Taxation of Individual Income Outline · 2014 SPRING TAXATION OF INDIVIDUAL INCOME! MURPHY! Page 3...

2014 SPRING TAXATION OF INDIVIDUAL INCOME MURPHY

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Taxation of Individual Income Outline Professor: Ann Murphy Chapter 1 - Introduction

1 Sources Of Law a 16th Amendment gave power to Tax

b The Internal Revenue Code - Enacted by Congress i Title 26 of the United States Code ii Subtitle A: Income Taxes (Individual and Business) iii Subtitle F: Procedure & Administration

1 § Subchapters: a A: Determination of Tax Liability b B: Computation of Taxable Income c O: Gain or loss on disposition of property d P: Capital gains & losses

c Regulations - Created by Internal Revenue Service & Treasury Department i Enabling Statute: §7805(a):gives Secretary of Treasury power to “prescribe all needful

rule & regulations for the enforcement of this title.” ii Found In: 26 C.F.R.____; Tres. Reg. ___ iii What They Cover: Treasury regs expands on how things are taxed but does not change

taxpayers substantive rights as to what is subject to tax. iv As long as the Treasury doesn’t clearly exceed authority, the regulation is as good as

law.Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)

v Types of Regulations 1 Proposed Regulations: 30 day notice and comment period 2 Legislative Regulations: force of law, follows notice and comment rules 3 Temporary Regulations: 3 year expiration unless it becomes Leg. Reg.

d Administrative Rulings - From IRS in form of Rulings and Pronouncements i Private Letter Rulings: Put together from a specific question to the IRS

1 Binding only to TP ii Technical Advice Memoranda: Request by IRS agent during an audit on a question

that can’t be answered locally. Applies only to taxpayer. More useful than PLR. iii Determination Letters: Not precedent but are useful for understanding IRS position

and strategy. iv Revenue Ruling- declaration of how IRS is going to treat an issue

e Case Law - Courts with jurisdiction over tax cases and their precedential value i U.S. Tax Court: Don’t have to pay the tax before court, no jury, jurisdiction over entire


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tax return, does not decide on amount of tax owed, precedent is binding on all taxpayers across U.S. unless overruled by higher court, appeal to Circuit Court of Appeals.

1 T.C. Decision: Citable precedent 2 T.C. Memorandum Decision: Not precedent but useful if nothing else

ii U.S. District Courts: Refund case only, jury optional, limited jurisdiction to hear certain issues disputed by the taxpayer, precedents are binding on taxpayers within the jx of the district court, appeal to Circuit Court of Appeals.

iii U.S. Court of Federal Claims: Refund cases only, jurisdiction limited to certain issues disputed by the taxpayer, precedents binding on all taxpayers across U.S., appeal to the Circuit Court of Appeals.

iv U.S. Circuit Court of Appeals: Hears appeals for all trial courts on taxation, precedent only binding on taxpayers with in the court’s respective circuit.

2 Tax Rates and Progressivity a Progressive Taxation: As taxable income increases, the tax rate increases. (U.S. system).

i Argument for Progressivity in Taxation 1 As one becomes wealthier, the utility of their money declines 2 Wealthy people should pay more because they benefit more from usage. 3 Accomplishes some degree of wealth redistribution

ii Arguments against Progressivity in Taxation 1 Makes the tax code more complex 2 Distorts taxpayer decisions to work or not work 3 Inequities between similar TP

b Regressive Taxation: All taxpayers pay the same amount of tax in relation to the tax base. c Effective Tax Rate: Describes the average rate at which taxpayer is taxed on their income

i Calculation = Tax Liability / Taxable Income d Marginal Tax Rate: The tax rate applicable to taxpayer’s next dollar of taxable income

i Note: This will be the % of the tax bracket the taxpayer is in. 3 Impact of Filing Status

a Generally i §1: Tax liability depends on 1) individual's filing status and 2) taxable income ii MARRIED PPL must file 1 of 2 married options

b Married Filing Jointly i §1(a) Tax table: Married filing jointly (spouses combine income, must be married)

1 Policy: man + wife = 1 economic unit ii § 7703(a): if the couple is married on the last day of the taxable year, the couple can file

a joint return for the year. iii §2(a)- surviving spouse generally an individual whose spouse died in either of the 2

prior years and who maintains a home that is also the principal residence of their child or stepchild.

iv Same sex couples can file this status if in state where marriage is legal, or if married where marrigage is legal.

c Head of Household


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i §1(b) tax table for HOH ii §2(b)- Head of Household: one who maintains home as a principal residence with a

dependent (child/ stepchild/ gkid/ step- gkid), for at least half the year, and neither married nor a surviving spouse.

d Unmarried/Single and Not Head of Household i §1(c)- Unmarried & Not Head of Household tax table

e Married Filing Separately i §1(d)- Married filing Separately (pay more tax than indv.)

f Adjustments to Basic Rate Tables i §1 (f)(1)- inflation adjustments → Annual adjustment to keep up with inflation ii §1(f)(2)-(6)- rules for adjustments iii §1(f)(8)- mitigates “marriage penalty” effect in lower tax brackets & requires ceiling of

15% tax bracket for unmarried ind. iv §1(i)(1)- 10% rate bracket (now 6 rate brackets) v §1(i)(1)(B)- sets fixed bracket amounts for lowest rate vi §1(i)(1)(c)- requires inflation adjustments to amounts as of 2004. vii §1(i)(2)- rate reductions applicable to four highest brackets for all taxpayers.

4 Liability for Tax & The Innocent Spouse Rules a Code Sections Applicable

i IRC §§6013(d); 6015(a)-(c)(3), (f) ii IRC §§6012(a); 6072(a); 6151(a) iii Treas. Reg. § § 1.6015-1 through- 5

b Rules i Minimum Filing Requirements

1 §6012(a)- requires taxpayers prepare & file income tax return if their “gross incomes” exceed certain min. levels.

2 §6072(a)- most individuals required to file a return by April 15 of the following year.

ii J&S Liability / Payment Requirements: 1 §6151(a)- If return shows tax due required to include tax with the return. 2 §6012(d)(3)- J&S liability for any deficiency of married filing jointly return-

either person liable to pay entire tax deficiency iii 3 instances for relief from J&S liability: §6015- relief rules for innocent spouse

1 § 6015(b)- relief is satisfy 5 requirements 2 § 6015(c)- Spouse who filed joint return can elect to limit income tax liability for

that year to sep. liability amount only if 1) no longer married, legally separated, or do not reside together over a 12 month period and 2) had no actual knowledge of the item causing a deficiency at the time the spouse signed the return.

3 § 6015 (f)- Sec. of Treasury may grant equitable relief if not available under b or c.

4 NOTE: Taxpayer has BOP for all except (c )(3) knowledge requirement. iv INVALID if evidence of fraud transfer between parties


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c Case Law i Cheshire v. Commissioner, 282 F.3d 326 (US.Ct.Ap.5th Cir. 2002)- p.19

1 Issue: Does a wife apply for innocent spouse relief under (c )(3) or (f) when the husband took $ out of IRA early and told wife it was not taxable because used to pay the mortgage & confirmed by the CPA?

2 Rule: Actual knowledge= “knew or had reason to know” that the deduction would create a tax understatement at the time of signing.

a Test for “reason to know:” Factual inquiry whether a reasonably prudent taxpayer in spouses position at the time she signed the return could be expected to know that the stated liability was erroneous or that further investigation was warranted.

b Legislative history refers to “the incorrectness of the item.” 3 Holding: No relief under (c ) because spouse had knowledge. Knew enough

about the underlying transaction that defense is a mistake of law, then reason to know. Plus amount taken out & amount of interest.

a No equitable relief under (f) because $ went to pay off mortgage & she benefited.

b Most important factor: whether the spouse seeking relief significantly benefited from the understatement of tax.

Chapter 2: Computing Liability for Tax 1 Everything is included in income under §61, unless there is a specific exclusion. 2 Determining Taxable Income

a Gross Income: §61(a)- Gross income is “all income from whatever source derived.” (15 exs)


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i Def. parallels 16th Amendment - Congress desire to exert full measure of tax authority. d Adjusted Gross Income: § 62(a): AGI = Gross Income - 18 above the line deductions

(available to all e Taxable Income: Two different ways to calculate taxable income →

i §63(a): taxable income (Standard) adjusted gross income is gross income minus deductions (other than standard deduction).

ii § 63(b)- alternative def. of taxable income. (Itemized) taxable income = “AGI minus standard deduction & deduction for personal exemptions.”

iii Taxpayer choice as to selection between §63(a) & (b). f Personal Exemptions: A reduction of taxable income per person claimed on tax return

i Application: § 151- authorizes taxpayer to deduct, on his/her return, a set amount per person claimed on the return. People can claim themselves, spouses, and dependents.

ii Policy: personalized exemptions to allow certain amount of income to meet basic subsistence needs.

iii Amount: §151(d)(1)- exemption amount = $2,000 per exemption iv Adjustment: §151(d)(4) – allows amount to be adjusted for inflation annually. v Dependents: dependents may be claimed as deduction if they are a “qualifying child”

(§152c) or “qualifying relative” (§152d) as defined by the code’s tests vi Qualifying Relative: 5 Part test →

1 the individual must have 1 of 7 listed relationships to the taxpayer or be a member of the taxpayer’s household;

2 the taxpayer must provide over half of the individuals total support; 3 the individual’s gross income must be less than the exemption amount; 4 the individual must be a citizen or resident of the U.S. or a resident of Canada or

Mexico; and 5 the individual does not file a joint return with a spouse.

vii Qualifying Child: 5 Part Test → 1 the individual must be the taxpayer’s child (biological or adopted son/ daughter,

stepson/ stepdaughter, eligible foster child or any descendent of such child) OR sibling (brother, sister, stepbrother, stepsister, half brother/ sister, or any descent of such a sibling);

2 the individual must be under the age of 19 (or under the age of 24 & a full-time student);

3 with some exceptions individual must be a citizen or resident of US or a resident of Canada or Mexico who does not file a joint return with a spouse;

4 the individual’s principal place of abode for more than half of the year must be the same as the taxpayer’s; and

5 the individual must not have provided over half of their own support. viii Support of Dependent: The amount of money spent on your punk ass kid

1 Reg Definition: Reg. §1.152-1(a)(2)(i): “support” includes items like food, shelter, clothing, medical & dental expenses, education expenses, & similar items.


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2 Case Law Definition: Court has given “support” broad interpretation (ex- cost of car given to child & title in child’s name, cost of care for dog. (See p.41- rev. ruling)

3 Students: § 152 (f)(5)- Special support test for students 4 Divorced Parent Support Test: § 152 (e)- Special support tests for children of

divorced parents. Depends on who pays for what for the child. Only one parent can claim the exemption. (Can’t split the exemption)

5 Divorced Parent Support Agreement: § 152(d)(3)- “Multiple Support Agreements” if no one taxpayer furnishes over half of individual’s support. May choose own agreement for who may claim dependency exemption, so long as together supporters together furnish over half of individual’s support & the chosen provider supplied over 10% of the total support.

6 SSN Requirement: Taxpayer must put child’s SSN # on the tax return. This prevents multiple taxpayers from claiming the same person. If child/relative has no SSN, they can get an ITIN to put in the box.

g Deductions: A reduction of taxable income per a statutory allowance in the tax code i General Rule: § 161 – Items are only deductible if the code specifically authorizes the

deduction.(narrow interpretation). ii Where do Deductions Come In: Pre-AGI Deductions are subtracted from gross income

to get adjusted gross income, & Itemized/Standard deductions are subtracted from adjusted gross income to get taxable income.

iii Two Types of Deductions: There are “Above the Line” and “Below the Line” 1 Above/Pre-AGI: deductions: subtracted from gross income to reach AGI. 2 Below/Post-AGI: deductions subtracted from AGI to get taxable income.

iv Two Methods for Below the Line: A taxpayer either takes a “standard deduction” or an “itemized deduction”

1 Standard: §63(c) – a set amount that the taxpayer may deduct. The basic standard deduction is per the taxpayer’s filing status. There is also an additional standard deduction for blind people and elderly people.

2 Itemized: §63(d)- itemized deductions are below the line deductions (excluding personal exemptions) that are specifically allowed (ex. home mortgage, medical)

v Inflation Adjustment: §63(c)(4)- adjusted for inflation per year published by IRS vi Tax Ladder: p.33- the process by which taxable income is calculated

h Limitations on Itemized Deductions i Misc Itemized: §67- reduced by 2% of AGI. (Ex. unreimbursed expenses from work,

etc) ii Misc Itemized Phase-Out: §68- gradually phases out amount of itemized deductions for

most affluent taxpayers. (see calc below) iii The Two Percent Haircut: §67(a)- taxpayer can deduct Misc. Itemized Deductions

only to the extent that such deductions, in aggregate, exceeds 2% of the taxpayer's adjusted gross income. Amount disallowed (the 2%) is not preserved/ carry over to Year 2- it’s permanently disallowed.


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iv Misc Itemized Deduction Composition: §67(b)- definition of “Misc. Itemized Deductions” = ALL itemized deductions other than the 12 deductions listed in §67(b), which are the 12 itemized deductions listed as “regular itemized deductions” not subject to the 2% haircut. Misc.- deductions not listed in §67(b) nor §62(a).

1 Note: largest is unreimbursed business expenses by employee & charitable contributions.

v AMT Calculation: NOT deductible for purposes of the “alternative min. tax.” 1 Note: Too many misc itemized deductions will increases chance of liability for

Alt. Min. Tax in addition to regular federal income tax and increase chances of audit.

vi Phase-Out of Itemized Deductions 1 Ceiling Amount: §68- After 2012 only taxpayers with taxable incomes in excess

of an “applicable amount” will lose up to 80% of their total itemized deductions. 2 Note: For 2010, 2011, & 2012 allowed to deduct full amount of itemized

deductions plus amount left after application of §67- 2% haircut. 3 Applicable Amounts

a §68(b)(1)- individual, except married but filing separate returns, applicable amount = $100,000.

b §68(b)(2)- Married filing separate applicable amount = $50,000 4 Calculation: §68(a) – requires a reduction by the lesser of 3% of the excess OR

80% of the total itemized deductions. 5 Excesses: If in excess of applicable amount MUST reduce amount of itemized

deductions by 3% of the excess (in addition to 2% haircut under §67). a 3% disallowed amount does not carry over to next tax year. b Total itemized deductions are phased out as taxpayer’s adjusted gross

income increases. c Reduction under §68 shall never exceed 80% of total itemized

deductions, they are never fully phased out. 6 Exceptions to Rule: §68(c)- “Fantastic Four” itemized deductions, not subject to

§68 phase- out. i Business Deductions: Deductions the taxpayer can take as part of their business (Pre-AGI)

i General Rule: § 162(a)- allows deduction of “ordinary & necessary expenses paid or incurred during the taxable year in carrying on a trade or business.” Also applies to individual employees’ business expenses, BUT those are treated as misc. itemized deductions subject to 2% haircut. Used in less than a year, deduction in year 1.

ii Policy: Allows businesses to deduct the cost of doing business, prevents taxpayer from being taxed on gross profits.

iii Exclusions 1 Does NOT include costs incurred in producing earned income (Hantzis) 2 Generally, with 1 exception, §162 are “above the line” deductions / Pre-AGI

j Investment Related Deductions: Deductions that taxpayer takes for production of income i General Rule: § 212- allows deduction for “all the ordinary & necessary expenses paid


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or incurred” for the taxable year for: 1 the “production or collection of income” ; 2 the “management, conservation, or maintenance of property held for the

production of income”; and 3 expenses incurred in the connection with the collection of refund of any tax

ii Note: Generally, categorized as Misc. Itemized deductions, subject to 2% haircut. 5 Overview of Credits

a IRC §§ 21; 25A; 26; 31(a); 32 b Function of Credits: Claim credits against tentative tax liability. Any tax liability remaining

after application of credits = final tax liability which is what you owe the government. Apply credits, after calculating taxable income & tax owed. If credits exceed tax liability, might be refund.

c Credit v. Deduction: Credits are preferable to deductions because credit reduces tax liability dollar for dollar. Opposed to deductions that only have tax savings equal to amount of deduction times taxpayer’s marginal rate (rate at which the last dollar of taxable income is taxed).

d Types of Tax Credits: Two kinds of tax credits that reduce tax liability i Refundable: reduce your tax below zero and provide you with a refund. ii Non-Refundable: reduce tax owed to zero, but can’t be used to get a refund

e 4 Credits We Cover: DCC, Education, Taxes Paid, EIC i Credit for Income Taxes Paid: Employers withhold taxes on your paycheck and some

taxpayers pay quarterly installments to the IRS for other income tax reasons. 1 For Earned Income: Withheld “at the source.” (Employee’s paycheck) §31(a):

Amounts withheld from wages are credited against the taxpayer’s pre-credit tax liability to determine if sufficient tax was collected through withholding process.

2 Refundability: Refundable if exceeds pre- credit tax liability; the excess tax is refunded, without interest.

ii Earned Income Credit: Credit for taxpayers that make earned income 1 General Rule: §32- eligible taxpayers can credit 7.65- 40% of “earned incomes”

against their pre-credit federal income tax liabilities. 2 Policy: targets low- income taxpayers, work incentive. 3 Phase Out: Phased out as AGI exceeds $5,280 4 Calculation: Credit % is a function of the number of “qualifying children. 5 Refundability: Refundable credit 6 Married: Only claim credit if filing joint return (32(d))


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Chapter 3: The Meaning of Gross Income

1 Judicial and Administrative Definitions of Income a General Approach of Tax Code: IRC §61(a)- Gross income is “all income from whatever

source derived.” Basically means that everything is income unless we say it isn’t income. b Power To Tax The People: From 16th Amendment of US Constitution (1913) that gives

Congress the power “to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states and without regard to any census or enumeration. Intent to exercise full authority.

c Early Definition of Income: Haig-Simons (unofficial) definition of income → Income is the sum of a taxpayer’s consumption plus change in wealth for a particular period. (Income= Consumption + Change in Wealth).

d Regulations Defining Income: Treas. Reg. § §1.61-2(d)(1); 1.61-14(a) e Examples of Income: 61(a), not an exclusive list

2 Defining Gross Income: a Eisner v. Macomber, 252 U.S. 189 (1920)-p.60

i Facts: Taxpayer received a proportionate stock dividend. IRS sought to tax it ii Holding: No, a stock dividend , with receipt of 1,100 additional shares, is not gross

income because “in substance, not form” he has not received income under 16th amendment definition. If sold, it is then subject to tax.

iii Rules: 1 Income: “may be defined as the gain derived from capital from labor, or from

both combined…” it includes profit gained through a sale of conversion of capital assets. Gain= a profit, something of exchangeable value derived from property


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2 Realization Requirement: taxpayer must receive some right or asset that is sufficiently distinct from the property. (no longer constitutionally required)

3 Essential and controlling factor: the Stockholder has received nothing from the company’s assets for his separate use and benefit. (remains property of the company & subject to business risk, which could be eliminated).

b Commissioner v. Glenshaw Glass Company 348 US 426 (1955)- p.63 i Facts: Settlement money as exemplary damages for fraud. Also punitive for antitrust

recovery, which did not report as income. IRS sought to tax it. ii Holding: Yes, punitive damages paid from litigation are taxable income because the

money was from a punishment to wrongdoers does not reduce the taxable income to the recipient & meets definition.

iii Rules: 1 Pre §61: §22(a)- Defines Gross Income [predecessor of 61(a) 2 Modern Definition of Income: p. 65- “Undeniable accession to wealth, clearly

realized, & over which the taxpayers have complete dominion & control.” 3 Finding Free Stuff

a Cesarini v. United States,296 F.Supp. 3 (N.Dist. Ohio 1969) p.67 i Facts: People found money in piano and reported it as income then sued for refund ii Hold: Taxpayers are not entitled to a refund for amount paid in taxes on money found in

their piano. Income from all sources is taxed unless there is an express exemption. Also since there was no sale or exchange, they are not entitled to capital gains treatment, rather incur tax liability at ordinary income rates. (Dismiss case).

iii Rules: 1 Found Money: Found money is “clearly realized” when found. 2 Realized When?: Clearly realized is when it accessible to the taxpayer, not

referring to a subjective awareness. Once the taxpayer has asserted complete dominion over the found treasure trove, they have acceded to that wealth.

b Found Items Under Code i Treasure Trove: When you find property/money that does not belong to you and you

then assume control and assert dominion over that property. ii SOL: Statute of Limitations is typically 3 years from the time of filing. iii Exemptions:

1 §74- value of prizes & awards in gross income in most cases. 2 §102 value of gifts received from gross income 3 § 1.61-1(a) Treas. Reg.- income is “not limited to” 15 exs.

c Rev Rul. 61, 1953-1, Cum. Bull. 17 i Rule: The finder of a treasure trove is subject to Federal income tax to the extent of its

value in US Currency for the taxable year in which they undisputedly possessed it. Treas. Reg. §1.61-14(a);

4 Barter and Imputed Income → Usually is taxable income a Revenue Ruling 79-24 (1979-1 C.B. 60)

i Facts: A few fact patterns of group who exchanges services for services


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ii Holding: Yes, exchange of services are taxable and included in gross income under §61. iii Rule: §1.61-2(d)(1): If services are paid for other than in money, the FMV of the

property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in absence of evidence to the contrary.

b Imputing Income: When the taxpayer has realized some sort of benefit but the transaction was not something that is easily discernable, the IRS may impute income to the taxpayer by requiring the taxpayer to recognize income on that item.

c Barter Exchanges: barter exchange with another is taxable. Perform services for others in exchange for their services. This is no different than someone paying you because they just paid you with their services, not money.

5 Illegal Income → Usually is taxable income a James v. United States, 366 U.S. 213 (1961) p.79

i Facts: Union official embezzled funds for personal gain. IRS says its income ii Holding: Yes, embezzled funds are included as “gross income” for the year the funds

are misappropriated. However , the “willful” element can not be proven by failing to include the funds on the tax returns, case reversed & dismissed.

iii Rules: 1 Unlawful Gains: Earnings acquired, lawfully or unlawfully, without the

consensual recognition, express or implied, of an obligation to repay and without restriction to their disposition, it is income & must be included on the return, even though the taxpayer may still be adjudicated liable to restore its equivalent.

2 Gain: Gain “constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.”

3 Dominion/Control: Taxpayer has “actual command over the property taxed- the actual benefit for which the tax is paid.” (if victim later recovers back the misapproprated fund, embezzler’s income reduced)

4 Tax Evasion: § 7201 (1954): Attempting to willfully evade federal income tax due. Now penalized by $100k fine and up to 5 years in prison.

5 Willfulness: requires specific intent that must be proven by independent evidence and can’t be inferred from mere understatement of income.

Policy:Dont want to make hard workers pay tax, but the thief not. 6 Compensation for Services

a Payments to Third Parties: §61(a)(1)- all forms of compensation for services must be included in gross income. Taxable compensation does not have be received directly by the taxpayer.

i Additional Info: Treas. Reg. § §1.61-2(a)(1); 1.61-2(d)(1)-(2)(i) ii Old Colony Trust Co. v. Commissioner 279 U.S. 716 (1929) p.84

1 Facts: Employer’s paid an employee/officer’s income taxes for him and the IRS said that it constitute taxable income to the employee

2 Holding: Yes, it is income to the employee & taxable. It was paid in consideration of the services rendered by the employee from his labor. The form


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of the payment does not make a difference & doesn’t matter that taxes were paid directly to the government. The discharge by a 3rd person of an obligation is equivalent to it being the person taxed. It is not a gift, for services, although voluntary is compensation.

iii McCann v. US (p86) 1 Facts: employee wins a “business trip” for seminar in las vegas. When there is

“partying & carousing” with topless dancers. (IRS says it’s a problem... is it?) 2 Holding: Yes income, it was not a business adventure and for services rendered

when you deviated. Look at Primary Purpose of the trip: won in sales dept. based on sale %.

3 Rule: When the employee is the one clearly benefiting from the trip and primary purpose of the trip is not for the employer’s benefit, then the trip is taxable to employee. Gross income includes prizes and awards. When payment is not made in cash, you use FMV of what was received.

iv US v. Gotcher, 401 F.2d 118 (1968) 1 Facts: Husband and wife were flown to Germany by VW for Husband’s

involvement in being a VW distributor in America. The trip was to see VW factories and meet VW execs. The Gotchers did do some non-business activities but Mr. Gotcher’s activities were primarily all business.

2 Holding: Taxable to wife, not taxable to husband. Mr. Gotcher was there for the primary purpose of benefiting VW. The trip need not be boring or not-enjoyed to not be taxable. Wife was there to accompany husband and her trip was primarily personal.

3 Rule: If the taxpayer shows the presence of a legitimate purpose and that no appreciable amount of time was spent on personal benefit and enjoyment. If the personal benefits are incidental to the dominant/primary purpose of benefiting the employer, then the trip is not taxable.

b Meals and Lodging Furnished on Employer’s Premises (119(a)) i Meals: An employer can’t pay you so that you can buy your own meals, there are 3

specific requirements that allow employer to deduct cost and employee non-recognition: 1 Meals must be furnished by the employer; 2 Meals must be for the convenience by the employer; and 3 Meals must be served on the business premises of the employer.

ii Lodging: An employer may provide your lodging as part of employment, deduct it, and have the taxpayer not recognize it. There are 4 special requirements for it:

1 lodging must be furnished by the employer; 2 lodging must be for the convenience by the employer; 3 lodging must be on or near the business premises of the employer; and 4 Employee is required to accept the lodging as condition of employment.

iii Commissioner v. Kowalski, 434 US 77 (1977) pg 97 1 Facts: Cops used to eat at the dispatch station. Detachment started paying cops a

cash stipend to purchase food in the field because it was easier and more


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convenient. Pigs didn’t recognize it in income and taxes not withheld. 2 Holding: Yes, it is taxable income. The cops were free to do with the meal

stipend as they saw fit and were not required to give receipts. On the same check as salary, unaccounted for, and had complete control over it.

3 Rules: See meal rules above. iv Adams v. United States, 585 F.2d 1060 (1978) pg 103

1 Facts: Employee sent to Japan and put up in nice house in order to upgrade standing in business community. Employee worked at the house, held meetings, etc. It was used for mixed social and business purposes.

2 Holding: Fair Market Value of residence is excluded from income. He was required to use the house as part of job. He used it for business purposes when he was supposed to.

3 Rule: a Income Recognition General Rule: If services are paid for other than in

money, the fair market value of the property or services taken in payment must be included in income

b Exclusion: Lodging is excluded if it meets requirements (listed above) c Statutory Fringe Benefits: Fringe benefits are usually excluded from GI if the taxpayer can

prove they fit into one of the statutorily excluded sections. Taxable benefit if available to the general public. If not available to general public then may be a fringe benefit.

d Rule: Excludable fringe benefit must be for the convenience of the employer & on the employer’s premises.

e §132(a): Lists 8 types i no-additional-cost service, (providing employees services, at actual costs, no revenue)

1 Airlines, hotels, NO RESERVATIONS ALLOWED ii qualified employee discount, iii working condition fringe, iv de minimis fringe, v qualified transportation fringe, (132(f)

1 240 transit pass, 240 a month in parking vi qualified moving expense reimbursement, (132(g)) vii qualified retirement planning services, or viii qualified military base realignment and closure fringe.

f Property Received for Services: Included in GI when it’s not subject to forfeiture but may elect to be taxable in year of transfer.

7 Gifts and Bequests: Not taxable to the receiving party. If taxed, taxable to donor/transferor. a Policy: Difficult for IRS to track. Matter of administrative convenience. Tax on donor for inter-

vivos transfers. Not equitable to tax donee. Gift goes out at cost, not FMV. b Tax Consequences: Gifts are viewed as personal consumption to donor, therefore no deduction.

No gains on appreciated property transferred as gift. Gifts of property take transfer basis. c Gifts of Income: Property gift might not be taxable but later income derived is. A straight gift

of income stream is taxable as GI. Gifts given from employer are taxable.


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d Commission v. Duberstein, 363 US 278 (1960) pg 117 i Facts: Business associate gave duberstein a car as gift. Gift was given as part of a

business arrangement of passing leads back and forth. It wasn’t meant to be compensation but the IRS sought to treat it as such.

ii Holding: Yes, the car was taxable income. Outcomes will be very fact specific. Here, the associate gave Duberstein the car in hopes of additional future leads as was meant to pay him off for giving him the leads. Although not a formal arrangement, the facts are clear.

iii Rules: A gift must be given with detached disinterested generosity. Must be out of respect, generosity, charity.

e Gifts to Employees: A gift from an employer to an employee is almost always taxable. §102(a) exclusion for certain things. Doesn’t apply to former employees, independent contractors, survivors of employees.

i Olk v. United States, 536 F.3d 876 (1976) pg 126 1 Facts: Taxpayer was employee of casino, dealer. He received tips but the casino

forbids direct tipping so the tips are placed in general pool and divided among employees equally. It was alleged that the tips were not income but gifts because it was impulsive generosity, detached and disinterested.

2 Holding: Yes, Taxable. The tips did in fact constitute income. The tips were received in the course of employment for the employee’s services.

3 Rule: Receipts by taxpayers engaged in rendering services contributed by those with whom the taxpayers have some personal or functional contact in the course of the performance of the services are taxable income when in conformity with the practices of the area and easily valued. The Court enumerated a number of factors to consider in making the determination that the tips should be reasonably regarded as compensation for services, including:

a the regularity of the flow b the equal division of receipts, and c the daily amount received

f Exclusions for Bequest/Devise/Inheritance: No tax owed on gifts made at death. The distributee never pays tax on this type of receipt. Some states have tax on distributor. Same requirements as other gifts, “detached disinterested generosity”

i Wolder v. C. I. R., 493 F.2d 608 (2d Cir. 1974) pg 131 1 Facts: Wolder, was an attorney and he entered into an agreement with a client

that the client bequeath to him 500 shares of common stock or other security in return for lifetime legal services without charge. The client did leave Petitioner $15,845 in cash and 750 shares of stock. Petitioner argued that the amount is excluded from income.

2 Holding: the bequest was income because it was payment for services rendered. Here the, the bequest was just delayed payment of income.

3 Rule: Generally, gross income does not include property acquired by gift, bequest, devise, or inheritance. Gross income does however include payment for


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services rendered ii Rev. Rul. 67-375, 1967-2 C.B. 60 (1967) pg 135 ish

1 Facts: Taxpayer’s stepfather was old and couldn’t take care of himself. Taxpayer and stepfather agreed that if taxpayer took care of him, that he would leave taxpayer his estate. Taxpayer took care of him per agreement and received bequest.

2 Ruling: IRS said it was income because it was delayed payment of services. 8 Loans and the Cancellation of Debt

a Code Sections: IRC §§61(a)(4), (a)(12); §108(a)-(b)(2), (c)-(d)(3), (e)(5); Skim §§163; 1017 b General Rule: A loan is not gross income to the borrower but the forgiveness of debt is income

to the forgiven party. c Loans

i Non-Recognition on Loan: Borrower has an obligation to repay the loan, there is no accession to wealth from the loan. Liable to repay the amount of the proceeds. The lender may not deduct the amount of the loan. Loan just converts one asset (cash) into another asset (promise of repayment).

ii Repayment: Amounts paid to satisfy the loan obligation not deductible by the borrower. Loan repayment is not a real “cost” to the borrower, just repayment of the amount. Repayment of the loan is not gross income to the lender. Just return of capital to the lender, no accession to wealth.

iii Interest: Interest paid to the lender is included in the lender’s gross income and is sometimes deductible by the taxpayer. §61(a)(4): Interest paid is compensation for the use of money or property and is a profit/ accession to wealth. Interest income will be imputed on the lender even if they fail to charge a min. amount.

iv Deductibility of Interest: §163: deductibility of interest payments. Interest paid in connection with borrower’s business activity will be deductible, but interest paid on loans for personal activities/ expenses (exception of home mortgage) are not deductible.

d Cancellation of Debt i United States v. Kirby Lumber Co., 284 US 1 (1931) p.137

1 Facts: Kirby Lumber issued bonds for $12,126,800 and received par value. Later the same year it purchased some of the same bonds at less than par in the open market, with a difference of $137,521.30. IRS contends it was a gain.

2 Rule: (rule set out in what is now the treasury reg listed) a Treas. Reg. §1303: “If the corporation purchases and retires any of such

bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.”

3 Holding: the difference should be considered as taxable gain or income. Reasonings that if you received loan monies and only had to pay back some of it, you, that is a effectively a cancellation of debt and is therefore taxable income.

ii Codification of loan cancellation from Kirby: Congress later codified it. 1 §61(a)(12): generally requires inclusion of “COD” (cancellation of debt) income.


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2 §108: 4 (now 5) types of limited exclusions: a the discharge occurs in a title 11 case (bankruptcy), b the discharge occurs when the taxpayer is insolvent (usually bankruptcy), c the indebtedness discharged is qualified farm indebtedness, d in the case of a taxpayer other than a C corporation, the indebtedness

discharged is qualified real property business indebtedness, or e the indebtedness discharged is qualified principal residence indebtedness

which is discharged before January 1, 2013 (discharge of home mortgage).

iii Zarin v. Commissioner, 916 F.2d 110 (1990) p.140 1 Facts: Zarin, was granted a credit of $10,000 to gamble at a casino. He

eventually received a permanent line of credit of $200,000. He lost $2.5 million at the craps table over a short-time period and he paid it in full. He then accumulated a gambling debt of $3,435,000 by 1980 after the casino continued to give him lines of credit. He settled with the resort for $500,000. The Commissioner determined that he should have reported the cancellation of the indebtedness as income. The Tax Court affirmed the Commissioner.

2 Rule: “A taxpayer does recognize income if a loan owed to another party is cancelled, in whole or in part.” Note that the taxpayer is only responsible for tax on debt that is a legally enforceable obligation. §108(d)

3 Holding: Not liable for tax deficiency & there is no income from the discharge of the debt (settlement) because does not qualify as income under §61 or §108 because he was not liable for the gambling debt was not enforceable as a matter of NJ state law (§108(2)(1)(A)), nor was it subject to property under (B) because gambling chips are not property subject to the debt, but only an “accounting mechanism to evidence debt.”

iv Contested Liability Doctrine: If a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of the debt cognizable for tax purposes. The excess of the original debt over the amount determine to have been due is disregarded for both loss and debt accounting purposes. (Amount of settlement is treated as the amount of the initial loan- no income/ gain from the amount forgiven, settlement only fixes the amount of the debt).

9 Gains From Dealings in Property a Legal Authorities

i Code Sections:IRC § §61(a)(3); 109; 1001(a)-(c); 1011(a); 1012; 1017 ii Regs: Treas. Reg. §§1.61-6(a); 1.263(a)-2(e); 1.1012-1(c)(1)

b Computation of Capital Gains and Losses i Terminology/Glossary

1 Amount Recognized: meaning that the item is reported as taxable income 2 Amount Realized (AR): the sum of any money received plus the fair market value

of the property (other than the money) received” = the value of what the taxpayer receives in exchange. §1001(b)


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3 Recovered: meaning you at least got back what you paid for it. 4 Adjusted Basis (AB): What you paid for the property plus any capital investments

after you bought it. Ex. Buy a house a put new roof on it. ii General Rule: §61(a)(3): Gross income includes gains from property. This could be the

sale of personal property, real property, etc. The gain is only recognized when the gain is realized. The gain is realized when the when the cost of the capital investment is recovered.

iii General Calculation Concept: Take the gross proceeds of the sale and deduct the sum of the cost of the capital investment and any capitalized additions to the capital account.

iv Computation of gain and loss: §1001(a) covers how to measure the G/L 1 Application: §1001 ONLY applies when there is an exchange & taxpayer

receives money or other property in the transaction! (increase in basis = gain decreases) (decrease in basis = costs goes down: depreciation, loss sustained)

a Gain= excess of the amount realized over the adjusted basis in the property exchanged

b Loss= excess of the adjusted basis over the amount realized. v Formulas

1 Amount Realized (AR) – Adjusted Basis (AB) = Realized Gain (RG) 2 Adjusted Basis (AB) – Amount Realized (AR) = Realized Loss (RL)

vi Exchange Occurrence: Hard to determine when a gain has occurred sometimes. 1 Helvering v. Bruun, 309 US 461 (1940) p. 151 *No longer good law!

(Superseded by §109 & §117) a Facts: Tenant on 99-year lease defaulted. Landlord took possession back.

The land now had a new building on it that was built by tenant. IRS contends gain of amount for building.

b Hold: Taxpayer realized a gain from the new building upon repossession of the leased property. Repossession of an asset with an enhanced value from a transaction with another is gross income.

c Rule: Gain does not have to be in cash from the sale of an asset. (note that policy of most gain provisions does not tax until there is a cash transfer so that the taxpayer is sufficiently liquid so as to be able to pay the tax)

2 Realization Events: Occasions when a gain is realized and may be recognized. a Events: Realization of Gain or Loss may occur from “Realization

Event”: i a property exchange; ii relief from a legal obligation owed to a third party. iii relief from a legal obligation owed to the party receiving the

property; and iv “other” profit transactions.

b Property Exchanges: 2 parties exchange assets, severance occurs when each surrenders their interest in one asset to receive another asset.


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c Landlord/Tenant Rules: §109: Lessor of real property may exclude the value of improvements made by a tenant. §1017: Prohibits the taxpayer from adding the value of these improvements to the taxpayer’s “basis” in the building.

c Adjusted Basis: The amount a taxpayer values, per the code, an investment. Consists of cost, a taxpayer then increases basis for capital improvements to property and decreases basis for depreciation deductions allowed for such property, casualty losses.

i Code Definition: §1011(a): “adjusted basis” is the taxpayer’s “basis” as “adjusted. ii General Rule: §1012: Basis is a taxpayer’s cost in acquiring property, except as

provided in §§ 1001-1092. §1016(a): 27 adjustments to basis in the code. iii Depreciation Deductions: Reduce basis each year by the amount of the depreciation

deduction on item. Deductions for depreciation are per depreciation deductions allowed by the code under Modified Accelerated Cost Recovery System (MACRS) in §167

iv Capital Improvements: Capital improvements must be added to the adjusted basis but only if the improvements last substantially beyond the end of the tax year. §168

v Casualty Losses: If a hurricane comes in and takes your damn house out, you’ll get insurance money. The item had been converted from property to cash and basis is adjusted accordingly.

d Carryover/Transfer Basis: When you assume the basis from another source other than cost. i Sources: Other adjusted bases may come from other source such as: Property Acquired

by Gift (§1015); Property Acquired by Exchange (§1031(d)); Property Constructed By/For the Owner (§263(A)); Property Acquired by Inheritance (§1014).

ii Inter-vivos Gifts: Use carryover basis. Donee will have the same basis as the donor did. §1015

iii Inheritance: Basis is FMV at the date of death (Stepped up value). Current limit on estate tax = $5 million (tax free). Basis = Taxpayers BOP. §1014

iv Philadelphia Park Amusement Co. v. United States, 126 F.Supp. 184 (1954) p.158 1 Facts: 10 year extension on a railroad franchise given in exchange for a bridge

and whether the exchange was fair. 2 Hold: taxpayer is entitled to use as the cost basis of the 10-year extension its fair

market value as of the date of the exchange. The question of the value of the extended franchise remanded.

3 Rule: Cost basis of the property received is the FMV of the property given. If an arms length transaction, the value of property received is assumed to be equal when the FMV is unknown. § 1012: taxpayer’s basis in property is their cost to acquire the property.

v Table

Donee’s Basis for computing GAIN

Donee’s Basis for Computing LOSS

FMV ≥ Donor’s AB at time of Gift

Donor’s AB Donor’s AB


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FMV < Donor’s AB at time of gift

Donor’s AB FMV (loss does not carry over)

e Transfer in Satisfaction of Obligaion

i United States v. Davis, 370 U.S. 65 (p. 166) OVERRULED! 1 Facts/Issue: How to value a marriage (non- community property state) and

whether there is an equal exchange when upon divorce the wife gives up all marital rights to property in exchange for 1,000 shares of stock?

2 Hold: Transfer is the taxable event because consideration received and the amount realized from release of her marital rights were equal to the shares of stock transferred even though husband reported a gain.

3 Rule: (still valid): Taxpayer recognizes a gain on the transfer of appreciated property in satisfaction of a legal obligation.

4 Legislation To Follow: Holding Overruled by § 1041 ii Marriage Rule: § 1041: Generally, nonrecognition (no tax consequences) of all

property transfers between spouses or former spouses if from the divorce. (doesn’t apply to same-sex)

10 Introduction to Timing of Income (p. 173): Certain income may be deferred for recognition purposes a Timing of Income: All about when the income occurs and is therefore recognized on tax return b The Tax Year: Each year stands alone. Most things aren’t carried over. If something is realized

in the tax year, good chance it is going to be recognized in that same year. See Vodka v. Titties. c Time Value of Money: $ now better than $ later. With Costs = opposite (future cost is better

than a current cost). Tax being the cost. Ideally you defer a tax as long as humanly possible. d North American Oil Consolidated v. Burnet (p. 175) - Claim of Right Doctrine

i Facts/Issue: What year is the income for $ NAOC earned in 1916 but not received until 1917 because of a competing claim & the $ was held in a receivership, or 1922 when the final appeal was exhausted?

ii Hold: Income in 1917 when first became entitled to $ & actually received it. If reversed on appeal then entitled to a deduction from profits in 1922. TC is a final ruling because had access to $ & income realized.

iii Rule: Claim of Right Doctrine: “In a taxpayer receives earnings under a claim of right and without restriction to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the $, and even though he may still be adjudged liable to restore its equivalent.”

iv James v. US: Adds: “When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction...”

e Advanced Payments & Deposits: Advanced Payments of Income= included in gross income


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even though the payments have not been earned at the time of receipt. Deposits are not included in gross income because they are more analogous to a loan or escrow.

f Commissioner v. Indianapolis Power & Light Company (p. 178) i Facts/Issue: Whether payments are advanced payments or deposits when IPL (operating

by gov. grant) requires customer with bad credit to pay $ in advance to ensure future payment of bills for electricity service that will be paid back with interest at the end of the term or the customer can prove good credit & are reimbursed, if they do not it escheats to the state?

ii Hold: $ = loan, not income because not an unrestricted right to $ + incurs interest. iii Rule: If no complete access at the time payments are made it is a loan & not GI.

11 Assignment of Income: Taxpayer may assign the right to receive income but the taxation of that income may or may not follow the income. Depends on the characteristics of the transaction.

a Income from Personal Services: Generally, income from services is taxed to the party who performed the services. This is a “tree that bears the fruit” argument.

b Lucas v. Earl (p. 184) - i Facts/Issue: Whether E is taxed for all of his salary & attorney’s fees earned by him or

only half because made K with wife for ½ of all attorney’s fees? ii Hold: Total amount of income is taxed to Mr. E who earned it. “The fruit of the Tree:”

Earner= tree, fruit = income earned, can’t separate the two. c Teschner v. Commissioner (p. 185)

i Facts/Issue: Whether the prize value earned from a writing contest is income to the father or the daughter when the sad little man wrote the piece & won the prize under his daughter’s name because you had to be under 17.5 to enter?

ii Hold: The daughter is taxed for the value of the prize because he never had a legal right to claim it.

d Whip-saw Position: IRS assess statutory deficiency on taxes both individuals to keep the SOL for returns (3 years) open, then drop claim when determined.

e Helvering v. Horst (p. 187) i Facts/Issue: Whether a dad’s gift given to his son of an interest coupon detached from a

bond delivered the same year & then paid at maturity is taxable income to the donor/ dad?

ii Hold: The dad earned the interest, so he owns the interest because he still owns the bond & can’t gift interest. (if gave entire bond, then gift). Interest is the “fruit” of the bond & whoever holds the bond gets the $ & gets taxed. Coupons & bonds = 2 independent & separable rights.

f Salvatore v. Commissioner (p.191) i Facts/Issue: Whether Widow is taxable on all or half of the gain realized from the sale

of a gas station & land when she formally accepted the offer & still retained the land the month before she gifted ½ the real property to her 5 kids & paid the gift tax & kids reported % share of gain from the sale?

ii Hold: Mama pays all the tax because she owned the whole when she formally accepted the offer = time when it’s income.


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g Estate of Stranahan v. Commissioner (p.193) i Facts/Issue: Can a father K with son the right to receive future earnings in exchange for

$ now so dad has enough income now to receive the full benefit of income deduction for IRS interest on estate & gift tax for trust?

ii Hold: Yes, because dad pays value to son (not a gift) and some assumes the risk he may never actually receive that amount.

iii Rule: Substance over form of the transaction to determine the taxable consequences. h Commissioner v. Banks/ Banaitis (p. 197)

i Facts/Issue: Whether $ from a judgement or settlement paid for attorney’s fees under a contingent- fee K is income to the taxpayer?

ii Hold: Entire amount is taxable to the client (b/c not for personal injury). iii Rule: Only recoveries that are allocable to physical injuries are not income. §62(a)(20):

Costs involving Employment discrimination suits: anby loss under this section is deductible, above the line.§104: to pay for a personal physical injury = taxable.

Chapter 4: Tax Treatment of Taxpayer Costs

1 2 General Concepts

a Code Sections Covered: IRC §161, 162(a), 165(c), 212, 262 b Types of Taxpayer Costs: Several different types and terminology

i Capital Expenditures: Expenditures where benefit extends beyond the tax year ii Depreciation: Cost recovery of tangible assets over time. iii Amortization: Cost recovery of intangible assets over time. iv Losses: Not an actual outlay but represents costs not recovered from sale of asset. v Expenses: Costs that don’t acquire or extend life of an asset. Deductible if related to

“trade or business activity” § 162. c Classes of Taxpayer Costs: The vertical division of types of taxpayer costs.


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i Business Activities: Expenses incurred in relation to running a business ii Investment Activities: Expenses related to investing activities (interest, fees).

Deductible for investment activity § 212 iii Personal Activities: Expenses for one’s self. Not usually deductible at all unless

personal casualty loss, theft loss, etc. § 262. f Time Frame to Claim Costs Back

i Deduct in 1st year = Deduction (recover immediately) ii Value overtime/ life of the asset = Capitalization (expense later)- change basis each time

you take depreciation deduction to match time with cost/ match income with expense (time value of $)

3 Expenses OR Capital Expenditure: Series of tests and classes to determine if it is capital or not a Costs Related to Tangible Assets

i General Capitalization Rule: if it last over a year you have to capitalize the asset & take it over time, if it lasts less than a year you can take the full deduction.

ii Tangible or Intangible Asset?: 1 Tangible asset (car, chairs, etc) = depreciation deduction § 167 & § 168 2 Intangible asset (goodwill, IP rights, etc.) = amortization deduction §197

iii Uniform Capitalization Rules: § 263(a) Generally all direct & indirect costs allocable to the construction or production of real property or tangible property must be capitalized.

1 Indirect Costs: includes repairs, depreciation, utilities, rent, sales, tax, property tax, insurance, storage, and packaging.

2 Selling Expenses: state income taxes, and advertising and distribution costs are not included.

3 Exceptions: wholesalers & retailers of personal property with average annual gross receipts of $10 million or less (§263A(b)(2)(B))- personal- use property (§263A(c)(1) and - certain animals & plants produced by farmers & ranchers (§263A(d))

iv Expenditures that Must Be Capitalized: 4 Types 1 New buildings 2 Permanent improvements intended to increase value

a Pre-Existing Defects: Money spending fixing this, even if defect not known at time of purchase b Pre-Use Costs- the costs related to work performed on property prior to the use by taxpayer c Adaptations- costs for adapting property to new use, no matter if the costs permanently alters the composition of the property d Betterments- costs results in betterment of property or material addition, improves property quality or strength, or causes property to be expanded e ncreased Productivity- results in a material increase in capacity, productivity, or efficiency.


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3 Restoration costs 4 Expenditures that will give right to exhaustion deductions (i.e. depreciation,

amortization, and depletion). 5 NOTE: § 263(a)(1): Wages paid to builders and other construction workers must

be capitalized when they relate to the construction of an asset that’s benefit lasts more than a year.

v Commissioner v. Idaho Power Co. (p.214) 1 Facts/Issue: Can a taxpayer deduct from gross income, under §167(a),

depreciation on equipement they own and use in the construction of their own capital facilities or does the capitalization provision of §263(a)(1) bar the deduction?

2 Hold: equipment depreciation allocable to taxpayer’s construction of capital facilities is capitalised.

vi Fedex Corp. v. US (p. 220) 1 Facts/Issue/Hold: Engine shop visits are an a expense because it did not change

to plane to a new or different use, prolong the plane’s life, or add value & is a repair.

2 vii Rev. Rule 2004-62

1 Facts/Issue/Hold: Fertilizing tree farm is an expense and does not substantially prolong the life of the asset.

b Repair, Improvement, and Restorations i Repair: bring it back to original purpose to continue in same manner. The amount paid

or incurred for incidental repairs and maintenance of property are not capital expenditures. Treas. Reg. §1.263(a)-1(b)

ii Improvement: adds material value to the underlying asset iii Permanent restoration: Deduction is deferred because costs added to property’s basis.

- Must capitalize costs that restore property, substantially prolong the economic useful life of the unit of property. Reg. §1.263(a)-1(b)(1).

iv Midland Empire Packing Company v. Commissioner- p.224 1 Facts/Issue: Is Expenditure for a concrete lining to prevent neighboring nuisance

an expense? It was leakage sewage into the basement of a meat packing plant. They only wanted to be able to get back to the same point they were before they discovered the sewage, running the business.

2 Hold: Yes, Repair and can deduct as ordinary & necessary business expense & deduct in the year you make the repair. A repair is for the purpose of keeping property in an ordinarily efficient operating condition. It merely keeps property in operating condition over original life, but not expanding or making property last longer.

v Mt. Morris Drive- In Theatre Co. v. Commissioner- p.227 1 Facts/Issue: Put in drainage system which was leaking onto neighbor’s land-

repair or improvement. Taxpayer says repair, IRS says improvement


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2 Hold: No, its improvement because made a difference & improved the land. It materially adds to the value. Also they knew of the issue when they bought the problem. Also, lasts a long time!

vi INDOPCO, Inc. v. Commissioner (p. 232) 1 Facts/Issue: Takeover of another company. Unilever acquiring National Starch,

which later became INDOPCO. Are professional expenses to an investment bankering firm in the SH’s interest for a friendly takeover a deductible ordinary & necessary business expense deductible in 1 yr.?

2 Holds: With with a friendly takeover to merger companies, advice to do so is a long term benefit, taken over time & capitalize expenses! If it’s a hostile takeover & fighting to keep company, then deductible in year & carry over if prove expenses to prevent takeover!

c Regs Developed After INDOPCO (p.239) i Separate and Distinct Asset Test: Treas. Reg. § 1.263(a)-(f): generally require

capitalization of certain amounts paid to acquire or create intangible assets and require capitalization of expenses that create or enhance a separate and distinct capital asset. Require capitalization of expenditures that “create or enhance a future benefit” but ONLY IF specifically noted by the IRS in published guidance. (= separate & distinct test unless future benefit test applies)

ii De minimis Rule: $5,000 (currently) Don’t have to capitalize amounts paid to induce another to enter into, renew, or renegotiate a K relates to a service in the provision.

iii Used W/In 12 Months: If amount or less of long term improvement will be used in the next 12 months of tax year, you can take it. Reg. § 1.263(a)-4(f) (p.1224 in purple bk)

1 If you use it in 12 months, you can deduct it in this year. 2 If over 12 months, have to look at capitalization (may be deductible under

§1279). iv Creation of Intangible: Treas. Reg. § 1.63(a)-4(e)(1): must capitalize the cost to

facilitate the acquisition or creation of an intangible asset, unless De Minimis, then expense.

v Bar Dues: Yearly dues: can be deducted under 12 month rule, subject to 2% haircut, because goes towards the production of income Determines whether fit to practice law- must be capitalized!

vi Bar Exam and Review: Bar Admission Reg. §1.263(a)- (4)(d)(5) Example 2 = Expense, get deduction. Must capitalize payment to bar for review exam.

d §179 Deductions: (Discussed in Depreciation section) 4 Deduction for Expenses: Once you determine if something is an expense or capital expenditure,

determine if it is deductible. Remember general rule that it is not deductible unless IRS says it is. a General Rule: deduct if related to trade or business activity or paid or incurred in the

production or collection of income. §162, or if investment expense, §212 & special treatment for start-up expenditures, § 195, incurred prior to the commencement of a business or investment activity.


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b Trade or Business Expenses: Expense incurred in course of business are deductible if the are ordinary and necessary expenses of a trade or business. (p.243)

i Code Language: §162 - allows business to deduct from its income its “ordinary & necessary business expenses paid or incurred during the taxable year in carrying on any trade or business,” including a “reasonable allowance for salaries or other compensation for personal services actually rendered.” → 6 Separate elements required

1 Ordinary: common or customary to the trade 2 Necessary: useful or helpful 3 Expense: expensed when useful life doesn’t last beyond end of tax year.

a 162(e)- lists prohibition to deductions 4 Paid or incurred during the taxable year: Cash or accrual 5 Carrying on: Must be during business, prior to business is §195 start up

expenditure. Must be same trade or business. 6 Trade or business: Business engaged in for profit not personal in nature. Done

full time. ii Welch v. Helvering (p. 244) → Ordinary Rule

1 Facts/Issue: Whether creditor debt of bankrupt company discharged by company executive to maintain reputation & business relations deductible?

2 Rule: BOP is on the taxpayer, Commissioner is always presumed correct. 3 Hold: (Cardozo) No not ordinary, not a Bus. expense. This was extraordinary.

iii Jenkins v. Commissioner (p.246) → Necessary Rule 1 Facts/Issue: Harold L. Jenkins (aka Conway Twitty) paid investors in failed

business, Twitty Burger. May he deduct it on his personal returns? 2 Hold: yes, ordinary & necessary because flawless financial & personal

reputation directly affects success as country music performer. Find “proximate relationship between payments made to the holders of Twitty Burger debentures and petitioner’s trade or business as a country music entertainer.” (p.254) Only because “unique facts of the case.” Ordinarily not deductible! Twitty claims connection between 2, because payment was to prevent reputation effect, which is everything in country music....good experts.

iv Exacto Springs Corp. v. Commissioner (p.257) → Excessive Salary Rule 1 Facts/Issues: Are the amounts deducted for CEO salary reasonable or excessive

when the company was bringing in excessive ROI above industry average and the salary was tied to the company success?

2 Hold: Tax Court allowed tax deduction for salary that was midway between actual compensation & IRS determination.Generally, IRS loses these cases. If closely-held company it looks more suspicious. The company should be presumptively correct. Amount paid= presumed correct. Otherwise, CEOs would constantly fear liability & pay less than they are worth.

3 7-Factor Test Rejected By Court But Used by TC: (p.257)- majority test a the type and extent of the services rendered; b the scarcity of qualified employees;


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c the qualifications and prior earning capacity of the employee; d the contributions of the employee to the business venture; e the net earnings of the employer; f the prevailing compensation paid to employees with comparable jobs; g the peculiar characteristics of the employer’s business.

4 Indirect Market Test: (minority approach) The higher the rate of return (adjusted for risk) that a manager can generate , the more reasonable a higher salary is.

v Estate of Rockefeller v. Commissioner (p.265) → Carrying on Trade/Biz Rule 1 Facts/Issue: Are the cost for VP confirmation hearings deductible expenses

carrying on the SAME trade or business? 2 Hold: No, not deductible not the same trade or business, previously was a

businessman on committees. 3 Rule: Only deductible if it is “carrying on” the same trade or business. If new

trade or business it is not deductible. Fact specific test, look at length of time. vi Commissioner v. Groetzinger (p.272) → Carrying on Trade/Biz Rule- GAMBLING

1 Facts/Issue: Whether “professional gamble” is a trade or business? 2 Test: Facts & Circumstances. Must be involved in activity with continually &

regularly, primary purpose is to make $. Factors: registered, makes $/time/ labor/ attention spent.

3 Rule: Can take the amount of gambling losses up to the amount of earnings. (§165(d)). If losses are more than earnings, then can only take to the extent of gains. Gains are income.

4 Hold: Yes ,T or B, studying & spends a lot of time doing it. It is legal in setting. Not carrying on another. Because not an item of tax preference, this no Alt. Min. Tax & business deduction is above the line, not itemized. 1982 Amendments: Gambling is NOT a trade or business. IRS changed Rule w/ gambling- not trade or business.

vii Startup Expenses: start up expenses are what you use spend to get a business off the ground and are NOT incurred prior to creating the business.

1 Rule: §195: Start up expenses: portion of costs may be deducted in 1st year of business, balance then amortized over 15 years.****

viii AMT: Alternative Min. Tax (§ 56(a)) - Intended to capture high income earners not paying any tax & require them to pay a min. tax. Not adjusted for inflation. Now affects middle income earners too. Affected by Itemized deductions! - AMT re-calculates tax liability & disallows certain itemized deductions & adjustments to determine “tentative min. tax.” If TMT exceeds regular tax liability that year, computed under §1.

1 Item of tax preference: take out the itemized deductions because too high. (= employee bus. expenses + others)

a Subtract out tax preference items so tax is higher. b Regular tax rate: Income, Deductions, Itemized Deduction, Credits = Tax

c Policy Limitations on Deductibility: There are holdings and one code provision that recognize


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that something might appear to be perfectly in line with the tax laws but for some reason is against public policy and should not be deductible for public policy reasons.

i Statutory Prohibitions: The tax code has some specific provisions that disallow deductions for things that are enumerated as against public policy.

1 Bribery: Can’t take deduction for bribes, kickbacks even if connected with trade or business. §162(c)

2 Illegal Activity: Can’t deduct for any illegal payment. §162(c)(2) 3 Lobbying: Can’t deduct expenses incurred with political lobbying activities &

campaigns for officer. §162(e) 4 Punitive/Treble Damages: Can’t deduct treble damage payments if convicted or

plead guilty to federal antitrust violation. §162(g) 5 Illegal Substances: Can’t deduct for ordinary & necessary business expenses if

engaged in illegal sale or trafficking of controlled substances. §280(e) ii Commissioner v. Tellier (p.282) →

1 Facts/Issue: Are attorney’s fee’s for criminal securities fraud charge, connected to the business not deductible because contrary to public policy? Are the fees personal or business?

2 Hold: Yes, allowable business deduction. No public policy exception under §162.

3 Attorney Fee Rule: NOT deductible if in connection with personal expense, but deducted if in connection with earning income, then can deduct that portion.

4 Test - Origin of the claim: (p.283) Look at the origin & character of the claim. Origin= claim from the business

iii Vitale v. Commissioner (p.286) Prostitution for Dummies 1 Facts/Issue: Can a writer deduct the costs to investigate legal prostitution for his

book? 2 Hold: No. Look at origin of the claim, visit brothels to research book, but

services are too personal. It is not ordinary or necessary business expense & won’t make taxpayer’s liable. Precedent example: Paying religious pastor does not qualify.

3 Rule: Can’t deduct if it is too personal in nature. iv Misc Listed Case Law In Book

1 Rape In Course of Biz: Attorney’s fees for rape charge is a deductible business expense when man visited husband to ask wife’s permission to work after a business interview (1950;’s), & man then charged with rape & latter found not guilty.

2 Rape Not In Course of Biz: Attorney’s fees for rape claim are not a deductible expense when man’s business was to entertain clients at a hotel & drink, then hit on girl & got rapey in a hotel room. Stopped being part of trade or business & when initiated hitting on chick, stuff got personal!

5 Independent Contractor v. Employee: Differing treatment for tax purposes and how they are recognized in given circumstances


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a Independent Contractor: Has the following characteristics i Pays own taxes, not withholding at the source + not benefits. ii Typically pay all employment taxes via quarterly payments. iii Greater business expense deductions, but normally more $ spent. iv ex: Typist, unless long term relationship. v MOST BUSINESSES WANT THIS

b Employee: Has the following characteristics i Share of SS previously withheld ii IRS prefers. If determine IC is an employee, the company must pay employee back

benefits & pay IRS back employment taxes. iii Can only deduct ordinary & necessary business expenses that exceed 2% of AGI, it

itemize. iv ex: UPS mail carrier, require the when & where for deliveries & beneficial mileage rate

c Common Law Approach: focus on the control exercised over what & how work is done. i Behavioral Control: Does employer have right to control details or have they relinquished control. ii Financial Control: Address the business’ right to control business aspect of worker’s job iii Relationship of Parties: Is there:

1 Written K 2 Benefits the business provides to the employee 3 Permanency of Position

d Test: Facts & Circumstances (20 factors): Rev. Rul. 87-41 (HANDOUT) i employee compliance with instructions required ii training,

1 Does employee receive training from, or at direction of employer? iii integration of worker’s services into the business. iv services are rendered personally,

1 Employees must do work themselves, IC can assign work v ability to hire, supervise, and pay assistants,

1 If employer hires, the worker is employee, 2 If you can hire assistance, most likely IC

vi a continuing relationship, 1 Can be relationship if irregular intervals, are frequent

vii set of hours of work are established, viii full time is required, ix payment by hour, week, or month, x payment of business and/or travel expenses, xi tools and materials furnished, xii worker invests in facilities, xiii worker can realize a profit or loss, xiv worker performs services for more than one business at a time,


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xv worker makes services available to the general public, xvi business has the right to discharge worker, and xvii worker has the right to terminate the relationship.

6 Investment Expenses a General Rule: §212: Investments generally deductible is for 1) production or collection of

income, 2) management, conservation, or maintenance of property held held for production of income, or 3) in connection with the determination, collection or refund of any tax.

i Note: Does not have to be for trade or business ii Note: Expensed that year, or deducted over time same way. iii Cant be for convention, seminars, or other meetings (274(h)(7))

b Prohibitions: 1.212-1(e) - (o)s)) 7 Amortization of Start-Up Expense: There is a substantial difference between expenses incurred in the

course of investigating a business that might be started and expenses incurred in the course of starting up a business that is going to happen for sure / is in progress of being formed.

a b General Rule: §195 - $5k deduction in first year, $50k phase-out dollar for dollar, remainder is

amortized over 180 months ratably. c Frank v. Commissioner : Travel and legal expenses to investigate properties are not allowed

because prior to start of business, must be capitalized & added to the value of the business asset (§195(a))

d Richmond Television Corp. v. US: Job training expenses prior to opening must be capitalized to match expense & time for which it benefits the company.

e Exception: amortization for startup expenses to take now: §179. f Process to Handle Issue: Start with Go Date (day on which the transaction to acquire or start

business is FOR SURE) i Expenses Before Go Date

1 Capitalize: Inherently facilitative costs 2 Expense: All other investigation costs

ii Expenses After Go Date 1 Expense: Employee comp, overhead, de minimis (5k aggregate) cost 2 Capitalize: All other costs in pursuing the transaction


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iii If Capitalized: No §195 deduction. Add to asset basis iv If Expense: Use §195 election available v If Costs are under 5000: The can be amortized under a de minimus rule (1.263(a)-

5(d)(3)) 8 Treatment of Capital Expenditures

a Cost Recovery In General: In order for a business to recovery the costs of purchasing assets that are not currently deductible, the business must depreciate (tangibles), amortize (intangibles), or deplete (natural resources) the asset that was capitalized over time per the requirements of the IRC.

b Depreciation of Tangible Property: §167 and §168 - deduction over time for obsolescence and exhaustion of property used in a trade or business for the production of income.

i Requirements: 2 basic requirements → 1 It has useful life beyond the end of tax year (reason capitalized in first place) 2 It wears out or decays with time due to natural causes and usage or becomes

obsolete ii Exclusions: Do not depreciate inventory, land, securities, or other highly liquid items.

c Simon v. Commissioner (and thereafter appeals in 2nd Cir. Ct. App.) (pg. 297) i Facts/Issue: Are specially crafted collector’s violins depreciable musical instruments if

the taxpayers are professional musicians and the violins are used in the course of their musical profession regardless of whether the violins are actually appreciating over time?

ii Hold: Yes, they are depreciable. Even though the fair market value of bows increased, the court stated that for it to look into determining whether an asset has a "separate, non business" value for depreciation purposes would be contrary to Congress’s intent to simplify this concept.

iii Rule: Under § 168(a), a taxpayer may deduct depreciations of "recovery property" which is property that is (1) tangible, (2) placed in service after 1980, (3) of a character subject to the allowance for depreciation, and (4) used in the trade or business, or held for the production of income. The court defined subsection (3) to mean that the "property must suffer exhaustion, wear and tear, or obsolescence in order to be depreciated."

9 Bonus Depreciation By Election and Limits on Depreciation: a Generally: The tax code has a couple provisions that allow taxpayers to deduct certain capital

expenditures upfront. These were used as economic incentives to go buy stuff right now but most set to expire at the end of 2012.

b §179 Expensing: Big exception to average capitalization rules. Can deduct up to certain amounts of asset purchases in the current year if you meet the requirements of 179. 3 limitations to the expensing.

i Dollar Limitation: For 2011 it was $500k, for 2012 it was $125k, for 2013 it is $25k ii Phase-Out Limitation: If total qualifying property purchases in the year are over the

phase-out amount, the amount deductible is reduced dollar for dollar by the amount that purchases exceed the limitation. (2011 limit = $2mil, 2012 = $500k, 2013 = $200k)

iii Taxable Income Limitation: §179 deduction cannot exceed the taxpayer’s taxable


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income for the year. c 50% Bonus Depreciation: A taxpayer may deduct up to 50% of the adjusted basis of an asset

in the year of acquisition up front. This expires in 2013. d Application of Bonus Depreciation and §179: Taxpayer will apply depreciation to the

adjusted basis of an asset in the following order: §179, Bonus Depreciation, MACRS e Depreciation Limits: §280F imposes limit for deduction of certain “listed property.” Basically

you cannot deduct beyond a certain limit for things like luxury cars, etc. Limits are also determined by whether or not the property is used for personal/investment/other purposes.

10 Amortization of Intangible Property §197. Pg 325 a General Rule: If TP can prove that a particular asset can be valued, and that the asset has a

limited useful life which can be ascertained with reasonable accuracy, he may depreciate the value over the useful life regardless of how much the asset appears to reflect the expectancy of continued patronage (goodwill).

b Definition of Intangible: any property that fits one of the following categories i Goodwill or going concern ii intangible property relating to info-base, know-how, customers, suppliers, ejusdem

generis iii Any license, permit, or other government granted right iv Covenant not to compete consideration entered into as part of sale of biz v Franchise, trademark, or trade name.

c Excluded From Intangibles: following are not qualified to be intangibles under 197 i Interest in corp/PS/trust/estate ii Interest in futures K, foreign currency K, notional principal iii Interest in land iv certain computer software v certain interest in films, sound, recordings, videotapes, books, and other artistic property vi certain rights to receive an intangible property vii certain interest in patent or copyright viii interest in lease of tangible property ix franchise costs to engage in professional sport x certain transaction costs.

d Application: §197 sets the rule that all intangibles are amortized over 15 years with a monthly convention and are not eligible for bonus/§179 deduction. Amortization is pure straight line.

e Exception: If asset does not qualify under 197, TP can still depreciate cost using straight line method if useful life can be proven. Reg. §1.167(a)-3.

f Selig v. United States (pg 325) (1984 - Pre Amortization §197) i Issue: When a taxpayer acquires a baseball franchise under a contract that specifically

allocates a percentage of the purchase price to the player’s contracts, may the taxpayer amortize the value of the players contracts?

ii Holding: Yes. The players' contracts were properly valued as a whole and the therefore the players contracts were depreciable/amortizable. Because this sort of bulk sale was the reality of the "club" market, the players should be valued in accordance with the


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market's nature iii Takeaway: Basically when there was no amortization code section, there was

substantial confusion on the issues of whether taxpayers could deduct intangible assets and how they should approach the deduction of them given that they were not subject to wear and tear.

11 Losses: Special rules on how to deal with losses from capital asset transactions a General Rule: §1001(a) - Loss from the sale or exchange of property in excess of adjusted

basis over amount realized. b Calculation: Amount of Loss = Amount realized - Basis (opposite of gain, if value decreased,

than basis > amount realized) c Nature of Losses: Usually can’t take personal losses unless specifically allowed by the code but

business/investment losses are usually deductible subject to limitations. d Deductibility: §1001(c): Realized losses are Recognized (deductible) only if it falls into one of

the following categories. e Individual Losses: §165(c) - Limitation of Individual Losses - Can only deduct 3 types of

uncompensated losses incurred: i in a trade or business; ii in profit- motivated transactions; and iii casualty & theft losses for personal property. iv Note: Can only deduct what exceeds 10% of AGI. (usually only catastrophic uninsured

losses) f Individual Loss Limitation: §165(a) - 2 Limitations

i loss must be “sustained;” and 1 Defined: Similar to gain must be “realized”/ must be “real” loss. ex: @ sale 2 Proven: using a police report, etc.

ii taxpayer can’t be compensated for the loss (i.e. insurance, settlement). 1 Ex: Can deduct amount not compensated for, but must show via

documentation.(165(h)(4)(E)) 12 Business and Investment Losses

a Basis Limit In Loss Property: §165(b): Loss deduction is limited to the basis in the property. Can’t deduct loss if can’t collect $.

b Gambling Losses: § 165(d) - Loss is limited to the amount of gain, regardless of business, investment, or personal. (public policy discourages)

c Business/Investment Losses: § 165(c)(2): Any loss from sale or exchange or property, including investment losses = above the line deductions (§62(a)(3)).

d Miller v. Commissioner (pg 337) i Facts/Issue: Does your drunk friend damaging your boat count if you don’t notify

insurance & claim amount minus minimal cash friend paid? ii Hold (IRS overrules): Allowable, plain language of statute. §165(h)(4)(e): Loss, extent

not covered by insurance, can only apply only if individual files a timely insurance claim for the loss.

13 Casualty & Theft Loss: § 165(h)


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a General Rule: Casualty and theft losses must be sudden, unexpected, or unusual. They are subject to limitation for deductions on the taxpayer’s tax return.

b Mazzei v. Commissioner i Facts/Issue: Does a taxpayer who entered into a conspiracy to produce counterfeit U.S.

currency incur a theft loss when the taxpayer provided currency which was supposed to be used in the reproduction process it was taken from him by fraud?

ii Hold: While the taxpayer may have sustained a ‘theft’ loss, it was the direct result of the criminal conspiracy on his part. Therefore, the loss was not an allowable deduction under sec. 165(c)(2) or sec. 165(c)(3)

iii Rules: §165(h): Treatment of casualty gains & losses: - any casualty & theft loss has a $100 limitation per casualty. (Subtract $100 from loss)

1 Then the net loss is allowed only to the extent it exceeds 10% of AGI c Rev. Ruling 79-1174: Beetles killing trees, deductible loss.

i Rule: Casualty loss must be sudden, unexpected, or unusual. d Carpenter v. Commissioner (pg 351)

i Facts: Husband fail. He knocked diamond engagement ring down the disposal but wife can’t deduct the loss because it was unintentional.

ii Holding: Absent some willful conduct to lose ring, the wife cannot deduct the loss. iii Rule: Wherever force is applied to property which the owner-taxpayer is either unaware

of because of the hidden nature of such application or is powerless to act to prevent the same because of the suddenness thereof or some other disability and damage results, he has suffered a loss which is, in that sense, like or similar to losses arising from the enumerated causes.

e Net Operating Losses (“NOL”) i General Rule: §172: Business Losses (must be operated for profit) the entire amount is

allowed, can carry back 2 years and forward 20 years. (if Corp., can carry forward operating losses forever)

1 Must go back 2 years first, before going forward. (Back that ass up!) 2 If loss is not covered within time frame, too bad. 3 Must have income to take it against in past (if not, then carry forward) 4 Individual loss on private business if qualified deductions are > gross income

ii Loss can only arise from business expenses and losses exceeding gross income (172(d)(4)) iii American Recovery and Reinvestment Act of 2009

1 “eligible small business” a sole proprietorship, corp., or partnership w/ annual gross receipts of no more than 15 million over prior 3 years)

2 with loss from 2008-09 could carry back 3,4, or 5 years 14 Capital Losses :(

a General Rule: §1211 (b) - Capital loss allowed is limited to the extent of your capital gain + $3,000 per year. If loss exceeds that limit, then can carry forward indefinitely (§1212(b)(1)).

b Capital Asset: Generally, investments. Not held for trade or business as some sort of inventory


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or other like kind item that is bought and sold as part of business. c Long-Term or Short-Term: If held for more than a year= long-term capital loss. If for one

year or less = short-term capital loss. 15 Loss Limitations for Related Persons: §267(a)-(d) disallows losses on sales/exchanges to and from

Related parties transactions a Rule: Losses realized on sales between related parties are disallowed. Related parties are à

i Members of a family, as defined in subsection (c)(4); ii An individual and a corporation more than 50 percent in value of the outstanding stock

of which is owned, directly or indirectly, by or for such individual; iii Two corporations which are members of the same controlled group (as defined in

subsection (f)); iv A grantor and a fiduciary of any trust; v A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of

both trusts; vi A fiduciary of a trust and a beneficiary of such trust; vii A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of

both trusts; viii A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding

stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

ix A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

x A corporation and a partnership if the same persons own— 1 more than 50 percent in value of the outstanding stock of the corporation, and 2 more than 50 percent of the capital interest, or the profits interest, in the

partnership; xi An S corporation and another S corporation if the same persons own more than 50

percent in value of the outstanding stock of each corporation; xii An S corporation and a C corporation, if the same persons own more than 50 percent in

value of the outstanding stock of each corporation; or xiii Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an

executor of an estate and a beneficiary of such estate. 16 Tax Exempt Organization - Disallowed Expenses: §501(c)(3)- Tax exempt status for

churches/charities for any income received but disallows certain expenditures a To maintain status may not endorse or oppose a candidate and “no significant amount” $

towards lobbying. b Not prohibited from endorsing or opposing issues c Do not have to apply, automatic tax exempt status


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Chapter 5: Statutory Exclusions from Gross Income

1 Specific Exclusions from Income: The tax code specifically authorizes certain income items to not be recognized as income on the taxpayer’s return and therefore is not taxable.

2 Gift & Inheritances (§102): Receiver no federal tax on the original amount, taxed at source (donor/ estate/ gift tax). If future income from gift/ inheritance, taxed for future use.

3 Life Insurance Proceeds (§101): Amount payable to beneficiary because death of insured are not taxed as income (non-probate asset). Policyholder previously taxed on premiums paid.

4 Annuity (§72): Pay premium for the right to regular series of future cash payments received for fixed time or life (v. lumpsum).

a Annuities: investment, basis in right to future payments. b Application: Not actual exclusion, but portion of annuity payment that represents the basis in

the investment is excluded from gross income as a return of capital. c Calculation: “Exclusion ratio”-§72(b)) = Investment (aka Basis) / Expected Return (total

received over life expectancy). % = amount of each payment that is a return on basis not income. Basis is recovered and the excess amount = taxable income.

5 Exceptions to Rules: Certain excluded items are not still excluded in certain circumstances. a Transfer of Policy for Value: § 101(a)(2) - If owner- beneficiary of life insurance policy

acquires the policy for “valuable consideration,” the exclusion is limited to the amount of consideration & any amounts (including premiums) paid after transfer.

b Installment Payments After Death: § 101(d) - Portion of installment payment that is interest is included in gross income. Only the amount of the principal is excluded. Gross death benefit / # of payments made... excess is interest (income)

c Surrender Life Insurance Policy: If surrender for “cash value” & not dead, then §101(a) doesn’t apply. Instead §72: The cash is gross income to the extent it exceeds the aggregate premiums paid (aka basis)

d Payments to Terminally Ill / Chronically Ill: § 101 (g)(1) - They are allowed to cash out early so long as owner insured is terminally or chronically ill because I got bills yo!... or if you sell the policy to “viatical settlement company” for lump-sum cash payment- excluded from gross income.

i Terminally Ill Definition: §101(g)(4)- Terminal = Dr. certified that you have 24 months or less from date of cert.; Chronically ill= severely disabled (§7702B(c)(2))

ii Note: Ascertain if the Term v. Whole Insurance for premium’s basis adjustments 6 Scholarships & Fellowships (§117)

a General Rule: Certain scholarships and tuition reductions are beneficial to the taxpayer but are not included in the taxpayer’s taxable income for policy reasons promoting education.

b Qualified Scholarships: §117(a) - Must be used for “qualified tuition” (tuition & fees) + related expenses (books, supplies, related equipment). Must be a “scholarship or fellowship grant.” Amount of scholarship applied to qualified expenses is not included in gross income.

c Qualified Tuition Reductions: §117(d)(1) - Scholarship is excluded if not in exchange for services/ condition to do something.

i Athletics: Rev. Ruling 77-263: Student athletes with a “full ride” are excluded.


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ii Academic: Academic Merit Scholarships (maintaining GPA) are excluded. d Bingler v. Johnson (pg 371)

i Facts/Issue: Does a fellowship that pays the grantee a stipend, gives grantee a tuition reduction, and requires grantee to provide services to the grantor constitute income to the grantee ?

ii Hold: Grants given to taxpayers by their employer so that they could research and write their doctoral theses in engineering were taxable ‘compensation’, rather than excludable ‘scholarships.'

iii Rule: Definitions of “scholarship” and “fellowship”, supplied by tax regulations show that the ordinary understanding of such terms means relatively disinterested, “no-strings” educational grants, with no requirement of any substantial quid pro quo from the recipients.

e Employer Paid Educational Expenses: §127 - Employees can exclude up to $5,250 of educational assistance from employer is from an “educational assistance program.” for tuition, fees, books, supplies that the employee doesn’t 1) keep after the program, 2) not for transportation, meal, lodging, and 3) not for sports, games, or hobby courses.

f Income from Savings bonds (135) i Phase out (135(b)(2)) ii MARRIED PEOPLE MUST FILE JOINT (135(d)(3)

7 Compensation for Personal Injuries & Sickness (§104)

a General Rule: (a)(2): Settlements (non-punitive) damages from insurance company / jury trial for personal physical injuries or physical sickness are excluded. No exclusion for mental anguish.

b Amos v. Commissioner (pg 376) → Dick Kick i Facts/Issue: Dennis Rodman kicks cameraman in the nads! & settles for $200,000,

Rodman writes off as a business expense. Divide physical v. non-physical amount. If there is a settlement for a claim of physical and mental pain, how do you divide the settlement into physical and mental portions?

ii Rule: §104(2): Physical? - Emotional distress is not excluded, but amount for medical care “attributable to injury” is exempt. Punitive damages = taxable.

iii Test: (Facts & Circumstances “Smell” test) 1 Look at the “orgin of the claim”- what was the “injury” (Look at the nature &

character, not the validity) 2 Look at the intent of the payor- dominant reason for payment?

iv Held: taxpayer was entitled to exclude from income 60% of award as received on account of personal injury or sickness.

c Johnson v. US (pg 386) i Facts/Issue: Must an wrongful termination award for a claim under the ADA be

included in a taxpayer’s gross income? ii Held: taxpayer's front and back pay awards in disability discrimination action were not

excludable from income


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iii Rule: Damage awards to taxpayer of front and back pay in a discrimination action are not excludable from gross income if they were “on account of” discrimination, not physical injuries; taxpayer's discriminatory discharge separates the direct causal link between taxpayer's physical injuries and his recovery on disability discrimination claim.

d Private Letter Ruling 200041022: Sexual harassment is not physical. But divide injury into several activities, & one w/ physical injury (bitch got hit) is exempt.

e Employee Exclusions: §105 - Amount received for health insurance plans and healthcare provided by employer are not included in gross income to the extent it doesn’t exceed amount in §106 (exclusion for employer-provided accident & health insurance plans).

f Recovery of Non-Injury Awards: Not all recoveries are for physical injuries but could potentially be for losses under a contract or lost profits.

i Lost Profits Recovered: If you recover amounts that are designed to replace income, that amount is included in gross income,

ii Recovery of Capital: If the recovery is simply recovery of an investment in something, then the amount recovered over the adjusted basis in the investment is taxable income.

g Damages that come from personal injury- including Loss wages, Emotional damages are excludable (104(a)(2)). 1.104-1(c)

h Murphy v. US (pg 390) - Case in book was overruled by a rehearing of the same court. i Facts/Issue: Does the restoration of a person back to their previous mental condition

constitute an ejusdem generis extension of restoration of capital exclusion? ii Rule: §104 is Constitutional & not all injuries must be covered, only physical. It is

taxable income if not physical injury, otherwise it is compensation. (human capital restoration is not a real thing).

1 Note: If amount is excluded from income, can’t deduct attorney’s fees to recover it

2 Note: Attorney’s fees typically not above the line deduction & large settlements may trigger Alt. Min. Tax (if excluded from income, no deduction yo!)

iii Holding: gross income under section 61 of the Internal Revenue Code does include compensatory damages for non-physical injuries, even if the award is not an "accession to wealth," and the income tax imposed on an award for non-physical injuries is an indirect tax, regardless of whether the recovery is restoration of "human capital.”

8 Exclusion for Interest on Certain Municipal Bonds: §103(a) - Tax-free Government Bonds (gov. pays interest on $ borrowed). Double-Tax Free Bond: No State or Federal Tax.

9 The Parsonage/ Clergy Exclusions: §107 - 2 items excluded from “a minister of the gospel’s” gross income:

a Rental value of a home furnished as part of the minister’s compensation (congregation pays), & b Any rental allowance paid as compensation, to the extent such allowance is actually used by the

minister to rent or provide for a home. c Note: Own or rent: FMV is excluded from income. d ONLY FOR ONE HOUSE

10 Exclusion of Tenant Improvements: §109 - Value of the tenant’s improvement’s is excluded from the landlord’s gross income. §1019 says you can’t increase basis for amounts excluded under §109. Include


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as a decrease in basis when you sell it. a Helvering v. Brunn OVERRULED by §109 - Permanent improvements to landlord’s property

by tenant are gross income to the LL when LL reclaims property after tenant’s vacancy 11 The Exclusionary Arm of the Tax Benefit Rule: §111

a Tax Benefit Rule: Include recoveries in gross income in the year recovery occurs. b Application: §111 - Excludes recognition of recovery of prior deductions when it did not

actually reduce the taxpayer’s liability. 12 Exclusion of the Gain from the Sale of a Principal Residence: §121

a Availability: Available to all on a recurring basis (every 2 yrs) b Exclusion Amount: Can exclude up to amount (Individual = $250,000, Couple= $500,000) of

realized gain from sale of principal residence. c Requirements:

i Must treat as principal residence- owned or used home for 2 of 5 years prior to the sale, &

ii Must not have claimed exclusion (to any extent) in 2 years prior. 13 Disaster Relief Payments Exclusion: §139

a Rule: Amounts individual receives as a “qualified disaster relief payment” are not gross income.

b Qualified Events: Events include terroristic or military actions, Presidentially declared disasters, certain catastrophic accidents. (139(c)

i PERPETRATORS OF DISASTER CAN’T CLAIM (139(e)) c Qualified Payments: For: 1) reasonable & necessary personal expenses from, 2) r&n for

repairs to personal residence or furnishings, 3) made by a common carrier by reason of death or physical injury from, & 4) from gov. agency as relief.

d 7 receipts that eligible: i Payments for “reasonable and necessary” personable expenses resulting from “qualified disasters” (139(b)) ii Payments for “reasonable and necessary” repairs to primary residence or furnishings because of disaster (139(b)) iii Payments from common carrier for death or physical injury stemming for qualified disaster (139(b)) iv Payments made from govt. agency as relief from qualified disaster (139(b)) v Payments from 9/11 Victim Comp Fund are Excluded (Revenue Ruling 2003-115) vi Grants from state programs (Revenue Ruling 2003-12) vii Grants from disaster relief agencies (Red Cross) (Revenue Ruling 2003-12) viii Employer grants for disaster relief (Revenue Ruling 2003-12)

Chapter 6: Timing of Income

1 Accounting Methods


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a General Concept: The tax code has hundreds of provisions about how and when to recognize gross income and deduction but the IRS does give the taxpayer a few options about which accounting method to utilize.

b Application in General: Basically the taxpayer accounts for their operations and business under the accounting method they see fit but only so long as it does not conflict with code or case law.

c Keep in Mind: Note that the accounting method chosen by the taxpayer has nothing to do with WHAT you recognize, only guides WHEN you recognize it.

d Mandated Accounting Methods: Some taxpayer/biz are required to use one method of the accounting. These mandates usually only apply to large corporations. §448(a) lists C-Corps, partnerships with C-Corp partner, and tax shelters as mandatory accrual users. Reg §1.446-1(c)(2)(i) requires that companies with an inventory function must use accrual.

2 Cash Method: Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.

a Pros and Cons of Cash Method: In this case, the taxpayer can accrue receivables and other monies owed to him but not pay tax until it is later received.

b Income Items: Traditionally, income would not be recognized until the taxpayer actually receives the payment itself, in cash or cash equivalent.

i Issue: There is a problem with cash method taxpayer deferring income per an agree to pay in years after a service is performed.

ii Constructive Receipt Doctrine: A taxpayer is subject to tax in the current year if he or she has unfettered control in determining when items of income will or should be paid. Unlike actual receipt, constructive receipt does not require physical possession of the item of income in question. Reg §1.451-2

iii Hornung v. Commissioner (pg 412) 1 Facts/Issue: Whether the value of a 1962 Chevrolet Corvette won by Paul

Hornung (taxpayer) for his performance in the 1961 NFL championship game should be included in his gross income for the taxable year 1962?

2 Rules: Under the cash receipts method, items constituting gross income are to be included for the taxable year in which they are actually or constructively received. An item is constructively received when it has been set apart for the taxpayer (or credited to an account) or otherwise made available for him to draw upon, if the intention to do so is known, but "income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions."

3 Holding: Yes. The corvette was not a gift and is includible in the taxpayer’s income in the year that the taxpayer had unfettered access to it.

iv Davis v. Commissioner (pg 419) 1 Facts/Issue: Did a taxpayer that missed a mailed severance pay check on new

years eve of 1974 improperly report the income in 1975 if the taxpayer did not actually have possession of the check in 1974?

2 Holding: No. Regardless of the fact that the company had unqualifiedly


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committed the funds to the taxpayer, the funds must be available to the taxpayer. 3 Rule: Funds must be made available to the taxpayer without substantial

limitations in order to be constructively received. a Exception: Income will be considered constructively received by the

taxpayer if the taxpayer turns his back on the income by choosing not to receive it in the current tax year.

v Veit v. Commissioner (pg 420) - Two cases from same taxpayer 1 Facts: Taxpayer was president of a company and was entitled to a fixed salary

plus a bonus of 10% of the corporation's profits for the years 1939 and 1940, with the bonus to be paid in 1941 but the contract was revised in Nov 1940 to provide that the bonus from the 1939 profits would be paid in 1941, and the bonus from the 1940 profits would be paid in 1942.

2 First Case: IRS objected to the new K, claiming that the bonus from the 1940 profits was constructively received in 1941 and should have been included as part of the taxpayer's gross income for 1941. TC found that the November 1940 agreement was "an arm's length business transaction . . . mutually profitable" to both the corporation and the taxpayer. Only if deferral of the 1940 bonus were "a mere subterfuge and sham" to allow the taxpayer to postpone paying income tax on the bonus could the court have found constructive receipt, it said, and there was no evidence of such intent. In fact, it was apparent that deferral was a common practice for this corporation, and it was the corporation's idea, not the taxpayer's. The court found for the taxpayer.

3 Second Case: At issue was a further agreement, entered into in December 1941, allowing the 1940 bonus to be paid in five equal installments annually from 1942 to 1946, instead of the entire amount in 1942. Again, the IRS objected to the deferral of the payment, and again, the TTC found for the taxpayer. The deferral was at the request of the corporation, and the full amount of the bonus was never "unqualifiedly subject to [the taxpayer's] demand or withdrawal."

vi Cash Equivalence Doctrine: If a taxpayer has either actually received an item, or constructively received an item he must determine whether the item received is a cash equivalent, using the six factors described in Cowden. Reg §1.446-1(c)(1)(i)

vii Cowden v. Commissioner (pg 425) 1 Facts: The taxpayers made a contract for oil and gas royalty payments with

"bonuses" payable in two subsequent years. They next signed these contracts over to a bank reporting the amounts received as long term capital gains. The Commissioner disagreed as to their designation making them taxable as capital gains.

2 Rules: A promissory note, negotiable in form, is not necessarily the equivalent of cash. But that principle also has a true inverse—that a non-negotiable instrument can be a cash equivalent if the following factors are met. A promise to pay will be considered a cash equivalent for cash method taxpayers if:

a the promise to pay is unconditional;


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b the promise is made by a solvent person; c the promise is assignable; d the promise is not subject to set-offs; and e the promise is marketable.

c Deduction Items: Traditionally, under the cash method things are only deducted when the taxpayer has actually paid the expenditure out of their funds.

i NO Constructive Payment: §461 Unlike income, there is NO constructive payment doctrine that allows the taxpayer to deduct something before it is actually paid. Therefore, you can’t issue a promissory note in payment for something and then deduct it.

ii Determining Actual Payment: Problem arises when the taxpayer performs services or transfers property in lieu of paying a deductible expense.

1 Services: Taxpayer recognizes gross income in the amount of the deduction that satisfied with the performance of services so that it becomes a wash afterwards.

2 Transfer of Property: Taxpayer must recognize gain, but not loss, on the transfer of assets in lieu of cash payment for otherwise deductible item in the amount of the deduction over the property’s adjusted basis.

3 Payment by Check: Recognized when the check is delivered to payee and NOT when it is cashed. Estate of Spiegel v. Commissioner.

4 Payment by Promissory Note: Not deductible when the note is issued but IS deductible when the note is paid. Helvering v. Price. Note: Taxpayer may borrow funds to make a deductible payment. Granan v. Commissioner.

5 Credit Card Payments: Credit card payments are deemed made at the point of sale, not when the payment to the credit card company is made.

iii Deductibility of Advance Payments: If a taxpayer pays an expense in advance, the taxpayer may deduct the full payment up front. This has beneficial tax implications if the taxpayer needs to reduce current taxable income. If you pay really far in advance then you run into an asset that lasts, “substantially beyond end of tax year.” Reg §1.461-1(a)(1).

iv Commissioner v. Boylston Market Association (pg 433) 1 Facts/Issue: Whether a cash method taxpayer is limited to the deduction of

insurance premiums actually paid in any year or whether he should deduct each year the pro rata portion of the prepaid insurance attributable to that year?

2 Holding: A taxpayer that kept its books and makes its returns on a cash receipts and disbursements basis, and which purchases fire and other policies covering periods of three or more years, should deduct for each tax year the pro rata portion of the prepaid premiums applicable to that year on ground that taxpayer should treat the prepaid premiums as a “capital expense”

v Zaninovich v. Commissioner (pg 434) 1 Facts/Issue: whether a rental payment by a cash basis taxpayer for a lease year


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that extended eleven months beyond the year of payment is fully deductible in the year of payment as an ordinary and necessary business expense1 or must be deducted on a prorated basis as a capital expenditure

2 Hold: that a rental payment by a cash basis taxpayer for a lease year that extended 11 months beyond year of payment is fully deductible in the year of payment as an ordinary and necessary business expense and it need not be deducted on a prorata basis as a capital expenditure.

3 Rule: Under the one year rule, an expenditure is treated as a capital expenditure if it creates an asset, or secures a like-kind advantage to the taxpayer, having a useful life in excess of one year.

vi Grynberg v. Commissioner (pg 439) 1 Facts: taxpayers prepaid certain business expenses each Dec that were not due

until Feb and March of the following year and deducted the prepaid expenses when they were paid, rather than when they would otherwise be due.

2 Test: To determine if prepayments are deductible, apply the three-prong test. The test applies whenever the issue is the deductibility of prepaid items under §§ 162 and 446(b). Each prong is independent and must be satisfied for a prepayment to be deductible:

a First, there must be an “actual payment of the item in question.” A mere refundable deposit will not support a deduction.

b Second, there must be a “substantial business reason” for making the prepayment early. If prepayment occurred simply to accelerate a tax deduction, no deduction will be allowed in the year of prepayment. Tax reduction is not considered a “valid business purpose,” and thus is not an ordinary and necessary expense under § 162.

c Third, prepayment of the item must not cause a “material distortion” in the taxpayer’s taxable income in the year of prepayment. IRC § 446(b). The taxpayer carries a heavy burden to overcome the IRS’s determination that the taxpayer’s method of accounting does not clearly reflect income.

3 Holding: Taxpayer meets first element, fails second element and third element is not evaluated. Therefore, not deductible until it is due.

vii Prepaid Interest: §461(g) covers prepaid interest. Places cash method TP’s on the accrual method for prepaid interest payments. Does not apply to paid for points on mortgages.

viii The One-Year Rule in the Regulations: Applies the Zaninovich on-year-rule to any payments that create a right or benefit to the taxpayer.

3 Accrual Method: Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.

a Income Items: Reg §1.446-1(c)(1)(ii)(A) Income is recognized under the accrual method when all the events have occurred that fix the right to receive the income and the amount of the


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income can be determined with reasonable accuracy. i Rev. Rul. 74-607 (pg 445)

1 Facts/Issue: Whether points paid to a lender for a mortgage are recognized prorata or in the year they are received?

2 Rule: All the events that fix the right to receive income occur when: a the required performance occurs; and b the earlier of the following occurs

i payment is therefore due, or ii payment is therefore made.

ii Prepayment of Income: The “earlier of” from the preceding rev rul. applies to taxpayer who receive prepayment for work so as to force them onto the cash basis in this situation.

iii Doubts as to Collectibility: Problem occurs when a taxpayer provides services to financially troubled client who taxpayer reasonably believes might not be able to pay and therefore presents a situation where taxpayer may not want to report income.

iv Spring City Foundry Co. v. Commissioner (pg 449) 1 Facts/Issue: Did the TP have GI in 1920 from its sales on account to a customer

when facts subsequent to the sales but before the end of the year suggest that the taxpayer will not collect payment?

2 Holding: Yes. The taxpayer has met all the requirements for the right to the income to be fixed and the amount fixed.

3 Rule: If accounts are determined to be uncollectible, the proper approach is to deduct the uncollectible portion under the applicable statute when the account is deemed to be uncollectible. Later events do not change the fact that there was income.

v Clifton Manufacturing v. Commissioner (pg 450) 1 Facts/Issue: whether any part a the sum received in 1937 should have been

included in the gross income of that year rather than in the gross income of an earlier year when it was due and payable and its collectibility was assured?

2 Holding: The interest should have been accrued in 1936, the year the taxpayer knew that it would become collectible.

3 Rule: Interest is not accrued as long as reasonable doubt exists as to the amount that is collectible by reason of the financial condition or insolvency of the debtor. Interest/debt should only be accrued and reported as income when it’s collectibility is assured.

4 All events test a Right to receive income is fixed b The amount can be determined with reasonable accuracy c They superimpose the earliest of

i When the required performance occurs §461 ii When the payment therefor is due (or?) iii When the payment is made


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iv Special Rule For Services: §448(d)(5) An accrual method service provider can defer the accrual of the portion of amounts due for services rendered on the basis of past experience that it is unlikely to be collected.

1 Reg’s Calculation: uncollectible portion of AR must bear same ratio as total bad debts expensed to the year end AR.

v Contested Income and Unenforceable Claims: The “all events” test is not satisfied if the debt or receivable is contested but the income accrues when a final judgment is rendered or when all appeals have been exhausted. Lamm v. Commissioner.

vi Flamingo Resort, Inc. v. United States. (pg 453) 1 Facts/Issue: whether the right to receive income from the "markers" was "fixed"

for accrual purposes when the "markers" were first extended or if the right was not "fixed" until the casino collected on the loans?

2 Holding: that the right to receive income was sufficiently "fixed" when the credit was extended and therefore required the casino to include the $676,432.00 in dispute on their 1967 tax return.

3 Rule: there doesn’t need to be a legal liability to pay the debt, only that the obligation be "fixed" and there be a "reasonable expectation" that the obligation would be collected.

vii Prepayment Issue: If an accrual taxpayer receives a pre-payment of income, the taxpayer must recognize that income in the year that it was received. Part of 3 case supreme court trilogy that tossed out the idea that a taxpayer could recognize pre-paid income over time.

viii Schlude v. Commissioner (pg 459) 1 Facts/Issue: Was it proper for the Commissioner, exercising his discretion under

§446(b) to reject the studio’s accounting system as not clearly reflecting income and to include as income in a particular year advance payments by way of cash, negotiable notes, and contract installments falling due but remaining unpaid during that year?

2 Holding: it was proper for the Commissioner to include in income advance payments by way of cash, negotiable notes, and contract installments falling due but remaining unpaid during that year.

3 Rule: Court adopted “earlier-of” and disregarded the matching principle. ix Artnell Company v. Commissioner (pg 466)

1 Facts/Issue: Must a taxpayer include in gross income for 1962 the sale proceeds received from tickets allocable to games to be played in 1963?

2 Holding: No. The earlier of test only applies to cases where the future date on which the performance would occur was uncertain. Here it is absolutely certain when the performance would occur and deferral is appropriate.

3 Rule: Earlier of test will not apply and the matching principle will apply when the deferral technique so clearly reflects income that the court would find an abuse of commissioner discretion if it was rejected.


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x Tampa Bay Devil Rays, Ltd. v. Commissioner (pg 466) 1 Summarized: Restates the rule in Artnell. Narrow exception for deferring

income when the taxpayer can prove that services will be performed on fixed dates in one or more subsequent years which better matches income with expenses.

xi Rev. Proc. 2004-34: Limits Artnell rule application to deferral of recognition to only the taxable year immediately following the year of receipt of income. 8 Ex. in book pg 470.

xii Advance Payment From Sale of Goods: If pre-payment received for sale of goods, such prepayment must be recognized in year of receipt OR earlier of:

1 the year when the prepayments of would be reported for tax purposes OR 2 the year when the prepayments would be recognized for financial acct. purposes.

xiii Prepaid Subscriptions and Dues: §455 allows a taxpayer that provides a subscription to allocate pre-paid income over life of subscription. This must be done by affirmative election by attachment of statement to return. §456 has same standard for Dues paid to organization that does not resemble corporation. Both statutes limit deferral to 36 months.

xiv Warranty Contracts: Warranty contracts on houses/cars/etc present problem because K is sold to 3rd party insurer every time. Rev. Proc. 97-38 allows deferral up to 6 years for the amount that is turned around and paid to 3rd party insurer and immediate net profit is gross income in year of receipt.

d Deduction Items: Reg. § 1.461-1(a)(2)(i) Taxpayers may claim a deduction in the taxable year in which all the events have occurred that establish the fact of the liability can be determined with reasonable accuracy and economic performance has occurred with respect to the liability. Note: Third prong for economic performance

i Gold Coast Hotel & Casino v. United States (pg 475) 1 Facts: Whether a casino, on the accrual method, could deduct the value of slot

club points earned by slot club members in the tax year in which the members accumulated the minimum points required to redeem a prize, or whether the casino had to wait to deduct the value of the points until members actually redeemed them?

2 Holding: Gold Coast's accrual deductions were proper, as its liability to members became fixed upon their accumulation of the minimum number of club points whether or not they chose to redeem them and because the amount of liability was known with reasonable certainty. Did not assess 3rd prong, only first 2.

3 Rule: Three prong test for deductions (All events test) a all the events have occurred that establish the liability, b the amount of the liab can be determined with reasonable accuracy, and c economic performance has occurred with respect to the liability

ii Economic Performance Concept: §461(h) Economic performance definition 1 Services: When the services are actually provided 2 Property Transfer: when purchaser is provided with the property


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3 Use of Property: When taxpayer begins to use the property iii Contested Liabilities: Taxpayer cannot deduct an item that they have contested as not

owing. Dixie Pine Products v. Commissioner 1 Contested Defined: Taxpayer must have bona fide dispute as to valuation and

must commit an affirmative act of assertion that the liability is improper. Reg. §1.461-2(b)(2).

2 United States v. Consolidated Edison Co. of New York. (pg 485) OVERRIDDEN BY §461(f)

a Facts: Con Ed challenged a real estate tax levy against them. It paid the tax in the year of assessment to avoid penalties and interest. The problem is whether to accrue the liability/deduction in year of payment or year that dispute was settled.

b Rule: If contested tax item was otherwise accruable in tax year, payment-whether of character which would constitute admission of asserted liability or mere deposit to enable contest of liability-would not render item non-accruable, and if, in absence of payment, item was otherwise accruable in taxable year, payment would be immaterial or unnecessary to question of accruability

c Hold: that the contested part of real estate tax accrued not in the year the tax was assessed but rather in the year the contest was finally determined.

3 Final Rule on Payment w/Contest: Accrual method taxpayers can claim a deduction for a payment made in respect to a disputed settlement debt even though the dispute survives the payment. §461(f).

5 The Taxable Year: Each taxable year must be treated as a separate unit and all items of gross income and deduction reflected in terms of their posture at the close of such year, for federal income tax purposes.

a Annual v. Transactional Taxation: Federal income tax is an annual accounting taxation whereas things like sales tax are collected at the transaction, per the transaction. This annual reporting reduces compliance burdens and makes a more predictable gov income stream.

b Tax Year Choices: §441 has 4 possible options for tax years i Calendar Year per §441(d) ii Fiscal year per §441(e) iii Short taxable year per §441(b)(3) and §443 iv 52-53 week tax year per §441 (f)

c Short Explanation of Short-Year and 52-53 Years (Beyond scope of class) i Short Year: Usually not applied to individuals because it is for businesses changing

their accounting method mid year. People only have one short year, when they kick the bucket.

ii 52-53 Week: It is for businesses that end their business for the year on a specific day of the week. Taxpayer only has to keep books on that same basis.

d General Tax Year Usage (Most common usages) i Calendar Year: Most taxpayers individually are calendar year. It almost never happens


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for an individual to be on a fiscal year for cyclical income purposes. ii Fiscal Year: Only way to be able to use the fiscal year is to formally request to be able

to use it and get approval from IRS. §442. More prevalent for business entities e Standalone Rule: Each tax year stands alone as a single accounting period. The tax return for

that year should reflect that economic differences incurred during that period of time. There are statutory and common law exceptions to this rule.

f Burnet v. Sanford & Brooks Co. (pg 493) (VERY OLD CONCEPT)

i Facts: Problem with incurring expenses one year, sueing U.S. for payment in later year, and recovering the income in an even later year.

ii Holding: annual accounting system is a practical necessity if the federal income tax is to produce revenue ascertainable and payable at regular intervals. It is constitutional and appropriate because congress is not required to adopt another system.

g North American Oil Case Note i Claim of Right Rule: If a taxpayer receives earnings under a claim of right and without

restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money and even though he may still be adjudged liable to restore its equivalent.

h United States v. Lewis (pg 497) i Significance: Reinforces the claim of right doctrine. ii Restated Claim of Right: If you rightfully receive something and there are no

restrictions on its transfer, you must include it in gross income upon receipt, even if you may have to return the money in the future.

6 Error Correction: Several devices for taxpayers to correct mistakes. a Correction Devices

i Tax benefit rule ii §1341 restoration of right iii Res Judicata and Collateral Estoppel iv Equitable Recoupment v SOL Exceptions

b Tax Benefit Rule: If a taxpayer recovers an item that was previously deducted, and if the prior deduction reduced the tax liab in the year of deduction, then the recovery is included in income

i Right To Exclusion: §111(a) allows the taxpayer to exclude from income amounts recovered that were previously deducted and did not reduce the tax liability that year.

ii Applicable Tax Rate in Recovery Year: The general rule is that the item will be taxed in the current year at current rates but there are exceptions.

iii Alice Phelan Sullivan Corporation v. United States (pg 501) 1 Facts/Issue: Taxpayer sues claiming refund of amount of deficiency paid after

her charitable conveyance was reconveyed to her years later. Taxpayer alleges taxes due on reconveyance can not exceed tax deduction benefit she originally received by making conveyances

2 Rule: A transaction which returns to the taxpayer his own property gives rise to


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income when the recovered item was initially used as a deduction and provided a tax benefit to the taxpayer; the item recovered will be taxed in the current year at current tax rates.

3 Holding: The tax benefit rule makes no mention of the tax rate which should be applied to the recovery and the court determines, in light of the single-year model of our tax system, that the applicable tax rate is that of the year of recovery

iv Erroneous Deduction Exception: Tax Court and some App. Ct’s recognize it, but not all. Essentially, if a taxpayer deducts something in a prior year that the taxpayer should not have per the tax code, this does not prevent the tax benefit rule from applying.

v Unvert v. Commissioner (pg 505) (9th Cir) (Circuits are split) 1 Facts/Issue: Must a taxpayer include in income the recovery of the prepaid

interest expense even though the taxpayer erroneously deducted the expense in a prior year?

2 Holding: Yes. Recovery of the expense was required to be treated as income under the tax benefit rule regardless of whether the 1969 deduction had been improper

3 Rule: Regardless of whether original deduction of interest expenditure was improper, subsequent recovery of the expenditure was required to be treated as income in the year of recovery under the tax benefit rule.

vi Expansion of Erroneous Deduction Exception: The inclusionary aspect of the tax benefit rule now reaches not only recoveries of amounts previously deducted but also events that are fundamentally inconsistent with a prior deduction or exclusion.

vii Hillsboro National Bank v. Commissioner AND United States v. Bliss Dairy, Inc. (pg506)

1 Concept at Issue: Tax benefit rule application in two different cases. 2 Rule: Unless a nonrecognition provision of the IRC prevents it, the tax benefit

rule ordinarily applies to require the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction

3 Policy: Purpose of tax benefit rule is not simply to tax “recoveries,” but, on contrary, is to approximate results produced by tax system based on transactional rather than annual accounting, and basic purpose is to achieve rough transactional parity in tax and to protect government and taxpayer from adverse effects of reporting transaction on basis of assumptions that an event in subsequent year proves to have been erroneous.

c Restoration of a Claim of Right: §1341 allows a taxpayer that recovers under a claim of right a tax benefit rule item in a later year to get the tax benefit the taxpayer would have obtained in the original year of deduction if the taxpayer meets the following 3 requirements.

i Requirements Per §1341(a)(1-3) 1 an item was included in gross income for a prior taxable year (or years) because

it appeared that the taxpayer had an unrestricted right to such item; 2 a deduction is allowable for the taxable year because it was established after the


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close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

3 the amount of such deduction exceeds $3,000 ii Reynolds Metals Co. v. United States (pg 529)

1 Facts/Issue: Does a CERCLA clean-up project that establishes liability for the last 50 years of environmental contamination qualify for §1341 treatment?

2 Holding: No. Taxpayer is not repaying funds to anyone that it had erroneously received before.

iii Flavor of Item in Restoration of Claim of Right: The Arrowsmith doctrine states that restorations associated with prior income items take the same flavor as the prior income items.

iv United States v. Skelly Oil Co. (pg 531) Vodka 1 Facts/Issue: Taxpayer was in the natural gas business. After a change in the

minimum price order on natural gas, Taxpayer had to refund a large amount of money to customers previously claimed as gross income.

2 Holding: where taxpayer overcharged customers for natural gas for certain years and subsequently was required to refund overcharges, deduction allowable in year of repayment was required to be reduced by percentage of other tax benefits gained by previous recognition concepts.

3 Rule: If money was taxed at a special lower rate when received, the taxpayer would get an unfair tax windfall if re-payments were deductible from receipts taxable at the higher rate applicable to ordinary income.

v Limitation For Capital Loss: Keep in mind the§1211(b) $3000 capital loss limitation that can be used per year. It applies to §1341 losses that are flavored as capital losses that are taken in the current year.

d Res Judicata and Collateral Estoppel: Preclusion doctrines raise issues about what has been litigated by the taxpayer and IRS already. The close of tax year opens up a whole new period for litigation.

i Res Judicata: Generally known as claim preclusion ii Collateral Estoppel: Issue preclusion iii Commissioner v. Sunnen (pg 540)

1 Facts/Issue: Is the government precluded from arguing that the royalties paid to a related person were gross income to the taxpayer when the government previously found that royalties under an almost identical agreement were not gross income?

2 Holding: No. Res Judicata is generally not available in tax cases because each tax year is a new cause of action.

3 Res Judicata a Each year is the origin of a new liability and separate cause of action. b Res Judicata will only apply to subsequent proceedings on that same tax

liability of the same year. 4 Collateral Estoppel


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a Collateral estoppel acts only to prevent similar or unlike claims in subsequent years if the claim was presented and determined before.

b Collateral estoppel operates to relieve the government and the taxpayer of redundant litigation of the identical question of the statute’s application to the taxpayer’s status.

e Equitable Recoupment - Two wrongs = Right: Rarely used but occasionally a taxpayer makes a mistake in a prior year and realizes it after it is too late to amend; the IRS may permit the taxpayer to make another mistake in the current year so as to recoup the benefit lost or effectively right the previous wrong.

i United States v. Dalm (pg 543) 1 Facts: Taxpayer sought refund of gift taxes by way of recoupment, alleging that

taxes had been collected on mutually exclusive theory that transferred money was both income and gift

2 Holding: doctrine of equitable recoupment did not provide jurisdictional basis for independent suit to recover gift tax previously paid, after time for filing refund had expired

3 Rule: Fact that taxpayer does not learn until after limitations period has run that tax was paid in error, and that he or she has ground upon which to claim refund, does not operate to lift limitations bar. Tax refund claim not filed within limitations period cannot be maintained, regardless of whether tax is alleged to have been erroneously, illegally or wrongfully collected.

f Mitigation Provisions: Congress has provided exceptions to SOL where judicial deference to the statute would produce anomalous results. There are 4 exceptions to the SOL:

i Determinations under §1313 ii Circumstance of adjustment under §1312 iii Correction of the error must now be barred by law §6501 or §6511 iv Condition of adjustment §1311(b) v Mitigation Calculations: If mitigation is permissible, the adjustments are done per

§1314.

Introduction to the Flavor of Income (p. 169): The different kinds of income and treatment

a. Capital Gains Income: Gain from the sale of a capital asset. Not income from asset.§ b. Capital Asset Definition: §1221: (Negative Definition) Everything is a Capital Asset except: 8

types of items (see list) - if not on there then capital. c. General Application: property held for investment or personal use purposes (not trade or

business) is a capital asset. d. Long Term Assets v. Short Term Assets: In order to get the lower tax rate for capital gain, it

must be a long term capital gain. Long term assets must be held for over a year (§1222(1)-(4)), to be taxed at lower rate (15% LTCG v. Indiv Marginal % STCG/L).


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e. Applicable Rate Section:§1(h): individual must have a “net capital gain.” f. Net Capital Gain Calculation: § 1222(11): NCG= excess of “net long-term capital gains” over

“net short term capital losses.” i. Short term capital gain- taxed at ordinary rate, can be used to offset capital loss

g. Capital Gain Treatment Policy: adjusts for inflation (because basis doesn’t account for it); “Bunching”- better reflection of gain accrued over time because not realized until sold; Promote behavior & stimulate investment & savings activities.

Chapter 7: Flavor of Income

1 Capital Assets a General Definition: §1221(a) Capital asset is property held by taxpayer but does NOT include

property held primarily for sale to customers in taxpayer’s trade or business, stocks in trade, and artistic works.

b Exceptions: It does NOT include: (Exclusive List) i Own business stock or raw materials to produce/ manufacture own business inventory, ii Depreciable property or real property used in trade or business, iii copyright, literary, musical, or artistic composition, letter or memo, or similar property

that the taxpayer created or that the basis is determined while they hold. 1 Not from own efforts, but investor 2 Musical Composition held by composer: Taxed as capital asset if elected, but not

novelists! iv accounts or notes receivable acquired in ordinary course of trade or business for services

or property in (a), v U.S. Government publication, including Congressional Record, received other than

purchased at public sale, and the taxpayer either holds or basis is determined while held, vi commodities derivative financial instruments held by dealer, unless Secretary

determines the instrument is not connected to the dealer as a dealer, & identified in dealer’s records by the close of the day when it was acquired/ entered,

vii hedging transactions identified as such before the close of the day when acquired/entered, or

viii supplies regularly consumed in ordinary course of own trade or business. c General Gist of Exceptions: 2 Themes (not Capital Assets):

i assets held to produce ordinary T or B income ii assets where gain is from own efforts and not time.

d Capital v. Ordinary: Must have the same treatment for losses & gains. e Capital Gain Treatment: Taxed @ maximum of 15% (v. max. of 33%). Ex: Declared

dividends or sale/ exchange, Corp.’s carried interest. i Must be held for < 1 year. (held longer, lower % to equalize built-in inflation)

f Capital Loss Treatment: §1211(b) Limited to the amount of capital gain + $3,000 (to offset ordinary income). Ordinary loss is not limited, can carry forward to future years until loss is used.

g Byram v. US (pg 564)


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i Facts/Issue: Whether taxpayer is an investor or in his trade or business when he sold 7 pieces of real estate in a year for a lot of $ but did not have advertised, was not licensed real estate agent, and the transactions were initiated by the buyer.

ii Hold: Investment & capital gains treatment because he did not have an office, didn’t initiate sales, and was not licensed.

iii Testing: Whether something is a capital gain v. ordinary income is a question of fact. iv Fact- Intensive Test: 7 Factors Capital Gains Treatment

1 the nature & purpose of the acquisition of property & duration of ownership, 2 the extent & nature of the taxpayer’s efforts to sell the property, 3 the number, extent, continuity & substantiality of the sales, 4 the extent of subdividing, developing, and advertising the increase sales, 5 the use of a business office for the sale of the property, 6 the character & degree of supervision or control exercised by the taxpayer over

any representative selling the property, & 7 the time & effort the taxpayer habitually devoted to the sale.

h Corn Products Refining Co. v. Commissioner (pg 572) i Facts/Issue: Whether a manufacture of corn derived product’s subsequent gain or loss

from hedging, buying future K’s for corn at fixed price, ordinary business income or investment?

ii Hold: Ordinary trade or business income because at time was not included in §1221(a). After, “hedging” added to list of not a capital gain, instead investment.

iii Rule: Commodities futures are not a true capital investment if they are an integral part of taxpayer’s business, and are therefore ordinary.

i Arkansas Best Corp. v. Commissioner (pg 573) i Facts/Issue: Whether Bank’s stock sold at a loss is capital or ordinary & how to

interpret §1221 since CPR, broad v. narrow? ii Holds: (S. Ct.) Whether or not it is a capital asset, the test is not the taxpayer’s

motivation. Rather, strict interpretation of exclusive list. Broad interpretation of capital asset.

iii Rule: A taxpayer’s motivation in purchasing an asset is irrelevant in determining whether the asset is a capital asset and strict application of the §1221(a)’s list will determine what is not a capital asset.

j Womack v. Commissioner (pg 579) i Facts/Issue: Whether the gain from a lottery winner’ sale of the right to future

installments payments is capital or ordinary? Ordinary. ii Substitution of Ordinary Income Doctrine: when a taxpayer receives a lump sum

payment as a substitute for what would otherwise be received in the future as ordinary income, the lump sum is taxable as ordinary income.

k Sale or Exchange Requirement: §1222 - Capital gain or loss only when sold or exchanged. Otherwise it’s ordinary income or loss.

i Real Estate: Occurs on the earlier date of conveyance or date when the burdens & benefits of ownership pass to the purchaser.


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ii Other Sale/Exch Dates : Also occurs when → 1 corporate liquidation, 2 Securities become worthless, 3 failure to exercise a privilege or option on property that if acquired would have

been a capital asset. l Kenan v. Commissioner

i Facts/Issue: Whether the delivery of a trust estate’s securities to satisfy a claim is a gain?

ii Held: Trustees or taxpayers realized gain when they used securities to satisfy the claim on the estate because the trustee could satisfy the claim by either securities or $, if had been $ a taxable gain would have been realized.

iii Rule: Unlike “sale,” “exchange” doesn’t require a bilateral agreement & has broad definition.

m Preferential Rates for Long-Term Capital Gains & Qualified Dividend Income i General Rule Net capital gains taxed at a preferential rate (15%), applies only to gains

from sale or exchange of capital assets held over a year (LT). §1(h). ii Definition of Capital Gain: §1222(11): Net Capital Gain= excess of Net Long Term

Capital Gain/ Net Short Term Capital Loss. iii Netting: 1st) net short & long term capital gains & losses for each rate group separately,

2nd) if elect to treat amount of net capital gain as investment, subtract from total net CG. 1 1(h)(1)(A)Ordinary Income & Net Short-Term CG @ Regular Rate 2 (B) Adjusted net capital gain up 15% bracket @ 0% 3 (C) Remaining adjusted net capital gain @ 15% 4 (D) Portion of net capital gain consisting of unrecaptured depreciation on

depreciable real property @ 25% 5 (E) Portion of net capital gain consisting of collectibles @ 28%

iv Applicable Tax Rate for Gain: Applicable Rate for Net CG depends on the Marginal Tax Rate (the last dollar of ordinary income):

1 if exceeds 15%, Net CG taxed @ 15% 2 if 15% or less, Net CG taxed @ 0% (in 2012) 3 0% applies to married filing jointly income up to $69,000, individuals up to

$35,350. v Special Tax Rates: (or @ marginal ordinary income rate, whichever is lower)

1 Collectibles: Gains from sale or exchange of Collectibles @ 28% (§1(h)(1)(E)) → includes artwork, rugs, antiques, metals, gems, stamps, coins, alcohol. (§408(m)(2))

2 Recapture Gains: Gain attributable to Unrecaptured Depreciation Deductions on Real Property @ 25% (§1(h)(1)(D)). See also §1250

n § 1231: Gains & Losses i General Approach: “Best of Both Worlds”= Capital gains + Ordinary losses ii Policy: This was originally designed to dissuade taxpayers from trying to constantaly get

capital gain treatment on one thing and ordinary loss on similar item. Now, taxpayers


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just try to classify everything as §1231. iii Qualified §1231 Property: Business real estate or depreciable business property is

generally excluded from capital asset, But if qualifies under §1231, certain T or B, depreciable property, held more than a year, not in §1221, then qualifies as capital G/L

iv Sale or Exchange: Property gain or loss realized from the sale, exchange, or involuntary conversion of property.

v Treatment: Treatment of G/L per the code 1 If 1231 gains > losses, treated as long-term capital gain/loss. 2 If 1231 losses > gains, treated as ordinary income/loss.

vi Netting §1231 G/L: If 1231 gains from involuntary conversions ≥ losses, then included with other 1232 gains & losses to determine net for year. If gains ≥ losses, long-term capital gain/loss. If losses > gains, ordinary income/ loss.

vii Recapture Provision for Ordinary Loss: if net 1231 gain for year, then must review 5 prior years for possible recapture of 1231 losses for prior years. If net 1231 losses during period, must treat current year’s net 1231 gain as ordinary income to the extent of the amount unrecaptured net 1231 losses for the past period, recaptured losses on FIFO basis.

viii Trade or Business Property Only: Property must be used in trade or business: includes 1 either depreciable personal property or real property used in T or B, 2 is not in §1221 (a)(1) (inventory & property for customer sale), (3) (created

property), or (5) (Gov. publications). 3 T or B property held for more than a year & involuntarily converted, 4 capital assets held more than a year 5 crop sold with land held over a year, 6 livestock, & timber, domestic iron, ore, or coal.

o Depreciation Recapture: §1245 - A gain (if loss, doesn’t apply) on the sale or disposition (sale

& leaseback transaction, transfer upon foreclosure of security interest) of property in 1245 is taxed as ordinary income to the extent of all depreciation/ amortization deductions previously claimed on property.

i Computation: Amount treated as ordinary income is the excess of the lower of 1 property’s recomputed basis, OR

a Adjusted basis + previously allowed or allowable depreciation/ amortization reflected in adjusted basis.

b Note: Generally = to original pre-depreciation cost of property. 2 amount realized or FMV/ adjusted basis of property.

ii Application: Smaller # applied against taxpayer’s adjusted basis to determine recapture amount, portion of gain is treated as ordinary income.

p Depreciation Recapture for Real Property: §1250 - depreciation recapture provision but only applies when the taxpayer has taken “additional depreciation” on depreciable real property.

i Additional Depreciation Defined: excess of the amount of accelerated depreciation deductions allowed to taxpayer / amount of depreciation allowed if straightline method


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used. ii Outdated Application: Now, MACRS uses straight line depreciation w/ depreciable

real property.... so this is f’n useless & stupid!!! ← Ain’t stuffbut hoes and tricks. iii Rate Applied: Instead “unrecaptured 1250 gain” @ 25% tax rate (v. 15%)

Chapter 8: Transactions in Property

1 Property Transactions Generally a General Rules: §1001 guides taxpayers on the complex process of determining the amount of

gain or loss that is to be realized on the transfer of property i Realized Gain = Amount Realized - Adjusted Basis ii Realized Loss= Adjusted Basis- Amount Realized

2 Amount Realized (from sale or other disposition of property)= total cash received from sale + FMV of Property received (if purchaser assumes mortgage liability)

a Basis of (rental/ business/ investment) Home= Cost of purchase + Fees + Improvements - Depreciation

b Basis of (own) Home= Cost of purchase + Fees + Improvements (NO DEPRECIATION) c Recourse Debt: Lender can pursue debtor’s other assets for repayment if secured portion does

not satisfy the entire debt. d Non-recourse Debt: Lender’s recourse for default is limited to assets that specifically secured

the loan. Once securing asset is sold, that amount is all the loaner can recover. e Crane v. Commissioner (pg 623)

i Issue: How to determine the taxable gain on the sale of a home with a non-recourse loan? Whether the the buyer assumes the debt in amount realized if the seller no longer owes the debt?

ii Hold: Include amount of nonrecourse debt in basis & amount realized, the debt stays with the property.

f Commissioner v. Tufts (IRS wants to be a douche, & then there were tax shelters...) i Facts: Partners built apartment with note on deed trust to bank, non-recourse. Finish

construction and can’t make payments on note. All partners sell to 3rd party. FMV of property less than note. IRS says gain to partners.

ii Issue: When business property with a non-recourse note is sold loss, worth less than FMV, & the buyer only assumes a non-mortgage what is their amount realized & adjusted basis?

iii Holding: Taxable Gain. The debt relief is in essence paying the seller cash and the seller paying off the debt.

iv Rule: If value of property < Mortgage amount, a mortgagor who is not personally liable can’t realize a benefit = to mortgage. Nonrecourse loan as regular debt, but not personal liability + depreciation deductions. Include on both sides, obligation in AR = assumption of non-recourse debt, AB = deductions.

v Post- Tufts Tax Reform Act 1986: Must be liable for a real loss (personally liable) or actively participate.


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3 Tax Aspects of Homeownership: a Interest: Interest paid/ incurred during taxable year is not deductible: § 163(a)

i Exceptions: 6 Exceptions for Allowable Interest 1 Active Business Interest- § 163(h)(2)(A): Business Interest paid or incurred

with trade or business activity taxpayer materially participates in. Included in §1622(a) above the line deduction.

2 Taxable Investment Interest- § 163(h)(2)(B): Extent of taxable investment interest (to make $) paid to finance investment activities that will yield income subject to federal income tax. Deductible under §163(d)’s limitation on investment interest: “net investment income” or §212(1) “Expenses for Production of Income.”

3 Passive Activity Business Interest- §163(h)(2)(C): Debt incurred for a business activity as a passive (does not materially) participant, can deduct interest expense to the extent of income from all passive activities during the year exceeds other losses & deductions from passive activities.

4 Estate Tax Interest- §163(h)(2)(E): Can deduct interest expense incurred for deferring illiquid or unassignable assets.

5 Education Loan Interest- § 163(h)(2)(F): Interest for certain education loans is deductible. Above the line, limited by income.

6 Qualified Residence Interest - §163(h)(2)(D): Can deduct interest from mortgage & property taxes of primary & 2ndary residence.

a Property Taxes: Property taxes deductible. Amount based on current FMV, annually assessed.

b Second Mortgage: Also applies to 2nd mortgages as HELOC. c Nature of Interest: Interest must be from “acquisition indebtedness” or

“home equity indebtedness.” i Acquisition indebtedness: debt to acquire or substantially

improve residence up to $1,000,000 total debt. Limited to basis in home + improvements.

ii Home Equity Indebtedness: Any other indebtedness secured by a qualified residence. Must have equity in home. Amounts limited to extent of equity.

d Qualified Mortgage Insurance Premiums - §163(h)(3)(E): Premiums paid or accrued before 2012 for insurance K’s entered 2007-2012 & provided by Veterans Administration, Federal Housing Administration, Rural Housing Administration, or private mortgage insurance in 23 USC §4901, for acquisition indebtedness on qualified residence = qualified residence interest.

b §1001(c): Exclusion of gain on the sale of Principal Residence (also §121): Generally, a taxpayer usually does not have to recognize a gain on the sale of their personal residence per the exclusion amount.

i Requirements: To qualify for exclusion 3 requirements →


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1 Ownership Test: Must have owned for total of 2 yr period (730 days) w/in 5 yr period (1,825 days) prior to date of sale;

2 Use Test: Must have used as principal residence for total of 2 yr period w/in 5 yr period prior to date of sale; &

3 Once Every 2 years Test: Can not have used §121 exclusion within 2 yr period (730 days) prior to date of sale.

a 730 days within 5 yr period does NOT have to be consecutive! b Own & Use w/in 5 year period but do not have to be at the same time.

ii Exclusion Amounts: Married: $500,000/ Single: $250,000 of gain excluded. iii Safe Harbor Exceptions §121(c): If can’t meet 2 yr ownership & use because of

unforeseen circumstances (change in employment, health)- See Treas. Reg. 1.121-3 1 Employment Change: Change of employment if < 50 miles from residence sold

than previous job. 2 Health Reason: Sale or exchange for health reasons if to “obtain, provide, or

facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury.”

3 Unforeseen circumstances: event unanticipated prior to purchasing or occupying the home. Exclusion amount is prorated over period of use & ownership.

4 Like- Kind Exchanges §1031: A taxpayer may want to sell something and acquire another property of like kind shortly thereafter but does not want to recognize gain or may not have the funds to pay gains tax after purchase of new property.

a General Rule: Must be Business or Investment Property exchange for the same kind (business for business). Like Kind determined by “nature or character of the property.”

b Excluded Property: Generally does not apply to to stock in trade or other property held primarily for sale, stocks, bonds, notes, certificates of trust, beneficial interests, GP interests, securities or evidences of indebtedness or interest. Doesn’t apply to personal property, but usually can treat as “held for business” if rented for min. of 2 weeks in each of the 2 years prior & exchanged for the same, & minimal personal use.

c Terminology: 1st Property = Relinquished Property, 2nd = Replacement Property d Requirements: Determine whether gain is recognized. 6 basic requirements for non-

recognition: i Property in exchange must be business property ii Property must not be held for sale iii There must be an exchange of property iv Property must be tangible property v The property must be identified within 45 days vi Must be a complete transaction vii 180 days to receive replacement property

e Effect of Provision: like-kind exchange = delayed gain until the property is sold under a provision that will force recognition.

f Basis In §1031 Exchange Property: §1031(d)


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i Basis Rules: Basis for old property becomes the “substituted Basis” for the new property. Any boot is then adjusted against the basis depending on who paid what.

ii Basis Allocation Among Multiple Properties: Get appraisals and distribute old basis among new properties according to FMV.

iii Exchange as Part of Business Acquisition: Use residual method to allocate among assets when purchasing entire business.

iv Assumptions of Liability: Total consideration received = Amount of Both Mortgages (both sides) & Adjusted Basis. Buyer of Relinquished Property must include mortgage obligations on both sides.

g Strict Compliance w/ Deadlines: Requirements (a)(3): 45 days to identify the replacement property & 180 days to receive replacement property. Almost zero exceptions.

h Qualified Intermediary: Special brokers that deal in 1031 exchanges. Ensures no actual or constructive receipt by taxpayer of anything other than like- kind property. (Can not take control of $, otherwise = “boot” & taxed. Must have middleman hold $.)

i Starker v. United States (pg 672) - Note i Issue: Whether the sale & purchase of business property must be in the same day or can

6 months apart? No requirements it must be in the same day. ii Result: IRS amended & included deadline “days”. Days when the deal must be

complete, but not in use. j Reverse Stalker v. United States (pg 673) - Note

i Issue: Whether the deadline dates equally apply when the replacement property is found & identified before the relinquished property? Yes, same deadlines.

ii Result: Can buy replacement property 1st, but still have 180 days to identify & sell relinquished property.

k Like-Kind Exchange of Depreciable Property: Generally, extent basis in replacement property does not exceed basis in relinquished property (“exchanged basis”), is depreciated over remaining recovery period of relinquished property. (pick up where you left off)

i Applicable recovery period: Reg. §1.168(i)-6 OR ii may elect to treat replacement property as if purchased for cash in the year the

replacement property is placed in service. iii If replacement recovery period > relinquished, the exchanged basis is depreciated

beginning at replacement year over the remainder of the applicable replacement property’s recovery period as if replacement property in service same year as relinquished property.

iv Any “excess basis” is treated as property in service the same year as replacement property & can be expensed under §179.

l Like-Kind Exchange w/ Principal Residence : If first used as home, then or at the same time as business in like-kind exchange, must qualify for both §121 exclusion & §1031 nonrecognition. §121 must be applied first, & the exclusion does not apply to gain attributable to depreciation deductions claimed for the business/ investment portion of residence, §1031 applies to that gain. Any §1031 boot received applies only to the extent the boot exceeds the excluded 121 gain.


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i Basis Effect: Basis of replacement property is increased by any gain from relinquished property excluded under 121.

5 §1033 Involuntary Conversions: If property has an involuntary converted: 1) destruction whole or in part; 2) theft; 3) seizure; and 4) requisition or condemnation (threat or imminence of).

a Characteristics of Conversion:Does not have to be “sudden” destruction. Can be Business or Personal.

b Insurance Reimbursements: involuntary conversion into home. Insurance is for the worth of property, not basis. If insurance $ & buy another property = tax free!

c Basis Rule: Carry over basis- preserve gain, paid at sale of replacement property. d Replacing Property: If buy property worth less, must recognize gain on difference. e New Property Requirement: Must be “similar & related in service.” f Time Limit: (2)(b) Time limit = 2 years after close of taxable year.

6 Installment Sales: SKIPPED Chapter 9: Personal Matters

1 Itemized Deductions: Deductions that are not part of a taxpayer’s business but are permitted specifically through the tax code as a deduction against Adjusted Gross Income. (Schedule A)

a Utilizing Itemized Deductions: Congress has allowed several deductions for things like home mortgage interest, medical expenses, etc. but these are only used if the taxpayer is not using the standard deduction.

2 Extraordinary Medical Expenses §213 a General Rule: Taxpayer may deduct unreimbursed (not covered by insurance) uncommon

expenses that exceed 10% of AGI. (213) b Dependents: Covers individual & dependents (even those that don’t live with you). c Expenses Allowed: Covered expenses must be direct connection, not too attenuated. §213(d)

direct expenses means amounts paid for: i diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of

affecting any structure or function of the body; ii transportation primarily for or essential to care, (Food and hotel for sexual inadequacy is

not covered (rev. rul. 75-187)) iii Must be expenses primarily for prevention or alleviation of a physical or mental

defect/disease (1.213-1(e)) iv qualified long- term care services--In patient care- can include meals and lodging

(1.213-1(e)(1)(v)) v Qualified disease- recognized on books. vi Order to spend winter months in FL, lodging is not covered (Bilder) vii Living in apartment as part of treatment by psychiatrist not covered (wade volwiler)

d Insurance Premiums: insurance premiums of Medicaid Part B & insurance covering above conditions.

e Medication: Cost of Medicine covered, but must be prescribed, not over the counter or illegal.


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i Must required Rx of Dr. (213(d)(3) ii Only medicine that are legally procured (1.213-1(e)(2))

1 No medical marijuana f Elective Surgeries: §213(d)(9): Cosmetic Surgery: Not covered unless deformity/ abnormality

caused by accident/ trauma or disfiguring disease. g Rev. Ruling 75- 187: Are amounts couple paid for treatment for “sexual inadequacy &

incompatibility” are deductible? Psychiatrists treatment is deductible, but not the cost of meal & lodging at facility.

h Rev. Ruling 75-319: Expenses paid to church for “marriage counseling” for healthier & more meaningful relationship and not an included medical expense, but personal.

i Rev. Ruling 97-9: Amounts paid to obtain a controlled substance (pot) for recognized medical purposes, but illegal federally, are not a deductible medical expense, even if the state law allows with a prescription.

j Rev. Ruling 2003-57: Amounts paid for breast reconstruction surgery after a mastectomy for cancer + vision correction surgery are deductible medical expenses, but amounts for teeth whitening are not.

k Rev. Ruling 2003-58: Amounts paid for medicine or drugs that can be purchased without a Dr’s prescription are not deductible, but amounts for equipment, supplies, or diagnostic devices that can be purchased without a perscription are (diabetes & mobility devices).

l O’Donnabhain v. Commissioner i Issue: Whether gender surgery & hormone replacement therapy is deductible? ii Holding: Yes, qualifies because actual medical defect on books, but not part of the

breast augmentation because you don’t need D cups. ← OR DOES SHE? 3 Charitable Contributions §170: Charitable contributions are an itemized deduction that taxpayer can

claim if they made a donation or cash or property to a qualifying entity. a Requirements:

i must be a “qualified recipient” under © ii made a “contribution” to qualified recipient, & iii Determine amount of deduction. (b) & (e) limitation

1 If receive anything in return for contribution, must be reported in writing if value is over $1 & must subtract from deduction.

2 Can carry forward b Hernandez v. Commissioner (pg 724)

i Facts: Payments to the Church of Scientology for auditing & training are not deductible charitable contributions or gifts because there is a quid pro quo- taxpayer received a benefit in consideration for his contribution.

ii Rule: Contributions to a religious organization are not deductible if the taxpayer receives and identifiable benefit.

iii Holding: Regardless of the tangibility of the benefit, real or not, it was still a benefit to him subjectively at least. The contribution was structured to be beneficial to the taxpayer. To expand charitable deductions beyond this limitation would go further than congress intended.


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iv Sklar v. Commissioner (pg 735) 1 Facts/Issue: Taxpayer sent their child to Jew school. Taxpayer then tried to

deduct the cost of tuition and fees as charitable contribution. 2 Rule: Under the rule governing deductibility of a “dual payment” or a “quid pro

quo payment” to a charitable organization, a taxpayer must establish that its dual payment exceeds the market value of the goods received in return

3 Holding: Payments for tuition & fees to children’s Orthodox Jew School is not allowed.

c Learn to Burn Handout: Fire department offers to take house and burn it for firefighter training i Problem: How to determine the value of a house that was donated to the fire

department? ii Test: Benefit v. Burden, likely = to demolition costs & deduction is zero. (“Smell Test”)

1 Fact Specific: FMV from objective standard- what a willing buyer would sell for & willing seller would pay.

2 Factors: Cost paid if demolition, benefit/ value to firefighters, value of the land w/o structure.

d Bargain Sale to Charities: Sells property for less than FMV. If discount from “detached & disinterested generosity” of the seller.Treated as part gift, part sale, but under §1011(b) seller must apportion basis in transferred property between sale & contribution portion.

e Rev. Ruling 81-163: If a donor transfers property with an attached mortgage, the amount of the donation is the fair market value of the contribution less the mortgage still owing. The taxpayer may also recognize gain on the transaction for the amount that the mortgage release exceeds the allocable adjusted basis.

i Amount Realized = Amount of debt relieved ii Gain on Bargain Sale Donation = �� ∗ ��/��

f Substantiating Certain Contributions of Property: Generally, contribution of property w/ a deduction over $500, requires substantiation unless property is readily traded or can’t meet required sub. for good cause.

i Minimum Requirement: Contribution more than $500, required sub. = attach to return a description of property.

ii Higher Burdens: More than $5,000 = attach & obtain a qualified appraisal of property + other info. Secretary may require.

iii Large Contributions: More than $500,000= attach qualified appraisal of property. g Newspaper Morgue: SanFran donates “newspaper morgue to historic society & takes deduction.

But not allowed because previously deducted costs through employee’s salary & basis is zero.

h Limitations on Deductions For Charitable Contributions:

Type of Contribution Amount of Deduction % Limit if Contributed to a “public charity” in §170(b)(1)(A)

% Limit if Contributed to a “Private Charity”


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Cash FMV 50% of AGI 30% of AGI, but can’t exceed 50% of AGI - gists to public charities.

Loss Property (Basis > Value)

FMV 50% of AGI “ “

Ordinary Income Property (Value > basis, but not capital asset)

AB 50% of AGI “ “

Short-Term Capital Gain Property (Value > Basis in capital asset held for 1 year or less)

AB 50% of AGI 20% AGI, not can’t exceed (30% AGI - gifts to public charities)

Long- Term Capital Gain Real Property (Value > Basis, capital asset held more than a yr)

FMV or AB, if to a private foundation

30% of AGI “ “

Long-Term Capital Gain Intellectual Property (Value > Basis, IP capital asset held more than a yr)


Other Intangible Long-Term Capital Gain Property (Value > Basis in intangible capital asset held more than a year)

FMV or AB if to a private foundation, unless “qualified appreciated stock” under 170(e)(5)

30% of AGI “ “

Long-Term Capital Gain Related Tangible Property (value > basis in tangible capital asset related to the charity’s purpose)

FMV or AB if to private foundation

30% of AGI or 50% if to private foundation

“ “

Long-Term Capital Gain Unrelated Tangible Property (value > basis in tangible capital asset unrelated to charity’s purpose)


4 Taxes §164: Deductions only allowed for a tax, not penalty/ fee/ charge

a Deduction Allowable: State tax, local/ municipal tax, some business tax. (Usually, if individual


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then itemized.) i Sales Tax or Income Tax: States with no income tax may deduct sales tax w/ receipts

or use IRS tables.’ ii Tax Type Fees: License & Registration Fees = Tax

b Foreign Taxes: Can either deduct payments under §901 Foreign Tax Credit or under 164 Deduction. Usually more beneficial to tax FTC if you can.

5 Miscellaneous Expenses: Employee Business Expenses if unreimbursed employee expenses & not self-employed. Permits a Schedule A deduction w/ 2% of AGI haircut not allowed

6 Family Law Tax Aspects a Medical Expenses §213 - Covered Earlier b Qualified Adoption Expenses Credit §23: Nonrefundable tax credit- if credit > total tax

liability, reduced to zero & excess is not refundable. But excess can carry over and added to other credit amounts claimed in next 5 years.

i Qualified Expenses: Expenses “reasonable & necessary” that directly relate to adoption, if lawful, don’t relate to adopting spouse’s kid, & not reimbursed elsewhere.

ii Excluded Payments: §137- excludes from gross income amount expenses paid by employer.

iii Timing: Generally, claimed in year adoption is finalized. iv Limitation: 2 limits:

1 Total amount per year of 1 credit= $10,000 2 if AGI exceeds $150,000, credit amount is gradually reduced to zero @ AGI of

$190,000. v Carryover: Can carry over for 2 yrs, if expenses paid over 2 yrs, get credit in 2 yrs.

c Child Care Expenses: Child care has 2 different types of credits, the DCC and CTC. i Dependent Care Credit: § 21: Credit = 20-35% (depending on AGI) of employment-

related expenses to provide home for dependents & incapacitated spouses. 1 Qualified Expenditure: Pay others to care for kid or elder dependent 2 Qualify For DCC: Taxpayer must “maintain the household” (furnish over one-

half of the total cost of maintaining the household) for: a dependents under 13; b dependents of any age who share the same principal place of abode as the taxpayer and are physically or mentally incapable of caring for themselves; and c spouses of any age who share the same principal place of abode as the taxpayer and are physically or mentally incapable of caring for themselves.

3 Policy: Provide relief because General rule: costs incurred to provide for babysitting, day care, or similar services will at work are not deductible business expenses.

4 Calculation: %, generally between 20-35% of income tax liability, of costs taxpayer can claim depends upon adjusted gross income. Higher the AGI, lower the %. Credit decreases by 1% for each $2,000.


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5 Basis: Includes actual physical care of the dependent, but also ancillary “household” services (such as meal prep. & cleaning.) Household services MUST be related to the care of the child.

6 Limitations: Limited to payment for household services & care for qualifying dependent (= 12 or under or unable to care for self because of physical or mental incapacity, who shared same principal residence for more than half of taxable year).

7 Excluded Items: §21(b)(2)(A)- employment related expenses (summer camp expense expressly prohibited). Treas. Reg. 1.21-1(d)(3)-cap on household services

8 Refundability: Credit is non-refundable. Only reduces or eliminates tax liability. 9 Employer’s on-site child care: Employer credit for services (§45F), employee

can exclude all or part under §129. 10 Maximum Credit: amount =$3,000 (or $6,000 if 2+ dependents in year)

a Generally can’t exceed earned income that year. b Credit decreases 1% for each $2,000 & increase w/ AGI above $15,000.

ii Child Tax Credit: §24 - Get it just for having the kid 1 Rule: Partially refundable credit equal to fixed amount (until 2013 = $1,000) for

each “qualifying child”(can claim for dependency exception & is son/ daughter (+ their descendents), stepson/daughter (+ descendents), or eligible foster child) under 17.

2 Phase-Out: Phased out, to Zero (Individual AGI $75,000/ Married Joint = $110,000/ Married Separate = $55,000). Not annually adjusted for inflation.

3 Refundability: Refundable up to 15% of earned income in excess of 2012. 4 Transferability of Credit: One spouse can sign right to credit away

d Taxation of Children aka “Kiddie Tax” §1(g): i Requirements

1 Unearned income over $1,900 (in 2011) 2 of children under 19 & full-time students under 2 at the end of the taxable year, 3 the child has earned less than half the amount of support, 4 the child has at least 1 living parent at the end of the taxable year, & 5 child will not file a joint return with their spouse that year,

ii Application: then all of it is taxed at parent’ marginal rate, regardless of whether or not claimed as dependent. “Allocable parental tax”= net unearned kid’s income + parents income. Then apply tax rate.

iii Calculation: §1(g)(4)(A) Kid’s net unearned income = unearned income - larger amount of either #1) 2x min. standard deduction allowed to dependents ($1,900) or #2) min. standard deduction allowed to dependents ($950) + itemized deductions directly connected to production of unearned income.(Can’t ever exceed taxable income.)

e Elder Care: taxpayers can claim parent-dependents under §151 and may allocate the exemption under §152(c) when children of parent share costs of care.

7 Divorce & Separation: There are many transactions that occur in contemplation of marriage, during


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the marriage, and after the marriage. These transaction are usually tax free but support following is different.

a Alimony Payments §71:Deductible under §215 (above the line) to the payer, & under § 71 included in gross income of the receiver. (basically allocates income to another person).

i Qualified Payment: Applies only to cash payments ii Compliance: Must provide SS # of individual alimony paid to. iii Quarterly Filings: If substantial amount, file quarterly return to prevent tax penalty. iv Alimony Recapture: §71(f): “Recapture Trap”: If excessively high cash payments in

early years v. later, then excess payments are disguised property settlements & payor must include excess amount in income & recipient can deduct amount as if repaid to payor.

b Child Support §71(c): Not deductible or included in income.$ must be used for kids & their care.

c Gould v. Gould (pg 761) OLD RULE: Alimony payments under court decree do not decrease the payor’s taxable net income. (Override by statute)

d Okerson v. Commissioner (pg 763) - When the divorce documents require the payor, at the death of the payee to continue to make payments to substitute required alimony payments, they qualify as alimony for federal income tax purposes.

8 Property Division §1041: Dividing property between spouses is not a taxable event. Basis transfers over to party who keeps the house- gain stays with house. At time of sale, pay tax accumulated while held as marital or other individual's property (same as like kind), but if qualifies as primary residence for 2 yrs, then excluded (built in gain for free).

a DOMA: Does not apply to same-sex couples because federal government won’t recognize it. b Transfer to 3rd Party: Reg. §1.1041: Property transfers to 3rd party “on behalf of spouse or

former spouse” are treated as if directly made. c US v. Davis (pg 767) Holding Has Been Overruled

i Facts/Issue: Was a transfer of stock in exchange for a release of marital rights a taxable event? If so, what is the taxpayers amount realized from the transaction?

ii Hold: Husband’s transfer of appreciated stock to wife via property settlement K executed pre-divorce is a taxable event & husband’s gain is measured by stock’s value at date of transfer.

iii Rule: Taxpayer recognizes a gain on the transfer of property in satisfaction of a legal obligation.

d Divorce Related Transfer: §1041: No gain or loss is recognized by transferor if spouse transferred because of divorce & basis carries over.

e Assignment of Income Doctrine & §1041: When assign right to receive accrued but unpaid income to another, but may require taxpayer to still pay tax on income once paid to assignee.

i Priority: Assignment of income doctrine > 1041 ii Rev. Ruling 87-112

1 Deferred, accrued interest from the date of original issue of bonds to the date of the bond’s transfer to former spouse in included in taxpayer’s gross income.

2 The former spouses basis in the bonds immediately after transfer is equal to the


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taxpayer’s increased basis in bonds + interest income included by taxpayer as result of transfer.

iii Kochansky v. Commissioner 1 Facts/Issue: To what extent is the husband taxed on income from contingent fee

arrangements with clients? 2 Holding: Husband is taxed on the entire fee amount under contingent fee

agreement in year received. Fruit of the tree argument here. Lucas v. Earl. 9 Dependency Exemptions:§151(e)(2) allows parent to release claim to exemption to other parent by

signed written document promising not to claim as dependent. Other parent must attach to tax return. May waive exemption for one year, multiple, alternating, etc.

10 Attorney Fees in Dissolution of Marriage: Proceedings are inherently personal and therefore do not qualify for a deduction of attorney fees even if the divorce property includes a lot of business/investment assets.

a US v. Gilmer: Can’t deduct attorney’s fees for divorce. 11 Bad Debts & Worthless Securities: §166- Deduction for bad personal, business, & investment debts.

a Types of Bad Debt: 2 types: Both deductible in year become worthless. Deduction limited to basis in debt.

i Bad Business Debts, & ii Nonbusiness Bad Debts

b Limitation: (1) only deductible if entirely (v. partially) worthless, (2) must treat as short-term capital loss.

c Bugbee v. Commissioner (pg 778) i Facts/Issue: Whether a company’s majority SH, who gives $ that is used mainly for

personal not business expenses is a bad business expense or a non-business bad debt? ii Hold: Non-business bad debt & can only take up to short-term loss. Look to parties

intent & not indication of repayment depending on business’ success. d Whipple v. Commissioner (pg 783)

i Facts/Issue: Whether taxpayer engages in business activities with several controlled corporations so as to consider the debt a corporation owes to him a business debt rather than a non-business debt?

ii Holding: Taxpayer is not in the business or in the business of financing or money lending & is a non-business bad debt.

e Worthless Securities: §165(g): Deduction if stock or rights to receive shares of stock is completely worthless, not just declined in value. If business more than a year (short term) or more than (long term) capital loss.

Chapter 10: Dual Expenses

1 General Issue Covered: Certain expenditures present a problem of having a mixed nature to their benefits as being personal and business related.

a Provisions In Conflict: Part business (§162), part personal (§262) 2 Travel: Taxpayers are almost always allowed to deduct business trips if the trip is truly business only.

There is a problem when the trip partially business or there is unnecessarily nice accommodations for


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the taxpayer. a General Rule: §162(a)(2): Can deduct ordinary & necessary business travel expenses if “away

from home” & “in the pursuit of a trade or business.” If included, then can deduct cost of transportation, lodging, & meals.

b Test: Primary purpose- facts & circumstances- determine by # of days. Excess is personal expenses.

c Away From Home Requirement: If not “away from home” then §162(a) general deductions if business expense (no meals).

d Commuting: Commuting Expense is not the taxpayer “away from home.” No special deduction for commuting expenses if not away, even if work is far from home.

i Work Placements: Temporary work placements away from home, for less than a year, are deductible: 50% of reasonable Meal & entertainment only. p. 797 rules

ii Test if Placement Duration Unknown: Based on realistic expectation placement is less than a year, not what actually occurred.

e Sleep of Rest Rule: §799 May deduct 50% of meals only if work travel requires you to sleep or eat. Work must be so long as to require you to eat or sleep in between working basically.

f Commissioner v. Flowers (pg 791) Tax home = where you work i Facts/Issue: May a taxpayer deduct the cost incurred to travel between his hometown

and a distant town if his job moved there beyond his control and he was unwilling to move?

ii Holding: No. Facts show that his expenses for travel were not incurred in the pursuit of the business of his employer. Additional expenses as a result of travel were solely the result of taxpayer choice.

iii Rule: In order that traveling expenses while away from home in the pursuit of a trade or business may be deducted from gross income, the expense must be incurred while away from home and must be a reasonable expense necessary or appropriate to the development and pursuit of a trade or business.

g Rev. Ruling 99-7 (pg 794) i Issue: Amount of recognized gain on bargain sale of real property to charity? ii Allowable §170 charitable contribution via sale: AB for gain= AB in property: AB of

Amount realized to FMV

iii Property transferred w/ indebtedness, amount treated as amount realized for sale/

exchange even tho transferee doesn’t assume.

h US v. Correll (pg 799) i Facts/Issue: Taxpayer was a traveling salesman for a grocery company. He customarily

left home early in the morning, ate breakfast and lunch on the road, and returned home in time for dinner.

ii Holding: the ‘sleep or rest rule’ of Commissioner of Internal Revenue allowing taxpayer to deduct cost of meals only when taxpayer is on overnight trip is valid under provision of Internal Revenue Code allowing taxpayer to deduct traveling expenses ‘while away from home’ in pursuit of trade or business.


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i Hantzis v. Commissioner (pg 803) i Facts/Issue: Taxpayer was a law student at Harvard. Couldn’t find job in boston, got job

in NY, deducted cost of travel and maintaining apartment in NY. ii Holding: No deduction. Can’t deduct the cost produce income. Must establish

relationship w/both locations. iii Rule: A taxpayer that pursues temporary employment away from the location of his

unusual residence but has no business connection with that location is not away from home for §162 purposes.

j Meal Deduction Limitation: No Full Meals §274 (n)- limited to 50% of cost. k Other Travel Deduction Limits:

i International Travel: §274(c): Disallows deduction for portion of international travel expenses not for trade or business or investment. But can deduct all international travel expenses if total travel time is 1 week or less, or if “pleasure component” is less than 25% overall.

ii Spouse Rule: §274(m)(3): Disallows deduction for accompanying spouse or dependent’s travel expenses unless there is a business purpose for their attendance. Gotcher Rule.

l Substantiation Requirements § 274(d) i Requirement: Substantiation Required (not just oral testimony) for credit/ deductions

for 1) travel expenses (includes mean & lodging away from home), 2) entertainment activities, 3) gift expenses, & 4) listed property.

ii Records: must prove through “adequate records:” 1) amount of expenses, 2) time & place of travel, 3) business purpose of the trip, & 4) business relationship.

iii Documentation: Must document away from home lodging & any other travel cost $75+. Documentation must be contemporaneous with travel.

3 Entertainment Expenses & Business Meals a General Rule: §274(a)(1)(A): disallows deduction for entertainment, amusement, or recreation

expenses unless directly related to trade or business. If entrainment occurs before or after the business activity, the expense must be associated with a trade or business.

i Direct Relation: Directly related if: 1) more than a general expectation of benefit at some point, 2) active business activity during the entertainment, 3) facts & circumstances indicate the activity’s principal character was business, & 4) expense covers the taxpayer & person engaged in business activity during the entertainment.

ii Associated Relation: “Associated with” requires: 1) a substantial & bona fide discussion that precedes or follows the entertainment, & 2) such discussion generally occurring on the same day (or morning after or night before) as the entertainment.

b Reasonable Amount Limit: §162(a)(2): Reasonable allowances for meals while away from home if not lavish or extravagant under the circumstances, & taxpayer claiming deduction must be present. + must substantiate expenses claimed + deductions limited to 50% of total expense.

c Prior Gifts Limit: §274(b): If over $25 when added to total of prior gifts made that year, whether direct or indirect, is not deductible.

d Moss v. Commissioner (pg 821)


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i Facts/Issue: Law firm took whole firm out to firm lunch every day. During the meal, the employees talked about business. The luncheon was not optional to attend. Firm partner sought to deduct his portion of the lunch costs as business expenses.

ii Holding: §119 is limited in scope to the deduction of food provided to employees and therefore a business expense here would expand the scope of deduction further than what congress intended.

iii Rule: Expenses incurred for meals everyday are not business expenses because it does not fit the definition of §119 and are too personal in nature for §162 deduction.

iv §119 Rule: Allows meals to be deducted by employer if meals are served on the employer’s premises and the meals being served to the employee is for the convenience of the employer.

e Churchill Downs v. Commissioner (pg 825) i Facts/Issue: Taxpayer hosts Post-Kentucky Derby gala and other events for participants.

The taxpayer deducted these items as ordinary expenses. IRS contends they are solely entertainment expenses and are disallowed under §274(a).

ii Test: An objective test shall be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of this section and § 274(a)regardless of whether the expenditure can also be described otherwise, and even though the expenditure relates to the taxpayer alone.

iii Holding: The expenses were not deductible.

4 Job-Seeking Expenses & Moving Expenses a Clothing Rule: Work clothes are not deductible if can use for ordinary wear. (covered later) b Moving Expense Rule: Moving expenses (except meals) incurred in connection with starting a

new job, employee or self- employed, are deductible for individual & dependents who lived with you before & after.

i Must be unreimbursed ii Above the line deduction (1/3rd) offset against income. iii §217(c): Conditions for Allowance

1 Distance: new principal place of work must be more than 50 miles from former residence/ work,

2 Time: is a full-time employee for 39 weeks in 12 months after arrival OR 3 during 24 month period after arrival, is a full time employee or services as self-

employed on full-time basis during at least 78 weeks, only if they can’t meet the 1st test.

4 Partial Exclusion if do not meet time requirements because of circumstances out of your control.

c Rev. Ruling 75-120 i Expenses incurred in seeking new employment in same T or B are deductible

§162 (Trade or Business Expense), but not if new t or b even if job secured; ii Not deductible if lack of continuity between past job & search or seeking


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employment for 1st time. iii §212(1): Expenses for Production of Income only applies to expenses incurred

w/ existing profit- seeking not T or B. 1 Mixed business & pleasure trip, trip deductible only if” primary purpose” to seek new business. % of time on each activity. 2 If expenses at location deductible, may deduct even if traveling expenses are not.

5 Education Expenses a General Rule: 2 Part 2 Part Test: In order to be deductible (Reg 1.162-5(c))

i 1) Must improve skills in T or B, or, 2) condition of maintaining employment, & ii 1) not a minimum educational requirement for trade or business, or 2) related to course

of study to qualify as new trade or business. b Wassenaar v. Commissioner (pg 839)

i Facts/Issues: TP graduated from law school and went back for LLM. He then began working for law firm after LLM.

ii Holding: The graduate study was not deductible as educational expense for business because he was not already in the business of practicing law.

iii Rule: Taxpayers may deduct the cost of a graduate education in a business the taxpayer is already engaged in if:

1 the coursework improved existing skill sets; 2 the coursework is not needed as minimum education requirements to engage in

profession; and 3 the program of study is not a program for a new trade or business.

c Galligan v. Commissioner (pg 848) i Facts/Issue: A law librarian got her law degree while she worked at her job. She

deducted the cost of her law degree. Is this a qualified education expense? ii Holding: that cost of acquiring law degree qualified taxpayer for a new trade or

business, precluding deduction. iii Rule: Regulations establish an objective standard for determining whether an

educational expense is deductible; education for maintaining or improving skills required by taxpayer in employment or for meeting express requirements as a condition of continued employment is deductible

d Warren v. Commissioner (pg 845) i Facts/Issue: Taxpayer was attempting to become a higher member in the church. The

various levels of employment were dependent on the education of the individual in a degree focusing on divinity.

ii Holding: that taxpayer was not entitled to deduct educational expenses which qualified him for new trade or business

iii Rule: Education expenses are not deductible if they are “made by an individual for education which is part of a program of study being pursued by him which will lead to qualifying him in a new trade or business.” This is so even if the courses meet the express requirements of the employer. It is immaterial whether the individual


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undertaking the education intends to or does in fact become employed in a new trade or business.

iv Reasoning: Almost any bachelor’s degree will prepare people for all kinds of new businesses, disqualifying them from the deduction. The court is really just looking for something like a master’s program that focuses on one course of study, like a Master’s of some sort of specific science.

e Sharon v. Commissioner (pg 846) i Facts/Issues: whether the taxpayer is entitled to amortization deductions under section

167(a)(1) with respect to certain educational and licensing fees incurred to enable the taxpayer to obtain a license to practice law in NY?

ii Holding: The taxpayer may amortize the bar exam fee and his federal court licensing fees but not the costs of the his college education, law school, or his bar review course.

iii Rule: All costs of ‘minimum educational requirements for qualification in employment’ are ‘personal expenditures or constitute an inseparable aggregate of personal and capital expenditures.’ There is no ‘rational’ basis for any allocation between the nondeductible personal component and a deductible component of the total expense. Such expenses are not made any less personal or any more separable from the aggregate by attempting to capitalize them for amortization purposes.

6 Education Credits a Deduction OR Credit for Qualified Tuition & Related Expenses: Can’t claim both credit

(§25A) & deduction (§222) b TABLE of EDUCATION CREDITS: Pg. 51 c American Opportunity Education Credit: §25(a)(i)(3)

i General Rule: §25A(i)(2)- available for “tuition, & related expenses” incurred during the first 4 years of postsecondary education. Student must be enrolled on at least part-time.

ii Undergrad Only: 1st 4 years of post 2ndary education (college) at accredited university iii Criminal History: must be at least part time student & not convicted of felony drug

offense. iv Qualified Expenses: For tuition, fees, course materials, books, equipment, other

expenses not paid by school. Must be for enrollment or attendance. v Disallowed Expenses: Specifically does not include student activity, athletic fees,

insurance costs, or room & board expenses. vi Calculation: dollar for dollar for first $2k of expenses & 25% of next $2k vii Refundability: Up to 40% of the tax credit may be refundable. viii Phase-Out: Phased out starting at $80,000 ($160,000 married) & fully phased out at

$90,000 ($180,000 married) ix Determined by ratio: Modified AGI - initial phase out amount of AGI/ statutory

amount. d Lifetime Learning Credit §25(c)

i General Rule: §25A(c)- for qualified “tuition & related expenses” that relate to any course of instruction designed to develop or improve the student’s job skills. Must be


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currently paying (not deferred). ii Calculation: Limited to 20% of first $10k (max. for one year is $2k). iii Carryback Option: Can amend back 2 years iv Refundability: Not refundable, only applies if owe tax v Coordination: Can’t use same expenses for LLC as AOC.

e Interest on Education Loans §163(h) i Fiscal Cliff: Until 2013, phased out w/ income ii Limit: Deduction limited to $2,500 annually reduced by AGI in excess of $60,000

($120,000 married) iii Dependent Issue: Denied if other claims as dependent iv Requirements: Must be costs at post- 2ndary institution, for benefit of taxpayer/ spouse/

dependent, education expenses paid or incurred within reasonable time before or after loan incurred, & expenses for at least part-time student.

7 Home Office & Vacation Home Expenses §280A(a)-(e), (g) a Home Office Rule: Must be used regularly & exclusively for business only. b Employee’s Deduction: An employee can only claim if able to prove the business use of the

home office is for the employer’s convenience. ○ If own home, at sale the area can’t be included in the Home Mortgage Exclusion. ○ Deductible expenses include direct costs (depreciation & improvements) + indirect costs

(utilities, repair & maintenance costs, property insurance). ○ Limited to amount equal to the excess of gross income derived from home office over sum of 1)

business % portion of the expenses deductible even if home was not used for a home office (OAD “otherwise allowable deductions”). & 2) other deductions related to same business activity but not attributable to home itself (SBD “same business deductions”)

■ [GI] - [(OAD)+ (SBD)] = max home office deductions ■ Excess deductible expenses can be carried over to next year

○ Vacation Homes: ■ Business Use

● Personal use is not more than 14 days or 10% of days rented ● Generally, full deduction for mortgage interest & property taxes ● If attributable to business or investment a % of repairs, utilities, & depreciation. ● Amount deductible for all expenses is determined by:

○ # of days property is rented at FMV/ Total # of days property is used ● If remains business/ investment, then can deduct realized loss at sale.

■ Mixed Use ● Held primarily for rental purposes but personal use exceeds business use limits. ● Total deductions limited to amount of gross income from rent ● Must allocate expenses & other allowable deductions between business &

personal. If any remaining income, then can take business deductions to reduce remaining income, but deductions can’t produce net loss.

○ Allocation of expenses = days rented / days in year ■ Limited Rental


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● Property primarily held for personal purposes & rental period is 14 days or less. ● Can exclude from gross income any income derived from use.

● Clothing Expenses ○ Objective Test: If can wear publicly/ ordinary wear, not deductible. ○ Pevsner v. Commissioner

■ Facts/Issue: TP was manager at boutique clothing store that required the employees/manager to wear their clothing while at work. She spend $1300 on the company’s clothing to meet requirements and deducted it.

■ Holding: Not deductible. Can’t adopt taxpayer’s point of view because subjective test means evaluating all taxpayer’s sense of fashion and perception of clothing utility.

■ Rule: A taxpayer may only deduct the cost of their clothing if: ● The clothing is the type specifically required as a condition of employment; ● Not suitable as general usage clothing; and ● Not worn as general usage clothing by the taxpayer.

○ Nicely v. Commissioner ■ Facts/Issues: Whether taxpayer’s expenses incurred in a long commute that was

partially subsidized by his employer due to the distance were expenses deductible? ■ Holding:taxpayer was not entitled to claimed automobile expense deductions; taxpayer

was not entitled to claimed meal expense deductions; and taxpayer was not entitled to deduct unidentified clothes, gloves, and boots.

■ Rules: The elements that a taxpayer must prove with respect to an expenditure for traveling away from home on business, including a meal, are: (1) The amount of each such expenditure for traveling away from home, except that the daily cost of the traveler's own breakfast, lunch, and dinner may be aggregated; (2) the time of each such expenditure; (3) the place of each such expenditure; and (4) the business purpose of each such expenditure.

Hobby Loss §165(d), §183(a)-(d) ● §183: Activities Not for Profit

○ Not “engaged in for profit,” no deduction ○ Subjective-ish Test: If the taxpayer tried to make a profit, but reasonable. ○ Activity with 3+ years, trigger audit. ○ 2 allowable hobby deductions: 1) deductions allowable to taxpayer regardless if they related to a

hobby activity, & 2) deductions that would be allowable to the taxpayer if the hobby was instead a for- profit activity, but only to the extent that income from the hobby exceed type 1 deductions attributable to the hobby.

Chapter 14 – Sanctions, Agreements, Disclosures Penalties

1. Negligence Penalties: Charged with constructive knowledge of all IRC, if don’t comply then 20% added with audit.

2. IRS Criminal Investigation Unit: Civil $, Criminal jail. 3. Statute of Limitation:

a. Civil:


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i. Refund claim- 2 years ii. Regular Audit- 3 years from either date of filing or due date

1. For year 2011, but date is when filed on 10/2012 (b/c extension) 2. File early, then 3 yrs from April 15th. 3. IRS can extend SOL w/ taxpayers consent (sign or sued now)- If limit to certain

expenses, then tolling of SOL limited for audit. 4. Longer SOL w/ 5. Substantial Understatement: 6 yrs-Understated return by 25%+ (IRS has BOP

for omission) 6. Civil Fraud = No SOL but IRS has BOP for fraud 7. (IRS destroys returns after 10 yrs)

b. Criminal: i. Criminal Tax Evasion- SOL is 6 yrs (const. must limit crim)

Collection ii. IRS has 10 yrs after date of assessment to collect

iii. date “assessed”= doesn’t start to run if don’t file iv. Can’t pay: Payment plan

1. Offer in compromise (prove lack of funds/ assets, offer “pennies for dollars” & IRS can accept of reject)

4. Taxpayer Penalties a. Civil Penalties: In order to promote compliance, there are penalties for basically everything.

i. Types of Civil Penalties: Two different kinds 1. Ad Valorem: Penalties assessed on the value of the tax owed (interest) 2. Assessable: Penalties assess as flat dollar amount that is set by statute. 3. Note: Neither are deductible for income tax purposes.

ii. Imposition: Civil penalties imposed on people who violate w/out reasonable cause. This may be negligence, willful disregard, or fraud.

iii. Failure to File a Tax Return: Failure to file return is 5% of amount of tax owed less taxes paid/credits. This is assessed per month at maximum of 5 months (25%). If willful neglect and still doesn’t file w/in 60 days of filing date, lesser of $135 or all taxes due.

1. Reasonable Cause: If the taxpayer does not act reasonable in circumstance. This could be death or illness, mailed but returned for insufficient postage, bad info from IRS, sent to wrong IRS address, incarcerated, ignorant of the law, lack funds to pay tax.

iv. Failure to Pay tax: Failure to pay w/in 10 days of IRS assessment, penalty. 21 days when tax due is over 100k. Penalty is 0.5% of liability after payments/credits per month. Ups to 1% per month after notice and demand. Maximum is 25% of outstanding tax.

1. Reasonable Cause: same as failure to file except if auto-extension, then RC is presumed if balance doesn’t exceed 10% of total tax. No more than 5% total penalty assess for any month with Failure to file issue. IRS can assess both.

v. Accuracy Related Penalty: Penalty is stacked with negligence and understatement so that it can’t be leveled many times over. Only assessed when TP fails to show reasonable cause or good faith effort to comply. Interest on penalty applies to date of the return, not date of penalty. Its is 20% of the portion of underpayment attributable to:

1. Negligence of laws


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2. Substantial understatement of income tax 3. Substantial Valuation overstatement 4. Substantial overstatement of pension liabilities 5. Substantial understatement of estate and gift tax valuation.

vi. Additional Info on Accuracy Related Penalties and Elements 1. Overstatement of Value: Another 20% on overstated value of charitable

contributions if the item was value 150% or more of actual value resulting in underpayment of more than $5000 (10k for corp)

2. Transfer Tax Valuation: Claimed value is 65% or less than asset’s actual value resulting in underpayment of more than $5000. Penalty is 40% of misstatement.

3. Negligence: Failure to make a reasonable attempt to comply with code 4. Disregard: Includes careless reckless, or intentional disregard of the tax laws 5. Exception: TP may avoid penalty if position is disclosed and is supported by

Substantial Authority on 8275-R vii. Civil Fraud: Penalty is 75% of underpayment that is attributable to the fraud.

1. Burden of Proof: IRS must show fraudulent intent on the underpayment. Must be clear and convincing evidence of fraud.

2. All or Nothing: IRS shows that a portion is fraud, it’s all fraud. If TP shows portion is not fraud, then that portion is not fraud.

3. Judicial Doctrine: “Actual intentional wrongdoing …. The intent required is the specific purpose to evade a tax believed to be owing.” “Intentional violation of a known legal duty.”

4. Criminal Fraud Relationship: If TP convicted of criminal fraud, then can’t contest civil fraud. But if liable for civil fraud, can still contest criminal aspect.

5. Evidence: Evidence is circumstantial. If you do things like keep 2 sets of books, make false entries, destroy books or records, conceal assets or sources of income, understate income or overstate deductions, avoid making business records.

viii. Failure to make estimated payments: Penalty for failing to make a payment in anticipation of tax. Calculated per quarterly installment. Was 4% in 2010. Penalty keeps getting assessed until earlier of payment or return due date.

1. Individuals: underpayment is calculated by the difference between amounts paid on Qtr due dates and the lesser of the followingà

a. 90% of the tax shown on CY return b. 100% of prior year’s tax, if a return was filed. Threshold goes to 110% if

AGI is over $150k. c. 90% of the tax that would be figured by annualizing the income earned

during the year up to month where qtr payment is due. d. Note: Penalty can be waived for disasters, deaths, reasonable cause. 4th Q

is penalty waived if paid w/return in January. 2. Corporations: Amount is difference between actual payment and 100% of tax

shown on return but not paid. Penalty not applied if tax due is less than $500 or if payments made on applicable installment dates are equal to the lest of the following:

a. 100% of non-zero tax shown on return for preceding full tax year. (not applied to large corp w/income above 1million)

b. 100% of CY liability. c. 100% of tax due on seasonal installment method or annualized CY

income.


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ix. Failure to make deposits of taxes or overstatements of deposits: Funds remitted for employment taxes FUTA, FICA, etc are considered to be borrowed from gov. Heavy fines for corp and officer/director responsible. Penalty is % of underpayment, 2-15% depending on when failure is corrected. Penalty avoided if failure was from reasonable cause. Person responsible can be liable for penalty of 100% of tax imposed.

x. Giving false information with respect to withholding: $500 fine to those who lie to their employer about how many exemptions they take on their W4.

xi. Filing a frivolous return: Penalty of $5000 for frivolous return where TP claims some sort of Tax Protester argument.

xii. Other civil penalties: Various penalties for specialized areas. Always look up stuff. xiii. Reliance on Written advice of the IRS: Sec of Treas must abate civil penalties based

on TP actions resulting from written advice of IRS employee. Only for formal requests of information by the IRS and won’t work if TP didn’t give IRS enough info to work with.

b. Criminal Penalties: Designed to prohibit and punish fraud on taxes. Def has same rights as regular.

i. Nature of Criminal penalties: You can have criminal and civil penalties. Can refuse to talk to IRS on incrimination grounds. Usually won’t pursue conviction unless certain to get it, flagrant violation of law, and 3 consecutive years of violation.

ii. Criminal Tax offenses: Several offenses addressed in the code 1. Willful Attempt To Evade Tax: Felony w/ up to 5 years in prison and a fine of

$100k or $500k for corp. Also can get prosecution costs. 2. Willful Failure to File Return: Misdemeanor punishable by $25k fine or $100k

corp. Up to 1 year in prison or 5 if money laundering. 3. Willful Assistance In Evading Tax: when you help prepare return, or make

statement about truthfulness. Felony w/ up to 3 years in prison and a fine of $100k or $500k for corp. Also can get prosecution costs.

4. Willful Filing of False Document: Misdemeanor w/up to 1 year in prison and fine of $10k or $50k for corp. NO prosecution costs.

5. Disclosure of Tax information: Fine of up to $1000 and one year in prison. 6. Other Penalties: many have to do with specialized areas of tax law.

iii. Defenses to Criminal Penalties: Must convince beyond a reasonable doubt. Good defense:

1. Unreported income was offset by deductions 2. Unreported income was in reality a gift or some other excludible receipt. 3. Taxpayer was confused or ignorant as to the applicable law; thus one can’t intend

to violate a law when they don’t know the law. 4. Taxpayer relied on the erroneous advice of competent tax advisor 5. Taxpayer has mental illness à can’t act willfully 6. SOL has expired 7. Taxpayer enters a plea bargain and accepts lesser offense.

5. Penalties on Return Preparers a. Definition of Return Preparer: person who prepares returns for compensation. Can be the

employer, employee, or SE person. Liability will depend on who did what and who knew. If gratuitous preparation, not a TRP. Preparer must do substantial portion for sanctions to apply. Amount is not substantial if less than 2k or 100k+20% of AGI or GI.

b. Definition of Return preparation: includes any activity where TRP furnishes TP with “sufficient information and advice so that completion of the return or claim for refund is largely


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a mechanical matter.” Not a TRP for clerical work, prepares as employee of business, fiduciary return, prepares during course of audit or appeal, employee of IRS, no compensation, VITA people.

c. Preparer disclosure of penalties: 5 key penalties for prepares who disclose info i. $50 per violation of TP not getting a copy of return

ii. $50 for TRP not signing return iii. $50 per time TRP doesn’t put TRP number iv. $50 per time TRP doesn’t retain copy v. $50 per time TRP doesn’t identify employment location

vi. Maximum penalties won’t exceed $25k per year. d. Preparer Conduct of Penalties: Maybe civil or criminal

i. Endorsing or Negotiating a refund check: $500 per time. Can’t do it for TP. ii. Understatements due to unreasonable position: Must be substantial authority for

positions. Greater of 1k or one half of TRP’s fees derived from the engagement. iii. Willful understatement: If TRP disregards TP supplied info or just lies. Penalty is

greater of 5k or one half of fees derived. iv. Organizing abusive tax shelters: If you help people set up or try to sell a tax shelter.

No understatement needs to exist in order to penalize. Valuation must be 200% off of correct value. Penalty is lesser of 1k or 100 of fee derived or to be derived by the TP from project.

v. Aiding and abetting understatement: Applied to ANY person who assists in tax evasion. Also imposed on management who forces subordinate to understate. Penalty is 1k and 10k for corps per understating TP.

vi. Aiding or assisting in the preparation of a false return: Felony w/3 year imprisonment and 100k indiv/500k corp fine. Most severe penalty out there. Can also be just a tax related doc, not just returns.

vii. Disclosure or use of information by return preparers: Penalty is 250 per improper use. Maximum is 10k per year. Willful disclosure is criminal, 1 year imprisonment and 1000 fine

6. Injunctions a. Injunction Intro: IRS can enjoin two classes: TRP’s and promoters of abusive shelters. b. Action to enjoin TRP’s: When IRS seeks injunction against TRP for misconduct. Must be

shown that injunctive relief is needed to prohibit activity and that fines won’t fix it. Must be continually violating the prohibition. TRP must have:

i. Violated preparer penalty or criminal provision ii. Misrepresented his or her eligibility to practice

iii. Guaranteed payment of any tax refund or the allowance of a credit iv. Engaged in other fraudulent behavior interfering with tax laws

c. Action to enjoin promoters of abusive tax shelters: Shelter must be abusive and the injunction must be appropriate way to stop it from happening.

7. Interest a. Generally: Adjustable rate and compounds daily. Eliminates incentive to delay tax payments. b. Interest computation conventions: Rates start on the day the tax is due, not extended dates,

and goes until the interest is paid. The interest compounds daily. Interest rate updated quarterly. Interest accrues on the tax owed but also the penalty if not paid w/in 21 days of IRS request.

i. Criminal Penalties: No interest on these. ii. No authority to forgive Interest owed: Still owe interest if reasonable cause but abated

if unreasonable error or delay by IRS employee. IRS employee must have lost records,


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illness, or transfer/leave. iii. Overpayment: Gov required to pay interest on overpayment à credited against tax

liability. Runs from date of payment not credited against liability to 30 days before date of refund check.

c. Applicable interest rate: Varies per circumstance i. Overpayment: 2% above the federal ST rate

ii. Underpayment: 3% above the federal ST rate iii. Corporations: 2% higher than usual underpayment rate and 1.5% less than standard rate

on overpayment if overpayment is over 10k. 8. Statute of Limitations

a. Nature of Statute of Limitations: Limits time that TP can claim refund and limits the time in which the Government can make a claim for taxes owed.

b. Assessment: Generally SOL is 3 years from date return filed or 3 years from due date(no extension)

i. Extension of SOL: Goes to 6 years if omitted >25% of §61 GI w/out COGS and disclosed omissions. Not extended for overstatement of deductions.

ii. International: If not disclosed on return, SOL tolled until info reaches IRS. If failed to furnish info for reasonable cause then SOL tolled only as to that item, not entire return.

iii. Irregular Returns: Fraudulent returns are open to review indefinitely. Can’t later file amended correct return and start the SOL.

iv. Failure to File: Failure to file returns are open to review indefinitely. v. Acceleration, Extension, and Carryback Effects: Filing requirements used to allow

late filing of amended return to result in a situation where IRS wouldn’t have time to assess penalties or look for omissions before SOL ran out. Now amended return doesn’t affect limitations period.

1. Acceleration: SOL reduced to 18 months if filing a request for prompt assessment. Made for estates or corp in dissolution.

2. Carrybacks: SOL starts on year the CB originated, not year affected. Not extended for carryforward.

vi. IRS Requested Extensions: IRS may request extension of SOL in order to carry out negotiations or investigation. Court may grant it but doesn’t have to. If court doesn’t grant it, can result in immediate issuance of deficiency and halt negotiations. Don’t sign waiver of SOL until agent has completed RAR and at least one issue that can be litigated exists.

c. Collection: IRS must administratively collect the taxes before 10 years SOL, if not, then the IRS must go to court and reduce it to a judgment before the 10 years is up. IRS and TP can agree to an extension. Begins on date of assessment.

d. Claim for Refund or Credit: Amended claim is 1040X or 1120X. i. Overpayment: Overpayments may be applied to ongoing tax debt.

ii. Large Refunds: Any refund over 2 million goes to the joint committee on taxation. iii. NOL Acceleration: If refund from NOL CB/CF, file application for tentative refund. If

denied, can’t start legal action until 6 months after return is filed. Must file claim for refund in allowable period.

iv. Limitations Period: If you file return, you have the later of 3 years to claim return from date of filing or 2 years after tax was collected. Early returns are deemed filed on due date.

v. Other Extensions: Can be extended for business bad debt or worthless securities out to 7 years.


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vi. Amount of Credit or Refund: Can’t get refund for anything greater than 3 years ago plus extension periods. Refund limited to last two years on late filing for previous 3 years.

e. Suspension of Period or Assessment and Collection: usually must be assessed w/in 3 years and collected w/in years. When IRS mails 90-day letter, there is 150-day suspension of SOL (210 for persons outside US). Suspension is also in effect during Tax Court dispute and until 60 days after TC decision. Offer to compromise to the IRS suspends it for one year from date of submission. SOL also tolled for:

i. TP assets in custody of a court ii. TP outside US for 6 or more consecutive months

iii. TP’s assets are wrongfully seized iv. Fiduciary or receiver is appointed in bankruptcy case v. IRS prohibited by bankruptcy law from collection

vi. Collection of excise or termination taxes is otherwise prohibited by law. f. Migration of SOL: SOL can be moved if the IRS or TP try to take advantage of SOL

expiration. 9. Statutory Agreements: Two types of agreements allowed by the code for tax disputes.

a. Closing Agreements: Written agreement between TP and IRS. Formal. Only one recognized as binding. Closes the case unless there is later discovered fraud, malfeasance, etc. Final in dispute and prevents later opening of case which is often needed by creditors and helps to reduce further litigation. IRS discourages use of these because they are hard to process and are very final.

b. Offers in Compromise: Offer by Commissioner to settle civil or criminal case before it is referred to justice department for prosecution. Compromise of more than 50k must be approved by Chief counsel. Covers entire TP’s liability and rescinds right to prosecute further unless fraud. If TP defaults, agreement is void.

i. Usage: Usually used when disputes still exist and want to avoid litigation ii. Doubt: Not sure if they can collect whole amount or otherwise overall claim

iii. Disputed Amount: If it might end up as economic hardship, just take lesser amount.

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