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Tax Law Outline Overview of federal income tax system (1-40) o Gross Income 61 less Exclusions from Gross

ss Income less Above-the-Line Deductions 62 equals Adjusted Gross Income (AGI) o AGI less Deductions/Exemptions 63 = Taxable Income x Rate 1 Credits = Tax o Tax Base the pool of economic activity from which tax revenue is gathered. All else being equal, the broader the tax base, the more revenue a tax system will collect at a given rate o Comprehensive Income Tax Base Perhaps the broadest tax base, would include all forms of income. Most people think of income strictly in terms of wages. But a comprehensive measure of income also includes anything that allows you to spend more, either now or in the future. Capital gains and losses, dividends, rental income, and royalties all represent income that does not come in the form of wages. Income can also include noncash increases to wealth, such as healthcare insurance or other fringe benefits provided by an employer. Some components of income are accruals that do not involve any current cash flows o Gross Income this is the starting point for the tax calculation. Taxpayers start by adding up their taxable income from different sources: wages and salaries, taxable dividends, taxable interest, rents, royalties, capital gains, business income (or losses), taxable pensions and annuities, taxable Social Security benefits, etc. Under current law, taxpayer are allowed to deduct certain expenses, such as the costs of moving for a new job or their contributions to individual retirement accounts, from gross income. After taking into account these adjustments, sometimes called above-the-line deductions, the taxpayer takes the resulting amount, called adjusted gross income (AGI), and applies further adjustments to calculate taxable income o Tax base above-the-line deductions = Adjusted Gross Income o AGI exemptions (compare larger of: (1) Standard deduction or (2) Itemized deductions) = taxable income o Taxable income.apply tax rates = Tax Liability before Credits o Subject Tax credits = Regular tax liability o Above-the-line deductions trade or business expenses, moving expenses, educator expenses, self-employed health insurance premium payments, student loan payments, tuition and fees, alimony paid, etc. o Taxable Income in mathematical terms, equals AGI minus applicable exemptions and deductions. Exemptions and deductions remove a further amount of income from the tax base. In certain cases, these tax provisions, or tax preferences, are in place to encourage certain kinds of economic activity, such as the purchase of homes. o Exemptions most taxpayers in our system are eligible to exclude a certain amount of income from taxes. This exemption depends on family size. Not every taxpayer is

allowed to claim an exemption. Personal exemptions are phased out for higher income taxpayers with AGI in excess of certain amounts. The personal exemption is an example of a tax preference designed to adjust tax liabilities for family size that, for revenue reasons, is not available to higher-income taxpayers. o Deductions Like exemptions, deductions are subtracted from AGI to determine taxable income. Taxpayers are allowed to choose whether to subject a standard deduction amount determined by filing statussuch as single or marriedor to subtract the total of their itemized deductions. Only specific expenditures may be claimed as itemized deductions. Many of the most prominent tax preferences, including deductions for charitable contributions, home mortgage, and state and local taxes, come in the form of itemized deductions. The value of a deduction (exclusion) is worth more to a taxpayer in a higher tax bracket than a lower one. o Tax Credit like deductions, exemptions, and exclusions, tax credits provide taxpayers with a tax benefit. However, tax credits are applied after the taxpayers tax liability is calculated; they are subtracted, just like a coupon at the supermarket. Tax credits provide a dollar-for-dollar decrease in tax liability for all taxpayers who pay tax, therefore they provide an equal benefit to taxpayer sat all income levels. o Tax Threshold the amount of income at which a family starts to pay tax. It has important implications for how the burden of the tax is distributed and how people participate in the tax system and support the federal government o Marginal Rate of Tax the applicable rate of tax at each bracket level o Average/Effective Rate the rate that is applicable to the taxpayers income as a whole. A taxpayers average tax rate (or effective tax rate) is the share of income that he or she pays in taxes. By contrast, a taxpayers marginal tax rate is the tax rate imposed on his or her last dollar of income. Taxpayers average tax rates are lower usually much lowerthan their marginal rates. There are 3 reasons for this: 1) Because of exemptions and deductions, not all income is subject to taxation 2) The top marginal rate applies only to a portion of taxable income 3) Credits directly reduce the amount of faxes a filer owes o A gain or loss is said to be realized when there has been some change in circumstances such that the gain or loss would ordinarily be taken into account for tax purposes. The classic realization event is a sale or exchange of the underlying property. A gain or loss is said to be recognized when no applicable provision calls for non-recognition, that is, temporary or permanent (and either partial or complete) disregard of the fact that a realization event occurred. Thus, where there is realization there may or may not be recognition, but where there is recognition there must have been realization. COURTS o Judiciary US tax court, federal district court, court of federal claims

o U.S. District Court you have to pay the tax and sue for a refund. You can get a jury trial. The judge in the DC is not likely to be a tax expert o U.S. Tax Court available only if the tax has not been paid as of the date of the petition. Here you dont get a jury. You get a tax specialist. TC judgments are reviewable by the federal circuit courts of appeals. If the TP loses, the tax must be paid with interest to the date of payment, so an important factor in deciding whether to follow the TC route is the current interest rate charged by the government on deficiencies. The minute you get into court youre going to want to pay so you stop running up interest. o Court of Federal Claims you have to pay the tax and sue for a refund here. It is appealed up to the appellate court for the federal circuit. Theyre not specialists. You dont get a jury. The key is where its appealed to. o Golsen Rule under this rule, the US Tax Court case gets appealed to the circuit in which the TP resides. If you litigate in the DC, they find in your favor, it goes up to the third circuit finds in the governments favor. The next person shouldnt go to the US tax court b/c if it goes up on appeal, theyll have to go on precedent. Requires the TC to follow a decision of the CoA that has direct jurisdiction over the TP in question. o Tax Planning Three strategies: Timing, income shifting, and changing the character of income o Business Purpose Doctrine The business purpose doctrine holds that a transaction will be recognized for tax purposes only if it is made for some business or economic purpose other than a tax avoidance motive o Committee Reports As a bill proceeds through Congress, various committee reports are generated. What three committee reports are generated as a result? The House Ways and Means Committee; the Senate Finance Committee; and the Joint Conference Committee may generate committee reports in the process of a bill becoming a law. o Letter Ruling vs. Revenue Ruling A letter ruling is issued to a specific TP to provide guidance on how a planned transaction will be taxed. It generally applies only to the TP to which it was issued and may not necessarily apply to another TP in a similar situation A revenue ruling is issued as general guidance on the tax consequences of a particular transaction. It is usually issued for ambiguous tax situations. Although these rulings are generally fact specific, TPs with similar fact situations can rely on them for guidance.

Characteristics of Income: What is Income? Introduction: the Concept of Income (45-49) 61 o Haig-Simons = increases in wealth + consumption Problem: isnt workable administratively, as everyone would have to appraise their property each year. All income is either saved or spent, and thus definition usually produces a higher income figure than government definition. o Government definition GI (61) = all income from whatever source derived Glenshaw Glass: an undeniable accession to wealth, clearly realized, over which individual had complete control Problem: tautological Tax Accounting o Cash Method: mostly used by individuals Amounts are treated as income when received in cash and deductible when paid Capital costs: can only be deducted when the asset is used or sold, not when the cash outlay is made Constructive receipt: a right to a payment is treated as received when the taxpayer has a right to receive cash, even if the case is not taken o i.e., a check is income, even if never cashed Cash equivalent/Economic benefit: people are treated as if they had received cash when they receive valuable property or rights. o Accrual Method: mostly used by businesses Amounts are treated as income when earned, regardless of when payment is received, and expenses are deductible when the obligation to pay is incurred, regardless of when payment is made. Entities o Sole proprietor: a person who owns a business solely and directly All business income/expenses are treated as his income/expenses o Partnership: two or more people who carry on a business It files a tax return but pays no tax Pass-through taxation: partners report their share of profits/losses on their own individual returns o Partnerships are also referred to as a conduit o Some people use them as tax shelters o Trust: legal device where a trustee holds and invests property for the benefit of a beneficiary The trust may be required to pay a tax o Corporation: legal devices for organizing economic activity

Treated as separate taxpaying entities Special rate: 15% of first 50k, 25% of next 25k, etc. Dividends: income paid to shareholders, which they must report as income. NONCASH BENEFITS o Meals and Lodging Provided to ERs 119 is the benefit to the TP incidental to the benefit to the ER Convenience of the ER Rule: (a) meals & lodging supplied to the EE, his spouse or dependents shall be excluded from his gross income if provided for the convenience of his ER &; o (1) the meals are provided on the premises of the ER o (2) The lodging are on the ERs premises & are a condition of his employment Bengalia: TPs lived at the Hawaiian resort where they worked and received all of their meals from the hotel. They lived at the resort purely for the convenience of the TPs ER. The IRS computed the value of the rooms and food and added it to their Gross Income. Rule: Convenience of the ER. Holding: The court held that since the TP lived at the hotel for the convenience of the ER, the value of the rooms and food were not taxable. Reasoning: the benefit to the TP was purely incidentally to the performance of his duty; the dominant benefit of the TPs lodging was the convenience of the ER. Special Rules o (1) Provisions of an employment K or State statute fixing terms of employment are not determinative of whether the meals & lodging are provided for the convenience of the employer o (2) That fact that a charge is made for such meals or that the EE may accept or decline the meals are not determinative either o (3) Certain fixed charges for meals ER collects $$ to provide meals for the EE TPs. o (4) Meals furnished to EEs on business premises where meals of most EEs are otherwise excludable Some courts will allow groceries under this rule Furnished The ER must provide the food as opposed to just providing the EE w/ the money for such. Employee

This rule can be extended to sole shareholders of a corporation Old Colony Trust Co. v. Commissioner the company adopted a resolution whereby it would pay the officers tax liability. The IRS argued that the payment by the ER of the income taxes assessable against the EE constituted additional taxable income to the EE. The SC agreed and held that the payment constituted income to the employees. the SC reasoned that the payment was in consideration of the services rendered by the EE and was a gain derived by the EE from his labor and therefore subject to income tax. Food and Lodging Deductibility 119(a)-(b) o Justified as forced consumption = policy reason o Following criteria must be met: 1) Must be furnished Kowalski: cash meal allowances to state troopers is NOT furnishing food, implying that the meal must be furnished in kind (bought by employer and handed to employee) 2) On the business premises functional, not spatial test 3) For the convenience of the employer requires a substantial noncompensatory purpose Prong satisfied by: o Being required to be on call after business hours o Policy that precludes employers from eating away from business premise 4) Must be accepted as a condition of employment (for lodging only) o Lodging three tests: 1) required to accept lodging as condition of employment 2) furnished for convenience of employer 3) on business premises o Benaglia v. Commissioner Wife and manager of 2 hotel resorts allowed to exclude cost of hotel suit and dining room expenses. o Perhaps, however, the convenience-of-the-employer rule is really a short-ahnd way of acknowledging the factor of restricted preference mentioned in connection with the endowment policy case above. In Benaglia, as in the endowment policy case, there is an element of personal compulsion which raises doubt about the value of the benefit to the recipient. Indeed, his freedom is still further restricted: not only is the hotelmanager forced to consumer when he might prefer to save, but he is forced to consumer particular goodshotel food and accommodationsinstead of having the same free choice among commodities that is afforded to the rest of us. o The position of the IRS is that if no exclusion provision (such as 119) applies, in-kind benefits are taxable at their fair market value, rather than at the taxpayers lower subjective valuation.

119 codifies Benaglia (and applies to spouse and dependents) Meals: hot plates; sometime grocery stores included (Jacob) Furnished: employer must supply food, not money to buy food Convenience of the employer: business reasons other than tax purposes (i.e. employee needs to be on call outside of business hours) o Business premises of the employer: the property, house across the street, but not house two blocks away; every state and highway for state police. Statutory Treatment of other Fringe Benefits 132(a)-(j); 125(a), (d)(1), (f) o These are in-kind benefits as opposed to cash o Included in income unless specifically excluded by another section, based on language of 61 o Four categories 132(a) extends benefit to spouse and dependent children for (a)(1), (2) and parents for air travel 132(h)(2), (3) (1) No additional cost service service offered in ordinary course of business of employer (like extra space on an airplane for airline employees). Must be provided in the same line of business in which that employee is employed, be non-discriminatory, and the ER cannot incur any substantial cost in providing the benefitso airline can give EEs free tickets as long as they dont bump someone from the plane). (2) Qualified Employee Discount 132(a)(2) as long as discount is for property or services (not for investment but something offered for sale to customers) and doesnt exceed (a) in case of property gross profit percentage of price for customers [(aggregate sales cost of goods sold/aggregate sales)] or (b) for services, a 20% discount. If discount is 45% and gross profit is 40% for ER, then 5% is counted as income Must be in same line of business, be non-discriminatory, on services the discount cannot exceed 20%, on property the discount cannot exceed the ERs gross profit percentageemployee cant purchase it at less than cost). Cant be something ER doesnt offer to customers. Must not be discriminatory or favor highly compensated employees. o NOTE: anti-discriminatory requirement only applies to no additional cost services and qualified employee discount and retirement planning services. (3) Working Condition Fringe 132(a)(3) if paid for by employee would be deductible by employee under 162 as trade or business expense or under 167 for depreciation compare employee to self-employed paying $ to run office (secretaries, A/C, flying to produce income)

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Business use of a company car or a free subscription to a magazine that relates to the employees job (4) De minimis fringe excluded when accounting for them would be unreasonable or administratively impractical. Low value holiday gifts, occasional sporting event tickets, picnics for employees. Occasional meal money or local transportation fee excludable as de minimis if its occasional, provided to enable overtime work or meal money Reg. 1.1326(d)(2)(i) (5) Qualified Transportation Fringe (excludes transportation in a commuter vehicle, transit pass, or qualified parket used to get to worklimit is $175 a month for parking and $100 per month for the rest). Deadweight loss: when an ER pays more for a benefit than it is worth to the employee b/c the tax rate makes it wasteful to take the taxable cash instead of the non-taxable benefit. (6) Qualified Moving Expense Reimbursement The first two categories includes: current employees, retired employees, disabled exemployees, the spouses and dependent children of employees, the surviving spouses of employees or retired or disabled ex-employees 132 excludes the first two classifications of fringes and employee eating facilities provided to highly compensated employees only if those fringes are offered to all employees on a nondiscriminatory basis. Questions 1-8 on pp. 65 Turner v. Commissioner Cafeteria Plans A plan under which an employee may choose among a variety of noncash taxable benefits or may choose to take cash (which is taxable). In other words, an employee may in effect elect to reduce his or her taxable salary and take noncash benefits instead. This makes it possible for an employer to provide nontaxable fringe benefits to those employees who want them without disfavoring employees who have no need for them. Section 125 expressly authorizes cafeteria plans. Were it not for that provision, the doctrine of constructive receipt would result in an employee being taxed on the cash that he or she could have taken, even if a nontaxable benefit were chosen instead. In other words, without Section 125, cafeteria plans in which there was an option to take cash would not be tax effective. Section 125 greatly increases the potential use of non-taxable fringe benefits by removing the element of employee envy that would restrain an employer from offering fringe benefits for which some employees have no use. Use-it-or-lose-it rule if an employee elects at the beginning of each year to take $5,000 worth of child-care reimbursements instead of the same amount of cash compensation or other benefits, any part of the $5,000 not used for child care will be

lost to the employee. The unused portion cannot at the end of the year be paid out to the employee as additional taxable compensation or carried forward to the next year. o Frequent Flyer Credits when they are earned from personal travel they can best be thought of as reductions in the price of flights from which they are earned. They are tax free. However, for business trips there is a tax issue. o Health Insurance (66) ERs are allowed to deduct the cost of medical insurance that they buy for their EEs. at the same time, the benefits received by EEs are excluded from their gross income. Sec. 106(a). The exclusion extends to an employees spouse or dependents. The benefits are also excluded from wages for the purposes of determining payroll tax. MORE HERE Things considered taxable income: o Free items given to a charity will be taxable if the TP donated them to charity and claimed them as a deduction (Haverly) Free books donated to a schools library are taxable if the TP claims them as a deduction b/c when the TP has to account for the books as income and then claims a deduction everything equals zero. Another Approach to Valuation o Turner v. Commissioner Steamship case court averages the opposing bids of steamship tickets won on a radio show to determine value. Courts may determine valuation. o The position of the IRSoverwhelmingly supported by the courts in post-Turner casesis that if no exclusion provision (such as 119) applies, in-kind benefits are taxable at their FMV, rather han at the TPs lower subjective valuation. The IRS has ruled that a TP in this situation can avoid the tax by declining to accept the prize. o It comes down to a problem of valuation. If a 35% TP gets a prize worth 10k but only subjectively values it at 3k. He is taxed 3.5k. He can decline the gift. Windfalls and Gifts (78-91) (99-103) Code 102 o Justified because donor has already included amount in income, and it shouldnt be counted again in donees income = policy reason o While Haig-Simons would tax the donee and not the donor, the IRS taxes the donor and not the donee Administratively easier to trace $ and donor is more likely to be in a higher tax bracket. Parents gift to children. Parents are more likely in higher bracket. o Windfalls are taxable Punitive damages are considered taxable taxable o Commissioner v. Glenshaw Glass Co. The TPs had undeniable accessions to wealth, clearly realized, over which [they] have complete domintion.

BUT, damages for personal injuries are not taxable (because we want to make the TP whole after their injuries). Found/discovered money is taxable also. 102: Gifts and inheritances are not taxable o NOTE: gifts in excess of $11k may be subject to gift tax liability o To qualify as a gift, the item must be given with a detached and disinterested generosity. TC examines, appellate court follows clearly erroneous standard. o Commissioner v. Duberstein Cadillac given from one businessman to another not a gift b/c it was given recompense for past services; absence of legal or moral duty is not sufficient to constitute a gift. The fact that Berman took a business deduction indicated that the Cadillac was a business expense, not a detached/disinterested gift Whether there is a gift is a fact-based inquiry into the dominant motivation of the donor Gift = proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity, etc. o Ex: giving Employees a Christmas turkey/ham Not gift = proceeds from the constraining force of a moral/legal duty, incentive of anticipated benefit, or where payment is in return for services o Ex: not gifts: Christmas bonus, waitress tips, dress provided for an actress to wear to the Oscars; Cadillac given to Duberstein o Limitations on exclusion: 102(c) transfers from ER to EE is always income, except if EE is ERs child and gift doesnt relate to business Business gifts $25 limit However 274(b) permits a $25 de minimis exception to this basic rule Donor and donee viewed together, so donor deducting the expense negates detached and disinterested generosity needed to qualify as a gift o Stanton v. United States was a $20k gratuity given to a retired church comptroller a taxable income? NO. Fact-finders opinion on Stanton was too sparse, cant tell if it why it was not a giftremanded. Gifts versus Compensation The stock received in Taft v. Bowers was plainly a gift. If the transfer had been compensatory, the basis rule would have been different. For example, suppose that L (lawyer) performs services for C (a client) and bills C for $2,000. C admits she owes the $2,000 but offers to pay by transferring to L shares of stock of IBM that C had bought for $1,000 and that presently are worth $2,000. L accepts, and the shares are transferred. L has income of $2,000, and her basis for the shares is $2,000. The basis is

arrived at under 1012, which refers to Cost; cost has a special meaning for tax purposes. The results are as they should be, the same as they would be if C had paid L $2,000 cash and L had used the cash to buy the shares. o By virtue of the transfer of the shares to L, C has a taxable gain of $1,000, just as if she had sold the shares and paid L cash. Scholarships and fellowships (including $ for teaching/rendering other services) under 117 o Exclusion for $ covering tuition, fees, books, and supplies, but not room and board o Must be in courses of instruction at an educational organization (no research grant to work at NIH) Bequests o Under 102, bequests are excluded from income along with gifts. (As long as they are not belated compensation for services rendered to the decedent during his lifetime). See Wolder: a bequest to a lawyer who rendered legal services w/o charge was considered income But see McDonald: a bequest to a nurse in appreciation of services was not considered income Payments in settlement of a contested will is a bequest (Lyeth) Welfare and other govt. benefits o Traditional welfare payments are not taxable, not because they are excluded under 102, but because they are not considered income within the meaning of 61. Under TANF, recipients are required to work and, if they reach a certain threshold, may be taxed on the income earned from the job. o Social Security may or may not be taxable depending on TPs AGI. Alimony is deductible by the payor and taxable to the recipient Transfer of unrealized gain (i.e. stock) (103-109) 1014(a), 1015(a) o Statutory Basis: 61(a)(3): gross income includes gains from dealing in property (i.e. stock) 1001: gain = amount realized (AR) adjusted basis (AB) 1012: adjusted basis = the cost (of the property/stock) 1015: exception for property acquired by gift Donees basis = donors basis Unless at the time of transfer the donors basis is greater than the FMV (meaning the donor would have taken a loss if he sold the stock); in such a case, to compute the donees loss (but not gain), the basis = FMV o Gifts v. Compensation Gift stock transfers are excluded from income under 102(a) (so there will be a taxable event at the time the property is sold, but not at the time the property is transferred) There are different basis rules for compensatory stock transfers

If a client owes a lawyer $2,000 and gives him stock that he bought for $1,000 but is now valued at $2,000, the lawyer has income of $2,000 at the time of transfer and the client has a gain of $1,000. o Lawyers basis is $2,000 (which creates the same result as if the client had given the lawyer $2,000 in cash which he then used to purchase the stock), so if the lawyer later sells the stock for $5,000, she has a gain of $3,000) o Taft v. Bowers transferee must pay taxes on diff. between AR and OB (org. basis) TP received stock as a gift from her father which appreciated in value by the time she sold it. IRS said the basis was what he paid for the stock, but TP said the basis was the stocks FMV at the time she received it. Court held that the transferee must pay taxes on the difference between the AR and the OB (original basis), not the difference between the AR and the FMV at the time of the transfer. (That is, the donor accepts the donees basis 1015) The 16th Amendment allows taxation on the difference between amount that donor paid ($1,000) for the stock and the amount that donee sold it for ($5,000), even though donee received the stock when its FMV was between those two amounts ($2,000). I.e. 1015 is constitutional There is nothing in the Constitution which lends support to the theory that gain actually resulting from the increased value of capital can be treated as taxable income in the hands of the recipient only so far as the increase occurred while the recipient owned the property (stock) Put another way, the effect of 1015(a) and the Taft decision is really to permit TPs to decide for themselves just who shall be the recipient of taxable income in the light of their own tax situations. The donee usually is poorer (lower marginal rate). The main effect of 1015(a) is to carry over the donors basis to the donee. o 1015(a) transfer of appreciated gifts Donors original cost = $1,000. Value at time of gift = $2,000 Donees basis = $1,000 (donors basis = donees basis) Donee sells at: o $5,000 Gain of $4,000 o $1,750 Gain of $750 o $600 Loss of $400 o Donors original cost = $2,000 FMV at date of gift = $1,000

Donee sells stock for: $750 o Loss of $250 $1,600 o Produces neither loss nor gain. $2,250 o Gain of $250 ELIMINATED FOR WHERE DONEE IS (OR WAS) THE DONORS SPOUSE o 1014 when property is transferred after someones death via a will, the basis = FMV at the time of death or (if the executor elects) six months after the death. Appreciation and Depreciation in value are both wiped out by death. 1014(e) if a person receives property within one year of his death from a donor, the basis of that property to that donor will be the adjusted basis, not the FMV I.e. a person buys property for $1,000 which appreciates to a value of $100,000, and then transfers it to a dying relative. If the relative then transfers the property back to that person via a will who then sells it for $105,000, the basis will still be $1,000, and not $100,000 The effect of 1014 is to encourage people to hold on to appreciated property until death, which results in some degree of immobility of capital, which economists find troubling. Although there is no realization of gain or loss by a decedent, under 1014 the basis of all property acquired by inheritance becomes its FMV at the date of the decedents death. Thus, appreciation and depreciation are both wiped out by death, and the decedents heirs are obliged to recognize only those changes in property value that take place subsequently. The basis is either stepped-up or stepped-down. If an investor buys property for $1,000, and the property is worth $1,500 at his death, the investors heirs will take it over at a steppedup basis of $1,500 and the $500 appreciation will be eliminated for tax purposes. Questions on Page 109!!! Recovery of Capital and Annuities (110-113, 117-122) 72(a), (b) o Basis First: (Inaja Land) TP allowed to recover her basis before she has to include the $$ received as income o Income includes returns on ones capital and gains from the sale of that capital, but it does not include returns or recoveries of ones capital (so TP only pays taxes on money in excess of cost) Example: Joan owns 30 collectible cows

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10 were a birthday gift (cost = $300; FMV = $1,000) 10 were given in a will (cost = $700; FMV = $1,500) 10 she purchased at the mall (cost = $700) Her basis = $300 ( 1015) + $1,500 ( 1014) + $700 = $2,500 If she sells all 30 cows for $3,600, her gain = $3,600 $2,500 = $1,100. But what if she sells 15 cows for $2,200? She cant say that because she hasnt reached her total basis of $2,500 yet she has no gain; instead, she has to identify the specific cows she sold and calculate her gain from that Bob owns 40 acres of property (cost = $20,000) If he sells 20 acres for $15,000 can he make the basis first argument? o No, because an expert appraiser can determine the value of the sold and leftover property. BUT, what if the nature of the transaction is such that the value of the interest sold cant be determined? In that case, you can make the basis first argument. See Inaja Inaja Land Co. v. Commissioner TP was compensated for citys easements of his water preserve on his land and argued he couldnt apportion the money to the disposition of certain units. The court held that TP was not responsible for paying taxes on the money received because 1) the apportionment could not be determined with reasonable accuracy, and 2) the amount received did not exceed TPs costs So the TP did not have to start paying taxes on money received until his entire basis was recouped. Think of cow example above, so none of that $2,200 would be taxable. The TP bought 1,250 acres of riverfront land, together with related water rights for $61,000 with a view to using the property as a private fishing club. Twelve years later, Los Angeles City began contaminating it and killed the fish. Subsequently, with litigation threatened, the City settled by paying the TP $50,000 for the grant of a perpetual right to continue diverting contamination into the river. The TP treated the $50,000 as a non-taxable recovery of basis. IRS contended that the payment represented compensation for the loss of future business profits. Holding for the TP, the Court found that the $50,000 had been paid for the sale of an easement that was essentially an interest in the property itself. The 50k would therefore be offset against the TPs total property cost of 61k to 11k. If the remaining property were finally soldat least if sold for more than 11kthe TPs gain could then be accounted for and taxed. The decision does illustrate a fairly common judicial reaction to the difficulty that arises when the recognition of taxable gain requires a valuation of non-marketable property rights. As in Inaja, the courts quite often duck the valuation problem by

resorting to tax postponement, that is, by deferring recognition until the TPs investment has been fully recovered and gain (or loss) can finally be determined. o 1014(a) relieves from taxation income or gain that had not been realized at the time of decedents death. Suppose, however, Lawyer L performs legal services for a client in 2011, bills the client $10,000 for those services in 2011, and then dies. The $10,000, which has been earned, in an accrual accounting sense, before death is called income in respect of a decedent and is subject to income tax under 691. Depending on Ls accounting methods, and the year in which payment is received, the income tax will be paid as part of Ls final return in 2011, or paid by an income tax return filed by the estate in a later year. Annuity Payments o An annuity is an arrangement under which one buys a right to future money payments (person might pay company $60,000 for the right to receive $5,000 a year for life) o Congress has recognized that there is an income element in each annuity payment from the outset. o 72 allows a recovery of capital over the expected life of the contract by excluding the portion of each payment that is the ratio of the investment in the contract to the expressed return under the contract. The excess is taxed as the income element in each payment. For example, if Bob pays an insurance company $60,000 and they agree to pay him $5,000/year for life, with a 20-year life expectancy Investment in the contract = $60,000 Expected return under the contract = $100,000 ($5,000 x 20 years) Investment___ Expected return $60,000 $100,000 x Payment received = amount excluded


= $3,000 (taxable amt = $2,000)

If annuitant lives beyond her life expectancy and fully recovers her investment in the contract, the full amount of any subsequent annuity payment is included in her gross income. If she dies without fully recovering her investment, the amount of the unrecovered investment is allowed as a deduction on her last income tax return. o (B) Payments to other persons if someone else other than the annuitant is receiving payments under the annuity K then that person is allowed to take the deduction. Annuities are when you pay a company $100k in exchange for the promise to pay $9k/year for life (assume a life expectancy of 20 years, so $5k 1(100/20yrs) of that yearly payment is what she initially gave the company and $4k is what they earn by investing the $100k at a 6.4% interest rate).

Different ways to deal with taxation on that yearly $5k o Investment-first rule Each payment is a tax-free recovery of capital until the entire $100k is recovered, then all payments are treated as income i.e. what the TPs in Inaja wanted to do only allowed for private annuities (unsecured promises by individuals) o 72(b) Exclusion ratio Investment/expected return X annual payout In above example, the TP is expecting to get a return of $180k ($9/yr X 20 yrs), so her nontaxable amount is = 100k/180k = 55.55% x $9k = .5555 x $9k = $5k (so she is taxed on $4,000) If she dies before 20 yrs, she can deduct the portion of her investment that was not recovered. If she lives longer than 20 years, she is taxed on the entire $9k. o 72(e): TP who takes out a loan against an annuity policy will pay taxes on either: The amount of the loan; or The increase in the value of the policy (whichever is less) Deferred Annuities 72(e) o If the TP takes out a loan against an annuity, he must recognize the amount of the loan or the increase in the value of the policy whichever is less o If the TP takes his $$ out before the age of 59 he must recognize the gain and pay a penalty of 10% of the income Gains/Losses from Gambling o 165(d) gambling gains are taxable, and losses are deductible only to the extent of gains from the same taxable year (basketing) i.e. gambling losses are not deductible in and of themselves, they can only be used to offset winnings If TP loses $40k, they cant claim a deduction, but if they win $60k and then lose $40k, they only have to report $20k as income o Ex: TP wins $700 but then losses $800 later. He can only receive a deduction for $700, the amount of his gains from gambling. Annual Accounting Principle (132-142) Code 1341(a), 111(a) o Tax system uses annual, not transactional, accounting o Skipped this part in book, went straight to Claim of Right Claim of Right o TP has income if he receives it under a claim of right without restrictions on its use even though he may have to later return or restore that money.

o North American Oil v. Burnet a lawsuit was filed against TP to oust them from oil property they owned. In 1917, a court said that the property belonged to TP and awarded money for income earned in 1916. The P appealed and the case was finally decided, again in TPs favor, in 1922. IRS said the award shouldve been reported in 1917 but TP said they should pay taxes in either 1916 (when the money was accrued) or in 1922 (when the litigation was finalized). The Court said the income should be reported in 1917 when the TP received the money without restrictions (if the P had prevailed in 1922 and TP had to return the money it would have been entitled to a deduction in 1922). Illinois Power Co. v. Commissioner no claim of right when TP is just a custodian of the money and is under a duty to repay it. o North American can be explained and defended on practical grounds. The Treasury has a plausible interest in immediate taxation. Postponement creates the risk that the TP might become insolvent before the tax is paid. In addition, the task of deciding when income has attained an appropriate level of certainty would be administratively burdensome. The actual receipt of the disputed funds (1917) is an even that is easier to identify than the final resolution of the controversy (1922). United States v. Lewis TP was given a bonus in 1944 and paid taxes on it but had to return half of it in 1946. TP wanted to recomputed his 1944 taxes (because of higher rate during WWII) but IRS argued TP should deduct half the bonus at a loss on his 1946 return. Court agreed with the IRS. o NOTE: This case may have gone the other way if the TP had been compelled to pay rather than doing so voluntarily. o 1341 (Congressional Reaction to Lewis): If deduction in the year of repayment is more than $3,000, the tax owed is either the ordinary deduction or a credit for the tax that would have been saved by excluding the item in the earlier year, whichever is less. The tax for the later year will be whichever of the following is lesser: (a) The tax in the later year computed with the deduction (b) The tax in the later year without the deduction, but reduced by the amount by which the tax in the earlier year would have been decreased if the item in question had been excluded from the earlier years income. But mere errors such as arithmetic mistakes dont count, and embezzlers who return embezzled funds dont qualify (b/c they dont have an unrestricted right to the money). When 1341 applies, TPs never lose and often win. If a TPs marginal rate was higher in the earlier inclusion year than in the later repayment year, the TP chooses option (b) and obtains a tax reduction in the later year equal to the tax cost of the inclusion in the earlier year (thus not losing). If the TPs marginal rate was lower in the earlier year than in the later year, the TP chooses option (a) with the result that the TP obtains a deduction in the later

year that is more beneficial than the inclusion in the earlier year was costly (thus winning). o NOTE: TP can only file an amended return if he made a mistake at the time of reporting (i.e. if, on the basis of the facts existing at the time the return was filed, the return was in error). If the TP makes a mistake that becomes evident only b/c of events that occurred after the year ended, he has to make an adjustment in the year that the true facts were discovered. o Claim of right was a rule of finality which was deeply rooted in the tax system, and no exception could be permitted merely because the TP was mistaken as to the validity of his claim. Tax Benefit Rule o (1) TP takes a deduction for something he gives away or loses o (2) Then the TP gets the $$ or property back o (3) He must report it as income o When a TP claims a deduction in an earlier year and then recovers the deducted amount in a later year 111: Exclusions Recovery of tax benefit items If a deduction does not reduce a TPs liability and loss carryovers resulting from it have expired without being used, the recovery of the amount deducted doesnt have to be included as income. o i.e., TP need not report an income tax refund as income. o By far the most common application of this is with respect to state income tax refunds. If a TP claims state income taxes among his itemized deductions in one year, and receives a refund of some portion of those state income taxes in a later year, the refund will be taxable in the later year under the tax benefit rule. But if the TP claims the standard deduction in the year in which he paid the state income taxes, then a state income tax refund will be excluded under 111. Inclusions If TP has received a tax benefit and the amount of the subsequent offsetting gain is not clear, the amount of the prior deduction must be included as income. Alice Phelan Sullivan Corp. v. U.S. TP gave a gift of property and claimed a charity deduction. When the property was returned 20 years later, TP had to pay income in the amount of the earlier deduction (instead of on the value of the property in the year it was returned).

Bliss Diary Tax benefit rule only applies when the later event is fundamentally inconsistent with the premise on which the deduction was initially based. The subsequent recovery is included in the TPs income, provided that the earlier deduction produced a tax saving in the prior period. The general rule that events in later years do not affect tax results for earlier years applies in both the claim of right and tax benefit contexts. Instead, the required tax adjustmentfor the repayment or recovery, as the case may beis made in the later year. By far the most common application of this rule is with respect to the state income tax refunds. If a TP claims state income taxes among his itemized deductions in one year, and receives a refund of some portion of those state income taxes in a later year, the refund will be taxable in the later year under the tax benefit rule. But if the TP claims the standard deduction in the year in which he paid the state income taxes, then a state income tax refund in a later year will be excluded under 111. The Tax Benefit Rule will cancel out earlier deductions only when a careful examination shows that the later event is indeed fundamentally inconsistent w/ the premise on which the deduction was initially based Ex: If a TP made a rental payment for 1 month at the end of the year and the leased premises are destroyed by fire on January 10th then the liability of the TP to use the property is not fundamentally inconsistent event If the TP converts it from business to personal use this would be a fundamentally inconsistent event If you have a subsequent event that changes the bottom line for the deduction, then its fundamentally inconsistent. Ex: What if you pay rent for business premises in December for a 3-year lease (you deduct that.) Then in January you decide to move in there and make it for personal residence. Is that a recovery? The SC says yes, because you were allowed that deduction for business rent on the premise that you were going to use it for business purposes. That is a fundamentally inconsistent event with business use.

Recoveries For Personal and Business Injuries o For companies: Damages for lost profits and punitive damages are taxable in the year received If a company recovers damages to compensate for destroyed or damaged property, it must pay taxes if the amount received is more than the basis 1033: exception that allows a TP to defer taxation if they reinvest the money in a similar or related use. o For individuals: 104: Damages for personal injuries are not taxable But punitive damages for personal injuries are still taxable

104(a)(2): TP doesnt have to pay taxes on damages for personal injuries even they defer current payment and elect to take periodic payments (even though deferred payments usually contain some interest) The non-taxation of the interest component creates an incentive for tort victims to structure settlements to provide deferred periodic payments. After all, if one received a lump-sum payment and invested it, the interest returns would presumably be taxable. FUTURE WAGES? o Medical Expenses Medical expenses, including premiums paid for medical insurance, are deductible only to the extent that in the aggregate they exceed, for the taxable year, 7.5% of AGI. ( 213) 104(a)(3): recovers under an insurance policy is excluded from taxation even if the recoveries exceed the cost of medical care Exception for payments received in reimbursement of expenses previously deducted (b/c of the tax benefit rule) 104(a)(1) excludes workers compensation o Recoveries for personal and business injuries Compensatory damages Nontaxable (except for emotional distress which is taxable) Punitive damages taxable It doesnt matter from whom the TP recovers from The purpose of excluding recovery from gross income is that the money the TP received only made him whole as opposed to a windfall (punitive) goes beyond making him whole Sec. 104 Compensation for injuries or sickness (a) In general except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, the following are not taxable o (1) Amounts received under workmans comp acts as compensation for personal injuries or sickness; o (2) The amount of any damages received whether by suit or agreement and whether as lump sums or as periodic payments on account of personal/physical injuries or physical sickness Exceptions: Punitive damages; awards for emotional distress The interest earned on periodic (structured) payments are nontaxable Deferred payments are more favorable to the TP

o (3) Amounts received through accident or health insurance (or through an arrangement having the effect of an accident or health insurance) for personal injuries or sickness Exceptions: other than amounts received by an EE, to the extent such amounts (A) are attributable to conditions by the ER which were not includible in the gross income of the EE, or (B) are paid by the ER) These payments also include $$ set aside by self-employed people for this purpose which were not taxed when set aside o (4) Amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces o Hypo: Tom is standing on the corner and sees a car driven by a DD. The car strikes his wife, C. C sues and recovers $100k for physical injury. She gets $50k for med expenses and $1m for punitive damages. Tom sues and recovers $100k for loss of consortium $ emotional trauma & $10k for psychiatrist bills. Whats excludable and whats not? C $100k for PI excludable C $50k for med expenses excludable o R: As long as she hasnt taken any deductions for the medical expenses then they are excludable C $1m includable T $10k excludable T $100k excludable o Business injuries General Rule the recovery is taxable in the year received to the extent it exceeds the basis of the property Exception: if the TP reinvests the $$ in a similar or related use then he is allowed to defer taxation Ex: The TP corporation has a building w/ a basis of $600k and FMV of $700k and the building is destroyed in a fire. The TP receives $700k from the ins. co. If the TP buys another building similar to the one destroyed, then only $100k is taxable. o Medical Expenses and Other Recoveries & Benefits Medical expenses are only deductible if theyre above 7.5% of the TPs income 7.5% is the standardized deduction everyone gets An EE cannot deduct the amount she pays for health insurance from her gross income.

SEE HANDOUT HERE!! Transactions Involving Loans Income from the Discharge of Indebtedness o 61(a)(12): income from discharge of indebtedness If ER cancels the debt you owe; that is considered a form of income and is taxed. A TP can have an increase in wealth both from an increase in assets and a decrease in liabilities o Loan proceeds are not considered taxable income (no distinction between recourse and nonrecourse loans). Loans dont increase the TPs net worth because it must be paid back. o Loan repayments are not tax deductible These rules apply to recourse loans (where TP is personally liable) an nonrecourse loans (where lender has to collect the property offered as security for the loan) o 61(a)(12): income from discharge of indebtedness is taxable o Kirby Lumber Co.: TP issued bonds valued at $1M and later repurchased the same bonds for $862k, which means they purchase the bonds for $138k less than they issue them for. The court held that TP realized an accession to income and had to pay taxes on the $138k. Exclusions from 108 108: If TP is insolvent or a debtor in a Bankruptcy Court at the time of discharge, the income from the discharge of indebtedness is excluded, but certain tax attributes must be reduced The amount excluded is limited to the extent to which his liabilities exceed his assets. i.e. if Company has NOL of $135k and $100k is discharged, only $35k can be used to apply to past or future income (b) Reduction of tax attributes The quid pro quo for non-recognition is that the TP must reduce certain tax benefits or the basis in his property by the amount of the debt cancellation 108(e)(5): when a TP has purchased property, if the seller discharges some of the money owe on the property the discharge is treated as a reduction in the sale price instead of income. This is a situation where theres seller financing. Youre sold a car for 50k. If you come back and say you cant pay it all back, the guy forgives 5k, then you only owe $45k. That 5k is treated as a reduction in the sale price instead of income. The basis is $45k instead of 50k.

108(f)(2): Cancellation or repayment of student loans is not considered income as long as the cancellation is contingent upon working for a charitable or educational institution. 108(h): Mortgage forgiveness. TP can exclude up to $2m of forgiven qualified principal residence indebtedness Usually arises when the home is foreclosed or the mortgage company renegotiates the terms of the mortgage The TP must reduce her basis in the principal residence (but not below zero) by the amount excluded o If there is a discharge of indebtedness where the debt is paid in full by a third party (i.e. an employer), tax is impose under 61(a)(1) instead of under 61(a)(12). Exception: if someone pays the debt as a gift (i.e. a parent), no taxation under 102(a). o Net operating losses (NOL) are deductions. Lets say in Year 1, you have a NOL of 1k. It means the first 1k of income you earn in Year 2 is tax free. This is because the deduction will wipe it out. If you take that away, theres a cost. Thats what 108 tells you to do. The standard definition of income is found in Glenshaw Glass. The Court defined income as 1) Accession to wealth; 2) Clearly realized; and 3) Over which the TP has complete dominion. o Prior to the decision, the SC had already determined that the cancellation of debt was a freeing of assets. Essentially, when debt is cancelled, money that would have been used to pay that debt is now free to be used on anything else the TP wants. This is also known as accession to wealth. o Contested Liability: doctrine that the amount of a disputed debt is the amount for which the debt is settled Zarin case: TP incurred $3.4M in gambling debts, which was discharged for $500k. The IRS argued that the TP had realized income of $2.9M. The court held that the TPs situation did not classify as indebtedness b/c (1) he was not liable for the debt (b/c it was illegal to extend credit to gamblers in NJ so his debt was unenforceable), and (2) he did not hold property subject to that debt (b/c the gambling chips were not property, they didnt have an economic value outside the casino). B/c the amount of debt was disputed, the settlement indicated that the total amount owed $500k and since thats what he received there were no additional tax consequences. Nonrecourse Debt o Whether debt is recourse or nonrecourse can have significant consequences if the debt is settled in foreclosure of the secured property. Generally, while the net gain or loss is the same regardless of the classification of the debt, there are potentially huge tax differences.

o When property burdened by nonrecourse debt is foreclosed upon, there is no cancellation of indebtedness even if the amount of the loan exceeds the FMV of the property. That case of Commissioner v. Tufts holds that in such a situation, the amount realized is the amount of the debt, and the FMV of the property is irrelevant. That this difference between the adjusted basis of the property and the amount of the debt is simple gain rather than Cancellation of Debt has potential upsides and downsides. On the one hand, the gain would be capital gain assuming the property foreclosed upon were a capital asset, unlike COD which is ordinary. On the other hand, COD is potentially excludable, as by insolvency. o If the same property had been burdened by recourse debt, and, as above, that property were foreclosed upon in full satisfaction of the debt, you would get a different result. The gain or loss would be determined with reference to the FMV of the property, and the difference between the FMV and the debt would be Cancellation of Debt. (With recourse debt, any cancellation of the outstanding balance of the debt, after it has been satisfied to the extent of the FMV of the property given up, really is a termination of personal liability to pay that amount, unlike in a situation where the debt is nonrecourse). o If the property has a value lower than its basis, then in the case of recourse debt you could get a capital loss and COD ordinary income on the same transaction, netting to the same dollar figure as with nonrecourse debt but potentially must worse for the TP: The TP would not only be burdened with ordinary rather than potentially capital gains, but may have more total income to report, offset only by a capital loss that would be unusual if the TP had no other capital transactions for the year. Transfer of Property Subject to Debt o When property is purchased using a recourse loan, TP is treated pretty much the same Example: TP gets a loan for $5k and uses that money to buy the machine Income = $0 (b/c a loan is not income) Basis = $5k After these initial differences, the TP is treated exactly the same way o When property is purchased using non-recourse loans, the amount of debt is also considered part of the basis. Crane v. Commissioner o TP inherited a building that had a $262k mortgage (which was the exact estimated value of the building). TP claimed depreciation deductions of $25.5k an later sol the property (with the attached mortgage) for $2.5k. TP only wanted to pay taxes on the $2.5k but the IRS argued that her basis was $234k (the original value of the land minus depreciation) and her amount realized include the principal amount of the outstanding mortgage, meaning she had a gain of $23.5k. The Court held that the TP had to include the unpaid balance of the mortgage in the computation of the amount

realized on the sale and held that the TP had realized $257.5k on the sale (see 113(a)(5) which states that the basis of property received by inheritance is the FMV at the time of acquisition). o The amount realize by a seller of mortgaged property included both the cash received from the buyer and the face amount of the mortgage to which the property was subject. The seller, it was said, had received a benefit by being relieved of the mortgage indebtedness, and hence her gain was computed by subtracting her basis in the property from the total of the cash received plus the mortgage. Example: o Assume an investor purchases an acre of land for $4,000, paying $1,000 and borrowing $3,000 on a mortgage. A year later, after $200 has been paid on the mortgage principal, the property is sold for an mount exactly equal to its original purchase price, $4,000, the buyer paying $1,200 in cash and assuming the mortgage balance of $2,800. Under Crane, the Amount Realized by the seller is $4,000, that is, the cash received plus the mortgage assumed by the buyer. Since the seller has obviously realized no gain or loss on the transaction, it must be the case that his basis is also $4,000 and includes both cash investment and mortgage balance as well. Parker v. Delaney o TP acquired apartment building with 0 cash investment and un-assumed mortgage of $273,000. Using the $273k as his cost, the TP took depreciation deductions totaling $45k during the 10-year period and paid $14k on the principal of the mortgage. In year 11 he disposed of the property for no cash but still subject to an outstanding mortgage balance of $259k (that is $273 (original cost) less the $14k he paid back). The TPs adjusted basis for the property at that date was $228k($273k (original cost) less $45k of depreciation. Finding that the mortgage balance represented an amount realized in accordance with the Crane decision, the court held that the TP had a taxable gain of $31k($259k, the Amount Realized, less his basis $228k). Tufts o Similar fact pattern to Crane but in this case the value of the property was less than the mortgage. Loan amount was $1.85M and the basis was $1.85M $444k (the total amount of deductions), or $1.455M, but the FMV was $1.4M. TP argue that they had a loss of $55k ($1.455M $1.4M), but the IRS argued there was a gain of $395k ($1.85M $1.455M). Court held that assuming a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the FMV of the property. The mortgage amount is included, tax free (b/c it has to be repaid), in the basis. When a mortgage is transferred, its almost like the seller was paid in cash which he then use to pay off the mortgage, so that is clearly taxable income. o The appropriate measure of gain in Tufts was the difference between the deductions allowed, $440,000, and the amount invested by the TPs, about $40,000 = $400,000. OConnors concurrence

o If it wasnt for Crane she would have treated this as cancellation of indebtedness o Bifurcate the situation: the loan and the buying/selling of the property They would realize the loss on the property (sell for FMV and take $50k loss) AND then pay off the debt with the proceeds of the asset sale lender will have implicitly reduced the NRD from $1.85M less $1.4M = $45k cancellation of indebtedness income They have depreciated their basis from $1.85M$1.45M, so they would recognize a capital loss of $50k (difference between $1.45 basis and $1.4FMV) LEARN THIS MORE Sale of a Principle Residence 121 o General Rule: Gain from the sale of a TPs primary residence is excluded from income if the TP owned the property and used it for his primary residence for at least 2 years during the 5 year period before selling Primary residence should be determined by the place the TP spends the majority of his time. If this is not easily determinable, then you should look to the other norm factors, reg to vote? Address on license? etc. Vacant land is only included if its used as part of the TPs primary residence and is adjacent to the property o Limits $250k Single Married Exclusion $500k Only one of the married TPs must have owned the property for at least 2 years during the 5 year period before the sell Both spouses must have used the residence as his/her primary residence for at least 2 years during the 5 year period before sell Neither spouse could not have used the exclusion w/in the last 2 yrs Exception: Widowed TPs are allowed to take the $500k exclusion for married couples if the sale of the property takes place 2 years after the death of the deceased spouse and the ownership and holding periods were satisfied. o General rule: TP can only take the exclusion every 2 years. Exception: If the sale or transfer of the property is by reason of a change in place of employment, health, or to the extent provided in regs, unforeseen circumstances. 121(c)(2)(B) If the TP qualifies for this exception the amount of the exclusion will be pro-rated by the amount of time she actually owned and used the property

o Ex: Unmarried TP lived in the PR house for 1 yr then gets transfer to NY from CA. the amount of exclusion she can take for the gain of the sale of the house is $125k! o Losses and Gains above the limits Losses on primary residences are not deductible b/c they are considered personal losses Gains above the $250k and $500k limits are taxable at the TPs Marginal Tax Rate o VACATION HOMES SALE Interest on State and Local Bonds o Holders of tax-exempt bonds pay a putative tax. Tax-exempt bonds pay a lower rate of interest than taxable bonds because people buying tax-exempts are willing to accept a lower rate of interest in orer to obtain the exemption. o SEE CLASS NOTES o If only people in the highest marginal tax brackets bought these bonds, the market could equilibrate. This is a concept called putative tax. The 2,000 that they would have paid in tax, theyre basically paying in foregone interest. o 1) You must understand the concept of putative tax Can you identify the putative tax it is the $2,000 of foregone interest Tax-exempt bonds pay a lower rate of interest than taxable bonds because people buying tax-exempts are willing to accept a lower rate in order to obtain the exemption. The putative tax is equal in amount to the actual tax that is avoided. o 2) Understand the concept of tax arbitrage Borrowing money at tax-exempt rates in order to finance a tax exempt investment. Youre double dipping because youre borrowing to generate money for a tax exempt investment. Congress disallowed that with 265 If you borrow money to purchase or carry Tax Exempt bonds, 265 disallows the interest deduction The state and local governments have to be using this special financing for things that are the province of the state and local governmentsschools/roads/etc. Individual TP, T, with taxable income from a salary of $90,000 and MTR of 33%, and has no investments. T borrows $100,000 at 10%, or $10,000, per year, and uses the loan proceeds to buy tax-exempt bonds that pay 9%, or $9,000/year. Suppose that the annual $10,000 interest payment is deductible (in fact, under 265(a)(2), its not). The transactionthe loan and the investmentwould cost T $1,000 before taxes (the difference between the interest paid and the interest received), but the $10,000 deduction would reduce Ts taxes by $3,300, so T would be ahead by $2,300. The tax savings

arise because Ts interest expense is deductible, while Ts interest income is tax exempt. U.S. Treasury Bonds o 135 exempts from taxation the interest on certain US Treasury savings bonds if the proceeds of the redemption of the bonds do not exceed tuition and fees for higher education for the TP and her or his spouse or dependents. The exclusion is phased out as income rises above $40k ($60k for joint return). Interest Tax Exempt Int Rate 8% Interest 20% tax rate After tax rate

100k bond $8,000 -0$8,000

Tax 10% $10,000 $2,000 $8,000

However, when purchases have incomes such that their marginal rates are greater than the spread between the tax-exempt and the taxable rate (in the hypo 20%). For a person taxed at a marginal rate of 30%, if the taxable rate is 10 percent and the tax-exempt rate is 8%, then on an investment of $100k, the after-tax return on the taxable investment will be $7k while the after-tax return on the tax-exempt investment will be $8k. Such an investor pays a putative tax of $2,000 by buying a tax-exempt instead of an actual tax of $3,000. Congress has responded to state and local governments using their ability to borrow at low rates to finance projects having little or nothing to do with traditional government activities. Congress imposed limitations on the use of tax-exempt financing for private purposes. Exemption continues to be available, without limit, for bonds whose proceeds are used for traditional governmental purposes such as financing schools, roads, and sewers. All other bonds are called private-activity bonds and are not exempt unless they fit within a specific exception. One major exception is for exempt-facility bonds. These include bonds used to finance airports, docks and wharves, mass commuting, etc. Dividends o Dividends (that is, distributions by corporations to their shareholders) are included in gross income. 61(a)(7). In 2003, Congress gave dividends the same tax rate as is applied to capital gains. o The distinction between a corporation and its owners is reflected in the fact that a second-level tax is imposed on the corporations shareholders when corporate earnings are distributed as dividends. The divided (if in cash) is includable in the shareholders gross income in fullit is ordinary income in the customary phrase. But although taxable to the shareholder, the dividend distribution is not deductible by the corporation. Dividends are not regarded as business expenses and cannot be

deducted in computing corporate taxable income. As a result, corporate income is taxed once at the entity level when received by the company itself; when (or if) the companys after-tax earnings are distributed to the shareholders as dividends, a second tax is imposed on the shareholders themselves. o From a tax standpoint, the important point is that retained earnings are not taxed to the shareholders until they are actually distributed as dividends o Dividends (after-tax sharing of profits) No deduction to business; income to EE (taxed twice) o Qualified Dividends (not-shared profits) No deduction to business; capital gain to EE Problems of Timing Non-recognition Provisions Timing is important for 2 reasons: o (1) A TPs MTR may go down from one year to the next o (2) The time value of $$ and the ability to earn interest Exceptions that allow a TP to engage in exchanges in property without having to account for gain, but they also cant deduct for losses (i.e. 1031, 1033) o 1031: TP not required to recognize gain/loss even if that gain/loss is realized if property is exchanged for like-kind property Only applies for exchanges, not sales, of property for business Sometimes allowed for personal/residential within limits (see 1031(a)(2) and Regs 1.1031(b)) Does not apply to: Stock, bonds, securities or evidence of indebtedness, interests in partnerships, certificates of trust or beneficial interests, choses in action. Time constraints ( 1031(a)(3)) Property to be received must be identified within 45 days after TP transfers property Property is received after the earlier of either 180 days or the TPs tax return due date Definition of like-kind Regs 1.1031(a)-1(b) Revenue Ruling 82-166: Exchange of gold bullion held for investment for silver bullion held for investment not considered like-kind Statutory Non-recognition Provisions o The function of the rule is to allow TPs to defer recognition of a gain or loss to a later time Administrative feasibility; problems w/ valuation of items; Horizontal equity argument Horizontal equity all like TPs should be treated the same

The nature of the investment hasnt changed so the TPs should be treated as someone who held on to their property o Exception this subsection shall not apply to any exchange of (a) Stock in trade or other property held primarily for sale (b) stocks, bonds, or notes (c) other securities or evidences of indebtedness or interest, (d) Interests in a partnership (e) certificates of trust or beneficial interests, or (f) chooses in action o Like Kind Rule 1031 If there is a property transfer of like kind property & no boot, then the TP doesnt recognize anything and the basis gets transferred If there is a boot involved in the transaction then the TP will recognize the amount of gain up to the amount of the boot If the TP pays a boot then it becomes part of her basis A+B=C A = Original Basis B = Gain recognized C = total basis to be allocated between the like-kind property recommended & the boot. The Like-Kind Requirement Reg. 1.1031(a)-1(b) like kind refers to the nature or character of the property not its grade or quality o Private letter ruling: TP wanted to know whether the exchange of an easement for a fee interest in another property that was also burdened with the same easement was a like-kind event. o IRS said yes & they listed example in the Regs of other exchanges that are considered like-kind Nonrecognition of gain or loss from exchanges in kind 1031(a)(1) In general no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. The property cannot have been held as inventory; it must have been for investment or trade or business. It must be the same thing exchanged. 1033 Hardship situations (fire, theft, destruction, or condemnation) Non-recognition applies to property that is compulsorily or involuntarily converted & replaces w/ property that is similar or related in service or use

Cash received for involuntary conversion of property o TP must replace the property within 2 years o Anything left over after the TP replaces the property must be included in income or realized Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property o GAIN RECOGNIZED If there is gain, it is recognized to the extent of the boot. 1031(b). Thus, the amount of gain recognized is the lesser of the amount of gain realized or the amount of the boot. o A/R Basis = gain realized BASIS in Exchanged Property = Original Basis + Gain Recognized FMV of boot + any additional investment *** o Section 1031(d) Substituted basis Generally, there will be a substituted basisthat is, the basis for the property received will be the same as the basis of the property relinquished. With BOOT, it is complicated First, in a simple exchange of like-kind property with no boot, the property received must take on the basis of the property relinquished so that when the property received is ultimately disposed of in a recognition transaction, any previously realized but unrecognized gain or less will be taken into account. SECOND, when gain is recognized because of BOOT, basis must be increased in the amount recognized so that the gain will not be taxed again; the basis of the like-kind property received plus the basis of the boot must therefore equal the basis of the original property plus the amount of gain recognized. Ex: If S exchanges his X farm, with a basis of $10,000, for Y farm, worth $100,000, and receives $15,000 cash to boot, he must recognize his gain to the extent of the $15,000, and his basis must be increased by that amount. The basis of the property received plus the basis of the cash must therefore by $25,000. THIRD, the total basis thus calculated, a portion equal to the FMV of the boot must be allocated to that boot, with the remainder being allocated to the likekind property. Thus, $15,000 of the total basis must be allocated to the cash. If the boot had consisted of a tractor worth $15,000 (rather than cash), $15,000 of the basis would be allocated to the tractor. S is treated as if he had received cash equal to the tractors FMV and had used the cash to buy the tractor. FOURTH, if boot is paid, rather than received, the amount of the boot added is added to basis. If T owns Y farm, with a basis of $10,000, and exchanges it, plus $15,000 cash, for X farm, in an exchange that qualifies under 1031, Ts basis in the X farm will be $25,000.

o Hypothetical #1 A transfers Whiteacre to B in exchange for Blackacre. As basis in Whiteacre was 60; the FMV of Whiteacre is 100. How much gain does A recognize, and what basis will A have in Blackacre? Look to 1001. A sold or disposed of his property. The A/R was 100 b/c it is the sum of the money receipted plus the FMV. He received no money and the FMV was 100. The basis was 60. So, the gain was 40 Under 1031 Does this provision apply? Yes, if you assume certain conditions, such that the property was used in trade or business, etc. Also, assuming that they are like-kind. He did not receive any property that was not like-kind. So, there is no gain recognized. Now, turn to the basis of the property acquired. The rules are in 1031(d) The basis shall be the same as the property given up, which was 60. Decreased by the amount of the money received, which is zero. Add the gain recognized, which is zero. So it remains 60. o Hypothetical #2 A transfers Whiteacre to C. In exchange, C transfers Yellowacre and $15 in cash. As basis in Whiteacre was 60; the FMV of Whiteacre is 100. How much gain does A recognize, and what basis will A have in Yellowacre? First, compute the amount of gain A realized on the disposition of Whiteacre. Under 1001 the A/R shall be the sum of any money received ($15) plus the FMV of the property received (this amount not given in the problem, but should be $85, assuming the two properties are worth the same). So the A/R was $100. The adj basis was 60, so the gain realized was 40. Need to take this preliminary step to figure out the gain realized under 1001 before you turn to 1031 to figure out gain recognized Assume that they are like-kind. Then the A/R that is not like-kind was $15. Now, turn to 1031. 1031(a)(1) does not apply b/c he also got cash. However, 1031(b) does apply. Then the gain realized if any should be recognized, but in amount not in excess of the sum of the money and the FMV of the property. This is basically saying that the gain recognized is the number which is whatever is lessthe gain realized or the amount of the property or cash realized that is not in cash. In this case, it was $15. 1031(b) means the A/R would be either, (1) the total amount of gain realized or, (2) the amount of non-like kind property that is received, WHICHEVER IS LESS. Finally, the gain realized = 40. The gain recognized = 15. So, the amount preserved is 25. o 1031(d)

o Like-Kind Exchange w/ Boot If the TP receives a boot the gain is only recognized up to the amount of the boot received or the FMV of property given as boot Ex. [Gain] A has $50 basis in his building. A exchanges his building worth $100 for a new apartment building worth $90 & receives $10 in cash. His basis remains the same ($50) and he must recognize the $10 in gain. Ex [Loss] As basis - $120. FMV of the building - $100. He exchanges it for new property worth $90 & $10 in cash. As new basis $110 ($120 original basis $10 BB) Ex. [Mortgaged property] A purchased a building for $40 cash and $20 mortgage. As basis under the Crane rule is $60. FMV at the time of the exchange $100. If A then exchanges the building for a new un-mortgaged property worth $80 plus the $20 mortgage assumed by the transferee. A would recognize a gain of $20 OB + G/R = TB TB BB = NB o Total basis; boot basis (FMV); New basis o Use this formula when the question asks what is the new basis of o FORMULA = Original basis + gain recognized FMV of boot + additional investment 1033 Involuntary Conversions o Installment Sales (254-256) 453, 453A, and 453B o A set of accounting rules that permit non-recognition of gain in transactions involving the sale of property. o Congressional objective: provide relief from the harshness of an obligation to pay taxes when the TP has not received cash with which to pay them, but the benefits are enjoyed by many TPs who have no problem of cash availability but who prefer, as to most TPs, to pay taxes later rather than sooner. o Basic Approach The TP computes a ratio of gain to total expected payments and applies this ratio to each payment. o For example, suppose a TP sells property with a basis of $100,000 in return for a total stated amount of $300,000 in the form of payments to be received at the end of each of the subsequent five years of $30,000, $60,000, $30,000, $60,000, and $120,000 (plus adequate interest on each payment). Since the basis is $100,000 and the total to be received is $300,000, two-thirds of each payment received is treated as gain; the other one-third is recovery of basis. This is an inclusion ratio. Under annuities, it was an exclusion ratio.

Gross Profit = Inclusion ratio Contract Price

Investment in K Expected return

= Exclsion

Gross profit = 300,000 100,000 In this case 200,000 (gross profit) = 2/3 300,000 Basis = $100,000 Year Amount received Gain recognized 1 $30,000 $20,000 2 60,000 40,000 3 30,000 20,000 4 60,000 40,000 5 120,000 80,000 Totals = 300,000 200,000

Basis Used $10,000 20,000 10,000 20,000 40,000 100,000

Basis Remaining $90,000 70,000 60,000 40,000 -0-

Constructive Receipt (256-263) o If the check is already made out for the TP then its constructive receipt and E.B. o If the payor says he will pay but no check has been cut then its just constructive receipt o If the $$ is put somewhere (bank acct) for the TP then its just E.B. o Income is received or realized under this doctrine when it is made subject to the will and control of the TP and can be, except for his own action or inaction, reduced to actual possession. Amend (case law) It is irrelevant why the TP has failed to take control of the $$. The only determining factor is whether he could have Ask yourself is the $$ fully available to the TP? o Reg. 1.451-2 Constructive receipt of income (a) General Rule Income although not actually reduced to a TPs possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the TPs control of its receipt is subject to substantial limitations or restrictions. Thus, if a corporation credits its EEs with bonus stock, but the stock is not available to such EEs until some future date, the mere crediting on the books of the corporation does not constitute receipt. In the case of interest, dividends, or other earnings (whether or not credited) payable in respect of any deposit or account in a bank, building and loan association, savings and loan association, or similar

institution, the following are not substantial limitations or restrictions on the TPs control over the receipt of such earnings: o TP is taxed on amounts that are set aside or available if he has a legal claim over them o Amend v. Commissioner: TP sold wheat in 1944 and buyer promised to pay (in 1944) for the wheat in January of 1945. Service tried to tax TP in TPs 1944 income under the theory of constructive receipt. Court held that CR could not be applied in this case b/c the TP had no legal right to demand and receive his money until January 1945, as stated in their contract Rule: A promise to pay in the future does not fall under the doctrine NOTE: under the current installment method, TP would report his entire gain in 1945 b/c thats when he received the payment, but if he opted out of installment method he would be required to report the FMV of the buyers obligation to pay in 1944 BUT, if the TP had the option to take the money in 1944, the TP would have had to report the money in 1944 and could not have deferred recognition under the installment method o Economic Benefit: TP must report income when they have the absolute right to the income in the form of a fund which has been set aside and is beyond the reach of creditors. o Pulsifer v. Commissioner: TPs were minors when they won a sweepstakes. Their father had the winnings deposited into an account until the TPs were 21. IRS argued the money should be included in the year they gained access to it. Court held that the economic benefit rule applied b/c if the TPs wanted access to the money all they needed was for their legal representative to apply for the funds. o If the TP is required to perform substantial services or substantial conditions are posed upon him before he can actually get the $$ then EB is not applicable Constructive Receipt vs. Economic Benefit Doctrines o Under CR, the TP must be able to get at the money. However, under EB, whether or not the TP will be taxed on the $$ is based on whether the $$ has been set aside for the TP, it is irrelevant whether or not they can get to it. The $$ must be irrevocably set aside for the TP, nonforfeitable and beyond the reach of the payors creditors. o Constructive receipt this is about timing and control. Control: because its whether or not the funds are available to you. o EB doctrine you dont have to be able to access them. Here its about having enough of the indicia of ownership. Is it safe/secure enough? Do you have an absolute right to it? If enough of the indicia are present, we tax you early o Claim of right doctrine this is a dispute over ownership and over who gets the money. COR doctrine kicks in when the TP receives the funds. In this doctrine, you actually are getting the funds. The question here is what is the appropriate year to tax?

o o

o o

Here, even though your legal right might be under further dispute, the fact that you actually had the cash, thats when you should include it under income. Burrus agrees that Amend can come into his office at any time and then hell write out the check for him Constructive receipt TP receives check for $3 mil in December 30th, goes to bank to deposit it but hes not allowed to draw agains tit because it hasnt cleared the payor bank Wright v. U.S. still taxable in the current year under the E.B. doctrine Burrus writes out a check to Amend, keeps it in his office, tells Amend he can pick it up at any time definitely CR. EBD? Burrus agrees to put the money in a special account at the bank, in Amends name, but instructions say the money cant be withdrawn until January 1st? Currently taxable EBD Burrus signs a written contract, duly notarized, promising to pay Amend on January 1st of the following year. Not C.R. Its just a mere promise to pay thats in writing.

Deferred Compensation and Qualified Employee Plans (263-275) o Under a nonqualified plan, theres no limit to the amt of current compensation the TP can defer o These types of questions are analyzed under the CR & EB doctrtines o A TP is not taxable by an ERs mere promise to pay, but when money is set aside in a trust for the benefit of the EE, out of control of the ER, the EE is taxed at the time the money is paid to the trustee (but the ER will not receive a deduction for the amount to be paid in the future until the year the EE recognizes income) o 83(a) A TP must report any property (cash) given to him for performance of services unless the TPs rights in such property are subject to a substantial risk of forfeiture. o Minor v. United States: TP, doctor, entered into an agreement where he could utilize deferred compensation (he took only 10% of his fees). All the money not received by the doctor at that time was put into a trust, of which the physicians group was the beneficiary of the trust. IRS argued the amount paid into the trust was taxable. Court held that the TP did not have taxable income b/c his rights to receive benefits under the plan were subject to a number of conditions and subject to a risk of forfeiture (i.e. his receipt of benefits under the plan was contingent upon his agreement to limit his practice after he retired and refrain from competition. o Rule: The EBD is applicable only if the ERs promise is capable of valuation; that is, the ER makes a contribution to the EE deferred compensation plan that is (1) nonforfeitable; (2) fully vested in the EE, (3) out of the reach of the ERs credit (in a trust). o In Rev. Rule 60-31, an exec was employed under an agreement which provided for an annual salary plus deferred compensation, the latter to be paid after termination of

employment. The deferred payment obligation was annually credited on the ERs book and, once credited, was non-forfeitable. The IRS ruled that the exec would be taxable only when he received the deferred amounts, because a mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method. TPs can deduct contributions to IRAs. o Unlike IRAs and qualified plans, nonqualified deferred compensation is not subject to any ceiling on the amount of income that can be deferred. And unlike qualified plans, nonqualified deferred compensation is not subject to nondiscrimination rules. Beneficial for high income earners. BUT.409A Provides for immediate taxability rather than deferral if the amounts payable in the future can be accelerated by the TP-EE or if such amounts can be funded, and hence shielded from the corporations creditors, in the event of a deterioration of the corporations financial health. Qualified EE plans (i.e. benefit plans, contribution plans such as 401(k)) o Three characteristics Amounts paid into the plan by ER is not taxable for the EE when benefits are earned, only when received on retirement ER can deduct contributions into the plan immediately (so ER doesnt care whether it pays EE is salary or contribution) Inside build-up is protected as interest accrues (deferral, not forgiveness) o Downside/safeguards Necessity of including rank-and-file EEs means a range is established that is less beneficial for highly compensated EEs. Vesting requirements must be met ( 411), which ensures that after a specified period of service an EEs retirement benefit becomes nonforfeitable Part-time EEs not covered at all Penalties of 10% for early withdrawal before the age 56 unless the EE retired after age 55, died, or became disabled, or withdraws the money for qualified higher education expenses or first-time home purchases Mandatory minimum distributions before at age 70 Maximum benefit under any plan cant exceed $160k o Pensions: ER invest the $$ received from its EEs before tax earnings. The ER agrees to pay its EEs a set amount of $$ every year upon retirement. The ER bears the risk of the market o 401k: EE invests his own $$ before taxes in the market for retirement. The EE bears all the risk. The ER will usually offer some sort of match. The EE doesnt pay taxes on the $$ until he withdraws it. o IRA vs. Roth IRA

Contributions to a Roth IRA are nondeductible but there is no annual tax on the income earned by funds in an IRA and qualified distributions are tax free. A Roth IRA will be more advantageous than a normal IRA for TPs who wish to save for qualifying first-time home purchase expenses, or who are in a lower tax bracket in the time of contribution than in the time of withdrawal. Otherwise, under reasonable assumptions, the value of deducting the contribution (as in the case of a normal IRA) is exactly equal to the value not paying tax on the distribution (as in a Roth IRA), but since the Roth IRA is established with after-tax dollars, the amount sheltered from taxation, as compared with an ordinary IRA, in effect includes the amount of tax already paid. o Traditional IRA if you arent covered by an ER provided pension plan, you can contribute up to $5k into your IRA and get an above-the-line deduction on your return. Above-the-line means that even if you dont itemize your deductions, you can take advantage of this. What if your ER does have a plan? Then you can still take advantage of this if your income is below a certain level. If your ER has a plan and your income is over a certain level, you can still participate in the traditional IRA but you dont get the deduction. Why do it then? Your earnings are still not taxed until you take out the money. Tax consequences when you take out the money? Just like a defined contribution plan. Since you got a deduction going into the IRA, its all taxable. What if you put away this money and you want access to it? Theres a penalty if you take it out for most reasons. But the reasons have been eroded. You can take it out for first-time homebuyer up to $10k, also for qualified higher education; and death. Disability and medical insurance also works. o When would you rather do a Roth? When your tax rate is lower at the time of contribution. o Roth IRA you pay taxes going in and youre not taxed going out, as long as you meet the 5 year rule and the distribution has to be 59 and other stuff. o If your marginal rate of tax is the same going in as it is going out, then the Roth IRA and traditional IRA are the same. Marriage and Divorce o 1) Property Settlement (dividing the wealth) Not deductible by the payor and not income for receiver U.S. v. Davis: TP transferred stock to his ex-wife in a divorce settlement. TP argues there was no taxable event b/c the transfer was just a division of property between co-owners. The IRS argued that was a taxable event b/c the transfer was not a gift (obviously not motivated by love, affection or charity)

and said the consideration was the release of all claims to his property. Court held that the transfer was a taxable event and the TP had to report the FMV at the time of transfer less the basis as capital gains Davis has been overruled in the marriage context, so if appreciated property is being transferred between non-married persons to settle a claim, the Davis rule still applies o Ex: A transfers property to B (but they are/were not spouses). Basis = $40k and value of Bs claim = $95k As amount realized = $95k (b/c the parties are dealing at arms length, so you can assume the FMV of the stock = the value of the claim) As income = $95k - $40k = $55k Bs basis = $95k 1041 Congressional reaction to the harsh results in Davis (only applies to MARRIED couples) No gain or loss will be recognized on transfers of property between spouses or incident to divorce o Example: if Husband transfers stock to wife (Basis = $20k and FMV at time of transfer = $45k) After Davis, H would have $25k in taxable income and Ws basis = $45k After 1040, H would have no income and Ws basis = $20k NOTE: only transfers from a sole title holder to a non-title holder applies Davis or 1041. In any situation where the law is community property or if both H and W were co-owners, there is no taxable event and the property is divided. o Ex: If propertys basis = $100k and FMV = $400k, a division for joint owners means both husband and wife have a basis = $50k and FMV = $200k NOTE: 121 allows the exclusion of gain from the sale of a home if the owner has lived in the house for 2 of the 5 years prior to the sale. What if a divorce settlement allows the H to remain in a home for 6 years until the kids turn 18 while the W lives in an apartment. When the house is sold can the W exclude half of the sale proceeds from income under 121? o On its face, it doesnt look like it b/c the W hasnt lived theref or 2 of the 5 year period before the house is sold o BUT 121(d)(3)(b) allows up to a $250k deduction where a spouse is granted use of the property under a divorce.

1041 is the final basis rule. 1012 (cost), 1014 (FMV at date of gift?), 1015 (gift), 1041 (marriage basis). You do this just like you do with the giftyou substitute basis. Its not totally the same as 1015. It differs because with a gift you cant transfer losses. Here we are going to allow for transfers of loss property between spouses or former spouses. Then the loss can be recognized when the property leaves the family unit. o 2) Alimony (support issues; transferring income from more affluent to less affluent spouses) Payments received are taxable to the receiver ( 71(a)) and deductible to the payor ( 215) as an above-the-line deduction (gross income AGI) as long as certain conditions (outlined in 71) are met: Payment must be in cash (i.e. transfer of appreciated property doesnt count) Payment must be received under an instrument of divorce or separation maintenance (i.e. unmarried couple and oral agreements dont work) Parties cant agree that the payments will be non-taxable to the receiver and nondeductible to the payor Parties cant live in the same house Payments cant continue after the death of the paying spouse You can have the contract say For Federal income tax purposes, payments made under this agreement are not to be treated as gross income under Section 71 for (payee), and are not deductible under Section 215 by (payor). Payments cant be made for child support o i.e. a payment that is called alimony but terminates when a child dies or reaches 18 is treated as child support rationale is that it the payor has custody of the child, eh wouldnt be able to deduct those child-rearing costs, so he shouldnt be allowed to claim deductions just b/c the child doesnt live iwht him Payments cant be front-loaded o Only payments that are substantially equal for the first three years are considered alimony o This requirement distinguishes between regular support payments (alimony) and once-and-for-all settlements (property settlements) o If the 1st year payments exceed the average of the 2nd and 3rd year payments by more than $15k, payments are initially treated like alimony but the excess amounts are recaptured

in the 3rd year (meaning the payor must include the excess in income to make up for the amount previously deducted) Ex: TP pays $50k in alimony in year 1 and nothing in years 2 and 3. The amount recaptured in the 3rd year is $35k ($50k $15k threshold) which must be included in the TPs income And the receiver, who included $50k as income in the 1st year, must deduct $35k in year 3 Section 682 allows one spouse to set up an alimony trust for the other. The income from the trust is taxable to the payor. o Ex. A has to pay B $25k/yr for 2 yrs. A has bonds that pay interest of $25k/yr. A can create a trust w/ a duration of 2 yrs w/ B as the income beneficiary and w/ the reversion to A. the amounts received will be taxed to B each year for 2 years and then returned to A.

o 3) Child Support Not deductible by the payor and not income for receiver Even if the paying parent defaults on payments, the receiving parent can not claim a deduction o Marriage Penalty/Bonus Tax legislation since 2001 has substantially reduced marriage penalties and increased bonuses, by raising the standard deduction for couples to twice that for single filers and by setting the income ranges of the 10 and 15% brackets for couples to twice the corresponding ranges for individuals. Legislation also raised the starting point for the EITC phase-out range by $3,000 for married. TPs who might qualify for the EITC can suffer particularly large marriage penalties if the income of one spouse disqualifies the other from getting the credit. However, marriage can increase the EITC if a nonworking parent marries a low-earning worker. Deductions for Cost of Earning Income o Current Deduction v. Capitalization (465-480) 161, 162, 263 262 Personal Living Expenses no deduction allowed for personal expenses except as otherwise noted Rule: 162(a) allows the deduction of all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business (a) Exception: Capital Expenditures o No deduction even if they are ordinary & necessary biz expenses

o Ordinary and Necessary Business Expenses (a) 162. Trade or business expenses In general 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 o (1) A reasonable allowance for salaries or other compensation for personal services actually rendered; o (2) Traveling expenses (including amts 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 of business; nad o (3) Rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the TP has not taken or is not taking title or in which he has no equity o 263 Capital expenditures What is a capital expenditure? Something that will produce income over a period of time; its useful life must be more than a year Cars are wasting assets Property is a wasting asset General Rule 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 estate. This paragraph shall not apply to o (B) research and experimental expenditures deductible under 174 o (C) Soil and water conservation expenditures under 175 o (D) Expenditures by farmers for fertilizer, etc., deductible under 180 o (G) Expenditures for which a deduction is allowed under 179 Encyclopedia Britannica v. Commissioner TP corporation took a deduction for an advance it paid to a publisher for its encyclopedias as a business expense. The court held that the payment was a capital expenditure and thus not deductible as a business expense. The court reasoned that the work the TP paid for was intended to generate income over a period of years. The court stated the purpose of 162 and 263 is to match up expenditures with the income they generate. However, when the income is generated over a period of years the expenditures should be classified as capital

If encyclopedias decided to scrap part of the work from the publisher, it still would not be allowed a loss deduction. The amount paid for the original manuscript would be treated as the cost of what was ultimately used. Authors, writers, photographers, and artists do not have to follow 263 rules 263A(h) Repairs & Alterations (a) Incidental Repairs are not capitalized o Repair is something with a limited purpose to continue the propertys operation for the duration of its expected life or to maintain its norm outlay & existing capacity (b) Unless, it extends the life of the asset then it must be capitalized o Mt. Morris Drive-In the TP bought a tract of farm and ladn with the intentions of making a drive-in movie theater. The construction on the farm caused flooding of the neighbors property. The neighbors threatened to sue so the TP added a drainage system. The court held that the costs for the drainage system were a capital expenditure and thus not deductible. o Expenses acquired by unplanned events will more than likely not require capitalization / deduction o PTs property was 25 yrs old. Stuff from the refinery next to TPs property started to seep into the basement where she kept animal hides. The authorities told her she had to fix it or shut down. The court held the expense was deductible even though it was essentially a repair. One reason maybe because the property was so old the property had been fully depreciated so there was no basis in the property. Any repairs done to the property after full deprecation are life-prolonging and thus deductible. Hypos o Small repairs no capitalization o Raising the floor to protect from flood damage capitalized o Cement flood wall capitalized o Steel beams to fix a sagging floor capitalized Even if the TP is required to make the repair by the government, it will not be automatically deductible. o Hotel Sulgrave the TP was required by the city to install sprinkler system in a hotel in order to comply with the city fire code. The court held the system had to be capitalized

Business Intangibles & Advertising Marketing, advertising and things that relate to sales do not have to be capitalized INDOPCO Regs o Cover expenses for acquiring intangibles related to business even though they may provide future benefits E.g. goodwill, customer lists, covenants not to compete, an assembled workforce, license to practice law, training materials, etc. Regs 1.263(a)-4(b)(3) o If the expense creates or facilitates the creation of a separate & distinct intangible then it must be capitalized Separate & distinct an intangible asset that has a (1) measurable value in moneys worth (2) legally protected; and (3) Capable of being sold, transferred, or pledged Separate & apart from a trade or business De minimis rule excludes expenses under $5k o Cell phone exception cell phone companies can deduct the cost of the free cell phone it gives to customers to induce them to sign multi-year contracts. Lease of purchase (a) If the property is something so unique & specific to the TP that the original owner could have no significant interest in the property then it must be capitalized Starrs Estate the TP leased a weird sprinkler system for 5 years. The court held that the system had to be capitalized because of the individualized nature of the equipment, the fact that the lease for the thing was renewable at no cost, that the owner of the thing really did not want it back or had no interest in claiming it back. Prepaid expenses 461(g) A TP must capitalize must forms of prepaid interest Uniform Capitalization Rules of 263A UNICAP the costs of producing inventory & other self-created assets must be capitalized Not only includes the salaries of people writing the manuscript but such indirect expenses as the allocable share of the salaries of supervisory & admin. people. Extends to all manufacturers

Which of the following costs must be included in inventory by a manufacturer under the UNICAP rules? o Factory insurance yes o Advertising no o Payroll taxes for factory EEs yes o Research and experimentation costs no o Repairs to factory equipment yes o General and administrative expenses that do not relate to production no

COMBINE THESE At one end of the spectrum 162(a): allows deduction for ordinary and necessary expenses paid incurred in carrying on any trade or business o i.e. office expenses, salaries, auto expenses, travel, entertainment expenses o These are above-the-line deductions A salaried associate would rely on this section to deduct unreimbursed expenses such as legal periodicals, bar dues, CLEs BUT when the EE uses 162 instead of the ER: o He is subject to the 2% threshold ( 67) BUT, EE can ease this by establishing reimbursement allowance arrangement ( 62(a)(2)(A)) o His deductions they are below-the-line deductions (AGI taxable income) 212: allows deductions for expenses of generating income from sources other than a trade or business o i.e. stocks and bonds, so TP could deduct fees paid to investment advisors, expenses incurred in attending investment seminars, etc. These are below-the-line deductions (AGI taxable income) o 212 is subject to the 2% threshold ( 67) At the other end of the spectrum 262: no deductions allowed for personal, living or family expenses 67: limits the amount of deductions allowed Certain deductions are allowed only if they, in the aggregate, exceed 2% of AGI

o i.e. deductions under 212 and deductions under 162 if claimed by EEs o Ex: TP earns $40k and spends $5k continuing his education. He tries to deduct the $5k under 162 2% of $40k is $800, so TP can only deduct $4.2k ($5k $800). Business Expenses Code 162(a) authorizes the deduction of all the ordinary and necessary expenses incurred during the taxable year in carrying on any trade or business. 212 extends the same treatment to costs associated with investment activities. 163 relating to interest 167 and 168 relating to depreciation Taking this approach, the principal limitations on the scope of the section are usually said to involve the following issues: (1) Whether or not the particular expense was ordinary and necessary (2) Whether the expenditure was a current expense or a capital investment; and (3) Whether the expense was incurred in business or for personal reasons Capital Expenditures 263 (with help from 263A) disallows deductions for the cost of acquiring property, the useful life of which extends substantially beyond the close of the taxable year. 167 authorizes an annual allowance the exhaustion or wear and tear of capital assets, so that in the case of plant, equipment or other productive assets with limited useful lives the construction or acquisition cost will be recovered on a year-by-year basis through the medium of depreciation or amortization deductions. Whether its an expense or a capital expenditure usually boils down to timing. If the outlay in question is an expense, it is deductible at once and reduces the taxable income of the current year. If the outlay is a capital expenditure, it is deductible over a period of years; in the case of tangible property the number of years in the recovery period is specified by 168. If the outlay is a capital expenditure but the property acquired is of indefinite useful life, then the outlay is recoverable only as an offset against the proceeds of final sale. Repairs or alterations In addition to the original acquisition cost of plant, machinery and the like, which always has to be capitalized, the Regulations require that subsequent expenditures that alter the propertys capacity or function, or that extend its useful life, be capitalized as well.

Incidental repairs are permitted to be deducted as a current expense under 162(a). A machine that breaks down because a vital part malfunctions can be said to have sustained a kind of accidental impairment that resembles a casualty in the sense that it results in a sudden loss in the value of the machine itself and is more or less unexpected. If the TPs equipment were damaged by a true casualtyfire, etc.the resulting loss (unless covered by insurance) would be deductible as a casualty, while subsequent outlays for repair would be capitalized and added back to basis. Machine with adj basis $10k sustains $2k damage in fire, the casualty loss is fully deductible and the basis of the machine is reduced to $8k. if the TP then spends $2k to repair the machine, the oulay is nondeductible because there was already a deduction. An equivalent loss attributable to a malfunction results in no deductible loss and no reduction of basis. But if the TP repairs the machine at the same $2k, a current deduction is permitted and the overall tax effects are just the same. A repairas distinguished from a use-expanding or life-prolonging alterationis described by the Regulations as an outlay whose limited purpose is to contribute to the propertys operation for the duration of its expected life or to maintain its normal output and existing capacity.. The Mt. Morris case can be contrasted with the Midland Empire Packing case, in which the question was whether the cost of lining basement walls with concrete to preven toil seepage created by a neighboring refinery should be treated as a deductible repair or as a capital expenditure. The walls of the basement, which had been used for 25 years for the storage of meat and hides, had proved entirely satisfactory until the refinery went up, at which point the said seepage began and the TP was told by federal inspectors that it had a line the walls or shut down. The TC held that the expenditure was essentially a repair and hence deductible.

o Overview of Depreciation and Expensing (504-512) 167, 168, 179, 197, 1245 Recovering costs over a period of time. Recover costs as asset decreases in value. Periodic deductions of cost recovery Tax depreciation is different from economic & financial accounting depreciation. This is more generousallows acceleration of cost recovery Theory: cost of an asset should be recovered & apportioned over its useful life

Steps: (1) See if it is a capitalized expense; (2) Determine value based on 1011, 1014-1016, Reg. 1.165(g)-(1); (3) Determine depreciation deduction; (4) Reduce adjusted tax basis by deprecation deduction under 1016(a)(2) Depreciation system doesnt take inflation into account Depreciation starts when the item is placed in service. ONLY ALLOWED FOR BUSINESS EXPENSES Land does not depreciate Inventory N/A Intangible assets do not depreciation they amortize IP assets that amortize Goodwill; going concern value; the value of work force in place; and the value of current relationships with customers or suppliers These assets amortize over 15 years Under settled practice, those outlays, although made for the purpose of maintaining or enhancing the value of a capital asset, are themselves treated as currently deductible business expenses. In combination then, the TP is permitted both (1) to amortize a capital asset that is presumed (by 197) to have a limited useful life, but then also (2) to deduct as a current expense the annual cost of rebuilding that asset in order to prevent its useful life from ever coming to an end. Limiting Expensing 179 allows for an immediate deduction of the full amount of personal property, e.g. widget maker, furniture can be immediately expensed to the extent that the item exceeds $2 million Up to $500k is available for immediate expensing Anything below $2 million must be capitalized Question may appear on the exam as whether the TP can expense In 2012, the maximum amount deductible under 179 is $125,000. The $125,000 ceiling is reduced by one dollar for every dollar by which the TPs cost of 179 property purchased during 2012 exceeds $500,000. Thus, no deduction is allowed under 179 to a TP paying $625,000 or more in 2012 for machinery and equipment. 167 Provides for annual deduction to reflect decline in value of long-lived business and investment assets Property is depreciable if its useful life is definite and finite Land cannot be depreciable because its useful life is indefinite Policy Behind Choice of Depreciation At first, depreciation allowance intended as realistic allowance for assets decline in value. Useful life of tangible assets no longer determined on

individual basis. Each asset falls into a category and is depreciated over applicable recovery period. Tax depreciation of tangible assets no longer intended to mirror economic decline. Accelerated Cost Recover System (ACRS) 168 3-year (special tools); 5-year (computers, copiers and trucks), 7-year (office furniture, fixtures and equipment), 10-year; 15-year; 20-year 3, 5, 7, and 10 year property receive 200% (double) declining balance 15 and 20 property receive 150% declining balance depreciation Real Property Under ACRS Real property receives S-L depreciation Recovery period for residential real property is 27.5 yrs Recovery period for other real property is 39 years Land is not depreciable Separate cost of acquiring or constructing building from that of acquiring land and depreciate. Mid-Year Convention By convention, personal property receives a depreciation deduction of half of a full year deduction in 1st year placed in service. Similar half-year convention applies in year of disposition Conventions Mid-year convention creates incentive to place property in service at years end Thus, if more than 40% of all property is placed in service in last quarter a mid-quarter convention applies. For real property, there is a mid-month convention. Deduction is pro-rated to reflect number of months in service.

Gains and Losses from Capital Assets (609-624) 1221, 1222, 1223, 1231 o More than 12 months long-term capital asset & preferential treatment Less than 12 months short-term capital gains o 1221 A capital asset is something that the TP is holding for appreciation or income In contrast property held for sale to a customer is not included as a capital asset Inventory Copyrights & similar items not purchased Publicans of the US government o 1202 small business stock TP must have held the qualified stock for more than 5 years o Holding period 1223

A capital asset must be held for at least 1 year in order to receive the preferential tax rate for capital gains The original owners holding period is transferred with the capital asset when he gifts it to someone else If the capital asset is received from a dead person or received by a person who received it from a dead person, the 1 year holding period will be satisfied if the TP sells/disposes of the capital asset within a year after receipt Capital assets held for less than a year (Short Term ST) receive ordinary tax treatment o Capital Losses Rule: Capital Losses are only deductible up to the amount of Capital Gain $3k per year The TP cont to take the $3k deduction until the loss is depleted (up to the amount of the Capital Gain) o Problems: #1. T has taxable income of $3 mil T has LTCL of $100k T has no other capital losses during that year T can only deduct $3k. Then he carries over the rest until its depleted o Netting Capital Gains & Losses (1) Determine the long term capital gain and loss (2) Determine the short term capital gain and loss (3)(a) If step 1 & 2 equal negative losses then you get $3k a year for losses o It comes first from short term and then long term (3)(b) If step 1 & 2 equal positive numbers then they are taxed at the respective CG tax rate (3)(c) If theres a positive and a negative then we combine them & the larger number determines the tax treatment LTCG $5k STCG $1k STCL (-$2k) o Net the ST-negative $1k Then combine the two $5k LTCG o 1231 Quasi Assets Inventory Depreciable property used in a trade or business or real property used in a trade or business

Any recognized gain on the sale or property used in a trade or business When you sell at a gain you get capital gain treatment and when you sell at a loss you get ordinary loss treatment Depreciation Recapture o T purchases a machine for $50k for business use $50k is the basis 1012 $20k of depreciation $30k adjusted basis 1016 Amount received for machine when sold $40k $30k adjusted basis $10k ordinary income To the extent of depreciation taken you must recapture o 1231 property include depreciable property and real property (e.g. buildings and equipment) used in a trade or business and held for more than one year. Timber, coal or domestic iron ore, and some types of livestock are also covered. 1231 property DOES NOT include: inventory, property held for sale in ordinary course of business, artistic creations held by their creator, government publications. o A TP may net all 1231 gains and losses. If the result is a loss, then it is an ordinary loss. If the result is a gain, then the gains and losses will be treated s long term capital gains and losses. WHAT IS SEC. 1231 PROPERTY? Types of 1231 property include depreciable property and real property (e.g. buildings and equipment) used in a trade or business and held for more than one year. Timber, coal or domestic iron ore, and some types of livestock are also covered. o 1221 property does NOT include: inventory; property held for sale in ordinary course of business; artistic creations held by their creator; government publications. o Non-recaptured loss is covered by 1231(c). It refers to a situation when a TP claims a 1231 loss in year one, but seeks a 1231 gain in any of years 2-6. Any gain which is less than or equal to the loss in year one will be characterized as ordinary income, rather than LTCG. For example, A takes a $20k 1231 loss in year one, and in year two takes a $10k 1231 gain. All of the gain will be ordinary income. If in year three A takes another $25,000 1231 gain, $10,000 would be ordinary income (to recapture) and $15,000 would be LTCG. It is the best of both worlds because it allows the favorable capital gains while avoiding the negative implications of capital loss treatment. Ordinary losses are 100% deductible while capital losses are subject to the $3k limit. EXAMPLE:

DDF Corp sold land it had used for parking and storage for 20 years for $575,000. Its basis in the land was $68,000. It also sold some manufacturing equipment for $125,000 that it replaced with more modern equipment. The equipment sold had a basis of $760,000. o Determine the amount and character of DDFs gains or losses on these sales o If DDF has no other property transactions, how is the net gain or loss treated? DDF has $507,000 ($575,000 $68,000) Section 1231 gain on the land sale. It has a $635,000 ($125,000 $760,000) Section 1231 loss on the sale of the equipment The $635,000 loss is netted against the $507,000 gain. The result is a $128,000 net Section 1231 loss that is deducted against DDFs ordinary income. Barry Corp sold a machine used in its business for two years for $27,000. The machine originally cost $24,000 and it had an adjusted basis at the tiem of the sale of $17,000. Determine the amount and type of gain realized on the sale o $27,000 $17,000 = $10,000 total gain. $7,000 ($24,000 $17,000) of the gain is taxed as ordinary income due to Section 1245 recapture; the remaining $3,000 gain is Section 1231 gain. THE AMOUNT GREATER THAN THE ORIGINAL BASIS IS THE 1231. THE AMOUNT BELOW THE BASIS IS THE 1245 RECAPTURE. Grid Corp owns a bank of boring machines. They regularly replace two machines each year. In the current year, the company sold Machine 8 for $12,000. It was purchased six years earlier for $40,000 and its adjusted basis was $14,000. Machine 6 was sold for $24,000. It was purchased four years ago for $45,000 and had an adjusted basis of $19,000. o How much gain or loss is realized on each asset? o What is the character of the gain or loss? o If the company disposed of no other assets during the year, how are the results of these sales treated for tax purposes? Machine 8: $12,000 (A/R) $14,000 (adj basis) = $2,000 loss realized. Machine 6: $24,000 $19,000 = $5,000 gain realized The machines are Section 1231 property. The loss on Machine 8 is a section 1231 loss; the gain on Machine 6 is ordinary income to Section 1245 recapture because the gain is less than the prior depreciation deductions ($45,000 $19,000 = $26,000 accumulated depreciation). LESS THAN THE ADJUSTED BASIS. If it was over the Adjusted Basis, it would be LTCG. Jonas, an individual, acquired a building nine years ago for $650,000. He sold it in the current year for $680,000 when its adj basis was $500,000. Determine the amount and type of gain or loss realized on the sale. o If the building is a factory $680,000 $500,000 = $180,000 Section 1231 gain; $150,000 ($650,000 $500,000) of this gain would be unrecaptured Section 1250 gain subject to a maximum 25% rate.

o If the building is an apartment complex Same as above o If Jonas is a corporation rather than an individual $30,000 Section 291 recapture ($150,000 x 20%); the remaining $150,000 ($180,000 $30,000) of gain is Section 1231 gain. Barbara had the following Section 1231 gains and losses in the previous four years o Year Section 1231 gain (loss) o 1 $50,000 o 2 ($45,000) o 3 $20,000 o 4 $15,000 = $40,000 How will Barbara treat a $25,000 gain in year 5? o Only $10,000 of the $25,000 of Section 1231 gain must be recaptured as ordinary income; Barbara deducted a $45,000 Section 1231 loss in year 2, and $35,000 ($20,000 + $15,000) was recaptured in years 3 and 4. The remaining $15,000 ($25,000 $10,000 recaptured) of the gain is simply Section 1231 gain Is there any unrecaptured Section 1231 loss remaining? o There is no un-recaptured loss remaining after year 5. o 1245 trumps 1231 1245 Gain from disposition of certain depreciable property This is used for personal property used in business or trade, i.e. machines, cpu, etc. Use this when the TP has taken depreciation deductions TP only realizes gain from amount of property used in trade or business that exceeds her adjusted basis o Ex. TP sells depreciable property used in trade or business o TPs original basis = $80k o Depreciable deductions $70k o Adjusted basis = $10k o NO gain unless the sale price is above $10k Regs 1.1245-1(b)(2) Example 1. On January 1, 1964, Brown purchases 1245 property for use in his manufacturing business. The property has a basis for depreciation of $3,300. After taking depreciation deductions of $1,300 (the amount allowable), Brown realizes after selling expenses the amount of $2,900 upon sale of the property on January 1, 1969. Browns gain is $900 ($2,900 amount realized minus $2,000 adjusted basis). Since the A/R upon disposition of the property ($2,900) is lower than its recomputed basis ($3,300, i.e. $2,000 adjusted basis plus $1,300 in depreciation deductions), the entire gain is treated as

ordinary income under 1245(a)(1) and not as gain from the sale or exchange of property described in 1231. Example 2. Assume same facts as above, except that Brown exchanges the 1245 property for land, which has a FMV of $3,700, thereby realizing a gain of $1,700 ($3,700 amount realized minus $2,000 adjusted basis). Since the recomputed basis of the property ($3,300) is lower than the A/R upon its disposition ($3,700), the excess of recomputed basis over adjusted basis, or $1,300, is treated as ordinary income under 1245(a)(1). The remaining $00 of the gain may be treated as gain from the sale or exchange of property described in 1231 o A/R = $60k o Adj basis = $30k o Gain = $30k o The first $20k will be treated as ordinary income o The other $10k will be treated as 1231 gain

o 1250 This is not for LAND only real property When real property is transferred the portion of the gain reflecting previously taken depreciation deductions must be recaptured Hypo: Apartment building = $500k (minus) Depreciation = $45k = Adjusted basis $455k A/R = $520 (minus) $455k = Gain $65k Capital gain $45k (the amount of the deduction) 25% $20k capital gain 15% Lock-in effect This is one the prof says persuades her the most It may force people to hold on to stuff that is not the most proficient use of the capital Generally, real estate investment property, as defined under Section 1250, must be depreciated for income tax purposes. A maximum rate of 25% will apply to whats called unrecaptured section 1250 gain and a maximum rate of 15% will apply to the balance of the gain. Unrecaptured section 1250 gain refers to the portion of gain that is eligible for capital gain treatment even though it is attributable to previously allowable deprecation. Thus, if you sell, at a gain of $200,000, a building on which $90,000 of depreciation deductions were allowable to you through the time of sale,

$90,000 of the gain is unrecaptured section 1250 gain that will be taxed at a rate of 25%. The remaining $110,000 of the gain will be taxed at 15%. Personal Deductions Below the Line Deductions o Casualty Loss The amount of TPs loss (Lesser in drop in FMV or Basis) 10% of AGI $100 (floor) $$ received from insurance company for reimbursement = Casualty Loss Deduction Basis = FMV or TPs original basis, whichever is lower What is a casualty? o Losses of property not connected to a trade or business o Losses from fire, storm, shipwreck or from other casualty or theft Suddenness Requirement The damages have to have occurred w/ the same suddenness comparable to that caused by fire, storm or shipwreck o Termite damage not deductible o Diamond rings It seems like theres no real logic to what type of event triggers a ND Depreciation in value of property Chamales v. Commissioner OJ Simpson case. TPs argued that the murders were sudden, unexpected, and unusual events and b/c the hoopla surrounding the murders have caused them to suffer a casualty loss. o INVOLUNTARY CONVERSION Reinvested $$$ - Rule The gain must be recognized. Its the lesser of the amount not reinvested or the gain realized. Negligence Negligence by the TP per se is not a bar to casualty loss deduction; however, gross negligence by the TP is o Gross negligence willfully and knowingly damaging or allowing to be damaged TPs own property 165(h)(1) de minimis rule Theres a $100 floor for casualty loss 165(h)(2) The net casualty loss is limited to the extent it exceeds 10% of your income. Anything below 10% of your gross income is ND Limited to the drop in FMV or the adjusted basis in the property Hypo Uninsured car basis: $20k

FMV $20k, Hurricane destroys car dropping the FMV to $8k. the casualty loss: $12k $100 floor = $11,900 deduction o Medical Expenses 213(a) Medical expenses above 7.5% of the TPs AGI are deductible The % increases to 10% for AMT HSA Health Savings Account Thing I have TP can take this deduction even if they do not itemize Not subject to AMT & no phase out amount Most questions involve what is medical care?

Interest o What is the loan for? Business The proceeds must be used for the production of income in order to get the deduction Personal Acquisition must be used to buy, improve or build a home Limited to $1 million Home equity can be used for anything If it looks like a home equity loan, treat is as such Limited to whichever is less: o $100k or the FMV of the property o Business or Investment Interest Interest incurred in a trade or business or for the production of income Limitations 163(d) o Investment Interest The amount of interest deducted for an investment cannot exceed the net amount of the investment income in a tax year The amount of interest remaining can be carried over to the next year for the deduction o (B) Exceptions the Term investment interest shall not include: (i) Any qualified residence interest o Tracing If a TP takes a loan secured by his business and uses the $$ for personal use, the interest is not deductible

Its the use of the loan proceeds that determines whether its personal or business interest. Interest is allocated based on the use o Personal Interest Only interest accrued for qualified residences is deductible as personal interest Allowable for one other home such as a vacation home but it is limited to $1m for both This includes interest on home equity loans o It doesnt matter what the TP uses the $$ from the home equity loan for o FMV Limit this is limited to the lesser of $100k or the FMV of the property (-) any acquisition indebtedness on the property Ex: The FMV of the home is $975k and the Acquisition Indebtedness is $900k. Only the interest on the $75k is deducted. {Its the lesser of the FMV of $975} $975k $900k = $75k < $100k so you get the $75k Problem: B buys a home for $300k w/ a loan of $115k and $185k from her savings. A month later she takes out another $125k loan. The acquisition indebtedness is $115k. The other loan is only deductible for $100k (home equity debt) o This is not allowable for 2nd mortgages when the TP takes the mortgage after he has paid off the original principal of the residence Whether the property is a qualified residence is determined at the time the interest is accrued Acquisition Indebtedness Section 163(h)(3)(B) Interest paid on debt used to buy, build or improve the qualified residence that is secured by the property is deductible Limit $1 m Problems: o TP has $50k in savings. She uses the $50k to buy a Benz & the next day borrows $50k to buy a fast-food place that she intends to operate. Will the interest on the loan be deductible? Yes. The loan was used for a business expense If she would have bought a benz then it wouldnt be deductible b/c the loan was used for personal uses. o TP owns her house outright. The FMV on the house is $100k. She takes out a $50k home equity loan. Is the interest deductible if:

(a) She uses the $$ to buy a Benz Yes. It doesnt matter what the TP does w/ the $ (b) She uses the $$ to buy taxable bonds NO no deduction for interest accrued on debt used to buy nontaxable items (c) She uses the $$ from the loan to buy taxable bonds, but at the time she holds $50k of tax-exempt bonds NO b/c the loan allowed her to continue to hold tax-exempt bonds. But for the law she would have had to sell the bonds. o TP has a portfolio of stocks and bonds worth $200k. The annual income from the portfolio is $12k. Joe borrows $50k on a margin loan % uses the proceeds to buy a Benz. Since the proceeds are used to buy the Benz, the interest on the loan is personal interest. Sell $50k worth of stock. Use the proceeds to buy the car and then borrow on the margin later and then buy the stocks back. Student Loan Interest 221 TP is allowed to deduct up to $2,500 for interest paid on student loans for himself, spouse & dependents The deduction is subject to certain income limitations o SALT State and Local Taxes 154 An itemize deducting TP is allowed to deduct the $$ it pays in SALT Deduction appears on Schedule A Rationale Alternatives to current method of SALT taxation Allow people who pay more in taxes than the benefits they receive get a deduction for the excess And people who receive more benefits than what they pay in taxes would be taxed on the excess Not give the deduction at all treat the payment as a gift User fees are deductible Foreign taxes Miscellaneous Itemized Deductions o 67 TP is allowed a below-the-line deduction for non-reimbursed employment expenses. Only to the extent that they exceed 2% of your AGI o The purpose is to disallow expenses that have a general personal purpose o NOT ALLOWED UNDER AMT o Employee Business Expenses

Reimbursed EE business expenses are treated as above-the-line expenses, therefore, they are deducted from the TPs gross income The ER takes the deduction as a business expense Unreimbursed EE business expenses are treated as below-the-line expenses/deductible only to the extent that they exceed 2% of AGI o Miscellaneous deductions are added back to the taxable income for AMT purposes o 62(a)(19) TP is allowed an above-the-line deduction for attorneys fees & court costs for claims of unlawful discrimination under civil rights law o TP does not have to itemize in order to get the deduction (20) Costs involving discrimination suits, etc. Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the TP in connection with any action involving a claim of unlawful discrimination or a claim of a violation. Deduction Problem on Exam o Miscellaneous Itemized Deductions Wanda who is in the 35% bracket and itemizes, has AGI of $400,000 and total Miscellaneous Itemized Deductions of $11,800. $400,000 x .02% = $8,000. $11,800 (deduction) $8,000 (threshold amount) = $3,800. $3,800 x .35 = $1,330 o Medical expenses Take AGI (multiply by) .075 (for 7.5% of GI). Then Do unreimbursed medical expenses (subtracted by) the 7.5% of AGI. Multiply by marginal tax rate. Personal & Dependency Exemptions o 151 every TP is allowed a deduction for a personal exemption o No phase outs!! o 151(c) Dependents Each TP gets an exemption for each qualifying dependent child Must be younger than 19 or 24 (if in school) Has not provided more than of his own support; and Lives w/ the TP for more than a year Each TP gets an exemption for each qualifying relative A family member other than the child or someone who lives w/ the TP Receives more than of his support from the TP Has gross income less than the exemption amount Support Test in Case of Child of unmarried parents 152(e) Who gets the exemption for the kid? The person who:

o (A) a child receives over one-half of the childs support during the calendar year from the childs parents (i) who are divorced or legally separated under a decree of divorce or separate maintenance (ii) who are separated under a written separation agreement, or (iii) who live apart at all times during the last 6 months, and -o (B) such child is in the custody of 1 or both of the childs parents for more than one-half of the calendar year, such child shall be treated as being the qualifying child or qualifying relative of the noncustodial parent for a calendar if the requirements described in paragraph (2) or (3) are met Credit Based on Personal Circumstances o ***Refundable even if you have no tax liability the government will give you a check*** o Earned Income Tax Credit 32 Qualifying child must be < 19 years old Is refundable, thus the TP receives a payment from the government for the excess above his tax liability Is like a wage subsidy or supplement FILL THIS IN BETTER Marriage Penalty If the TPs would qualify for the EITC then they shouldnt get married. This would reduce the amount of the EITC b/c their income would increase However, if the TPs wouldnt qualify separately (one has kinds but no income and the other has qualifying income but no kids) then they would get a benefit from marriage b/c they would then qualify for the EITC o Credit for the Elderly & the Permanently & Totally Disabled 22 provides a credit for senior citizens who pay for their own retirement, either from investments or working The credit is reduced for single TPs w/ income of $7,500 or above, married $10k or higher and married but filing separately to $5k o Child Tax Credit 24 provides a $1k credit for each dependent child under the age of 17 This is reduced by $50 for every $1k of AGI above the threshold amount o Threshold amts:

Married $110k; Single $75k o Phase-out amounts (once the TPs income hit these levels, they would no longer be entitled to the CT credit Married: $150k; Single $115k Middle income people benefit from this credit 24(d) the CT credit is refundable to the extent that 15% of the amount by which the TPs earned income exceeds $8,500 Ex: TP w/ earned income of $20k. The TP would be entitled to $1,725 (15% x $20k $8500). o 15% x Earned Income $8,500 = CT credit o Child Care Expenses 21 21 provides a credit for household services <$3k for 1 kid <$6k for 2 or more kids The percentage used to the determine the amount of the credit declines as the income rises. o 20% high income o 35% low income Qualifying Dependent must be Younger than 13 years old for healthy children Any age if the dependent is disabled Qualifying Child Care Provider Relatives Cool but not: o One of the TPs dependents o TPs child under 19 yrs even if TP cant claim the child o Spouse o Parent of the qualifying child When the MTR is lower than the CC credit the TP should use the 21 credit Employment Related Expenses The CC credit is not allowed for the cost of overnight camps Problems TPs Earned Income = $10k - $3k (new amt for 2010) $7k x 15% = $1050 is the amt refundable to the TP o The family has to make $11,400 (standardized deduction) before it pays any taxes plus the $14,600 for the 4 exemptions ($3,650x4) = $26k (the TP has to make this before they will have any tax liability Hypo: under which would the TP get the better benefit 21 if the TP is low income & has 2 children

o 35% x $6k = $2,100 21 if the TP is high income the rate is increased to 20% x $6k (for 2 children) = $1,200 129 $5k x 35% (MTR) = $1,750 {high income} o The low income TP would be better off w/ the 21 The high income TP would be better off w/ the 129 Unemployed Full-Time Student If the TP is a full-time student, his yearly income will be imputed as $3k if he has one child, $6k if he has 2 children. 21(c) o 129 allows the TP to exclude the value for child care provided by the ER, both on-site & off-site o 129 ER provided or paid Child Care Limit $5k Formula Amount paid x MTR = value to the TP/Tax savings Education o See handouts o Coverdell Education Savings Accounts 530: the TPs are permitted to contribute up to $2,000 annually to a tax-favored investment account set up to fund the beneficiarys future tuition, books, and R&B. There is NO DEDUCTION going in, but the earnings on the investment youve set aside for the beneficiary are not taxed. As long as the beneficiary uses the funds to pay for education, they will not be taxable. This is the grandparent IRA. A lot of people cant take advantage of this b/c of the phase-outs. If youremaking money below the phase-out you probably dont have disposable income to contribute. Whats special here? They expanded what they can be used for to include a lot more. This is the only one you can use K-12. 529 no income phase-outs. Qualified Tuition Program (QTP). No one was using 530 once 529 is enacted. o Can deduct courses that improve Xs skills as a teacher and do not qualify him for a new trade or business under the Regulations. Allowed an English teacher to deduct for courses at local college to become Principal or History teacher. o Philly lawyer could not deduct the cost of taking bar exam in NJ because it qualifies him for a new trade or business. Law students in accredited law schools cannot deduct the expenses for their education leading to a J.D. b/c they are qualifying for a new trade or business. In this case, however, the MBA degree does not qualify Mike for a new trade/business, and improves the skills used in his profession. Alternative Minimum Tax (AMT)

o Has its own tax rate structure 26% on the first $175k 28% on amounts over $175k o Formula AMTI AMT exemption = AMT Taxable Excess AMT Taxable Excess x AMT rate = TMT TMT Reg Tax = AMT TP has to pay the larger of the TMT or the reg tax o Long-term capital gain Still get the same preferential tax rate; however, it may cause you to be subject to the AMT o Exemption preference $45k for married couples $33,750 for single TP 50% of AMT for married filing separately o Personal exemptions & certain itemized expenses are not allowed for AMT purposes Miscellaneous expenses & SALT o Problems w/ AMT It hasnt been adjusted for inflation while everything has Doesnt provide a dependent deductions So large families get caught in the AMT net when based on the amount of $$ & the amount of people who rely on it they are really not rich. o Even though the highest tax rate under the AMT (28%) is lower than in regular tax (35%), AMT victims are paying more b/c theyre paying on a greater amount of taxable income. o Taxable income, add back the preferences = AMTI. Once you get to your AMTI, you are allowed to an exemption amount. (see above). Only those at target income levels are allowed the exemption. If youre married filing joint, its $150,000. o AMTI with the exception = AMT excess Then take AMT excess (multiply) by 26% = TMT The first 175k is taxed at 26%, the next dollar after is taxed at 28% TMT = tentative minimum tax Then you compare the TMT and the regular tax. If the regular tax is lower, then you pay the difference between the TMT and the regular tax.thats on top of the regular tax you already pay. Tax Shelters o Elements of a Tax Shelter 1) Deferral 2) Conversion

3) Tax arbitrage Involves incurring expenses that are deductible in order to generate income that is tax favored, thus creating a tax loss in excess of any economic loss. Congress has shut down arbitrage in one way through Section 265 this is a situation where its a legitimate tax reduction technique (buying tax exempt bonds and not including interest on tax return). 265 says youre not allowed to borrow to carry or purchase tax-exempt bonds. You can do it, but you cant take the deduction for the interest expense. 4) Misattribution of income 5) Ambiguity in statute Codification of the Economic Substance Doctrine GARs (general anti-avoidance rules). This has existed as a judicial doctrine since 1934. SC developed a doctrine called business purpose. They couldnt find a statutory problem in the specific case, but said it so obviously contradicted the intent of congress b/c it lacked a substantial business purpose. o 7701(o) requires that the transactions you enter into have some economic substance. There are two requirements: 1) Objective test (transaction has economic substance only if theres a meaningful change to the TPs pre-tax economic position). The predominant motivation of your act cant be save taxes 2) Subjective must have a substantial non-tax purpose o This is linked to sanctions. This is what raised the money. It was a 20% strict liability penalty on any underpayment with respect to your transaction which is found to not have economic substance (if you disclose it). If you dont disclose, the penalty goes upt o 40%. o If a judge decides the economic substance doctrine is relevant in a particular case, the transaction will be treated as possessing economic substance only if: (1) it changes in a meaningful way (apart from Federal income tax effects) the TPs economic position, and This first requirement involves an objective analysis of the economics of the transaction (2) the TP has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. This looks to the subjective motivation of the TP.