taxation of individual income outline · 2014 summer taxation of individual income! murphy! page 2...

2014 SUMMER TAXATION OF INDIVIDUAL INCOME MURPHY

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Taxation of Individual Income Outline Professor: Ann Murphy

I. INTRODUCTION A. Sources Of Law

1. Constitution a) 16th Amendment gave power to Tax

2. Internal Revenue Code a) Title 26 of the United States Code b) Subtitle A: Income Taxes (Individual and Business) c) Subtitle F: Procedure & Administration

3. Regulations a) General: created by Internal Revenue Service & Treasury Department b) Enabling Statute: gives Secretary of Treasury power to “prescribe all needful

rule & regulations for the enforcement of this title.” (26 USC § 7805(a)) c) Found In: 26 C.F.R.____; Tres. Reg. ___ d) What They Cover: Treasury regs expands on how things are taxed but does not

change taxpayers substantive rights as to what is subject to tax. e) As long as the Treasury doesn’t clearly exceed authority, the regulation is as

good as law. (Chevron) f) Types of Regulations

(1) Proposed Regulations: 30 day notice and comment period (2) Legislative Regulations: force of law, follows notice and comment rules (3) Temporary Regulations: 3 year expiration unless it becomes Leg. Reg.

4. Administrative Rulings a) General: from IRS in the form of Rulings and Pronouncements b) Private Letter Rulings: answer to a specific question put to the IRS

(1) Binding only to the taxpayer that requests/receives it c) Technical Advice Memoranda: Request by IRS agent during an audit on a

question that can’t be answered locally. Applies only to taxpayer. More useful than PLR.

d) Determination Letters: Not precedent but are useful for understanding IRS position and strategy.

e) Revenue Ruling: declaration of how IRS is going to treat an issue 5. Case Law

a) General: US Tax Courts and US District Courts have jurisdiction over tax cases b) U.S. Tax Court

(1) Taxpayer doesn’t have to pay the tax before challenging the tax in court (2) No jury (3) Jurisdiction over entire tax return (4) Precedent is binding on all taxpayers across U.S. unless overruled by

higher court, appeal to Circuit Court of Appeals. (5) Tax Court Decision: citable precedent (groundbreaking)


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(6) Tax Court Memorandum Decision: citable but less weight (mundane) c) U.S. District Courts

(1) Refund Cases: taxpayer must pay tax before challenging the tax in court (2) Jury Optional (3) Limited jurisdiction to hear certain issues disputed by the taxpayer (4) Decisions binding on taxpayers within the jurisdiction of the district court (5) Appeal to Circuit Court of Appeals

d) U.S. Court of Federal Claims (1) Refund Cases: taxpayer must pay tax before challenging the tax in court (2) Jurisdiction limited to certain issues disputed by the taxpayer (3) Precedents binding on all taxpayers across U.S. (4) Appeal to the Circuit Court of Appeals.

e) U.S. Circuit Court of Appeals (1) Hears appeals from all trial courts on taxation (2) Precedent only binding on taxpayers within the court’s circuit

B. Tax Rates and Progressivity 1. Progressive: as taxable income increases, the tax rate increases (US System)

a) Argument for Progressivity in Taxation (1) Marginal Utility: as one becomes wealthier the utility of money declines (2) Wealthy people should pay more because they benefit more from usage. (3) Accomplishes some degree of wealth redistribution

b) Arguments against Progressivity in Taxation (1) Makes the tax code more complex (2) Distorts taxpayer decisions to work or not work (3) Inequities between similar taxpayers

2. Regressive Taxation: all taxpayers pay the same amount of tax in relation to the tax base 3. Effective Tax Rate: average rate at which a taxpayer is actually taxed on income

a) Calculation = Tax Liability / Taxable Income 4. Marginal Tax Rate: rate applicable to taxpayer’s next dollar of taxable income

a) Note: this will be the % of the tax bracket the taxpayer is in C. Impact of Filing Status

1. Generally a) Liability (§1): tax liability depends on

(1) 1) individual's filing status and (2) 2) taxable income

b) Required to file a return by April 15 of the following year unless income less than exemption plus standard deduction (§6072(a))

c) SOL: Statute of Limitations is typically 3 years from the time of filing. 2. Married

a) Married Filing Jointly (1) Spouses combine income and tax returns (§1(a))

(a) Policy: man + wife = 1 economic unit (2) Last Day: if the couple is married on the last day of the taxable year, the

couple can file a joint return for the year (§ 7703(a)) (3) Surviving Spouse: a surviving spouse is generally an individual whose

spouse died in either of the 2 prior years and who maintains a home that is also the principal residence of their child or stepchild. (§2(a))

(4) Same Sex: same sex couples can file jointly if they live in a state, or were


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married in a state, where same-sex marriage is legal. (5) Liability: if return shows taxes due when filing jointly, both spouses are

jointly and severally liable for full amount (§6151(a)) (6) The Innocent Spouse Rules

(a) General: there are 3 methods for an innocent spouse to be relieved of joint and several liability (§6015)

(i) Innocent Spouse (§6015(b)) (a) Joint return filed (b) Understatement due to erroneous items of one

spouse (c) Other spouse did not know or have reason to know

(i) Reason to Know: factual inquiry whether a reasonably prudent taxpayer in the spouses position at the time she signed the return could be expected to know that the stated liability was erroneous or that further investigation was warranted. (Cheshire)

(ii) Separated: spouse who filed joint return can elect to limit income tax liability for that year to separate liability amount only if (§6015(c))

(a) No longer married, legally separated, or do not reside together over a 12 month period and

(b) Had no actual knowledge of the item causing a deficiency at the time the spouse signed the return.

(iii) Secretary of Treasury: may grant equitable relief if not available under b or c. (§6015(f))

(b) Burden of Proof: taxpayer has burden of proof for (b) and (c )(3) knowledge requirement.

(c) INVALID if evidence of fraudulent transfer between parties b) Married Filing Separately

(1) Married person files separate from spouse (2) Tax rates are half of the married filed jointly (§1(d)) (3) Preferred if do not trust spouse or if wanting to maintain separate

property 3. Single

a) Unmarried/Single (1) Unmarried & Not Head of Household (§1(c))

b) Head of Household (1) More generous tax rates than unmarried (§1(b)) (2) Head of Household (§2(b)

(a) Person who maintains home as a principal residence with a dependent (child/ stepchild/ grandchild)

(b) For at least half the year, and (c) Neither married nor a surviving spouse

4. Adjustments to Basic Rate Tables a) Inflation adjustments: annual adjustment to keep up with inflation (§1(f)(1)) b) Rules for adjustments (§1(f)(2)-(6)) c) Mitigates marriage penalty effect in lower tax brackets (§1(f)(8))


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d) Added 10% rate bracket (now 6 rate brackets) (§1(i)(1)) e) Sets fixed bracket amounts for lowest rate (§1(i)(1)(B)) f) Requires inflation adjustments to amounts as of 2004 (§1(i)(1)(c)) g) Rate reductions applicable to four highest brackets for all taxpayers (§1(i)(2))

5. Tax Brackets a) < $36,900 - 15% b) to $89,150 - 28% c) to $140,000 - 31% d) to $250,000 - 36% e) > $250,000 - 39.6%

II. INCOME A. General: Everything is included in income under §61, unless specifically excluded.

1. Determining Taxable Income a) Gross Income: “all income from whatever source derived.”(16th Amendment)

including (§61(a)): (1)

b) Equation (§62(a)): Adjusted Gross Income (AGI) = Gross Income - Above Line Deductions

c) Taxable Income: the code has two methods for determining taxable income based upon whether the taxpayer uses the standard deduction or itemized deductions.

(1) Standard (§63(b)) (a) Taxable Income = Adjusted Gross Income minus Standard

Deduction and Personal Exemption(s) (2) Itemized (§63(a),(c))

(a) Taxable Income = Adjusted Gross Income minus Personal Expense Deductions & deduction for personal exemptions.”

(3) Choice (§63(e)): Taxpayer choice as to selection between §63(a) & (b). B. Gross Income

1. Definitions of Income a) IRC §61(a): “all income from whatever source derived.” Using language from

the 16th Amendment. This includes: (1) Compensation for services, including fees, commissions, fringe benefits,

and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest earned (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.


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b) Early: (unofficial) the sum of a taxpayer’s consumption plus change in wealth for a particular period. (Haig-Simons)

(1) Income = Consumption + Change in Wealth c) Regulations: Treas. Reg. §§1.61-2(d)(1); 1.61-14(a) d) Examples of Income: §61(a) not an exclusive list

2. Defining Gross Income a) OLD: the gain derived from capital from labor, or from both combined (Eisner,

split in stocks) b) NEW: an accession to wealth, clearly realized, & over which the taxpayer has

complete dominion and control. (Glenshaw Glass, punitive damages) 3. Found Money

a) General: found money is “clearly realized” when found. (Cesarini, piano cash) b) Treasure Trove: the finder of a treasure trove is subject to Federal income tax to

the extent of its value in US Currency for the taxable year in which they undisputedly possessed it. (Treas. Reg. §1.61-14(a)); (Rev Rul. 61, 1953-1, Cum. Bull. 17)

4. Bartering a) General: when payment is received in services or goods the fair market value of

the property or services is taxable income. (Treas. Reg. §1.61-2(d)(1)); (Revenue Ruling 79-24 (1979-1 C.B. 60))

5. Imputing Income: when the taxpayer has realized some sort of benefit but the transaction was not something that is easily discernable, the IRS may impute income to the taxpayer by requiring the taxpayer to recognize income on that item. Substance over form.

6. Illegal Income a) General: earnings acquired, lawfully or unlawfully, without the consensual

recognition, express or implied, of an obligation to repay is income (James, embezzled funds)

b) Restitution: a victim’s restitution claim is secondary to the IRS’s tax lien on stolen funds.

7. Compensation for Services a) Payments to Third Parties §61(a)(1): all forms of compensation for services must

be included in gross income. Taxable compensation does not have be received directly by the taxpayer. (Treas. Reg. § §1.61-2(a)(1); 1.61-2(d)(1)-(2)(i)) Including:

(1) Taxes: paying employee’s taxes(Old Colony Trust, employer pays taxes) (2) Vacations: rewarding employee with trip to Vegas (McCann, Vegas

“business trip”) (a) EXCEPT: the presence of a legitimate purpose and no appreciable

amount of time was spent on personal benefit and enjoyment. (Gotcher, VW Germany trip)

(3) Meals and Lodging (a) Furnished on Employer’s Premises (119(a))

(i) Meals (Kowalski, meal stipend): employer may deduct, and employee not include as income, meals when

(a) furnished by the employer; (b) for the convenience by the employer; and (c) served on the business premises of the employer.

(ii) Lodging (Adams, Japan business home): An employer


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may provide your lodging as part of employment, deduct it, and have the taxpayer not recognize it. There are 4 special requirements for it:

(a) lodging must be furnished by the employer; (b) lodging must be for the convenience by the

employer; (c) lodging must be on or near the business premises

of the employer; and (d) Employee is required to accept the lodging as

condition of employment. (4) Property Received for Services: Included in income when it’s not subject

to forfeiture but may elect to be taxable in year of transfer. (5) Statutory Fringe Benefits: excludable fringe benefit must be for the

convenience of the employer & on the employer’s premises. (a) Excluded Fringe Benefits (§132(a))

(i) No-Additional-Cost Service: if the employer provides the employee a service which does not cost the employer anything additional

(a) Examples: Airlines - free flights, Hotels - free room

(b) NO RESERVATIONS ALLOWED (ii) Qualified Employee Discount: discounts for employees

within the acceptable range (iii) Working Condition: things that would be business

expenses for the self-employed (licensing costs) (iv) De Minimis: accounting for it is administratively

impractical (a) Turkey once a year, but not regular turkeys (b) Donuts

(v) Qualified Transportation (§132(f)): an employer may provide $130 transit pass, or $250 a month in parking

(vi) Qualified Moving Expense Reimbursement (§132(g)): (a) Items that would be deductible under §217 (b) Transportation and moving your items (c) EXCEPT: Food

(vii) Qualified Retirement Planning Services, or (viii) Qualified Military Base Realignment and Closure

(b) Additional Fringe Exclusions (i) Auto Salesman using cars for demonstration

(ii) On-premises gyms and athletic facility C. Not Income

1. Gifts a) General: specifically excluded and not taxable to the receiving party. (§102(a))

(1) Estate Tax: may be taxable to donor/transferor. (2) Policy: Difficult for IRS to track. Matter of administrative convenience.

Not equitable to tax donee. (3) Deduction: gifts are viewed as personal consumption to donor, therefore

no deduction.


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(4) Gains: no gains on appreciated property transferred as gift. Gifts of property take transfer basis.

b) Gifts of Income: a gift of income stream is taxable income. c) Gifts to Employees: the donor must exhibit detached and disinterested

generosity. (Duberstein, car for leads) (1) Tips: are income and not gifts.(Olk, casino tips) Court looked at

(a) the regularity of the flow (b) the equal division of receipts, and (c) the daily amount received

(2) EXCEPTIONS: (a) Former employees (b) Independent contractors (c) Survivors of employees.

2. Bequest/Devise/Inheritance a) General: distributee never pays tax on receipts through bequest, devise, or

inheritance. (1) State Estate Tax: some states have tax on distributor. (2) Requirement: receipts by bequest must be from “detached disinterested

generosity” and not payment for services. (Wolder, legal services for stock) (Rev. Rul. 67-375, 1967-2 C.B. 60 (1967), estate for end of life care)

3. Loans and the Cancellation of Debt a) General Rule: A loan is not gross income to the borrower but the forgiveness of

debt is income to the forgiven party. (IRC §§61(a)(4), (a)(12); §108(a)-(b)(2), (c)-(d)(3), (e)(5))

(1) Loans (a) Loan: not income because borrower has an obligation to repay the

loan, there is no accession to wealth from the loan. Loan just converts one asset (cash) into another asset (promise of repayment).

(b) Repayment: amounts paid to satisfy the loan obligation not deductible by the borrower.

(c) Interest: interest paid to the lender is included in the lender’s gross income and is sometimes deductible by the taxpayer. (§61(a)(4))

(i) Deductibility of Interest: interest paid in connection with borrower’s business activity will be deductible, but interest paid on loans for personal expenses (exception of home mortgage) are not deductible. (§163)

b) Cancellation of Debt (1) General: cancellation of debt is income. (§61(a)(12)) (Zarin, gambling

debt settlement) (2) “If the corporation purchases and retires any of such bonds at a price less

than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.” (Treas. Reg. §1303) (Kirby Lumber Co., buy back bonds cheap)

(3) EXCEPTIONS (§108): (a) the discharge occurs in a title 11 case (bankruptcy),


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(b) the discharge occurs when the taxpayer is insolvent (usually bankruptcy)

(c) the indebtedness discharged is qualified farm indebtedness, (d) in the case of a taxpayer other than a C corporation, the

indebtedness discharged is qualified real property business indebtedness, or

(e) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013 (discharge of home mortgage).

(4) Contested Liability Doctrine: If a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of the debt cognizable for tax purposes.

4. Gains From Property a) General Rule: income includes gains from the sale of property. (§61(a)(3))

(1) Recognition: gain is only recognized when the gain is realized. (2) Realization: gain is realized when the cost of the capital investment is

recovered. b) Legal Authorities

(1) Code Sections:IRC § §61(a)(3); 109; 1001(a)-(c); 1011(a); 1012; 1017 (2) Regs: Treas. Reg. §§1.61-6(a); 1.263(a)-2(e); 1.1012-1(c)(1)

c) Computation of Capital Gains and Losses (1) Terms

(a) Gain: excess of the amount realized over the adjusted basis in the property exchanged

(b) Loss: excess of the adjusted basis over the amount realized (c) Amount Recognized: the amount reported as taxable income (d) Amount Realized: the sum of any money or property (FMV)

received (§1001(b)) (e) Adjusted Basis: What you paid for the property plus any capital

investments after you bought it and minus any depreciation deductions and capital losses. (§1011(a))

(i) Depreciation Deductions: taxpayer deduction equal to the reduction of basis in a capital asset according to the Modified Accelerated Cost Recovery System (MACRS). (§167)

(ii) Capital Improvements: capital improvements must be added to the adjusted basis but only if the improvements last substantially beyond the end of the tax year. (§168)

(iii) Casualty Losses: If a hurricane comes in and takes your damn house out, you’ll get insurance money. The item had been converted from property to cash and basis is adjusted accordingly.

(iv) Ex. Buy a house ($100,000) a put new roof on it ($5,000) take 3,000 deprecaition expense

(a) $100,000 + $5,000 - $3,000 = $105,000 Adjusted Basis

(2) Formulas (a) Adjusted Basis = Cost + Capital Investments - Depreciation -


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Capital Losses (b) Amount Realized – Adjusted Basis = Realized Gain (c) Adjusted Basis – Amount Realized = Realized Loss

(3) Realizing Exchange: realization of gain and loss only occurs when there is an exchange and the taxpayer receives money or other property. (§1001)

(a) Property Exchange: parties exchange assets, severance occurs when each surrenders their interest in one asset to receive another asset.

(b) relief from a legal obligation owed to a third party. (c) relief from a legal obligation owed to the party receiving the

property; and (d) “other” profit transactions.

(4) Tenant Improvements of Property (a) OLD: Repossession of an asset with an enhanced value from a

transaction with another is gross income. (Bruun, default tenant improved property)

(b) NEW: Lessor of real property may exclude the value of improvements made by a tenant. (§109)

(c) Basis: the taxpayer may not add the value of these improvements to the taxpayer’s “basis” in the building. (§1017)

(5) Transfer in Satisfaction of Obligation (a) OLD: taxpayer recognizes a gain on the transfer of appreciated

property in satisfaction of a legal obligation. (Davis, stocks for marital rights)

(b) NEW: Marriage Rule: Generally, nonrecognition (no tax consequences) of all property transfers between spouses or former spouses if from the divorce. (doesn’t apply to same-sex) (§1041)

(6) Carryover/Transfer Basis: assume the basis from another source other than cost.

(a) Sources: transfer basis bases may come from (i) Property Acquired by Gift: donee uses the same basis as

the donor did. (§1015) (ii) Property Acquired by Exchange (§1031(d))

(iii) Property Constructed By/For the Owner (§263(A)) (iv) Property Acquired by Inheritance (§1014).

(a) Basis is FMV at the date of death (i) Stepped up value

(b) Current limit on estate tax = $5 million (tax free). (7) Burden of Proof

(a) Basis = Taxpayers BOP. §1014 (i) If an arms length transaction, the value of property

received is assumed to be equal when the FMV is unknown.

(ii) Taxpayer’s basis in property is their cost to acquire the property. (§1012) (Philadelphia Park Amusement, bridge for lease)

(b) Table


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Donee’s Basis for computing GAIN Donee’s Basis for Computing LOSS

FMV ≥ Donor’s AB at time of Gift

Donor’s AB Donor’s AB

FMV < Donor’s AB at time of gift

Donor’s AB FMV (loss does not carry over)

III. PERSONAL EXEMPTION

A. General: a reduction of taxable income per person claimed on tax return. (§151) 1. Taxpayer may claim himself, spouses, and dependents.

B. Policy: personalized exemptions to allow certain amount of income to meet basic subsistence needs.

C. Calculations 1. Amount §151(d)(1): $2,000 exemption per person 2. Inflation §151(d)(4): allows amount to be adjusted for inflation annually.

a) $3,900 on 2013 1040 Form 3. Dependents: dependents may be claimed as deduction if they are a Qualifying Child

(§152(c)) or Qualifying Relative (§152(d)) and a citizen or resident of US, Canada or Mexico and does not file a joint return with a spouse;

a) Qualifying Child: 5 Part Test (1) Relation: the individual must bear a relationship to the taxpayer

(a) biological or adopted child (son/daughter, stepson/ stepdaughter, eligible foster child) or any descendent of such child OR

(b) sibling (brother, sister, stepbrother, stepsister, half brother/ sister), or any descent of such a sibling

(2) Abode: the individual’s principal place of abode for more than half of the year must be the same as the taxpayer’s; and

(3) Age: the individual must be younger than the taxpayer and under the age of:

(a) 19; (b) 24 AND a full-time student; OR (c) permanently and totally disabled

(4) Support: the individual must not have provided over half of their own support.

(5) Spouse: has not filed a joint return (other than only for a claim of refund) with the individual’s spouse under section 6013

b) Qualifying Relative: 4 Part test (1) Relation: the individual must bear a relationship to the taxpayer

(a) A child or a descendant of a child. (b) A brother, sister, stepbrother, or stepsister. (c) The father or mother, or an ancestor of either. (d) A stepfather or stepmother. (e) A son or daughter of a brother or sister of the taxpayer. (f) A brother or sister of the father or mother of the taxpayer. (g) A son-in-law, daughter-in-law, father-in-law, mother-in-law,

brother-in-law, or sister-in-law.


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(h) An individual (other than an individual who at any time during the taxable year was the spouse, determined without regard to section 7703, of the taxpayer) who, for the taxable year of the taxpayer, has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household.

(2) the individual’s gross income must be less than the exemption amount; (3) the taxpayer must provide over half of the individuals total support; (4) not a qualifying child of such taxpayer or of any other taxpayer for any

taxable year beginning in the calendar year in which such taxable year begins.

D. Support of Dependent: the amount of money spent on your child 1. Support: includes items like food, shelter, clothing, medical & dental expenses,

education expenses, & similar items. (Reg. §1.152-1(a)(2)(i)) a) Case Law: Court has given “support” broad interpretation (ex- cost of car given

to child & title in child’s name, cost of care for dog. (See p.41- rev. ruling) 2. Students: support test for students excludes scholarships received (§152(f)(5)) 3. Divorced Parent Support Test: test for children of divorced parents depends on who pays

for what for the child. Only one parent can claim the exemption. (§152(e)) 4. Multiple Support Agreement (§152(d)(3)): a “Multiple Support Agreements” is used if

no one taxpayer furnishes over half of an individual’s support. They may agree on who may claim dependency exemption, so long as

a) together supporters together furnish over half of individual’s support & b) the chosen provider supplied over 10% of the total support.

5. SSN Requirement: Taxpayer must put child’s SSN # on the tax return. This prevents multiple taxpayers from claiming the same person. If child/relative has no SSN, they can get an ITIN (individual taxpayer identification number) to put in the box.

IV. TIMING A. Introduction

1. General: certain income may be deferred recognition purpose a) Typically: each year stands alone and is realized in the tax year it occurred. See

Vodka v. Titties. 2. Time Value of Money: money now is more valuable than money later. 3. Claim of Right Doctrine: If a taxpayer, lawfully or unlawfully, receives earnings under a

claim of right and without restriction to its disposition, it is income, 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, money dispute ruling appeal) (James, embezzle restitution)

B. Advanced Payments & Deposits 1. General: included in gross income even though the payments have not been earned at the

time of receipt. 2. Deposits are not included in gross income because they are more analogous to a loan or

escrow. a) Distinguishing Deposits: if money is held by a party who does not have an

unrestricted right to the money and pays interest on the money while holding it, the money is a deposit. (Indianapolis Power & Light Co., energy company deposit)

C. Assignment of Income: Taxpayer may assign the right to receive income but the taxation of that income may or may not follow the income, depending on the characteristics of the transaction.


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1. Income from Personal Services: Generally, income from services is taxed to the party who performed the services.

2. Fruit of the Tree: when income for services is assigned to the another person, the earner is the taxed because, although the earner never holds the money, the income is the fruit and comes from the earner, the tree. (Lucas, attorney gives half salary & fees to wife) (Teschner, father wins story contest for daughter)

3. Whip-saw Position: IRS assesses statutory deficiency for both individuals to keep the Statute of Limitations (3 years) open, then drop claim when determined.

4. Bond Coupon: the holder of the bond is the earner of bond income and interest assigned by giving the coupon is still taxed to the bondholder. (Horst, dad bonds)

5. Property: income from the sale of property is determined at the time of formal acceptance. (Salvatore, mom kids gas station)

6. Work-Around: a person may pay money now to receive future earnings in order to delay the realization of income. (Estate of Stranahan, father buys future money)

a) IRS and courts closely scrutinize these transfers when between family 7. Contingency Fees: amount paid to attorney in contingent fee case is taxable.

(Banks/Banaitis) a) EXCEPTION: recoveries that are allocable to physical injuries are not income.

(§104(a)(2)) b) Discrimination Suits: fees are deductible above the line. (§62(a)(20))

V. DEDUCTIONS A. Generally

1. Deductions: A reduction of taxable income per a statutory allowance in the tax code a) General Rule (§161): items are only deductible if the code specifically authorizes

the deduction. (1) Deductions are narrowly interpreted

2. Types of Deductions: There are “Above the Line” and “Below the Line” deductions a) Above/Pre-AGI deductions: subtracted from gross income to reach AGI. b) Below/Post-AGI deductions: subtracted from AGI to get taxable income.

B. Above-The-Line 1. Business Deductions: Deductions the taxpayer can take as part of their business (Pre-

AGI) a) General (§162(a)): taxpayer may deduct “ordinary and necessary expenses paid

or incurred during the taxable year in carrying on a trade or business.” b) Used in less than a year, deduction in year 1. c) Policy: Allows businesses to deduct the cost of doing business, prevents taxpayer

from being taxed on gross profits. d) Exclusions: does NOT include costs incurred in producing earned income

(Hantzis) 2. Discrimination Suit Fees

C. Below-The-Line 1. Methods for Below the Line Deductions: a taxpayer may take either a “standard

deduction” or an “itemized deduction” a) Standard (§63(c)): a set amount that the taxpayer may deduct.

(1) Amount: determined by filing status (2) Additional: standard deduction for blind people and elderly people.

b) Itemized (§63(d)): itemized deductions are below the line deductions (excluding personal exemptions) that are specifically allowed (ex. home mortgage, medical)


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2. Limitations on Itemized Deductions a) Miscellaneous Itemized

(1) Haircut (§67): miscellaneous itemized deductions are reduced by by 2% of AGI.

(2) Phase-Out (§68): gradually phases out amount of itemized deductions for the most affluent taxpayers

(3) Definition (§67(b)): ALL itemized deductions EXCEPT the 12 deductions listed “regular deductions” including:

(a) Unreimbursed business expenses by employee (b) Charitable contributions

b) Regular Deductions (1) (2)

c) Phase-Out of Itemized Deductions (1) Ceiling Amount (§68): After 2012 only taxpayers with taxable incomes in

excess of an “applicable amount” will lose up to 80% of their total itemized deductions.

(2) Calculation (§68(a)) taxpayer whose income exceeds the applicable amount must reduce the itemized deductions by the lesser of

(a) 3% of AGI in excess of applicable amount OR (b) 80% of the total itemized deductions

(3) Applicable Amounts (a) §68(b)(1): individual, except married but filing separate returns,

applicable amount = $100,000. (b) §68(b)(2): Married filing separate applicable amount = $50,000

(4) Exceptions to Rule §68(c): certain itemized deductions are not subject to §68 phase out

(a) Medical Dental (b) Investment Interest (c) Casualty or Theft Loss (d) Wagering Losses

d) Investment Related Deductions: deductions that taxpayer takes for production of income

(1) General Rule (§212): allows deduction for “all the ordinary & necessary expenses paid or incurred” for the taxable year for:

(a) the “production or collection of income” (b) the “management, conservation, or maintenance of property held

for the production of income”; and (c) expenses incurred in the connection with the collection of refund

of any tax VI. CREDITS

A. Overview of Credits 1. Function of Credits: taxpayer claims credits against tentative tax liability.

a) Taxable Income - Credits = Liability (possibly refund) 2. Credit v. Deduction: Credits are preferable to deductions because

a) Credits reduces tax liability dollar for dollar instead of a tax savings equal to amount of deduction times taxpayer’s marginal rate

3. Refundable: some tax credits are refundable, meaning that instead of simply eliminating


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tax liability a credit in excess of the taxable income is refunded to the taxpayer. 4. 4 Credits We Cover: DCC, Education, Taxes Paid, EIC

a) Income Taxes Paid: Employers withhold taxes on your paycheck and some taxpayers pay quarterly installments to the IRS for other income tax reasons.

(1) For Earned Income: Withheld “at the source.” (Employee’s paycheck) §31(a): Amounts withheld from wages are credited against the taxpayer’s pre-credit tax liability to determine if sufficient tax was collected through withholding process.

(2) Refundable: if amount exceeds taxable income; the excess tax is refunded, without interest.

b) Earned Income Credit: Credit for taxpayers that make earned income (1) General Rule: §32- eligible taxpayers can credit 7.65- 40% of “earned

incomes” against their pre-credit federal income tax liabilities. (2) Policy: targets low- income taxpayers, work incentive. (3) Phase Out: Phased out as AGI exceeds $5,280 (4) Calculation: Credit % is a function of the number of “qualifying children. (5) Refundability: Refundable credit (6) Married: Only claim credit if filing joint return (32(d))

(7) VII. Chapter 4: Tax Treatment of Taxpayer Costs

A. General Concepts 1. Code Sections Covered: IRC §161, 162(a), 165(c), 212, 262 2. Types of Taxpayer Costs: Several different types and terminology

a) Capital Expenditures: Expenditures where benefit extends beyond the tax year b) Depreciation: Cost recovery of tangible assets over time. c) Amortization: Cost recovery of intangible assets over time. d) Losses: Not an actual outlay but represents costs not recovered from sale of

asset. e) Expenses: Costs that don’t acquire or extend life of an asset. Deductible if related

to “trade or business activity” § 162. 3. Classes of Taxpayer Costs: The vertical division of types of taxpayer costs.

a) Business Activities: Expenses incurred in relation to running a business b) Investment Activities: Expenses related to investing activities (interest, fees).

Deductible for investment activity § 212


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c) Personal Activities: Expenses for one’s self. Not usually deductible at all unless personal casualty loss, theft loss, etc. § 262.

4. Time Frame to Claim Costs Back a) Deduct in 1st year = Deduction (recover immediately) b) Value overtime/ life of the asset = Capitalization (expense later)- change basis

each time you take depreciation deduction to match time with cost/ match income with expense (time value of $)

B. Expenses OR Capital Expenditure: Series of tests and classes to determine if it is capital or not 1. General: if it last over a year you have to capitalize the asset & take the depreciation cost

over time, if it lasts less than a year you can take the full cost as a deduction. a) Tangible asset (§167) (§168) (car, chairs, etc) = depreciation deduction b) Intangible asset (§197) (goodwill, IP rights, etc.) = amortization deduction

2. Uniform Capitalization Rules (§263(a)): Generally all direct & indirect costs allocable to the construction or production of real property or tangible property must be capitalized.

a) Indirect Costs: includes repairs, depreciation, utilities, rent, sales, tax, property tax, insurance, storage, and packaging. (Idaho Power, construction equipment) Selling Expenses: state income taxes, advertising and distribution costs are not included.

b) EXCEPTIONS (1) Wholesalers & retailers of personal property with average annual gross

receipts of $10 million or less (§263A(b)(2)(B)) (2) Personal Use property (§263A(c)(1) (3) Certain animals & plants produced by farmers & ranchers (§263A(d))

3. Expenditures that Must Be Capitalized: 4 Types a) New buildings b) Permanent improvements intended to increase value

(1) Pre-Existing Defects: Money spending fixing this, even if defect not known at time of purchase

(2) Pre-Use Costs: the costs related to work performed on property prior to the use by taxpayer

(3) Adaptations: costs for adapting property to new use, no matter if the costs permanently alter the composition of the property

(4) Betterments: costs results in betterment of property or material addition, improves property quality or strength, or causes property to be expanded

(5) Increased Productivity: results in a material increase in capacity, productivity, or efficiency.

c) Restoration costs d) Expenditures that will give right to exhaustion deductions (i.e. depreciation,

amortization, and depletion). e) NOTE: Wages paid to builders and other construction workers must be

capitalized when they relate to the construction of an asset that’s benefit lasts more than a year. (§263(a)(1))

4. Repair, Improvement, and Restorations a) General: costs for simple maintenance, and not improvement, of property are

deductible expenses and not capitalized as expenditures. (Fedex Corp., airplane engine overhaul) (Rev. Rule 2004-62, tree fertilizer) (Treas. Reg. §1.263(a)-1(b))

(1) Repair: bring it back to original purpose to continue in same manner. (2) Improvement: adds material value to the underlying asset


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b) Permanent restoration: Deduction is deferred because costs added to property’s basis. Taxpayer must capitalize costs that restore property, substantially prolong the economic useful life of the unit of property. Reg. §1.263(a)-1(b)(1).

c) Operating Condition: costs for the purpose of keeping property in an ordinarily efficient operating condition are repairs. (Midland Empire Packing, concrete for meat)

d) Pre-Existing Condition: costs for fixing a condition that existed prior to the purchase of the property is an improvement. (Drive- In Theatre, drainage)

5. Mergers a) General: costs for arranging a friendly takeover are capitalized expenditures

while costs of fighting a hostile takeover are expenses. (INDOPCO, unilever merger)

6. Separate and Distinct Asset Test a) General: requires capitalization of certain amounts paid to acquire or create

intangible assets and requires capitalization of costs that create or enhance a separate and distinct capital asset. (Treas. Reg. § 1.263(a)-(f))

(1) Published Guidance: if specifically noted by the IRS in published guidance, costs that “create or enhance a future benefit” are capitalized

7. EXCLUSIONS a) De minimis: $5,000 (currently) b) Less Than A Year: costs for items used within a year are not capitalized. Reg. §

1.263(a)-4(f) (1) If you use it in 12 months, you can deduct it in this year. (2) If over 12 months, have to look at capitalization (may be deductible under

§1279). c) Creation of Intangible: must capitalize the cost to facilitate the acquisition or

creation of an intangible asset, unless De Minimis, then expense. (Treas. Reg. § 1.63(a)-4(e)(1))

d) Bar Dues: Yearly dues: can be deducted under 12 month rule, subject to 2% haircut, because goes towards the production of income.

8. Bar Exam and Review: Bar Admission Reg. §1.263(a)- (4)(d)(5) Example 2 = Expense, get deduction. Must capitalize payment to bar for review exam.

9. §179 Deductions: (Discussed in Depreciation section. C. Deduction for Expenses: Once you determine if something is an expense or capital expenditure,

determine if it is deductible. 1. General Rule: deduct if

a) Trade or Business: related to trade or business activity or paid or incurred in the production or collection of income (§162)

b) Investment Expense: if an investment expense (§212) OR c) Start-up Costs: a start-up expenditure incurred prior to the commencement of a

business or investment activity. (§195) 2. Trade or Business Expenses: Expense incurred in course of business are deductible if the

are ordinary and necessary expenses of a trade or business. (p.243) a) RULE: business may deduct from its income its “ordinary & necessary business

expenses paid or incurred during the taxable year in carrying on any trade or business,” including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” (§162)

b) ELEMENTS:


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(1) Ordinary: common or customary to the trade. (Welch, discharge debt for reputation is extraordinary)

(2) Necessary: useful or helpful (Jenkins, country singer reputation necessary)

(3) Expense: expensed when useful life doesn’t last beyond end of tax year. (a) 162(e): lists prohibition to deductions

(4) Paid (Cash) or Incurred (Accrual) during the taxable year (5) Carrying on: Must be during business.

(a) Prior to business is §195 start up expenses (b) Must continue in SAME trade or business. (Rockefeller, VP

nomination expenses) (6) Trade or business: Business engaged in for profit not personal in nature.

Done full time. c) Excessive Salary

(1) General: CEO compensation is presumptively correct but an excessive salary may not be deductible. (Exacto Springs, high ROI CEO)

(a) 7-Factor Test (Majority) (i) the type and extent of the services rendered;

(ii) the scarcity of qualified employees; (iii) the qualifications and prior earning capacity of the

employee; (iv) the contributions of the employee to the business venture; (v) the net earnings of the employer;

(vi) the prevailing compensation paid to employees with comparable jobs;

(vii) the peculiar characteristics of the employer’s business. (b) Indirect Market Test (Minority): The higher the rate of return

(adjusted for risk) that a manager can generate, the more reasonable a higher salary is.

d) Gambling (1) Gambling Losses: taking each year separately, losses may only be taken

up to the extent of a gambler’s gains. (§165(d)) (2) Requirements (Groetzinger)

(a) Professional: only “professional gambler” can deduct as a trade or business.

(b) Continually & Regularly (c) Primary Purpose is to make money (d) Money earned for time/labor/attention spent

e) Attorney Expenses: did the “origin of the claim” arise from a business transaction. (Tellier, securities fraud)

f) Personal Expenses: some costs are too personal in nature and may not be deducted as businesses expenses. (Vitale, Prostitution for Dummies author)

g) Startup Expenses: portion of costs may be deducted in 1st year of business, balance then amortized over 15 years.(§195)

(1) Start-up Expenses: costs to get a business off the ground and are NOT incurred prior to creating the business.

3. Public Policy a) Limitations on Deductibility: There are holdings and one code provision that


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recognize that something might appear to be perfectly in line with the tax laws but for some reason is against public policy and should not be deductible for public policy reasons.

b) Specifically Disallowed (1) Bribery: Can’t take deduction for bribes, kickbacks even if connected

with trade or business. §162(c) (2) Illegal Activity: Can’t deduct for any illegal payment. §162(c)(2) (3) Lobbying: Can’t deduct expenses incurred with political lobbying

activities & campaigns for officer. §162(e) (4) Punitive/Treble Damages: Can’t deduct treble damage payments if

convicted or plead guilty to federal antitrust violation. §162(g) (5) Illegal Substances: Can’t deduct for ordinary & necessary business

expenses if engaged in illegal sale or trafficking of controlled substances. §280(e)

D. Independent Contractor v. Employee: Differing treatment for tax purposes and how they are recognized in given circumstances

1. Independent Contractor: Has the following characteristics a) Pays own taxes, not withholding at the source + not benefits. b) Typically pay all employment taxes via quarterly payments. c) Greater business expense deductions, but normally more $ spent. d) ex: Typist, unless long term relationship. e) MOST BUSINESSES WANT THIS

2. Employee: Has the following characteristics a) Share of SS previously withheld b) IRS prefers. If determine IC is an employee, the company must pay employee

back benefits & pay IRS back employment taxes. c) Can only deduct ordinary & necessary business expenses that exceed 2% of AGI,

it itemize. d) ex: UPS mail carrier, require the when & where for deliveries & beneficial

mileage rate 3. Common Law Approach: focus on the control exercised over what & how work is done.

a) Behavioral Control: Does employer have right to control details or have they relinquished control.

b) Financial Control: Address the business’ right to control business aspect of worker’s job

c) Relationship of Parties: Is there: (1) Written K (2) Benefits the business provides to the employee (3) Permanency of Position

4. Test: Facts & Circumstances (20 factors): Rev. Rul. 87-41 (HANDOUT) a) employee compliance with instructions required training,

(1) Does employee receive training from, or at direction of employer? b) integration of worker’s services into the business. c) services are rendered personally,

(1) Employees must do work themselves, IC can assign work d) ability to hire, supervise, and pay assistants,

(1) If employer hires, the worker is employee, (2) If you can hire assistance, most likely IC


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e) a continuing relationship, (1) Can be relationship if irregular intervals, are frequent

f) set of hours of work are established, g) full time is required, h) payment by hour, week, or month, i) payment of business and/or travel expenses, j) tools and materials furnished, k) worker invests in facilities, l) worker can realize a profit or loss, m) worker performs services for more than one business at a time, n) worker makes services available to the general public, o) business has the right to discharge worker, and p) worker has the right to terminate the relationship.

E. Investment Expenses 1. General Rule (§212): investment costs generally deductible for

a) production or collection of income, b) management, conservation, or maintenance of property held for production of

income, OR c) in connection with the determination, collection or refund of any tax.

2. Trade or Business: does NOT have to be for trade or business 3. Expensed that year, or deducted over time same way. 4. Can’t be for convention, seminars, or other meetings (§274(h)(7)) 5. Prohibitions: 1.212-1(e) - (o)

F. Amortization of Start-Up Expense: There is a substantial difference between expenses incurred in the course of investigating a business that might be started and expenses incurred in the course of starting up a business that is going to happen for sure / is in progress of being formed.

1. 2. General Rule: $5k deduction in first year, $50k phase-out dollar for dollar, remainder is

amortized over 180 months ratably. (§195) 3. Travel and legal expenses to investigate properties are not allowed because prior to start

of business, must be capitalized & added to the value of the business asset (§195(a))(Frank)

4. Job training expenses prior to opening must be capitalized to match expense & time for which it benefits the company. (Richmond Television)

5. Exception: amortization for startup expenses to take now (§179)


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6. Process to Handle Issue: Start with Go Date (day on which the transaction to acquire or start business is FOR SURE)

7. Expenses Before Go Date a) Capitalize: Inherently facilitative costs b) Expense: All other investigation costs

8. Expenses After Go Date a) Expense: Employee comp, overhead, de minimis (5k aggregate) cost b) Capitalize: All other costs in pursuing the transaction

9. If Capitalized: No §195 deduction. Add to asset basis 10. If Expense: Use §195 election available 11. If Costs are under 5000: Then can be amortized under a de minimus rule (1.263(a)-

5(d)(3)) G. Treatment of Capital Expenditures

1. Cost Recovery In General: In order for a business to recovery the costs of purchasing assets that are not currently deductible, the business must depreciate (tangibles), amortize (intangibles), or deplete (natural resources) the asset that was capitalized over time per the requirements of the IRC.

2. Depreciation of Tangible Property: §167 and §168 - deduction over time for obsolescence and exhaustion of property used in a trade or business for the production of income.

a) Requirements: 2 basic requirements → (1) It has useful life beyond the end of tax year (reason capitalized in first

place) (2) It wears out or decays with time due to natural causes and usage or

becomes obsolete b) Exclusions: Do not depreciate inventory, land, securities, or other highly liquid

items. 3. Simon v. Commissioner (and thereafter appeals in 2nd Cir. Ct. App.) (pg. 297)

a) Facts/Issue: Are specially crafted collector’s violins depreciable musical instruments if the taxpayers are professional musicians and the violins are used in the course of their musical profession regardless of whether the violins are actually appreciating over time?

b) Hold: Yes, they are depreciable. Even though the fair market value of bows increased, the court stated that for it to look into determining whether an asset has a "separate, non business" value for depreciation purposes would be contrary to Congress’s intent to simplify this concept.

c) Rule: Under § 168(a), a taxpayer may deduct depreciations of "recovery property" which is property that is (1) tangible, (2) placed in service after 1980, (3) of a character subject to the allowance for depreciation, and (4) used in the trade or business, or held for the production of income. The court defined subsection (3) to mean that the "property must suffer exhaustion, wear and tear, or obsolescence in order to be depreciated."

H. Bonus Depreciation By Election and Limits on Depreciation: 1. Generally: The tax code has a couple provisions that allow taxpayers to deduct certain

capital expenditures upfront. These were used as economic incentives to go buy stuff right now but most set to expire at the end of 2012.

2. §179 Expensing: Big exception to average capitalization rules. Can deduct up to certain amounts of asset purchases in the current year if you meet the requirements of 179. 3


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limitations to the expensing. a) Dollar Limitation: For 2011 it was $500k, for 2012 it was $125k, for 2013 it is

$25k b) Phase-Out Limitation: If total qualifying property purchases in the year are over

the phase-out amount, the amount deductible is reduced dollar for dollar by the amount that purchases exceed the limitation. (2011 limit = $2mil, 2012 = $500k, 2013 = $200k)

c) Taxable Income Limitation: §179 deduction cannot exceed the taxpayer’s taxable income for the year.

3. 50% Bonus Depreciation: A taxpayer may deduct up to 50% of the adjusted basis of an asset in the year of acquisition up front. This expires in 2013.

4. Application of Bonus Depreciation and §179: Taxpayer will apply depreciation to the adjusted basis of an asset in the following order: §179, Bonus Depreciation, MACRS

5. Depreciation Limits: §280F imposes limit for deduction of certain “listed property.” Basically you cannot deduct beyond a certain limit for things like luxury cars, etc. Limits are also determined by whether or not the property is used for personal/investment/other purposes.

I. Amortization of Intangible Property §197. Pg 325 1. General Rule: If TP can prove that a particular asset can be valued, and that the asset has

a limited useful life which can be ascertained with reasonable accuracy, he may depreciate the value over the useful life regardless of how much the asset appears to reflect the expectancy of continued patronage (goodwill).

2. Definition of Intangible: any property that fits one of the following categories a) Goodwill or going concern b) Intangible property relating to info-base, know-how, customers, suppliers,

ejusdem generis c) Any license, permit, or other government granted right d) Covenant not to compete consideration entered into as part of sale of biz e) Franchise, trademark, or trade name.

3. Excluded From Intangibles: following are not qualified to be intangibles under 197 a) Interest in corp/PS/trust/estate b) Interest in futures K, foreign currency K, notional principal c) Interest in land d) certain computer software e) certain interest in films, sound, recordings, videotapes, books, and other artistic

property f) certain rights to receive an intangible property g) certain interest in patent or copyright h) interest in lease of tangible property i) franchise costs to engage in professional sport j) certain transaction costs.

4. Application: §197 sets the rule that all intangibles are amortized over 15 years with a monthly convention and are not eligible for bonus/§179 deduction. Amortization is pure straight line.

5. Exception: If asset does not qualify under 197, TP can still depreciate cost using straight line method if useful life can be proven. Reg. §1.167(a)-3.

6. Selig v. United States (pg 325) (1984 - Pre Amortization §197) a) Issue: When a taxpayer acquires a baseball franchise under a contract that


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specifically allocates a percentage of the purchase price to the player’s contracts, may the taxpayer amortize the value of the players contracts?

b) Holding: Yes. The players' contracts were properly valued as a whole and the therefore the players contracts were depreciable/amortizable. Because this sort of bulk sale was the reality of the "club" market, the players should be valued in accordance with the market's nature

c) Takeaway: Basically when there was no amortization code section, there was substantial confusion on the issues of whether taxpayers could deduct intangible assets and how they should approach the deduction of them given that they were not subject to wear and tear.

VIII. Losses A. Capital Asset Transactions

1. Special rules on how to deal with losses from capital asset transactions (§1001(a)) a) General Rule: Loss from the sale or exchange of property in excess of adjusted

basis over amount realized. b) Calculation: Amount of Loss = Amount realized - Basis

(1) Opposite of gain, if value decreased, then basis > amount realized 2. Nature of Losses: Usually can’t take personal losses unless specifically allowed by the

code but business/investment losses are usually deductible subject to limitations. 3. Deductibility: Realized losses are Recognized (deductible) only if it falls into one of the

following categories. (§1001(c)) B. Individual Losses

1. Limitation of Individual Losses a) Only deduct 3 types of uncompensated losses incurred (§165(c)) :

(1) in a trade or business; (2) in profit- motivated transactions; and (3) casualty & theft losses for personal property.

b) Note: can only deduct what exceeds 10% of AGI. (usually only catastrophic uninsured losses)

2. Individual Loss Limitation: (§165(a)) a) Loss must be “sustained;” and

(1) Defined: loss must be “realized” during the taxable year. (2) Proven: using a police report, etc.

b) Uncompensated for the loss (i.e. insurance, settlement). (1) Ex: Can deduct amount not compensated for, but must show via

documentation. (§165(h)(2)(B)) 3. Business and Investment Losses

a) Basis Limit In Loss Property: §165(b): Loss deduction is limited to the basis in the property. Can’t deduct loss if can’t collect $.

b) Gambling Losses (§165(d)): Loss is limited to the amount of gain, regardless of business, investment, or personal. (public policy discourages)

c) Business/Investment Losses: § 165(c)(2): Any loss from sale or exchange or property, including investment losses = above the line deductions (§62(a)(3)).

d) Miller v. Commissioner (pg 337) (1) Facts/Issue: Does your drunk friend damaging your boat count if you

don’t notify insurance & claim amount minus minimal cash friend paid? (2) Hold (IRS overrules): Allowable, plain language of statute.

§165(h)(4)(e): Loss, extent not covered by insurance, can only apply only


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if individual files a timely insurance claim for the loss. 4. Casualty & Theft Loss: § 165(h)

a) General Rule: Casualty and theft losses must be sudden, unexpected, or unusual. (Rev. Ruling 79-174, beatles killing trees)

b) Limits (Publication 547) (1) Itemized Deduction (2) Subtract $100 per casualty from the loss before applying 10% rule (3) 10% Rule: subtract 10% of the Adjusted Gross Income from the loss

c) A theft loss is not deductible when the loss resulted from taxpayer’s criminal behavior. (Mazzei, counterfeit conspiracy)

d) Other Casualty: wherever force is applied to property and the taxpayer is powerless to act to prevent it, the damage is an “other casualty.” (Carpenter, ring garbage disposal)

5. Net Operating Losses (“NOL”) a) General Rule (§172): taxpayer may deduct the entire amount of Business Losses

(must be operated for profit) against income (1) If not enough income in current year for the deduction, carry back 2 years

and forward 20 years (2) If loss is not covered within time frame (22 years), too bad. (3) Must have income to take it against in past (if not, then carry backward

then forward) (4) May elect to go forward with losses instead of carrying backward first

b) Loss can only arise from business expenses (§172(d)(4)) c) American Recovery and Reinvestment Act of 2009

(1) “eligible small business” (a) sole proprietorship, corp., or partnership w/ annual gross receipts

of no more than 15 million over prior 3 years) (2) with loss from 2008-09 could carry back 3,4, or 5 years

C. Capital Losses :( 1. General Rule: a taxpayer may deduct losses from capital assets (§1211(b))

a) Loss allowed is limited to the extent of your capital gain + $3,000 per year. b) If loss exceeds that limit, then can carry forward indefinitely (§1212(b)(1))

2. Capital Asset: property not held for trade or business as some sort of inventory or other like kind item that is bought and sold as part of business (usually investments)

3. Long-Term or Short-Term: If held for more than a year= long-term capital loss. If for one year or less = short-term capital loss

D. Loss Limitations for Related Persons: §267(a)-(d) disallows losses on sales/exchanges to and from Related parties transactions

1. Rule: Losses realized on sales between related parties are disallowed. Related parties are à

a) Members of a family, as defined in subsection (c)(4); b) An individual and a corporation more than 50 percent in value of the outstanding

stock of which is owned, directly or indirectly, by or for such individual; c) Two corporations which are members of the same controlled group (as defined in

subsection (f)); d) A grantor and a fiduciary of any trust; e) A fiduciary of a trust and a fiduciary of another trust, if the same person is a

grantor of both trusts;


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f) A fiduciary of a trust and a beneficiary of such trust. g) A fiduciary of a trust and a beneficiary of another trust, if the same person is a

grantor of both trusts; h) A fiduciary of a trust and a corporation more than 50 percent in value of the

outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

i) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

2. A corporation and a partnership if the same persons own— a) more than 50 percent in value of the outstanding stock of the corporation, and b) more than 50 percent of the capital interest, or the profits interest, in the

partnership; 3. An S corporation and another S corporation if the same persons own more than 50

percent in value of the outstanding stock of each corporation; 4. An S corporation and a C corporation, if the same persons own more than 50 percent in

value of the outstanding stock of each corporation; or 5. Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an

executor of an estate and a beneficiary of such estate. E. Tax Exempt Organization - Disallowed Expenses: §501(c)(3)- Tax exempt status for

churches/charities for any income received but disallows certain expenditures 1. To maintain status may not endorse or oppose a candidate and “no significant amount” $

towards lobbying. 2. Not prohibited from endorsing or opposing issues 3. Do not have to apply, automatic tax exempt status

IX. Chapter 5: Statutory Exclusions from Gross Income A. Specific Exclusions from Income: The tax code specifically authorizes certain income items to

not be recognized as income on the taxpayer’s return and therefore is not taxable. B. Gift & Inheritances (§102): Receiver no federal tax on the original amount, taxed at source

(donor/ estate/ gift tax). If future income from gift/ inheritance, taxed for future use. C. Life Insurance Proceeds (§101): Amount payable to beneficiary because death of insured are not

taxed as income (non-probate asset). Policyholder previously taxed on premiums paid. D. Annuity (§72): Pay premium for the right to regular series of future cash payments received for

fixed time or life (v. lumpsum). 1. Annuities: investment, basis in right to future payments. 2. Application: Not actual exclusion, but portion of annuity payment that represents the

basis in the investment is excluded from gross income as a return of capital. 3. Calculation: “Exclusion ratio”-§72(b)) = Investment (aka Basis) / Expected Return (total

received over life expectancy). % = amount of each payment that is a return on basis not income. Basis is recovered and the excess amount = taxable income

E. Exceptions to Rules: Certain excluded items are not still excluded in certain circumstances. 1. Transfer of Policy for Value: if owner beneficiary of life insurance policy acquires the

policy for “valuable consideration,” the exclusion is limited to the amount of consideration & any amounts (including premiums) paid after transfer. (§101(a)(2))

2. Installment Payments After Death: portion of installment payment that is interest is included in gross income. Only the amount of the principal is excluded. Gross death benefit / # of payments made... excess is interest (income) (§ 101(d))


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3. Surrender Life Insurance Policy: If surrender for “cash value” & not dead, then §101(a) doesn’t apply. Instead §72: The cash is gross income to the extent it exceeds the aggregate premiums paid (aka basis)

4. Payments to Terminally Ill / Chronically Ill: § 101 (g)(1) - They are allowed to cash out early so long as owner insured is terminally or chronically ill because I got bills yo!... or if you sell the policy to “viatical settlement company” for lump-sum cash payment- excluded from gross income.

a) Terminally Ill Definition: §101(g)(4)- Terminal = Dr. certified that you have 24 months or less from date of cert.; Chronically ill= severely disabled (§7702B(c)(2))

b) Note: Ascertain if the Term v. Whole Insurance for premium’s basis adjustments F. Scholarships & Fellowships (§117)

1. General Rule: Certain scholarships and tuition reductions are beneficial to the taxpayer but are not included in the taxpayer’s taxable income for policy reasons promoting education.

2. Qualified Scholarships: Must be used for “qualified tuition” (tuition & fees) + related expenses (books, supplies, related equipment). (§117(a))

a) Must be a “scholarship or fellowship grant.” b) Amount of scholarship applied to qualified expenses is not included in gross

income 3. Qualified Tuition Reductions: Scholarship is excluded if not in exchange for services/

condition to do something. (§117(d)(1)) a) Athletics: Student athletes with a “full ride” are excluded (Rev. Ruling 77-263) b) Academic: Academic Merit Scholarships (maintaining GPA) are excluded. c) Doctoral Grants: Grants given to taxpayers by their employer so that they could

research and write their doctoral theses in engineering were taxable ‘compensation’, rather than excludable ‘scholarships. (Bingler)

d) Exception: if services are performed for a separate nonprofit organization then the scholarship is still excluded (e.g. Foley)

4. Employer Paid Educational Expenses: Employees can exclude up to $5,250 of educational assistance from employer is from an “educational assistance program.” (§127)

a) For tuition, fees, books, supplies that the employee doesn’t (1) keep after the program, (2) not for transportation, meal, lodging, and (3) not for sports, games, or hobby courses.

G. Income from Savings bonds (§135) 1. Phase Out (§135(b)(2)) 2. MARRIED PEOPLE MUST FILE JOINT (§135(d)(3)

H. Compensation for Personal Injuries & Sickness (§104) 1. General Rule: Settlements (non-punitive) damages from insurance company / jury trial

for personal physical injuries or physical sickness are excluded. (§104(a)(2)) 2. Attributable to Physical Injury

a) NOT mental anguish / emotional distress b) NOT punitive damages c) YES pain and suffering d) YES medical/psychological or other care resulting from injury e) YES “on account of physical injury or physical sickness”


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(1) Look at the “origin of the claim” what was the “injury” (Amos, Rodman Groin)

(2) Bruise Rule: sexual harassment is not physical but when plaintiff is bruised divide the injury and the physical injury is exempt. (Private Letter Ruling 200041022)

3. Discrimination: taxpayer's front and back pay awards in disability discrimination action were not excludable from income. (Johnson, ADA back pay)

4. Combat-Related Injuries a) Direct result of armed conflict b) Extra hazardous service OR c) Conditions simulating war

5. Employee Exclusions: §105 - Amount received for health insurance plans and healthcare provided by employer are not included in gross income to the extent it doesn’t exceed amount in §106 (exclusion for employer-provided accident & health insurance plans).

6. Recovery of Non-Injury Awards: Not all recoveries are for physical injuries but could potentially be for losses under a contract or lost profits.

a) Lost Profits Recovered: If you recover amounts that are designed to replace income, that amount is included in gross income,

b) Recovery of Capital: If the recovery is simply recovery of an investment in something, then the amount recovered over the adjusted basis in the investment is taxable income.

7. Damages that come from personal injury- including Loss wages, Emotional damages are excludable (104(a)(2)). 1.104-1(c)

I. Municipal Bonds: interest earned on money borrowed by the government. (§103(a)) 1. Double-Tax Free Bond: No State or Federal Tax.

J. Parsonage/ Clergy Housing (§107): 2 items excluded from “a minister of the gospel’s” gross income:

1. Rental value of a home furnished as part of the minister’s compensation (congregation pays)

2. Any rental allowance paid as compensation, to the extent such allowance is actually used by the minister to rent or provide for a home.

a) Fair Market Value: Own or rent FMV is excluded from income. b) ONLY FOR ONE HOUSE

K. Tenant Improvements: value of the tenant’s improvements is excluded from the landlord’s gross income. (§109)

1. Include as a decrease in basis when you sell it. 2. OVERRULED Helvering v. Brunn

L. The Exclusionary Arm of the Tax Benefit Rule: §111 1. Tax Benefit Rule: Include recoveries in gross income in the year recovery occurs. 2. Application: §111 - Excludes recognition of recovery of prior deductions when it did not

actually reduce the taxpayer’s liability M. Gain from Sale of Principal Residence (§121)

1. General: an individual may exclude gain from the sale of a principal residence a) Individual = $250,000 b) Couple= $500,000

2. Availability: available to all, every 2 years, on a recurring basis 3. Requirements

a) Principal Residence: must treat as principal residence


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(1) Owned or used home for 2 of 5 years prior to the sale b) Time: must not have claimed exclusion (to any extent) in 2 years prior

N. Disaster Relief Payments Exclusion (§139) 1. Rule: Amounts individual receives as a “qualified disaster relief payment” are not gross

income. 2. Qualified Events: Events include terroristic or military actions, Presidentially declared

disasters, certain catastrophic accidents. (139(c) a) PERPETRATORS OF DISASTER CAN’T CLAIM (139(e))

3. Qualified Payments: For: 1) reasonable & necessary personal expenses from, 2) r&n for repairs to personal residence or furnishings, 3) made by a common carrier by reason of death or physical injury from, & 4) from gov. agency as relief.

4. 7 receipts that eligible: a) Payments for “reasonable and necessary” personable expenses resulting from

“qualified disasters” (139(b)) b) Payments for “reasonable and necessary” repairs to primary residence or

furnishings because of disaster (139(b)) c) Payments from common carrier for death or physical injury stemming for

qualified disaster (139(b)) d) Payments made from govt. agency as relief from qualified disaster (139(b)) e) Payments from 9/11 Victim Comp Fund are Excluded (Revenue Ruling 2003-

115) f) Grants from state programs (Revenue Ruling 2003-12) g) Grants from disaster relief agencies (Red Cross) (Revenue Ruling 2003-12) h) Employer grants for disaster relief (Revenue Ruling 2003-12)

X. Chapter 6: Timing of Income A. Accounting Methods

1. General Concept: the IRS gives the taxpayer a few options about which accounting method to utilize for determining when income is received and deductions are paid.

a) Cannot Switch: a taxpayer cannot switch the accounting method used unless permission is granted by the commissioner.

b) Mandated Accounting Methods: some taxpayers are required to use one method of the accounting.

(1) Tax Shelters: usually only applies to large corporations. §448(a) lists C-Corps, partnerships with C-Corp partner, and tax shelters as mandatory accrual users. Reg §1.446-1(c)(2)(i) requires that companies with an inventory function must use accrual.

2. Timing: the accounting method chosen by the taxpayer has nothing to do with WHAT you recognize, only guides WHEN you recognize it.

B. Cash Method 1. General: income is not counted until actually received (in cash or check), and expenses

are not counted until they are actually paid. 2. Benefit: the taxpayer can accrue receivables and other monies owed to him but not pay

tax until it is later received. 3. Constructive Receipt Doctrine: A taxpayer is subject to tax in the current year if he or

she has unfettered control in determining when items of income will or should be paid. Unlike actual receipt, constructive receipt does not require physical possession of the item of income in question. Reg §1.451-2

a) Exception: income is not constructively received if the taxpayer's control of its


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receipt is subject to substantial limitations or barriers. (Hornung, NFL corvette) (Davis, severance check)

4. Income Items: income would not be recognized until the taxpayer actually receives the payment itself, in cash or cash equivalent.

5. Deferred Payment: deferred payment is received in the year it is unqualifiedly subject to [the taxpayer's] demand or withdrawal. (Veit )

a) Cash Equivalence Doctrine: If a taxpayer has either actually received an item, or constructively received an item he must determine whether the item received is a cash equivalent, using the six factors described in Cowden. Reg §1.446-1(c)(1)(i)

b) Cowden v. Commissioner (pg 425) (1) Facts: The taxpayers made a contract for oil and gas royalty payments

with "bonuses" payable in two subsequent years. They next signed these contracts over to a bank reporting the amounts received as long term capital gains. The Commissioner disagreed as to their designation making them taxable as capital gains.

(2) Rules: A promissory note, negotiable in form, is not necessarily the equivalent of cash. But that principle also has a true inverse—that a non-negotiable instrument can be a cash equivalent if the following factors are met. A promise to pay will be considered a cash equivalent for cash method taxpayers if:

(a) the promise to pay is unconditional; (b) the promise is made by a solvent person; (c) the promise is assignable; (d) the promise is not subject to set-offs; and (e) the promise is marketable.

6. Deduction Items: Traditionally, under the cash method things are only deducted when the taxpayer has actually paid the expenditure out of their funds.

a) NO Constructive Payment: §461 Unlike income, there is NO constructive payment doctrine that allows the taxpayer to deduct something before it is actually paid. Therefore, you can’t issue a promissory note in payment for something and then deduct it.

b) Determining Actual Payment: Problem arises when the taxpayer performs services or transfers property in lieu of paying a deductible expense.

(1) Services: Taxpayer recognizes gross income in the amount of the deduction that satisfied with the performance of services so that it becomes a wash afterwards.

(2) Transfer of Property: Taxpayer must recognize gain, but not loss, on the transfer of assets in lieu of cash payment for otherwise deductible item in the amount of the deduction over the property’s adjusted basis.

(3) Payment by Check: Recognized when the check is delivered to payee and NOT when it is cashed. Estate of Spiegel v. Commissioner.

(4) Payment by Promissory Note: Not deductible when the note is issued but IS deductible when the note is paid. Helvering v. Price. Note: Taxpayer may borrow funds to make a deductible payment. Granan v. Commissioner.

(5) Credit Card Payments: Credit card payments are deemed made at the point of sale, not when the payment to the credit card company is made.

c) Deductibility of Advance Payments: If a taxpayer pays an expense in advance,


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the taxpayer may deduct the full payment up front. This has beneficial tax implications if the taxpayer needs to reduce current taxable income. If you pay really far in advance then you run into an asset that lasts, “substantially beyond end of tax year.” Reg §1.461-1(a)(1).

d) Commissioner v. Boylston Market Association (pg 433) (1) Facts/Issue: Whether a cash method taxpayer is limited to the deduction

of insurance premiums actually paid in any year or whether he should deduct each year the pro rata portion of the prepaid insurance attributable to that year?

(2) Holding: A taxpayer that kept its books and makes its returns on a cash receipts and disbursements basis, and which purchases fire and other policies covering periods of three or more years, should deduct for each tax year the pro rata portion of the prepaid premiums applicable to that year on ground that taxpayer should treat the prepaid premiums as a “capital expense”

e) Zaninovich v. Commissioner (pg 434) (1) Facts/Issue: whether a rental payment by a cash basis taxpayer for a lease

year that extended eleven months beyond the year of payment is fully deductible in the year of payment as an ordinary and necessary business expense1 or must be deducted on a prorated basis as a capital expenditure

(2) Hold: that a rental payment by a cash basis taxpayer for a lease year that extended 11 months beyond year of payment is fully deductible in the year of payment as an ordinary and necessary business expense and it need not be deducted on a prorata basis as a capital expenditure.

(3) Rule: Under the one year rule, an expenditure is treated as a capital expenditure if it creates an asset, or secures a like-kind advantage to the taxpayer, having a useful life in excess of one year.

f) Grynberg v. Commissioner (pg 439) (1) Facts: taxpayers prepaid certain business expenses each Dec that were not

due until Feb and March of the following year and deducted the prepaid expenses when they were paid, rather than when they would otherwise be due.

(2) Test: To determine if prepayments are deductible, apply the three-prong test. The test applies whenever the issue is the deductibility of prepaid items under §§ 162 and 446(b). Each prong is independent and must be satisfied for a prepayment to be deductible:

(a) First, there must be an “actual payment of the item in question.” A mere refundable deposit will not support a deduction.

(b) Second, there must be a “substantial business reason” for making the prepayment early. If prepayment occurred simply to accelerate a tax deduction, no deduction will be allowed in the year of prepayment. Tax reduction is not considered a “valid business purpose,” and thus is not an ordinary and necessary expense under § 162.

(c) Third, prepayment of the item must not cause a “material distortion” in the taxpayer’s taxable income in the year of prepayment. IRC § 446(b). The taxpayer carries a heavy burden to overcome the IRS’s determination that the taxpayer’s method of


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accounting does not clearly reflect income. (3) Holding: Taxpayer meets first element, fails second element and third

element is not evaluated. Therefore, not deductible until it is due. g) Prepaid Interest: §461(g) covers prepaid interest. Places cash method TP’s on the

accrual method for prepaid interest payments. Does not apply to paid for points on mortgages.

h) The One-Year Rule in the Regulations: Applies the Zaninovich on-year-rule to any payments that create a right or benefit to the taxpayer.

C. Accrual Method: Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.

1. Income Items: Reg §1.446-1(c)(1)(ii)(A) Income is recognized under the accrual method when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.

a) Rev. Rul. 74-607 (pg 445) (1) Facts/Issue: Whether points paid to a lender for a mortgage are

recognized prorata or in the year they are received? (2) Rule: All the events that fix the right to receive income occur when:

(a) the required performance occurs; and (b) the earlier of the following occurs

(i) payment is therefore due, or (ii) payment is therefore made.

b) Prepayment of Income: The “earlier of” from the preceding rev rul. applies to taxpayer who receive prepayment for work so as to force them onto the cash basis in this situation.

c) Doubts as to Collectibility: Problem occurs when a taxpayer provides services to financially troubled client who taxpayer reasonably believes might not be able to pay and therefore presents a situation where taxpayer may not want to report income.

d) Spring City Foundry Co. v. Commissioner (pg 449) (1) Facts/Issue: Did the TP have GI in 1920 from its sales on account to a

customer when facts subsequent to the sales but before the end of the year suggest that the taxpayer will not collect payment?

(2) Holding: Yes. The taxpayer has met all the requirements for the right to the income to be fixed and the amount fixed.

(3) Rule: If accounts are determined to be uncollectible, the proper approach is to deduct the uncollectible portion under the applicable statute when the account is deemed to be uncollectible. Later events do not change the fact that there was income.

e) Clifton Manufacturing v. Commissioner (pg 450) (1) Facts/Issue: whether any part a the sum received in 1937 should have

been included in the gross income of that year rather than in the gross income of an earlier year when it was due and payable and its collectibility was assured?

(2) Holding: The interest should have been accrued in 1936, the year the taxpayer knew that it would become collectible.

(3) Rule: Interest is not accrued as long as reasonable doubt exists as to the


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amount that is collectible by reason of the financial condition or insolvency of the debtor. Interest/debt should only be accrued and reported as income when it’s collectibility is assured.

2. All Events Test a) Income

(1) Test: income is earned when (a) Liability: all the events have occurred that fix the right to receive

the income, and (b) Amount: can be determined with reasonable accuracy. (Treas.

Reg. §1.451-1(a); Treas. Reg. §1.446-1(c)(1)(ii)) (2) Earliest of

(a) When the required performance occurs (§461) (b) When the payment is due (Schlude, dance studio) OR (c) When the payment is made

(i) Exception: prepayment does not count as income until the work is service or work is performed. (Artnell/Tampa Bay Devil Rays, baseball season tickets)

(3) Regulation’s Calculation: uncollectible portion of AR must bear same ratio as total bad debts expensed to the year end AR.(Flamingo Resort, 95% gambling credit)

b) Deductions (1) Test

(a) all the events have occurred that establish the liability, (b) the amount of the liab can be determined with reasonable

accuracy, and (c) economic performance has occurred with respect to the liability

(2) Service Providers: an accrual method service provider can defer the accrual of the portion of amounts due for services rendered on the basis of past experience that it is unlikely to be collected. (§448(d)(5))

3. Contested Income and Unenforceable Claims: The “all events” test is not satisfied if the debt or receivable is contested but the income accrues when a final judgment is rendered or when all appeals have been exhausted. Lamm v. Commissioner.

a) Rev. Proc. 2004-34: Limits Artnell rule application to deferral of recognition to only the taxable year immediately following the year of receipt of income. 8 Ex. in book pg 470.

b) Advance Payment From Sale of Goods: If pre-payment received for sale of goods, such prepayment must be recognized in year of receipt OR earlier of:

(1) the year when the prepayments of would be reported for tax purposes OR (2) the year when the prepayments would be recognized for financial acct.

purposes. c) Prepaid Subscriptions and Dues: §455 allows a taxpayer that provides a

subscription to allocate pre-paid income over life of subscription. This must be done by affirmative election by attachment of statement to return. §456 has same standard for Dues paid to organization that does not resemble corporation. Both statutes limit deferral to 36 months.

d) Warranty Contracts: Warranty contracts on houses/cars/etc present problem because K is sold to 3rd party insurer every time. Rev. Proc. 97-38 allows deferral up to 6 years for the amount that is turned around and paid to 3rd party


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insurer and immediate net profit is gross income in year of receipt. 4. Deduction Items: Reg. § 1.461-1(a)(2)(i) Taxpayers may claim a deduction in the

taxable year in which all the events have occurred that establish the fact of the liability can be determined with reasonable accuracy and economic performance has occurred with respect to the liability. Note: Third prong for economic performance

a) Gold Coast Hotel & Casino v. United States (pg 475) (1) Facts: Whether a casino, on the accrual method, could deduct the value of

slot club points earned by slot club members in the tax year in which the members accumulated the minimum points required to redeem a prize, or whether the casino had to wait to deduct the value of the points until members actually redeemed them?

(2) Holding: Gold Coast's accrual deductions were proper, as its liability to members became fixed upon their accumulation of the minimum number of club points whether or not they chose to redeem them and because the amount of liability was known with reasonable certainty. Did not assess 3rd prong, only first 2.

(3) Rule: Three prong test for deductions (All events test) (a) all the events have occurred that establish the liability, (b) the amount of the liab can be determined with reasonable

accuracy, and (c) economic performance has occurred with respect to the liability

b) Economic Performance Concept: §461(h) Economic performance definition (1) Services: When the services are actually provided (2) Property Transfer: when purchaser is provided with the property (3) Use of Property: When taxpayer begins to use the property

c) Contested Liabilities: Taxpayer cannot deduct an item that they have contested as not owing. Dixie Pine Products v. Commissioner

(1) Contested Defined: Taxpayer must have bona fide dispute as to valuation and must commit an affirmative act of assertion that the liability is improper. Reg. §1.461-2(b)(2).

(2) United States v. Consolidated Edison Co. of New York. (pg 485) OVERRIDDEN BY §461(f)

(a) Facts: Con Ed challenged a real estate tax levy against them. It paid the tax in the year of assessment to avoid penalties and interest. The problem is whether to accrue the liability/deduction in year of payment or year that dispute was settled.

(b) Rule: If contested tax item was otherwise accruable in tax year, payment-whether of character which would constitute admission of asserted liability or mere deposit to enable contest of liability-would not render item non-accruable, and if, in absence of payment, item was otherwise accruable in taxable year, payment would be immaterial or unnecessary to question of accruability

(c) Hold: that the contested part of real estate tax accrued not in the year the tax was assessed but rather in the year the contest was finally determined.

(3) Final Rule on Payment w/Contest: Accrual method taxpayers can claim a deduction for a payment made in respect to a disputed settlement debt even though the dispute survives the payment. §461(f).


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D. The Taxable Year: Each taxable year must be treated as a separate unit and all items of gross income and deduction reflected in terms of their posture at the close of such year, for federal income tax purposes.

1. Annual v. Transactional Taxation: Federal income tax is an annual accounting taxation whereas things like sales tax are collected at the transaction, per the transaction. This annual reporting reduces compliance burdens and makes a more predictable gov income stream.

2. Tax Year Choices: §441 has 4 possible options for tax years a) Calendar Year per §441(d) b) Fiscal year per §441(e) c) Short taxable year per §441(b)(3) and §443 d) 52-53 week tax year per §441 (f)

3. Short Explanation of Short-Year and 52-53 Years (Beyond scope of class) a) Short Year: Usually not applied to individuals because it is for businesses

changing their accounting method mid year. People only have one short year, when they kick the bucket.

b) 52-53 Week: It is for businesses that end their business for the year on a specific day of the week. Taxpayer only has to keep books on that same basis.

4. General Tax Year Usage (Most common usages) a) Calendar Year: Most taxpayers individually are calendar year. It almost never

happens for an individual to be on a fiscal year for cyclical income purposes. b) Fiscal Year: Only way to be able to use the fiscal year is to formally request to be

able to use it and get approval from IRS. §442. More prevalent for business entities

5. Standalone Rule: Each tax year stands alone as a single accounting period. The tax return for that year should reflect that economic differences incurred during that period of time. There are statutory and common law exceptions to this rule.

6. Burnet v. Sanford & Brooks Co. (pg 493) (VERY OLD CONCEPT) a) Facts: Problem with incurring expenses one year, sueing U.S. for payment in

later year, and recovering the income in an even later year. b) Holding: annual accounting system is a practical necessity if the federal income

tax is to produce revenue ascertainable and payable at regular intervals. It is constitutional and appropriate because congress is not required to adopt another system.

7. North American Oil Case Note a) Claim of Right Rule: If a taxpayer receives earnings under a claim of right and

without restriction as to its disposition, he has received income which he is required to 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.

8. United States v. Lewis (pg 497) a) Significance: Reinforces the claim of right doctrine. b) Restated Claim of Right: If you rightfully receive something and there are no

restrictions on its transfer, you must include it in gross income upon receipt, even if you may have to return the money in the future.

E. Error Correction: Several devices for taxpayers to correct mistakes. 1. Correction Devices

a) Tax benefit rule


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b) §1341 restoration of right c) Res Judicata and Collateral Estoppel d) Equitable Recoupment e) SOL Exceptions

2. Tax Benefit Rule: If a taxpayer recovers an item that was previously deducted, and if the prior deduction reduced the tax liab in the year of deduction, then the recovery is included in income

a) Right To Exclusion: §111(a) allows the taxpayer to exclude from income amounts recovered that were previously deducted and did not reduce the tax liability that year.

b) Applicable Tax Rate in Recovery Year: The general rule is that the item will be taxed in the current year at current rates but there are exceptions.

c) Alice Phelan Sullivan Corporation v. United States (pg 501) (1) Facts/Issue: Taxpayer sues claiming refund of amount of deficiency paid

after her charitable conveyance was reconveyed to her years later. Taxpayer alleges taxes due on reconveyance can not exceed tax deduction benefit she originally received by making conveyances

(2) Rule: A transaction which returns to the taxpayer his own property gives rise to income when the recovered item was initially used as a deduction and provided a tax benefit to the taxpayer; the item recovered will be taxed in the current year at current tax rates.

(3) Holding: The tax benefit rule makes no mention of the tax rate which should be applied to the recovery and the court determines, in light of the single-year model of our tax system, that the applicable tax rate is that of the year of recovery

d) Erroneous Deduction Exception: Tax Court and some App. Ct’s recognize it, but not all. Essentially, if a taxpayer deducts something in a prior year that the taxpayer should not have per the tax code, this does not prevent the tax benefit rule from applying.

e) Unvert v. Commissioner (pg 505) (9th Cir) (Circuits are split) (1) Facts/Issue: Must a taxpayer include in income the recovery of the

prepaid interest expense even though the taxpayer erroneously deducted the expense in a prior year?

(2) Holding: Yes. Recovery of the expense was required to be treated as income under the tax benefit rule regardless of whether the 1969 deduction had been improper

(3) Rule: Regardless of whether original deduction of interest expenditure was improper, subsequent recovery of the expenditure was required to be treated as income in the year of recovery under the tax benefit rule.

f) Expansion of Erroneous Deduction Exception: The inclusionary aspect of the tax benefit rule now reaches not only recoveries of amounts previously deducted but also events that are fundamentally inconsistent with a prior deduction or exclusion.

g) Hillsboro National Bank v. Commissioner AND United States v. Bliss Dairy, Inc. (pg506)

(1) Concept at Issue: Tax benefit rule application in two different cases. (2) Rule: Unless a nonrecognition provision of the IRC prevents it, the tax

benefit rule ordinarily applies to require the inclusion of income when


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events occur that are fundamentally inconsistent with an earlier deduction (3) Policy: Purpose of tax benefit rule is not simply to tax “recoveries,” but,

on contrary, is to approximate results produced by tax system based on transactional rather than annual accounting, and basic purpose is to achieve rough transactional parity in tax and to protect government and taxpayer from adverse effects of reporting transaction on basis of assumptions that an event in subsequent year proves to have been erroneous.

3. Restoration of a Claim of Right: §1341 allows a taxpayer that recovers under a claim of right a tax benefit rule item in a later year to get the tax benefit the taxpayer would have obtained in the original year of deduction if the taxpayer meets the following 3 requirements.

a) Requirements Per §1341(a)(1-3) (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; and

(3) the amount of such deduction exceeds $3,000 b) Reynolds Metals Co. v. United States (pg 529)

(1) Facts/Issue: Does a CERCLA clean-up project that establishes liability for the last 50 years of environmental contamination qualify for §1341 treatment?

(2) Holding: No. Taxpayer is not repaying funds to anyone that it had erroneously received before.

c) Flavor of Item in Restoration of Claim of Right: The Arrowsmith doctrine states that restorations associated with prior income items take the same flavor as the prior income items.

d) United States v. Skelly Oil Co. (pg 531) Vodka (1) Facts/Issue: Taxpayer was in the natural gas business. After a change in

the minimum price order on natural gas, Taxpayer had to refund a large amount of money to customers previously claimed as gross income.

(2) Holding: where taxpayer overcharged customers for natural gas for certain years and subsequently was required to refund overcharges, deduction allowable in year of repayment was required to be reduced by percentage of other tax benefits gained by previous recognition concepts.

(3) Rule: If money was taxed at a special lower rate when received, the taxpayer would get an unfair tax windfall if re-payments were deductible from receipts taxable at the higher rate applicable to ordinary income.

e) Limitation For Capital Loss: Keep in mind the§1211(b) $3000 capital loss limitation that can be used per year. It applies to §1341 losses that are flavored as capital losses that are taken in the current year.

4. Res Judicata and Collateral Estoppel: Preclusion doctrines raise issues about what has been litigated by the taxpayer and IRS already. The close of tax year opens up a whole new period for litigation.

a) Res Judicata: Generally known as claim preclusion


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b) Collateral Estoppel: Issue preclusion c) Commissioner v. Sunnen (pg 540)

(1) Facts/Issue: Is the government precluded from arguing that the royalties paid to a related person were gross income to the taxpayer when the government previously found that royalties under an almost identical agreement were not gross income?

(2) Holding: No. Res Judicata is generally not available in tax cases because each tax year is a new cause of action.

(3) Res Judicata (a) Each year is the origin of a new liability and separate cause of

action. (b) Res Judicata will only apply to subsequent proceedings on that

same tax liability of the same year. (4) Collateral Estoppel

(a) Collateral estoppel acts only to prevent similar or unlike claims in subsequent years if the claim was presented and determined before.

(b) Collateral estoppel operates to relieve the government and the taxpayer of redundant litigation of the identical question of the statute’s application to the taxpayer’s status.

5. Equitable Recoupment - Two wrongs = Right: Rarely used but occasionally a taxpayer makes a mistake in a prior year and realizes it after it is too late to amend; the IRS may permit the taxpayer to make another mistake in the current year so as to recoup the benefit lost or effectively right the previous wrong.

a) United States v. Dalm (pg 543) (1) Facts: Taxpayer sought refund of gift taxes by way of recoupment,

alleging that taxes had been collected on mutually exclusive theory that transferred money was both income and gift

(2) Holding: doctrine of equitable recoupment did not provide jurisdictional basis for independent suit to recover gift tax previously paid, after time for filing refund had expired

(3) Rule: Fact that taxpayer does not learn until after limitations period has run that tax was paid in error, and that he or she has ground upon which to claim refund, does not operate to lift limitations bar. Tax refund claim not filed within limitations period cannot be maintained, regardless of whether tax is alleged to have been erroneously, illegally or wrongfully collected.

6. Mitigation Provisions: Congress has provided exceptions to SOL where judicial deference to the statute would produce anomalous results. There are 4 exceptions to the SOL:

a) Determinations under §1313 b) Circumstance of adjustment under §1312 c) Correction of the error must now be barred by law §6501 or §6511 d) Condition of adjustment §1311(b) e) Mitigation Calculations: If mitigation is permissible, the adjustments are done

per §1314. XI. Chapter 7: Flavor of Income

A. Introduction: the different kinds of income and treatment


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1. Capital Gains Income: gain from the sale of a capital asset 2. Capital Asset Definition (§1221(a)

a) If it is NOT on the list, it is NOT a capital asset but the list is interpreted broadly. (Arkansas Best)

(1) Own business stock or raw materials to produce/ manufacture own business inventory

(2) Depreciable property or real property used in trade or business (3) copyright, literary, musical, or artistic composition, letter or memo, or

similar property that the taxpayer created or that the basis is determined while they hold.

(a) Not from own efforts, but investor (b) Musical Composition held by composer: Taxed as capital asset if

elected, but not novelists! (4) accounts or notes receivable acquired in ordinary course of trade or

business for services or property in (a), (5) U.S. Government publication, including Congressional Record, received

other than purchased at public sale, and the taxpayer either holds or basis is determined while held,

(6) commodities derivative financial instruments held by dealer, unless Secretary determines the instrument is not connected to the dealer as a dealer, & identified in dealer’s records by the close of the day when it was acquired/ entered,

(7) hedging transactions identified as such before the close of the day when acquired/entered (Corn Products, corn commodity hedging)

(8) supplies regularly consumed in ordinary course of own trade or business. 3. General Application: property held for investment or personal use purposes (not trade or

business) is a capital asset. a) assets held to produce ordinary Trade or Business income b) assets where gain is from own efforts and not time.

4. Applicable Rate Section (§1(h)): individual must have a “net capital gain” a) Net Capital Gain Calculation (NCG) (§1222(11)): excess of “net long-term

capital gains” over “net short term capital losses” (1) Long-Term Capital Asset Gains

(a) 1-Year Minimum in order to get the lower tax rate for a capital gain, it must be a long term capital gain (held for over a year). (§1222(1)-(4))

(b) Preferential Rate: 20%, which is lower than individual income rates

(2) Short Term Capital Asset Gain: taxed at ordinary rate, CAN offset capital loss

b) Capital Gain Treatment Policy (1) Inflation: adjusts for inflation because basis doesn’t account for it (2) Bunching: better reflection of gain accrued over time because not realized

until sold 5. Capital Loss Treatment: §1211(b) Limited to the amount of capital gain + $3,000 (to

offset ordinary income). Ordinary loss is not limited, can carry forward to future years until loss is used.

6. Byram v. US (pg 564)


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a) Facts/Issue: Whether taxpayer is an investor or in his trade or business when he sold 7 pieces of real estate in a year for a lot of $ but did not have advertised, was not licensed real estate agent, and the transactions were initiated by the buyer.

b) Hold: Investment & capital gains treatment because he did not have an office, didn’t initiate sales, and was not licensed.

c) Testing: Whether something is a capital gain v. ordinary income is a question of fact.

d) Fact- Intensive Test: 7 Factors Capital Gains Treatment (1) the nature & purpose of the acquisition of property & duration of

ownership, (2) the extent & nature of the taxpayer’s efforts to sell the property, (3) the number, extent, continuity & substantiality of the sales, (4) the extent of subdividing, developing, and advertising the increase sales, (5) the use of a business office for the sale of the property, (6) the character & degree of supervision or control exercised by the taxpayer

over any representative selling the property, & (7) the time & effort the taxpayer habitually devoted to the sale.

7. Sale or Exchange Requirement: §1222 - Capital gain or loss only when sold or exchanged. Otherwise it’s ordinary income or loss.

a) Real Estate: Occurs on the earlier date of conveyance or date when the burdens & benefits of ownership pass to the purchaser.

b) Other Sale/Exch Dates : Also occurs when → (1) corporate liquidation, (2) Securities become worthless, (3) failure to exercise a privilege or option on property that if acquired would

have been a capital asset. 8. Kenan v. Commissioner

a) Facts/Issue: Whether the delivery of a trust estate’s securities to satisfy a claim is a gain?

b) Held: Trustees or taxpayers realized gain when they used securities to satisfy the claim on the estate because the trustee could satisfy the claim by either securities or $, if had been $ a taxable gain would have been realized.

c) Rule: Unlike “sale,” “exchange” doesn’t require a bilateral agreement & has broad definition.

9. Preferential Rates for Long-Term Capital Gains & Qualified Dividend Income a) General Rule Net capital gains taxed at a preferential rate (15%), applies only to

gains from sale or exchange of capital assets held over a year (LT). §1(h). b) Definition of Capital Gain: §1222(11): Net Capital Gain= excess of Net Long

Term Capital Gain/ Net Short Term Capital Loss. c) Netting: 1st) net short & long term capital gains & losses for each rate group

separately, 2nd) if elect to treat amount of net capital gain as investment, subtract from total net CG.

(1) 1(h)(1)(A)Ordinary Income & Net Short-Term CG @ Regular Rate (2) (B) Adjusted net capital gain up 15% bracket @ 0% (3) (C) Remaining adjusted net capital gain @ 15% (4) (D) Portion of net capital gain consisting of unrecaptured depreciation on

depreciable real property @ 25% (5) (E) Portion of net capital gain consisting of collectibles @ 28%


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d) Applicable Tax Rate for Gain: Applicable Rate for Net CG depends on the Marginal Tax Rate (the last dollar of ordinary income):

(1) if exceeds 15%, Net CG taxed @ 15% (2) if 15% or less, Net CG taxed @ 0% (in 2012) (3) 0% applies to married filing jointly income up to $69,000, individuals up

to $35,350. e) Special Tax Rates: (or @ marginal ordinary income rate, whichever is lower)

(1) Collectibles: Gains from sale or exchange of Collectibles @ 28% (§1(h)(1)(E)) → includes artwork, rugs, antiques, metals, gems, stamps, coins, alcohol. (§408(m)(2))

(2) Recapture Gains: Gain attributable to Unrecaptured Depreciation Deductions on Real Property @ 25% (§1(h)(1)(D)). See also §1250

10. § 1231: Gains & Losses a) General Approach: “Best of Both Worlds”= Capital gains + Ordinary losses b) Policy: This was originally designed to dissuade taxpayers from trying to

constantaly get capital gain treatment on one thing and ordinary loss on similar item. Now, taxpayers just try to classify everything as §1231.

c) Qualified §1231 Property: Business real estate or depreciable business property is generally excluded from capital asset, But if qualifies under §1231, certain T or B, depreciable property, held more than a year, not in §1221, then qualifies as capital G/L

d) Sale or Exchange: Property gain or loss realized from the sale, exchange, or involuntary conversion of property.

e) Treatment: Treatment of G/L per the code (1) If 1231 gains > losses, treated as long-term capital gain/loss. (2) If 1231 losses > gains, treated as ordinary income/loss.

f) Netting §1231 G/L: If 1231 gains from involuntary conversions ≥ losses, then included with other 1232 gains & losses to determine net for year. If gains ≥ losses, long-term capital gain/loss. If losses > gains, ordinary income/ loss.

g) Recapture Provision for Ordinary Loss: if net 1231 gain for year, then must review 5 prior years for possible recapture of 1231 losses for prior years. If net 1231 losses during period, must treat current year’s net 1231 gain as ordinary income to the extent of the amount unrecaptured net 1231 losses for the past period, recaptured losses on FIFO basis.

h) Trade or Business Property Only: Property must be used in trade or business: includes

(1) either depreciable personal property or real property used in T or B, (2) is not in §1221 (a)(1) (inventory & property for customer sale), (3)

(created property), or (5) (Gov. publications). (3) T or B property held for more than a year & involuntarily converted, (4) capital assets held more than a year (5) crop sold with land held over a year, (6) livestock, & timber, domestic iron, ore, or coal.

11. Depreciation Recapture: §1245 - A gain (if loss, doesn’t apply) on the sale or disposition (sale & leaseback transaction, transfer upon foreclosure of security interest) of property in 1245 is taxed as ordinary income to the extent of all depreciation/ amortization deductions previously claimed on property.

a) Computation: Amount treated as ordinary income is the excess of the lower of


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(1) property’s recomputed basis, OR (a) Adjusted basis + previously allowed or allowable depreciation/

amortization reflected in adjusted basis. (b) Note: Generally = to original pre-depreciation cost of property.

(2) amount realized or FMV/ adjusted basis of property. b) Application: Smaller # applied against taxpayer’s adjusted basis to determine

recapture amount, portion of gain is treated as ordinary income. 12. Depreciation Recapture for Real Property: §1250 - depreciation recapture provision but

only applies when the taxpayer has taken “additional depreciation” on depreciable real property.

a) Additional Depreciation Defined: excess of the amount of accelerated depreciation deductions allowed to taxpayer / amount of depreciation allowed if straightline method used.

b) Outdated Application: Now, MACRS uses straight line depreciation w/ depreciable real property.... so this is f’n useless & stupid!!! ← Ain’t stuffbut hoes and tricks.

c) Rate Applied: Instead “unrecaptured 1250 gain” @ 25% tax rate (v. 15%) XII. Chapter 8: Transactions in Property

A. General: subtract adjusted basis from amount received to determine the amount of gain, if positive, or loss if negative

1. Equation: Amount Received - Adjusted Basis = Gain (+) / Loss (-) (§1001) 2. Realized Gain = Amount Realized - Adjusted Basis 3. Realized Loss = Adjusted Basis - Amount Realized

B. Amount Realized (from sale or other disposition of property)= total cash received from sale + FMV of Property received (if purchaser assumes mortgage liability)

1. Basis of (rental/ business/ investment) Home= Cost of purchase + Fees + Improvements - Depreciation

2. Basis of (own) Home = Cost of purchase + Fees + Improvements (NO DEPRECIATION)

3. Recourse Debt: Lender can pursue debtor’s other assets for repayment if secured portion does not satisfy the entire debt.

4. Non-recourse Debt: Lender’s recourse for default is limited to assets that specifically secured the loan. Once securing asset is sold, that amount is all the loaner can recover.

5. Crane v. Commissioner (pg 623) a) Issue: How to determine the taxable gain on the sale of a home with a non-

recourse loan? Whether the the buyer assumes the debt in amount realized if the seller no longer owes the debt?

b) Hold: Include amount of nonrecourse debt in basis & amount realized, the debt stays with the property.

6. Commissioner v. Tufts (IRS wants to be a douche, & then there were tax shelters...) a) Facts: Partners built apartment with note on deed trust to bank, non-recourse.

Finish construction and can’t make payments on note. All partners sell to 3rd party. FMV of property less than note. IRS says gain to partners.

b) Issue: When business property with a non-recourse note is sold loss, worth less than FMV, & the buyer only assumes a non-mortgage what is their amount realized & adjusted basis?

c) Holding: Taxable Gain. The debt relief is in essence paying the seller cash and the seller paying off the debt.


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d) Rule: If value of property < Mortgage amount, a mortgagor who is not personally liable can’t realize a benefit = to mortgage. Nonrecourse loan as regular debt, but not personal liability + depreciation deductions. Include on both sides, obligation in AR = assumption of non-recourse debt, AB = deductions.

e) Post- Tufts Tax Reform Act 1986: Must be liable for a real loss (personally liable) or actively participate.

C. Tax Aspects of Homeownership: 1. Tax Benefits

a) Qualified Residence Interest: Mortgage Interest & Property Tax Deductions (1) Itemized deductions

b) Exclusion of Gain (§121): exclusion of gain on the sale of a principal residence (1) Requirements

(a) Ownership Test: must have owned for at least 2 years (730 days) within a 5 year period (1,825 days) prior to date of sale;

(b) Use Test: must have used as principal residence for at least 2 years (730 days) within a 5 year period (1,825 days) prior to date of sale;

(c) Once Every 2-Years Test: Can not have used §121 exclusion within 2 yr period (730 days) prior to date of sale.

(i) 730 days within 5 yr period does NOT have to be consecutive

(ii) Own & Use within 5 year period but do not have to be at the same time

(2) Partial Exclusion (§121(c)) (a) If one of the unforeseen circumstances applies then the taxpayer

may use a prorated exclusion based on amount of 2-year requirement met.

(3) Special Rules (§121(d) (a) Joint Returns (b) Deceased Spouse (c) Spouse or Former Spouse

2. Interest a) General: Interest paid/ incurred during taxable year is not deductible (§163(a)) b) EXCEPTIONS

(1) Active Business Interest (§163(h)(2)(A)): Business Interest paid or incurred with trade or business activity taxpayer materially participates in. Included in §1622(a) above the line deduction.

(2) Taxable Investment Interest (§163(h)(2)(B)): Extent of taxable investment interest (to make $) paid to finance investment activities that will yield income subject to federal income tax. Deductible under §163(d)’s limitation on investment interest: “net investment income” or §212(1) “Expenses for Production of Income.”

(3) Passive Activity Business Interest (§163(h)(2)(C)): Debt incurred for a business activity as a passive (does not materially) participant, can deduct interest expense to the extent of income from all passive activities during the year exceeds other losses & deductions from passive activities.

(4) Estate Tax Interest (§163(h)(2)(E)): Can deduct interest expense incurred for deferring illiquid or unassignable assets.


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(5) Education Loan Interest (§163(h)(2)(F)): Interest for certain education loans is deductible. Above the line, limited by income.

(6) Qualified Residence Interest (§163(h)(2)(D)): Can deduct interest from mortgage & property taxes of primary & secondary residence.

(a) Property Taxes: Property taxes deductible. Amount based on current FMV, annually assessed.

(b) Second Mortgage: Also applies to 2nd mortgages as HELOC. (c) Nature of Interest: Interest must be from “acquisition

indebtedness” or “home equity indebtedness.” (i) Acquisition indebtedness: debt to acquire or substantially

improve residence up to $1,000,000 total debt. Limited to basis in home + improvements.

(ii) Home Equity Indebtedness: Any other indebtedness secured by a qualified residence. Must have equity in home. Amounts limited to extent of equity.

(d) Qualified Mortgage Insurance Premiums (§163(h)(3)(E)): Premiums paid or accrued before 2012 for insurance K’s entered 2007-2012 & provided by Veterans Administration, Federal Housing Administration, Rural Housing Administration, or private mortgage insurance in 23 USC §4901, for acquisition indebtedness on qualified residence = qualified residence interest.

3. Exclusion of gain on the sale of Principal Residence (§121): Generally, a taxpayer usually does not have to recognize a gain on the sale of their personal residence per the exclusion amount.

a) Requirements: To qualify for exclusion 3 requirements → (1) Ownership Test: Must have owned for total of 2 yr period (730 days)

w/in 5 yr period (1,825 days) prior to date of sale; (2) Use Test: Must have used as principal residence for total of 2 yr period

w/in 5 yr period prior to date of sale; & (3) Once Every 2 years Test: Can not have used §121 exclusion within 2 yr

period (730 days) prior to date of sale. (a) 730 days within 5 yr period does NOT have to be consecutive! (b) Own & Use w/in 5 year period but do not have to be at the same

time. b) Exclusion Amounts: Married: $500,000/ Single: $250,000 of gain excluded. c) Safe Harbor Exceptions §121(c): If can’t meet 2 yr ownership & use because of

unforeseen circumstances (change in employment, health)- See Treas. Reg. 1.121-3

(1) Employment Change: Change of employment if < 50 miles from residence sold than previous job.

(2) Health Reason: Sale or exchange for health reasons if to “obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury.”

(3) Unforeseen circumstances: event unanticipated prior to purchasing or occupying the home. Exclusion amount is prorated over period of use & ownership.

D. Like- Kind Exchanges (§1031) 1. General: “No gain or loss shall be recognized on the exchange of property held for


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productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

2. Requirements: (1) Property must be business property (2) Exchange must be for another of like kind

(a) Like-Kind: same nature or character (b) Within the same asset class as listed in regs

(3) Proceeds from sale of 1st property cannot be received by taxpayer (4) Identify exchange property within 45 days (5) Close on sale of 2nd property within 180 days of selling 1st property

3. Starker & Reverse Starker 4. Excluded Property

a) stock in trade or other property held primarily for sale b) stocks c) bonds d) notes e) certificates of trust f) beneficial interests g) GP interests h) securities or evidences of indebtedness or interest. i) Doesn’t apply to personal property, but usually can treat as “held for

business” if rented for min. of 2 weeks in each of the 2 years prior & exchanged for the same, & minimal personal use.

5. Terminology: a) 1st Property: Relinquished Property, b) 2nd Property: Replacement Property c) Boot: anything of not like kind that the taxpayer recognizes from the

transaction. (1) Taxed as individual income (2) Includes: Cash, items that are not like kind, assumed mortgage

6. Effect: like-kind exchange = delays gain until the property is sold under a provision that will force recognition.

7. Basis In Exchange Property (§1031(d)) a) Basis Rules: Adjusted Basis for 1st property becomes the “substituted Basis” for

the new property. b) Any boot is then adjusted against the basis depending on who paid what. c) Basis Allocation Among Multiple Properties: Get appraisals and distribute old

basis among new properties according to FMV. d) Exchange as Part of Business Acquisition: Use residual method to allocate

among assets when purchasing entire business. e) Assumptions of Liability: Total consideration received = Amount of Both

Mortgages (both sides) & Adjusted Basis. Buyer of Relinquished Property must include mortgage obligations on both sides.

8. Strict Compliance w/ Deadlines: Requirements (a)(3): 45 days to identify the replacement property & 180 days to receive replacement property. Almost zero exceptions.

9. Qualified Intermediary: Special brokers that deal in 1031 exchanges. Ensures no actual


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or constructive receipt by taxpayer of anything other than like- kind property. (Can not take control of $, otherwise = “boot” & taxed. Must have middleman hold $.)

10. Starker v. United States (pg 672) - Note a) Issue: Whether the sale & purchase of business property must be in the same day

or can 6 months apart? No requirements it must be in the same day. b) Result: IRS amended & included deadline “days”. Days when the deal must be

complete, but not in use. 11. Reverse Stalker v. United States (pg 673) - Note

a) Issue: Whether the deadline dates equally apply when the replacement property is found & identified before the relinquished property? Yes, same deadlines.

b) Result: Can buy replacement property 1st, but still have 180 days to identify & sell relinquished property.

12. Like-Kind Exchange of Depreciable Property: Generally, extent basis in replacement property does not exceed basis in relinquished property (“exchanged basis”), is depreciated over remaining recovery period of relinquished property. (pick up where you left off)

a) Applicable recovery period: Reg. §1.168(i)-6 OR b) may elect to treat replacement property as if purchased for cash in the year the

replacement property is placed in service. c) If replacement recovery period > relinquished, the exchanged basis is depreciated

beginning at replacement year over the remainder of the applicable replacement property’s recovery period as if replacement property in service same year as relinquished property.

d) Any “excess basis” is treated as property in service the same year as replacement property & can be expensed under §179.

13. Like-Kind Exchange w/ Principal Residence : If first used as home, then or at the same time as business in like-kind exchange, must qualify for both §121 exclusion & §1031 nonrecognition. §121 must be applied first, & the exclusion does not apply to gain attributable to depreciation deductions claimed for the business/ investment portion of residence, §1031 applies to that gain. Any §1031 boot received applies only to the extent the boot exceeds the excluded 121 gain.

a) Basis Effect: Basis of replacement property is increased by any gain from relinquished property excluded under 121.

E. Involuntary Conversions (§1033) 1. General: If property has an involuntary converted

(1) destruction whole or in part; (2) theft; (3) seizure; and (4) requisition or condemnation (threat or imminence of).

2. Characteristics of Conversion:Does not have to be “sudden” destruction. 3. Can be Business or Personal. 4. Insurance Reimbursements: involuntary conversion into home. Insurance is for the

worth of property, not basis. If insurance $ & buy another property within 2 years = tax free!

5. Basis Rule: Carry over basis- preserve gain, paid at sale of replacement property. 6. Replacing Property: If buy property worth less, must recognize gain on difference. 7. New Property Requirement: Must be “similar & related in service.” 8. Time Limit: (2)(b) Time limit = 2 years after close of taxable year


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F. Installment Sales: SKIPPED XIII. Chapter 9: Personal Matters

A. General Rule: except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses. (§262)

B. Itemized Deductions: Deductions that are not part of a taxpayer’s business but are permitted specifically through the tax code as a deduction against Adjusted Gross Income. (Schedule A)

1. Use: Congress has allowed several deductions for things like home mortgage interest, medical expenses, etc. but these are only used if the taxpayer is not using the standard deduction.

C. Extraordinary Medical Expenses (§213) 1. General Rule: Taxpayer may deduct unreimbursed (not covered by insurance)

uncommon expenses that exceed 10% of AGI. (§213(a)) 2. Dependents: Covers individual & dependents (even those that don’t live with you). 3. Expenses Allowed: covered expenses must be direct connection, not too attenuated.

§213(d) direct expenses means amounts paid for: a) diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose

of affecting any structure or function of the body; (§213(d)(1)(A)) b) for transportation primarily for and essential to medical care; (§213(d)(1)(B)) c) qualified long- term care services-In patient care- can include meals and lodging;

(§213(d)(1)(C)) d) for insurance, including premiums; (§213(d)(1)(D)) e) Lodging: amounts paid for lodging while away from home primarily for and

essential to medical care (§213(d)(2)) (1) Medical care must be in a licensed medical facility (2) there is no significant element of personal pleasure, recreation, or

vacation in the travel away from home. (3) Max $50 per night for each individual

f) Prescribed drugs (§213(d)(3)) (1) Does not include over the counter (Rev. Ruling 2003-58) (2) Only medicine that are legally procured

(a) No medical marijuana (Rev. Ruling 97-9) g) Psychiatrist treatment for “sexual inadequacy & incompatibility” (Rev. Ruling

75-187) h) Gender Surgery: surgery & hormone replacement therapy qualifies because

actual medical defect on books, but not part of the breast augmentation because you don’t need D cups. (O’Donnabhain)

i) Breast reconstruction surgery after a mastectomy for cancer (Rev. Ruling 2003-57)

j) Vision correction surgery (Rev. Ruling 2003-57) 4. Not Allowed

a) Cosmetic Surgery (§213(d)(9)) (1) Not covered unless deformity/ abnormality caused by accident/ trauma or

disfiguring disease. b) Food and hotel for sexual inadequacy is not covered (Rev. Ruling 75-187) c) Marriage counseling with clergy (Rev. Ruling 75-319) d) Living in apartment as part of treatment by psychiatrist not covered (Rev. Ruling

75-187) e) Teeth whitening (Rev. Ruling 2003-57)


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f) Payment to Relatives: cannot deduct payments to relatives for medical care when (§213(d)(11))

(1) taxpayer’s spouse or relative unless licensed professional (2) provided by corporation or partnership related to taxpayer

g) Order to spend winter months in FL, lodging is not covered (Bilder) D. Charitable Contributions (§170)

1. General: charitable contributions are an itemized deduction that taxpayer can claim if they made a donation or cash or property to a qualifying entity.

2. Requirements: a) must be a “qualified recipient” under (C) b) made a “contribution” to qualified recipient, & c) Determine amount of deduction. (b) & (e) limitation

(1) If receive anything in return for contribution, must be reported in writing if value is over $1 & must subtract from deduction.

(2) Can carry forward 3. Quid Pro Quo: Contributions to a religious organization are not deductible if the

taxpayer receives and identifiable benefit. (Hernandez, Church of Scientology) 4. Sklar v. Commissioner (pg 735)

a) Facts/Issue: Taxpayer sent their child to Jew school. Taxpayer then tried to deduct the cost of tuition and fees as charitable contribution.

b) Rule: Under the rule governing deductibility of a “dual payment” or a “quid pro quo payment” to a charitable organization, a taxpayer must establish that its dual payment exceeds the market value of the goods received in return

c) Holding: Payments for tuition & fees to children’s Orthodox Jew School is not allowed.

5. Learn to Burn Handout: Fire department offers to take house and burn it for firefighter training

a) Problem: How to determine the value of a house that was donated to the fire department?

b) Test: Benefit v. Burden, likely = to demolition costs & deduction is zero. (“Smell Test”)

(1) Fact Specific: FMV from objective standard- what a willing buyer would sell for & willing seller would pay.

(2) Factors: Cost paid if demolition, benefit/ value to firefighters, value of the land w/o structure.

6. Bargain Sale to Charities: Sells property for less than FMV. If discount from “detached & disinterested generosity” of the seller.Treated as part gift, part sale, but under §1011(b) seller must apportion basis in transferred property between sale & contribution portion.

7. Rev. Ruling 81-163: If a donor transfers property with an attached mortgage, the amount of the donation is the fair market value of the contribution less the mortgage still owing. The taxpayer may also recognize gain on the transaction for the amount that the mortgage release exceeds the allocable adjusted basis.

a) Amount Realized = Amount of debt relieved b) Gain on Bargain Sale Donation = �� ∗ ��/��

8. Substantiating Certain Contributions of Property: Generally, contribution of property w/ a deduction over $500, requires substantiation unless property is readily traded or can’t meet required sub. for good cause.


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a) Minimum Requirement: Contribution more than $500, required sub. = attach to return a description of property.

b) Higher Burdens: More than $5,000 = attach & obtain a qualified appraisal of property + other info. Secretary may require.

c) Large Contributions: More than $500,000= attach qualified appraisal of property. 9. Newspaper Morgue: SanFran donates “newspaper morgue to historic society & takes

deduction. But not allowed because previously deducted costs through employee’s salary & basis is zero.

10. Limitations on Deductions For Charitable Contributions: 11.

Type of Contribution Amount of Deduction

% Limit if Contributed to a “public charity” in §170(b)(1)(A)

% Limit if Contributed to a “Private Charity”

Cash FMV 50% of AGI 30% of AGI, but can’t exceed 50% of AGI - gists to public charities.

Loss Property (Basis > Value)

FMV 50% of AGI “ “

Ordinary Income Property (Value > basis, but not capital asset)

AB 50% of AGI “ “

Short-Term Capital Gain Property (Value > Basis in capital asset held for 1 year or less)

AB 50% of AGI 20% AGI, not can’t exceed (30% AGI - gifts to public charities)

Long- Term Capital Gain Real Property (Value > Basis, capital asset held more than a yr)

FMV or AB, if to a private foundation

30% of AGI “ “

Long-Term Capital Gain Intellectual Property (Value > Basis, IP capital asset held more than a yr)


Other Intangible Long-Term Capital Gain Property (Value > Basis in intangible capital asset held more than a year)

FMV or AB if to a private foundation, unless “qualified appreciated stock” under 170(e)(5)

30% of AGI “ “

Long-Term Capital Gain Related Tangible Property (value > basis in

FMV or AB if to private foundation

30% of AGI or 50% if to private foundation

“ “


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tangible capital asset related to the charity’s purpose)

Long-Term Capital Gain Unrelated Tangible Property (value > basis in tangible capital asset unrelated to charity’s purpose)


12. Taxes §164: Deductions only allowed for a tax, not penalty/ fee/ charge 13. Deduction Allowable: State tax, local/ municipal tax, some business tax. (Usually, if

individual then itemized.) a) Sales Tax or Income Tax: States with no income tax may deduct sales tax w/

receipts or use IRS tables.’ b) Tax Type Fees: License & Registration Fees = Tax

14. Foreign Taxes: Can either deduct payments under §901 Foreign Tax Credit or under 164 Deduction. Usually more beneficial to tax FTC if you can.

E. Miscellaneous Expenses: Employee Business Expenses if unreimbursed employee expenses & not self-employed. Permits a Schedule A deduction w/ 2% of AGI haircut not allowed

F. Family Law Tax Aspects 1. Medical Expenses §213 - Covered Earlier 2. Qualified Adoption Expenses Credit §23: Nonrefundable tax credit- if credit > total tax

liability, reduced to zero & excess is not refundable. But excess can carry over and added to other credit amounts claimed in next 5 years.

a) Qualified Expenses: Expenses “reasonable & necessary” that directly relate to adoption, if lawful, don’t relate to adopting spouse’s kid, & not reimbursed elsewhere.

b) Excluded Payments: §137- excludes from gross income amount expenses paid by employer.

c) Timing: Generally, claimed in year adoption is finalized. d) Limitation: 2 limits:

(1) Total amount per year of 1 credit= $10,000 (2) if AGI exceeds $150,000, credit amount is gradually reduced to zero @

AGI of $190,000. e) Carryover: Can carry over for 2 yrs, if expenses paid over 2 yrs, get credit in 2

yrs. 3. Child Care Expenses:

a) Dependent Care Credit: § 21: Credit = 20-35% (depending on AGI) of employment-related expenses to provide home for dependents & incapacitated spouses.

b) Qualified Expenditure: Pay others to care for kid or elder dependent c) Qualify For DCC: Taxpayer must “maintain the household” (furnish over one-

half of the total cost of maintaining the household) for: (1) dependents under 13; (2) dependents of any age who share the same principal place of abode as the

taxpayer and are physically or mentally incapable of caring for


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themselves; and (3) spouses of any age who share the same principal place of abode as the

taxpayer and are physically or mentally incapable of caring for themselves.

d) Policy: Provide relief because General rule: costs incurred to provide for babysitting, day care, or similar services will at work are not deductible business expenses.

e) Calculation: %, generally between 20-35% of income tax liability, of costs taxpayer can claim depends upon adjusted gross income. Higher the AGI, lower the %. Credit decreases by 1% for each $2,000.

f) Basis: Includes actual physical care of the dependent, but also ancillary “household” services (such as meal prep. & cleaning.) Household services MUST be related to the care of the child.

g) Limitations: Limited to payment for household services & care for qualifying dependent (= 12 or under or unable to care for self because of physical or mental incapacity, who shared same principal residence for more than half of taxable year).

(1) Excluded Items: §21(b)(2)(A)- employment related expenses (summer camp expense expressly prohibited). Treas. Reg. 1.21-1(d)(3)-cap on household services

(2) Refundability: Credit is non-refundable. Only reduces or eliminates tax liability.

(3) Employer’s on-site child care: Employer credit for services (§45F), employee can exclude all or part under §129.

(4) Maximum Credit: amount =$3,000 (or $6,000 if 2+ dependents in year) (a) Generally can’t exceed earned income that year. (b) Credit decreases 1% for each $2,000 & increase w/ AGI above

$15,000. h) Child Tax Credit: §24 - Get it just for having the kid

(1) Rule: Partially refundable credit equal to fixed amount (until 2013 = $1,000) for each “qualifying child”(can claim for dependency exception & is son/ daughter (+ their descendents), stepson/daughter (+ descendents), or eligible foster child) under 17.

(2) Phase-Out: Phased out, to Zero (Individual AGI $75,000/ Married Joint = $110,000/ Married Separate = $55,000). Not annually adjusted for inflation.

(3) Refundability: Refundable up to 15% of earned income in excess of 2012.

(4) Transferability of Credit: One spouse can sign right to credit away 4. Taxation of Children aka “Kiddie Tax” §1(g):

a) Requirements (1) Unearned income over $1,900 (in 2011) (2) of children under 19 & full-time students under 2 at the end of the taxable

year, (3) the child has earned less than half the amount of support, (4) the child has at least 1 living parent at the end of the taxable year, & (5) child will not file a joint return with their spouse that year,

b) Application: then all of it is taxed at parent’ marginal rate, regardless of whether


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or not claimed as dependent. “Allocable parental tax”= net unearned kid’s income + parents income. Then apply tax rate.

c) Calculation: §1(g)(4)(A) Kid’s net unearned income = unearned income - larger amount of either #1) 2x min. standard deduction allowed to dependents ($1,900) or #2) min. standard deduction allowed to dependents ($950) + itemized deductions directly connected to production of unearned income.(Can’t ever exceed taxable income.)

5. Elder Care: taxpayers can claim parent-dependents under §151 and may allocate the exemption under §152(c) when children of parent share costs of care.

G. Divorce & Separation: There are many transactions that occur in contemplation of marriage, during the marriage, and after the marriage. These transaction are usually tax free but support following is different.

1. Alimony Payments §71:Deductible under §215 (above the line) to the payer, & under § 71 included in gross income of the receiver. (basically allocates income to another person).

a) Qualified Payment: Applies only to cash payments b) Compliance: Must provide SS # of individual alimony paid to. c) Quarterly Filings: If substantial amount, file quarterly return to prevent tax

penalty. d) Alimony Recapture: §71(f): “Recapture Trap”: If excessively high cash

payments in early years v. later, then excess payments are disguised property settlements & payor must include excess amount in income & recipient can deduct amount as if repaid to payor.

2. Child Support §71(c): Not deductible or included in income.$ must be used for kids & their care.

a) Gould v. Gould (pg 761) OLD RULE: Alimony payments under court decree do not decrease the payor’s taxable net income. (Override by statute)

b) Okerson v. Commissioner (pg 763) - When the divorce documents require the payor, at the death of the payee to continue to make payments to substitute required alimony payments, they qualify as alimony for federal income tax purposes

3. Property Division §1041: Dividing property between spouses is not a taxable event. Basis transfers over to party who keeps the house- gain stays with house. At time of sale, pay tax accumulated while held as marital or other individual's property (same as like kind), but if qualifies as primary residence for 2 yrs, then excluded (built in gain for free).

a) DOMA: Does not apply to same-sex couples because federal government won’t recognize it.

b) Transfer to 3rd Party: Reg. §1.1041: Property transfers to 3rd party “on behalf of spouse or former spouse” are treated as if directly made.

c) US v. Davis (pg 767) Holding Has Been Overruled (1) Facts/Issue: Was a transfer of stock in exchange for a release of marital

rights a taxable event? If so, what is the taxpayers amount realized from the transaction?

(2) Hold: Husband’s transfer of appreciated stock to wife via property settlement K executed pre-divorce is a taxable event & husband’s gain is measured by stock’s value at date of transfer.

(3) Rule: Taxpayer recognizes a gain on the transfer of property in


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satisfaction of a legal obligation. d) Divorce Related Transfer: §1041: No gain or loss is recognized by transferor if

spouse transferred because of divorce & basis carries over. e) Assignment of Income Doctrine & §1041: When assign right to receive accrued

but unpaid income to another, but may require taxpayer to still pay tax on income once paid to assignee.

(1) Priority: Assignment of income doctrine > 1041 (2) Rev. Ruling 87-112

(a) Deferred, accrued interest from the date of original issue of bonds to the date of the bond’s transfer to former spouse in included in taxpayer’s gross income.

(b) The former spouses basis in the bonds immediately after transfer is equal to the taxpayer’s increased basis in bonds + interest income included by taxpayer as result of transfer.

(3) Kochansky v. Commissioner (a) Facts/Issue: To what extent is the husband taxed on income from

contingent fee arrangements with clients? (b) Holding: Husband is taxed on the entire fee amount under

contingent fee agreement in year received. Fruit of the tree argument here. Lucas v. Earl.

4. Dependency Exemptions:§151(e)(2) allows parent to release claim to exemption to other parent by signed written document promising not to claim as dependent. Other parent must attach to tax return. May waive exemption for one year, multiple, alternating, etc

5. Attorney Fees in Dissolution of Marriage: Proceedings are inherently personal and therefore do not qualify for a deduction of attorney fees even if the divorce property includes a lot of business/investment assets.

a) US v. Gilmer: Can’t deduct attorney’s fees for divorce H. Bad Debts & Worthless Securities: §166- Deduction for bad personal, business, & investment

debts. 1. Types of Bad Debt: 2 types: Both deductible in year become worthless. Deduction

limited to basis in debt. a) Bad Business Debts, & b) Nonbusiness Bad Debts

2. Limitation: (1) only deductible if entirely (v. partially) worthless, (2) must treat as short-term capital loss.

a) Bugbee v. Commissioner (pg 778) (1) Facts/Issue: Whether a company’s majority SH, who gives $ that is used

mainly for personal not business expenses is a bad business expense or a non-business bad debt?

(2) Hold: Non-business bad debt & can only take up to short-term loss. Look to parties intent & not indication of repayment depending on business’ success.

b) Whipple v. Commissioner (pg 783) (1) Facts/Issue: Whether taxpayer engages in business activities with several

controlled corporations so as to consider the debt a corporation owes to him a business debt rather than a non-business debt?

(2) Holding: Taxpayer is not in the business or in the business of financing or money lending & is a non-business bad debt.


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c) Worthless Securities: §165(g): Deduction if stock or rights to receive shares of stock is completely worthless, not just declined in value. If business more than a year (short term) or more than (long term) capital loss.

XIV. Chapter 10: Dual Expenses A. General Issue Covered: Certain expenditures present a problem of having a mixed nature to

their benefits as being personal and business related. 1. Provisions In Conflict: Part business (§162), part personal (§262)

B. Travel: business trips are deductible if the dominant purpose of the trip is business. 1. Fact Sensitive: look at the facts and circumstances of the trip to, especially the number

of days. 2. Flight: dominant purpose business or pleasure; fact sensitive; primarily look at

time spent on business 3. General Rule: §162(a)(2): Can deduct ordinary & necessary business travel expenses if

“away from home” & “in the pursuit of a trade or business.” If included, then can deduct cost of transportation, lodging, & meals.

4. Test: Primary purpose - facts & circumstances - determine by # of days. Excess is personal expenses.

5. Away From Home Requirement: If not “away from home” then §162(a) general deductions if business expense (no meals).

6. Home: the place where you work / have a business connection. (Hantzis) 7. Substantiating expenses: 264

C. Commuting: Commuting Expense is not the taxpayer “away from home.” No special deduction for commuting expenses if not away, even if work is far from home.

1. Work Placements: Temporary work placements away from home, for less than a year, are deductible: 50% of reasonable Meal & entertainment only. p. 797 rules

2. Test if Placement Duration Unknown: Based on realistic expectation placement is less than a year, not what actually occurred.

3. Sleep of Rest Rule: §799 May deduct 50% of meals only if work travel requires you to sleep or eat. Work must be so long as to require you to eat or sleep in between working basically.

4. Commissioner v. Flowers (pg 791) Tax home = where you work a) Facts/Issue: May a taxpayer deduct the cost incurred to travel between his

hometown and a distant town if his job moved there beyond his control and he was unwilling to move?

b) Holding: No. Facts show that his expenses for travel were not incurred in the pursuit of the business of his employer. Additional expenses as a result of travel were solely the result of taxpayer choice.

c) Rule: In order that traveling expenses while away from home in the pursuit of a trade or business may be deducted from gross income, the expense must be incurred while away from home and must be a reasonable expense necessary or appropriate to the development and pursuit of a trade or business.

5. Rev. Ruling 99-7 (pg. 810) a) Issue: Amount of recognized gain on bargain sale of real property to charity? b) Allowable §170 charitable contribution via sale: AB for gain= AB in property:

AB of Amount realized to FMV c) Property transferred w/ indebtedness, amount treated as amount realized for sale/

exchange even tho transferee doesn’t assume. 6. US v. Correll (pg 799)


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a) Facts/Issue: Taxpayer was a traveling salesman for a grocery company. He customarily left home early in the morning, ate breakfast and lunch on the road, and returned home in time for dinner.

b) Holding: the ‘sleep or rest rule’ of Commissioner of Internal Revenue allowing taxpayer to deduct cost of meals only when taxpayer is on overnight trip is valid under provision of Internal Revenue Code allowing taxpayer to deduct traveling expenses ‘while away from home’ in pursuit of trade or business.

7. Hantzis v. Commissioner (pg 803) a) Facts/Issue: Taxpayer was a law student at Harvard. Couldn’t find job in boston,

got job in NY, deducted cost of travel and maintaining apartment in NY. b) Holding: No deduction. Can’t deduct the cost produce income. Must establish

relationship w/both locations. c) Rule: A taxpayer that pursues temporary employment away from the location of

his unusual residence but has no business connection with that location is not away from home for §162 purposes.

8. Meal Deduction Limitation: No Full Meals §274 (n)- limited to 50% of cost. 9. Other Travel Deduction Limits:

a) International Travel: §274(c): Disallows deduction for portion of international travel expenses not for trade or business or investment. But can deduct all international travel expenses if total travel time is 1 week or less, or if “pleasure component” is less than 25% overall.

b) Spouse Rule: §274(m)(3): Disallows deduction for accompanying spouse or dependent’s travel expenses unless there is a business purpose for their attendance. Gotcher Rule.

10. Substantiation Requirements § 274(d) a) Requirement: Substantiation Required (not just oral testimony) for credit/

deductions for (1) travel expenses (includes meal & lodging away from home), (2) Entertainment / amusement / recreation activities: directly related to, or,

in the case of an item directly preceding or following a substantial and bona fide business discussion, that such item was associated with, the active conduct of the taxpayer’s trade or business

(a) Directly Related To (occurs during) (i) More than a general expectation of some benefit at some

point in time (ii) Active business during the entertainment

(iii) The facts and circumstances indicate the activity had the principal character of a business activity, and

(iv) The expense covers the taxpayer and the person(s) that engaged in the business activity during the entertainment

(b) Associated With (before or after) (i) A substantial and bona fide business discussion that

precedes or follows the entertainment, AND (ii) Such discussion generally occurring on the same day as

the entertainment (or, if not on the same day, perhaps the night before or the morning after)

(3) gift expenses, AND (4) listed property


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b) Records: must prove through “adequate records:” (1) amount of expenses, (2) time & place of travel, use of property, description & date of gift (3) business purpose of the trip, AND (4) business relationship.

c) Documentation: Must document away from home lodging & any other travel cost $75+. Documentation must be contemporaneous with travel.

D. Entertainment Expenses & Business Meals 1. General Rule: §274(a)(1)(A): disallows deduction for entertainment, amusement, or

recreation expenses unless directly related to trade or business. If entrainment occurs before or after the business activity, the expense must be associated with a trade or business.

a) Direct Relation: Directly related if: 1) more than a general expectation of benefit at some point, 2) active business activity during the entertainment, 3) facts & circumstances indicate the activity’s principal character was business, & 4) expense covers the taxpayer & person engaged in business activity during the entertainment.

b) Associated Relation: “Associated with” requires: 1) a substantial & bona fide discussion that precedes or follows the entertainment, & 2) such discussion generally occurring on the same day (or morning after or night before) as the entertainment.

2. Reasonable Amount Limit: §162(a)(2): Reasonable allowances for meals while away from home if not lavish or extravagant under the circumstances, & taxpayer claiming deduction must be present. + must substantiate expenses claimed + deductions limited to 50% of total expense.

3. Prior Gifts Limit: §274(b): If over $25 when added to total of prior gifts made that year, whether direct or indirect, is not deductible.

4. Moss v. Commissioner (pg 821) a) Facts/Issue: Law firm took whole firm out to firm lunch every day. During the

meal, the employees talked about business. The luncheon was not optional to attend. Firm partner sought to deduct his portion of the lunch costs as business expenses.

b) Holding: §119 is limited in scope to the deduction of food provided to employees and therefore a business expense here would expand the scope of deduction further than what congress intended.

c) Rule: Expenses incurred for meals everyday are not business expenses because it does not fit the definition of §119 and are too personal in nature for §162 deduction.

d) §119 Rule: Allows meals to be deducted by employer if meals are served on the employer’s premises and the meals being served to the employee is for the convenience of the employer.

5. Churchill Downs v. Commissioner (pg 825) a) Facts/Issue: Taxpayer hosts Post-Kentucky Derby gala and other events for

participants. The taxpayer deducted these items as ordinary expenses. IRS contends they are solely entertainment expenses and are disallowed under §274(a).

b) Test: An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally


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considered to be entertainment, it will constitute entertainment for purposes of this section and § 274(a)regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone.

c) Holding: The expenses were not deductible. E. Job-Seeking Expenses & Moving Expenses

1. Clothing Rule: Work clothes are not deductible if can use for ordinary wear. (covered later)

2. Moving Expense Rule: Moving expenses (except meals) incurred in connection with starting a new job, employee or self- employed, are deductible for individual & dependents who lived with you before & after.

a) Must be unreimbursed b) Above the line deduction (1/3rd) offset against income. c) §217(c): Conditions for Allowance

(1) Distance: new principal place of work must be more than 50 miles from former residence/ work,

(2) Time: is a full-time employee for 39 weeks in 12 months after arrival OR (3) during 24 month period after arrival, is a full time employee or services

as self-employed on full-time basis during at least 78 weeks, only if they can’t meet the 1st test.

(4) Partial Exclusion if do not meet time requirements because of circumstances out of your control.

3. Rev. Ruling 75-120 a) Expenses incurred in seeking new employment in same T or B are deductible

§162 (Trade or Business Expense), but not if new t or b even if job secured; b) Not deductible if lack of continuity between past job & search or seeking

employment for 1st time. c) §212(1): Expenses for Production of Income only applies to expenses incurred

w/ existing profit- seeking not T or B. (1) Mixed business & pleasure trip, trip deductible only if” primary purpose”

to seek new business. % of time on each activity. (2) If expenses at location deductible, may deduct even if traveling expenses

are not. F. Education Expenses

1. General Rule: 2 Part 2 Part Test: In order to be deductible (Reg 1.162-5(c)) a) Part 1 Must

(1) Maintain or Improve skills in trade or business, OR (2) Condition of maintaining employment, &

b) Part 2 Must NOT be (1) Minimum educational requirement for trade or business, OR (2) Related to course of study to qualify as new trade or business

2. Wassenaar v. Commissioner (pg 839) a) Facts/Issues: TP graduated from law school and went back for LLM. He then

began working for law firm after LLM. b) Holding: The graduate study was not deductible as educational expense for

business because he was not already in the business of practicing law. c) Rule: Taxpayers may deduct the cost of a graduate education in a business the

taxpayer is already engaged in if:


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(1) the coursework improved existing skill sets; (2) the coursework is not needed as minimum education requirements to

engage in profession; and (3) the program of study is not a program for a new trade or business.

3. Galligan v. Commissioner (pg 848) a) Facts/Issue: A law librarian got her law degree while she worked at her job. She

deducted the cost of her law degree. Is this a qualified education expense? b) Holding: that cost of acquiring law degree qualified taxpayer for a new trade or

business, precluding deduction. c) Rule: Regulations establish an objective standard for determining whether an

educational expense is deductible; education for maintaining or improving skills required by taxpayer in employment or for meeting express requirements as a condition of continued employment is deductible

4. Warren v. Commissioner (pg 845) a) Facts/Issue: Taxpayer was attempting to become a higher member in the church.

The various levels of employment were dependent on the education of the individual in a degree focusing on divinity.

b) Holding: that taxpayer was not entitled to deduct educational expenses which qualified him for new trade or business

c) Rule: Education expenses are not deductible if they are “made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.” This is so even if the courses meet the express requirements of the employer. It is immaterial whether the individual undertaking the education intends to or does in fact become employed in a new trade or business.

d) Reasoning: Almost any bachelor’s degree will prepare people for all kinds of new businesses, disqualifying them from the deduction. The court is really just looking for something like a master’s program that focuses on one course of study, like a Master’s of some sort of specific science.

5. Sharon v. Commissioner (pg 846) a) Facts/Issues: whether the taxpayer is entitled to amortization deductions under

section 167(a)(1) with respect to certain educational and licensing fees incurred to enable the taxpayer to obtain a license to practice law in NY?

b) Holding: The taxpayer may amortize the bar exam fee and his federal court licensing fees but not the costs of the his college education, law school, or his bar review course.

c) Rule: All costs of ‘minimum educational requirements for qualification in employment’ are ‘personal expenditures or constitute an inseparable aggregate of personal and capital expenditures.’ There is no ‘rational’ basis for any allocation between the nondeductible personal component and a deductible component of the total expense. Such expenses are not made any less personal or any more separable from the aggregate by attempting to capitalize them for amortization purposes.

G. Education Credits 1. Deduction OR Credit for Qualified Tuition & Related Expenses: Can’t claim both credit

(§25A) & deduction (§222) 2. TABLE of EDUCATION CREDITS: Pg. 51 3. American Opportunity Education Credit: §25(a)(i)(3)


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a) General Rule: §25A(i)(2)- available for “tuition, & related expenses” incurred during the first 4 years of postsecondary education. Student must be enrolled on at least part-time.

b) Undergrad Only: 1st 4 years of post 2ndary education (college) at accredited university

c) Criminal History: must be at least part time student & not convicted of felony drug offense.

d) Qualified Expenses: For tuition, fees, course materials, books, equipment, other expenses not paid by school. Must be for enrollment or attendance.

e) Disallowed Expenses: Specifically does not include student activity, athletic fees, insurance costs, or room & board expenses.

f) Calculation: dollar for dollar for first $2k of expenses & 25% of next $2k g) Refundability: Up to 40% of the tax credit may be refundable. h) Phase-Out: Phased out starting at $80,000 ($160,000 married) & fully phased out

at $90,000 ($180,000 married) i) Determined by ratio: Modified AGI - initial phase out amount of AGI/ statutory

amount. 4. Lifetime Learning Credit §25(c)

a) General Rule: §25A(c)- for qualified “tuition & related expenses” that relate to any course of instruction designed to develop or improve the student’s job skills. Must be currently paying (not deferred).

b) Calculation: Limited to 20% of first $10k (max. for one year is $2k). c) Carryback Option: Can amend back 2 years d) Refundability: Not refundable, only applies if owe tax e) Coordination: Can’t use same expenses for LLC as AOC.

5. Interest on Education Loans §163(h) a) Fiscal Cliff: Until 2013, phased out w/ income b) Limit: Deduction limited to $2,500 annually reduced by AGI in excess of

$60,000 ($120,000 married) c) Dependent Issue: Denied if other claims as dependent d) Requirements: Must be costs at post- 2ndary institution, for benefit of taxpayer/

spouse/ dependent, education expenses paid or incurred within reasonable time before or after loan incurred, & expenses for at least part-time student.

H. Home Office & Vacation Home Expenses §280A(a)-(e), (g) 1. Home Office Rule: Must be used regularly & exclusively for business only. 2. Employee’s Deduction: An employee can only claim if able to prove the business use of

the home office is for the employer’s convenience. a) If own home, at sale the area can’t be included in the Home Mortgage Exclusion. b) Deductible expenses include direct costs (depreciation & improvements) +

indirect costs (utilities, repair & maintenance costs, property insurance). c) Limited to amount equal to the excess of gross income derived from home office

over sum of 1) business % portion of the expenses deductible even if home was not used for a home office (OAD “otherwise allowable deductions”). & 2) other deductions related to same business activity but not attributable to home itself (SBD “same business deductions”)

(1) [GI] - [(OAD)+ (SBD)] = max home office deductions (2) Excess deductible expenses can be carried over to next year

3. Vacation Homes:


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a) Business Use (1) Personal use is not more than 14 days or 10% of days rented (2) Generally, full deduction for mortgage interest & property taxes (3) If attributable to business or investment a % of repairs, utilities, &

depreciation. (4) Amount deductible for all expenses is determined by:

(a) # of days property is rented at FMV/ Total # of days property is used

(5) If remains business/ investment, then can deduct realized loss at sale. b) Mixed Use

(1) Held primarily for rental purposes but personal use exceeds business use limits.

(2) Total deductions limited to amount of gross income from rent (3) Must allocate expenses & other allowable deductions between business &

personal. If any remaining income, then can take business deductions to reduce remaining income, but deductions can’t produce net loss.

(a) Allocation of expenses = days rented / days in year c) Limited Rental

(1) Property primarily held for personal purposes & rental period is 14 days or less.

(2) Can exclude from gross income any income derived from use. I. Clothing Expenses

1. Objective Test: If can wear publicly/ ordinary wear, not deductible. 2. Pevsner v. Commissioner

a) Facts/Issue: TP was manager at boutique clothing store that required the employees/manager to wear their clothing while at work. She spend $1300 on the company’s clothing to meet requirements and deducted it.

b) Holding: Not deductible. Can’t adopt taxpayer’s point of view because subjective test means evaluating all taxpayer’s sense of fashion and perception of clothing utility.

c) Rule: A taxpayer may only deduct the cost of their clothing if: (1) The clothing is the type specifically required as a condition of

employment; (2) Not suitable as general usage clothing; and (3) Not worn as general usage clothing by the taxpayer.

3. Nicely v. Commissioner a) Facts/Issues: Whether taxpayer’s expenses incurred in a long commute that was

partially subsidized by his employer due to the distance were expenses deductible?

b) Holding:taxpayer was not entitled to claimed automobile expense deductions; taxpayer was not entitled to claimed meal expense deductions; and taxpayer was not entitled to deduct unidentified clothes, gloves, and boots.

c) Rules: The elements that a taxpayer must prove with respect to an expenditure for traveling away from home on business, including a meal, are: (1) The amount of each such expenditure for traveling away from home, except that the daily cost of the traveler's own breakfast, lunch, and dinner may be aggregated; (2) the time of each such expenditure; (3) the place of each such expenditure; and (4) the business purpose of each such expenditure.


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J. Hobby Loss §165(d), §183(a)-(d) 1. §183: Activities Not for Profit

a) Not “engaged in for profit,” no deduction b) Subjective-ish Test: If the taxpayer tried to make a profit, but reasonable. c) Activity with 3+ years, trigger audit. d) 2 allowable hobby deductions: 1) deductions allowable to taxpayer regardless if

they related to a hobby activity, & 2) deductions that would be allowable to the taxpayer if the hobby was instead a for- profit activity, but only to the extent that income from the hobby exceed type 1 deductions attributable to the hobby.

XV. Chapter 14 – Sanctions, Agreements, Disclosures A. Penalties

1. Negligence Penalties: Charged with constructive knowledge of all IRC, if don’t comply then 20% added with audit.

2. IRS Criminal Investigation Unit: Civil $, Criminal jail. 3. Statute of Limitation:

a) Civil: (1) Refund claim- 2 years (2) Regular Audit- 3 years from either date of filing or due date

(a) For year 2011, but date is when filed on 10/2012 (b/c extension) (b) File early, then 3 yrs from April 15th. (c) IRS can extend SOL w/ taxpayers consent (sign or sued now)- If

limit to certain expenses, then tolling of SOL limited for audit. (d) Longer SOL w/ (e) Substantial Understatement: 6 yrs-Understated return by 25%+

(IRS has BOP for omission) (f) Civil Fraud = No SOL but IRS has BOP for fraud (g) (IRS destroys returns after 10 yrs)

B. Criminal: 1. Criminal Tax Evasion- SOL is 6 yrs (const. must limit crim) 2. Collection

a) IRS has 10 yrs after date of assessment to collect b) date “assessed”= doesn’t start to run if don’t file c) Can’t pay: Payment plan

(1) Offer in compromise (prove lack of funds/ assets, offer “pennies for dollars” & IRS can accept of reject)

C. Taxpayer Penalties 1. Civil Penalties: In order to promote compliance, there are penalties for basically

everything. a) Types of Civil Penalties: Two different kinds

(1) Ad Valorem: Penalties assessed on the value of the tax owed (interest) (2) Assessable: Penalties assess as flat dollar amount that is set by statute. (3) Note: Neither are deductible for income tax purposes.

b) Imposition: Civil penalties imposed on people who violate w/out reasonable cause. This may be negligence, willful disregard, or fraud.

c) Failure to File a Tax Return: Failure to file return is 5% of amount of tax owed less taxes paid/credits. This is assessed per month at maximum of 5 months (25%). If willful neglect and still doesn’t file w/in 60 days of filing date, lesser of $135 or all taxes due.


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(1) Reasonable Cause: If the taxpayer does not act reasonable in circumstance. This could be death or illness, mailed but returned for insufficient postage, bad info from IRS, sent to wrong IRS address, incarcerated, ignorant of the law, lack funds to pay tax.

d) Failure to Pay tax: Failure to pay w/in 10 days of IRS assessment, penalty. 21 days when tax due is over 100k. Penalty is 0.5% of liability after payments/credits per month. Ups to 1% per month after notice and demand. Maximum is 25% of outstanding tax.

(1) Reasonable Cause: same as failure to file except if auto-extension, then RC is presumed if balance doesn’t exceed 10% of total tax. No more than 5% total penalty assess for any month with Failure to file issue. IRS can assess both.

e) Accuracy Related Penalty: Penalty is stacked with negligence and understatement so that it can’t be leveled many times over. Only assessed when TP fails to show reasonable cause or good faith effort to comply. Interest on penalty applies to date of the return, not date of penalty. Its is 20% of the portion of underpayment attributable to:

(1) Negligence of laws (2) Substantial understatement of income tax (3) Substantial Valuation overstatement (4) Substantial overstatement of pension liabilities (5) Substantial understatement of estate and gift tax valuation.

f) Additional Info on Accuracy Related Penalties and Elements (1) Overstatement of Value: Another 20% on overstated value of charitable

contributions if the item was value 150% or more of actual value resulting in underpayment of more than $5000 (10k for corp)

(2) Transfer Tax Valuation: Claimed value is 65% or less than asset’s actual value resulting in underpayment of more than $5000. Penalty is 40% of misstatement.

(3) Negligence: Failure to make a reasonable attempt to comply with code (4) Disregard: Includes careless reckless, or intentional disregard of the tax

laws (5) Exception: TP may avoid penalty if position is disclosed and is supported

by Substantial Authority on 8275-R g) Civil Fraud: Penalty is 75% of underpayment that is attributable to the fraud.

(1) Burden of Proof: IRS must show fraudulent intent on the underpayment. Must be clear and convincing evidence of fraud.

(2) All or Nothing: IRS shows that a portion is fraud, it’s all fraud. If TP shows portion is not fraud, then that portion is not fraud.

(3) Judicial Doctrine: “Actual intentional wrongdoing …. The intent required is the specific purpose to evade a tax believed to be owing.” “Intentional violation of a known legal duty.”

(4) Criminal Fraud Relationship: If TP convicted of criminal fraud, then can’t contest civil fraud. But if liable for civil fraud, can still contest criminal aspect.

(5) Evidence: Evidence is circumstantial. If you do things like keep 2 sets of books, make false entries, destroy books or records, conceal assets or sources of income, understate income or overstate deductions, avoid


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making business records. h) Failure to make estimated payments: Penalty for failing to make a payment in

anticipation of tax. Calculated per quarterly installment. Was 4% in 2010. Penalty keeps getting assessed until earlier of payment or return due date.

(1) Individuals: underpayment is calculated by the difference between amounts paid on Qtr due dates and the lesser of the followingà

(a) 90% of the tax shown on CY return (b) 100% of prior year’s tax, if a return was filed. Threshold goes to

110% if AGI is over $150k. (c) 90% of the tax that would be figured by annualizing the income

earned during the year up to month where qtr payment is due. (d) Note: Penalty can be waived for disasters, deaths, reasonable

cause. 4th Q is penalty waived if paid w/return in January. (2) Corporations: Amount is difference between actual payment and 100% of

tax shown on return but not paid. Penalty not applied if tax due is less than $500 or if payments made on applicable installment dates are equal to the lest of the following:

(a) 100% of non-zero tax shown on return for preceding full tax year. (not applied to large corp w/income above 1million)

(b) 100% of CY liability. (c) 100% of tax due on seasonal installment method or annualized

CY income. i) Failure to make deposits of taxes or overstatements of deposits: Funds remitted

for employment taxes FUTA, FICA, etc are considered to be borrowed from gov. Heavy fines for corp and officer/director responsible. Penalty is % of underpayment, 2-15% depending on when failure is corrected. Penalty avoided if failure was from reasonable cause. Person responsible can be liable for penalty of 100% of tax imposed.

j) Giving false information with respect to withholding: $500 fine to those who lie to their employer about how many exemptions they take on their W4.

k) Filing a frivolous return: Penalty of $5000 for frivolous return where TP claims some sort of Tax Protester argument.

l) Other civil penalties: Various penalties for specialized areas. Always look up stuff.

m) Reliance on Written advice of the IRS: Sec of Treas must abate civil penalties based on TP actions resulting from written advice of IRS employee. Only for formal requests of information by the IRS and won’t work if TP didn’t give IRS enough info to work with.

2. Criminal Penalties: Designed to prohibit and punish fraud on taxes. Def has same rights as regular.

a) Nature of Criminal penalties: You can have criminal and civil penalties. Can refuse to talk to IRS on incrimination grounds. Usually won’t pursue conviction unless certain to get it, flagrant violation of law, and 3 consecutive years of violation.

b) Criminal Tax offenses: Several offenses addressed in the code (1) Willful Attempt To Evade Tax: Felony w/ up to 5 years in prison and a

fine of $100k or $500k for corp. Also can get prosecution costs. (2) Willful Failure to File Return: Misdemeanor punishable by $25k fine or


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$100k corp. Up to 1 year in prison or 5 if money laundering. (3) Willful Assistance In Evading Tax: when you help prepare return, or

make statement about truthfulness. Felony w/ up to 3 years in prison and a fine of $100k or $500k for corp. Also can get prosecution costs.

(4) Willful Filing of False Document: Misdemeanor w/up to 1 year in prison and fine of $10k or $50k for corp. NO prosecution costs.

(5) Disclosure of Tax information: Fine of up to $1000 and one year in prison.

(6) Other Penalties: many have to do with specialized areas of tax law. c) Defenses to Criminal Penalties: Must convince beyond a reasonable doubt. Good

defense: (1) Unreported income was offset by deductions (2) Unreported income was in reality a gift or some other excludible receipt. (3) Taxpayer was confused or ignorant as to the applicable law; thus one

can’t intend to violate a law when they don’t know the law. (4) Taxpayer relied on the erroneous advice of competent tax advisor (5) Taxpayer has mental illness à can’t act willfully (6) SOL has expired (7) Taxpayer enters a plea bargain and accepts lesser offense.

D. Penalties on Return Preparers 1. Definition of Return Preparer: person who prepares returns for compensation. Can be the

employer, employee, or SE person. Liability will depend on who did what and who knew. If gratuitous preparation, not a TRP. Preparer must do substantial portion for sanctions to apply. Amount is not substantial if less than 2k or 100k+20% of AGI or GI.

2. Definition of Return preparation: includes any activity where TRP furnishes TP with “sufficient information and advice so that completion of the return or claim for refund is largely a mechanical matter.” Not a TRP for clerical work, prepares as employee of business, fiduciary return, prepares during course of audit or appeal, employee of IRS, no compensation, VITA people.

3. Preparer disclosure of penalties: 5 key penalties for prepares who disclose info a) $50 per violation of TP not getting a copy of return b) $50 for TRP not signing return c) $50 per time TRP doesn’t put TRP number d) $50 per time TRP doesn’t retain copy e) $50 per time TRP doesn’t identify employment location f) Maximum penalties won’t exceed $25k per year.

4. Preparer Conduct of Penalties: Maybe civil or criminal a) Endorsing or Negotiating a refund check: $500 per time. Can’t do it for TP. b) Understatements due to unreasonable position: Must be substantial authority for

positions. Greater of 1k or one half of TRP’s fees derived from the engagement. c) Willful understatement: If TRP disregards TP supplied info or just lies. Penalty is

greater of 5k or one half of fees derived. d) Organizing abusive tax shelters: If you help people set up or try to sell a tax

shelter. No understatement needs to exist in order to penalize. Valuation must be 200% off of correct value. Penalty is lesser of 1k or 100 of fee derived or to be derived by the TP from project.

e) Aiding and abetting understatement: Applied to ANY person who assists in tax evasion. Also imposed on management who forces subordinate to understate.


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Penalty is 1k and 10k for corps per understating TP. f) Aiding or assisting in the preparation of a false return: Felony w/3 year

imprisonment and 100k indiv/500k corp fine. Most severe penalty out there. Can also be just a tax related doc, not just returns.

g) Disclosure or use of information by return preparers: Penalty is 250 per improper use. Maximum is 10k per year. Willful disclosure is criminal, 1 year imprisonment and 1000 fine

E. Injunctions 1. Injunction Intro: IRS can enjoin two classes: TRP’s and promoters of abusive shelters. 2. Action to enjoin TRP’s: When IRS seeks injunction against TRP for misconduct. Must

be shown that injunctive relief is needed to prohibit activity and that fines won’t fix it. Must be continually violating the prohibition. TRP must have:

a) Violated preparer penalty or criminal provision b) Misrepresented his or her eligibility to practice c) Guaranteed payment of any tax refund or the allowance of a credit d) Engaged in other fraudulent behavior interfering with tax laws

3. Action to enjoin promoters of abusive tax shelters: Shelter must be abusive and the injunction must be appropriate way to stop it from happening.

F. Interest 1. Generally: Adjustable rate and compounds daily. Eliminates incentive to delay tax

payments. 2. Interest computation conventions: Rates start on the day the tax is due, not extended

dates, and goes until the interest is paid. The interest compounds daily. Interest rate updated quarterly. Interest accrues on the tax owed but also the penalty if not paid w/in 21 days of IRS request.

a) Criminal Penalties: No interest on these. b) No authority to forgive Interest owed: Still owe interest if reasonable cause but

abated if unreasonable error or delay by IRS employee. IRS employee must have lost records, illness, or transfer/leave.

c) Overpayment: Gov required to pay interest on overpayment à credited against tax liability. Runs from date of payment not credited against liability to 30 days before date of refund check.

G. Applicable interest rate: Varies per circumstance 1. Overpayment: 2% above the federal ST rate 2. Underpayment: 3% above the federal ST rate 3. Corporations: 2% higher than usual underpayment rate and 1.5% less than standard rate

on overpayment if overpayment is over 10k. H. Statute of Limitations

1. Nature of Statute of Limitations: Limits time that TP can claim refund and limits the time in which the Government can make a claim for taxes owed.

2. Assessment: Generally SOL is 3 years from date return filed or 3 years from due date(no extension)

a) Extension of SOL: Goes to 6 years if omitted >25% of §61 GI w/out COGS and disclosed omissions. Not extended for overstatement of deductions.

b) International: If not disclosed on return, SOL tolled until info reaches IRS. If failed to furnish info for reasonable cause then SOL tolled only as to that item, not entire return.

c) Irregular Returns: Fraudulent returns are open to review indefinitely. Can’t later


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file amended correct return and start the SOL. d) Failure to File: Failure to file returns are open to review indefinitely. e) Acceleration, Extension, and Carryback Effects: Filing requirements used to

allow late filing of amended return to result in a situation where IRS wouldn’t have time to assess penalties or look for omissions before SOL ran out. Now amended return doesn’t affect limitations period.

(1) Acceleration: SOL reduced to 18 months if filing a request for prompt assessment. Made for estates or corp in dissolution.

(2) Carrybacks: SOL starts on year the CB originated, not year affected. Not extended for carryforward.

f) IRS Requested Extensions: IRS may request extension of SOL in order to carry out negotiations or investigation. Court may grant it but doesn’t have to. If court doesn’t grant it, can result in immediate issuance of deficiency and halt negotiations. Don’t sign waiver of SOL until agent has completed RAR and at least one issue that can be litigated exists.

g) Collection: IRS must administratively collect the taxes before 10 years SOL, if not, then the IRS must go to court and reduce it to a judgment before the 10 years is up. IRS and TP can agree to an extension. Begins on date of assessment.

3. Claim for Refund or Credit: Amended claim is 1040X or 1120X. a) Overpayment: Overpayments may be applied to ongoing tax debt. b) Large Refunds: Any refund over 2 million goes to the joint committee on

taxation. c) NOL Acceleration: If refund from NOL CB/CF, file application for tentative

refund. If denied, can’t start legal action until 6 months after return is filed. Must file claim for refund in allowable period.

d) Limitations Period: If you file return, you have the later of 3 years to claim return from date of filing or 2 years after tax was collected. Early returns are deemed filed on due date.

e) Other Extensions: Can be extended for business bad debt or worthless securities out to 7 years.

f) Amount of Credit or Refund: Can’t get refund for anything greater than 3 years ago plus extension periods. Refund limited to last two years on late filing for previous 3 years.

4. Suspension of Period or Assessment and Collection: usually must be assessed w/in 3 years and collected w/in years. When IRS mails 90-day letter, there is 150-day suspension of SOL (210 for persons outside US). Suspension is also in effect during Tax Court dispute and until 60 days after TC decision. Offer to compromise to the IRS suspends it for one year from date of submission. SOL also tolled for:

a) TP assets in custody of a court b) TP outside US for 6 or more consecutive months c) TP’s assets are wrongfully seized d) Fiduciary or receiver is appointed in bankruptcy case e) IRS prohibited by bankruptcy law from collection f) Collection of excise or termination taxes is otherwise prohibited by law.

5. Migration of SOL: SOL can be moved if the IRS or TP try to take advantage of SOL expiration.

I. Statutory Agreements: Two types of agreements allowed by the code for tax disputes. 1. Closing Agreements: Written agreement between TP and IRS. Formal. Only one


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recognized as binding. Closes the case unless there is later discovered fraud, malfeasance, etc. Final in dispute and prevents later opening of case which is often needed by creditors and helps to reduce further litigation. IRS discourages use of these because they are hard to process and are very final.

2. Offers in Compromise: Offer by Commissioner to settle civil or criminal case before it is referred to justice department for prosecution. Compromise of more than 50k must be approved by Chief counsel. Covers entire TP’s liability and rescinds right to prosecute further unless fraud. If TP defaults, agreement is void.

a) Usage: Usually used when disputes still exist and want to avoid litigation b) Doubt: Not sure if they can collect whole amount or otherwise overall claim c) Disputed Amount: If it might end up as economic hardship, just take lesser

amount.

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