Federal Income Taxation Lecture Notes (Fall 2022) PDF

**Federal Income Taxation -- Prof. Hanna (Fall 2022)** [I. Overview of Federal Income Taxation 7](#_Toc120480537) [A. Gross Income 7](#gross-income) [B. Deductions 7](#deductions) [C. Calculating Federal Income Tax Liability 8](#calculating-federal-income-tax-liability) [D. Internal Revenue Code Provisions 9](#internal-revenue-code-provisions) [E. Tax Brackets and History 10](#tax-brackets-and-history) [F. Sources of Federal Tax Law 10](#sources-of-federal-tax-law) [1. Taxation Tools: 11](#taxation-tools) [i. Internal Revenue Code of 1986 as amended 11](#internal-revenue-code-of-1986-as-amended) [ii. Treasury regulations 11](#treasury-regulations) [iii. Case law 11](#case-law) [iv. Revenue rulings and Revenue Procedures 11](#revenue-rulings-and-revenue-procedures) [v. Legislative history 11](#legislative-history) [G. Tax Policy Considerations 12](#tax-policy-considerations) [1. Efficiency 12](#efficiency) [2. Equity/Fairness 12](#equityfairness) [3. Simplicity 12](#simplicity) [H. Tax Reform Act of 1986 12](#tax-reform-act-of-1986) [I. Cary Brown Model 12](#cary-brown-model) [J. Bonds 13](#bonds) [1. Bond Purchase price 13](#bond-purchase-price) [2. Bond & Market Relationship 13](#bond-market-relationship) [3. Zero coupon bonds 13](#zero-coupon-bonds) [4. Interest Earned on Bonds 13](#interest-earned-on-bonds) [K. Tax Systems 13](#tax-systems) [1. Progressive rate system 13](#progressive-rate-system) [2. Flat tax system 13](#flat-tax-system) [3. Consumption tax system 14](#consumption-tax-system) [4. Wage tax system 14](#wage-tax-system) [5. Stanley Surrey 14](#stanley-surrey) [6. Scheduler Taxation 14](#scheduler-taxation) [II. Gross Income---§61 15](#gross-income61) [*A.* Income Defined 15](#income-defined) [B. Realization Event Doctrine 16](#_Toc120480570) [**1.** **Mark to Market Method** 16](#mark-to-market-method) [III. Inclusions to Gross Income 16](#inclusions-to-gross-income) [A. Compensation for Services---§61(a)(1) 16](#compensation-for-services61a1) [B. Prizes and Awards 16](#prizes-and-awards) [**1.** **Exceptions:** 16](#exceptions) [C. Scholarships 17](#scholarships) [**1.** **3 Exceptions:** 17](#exceptions-1) [i. Qualified Scholarship §117(a), §117(b)(2) 17](#qualified-scholarship-117a-117b2) [♠ Qualified tuition and related expenses---§117(b)(2) 17](#qualified-tuition-and-related-expenses117b2) [♠ Qualified Tuition Reduction---§117(d) 17](#qualified-tuition-reduction117d) [**♠** Educational assistance programs: 17](#educational-assistance-programs) [ii. Athletic Scholarships 17](#athletic-scholarships) [iii. Educational Grants 17](#educational-grants) [D. Annuites 18](#annuites) [E. Compensatory and Punitive Damages---§104 18](#compensatory-and-punitive-damages104) [**3.** **Exceptions:** 18](#exceptions-2) [F. Social Security Benefits 18](#social-security-benefits) [G. Discharge of indebtedness---§61(a)(11); §108 18](#discharge-of-indebtedness61a11-108) [1. Loans Between Taxpayers 18](#loans-between-taxpayers) [iv. Borrowed Funds 18](#borrowed-funds) [v. Repayment of Principal 18](#repayment-of-principal) [vi. Payment of Interest 19](#payment-of-interest) [2. Exceptions 19](#exceptions-3) [i. Bankruptcy 19](#bankruptcy) [ii. Insolvency 19](#insolvency) [iii. Qualified principal residence acquisition indebtedness 19](#qualified-principal-residence-acquisition-indebtedness) [iv. Student loans 19](#student-loans) [v. Cancellation of debt (COD) 19](#cancellation-of-debt-cod) [vi. Contested liability doctrine 19](#contested-liability-doctrine) [3. Gambling Losses 19](#gambling-losses) [IV. Exclusions from Gross Income 20](#exclusions-from-gross-income) [A. Punitive Damages for Wrongful Death 20](#punitive-damages-for-wrongful-death) [B. Compensatory Damages for Physical Injury 20](#compensatory-damages-for-physical-injury) [**1.** **Settlement payments---Rev. 85-98** 20](#settlement-paymentsrev.-85-98) [**C.** Gifts and Inheritances 20](#gifts-and-inheritances) [1. Gift Defined 20](#gift-defined) [2. Exceptions: 20](#exceptions-4) [D. Employee Benefits 21](#employee-benefits) [1. Certain Fringe Benefits § 132 21](#certain-fringe-benefits-132) [a. No -Additional Cost Service §132(b)(2) 21](#no--additional-cost-service-132b2) [**b.** Qualified employee discount **§132(c)** 21](#qualified-employee-discount-132c) [vii. Working Condition Fringe §132(d) 21](#working-condition-fringe-132d) [**a.** De minimis fringe benefits **§132(e)** 21](#de-minimis-fringe-benefits-132e) [♠ Certain eating facilites **§132(e)(2)** 22](#certain-eating-facilites-132e2) [b. Qualified Transportaion §132(f) 22](#qualified-transportaion-132f) [**i.** Meals and lodging **§119** 22](#meals-and-lodging-119) [**ii.** Educational assistance up to \$5,250 per employee **§127(a)(1), (2)** 22](#educational-assistance-up-to-5250-per-employee-127a1-2) [**iii.** Employer-provided insurance §106(a) 22](#employer-provided-insurance-106a) [E. Life-Insurance Proceeds 22](#life-insurance-proceeds) [F. Some Prizes/Awards 22](#some-prizesawards) [i. Prizes transferred to charity 22](#prizes-transferred-to-charity) [ii. Employee Achievement Awards 23](#employee-achievement-awards) [**iii.** Olympic/Paralympic winner payments & medal value 23](#olympicparalympic-winner-payments-medal-value) [G. Imputed Income 23](#imputed-income) [1. 2 Types of Imputed Income: 23](#types-of-imputed-income) [viii. TP Lives in Home Owned by Business 23](#tp-lives-in-home-owned-by-business) [H. Gain from the sale of a principal residence 23](#gain-from-the-sale-of-a-principal-residence) [I. Income Earned Abroad 24](#income-earned-abroad) [J. Interest earned on municipal ("tax-free" state and local") bonds **§103(a)** 24](#interest-earned-on-municipal-tax-free-state-and-local-bonds-103a) [K. Short Term Rental of TP's Home 24](#short-term-rental-of-tps-home) [V. Haig-Simons Income 24](#haig-simons-income) [VI. Separation and Divorce 25](#separation-and-divorce) [**A.** Alimony Payments 25](#alimony-payments) [1. Divorces Before 2019: 25](#divorces-before-2019) [**2.** Divorces After 2019: 25](#divorces-after-2019) [B. Property Settlements---§1041 25](#property-settlements1041) [**1.** Nonrecognition rule 25](#nonrecognition-rule) [ix. Transfer incident to divorce---**§1041(c)** 25](#transfer-incident-to-divorce1041c) [C. Attorney's Fees 25](#attorneys-fees) [VII. Gain from Dealings in Property 26](#gain-from-dealings-in-property) [A. Fundamental principles of property transactions (*Crane*): 26](#fundamental-principles-of-property-transactions-crane) [B. Amount realized 26](#amount-realized) [C. Amount recognized 26](#amount-recognized) [D. Adjusted basis 26](#adjusted-basis) [1. Adjustments for Lessee Improvements 26](#adjustments-for-lessee-improvements) [E. Debt Financing 27](#debt-financing) [i. Recourse Debt 27](#recourse-debt) [ii. Non-recourse Debt 27](#non-recourse-debt) [2. Assumption 27](#assumption) [3. Take subject to 27](#take-subject-to) [x. Interest Payments 27](#interest-payments) [F. Basis Rules 27](#basis-rules) [1. Basis Rule \#1 -- Property Acquired by Purchase 27](#basis-rule-1-property-acquired-by-purchase) [2. Basis Rule \#2 -- Property Acquired in an Exchange for Property 27](#basis-rule-2-property-acquired-in-an-exchange-for-property) [3. Basis Rule \#3 -- Property Acquired where FMV is included in GI 27](#basis-rule-3-property-acquired-where-fmv-is-included-in-gi) [4. Basis Rule \#4 -- Property Acquired by Gift 28](#basis-rule-4-property-acquired-by-gift) [i. If the donor also got the property by gift 28](#if-the-donor-also-got-the-property-by-gift) [5. Basis Rule \#5 -- Part-Gift/Part-Sale Transaction 28](#basis-rule-5-part-giftpart-sale-transaction) [♠ Transferee's Basis 28](#transferees-basis) [♠ Transferor's Basis 28](#transferors-basis) [o Transferee is a Charitable Organization 28](#transferee-is-a-charitable-organization) [o Encumbrance with a mortgage 28](#encumbrance-with-a-mortgage) [6. Basis Rule \#6 -- Transfer of Property Between Spouses 29](#basis-rule-6-transfer-of-property-between-spouses) [7. Basis Rule \#7 -- Property from a Decedent 29](#basis-rule-7-property-from-a-decedent) [ii. Inherent from death of a spouse 29](#inherent-from-death-of-a-spouse) [VIII. Assignment of Income 30](#assignment-of-income) [A. Ownership Defined 30](#ownership-defined) [1. Agreements 30](#agreements) [a. Anticipatory agreements 30](#anticipatory-agreements) [b. Disclaiming income before it is earned 30](#disclaiming-income-before-it-is-earned) [B. Type of Assignment 31](#type-of-assignment) [1. Kiddie tax 31](#kiddie-tax) [2. Vertical assignment 31](#vertical-assignment) [3. Horizontal assignment 31](#horizontal-assignment) [IX. Deductions -- Generally 32](#deductions-generally) [A. Deductions 32](#deductions-1) [1. Business 32](#business) [2. Investment 32](#investment) [3. Personal 32](#personal) [B. Categories of Deductions: 32](#categories-of-deductions) [1. Above-the-line 32](#above-the-line) [2. Below-the-line 32](#below-the-line) [iii. Standard deduction 32](#standard-deduction) [iv. Itemized deduction 33](#itemized-deduction) [X. Business Deductions 33](#business-deductions) [**A.** Business Expenses 33](#business-expenses) [1. Ordinary 33](#ordinary) [2. Necessary 33](#necessary) [3. Expense 33](#expense) [4. Paid or incurred during the taxable year 33](#paid-or-incurred-during-the-taxable-year) [5. Carrying on an active, preexisting trade or business 33](#carrying-on-an-active-preexisting-trade-or-business) [B. Must rise to the level of trade or business 33](#must-rise-to-the-level-of-trade-or-business) [C. Employees are in the trade or business of providing services to their employer 34](#employees-are-in-the-trade-or-business-of-providing-services-to-their-employer) [D. Expenses to find a new job 34](#expenses-to-find-a-new-job) [E. 168(k) Deduction 34](#k-deduction) [1. Requirements 34](#requirements) [v. Examples of ordinary and necessary business expenses 34](#examples-of-ordinary-and-necessary-business-expenses) [F. Qualified improvement property 34](#qualified-improvement-property) [G. Start-up Expenses---§195 35](#start-up-expenses195) [1. Requirements: 35](#requirements-1) [2. 4 ways to deduct under §195: 35](#ways-to-deduct-under-195) [**H.** Qualified Business Income Deduction **§199A** 35](#qualified-business-income-deduction-199a) [I. Demolition Deduction §208(b) 36](#demolition-deduction-208b) [XI. Deductions for Investment Activities 36](#deductions-for-investment-activities) [A. §212 Deductions 36](#deductions-2) [1. Requirements: 36](#requirements-2) [2. §212 vs. other provisions: 36](#vs.-other-provisions) [XII. Deductions Not Limited to Business/Profit-Seeking Activities 37](#deductions-not-limited-to-businessprofit-seeking-activities) [**A.** Interest Deductions 37](#interest-deductions) [1. Disallowance of Deduction for Personal Interest **§163(h)(1)** 37](#disallowance-of-deduction-for-personal-interest-163h1) [2. Qualified Residence Interest (QRI) §163(h)(3) 37](#qualified-residence-interest-qri-163h3) [i. Qualified Residence 37](#qualified-residence) [ii. Acquisition indebtedness 37](#acquisition-indebtedness) [iii. Home equity indebtedness 37](#home-equity-indebtedness) [**3.** Investment Interest Deductions 37](#investment-interest-deductions) [iv. Tax-exempt investment interest 38](#tax-exempt-investment-interest) [**4.** Taxes -- §164 38](#taxes-164) [v. Federal Income Tax 38](#federal-income-tax) [vi. State & Local Income and Sales Tax 38](#state-local-income-and-sales-tax) [**vii.** Refund from State & Local Taxes 38](#refund-from-state-local-taxes) [**viii.** Limitation on individual deductions (2018-2025) **§164(6)** 38](#limitation-on-individual-deductions-2018-2025-1646) [XIII. Deductions for Individuals Only 39](#deductions-for-individuals-only) [A. Miscellaneous Itemized Deductions 39](#miscellaneous-itemized-deductions) [**B.** Itemized Deductions Allowed **§67(b)(1)-(12)** 39](#itemized-deductions-allowed-67b1-12) [C. Specified Losses 39](#specified-losses) [XIV. Depreciation and Losses 40](#depreciation-and-losses) [A. Theories of Depreciation 40](#theories-of-depreciation) [1. Samuelson Depreciation 40](#samuelson-depreciation) [B. Depreciation Deductions **§167; §168** 40](#depreciation-deductions-167-168) [1. Requirements for depreciable property: 40](#requirements-for-depreciable-property) [C. Modified Accelerated Cost Recovery System (MACRS) 40](#modified-accelerated-cost-recovery-system-macrs) [1. Steps for depreciation: 40](#steps-for-depreciation) [D. Depreciation for Tangible Property §168 41](#depreciation-for-tangible-property-168) [**1.** Applicable Depreciation Method (ADM) **§168(b)** 41](#applicable-depreciation-method-adm-168b) [ix. 200% declining balance method §168(b)(1)(A) 41](#declining-balance-method-168b1a) [x. 150% declining balance method §168(b)(2) 41](#declining-balance-method-168b2) [xi. Straight-line method §168(b)(3) 41](#straight-line-method-168b3) [xii. Applicable Recovery Period (ARP) §168(c); §168(e)(1) 41](#applicable-recovery-period-arp-168c-168e1) [xiii. Applicable Convention (AC) §168(d) 41](#applicable-convention-ac-168d) [♠ Half-year convention 41](#half-year-convention) [♠ Mid-month convention 41](#mid-month-convention) [xiv. Bonus Depreciation 42](#bonus-depreciation) [xv. Election to expense certain depreciable business assets §179 42](#election-to-expense-certain-depreciable-business-assets-179) [♠ Limitations **§179(b)** 42](#limitations-179b) [♠ Requirements: 42](#requirements-3) [→ Difference between §168(k) and §179 42](#difference-between-168k-and-179) [E. Depreciation of Real Property 42](#depreciation-of-real-property) [1. Residential Real Property 42](#residential-real-property) [2. Nonresidential Real Property 42](#nonresidential-real-property) [F. Amortization of Intangible Property §197; §167(i)(2) 43](#amortization-of-intangible-property-197-167i2) [1. Requirements: 43](#requirements-4) [**xvi.** Amortizable assets 43](#amortizable-assets) [G. Losses §165 43](#losses-165) [XV. Income Producing Entities 44](#income-producing-entities) [**A.** Corporations 44](#corporations) [1. C---Corporations 44](#ccorporations) [2. S---Corporations 44](#scorporations) [**B.** Partnerships 44](#partnerships) [1. General partnership 44](#general-partnership) [2. Limited partnership 44](#limited-partnership) [C. Up-C structure 44](#up-c-structure) [D. Limited liability companies 44](#limited-liability-companies) [**E.** Trusts 45](#trusts) [1. Complex trust 45](#complex-trust) [2. Simple trust 45](#simple-trust) [F. Buying/Selling a Business: 45](#buyingselling-a-business) [XVI. Capital Expenditures 45](#capital-expenditures) [A. Capital Expenditures Defined 45](#capital-expenditures-defined) [B. Repairs vs. Improvements 45](#repairs-vs.-improvements) [1. Expense 45](#expense-1) [2. Capital Expenditure 45](#capital-expenditure) [XVII. Capital Gains and Losses 46](#capital-gains-and-losses) [**A.** Capital Asset 46](#capital-asset) [**B.** Not Capital Assets **§1221(a)** 46](#not-capital-assets-1221a) [C. Holding Period for Capital Assets 46](#holding-period-for-capital-assets) [D. Substitute-for-ordinary-income doctrine 46](#substitute-for-ordinary-income-doctrine) [E. 5th Circuit Test---Property Held in Ordinary Course of TP's Trade or Business 47](#th-circuit-testproperty-held-in-ordinary-course-of-tps-trade-or-business) [F. Amendments 47](#amendments) [1. The Eisenhower Amendment (1950) 47](#the-eisenhower-amendment-1950) [2. The Nixon Amendment (1969) 47](#the-nixon-amendment-1969) [3. General Charity Deduction Rule 47](#general-charity-deduction-rule) [XVIII. Characterization Preferences 48](#characterization-preferences) [A. Characterization Rules: 48](#characterization-rules) [1. Plateau 1 48](#plateau-1) [2. Plateau 2 48](#plateau-2) [**B.** Long-Term Capital Gain or Loss 48](#long-term-capital-gain-or-loss) [**C.** Short-Term Capital Gain or Loss 48](#short-term-capital-gain-or-loss) [D. Net Capital Gain or Loss 48](#net-capital-gain-or-loss) [E. Netting Possibilities 48](#netting-possibilities) [**F.** Cubbyholes **§1(h)** 49](#cubbyholes-1h) [**1.** 28% Rate Gain (collectibles) **§1(h)(4)-(5)** 49](#cubbyhole-128-rate-gain-collectibles-1h4-5) [**2.** Unrecaptured §1250 Gain **§1(h)(6)** 49](#cubbyhole-2unrecaptured-1250-gain-1h6) [**3.** Adjusted Net Gain **§1(h)(3)** 49](#cubbyhole-3adjusted-net-gain-1h3) [**G.** Limitation on Capital Losses **§1211** 49](#limitation-on-capital-losses-1211) [**1.** Corporations **§1211(a)** 49](#corporations-1211a) [**2.** Individuals **§1211(b)** 49](#individuals-1211b) [H. Order of Taxation on GI 49](#order-of-taxation-on-gi) [I. Capital Gain or Loss Computation 49](#capital-gain-or-loss-computation) [XIX. Recharacterization under §1231 50](#recharacterization-under-1231) [A. Gains and Losses Under §1231 50](#gains-and-losses-under-1231) [1. Compulsory Conversion 50](#compulsory-conversion) [2. Involuntary Conversion 50](#involuntary-conversion) [B. Prof. Hanna's Hotchpots \[§1231\] 50](#prof.-hannas-hotchpots-1231) [**1.** Sub-hotchpot 50](#sub-hotchpot) [2. Main Hotchpot §1231(a)(1)-(a)(4)(B) 50](#main-hotchpot-1231a1-a4b) [XX. Depreciation Recapture 51](#depreciation-recapture) [A. §1245 51](#section-3) [1. Recomputed Basis 51](#recomputed-basis) [2. Sale, exchange, or involuntary conversion 51](#sale-exchange-or-involuntary-conversion) [3. Some other disposition (condemned) 51](#some-other-disposition-condemned) [4. Exceptions: 51](#exceptions-5) [B. §1250 51](#section-4) [1. Additional depreciation **§1250(b)(1)** 51](#additional-depreciation-1250b1) [XXI. Bad Debt Deductions 52](#bad-debt-deductions) [A. Two ways a bad debt may result for an Individual: 52](#two-ways-a-bad-debt-may-result-for-an-individual) [1. Loan of money that TP cannot collect 52](#loan-of-money-that-tp-cannot-collect) [2. Nonpayment for rendered goods or services 52](#nonpayment-for-rendered-goods-or-services) [B. Worthless Securities: 52](#worthless-securities) [XXII. Tax Accounting Methods 53](#tax-accounting-methods) [A. Cash Method 53](#cash-method) [1. Actual Receipt 53](#actual-receipt) [2. Constructive Receipt 53](#constructive-receipt) [3. Deductions 53](#deductions-3) [**4.** Pre-payment of expenses 53](#pre-payment-of-expenses) [xvii. 12-Month Rule 53](#month-rule) [B. Accrual Method 54](#accrual-method) [1. Inclusion in GI 54](#inclusion-in-gi) [2. Deduction 54](#deduction) [3. Pre-payment of Services 54](#pre-payment-of-services) [xviii. *Shlude* Doctrine 54](#shlude-doctrine) [♠ Exceptions to *Schlude*: 54](#exceptions-to-schlude) [♠ *Artnell* Exception 54](#artnell-exception) [C. Installment Method 55](#installment-method) [1. Gross profit ratio 55](#gross-profit-ratio) [XXIII. §267 Disallowance of Losses 56](#disallowance-of-losses) [XXIV. Tax Credits 57](#tax-credits) Overview of Federal Income Taxation =================================== Gross Income ------------ 1. Is there undeniable accession to wealth, clearly realized and controlled by TP? 2. Is it GI or is there an exclusion provision (or nonrecognition provision)? 3. How much is gross income? 4. Is it the TP's gross income or someone else\'s (assignment of income)? 5. When is it gross income (method of accounting)? 6. What is the character (ordinary income unless \"gain\")? - **[§1245]** (gain on depreciable personal property) or **[§1250]** (gain on depreciable realty) - **[§1221/1222]** (sale or exchange of a capital asset- long-term or short term) or **[§1231]** (primarily focusing on sale or exchange of "property used in the trade or business\") 7. Is there net capital gain? **[(§1222(11)]** = NLTCG-NSTCL - **[§1(h)]** add qualified **dividend** income to net capital gain and then cubbyhole 8. What is the TP's basis in any property received (usually cash is received but could be an exchange transaction like *Philadelphia Park* or found property)? 9. What is the holding period of any property received (usually fresh holding period but property from gift = tacking of holding period; property from decedent = long-term holding period)? Deductions ---------- Normally payments associated with (1) Trade or Business, and (2) Investments, profit-oriented **[Deduction Provisions]** 1. §162 -- ordinary necessary business expenses 2. §163 -- interest 3. §164 -- taxes 4. §165 -- losses 5. §166 -- bad debts 6. §167/§168 -- depreciation 1. Is there a detriment, obligation, burden, or expenditure (payment)? 2. Is it deductible (provision allowing deduction + nonrecognition provision not applicable)? 3. How much is deductible? 4. Is it the TP's deduction or someone else\'s? 5. When is it deductible (method of accounting)? 6. What is the character (ordinary deduction unless \"loss\")? a. **[§1221/1222]** (sale or exchange of a capital asset long-term or short-term) or **[§1231]** (focus on sale or exchange of \"property used in the trade or business\") b. Are capital losses greater than capital gains [(**§1211**] (limitation) and **[§1212]** (carryforward))? 7. What is the basis of any property received (usually no property is received)? 8. What is the holding period of any property received? Calculating Federal Income Tax Liability ---------------------------------------- - **Exclusions from GI** - **[Life insurance ]** - **[Inheritances]** - **[Gifts]** **§102(a)** - **[State and local bond Interest]** - **[Damages]** for a **[physical injury ]** - Receipts from **[health or accident insurance]** are excludable. - Up to \$250,000 in gain (\$500,000 for married couples filing jointly) **[on the sale of a personal residence is excludable.]** i. **[Interest]** on **[higher education loans ]** ii. **[Reimbursed business expenses]** iii. **[Employer Provided lodging and meals ]** iv. Below certain thresholds, **[Social Security]** income is not taxed. v. Employee **[fringe benefits]** vi. **§162** ---Trade or business deductions, vii. **[Capital losses]** from the sale or exchange of property; viii. Deductions attributable to rents and royalties; ix. Contributions to approved pension plans of self-employed individuals, individual x. retirement accounts ("I.R.A.s"), health savings accounts ("H.S.A.s"), and medical xi. savings accounts ("M.S.A.s"); xii. Alimony payments made pursuant to agreements entered before 2019; xiii. Qualified charitable contributions up to \$600. i. The *greater of:* a. **Standard deduction:** i. \$12,950 for individuals; and ii. \$25,900 for married couples filing jointly. b. **Itemized deductions include:** iii. Mortgage interest; iv. state, local, real property, and personal property taxes (capped at \$10,000); v. casualty losses incurred as a result of a federally declared disaster; vi. gambling losses (deductible to the extent of the gambling gains); vii. charitable contributions (up to 60% of AGI); viii. and medical expenses (up to 7.5% of AGI). - **disallowed until 2025** - An individual who earns business income (earned through an S corporation, a partnership, a sole proprietorship, or an LLC), this provision allows you a **deduction of 20% of your GI.** Internal Revenue Code Provisions -------------------------------- - Basis -- 1012 - Adjusted Basis -- 1016(a)(1) - Gain/Loss Realized -- 1001(a) - Amount Realized -- 1001(b) - Gain/Loss Recognized -- 1001(c) - Gifts -- 102(a) - Gross Income -- 61(a) - Transferred Basis -- 1015(a) - Transfers of Property between Spouses -- 1041 - No gain/loss recognized -- 1041(a) - Spouse transferred basis -- 1041(b) - Stepped-up basis -- 1041(a)(1) - Part Gift/Part Sale -- Reg 1.001-1(e)(1) - Discharge of Indebtedness -- 108 - Cancellation of Debt -- 61(a)(12) - Exclusion of Damages for Physical Personal Injuries -- 104(a)(2) - Alimony -- 71 - Alimony Payor Deduction -- 215(a) - Alimony Recipient GI -- 71(a) - Alimony Recapture -- 71(f) - Child Support -- 71(c) - No GI/Deduction for Child Support -- Reg 1.71-1T(c)QA16 - Child Support Common Age (1 yr) -- Reg 1.71-1T(c)QA18 - Trade or Business Deductions -- 162 - Depreciation -- 167 - MACRS -- 168 - Elections -- 179 - Goodwill -- 197 - Expenses for production of income -- 212 - Payee spouse can deduct portion of attorney fees relating to alimony or tax aspect under 212; Reg. 1.262-1(b)(7) - Interest -- 163 - Disallowance of deduction for personal interest -- 163(h) - Qualified residence interest/home mortgage interest -- 163(h)(3) - Investment interest -- 163(a) - Expenses & Interests Relating to Tax Exempt Income -- 265 - Adjusted Gross Income -- 62 - 2% floor on miscellaneous itemized deductions -- 67 - Overall limitation on itemized deductions -- PEASE -- 68 \[suspended\] - Allowance of deductions for personal exemptions -- PEPS -- 151 - Gross Income Upon Receipt -- 451(a) - General Rule for Taxable Year of Inclusion -- Reg 1.451-1(a) - Taxable Year of Deduction -- 461(h) - Capital Asset Defined -- 1221 - Other Terms Relating to Capital Gains/Losses -- 1222 - Losses -- 165 - Net Capital Gain -- 1222(11) - Holding Period of Property -- 1223(9) - Cubbyhole \#1 -- 28% rate gain -- 1(h)(4),(5) - Cubbyhole \#2 -- Unrecaptured 1250 gain -- 1(h)(6) - Cubbyhole \#3 -- Adjusted Net Capital Gain -- 1(h)(3) - Limitation of Capital Losses -- 1211 - Sub-hotchpot -- 1231(a)(4)(c) - Main Hotchpot -- 1231(a)(1) -(a)(4)(B) - Gain from Depreciable Personal Property -- 1245 - Gain from Depreciable Real Property --1250 - Bad Debt Deduction -- 166 **\ ** Tax Brackets and History ------------------------ 1. **1950s -- Max 92%** 2. **Pre-1981 -- Max 70%** i. Economic Recovery Tax Act (ERTA) (1981) ii. Accelerated depreciation; piece of property depreciates faster over shorter time period iii. Instead of an equal amount of depreciation each year, depreciation deductions are higher on the front end then decrease over time 3. **Pre-1986 -- Max 50%** iv. TRA '86 (Reagan) -- 28%; 15% (lowest rate) v. If your income was high enough, the first part of your income would be taxed at 15% and then second chunk would be taxed at 28%. Apply low rates to a much broader base 4. **1990 Act (Bush 41) - 31%; 28%; 15%** vi. Viewed as a necessity because of the budget deficit. 5. **1993 Act (Clinton) - 39.6%; 36%; 31%; 28%; 15%** vii. Thought high income would start at 36 & then pay 10% on that. (36% + 3.6% = 39.6%) 6. **2001-2003 (Bush 43) - 35%; 33%; 28%; 25%; 15%; 10%** viii. big tax cut to help stimulate the economy **Pre-1986 Act** **1986 Act** **1990 Act** **1993 Act** **97-98** **2003 Act** --------------------------- ------------------ -------------- -------------- -------------- ----------- -------------- **Ordinary Income rate** **50%** **28%** **31%** **39.6%** **39.6%** **35%** **Net Capital Gain rate** **20%** **28%** **28%** **28%** **20%** **15%** **Preference** **30%** **0%** **3%** **12%** **20%** **20%** 7. 2013 ATRA (Obama) - 39.6%; 35%; 33%; 28%; 25%; 15%; 10% - ix. American Tax Payer Relief Act - this act added back the 39.6%. Idea was that the tax rate during the Clinton years for the highest income TP. x. Kept low rate from Bush & added high rate from Clinton 8. 2017 TCJA xi. §199A xii. 20% deduction applies to business (entrepreneurial) income, not salary xiii. Alternatively, could tax the entire GI at 29.6% instead of 37% **2022 Tax Brackets** ------------------------ ------------------------------------------------------ **Income:** **Tax:** Below \$9,525 10% \$9,525 -- \$38,700 \$952.50, plus 12% of the excess over \$9,525 \$38,700 -- \$82,500 \$4,453.50, plus 22% of the excess over \$38,700. \$82,500 -- \$157,500 \$14,089.50, plus 24% of the excess over \$82,500. \$157,500 -- \$200,000 \$32,089.50, plus 32% of the excess over \$157,500. \$200,000 -- \$500,000 \$45,689.50, plus 35% of the excess over \$200,000. \$500,000+ \$150,686.50, plus 37% of the excess over \$300,000. Sources of Federal Tax Law -------------------------- 1. Congress enacts laws 2. Treasury Department -- implements laws; binding regulations 3. Internal Revenue Service -- administers laws; nonregulatory guidance ### Taxation Tools: #### Internal Revenue Code of 1986 as amended 1. (The Code) (THE TAX LAW) Any changes in the IRC are called "tax reforms" Most of the IRC comes from the Tax Reform Act of 1986 and the Tax Cuts and Jobs Act of 2017 (TCJA) #### Treasury regulations (Regulations, NOT the law, issued by the treasury---executive branch) Issued/promulgated by the treasury department to interpret and explain the IRC Final Regulations (most persuasive) Temporary Regulations (effective upon issuance) Proposed Regulations (least persuasive, awaiting comment/hearing process) #### Case law - District court and court of federal claims refund jurisdictions - Tax court litigate first, then pay taxes if you lose - **Courts with Original Jurisdictions** - Tax Court Not yet paid taxes - Court of Federal Claims - District Court #### Revenue rulings and Revenue Procedures a. [Revenue ruling] -- formal application of tax laws to a specific recurring fact pattern; less deference than regulations - Fact pattern w/ IRS answer - 1st \# = year issued; 2nd \# = number of rulings that year b. [Revenue procedure] -- like a revenue ruling but dealing with procedural rather than substantive tax law c. [Private letter ruling] -- response to request for guidance from specific TP #### Legislative history *Mayo Foundation for Med. Educ. & Research v. US* Wwhen Congress has not directly addressed an issue but has delegated rule-making authority to an agency, and the agency's interpretation is a reasonable construction of what Congress has said, the agency's rule will be upheld *Chevron* Congress authorized treasury to enact regulations interpreting IRC Has congress directly addressed the question at issue in a case? If not, does the agency's action constitute a reasonable interpretation of the statute? If reasonable must uphold Tax Policy Considerations ------------------------- ### Efficiency a. Investments should go where they will get their highest return; as a general proposition, taxes should interfere as little as possible with business and investment decisions b. Inverse relationship with equity; more efficiency means less equity ### Equity/Fairness c. Individuals with the same income should pay the same amount in taxes ### Simplicity d. How simple it is for government to administer & people to comply Tax Reform Act of 1986 ---------------------- - revenue-neutral act (it was not intended to raise or lower the gov't total tax income); - goal = broaden the tax base and lower income tax rates - **Two ways to broaden the tax base:** 1. Increase items included in GI (same as cutting out exclusions, such as **§74(c)** seriously limiting exclusions for prizes and awards) 2. Decrease items allowed as deductions Cary Brown Model ---------------- 1. **Immediately deducting** the cost of an asset/investment **is equivalent** to **[exempting the income]** of the asset/investment from tax instead of deducting cost of the asset 2. Consumption tax and wage tax systems are identical, assuming constant tax rates i. Current system moves toward a consumption / wage tax system with the preferential tax treatment for capital gains ii. To keep income-based system, there must be a distinction between capital expenditures and expenses a. **Capital expenditures** must be given a basis and allowed deductions over time, otherwise it is like consumption and immediately deductible. 3. A taxpayer earns salary of \$100,000. The taxpayer wants to purchase land and then rent/lease the land. The rental payments are 10% of the amount paid for the land (i.e., 10% return on the land). The tax rate is 40%. iii. Under Option 1, the taxpayer can immediately deduct the cost of the land. iv. Under Option 2, the taxpayer cannot deduct the cost of the land, but the rental income is exempt from tax Option 1 Option 2 -------------------------------------- ----------- ----------- Gross Income \$100,000 \$100,000 Deductions \$100,000 \$0 Taxable Income \$0 \$100,000 Taxes \$0 \$40,000 Investment in Land \$100,000 \$60,000 Rental Income from Land (10% Return) \$10,000 \$6,000 Tax on Rental Income \$4,000 Exempt Net Return \$6,000 \$6,000 Bonds ----- 1. Debt issued by the government or a corporation i. **[Maturity Date]** = when the face value of the bond is paid ### Bond Purchase price i. **Less than face value = discount** ii. **Greater than face value = premium** iii. **Par value = market rate** ### Bond & Market Relationship iv. Bond rate **[above market rate]** investor will want to buy the bond to receive the higher interest rate; bond would be priced at a premium (above face value) v. Bond rate is **[below market rate]** investors would instead invest in the market, causing bonds to be sold at a discount (below face value). vi. **[Inverse relationship]** between market rate of interest and value of bond a. Interest rates increase bond prices decrease b. Interest rates decrease bond prices increase ### Zero coupon bonds i. No payments while the bond is outstanding ii. BUT **pay out a greater** amount once the **bond matures** iii. Interest accumulates and will be paid out upon maturity, compounding in the meantime a. May be beneficial for a business so they do not have to make interest payments until the end; does not reduce cash flow during the time the bond is outstanding iv. Must calculate the associated interest payments that would result if the bond were making coupon payments, because it must be include it in your GI and taxed accordingly ### Interest Earned on Bonds v. Unless an individual affirmatively elects to report, as interest, the annual increases in such a bond's value, the recognition f interest is deferred until the bond matures (or is redeemed or otherwise disposed of sooner) **§454(a)** Tax Systems ----------- ### Progressive rate system i. Declining marginal utility of income the more income earned, each additional dollar of income is less important, thus gov. can take greater percentage of this additional income ii. Avoid disincentive on earning additional income - If tax additional income at too high of marginal rate, then it would reduce incentive to work iii. Reducing economic inequalities (This is criticized) iv. Criticism of income tax system discourages savings; double taxation (taxed on income and on interest) ### Flat tax system v. Most of the recent proposals of flat taxes are essentially consumption (not income) tax systems vi. Close to a flat rate income tax system in 1986 a. Only two rates: 15%, 28% b. But there was no preferential treatment for capital gains ### Consumption tax system vii. tax on what is consumed by TP viii. Burdens lower income TPs more because a person making \$200K and a person making \$60K will be taxed equally if both consume \$40K ix. Promotes saving money because the alternative is consumption and taxation - No double taxation on savings x. Ex.) state and local sales taxes; retirement plans = evidence of consumption ### Wage tax system xi. Only tax income from services, not capital assets xii. Benefits higher income TPs c. Consumption tax system and wage tax system are equivalent, assuming constant rates d. **[US Federal Income Tax System]** -- hybrid of consumption and income tax systems e. [Excess Profits/Supernormal Returns] -- excess profit due to luck or special ingenuity are taxed at a higher rate - IP must have huge profits before higher rate of taxation kicks in ### Stanley Surrey i. US tax system broken into 2 parts: a. Tax system in accordance with sound tax policy ("pure") b. Items tacked on by Congress to provide incentives or disincentives for behavior ii. **[Tax expenditures]** -- provisions in the tax code that can be viewed as equivalent to government spending ### Scheduler Taxation iii. deduction is taken against the same type of income iv. Gambling loss deduction can only apply to gambling winnings (*Zarin*) v. Capital loss deduction can only apply to capital gains vi. Investment interest expense can only apply against net investment income **§163(d)** Gross Income---§61 ================== A. [Gross Income] **[all income from whatever source derived]** **§61(a)** 1. Includes income derived from **[illegal activites. ]** 2. Does not include products or services TP produces for themselves 3. GI includes income in any form (cash, property, or services) **Reg 1.61-1(a)** 4. **§71-90** = **included** in GI Income Defined -------------- 1. **undeniable accession to wealth,** 2. **clearly realized,** 3. **over which TP has complete dominion**. ***Commissioner v. Glenshaw Glass Co. (1955)*** i. Undeniable accession to wealth increase in net worth ii. Clearly realized realization event; sale or exchange/change in disposition iii. Complete dominion if TP has genuine command over the taxable value a. TP can use it, benefit from it, or assert any rights to it = control A. ***Cesarini v. U.S. (1970)*** 4. The FMV of **"[Found property]**" when the property is reducuded to undisputed posseseion is specifically [included in GI] **Rev. 1.61-14(a)** iv. The current FMV of the found property is included, NOT the original "face value" v. Found money inside of a piano purchased for a nominal amount is still GI vi. Finding the money is the realization event vii. Burden on TP to show IRC provision excluding GI 5. "**Bargain purchase**" situations buyer becomes aware that item purchased for a low amount is actually worth much more viii. There is no realization event until item is sold/lost not included in GI Realization Event Doctrine -------------------------- ### **Mark to Market Method** ix. This is a new method which moves away from the realization doctrine x. In certain limited areas, appreciation is taxed before it is realized xi. Problems with mark to market: b. Difficulty determining FMV on non-publicly traded items c. Liquidity to pay taxes if the item has not been sold (gain realized) d. If the property depreciates, does the TP get to take the loss? Inclusions to Gross Income ========================== Compensation for Services---§61(a)(1) ------------------------------------- 1. Any economic benefit conferred upon TP in exchange for, as a reward for, or to obtain/retain TP's time and effort 2. Direct payments to TP 3. Wages, fees, tips, salaries, profit sharing, bonuses, severance pay, etc. 4. Expense-paid vacations, fringe benefits, personal services, use of property 5. Payments to third parties for TP's benefit 6. Payments to discharge TP's debt 7. Payments for anyone's benefit made at TP's direction 8. If services are paid for other than in money, the FMV of the property or services ***taken (received)*** must be included in income **§1.61-2(d)(1); Rev. 79-24** 9. ***Old Colony Trust Co. v. Commissioner** (1929)* i. **[discharge by a third party]** of an obligation owed by TP is included in GI for TP as compensation for services ii. If company pays employees taxes owed, it is GI for employee, not a gift iii. Look at relationship to determine why the parties are doing the transaction (here it was based on the employer/employee relationship) Prizes and Awards ----------------- 1. included in GI unless otherwise provided in **§117; §74** i. *Washburn* -- cash gift exempted from GI which led to the enactment of **§ 74** ### **Exceptions:** ii. Prizes and awards transferred to a qualified charitable organization: **§74(b)** a. That were made in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, and b. Where the recipient was selected without any action on his part to enter the contest or proceeding. **§74(b)(1)** iii. Two types of employee achievement awards **§74(c); §274(j)** iv. Olympic winner payments or medal value (enacted in 2016) **§74(d)** Scholarships ------------ - Included in GI unless it falls into one of the following exceptions. ### **3 Exceptions:** #### Qualified Scholarship §117(a), §117(b)(2) ##### Qualified tuition and related expenses---§117(b)(2) - **tuition and fees to enroll or attend; and REQUIRED** books, fees, supplies, and equipment required for classes (not lodging) [NOT included in GI] **§117(b)(2)** - Remainder of the scholarship [not used for "qualified" things] is **[included in GI]** - Not excludable from GI if grantor receives a benefit from recipient - [Room and board are **included in GI**] ##### Qualified Tuition Reduction---§117(d) - **[Excluded from GI]**; the amount of any reduction in tuition provided to an employee (or their children) of an organization for the education (below the graduate level) of an employee or person treated as an employee **§117(d)** - **Unless [(included in GI])** graduate student who performs teaching or research for the institution the student attends may be eligible for QTR exclusion - Highly compensated employees are eligible for QTR exclusion if QTR is available on the same terms to each member of a group - Does not apply to any portion of the benefit representing compensation for services that the student must perform as a condition of the benefit ##### Educational assistance programs: - Employers will encourage their employees to get an education; they can provide assistance for them to take courses and even work towards a degree - ***[limit for this deduction -- \$5,250.]*** #### Athletic Scholarships a. **Rev. Ruling 77-263** b. [Not included in GI if]: **three requirements** - School does not require student to participate in a particular sport; - School does not require any other activity in lieu of participation; or - School does not terminate scholarship if the student cannot participate c. [Included in GI] if: - The scholarship is **compensation** for athletic **participation** #### Educational Grants - made by an employer are generally taxable b/c they represent compensation for services, even if there is no further obligation to render future services Annuites -------- 1. **IRC § 72** requires that an "**exclusion ratio**" be established based on certain criteria. i. In essence, a portion of each payment received from the annuity contract is excluded (recouping your original contribution) and a portion of each such payment is included in gross income (representing earnings on your money deposited). a. After applying this ratio to each payment received, once the taxpayer (the "annuitant") receives, in the aggregate, the amount of their original contribution, this prorated exclusion ends, and the full amount of each subsequent payment is included in income. Compensatory and Punitive Damages---§104 ---------------------------------------- 1. Generally included in GI 2. If damages in lieu of lost profits, that is compensation for services GI 3. ### **Exceptions:** i. Punitive damages for **[wrongful death]** ii. Compensatory damages received on account of **[physical illness or personal injury]** under **(§104(a)(2))** Social Security Benefits ------------------------ 1. Up to 85% of Social Security benefits can be included in gross income dependings on the TP's income level from other sources. **§86** Discharge of indebtedness---§61(a)(11); §108 -------------------------------------------- 1. Income from discharge of indebtedness is [included] in GI **§61(a)(11)** i. Must be an enforceable debt in the first place (*Zarin*) a. When there is a legitimate (good faith) disagreement as to what the actual amount of debt is, an agreement or settlement as to the debt amount is not considered a discharge or forgiveness of debt. b. It bears repeating that to have a discharge or forgiveness of debt (giving rise to income) one must first have a "debt" which is subsequently discharged/forgiven in whole or in part. c. This is what is sometimes referred to as the "contested or disputed liability doctrine." \[See Zarin v. Comm'r, 916 F.2d 110 (3rd Cir.1990).\] 2. Mortage debt ii. Indebtedness of TP = recourse **§108(d)(1)(A)** or secured by TP's property **§108(d)(1)(B)** iii. Discharge of indebtedness occurs when creditor agrees to take something less than what they originally agreed to take in satisfaction of the loan d. Exchanging services in exchange for cancellation of a debt represents compensation for services GI **Reg. § 1.61-12** e. Payment deferral or payment by third party is not a discharge ### Loans Between Taxpayers #### Borrowed Funds f. [NOT GI to borrower] because the tax systems assumes repayment #### Repayment of Principal g. is [NOT GI to lender] & [NOT deducible by borrower] - Even if the repayment is givien to the lender in a will, the principal is not included in GI #### Payment of Interest h. [IS GI to lender] & [IS deductible by borrower] ### Exceptions i. #### Bankruptcy i. debt discharged in a title 11 bankruptcy case **§108(a)(1)(A)** #### Insolvency j. exclusion limited to amount of insolvency **§108(a)(1)(B)** k. Excess of liabilities over FMV of assets; owe more than what you have l. AR = FMV at time of transfer AB **Reg. 1.1001-2(c) Ex. 8** #### Qualified principal residence acquisition indebtedness m. discharge is before 2017; limited to \$2m **§108(a)(1)(E)** #### Student loans n. due to death, disability, or due to student working for governmental/nonprofit organization **§108(f)(5); Rev. 2008-34** #### Cancellation of debt (COD) o. GI = amount of cancelled debt -- amount repaid **§108** p. Becomes important during economic downturns #### Contested liability doctrine q. If a TP, in good-faith, disputes amount of a debt, the subsequent settlement is treated as the actual amount of the debt for tax purposes 3. *United States v. Kirby Lumber Co. (SCOTUS 1931)* iv. discharge event "frees up" assets of the debtor, generating income to the debtor (problematic) v. Corp. issued bonds at par value, and later that year bought the bonds back at a discount **discharge of indebtedness for below face value bonds = gain for corp.** ### Gambling Losses vi. *Zarin v. Commissioner* r. An **[unenforceable obligation is not "indebtedness"]** within the meaning of the code, and its discharge is not GI under **§61(a)(12)** s. Zarin accumulated \$3.4M in gambling debts but the Casino settled for \$500K t. Not discharge of indebtedness; did not meet **[requirements of]** **§108(d)(1):** - Indebtedness for which TP is liable; OR - Indebtedness subject to which the TP holds property u. This was nonrecourse debt (not enforceable), casino chips are not "property," rather they are just an accounting mechanism used to track TP's debts and they had no other economic benefit to TP other than to be used in gambling and to purchase services at the casino - **[Gambling losses]** are [ **ONLY deductible against gambling gains**] **§165(d)** - A professional gambler cannot deduct it as a business expense - To prove losses, write down table number and keep receipts for bank withdrawals Exclusions from Gross Income ============================ 1. **§101-139A** = **excluded** from GI Punitive Damages for Wrongful Death ----------------------------------- 2. excluded from GI if awarded for a wrongful death action under state law if punitive damages are the only wrongful death recovery **§104(c); Rev. 88-108** Compensatory Damages for Physical Injury ---------------------------------------- 3. requires a [direct causal connection between bodily injury and award] **§104(a)(2)** 4. Applies to any harm flowing from the bodily injury, including emotional distress i. However, it **DOES NOT** apply to a physical injury caused by emotional distress!!! ii. If there is any physical injury, then ALL damages are excluded from GI (except punitive) damages for backpay, emotional distress, etc. are excludable if there is physical injury **§104(a)(flush)** iii. Applies to recipients other than primary victim ### **Settlement payments---Rev. 85-98** iv. Applies if the purpose of the payment is to compensate the recipient for alleged bodily injury; exclude from GI only the portion of payment relating to the injury v. Amounts expended on medical care for **[emotional distress]** due to nonphysical injury also [excluded] from GI **§213(d)(1); §104(a)(flush)** Gifts and Inheritances ---------------------- 1. Excluded from GI **§102(a)** ### Gift Defined i. Transfer must arise out of a **[detached and disinterested generosity]** to be excluded from GI *Commissioner v. Duberstein (SCOTUS 1960)* ii. Key = donor's underlying motivation for transfer; also applies to bequests a. Cannot be compensation for services not disinterested iii. **[3 factors that against]** finding a gratuitous transfer to be a gift: b. Whether the donor is a corporation or other business entity c. Whether the donor deducts the amount of the transfer as a business expense d. Whether there is some significant business relationship between the donor and donee ### Exceptions: iv. Any **[interest or income]** generated from the gift is included in GI of recipient **§102(b)** v. **[Transfer]** is by/for **[an employer to]**/for benefit of **[an employee]** **§102(c)** 2. *Lyeth v. Hoey (SCOTUS 19238)* **[property received]** in **[settlement of a will contest]** is considered an inheritance, which is [excluded] from GI 3. *Wolder v. Comm'r (2d Cir. 1974)* to determine if a gift is made, look at the circumstances surrounding the transfer, rather than the form of the transfer (it does not matter that the bequest was made in a will) Employee Benefits ----------------- 1. [Excluded from GI ] ### Certain Fringe Benefits § 132 a. #### No -Additional Cost Service §132(b)(2) a. Three Major Requirements to [exclude from GI]: - \(1) The service that the employee is receiving must be the type of service offered for sale to customers in the line of business in which the employee is working. This is called the "**line of business**" test. **§132(b)(1)** - \(2) The employer cannot incur substaintial additional cost in providing such services to the employee. **§ 132(b)(2)** - \(3) Only applies to highly compensatied employees if the same benefit is available to all employees on substantially the same terms. **§ 132(j)(1)** #### {#section-1.ListParagraph} b. #### Qualified employee discount **§132(c)** i. Three Major Requirements to [exclude from GI]: 1. \(1) The service that the employee is receiving must be the type of service offered for sale to customers in the line of business in which the employee is working. This is called the "**line of business**" test. **§132(c)(4)** 2. \(2) The amount of the discount available. a. The statutory maximum tax-free discount applicable to employer provided "**[services]**" is 20%. **§132(c)(1)(B)** i. Includes staying in the company hotel if TP replaced a paying guest... see practice exam 1 Q 22. b. In the case of discounts for "**[products]**" (tangible personal property), the statute states that the discount cannot exceed the employer's "gross profit percentage." **§ 132(c)(1)(A).** 3. \(3) Only applies to highly compensatied employees if the same benefit is available to all employees on substantially the same terms. **§ 132(j)(1)** a. Ex.) employee gets \$10 off \$100 sweater; discount is [excluded from GI ] - Only applies to highly compensatied employees if the same benefit is available to all employees on substantially the same terms. **§ 132(j)(1)** #### Working Condition Fringe §132(d) b. Can be excluded if it can be deducted under §162 as a trade or business expense c. Examples - Professional association **[membership fees]** & professional **[liability insurance]** are excluded from GI because they can be deducted under **§162** as a trade or business expense #### {#section-2.ListParagraph} c. #### De minimis fringe benefits **§132(e)** d. [Excluded from GI] if e. Any property or service the value of which (after taking into account the frequency at which similar fringes are provided by the employer to the employer\'s employees) is so small it makes accounting for it unreasonable or impracticable ##### Certain eating facilites **§132(e)(2)** - Where an employer operates an eating facility and employees pay less than the FMV - Requirements to exclude: - \(1) the amount employees pay must at least cover the employer's operating costs of such facility, and - \(2) the employer must not discriminate in favor of "highly compensated employees" as to the availability among employees to such eating facility d. #### Qualified Transportaion §132(f) f. An employer-provided monthly train pass is [excluded] from GI provided the amount of the benefit **[does not exceed \$175 per month]** as a qualified transportation fringe under i. ### Meals and lodging **§119** g. Excludable from emplpyee's GI if: **§119(a)(2);** - \(1) qualified lodging is provided for convenience of the employer; - \(2) MUST be on the business premises of the employer **Reg. §1.119-1(c)(1)**; and - \(3) must be a condition of the TP's employment. **Reg. §1.119-1(b)(3)** h. Note: - When one employee, say the employer's kid, is given better lodging than all of the other employees the amount of the lodging that ever other employee is given is still deductable under **§119(a)(2).** - The excees is not deductable under this section. It is however deductable as a gift under section **§102(a)** eventhough it is between an employer and employee because they are also parent and child. ii. ### Educational assistance up to \$5,250 per employee **§127(a)(1), (2)** i. If employee can show that the transfer was not made in recognition of the employee's employment status may be excluded from GI **Proposed Regulation 1.102-1(f)(2)** iii. ### Employer-provided insurance §106(a) j. Employer provided health insurance - [Excluded] from the employee\'s gross income under **§ 106(a).** k. Employer-provided group term life insurance - [Excluded] from GI if the policy is for \$50,000 of coverage or less under **§ 79(a).** 2. *Charley v. Commissioner (9^th^ Cir. 1996)* **[frequent flyer miles]** accumulated by employees on business travel, subsequently used to purchase personal travel are [excluded from GI] Life-Insurance Proceeds ----------------------- 3. Death benefits are [excluded from GI] **§101(a)(1)** i. However, **[interest]** earned from death benefits is [included] in gross income. **§101(c)** l. *See* investment interest section to see "annuity like payments of life insurance benefits" Some Prizes/Awards ------------------ 1. [Excluded from GI] by exceptions to **§74** iv. ### Prizes transferred to charity a. Excluded from GI: **§74(b)** b. Must be primarily in recognition of certain achievements c. Selected without any action on recipient's part (simply picked) **§74(b)(1)** d. Not required to render substantial service in the future (otherwise comp. for services) **§74(b)(2)** e. Winner cannot accept award; must be directly transferred to the charity **§74(b)(3)** - Added in 1986 and pretty much killed the exception v. ### Employee Achievement Awards a. Excluded in GI: **§74(c)** b. **[Length of service of awards]** (must be employed a minimum of 5 years and can only be awarded every 5 years) **§74(c)(1)** c. **[Safety achievement]** (for not having costly accidents) **§74(c)(2)** vi. ### Olympic/Paralympic winner payments & medal value a. Since 2016 **§74(d)** Imputed Income -------------- 1. income that is "created out of thin air"; the value of a TP's own services or goods that are used to benefit TP 2. [Not included in GI] i. It has never been taxed ii. There is an argument it is unconstitutional (*Independent Life Ins.*) iii. Burden on the TP, would be required to keep records of work iv. Liquidity problem; wouldn't have cash to pay (weak) ### 2 Types of Imputed Income: v. **Goods and Services TP Produce for Themselves** a. (lawyer drafting own will or accountant doing own taxes) vi. **TP using their own residence and other durable goods** b. (TP buying a house and using it as their own home) 3. *Helvering v. Independent Life Ins. Co. (1934)* vii. Rental value of a building used by the owner of the building is not imputed income and not GI viii. Argument that taxing imputed income is unconstitutional #### TP Lives in Home Owned by Business c. *Cf. Dean v. Commissioner (1951)* - TPs own all of the stock of a corporation, but corporation has title to building which is also the TP's residence. Is the rental value of the property taxable? - Yes, TP has a legal obligation to provide a family home and if it is done by the occupancy of the property which is held in the name of the corporation of which he is the president, then the **FMV of the occupancy is income to TP.** Gain from the sale of a principal residence ------------------------------------------- 4. TP may [exclude] from GI **[up to \$250k (\$500k for joint)]** of gain from sale of a principal residence **§121(b)(1)** 5. TP must occupy the principal residence for 2 of the last 5 years **§121(a)** ix. **§121** may [only be used] to exclude gain [once every 2 years] Income Earned Abroad -------------------- 6. Some of TP's foreign income may be [excluded] from GI [if TP lived out of the US] for at least [330 out of the last 365 days.] **§911** Interest earned on municipal ("tax-free" state and local") bonds **§103(a)** ---------------------------------------------------------------------------- 7. **Excluded** from GI 8. **§103(a) specifically excludes, from gross income, interest from state and local bonds** 9. Usually included in GI per **§61(a)(4)** 10. Allows state and local gov't to issue bonds with lower IR and not have to compete with other corp. bond issuers who may pay higher IR because TP will not have to pay interest for municipal bonds Short Term Rental of TP's Home ------------------------------ 1. **IRC § 280A(g)** provides that a taxpayer renting out his or her home for **[less than fifteen (15) days]** during the year, [excludes, from gross income], any rent received for such period. The dollar amount of this exclusion is unlimited. To be fair, this section also precludes any rental expense deductions for this period. Haig-Simons Income ================== A. [Haig-Simons income] 1. **[sum of]** an TP's **[consumption for personal use]** + any **[increase in value of TP's assets]** 2. Determines income based on how funds are used 3. Includes products or services TP produces for themselves 4. **No realization doctrine** appreciation included in GI as it occurs 5. Disadvantages: i. You would have income for the appreciation of assets at the time it appreciates, rather than at the time in which it is disposed ii. Imputed income would be included 6. Application to *Zarin* TP receives 3.4M, which he consumes (entertainment); 3.4M included in GI but offset by 500k settlement (decrease in the TP's assets) iii. Could argue that gambling is not really consumption; generally, the greater cost of consumption, the greater pleasure for the consumer, but with gambling as you continue to lose (consume) your pleasure decreases iv. If this is the case, Zarin would have no income from gambling, and a 500k decrease in his assets, thus Zarin would instead suffer a 500k loss Separation and Divorce ====================== Alimony Payments ---------------- ### Divorces Before 2019: v. Alimony payments are included in the GI of the payee spouse **§71(a)** vi. If alimony is included in GI of payee payor spouse gets deduction **§215; 62(a)** vii. Child support payments are tax neutral **§71(c)** viii. These provisions still apply to divorces before 2019 unless divorce instrument provides otherwise ### Divorces After 2019: i. Alimony, maintenance payments, child support, and property settlements are all tax-neutral ii. [NO GI for Payee] & [NO deduction for Payor] Property Settlements---§1041 ---------------------------- ### Nonrecognition rule iii. for gains and losses for any transfer of property between current spouses or former spouses if transfer is incident to divorce **§1041(a)** #### Transfer incident to divorce---**§1041(c)** a. It occurs within one year of marriage ceasing **§1041(c)(1); Reg. 1.1041-1T(b)** b. Related to cessation of marriage **§1041(c)(2)** - Pursuant to a divorce or separation instrument (defined in **§71(b)(2));** and - The transfer occurs **[within 6 years]** of the marriage ceasing c. If not **[within 6 years]**, the transfer is presumed as unrelated to the cessation of marriage - This may be rebutted by showing that the transfer was made to affect the division of property owned by the former spouses at the time of divorce Attorney's Fees --------------- 1. Generally, attorney's fees and other costs paid in connection with a divorce are **[NOT deductible]** iv. May take **[deduction for fees]** associated with **[tax aspects of divorce]** under **§212(3)** d. Requires an itemized bill from the attorney to separate those costs associated with the tax aspects from the other costs Gain from Dealings in Property ============================== 1. GI includes gains from dealings in property **§61(a)(3)** 2. Gain or loss = -- adjusted basis **§1001(a)** Fundamental principles of property transactions (*Crane*): ---------------------------------------------------------- 3. Fundamental \#1: i. Liabilities, recourse or non-recourse, assumed, taken subject to or otherwise incurred in the acquisition of property are included in the **buyer's basis** 4. Fundamental \#2: ii. Liabilities of a seller, recourse or non-recourse, assumed or taken subject to by the buyer are included in the **seller's amount realized** **Reg. 1.1001-2(a)(1)** Amount realized --------------- 5. Amount Realized -- cash + FMV of any property received §1001(b) iii. \+ FMV for services received *International Freighting Corp.* iv. **+ Liabilities of seller assumed by the buyer *Crane*** 6. ***Crane (SCOTUS 1947)*** v. TP who sells property encumbered by debt (such as a mortgage) must include the unpaid balance of the debt in the amount realized on the sale 7. ***Tufts (SCOTUS 1983)*** vi. applies same rule in *Crane* even when debt \> FMV 8. *International Freighting Corp.* vii. when a TP exchanges property for services, the exchange is a realization event and gain must be calculated viii. Extends **§1001(b)** Amount recognized ----------------- 9. entire amount realized is recognized unless code says otherwise **§1001(c)** ix. Ex.) sale of property between spouses amount realized is not recognized Adjusted basis -------------- 1. events occurring after property acquisition change basis **§1011; §1016** 2. Original basis + investments/improvements -- depreciation 3. [When AB occurs]: i. Ex.) dividend paid in the form of additional stock ii. Ex.) depreciation or improvement of equipment or a building iii. Ex.) inheritance of property receive a "stepped-up" basis ### Adjustments for Lessee Improvements iv. §109 and §1019 act together to defer tax until sale of property, then the improvements are taxed as gain on the property v. Typically, improvements made by lessee (tenant) are **[not GI to lessor]** (owner) **§109** vi. If a lessee makes improvements on the property, there is no adjustment to the basis of the property for such improvement **§1019** a. Either include in both GI and AB or exclude from both GI and AB Debt Financing -------------- 1. Types of debt: vii. ### Recourse Debt a. Borrower is personally liable on the debt viii. ### Non-recourse Debt b. Borrower is not personally liable on the debt; lender can only take possession of the property i. Property transfers: ### Assumption ii. ### Take subject to iii. 2. Under tax law, it usually **[does not matter if it is recourse or nonrecourse]** (*Crane*) iv. **O'Connor believes both types of debts should be treated the same (***Tufts*) 3. **Difference between recourse and nonrecourse debt \> asset** v. **Recourse AR = Current FMV** c. **Bifurcate; consider COD and gain/loss separately** vi. **Nonrecourse AR = current amount of debt (***Crane; Tufts***)** 4. **[Parties to debt transaction]**: vii. Mortgagor (Mgor) = borrower, obligor, debtor viii. Mortgagee (Mgee) = lender, obligee, creditor #### Interest Payments d. DO NOT affect **[buyer's basis]** (may be deducted under **§163(a)**) e. If seller is financier, then **interest paid** (only interest, not principal) IS **seller's GI** **§61(a)** Basis Rules ----------- ### Basis Rule \#1 -- Property Acquired by Purchase i. Property aquired by purchase a. **[Cost basis]** (amount paid in cash) **§1012; Reg. § 1.1012-1(a)** ### Basis Rule \#2 -- Property Acquired in an Exchange for Property ii. **[1^st^]** FMV of acquired property; b. if FMV of property received cannot be determined then iii. **[2^nd^]** FMV of property given up (Assumes *arms-length transaction*) c. If FMV of property received or given up cannot be determined then iv. **[3^rd^]** in rare and extraordinary cases, the basis of the property given up becomes the basis of the acquired property. ***Philadelphia Park Amusement Co. v. US*** ### Basis Rule \#3 -- Property Acquired where FMV is included in GI i. Property acquired where FMV is included in gross income **Reg. § 1.61-2(d)(2)(i)** a. **[Tax Cost Basis]** (basis in acquired property is equal to the amount included in GI) - Ex.) found ring with FMV of \$50k Basis = \$50k; GI = \$50k - Ex.) employer gives property to an employee as compensation ### Basis Rule \#4 -- Property Acquired by Gift ii. Property acquired by gift b. **[Transferred Basis]** **§1015(a)** *Taft v. Bowers* - Donee's basis = donor's basis c. **[Unless Basis \> FMV]**, then - If the property is **[sold for \< FMV]**, then basis = **[FMV at time of gift] §1015(b)** - Prevents trafficking losses to higher tax brackets through gifting - If the property **sold [FMV \< \> basis ]** **[no gain or loss]** **Reg. § 1.1015-1(a)(2)** i. #### If the donor also got the property by gift - basis = adjusted basis of the last owner who acquired the property other than by gift - *Farid-Es-Sultaneh v. Commissioner* shows tax treatment for income tax purposes may differ from gift/estate tax treatment - Wife received stock from husband but gave up marital claim to his property, thus for income tax law the stock was not considered a gift, and her basis is the FMV of property received (exchange) ### Basis Rule \#5 -- Part-Gift/Part-Sale Transaction i. When FMV and AR do not match, it is not an arms-length transaction (likely a hidden gift) a. **Start with sale**; allocate enough to sale to make it arm's length **excess is a gift** ##### Transferee's Basis - The ***[greater]*** of: - Amount paid by the Transferee; or - Transforeror's adjusted basis in the property **Reg. § 1.1015-4(a)(1)** - Gift component to transferee = FMV -- amount paid ##### Transferor's Basis - treated as having realized a **gain** in the amount that the **AR exceeds the adjusted basis**; **[cannot realize a loss]** on this type of transaction **Reg 1.1001-1(e)** - Amount realized -- adjusted basis = gain - Inability to realize loss is consistent with **§267** disallowance of deduction of losses arising from transactions with related parties (family) ##### Transferee is a Charitable Organization - **Adjusted Basis is split between the gift and sale component;** - **Transferor must be taxed at disposition because otherwise the taxes would be lost since the charitable organization does not pay taxes Reg. 1.1011-2** ##### Encumbrance with a mortgage - Sale component = amount of mortgage - Gift component = FMV -- mortgage (excess) - No gain or loss recognized on a gift - Transferor AB allocated to sale component ### Basis Rule \#6 -- Transfer of Property Between Spouses ii. Between Current Spouses---NOT incident to Divorce b. Basis is **[Transferred Basis]** from the spouse who originally owned the property **§1041(b)(2)** - AND **[no gain or loss recognized]** **§1041(a)(1)** iii. Incident to Divorce c. No gain or loss is recognized, **[NOT an appropriate time to tax]** **§1041(a)** ### Basis Rule \#7 -- Property from a Decedent i. Property acquired by inheritance from decedent a. **[FMV]** of acquired property on the **[date of decedent's death]** **§1014(a)(1)** - Also called "step-up," "step-down," or "fresh start" basis #### Inherent from death of a spouse b. If one spouse dies, **[all community property]** receives a **[stepped-up basis]** **§1014(b)(6)** c. If **[appreciated property]** is acquired by a decedent within the one-year period ending on the decedent's death and if the property passes from the decedent back to the donor or the donor's spouse, the donor/recipient's basis is the adjusted basis of the property in the hands of the decedent immediately before death (no stepped-up basis) **§1014(e)** - This section creates a "locked-in" effect for older owners of appreciated property, which encourages them to hold onto appreciated property until they die to avoid tax consequences. - If the property depreciates during the time that the transferor holds the property, they should sell the property prior to passing so they may recognize the loss, otherwise the loss disappears - Justifications more difficult to apply transferred basis because decedent is not alive to determine their basis and avoid double taxation (but this argument is weak) Assignment of Income ==================== A. [Assignment of Income] 1. **[Determines correct TP to be taxed]** 2. Assignment of income is one reason Congress did not repeal gift taxes in 2010 i. If gift taxes were repealed, a higher income TP could horizontally transfer property to a lower income TP, with an agreement transfer the property back at some point ii. The gift tax was designed as a back-stop to the assignment of income doctrine; gift taxes prevent horizontal assignment of income producing property for a period, and then being transferred back (to avoid assignment of income doctrine) from being beneficial Ownership Defined ----------------- iii. Ownership Power to dispose of income iv. Ex.) Speaker's fee is being given to charity; if speaker elects which charity, that is "power to dispose of income" and the speaker has GI 3. *Lucas v. Earl (1930)* income from services is **[taxable]** to the **[person performing the services]**, even if paid to someone else; tax person that earns the income v. Fruits (\$) must be attributed/taxed to the tree (services) from which they grew 4. *Helvering v. Horst (1940)* assignment of the right to receive income from property is **[taxed to the assignee of that income]** vi. A gift of interest coupons detached from bonds amounts to realized income to the donor vii. Cannot avoid tax liability on income from property by transferring right to receive income a. Transfer of income from property = violation of assignment of income vertical assignment owner of property is still taxed b. Transfer of income-producing property = valid transfer ### Agreements e. #### Anticipatory agreements a. are normally disregarded because they are often only used if to shift tax burden to others b. Congress addressed this issue, see "kiddie tax" below f. #### Disclaiming income before it is earned b. Disclaimers may prevent recognition of income as long as they are made before the income is earned and there is no assignment of the disclaimed income. c. **Rev. Rule 74-581; 69-274** - Income earned for services that the TP's employment contract require be remitted the the employer can be [excluded] from GI. - Examples - Law professor receiveing fees for representing clients through the schools clinic law proffessor's employment contract required her to remit the fees to the school. [excluded] from law professor's GI - Doctor who worked at a medical school who received statutory fees for working at an outreach program caring for indigent patients, doctor's employment contract required her to remit these fees to the university [excluded] from doctor's GI Type of Assignment ------------------ ### Kiddie tax i. income assigned to children will be taxed at the highest tax rate (37%) -- so there is no benefit from assigning income to your child **§1(g)** ### Vertical assignment ii. Violates the assignment of income doctrine c. Attempt to reduce tax liability on that income will be ineffective (*Helvering v. Horst*) iii. **[Transfer of right to property]**, but [NOT] a transfer of **[property itself]** d. Transfer can still occur, but actual [owner (donor) will be taxed] ### Horizontal assignment iv. transfer of a partial interest of the property; not really an assignment of income of the property e. Actual **[property is transferred]** donee is taxed f. Here you are not transferring the fruits of the tree, you are transferring part of the tree and the income associated with that part Deductions -- Generally ======================= +-------------+-------------+-------------+-------------+-------------+ | **Event** | **Gain - | **Loss - | **Expenses | **Depreciat | | | include in | Deductible? | of | ion** | | **Activity | GI?** | ** | Maintaining | | | ↓** | | | ** | | +=============+=============+=============+=============+=============+ | **Trade or | Yes | Yes | Yes | Deductible, | | Business** | | **§165(c)(1 | | if | | | **§61(a)(3) | )** | **§162(a)** | depreciable | | | ; | | | property | | | 1001(a), | | | **(§167(a)( | | | (c)** | | | 1))** | +-------------+-------------+-------------+-------------+-------------+ | **Investmen | Yes | Yes | Yes - | Deductible, | | t** | | **§165(c)(2 | **§212** | if | | | **§61(a); | )** | | depreciable | | | 1001(a), | | Cf. | property | | | (c)** | | *Higgins* | **(§167(a)( | | | | | | 2))** | +-------------+-------------+-------------+-------------+-------------+ | **Personal* | Yes | No | No | No; not in | | * | **1001(a), | **§165(c)(3 | **§262(a)** | IRC | | | (c)** | )** | | **(§167(a)) | | | | unless | | ** | | | | casualty | | | +-------------+-------------+-------------+-------------+-------------+ Deductions ---------- 1. Legislative grace; *New Colonial Ice* *Co. v. Helvering (1934)* i. TP must find specific code section allowing a subtraction from GI **§161** ### Business ii. What TP does for a living iii. **[Above-the-line]** deductions (other than those incurred from being an employee) iv. Office rent; administrative assistant salary; lease expense for equipment; etc. ### Investment v. Something TP does on the side to generate income vi. Fees for investment advisor; rental property maintenance expenses; etc. ### Personal i. Generally [not deductible]; **[below-the-line]** ii. No personal exemptions from 2018-2025 Categories of Deductions: ------------------------- ### Above-the-line iii. subtracted directly from GI to calculate AGI **§62(a); 63(a)** iv. Want to reduce AGI as much as possible because AGI measures the overall limitation on itemized deductions **§68** a. Limitation on itemized deductions suspended until 2025 due to TCJA ### Below-the-line i. Subtracted from AGI to calculate taxable income; subject to limitations and phase-outs ii. TPs will select the greater of the two as permited by **§63(b)** a. Sometimes political figures or aspiring political figures will always choose the standard deduction even if it lower than the itemized deduction to avoid any possible probems with their tax returens #### Standard deduction b. **§62(a)(1)-(21)** c. Most commonly used d. Statutorily fixed \[\$12,500 in 2021; \$25,100 in 2022\] e. [Bonus] standard deduction - \$600 if TP or spouse is 65 + \$600 if TP or spouse is blind **§63(c)(3)** #### Itemized deduction f. **§63(d)(1)** g. Only used if it ends up being more than the standard deduction h. Includes all deductions outside of §62 (education, charitable contribution, qualified residence interest, real property taxes on residence) i. Miscellaneous itemized deductions [not allowed 2018-2025] **§67(a); 67(g)** Business Deductions =================== Business Expenses ----------------- 1. Deductions allowed for ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business **§162(a)** ### Ordinary iii. Must [NOT be a capital expenditure]; foreseeable to arise in business j. **[usual or customary]** = ordinary; k. frequency of payments is irrelevant - **Payment** of **other's debts** without legal obligation is not ordinary and is **[not deductible]** as a business expense *Welch v. Helvering (SCOTUS 1933)* l. Ex.) litigation is uncommon for most TPs but it is generally foreseeable to arise in business, so it is an ordinary expense ### Necessary iv. Expenses that are appropriate; closely connected to trade or business v. **[appropriate or helpful]** = necessary *Welch v. Helvering* *(SCOTUS 1933)* vi. Usually, the court will defer to TP's judgment as to whether an expense is ordinary and necessary, so this is rarely an issue ### Expense vii. **Most litigated issue** is it an expense or capital expenditure? m. Expense = payment where benefit (deduction) is immediate; preferable n. Capital expenditure = payment that will benefit TP over time beyond the taxable year or adapts property to a different use than when the property was placed in service; deducted over time ### Paid or incurred during the taxable year ### Carrying on an active, preexisting trade or business viii. Continuous, considerable, and regular ix. Start-up expenditures to establish or acquire a new substantial lack of continuity are not deductible (exception - §195) Must rise to the level of trade or business ------------------------------------------- 2. Profit-seeking motive §183 3. Trade or business = TP regularly and consistently devotes such time, effort, and energy to it, that it is a livelihood/occupation 4. No hobbies, amusements, or passive investment activities Employees are in the trade or business of providing services to their employer ------------------------------------------------------------------------------ 1. Employee's reimbursed expenses are above-the-line deductions **§162(a)(2)(A)** 2. Employee's unreimbursed expenses are disallowed miscellaneous deductions **§67(a)** 3. Distinction between employee and independent contractor i. Employee expenses associated with working become the employee's own trade or business expenses when they are not reimbursed by the employer **§67** ii. Independent contractor can deduct all expenses related to the trade or business under **§62** Expenses to find a new job -------------------------- 4. Expenses to find a new job in the same trade or business as TP's current or most recent job are deductible if there is no substantial lack of continuity **Rev. Ruling 75-120** 5. Substantial lack of continuity = gap longer than one year 6. Expenses to find new job in different trade or business are not deducible 168(k) Deduction ---------------- 7. Costs for tangible property with a **[recovery period less than 20 years]**, new or used, may be immediately deducted in the current taxable year **§168(k)** 8. **168(k) Steps** iii. **Is it wearing out over time**? Yes. iv. **Is it used in business**? Yes. à depreciation deduction allowable à go to (k) v. **Does it have a depreciation recovery period of less than 20 years**? Yes. ### Requirements i. Between 2018-2022 a. After Jan. 1, 2023, there is a phase out period reducing the max amount that may be immediately deducted each year ii. Only applies to tangible property iii. Intangible property is given a basis with deductions taken over the ARP **§197** iv. **[ARP must be less than 20 years]** v. Just excludes real property, almost everything else has an ARP \< 20 years vi. **[No dollar limit;]** 100% of the cost is deductible §168(k)(6)(A) b. **Does not matter if the cost is an expense or a capital expenditure** 1. *INDOPCO v. Commissioner* *costs to acquire intangible property, where such property offers a "significant future benefit" shall be given a basis and depreciated over the property's useful life; 168(k) does not apply* vii. *Treasury has tried to distance itself from the Indopco standard look for a **[separate and distinct asset]** which may be given a basis and depreciated/amortized* ii. #### *Examples of ordinary and necessary business expenses* - *Paying employees, rent, maintenance, R&D, repairs, advertising, utilities, K labor, etc.* - *As a result of Indopco R&D and advertising both became uncertain as to whether those costs could be expensed* - ***§174** -- R&D costs may be immediately deducted* - ***Rev. Rule 92-80** -- advertising that was immediately deductible pre-Indopco may be immediately deducted* ### Qualified improvement property viii. Any improvement to the interior portion of a building which is nonresidential real property if such improvement is placed in service after the date that the building was first placed in service ix. **[Does not qualify for §168(k)]** Start-up Expenses---§195 ------------------------ 2. Deduction for start-up expenses for a business taken in the year the business begins ### Requirements: x. First 4 requirements of §162; and xi. **§195(c)(1)(A) -** the payments must be the type that would be deductible if incurred in carrying-on an existing business, but instead are incurred: c. investigating the creation or acquisition of an active trade or business; or d. creating an active trade or business; or e. any activity engaged in to produce income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business ### 4 ways to deduct under §195: i. Expense **less than \$5k** a. Deduct entirety [in the year trade or business begins] ii. Expense **between \$5k and \$50k** b. Deduct 5k in the year trade or business begins, and c. The remaining amount is deducted over 180 months (15 years) iii. Expense **between \$50k and \$55k** d. Reduce 5k immediate deduction by the amount of expense exceeding 50k and - Ex.) \$53k of expenses - \$50k = \$3k exceeding the \$50k reduce \$5k deduction by \$3k excess expenses = \$2k immediate deduction e. The remaining amount is deducted over 180 months (15 years) iv. Expense **more than \$55k** f. No immediate deduction; g. Entire amount is deducted over 180 months (15 years), begining the year the business begins 1. Automatically elected unless TP affirmatively elects out **§195(b); TR 1.195-1(b)** 2. No deduction if there is no start-up or plans are abandoned 3. Does not include interest, taxes, or research expenses which are deductible under their respective sections **§195(c)(1) (flush)** 4. *Morton Frank v. Commissioner (1953)* pre-trade or business expenses are not deductible under §162(a) because trade or business is not already in existence v. **Can deduct** under §195 Qualified Business Income Deduction **§199A** --------------------------------------------- 5. Enacted as part of the 2017 Tax Cuts and Jobs Act 6. If you are an individual who earns business income (earned through an S corporation, a partnership, a sole proprietorship, or an LLC), this provision allows you a **deduction of 20% of your GI.** vi. If you make \$100, you will only be taxed on \$80 of that income vii. Only applies to business income or entrepreneurial income (to be some sort of ownership income) 7. Severely criticized viii. Businesses obviously love this provision ix. Unfair taxing one business owner less than another business owner x. The business owner is taking risk by having to put up capital with respect to their business, but the person taking the salary is not taking much risk at all. h. These are two very different situations i. Part of the justification for having Section 199A 8. Does not include compensation for services as an employee (salary) Demolition Deduction §208(b) ---------------------------- 1. TP is denied a loss deduction for the structure and denied any deduction for expenses incurred in the demolition 2. Basis in the removed structure and any cost incurred in its removal are added to the basis for the land on which the structure stood Deductions for Investment Activities ==================================== A. *Higgins v. Commissioner (1941)* refused deduction for losses related to investment activities because there was no Code provision allowing such a deduction at the time 3. Overruled by Congress enacting §212 allowing for such deductions §212 Deductions --------------- 4. Itemized deduction for profit-seeking activity not at level of trade or business 5. **[Suspended 2018-2025]** i. Just because there is a code section that allows a deduction, there are other provisions that may cause TP to lose this deduction (§67(g)) ### Requirements: i. Ordinary ii. Necessary iii. Expense iv. Paid or incurred during the taxable year for: v. The production of income **§212(1)** vi. Management, conservation, or maintenance of property held for the production of income **§212(2)** vii. In connection with the determination, collection, or refund of any tax **§212(3)** 1. Example viii. Classic example is payment to an investment advisor ### §212 vs. other provisions: ix. §162 is intended to apply to the same type of expenses, but for businesses x. §165 does not deal with expenses, only losses from investments xi. §262 generally disallows deduction for personal, living, or family expenses A. §212(3) was added 10 years after §212 was passed (should be a separate code provision) 2. Commissions paid in selling securities are an offset against the selling price, except that in the case of dealers in securities such commissions may be treated as an ordinary and necessary business expense **Tres. Reg. § 1.263(a)-2(f)(3)** xii. Ex.) S buys 100 shares of Company stock for 3k, paying broker a commission of \$50. 14 months later S sells the shares for 4k paying a commission of \$60 on the sale. They are both deductible under § 165, but what about under § 212? Both transactions are ordinary, necessary, paid or incurred in the taxable year to produce income, but neither is an expense -- just part of the cost of acquiring/selling the asset a. Add the \$50 stock price to your basis: \$3k + \$50 = \$3050 basis b. Subtract \$60 sale price from AR: \$4k -- \$60 = \$3940 c. \$3940 (AR) -- \$3050 (basis) = 890 gain to be included in GI Deductions Not Limited to Business/Profit-Seeking Activities ============================================================ 1. No deductions for personal, living, or family expenses **§262** Interest Deductions ------------------- 2. Allows deduction of all interest paid or accrued within the taxable year on indebtedness **§163** 3. **[Interest]** = the amount paid as compensation for the use of money **Rev. Ruling 69-188** i. Does not need to be labeled as "interest" to be classified as interest ii. Method of computation does not control deductibility as long as the amount in question is an ascertainable sum contracted for the use of borrowed money iii. Payment must be compensation for the use or forbearance of money and not a payment for specific services which the lender performs in connection with the borrower's account iv. Funds used to pay interest were not originally obtained from the lender 4. **Borrower** interest payments deductible under **§163(a)** 5. **Lender** interest payments received must be included in GI under **§61(a)(4)** v. Principal repayment is not included in GI or deducted 6. Interest is already deductible for business and investment activities **§162(a); §212(1)-(2)** vi. Even in the absence of 163, 162(a) allows deductions of necessary and ordinary business expenses can argue paying interest falls into this category (or 212) ### Disallowance of Deduction for Personal Interest **§163(h)(1)** i. **§163(h)(2)** -- lists what is not considered personal interest (deductible) ii. Even with interest includable in GI (lender) or deductible (lendee) based on compounding, the lender still must pay taxes on the interest even if the lender has not received the interest payment iii. This is based upon the matching principle (Samuelson's Depreciation Theory), since the lendee can deduct interest expense over the course of the loan iv. Samuelson proposed matching depreciation to the estimated income the asset is going to generate over the depreciation period, but useful life and income estimates were imprecise v. Congress applies this same principle to accounting for interest on bonds (duration and amount of income are certain) ### Qualified Residence Interest (QRI) §163(h)(3) i. #### Qualified Residence a. principal residence (where majority of time is spent) and only one other residence **§163(h)(4)(A)(i)** #### Acquisition indebtedness b. interest incurred in acquiring, constructing, or substantially improving any qualified residence of TP, and is secured by the residence **§163(h)(3)(B)(i)** - Previously \$1M limitation, now \$750k through 2025 **§163(h)(3)(B)(ii); 163(h)(3)(F)(i)(II)** #### Home equity indebtedness c. Indebtedness secured by a qualified residence to the extent that it does not exceed FMV reduced by acquisition indebtedness - Cannot deduct interest payments on home equity indebtedness from GI through 2025 regardless of when debt was incurred **§163(h)(3)(C)(i)** ### Investment Interest Deductions vi. Investment interest is only deductible against investment activities **§163(d)** vii. Investment income does not include capital gains or dividend income d. Since these already taxed at a preferential rate, if they were allowed to be included the TP would get a double benefit e. TP can elect to forego the preferential rate if he wants to include in net investment income #### Tax-exempt investment interest a. interest on a loan used to purchase tax-exempt obligations (municipal bonds / life insurance annuities) cannot be deducted **§265(a)(2)** b. Congress was concerned TP would purchase growth (no dividend) stock with a loan and receive no GI until stock was sold thus the interest deductions would be used to offset ordinary income, essentially creating a tax shelter ### Taxes -- §164 #### Federal Income Tax c. No deduction for federal income taxes **§275(a)** #### State & Local Income and Sales Tax d. Taxes allowed as a deduction for taxable year in which paid or accrued **§164(a)** - State and local, and foreign, real property taxes **§164(a)(1)** - State and local personal property taxes **§164(a)(2)** - State and local, foreign, income, war profits, and excess profits taxes **§164(a)(3)** - Generation skipping transfer tax imposed on income distributions **§164(a)(4)** e. Allows TP to deduct State & Local sales tax instead of State & Local income taxes **§164(b)(5)

Federal Income Taxation Lecture Notes (Fall 2022) PDF

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