest, devise, or inheritance

The question addressed in Lyeth v. Hoey, was whether property received by an heir from the estate of his ancestor is acquired by inheritance when it is distributed under an agreement settling a contest by the heir of the validity of the decedents will. The court decided that what he got from the estate came to him because he was an heir and hence the exemption applies.

In Welder, instead of paying for legal services, the client agreed to remember the attorney in her will. IRS says that this is payment for services rendered and is therefore taxable income.

            Note: Tips are income, as are “tokes”

Employee Benefits

Exclusions for Fringe Benefits

If an employee benefit is not specifically excluded from gross income, its value must be included within gross income

§132 excludes from gross income several categories of fringes

Exclusion from gross income -- Gross income shall not include any fringe benefit which qualifies as a;

(1)   no-additional-cost service, (must be provided in the same line of business in which that employee is employed, be non-discriminatory, and the employer cannot incur any substantial cost in providing the benefit – so airline can give employees free tickets and long as they don’t bump someone from the plane to get you a seat)

(2)   qualified employee discount, (must be in same line of business, be non-discriminatory, on services the discount cannot exceed 20%, on property the discount cannot exceed the employers gross profit percentage – employee can’t purchase it at less than cost)

(3)   working condition fringe (includes use of company car or plane)

(4)   de minimis fringe (the value of the property or service is small – low value holiday gifts, occasional sporting event tickets, picnics for employees)

(5)   qualified transportation fringe, (excludes transportation in a commuter vehicle, transit pass, or qualified parking used to get to work – limit is $175 a month for parking and $100 per month for the rest)

(6)   or qualified moving expense reimbursement 

The first two categories includes: current employees, retired employees, disabled ex-employees, the spouses and dependent children of employees, the surviving spouses of employees or retired or disabled ex-employees

§132 excludes the first two classifications of fringes and employee eating facilities provided to highly compensated employees only if those fringes are offered to all employees on a nondiscriminatory basis (can’t just give these perks to the bigwigs)

In case the case of air transportation, parents of employees are treated as employees

Employees may exclude from gross income the value of the use of any on-premises athletic facility

§129 Employer can provide dependent care and employee can exclude up to $5000

§137 If employer pays for adoption expenses then employee can exclude up to $5000

§112 servicemen can exclude certain income for serving in a combat zone

Exclusions for Meals and Lodging

§119 Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to employment.--There shall be excluded from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer, but only if—

(1)   in the case of meals, the meals are furnished on the business premises of the employer, or

(2)    in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment

In Herbert G. Hatt, the court outlined the three requirements for lodging:

1.      the lodging is on the business premises (can include a place where the employee performs a significant portion of his duties or where the employer conducts a significant portion of his business)

2.      the employee is required to accept such lodging on the business premises of his employer as a condition of his employment

3.      the lodging is furnished  for the convenience of the employer (if employee is providing lodging as a benefit then it should be taxed as income)

Requirements for meals:

1.      Meals are served on the business premises

2.      for the convenience of the employer (e.g. waiters are often given free meals. Why? so the person is not hungry while serving food or does not have to take a long lunch)

Normally if your lodging is excluded then your meals will be excluded

Reimbursement does not qualify, the employee has to be served free meals (meals in kind)

§119 does not apply to sole proprietors (have to be an employee) but the fact that a person incorporates his business does not automatically disqualify him

§119(d) excludes Lodging furnished by certain educational institutions to employees:

In the case of inadequate rent the exclusion does not apply to the extent of the excess of  -

the lesser of :

1.      5% of the appraised value of the qualified campus lodging

2.      the amount someone else would pay to rent it (normal fair rental value)

So if employee pays $400/month on a house that is worth $200,000 ands the fair rental value of the house is $1000/month, 5% of the appraised value is $10,000 which is lesser than the normal annual rent of $12000, therefore employees would pay tax on the excess of the inadequate rent up to $10,000:

            10000

        - (400 x 12)

        =     5200 (taxable amount)

Awards

            §74 only excludes prizes and awards from gross income in two limited circumstances:

1.      if the prize or award is made to recognize achievement in a specified filed (religious, charitable, scientific, educational, artistic, literary or civic), the recipient was selected without any action on his part, and he designates a charity or governmental unit to receive the award

2.      employee achievement awards:

·         if it relates to length of service (at least 5 years) or to safety,

·         is in the form of tangible personal property, and

·         is awarded as part of a meaningful ceremony.

Note: Athletic awards do not qualify

Scholarships and Fellowships

§117(a) Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization

"qualified tuition and related expenses" means tuition and fees, books, supplies, and equipment required for courses of instruction at such an educational organization.

It does not include meals and lodging, or expenses for travel and research

The exclusion does not apply if the university expect services in return, in the case of an athletic scholarship, the exclusion is allowed if the university expects but does not require the student to participate in the sport

117(d) allows a "qualified tuition reduction" provided to an employee of an educational organization for the education below the graduate level

If an employer give an employee a scholarship, it is compensation, but it might be excluded under §127 which permits an employee to exclude up to $5,250 from gross income for amounts paid by the employer for educational assistance, provided that the program:

·         does not discriminate in favor of highly compensated employees

·         does not include assistance for course involving sports, hobbies, or graduate level courses

Life Insurance Proceeds and Annuities

            Life insurance paid by reason of death is not taxed §101

If an insured elects to take the cash surrender value, the insured will realize an amount in excess of the basis, which is a taxable gain that is unprotected by §101

The exclusions do not apply to the proceeds of a policy that has been transferred for valuable consideration during the insured life (this rule does not apply if the transferee has the same basis as transferor or if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer)

Congress has made some exceptions where even though a policy is cashed out during the insured’s lifetime, the gain on the policy is excluded from gross income:

terminally ill:  individual persons ( a person reasonable expected to die within 24 months) can exclude the whole amount

chronically ill: individual (loss of functional capacity, cognitive impairment) can exclude costs of qualified long term care of to payments of $175/day reduced by any medical insurance reimbursements

Note: If person transfers a policy to spouse it is covered by §1041 (transfers between spouses are not taxed) and is deemed a gift

Annuity Payments

An annuity is an arrangement under which one buys a right to future money payments (person might pay company $60,000 for the right to receive $5000 a year for life)

Congress has recognized that there is an income element in each annuity payment from the outset

§72 allows a recovery of capital over the expected life of the contract by excluding the portion of each payment that is the ratio of the “investment in the contract” to the “expected return under the contract”. The excess is taxed as the income element in each payment:

For example, if Bob pays an insurance company $60,000 and they agree to pay him $5000/year for life, with a 20-year life expectancy

            investment in the contract = $60,000

            expected return under the contract = $100,000 ($5000 x 20 years)

 Investment                                                     

                            X         payment received        =      amount excluded

Expected return

 $60,000                                                         

                            X         $5000              =      $3000 (taxable amt = $2000)

 $100,000

If annuitant lives beyond her life expectancy and fully recovers her investment in the contract, the full amount of any subsequent annuity payment is included in her gross income. If she dies w/o fully recovering her investment, the amount of the unrecovered investment is allowed as a deduction on her last income tax return.

DISCHARGE OF INDEBTEDNESS

If someone pays your liability or a creditor voluntarily discharges your indebtedness you may have gross income as gross income includes the discharge of indebtedness

If you decrease your liabilities you receive an accretion to wealth

In the Zarin case the taxpayer owed over $3 million but the casino agreed to settle for $500,000, the IRS claimed the gambler owed taxes on the difference as it was a discharge of indebtedness. If you borrow money, you receive cash and owe the creditor and so if the debt is forgiven it is an accretion to wealth since you did not have to pay it back. Here, the gambler only received chips (instead of cash). Ct said this is not income because it was not a valid debt (was unenforceable in the courts) so there is no liability that has been discharged.

General rule: income is realized when indebtedness is forgiven or in other ways cancelled

§108 provides some exclusions

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

                        (A) the discharge occurs in a title 11 case, (bankruptcy)

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness

Insolvency exclusion limited to amount of insolvency -- In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.

Also, the taxpayer has to reduce the basis of the property equivalent the amount discharged

NOTE: A debt cancellation which constitutes a gift or bequest is not treated as income to the donee debtor.

If a discharge of indebtedness occurs when the taxpayer is insolvent, the amount of debt discharged is excluded from gross income up to the amount by which taxpayer is insolvent

A discharge of indebtedness is treated differently is the debt is recourse or nonrecourse: (see problem 2, p. 179, for facts)

If the debt is nonrecourse the amount realized can never be less than the nonrecourse debt amount: so you simply subtract the basis from the debt to calculate the amount realized

In a recourse mortgage, the process is bifurcated and treated as two separate transactions: the sale of the property and the payment of the debt

DAMAGES AND RELATED RECEIPTS

            Damages in General

As a general rule damages are taxable, but you have to look at the nature of the recovery: what are the damages in lieu of?

            If damages are in lieu of profits, then they are included as gross income

If the suit is to recover damages from the destruction of business and good will, then the recovery represents a return of capital, which is not taxable.

For example if the basis in your house is $100,000, it burns down and you receive an insurance payment of $110,000, your taxable gain is $10,000 and your new basis is $10,000

Note: Good will is the intangible asset of a business (location, clientele, above average earnings) If you purchase a business for more than the FMV of all the tangible assets, you will have a basis in good will.

Damages and Other Recoveries for Personal Injuries

§104(a)(2) excludes damages incurred on account of personal physical injuries or physical sickness.

Damages for nonphysical injuries, such as defamation, First amend rights, and sex and age discrimination are not excludable

Damages recovered for emotional distress incurred on account of physical injury are excludable, however, emotional distress itself is not a physical injury

Punitive damages are gross income (except for punitive damages awarded in a wrongful death action under a state law in effect in 1995, if punitive damages are the only wrongful death recovery)

Under §104(a)(2) the following are excluded from gross income:

(1) amounts received under workmen's compensation acts as compensation for personal injuries or sickness;

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

(3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer);

(4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces

(5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a violent attack which the Secretary of State determines to be a terrorist attack and which occurred while such individual was an employee of the United States engaged in the performance of his official duties outside the United States.

Under §106 premiums paid by employer to accident and health plan for employee are excludable

Under §105(a) amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, (have to include since you include premiums paid by employer under 106)

§105(b) Amounts expended for medical care --Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care

If an employee receives benefits from a policy he paid for, he is not taxed. But he is taxed if the employer provided the policy, he is taxed except to the extent benefits are used for medical – anything over medical expenses is taxed. But what if employee has his own policy and employer has a policy? If medical expenses totaled $4000, and employee policy paid $3000 and employer policy paid $2000, you have to calculate the ratio of employer to employee contribution and the amount in excess of medical expense is subject to that ratio

2/5 of benefits received is attributable to employer, 2/5 of $1000 (the excess) is $400 (which is taxable)

See Handout on Structured settlements

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OTHER EXCLUSIONS FROM GROSS INCOME

            Gain From the Sale of a Principle Residence

Under §121 a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principle residence (don’t have to reduce the basis)

Taxpayer can use the exclusion once every two years

Residence includes a house, house trailer, houseboat, stock in cooperative housing unit

It must be the taxpayers principle residence

To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal resident for at least two of the five years prior to the sale or exchange

A taxpayer who fails to meet the requirements by reason of a change of place of employment, health, or unforeseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met: For example if taxpayer sold house (with basis of $150000) because of job and only lived there 12 months he can exclude: (in this instance his entire gain of $100,000 is excluded)

                                                12 (months held)

            $250,000         X                                             = 125,000

                                               

                                                24 months

If the transfer is pursuant to divorce you can be deemed to both owned and used for 2 years

Note: if you take depreciation on your home (which you can only do in limited circumstances) and then sell – you will be taxed on gain equivalent to amount previously deducted

Income Earned Abroad: all income is taxed, even when earned abroad. However, if you stay overseas for 330/365 days you can exclude up to $72,000 from US income tax

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HANDOUT:  EDUCATIONAL BENEFITS

State Tuition Programs (§529) (locks in tuition, is the only one that is not phased out)

1.                  Small Business Jobs Protection Act of 1996 granted tax exempt status to “qualified state tuition programs.”

2.                  No tax on earnings

3.                  Children include in income amounts distributed or education benefits received to extent amounts distributed exceed parents’ contributions

4.                  Amounts paid into program can only be used to pay qualified educational expenses

5.                  Qualified educational expenses are tuition, fees, books, supplies, and equipment required for enrollment or attendance at college (and some vocational schools)

Education IRA (§213) (no one is taxed, but can only out in $500/yr)

6.                  Annual contributions of $500 per beneficiary (child) to trust created for purpose of paying qualified education expense of beneficiary

7.                  Contributions are not deductible, must be in cash, and for beneficiary under 18

8.                  Income is tax exempt to extent used for qualified education expenses

9.                  Qualified education expenses are tuition, books, supplies, and room and board if student-beneficiary is at least half-time student

10.              10% penalty for distributions in excess of qualified education expenses

11.              Ability to contribute to education IRA is phased out for AGI of $95,000 to $110,000 and $150,000 to $160,000 for joint return

Hope Credit (§25A)

12.              Credit of 100% of first $1,000 or qualifying expense and 50% of next $1,000 per eligible student.  (Maximum would be $1,500 per student) ($1,000 is adjusted for inflation after 2001)

13.              Only expenses incurred by taxpayer, taxpayer’s spouse, and taxpayer’s dependents qualify

14.              Credit is only for expenses in first two years of post-secondary education

15.              Qualifying education expenses are tuition and fees only.

16.              Credit is phased out for AGI between $40,000 to $50,000 and $80,000 to $100,000 for joint return

Lifetime Learning Credit (§25A)

17.              Credit of 20% of first $5,000 of qualifying expense ($10,000 after 2002) incurred by taxpayer, spouse, and dependents for education leading to a degree or certificate for non-degree courses that help student improve or acquire job skills.

18.              Qualifying expenses are tuition and fees only.

19.              Available annually but not if Hope credit is claimed

Student Loan Interest (§221)

20.              Deduction (in arriving at AGI) for interest paid on qualifying student loan

21.              Maximum of $1,000 in 1998, $1,500 in 1999, $2,000 in 2000 and $2,500 in 2001 and thereafter

22.              Qualifying student loan is loan used to pay qualified education expenses at colleges and post-secondary vocational schools

23.              Qualifying expenses include tuition, fees, room and board

24.              Phased out when for AGI of $40,000 to $55,000 and $60,000 to $75,000 for joint return

U.S. Savings Bonds for Higher Education Tuition and Fees (§135)

25.              No income from qualified bonds to extent used to pay qualified higher education expenses

26.              Qualified bonds are U.S. savings bonds issued after December 31, 1989, to individual who has attained age of 24 before date of issuance

27.              Qualified higher education expenses are tuition and fees for taxpayer, taxpayer’s spouse, and dependents

28.              Qualified educational institution includes vocational school

29.              Amount excluded from income phased out for AGI of $40,000 to $60,000

Education Assistance Programs (§127)

30.              Employees can exclude from taxable income amounts paid by employer for educational expenses

31.              Educational expenses are tuition, fees, books, supplies, and equipment

32.              Maximum exclusion is $5,250

33.              Exclusion applies to graduate-level courses beginning in 1997

34.              Employer program may not discriminate in favor of highly compensated employees

35.              Employees must be notified of program

36.              Exclusion was extended to Dec 31, 2001

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            Bonds

§103 interest on bonds you buy from the government entity will not be taxed (only applies to state and local bonds)

§115 arbitarge bonds (portion of the proceeds of a bond issue is used to acquire investment property which produces a yield higher than the return paid on the bond) non-registered, and private activity bonds are all taxed

However, some private activity bonds may receive the interest exclusion benefits of §103, these are known as qualified bonds

Bonds must be registered to qualify, otherwise taxpayers could conceal their income tax gain from the bonds (non-registered bonds are bearer bonds)

ASSIGNMENT OF INCOME

To whom is income taxed?

Progressive income tax rates provide a strong incentive for an individual taxpayer to try and fragment income.

For example if parents are in the 39.6% bracket and child has no income (so is in the 15% bracket) there is an incentive to transfer income to the child and have it taxed at his lower rate

Prior to ’86, income was taxed at a high rate and there was more incentive to shift income

After ’86, there are still some opportunities to shift income

            Income from services

In Lucas v. Earl, husband had agreement with wife that any property acquired by either should be held as joint tenants. Court held that Husband's entire salary is taxable. The statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.

            Lucas began the Fruit Tree Doctrine: income is taxed to the person who owns the tree

                       

You may never assign income earned from personal services rendered by you (you will be taxed)

In Commissioner v. Giannini, the taxpayer was supposed to receive a bonus, but taxpayer told Corp he did not want it and suggested that they do something good with it. The Corp gave it to a university. IRS said the taxpayer should be taxed. Court said that this was a disclaimer of property and was therefore not income. You must disclaim it prior to earning and cannot designate where it goes. You have income if you can order where the money goes.

Are the amount an executor could have charged as fees considered income if he refuses to charge fees? Not if you disclaim them within six months

Do professors running clinical programs have income from client payments that they turn over to the school? No, if there is a prior contract that says all these funds should be turned over

If X directs that his salary be paid to Y, X is taxed

Income from Property

The person that owns the underlying property is taxed on the income

In Horst, the taxpayer had bonds, detached the coupons and gave them to his children and wants them to be taxed on the income. Court says that the donor is taxed on the income (interest coupons) since the donor continues to hold the underlying property.

If he gave the whole bond away he would not be taxed.

The power to control and dispose of income is the equivalent of the ownership of the income

In Blair, the taxpayer had a LE in an income trust (which is a property interest) and assigned a portion of it to someone else. You can give a portion to someone else and they will be taxed (the donee) since you no longer have an underlying interest. However, if the taxpayer had the remainder, then he (donor) would be taxed if he gave a way a portion of the income interest because he still has an underlying interest.

When, by the gift of the coupons, he has separated his right to interest payments from his investment and procured the payment of the interest to his donee, he has enjoyed the economic benefits of the income in the same manner and to the same extent as though the transfer were of earnings and in both cases the import of the statute is that the fruit is not to be attributed to a different tree from that on which it grew

In Stranahan, the taxpayer had a substantial interest deduction that he could take, but did not have sufficient income to offset the deduction. So he accelerated his future income (by selling his rights to recover future dividends) to avoid losing the tax benefit. Court said this was a valid assignment as it was sold for valid consideration (FMV).

In Salavaotore, the wife owned a gas station and wanted to sell it but did not want all of the taxation, so prior to selling it she deeded half of it to her children. The IRS said (and court agreed) that this was all income to her as the gain on the sale of property was already realized (although not earned) at the time she deeded it to children as she knew she was going to sell it.

The owner of a tree picks some fruit and gives it to another who converts it to cash. As the owner has kept the tree that produces the fruit, the trees’ produce (interest later paid) remains his for tax purposes, even though economically it has become the property of another.

The point is that if you want to give a gift you going to have to pay tax on your income first. This is too prevent the shift of income in order to avoid taxes.

If the owner gives the tree away the donee in general is taxable on the fruit subsequently produced, because he has become the owner of the income-producing property itself.

Dividends present a special issue, because interest accrues over time. This accrued interest or ripe fruit is taxable. If the income generated by a property accrues ratably over time, that portion accrued at the time of the gift is ripe and is taxed to donor. For example, if interest on a coupon bond is payable semi-annually on Jan 1 and July 1 and a donor transfers the bond (not just the coupon) on APR 1 midway between payment dates, one half of the current interest coupon is ripe as of the time of the transfer and one half of the coupon is taxed to the donor the other half to the donee.

Stocks (3 important dates for dividends: declaration date, record date, and payment date): for closely held corps, there is ripe fruit after the declaration date of a dividend. For publicly traded corps, there is ripe fruit after the record date of the dividend.

Patents and copyrights are deemed to be separate property rights, so if you transfer the whole right then the royalties are taxed to the donee.

Deductions

Section 62 Deductions (Deductible in arriving at AGI)

Alimony (§215)

Losses from sale or exchange of business property or property held for production of income

Contributions to IRA (§219) and to pension plan by individual proprietor or partner

Moving expenses (§217)

Deduction if new principal place of work or business is at least 50 miles farther from former residence than was former principal place of work or if no principal place of work at least 50 miles from former residence and

Employee remains at new place of work as full-time employee for at least 39 weeks during next 12-month period or self-employed remains at new principal place of employment at least 78 weeks during next 24-month period.

Deduction for

Moving household goods from former residence to new residence and

Traveling (including lodging) from former residence to new residence. 

Section 212 expenses only as to rent and royalty property

Section 162 expenses (employee expenses, except for qualifying performing artist, only to extent of employer reimbursement)

Must be ordinary and necessary and incurred while carrying on trade or business

No deduction for capital expenditure (§263)

No deduction for personal expenses (§262)

Travel

Must substantiate with records (§274(d))

Transportation expenses

Includes taxi fares, automobile expenses (32.5 cents per mile for 200), tolls

No deduction for commuting (expenses to and from first work station)

If trip is business and personal

100% if primarily business

No deduction if primarily personal

If foreign travel and travel exceeds one week or personal travel is at least 25% of total time

no deduction if primarily personal

if primarily business, allocate between personal and business—only business portion is deductible.

Meals and Lodging

Deductible if away from home overnight

Cannot be lavish or extravagant

50% of cost of meals (§274(n))

No deduction for food or beverages unless taxpayer (or employee of taxpayer) is present at furnishing of food or beverages

Tax home is area in which taxpayer derives principal source of income or is based on amount of time spent in each year.

Temporary Assignments

One year or less

If indefinite assignment to new post, not deductible

Two Places of Business

Deduct meals and lodging at lesser place of business

Expense of traveling from one job to another is deductible

Travel between work stations is deductible

Convention

Must be directly related to trade or business

No deduction if convention related to investment property

No deduction for convention in foreign country unless business reason to have convention in foreign country

No deduction for convention on cruise ship unless ship registered in U.S. and ports of call are in U.S. or possessions of U.S.

Must attach to return a written statement from individual attending meetings which includes information about total days of trip, program, written statement by organizations sponsoring meeting about schedule of business activities, etc.

If expenses on cruise are deductible, deduction limited to $2,000

No deduction for spouse, dependent, or other individual unless

spouse, dependent, or other individual is employee of taxpayer

travel of spouse, dependent, or other individual is for bona fide business purpose, and

expenses would otherwise be deductible by spouse, dependent, or other individual.

No deduction for travel as form of education (e.g., French teacher goes to France)

Entertainment

Directly related to active conduct of trade or business or

Associated with active conduct of trade or business if business discussion preceding or following entertainment

No deduction for entertainment facility or for dues paid to business, social, or sports club

Deduction limited to 50% of expense

Education

Maintain or improve skills or

Required

Not deductible if:

(1) to meet minimum educational standards to qualify for position or

(2) qualifies taxpayer for new position

Legal Expenses

Incurred in trade or business

Lawsuit—origin of claim test

If obtain or defend title to property—capitalize as part of cost of property

Other Expenses o r Losses

            Interest – incurred in a trade or business or on rental or royalty property

            Taxes – incurred in a trade or business or on rental or royalty property

Losses – incurred in a trade or business or incurred in transaction entered into for profit

Bad debts – Trade or business = ordinary loss, Nonbusiness = STCL

Worthless securities – Deemed to be a sale or exchange as of last day of taxable year in which stock became worthless. LTCL or STCL depending upon when security was acquired

Itemized Deductions

Deduct only if in excess of standard deduction

Interest Expense (§163)

Interest to acquire investment other than rent and royalty property

Qualified Residence Interest (§163(h))

Acquisition Indebtedness

1.Principal residence and one other residence

2. Includes cooperative apartments, condominiums, mobile homes, and boats (if living quarters)

3. Home mortgage on indebtedness up to $1,000,000 ($500,000 if married filing separately)

4. Includes second mortgage to substantially improve residence

5. Refinancing but no more than refinanced indebtedness

Home Equity Indebtedness

Utilize residence as security for loan for other personal purposes

Interest deductible on portion of home equity loan not in excess of lesser of

(a)    FMV of residence reduced by acquisition indebtedness or

(b)   $100,000 ($50,000 if married filing separately)

Taxes (§164)

Real and personal property taxes

State and local income taxes

Foreign income taxes (can elect to expense or to take credit against U.S. tax—§901)

Charitable Contributions (§170)

Deduction for donations to qualified organizations (§170(c))

State or possession of U.S. if for public purpose

Charitable organization qualified under §501(c)(3)

War veterans’ organization

Cemetery organization

Deduction limited to 50% of AGI for contributions to public charities and private operating foundations (30% if long term capital gain property) and 30% if to private non-operating foundation (20% if long term capital gain property)

Carryover of excess contributions for five years (§170(d))

Donations of property (§170(e))

Deduction is FMV if property would produce long term capital gain or §1231 gain if sold and donated to public charity or private operating foundation

Amount of donation of property producing ordinary income if sold is limited to donor’s adjusted basis in property.  Amount is also donor’s adjusted basis if donated to

(1)               private non-operating foundation or

(2)               if a donation of tangible personal property to public charity or private operating foundation and donee charity puts property to unrelated use

No deduction for contribution of services or partial interest in property (unless remainder interest in personal residence or farm or donation for conservation purposes) (§170(f))

May deduct transportation on behalf of qualified charity at 14 cents/mile

Must have substantiation from donor for gifts of $250 or more

Bargain Sale to Charity (§1011(b))

Charitable contribution deduction for FMV of property less mortgage on property which charity assumes or takes subject to or any other payment by charity for property

Deemed to be sale to extent of amount paid by charity for property (mortgage on property which charity assumes or takes subject to or any other payment for property)

Amount realized is amount of mortgage on property plus any other amount charity pays for property

Adjusted basis in determining gain or loss on “part sale” is adjusted basis multiplied by fraction—numerator is amount realized and denominator is FMV of property

Example: Taxpayer donates a vacation residence to a public charity.  Taxpayer’s basis in the residence is $120,000.  The residence is worth $200,000.  There is a mortgage on the residence, which the charity assumes, in the amount of $150,000.

Taxpayer has a charitable contribution deduction of $50,000 [$200,000 (FMV of residence) - $150,000 (mortgage on residence)].

Taxpayer has a gain of $60,000 on the “part sale) of the property to the charity.

Amount realized is $150,000, the amount of the mortgage.

Adjusted basis to determine gain or loss on the “part sale” is $90,000, computed as follows: $120,000 (basis) X $150,000/$200,000, or $120,000 X 75% = $90,000.

Gain on the “part sale” is $60,000 [$150,000 (amount realized) - $90,000 (recalculated adjusted basis)].

Personal Casualty Losses (§165(c)(3))

Must be sudden event

Measure loss initially by lesser of

Adjusted basis or property or

Sustained loss (difference between FMV of property before casualty and FMV after casualty)

Deduct in year of loss under disaster area loss (in which case taxpayer may elect to deduct loss in preceding taxable year).

Reduce loss by

Insurance or other recovery and

$100

Net personal casualty gains and losses (after deducting $100 per casualty)

If net gain, net gain is capital gain

If net loss, reduce loss by 10% of AGI— remainder is itemized deduction.

Medical and Dental (§213)

Medical expenses—for medical care

Expenses for unnecessary cosmetic surgery not deductible

Full cost of home-related capital expenditures for physically handicapped

Other capital expenditures—excess of cost over in value of property

Transportation (9 cents/mile)

Lodging if primarily for and essential to medical care provided in medical facility—limited to $50 per night for each person.

Medical insurance premiums

Deduction limited to excess of deductible medical expenses over 7.5% of AGI.

Miscellaneous Deductions (§67)

Deductible to extent expenditures exceed 2% of AGI

Section 212 deductions (other than for rent and royalty property)

Employee §162 expenses not reimbursed by employer property

Hobby losses up to amount of hobby income

Overall Limitation on Itemized Deductions (§68)

Total itemized deductions are reduced if AGI exceeds threshold amount—$128,950 in 2000 ($64,475 for married filing separately)

Limitation applies to all itemized deductions except

Medical expenses

Investment interest

Casualty and theft losses

Wagering losses to extent of wagering gains

Deductions are reduced by 3% of excess of AGI over threshold amount.  Reduction may not be more than 80% of covered itemized deductions [those not listed in (2) above].

BUSINESS DEDUCTIONS

Gross income is reduced by any legitimate deduction

Deductions are different from exclusions

Exclusions are something that you receive but is specifically excluded from your income, deductions are from expenditures that you pay out

There are two major types of deductions:

Trade or Business deductions (which are expenditures incurred to carry on trade or business and are covered by §162) and Investments (covered by §212)

The deductions are affected by §263 (which says you have to capitalize if expenditure will benefit you in the future, you do this by depreciating it or amortizing it) and §262 (which says if expenditures are personal in nature they are not deductible.

Note: An income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer

The Anatomy of the Business Deduction Workhorse §162

The section has three requirements

There shall be allowed as a deduction all the (1) ordinary and necessary (2) expenses paid or incurred during the taxable year in (3) carrying on any trade or business

Ordinary and necessary

In Welch, the taxpayer, secretary of bankrupt corporation engaged in grain business,  decided to make Payments to corporation's creditors for purpose of strengthening his individual standing and credit and re-establishing business relations with corporation's former customers. The court held that the payments were not deductible from his income as "ordinary and necessary expenses". People do not normally pay the discharged debts of another entity (was not ordinary)

However, if an officer of S&L donates money to bail the S&L out, he can deduct it as he is protecting his reputation in an existing business. It is necessary and ordinary to protect his business reputation.

No deduction if you are entitled to reimbursement (by employer) as deduction is not necessary because  you could have been reimbursed.

The term "necessary" imposes "only the minimal requirement that the expense be 'appropriate and helpful' for 'the development of the [taxpayer's] business,' " quoting To qualify as "ordinary," the expense must relate to a transaction "of common or frequent occurrence in the type of business involved" . The Court has recognized, however, that the "decisive distinctions" between current expenses and capital expenditures "are those of degree and not of kind and that because each case "turns on its special facts the cases sometimes appear difficult to harmonize.

In INDOPCO, INC, Following denial of deduction for investment banking fees and expenses incurred during friendly acquisition, target corporation sought redetermination. The Tax Court ruled that expenditures were capital in nature and not deductible, and corporation appealed. The Supreme Court held that investment banking, legal and other expenses incurred in friendly takeover did not qualify for deduction as "ordinary and necessary" business expenses.

Note: if the expenditures create a separate asset they have to be deducted

Note: Expenses incurred in defending a corp from a hostile takeover would be currently deductible. A bank can deduct loan origination fees (credit checks, review of loan application)

§ 263 requires taxpayers to capitalize costs incurred for permanent improvements, betterments, or restorations to property. In general, these costs include expenditures that add to the value or substantially prolong the life of the property or adapt such property to a new or different use. In contrast, § 162 permits taxpayers to currently deduct the costs of ordinary and necessary expenses (including incidental repairs) that neither materially add to the value of property nor appreciably prolong its life but keep the property in an ordinarily efficient operating condition. Deductions are exceptions to the norm of capitalization. An income tax deduction is a matter of legislative grace; the taxpayer bears the burden of proving its right to a claimed deduction.

If you want a current deduction the expenditure can’t:

1.      substantially benefit future periods or

2.      create a separate asset

§ 198 allows automatic deduction of cost incurred to remove hazardous materials from buildings in the building is located in a “targeted area”

In Norwest, the business decided to remove asbestos-containing materials in coordination with an overall remodeling project and attempted to deduct the removal costs. The court said expenditures must be capitalized because the corp had a general plan to renovate the whole building and the asbestos removal was incidental to the overall plan.

Repairs are currently deductible (fix roof) replacements are not (replace roof)

            “Carrying on” Business

In Morton Frank, the taxpayer sought to buy a radio station or a newspaper. He traveled around the US looking for one and incurred a lot of expenses along the way. He finally bought a paper and wants to deduct costs for traveling. Ct says these expenses are not deductible as he was not carrying on a business at the time, These are merely startup costs for a business.

Note: under §105 you can still elect to amortize the startup expenditures over a five year period

You cannot deduct expenses incurred while looking for employment because you are not carrying on a trade or business. You can deduct if you are looking for the same type of job you currently have in a different city. Being an employee is considered carrying on a trade or business.

Specific Business Deduction

§162 There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—

(1)     a reasonable allowance for salaries or other compensation for personal services actually rendered;

(2)     traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and

(3)     rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

            Reasonable Salaries

In Harolds Club, two sons are shareholders of a corp and employ their dad and pay him a substantial salary. § 162 only permits deductions for reasonable salaries. The IRS said this salary was unreasonable (and was therefore a disguised dividend – corps cannot deduct dividends). Court said the salary wsa not a free bargain, and it ode snot matter if dad was not a shareholder, the salary still has to be reasonable in order to take the deduction.

§162(m) imposes a $1 million ceiling on the amount of CEO compensation that a publically held corporation may deduct in any year as remuneration for services performed by the covered employee (CEO or employee who is one of the four highest compensated officers)

§280 (g) prohibits a §162 deduction to the payor corporation for excess parachute payments. The payment must be contingent on a change of ownership or control of the corporation and must equal or exceed 3x the individuals base amount (average annual income). If  a parachute payment meet the threshold requirements, then to the extent the payment in any year exceeds the individuals base amount (not three times that amount) the excess is presumed to be an unreasonable amount of compensation. For example if employees base salary is $100,000 and he receives a parachute payment in the amount of $290,000, the corp can deduct the whole amount as it does not exceed 3x his base ($300,000). If the employee receives a parachute payment in the amount of $400,000, the corporation will only be able to deduct the base ($100,000) and employee will pay a additional 20% excise tax on $300,000.

Travel Away From Home

In Rosenspan v. US, the taxpayer was a travelling jewelry salesman who spent 300 days a year on the road and had no permanent residence. The IRS disallowed his deductions for meals and lodging because he ha d no “home” to be “away from”. The taxpayer argued that home for tax purposes means his business headquarters. Court relies on the ordinary meaning of the statute and holds that “home” means “home” and the taxpayer had none.

Travel expenses are deductible only if: (1) reasonable and necessary, (2) incurred while away from home and (3) incurred in pursuit of business

In Andrews, the taxpayer operated two seasonal businesses in two different locales and therefore maintained two separate homes. He attempted to deduct the usage of one of his houses as a business expense. The Tax court held that he had “two tax homes” and disallowed the deduction. The court here states that a persons personal income should not include the cost of producing that income. Living expenses are deductible to the extent business necessity requires that they be duplicated. Here, taxpayer was required to incur duplicate living expenses and is therefore entitled to a deduction for the minor residence.

“Travel” includes transportation, meals and lodging. To be considered “traveling” you must be away from home overnight (otherwise meals and lodging are not deductible). §262 disallows personal deductions like meals, but 162 allows this if it is for travel.

§274(m) meals (and entertainment expenses) are limited to 50% of cost

Commuting between the taxpayers residence and the taxpayers place of business or employment are nondeductible personal expenses.

            However, you can deduct:

·         the cost of going between one business location to another business location

·         daily transportation expense are deductible business expense when paid or incurred between the taxpayers residence and a temporary worksite outside the metropolitan area

·         if your residence is your principal place of business you can deduct transportation to any business site within or outside the metro area

Temporary site is one year or less (if you learn at 8months that job will be permanent then can deduct only the 8 month period when you thought it was temporary)

For travel costs you have to determine the primary purpose of the trip, if there is some element of pleasure in the trip, meals and lodging are only deductible for the business days. If a trip is primarily for pleasure there is no transportation deduction

274(m) no deduction for costs of bringing spouse on business trip (unless she was a necessary employee)              

274(m)(1) disallows luxury watercraft as a means of transportation

                       

Foreign travel: code places limits on deductions for foreign travel if it exceeds one week or pleasure part is more than 25%. If it meet one of the criteria, the deduction is limited to the amount spent on business. So if you stay 9 days (3 pleasure and 6 business) you can deduct 2/3 of transportation costs, 6 days of lodging and 50% of meals for 6 days.

Note: Costs for conventions outside North America are usually not deductible.

Necessary Rentals and Similar Payments

If you rent property, versus buying it, you can deduct rental payments (and it is better to deduct rent than depreciate)

In Starr’s Esatte case, deals with a lease back provision. Taxpayer owned a business and leased a sprinkler system for it. (the lease provided for five years of payment that amounted to sale price then five years of nominal payments). IRS says that in reality this was a sale (capital expenditure) and therefore the rent was not deductible. Court agrees and says that, in essence, this was a purchase.

Note: In the past, depreciation was much lower so there were a lot of the above type of cases.

The White case, dealt with a lease back situation – where the business owner sells his property to family member then leases it back from the family member. Here, the taxpayer sold property to his wife, then leased it back so he could deduct the rent (plus it transferred income to her). Court disallowed the deduction and said the sale was ineffective since the husband retained control/dominion of the property.

            Expenses for Education

You can take deduction if the education

(1)   maintains or improves skills required by the individual in his employment or trade or business

(2)   meet the express requirements of individuals employer  or the law to retain job

            The education expense are not deductible if :

(1)   for education which is require of him in order to meet the minimal educational requirements for qualification in his employment or trade or

(2)   the education qualifies him for a new trade or business (a specialty program is not a new trade)

            There is no deduction for travel as a form of education

            Miscellaneous Business Deductions

§274 provides that expenses related to any business meals or entertainment, amusement, or recreational activity are deductible, only if the meal of activity is ”directly related to” or “associated with” the taxpayers business.

If you the meet the above requirements, you are still only allowed a 50% deduction

“associated with” means business discussions take place before or after entertainment

Entertainment must be related to a specific business transaction, there are deductions for trying to maintain or attain client goodwill

Dues to social, athletic, or sporting club are not deductible (dues to professional societies are deductible)

Meals cannot be lavish or extravagant and taxpayer must be present

If you give clients tickets to a game, only 50% of the face value is deductible

No deduction for private sky box

Uniforms – you can deduct if the uniforms are required as a condition of employment and they are not a type of clothing that can be worn elsewhere

Business Losses

§165 permits deduction by an individual of any loss incurred in a trade or business – loss must be realized

No deduction for demolished buildings

DEPRECIATION

Depreciation is an accounting method whereby the cost of a capital asset is spread out over its estimated useful life

Prerequisites for deduction: §167 and 168 restrict the depreciation deduction to (1) property used in a trade or business and (2) property held for the production of income

Useful life concept: only property that has an identifiable useful life to the taxpayer will qualify for the deduction (no deduction for real property as it has a perpetual life)

There are three principle methods to depreciate:

(for each example the taxpayer bought a light truck (for his business) for $100,000 with a useful life of 5 years)

(1)   Straight line method: the cost of the asset, less its estimated salvage value (if any)  is determined first, then this amount is written off in equal amounts over the period of the estimated useful life of the asset

$100,000 (cost) divided by 5 (years of useful life) = $20,000 (amount of yearly depreciation)

           

(2)   Sum-of-the-years digits method: the annual depreciation allowance is computed by multiplying the depreciable cost basis (cost less salvage value) by a constantly decreasing fraction. The numerator of the fraction is represented by the remaining years of the useful life of the asset at the beginning of each year and the denominator is always represented by the sum of the years digits of useful life at the time of acquisition

                        Years                                                   Depreciation amount

                        1                      5/15 x $100,000 =       $33,300

                        2                      4/15 x $100,000 =       $26,600

                        3                      3/15 x $100,000 =       $20,000

                        4                      2/15 x $100,000 =       $13,300

                        5                      1/15 x $100,000 =         $6,600    

                        15 (denominator)                                 $100,000

(3)   Double declining method: Spreading the initial cost of a capital asset over time by deducting in each period double the percentage recognized by the straight-line method and applying that double percentage to the undepreciated balance existing at the start of each period. No salvage value is used in the calculation.

Double the straight line rate of 20% is 40%, in year 1 you deduct 40% of the balance. in year two you deduct 40% of the adjusted balance and so on

Year                             Basis                            Deduction (40% of balance)

1                                  $100,000                     $40,000

2                                  $60,000                                   $24,000

3                                  $36,000                                   $14,400

4                                  $21,000                                   $8,640

and so on

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HANDOUT DEPRECIATION (§§167 and 168)

A.                 Depreciation methods under §167

a.                   Straight line: cost of asset minus salvage/useful life

b.                  Declining balance: Adjusted basis of asset times percentage of straight line rate (for double declining balance --- 200% of straight line rate)

c.                   Sum of years digits: cost of asset minus salvage times fraction determined by adding years of useful life

d.                  Machine hours or production: cost of asset minus salvage value/no. of hours of production

B.                 Modified accelerated cost recovery system (§168)

Under this system you have to determine how each of the following categories apply:

(1)   Depreciation method (168b)

(a)    Perosnalty – 200% DB (can elect 150% DB or straight-line)

(b)   Realty – straight line only (applies to buildings, not land, there is no depreciation for land)

(2)   Recovery period

(a)    Personalty

(i)                 Three year life – Race horses more than three years old at the time placed into service and other horses more than 12 years old at the time placed in service (horse are the only ones w/ a 3 year life)

(ii)               Five year life – automobiles, light trucks, computers, R and D equipment

(iii)             Seven year life – other equipment, machinery, furniture, ect.

(b)   Realty

(i)                 Residential realty – 27.5 years

(ii)               other realty – 39 years

(3)   Convention (conventions determine how much depreciation you get in the first year 168d)

(a)    Personalty

(i)                 Half year except

(ii)               Mid quarter if more than 40% of value of property other than realty placed in service during last quarter of year (can ignore this for purposes of the test)

(b)   Realty – mid-month

C.                 Election to expense asset (§179)

(1)   §179 permits taxpayer to elect to deduct up to $ 20,000 (in 2000) of cost of tangible personalty used in a trade or business.

(2)   Annual election under §179 as to eligible property purchased each year

(3)   Annual limitations

(a)    If cost of eligible property exceeds $200,000, reduce dollar for dollar for excess over $200,000

(b)   Deduction under §179 may not exceed taxable income from conduct of trade or business (excess can be carried over to future year)

(4)   Basis of property is reduced by deduction under §179 for purposes of computing regular depreciation thereafter

D.                 Percentages to compute accelerated cost recovery for personalty (realty is straight line) under §168 for 5 and 7 year property (Congress simplified the DB method and set out the percentages to be used, the end result Is the same but the calculation is easier)

                                                            5 year (%)                                7 year (%)

                        Year 1                             20                                         14.29

                        Year 2                             32                                         24.49

                        Year 3                             19.2                                      17.49

                        Year 4                             11.52                                                12.49

                        Year 5                             11.52                                                8.93

                        Year 6                             5.76                                      8.92

                        Year 7                                                                          8.93

                        Year 8                                                                          4.46

Example: Taxpayer purchased truck to be used in taxpayer’s business in march of 2000 at a cost of $50,000. To obtain maximum depreciation in 2000, depreciation is computed as follows:

1.                  First year deduction under §179 of $20,000

2.                  Basis for additional cost recovery is $30,000 ($50,000 - $20,000)

3.                  Additional cost recover for first year is $6,000 (30,000 x 20%)

4.                  Total first year depreciation is $26,000 ($20,000 + $6,000)

5.                  Adjusted basis of truck at end of 2000 is $24,000 ($50,000 - $26,000)

6.                  Depreciation for 2001 will be $9,600 ($30,000 x 32%)

7.                  Adjusted basis of truck at the end of 2001 is $14,400 ($24,000 - $9,600)

8.                  Depreciation for 2002 will be $5,760 ($30,000 x 19.2%)

9.                  Adjusted basis of truck at end of 2002 is $8,640 ($14,000 - $5.760)

Adjusted basis is computed as follows: $50,000 - $20,000 - $6,000 - $9,6000 - $5,760 + $8,640

E.                 Depreciation of automobiles

Any four-wheeled vehicle manufactured primarily for use on public streets and highways and rated at 6000 lbs on unloaded gross weight or less is treated as an automobile.  A truck or van is treated as an automobile if its gross vehicle weight is 6000 lbs or less. A sports-utility escapes depreciation cap if its gross vehicle weight exceeds 6000 lbs (as a result a lot of businesses bought Suburbans)

1. Subject to limitations under §280F(a)

2. Depreciation is limited in each year

3. Limitations for 2000:

Year 1                         $3,060

Year 2                         $4,900

Year 3                         $2,950

Year 4                         $1,775

Remaining years          $1,775

4. Multiply limitations in (3) above by percentage of usage for business purposes (or in  

    investment context)

Example: Taxpayer purchased an auto in 2000 at a cost of $30,000. It is used 70% for business purposes in 2000. Deductible depreciation in 2000 is $2,142, computed as follows: $30,000 x 20%(§168) = $6,000, but amount is limited to $3,060. Because business usage is only 70%, multiple $3,060 by 70% for depreciation deduction of $2,142.

Note: as an alternative to this whole process the taxpayer can take a simple 331/3 cent per mile deduction

F.                  Mixed-Use Asset

1.         Depreciate only portion of asset used in trade or businesses (or for investment purposes)

2.         If listed property (property used as means of transportation or computers), 50% or less business use subjects property to limitations under §280(b)

(a)                Depreciation must be straight-line (168g)

(b)               No §179 deduction

(c)                If business usage more than 50% in previous year but 50% or less in subsequent year, there is income recapture in year business usage is 50% or less

(i)                 Income recapture is excess of depreciation taken in earlier years over depreciation had straight-line been used

(ii)               In example above, if automobile is used only 50% for business in 2001, depreciation for 2001 will be computed using straight-line but will be limited to $4,9000 x 50%, or $2,450. {straight line would be $30,000 divided by 5, or $6,000, but still limited to amount under §280F, which would be $4,900} For 2000, taxpayer would recapture as income$42, computed as follows: Taxpayer should have used straight line in 2000 because usage I s50% or less. Thus straight-line would have been $3,000 [$30,000     5 = $6,000/2  (for half-year convention in year of purchase)] This amount is multiplied by 70% for depreciation deduction of $2,100. Because taxpayer claimed $2,142, taxpayer must recapture as income $42.

If someone buys a business and they pay more than the FMV, the difference is considered goodwill. What do you do? (for tangible assets you would depreciate under 168) For intangibles you amortize:

            Amortization

·         cost of intangible asset is charged against income by amortization

·         amortization charges cost over useful life using straight line method

·         assets such as goodwill, going concern value, patents, copyrights, have 15 year useful life

What about depletion?

            Depletion (§§612, 613, 613a). two methods

(1) Cost depletion (§612): cost divided by recoverable units equals the depletion 

      per unit times units sold equals the depletion deduction

(2) Percentage depletion (§613 or 613A for small producers and royalty owners

      of oil and gas wells)

a.       Percentage as set out in §613 or 613A times gross income from property

b.      Oil and gas wells – (small producers and owners – no more than a 1000 barrels a day) – 15% and limited to 65% of taxable income from property (before depletion and deduction)

c.       Limited to 50% of taxable income from property (before depletion deduction)

Historic Structures: if you have a historic structure you can take a 20% credit for the cost of rehabilitating the structure (if it is used for business). You van take a 10% credit if the structure was built before 1936 but is not certified historic. However, in order to qualify the rehabilitative expenses must be greater than the adjusted basis of the building or $5,000 – whichever is greater. So if the adjusted basis of the building is $100,000 your expenses have to exceed $100,000 before you can take a credit.

DEDUCTIONS FOR PROFIT MAKING NONBUSINESS ACTIVITIES

Important §§ for deductions:              

            §162 – provides deduction for ordinary and necessary business expenses

            §212 – provides deduction for expense incurred for the production of income

            §262 – no deduction shall be allowed for personal, living, or family expenses

            §263 – no deduction allowed for capital expenditures

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

(1) for the production or collection of income;

(2) for the management, conservation, or maintenance of property held for the production of   

      income; or

(3) in connection with the determination, collection, or refund of any tax.

There have been a number of cases concerning what you can and cannot deduct:

Can you deduct litigation expenses in a suit that questions your purchase of stock? No, it benefits future periods so expenses must be capitalized in the purchase price of the stock (purchase of stock is a capital expenditure). The 263 restriction applies to 212 see above

Can you deduct proxy fight expenditures? In Surasky, the management of the company was very conservative and some of the shareholders believed this was to the detriment of the company and formed a committee to gather proxies in order to oust management. The taxpayer sought to deduct the expense he incurred as a result of the proxy campaign. He argued that the expenses were incurred for the production of future dividend income (since new management were enable the company to prosper). The court agreed and said such expenses were ordinary and necessary.

Note: the IRS has ruled that in order to deduct proxy fight expenditures, they must be proximately related to the production or collection of income, or the maintenance of property held for the production of income. If you incur expenses to defend title to stocks – no deduction. If you incur expenses to increase dividend income then it is deductible.

Can you deduct legal expense incurred in defending lawsuit to set aside an antenuptial contract? No – suit is personal

Can you deduct legal expense incurred in a divorce property settlement dispute? No – suit is personal

You must look at the origin of the lawsuit – if it is personal then no deduction

Can you deduct legal expense incurred in to collect alimony payments? Yes, as this relates top the production of income

Note: legal expenses incurred to give tax advice are deductible to the extent the advice relates to tax aspects of the matter ( so you deduct legal expenses for drafting a will to the extent that the legal advice concerns tax matters

            Charges Arising out of Transactions Entered into for Profit

            If you convert personalty into a business property you may take a deduction

In Horrmann, the taxpayer acquired house, redecorated it, lived there, moved out, tried to rent and then sold it. The taxpayer now wants to deduct depreciation on the property (for the period when he was  trying to rent/sell it). Court says that when a house is abandoned and put up for rent, it is converted to the production of income (an investment property) and the taxpayer can then deduct depreciation and maintenance.

§165(c) provides that in the case of an individual, the deduction under subsection (a) shall be limited to-- (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business

Can you take a loss deduction of the sale of a house? Only if you actually rent it then sell it. The transaction must be one entered into for the production of income – if you have not rented or sold it then you have not entered into a transaction for a profit.

In Lowry, the taxpayer had a house, abandoned it, put it up for sale and wanted to deduct cost for maintenance since date of abandonment. Court said that taxpayer was looking at making a profit on the sale so he was holding the house for the production of income (have to be looking to a post-conversion profit as evidenced by taxpayers intent)

Can taxpayer deduct expense incurred traveling around looking for investment property? No, such investments benefit future periods.

Deductions Not Limited to Business or Profit-Seeking Activities

Generally §262 precludes deductions for personal, living or family expenses. The following deductions are exceptions to the general prohibition:

Interest

§163(a) General rule.--There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

Interest is compensation for the use or forbearance of money (payment for specific services is not deductible)

Since interest was deductible a lot of people began loaning money – interest free – to relatives to get around assignment of income provisions (would loan money to child who invests the money and interest on investments is taxed to child) Congress recognized that this was a problem and added §7872:

(a) Treatment of gift loans and demand loans.--
(1) In general.--For purposes of this title, in the case of any below-market loan to which this section applies and which is a gift loan or a demand loan, the forgone interest shall be treated as--
(A) transferred from the lender to the borrower, and
(B) retransferred by the borrower to the lender as interest.

§7872 basically says that the parent will be deemed to have received interest from the child and they will be taxed on that interest income.

The § generally divides loans with below-market interest rates into two broad categories – gift loans and non-gift loans. It then subdivides each category according to the terms of the repayment of the loan, i.e., term loans and demand loans

Under the §. all loans that carry a below market interest rate (or charge no interest at all) are recharacterized to impute the payment of interest – the rate used is the applicable Fed rate

Gift loans consist of loans in which lenders foregoing of the borrowers interest payments is characterized as a gift from the lender to the borrower. The other types of loans are employer/employee loan and corp/stockholder loan

SO first you must determine which type of loan it is (so you know how to characterize the transfer. For example between a father and son there is deemed a transfer of  a gift which allows the lender to pay the interest and the father is then taxed on the interest.

            Lender                                     Debtor

            Gift                                          Gift

            Interest Income                                    Interest expense

            Result = interest income to the parent

For non-gift loans, the amount transmitted from lender to borrower is characterized, not as a gift, but rather according to the nature of the relationship between the lender and the borrower

            Corporation                             Shareholder

            Dividend                                  Dividend

            Interest Income                                    Interest expense

Here, the corp is deemed to have made a dividend payment to shareholder in order to allow him to pay the interest on the loan

Result: income on both sides (although shareholder may be able to offset dividend w/ interest payment deduction)

            Employer                                 Employee

            Compensation                          Compensation

            Interest Income                                    Interest expense

                        Result: both have income but both can deduct

            For gift loans, there two exceptions:

·         De minimis exception: if the amount of loan is $10,000 or less, there is no imputed interest (provided the loan proceeds are not used to purchase income-producing assets)

·         If loan does not exceed $100,000, the amount of imputed interest Is limited to borrowers net investment income, and if borrowers net investment income does not exceed $1,000, no interest allocation rule applies

                        So if loan is < $10,000 = no income to parent (as long as loan is not used for

                               income production)

           

      $10,001 – 100,000 = no income to parent If child has investment

                        income of < $1,000, if more, interest is

                        imputed to the extent of net investment income

                                        > $100,000 = Income to parent at fed interest rate

§163(h) disallows deductions for mots personal interest. However there are some exceptions, interest on indebtedness is deductible If incurred:

·         trade or business (always)

·         investment

·         educational loan

·         on a home

            Note: the last three are limited

            Qualified Residence Interest

Interest paid on two categories of debt, Acquisition indebtedness and home equity indebtedness secured by a qualified residence is fully deductible as qualified residence interest

Acquisition indebtedness: debt secured by a qualified residence, which is incurred by the taxpayer in acquiring, constructing, or substantially improving a qualified residence

·         limited to one million (but can be on two residences)

·         also applies to refinancing, but only to the extent of the current debt on the home (so if current debt is $300,000 and taxpayer borrows $400,000, only $300,000 is treated as acquisition indebtedness)

Home equity indebtedness: any debt (other than acquisition debt) secured by a qualified residence

           

·         the amount of such debt is limited to the amount of equity a taxpayer has in his home and may never exceed $100,000. So can never exceed $100,000 but must have sufficient equity (if taxpayer equity is $60,000 and takes out a home equity loan for a $120,000, only $60,000 is considered home equity indebtedness

·         can use proceeds of the loan for anything

·         If the amount of home acquisition indebtedness exceeds the 1 million cap, can consider $100,000 of the excess as home equity indebtedness If the fair market value of residence (or two residences combined) exceeds the amount of acquisition indebtedness by $100,000

            Qualified education loans

A qualified education loan is a loan incurred by the taxpayer solely to pay for the qualified higher education expenses of a student who is the taxpayer

The deduction is only allowed during the first 60 months during which interest payments are required

Max is $1000 in 1998, increasing by $500 per year to $2500 in 2001

Phase out occurs for single taxpayers with modified adjusted gross income between $40,000 and $55,000 (and between $60,000 and $75,000)

Investment Income

§1639(d) the amount allowed as a deduction under this chapter for investment interest for any taxable year shall not exceed the net investment income of the taxpayer for the taxable year.

Net investment income is the excess of investment income over investment expense.

The more investment income you have, the more investment interest expense you can deduct

Amount that is not deductible in current year can be carried forward

Note: Under §265(a)(2) no deduction is allowed for interest on indebtedness incurred to purchase tax-exempt bonds.

            Taxes

            Under §164(a) taxpayers are generally allowed a deduction on taxes

Taxes are deductible only by the person upon who they are imposed (you may not take a deduction on taxes unless it is your obligation)

            All property taxes are deductible

            All state and local income taxes are deductible

            Sales tax is not deductible

            If you sell property, taxes must be apportioned (regardless of what parties agree to)

THE CHARITABLE DEDUCTION

§170 (a)(1) General rule.--There shall be allowed as a deduction any charitable contribution (as defined in subsection (c)) payment of which is made within the taxable year. A charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary.

A charitable donation must be a gift – assumes there is no quid pro quo

Fund raising activities (by charities) if you buy a ticket/meal you get something in return for your donation, you can only deduct the amount you paid over the FMV received

Note: When a donor makes a contribution over $75 the charity must give you a statement that says how much is the gift portion (your check is not good enough verification)

Contributions for partial consideration: A part-gift part-sale transaction occurs. You can only deduct the actual value of the gift. The sale is bifurcated. For example if the FMV of a house is $180,000 and the donor sells it the charity for $120,000, you first determine the deduction and then the gain

            FMV    $180,000

     -  sale price $120,000

    =                  $60,000                       charitable contribution deduction

            how much gain?

            Amt realized    $120,000

   -      Adjusted basis   $80,000 (2/3 of $120,000) only 2/3 is  asale so you can only use

                        gain      $40,000                2/3 of the basis in computing the gain

IN this case: deduction = 60,000 and gain = 40,000 (you cannot just report a 20,000 deduction, must report both)

            If you give cash you can deduct the amount of the cash.

            If you give property you have to reduce by the amount of the built-in gain.

If you give a capital asset that you have held for more than one year you can deduct the FMV

STEPS to consider:

(1) Is there a contribution?

Must be a voluntary transfer of money or property with no expectation of procuring a financial benefit commensurate w/ the amount of transfer

There is no deduction for services rendered to a charity (although you can deduct travel expense as long as there is no recreational element to the trip)

(2) Is the contribution made to or for the use of a qualified organization?

            The organization has to be a §501(c) organization (tax-exempt organizations)

            Two groups:

·         public charities- get at least 1/3 of their support from the general public

·         private foundations: private charities funded by small groups of private individuals or families

            (3) What is the amount of the contribution?

                        If taxpayer receives a quid pro quo there is no contribution

If taxpayer receives partial consideration, he can only deduct the amount that is a gift

                        When property is sold to charity, it is a part-sale part-gift transaction

There are some reductions for property contributions (there are no reductions for cash contributions)

Have to determine the nature of the gain:

If the property is long-term capital asset (have held it longer than a year) you can deduct the FMV if you give it to a public charity

If the you give a private charity a gift of “qualified appreciated stock” you can deduct the FMV (you have to give them the actual stock and let them sell it)

If you give capital assets held less than one year to either a public or private charity or long term capital assets to a private charity you have to reduce contribution amount by the amount of gain/

(4) After determining the amount of the contribution you must determine the amount of 

      the deduction:

The taxpayers deduction cannot exceed his contribution base which is 50% of his adjusted gross income

                        Type                            normal limit                             limit if is appreciated

                                                                                                            capital gain property

            PUBLIC                       50%                                         30%*

            PRIVATE                    30%                                         20%

*There is an election whereby the taxpayer can treat the FMV as the gift (and limit amount to 30%) or take a reduction to the basis (and limit is 50% w/ no carryover). A taxpayer might do this if needs a large deduction this year.

            Note: you use up public charity donations first

IN SUM: If you give property that is a capital asset (personal or investment property) and give it to a charity, you can deduct the FMV, otherwise you deduct your basis. Any gift you give to a private charity, you can only deduct your basis unless it is a “qualified appreciated stock”

Casualty and Theft Losses

Generally losses that occur outside the taxpayers business and in a transaction not entered into for a profit are not deductible (§262 prohibits deductions for personal, living or family expenses)

However, subject to some limitations, §165(c)(3) permits a deduction for Casualty and  theft losses.

If personal property is destroyed or stolen you can take the deduction.

Is there a casualty loss for termite damage? No, the casualty must be something that happens suddenly.

What if neighboring homes are destroyed in a mudslide and as a result the value of your house depreciates? No deduction, there must be an actual physical loss

There is a deduction if your wallet is stolen but not if you lose it

Timing: Casualty losses are deductible for the year in which the loss is sustained

Measuring the loss:

·         the first $100 of loss is disallowed

·         The amount you deduct is FMV before the casualty minus the FMV after the casualty – the sustained loss

·         You must net casualty gains and losses to determine actual loss (because insurance company may give you more than you actually lost, which would then be income)

·         You must also reduce the amount of loss by 10% of your adjusted gross income

·         You also must reduce by insurance you recover or would have recovered had you made a claim

For example if X (whose adjusted gross income is $30,000) get in a wreck and his car which was worth $8,000 is now worth $1,000 and insurance paid $1,000. How much can he dedcut as a loss/

            $7,000  sustained loss

-           $1,000 insurance

-             $100  163 (h) reduction

            $5,900 loss

-           $3,000 reduce loss by 10% of adjusted gross income

            $2,900 Deduction

DEDCUTIONS FOR INDIVIDUALS ONLY

There are two types of deductions: those described in §62 (above the line deductions) and those outside §62, which are called “itemized” deductions (below the line deductions)

§62 deductions are allowed in their entirety are subtracted from gross income

Itemized deductions are taken from adjusted gross income and can be taken only as elective itemized deductions in lieu of the standard deduction.

FORMULA:

                        Gross Income

                        §62 deductions                                                above the line

                        Adjusted Gross Income

                        Greater of itemized

                        deductions or Standard Deduction*     below the line

                        Personal exemptions

            =         Taxable Income

*you could be eligible for a deduction, but if it is not greater than the standard deduction, you lose it (so casualty, interest, taxes, charitable and all other itemized deduction have to exceed the standard deduction)

Miscellaneous itemized deductions: deductions other than those deductible under §62 (above the line), exemptions, and those specifically listed in §67(b). These deductions are allowed to be deducted as itemized deductions to the extent that their total amount exceeds 2% of the taxpayers adjusted gross income.

So, in determining whether or not to elect to itemize deductions, a taxpayer must first add up his itemized deductions not listed in §67(b) and subject hat total to the 2% floor and add the resulting figure to his 67(b) deductions and see if that figure exceeds the standard deduction.

Moving Expenses

            Is a §62 deduction

§217 Deduction allowed.--There shall be allowed as a deduction moving expenses paid or incurred during the taxable year in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work.

For purposes of this section, the term "moving expenses" means only the reasonable expenses--
(A) of moving household goods and personal effects from the former residence to the new residence, and
(B) of traveling (including lodging) from the former residence to the new place of residence.

Does not include meals

There are two requirements:

Distance: the taxpayer's new principal place of work must be at least 50 miles farther from his former residence than was his former principal place of work, or if he had no former principal place of work, is at least 50 miles from his former residence (see pg.536)

Time: full-time employee must be employed 39 weeks-out-of-12-month period, if self employed must be employed 78-out-of-24-months (partners in business are considered self-employed)

You must take deduction for moving expense in the year you incur them , even if you have not met the requirements yet

Extraordinary Medical Expenses

§213 Allowance of deduction.--There shall be allowed as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent (as defined in section 152), to the extent that such expenses exceed 7.5 percent of adjusted gross income.

"medical care" means amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,

                               

            Medical expenses include; insurance, prescription medicine, doctor’s bills,

Can deduct capital expenditures to the extent that they do not enhance the value of the house. For example, if taxpayer needs a pool for medical reasons and pool costs $10,000, but increases home value by $5,000, taxpayer is only entitled to deduct $5,000.

Personal and Dependency Exemptions

Almost every individual taxpayer has at least one automatic deduction, the so-called “personal exemption”

The amount of the personal exemption is adjusted for inflation each year (current amount = $2800)

A taxpayer can also take a dependent deception if the following four tests are met:

2.                  Gross Income Test: dependents gross income cannot exceed the amount of the personal exemption ($2800) unless dependent is a child of the taxpayer under age 19 or a student under age 24

3.                  Support Test: taxpayer must pay more than ½ of the support for the person during the year

4.                  Relationship test: either must be related to(see list) or live with taxpayer for the entire year

(1) A son or daughter of the taxpayer, or a descendant of either,
(2) A stepson or stepdaughter of the taxpayer,
(3) A brother, sister, stepbrother, or stepsister of the taxpayer,
(4) The father or mother of the taxpayer, or an ancestor of either,
(5) A stepfather or stepmother of the taxpayer,
(6) A son or daughter of a brother or sister of the taxpayer,
(7) A brother or sister of the father or mother of the taxpayer,
(8) A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in- law, or sister-in-law of the taxpayer, or

5.                  Citizen test: dependent must be a citizen of US, unless native of Mexico or Canada

§152 also allows for Multiple Support Agreements: if no one person furnishes ½ of the support, but a number of persons do (and give at least 10%) they can choose one person to take the deduction each year

Multiple support agreements.--For purposes of subsection (a), over half of the support of an individual for a calendar year shall be treated as received from the taxpayer if--
(1) no one person contributed over half of such support;
(2) over half of such support was received from persons each of whom, but for the fact that he did not contribute over half of such support, would have been entitled to claim such individual as a dependent for a taxable year beginning in such calendar year;
(3) the taxpayer contributed over 10 percent of such support; and
(4) each person described in paragraph (2) (other than the taxpayer) who contributed over 10 percent of such support files a written that he will not claim such individual as a dependent for any taxable year beginning in such calendar year.

In case of divorce the custodial parent gets the deduction even if other parent pays more than half of support, unless court decree provides otherwise

Standard Deductions

The standard deduction is an alternative to claiming deductions for items such as taxes, interest, extraordinary medical expense, and any others not specified under §62.

            The standard deduction is taken in lieu of itemized deductions if it is higher

            Additional standard deductions are allowed for the elderly and the blind.

CAPITAL ASSET TRANSACTIONS

Gains and losses are characterized as “ordinary” or “capital”

A “capital gain” may qualify for special tax treatment

A capital asset is investment property and property held in a personal context. [§1222 defines capital asset as all assets except inventory, property held primarily for sale to customers, depreciable property and realty held in a trade or business, notes and accounts receivable, and property created by taxpayer’s efforts (copyright, artistic work, letters, memoranda, etc.)].

A capital asset must be property not income.

There are three ways to characterize capital gains:

            1. “collectibles” which are taxed at 28%

            2. §1250 property (buildings) which are taxed at 25%

            3. all others – stocks, bonds, land

§1222 Process

            First you determine if it is a short term or long term gain or loss

            Then you net the short term gain and losses

            Then you net the long term gain and losses

            Then you net these, this process is called double-netting

                        Short term capital gain                         Long term capital gain

            _          short term capital loss              -           Long term capital loss

            =          Net short term capital gain or loss        Net long term capital gain or loss

            Next, the net shorts are netted against the net longs to arrive at net capital gain or loss

            see example on page 666

           

            see below D (1)

                        Salary                          $50,000

                        Net Capital Gain          $15,000

                        __________________________

                        AGI                             $65,000

            -           Std Dec                                      $4,400

            -           Per Ex                            $2,800

                        ___________________________

            Taxable income                       $57,800 (now you break out the 15,000 and tax it at 20%)

                                                           

`           Short term capital gain is treated as ordinary income and is taxed according to your

            tax bracket

            Note: If you buy an asset in 2001, and hold it for 5 years, your rate will be 18% if

            you hold the asset for 5 years. If you are already holding assets, you can make a

            constructive sale in 2001 and then hold onto it for 5 years to get 18% rate (persons in

            15% bracket get an 8% rate)

            Short term losses offset gains that are taxed at higher rate first, so if taxpayer has gains of

                                               

                                                $5,000 Collectibles (taxed at 28%)

                                                $5,000 Long term Stocks (20%)

                                                and losses of $5,000 short term stocks

                        Net gains of $5,000 is taxed at 20%

                        The short-term loss of 5,000 offset the collectible gain of 5000

                                               

            §1202 gain, this section is meant to encourage investors to invest in start up companies:

           

If (after ’93) you buy qualified stock in a small business Corp (at date of purchase capitalization of company was $50 million or less) if you sell it five years later – you can get a 50% capital gain deduction

For example if bought stock in ’93, and sell it now (> 5 years later) for a $100,000 gain, you get a $50,000 LTCG deduction and the rest is taxed at 28%, so actual tax rate is 14%

If you go through double netting process and end up with a net capital loss, you can use up to $3,000 of capital loss to offset ordinary income (this is an above the line deduction)

            The short-term loss is used first

Any losses over $3000 are carried over to the next year and are thrown into the double netting process again

            Characterization on the Sale of Depreciable Property

            How do you characterize a gain or loss on the sale of property?

            Depreciation deductions of real or personal property are characterized as ordinary losses.

If the depreciable property is used in a trade or business, it is not a capital asset, However, §1231 may intervene to recharacterize such gain or loss as long term capital gain or loss.

Property that is depreciable and is held for more than one year and realty is a 1231 asset

§1231 provides that if the gains on the disposition of certain types of property (business, investment property and causality losses) exceed the losses on the disposition of the same types of property, all the gains and losses are treated as long term capital gains and long term capital loses.

If losses on the disposition of these properties equal or exceed the gains, all the gains and losses are treated as ordinary.

The §1231 process involves a main hotchpot and a sub-hotchpot

            Process:

                        (1) Personal casualty gains and losses - §165(h)

First you Net the gains and losses (after $100 deduction from loss amount)

If gains exceed losses then the net gain is LTCG

If losses exceed gains, loss in excess of 10% of AGI is an itemized deduction

(2) Casualty gains and losses (Sub-hotchpot)– Business and investment property

§165(b) says amount of loss is the adjusted basis (minus any insurance recovery)

First you net the causality gains and losses

If losses exceed the gains they are ordinary losses

If gains exceed losses, the net gain is a §1231 gain and is netted with the main hotchpot

(3) §1231 Gains and Losses (Main hotchpot) – Sales or condemnations of Business and investment property

            First net gains and losses

            If losses exceed gains, then the losses are ordinary

            If gains exceed losses, then the net gain is LTCG

§1231 assets are depreciable and real property held for business and must be held for more than one year

            §1231 tells you how to characterize the gain – on land used in trade or business

If after the main hotchpot netting you end up w/ a 1231 gain it is a capital gain (and goes on schedule D)

For example, if you sell a building used for several years in a business (sale price is $15,000 and adjusted basis is $5,000) ands two-year old car, used exclusively in business, is totally destroyed in a fire. (car had adjusted basis of $6,000 but was worth $8,000, and you receive $4,000 in insurance)

§1231 applies because it depreciable property and casualty loss used in business and held for at least one year

                        Causaulty                                            Building

Insurance         4,000               Amount Realized         15,000

            Adj. Basis        6,000               Adj. Baiss                    5,000

            Loss                 (2,000)             Gain                             10,000

            Since there are no                    Under §1231 the Gain becomes LTCG

            casualty gains, the loss

            is an ordinary loss

Recapture provision – if you have a net 1231 loss in the past five years you have to recapture it when you get a 1231 gain. You recapture it by considering that amount of gain to be ordinary

For example, if you have a net §1231 gain of 12,000, but in the last five years you had a $5,000 and $3,000 net loss (these losses are called unrecaptured 1231 losses), to the extent of the unrecaptured losses your gain is ordinary:

            So of the $12,000: $8,000 is ordinary gain and $4,000 is LTCG

Note: When you sell a business, each asset is treated separately for purposes of characterizing the gains and losses.

§1239: If you sell an asset, that would give you a capital gain if you sold it to a 3^rd party, to a corp that you own more than 50% of the stock – your gain is ordinary (if that entity is going to depreciate the property)

1239 prevents taxpayers from fully depreciating property, selling it to a corp they own (taxed at 20%) and then letting the corp depreciate the property

§1245 is an attempt to erode some of the benefits of 1231, it applies to personalty and reconstitutes gain. Basically the section says that to the extent of depreciation taken on personalty, the gain is ordinary

For example, if taxpayers basis in some equipment is $2000, he takes $1300 depreciation and turn around and the sells the equipment for $3700. He would have a $1700 gain, but to the extent that he has depreciated the property the gain will be ordinary, so 1300 will be ordinary gain and the other $400 will be 1231 gain

---------------------------------------------------------------------------------------------------------------------

HANDOUT

Characterization of Gains and Losses

I   Capital Gains and Losses

A.     Gain or loss from sale or exchange of a capital asset is a capital gain or loss. (§1222)

            The sale or exchange is the triggering mechanism

B.     If a capital asset is held more than one year, the gain or loss is long-term

C.     A capital asset is investment property and property held in a personal context. [§1222 defines capital asset as all assets except inventory, property held primarily for sale to customers, depreciable property and realty held in a trade or business, notes and accounts receivable, and property created by taxpayer’s efforts (copyright, artistic work, letters, memoranda, etc.)].

D.     Mechanics of reporting capital gains and losses:

1.         Gains and losses from capital assets held one year or less are netted to arrive at short term gain or loss.

2.         Gains and losses from capital assets held more than one year are

            netted to arrive at long term gain or loss.

3.         Short term net gain or loss is netted with long term net gain or loss to arrive at net capital gain or loss

4.         If net capital gain is long term, taxpayers other than corporations are taxed at maximum rate of 20% (or 10% if in 15% tax bracket) except that §1250 gain is taxed at maximum rate of 25% and collectibles and §1202 gain are taxed at maximum rate of 28%. [§1202 is gain on sale of stock in a qualified corporation (one with gross assets of $50,000,000 or less at time of investment). Stock must have been held more than 5 years. Taxpayers with a §1202 gain have a 50% long term capital gain deduction. The remaining gain (after taking a 50% long term capital gain deduction) is taxed at 28%. The maximum rate on total long term capital gain is then only 14% (50% of 28%).]

6.                  A net short term capital gain is taxed at regular tax rates

7.                  A corporate taxpayer receives no preferential tax treatment for a net capital gain (§1201).

8.                  For capital assets purchased after 2000, adjusted capital gain on capital assets held more than 5 years will be taxed at a maximum rate of 18% (capital assets other than collectibles and §1250 property)

9.                  If the taxpayer is in the 15% bracket, the rate will be 8% for capital assets (other than collectibles and §1250 property) sold after 2000 if the capital asset has been held at least 5 years.

10.              If net capital loss, taxpayers other than corporations may deduct up to $3,000 against ordinary income.

1.                  Remainder of loss is carried forward indefinitely to be offset in full against capital gains but only as to $3,000 against ordinary income.

2.                  The $3,000 deduction is applied first to short term capital losses in determining the character of loss carried over to succeeding tax year.

11.              Corporations may not offset capital losses against ordinary income.

1.                  Net capital losses are carried back three years and forward five years to offset capital gains.

2.                  Capital loss becomes short term capital loss as it is carried back and/or forward.

E.      Although gain on sale of capital asset held in a personal context is taxed, loss on such a sale or exchange is not deductible.

F.      Holding Period

1. Excludes date of acquisition; includes date of disposition.

2. Non-taxable exchange where carryover of basis—carryover of holding

    period.

3. Inherited property—holding period is long term (§1223(11))

II          Section 1231 Gains and Losses

A.     Gains and losses from sale of Section 1231 property are netted.

B.     Two netting processes:

1.                  Net gains and losses from casualties of §1231 property and of assets held for investment.

1.                  If gains exceed losses, net gain is netted in second process.

2.                  If losses exceed gains, net loss is ordinary.

2.                  Net gains and losses from sales of §1231 assets from condemnations of §1231 assets and assets held for investment.

1.                  If gains exceed losses, net gain is long term capital gain.

2.                  If losses exceed gains, net loss is ordinary.

2.                  Section 1231 assets are realty and depreciable property held for more than one year in a trade or business; timber, coal and iron ore; livestock (cattle and horses held more than two years; other livestock held more than one year); unharvested crop held more than one year and sold with land. (§1231(b))

3.                  If taxpayer has had net §1231 losses in previous five years, to extent of such §1231 loss, §1231 gain is ordinary. 

III        (§1231(c)) Recapture of Depreciation

A.        If personalty is sold at a gain, §1245 recaptures as ordinary income, the lesser of the gain or depreciation (or amortization) taken on the property.

B.         Personalty must be sold at price in excess of cost (or other acquisition basis) in order to provide §1231 gain on the sale.  (Excess of amount realized over original cost or other basis is amount of §1231 gain.)

C.         If realty is sold at a gain, §1250 recaptures as ordinary income only excess  of depreciation taken over depreciation allowed had straight-line depreciation been used.  Because realty must now be depreciated using straight-line depreciation, generally no recapture.

IV        Options (§1234)

For sale or exchange of option or loss on lapse of option, character of gain or loss is determined by character of underlying property.  (§1234)

Gain on lapse of option is ordinary because no deemed sale or exchange.

If option is exercised, cost of option is added to basis of property purchased.

Holding period of purchased property begins on day after option is exercised.

V         Patents (§1235)

1.                  Transfer of all substantial rights by holder of patent is treated as sale or exchange.

2.                  Payments received, even if periodic royalty payments, are long term capital gains.

3.                  Holder must be individual and generally is creator of invention.

VI        Sale of Subdivided Property (§1237)

1.                  Investors receive capital gain treatment on sale of lots if:

A. No substantial improvements (unless land held at least 10 years), and

B. Land has been held for at least 5 years.

2.         Gain is ordinary to extent of 5% of selling price less selling expenses in year 6^th lot is sold.

3.         Taxpayer may not be a corporation.

4.         taxpayer may not be a real estate dealer.

Note: Worthless stock is tetrad as a capital loss. You are deemed to have sold it on the last tax day of the year

VII       Example

The following transactions occur in 2000:

1.                  Machine A, used in taxpayer’s business, is sold for $11,000 on July 1, 2000.  The machine was purchased on February 1, 1998 at a cost of $10,000, and taxpayer claimed depreciation of $6,000.

2.                  Machine B, used in taxpayer’s business, was sold for $6,000 on April 5, 2000.  The machine was purchased on March 1, 1998 at a cost of $10,000, and taxpayer claimed depreciation of $3,500 on the machine.

3.                  A computer acquired March 1, 1995, and used in taxpayer’s business was stolen.  The theft was discovered May 1, 2000.  Taxpayer paid $5,500 for the computer and had claimed depreciation of $2,000.  Taxpayer received $2,000 insurance.

4.                  Land taxpayer had held for investment purposes was sold under threat of condemnation of March 15, 2000, for $50,000.  Taxpayer paid $30,000 for the land on February 10, 1991.

5.                  Taxpayer sold stock in WZ Corporation on March 5, 2000, for $10,000.  Taxpayer purchased the stock February 1, 1999 for $8,000.  Taxpayer also sold stock in XY Corporation on June 3, 2000 for $30,000.  Taxpayer purchased the stock on January 10, 2000 for $40,000.

Machine A produces a gain of $7,000, $6,000 of which is ordinary income and $1,000 of which is §1231 gain.  Machine B produces a §1231 loss of $500.  The computer produces a casualty loss of $1,500 which is ordinary because there are no other casualty losses.  The land produces a §1231 gain of $20,000.  The sale of stock in WZ Corporation produces a long term capital gain of $2,000.  The sale of stock in XY Corporation produces a short term capital loss of $10,000.  The §1231 gains and losses are netted [$1,000 (gain on machine A) - $500 (loss on machine B) + $20,000 (gain on land condemnation)].  The result is a net $20,500 long term capital gain that is netted on Schedule D with other capital gains and losses.  The taxpayer has a $2,000 long term capital gain plus the $20,500 §1231 gain that is reduced by the $10,000 short term capital loss for a net $12,500 long term capital gain.  The taxpayer also has ordinary gain of $4,500 [$6,000 (§1245 gain on machine A) less $1,500 (casualty loss on theft of computer)].

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RESTRICTION ON DEDUCTIONS

Limitations on Deductions

There are two types of provisions, those that disallow deductions and those that postpone deductions

A number of different sections limit deductions

Section 274 [travel, entertainment, business gifts—deduction limited to $25 per person per year]

Section 280A—office in home

No deduction unless

·         Use is on regular basis and exclusively business and either

·         Principal place of business for trade or business of taxpayer or

·         Place of business used by patients, clients, or customers in normal course of business or

·         Separate structure not attached to residence used in taxpayer’s trade or business.

Not applicable to rental use of residence or providing day care services.

If deduction permitted, deduction is limited to income derived from such use over deductions allocable to such use that would otherwise be deductible, such as interest and taxes.

Section 280F (automobiles and listed property)

Section 162(c), (e), and (f) [Illegal bribes and kickbacks, lobbying expenses and political campaign expenditures, fines, and penalties]

Section 183 deals with so-called  “Hobby losses”:  is a gentleman farmers activity actually engaged in for profit; if not, section 183 limits the deduction of expenditures or losses of the farm

If a gentleman farmer is legitimately engaged in his farming activity to earn a profit, his deductions should be fully allowed to the extent that he is “at-risk”

Applies to individual or S-corporation

If not profit-seeking activity, expenses in excess of income not deductible

Rebuttable presumption that activity is profit-seeking if profit in at least 3 out of 5 prior consecutive years (2 out of 7 for horse breeding)

If “hobby” under §183, deduct expenses in three categories: (you can deduct up to the amount of income from the hobby)

Category 1—expenses that would be deductible otherwise (ex. taxes)

Category 2—other expenses except depreciation and amortization

Category 3—expenses that reduce basis (ex. depreciation)

Deduct expenses in above order to extent of income from venture

(If venture is deemed to be a hobby, expenses to extent of income from venture become itemized deductions.)

Vacation Home (§280A)

280(a) limits deductions attributable to a taxpayers residence, which the statute defines as a dwelling unit that the taxpayer uses for personal purposes more than 14 days or 10% of the rental period.

Rented 15 days or more and

Personal use greater of 14 days or 10% of rental use

You must Allocate expenses as per rental usage and personal usage

Interest and taxes—rental days/365

Other expense—rental days/rental days + personal days

After determining expenses attributable to rental usage, as  above, deduct expenses to extent of rental income in three categories as set out above for §183.

For example: If T owns a two bedroom vacation home and rents for 90 days and uses for personal use for 30 days. Gross rental income = $3,000, property taxes = $1,000, mortgage interest = $1,000, other expenses (including $2,000 of depreciation) = $3,600. What can T dedcut?

            You start with amount of gross rents and then go through the categories:

                        Gross rents                                                       $3,000

I. Then you take the category I expenses (expenses that would be deductible otherwise) and multiply them by the number of rental days divided by the number of days in the year:

                        $2,000 (interest + Taxes)   X   90/365  = $500

                        Subtract the $500 from the gross rents = $2,500

II. Take other expenses (except depreciation) and multiply by rental days/rental days + personal days”

                        $1,600   X  90/120  =  $1,200

                        Subtract the $1,200 from the $2,500 =  $1,300

III. Take Depreciation and multiply by rental days/rental days + personal days

            $2,000 X 90/1000 = $1,500

            So we are able to deduct everything but $200

                        $3,000 Gross Rents

            -           $500    Category I

            -           $1,200 Category II

            -           $1,500 Category III

            =          $200 (as we are limited by amount of rental income)

Section 465 (at risk limitations)

This section limits a taxpayers deductible losses from a specific business or investment activity to the amount the taxpayer is personally “at risk” in that activity, if effect what one personally stands to lose from failure in the activity.

You cannot take deductions unless you are at risk

Applies to individuals and closely held corporations

Deductible loss from activity is limited to amount taxpayer is “at risk”

Amount “at risk” is sum of

Amount of cash and adjusted basis of property contributed to activity and

Amounts borrowed for use in activity to extent taxpayer is personally liable

Not at risk if nonrecourse loan unless qualified nonrecourse loan in activity involving holding of real estate. (as long as financing is from govt. or qualified lender see pg. 502)

If you have nonrecourse financing – all depreciation deductions cannot be taken until taxpayer is “at-risk” or sells the property

You can take a deduction to the extent you are “at risk”

Section 469 (passive loss limitations)

Applies to individuals, trusts, estates, closely held corporations, and personal service corporations

If a “passive activity,” losses (deductions in excess of income from activity) may only offset income from other passive activities.  Excess loss is “suspended”-- carried over until offset against passive income or until passive activity is disposed of. Once you have passive income you can use suspended losses.

Passive activity is one in which

Taxpayer does not “materially participate”

Material participation is

(1)               More than 500 hours a year in trade or business or

(2)               “Significant” participation—at least 100 hours and aggregate participation in all activities is more than 500 hours or

(3)               Participation is more than 100 hours and taxpayer’s participation in activity is not less than participation of any other individual for year or

(4)               Less than above hours if taxpayer’s participation is substantial participation as compared to participation of all individuals in activity for the year or

(5)               Facts and circumstances test—participation was regular, continuous, and substantial.

If you do materially participate you can use losses to offset other income

Prior participation is material participation for 5 out of 10 immediately preceding tax years (for personal service activity, any 3 preceding years)

Classification of Income and Loss

Active: Salary and other payments for services rendered

Trade or business in which taxpayer materially participates

Qualified low income housing project

Income from intangible property if taxpayer’s personal efforts created property

Portfolio: Interest, dividends, annuities, royalties

Gain or loss from portfolio property

Passive: (1) Trade or business in which taxpayer does not materially participate (all limited partnerships are passive activities)

(2) All rental activities (real estate activities is a passive activity unless you are a professional)

If “active” participation may deduct $25,000 of losses against other income (active or portfolio) but

1)                  reduced by 50% of AGI in excess of $100,000 (can deduct up to $25,000 if AGI is less than $100,000)

2)                  no deduction when AGI reaches $150,000

Must own 10% or more of all interests in activity during tax year

Active” participation is regular, continuous, and substantial involvement

Note: “Active participation” is different than “material” participation

Passive losses may only offset passive income except for closely held corporations which may offset passive losses against active income (but not portfolio income).

Treatment of suspended losses from passive activities:

Passive losses may be deducted against active and portfolio income when taxpayer disposes of entire interest in passive activity (sale or exchange to third party)

If transfer by reason of taxpayer’s death, deduction of suspended losses to extent suspended losses exceed amount of step-up in basis of property upon death

                                    If disposition by gift, suspended losses are added to basis of property.

Once property is sold any suspended losses can be used to offset any gain and if more is left over you can use those losses to offset ordinary income.

            See examples on p.523

            Illegality or Impropriety

                        §162(c) certain expense are disallowed based on public policy

You can’t deduct fines and penalties (otherwise it takes the sting out of those penalties)

Referral fees paid by law firms are not deductible if such payments are illegal in that state

Contributions to political campaigns are never deductible

If you are convicted of  a criminal offense – no deduction. However, if you are indicted for a criminal offense in a business context you can deduct your attorneys fees

§280(e) denies deductions for drug dealers expenses

SEPERATION AND DIVORCE

Alimony and separation maintenance payments

Payments that qualify as alimony or separate maintenance are gross income to the payee spouse (§71a) and deductible by the payor spouse under §215(a)

A payment that is made in cash (or check or money order) qualifies as alimony or as separate maintenance, if five requirements are met:

(1) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument

                         

(2) the divorce or separation instrument does not designate such payment as a non-alimony payment

The parties are free to designate the payments as non-alimony in order to allocate the tax consequences between themselves. If the payment is designated as non-alimony then recipient receives no gross income and payor receives no deduction.

(3) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made, and

(4) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

It is thought that payments made after the death of spouse are a property settlement or child support.

(5) the payment is not for child support (can’t disguise child support as alimony)

You can’t disguise settlement payments as alimony (payor would want to in order to take a deduction)

§71(f) Alimony recapture provision:

If payments are made for at least three years they are presumed to be alimony but if there is front loading (disproportionately large payments are made in the early years) the recapture provision will come into play.

The recapture take the form of an amount includes in the payors spouse’s gross income for year 3 (off-setting prior deductions) and a deduction in the same year by the recipient spouse (off-setting prior inclusions)

Note: rear loading is OK

            To determine if recapture provision applies you must go through a two-step process”

            FORMULA

            (1) Step One – look for excess payment in year 2:

                                          Year 2 payment

                                    -    (3^rd year payment + 15,000)

                                   

                                    =   year 2 excess

            (2) Step two – look for excess payment in year 1

                       

                        Year 1 – [    YR3 + ( YR 2 – YR2 excess)   + 15,000] = YR1 excess                                                                            2

            Example if there are payments of $80,000, $80,000, and $30,000

            Step One:         80,000 – (30000 + 15000) = 35,000 excess in year two

            Step Two:       

            80000 – [    30000 + ( 80000 – 35000)   + 15,000] = 27,500 YR1 excess                                                                                       2

The total excess alimony payment equal 62,500, which payor will have to report as income in year three and payee can deduct in year three

Tax Considerations in Divorce

Alimony Payments

Contractual alimony is legally enforceable in Texas.  Francis v. Francis, 412 S.W.2d 29 (Tex. 1967). (court cannot award alimony but parties can contract for it)

Pursuant to §215 of the IRC, the payor of alimony is entitled to a deduction for payments that are treated as income under §71.

Alimony is income under §71 if:

(1) It is a cash payment,

                        (2) Received under a divorce or separation instrument,

(3) When there is no liability to make a payment after the death of the payee spouse.

(4) If the couple is separated under a decree of divorce or of separate maintenance, they are not members of the same household.

(5) Cash payments to third parties (rent, mortgage payment, etc.) qualify as alimony if:

Not made to maintain property owned by payor spouse

Example: Payor spouse pays mortgage on home owned equally by payor and payee ex-spouse in which payee resides.  One-half of payment qualifies as alimony.

To insure that alimony payments are not disguised property settlements, there are “front-loading” provisions in §71(f) that cause the payor to have income and the payee to have a deduction (in the third payment year).

A part of the first and second year payments are recaptured as income to the payor and a deduction to the payee in the third year if payments in the first and second years exceed the following year’s payment by $15,000.

Excess recaptured as income to payor and a deduction to payee is illustrated in the following example:

Example: H and W are divorced.  An agreement incident to the decree requires W to pay H alimony of $60,000 per year for six years, with payments to cease upon H’s death.  In the first year W makes the full $60,000 payment; in the second year she paid only $30,000; in the third and fourth year she paid $10,000.  W will have a tax deduction of $60,000 in Year 1, $30,000 in Year 2, and $10,000 in Years 3 and 4.  H will report these amounts as income.  But in Year 3, W will also report $32,500 as income and H will have a deduction of this amount.  The $32,500 (income to W; deduction to H) is computed as follows:

Year 2 Recapture:

Year 2 Payment                                               30,000

Less:

Year 3 Payment           10,000

Plus                              15,000            

                                                            25,000

Year 2 Recapture                                 5,000

Year 1 Recapture:

Year 1 Payment                                               60,000

Less:

Year 2 Payment           30,000

Less Recapture

for Year 1 (amount

computed above)           5,000

25,000

Plus Year 3 Payment    10,000

35,000

Divide by 2                  17,500

Add                                 15,000         32,500

Year 2 Recapture                                 27,500

Total Recapture (Income to W and

deduction to H)                                                            $32,500

To avoid front-loading provisions of §71(f), consider alimony trust pursuant to §682.

Property Settlements (are not alimony)

Not taxed to either party (§1041)

Section 1041 of the IRC treats a transfer of property between spouses either during marriage or pursuant to a divorce as a nontaxable exchange

The recipient of the property will take the transferor’s tax basis in the property.

Child Support

Not taxed to recipient (§71(c))

No deduction to payor

Payments that end upon any contingency related to child or children are child support

If payments in a year are less than alimony and child support, payments are applied to child support first.

Dependency Exemption for Children (§151(e))

Custodial parent takes exemption unless

Custodial parent agrees in writing not to claim dependency exemption for child.  (Claiming exemption is dependent on written agreement between parties, not on court order or meeting support test for dependents.)

For non-custodial parent to claim exemption, custodial parent completes Form 8332.  Non-custodial parent attaches Form 8332 to his or her return.

Release of exemption to non-custodial parent can be for single year, a number of specified years, or all future years.

Tax Planning between Ex-spouses in Divorce Can Save Income Taxes

Ex-spouse with greater amount of income should structure payments to other ex-spouse in form of alimony

If custodial parent is party with lessor income, custodial parent should release exemption to non-custodial parent. But Note:

(1) If one parent has adjusted gross income in excess of $128,950 if single, $169,150 if head of household, or $193,400 if married filing joint return, dependency exemption begins to be phased out §151(d)(3)

(2) Exemptions are phased out by 2% for each $2,500 (or fraction thereof) by which adjusted gross income exceeds amounts in (1) above

(3) If one parent’s adjusted gross income is very high, (adjusted gross income exceeds phase out amount and exemptions are phased out) that parent obviously should not claim dependents.

H and W divorce in the current year. They have three minor children. W is not working. H has annual income of $100,000. W is the custodial parent. W will live with the children in the couples home. H and W had community property valued at 400,000.

1. Assume the parties divide the property equally with W receiving property worth $200,000. H will pay her child support of 1000 per moth. There are no tax consequences with regard to the property settlement. The child support is not income to W and not a deduction to H. In 2000 W will have no tax liability. H will have tax liability of $23,449 computed as follows:

            Gross Income                                      100,000

            - Standard deduction                               4,400

              (single taxpayer)                                95,700

            - Personal exemption                              2,800

            Taxable Income                                               92,800

            Tax Liability

              Tax on 63,550                       14381.50

              Plus 31% of 29,250

              (92,900 – 63,550),

            or                                 9067.50                       23,449

2. Assume the parties agree that H will retain the property worth 400,000 and will pay 200,000 in cash to W over a period of 5 years, or 40,000 per year. The payments will end upon W’s death so that the payments qualify as alimony for tax purposes. In addition, W signs an agreement to permit H to claim the children as his dependents.

W will now have tax liability of 4,612.50 computed as follows:

            Gross Income (Alimony)                     40,000

            - Standard deduction                               6,450

              (head of household)                          33,550

            - Personal exemption                              2,800

            Taxable Income                                               30,750

            Tax Liability for head of

            household (all income is in 15%

            tax bracket)                                          4,612.50

H will have tax liability of 9,019.50, computed as follows:

            Gross Income                                      100,000

            - Alimony                                              40,000

            - Standard deduction                               4,400

              (single taxpayer)                                55,600

            - Personal exemptions                         

  (4 x 2800)                                          11,200

            Taxable Income                                               44,400

           

Tax Liability (single)

Tax on 26,250             3937.50

28% of 18,150

  (44,400 – 26,250),

                                    5082.00                       9019.50

Combined tax liability is 13,632 (4612.50 plus 9,019.50) This is a tax savings of 9,817 [23,449 (H’s tax liability in no alimony payment) – 13,632 (combined tax liability when H pays alimony)]

H could agree to make higher payments to W because of his tax savings. For example, H could pay W an additional 800 per month as child support (which would have no additional tax effect to the parties) and still be paying less than under the first example where the parties simple divide their property equally [H could easily pay 9,600 additional child support as H saves 14,429 in taxes. W could easily pay income taxes of 4,613 as W receives an additional 9,600 in child support.

Problem Areas Regarding Property Settlements

Property A, with a fair market value of $5000,000, tax basis of $100,000, is given to H. Property B with fair market value of $500,000, tax basis of $400,000 is given to W. Both parties sell the properties shortly after divorce for cash.

H will have a taxable gain of $400,00 (500,000 – 100,000) on the asle of his property. H will pay tax of $158,000 on the sale (400,000 x 39.6). Thsu H will have net cash of $341,6000 (500000 – 158000). W will have a taxable gain of 100,000 (500,000 – 400,000) and will pay tax on the sale of only 39,600 . Thus, W will have net cash of 460,4000 (500,000 – 39,600)

Passive loss property

            Passive losses are suspended (§469)

            Passive losses can offset passive income

Divide property so that spouse awarded property with passive losses also has property with passive income

            Personal Residence

If house is sold as part of divorce, each spouse can qualify for provisions of §121 (first 500,000 of gain not taxed if the parties have lived in the home two out of five years before the sale)

If transferred to one spouse pursuant to divorce, holding period o f transferee spouse includes holding period of transferor spouse

If residence is transferred to spouse who resides in the residence, that spouse qualifies under §121 upon later sale

Exclusion under §121 is not available to spouse who is no longer owner of residence. Only one half qualifies for exclusion under §121. But if sold after divorce and co-owners, exclusion can probably be claimed by both spouses (if both lived in home 2 out of previous 5 years) so that total gain exclusion of $500,000

            Property Transfers

                        Record divorce decree as to property division

                        Obtain and record deeds to property

                        Federal tax lien applies to all property of taxpayer

Tax lien filed against one spouse is valid as against third party purchaser from other spouse even though property was awarded to other spouse as that spouses separate property if decree was not properly recorded in deed records

            Retirement Benefits

Have qualified Domestic Relations Orders (QDRO) in which non-employee spouse is designated surviving spouse

Can have early distribution w/o 10% penalty tax (except for IRA or SEP)

Participant spouse is not taxed on nonparticipating spouses interest in community property held by plan trust and distributed to non-participant spouse

If proceeds of plan are distributed pursuant to marital property settlement under which non-employee spouse is entitled to all of pension benefits, participant is subject to taxation on his ½ community property interests in those benefits at time distribution is made

Can be rolled over within 60 days into IRA with no tax consequences

Should be in new fund not controlled by ex-spouse

Note: Under regular IRA you can a deduction but earnings are taxed, under the Roth IRA you do not get a deduction but earnings are not taxed

FUNDAMENTAL TIMIMNG PRINCIPLES

You can use calendar year or fiscal year

The period for which the taxpayer reports items of income or deductions is affected by the methods of accounting that the taxpayer has adopted.

Two principle methods:

(1) Cash receipts and disbursements method: measures tax liability by including an item of income or allowing a deduction at the time that cash or its equivalent is received or paid (primarily used by individuals) Have income when you receive cash

(2) Accrual method: measures tax liability by including an item in income at the time the taxpayer becomes entitled to it and allowing a deduction at the time a deductible obligation becomes fixed and certain (primarily used by businesses) Have income when all events occur to entitle you to income

No method is acceptable unless it clearly reflects income; by employing the consistent application of generally accepted accounting principles

Cash receipts and disbursements method

Property: a bonus, new car, vacation – are all reported as income to the extent of fair market value

Checks: is a cash equivalent, checks delivered to taxpayers are income in the year of delivery (even if you get check at 11pm on Dec 31^st)

Promissory notes: negotiable note is cash equivalent (However, if note is just evidence of indebtedness then it is not a cash equivalent)

            Credit cards: is now considered payment by cash

Doctrine of constructive receipt: all items which constitute gross income are to be included for the taxable year in which the y are actually or constructively received. Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

Note: there is no parallel doctrine of constructive payment

Contracts can be cash equivalents (bonus payment in an oil and gas lease, was payable over a number of years to avoid tax, govt. says you get taxed on whole amount in year one)

The creation of an asset that has a useful life substantially beyond the close of the taxable year may not be fully deducted in the year payment is made. Instead the expenditure must be capitalized and deductions may only be taken over the useful life if the asset (deduct in the year you get the benefit)

Example; if you buy  a three year insurance policy and want to pay the whole premium up front – you still have to spread the deductions over three years

Points: if you pay points on personal residence to buy or improve it, you may deduct them

Charitable contribution

Some examples: (under cash method)

If debtor mails a check for $5000 interest to lender on DEC 31, of year one and It is delivered to lender on JAN 2 of year two: debtor has a deduction in year one and lender has income in year two

            The Accrual Method

                        Is somewhat like the accounting method

                        When the right to receive an amount becomes fixed, the right accrues

Under the accrual method of accounting, income is includible in gross income when all events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy

General rule: Prepaid (advanced) income must be reported in the year of receipt

Exceptions (when it can be deferred)

(1)               prepaid club dues

(2)               prepaid subscriptions

(3)               payment for services rendered if you can and will perform all services in 

             the next tax year

Pre-paid interest or rent is taxed in the year of receipt

May only deduct expense as you incur them

see problems p. 621