Tax Master Outline 11/23/11 11:58 AM

II: Gross Income- Concepts and Limitations

A: What is Gross Income? – “accession to wealth”

o i: Internal Revenue Code

§61: Gross Income: Gross income means all income from whatever source

derived, including but not limited to: compensation for services (fees,

commissions, fringe benefits etc), gross income derived from business, gains

derived from dealings in property, interest, rents, royalties, dividends,

alimony and separate maintenance payments, annuities, income from life

insurance and endowment contracts, pensions, income from discharge of

indebtedness, distributive share of partnership gross income, income from a

decedent or income from an interest in a trust or estate.

§85: Unemployment compensation is included under gross income

§86: Social Security is generally included under gross income.

o ii: Treasury Regulations

§§1.61-1: Gross Income: All income from whatever source derived unless

excluded by law. Realized in any form.

§§1.61-2(a)(1): Compensation For Services: Taxable income includes wages,

salaries, commissions, tips, bonuses, severance pay, rewards, jury fees,

marriage fees to clergymen, retirement, pensions

§§1.61-2(d)(1): Compensation Paid Other than in Cash: If services are paid

for in property the FAIR MARKET VALUE of the property must be included in

income as compensation. If paid for in other services the fair market value

of those services must be taken in income as compensation- if given at a

stipulated price, that price will be taken as the FMV.

§§1.61-2(i): Property Transferred to An Employee or Independent

Contractor: if property if transferred by an employer to an

employee as compensation for an amount less than its FMA, the

difference between the amount paid and the FMW at the time of

transfer is compensation and shall be included in gross income. In

subsequent sale, to compute gain or loss, the basis shall be the

amount paid for the property increased by the amount included in

gross income.

§§1.61-8(a) Rents and Royalties: Gross income includes rentals received or

accrued for the occupancy of real estate or the use of personal property.

Gross income also includes royalties (like from publishing a book)

§§1.61-9(a): Dividends: Dividends are included in gross income. Dividends

may give rise to a credit against tax under §34.

§§1.61-11(a): Pensions: Pensions and retirement are income unless

excluded by law. If employer did not contribute to pension then the full

amount is taxable gain. If the employer did contribute then the amount in

excess of the contribution might be taxed as capital gain rather than

income.

§§1.61-14(a): Misc. Taxable Income: Punitive damages, another person’s

payment of income tax, illegal gains treasure trove, prizes, awards, damages

for personal injury, income taxes paid by the lessee corporation,

scholarships and fellowships, tax free covenant bonds, notional principal

contracts.

o iii: Cases:

US v. Kirby Lumber Co: Discharge of a corporate debt for an amount less

than the face of the debt does not result in income to the debtor

Commissioner v Glenshaw Glass: Glenshaw sued Hartford Empire Co for

damages for fraud and damages for violation of antitrust laws. Hartford paid

Glenshaw a settlement of $800,000. $324,529 of that represented payment

of punitive damages for fraud and anti-trust violations, Glenshaw did not

report this as income claiming it was a wind fall from the culpable conduct

of a third party and was not within the scope of taxable income. However

the court held that all gains are taxable except those which are specifically

exempted. SC defined income as an accession to wealth clearly realized and

over which the tax players have complete dominion.

Old Colony Trust: Mr. Woods company paid his taxes for him based on his

pay. The Board claimed that Mr. Woods should have included the amount

paid by his employer as additional income.

Held: The SC stated that it made no different whether the party had

bargained for the payment or merely acquiesced in it. The Court

found that the payment was in consideration for services rendered

and therefore was includable in income . Form of payment made no

difference. The taxpayer owed a tax, it was discharged by the

employer, the discharge was equivalent to receipt. Discharge will

not likely be a gift when it arises out of employer-employee

relationship.

McCann: McCann and her husband went on a business trip which

was paid by her emplyoeer. They did not claim the trips expenses

on their taxes. They were sued, claiming that they should have

reported the cost of the trip. Gross income may be in any form. If an

employeer pays an employees expenses on a trip as a reward for

services rendered then this amounts to an award and must be

taxed.

B: Realization Requirement

o i: Treasury Regulation

§§1.1001-1(a): Gain or loss is realized from the conversion of property into

cash or from the exchange of property for other property differing

materially in kind or extent.

o ii: Cases

Eisner v. Macomber: P owned stock, of which she and the other

shareholders received a 50% stock dividend in the form of additional

corporate stock rather than cash dividend. Court held that because no gain

and no income had been realized by reason of the stock dividend Congress

had no power to tax it.

Cottage Savings Association v. Commissioner: The issue presented was

whether a savings and loan association “realized” losses on the exchange of

its interest in one group of home mortgage loans for interests in a different

group of home mortgage loans, the court concluded that losses had been

realized because the exchanged property were materially different under

1001(a).

o iii: Measure of Gain or Loss

Code §1001(a): Gain or loss is the difference between the aggregate amount

realized and the adjusted basis for the property

Amount realized is the sum of money received plus the FMV of the

property (1001(b))

Adjusted basis is the

C: Imputed Income

o i: Imputed Income is income that is not taxable and usually comes from owning and

using one’s own property or in using self-help (ie: helping one’s own family)

D: Bargain Purchases

o i: If you purchase an asset at bargain price, the difference between the bargain price

and the fair market value does not constitute gross income.

o ii: Cases

Pellar v. Commissioner: Pellar built a home for cheaper than the fair market

cost because the person building it for them wanted to stay in their

goodwill. The court held that this difference did not constitute taxable

income (bargain purchase).

EXCEPTION: Keep in mind §1.61-2(d)(2)(i): if property is transferred

as compensation for services in an amount less than its FMV, the

difference between the FMV and the amount paid is gross income.

III: Effect of an Obligation to Repay

A: Loans

o i: Loans are NOT gross income. It does not represent an accession to wealth”. The

borrower has an obligation to repay the loan, it is this obligation that negates a loan

as income.

Commissioner v. Tufts:

Facts: Tufts contended that the assumption of a mortgage that

exceeded the FMV of the property by the purchaser was not taxable

Held: This is taxable. When an obligation to repay is relieved, the

taxpayer has recognized income. When the mortgage is assumed, it

is as if the mortgagor was paid the amount in cash and then paid off

his mortgage.

o ii: HOWEVER, a failure to repay a loan may generate tax consequences.

If a third party pays off the loan of behalf of the borrower

If the debt is forgiven by the lender.

Old Colony Trust v: (See Chapter 2 PG ____)

o iii: What constitutes a loan?

In order for a transfer of funds to constitute a loan, at the time the funds are

transferred there must be an unconditional obligation to repay and an

unconditional intention of the part of the transferor to secure repayment.

Look objectively at factors such as the presence or absence of a debt

instrument, collateral securing the loan, interest accruing, repayments of

the transferred funds, attributes indicative of an enforceable obligation.

Morrison v. Commissioner: Tax Court held that payments and

disbursements made to a shareholder were loans because the court found

that the corporation has enough funds to make the loans, the shareholder

has enough income to repay the loans, and there was evidence that the

shareholder has made repayments including interest.

B: Claim of Right

o i: If a taxpayer receives earning under a claim of right and without restriction as to

its disposition, he has received income which he is required to report on his tax

return, even though it may still be claimed that he is not entitled to retain the

money and even though he may still be adjudged liable to restore its equivalent.

(North American Oil Consolidated v. Burnet)

Deduction: Rightfully so, a taxpayer who reports income under a claim of

right is entitled to a deduction if he is required to refund the money.

See Section §1341 of the Code. (a) If— (1) an item was included in gross

income for a prior taxable year (or years) because it appeared that the

taxpayer had an unrestricted right to such item; (2) a deduction is allowable

for the taxable year because it was established after the close of such prior

taxable year (or years) that the taxpayer did not have an unrestricted right

to such item or to a portion of such item.

o ii: Funds over which a taxpayer only acts as a conduit are not received under claim

of right.

ex: Nonprofit corporation receiving funds to be solely for nonprofit

purposes. Court held funds were received in trust with no gain accruing to

the taxpayer (Ford Dealers Advertising Fund v. Commissioner)

C: Illegal Income

o i: Gains from illegal funds ( US v. Sullivan) or embezzlement may be taxed (James v

US).

Gilbert v. Commissioner: Taxpayer illegally withdrew corporate funds.

However, he has informed several of the officers and his withdraws and

believed he was acting in the best interest of the corporation. The Court

held that the taxpayer did not realize income but the withdraws were

merely loans which he intended to repay.

o ii: Repayment of illegal income entitles the taxpayer to a deduction. (Rev Ruling 65-

254)

D: Deposits

o i: Rent paid in advance generally constitutes gross income in the year it is received

regardless of the period covered or the taxpayer’s method of accounting. Reg §1.61-

8(b)

o ii: Security deposits

Commissioner v.Indianapolis Power and Light: Control over the conditions

of the refund if the determining factor in deciding whether a “deposit” will

be taxable. If the payor controls the conditions under which the money will

be repaid then the payment is not income to the recipient. On the other

hand, if the recipient has control over the conditions under which the

payment will be repaid then the recipient has some guaranty that it will be

allowed to keep the money and hence has dominion over it.

Highland Farms v. Commissioner: Residents of an apartment complex were

required to pay an entry fee prior to occupancy and monthly rentals

thereafter. At the end of five years the entry fee was fully nonrefundable,

however a resident who terminated occupancy before this period ended

was entitled to a pro rata refund. Court held the refunds were within the

tenants control and the petitioner needed to only include in his income the

portion of the entry fee which become nonrefundable after each year.

Perry Funeral Homes: Taxpayer prepaid for funeral goods, contract could be

cancelled anytime prior to actual provision of the goods. Therefore this was

not income until the funds were used to purchase the items.

IV: Gains Derived from Dealings in Property

A: Terminology

o i: Gain

§1.61-6(a) is the excess of the amount realized over the unrecovered cost or

other basis for the property sold or exchanged.

§1001(a): excess of the amount realized over the adjusted basis

(unrecovered cost).

o ii: Amount realized

§1001(b): Amount realized on the sale or other disposition of property

equals the money received plus the FMV of any other property received.

o iii: Adjusted Basis:

§1011(a): adjusted basis is equal to the basis as determined under §1012

adjusted as provided in §1016. According to §1012, adjusted basis equals

costs (amount paid for an item), except as otherwise provided. §1016

requires a taxpayer to adjust the basis to reflect any recovery of her

investment or any additional investment made in her property (ie: additions

to a home must be added in figuring the adjusted basis)

B: Tax Cost Basis

o i: §1.61-2(d)(2)(i): Basis is the value of property received (Ex: If I perform $50k worth

of legal work and X gives me property work 50K, which I then sell for 60K, my basis

in the property is 50K. Another example is, if lawyer does 50k worth of worth and

client gives lawyer property worth 60K but only makes lawyer pay 10K then lawyers

basis in the land is not merely 10k but the total 60K)

C :Impact of Liabilities

o i: Impact on Basis

Loans: When using loans to pay for land or other items, because of the

obligation to repay the taxpayer is entitled to include the amount of the

loan in computing the basis in the property. Commissioner v. Tufts

§1012: The loan is a part of the basis even if the lender is the seller

or if the buyer pays in installments over time.

o ii: Impact on Amount Realized

§1.1001-2(a)(1): The amount realized from a sale or other disposition of

property includes the amount of liabilities from which the transferor is

discharged as a result of the sale or disposition.

Recourse liabilities incurred by a taxpayer in the acquisition of property are

included in the taxpayer’s basis in that property and the recourse liabilities

of a seller, assumed by a purchaser, are included in the seller’s amount

realized.

D: Basis of Property Acquired in Taxable Exchange

o i: The cost basis of property received in a taxable exchange is the fair market value

of the property received in the exchange plus any cash or other property given for

the property in question. Philadelphia Park Amusement Co v. US

o Where the transfer was made at arm’s length and the new asset cannot be valued,

it is deemed to be equal to the value of the asset that was given up by the taxpayer.

V: Gifts, Bequests, and Inheritance

A: What is Excluded From Income?

o i: 102 excludes gifts as well as property acquired from a decedent through bequest,

devise or inheritance

What is a gift?: The motive of the donor is critical in characterizing receipts

as gifts. In Commissioner v. Duberstien the court said to look to the motive

of the donor but to also apply the mainsprings of human conduct to the

facts of each case. In Duberstein the D was given a car by a business

associate as a result of a useful referral but did not declare the car as

taxable income, deeming it a gift. Court held that the car was not given out

of a detached and disinterested generosity, or out of affection, respect,

admiration, or charity, and therefore was not a gift.

o ii: Exclusions

§103(a) does not allow a deduction for amounts transferred by an employer

to, or for the benefit of an employee.

§274(b) disallows a deduction for gifts made by businesses to individuals in

excess of $25. (this does not include employees because as listed above,

gifts from employers to employees are never deductible)

B: The Nature of the Bequest or Inheritance

o i: Must evaluate whether the inheritance or bequest is cash or property received as

a gift or as compensation or some other form of taxable income.

Wolder v. Commissioner: P agreed to render legal services to a client

without billing for them in exchange for money and stocks bequeathed to

him in her will. Court held that when a gift or bequest if given for the

purpose of payment for services performed it because taxable income.

Olk v. US: P was a craps dealer who claimed that tokes given to him by

players at the casino were non-taxable gifts given out of superstition. Court

held that money received by taxpayers who are engaged in rendering

services, contributed by those with whom the taxpayers have some

personal or functional contact are taxable income when in conformity with

the practices of their area of work. Furthermore, the regularity of receipt of

the money indicated it was likely income.

Goodwin v US: Revered Goodwin was given a “special occasion gift” from

the members of their congregation and claimed that it was nontaxable.

Court held that regular sizeable payments made by persons to whom the

taxpayer provides services are customarily regarded as a form of

compensation and therefore is taxable income.

C: Basis of Property Received by Gift, Bequest, or Inheritance

o i: Gifts of Appreciated Property

§1015: a receiver of a gift gets whatever basis the giver has in the gift

(transferred basis)

ex: Stock purchased for $200, is worth $500 when is gift as a

gift. The receiver of the gift takes the $200 basis in the

stock.

Taft v. Bowers: Father gave stock to his daughter. Daughter

sold the stock and argued that she was only taxable on the

appreciation of the stock while she owned it, not while her

father owned it. The court disagreed. The daughter takes

the father’s original basis, thus she will be taxed on the full

value of the gain.

o ii: Gifts of Property Where the Basis is in Excess of the FMV

§1015 shifts gain from donors to done, however, losses may not be shifted.

If X gives Y a stock with a basis of $200, and Y sell it for $100, Y does

not report the loss according to §1015(a) and Reg §1.105-1(a)(2) it

simply disappears.

o iii: Basis of Property Received by Bequest or Inheritance

§1014 provides that property acquired from a decedent generally takes a

basis equal to the fair marker value of the property at the date of the

decedent’s death.

This provides an amnesty for gain. The heir receiving the stepped up

basis can sell the property for its value as of the decedent’s death

and not have to report any gain for their taxes.

o iv: Part-Gift, Part-Sale:

Seller’s gain/loss: §1.1001-1(e) states that the seller-donor has gain to the

extent that the amount realized exceeds the adjusted basis of the property.

No loss is recognized on such a transaction.

Donee’s Basis: §1.1015-4 provides that the donee’s basis will be the greater

of the amount the done paid for the property or the adjusted basis of the

donor.

For the purpose of computing losses however the donee’s basis is

limited to the FMV of the property at the time of transfer to the

donee.

Liability assumed by the donee is treated as an amount paid. §1.1001-2(a)

(1), (4)(ii)

Gain can be recognized on the part of the donor the liability

assumed exceeds the donor’s basis in the property.

Example: If S sells land to E for $15K, S had an adjusted basis of 30k and the

land had a FMV of 60K. S has no gain or loss because her amount realized

does not exceed her adjusted basis. E has an adjusted basis of 30k because

her adjusted basis is the greater of the amount she paid (15k) or the donor’s

adjusted basis (30K). Is instead of paying 15K, E assumes S’s liability of 45k,

then S has a gain of 15K and E has an adjusted basis of 45K.

VI: Sale of Principal Residence

A: Ownership and Use Requirements of §121

o i: Under §121 taxpayers may exclude up to $250,000 (or 500K for joint returns) of

the gain on the sale or exchange of a qualifying principal residence, it does not need

to be one’s principal place of residence at the time of the sale or exchange but

rather the sellers must have lived in the property as a PPR and owner the property

for periods aggregating to two years (does not need to be continuous) or more

during the five year period prior to the sale 121(a).

o ii: Ownership and use requirements may be satisfied during nonconcurrent periods

so long as the taxpayer satisfied each of them within the five year period ending on

the date of sale or exchange. §1.121-1(c)

ex: Rented home in 2000, purchased in 2004, sold in 2006, they can exclude

gain upon sale because they lived in home as PPR for 2 of 5 years and

owned the home for previous 2 of 5 years.

o iii: Short temporary absences will be counted in periods of use (ie vaca)

o iv: If an unmarried individual sells or exchanges property subsequent to the death of

his or her spouse, the individuals’ use and ownership period will include the period

the deceased spouse owned and used the property. §121(d)(2)

o v: If receives property from transaction described in §1021 (spouse or former

spouse), ownership period (not use) will include ownership period of transferor

ex: Anna and Bob divorce, Anna transfers title to a home she owned to Bob.

Although Bob never had any ownership interest in the home for purposes of

121(a), Bob will be considered to have owned the home for the period that

Anna owned the home. (however the use requirement will not transfer)

o vi: If an individual continues to have ownership interests in a residence but is not

living in the residence because the individual’s former spouse is granted use of the

residence under the divorce, the individual with nonetheless be deemed to use the

property during the period her former spouse is granted use of the property.

§121(d)(3)(B)

o vii: The use rules are modified if someone becomes physically or mentally incapable

of self-care. If the individual owns and uses the residence for one year in the five

year period, the individual will be treated as using the property for any period

during the five year period in which the individual resides while owning the

property. §121(d)(7).

o viii: To prevent a windowed spouse from having to rush to complete a sale of their

home within the same year of the death of the spouse to claim the $500,000

exclusion, Congress enacted §121(b)(4) which allows a widowed taxpayer who has

not remarried, to claim the entire $500,000 exclusion if he sells or exchanges the

residence within two years of the date of the death and the original requirements

were met before the date of the spouse’s death.

B: Amounts Excludable Under §121

o i: Taxpayers are allowed to exclude up to $250,000 on the sale of their PPR, this

exclusion applies to only one sale or exchange every two years. §121(b)(3)

o ii: Couples are able to exclude up to $500,000 if they files joint returns, and if certain

requirements are met under §121(c)

1) One of the spouses must satisfy the ownership requirement

2) Both spouses must satisfy the use requirement

3) Neither spouse has used the exclusion within the past two years

o iii: If sale or exchange occurs because of change in place on employment(new job

must be at least 50 miles from the old residence), health (requiring a physician

recommended change in residence), or other unforeseen circumstances and the

taxpayer consequently fails to meet the ownership and use requirements of

§121(a), §121 (c) provides that some or all of the gain may still be excluded. The

amount excludable will be a fraction of the $250,000 (or $500,000) limit.

§121(c)(1) gives the formula for finding what amount is excludable under

this situation. The fraction will have as its numerator, the length of the time

the taxpayer owned and used the home as his PPR, and the denominator

will be 2 years.

Ex: If X lived in the home as his PPR for 1 year then had to move

because of a job he can claim ½ or half of the $250,000 limit.

Ex: X and Y are married July 1, 2007 and move into X’s PPR as their

PPR. A year later they have to move because of jobs. Because they

both did own and use the house for the required time, they cannot

claim the joint $500,000 but must file separately. X can exclude the

entire $250,000 because he satisfied the requirements. Y must take

a fraction, ½ of the $250,000. Therefore together they can exclude

$375,000.

If a spouse has to move because of a husbands change in

business she can still qualify for this safe harbor provision

under §1.121-3(c)(1).

C: Principal Residence

o i: PPR: If the taxpayer has two residence, the residence the taxpayer uses for the

majority of the year will be considered his PPR §1.121-1(a)(2)

Regulation 1.121-1(a)(2) includes factors relevant in identifying a property

as a taxpayers PPR 1) taxpayers place of employment 2) principal place of

abode for family members 3) address listed on the taxpayer’s federal and

state tax returns, drivers license etc 4) tax payers mailing address for

bills/letters 5) Location of the taxpayers banks 6) location of religious

organizations and clubs which the taxpayer is part of.

Guinan v. US: P owned residences in GA, AZ and WI, and contended that he

could exclude the gain from the sale of his house in WI because he resided

there for more days that he resided at the other places during the 5 year

period. Court held that the time spent at the residence is not the single

determining factor as to whether a residence is a PPR. In evaluating the

taxpayer under other factors it found that the home in WI was not his PPR.

o ii: Property owned in conjunction with the dwelling may be considered as part of

the PPR.

Bogley v. Commissioner: Taxpayer subdivided his 13 acres of land on which

his house sat and sold all the different sections. Because all the land was

used as the PPR each sale could be applied to the exclusion.

o iii: If a vacation home is not the PPR then time spent there will not be able to be

aggregated to satisfy the two year period, since it isn’t the PPR.

IX: Discharge of Indebtedness

A: Overview

o §61(a)(12): income from discharge of debt is indebtedness

o §108 provides an exclusion from income when discharge occurs in certain

circumstance (bankruptcy or insolvency)

o Kirby Lumber Co: KL issued bonds at par value and then later repurchased some on

them at below market par. Difference between the issuing price and the repurchase

price was taxable gain. Taxpayer was solvent at all times.

Established the “freeing of assets theory” : taxpayer realizes gain when a

debt is discharged because after the discharge the taxpayer has fewer

liabilities to offset her assets.

B: Specific Rules Governing Exclusions

o i: Discharge of Indebtedness when the taxpayer is insolvent

§108(a)(1) specifically provides the discharge of indebtedness will not

generate gross income if the discharge occurs in a bankruptcy or if the

discharge occurs when the debtor is insolvent.

§108(a)(3): Limits the amount of the insolvency exclusion to the

amount that the debtor is insolvent

ex: D owes $100 to C, D has assets of $130 and another

liability of $100. C discharged D’s debt for the price of $20.

The debtor was insolvent by $70 (liabilities (200) – assets

(130) = $70) so the amount of D’s exclusion cannot be

greater than that. D has realized gain of $80 because C

discharged him of $80 worth of debt. He cannot exclude the

full $80 because he was only insolvent by $70, so he can

exclude the $70 and need report only $10 worth of gain.

§108(d)(3): Insolvent means an excess of liabilities over the fair

market value of the assets

Gehl v. Commissioner: P transferred farmland (with a FMV above basis) to

satisfy debt, creditor forgave the rest of the debt. Court held that while the

actual discharge of debt was not taxed, the amount realized on the land sale

(FMV-adjusted basis) was taxable sale or exchange of property under §1001

because the transaction was not a discharge of indebtedness .

Revenue Ruling 84-176: Facts: Amount owed was forgiien in exchange for

realize of contract counterclaim Amount was paid as settlement for lost

profits in a contract suit and therefore was NOT INCOME but merely

recovery of lost profits.

o ii: Disputed or Contested Debts

Excess of the original debt over the amount determined to have been due is

to be disregarded in calculating gross income. Preslar v. Commissioner

Payne v. Commissioner: Credit card debt was reduced from $21,270 to

$4,592. The cardholders did not report $16, 678 worth of income. Tax court

ruled that no exclusion applied to the taxpayers and that they should have

report the discharged debt as income.

o iii: Purchase Money Debt Reduction for Solvent Debtors

§108(e)(5) codifies a rule that if a purchaser of property refuses to pay the

balance due to an irregularity with the sale or a defect in the property and

the seller agrees to a reduction in the purchase price this does not

constitute a discharge of debt but rather a retroactive reduction in purchase

price.

o iv: Acquisition of Indebtedness by person related to the debtor

§108(e)(4): if a person related to a debtor acquires the indebtedness, the

acquisition shall be treated as an acquisition to the debtor.

ex: D owns more than 50% of stock in X corporation and is therefore

related to X within the meaning of §108(e)(4). X issues its own

bonds for which it receives par value, D repurchases the bonds on

the open market for an amount considerably less than par. D’s

acquisition of the bonds is treated as being the same as X’s

acquisition of the bonds because the two are related.

o v: Discharge of deductible debt

§108(e)(2) provides that forgiveness of a debt does not generate income if

the payment of the debt would have been deductible.

ex: If a landlord doesn’t make you pay rent.

o vi: Discharge of certain student loans

§108(f)(1) discharge of student loans in certain circumstances is not income

if it is discharged for certain work (Ie: if the student engages in public

services occupations or areas with unmet needs such as rural or low-income

areas)

o vii: Discharge of qualified principal residence indebtedness

In response to the foreclosure problem (house goes into foreclosure and

the taxpayer does not have enough to pay off the outstanding mortgage,

lenders often forgive the remainder) Congress enacted §108(a)(1)(E) and (h)

which provides for an exclusion for qualified PPR indebtedness discharged

after Jan 1, 2007 and before Jan 1, 2013.

This is not limited to foreclosure sales but also includes if there is a

discharge of debt directly related to a decline in the value of the

house or the employment condition of the taxpayer (h)(3)

A taxpayer taking advantage of the above exclusion must reduce her basis

in the residence by the amount excluded.

o vii: Other Exclusions

§108(a)(1)(C): qualified farm indebtedness discharge rule permits certain

solvent and insolvent farmers to exclude from gross income the discharge of

farm debt up to the combined amount of certain tax attributes and the basis

of qualifying property.

§108(a)(1)(D): a non-corporate taxpayer can avoid gross income where, as a

result of the decline in the value of the business property, there is a

discharge of acquisition indebtedness with respect to that property. The

taxpayer must however reduce the basis of the business property.

C: Discharge of Indebtedness as gift, compensation etc

o i: Gift exclusion is not applicable where the debtor purchased his own obligations at

a discount Commissioner v Jacobson

o ii: In certain contexts the cancellation of indebtedness can be an excludable gift.

ex: If a parent lends money to a child and then forgives the debt this

forgiveness would likely be considered a gift under §102(a)

o iii: Where an employer discharges indebtedness, it is likely compensation income

rather than discharge of indebtedness

X: Compensation for Personal Injury and Sickness

A: Damages

o i: Business or Property Damages

Raytheon Products Corp v Commissioner instructs that with respect to

business or property damages we ask what the damages were in lieu of.

Damages awarded on account of lost profits would be taxable. A

recovery for property damage would be measured against the basis

of the property to determine the taxpayer’s realized gain or loss.

Where the damages are awarded for injury to good will then it is

not taxable.

o ii: Damages Received on Account of Personal Physical Injuries or Sickness

§104(a)(2) excludes from income any damages received, whether by suit or

agreement, as a lump-sum or periodic payment, on account of personal

physical injuries or physical sickness.

Policy: They do not add wealth but merely loss of capital

Us v. Gerber: The exclusion necessitates some sort of tort claim

against the payor. The mere fact that the taxpayer experienced pain

and discomfort is not enough.

The Tax Court in Threlkeld v. Commissioner (1986) held that personal injury

referred to any invasion of the rights that an individual is granted by virtue

of being a person in the sight of the law.

Thus, prior to the amendments made in 1996, employees

recovering damages for wrongful discharge, sex discrimination or

any employment related claim constituting personal injury within

this definition could exclude the damages received as well as lost

wages.

o iii: Supreme Court Limitations on §104(a)(2)

Burke v US: Employees of the Tennessee Valley Authority settled an action

under the civil rights act alleging that TVA had engaged in illegal sex

discrimination. The SC linked the personal injury definition with tort

principals. In holding that the statute under which the damages were

awarded did not create a tort-type claim, the damages were not excluded

under §104(a)(2) (THIS WAS REVERSED IN 2009)

Commissioner v. Schleier: The court shifted their focus to the statutory

language, emphasizing that the key question to be asked in apply 104(a)(2)

is whether the damages received were on account of (ie actually

compensated for) personal injury.

Damages are on account of personal injury only if they bear a close

nexus to the personal injury. If this relationship does not exist then

no exclusion is available.

o iv: 1996 Amendment to §104

Congress still considered 104 too broad in scope. Therefore they limited the

exclusion by restricting it to those damages received on account of physical

injuries or physical sickness.

Emotional distress was not be treated (save only for related

medical care expenses) as a physical injury or sickness. (see next

point)

Origin of claim notions: If an action has its origin in a physical injury or

physical sickness then all damages that flow therefrom are treated as

payments received on account of physical injury. Conference Committee

Report

If the claim has its origin in personal injury then a recovery for

emotional distress may be excludable.

If the claim has its origin in a physical injury it is not necessary that

the recipient of the damages is the individual who suffered the

physical injury.

Physical Injury as defined by Private Letter Ruling 200041022: “direct

unwanted or uninvited physical contact resulting in observable bodily harms

such bruises, cuts, swelling, and bleeding are personal physical injuries

under 104(a)(2).

Physical restraint from being handcuffed and searched are not

physical injuries (Stadnyk v. Commissioner).

o v: Punitive Damages

104(a)(2) exclusion doe not apply to punitive damages.

o vi: Allocation of Awards

Defendant’s will be tempted to settle cases insisting that the entire

settlement amount be allocated to physical injury rather than punitive

damages so that the money need not be reported as income. However

courts reserve the right to inquire into this allocation.

Robison v Commissioner: Jury awarded damages for personal injury as well

as $50 million in punitive damages. The P entered into a settlement

agreement for much less, in return of the defendant allocation the damages

to physical injury. The tax court made its own judgment and held that he

could exclude a portion of the settlement as damages for physical injury but

not the entire amount.

Bagley v. Commissioner: Key question in settlement is what the damages

were in lieu of.

o vii: Periodic Payments

Periodic payments are excludable under 104(a)(2).

B: Accident and Health Insurance

o 104(a)(3) payments received through accident or health insurance policies are

excluded from gross income provided the policy was not financed by the taxpayer’s

employer or by employer contributions not includable in the taxpayer’s income.

C: Previously Deducted Medical Expenses

o Section 213 permits a deduction for unreimbursed medical expenses on account of

physical injury.

o However, if these expenses are reimbursed the following year the amounts

attributable to previously deducted medical expenses are not excluded from income

104(a) and 105(b).

D: Workers’ Compensation

o 104(a)(1) excludes from income amounts received under workers’ compensation

acts as compensation for personal injuries or sickness.

Compensation for nonoccupational injury or illness does not fall under this

section even if the label of workers comp is placed on the payment

E: Certain Disability Pensions

o 104(a)(4) excludes military disability pensions.

However, this is limited by 104(b) to compensation for combat related

injuries and to those who would on application receive disability

compensation from the Veterans’ Administration.

XI: Fringe Benefits

A: What are fringe benefits

o Fringe benefits are taxable income

61(a)(1) provides that among other things, gross income includes fringe

benefits

1.61-1(a) provides that income may be realized in the form of services,

meals, accommodations, stock, or other property as well as cash.

B: Meals and Lodging

o Convenience to the employer: Meals and lodging provided to employees are

excludable if the exclusions were premised on the notion that the benefits given

were for the convenience of the employer.

Required the taxpayer to establish that the benefits were grounded in

business necessity.

Benaglia v. Commissioner:

Facts: Occupied a suite of rooms in a hotel where he was required

to be constantly on duty. He did not report the lodging as income.

Held: This was for the purpose of benefitting the employer so it was

properly excludable from income. Being on the property at all time

was necessary for his job.

§119(b) clarified that the service must be for the convenience of the

employer and that the taxpayer need not be an employee by contract.

Regulation 1.119-1(b)(3) provides that condition of employment means that

the employee be required to accept the lodging in order to enable him

properly to perform the duties of his employment

Employees spouse and dependents are also excluded under 119(a)

When the employee needs to be available at all time: Caratan v.

Commissioner: P failed to establish that he was required to accept the

lodging as a condition of employment and there was available lodging ten

minutes away. However, the appeals court reversed, relying on 1.119-1(b)

(3), holding that it was enough that the taxpayer established that he was

required to be available for duty at all time. It was not necessary to show

that the duties would be impossible to perform without such lodging.

Commissioner v. Kowalski: Case payments were made to state police

troopers as meal allowances. Court held that these payments were not

excludable. Occasional supper money is excludable as a de minimis fringe

benefit, however it would not be applicable to meal allowances provided to

the state troopers because they were regularly paid and could not be

considered occasional.

C: Fringe Benefits and §132

o i: §132

132 lists seven categories of excludable fringe benefits

1) no-additional cost service

2) qualified employee discount

3) working condition fringe benefit

4) de minimis fringe

5) qualified transportation fringe

6) qualified moving expenses

7) qualified retirement planning services

o i: No-Additional-Cost Service

Companies engage in airline, railroad or hotel businesses often have excess

capacity which will remain unused for lack of paying customers. Such

business will commonly make this excess capacity available to employees

and their families free of charge. Because there is no cost to the employer

this can be excluded from income subject to some restrictions:

1) the service must be one offered for sale to customers in the

ordinary course of business 132(b)(1)

2) The service must be offered in the line of business of the

employer in which the employee is performing services.

3) The employer cannot incur substantial additional cost including

foregone revenue 132(b)(2)

1.132-2(a)(5): for purposes of determining whether any

revenue is forgone it is assumed that the employee would

not have purchased the service unless it were available to

the employee for the price which they accepted it

4) Prohibits discrimination in favor of highly compensated

employees. 132(j)(1)

132(i) allowes for reciprocal agreements between employers in the same

line of business, thus enabling the employers to provide tax free benefit to

one another’s employees.

Exclusion is limited to services provided to employees

employees is defined by section 132(h) as one’s spouse and

dependents as well as certain retired and disabled employees and

the surviving spouse of a deceased employee.

Charley v. Commissioner: D excluded income amounts he received for

frequent flyer miles which he converted to cash. The court held tat the

company did not offer frequent flyer miles for sale to customers in the

ordinary course of business and therefore constituted gross income.

o ii: Qualified Employee Discount

Businesses provide discounts to their employees on the same goods as

services they sell to the general public. These employee discounts are not

taxable.

132(c) however provides some limitation. The exclusion for employee

discounts on services is limited to 20% of the price at which the services are

being charged to customers. The exclusion for discounts on property is

limited to the employer’s gross profit percentage, which is the excess of the

aggregate sales price for the property to the employer over the aggregate

cost of such property to the employer, divided by the aggregate sales price.

132(c)(4) defines qualified property or service as the same for sale to

customers in the employees line of business. Does not apply to stocks,

bonds, gold coins, or residential and commercial real estate.

o iii: Working Condition Fringe Benefits

When employers provide employees with tools connected to job

performance (office space, supplies, etc) to facilitate the employees work

they should not be considered compensation and are excludable as working

condition fringe under 132(a)(3).

Cash payments do not qualify unless the employee is required to use the

payments for expenses incurred in a specific or pre-arranged qualifying

activity, verify such use, and return any excess to the employer. 1.132-5(a)

(1)(v)

If an employer derives a substantial business benefit from the provision of

such outplacement services, such as promoting positive corporate image,

maintaining employee morale, etc, the service may generally be treated as

working condition fringe.

Townsend Industries v. US : Employees attended an annual fishing trip held

and paid for by the employer. Although the trips were voluntary nearly all

employees felt an obligation to attend, considerable business discussions

took place on these trips, and the company had reason to expect future

benefits from these trips. Therefore the taxpayers were able to exclude the

cost of the trip as a working condition fringe.

o iv: De Minimis Fringe Benefits

Frequency is key to determining whether something is a de minimis fringe

benefit

Does not require an employer-employee relationship

Special rules exclude meals and occasional meal money received and the

value of meals provided in an employer-operated eating facility 1.132-6(d)

(2)

Denied to cash or cash equivalent other than those allowed by special rules.

o v: Qualified Transportation Fringe Benefits

Qualified transportation benefits include parking, transit passes, vanpool

benefits and bicycle commuting reimbursement benefits.

Section 132(a)(5) excludes these benefits. Cash reimbursement for these

items is also excludable.

D: Valuation

o Fringe benefits which are not exclude are subject to tax. The measure of the taxable

income is the fair market value of the fringe benefit less any, less any excludable

portion of the fringe benefit an any amount paid by the recipient 1.61-21(b)(1)

XII: Business and Profit Seeking Expenses (Deductions for ordinary personal living and family expense

not allowed 262)

A: Business Deductions §162

o The Business deductions of 162 and the profit seeking deductions of 212 reflect the

principal that “net income” rather than gross income, should be subject to tax and

that expenses necessary to the earning of items of gross income ought to be

allowed as deductions.

o Regulation 1.61-3(a): interprets the language of 61(a)(2) to mean “gross income

derived from business” to mean “total sales, less the cost of goods sold.”

o 162(a) establishes a number of requirements for the deductions

1) the cost must be an expense

2) the expense must be ordinary

3) it must be necessary

4) it must be paid or incurred during the taxable year

5) it must be paid or incurred in carrying on a trade or business

o i: Ordinary and Necessary

a: Ordinary

Ordinary means customary or expected in the life of a business

(Welch)

Must be distinguished from capital expenditures such as goodwill

Welch v. Helvering: A grain commission agent, Welch repaid debts

of the bankrupt corporation he used to work for to reestablish

relations with his customers. The commissioner disallowed

deductions claiming they were capital expenditures for reputation

and goodwill.

Court ruled that in order to be deductible an expense must

be ordinary and necessary and that ordinary means

accepted practice in a given segment of the business world.

Conway Twitty paid back people who invested in his Twitty burger

business and claimed that he paid them back in order to protect his

personal business reputation so the court deemed that the

payments were excludable.

Deputy v. Dupont: Ordinary means that the transaction which gives

rise to the expense must be of common or frequent occurrence in

the type of business involved.

Dancer v. Commissioner: Court allowed a deduction for costs a

taxpayer occurred in settling a negligence action arising from an

automobile accident which occurred while he was traveling on

business, because automobile travel was an integral part of his

business.

However, did not allow exclusion for damages incurred

when an artist had an outburst on a plane and had to settle

for damages because that was not general conduct that

artists engage in (Gillian)

b: Necessary

In the Welch case, the court interpreted the term “necessary” to

mean appropriate and helpful and indicated that it would be slow to

override the judgment of a business person regarding the necessity

of any costs incurred.

Henry v Commissioner: Taxpayer bought a yacht on which he flew a

flag with 1040 on it (he was a tax lawyer) he claimed use of his yacht

promoted his business. Tax court held this was not necessary for his

trade or business.

Courts have held that proof that the activity is the main and

exclusive way of procuring clients is helpful in establishing if it is

necessary (Topping)

An unreasonably large salary is not an ordinary and necessary

expense of a business.

162(a)(1) provides that only reasonable salaries may be

deducted.

The court has come up with a number of factors that are

relevant to determining whether the compensation at issue

was reasonable and attributable to the taxpayer’s

employment or it’s role as shareholder (ie would he have

paid a normal employee what he was getting paid?)

o 1) employee’s role in the company (hours, duties,

importance, etc)

o 2) Comparison of the employee’s salary to salaries

paid by similar companies for similar services

o 3) the size and complexity of the company and

general economic conditions

o 4) the existence of relationship between company

and employee which would permit nondeductible

corporate dividends to be disguised as deductible

compensation.

o 5) whether the compensation at issue stems from a

compensation program that itself is reasonable,

longstanding, and consistently applied.

These factors are part of the independent investor test:

whether an inactive, independent investor, would be willing

to compensate the employee as he was being

compensated. (Elliotts Inc, v. Commissioner)

1.162-7(b)(3) provides that reasonable compensation is only

such amount as would ordinarily be paid for like services by

like enterprises under like circumstances.

o Exacto Spring Corporation (243):

o Menard v. Commissioner (244-245):

In some circumstances the business related nature of the taxpayer’s

clothing may warrant a deduction.

Pevsner v. Commissioner: P contended that because the

clothing she was required to purchase and wear in her

employment was not consistent with her personal lifestyle

she could deduct their cost as a business expense. The court

held that clothing cost is deductible as a business expense

only if the clothing is specifically required as a condition of

employment, it is not adaptable to general usage as

ordinary clothing, and it is not worn as ordinary clothing. In

this case, P’s clothing were adaptable to ordinary use, she

simply chose not to wear them as such, but the

determination is an objective standard not subjective.

Costs cannot be considered necessary if allowance of the deduction

would frustrate sharply defined national or state policies prohibiting

particular types of conduct. (ie allowing a truck company to deduct

a fine or violating state maximum weight laws)

162(e) disallows deducted for amounts paid to influence legislation

or an office (ie bribes)

o ii: Carrying On a Trade or Business

A: What is a trade or business

The court to Groetzinger state that “we accept the fact that to be

engaged in a trade or business, the taxpayer must be involved in the

activity with continuity and regularity and the taxpayer’s primary

purpose for engaging in the activity must be for income or profit. A

sporadic activity, a hobby, or an amusement diversion does not

qualify.

Commissioner v. Groetzinger: G attempted to earn a living

solely through wagering on dog races, but he suffered a net

loss for the for the year and declared no gross winning from

gambling. Court found that determining what consisutes a

trade or business is predominantly a case-by-case factual

endeavor, an activity pursued with a full-time, good faith

intention to produce income will usually qualify as a trade

or business. Court held that P was engage in a diligent,

regular, full-time effort to earn an income through

wagering-it was an attempt to earn a livelihood, not just a

hobby, so he shouldn’t have to file the tax preference for

gambling losses because this is a business not a hobby.

Reg 1.183-2(a) lists the following factors for determining whether

an activity is engaged in for profit: 1) the manner in which the

taxpayer carries on the trade or business 2) the expertise of the

taxpayer or his or her advisers 3) the time and effort expended by

the taxpayer in carrying on the activity 4) the expectation that

assets used in the activity may appreciate in value 5) the success of

the taxpayer in carrying on other similar or dissimilar activities 6)

the taxpayer’s history of income or losses with respect to the

activity 7) the amount of occasional profits, if any, which are earned

8) the financial status of the taxpayer 9) elements of personal

pleasure ore recreation

Trader v. investor: a trader is considered to be engaged in a trade or

business, while an investor is not.

Higgins v. Commissioner: Higgins, who employed individuals

and incurred substantial expenses incident to managing his

properties and investments, sought a business deduction

for salaries and expense. Salaries and other expenses

incurred in the management of personal assets are not

deductible business expenses. Management of personal

finances does not fall into the category of carrying on a

business, even if done with substantial investment of time.

However, not under 212 investor expenses would be

deductible as costs related to the production of income.

B: The Carrying on Requirement

The investigatory stage In which a person may review various kinds

of business before decided to enter into a specific business DOES

NOT COUNT. (Frank v. Commissioner: Searching for a newspaper

business).

Preparing for a business/pre-operating costs are also not deductible

because the taxpayer has not actually begun to be engaged in

carrying on a trade or business. (Richmond Television)

Such costs incurred in investigating a business, training personnel,

lining up distributors, suppliers, etc, provide benefits long beyond

the current tax year and should not be deducted.

o iii: Section 195 and the Amortization of Certain Pre-Operational or Start Up Costs

In 1979 Congress added §195 to the Code authorizing amortization of start

up expenses.

To qualify for amortization under §195, the expenditure must be paid or

incurred in connection with creating or investigating the creation or

acquisition of a trade or business entered into by the taxpayer. Second, the

expenditure involved must be one which would be allowed as a deduction

for the taxable year in which it is paid or incurred if it were paid or incurred

in connection with the expansion of an existing trade or field as that entered

into by the taxpayer.

In 2003 the legislation was changed to allow a taxpayer to deduct $5,000 of

start up expenditures in the taxable year in which the active trade or

business begins. However, the 5k amount if reduced by the amount the

start-up costs exceed 50k.

If the costs are 5k or less they are fully deductible, if the costs are

between 5k and 50k the deduction is 5k and the remainder is

amortized over 180 months, if the start up costs are above 50k and

between 55k the amount is reduced by how much it exceed 50k (ie

at 55k there is no deduction) and the amount is amortized over the

180.

o iv: Application of the “carrying on” requirement to employees

Taxpayers may be in the trade or business of “being an employee”

If expenses were incurred by an employee in finding work in the same trade

or business, the “carrying on” requirement would be satisfied and the costs

(resume costs, postage, etc) would be deductible. However, if the employee

is seeking employment in a new trade or commencing a new trade, the

carrying on requirement would not be satisfied and the expenses will be

treated as capital expenditures.

Revenue Ruling 75-120: Expenses incurred in seeking new employment in

the employee’s present trade or business are deductible under 162 even if

new employment is not secured. However, such expenses are not

deductible if an individual is seeking new employment in a new trade or

business even if employment is secured.

While it is possible for an employee to retain, at least temporarily, his status

of carrying on a business, it holds true that a prolonged period of

unemployment will terminate one’s status as being engaged in a trade or

business.

Furner v. Commissioner (252):

B: Section 212 Deductions

o Section 212 allows a deduction for the “ordinary and necessary” expenses of

producing or collecting income, maintaining property held for the production of

income, or determining, collecting, or refunding any tax. (investors would be able to

deduct their expenses under 212)

allows the deduction of expenses incurred in the production or collection of

income or in the management, conservation, or maintenance of property

held for the production of income. However, traveling to start an income

does not fall under this because they were trying to start a business which

might in the future produce income.

XIII: Capital Expenditures

A: Deductible Expense or Capital Expenditure?

o §263 denies deductions for the cost of capital expenditures.

denies deductions for new buildings or for permanent improvements or

betterments increasing the value of property and for restoration costs for

which an allowance is made.

The regulations add that the disallowance applies to expenditures that add

to value or substantially prolong the useful life of property or adapt

property to new an different use but not to incidental repairs or

maintenance. (1.263(a)-2(a))

o A capital expenditure provides a benefit that persists, that continues generating

income over a period of year,

B: Defining Capital Expenditure – INDOPCO

o INDOPCO v. Commissioner: The third court held that consulting and legal fees

related to takeover are capital expenditures because they provide longterm benefit.

SC affirmed, P failed its burden of establishing that the expenses were ordinary and

necessary within the meaning of 162(a), rather the facts demonstrated that the

transactions produced significant benefits that stretched beyond the year in

questions.

o Lincoln Savings and Loan: Established a new test, the “separate and distinct asset”

test for determining whether expenditures had to be capitalized. In Lincoln the

court required the taxpayer to capitalize the additional premium (paid to insure

their deposits) because the additional premium created a “separate and distinct

asset”. The creation of a separate and distinct asset may well be a sufficient but not

a necessary condition to classification as a capital expenditure.

o US Freightways Corp v. Commissioner: Purchased a permit in year one and

continued to use it into year 2 but deducted it on it’s tax returns in year one as a

business expense. Court held that the expense should have been deducted ratably

over year 1 and 2. No matter what other characteristics an expenditure has, if it is

made in one tax year and its useful life extends substantially beyond the close of

that year then it must be capitalized.

C: Selected Categories of Capital Expenditures

o i: Cost of Acquisition and Costs Incurred in Perfecting and Defending Title

Acquisition costs constitute capital expenditures (ie: buildings, machines,

vehicles, or such intangible property as a copyright, patent or interest in a

corporation or partnership. The asset produces a continuing, long term

benefit and its cost must be capitalized which means that the taxpayer will

take a basis in the asset equal to the cost.

ex: If the taxpayer pays $500,00 for a building to be used in the

taxpayer’s business, the building cost must be capitalized and

become the taxpayer’s initial basis in the building. Other costs

associated with acquiring the building (brokerage fees etc) would

also be capitalized as part of the cost of the building and would be

factored into the building’s basis. If two years later the taxpayer

spent $300,000 to repair the building it would also be capitalized

and would result in an upward adjustment of the basis under

1016(a)(1)

PROPOSED Regulations require capitalization of amounts paid to

acquire or produce a unit of real or personal property, including the

purchase or invoice price, transaction costs, and cost for work

performed prior to the date the unit of property is placed in service.

1.263-(a)-2(d)(1)(i)

Transaction costs are costs paid to facilitate acquisition of

real or personal property and include among other items

amounts paid for 1) negotiating the terms or structure of

the acquisition 2) preparing and reviewing the documents

that effectuate the acquisition (ie preparing the bid, offer,

sales contract or purchase agreement 3) conveying property

between the parties, including sale and transfer taxes and

title registration costs and 4) broker’s commissions

Proposed Regs 1.263-(a)-2(d)(1), 3(i), (ii)(A), (B)

Woodward v. Commissioner: The issue was the deductibility of

appraisal and litigation costs the taxpayers incurred in determining

the price of stock they were required to purchase. The relevant

question is not whether the purpose of the litigation was to acquire

stock but whether the origin of the claim litigated was in the

acquisition of stock, if so then it was a capital expenditure.

Costs incurred in defending or protecting title are capital

expenditures and cannot be deducted (Georator Corp v. US)

However, if the dispute doesn’t relate to title, but rather

income from title (ie additional royalty payments) the cost

related to litigation can be deducted. (Southland Royalty Co.

v. US)

The cost of disposing of an asset may also in a sense be regarded as

part of its acquisition. (Woodward)

However, if it is simply retired and discarded then it is

deductible. (ex: old telephone poles taken out, new ones

put in, cost of removal is deductible because it’s allocated

to old poles (Rev. Ruling 2000-7)

Stegar v. Commissioner: Taxpayer, upon retirement from law

practice, purchased a non-practicing malpractice insurance policy,

the purpose of which was to provide insurance coverage for an

indefinite period of time for any malpractice the taxpayer may have

committed prior to the retirement. Rule: if a taxpayer incurs a

business expense but is unable to deduct it as a current expense or

through yearly depreciation deductions, the taxpayer is allowed to

deduct the expense for the year in which the business ceases to

operate.

Commissioner v. Idaho Power Co: Idaho Power Co attempted to

completely deduct the amount of depreciation attributable to

construction equipment for the year, even though the equipment

was partially used for that year to make additions and

improvements to capital facilities.

Held: The part of the equipment that was used in

constructing capital improvements must be capitalized over

the useful life of the asset constructed.

§263A requires capitalization of direct and indirect costs, including

certain interest costs, incurred by taxpayers who manufacture,

construct, or produce real or tangible personal property or who

acquire or hold inventory property for resale.

o ii: Repair or Improvement

a: Old Rules

1.162-4 and 1,263(a)-1(b) provide that expenditures for repairs or

maintenance, which do not materially add value or appreciably

prolong useful life are deductible; replacements or improvements,

on the contrary are not and must be capitalized.

Midland Empire Packing Co v. Commissioner: Midland Empire

Packing oil-proofed its basement to protect against oil seepage from

a nearby refinery. A structural change that does not increase the

useful life or use of a building and that is the normal method of

dealing with a given problem, is a repair for tax purposes. Held that

the oil-proofing was merely to keep the property in an operating

condition and thus was a deductible expense. The repair must be

“ordinary” but not habitual, merely the common means of

combating a given problem.

Mt. Morris Drive-In Theatre v. Commissioner: P cleared land to build

a drive in theatre, it was evident by the way in which the land was

cleared that there would be a drainage problem. So P build a

drainage system under threat of litigation from his neighbor.

Because this problem was foreseeable when construction began,

the cost of the constructing the drainage system was really part of

the process of completing the initial investment in the land for its

intended use, so it was a capital expenditure.

United States v. Wehrli: Taxpayer sought to deduct as repairs the

costs involved in preparing the building for a new tenant. The court

established what was called the one-year rule of thumb under

which an expenditure could be capitalized if it brings about the

acquisition of an asset having a period of useful life in excess of one

year, or if it secures a like advantage to the taxpayer which has a life

of more than one year. However, we think this to be more of a

guidepost. Expenses such as replacement of a broken window, a

damaged lock, or a door, or even a periodic repainting of the entire

structure may be treated as a deductible even though the benefits

extend beyond one year.

General Plan: Expenditures made for an item which is part of a

general plan of rehabilitation, modernization, and improvement of

the property, must be capitalized, even though standing alone the

item may appropriately be classified as one of repair. (Wehrli)

Revenue Ruling 2001-4: The taxpayer, an owner of a commercial

airline was required by the FAA to make and stick to a continuous

maintenance program. This included a heavy maintenance visit

every 8 years. Are costs incurred by this visit deductible as ordinary

and necessary business expenses under 161 or must they be

capitalized under 263? Costs incurred by a taxpayer to perform

work on its aircraft airframe as part of a heavy maintenance visit

generally are deductible as ordinary and necessary business

expenses under 162, however, costs incurred in conjunction with a

heavy maintenance visit must be capitalized to the extent they

materially add to the value of, substantially prolong the useful life

of, or adapt the airframe to a new or different use. In addition costs

incurred as part of a plan of rehabilitation, modernization, or

improvement must be capitalized.

Illinois Merchant Trust: Repair and maintenance expenses are

incurred for the purpose of keeping the property in an ordinarily

efficient operating condition over its probable life for the uses for

which the property was acquired. Capital expenditures are for

replacement, alterations or additions that prolong the life of the

property, materially increase its value or make it adaptable to a

different use.

Plainfield Union: Court stated that if the expenditure merely

restores the property to the state it was in before the situation

prompting the expenditure arose and does not make the property

more useful, valuable or longer lived, then it is deductible.

b: Proposed Regulations: Improvements and Repairs

The existing regulations focus on whether expenditures materially

increase the value of property, the PROPOSED regulations steer

clear of focusing of value in addressing amounts paid to improve

tangible property. The PR provide general rules for determining the

appropriate unit of property to which the improvement regulations

apply and require capitalization of amounts paid to bring about a

betterment to a unit of property, to restore a unit of property, or to

adapt a unit of property to a new or different use (PR 1.263(a)-3(d)

(1) and (2))

One must FIRST identify the unit of property that will be the focus of

the repair/improvement analysis.

The unit of property determination will be made using a

functional interdependence standard. All components that

are functionally interdependent comprise a single unit of

property. Components of property are functionally

interdependent if the placing in service of one component is

dependent on the placing in service of the other component

by the taxpayer. (PR 1.263(a)-3(d)(2)(iii))

Betterment: An amount paid results in a betterment of property if:

1) it ameliorates a material condition or defect that existed prior to

the taxpayer’s acquisition of the unit of property 2) results in a

material addition to the unit of property 3) results in a material

increase in capacity, productivity, efficiency, strength or quality of

the unit of property. PR 1.263(a)-3(f) (and see examples)

Restoration: Identifies a range of situations in which am amount will

be treated as restoring a unit of property:

1) if it returns the unit of property to its ordinarily efficient

operating condition after the property has deteriorated to a

state of disrepair and is no longer functional for its intended

use. 2) if it results in the rebuilding of the unit of property to

a like-new condition after the end of the economic useful

life of the property. 3) if it is for the replacement of a major

component or a substantial structural part of the unit of

property. PR 1.263(a)-3(g)(1)

Percentage SAFE HARBOUR: replacement of a major

component or substantial structural part means the

replacement of a) a part of the unit of property, the cost of

which comprises 50% or more of the replacement cost of

the unit b) a part of the unit of property that comprises 50%

or more of the physical structure of the unit of property PR

1.263-(a)-3(g)(3)(i)

New or different use: Amount paid will be treated as being paid to

adapt a unit of property to a new or different use if the adaptation

is not consistent with the taxpayer’s intended ordinary use of the

unit of property at the time originally placed in service by the

taxpayer. ( PR 1.263-(a)-3(h)(1)).

Routine maintenance SAFE HARBOUR: An amount will not be

deemed to improve the unit of property if it Is merely routine

maintenance. (ie: the inspection, cleaning, and testing the unit of

property, and the replacement of part of the unit of property with

comparable and commercially available and reasonable

replacement parts. PR 1.263(a)-3(e)

Employee training costs are deductible (unless it provides a benefit

significantly beyond those traditionally associated with training in

the ordinary course of business)

o iii: Intangible Assets

Amounts paid to acquire or create an intangible not otherwise required to

be capitalized by the regulations is not required to be capitalized on the

ground that it produces significant future benefits for the taxpayer, unless

the IRS publishes guidance requiring capitalization of the expenditure.

The general rule of regulations requires the capitalization of amounts paid

to acquire or create an intangible, to facilitate the acquisition or creation of

an intangible, or to create or enhances a separate and distinct asset (reg

1.263(a)-4(b)(1).

ACQUIRED INTANGIBLES include: ownership interests in corporations,

partnerships or other entities, debt instruments, options to provide or

acquire property, leases, patents or copyrights and franchise or trademarks.

1.263-(a)-4(c)(1). Cost of acquiring these must be capitalized.

CREATED INTANGIBLES: Financial interests (ownership interest in

corporations, partnerships, or other entities, debt instruments, and options

to provide or acquire property), prepaid expenses, certain membership fees,

amounts paid to create or terminate certain contracts for property or

services, and amounts paid to defend title to intangible property. 1.263-(a)-

4(d)(2). Cost of creating these intangibles must be capitalized.

The regulations also provide for capitalizing amounts paid to facilitate the

acquisition or creation of an intangible. The rule of regulations is that an

amount facilitates a transaction and thus must be capitalized, if the amount

is paid in the process of investigating or otherwise pursuing the transaction.

1.263(a)-4(e)(1)(i)

“12 month rule”: capitalization is not required for amount paid for a right or

benefit that does not extend beyond the earlier of (1) 12 months from first

realizing the right or benefit or 2) the end of the tax year following the year

of payment.

Amounts paid to facilitate the acquisition of a trade or business or to change

the business’ capital structure must also be capitalized. 1.263(a)-5(a)

o iv: Expansion Costs

Briarcliff Candy Corp v. Commissioner: Cost’s in establishing a “franchise”

division to promote sales in new retail outlets were held to be deductible.

Organizational changes which the taxpayer had made in that case in order

to spread its sales into a new territory were not comparable to the

acquisition of a new additional branch or division to make and sell a new

and different product.

Colorado Springs Bank v US: The issue was whether costs incurred by a bank

in creating credit card services for customers was currently deductible or

had to be capitalized. The court held that the bank had no property interest

in the credit card procedures, so the costs incurred in establishing the credit

card operation were deductible.

Downsizing (ex: severance payments) does not need to be capitalized. It

relates to previous services of employees rather than creating future

benefits.

o v: Advertising Costs

Advertising is generally treated as being deductible under 162 even though

advertising may have some future effects on the business.

RJR Nabisco v. Commissioner: Tax court held that expenditures for ordinary

business advertising are ordinary business expenses if the taxpayer can

show a significant connection between the expenditure and the taxpayer’s

business. However, expenditures for billboards, signs and other tangible

assets associated with advertising remain subject to the usual rules

regarding capitalization.

D: Purchase or Lease

o i: 162(a)(3) specifically authorizes the deduction of rental payments with respect to

property used in a trade or business, but only if the taxpayer does not take title and

has no equity in the property.

o Estate of Starr v. Commissioner: “lease” of a custom-made automatic sprinkler

system installed in a building was in fact a sales arrangement. No way they would

come back to reclaim the system, and no property owner would agree to this

XIV: Depreciation

A: Depreciation: Depreciation is an accounting device which recognizes that the physical

consumption of a capital asset is a true cost, since the asset is being depleted. As the

process of consumption continues and depreciation is claimed and allowed, the asset’s

adjusted income tax basis is reduced to reflect the distribution of its cost over the

accounting periods affected.

o i: Depreciable Property

§167 defines depreciation as a reasonable allowance for the exhaustion,

wear and tear (including a reasonable allowance for obsolescence)- 1) the

property used in the trade or business or 2) of property held for the

production of income.

Trade, business, and investment limitation applies, one may not depreciate

a personal residence.

Depreciable items must be subject to wear and tear, decay or decline from

natural causes. Land, stock (1.177(a)-3), and other assets that do not decline

in value are not depreciable.

o ii: Recovery Period- The Useful Life Concept

A direct correlation exists between the useful life of an asset and the size of

the annual depreciation deduction.

Congress in 1971 enacted §167(m) authorized the treasury to create an

Asset Depreciation Range providing an industry wide set of useful lives for

classes of assets. This system did not provide useful lives for real property

which continued to be governed by earlier guidelines providing useful lives

ranging from 40 years for apartment buildings to 60 years for warehouses.

in 1981 the ACRS (accelerated Cost Recovery System, significantly de-

emphasized the useful life concept by assigning all tangible property to one

of five recovery period based on assets class life.

Most real property was classified as 15 year property.

Most tangible property was classified as 3 year property or 5 year

property.

1986 Modified Accelerated Cost Recovery System (MARCS)

Non-residential rental property is depreciated over 39

years.

Residential real property over 27,5 years

Other property must be classified within one of six recovery

periods- 3, 5, 7, 10, 15, 20

168(e)(1) defined each of these classes by reference to the

class life of assets.

168(e)(3)(B)(i) provides that 5 year property includes among

other things, automobiles or light general purpose trucks,

computers, copying equipment, and heavy general purpose

trucks.

The 7 year property class is now the catchall class and

includes personal property such as office furniture, fixtures,

and equipment.

Historically, only assets with a determinable useful life were

depreciable.

Revenue Ruling 68-232: Valuable piece of art was not

considered depreciable property because it did not have a

determinable useful life.

Simon v. Commissioner: P, a professional violinist claimed

depreciation on two 19th century violin bows use in their

trade or business. The court reasoned that the availability of

a deduction for depreciation on tangible personal property

depends on whether the asset falls within the meaning of

“recovery property.” Property is “recovery property” under

the ERTA of 1981 if it is (1) tangible and (2) placed in service

after 1980 (3) of a character subject to the allowance for

depreciation and (4) used in the trade or business, or held

for the production of income. The court held that 1,2, and 3

are met because the bows are subject to exhaustion, wear

and tear and old age. 4 is met.

o Liddle v. Commissioner: P sought a depreciation

deduction under ACRS on a 17th century viol. Same

analysis as above

o iii: Depreciation Methods

There are two categories of depreciation methods.

1) Straight Line Depreciation Method

Under this method you divide the cost of the asset by the

number of years in the recovery period to determine the

depreciation allowance for the given year.

o ex: $275,000 asset, useful life of 27.5 years.

$275,000/27.5 =$10,000 each year (to find what

rate this is you would then take

$10,000/275000-.036, so you are deducting at a

rate of 3.6% each year)

Reg §1.176(b)-1: Under the straight line method the cost or

basis of the property less its estimated salvage value is

deductible in equal annual amounts over the period of the

useful life of the property.

Code §168(b)(4): Provides that the salvage value is treated

as zero, this allowing the taxpayer to recover the entire cost

of property during the recovery period.

2) Accelerated Depreciation Methods

Declining Balance Method: Under the declining balance

method a uniform rate is applied each year to the

unrecovered cost or other basis of the property. (1.167(b)-

2(a). Most common declining balance methods are the so-

called double or 200% method and the 150% declining

method.

ex: (double) $30,000 asset with a useful life

of 5 years, the straight line deduction would

be 20% ($30,000/5=6000/30,000= 20%), so

using the double deduction method the

taxpayer can deduct 40% each year from

the unrecovered cost:

Year 1: Can deduct $12,000

(.4X30,000)

Year 2: Can deduct $7,200 (30,000-

12,000= 18,000 unrecovered cost,

x .4)

Year 3: $4, 320 ( $18,000-7, 200=

10, 800 x .4)

Year 4= 2592 ( 10,800-4, 320= 6480

x.4)

Year 5= 1555 (6480-2592=3888x.4)

168(b)(1) provides that, with respect to the 3,5, and 7 year property the

200% declining balance method should be used, but the taxpayer shall

switch to the straight line method in the year that method, if applied to the

adjusted basis at the beginning of such year would produce a large

deduction.

§168(b)(3) requires taxpayer to use STRAIGHT LINE METHOD FOR

RESIDENTIAL RENTAL PROPERTY AND NONRESIDENTIAL REAL PROPERTY.

The acceleration method may be used with respect to real property and will

lengthen period over which the deductions occur.

o iv: Conventions (When can property begin to be deducted)

Recovery period during which depreciation may be claimed begins when the

property is placed in service.

(1.46-3(d)(1)(ii) defines placed in service to mean placed in a condition or

state of readiness.

according to 168(d)(2)(4)(B), residential rental property and nonresidential

real property placed into service during any month, are deemed to be

placed in service on the mid-point of such month

No depreciation deduction is allowed for property placed in service and

disposed of during the same taxable year (1.168(d)-1(b)(3)(ii)

All other classes of property are generally subject to a half-year convention,

meaning that any property placed in service, during the tax year is deemed

placed in service on the mid-point of the tax year 1.168(d)-1(b)(3)(ii)

Intangible property follows the 167 depreciation rules unless the fall under

197.

Computer software is depreciable over a 36 month period 167(f)(1)

B: Computing the Depreciation Deduction

o i: 168(a) provides the depreciation deduction shall be determined by using the (1)

applicable depreciation method (2) the applicable recovery period and (3) the

applicable convention.

Start with the adjusted basis of the property which will usually be the cost

1.167(g)-(1)

Then find the appropriate recovery period under 168

Find if the half year or half month convention applies.

If the half year applies, then for the first year of deduction you are

only going to deduct half of the percentage you would otherwise

deduct for a full year. (ie: if the 200% was 40% and you start in a

half year, then you deduct 20% the first time)

Look at table 87-57 for deduction percentages

Qualified Property: Because of the economy crisis, congress added 168(k) in

2008 which permits an additional first-year depreciation deduction equal to

50% of the adjusted basis of qualified property. This is taken first and then

the additional deduction provisions also apply in the first year and in

subsequent years. Ex. If $1000 5 year property. Year 1 you get $500

deduction under 168(k) (1,000-500) and another $100 ($500 x .2=100)

deduction for a total first year of $600.

To qualify for additional first year depreciation, property must meet

all of the following requirements:

Property to which the MACRS applies with an applicable

recovery period of 20 years or less

Original use of property must commence with the TP after

12/31/07

TP must purchase property within applicable time period.

C: Amortization of Intangibles

o i: 1993 Congress added 197 which allows TP’s to amortize certain intangibles ratably

over a 15-year period. Negates the concern over whether intangibles have a useful

life.

D: Relationship Between Basis and Depreciation

o Depreciation is the means whereby a taxpayer recovers the cost of property used in

a trade or business or investment activity because he was required to capitalize it

rather than currently deduct/expense it. Taxpayer recovers basis through

depreciation deductions, thus, Adjusted basis thus reflects the unrecovered cost of

property.

o TP must reduce basis in depreciable asset by depreciation claimed but not less than

the amount allowable.

Means you can’t choose when deprecation will be deducted, even if TP fails

to claim an allowable depreciation deduction with respect to an asset, must

still reduce basis by allowable depreciation amount.

ex: Buys building for $200,000, uses it for business for ten years,

sells it for 150,000. During the then years owned, the depreciation

was 75,000. Adjusted basis in the house is 200,000-75,000=

125,000. Her gain realized on the sale of the house therefore would

be 25,000.

E: Section 179- Expensing Tangible Personal Property

o i: 179 is an exception that permits a taxpayer to currently expense what would

otherwise be capitalized property subject to depreciation.

This elective provision applies only to 179 property—tangible personal

property acquired by purchase for use in the active conduct of a trade or

business.

o 179(b)(1) limits the amount that can be expensed to $250k for years beginning after

2007 and before 2011. In 2011 it is to change to $25k.

o 179(b)(5) has a special rule for SUV’s, the current expense cannot exceed $25k.

o The $250k deductible amount is reduced dollar for dollar by the amount the

cumulative 179 property placed in service during the taxable year exceeds $800k.

(Will be reduced to $200k in 2011).—suggests that this section was intended as a

break for small business.

o 179(b)(3) limits the deduction to the amount of income from the TP’s trade or

business during the year

o But TP may carryover the amount of any deduction which would otherwise be

allowable. 179(b)(3)(A)

o Adjustment must be made to basis in property to the extent of the expense taken

1.179-1(f)

o This deduction is take before computing the depreciation deduction, thus the

reduced basis is used for application of the relevant percentage

o If there are multiple pieces of equipment, the TP may divide the $250k in any

proportion she wishes between the pieces of equipment.

F: The Relationship of Debt to Depreciation

o 179 is applicable regardless of whether the taxpayer used her own funds or

borrowed funds to purchase the property.

o Benefits to TP because he has not yet incurred any expense but is still permitted to

take depreciation deduction.

XV: Losses and Bad Debts

A: Losses

o i: The Business or Profit Requirement for Individuals

165(a) authorizes a deduction for any uncompensated loss sustained

However the loss MUST be for trade or business losses, losses in

profit-seeking transactions and casualty or theft losses. (165(c)(1)

and (2)). Does it qualify as a trade or business for §162.

Under the regulations, personal property may be converted into income-

producing property so as to qualify for a 165(c)(2) deduction on disposition.

Cowles v. Commissioner: P listed their personal residence for sale or

rent and then claimed a loss on the eventual sale as a tax deduction.

Holding/Rule: Mere offers to rent or sell a personal

residence to not provide the necessary foundation for the

deduction of a loss under 165(c)(2)

If a taxpayer believes that the value of property may appreciate and decides

to hold it for some period in order to realize upon such anticipated

appreciation, as well as any excess over his investment, it can be said that

the property is being held for the production of income.

Taxpayers primary purpose will be controlling

If property is used partly for personal and partly for profit purposes,

allocation of a loss for the profit part is permissible.

Ex: If a residence is converted to profit purpose, the period of

personal use in non-deductible.

A loss in excess of the basis is not permitted. Basis is, for loss purposes, is

limited to the lesser of the FMV OR basis at the time of conversion for

adjusted item (1.167-g(1))

ex: FMV at time of conversion of car from personal is business use is

$15k. (loss cannot exceed 15k) Taxpayer initially paid $30k for car.

Depreciation deductions calculated with references to $15k. If

$5,400 in depreciation, Taxpayer’s adjusted basis is $9,600 (15-5.4).

If the taxpayer sells the car for anything less than $9.6k he will be

entitled to a loss. For purposes of gain, you don’t apply the “lesser

of” rule. The taxpayer’s adjusted basis is $24.6k (30-5.4). Thus for a

sale price between $9.6 and $24.6 neither gain or loss will be

realized.

Devisee: Uses property as solely personal, transfers it upon death and

devisee immediately sells it without ever having made personal use of it and

sustains a loss. Courts have allowed a deduction under these circumstances

holding that the tax status of the property became neutral at the moment

of death and the use the devisee made of it determined it’s status. If sells

immediately then it was for profit and loss can be sustained.

o ii: When is a Loss Sustained

A loss must be evidenced by closed and completed transactions, fixed by

identifiable events 1.165-1(b)

A sale or exchange typically fixes a loss but a mere decline in value is not

necessarily a loss sustained.

A loss for securities is allowed when they become worthless (165(g)(2))

Theft losses are treated as sustained in the year the theft occurs. 165(e)

Revenue Ruling 2009-9: PONZI SCHEME. B intent to deprive A of her

investment money by criminal acts, therefore B’s action constituted

a theft and therefore a theft loss may be claimed.

Had B not had the intent to deprive A of money then A’s

lost investment would be a capital loss. A loss that is

sustained on the open market for investment is a capital

loss, even if the decline in value of the stock is attributable

to fraudulent activities on the part of the directors, so long

as there was not specific intent to deprive.

o iii: Amount of the Deduction

165(b) limits the amount of the loss deduction to the adjusted basis of the

property in question.

To the extent that the taxpayer receives insurance or other compensation

the loss is offset and the deduction reduced. 165(a)

Rev Ruling 2009-9: The amount of theft loss from a fraudulent investment

arrangement will, under some circumstances, include not only the amount

the taxpayer initially invested but also the amount of income the taxpayer

reported on the investment.

If there is a reasonable prospect of recovery in year 1, the loss is not treated

as sustained until the matter of reimbursement is determined with

“reasonable certainty” 1.165-1(d)(2) and (3)

If there is no reasonable prospect of recovery and a loss is allowed in year 1

and then in year 2 a recovery does occur, the recovery is treated as income

in year 2.

B: Bad Debts

o i: Bona Fide Debt Requirement

Section 166 allows a deduction for debts becoming worthless within the

taxable year.

166 is applicable ONLY if a bona fide debt exists. There must be a debtor-

creditor relationship based on a valid, enforceable obligation to pay a fixed

or determinable sum of money (Reg 1.166-1(c))

o ii: Worthlessness

Debt must be a BAD debt

Even if a bona fide debt is present, forgiveness or cancellation of the

debt may constitute a gift rather than evidence of worthlessness

6511 provides a 7 year SOL for refund claims under 166

o iii: Business or Nonbusiness Debts

Business debts are deductible under 166 in the year that they become

totally worthless. Partially worthless business debts are also deductible

under 166(a)(2) up to the amount charged off within the yea.

Nonbusiness bad debts are deductible only upon becoming wholly

worthless.

Nonbusiness debt is define in 166(d)(2) as a debt other than a debt

created or acquired in connection with the taxpayers business.

Nonbusiness debts, even when completely worthless, are

deductible only as short term capital losses rather than as ordinary

losses.

Capital loss under 1211 is limited in a given year only to the

extent of the individuals capital gain plus an additional

3,000

An employee engages in a trade or business as an employee, and if

a loan is required to continue employment it can be counted as a

loss.

US v. Generes: Generes attempted to deduct funds paid by him

under the terms of an indemnification agreement of a corporation

that become insolvent as a bad business debt.

Holding/Rule: Generes was a shareholder (nonbusiness) and

an office (business), his shareholder motive was the primary

motive so this was a nonbusiness debt and only short term

capital can be claimed.

o iv: Amount Deductible

The amount of a bad debt deduction is the debt’s adjusted basis 166(b)

No bad debt deduction is allowed unless such amounts have been included

in income, which would not be the case with the cash method taxpayer.

(1.166-1(e)).

o v: Guarantees

Losses arising out of loan guarantees are treated as losses fro bad debt

(1.166-9)

C: Bad Debts and Losses: The Interplay Between 165 and 166

o Depending on the circumstances taxpayer may seek to characterize a loss under 166

rather than 165.

o Investment related loss is capital loss if under 166 (not under 165)

o If a personal loss, 165 denies deduction except for casualty and theft, while 166

allows short-term capital loss.

XVI: Travel Expenses

A: Commuting

o i: Commuting costs are viewed as personal in nature since you can choose how close

or far you’d like to live to work, and therefore are nondeductible under 262.

o ii: Flowers for deductibility TEST

To be deductible, a travel expenses must satisfy three elements:

1) It must be necessary and reasonable

2) It must be incurred away from home

3) It must be incurred in the pursuit of business

o Revenue Ruling 55-109: A taxpayer who works in two different locations on the

same day for the same employer may deduct the cost of travelling from one work

location to the other. “If at the end of the workday he goes directly home from his

second place of employment, his trip would ordinarily be regarded as commuting

and nondeductible (if the distance from the second location to home does not

exceed the distance from the headquarters to home). (pg 370)

o TEMPORARY WORK LOCATION

Revenue Ruling 99-7: In general daily transportation expenses incurred in

going between a taxpayer’s residence and a work location are

nondeductible commuting expenses. However such expenses are

deductible under these circumstances:

(1) Going between residence and temporary work location outside

metropolitan area where taxpayer lives and normally works are

deductible, but temporary work locations within the metropolitan

area where taxpayer lives/works are non-deductible unless (2) and

(3) apply

(2) if the taxpayer has a temporary work location and has

one or more regular work locations away from residence

(more than just a temp. location) then expenses incurred in

going between the residence and temp work location in

same trade or business are deductible

(3) if residence is principal place of business, taxpayer may

deduct transportation expense between residence and

another work location.

Temporary is based on a reasonable belief that it will be less than a year.

Doesn’t matter if you think more than a year and it ends up being less.

Treated as temporary until you realistically believe that it will last more than

a year.

Pollei v. Commissioner: Police were able to deduct the maintenance and

operating costs of driving their personal cars between their homes and

police headquarters based on their being “on-duty” status at such times.

Other people will not be allowed to deduct their travel expenses simply

because they voluntarily chose to do work when they travel. A personal

expense may become a business expense when it loses it’s voluntary nature

and is proscribed by company regulations.

B: Other Transportation Expenses

o Ordinary and necessary travel that is solely business related is deductible (i.e. fly

somewhere to take a deposition)

o If you use your own car to travel across town to interview a client, it’s deductible

o If your principal place of business is your own residence, the entire amount of

transportation driving from home for business is deductible.

o If primary purpose of travel is business, transportation costs are deductible. If

personal, then transportation costs not deductible, but expenses incurred allocable

to business are deducible. 1.162-2(b)(1)

o 247(m)(1) disallows deductions for business expenses incurred on luxury water

transportation.

o Travel as a form of education is also non-deductible 247(m)(2).

Ex: Latin teacher who spends the summer in Rome cannot deduct as an

educational expense.

C: Expenses for Meals and Lodging

o Initially, 162(a)(2) allowed a taxpayer to deduct the entire amount of meal an

lodging when the taxpayer was away from home, however, now 274(n) limits the

deduction of meals to 50% of their cost.

o Over-night Rule

Employees who have been authorized to stop performing their regular

duties to get substantial sleep or rest prior to returning to their home

terminals may deduct the costs of their meals and lodging

US v. Correll: Corell was a traveling salesman who sought to deduct the cost

of breakfast and lunch eaten on the road as a business expense.

Holding/Rule: Taxpayer traveling on business may deduct the cost

of his meals only if his trip requires him to stop for rest or sleep. His

travels did not require this so the deduction was disallowed.

o 162(a)(2) applies when a taxpayer who because of the exigencies of his trade or

business must maintain two places of abode and thereby incur additional and

duplicate living expenses.

D: Away from Home

o Home within the meaning of 162(a)(2) is the taxpayer’s principal place of business.

If taxpayer has more than one PPB look to amount of time and business

activities located in each place.

Robertson v. Commissioner (375)

o Rosenpan v. US: Traveling salesperson, had no home to be away from so could not

deduct business expenses.

o Henderson v. Commissioner: Deducted living expenses he incurred while living away

from home with his traveling ice show.

Holding/Rule: When a taxpayer does not have a business connection to a

place and is not duplicating his expenses, he cannot claim it was his home

for tax purposes. H had no legal tax home since he continuously traveled for

work

o Expenses incurred in connection with the temporary assignment away from home

are deductible, BUT it is not temporary if it exceeds one year

ex: Taxpayer reasonably expects to be on assignment for only nine months,

but once she is there she is asked to stay for 7 more months. Service

concluded that the first 9 months can be treated as temporary and the

remaining seven treated as permanent.

o A seasonal job to which an employee regularly returns year after year is regarded as

being permanent rather than temporary.

BUT see Andrews v. Commissioner: Man worked part of the year in boston

and part in florida and had homes in each.

Holding: taxpayer could only have one “home” for purposes of

§162(a)(2) and that duplicative living expenses while on business at

the other home (“the minor post of duty”) were a cost of producing

income and therefore deductible.

E: Spouse Travel Expense

o 274(m)(3) severely restricts deductions for the travel expenses of a spouse. Under

this provision, taxpayer may deduct for a spouse if

1 ) spouse is a bona fide employee of the taxpayer

2) travel of the spouse is for a bona fide business purpose

3) spouse could otherwise deduct the expense.

o May be treated by employer (if not deductible under §274(m)(3)) as deductible

compensation to the employee pursuant to §274(e)(2), this employer-paid expense

is presumable a fringe benefit.

F: Reimbursed Employee Expenses

o Follow the special rule of §62(c) they will qualify as an above the line deduction

rather than a below the line deduction (subject to reduction under 2% floor rule of

§67 and useful only for taxpayers who itemize). This means that the expense is

essentially eliminated from gross income, and thus the expense is not deductible.

o Qualifying reimbursement arrangements are “accountable plans” (1.62-2(c)(4)).

Amounts paid under a “nonaccountable plan” are included in gross income and the

expense is deductible only as a below the line miscellaneous itemized deduction

(1.62-2(c)(5)).

o Accountable plan must satisfy a 3 part test:

“business connection”—allowances only for deductible business expenses

1.62-2(d)(1)

Must be properly substantiated (amount, time, place submitted) 1.62-2(e)

(1)

employee must be required to return any excess of substantiated expense

(f)(1) any amount not returned is included in income (non-account)(c)(3)

G: Business-related Meals

o If not away from home 162(a)(2) applies and meals can still be deductible as

ordinary and necessary business expenses 1.262-1(b)(5), meal expense deduction

limited to 50%

o 274(a) requires the taxpayer to be present at a meal for which an expenses

deduction is sought

o 274(n) limits the deduction to 50% its cost

XVII: Entertainment

A: Business or Pleasure

o Because of the close call between business entertainment and pleasure, Congress

limited the deduction for business meals and entertainment to 50% of the cost. 274

o Churchill Downs v. Commissioner: P was owner and operator of horse race track

which argued that several of the events it hosted were deductible as ordinary

business expenses spent to publicize the taxpayers racing events.

Holding: Court held that purely social, public relations events hosted by a

taxpayer for the purpose of promoting its product are entertainment, and

are therefore limited to the deductibility of entertainment expenses to 50%.

B: Entertainment Activities

o 274(a)(1) disallows any deduction for an activity of a type generally considered to

constitute entertainment, amusement, or recreation UNLESS the taxpayer satisfies

one of two tests:

1) the expenditure is directly related to the active conduct of the trade or

business

The “directly related to” standard requires that the taxpayer:

1) reasonably anticipate some income or specific business

benefit from the expense

2) actively engage in a business discussion

3) be motivated principally by the business aspect of the

business-entertainment combination

4) establish the expenditure is allocable to the taxpayer and

persons with whom the taxpayer is engaged in the active

conduct of the trade or business. (not necessary that more

time be spent on business than entertainment)

2) the expenditure is associated with the active conduct of the trade or

business and directly preceded or followed by a substantial and bona fide

business discussion.

Much looser standard. Taxpayer must have a clear business purpose

for making the expenditure but an intent to maintain business

goodwill or obtain new business satisfies this requirement. 1.274-

2(d)(2)

o If taxpayers are not present, or if there are substantial distractions such as at

nightclubs, theatres, sporting events and cocktail parties, the expenditure is not

considered directly related to the taxpayers business 1.274-2(c)(7).

o Meal deduction is not allowed if the meal is lavish or extravagant.

If it is extravagant under 274(k) take away the amount that it is extravagant

and deduct 50% of the remaining amount

If an employee gets reimbursed by the employer, the employer gets to

report the 50% deduction.

o Walliser v. Commissioner: P was VP and branch manager of a bank. He and his wife

traveled in tour groups for people involved in the building industry because it gave

the P a chance to associate with potential customers. P deducted for his travel

expenses.

Held: – trip was “entertainment” and requires directly related test of §274.

More than general expectation of deriving some income at some indefinite

future date

C: Entertainment Facilities

o 274 generally denies any deductions for entertainment facilities (ie hunting lodges,

swimming pools, etc)

There is an exception where the facility is used primarily for business

purposes (ie: more than 50% business use.

o A taxpayer will establish under 1.274-2(e)(4)(iii)(b) that a faculty was used primarily

for furtherance of his trade or business if he establishes that more than 50% of the

total calendar days of use of the facility, by the taxpayer during the taxable year

were days of business use.

If on a given day the taxpayer uses the facility in the ordinary and necessary

course of business that will constitute a day of business use.

D: Substantiation Requirements

o Section 274(d) imposes special substantiation requirements on entertainment

expenses, travel expenses, etc. A taxpayer is required to substantiate either by

adequate record or by sufficient evidence:

1) The amount of the expense

2) The time and place it was incurred

3) The business purpose for the expense

4) the business relationship to the taxpayer of the person entertained.

o Without this substantiation requirement the deduction is disallowed.

o The adequate record requirement is satisfied by maintaining a book, diary, or similar

record, together with bills and receipts (1.274-5T(c)(2). However for under $75 the

documentary evidence is not needed.

E: Business Meals

o Sutter v. Commissioner: Cost of meals, entertainment and similar items for one’s

self and dependents, at leas while not away from home, is a personal expense and

nondeductible. Unless it can be shown by clear and convincing evidence that the

expenditure in question was different in form or in excess of what which would have

been made for the taxpayer’s personal purpose.

o Moss v. Commissioner: Moss was a partner in a firm. Firm members met for lunch

DAILY where they discussed cases, etc. Lunch was the most convenient meeting

time. Sought to deduct.

Dailey business meeting lunches among co-workersare not deductible.

XVIII: Education Expenses

A: Deductibility of Educational Expenses Under Section 162

o Under 162 an individual may deduct educational expenses that either

1) maintain or improve skills required in his employment or trade or

business

2) meet the express requirements of his employer, or applicable law,

necessary to retain his established employment relationship, status, or rate

of compensation. (1.162-5(a)

o HOWEVER an expense is NOT deductible under 162 even though it satisfies the

above tests if

1) it meets the minimum educational requirements for qualification in the

taxpayer’s employment or trade or business

2) if it qualifies the taxpayer for a new trade or business

B: The Skill-Maintenance or Employer-Requirement Tests of 1.162-5(a)

o 1) Skill Mainenance

Refresher courses or courses dealing with current developments as well as

academic or vocational courses fall in this category (1.162-5(c)(1)

Sufficient Relationship

Carrol v. Commissioner: Police officer was not permitted to deduct

the cost of college studies in philosophy because even though the

police department encouraged policemen to attend college and

although it may improve their job skills, the taxpayer failed to

demonstrate A SUFFICIENT RELATIONSHIP between the education

and the particular job skills required by policemen.

Takahashi v. Commissioner : Petitioners were science teachers. By

law they had to complete a minimum of two semester units in a

course of study dealing with multicultural societies. Petitioner

attended a seminar held in Hawaii about Hawaiian culture. They

spent 10 days in Hawaii with their son. Seminar was 9 out of the 10

days. This course was held to not have maintained or improved the

skills required by them to perform their jobs as science teachers.

They would have had to demonstrate a connection between the

course of study and the particular job skills

Carrying on Trade or Business

Another issue is whether the taxpayer was carrying on a trade or

business at the time the educational expense occurred.

Implicit in both 162 and the regs, is that the taxpayer must be

established in a trade or business before any expenses are

deductible.

Wassenaar v. Commissioner: A taxpayer who has not

practiced law as an attorney was not allowed to deduct the

cost of his master of laws degree in taxation.

Link v. Commissioner: TP graduated from college and

enrolled in an MBA program, after working at Xerox for

three months. Court held Xerox was just a temporary hiatus

between education and not a trade.

Rev Ruling 68-591: Suspension of employment for a year or less will

be considered temporary. (however, there is no magic limit here,

and all the facts and circumstances must be evaluated. If the

taxpayer is found to have abandoned his trade or profession then

he cannot deduct educational expenses claiming to further his trade

or business.

Furner v. Commissioner: Petitioner majored in social studies at a

teachers college where she received her BA. To gain greater depth

of understanding on the subject she enrolled as a full time grad

student at Northwestern. She had to resign from school for a year

to do so. It was not unusual for teachers to enroll in full time

graduate study for an academic year in order to keep up with

expanding knowledge and improve their understanding of the

subjects they teach. A year of graduate study is a normal incident of

carrying on the business of teaching.

o 2) Employer Requirement

To meet the deduction, the requirements must be imposed for a bona fide

business purpose.

In addition only the minimum education necessary for retention of the job,

status or pay will qualify.

Hill v Commissioner (423)

C: The Minimum-Educational Requirements and New trade or Business tests of regulation

1.162-5(b)

o 1) Minimum Educational Requirements Block

162-5(b)(2): An individual may not deduct educational expenses required to

meet the minimum educational requirements for qualification in his

employment or trade or business.

o 2) New Trade or Business Block

162-5(b)(3)(i): individual is prohibited from deducting educational expenses

which are part of a program of study that will lead to qualifying him in a new

trade or business.

The fact than an individual may not intend to pursue the new trade or

business but may simply wish to improve his skills in his present

employment does not make the expense deductible.

Warren v. Commissioner (pg 424): Taxpayer took courses he deemed

relevant to his ministry. Applying the objective test of the regulations, the

Tax Court concluded that the degree program qualified the taxpayer for a

new trade or business.

Mere change of duties is not equivalent to a new trade or business if the

new duties involve the same general type of work as the present

employment.

Glen v. Commissioner (pg 424): Common sense approach to determining

when new titles or abilities constitute a new trade or business. Compare the

types oft asks and activities which the taxpayer was qualified to perform

before the acquisition of a particular title or degree and those which he is

qualified to perform afterwards. This case held public accountants and

certified public accounts to be in separate trades or businesses given this

test.

Sharon v. Commissioner: Using the common sense approach, held that a NY

attorney qualified for a new trade or business on obtaining his California

license to practice law.

Allemeier v. Commissioner (pg 425): MBA deductible because getting it did

not qualify him for activities he was not able to perform prior to getting the

MBA.

Foster v Commissioner (pg 425): MBA nondeductible because taxpayer was

a project manager for an engineering consulting company and getting the

MBA qualified him to perform activities he was not qualified to perform

prior.

TEACHER EXCEPTION: For a teacher who moves from elementary to

secondary school or from one subject matter to another is not considered to

have a new trade or business, ALSO a change from teacher to guidance

counselor or principal is also NOT a new trade or business (1.162-5(b)(3)(i))

D: Travel Expenses

o 247(m)(2) disallowed any deduction for travel as a form of education.

o Any business purpose served by traveling for general education purposes, in the

absence of specific need such as engaging in research which can only be performed

at a particular facility is at most indirect and insubstantial.

o Committee bill disallows deductions for travel that can be claimed only on the

grounds that the travel itself is educational but DOES ALLOW for travel that is a

necessary adjunct to engaging in an activity that gives rise to a business deduction

relating to education.

o 162-5(e)(1): Travel expenses, meals and lodging remain deductible where an

individual travels away from home “primarily” to obtain education, the expenses of

which are deductible.

XIX (C) : Legal Expenses

Origin of the Claim Test

o If the origin of the claim lies in personal, as oppose to business o profit-seeking

transactions the legal expenses are non-deductible.

o US v. Gilmore: Whether the claim arises in connection with the taxpayers profit-

seeking activities. Does not depend on consequences that might result to a

taxpayer’s income producing property from a failure to defeat the claim

Wife’s claim to income producing property stemmed entirely from the

marital relationship

o US v. Patrick: Deny deduction for legal fees related to a property settlement.

o 1.262-1(b)(7): permits a deduction for fees and costs property attributable to the

production or collection of alimony which is taxable income under §71.

o Even if business related, legal expenses are still subject to 263 capital expenditure

rule

Capital Expenditures:

o 212(3) Expenses of contesting tax liabilities are deductible, as well as a deduction for

tax planning advice (ex. portion of estate planning attributable to tax advice)

o 1.263(a)-(5) Amounts paid or incurred to facilitate an acquisition of a trade or

business, a change in the capital structure of a business entity and certain other

transactions (??)

XX: Hobby Losses

A: Historical Development

o In making the determination of whether an activity is NOT engaged in for profit, an

objective rather than a subjective approach is employed, thus although reasonable

expectation of profit is not required, facts and circumstances would have to indicate

that the taxpayer entered the activity with the objective of making a profit.

o Can qualify under this test even if the expectation of profit were unreasonable.

1.183-2(a)

B: Section 183 Activities

o 183 applies to activities not engaged in for profit.

o Each activity must be tested separately as to whether it is an activity “not engaged

in for profit”

Ie: Those activities which do not qualify for deductions under 162 or 212

o The following factors help to determine whether an activity is engaged in for profit

(1.183-2(b))

i: Manner is which the taxpayer carries on the activity

ii: Expertise of taxpayer or his advisors

iii: Time and effort expended by the taxpayer in carrying on the activity

iv: Expectation that assets used in the activity may appreciate in value

v: Success of the taxpayer in carrying on other similar or dissimilar activities

vi: Taxpayer history of income or losses with respect to the activity

vii: Amount of occasional profits which are earned

viii: Financial status of the taxpayer

ix: Elements of personal pleasure or recreation

o Regulations employ an “all the facts and circumstances” test with greater weight

given to objective facts than to the taxpayer’s mere statement of his intent

Antonides v. Commissioner: Court held that a yacht chartering venture was

an activity not engaged in for profit. Taxpayer was not actually motivated by

the prospect of profit in acquiring the yacht.

Missley v. Commissioner: Taxpayers operated an Amway distributorship.

The tax court noted that the distributorship generated consistent and

substantial losses, the taxpayers failed to maintain a written business plan

or budget, they had substantial income from other sources, and they

derived personal pleasure from the Amway activities. The court thus held

they had not engaged in the Amway activity for profit.

C: Deductions Allowable Under Section 183

o 183(b) establishes 3 categories of permitted deductions:

Category 1: Those such as home mortgage interest under 163(h)(3) and

state and local property taxes under 164 which are allowed to a taxpayer

whether or not an activity is engaged in for profit

Deductions that are attributable to the activity but don’t come

within the first category are allowed only to the extent that the

gross income from the activity exceeds the total Category 1

deductions 183(b)(2).

Ex. Profit $1000, Category 1 deduction of $1100—all is

deductible. But if $700 is Category 1 only $300 of Category

2 can be deducted.

o Non Category 1 deductions are divided into 2 other categories.

Category 2: do not result in a basis adjustment and would otherwise be

allowed if the activity were engaged in for profit (garden variety 162 or 212

expenses)

Category 3: deductions such as depreciation, result in basis adjustments and

would be allowed if the activity were engaged in for profit. (may only be

taken after Category 2 deductions)

o 1.183(b)(2) In the event the activity use more than one depreciable asset, there’s a

formula for allocating the basis adjustments among the depreciable assets.

o Policy: 183 Adopts the basic policy that deductions attributable to a not-engaged-in-

for-profit activity should always be allowable at least to the extent of the income

from the activity.

o Dreicher v. Commissioner : Dreicer (P) claimed deductible losses for expenses related

to his alleged profession as a writer.

RULE: deductible losses under §183 of the IRC are allowed even if the

taxpayer entered into an activity with the actual and honest objective of

making a profit

HELD: Taxpayer’s motive is the ultimate question, and it must be

determined by a careful analysis of all the surrounding objective facts.

Statement of intent should only be one of the relevant factors. Here there

were large losses for many years, expenses were not conducted in a

businesslike manner to earn a profit, thus the deductions are disallowed on

the grounds that the expenses arose from activities not pursued for profit.

o Remuzzi v. Commissioner : a surgeon claimed losses from operating a farm where his

family lived

RULE: in determining whether an activity is engaged in for profit, objective

facts regarding the manner, success, and history of the taxpayer’s efforts

are given greater weight than the taxpayer’s stated interest.

HELD: Section 183 of the IRC allows deductible expenses if an activity is

engaged in for profit and lists 9 factors to be taken into account. No

evidence surgeon tried to decreased expenses and maximize revenues of

farm, had no expertise, and moved to the farm for personal enjoyment.

Failed to prove he entered business for profit.

XXI: Home Offices, Vacation Homes and Other Dual Use Property

A: Home Office Deductions

o Bodin v. Commissioner: P , a lawyer, used an office at home for work in the evenings

and weekends because it was more convenient than traveling back to the office. He

tried to claim a deduction for use of his study as a home office.

Holding: The applicable test for judging the deductibility of home office

expenses is whether, like any other business expense, the maintenance of

an office in the home is appropriate and helpful under all circumstances.

Tax court held that it made no difference that the petitioner was not

required to maintain a home office. The expense was “necessary” because

they were appropriate and helpful in the conduct of his business. They

enabled him to jeep a facility in his home wherein he could and did work,

they were ordinary in nature

o With the enactment of 280A(c)(1), taxpayers can deduct their home office expenses

if they satisfy the exclusivity and regular use standards and the convenience of the

employer standard. (Bodin would have failed these standards)

o Determining PPB: Soliman v. Commissioner: A self-employed anesthesiologist

worked at 3 different hospitals and did all of his administration and management

work for his job at home because he had no office in any of the buildings.

Rule: In determine the PPB consider:

The relative importance of the activities performed at each business

location and

The time spent at each place.

While this court held that he could not deduct, this case has since been

reversed however the two rules still apply.

o 280A(c)(I), says that a home office can be a principal place of business if it is used for

administrative or management activities and if there is no other fixed location of

such trade or business where the taxpayer conducts substantial administrative or

management activities. (reversed Solimon)

o Convenience of the employer standard:

ex: Weissman v. Commissioner: P working at a home office spared the

employer the cost of providing a suitable private office and thereby served

the convenience of the employer.

o Popov v. Commissioner: Popov was a professional violinist who sought to obtain a

home office deduction for the space she used in her home to practice for orchestra

performances and studio recordings.

Rule: A professional musician is entitled to deduct the expenses from the

portion of her home used exclusively for musical practice when the activities

performed and the time spent at each business location are considered and

weighed in favor of the musician. Relative importance of activities

performed at each location and the time spend at each place are to be

considered. Here importance of practice is essential and she spent more

time practicing than performing. Thus she was entitled to a deduction since

the home space was used exclusively for PPB.

o 280A(c)(5) severely limits the deductions allowed for a home office

The gross income from the use of the residence for trade or business

purposes is the ceiling for the deductions. This ceiling is the reduced by

1) the deductions the taxpayer can claim regardless of whether the

home office were used for trade or business purposes (real estate

taxes allocable to the home office) and

2) those deductions attributable to the trade or business activities

but not allocable to the dwelling unit itself (such as secretarial

expenses, supplies, business phones, etc)

EXAMPLE: Sum of allowable business deductions of office is 1,050 ($1,900 of

gross income less $850 of expenditures not allocable to the unit).

Gross Income from consulting services $1900

Less

(1) Always Allowable deductions ((§280A(c)(5)(B)(i))

Total Allocable to Office

Mortgage $5,000 $500

Real Estate $2,000 $200

Total Allocable to Office. . . . . . . . . . . . . $700

(2) Expenditures not allocable to use of (§280A(c)(5)(B)(ii))

Secretarial $500

Business Telephone $150

Supplies $200

Total . . . . . . . . . . . . . . . . . . . . . . . $850

Sum of (1) and (2) . . . . . . . . . . . . . . . . . . . . .$1550

o Section 280A(c)(5) limit on further deductions

Gross income $1900 less $1550 . . . . . . . . . . . . . . $350 (thus only

$350 of the taxpayers other expenses may be deducted under 280A(c)(5)

o Assume other expenses attributable to home office are

Total Allocable to Office

Insurance Utilities $600 $60

Utilities $900 $90

Lawn Care $500 $0

Depreciation $3200 $320

Total Allocable to Office . . . . . . . . . . . . $470 (only $350 can be

deducted, the utility and insurance charges totaling 150 would be

deductible first, leaving 200 of the depreciation able to be deducted. The

120 left over from the depreciation may be carried over to the succeeding

tax year.

B : Vacation Home Deductions

o 280A limits deductions a taxpayer may claim with respect to rental of a dwelling unit

if taxpayer uses dwelling unit for greater of 14 days or 10% of number of days for

which home is rented for a fair value 280A(d)(1)

o Deductions may not exceed the excess of the amount y which the gross income

derived from the rental activity exceeds the deductions otherwise allowable without

regard to such rental activity (ie: mortgage interest, and real estate taxes).

o The portion of expenses (insurance, depreciation, utilities) allocable to rental

activities is limited to an amount determined on the basis of the ratio of time the

home is actually rented for a fair rental, to the total time the vacation home is used

during the taxable year for all purposes, including rental.

C: Other Dual Use Property

o i: Computer and other “Listed Property”

Unless the business use percentage for the taxable year exceeds 50%, the

taxpayer is required to use the alternative depreciation system of 168(g)

and is limited to straight line depreciation on the property. (280F(b)(1),(3).

Recapture Rule 280F(d)(3), to address situations where, in a year following

the year the “listed property” is placed In service, the taxpayer fails to meet

the 50% use standard.

If the employee uses his own computer in connection with his employment,

no depreciation is available to the employee unless he can establish that the

use of the computer is for the convenience of the employer and is required

as a condition of his employment 280F(d)(3)

o ii: Passenger Automobiles

Are also treated as “listed property” and subject to the same limitations as

above., thus unless the taxpayer uses the passenger automible more than

50% of the time for trade or business purposes the taxpayer may not use

the accelerated depreciation provided by 168 and no 179 election is

available.

280F(a)(1)(A) Congress limited the depreciation allowable with respect to a

passenger automobile in the year it is placed in service and succeeding years

Yr 1 max depreciation allowed is 2,560

Yr 2 – 4,100

Yr 3- 2, 450

Each yr after – 1, 475

Limitation is applied after depreciation is computed under §168 and amount

is reduced to reflect portion used for personal use.

Ex. 25% business and 75% personal can’t use accelerated

depreciation so must use straight line. Total car was $30k. Max

depreciation is still as listed above. Under 168(g) it would have

been 10% of $30k. or $3000 but according to 280F(a)(1)(A) it’s only

$2560. Then you can only deduct the portion attributable to

business use (25%). Thus, $640 is deductible. Even if the auto was

used exclusively in her business, the maximum depreciation

allowance means that only $2560 is deductible in year 1. Under

simple §168, $6000 would have been deductible (straight line over 5

years).

XXII MECHANICS NOT ON EXAM

XXIII: MECHANICS NOT ON EXAM

XXIV: Casualty Losses

A : Definitional Questions

o 165(c)(3) authorizes a deduction for an individuals uncompensated casualty and

theft losses unconnected with a trade or business.

Each lost is first subject to a $100 nondeductible floor, in addition the new

casualty loss for the year is allowed only to the extent that it exceeds 10% of

the taxpayer’s adjusted gross income. 165(h)(1), (2)

o The average taxpayer rarely get to apply the casualty loss since it must be a loss

uncompensated by insurance and it must be more than 10% of gross income.

o Loss can be collected in the case of a “fire, storm, shipwreck or other casualty” Rev

Ruling 72-592

What is “other casualty”?

Event MUST be “identifiable of a sudden, unexpected, and unusual

nature”

o Examples of Deductions Permitted :

White v. Commissioner:

Deduction was allowed for a diamond ring lost when a car door was

slammed on a woman’s hand.

Revenue Ruling 75-592: (reviewed the white case above) Ruled that

property that is accidentally and irretrievably lost can be the basis for a

causality loss deduction if it meets the other qualifications and must be

1) Identifiable

2) Damaging to property

3) Sudden (swift, not gradual or progressive), unexpected

(unanticipated, without intent of the one who suffers) and unusual

(does not commonly occur in the course of day to day living) in

nature

Carpenter v. Commissioner:

Deduction was allowed when a woman placed her ring in a glass on

ammonia for cleaning and her husband poured it in the sink by

accident and ruined it.

o Example of Deductions NOT permitted:

Keenan v. Bowers

No deduction was allowed when a woman took off her wedding

rings, wrapped them in tissue and her husband accidentally flushed

them down the toilet. RULE: Damage that results from the

taxpayer’s willful act or willful negligence” will not be allowed.

TERMITE damage is not sudden, unusual or unexpected in nature

Maher v. Commissioner

Water heater burst from rust and corrosion was not a casualty loss

but the damage to the rugs and carpet due to bursting was.

o Foreseeability or negligence will not take an occurrence outside the ambit of “other

casualty”

Heyn v. Commissioner: While meteorological forecasts may warn of

impending hurricanes or tornados they are still casualty losses under the

law. In addition, even though a drivers negligence may have contributed to

a car accident, thus will not deprive him of a casualty loss.

1.165-7(a)(3)

o While the regulations do not require it, the court has held that PHYSCIAL DAMAGE

must be shown in order to establish a casualty loss.

Chamales v. Commisioner: Chamales lives near OJ Simpson the year he was

charged with murder. Because of the high amount of press, Chamales’

broker said that his house decreased in value by 20-30%.

Rule/Holding: A casualty loss arises when the nature of the

occurrence precipitating the damage to the property qualifies as a

casualty loss under 165 and when physical damage or permanent

abandonment of property has occurred. Temporary decline in

marker value will not be allowed as a deduction.

Lund v. US

Court denied a loss when taxpayers claimed that avalanche risk

lowered the value of their home.

o However, some courts have not required a showing of physical damages

Finkbohner: When PERMANENT buyer resistance exists (ie total change in

the result of the neighborhood) and impact the FMV of the property, the

taxpayer may claim a casualty loss deduction. The loss deduction is the

difference between the FMV before the casualty and the FMV after

casualty.

Theft Loss

o The regulations provide that theft includes, but is not limited to, larceny,

embezzlement and robbery. 1.165-8(d)

o Illegal taking of property, done with criminal intent, constitutes a theft loss for

purposes of 165(c)(3) even though the act may not fall under the state law

definition of theft.

Kriener v. Commissioner: Fortunetellers charged him $19,000 claiming to be

able to improve his health and sole his problems. Tax court noted that theft

constitutes a broad field including and criminal appropriation of another’s

property to the use of the taker, particularly including theft by swindling,

false pretenses, and any other form of guile.

o Taxpayer must prove a theft has occurred, a mere mysterious disappearance of

property will not suffice (Allen v. Commissioner)

o However, the taxpayer need not prove who stole the property, it is sufficient that

the reasonable interference from the evidence point to theft rather than mysterious

disappearance (Jacobson v. Commissioner)

Popa v. Commissioner:

facts: Popa an executive in Vietnam, lost his possessions when the

government collapsed and Americans were ordered to evacuate.

Rule/Holding: Under certain circumstances taxpayers are

not required to eliminate all possible noncasualty causes of

a loss in order to claim a 164 deduction. Here the most

reasonably conclusion is that Popa suffered a qualifying

casualty loss.

B: Timing of the Loss

o A casualty loss is deductible in the year sustained, theft loss is deductible in the year

discovered! (165(a),(e))

o If a taxpayer has made a claim for reimbursement, allowance of a deduction must

await the resolution of the claim with reasonable certainty. 1.265-1(d)(2),(3).

C: Amount of the Loss

o The amount of casualty loss under 165(c)(3) is the lesser of THE ADJUSTED BASIS

and the DIFFERENCE BETWEEN THE FMV of the property before vs the property

after. 1.165-7(b)(1)

o For THEFT it is the lesser of the basis or value 1.165-8(c)

ex: Diamond ring purchased for $1,000 increases to $3,000 in value, then it

is stolen, there can only be a $1,000 deduction.

ex: Car purchases at 10k, declines in value to 4k then it is wrecked, can only

get a 4k deduction.

o With respect to business related property , if the basis exceeds the value, the lesser

of rule does NOT apply (1.165-7(b)(1))

o The amount of the loss must be reduced by an reimbursement and by $100 (the

$100 is applied to each casualty or theft rather than each item destroyed in a single

casualty or theft) 165(h)(1) and 1.165-7(b)(4)(ii)

Once the personal casualty and theft losses have been determined they will

be deductible to the extent of any personal casualty gains for the year

165(h)(4)A)

ex: You lose a ring worth $1,000 and you get $2,000 from your

insurance claim, you now have a $1,000 casualty gain which can be

deducted

If the losses exceed the gain for the year, the net casualty loss is deductible

only to the extent that it exceeds 10% of the taxpayer’s adjusted gross

income 165(h)(2)

ex: Taxpayer sustains 2 casualty losses, one worth 1,700 and

another worth 80. He has NO personal casualty gains. He has a gross

income of $20,000. The resulting 165(c)(3) deduction would only be

$300. The losses total 2500, and they must be reduced by 100 per

casualty which leaves him with 2300. Then the 2300 can only be

collected in the amount which exceeds 10% of the taxpayers

income. He has income of 20,000 so 10% is 2,000. 2300-2000 is 300.

D: Insurance Coverage

o Casualty losses may only be taken into account if timely insurance claim is filed, to

the extent items are covered by insurance. 165(h)(4)(E)

o To obtain this deduction, a taxpayer is now required to file an insurance claim if he

has obtained insurance coverage, but is not required to obtain the insurance

coverage to being with.

XXVII: NOT ON EXAM

XXVIII: Cash Method Accounting

A: Income Under the Cash Method

o i: In General

Section 446(c)(1) authorizes the use of the cash method of accounting so

long as it clearly reflects the taxpayers income.

This method requires taxpayers to report cash (and income in other forms)

as received and to deduct expenses as they are paid.

o ii: Constructive Receipt

a: Specific Factors Affecting Application of Constructive Receipt Doctrine

Generally under this method, all items which constitute gross

income are to be included for the year in which they are actively or

constructively received. 1.446-1(c)(1)(i)

Constructive receipt occurs in the year which the income 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.

(1.451-2(a))

ex: Dec 1, tenant offers landlord the rent check for December. Even

though rent was then due, the LL tells T to hold onto the check and

give it to him in January. LL must report the rent for the December

year because he is in constructive receipt of the check.

Two requirements must be satisfied before the doctrine of

constructive receipt is applicable 1.451-2(a)

o 1) the amount must be available to the taxpayer

o 2) The txapayer’s control over receipt must not be

subject to substantial restrictions or limitations

Hornung v. Commissioner: Basis of constructive receipt is

essentially unfettered control by the recipient over the date

of actual receipt.

Baxter v. Commissioner: Although the notion of

constructive receipt blends a factual determination of what

actually happened and a legal assessment of its significance,

we have held that a finding of constructive receipt is a

finding of fact. ..and can be set aside only if clearly

erroneous.

Ames v. Commissioner: Did Ames constructively receive

income from illegal espionage activities when it was

allegedly promise him or when it was deposit in his

account?

o Held: Taxpayer did not have access to the funds

initially. They were held in a bank until certain tasks

were completed by taxpayer, of which there was no

certainty that they could be completed. So long as

the soviets had the funds taxpayer did not need to

report income

Courts will evaluate several factors relevant to whether a

taxpayer had unfettered control over income

o 1) Distance: Geographic proximity to the location

where an item of income is being made available to

the taxpayer.

ex: Hornung wins car for being MVP.

However, he is in Wisconsin and the car is in

New York and the dealership was closed for

the weekend. Court held he did not have

control necessary for constructive receipt.

Generally the date a check is RECEIVED and

not the date it is MAILED determined the

year of taxation, but if the taxpayer could

have picked up the check he will have

constructive receipt (Rev-Ruling 73-99)

o 2) Knowledge: Was the taxpayer aware that the

check was coming to him?

Rev Ruling 76-3 (pg 628)

Davis v Commissioner

o 3) Contractual Arrangement

If payment is made before it was due the

acceptor does not have to accept it and will

not be held to be in constructive receipt

(Rev Ruling 60-31)

o 4) Forfeitures or Other Penalties

Reg 1.451-2(a)(2) provides that there will be

no constructive receipt of interest on a

certificate of deposit or any other deposit

agreement if an amount equal to three

months interest must be forfeited upon

withdrawal or redemption before maturity

of deposit arrangements one year or less.

o 5) Relationship of the Taxpayer to the Payor

Before a shareholder-employee will be

considered in constructive receipt of the

salary owed her by her corporation, there

must be some corporate action to set aside

or otherwise make the salary available to

the shareholder-employee. In addition he

must have some authority to draw a check

to himself on corporate accounts. Rev-

Ruling 72-317 (pg 630)

b: Specific Exceptions to Constructive Receipt Rules

Various Exceptions Exist to the rule that one who has unfettered

control over the receipt of income must report it.

ex: a taxpayer who refuses a prize does not need to report it

as income. Rev-Rul 57-374

125 (cafeteria plans) an employee who chooses to receive

excludable fringe benefits in lieu of cash from his employer

has turned his back on income, under 125 he does not need

to report this.

o iii: Cash Equivalency Doctrine

1.61-1(a): gross income includes income in any form, whether in money,

property or services.

ex: Things that DO qualify as income

- receipt of an automobile (property with a clear value)

- stock in an account (property with a clear value)

- a bearer bond (represents a promise to pay and should be

included at its FMV at time of receipt 1.161-2(d)(4))

Ex; Things NOT qualified

- Promissory note to pay

- Letter acknowledging promise to pay

- Oral Promise

Cash Equivalency Doctrine: With reference to intangibles (like the

promissory note) this doctrine embodies the notion that certain intangibles

have so clear a value and are so readily marketable that a cash method

taxpayer receiving them should not be entitled to defer reporting of

income. By contrast, other intangibles have no market or even clear

property flavor.

Cowden v. Commissioner

Facts: Cowden and wife leased mineral rights in exchange

for an advance of royalty payment. The payments were

deferred over a period of year. Coweden report them as

long term capital gains, Commissioner say they should have

been taxed on the full amount regardless of the deferred

payment arrangement because it was equivalent to cash.

Rule: A promise to pay will be considered a case equivalent

if it is made by a solvent obligor, “is unconditional and

assignable, not subject to set offs, and is of a kind that is

frequently transferred to lenders or investors at a discount

not substantially greater than the generally prevailing

premium for money.

Williams v. Commissioner:

Facts: Taxpayer performed services for a client who gave

the taxpayer a promissory note payable approximately 8

months later. At the time he gave the taxpayer the note he

has no funds to pay it. He did not report it as income

o Court agreed with the taxpayer reasoning that the

note had been given only as a security for

indebtedness. Considering the note bore no interest

and was not marketable it had no fair market value.

Rev Ruling 68-606: Deferred payment obligation which is readily

marketable and immediately convertible to cash is properly

includable on receipt under the cash method to the extent of its

FMV.

Kahler v. Commissioner: The taxpayer received a commission check

on Dec, 31st after bank hours had closed. Court still held that the

taxpayer should have reported the check as income for that year.

Where services are paid for other than by money, the amount to be

included as income is the FMV of the property taken in payment.

Post-dated checks however will not likely meet the

requirements to result in income.

o iv: Economic Benefit Doctrine

Economic Benefit Doctrine: Gross income includes any economic benefit

conferred upon a taxpayer to the extent that the benefit has an

ascertainable fair market value.

Sproull v. Commissioner: An amount irrevocably placed in trust for the

benefit of an employee constituted income to the employee in that year,

even though the money was not payable to the employee until subsequent

years.

Commissioner v. Smith: Recognized that an economic or financial

benefit conferred upon an employee as compensation was included

in the concept of income.

Minor v. US: Under this doctrine, an employer’s promise to pay deferred

compensation in the future may itself constitute a taxable economic benefit

if the current value of the employer’s promise can be given an appraised

value.

o v: Deferred Compensation

a: Non-qualified Deferred Compensation Arrangements

A non-qualified deferred compensation plan is any elective or non-

elective plan, agreement, method or arrangement between an

employer and an employee to pay the employee compensation

some time in the future. Nonqualified deferred compensation plans

do not afford employers and employees the tax benefits associate

with qualified plans because they do not satisfy all of the

requirements.

Establishing constructive receipt requires a determination that the

taxpayer had control of the receipt of the deferred amounts and

that such control was not subject to substantial limitations or

restrictions.

If an employee has unfettered control over deferred

amounts then the doctrine of constructive receipt will

defeat the deferral objectives of employees possessing such

control .

If a promise to pay in unconditional, assignable,, and the kind

frequently transferred to lenders or investors, such a promise is the

equivalent of cash and taxable in a like manner.

b: Property Transfer Under Section 83 ??

Property transferred in connection with the performance of services

is taxable to the extent that the FMV of the property exceeds the

amount paid for the property by the transferee

Section 83 was designed to heal with situations where the

recipient is the employee of the transferor and the

employee must return the property to the employer if the

employee quits.

o ex: Employer transfers to an employee a share of

corporate stock requiring the employee to earn out

the right to keep the stock by continuing to work for

the employer for a requisite time. If the employee

quit before the time passed he forfeited the stock.

Compensation income would only be reported

when the time of forfeiture lapses.

c: Section 409A and Revenue Ruling 60-31

Rev Ruling 60-31: Hold that a mere promise by the service recipient

to pay the service provider, not represented by ntoes or secured in

any way, does not consititute receipt of income.

Section 409A requires that all amounts deferred under a non-

qualified plan, unless subject to substantial risk of forfeiture, are

currently includable in income UNLESS certain requirements are

satisfied

1) Distributions of deferred compensation must be allowed

only upon separation from service, death, a time specified

in a plan, change in corporation ownership, disability or

unforeseen emergency 409A(a)(2)

2) Except as provided by regulations, acceleration of

benefits is prohibited 409A(a)(3)

3) The election to defer compensation must be made no

layer than the close of the preceding taxable year (before

income has actually been earned) (409A(a)(4)(B)

4) Certain requirements must be met if the plan permits a

delay in payment or change in the form of payment (such a

plan shall not take effect until at least 12 months after the

date on which the election is made) 409A(a)(4)(c)

409A does not apply to arrangements between a service provider

and service recipient if:

1) the service provider is actively engaged in the trade or

business of providing substantial services other than

o a) as an employee

o b) as a director of a corporation

2) The service provider provides such services to two or

more recipient’s to which the provider is not related and

they are not related to one another.

o vi: Prepayments

If the taxpayer is prepaid he must include it in income

1.61-8(b) specifically requires prepayments of rent to be included in the

year of receipt regardless of the period covered.

B: Deductions Under the Cash Method

o i: In General

Expenses are deductible when paid 1.446-1(c)(1)(i), 1.461-1(a)(1)

Deductions are allowed for payments only when “actually made” for

expenditures only “when paid”

When a tax payer “pays” with borrowed funds it is treated as payment for

tax purposes.

Payment is considered as being made when a check is delivered 1.170A-1(b)

The mailing of a check is regarded as delivery

Issuing of a promissory note is not considered payment (Helvering v. Price)

o ii: Cash Method Payments

The deduction method rules of 461 are subject to the capital expenditure

rules of 261

Capital expenditures are not currently deductible

One Year Rule:

Zaninovich v. Commissioner: The ninth circuit adopted the rule in

this case, allowing a taxpayer to deduct a rental payment made in

December for a lease year that extended through November, eleven

months into the following year. The one year-rule preserves the

simplicity of the cash method.

263: 12 month rule under which a taxpayer is not required to

capitalize benefits not extending beyond 12 months, or does not

extend beyond the end of the taxable year in which the payment is

made. 1.263-a-4(d)(3)(1)

ex: On Dec 31, 2010 a taxpayer makes a payment for

insurance which starts on January 10, 2011 and lasts for a

year. The 12 month rule does not apply because the right

attributable to the premium payments extends beyond the

end of the taxable year following the taxable year in which

the payment was made.

XXX: Annual Accounting

A: Restoring Amounts Received Under Claim of Right

o Income is an amount received under a claim of right, without restriction as to

disposition (North American Oil case)

o A tax increase that results from including in income an amount received under a

claim of right will not always be the same as the tax savings resulting from deducting

its repayment in a later year.

o A taxpayer who meets the requirements of 1341(a)(1)-(a)(3) is directed to compute

tax liability under the approach that meets the more favorable tax result

If the tax rate has gone up in year 2, you take a DEDUCTION under 1341(a)

(4) using the year 2 tax rate

If the tax rate has gone down in year 2 you take a TAX CREDIT under 1341(a)

(5) in an amount equal to the added tax occasioned by the prior year’s

inclusion in income. (when you first acquired the income under a claim of

right you compute it’s tax cost (marginal tax rate x amount), and the gain is

this amount)

Credit is only applied when it produces a bigger tax savings than the

deduction alternative

o What are the requirements?

1) There is a $3,000 dollar threshold requirement

2) The restored item must have been included in income for a prior year

because it appeared the taxpayer had an unrestricted right to the income.

You don’t need to have an unchallenged right to the money, but you

have to have more than NO right. You just need to have an

apparent right to the funds.

IRS defines an apparent right as “a semblance of an

unrestricted right in the year received.” Depends on all the

facts available at the end of such year (Rev Rul 68-153)

Does not apply to repayment of funds where taxpayers mere error

or sub sequent event causes taxpayer to have to repay funds which

it did not have a clear right to in the first place.

Dominion Resources v. US: Public Utility company applied 1341 to

customer refunds made in when rates were lower than they had

been when payments were collected in prior years. Service tried to

argue that 1341 does not apply where the taxpayer had actual right

to income

Rule/Holding: There is no a test for actual vs. apparent

control, the test is the “same circumstances rule” –requisite

lack of an unrestricted right to an income item.

3) 1341(a)(2) requires the taxpayer to establish that he did not have an

unrestricted right to the amount received in the prior year.

ie: Voluntary payments would not qualify.

Barret v. Commissioner : TP brought proceeds of option sales into

income. SEC brought charges. TP settled by repaying proceeds.

HELD: good faith, arm’s length settlement of the dispute

had the same effect as a judgment in establishing the fact

and amount of taxpayer’s legal obligation for repayment

and establishing that he didn’t have an “unrestricted right”

when funds were received.

This approach was rejected by Parks v. United States: man sold

business for profit and subsequently settled fraud litigation.

HELD: that the settlement didn’t allow the government the

opportunity to determine if the settlement was the result of

fraud thus making 1341 inapplicable. To refuse to look

behind the settlement essentially reads 1341(a)(1) out of

the statute.

Distinguished in Wang v. Commissioner: TP sold inside info, SEC

initiated criminal proceedings. Settlement, TP repaid funds.

HELD: no initial claim of right, or appearance thereof, for

funds received

B: The Tax Benefit Rule (when TP receives income for items previously deducted)

o Taxpayer recovers an amount that had been deducted in a prior year (you thought it

was a loss, but now you recover it). Ex. Bad Debt Expense was deducted, then

someone repaid, or you paid your state taxes, but then got a refund. TP includes

the recovered amount in income, essentially giving back the tax benefit.

o The inclusionary aspect of the tax benefit rule provides that the recovery constitutes

gross income

However, Section 111 codified the exclusionary aspect. To the extent that a

previously deducted amount did not produce a tax savings, its recovery will

not constitute income.

o Alice Phelan Sullivan Corp v US: (1341 does not have a TAX BENEFIT equivalent)

Facts: 2 Parcels of property were donated to charity by the corporation and

during that year P claimed a charitable deduction and enjoyed a tax benefit.

The lands were returned and taxed as income during the year of recovery.

Held/Rule: Return of charitable gifts is treated as income in the year of their

recovery. Can’t apply tax rate of year of gift.

o No actual recovery of funds in necessary in order to apply the tax benefit rule, all

that is necessary is that the event be fundamentally inconsistent with the prior

deductions

Hillsboro National Bank v. Commissioner:

Facts: Commissioner claimed that H should have reported as

income a refund for tax for which H had taken a deduction even

though the actual funds were returned to shareholders, not to H.

Held/Rule: The basic purpose of the tax benefit rule is not

simply to tax recoveries but to approximate the results of a

transaction-based tax system. Even if TP didn’t get money

back from shares, if it’s later determined he shouldn’t have

taken the deduction in the first instance, he must include

the previous deduction taken in income.

C: Net Operating Losses

o §172: provides that a loss in one year may be used to offset income in another year

so the loss is not wasted.

o §172 is form of relief from harsh result in Burnet v. Sanford & Brooks Co.

Burnet v. Sanford and Brooks Co: Sanford was paid under performance

installments for a long-term dredging contract. Sanford brought suit when

the contract was abandoned. They recovered their losses from the suit and

Commissioner assessed a delinquent tax in the year the funds were

recovered. Was the recovered loss income that needed to be reported?

Holding: Money received was from a contract entered into for profit

and any money earned from the contract must be reported.

172 was created to provide a carryback or carryover period

to lessen this burden

o It may be carried back two years and carried forward twenty years until it has been

fully absorbed.

o TP may elect to totally dispense with the entire two-year carry back period and carry

the loss forward only. 172(b)(3).

ex: Assume a year 3 loss of $100,000. Assume taxable income of $20,000 in

years 1 and 2 and 4. The $100,000 loss is first carried back to year 1 where it

fully offsets the income, Year 1 is therefore reduced to zero and the

taxpayer will file an amended year 1 tax return to this effect and obtain a

tax refund. The remaining $80,000 is then absorbed by year 2 in the same

manner. The unused $60,000 is then carried forward to year 4, where

20,000 more is absorbed. This leaves 40,000 of unused loss to carry forward

to year 5 etc.

o Losses that may be carried forward and backwards are business losses, capital losses

have a different carryover provision. 172(d)(2)

o Unused personal exemptions may not be carried over to other years. 172(d)(3)

o Nonbusiness deductions of individuals are allowable in computing a net operating

loss only to the extent of nonbusiness income. 172(d)(4).

SUMMARY: add together business deductions and nonbusiness deduction

to the extent they do not exceed nonbusiness income. From this total

subtract taxpayer’s gross income and the balance is the individual

taxpayer’s net operating loss.

XXXI: Capital Gains and Losses

A: Historical Overview

o i: Preferential Treatment for Long-Term Capital Gain

The idea is that gain on capital assets accrues over a number of years, and

favorable capital gains treatment is meant to prevent a bunching problem of

having to pay all appreciation tax at the end.

Currently, 15% is the maximum tax rate on capital assets, which must be

held for more than 1 year. See section 1(h)

To encourage investors to fund new ventures and small businesses,

Congress in §1202 allows an exclusion from gross income of 50% of the gain

from the sale or exchange of small business stock held for more than 5

years.

The remainder (other 50%) is taxed at 28% for an effective rate of

14%. 1202 is limited to the greater of (1) 10 times the basis in the

stock or (2) $10k of gain from the disposition of stock 1202(b)(1).

Must be original issue. See 1202 for all requirements.

o ii: Limitation on the Deduction of Capital Gain

Capital losses may only be deducted to the extent of capital gains plus

$3000, and can be carried forward until used.

o iii: Justification for Preferential Capital Gain Treatment

Pros: we shouldn’t tax inflation, prevents lock-in—people wouldn’t transfer

highly appreciated assets until death, this would harm the economy,

encourages investments (stock) which means higher economic growth

Cons: creates needs for complex statutory provisions, better ways to

address issues i.e. adjust basis for inflation.

B: Current Law: Section 1(h)

o i: Maximum Rates on Long-term Capital Gain under the Current Law

Preferential rates of 1(h) apply only to “net capital gain” (NCG)—1222(11)

which is the excess of net long-term capital gain defined as:

[Excess of net long term capital gain (LTCG – LTCL)] – [Short term

capital loss (STCL-STCG)]

Net capital gain is NLTCG-NSTCL

Preferential treatment exists only for long-term capital gains, and

technically only when LTCG exceeds the sum of LTCL and STCL.

STCG are accorded no preference and are therefore subject to tax at

ordinary income rates.

Example 1: STCG Only: Held stock for 10 months and had a $10k

gain. No NCG because this is short term and thus NCG = $0 and

$10k is subject to ordinary income.

Example 2: LTCG Only: Held stock for 2 years. NCG of $10k (NLTCG

of $10k – NSTCL of $0 = NCG of $10k). Thus, $10k is taxed at a

preferential rate of 15% under current law.

Example 3: LTCG and STCG: Assume in addition to facts above, also

has STCG of $10k. NCG would still be $10k. NLTCG of $10k – NSTCL

of $0 = $0). Would pay preferential rate on NCG of $10k and

ordinary income rates on STCG of $10k.

Example 4: LTCG and LTCL: Assume Ex. 2 but also LTCL of $10k. $0-

NCG. NLTCG is $0 – NSTCL is $0 thus NCG = $0.

After 1997 1(h) amendments Congress provided a different rate structure

but kept 1222 definitions.

o ii: The Components of Net Capital Gain

Under 1(h), maximum capital gain rate on NCG will vary depending on

nature of assets giving rise to LTCG.

Will not exceed 28%.

3 components to NCG:

(1) determine portion of NCG which is made up of 28% rate gain

(taxed at max rate of 28%)

(2) determine which portion is unrecaptured 1250 gain (taxed at

max rate of 25%)

(3) any remaining NCG is “adjusted net capital gain” 1(h)(3)

a: 28-Percent Rate Gain

Only subject to 28% tax if 28% is less than income tax. If income tax

is less than 28%, only that amount of tax will be applied to taxes

under this provision. Ex. if ordinary income is 15%, tax this gain

under 15%. If ordinary income is 32%, tax this gain at 28%.

Formula : 28% Rate Gain = Collectibles Gain + 1202 Gain.

Collectibles Gain : 1(h)(5) gain from the sale or exchange of

any rug or antique, metal, gem stamp or coin or other

collectible as defined by 408(m), which is a capital asset

held for more than one year.

1202 gain : defined in 1(h)(7) is 50% of the gain from the sale

or exchange of certain stock (certain small business stock)

described in 1202

Example:

TP in 35% bracket. $5k in LTCG from sale of antique

furniture and $10k in LTCG from a work of art held for three

years. NCG is $15k. Gains from sale of both are 28% rate

gain assets as collectibles under 1(h)(5). Thus subject to

28% on $15k and 35% on other income. If only in 15%

bracket, subject to 15% on all income.

b: Unrecaptured Section 1250 Gain

Subject to a max tax rate of 25% 1(h)(1)(D)

Attributable to long-term capital gain from depreciation allowed

with respect to real estate held for more than one year. 1(h)(6).

Ex: Anna purchased building for $100k. Over 10 years to

$25k in deductions. 10 years later sold building for $100k.

Basis was $75k, so gain was $25k. The only reason Anna

had gain was because she had claimed deprecation and had

to adjust her basis down, thus all $25k is the result of

depreciation deductions and is 1250 gain subject to 25%

tax.

c: Adjusted Net Capital Gain

Total capital gain- 28% gain- unrecaptured 1250 gain = adjusted net

capital gain which is subject to a max tax rate of 15%.

If the taxpayer is in the 15% bracket already, the adjusted net

capital gain is zero.

Classic example of this kind of gain is the sale of stock that is non

qualified small business stock under 1202 that was held by the tp

for more than one year.

Example 1 : Mark is in 35% tax bracket, had $10k in LTCG as

a result of sale of IBM stock held for more than one year.

No other capital gain/loss. Adjusted net cap. Gain is thus

$10k. Thus Mark will pay 15% on his $10k.

Example 2 : Carl has $100k of income. $66 is ordinary, and

$34 is LTCG from sale of Microsoft stock held for more than

one year. First $70 of income is subject to 15% tax.

Amounts less than $140 taxed at 28%. Thus, were it not for

special rules in 1(h), $4k of the capital gain would be subject

to 15% tax, and the remaining $30k would be subject to

28% tax. Thus because of 1(h)(1)(B) the portion of capital

gains that would have been subject to 15% is now subject to

0% and the portion subject to rates higher than 15% is now

subject to 15%. Thus $4k*0%+ $30k*15% = tax on capital

gains.

Example : Mixture of Short-Term Gain, 28-Percent Rate Gain and

Adjusted Net Capital Gain:

Martin is in the 35% tax bracket, during 2010 he has STCG of

$10k, LTCG from sale of work of art of $10k, LTCG from sale

of stock held for more than 2 years. Thus NCG is $20k

(NLTCG-NSTCL). His NCG will be taxed as follows: $10 at

28%, $10k at 15%, and the remaining income (including

STCG) will be taxed at 35%.

d: Adjusted Net Capital Gain: Qualified Dividend Income

Qualified dividend income is treated as part of adjusted net capital

gain and thus taxed at 15% or 0%. 1(h)(3)—first you calculate NCG

absent qualified dividend income, and then add dividend income.

Scheduled to expire at the end of 2010

Qualified dividend income includes dividends from U.S>

corporations and from certain foreign corporations 1(h)(11)(B).

Example 1 : Qualified Dividend Income, With Additional Net

Capital Gain

o L has $10k LTCG from sale of stock, $5k LTCG from

sale of collectible and $3k qualified dividend

income. Thus NCG is $15k (gain sans dividends) -

$5k = $10k; Then $10k + $3k = $13k adjusted net

capital gain.

Qualified dividend income is added only after the preliminary

determination so that if you have a net LTCL, the dividend income

will still be taxed.

Example 2 : Stock sale produces a LTCL rather than a gain.

So NCG is $0. (-$10k - $5k—can’t have negative). Then

adding dividend income produces an adjusted net capital

gain of $3k.

Thus qualified dividend income is assured of taxation at preferential

rates even when there otherwise is no NCG.

o iii: Attribution of Capital Losses Included in the Computation of Net Capital Gain

It is important to determine which long term gains are offset by which

losses. The rules are very pro-TP

STCL are first offset against STCG, and it is only net STCL that must be

attributed to one of the categories of LTCG.

Ex. $5 STCG, $10 STCL, $15 LTCG NCG = $10k

STCG – STCL = $5 NSTCL; LTCG – NSTCL = $10 NCG

Short-term Capital Losses : STCL are first applied to reduce STCG. NSTCL is

then applied to reduce any net gain in the 38% category, then any

unrecaptured 1250 gain, then to reduce any adjusted net capital gain

Long-term Capital Losses : first applied against the LTCG in the same

category (e.g. collectibles to collectibles) then net loss in the 28% category is

applied to reduce unrecaptured 1250 then adjusted net capital gain. Any

net loss in 15% group first reduces 28% gain then reduces unrecaptured

1250 gain.

Example 1: Allocating a NSTCL among Multiple Categories of LTCG

Assume TP is in 35% bracket and has a total LTCG of $15, $9

of which is attributable to sale of stock, and $6 of which is

from the sale of antiques. Also assume $5 NSTCL. Thus,

NCG is $10k ($15-5). The NSTCL first applies to the 28%

gain, so $6-5 is $1. Then to get ANCG subtract 28% gain

from NCG ($10-1)= $9. So $1 will be taxed at 28% and $9

will be taxed at 15%.

Example 2: Allocating Collectibles Loss Among Multiple Categories

of LTCG straight forward pg. 741 if confused

Example 3: Allocating Other LTCL Among Multiple Categories of

LTCG

$5 LTCL resulting from sale of stock held for more than 1

year. NCG is again $10k. ($15-$5) LTCL must be attributed

to the $9k stock sale rather than the 28% gain. Thus, ANCG

is $4 ($10 NCG - $6 28% gain). The remaining $4 is taxed at

15%.

C: Current Law: Application of Section 1211(b) Limitation on the Deduction of Capital Losses

o Capital Losses may be deducted dollar for dollar to the extent of capital gains. For

this limitation makes no difference whether CG and CL are ST or LT.

o To the extent CL exceed CG, up to $3k of additional CL may be deducted from

ordinary income in a given tax year.

o CL which a TP could not deduct because of the 1211(b) limitation may be carried

over to the next tax year 1212(b)

o 1211 is not a deduction granting provision, rather it serves to limit the deduction of

losses which are deductible under other provisions of the code.

Example 1:

Assume Salary is $75k, $5k LTCG from sale of stock, $1k STCG from

sale of stock, $8k LTCL from sale of stock. Thus Gross Income is

$81k ($75k+$5k+1k).

Loss from sale of stock is deductible under §165(c)(2) as a loss on a

transaction entered into for profit.

§165(f) provides that a capital loss may be deducted only to the

extent provided in 1211 and 1212.

1211(b) has two limitations:

Capital gain offset rule : capital losses may be deducted to the extent

of capital gains. PLUS

Ordinary Income offset rule : under 1211(b)(1) and (2), up to $3k of

any capital losses in excess of capital gains may be deducted against

ordinary income.

Thus, total capital loss is $8k and exceeds total capital gains

by $2k. T may deduct capital losses of $6k under the Capital

Gain Offset Rule and $2k of excess capital loss as well under

the Ordinary Income Offset Rule since that amount is less

than $3k—here T may deduct all losses and Adjusted Gross

Income will be $73k ($81k-$8k).

Example 2:

Assume Salary is $75k, $5k LTCG from sale of stock, $1k STCG from

sale of stock, $8k LTCL from sale of stock, $3k STCL from sale of

other investment property. Thus Gross Income is $81k ($75k+

$5k+1k). Total of $11k in capital losses ($8k LTCL and $3k STCL).

§165(c)(2) authorizes a deduction for these losses subject to the

1211(b) limitation. The deduction for capital losses will be limited

under 1211(b) to $9000. She may deduct CL to the extent of CG

($6k) plus up to $3k of the excess of capital losses over capital gains

($3k). AGI is $72 ($81-$9) and T may carry forward $2k of CL.

o Loss of stock is deduction under 165(c)(2), 1211(b) only represents a potential

limitation on the amount of the deduction which may be claimed in the current

year.

o Qualified dividend income is not treated as capital gain income for purposes of

determining the dollar limitation on deductible capital losses because it is not a gain

from the sale or exchange of a capital asset (§1221(1), (3)), thus it is not part of the

1211(b) calculation on deduction capital losses.

o Under 1212(b), capital losses carried over retain their LT or ST status and are

deemed to have been incurred in the carry over year. Excess losses are carried over

from year to year to offset gain or income until used. At death the disappear.

1212(b) establishes two rules for determining which losses were deducted (ST or LT)

and therefore which losses remain to be carried over:

RULE 1 :STCL are netted first against STCL, and LTCL will be netted first

against LTCG. Remaining STCL will then be netted against LTCG. If LTCL

exceed LTCG, excess LTCL ill be netted against STCG if any.

RULE 2 : STCL are deemed to have been deducted first in the ordinary

income offset part of 1211(b), because 1212(b) says the ordinary income

part shall be treated as STCG.

Example : use above facts. First use $5k LTCL to offset LTCG. $3k

LTCL remains. Then use $$1k STCL to offset $1k STCG. $2 STCL

remains. Then the offset the $3k of ordinary income by the

remaining $2k STCL. $1k of ordinary income remains to be offset by

the $3k LTCL. Thus, $2k LTCL carries forward.

D: Definition of Capital Asset

o i: Section 1221(a)(1): Inventory, Stock in Trade, and Property Held Primarily for Sale

The three types of assets listed above are excluded from the definition of

capital asset. Losses on Property in the normal course of business should be

ordinary rather than the recipient of preferential treatment.

Although these categories have some overlap, there are certain things

which might be included in one category, but not another. Ex. Tracts of

land held by a dealer in real property might not be considered either

inventory or stock in trade. Raw materials while inventory might not be

considered property held for sale in ordinary course…

a: Most difficult determination had been the meaning of “property

held primarily for sale to customers in the ordinary course of

business”

Malat v. Riddell: TP was in a joint venture which had

acquired property with intent to develop commercially or

sell at a profit

o Held: Primarily means “of first importance” . TP’s

sole purpose in holding the property was to sell it.

b: Other big issue is gains derived from sales of subdivided real

estate

Ex: TP farmer decides it would be more profitable to dvide

his land and sell it. What is the character of the farmers gain

on the subdivided land?

o Bynum v. Commissioner: B purchased land and lived

on property and conducted a nursery and

landscaping business on the property. Business

borrowed money but was unprofitable, B in an

attempt to pay off the mortgage, improved and

subdivided part of the property and advertised lots

for sale. 20 lots were sold directly by B who

continued to spend 90% of time on nursery, then

claimed resulting income from lot sales as general

contractor. Commissioner said income was ordinary

income since B was in the business of selling lots.

Rule: Capital gains treatment for real estate

is available only for passive investors

Held: LTCG rates should be construed

narrowly. Each determination must be

made on particular facts of case. B was

doing more than simply trying to get out of

debt, he was attempting to subdivide his

lots and personally conduct the

improvements and promotional activities. B

was in essence actively engaged in a second

business. Thus no LTCG treatment.

o ii: Section 1221(a)(2): Property Used in the Taxpayer’s Trade or Business

Real or depreciable property used in a TP’s trade or business does not

qualify as a capital asset (Also see next chapter on Quasi-Capital Assets--

§1231)

o iii: Section 1221(a)(3): Copyrights, Literary, Musical, or Artistic Composition

Copyright, literary, musical, or artistic composition; or similar property was

not a capital asset if held by a taxpayer whose persona efforts created the

property or by a taxpayer whose basis in the property was determined in

whole or in part by reference to the basis of the property in the hands of a

person whose efforts created the property.

Expanded in 1969 to include letters, memoranda, and similar property.

2006 congress provided special tax break for self-created musical works, TP

may elect to have 1221(a)(1) and (a)(3) not apply to sales or exchanges of

TP-created musical compositions or copyrights in musical works—thus they

will receive capital gains treatment, rather than ordinary income treatment

at the election of the TP

o iv: Section 1221(a)(4): Accounts Receivable

No capital asset status for sale of accounts receivable for services rendered

or for inventory type assets sold. Gain realized from sale of AR will be

ordinary income. (Or for accrual TP loss will be ordinary loss).

o v: Section 1221(a)(5): Certain Publications of the US Government

TP contributing publications will not be entitled to charitable deduction, and

if he sells the publications, it will be ordinary income gain.

Only applicable if publications are held but then received the publication or

by a TP whose basis in the publication is determined by reference to the

basis of the publication in the hands of the TP who received the publication.

Ex. If gov. pub. Received by a member of congress free of charge and

donated, no charitable deduction if donated, and if sold, generates ordinary

income. Also if given to a family member who then sells or donates,

ordinary income/no donation.

o vi: Section 1221(a)(8): Supplies Used or Consumed in the Taxpayer’s Trade/Business

No capital asset status for supplies of a type regularly used on consumed by

the TP in the ordinary course of trade or business—so close to inventory

might have been excluded under 1221(a)(1).

o vii: Judicially Established Limited on Capital Asset Characterization

Corn Products Refining Co. v. Commissioner (SCT 1955): a manufacturer of

products made from grain corn sought to protect itself from share increases

in raw corn prices by buying “corn futures” (K for future delivery of raw corn

at a set price) whenever the price of these futures was favorable. TP took

delivery on the futures Ks when necessary to its operations. TP made a

profit on futures contracts, and contended that the futures were capital

assets, generating capital gains and losses on their sales.

HELD: noting the TP’s purchases of futures K’s had been found to

“constitute an integral part of its manufacturing business” held to

the contrary and said that although corn futures do not come within

the literal set of 1221 exclusions, Congress intended that profits and

losses arising from the everyday operation of a business be

considered as ordinary income or loss rather than capital gain or

loss. Capital gains treatment applies only to transactions in

property not a normal sources of business income. Capital assets

definition must be narrowly applied and its exclusions interpreted

broadly.

Essentially added a gloss to 1221.

Thus, when dual purposes applied (held stock to assure source of supply as

well as for investment purposes), TP realizing gain on sale of stock found it

advantageous to emphasize an investment purpose, thus hoping to assure

capital gain treatment. BUT if a loss were realized on sale of stock of

securities, TP relied on Corn Products, and argue that the primary purpose

had been for business reasons, thus qualifying for an ordinary loss.

Tax Court eventually held in WW Windle Company v. Commissioner: “stock

purchased with a substantial investment purpose is a capital asset even if

there is a more substantial business motive for the purchase” and that a

subsequent abandonment of the investment motive was irrelevant. BUT

the Supreme Court rejected this motivation test in Arkansas Best Corp and

said characterization of Corn Products was simply a broad reading of the

inventory exclusion in 1221(a)(1).

Arkansas Best Corp v. Commissioner (1988): a diversified holding company

began acquiring stock in National Bank of Commerce in 1968. Bank

prospered until 1972, when it began to experience problems because of

heavy real estate loans. ABC continued to purchase stock in Bank, and

sought to take an ordinary loss. Tax court said acquisitions after 1972 were

made and held exclusively for business and not investment purposes and

got ordinary loss treatment

RULE: A TP’s motivation in purchasing as asset is irrelevant in

determining whether the asset is a capital asset and thus subject to

capital loss treatment.

HELD: This is a capital loss. Although the stock was bought for

business rather than investment purposes, 1221 does not discuss

motive, listed exceptions to 1221 were meant to be exclusive, to

read a motive requirement into the 1221 exceptions would render

the list superfluous. Corn Products involves an application of 1221’s

inventory exception. ABC is not a dealer in securities, and has never

suggested that Bank stock falls within the inventory exception.

Cenex Inc. v. United States : TP sold petroleum products and, to assure a

sources of supply of refined petroleum products, acquired stock in a

corporation that operated an oil refinery. TP said purchased as an inventory

substitute.

RULE: a TP may not argue that stock is held to ensure a source of

supply and that the loss upon the sale of stock is therefore ordinary.

HELD: inventory subs must bear a close relationship to actual

inventory and can do so if they are closely related to the TP’s

inventory purchase system. Corn futures in Cord Products satisfied

this bc they were redeemable for corn and bc the cost of inventory

was directly related to the cost of the corn futures (gains and losses

on futures was same as gains and losses on corn). Source of supply

doctrine is incompatible with Arkansas Best and not a basis on

which to treat the stock as an ordinary asset.

Azar Nut Company v. Commissioner : part of an employment package offered

to a high level executive was an agreement to purchase the executive’s

house for FMV in the event that he was fired. He was, and company sold

house at a substantial loss. Claimed ordinary loss because residence was

used in trade or business because under a K it was part of an agreement

that was integral to the TP’s trade or business even if asset never played a

role in business operations.

HELD: business purpose is irrelevant to determining whether an

asset is capital. Must play a role in TP’s business operations to not

be capital. To qualify for the “used in” trade or business exception,

an asset must be “used in” the TP’s business, and an asset that has

no meaningful association with the TP’s business operations after it

is acquired cannot reasonably fall within the plain words of the

statute.

Substitute for Ordinary Income Doctrine : Another issue is how to

characterize payments received by the TP who has sold his right to collect

future income:

Stranaham v. Commissioner : TP sold right to collect future dividends

on certain stock

RULE: When proceeds are a substitute for ordinary income,

TP is not entitled to preferential capital gain treatment on

sale.

HELD: Amounts received for the right to collect dividends

must be treated as ordinary income

Hort v. Commissioner : Hort was left a building under the term so fhis

father’s will. One of the tenants wishes to terminate the lease prior

to its expiration date. They settled the leas by paying Hort $140k in

exchange for being released from it. Hort did not report the $140k

as income and claimed a deduction for the difference between the

FMV of the space for the lease and the $140k received.

Commissioner disallowed the deduction and assessed a deficiency

tax on the $140k, Hort claimed $140k as a capital gain, and even if

ordinary income he sustained a loss on the unexpired portion of the

lease.

RULE: When a lease is terminated prior to the expiration

date and the TP received cash compensation, it must be

reported as ordinary income.

HELD: Hort received the payments as substitute for rent,

and 61(a) would have required Hort to include prepaid rent

or an award for breach of K as income. H received money in

lieu of rental income he was entitled to under the lease.

Since it was a substitute for ordinary income it must be

treated in the same manner. Furthermore no loss was

sustained, he released a lega right for a settlement sum, he

didn’t have to do so, injury can only be fixed when extent of

loss can be ascertained, i.e. when property is re-rented.

Until that time, no loss is deductible.

Davis v. Commissioner : Davis claimed that amounts he received in

exchange for his assignment of his right to receive a portion of

annual lottery payments that he had won were capital gains, but the

IRS determined that they were ordinary income.

RULE: Amounts received by a TP in exchange for the

assignment of their right to receive a portion of certain

future annual lottery payments are ordinary income.

HELD: The issue is whether the right to receive future

annual lottery payments constitutes a “capital asset” as

defined in IRC 1221. Right to receive future lottery

payments is not a capital asset, thus payment for that right

is not a capital asset

E: The Sale or Exchange Requirement

o 1222 requires a sale or exchange before gains and losses on capital assets can be

treated as capital gains and losses, but sale or exchange has been given a broad

meaning.

o Examples:

Kenan v. Commissioner : satisfaction of a bequest with appreciated property

constituted a sale or exchange.

Yarbro v . Commissioner: abanconment of inimproved real estate subject to

a nonrecourse mortgage exceeding the market value is sale or exchange

Helvering v. Nebraska Bridge Supply & Lumber Co .: tax forfeiture constituted

a “sale or exchange”

Helvering v. Hammel : involuntary foreclosure sale of real estate is a sale or

exchange

Freeland v. Commissioner : conveyance of land to a mortgagee by a quitclaim

deed is a sale or exchange

o These things are different in substance but not form from a sale or exchange and a

TP should not be able to avoid capital characterization simply by not “actually”

selling.

F: The Arrowsmith Rule: Characterization of Certain Gains or Losses Dependent on Prior Tax

Treatment of Related Gains or Losses.

o When a company liquidates, liquidation proceeds are considered gains or losses

from an exchange of stock and thus a capital gain or loss. Subsequent to liquidation,

however, shareholders may be held liable for unpaid debts of the corporation, and

then is entitled to claim a loss, an issue arises as to the characterization of that loss.

o Arrowsmith v. Commissioner : even though payment of corporate debt does not

constitute sale or exchange, it is considered a sale or exchange because it is

considered in conjunction with the overall liquidation, and if payment would have

been made before sh received pay out it would have been a reduction in capital

gain.

o U.S. v. Skelly Oil : TP refunded approximately $505,000 to certain customers for

overcharges on sale of natural gas in prior years, had included in income in prior

year, thus sought a deduction under the claim-of-right doctrine. However, in prior

year, TP had taken a 28% depletion deduction

HELD: Annual accounting doesn’t require court to close eyes to what

happened in prior years. TP should not be given a deduction for refunding

money that was not taxed when received, thus the 28% will not give rise to

a deduction but the remaining amount of the refund may be deducted.

o OVERALL RULE: gains or losses generated as a result of a transaction covering more

than one year may be characterized as capital gains or losses even though

technically the sale or exchange requirement does not appear to be met.

G: Holding Period

o Property must be held for more than one year before its sale or exchange if there is

to be a long-term capital gain or loss.

o Limitation on deductibility of capital losses does not depend on long term or short

term nature of the loss.

XXXIV: Assignment of Income

A: Progressive Rate Structure

o There is an obvious tax savings to taxpayers in shifting income from a higher-bracket

taxpayer to a lower-bracket taxpayer

o Our tax system taxes people at progressive rates on net income.

B: Development of Rules for Limiting Income Shifting

o Stranahan v. Commissioner : Decedent Stranahan assigned his rights to anticipated

dividends to avoid tax liability. Assigned his rights to anticipated dividends in certain

tocks to his son in consideration of $115k.

RULE: a taxpayer stockholder may assign his rights to anticipated dividends

in exchange for the present discounted value of those dividends in order to

avoid tax liability so long as the assignment is a bona fide, good-faith

commercial transaction. (Outcome would have been different if assignment

was gratuitous rather than for consideration)

HELD: Must be a commercial transaction, here it was economically

realistic, P received payment, and divested himself of interest in the

dividends.

o Characterizing income as capital gains may also lower the tax

o 2 general rules for determining the “who” question

(1) Income is taxed to the taxpayer who controls the earning of the income

i.e. high tax bracket employee can’t direct his income to be paid to

his low income bracket child in order to avoid taxes

Lucas v. Earl: Earls entered into a contract whereby they agree that

whatever each acquired in any way during their marriage would be

received and owned by them as joint tenants. Hear claimed he

could be taxed for only half of his income.

RULE: a statute can tax salaries of those who earned them

and can provide that a tax cannot be escaped by

anticipatory arrangements or contracts that prevent salary

from vesting even for a second in the person who earned it.

tree fruit metaphor : fruits cannot be attributed to a

different tree than that from which they grew.

Helvering v. Eubank : Eubank was terminated as a life insurance

agent, after his termination he assigned commissions to become

payable for services performed before his termination.

RULE: commissions assigned by the taxpayer are taxable in

the year in which they became payable, thus he is

responsible for paying the tax on them rather than the

individuals to which he assigned his earlier earned income.

(2) Income from property is taxed to the one who owns the property

i.e. landlord can’t direct tenant payments to child

Helvering v. Horst : Shortly before their due date, Horst detached

negotiable interest coupons from negotiable bonds and gave them

to his son, who in the same year collected them at maturity

RULE: For income tax purposes, the power to dispose of

income is the equivalent of ownership of it, and the exercise

of that power to transfer payment of the income to another

is the equivalent of realization of the income.

HELD: the owner of bonds is lender, and when by gift of

coupons he separates his right to interest payments and

procures payment of interest to donee, he is essentially

transferring earnings. The fruit is not to be attributed to a

different tree from that on which it grew. Horst must pay

taxes. (donor)

May v. Commissioner : May deeded property to an irrevocable trust

for the benefit of his children and then leased back the property

from the trust for $1k per month. Attempted to deduct rental

expense as a ordinary and business expense deduction.

RULE: in a gift-leaseback situation, rental payments are

deductible if the transfer was irrevocable and the benefits

inure to the trust

HELD: The issue is the sufficiency of the property interest

transferred. 4 factors must be considered:

o Duration of the transfer

o Controls retained by the donor

o Use of the property for the benefit of the donor

o Independence of the trustee

o Community Property

Earnings during marriage are deemed the property of the husband-wife

community and not the property of the spouse performing the services

generating the earnings.

Poe v. Seaborn : each spouse was taxable on half of his or her earnings and

on half of the spouse’s earnings. This permits spouses to split their income.

This rule means couple’s tax rate could vary depending on if they live in CL

or community property jurisdiction—Congress now allows joint returns.

Where community property jurisdiction applies, Eatinger v. Commisioner:

employee spouse required as part of a divorce decree to pay half of pension

to non-employee ex spouse. Each will be taxable on half the pension

benefits. Also applies when spouse postponed benefits

Dunkin v. Commissioner . Giving spouse could deduct half from income,

receiving spouse had to report half in her income.

Court distinguished Lucas as this being a community property case

C: Application of the Assignment of Income Rules

o Kochansky v. Commissioner : husband agreed to pay wife part of contingent fee for

client representation in divorce settlement. Court said this was governed by Lucas

and the husband had to pay the entire tax because he earned the income.

o Commissioner v. Ginnini : taxpayer refused to accept compensation for his services

to BOD. Said they could donate it. Court said he had refused a right to property,

when there is abandonment, without transfer of property to another, the property

cannot be taxed upon the theory that it was received. He didn’t tell the corp. to

give money to any specific corporation—therefore this is not an assignment of

income. He never had income to begin with.

o Sometimes turns on Agency Law:

Worked in clinic for law school and gave all funds to school—no income

received

Psychologist taking vow of poverty still received amounts as income

because he selected clients, established fees, maintained records (even

though he turned over money, he still received it in the first instance).

Foggerty v. Commissioner: Priest who received salary for teaching had to

pay taxes on salary, not merely an agent of the church.

o Sometimes services create property.

Ex. author mother gives copyright to son. One might argue income from

story is personal services income, but the copyright would be treated as

property and the amounts received by the son upon the sale of the story to

a publisher would constitute income to the son and not to the author.

o When you must transfer property—before income has actually been realized

(distinction between declaration and record date as it relates to stocks)

Bishop v. Shaughnessy : if a corp declares a stock dividend payable to

holders on record date, a gratuitous transfer on record date will not deflect

dividend to the donee

Caruth v. U.S. : s/h transferred stock after dividend but before record date,

dividend income not taxed to donor

Crucial question is whether the asset itself or merely the income

from it has been transferred. If the taxpayer gives away the entire

asset, the assignment of income doctrine does not apply.

Fail to see why the ripeness of the fruit is relevant so long as the

entire tree is transplanted before the fruit is harvested

o Rauenhorst v. Commissioner : corp received notice that corp. would be acquired,

and taxpayers gave their warrants to stock to charities. Charities under no

obligation to sell to acquirers, but did. Taxpayer not responsible for taxes, because

charities had discretion of what to do with warrants—could have kept them.

o Salvatore v. Commissioner: Salvatore conveyed half of her gas station to her

children as a gift just prior to selling it.

RULE: The true nature of a transaction, rather than formalisms, determines

the tax consequences

HELD: Salvatore’s tax liabilities cannot be altered by a rearrangement of the

legal title after the sale was already contracted. Therefore, all of the gain on

the sale was property taxable to Salvatore.

D: Income Shifting Within Families and Between Related Parties

o Intra-family income shifting “kiddie tax” §1(g)effect of taxing the unearned income

of certain children at the top marginal rate of their parents. Negates benefit of

shifting income to a lower-bracket taxpayer.

o If one corporation does work for the other and under or over charges for work,

income has been artificially shifted

o Individual service provider makes corp which hires service provider and contracts

with third parties

o Ordinarily corporate formalities are respected but sometimes there are

controversies

Sargent v. Commissioner : professional hockey player formed personal

service corp. which hired payer as employee and contracted with

professional hockey team.

Court of appeals found he was employee of corp. didn’t matter that

team had control

Leavell v. Commissioner : same facts, except a basketball player

Tax court found basketball team not personal service corp

controlled manner in which the taxpayer provided services, thus he

was an employee of the team

XXXVIII: Nonrecourse Debt: Basis and Amount Realized Revisited

A: Crane v. Commissioner

o Facts: TP inherited property encumbered by considerable nonrecourse debt.

Claimed depreciation deduction based on FMV of property at time of decedents

death. Later sold for small amount of cash, and purchaser took property subject to

outstanding debt.

o Question: what was the amount of gain realized on the sale.

o Basis: on property when acquired is FMV at decedents time of death §1014(a)

o Amount Realized: includes amount of nonrecourse debt taken subject to by the

purchaser

o RULE:

Liabilities, whether recourse or nonrecourse, taken subject to or otherwise

incurred in the acquisition of property, are included in TP/purchasers basis

Liabilities of seller, recourse or nonrecourse, assumed are included in

seller’s amount realized

o FN 37 : considered the idea that nonrecourse assumed might not be included in

amount realized if the mortgage is greater than the FMV of the property.

B: Commissioner v. Tufts

o FACTS: FMV of property went down so that mortgage ended up exceeding FMV. TP

sold property and contended that the assumption of a mortgage that exceeded the

FMV of the property by the purchaser should not be included in amount realized.

o RULE: The assumption of nonrecourse mortgage constitutes a taxable gain t the

mortgagor even if the mortgage exceeds the FMV of the property.

o Held: Supreme Court reversed the lower court’s decision and found that the entire

amount of nonrecourse indebtedness had to be included in the amount realized.

See also §7701(g). Entire amount of mortgage is included in the orginal basis and

must be taken into account on sale.

o 1001-2(b) FMV of property is not relevant in determining the TP’s amount realized.

o Revenue Ruling 91-31 : nonrecourse debt reduced by creditor (not the seller of the

property), service held this was discharge of indebtedness under 61(a)(12) rather

than reduction in basis of property.

What result of seller was also creditor? Purchase Money Debt Reduction

(see chapter 9).

o Aizawa v. Commissioner : A purchased property for $120k and gave a recourse

mortgage for $90k. Defaulted, creditor said entire deficiency judgment (including

interest) was $133,506. Sold land for $72,700—reduced deficiency judgment to

$60,806k. A claimed his amount realized on the sell should be the amount of debt

forgiven, which he calculated as the original principal, minus the new deficiency

judgment owed--$29,193 ($90k-60,806).

HELD: The remaining deficiency judgment against A includes not only

principal amounts, but also interest, atty’s fees and other costs. Where the

discharge of recourse liability is separated from the foreclosure, the amount

of the proceeds from the sale becomes insignificant, thus the true amount

realized is $72,700 (the amount the property sold for) which can be

deducted from A’s original basis to determine his loss. Thus, A’s loss is

original basis of $100,091 (depreciation deductions) - $72,700 = $27,391.

RULE: Amount realized on a foreclosure sale is represented by the proceeds

of the sale.

o But think about 1.1001-2(a)(1): amount realized includes the amount of liabilities

from which the transferor is discharged on account of the sale

C: Nonrecourse Borrowing and the 108 Insolvency Exclusion

o The amount by which a nonrecourse debt exceeds the FMV of the property securing

the debt should be treated as a liability in determining insolvency for purposes of

§108(d)(3) of the Code to the extent that the excess nonrecourse debt is discharged.

Revenue Ruling 92-53. Otherwise the discharge could give rise to a current tax

when the taxpayer lacks the ability to pay that tax.

o Nonrecourse debt should also be treated as a liability in determining insolvency

under §108 to the extent of the FMV of the property securing the debt.

o However, when that debt is not discharged, it should not be treated as a liability for

insolvency purposes.

o Ex.

Figures:

TP owed $500k on nonrecourse loan, secured by property FMV

fallen to $400k.

Other assets FMV $100k. Other debts $50k.

Bank agreed to reduce nonrecourse debt by $75k.

Indebtedness for purposes of the 108(a)(1)(B) exclusion:

Recourse debt $50k

Nonrecourse up to FMV $400k (see b above)

Nonrecourse forgiven $75k (see a above)

The $25k remaining non-recourse is not included because the

creditor did not forgive this nonrecourse debt. (see c above)

Total indebtedness = $525k

Taxpayer’s total assets are $500k

$400k in property + $100k in other assets

Thus, the taxpayer’s debt exceeds his assets by $25k ($525-$500),

and the TP is considered insolvent to that extent, thus, $25k of the

$75k of discharged indebtedness will be excluded from income and

he will only be taxed on $50k.

D: Nonrecourse Borrowing and Appreciated Property

o Example:

Facts:

B purchased building for $100k ($20k cash + $80k nonrecourse loan)

Paid loan down to $30k.

Building is now worth $500k FMV.

B refinances and borrows $280k

$30k, pays off old mortgage

$250k invests in business venture

B’s adjusted basis in the building is $40k (resulting from $60k

depreciation)

B sells he building a year later for $600k ($320k in cash and subject

to the $280k mortgage)

Analysis:

Because loan is not used to improve building, doesn’t result in any

adjustment of the building’s basis.

Thus, B’s amount realized is $600k, his adjusted basis is $40k, thus

his gain recognized is $560k

o Woodsam Associates, Inc. v. Commissioner: (1952): Woods borrowed on a

nonrecourse basis an amount in excess of her adjusted basis in the property. Later

contributed property to corp, which disposed of property at foreclosure sale. Court

held that borrowing against property didn’t increase basis in property.

E: Impact of Contingent Liabilities

o Potential for abuse. A buyer could purchase property with a nonrecourse note and

pay an inflated purchase price so that deductions would be larger and interest

payments would be deductible. Seller would have no risk because he could just

report gain only if and when paid on an installment basis.

o Some circuits deny any inclusion in basis for nonrecourse debt when the amount is

excessive in relation to the property’s fmv:

Estate of Franklin (9th Cir.):

HELD: purchase price for certain real property exceeded its fair

market value and therefore the TP could not be expected to make

the investment represented by the nonrecourse debt. As a result,

the court ignored the nonrecourse payment for purposes of

depreciation and interest deductions.

RULE: depreciation is not predicated upon ownership of property

but rather upon an investment in the property

Berstrom v. U.S. (Fed. Cir.) when nonrecourse purchase money debt

exceeds a reasonable approximation of the property’s FMV, the debt is

disregarded in its entirety for the purposes of determining depreciation and

interest deductions.

o Other circuit’s permit inclusion of nonrecourse debt in basis up to the FMV of the

property:

Pleasant Summit (1988) (3rd Cir.): permitted the nonrecourse debt itself to

generate basis to the extent of the FMV of the property.

Lebowitze v. Commissioner: (2d Cir.) Even if the value of the underlying

asset was “substantially less” than the nonrecourse debt, the TP was still

entitled to a basis in the asset up to the FMV.

Lukens v. Commissioner (5th Cir.): relevant question is whether it would be

reasonable for the buyer/debtor to make a capital investment in the unpaid

purchase price.

o Reconciling the rules in Tufts and Estate of Franklin

Tufts requires nonrecourse debt to be included in the amount realized on

the disposition of property even though the debt exceeds the FMV of the

property

Estate of Franklin court refused to recognize debt because it exceeded FMV

The two cases are factually distinguishable:

Tufts: original debt did not exceed the value of the property

Estate of Franklin: debt incurred exceeded the FMV of

property securing its payment

F: Bifurcation of Recourse Liability Assumed

(This section is based on a John Lee class discussion)

o RULE: When you transfer property to a creditor that is subject to a nonrecourse

debt and you transfer the property back to the creditor in satisfaction of that debt,

the entire amount of the debt is included in the amount realized, even if the FMV of

the property is less than the value of the debt. See Treas. Reg. § 1.1001-2(c) ex. 7.

Also see example 8—the entire amount of nonrecourse debt is the amount realized.

HOWERVER, if the debt is recourse, you bifurcate the debt. First transaction

is the discharge of debt (which is ordinary gain/loss), the second is the land

sale (which is capital gain /loss)

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11/23/11 11:58 AM