Tax I – KoonceSpring 2008

Part 1 – Introduction

Chapter 1 – Orientation o How does Fed Gov have right to tax?

o Con Art 1 §8 clause 1- gives Congress the power to lay and collect taxes, duties, imposts and excises (gives Congress the power to tax)

o Subject to 2 restrictions (in Const.): o Apportionment restriction - requires direct taxes be apportioned b/w the several states in accordance

with the population of each state Direct tax – demanded from the person it is intended to pay-can’t shift to another person and

can’t avoid it If Congress does pass a direct tax, then the apportionment restriction comes into play SCOTUS has held that income tax is direct tax (see Pollick below)

Indirect tax is one that is not direct- can shift burden to another person Sales tax is indirect – avoid paying by not buying

Pollick – income tax is direct tax (don’t have option not to earn income), thus subject to apportionment. The income tax was not, therefore SCOTUS struck it down. In response, nation passed 16th.

Couldn’t work so we passed the 16th amend (can’t survive without income tax and Pollick made income tax unconstitutional- so passed 16th)

o 16th- Can collect income tax from whatever source derived, w/o apportionment or w/o regard to any census/enumeration

o 16th basically reverses Pollick o Can have income tax, but it must be apportioned b/w the states

So, unless it is a tax on the income, it is unconstitutional Murphy v. IRS (D.C. Circuit opinion)- a provision (Section 104) in the Internal Revenue Code

(we’ll get to later) is unconstitutional Damages for emotional distress are subject to being taxed (exclusion doesn’t apply)

b/c intended to make person whole, so doesn’t amount to income as stated in 16th Physical injury or sickness are excluded from income This is NOT a SC case- has been universally criticized (guys must have been on

crack) Case was heard on rehearing and reversed.

o Uniformity restriction – all duties, imposts, and excises shall be uniform throughout the US (Article 1, § 1, clause 1)

Held to only apply to geographic uniformity (can’t tax La and Ms at diff rates) Does lack of uniformity in judicial decisions mean that income tax is not uniform and

therefore unconst? Don’t try to challenge this. You will end up in jail. o Con law does play imp role in state and local taxes

o But w fed taxes, not much of an issue anymore o One of the big issues has been whether or not there was enough contact with a certain state to be

taxed/included in that stateo Practitioner’s Tools (be familiar with)

o Primary = Code o Other Fed statutes that affect taxes

Very unusual – don’t deal with in this classo Bills

JK tries to keep up with the Bills that look like they are going to pass He is at least familiar with it

o Hearings

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Can look back to the hearings to determine the purpose behind the billo Committee Reports

Very imp If House and Senate bills differ they have ad hoc conference that reconciles the differences

Distinct from the normal tax committeeo Debateso Prior law

Includes current transaction and ones that happened a while ago o Treaties

International Tax law So if dealing with international, need to look not only at code, but at the treaties Supersedes Fed Tax law

o Administrative materials Regulations (very imp)

Interpretive Regulations o Secretary of the treasury under code 7805 can issue and 1017 b 1 reg’s to

explain code sections Final Regulations – have to be submitted for public debate Temporary Regulations – have the same force as final regulations but

by their own terms expire after three years Proposed Reg – does not have the same regulation as the other two

and is in force immediately and are considered pretty good source if there is no information out there

The treasury will have a comment period on these reg’s like the final and temporary reg’s

o Code authorizes the IRS to prescribe all rules/regulations for the enforcement of the Internal Revenue Code

So they can issue interpretive regulations (IRS tells what the stat means)- Treasury Dept. does

Then the cts determine the statutes by Congress If the regs conflict with the Code, the Code supersedes

Rare Don’t go a/g reg if it is directly on point

Legislative Regulations o Congress authorizes the dept of treasury to make rules in specific area

Ex.- Section 10-17b1 (we’ll deal with later)o These regulations are law (big difference with interpretive)

Mayo Foundation for Medical Education v US - 131 S.Ct. 704 – Clarifies when treasury regulations can be invalidated

As a general “students” are exempt from social security taxes, the treasury issued a reg that said that Medical Residents were not exempt from SS taxes

Mayo foundation sued for a refund after they have paid the taxes SCOTUS said that there is a two part test to determine whether a regulation is valid

o Has congress directly addressed the question at issue? If they have then the Treasury cannot go over the congress’s head

o Is the Treasury’s reg arbitrary or capricious in substance or manifestly different from the purpose and wording of the Code? Is the treasury acting within the meaning and purpose of the code, are they acting reasonably?

o Previous case law use to look at the regs whether they were interpretive regs versus the legislative regs

We do not doubt that Mayo's residents are engaged in a valuable educational pursuit *716 or that they are students of their craft. The question whether they are “students” for purposes of § 3121, however, is a different matter. Because it is one to which

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Congress has not directly spoken, and because the Treasury Department's rule is a reasonable construction of what Congress has said, the judgment of the Court of Appeals must be affirmed.

Rulings Revenue ruling and revenue procedures (currently found online)

o Reflects the current policies of the IRSo Published in internal revenue bulletin o If find one directly on point – it Is binding lawo You can write letter to IRS and they will give you a private letter ruling with

their decision (but it costs so save it for a big issue) If the IRS does it, it is binding for that taxpayer only

o So can rely on internal revenue bulletin for anyone, but only binding on that taxpayer for private letter ruling (but usually will apply to you as well)

Acquiescence At the end of big case, the IRS usually issues an acquiescence or non-acquiescence

o Acquiescence = we will not rule on this again (you can rely on this case without a doubt)

o Non-Acquiescence = we think this is big issue and we will litigate again (decent chance the IRS will come after you)

o Typically only done with really big cases Other IRS pronouncements

IRS Noticeso Ex.- after Katrina, the IRS did quite often

o Judicial Rulings (1) Jury trial with (normal) district court. You have to pay IRS request and ask for a refund in

Fed. Dist. Ct. (2) US Tax Ct (only option if client doesn’t have money to pay)

Can try to get a tax declared null w/o having to pay tax at all (big advantage- so long as file within the 90 day time frame)

Art 1 judge – have term that expires This is the only alternative if you don’t want to pay the tax Tax Ct can issue opinions individually

o All tax ct judges are in DCo They ride the circuits to hear the cases

No jury trial in the tax ct If rule individually, they issue opinion

(3) Ct of Fed Claims Pay tax first and sue for refund No jury trial A little more unpredictable Appeals go to Fed Circuit Ct Typically the only reason to go here is if they have issued something right on point in

your favor In all 3 cases, you must first get admin ruling by IRS

Ex – in US Tax Ct – you file petition at tax ct and then have admin hearing at the IRS Only then, if you can’t resolve, do you go to tax ct and have full trial

o Unofficial Tax materials – pg 28 CCH; Research Institute of America; BNA Fed Tax Citator Tax Notes Tax Law Review

NYU; Florida Annual Institutes

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Week-long update on taxes o Tax Policy Considerations

o In 2005, Bush appointed a committee that gave recommendations but were ultimately ignoredo Road Ahead

o Gross Incomeo LESS: Deductions o Equals: Taxable Incomeo Rates applied to taxable incomeo Determines tax liability o LESS : Credits (offsets taxable income dollar for dollar) – better than deductions o = Tax due

Part 2 – Gross Income

Gross Income: The Scope of Section 61 Equivocal Receipt of Financial Benefit

o §61 – Gross Income Definedo Gross Income means all income from whatever source derived, including (but not limited to):

(1) Compensation for services, including fees, commissions, fringe benefits (2) Gross income derived from biz (3) Gains derived from dealings in property (4) Interest (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

Ex – banks forgiving debt of victims of Katrina should be included in GI under gen rule (special exclusion, though)

(13) Distributive share of pship gross income (14) Income in respect of a decedent (15) Income from an interest in an estate or trust

o History of Income Tax-Art I§8cl.1 Congress has general authority to lay taxes-direct taxes must be apportioned among several states according to population -Pollick said income tax is direct tax, and b/c it is not apportioned among several states then it is unconst.-Therefore, 16th amend passed saying congress can collect taxes from whatever source derived

o “All income from whatever source derived” = verbatim from the 16th – Congress is trying to include in income in §61 any items which are allowed to be taxed under 16th – trying to be as broad as possible- if it’s constitutionally permissible to tax something based on the 16th, then Congress is trying to include it within §61

o GI under 16th is not necessarily the same as income in other contextso Ex – economists have def of income, individuals have idea of income o Ex—treasure trove is income under the 16th, but not income to an economist

o There is not much guidance as to what the 16th amend includes o Section 61 provides 15 items that are specifically included

o Section 71, et al – items specifically included in Gross Incomeo Section 101, et al – items specifically excluded form GI

o Regulations:o “1.” Means it deals with income, “61” means that it deals with GI

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o §1.61-1 – Gross income means all income from whatever source derived unless excluded by law. GI includes income realized in any form, whether in money, property, or services. Income may be realized therefore, in the form of services, meals, accommodations, stock, or other property as well as in cash.

You don’t have to have cash in your hand for it to be GI Property and services given to you are also includible in GI This is not an exhaustive list, instead it’s illustrative If there’s a statute that provides specific treatment, then it controls

o §1.61–2(a)(1) – More detail with regard to compensation for services Wages, salaries, commissions paid salesmen, compensation for services on the basis of a

percentage of profits, commissions on insurance premiums, tips, bonuses (include Christmas), termination or severance pay, rewards, jury fees, marriage fees and other contributions received by a clergyman, retired pay, pensions, retirement allowances…are income to the recipients

(d) Compensation paid other than cash - If services are paid for in property, the fair market value (FMV) of the prop taken in payment must be included in income as compensation. If services are paid for in exchange for other services, the FMV of such other services taken in payment must be included in income as compensation. If the services are rendered at a stipulated price, such price will be presumed to be the FMV of the compensation received in the absence of evidence to the contrary.

Ex – if someone gives you item for services, you don’t include in income what they paid for it, you include the FMV of the item

Ex – JK performs legal services for me and I fix his roof, we both include the FMV in income

o §1.61–14(a) – Miscellaneous items of GI In addition to the items in §61(a), there are other kinds of GI. Example – punitive

damages such as treble damages under the antitrust law and exemplary damages for fraud are GI.

Another person’s payment of the taxpayer’s income taxes = GI to the taxpayer. Illegal gains are GI

Ex) If someone pays you cash for drugs, that cash is taxable Treasure trove, to the extent of its value in US currency = GI for the taxable year in

which it is reduced to undisputed possession.

o Cesarini o Bought used piano for $15 at an auction and later found old currency hidden inside the piano o They converted it to new currency and included the money in income and then amended and asked for

refund o Their 1st argument was that it wasn’t GI under §61

2nd argument- Also, even if it is income, it was due in 1957 when they bought piano and statute of limitations had run (3 years for IRS to challenge)

3rd- it was a capital gain and not ordinary income (don’t worry about for purposes of this class)o Holding - They are not entitled to refund b/c treasure trove is taxable income and they do have to pay

in 1964 b/c that was when it was reduced to undisputed possession under state law. o Ct starts with §61 – “whatever source derived” – not very helpful, needed to look further (always start

with the Code, then go to regulations/cases) Under list of specific inclusions and exclusions, nothing really helps The ct confirms that Congress intended to include the full measure (every item) of its taxing

power under the 16th amend IRS had revenue ruling directly on point, thus it would have been hard to beat The ct found broad lang in §61 and a revenue ruling on point and a Reg – “treasure trove, to

the extent of its value in US currency, constitutes GI for the taxable year in which it is reduced to undisputed possession”

Interpretive regs can be overturned, but very difficult to do so5

§61 shows an intention of Congress to tax everything, §61 et seq. and §71 et seq. provide guidance

o 1st argument- set aside, creative but not proper b/c ignores statutory schemeo 2nd argument- cited Doughtery case, but ct said the case didn’t specifically address this issue (doesn’t

stand for proposition that for it to be taxable income, it has to be earned income)o Taxpayer had no argument on point, while the IRS had §61 and a revenue ruling directly on point…

also the petitioner left out of their brief that treasure troves are taxableo When was cash reduced to undisputed possession?

Ct had to look at state law b/c no fed law on when title passes and found that CML says they must have actually found it to have title pass

Point – the way to determine when it is taxable is to look at state law – when you are entitled to it under state law and when it is taxable is very imp

So even though fed law taxes it, state law determines when it is taxed *Treasure trove is income and taxable in the year found

This case shows how state law can affect when income is realized- *look to state law to see when it’s reduced to undisputed possession

o Old Colony Trust (SCOTUS)o Employer agreed to pay Employee’s (Wood) income taxes associated with his salary (extremely large

salary- $900K, $550K) o The issue is whether the payment of taxes are additional income to Employee Woodo Wood is arguing that it is a gift – he never touched the money – the Employer just paid the taxes –

how can you be taxed on something that you never receive b/c they are being paid directly to IRS?o The Ct disagreed – they said the payment of tax was clearly in consideration for his services

(clearly not a gift…given to him b/c rendering very valuable services to the corp.) – if he didn’t work there, they wouldn’t pay the money – b/c of that, it is payment for services even if you didn’t touch the money

Ct notes that the label put on the transaction is irrelevant – if the substance of it is income, it will be taxable no matter what you call it

Also, see 1.61-14 – payment of another person’s taxes is now specifically included in income o Ct cites Noel – a Corp gave $3 per share to Shareholder’s/Employees – ct said, “In no view of the

evidence can the $35,000 be regarded as a gift. It was either compensation for services rendered or a gain or profit derived from the sale of the stock of the corp, or both, and either way, it was taxable as income.”

Ct said it was not just gratuitous – if you weren’t a shareholder and employee you wouldn’t have gotten the money

o Taxpayer argues that this would snowball into me owing taxes forever – I would have to pay taxes on the additional income and if the co paid taxes on that I would have to pay taxes on that and so on…

Ct said that issue is not before the court, you’ll have to deal with the absurd snowball effect…you should have thought about that before agreeing to the deal

o What he should have done is not put this comp scheme in the employment K, but just gross up his payment

If you want to net certain salary, estimate what your taxes would be beforehand and pay enough to reach that amount

o Koonce thinks right result otherwise he is getting huge benefit that is not taxedo To solve this problem from a practical standpoint, use an algebraic formula where Y x %tax paid =

salary…gives you your salary that you want after taxeso *Glenshaw Glass (SCOTUS)

o **Anytime you have Gross Income case, you cite this case – one of main cases in area o The Question/Issue is whether plenary and punitive damages can be taxedo In Glenshaw they settled lawsuit but they got fraud and treble damageso In Broadmoor Theaters, they had judgment rendered for treble damageso In both cases they did not report as income o Taxpayers argument – it is not taxable income

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They gave us $324,000 but were damaged by less than that – we should only be taxed by what we were really damaged

The point of the damages is to punish the wrongdoers, and we didn’t do anything to earn it – it was not to reward us, so we shouldn’t have to pay tax on it

o Always start with statute- §61 – confirm that Congress wanted the full power of taxing authority under 16th

o Def of GI – “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”

Ct says it doesn’t matter that money was awarded to punish the s, the s still got something out of it

This is the closest thing we have to a definition of GI- this is the big thing that comes from the case

o They also argue that it was a gift Doubtful if you just sued them they would give you a gift Punitive damages are NOT gifts

o Distinguished Eisner case in that the money received was a stock dividend- there was no value bestowed upon the people, so the case is irrelevant to Glenshaw Glass

o ***Glenshaw Glass def of GI has 3 components : o (*use to analyze whether something is GI*)

o (1) Gain or accession to wealth Occurs if taxpayer gains economically from a transaction

Basically if you’re wealthier after the smoke clears, there is an accession to wealth. Ex – in Old Colony he was wealthier b/c ER paid taxes for him – if ER wouldn’t have

paid, he would have had to pay, so he is wealthy b/c of it Ex – Charley – he ended up with cash and wealthier b/c of the sale of the miles

o (2) Income Clearly realized What does it mean to realize income?

Eisner – accession to wealth is clearly realized when sufficiently fixed and definite to be treated as GI

Helvering (SCOTUS) – realization occurs when taxpayer takes the last step for which the economic gain comes to fruition

Under these rules, there must be a transaction involving the taxpayer for there to be clearly realized accession to wealth

o Ex – mere fluctuation in the value of your prop is not income – you haven’t taken the last step to realize- not taxable

Ex- you buy stock in IBM and the value of the stock goes up…that is not realized gain- so even though you might be worth more, you still haven’t taken that last step

o Ex – Cesarini – cash effectively realized when they found the prop b/c under Ohio law says that’s when it became theirs

o (3) Taxpayers have complete dominion/control Taxpayer must control the prop Ex – taxpayer tells his ER not to pay him, but pay IRS

In Old Colony he argued that you can’t tax him b/c he never got the money But the taxpayer exercised complete dominion b/c during negotiation the taxpayer could

have asked to be paid, but he asked to pay the IRS instead

o Charley o Issue – can travel credits converted to cash be taxed?o Ct said this was taxable o Start with §61 – all income from whatever source derived o Cites Glenshaw Glass and defines GI as above

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o The facts remain, after all these transactions, the guy was wealthier…essentially selling his frequent flyer miles (pay for 1st class, downgrade to coach and get money in return, then use frequent flyer miles to upgrade to 1st class)

It’s either compensation or sale of frequent flyer miles- no matter what you call it, if you’re wealthier at the end of the transaction, then it’s taxable

o Taxpayer argues issue of whether frequent flyer miles were taxable – ct said this was not issue – either this is additional compensation or a sale of the miles

B/c he didn’t use miles just to get airline flight, he basically used them but got cash and b/c of that they are taxable

o IRS has come out with a ruling on frequent flyer miles You won’t be taxed on it – not taxable income

o But in this case, that was not the issue at all – the issue was when you basically sell the miles, do you have to pay tax on it?

o Is a loan income?o Cases have held that loan is not incomeo Issue – if you receive money, you are receiving something of value, so why is it not income – it is an

accession to wealth, clearly realized over which you have complete dominiono The reason it is not income is b/c when you take out loan, there is an offsetting obligation to repay

the loan and b/c of that, loans are not income You’re not any wealthier, just trading cash for an obligation (likely less wealthy) However, if dad (or employer) loans me $500 and I have no intention to repay, then it’s

considered incomeo Indianapolis Power and Light – deposit = loan

SCOTUS held that the contractual arrangement b/w the customers and the power company cast the deposit as a loan to the co

In this situation, the power co has to repay it eventually (when they cut off electricity) So there was the offsetting responsibility to repay, and it was not income

o **But, if you have loan with no intent to repay, it is income Ex – Employer gives you loan and says pay it back whenever you want, but I don’t really

expect you to pay it back - then there is no offsetting obligation, it is not a loan and it is income

JK and I have agreement – I am supposed to pay him back $100. 1 year later, he realizes I won’t pay, and he says just forget about it – at that point, it is taxable income

So if make loan at the beginning with no intent to repay, it is income right away But if it becomes no intent to repay later, it becomes income then

o Early cases didn’t distinguish b/w loans and illegal income b/c of obligation to repay the amounts o Wilcox – SCOTUS - Embezzlers did not have income b/c they had obligation to repay the stolen funds

– you stole the money, but b/c you have to pay it back, it wasn’t incomeo Rudkin – distinguished b/w extortionist and embezzlers b/c you are less likely to repay – thus it is

income and you must pay tax if you get money due to extortion

o However, this was resolved in James = illegal income still income Overruled Wilcox and held that illegal gains are income, thus are taxable

Revised definition of GI deleted the word “lawful” so inferred the intent to tax unlawful as well as lawful gains

Ex- this is how Al Capone was put away…same with drug dealers- might be difficult to prove that they do drugs, so this is an easier way to get them (tax evasion)

CID investigates for tax evasiono Hague-Simmons definition of GI (what economists use)is consumption + changes in net worth = Gross

Income…this is completely irrelevant in tax- different definition for economists/accounting purposeso Issue – Extreme Makeover Home Edition – is this taxable income to the recipient? IRS has begun to question

this. o Accession to wealtho Clearly realized

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o Complete Dominion and control may be the issue. You can argue other things, but right now we are sticking

73 University Cincinnati Law Review 1665 (2005) is a law review article dealing w/ issue Said don’t tax b/c difficult to value and bad public policy. Difficult to value will never fly w/ IRS. 40 Gonzaga Law Review 481 (2005) article said IRS has difficult issue. Simply does

IRS enforce letter of law or let spirit of good will continue. IR 2006-0012 (on Moodle)

o Issue – if you catch McGwire’s ball, is that taxable income? o Some people think it is taxable income b/c accession to wealth, etc. o Some people did sell it, but some didn’t – what about the ones who just keep it? o Or what if you go fishing and catch fish – is that accession to wealth?o Post-Katrina – if you get FEMA money, is that taxable income? (general rule, not exclusions)o Ex) Post Katrina if Extreme Makeover builds you a new house is this taxable income? YES

It is an accession to wealth that is clearly realized when they given them the title to the house and they have complete control.

Biggest problem with this would be a PR problem b/c this was a gift and helped these poor people out and now the IRS is coming in and making them pay all these taxes.

§280(A)(g) is what this show follows because they say they are renting the house while making all these improvements, so under this § it wouldn’t be taxable. (this is weird, but may work)

o Ex) Barry Bonds scenario o (1) Fan catches baseball and throws it back – income?

IR-98-56 (notice issued by IRS)- Not income and this would be treated like declining a prize or gift so it wouldn’t be taxable.

Must look at value at the time it is realized However, difficult to value (would have to get appraiser) Technically this would be taxable income

If someone sends you unsolicited items and you send it back, you’re NOT TAXED Also, you are giving it back to original owner (never really your baseball so never a realization

event) o (2) Catch ball and don’t give it back – income?

Most commentors think it would be income under the rules if you kept the ball. Comparable to treasure trove and is taxable to extent of its value in US currency.

Not income until you sell it – the issue is, what is the value? When catch, accession to wealth, clearly realized, complete dominion IRS does not address the issue where fan catches and keeps it (only say it is taxable if you sell it) Reg 61-14 – it is income when you catch it (treasure trove, to the extent of its value…)

Said this is treasure trove Analogized to winning the lottery But the concern here is equity – poor kid catches baseball worth 3 mil, and he keeps it – how not

let him keep it? Why should he have to pay taxes or be forced to sell this rare catch??? **IRS has never taxed non-cash treasure trove b/c it is too difficult to find value and just

not practicable…Koonce says same as catching blue fin tuna worth thousands, but instead of selling it you eat it.

The Q is bringing it to fruition – to bring to fruition, you don’t have to get cash. It is clearly realized b/c it is your ball

You don’t necessarily need to have cash for there to be income Article concludes not taxable income – they argue that the IRS has never taxed non-cash treasure

trove – distinguish cash treasure trove (like Cesarini where you find cash) and non-cash (like baseball) – but regs don’t distinguish b/w cash and non-cash so if you follow reg, you would tax it

Ex- non-cash treasure trove is also the deer/ducks you kill when hunting

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Imputed income – never been taxed – self created prop – making analogy b/w prop that you create that is not taxed and catching the baseball

Article – b/c IRS have never taxed non-cash income, it shouldn’t be taxedo (3) Catch it and sell it on Ebay for cash

IRS announcement says if you catch it and sell it, it is clearly taxable when you sell it (you get cash for it)

o (4) Fan catches and give back to McGwire Could argue it is a gift (I guess for tax liability on McGwire)

Might be specific exclusion Under §61 and 16th, most people would say it is clearly income – accession to wealth, clearly

realized, complete dominion, etc Also, some fans get memorabilia for it – autographed bat, etc

This is basically the barter system Arguably there, it is them giving baseball worth something to him, and unless specifically

excluded, should be included in taxable income, and you get back bat, etc worth something and should ordinarily be taxed – not non-cash treasure trove – you are getting something in return for the ball

o Hotel Points Tricky scenario if ER pays for hotel room and you get the points- that is taxable income (meets all

3 points) IRS notice- b/c of administrative purposes, they will not tax this

If you buy the hotel room and get the points, then it’s not taxable b/c it’s just as you bought the points when you buy the room

o FEMA aid If you get check, it is clearly income under Section 61. Yes – but there is an exclusion (Section 139 I think) enacted after 9/11 that excludes from income

qualified disaster relief payments So, generally, it is taxable, but if you meet one of the exclusions, it isn’t taxable

o Oprah Winfrey Gave audience a $1000 debit card but had to spend it on someone else Could argue it either way

Koonce likes the argument that it’s not taxable b/c not really an accession to wealth- not benefiting at all b/c must give to someone else

Could also argue that you’re acting as an agent for Oprah Also gave away cars- Old Colony clearly shows that this is taxable (but could still argue it either

way)o Problems pg. 63

o #2 – Winner attends the opening of a new dept store where he is given a free raffle ticket for a watch worth $200. Must he include anything in GI when he wins the watch?

Yes – it is income. Amount of gain = $200 (it is 1)accession to wealth; 2)clearly realized; and 3) person exercises dominion or control)

§20.2031-1(b)- estate tax definition of Fair Market Value – the price at which property would change hand b/t a willing buyer and a willing seller, both under free will and having complete knowledge of facts.

What if you didn’t win (is value of ticket still taxable) … maybe to the extent / value you could sell the ticket for, but not if the store was just giving away the ticket.

o #3 – EE has worked for ER for several years at salary of $40,000. Another co wants to hire EE, but ER persuades him to stay for at least 2 more years by giving EE 2% of the co’s stock, which is worth $20,000 and by buying EEs spouse a new car worth $15,000. How much income does EE realize from these transactions?

Income to the EE and then a donation from the EE to his spouse (could argue it is a gift, but what about disinterest)

Specific inclusion - §83(a) – if, in connection with the performance of services, prop is transferred to any person, other than the person for whom such services are performed, the

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excess of the FMV of the prop over the amount paid for such prop shall be included in GI of the person who performed such services.

If in connection with performance of services prop is transferred (car) = $15,000 (FMV) - $0 (amt paid) = $15,000 taxable and include in income

For the stock, you can realize income w/o cash – similar to baseball Helvering v. Horst – economic gain can occur even though not getting cash – it increases

his wealth so would be taxed It is accession to wealth, it is clearly realized b/c last transaction necessary to own stock,

and exercising dominion, so include the $20,000 in income too 20K is the basis – if he sells later for 25K, he will realize 5K in gain

Note – Bargain Sale – a bargain sale to the Gen Public is not taxed, but a bargain sale to an EE is taxable income (paid in connection with performance of services). A bargain sale to an EE below FMV is taxed to the extent it is below FMV.

o #4 – Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals.

(a) – Does Adjuster have GI? Income under §61 b/c derived from biz (main pt, doesn’t matter what label you give it)

(b) – Even if the arrangement violated local law? Still taxable, even if illegal, under James

o #5 – Owner agrees to rent tenant her lake house for the summer for $4,000. (a) – How much income does Owner realize if she agrees to charge only $1,000 if Tenant makes

$3,000 worth of improvements to the house? After the improvements, she will own the improvements – that’s all it takes for realization

– it can be non-cash and have it still be taxed – thus, 4,000 is taxable (b) – Is there a difference in result to Owner in (a) if Tenant effects exactly the same improvements

but does all the labor himself and incurs a total cost of only $500? §1.61-8C – if lessee places improvements on real estate which constitute, in whole or

in part, a substitute for rent, such improvements constitute rental income to the lessor.

Even though lessee putting improvements, still taxable at 4000 to the Owner (c) – Are there any tax consequences to Tenant in part (b)?

Doesn’t have to pay $3,000 worth of rent Cost $500 to put it up, but accession to wealth of $2500 b/c tenant is relieved from paying

that much in rent It is clearly realized b/c rent due date has passed and no longer have to pay it and you are

exercising complete dominion over it - All 3 prongs met o #6 – Flyer receives frequent flyer mileage credits in the following situations. Does Flyer have GI?

(a) – Flyer receives the mileage credits as a part of a purchase of ticket for a personal trip. The credits are assignable.

Part of the price you pay for your ticket is the right to get frequent flyer miles, so not taxable

Rev ruling 76-96 says rebate from manufacturer was reduction in the purchase price – basically part of what you paid for it

Private letter ruling 99-2003-1 – cost of mutual fund that awarded frequent flyer miles meant you allocate part of the purchase price to the trip and part to the frequent flyer miles

(b) – Flyer receives credits from ER for biz flights Flyer takes for ER. The credits are assignable. Doesn’t pay anything – would be income under Glenshaw analysis Announcement 2002-18(administrative exception)- the IRS has administratively decided

they aren’t going to tax this (although they could under the 16th) b/c too much of a hassle (numerous technical issues)

o Doesn’t apply to benefits convertible to cash (like the Charley case) However, IRS says not taxable in 2002 – b/c there are administrative issues, they won’t

tax it – problems: timing – is it when you receive it? Also, Ees may not want the miles.

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They may not ever use them. Hard to attribute biz and personal use – there are many practical issues

(c) –Flyer receives the credits under the circumstances of (b), but they are nonassignable? Only affects the valuation – still taxable under gen rules – but IRS won’t tax for other

reasons (d) – Same as (c), except Flyer uses the nonassignable ER-provided credits to take a trip?

Would be taxed except for the exception for miles

Income without Receipt of Cash or Property o 1.61-2(a)(1) & (d)(1) from above – if you get paid for in a form other than cash, you are still taxed at the Fair

Market Value of what you receive o Helvering – issue: must a taxpayer include in gross income the rental value of a building owned and operated by

the taxpayer? o Held – not income under 16th, thus it would be direct, subject to apportionment, and it isn’t apportioned,

so it is unconstitutionalo If you live in your own house, that is not income w/i meaning of 16th amendo This is imputed income – one of the few traditional exceptions to what is income. Imputed income is

applied as a family unit Imputed Income = a flow of satisfaction from durable goods owned and used by the taxpayer, or

from goods and services arising out of the personal exertions of the taxpayer on his own behalf Basically includes self performed services, self created prop and the use of your own prop

However, if you sell to someone, that is included in gross income b/c no longer for your benefit only

Ex – if you are an artist and you buy oil and canvas, and you paint the painting, you might have something worth $5000 – it is accession to wealth, clearly realized, etc, but it is imputed income, which is not income w/i 16th and b/c of that would be unconstitutional to include under §61

Not taxable if redneck builds his own house, shed, deer stand, etc.o The rule is applied to the family unit

Take family recipe and give meal to family … not taxable to kids.o Rev ruling 79-24

o Issue 1 – in return for legal services, housepainter painted lawyer’s residenceo Issue 2 – owned apt building and received painting in return for rent free use of apto 1-61-2(d)(1) – can receive compensation in a form other than cash, and still be taxable – in both situations,

it is still taxable Lawyer receiving something of value when painter paints house and painter receiving something

with law services FMV of apt rent and painting are included in GI

o Note - artist does not recognize income when he paints painting b/c imputed income – but when he trades it for rent, he includes it

o Rev ruling 80-52o Barter club gave credits for services when services rendered to other members…can redeem the credits

(points) with any other membero This is clearly taxable when you receive the credits

o Dean o Issue – is the rental prop owned by corp and used by SH, income?o Bank required H and W to put house in corp (that they also own) – now they don’t own house, bank does,

but they still live there and they must include the fair rental value of the house in gross incomeo Ct held this is income – not imputed income b/c not using own home, using income of a 3rd party o From equity standpt, doesn’t seem fair b/c would have been imputed income if they would have continued

to own it, but now it is owned by the corp o Imputed income is when you create something yourself and use it yourself.o May seem unjust w/ particular fact pattern, but must look at big pic b/t corp & execs.

Problems pg. 67

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o 1. Vegy grows vegetables in her garden. Does she have GI when:o (a) – She harvests her crop?

Technically would be income, but exception for imputed income (so not taxable) and this is use of her own prop

Not taxable until farmer sells produce under a regulation. o (b) She and her family consume $100 worth of vegetables?

Same as (a) – imputed income, so not taxable Note – the imputed income rule applies to the family unit – doesn’t matter that kids are consuming

– still not taxable b/c she did this for herself and her family o (c) Sells vegetables for $100?

No longer imputed, and is income of 100, so taxable Doesn’t matter that they got $100 worth of cash, it could have been other services, etc

o (d) Exchanges with Charlie for $100 worth of tuna that Charlie caught? Is taxable – doesn’t have to be cash No income when fish caught or veggies grown b/c imputed, but is income when sold or exchanged This is effectively a barter system (like Rev Ruling 79-24) where they exchange products Note – if they were mother and son and lived in same household, this would be included as

imputed income and excluded from GI due to family unito 2. Doctor needs income tax return prepared. Lawyer would like general physical check up. Doctor would normally

charge $200 for the physical and Lawyer would normally charge $200 for the income tax return preparation. o (a) What tax consequences to each if they simply swap services without any money changing hands?

Each recognizes income in the amount of the services they exchange o (b) Does Lawyer realize any income when she fills out her own tax return?

No – it would be imputed income – not taxed

The Exclusions of Gifts and Inheritances o Specific rules take precedence over §61o Need to recognize the distinction b/w exclusions and deductions

o Have same practical effect, but they are diffo Makes difference b/c certain items are phased out of the AGI

Giftso §102a – GI does NOT include the value of prop acquired by gift, bequest, or inheritance

o General rule…(b) include exclusionso §102b – Subsection (a) shall not exclude from gross income: (1) the income from any property referred

to in subsection (a) OR (2) where the gift, bequest, or inheritance is of income from prop, the amount of such income.

o If someone gives you stock and then you get div next year, the stock itself (gift) is excluded, but still have to pay the tax on the div

o Also, someone can’t donate to you their income/paycheck and avoid paying tax on it themselves. You can’t avoid being taxed by trying to give away your income…someone has to be taxed on it.

o Income received from decedent (last paycheck) is an ex of 102(b)(2) So if you receive gift, inheritance, etc of actual income then the exclusion does not apply

o 1.102-1(a) – Prop received as a gift, or received under a gift or will is not includible in GI, although the income from such prop is includible in GI. §102 does not apply to prizes and awards nor to scholarships and fellowship grants.

o (b) – The income from any prop received as a gift or under a will shall not be excluded from GI under para (a) of this section

So if you donate $10K worth of land to your kid, it isn’t taxed. However, any subsequent income from that land will be taxed.

Only the gift itself is excluded from income, not the income derived from the gift but if you donate your income as a gift it won’t be excluded

o If you go by Glenshaw Glass, gifts would be included in income, but there is specific exclusion o Main reason why they are not subject to income tax is that they are subject to estate and gift tax system

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o Currently with the gift tax system, if you give something away then it’s not taxed as an income tax but instead as estate/gift tax. There is a much higher percentage of gift/estate tax when compared to income (37% to in the 55% range).

o There is an annual exclusion you can give to kids- $12K per kid per year for each parent (gift tax)o There is also a lifetime exclusion of $1 million (gift tax)o There is a $2 million exclusion for estate tax purposes (both husband and wife- $4 million). It’s

extremely important that both are utilized.o Whatever you use up of your gift tax exclusion, then it also decreases your estate tax exclusion (not

including the annual exclusion).o Duberstein

o Consolidated w/ Stanton o Case 1 – Duberstein

Facts: Duberstein (D) is pres of Co. and did biz w Pres of another co, Berman (B). They used phone to do biz. Said they knew each other personally. D gave other pres a list of potential customers which was helpful to him getting clients. D said he didn’t owe him anything, but B insisted on giving D a Cadillac. D didn’t really need this car b/c he already had one. D said he didn’t think he would have given the car but for the referrals he gave to B. B deducted the cost of the car and D excluded it from income as a gift under §201. (IRS was whipsawed aka, pissed b/c one person got a deduction and the other person got an exclusion – it is a big loss for the gov b/c typically there is symmetry where a deduction on one side results in an inclusion on the other) Tax ct denied exclusion; 6th Cir reversed (said was exclusion)…currently before the SC

o Case 2 – Stanton Facts: Stanton worked at church for 10 years. He resigned and upon resignation, BOD passed

resolution giving $20,000 over 10 months. Church released from all rights and claims for retirement basis. Why did they do it? Officers said it was b/c he was liked by all, did a very good job, great personality, and they felt he was entitled to goodwill of a gift.

It didn’t matter what they called it – it mattered what it waso Issue: are these things gifts or compensation? Aka What is a gift for purposes of §102?

1st – ct rejected IRS request for a new definition IRS wants gift defined as: transfer of prop made for personal instead of business

reasons Ct said we need general principles, not hard rule b/c governing principles are general

not specific Also, gift does not have common law meaning, but more colloquial meaning A voluntarily executed transfer of prop, w/o consideration, even though common law gift, is

not necessarily a gift for tax purposes In these cases, probably is a CML gift

Old Colony – mere absence of legal or moral obligation does not establish that it was a gift Guidelines the ct gives to determine gift : “If the payment proceeds primarily from the

constraining force of any moral or legal duty, or from the incentive of anticipated benefit of an economic nature, it is not a gift. And, conversely, where the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it. A gift in the statutory sense, on the other hand, proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses. And in this regard, the most critical consideration, is the transferor’s written intention.”

Gift:o Proceeds from detached and disinterested generosity o Most critical consideration is transferor’s intention

***Def of gift often quoted from Duberstein “A gift proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses, and the most critical consideration is the transferor’s intention.”

The characterization/label on the transfer is irrelevant

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Ct said you should make the determination from principles of existing case law Transfers from Employer to Employee are normally not gifts Also relevant if deduction is taken by the person giving the item

That shows that at least on the transferor end, it was not completely disinterested – shows they had a biz relationship and thought it was enough to deduct

Primary weight must be given to the conclusions of the trier of fact – appellate review restricted

Ct says : “The only inquiry is whether it cannot be said that reasonable men could reach differing conclusions on the issue. Where the trial has been by a judge without a jury, the judge’s findings must stand unless clearly erroneous”(trial ct level)

Lots of discretion to Trial Ct. – most often won or lost at trial level b/c a factual test of whether there was disinterested generosity

Analysis: in Duberstein, the tax ct not clearly erroneous In Duberstein not excluded under §102 and was taxable income as recompense for

prior withdrawals In Stanton, remanded to determine gift b/c trial ct had no analysis at all – on remand,

said it was a gift and it was affirmed on appealo Kaiser – SCOTUS upheld gift tax treatment of union payments to non-union members for respecting a strike.

The court emphasized the factual nature of the decision. Intentions of transferor were merely gratuitous and only to those who needed the money financially.

o Kaiser, a non-union member received strike benefitso Colwell- compensated for respecting the strike, not just out of generosity. They would have given the money

to anyone who respected the strike. o Employee Gifts

o IRS/treasury dept. gives proposed regulations – not official, not binding, but requests comments – eventually may adopt in final form, may withdraw, may leave in proposed form

Pretty good authority – if nothing else out there, taxpayers can rely ono Proposed Reg 1.102-1(f) – (1) §102(a) does not apply to prizes and awards, certain de minimus

fringe benefits, any amt transferred by Employee to or for benefit of Employee, or to qualified scholarships.

(2) for purposes of §102(c), extraordinary transfers to the natural objects of an ER’s bounty (children) will not be considered transfers to, or for the benefit of, an EE if the EE can show that the transfer was not made in recognition of the EE’s employment. Accordingly, §102(c) shall not apply to amounts transferred b/w related parties (e.g. father and son) if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment.

Can almost be treated like a final regulation b/c it was proposed in 1989 and is still used.

Ex - if you work for your dad during summer, and he gives you Christmas present, even though arguably, he is your ER, b/c you are natural object of dad’s bounty, then it is a gift. But if giving in ER/EE relationship then §102(c) kicks in

o Under §74(c)(1), GI does not include the value of an Employee achievement award if the cost to the ER does not exceed the amount allowable as a deduction to the ER

So if the ER gives an award to the EE that Employer can deduct, then the EE can also exclude it from his income

If not fully deductable, only the deductable portion can be excluded from employee’s income o §274(j)(3)(a) – EE achievement award means an item of tangible personal prop which is

transferred by an ER to an EE for length of service achievement or safety achievement, awarded as part of a meaningful presentation and awarded under conditions and circumstances that do not create a likelihood of the payment of disguised compensation

o 274(j)(2) places limits on Ers deduction o 102(c) – Employee Gifts: Subsection (a) shall not exclude from GI any amt transferred by or for

an ER to or for the benefit of an EE

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Can’t directly or indirectly have ER make donation to an EE – if done b/c of ER/EE relationship, it won’t be excluded from income

Can’t disguise income as gift and try to have it excluded Ex.- Christmas bonuses are under 102c

o §274(b)(1)- Disallowance of certain entertainment, etc, expenses – gifts No deduction shall be allowed for any expense for gifts made directly or indirectly to any

individual to the extent that such expense, when added to prior expenses of the taxpayer for gifts made to such individual during the same taxable year, exceeds $25. For purposes of this section, the term “gift” means any item excludable from GI of the recipient under §102, which is not excludable from his GI under any other provision of this chapter, but does not include (A) an item having a cost to the taxpayer not in excess of $4.00 on which the name of the taxpayer is clearly and permanently imprinted and which is one of a number of identical items distributed generally by the taxpayer OR (B) a sign, display rack, or other promotional material to be used on the biz premises of the recipient.

Ex for (A): Westlaw giving you a pen that says Westlaw on it is a gift and Westlaw gets to deduct it

Ex for (B): Budweiser hanging a sign advertising at a bar Generally disallows deduction from the donor of a gift (prevents whipsaw of IRS)

Do the Duberstein analysis first (generally if someone can exclude from income, then the other person isn’t allowed to make a deduction)

o §132(e) – de minimus fringe benefit not included in GI Ex – you print personal photos on Employer’s printer – technically it is income b/c you took

their paper, but you have exclusion under §132(e) b/c it is de minimus fringe benefit Problems

o 1. ER gives all EEs, except her son, a black and white tv set at Christmas worth $100. She gives Son, who is also an EE, a color TV set worth $500. Does Son have GI?

o Look at facts and circumstances– under 102(c), if given in ER/EE relationship, then it is not excluded and so included in income. Proposed reg says if you are giving to the natural object of your bounty then the exception to the exclusion rule does not apply and you can exclude it.

o We don’t have all the facts here, and this is fact sensitive – so ask whether it is under the Christmas tree at moms house? That makes it look more like gift from mother to son.

If so, his $500 would be excludable o Arguably, maybe you can split the son’s portion b/c even if not her son he would have gotten $100 tv

– he got the additional $400 b/c he was her son so maybe the $100 would need to be included, as for the rest of the EEs

o Is it de minimus fringe benefit under 102, which allows it to be excluded? Pretty significant amount, so prob not

o 2. Give waiter a $50 tip to assure a good table and the card dealer a $50 “toke” after a good night with the cubes – GI?

o Both qualify as income – §1.61(2)(a) – tips are specifically included in income Tips not excluded under §102

o Under Duberstein, look at donor’s intention – is it detached and disinterested when giving $50 to get table? Probably not b/c you give it to them b/c you want a good table

o With the toke, you are giving it to them – is it detached and disinterested generosity? Or are you giving it to them for good luck? Are you doing it just out of generosity or b/c you want to keep having good luck?

o The 9th circuit has said in Olk that tokes are income, and not excludedo The key is to look at the intentions of the donor

o 3. The congregation for whom Reverend serves as minister gives her a check for $5000 on her retirement. Does she have GI?

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o Under 61 seems like obvious income (accession to wealth, clearly realized, dominion and control), however, under 102, it might be a gift

o Need to look at the makeup of the payment – it could be compensation for past services or a gifto Might be excluded under 102(a) as a gift, but might be included under 102(c) as an EE gifto Was it given in context of ER/EE? Fact intensive and we don’t have enough facts

5th circuit case (Shaub) and IRS rev ruling both said reverend not treated as EE of congregation under 102(c) b/c of more personal relationship than regular ER/EE

So in context of church, it is more detached and disinterested generosity Difference in Duberstein – the only contact that they had was biz oriented and only reason

they had it was b/c D was giving other guy referrals o Could you argue under 74(b) that it is an award for religious achievement?

Might be a good argument but probably wouldn’t work o

o 4. Retiree receives a $5,000 trip on his retirement. To pay for the cost of the trip, ER contributed $2000 and fellow EEs contributed $3000. Does Retiree have GI?

o Under §61 received something of value so gross incomeo §102(a) – can it be considered a gift?

Maybe excluded under gen ruleo However, there is exception for ER/EE relationship under 102(c)

ER giving is prob excluded However EEs also give it and it isn’t an ER/EE relationship there, so the 102(c) exception to

the exclusion is not applicable here o Is it detached and disinterested on the part of the co-workers, to make it a gift by them?

What if Retiree brought in lots of work and they think that in retirement he will continue to bring in biz, and they want to get him to keep doing it – in that case, it might not be detached and disinterested

However, if they really just liked working with person, maybe just generosityo $3000 pretty good argument that not subject to 102(c) exception, and might be excluded from GI as a

gift b/c the donors are fellow employees and are probably giving the money out of pure generosity, however you still need to analyze all angles.

o $2000 ER portion is probably not subject to exclusion under 102(a) b/c 102 (c), however it could potentially be excluded under 132(e) if it is considered a traditional retirement gift. The important to thing is the intention of the transferor and here it is employer/employee relationship

Bequests, Devises and Inheritanceso Lyeth v. Hoey

o Facts: Decedent gave heirs small legacies and left balance of her estate to a trust that gave income to another trust that in turn preserved the records/writings of a person.

o The heirs contest the will and they settle the dispute w/out going to ct Say there was lack of capacity and undue influence

o Appeals ct looked at local Mass. law – under that analysis, it did not fall under 102 b/c received by settlement not inheritance

o SC rejected – said exemption under Fed statute is not determined by local law Determining whether amt received is acquired by inheritance is a question of federal law This is distinguished from Cesarani that said to look to local law for treasure trove.

o “Bequest, devise or inheritance” was used by Congress as comprehensive terms embracing all acquisitions in the devolution of a decedent’s estate.

So even though this is settled, the fed estate tax is applied to the entire net estateo Ct said only reason taxpayer received anything at all is b/c they were an heir so they fit the

exceptiono The distinction b/w inheritance and settlement is too fine – so the exception applieso If you get anything b/c of your position as an heir, no matter how you get it (including by settlement),

the exclusion under §102 applies 17

o You don’t look to state law but instead to federal law b/c we want uniformityo Wolder

o Facts: Lawyer/client agreement – lawyer agreed to perform services if client would put him in his will o Issue: is this excluded from income under §102?o This is income under §61(a)(1) – the only issue is whether excluded under 102(a) as bequest, devise or

inheritance o Taxpayer argues that Merriam allows §102 to apply to bequests made on acct of some consideration

flowing from the beneficiary to the decedent. Merriam – testator made cash bequests to certain persons who were named executors of the

estate, and these bequests were “in lieu of all compensation or commissions to which they would otherwise be entitled as executors or trustees.” Ct held *that the legacies were exempt from taxation drawing a distinction b/w cases where compensation is fixed by will for services to be rendered by the executor and where a legacy is paid to one upon the implied condition that the shall clothe himself with the character of executor

If you require them to serve as executor for the cash to apply, then it is not subject to exclusion

But if you say I would like you to be executor and by the way I am giving you money, then the exclusion does apply

o Holdings: Ct said §102 does not apply even under Merriam b/c there was no dispute that it was in

return for services He got bequest b/c he was doing will

Ct also says Duberstein should apply even with respect to bequests (even though it was a gift case) – need to look at intent of parties to determine if there is detached, disinterested generosity

o In this case, the only reason transfer made is b/c lawyer drew up the will so exception does not apply o This is substance over form – the substance was compensation for legal services rendered, even

though it was formed as a bequest Problems

o 1. Consider whether 102 applies:o (a) – Father leaves Daughter $20,000 in his will

Excluded b/c bequest under §102ao (b) Father dies intestate and daughter receives $20,000 worth of real estate as heir

Excluded under 102a as inheritance (however income generated from that realestate would be taxable income)

o (c) Father leaves several family members out of his will and daughter and others attack the will. As a result of a settlement of the controversy, Daughter receives $20,000.

Just like Lyeth – excluded from income under §102 – would not have received but for her status as the daughter. It doesn’t matter if its received via inheritance or settlement b/c status as daughter.

o (d) – Father leaves daughter $20,000 in his will stating that the amount is in appreciation of Daughter’s long and devoted service to him.

Excluded under §102 b/c of the family relationship – Duberstein analysis applies (b/c Wolder says you can apply it here) – is he giving it b/c of long and devoted services such as caring for him - is it recompense ? Or is it complete detached and disinterested generosity? Look to intent of donor!!

o (e) Father leaves daughter $20,000 pursuant to a written agreement under which Daughter agreed to care for Father in his declining years.

prob not an exclusion b/c it is employment type relationship he isn’t giving b/c it is his daughter, he is giving it b/c of the written agreement for services

o (f) Same as (e) except father died intestate and Daughter successfully enforced her $20,000 claim under the agreement against the estate.

prob not excluded b/c the bottom line is that she is getting b/c of her services to her father

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under Lyeth – look at why you received it, even though it is a settlement (if received b/c of heir then exclusion applies – if for another reason then no exclusion)

Wolder says apply Duberstein analysis to these situations Here, she would not have received money had she not performed services under the written

contracto (g) Same as (f) except that Daughter settles her $20,000 claim for a $10,000 payment.

same as (f) b/c the reason she has claim is b/c of the contract o (h) Father appointed Daughter executrix of his estate and Father’s will provided Daughter was to

receive $20,000 for services as executrix. Not excluded b/c daughter not disinterested, she is getting income for her service as

executrix– meets Lyeth o (i) Father appointed Daughter executrix of his estate and made a $20,000 bequest to her in lieu of all

compensation or commissions to which she would otherwise be entitled as executrix. Under Merriam would be excluded Under Wolder, look to Duberstein and the intent of donor– giving b/c of detached and

disinterested generosity, or is it b/c she serves a executrix?o 2. Boyfriend has mental problem with marriage and agrees with taxpayer that he will leaver her “everything”

at his death in return for her staying with him w/o marriage. She does, he doesn’t, she sues his estate on a theory of quantum meruit and settles her claim. Is her settlement excludable under §102?

o The underlying claim is quantum meriut for past services rendered so settlement is GI under Woldero Not excludable under §102 b/c she isn’t heir and the only reason she was receiving the settlement was

for services rendered o LOOK TO INTENT OF THE DONOR!!!

Employee Benefitso The problem with taxing EE benefits is that it is hard to enforce and hard to value

o How do you value printing your daughter’s birthday invitation?

Exclusions for Fringe Benefitso Fringe benefits are included in Gross Income under §61(a)(1) unless specifically excluded under §132o 1.61-21(a)(1) – §61(1)(a) :GI includes compensations for services, including fees, commissions, fringe

benefits, and similar items. Fringe Benefit Ex) ER-provided car, flight on ER-provided aircraft, ER-provided free or discounted commercial airline flight, ER-provided vacation, ER-provided discount on property or services, ER-provided membership in a country club or other social club, ER-provided ticket to an entertainment or sporting event.

o These items are generally included in GI under the general ruleo 1.61–21(a)(2) – To extent that a particular fringe benefit is specifically excluded from GI pursuant to

another section of Code, that section governs the treatment of the fringe benefit, and if the requirements of the section are met, the fringe benefit may be excluded from GI. Excludable Fringe Benefit Ex)qualified tuition reimbursements (§117(d)); meals and lodging furnished to EE for convenience of ER (§119); benefits provided under dependent care assistance program (§129); and no-additional cost services, qualified EE discounts, working condition fringes, and de minimus fringes (§132)

o 1.61-21(b)(1):Valuation of fringe benefitso An EE must include in GI the amount by which the Fair Market Value (FMV) of the fringe benefit

received exceeds the sum of (1) the amount (if any) paid for the benefit by or on behalf of the recipient and (2) the amount, if any, specifically excluded from GI by another section of the code.

o (b)(2) –FMV is determined on basis of all facts and circumstances. FMV of a fringe is the amount an individual would have to pay for the particular fringe in an arms length transaction.

If ER sells items to the general public, it is easy to get the FMV – it is just the amount you have to pay as part of the general public. However, it can sometimes be difficult and you base it on the facts and circumstances

o Definitions and Gen Rules applicable to §132:

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o “Employee” Expanded def. of EE for some fringe benefits – might be more than just EE of co. When dealing w/ EE on exam, make sure person is considered an EE for that particular fringe

benefit 1.132-1(b)(1):For purposes of §132(a)(1) (no additional cost services) and §132(a)(2) (qualified

EE discounts) term “Employee” means: (i) individual who is currently employed by the ER in the line of business (ii) individual who was formerly employed by the ER in the line of business and

separated from service b/c of retirement or disability (iii) widow of an individual who died while employed by ER in the line of business or

who separated from service b/c of retirement or disability Partner who performs services for a partnership is considered an EE of the pship

o Even though by state law, you aren’t considered EE, you are for this purpose use by spouse or dependent child of EE is treated as use by the EE For purposes of no additional cost service, any use of air transportation by a parent

of an EE will be treated as use by EE (doesn’t include parent of a widow)o Ex.- JK’s brother is a pilot, so JK’s parents get to use the fringe benefit of free

flights that JK’s brother enjoys 1.132-1(b)(5): “dependent child” = son, stepson, daughter, stepdaughter of EE who is a

dependent of the EE… 1.132-1(b)(2):For purposes of §132(a)(3) (working condition fringes), Employee means:

(i) individual currently employed by the ER (ii) partner who performs services for the partnership (iii) director of the ER

o BUT, cannot exclude the value of use of consumer goods provided pursuant to a product testing program

(iv) independent contractor who performs services for the ER.o BUT, cannot exclude the value of parking or use of consumer goods provided

pursuant to a product testing program 1.132-1(b)(3):For purposes of §132(h)(5) (on-premises athletic facilities) Employee means:

(i) individual who is currently employed by an ER (ii) individual who was formerly employed by ER and who separated from service w/

ER by reason of retirement or disability (iii) widow of an individual who died while employed by ER or who separated from

service due to retirement or disability partner who performs services for a pship is considered employed by the pship. use by spouse or dependent child of EE will be treated as use by the EE.

1.132-1(b)(4):For purposes of §132(a)(4) (de minimus fringe) Employee =any recipient of a fringe benefit

So JK can bring us in to his office and let us use the copy machine, and we would be considered EE for that purpose

o Non-discrimination Rules 1.132-8(a)(1) – A highly compensated EE who receives a no-additional cost service, qualified

EE discount, or meal provided at ER-operated eating facility for EEs, shall not be permitted to exclude such benefit from his income unless the benefit is available on substantially the same terms to (i) all EEs of the ER or (ii) A group of EEs of the ER which is defined under a reasonable classification by ER that does not discriminate in favor of highly compensated EEs

Excluded from the income of highly compensated EEs only if they are offered to the other EEs on non-discriminatory basis

The exclusion applies for the non-highly compensated EEs regardless of discrimination – so even if high compensated ones can’t exclude from income, the non-highly compensated ones can

Highly Compensated Employee:

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414(q) employee who: o (1) Was a 5% owner at any time during the year or preceding yearo (2) Had compensation from ER in excess of 80,000 (adjusted for inflation-

currently $110K) AND if the ER elects the application of this clause, was in the top-paid group of EEs for the preceding year.

o Don’t rely on 1.132-8(f) definition b/c it is incorrect 1.132-8(a)(2): If fringe benefits provided to a highly compensated EE do not satisfy

nondiscrimination rules, individual shall be unable to exclude from GI any portion of the benefit.

Ex)ER offers a 20% discount (satisfies the requirements for qualified EE discount) to all non-highly compensated EEs and a 35% discount to all highly compensated EEs. The entire value of the 35% discount (not just the portion exceeding 20%) is includible in GI

o If they would have left discount at 20%, the highly compensated EEs could have excluded the whole amount, but b/c they bumped up and discriminated, they don’t get any of it

1.132-8(b)(1):For purposes of determining whether exclusions for no additional cost services and qualified EE discounts are available to highly compensated EEs, the nondiscrimination rules are applied by aggregating the EEs of all related ERs except that EEs in different lines of business are not to be aggregated. Thus, in general, the term “Employees of the Employer” refers to all EEs of the ER who performs work w/i the same line of business.

(b)(2):For purposes of determining whether the exclusions for meals provided at ER-operated eating facilities are available to highly compensated EEs, the nondiscrimination rules are applied by aggregating all EEs of all related Ers who regularly work at or near the premises on which the eating facility is located except that EEs in different lines of business are not to be aggregated. The nondiscrimination rules are applied separately to each eating facility. Each dining room or cafeteria in which meals are served is treated as a separated eating facility, regardless of whether each such dining room or cafeteria has its own kitchen or other food preparation area.

1.132-8(d)(5):If access to an ER-operated eating facility for EEs is available to a classification of EEs that discriminated in favor of highly compensated EEs, then the classification will not be treated as discriminating in favor or highly compensated EEs unless the facility is used by one or more executive group EEs more than a de minimus amount.

Ex)executive dinging hall. If exclusively for executives, then discriminatory, but if they use no more than de minimus amt, then its ok

1.132-8(c)(1) – The determination of whether a benefit is available on substantially the same terms shall be based on the facts and circumstances of each situation.

Don’t want black and white test – want to be able to look at all facts to make decision See code section for examples (c)(2) – Certain benefits available to EEs only in limited quantities that may be

insufficient to meet EE demand. This situation may occur b/c of ER policy (only a certain number of units of a certain item made available to EEs each year) or b/c of the nature of the fringe benefit (like where ER provides no additional cost transportation service that is limited to the number of seats available just before departure.) The ER may need to establish some method of allocating the limited fringe benefits among EEs. The ER may establish the following priorities:

o (1) First come, first served basis. The benefit will not be considered to not be on substantially the same terms as long as the same notice of the terms of availability is given to all EEs.

can’t just give notice to highly comp EEso (2) Seniority basis. Solely for purposes of 1.132-8, the benefit will not be

considered to not be on substantially the same terms as long as the same notice of availability is given to all EEs in the group, AND the average value

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of the benefit provided for each non-highly compensated EE is at least 75% of that provided for each highly compensated EE. (See Code for calculation of avg. value)

o Same Line of Business Limitation Prevents giving conglomerates an advantage 1.132-4(a)(1) :A no additional cost service or a qualified EE discount provided to an EE is

only available w respect to property or services that are offered for sale to customers in the ordinary course of the same line of business in which the EE receiving the benefit performs substantial services.

The services must be offered to customerso line of business limitation is not satisfied if ERs products/ services are sold

primarily to EEs, rather than customers. An EE who performs substantial services that directly benefit more than one line of

business of an ER is treated as performing substantial services in all such lines of business.

o So if EE works in accounting and provides substantial services for Seaworld and Anheiser Busch, then he can get discounts from both

(a)(2) : use ESIC manual to determine line of biz (a)(3) - More than one line of biz can be combined and treated as a single line of business if

one or more of the following rules applies: (1) If it is uncommon in the industry of the ER for any of the separate lines of

business of the ER to be operated w/out the otherso So if industry standard to combine, then you can

(2) Common for substantial number of EEs to perform substantial services for more than one line of business of the ER, so that determination of which EEs perform substantial services for which line of business would be difficult

o Ex – ER operates deli with an attached service counter where food is sold for consumption on the premises. Most, but not all EEs work at both the deli and the service counter. Under this aggregation rule, the deli and the service counter are treated as one line of business

(3) If retail operations of an ER that are located on same premises are in separate lines of business but would be considered w/i one line of business if the merchandise were offered for sale at a department store, then the operations are treated as one line of business.

o Ex – On the same premises, ER sells both women’s apparel and jewelry. B/c, if sold together at a department store, the operations would be part of the same line of business, the operations are treated as one line of business.

Reason for this is so dept stores don’t have advantage over local storeso §132:Certain Fringe Benefits

o (a) GI shall NOT include any fringe benefit which qualifies as a: (1) No-additional cost service (2) Qualified EE discount (3) Working condition fringe (4) De minimus fringe (5) Qualified transportation fringe (6) Qualified moving expense reimbursement (7) Qualified retirement planning services

o No-additional cost service fringe:§132(b) & §1.132-2 o service provided by ER to EE are excluded if:

(1) services offered for sale to customers in the ordinary course of the line of business of the ER in which the EE is performing services

(2) ER incurs no substantial additional cost (including forgone revenue) in providing the service

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(3) non-discriminatory basis o 1.132-2(a)(5)(i):exclusion applies only if ER does not incur substantial additional cost in providing

the service to the EE. “Cost” includes revenue that is forgone b/c the service is provided to an EE rather than a non-EE.

Ex) Commercial airline permits its EEs to take personal flights on the airline at no charge and receive reserved seating. B/c the ER forgoes potential revenue by permitting the EEs to reserve seats, EEs receiving such free flights are not eligible for the no-additional cost exclusion. This is why JK’s parents must fly standby (from example above).

o 1.132-2(a)(2):Services eligible for treatment as no additional cost services include excess capacity services, such as hotel accommodations; transportation by aircraft, train, bus, etc; and telephone services. Services not available for no additional cost treatment are non-excess capacity services such as facilitation by a stock brokerage firm of the purchase of stock. EEs who receive non-excess capacity services may be eligible for qualified EE discount of up to 205 of the value of the service provided.

For excess capacity services, if the hotel room is empty and will be empty anyway, or if the seat on the plane is empty right before take-off, there is no additional cost to ER to let you stay there

With the non-excess capacity services, like stock, the firm is not placing the order anyway, they have to do something particularly for the EE

o 1.132-2(a)(3) :Exclusion applies whether the service is provided at no charge or at a reduced price, and if benefit is provided through a partial or total cash rebate of an amount paid for service

o 1.132-2(5)(ii):Labor intensive services Generally, ER must include the cost of labor incurred in providing the services when

determining whether there is substantial additional cost. ER generally incurs no substantial additional cost, however, if services provided to the EE are merely incidental to the primary service being provided.

Ex) in-flight services of a flight attendant and the cost of in-flight meals, as well as maid service in a hotel are merely incidental to the primary service being provided.

Thus, even if they would have otherwise been idle, if the service is merely incidental, it is not included in determination of substantial additional cost

o 1.132-2(b):Reciprocal agreements b/w different Employers An exclusion is available to an EE of one ER for a no-additional cost service provided by an

unrelated ER only if all of the following requirements are satisfied: (1) service provided is same type of service generally provided to non-EE customers

by both the line of business in which EE works, and line of business in which service is provided to EE (so that the EE would be able to exclude if it were being provided directly by his own ER)

o Ex)if you are a maid at Holiday Inn and they have reciprocal agreement w/ Hilton you are considered EE for Hilton

(2) Both ERs must have written reciprocal agreement under which a group of EEs of each ER may receive no additional cost services from the other ER and

o Can’t just do this on one time basis, it must be available to everyone (3) Neither ER incurs substantial additional cost in providing such service

o Qualified Employee Discount: §132(c) & §1.132-3 Any EE discount with respect to qualified property or services:

(A) For Property: limited to gross profit percentage of the price at which the property is being offered by the ER to customers

(B) For Services: limited to 20% of the price at which the services are being offered by the ER to customers

o Gross profit percentage=Aggregate sales price –(minus) aggregate cost/ (divided by)aggregate sales price

Essentially the percentage of your profito Gross Profit Percentage determined on basis of all PROPERTY offered to customers in ordinary

course of the line of business

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Aggregate sales price includes sales to EEs Ex) 800,000 in gross sales and 600,000 in cost for prior year, results in 25% Gross Profit

Percentage (800K-600K/800K) So you can allow 25% EE discount and EEs can exclude it from GI

o *This is only for property* w/ services, it is flat 20%!!o EE discount – amount by which the price at which the prop or services are offered to the EE is less

than the price at which the prop or services are offered to the customers Difference b/w what EE pays and what ER charges customer The price is determined at the TIME OF THE EE’s PURCHASE (1.132-3(b)(2)(i))

o Qualified prop or services = any prop or services which are offered for sale to customers Does NOT apply to real property or investments

o 1.132-3(a)(2)(ii):Exclusion specifically does NOT apply to real estate or investments (iii) Qualified prop or services does NOT include something not offered for sale to customers

Ex) EE discounts provided on prop or services offered for sale primarily to EES and their families, such as at an EE store

o 1.132-3(a)(3) :Reciprocal agreements are not allowed for this exclusion (qualified EE discount does not apply to prop or services provided by another ER pursuant to a written reciprocal agreement

o 1.132-3(a)(4) :Exclusion applies whether or not there is charge, reduced rate, or cash rebate o 1.132-3(a)(5) :Prop or services may be provided thru a 3rd party

Ex)if you represent Kitchenaid, the mfg, it may allow you to get EE discount at Best Buy (where the product is sold)

o 1.132-3(b)(2)(ii):A quantity discount can’t apply unless the EE actually buys the number required for the discount

Ex) if the discount applies for 10 units, the EE only gets the discount if they buy 10 unitso What if the ER discounts all items?

If at least 35% of the ER’s sales are discounted, then the discounted price is used (1.132-3(b)(2)(iv)

Ex)some industries have retail price, but they don’t sell for the retail price, they sell for a discount Most commonly used discount is controlling

o So if have 10% and 20% discounts, whichever you use the most is the winnero GPP is calculated based on the prior year, so for 2006, the discount for prop is based on 2005 numbers

1.132-3(c)(1)(iii): in first year of operation, you can either use the markup from cost, or you can determine the GPP by reference to an appropriate industry average

o If substantial changes in ERs business that indicate at any time that the prior years GPP is inaccurate, then you must redetermine the GPP

Ex) the Apple IPOD starts selling like crazy this year, or doesn’t sell at all, have to redetermineo Use Generally Accepted Accounting Principals to determine the sales price

o Working Condition Fringe:§132(d) & §1.132-5 o Any property or services provided to an EE where, if EE had paid for such prop or services, the

payment would be deductible as a biz expense (§162) or depreciation (§167) Reason: it would probably be a wash if the EE had income and then received a deduction Ex)ER gives you car and you can only use for biz purposes, EE would include in income and then

turn around and deduct as biz expense on return…would wash Ex) bodyguard for security; on the job training; firm pays for CLE (technically income, but

deductible as working condition fringe)o Personal Use of Vehicles is not excluded from Gross Income

However, most people don’t include in GI If EE uses car 80% for work and 20% for personal use, then 20% of the value of the car is not

excluded from income Auto Dealership Exception:132(j)3: a full time auto sales person can exclude the use of demo car

if used primarily to facilitate the sales person’s use of services for ER So they can use car for personal use, but w/ significant restrictions Rationale: want EEs to use the car so they can be familiar w/ it to sell to people

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o 1.132-5(c): must meet same substantiation requirements as if EE had directly incurred expense. The substantiation requirements are satisfied by “adequate records or sufficient evidence corroborating the EE’s own statement.”

Ex)at Phelps, if you take someone to lunch for work purposes, the firm reimburses that amount, it is a working condition fringe (not on tax return), but you must give copy of receipt and tell who you went to lunch with which fulfills substantiation requirement

o 1.132-5(a)(1)(v):cash payment does NOT qualify as working condition fringe UNLESS Employer requires Employee to:

(1) use the payment for a specific pre-arranged activity for which a deduction is allowable under 162 or 167

(2) verify that payments are actually used for that purpose (3) return unused cash Ex)pilot flies somewhere for a few days, and the owner of co gives him $200 cash to eat while

there – this is fine, but must use money to eat and give whatever cash you don’t use back to ownero De Minimus Fringe §132(e) & §1.132-6

o Any property or services the value of which is (after taking into acct the frequency w/ which similar fringes are provided by ER to EEs) so small as to make accounting for it unreasonable or administratively impracticable.

size of transaction/expense is what matters Can’t say that b/c you are Coke, $10,000 means nothing – it is the size of the transaction

that matters and a $10,000 transaction matterso §1.132–6(e):Ex)secretary occasionally typing personal letters; occasional use of copy machines;

occasional cocktail parties, group meals or picnics; occasional supper money or taxi fare b/c of overtime work, coffee and donuts, occasional theater and sporting event ticket (no season pass), traditional birthday or holiday gifts of property (not cash) with a low FMV; local telephone calls; flowers, fruit books, etc provided under special circumstances (EE ill)

Must consider frequency that fringes are provided If frequency to which EE receives benefit (gets a donut), then you can look at how often

the ER is giving the benefit to all employees (how often employer puts the donuts on the table)

Ex)every once in a while having supper is ok, but breakfast, lunch and dinner every day is no longer fringe

practicality of figuring out the price of, say, a donut is the reasoning behind thiso 1.132-6(c):A cash fringe benefit is NEVER excludable as a de minimus fringe benefit even if the

prop or service acquired w/ the cash would be excludable as a fringe benefit. Ex)amount of copying would be $10 - ER can’t give you the money and say go make your copies

at Kinko’so 1.132-6(d):However, meals, meal money, or local transportation fare provided to an EE is excluded

as a de minimus fringe benefit if it is “reasonable” and meets the following requirements: (1) Provided only on occasional basis (2) Provided to EE b/c overtime work necessitates an extension of EE’s normal work

schedule (3) meal or meal money is provided to enable EE to work overtime In no event shall meal money, or local transportation fare calculated based on number of

hours worked ($1.00 per hour over 8 hours) be considered a de minimus fringe Can’t say if work certain timeframe you get money – must only be when it is necessary to

work late (ex. if you guys work late, I’ll get you McDonald’s)o 1.132–6(d)(2)(iii): if ER provides transportation (such as taxi fare) for commuting to and from work

b/c of unusual circumstances and b/c it is unsafe for EE to use other available means of transportation, the excess of the value of each one-way trip over $1.50 per one-way may be excluded from GI

Ex)if EE lives in a bad neighborhood and it’s unsafe for EE to commute, then sending a van/bus is a de minimus fringe benefit

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Ex)EE usually goes home at 6, and you call them at 3 AM to come to office and it is not safe for them to drive at that time, you can give them cab fare and to the extent it is more than $1.50, EE can exclude

o 1.132–6(d)(3):If benefit is not de minimus, then none of it is excluded If you have too much copying, then it is no longer de minimus and you can account for it and the

entire amount of the copying is included in income difference b/w this rule and qualified EE discount=for services, you can discount 20% and exclude

it all and if you discount 25%, you can still exclude 20% and include 5% -however, if it were a de minimus fringe benefit, you would have to include the entire 25%

o Non-discrimination rules don’t apply Even if the president is only one w/ a secretary to type personal letters, doesn’t make it non-

excludableo ER operating eating facilities might come under these rules

Ex – cafeteria at hospital is example ER operated eating facilities are a de minimus fringe if:

Such facility is located on or near the business premises of the ER; and Revenue derived from such facility normally equals or exceeds the direct operating

costs of such facility. This exclusion does apply the non-discrimination restrictions and does not cover spouses or

dependant children 1.132-7(a) – defines e’or operated eating facility as one that:

Is owned or leased by the e’or Is operated by the e’or Located on or near the business premises of the e’or. Meals furnished at the facility are provided during, or immediately before or after

the e’ees workday. o Other Fringes

o Qualified transportation fringe – §132(a)(5) o Excludes from GI benefits provided to EE in the form of o (1) Transportation in a commuter highway vehicle if such transportation is in connection with

travel b/w the EE’s residence and the place of employment Ex – minibus

o (2) Any transit pass Token, etc for mass transit or mass transportation Limitation on exclusion – The sum of 1 & 2 can’t exceed $100 per month

o (3) Qualified parking Limitation on exclusion – can’t exceed $175 per month Must be on or near the business premises of the ER (or a location where EE parks to

take any transportation in (1)) Ex – I can exclude TP giving me parking for $175/month for qualified parking

o If fringe is w/i the def of qualified transportation fringe, by def it cannot also qualify as working condition or de minimus fringe

So if dealing with a qualified transportation fringe, look at this provision, not the otherso Qualified moving expense reimbursement - §132(a)(6)

o If new ER pays for moving, in some situations, you can exclude from incomeo Qualified retirement planning services - §132(a)(7)

o Excludes retirement planning advice or info to EE or spouse by EE having a plano Athletic Facilities - §132(j)(4)

o This excludes the value of the use of any gym, pool, golf course, tennis courts, etc on the ER premises and operated by ER if substantially all of the premises are used by EEs and their spouses and dependents

Ex – only one JK knows of in BR is Shaw Has EE gym for the EEs to work out at

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o Other exclusions o §79 – group term life ins premiums for up to 50,000 worth of coverage

o Whatever exceeds that, you have to include premium in GIo §120 – excludes value of group legal services o §129 – excludes amounts paid by ER for dependant care expenses up to 5000o §137 – excludes ER payments of qualified adoption expenses o §112 – excludes military personnel…o §134 – excludes add’l military benefitso §125 – allows establishment of cafeteria plans

o Allows EEs to choose the fringe benefits they want out of a number of fringe benefits

Steps in the analysis of whether a fringe benefit is included in GI:(1) Generally GI under 61(a)

a. Accession to wealth(2) Does an exclusion rule apply?

a. Go thru the rules and the analysisb. Also apply the small rules

i. Is this an EE?ii. Nondiscrimination?

iii. Same line of business?

Problemso 1. Consider whether or to what extent the fringe benefits listed below may be excluded from GI:

o (a) EE of a national hotel chain stays in one of the chain’s hotels in another town rent-free while on vacation. The hotel has several empty rooms

132(a)(1) – no additional cost We don’t know if this is non-discriminatory. If it is, and he is highly compensated EE, not

excludableo (b) Same as (a), except that the desk clerk bounces a paying guest so EE can stay rent-free.

Not excludable as a no-add’l cost fringe b/c didn’t allow customer to stay (ER forgoing revenue to let him stay)

Exam – say “it looks like no additional cost service, but it is not b/c the ER is forgoing revenue” What about qualified EE discount fringe?

It would be services so you can exclude the first 20% of the cost o (c) Same as (a) except that EE pays the bill and receives a cash rebate from the chain.

Exclusion as no add’l cost service Rebate is irrelevant If you pay and get reimbursed later, it is still excludable

o (d) Same as (a) except that EEs spouse and dependant children traveling wo EE use the room on their vacation

Exclusion still applies to spouse and dependent children – §132(h)(2)(a) However, must still be non-discriminatory

o (e) Same as (a) except EE stays in the hotel of a rival chain under a written reciprocal agreement under which EEs pay 50% of the normal rent

Might be a no additional cost service, so under 132-2(b) it must meet the requirements Agreement must be written Neither ER must incur substantial additional costs Same line of business The nondiscrimination rules still apply

Fact that they paid 50% is irrelevant – don’t worry about the cost of the discount for a no-additional cost service

Portion not paid for, as well as portion paid for is excludable

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o (f) Same as (a), except that EE is an officer in the hotel chain and rent-free use is provided only to officers of the chain and all other EEs pay 60% of the normal rent

Looks discriminatory, but we don’t know if this EE is highly paid Issue – just b/c officer, doesn’t make him highly compensated – look at 414(q) def If is highly comp, then the entire amt is included in income and you don’t get to exclude the 40%,

even though everyone gets 40% off We don’t have enough facts to know if highly comp 1.132-8(a)(2) is the proper reg

o (g) Hotel chain is owned by a conglomerate which also owns a shipping line. The facts are the same as (a) except that EE works for the shipping line.

Not excludable b/c violates the same line of biz – fails to be no add’l cost and EE disc b/c both require to be in same line of biz

132(c)(4)o (h) Same as (g) except that EE is comptroller of the conglomerate.

Excluded b/c the comptroller provides services that directly benefit more than one biz – regs say requires substantial services in the line of biz- if we assume this, then we meet same line of biz requirement

We also assume it is non-discriminatory More than likely, it is excluded

o (i) EE sells insurance and ER Insurance Co allows EE 20% off the $1000 cost of the policy The legislative history indicates that life insurance is service under the qualified EE discount

fringe, so can exclude the 20% if this is nondiscriminatory This is considered a service and not a product

o (j) EE is a salesman in a home electronics appliance store. The prior year, the store had $1,000,000 sales and a $600,000 cost of goods sold. EE buys a $2,000 video cassette recorder from ER for $1,000

Discount EE got is greater than the GPP – so he cannot exclude the difference b/w the two 400,000/1,000,000 = 40% He buys 2000 recorder - 40% = 800 So the first 800 qualifies for exclusion and the add’l 200 must be included in income

o (k) EE attends a business convention in another town. ER picks up EE’s costs Working condition fringe, but don’t know if he was paid directly or reimbursed If ER paid for it or if EE paid and was reimbursed, either way it is working condition fringe

o (l) ER has a bar and provides the EEs with happy hour cocktails at the end of each week’s work De minimus fringe – but usually this is stuff that you can’t get the price Regs do say that occasional meals is a fringe Look at frequency – this is every week, but still might be hard to account for Best argument is for de minimus fringe Other than that, try qualified EE discount since they work in same line of biz and look at the GPP

for propo (m) ER gives EE a case of scotch each Christmas.

Is this a traditional holiday gift with pretty low FMV? Case of scotch pretty expensive 1.132-6e1 – “traditional holiday gift with low FMV” – so then you have to determine if case of

scotch is low FMV Probably not excludable as de minimus fringe

Exclusions for Meals and Lodging§119(a) – Exclude from GI of the EE the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his ER for the convenience of the ER, but only if:

o (1) In the case of meals, the meals are furnished on the biz premises of the ER, oro (2) In the case of lodging, the EE is required to accept such lodging on the biz premises of his

ER as a condition of his employmentMEALS:

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o 1.119-1(a)(1) – Exclude the value of meals furnished to EE if (1) meals furnished on the biz premises of the ER and (2) meals furnished for the convenience of the ER. The Q of whether the meals are furnished for the convenience of the ER is one of fact to be determined by analysis of all the facts and circumstances in each case. If test (1) & (2) are met, the exclusion applies irrespective of whether under an employment contract such meals are furnished as compensation.

o So even though might be taxable under FICA or other purposes, if you meet the 2 requirements, it is excluded under §119

o Meals “provided for the convenience of the ER”o §1.119-1(a)(2)(i) – Meals furnished by an ER without charge to the EE will be regarded as

furnished for convenience of ER, if the meals are furnished for a substantial noncompensatory biz reason of the ER.

There must be a business reason for furnishing the mealo If ER furnishes meals as a means of additional compensation to his EE (and not for a substantial

noncompensatory biz reason of ER) the meals are not regarded as furnished for the convenience of the ER

Given for compensation doesn’t exclude it from GIo If the ER furnishes meals for a substantial noncompensatory biz reason, it doesn’t matter if the

meals are also furnished for a compensatory reason o Generally meals furnished before of after the working hours of the EE will not be regarded as

furnished for the convenience of the ER but there are some exceptions. Normally if get meal before or after regular working hours, it is not excluded

o If the EE is required to occupy living quarters on the biz premises of his ER as a condition of employment, the exclusion applies to the value of any meal furnished w/o charge

o Examples of meals provided for a substantial noncompensatory biz reason of the ER: §1.119-1(a)(2)(ii)o (b) – ER provides meals b/c they have to restrict eating time to a short period, such as 30 to 45

mino (c) – ER provides b/c there are insufficient eating facilities around the ER premises o (d) – Meal furnished to a food service EE for each meal period in which the EE works,

regardless of whether the meal is furnished during, or immediately before, or after the working hours of the EE

Ex- Outback EEs get to work early for a meal immediately before work…this is oko (f) – If ER would have furnished meal during working hours, but had to provide immediately

after working hours b/c his duties prevented him from getting meal during working hourso §119(b)(2) – In determining whether meals are furnished for the convenience of the ER, the fact that a

charge is made for such meals, and that EE may accept or decline such meals is not taken into accounto ER can give discount instead of free meal and it is still excludableo Under (b)(3), if you do charge for the meal, there are rules that apply – if EE required to pay on

a periodic basis a fixed charge for the meal, and the meals are furnished for convenience of ER, you shall exclude an amount equal to the fixed charge

Even though charge for meals, and it would otherwise be excludable, you can exclude from income

The purpose is to treat equally situations where the EE eats for free and situations where the EE has to pay for it under the same conditions

o Under (b)(4), if more than half of the EEs on the premises receive meals for the convenience of the ER, then ALL of the meals are excludable from GI

LODGING:o 1.119-1(b) – Value of lodging provided to EE by ER is excluded from GI if 3 tests are met:

o (1) Lodging furnished on biz premises of ERo (2) Lodging furnished for convenience of ERo (3) EE required to accept such lodging as a condition of employment

Condition of employment means that EE is required to accept lodging in order to enable him to properly perform the duties of his employment

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Ex – lodging furnished b/c the EE is required to be available for duty at all times or b/c EE could not perform the services required of him unless he is furnished the lodging

o Firemen What you can’t do is say you will hire me as a lawyer and “require” me to live in a

nice house in a good part of towno If (1) (2) (3) met, exclusion applies regardless of whether there is a charge or the lodging is

furnished as compensation. o Special rules with lodging furnished by special education institutions: §119(d)

o (d)(1) GI shall not include the value of qualified campus lodging furnished to an EEo (d)(3) “Qualified campus lodging” – lodging to which subsection (a) does not apply and is (1)

located on or near a campus of the educational institution and (2) furnished to EE, spouse and any dependents by or on behalf of such institution for use as a residence

o (d)(4) “Educational institution”- cross ref to 170 – basically a normal college Ex – Chancellor O’Keefe has his house on the lakes (within the proximity of LSU)

o (d)(2) – The exception shall not apply to the extent of the lesser of (i) 5% of the appraised value of the qualified campus lodging or (ii) the avg of the rentals paid by individuals (other than EEs or students of the educational institution) over the rent paid by the EE for the lodging.

Ex – 5% of appraised value of campus lodging = appraised at 200,000, so 5% is 10,000. Lesser of 10,000 or avg of rentals paid over rent paid by the EE is not excluded. The university is paying 12,000 on his behalf. So, he excludes 10,000 and includes 2,000 in his GI.

o §107 – special rule for ministers – GI does not include (1) rental value of a home furnished as part of his compensation OR (2) rental allowance paid to him as part of his compensation, to the extent he uses it for a home and to the extent such allowance does not exceed the fair rental value of the home

o This is a lot more liberal than §119 - the rationale is that ministers are more likely to use their home for “business” purposes than others

o Normally people get in trouble when they have something they call a church but it isn’t really a church o Hatt

o Hatt married Dorothy and she transferred control of the Corp to him and he was named as Pres. Corp owned funeral home and had dormitory for ambulance service. Hatt lived in apt inside funeral home – the biz telephone rang in apt and he met with customers in apt after hours

o This is §119 issue. 3 requirements – (1) lodging on biz premises of ER (2) lodging provided for convenience of ER (3) EE required to accept as condition of employment

o Ct says – convenience of ER and condition of employment test are similar. IRS argues he can’t determine whether it is condition of employment since he makes the

decision – can’t require himself to live there The ct said this only requires careful scrutiny and does not automatically exclude him

o Ct concluded – b/c of 24 hour nature of the biz, and b/c it was normal in that area for EEs to live in the funeral home, the last 2 requirements are met

o So, application of gen rules tells us that even though you control the company, you can make decision of whether living there is req’d

o Anderson – manager of hotel on call a few blocks from hotel and the house owned by hotel owner – ct held on the biz premises means “either at the place where EE conducts significant portion of his duties or where the ER conducts a significant portion of his biz”

o So even though only a couple of blocks away, he didn’t perform sub part of his biz there, so did not meet exclusion

o Jack B. Lindeman – ct held that a residence adjacent to the motel (across the street) was not geographically separated from the motel and was therefore “on the biz premises”

Problems pg 1061. ER provides EE and Spouse and Child a residence on ER’s biz premises, having a rental value of $15,000 per year, but charging EE only $6,000. (a) What result if the nature of EE’s work does not require EE to live on the premises as a condition of employment?

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o Include $9000 in GI. The 3 part test in §119 has not been met b/c it is not a condition of employment (b) What result if ER and EE simply agreed to a clause in the employment contract requiring EE to live in the residence?

o Is staying there truly for the convenience of the ER? This clause has no effect b/c it must be determined whether it is truly for the convenience of the ER

(c) What result if the EE’s work and contract require EE to live on the premises and ER furnished EE and family $6,000 worth of groceries during the year?

o The lodging is excluded from GI under §119-i b/c it is required for EE to live on the biz premise. §119-i exclusion applies to both the taxpayer, spouse and dependant and can be excluded.

o Tax ct (Tougher) says groceries are not meals b/c meals should be given the ordinary meaning (ready to eat servings)

o However, 3rd circuit (Jacob v. U.S.) says groceries are an ordinary part of meals, so should be included with meals

o Groceries are probably not meals (d) What result if ER transferred the residence to EE in fee simple in the year that EE accepted the position and commenced work? Does the value of the residence constitute excluded lodging?

o Fee simple = full ownership (now EE owns the home)o The value of the residence should probably be included in GI b/c it is no longer the biz premises – it is now the

EE’s propertyo JK says probably won’t qualify for exclusion under 119

2. Planner incorporated her motel biz and the corporation purchased a piece of residential property adjacent to the motel. The corporation, by K, “required” Planner to use the residence and also furnished her meals. Planner worked at the motel and was on call 24 hours a day. May Planner exclude the value of the residence or the meals from her GI?

o In Anderson, just b/c she was on call was not enough to exclude the house b/c it was not a significant portion of the biz. However, Lindeman says that adjacent to the biz is close enough to be on the biz premises. Lodging excludable here

o Is she an EE under 119? Self employed person can’t be EE of himself, however a corp is a sep taxable entity (Hatt and Dean) – so if sep taxable entity owns it, then you could potentially be EE. If Planner proved meals and lodging as EE, income can be excluded if meet the other requirements of 119.

o Remember, Hatt requires careful scrutiny to determine if really an EE and not just trying to get an extra benefit for yourself

o Note – partner of pship can be EE if the other requirements are met. o Here, there is corp, so probably can be EE.

o Is this on the biz premises of the ER? Lindeman says prop across the st is on the biz premises, so probably ok here.

o Conditions of employment – is it condition of employment for convenience of ERo Hatt says diff to determine- must have careful scrutiny b/c same person looking for exclusion is

making decision about convenience, but it is a Q of fact and look at all the circumstanceso Looks like for convenience of ER b/c Planner required to be there 24 hours/day

o If lodging met, then meal exclusion automatically met – 1.119-1(a)(2)(i) last sento Also assume the food provided here was a meal

3. State highway patrolman required to be on duty from 8am to 5pm. At noon, he eats lunch at various privately owned restaurants which are adjacent to the state highway. At the end of each month, the state reimburses him for his lunch expenses. Are the reimbursements included in GI? Commissioner v. Kowalski

o Issues: (1) reimbursement of expenses (can you receive cash instead of meals?) (2) Is it for convenience of ER? (3) Is this biz premises of ER?

o (1) Ct said reimbursements are usually income - Not excludable under §119 b/c must receive mealso (2) But, assume he got meals, would it be for convenience of ER? The Ct said that you base it on whether or

not the meal was required for the EE to properly perform his duties. Was it req’d for the police to eat there b/c he was a state trooper?

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o Ct said it might be for the convenience of the ER, but it didn’t matter here b/c they got cash and §119 requires a meal in kind

o (3) Must it be on the biz premises of the ER?o Cts split on this issue o Is the biz premises the highway which is where he performs his job?o The issue is whether police performs a significant amount of duties at that restaurant

Maybe he takes his radio into the restaurant to screen for calls?

Awardso Congress broadened the tax base in 2 ways:

o (1) prizes and awards o (2) scholarships and fellowships

Prizeso Used to have to argue that prizes were gifts and excluded under §102

o §74 applies now, and not §102 if §74 does not exclude it from GI, then you can’t go to §102 and try to exclude it

o General rule: prizes and awards are includedo Exception 1 - transfer to charityo Exception 2 – EE achievement award

o §74(a):Except as otherwise provided in this §, Gross Income includes amounts received as prizes or awardso §1.74-1(a) :Examples of what is INCLUDED in GI: Amounts received from radio and television giveaway

shows, door prizes, awards in contests of all types, awards from ER to EE in recognition of achievement in connection w/ employment

o Ex) guy on survivor didn’t pay his taxes when he won and got sent to jailo What about Extreme Makeover – why aren’t the houses taxable?

o 74(b): Exception 1: GI does NOT include prizes and awards made primarily in recognition of religious, charitable, scientific, educational, artistic, literary or civic achievement, but ONLY IF:

o *must be an award in recognition of one of the fields listed above AND meet (1)(2)and (3)o (1) recipient selected w/o any action on his part to enter the contesto (2) recipient not required to render substantial future services as a condition to receiving prize or

awardo (3) prize or award transferred to a governmental unit or organization

Must be transferred directly to charity or govt unit (taxpayer can’t keep it…can’t be enjoyed by taxpayer)

o Proposed Reg. 1.7401(b): specifically lists the Nobel and Pulitzer Prize as examples of excludable prizes if transferred to charity (if you don’t receive any cash benefit or if you transfer that cash benefit to charity)

o Designation requirement: o 1.74-1(c): To qualify for the exclusion, recipient must make a qualifying designation in writing w/in

45 days of date prize or award is granted. Designation is only req’d to indicate that a designation is being made, it doesn’t need to state that the organizations are qualifying

o 1.74-1(e)(3) :“granted” =subject to recipient’s dominion/control to such extent that it otherwise would be includible in recipient’s GI

Basically as soon as would be GI under Glenshaw, you have 45 days to designate in writing who the recipient will be

Ex) I designate TAF to receive this award. (good enough if in writing and w/in 45 days)o Transfer requirement:

o 1.74-1(d): Exclusion not available unless the designated items or amounts are transferred by the payor to one or more qualified donee organizations no later than the due date of the return for the taxable year where the recipient would have had to include in GI.

Ex) Individuals tax returns are due on April 15th so, you due April 15th of the year after you receive the award

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Transfer may be accomplished by any method that results in the receipt of the items/amount by the donee organization from the payor and does not involve the disqualifying use of the items or amounts.

Possession of a prize/award by any person before designation is made will not result in disallowance of an exclusion unless a disqualifying use is made.

o (e)(2):“disqualifying use” =in the case of cash or other intangibles, spending, depositing, investing or otherwise using the prize or award. In the case of tangible items, physical possession of the item for more than a brief period of time by any person other than the grantor or a donee organization.

For example, receipt of an unexpected tangible award at a ceremony will not constitute a disqualifying use unless the recipient fails to return the item to the payor as soon as practicable after the receipt.

So if they give you a gold mug, and it is worth $$, you can only keep for brief period of time. Either let the person giving you hold on to it, or you can take it and then transfer it away soon after

o §74(c):Exception 2: GI shall NOT include the value of an EE achievement award (§274(j)) received by the

taxpayer IF the cost to ER of the award does not exceed the amount allowable as a deduction to the ER for the cost of the EE achievement award.

o §74(c) creates an exclusion for EE achievement awards. o Must examine in conjunction with other Code sections.

§102(c) does not include gifts from an ER to an EE w/i the §102(a) gift exclusion rule, thus requiring inclusion of such gifts in an EE’s GI.

However, a gift from an ER to an EE such as a retirement gift after a long period of service may escape GI inclusion by qualifying as a § 132(a)(4) de minimus fringe benefit. §74(c) adds an exclusion or partial exclusion from GI for the value of certain EE achievement awards.

104c, de minimus fringe benefit, 74c all exclude from income similar thingso To exclude from income, there are 3 arguments you can make for transfer to EE from ER. Could be gift,

but 102 says EE achievement does not apply. Also have potential de minimus fringe benefit argument. And there is also 74(c).

o §274(j): allows the ER to get a deduction. Once you figure out what is deductible, can go to 74(c) to see what is excludable

§274(j)(1) – no deduction allowed under 162 or 212 (ordinary or necessary biz expense) except to the extent that such cost does not exceed the deduction limitations

§274(j)(3)(a) :“EE achievement award” =item of tangible personal prop which is o (1) transferred by ER to EE for length of service achievement or safety achievemento (2) awarded as part of a meaningful presentation and o (3) awarded under circumstances that do not create a significant likelihood of the

payment being disguised as compensation (this is a catch all)o Either EE has been there a long time, or don’t mess up for a period of time

o Deduction limitations: if it is an EE achievement award, it is only deductible if under these limits: §274(j)(2) - (1) if not qualified plan award, when added to the cost to the ER for all other EE

achievement awards made to such EE during the taxable year, shall not exceed $400. o So you can’t give person under non-qualified plan award any item worth more than $400

§274(2) If is qualified plan award, when added to the cost to the ER for all other EE achievement awards made to that EE, can’t exceed $1600 (for the taxable year)

Need to make sure you are under the limitations so EE won’t have to include in GI…capped at $1600

o What is qualified plan award? (j)(3)(B)(i):awarded as part of an established written plan or program that does not

discriminate in favor of highly compensated EEs and the average cost of all gifts can’t exceed $400.

o average costs is determined by including entire cost of qualified plan awards w/out taking into account EE achievement awards of nominal value.

o you can give some awards up to $1600, but the average of all of them can’t exceed $400

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o if someone there for 50 years give him expensive gift and if someone there for a shorter time, give cheaper gift to average it out

o you can’t give nominal awards and consider them, aka can’t give expensive gifts to everyone and give slip of paper to another and say it was 25 cents to average under $400

o What if you go above the limitation? What about $4500 award not part of a qualified plan?o §74(c)(2) :Excess deductions: if cost exceeds amt allowable to ER then GI includes the greater of:

(a) amount equal to the portion of the cost to ER of the award that is not allowable as a deduction to the ER

o If the cost is a lot, you use that (b) Amount by which the value of award exceeds the amount allowable as a deduction to the

ERo The excess is the amount included in income

o (c)(3): Treat tax-exempt ER as if they were not tax-exempt The tax-exemption won’t have the deductions since they don’t have tax, so for purposes of this

exclusion, pretend they are taxed and see if it would have been excluded for themo McDonell

o Issue:what is a prize or award?o Facts: McDonnell is employed by DECO as assistant sales manager. o Company gave him a trip to Hawaii as a prize for salesmen o Co also decided to send sales manager and their wives b/c previous complaints.The sales manager was

selected randomlyo Business purposes of the trip= “Allen was one of the 4 chosen. They were told that those selected and their

wives were expected to go although they would have been excused for good reasons. They were instructed they should consider the trip as an assignment and not a vacation and their job was to stay constantly w/ the contest winners, participate in all scheduled activities, and not to go off alone. Objective was not only to make sure that every winner enjoyed himself, but to guide anticipated informal discussion relating to DECO’s biz to protect and enhance DECO’s image w/ its distributors and territorial salesmen. The wives were essential participants in the achievement of this objective. DECO felt it would be impossible for stag salesmen to host a trip for couples.”

This is their rationale for doing this as a company (purported business purpose)o There was only 1 day of direct work (sales meeting), and the rest was time for them

but, the assistants had duties which took up almost all of their time , so there was not time for swimming or shopping

o M said this was a requirement of the jobo IRS says it was prize or awardo Ct said: just b/c selected randomly does not make it prize or award (just b/c the names are pulled out

of a hat doesn’t make it a prize/award)…they didn’t want anyone to feel slighted, so this is why they went about it this way

o Distinguished taxpayer in this case from contestant winners who clearly win a prize or award. Also distinguished from cases (Patterson) where EE req’d to attend convention, but work is minimal (here, they had to perform all of these business duties)

o taxpayer was req’d to devote substantiality all time to employment while on tripo Fact that they enjoyed the trip is irrelevant (can mix business with pleasure)o Fact that trip to a resort area is a fact to be taken into account, but not conclusive o Right to go was not based on work performance so further evidence that this is not disguised remuneration

If they would have given this trip for those who performed well at the office it would have been disguised remuneration

o taxpayer wife is a little more difficult since not EE, so is it like prize to her? Ct said the services of the wife were substantial b/c could not be done by stag men, so ct held

it was not a prize eithero Analysis: was it for sound biz reasons, or was it an award or incentive to EEs? Here it was for biz

reasons

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o Ct did not consider alternative argument that trip had no Fair Market Value b/c they found no prize or award to begin with – if it were prize or award, you would have to look at FMV

o Note – today you might be able to exclude trip as working condition fringe – it is arguably part of their job, and would be deductible if they paid for it…

Problems pg 1101. Each year national sportswriters get together and select the single most outstanding amateur athlete in the country and award that person a check for $5,000. P, a talented skier, has been selected for this year’s award. The award is given with the stipulation that the winner deliver a 15 minute “acceptance speech” at the awards banquet. In his speech, P designates the National Ski Patrol Organization, as charity under §170, to receive the award. The sportswriters send the check to the Ski Patrol Organization. Can P exclude the $5000 from GI?

o Prizes and awards are generally taxed, so it needs to fall under exception…o Under gen rule 74(a), it is income. o issue is whether it is one of the enumerated reasons in 74(b) in order to qualify for the exclusion. The

award must be for one of the listed categories - only real argument is if it is civic or artistic achievement Two cases confirm that awards received by professional athletes are not w/i 74(b) classification of

civic or artistic achievement May be Civic achievement under 74(b) defined as “achievement that is a positive action which is

exemplary, unselfish and broadly advantageous to community” b/c here we are dealing w/ amateur athlete and not professional and no pay

o What if this was one of the enumerated reasons? Would it qualify as excludable? Can you argue that b/c of the stipulation that P deliver a 15 min speech it is requiring substantial

future services? Rev ruling 50-89 – An appearance to receive award/speech does not count as substantial future

services (so, fine here)o If we assume it is a civic award and the speech is not substantial future services (which it prob isn’t), then

74(b) would be met in that case and the $5000 would be excluded If you do qualify, you can’t double dip – you can’t accept the award, transfer to charity, exclude

from income and get deduction under 170. o However, in this Q, it is probably included b/c doesn’t qualify as one of the categories of 74(b)o §1.74-1(f)- Neither the payor nor the recipient will be allowed a charitable deduction for the value of any prize or

award that is excluded under this section

2. Gusher Oil desires to make its EEs feel more appreciated. To implement this desire, Gusher creates an awards program whereby EEs are given awards for achieving certain lengths of service. In each case, determine the extent to which EE, C, is able to exclude the award from GI.(a) Cliff has been working for Gusher for 12 years. Announcing Cliff’s retirement at the Ball, Gusher gives him a $300 gift certificate.

o It’s EE award b/c for length of service o Gift certificate (cash) is not tangible personal prop – it is intangibleo It is income under 74(a) b/c prize or award, so the issue is whether it meets 74(c) exception – in order to

do so it must be deductible under 274(j)- under (a) it must be tangible prop, but here, the gift certificate is not tangible personal prop so wouldn’t qualify under 74(c)

If it were tangible personal prop, exclude b/c falls under $400 under 274(j) (as long as no other $100 or more awards to C this year)

o What about other exclusions – like de minimus fringe under §132? Might be a stretch - legislative history says traditional retirement gifts are excludable (gold watch

examples) maybe can use that argument to say it is de minimus b/c traditional retirement gift (but can you argue gift certificate is traditional retirement gift?)

(b) Cliff (continuing to work for Gusher) receives a gold watch worth $300 for his 12 years of service, presented at the Ball.

o 274j – it is tangible prop and w/in $400 dollar limitation – see analysis in part (a)

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(c) Same as (b) except Cliff has worked for Gusher for only 4 years. o 274(j)(4)(b) main issue here = length of service award, so you need to work there for at least 5 yearso It is tangible, under dollar amount, excludable, but, it doesn’t qualify b/c doesn’t meet the 5 year

requirement

Scholarships & Fellowships

o §117(a) :GI does NOT include any amount received as a “qualified scholarship” by an individual who is a “candidate for a degree” at an “educational institution.”

o §117(b)(1):Qualified Scholarship=any amount received by an individual as a scholarship or fellowship grant to extent the individual used the amount for qualified tuition and related expenses.

o Proposed reg 1.117-6(c)(3iii): Scholarship/ fellowship grant=cash amt paid/allowed to an individual to aid in pursuit of study or research. May also be in the form of a reduction in the amt owed to an educational institution.

But, it does NOT include amount provided by an individual to aid a relative, friend or other individual in pursuit of study or research if grantor is motivated by family or philanthropic considerations

Ex) Can’t set up a scholarship and name your child as recipient (can’t donate to school and tell school to give it to child)

o Prop reg 1.117-6(c)(2):Qualified tuition related expenses are : (1) tuition and fees req’d for enrollment or attendance of a student at an educational

organization (2) Fees, books, supplies, and equipment required for courses of instruction at such an

educational institution. must be required of all students in the particular course of instruction.

Incidental expenses are NOT considered related expenses. expenses incurred for room and board, travel, research, clerical help, and equipment

and other expenses not required for attendance (food/lodging/travel NOT excluded).o Prop Reg 1.117-6(c)(4):Degree candidate=includes primary & secondary school students,

undergraduate/grad students, full time student at educational institution. §170(b)(1)(A)(ii): Educational Institution= institution which maintains regular faculty and

curriculum (pretty much a school in the traditional sense) Don’t want you having qualified scholarship to pottery class or something that is not a real

schoolo §117(c):Exclusion does not apply to that portion of any amount received representing payment for

teaching, research, or other services by the student req’d as a condition for receiving the scholarship o So if the work is a job, probably won’t qualify

o Educational grants by ER are generally taxable b/c represent comp for past future or present services…o Under §117, if ER gives EE money it generally won’t qualify for exclusion

o §117(c):services rendered to school are still compensation even if they are required to get your degreeo won’t qualify if they are making you work 1.117-6(d)(2)

For past, present, or future services McDonnell- if you send your EE to law school, it’s not excludable

o Revenue ruling 77-263 o Allows exclusion for a university athletic scholarship if the university expects, but does not require the

student to participate in a particular sport, requires no particular activity in lieu of participation (such as being a trainer instead of playing football), and the school cannot terminate the scholarship if the student can’t participate (e.g. injured).

Athletic scholarships do not require services if the university expects, but does not require services

Ex) If scholarship athlete gets injured and doesn’t play, he still gets the free ride

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o For scholarship to not be services use test similar to Duberstein: is it detached & disinterested generosity? They think you are a bright person and want to help, or is it in exchange for something else?

o What is the true intent of the person paying the scholarship??o §117 allows exclusion for qualified tuition reduction

o §117(d)(2): qualified tuition reduction = amt of any reduction in tuition provided to EE of an educational institution for the education below the graduate level, at such organization of

(1) the EE or (2) any person treated as an EE under §132(h) {expanded def of employee (spouse and

dependant children and surviving spouse of deceased EE)} Deals w/ EEs of the institution

o §117(d)(3) Exclusion only applies if doesn’t discriminate in favor of highly comp EEs o Generally educational grants by ER are taxable, but §127 has a limited exclusion aka excludes up to $5,250 for

amounts paid by ER for educational assistanceo There are several limitations :

(1) can’t discriminate in favor of highly compensated EEs (2) Can’t provide more than 5% of the benefits to owners (3) Can’t allow EEs a choice to be educational assistance and other remuneration includible in

GI (can’t give choice of getting cash or assistance) (4) EEs must be given reasonable notice of the program (can’t just have the program and only

let your kids know about it)o §127(c)(1) – “educational assistance”

o (a) payment by ER for expenses incurred by/on behalf of EE including tuition, fees, books, supplies, equipment

o (b) provision by an ER of courses of instruction. But, does NOT include payment for tools/ supplies that can be retained by EE after the

course is over, benefits with respect to any course or other education involving sports, games, or hobbies.

Ex) Can’t get ER to pay for your wine tasting course at LSU leisure classes or your flag football team (must be real education)

o **don’t need to determine whether amounts are excluded under §127 are compensation b/c by its nature it is compensation – the only reason you are getting it is b/c you are EE, but there is this exclusion to encourage EEs to further their education

o Also, in §127, ok if it is performed for services, b/c the reason they are giving it to them is for services

Problems pg 1121. Student working toward degree is awarded scholarship of $6,000 for full tuition and for room and board during the academic year. The tuition, including the cost of books is $3,000 and the room and board is $3,000. As a scholarship recipient, Student is required to do about 300 hors of research for the professor. Nonscholarship students, if hired, receive $10/hour for such work. (a) What tax consequences to student?

o Prop reg 1.117-6(c)(2) says room and board NOT excluded under §117, so clearly, $3000 of the scholarship must be included in GI

o The other $3000 can potentially be excluded b/c used for books, if you disregard that he is required to do work, then you can exclude the $3000 for books.

o Issue: whether scholarship is given in exchange for services performed. If so, it is included in incomeo Under §117b, is there a qualified tuition reduction for the research? o Might have to allocate the amount – half of what he is receiving is for the service (research) and the other half

is just for scholarship – so you would exclude $1500 as part of scholarship and include $1500 as exchange for services. At the end of the day, you would be including $4500 in income and excluding $1500 from income

o Note* if the entire scholarship is in exchange for services, the rule doesn’t apply, so you include the entire $6000 in income.

o 127 only applies when ER gives it to EE (so doesn’t fit here) (b) What tax consequences to Student if all students are required to do 300 hours of research for the faculty?

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o same answer as (a). Prop reg 1.117-6d2o if you are receiving an amt in exchange for services, it doesn’t matter that all student req’d to do it

(c) What result if Student is not required to do any research but receives the $6,000 as an athletic scholarship?o issue is whether this is in exchange for services rendered?o Rev ruling 77-263:athletic scholarship not considered services in certain circumstances (see above)

(d) What tax consequences to Student if Student receives only tuition scholarship worth $9,000 (no books)b/c student’s spouse is an employee at neighboring educational institution and the tuition scholarship is part of a nondiscriminatory plan b/w several institutions applicable to all employees of such institutions.

Issue: whether it is a qualified tuition reduction. Spouses are included as qualified Employees under expanded definition and it would be excluded if it were below graduate level.

2. Secretary receives a $10,000 stipend from her firm to assist her while on a leave of absence to obtain a college degree. The stipend is part of a firm plan under which all recipients are required to return to the firm following their educational leave(a) What tax consequences to secretary?

o 117 will not apply b/c of the requirement of services (117(d)). o This is an educational assistance program – Secretary is responsible b/w the allowable amount $5250 and the

amount received $10,000 (127(a)(2) - $4750 would be income (b) What tax consequences to Secretary if she is not required to return to the firm after completing her degree?

o §127 – apply same analysis as (a) o Under §117 – it is still for services (past services) so you can’t apply due to §117(d)

o The services under 117 can be past, present or futureo W/out requirement to return, it might be a qualified scholarship, but might be for services provided ???

(c) What are the tax consequences to Secretary if she is not an EE, but instead receives the stipend as a prize in an essay contest?

o This is income under 74(a), unless it is excluded by §117o If it is a qualified scholarship, it can be excluded under §117 b/c even though it is a prize or award, it is a

scholarship o She is not employee, so no problem with it being in exchange for services o It is excluded if proceeds are used for tuition and books. Looks like it would be excluded if not for room and

board, etc.

Other Exclusions from Gross IncomeExclusions and Other Tax Benefits Related to the Costs of Higher Education

Credito dollar for dollar credit to your incomeo Much more valuable than a reduction b/c credit reduces tax liability dollar for dollar

Hope Credit & Lifetime Learning Credit - §25Ao non-refundable credits

o if the credits are greater than the amount of taxes you owe, you don’t get the credit=nonrefundable contrast w/ EIC, which you can get back over the amount you paid=refundable

o §25A(f)(1)(a) : “qualified tuition and related expense” = tuition & fees req’d for enrollment/attendance of (i) the taxpayer (ii) the taxpayer’s spouse (iii) dependant of taxpayer whom taxpayer gets a deduction for, at an eligible institution for courses of instruction

o 25A(g)(2) :Amount of qualified tuition and related expenses is reduced by any amounts paid for the benefit of the individual which are (A) a qualified scholarship excludible from GI under §117 (B) educational assistance allowance (C) payment for education expenses excludible from GI under any law

o any amounts paid w/ funds excluded from income generally don’t qualify for the credits o However any amounts excluded as gift or inheritance can qualify for the credit

so if parents give you money and you pay the tuition, you still qualify for the credit o Hope Scholarship Credit [§25A(b)]

o Per student credit (as opposed to per taxpayer)

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o Credit is an amount equal to the sum of 100% of the qualified tuition and related expenses paid by the Tax payer during the taxable year as does not exceed $1000 PLUS 50% of such expenses which exceed $1000 but does not exceed the applicable limit (2,000)

The max credit you can get is $1500o Only available for first 2 years of the post-secondary education

o The Lifetime Learning Credit [§25A(c)]o Per TP credit o Credited 20% of qualified tuition and related expenses up to $10,000

Results in max credit of $2,000 for any year of student’s post secondary education. Not index for inflation, so Hope credit could eventually surpass Lifetime Can use throughout post secondary education

o Applies on per taxpayer basis (not per student basis) aka a husband and wife both in school could both get the credit

o Note **Lifetime Learning is not always better b/c if you only pay $2000, you can get 100% of it w/ Hope and only 20% of it w/ Learning

o The total amount of combined credit is reduced (phases out) from 40k – 50k for single and 80k – 100k for joint(married)

o Ex)entitled to $2000 Learning Credit and you are married and you have 90k AGI, instead of getting full credit, you get half , phased out pro-rata. So if at $100,000, you get nothing

o Each year, only one of the two credits is allowed w/ respect to each studento determine if Hope of Lifetime is better and take that one

Savings Bond Income Used to Pay Higher Education Tuition and Fees §135o §135(a) :allows an exclusion from income for the gain on redemption of US savings Bond to the

extent taxpayer pays qualified higher education expenses during the yearo Ex) If you buy US savings bonds and it earns income and you redeem the savings bonds, if you use

that money for educational expenses you don’t have to pay taxes on the income earned by the bondso §135(c)(1) : “US savings bond”=any bond issued after Dec 1, 1989 to individual who attained age 24 before

date of issuance and issued at a discounto §135(d)(1) & (2): amounts are reduced by amounts received as scholarships, payment or waiver or

reimbursement of qualified higher education expenses (tuition and fees, but not room and board) o You can’t double dip aka can’t take advantage of these expenses and all the others as well

o if the bond redemption for the yr exceed the qualified higher education expenses for the year, only a portion of the interest income from bonds is excluded equal to the ratio of the expenses to the proceeds.

o Ex)50k of bonds that are redeemed, but you only use 30k of the cash for qualified higher education expenses. Only 60% (30k of the 50k) from the bond is excluded from income b/c you only used 60% of the proceeds for the qualified education expense.

o The way these bonds work is you buy 50k worth of bond at discount aka for 40k. SO normally when you redeem it, you recognize 10k in income. But here, you can exclude 60% of the income from GI

o The exclusion is phased out b/w 40k - 55k for single and 60k - 90k for marriedQualified Tuition Programs §529

o Under current law, the money in §529 plan can be used at any public or private school o the preferred way to go to save taxes w/ educational expenses o Plan must provide funds for qualified higher education expenses

o §529(e)(3): “qualified higher education expenses” = (i) tuition, fees, books, supplies, and equipment req’d for attending educational institution and (ii) expenses for special needs services in the case of a special needs beneficiary

similar to other definitions, but includes supplies, equipment, books, and expenses for special needs services

o §529(a): income from the plans are generally not taxed as earnedo §529(c)(3):distributions from plan are not taxed to the extent they are used for qualified education

expenseso so if you use all the money on the qualified education expense, you aren’t taxed on it

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o good thing to start saving when kids are youngo Excess distributions are taxed as in §72 (Rule 529c3a)

o Ex pg 230) if $40,000 were contributed to a plan and in the 4 years of college the designated beneficiary receives payments or in kind distributions of $30,000 per year, $20,000 of which is used for qualified higher education expenses, only the $10,000 per year not used for education expenses would be taxed and the ratio of the investment in the contract to the expected return ($40,000/$120,000) to each $10,000 payment, here $3,333, would be excluded from GI and $6,667 would be included and taxed in the beneficiary’s gross income in each year.

If you put 40k into the plan and you take 50 out. The issue is the growth and how much would be taxed when you take it out.

20,000 is clearly excluded b/c you use it for appropriate education expenses. You have to determine how much of the 10k is what you put into account, and how much is what you earned.

o Can avoid the tax on the excess distributions from the plan with a roll over plan for the benefit of the beneficiary or family member. Taxation of distributions may be avoided, subject to several limitations, by a rollover w/in 60 days of distribution from such plans to other plans or to other family members.

o §529e2 :broad def of family (spouse of beneficiary, individual who bears relationship…dependant, and any first cousin of a beneficiary)

o So if parents set up for me, and I don’t spend all the money, I can roll it into a plan for the benefit of another person falling into the definition of “family member”

o Rule 529c6: If a distribution is taxed, there is a 10% penalty tax on the amount taxed (example above would be $667 each year)

o so instead of paying only the regular tax, you pay 10% on top of it as taxo There is NO phase out for high income tax payers!!

o This is 1st plan allowing substantial tax benefits to high income tax payers Good for docs, lawyer, biz owners

Coverdell Educational Savings Accounts §530 o similar to 529 plano differences from 529 plan: educational savings acct must be established exclusively for the purpose of paying

qualified education expenses, including elementary and secondary(high school) expenses o (529 plan deals only with college)

o the contributions must be made in cash and can’t exceed $2000 per year o (529 plan has no limit)

o contributions must be made prior to the individual beneficiary’s 18th birthday o phase out b/w 95k- 110k for single and 190k- 220k for marriedo can’t make contribution to §530 plan to the extent you make contribution to §529 plan

o you have to pick either 529 plan or qualified education savings account o Practical Standpoint

o The 2 issues dealt with most are 529 plans and 530 plans b/c of the phase outs (which are higher, and not there for 529)

Problems pg 2321. Law Student and Spouse are self-supporting and Spouse works while Student attends Law School. Consider the amount of any §25A credit they may elect in the following circumstances assuming they file a joint return:(a) Student pays $10,000 in tuition for the current year. Spouse works and Spouses have a modified AGI of $30,000

for the year. o They are not in first 2 years of their higher education (b/c in law school now) so can’t get Hope o They do qualify for Lifetime, and can get 20% of the 1st $10,000 aka $2000 b/c they only spent $10,000o no phase out b/c don’t reach the amount b/c only have $30,000 of AGI

(b) Same as (a) except the tuition is from a student loan.o Same result as (a)

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o can’t double dip with 117 and ER provided exclusion, but there is no problem if paying with student loan. Note *you also might be able to deduct the interest on the loan

(c) Same as (a) except that Student is granted a $7,000 scholarship excluded by §117 that reduces the tuition to $3000.o The 7000 scholarship will reduce the amount of the credit involved o Take 20% of $3,000 b/c you can’t take amt from scholarship aka the 25a credit is reduced by any scholarship

so only 3000k (10k-7k) can be used for 25a credit – so 3k x 20% = 600 credit (d) Same as (a) except that Student’s Parents pay $8000 of the tuition and Student pays $2000, although Student is not a dependent of Parents.

o since parents paid, it is like a gift under §102, so no different than (a)o parents don’t get the credit b/c child isn’t dependant, but student can get full 2000 credit o it is ok that student excludes gift under §102 and then uses 25A credit. o If someone donates the money to you, you can qualify for the credit. Even if parents pay qualified tuition

related expenses, you can use it for the credit(e) Same as (a) except that Spouses have a modified AGI of $100,000 for the year.

o credit phased out b/c they make more than the phase out amount, so they are entitled to no credit (f) Same as (a) except that Spouse is also in college. Spouse in the 3rd year of college and pays $5,000 in tuition.

o Spouse doesn’t get Hope b/c in 3rd year of college, but both qualify for Lifetime o Hope is allowed per student, but Lifetime is allowed per taxpayer. B/c spouses file joint return, they are

considered “taxpayer” together, so it is only allowed for one. 25A and 25Ac1o If they both entitled to Hope, they both get it, but since it is Lifetime, credit will be same as (a) b/c

they qualify once(g) Same as (a) except that after Law Student graduates, Spouse, who has not previously attended college, quits work and enters a vocational school as defined in §25A(f)(2). Spouse pays $10,000 in tuition and Lawyer earns $75,000.

o AGI is still below phase out amt and she qualifies for Hope b/c still in first year. o She gets 2k credit since they spend 10k. o They qualify for both credits – they get 2k for Hope and 20% of 10k which is 2k too. They can’t take both

credits, So they can pick which one they want to take(h) What result in (a) if before credits, the Spouses had $3000 of tax liability and $3000 of withholding from wages which qualifies for a potentially refundable credit under §31?

o Use nonrefundable credit 1st then apply refundable credit o there is a 2k credit. They already have a credit – a 3k refundable credit (from withholding wages) and a 2k

nonrefundable credit. o Which one do you apply first? If you use 2k nonrefundable credit first, you go from tax liability of 3k to 0 and

then you can’t use the 3k refundable and get 2k back.

Hypo: if in (g) lawyer earned $90,000, how would that affect the credit? They would get 1,000 credit. This is pro-rata phase out. If the lawyer earned 85,000 it would be 1500 credit, and so on.Note*if lawyer made $110,000 they wouldn’t qualify for any 25A credits at all. They would qualify for §529 (no phase out amount) and §530 (higher phase out amount)

2. Couple concerned as to the funding of their children’s’ higher education costs. Their alma mater has a Qualified Tuition Program and they have also heard about savings bonds and Educational Savings Accounts. What is your advice to them?

o This is a young professional couple, so they probably have high income, or will have high income in the futureo There are 6 issues the couple should consider:o (1) What types of education costs qualify for the exclusion?

o §135 bond exclusion is only for tuition and feeso however §529 ((b)(3)) and §530 ((b)(4)) allow broader exclusions (also includes books and equipment,

etc) o §530 educational savings acct allows exclusion for elementary and secondary expenses.

o (2) What is the potential amount of the exclusion?o §135 applies to bond. No penalty if you redeem.

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o Under 529 and 530 contributions are gifts to the beneficiary of the plan and ordinary acct. earnings are excluded to the extent they are used to pay for qualified education expenses and the excess is taxed to the extent it is considered income (but not to the extent you are getting your money back that you put in) plus you get 10% penalty.

o Side note – practical limitation – 530 plan has 2k per yr limit for contributions and 529 has no limit. However you don’t want to overfund it b/c can only be used for appropriate purposes

o It is gift to the beneficiary of the plan – so they are not taxed if it doesn’t exceed the amt of the gift tax – this year it is 12k.

o (3) What is the phase-out amount?o 135 bond interest exclusion – phased out b/w 40 - 55 for single and 60 – 90 for married (both indexed

for inflation)o 530 – 95 – 110 for single and 190 – 220 for jointo 529 has no phase out

o if taxpayer wants to put more than $2000 in plan or will be phased under 530 then must go with 529o (4) What is the relation with other benefits?

o all of them are reduced by amounts in 117, etc, BUT NOT amounts of a gift under 102o with 529 and 530 the 25A credits are not affected, but to the extent the 25A credit is taken, no 135,

529 or 530 exclusions can be used. o Reference 135d2 and 529c3b5(2) and 530d2ci2o Cannot contribute to 530 plan in a yr a contribution made to 529 plan

o (5) Is there a possibility of rolling unused benefits into an account for another family member?o allowed in both 529 and 530 plans. o §135 bonds are not for particular beneficiary, so no restrictions there

o (6) What are the investment options?o investment options are more flexible with 529 plans

all states have different 529 plans, LA is more conservative and Alaska is very flexible o §135 plans earn interest which can be used to finance education

Deductions for Individuals OnlyQualified Tuition and Related Expenses

o No deduction in 222 after 2005o §222 – In case of individual, there is allowed as a deduction an amount equal to the qualified tuition and

related expenses paid by the taxpayer during the taxable year. However, the amount allowed as a deduction can’t exceed the dollar limit

o so basically, if you earn too much, you get nothing o qualified tuition and related expenses has same meaning as under 25Ao costs do not include cost for books, housing, student sports activities, or for courses related to sports or

hobbieso can’t get double deduction – can’t exclude something from income and then get this deductiono reduced for amounts used under 135, 529 and 530o amts deducted under 162 (ord and necc biz expense) doesn’t qualifyo no deduction allowed for dependent or married filing separate

Problems pg 564 – 1. Law Student, who is single, has $30k of AGI prior to consideration of §222 and pays $10k of law school tuition in the current year. (a) What is the amount of Student’s §222 deduction?

o When you ignore 222, the AGI does not exceed 65k, so you get the full 4k deduction o The 25A lifetime learning credit might be preferable b/c you are spending 10k on tuition and you would get 2k

credit(b) Same as (a), except that Law Student uses $8k of a §117 scholarship to pay $8k of the tuition?

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o Can’t get double deduction so limited to 2k. only the remaining 2k is deductible since they only spent 10k (10k-8k=2k)

(c) Same as (a) except that Law Student is married filing a joint return and Law Student and Spouse have $140k of AGI prior to consideration of §222. o Under phase out rules, you get 2k deduction (222b has phase out rules)

2. Single Law Student has 30k of AGI prior to §222 deduction and pays 10k of tuition in the current year. Student asks for your advice whether to take a§222 deduction or a §25A credit for the year. Student had a $3k withholding on wages.

o Neither phase out limit is met so the issue is whether the 4k deduction or 2k credit is better. Student is in 25% tax bracket so a deduction would only save you $760 whereas the credit is dollar for dollar offset of the taxes owed. So you save 2k instead of 760. If income is higher, the phase out rules may produce different results.

o In reality, Turbo Tax makes these deductions.

Gains from Dealings in Propertyo §1001(a), (b), (c); 1011(a); 1012o Gain determined based on the basis of a particular item.

o Basis= initial cost adjusted for amounts put into the item. o Basis

o what you have invested in a particular itemo Ex)if I buy a car for 10k, and then spend 5k on accessories for it, my basis is 15k o Basis is completely diff than value. Basis has nothing to do with how much the thing is worth. When

you purchase something the basis and value are usually the same. However, if you buy something like stock for 100, the tax basis is 100, but if it goes up in value tomorrow, the basis is substantially diff than the value – could be worth 500, but your basis is still 100.

o §1001(a):Determining gain and losso The gain from the sale or other disposition of prop is the excess of the amount realized over the

AB from §1011. Loss is the excess of the AB over the amount realized. o §1001(b):Amount Realized from the sale=the sum of any money received plus the Fair Market Value of

the property (other than money) receivedo Ex w/ car)AB of 15k. If you sell for 25k, you have 10k worth of gain. 25k amt realized – 15k AB. If

you only sell for 5k, you have tax loss of 10k. o §1001(c):except as otherwise provided, the entire amount of gain or loss realized in a sale or exchange

shall be RECOGNIZED. o the amt realized is the amt you receive in the transaction and the amt recognized is the amt you show

on tax return for the transaction o §1012:Basis of property = the cost of such property. The cost of real prop does not include prop taxes. o §1011:Adjusted basis = basis determined under §1012 (cost), adjusted as provided in §1016. o §1016:Proper adjustment to the property shall be made:

o (1) for expenditures, receipts, losses or other items properly chargeable to capital accounts Ex) if you buy car for 10k, that is the original basis under §1012. Adjusted Basis under §1011

is still 10k. but when you put 5k into car, it is adjusted under §1016 b/c it is an expenditure chargeable to cap (investing 5k more in capital)

Determination of BasisCost as Basis o Philadelphia Park Amusement Co. v. US

o Tax Payer granted grant to build bridge. Built bridge for $381,000. Also had a 50 year franchise. o Deeded bridge to city in exchange for 10 yr extension of franchiseo Issue: what is Tax Payer’s basis in the 10 yr extension of the franchise?

o Why? To determine depreciation and the loss when they sale the franchise

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o Specific Issue :when they exchanged bridge for 10 yr franchise extension, is the basis /cost the FMV of the asset given or the FMV of the asset received? (what is the cost? FMV of what you give up, or FMV of what you receive?)

o Held : the Basis is the Fair Market Value of the asset received (cost is the fair market value of the property received)

o This is now in the code - 1001(b) – amt realized from the sale shall be the sum of FMV of prop received + sum of anything other than money received

o w/ the exchange of prop, you are taxed on difference b/w fair market value of prop received and the adjusted basis that is given

o “It is necessary to consider the FMV of the prop received as the cost basis to the TP. The failure to do so would result in allowing the TP a stepped-up basis, without paying a tax therefore, if the FMV of the property received is less than the FMV of the property given, and the TP would be subjected to a double-tax if the FMV of the prop received is more than the FMV of the prop given.”

o Normally the FMV of what you give and receive is the same.o Ex 1) TP has Google stock bought for $5000 (5000 b) and $10,000 FMV o Wal-Mart stock with 10,000 FMVo TP exchanges the Google stock for WM stock o There is $5000 recognized gain under 1001 on the exchange and the b in WM stock is $10,000

This was easy b/c the FMV of the two is the sameo Ex 2)exchanges Google stock, but the exchange does not occur for a few days. On day agree to

exchange, both stocks are worth $10,000. But at the time the exchange happens, the WM stock went down to $9,000. Under 1001, the amt realized is the FMV of what you receive $9000 – the adjusted basis $5000. So you recognize a $4000 gain. If we used the basis of what he gave up, he would have a $10,000 basis in WM stock, even though it was really worth $9,000. It is a stepped up basis of $1,000. So we use the FMV of what he receives and he has a $9,000 basis in the WM stock.

o Ex 3) Same facts as Ex 2 but : If WM went up to $11,000, then you would recognize a $6000 G, but if you used the FMV of what you gave up, you would have $10,000 basis. If you were to turn around and sell the WM stock right away, it is worth $11,000 and your basis is $10,000 so you would recognize a $1000 gain which you just paid tax on. Effectively you would be double taxed.

o Held: In this case, it would be the FMV of the 10 year franchise extension. If the value of the extension could not be determined then the value of the bridge were to be used. If the value of both prop could not be determined, then the b in the old prop will be carried over (rare). Although the value of the franchise is difficult to determine, the value of bridge should be able to be determined with expert testimony

Problems pg 1181. Owner purchases some land for $10,000 and later sells it for $16,000. (a) Determine the amount of the Owner’s gain on the sale.

o Under 1001(a), basis is 10k. Amount realized is 16k. Gain is 6k o (1001(a) – Amt realized – AB = Gain)

o Under 1001c, unless there is special rule that applies, you recognize the entire gaino Note – if paid real estate agent to acquire prop, add that to the AB of the prop.

(b) What difference in (a) if Owner purchased the land by paying $1,000 for an option to purchase the land for an additional $9,000 and subsequently exercised the option?

o Under 1012 the total cost is still 10k so the gain is 6k just like (a). The option is included as a cost of acquiring the property .

(c) What result to Owner in (b) if rather than ever actually acquiring the land Owner sold the option to Investor for $1,500?

o The basis in the option is 1000. The amount realized on the sale is 1500. Thus, the gain realized and recognized is $500

(d) What difference in (a) if Owner purchased the land by making a $2,000 cash payment from Owner’s funds and an $8,000 payment by borrowing $8,000 from the bank in a recourse mortgage (on which Owner is personally liable?) Would it make any difference if the mortgage was a nonrecourse liability (on which only the land was security for the obligation?)

o Still have 10k invested in the property so basis is still 10k, and 6k is the gain

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o Borrowed funds are part of the basis (e) What result in (a) if Owner purchased the land for $10,000, spent $2,000 in clearing the land prior to its sale and sold it for $18,000?

o Add 2k (capital expenditure) to the 10k basis under §1016 for 12k AB. When you sell for 6k = 6k gain realized and recognized

(f) What difference in (a) if Owner had previously rented the land to Lessee for 5 years for $1,000 per year cash rental and permitted Lessee to expend $2,000 clearing the property? Assume that, although Owner properly reported the cash rental payments as GI, the $2,000 expenditures were properly excluded under §109. (§1019)

o Rental payments included in income, but doesn’t affect basis b/c not properly chargeable to capital. B/c improvements made by lessee, under 109 and 1019, it doesn’t affect basis. Basis is still 10k and you get 18k on sale so the gain is 8k.

o Note* the improvements of 2k are income under Glenshaw Glass, however, there is a special exclusion under 109. And the gain is deferred b/c of 1019. If 109 did not apply, then the basis would be 12k under 1.61-2(d)(2)(i).

(g) What difference in (a) if, when the land had a value of $10,000, Owner, a real estate salesperson, received it from ER as a bonus for putting together a major real estate development, and Owner’s income tax was increased $3,000 by reason of receipt of the land?

o Amt paid in taxes is not added to the basis, so the basis, is still 10k. (h) What difference if Owner is a salesperson in an art gallery and Owner purchases a $10,000 painting from the art gallery, but is required to pay only $9,000 for it (instead of $10,000 b/c Owner is allowed a 10% EE discount which is excluded from GI under §132(a)(2)), and Owner later sells the painting for $16,000?

o unclear what the ans is – it depends on intent of congress. o If it is to make the 132 exclusion permanent, then the basis would be 10k b/c it is the cost under §1012 and

there is a 6k gain. Under Philadelphia, he thinks you have a good argument that 10k is the basis b/c the basis is the FMV of what you receive.

o alternative is to have a 9k basis b/c that is what you pay for and that is your cost to you and you would have 7k gain

Property Acquired by Gifto §1015: If property acquired by gift, basis is the same as it would be in the hands of the donor or the last

preceding owner by whom it was not acquired by gift, EXCEPT if the basis is greater than the FMV of the prop at the time of the gift, then for the purpose of determining loss, the basis is the FMV.

o The basis will be a transferred basis except for losso this is example of when your basis is diff for gain and loss. this is so you can’t shift losses. If you

wanted to shift losses, you would just donate something to a person in higher tax bracket who would better be able to use the loss, and they would sell it and recognize the loss

o Regulation 1.1015-1(a) Ex) A acquires a gift of property which has an AB of 100k at the date of the gift. The FMV at the date of the gift is 90k.(basis is exceeding FMV) A later sells the prop for 90k. In such case, there is neither gain nor loss. The basis for determining loss is 90k (FMV), therefore there is no loss. The basis for determining gain is 100k, therefore there is no gain.

o §1015(d): If prop acquired by gift, the basis is increased (but NOT above FMV at the time of the gift) by the amount of gift tax paid with respect to the gift. (gift 1958-1976)

o if you donate prop worth 100k and you have 50k b, and you pay 5k in gift taxes, you can increase the b by the amount attributable to the taxes

o You increase your basis by the amount of gift tax paid, but it is not the entire gift tax paid. o To calculate a ratio of the net appreciation in value of the gift to the FMV of the gift.

Appreciation is the amount by which the FMV of the gift exceeds the donor’s adjusted basis immediately before the gift.

Ex. 20k basis for donor immediately prior to donation. The FMV is 30k. They paid $3000 in gift taxes.

Appreciation is 10,000. (10k / 30k) x 3000 – 1000.

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This means the basis is 20k + 1000 = 21k. o It is the ratio b/w the appreciation v. the FMV. That ratio is amount of the gift tax that is included in

the basis.o 1015(d) 6 – gift after 1976 – modified increase; multiply gift tax paid by ratio (net appreciation in

value of gift (about by which FMV of gift exceeds transferor’s AB) by amount of gift) (FMV-AB)/FMV x gift tax

o Before 1976 – tack on 100% of gift taxo After 1976 – use the ratio

o 1015(e): spouses – transfer/gift/exchange between spouses – 1041, NOT 1015o 1015 does not apply to transferred between spouses; or former spouses if incident to a divorceo Governed under 1041

o Taft v. Bowerso Father makes gift of appreciated stock to taxpayer daughter who sells for value greater than FMV at

the time of donation. o A purchased stock for $1000 and held for 8 years until FMV was $2,000. Then he gave them to B who

sold them for $5,000. IRS claims B must pay tax on $4,000 as realized profits. B claims that he only has to pay tax on $3,000 – the appreciation during her ownership.

o Ct – Congress clearly intended to tax the full amt, and the only issue is whether it had power to do soo If father had sold the stock, it would have clearly been taxable so can he merely make a gift and dodge

the taxes? What if donee made further transfer – it would never be taxed if kept passing it alongo Nothing in Con says that the only g that can be taxed is the increase in the hands of the TPo So, it is constitutional to tax the full amt of the appreciation. o The only investment of capital was the $1,000 so subtract $1,000 from $5,000o The rule in 1016(a) is valid under 16th amed.o Taft:

Use transferred basis (not FMV) to determine subsequent gain Realization event (something is done with the property – sold, abandoned, transferred) If FMV is less than AB, any sale between those prices – realized but not recog (no gain or

loss)o Farid-Es

o Issue: What is a gift?o Prospective Husband gives prospective wife stock in exchange for marriage o “made as gift by H to W as ante-nuptial settlement…o so he is giving her stock in exchange for relief of valuable rightso tax ct said this is gift o ct says just b/c gift for gift tax purposes does not mean it is gift for income tax purposes. The estate

and gift tax is meant to be read in pari materia with income tax – not binding just b/c there is gift tax rule on it.

o In these facts, no gift b/c no donative intent (doing in exchange for valuable rights) o Main point: even if something is gift for gift tax purposes, not necessarily binding for income tax

purposes

Problems pg 1251. Donor gave Donee property under circumstances that required no payment of gift tax. What gain or loss to Donee on the subsequent sale of the property if:*(a) The property had cost Donor $20,000, had a $30,000 FMV at the time of the gift and Donee sold it for:

o Donor had a basis of 20k when gift was made. This basis transfers to Donee under §1015, so Donee also had a 20k basis. This is appreciated property, so don’t need to worry about the special rule with regard to losses on the sale of gifts.

(1) $35,000 (sold – cost) (35-20)o 15k gain

(2) $15,000 (15-20)

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o 5k loss(3) $25,000 (25-20)

o 5k gain (b) *The property had cost Donor $30,000, had a FMV of $20,000 at the time of the gift and Donee sold it for:

(1) $35,000 (sold-cost) (35-30)o 5k gain

(2) $15,000 (sold-FMV b/c exceeds) (15-20)o 5k loss. This is the special rule. Determine the loss based on the FMV at the time of the gift

(3) $24,000 o No gain, no losso Donee has basis for realizing gain of 30k – but the amount realized on the sale is 24k, so

there is no gain o Donee has a basis for realizing loss equal to the FMV, which is 20k – but the amount

realized on the sale is 24k, so there is no losso Thus, there is no gain or loss o This provides an example of why you must analyze which assets are better to donate. Here,

you are better off donating appreciated prop so you don’t lose the losso Note – if donor’s basis is greater than the donor’s FMV at the time of the gift, the special

rule for losses applies. If the subsequent sale is b/w those two values, then neither a gain nor loss is recognized.

2. Father had some land that he had purchased for $100,000 but which had increased in value to $200,000. He transferred it to Daughter for $100,000 in cash in a transaction properly identified in part a gift and in part a sale. Assume no gift tax paid on the transfer. (a) What gain to Father and what basis to Daughter under Reg. §1.1001-1(e) and 1.1015-4?

o Father has no gain or loss b/c the amount realized $100,000 is the same as the basis, $100,000. The unadjusted basis to Daughter is $100,000.

o 1.1015-4 (basis) – Transfers in part gift and in part sale: (a) The unadjusted basis to the transferee is, whichever is greater, (i) The amount paid by the transferee, or (ii) The transferor’s adjusted basis Plus the amount, if any, of gift tax paid.

o Hypo. Same transaction, but daughter pays $100,000.o Father realizes a loss of $20,000, but the transferor will not recognize a loss because it’s a gift.

(§1001-1(e)). o 1.1001-1(e) (amount): where a transfer of property is in part a sale and in part a gift, the

transferor has a gain to the extent that the amount realized exceeds the adjusted basis in the property (then gift to the extent that FMV of property exceeds amount paid). No loss is sustained on such a transfer if the amount realized is less than the adjusted basis.

o Daughter’s basis = $120,000 because dad was disallowed the loss on the transfer, thus she shouldn’t have to pay taxes on it when she laters sells it for fmv at $180,000

o Hypo. Same transaction, but fmv = $100,000 and daughter pays $90,000o Father realizes a $30,000 loss, but it won’t be recognized because it’s a gift. o Daughter’s basis = $120,000 for recognizing gain, but $100,000 for recognizing loss. (She sells it at

$90,000) Thus, she recognizes $10,000 for loss.(b) Suppose the transaction were viewed as a sale of 2/3 of the land for full consideration and an outright gift of the other 1/3. How would this affect Father’s gain and Daughter’s basis?

o 1.1001-1(e) :if transfer of property is part gift, part sale, the transferor has gain only if he realizes more than his AB. So here, Father does not have any gain. (100k basis and realized 100k)

o Daughter’s basis? 1015 - basis in property is transferred by gift. Reg. 1.1015-4(a) where transfer in property is part gift part sale, the unadjusted basis of the property in the transferees hands is the sum of:

o the greater of the amount paid by the transferee or transferors basis, ANDo the amount of increase, if any, for gift tax paid.

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o Here, no gift tax was paid, so ignore that part. Daughter paid $120K. Fathers basis was $100K. These figures are equal, so daughter’s basis is $100K.

o If part gift, part sale, you get the entire amt of basis – you don’t allocate it. You use all basis for sale. So it is only taxable to the extent the sale proceeds is higher than the entire basis

1.1001-1(e) - gain 1.1015-4 – transee’s basisAB 30k 30k gain 60k + gift taxAR 60k 30k giftFMV 90k

AB 60k 0k gain 60k + gift taxAR 30k 30k loss (but NOT recog)FMV 90k 60k gift

1.1001-1(e) - gain 1.1015-4 – transee’s basisAB 30k 0k gain 30k + gift taxAR 30k 30k giftFMV 60k

AB 90kAR 90k 60k loss (but NOT recog)FMV 60k 30k giftProperty Acquired b/w Spouses or Incident to divorce

o §1041 provides tax neutrality to transfers b/w spouses and former spouses incident to divorceo §1041(a): no g/l recognized on transfer of prop from individual to:

o (1) a spouse or o (2) a former spouse, but only if the transfer is incident to the divorce.

o §1041(c):Transfer of prop is “incident to divorce” if the transfer:o (1) occurs w/i 1 year after divorce or o (2) is related to the cessation of the marriage (pursuant to instrument and w/i 6 years)

o §1041(b):Transfer is treated as gift aka transferee gets transferor’s basis o The property is treated as if it were acquired by transferee by gift (transferred basis) and the

basis is the AB of the transferor (straight transferred basis – no exceptions – easy) o §1041(e): Special rule for transfers of prop in trust where liability exceeds the basis

o Subsection (a) will not apply to the extent that the sum of the amount of liabilities assumed, plus the amount of the liabilities to which the prop is subject exceeds the total AB of the prop transferred. Proper adjustment shall be made under subsection (b) in the basis of the transferee in such property to take into account gain recognized here.

so if you recognize gain under (e) you can bump up the basis o Gen rule: transfer to spouse or former spouse incident to divorce, you go back to rules in §1015 for gifts o However, unlike gift basis rules, in §1041 there is always a transferred basis (no diff basis for gain and loss)

o This does not have the rule illustrated in 1015 where if the FMV is less than the basis then it controls…it will always be the transferred basis with respect to the spouses

o 1.1041-1To 1041 not limited to prop incident to divorce. It applies to any transfer of prop b/w spouses

regardless of whether the transfer is a gift or is a sale or exchange b/w spouses acting at arm’s length

o 1041 only applies to transfers of prop - transfers of services are not subject to rules of 1041 and are taxable (won’t necessarily have the tax free benefit).

o The prop does not have to have been owned by the transferor spouse during the marriage. A transfer of prop acquired after the marriage ceases may be governed by §1041.

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Problem pg 1311. Andre purchased some land 10 years ago for $40,000 cash. The prop appreciated to $70,000 at which time Andre sold it to his wife Steffi for $70,000 cash, its FMV. (a) What tax consequences to Andre?

o Basis = 40k. FMV = 70k. Andre realizes gain of 30k (70k-40k) gain on the sale, but does not recognize it due to 1041(a). The end result is that there’s no gain recognized.

(b) What is Steffi’s basis in the prop?o 40k. She gets Andre’s transferred basis (take the basis of the transferor)

(c) What gain to Steffi if she immediately resells the property?o When she later sells for 70k, she has a gain of 30k, even though she paid 70k for the property. Steffi gets

screwed here with the 1041(b) transferred basis rule. (d) What results in (a)-(c) if the prop had declines in value to $3,000 and Andre sold it to Steffi for $3,000 (this question illustrates the difference in 1015 and 1041)?

o 4k basis – 3k FMV – sale for 3ko Andre realizes a loss of 1k, but does not recognize in 1001(c) b/c of 1041(a). Steffi’s basis is 4k (1041(b)). o If she immediately sells if for 7k, she would have 3k gain.o If she immediately sells for 3k, she would have 1k loss.

(e) What results to Andre and Steffi if Steffi transfers other prop with a basis of $5,000 and value of $7,000 (rather than cash) to Andre in return for his property?

o When the prop is swapped, each realizes a gain and a loss. o A- amount realized is 7k and his basis is 4k so 3k gain realized, but not recognized due to 1041. o S realized 7k and basis was 5k so 2k gain realized, but not recognized b/c of 1041. o At end of day, Steffi’s basis is 4k. Andre’s basis is 5k for what he gets from her. The FMV is the same.o Here, Steffi is getting the shaft b/c she lost some of the basis o Point – 1041 applies both directions

Property Acquired from Decedento §1014(a) :the basis of prop in the hands of person acquiring prop from decedent or to whom the prop

passed from a decedent shall, if not sold or disposed of before the decedent’s death, be the FMV of prop at the date of decedents death…

o If you inherit prop, the basis gets stepped up or down to the FMV as of the date the person dies (with no tax consequence to anyone)

Look at the FMV of the property the day the person dieso §1014(b) – The following prop is considered to have been acquired from a decedent (1) acquired by

inheritance (2) prop transferred by the decedent during his lifetime in trust (living trust) (4) prop passing due to general power of appt (6) IMP – prop which represents the surviving spouse’s ½ share of the community prop (9)

o Ex: if H dies and they own house worth 500k not only will wife’s ½ comm. prop int be stepped up to 250k, the H will also be stepped up to 250k. Great benefit to living in comm. prop state

This rule balances community property and non-community property states…this makes things more equal…each side will get stepped up

o If D passes away and has ½ int in comm. prop, their ½ int gets stepped up, AND the spouses int gets adjusted up also!

o Ex: buy stock for .01 and it is worth 100,000 40 years later. When spouse dies, both halves go up so the living spouse wouldn’t recognize the huge gain

o 1015 (e) Appreciated prop (increased FMV above basis) acquired w/i 1 year of deatho If appreciated prop was acquired by the decedent by gift during the one year period before the

decedent’s death, and the prop is acquired from the decedent by the donor of such property, the basis of the prop in the hands of the donor shall be the AB of the prop in the hands of the decedent immediately before the death of the decedent.

If you donate prop to someone and w/i one year they pass away, your basis is going to be your original basis

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What you can’t do is give your dying grandma your 1 mil worth stock that you paid 1 dollar for to get her stepped up basis when you get it back upon her death

o 1.1014-3(a) :Defines FMV:value of prop as of the date of the decedent’s death as appraised for the purpose of fed estate tax

o Value for estate tax purposes is 20.2031-1(b) :“FMV is the price at which prop would change hands b/w willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

o In 2010, the estate tax will be completely repealed (1014f says this). 1014 will be completely repealed and replaced by a more complex rule. Koonce is confident that this won’t happen though.

Updates to 1014 – Bush repealed the estate tax as of Dec 31, 2010. Need to figure out these new rules under 1022 and 1014. 1.3 million step up in basis allowed, and 3 million allowed for spouses under

Go back and look at code §1022, if someone died or received property from someone who died in 2010 have to look at if they elected out of estate taxes.

Problem pg 1301. In the current year, Giver has 2 blocks of stock, both worth $1,000,000. Giver purchased 1 block years ago for $50,000 and the 2nd block more recently for $950,000. Giver plans to make inter vivos gift of one block, and retain the second until death. Which block of stock should Giver transfer inter vivos?

o Giver has 50,000 basis in one block and 950,000 basis in other block. 2nd block is what he should transfer b/c there is transferred basis in a gift. Thus, the transferee would have a 950k basis. Keep the 50k block until he dies b/c then, the transferee gets a basis equal to the FMV( probably 1,000,000) at the time of his death. Thus, there would only be a 50k gain if the transferee sold both blocks (1,000,000 - 950,000.) There would be no tax on the 1st block b/c the basis is 1,000,0000 which is what it is sold for (worth)

The Amount Realizedo International Freighting Corp

o taxpayer had stock bonus plan – as bonus, they give stock in parent corporation o Basis of prop was $16,000. FMV 24,000 (FMV greater than basis)o Issue (1) Is this deductible an ordinary and necessary biz expense? Ct says yes under §162o Issue (2) Were their realized profits on the disposition of the stock?

If you pay an EE a bonus with stock that is appreciated, must you recognize gain on that appreciation?

ct said this is not a gift, it is for compensation (not detached and disinterested generosity) 1001(a) gain is the excess of the amount realized over the AB 1001(b) doesn’t mention services when talking about amt realized

Thus, read very literally, 1001b does not include services (ER claiming that this shouldn’t be included b/c only received services)

But, ct said services are considered “money’s worth” and included it in amt realized – they didn’t care that services wasn’t specifically mentioned

Amt realized is the sum of any money received + FMV of prop other than money received o Thus, if ER gives stock for EEs services, then ER must recognize the gain on the appreciated stock

even though services are not mentioned in 1001(b)o There is a gain to the extent the value of services exceeds basiso EE – Remember Section 61 – GI is FMV of property received for compensationo 1.61(2)(D)2o General Rule: when someone provides services and they receive appreciated property in return, the person

providing services has GI equal to FMV of property, and the basis will be FMV of property (no different than had they been paid in cash then turned around and bought property); payer of appreciated property will have G/L to the extent that FMV exceeds AB of property/is less than AB

o Cottage Savings

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o Savings assoc. had pool of mortgages that they exchanged for another pool of mortgageso Is there an amt realized? (even though the two things were very similar?)o Yes, there was amt realized b/c the pool of mortgages given up was materially diff from the ones that

were received o Rules now in Reg 1.1001-3

If you exchange things that are materially different then realize that amount

o Crane v. Commissioner (Imp tax case)o Husband leaves his wife an apt building and a lot subject to mortgage of 255k and interest of 7k o wife not personally liable for the debt (non-recourse loan)

Thus, if they default on the loan, only thing bank can do is go after the building o Appraised value (FMV) of building and lot is the sum of mort and interest (thus, it is worth what she owes

– 262k= original basis)o For 7 years, W pays all net rentals to bank o Claims rent is income and takes expenses for depreciation, etco In the meantime the interest arrearages climb from 7k to 16k o Eventually sold to 3rd party – all she got was 3k cash and the purchaser assumed the mort.o She paid $500 in sales expense (net $2500 from sale)o W only reports $2500 gaino The prop she acquired was the equity in the building and land – she says b/c the FMV equaled the

mortgage and accrued int as of H death, she received 0 basis in the prop (b/c worth net of nothing when received). And the $2500 was amt realized on the sale (the money she put in her pocket)

o IRS says the prop acquired and sold was the prop itself (not the equity) so they said the original basis was 262k. W took 28k in depreciation. That left about 178k in basis in the building

o IRS says the amt realized is the $2500 + amt of debt assumed (even though she isn’t personally liable) which left a tax gain of 23k

Includes not only the case received but also the debt reliefo IRS: Amt realized = 2500 + debt release of 262k = 264,500

Less basis 178,997 = Tax Gain of 23,502.60

o IRS says you look at total value of prop for calculating basis and the total value of the prop looking at amt realized

o Issue (1) – what is basis of the prop? If prop is the equity received (as the wife argued), basis is 0 If prop is land and building themselves (as the IRS argued), then basis is 262k 1. The court says the term property should be given ordinary meaning

“Equity is not a synonym with prop. Indeed equity is defined as the value of prop above the total of the liens.” So can’t say equity and prop are the same thing

2. Reg on point – “value of prop as of the date of the death of the decedent as appraised for the purpose of the Fed estate tax shall be its FMV”

The property is the land and buildings themselves. So the basis is 262ko Issue (2) – what is amt realized?

Prop should be given ord meaning w regard to amt realized Absurd to argue she sold prop worth quarter of million but only realized 2500 on the sale So the ord meaning says that the amt realized is the FMV of the prop W realized benefit on the mortgage assumption even though she wasn’t personally liable – she still

benefited by having debt released Would you have same result if FMV of the prop is worth less than the debt?

FtNote 37: “Obviously, if the value of the property is less than the amount of mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage…”

They don’t decide this issue in this case, but see Tuftso Is it income under 16th amend, thus allowed to tax it?

Taxing debt release is allowed under the 16th amend51

o Rule from case – The property you receive is not the equity, it is the actual property itself. Non-recourse debt makes no difference

o Commissioner v. Tuftso FtNote 37 of Crane issue comes up hereo Dealing with nonrecourse debt release where the FMV of the prop is less than the debt releaseo Partnership obtains a 1.85 million loan to construct apt complexo Nonrecourse loan so neither pship nor partners had liability on loan(creditors could only take the property)o Took depreciation And made total of 44k capital contributiono had an adjusted basis at time of sale of 1.455 milliono Sold to 3rd party and didn’t get any real cash out of the saleo The prop is worth 1.4 million dollars (FMV)o Nonrecourse loan is assumed of 1,845,500o Basis (debt) of 1.85 million o Petitioners say they have loss – you should take the basis and would have loss of 55ko IRS said amt realized is the full amt of the nonrecourse obligation and they have gain of 400ko The reason for difference is b/c the IRS says the gain is due to the debt release even though it is

nonrecourse obligationo Held – same rule as Crane applies here – the basis and the amt realized include the release of the mort

even though the FMV of the prop is less than the morto So when you give prop up, even though prop less than amt owed, it is still included in amt realized even

though nonrecourse debt exceeds FMVo Diff b/w recourse and nonrecourse does not alter the fact that TP received loan proceeds and included in

basis (doesn’t alter the fact that they took advantage of the basis on the front end…so should have to include it also on the back end)

o To the seller, it is just as if purchaser gave money in cash and the debt extinguished. Just as if they gave 1.8 million in cash and they paid off note in full

o This conclusion avoids absurdity that depreciation should be allowed below the value o The loan proceeds are included in the basis and the amt realized. So with nonrecourse debt, at the

beginning included in b and at the end included in proceeds – this is regardless of whether loan amt greater than basis or FMV

77 Journal of Taxation 260

o Reviewo Crane – nonrecourse debt is included in the basis and in amount realized on sale (debt is less than FMV of

property)o When you sell the prop, the release of the debt is included in amt realized b/c you were able to take into

basis on front endo Here, the FMV of the prop was more than amt of debt

o H died and left W apt complex. The net value of the prop was nothing, but she took depreciation on it. She took rent money and gave it straight to the bank as payment for loan. She sold the prop and only netted $2500 cash from the sale.

o Issue 1 – what is basis when she receives apt complex?o W said original basis was 0 and when she sold it she realized $2500o IRS said under 1014 her original basis is $262,042.50 (principal debt of 255k+interest of 7,042.50)

less depreciation deductions that W used of $28,045 so her basis at the time of the sale is 233, 997. o Issue 2 – Was the debt release included in the amount realized on the sale?

o YESo Debt assumed by buyer was 255k. When you add the cash Q received of $2500 it equals a total amt

realized 257,500. Subtract her AB at time of sale of 233,997.40 for a gain recognized of 23,502.60. o Holding = nonrecourse debt is included in basis when the property is purchased. Nonrecourse debt release

is included in the amount realized when the property is later sold.

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o Here, the debt was either equal to or less than FMV So it was easy to say included in basis and easy to say included in amt realized b/c less than FMV.

Crane specifically does not address issue of what happens if FMV is less than debto Note - This wasn’t that bad of a transaction b/c she got the depreciation deduction

o Tufts (77 Journal of Taxation 260)– nonrecourse debt is included in basis and in amount realized on sale (debt is more than FMV of the prop)o Pship acquired prop with nonrecourse debt – amt of nonrecourse debt is included in basis when prop acquired. o AB at time of sale was 1,455,740 = Original basis of 1,851,500 less depreciation of 439,972 plus additional

capital contributions of 44,212 o Main point – assumption of the debt, even though nonrecourse is included in b

o Buyer assumed amt of debt 1,851,500 less the AB at time of sale of 1,455,740 Equals amt realized of 395,760o Main significance of this case, the FMV of the prop at the time was less than the 1.8 million debt release, and

the amount realized still includes the full amount of the debt release.o So today, it is clear that you include nonrecourse debt in basis and when you sell, the debt release is included in

amt realizedo What about buyer in Tufts? He gets prop worth 1.4 mil but subject to 1.8 million nonrecourse debt – how much

should he include in basis?o Would he now have 1.8 mil basis in prop worth less? the ans to this Q is unclearo Journal of Taxation Art. On this pt 77 JOT 260

o Net Gifto Gift of 150k and donee pays 50k gift tax and donor has basis of 10k. o Diedrich – donor realizes a 50k gain and recognizes 40k gain (50-10k basis)o Basis of donee would be 50k b/c he paid a 50k gift taxo Donor is primarily liable for the gift tax. If it is a regular gift, it is a transferred basis. But effectively, that

50k is a debt of the donor and when paid by the donee it is a release of debt to the donor and therefore, an amount realized.

Problem pg 1531. Mortgagor purchases a parcel of land from Seller for $100,000. Mortgagor borrows $80,000 from Bank and pays that amount and an additional $20,000 of cash to Seller giving Bank a nonrecourse mortgage on the land. The land is the security for the mortgage which bears an adequate interest rate. (a) What is Mortgagor’s cost basis in the land?

o Basis is the mortgage (80k) plus the cash paid (20k) = 100k. Under both Crane and Tufts, doesn’t matter that loan is nonrecourse – still included in basis on front end. Crane – full amount of mortgage (recourse and nonrecourse) is included in basis as long as the loan proceeds were used to acquire land. As he pays off the mortgage, his basis does not increase b/c he has already included the full amount of the mortgage in the basis.

(b) Two years later when the land has appreciated in value to $300,000 and Mortgagor has paid only interest on the $80,000 mortgage, Mortgagor takes out a second nonrecourse mortgage of $100,000 with adequate rates of interest from Bank again using the land as security. Does Mortgagor have income when she borrows the $100,000?

o No income here. When they take out additional 100k loan, not included in income b/c of the accompanying duty to repay.

o What is the basis in the prop after the second mortgage? Depends on what the money is used for. If 100k were used to improve the prop, it would increase the basis. If it were used for vacation, it wasn’t reinvested in the prop, and the basis would stay the same.

(c) What is Mortgagor’s basis in the land if the $100,000 of mortgage proceeds are used to improve the land?o This is improvement and subject to depreciation. So if they put 100k into land, it increases the basis to 200k.

This is cap expenditure, so under 1016 it is properly chargeable to cap acct so increase basis by 100k (d) What is Mortgagor’s basis in the land if the $100,000 of mortgage proceeds are used to purchase stocks and bonds worth $100,000?

o Because proceeds not going into land, won’t change the basis of the land (still 100K) – now they have 100k basis in stocks

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(e) What result in (d) if when the principal amount of the two mortgages is still $180,000 and the land is still worth $300,000, Mortgagor sells the prop subject to both mortgages to Purchaser for $120,000 of cash? What is Purchaser’s cost basis in the land?

o Seller’s basis is 100k. Total mortgage is 180k. Buyer paid 120k and takes 180k mortgage. o Seller’s amt realized is the 120k cash received + the 180k of debt release (relieved of both mortgages) = 300k.

(Crane and Tufts say when the sale is subject to a nonrecourse mortgage, the amount realized is equal to the cash received and amount of the mortgage.) Less basis of 100k = 200k recognized gain for Seller

o Under 1012, the basis is the cost, and under Crane and Tufts, the cost includes the cash paid plus the 180k liability. The purchaser has basis of 300k (120 cash + 180 of nonrecourse debt)

(f) What result in (d) if instead Mortgagor gives the land subject to the mortgages and still worth $300,000 to her Son? What is Son’s basis in the land?

o Basis is100k still. So giving to son – still owes 180k. o Although it is donation, they are still relieved of 180k total debt (both mortgages) so amt realized is 180k. the

basis is still 100k. (amount realized – basis= gain )so the gain is 80k o The son’s basis is 180k. o Effectively this is part gift, part sale (the donor is being released of a liability so there is consideration present

in the amount of the debt release). Regulation 1.1015-4 : basis in the hands of the transferee is the greater of the amt paid (180) and the transferor’s basis (100+ 80 gain = 180) – so in this case they are both the same

o Any time you give a gift subject to a mortgage then it’s a part gift/part sale(g) What results in (f) if Mortgagor gives the land to her Spouse rather than to her Son? What is Spouse’s basis in the land? What is Spouse’s basis in the land after Spouse pays off the $180,000 of mortgages?

o The recipient spouse takes the donor spouses basis so it remains at 100ko Realize gain of 80k (180-100b), but it is not recognized b/c of 1041 transfer b/w spouses. o The effect of the spouses paying off the mortgage is nothing. Even if Spouse pays off the mortgage, the basis

remains at 100k. (h) What results to Mortgagor in (d) if the land declines in value from $300,000 to $180,000 and Mortgagor transfers the land by means of a quitclaim deed to Bank?

o This extinguishes the loan. Has 80k gain b/c he realized 180K and the basis is 100K.o 180k gain and 100k basis so there is 80k gain realized and it is recognized b/c there is no other provisions here

to keep it from being recognizedo This is essentially the Crane case

(i) What results to Mortgagor in (h) if the land declines in value from $300,000 to $170,000 at the time of the quitclaim deed?

o This is Tufts – debt of 180k, and FMV of 170. Amt realized is still 180 and basis is 100 so gain of 80k. Disregard the FMV (even though the FMV is less than the debt it’s still disregarded)

2. Investor purchased 3 acres of land, each worth $10,000 for $30,000. Investor sold one of the acres in year one for $14,000 and a second in year 2 for $16,000. The total amount realized by Investor was $30,000 which is not in excess of her total purchase price. Does Investor have any gain or loss on the sales? Reg § 1.61-6(a).

o 1.61-6a - if you buy separate parcels of land in one purchase, you are required to allocate to each parcel based on the FMV of the land on the date of the purchase (doesn’t matter if the value of the land fluctuates…the FMV on the date of purchase is what counts)

o Divide the 30k by 3 (equally apportioned b/w parcels)o Sale of each part is a separate transaction. Each parcel has basis of 10k. There is 4k gain on one and 6k gain on

the other for a total gain of 10k. 3. Gainer acquired an apt by inter vivos gift from Relative. Both used it only as a residence. It had been purchased by Relative for $20,000 cash and was given to Gainer when it was worth $30,000. Relative paid a $6,000 gift tax on the transfer. Gainer later sells the apt to Shelterer. (a) What gain or loss to Gainer on his sale to Shelterer for $32,000?

o 1015(d) – include in basis the amt of gift taxes paid that relate to the appreciation in the prop. o Net appreciation / amount of gift x tax paid = basis when there is a gift taxo 10,000 / 30,000 x 6,000 = 2,000o B is 20,000 + 2,000o So the transferred basis + 1015(d) adjustment

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o = 22,000 basiso 32,000 realized – 22,000 b = 10,000 recognizedo Review of the rules: Relative bought prop for 20k (cost b starting point). Relative donates to Gainer.

Under 1015 if you make donation it is generally a carried over basis as the general rule. 1015(d) says to increase that basis to the extent that the gift taxes paid relate to the appreciation in the donated prop. This is where formula comes in. Donates prop worth 20k so that is the general transferred basis. But there is 6k gift tax paid so you have to figure that into the basis. Use the formula to figure out how much of the gift taxes relate to the appreciation. (Only include the amt related to the appreciation (10k) since the relative purchased the gift – don’t include the entire amt of the gift tax paid)

o *gift tax is paid by donoro Regulation 1.1011-2: if donee is charitable organization, you must allocate the basis b/w what is the sale

portion and what is the gift portion. (b) What is Shelterer’s basis in the apt?

o 32k b/c that is what he paid for it(c) Same questions assuming Relative acquired the property for $8,000 cash, but subject to a $12,000 mortgage on which neither she nor Gainer was ever personally liable. Relative paid $3,000 tax on the gift. §1015(d)(6). Upon purchase, Shelterer merely took the property subject to the mortgage, paying $20,000 cash for it.

o Deals with Crane and Tuftso Relatives basis in the prop is 20k still b/c there is 8k cash + 12k liability (under Crane & Tufts you take liab

into b)o When transferred by relative to gainer, it is transferred basis of 20k, but you make adjustment under 1015(d)

(6)o Net appreciation / amt of the gift tax paid = adjustment to basiso Net appreciation = excess of FMV less the donor’s b before the gift. Here, it is unclear as to what FMV is – is

it 30k b/c that is value of prop or is it 18k which is FMV less mortgage? o If use gross value: 10k appreciation/30k gross value x 3000 gift taxes = 1000 adjustment

o Transferred b of 20k + 1k (adjustment) = 21,000 b that G now has in it. When he sells the prop, it is 32k realized – 21k b = 11k recognized gain

o This is ignoring the fact that there are liabilities o This is the easy way to do this

He thinks the appropriate way to treat this is as a gross gift, but there is argument to treat as a net gift (takes into account the liabilities – very difficult)

o We don’t need to figure out how to calculate it taking into acct the liabilities

Life Insurance Proceeds and AnnuitiesLife Insurance

o Generally this would be income under §61, but b/c of §101 the items are excluded from GIo §101:General Rule: except as provided in paragraph (2) and subsection (d) and (f), GI does NOT

include amounts received (whether in single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.

o Reasoning – under §102 and §1014, generally the life insurance is included in the estate for estate tax purposes and if you pay estate taxes they don’t want to make you pay twice.

o A life insurance K is an agreement to pay a beneficiary in the event of the insured’s death (when the insured dies, the beneficiary receives the face amount of the policy)

Term life insurance- pure life insurance…paying for risk that you’ll die within that yearo There are 10 year, 20 year level term life insurance policies

Permanent life insurance- pay an additional amount that is placed in an investment account…eventually the policy pays for itself (the amount in the investment will pay for the amount owed under the policy each year)

Variable policy- not a guarantee, premium may go up or down o Life insurance contract = agreement to pay designated amount in the event of the insured’s deatho “By reason of death of the insured” – exclusion does not apply if life insurance is canceled

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o So if you have 150k saved up and only paid 100k in premiums, canceling life insurance contract will result in 50k income.

o Exceptions to “by reason of death of the insured” o (1) Accelerated benefits from policy on the life of a person who is terminally ill or chronically ill –

If someone is terminally ill and cancels, then they are deemed to have received the policy so can exclude the total amount from their income

o §101(g) The following amounts are treated as an amount paid by reason of the death of an insured:

Any amount received under a life insurance contract on the life of an insured who is a (A) Terminally ill individual

o 101(g)(4)(a) – “terminally ill individual” is one who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification

(B) Chronically ill individual o §101(g)(4)(b) – “chronically ill individual” has the meaning from §7702B(c)

(2) Individual who has been certified by a licensed health care

practitioner as (i) unable to perform (wo substantial assistance) at least 2 activities of daily living for a period of at least 90 days due to a loss of functional capacity; (ii) having level of disability similar to (i); (ii) requiring substantial supervision for health and safety

o If you are terminally or chronically ill, you can enjoy the benefits now, and not get hit with the tax on it

o (2) Sold or assigned to viatical settlement provider - §101(g)(2) (A) If any portion of a death benefit under a life insurance K is sold or assigned to a viatical

settlement provider, the amount paid for the sale or assignment is treated as an amount paid under the life insurance K by reason of death of the insured.

(B) “Viatical settlement provider” = any person regularly engaged in the trade or biz of purchasing or taking assignment of life ins Ks if person licensed in the state where the insured resides

o §101(a)(2) – In the case of transfer for valuable consideration, by assignment or otherwise, the amount excluded from GI shall not exceed the actual value of the consideration and the premiums and other amounts subsequently paid by the transferee (essentially only the amount they paid for it is the amount they will be able to exclude). This does not apply in a transfer if:

o (A) The K of interest has a basis for determining g/l in the hands of a transferee determined by the basis in the hands of the transferor OR

If you receive by transferred basis (Ex: gift; 1041 transfer b/w spouses), even if it is a transfer for value, the transfer for value exception does not apply

Any time there is a transferred basis, the above does not applyo (B) If transfer is to the insured, to a partner of the insured, to a pship in which insured is a P, or to a

corporation in which the insured is a SH or officer. o Basically, if you buy life ins policy from someone else, the exclusion only applies to the amt you pay

If I buy Lucie’s 1 mil policy for 100k, and I die the next day, only 100,000 is excluded and 900,000 would be included in GI

o §101(c) – Exclusion does not apply to interest – the interest payments are included in GIo So if 1 mil ins policy, but you don’t make claim for a few months, and interest accrues, the exclusion

applies to the principal 1 mil, but not the interest you receiveo §101(a)(1) does not exclude whatever amount is paid by reason of the insured’s death. §101(d) places a limitation

on that. Insured might have option to elect a fixed monthly payment of amounts determined with reference to age and life expectancy for the rest of her life.

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o §101(d) – Amounts held by insurer shall be prorated over the period with respect to which such payments are to be made. Can exclude from GI an amount determined by the proration. GI includes the amounts not excluded in the preceding sentence. Does not apply to amt that (c) applies to.

o Ex – Ms has option of 100k face amount of the policy or $250 each month for life ($3000 per year). Her life expectancy is 50 years. If she were to live that long, she would receive overall 150k (50 x $3000). What should be excluded from GI? Must determine how much is related to the expected growth. She would be able to exclude $2000 from every $3000 check and would have to include in GI $1000. That is how much is related to interest.

Note – If she lives years beyond her life expectancy, the same exclusionary rule continues to apply in subsequent years.

o Note – the 101(c) provision excluding interest applies when the insured holds a policy in which interest accrues, but he never takes out any principal. 101(d) provision excluding interest applies when the payments are made over time. These two exclusions are mutually exclusive – you can either fall under interest rule or deferred payment rule, but not both.

o You’ll either use 101(c) or 101(d)…they’re mutually exclusive

Problems pg 1581. Insured died in the current year owning a policy of insurance that would pay Beneficiary $100,000 but under which several alternatives were available to Beneficiary.(a) What result if Beneficiary simply accepts the $100,000 in cash?

o Not income under §101(a), thus not taxable. (b) Instead, Beneficiary leaves all the proceeds with the company and they pay her $10,000 interest in the current year?

o Under 101(c), the 10k interest in included as taxable gross income(c) Insured’s Daughter is Beneficiary of the policy and she elects for the company to pay her $12,000 in the current year? Such payment will be made annually for her life and she has a 25-year life expectancy.

o 12k x 25 (life expectancy) = 300,000 expected payments.o $100,000 insurance K / $300,000 expected payments = 1/3 exclusion ratio. o Multiply the 12k per year payments x 1/3 ratio = 4k excluded from GI under 101(d). The remaining 8k is

included in income. o Thus, for every 12k payment, 4k is excluded and 8k is included.

(d) Same as (c) except Insured’s Daughter lives beyond 25-year life expectancy and receives $12,000 in the 26th year. o 4k is still excluded from GI and 8k is included. o The exclusion ratio continues no matter how long the person lives. 1.101-4(c)o This works both ways – if the Daughter dies early, there is no deduction on her final tax return.o Policy – if the person lives beyond life expectancy, he is old and used to having the exclusion.

2. Jock agreed to play football for Pro. Pro, fearful that Jock might die, acquired a $1 million insurance policy on Jock’s life. If he dies during term of policy, proceeds are paid to Pro. What diff consequences will Pro incur under the following alternatives?(a) With Jock’s consent Pro took out and paid $20,000 for a two-year term policy with Jock’s life.

o No tax consequences to beneficiary. No transfer for value b/c Pro is the initial owner. It can exclude the million dollars. 101(a)

(b) Jock owned and paid-up a 2 year term $1 million policy on his life which he sold to Pro for $20,000, Pro being named beneficiary of the policy?

o 101(a)(2) transfer for value would include this in GI. None of the exceptions for transfer for value apply. Only the $20k Pro paid is excluded from income. The remaining $980k is included in GI and taxable.

o How could Pro have avoided this? Buy their own policy on Jock or make Jock an owner or SH in the corp. (c) Same as (b), except that Jock was a SH of Pro?

o Still 101(a)(2) transfer for value. However, it meets the exception here since it is transferred to a corp in which Jock is a SH. The entire amount is excludable (transfer for value rule doesn’t apply if the transferor is a SH in the corp.).

o This only applies if he transfers to the corp – not if he were to transfer to another SH.

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o What if Jock only owns 1 share out of 1 million? If you read the statute literally, the transfers for value rule still wouldn’t apply. However, is this a sham? Must it be a substantial interest in the corp? No answers!

3. Insured purchases a single premium $100,000 life insurance policy on her life for a cost of $40,000. What tax consequences to Insured and the purchaser of the policy in each of the following situations:(a) Insured sells the policy to her Child for its $60,000 FMV and, on Insured’s death, the $100,000 of proceeds are paid to Child.

o There are 2 tax situations:o (1) Insured when she sells to child

o Insured has 20k gain b/c has basis of 40k in policy and realized 60k on sale. §101 does not apply to a sale.

o When child get 100k for policy, she can exclude 60k under the transfer for value rule and include 40k in GI(b) Insured sells the policy to her spouse for its $60,000 FMV and, on Insured’s death, the $100,000 of proceeds are paid to Spouse.

o Under 1041, the spouse takes her basis. This is an exception to the transfer for value rule §101(a)(2)(a). o Thus, there is no gain or loss to either on the sale. The spouse takes the transferred basis. When the insured

dies, the gen rule under 101(a) applies and the entire 100k is excluded. The transfer for value rule doesn’t apply here

(c) Insured is certified by her physician as terminally ill and she sells the policy for its $80,000 FMV to Viatical Settlement Provider who collects the $100,000 of proceeds on Insured’s death?

o This is all tax-free to insured if the VSP is certified. Under 101(g)(2)(a), the entire amount is treated as if paid under 101(a).

o Note – also determine if “terminally ill” under definition in 101(g)(4)(a)o To the viatical settlement provider, the tax consequences are that 80k of the 100k proceeds are excluded

leaving 20k gain to be included in GI.o Annuity Payments o Many diff types of annuities:

o Single life (pay an annuity co. a certain amount and they will pay you a certain amount the rest of your life), joint life (used by H/W…similar to single life but joint instead), term certain (x dollars for y years), cash value (investment accounts inside the annuity account), guaranteed payments, variable payments

o Annuities pass outside of a will – it doesn’t matter what your will says. Whoever is named as beneficiary of annuity is the person who will get the annuity payment

o §72 – (a) General rule for annuities. Except as otherwise provided, GI includes any amt received as an annuity under an annuity, endowment or life insurance contract.

o (b) Exclusion ratio – (1) GI does not include the part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract bears to the expected return under the contract.

o (2) Exclusion limited to investment. The portion of any amount received as an annuity which is excluded from GI under para (1) shall not exceed the unrecovered investment in the contract immediately before the receipt of such amount.

o (3) Deduction where annuity payments cease before entire investment recovered. If, (i) after the annuity starting date, payments as an annuity cease by reason of the death of the annuitant, and (ii) as of the date of such cessation, there is unrecovered investment in the contract, the amount of the unrecovered investment shall be allowed as a deduction on the annuitant’s final tax return.

o General rule in 72 is that return of capital is tax free and gain is taxedo Excluded amount = amount received x (investment in K/expected return) o Ex – If you invest 100k in K and you expect to receive 150k over period of time, then with regard to

each payment 2/3 (100k/150k) will be excluded – that is effectively just return of your cap and is not income.

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o Imp distinction b/w annuities and §101 – under 101 you have exclusion ratio if you have life ins policy and you take out amt over certain time and the exclusion ratio stays the same for your whole life. Under §72, after initial investment returned, all the proceeds are taxable.

o So in above ex, after already excluded 100k from income, and you continue to get money, then all of it is taxable. If annuitant dies before able to exclude entire 100k, the annuitant is allowed exclusion on last tax return.

o §72(c)(2) Annuity has refund feature. If the expected return under the K depends in whole or in part on the life expectancy of an individual, the K provides for payments to be made to a beneficiary on or after the death of the annuitant, and such payments are in the nature of a refund of the consideration paid, then the value of such payments on the annuity starting date shall be subtracted from the amount determined under para (1).

o If has a refund feature, value of such feature must be subtracted from investment in Ko Buy for 100,000 and death benefit of 50,000 and expected return is 150,000, only 1/3 would be

excludedo The portion of the refund feature is dealt with under §101, but not included in §72 calculation

o §72(h) If a K provides for payment of a lump sum in full discharge of an obligation, subject to an option to receive an annuity in lieu of such lump sum; the option is exercised wi 60 days after the day on which such lump sum first became payable; and part or all of such lump sum would be includible in GI by reason of (e)(1), then no part of such lump sum shall be considered as includible in GI at the time such lump sum first became payable.

o Allows you to roll money from one annuity into another annuity. Some people invest money in variable annuities and after 10 years when annuity is due, you have to decide whether you want to roll into new annuity and not pay taxes on it, or not reinvest in annuity and pay taxes on it (60 day window for this decision)

o §1035 : Allows for exchange of one annuity contract for another income tax freeo Also allows for exchange of life insurance policy for an annuity income tax free

Problem 1601. In the current year, T purchases a single life annuity with no refund feature for $48,000. Under the K T is to receive $3,000 per year for life. T has a 24-year life expectancy. (a) To what extent is T taxable on the $3,000 received in the first year?

o Expected Return = 24 years x 3,000 = 72,000. o Exclusion Ratio under 72(b) = 48,000/72,000 = .6667 or 2/3o 2/3 x 3,000 = 2,000 is excluded from GI and 1,000 is taxed

(d) If the law remains the same and T is still alive, how will T be taxed on the $3,000 received in the 30th year of the annuity payments?o He is taxed on the entire 3,000. He used up the investment in years 1-24. Anything after that, he is taxed ono Contrast this with problem 1(d) pg 158. That problem dealt with same issue under 101d for life insurance. o Here, §72 says once you get investment in K back, 100% is taxable

(e) If T dies after nine years of payments will T or T’s estate by allowed an income tax deduction? How much?o Yes, he is allowed under 72(b)(3). He gets 30k. Already been able to exclude 18k (9 x 2,000, which is amount

acquired tax-free) of the 48k.(f) To what extent are T and T’s spouse taxable on the $3,000 received in the current year if at a cost of $76,500 they

purchase a joint and survivorship annuity to pay $3,000 per year as long as either lives and they have a joint life expectancy of 34 years?o 3k x 34 years = 102,000 expected return. o Invested 76,500/ 102,000 so it is ¾ ratio. o ¾ x 3,000amt received = 2250 is excluded and 750 is included

Discharge of Indebtednesso 61(a)(12) specifically includes discharge of indebtedness as income.o Reg 1.61-12(a) – reiterates that ruleo From Crane and Tufts and regs under 1.1001-2, discharge of liabilities is included in amt realized.

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o So if transfer prop and discharged from liability, it is included under Crane and Tuftso DOI can be excluded as gift. Frequently done thru intra-family sales. Mom can sell prop worth 100k to me,

and since I can’t pay, each year, Mom can forgive the annual gift exclusion (12k), and when they forgive the debt, it is generally taxable income under 61a12, but is excluded in this case as gift under 102.

o Imp distinction – stock vs debt rules. In order to figure out if debt forgiven you must determine whether something is debt in the first place, or is something else, like stock

o §385 and Regs o Facts and circumstances test

o Kirby Lumbero Issued bonds for 12 million and later same year, bought some back for less than par. Diff b/w issuing

price and what they paid was 137,521. Issue – is this income?o Ct cites prior version of 61 for def of GI – similar to one we have now.o IRS also has Reg directly on point concluding that this is income. Now we have 1.61-12a which says

DOI is taxable incomeo Court distinguished Bowers, which is a case where the TP borrowed funds in German Marks, lost the

money and repaid at a greatly diminished value. In that case, the TP losses greatly exceeded the gain, so they didn’t include in income

o Concluded at end of day that they now had 137k more money. So the effective DOI was income – even though discharged own debt, it is still taxable income

o Zarin v. Commissionero Zarin is compulsive gambler. Lost and paid 2.5 million playing craps. The NJ courts ruled that resort

could not give him any more credit. However, Resort still gave him more credit, which was subsequently found to be illegal. Zarin incurred almost 3.5 million in debt to Resort. Resort sued him. Zarin claimed debt unenforceable under NJ order so they settled for 500k.

o Now IRS claims he has discharge of indebtedness income in the difference of amt from his debt to what he paid = 2.5 million.

o He was in 70% tax bracket and it ended up being over 2 million in taxes.o Ct says the IRS wrong for 2 reasons: (1) §108 and §61(a)(12) don’t apply (2) settlement does not

produce income under disputed debt doctrineo 1. 61(a)(12) does not define indebtedness, so the ct looks at 108(d)(1) for definition of DOI –

“indebtedness of the TP means any indebtedness for which the TP is liable or subject to which the TP holds property.”

Ct says not debt for which TP is liable b/c unenforceable under NJ law Also, this is not subject to which he holds prop b/c the chips are not prop, but are a medium of

exchange in casino. Does not meet either of the criteria for indebtedness of the TP so can’t be DOI “Gaming chips were regarded solely as evidence of debt owed to the casino and shall be

considered at no time property of another other than the casino issuing them. Thus, under NJ state law, gambling chips were Resorts’ property until transferred to Zarin in exchange for the markers, at which point the chips became “evidence” of indebtedness, (and not the prop of Zarin.)”

Also say chips are not prop b/c cannot leave casino wo repaying the IOU’s o 2. Not income b/c debt was a contested liability

Cites Sobel – here, ct held loss was not fixed until the dispute was settled. B/c it was disputed, only once they actually fixed the amount, was the amt of the debt known.

Imp exception to DOI rules – no debt discharged if you dispute debt and you settle b/c debt not fixed until you actually settle the case

Hall – owed unenforceable gaming debt – alleged debt was 225k and settled for 150k. Paid debt with 148k worth of cattle. Ct said parties fixed debt at 150k so the DOI was only the diff b/w 150 and 148 given in cattle (not diff b/w 225 and 148)

In Zarin, IRS argued contested liability does not apply to a liquidated debt. Ct says b/c debt unenforceable, the amt of the debt and not just whether or not there is a liability, is in dispute

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In this case, under both disputed debt and contested liability, the debt is 500k and there is no DOI income.

o Collins v Commissioner – TP worked at horse race track and illegally made bets w track’s money. He lost 49k. They held was taxable income b/c he stole the money and the amt of income is the price at which prop would change hands b/w willing buyer and seller. It is an amount others would have paid for the tickets (face value of the tickets.) Ct distinguished Zarin and said it was limited to its facts.

o Point – Even though Zarin not specifically overruled, it is limited to facts of the case and has been criticized by commentators

o Even though §61(a)(12) specifically includes DOI income in GI, §108 applies exclusions in certain circumstances

o §108(a) Exclusion from GI. (1) Gen rule – GI does not include any amount which would be includible in GI by reason of the DOI of the TP if (A) discharge occurs in Title 11 case (bk) (B) discharge occurs when TP insolvent (C) debt discharge is qualified farm debt (§108(g)) (D) in case of a TP other than a C corp, the indebtedness discharged is qualified real prop biz indebtedness

o 108(a)(2) Coordination of exclusions:o (A) Title 11 exclusion takes precedence. (B), (C), and (D) do not apply to a discharge which

occurs in a Title 11 case. If the discharge occurs in Title 11 case, the full amount of discharge is excluded.

o (B) Insolvency exclusion limited to amount of insolvency. The amount excluded shall not exceed the amount by which the TP is insolvent.

1million debt and 800k assets and 300k DOI – the exclusion only applies for 200k - to extent of insolvency. The remaining 100k would be taxable

This exclusion takes precedence over exclusions in (C) and (D)o §108(b)(2) – Reduction of tax attributes. (1) The amount excluded from GI under 108(a)(1)(A) (B) or (C)

shall be applied to reduce the tax attributes of the TP as provided in para (2). o (2) Tax attributes affected – order of reduction. Except as provided in para (5), the reduction

shall be made to the following tax attributes in the following order:o 1. Net operating losses – any NOL for the taxable year of the discharge, and any net operating

loss carryover to such taxable year. Must reduce to the extent you have DOI

o 2. Gen biz credit o 3. Minimum tax credito 4. Capital loss carryovers – any capital loss for the taxable year of the discharge and any

carryover o 5. Basis reduction o 6. Passive activity loss and credit carryovero (3) Amount of reduction – Except for credit carryover reduction, the reductions shall be dollar

for dollar. o (5) Election to apply reduction first a/g depreciable property. (A) General Rule: TP may elect to

apply any portion of the reduction to the reduction under §1017 of the basis of the depreciable property of the TP.

(B) Limitation: Amount shall not exceed the aggregate AB of the property as of the beginning of the taxable year following the taxable year in which the discharge occurs.

(C) Other tax attributes are not reduced. Para (2) shall not apply to any amount to which an election under (5) applies.

TP could elect to first reduce the basis of their prop. In effect, instead of getting to b 5th, you can elect to make it first.

Might want to do this is you are not planning to sell prop anytime soon, but expect lots of income so that you need to take the NOL

If you do get to reducing b of assets, §1017 contains the rules on how to determine the reduction in your basis

§1017(b)(2) – Limitation in Title 11 or insolvency: In the case of discharge to which §108(a)(1)(A) or (B) applies, the reduction in basis shall not exceed the

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excess of the aggregate of the bases of the prop held by the TP immediately after the discharge, over the aggregate of the liabilities of the TP immediately after the discharge. This does not apply to reduction in basis election under §108(b)(5).

The basis is not reduced below the amount of the TP’s undischarged liabilities o After you go thru all tax items and there is still more debt discharged, you ignore that – you are off the hooko §108(c)(3) – “qualified real prop biz indebtedness” means indebtedness which (A) was incurred or

assumed by the TP in connection with real property used in a trade or biz and is secured by such real property, (B) was incurred or assumed before Jan 1, 1993, or if acquired after that date, is qualified acquisition indebtedness. Includes indebtedness resulting from the refinancing of indebtedness under (B), but only to the extent it does not exceed the amount of indebtedness being refinanced.

o §108(c)(4) – “qualified acquisition indebtedness” means, indebtedness incurred to acquire, construct, reconstruct, or substantially improve such property.

o §108(c)(2)(a) – exclusion limited to TP basis in depreciable assets. Must have some b to reduce to make this election

o 108(e)(5) – purchase price adjustments – if the debt of a purchaser of prop to the seller of such prop which arose out of the purchase of such prop is reduced, such reduction does not occur in a title 11 case, or when the TP is insolvent, and but for this para, such reduction would be treated as income to the purchaser from the DOI, then such reduction shall be treated as a purchase price adjustment.

o If seller reduces the debt (and debt arose in the purchase) and reduction does not happen in bankruptcy or insolvency, that amount is excluded

o §108(e)(8) – if corp/pship satisfies debt with his own stock/interest, such corp/pship will be treated as having satisfied the indebtedness with an amount of money equal to the FMV of the stock or interest

o Corp. can pay off debt with own stock and won’t have DOI income o Mortgage Forgiveness Debt Relief Act of 2007

o Discharge of Indebtedness of Principal Residence from Gross Incomeo Acquisition indebtedness is incurred in acquiring, improving residence of taxpayer where loan is

secured (typical mortgage) Original mortgage to purchase, improve home

o Rule only effective until January 1, 2010

Problems pg 1801. Poor borrowed $10,000 from Rich several years ago. What tax consequences to Poor if Poor pays off the so far undiminished debt with:(a) A settlement of $7000 of cash?

o Not enough facts. It’s probably classic discharge of debt but d/n know if there are any exceptions per 108 (like insolvent or bk). If no exceptions, then $3K is discharge of indebtedness income under Kirby.

(b) A painting with a basis and FMV of $8000?o $8K property transferred for $10K debt. The $2K is income from discharge of indebtedness. Its as if TP sold

the painting for $8K and gave it to Rich from debt discharge(c) A painting with a value of $8000 and a basis of $5000?

o There would be a $3K gain on the painting if it were sold, thus Poor recognizes 3k gain. o Because of the transfer, there is a $2K income on discharge of debt under Kirby. (10K debt minus 8K FMV).

(d) Services, in the form of remodeling Rich’s office, which are worth $10,000?o $10K of services for $10K of debt. The discharge is compensation for services. It’s as if Rich paid Poor to

remodel the office and Poor used the money to pay the debt. There is no discharge of indebtedness income, but there is compensation for services. The full 10k is included as compensation.

o §61 Regs say if you perform services in exchange for something of equal value then you recognize as income (e) Services that are worth $8000?

o $8K of income as compensation for services. (see [d] above.) Also, $2K of discharge of indebtedness income per §108 & Kirby Lumber

(f) Same as (a) except that Poor’s ER makes the $7000 payment to Rich, renouncing any claim to repayment by Poor.

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o ER is paying Rich because Poor provides the services to ER. The $7K is additional wages to Poor. The $3K difference is discharge of indebtedness income, assuming no exception in '108 applies.

o So 10k is income to EEo It is like ER paid wages to EE who then took the wages and paid Rich, who discharged 3k worth of

debt. In order to exclude this amount, would have to find a §108 exception o Old Colony – ER paid taxes for EE – indirect compensation. Maybe you could try to argue gift, but it won’t

work here b/c can’t argue gift under 102(c) if it is EE

2. Mortgagor purchases parcel of land from Seller for $100,000 with $20,000 of cash paid directly by Mortgagor and $80,000 paid from the proceeds of a recourse mortgage incurred from Bank. Mortgagor is personally liable for the loan and the land is security for the loan. When the land increases in value to $300,000, Mortgagor borrows another $100,000 from Bank again incurring personal liability and again with the land as security. Mortgagor uses the $100,000 of loan proceeds to purchase stocks and bonds. Several years later when principal amount of the mortgages is $180,000, the land declines in value to $170,000. Mortgagor transfers the land to Bank and Bank discharges all of Mortgagor’s indebtedness.(a) What are the tax consequences to Mortgagor?

o Because it’s a recourse mortgage, it’s as if the m/or sold the property for $170K. So m/or has realized $170K. The $10K difference is discharge of indebtedness income.

o 10k discharge under Kirby (b/c exchanging prop worth 170 for 180 of debt)o Amt realized is FMV of the prop = 170. He still owed 180k so that is the discharge of indebtednesso Basis is 100k in prop, so he has 70k gain b/c prop went up in value which he recognizes under 1001.o Thus, there are 2 items of income here – 1 is gain from exchange and 1 is income from discharge of

indebtedness(b) What are the tax consequences to Mortgagor if the liabilities had been nonrecourse liabilities?

o Because it’s a nonrecourse mortgage, Tufts applies and the amount realized is $180K (amount of mortgage). The basis in the property is $100K, so there is a gain of $80K. However, no discharge of indebtedness income b/c he’s not personally liable for the debt.

o The difference in (a) is that the person is personally liable so the Bank can go after him so it was discharge of indebtedness. Here, they can’t go after him personally. The bank is not letting the individual off, b/c he was never individually liable

o Need to distinguish b/w the types of income – the reason is b/c it would matter with regard to the discharge of indebtedness income in part (a) whether or not the mortgagor was insolvent. However, that fact wouldn’t matter with regard to the 70k gain!

3. Business borrows $100,000 from Creditor to start an ambulance service. He then purchases ambulances for use in his business at a cost of $100,000. Assume the ambulances are his only depreciable property and after some time their adjusted basis and value are still $100,000. What consequences under §108 and §1017 in the following circumstances:(a) Businessman is solvent but is having financial difficulties and Creditor compromises the debt for $60,000.

o Per Kirby, there is $40K income (assuming he isn’t insolvent or bk). This is not Purchase Money Mortgage b/c we’re not told he bought it from the creditor.

o No 108 exceptions met so he recognizes 40k discharge of indebtedness income(b) Same as (a) except that Creditor is also the ambulance dealer who sold the ambulances to Businessman and, as a result of depreciation deductions, the AB of the ambulances is $35,000.

o If basis in ambulances is $35K, it’s because he used $65K in depreciation up to this point. Creditor is the seller so 108(e)(5) applies. The discharge is not income but reduces the purchase price. Because he discharged $40K of the original debt, its as though Businessman purchased property for $60K. But he’s already taken $65K in depreciation! Per the Tax Benefit Rule, he’ll have to include $5K in income.

o After the discharge of indebtedness, the basis in the ambulance is zero.o Adjusted purchase price exception – 108(e)(5). Normally, we include this discharge in income, but b/c of this

special exception, we treat it as a reduction in purchase price. We are assuming that bk and insolvency exceptions don’t apply or else we would have to use those exceptions. There is 40k adjustment and only 35k basis. The purchase price adj exclusion only applies to the extent of the basis so you can exclude 35k (his basis

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in the ambulances.) The remaining 5k can’t be excluded (include as income). The basis of ambulances adjusted to 0

o Notes – if person who sold prop gives back a portion of that debt, that is treated as purchase price adj. Generally that is excluded from income but only to the extent of your b in the asset. Here there is only 35k b left, so the first 35k is excluded from income as purchase price adj, and the remaining 5k you recognize

(c) Same as (a) except that Businessman is insolvent and his liabilities of $225,000 exceed his assets (ambulances worth $100k) by $125,000. Further, Businessman has no net operating losses, gen biz credit carryovers, min tax credit, cap loss carryover, passive activity loss, etc. Creditor discharges $40,000 of the $100,000 loan wo any payment.

o $40K in discharge of debt. But the $40K isn’t income b/c TP is insolvent. 108(a)(3). Only exclude discharge income up to amount of insolvency. Here, the discharge is less than the amount of the insolvency so no income.

o But - must reduce tax attributes. 108(b). The only attribute is the $100K basis in the ambulances which may have to be reduced. See '1017(b)(2) - limits basis reduction where discharge was permitted b/c of insolvency or bk. Formula to determine amount of basis reduction:

o Basis in property after discharge 100K o Liability after discharge -185Ko Amount of basis reduction -85Ko So here, zero reduction in basis. Keep 100K basis in ambulances. The $40K discharge does not affect his

basis in the ambulances. '1017 (b)(2).o Note – Process for exam: 61(a)(12) discharge of indebtedness is generally income. Then go to 108 to see if

any exclusions apply. In this case, 108(a)(1)(b) – TP is insolvent, so exclusion applies to extent TP is insolvent. From there, b/c of exclusion, go to 108(b) which requires you to reduce certain tax attributes in the event 108(a) excludes from income. In these facts, there are no tax attributes, except basis. 108(b)(2)(e) looks like you must reduce b to extent of debt reduction. But, go to 1017, which says that if an amount is excluded from GI under 108a, and under 108b, any portion is supposed to apply to reduce the basis, then the code section applies to determine how much basis is reduced. 1017b2, in the case of discharge to which a or b of 108a1 applies (we have 108a1b) the reduction in the basis under (A) shall not exceed the excess of the aggregate basis of the prop held by the TP immediately after the discharge…in this case, after discharge, basis is 100k and he still owes 185k so the basis does not exceed the amt remaining. So there is no requirement to adjust basis at all. If b had exceed the amount remaining, then would have to reduce the basis.

(d) Same as (c) except that Businessman has a $30,000 net operating loss.o Still $185K liabilities after discharge. Still $100K basis. But here, TP has $30K NOL. TP got advantage of

excluding $40K from income. If TP d/n make the special election per '108(b)(5), the $40K discharge will wipe out the NOL, leaving $10K of discharge to account for.

o Will the $10K discharge reduce the $100K basis? '1017(b)(2) - only to extent it exceeds, after discharge, the $100K liability. It d/n exceed, so keep the $100K basis in ambulances.

o If TP takes election per '108(b)(5) - TP can first use discharge to reduce basis in ambulances. By making the election, the $40K discharge merely reduces basis in ambulances to $60K. So its probably more worthwhile to take the NOL. If NOL is about to expire, maybe it would be better to keep basis and wipe out the NOL.

o Generally income under 61a12. exclusion still met under 108a, so it is all excluded from income under 108a. 108b determines extent to which reduce your tax attributes. Here, there is 30k net operating loss which is completely eliminated. There are still 10k of tax attributes that need to be reduced. But as in c, don’t have to reduce basis b/c there is still total amt of debt outstanding that exceeds basis.

o Note liability is now 185k(e) Same as (c) except Businessman’s liabilities exceed his assets by $25,000.

o Liabilities before discharge = $125K. (figure out b/c it says liabilities exceed assets by 25k and his b is 100k)o Assets = $100K.o Discharge = $40K. TP is insolvent by $25K. '108(a)(3) - if rely on insolvency exception, TP may exclude

discharge but only to extent of his insolvency before the discharge.o So, $25K of discharge is tax free. $15K is income unless some other '108 exception applies (40k discharge –

25k insolvency). This was a clear rule.

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o The issue is to what extent you need to reduce b under 1017? 1017 says you only reduce b to the extent b exceeds liab after discharge. The problem with this is that under 1017 there are two ways to interpret which liabilities remain after “the discharge”

o (1) 1017(b)(2) “In the case of discharge to which 108(a)(1) applies, the reduction in basis under (a) shall not exceed the excess of the aggregate of the bases of the property held by the TP immediately after discharge over the aggregate of the liabilities of the TP immediately after the discharge.”

This seems to mean the liability remaining after the discharge is 125k – 40k discharged debt = 85k of remaining liability. Thus, the basis reduction is limited to the extent of the basis of 100k –85k remaining liability = 15k. SO, the basis reduction would be limited to 15k.

100k b – 15k reduction = 85k basis. This approach is probably the correct way to deal with this.

o (2) 1017(b)(2) – “discharge to which 108(a)(1) applies” could be talking about the entire 40k discharged as above, or only about the actual 25k to which 108 applies.

This would mean that you would only subtract 25k from the aggregate liabilities. 125k – 25k = 100k of remaining liab.

100k b – 100k liabilities after the “discharge” = 0, so the basis would not be reduced at all. JK says this number will always be 0 which is another reason why it may not be appropriate.

o On exam, try to argue both ways! But mostly it is issue spotting b/c there isnt much time. Say you reduce to the extent it exceeds b, but you could argue discharge is this…or this…

o Regs seem to say we should use option 1 in this scenario. It doesn’t include the lang “in the case of a discharge to which 108 applies.”

o At end of the day, $25K is tax free, $15K is income, and basis in ambulances is reduced by $15K to $85K.

4. Decedent owed Friend $5,000 and Nephew owed Decedent $10,000.(a) At Decedent’s death Friend neglected to file a claim a/g Decedent’s estate in the time allowed by state law and Friend’s claim was barred by the statute of limitations. What result to Decedent’s estate?

o Estate has $5K income, depending on why friend let it prescribe. If forgot/mistake, its income b/c estate got enriched and heirs will get more money. It will be discharge of indebtedness b/c estate enriched by 10k.

o Bankhead – confirms that if someone does not file claim wi statute of limitations and debt discharged for that reason, that is discharge of indebtedness income.

o Maybe you can argue it is a gift though, if person did not forget to file, but wanted prescription to run (see below)

(b) What result to estate in (a) if instead, Friend simply permitted the statute to run stating that she felt sorry for Decedent’s widow, the residuary beneficiary of his estate?

o If friend permitted prescription to run, its a gift to the widow so no income to widow or estate. '102(a).o We have a few more facts so the 102 argument is better – there is more detached and disinterested generosity

so more likely a gift(c) What result to Nephew if Decedent’s will provided that his estate not collect Nephew’s debt to the estate?

o It’s a bequest, so no income per '102(a).o This was discharge of indebtedness but excluded under 102 as bequest.

Damages and Related ReceiptsDamages in General

o Determination as to whether or not damages & related receipts = income is in §104 and §106 and in part by CML

o Raytheon Production Corp. o R settled antitrust lawsuit a/g RCA (RCA violated anti-trust laws, putting us out of business)o Issue – should the settlement proceeds be included in TP GI?o The proceeds are not necessarily a return of capital. Can be (1) damages for loss of GW, or (2)

damages for lost profits – they have diff tax consequenceso If lost GW, it is merely a return on capital and is not taxableo If lost profits, it is taxable o Q to ask to determine if the proceeds are taxable is, “in lieu of what were the damages awarded?”

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o Here, R alleged that illegal conduct of RCA completely destroyed the biz of R. They are saying their GW is totally destroyed b/c of the behavior of RCA

o Conclusion – R’s biz no longer exists so damages can’t be lost profits. It must be lost biz. Here, they wiped them off of the playing field altogether so damages are for lost biz altogether. (implies if biz were still going on, it might be loss of profits??)

o During case, there was evidence of lost profits, but ct said evidence of lost profits was necessary to determine value of GW and biz.

So had to look at lost profits to determine what biz worth, but what they lost here was not simply the profits, but the lost biz

o Fact that case settled doesn’t mattero They determined that here, the damages were for GW. But the conversion of the biz to cash made a

gain to the extent that there was an amount realized that exceeded the GW. So is taxable to the extent basis exceeds the GW.

o Damages here are not for lost profits, but for lost businesso Because the suit was to recover damages for the destruction of the business and good will, the

recovery represents a return of capital. Therefore, it’s not taxable.o Note –under Glenshaw Glass, punitive/exemplary damages are income that are taxable even if they’re a

windfallo Smith – K provided liquidated damages rather than penalties for anticipatory breach of K and ct held it was

income b/c the TP did not give up any prop interest. Here, the TP did not give up anything. Didn’t give up prop, it was just damages. There was no lost business, simply a windfall. Therefore, it was ordinary income as opposed to a disposition of property in Raytheon.

o If damages relate to several items, you must allocate the damages among the itemso The general rules can all be altered by statute. For example, 186 allows a deduction for certain patent

infringements. o The labeling of the damages doesn’t matter. You must look to what the damages really are and why they’ve

been given.

Problems, p. 1851. brought suit and unless otherwise indicated, successfully recovered. Discuss the tax consequences in the

following situations:(a) ’s suit was based on a recovery of an $8K loan made to Debtor. . recovered $8500 cash - $8K for the loan

plus $500 of interest.o $8K = return of capital and not income so not taxable.o $500 interest is income so it’s taxable.

(b) What result to Debtor under (a) if instead, Debtor transferred some land worth $8500 w/ a basis of $2000 to to satisfy the obligation? What is ’s basis in the land?o $8500 given to from D. It=s as if D sold the land for $8500 and gave the money to . D realized

$8500, basis was $2000, so D had gain of $6500. Not discharge of indebtedness b/c transferred property w/ FMV of full amount of the debt. (International Freighting – recognize gain to the extent FMV exceeds b in prop…if you satisfy a debt with appreciated property, then it’s taxable)

o The $8K to is return of capital. $500 interest is income. basis is 8500 - it=s as if took the money from D and bought the land for $8500.

(c) ’s suit was based on a breach of a business K and recovered $8K lost profits and $16K of punitive damages.o $8K income (lost profits are taxable) - Raytheon. $16K income - Glenshaw Glass: include punitive

damages. Total income = 24k. (d) s suit was based on a claim of injury to the goodwill of s business arising from a breach of business K.

had a $4K basis in the goodwill. The goodwill was worth $10K at the time of breach of K.(1) What result to if the suit is settled for $10K in a situation where the goodwill was totally destroyed?o $4K basis. $10K FMV. $6K gain on the goodwill is income so taxable. Treat as forced sale of goodwill.

Apply 1001.

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(2) What result if recovers $4K b/c the goodwill was partially destroyed and worth only $6K after the breach of K?o $4K basis. $6K FMV. recovered $4K. Forced sale of goodwill. No income before $4K recovered and

$4K basis. So TP=s basis becomes zero. o Treated as if sold the GW for 4k, so the basis is reduced to 0.o 205-1011(3) What result if recovers only $3K b/c the goodwill was worth $7K after the breach of K?o This completely offsets the amt realized. There is no gain. The basis is reduced by 3k. 3k is realized b/c

that is what he recovered. 1k basis is left over. Note – if there are damages and the damages relate to GW, you can use the basis up to the amt realized. In d2, the b is 4k so you can use all the b to offset the gain. And basis is 0. In 3, you can use 3k of b to offset gain, and there is still 1k left over.

General Rule: Damage awards are taxable income. The general rule for determining whether the award is includible is in reference to the underlying claim.

Lost wages = taxableLoss of capital asset = treated as though sold for cash

Exceptions: Belowo 104(a)(2) – damages awarded for personal injuries.

o Commissioner v Shlear Age discrimination case – he was airline pilot forced to retire at 60. SCOTUS said it is

employment related and not excludible. Announced 2 prong test for damage exclusion:

(1) Damage must be grounded in tort or tort type claim (2) Award must be on account of personal injuries

Damages and Other Recoveries for Personal Injurieso Congress stepped in to provide clarity in the area. Limited the scope of 104(a)(2) in 1996.o §104 – Compensation for injuries or sickness

o (a) Except for amounts attributable to deductions allowed under §213 for any prior taxable year, GI does not include:

(1) Amt received under WC act as compensation for personal injuries or sickness Also excludes death benefits paid under WC statute – 1.104-1(b) Payments under WC stat for injury or death that are not job related are not excluded

under this provisiono Must be job related – no open ended WC statutes

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

Emotional distress is not treated as physical injury or physical sickness. But, this does not apply to an amt of damages not in excess of the amt paid for med care attributable to emotional distress

Emotional distress will be excluded if the distress is as a result of a physical injury or physical sickness

Medical expenses, lost wages, etc. are excluded if they’re on account of a physical injury or sickness

(3) Amt received thru accident or health ins for personal injuries or sickness (other than amts received by an EE, to the extent such amounts were attributable to contributions by ER which were not includible in GI of EE; or are paid by ER)

So if ER pays the payments, or if attributable to contributions made by ER, you don’t get exclusion

(4) Armed services

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(5) Terrorist or militaryo (c) Punitive damages are excluded from income if awarded in a civil action (1) which is a

wrongful death action and (2) with respect to which applicable state law (in effect before Sept 13, 1995) provides, or has been construed to provide that only punitive damages may be awarded in such action.

Very narrow exceptiono Must be physical injury or sickness!o Non-physical injuries are not excludable (so sex and gender discrimination are not included)o “On account of” –includes anything received on acct of the physical injury or sickness. So med

payments, out of work pay for being out of work, etc – this is all on acct of the physical injury so can all be excluded

o Damages from emotional distress are not physical injury or sickness except to amt that related to items paid for med care

So if you sue for emotional distress, you can only exclude the amt provide for med care However, emotional distress recovered on account of physical injury can be excluded (b/c not

something incurred only b/c of emotional distress)o Murphy (from 1st day of class)- b/c the exclusion doesn’t encompass emotional distress, the D.C.

circuit court held the provision to be unconstitutional. However, this case has been severely criticized. This case has now been reversed!!

o Allocation – many claims contain both items that are excluded and some that are included, so must allocate. Not as bad now, b/c everything from physical injury is excluded b/c all paid on acct of a physical personal injury. However, there are situations where part of what you are claiming is excluded and part is not excluded.

o IRS refuses to rule on specific cases – so can’t request private letter ruling on how it should be allocated. All they have issued is RR 85-98 that concludes that the petition is the best evidence for determining allocation of a settlement

o In RR 85-98, the TP requested 15 for compensatory damages and 45 of punitive damages. The TP received 24 in full settlement of all claims. Ruling concludes that the settlement should be characterized in proportion to the request in the complaint (25% for compensatory damages and 75% for punitive damages)

o The Tax Court has stated that an express allocation in the settlement agreement generally will be followed for tax purposes if the agreement is entered in an adversarial context (truly a negotiated amount) at an arm’s length transaction and in GF. But, allocation in settlement not necessarily determinative if other facts indicate that the payment was intended by the parties to be for a different purpose.

It doesn’t matter what you call, you must look to why you’re settling. It needs to be a true allocation of what you’re settling.

o Other exclusions:o 106(a) – Except as otherwise provided, GI of an EE does not include ER-provided coverage

under an accident or health plan. o If something wasn’t excludable under 104(a)(3), try the §105 exclusion

(a) Except as otherwise provided, amts received by EE thru accident or health insurance for personal injuries or sickness shall be included in GI to the extent such amounts (1) are attributable to contributions by the ER which were not includible in the GI of the EE, or (2) are paid by the ER.

Exceptions: (b) – Except in the case of amounts attributable to deductions allowed under §213 (med expenses) for any prior taxable year, GI does not include amounts in (a) if the amounts are paid directly or indirectly, to the TP to reimburse the TP for expenses incurred by him for the med care.

Difference 104a3 covers any amts paid by insurance, not just the expenses. If you pay for own health, exclude everything.

Usually there is not much difference b/c typically health insurance policies don’t pay more than med expenses anyway.

106a- if an ER makes a contribution to your plan, then it’s all excludable

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What if there are 2 policies? One paid by the EE and one by the ER?o 104(a)(3) excludes the full amount given on the EEs own policy. o 105(b) limits the exclusion for the ER provided policy for amounts that

“reimburse” the individual for medical If an ER directly or indirectly reimburses an EE for expenses for

medical care for the EE or the EE’s spouse/dependents, the amount received is excluded from GI

o 105(c)- if an EE receives payments through health or accident insurance provided by an ER without tax cost to the EE for loss of a member or function of the body or for disfigurement of the EE or EE’s spouse/dependent, and if the amount is computed only with regard to the nature of the injury and not to the period the EE is absent from work, the amount is excluded from GI

Remember, ER must have paid for the insurance (c) – GI does not include amts referred to in (a) to the extent such amounts (1) constitute

payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement of the TP, his spouse, or a dependent and (2) are computed with reference to the nature of the injury wo regard to the period the EE is absent from work.

o Exclusions under 104 and 105 are reduced to extent the amts are related to med expense deductions from prior year

o If deduct med expense in year 1 and in year 2 you get amounts reimbursed you can’t exclude – must recognize as income to offset deduction from prior year.

o RR 65-29 – where TP received the present value of excludable award and invests it, the TP is taxed on the interest (income)

o 79-313 – if settlement agreement provides that TP will receive payments over time, all payments are excludable – 104(a)(2) “lump sum or periodic payments” – note – this is better than getting award and investing it b/c they will be taxed on the interest – have them paid over time

o If payments paid over time, can generally buy annuity and assign the incomeo These provisions rely on the thought that if a person has suffered personal injury, he should not additionally

suffer damage to his purse in the form of tax liability

Problems pg 1931. brought suit and successfully recovered in the following situations. What tax consequences to ?(a) , professional gymnast, lost use of her leg after a fan assaulted her. awarded damages of $100,000.

o We do not know if any was for punitive or pre-judgment or post-judgment interest (wouldn’t be excluded). o If it’s all for personal physical injury, its all tax free. §104(a)(2).

(b) $50,000 of the recovery in (a) is specifically allocated as compensation for scheduled performances failed to make as a result of the injured leg.

o Looks like lost wages, but its loss on account of physical personal injury. 104(a)(2). If it weren’t for the PI, would not have this recovery, so it’s excluded. Raytheon (asks what are damages for?)

o This is excluded as well since if it is physical injury, all damages that flow from it are excluded!(c) Jury also awards $200,000 in punitive damages

o $200K is income. Punitive damages are specifically not excluded from income under 104(a)(2) (d) Jury also awards damages of $200,000 to compensate for s suicidal tendencies resulting from the loss of use of her leg.

o It’s for emotional distress arising out of physical PI. So no income per 104(a)(2). See last para. of 104 - if its just for emotional distress and not physical PI, its income. But if part of physical PI, or for medical expenses as part of emotional distress (i.e., psychological expenses in defamation suit), it’s excluded.

o Emotional distress is excludable if paid on account of a physical injury. So it is excluded under 104(a)(2)(e) , in separate suit, recovered $100,000 of damages from a fan who mercilessly taunted about her voice, causing extreme anxiety and stress.

o It’s not for physical injury. Its just emotional distress and its taxable except to the extent had medical expenses for the emotional distress.

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o 104(a) last 2 sentences – to the extent emotional distress relates to medical care it is excluded – since not excluded b/c of physical injury, you can’t exclude all of it, but last 2 sentences say she can exclude the medical expenses

(f) recovered $200,000 in a suit of sexual harassment a/g her former coacho Not PI - all is taxable.o If she alleges physical injury, then maybe you can argue that it is on account of a PI, but there aren’t enough

facts to decide(g) dies as a result of the leg injury, and her parents recover $1,000,000 of puni damages in wrongful death action under a state statute.

o Generally puni damages are not excluded, but there is a limited exclusion under 104(c)o 104(c) - punitives are excluded if for wrongful death action and applicable state law in effect on 9/13/95 hasn’t

been modified and provides for punitives. Here, we don’t know:o (1) has stat. been in effect w/o modification since 1995, o (2) does it allow for damages other than punitives [if so, other damages are tax free but punitives are

income], or o (3) have courts of that state interpreted the statute to mean it only provides for punitives? (Meaning

punitives are the only wrongful death recovery)o Assuming we meet all requirements of 104(c) then it is excludable

2. Injured and Spouse were injured in car accident. Their total med expenses for the year incurred were $2,500.(a) In year of accident, they properly deducted $1500 of the expenses on their joint tax return and filed suit a/g wrongdoer. Next year, they settled their claim a/g wrongdoer for $2500. What tax consequences on receipt of the $2500 settlement?

o TP deducted $1500. Recovered $2500. 104(a)(2) o Cannot deduct the $1500 that was already deducted. Doesn’t say what the award is for, but if for PI, then can

exclude the amount left over ($1000).o The exclusion does not apply to the extent it was deducted the prior year.

(b) In succeeding year, Spouse was ill, but they carried med insurance and Spouse had insurance benefits under policy provided by ER. Spouse’s med expenses totaled $4000 and they received $3000 of benefits under their policy and $2000 of benefits under ER’s policy. To what extent are the benefits included in GI?

o Received $3K benefits from own policy. Rec’d $2K from ER policy. So they collected $5K for $4K of expenses. 104(a)(3) - the entire $3K from own policy is excluded.

o But '105(b) - ER provided policy - amount is excluded only to extent it is reimbursement for actual medical expenses. Rev. Ruling 69-154 allocate as follows: (if receive amounts completely excludable under 104 and partially excludable under 105, to determine what comes from where, you need to allocate)

o How much of $5K total reimbursement is attributable to ER-provided insurance? 2000 / 5000 x 4K = $1600 (portion which is attributable to actual medical expenses) So, 40% of the 4k med expenses is the ER policy.

o So $1600 of the $2K payment was applied to actual medical expenses and is excluded under 105(b). The balance of $400 of the $2K payment is income.

(c) Under (b), may Injured and Spouse deduct the med expenses?o No double dipping. 213 allows for med. expenses to be deducted if the expenses weren’t reimbursed by ins.

co. If exclude, cannot deduct, and vice versa. If TP is reimbursed in same year as expense is incurred, he excludes the reimbursement and does not deduct the expense.

o 213 says deduction if for med expenses to the extent not compensated for ins etc, so can’t deduct here

3. Injured, who has a 20-year life expectancy, recovers $1 million in a personal injury suit arising out of boating accident. (a) What tax consequences to Injured if the $1 million is deposited in a money market account paying 5% interest?

o MM Account - got $1mill but d/n know what recovery is for. Punitives? Interest? Look for missing facts. Once exclusion is determined, invest the $1mill. The interest on the investment is income- 61.

o Interest will be taxable RR 69-25. o 1M excluded under 104(a)(2)

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(b) What tax consequences to Injured if the $1 million is used to purchase annuity to pay Injured $100,000 per year for Injured’s life?

o 1M still excluded but §72 would tax the interest portion of it. It is the same result as (a). (c) What tax consequences to Injured if the case was settled, and in the settlement, Injured received payments from of $100,000 a year for life?

o What is settlement for? Here, lump sum proceeds are paid annually. Are any of the payments income? If all for physical PI, it’s all tax free per Rev. Rul. 79-313. If part of the $1mill recovery isn’t for physical PI, a portion of each payment will be income.

o Point – if judgment or settlement requires you to pay 100k per year, then the whole amount is excluded, including the amount that would otherwise be interest (commonly referred to as “structured settlement”). This may be beneficial to both sides. The in the long run is protected b/c not taxed and won’t be able to blow the amount in a lump sum

Pg 218 Kevin and Brittany’s divorce decree and becomes effective on January 1 of year one. Discuss the tax consequences of the following transactions to both Kevin and Brittany:

(a) Pursuant to their divorce decree, Kevin transfers to Brittany in March of year one a parcel of unimproved land he purchased 10 years ago (add in the rest of these questions and answers)

PLR – one PLR that states that it is not per-se assumed to beSeparation and DivorceIn 1942 the rules were changed. Before then, alimony was not included nor deducted.

o 71(a) – GI includes amount received as alimony or separate maintenance payments.o What is alimony or separate maintenance payments? See 71b

o 215(a) There shall be allowed a deduction in an amount equal to the alimony or separate maintenance payments made during the individual’s taxable year.

o 71(b)(1) Alimony or separate maintenance payments defined. Means any payment in cash if (A) such payment is received by or on behalf of a spouse under a divorce or separation instrument, (B) the divorce or separation instrument does not designate the payment as one not includible in GI and not allowable as a deduction under §215 (C) in the case of an individual legally separated, the payor and payee spouses are not members of the same household (D) there is no liability to make payment after the death of the payee spouse and no liability to make payment as a substitute for such payments after the death of the payee.

o 71 only includes cash payment in def of alimony (or check or money order)o Must meet all 4 requirements + payment must not be for child support in order for it to be alimony:o (1) Payment to be received by, or on behalf of (shows that cash can be indirect), a spouse under a

divorce or separation instrumento (2) The divorce or separation instrument dose not designate the payment as a non-alimony payment

If specifically say it is not alimony, then it is not alimony This allows for tax planning if you can get the spouses to cooperate. If the payee spouse is in

the higher tax bracket, they may not want to have to include in income. Maybe allow the payor spouse to pay less. The parties can decide if it’s classified as alimony or not. If there’s cooperation, then you can avoid the tax situation by giving more in alimony, etc.

o (3) In the case of decree of legal separation or of divorce, the parties are not members of the same household at the time the payment is made

The spouses can’t be living in the same household 1.71-1tbQ&A 9: a dwelling unit formerly shared can’t be considered separate households if

both live under the same unit and claim that it’s separate (by living in different parts- e.g. husband in the garage, wife in the house).

Remember, this only qualifies if they’re legally separated/divorce to qualify as separate households

o (4) No liability to make any payment in cash or property, after the death of the payee spouse If paying after they die, it is by def not alimony

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Remember, alimony is only for support while someone is alive. It doesn’t make sense to continue after death.

o 71(b)(2) – Divorce or separation instrument defined. Means (1) a decree of divorce or separate maintenance or a written instrument incident to such decree (2) a written separation agreement (3) a decree requiring a spouse to make payments for the support or maintenance of the other spouse.

o 71(c)1- child support is excluded from the definition of alimonyo There are some things where it’s clear that it’s child support. Some people try to make it appear that

it’s really alimony, however, these rules prevent that and deem it child support.o If any amount will be reduced by an instrument relating to a child (contingency clause- reaching

certain age, etc.), then it will be considered child support.o If you’re paying $200/month in child support and $800/month in alimony, and the payor only pays

$500, then what is it classified as? The first $200 is considered child support, and the rest is deemed alimony.

o 71(e) Exception for joint returns. This § and §215 don’t apply if the spouses file a joint return w each other.

o If file a joint return, it would just be a wash – you would be including and excluding on the same return

o Distinguish b/w alimony and prop settlement – alimony is include in income and deducted from income for payor. Prop settlement is tax neutral.

o 71(f) – Recomputation where excess front-loading of alimony payments. (1) If there are excess alimony payments (A) the payor spouse shall include the amount of such excess payments in GI for the 3rd taxable year post-separation and (B) the payee spouse shall be allowed a deduction to GI for an amount of such excess payments for the 3rd taxable year post-separation.

o (2) Excess alimony payments = excess payments for 1st year + excess payments for 2nd year o (3) Excess payments for 1st year (See formula below)o (4) Excess payments for 2nd year (See formula below)o If you front-load too much money in the first 3 years, then it will be considered a property settlemento If too much money paid in yr 1 and 2 compared to 3, an amount is recaptured in year 3.o Regardless of what label you put on this, if you try to make it alimony, but you pay too much in the

first 2 years, it is treated as a prop settlement.o Reason – steady level payments look like alimony, but large initial payments look like prop

settlements o First step compute the excess paid in year 2 (how much excess alimony did you pay in year 2).

2nd year excess payment = 2nd year payments – (3rd year payments + 15,000)o Second step compute the excess paid in year 1

1st year excess payment = 1st year payment – [(2nd year payments – 2nd year excess payments) + 3rd year payments / 2 + 15,000]

o Third step add the two together. This amount is included in payor’s GI for year 3 and is deducted from payee’s income in year 3.

Essentially you reverse the excess payments that were made in years 1 and 2.o In real life, a CPA will compute this for you…but it’s important to be able to spot this issue.o HYPO: Under the divorce of separation instrument, the following annual payments are made:

Year 1 80,000 Year 2 80,000 Year 3 30,000 Year 4 30,000

At least a portion of the total sum of 160,000 paid during the 1st 2 years has the flavor of a cash property settlement. Where the amount of one or more of the payments is inordinately large in relation to the amount of payments for the other years, something may be wrong. If so, such an amount is recaptured in the 3rd year.

2nd year excess payment = 80,000 – (30,000 + 15,000) = 35,000 1st year excess payment = 80,000 – [(80,000 – 35,000) + 30,000 / 2] + 15,000

= 80,000 - (37,500 + 15,000)

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= 80,000 – 52,500 = 27,500

3rd year recapture = 35,000 + 27,500 = 62,500 So, in the first 2 year, the 80k was alimony. In the 3rd year, the person recognizing as income

will now get deduction and person paying will now have to include 62,500 in income!o Note - §71(f) is a one shot deal – all the action occurs in year three. o Note – the statute is only concerned with front-loading and is not concerned with rear-loading.

Ex: if payments which otherwise qualify as alimony equal 30,000 in year 1 and year 2, but equal 80,000 in year 3, all will qualify as alimony even though the 80,000 payment seems in the nature of a cash property settlement.

o 71(f)(5) Exceptions: (A) Recapture shall not apply if either spouse dies or remarries before the close of the 3rd post separation year and the payments stop as a result of the death or remarriage.

o (B) Recapture does not apply to payments received under decree So if judge says it in a decree, it will be alimony and not subject to the recapture rules

o (C) – Fluctuating payments beyond control of payor. Recapture does not apply to any payment to the extent it is made pursuant to a continuing liability (over a period of not less than 3 years) to pay a fixed portion of the income from a biz or property or from compensation for employment.

Ex – Judgment says you have to pay spouse 50% of net income from biz. You might have good year in 1 and 2, and then biz tanks – thus the first 2 payments would be high and the 3rd would be low, but that is fluctuation not subject to the payor’s control and you don’t have to recapture.

The same is the fact if you say I’ll give you 10% of my salary.

Problems Pg 203 1. Determine whether the following payments are accorded “alimony or sep. maintenance” status and therefore are includable in the recipients gross income per §71(a) and deductible by the payor under '215(a). Unless otherwise stated, Andy and Fergie are divorced and payments are called for by the divorce decree.(a) The div. decree directs Andy to make payments of $10K per year to Fergie for her life or until she remarries. Andy makes a $10K cash payment to Fergie in the first year.

o It looks like alimony, but are all the requirements met? D/n know if the decree says it’s not for alimony. D/n know that they aren’t living together.

o If all requirements met, Andy can deduct the 10k, and Fergie must include 10k. This is the gen rule under 71(b) Same as (a), except that Andy is short on cash so transfers a $10K promissory note to Fergie.

o This is not payment in cash. Andy should borrow the money and pay the cash to get the deduction.o Not alimony since not in the form of cash. Since he did not pay alimony, then there is no deduction. Fergie

includes nothingo Reg –1.71-1T(b) Q5: May alimony or sep maintenance payments be made in a form other than cash?

o Ans: No. Only cash payments (including checks and money orders) qualify as alimony. Transfers of services or property (including a debt instrument of a 3rd party or an annuity K), execution of a debt instrument by the payor, or the use of property of the payor do not qualify as alimony.

(c) Same as (b), except that instead of PN, Andy transfers a piece of art work w/ a FMV of $10K.o -This is not payment in cash. Not alimony.

(d) Same as (a) except that in addition, the decree provides that the payments are nondeductible by Andy and are excludable from Fergie’s gross income.

o -Not alimony. But see reporting requirements to keep IRS from being whipsawed - Reg. 1.71-1T(b) Q&A 8 –If parties are treating it as non-alimony, parties must attach copy of the divorce decree to payee’s tax return.

o 71(b)(1)(b) – if you say not alimony, it is not alimony (e) Would it make any difference in (d) if you learned that Andy anticipated that he would have little or no taxable income in the immediate future, making the §215 deduction practically worthless to him, and as a consequence of this agreed to the “nondeductibility” provision in order to enable Fergie to avoid the imposition of federal income taxes on the payments?

o -No difference.

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(f) What result in (a) if the divorce decree directs Andy to pay $10K cash each year to Fergie for a period of 10 years?

o The payments do not qualify if there is obligation to provide the payments after the death of the spouse. Potential problem here is that payments must cease on death of payee. 71(b)1(d). If Fergie dies in year 8 and payor is obligated to keep paying, its not alimony. If local law says payments cease on death of payee, or if there is another provision that says payments cease at death, its okay and still alimony. Otherwise all payments are non-alimony.

(g) Same as (f) except that under local law Andy is not required to make any post-death payments.o Now we know that the payments must cease, so this is alimony. The divorce decree does not specifically need

to say they terminate at death if that is the outcome under state law. (h) Same as (a) except that the divorce decree directs Andy to pay $10K cash each year to Fergie for a period of 10 years or her life, whichever ends sooner. Additionally, the decree requires Andy to pay $15K each year to Fergie or her estate for a period of 10 years. Andy makes a $25K cash payment to Fergie in the year.

o -Only the 1st $10K is alimony each year. The other $15K is not required to cease where she dies. It will not qualify as alimony – probably is either child support or property settlement.

(i) Same as (a), except that at the time of the payment, Andy and Fergie are living in the same house.o -Not alimony b/c they are living together. See '71(b)(1)(C).o Note – the same result would occur even if they live on separate floors or otherwise physically separate

themselves while w/i the dwelling unit. 1.71-1TB Q 9. o So, if same house, then don’t meet definition even if not technically living “together”

(j) Same as (i) except that Andy and Fergie are not divorced or legally separated and the payments are made pursuant to a written sep. agreement instead of a divorce decree.

o Still alimony b/c 71(b)(1)(c) only applies to those who are legally separated or divorced – thus if not legally separated or divorced can still live together.

o Caveat – if they file joint tax return, then would not be alimony under 71(e) – that would be a wash!

2. A divorce decree requires Tina to make the following payments (which all meet the requirements of '71(b)) to Ike:Year 1 $80,000Year 2 40,000Year 3 10,000(a) What are the tax consequences of these payments to Tina and Ike?

o -See '71(f). If excess alimony payments, payor includes excess payments in gross income in 3rd post-sep. year. For 1st 2 years, Payor spouse deducts $80K and $40K respectively. In year 3, Tina must include some of this as gross income. Payee spouse will include in gross income $80K and $40K in years 1 and 2, and deduct some of this from income in year 3.

Year 2: 40K - (10K + 15K)40K - 25K = 15K (excess payment in year 2)

Year 1: 80K - (40K - 15K) + 10K 2

= 80K - (17,500 + 15K) = 80K - 32,500 = $47,500 (excess in year 1).

47,500 (year 1 excess)+15,000 (year 2 excess)$62,500 - recaptured amount in year 3.

o So in year 3, Tina will include in income $62,500 and deduct $10K for the year 3 payment, for $52,500 income in year 3.

o Ike will get deduction in year 3 of $62,500, plus income of $10K, for total deduction of $52,500. o Tina will add to income to offset the deductions that she took which were excessive in the first 2

years. Ike will use deductions to offset the amounts he included in income in those first 2 years. (b) What result if the payments are:

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Year 1 $80,000Year 2 70,000Year 3 60,000

o Looks like frontloading but no recapture. If this is on exam, still cover the formula:Year 2: 70K - (60K + 15K)

70K - 75KNo excess payments in year 2.

Year 1: 80K - 70K + 60K + 15K2

= 80K - (65K + 15K)= 80K - 80K = 0

No excess payments in year 1. (c) What result if the payments are:Year 1 $30,000Year 2 40,000Year 3 80,000

o This is rearloading. Its all income / deductible.o Recapture doesn’t apply and the regular rules applyo If remains steady or decreases don’t need to work thru the formula. o If there is increase, work the formula for the test (even if not substantial increase)

(d) What result if the payments are:Year 1 $80,000Year 2 50,000Year 3 80,000

o -Year 2 payment d/n exceed year 3 payment by $15K. So no excess payment for year 2. So go to year 1:50K + 80K = 130K.130K / 2 = 65K.65K + 15K = 80K

o Year 1 payment of 80K - 80K (from formula) = 0. So no excess payment for year 1. So no recapture at all.o JK says anytime there is a decrease, go ahead and crunch the numbers to see if there is recapture

(e) Suppose that instead of requiring Tina to make the payments set forth in (a), the divorce decree requires Tina to pay Ike 50% of the net income (before taxes) of her oil business for 3 years. The payments represent 50% of the net income from the oil business for the respective years. What tax consequences to Tina and Ike?

o -'71(f)(5)(C) - Exceptions to recapture. If payment based on a fluctuation beyond the control of the person paying the alimony, no recapture. Notice - for purposes of anti-front loading rules only!! Its still alimony so still income / deductions.

(f) What are the tax consequences if the decree instead provides for level payments of $80K/year for 3 years, but Ike dies at the end of year 2 and the payments terminate at that time according to the express provision of the instrument?

o Its alimony. Parties had no control over when Ike would die. '71(f)(5) - front loading d/n apply if death/remarriage w/i 1st 3 years. No need to do recapture.

(g) What result in (a) if the payments are made pursuant to a '71(b)(2)(C) decree for support?o -Where TPs are still married - 71(f)(5)(B) - no recapture rules.o Not recapture b/c not under decree for maintenance o If the judge signs off on it and calls it support, we assume it is support and don’t do recapture.

(h) Tina and Ike are legally divorced and live in the same household in year 1. Tina moves to a new apartment at the beginning of year 2. Under the divorce decree, Tina makes payments to Ike of:Year 1 $120,000Year 2 80,000Year 3 70,000Year 4 60,000What results to Tina and Ike in each of these years?

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o -No front loading. Year 1 – they’re still living together so not alimony under 71(b)(1)(c). After year 1, it’s just like problem 2(b). Years 2-4 qualify as alimony b/c don’t live in same house, but no recapture b/c no frontloading (basically same result as 2b)

Indirect Paymentso Alimony can be received indirectlyo 71(b)(1)(a) – be received by or “on behalf of” – this is indirect authority for it to be received by indirect

paymentso What types of indirect payment scan qualify as alimony?o IT- 4001

o 2 situations – H paying premiums on a life ins policy and the issue is whether it qualifies as alimonyo (1) Assigned absolutely to former W and she is irrevocable beneficiary – in a few years he will

exchange policy and transfer to W. These payments are alimony. o (2) Their children named as primary beneficiaries and the wife is contingent beneficiary. This does not

qualify as alimony. o Rule – to the extent the payments are made to maintain prop owned by the paying spouse, but simply

being used by the payee spouse, the payments are not alimony. So in (2) it is prop owned by H but it is just being used by the W b/c she is contingent beneficiary (she did not own it – the H owned it and he could change it at any time)

o If H pays wife’s bills, that is alimony (paying off an obligation of W) o If H pays off Ws house note – that’s alimonyo But if H makes payment on prop he owns, but W uses the prop, that is not alimony

o Reg 1.71-1T(b) – Q 6 – May payments of cash to a third party on behalf of a spouse qualify as alimony or separate maintenance payments if the payments are pursuant to the terms of a divorce or separation instrument?

o A 6 – Yes. Assuming all other requirements are satisfied, a payment of cash by the payor spouse to a 3rd party under the terms of the instrument will qualify as a payment of cash which is received “on behalf of a spouse”. For example, cash payments of rent, mortgage, tax or tuition liabilities of the payee spouse made under the terms of the divorce/sep instrument will qualify as alimony payments. Any payments to maintain prop owned by the payor spouse and used by the payee spouse (including mortgage payments, real estate taxes and insurance premiums) are not payments on behalf of a spouse even if those payments are made pursuant to the terms of a divorce/sep instrument. Premiums paid by the payor spouse for term or whole life insurance on the payor’s life made under the terms of the divorce or separation instrument will qualify as payments on behalf of the payee spouse to the extent that the payee spouse is the owner of the policy.

o Reg. 1.71-1T(b) - Q 7 – May payments of cash to a 3rd party on behalf of a spouse qualify as alimony or sep maintenance payments if the payments are made to the 3rd party at the request of the payee spouse?

o A 7 – Yes. Ex, instead of making an alimony or sep maintenance payment directly to the payee, the payor spouse may make a cash payment to a charitable organization if such payment is pursuant to the written request, consent or ratification of the payee spouse. Such request, etc must state that the parties intent the payment to be treated as an alimony or separate maintenance payment to the payee subject to the rules of §71, and must be received by the payor prior to filing his tax return.

Problems, p. 207:1. Tom and Nicole are divorced. Pursuant to their written sep. agreement incorporated in the div. decree, Tom is required to make the following alternative payments which satisfy the '71(b) requirements. Discuss the tax consequences to both Tom and Nicole.(a) Rental payments of $1000 per month to Nicole’s landlord.

o -Here, the payments are on behalf of Nicole, so its alimony. The general rule of alimony under §71 applies. Reg. 1.71-T(b), Q&A 6. Rent is specifically mentioned.

(b) Mortgage payments of $1000/mo. on their family home which is transferred outright to Nicole in the div. proceedings.

o This is alimony b/c paid on behalf of Nicole.

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o Note – with indirect payments, it is alimony so H gets deduction and W gets income, even though she doesn’t receive the money. She will have tax liability, so make sure she has other money to pay the tax liability or Tom gives her more money to pay tax

(c) Mortgage payments of $1000 / mo. as well as real estate taxes and upkeep expenses on the house where Nicole is living which is owned by Tom.

o -Tom owns the house so the payment is on behalf of himself. So its not alimony b/c it is owned by Tom.

2. Roseanne agrees to pay Tom $15K a year in alimony until the death of either or the remarriage of Tom. The alimony satisfies the '71(b) requirements. After 3 years, Tom is concerned about Roseanne’s life expectancy and they agree to reduce the alimony amount to $10K / year if Roseanne provides Tom $100K of life insurance on her life.(a) What are the tax consequences to Tom and Roseanne if Roseanne purchases a single premium $100K policy on her life for $60K and she transfers it to Tom?

o -This is a transfer of property, not cash. So its not alimony.o This would qualify as transfer under 1041.

(b) What result in (a) if Roseanne instead pays Tom $60K cash and he purchases the policy for $60K?o -To be alimony, it must be transferred per a written sep. decree. We do not know here if the agreement is in

writing. o It looks like alimony to him of 60k. It is cash and looks like it qualifies. Note – the 71(f) recapture won’t apply

since it is an increase in year 3 (but if this were done in year 1, it would be subject to recapture)(c) What result if Roseanne buys an ordinary policy on her life for $5K, transfers it to Tom, and agrees to transfer $5K cash to him each year so he can pay the annual premiums on the policy?

o This is not cash so does not qualify as alimony. However, the subsequent payments of the $5k do qualify as alimony b/c it is cash

(d) Same as (c) except that Roseanne pays the $5K annual premiums directly to the insurance company.o This is just like IT-4001 – first scenario – he owns the prop and she is paying the premiums. The initial

transfer is not alimony b/c it was not cash. (e) Same as (d) except that instead of transferring the policy to Tom, Roseanne retains ownership of the policy but irrevocably names Tom as its beneficiary.

o Not alimony b/c alimony cannot include payments for maintaining your own prop – Reg1.71-1T(b) Q6 o -Its irrevocable, but Tom still does not own the policy (b/c how is the IRS to know he’s an irrevocable bene.?)

Also, it must be per a written divorce decree.

Property Settlementso If transfer b/w spouses, and it isn’t alimony, it is tax neutral – not deductible by payor or included by payeeo 1041 – provides tax neutrality (no g/l recognized) if transferred b/w spouses or to a former spouse incident to

divorceo Here, unlike the gift rules, it is always a transferred basiso Incident to divorce = w/i one year or related to cessation of the marriage

So, if it’s within 1 year, then no matter what it’s incident to divorce. If not within 1 year, then it must be related to the cessation of marriage.

o 1.1041-1T(b) Q&A 7- Transfer of prop is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and occurs not more than 6 years after marriage ceases.

o This is a safe harbor default rule.o 1.1041-1T(a) Q&A 4 – Only transfers of property are governed by §1041. Transfers of services are not subject

to the rules of §1041.

Problems, p. 212:1. Michael and Lisa Marie’s divorce decree becomes final on Jan. 1, 2000. Discuss the tax consequences of the following transactions to both Michael and Lisa Marie.(a) Pursuant to their div. decree, Michael transfers to Lisa Marie in March, 2000 a parcel of unimproved land he purchased 10 years ago. The land has a basis of $100K and a FMV of $500K. Lisa Marie sells the land in April, 2000 for $600K.

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o -See '1041(a)(1)-(2) - applies to transfers to spouse or former spouse, but only if the transfer was incident to divorce. Here, it is incident to divorce and occurs w/i one year of divorce - '1041(c)(1). She will have a transferred basis of $100K and she’ll have a $500K gain when she sells it.

(b) Same as (a), except that the land is transferred to satisfy a debt that Michael owes Lisa Marie. The land has a basis of $500K and a FMV of $400K at the time of the transfer. Lisa Marie sells the land for $350K.

o -'1041 applies because still a transfer w/i 1 year of divorce which makes it incident to divorce. When she sells, she’ll have basis of $500K ('1015[e] - basis rule for gifts do not apply to spouse transfers!!) She’ll have a $150K loss when she sells.

o Note – if this were a gift instead of transfer b/w spouses, under 1015 her basis would have been 400k, and her loss would then be 50k. That is b/c when determining a loss for a gift, the basis that transfers is the FMV at the time of the transfer.

(c) What result if pursuant to the divorce decree, Michael transfers the land in (a) to Lisa Marie in March, 2005?o –It’s not w/i 1 year of divorce, so is it incident to the divorce? '1041(c)(2) - is it related to the cessation of the

marriage? Reg. 1.1041-1T(b), Q&A 7. Here, both requirements are met so '1041 applies. It is pursuant to a divorce decree and wi 6 years of cessation of marriage. Thus, her basis is $100K and her gain is $500K.

(d) Same as (c), except that the transfer is required by a written instrument incident to the divorce decree.o -Same as (c).o Is there a difference b/w “incident to” and “pursuant to” o Code states incident to and Regs state pursuant to…but talking about same thing o What is the difference b/w the 1 year and 6 year requirements? The difference is, w/i one year, it doesn’t even

have to be in any agreement – any transfer b/w them is “incident to divorce”. If out of 1 year, can be w/i 6 years if made pursuant to divorce or separation agreement.

(e) Same as (c), except that the transfer is made in March, 2007.o –It’s beyond 6 years, so it is presumed not to be related to the cessation of the marriage. But it’s still related to

the cessation of the marriage because the presumption can be rebutted. Regs. say to rebut, the parties must show that the purpose was to divide the marital property and that they were unable to complete the division within 6 years b/c of a business or legal impediment or there was a valuation argument.

o 93-06-015

Other Tax Aspects of DivorceChild Support

o 71(c) – Payments to support children. (1) (a) does not apply to that part of any payment which the terms of instrument fix as a sum which is payable for the support of children of the payor spouse.

o Child support is specifically excluded from def of alimony. o (2) For purposes of (1), if any amount specified in the instrument will be reduced (A) on the

happening of a contingency specified in the instrument as relating to a child (such as attaining a specified age, marrying, dying, leaving school, etc), or (B) at a time which can clearly be associated with such a contingency, an amount equal to the reduction will be treated as fixed as payable for the support of children of the payor spouse.

o These payments are automatically deemed to be child support o So if you say you will pay ex spouse until child reaches 18 then it doesn’t matter what you call it –

even if call it alimony, it is still child supporto Hypo: Divorce instrument requires the payor to pay $12,000 each year for the life of the payee spouse for the

payee’s support and for the support of their child. When the child reaches majority, marries or dies, the annual sum is reduced to $8,000. §71 provides that if any amount specified in the instrument will be reduced on a child attaining a specified age, marrying, dying, leaving school, or upon similar contingencies, or at a time which can clearly be associated with such a contingency, then the amount of the reduction will be treated as an amount “fixed” as payable for the support of the child of the payor spouse. Accordingly, of the $12,000 total paid, $4000 would be deemed fixed for child support and only $8000 would be for alimony.

o 1.71-1(c) Q&A 18 – When is a payment treated as reduced at a time clearly associated with contingency relating to a child? 2 situations qualify:

o Where payment are to be reduced not more than 6 months before or after the date of the child is to attain age of 18, 21 or the local age of majority or

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o Where the payments are to be reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24 inclusive

Problems, p. 214:1. Sean and Madonna enter into a written support agreement which is incorporated into their divorce decree at the time of their divorce. They have one child who is in Madonna’s custody. Discuss the tax consequences in the following alternative situations:(a) The agreement requires Sean to pay Madonna $10K / year and it provides that $4K of the $10K is for the support of their child.

o -Do not know if all '71 requirements are met, but assuming they are, $6K is alimony and $4K is c/s.o The 4k child support is not taxable – the 6k alimony is deductible by Sean and income to Madonna

(b) The agreement requires Sean to pay Madonna $10K / year, but when their child reaches age 21, dies, or remarries prior to reaching 21, the amount is to be reduced to $6K / year.

o -'71(c)(2)(A) - contingency - amount is reduced so, $4K is c/s and $6K is alimony. (c) The agreement requires Sean to pay Madonna $10K / year but that the payments will be reduced to $8K / year on Jan. 1, 2008 and to $6K / year on Jan. 1, 2012. Sean and Madonna have 2 kids: Daughter (born 6/17/1990) and Son (born 3/5/1993).

o -Daughter - 6/17/90 (+ 18 = 2008).o -Son - 3/5/93 (+18 = 2011).o '71(c)(2)(B) - at a time clearly associated w/ a contingency relating to a child, so amount of reduction is c/s.

How know if it’s clearly associated? o Reg. 1.71-1T(c), Q&A 18 - provides 2 situations (the only 2) that create the presumption that its clearly

related:1. Where payments are reduced not more than 6 mos. before or after a kid turns 18, 21,

or the local age of majority. <For 1 kid>2. Where payments are reduced on 2 or more occasions during not more than 1 year

before or after a different child of payor spouse attains a certain age. Also, must be same age for each child and 2+ reductions occur not more than 1 year before or 1 year after each child reaches between ages 18 and 24 - must be same age for each child. <For 2+ kids>

o Here, daughter reaches age 18 on 6/17/08. She turns 18 w/i 1 year after 1st reduction. Son, turns 18 on 3/5/11 - within a year before the 2nd reduction (not within 6 mos. of reduction). So the years of deduction correspond to the years the children become majors - 2nd presumption. If see 2+ reductions occurring w/i 1 year before or after reaching an age between 18 and 24 (same age for each), it looks like c/s. Say amounts are reduced on an occasion relating to a contingency...

(d) What result in (a) if Sean pays Madonna only $5K of the $10K obligation in the current year?o -Only $1K is alimony. Other $4K is child support. '71(c)(3).o Take amount fixed for child support – it doesn’t exceed so the diff of 1k is alimony. The person receiving the

money is penalized already b/c not receiving everything they should so we carve out the amount that is alimony. The remaining 4k is child support.

o Go to child support first – the first 4k is child support (not income for her and not deductible for him) and the remaining is alimony.

o Reasoning – if she is supposed to get 10k per month, it wouldn’t be fair if he were slacking on payment and he gets full deduction first. He must pay the whole amount to get the deduction.

Annuity Paymentso 71 and 215 do not apply to transfers of annuity b/c not cash – payee recognizes income under principles of 72.

so not alimony if annuity – recognize income under 72 principles

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o §682 – can set up a trust and make trust payments to W. §71 and 215 won’t apply. W treated as beneficiary of trust and will be taxed as beneficiary of trust. If part of the payments are child support, then H is treated as if he is the beneficiary of the trust.

o §682 applies to transfers of annuity and says that income from trust excluded from income of payor (so for the person paying in money, it will be excluded.) This provision needed b/c otherwise would be DOI income – b/c he is obligated to pay the amount. The payee treated as beneficiary of trust and taxed under normal trust rules. Thus any income related to trust, the portion relating to income will be taxed (as in a trust)

o 7701(a)(17) – applies when either H or W paying (even though code section only mentions H paying W)

Issues with Divorce Decree Itselfo The irs will generally not q the validity of any divorce decree for federal income tax purposes until a court of

competent jurisdiction declares the divorce to be invalid. After declared invalid, it is no longer alimony.o 67-442 revenue ruling – say sections 71 and 215 do not apply in situations from the beginning when they get a

divorce decree in place other than that of the spouse’s domicileo where a state court of competent jurisdiction declares the prior divorce to be invalid, the service will

usually follow the later court decision rather than the divorce decree for federal income tax purposeso deny the H section 215 deduction

o some cases hold – alimony paid by the payor spouse subsequent to the invalidation decree should not be income to the payee under section 71a or deductible to the payor under 215

o until date on which divorce decree is invalidated the divorce should be respected

Other Exclusions from GIGain from sale of principal residence

o Many people still think if you sell house, you must buy another one to get to exclude the gain – this is not true!! You no longer have to roll the gain into another house to exclude it.

o §121 – (a) Gi shall not include gain from the sale/exchange of prop if, during the 5-year period ending on the date of the sale or exchange, such prop has been owned and used by the TP as the TP’s principal residence for periods aggregating 2 years or more.

o Since the TP must own and occupy house for at least 2 of the 5 years prior to the sale, if they move and then sell house, it must be done wi 3 years

o (b) Limitations. (1) the amount of gain excluded from GI shall not exceed $250,000. (2) In the case of H and W filing a joint return, you can exclude up to $500,000 if (i)

either spouse meets the ownership requirements (ii) both spouses meet the use requirements and (iii) neither spouse is ineligible for the benefits of (a) by reason of para (3). If the spouses do not reach these requirements, the limitation is the sum of what the spouses would be allowed if they were not married. For these purposes, each spouse shall be treated as owning the prop during the period that either spouse owned the prop.

At least one spouse must own the house for 5 years and both spouses must use the house for 2 years to get the 500k exclusion. If not, only get 250k exclusion.

(3) Only 1 sale or exchange is allowed every 2 years. o (c) If a sale falls under this subsection, the ownership and use requirements do not apply, but

the dollar limitation is equal to (A) ratio of the shorter of the aggregate periods during the 5-year period ending on the date of sale that prop has been owned and used by the TP as his principal residence or 2 years. This subsection applies to any sale if (A) (a) would not apply b/c of failure to meet the ownership and use requirements of more than 1 sale in 2 years and (B) such sale is by reason of a change in place of employment, health, or, to the extent provided in the regs, unforeseen circumstances.

Ex - If you live in house for 1 of the 5 years prior to sale but you have to move b/c of change of job or health, you can’t take the whole 250k, but you get 125k

o Section (d) = Special Ruleso (d)(4) – Property owned by spouse or former spouse. In the case of an individual holding prop

transferred to him in a transaction under 1041(a), the period he owns the prop shall include the period that the transferor owned the prop.

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An individual is treated as using the prop as his principal residence during any period of ownership while his spouse or former spouse is granted use of the prop under a divorce or separation instrument.

o (d)(6) – (a) does not apply to the gain from the sale of prop that related to depreciation recapture.

if you use part of your home as a home office and you depreciate it, when you later sell your home, the part of sale gain that applies to the depreciation, you don’t get to exclude

o (d)(7) – If a TP becomes physically or mentally incapable of selfcare, and owns and uses prop as his principal residence for at least 1 year then the TP is treated as using the prop during the 5 year period before sale in which the TP owns the prop and resides in a facility licensed to care for a person in the TP’s condition.

If TP uses home as principal residence for 1 year and then moves into care facility b/c can’t care for themselves, they are treated as living in house while they are in facility.

o (d)(8) – At the election of the TP, the exclusion also applies to the sale of a remainder interest in the principal residence, but not if it is sold to a related party.

o What is residence? o §1.121-1(b)(1): Whether prop is used as the TP’s residence depends on the facts and

circumstances. Prop used as the TP’s residence may include a houseboat, a house trailer, or the house or apt that the TP is allowed to occupy as a tenant-stockholder in a cooperative housing corp.

o (2) – Whether prop is used as the TP’s principal residence depends on the facts and circumstances. If the TP alternates b/w 2 properties, using each as a residence for successive periods of time, the prop that the TP uses a majority of the time will be considered the principal residence. Also gives other factors relevant in the analysis of principal residence.

o A residence can include the surrounding prop as long as not used for biz or profit. So even if you have modest house, but is sitting on 500 acres, that is all included Ex of surrounding prop that is excluded – a farm.

o If TP sells land underneath house and moves the house, that is not sale of principal residence. It is sale of land.

o §1.121-1(c)(4) Ex 1 – Gen rule: TP A has owned and used his house as his principal residence since 1986. On Jan 31, 1998, A moves to another state. A rents his house to tenants from that date until April 18, 2000, when he sells it. A is eligible for the §121 exclusion b/c he has owned and used the house as his principal residence for at least 2 of the 5 years preceding the sale.

Problems, p. 226:1. Determine the amount of gain that TP=s (a married couple filing a joint return) must include in gross income

in the following situations:(a) TP=s sold their principal residence for $600K. They had purchased the residence several years ago for $200K and lived in it over those years.

o Assuming TP hasn=t used a portion of the home as an office (see below), the basis is $200K, so the realized gain is $400K. However, the gain is excluded under §121. IF they are filing jointly and neither has used the exclusion w/i past 2 years, they get the whole $400K exclusion. If there were filing separately, each can take $250K on their individual returns.

(b) TPs in (a) purchased another principal residence for $600K and sold it 2 1/2 years later for $1mill.o Same as (a).o They can exclude the full 400k because they have lived there for at least 2 years and the sale was outside of the

2 year limitation on selling principal residences. (c) What in (b) if the 2nd sale occurred 1 1/2 years later?

o -D/n know if they took the exclusion on the first home, or if second home was sold for job or health reasons. If so, only exclude a portion.

o Assuming they took the first exclusion, this time the exclusion won’t apply b/c you can only take advantage of exclusion every 2 years.

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(d) What in (b) if TPs sold their first residence and were granted nonrecognition under former §1034 (the rollover provision) and, as a result, their basis in the 2nd residence was $200K?

o -Old '1034 will haunt a lot of people. There, TP was permitted to exclude all gain if TP purchased another principal residence w/i 2 years before or after the sale of the 1st residence, and 2nd residence cost at least what TP sold the 1st home for.

o So, if TP got home for $20K and later sold it for $50K, the $30K gain wasn’t taxed if the new residence cost at least $50K and was bought w/i 2 years. The basis in the new residence was $50K minus gain not recognized (30K), or $20K. Then, when TP later sells the 2nd residence for $100K, he realizes a $80K gain. So now, older TPs may own homes worth $500K but only have a $20K basis.

o Under '1016, the TP retains the old '1034 basis. So if sell, still exclude only $250K or $500K.o Under (d), they can exclude $500K, but $300K is income, regardless of how much the next house cost,

because '1034 is gone now. (e) What in (a) if the residence was TPs summer home which they used 3 mos. out of the year?

o -All $400K is income. Its not a principal residence.(f) What result if TP who met the ownership and use requirements is a single TP who sold a principal residence for $400K and it had an adjusted basis of $190K after TP validly took $10K of post-1997 depreciation deductions on the residence which served as an office in TP=s home?

o The gain realized is 210. Since he is single TP, he can generally exclude 250k so could exclude all the gain. However, part of it is related to depreciation recapture. He can’t exclude this portion. Thus, he can exclude 210-10 = 200k.

2. Single TP purchased a principal residence for $500K and after one year Single sold the residence for $600K because Single’s ER transferred Single to a new job location.(a) How much gain must Single include in gross income?

o -If §121 applies, TP can exclude up to $250K, but there is a 2 year ownership problem here. Also do not know if TP sold another residence w/i 2 years. Assuming no prior sale w/i previous 2 years, look to fraction in §121(c) b/c its a job related move:

12 mos. x 250K = $125,00024 mos.

o So all of the $100K gain is excludable. (b) What in (a) if Single sold the residence for $700K?

o -$200K gain. Per (a), he could exclude up to $125K, so $75K is income.

NEW 4!!!! page 2333. TP has owned and lived in TP’s principal residence for 10 years, the last year w/ TP’s spouse after they married. Spouses decide to sell the residence which has a $100K basis, for $500K.(a) If the Spouses file a joint return, do they have any gross income?

o -Gain = $400K. '121(b)(2). Problem here is that only H satisfies the requirements. W does not. The ownership requirement is met by H, but both spouses must satisfy the living requirement to get the 500k exclusion. So only get $250K excluded per '121(b)(2)(B). This leave 150k to be taxed

o If W had lived in home w/ H before marriage, they would have gotten the whole $400K. o Live in sin!

(b) What result if Spouses had lived together for 2 years in TP’s residence prior to their marriage and sold the residence after one year of marriage for $500K?

o -See (a).o both spouses owned it, both lived there for 2 years, so they qualify under §121(b)(2)(a) for the full 500k

exclusion. o The spouses don’t have to be married to meet the 2 year use requirements, but they must be married and file a

joint return when they sell it. Also, if they each owned half the house and were not married, they could each exclude 250k on their own individual return.

o Reg 1.121-2(a)(4) ex 1&2. (c) What in (a) if after one year of marriage, TP pursuant to their divorce decree, deeded 1/2 of the residence to Spouse and Spouse lived in the residence while TP moved out and, one year later, they sold the residence for $500K?

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o -TP owns the home until divorce. Gain = $400K. Each spouse has $50K basis (spouse gets 1/2 basis of TP’s basis). Also, each spouse gets $200K gain. Q: Can each exclude their gain? TP can exclude his b/c he owned and used the home at least 2 out of last 5 years. But Spouse? Used home as principal residence for 2 o/o 5 years, but only owned 1 year. See '121(d)(3)(A) - where its transferred b/c of '1041(a), the period of ownership includes the period of the transferor’s ownership in the property. So Spouse owned for 10+ years and used it for 2 years. So Spouse gets to exclude the full $200K gain.

o Him – owned and lived in for more than 2 year – gets 250k exclusion. She meets live in requirement but not ownership. But, she can tack the holding period of her husband. 121(d)3a – can tack on the ownership of the other spouse if transfer under 1041.

o Note - TP could have tacked spouse’s use to his use if he did not otherwise meet the 2 year requirement 1.121-4b2

(d) What in (a) if after one year of marriage, TP pursuant to their divorce decree deeded 1/2 of the residence to Spouse and TP continued to occupy the residence while Spouse moved out, and, one year later, they sold the residence for $500K?

o -'1041 transfer. Each has $50K basis in the property. Ok for TP to exclude b/c all requirements are met. Spouse gets TP’s period of ownership, but Spouse only used the home as principal residence for 1 year. See '121(d)(3)(B) - only for §121 - spouse uses property as principal residence if spouse or former spouse used property per div. or sep. instrument. So Spouse is deemed to have “used” the property here for the time the TP used the prop and W gets the $200K exclusion.

4. Estate planner sold a remainder interest in Planner’s principal residence for $300K (its FMV) to Planner’s Son. Planner’s basis in the remainder interest was $125K. Does Planner have any gross income?

o Although §121(d)(8)(a) generally allows exclusion to apply, it does not apply to sale to related party. Thus, Planner must include the gain in GI.

Earned Income Abroad o §911 provides a limited exclusion for certain amounts of income earned abroado To qualify for the exclusion from GI, an Am citizen must be a bona fide resident of a foreign country or

countries for an uninterrupted period that includes an entire taxable year, or an Am citizen or resident must be present in a foreign country or countries for at least 330 days during any period of 12 consecutive months.

o The exclusion only applies to foreign earned income which is defined as income from a foreign source which is attributable to the TP’s performance of services.

o The max exclusion is currently 80k. o Thus, if a person has a job earning 80k per year and is an Am citizen working out of country, they can

exclude the first 80k from their income if it is related to their services o §911 also provides an exclusion for amounts paid as reimbursement of foreign “housing expenses” in excess

of a statutorily provided base housing amount, if the housing expenses are paid for by the TP’s ER. Qualified TPs whose housing costs are not paid for by Ers may elect to deduct a limited amount of housing costs in computing GI. The housing expenses include reasonable amounts paid for housing in a foreign country .

o Both of the exclusions (earned income and housing) are elective and once elected remain in effect for future years unless revoked.

Deductions in Computing Taxable IncomeBusiness DeductionsIntroduction

o §1 – contains the various tax rates o §63(a) – defines TI as GI less allowable deductions (other than the standard deduction) o Expenses can be constitutionally disregarded. Under the Con, if it is GI, it can be taxed

o Deductions are narrowly construed - find a stat specifically allowing a deduction in order to take it

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The Anatomy of the Business Deduction Workhorse: §162o §162(a) – There shall be allowed as a deduction all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or business, including, (1) a reasonable allowance for salaries or other compensation for personal services actually rendered (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business (3) rentals or other payments req’d to be made as a condition to the continued use or possession, for purposes of the trade or business, of prop to which the TP has not taken or is not taking title or in which he has no equity.

o TP will not be treated as temporarily away form home during any period of employment if such period exceeds one year.

o 1.162-1(a) – Business expenses are not deductible to the extent they are used as a basis for a deduction or credit under other provisions of the law.

o Included in business expenses are management expenses, commissions, labor, supplies, incidental repairs, operating expenses of cars used in the trade or business, traveling expenses when away from home solely in pursuits of a trade or business, advertising and other selling expenses, together with insurance premiums against fire, storm, theft, accident or other similar losses in the case of a business, and rental for the use of business property.

o The full amount of the allowable deduction for ordinary and necessary expenses is deductible, even though such expenses exceed the GI derived during the taxable year from such business.

o This sounds really simple, but the application is difficult. This is one of the most litigated areas. There is no black and white rule here.

Ordinary and NecessaryWelch v Helvering o TP was secretary of Welch Co, which went bk so the TP decided to start his own bizo To reestablish relations with the customers he paid the debts of the Welch Co to the extent he was able to. He

was not obligated to pay – he just did it to establish relationso IRS said payments are cap outlays for reputation and GW and are not deductible expenses.o Is this payment necessary? The ct assumes the payments were necessary b/c the TP thought they were and they

were hesitant to override his judgment. o Generally, if the TP thinks an expense is necessary, the ct agreeso Is this payment ordinary? (b/c it must be both)o What is ordinary is a variable affected by time and place and circumstance. Ordinary does not mean that the

payments must be habitual or normal in the sense that the same TP will have to make them often. Even if the situation is unique in the life of the individual affected, as long as it is not in the life of the group or community in which he is a part, it can be ordinary.

o So the Q is, if someone were to open a biz in a related field, would that person be paying the debts?o There is no verbal formula to define ordinary. “Life in all its fullest must supply the answer to this riddle”

o This means it is a facts and circumstances analysis. Must look at each case on the merits and determine if a person in that position would make the expenditure

o Ct concluded that this was a necessary expense, but not ordinary expense in the operation of a biz – it is more along the lines of a capital outlay – an expense you pay to help you down the road

o Contrast with Jenkins v Commissioner: Conway Twitty started fast food restaurant which failed. He paid off the debts to protect his reputation. Here, the ct allowed the deduction b/c they held it was necessary for Conway to continue in his country music immediately vs. something that would benefit him in the future.

Pg 319 1. Taxpayer is a businessman, local politician who is also an officer of a savings and loan association of which he is

founder. When partially due to his mismanagement, the savings and loan began to go under, he voluntarily donated nearly ½ a million dollars to help bail it out. Is this deductible under 162?o is it an immediate need to pay the expense to continue the biz or is this more of a long-term benefit (in which

case it is a cap outlay and must be capitalized)?

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o Gould – EE of corp who is also the sole SH owed money to his ER - he was allowed the deduction on payment of debt to creditor b/c he made the payment to retain his status as EE. Ct said this was immediate (would have lost job), so deductible.

o Loups – dealer in agricultural produce made deductible payoff of debt of corp biz in order to maintain his own credit rating and retain license to deal in ag commodities. Here, it was more of immediate need – couldn’t have continued biz wo repayment

o Conti – allowed expense to be deductible b/c it protected his business rep as to providing GWo Distinction – in Welch, he was generally improving his GW. In Conti, it was needed immediately to

continue business as a businessman.

2. E’ee incurred ordinary and necessary expenses on trip that she could have been reimbursed by her ER for. She failed to fill out the voucher to get reimbursed. Can she take this as a deduction? o It is not ordinary b/c an ordinary person in that situation would have filed out voucher and gotten

reimbursement even though she was withholding so as not to be criticized for spending so much. It is not ordinary thing to do to pay yourself when you could have gotten reimbursed.

o Flowers – TP was independent contractor entitled to expense reimbursement on death or retirement. They paid expense themselves, but whenever dies got reimbursement. Ct said not deductible expenses, they were effectively loans and the ER could deduct the expense whenever they paid it upon the death of the EE

Expenseso §263(a) – No deduction shall be allowed for (1) Any amount paid out for new buildings or for permanent

improvements or betterments made to increase the value of any property or real estate (2) any amount for restoring the prop.

o No deduction allowed for capital expenditures. You can’t deduct, you must capitalize and include as part of your basis

o Must distinguish b/w deductible expenses and capital expenseso Really a matter of timing – if deductible, you immediately deduct and save money on taxeso If cap, you still deduct (write it off over time - still deductible, just not immediately) or you can deduct it when

you sell the itemo So this really deals with the time value of money, which is still valuableo Ex – if you deduct $500,000 this year, it might save you $200,000 in taxes. You can take this money

you would save and put in CD and earn 5% interest. But, what if you have to capitalize and recoup the investment over 5 years (you don’t deduct it

all in the first year, but spread it out over 5 years.) If you do this, you don’t earn the interest on the CD. Thus, the value is less.

Thus, in this example, you being able to deduct today saves you money. o Idaho Power Co – Issue: Are depreciation expenses on equipment used to construct other property expense

now, or capitalized? Holding: Capitalized b/c the capital outlay is really benefiting the construction of the new asset that will be used over time.

o Accepted accounting practice and established tax principles require the capitalization of the cost of acquiring a capital asset. It has long been recognized, as a general matter, that costs incurred in the acquisition of a capital asset are to be treated as capital expenditures. This principle applies to the acquisition of a capital asset by purchase, but has also been applied to the costs incurred in a TP’s construction of capital facilities. Other construction related expense items – tools, materials, wages paid to construction workers – are treated as part of the cost of acquisition of a capital asset. When wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and then are amortized over the life of the capital asset.

o Construction related depreciation is not unlike expenditures for wages for construction workers. Construction related depreciation on equipment is not an expense to the TP of its day-to-day business. It is part of the TP’s cost or investment in the capital asset.

o Additionally, capitalization of construction related depreciation by the TP who does its own construction work maintains tax parity with the TP who has its construction work done by an independent contractor. The depreciation on the contractor’s equipment incurred during the

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performance of the job will be an element of cost charged by the contractor for his services, and the entire cost will be capitalized by the TP having the construction work performed.

The point is that any expenses incurred in constructing prop, whether it be tools, etc or depreciation deductions must all be capitalized instead of expensed.

This rule is contained in §263A.

Midland Empire Packingo TP installed concrete lining in basement to oil-proof it. Is it a §162 deduction or a capital expenditure?o IRS said capital b/c they are improving the basement. o Repairs are clearly deductible (specifically named in reg) but improvement have to be capitalizedo So is this repaid or improvement? o §1.162-4 – The cost of incidental repairs which neither materially add to the value of the prop nor

appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the TP’s plant, equipment or other prop is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the prop, shall be capitalized.

o So if simply repairing to keep in operable condition – it is repair and is deductible. If you are somehow improving its life, that is capital expenditure

o Illinois Merchants Trust – “It will be noted that the first sent of the article relates to repairs while the second deals with replacements. In determining whether an expenditure is capital or chargeable a/g operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied a/g current earnings.”

o In this case, they used the basement to cure hams, so they couldn’t have oil in the basement. In fact, the fed meat inspector said the only way they could keep using it was if they took care of the oil. The repairs didn’t add to the value or improve the basement – it simply keep it operable.

o Remember Welch - the expense does not need to be common to be ordinary. It doesn’t matter if this is the only time that the TP does this, it can still be ordinary. This specific TP doesn’t have to ordinarily do this, as long as it is ordinary for a person who cures ham to do this in this situation.

o This was the ordinary thing to do in this case- this was a repair and deductible o American Bemburg – allowed deductions, on the ground that they were ordinary and necessary expenditures to

prevent disaster, although the repairs were of a type which had never been needed before, and were unlikely to recur. The repairs were necessary to continue operating.

o Basic Distinction = TP can paint, patch, repair and add some new shingles. These are ordinary and necessary business expenses. If one undertakes in the same activities as part of an overall restoration of a building, one must capitalize these expenditures.

o Note – the fact that expenses are made under compulsion are irrelevant – the issue is still whether it improves the life or is necessary to keep the thing operating (must look at what the expenditures actually do.

INDOPCO o Issue – whether or not professional expenses incurred by target corp in the course of a friendly takeover are

deductible expenses or nondeductible capital expenditures?o The TP deducted these expenses. The IRS said to capitalize b/c they were incurred in the course of the

takeover. It was more long-term.o The Tax ct held they were capital in nature b/c of the long-term benefits of the acquisition.o The SCOTUS cites 162 and 263

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o The burden for proving that a deduction exists is on the TP. Deductions are strictly construed and only allowed if you can find a specific statute.

o Ct says – it does not have to create a separate and distinct asset in order to capitalize it. o In order to determine, you need to look at whether there is some future benefito Here, they concluded that the fact that there were significant future benefits is imp. If an expenditure creates

significant future benefits, arguably under INDOPCO, you should capitalize and not deduct it. o “Courts more frequently have characterized an expenditure as capital in nature b/c the purpose for which the

expenditure is made has to do with the corporation’s operations and betterment, sometimes with a continuing capital asset, for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year.”

o The future benefit is undeniably important in determining if it’s a deductible expense or must be capitalized.o If there is no undeniable future benefit and it meets the other requirements, then it can be deducted

o What does this mean? If you advertise, there is clearly a significant future benefit. People will remember the advertisement and continue biz for a long time. So people were uneasy – was nothing deductible?

o To clarify, the IRS issued regs which deal with the capitalization rules for intangible assets (Indopco dealt with legal fess, acting fees, etc – so they were intangible assets)

o The final regs deal with whether or not you can capitalize the intangible asst or expense it. o §1.263(a)-4 (a)-(c)(1); (d)(1); (e)(1)(i); (e)(2)-(4)(i)o §1.263(a)-5(a) & (b)(1)o Note – advertising expenses are deductible

Pg. 330- gives a good summary of case holdings and their positions on deductions

o 1.263-(a)-4(b)(1) – Except as otherwise provided, a TP must capitalize an amount paid to: o (1) Acquire an intangible o (2) Create an intangibleo (3) Create or enhance a separate and distinct intangible asset o (4) Create or enhance a future benefit identified in published guidance as an intangible for

which capitalization is req’d under this section Leaves open for IRS to come out with rev rules or procedures on specific guides for specific

itemso (5) Facilitate an acquisition or creation of an intangible

o (b)(3)(i) – The term separate and distinct intangible asset means a property interest of ascertainable and measurable value in money’s worth…

o (b)(3)(ii) – Amounts paid to another party to create…an agreement with that party that produces rights or benefits for the TP are treated as amounts that do not create a separate and distinct intangible asset w/i the meaning of this paragraph.

o (b)(3)(iii) - Amounts paid for performing services are treated as amounts that do not create a separate and distinct intangible asset (won’t have to capitalize); (b)(3)(iv) - creation of computer software (if you pay someone to write computer program for you, you don’t have to capitalize unless it is req’d to be capitalized under another section); (b)(3)(v) - amount to create a package design (arguably under the general rule it would be separate and distinct, this says that you don’t have to capitalize and can expense the amount)

o –4(c) – gives examples of amounts paid to acquire an intangible, which must be capitalizedo –4(d)(1) – The determination of whether an amount is paid to create an intangible is to be made based

on all the facts and circumstances.o –4(e)(1) – amount paid to facilitate the acquisition…If you are looking at acquiring intangible and you are

thinking of hiring an appraiser, you must capitalize that fee and cannot expense ito 1.263(a)-5 – different ways to acquire companies. This is spelled out the INDOPCO case.

o (b) Amt paid to facilitate transaction described in (a) if the amount is paid in the process of investigating or otherwise pursuing the transaction.

Problems – pg 336

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1. Landlord incurs the following expenses during the current year on a 10-unit apartment complex. Is each expenditure a currently deductible repaid or a capital expenditure?

o Note – these deal with tangible assets, so dealing with prior cases and not the regs (b/c they deal w intangible assets)

(a) $350 for painting one of the 3 rooms of one of the apartmentso Deductible expense b/c keeps it operating - not extends the lifeo Painting has been held to be capital expenditure where it is part of the general reconditioning or overhaul

project. This is more along the lines of an improvement and substantially prolonging the life(b) $1500 for replacing the roof over an apt. The roof had suffered termite damage

o This will need to be capitalized. It is an improvement that prolonged the life. The fact that it is compulsory is irrelevant.

o If all they are doing is patching the roof, then it would be expensed and deductible – it is just keeping it operable, not prolonging the life

o Issue – does replacing the roof over one apt prolong the life of the entire apt complex? More than likely it is an improvement either way. But maybe you can argue that just replacing a part of the complex will still require you to replace the entire roof in 5 years and maybe you can expense it.

o Georgia Car o Patching roof is expensed – Kingly

(c) $500 for patching the entire asphalt parking lot area.o Since patching, probably means you are trying to just keep it in normal operating condition. It is a repair vs an

improvement(d) $750 for adding a carport to an apt

o This is capital. Is there any way to say it is necessary to put up a carport? Doubt it!(g) $100 for advertising for a tenant to occupy an empty apt.

o Expense per Indopco – even though created future benefits, it is needed for operation. Advertising as a gen matter is deductible expense

3. Suppose the TP in INDOPCO had performed some of the services in connection with the takeover transaction itself “in house.” Would the proposed regs require those expenses to be capitalized? Compare that situation with the TP who pays an EE in connection with the construction of a new building. Is the difference in the results justified?

o 1.263-4(e)(4)(i) – EE compensation is treated as not facilitating the acquisition of an intangible so it is deductible.

o Contrast this with Idaho Power – with regard to tangible assets, in house services performed are not deductible and have to be capitalized.

o It is diff if you pay own EEs in compensation, then it is not treated as facilitation of an intangibleo Issue is whether the expenses facilitated the acquisition.

o Rule – an amount paid to facilitate acquisition or creation of an intangible asset has to be capitalized. o Issue – Whether EE expenses facilitate acquisition of an intangible – EE compensation not considered

to facilitate o Bottom line – if what you are creating is intangible – then it is deductible. If tangible, has to be capitalized.

o If it prolongs the life, expands the property, replaces the property, then these are situations where it has to be capitalized.

o Jk thinks this is probably not justified

“Carrying On” a biz§162(a); 195; 262Regs §1.195-1(a)

o You can only deduct under §162 if you are “carrying on a trade or biz”

Morton Frank v Commissionero TP incurred substantial expenses searching for newspaper biz to purchase. He finally bought newspaper. The

issue is whether these expenses were incurred while carrying on a trade or biz?

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o You actually have to be carrying on the trade or business for it to count as a deduction. If Frank had already been in the newspaper business, then it would have been deductible.

o “The trips made by the TP were not related to the conduct of the biz that they were then engaged in but were preparatory to locating a biz venture of their own. The expenses of investigating and looking for a new biz and trips preparatory to entering a biz are not deductible as an ordinary and necessary biz expense incurred while carrying on a trade or biz. The word “pursuit” in “in pursuit of a trade or biz” (old statutory lang) is not used in the sense of “searching for” or “following after”, but in the sense of “in connection with” or “in the course of” a trade or biz. It presupposes an existing biz with which TP is connected.”

o They can’t deduct b/c they were not in “pursuit of biz” (under current lang, they were not “carrying on a biz”)o If he was currently in newspaper biz and were looking to expand, then prob could deducto Also distinguish this from situation where the TP has entered into the transactional stage (located biz and is

now negotiating to buy). Those expenses are normally capitalized. o §195(a) Capitalization of expenditures: No deduction shall be allowed for start-up expenditures. o §195(c)(1) – “start-up expenditures” = any amount (A) paid or incurred in connection with (i)

investigating the creation or acquisition of an active trade or biz, or (ii) creating an active trade or biz or (iii) any activity engaged in for profit and for the production of income before the date on which the active trade or biz begins, in anticipation of such activity becoming an active trade or biz and (B) which, if paid or incurred in connection with the operation of an existing active trade or biz, would be allowable as a deduction for the taxable year in which paid or incurred.

o §195(b) Allowance of deduction: If TP elects, with respect to any start-up expenditures, the TP shall be allowed a deduction for the taxable year in which the active trade or biz begins equal to the lesser of: (i) the amt of start-up expenditures with respect to the active trade or biz or (ii) $5000 reduced by the amount by which the start-up expenditures exceed $50,000.

o The remainder of the start-up expenditures are allowed as a deduction ratably over the 15 year period beginning with the month in which the active trade or biz begins.

o Note – you cannot amortize your start up expenses unless you actually start the biz. o Note – the reason you cannot deduct the start up expenses is b/c you are not carrying on a trade or bizo What if you are seeking growth or employment in a trade or biz you are already in? §195 does not

apply b/c already in the trade or biz. Being an EE constitutes being in the trade or biz RR 75-120: You are considered in the trade or biz even if looking for a new job (but must be

looking w/i the same trade or biz you are already in). Does not apply to a new trade or biz You are not in the trade or biz if there is lengthy unemployment

Problems pg 3441. Determine the deductibility under '162 and §195 of expenses incurred in the following situations:(a) Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric millionaire. Tycoon decided to invest a part of her fortune in the development of industrial properties and she incurred expenses in making a preliminary investigation.

o Tycoon is a doctor and not in the business of developing property. Thus, this is not deductible under §162 b/c she is not already in the trade or biz. Start-up costs can be capitalized and amortized under '195 over 15 years or longer once the business starts (if make election.)

o Why spread over 15 years? B/c often in early years, there=s more deductions than income so want to spread out deductions for later years when have greater income.

(b) The facts are the same as (a) except that Tycoon, rather than having been a doctor, was a successful developer of residential and shopping center properties.

o Tycoon is going from shopping center properties to industrial property. Is expanding an existing trade/business still applicable under '162? Are these properties similar enough?

o York (1958) - Yes, it’s all real estate. If it’s just an expansion, it’s deductible under '162 and it’s not start-up costs.

o This would be an expansion, so deductible. She is already in the trade or biz here, so since she is, she can deduct under §162 which is better than amortizing under §195

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(c) Same as (b), except that Tycoon, desiring to diversify her investments, incurs expenses in investigating the possibility of purchasing a professional sports team.

o Just investigating the possibility of purchasing is not deductible under §162 b/c not ordinary and necessary.o Doesn’t say that she actually did diversify and purchase the team and investigation expenses are not deductible

under §195(a). Must enter transactional stage before they are deductible.o So, she cannot deduct these expenses and she can only capitalize and amortize these expenses if she actually

purchases the team(d) Same as (c) and Tycoon purchases a sports team. However, after two years Tycoon’s fortunes turn sour and she sells the team at a loss. What happens to the deferred investigation expenses?

o Under §195she can capitalize and amortize those expenses since she entered the trade. o §195(b)(2) – In any case in which the trade or biz is completely disposed of by the TP before the end of the 15

year period, any deferred expenses may be deducted at that time. o So, at the end of year 2 when she sells the team, she can deduct the remaining investigation expenses at that

time.

2. Law Student’s Spouse completed secretarial school just prior to student entering law school. Consider whether Spouse’s employment agency fees are deductible in the following circumstances:(a) Agency is unsuccessful in finding Spouse a job.

o Not deductible under §162 b/c she is not already carrying on a trade or biz. o Rev Ruling 75-120 supports this o Can’t capitalize and amortize under §195 unless actually get into biz

(b) Agency is successful in finding Spouse a job.o Same answer o Not deductible under §162 b/c not already carrying on a trade or business. Unclear whether §195 applies to

EEs. 195(b) requires an active trade or biz which seems to exclude EEs. If she was in the biz herself, then could deduct, but it is unclear what happens if you enter as an EE. The legislative history supports this (that 195(b) doesn’t apply to EEs).

(c) Same as (b), except that Agency’s fee was contingent upon its securing employment for Spouse and the payments will not become due until Spouse has begun working

o Like Hundly – she makes no payments until she is actually in the trade or biz. It is deductible if in the trade or biz when you make the payments.

o The payments aren’t made until you’re in the trade or business, so it would be deductible.(d) Same and (a) and (b) except that Spouse previously worked as a secretary in Old Town and seeks employment in New Town where student attends law school.

o As long as she is seeking employment in the same line of work, it is deductible.o If there is substantial lack of continuity, then no longer deductible b/c not in trade or bizo If sit out of work for several years (lengthy unemployment) and then try to find job, then it is not deductible

b/c there is not substantial continuity. o Look at the time of unemployment to determine!

(e) Same as (d) except that Agency is successful in finding Spouse a job in New Town as a bank teller.o Probably not deductible b/c it is different line or work – arguably a diff trade or biz!o Might try to argue that it is deductible if you are looking for job as secretary, but find one as teller instead. o But if looking for job as teller from the beginning, it is diff trade or biz and not deductible.

Specific Business Deduction“Reasonable” Salaries§162(a)(1); 162(m); 280(G)Regs 1.162-7, -8, -9

o §162(a)(1) – Allows a deduction for all the ordinary and necessary expenses paid or incurred in carrying on any trade or biz including a reasonable allowance for salaries or other compensation for services actually rendered…

o Regs give examples of when salaries might be unreasonable:

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o 1.162-7(b)(1) – Any amount paid in the form of compensation but not in fact as the purchase price of services is not deductible.

o So if paying someone salary, and it is not really salary then it might not be deductibleo An ostensible salary paid by a corp may be a distribution of a dividend on stock. This is likely to

occur in the case of a corp having few SHs, practically all of whom draw salaries. If the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stock holdings of the officers or EEs, it would seem likely that the services are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings on the stock.

A C Corp must pay taxes at the corporate level. When they declare a dividend, there is a second tax at the SH level. Common way to get around is to 0 out the corp tax by paying it all as a salary.

Ex – you are only SH and corp earns 1M. You can pay it all out as salary. So instead of having 1M income and paying tax on it at the corp level, you pay it all out as salary and pay tax on your individual income and avoid the double tax.

However, the salary must be reasonable. So if not reasonable, the IRS will say that there is no way that you should have earned 1M. It is effectively a dividend. Then the 1M will be allocated b/w what is a reasonable amount to pay you as salary, and the rest will be taxed at the corp level as income and considered distributed to you as a dividend. You will then be taxed on it again. Ex: if 100k is reasonable salary, you will receive 100k as income to report on your individual tax return, and the Corp can deduct it as a reasonable salary paid. But, the remaining 900k will be taxed as income to the Corp, and then will be taxed as a dividend when distributed to you.

o An ostensible salary may be in part payment for property. This may occur where a pship sells out to a corp, the former Ps agreeing to continue in the service of the corp. In such a case, it may be found that the salaries of the former Ps are not merely for services, but in part constitute payment for the transfer of their biz.

Ex – Ps say they will help minimize taxes down the road and you pay us a salary for that, but it is really not worth what they pay for it.

o Exacto Spring Corpo Facts: Closely held corp. Co founder, chief executive and owner had 1M and 3M in salary. IRS said

he should not have been paid more than 380k and 400k for those yearso Issue – what is the reasonable amount?o Tax Ct found reasonable amount was 900k and 700k – which was basically in b/w the salary paid and

what the IRS said should have been paido TC gave 7 factor test (none entitled to any specific weight relative to another)–

Type and extent of services rendered Scarcity of qualified e’ees Qualifications and prior earning capacity of e’ee The contributions of the e’ee to the business venture. Net earnings of the e’or Prevailing compensation paid to e’ees w/ comparable jobs. Peculiar characteristics of the e’ors business.

o The appellate court says the test is inappropriate (pretty much slammed it) to use b/c: (1) It is non-directive – doesn’t give any indication on how to weight it. (2) No clear relation of the factors either to each other or to the primary purpose of §162 (to

prevent dividends which are not deductible from income as being disguised as salary and being deducted)

(3) TC is setting itself up as personnel dept for closely held corps (they are the ones determining how much someone should be paid)

(4) It invites arbitrary decisions (the TC came up with figures right in the middle of the dispute – there is no way the 7 factors came up with this amount – it was just a number pulled out of the air)

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(5) It is unavoidable and there are risks as to what you pay EEso TC found most of these factors favored the TP, but they still split the baby so it doesn’t make much

senseo Thus, the ct rejects the 7 factor test and other multi factor tests and adopted an “independent investor

test” Independent Investor Test: look thru the lens of an independent investor and determine how

much they would be willing to pay you as your salary Rule: determine how much an independent investor would be willing to pay an EE

“Indirect mkt test” – corp can be analogized to a K where the owner of assets hires a manager to manage assets. Owner pays the manager a salary and in exchange, the manager works to increase the value of the assets. The higher the return on the assets, the higher the manager’s salary can be. If the rater of return is extremely high, it is difficult to prove that the manager is being overpaid.

Thus, if you hire person who makes you more money, it makes sense to pay more.o They reversed the TC. This is the first ct to reject the multi factor test. This is the only circuit to not

use the multi factor test. All other circuits use some form of the factors or use the multi factor test along with the independent investor test

o From a practitioner’s standpoint – JK thinks that even if the 7 factor test is arbitrary, so is the independent investor test. Most of it is a smell test. If every year the salary comes out equal to the income, then it looks bad. However if you pay the same amount every year, and it is normal to pay this amount, it is probably fine.

o At the end of the day, it is facts and circumstances and just need to make sure that it really is salaryo 1.162-9 – Bonuses to EEs: Bonuses to EEs will constitute allowable deductions from GI when such

payments are made in GF and as additionally compensation for services actually rendered by the EEs provided that the payments, when added to stipulated salaries, do not exceed a reasonable compensation for the services rendered. Donations made to EEs and others which do not have in them the element of compensation or which are in excess of reasonable compensation or which are in excess of reasonable compensation for services are not deductible from GI.

o 1.162-7(b)(2) – The form or method of fixing compensation is not decisive as to deductibility. Rule: Generally speaking, if contingent compensation is paid pursuant to a free bargain b/w the ER and the individual, made before the services are rendered, not influenced by any consideration on the part of the ER other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the K it may prove to be greater than the amount which would ordinarily be paid.

o If you set the thing up b/f the services rendered, and it is a free bargain, etc, but ends up making someone 10M, it is still reasonable b/c when you set it up, it was a free bargain.

o Even though you make a lot more money in hindsight, as long as you made the reasonable agreement beforehand, then it’s ok.

It cuts both ways…if you don’t do so well, then you won’t get the large amount of money.

Harold’s Clubo Co paid Smith 10k plus % of the profits, which was a significant amount. Co was owned by Smith’s two sons.

The issue is whether the salary was reasonable. o TC said arrangement is not the result of a free bargain b/c of the family relationship and the fact that the father

dominated the two sonso The 9th circuit said it is a factual determination – ultimately agreed with TC that father dominated sons. o If the compensation is unreasonable and can’t be deducted as salary, what is it?o It is prob a gift (can’t be a dividend b/c dad is not a SH). So not only does the corp lose the deduction, it is

taxable to the sons. (has to get to father thru the sons) – so taxed at corp level and then taxed again when the sons take it out, and then possibly gets hit with gift taxes.

o Note – only the portion they determine to be unreasonable is what will be subject to tax and not deducted. So whatever is reasonable salary is still allowed to be deducted as salary.

Golden Parachute Payments

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o BOD and officers would make a K saying that if someone takes over this co, we each get 10M and we bail out of co. This is perceived to be unfair to the SH of the corp. To prevent this, Congress imposed §280G which disallows a deduction for a parachute payment from the corporate perspective. Also §4999 imposes excise tax to the recipient. So you can still do this, but it is not deductible at corporate level and the recipient gets an excise tax.

o Generally, if a company is going to be taken over, the executives are going to be paid a windfall. So, this prevents other companies from taking over your company so they won’t have to pay the windfall. This wasn’t good for the SHs and the public because the executives may sign off on a takeover, even if it wasn’t in the best interests of the shareholders.

o 2 consequences:o No deduction for corporationo Recipient must pay excise tax

o §280G(a) – No deduction shall be allowed for any excess parachute payment. o § 280G(b)(1) – “Excess Parachute Payment” = an amount equal to the excess of any parachute payment

over the portion of the base amount allocated to such payment. o (2) “Parachute Payment” = any payment in the nature of compensation to or for the benefit of a

disqualified individual if (1) the payment is contingent on a change (I) in the ownership or effective control of the corporation, or (II) in the ownership of a substantial portion of the assets of the corporation and (2) the aggregate present value of the payments in the nature of compensation to or for the benefit of such individual which are contingent on the change equals or exceeds 3 times the base amount.

o Can be stock or asset acquisitiono So the general rule, if there is a payment in the nature of compensation contingent on acquisition and it

exceeds 3 times the base amt = parachuteo §280G(b)(3) - Base amount = TP’s individualized includible compensation for the base period.

o Base period = generally the 5 taxable years ending prior to the year of change in control.o To determine base amount, take 5 years of annual compensation prior to change of control (base

period) and take average annual income over that time frame prior to the payment. If the compensation is 3x that base amount, then it’s a parachute payment and 280G will apply.

o These rules only apply to disqualified individuals. o Disqualified individuals – EE, independent contractor or other person specified in the regs who

performs personal services for the corporation and who is an officer, SH, or highly compensated individual of such corporation.

So if the regular workers get some sort of bonus, that’s ok. This rule only deals with the upper level EEs

The upper echelon of the corporation (calling all of the shots)o If the payment exceeds 3 times the base amount, then it is a parachute payment, but the disallowance is only 1

time above the base amount. o So in order to qualify as parachute payment, then it must exceed 3 times base amount. If it is a

parachute payment, then 280G only disallows 1 times the base amount. o §280G(b)(4) – The amount treated as a parachute payment will not include the portion of the payment

which the TP establishes by clear and convincing evidence is reasonable compensation for personal services.

o Ex: As part of the take-over negotiations, a CEO may be permitted to keep working. They new co may substantially raise his salary. Technically, you may meet the def of parachute payments, but if you can show that it is not a real parachute payment, the excess amount will be reduced by what you prove.

o The rebuts the parachute payment presumptiono Hypo: Disqualified individual’s base amount is $100,000. A payment totaling $400,000 which is contingent

on a change in control, is made to the disqualified individual on the date of the change. o Parachute payments total $400,000 and the provisions of §280G apply b/c $400,000 exceeds $300,000

(which is 3 times the base amount.) o Excess parachute payments are as much as $300,000 ($400,000 less the $100,000 base amount).

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o What if TP establishes by clear and convincing evidence that reasonable compensation for services compensated for by the parachute payment total $150,000?

Excess parachute payments will equal $250,000 ($300,000 less ($150,000 less $100,000)o What if the payments contingent on the change in liability total $290,000?

§280G does not apply. The payment does not equal or exceed $300,000 (3 times the base amount)

This result follows even if the TP were unable to establish that any of the $290,000 was reasonable compensation for personal services actually rendered.

o §162(m) – In the case of any publicly held corp, no deduction shall be allowed for EE remuneration to a covered EE the extent that it exceeds 1M for a taxable year.

o The 1M ceiling only applies to “covered” EEs.o §162(m)(3) – “Covered EE” = CEO or EE whose total compensation is req’d to be reported to SH b/c he

is among the 4 highest compensated officers for the taxable year. o So if you just pay straight up 1M of compensation to an EE, the corp cannot deduct the amt

o §162(m)(4) - Exceptions:o Commission, Performance-based, amounts excluded from recipients GI, payments under

binding K before 1983…o What happens with the large cos is the pay 1M flat salary but give larger salaries thru stock options. This

meets exception of comp paid solely on acct of performance goals. This way, the Corp can still deduct the salary under §162(m)

o Note – even if it meets the exception, the compensation still must be reasonable under 162(a). Also, even if the compensation is less than 1M, it still must be reasonable.

Problems pg 3591. EE is the majority SH (248 out of 250 shares) and president of Corporation. Shortly after Corp was incorporated, its Directors adopted a resolution establishing a contingent compensation K for EE. The plan provided for Corp to pay EE a nominal salary plus an annual bonus based on a percentage of Corp’s NI. In the early years of the plan, payments to EE averaged $50,000 annually. In recent years, Corporation’s profits have increased substantially and, as a consequences, EE has received payments averaging more than $200,000 per year. (a) What are Corporation’s possible alternative tax treatments for the payments?

o Under §162(a)(1) if they can show it was reasonable, then they can deduct it (general rule).o Contingent payments regulations - Must be a free bargain established before the services are renderedo If he owns 248 out of 250 shares is it a free bargain? Hard to say free bargain if he completely controls the

corpo Start with 162(a)(1) – Exacto Springs – to determine whether it is reasonable use the multi factor test. o But remember, since it is a contingent fee, it can still be reasonable in hindsight under Harold’s Club and the

Regs if it constitutes a free bargain b/f the services are actually rendered. (b) What factors should be considered in determining the proper tax treatment for the payments?

o Determine whether it is reasonable compensation under normal rules (162(a)(1))o Begin with the 7 factors (Exacto Springs) or the independent investor test

o Then decide if free bargaino But there is also the 1M cap unless he meets some of the exceptionso At the end of the day, it’s a totality of the circumstances test to determine if the compensation was reasonable.

(c) The problem assumes EE always owned 248 shares. Might it be important to learn that the compensation K was made at a time when the EE held only 10 shares?

o Here, it would be easier to establish that it was a free bargain as req’d in 1.162-7(b)(2) since he only owned 10 shares (appears that he doesn’t own the corporation…having 248 shares appears that it would not be a free bargain)

o This appears to be free bargain and arms length b/c he had to make the deal with someone else

Travel “Away From Home”§162(a)(2); 162(a) second to last sentence; 274(n)(1)

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§1.162-2 (omit –2(c))o 162(a)(2) –Allows a deduction for ordinary and necessary expenses paid or incurred during the taxable year

in carrying on a trade or biz including traveling expenses while away from home in the pursuit of a trade or biz.

o For purposes of paragraph 2, the TP shall not be treated as being temporarily away from home during any period of employment if the period exceeds 1 year.

Temporarily away from home NOT over 1 yearo 1.162-2(a) – Traveling expenses include travel fares, meals and lodging, and expenses incident to travel such

as expenses for sample rooms, telephone, etc. Only such traveling expenses as are reasonable and necessary in the conduct of the TP’s biz and directly attributable to it may be deducted. If the trip is for other than biz purposes, the travel fares and expenses incident to the travel are personal expenses and the means and lodging are living expenses. If the trip is solely for biz, the reasonable and necessary traveling expenses, including travel fares, meals and lodging, and expenses incident to travel are biz expenses.

o So if biz trip, generally, you can deduct all these items (must be business related travel expenses)o What if doing for part personal and part biz?

o 1.162-2(b)(1) – If TP travels to a destination and while at such destination engages in both biz and personal activities, traveling expenses to and from such destination are deductible only if the trip is related primarily to the TP’s trade or biz. If the trip is primarily personal in nature, the traveling expenses to and from the destination are not deductible even though the TP engages in biz activities while at such destination. However, expenses while at the destination which are properly allocable to the TP’s trade or biz are deductible even though the traveling expenses to and from the destination are not deductible.

So look at whether the trip is primarily related to personal or biz o -2(b)(2) – Whether a trip is related primarily to the TP’s trade or biz or is primarily personal in

nature depends on the facts and circumstances in each case. The amount of time during the period of the trip which is spent on personal activity compared to the amount of time spent on activities directly relating to the TP’s trade or biz is an important factor in determining whether the trip is primarily personal.

Ex – if the TP spends one week in Aspen for a CLE which is directly related to his trade or biz, and then spends an additional 5 weeks there skiing, the trip will be considered primarily personal in nature unless there is a clear showing to the contrary. Since the trip is for personal reasons, the TP cannot deduct the expense for the trip there and back (airfare), but can deduct any expenses directly related to the CLE or biz portion of the trip.

There is a lot of gray area. o -2(d) Expenses incurred by the TP in attending a convention or other meeting may constitute an

ordinary and necessary biz expense under §162 depending on the facts and circumstances. No distinction will be made b/w self-employed persons and EEs. The allowance of deductions for such expenses will depend upon whether there is a sufficient relationship b/w the TP’s trade or biz and his attendance at the convention so that he is benefiting or advancing the interests of his trade or biz by such attendance. If the convention is for political, social, or other purposes unrelated to the TP’s trade or biz, the expenses are not deductible.

If go to Ducks Unlimited Convention, that is not related to your practice of law and not deductible Basically, look at the facts and circumstances of each situation.

o Rosenspano Were these expense incurred while away from home?o TP was traveling jewelry salesman and lived on road 300 days a year and ate at restaurants and stayed at

hotels. 5 times a year he went to his ERs office. He used brother’s address for mail. He stayed at an inn nearby so as to not abuse his welcome at his brother’s home. Problem – what is the TP home? And if he doesn’t have a home, how can he ever be away from it to deduct expenses?

IRS- “home” = business quarters…so here, it was the hotelo Flowers – Lawyer lived in Jackson but worked in Mobile. Ct denied deductions b/c the TP decision to live

in Jackson was personal and not req’d for the biz (not a business decision). So it doesn’t make sense to allow it as a deduction for biz expense when it was a personal reason.

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This ct does not agree in defining home as principal place of biz (no definition of home given) Gave a 3 part test (1) reasonable and necessary (2) incurred while away from home (3) incurred in

pursuit of bizo Peurifoy – Construction workers working in N Carolina. Maintained other homes. They said the expenses

incurred in N Carolina were not deductible b/c they chose that profession.o Stidger – refused to define home. Marine Corp captain stationed in Tokyo while family in Ca – they

denied expense while in Tokyo b/c he chose the professiono The expense must be incurred in pursuit of biz. This means that there must be a direct connection b/w the

expenditure and the carrying on of the trade or biz of the TP or his ER. Also, such an expenditure must be necessary or appropriate to the development and pursuit of the biz or trade.

o When an assignment is truly temporary, it would be unreasonable to expect the TP to move his home, and the expenses are thus compelled by the “exigencies of biz”; when the assignment is “indefinite” or “indeterminate”, the situation is different and if the TP decides to leave his home where it was, disallowance is appropriate b/c his failure to move his home was for his personal convenience and not compelled by biz necessity.

This is the reason that when the marine is in Tokyo or construction workers live in S Carolina for a long period of time, the exigencies of biz don’t require you to maintain two homes, and they were not allowed a deduction. You could sell your home and when you get back, get another one. Maintaining these duplicate expenses is a personal decision and not biz necessity

o This ct does not care whether or not he has a home. They don’t think he has one. In this case they say that Rosenspan did not have duplicate expenses so there is no reason to allow the deductions.

o Rather than try to come up with a definition of home, ct says what matters is whether expenses are incurred b/c of being in a trade or biz.

o Andrewso Swimming pool biz in New England and horseracing in Flo He had house in New England and Fl – he deducted the expenses in Fl as biz expenses incurred while in

FL. He spent 6 months at each house. o The IRS asserts that the home is the area of the TP place of biz. The ct noted that most of the appellate

courts agree with this. o TC concluded that Andrews had 2 tax homes, but the appellate ct did not agree. They said if the TP biz

requires 2 homes, then the expenses should be deductible.o The issue is why the TP has 2 homes – if it is b/c the biz requires it, then it should be deductible. This case

was remanded to TC to determine which expenses should be deductible.o The Ct did not tell the Tax Court how to determine which house (FL or New England) was the “tax home”

and which house gave rise to deductible duplicate living expenses while “away from home in pursuit of a trade or biz.” Guiding policy – the TP is reasonably expected to locate his home for tax purposes at his “major post of duty” so as to minimize the amount of business travel away from home that is req’d. A decision to do otherwise is motivated not by biz necessity, but by personal considerations, and should not give rise to greater biz travel deductions. The length of time spent engaged in biz at each location should ordinarily by determinative of which is the TP’s “principal place of biz” or “major post of duty.

If you have 2 homes and the reason why you have them is for biz purposes and one is your major post of duty, then you deduct the expenses from the other one (the minor post of duty)

The focus is on duplicate living expenses with one occurring on the exigencies of businesso Rev Ruling 99-7 (Transportation b/w work and home)

o Gen rule – transportation expenses b/w work and home (commuting expenses) are not deductible o 3 Exceptions where travel expenses are deductible:

(1) Traveling from home and temporary location outside of metropolitan area (2) TP has one or more regular work locations away from home

Ex- JK’s brother-in-law is a urologist with offices in Eunice, Bunkie, and Mamou. He gets to deduct when traveling to each office.

(3) TP’s residence is his principal place of biz Can deduct regardless of whether outside metro area or temporary

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o Expenses incurred in traveling b/w home and temporary biz locations outside of the metropolitan area are deductible

So if practice in BR and go to see client in Shreveport, that is deductibleo If have one or more locations away from home, then expenses incurred in traveling b/w places are

deductibleo If TP residence is his principal place of biz (biz out of house) expenses incurred b/w work and home are

deductible regardless of whether it is temporaryo Def of temporary work location – If employment at work location is realistically expected to last and does

last for 1 year or less, it is temporary. But if employment at a work location is realistically expected to last for more than 1 year or there is no realistic expectation that the employment will last for 1 year or less, the employment is not temporary, regardless of whether it actually exceeds one year. If employment at a work location initially is realistically expected to last for 1 year or less, but at some later date the employment is realistically expected to exceed 1 year, that employment will be treated as temporary until the date that the TP’s realistic expectation changes, and will be treated as not temporary after that date.

o Meal expenses while travelingo Correll – “sleep or rest” rule – you can only deduct your meals in situations where sleep or rest is req’do So if you spend the night somewhere, you can deduct those meals o §274(n)(1) - Deduction for meals is limited to 50% of the cost

Problems pg 3771. Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch in various restaurants

in City.(a) May commuter deduct his costs of transportation and/or meals? See Reg. 1.162-2(e).

o Transportation (commuter fares) is not deductible. o Cost of Commuting is a personal expense (nondeductible) with 3 exceptions:

1. If must go to a temporary work location outside of the metropolitan area where TP lives and works. (i.e., lives and works in BR, and must go to Houston for business. The mileage to airport, airfare, etc. are ded.)

2. If 2+ work locations away from residence - can deduct transportation expenses of going between them. (i.e., TP = accountant w/ office in BR. TP must go to client=s office and review books. Cost of going home to client=s office is ded.)

3. If TP=s residence is PPB, any traveling (even in town) is deductible. o Meals are not deductible either b/c he returns the same day. See Correll - traveling salesman 6a - 6p each day,

5 days/week. TP wanted to deduct cost of meals. Court said no b/c only if have to sleep or rest along the way are meals ded. So meals are ded. only if gone overnight. What should TP do? Take a client out to lunch - '274(n)(1) - subtract 50% of the cost. If you take client, you can deduct b/c it is related to trade or biz.

o Meals are deductible only if they are related to biz. If not, they are personal expenses b/c you have to eat lunch anyway!

o Note - Parking expenses are generally not deductibleo Pollei – police captains were permitted to deduct their commuting expenses for using their own unmarked cars

(rationale – they were on duty and working while they were commuting)(b) Same as (a), but Commuter is an atty and often must travel between his office and the City Courthouse to file papers, try cases, etc. May Commuter deduct all or any part of his costs of transportation and meals?

o First trip in the morning is commuting (not ded.) All expenses thereafter are ded (from office to courthouse.) o What about traveling from courthouse back to house? Prob not deduct. The issue is whether the courthouse is a

temp location. o Meals not deductible under Correll b/c no sleep or rest req’do If the transportation expenses are deductible, you can deduct the actual expenses (keep track of gas,

depreciation on car, etc) OR use the stand mileage rate which accts for everything included in the travel (IRS comes out with every year).

o Note – if travel is related to doing charity work related to Katrina, you can include your transportation expenses at a reduced rate as a charity deduction

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(c) Commuter resides and works in City but occasionally must fly to Other City on business for his ER. He eats lunch in Other City and returns home in the late afternoon or early evening. May he deduct all or a part of his costs?

o If he has to fly it is outside the metro area so deductible o Meals are not deductible b/c there is no sleep or rest req’d

2. TP lives w/ H and children in City and works there.(a) If her ER sends her to Metro on business for 2 days and one night each week and if TP is not reimbursed for her expenses, what may she deduct? '274(n)(1).

o TP can deduct travel expenses b/t home and airport, parking at airport and airfare. TP can also deduct lodging at Metro b/c PPB is City. Per Andrews, look at amount of time spent where. Tax home = City. Minor Post of Duty = Metro.

o Meals - Correll - must sleep while gone. TP here does so cost of meals is deductible. But see §274(n)(1) - only 50% of cost of meal is deductible.

o Note – she can deduct these meals even if eating w/o a client. This is b/c overnight stay is req’d. (b) Same as (a) except she works 3 days and spends 2 nights each week in Metro and maintains an apartment there.

o Main issue is what is her tax home?o IRS will say that PPB is the tax home. o Factors to consider to determine what is the major post of duty: time spent in each city, biz activity in each

city, where income is derived, location of family.o Andrews: place where you spend the most time is the most significant facto If City is tax home then transportation, lodging, and 50% of meals are deductible

(c) TP and H own home in City and H works there. TP works in Metro, maintaining an apt. there, and travels to City each weekend to visit her H and family. What may she deduct?

o Same issue b/c 2 homeso Nothing is deductible. o The issue is what is her tax home – argument is that her tax home is where her family is. o However, she is in Metro majority of the time, so that is likely her tax home. o TP=s tax home = Metro. H=s tax home = City. It was TP=s decision to marry a guy who lives in another

town.o The travel does not sound like it is biz related.

3. Burly is a professional football player for the CityStompers. He and his W own a home in Metro where they reside during the 7-month “off season.”(a) If Burly’s only source of income is his salary from the Stompers, may Burly deduct any of his City living expenses which he incurs during the football season?

o Expenses in Metro – not deductible b/c personal choiceo City is his home, so those expenses are not deductibleo Burley’s PPB (“tax home”) is City. No deduction in Metro because no there is no pursuit of business

(b) Would there be any difference in result in (a) if during the 7-month “off season” Burly worked as an insurance salesman in Metro?

o Issue of what the tax home iso What if tax home in Metro – what could he deduct?

o He can deduct the expenses incurred in the City (lodging, 50% of meals)o What if tax home in City

o Deduct expenses in Metroo This is like Andrews case. o Length of time is imp factoro But, consider an extreme example where he makes 1M in City and 50k in Metro. Even though more time in

Metro, the fact that he makes so much more money might weigh in to determine tax home

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o What if tax home is the City and an Apt in city is not maintained during off season?o It is unclear. The issue is that in this case there are no duplicate living expenses. Likely he can’t deduct

if not maintaining both homes. o If tax home is City where he plays football and off season he moves from city and doesn’t have the

duplicate expenses during the off season, then some courts won’t let you deduct expenses

4. Temporary works for ER in City where Temporary and his family live.(a) ER has trouble in Branch City office in another state. She asks Temporary to supervise the Branch City office for 9 mos. Temporary=s family stays in City and he rents an apt. In Branch City. Are Temporary=s expenses in Branch City ded.?

o See Peurifoy (in Rosenspan) - EE on biz o/o town temporarily can ded. expenses. All expenses were ded. b/c on “indefinite leave of absence.@ This is diff. from Atemp.@

o How long can Temporary be gone for it to no longer be temporary?o '162(a) - 1 year. Here, Temp. plans to stay less than 1 year so transportation, lodging, 2 meals, are

ded. as unreimbursed biz EE expenses.o As long as temp and not indefinite, you can deduct ito Hypo: Mitchell – TP lived in Il but worked in Ca 100 days a year for 5 consecutive years. Ct allowed ded b/c

said did not violate the 1 year rule b/c didn’t live there for one consecutive year.(b) What result in (a) if the time period is expected to be 9 mos., but after 8 mos. it is extended to 15 mos.?

o To be temp., TP may not be gone longer than 1 year, but if TP expects to be gone for less than one year and then stay is later extended, TP may deduct expenses until TP finds out that the stay will be extended. So here, it=s all ded. in 1st 8 mos. As soon as Temp. finds out the news, all expenses thereafter are personal exp.

o If do 2 temporary jobs of 8 mos. each, and it=s done close together, court may collapse them into one trip, in which case none will be ded.

o They expected it to be less than a year so up to the point they expect it to be more than 1 year they can deduct. This is situation 3 in the RR

(c) What in (a) if Temporary and his family had lived in a furnished apt. in City and he and family gave the apt. up and moved to Branch City where they lived in a furnished apt. for the 9 mos.?

o Problem is that there is no duplication of expenses. There=s only one residence, so no deductions.o The trend is to require duplication of expenses (not 100% yet, but still the trend).

o If they give up their apt in the city, there are no duplicate expenses, so they prob can’t deduct (note – this is not in the code, but seems to be exercised in the recent cases)

5. Traveler flies from her personal and tax home in NY to a business meeting in Fla. on Monday. The meeting ends late Wed. and she flies home on Friday afternoon after 2 days in the sunshine.

(a) To what extent are Traveler=s transportation, meals, and lodging deductible? See Reg. 1.162-2(a) and (b).o Lodging for Mon., Tues., and Wed. are bus. days so 100% is ded., as are 50% of meals.

o -Thurs. and Fri. - personal vacation so nothing is deductible.o Airfare? - Reg. 1.162-2(b) - cost of domestic transportation is all or nothing. If part biz and part pleasure, must

decide if primarily biz or pleasure (need to determine the primary purpose of the trip.) If primary biz, full cost of transportation is ded. If primarily pleasure, nothing in transportation cost is ded.

o Apply facts and circumstances test. According to the regs, the most imp factor is the amount of time devoted to business and amount devoted to pleasure. Here, 3 days biz, 2 days pleasure, so airfare should all be ded.

o Note - While she is there, only her biz expenses are ded(b) May Traveler deduct any of her spouse=s expenses if he joins her on the trip? '274(m)(3).

o Unless there is a true biz reason for the spouse being there, it is not dedo 274(m)(3) - No deduction allowed for travel expenses for spouse, dependent or other individual

accompanying the TP on biz travel unless: o (1) The spouse, etc is EE of TPo (2) The travel is for bona fide biz purposeo (3) Such expense would otherwise be deductible by the spouse, etc

o Here, it is highly unlikely the spouse fits all this.

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o Note – if stay in same hotel room, lodging is still deductible as if Traveler were there alone. (c) What result in (a) if Traveler stays in Fla. until Sunday afternoon?

o What is the primary purpose of the trip? M-W on bus. (3 days). 4 days on pleasure. Not so easy answer here b/c would not be expected to work on Sat. and Sun. anyway. TP probably can argue she would have been at home on pleasure on Sat. and Sun. Anyway and 3/5 work-week days were spent on business.

o In this case, it would mean she spent more time for personal so this would make the travel expenses to get there not ded. However, biz expense while there are ded

o But this is facts and circumstances analysis. If you find out that it is cheaper to fly back on Sun, then maybe you can argue it is a biz reason, however, more than likely it won’t be ded

o Last sent in 1.162-2(b)(1) allows you to still deduct biz expenses while you are there, even if commuting back and forth is not deduct

(d) What result in (a) if Traveler takes a cruise ship leaving Fl on Wed night and arriving in NY on Friday? o See §274(m)(1) – Generally no deduction allowed for expenses incurred for transportation by water if

they exceed twice the per diem amounts for days of such transportation (luxury transportation.) There is an exception if the luxury transportation expenses are allocable to a convention, seminar or other meeting held on a cruise ship.

(e) What result in (a) if Traveler=s trip is to Mexico City rather than Fla.? '274(c).o If outside of U.S., concern is foreign travel - is it really on business or just pleasure? o '274(c) – Generally, if an individual travels outside the US away from home in the pursuit of a trade/biz, no

deduction is allowed. Exceptions (1) travel does not exceed one week (2) TP spends less than 25% of the total time of travel on activities not related to trade/biz

o See Reg. 1.274-4 - if '274(c) applies, the cost of transportation -Primarily for Business Test does not apply.o In general - TP will multiply: (transportation expenses x [bus. days / total travel days])o But general rule d/n apply here b/c '274(c)(2)(A) says this rule applies only if travel exceeds one week. Here,

gone only 5 days. So go back to Primarily for Business Test.o She can deduct b/c not longer than 1 week

(f) What result in (e) if Traveler went to Mexico City on Thurs. and conducted bus. on Thurs., Fri., Mon., and Tues., and returned to NY on the succeeding Fri. night? Reg. 1.274-4(d)(2)(v).

o 4 days of business. Per this Reg., if travel outside of U.S., in determining # of bus. days, Sat. and Sun. and legal holidays or stand-by days are bus. days.

o So, here, Sat. and Sun. are included in bus. days. Gone over 1 week so use the fraction - looks like 6 out of 9 days are bus. - BUT last day was spent getting home. Reg. 1.274-4(a)(2)(i) - transportation days. If finish bus. late in the day, may not be able to get flight out until next day. So travel days are counted as bus. days.

o So total bus. days here: Th., F., Sat., Sun., Mon., Tues., Fri. - 7 out of 9.o Also - 274(c)(2)(B) - another exception - if less than 25% of over 1 week away from home outside of U.S. is

for pleasure, its all bus o 2 nights out of 9 = 22%. So it’s all bus. All meals and lodging on bus. days are ded. Nothing on 2 pleasure

days are ded.o Only issue is transportation.o If 3 out of 9 days is personal, 2/3 of the transportation cost is ded. o The one week exception would not apply so the limitations would apply b/c only 6/9 of the biz costs are

allocable b/c it is more than 1 week and then you can only deduct the portion that is related to bizo The biz activity must be more than 25% of the time, but that is met b/c 4 days – can take ded on those dayso The weekends are counted as biz days if they are stand by during the work period.o 274(c)(1) – Gen rule – generally can only deduct the portion of your costs that relate to biz (so if 50% of time

is pleasure and 50% biz, you can only deduct 50% of travel expense) (g) What result in (e) if Traveler’s trip to Mexico City is to attend a biz convention?

o §274(h) – Generally, if an individual attends a convention, seminar, or similar meeting outside the North American area, no deduction shall be allowed for the expenses allocable to the meeting unless the TP establishes that the meeting is directly related to the active conduct of his trade or biz and that it is reasonable to have the meeting outside of North America.

o §274(h)(3)(A) includes Mexico as w/i the US

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o If this were in Italy, they would have to show this is appropriate

Necessary Rental and Similar Payments §162(a)(3)§1.162-11(a)

o §162(a)(3) Allows a deduction for ordinary and necessary biz expenses paid/incurred in carrying on a trade or biz including rentals or other payments req’d to be made as a condition to the continued use or possession (for purposes of trade or biz) of prop

o §1.162-11 – can deduct rental expenses based on an allocated sum for the years the lease has to run. Taxes paid by tenant for a landlord for biz prop are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, and the tax is deductible by the latter.

o If you sign a 5 year lease and prepay the lease, you can only deduct in year 1 the rent for year 1 (can’t deduct it all in year 1)

o If the landlord owes the tax but under the terms of the lease, the tenant pays it, the tenant gets deduction and the landlord gets income

o Issue – whether or not it is rent if you buy something o Starr’s Estate

o Issue: were they renting or purchasing equipment?o SUBSTANCE OVER FORM…no matter what you label it, it will be deemed whatever it actually iso TP leased fire sprinkler system at mfg plant. Contract provided for payments for 5 years and nominal

payments for next 5 years and was silent as to what happened after 10 yearso If this is a purchase and not rent, you have to capitalize it and depreciate over time instead of

deducting rent over the 5 years. o This makes big diff due to time value of moneyo If the practical effect of renting is to produce title eventually, the form of the transaction can be

ignored and the substance of the transaction will determine the tax effect of the dealings (in this case, looked like purchase)

Facts indicated this is really a purchase The contract never specifically gives it to lessee, but the salvageable value is negligible b/c it

is tailored to the plant (lessor would get nothing for removing sprinkler system from plant) Also, hard to believe that the lessor would ever come after the system

o Looking at the fact, even though calling it a lease, after 10 years go by, they are silent as to who owns it so lessee is not entirely entitled to it, but it doesn’t make sense to think that they won’t get it. The practical effect is that it is a purchase

o Ct distinguished Western Contracting Ct treated as rental In that case, there was no evidence that the payments on the substituted basis of rent would

produce for the “lessor” the equivalent of his normal sales price plus interest. There was no right to acquire for a nominal amount at the end of the term and the value to the “lessor” has not been exhausted. And there was no basis for inferring that Western would just keep the equipment for what it had paid. It appeared that Western paid substantial amounts to acquire the equipment at the end of the term. It appears that Western paid substantial amounts to acquire the equipment at the end of the term.

So unlike in Starr, they actually did pay for the equipment at the end of the term b/c it was actually worth something. So it looked more like rental during the term. The lessor would have come after the equip at end of term if lessee would not have paid for it

o So it is ok to have lease to buy option – where you make lease payments and at the end can buy, but can’t do like Starr where it looks like it is a purchase up front.

o Substance over form – doesn’t really matter what you call something, the court can look at it and overruleo In Starr’s case, the ct said he really purchased it and must capitalize and depreciate instead of deduct

the rental payments over the 5 years

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Expenses for education Recall from earlier in the outline info about education, so be sure to include both on the final

§162(a); 262; 274(m)(2)§1.162-5(a); (b)(1), (2)(i), (3)(i), (c), (d), (e)(i)

o Can education expenses be deducted as ordinary and necessary biz expense?o §162(a): Shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred

during the taxable year in carrying on any trade or business o §262: no deduction shall be allowed for personal, living or family expenses. o §274(m)(2): no deduction shall be allowed for expenses for travel as a form of education

o Can’t go to France and say you are studying French culture and deduct that Of course, traveling to and from a business destination is deductible

o §1.162-5(a) – Expenditures for education, which are not the type described in para (b)(2) or (b)(3) are deductible as ordinary and necessary biz expenses if the education: (1) Maintains or improves skills req’d by the individual in his employment or other trade or biz (Coughlin) OR (2) Meets the express requirements of the individual’s ER or the requirements of applicable law or regulations, imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation (Hill)

o (b) Educational expenses in (2) and (3) are personal expenditures and are not deductible as ordinary and necessary biz expense even though the education may maintain or improve skills req’d by the individual or meets express requirements of the individual’s ER or laws.

o (2) Minimum educational requirements: expenditures made by a individual for education which is req’d of him in order to meet the minimum educational requirements for qualification in his employment. The fact that an individual is already performing service in an employment status does not establish that he has met the minimum educational requirements for qualification in his employment. Once an individual has met the minimum educational requirements for qualification in his employment, he shall be treated as continuing to meet those requirements even though they are changed.

Ex: law degree is req’d as min education just to get into the profession, thus my law school expenses are not deductible.

Bar Review Course expenses not deductible b/c not in the trade or biz yet If LASC changes the requirements to practice law and say every lawyer must go back to

school and take 6 hours, people who are already lawyers can deduct their expenses b/c they are considered as already being in the trade or biz.

If you’ve been teaching at LSU with a Masters Degree, you are considered to meet min requirements. If you go back to get a PHD, you can deduct it.

o (3) Qualification for new trade or biz: education which will lead to qualifying the individual in a new trade or biz. For an EE, a change of duties does not constitute a new trade or biz if the new duties involve the same general type of work as the individual’s present employment. For this purpose, all teaching and related duties shall be considered to involve the same general type of work.

o Hill o VA teacher taught for 27 years and attended summer school at Columbia. The issue is whether the

summer school expenses are deductible?o In order to keep her teaching certificate, she either had to go to summer school or take exam on 5

books. She decided to go to summer school. TC said it was not ordinary expense b/c the teachers do not usually elect to go to summer school

o The appellate ct said it was unreasonable to look at how many teachers actually elect the summer school.

o Welch – it doesn’t matter that this TP doesn’t do it on a regular basis, it is what would a particular TP would do?

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o Just b/c most teachers don’t do this, doesn’t mean it was not ordinary for this teacher to do it. Most teachers can’t afford summer school which is why they don’t go. It was ordinary for this teacher to choose this

o Appellate court used the reasonable person test…found that what she did was ordinary, even though her colleagues in VA chose not to

o Allowed the deductiono Coughlin

o Tax lawyer went to get his tax LLM. TC said not ordinary and necessaryo Gen rules: the expenses would be deductible under §162 if they were directly connected with or

proximately resulted from the practice of his profession. o If it were usual for lawyers in his practice to incur such expenses they were ordinary and if it was

helpful they were necessaryo Expenses for books, etc are similar o IRS said these were cap expenditures b/c would have benefit in future years. Ct didn’t agree b/c they

said these were evanescent since the laws change all the time – they were deductible. o So If going to benchbar conferences, rely on this caseo Continuing Education (CLE) classes are deductible

o Note – among the things a professional person may deduct include: dues to professional organization societies; subscriptions to professional journals; amounts currently expended for books whose useful life is short

Problems pg 3921. A B C D college roommates who went on after college to become a doctor, dentist, CPA, and a lawyer. In the current year, after some time practicing as an orthopedic surgeon, A, who was often called to give medical testimony in malpractice suits, decided to go to law school so as to better understand this aspect of her medical practice. B enrolled in a course of postgraduate study in orthodontics, intending to restrict her dental practice to that specialty in the future. C enrolled part time in law school (with eventual prospects of getting a degree) so as to better perform her accounting duties in areas in which law and accounting tend to overlap. And D took a leave of absence from her firm to enroll in an LLM course in taxation, intending to practice exclusively in the tax area. Which, if any, is incurring deductible expenses of education?

o A: doc going to law school to better understand med practice. o No ded under 1.162-5(b)(3) b/c it qualifies her for new trade or bizo If A were to stop practicing and become expert witness, could she deduct law school expense then?

No, it would still be a new trade or bizo B: dentist who wants to become an orthodontist

o Can deduct b/c related to field and doesn’t qualify as a new trade or biz – just changing duty w/i the trade or biz so can be deductible

o In determining whether same trade or biz look at same gen duties you had beforehand - 1.162-5(b)(3)o C: CPA and law school

o No deduct b/c law school qualifies her for new trade or bizo Example in 1.162-5(b)(3) Ex. 1o Maybe can argue that the expenses were deductible if they are just auditing classes b/c you can’t

qualify for new trade or biz b/c you can’t be lawyer just by auditing classes.o However, this won’t apply here b/c she had the interest of possibly attaining a degreeo However, JK has never seen any cases where anyone can deduct the expenses of law school but might

be able to try it if just auditing a few classes o D: lawyer who enrolls in LLM in taxation courses

o Already practicing in tax area, so is this a new trade or biz? Is tax law diff trade or biz than reg law?o Johnson – LLM qualified the TP for a new trade or biz so no deductiono Rooman – lawyer was allowed to deduct expenses of general (not tax) LLM o But there are fairly lenient rules under reg 1.162-5 which might allow her to deduct

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2. Assume D’s expenses above are deductible. If she is a practitioner in Seattle who travels to Gainesville for a year to participate in their LLM program, what expenses, in addition to tuition and books, may she deduct?

o Reg 1.162-5(e) – if an individual travels away from home primarily to obtain education, his expenses for travel, meals, and lodging while away from home are deductible.

o §274(n)o If over a year then not temporarily away from home o Are there duplicate expenses? Maybe if you can establish that you have practice in WA and you keep a house

there and fly back on weekends to meet with clients, might still have house there for biz purposeso But other than that, it is unlikely that you will be able to deduct b/c probably will just sell house and move to

Fl and there will be no duplicate expenseso But should be able to deduct 50% of meals assuming she is traveling away from home

3. Carl earned a bachelor’s degree in education and he teaches world history at a jr high school. In the current year he contemplates a summer European tour doing things that will be beneficial to his teaching efforts. May he deduct his expenses?

o §274(m)(2)o Seems like the travel is educationo If the travel is form of education, it is not deductible

4. Dentist attends a 5-day dental seminar at a ski resort. All of the seminar proceedings are taped and Dentist skis on clear days and watches all of the tapes on snowy days or in other off-the-slopes time prior to his return home. Are Dentist’s travel, meals and lodging deductible?

o The conference committee report says that this is not deductible when the tapes can be viewed at the leisure of the participant

o So can’t deduct the travel expenses b/c can watch the tapes whenever you want (could have stayed home and watched them)

Miscellaneous Business Deductions o 274 – Disallowance of certain entertainment, etc., expenses

o (a) – Entertainment, amusement, or recreation: (1) A deduction shall not be allowed (A) with respect to an activity which is of a type generally considered to constitute entertainment, amusement, or recreation, unless the TP establishes that the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide biz deduction, that such item was associated with, the active conduct of the TP’s trade/biz OR (B) with respect to a facility used in connection with such an activity

The expenses must be directly related to or associated with the TP business Expenses related to entertainment facilities are not deductible (Ex: yacht)

o (a)(3) – No deduction is allowed for membership in any club organized for biz, pleasure, recreation or other social purpose

So if I join CCL, even if it is b/c I am a lawyer and all the other lawyers belong, I cannot deduct my dues

o 1.274-2(c)(3) – Expenditure for entertainment is directly related to the active conduct of the TP’s trade/biz if: (i) at the time the TP made the entertainment expenditure, the TP had more than a general expectation of deriving some income or other specific biz benefit (ii) during the entertainment period to which the expenditure related, the TP actively engaged in a biz meeting, negotiation, discussion for the purpose of obtaining income or some other biz benefit (iii) all facts and circumstances show that the principal character of the combined biz and entertainment to which the expenditure related was the active conduct of the TP’s trade/biz (iv) the expenditure was allocable to the TP and a person with whom the TP engaged in the active conduct of trade/biz

o So if go to LSU game, ask the person something about biz during gameo 274(k) – Business meals: No deduction is allowed for the expense of any food or beverage unless such an

expense is not lavish or extravagant under the circumstances and the TP (or an EE of the TP) is present at the furnishing of the food or beverage.

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o 274(l) – Limitations on entertainment tickets: (A) for determining the deduction for a ticket to an activity, the amount taken shall not exceed the face value of such ticket.

o If you buy a ticket on eBay for 50 times face value, you cannot deduct the entire price – only the face value

o Exceptions for certain charitable sports events : the limitation in part (A) does not apply to any ticket for a sports event which is organized for the primary purpose of benefiting an organization described in §501(c)(3), all of the net proceeds are contributed to such organization, and which utilizes volunteers for substantially all of the work performed in carrying out such an event.

In this case, you can deduct the full amount of the ticketo Skyboxes : In the case of a skybox or other private luxury box leased for more than 1 event, the

amount allowed as a deduction shall not exceed the sum of the face value of the non-luxury box seat tickets.

o 274(d) Substantiation Required : No deduction is allowed (1) under 162 or 212 for any traveling expense, (2) entertainment expense (3) expense for gifts, (4) listed property… unless the TP substantiates by adequate records

o (A) The amount of such expense o (B) The time and placeo (C) The biz purpose of the expense o (D) The biz relationship to the TP of persons entertained

So if take someone to lunch, need to write down info – who with and generally what you discussed. Normally the receipt has the time, place and amount, so on back of receipt you need to write the person who meal, etc was with and why you had meal with them

The consequence of not substantiating is that you don’t get the deduction (Note – the 50% limitation applies regardless, but if you don’t substantiate, you don’t even get to take 50%)

o 274(n) – Only 50% of meal and entertainment expenses allowed as a deduction o Uniforms

o EE is considered to be in a trade/biz in his role as an EE, thus he may deduct unreimbursed expenses that he incurs which otherwise meet §162 requirements.

o EEs may deduct the cost of obtaining and maintaining their uniforms only if (1) The uniforms are specifically req’d as a condition of employment and (2) Are not of a type adaptable to general or continued usage to the extent that they take the

place of ordinary clothingo Thus, policeman, firemen, baseball players, jockeys, etc may deduct their uniform costs b/c their req’d

uniforms are not adaptable to personal use. Lawyers cannot deduct the cost of their suits b/c they can be worn outside of being a lawyer

o Uniforms of military personnel are for general use and generate no deductions, but there is an exception for uniforms of reservists that are worn only occasionally and also for swords.

o Advertising o Generally deductible expense in the year incurred even though the benefits may extend over several

yearso But, make sure the advertising expenditure is not capital in nature

If a co buys their own billboard, that is capital expenditure But if you pay Lamar to advertise on their billboard, that is a deductible expense

o Contributions directly or indirectly to political candidates and political parties are not allowed as deductionso Make sure advertising does not border on the area of political contributions

o Dueso IN general, dies paid to organizations directly related to one’s biz are deductible under §162o Thus, atty dues paid to local bar are deductibleo But remember – club dues are not deductible

o Lobbying o 162(e) – generally not deductible

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o See Pg 399 for summary of rules(k)

Problems, p. 3991. EE spends $100 taking 3 biz clients to lunch at a local restaurant to discuss a particular business matter. The $100 cost includes $5 tax and $15 tip. They each have 2 martinis before lunch.(a) To what extent are EE=s expenses deductible?

o Business meal. Per Regs, there are 2 alternate tests to satisfy before entertainment expenses are ded. Meal is either (1) directly related to, or (2) associated with the trade or bus.

o “Directly related to@ - Reg. 1.274-2(c) - cost of meals/entertainment is directly related to . . . if business goes on during the meal / entertainment in which the ded. is claimed.

But not sales pitch during ball game - Reg. 1.274-2(c)(7) - if substantial distractions exist.o “Associated with” - entertainment must have a bus. purpose and must immediately precede or follow a

bona fide discussion. Meals eaten on way home d/n qualify. If invite customer and his spouse to dinner - too many non-business persons present, it=s

entertainment so not discussing business. o Here, it’s over lunch, so meal is directly related to TP’s trade / business. o Other requirements in '274(d) - expense must be substantiated. Also, cost of meal must not be lavish. (Rev.

Rul. says just because it’s first class does not mean it’s lavish.) This is probably not lavish, even though they have martinis. TP must be present at the meal / entertainment.

o If all requirements are met, 50% of the meal is deductible. o Note – tax and tip are included as biz expense and you can deduct 50% of them as well

(b) To what extent are meals ded. if the lunch is merely to touch base w/ the clients?o Issue is whether this is directly related to a biz purpose if they are just touching base.o No ded. The expense isn’t directly related to or associated w/ . . . unless bona fide biz conducted before or

after meal. Reg. 1.274-2(c)(3)(i) - for entertainment exp. to be directly related to bus., TP must have more than a “general expectation . . . other than goodwill.@

(c) What result if EE merely sends the three clients to lunch w/o going herself but picks up their $75 tab?o EE must be present for it to be deductible according to 274(k)(1)(B)o Maybe can argue that it is a gift which is deductible under 274(b)(1) (possibly) – this would allow the client to

deduct the first $25. (d) What result in (a) if in addition, e/ee incurs a $15 cab fare to transport the clients to lunch?

o Reg. says the cab fare should be subject to 50% meal ded. Leg. history says cab fare isn=t limited to 50% ded.

o In order to get the deduction would have to argue ordinary and necessary biz expense under 162o 274(k)(1)(B) requirement that TP be present only applies to meals – don’t have to be present for the cab fares. o More than likely you could deduct the full amount of this – note – it is the full amount since it is not meals or

entertainment (not subject to 50% rule)(e) What result in (a) if ER reimburses E/ee for the $100 tab?

o 274(e)(3)(A) – Subsection (a) does not apply if…expenses are paid or incurred by the TP, in connection with the performance by him of services for another person, under a reimbursement…

o Thus, the EE is not allowed a deduction. This will be treated as taxable income to the EE (compensation), but he can deduct the full amount of the reimbursement (amounts to a wash.)

o The ER who made the reimbursements is allowed a deduction of 50% if the expenses otherwise meet the requirements of §274.

o 274(k) (lavish, extravagant rule) does not apply to reimbursed expenses and 274(n) does not apply to reimbursed expenses

o The reasoning is out of fairness

2. Businessperson who is in NY on bus. meets w/ 2 clients and afterward takes them to the Broadway production of The Producers. To what extent is the $600 cost of their tickets deductible if the marked price on the tickets is $100 each but Businessperson buys them from the hotel concierge for $200 each?

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o Is any of it deductible? Go thru all the requirements of 274. It’s immediately after a bus. meeting, so expense is associated with a biz. . .But how much? 274(e)(1)(A) - face value of ticket. And b/c it’s entertainment, per 274(a) and (n)(1)(B), only 50% is ded.

o So $100 (face amount) x 3 = 300 x 50% = $150 deductible

3. Airline Pilot incurs the following expenses in the current year:(a)$250 for cost of new uniform.

o It is a required as a condition of employment and it is not be suitable for ordinary wear or adaptable for extensive use.

(b) $30 for dry cleaning the uniform.o Cost of maintaining an otherwise deductible uniform is deductible (ordinary and necessary biz expense)

(c) $100 in newspaper ads to acquire a new job as a property manager in his spare time.o No ded. b/c not in bus. of being a property manager.o This is like Morton Frank case – costs of wanting to go into a biz is not deductible

(d)$200 in union dues.o They are generally 100% deductible under 162, as long as directly related to bizo 162(e) deals with political expenses – you can’t deduct dues if they are related to lobbying o So normally union dues are deductible – just can’t deduct the portion related to political expenses

(e)$50 in political contributions to his local legislator who he hopes will push legislation beneficial to airline pilots.o '162(e)(1)(A) - no deduction for influencing legislation o Or under (e)(1)(B) – no deduction for participation in any political campaign on behalf of any candidate for

public office (f)$500 in fees to a local gym to keep in physical shape for flying.

o Can you consider this related to trade or biz b/c he needs to keep up with his shape?o The issue is whether it is ordinary or necessary biz expenses (analyze this) o JK thinks not deductible – it is more along the lines of a personal expense

NOTE for later: All these expenses are misc. itemized deductions – so add up the ded., subtract 2% AGI for deduction.

Business Losseso 165(a) – There shall be allowed as a deduction any loss sustained during the taxable year and not

compensated for by insurance or otherwise.o 165(c)(1) – In the case of an individual, the deduction under (a) shall be limited to

o (1) Losses incurred in a trade or bizo (2) Losses incurred in any transaction entered into for profit, though not connected with a trade

or bizo (3) Losses of property not connected with a trade or biz or a transaction entered into for profit,

if such losses arise from fire, storm, shipwreck or other casualty, or from thefto There are only 3 situations where an individual can deduct - we deal with (2) and (3) in another ch

o A mere decline in value does not authorize a deduction in 165 (realization concept)o 165(b) – the basis for determining the amount of deduction for any loss is the AB (not necessarily the

FMV)o Example: C pays $1,000 for an option. She forfeits the option when she decides not to exercise it. Her

loss is the AB of the option = $1,000o Casualty Loss: o 1.165-7(b)(1) – In the case of a casualty loss, whether or not incurred in a trade/biz or transaction

entered into for profit, the amount of loss for purposes of §165(a) shall be the lesser of: o (i) FMV of the property immediately before the casualty reduced by the FMV immediately after o (ii) The AB o However, if property is used in a trade/biz or held for the production of income is totally

destroyed by casualty, and if the FMV of such property immediately before the casualty is less

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than the AB of the property, the amount of the AB of the property shall be treated as the amount of loss for §165(a)

The starting point is what is the FMV…it can’t be more than the adjusted basiso Ex: D buys a boat to use for biz, which is later demolished in a storm.

If D had a $6k AB in the boat and it had a 10k FMV before the storm, and its value after the storm is 7k, D has a 3k loss.

If the boat is totally destroyed, D would have a 6k loss. If D recovered 4k of insurance for the boat, his loss would be limited to 2k. If the boat were fully insured, D’s recovery of 10k of insurance would result in a 4k

casualty gain. o Note - You can’t deduct the amt to the extent you are compensated by insurance

o 280B – Demolition of Structures: In the case of the demolition of any structure (1) no deduction shall be allowed for (A) any amount expended for such demolition or (B) any loss sustained b/c of demolition and (2) those amounts shall be added to the capital account of the land on which the demolished structure was located.

o Ex – people spend 150k on a raggedy house, mow it down and build a new house. In that case, the entire amount you paid for house that was demolished gets allocated to the basis of the land.

o Buy lot with house for 300k. The house is worth 150 and land worth 150. If you demolish house, land has 300k basis. If you build new house worth 200k, you have 300k basis in land and 200k basis in new house. So if you sell new house and land for 50ok you have no gain or loss.

o The real significance in this comes in with depreciation – for example if you are dealing with commercial prop, then the TP can depreciate the value of the building. But, you can only depreciate the value of the new building (b/c the old building was added to the land which cannot be depreciated)

Problems pg 4021. Taxpayer has an automobile used exclusively in Taxpayer’s business, which was purchased for 40k and as a result of depreciation deductions has an adjusted basis of 22k. When the auto was worth 30k, it was totally destroyed in an accident and taxpayer received 15k in insurance proceeds.(a) What is taxpayer’s deductible loss under section 165?

o Since totally destroyed and for biz use, you can deduct the total amount of the basis = 22ko But you have to subtract the 15k insurance proceeds – so it is a total loss of 7k

(b) What result in (a) above if the automobile had not been completely destroyed but was worth 10k after the accident?

o §1.165-7(b)(1)o Will be either the lesser of the FMV before minus the FMV after the casualty loss (change in value) or the

ABo FMV before 30k – FMV after 10k = 20k. This is lower than the AB of 22ko 20k loss, but you have to reduce for the 15k insurance for a total loss of 5k

(c) In (b), what is TP’s AB in the automobile assuming TP incurs $17,000 fixing the automobile?o Start with the original basis and reduce by the loss. Then you add whatever amounts you put into the property. o The original basis is 22k reduced by the 20k loss which leaves a 2k basis. That is increased by the repairs of

17k. So the basis is 19k

Deductions for Profit-Making, Non-business Activities§212 Expense

o Higgins – history behind §212o TP had extensive investments in stocks and bonds, etco Hired others to assist him with managing his stocks and bondso TP did not participate in the mgt of the companies in which he owned stocks or bonds, but deducted

the expenses under 162o IRS said the expense are ordinary and necessary, but denied the expenses related to stocks and bonds

b/c argued that merely investing is not a bizo Arguments:

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Petitioner - elements of continuity, constant repetition, regularity and extent differentiate his activities from the occasional like actions of the small investor. His activity is, and the occasional investor is not, “carrying on a biz.” (TP argues that he is so involved with his investing, it is like a trade/biz)

Respondent – mere personal investment activities never constitute carrying on a trade or biz, no matter how much of one’s time or of one’s EEs time they may occupy. (IRS is saying personal investment activity can never be a trade/biz)

o Ct agrees with IRS and says he was not in trade or biz b/c just investing. TP argued that b/c the IRS conceded that the real estate is one biz, and b/c the stocks or bonds are so closely related to the real estate, it should all be trade or biz. But ct says you need to allocate the amt of time spent on real estate and time spent on stocks.

o Congress did not agree with this case, so they enacted §212 so people could have deductions for that type of activity

o §212 – In the case of an individual, there shall be a deduction of all the ordinary and necessary expenses paid or incurred

o (1) For the production or collection of incomeo (2) For the mgt, conservation, or maintenance of property held for the production of incomeo (3) In connection with determination, collection, or refund of any tax

Good for tax lawyers - if you are helping someone with the collection, or refund, of a tax, they can deduct your legal fees

So, if TP fighting with the IRS, they can deduct their legal feeso Here, you can deduct even if not a trade or biz (can meet §212 of trying to produce income even though can’t

meet §162 biz)o Still need to meet ordinary and necessary testo Still must not be cap expenditures

o Bowers o TP owned interest in stock of corp. TP purchased the remaining corp stock from an orphanage. The

court tried to cancel the sale and the TP incurred significant legal fees in defending the sale, which she tried to deduct under §212

o The TP and IRS both agreed that the expenses would be cap under §162, but the TP argues that §212 is broader than §162 (even though it would be cap expenditure if trade or biz, §212 is broader and you are allowed to expense things that would otherwise be cap expenditure under 162)

o “It is contended that the phrase “all the ordinary and necessary expenses” in the amendment covers more ground than it did in the original act b/c the amendment expressly authorizes a deduction for expenses paid “for the mgt, conservation, or maintenance of property held for the production of income”. The term “conservation” can be given effect if it is limited to expenses ordinarily and necessarily incurred during the year for the safe-guarding of the property, such as the cost of a safe deposit box for securities.”

TP is trying to say that, b/c of the word conservation in §212 , what would otherwise be capital is deductible under 212

o Ct disagrees – adopts the IRS reg – “(b) Except for the requirement of being incurred in connection with a trade or biz, a deduction under this section is subject to all the restrictions and limitations that apply in the case of the deductions under §162 of an expense paid or incurred in carrying on any trade or biz.

o So in §212, other than the trade or biz requirement, you still must meet all other requirements under §162

o The court concluded that these legal fees were capital expenditures. They will be added to the basis of the stock b/c they were costs incurred to keep the stock

o Suraskyo TP had stock in MW. They instituted a proxy campaign to elect new BOD or replace majority of BOD

to institute changes. The purpose of the campaign was to increase the value of his stock o TP incurred substantial expenses in this proxy campaign. The campaign was mostly successful o TC denied deduction - said too speculative to be related to producing income.

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o 5th Cir said that standard is too stringent. Did not adopt TC view. Both parties agreed that you read §162 and §212 together

o Lower court relied on IRS regs for its analysis Under the IRS regs, “expenses must be reasonable in amount and must bear a reasonable and

proximate relation to the production or collection of taxable income or to the mgt, conservation or maintenance of property held for the production of income.”

o The proximate relation rule is not contained in the statute and not in case law. o Cites Welch for necessary and ordinary test

Necessary = expenditures were necessary and helpful. If TP thought they were, then the court should “be slow to override his judgment”

Ordinary = the standard is a way of life. “Life in all its fullness must supply the answer.”o So same rules apply under §212 for ordinary and necessary as they did in §162o The 5th circuit allows this expense to be deductible

o RR 64-236o Will follow Surasky, but not to the extent that the court indicates that to be deductible expenditure they

don’t need to be proximately related to either the production or collection of income or to the mgt, conservation or maintenance of property held for the production of income.

o So the IRS is still clinging to the rego But in the 5th we have this case saying they are not following the rego So arguably in the 5th circuit, the expenditure does not have to be proximately related…

o Fleischman o Guy is divorcing wife and she wants to annul the pre-nupo TP deducted expenses to defend the pre-nup – said the expenses incurred were for the conservation of

his income b/c was for him to keep his moneyo Issue – can he deduct those expenses under §212?o The expenses sprang from property rightso §212(3) clearly does not apply b/c not dealing with taxo §212(1) does not apply b/c not dealing with collecting income but propertyo So that only leaves §212(2) – expenses for mgt, conservation, or maintenance of prop held for the

production of income o Ct cites Gilmore – in determining whether legal fees are deductible, must first look to the origin and

nature of the claim giving rise to such expenses rather than the consequences of the origin… Look at why he is making the claim to determine whether or not it is for the mgt, conservation

or mgt of prop Where does the claim originate?

o Claim for divorce suit arises not from the conservation of prop – it arises from the marital relationship o Ct basically adopts a but-for test – but for marriage, would the wife have a claim? If ans no, then the

expenses are personal and therefore not deductible o At end of the day, the ct said these are personal expenses and not expenses for the conservation of

propertyo Divorce Fees

o When are they collectible under §212?o If they are related to the collection or determination of any tax, they are deductible

If tax lawyer represents H or W and is giving them tax advice, then they can deduct it If dealing with the collection of alimony, then under 212(1), it is deductible b/c it is the

collection of income o Fleischman tried to deduct under 212(2) as a cost related to the property settlement. The court did a

but-for test and said that but-for the relationship he had with W, the expenses would not have been incurred, and they disallowed the deduction.

Basically, costs associated with property settlements are not deductible o 274(h)(7) – No deduction is allowed under §212 for expenses allocable to a convention, seminar, or

similar meeting.

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o Regs o 1.212-1(g) – Fees for services of investment counsel, custodial fees, clerical help, office rent, and

similar expenses paid or incurred by the TP in connection with investments held by him are deductible under §212 only if (1) they are paid or incurred by the TP for the production or collection of income or for the mgt, conservation or maintenance of investments held by him for the production of income; and (2) they are ordinary and necessary under all the circumstances

o 1.212-1(k) – Expenses paid or incurred in perfecting title to property, in recovering property, or in developing or improving property, constitute a part of the cost of the property are not deductible expenses.

o 1.212-1(l) – Expenses paid or incurred by an individual in connection with the determination, collection, or refund of any tax, are deductible. Thus, expenses paid to tax counsel or in connection with the preparation of tax returns or in connection with any proceedings involved in determining the extent of his tax liability or in contesting his tax liability are deductible.

o 1.212-1(m) – An expense paid in determining or contesting a liability a/g an individual does not become deductible by reason of the fact that the property held by him for the production of income may be req’d to be used or sold for the purpose of satisfying such liability.

o 1.262-1(b)(7) – Generally, attorney’s fees and other costs paid in connection with a divorce or decree for support are not deductible by either the H or the W. However, the part properly attributable to the production or collection of amounts includible in GI under §71 are deductible by the W under §212.

Problems pg 4641. Speculator buys 100 shares of Sound Co. stock for $3,000, paying her broker a commission of $50 on the purchase. 14 months later she sells the shares for $4,000 paying a commission of $60 on the sale. (a) She would like to treat $110 paid as commissions as §212 expenses. Why? Can she?

o Spreckels v. Helvering, 315 U.S. 626 o Is commission more along lines of capital expenditure or expense?o 1.263(a)-2(e) – Commissions paid in purchasing securities are a capital expenditure. Commissions paid

in selling securities are an offset a/g the selling price, except in the case of dealers in securities such commissions may be treated as an ordinary and necessary business expense.

o The $50 commission is a capital expenditure, so not deductible as an expenseo The basis of the stock would be the 3k purchase price plus the commission on the purchase: 3000 + 50 = 3050 o The commissions realized on the sale would offset the amount realized

o 4000 – 60 commission = $3940 amt realizedo Results in a gain of $890 - 3940 – 3050 = 890 o Rule: commissions are cap expenditures on the front end, and they offset the amount realized on the back end

(b) What result in (a) if instead, she sells the shares for $2500 paying a $45 commission on the sale?o §165(c)(2) – For an individual, the deduction is limited to…losses incurred in any transaction entered into for

profit, though not connected with a trade or biz o This appears to be transaction entered into for profit but not a trade or biz. Thus, she can take the deduction. o Amount realized on the sale is $2455 (2500 – 45 commission)o The adjusted basis is still 3050o This will produce loss (basis is more than amount realized) of $590 that you can take under §165 (3050 –

2455) (c) Speculator owned only 1/10 of 1% of the Sound Co stock but, being an eager investor during the time she owned the stock, she incurred $500 of transportation, meals and lodging expenses in traveling 1000 miles to NY City to attend Sound’s annual SH meeting. May she deduct her costs under §212(2)?

o Probably not - b/c she owns such a small percentage of stock this would not be ordinary and necessary o 1/10 is prob not significant under 212(2) to be ordinary and necessary o Ordinary and necessary means the same thing as in Welch v. Helvering – necessary must be appropriate and

helpful (low hurdle to meet). To be ordinary – you test life in all its fullest (so probably doesn’t meet this higher requirement) is the answer to this riddle

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o Basically if it would be a normal thing for a person in that situation to attend that meeting it would be ordinary – here, it is likely not ordinary b/c a person who owns 1% of a publicly traded stock will not go to investor meeting

(d) What result in (c) if instead, Speculator owned 10% of the total outstanding Sound stock, worth $300,000?o Under 212(2), 10% probably is enough – transportation will probably be considered ordinary and necessary

expenseo This is a lot more like the Surasky case – 10% is a little more and might be ordinary and necessary to attendo RR 56-511 – if you are simply attending to determine whether to make future investments, it is not deductible.

If you are trying to decide whether you want to enter transaction for profit, you won’t be able to deduct b/c you are not already in the transaction for profit

(e) What result to Speculator if she incurred the expenses in (c) to attend a seminar on investments?o Not deductible under 274(h)(7) – no deduction allowed under §212 for expenses allocable to a convention,

seminar, or similar meeting(f) Speculator owns 10% of Sound’s stock worth $300,000 and she incurs $10,000 in legal fees and personal costs

investigating the operation of the business after the business has some serious setbacks. Is the $10,000 deductible?o If this is ordinary and necessary, can deduct under §212o Nichols- TP a majority SH and his family went to Europe for a month to determine why the corp. wasn’t

doing so well…this was NOT an ordinary expense incurred so NOT deductible

2.After reading the Fleischman, consider in what situations:(a) Payor Spouse may deduct attorney’s fees incurred in getting a divorce.

o Gilmore – generally expenses in getting divorce are not deductible o However, those related to the tax aspects of divorce are deductible under 212(3) o In most divorce cases, there are significant tax issues. The advice related to those issues is deductible. The

advice un-related to those issues is likely personal expense and non-deductible (b) Payee Spouse may deduct attorneys’ fees incurred in getting a divorce.

o If for tax advice, then would be deduct under 212(3). o Same answer as (a) but look to see if expenses incurred trying collect alimonyo If payee were trying to collect alimony then would be deductible under 212(1)

o Jernigan - if collecting alimony it is deductible under 212(1)(c) Payee Spouse’s attorneys’ fees incurred in getting a divorce are deductible by Payor if Payor pays them.

o Would argue that only the tax expenses would be deductible under 212(3)o If the payor is paying them, he is not necessarily paying to protect his income, he is paying so his ex-

spouse can protect her income. Under 212(1) he might not be able to deduct b/c not protecting his income o He is not paying for the protection of income, he is paying b/c he is obligated too But 212 only says “for the production or collection of income” – doesn’t say for the TP’s collection of

income – maybe can argue that it is deductible even though it was for the production of someone else’s income??

o Another argument – possible deductible under 215 – if this would qualify for alimony, and it was taxable income to payee spouse, could be deductible to payor under 215.

o However, there is a case – Riviera where the TC denied this deduction under 215 b/c the TP could not establish that the payment obligation would end upon the death of the payee spouse

o Probably not deductible b/c probably can’t meet definition of alimony o But-for issue = in order to deduct under 212, in order to determine whether or not a cost is for the

maintenance, conservation, etc of prop, you must ask what the original purpose of the payment is – would you have made this payment but for this divorce. Ask why the expenses are originating

o They are not for only biz matters, but b/c of a divorceo They distinguish cases that allow deduction under 212(1) or (3) for alimony or tax advice. Even

though dealing with your assets, you would not have incurred them if it were not for your divorce

3. Planner consults his attorneys with respect to his estate plan. They decide to make various inter vivos gifts and draft his will. To what extent, if any, are Planner’s legal fees deductible under §212(3)? Under §212(2)?

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o RR 72-545o Deductible only if they are solely related to tax advice

o Sidney Merians v. Commissioner, 60 T.C. 187o Allowed to deduct amount related to tax advice and not the amount related to personal issues

o Here, you need to determine which amount of estate planning is related to tax advice and that portion is deductible. Anything not SOLELY related to the tax advice is not deductible (even if tax advice is ancillary to the estate planning)

o Hall – req’d substantiation in accordance with 72-545o They didn’t say that it looks like 20% related to tax advice so we will allow you to deduct 20% - they

req’d you to substantiate it to determine what is deductible o You have to allocate and substantiate what is related to tax advice and not to personal advice

JK thinks this is the best way…to allocate and substantiate

Charges Arising Out of Transactions Entered Into for Profito §167(a)(2) – There shall be allowed a deprecation deduction of property held for the production of

income. o If holding prop for the production of income, you not only have 212 ded for the expenses related to it,

you also have depreciation deduction o Horrmann

o TP inherited home from his mother – redecorated the house and moved in just a few months later. 2 years later, he abandoned house b/c too large and expensive. He considered turning into apts, but then sold it. Took a few years b/w abandoning house and actually selling house. At the time acquired, was worth 60k and at time abandoned worth 40k and sold for 20k.

o Court’s analysis on whether depreciation deduction is allowed: “Petitioner is entitled to a deduction for depreciation provided the property was held for the production of income. (167(a)(2) rule). In determining whether this rule is satisfied, the use made of the property and the owner’s intent in respect to the future use or disposition of the property are generally controlling.” “The mere abandonment of such use does not mean that thereafter the property was held for the production of income. But, when efforts are made to rent the property, the property is then being held for the production of income and this may be so even though no income is in fact received from the property, and even though the property is at the same time offered for sale.”

So even though he didn’t actually rent it, his intent was to rent it and that is ok even though trying to sell at the same time.

“The evidence, when considered in its entirety, supports the conclusion that petitioner continuously offered to rent the property until it was sold.”

He intended to hold for the production of income even though it didn’t actually produce income.

Rule: entitled to depreciation if property is held for the production of income. Test: use made of the property and owner’s intent are generally controlling

Mere abandonment does not mean property held for production of income.o Must do more than abandon the property and list it for sale or rent under §165

(for transaction entered into for profit) Just fact you are renting or trying to rent the property is enough to convert it to

property held for production of income. When effort made to rent property, property then held for production of income, may be so even though no income in fact received from property

o Second issue – Is petitioner entitled to a deduction for expenses incurred for the maintenance and conservation of the property?

Yes, not only do you get depreciation, you also get the other expenses under 212(2) if the property is held for the production of income.

o Third issue – Is petitioner entitled to a deduction for a long-term capital loss (under §165) arising from the sale of the property?

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165(a) says you can deduct any loss. 165(c) says can only deduct for individual if you meet any exceptions – the only possibility here is (c)(2) – the issue is whether or not this is transaction entered into for profit.

Ct says that the diff lang may allow a deduction under 1 section and not another So you can have prop held for the production of income that is not transaction entered into for

profit If is prop held for prod of income, you can have deduction under 212(2) and depreciation

under 167(a)2 – but this does not mean that if you meet this test it is automatically a transaction entered into for profit

“When prop has been used as a personal residence, in order to convert the transaction into one entered into for profit the owner must do more than abandon the property and list it for sale or rent.”

“If an owner rents, his decision is irrevocable, at least for the term of the lease, and if he remodels to fit the building for business purposes, he has likewise made it impossible to resume residential uses by a mere change of mind. When, however, he remains subject to his unfettered will, he may revoke the agency at any time. It strains the language of the statute to find that property is “appropriated to” and “used for” income producing purposes by merely listing it with a broker for sale or rental.”

o Ct says renting is not absolutely necessary to get deduction under 165 Assmann and Crawford – deduction under 165 was allowed with inherited prop that was not

rented, but in both of those cases it was abandoned almost immediately after inherited. In Horrmann, the TP lived in it for a few years. That is a bad fact b/c then doesn’t look like it

was for the production of income (distinguishes from above 2 cases) Just because he offered it for rent does not convert the property b/c he lived in the

house as a residence for 2 years and that fixed it as a residence unless he actually rented it.

Easier to meet test if you don’t live in it for a personal residence first So if live in house for a little while, it is more difficult to show that it is prop entered into for

profito The court concluded that it was not transaction entered into for profit, so the loss on the sale was not

deductible under 165o So, b/c intent was to rent, he met test under §212 and §167 (held for the production of income) [easier

thresholds to meet], but b/c he lived in it, it was not transaction entered into for profit, so not deductible under 165

o Lowryo TP ceased to use property on Martha’s Vineyard and immediately offered for sale. o Issue – was the prop converted to prop held for the prod of income under 212 to allow a deduction for

the care or maintenance while prop was on the mkt?o TP argues the prop was income-producing once he listed it on the mkto IRS disallowed the expense under §262 saying it was a personal expense o After house put on mkt, he didn’t live there, but went back in the spring to open the house for the

summer – this took 2 or 3 days. Each fall he returned to close the house – took 2 or 3 days. Only other time he occupied was once a year for the SH meetings. Thus, he established a good record that he was doing only the things necessary to offer the prop for sale

o Newcombe – key Q is purpose and intent of the TP in light of all facts and circumstances Factors considered: length of time the TP occupied his former residence prior to

abandonment; availability of the house for the TP’s personal use while it was unoccupied; recreational character of the property; attempts to rent the property; whether the offer to sell was an attempt to realize post-conversion appreciation.

o Even though he wasn’t trying to rent it, his purpose was to get the appreciation so they concluded that it was prop held for the production of income and he was allowed deductions

o Ct noted – the TP here had good reasons for not renting (rent would not be high enough, etc)

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o So we have Horrmann where he never rented, but intended to and the way he established that it was prop held for the production of income is that he intended to rent it even though he never got income. In Lowry he got 212 deduction as property held for prod of income, b/c post-conversion, he established that he was holding for the appreciation that would occur post conversion

o IRS reg 1.212-1(h) does not require that prop be rented for the prop to be for the prod of income o Here, the appreciation was the purpose of him holding it, which was for the production of income o Now, we can look at factors to consider whether property is held for production of income

o 1.165-9(b) – (1) If property purchased or constructed by the TP for use as his personal residence is, prior to its sale, rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale, a loss sustained on the sale of the property shall be allowed as a deduction under §165(a).

o (2) The loss allowed under this paragraph upon the sale of the property shall be the excess of the adjusted basis (1.1011-1) for determining loss over the amount realized from the sale. For this purpose, the adjusted basis for determining loss shall be the lesser of either: (i) FMV at the time of conversion or (ii) adjusted basis for loss, at the time of conversion.

What you can’t do is have prop that has depreciated significantly and convert that prop into prop held for the production of income, hold it that way for 6 months or year and then sell and get a huge loss!

This wouldn’t make sense to allow this b/c the depreciation did not occur at the time it was a trans entered into for profit.

So it will be lesser of FMV or basis at the conversion date – can’t take adv of depreciation pre-conversion

o Rules: If have prop held for prod of income, you can have deduction under §212 and §167(a)(2). May also have deductions under 165(a)(2) analysis which allows a deduction if it is a transaction entered into for profit. (This is a sep analysis from the analysis for §212 and §167(a)(2) – can have one and not the other)

Problems pg 4741. Recall the Morton Frank facts:(a) Should Frank’s expenses in searching for a newspaper have been deductible under §212 or §165(c)(2)?

o Under §212 it must be ordinary and necessary and since he is not in the biz, this deduction would not apply. o In the case the court held that you must actually be holding the prop to deduct the expenses – not just

trying to obtain income o Must be expenses incurred in actual production and collection of income and expenses incurred in

actual obtainment of income o §165 only allows a deduction for a transaction entered into for profit - searching for suitable biz is not a

transaction entered into for profit (b) If Frank decided to buy the newspaper and incurred capital expenditures to begin operations, but then abandoned his plans, would he have been allowed a deduction?’

o Would not be a deduction under 212 b/c capital expenditures not deductible under 212o Under 165, the Q is whether it is a transaction entered into for profit.

o Domenie – TP decided not to begin operations and the ct said he could deduct the expense in his search for a biz for profit.

o RR expanded – said if just searching you cannot deduct those expenses, but as soon as you make a capital expenditure, you can deduct on the back end.

o Already in negotiations and entered into biz by making capital expenditure vs. just searching for biz(c) If Frank entered the business and elected to use §195 but ceased operations wi the 60 month period, to what extent could he take a §165(c) loss?

o Under §195 his expenses would have to be amortized. §195(b)(2) says if the biz ceases before the 180 month period you are allowed to amortize over, TP can deduct the remainder of expenses

2. Homeowners purchased their vacation residence for 180k (20k allocable to the land). When it was worth 160k (20k allocable to land) they moved out and put it up for sale, but not rent, for 170k.

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(a) May they take deductions for expenses and depreciation on the residence? If so, what types of expenses would qualify?o The moved out right away and didn’t really hold the prop for appreciation (even though they tried to sell it for

more), don’t think it is deduction – the issue is their intent o This is unclear – the issue is whether they actually believe that the value of the prop may appreciateo May be able to read this to say you actually must believe that it will appreciate…

(b) Assume instead that they rented the property and properly took $10,000 of depreciation on it. What result when they subsequently sell the property for:

a. $145,000i. 1.165-(9)(b) – the basis for determining loss is the lesser of the FMV of the prop on the conversion

date (160k) or the basis on the conversion date (180k) o Use FMV 160k – 10k of depreciation = basis of 150k

ii. When sell for 145, realize a 165(a) loss of 5k. 150k – 145k sale price b. $175,000

i. 1.165-9(b) only applies if there is a loss. If you sell for gain, the regular rule applies – the amt realized of 175k minus basis of 170k = 5k gain

1. Basis = 180k – 10k depreciation = 170k c. $165,000

i. Here, there is a diff basis for loss and for gain. The basis for determining gain is 170k (180k-10k in depreciation). The basis for determining loss is 150k (160k FMV- 10k).

ii. This results in no gain or loss b/c the amount sold for is in between (amt realized is in b/w = no gain or loss)

(c) What result in (b)(2) if the property had been Homeowner’s principal residence, they had owned and used it for 4 of the prior 5 years, and the depreciation was taken after 1997?

a. 121(a) – GI shall not include gain from the sale or exchange of property if, during the 5 year period ending on the date of the sale or exchange, such property has been owned and used by the TP as his principal residence for periods aggregating 2 years or more.

i. Generally, when you sell property you will get $250 or $500k exclusion b. 121(d)(6) – Subsection (a) does not apply to the gain on the sale that does not exceed the portion of

depreciation i. But, if you take depreciation, you recapture depreciation first, then after that you can take

advantage of the exclusion c. Here, there was a 5k gain, which is generally excludible, but, since he took depreciation, it must be

included. Basically, he won’t have an exclusion unless the gain exceeds the 10k depreciation.

Deductions Not Limited to Business or Profit-Seeking Activities o Deals with personal deductions (not in trade or biz, you just get deduction)

Interesto §163(a) – There shall be allowed as a deduction all interest paid or accrued wi the taxable year on

indebtednesso 163(h) – (1) In the case of a TP other than a corporation, no deduction shall be allowed for personal

interest paid or accrued during the taxable year. o (2) “Personal Interest” = any interest allowable as a deduction other than:

interest paid or accrued on indebtedness properly allocable to trade/biz (other than trade/biz of performing services as an EE)

any investment interest (wi meaning of (d) interest taken into account under §469 in computing income or loss from passive activity

of the TP qualified residence interest (wi meaning of para (3)) interest payable under §6601 on any unpaid portion of the tax imposed by §2001 for the

period during which an extension of time for payment of such tax is in effect under §6163

If you meet certain requirements, you can pay estate taxes in installments…under certain circumstances, those payments are deductible

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interest allowed as deduction under §221 (relating to interest on educational loans)o Only way an individual TP can get an interest deduction is to meet one of these rules o If you take out a loan to go on vacation, that is personal loan and the interest won’t be deductible

o RR 69-188 (background)o IRS gives a definition of interesto In conjunction w a conventional mortgage, TP paid the lender a processing feeo Issue – is this loan processing fee interest, and therefore deductible under §163?o Payment or accrual of interest must be incidental to a legally enforceable obligation o Not necessary to label a payment made for the use of money as interest for it to be interest o Method of computation does not control its deductibility

As long as the amount in question is an ascertainable sum contracted for the use of borrowed money it can be interest

o To qualify as interest, the payment, by whatever name called, must be compensation for the use or forbearance of money per se and not a payment for specific services which the lender performs in connection with the borrower’s account. For example, interest would not include separate charges made for investigating the prospective borrower and his security, closing costs of the loan and papers drawn in connection with, or fees paid to a 3rd party for servicing and collecting that particular loan.

o In this case, it would depend on what processing fee is – if simply a portion for closing costs, then it is not interest.

o In this case, TP was able to establish the fee was paid as compensation solely for the use or forbearance of money. Was determined to be interest

o Time Value of Money Example:o This is to show the benefits of receiving (or consequences of giving) an interest free loano 5-year, $100k Interest-Free Loan invested in investment with 5% simple interest

If you borrow 100k and are not obligated to pay interest to that person, and you put into a CD that makes 5% interest, you get 5k per year for doing nothing. After 5 years, you receive 25k for just borrowing the money and investing. After the 5 years, you give the 100k principal back to the lender, and you have made 25k!

o This shows that holding money over time w/o paying interest is a valuable asset o J Simpson Dean (background)

o Owned majority of N Corp. They borrowed 5M from Corp and didn’t pay interesto 3rd Cir – the interest free loans may be looked at as passing the money to the SH in lieu of giving a

dividendo Issue – whether TP realized income of economic benefit in the use of the fundso Ct makes a stretch in analysis – say there is a difference b/w interest free loan and use of Corp prop caseso In this case, the ct says it is a wash b/c if they have income, there is also deduction – also held that interest

free loans are not taxable at all b/c there is a potential for deduction of interest payments o Post dean cases clung to this rule – said there is a blanket rule that interest free loans are not taxable o In 1984, §7872 was enacted

o (1) Gift loan Father makes interest free loan to son – each year, the son is deemed to make interest payment

to the father on the imputed interest and the father is deemed to make gift right back to son of the same interest payment

This occurs even though no money exchanges hands – under 7872 the transfer is re-characterized this way

It is possible that the son receives an interest deduction, but there are limitations under §163 Make analysis as to whether it is deduction just as if the payments for interest had been made

o (2) Corporation and SH Corp makes interest free loan to the SH as a dividend and each year SH is deemed to make

interest payment back to corporation and corporation deemed to declare a tax dividend to the SH

o (3) ER/EE

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On an interest free loan from an ER to an EE, each year EE deemed to make interest payment to ER and ER deemed to give additional compensation back to EE

o In all these examples, the things are taxed on their substance rather than what it is called o Interest is computed by using the AFR (applicable federal rate)

o This is the average yield of US securities with comparable termso This is published each month by the IRS o You don’t have to ever compute the rates…just use the AFRo Rates: Short-term (not over 3 years), mid-term (between 3 and 9 years), and long-term (over 9 years)

A demand loan is short term o Gift loans vs. Non-gift loans (in §7872)

o Treated differently if gift loan vs. all the other loans o Gift loans and non-gift loans are further subdivided into term loans and demand loans

Each one taxed differently §7872(f)(5) – “Demand Loan” – any loan which is payable in full at any time on the

demand of the lender. §7872(f)(6) – “Term Loan” – any loan which is not a demand loan.

o Gift loans: §7872(a) Treatment of gift loans and demand loans – (1) In the case of any below-mkt

loan to which this section applies and which is a gift loan or demand loan, the forgone interest shall be treated as

Transferred from the lender to the borrower and Retransferred by the borrower to the lender as interest (2) Time when transfers made: forgone interest treated as transferred (and

retransferred) on the last day of the calendar year. Treated as a gift each year to the borrower, and an interest payment each year to the lender

The gift would not be included in income if it doesn’t exceed the gift amount It might be possible for borrower to deduct the deemed interest payment if the money

is used for biz purposes (we didn’t talk about this much) Demand Gift Loan

Lender is deemed to make gift of the funds necessary to pay the constructive interest to the borrower – borrower deemed to repay the loan amount as an interest payment

The timing of the loan is the end of each calendar year (loan made, repayment of interest immediately repaid)

Parent deemed to make constructive gift to the child (person paying the interest) and the child is immediately deemed to repay it

Amount of interest is the actual interest payment due subtracted from amt of interest that would have accrued by paying AFR

o Thus, if they aren’t paying any interest, the amt of forgone interest would be the AFR

o If they do pay something, you just subtract that from the AFRo Ex: Father lends son $100k interest free payable in full upon father’s

demand. If the loan remains outstanding during the entire taxable year, only one calculation is required. The interest rate is 12%, so 100k x 12% compounded semi-annually = 12, 360. Father is deemed to make gift to son of $12,360 on Dec. 31 of year one, and son is similarly treated as paying the same amount back to father as interest, which creates income for father.

The lender is deemed to make a gift on the last day of the calendar year for any years the loan is still outstanding and the borrower deemed to make interest payment on the last day

o So the deemed gift and deeded repayment of interest occurs on the last day of the calendar year

Term gift loan

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Constructive interest (amount deemed as transmitted from the father to the son) is taxed as a gift. Constructive interest is the amount loaned less the present value of all principal and actual interest payments (the total payments are discounted using the appropriate applicable federal rate – we don’t need to make PV calculations on the exam) to be made under the loan

o Note – this requires an extra calculation for the amount of the gift from father to son to be determined on the date the loan is made. This differs from a demand loan where the amount of the gift was not a separate calculation. With a demand loan, the amount of the gift is the same as the lender’s interest income – subtract any actual interest paid from the AFR.

Ex: $100k loan from father to son on Jan 1 of year one, due 4 years later on Dec. 31 of year four. (Term loan). This loan is made with donative intent. The fed mid-term rate in effect is 12%. This loan is a gift loan under §7872.

o The amount of the constructive interest is the amount loaned less the present value of all principal and all actual interest payments to be made under the loan. No interest payments are called for by the loan, so calculate the present value of 100k for 4 years at 12% = $62,741.24 and subtract that amount from 100k. The $37,258.76 difference is the constructive interest – the amount of the gift from father to son. This gift is deemed to be made on the date the loan was made.

o The father’s interest income is computed annually for each calendar year the loan is outstanding. The amount of interest that would have accrued under the AFR is reduced by any actual interest payable and the remainder is the forgone interest.

o Since father’s loan to his son called for no interest, the forgone interest for each year of the loan is simply 12% interest compounded semi-annually on $100k which is $12,360. This is the amount of interest the son is deemed to pay father each year in interest.

o Forgone interest is treated as having been paid by the borrower to the lender on the last day of each calendar year during which the loan is outstanding.

o Thus, on Dec. 31 of year 1, son is treated as having paid his father $12,360 – this results in income to the father and a possible deduction to the son. An exact duplicate of the transaction is deemed to occur on Dec. 31 of each of the 3 subsequent years the loan is outstanding.

What we need to do for the exam is recognize when a §7872 issue is there, describe the rules, and explain the consequences – no calculations

o Non-gift loans: Interest is still deemed to be charged by the lender. The borrower is deemed to have paid that

interest, generating income to the lender and a possible corresponding deduction for the borrower. The amount transmitted from the lender to the borrower to pay the constructive interest is characterized, not as a gift, but rather according to the nature of the relationship b/w the lender and the borrower.

The various relationships are the 5 sub/categories of non-gift loans in §7872(c): Compensation related loans

o The imputed payment from the ER to the EE is deemed to be compensation b/c of their relationship

o Can be b/w ER/EE or Independent contractor and a person for whom such independent contractor performs services

o Ex – treated each year as 10k compensation to EE. Also, a corresponding 10k interest payment to ER each year. Since the ER “paid” the EE an additional 10k each year, the ER gets 10k deduction for biz expenses. EE may or may not be able to deduct under §163, depending on what he does with the money.

Corporation/SH loans

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o The imputed payment from Corp to SH borrowing money is deemed to be a dividend b/c of their relationship

o Ex: treated as 10k dividend to SH. Not deductible by corporation, but is income to SH. Treated as corresponding 10k interest payment to corporation by SH.

Tax avoidance loans Other below-mkt loans

o This is a catch-all category Loans to qualified continuing care facilities

Demand – all deemed transfers occur on the end of the last day of the calendar year Term – the borrower is deemed to receive the benefit on the date the loan is made and interest

is deemed to be paid over the term of the loan ER/EE – on the date the loan is made, the ER gets deduction and the EE has deemed

compensation. Interest is deemed to be paid over the term of the loan So the timing is very similar, but the characterization is diff b/c of the relationships

o 3 exceptions to these rules Gift Loans

(1) $10k exception – §7872(c)(2)o In the case of any gift loan directly b/w individuals, 7872 does not apply

to any day on which the aggregate outstanding amount of the loans b/w such individuals does not exceed $10,000.

This exception does not apply if the loan proceeds are used to purchase income-producing assets.

o Note - this exception applies even if it has the principal purpose of avoiding taxes

(2) $100k exception – §7872(d)o (A) In the case of a gift loan directly b/w individuals, the amt treated as

retransferred by the borrower to the lender as of the close of the year shall not exceed the borrower’s net investment income

o (B) This exception does not apply if the principal purpose is the avoidance of federal tax

o (C) If the borrower has more than one outstanding gift loan, the net investment income is allocated among the loans in proportion to the respective amounts which would be treated as retransferred by the borrower

o (D) Exception only applies if the aggregate amount of outstanding loans does not exceed 100k.

o (E) “Net Investment Income” has the same meaning as in §163(d)(4) (net investment income over investment expenses).

If the net investment income does not exceed 1k, net investment income is treated as 0.

o §7872 rules do not apply if a gift loan does not exceed 100k, and the amount of imputed interest is limited to the borrower’s net investment income, and if the net investment income does not exceed 1k, you can ignore and there is no imputed interest at all

Non-gift loans - §7872 (c)(3) (3) 10k de minimus exception for compensation related and corporation/SH loans

o In the case of a compensation related or corporate/SH loan, §7872 does not apply to any day on which the aggregate outstanding amount does not exceed $10,000

o This exception does not apply if one of the principal purposes of the loan interest arrangements is the avoidance of tax.

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o Other non-gift loans do not contain the exception – so if not ER/EE and Corp/SH or gift loan, then there is no 10k de minimus exception

o If the loan amt ever goes above 10k, then the 10k de minimus exception will NEVER apply again 7872(f)(10)

Once you go above, you blow the exception You can make 1 or 2k loans, and can do interest free loan for a few

thousand dollars for a year or two and that is ok as long as principal purpose is not to avoid income taxes

o All loans b/w same lender and borrower are aggregated to determine whether the exceptions are met.

o Note – Under §7872(f)(7) – spouses are treated as one person o Note – look at each category (gift or non-gift and term or demand) to figure out how it is taxed and then look

at the 3 exceptions to see if they apply! o Other statutes that deal with interest:

o §1272 and surrounding sections – create interest for low interest or no interest bondso §163(c) – classifies redeemable ground rents as interest

o Disallowance of interesto Courts have disallowed interest deductions if the device is tabbed a mere artifice

o §163(h) – generally disallows interest deduction for personal interesto Unless you meet one of the requirements under (h)(2), if you are not a corporation, you cannot deduct

the interest o “Qualified Residence Interest” (h)(4)(a)(i)

Doesn’t matter that not a corp, if have qualified residence interest, you can deduct the interest Qualified residence = the principal residence (w/i the meaning of §121) of the TP and 1

other residence of the TP which is selected by the TP for these purposes and is used by the TP as a residence (w/i the meaning of §280A(d)(1)

So you get 2 residences for purposes of determining qualified residence income 280A(d)(1) – TP uses a dwelling unit as a residence during the taxable year if he uses the

unit for personal purposes for the greater of 14 days or 10% of the number of days during the year that the unit is rented at fair rental value.

So if you rent it out for 300 days, you need to use it for personal purposes for 30 days – 10% of the days it is rented out

Unit not treated as rented at fair rental for any day for which is it used for personal purposes.

Residence can include mobile homes or live-in boats (can sleep in yacht for more than 14 days and don’t rent it out and if have mortgage on yacht, can treat the interest as qualified residence interest)

(h)(3)(A) – Qualified residence interest means any interest which is paid or accrued during the taxable year on (i) acquisition indebtedness with respect to any qualified residence of the TP or (ii) home equity indebtedness with respect to any qualified residence of the TP. The determination of whether any property is a qualified residence of the TP shall be made as of the time the interest is accrued.

(h)(3)(B) – Acquisition indebtedness means any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the TP, and is secured by such residence. Also includes indebtedness secured by such residence from the refinancing of indebtedness meeting the requirements of the preceding sentence, but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

Needs to be for improvement of home Ex.- if you buy a house for $500K, pay it off until you owe $300K and then

refinance…only $300K goes to acquisition indebtedness (even if the amount financed is more)

This would include building a swimming pool

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Cap: The aggregate amount of acquisition indebtedness can’t exceed 1M (500k in the case of a married individual filing a separate return)

(h)(3)(C) – Home Equity indebtedness means any indebtedness (other than acquisition) secured by a qualified residence to the extent the aggregate amount does not exceed the FMV of the qualified residence, reduced by the amount of acquisition indebtedness with respect to such residence.

Can use this loan for anything – doesn’t have to be for improvements to a home Can’t get more than FMV of house minus the acquisition indebtedness Cap: The aggregated amount of home equity indebtedness for any period cannot

exceed 100k. Examples: Interest paid on two categories of debt – “acquisition indebtedness” and “home

equity indebtedness” secured by a qualified residence is fully deductible as qualified residence interest.

For acquisition indebtedness, the amount can include refinancing of the debt, however it can never exceed the outstanding principal of the debt which is being refinanced. So, if TP reduces the principal balance of an acquisition debt from $200k to $150k, the maximum amount of any subsequent refinancing debt which may then qualify as acquisition indebtedness is $150,000.

Hypo: in the current year, TP purchases two qualified residences. If the first residence is subject to a $500k acquisition mortgage and the second residence is subject to a $600k acquisition mortgage, $100k of the total indebtedness will be disqualified as acquisition indebtedness b/c of the $1M cap. However, the $100k excess may qualify as home equity indebtedness if the FMV of the residence securing the $100k loan exceeds the amount of the acquisition indebtedness with respect to that residence by at least $100k. Thus, if the second acquired residence, which has a $600k acquisition mortgage, caused the $1M limitation to be exceeded, then only $500k of the mortgage on the second residence would be treated as acquisition indebtedness (along with the $500k mortgage from the first residence.) The remaining $100k debt from the second residence is home equity indebtedness whose interest is fully deductible if the second residence has a FMV of at least $600k.

o Similarly, if TP has a single residence with a $600k FMV and subject to a $300k acquisition indebtedness, and she takes out a second mortgage on the residence, the interest on up to $100k of the proceeds of the second mortgage is fully deductible as home equity indebtedness regardless of the use of such proceeds. However, if the proceeds are used to substantially improve the residence, the indebtedness would them qualify as acquisition indebtedness.

o §163(h)(3)(D) – any debt incurred on or before Oct 13, 1987 that was secured by a qualified residence as of that date, is treated as acquisition indebtedness and not subject to the $1M cap (although it does reduce the cap for other acquisition indebtedness).

Therefore, any interest on the secured Pre-October 13, 1987 indebtedness remains fully deductible regardless of the aggregate amount of the debt.

The resulting debt, or any refinanced debt from grandfathered debt will be treated as acquisition indebtedness only until the term the grandfathered debt expires, or the earlier of 30 years.

o Qualified education loan exception o The interest is not personal interest and you can deduct even if not a corpo 163(h)(2)(f) – any interest allowable as a deduction under §221 (interest on educational loans) is

allowed as a deduction 221(d)(1) – “qualified education loan” – indebtedness incurred by the TP solely to pay

qualified higher education expenses which are incurred on behalf of the TP, spouse or dependant, which are paid w/i a reasonable period of time before or after indebtedness incurred, and attributable to education furnished when recipient was an eligible student.

Does not include indebtedness owed to a person who is related to the TP 221(b)(2)(B) – deduction is phased out b/w 50k and 65k (100k and 130k for married couple)

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This is a max deduction of 2500 if you meet all the requirements, and it is not a credit, so it isn’t a huge deal, but to some people it might be important

o Investment interest exception o §163(d)(1) – For a TP other than a corporation, the amount allowed as a deduction for

investment interest shall not exceed the net investment income of the TPo Net investment income = the excess of investment income over investment expenses.

Don’t have to calculate on examo Investment interest means any interest allowable as a deduction which is paid or accrued on

indebtedness properly allocable to property held for investment. o Investment interest does not include any qualified residence interest ((h)(3)) or any interest

which is take into account under §469 in computing income or loss from a passive activity of the TP

o Examples: investment interest can occur on money taken out to buy stocks and bonds o If you have investment interest, but not net investment income to take deduction, you can carry it

forward indefinitelyo 1000 investment interest and only 500 net investment income, you can only deduct 500 that

year and you carry the other 500 forward until a year where you have net investment income to cover it

o 264(a)(2) – no deduction is allowed for any interest on debt incurred to buy a single premium life insurance or annuity

o You can’t borrow money to buy these things and then deduct the interest o 265(a)(2) – no deduction is allowed for interest on indebtedness incurred to carry or purchase tax

exempt bonds.o How much connection must there be b/w the interest and the tax exempt bonds?o Simultaneous existence alone is not enough.

So just b/c you owe someone money and also have tax exempt bond, that’s not enough

o But if you secure the loan by the bond, that is enough Bank sometimes require you to have a SI in the bond in order to loan you the money

o 163(f) – TP cannot deduct bond interest unless the bonds are registered

Problems Pg 502 3. TPs purchase a home in the current year which they use as a principal residence. Unless otherwise stated,

they obtained a loan secured by the residence and use the proceeds to acquire the residence. What portion of the interest paid on such loan may TPs deduct in the following situations:

(a) The purchase price and FMV of the home is $350K. TP obtains a mortgage for $250K of the purchase price.o This is an acquisition debt, but d/n know if there’s a vacation home that’s borrowed against, or whether

there are other homes that kick TP over the $1mill. limit. Assuming this is the only residence, interest on all of the $250K mortgage is deductible. (Itemized).

o It is acquisition indebtedness and it is deductible.o 163(a) – all interest is deductibleo 163(h) if not corp, not deductible if personal interesto (h)(2) – all interest is personal except the following…(D) qualified residence interesto Acquisition indebt is one type of qualified residence interesto So this is deductible and none of the restrictions apply

(b) Same as (a) except that in two years, TPs have reduced the outstanding principal balance of the mortgage to $200K and the FMV of the residence has increased to $400K. In the later year, TP takes out a 2nd mortgage for $100K secured by the residence to add a 4th bedroom and den to the residence.

o The second mort. for $100K is an acquisition debt b/c used to remodel. As long as TP stays within the $1mill. limit on acquisition debt on all homes (2 limit), then all the interest is deductible.

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o They now have a total of 300k debt and the full amount of interest will be deductible. (the first 200k is the original acquisition indebtedness and the second 100k is also acquisition indebtedness because they used it to remodel.)

o You can refinance and can do so up to the balance of the existing mortgage. o The test is whether this substantially improves the residence. The point is that acquisition indebt does not

have to be a loan used to acquire a residence, can also be to sub improve residenceo Adding 4th bed and den would improveo This cannot exceed the balance of the mort at the time you refinance. Reduce the outstanding principal

balance to 200k, then you can take out the second mortgage for up to 200k. o Here, it is for 100k, so it is ok.o 163(h)(3)(b) –Acquisition indebtedness includes any indebtedness secured by such residence resulting

from the refinancing of indebtedness meeting the requirements of the preceding sentence, but only to the extent the amount of the refinancing does not exceed the amount of the refinanced indebtedness. .

o If it were a 300k second mort, then 200k could be acquisition indebtedness and the other 100k could possibly be home equity indebt

(c) Same as (b), except that TP uses the proceeds of the $100K mortgage to buy a Ferrari.o This is home equity debt. FMV of property is $400K. Outstanding balance of acquisition debt is $200K.

The acquisition debt is still ded., and the $100K home equity debt is ded. (assuming no other residences w/ home equity debt b/c $100K is the max.)

o When it is home equity indebtedness, it doesn’t matter what you use money for under 163(h)(3)(c)(i) o As long as the loan is secured by the house, it doesn’t matter what you use the money for.

(d) Same as (a). 10 years later, TP has paid off $200K of the $250K mortgage and the residence is worth $500K. In the later year, TP borrows $200K on the residence, $50K of which is used to pay off the remaining balance of the original mortgage and the remainder is used to pay personal debts.

o How much is acquisition indebtedness? 50k is used to pay off remaining balance of original balance. This is effectively refinancing. This 50k would qualify as acquisition indebtedness under 163h3b rule and the interest is deductible.

o Home equity indebtedness? 100k of it can be treated as home equity. (b/c lesser of FMV or 100k and here, the FMV is 500 less the acquisition indebtedness is 50k = 450k.)

o Equity in house = FMV of the house minus the acq indebtedness as of the date you acquire that debt (refinance)

500k – 50k = 450k o Thus, the interest on 150k out of the 200k mortgage is deductible under 163

o 150/200 = 75% of the total interest that you pay is deductible o The other 25% is a non-deductible personal expense.

o Note – even if the money they borrowed was used to fix the house which would qualify as acquisition indebtedness, still only 50k would be deductible as acq indebtedness b/c of the original balance on the date they refinanced. The rest could still be home equity indebtedness

o Note - If TP had another home for which he took the $100K home equity debt deduction, then only the $50K acquisition debt here would be ded.

(e) Same as (a), but also, towards the end of the current year, prospects TP purchases a luxury vacation residence in Fla. for the FMV of $1,250,000. He finances $950K of the purchase price w/ a note secured by a mort. on the Fla. house, use the house 45 days of the year, and elect to treat the residence as a qualified residence.

o Principal home: 350K FMV. 250K acquisition debt.

o Fla. home: 1.25 mill. FMVo 950K acquisition debt on Fl homeo All of $250K is acquisition debt on first home. o To qualify for qualified residence interest, the 2nd home must be treated as a residence under 280A(d)(1)

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o The Fl home qualifies b/c stay there more than 14 days. They use it for 45 days to meet this. o Since we know it is a “residence”, must figure out how much is acquisition indebtedness and how much is

home equity indebtedness. o There is a $1M cap on acquisition indebtedness. 250k is allowed on the original home. On the second

home there is a total of 950k indebtedness secured by that residence. There is a total of 750k left.o Another $750K will be allowed as acquisition indebtedness for the Fla. Home. o That will max out the acquisition debt. But there is still 250k left on the Fl home. Another $100K can

qualify as home equity indebtedness. o Equity in the house is 1.25M-750k = plenty of equity to use home equity o 100k will be allowed on the Fla. home as equity debt.

o So principal home, all $250K interest is deductible. For Fla. home, $850K qualifies. So with Fla. home, it will be (850/950) x interest payment for amount of deduction.

o So only 150k on the new loan does not qualify for any deductions. o It is unclear whether the TP will get to choose which loan he gets to deduct first. Legislative history says

go in chronological order. Have to deduct the interest from the first 250k loan first, then from the new house.

o Why would this matter? If the TP has a higher interest rate on his second mortgage, he would want to be able to deduct those payments first.

(f) Same as (a), but the year of acquisition of the $350K residence subject to the $250K mortgage was 1985. In addition, instead of using all of the loan proceeds to purchase the residence, TP applied $200K toward its cost and used the other $50K of the proceeds to buy a sailboat. By the current year, TP had reduced the o/s principal of the 1985 loan to $175K. Also in the current year, TP refinanced the property (now worth $500K) w/ a loan for $300K which is secured by the residence. TP uses $175K of the proceeds from the current year loan to pay off the balance of the 1985 loan and the remaining $125K to pay off his children’s educational loans.

o This is a Grandfather debt – 163(h)(3)(D)(i). $175K qualifies as acquisition debt b/c incurred before 10/13/87. Of the other $125K, $100K is home equity indebtedness (b/c of 100k cap). The other $25K is a personal expense.

o So the interest on 275k of the 300k loan is deductible

4. Single TP T, who grad from law school, pays $3k of interest in the current year on qualified educational loans.(a) If T has $40,000 of modified AGI in the current year, what amount of interest can T deduct?

o Cap is 2500 so only interest on 2500 of the 3k is deductible o He is below the phase out so gets full deduction of 2500

(b) Same as (a) except T has $57,500 of modified AGI in the current year. o Falls into phase out level o The ded is phased out b/w 50 and 65k for single TP – If below 50k, you get all deduction, if above 65, you

get nothing. But here it is right in the middle, so it is phased out 50%.a. We won’t have to do this on examb. What we need to know is that if below 50k, they get full deduction and if above 65k get no

deduction and if in b/w, it is phased out ratably(c) Same as (a) except T is married and T and Spouse file a joint return and have $140k of modified AGI in the

current year. o B/c they are above 130 (for married), they won’t get any of the deduction.

(d) Same as (c) except that T and Spouse delay paying the $3k of interest (along with a $300 penalty) from the current year to succeeding year when their modified AGI is $80k (b/c Spouse ceases working) and when no other interest payments are made. o They are under the cap of 100k, so it seems like they can deduct the entire amount. The issue is whether

they can defer the payment/ prob can, but prob can’t ded the penalty. o Then the issue is, what is worse for them, the 300 bank penalty, or not getting the ded

a. Take the tax rate and multiply by 2500 – it would come out better than a 300 penalty o In this case, the ded of 2500 is more valuable than the 300. o Interest would be deductible, but bank penalty is not interest, it is penalty so not deductible

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(e) Treated as a gift from the father to the son

5. Investor incurs investment interest of $100,000. To what extent is it deductible in the current year if:(a) She sell stock during the year at a $60k gain and has $20k in dividends on all her stock, but assume that under

§163(d)(4)(B)(iii) neither qualifies for §1(h) preferential treatment, and she has $10,000 in deductible investment adviser fees? Are there any other tax consequences to Investor?o Gross investment income is 60k +20k – 10k = 70k. Under 163(d) can only deduct interest to the amount of

net investment income. Thus, she can only deduct 70k of the 100k investment interest. The disallowed 30k is carried forward until the next year when she has enough investment income to allow it.

(b) The interest of $100k is on loans whose proceeds are used to purchase tax exempt bonds?o Tax exempt bonds – if you borrow money to purchase tax exempt bonds, 265(a)(2) says you don’t get the

deduction(c) Proceeds of the loans are used 50% to purchase tax exempt bonds and 50% to buy stock and the bonds and

stock are her only investments?o Only 50% is deductible since 50% is for the tax exempt bonds (and you don’t get deduction for those)

Taxeso 164(a) – Except as otherwise provided, the following taxes are allowed as a deduction (a/g federal income

taxes):o State and Local and foreign real property taxes o State and local personal prop taxes

Not real issue in LAo State and local and foreign income taxes

So LA income taxes are deductible a/g your fed income taxeso If payment falls into one of these categories, it is deductible whether or not you are in a trade or biz.o In addition, there shall be allowed as a deduction State and local and foreign taxes not described

above which are paid or accrued w/i the taxable year in carrying on a trade or biz or an activity un 212 for the production of income.

o Any tax not described in the first part of (a) which is paid or accrued by TP in connection with an acquisition or disposition of property shall be treated as part of the cost of the property, or as a reduction in the amount realized on disposition.

o 164(b) definitions: (1) personal prop tax = ad valorem tax imposed on an annual basis in respect of personal property

o (2) State and local tax – only a tax imposed by a State, a possession of US, a political subdivision of one of those, or by the Dist. Of Columbia.

o 164(c) – no deduction allowed for the following taxes:o Taxes assessed a/g local benefits of a kind tending to increase the value of the property assessed

If impose tax but it increases the value of your property, that deduction is disallowed under (c)(1). However, it does not apply to maintenance or interest.

o Taxes on real property to the extent that (d) requires the taxes to be treated as imposed on another TP.

o 164(d) – Apportionment of taxes on real property b/w seller and buyer: requires you to allocate real prop taxes b/w the part of the year that you own the prop

o If you sell the prop on June 30, then the seller gets the deduction for half the prop taxes for the year and the buyer gets the other half

o §275 – no deduction is allowed for: federal income taxes; estate and gift taxes; taxes that 164(d) requires to be imposed on another TP

o 1001(b)(2) – the amt realized from the sale of property shall be the money received + the FMV of property received. In determining the amount realized, there shall be taken into account amounts representing the real property taxes which are treated under 164(d) as taxes to be paid by the purchaser.

o Tax Relief and Health Care Act (2006) amended §164b5(I) so that 2006 is changed to 2008

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o Cramer o TP had many houses that she was paying the property taxes on.

#1 – Prop she owned, but had sold. She sold it but retained title and was forced to pay prop taxes when the buyer failed to pay them.

#2 - her mother’s prop that she paid prop taxes on for her mother #3 - her own residence which she was allowed the deduction for prop taxes w/o question.

o The issue is whether the prop taxes on the first 2 prop is deductibleo Holding - Prop taxes only deductible to the person on whom they are imposed

So taxes she paid on her mother’s home are not deductible – she was not legally obligated to pay. No one can deduct these taxes.

State law req’d the TP to pay the taxes on the house she sold, b/c imposed on owner and occupant. Since she paid the tax it is deductible in 1965. However, in 1966 she sold the property again and transferred title, so under 164(d) only a pro rata portion are treated as going to the seller and the other part to the buyer. So even though she paid the entire amount of taxes, the deduction had to be split during the part of the year she owned the prop

So 164(d) requires you to allocate even if you don’t, in reality, allocate the payment.

Problems pg 507 1. Which of the following taxes would be deductible as such under §164?

(a) A state sales tax imposed at a single rate on sellers but not required to be separately stated and paid by purchasers to seller, applicable to retail sales of any property except food, clothing and medicine.o Not deductible. It is not specifically listed in 164(a) so unless in trade or biz or §212 activity for

production of income it is not deductible. (b) A state real property tax of $1k for which A became liable as owner of Blackacre on Jan 1st but which B

agreed to pay half of when he acquired Blackacre from A on July 1st. o A gets to deduct half and B gets to deduct half

(c) A state income tax.o They can deduct under 164(a)(3)

(d) The federal income tax.o Cannot deduct

(e) A state gasoline tax imposed on consumers.o Not deductible

2. Which of the following expenditures would be deductible, if not as taxes, as §162 or §212 expenses within the second sentence of §164(a)?

(a) A state tax on cigarettes (imposed on their sale at a rate 5 times the rate of the general sales tax) paid for cigarettes provided by the TP gratuitously to customers. o 164(a) – not deductible under 1-5. Second sentence allows a deduction for state and local and foreign taxes

that are paid or incurred for carrying on a trade or bizo JK thinks it is deductible under 164, but probably not necessary b/c deductible under 162.

(b) A filing fee required to be paid to the State Democratic Party by candidates entering state primary elections. o This is not trade or biz or activity to produce profit

3. Son, who is still in college owns substantial securities. Father, when paying his own intangibles tax to State X, pays the intangibles tax due by Son.

(a) May Father deduct the tax paid? Based on Cramer, where she paid her mother’s prop taxes, but was not allowed a deduction since the taxes

were not imposed on her, Father does not get deduction b/c the tax not imposed on him. To be ded, the tax must be imposed on you

(b) Is it deductible by Son? Unclear – nothing on point

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164 seems to imply that the son actually write a check. But what is the diff if the father pays it directly, or just gives a check to son and he writes a check. The safe way to do it is have the father write check to son and then have son pay it

When dealing with selling property, you can reduce the purchase price of house a little bit and have the buyer pay their own prop taxes and get the deduction (b/c they wouldn’t be able to deduct if you paid the entire amount of prop taxes, and you wouldn’t be able to deduct for the portion of the year after they purchase house, even though you paid the tax.)

4. Dr. Medic employs Charles to work for her as receptionist. She pays Charles’s salary, but withholds X dollars to which she adds Y dollars all of which she pays to the fed gov under the Fed Insurance Contributions Act (for “social security”).

(a) Can Dr. Medic deduct amount X? Amount Y? X plus Y? Under FICA, the total tax is 15.3% - ER pays half and EE pays other half, but ER withholds from check

and pays it. Case allows both X and Y ded under 162. this is b/c it is ord and nec biz expense. So even though not ded

under 164, it is ded under 162 Ex – Pay 10k salary. Total Fica is 1000k – 500 for ER portion and 500 for EE portion. ER can deduct all

of it. EE gets screwed b/c even though withheld from paycheck, and had to pay the tax, they can’t deduct it.

(b) Is Charles entitled to a deduction for the payments? Under 275a1a, the ded is not allowed: disallows the tax imposed by §3101

5. The City of Oz constructs a yellow brick road that runs past Woodman’s property. He and other property owners adjacent to the road are assessed varying amounts by Oz, based on the relative amounts of front footage of their properties. Woodman elects to pay off the assessment over 5 years and pays $400 in the taxable year. Deductible?

o Not ded if it increases their prop value – 164c1

La motion picture tax credit- companies come to LA to film movies, get tax credits, sell them to brokers, who sell them to others, etc. Under 164, how will that be taxed? If the state gives you the credit, then that counts as a reduction in your state income tax liability (you are the original owner of the tax credit). If you purchase the tax credit from another person, then it’s treated for federal tax purposes as having an appreciated value on your property.

Deductions for Individuals OnlyThe Concept of AGI

§62 – “AGI” means, in the case of an individual, gross income minus the following deductions: o (1) Trade and biz deductions – deductions attributable to the trade or biz of a TP if the trade or

biz is not the performance of services by the TP as a EE. o (2) Certain trade and biz deductions of EEs

(A) Reimbursed expenses of EEs - incurred in connection with the performance of services as an EE

§62(c) – arrangement not considered a reimbursement arrangement if it does not require the EE to substantiate the expenses or provides the EE the right to retain any amount in excess of the substantiated expenses

(B) Certain expenses of performing artists (C) Certain expenses of officials – deductions allowed by 162 which are expenses with

respect to services performed by an official as an EE of a state or political subdivision (D) Certain expenses of elementary and secondary school teachers – deductions allowed

by 162 consisting of expenses not in excess of $250 for books, supplies, computer equipment, and other supplementary material used in the classroom.

o (10) Alimony - §215o (15) Moving Expenses - §217o (17) Interest on education loans - §221o (18) Higher education expenses - §222o The same item is not allowed to be deducted more than once!

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§62 does not authorize a deduction – all it does is say which deductions are able to be taken in arriving at AGI (the deductions are listed elsewhere in the code)

AGI is used as measuring device elsewhere in the code. Certain items are phased out if AGI is at a certain level.

Examples of how AGI is used as a measuring device:o Charitable deduction – generally if making deduction to public charity you can only deduct up to a

certain amount of your AGIo Floor on med expenses (7.5%)o Casualty and theft losses o Some itemized deductions

§62 provides the “above the line deductions” – these deductions are subtracted from gross income to determine AGI. If it is not an above the line deduction, it is “below the line deduction” and are itemized deductions that can be taken in lieu of the standard deduction.

o So if identified in §62, you can take deduction no matter whato If below the line (not specifically listed) it is an itemized deductiono You have to option of either taking the itemized deduction or the standard deduction (everyone gets no

matter what) – take whichever one is greater The concept of AGI has relevance only with respect to individual taxpayers. It has no significance for

corporate taxpayers, or estates, trusts, or partnerships.

This chapter deals with deductions available to individuals no matter what – it doesn’t matter if they are in trade or biz or trying to produce income.

Moving Expenses §217 – Allows a deduction for moving expenses incurred during the taxable year in connection with the

commencement of work by the TP as an EE or as a self-employed individual at a new principal place of work.

o Basically allows TP to deduct any moving expense you incur moving to a place of work if you are an EE, or if you are self-employed allows the expenses you incur in moving your biz

o Examples of what is a deductible expense: expenses for moving household goods and personal effects from former residence to new residence. Includes the cost of crating and moving insurance for the items, but does not include not-in-transit storage charges (PODS are not included).

Includes cost of moving pets, but not moving a yacht TP may deduct the expenses of traveling (including lodging) from the former residence to new

one. Only one such trip may be made by the TP and the members of his family, but not necessary that they all travel together or at the same time. The only limitation is that the expenses be reasonable and no deduction is allowed for meals.

o Must be moving for the commencement of work (not school, for retirement, etc.) §217(b): “Moving Expenses” means only reasonable expense of moving household goods and personal

effects from the former residence to the new residence and of traveling, including lodging, from the former residence to the new residence, but not expenses for meals.

o The mover, mileage driving from place to place, renting a U-Haul, also traveling, including lodging, but not the cost of meals

So if moving to LA, can deduct the hotel on the way, but not the cost of meals o In the case of a person other than the TP, such expenses will be taken into account only if the

person has both the former and new residence as the principal place of abode and is a member of the TP’s household.

E.g.- expenses of kids included 217(c) - Conditions for allowance of deduction:

o (1) Distance requirement TP’s new principal place of work must be at least 50 miles farther from his former

residence and his old place of work, OR

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So if you live 5 miles away from work, your new residence upon moving must be 55 miles away

If no old principal place of work, must be at least 50 miles from former residence. o (2) Time requirements

TP must work at the new principal place of work for period of time: Either: during the 12 months immediately following his arrival in the general location of

new principal place of work, TP is a full-time EE for at least 39 weeks, OR During the 24 months immediately following his arrival in the general location of new

principal place of work, TP is full time EE or performs services as a self-employed individual on a full-time basis during at least 78 weeks (and 39 weeks still must be during the 12 month period above.)

Must meet one of the 2o 217(d)(1) – the time requirement does not apply if the reason you don’t meet requirement is that you

die, become disabled, or are fired. o 217(d)(2 & 3) - If the requirements are not met as of date of filing return, you can still claim

deduction, but it TP fails the test down the road, then must recapture the deduction on subsequent return or file amended return

Moving expenses are above the line deduction – 62(a)(15) If ER pays for moving expenses (Reimbursement):

o If reimbursements made in the same year, it is a wash. Excluded from income, but no deduction allowed

o If reimbursed in later year, in year 1 get deduction and year 2 recognize the amount you are reimbursed as income (132(g))

Foreign moves o In addition to the normal deductions for moving household goods, the cost of storing household goods

and moving the items to or from storage are also deductions (under gen rule can’t ded storage, but with foreign you can – 217(h)(1))

o On returning to the U.S., the TP only has to satisfy the distance, not time requirements – 217(i)(1) and (2)

o Same rule applies to surviving spouse and dependent of a decedent whose principal place of biz was outside the US if the expenses are incurred w/i 6 months of the decedent’s death.

Problems1. Lawyer has been practicing law in Town X and he and his family live in Suburb of Town X ten miles away. He decides to open an office in Town Y. Consequently he moves himself and his family to a home in Town Y.(a) How far away from Suburb must Town Y be located in order for Lawyer to be allowed a moving expense deduction?

At least 50 miles further than the distance from his former residence to old place of work Take the distance b/w his first residence and work at the time which is 10 miles and you must be at least 50 +

the amount further. 50 miles + 10 miles = 60 miles. Must move at least 60 miles to get the deduction(b) How far away from Suburb must Town Y be located in order for Lawyer to be allowed a moving expense deduction if Lawyer has just graduated from law school in Town X and he was not employed?

Doesn’t matter that he was in the job market or just entering, he gets a deduction Since he didn’t have a former place of work, it is 50 miles from the former residence

(c) Assuming Lawyer is a sole practitioner what time requirements are imposed on him in order for §217 to apply? Since he is self employed, must satisfy both the time requirements Must meet 217(c)(2)(b) – both of them which require you to work there 39 weeks in the first 12 months and 79

weeks in 24 months(d) What difference in result in (c) if Lawyer joins a firm in Town Y as a partner?

Same result b/c Ps are considered to be somewhat self-employed. 217(f) (e) What difference in result in (c) if Lawyer goes to work for a firm in Town Y but as an associate rather than a partner?

If he is an associate it is like he is an EE, so he only has to meet the c(2)(a) requirement.

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(f) Assuming the necessary time and distance requirements are met, and that a joint return is filed, what is the amount of Lawyer’s §217 deduction if he incurs the following expenses: $400 in moving his family’s belongings; $150 in transporting his family; and $100 in lodging and $200 in meals in conjunction with transporting the family?

H will be able to deduct all of it expect the meals The def of moving expenses in 217b specially does not allow moving expense related to meals. But everything

else is deductible(g) Is there any difference in the result in (f) if Lawyer’s spouse also takes a job in Town Y and meets the necessary time and distance requirements?

There is no difference. The 217 requirements are met if either of them meets the time and distance requirements – the entire family will get the 217 deductions

(h) If lawyer’s firm reimburses Lawyer for $850 of his expenses in the year they are incurred, what tax consequences will the reimbursement have?

He cannot deduct the amount reimbursed, but it would be excluded as a qualified moving expense reimbursement – 132a6. The only thing not excluded from income are the meals. They are not a qualified moving expense so they are included in income

B/c reimbursed during same taxable year, it is excluded from income and no deduction.

2. When ER moved her to Indianapolis, Ms. Keen bought a house for $140,000. Several years later her ER asked her to move to San Fran which she did. The best offer Ms. Keen could get for her house was $135,000 so, under her employment K, ER bought the house from her for $140,000 (her cost). He later resold it for $135,000. What are the tax consequences to Ms. Keen and to ER.

Seth E. Keener, 59 T.C. 302 ER: This was allowed as a 162 deduction for ER for buying house. Is it an ordinary and necessary biz

expense? If you need to do it to get EE to move for work, it probably is. It is probably ordinary and necessary biz expense

EE: had compensation income b/c the ER paid this amount for them. Here, the EE will have additional income of 5000 – difference b/w 135k and 140k The ER gets a 162 deduction

3. Professor Bionic took a year’s leave of absence from the Biology Dept at a La college to teach Biology at a college in Vt. He left La in June 1994, and returned in Sept, 1995. At a cost of $3,000 he moved his modest apt furnishings to Vt and back, saving an estimated $1,000 additional expense in Vt. May he deduct the $3,000 under §217?

In the Goldman case, the ct said that you need a commencement of a new job, not merely visiting and returning.

The deduction under 217 is only allowed if you acquire a new “principal place of work” Under Goldman, they found this was not new principal place of work, just a temporary assignment But, under Peurifoi, the travel expenses should be deductible under §162a2 – expenses while traveling away

from home Under 162a2, that allows a deduction for travel expense while away from the taxpayer’s home and 217 allows

deduction for moving expenses when the TP principal place of work changeso 1.217-2c3iii, the 2 provisions are supposed to be mutually exclusive. So if you acquire a new principal

place of work, you get a 217 deduction but not the 162a2 deduction for expense while traveling away from home. Can’t say you are acquiring new principal place of work and traveling away from home

o RR 93-468 – allowed a new Congress member to make deduction under both sections, but that was very specific situation. Under general rule, rely on reg – you get one or the other deduction

Extraordinary Medical Expenses §213(a) – TP can deduct med expenses, not compensated by insurance for medical care of the TP, his

spouse, or a dependent but only to the extent the expenses exceed 7.5% of AGI. o It is very rare the med expenses are high enough to meet this floor.

Dependent is defined in §152 – but the 3 special rules in 152 don’t apply (Special rules: (1) person claimed as dependent can’t claim a dependent (2) married filing joint can’t be dependent (3) to be qualifying relative, the person can’t have GI that exceeds exemption amount)

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§213(b) - Limitations on deduction with regard to medicine and drugs: Amount paid for medicine or drugs shall be taken into account in (a) only if it is a prescribed drug or insulin.

§213(d)(1) “Medical Care” means amounts paid for o The diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of

affecting any structure or function of the body; o Transportation primarily for and essential to medical care; o Qualified long-term care services; o Insurance covering med care or qualified long-term care insurance contract.

In the case of qualified long term care insurance contracts, only eligible long-term care premiums may be taken into account.

§213(d)(2) – Certain amounts paid for lodging away from home treated as paid for medical care: Amounts paid for lodging (not lavish or extravagant) while away from home primarily for and essential to medical care shall be treated as amounts paid for medical care if (A) the med care is provided by a physician in a licensed hospital or equivalent, and (B) there is no significant element of personal pleasure, recreation, or vacation in the travel away from home. The amount taken into consideration shall not exceed $50 per night for each individual.

o So you can’t pick Orlando to get your eye surgery and then go to Disney world while you are there – must be for med reasons

213(d)(9) – Medical care does not include cosmetic surgery unless it is necessary to ameliorate a deformity from a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.

o Cosmetic surgery means any procedure directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

Gerard o TP daughter had cystic fibrosis. They were forced to install central AC. o Generally medical expense is deductible under 213. But disallowed under 263a1 if improves value of

house or property. So if you spend money that could be med care, but increase the value of the prop, 263a1 disallows deduction, but only to the extent it increase the value of the prop

o The issue is whether this increased the value of prop? Generally capital expenditures are disallowed under the rule, but just because it is a capital

expenditure doesn’t mean it is disallowed. o Wiseman – cost of installing elevator in deductor’s home was deductible as med expense b/c even

though it was cap expenditure, the elevator did not increase the value of the prop o In Gerard, Ct held the expense was deductible to the extent the cost of the improvement increased the

value of the home. The difference of $500 was allowed as a deduction (cost of 1300 and improved value of home was 800)

RR – 2002-19 o TP A is diagnosed as obese and B is diagnosed with hypertension and both prescribed to lose weight.

Both joined weight watchers. o Are these deductible as med care expenses?o Deduction for med care expenses are confined strictly to the expenses incurred primarily for the

prevention or alleviation of a physical or mental defect or illness. An expense merely beneficial to the general health of an individual is not an expense for medical care. Whether expense is primarily for med care or is merely beneficial to general health is a Q of fact.

o §262 provides that no deduction is allowed for personal, living or family expenses. o TP who participates in weight loss program to improve TP’s appearance, or general health and not to

cure a specific ailment or disease, may not deduct the cost as a med care expense under §213. o RR 55-261: med care includes the cost of special food if (1) the food alleviates or treats an illness, (2)

is not part of the normal nutritional needs of the TP (3) need for the food is substantiated by a physician. However, special food that is a substitute for the food the TP normally consumes and that satisfies the TP’s nutritional needs is not med care.

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o Ruling concludes that obesity and hypertension are specific diseases so the expenses related to curing them are generally ded, but the cost of the food is not deductible b/c it is used to substitute what you would normally eat

Book has lots of examples of med expense that may or may not be ded pg 556-558. The key with dealing with these things is to research the specific facts of your case.

RR 75-316 – Where it is questionable whether an expense is deductible as a biz expense rather than a med expense, the expense may be deducted under §162 if the following 3 elements are met:

o (1) The nature of the TP’s work clearly requires that he incur a particular expenses to satisfactorily perform such work

o (2) The goods or services purchased by such expense are clearly not required or used, other than incidentally, in the conduct of the individual’s personal activities,

o (3) The Code and Regs are silent as to the treatment of such expense. It is a bit unclear whether lodging and 50% of meals when traveling to and from the place to get med care is

deductible as a “transportation expense” o JK thinks it is, but it is a bit unclearo If you go to Cali to get med expenses, it is unclear whether the lodging and expenses along the way

are deductible

Qualified long term care o Qualified long-term care services are services prescribed by a licensed health care practitioner for a

chronically ill individual. Treated as medical expenses

o Chronically ill individual is one who is unable to perform at least 2 activities of daily living for a period of at least 90 days due to a loss of functional capacity or as having severe cognitive impairment requiring substantial supervision to protect the individual from threats to health ad safety.

213d1d – includes med insurance cost and insurance for long term care in the def of med care expenseo The inclusion of insurance expense may be significant although the 7.5% floor applicable to the

deductibility of all of one’s medical expenses may preclude deductibility. 162(l) allows self employed individuals to deduction the full cost of med insurance (not subject to the 7.5%

floor)

Problems1. Divorced homeowner received no help from former husband and fully supported her 20 yo Daughter who had no income, lived with Homeowner and was a dependent of Homeowner under §152. In the current year, Homeowner installed a central air conditioning system at a cost of $4100 which Dr. said was an elementary requirement in caring for Daughter’s respiratory problems. After installation, Homeowner’s home has increased in value by $2100. Other med expenses paid during the year by Homeowner and Daughter consisted of prescription medicine in the amount of $320 and doctors’ bills in the amount of $400. Late in the year, she also paid $300 in premiums for health insurance but received no reimbursements under the policy that year. (a) If Homeowner’s AGI is $12,000 for the year, what will be the amount of her medical expense deductions?

The allowance of the ded is 7.5% of AGI which is $900 so any med care expense in excess of 900 are ded. Med 320 + doc bill 400 + ins 300 + air conditioner 2000 (4100-2100 because can’t ded to the extent increases

value of prop: 263(a)(1) and Gerard case) = total expenses of 3020. Subtract the allowed amount of 7.5% AGI which is 900. This leaves a total §213 deduction of 2120.

(b) Would it make better sense, and if so, be possible under the present statute to allow a deduction of $400 per year for the air conditioning expenditure, assuming the system has a 5-year life?

There is no authority for this. 167 and 168 are the sections that generally would allow depreciation but they don’t give it to you for med expenses

(c) If in the current year, Homeowner incurs maintenance expenses of $300 on the air conditioning system can that be taken into account as a med expense? Would a $150 deduction for those expenses be more supportable assuming Daughter is still there and still asthmatic? And what about an estimate that $400 of the year’s electricity bill is attributable to running the air conditioning system?

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These expenses are not increasing the prop value, they are just the expenses of running it. Under Reg 1.213-1(e)(1)(iii) expenses for operating the med expenditure are ded, but you must allocate Cohen – must allocate b/c the people living in house that are not asthmatic are using it for personal use

2. A and B both went from their hometowns to Big City on business, each planning to return the next day, which A did. A incurred costs for transportation, meals, and lodging in the amount of $200. B became ill at the end of his biz day and remained in his hotel for two extra days until he was well enough to return home. His expenses, which wo illness would have been the same as A’s, came to $300. What may B deduct and on what authority?

Probably can’t do anything under 213 b/c didn’t go to doc. But might be able to deduct under typical biz ded under 162

Kelley – if biz trip is extended by illness it is viewed as attributable to biz. Ordinary and necessary biz expense b/c would not have to incur the expense unless he was on biz

3. Sickly made frequent visits to his Psychiatrist. Late in the year he sent the doc $6000, indicating it was to apply a/g future charges for services. Wobbly checked into a retirement home in the same year. She paid the home $20k for the lifetime right to live in the home and receive care, including medical care. The home gave her a statement indicating that $6k of the charge was for med care. May either Sickly or Wobbly deduct the $6k payments?

Sickly, since no services performed yet, can’t take a ded – only take as the doc charges a/g the 6k deposit Wobbly –. For the living expenses it is clearly not ded. But, the 6k for med care is deductible. Basset – mere deposit a/g potential med services are not ded. RR 73-302 say that advance payments on promises for med care can be deducted So if you just give someone a deposit for med care, its not ded But if you give someone a deposit and they obligate themselves to perform the services, that is ded – like

Wobbly here b/c the doc is obligated to perform those services

Personal and Dependency Exemptions Just like a deduction, even though called an exemption. Not above the line b/c not in §62. These deductions are

allowed regardless of whether you take the standard deduction or itemize your deductions. Every TP gets a deduction for an exemption for themselves unless claimed as D of another (151 and 152)

o TP receive 2 exemptions if they file a joint returno If married TP files separate returns, one TP can claim an exemption on their return for the other as a D

but only if the other has no income and was not claimed as a D by another person 151b TP also gets exemptions for each individual claimed as a dependent – 151(c)

o 152 – “dependent” means a qualifying child or a qualifying relative. o 152(c) - “qualifying child” means an individual (A) who bears a relationship to the TP in para

(2), (B) who has the same principal place of abode as the TP for more than ½ of the year, (C) who meets the age requirements of para (3), and (D) who has not provided over ½ of his own support.

(c)(2) Relationship: (A) child of TP or descendent of such child, or (B) brother, sister, stepbrother, stepsister of TP or descendent of any such relative. (nephew, niece)

(c)(3) Age requirement: Individual (i) has not reached age of 19 as of the close of the calendar year or (ii) is a student who is not 24 at the close of the calendar year.

152(c)(4) – If an individual may be and is claimed as a qualifying child by 2 or more TPs for a taxable year the individual shall be treated as the qualifying child of the TP who is (i) a parent of the individual or (ii) if no parent, the TP with the highest AGI for the taxable year.

If the parents of the child do not file a joint return the child is treated as the qualifying child of the parent with whom the child resided for the longest period of time during the taxable year, or if resides with both for the same amt of time, the one with the highest AGI.

Basically – 1st goes to parent and if no one is parent, then goes to person with highest AGI. If more than one parent, then the parent with whom the child resided during the taxable year

o 152(d) - “qualifying relative” means an individual (A) who bears a relationship to the TP described in (2), (B) whose gross income is less than the exemption amount, (C) with respect to

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whom the TP provides over ½ the support, and (D) who is not a qualifying child of such TP or any other TP.

(d)(2) Relationship: (A) child or descendent of a child (B) brother, sister, stepbrother, stepsister, (C) father or more or ancestor of either, (D) stepfather or stepmother (E) son or daughter of brother or sister of TP (F) aunt or uncle (G) son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law (H) any individual who has the same principal place of abode as the TP and is a member of the TP’s household.

So if live with you, doesn’t even have to be related and can still have relationship requirement met.

If multiple people provide support – 152c – over ½ of the support of an individual for a calendar year shall be treated as received from the taxpayer if

o No one person contributed over ½ of such support, o Over ½ of such support was received from persons each of whom, but for the fact that he did not

contribute over half of such support, would have been entitled to claim such individual as a dependent for a taxable year beginning in such calendar year

o The taxpayer contributed over 10% of such support ando Each person described in paragraph 2 (other than the taxpayer) who contributed over 10% of such

support files a written declaration (in such manner and form as the secretary may by regulations prescribe) that he will not claim such individual as a dependent for any taxable year beginning in such calendar year

152e – divorced parentso Generally, the rules apply if the parents have custody of the child for at least ½ of the year, if they

provide more than ½ of the child’s support, if they don’t file a joint return, and if the child is not the subject of a multiple support agreement

o Custodial parent generally is entitled to the dependency deductiono If the custodial parent signs a waiver that he or she will not claim the child as a dependent for the

taxable year, the non custodial parent is entitled to the deduction if he or she attaches the waiver to his or her return for the year

Problems 1. State the number of deductions for personal exemptions available. Facts (unless otherwise stated): T was married; T’s spouse had no GI during the year and was not a dependent of any other person; T files a separate return. (a) T married H on Dec. 31 and H’s only income for the year was $50 of interest on tax exempt bonds.

2 exemptions – 1 for TP, one for H marital status is determined on Dec 31. b/c they were married then, they are treated as married requirements of 151b are met b/c T and H don’t file joint return. H has no tax income and H is not D of

another TP (b) Same as (a) except on Dec 31 H also received $100 as a wedding present from Uncle.

Same result b/c the present is excluded from income under 102 – there is still no tax income(c) Same as (a) except that the $50 was gain from the sale of the bonds in (a).

The requirements of 151b is not met b/c H has taxable income(d) Facts of (c) – may T claim a dependency exemption for H if a spousal exemption is foreclosed?

No b/c H is not D under 151 b/c the relationship requirement of 152a is not met (e) Same as (c) except T and H file a joint return.

2 exemptions allowed b/c the TP and H are both “TP” on joint return

2. Is T entitled to a dependency exemption for the particular person involved? Facts (unless otherwise stated): Taxable year is 1989; T was married but filed a separate return; T furnished over ½ the support for the particular person involved. Also, the person earned less than $2k GI during the year and did not live with T.(a) X was T’s wife’s brother.

Do get exemption 152d2 describes relationship to have a “qualifying relative” Brother in law qualifies

(b) Same as (a) but (1) T’s wife died the year before (2) T and W were divorced the year before.

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(1) Same result The issue is if the person is still brother in law when spouse dies 1.152-2d says you can still consider to be brother in law (2) Probably can still call person brother in law

(c) X was T’s wife’s deceased sister’s husband Not a brother in law so no deduction RR 71-72 Issue in all of these is whether or not you meet the relationship test

(d) Same as (c) except that X lived with T the entire year. No relationship req’d if X uses Ts home as his principal household 152d2 – last part – even if no relationship, if they live in your house, it is considered to meet the relationship

test (e) X is T’s son who is 19 this year and who earned $2k from summer jobs during the year but who is a full-time college student, except in the summer.

Issue here is the age requirement, b/c generally under 152c3 you must be 18 or younger, but if you have not made 24, you can still maintain age requirement if you are a student

(f) X is T’s 18 year old daughter who had only $500 of GI during the year, but who married Y during the year with whom she files a joint return

Cannot claim their daughter b/c she was married and file a joint return – can’t claim her as a D(g) Same as (f) but Y also had relatively little income from which tax was withheld and their return was filed only for purposes of obtaining a refund.

Issue – was there a joint return filed? The only reason was to get a refund According to RR, if the only purpose of filing return is to get a refund, then it is not considered to be filed

(h) X was T’s 18 yo son for whom T contributed $2k in support while X, who had no GI, applied $3k out of gifts from Uncle to his support.

152c1d – child can’t provide over half of their own support(i) Same as (h) except that X’s only contribution to his own support was a $3k scholarship enabling him to attend Embraceable U.

support in the form of a scholarship is disregarded so T can probably claim the exemption - 152f5

3. T=s father X, who has no gross income, was supported in the current year by T, T=s two brothers (A and B), and C, an unrelated friend. A total of $4K was spent for X=s support which was contributed in the following proportions by the above persons: X - 15%

T - 25%A - 20%B - 10%C - 30%

Which of these persons, if any, is entitled to claim X as a dependent and what procedures must they follow? '152(c) - Dad could claim himself but it would be worthless. C is not related to dad. If X was member of C=s HH and had PPA in C=s home for the year, '152(a)(9)

would allow C to claim X. But assuming that is not the case, C is out. Of the kids:

o T and A contributed over 10%. B contributed just 10%. B is out. (B should have thrown in one more dollar.)

o T and A should decide between themselves and he who does not claim X this year must file a written declaration that he will not claim X, and he who does claim X must attach a copy of the declaration to his return.

(Suppose for a moment that X had $3K gross income and together they provided $4K support. X gets dependency exemption, though it=s worthless. No one else could claim him.)

Special rule for multi support – go thru the rules:o Applies if no one contributed over half support – this is meto No one person … would have been entitled to claim as D…this is met b/c T meets the relationship test

and so do A and B, and they contributed 70% of the support. But for not giving him over half the support, they could have treated him as D

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o TP contributed over 10% of the supporto Each person files a written declaration – all must get together and decide that TP gets the exemption

In this scenario, either T or A could get the exemption if the other files a statement that he won’t claim it

4. W, upon graduation from law school, decides to divorce H after 3 years of marriage. The divorce becomes final in the current year and Q is awarded custody of their son H, Jr. Who is entitled to the dependency deduction in the following circumstances?(a) W furnishes 40% of Jr.’s support and H furnishes 60%.

Noncustodial parent only gets the exemption if requirements of (e)(2) are met (custodial parent signs over the right to get the exemption.) here, W gets the exemption under 152c b/c the 152(e) exception is not met

(b) Same as (a) except that W waives claiming any dependency deduction As long as the 152e2 requirements to waive the ded are met, H gets the exemption

(c) Same as (a) except that Jr. lives with Grandpa for 9 months out of the year. W does not qualify for the exemption b/c 152c, in order for jr to be qualifying child (c1b) the child must share

the same principal place of abode for more than ½ of the taxable year. Grandpa can claim the child as a D b/c the relationship test is met

o Child of TP or descendent of such child Under 152e, W does have the authority to sign the exemption to H if she wants to

o B/c she has legal custody even though Jr doesn’t live with her Under the current rule, it is a screwy rule b/c if W does not sign the waiver, grandpa gets the exemption and if

she does sign it, H can get the exemption. But in neither way, W gets the exemption Note – is e1B – custody means legal custody, doesn’t have to be physical

(d) Instead of getting divorced, W moves out of the house into her own apartment on May 1 of the current year and continues to reside there throughout the year. Jr. lives with H and both W and H equally provide for Jr’s support.

H gets the exemption under 152c

The Standard Deduction Can either take the stand deduction or itemized deductions Standard deduction automatically applies unless you elect to take itemized deduction First you must determine the amt of your itemized deductions There are restrictions on the itemized deduction: §67- miscellaneous itemized deductions are allowed only to the extent the aggregate exceeds 2% of AGI

o Miscellaneous itemized deductions means every itemized deduction except the deduction: section 163 relating to interest section 164 relating to taxes 165a for casualty or theft losses section 170 relating to charitable contributions and gifts, and section 642c relating to

deduction for amounts paid or permanently set aside for a charitable purpose section 213 relating to medical, dental, expenses allowable for impairment-related work expenses 691c relating to deduction for estate tax in case of income in respect of the decedent allowable in connection with personal property used in a short sale section 1341 relating to computation of tax where taxpayer restores substantial amount

held under claim of right section 72b3 relating to deduction where annuity payments cease before investment

recovered section 171 relating to deduction for amortizable bond premium section 216 relating to deductions in connection with cooperating housing corporations

o Even though other deductions are itemized deductions, you can’t take it unless all of them exceed 2%o One of the most common misc item deductions are EE expenses (if you are hired as EE and not

reimbursed for something, that is misc item deduction, which under gen rules, you can take, but you are not in trade or biz so it is subject to 2% floor (unless you have substantial misc item ded)).

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§68 – Limitation: In the case of an individual whose AGI exceeds the applicable amount, the amount of the itemized deductions otherwise allowable shall be reduced by the lesser of (1) 3% of the excess of AGI over the applicable amount (2) 80% of the amount of the itemized deductions otherwise allowed.

o If you earn too much money, you may not be able to take a lot of itemized deductions o Ex – 100k is the applicable amount. 500k AGI which exceeds 100k by 400k. Multiply 400k by 3%

which is 12k. You must reduce all of those misc item ded by the lesser of 12k or 80%. Assume there are 20k of item ded (after reducing the 2% floor for misc). Then you have to

reduce by 12k. You are only left with 8k of itemized deductions. First step – figure out all of your itemized deductions. Go to §62 to figure out what are above the line

deductions. Everything else are itemized deductions. After that, figure out what are your misc item deductions. Go to §67 to figure that out. You must reduce all misc item ded by 2% of AGI (can only ded to the extent they exceed 2% of your AGI). Next, figure out how much does your AGI exceed the applicable amount (which is generally 100k). After you get this amt you compare to stand ded and you take the greater of the 2.

Sinyard Issue – how do you treat the legal fee? It is a typical contingency fee case – the lawyer gets percentage of the fees Should the get taxed on the full amount of the recovery or some type of deduction for the legal fees they

are paying, or can somehow none of it be included? Sinyard said it was an itemized ded and subject to itemized ded restrictions. Effectivley, the TP was not allowed to ded much of the fees at all

This case was legislatively overruled by 62a20 (tells which items are itemized deductions) Now, age disc cases are not included in §62 So you can ded the full amount of those legal fees (see handout)

JW Banks – handout ( Current law) All of it is income to the , and it is an itemized deduction (and a misc item ded so you are subject to the

2%) Now, lawyers are trying to get the law changed b/c it doesn’t seem very fair! As of right now, the legal fees that are paid to the lawyer from the is taxed to the , even though they

pay the lawyer with the fees and never get the benefit of the fees. We just need to be generally familiar standard vs. itemized deductions – don’t worry about the problems pg 562 (see Kim’s outline for answers)

Deductions Affected by Characterization PrinciplesBad Debts & Worthless Securities

§166 – Bad Debts: (a) Wholly worthless debts: There shall be allowed a deduction for any debt which becomes worthless w/i the taxable year. Partially worthless debts: If the debt is recoverable only in part, the IRS may allow a deduction for the unrecoverable part.

o (b): Amount of deduction: The basis for determining the amount of deduction for any bad debt shall be the AB from §1011 for determining the loss from the sale of property.

AB will normally be the amt you loaned minus the principal repayments Your loss is limited to your basis

o EXCEPTION – (d) Nonbusiness debts: For a TP other than a corp, (A) subsection (a) does not apply to any nonbusiness debt, and (B) where any nonbusiness debt becomes worthless w/i the taxable year, the loss shall be considered a loss from the sale or exchange of a short term capital asset.

For any nonbiz debt, this rule does not apply and it is treated as a capital loss. Biz bad debt is treated as ordinary loss. More restrictions on capital losses (can only deduct to the extent of capital gains) Nonbusiness debt- debt other than that acquired in the trade/business of the TP

o (e): This section foes not apply to a worthless security defined in §165(g)(2)(C) 165(g)(2)(c) – a registered bond, debenture, note, certificate or other evidence of indebtedness

issued by a corp or political subdivision.o Analysis: Is there a debt? Is it a bad debt? Is it a business bad debt (if not, then potentially subject to

166D limitation)?

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Bugbeeo TP met Billings at his beer parlor. Billings became godfather to one of his children. He began to loan

money to Billings. Provided for interest but no interest ever repaid. Never repaid the principal. He used the money to investigate biz ventures, but most money was used for living expenses.

o Issue: Whether TP can claim a STCL as a result of Billings’ failure to repay the loan. (Was there a D-C relationship involved?)

There must be a bona fide debt which arises from a D-C relationship based upon a valid and enforceable obligation to pay a fixed and determinable sum of money.

“Whether a transfer of money creates a bona fide debt depends on whether the intent of the parties at the time of the transfer was to establish an enforceable obligation of repayment.”

Test of intent made at the time the loan/transfer is made (at time give money, did you intend for them to pay you back).

Ct says, even though Billings in poor financial condition at time loan made, it doesn’t mean it wasn’t a loan. There does not have to be an unqualified expectation of repayment. TP does not have to be absolutely certain that he is getting repaid.

o Holding: A debtor-creditor relationship existed and the deduction was allowed under §166(d)o Ct distinguished Zimmerman – TP put money into new co where would be repaid only if SH put dues

into money. No deduction was allowed b/c TP getting paid was not conditioned on the success of biz. o JK doesn’t think this would be a biz debt, so can only deduct to the extent it is a capital loss.

1.166-1(c) – Bona Fide Debt req’d: Only a bona fide debt qualifies for §166. Bona fide debt is one which arises from a D-C relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money…A gift or contribution shall not be considered a debt.

o So if truly a gift, not a bad debt. Also, if you haven’t been paid your wages, you can’t deduct as bad debt if you haven’t included in income.

Intra-family transfers are deemed a gift unless there is explicit evidence to the contraryo (d) Amount Deductible: the basis for determining the amount of deduction is the ABo (f) Recovery of bad debt: Any amount attributable to the recovery of a bad debt which was allowed

as a deduction in a prior taxable year, shall be included in GI for the taxable year of the recovery If you write off debt as bad and don’t ever expect it to be paid, but 5 years later, the person

pays you back, if you took deduction already, you have to include in income when you get the money

Must be a bad debt (not to be repaid) Three Part Approach to Bad Debt Deductions:

o (1) Is there a debt? Bugbee analysis - Must establish D/C relationship and the rules set forth in Bugbee made that

determination This Q is likely to arise with respect to individuals Presumption that transfers to relatives and close friends are gifts and not loans

Note – Bugbee decided they were not “close friends” At the beginning it does not matter if it is gift or loan b/c neither is deductible, and neither is

income, but if bad debt deduction is later asserted, it cannot be supported unless the original transaction was in fact a loan.

o (2) Is it a bad debt? A gratuitous forgiveness of loan does not generate deduction. The debt must be bad. So you can’t just say, I just forgive the balance and call it a bad debt 1.166-2 – Consider all pertinent evidence. For example, financial condition of D. Legal action

to enforce payment not req’d. Bankruptcy is generally an indication of the worthlessness of at least part of a debt.

o (3) Is it a biz bad debt? 1.166-5(b) – Nonbiz debt defined: A non-biz debt is any debt other than (1) one created or

acquired in the course of a trade of biz of the TP, or (2) A debt from which the worthlessness is incurred in the TP’s trade or biz.

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So it can be a biz debt if either (1) created or acquired in TP biz (used in biz at time acquired) or (2) becomes worthless in the trade or biz (used in biz at time becomes worthless)

Under Whipple, a SH or EE loan to a corp is typically a non-biz loan Normally SH or EE loans are not a biz loan, which means you won’t get 166

deduction Corp’s biz is not the biz of the SH. It must be the SH biz if the SH wants the §166 ded If the TP furnished regular services to a corp, maybe that TP had individual trade or

biz separate from the corp. When the only return is that of an investor, the TP has not established that he is

engaged in a trade or biz since investing is not a trade or biz. It will be the corp’s biz. Very difficult for a SH to make a loan to the corporation and establish that it is a biz

loan – have to show that it is the SH’s own trade or biz So you must distinguish b/w corp trade or biz and SH trade or biz – if the SH makes the loan,

he must be participating in the trade or biz to get the §166 deduction If SH or EE makes loan to he corp to ensure continued employment, it is biz debt b/c it is

arising out of her trade or biz of performing services to her ER Biz purpose must be the dominant purpose for it to be a biz debt

Haslam o TP employed by co in explosive division. o Established a corp. TP managed the corp biz and was employed as a salesman. o TP guaranteed loans made to Corp. o Issue: Is this a biz or nonbiz bad debt?

Need to determine TP’s “dominant motive” (Q of fact – TP bears burden of proof)o Under 166, biz bad debts are deductible a/g ordinary income and nonbiz bad debt generate short term

capital losses. Test: The character of a bad debt is determined by the relationship it bears to the TP’s trade or

biz. A debt will only qualify as a biz bad debt if it bears a direct relationship to the TP’s trade or biz

Where a TP sustains a loss on a guarantee to a corp in which he is both EE and SH, a proximate relationship b/w the TP’s trade or biz as an EE and his loss is established only if the TP’s dominant motivation in giving the guarantee was to protect the EE interest.

o Ct says this is biz bad debt b/c his “dominant motive” of the loan was to keep his job as EE of the corp Determined he was in this trade or biz so gets §166 deduction

o Here, he was full time EE of this corp and had no other employment (not just an investor) Had no other income Skills not readily marketable More likely he was interested in preserving his position as EE rather than as just an investor

b/c this is how he made his living Found his dominant position was to protect his employment and not the 20k he invested as a

SH 165(g) – Worthless Securities: If any security that is a capital asset becomes worthless in the taxable

year the loss shall be treated as the loss from sale or exchange, on the last day of the taxable year, of a capital asset (loss on a capital asset).

o So if you invest in stock and it tanks, on the last day of the tax year, you can treat as a deductiono Defined : “Security” means: (A) share of stock in a corporation; (B) right to receive a share of

stock in a corporation; (c) a registered bond, debenture, note, certificate or other evidence of indebtedness issued by a corp or political subdivision (registered security).

o 1.165-5 – Ordinary Loss: If a security which is not a capital asset becomes wholly worthless at any time during the taxable year, the loss may be deducted under §165(a) as an ordinary loss. Capital Loss: If a security which is a capital asset becomes wholly worthless, the loss is treated as a loss on sale of a capital asset on the last day of the taxable year.

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Generally, the stat of limitations on claiming a refund is normally the later of 2 years after tax paid or 3 years after return was due

o 65(11)(d)(1) – extended to 7 years if the claim for refund is for bad debt (§166) or worthless security (§165g)

Reason – if you say debt becomes worthless, you might not know w/i 3 years that it is worthless

Problems pg 783In year 1, Lawyer performs services for Client and bills him $1000. Client does not pay lawyer. In year 6, it becomes clear that debt will not be repaid. (a) What else must be known to determine whether Layer is entitled to a bad debt deduction? What is the character of the deduction?

Need to know if Lawyer previously included in income. Only allows ded to the extent of your basis. If you previously included in income, would have a basis and would be ded to that extent. If did not include in income, no deduction b/c no basis – 166b

o Accrual accounting- may or may not be included (depends if have a basis)…cash accounting- no action

(b) If debt in fact became worthless in Year 2, is Lawyer’s use of bad debt deduction foreclosed by stat of limitations? No – there is a special 7 year limitation in determining whether a debt has become bad – 6511(d)(1) So they have 7 years to come back and make the argument (rather than the normal 3 years)

(c) If Lawyer was allowed deduction in Year 6, what tax consequences if Client pays the money in year 7. What if Lawyer was not allowed deduction in Year 6, and then is repaid in Year 7?

Its income when repaid in Year 7 unless it is properly excluded somehow – 111 allows exclusion of the recovery if the ded in the prior year did not reduce your taxes. So if the debt becomes worthless in a particular year but the 166 ded doesn’t reduce your taxes, you don’t have to include in income when repaid

If no deduction in year 6, in year 7 it will just become income

2. SH is a single TP and has GI of $60k and §62 & §63 deductions of $20k, and taxable income of $40k in the current year. (1) SH owns a $5000 note of Corp which she got from Corp for a loan. Corp foes bk and SH’s note is worthless. The note represents an equity contribution to Corp. SH acquired note 2 years ago.

Cap loss under 165(g)(2)(C) b/c it is a worthless security - not bad debt b/c it is not a loan. (2) SH owns common stock in Corp which also becomes worthless. She paid $3k for the stock 3 years ago.

(g)(2)(A) this is worthless security (3) 2 years ago SH loaned her friend Mooney $2600. The loan becomes worthless. What factors considered to determine if the loan created a bona fide debt?

Bugbee analysis – if loan to family or close friends it is subject to close scrutiny under Bugbee – also look at whether date set, interest rate set, etc.

o Is this a debt or is this a gift? B/c of the close relationship, it will be under strict scrutiny. This is a facts and circumstances analysis. If this is a gift, then the analysis ends. If a debt, then determine if a bad debt (they tell us it is). Is it a business bad debt (capital loss v. ordinary loss)?

Charitable Deductions Test for charitable deductions: Are getting something for what you are “donating” (quid pro quo) or is it pure

charity? RR 83-104

o Issue – whether it is charitable ded made to school or tuition paid for attendanceo Rule: A contribution for purposes of §170 is a voluntary transfer of money or property that is made

with no expectation of receiving a financial benefit commensurate with the amount of the transfer. So if you are expecting something in return, it is not charitable deduction

o Whether a transfer of money by a parent to an organization that operates a school is a voluntary transfer that is made with no expectation of obtaining a benefit depends on whether a reasonable person, taking into acct all facts and circumstances, would conclude that enrollment in the school was in no manner contingent upon making the payment; that the payment was not made pursuant to a plan

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to convert nondeductible tuition into charitable contributions; and that receipt of the benefit was not otherwise dependent on the making of the payment.

If you go too far with the payment it might be considered tuition It is a facts and circumstances analysis – must really be charitable

o Presence of one or more following factors creates presumption that payment is not a charitable contribution:

Existence of a k under which a taxpayer agrees to make a contribution and which contains provisions ensuring the admission of the taxpayer’s child,

A plan allowing taxpayers either to pay tuition or to make contributions in exchange for schooling

School requests each parent to make $400 contribution – if not, must pay tuition Earmarking of a contribution for the direct benefit of a particular individual, Unexplained denial of admission or readmission to a school of children of taxpayers who are

financially able, but who do not contribute Admit more students whose parents make contributions

Absence of tuition charge If no tuition charged, and contributions are solicited from all society members (not

only parents of students), it is still not deductible unless contributions from sources other than parents are of such magnitude that they constitute most of the support of the school

“Pressure” on parents to make contribution While applications are pending every parent makes contribution and no tuition

charged This is implied agreement that if you don’t make contribution you won’t get in

RR 67-246o Issue – is it a quid pro quo?o The issue here is whether you are purchasing something or if it is a donationo Still facts and circumstances but give gen rules o General Rule: If a transaction involving payment is in the form of a purchase of an item of value, the

presumption is that no gift has been made for charitable contribution purposes. Burden to prove that the amount paid is not a purchase price is on the TP.

Essential element is proof that the portion of the payment claimed as a gift represents the excess of the total amount paid over the value of the consideration received therefore.

Another element important in establishing that a gift was made is evidence that payment in excess of the value received was made with the intention of making a gift.

o The organization should make clear what is the price of what you are purchasing and what is the charitable donation

o The amounts should be specifically stated on the receipt Ex – if you buy meal for $50, they may say value of meal is $5 so you can write off $45

o Symphony Concert: Ex 1 – charge $5 for balcony and $10 for orchestra. Emphasize that concert for the benefit of a charity. They don’t state how much of the price is for the actual cost of the show and how much is charity.

It doesn’t matter if the TPs who purchase the tickets think they are making a charitable contribution, and it doesn’t matter if the tickets say “tax deductible”, no part of the payments are deductible as a charitable contribution. This is b/c the payments approximate the established admission charge for similar events – there is no gift.

Also, it wouldn’t matter if the TP pays for the ticket, but does not use it – still not charity. o Ex 2 – The price for admission is $15 for balcony and $30 for orchestra. The tickets clearly indicate

that the normal price for the tickets is $5 and $10 and that the excess amounts are contributions to charity.

Here you can deduct the excess b/c charging more than what they are worth and it is clearly identified on the ticket

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o So the Rule is, are you getting a quid prop quo – getting something for what you are paying – or are you just giving money b/c you want to help the charity?

§170 – Charitable Contributions: There shall be allowed as a deduction any charitable contribution made wi the taxable year.

o Available to 5 diff types of charities – §170(c) o (1) Fed or state governmento (2) 501(c)(3) organization (religious, charitable, scientific, literary, educational, etc organizations) o (3) War veterans organizationso (4) Domestic fraternal societies

Organization where they use the money for charitable purposeso (5) Non-profit cemetery companies o Typically, when making charitable contributions it will be 501c3 organizations or to the fed govo 501 describe all the various organizations. (a) not-for profit organizations don’t generally pay income

taxes. (c) Lists the organizations that are not-for profit. (c)(3) are the most common, but there is also 1-30 which are charitable organizations.

Once you qualify as 501, all charitable organizations are then classified again as public charity or private foundation in §509.

Basically if you receive support from general public or if you are one of the specific automatically qualifying organizations, then you qualify as public charity. There are many benefits to being a public charity.

o No deduction under 170 if there is a quid pro quo The donor could potentially receive §162 ded (if qualified biz expense) – so keep in mind that

you might get the 162 deduction (might rather this anyway b/c not subject to the limitations that 170 is as an itemized deduction)

(Part gift part sale) If prop other than cash transferred to charity and partial consideration received, a part gift part sale transaction occurs. When a charitable part gift part sale occurs, the transaction is divided into two simultaneous transfers – one a sale and the other a gift. (Examples: transfer of property encumbered with debt; transfer to charity for some amt of money.)

o For the sale part: the amt realized is the partial consideration received from the charity on the transfer. o The gain is the amt realized minus the portion of the AB of the transferred property which bears the

same ratio to the total AB of the property as the consideration received from the charity bears to the total FMV of the property.

o The remaining FMV of the property is treated as the gift contribution with the property having an AB equal to the remaining AB of the property.

o Ex: Donor transfers land = $120k / 180k to charity and that property either encumbered with 120k liability, or charity pays 120k cash.

Two transactions: Sale of 2/3 of the property (120k/180k) and gift of the remaining 1/3 Sale property has 80k basis (2/3 of 120k) which results in 40k gain recognized to Donor on

“sale” (120k amt realized-80k basis). If treated as charity taking the encumbered property, the amt realized is the amount of

the debt release under Crane and Tufts: 120k. If treated as charity paying cash, the amt realized is the amt of cash received: 120k

Gift property has 40k basis (1/3 of 120k) and Donor considered to have made a gift of the remaining property worth 60k.

Limitations – if prop donated that has built in gain, other than built in cap gain, the ded is limited to your basis. o In above example, if the built in gain is LTCG then can ded the 60k. But if this is prop that was

depreciable and the built in gain is ordinary gain, then the ded is limited to the basis – would be 40k deduction as gift instead of 60k

o Even if prop with built in LTCG, still have to reduce to the basis if the prop is unrelated to the charity’s purpose or to a private foundation.

Exceptions for qualified appreciated stock to private charity, you still get full FMV deduction as opposed to limiting to basis.

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“Qualified appreciated stock” is publicly traded stock which would result in LTCG to TP in a sale, but only to the extent the TP or his family’s total contributions of such stock tp private charities do not exceed 10% of the value of the stock of the corp.

basically if you transfer investments (publicly traded securities) and you don’t have more than 10% interest in the co, you will get full FMV, this is the norm – either donate cash or appreciated stock

Donations of partial interests – We just mainly need to be aware of these things o Rule – you can’t receive charitable income tax ded for a partial interest donation thru a trust

Services rendered to charity are not deductible Unreimbursed expenses are deductible

o So if you travel for charity purchases, the mileage is ded, etco Can’t deduct if travel is also pleasure

Limitations o If you are limited in the amount you can deduction, any amts above the limitations can be carried

forward for 5 years until you can use the deductiono The limitations ceilings are contribution based (determined with regard to AGI w/o NOL)o Limitations – may deduct contributions to public charity to the extent contributions do not exceed 50%

of AGI May deduct contributions for the use of public charities and to or for the use of private

charities to the extent the contributions do not exceed 30% of AGIo Contributions of appreciated capital gain property – limitations pg 800-801o Contributions by corporate TPs – may not exceed 10% of corporations taxable income subject to

several adjustments. For contributions in excess of the 10%, there is a 5 year carry-forward rule. Changes: end of 2004 – AM jobs creation act created additional rules for substantiation if you make large

contributions o Car donations: If contribute a car and charity sells wi 2 years, can only deduct the amt sold for. If

don’t sell wi 2 years, you can deduct FMV.

Problems pg 8041. Ts contribution base for the year of the following gifts is 150k. During the year T makes contributions to Suntan U (public) and Private Foundation. In each of the following circumstance what are the effects? (a) T gives $100k cash to Suntan U

Suntan U is public so it is limited to 50% of contribution base which is 75k. Since he donated 100k, the remainder of 25k is carried forward for the next 5 years until it can be used

(b) T gives $100k cash to Private Foundation Private Foundation subject to 30% of contribution base, which is so it is 45k, and the remainder is carried

forward.

3. (b) P teaches Sunday School at church. Will he be allowed charitable deduction for the value of his services? Under reg 1.170A-1(g), not allowed a deduction unless he has incidental unreimbursed expenses (which would

be ded)(f) P donates car to Charity. Car is dented and has some mechanical problems. Charity’s ad states that he may deduct the car’s full BlueBook value, which is $6000.

Under the 2004 am job creations act, he will be subject to additional rules – charity has to sign contemporaneous acknowledgement and if they sell it, he can only deduct what it was sold for. Also, b/c it is worth over 5k, he needs qualified appraisal. Also could potentially be subject to the appreciated prop rules (but probably unlikely b/c this is probably LTCG)

Casualty and Theft Losses 165(a) generally allows deduction for any loss sustained during a year and not compensated for by

insurance or otherwise 165(c) limits the deduction to 3 situations for an individual:

o (1) Loss incurred in trade or biz

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o (2) Loss incurred in transaction entered into for profit o (3) – losses of prop not connected with a trade or biz or transaction entered into for profit, if

such losses arise from fire, storm, shipwreck or other casualty or from theft RR 63-232

o What is a casualty?o Dealing w structure damaged by termiteo Concluded little structural damages caused wi the first 2 years of infestation and in years 3-8 is when

the damage really occurs. The IRS said not an “identifiable event of a sudden unusual nature” (which is req’d for causality) so there is no 165(c)(3) ded here

Pulverso Issue – can the TP take an “other casualty loss” under 165c3 when a landslide ruins 3 nearby homes?o Didn’t damage his home but reduced the value b/c of fear that landslide could potentially damageo All of the examples in c3 - fire, storm, shipwreck - involve physical damage or otherwise physical

damage or loss of property and the ct reads it to say potential loss is not enough under c3. He had no property loss or damage himself so cannot get casualty ded

o Ct notes – this reading is the correct one from common sense otherwise there would potentially be limitless deductions under 165c3

Ex – Master P moving into CCL and causing neighbors value of homes to go down – this is not deductible, but if the TP had won their argument here, it could possibly be. Need damage or loss of property for it to be ded

Mary Francis Alleno TP owned broach that she lost while visiting the Met. Took 165c3 ded as theft. Ct said TP had burden

to prove the broach was stolen and not lost. If lost, no ded, if stolen, get ded. B/c the TP could not prove stolen, and did not get ded in that case. Put burden on her and b/c she couldn’t prove that she didn’t just simply lose it, she didn’t get ded

RR 81-24 o IRS denied arsonist an 165c3 ded b/c to allow the ded would frustrate public policy

Can’t set fire to own house and get the ded for casualty loss H Slammed car door on his wife’s hand causing diamond to slip out of ring. May they claim a casualty loss

deduction?o Ded was allowed b/c the physical damage (casualty) occurred suddenlyo Diff result would have occurred if the door slammed on right hand and she flared her left hand and

caused the diamond to be lost b/c there, the physical damage was not caused by the casualty event.

Other Aspects of Casualty and Theft Losses Timing of Casualty Losses:

o 1.165-7(a)(1) – Casualty losses are deductible for the year in which the loss is sustained. If extent of loss can’t be known until subsequent year, then loss is sustained until following year.

o 165(i) exception – if the casualty loss is attributable to a disaster, theTP can elect to deduct the loss the year before the casualty occurred.

So after Katrina, TPs could have filed amended 2004 return and taken the casualty loss in that year and asked for a refund.

o 165(e) – theft loss deductible in year theft discoveredo 1.165-1(d)(2) and (3) – If, in the year of the casualty or discovery of the theft, there is reasonable

prospect of recovery of the loss or portion of the loss, that portion is not deductible until it is clear that there will be no recovery

If you have already deducted loss and then recover it (from insurance, etc) you have to recognize as income when you recover

1.165-7(b) –Amt of the deduction. o The amount of a casualty loss shall be the lesser of:

(1) FMV of the property immediately before the casualty reduced by the FMC of the property immediately after the casualty

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(2) Amt of the AB for determined the loss from the sale or other disposition of the property involved

o However, if the prop used in trade or biz or held for the production of income, and is totally destroyed by casualty, and the FMV immediately before the casualty is less than the AB of the property, the amt of the AB shall be treated as the amt of loss.

This will not occur with the issues in 165c3. It is for (b)(1) & (2). 165(h)– Limitations on casualty losses

o (1) Limitation Per Casualty Loss : Loss for casualty or theft only allowed to the extent it exceeds $100.

So if loss is $200, you can only deduct $100 of it. o (2) Limitation on Net Casualty Loss : basically, only allows casualty losses to the extent they exceed

10% of AGI so it is rare, unless have huge casualty loss, that you can deduct it. The 100 is usually able to meet, but the

10% of AGI is difficult. However, that is the point, they only want you to deduct extreme substantial casualty losses. (However, exception for Katrina)

Problem pg 8162. Shaky’s house damaged due to earthquake. He and family are forced to live in hotel and eat meals in a restaurant while repairs are made. Insurance pays the total cost of the repairs and also pays $1200 of the family’s meals and lodging which totaled $1800. Normally Shaky would pay only $1000 for these expenses.

b/c the prop loss Is fully compensated by insurance, there is no 165 ded. Under 123, ins proceeds for living expenses are excluded only to the extent actual living expenses exceed ordinary living expense. Thus 1200 is only excluded to the extent actual living expenses of 1800 exceeds ordinary living expenses of 1000, which is 800 – so of the 1200, only 800 is excluded under 123. The remaining 400 is included.

Restrictions on Deductions Deductions Limited to Amount at Risk

§465 – (a) In the case of an individual or a closely held C Corp (5 or fewer SH hold 50% or more of corp), engaged in an activity under §465, the loss from the activity is allowed only to the extent the TP is at risk for such activity.

o At risk limitations apply to pships and S Corp, but they are applied at the individual P or SH level o At risk- the amount that you personally stand to lose (not the technical definition, but the practical

definition)o (b) TP considered at risk for an activity with respect to amounts including:

(1) Amt of cash and AB of other property contributed by the TP to the activity, and If you put up cash and you’re at risk to lose it

(2) Amounts borrowed with respect to such activity if TP: (a) Personally liable for the repayment (b) Has pledged property as security (at risk to extent of FMV of property)

o At risk = amt you stand to personally lose (Can be at risk for 5 categories: cash + AB of prop contributed + amt TP personally liable for loan + FMV of property pledged as security + qualified NR financing)

Before 465, under traditional tax shelters, LP would get large nonrecourse loans (you are not at risk for) that generate a tax loss

o They would contribute 10k, and they would get large tax write off from the loans, but only stood to lose the small amt - 10k – that they put in. 465 doesn’t allow b/c if you only put in 10k you are only at risk 10k and can’t get write off of more (465b5)

o We know now that from Crane and Tufts the nonrecourse is included in your basis Not at risk for any loans from related person

o So can’t have loan from your parents and considered at risko 465(b)(3)(C) - “related person” is same as relative in §267(b) or §707(b)(1)

Any losses allowed from activity reduce the amt at risko So once you get deduction it reduces amt you are considered at risk

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Not at risk with respect to nonrecourse financing but you ARE at risk for qualified nonrecourse financing (see below)

Exception: In general, a TP is at risk with respect to nonrecourse financing of real estate activities (dealing with real property) if the financing is from the gov, is guaranteed by the gov, or is from a qualified person who is in the biz of lending money.

o This permits some nonrecourse financing to be at risk amountso This is b/c they are trying to target the tax shelter where promoter is providing financing. A bank or

the gov won’t make loan unless they think the amt of loan is secured adequately by the property and that it is a legitimate biz enterprise.

o §465(b)(6) – (A) If activity is holding real property, TP considered at risk for TP’s share of qualified nonrecourse financing which is secured by real property used in such activity.

o (B) “Qualified nonrecourse financing” = financing (1) borrowed by TP with respect to the activity of holding real property, (2) borrowed from qualified person or from the gov, (3) except as provided in the regs, with respect to which no person is personally liable for repayment, AND (4) which is not convertible debt (can’t be a debt that can be converted into some sort of equity).

o (D) Qualified person can include a related person if the financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons

Can’t give them a special deal because they’re related persono (E) Activity of holding real property includes the holding of personal property and the providing

of services which are incidental to making real property available as living accommodations If disallowed a loss, it can be carried forward to future years.

o Any loss disallowed must be used in the first succeeding year that the TP is sufficiently at risk. So if you become more at risk in the future, you can take deduction at that time (465a2)

465(e) – Recapture rule: If amt at risk is less than 0, the TP shall include in GI for the taxable year, an amt equal to the excess, and that amt shall be treated as a deduction in the first succeeding taxable year.

o Could be below 0 b/c TP took losses and deductions in prior years to make it fall o If the amts allowed as loses in previous years exceed the amts currently at risk, must recapture the

incomeo This amt recaptured is treated as disallowed loss that can be taken in future years if you again become

at risk 465 only applies to individuals, certain C corporations, partners in S corp. and SH at the individual level

o Limited to activities in a trade or business or for the production of income

Problems1. To what extent does §465 limit TP’s deductions, generates recapture income out of previously allowed loss deductions, or allows the use of a loss carryover in the following situations:(a) TP purchased farm for $50k cash and his personal note for $400k, secured by a mortgage. In the first 2 years of operation he put in an additional $50k each year, by way of cash and personal loan. In the first year of operations his loss was $80k and he has another $80k loss in the 2nd year. No principal paid on the liability either year.

In year 1, 500k at risk (100k cash + 400k personal note – recourse liability) So he can take deduction of 80k in year 1. This reduces amt at risk to 420k. In year 2, he put in additional 50k, and he can take the other 80k, which reduces amt at risk to 390k.

(b) Same as (a), but farm acquired with 50k cash and 400k nonrecourse financing. 50k cash is an amt at risk + additional 50k he put in year 1 and 2 = 100k at risk The 400k loan is nonrecourse loan so he is not at risk Thus, he can take 80k in year one, which reduces his amt at risk to 20k. In year 2, he put in another 50k, which increases amt at risk to 70k. He can take 70k loss, and the remaining

10k loss carries forward until the first succeeding year that he has a sufficient amt at risk to deduct it (but included in GI).

(c) Same as (a) But In the 3rd year of operations, when the farm broke even, TP converted his personal liability of $400k, to a nonrecourse loan.

He took a total of 160k deductions b/c he had a sufficient amt at risk while the note was recourse and he was still liable for it. When he converts it to nonrecourse, he is no longer personally liable for 400k, thus he is not

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at risk for 400k. He is only at risk for 150k (cash contributed year 1 and 2.) He will need to recapture the additional 10k that he included as a nonrecourse deduction in year 1 and 2. He will need to recapture the amt he was not at risk for. So in year 3 he has to recapture 10k. (he is at risk for

150k and he took 160k in deductions) (d) Same as (b) but TP pays off $10k of the nonrecourse loan in year 2.

He puts in an additional 10k, which increases his amt at risk, so he can take the deduction for the all of the 80k loss in year 2 (as well as year 1)

o As you pay off your nonrecourse debt, your amount at risk goes upo With recourse debt, if you pay it off, it does NOT change your amount at risk (you were already at risk

for it b/c you were already liable for it)(e) Same as (b), but the farm breaks even in year 3 and TP pays off $10k of the nonrecourse loan in year 3.

He is at risk for an additional 10k, so he can take the amt that was carried forward.

2. Does §465 apply to limit the deductions of Vestor who invests in an apt in the following situations:(a) Vestor obtains a $200k nonrecourse loan from an unrelated commercial bank to purchase the apt from Seller

Normally nonrecourse is not at risk, but there is exception when it is an unrelated commercial bank and TP is in the biz of real estate

465b6b exceptiono This meets the requirements: he borrowed money with respect to activity of holding real property. He

borrowed from a qualified person. No person is personally liable for repayment. Also it is not convertible debt.

He was considered at risk and can take deductions of $200K(b) Same as (a) but Vestor obtains the nonrecourse loan from Seller

Doesn’t meet the def of qualified nonrecourse financing so he can’t take deduction

(c) Same as (a) but Vestor obtains the NR loan from her brother (a “related person’) who is a commercial lender. The loan is at an interest rate 3% below the mkt rate of interest.

Usually related parties don’t qualify to make him at risk, but then you have to determine if this relative meets the exception – 465d

Only considered qualified person if the loan is “commercially reasonable” and on same terms as qualified persons

Here since loan is 3% below mkt, probably not the same and not at risk b/c not qualified person(d) Same as (c) except the interest rate on the loan is equal to the mkt rate of interest.

Interest rate is mkt rate, so unless other terms in loan make it better than loan available to regular person, the person is probably qualified person and the loan meets qualified nonrecourse financing, and this amt is at risk

Activities Not Engaged in for Profit “Hobby loss restrictions” §183 – Activities not engaged in for profit: (a) General Rule: In the case of an activity engaged in by an

individual or S Corp, if the activity is not engaged in for profit, no deduction attributable to the activity shall be allowed (see 183b for extent that deductions can be taken).

o Applies to individuals, S Corp & estates and trustso Regs – 1.183-1a: rule also applies to trusts and estates

183(c) – “Activity not engaged in for profit” means any activity other than one with respect to which deductions are allowed under §162, §212(1) or (2)

o Basically, if you can get a trade or biz deduction, then activity considered to be one engaged in for profit and the limitations don’t apply

o Regs examples – sports, hobbies or other recreation – you won’t get 162 deduction b/c not trade or biz, and not engaged in for profit under 212(1) or (2)

1.183-2a gives exampleso Presumption: If you do make a profit during 3 of the last 5 years, then you are presumed to be

engaged in activity for profit

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Special rule for horses – if during 2 of the last 7 years the income exceeds deductions you are presumed to be engaged in activity for profit

o Regs contain factors to consider in determining whether an activity is engaged in for profit [1.183-2b] Expertise of TP Time, effort expended by TP Expectation that assets may appreciate in value Success of TP in carrying on similar/dissimilar activities Manner of activity…

183(b) – take gross profit from activity and subtract deduction to which you would otherwise be entitled and then you can use what’s left for the other deductions

o Even if not engaged in for profit, then all items conventionally deductible are allowed w/o limitation o Need to take out taxes related to things you would get regardless of whether you are engaged in profit. o If you produce income, you can get deductions, but can’t generate a loss that won’t produce

deductions for other income

Restrictions on Deductions on Homes 280A – General rule: If the TP is an individual or an S Corp, no deduction is allowed with respect to use

of a dwelling unit which is used by the TP during the year as a residence. o So if use as residence during year, can’t get deduction related to ito Regs: also applies to trusts and estates

“Residence” – 280Ad1: Dwelling unit used as residence if used for personal purposes for the greater of:o 14 days oro 10% of the number of days for which rented for FMV o Note – unit not treated as rented at FMV for any day which it is used for personal purposes

If 280A applies (used as a residence) the restrictions in 183 (activity not engaged in for profit) do not apply (280Af3)

o If 280A applies, then it supersedes 183o If 280A does not apply, look to 183 to see if activity engaged in for profit to determine the

deductibility.o If activity not engaged in for profit, apply 183 restrictionso If activity is engaged in for profit, the 183 restrictions don’t apply, and you can deduct any expenses

allocable to that activity…look to 280Ae to determine what expenses are allocable Exception : 280A(b) Exception for interest, taxes, casualty losses: TP still allowed to deduct expenses

which are allowable without regard to whether activity engaged in for profit or trade/biz. (limitations in 280Aa do not apply)

o Ex: §164 deduction – you get it regardless of whether activity engaged in as trade or biz; some interest is deductible regardless of whether trade or biz

Gen Rule: (a) can’t get any deductions if use dwelling unit as residence. o Exception (1): 280Ac3: (a) does not apply if the expenses are attributable to the rental of the

dwelling unit (after applying (e)). o 280A(g) – Special Rule: If a dwelling unit is used during the taxable year by the TP as a

residence and it is actually rented for less than 15 days during the taxable year, then: No deduction otherwise allowable b/c of the rental use is allowed, and Income derived from the use for the taxable year not included in GI of the TP under §61 Basically de minimus exception – if you use as residence and rent out for less than 15 days,

you don’t get deduction but don’t have to include the rent in your income (effectively ignored) o 280Ac5 – Limitation on the deductions: If 280A applies (dwelling unit is used by the TP during

the taxable year as a residence) and is rented for more than 15 days, the deductions related to the unit are limited to the excess of

The GI derived from such use for the taxable year, over (minus) The sum of:

(1) Deductions allocable to personal use which are allowed regardless of whether or not the unit rented (taxes and interest)

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(2) Expenses allocable to the rental use Get deductions you would get regardless of what the dwelling unit is used as, and any NI left

over (after subtracting the deductions from GI) is the restriction Gross Rental Income Less: allocable portions of deductions allowed regardless of whether the unit is rented

(interest, taxes) (these are allocated by the # of days rented/365 under 280Ae2) Equals: 280Ac5 limit on deductions (applied first to non-depreciation deductions,

then to depreciation)(these deductions are allocated by # of days rented/ # of days used under 280Ae1)

Any amount not allowable as a deduction is carried forward to the succeeding taxable year.

280A limitation: 1st apply to non-depreciation deduction. 2nd, If any left over, apply to depreciation deductions 280e: Expenses allocable to rental (as opposed to personal use) – If the TP uses the dwelling unit for

personal purposes during the year, the amt deductible with respect to the rental expenses shall not exceed the number of days during the year that the unit is rented over the total number of days during the year that the unit is used.

o Total number of days unit is rented / total number of days unit is used (both for rental and personal purposes) = amt allocable to rental

o 280Ae allocation does not prohibit you from taking deduction which is allowed regardless of whether or not unit rented (so if allowed deduction somewhere else, regardless of rented, you can still deduct)

Formula:o Gross rental income

Less: allocable portion of deductions allowed regardless of whether the unit is rented (e.g.: interest and taxes) (these are allocated by # of days rented /365 days under 280Ae2)

Equals: 280Ac5 limit on deductions (apply 1st to non-depreciation deductions then to depreciation) (deductions are allocated by # of days rented / # of days used under 280Ae1)

Note – on exam – if see home, either can deduct under 183 or 280A. See which one applies Example: TP owns a vacation home that TP rents for 60 days and personally uses for 30 days. (Total days

used = 90) Gross rental income = $5400. TP pays real estate taxed and “qualified residence interest” = $3600. TP incurs other expenses related to the home: utility and maintenance = $1500 and depreciation of $6300.

o TP does not meet the minimal use requirements of 280Ad, b/c the home was rented for more than 15 days during the taxable year under 280Ag, and during the year the home is used for personal purposes for more than 14 days or 10% of actual rental time.

Thus, this home is a residence, and the 280A restrictions applyo TP’s deductions (other than expenses deductible regardless of whether it is a rental activity) are

limited by gross rental income:o (1) Gross Rental Income: $5400o (2) Less: allocable portion of deductions allowed regardless of whether

the unit is rented (Interest and Taxes) = # of days rented / 365 days x expenses = 60/365 x 3600 ($600)

o (3) Equals: §280Ac5 limitation on deductible rental income expenses other than Interest and taxes $4800

o (4) 1st Allocable portion under §280Ae of rental expenses other than depreciation = # of days rented / # of days used x expenses = 60/90 x 1500 ($1000)

o (5) Limit on depreciation deduction (if anything is left over, go to depreciation) $3800o (6) 2nd Allocable portion under 280Ae of depreciation deduction

= # of days rented / # of days used x expenses = 60/90 x 6300 = $4200 But, limited by 280Ac5 to ………………………………………………. $3800

o TP can deduct $4800 of the $5200 expenses allocable to rental of the home. TP can deduct all of the $3600 interest and taxes b/c such expenses are deductible w/o regard to rental use.

o The remaining $400 of depreciation deduction that was disallowed can be carried forward. o Notes: How do you determine what is deductible regardless of whether a unit is rented?

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You can’t get depreciation or deduct utility expenses on your personal residence. Thus, in order to get a deduction for those things, you must rent.

The difference with interest and taxes is that, under §164, they are deductible even on a personal residence!

Special Rule – 280Ad4a: personal use as a principal residence that occurs before or after a qualified rental period is ignored in applying 280A rental limitation

o Qualified rental period = consecutive period of (i) 12 or more months which begin or end in the taxable year, or (ii) less than 12 months which begin in the taxable year, and at the end of which the dwelling unit is sold, and for which the unit is rented at fair rental value.

o Example- have condo and have rented for 365 days each year, and that ends during taxable year, and you use for personal purposes then sell it. That’s ok and the personal use is ignored.

o Ex: own home and buy a new one and begin to rent old one. You can ignore the first few months that you lived in it.

Gen Rule: (a) can’t get any deductions if use dwelling unit as residence. o Exception (2) – home office deduction (280Ac1)

(a) Does not apply to portion of home used exclusively and on regular basis (1) As the principal place of biz for the biz of a TP

o You need to really use this as personal office (2) As a place of biz used by patients, clients, or customers in meeting or dealing

with TP in normal course of trade or biz (3) In the case of a separate structure which is not attached to the dwelling unit,

in connection with the TP’s trade or biz. Even if used exclusively and on regular basis for biz purposes, the 280A5 limitation will apply

in determining how much deduction you actually get. Same analysis- gross income less allocable portion of expenses you otherwise get, less an

allocable portion of the deductions…. Make certain this is really used exclusively and on a regular basis. Make sure the room is only

used for that certain purpose, etc. The home office deduction is carried forward if the deduction is disallowed solely b/c of the

income limitation. Congress has gotten stricter on the home office deductions, so don’t play around!!!

Note – for the 280Ac5 limitation, anything that it limits is carried forward.

Problems pg 5231. T owns 2-bedroom vacation home that T rents for 90 days and uses for personal purposes for 30 days. Receives gross rental income from the home of 3k. Pays property taxes of 1k and mortgage interest on 1k. Incurs other expenses – 2k of depreciation and 1600 of non-depreciation expenses. (In (a)-(c) the mortgage interest is “qualified residence interest” under §163(h)(3).)(a) Will T’s deductions be limited by §183 or §280A?

Yes. If the dwelling unit is used as residence, 280A applies instead of 183. To be residence, look at def – this meets residence b/c used for personal purposes for 14 days.

Also rented for more than 15 days so the de minimus exception wouldn’t apply (280Ag)(b) What amount of expenses, other than property taxes and mortgage interest, may T deduct?

GI = 3k Less allocable portion of deductions allowed regardless of whether the unit is rented – 90/365 x 2000 =

500 280Ac5 limitations on deduction = 2500 Less: allocable portion of non-depreciation items – 90/120 (# of days used) x 1600 = 1200 Max depreciation deduction = 1300 (2500-1200 = 1300) Allocable portion of depreciation deduction - 90/120 x 2000 = 1500

But limited to max depreciation deduction of 1300. So T gets 1200 of non-depreciation expenses & 1300 of a depreciation deduction (b/c 1300 is the max).

Excess 200 of depreciation deduction is carried over to the next year

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Note – you do get entire deduction for taxes and interest, you only have to deduct here to get the 280Ac5 deduction limitation on depreciation

(c) May T deduct all of T’s property taxes and mortgage interest? Yes. 280Ab says that if entitled to the deduction regardless of whether the unit is rented, then you get the

full deduction. (d) Only difference, T rents the home for only 3 weeks, and vacations in it with family for one week

Falls under 280A. If is engaged in for profit, then 183 does not apply. If 183 restrictions do apply – not activity engaged in for profit Since used less than 14 days, property is not used as residence under 280A. So 280A does not apply. Go to

183 (hobby restriction) - If property use is not “engaged in for profit” 183 applies. If 183 limitations are applicable, the results are:

Gross Rental income = 3000 Less taxes = 1000 (interest not deductible under 163 b/c property does not qualify as “qualified residence

interest” under 163 b/c not used as residence for 14 days) 183b limit on rental expense other than taxes = 2000 Less: allocable portion of non-depreciation items including interest (21/28 x 2600) = 1950 Include interest since it was not allowed at the top (not deductible regardless of rental since

this doesn’t qualify as residence) Max depreciation deduction = 50

If not engaged in for profit, what can you still deduct? Taxes; interest is personal interest and not deductible unless it could be investment interest

and deductible under 163(d) b/c now is activity engaged in for profit (can’t be residence interest, but maybe investment)

So still allocate under 280Ae to figure out expenses for interest, and depreciation Take allocable portion of remaining deductions (interest, other expenses and depreciation –

21/28 x 3400 of potential deductions = 3450 + the allocable taxes = 3450 of total deductions.)o If engaged in for profit, then you get all of the deductionso If 280A or 183 don’t apply, then can deduct any allocable business expenses

2. TP operated consulting biz out of home. Uses office in home exclusively on regular basis, as principal place of biz for his consulting biz. TP has 2k GI from his consulting biz. He has biz deductions of 1600 for supplies and secretary expenses. Mortgage interest and real estate taxes allocable to his office total $400. $200 utilities and $150 depreciation allocable to his office. How much of the utility expense and depreciation is deductible?

280Ac5 determines extent of deduction you can get. How much utility expenses and depreciation?

o 1600 biz deductions you get regardless. The 400 of mortgage interest and taxes you get regardless. You don’t get any utility expenses or depreciation expenses. C5 limitation is 0 so you are unable to take any utility expenses or depreciation deduction for the current year, and it is carried forward to the next year.

o Under 280Ac5, the limitation on utility and depreciation deductions = 2k GI minus 1600 biz deductions that are allowed regardless minus the 400 taxes that are allowed regardless. That = 0, so nothing allowed to be deductions for utility and depreciation expenses.

o Since 2k equals the income, that’s all you can get and you carry forward the allocable utility and depreciation costs

3. Widow rented 3 rooms in her large house. Are the deductions related to the rooms (depreciation, utilities, repairs, interests and taxes) limited by 280A?

Reg 1.280A-1(c)- the rooms are treated as separate DU…b/c solely rented out for use for paying customers and never used for her personal purposes, 280A doesn’t apply

DU includes house, apt, etc. Here, it is her house. Since she is not renting out entire DU, just the rooms, she is not able to get the deduction.

If it were separate apts, the ans may be diff. An apt is considered a separate dwelling unit. Look at each one separately under 280A. But since this is just one DU, she gets no deduction

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Passive Activity Limitations 469 – passive activity losses and credits are disallowed, but can be carried forward into future years and also

used when activity sold These restrictions are important with regards to the Gulf Opportunity Zone Act TP subject to the limitations – 469a2 –

o Individuals, estates, trusts, closely held C Corp and personal service corporationso Closely held C Corp – corp where 50% or more is owned by 5 or fewer individuals (469j1)o Personal service corp – principal activity is to offer personal services performed substantially by EE

SHs (engineering, doctor, etc.)o Corps are excluded if 10% or less of the stock value is owned by EE SHs (469j2)o Partnerships subject to this limitation at the owner level

Carry forward: 469g1 – effectively the rules are just postponement deductions – not completely disallowed Passive activity losses = passive activity losses over passive activity income (passive activity losses cannot

offset active income) o (1) Define activityo (2) Determine if passiveo (3) Take net passive losses over passive income, and that is limitation – can’t be taken and must be

carried forward to future years. In future years, can take loss if have enough passive income or if sell activity

469(c)(1) – “Passive activity” – any trade/biz or profit-seeking “activity” in which the TP does not “materially participate”

Look at what is the activity: facts and circumstances test When you are applying the materially participating test, it is done on activity-by-activity basis.

If you segregate biz into two activities, you might not meet material participation when you would meet it if the activity were one and vice versa. Also it is important when you sell the activity (b/c you get to recognize the loss then)

Regs use “appropriate economic unit test” to segregate appropriate activities A stand-alone unit = activity Ex: You may have a restaurant w/ a catering service. You actively participate in the

restaurant but you don’t in catering. Initially you may want to conglomerate them. Later down the road you may want to separate them if you sell the catering so you can take the loss then.

1.469-4c2 list of factors to determine which items are “activity” Once something is grouped as an activity, you can’t regroup unless the original grouping was

clearly inappropriate or there was a material change in facts and circumstances Once you have activity, determine whether it is passive

o Passive if not “material participation” o Regs – 1.469-5Ta – an individual is treated for purposes of 469 as “materially participating” if meets

one of the 7 situations: (if meet one of these test, will be active participation and not subject to the limitations)

(1) If individual participates in activity for more than 500 hours for a year (2) If individuals participation in the activity for the year constitutes substantially all of the

participation in such activity of all individuals for the year (running the entire show) (3) Participates more than 100 hours & the participation is not less than the participation of

any other individual So you only need 100 hours if no one else works at it more than you do

(4) “Significant participation activity” and the individual’s aggregate participation exceeds 500 hours for all activities

“Significant participation activity” – one in which individual participates for more than 100 hours but not material participation

So if you participate in more than 1, and all combined equal more than 500 then you materially participate

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(5) Individual materially participated in the activity for any 5 taxable years during the 10 taxable years immediately preceding this taxable year

(6) Personal service activity and the individual materially participated in the activity for any 3 taxable years before this taxable year

“Personal service activity” = one in which personal services performed in field of health, law, etc (service-oriented activity and not where capital is making the money)

(7) Facts and circumstances test – the individual participates in the activity on a regular, continuous, and substantial basis during the year

TP must also participate for 100 hours to meet the facts and circumstances test o Don’t want to rely as much on this since it is facts and circumstances and the

others are definite rules Special rules:

o 469h4 – closely held C corp and personal service are treated as materially participating only if (1) 1 or more of the SH owning stock representing 50% of the outstanding stock materially

participate in the activity (2) If special requirements of 465c7C are met – look at FN 55 Basic rule: if closely held C Corp or personal service usually only can materially participate if

50% of the SH by value materially participateo Rental activities:

469(c)(2) – Gen rule: passive activities include rental activities (rental activities are per se passive)

Rental activity 469j8): activity where payments are principally for the use of tangible property 469(c)(7): Special rule for TP in the rental activity biz:

Para (2) does not apply to any rental real estate activity of a TP for the taxable year, and this section will apply as if each interest of the TP in rental real estate were a separate activity.

A TP may elect to treat all interests in rental real estate as one activity. This applies to TP if:

o More than ½ of the personal services preformed in the trades or biz by the TP during the taxable year are performed in real property biz in which the TP materially participates, and

o The TP performs more than 750 hours of services during the taxable year in real property biz in which the TP materially participates

(D) If closely held C corp is in real estate biz they are not subject to the automatic passive rule for real prop

(E) Personal services as an EE = not treated as performed in real property biz. o Can’t go work for a developer in town and then on the side have an activity –

the services as an EE don’t count for the special rule o Limited Partner: Generally their services are passive (469h2)

Reg –5Te3ii – if the TP is also a General Partner he may be treated as materially participating w/ respect to both interests

So if just Limited Partner, it is considered passive activity (per se), but if also a GP, you could be considered to materially participate

Compute passive activity – 469do You compute for each activity first, and then combine – the reason is b/c you have to determine how

much loss is attributable to each activity for use when the activity is sold so you can carry the loss forward

Portfolio income is excluded under 469e1 o Don’t want you to participate in the tax shelter and get dividend or something and then get to exclude

the losses o Can’t participate in stock market and try to use your gains from there and try to exclude the losses

2 exceptions for disallowance:

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o (1) 469i1 – General Rule: Allowed to take up to 25k of passive activity deductions if you actively participate in a rental real estate activity and you own at least 10% of the activity

Active participation is lower standard than material participation - met if TP makes significant mgt decisions

o (2) LP can’t actively participate (if LP, you are pretty much subject to the limitations in 469)o Phase out rules – phased out b/w 100k and 150k of AGI.

If earn less than 100k you can get the 25k deduction If earn more than 150k you don’t qualify at all

If closely held C corp, can offset and utilize the passive activity loss and credits – 469e2 When are these losses released?

o Carry forward – ones that are unable to take deduction under 469 are carried forward under 469bo 469(f)(1) – if activity is former passive activity, any unused deduction allocable to the activity shall be

offset against the income from such activity for the taxable year. If losses suspended and the TP subsequently materially participates, can offset losses of

income from that point forwardo Similar rule if C Corp or personal service…

Ex – if closely held C corp all of a sudden doesn’t have 5 or fewer SH, no longer subject to 469 but all the losses previously suspended will still remain suspended

o Under 469g1, the suspended losses can be taken in the yr the activity is disposed of Rationale- a real economic gain or loss can now be computed Losses applied first to the specific activity – then to offset other passive gains – then they can

offset other gains (non-passive gains)o If activity sold on installment basis, losses are taken as each payment madeo If activity disposed of in non-recognition transaction then losses remain suspended and carry over to

new prop If corp merges into another corp, that is non-recognition, but the losses carry over to new

activityo If dispose of activity to a related TP, loss remains suspended until related TP disposes of the activity

Can’t get around rules just by transferring to related TP and then trying to take the losses o If dispose of by gift, the basis of the gifted prop is increased by the amt of the suspended loss. But no

loss can be taken when you transfer by gift. When the donee sells the prop on subsequent sale, the donee’s basis can’t exceed the FMV at the time of the gift (1015)

If you dispose of passive activity by gift, you don’t get loss, but you increase basis to extent of suspended loss. The donee in turn, when they sell the prop, their basis in determining the loss will be limited to the FMV at the time of the gift

o Suspended losses can be taken on death of TP to the extent the loss exceeds the step up in basis Ex – if you have activity and you have 1000 basis, worth 5k, and you have 10k in suspended

loss, you get 4k step up in basis when they die and can only use the loss to the extent the 4k exceeds the step up in basis. (Would only get 6k loss – b/c that’s what 10k exceeds 4k)

Suspended credits - generally remain suspended until sale of passive activity

Problems 1. Lawyer earns $200k of the taxable income from her practice in the current year. How do these affect taxable income?(a) Lawyer also has 10k dividends and interest for the year. She invests as a LP in a pship that films movies. Her share of the pship’s movie losses for the year is $50k.

The law practice is active income The 50k of movie loss is passive The 10k is portfolio income that is excluded from def of passive income (not passive income) – 469e1ai The interest in the LP is also passive in 469h2 Since it is passive, none of the loss can offset any gain. Here, the losses would not be able to offset. There is 50k of passive loss which cannot offset income, so it is

carried forward to the next year assuming she has no other passive income.

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(b) Lawyer also has a $30k gain from her LP investment in a tax shelter. Since 30k of passive income, you can net with the 50k passive loss. So if she does have passive income, she

can take the loss to offset. The remaining 20k carries forward to future years. (c) In succeeding year the movie LP makes a gain of $90k.

Still have the 50k loss from (a) but also have passive income of 90k. So you can offset with the 50k loss. The 40k remaining is passive gain.

So in the second year, you are able to use the loss that was carried forward. 469 not a disallowance, but a postponement

(d) Lawyer sells movie LP interest at the beginning of the succeeding year at a gain. Get rid of entire interest and all suspended losses are allowable first a/g that particular activity, then other

passive activity, then ordinary income It is a real economic loss at the point you sell so you can deduct

(e) Same monetary figures as (a), except Lawyer’s LP interest is in rental real estate rather than in a movie. Since LP, it is still passive. None of the 50k can offset the 210k income b/c not passive income. So it is the

same result. You can’t actively participate with a LP interest. Another reason, the 25k active participation standard is phased out b/w 100k and 150k. So the real estate

exception won’t apply either.

2. In the current year Grocer purchases a grocery store and spends 35 hours per week operating it to the exclusion of all other biz and investment activities. Grocer’s loss from all grocery store biz is $50k. How much loss is deductible?

Not passive activity b/c based on the number of hours, it doesn’t meet the hour requirements – it is more than 500 hours so he materially participates

Therefore it is deducted as trade or biz3. In year 1, Eileen purchases a house and uses it as her primary residence. In year 2, she changes her primary residence and decides to rent out her former residence. Eileen hires a rental agent to handle day-to-day problems but she approves new tenants, sets rental terms and approves capital or repair expenditures. Eileen’s loss from the apt is $8k and her other AGI is $40k. How much is deductible?

Generally rental activity is passive under 469c2, but there is 25k exception if she actively participates. The issue in determining whether she actively participates is if she makes significant mgt decisions. Since she hired someone else to do it, and she has nothing to do with it, probably not making significant mgt decisions

Maybe you can argue that she does actively participate since she makes repair decisions and approves new tenants

If she does actively participate, she an get the 25k deduction b/c she doesn’t reach the phase out requirements So if she actively participates, she can take entire loss. Note – if she had 30k loss, she could only take 25k of it

Illegality or Impropriety §162(c) – disallow deductions for illegal bribes, kickbacks and other payments

o (1) Illegal payments to gov’t officials – no deduction allowed for payment made directly or indirectly Can’t deduct bribe to do biz

o (2) Other illegal payments – no deduction allowed for a payment made directly or indirectly to any person if the payment would subject payor to criminal penalty or loss of license

So even if the bribe is not to gov’t official, it is still not allowed as ded if it is illegal under fed or state law that is generally enforced

o (3) Medicare, Medicaid anti-kickback rules – disallows deduction for any bribe or kickback to any person who furnishes these services

Basically, under Medicare laws, it is illegal to give kickback for referring a pharmacy, therapist, etc – can’t refer a patient to PT and get 50k for every patient they refer.

162(f) – disallows for fines and penalties – if you have to pay parking ticket, you can’t deduct it 162(g) – treble damages in anti-trust laws 165(d) – gambling losses are deductible to the extent of gambling gains 280E – precludes deductions related to drug biz Tellier

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o TP was in securities biz and was indicted on 36 counts of fraud and the TP found guilty. The issue is whether he could deduct his legal fees in defending these charges as a reasonable and necessary biz expense

o SCOTUS said he could deduct – said expenses are clearly an expense of the biz (he wants to stay in biz of trading securities)

o In determining whether legal fees are ded, look at nature of claim (here, the source of the claim was the TP’s biz)

From Gilmoreo So it is ok to deduct legal fees for the illegal activity. But if he has any fines or penalties as a result of

getting convicted, can’t deduct under 162fo Note - some deductions can be disallowed for public policy reasons

Only where the allowance of a deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct. No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense.”

Assignment of Income People assign income to pass off income they would otherwise be taxed on Ex: to their children - giving a gift to children and it will be taxed on child’s tax rate which is generally lower

o However, “kiddie tax” prevents some of this If child is under 14, their income is taxed at parent’s rate. But once over 14, they are taxed at

their own rateIncome from Services

Lucas v. Earl o TP made a K with wife that all income earned would be treated as earned by both of them. o Issue: can he say the income he earns is half of for the wife?o Salaries are taxed on those who earn them and the income can’t be escaped by those who earn them. o If you are really the one earning it, you are the one taxed on it.o “The tax can not be escaped by anticipatory arrangements to prevent salary from vesting in the man

who earned it.” Giannini

o Giannini had income for the beginning of the year, and then said he didn’t want his salary for the rest of the year. Profit for the balance of the year was $1.5M. He told the corp to give it to a charity. The corp donated this money in honor of the TP.

o Issue – is the money included in the TP income?o In this case, he was not taxed on it b/c he didn’t get control over the money.

He did not beneficially receive the money or direct the money – he only refused the money and directed that they use it for a worthwhile cause.

In Lucas, he controlled the money – directed it to go to the wife. IN Giannini, he didn’t control it, he just said he didn’t want it. He did not direct where the money went so he was not taxed on it.

o Note – in Giannini, if he had said he didn’t want the money, but give it to a certain person, then he would be taxed on it b/c he exercised control over it and benefited by being able to decide where the money went.

RR 66-167 Executor of estate – waived executor fees Should this be taxed to the TP and be treated as gift from the TP to the legatees? The RR says the test in determining is whether or not the TP intended to serve gratuitously How do you determine the intent to serve is gratuitous?

o “Requisite intention to serve on a gratuitous basis will ordinarily be deemed to have been adequately manifested if the executor or administrator of an estate gives a formal waiver of any right to compensation for services w/i 6 months of his initial appointment.”

o If do this w/i 6 months of being named to serve, it is gratuitous and not taxed on the income But, If on tax return you say you are deducting the fees, that shows that at some point you intended to get it

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What you can’t do is intend to get paid, render the services to get paid, and then change your mind at the last minute – you need to waive up front if you want this to be gratuitous

RR 74-581 Had to do stuff as part of teaching duties. All amounts received were endorsed to the law school where they

were employed. o Issue: are they taxable on this income?

They had check, but immediately gave to law schoolo Holding: this is not taxable to EE b/c immediately gave away. EE was acting as agent

Gen Rule: if you earn or otherwise create right to receive income, you will be taxed on that Exceptions: if you are acting as a person’s agent, you are deemed to not have received the fees

o Statutory legal fees received by attorney that rep indigent defendants – immediately turn over to ER – not subject to income taxes

o Physician turns checks immediately over to hospital – no include in gross incomeo Officer – goes undercover as EE – in accordance with policy of department turns over to police

pension fund – said acting as agent of department and not entitled to receive it himself so not taxed on that income

o Medical school – not taxed on amount turned over to school according to policies and procedures in school

Purpose of income tax is to tax the person who received the benefit – if you don’t get the benefit b/c you have to turn over to ER, then you aren’t taxed on it

Executive has a salaried position with Hi Rolling Corp under which she earns $80k each year.(1) Who is taxed if Executive, at beginning of year directs that $20k of the salary be paid to her parents?

Under Lucas, She is taxed on the 20k. The parents are not taxed, but are treated as receiving gift which is excluded from their income under 102

She has the legal right to enjoy the benefits of the salary (2) Who is taxed, if at the beginning of the year, Executive directs that $20k of her salary be paid to any charity BOD selects? (She is not on the BOD)

Issue – does the Giannini exception to Lucas apply? In Giannini, the TP told the BOD to do something worthwhile – in that case, the TP did not direct where the

money should go and it was not included in income JK would say that it probably does apply – they are not directing to a specific charity, she is just letting them

pick. And, she is not on the BOD The executive has to direct this before the money is earned for the exception to apply Remember in Giannini, he earned a lot of money at the beginning of the year, and then said he didn’t want any

money later. In that case it was ok. What he couldn’t do is wait until Dec 30 to say he didn’t want it(3) Executive makes the same request with respect to a $10k year-end bonus which Corp has announced toward the end of the year, based on services rendered throughout the year.

If the executive rejects the bonus as soon as he becomes aware of it (before he beneficially receives the funds) the Giannini exception applies.

The issue is whether he has already “earned” it – has he already beneficially received? But if he didn’t know about it, and then when he receives it he automatically gives it back it might not be taxed

(4) Who is taxed if Executive, in her corporate role, gives a series of lectures on corp finance at a local biz school, and pursuant to her contract with Corp, turns over her $1k honorarium to the Corp?

RR 74-581, it is taxed to Corp and not executive b/c she is just acting in capacity as agent on behalf of Corp

Income from Property Helvering v Horst

o TP detached the interest coupons from bonds before due date and donated to son and son collected the interest. Is the interest income taxable to father or son?

o Ct says TP who controls the source of the income (person who owns the bonds) also control the disposition of the interest he could have received

o The TP here enjoyed economic benefit by the transfer of the coupon.

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o The power to dispose of the income is the equivalent of ownership of it. If you can give the income to whoever you want is the equivalent of having income yourself

o This is just like Lucas v Earl where you control where it goes – it is irrelevant if it is from services or property

o “The fruit is not to be attributed to a different tree from that on which it grew.” Blair

o TP only had income interest in trust and assigned portion of income to children. Issue – is the income still taxed to the TP?

o In other assignment of income cases where original owner is taxed, the TP retained the property giving the income. Here, the TP transferred all interest in the property. The distinction b/w this case and Helvering v Horst – in Horst, he held onto the “tree” – the bonds – and simply gave away the income

o In this case, all the TP had is income and he donated everything that he owned, which was the interest – this is transfer and the donee is taxed on the income

Stranahan o Sold his interest at a discount o Are the dividends taxable to the TP or the son as they are received? o Distinguishable from Horst and Lucas b/c the transfer is not gratuitous

It is not a loan b/c not guaranteed that he would get the money backo The son is taxed on the income o If you sell prop for FMV, you won’t get hit with assignment of income

Susie Salvatoreo TP owned service station and son operated service station. Son negotiated for sale of property to

Texaco. TP signed binding K to sell (but not actually sold) and took DP. After this was done, the TP donated an interest to her children. Is she taxed on whole proceeds or just one half of the proceeds?

o You can’t get around being taxed by using someone else as a conduito A conveyance of half the prop was only an intermediate step in the saleo All the gain is taxed to the TPo Once the fruit is too ripe (once deal is basically done) you can’t transfer the taxable gain by donating it

to someoneo Issue - how far along must you be for this rule to apply? When you put for sale sign out? When you

talk to someone? Who knows It applies whenever the deal is “effectively done” If you have signed binding K, that is Salvatore case, and we know that is far enough

o What distinguishes this from other cases – it was assignment of income b/c it was not sold yet RR 69-102

o TP sold endowment life ins K to charity and donated annuity K to sono Issue – when the Ks are redeemed, is the TP taxed on the proceeds when cash collected by

transferees?o “The issue is not whether the income has accrued in a legal sense, but whether the income has been

earned so that the right to payment at a future date existed when the gift was made.”o In this case, the person making the transfer would be taxed when the payment was redeemedo You can’t get around being taxed on it once you have already earned it – he had already earned it, just

had not cashed it ino The gain is taxable to the TP to the extent it exceeds the TP basis on the date of the transfer (amt of

cash he would have gotten out of K) Prothro

o TP was not taxed on the gain attributable to the 100 cows donated to YMCA b/c he donated both the principal and the income. He didn’t just donate the fruit, but donated part of his property and the gain, and b/c of that he is not taxed on the gain. (all goes to YMCA which is not taxed b/c it is a charity)

Tatum o TP received portion of the crops produced as rent (paid rent with crops instead of cash)

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o TP immediately donated the crops to the charity as soon as he received themo Ct held – TP still taxed on the income. This was earned as he received it (as rent) o Not taxed on the crops when he receives as income b/c doesn’t have the cash to pay for the tax at that

point. But when he sells it, it is income. Here, he will get hit with income when he directs where the crops will go

If you transfer both income and principal, that is Prothro and Blair which say if you transfer both income and principal, any subsequent income is not taxed to you. But if part of the income is already ripe, that portion is taxed. Half to transferor and half to transferee

Stock donations – issue – when is the fruit “ripe”?o Options: declaration date, record date (date if you own as of the date, you get div), payment date, date

of actual receipt Smith’s Estate – Held ripened on the declaration date – but this was small closely held Corp.

This makes sense b/c you are pretty much in control of when the dividend goes outo But if publicly traded corp, it is the record date – this is b/c you don’t control when dividend made

Rule: if you already earned the income when the property transferred b/c the fruit is ripe, and all you are trying to do is ship the income off to another party, you are taxed. But if you have not earned the income, it is not taxed. You can give it to another, and they are taxed when they receive it

1. Father owns a registered corp bond which he purchased for $8k. Has $10k face amount and is to be paid off in 2010. Current FMV is $20k. Bond pays 8% interest, semi-annually on April 1 and Oct 1($400 each payment). What tax consequences to Father and Daughter in the following situations?

(a) On April 2 of current year, father assigns daughter all interest coupons. o B/c father did not transfer the bond (only transferred the interest) he is taxed on the interest when it is

paid (b) On April 2, Father gives D the bond with the right to all interest coupons.

o B/c he transferred everything he owned, Prothro or Blair, the D is taxable (c) On April 2, father gives daughter ½ interest in the bond and the right to all the interest coupons

o In this case, half taxed to daughter and half taxed to him (b/c he transferred only half) (d) F owns an income interest in a trust which owns the bonds and on April 2, F gives his income interest

(right to succeeding interest coupons) to Do All that he owned was income interest in trust, and he transferred it all to D, she is taxed

(e) On Dec 31, F gives D bond with the right to all interest coupons o Here, ½ of the interest is ripe b/c he has already earned half the interesto Half the current interest is taxed to fathero RR 69-102 – b/c he already earned half he is taxedo The other half (earned after transfer date) and all subsequent interest is taxed to daughter b/c he

transferred everything he owned (f) On April 2, F sells D the right to the 2 succeeding interest coupons for $600 (FMV)

o Stranahan – F has 600 income when sold and the D is taxed upon receipt of interest o D has 300 basis for the 2 coupons. Only taxed on the remaining 100 of interest per coupon o The assignment of income doctrine won’t apply here- just like Stranahan – he was paid FMV for it.

This is just a straight up sale of the interest coupon o Daughter essentially purchased the int coupon for 300 each (600 total) – she has 300 basis in each

coupon – when she receives each 400 payment, she is taxed to the extent the amt realized exceeds her basis.

o With each interest payment the daughter gets hit with 100 tax (400-300) (g) April 2, Father sells the bond and directs that the 9k sale price be paid to D

o Taxed to father b/c he had the right to receive the amt and all he did was direct that it go to his daughter

o 9k realized – 8k basis = 1k gain (h) Prior to April 2, F negotiates the sale and on April 2, he transfers the bond to D who transfers the bond To

buyer who pays D 9k

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o Salvatore – the deal was essentially already done – if the negotiations had proceeded to a point where the deal is done, even though not complete the F is taxed

2. Playboy declared semiannual dividend Tuesday, but Hugh decided to give his back. Hugh holds 72% of the stock. How is this treated?

Gen rule: the record date will apply (particularly with publicly traded co) But in closely held co, the declaration date will be used. B/c Hefner owns 72% of stock, the declaration date is more appropriate – he essentially can decide when

dividend can be given B/c he is given this back after the declaration made, he will be taxed on the dividend. When he gives it back, what is it? (capital contribution or gift to other SH?)

3. Inventor develops new switch which she patents. Who is taxed on the proceeds of a sale if: (a) Patent is transferred gratuitously to Son who sells it to buyer?

o Son would be taxed b/c no sale that was already negotiated. (son gets tax instead of inventor)o It could be argued that this is effectively services b/c she invented this new switch. But, this was shot

down! o In the Tax Court case, there was actually property transferred

(b) Inventor transfers all her interest in the patent to buyer in K and then transfers the K gratuitously to Son prior to receiving any royalties.

o Could argue that income already ripe under Salvatore, but the courts have held this is assignment of the income producing prop itself and taxed to the son – similar to Blair or Prothro. All she had at time of transfer was right to future income and she transferred everything to the son.

Note – if you transfer and there is no discussion of sale at all – there is no assignment of income. But if there is a sale discussed, it is assignment of income – look at Susie Salvatore

AMT- Alternate Minimum Tax- Be Aware Of!!!!Failure to comply with Circular 230 means that you nor anyone in your firm can practice before the IRS. Now, it’s so broad that’s it easy to not comply. If you’re giving any sort of tax advice that is a “covered opinion,” then it must comply with Circular 230 (tax shelters, specifically evading taxes, reliance opinions). A reliance opinion is one which your client relies on to avoid the imposition of penalties for tax purposes. So, in email or other form of communication, include that this discussion should not be relied upon in order to comply with Circular 230 (JK has the Circular 230 opinion verbatim tagged on each email). Specifically §10.35 is the section to look at in this area.

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