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Course: Federal Income Tax Winter 2003
School: unknown
Year: 2003
Professor: unknown
Course Outline provided by Legalnut.com

FEDERAL INCOME TAX OUTLINE

 

  1. General Notes on Federal Income Tax

    1. Basic Material

      1. The tax law is built around ability to pay

      2. Hierarchy of tax law

        1. The Constitution/16th amendment

        2. Internal Revenue Code

          1. Passed by Congress – the IRS only has authority to the extent they can reasonably interpret the statute

        3. Treasury Regulations

          1. Again, the IRS only has authority to the extent they can reasonably interpret the regulation

        4. IRS Revenue Rulings/Revenue Proceedings

          1. These are less binding than the previous examples – according to Evans, these are challenged fairly frequently and the odds of success are often reasonably good. (On the other hand, it takes brass cojones to challenge treasury regs, and even more to challenge the IRC)

        5. IRS Private Letter Rulings

      3. Also note a taxpayer can pay tax on either the calendar or fiscal year.

    2. The Basic Tax Formula

      1. Personal

        1. Gross Income

        2. - “Above the Line” deductions

        3. Adjusted Gross Income (AGI)

        4. - “Below the Line” deductions

        5. Taxable Income

        6. x Tax Rate

        7. Tentative Tax Owed

        8. - Tax Credits

        9. Final Tax Due

      2. Corporate – essentially the same, but without parts c) and d)

    3. Tax Terminology

      1. Income (see also infra)

        1. Taxable Income – derived from gross income

        2. Gross Income – defined in §61; “all income from whatever source derived.”

          1. Any realized accretions to wealth is income

          2. Therefore, income need not be cash; income in-kind is also taxable.

      2. Deductions – reduce taxable income and thus provide a tax benefit; the amount of benefit increases as the taxpayer’s marginal rate increases.

        1. “Above the Line” – Deductions taken prior to computing AGI; always beneficial.

        2. “Below the Line” – Deductions taken after computing AGI; may be beneficial depending on floors, phase-outs, etc. based on AGI.

      3. Tax Credit – a dollar-for-dollar reduction in tax. Far more beneficial than a deduction.

      4. Fair Market Value (FMV) – the price paid between a willing buyer and seller with full information and no compulsion.

      5. Basis – generally, an item’s cost; also, adjusted basis is the basis after taking into account factors like depreciation, etc.

      6. Standard Deduction – in §63; inflation-indexed.

      7. Personal Exemption – in §151; inflation-indexed.

      8. Marginal Rates – each dollar over a given amount is taxed at a given level. Thus even a high-bracket married taxpayer’s first $36,900 of income is taxed at 15%; this is why it is a misnomer to say that moving into a higher bracket will make you worse off.

      9. Time Value of Money (TVM) – basically, a dollar is worth more today than tomorrow. Because of this, much of a tax lawyer’s work is in deferring recognition of income and gains, while accelerating the recognition of losses.

    4. Tax Policy

      1. Types of tax systems

        1. Progressive (ex.: FIT) – marginal rates increase as taxable income increases.

        2. Proportional (ex.: flat tax) – same rate at any income level.

        3. Regressive (ex.: sales tax, VAT) – marginal rate decreases as taxable income increases.

      2. There are three goals to any tax system:

        1. Economic Efficiency (minimal economic distortion)

        2. Simplicity (e.g., administrative ease)

        3. Fairness (e.g., ability to pay).

          1. horizontal equity (people in same situation pay same tax)

          2. vertical equity (progressivity)

        4. Thus, a comparison of FIT, a VAT, and poll or head tax looks like figure 1 (see end of document)

      3. Progressive Taxation vs. Non-progressive taxation

        1. Pro:

          1. Ability to pay (marginal utility of money declines)

          2. Encourages work via income effect

          3. Much wealth is from heredity, genetics, or luck

        2. Con:

          1. Problem of interpersonal comparisons of utility (e.g., penny-pinching law firm partner)

          2. Discourages work via substitution effect (e.g., substitute leisure for work)

          3. Reduces property rights

      4. Additional policy notes

        1. Sales taxes are regressive because they tax consumers and don’t tax savers, and low-income people tend to be consumers while upper-income people tend to be savers.

        2. Note the U.S. is the only country without a integrated corporate income tax, e.g., the only country that taxes dividends twice (once to the corporation as corporate earnings, then again to the taxpayer upon distribution)

          1. Who does the incidence of this fall to? The shareholders (e.g., progressive)? Or consumers (e.g., regressive)?

        3. Also note the problem of bracket creep; left unchecked, a taxpayer could find his income increasing due to inflation (and thus in a higher tax bracket) without any real increase in spending power. This is mitigated to a very large extent by the indexing of the rate structure, standard deduction, and personal exemption. (§§1(f), 151(f))

      5. Criminal And Other Sanctions

        1. Criminal Sanctions for:

          1. Willfully failing to file or pay tax (§7203)

          2. Attempting to evade tax (§7201)

          3. Committing fraud on the return (§7206)

        2. Ethics of the preparer

          1. The taxpayer can be penalized and the attorney can be sanctioned (by both the IRS and the bar) for taking an overly aggressive tax position

            1. “Overly aggressive” means there is no substantial authority for your position; this is interpreted to mean you have at least a 1/3 chance of winning litigation on the merits

            2. Basically, you can’t play the “audit lottery” if you know you’d lose

      6. The Tax Expenditure Budget

        1. Basically, a way of publicizing the “cost” to the treasury of various deductions, credits, etc.

        2. The idea is to make Congress just as accountable for credits as they are for expenditures

        3. Problems include: doesn’t account for behavior changes, numbers are projections (and thus not certain), some find it offensive (because it implies that your money belongs to the government, and only by their good graces can you keep it)

  2. Characteristics of Income

    1. Definitions of Income

      1. Eisner v. Macomber – narrow definition; basically, capital gains and labor income

      2. Com’r v. Glenshaw Glass – broader definition; no real restrictions on taxable receipts

      3. Haig-Simons Income – Algebraic sum of: FMV of consumption + change in value of saved property rights.

        1. Ex.: Wealth at 1/1 = 100; at 12/31 = 120; Consumption for the year = 30. H-S Income = 20 + 30 = 50

        2. Note change need not be positive; if in above example, wealth at 12/31 was 50, then H-S Income = (50) + 30 = (20)

    2. Non-cash exchanges (e.g., bartering)

      1. In a barter situation, the income received is equal to the FMV of the property received in payment (RR 79-24); Basis is then equal to FMV.

      2. Today, barter clubs must register with the IRS by statute

    3. Fringe Benefits

      1. Generally

        1. Other than the exceptions noted below, a fringe benefit is taxable as income.

        2. Why exempt fringe benefits?

          1. Pro

            1. It promotes the “right” behavior (e.g., health insurance)

          2. Con

            1. It distorts economic behavior.

              1. Ex.: say an employee in the 28% bracket can receive $10,000 in cash or meals costing the employer $10,000

              2. If she takes cash, then she nets $7,200 ($10k-28%)

              3. Thus, if she values the meals at $7,201+, then she will take the meals – her behavior is distorted by the tax code. A “non-mutual incentive” is in place.

              4. Note that this is wasteful – $10,000 of resources are used to fulfill only $7,201 of desire (utility).

            2. It may be viewed as unfair (leading to compliance problems)

            3. It can encourage consumption at the expense of savings

      2. Meals & Lodging (§119)

        1. These are excludable if they meet the following conditions:

          1. They are furnished on the premises of the employer

          2. The employee must live there as a condition of employment (for lodging)

          3. The meals or lodging are furnished for the convenience of the employer

        2. Policy – it would be unfair to tax employee, since he has no choice; presumably, employee’s personal utility in the benefit is less than FMV cost.

        3. Ex.: Hotel manager required to be “on-call” 24 hours a day at Hawaiian resort (Bengalia)

        4. Also note this only applies if the meals or lodging are given in-kind – cash to be used for meals is taxed as income

      3. Cafeteria Plans (§125)

        1. These are a way for employees to pay for certain items in pre-tax dollars by providing a deduction for them (e.g., child care, health insurance)

          1. Pro: Cheaper than buying them yourself

          2. Con: “Use it or Lose it” – if you haven’t spent it at year-end, the deduction is lost

      4. §132 Fringe Benefits

        1. No-Additional Cost Services

          1. You can give away to an employee a service that incurs no substantial additional cost

            1. “No Cost” includes foregone revenue – if the employee is taking away from a paying customer, it’s not excludable

            2. Available to wife & kids, since the code includes them in the definition of “employee” for this section

            3. Line of Business requirement – must be in company’s main line of business. Conglomerates can’t give no-cost services from all their subsidiaries to its employees.

            4. Can’t discriminate in favor of executive suite; must be available to the rank-and-file

          2. Policy: don’t want to waste resources

          3. Ex: Airline lets their employees fly standby for free

        2. Qualified Employee Discount

          1. Discount to employee down to cost (e.g., price paid is ³ cost) is excludable from income

            1. If a service, can discount up to 20% of sales price

            2. No discount for investments are allowed

            3. If the discount goes below cost, the difference between cost and discount is taxable as income

            4. Also, Line of Business and Anti-Discrimination requirement (see above)

          2. Ex.: Clothing store gives employees a discount on its merchandise

        3. Working Condition Fringe

          1. If the employee could deduct the item as a business expense (under §162), the employer may provide it and it is excludable as income

            1. Independent contractors are included as employees for purposes of this (TR §1.132-1(b)(2)(iv))

          2. Policy: doesn’t matter who takes it – tax effect (from IRS standpoint) is the same; why hassle with reporting?

          3. Ex.: Uniforms, bar dues, etc.

        4. De Minimis Fringe

          1. Can exclude benefits from income that are so small that the hassle of accounting for them isn’t worth the trouble

          2. Ex.: Coffee, one-time use of company car for short emergency trip

            1. Note sports tickets and clubs are not considered de minimis

        5. Qualified Transportation (not covered)

        6. Qualified Moving Reimbursement Expense (not covered)

      5. Other Excludable Fringe Benefits

        1. §79 – Group term life insurance up to $50,000 (taxed on the excess over $50,000, if any)

        2. §106 – Disability & Medical insurance (no limit)

 

        1. §127 – Education assistance from employer up to $5,250/yr. (but not for graduate school)

        2. §129 – Dependent Care up to $5,000/yr.

    1. Imputed Income

      1. This is basically “do it yourself” income – that is, the “income” you have from doing things yourself instead of hiring someone else to do it. It is not included in income.

      2. Ex.: Owning your own home – you have “income” in the amount that you don’t have to pay rent; if you moved out and rented the house, you’d have dollar-income that would be taxable.

      3. Policy: Primarily, it’d be impossible to assess. Plus, it would be incredibly unpopular – it’s too ‘theoretical’ for most folks.

      4. Analysis:

        1. This can lead to distortions in people’s choices

          1. Ex.: The marriage penalty – it’s often cheaper for one spouse to stay at home and do housework (earning “imputed” income) than to earn money from a job.

          2. Ex.: Distorts choice between owning and renting; absent the tax favoritism for owning (from imputed income and deductions) many would choose to rent.

            1. Also note how this favoritism may increase the cost of housing – homebuilders are aware of the tax provisions and may increase their prices accordingly.

    2. Windfalls

      1. Generally, a “surprise” increase in wealth; it is taxable at the time it occurs

      2. Ex.: You find a diamond bracelet. After turning it in to the police and waiting the requisite time, no one claims it. It is yours, and is taxable as income.

      3. Bargain Purchases

        1. Ex.: You buy a rare manuscript for $5

        2. Theoretically, these could be viewed as a windfall; however, they are not. You are taxed when you later sell the manuscript. If you sell it for $10,000, you are taxed on $9,995 of income.

        3. This only applies if the exchange was bargained-for; thus, if you buy a painting, take it home, and find an original draft of the Declaration of Independence behind the canvas it is taxable as a windfall.

    3. Gifts & Bequests

      1. These are not considered income for the Federal Income Tax (§102)

        1. They are picked up by the Estate & Gift Tax, though – be careful; Evans likes to throw in questions reflecting the E&G tax and ask “is this true under the FIT?”

        2. Also note the gift is not deductible by the donor (§262)

        3. The substance of the transaction, and not the form, controls

      2. When is a gift a gift?

        1. Use the Duberstein test – look at the motive of the donor

          1. Must be “detached & disinterested generosity” judged by “life in all it’s fullness”

          2. This is essentially a jury issue

      3. Basis Rules

        1. Gift

          1. Basis goes with the property – donee keeps donor’s basis (§1015)

            1. However, this is subject to the “goalpost rule” (see Fig. 2)

            2. Basically, if the gift’s FMV (when sold) is < Donor’s basis, then loss is only recognized to the extent the selling price is less than FMV.

            3. If basis is unknown, then basis = 0

          2. Thus, you can shift a gain to a lower tax bracket, but you can’t shift a loss to a higher tax bracket

            1. Gift of appreciated property – if donor is in higher tax bracket, then give gift; otherwise sell and give cash

            2. Gift of depreciated property –regardless of tax bracket, sell (and take the loss) and give cash (b/c loss can’t be passed)

        2. Bequest

          1. Basis is “stepped up” to FMV on date of death (or 6 months after) (§1014)

          2. Thus:

            1. Bequest of appreciated property – hold until death (donee gets tax advantage from step-up)

            2. Bequest of depreciated property – sell (and take loss), and bequeath the cash

      4. A brief summary of the Federal Estate & Gift Tax

        1. It is a tax on the transfer of wealth (e.g., not on income)

        2. §2001 in the Code; 55% is the top rate; it is levied on the donor (not the donee)

        3. Rate is graduated cumulatively over donor’s lifetime

          1. However, there is a credit of $192,800, which is the equivalent of a $600,000 cumulative lifetime exemption

          2. There is also a $10,000/yr. gift exemption per donee (this doesn’t count toward the total above; it is effectively doubled if you are married)

          3. Tuition costs are exempted (even if you’re not paying for your own kids), as are medical costs and gifts to charity

          4. There is a common-law exemption for support

          5. There is an unlimited marital deduction

        4. Basic Policy: Large concentrations of wealth are dangerous and should be “whittled down.” (populist sentiment)

    4. Recovery of Capital

      1. Recovery of capital is not taxes (only the gain)

      2. Principal difficulty arises when selling a portion of a nonhomogenous thing (e.g., land). How to calculate gain? (ex.: % sales price [as in gold mine])

    5. Life Insurance & Annuities

      1. Annuities permit tax-free accumulation of interest via insurance

        1. The only thing better are pension plans, which allows the same accumulation, but also allows you to pay for them in pre-tax dollars (but there are caps on how much you can put in)

      2. The question is, when the annuity is paid how do you determine what part is return of capital and what part is interest income?

        1. §72(b) – take principal/total return to get exclusion ratio [P/R = ER]

          1. Principal = amount paid for annuity

          2. Total Return = Annuities promised payments per year multiplied by life expectancy derived from Table 5 (unisex table) of TR §1.72-9 [$/yr. x LE = R]

            1. This, of course, assumes you’re getting an annuity for life; if it’s only for a specified period of time, then that time is what the payments are multiplied by to yield R

            2. Also note that the shift to unisex tables hurts men and helps women (by accelerating women’s deductions and decelerating men’s)

        2. Use this multiplier to determine how much of each of the annuities’ payments to exclude from income [$ x ER = Amount excludable]; [Amount taxable = $ x (1-ER)]

        3. Note that once all costs (principal) has been recovered, all of the annuities payments are taxable as income (e.g., if you outlive your life expectancy, it’s all taxable)

        4. Also note that if you die before recovering all of your principal, your estate can deduct the remaining principal as a loss (e.g., if you die before your life expectancy, then you get a loss)

      3. A brief note on life insurance

        1. Pure Term Life Insurance – no savings component; it only pays if you die; if you outlive the policy, tough luck

        2. Whole Life Insurance – has a savings component – pays annuity on end of policy if you’re still alive

          1. Premiums are split into insurance and savings components – only the savings component counts as basis

          2. Note these policies are a lousy deal – the savings interest rate is low and the increased cost eats away the tax advantage. Best bet: buy term and invest the difference

        3. Also note that payout on death is not taxed as income (§101(a)), but premiums are not deductible, either (but employer can provide some; see above)

      4. Policy (for not taxing interest until payout): encourages savings, especially for old age (penalty for early withdrawal, e.g., prior to age 59 ½ (§72(q))

      5. Also note that annuities are tax-favored when viewed with an amortization table – normally interest is paid early and principal is paid later. The exclusion ratio treats this as an even mix each year, and thus defers recognition of income (TVM).

        1. See Table 2 below

    6. Recoveries for Injuries (Damage Awards)

      1. Business lost profits awards are taxable

        1. But note §1033 involuntary conversion rules below

      2. Personal Awards (see also Table 3 below)

        1. Physical Compensatory Damages are not taxable

          1. However, lost wages should be taxable – since physical injury awards usually have a lost income component, it is inconsistent to exclude them from gross income

          2. Also note this may be a boon to defendants – if juries know the award isn’t taxed, the award will likely be smaller

          3. “Physical Injury” includes emotional distress resulting from a physical injury

        2. All punitive damages are taxable

        3. Non-Physical Damages are taxable (e.g., libel, etc.)

      3. Medical Insurance payouts aren’t taxable (even though premiums are deductible)

      4. Structured Settlements can give both plaintiff and defendant an advantage due to the tax system – plaintiff doesn’t have to worry about being taxed on investment proceeds, and defendant generally doesn’t have to pay as much for plaintiff to get what he wants due to those tax savings.

      5. Contingency Fees can reduce the amount included in income, but you have to show what portion of time the attorney spent working on compensatory damages, etc. (sometimes the IRS will let this be handled pro-rata)

    7. Cancellation of Debt (COD income – §61(a)(12))

      1. The discharge of indebtedness is a taxable gain

        1. Kirby Lumber – establishes “freed-up assets” theory – that debt forgiveness frees up assets and is thus a taxable event

          1. Thus, when Kirby bought back its $1,000 face bonds for $950, the $50 forgiveness was a taxable event

            1. If a company swaps equity for debt, the stock is viewed as a cash payment equal to the FMV of the stock (§108(e)(8))

          2. Diedrich – paying off another’s tax liability is the same as COD income (you’re canceling their debt with the IRS)

          3. This creates some ambiguities – does forgiveness of a loan that was a gift free up any assets? What if a corporation issues bonds in lieu of dividends?

      2. §108 exceptions

        1. Bankruptcy

          1. Debts discharged in bankruptcy are not considered COD income

            1. Policy: don’t want to kick people when they’re down; ability to pay

            2. This is only true to the extent of the bankruptcy; thus, with $100k of debt and $60k of assets, only $40k of debt is dischargeable in bankruptcy tax-free

            3. You must reduce your basis in your assets (defers taxation)

          2. Brief summary of the types of bankruptcy

            1. Chapter 7 – “Straight” bankruptcy – liquidate all assets to satisfy creditors; any remaining debt is discharged; usually used by individuals

            2. Chapter 11 – “Reorganization” bankruptcy – debt is scaled down, operations continue; used by large business

            3. Chapter 13 – Lets you keep your assets and pay creditors over time; used by small businesses

        2. Insolvency

          1. You may reduce debt to the point of solvency and not incur income

          2. You must reduce your basis in your assets (defers taxation)

        3. Farm Debt

          1. Forgiveness is excluded from income, but reduces the basis of the farm (thus deferring taxation)

    8. Tax Exempt Interest (§103)

      1. Interest on state, municipal, and other sub-federal government bonds are excludable from income.

        1. Policy: federalism – two separate, concurrent sovereigns – an IRS attempt to stay out of the state’s hair; allows local government to finance projects cheaper

 

        1. Higher tax brackets favor these bonds (A 10% taxable bond only pays 6% to a 40% taxpayer; it pays 7.2% to a 28% taxpayer)

          1. Thus, if the tax-exempt bond pays ³ 6%, a 40% taxpayer will favor it; it will have to yield ³ 7.2% for a 28% taxpayer to favor it

        2. Also, U.S. Treasury Bonds are excludable if used for higher education, but exclusion is phased out as income rises over $40k/single, $60k/married

      1. The Putative Tax

        1. A “putative tax” is paid on these investments in that you aren’t making as much as you could on a taxable investment since the interest rate is lower (and often the price is higher). This isn’t a tax in the true sense; rather, it just means you’re making less on your investment.

        2. Depending on your tax bracket, the exclusion may or may not offset this “tax”

      2. Arbitrage

        1. “Riskless Profit” – using the spread between tax-free and taxable bonds to make a sure profit.

        2. §148 prohibits arbitrage by a governmental entity – e.g., a city issuing debt to but private bonds and profiting on the difference

          1. Ex.: city issues 6% municipal bonds; uses proceeds to buy 10% corporate bonds; clears 4% effortlessly

          2. §148 denies the exclusion on a bond issued for this purpose

        3. §265 prevents “personal” arbitrage – e.g., borrowing at a certain rate that is higher than the municipal bond’s coupon, but still profiting from the tax exclusion – by prohibiting a deduction for the interest expense on the loan

          1. Ex.: Borrow at 8%, buy 6% municipal bonds; If you could deduct the interest on the loan (and you’re a 40% taxpayer), you would profit – you’re only paying the bank 4.8%, and thus clearing 1.2%)

          2. The IRS uses “tracing rules” to enforce this; it is crude and easily avoided (but banks use “averaging rules”)

  1. Transactions in Property

    1. Realization of Gains/Losses

      1. The Realization Doctrine – for gain to be recognized, it must be realized – i.e., there must be a change in the form of the investment (typically, a sale for cash)

        1. Therefore, under the realization doctrine, paper gains/losses aren’t recognized

        2. Thus, the realization doctrine favors capital gains by allowing untaxed inside buildup of non-dividend paying assets, and thus reduces the effective rate of tax paid (e.g., the ‘true’ tax rate – tax paid/pre-tax income)

        3. Cottage Savings v. Com’r – a swap of property is “realized” if there is a material difference in the legal entitlements of the property

          1. Thus, in Cottage Savings, a swap of loans is a taxable event (even though the loans were of the same type, they were different legal obligations on different homes – and thus different legal entitlements) (see also like-kind exchanges below)

          2. A note on Net Operating Losses (NOL): the banks in Cottage Savings were trying to create NOL’s. An NOL is first carried back to the past 3 year’s tax returns (generating a refund, if any), and then is carried forward for 15. It would also have generated a tax loss without hurting their financial accounting income

        4. Eisner v. Macomber – stock dividend is not income because it is not a realization of gain (the stockholder has more shares, but his financial position hasn’t changed – he still has the same percentage interest in the company, and thus no increase in wealth has occurred)

          1. Eisner was codified in §305

        5. Policy behind the Realization Doctrine – difficulty with valuation, liquidity problems (e.g., ability to pay)

      2. “Mark-to-Market” – an alternative to realization

        1. This includes the year-end increase in value in income, whether realized or not

        2. It is used in commodities futures markets (§1256) and for securities dealer’s inventory (§457) (because valuation and liquidity concerns are lesser for these)

        3. Many academics say this would be a better system generally, since it prevents the deferral of tax – this system is more closely aligned with the Haig-Simons theory of income than the realization doctrine

    2. Like-Exchanges (§1031)

      1. A like-kind exchange is not recognized as a taxable event

        1. Policy: to permit continuation of investment

        2. Limitations:

          1. Property must be held for trade, business, or investment

            1. This is looked at from the taxpayer’s point of view (the other party’s intended use of the property is irrelevant)

          2. Must be a “continuing investment” (e.g., must be sufficiently similar)

            1. Thus, a land-for-land swap is a like-exchange

            2. However, a stock swap is not a like-exchange (different legal entitlements)

            3. A swap of land for personalty is not a like-exchange (in fact, any exchange of personalty must be very similar)

            4. RR 87-166 – Gold for silver swap is not considered similar enough (because gold is “not industrial” while silver is) (Evans thinks this is a dumb ruling that could be challenged)

        3. Taxpayer retains his old basis; thus, if taxpayer swaps property A for property B, his basis in B is whatever his basis in A used to be

          1. This is done to preserve gain for recognition when taxpayer sells the property

          2. Note, however, that this is “forgiven” upon taxpayer’s death by the basis step-up rule (§1014; see also above)

      2. Handling a mix of cash and like-kind exchange

        1. Additional cash (or other additional consideration) is called “boot”

        2. General rule: gain is recognized to the lesser of boot received or gain realized

          1. Essentially, every dollar of boot given that is in excess of realized gain is recognized

          2. Ex.: X sells land A (basis $10k, FMV $200k) to Y for land B (FMV $150) plus $50k boot. X has $190 realized gain. $50 is recognized (because boot is the lesser of boot/gain)

          3. Ex.: X sells land A (basis $180k, FMV $200k) to Y for land B (FMV $150) plus $50k boot. X has $20 realized gain. $20 is recognized (because gain is the lesser of boot/gain)

          4. X sells land A (basis $240k, FMV $200k) plus $50 boot to Y for land B (FMV $240). X has $40 unrealized loss.

        3. New Basis = Old Basis + Gain Recognized - Boot Received

          1. In b2 above, new basis = $10k + $50 - $50 = $10

          2. In b3 above, new basis = $180k + $20k - $50 = $50

          3. In b4 above, new basis = $240 + $0 - $50 = $190

        4. Note these rules only apply to the recipient of boot; the giver of boot has basis equal to his basis in the old property plus boot given (see last examples above)

    3. Involuntary Conversions (§1033)

      1. If property is destroyed from fire, storm damage, etc., and insurance proceeds are immediately reinvested (within 2 years), no gain is recognized

        1. Ex.: Restaurant (Basis $100k, FMV $500k) burns down; Insurance pays $500k; if restaurant is rebuilt within 2 years, then no gain is recognized

      2. This rule applies to personal-use property as well as business property

      3. This rule is elective – you can just take the cash and recognize gain if you want; you can also recognize a loss, if that is the case

      4. Policy: like §1031, the continuation of investment

    4. Home Sales (§1034)

      1. No recognition of gain on sale of principal residence if new home is bought within 2 years before or after sale (“rolling over the gain”)

        1. Amount not rolled over is a capital gain

          1. Ex.: Old home (Basis $65k, FMV $100k) sold and new home bought (FMV $95k); CG = $100k - $95k = $5k

        2. Basis = Price of new home less the gain not recognized on the sale of the old home

          1. Ex.: Old home (Basis $65k, FMV $85k) sold and new home bought (FMV $100k). New basis = $100k - ($85k - $65k) = $80k

        3. You cannot use this provision more than once per 2 years (unless you are relocating to a new city)

        4. Must be primary residence (no summer homes)

        5. This provision is not elective

      2. §121 One-Time Exclusion

        1. Permits a taxpayer over 55 to exclude gain on home sale up to $125k

        2. A one-time deal – once it’s used, that’s it (even if you don’t use the full $125k) (don’t marry someone who has used it!)

        3. You must have lived in the old house 3 of the last 5 years

      3. Gains are taxable (but can be deferred as per above), but losses are not deductible (because home is personal consumption)

    5. Wash Sales (§1091)

      1. Sale and repurchase of security within same 30-day period

      2. Loss from such a transaction is not recognized

    6. Installment Sales (§§453, 453A, 453B)

      1. Provides relief from having to pay tax on accrual when payments are received in installments by allocating a portion of each payment to gain and a portion to basis recovery (and a portion for interest)

        1. The installment method is elective – you can pay tax up front if you wish (but why would you?) (§453(d)) (Installment method is the default)

      2. Steps

        1. Apply rules for unstated interest (§483) or OID (see below) if applicable

        2. Compute ratio of gain-to-payment

          1. Ex.: Property sold for $300k; Basis is $100k; Ratio = 2/3 ([300-100]/100) (assuming no interest)

        3. Apply ratio to each year’s payments

          1. Ex.: If above sales’ first year payment is $60k, then $40k of gain is recognized

      3. §453(e) prevents loophole of using relatives (e.g., selling by installment to lower-bracket relative, then having them sell for full price)

      4. Installment method cannot be used for:

        1. Personal property on a revolving credit plan (§453(k)(1))

        2. Sales of publicly traded property (§453(k)(2))

        3. Sales of inventory items (§453(b)(2))

        4. Time/share residential lots (not a total prohibition, but must pay interest on all tax deferred) (§453(l))

          1. Interest is also owed on deferral if sales price is greater than $150k

        5. Publicly traded debt instruments and demand notes (because they are the functional equivalent of cash) (§453(f))

        6. Depreciation recapture (also, recapture is taxed as ordinary income to prevent tax arbitrage)

      5. Contingent installment payments can be handled by (TR §15a.453-1(c))

        1. If you can determine a maximum amount to be paid, that amount is considered the selling price

        2. If you can’t do the above, but can figure a maximum length of time, then basis is allocated evenly over that time period

        3. If you can’t do either of the above, allocate basis evenly over 15 years

    7. Original Issue Discount (OID) and Market Discount

      1. Imputes an interest rate when either there is none or when the stated rate is not a true reflection of interest (e.g., zero-coupon bonds, and bonds issued at a discount)

        1. It applies to any debt instrument, however – bonds, debenture, note, certificate, or other evidence of indebtedness (§1275(a)(1)(a))

        2. §467 also makes OID rules applicable to deferred rent payments (for these, take PV of payment at 1.1 (110%) of the applicable rate)

 

        1. Note a tax-exempt bond’s discount is taxable

      1. Tax treatment

        1. Each year, look at Net Present Value (NPV) of bond; the increase is taxable as income (not capital gain)

          1. NPV = par value/(1+ rate)#years to maturity

          2. Gross income year 1 = NPV1 - NPV0

          3. Gross income year 2 = NPV2 - NPV1, etc.

          4. See Table 4 below

        2. If bond with coupons is sold at a discount, must tax both OID income and interest income from coupon payments

        3. If bond is given for property (instead of cash), the interest payments must meet the applicable federal rate (§1274(d)); the property is considered to be sold for the present value of the bond’s face amount

        4. Basis and early disposition

          1. Discount/ # years to maturity = accrued market discount per year

            1. Ex.: 5-year $1,000 bond sold for $800; $200/5 = $40/year

          2. The discount amount accrued is ordinary income when bond is sold; any excess is capital gain. This prevents taking the preferred CG rate by selling the bond shortly before maturity.

            1. Ex.: Same as above. 3 years after purchase, sell bond for $920 (gain = $920 - $800 = $120); $40 x 3 = $120; all of the gain is ordinary income

            2. Ex.: sell for $950 (gain = $950 - $800 = $150) of ; $40 x 3 = $120; $120 is ordinary income, $30 is CG

      2. Market Discount

        1. This is not the same thing as OID; it is discount after original issue caused by market conditions (interest ­, price ¯, and vice versa)

        2. Market discount is fully deferred until maturity

          1. Ex.: A buys 20-year bond at par ($1,000); 5 years later he sells it for $800

            1. Seller – gets a $200 capital loss

            2. Buyer – recognizes coupon payments as income each year, but does not recognize the $200 in income until maturity (a total deferral of discount)

        3. Note if OID bond is sold, the OID must be recognized as income by the buyer

  1. Taxation of the Family

    1. Marriage

      1. Brief history of joint returns

        1. Lucas v. Earle – held that husband could not shift his income to his wife to take advantage of marginal rates

        2. Poe v. Seaborn – community property state; court says that since husband and wife each own ½ of income, the income should be split between husband and wife

        3. Congress permits joint returns to prevent favoring community property states over other states; effect is that for a married couple, it doesn’t matter who earns the income

      2. The Marriage Penalty and Marriage Subsidy

        1. Penalty – when two high-wage earners marry, one spouse’s income is taxed at a higher marginal rate than it would be if they were single

        2. Subsidy – If there is only one wage earner in a family (or one is a very low-wage earner), there is a marriage subsidy since the wage earner is taxed at a much more favorable rate than if he/she were single

        3. It is impossible for a tax system to have progressive rates, joint returns, and neutrality toward marriage. One of the first two would have to go to eliminate the penalty/subsidy

    2. Divorce

      1. Some payments are taxable (§71(a)) to payee and deductible (§215) to payor

        1. Taxable/Deductible

          1. Alimony

          2. Maintenance

        2. Not taxable/deductible

          1. Child Support

          2. Property Settlements (§1041 – no tax on transfers between spouses, even as an incident to divorce)

        3. The basic rationale is that the nontaxable expenditures are those that would have to be made even if the couple had stayed married (child care) or is just a division of what is already owned (property)

        4. Note alimony is an “Above The Line” deduction

        5. Therefore, there is an incentive to make payments alimony – if payor is in high tax bracket, and payee is in lower tax bracket, payor gets valuable deductions while payee gets cash that is taxed at her lower rate

          1. Difference between rates x amount = tax savings

            1. (40% - 15%) x $140 = $35

            2. Say both parties want settlement to be $100

              1. Payor gets $16 savings: $140 - 40% = $84; $100 - $84 = $16 savings

              2. Payee gets $19 bonus: $140 - 15% = $119; $119 - $100 = $19 bonus

              3. $16 + $19 = $35 total tax savings

          2. You can elect to treat alimony as a nondeductible/nontaxable property settlement, but not vice-versa

      2. Requirements to classify a payment as alimony (§71):

        1. Must be paid in cash (no in-kind transactions)

        2. Must be an instrument of divorce or other maintenance (no oral agreements and no single people)

          1. Note that separation is OK too (“other maintenance”)

        3. Parties must not have agreed that it won’t be taxable/deductible

        4. Can’t be member of same household (must actually split up)

        5. Can’t have payments after death of payee (usually wife); have to break out alimony portion from property settlement portion

        6. Can’t be for child support

          1. Can’t cease upon child reaching a certain age, marrying, dying, etc.

          2. If the payments cease within 6 months of the child reaching the age of majority, then it is presumed to be child support

        7. Must be roughly equal payments for the first 3 years (e.g., no property settlements)

          1. The payments are recaptured if the first or second year payments are more than $15,000 than subsequent year’s payments

          2. Note that even if deductions are recaptured, you still have gotten a TVM advantage from the delay

    3. The Kiddie Tax (§1(g))

      1. Child under age 14’s unearned income is taxed at the parent’s marginal rate

        1. Tax is levied on the excess of $500 (plus either expenses or $500 of the standard deduction)

        2. Only applies to unearned income – paper routes, etc. are taxable to the child at his own rate. This only applies to interest, dividends, etc.

      2. Policy

        1. Age is < 14 because presumably once child is 14 the parents may be saving for college

        2. Not concerned with earned income because there is little chance for fraud

        3. Basically is designed to prevent parents from shifting income to their children (who are in lower tax brackets)

      3. Planning – give property to kids that won’t realize taxable gains until after they turn 14 (like real estate, stocks that don’t pay dividends, etc. – anything with a built-in deferral)

    4. The Earned Income Credit (§32)

      1. A “negative” income tax – pays to poor, even in excess of taxes paid

      2. Rises up until income reaches $8,425, then plateaus until income is at $11,000, then is phased out to zero at an income level of $27,000

      3. Operates as a percentage of earned income; more kids means a higher percentage (up to two); Most you can “make” is $3,370

        1. The credit is 40% of earned income until the “peak”, then after the plateau it is phased out at 21.06% of earned income over $11,000

      4. Policy: makes transfer payments less demeaning; encourages work

      5. Problems: fraud, adds to marriage penalty

  2. Personal Deductions

    1. Personal Exemption (§151)

      1. You get a personal exemption for yourself and one for each dependent

      2. Dependency requirements (§152):

        1. Related by blood, marriage, or adoption (or certain special cases in §152(a)(9))

        2. Taxpayer must provide over half support (giving scholarships is not included)

        3. The dependent must have income less than the exemption amount

      3. The personal exemption is phased out at higher income levels

        1. It is reduced by 2% for every $2,500 of AGI over the threshold amount ($100k for singles, $150k for married people)

        2. The $2,500 layers are not pro-rata – if you’re in the layer, you lose the full 2%

    2. Standard Deduction (§63)

      1. The standard deduction varies with the status of the taxpayer (married, single, etc.)

      2. The amount of the deduction is adjusted each year for CPI

      3. There is no phaseout for the standard deduction

    3. Itemized Deductions (§68)

      1. These are “below the line” deductions, and thus less valuable because of caps, threshold amounts, etc., than a “above the line” deduction

      2. The total of all allowable itemized deductions are reduced by the lesser of:

        1. 3% of AGI over a certain amount (which is indexed for inflation – base amount is $100k in 1991 dollars)

        2. 80% of allowable deductions

          1. For phaseout purposes, this only applies to home mortgage interest, property taxes, charitable contributions, and §212 investment expenses; medical expenses, casualty losses, etc., are not included in the computation

      3. Note this is designed to phase out itemized deductions at higher income levels; thus it “secretly” increases taxes on the wealthy to above the statutory rate

    4. Casualty Losses (§165(c)(3))

      1. Permits a deduction resulting from “fire, storm, shipwreck” or other casualty

        1. Generally, the loss must be similar to the specifically mentioned ones, i.e., the loss must occur with suddenness

        2. Ex.: Dyer – spastic cat knocks over vase; court says it’s not a casualty loss since it’s not similar enough to the listed casualties

        3. The loss is measured as the lesser of FMV and Basis

      2. Limitation on casualty loss deduction (§165(h))

        1. First, reduce the loss by $100

        2. Then, reduce that number by 10% of AGI

          1. Note this has the effect of increasing the tax on marginal AGI to above the statutory rate

      3. Policy: Expenses are involuntary, reduced ability to pay, unforeseen

    5. Extraordinary Medical Expenses (§213)

      1. Medical expenses are deductible for any amount in excess of 7.5% of AGI

        1. Note this is inconsistent, since medical benefits paid by employer are not taxable as income (§105(b), §106)

          1. Congress partially addressed this by permitting a 30% deduction of health insurance premiums for self-employed people (increasing to 80% by 2006) (§162(1))

        2. Also, recovery under medical insurance is not income even if it exceeds medical costs; if employer provides, he can deduct without employee recognizing income (§106, §162)

      2. What is a medical expense?

        1. Medical insurance premiums are considered medical expenses and are deductible

          1. This is inconsistent, since fire/homeowner’s insurance isn’t deductible as a casualty loss

        2. Most questions arise as to just what is “medical care”

          1. §213(d) says treatment, transportation to treatment, and insurance premiums

          2. Basically, there must be a “direct and proximate” relationship between the expense and the disease

            1. Thus, a general recommendation is not considered treatment (e.g., if doctor says “exercise,” you can’t deduct a pool – but if doc says “swim,” deduction may be permissible)

            2. OCHS – Sick mom can’t deduct boarding school for the kids as a medical expense

            3. Taylor – Doc tells patient not to mow lawn; paying for lawn service is not a medical expense

        3. You can only deduct for you, your spouse, and dependents (i.e., no pets)

        4. Policy: Expenses are involuntary, reduced ability to pay, unforeseen

 

    1. Charitable Contributions (§170)

      1. You may deduct contributions to certain charities (e.g., no bums). The types of charities permitted are listed in §170(c)

        1. Deduction makes it cheaper to give; ex.: 40% taxpayer donating $100 only actually gives $60; the rest is “paid” by the government

      2. The contribution cannot be a quid pro quo – the motive must be “pure”

        1. Thus, in Ottawa Silica a company donating land for a school cannot deduct the donation, since the school’s presence would increase the surrounding land’s value for development

          1. Investment company would have to capitalize the cost of donated land to the value of the remaining land

        2. For personal contributions, the value of the benefit received offsets the value of the deduction (thus, a charity dinner for $100/plate where food was worth $30 yields a $70 deduction)

        3. Also, de minimis quid pro quo is permissible (like Joe Jamail having the library area named after him in exchange for big contribution)

      3. Donations of property

        1. Deduction is valued at property’s FMV - donor’s basis

          1. Note then that you can making a donation of appreciated property is cheaper than cash – you avoid the gain, and the charity generally doesn’t pay tax if it sells the property

            1. For this to apply, the property must have been held by the donor for more than one year (e.g., must be long-term capital gain property)

          2. Note this treatment is anomalous – if you gave property in payment of services, you would be taxed as though you sold it

        2. The property cannot be inventory – it must be investment property

      4. Limitations on charitable deductions

        1. The deduction is limited to 50% of contribution base (generally AGI) for donations to churches, educational organizations, medical institutions, and certain publicly supported organizations and charities (e.g., the Red Cross)

        2. It is limited to 30% of their cost, and that is reduced if it exceeds 20% of AGI for contributions to other organizations (e.g., private foundations)

      5. Additional Notes on Charitable Contributions

        1. If property given is > $5,000, must have value appraised

        2. Must document if donation is > $250 (more than a canceled check)

        3. Note that self-interest is always better served by not giving; the deduction only makes it cheaper to give – it doesn’t make it a superior financial move compared to selling property for gain or investing

        4. You cannot deduct the value of services given

        5. The charity deduction is considered very tax-efficient

    2. Interest

      1. Business

        1. Generally, interest is deductible for use in trade or business

          1. It is permissible to finance recievables

          2. When financing construction, the interest incurred while the building is being erected is added to the basis of the building; however, once complete the interest is deductible in full as an expense each year (because then the building is generating income)

        2. The business deduction is taken “above the line”

      2. Investment

        1. Investment interest is deductible “below the line” (because the interest is being used to generate income)

        2. The deduction is limited to net investment income

          1. This equals all gain income from all portfolio investments

            1. Evans: this is where realization screws up the system – appreciated stocks, etc., aren’t counted toward the offset even though there has been an economic gain

          2. The deduction is carried forward indefinitely until it’s all used up

          3. If you want to include long-term capital gains in net investment income, it is taxed at ordinary income rates (it is elective, and the default is to not include it

            1. This is to prevent arbitrage (see tax-exempt bonds above) that would result from deducting at ordinary rate but recognizing gain at preferential rate

            2. If you expect to have ordinary gain in the next several years, it’s better to exclude LTCG; otherwise, include it

            3. This is not all-or-nothing – you can elect to recognize a portion of LTCG at the ordinary rate

      3. Personal

        1. Personal interest (e.g., credit cards, school loans) is not deductible (§163(h)(1&2); exception is home mortgage (see below)

        2. Tracing Rules

          1. If funds (borrowed/nonborrowed) are commingled, the borrowed funds are deemed to be withdrawn first (but can elect which came out first within 15 days)

          2. Like oil & water – borrowed funds are “oil” that floats to the top after 15 days

        3. How to beat this: (say you want to buy a car, and you own stock)

          1. Sell stock, buy car

          2. Borrow and re-buy the stock

          3. Note you can’t borrow to buy stock and then sell to buy car – tracing rules get you.

      4. Home Mortgage (§163(h)(3))

        1. Two types of home mortgage debt

          1. Acquisition Indebtedness (AI)

            1. Debt to buy, build, or improve home

            2. Limited to principal on primary and one secondary home up to $1M

          2. Home Equity Indebtedness (HE)

            1. Any debt secured by the primary or secondary residence

            2. Limited to principal up to $100k

            3. This type of debt is unenforceable in Texas due to the state constitution (though the provision may be changed in Fall ’97)

        2. Refinancing is permissible, but only the amount up to AI principal can be deducted as AI interest (but may be HE interest)

    3. Taxes (§164 personal, §§162, 212 business)

      1. Deductibility

        1. Taxes deductible above the line

          1. Employer’s share of FICA

        2. Taxes deductible below the line

          1. Property taxes

          2. State Income taxes

        3. Taxes that are not deductible

          1. Employee’s share of FICA

          2. Federal Income Tax (nor the gift and estate tax)

          3. Licenses and Fees

          4. Sales Tax

      2. Policy

        1. State taxes are involuntary and thus affect ability to pay (and thus even sales taxes should be deductible

          1. But are they? You can vote with your feet…move to Texas!

            1. But is that realistic? And there are some taxes in any state you move to

          2. Might state taxes equal services, which equal personal consumption?

          3. Also, deduction favors high-tax states at expense of low-tax states

        2. Federalism – two separate sovereigns, reduce interference between them

      3. FICA

        1. Independent Contractors

          1. No withholding by employer for FIT or FICA

          2. Contractor must pay double FICA for himself (15.3%)

        2. Employees

          1. Employer must withhold FIT and employee’s share of FICA

          2. Employer must pay employer’s share of FICA

        3. Key between the two is control

      4. Old Colony – if employer offers to pay FIT for you, it’s income (but recovery of improper assessment isn’t – Clark)

    4. Miscellaneous Itemized Deductions (§67)

      1. Includes hobbies (see below), non-reimbursed employee expenses (see below), and certain §212 expenses

        1. §212 = expenses used in generating income other than a trade or business (e.g., investment advice, WSJ subscription)

      2. Subject to 2% of AGI floor (can only deduct what is over that threshold)

        1. Designed to keep from nickel-and-diming the government to death

  1. Deductions for Mixed Business & Personal Expenditures

    1. Hobbies (§183(b))

      1. Hobby expenses (“from activity not carried on for profit”) can only be deducted to the extent it exceeds hobby income

      2. It is a miscellaneous itemized deduction and thus subject to the 2% floor

      3. It is clearly preferable to have an activity classified as “for profit” (so deductions can be taken “above the line”)

        1. Profit/not-for profit is based on taxpayer’s intent, but objective criteria is looked at to ascertain that intent

        2. To show for-profit, there are many factors (Nickerson), but the key is to make it look like a business; thus, keeping good records and running the operation professionally is the key

        3. It’s permissible if the operation won’t show profit for a long time (Nickerson)

    2. Business Travel & Entertainment

      1. Activity must be “directly related” to business. This is shown in two ways:

        1. An actual direct relation (e.g., business is the primary purpose)

        2. A “relation to” business – where business was done immediately before or after (e.g., after meeting, you go to dinner)

      2. You must substantiate all deductions (e.g., good recordkeeping)

      3. Meals & Entertainment

        1. Only 50% of meals and entertainment is deductible (the “50% haircut”)

        2. Cannot deduct cost of yachts, lodges or club dues, nor can you deduct conventions outside North America or cruises unless specific criteria are met

          1. Exception for on-premises food & drink

      4. Travel

        1. Must be away from home for less than one year

          1. Note that you can pretty much deduct anything remotely connected to business if traveling – airfare, meals (subject to 50%), hotel, cabs, dry-cleaning, etc.;

        2. Mixed purpose trips – must be primarily for business. Staying over one day is probably all right; staying two weeks probably isn’t

        3. The “stop and rest” rule – A meal by yourself is only deductible if the trip is long enough to have required stopping and resting (typically this means overnight)

      5. Reimbursed vs. Non-reimbursed business employee expenses

        1. Reimbursed – deductible “above the line” (so long as employer separates it out on W-2)

          1. 50% haircut hits employer (or client if billed to him)

        2. Non-Reimbursed – deductible “below the line” as a miscellaneous deduction (subject to 2% floor)

          1. Note that a partner/owner is not an employee! His business deductions are always taken above the line

        3. Why the different treatment? Because employer is more likely to check receipts carefully

    3. Child Care (§21)

      1. Smith v. Com’r – Court denies child care expenses as a deduction for working couple; rejects “but for” analysis

      2. Congress reacts by enacting §21, permitting a credit for child care expenditures equal to 30% of child care expenditures

        1. Credit cannot exceed $2,400 for one child, $4,800 on two or more children

        2. Percentage is phased down to 20% as income rises over $10k (-1% per $2k until 20% is reached)

        3. The child must be a “qualifying individual” (<13 or incapable of caring for him/herself

        4. Note the credit is better than a deduction for 15% taxpayers (by a 5% margin), but worse than a deduction for those in higher brackets

      3. §129 permits employer to give up to $5,000 of child care tax-free (but no double-dipping – you get §129 or §21, not both – §21(c))

    4. Commuting & Moving Expenses

      1. Commuting

        1. Commuting costs between home and work are not deductible

          1. Smith v. Com’r – Married Harvard law student takes NYC clerkship; court says NYC was her “home” and so commuting costs can’t be deducted

            1. Generally, the location of your principal place of business is your tax home (§162(a)(2))

        2. You can, however, deduct commuting expenses incurred on the job (e.g., from job location A to job location B)

 

        1. You may deduct living expenses if living away from your tax home for business reasons

          1. Your stay cannot exceed a year (otherwise, you are deemed to have moved) (§162(a))

            1. If you planned to stay less than a year, but circumstances make you stay longer, you may deduct expenses up until the point you learned of the extension (RR 93-86)

          2. You can use a per diem instead of keeping exact track of expenses

        2. Commuting expenses are deducted “below the line;” they are non-reimbursed employee expenses and are thus subject to the 2% floor on miscellaneous itemized deductions

      1. Moving Expenses (§217)

        1. If a new job adds 50 miles to your commute, and you work at least 39 weeks at new job in following year, moving expenses are deductible

          1. They are deductible “above the line”

          2. If your first job, then >50 miles from home

          3. If employer reimburses you, it is not income – it is an excludable fringe benefit (§132(a)(6))

          4. Note there is no requirement on how far to move – it’s only the length of your commute that matters

    1. Clothing (§162, §262)

      1. Requirements for deducting business-related clothing expenses

        1. Clothing is of type typically required by employment

        2. Clothing is not adaptable for business use

          1. Pevsner – boutique clerk loses on this one – even though she never wore the clothes outside of work, she could have

        3. Clothing is not actually worn for business use by taxpayer

      2. The idea is generally to allow uniforms to be deductible

    2. Legal Fees

      1. §212 – Can deduct any expense “above the line” incurred to secure property or generate income

        1. Yet in Gilmore, husband was denied a deduction for legal fees incurred in a divorce (to secure his property)

        2. Basic rationale: divorce is personal. The origin of the dispute determines deductibility

        3. Exceptions (these are “below the line”):

          1. Tax advice §212(3)

          2. Legal costs of securing alimony (because alimony is taxable) (Gilmore was a property settlement)

    3. Education

      1. Generally, education is not deductible unless it maintains your skills in a current trade or business

      2. TR §1.162-5 establishes test:

        1. No deduction if:

          1. Completing minimum requirements for new job, or

          2. Study which could lead to a new trade or business (this is why law school is not deductible)

        2. Deductions are permitted if:

          1. It maintains skills needed for a trade or business, or

            1. Thus, CLE is OK, as is a LLM (if you’ve practiced for awhile)

          2. Is an express requirement of employer or law as a condition of employment

        3. If deductible, it is a non-reimbursed business expense deductible “below the line” subject to the 2% floor

      3. Policy for not allowing deduction of college costs

        1. Indeterminate Life (why not use life expectancy?)

        2. Intractable mix of personal and business expenditure

        3. “Intellectual Capital” is deferred

      4. Job Search Costs (note how it’s inconsistent with moving expenses)

        1. Entry-Level – not deductible

        2. New Field – capitalized over life (Sharon)

        3. New Job in Same Field – current deduction (like repair expenses)

  1. Pure Business Expenditures

    1. Capitalization and Repairs

      1. Capitalization – adding a cost to basis and depreciating it; not deducting it immediately

        1. You are supposed to capitalize anything that extends an asset’s useful life beyond the end of the taxable year

      2. §263 UNICAP rules – require that any self-created asset be capitalized, and that both direct and indirect costs (e.g., salaries and overhead) of producing the asset by included in the capitalized amount

        1. Thus, GM must include the cost of supervisor salaries in its basis for cars (basically, basis thus means Cost of Goods Sold)

        2. GM doesn’t like this because this means the cost of supervisor salaries cannot be deducted currently; instead, the costs are capitalized in their year-end inventory and the cost is not recovered until the car is sold

        3. Side note: Evans worked on the UNICAP rules when he was at Treasury

      3. Exceptions to capitalization requirements (all are immediately deductible)

        1. Advertising

          1. This is mostly because of difficulty in determining a useful life – if a campaign is successful, it may last many years; if not, it may only last a month or so

          2. Also, the media lobby strongly opposes capitalizing these costs

        2. Research & Development Costs (§174)

          1. These should clearly be capitalized – R&D is always a long-term asset, virtually by definition

          2. Capitalization isn’t required since permitting a current deduction encourages research – something Congress wishes to do. Also, useful life is difficult to figure

        3. Intangible Drilling Costs (§§263(c), 263A(c)(3))

          1. Most of the costs of preparing to drill an oil well are immediately deductible (see also below in ‘depletion’)

          2. Why? Oil and gas lobby is powerful – also, oil is important to national security (so says the lobby)

        4. Timber Costs

          1. The costs of raising trees is immediately deductible

          2. Why? Again, politics (e.g., Sen. Packwood’s from Oregon)

        5. Raising Livestock

          1. Cost of raising a cow is deductible, even though the cow is clearly a long-term asset

          2. Why? That’s right, politics. (Evans jokes “farmers never have to pay taxes”). The “family farm” image of unsophisticated people working the land is an effective political tool (never mind that most farming these days are done by agribusiness). Farmers are damn well-organized

        6. Environmental Remediation (RR 94-38)

          1. Cost of returning land to unpolluted state is immediately deductible

          2. This is because it presumably isn’t an improvement – it’s considered merely returning the land to its prior condition

            1. Evans: this has been a hot area for about the past five years; when is something remediation and when is it an improvement? (ex.: asbestos replacement isn’t remediation)

      4. Repairs vs. Improvements

        1. A repair is immediately deductible; an improvement must be capitalized

          1. A repair is something that mends and asset and does not add to the asset’s value or prolong its life

          2. Improvements are just the opposite – they add to the value or improve its life

          3. This fits with Haig-Simons income – a repair doesn’t increase wealth; it just maintains the status quo

        2. There is no precise dividing line between which is which; it’s all judge-made, and the decisions are all over the board

          1. Rule of Thumb – the larger the expenditure is in relation to the asset’s value, the more likely its not a repair

    2. Reasonableness

      1. §162(a)(1) permits businesses to deduct a “reasonable” allowance for salaries paid

      2. This typically is an issue with closely held corporations, who attempt to disguise dividend payments as salary.

        1. The IRS looks at a lot of factors to determine reasonableness; Evans says this rarely comes up and he knows of many small corporations that pay large salaries to their principal stockholders with no problems

        2. Note this issue does not arise with partnerships or S corporations, since these entities don’t pay tax directly (the partners are taxed on earnings)

      3. §162(m) prohibits a widely-held corporation from deducting more than $1M per year for the salary of its CEO or next four highest paid employees

        1. This is done because of the controversy over salaries of guys like Mike Eisner

        2. There is an exception for performance-based salary (that is tied to income generation)

        3. §§280G, 4999 restrict deductions for golden parachutes

    3. Illegal Activities

      1. There is a line of cases (Sullivan, Tank Truck, Tellier) that developed varying times when expenses could be deducted for illegal activities

      2. Finally, the IRS decided that any business deduction would be permissible for illegal enterprises if there was not a statutory exception in the code.

        1. Evans: however, many courts will still deny such deductions for public policy reasons anyway; typically they do so under §165, which ostensibly isn’t controlled by §162

      3. Nondeductible items for illegal activities (§162)

        1. Cannot deduct fines paid to a government for violation of the law

          1. Policy: shouldn’t reduce the ‘sting’ of a fine, since that is the purpose of the fine in the first place

          2. Court-ordered restitution is not a fine, however; thus, Exxon was able to deduct the cost of the Valdez cleanup in Alaska

        2. Cannot deduct bribes and kickbacks to government officials, officials of foreign governments, or private individuals (if private bribery is illegal in the state in question)

          1. For foreign governments, it is illegal if it violates the Foreign Corrupt Practices Act

            1. Under that act, “grease” is legal – if the bribe is to “speed up” bureaucracy (and not to influence opinion), then a deduction permissible

            2. This is so because in many countries “grease” is considered a part of the official’s compensation (like tipping)

            3. Side note: §901 permits a credit for income taxes paid to other countries, but not if they aren’t recognized or are terrorist-supporting countries

          2. As for bribing private individuals – it is only not deductible if against state law and the law is enforced

        3. Cannot deduct the punitive portion (2/3) of an Clayton act antitrust violation

          1. However, this is only true if a criminal proceeding preceded the civil verdict

    4. Depreciation & Depletion

      1. Depreciation is a way to account for the “cost” of an asset being used

        1. The most accurate way to do this would be to depreciate the difference between what the asset could be sold for at the beginning of the year and at the end of year; however, this is impractical

        2. Thus, an asset is depreciated using a depreciation method based on its useful life (see below)

          1. Note that tax depreciation is generally in excess of economic reality; this is a political move to encourage investment

          2. Also note that depreciation is for business assets only – you cannot depreciate personal-use property

          3. Minor exception: certain small businesses can deduct whole amount up to $18,000 (indexed); however, the rules classifying which businesses can do this are so narrow that it is almost never used

        3. For tax purposes, an assets useful life depends on what asset class it belongs in (§168(e) lists items in classes)

          1. For personal property, there are 3, 5, 7, 10, 15, and 20 year asset classes

          2. For real property, depreciate using straight-line for 27.5 years if residential rental, 39 years for all other real property

            1. However, can’t depreciate raw land – there’s got to be a building there

 

        1. Note that depreciation may be subject to recapture provisions (see below, in ‘capital gains’)

      1. Depreciation Methods

        1. Straight-Line (SL) – Simplest method. Take asset’s cost/useful life, and depreciate that amount per year (tax code ignores salvage value)

          1. Straight-line is used for real property (see above)

          2. It is also used for purchased intangibles (for 15 years) §197

        2. Double Declining Balance (DDB) – Take whatever straight line would be; figure what percentage that is of cost; deduct double that percentage from basis each year (e.g., if SL = 20% of original cost, take 40% off current basis each year); Switch to SL when it becomes more favorable

          1. This method is used for 3-10 year personal property

        3. 150% Declining Balance (150DB) – same as DDB, but percentage used is 150% of SL percentage (instead of 200%)

          1. This method is used for 15 and 20 year personal property

      2. Depletion (§613)

        1. An mining or oil company can deduct a percentage of gross income each year for depletion (varying from 22% to 5%; 15% for oil) in an amount not to exceed 50% of taxable income

          1. This can be used forever, even in excess of cost

          2. Also, oil companies can deduct intangible drilling costs immediately (instead of capitalizing; see above); this includes the preparatory work for finding a site and building a rig (but not the rig itself)

    1. The Alternative Minimum Tax (AMT)

      1. The AMT is imposed on individuals to prevent them from ducking all tax liability; it is reached by taking taxable income, adding back certain preferences, and applying a lower rate

        1. The rate is 26% on the first $175k, 28% on the rest; for corporations, it is 20%

      2. Preferences added back:

        1. Business

          1. Depreciation (taken with longer depreciable life)

          2. Tax-exempt interest

          3. Percentage depletion in excess of cost

          4. Intangible drilling costs (excess over 10 yr. amount, to the extent it is in excess of 65% of oil & gas income)

          5. Accounting methods

          6. Research and Development (excess over 10 year amount)

          7. Various miscellaneous others

        2. Personal

          1. Incentive Stock Options (over FMV; AMT taxes when given, not when exercised)

          2. Passive Losses

          3. Itemized Deductions (disallow taxes, home equity loan interest, medical expense floor is increased to 10%)

          4. Capital Gains

        3. Corporate

          1. Bad-debt reserves

          2. Alternative accounting methods

          3. Various miscellaneous others

    2. Tax Shelters & Passive Loss Rules

      1. Tax Shelter – anything that creates an artificial tax loss, usually deferring income or converting from ordinary to preferential rate

      2. Prior to 1986 act, tax shelters were big business (from cattle farms to macadamia orchards to movie overvaluations)

      3. Congress responded by creating the Passive Loss rules (§469)

        1. Policy: shelters cause a waste of resources, shelters favor the wealthy

        2. A passive loss can only offset a passive gain (or can be deducted when passive activity is sold)

          1. The passive loss is carried forward indefinitely if not currently used

          2. Note the rule is crude: it also prevents deductions for real losses from passive activities

        3. A non-passive activity is one where the taxpayer materially participates; this means his participation is regular, continuous, and substantial

          1. TR §1.469-5T sets up “safe harbor” provisions that establish a non-passive activity (meet these and you’re golden):

            1. Taxpayer spends ³ 500 hours on the activity

            2. Taxpayer spends at least 100 hours on the activity, and this is as much as anyone else involved

            3. Taxpayer performs substantially all of the work for the activity

            4. Taxpayer has met the previous standards for 5 of the past 10 years

            5. other miscellaneous provisions

          2. The same TR says an activity is not passive if “facts and circumstances” show as much; even if you don’t fall into one of the above provisions you can argue this

        4. Similar “Basket” provisions in the tax code

          1. Passive Losses-Passive Gains

          2. Hobby Losses-Hobby Gains

          3. Gambling Losses-Gambling Winnings

          4. Investment Interest Expense-Investment Income

          5. Capital Loss-Capital Gain

  1. Capital Gains, Losses, and Recapture

    1. Capital Gains & Capital Losses

      1. These deal with sales of capital assets

        1. A capital asset is all property with the following exceptions (§1221):

          1. Inventory (“stock in trade”)

          2. Real or depreciable property used in a trade or business (but see §1231 gain below for exception)

          3. Copyrights held by their creator (e.g., self-created property); you cannot make a gift of this to get capital gain treatment

          4. Accounts Receivable (A/R) held in the ordinary course of business (also, notes receivable)

          5. U.S. government publications held by someone who received them at a reduced cost (e.g., congressmen)

        2. There must be a sale or exchange; no rent or interest is permitted

        3. Also note the “carve-out” problem (like selling the coupons on a bond) – “you can sell the whole tree, but not the leaves”

        4. The sales are divided into long-term (LT) and short-term (ST); the distinction is long term means the property has been held for more than one year

      2. A LT capital gain is taxed at a favorable maximum rate of 28%

        1. The corporate top capital gain rate is 35%

        2. One minor exception: “qualified small business stock” can give individuals a 50% exclusion of gain (if original issue, held for > 5 years, and company has £ $50M in assets) (§1202)

        3. Other exceptions:

          1. §1244 – loss on small business stock is an ordinary loss

          2. §631 – certain timber and coal sales are capital gains

          3. §1232 – OID gain is ordinary income

      3. Capital losses can only offset capital gains (for individuals, it can also offset $3,000 of ordinary income per year)

        1. This is to prevent “cherry picking,” or selling the losers to generate a loss to offset other income while holding on to the winners (realization doctrine)

      4. Netting Rules – must “net out” LT & ST capital gains and losses

        1. First, net ST gains and losses against each other; do the same for LT gains and losses

        2. If the result is either both LT & ST gain or both LT & ST loss, then no more netting is needed

        3. If the result is mixed (gain of one and loss of the other), then net them against each other

          1. Thus, a large net LTCG and a small net STCL yields a LTCG

      5. Policy

        1. Pro-favorable CG treatment

          1. Bunching (prevents “spike” in income)

            1. This isn’t really valid since the rate structure isn’t as progressive as it once was, and there is no more income averaging

          2. Lock-In (unfavorable treatment discourages sales

            1. The real problem is the realization doctrine; permitting rollover (as in home sales) would be a better solution

          3. Mitigates the effect of inflation

            1. But wouldn’t indexing of basis be a better solution?

          4. Incentive to new industries

          5. Reduce effects of double taxation of corporate income

        2. Pro-limit on CL deduction

          1. Prevent manipulation of recognition to yield fake losses (e.g., buying assets that move in opposite directions in the market)

          2. Reduces burden on treasury (e.g., cherry-picking would cause a drop in tax revenues)

          3. Congress is just plain greedy

    2. §1231 Gain

      1. This is a limit on the “real or depreciable property used in a trade or business” exception in the definition of capital asset

      2. It permits a net gain on this property to be treated as a capital gain, but net losses to be taken as ordinary losses

        1. Wow! What a deal! This is a WWII holdover provision

      3. §1231 gains and losses must be netted against each other; a net gain = CG and a net loss = ordinary loss

    3. §1245 Recapture

      1. On the sale of certain depreciable capital assets, any part of the gain taken for depreciation is ‘recaptured’ as ordinary income

        1. Ex.: $10k LT capital asset depreciated to $6k and sold for $11k; under §1245, $4k is ordinary income [e.g., the total of depreciation taken] and $1k is capital gain

      2. §1245 generally applies to machinery and equipment

        1. Note that §1250 applies similar rule for real property, but only requires recapture of depreciation in excess of straight-line


 

Table 1
 
Economic Efficiency
 
Simplicity
 
Fairness
FIT
Worst
Worst
Best
VAT
Better
Better
Worse
Poll/Head
Best
Best
Worst

 

 
 
 
 
 
 
 
 
 
 
 
Gain à
ß Loss
 
ß Zero Gain
or Loss à
 
 
 
 
 
 
 
Gain
FMV
 
 
 
 
 
 
 
 
“Goalpost Rules”
 
 
Figure 1

 

Table 3: Damage Awards
Compensatory
Punitive
Physical Injury
Not Taxable
Taxable (but didn’t used to be)
Non-Physical Injury (e.g. libel)
Taxable (but didn’t used to be)
Taxable

 

Table 2 – Annuities

5-year Loan at 10% for $379.08
 
$100/yr. Annuity purchased for $379.08
Year
Balance
Pmt.
Int. Pd.
Principal
 
 
Pmt.
Int.
Principal
1
379.08
100
37.91
62.09
 
 
100
25
75
2
316.98
100
31.70
68.03
 
 
100
25
75
3
248.68
100
24.87
75.13
 
 
100
25
75
4
175.53
100
17.56
82.44
 
 
100
25
75
5
90.91
100
17.56
90.91
 
 
100
25
75
 
 
 
GI to bank
 
 
 
 
GI to taxpayer
 

 

 

 

 

 
Table 4
5-year bond; PV = $1,000; Coupon = 4%; Market Interest = 8%
NPV of bond based on mkt. rate = 840
You pay less than face for bond because Coupon < Market
 
Taxable income
Coupon Payment
OID Income
Year 1
.08 x 840 = 67
40
27
Year 2
.08 x 867 = 69
40
29
Year 3
.08 x 898 = 72
40
32
Year 4
.08 x 918 = 74
40
34
Year 5
.08 x 1000 = 78
40
38
TOTAL
 
200
160

 

 

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