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 16th 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 5th 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
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 16th
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
---------------------------------------------------------------------------------------------------------------------
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
---------------------------------------------------------------------------------------------------------------------
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
---------------------------------------------------------------------------------------------------------------------
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
---------------------------------------------------------------------------------------------------------------------
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.
(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.
(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
(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.
(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 3rd 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 6th
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
- (3rd 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 31st)
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
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