Tax 1A Outline

I. RESOLUTION OF TAX DISPUTES................................................................................................................3

A. TRY TO RESOLVE WITH THE REVENUE AGENT. IF NOT ---................................................................................3

II. GROSS INCOME...............................................................................................................................................3

A. GROSS INCOME IS AN INCREASE IN WEALTH AS A RESULT OF A REALIZATION EVENT UNLESS CONGRESS HAS EXEMPTED IT.....................................................................................................................................................3

B. SECTION 61.......................................................................................................................................................3C. TREASURE TROVE.............................................................................................................................................3D. BARGAIN PURCHASE.........................................................................................................................................3E. ASSUMPTION/PAYMENT OF TAXPAYER LIABILITIES..........................................................................................3F. RECEIPT OF DAMAGES......................................................................................................................................4G. MISCELLANEOUS EMPLOYEE COMPENSATION..................................................................................................4H. LOANS...............................................................................................................................................................4I. BARTERS...........................................................................................................................................................4J. FREE USE OF PROPERTY...................................................................................................................................4

III. COMMON STATUTORY EXCLUSIONS AND LIMITATIONS TO GROSS INCOME....................4

A. GIFTS – SECTION 102........................................................................................................................................4B. INHERITANCES – SECTION 102..........................................................................................................................5C. EMPLOYMENT RELATED PAYMENTS.................................................................................................................5D. FRINGE BENEFITS..............................................................................................................................................5E. LODGING AND MEALS.......................................................................................................................................5F. PRIZES AND AWARDS........................................................................................................................................6G. SCHOLARSHIPS AND FELLOWSHIPS...................................................................................................................6

IV. GROSS INCOME FROM PROPERTY......................................................................................................6

A. INTRODUCTION..................................................................................................................................................6B. ADJUSTED BASIS...............................................................................................................................................6C. COST AS THE INITIAL BASIS - §1012................................................................................................................7D. BASIS OF PROPERTY RECEIVED IN EXCHANGE.................................................................................................7E. MULTIPLE PROPERTIES ACQUIRED IN A SINGLE TRANSACTION.........................................................................7F. SIMILAR PROPERTIES ACQUIRED IN MULTIPLE TRANSACTIONS.........................................................................7G. INITIAL BASIS OF PROPERTY ACQUIRED BY RELEASING A CLAIM...................................................................7H. INITIAL BASIS OF PROPERTY ACQUIRED AS A GIFT.........................................................................................7I. INITIAL BASIS OF PROPERTY ACQUIRED FROM SPOUSE OR IN DIVORCE.........................................................8J. INITIAL BASIS OF PROPERTY ACQUIRED FROM A DECEDENT...........................................................................8K. ADJUSTMENTS TO BASIS...................................................................................................................................8L. AMOUNT REALIZED..........................................................................................................................................8

V. MISCELLANEOUS ISSUES AND GROSS INCOME.................................................................................10

A. LIFE INSURANCE.............................................................................................................................................10B. ANNUITY.........................................................................................................................................................10C. DISCHARGE OF INDEBTEDNESS (DOI) OR CANCELLATION OF DEBT (COD) INCOME....................................10D. SECTION 108...................................................................................................................................................11E. STUDENT LOANS.............................................................................................................................................11F. RELATED PARTY DEBT ACQUISITION.............................................................................................................11G. DAMAGES AND RELATED RECEIPTS...............................................................................................................11H. SEPARATION AND DIVORCE............................................................................................................................12I. SALE OF RESIDENCE.......................................................................................................................................12J. INCOME FROM ABROAD..................................................................................................................................12K. PAYMENTS RELATED TO HIGHER EDUCATION................................................................................................12L. INCOME FROM STATE AND MUNICIPAL ACTIVITIES.......................................................................................12

Tax IA Outline 1

VI. IDENTIFICATION OF THE PROPER TAXPAYER.............................................................................12

A. ASSIGNMENT OF INCOME FROM SERVICES.....................................................................................................12B. ASSIGNMENT OF INCOME FROM PROPERTY....................................................................................................13

VII. OVERVIEW OF INCOME PRODUCING ENTITIES...........................................................................14

A. SINGLE OWNER VENTURES.............................................................................................................................14B. MULTIPLE OWNER VENTURES........................................................................................................................15C. CHECK-THE-BOX REGULATIONS.....................................................................................................................15

VIII. ORDINARY AND NECESSARY BUSINESS DEDUCTIONS...............................................................15

A. REQUIREMENTS FOR A DEDUCTION.................................................................................................................15B. §162................................................................................................................................................................15C. ORDINARY AND NECESSARY REQUIREMENT..................................................................................................15D. WHAT IS AN “EXPENSE”?................................................................................................................................16E. TRADE OR BUSINESS REQUIREMENT..............................................................................................................16F. START UP EXPENSES.......................................................................................................................................16G. COMPENSATION...............................................................................................................................................16H. TRAVEL AWAY FROM HOME..........................................................................................................................17I. EDUCATIONAL EXPENSES...............................................................................................................................17J. BUSINESS MEALS AND ENTERTAINMENT.......................................................................................................17K. UNIFORMS.......................................................................................................................................................17L. ADVERTISING..................................................................................................................................................17

IX. OTHER COMMON DEDUCTIONS.........................................................................................................17

A. LOSSES............................................................................................................................................................17B. DEPRECIATION AND AMORTIZATION..............................................................................................................18C. SECTION 212 – EXPENSES FOR PRODUCTION OF INCOME...............................................................................19D. INTEREST.........................................................................................................................................................20E. TAXES.............................................................................................................................................................22F. BAD DEBTS.....................................................................................................................................................22G. CHARITABLE CONTRIBUTIONS.........................................................................................................................22H. MOVING EXPENSES.........................................................................................................................................22I. MEDICAL EXPENSES........................................................................................................................................22J. QUALIFIED TUITION AND RELATED EXPENSES................................................................................................22

X. RESTRICTIONS ON DEDUCTIONS............................................................................................................22

A. PERSONAL RESIDENCE DEDUCTIONS - §280A................................................................................................22B. ‘AT RISK’ RULES - §465.................................................................................................................................22C. PASSIVE LOSSES - §469..................................................................................................................................23

XI. TIMING OF INCOME AND DEDUCTIONS...........................................................................................24

A. IMPORTANCE OF TIMING.................................................................................................................................24B. METHODS OF ACCOUNTING............................................................................................................................24C. TIMING OF INCOME RECOGNITION UNDER THE CASH METHOD OF ACCOUNTING.........................................24D. TIMING OF DEDUCTIONS UNDER THE CASH METHOD OF ACCOUNTING........................................................25E. ACCRUAL METHOD OF ACCOUNTING: GENERAL RULE.................................................................................26F. PREPAYMENTS UNDER THE ACCRUAL METHOD.............................................................................................26G. TIMING DEDUCTIONS UNDER THE ACCRUAL METHOD...................................................................................26

XII. CAPITAL GAINS AND LOSES.................................................................................................................27

A. INTRODUCTION................................................................................................................................................27B. PLANNING IMPLICATIONS...............................................................................................................................27C. REQUIREMENTS FOR A CAPITAL GAIN OR LOSS.............................................................................................27D. WHAT IS A CAPITAL ASSET?..........................................................................................................................27E. SECTION 1231.................................................................................................................................................27F. SALE OR EXCHANGE REQUIREMENT...............................................................................................................28G. Depreciation Recapture..................................................................................................................................28

Tax IA Outline 2

Tax IA Outline 3

I. Resolution of Tax DisputesA. Try to resolve with the revenue agent. If not ---

1. IRS will send a 30-day letter2. Try tax case in

a) Tax court(1) Do not have to pay the deficiency but it is incurring interest(2) Judges are tax lawyers(3) Bound by precedent of the Circuit Court in the circuit it was

tried(4) Unified Court

b) District Court(1) Have to pay tax first(2) Only court where you can get a jury(3) Bound by the precedent of the Circuit Court(4) Judges are not tax specialists

c) Court of Federal Claims(1) Have to pay tax first(2) Judges are tax lawyers

II. Gross IncomeA. Gross income is an increase in wealth as a result of a realization event unless

Congress has exempted it.B. Section 61

1. Basically says that everything is taxed unless exempted.2. In an arms length transaction, the value of what you are getting for something

establishes the value of that item.C. Treasure Trove

1. Cesarini v. United Statesa) Court says that treasure trove is gross income.

2. If no federal law to determine undisputed possession then it is within the providence of state property law.

3. If you assume that treasure trove is taxable then the issue is when the property was reduced to undisputed possession.

4. The realization event is when the person has undisputed possession of the item. When you have something you did not have before and there is no way someone can take it away from you then you have undisputed possession.

D. Bargain Purchase1. True bargain purchase does not result in gross income.

E. Assumption/payment of taxpayer liabilities1. Old Colony Trust v. Commissioner

a) Person would owe taxes on his compensation. Company agreed to pay these taxes.

b) Court says this is additional gross income.2. How can you avoid this

a) Put into settlement agreement that the violations are against the

Tax IA Outline 4

company and not against the employee3. Realization event in the assumption of liability is when someone assumes

your liability and agrees to pay it off.a) Owe someone something b) Claim against youc) In either case, your assets are subject to a claim in the amount of the

liability. When the liability is paid off, then you assets are free and clear.

4. Cancellation of Debt Income is NOT the same as assumption of Liability. Under assumption of debt the creditor will be paid, just paid by someone other than the taxpayer. In cancellation of debt the debtor is not being paid.

5. Good example of assumption of debt and when the realization event happens – Example #2-H – page 16-16 of lecture notes.

F. Receipt of Damages1. Commissioner v. Glenshaw Glass Co.

a) Plaintiff got regular damages and punitive damages.2. Section 104 excludes damages for personal physical injury from gross

income.3. Court will look at how the complaint is drafted in terms of determining the tax

consequences of damages.G. Miscellaneous Employee Compensation

1. Frequent Flyer Milesa) IRS has ruled they are not taxable to the employee

H. Loans1. When you borrow money it is not gross income since it is offset by a liability

a) Security deposits are not gross income to landlord since the tenant has the right to get the money back.

I. Barters1. FMV of the services goes to gross income

J. Free Use of Property1. Value of the use of the property must be declared as gross income.

III. Common Statutory Exclusions and Limitations to Gross Income

A. Gifts – Section 1021. Income that is a gift is excluded from gross income2. Commissioner v. Duberstein

a) Court says the tax definition of a gift is not the same as the everyday definition of a gift.

b) Have to focus on the intent of the giver and whether the giver gave the gift out of “detached and disinterested generosity.” This is the court’s definition of a gift.

(1) Have to consider all the facts. (2) Up to the trier of fact to determine if it is a gift.(3) Motivation of the giver has to be detached and disinterested

generosity. Intent of the donor is all that counts.3. Look for the DOMINATE reason that explains the actions of the donor. So

Tax IA Outline 5

long as the DOMINATE motivation is detached and disinterested generosity then the item is a gift.

4. After Duberstein, Congress added Section 102(c). 5. Section 102(c) relates to an employee and says the transfer is NOT a gift and

thus taxable as gross income.B. Inheritances – Section 102

1. Income from inheritance is excluded from gross income.2. If given in gratitude for services or for services rendered then it is not

excluded.C. Employment Related Payments

1. Retirement benefitsa) Qualified plans and non-qualified plansb) Under qualified plan the employer can deduct costs now and employee

does not pick up as income now. Person is taxed when they retire and collect the retirement benefit

c) Under non-qualified plan the retirement benefit is treated under the general rules of taxation.

D. Fringe Benefits1. In the absence of any particular statute, all fringe benefits would be taxable.2. Section 132 tells when fringe benefits are taxed and when not.

a) Section 132 excludes certain benefits from taxation.b) Some issues are – see §1.132-1 et seq. starting page 956 of code book.

(1) No extra cost to the employer(2) De minimis(3) The discrimination issue – everyone has to be able to have the

benefit (see Reg. 1.132-8(1)(2)) – does not apply to de minimis items.

(4) Spouse and children can benefit(5) Can’t displace a paying customer(6) Same line of business issue.(7) Qualified employee discount. Up to 20% for a service. Have

to report excess over 20%. If a product then apply the formula that is described on page 97 of the casebook.

E. Lodging and Meals1. Section 119

a) Lodging(1) Has to be on premises(2) Has to be for the convenience of the employer. Have to prove

it is serving an essential purpose of the employer by having the person living on the property.

(3) Strengthen case by putting something into employment contract that requires the person to live on the premises.

(a) State person is on duty 24 hours a day(b) Could show that to compete with other similar

businesses in the area you have to have a person on the premises.

b) Meals(1) Have to consider §132 – could be a working condition fringe

Tax IA Outline 6

benefit(2) So long as you charge employees what others would charge

there is not a problem with the IRS. If the employer makes a profit it is gross income to employer.

(3) Need to charge the employees enough to cover cost of running cafeteria.

(4) If you cannot get under §132 then you try to get under §119.(a) Is it for convenience of employer?

(5) §119 applies ONLY when the employer provides the meals. If the employer gives money to employee to buy meal then §119 does not apply. Under §132 it does not make any difference whether the employee is reimbursed for the meal or whether it is furnished by employer.

F. Prizes and Awards1. Most are gross income under §74.

G. Scholarships and Fellowships1. §117 and §127. §117 is most important2. Only exclusion is for tuition and related expenses. Room and board not

excludable.3. If you have to render services to institution then it is not excludable.

IV.Gross Income from PropertyA. Introduction

1. What is property?a) Tangible personal property, real estate, intangibles like stocks,

intellectual property, company good will, secrete formula, pending law suit are all property.

2. Overview of rules as to gross income from propertya) Difference between deriving income from the property and selling the

property.b) §1001 – gain from sale of property. Gain = amount realized minus

adjusted basis.c) Bundle of sticks doctrine

(1) If you give up most of the sticks then it is a sale.(a) If one of the sticks that is given away is the right to

have any appreciation in the property then it looks like an installment sale.

d) You can have a trade and still calculate gain or loss.e) A like kind exchange is NOT taxed under §1031(a)(1).

B. Adjusted Basis1. Best to have a high basis since this will maximize depreciation and reduce

gain when sold.2. COST IS THE INITIAL BASIS – default rule3. Get basis by paying tax on property.

a) Get bonus from employer of stock – since bonus would be taxed as gross income, the basis is the FMV of the bonus

b) Get a gift – no tax on gift – so the basis is transferred from the giver to

Tax IA Outline 7

the recipient. 4. All property is subject or gain or loss unless there is a statute to exclude the

gain or loss.5. If property is destroyed, this is a disposition and the amount realized is zero so

the maximum loss is the adjusted basis.6. Depreciation is always a negative adjustment to basis.

C. Cost as the Initial Basis - §10121. Cost is the initial basis unless some other code section applies.2. Amount of debt used to acquire property goes to the initial basis.

a) Interest DOES NOT affect basis3. If you assume a loan of the buyer the amount of the loan assumed goes to

basis.4. Don’t get basis in property unless you can demonstrate that tax has been paid

on that money that was used to acquire the property.D. Basis of Property Received in Exchange

1. Philadelphia Park Amusement Co. v. USa) Property at stake was an extension of a franchise (right to run a street

car line)b) Abandonment is a disposition of property. Amount realized is zero.c) When you acquire property in a taxable exchange (NOT a like kind

exchange), you look at the value (FMV not adjusted basis) of what you are getting in return to determine the initial basis.

2. If a like kind exchange under §1031, the initial basis of the new property is the basis you had in the old property you gave up.

a) Tax free exchanges are deferrals of tax.E. Multiple properties acquired in a single transaction

1. Have to determine the portion of sale price attributable to each item. This is initial basis for each item.

F. Similar properties acquired in multiple transactions1. If you are selling fungible items bought at different times you can try to

identity the specific items you are selling. 2. If you cannot identify the items you are assumed to be selling the oldest items

first.G. Initial Basis of Property Acquired by Releasing a Claim

1. If an arms length transaction, then your basis is equal to the FMV of what you are giving up if it were a taxable exchange

2. If this were a non taxable exchange, like damages for personal injuries, the initial basis would be the FMV of what you get for giving up the claim.

3. See page 32 of lecture notes for example.H. Initial Basis of Property Acquired as a Gift

1. §1015 – Get the basis from the donor. 2. General Rule for purposes of determining gain or loss is that you use the

donor’s basis and it is carried over to the donee.3. If the gift is large enough there is a gift tax and if a gift tax is paid, you add

that amount to the basis of the gift.4. Farid-Es-Sultaneh v. Commissioner

a) Woman gets stock from future husband and has to determine the basis since she sells the stock.

Tax IA Outline 8

b) She gave up her marital rights in the prenuptial which is something of value.

c) When you give up something of value in return for stock, your cost is the value of what you are giving up and you measure that by the value of what you are getting. This would be the value of the stock she is receiving.

5. Exception in §1015.a) If the basis is greater that FMV at time of gift then the basis is the

FMV for purposes of a loss.b) For purposes of determining a gain, you use the basis of the donor. c) Have to go through the calculation twice to see the result. There can

be a situation where there is no gain or no loss which is a tax free transaction (see problem (b) on page 128 of casebook). Use the chart.

I. Initial Basis of Property Acquired from Spouse or in Divorce1. Treated as a gift – Person getting property has the basis from the donor. No

gain or loss. Section 1041. a) See regulations starting on page 1471 of codebook.

2. U.S. v. Davisa) This was before §1041 became lawb) Wife is giving up rights under the divorce laws.c) Initial basis would be the FMV of the property she was getting.d) Congress changes this rule with enactment of §1041.

3. Now wife gets basis equal to the husband’s basis.4. Be careful of transactions that are incident to divorce. Rules apply if you are

selling to a spouse or a former spouse.5. Look at Example 5-B and page 34 of lecture notes.

J. Initial Basis of Property Acquired from a Decedent1. Adjusted basis goes to FMV on date of death.2. “Basis Step Up Rule” – avoids tax on all appreciated gain.

a) This rules does not apply to corporations or certain trusts.3. Tax planning ideas in Example 5-E and page 36 of lecture notes.

K. Adjustments to Basis1. There can be plus or minus adjustments to basis of the property2. Example #5-F is a good problem

L. Amount Realized1. If you sell a property for 1 million but have a $500,000 mortgage, you will

leave the closing with only $500,000 however, your amount realized is 1 million since you have paid off a debt.

2. Receipt of propertya) Amount realized = money plus FMV of any property received.

3. Receipt of servicesa) International Freighting Corp. v Commissioner

(1) When you use property as compensation you use the VALUE of the property to determine what is deductible.

4. Costs incurred in salea) The costs of the seller reduce the amount realized.b) The costs of the buyer increases the initial basis of the property.

Tax IA Outline 9

5. Liabilitiesa) Recourse and non-recourse loans

(1) Recourse loan. If default, can(a) Sue to get amount(b) If the loan is secured by a mortgage they can foreclose

on the property.(c) If the value of the property has declined and does not

satisfy the amount outstanding on the loan, the creditor can sue the borrower for the difference.

(d) Get a judgment and then pursue any other property owned by the person who defaulted

(e) Creditor stands in line with other creditors(2) If a non-recourse loan

(a) Buyer has no personal liability.(b) Lender can seize the property if they have a mortgage

but if the property has declined in value they cannot sue the person for the difference in price.

(3) Non-recourse and recourse loans are treated the same.b) Installment Purchase - Section 453

(1) Calculate: Gain/amount realized. Take this proportion of each payment and consider it the gain.

(2) If §453 applies the person does not realize gross income until money is paid on the note.

(3) Example #5-K – page 39 of lecture notes(a) Amount realized is amount of cash plus the amount of

the note. (b) Adjusted basis of property is $100,000 and amount

realized is $500,000 so gain is $400,000 but it will come over the term of the note which is for 5 years

(c) Since $400,000 of the $500,000 is gain, the ratio is 80% or 80% of the selling price is gain.

(d) Take this percentage and apply it to all cash received including the down payment.

(e) Thus 80% of each payment goes to gross income and the other 20% is return of capital.

(4) Section 453 does not apply if you are assuming a liability. In the case where a liability is assumed, it is treated as if you are receiving the amount of the liability in the year of the sale.

c) Buyer’s assumption of seller’s liabilities(1) The full amount of the liability that is assumed by the buyer

goes into the amount realized by the seller in the year of the sale. This can never fall under §453 as an installment sale.

(2) Any liabilities assumed by the buyer go to the full amount of the buyer’s initial basis and the seller’s amount realized.

(3) Example #6-C(a) Several ways to handle the assumption of debt

including wrapped mortgage

Tax IA Outline 10

V. Miscellaneous Issues and Gross IncomeA. Life Insurance

1. As a general rule, proceeds from life insurance are NOT included in gross income.

2. If you elect to receive the proceeds of life insurance as an annuity then §101(c) applies.

a) Divide base value of the contract by the life expectancy and this is how much the person gets tax free. The remainder of each payment is taxed as interest.

b) If the person outlives the life expectancy then they continue to receive the amount calculated above tax free which is different from annuity rules.

c) If person dies before the life expectancy time then there is no tax benefit.

d) See Example #6-E – page 43 of lecture notes – using life insurance to buy out a partner’s interest at their death.

3. §101(a)(2) – Transfer for Valuea) If life insurance policy is sold for consideration, then life insurance

proceeds that is excluded from tax is the amount the person paid for the policy plus any additional premiums. Everything else is taxed.

4. Look at lectures notes on page 43 and 44 for examples and how to structure for a partnership.

B. Annuity1. Proceeds from annuity are paid at retirement. Part of each payment is a return

of capital and part is interest.2. Look at life expectancy of the individual when they start to get the payments.

a) Divide the investment by the life expectancy. This amount is excludable each year.

b) The rest is considered to be interest and goes to gross income.3. If you live past the life expectancy then the whole amount is taxable each

year.4. If you die before the life expectancy, then you deduct the amount that was not

returned in the annual payments.C. Discharge of Indebtedness (DOI) or Cancellation of Debt (COD) Income

1. If a creditor reduces your debt, your net worth increases by the amount of the reduction and this amount goes to gross income as per §61.

2. This income can get favorable treatment under §108 (dealing with discharge of debt under bankruptcy, etc.). When debt is assumed by someone else it is NOT COD income.

3. Since §108 provides favorable benefits for COD income it is important to distinguish COD income from other types of income. Threshold question is whether there is a reduction or discharge of debt and if it a true debt cancellation or discharge.

4. If a family member holds the debt and reduces the debt, it may be considered a gift and not a COD. Have to consider the motivation of the al la Duberstein.

5. In addition, if an employer/employee situation the reduction might be considered a bonus or compensation.

Tax IA Outline 11

6. If the amount of the liability is in dispute and the amount owed is reduced it is NOT COD income. The debt will be treated from the beginning as being what is negotiated.

7. Zarin v. Commissioner8. A purchase price adjustment does not create COD in the buyer.

a) Might occur when someone agrees to pay a certain price and starts making payments. At some time later they find there is a problem with the item and the seller reduces the purchase price.

9. Consequences of something being COD incomea) It is included in gross income but it is a favored type of gross incomeb) It is favored because of §108. Even though it is gross income, under

some circumstances you can exclude the amount from gross income.D. Section 108

1. COD can be 100% excluded if the debtor is in bankruptcy. Has to be in a formal federal bankruptcy proceeding

2. COD can be excluded if you are insolvent.3. HOWEVER, if you exclude income you have to engage in tax attribute

reduction.a) Have to take the amount of COD income you are excluding and reduce

certain favorable tax attributes IN THE ORDER they are presented in the code.

b) §108(b)(5) – can elect to reduce the basis of property first. c) If you are reducing the basis, you cannot reduce the basis below the

level of the undischarged liabilities.(1) This limitation DOES NOT APPLY if you skip directly to

basis reduction. You can reduce basis to zero if you like. §1017(b)(2).

4. See Example #6-L and notes pages 48 and 49 for a good example.5. Insolvency

a) §108(d)(3) defines insolvency. Difference between the FMV of assets and total amount of liabilities.

b) You can exclude the COD income up to the level of the insolvency. What is left is gross income.

c) On amount that is excluded you have to do the same attribute reduction as for a bankruptcy.

6. Purchase Money debt reduction - §108(e)(5)a) Applies to original buyer and original seller.

E. Student loans1. Very narrow and person specific. If person agrees to work in certain areas

then the debt is reduce and there is NO COD income.F. Related Party Debt Acquisition

1. If a person who is related to the debtor acquires the debt from an unrelated party, even though the debt is outstanding, it is treated as a cancellation of debt.

G. Damages and Related Receipts1. §104 – Damages for personal physical injuries or physical sickness are NOT

included in gross income.a) If you can demonstrate a physical harm and emotional distress is the

Tax IA Outline 12

result of the physical harm then damages for the emotional distress are excluded from gross income.

2. Punitive damages are included in gross income as is reimbursement for lost profits.

3. §104(c) exception for wrongful death – H. Separation and Divorce

1. Section 1014a) Property transfers

(1) Treated as a gift and no tax consequences(2) Recipient gets the basis the former spouse had in the property.

2. Alimonya) §71 – ordinary income to the recipient and a deduction to the person

paying the alimony.b) Top of page 198 of the casebook gives the requirements for something

to be treated as alimony.c) §71(f) – front-end loading – If too much money is paid in Year 1 and 2

it has to be recaptured in Year 3.3. Indirect Payments

a) Payments to a third person on behalf of the ex-spouse. Still treated as alimony.

4. Property Settlements and Child Supporta) Tax neutral.

5. Parties in a divorce settlement are given a lot of leeway in how they categorize items in the divorce decree. However, if the payments are child support or a property settlement you cannot call it alimony.

6. One spouse has the house and the mortgage payments. Other spouse pays the mortgage payments. The spouse who pays the payments gets the deduction and the other spouse has to declare the mortgage payments as income.

I. Sale of Residence1. §121 – Gain from sale of personal residence that you have lived in for 2 years

is excluded from gross income.J. Income from Abroad

1. Earned income can be excluded.K. Payments related to Higher Education

1. See casebookL. Income from State and Municipal Activities

1. Income from municipal bonds is excluded. Municipality can only use the money from bonds for activities that support the municipality.

VI. Identification of the Proper TaxpayerA. Assignment of Income from Services

1. Lucas v. Earl2. Doctrine of Constructive Receipt

a) If all I have to do is pick up the money that is on the table then it is considered that I have constructive receipt of the money and it is taxable at that time even if I don’t take the money off the table.

Tax IA Outline 13

3. Commissioner v. Gianninia) He earned salary but did not want to receive salary.b) Money is not taxed to him because he no longer had dominance over

the money.c) If you have dominance and control over the money then the money

is taxable to you.4. General Rule

a) Once services are rendered it will be taxed to the person who rendered the services. If the agreement is entered into before services are rendered, it may be taxed to the person doing the services but if the person gives up ALL control over the money then it might be excluded from income under Giannini.

(1) Year-end bonus – have to pay the tax since services already rendered.

b) Contingent fees in lawsuit(1) Courts have held plaintiff is taxed for entire amount since

plaintiff has dominance and control over the lawsuit.B. Assignment of Income from Property

1. Two subgroupsa) Gross income from the ownership of propertyb) Gross income from the disposition of property

2. Assignment of income from Property Ownershipa) Helvering v. Horst

(1) Person owns bonds and lets son get the interest due on the bonds.

(2) Interest is taxable to father since father still owns the bonds.(3) “Fruit and Tree” analysis

(a) “Tree” is the bond and “fruit is the coupon. Person who owns the “tree” is the one who is taxed.

b) If a person gives up some ownership of property, they are not taxed on the income that comes from the portion of the property they have given up.

c) See Page 58 of lecture notes on how to use a trust to assign income.d) Blair v. Commissioner

(1) Blair (P) was to receive the income from a trust created by his father. P assigned interests in the trust to his children. The trustees accepted the assignments and paid the trust income directly to the assignees. The Commissioner held the assignments to be taxable to P, but the Board of Tax Appeals reversed his decision. The court of appeals revered, and P appeals.

(2) Held: One who is to receive the income as the owner of the beneficial interest is to pay the tax. If the interest is assignable without reservation, the assignee thius becomes the beneficiary. P could transfer a part of his interest as well as the whole. Here, the assignees become the owners of a specified beneficial interest, a form of property, and the income arising therein is taxable to them.

Tax IA Outline 14

e) Estate of Stranahan v. Commissioner(1) Father sells for fair consideration his rights to receive

dividends.(2) It is critical in this case that the transaction had real economic

consequences. If there is no economic risk in the assignment it may not be allowed by the IRS.

f) Income is taxable to whoever owns the property unless that right to income is sold or the property is sold.

3. Assignment of Income from Property Dispositiona) Susie Salvatore

(1) A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. Susie owned the station when she agreed to sell. Her conveyance to the children, when viewed as part of the whole transaction, was only an intermediate step in the transfer of legal title to Texaco.

VII. Overview of Income Producing EntitiesA. Single owner Ventures

1. Sole Proprietorshipa) Everything goes on the individual’s personal tax form.b) All income from business goes to individual.

2. Single Member LLCa) If the person does not elect to be a C Corporation (check the box) then

the single member LLC is just like a sole proprietorship and everything goes on personal tax form.

b) Limited Liability.c) Pass through entity so gains and losses pass through to the single

member.3. C Corporation

a) Entirely separate entityb) Files own tax returnc) Limited Liabilityd) Dividends are NOT deductible to corporation so corporation pays tax

on a dividend and the recipient of the dividend pays tax. Double taxation.

e) Compensation is deductible to the corporation. Can only deduct a reasonable amount for compensation.

f) There is a penalty tax if a corporation retains too much income. Have to have a good business reason to retain income.

4. S Corporationa) Files an election to be taxed as an S corporation rather than a C

corporation.b) Files its own returnc) Limited liabilityd) It is a PASS TRHOUGH entity. Income is not taxed at the corporate

level but is taxed to the shareholders even if the income is not

Tax IA Outline 15

distributed to the shareholders.(1) This gets rid of the double taxation problem with C

corporations.e) Lot of rules and requirements for an S corporation.

B. Multiple Owner Ventures1. Direct co-owners

a) Both are directly liable.2. General Partners

a) Each general partner is fully liable for all the debts and obligations of the partnership.

b) It is a pass through entity for tax purposes. Everything passes to the partners whether there is a distribution or not.

c) Partnership agreement determines how the pass through is divided up.3. Limited Partnership

a) Under state law there has to be at least one General Partner and the other partners are limited partners.

b) Pass through4. Multiple Member LLC or Limited Liability Partnership

a) Taxed like a partnership(1) Pass through as per partnership agreement

5. C Corporationa) Makes no difference if there are multiple members

6. S Corporationa) Same as with single member

7. For a new venture the LLC or a LLP is the best organizational structure.C. Check-the-Box Regulations

1. If you are a non-corporate entity like an LLC, a LLP, or a partnership, you can elect to be taxed as a C corporation.

2. If you DO NOT check the box you WILL NOT be taxed as a C corporation.

VIII. Ordinary and Necessary Business DEDUCTIONSA. Requirements for a deduction

1. Has to be a realization event that reduces your net worth and that fits into a specific code provision.

2. No deduction is deductible unless Congress has said so.3. As a general concept, Congress has said that only expenditures that are

incurred in the production of income can be deducted. However, there are exceptions to this general rule.

4. Deductions are a matter of “legislative grace.”B. §162

1. Three requirementsa) Ordinary and necessaryb) Incurred in a trade or businessc) Has to be an expense as opposed to a capital expenditure

C. Ordinary and Necessary Requirement1. Welch v. Helvering

a) Welch paid some of the debts of his former employer. Commissioner

Tax IA Outline 16

ruled these expenditures were not ordinary and necessary business expenses but were rather in the nature of capital outlays for the development of goodwill.

2. Ordinary = is it a common and accepted means of doing business.a) Like a reasonable person testb) Would a reasonable person make this expenditure in this situation?

D. What is an “expense”?1. If you pay for something that helps to generate income over a number of

periods then you have to capitalize that expenditure.2. Indopco v. Commissioner

a) Company incurs costs in evaluating an offer to take over the company. Wants to deduct the costs

b) Court held that the expenses incurred would benefit the company in the future and thus were not ordinary and necessary expenses.

c) If the expenditure generates an economic benefit that extends beyond the current year, then you have to capitalize the expenditure.

(1) This is consistent with the matching notion.3. Expense will not be deductible if

a) It results in a significant benefit to the company that will last for a number of tax periods, or

b) It is used to purchase an asset.4. Reg 1-162.4 – cost of incidental repairs are deductible. 5. If some expenditure increases the useful life or the value of something, then it

is not deductible as an ordinary and necessary business expense.6. If something drives down the value of an asset and there is an expenditure to

bring the value of the asset back up, that expenditure is deductible.7. Are you increasing the value of the asset → not deductible8. Are you restoring the value of the asset → deductible

E. Trade or Business Requirement1. Expenses incurred for the purpose of earning a profit2. Activity has to be ACTIVE rather than PASSIVE3. Distinction between a business and a hobby4. Question is did the taxpayer INTEND to make a profit. If so it is a trade or

business.F. Start up Expenses

1. Amortized over 60 months beginning with the month the business opens. §195.

2. Have to meet the test of §162 that it is a trade or business before you can deduct the start up expenses.

3. Morton Frank case indicates that deductible expenses may be incurred only in connection with the operation of an existing business.

G. Compensation1. Compensation has to be reasonable. 2. Dividends are NOT deductible3. If money is leaving the corporation and the IRS does not feel it is reasonable

as compensation, then the IRS will declare it a dividend.4. How to determine the reasonableness of compensation

Tax IA Outline 17

a) Exacto Springs case(1) Posner – used an “independent investor” test

(a) Call the salary unreasonable only if it reduces the level of corporate income to a point less than that which the investors would expect as a return on their investment.

(b) Posner rejects the multiple factor test.b) Harolds Club case

(1) Contingent compensation is ordinarily allowed as a deduction even though it may be greater than the amount ordinarily paid, if paid pursuant to a “free bargain” between the employer and the individual.

(2) In this case the payment was not the result of a free bargain.c) Salary expenses have to have a real relationship with the value of the

services rendered in order to be deductible.d) If the bargain is reasonable when made and is a free bargain then you

don’t have to worry about the reasonableness in the future. H. Travel Away from Home

1. §162(a)(2) allows the deduction of expenses for traveling, meals, and lodging while away from home and in the pursuit of a trade or business.

2. Have to be away from home for at least one night to qualify.3. Basically can deduct costs that would duplicate costs you are already

incurring at your home.I. Educational Expenses

1. Reg. 1.162-5 and problems on page 392 with answers on page 76 of lecture notes.

J. Business Meals and Entertainment1. Not talking about “away from home” expenses2. Substantiation Requirement

a) Have to have contemporaneous records3. Business Connection Requirement

a) Expense has to be either directly related to trade or business or associated with trade or business.

b) Reg 1.274-2 – must meet all parts of sections (i), (ii), (iii), and (iv) on page 1053 of Code book.

4. Percentage limitation on deductions for meals.K. Uniforms

1. If uniform is something you can use outside of your job then it is NOT deductible.

L. Advertising1. Deductible in the year the advertising occurs

IX. Other Common DeductionsA. Losses

1. What is a loss?a) This is NOT an operating loss which is covered under §162. This is a

loss covered under §165b) §165 concerns disposing of property for a loss

Tax IA Outline 18

(1) Could be sale or stolen or some other loss that results in an amount realized for the property to be zero.

c) Sell personal property for a loss and you cannot take a deduction. Sell personal property for a gain and you have to show the gain as gross income.

d) Ordinary loss is better than a capital loss.e) Loss has to be incurred in a trade or business, §165(c)(1) or an activity

entered into for profit, §165(c)(2) or loss from fire, storm, shipwreck, or other casualty, or from theft §165(c)(3).

(1) Casualty loss can be taken even if it is personal property.B. Depreciation and Amortization

1. Three ways to recover costs for tax purposesa) Deduct costs immediately under §162.b) Depreciationc) Reduce the gain – for those things that don’t wear out. Recover cost

when sold.2. Type of property

a) Tangible personal property ---- ACRS or MACRS appliesb) Intangible personal property ---- §197 allows for amortization.c) Real property --- ACRS or MACRS appliesd) §167(a) – property has to be used in a trade or business or held for

the production of income to qualify.e) Can’t depreciate item until the business opens the door.f) Can only depreciate items that will wear out.

(1) No land(2) No inventory

3. Recovery Periodsa) Items are put into a class and the class determines the life over which

the item can be depreciated.b) Residential real property --- 27.5 years --- NOT personal property

but for real property like apartment buildings used for a trade or business.

c) Non Residential Property --- 39 year useful life.d) Mixed property – Look at gross rental income and if 80% or more of

gross rents are from residential units then the whole building is considered residential.

e) Tangible Personal Property --- most in 3, 5, or 7 year class.f) Intangible Personal Property --- §197 --- 15 years useful life.g) Have to allocated items to different groups when you purchase a

business.4. Initial basis of a property would include

a) Cashb) Note signed to be paid over time or in futurec) Any assumption of liabilitiesd) Legal feese) This initial basis would have to be allocated to the various assets in the

purchase. Have to allocate in proportion to the FMV of the asset.

Tax IA Outline 19

5. Depreciation Methodsa) Straight line

(1) Take initial basis and divide by useful life(2) Reduce the basis each year by the amount of depreciation taken

that year.(3) Have to use straight line method for real estate and

amortization. b) Accelerated Methods

(1) Double declining balance(2) 150% declining balance

6. Depreciation Conventionsa) Tangible Personal Property

(1) Assume you put the property in service at mid-year.(2) Get ½ year depreciation the first year and ½ depreciation at end

of the number of years equal to the useful life.(3) Exception --- 40% rule – then mid-quarter convention.

b) Real Estate(1) Mid-month convention(2) Done on property by property basis.

7. Churning Rulea) Depreciation rules that are in effect when the property is put into

service are in effect until the property is completely depreciated or sold.

b) If sold to a new party then the new party can take advantage of any changes in the depreciation rule UNLESS the new party to whom the property is sold is a related party. (anti-churning rules)

8. §179a) Can deduct some of the cost of personal property (NOT REAL

ESTATE OR INTANGIBLE PROPERTY) in the first yearb) See code for amountc) For small businessesd) Reduce basis of property after taking the deduction.

9. §168(k)a) Taxpayer can take 30% of any equipment and take it as a first year

deduction.b) This deduction is IN ADDITION to §179c) Cannot be for real estate or intangible property. d) Has to have recovery period of 20 years or less.e) Reduces the basis.

10. §197 – Intangible Assetsa) Depreciated over 15 yearsb) Have to use STRAIGHT LINE method.

C. Section 212 – Expenses for Production of Income1. Congress wants to tax you on your PROFITS so any expense you incur for the

purposes of generating a profit should be deductible.2. §212 lets you deduct expenses

a) for the production of incomeb) for management, conservation, or maintenance of property held for

Tax IA Outline 20

production of incomec) in connection with the determination, collection, or refund of any tax.

(thus expense of hiring tax attorney or accountant is deductible)3. Deduction is allowed if the expenditure is reasonable when looking at all the

facts and circumstances (Surasky v. U.S.).D. Interest

1. Revenue Ruling 69-188a) ‘points’ are deductible

2. Two prongs on the definition of interesta) An amount one has contracted to pay for the use of borrowed money

or as the compensation paid for the use of the forbearance of money and

b) must be incidental to an unconditional and legally enforceable obligation of the taxpayer claiming the deduction.

3. Low Interest Loans - §7872a) Imputed Interest

(1) Two transactions – interest is given by the lender to the borrower and the borrower then gives the interest back. No money really changes hands.

b) Gift Loans(1) Foregone interest is the amount of interest that a person would

have charged under the Applicable Federal Rate.(2) Two transactions

(a) Lender is treated as having made a GIFT to the borrower of the foregone interest

(i) No income tax consequences on the gift(b) Borrower pays the “interest” back to the lender

(i) Borrower may get a deduction – look to see if it qualifies under §163

(ii) Lender will have to declare the amount of the imputed interest as gross income.

(3) If loan is LESS than $100,000(a) No difference on first step --- no tax consequences to

anyone with the GIFT of the imputed interest(b) Amount of the interest the lender has to declare is

limited to the amount of the borrower’s investment income. Investment income is from ANY source not just the investment income that comes from the money borrowed.

(4) If loan is $10,000 or less(a) No imputed interest. (b) No tax consequences

c) Non Gift Loans(1) Employer/employee

(a) First step - (i) Imputed interest is considered

COMPENSATION to the employee (borrower). (ii) Employer gets a deduction in the amount of the

Tax IA Outline 21

imputed interest.(b) Second step –

(i) Employer has to recognize the imputed interest coming back so this is a wash.

(ii) If the money the employee borrows is used for a purpose that allows an interest deduction (like home purchase) the employee gets a deduction. If not no deduction.

(c) No $100,000 exception in the non gift situation(d) $10,000 de minimis exceptions applies

(2) Loan to Shareholder(a) Payment of interest to shareholder (borrower) is

considered a DIVIDEND. Shareholder has to declare as gross income and company gets no deduction.

(b) Payment back to company(i) Company has to declare as income(ii) Shareholder may get a deduction depending

upon what the money is spent on.4. Imputed Interest on Sale of Property

a) §1274 – if seller does not charge interest on sale of property, IRS will treat some of the payment as interest.

b) Tax consequences(1) Seller – interest is considered income.; Seller has to recognize

the interest over the time period of the note.(2) Buyer – may be the type of interest that is deductible. BUT

interest is deducted over the period of the note that secures the purchase.

5. Original Issue Discount (OID)a) OID – interest – difference between what someone pays for a bond and

what the redemption value is. (Pay $900,000 for a bond that is remediable for 1 million. This would be $100,000 interest)

b) Recognize and deduct the interest over the period the bond is outstanding.

6. Tax Treatment of Interesta) §163(a) – interest is deductible but there are exceptionsb) §163(h) – no deduction for personal interest

(1) Exceptions(a) Borrow for trade or business – interest is deductible(b) Investment interest is deductible(c) Qualified Residence

(i) Interest paid on mortgage is deductible(a) Debt has to be secured by the residence(b) Applies to personal home and also on a

vacation home(c) Has to be acquisition indebtedness or

home equity debt.c) Qualified Education Loans

Tax IA Outline 22

d) Investment Interest(1) Deductible only to the amount of investment income.

E. Taxes1. §164 – lists 5 specific types of taxes that are deductible

F. Bad Debts1. If borrower cannot pay debt, borrower has cancellation of debt income and

this goes to gross income.2. Is it TRUE cancellation of debt?

a) If a parent/child relationship then it is not cancellation of debt but rather a gift.

b) If employer/employee then it may be compensationc) Have to examine the relationship between the lender and the receiver

to determine if it is TRUE cancellation of debt. 3. §166

a) If a BUSINESS DEBT, then under subsection (a) where you can take a partial deduction.

b) If a NON BUSSINESS loan you cannot take a partial deduction.4. If the debt is a business debt it may be deducted when it become wholly

worthless, or it may be deducted when partially worthless. If the debt is non business, such debts have to become wholly worthless before they can be deducted and then they are treated as short-term capital losses.

G. Charitable contributions1. Deductible if the charity is 501(c)(3).

H. Moving Expenses1. Two situations where you can deduct

a) New job increases computing distance by more than 50 milesb) New job more than 50 miles from home.

I. Medical Expenses1. Only to extent they exceed 7.5% of adjusted gross income.

J. Qualified tuition and related expenses1. See syllabus

X. Restrictions on DeductionsA. Personal Residence Deductions - §280A

1. Combined Residential and Rental Usea) If you live in the property 14 days or less it is just rental property.

2. Home officea) Has to be used as principal place of business for any trade or businessb) Used exclusively for business purpose.

B. ‘At Risk’ Rules - §4651. Can deduct operating loss only to the extent that you are economically at risk

in that activity.2. Additions to ‘at risk’ amount comes from

a) Cashb) Put your property into the activityc) Recourse debt d) Non recourse debt if it is part of qualified non-recourse financing

Tax IA Outline 23

which is borrowing in a real estate business from an unrelated institution.

(1) Regular non recourse debt does NOT qualify.3. If the taxpayer has loss that cannot be deducted, the loss is suspended.

C. Passive Losses - §4691. Second limitation in addition to at risk rules that have to be met in order to

take a deduction for a loss on one activity to offset income from another activity.

2. Three categories of activities – each considered to be in their own ‘basket’ - a) Passive activitiesb) Portfolio activitiesc) Non passive activities

3. A NET LOSS from passive activities CANNOT be used to offset net income from the other two activities.

4. A passive loss can be deducted against income for another passive activity. Thus look for PIGs (passive activity generators).

5. Passive income CAN BE offset by net losses from the other two activities.6. Check in lecture notes starting on page 103 for some examples; especially

examples with a pass through entity.7. Who is affected by the Passive Loss rules

a) Individuals, estates, and trustsb) Closely held “C” corporation impacted only by a limited amount.c) Pass through entities are NOT impacted BUT the individuals to whom

the stuff passes ARE affected.8. Two broad categories

a) Rental Activities(1) Anything where the principal course of income is rental.

Could be things other than property such as rental of equipment.

(2) General Rule: All rental activities are considered to be passive. They are per se activity

(3) Two narrow exceptions(a) Mom and pop exception – small investor(b) Owner is a true real estate professional

b) All Non Rental Activities(1) Material Participation Rule

(a) If taxpayer put in more than 500 hours per year then it is NOT passive activity.

9. Treatment of non-deducted passive lossesa) Suspended losses can be offset in later years if the taxpayer acquires a

PIGb) Also when you dispose of the ENTIRE ACTIVITY, the suspended

losses are freed up.(1) If you sell to a related party it is NOT considered to be a

disposition of the entire interest.c) When the losses are freed up they can be used to offset income from

other sources.d) At death, the suspended losses are freed up BUT are reduced by the

Tax IA Outline 24

amount of the step up basis.

XI. Timing of Income and DeductionsA. Importance of Timing

1. Tax delayed is tax reduced2. Delay tax by

a) Delay in recognition of incomeb) Accelerate deductions

B. Methods of Accounting1. Cash method

a) Recognize income for tax purposes when it comes in the door2. Accrual method

a) Have income when you have done everything needed to get the income and you have a legal right to get the income

b) Get a deduction when you have the legal right to the deduction.3. Choice of method

a) Anyone can be on accrual method but some taxpayers HAVE to be on cash method

C. Timing of Income Recognition under the Cash Method of Accounting1. General rule for when income is recognized.

a) When you get the cash or property, then it is gross income.2. Cash Equivalent

a) Check is considered to be equivalent of cash (Kahler case)b) Note is not like check and thus not equivalent to cash. (Williams)c) Test:

(1) “We are convinced that if a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investor at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is equivalent of cash and taxable in like manner as cash would have been had it been received by the taxpayer rather than the obligation.”

d) How easy is it for person to turn the instrument into cash without a big discount?

3. Economic Benefit Doctrinea) May arise as a deferred compensation plan or a buyer putting money

into escrow for a seller to receive at a later date.b) Test:

(1) Taxpayer has done everything necessary to earn the money(2) Payor (could be a buyer) is obligated to pay the money and

there are no contingencies on the payer(3) Money is set aside with a third party(4) Money is earning interest with the third party for the economic

benefit of the taxpayer, then(5) Taxpayer has to be taxed on the money.

Tax IA Outline 25

c) Rabbi Trust (1) Company puts money into a trust but trust agreement says that

company creditors can get to money in trust if need be. Keeps person who is eventual recipient of the trust from being taxed each year under the economic benefit doctrine.

4. Constructive Receipt Doctrinea) If a cash method taxpayer has an unqualified vested right to receive

immediate payment, the taxpayer cannot escape the recognition of the income by deferring the time that payment is to be made or by otherwise turning his back on the income. The income is recognized at the time the taxpayer has the right to immediate payment.

b) If the taxpayer agrees to the deferral of payment before his right to the payment has been earned, the taxpayer will not recognize the income until the date on which the deferred payment or payments are to be made.

c) Arises when three situations exist(1) Taxpayer has the legal right to get the money. Cannot be any

preconditions(2) Taxpayer has to have the practical ability to get money now(3) Taxpayer must voluntarily choose not to get the money now.

d) If a contract provides for payments in the future then the constructive receipt doctrine does not arise.

e) If there is a contract amendment, then see if there is additional consideration from both sides.

f) Good example --- Example #12-D and lecture notes on page 112.5. Installment Sales under §453

a) Take ratio of amount of gain/amount realized. This is the percent gain. Take this percent of all money, including down payment, received and recognize for tax purposes.

D. Timing of Deductions under the Cash Method of Accounting1. General Rule

a) When the payment is made in the form of cash or other property, then the deduction can be taken.

2. Cash Equivalent Doctrinea) When employer hands an employee a check it is a deduction at that

moment.b) When you sign a credit card statement, you can take the deduction.

3. Economic Benefit Doctrinea) When employer sets aside the money it is deductible at that time.b) If it is income to the employee it is a deduction to the employer.

4. Constructive Paymenta) No deduction here. May have income under constructive receipt but

no deduction under constructive payment.5. Expense v. Capitalization

a) When you prepay insurance and the benefits last over a number of years, you deduct the expense over the time the benefit lasts.

6. Prepaid Interesta) If you prepay interest it creates a benefit that extends into the future

Tax IA Outline 26

and you have to deduct over the years.E. Accrual Method of Accounting: General Rule

1. General Rulea) Recognized as gross income when all the events have occurred that fix

the right to receive such income and the amount thereof can be determined with reasonable accuracy.

b) Income is recognized on the FIRST to occur of(1) Performance of the duties, (2) Billing, or(3) Payment

2. Examplesa) Accounts Receivable – recognize when amount is billed. Under cash

method recognize when receive the money.b) Delinquent Account Receivable – if amount is fixed then recognize in

current year.3. “Claim of Right” Doctrine

a) North American Oil(1) If you get paid and claim you have a right to the payment, then

you have to report the income in that year even if there is a dispute as to the amount or the legal right and even if you have not received the money.

F. Prepayments under the Accrual Method1. Under some circumstances even if you have been paid, you can defer the

income until a later year.2. Artnell v Commissioner

a) Previous cases (Auto Club of Michigan, AAA, and Schlude case, led to conclusion that you needed to pick up all the prepaid income in the year it was received.

b) In Artnell, court said that since they knew when games would be played (good predictability) they could recognize the income in a future year for games to be played in that year.

G. Timing Deductions under the Accrual Method1. Period Costs versus Inventory Costs

a) §461(h) – another prong for test for deductions.(1) Have to be legally obligated to make the payment(2) Have to be able to estimate with reasonable accuracy(3) Cannot deduct until economic performance has occurred.

b) Conditions for economic performance(1) Services and property provided TO the taxpayer. If liability

of the taxpayer arises out of(a) Providing services to taxpayer by another person ---

economic performance when person provides the services

(b) Providing property to taxpayer by another --- economic performance when person provides the property

(c) Use of property by taxpayer --- economic performance when taxpayer uses the property.

(2) Services and property provided BY the taxpayer. If liability

Tax IA Outline 27

of the taxpayer requires taxpayer to provide property or services, economic performance when taxpayer provides such property or services.

(3) Tort Liabilities of the taxpayer. Economic performance occurs when the taxpayer pays the tort damages.

(4) Exception for certain recurring items(a) See Code – page 458.

XII. Capital Gains and LosesA. Introduction

1. Character of the income is what is important2. For deductions the threshold question is whether it is deductible under §165.3. The only time you can have a capital gain or loss is when you are selling or

exchanging the property.a) You have to transfer enough of the bundle of sticks in order for there

to be a capital gain or loss.B. Planning Implications

1. For gains, the order from best to worse is LTCG, STCG, Ordinary Income. 2. For Losses, the order from best to worse is Ordinary Loss, STCL, LTCL.

C. Requirements for a Capital Gain or Loss1. Has to be a SALE or EXCHANGE2. Property that is being sold or exchanged must be a capital asset.

D. What is a Capital Asset?1. Section 1221 says that ALL property held by the taxpayer, whether in trade or

business is a capital asset EXCEPT for the 8 listed exceptions.2. Property is broadly defined.3. Stautory exceptions under §1221

a) §1221(a)(1) – inventory and property held for sale to customers in the ordinary sale or business.

(1) Inventory is NOT a capital assets since it fall under the exception. Any sale of inventory generated ordinary income.

b) §1221(a)(2) – Property subject to depreciation or real property used in a trade or business.

(1) Items excluded here are picked up under §1231.4. Judicially Created Exception

a) Hort v. Commissioner(1) If all you have is a “naked contract right to future income”, you

do not treat this as a capital asset and thus cannot get capital gain treatment.

5. Thus, ALL property is a capital asset EXCEPT the 8 exceptions and the one judicial exception under Hort.

E. Section 12311. If you sell a §1231 asset for a gain it is a capital gain.2. If you sell a §1231 asset for a loss it is an ordinary loss.3. Net in the hotchpot.

Tax IA Outline 28

F. Sale or Exchange Requirement1. Kenan case

a) If you transfer property to someone else to satisfy a claim they have against you it is treated as a sale.

2. Arrowsmith Doctrinea) If the transaction is later years arose out of a sale or exchange of a

capital asset, then the new transaction is treated as arising out of the original transaction and if the original transaction was a capital transaction then the later transaction is also a capital transaction.

3. §1239a) Selling to a related party, even if a capital asset, change the transaction

into ordinary income.G. Depreciation Recapture

1. If you are selling depreciable property, your gain, even on a capital asset, is turned into ordinary income to the extent of you prior depreciation deductions.

Tax IA Outline 29