TABLE OF CONTENTS

BIG PICTURE 5

OVERVIEW OF INCOME TAX COMPUTATION: 5SOURCES OF FEDERAL INCOME TAX LAW 6BASIC CONCEPTS AND ISSUES 7COMPUTATION OF TAX LIABILITY 7CALCULATING TAXABLE INCOME 8

GROSS INCOME 10

§ 61. GROSS INCOME – DEFINITION AND OVERVIEW 10DEFINITIONS OF INCOME 10INCLUSIONS IN “GROSS INCOME” 11EXCLUSIONS FROM “GROSS INCOME”? 11ITEMS THAT ARE NOT INCOME 12

ITEMS INCLUDED IN GROSS INCOME 14

SPECIFIC INCLUSIONS IN GROSS INCOME 14COMPENSATION FOR SERVICES 14GROSS INCOME FROM BUSINESS - §61(A)(2) 14GAINS DERIVED FROM DEALINGS IN PROPERTY- §61(A)(3) 14INVESTMENT INCOME - 14ALIMONY AND RELATED PAYMENTS- §61(A)(8) AND §71 15INCOME FROM DISCHARGE OF INDEBTEDNESS - §61(A)(12) 16OTHER GROSS INCOME 16

ITEMS EXCLUDED FROM GROSS INCOME 17

SPECIFIC EXCLUSIONS FROM GROSS INCOME 17DEATH BENEFITS/LIFE INSURANCE PAYMENTS - §101 (P.103) 17GIFTS AND BEQUESTS - §102 18INTEREST ON STATE AND LOCAL BONDS - §103 20COMPENSATION FOR PERSONAL INJURY OR SICKNESS - §104 20AMOUNTS RECEIVED UNDER ACCIDENT AND HEALTH PLANS - §105 21CONTRIBUTIONS BY EMPLOYER TO ACCIDENT AND HEALTH PLANS - §106 22DISCHARGE OF INDEBTEDNESS INCOME - §108 22RECOVERY OF TAX BENEFIT ITEMS - §111 22QUALIFIED SCHOLARSHIPS - §117 23MEALS OR LODGING FURNISHED FOR CONVENIENCE OF THE EMPLOYER - §119 23EXCLUSION FOR GAIN ON SALE OF PRINCIPAL RESIDENCE - §121 23DEPENDENT CARE ASSISTANCE PROGRAMS - §129 24CERTAIN FRINGE BENEFITS - §132 24OTHER 25EMPLOYMENT RELATED EXCLUSIONS 25

ACCOUNTING PERIODS AND METHODS OF ACCOUNTING 26

ANNUAL ACCOUNTING 26NET OPERATING LOSS DEDUCTION- §172 26

DEDUCTIONS FOR PERSONAL EXEMPTIONS 27

§151. ALLOWANCE OF DEDUCTIONS FOR PERSONAL EXEMPTIONS— 27

§152. DEPENDENT DEFINED— 27

A.T.L. DEDUCTIONS FOR INDIVIDUALS 29

§165 LOSSES 29§215 ALIMONY, ETC., PAYMENTS 29§217 MOVING EXPENSES 30§219 CONTRIBUTIONS TO REGULAR IRAS 30§221 EDUCATION LOANS INTEREST 30§223 HEALTH SAVINGS ACCOUNT CONTRIBUTIONS 30

ITEMIZED DEDUCTIONS 31

SCHEDULE A (FORM 1040) – ITEMIZED DEDUCTIONS 31§213 MEDICAL AND DENTAL EXPENSES 31§164 STATE AND LOCAL TAXES PAID 31§163 INTEREST PAID 31§170 CHARITABLE CONTRIBUTIONS/GIFTS 32§165 CASUALTY AND THEFT LOSSES 33MISCELLANEOUS EXPENSES– 2% FLOOR 35

ITEMIZED DEDUCTIONS – BUSINESS (SCHED. C) 35

§161. ALLOWANCE OF DEDUCTIONS— 35§162. BUSINESS EXPENSE DEDUCTIONS 35TRAVEL EXPENSES - §162(A)(2) 38LOBBYING EXPENSES - §162(E) 39EDUCATIONAL EXPENSES REG. §1.162-5 39WORK RELATED CLOTHING 40§274 - MEALS AND ENTERTAINMENT 41OTHER DEDUCTIONS 42DEDUCTIONS FOR CAPITAL EXPENDITURES 42DEPRECIATION - §167 45ACCELERATED COST RECOVERY SYSTEM - §168 45NET OPERATING LOSS DEDUCTION - §172 45ELECTION TO EXPENSE CERTAIN DEPRECIABLE BUSINESS ASSETS - §179 45§212 – EXPENSES FOR PRODUCTION OF INCOME 45HOBBY LOSSES - §183 (P.576) 46

STANDARD DEDUCTION 49

STANDARD DEDUCTION 49

PROPERTY TRANSACTIONS 50

STEPS: 50DEFINITIONS 50§1001 51§1091 – WASH SALE RULE 52§1211 LIMITATION ON CAPITAL LOSSES 52

NONRECOGNITION TRANSACTIONS 52

§1031 LIKE-KIND EXCHANGES 53§1033 INVOLUNTARY CONVERSIONS 55

IDENTIFYING THE TAXPAYER 56

ASSIGNMENT OF INCOME 56PERSONAL EXEMPTION AND DEPENDENT EXEMPTION 57

CAPITAL VS. ORDINARY INCOME AND LOSS 58

PREFERENTIAL TAX RATES FOR CAPITAL GAIN 58LIMITATIONS ON DEDUCTION OF CAPITAL LOSS 58

BIG PICTURE

Overview of Income Tax Computation:

Start with: Gross Income

Subtract: Certain [§ 62] Deductions

This produces:

Adjusted Gross Income (AGI)

Then Subtract:

The Standard or Itemized Deductions

And Subtract: Personal Exemptions

This Produces:

Taxable Income

Multiply by: The Applicable Tax Rate(s)

This Produces:

Tentative Tax

Then Subtract:

Tax Credits

Finally! This produces:

Tax Due or Refund

Sources of Federal Income Tax Law US Constitution

o Article I, § 8o Sixteenth Amendment (1913)

The Internal Revenue Code (Title 26 US Code) Administrative Interpretations of Code

o IRS – bureau of Dept. of Treasury issues various admin interpretations of IRC

o Regulations General Authority Regulations - §7805 Specific Authority Regulations – Congress specifically instructs an

interpretation of the provision; greater deference by Courtso Type of Regulations:

Final Regulations Temporary Regulations Proposed Regulations

o Revenue Rulings Apply law to specific set of facts; t/per may rely if their own

facts/circumstances are substantially the sameo Revenue Procedureso Notices and Announcementso Written Determinations

Private Letter Rulings Taxpayers seek ruling by IRS on application of law to specific

facts; only tp to whom it is issued may rely on it Technical Advice Memoranda Chief Counsel Advice

Judicial Interpretation of the Codeo How a Tax Case Gets to Court (FIGURE)

Judicial Determinations US Tax Court US District Court US Court of Federal Claims

Appellate Jurisdiction Circuit Ct of Appeals US Supreme Court

o Process of Statutory Interpretation Deference: Courts will give deference to the IRS’s prelitigation,

published interpretation of a statutory term—will adopt IRS’s interpretation of unclear term if it is a reasonable interpretation of congressional intent.

Tools of Interpretation Language tools Extrinsic tools:

legislative history; Joint Committee on Taxation’s General Explanation of a tax bill; legislative inactions; other statutory schemes and commentary on a statute.

Functional tools:

Seek to interpret statutes consistently with their purpose within a legislative scheme- requires court to discern the purpose and to interpret its particular terms consistent with that purpose

Basic Concepts and Issues Exclusions

o A tax allowance is an exclusion if qualification for it depends on the source of an economic benefit (ex. damages from a tortfeasor)

or if it depends on both the source of the economic benefit and the nature of the economic benefit (ex. employer-provided parking)

o Effect is to reduce taxable income by the amount of the exclusiono The Tax Savings equals the amount of the exclusion times(*) the marginal

tax rateo Taxpayers may claim both exclusions and the standard deduction (use of

exclusions doesn’t affect itemized/standard deduction decision)o Examples: death benefits; gifts and inheritances; injury compensation

award; income from discharge of indebtedness; recovery of tax benefit items; qualified scholarships; meals/lodging for employer’s convenience; gain from sale of principal residence; fringe benefits

Deductionso A tax allowance is a deduction if qualification for it depends solely on the

use of funds by the taxpayer (ex. money used to pay home mortgage interest)

o Effect is to reduce taxable income by the amount of the exclusiono The Tax Savings equals the amount of the exclusion times(*) the marginal

tax rateo Taxpayers must choose between the itemized deductions and the

standard deductiono Most deductions reflect the notion that there ought to be a deduction for

the costs incurred in producing income; others reflect certain economic and social policies

o Deductions are expenditures, but not all expenditures are deductible- rather, they must be authorized by a specific code section

Deduction provisions of IRC start with §161 Credits

o Effect of credit is it directly reduces the tax liability, while a deduction or exclusion reduces tax liability indirectly by reducing taxable income.

o The Tax Savings equals the amount of the credit Contrast deductions: So the tax benefit of a $1,000 deduction is a

function of the taxpayers marginal tax rate; the higher the marginal tax rate, the greater the benefit

A credit equal to 20% of $1,000 of expenditures will be worth the same amount regardless of marginal tax rate

Computation of Tax Liability Tax Rate

o §1 sets forth the rates for various taxpayers

o max rate is 39.6% for individuals; 28% max on ‘net capital gain income’. Taxable Income (tax base)

o The applicable tax rate is applied to the ‘taxable income’ of the taxpayero §63 defines taxable income:

§63(b): for non-itemizing taxpayers, the taxable income means “adjusted gross income minus (1) the standard deduction , and (2) the deduction for personal exemptions provided in § 151.”

§63(a): For itemizing taxpayers, taxable income means “gross income minus the deductions allowed by this chapter (other than the standard deduction.)”

Adjusted Gross Incomeo Serves as dividing line between deductions allowed to all taxpayers

regardless of whether they itemize (‘above-the-line’ deductions) and those which may be taken only if the taxpayer itemizes (‘below-the-line’ deductions)

o AGI is important because: It is used to limit the deduction for certain personal expenses Is used as a basis in calculating various ‘tax-related’ amounts

Above-the-Line Deductionso Alimony—§215o Moving expenses—§217 o Contributions to regular IRAs—§219o Losses—§165

Trade or business losses—§165(c)(1) Investment losses—§165(c)(2) Casualty losses—§165(c)*3)

o Interest on education loans—§221o Medical savings accounts—§223o Costs incurred in civil rights or whistleblower actions

Below-the-Line (Itemized) Deductionso Interest—§163

Qualified residence interest Investment interest

o Taxes—§164o Casualty losses—§165(c)(3),(h)o Medical Expenses—§213o Charitable contributions—§170o Miscellaneous expenses—§67

Calculating Taxable Income Itemize or Elect Standard Deduction Section 67: 2% Floor on Miscellaneous Itemized Deductions

o Certain ‘Miscellaneous expenses’ are deductible only to the extent that they, in the aggregate, exceed 2% of the taxpayers AGI

Includes employee’s unreimbursed business expenses and certain investment expenses

163; 164; 165(a) for losses; 170; 213 Medical expenses; 691(c)

o The floor relieves taxpayers of burden of recordkeeping certain expenditures unless they expect that the expenditures will exceed this floor

Section 68: Overall Limitation on Itemized Deductionso Provides that, if the taxpayer’s AGI exceeds the applicable amount, the

amount of the otherwise allowable itemized deductions is reduced by the lesser of:

(1) 3% of the amount by which taxpayers AGI exceeds an inflation-adjusted “applicable amount”;

or (2) 80% of otherwise allowable itemized deductions.o A taxpayer’s itemized deductions will not be subject to the 68 reduction

unless the AGI exceeds their ‘applicable amount’ ($300k/$250k) 2013 “applicable amount” = $300,000 on joint return, $250,000 for

unmarried individualo “otherwise allowable itemized deductions” requires that §67 2% floor be

applied first, then §68 is applied to remaining allowable itemized deductions.

o Exceptions: doesn’t apply to §213 (medical expenses); investment interest §163(d); and §165(a) for individuals losses incurred in any transaction

entered into for profit (non trade or business) [165(c)(2)] or for casualty or theft losses on personal property (shipwreck, fire, storm etc) [165(c)(3)], or for wagering losses [165(d)].

Personal Exemptionso §151(a) provides a deduction for personal exemptionso Phaseout: §151(d)(3) provides that personal exemption is reduced by 2

percentage points for every $2,500 by which their AGI exceeds the ‘applicable amount’ from §68(b) [for 2013: $300,000 joint; $250,000 individual]

o The personal exemption amount is $3,900 Credits

o Credits are provided in §21-53 §31 credit for withholding taxes paid through the year by employers

on behalf of employees

GROSS INCOME

§ 61. Gross Income – Definition and Overview

§ 61. Gross income defined—(a) General definition

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;(2) Gross income derived from business;(3) Gains derived from dealings in property;(4) Interest;(5) Rents;(6) Royalties;(7) Dividends;(8) Alimony and separate maintenance payments;(9) Annuities;(10) Income from life insurance and endowment contracts;(11) Pensions;(12) Income from discharge of indebtedness;(13) Distributive share of partnership gross income;(14) Income in respect of a decedent; and(15) Income from an interest in an estate or trust.

(b) Cross referencesFor items specifically included in gross income, see part II (sec. 71 and following). For items specifically excluded from gross income, see part III (sec. 101 and following).

Definitions of Income

§61 begins with a catch-all clause—“gross income means all income from whatever source derived”—and then proceeds to enumerate fifteen specific classes of receipts which are regarded as within the income definition.

“Gross income” includes all items that are clearly realized accessions to wealth.

o Generally, an accession to wealth occurs when an event or transaction leaves the taxpayer in a better economic position than existed before the event or transaction occurred.

o For federal income tax purposes, an accession to wealth is realized when it is sufficiently fixed and definite to be treated as gross income.

Comr. v. Glenshaw Glass, 348 U.S. 426 (1955); Rutkin v. United States, 343 U.S. 130 (1952); see ¶1010.01.A.

Haig-Simons Definitiono Income is the sum of (1) the market value of rights exercised in

consumption plus (2) the change in the value of the store of property rights between the beginning and the end of the period.

Consumption rights- measures the expenditures of a tper for all items of consumption

Property rights- measures the net change in savings over the taxable period

Economic Benefit approacho Income is the value of the economic benefits received by the taxpayero Receipt of cash or property – the source is not important to determination

Commissioner v. Glenshaw Glass [US 1955] (p.71) “undeniable accessions to wealth, clearly realized, and over

which the taxpayers have complete dominion” are includable in gross income

Cesarini v. United States [6th Cir. 1970] (p.75) Tpers who found $5k in old piano had to include it in their

gross income under Reg. §1.61-14(a) which requires tpers finding treasures to include in in gross income when reduced to undisputed possession.

o Receipt of Intangible Benefit Noncash Compensation Satisfaction of Obligation Services- Barter

Rev. Rul. 79-24 – lawyer exchanges services with housepainter; both have income in amount equal to FMV of the services received

Inclusions in “Gross Income” Specifically Included in Statutory “Gross Income”: Non-Statutory Inclusions [‘clearly realized accessions to wealth']

o Windfalls (treasure trove, acquired property, and punitive damages award)

o Discharge of taxpayer's personal obligationso Property acquired for consideration other than money or serviceso Illegal gains (e.g., embezzlement, extortion, fraudulent schemes and

devices, illegal businesses and activities., illegally diverted funds);o Business insurance proceedso State gov’t payments; ando Gambling income

References: Regs. §§1.61-1 through -22; see ¶1010.02.B.

Exclusions from “Gross Income”? Non-statutory exclusions from gross income include:

o unrealized appreciation;o recoveries of the cost of goods sold;o receipts with regard to which a taxpayer may have an obligation to repay;o loan proceeds;o certain types of imputed income;o rebates from utilities;o government granted rights;o general welfare receipts; ando rehabilitation cost reimbursements.

References: Regs. §§1.61-1 through -22; see ¶1010.02.C Specifically Excluded from Gross Income: The Code specifically excludes

particular items from gross income:

o See §§ 101- 140 Certain Exclusions from under Other Statutes (not IRC)

o Ex. Housing and Community Development Act 1974; Farm Credit Act 1971; Domestic Volunteer Service Act; Hostage Relief Act 1980; America’s Recovery Capital Loan Program 2009; “Cash for Clunkers” Program; Reparations and Restitution Payments from government/agency for deprivation of personal or civil rights;

Items that are Not Income Imputed Income (p.116)

o “Imputed Income” is the FMV of your tper’s performance of services for his own benefit and the value of the tper’s personal use property that he owns

De Facto Exclusion (no provision expressly excludes it) The key to the exclusion is the absence of an exchange

o Examples Household Services- value of unpaid caretaking by stay-at-home

spouses Despite inefficiency of result, valuation and privacy

concerns are the policy behind the exclusion Owner-Occupied Property

ex. Owner-occupied housing- rental value of the home owned by the occupier

existing system favors home ownership over renting ameliorated by various tax provisions like child care

credit and exclusion rule of 129 Capital Recovery

o Capital is the taxpayer’s unrecovered economic investment in property. Upon sale or disposition of that property, the taxpayer has a right to be taxed only on income (profit) from the transaction, not his or her invested capital. Thus the taxpayer is entitled to recover his invested capital.

o 61(a)(3) says gross income includes “Gains derived from dealings in property.”

§1001 defined gain on the sale of property as the excess of the “amount realized” on the sale over the “adjusted basis” of the property

1001(b) defines “amount realized” on a sale as the cash received by the t/per plus the FMV of any non-cash property received

§1012 defines a t/per’s basis in an asset as “the cost of such property”

o If the original cost was paid with ‘after-tax’ dollars, shouldn’t have to pay 2nd tax on that amount when you recover it upon sale

Concepts of basis and adjusted basis are accounting devices for keeping track of amounts on which the tper has already been taxed, to prevent double taxation

o Only taxed on the gain (the excess amount realized over cost/adjusted basis)

o Limits of Cost-Free Recovery of Capital- Garber v. US (p.183)

Loans

o Loans are not gross income: do not represent an ‘accession to wealth’ or an increase in tpers net

worth because the loan proceeds are accompanied by an equal and offsetting obligation (liability) to repay

o Loan defined as the “unconditional and legally enforceable obligation for the repayment of money”

Identified by the mutual understanding between borrower/lender of the obligation to repay and a bona fide intent on the borrower’s part to repay the funds.

o Contrast -- Cancellation of Indebtedness- If the debtor’s obligation to repay is canceled in whole or part, the

debtor will have discharge of indebtedness income in amt of cancellation

Possible exclusion in §108 – discharge of indebtedness income is excluded from gross income in certain circumstances.

Kirby Lumber General Welfare Exclusion

o IRS takes position that payments to individuals by govt units under social benefit programs for the promotion of the general welfare are excludable from gross income; however, if payments are specifically addressed in the Code that defeats this IRS policy

ITEMS INCLUDED IN GROSS INCOME

Specific Inclusions in Gross IncomeCompensation for Services

§61(a)(1) includes “compensation for services, including fees, commissions, fringe benefits, and similar items”

Transaction: one person provides or promises services to another who then transfers money or other property (or promise of it) to the service provider

Forms of Compensationo Form doesn’t matter; must include the amount of money or FMV or the

property or services, received as compensation in gross incomeo Property

Rooney v. Commis. – the objective fmv (the value at which it will change hands between unrelated parties) must be used in determining amount; the service provider will then have a basis in the property equal to the amt included in gross income

o Barter of serviceso Income taxes paid- if the person receiving (paying for) services also pays

the income taxes on such compensation, the amount paid as taxes is also compensation income.

Gross Income from Business - §61(a)(2) 61(a)(2) includes the tper’s gross income from business, the tper actually

reports the net income/loss from business activities (gross income from business minus available deductions)

Gains Derived from Dealings in Property- §61(a)(3)Investment Income -

Identifying Investment Income: o Investment income generally means income from profit-motivated

activities that don’t rise to the level of a trade or business “Trade or Business”-

tper must be involved in the activity with regularity and continuity and primary motivation must be expectation of profit. Comm. V. Groetzinger (US 1987)

Investment Activity- the activities of owning stock and buying and selling for one’s

own account are not a trade or business, regardless of frequency of trades or amount of time devoted. Higgins v. Commis. (US 1941)

Dividends - §61(a)(7) Interest - §61(a)(4) Rental Income - §61(a)(5) Royalty Income - §61(a)(6)

o Royalty income is the amount paid for the use of intangible property, such as copyright, trademark, or patent.

Income Derived from Annuities - §61(a)(9) and §72

o Statutory Analysis – §72 General Rule: Gross income includes amounts received as an

annuity under an annuity, life insurance, or endowment contract. Section 72(b) excludes from gross income the portion of a periodic annuity payment equal to the payment multiplied by the exclusion ratio.

To determine the portion of the annuity payment that is excluded from gross income, multiply the payment by a fraction, called the ‘exclusion ratio’. The numerator of this fraction is the taxpayer’s investment in the contract. The denominator is the expected return under the contract. Both figures are calculated at the annuity starting date.

The total exclusion allowed under §72(b) is limited to the taxpayer’s investment in the contract (his basis).

If the taxpayer dies before recovering his investment in the contract, and the payments end by reason of his death, the executor will be able to claim a deduction on the t/pers last income tax return for the unrecovered portion of the investment. §72(b)(3).

Alimony and Related Payments- §61(a)(8) and §71 Statutory analysis — §71

o The recipient of alimony or separate maintenance must include it in her gross income.

o Definitional Issues: Cash: The payment must be in cash, rather than any other type of

property (ex. not stocks, bonds, etc.) §72(b)(1) Receipt under Decree: The payment must be received by (or on

behalf of) the spouse pursuant to a divorce decree or separation instrument. The payor spouse may pay a third party on behalf of the former spouse. (ex. a mortgage payment, health insurance premiums, or payment of tuition).

Private Ordering: The divorce decree or separation instrument must not designate the payment as nondeductible/non-includable.

No “live-in” divorces: The payor and recipient must not be members of the same household at the time of the payment. 71(b)(1)(C)

No payment if recipient dies: there must be no liability to make payments beyond the death of the recipient spouse. 71(b)(1)(D). Also, there must be no ‘substitute payments’ to replace payments to the recipient spouse after the latter’s death.

Not child support: child support is excluded from gross income of the custodial spouse. 71(c)(1). If the payment is tied to a contingency of a child (such as attaining majority), it will be considered child support, even if it is called and otherwise qualifies as alimony. 71(c)(2)(A).

“Front –end Loaded” Alimony – this rule ferrets out disguised property settlements, reducing the benefit of the deduction to the payor and the detriment of the inclusion to the recipient

o General: If alimony payments are front-end loaded, the statute requires an adjustment in the third taxable year. In that year, the payor includes the excess alimony payments in gross income, and the recipient is entitled to a deduction in computing adjusted gross income in the same amount. 71(f)(1)(A),(B).

A front-end loaded payment is a payment that is relatively large in the early year(s), compared with later payments. The statute focuses only on the first three years following the divorce; payments thereafter are irrelevant.

In general, there must be a variance among the payments due during the three-year period of more than $15,000 in order for the front-end loading rules to apply.

Front-End Loaded Alimony PaymentsStep 1

Calculate the excess alimony payment for the second post-separation year. Alimony Y2 – (Alimony Y3+15,000) = excess payment for second post-separation year.

Step 2

Calculate the excess alimony payment for the first post-separation year.

Step 3

Calculate the excess alimony payment: sum of steps 1 and 2

Step 4

Determine the consequences to payor and recipient in third post-separation year:Deduction to recipient in amount of excess alimony paymentInclusion to payor in the amount of excess alimony payment

Income from Discharge of Indebtedness - §61(a)(12)Other Gross Income

Prizes and Awards - §74o Generally, gross income includes amounts received as prizes and awards.

§74(a). Similarly, rewards paid for taking certain actions, such as giving information leading to conviction of a crime, are includable in gross income.

Helpful Paymentso Moving Expenses- §82

§82 includes in GI any payment or reimbursement for moving expenses related to employment or self-employment.

o Unemployment Compensation- §85o Social Security Benefits- §86o Disability Payments

Embezzled Fundso Illegal income, including from theft or embezzlement, must be included

unless embezzler repays the money in the same taxable year as the embezzlement.

o Collins v. Commis. (2d. Cir. 1993) (p.148)o

Damages

ITEMS EXCLUDED FROM GROSS INCOME

Specific Exclusions from Gross Income Exclusions Generally

o Exclusion from gross income means that the item is not included in gross income at all

Will reduce tax liability by amount if exclusion * tax rate; thus, value is higher for higher income/bracket taxpayers

Excluding an item means it will forever escape the income taxo vs. Deduction:

also reduces tax liability by amt*rate; but a deduction will offset an equal amount of income so that amount will not be taxed

o Phaseout of Benefits Based on Income

Death Benefits/Life Insurance Payments - §101 (p.103) Two categories of life insurance: term insurance and whole insurance

o Term Insurance – Provides insurance for stated period (ex. year); premium pays for

insurance or that period only, and insured gets no further benefit from K at end of period. Becomes more expensive as the insured ages.

Term premiums are not deductible and death benefits are not taxable

o “Whole Life” or Permanent Insurance- provides insurance for entire life of insured premiums paid over entire lifetime; ins.co. puts the excess

(unneeded) premium, in reserve fund to earn interest The interest earned on reserve fund isn’t taxed to tper tper has rights to borrow money against the reserve account

(from ins. co) and to receive ‘surrender value’ if it cancels the policy.

Neither the insured nor the insurance co is taxed on this ‘inside build up’ while it accumulates; this tax deferral is a central advantage of life insurance as an investment vehicle

This type of policy is often purchased for investment purposes as much as for insurance purposes

The increase in value of the contract (via reserve fund investment earnings) is not included in the gross income of the insured (unlike bank accounts, mutual funds, etc, in which income is taxed currently to the owner)

Statutory Analysis Special Rules and Exceptions

o Accelerated Death Benefit Under 101(g), qualifying amounts paid prior to death under life ins.

contract on insured who is terminally or chronically ill will be excluded from income as amount paid by reason of death of the insured.

o Surrender for Value

If tper surrenders ordinary policy for its cash value, the proceeds are not payable by reason of death, thus 101 doesn’t apply. §72(e) rules extend tax advantage by providing that proceeds are taxable only to extent they exceed total consideration paid fr policy.

o §7702 requires for definition of ‘life insurance’, an actuarially sound relationship between the premiums paid and the death benefits offered under the K

enacted in 1984 to cut back on abusive forms of ‘universal life insurance’

Universal Life Insurance: substantial investment aspects + core life insurance element; intended to use the tax-deferral opportunities of life insurance to shelter otherwise taxable investment income

o Employee death benefits Any amount paid by an employer for death benefits is generally

included in the gross income of the recipient, unless the death benefit is part of a life insurance arrangement. However §101(i) provides an exclusion from gross income for any amount paid by an employer with respect to the death of an employee who is a specified terrorist victim.

Gifts and Bequests - §102 Policy

o There a sense that pure transfer payments ought not to increase the aggregate gross income in the country, and this looks like a pure transfer payment; suppose we could achieve the effect of pure transfer payment by taxing the granddaughter as long as we allow a deduction for grandfather

o gifts tend to go downstream (from rich to poor, etc.); so there would be a systematic tendency to lessen revenue collections- if people in 35% bracket are deducting gifts they give to people in 15% bracket, fact that taxable income amounts zero out doesn’t mean that the tax will zero out- giver will save $3500 from the gift if deductible and granddaughter may only pay tax of $1000 on receipt of the gift

o better way views it not as consumption activity by giver but of transfer of consumption opportunity

o so the best theoretical explanation may be to tax the recipient and allow a deduction for the giver; but there is a practical reason we reject that approach... so that's what justifies our departure from Haig-Simmons ideal theory

Policy objections profferedo Both the donor and donee should pay tax on the gift because the gift is

consumption: The donor is getting $X in warm fuzzies This is a departure from the Haig-Simmons theory they said that

if you got a gift it increases your income and should be taxedo Really, the donee but not the donor ought to pay tax on the gift. The

problem with this is that it would cost the government too much money What justifies not taxing the $10k gift when it will buy just as much as $10k

from any other source? The explanation is based on understanding of income as the opportunity to consume

o Three part rationale:

1) each consumption opportunity should be taxed once and only once

2) the $10k cash represents only one $10k consumption opportunity, which G has transferred to R, and

3) G has already paid tax on the $10ko taxing R on the gift would be double-taxing a single consumption

opportunity; G has already paid the tax on R's behalf Statutory Analysis

o Must determine whether that which is received is properly characterized as a gift, bequest, devise or inheritance.

o Trouble arises when gifts are made in a commercial or business setting Definitional Issue—Gift

o Intent/Motive of Donor is critical: A gift is a transfer motivated by “detached and disinterested

generosity.. out of affection, respect, admiration, charity or like impulses... and in this regard, the most critical consideration... is the transferor’s intention.” Comm’r. v. Duberstein (p.81)

Key factor is the donors intention; inquires what the dominant reason that explains his action in making transfer.

Requires fact-finder to analyze totality of facts of case in light of their own human experiences/understandings

If the donor has an expectation of receiving economic value, the transfer will not be considered a gift even if it is made from one family member to another.

Business Giftso §102(c) – No Employee Gifts: no exclusion for any transfer made by

employer to, or for benefit of employee; these are compensation instead of gifts.

Not clear whether it applies to former employees as well as current. IRS would say it applies to both.

o §274(b) –denies the transferor a business expense deduction for any business gift, to the extent the total value of gifts made by the taxpayer to the recipient during the year exceeds $25 (businesses can make gifts but not in a value exceeding $25 per donee per year)

so employers can make small holiday gifts to their employees

thus, in the business context, gift is possible but value will be taxable to transferor’

Special Ruleso Income: the exclusion doesn’t apply to income from property received by

gift. 102(b)(1); also doesn’t apply where the gift is of income from property 102(b)(2).

§1015 - Basis of Gifted Property –“Transferred” or “Substituted” Basiso For property acquired by gift, the recipient’s basis in the property shall be

the same as the donor’s basis in the property Allows donor to shift potential gain in property via gift to lower

bracket taxpayer (so gain taxed at lowest rates)o EXCEPT , if such basis is greater than the FMV(when gifted), then for the

purposes of determining loss, the basis shall be = FMV(when gifted)

Where the FMV of property is less than the donor’s adjusted basis in the property, the donee for loss purposes only will take a basis equal to the FMV of the property

When property is given away with inherent unrealized loss, §1015 really provides donee with two possible basis calculations: one basis for determining gain, and one basis for determining loss.

prevents the shifting of loss to the done §1014 – Basis of Inherited/Bequest Property

o For property acquired from a decedent, the basis is the FMV of the property at the date of decedent’s death

‘steps-up’ (or down) basis of property acquired from a decedent to the FMV of the property at time of their death

negates any inherent gain preexisting before death/transfer, and also negates any loss inherent in the property

only the appreciation/gain occurring after the death will be subject to tax

o §1014(e). Appreciated property acquired by decedent by gift within 1 year of death—

Strategy considerations: T/per may attempt to give highly appreciated property to a terminally ill relative knowing they’ll recover it soon via inheritance, to get stepped-up basis tax-free

1014(e) forces the (fake) recipient in such circumstances to take the basis that decedent (initial donee) had; thus, the donor-heir will get her own basis back if its devised back within 1 year of gifting

Interest on State and Local Bonds - §103Compensation for Personal Injury or Sickness - §104

Policy Rationaleso No Income- because the t/p is merely placed back in her original

(undamaged) state, she has no benefit and therefore no income from the transaction

o Measurement- even if the taxpayer has some amount of income, its too hard to measure

o Adding insult to injury- would be cruel to an injured t/per to include these amounts in their income

Statutoryo Personal Physical Injury Requirement

Amos v. Commissioner [T.C.M. 2003] (p.97) – Rodman case Facts: Rodman kicked photog in groin during b-ball game;

photog taken to hospital with ‘pain’ but no observable swelling/bruising. Photog got a lawyer and Rodman quickly settled the matter for $200k- covering any injuries and agreement not to defame/disclose terms /assist prosecution

Found that some damages were excludable under 104(a)(2) even without a showing of bruises, cuts, or other observable bodily harms.

To determine if settlement amounts you receive by compromise or judgment must be included in your income, you must consider the item that the settlement replaces. The character of the income as

ordinary income or capital gain depends on the nature of the underlying claim.

Include the following as ordinary income: Interest on any award. Compensation for lost wages or lost profits in most

cases. Punitive damages, in most cases. It does not matter if

they relate to a physical injury or physical sickness. Amounts received in settlement of pension rights (if

you did not contribute to the plan). Damages for: Patent or copyright infringement, Breach

of contract, or Interference with business operations. Back pay and damages for emotional distress received

to satisfy a claim under Title VII of the Civil Rights Act of 1964.

Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income.

o Emotional Distress 194(a)(2) says emotional distress isn’t =physical injury/sickness Emotional distress itself is not a physical injury or physical sickness,

but damages you receive for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness. Do not include them in your income.

the exclusion doesn’t apply to damages received from claim of employment discrimination, or injured reputation accompanied by claim for emotional distress.

If the claim had its origin in a physical injury, recovery for emotional distress is excludable (Reg. 1.104-1(c)(1)) provides for exclusion of damages for emo. distress attributable to a physical injury/sickness.

If the emotional distress is due to a personal injury that is not due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), you must include the damages in your income, except for any damages you receive for medical care due to that emotional distress.

Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders.

o Previously deducted medical expenses: The exclusion does not apply to amounts the taxpayer has

deducted as medical expenses under §213. Ex. so if P was injured and deducted $2,000 that year as medical

expenses (incurred from the injury); then later receives $5000 payment from D as compensation for personal physical injuries, only $3000 of the payment is excludable from gross income, because the other $2k is attributable to previously deducted medical expenses.

o Recoveries by someone who didn’t suffer the injuries If action origin is in a physical injury/sickness, then all damages (not

punitive) flowing therefrom are ‘received on account of the injury/sickness’ whether or not the recipient of the damages is the injured party.

Ex. damages received by an individual on a claim of loss of consortium due to injury/sickness of his spouse are excludable.

Basis for Award in Propertyo RULE: If you get an award in property rather than cash, the basis of that

property is the FMV of that property at the time that you received it Lump Sum Settlement vs. Structured Settlement

o If the pre-tax cash flows are the same for each, prefer structured settlement for tax reasons because you get the benefit of tax deduction on what is essentially interest payments

Amounts received under accident and health plans - §105 Amounts received under Accident and Health Plans - §105

o §105(b) excludes from gross income the value of benefits received under employer-provided health insurance, to the extent the benefits constitute reimbursement of medical expenses

excludes amounts otherwise included under 105(a) if they are to reimburse the employee for medical care for him or his dependents, and if he has not deducted the amount under §213.

o §105(a) includes in the employee’s gross income any amounts received for personal injuries or sickness that are attributable to employer-provided premiums or coverage.

Contributions by employer to accident and health plans - §106 Contributions by employer to Accident and Health Plans - §106

o §106(a) excludes from the gross income of an employee the value of employer-provided health insurance coverage

o the exclusion applies only to health insurance for the employee, his spouse, or his dependents, as defined in §152

o applies not only to basic health insurance coverage, but also to “Cadillac employer-provided health insurance” with small or non-existent deductibles and co-pays, no or very high dollar ceilings on benefits, and broad definitions of covered conditions and treatments

Together, §§105-06 remove employer-provided health insurance (both premiums and benefits) from the base of the income tax

Discharge of Indebtedness Income - §108 §61(a)(12) provides that gross income includes ‘income from discharge of

indebtedness’o If a loan is discharged for less than the amount owed, the borrower must

include in income the amount of the discount (the amount owed less the amount paid to discharge the debt)

Under §108, a taxpayer may exclude from his or her gross income discharge of indebtedness income if any of the following conditions apply

o Bankruptcyo Insolvency (limited to the amount of the insolvency)

A t/per is insolvent, if and to the extent that, his liabilities exceed the FMV of his assets. §108(d)(3).

o Qualified Principal Residence Indebtedness:

The discharge is of acquisition indebtedness for a taxpayer’s principal residence when the discharge occurs before Jan. 1, 2013. The limit on this exclusion is $2,000,000. §108(a)(1)(E).

o Qualified Farm Indebtednesso Student Loans

Gross income doesn’t include any discharge of a student loan if the discharge occurs because the student works for a certain period of time for a nonprofit or governmental organization. 108(f)(1).

Definitional issueso “Indebtedness” : defined as a debt for which the taxpayer is liable or a

debt secured by the taxpayers property. §108(d)(1).

Recovery of Tax Benefit Items - §111 §111(a) Deductions — Gross income does not include income attributable to

the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.

Qualified Scholarships - §117 §117(a) General rule — Gross income does not include any amount received

as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in §170(b)(1)(A)(ii).

o excludes from gross income ‘any amount received as a qualified scholarship by an individual who is a candidate for a degree’ at a college or university.

Limited to the amount of the student’s tuition and fees, and the cost of course-related books, supplies and equipment (room-and-board scholarship isn’t excludable)

§117(c) provides that the exclusion doesn’t apply to “any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship.”

o applies to university teaching and research assistants; also applies to an employee of an employer of any sort, if he receives a scholarship as part of his compensation

117(d) Qualified Tuition Reductiono this is a reduction in tuition provided to an employee (or family member of

employee) of the qualifying educational org, if the benefit does not discriminate in favor of highly compensated employees and is used for undergrad study.

Rev. Proc. 76-47 (p.133)

o 117(d)o Imposes nondiscrimination rules that limit what you can do with a

scholarship program (cant be exclusively for children for executive staff)o But it really is compensation if you provide it to everyone or almost

everyone So it must be a genuine scholarship program that

o 4.02 – selection committee must consist wholly of individuals that are independent of the organizer or employer (don’t want executives to decide who gets the scholarship, could be basically a bonus)

o 4.05 – grant cant be terminated because the recipient or parents terminate employment

o 4.08 – says this cant go to everyone; in general there’s a 25% limitation that applies

cant exceed 25% of the number of children who were eligible and applied OR 10% who can be shown to be eligible (whether they applied or not) in that year

Rev. Proc. Basically provides a safe harbor- if you comply with these rules you’ll be ok, if you want to structure your program outside of these guidelines then you might be challenged

Other Related Education Incentiveso §25A – HOPE/American Opportunity tax creditso §529 and §530 – tax favored treatment for college savingso §221- deduction for interest on certain education loanso §127 – Employers educational assistance for employees

Meals or Lodging Furnished for Convenience of the Employer - §119

Exclusion for Gain on Sale of Principal Residence - §121 §121(a) Exclusion—Gross income shall not include gain from the sale or

exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.

§121(b) Limitations—o (1) In general—the amount of gain excluded from gross income under

subsection (a) with respect to any sale or exchange shall not exceed $250,000.

o (2) Special rules for joint returns—...(A) $500,000 limitation for certain joint returns

o (3) Application to only 1 sale or exchange every 2 years— Required Principal Residence Status in at least 3 of the last 5 years

o The taxpayer must have owned the residence and occupied it as a principal residence for at least 2 of the 5 years prior to sale or exchange

No limits to times §121 is Usedo The exclusion is allowed each time a taxpayer selling or exchanging a

principal residence meets the eligibility requirements, but generally no more frequently than once every two years

Dependent Care Assistance Programs - §129 §129(a) Exclusion— (1) In general—Gross income of an employee does not

include amounts paid or incurred by the employer for dependent care assistance provided to such employee if the assistance is furnished pursuant to a program which is described in (d).

o (2) Limitation of exclusion— (A) In general—The amount which may be excluded under paragraph (1) for dependent care assistance with respect to dependent care services provided during a taxable year shall not exceed $5,000 ($2,500 married filing separate)

Certain Fringe Benefits - §132 §132(a) Exclusion from gross income—Gross income shall not include any

fringe benefit which qualifies as a—o (1) no-additional-cost service,o (2) qualified employee discounto (3) working condition fringeo (4) de minimis fringeo (5) qualified transportation fringeo (6) qualified moving expense reimbursement,o (7) qualified retirement planning services, oro (8) qualified military base realignment and closure fringe.

No-additional-cost service defined §132(b)o If: (1) such service is offered for sale to customers in the ordinary course

of the line of business of the employer in which the employee is performing services, and (2) the employer incurs no substantial additional cost (including foregone revenue) in providing such service to the employee.

Qualified Employee Discount §132(c)o Means any employee discount with respect to qualified property or

services to the extent that such discount does not exceed— (A) in the case of property, the gross profit percentage of the price

at which the property is being offered by the employer to customers; or

Gross profit percentage = (B) in the case of services, 20 percent of the price at which the

services are being offered by the employer to customers. Working condition fringe defined §132(d) De Minimis fringe defined §132(e) Qualified Transportation fringe §132(f)

Other Partial exclusion for Social Security benefits - §86 Qualified disaster relief payments- §139

Employment Related Exclusions §119 certain meals and lodging §79 life insurance premiums §106 health insurance premiums §132 fringe benefits

o ..

ACCOUNTING PERIODS AND METHODS OF ACCOUNTING

Annual AccountingNet Operating Loss Deduction- §172

Under §172, the excess of (non-personal) expenses over income in a particular year may be claimed as a deduction (NOL) in other years.

Definition – Net Operating Losso No NOL deduction: in computing the excess of deductions over income,

no deduction is allowed for an NOL carryover from another year. 172(d)(1).

o No personal deductions: in computing the excess of deductions over income of an individual, no personal deductions are allowed, including personal exemptions and nonbusiness deductions such as medical expenses, casualty losses, and charitable contributions. 172(d)(3)-(4).

o Capital losses: in computing the excess of deductions, the deduction for nonbusiness (i.e., investment) capital losses is allowed only to the extent of capital gains.

Applies to both corporations and individuals, but with regard to individuals it applies only to business losses (investment losses aren’t NOL, not operational losses; no NOL from personal exemption and standard deduction- ex. if you had no income)

Generally, you have to use the earliest tax year available for offset (one exception is that you can waive carryback)

Carryover 172(b)(1)(A)o Carryback for 2 yearso Carry-forward for 20 years following the year of the loss o When carried to a particular year, it reduces taxable income in that year

potentially to 0; the loss must be applied to the earliest of the years first, and then in chronological order. 172(b)(2). However, the taxpayer may elect to waive the entire carryback period and apply the loss only to later years. 172(b)(3).

Does not eliminate graduated rate structure

DEDUCTIONS FOR PERSONAL EXEMPTIONS

§151. Allowance of deductions for personal exemptions— (a) Allowance of deductions—In the case of an individual, the exemptions

provided by this section shall be allowed as deductions in computing taxable income.

(c) Additional exemption for dependents—an exemption of the exemption amount ($3,900) for each individual who is a dependent of the taxpayer for the taxable year.

(d) Exemption amounto $3,900

(d)(3) Phaseouto The exemption shall be reduced by 2% for each $2,500 (or fraction

thereof) by which the taxpayer’s AGI

§152. Dependent defined— (a) In general —the term “dependent” means—(1) a qualifying child, or (2) a

qualifying relative.

A.T.L. DEDUCTIONS FOR INDIVIDUALS

§165 Losses (c) Limitation on losses of individuals—In the case of an individual, the

deduction under subsection (a) shall be limited to—o (1) Losses incurred in a trade or businesso (2) Losses incurred in any transaction entered into for profit, though not

connected with a trade or business; ando (3) except as provided in subsection (h), losses of property not connected

with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.

(h) Treatment of casualty gains and losses—o (1) $100 limitation per casualty—Any loss of an individual described in

(c)(3) shall be allowed only to the extent that the amount of the loss arising from each casualty (event) or from each theft, exceeds $100.

o (2) Net casualty loss allowed only to the extent it exceeds 10% of AGI–

(A) If the personal casualty losses for any taxably year exceed the personal casualty gains... such losses shall be allowed for the taxable year only to the extent of the sum of—

(i) the amount of the personal casualty gains for the taxable year, plus

(ii) so much of such excess as exceeds 10 percent of the AGI of the individual

o (5)(A) Personal casualty losses allowable in computing AGI to the extent of personal casualty gains— In any case to which paragraph (2)(A) applies, the deduction for personal casualty losses for any taxable year shall be treated as a deduction allowable in computing AGI to the extent such losses do not exceed the personal casualty gains for the taxable year.

§165(a) allows a taxpayer to claim a deduction for all ‘losses not compensated for by insurance or otherwise.’ §165(c) imposes significant limitations on the deductibility of losses from individuals.

Three types of deductible losses for individuals:o Trade or business losses: Individuals may deduct losses incurred in a

trade or business. 165(c)(1). These losses result from a trade or business activity in which expenses exceed income but may be subject to certain restrictions under §§465 and 469.

o Investment losses: Individuals may deduct losses incurred in activities entered into for profit, even if the activity does not rise to the level of a trade or business. 165(c)(2). This category includes losses from rental and royalty-generating activities, as well as losses on the sale or exchange of capital assets, such as real property, stocks, and other types of property.

o Personal casualty losses: Individuals may deduct losses incurred in fire, storm, shipwreck, theft, or other casualty. Personal casualty losses are deductible from gross income to the extent of the personal casualty gains (ATL). Any remaining losses (net casualty losses) are potentially deductible as part of the itemized deduction.

See rules under Itemized Deductions

§215 Alimony, etc., payments §215(a) General rule—In the case of an individual, there shall be allowed as a

deduction an amount equal to the alimony or separate maintenance payments paid during such individual’s taxable year.

Front-end loaded alimonyo If the alimony is front-end loaded, the payor must include the excess

alimony payment in gross income in the third post-separation year. §71(f)(1)(A)

§217 Moving Expenses §217(a) Deduction allowed—There shall be allowed as a deduction moving

expenses paid or incurred during the taxable year in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work.

§217(b) Definition of moving expenses—o (1) The term moving expenses means only the reasonable expenses

(A) of moving household goods and personal effects from the former residence to the new residence, and

(B) of traveling (including lodging) from the former residence to the new place of residence.

Such term shall not include any expenses for meals (c) Conditions for allowance

o (1) DISTANCE REQUIREMENT the taxpayers new principal place of work must be (A) at least 50 miles further from his former residence than was his

former principal place of work, OR (B) if no former place of work, at least 50 miles from his former

residence, ANDo (2) DURATION REQUIREMENT

(A) during 12-month period after arrival in new location, the taxpayer is a full-time employee, during at least 39 weeks, OR

(B) during the 24-month period after arrival, the taxpayer is a full-time employee or performs services as a self-employed on a full-time basis, during at least 78 weeks, of which not less than 39 weeks are during the first 12-month period.

Reimbursed moving expenses; coordination with §132o If an employer reimburses an employee for all or a portion of the moving

expenses, the employee will be able to exclude the reimbursement as a fringe benefit under §132. Any unreimbursed portion of otherwise qualifying expense would qualify for deduction under §217.

§219 Contributions to Regular IRAs§221 Education Loans Interest§223 Health Savings Account Contributions

ITEMIZED DEDUCTIONS

Schedule A (Form 1040) – Itemized Deductions§213 Medical and Dental Expenses

§213 allows taxpayers who itemize their deductions to claim medical expense deductions to the extent the expenses (that are not covered by insurance) exceed 10% of AGI

o allows a deduction for medical expenses paid or incurred by the taxpayer for care of the taxpayer or his or her spouse or dependents, to the extent these expenses exceed 10% of AGI. This is an Itemized deduction.

§213(d) defines the term “Medical Care”o Medical care means amounts paid - (A) for the diagnosis, cure, mitigation,

treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body; (B) for transportation primarily for and essential to medical care referred to in subparagraph (A);... (C) (D)...

o Medical vs. Nonmedical Consumption IRS is strict with respect to situations in which t/pers claim med

expense deductions for stuff that doesn’t look like medical care Cosmetic surgery: Expenses of cosmetic surgery do not qualify as

medical expenses unless the procedure is necessary to ameliorate a deformity arising from a congenital abnormality, a personal injury, or disfiguring disease.

§164 State and Local Taxes Paid

§163 Interest Paid §163(a) General Rule—There shall be allowed as a deduction all interest paid

or accrued within the taxable year on indebtedness. Disallowance of deduction for personal interest - §163(h)

o (1) In general—In the case of a taxpayer other than a corporation, no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year.

o (2) Personal Interest—...the term “personal interest” means any interest allowable as a deduction under this chapter other than:

Interest paid or accrued on indebtedness properly allocable to a trade or business

Any investment interest Any interest which is taken into account under §469 in computing

income or loss from a passive activity of the taxpayer Any qualified residence interest Any interest allowable as a deduction under section 221 (relating to

interest on educational loans)’o (3) Qualified residence interest—

(A) In general—the term ‘qualified residence interest’ means any interest which is paid or accrued during the taxable year on—(i) acquisition indebtedness with respect to any qualified residence of

the tax payer, or (ii) home equity indebtedness with respect to any qualified residence of the taxpayer.

(B)(ii) $1,000,000 Limitation—The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000.

(C) Home equity indebtedness— (ii) Limitation—The aggregate amount treated as home

equity indebtedness for any period shall not exceed $100,000

o 163(a) allows a deduction for interest paid or accrued during the taxable

year; for interest other than trade or business interest, this is an itemized deduction.

NO personal interest §163(h)(1)o Personal interest is interest other than trade or business interest,

investment interest, qualified residence interest, and passive activities interest

Qualified Residence Interest - §163(h)(3)o Acquisition Indebtedness

Three requirements: Use of funds- the debt must be incurred to acquire, construct,

or substantially improve any qualified residence. Security- the qualified residence must secure the

indebtedness Amount- taxpayer’s aggregate amount of acquisition

indebtedness cannot exceed $1,000,000o Home Equity Indebtedness

Three requirements: Equity- the indebtedness must not exceed the FMV of the

residence minus the acquisition indebtedness on the residence

Security- a qualified residence must secure the indebtedness Amount- a taxpayer’s aggregate amount of home equity

indebtedness cannot exceed $100,000. Investment Interest - §163(d)

o For taxpayers other than corporations, the deduction for investment interest is limited to the net investment income of the taxpayer for the year. §163(d)(1).

o Investment interest is interest on debt that is incurred to purchase investments such as stocks or bonds; Net investment income is the net income from these kinds of investments.

o If this limitation prevents the deduction of an amount of interest, the disallowed portion is carried forward and treated as incurred by the taxpayer in the next year. §163(d)(2).

§170 Charitable Contributions/Gifts §170 allows a taxpayer to claim as an itemized deduction his or her

charitable contributions made during the taxable year to qualifying charitable, educational, or religious organizations. §170(a).

Definitional Issues

o Charitable Organization In order for a gift to be deductible, it must be made to a qualifying

charitable organization that has §501(c)(3) status under federal lawo Private Benefit

A charitable donation assumes that the donor receives no benefit from the transfer. If the benefits received or expected to be received are substantial—i.e., greater than those inuring to the public from a charitable donation – the quid pro quo of the transfer removes it from the realm of deductibility

Special rules and exceptionso Amount: the amount of the contribution is the amount of money or the fair

market value of the property contributed Services: there is no deduction for services performed for a

charitable organization Reg. §1.170A-1(g). Expenses: Unreimbursed expenses incurred on behalf of the

charitable organization are deductible. Reg. §1.170A-1(g). Blood: one cannot claim a deduction for the donation or sale of

one’s blood. Lary v. United States. o Limitation for Individuals: the deduction for contributions by individuals is

limited to a percentage of their contribution base. Public charities—50%: For organizations that qualify as public

charities (generally, schools, churches, governmental entities, and other publicly supported orgs), the limitation is 50% of the taxpayer’s contribution base.

Contribution base = AGI computed disregarding the NOL deduction.

§165 Casualty and Theft Losses A casualty occurs when a taxpayer’s property is destroyed in a fire, storm, or

similar event, or is stolen. A casualty can produce a gain or a loss. o Ex. if P bought property for $1,000 that had appreciated to $10,000 and

then was stolen, and P receives insurance proceeds of $10,000- P would have a casualty gain of $9,000 (the difference between the insurance proceeds and P’s cost of the property)- the casualty gain must be included in gross income.

o Ex. if Ps property were not insured, then would have a casualty loss of $1,000 because the measure of loss is the lesser of the decrease in fair market value or the taxpayer’s adjusted basis in the property. Reg. §1.165-7(b)(1).

§165(c)(3) allows individuals to claim as a deduction losses of property arising from casualty events such as fires or storms or from theft, with limitations:

o The loss must exceed $100 per event, so the amount of any loss must first be reduced by $100 before any other rules are applied.

o Then, the treatment of casualty losses depends on the total casualty gains and losses of the taxpayer during the year:

More gains than losses: If a taxpayer’s personal casualty gains exceed personal casualty losses for the year, both the gains and losses are treated as capital gains and capital losses. This allows

the taxpayer to offset the gains (included in gross income) with the losses (deductible in computing AGI)

More losses than gains: If personal casualty losses exceed gains, the amount of loss equal to the amount of gain is allowed as a deduction from gross income in computing AGI. The balance is potentially an itemized deduction, but only to the extent this loss exceeds 10% of the taxpayer’s AGI.

Example–Casualty gains and losses: Kathy experiences two casualty events during the year. In the first event, her horse, Two Egg, is killed by lightning. Two Egg’s basis was $10,000, and he was insured for his fair market value of $40,000. In the second event, a Ming vase with a basis and value of $50,100 was stolen. The vase was not insured. Kathy’s AGI (disregarding these events) is $50,000.

Step 1: Include in Kathy’s gross income the personal casualty gain of $30,000 ($40,000 insurance proceeds minus Two Egg’s basis of $10,000).

Step 2: Subtract as a deduction from gross income in computing AGI the personal casualty loss equal to the amount included in gross income as a personal casualty gain. Kathy’s personal casualty loss is the loss from the Ming vase ($50,100) minus the $100 deductible. Thus her casualty loss is $50,000. Of this amount, $30,000 is subtracted as a deduction from gross income in computing AGI.

Step 3: Compute the itemized casualty loss deduction by applying the 10% limitation to the balance of the personal casualty loss. This amount will be deductible to the extent it exceeds 10% of AGI. Ten percent of Kathy’s AGI of $50,000 is $5,000. The remaining balance of the casualty loss ($20,000) is deductible to the extent it exceeds $5,000; thus the itemized casualty loss deduction is $15,000.

Summary : Kathy will be allowed a deduction of $45,000 of the total $50,100 loss; $30,000 as offsetting casualty gains and $15,000 as an itemized deduction.

Definitional Issueso Casualty loss requires a complete or partial destruction of property from a

sudden, unexpected, and unusual event. o Suddenness Requirement:

Generally, they are looking for something that does its damage suddenly, presumable under the theory that slow-paced damage is the sort of thing that is more accurately regarded as a result of the aging or consumption of the property, rather than a true, wealth-diminishing casualty.

Termite damage and similar gradual deteriorations do not occur with sufficient ‘suddenness’ to constitute a casualty

o Wedding Rings: outcomes are split- one got deduction for destroying it in a garbage disposal, the other didn’t get deduction for flushing down toilet

o Automobile Damage

Treas. Reg. §1.165-7(a)(3)(i) says damage to a car qualifies as casualty if the damage results from the faulty driving of the t/per or other person operating the auto but is not due to the willful act or willful negligence of the t/per

o Theft Losses from Ponzi Schemes- Rev. Rul. 2009-9 (p.407) says that a loss from criminal fraud or embezzlement in a

transaction entered into for profit is a theft loss (not capital loss), and you can take it as theft loss in year of discovery; and its a (c)(2) loss rather than (c)(3) loss, which allows you to avoid the $100 deductible

1033 – available for casualty loss items: if you have your casualty gain deferred by 1033 then you don’t use it in the formula (most often is the case)

Other Materials and Problemso Rules that have emerged have focused on 3 things:

Suddenness Permanence of the damage Physical nature of the loss

o Chamales v. Commissioner (p.497) Taxpayers bought the house neighboring OJ Simpsons house where

murders took place, property values declined There’s lots of things that can make property values decline, IRS is

reluctant to allow casualty loss deductions for this for number of reasons- they're typically unrealized losses, also when it comes to personal residences losses are not deductible except as a casualty

Miscellaneous Expenses– 2% Floor Employees Business Expenses - §162

o Employees are engaged in the trade or business of performing services for their employers; the ordinary and necessary expenses they incur (and aren’t reimbursed for) are deductible, as part of itemized deduction

o Common non-reimbursed employee business expenses: travel and entertainment; mileage; dues to professional associations; job search expenses in current occupation; home office deduction of an employee; malpractice insurance premiums; equipment used in the business; clerical help; publications; and legal fees

Investment Expenses - §212o Section 212 allows a deduction for expenses associated with the

production or collection of income, with the management or holding of property that produces income (but not in a trade or business), and with the collection or computation of tax.

ITEMIZED DEDUCTIONS – BUSINESS (SCHED. C)

§161. Allowance of deductions—

In computing taxable income under section 63, there shall be allowed as deductions the items specified in this part, subject to the exceptions provided in part IX.

§162. Business Expense Deductions §162(a) In general—There shall be allowed as a deduction all the ordinary

and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including

o (1) a reasonable allowance for salaries or other compensation for personal services actually rendered

o (2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and

o (3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

§162(c) Illegal bribes, kickbacks, and other payments §162(e) Denial of deduction for certain lobbying and political expenditures §162(f) Fines and Penalties §162(g) Treble damage payments under antitrust laws Rationale

o Haig-Simmons definition of income §162 allows a deduction for all the ordinary and necessary expenses paid or

incurred in carrying on a trade or business . Definitional Issues

o Trade or business- the principal function of the trade or business requirement is to

distinguish the expenses of a taxpayer’s business activities from other activities, like personal activities

Must be involved in the activity with continuity and regularity and must have the primary purpose of creating income or profit rather than merely engaging in a hobby. Comm’r v. Groetzinger.

An investor in stocks and securities is not carrying on a trade or business, regardless of the frequency or size of transactions. Higgins v. Comm’r.

o Profit Motive is requiredo Ordinary and Necessary

Necessary = “appropriate and helpful” in the development of the taxpayer’s business

Courts are reluctant to substitute their business judgment for that of business people and will disallow an expense as unnecessary only in extreme cases

The factual nature of inquiry makes reversal highly unusual This requirement is often used to distinguish between

personal and business activity Ordinary = one that is normally to be expected, in view of the

circumstances facing the business

Ordinary means usual in the course of general and accepted business practice, arising from a transaction commonly or frequently encountered in the type of business involved. Deputy v. DuPont.

o Expenses The expense requirement distinguishes between expenses and

capital expenditures. Only expenditures for expenses are deductible; amounts paid as capital expenditures are not – the capital expenditures are ‘capitalized’ (i.e., they become part of the basis of an item and are potentially subject to capital recovery.

Special Issueso Reasonable Compensation

A closely held company may try to pay shareholders/employees unreasonably high salaries (in lieu of dividends) because salaries may be deductible by corp but dividends are not. The IRS and courts review the allocation, and may recast a portion of the unreasonable salary as a dividend.

if its compensation for services, then corporate level of dual taxation will be eliminated because it can deduct the expense for compensation under §162(a)(1)

even though this would increase the eventual tax liability of individual because they would not get the preferred tax rate for capital gains vs. ordinary income

Exacto Spring Corp. v. Comm’r (p.552) RULE: §162 requires court to determine: Whether

compensation was reasonable? If not, what would be reasonable compensation?

7 factor test: Type and extent of services rendered Scarcity of qualified employees Qualifications and prior earning capacity of employee Contributions to the business venture Net earnings of employer Prevailing compensation paid to employees with

comparable jobs Peculiar characteristics of the employer’s business

Additional factor (or alternative test- by Posner) Independent Investor Test: If the rate of return of the

corporation is at least at the norms for the industry or above that – even considering the unreasonable compensation – then the compensation isn’t really unreasonable

Public Policy Limitationso Tank Truck Rentals, Inc. case (p.534)

RULE: A finding of 'necessity' cannot be made, however, if allowance of the deduction would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.

Codified in §162(f) – to disallow deduction of bribes, kickbacks, fees paid for a violation of law and antitrust settlements, etc...

o CHAMPS (medical marijuana case) (p.540)

Section 280E provides: No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

Rule: 280E doesn’t preclude petitioner from deducting expenses attributable to a trade/business other than that of illegal trafficking in controlled substances simply because he’s also involved in trafficking

o Comm’r v. Heininger The fed gov’t prosecuted t/p for misleading mail order advertising

and t/p deducted the legal fees he incurred to defend his business practices. IRS said they aren’t ‘ordinary and necessary’ because conducting business using illegal methods cant be ‘ordinary’.

Ct reversed. Defending a business against charges of violations of regulatory schemes is the usual and expected course of action and therefore these expenses were ordinary and necessary.

Bribes and Kickbacks o §162(c): No deduction allowed for illegal payments to any governmental

employee or illegal bribes or kickbacks to other persons. Fines:

o No deduction allowed for any fine or similar penalty paid to a government §162(f)

Treble damages: o No deduction for the 2/3 portion of antitrust damages attributable to

punitive damages. §162(g)(1),(2) Drug Trafficking:

o No deduction allowed for the expenses incurred in illegal drug trafficking

Travel Expenses - §162(a)(2) A taxpayer’s expenses while traveling away from home primarily for

business are deductible. Reg. §1.162-2(b)(1). o Requirements of §162:

“traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish and extravagant under the circumstances) while away from home in the pursuit of a trade or business.”

o Policy bc the taxpayer has burden of substantial continuing expenses that

are duplicated when he is required to travel for businesso Issue will be whether the travel is for business, or serves a personal

purpose of the t/p Tax-Home Rule: you must be away from your tax home (the general vicinity

of your principal workplace) in order to qualify for a business trip deductiono Two Requirements:

Away from Tax home= must be away from general vicinity of his work place

Must satisfy the ‘overnight rule’ – any trip that doesn’t involve a substantial rest period (~8hrs in bed) doesn’t put the t/p in travel status for deductibility

o Policy: Reflect that commuting costs and meal costs are ordinarily personal

consumption expenditures, not business expenses; commuting represents personal choices about where to live; meals would have been consumed in any event

Temporary vs. Indefinite Jobso (p.566) distinguish between temporary jobs (expected to last one year or

less)- for which travel expenses are generally deductible, and indefinite jobs (expected to last longer than one year or unknown time) for which they are not generally deductible

but still required that continued maintenance of the first home have a business justification

“if no business exigency dictates the location of the taxpayer’s usual residence, then the mere fact of his taking temp employment elsewhere cannot be a compelling business reason for continuing to maintain that residence. Only a t/p who lives one place, works another and has business ties to both is in the ambiguous situation that the temp employment doctrine is designed to resolve

Caseso Comm’r v. Flowers: ct found the personal decision to live in one city and

work in another made the commuting expenses personal expenses Three requirements for deductibility- (1) the expense must be

reasonable and necessary; (2) it must be incurred while ‘away from home’; (3) there must be a direct connection between the expenditure and the t/p’s trade or business or that of the t/p’s employer.

o Hantzis v. Comm’r (p.561): 2L in boston had summer job in NY while her hubby was still employed/living in boston, she tried to deduct her NY living expenses; ct said no because she was not ‘away from home’- she had no business connection to Boston because she wasn’t employed there

Temporary = less than 1 year (so can be gone up to 1 year) This would have been allowed if she were a professor at one school,

visiting another city as for a temporary visiting professor or clerking position

Lobbying Expenses - §162(e) No deduction is allowed for certain lobbying and political expenditures Geary v. Comm’r (p.547)

Educational Expenses Reg. §1.162-5 Deductible: Educational expenses are deductible as ordinary and necessary

business expenses if the education:o (1) maintains or improves skills required by the individual in his

employment or other trade or business, OR o (2) meets the express requirements of the individual’s employer, or the

requirements of an applicable law or regulations, as a condition of

retention in an established employment relationship, status, or rate of compensation.

The following expenses of education are Non-deductible: o (1) educational expenses that allow a taxpayer to meet the minimum

qualifications for a job or profession, and o (2) educational expenses that qualify taxpayer for a new trade or

business. In the case of an employee, a change of duties does not constitute

a new trade or business if the new duties involve the same general type of work as is involved in the individual’s present employment

Exampleso A, self-employed individual practicing a profession other than law (ex.

engineering, accounting) attends law school at night and after completing his studies receives a bachelor of laws degree. The expenditures made by A in attending law school are nondeductible bc it qualifies him for a new trade or business

o Same as above except that A is an employee, and his employer requires him to get a bachelor of laws degree and A intends to continue practicing his nonlegal profession as an employee. Nevertheless, the expenditures made by A in attending law school are not deductible since this qualifies him for a new trade or business.

o B, a general practitioner of medicine, takes a 2-week course reviewing new developments in several specialized fields of medicine. B’s expenses for the course are deductible because it maintains or improves skills required by him in his trade or business and doesn’t qualify him for new trade or business.

Caseso Namrow v. Commissioner (p.584)

Psychiatrists paid for extensive training program in order to qualify for specialized psychoanalytic treatment

"all of the activities for which the fees were paid were parts of a course of training which, in the opinion of psychiatrists generally, is needed to qualify a psychiatrist to engage in a certain type of psychiatric practice; these activities do not lose their quality as training techniques because they were similar to those used by qualified practitioners

large body of medical opinion, existence of institutes and societies and the organization of American Psychoanalytic Assoc. ....support the view that psychoanalysis is a specialty

NOTE: after this case, IRS wound up changing its position on psychiatric specialization training and added an example to the regulations to demonstrate their qualification for deduction

o Allemeier v. Commissioner (p.590) Salesperson enrolled in MBA program after 3 years of employment;

employer encouraged it but didn’t require the MBA Ct found the education was helpful but not necessary as entry

qualification and the basic nature of his duties didn’t change, so its deductible

t/p avoided both disqualifies- not an entry level position requirement or a new field

Commonsense Approach: requires comparison between the types of activities the t/p was qualified to perform before acquiring a particular title or degree with those that he was qualified to perform afterwards; if the activities are significantly different, then the educational expenses are deductible. OBJECTIVE test.

whether education qualifies t/p for a new trade/business depends upon the tasks and activities he was qualified to perform before the education and those that he was qualified to perform after

--> t/p's business after enrolling in MBA did not significantly change, involved the same general activities- involving sales, marketing, and management

o Problems p.590 lawyer takes estate planning update course, to meet mandatory

CLE requirements under state bar lawyer takes same estate planning course to improve his

knowledge in the area (no mandatory CLE requirement or CLE requirement has already been met)

5th grade teacher takes 2 courses toward masters in elementary education during summer; state teacher-cert requires work toward degree within 5 year period, but doesnt impose requirement that the courses be taken this year...

5th gd teacher takes last semester needed for bachelors, after being provisionally certified for last 10 months... provision cert would expire in 1 year unless teacher finishes bachelors degree

(d)- tp would probably be denied the deduction by IRS (e) lawyer taking course toward LLM degree in tax

some cases win others lose, in general IRS has been able to deny the deduction for those who go straight to LLM program, because they are not in the existing business of practicing law; if instead after law school and while employed, the lawyer takes night courses in tax as LLM then they may be deductible because they are in the existing business of practicing law

(f) lawyer takes accounting course to improve skills understanding financial information

(g) journalist attends law school, not to be an attorney, but to be a better legal journalist

clearly qualifying for a new field (ex. legal journalism), but certainly qualifying to do a whole bunch of things that you wouldn’t be qualified for without the JD degree --> denied

(h) sets up Allemeier case

Work Related Clothing General rule: the cost of clothing that is ‘adaptable for general use’ is

nondeductible as a personal expense. Subject to the 2% floor of §67(a). Tests

o Three Prong Test (Pevsner test) (1) Clothing must be required as a condition of employment (2) Clothing must not be suitable for general wear

no reference is made to the individual t/pers lifestyle or personal taste; instead adaptability for personal or general

use depends upon what is generally accepted for ordinary street wear

(3) clothing must not be so worno Generally, this is an objective test rather than a subjective test of whether

the taxpayer would purchase and wear the clothing but for the job requirements.

The cost of a uniform required by an employer or as a result of occupational requirements is generally deductible expense, but only if the uniform is of a type not suitable for general use.

Pevsner v. Comm’r (p.595)o Facts: woman worked at YSL and was required to buy their clothing. Tried

to deduct it as a business expenseo Taxpayer loses because although she doesn’t wear YSL clothes outside of

her job, they are suitable for general wear Why isn’t this a good rule?

o In Revenue Ruling 70-474 the IRS ruled deductible the uniform acquisition and maintenance costs for police officers, firemen, letter carriers, nurses, bus drives and railway men “required to wear distinctive types of uniforms while at work … Which are not suitable for ordinary wear.

o In Revenue Ruling 67-115 the cost of required military fatigue uniforms, the off-duty wearing of which was prohibited, was held deductible.

o NOTE: It is not enough that you wear distinctive clothing. The clothing must be specifically required by your employer. Nor is it enough that you do not, in fact, wear your work clothes away from work. The clothing must not be suitable for taking the place of your regular clothing.

§274 - Meals and Entertainment operates as a limitation on §162(a) and some of §212; it doesn’t authorize

any deductions but limits/conditions/prohibits certain deductions that those would otherwise permit

General Ruleo if an activity is ‘of a type generally considered to constitute

entertainment, amusement or recreation,’ its expense may be deducted only if (1) the activity is directly related to the t/p’s business, or (2) the activity is ‘associated with’ the conduct of the t/p’s business and it immediately precedes or follows a ‘substantial business discussion’.

Directly related= only if the entertainment is of a sort conducive to a business discussion (ex. hospitality room at a convention); so if not conducive to business because too loud or because no talking allowed then it is not directly related

Ex. basketball game or opera performance qualifies for deduction only if there was substantial biz discussion before or after the entertainment

Meal expenses: include food and beverages, including tips Entertainment expenses are for amusement, recreation, or

entertainment such as expenses of entertaining at nightclubs, theaters, sporting events, golf, and similar activities.

50% Cutback:

o §274(n): can only deduct 50% of the amount of such expense or item Requirements

o “ordinary and necessary” – must still meet the ordinary and necessary test under §162(a)

o certain expenses nondeductible expenses associated with facilities for entertainment (dues) aren’t;

like property owned or rented by a t/p (ex. yacht, hunting lodge, hotel suite); nor dues for social clubs §274(a)(3).

For meals- any amount that is ‘lavish’ or ‘extravagant’ or is incurred while the t/p is not present is nondeductible. §274(k)

For tickets- only face value is deductible §274(1)(1).o Substantiation Requirements §274(d)

Other Deductions §163 Interest Expense Deductionºº

o Section 163(a) allows a taxpayer to deduct ‘all interest paid or incurred within the taxable year on indebtedness.’ While §163(h)(1) disallows any deduction for personal interest, the definition of personal interest specifically excludes interest attributable to carrying on a trade or business. Thus, business interest is fully deductible.

§164 State and Local Tax Deductionsººo §164(a) allows a deduction for certain taxes paid or accrued during the

taxable year regardless of whether the taxpayer is carrying on a trade or business.

Deductible taxes: include state, local, and foreign real property and income taxes, and state and local personal property taxes. §164(a).

Foreign tax credit: Instead of deducting foreign taxes paid, a taxpayer may choose to claim a tax credit for certain eligible foreign taxes paid or accrued. §901(a)

§165 Losseso §165(c)(1) allows a deduction for losses incurred in a trade or business.

Losses can include a net loss from business operations, casualty losses, or theft losses. However, if the taxpayer is not economically at risk for the activity or does not materially participate in it, the loss may be limited by the at-risk rules or passive activity rules.

§166 Business Bad Debtso §166(a) allows a deduction for the portion of any debt that becomes

worthless during the taxable year in the amount of the adjusted basis of the debt to the taxpayer.

Charitable Contributiono Subject to limitations

Deductions for Capital Expenditures §263 disallows any deduction for capital expenditures, generally defined as

“permanent improvements or betterments made to increase the value of any property or estate.”

o Thus, if expenditure is a capital expenditure, the amount is capitalized and is added to the basis of the asset; the t/p may recover this capital

investment at some time during ownership of the asset- in the form of a deduction for depreciation or amortization, or otherwise upon disposition of the asset (t/p can take the basis into account to determine gain or loss on sale)

o Matching Principle Appropriate capital recovery is said to match income and the

expenses incurred to produce that incomeo Depreciable assets

Only tangible assets, used in a trade or business, that are subject to exhaustion, wear and tear, or obsolescence are eligible for depreciation. §§167(a); 168(a).

Ex. buildings, equipment, and certain intangibles like goodwill. Fine art and collectibles may not be depreciable. Raw land is not depreciable.

Definition—Capital expenditureo Acquiring Assets: Regs give examples including the costs of assets such

as buildings, machinery and equipment, furniture and fixtures, and “similar property having a useful life substantially beyond the taxable year.” Regs. §1.263-2(a).

Separate asset test – Comm’r v. Lincoln Savings: held that when a separate and distinct asset is created, the amounts expended in doing so are capital expenditures

Exploring a new venture: expenses of researching, investigating, and considering acquiring a new venture are capital expenditures.

Which expenses must be capitalized? A corp producing long-lived assets for sale (inventory) can choose to either buy or make them; if it buys them the costs of purchases are cap expenditures... under §263A UNICAP rules, the corps that make them must include the cost of salaries, wages, and administrative expenses in the cost of inventory that is capitalized

o Future Benefits Test— If an expenditure creates a more-than-insignificant future benefit to the taxpayer, the expenditure is a capital asset, even if no separate asset is created.

Indopco, Inc. v. Comm’r: Unilever sought to acquire corp in friendly takeover and

incurred investment bank and legal expenses in connection with the takeover.

Here, the benefits motivating the acquisition were to last many years; thus produced significant future benefit and = cap expenditures

In practice, the IRS limits the application of this test, allowing deduction for advertising, severance pay and employee training costs.

o Deductible repairs: Regs. say that the “cost of incidental repairs which neither

materially add to the value of the property nor appreciably prolong its life” is deductible as a repair

Ex. Repair necessary for ongoing operations Repairing Damage to Reputation

Welch v. Helvering: former employee of bankrupt corp voluntarily paid some of the company’s unpaid debts and deducted as §162 expenses in order to restore his reputation;

Ct said these are nondeductible as ordinary expenses, and are properly capitalized as expenditures to restore reputation.

Jenkins v. Comm’r: country singer was allowed to deduct payments to losing investors in a failed burger joint venture to protect his rep as a country singer.

So, results are fact-specific and may turn on whether a reputation is destroyed (welch) or only damaged and in need of repair (Jenkins)

o Education for new trade or business: Education undertaken to improve skills in a current job are

potentially deductible (Coughlin v. Comm’r). However, education that qualifies a t/p for a new job or profession is

a nondeductible capital expenditure. Reg. §1.162-5. Capital Recovery

o Unlike an ordinary business expense, a capital expenditure does not generate a deduction for the t/p in the year the expenditure is made, but will almost always be allowed to ‘recover’ the capital invested at some point

This means t/p will be able to offset income by deducting a portion of the capital invested in the asset, either during ownership of the asset or upon disposition

o Timing Matter for Congress to decide Three options:

Capital recovery first t/p may be allowed to recover capital investment

before reporting any income (ex. §179) Capital recovery during ownership

t/p may be allowed to recover cap investment on some schedule, apportioning recovery over his ownership of the asset. (ex. used to recover investment in tangible property-depreciation; or intangible property-amortization)

Capital recovery last t/p may be required to defer cap recovery until the end

of his ownership of the asset (ex. used for non-depreciable property like raw land)

o Relationship to Basis When the taxpayer claims capital recovery deductions, the basis of

the asset (representing cost) is reduced by the amount of the capital recovery claimed

MACRS deduction for tangible business assetso MACRS is the method by which t/pers claim capital recovery for tangible

assets used in a trade or business or held for the production of incomeo Two functions:

The MACRS deduction is a deduction from gross income in computing AGI §167(a)

The amount of the MACRS deduction reduces the basis of the asset. §1016(a)(2)

o Calculation of MACRS

The MACRS deduction is calculated by applying the applicable recovery method to the basis of the asset over the applicable recovery period, taking into account applicable conventions.

Basis Recovery Period §168(c)

Residential real property—27.5 years Nonresidential real property—39 years Other property—can be a 3-year, 5-year, 7-year, 10-year, 15-

year, or 20-year property Conventions

The applicable convention expresses the beginning date for capital recover which begins when the property is placed in service

Midmonth convention: t/pers are deemed to have made the purchase/sale of real property on the 15th day of the month in which the transaction occurs. §168(d)(4)(B).

Half-year convention: for tangible property other than real property, the purchase/sale is deemed to be made at the middle of the t/pers taxable year regardless of when it actually occurs. §168(d)(4)(A).

Recovery Methods Straight Line Accelerated Methods

Depreciation - §167 §167(a) General rule—There shall be allowed as a depreciation deduction a

reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)

Accelerated Cost Recovery System - §168 §168(a) General rule—Except as otherwise provided in this section, the

depreciation deduction provided by section 167(a) for any tangible property shall be determined by using—

o (1) the applicable depreciation method,o (2) the applicable recovery period, ando (3) the applicable convention.

§168(b) Applicable depreciation method—For purposes of this sectiono (1) Except as provided in paragraphs (2) and (3), the applicable

depreciation method is—(A) the 200 percent declining balance method, (B) switching to the straight line method for the 1st taxable year

Net Operating Loss Deduction - §172Election to Expense Certain Depreciable Business Assets - §179

§212 – Expenses for Production of Income §212. In the case of an individual, there shall be allowed as a deduction all

the ordinary and necessary expenses paid or incurred during the taxable year—

o (1) for the production or collection of income;

o (2) for the management, conservation, or maintenance of property held for the production of income; or

o (3) in connection with the determination, collection, or refund of any tax. §212 allows deductions for the ordinary and necessary expenses paid or

incurred during a taxable year for producing that income or for the management or maintenance of property

Investment Activitieso No matter how extensive a t/pers investments may be, this activity does

not rise to the level of a trade or business. o May deduct the non-capitalized costs of such activity (fees, subscriptions

to investment journals, office expenses, etc) from gross income, subject to the 2% floor of §67.

Note, this is mostly disallowed for AMT purposes Ex. C has extensive investment portfolio, spends several hours a

day researching stocks and bonds and making trades for his account. He incurs the following expenses in connection with that activity: $5k for subscriptions to investment publications; $3k for attendance at investment conferences; $500 safety deposit box fees; $10k commissions paid on purchases of stock. His AGI is $100k and these are his only miscellaneous deductions.

C may not deduct commissions because they are a capital expenditure (they are added to the basis of stock purchased or sold); of the other $8,500, he may deduct only the amount that exceeds 2% of AGI ($2,000) so $6,500 is deductible as a miscellaneous itemized deduction on Schedule A (but also consider AMT)

o Investment interest Interest incurred to purchase investments is deductible to the

extent of investment income §163(d); the remaining nondeductible amount of interest can carryforward

Investment income is income from dividends, interest, and certain other investments

o Investment losses §165(c)(2) allows a deduction for losses incurred in an activity

engaged in for profit, but that doesn’t rise to level of trade or business. Ex., theft losses that occur in connection with an investment are deductible.

Rental Real Estateo A t/per with real or personal property for rent is entitled to deduct the

costs of that property, including fees, taxes, interest, repairs, and capital recovery deductions.

o These expenses aren’t subject to the 2% AGI flooro Passive loss rules: the passive loss rules prevent most from deducting a

loss (expenses in excess of income) attributable to any rental activity

Hobby Losses - §183 (p.576) General Rule

o Under §183, a taxpayer engaged in an activity without a profit motive may only deduct certain expenses associated with that activity. These expenses are:

(1) Those that are deductible without regard to a profit motive §163 personal residence interest; §164 local taxes; §165

casualty losses (2) Expenses from profit seeking purposes in an amount (if any)

equal to the gross income from the activity after it has been reduced by the expenses in (1)

§162 business expense deductions; §§167-68 depreciation of real or personal property

o Breakdown of §183 Rule Begins with 183(a) provision that claims to eliminate all deductions

otherwise available in the case of an activity that is not engaged in for profit...

183(b) restores deductibility for two categories of deductions: 1st- items that do not depend on any business or profit-

seeking purpose ex. state and local property taxes are generally

deductible, even when assessed against property that isn’t held for business/investment purpose

basically, such taxes do not become nondeductible just because they are used in an activity that’s not for profit

2nd- those deductions that do depend on a profit-seeking purpose

CAP: these may be deducted under §183(b)(2), but only to the extent that they do not exceed the income from the activity, after that income has been reduced by the amount of any deductions claimed under (b)(1)

ex. deduction for ordinary and necessary business expenses under 162(a); depreciation of real or personal property under §167 and 168

Note: 183 is best viewed as a deduction-creating provision rather than -limiting... 162 authorizes business-expense deductions only for t/p with profit motives; were it not for 183(b)(2) there would be no authority for any business-related deductions in the context of an activity not engaged in for profit

no cap on business expenses...; (b)(2) are cappedo If engaged in an activity without a profit motive may only deduct....

Computation: Start with gross income from the activity, deduct those

deductions otherwise allowable without regard to his profit motive. Other deductions (that would be allowable if he had profit motive) may be deducted only to the extent of the excess amount of gross income from the activity

Requirements:o Activity Not Engaged in For Profit:

Must have entered into the activity or continued the activity with the objective of making a profit; not required to have reasonable expectation of profit

Determined by totality of objective factors, such as: (1) Manner in which the t/p carries on the activity

businesslike? With complete and accurate books? (2) The expertise of the t/p or his advisors

extensive study in preparation for the activity? (3) The time and effort expended by the t/p in carrying on the

activity withdrawal from another occupation to devote time

and energies to the activity? Limited time devoted but employs competent and qualified persons? Devotes much of personal time and effort?

(4) Expectation that assets used in the activity may appreciate in value

(5) The success of the t/p in carrying on other similar or dissimilar activities

(6) The t/p’s history of income or losses with respect to the activity

non-customary losses continue to be sustained past start-up? Series of years with net income realized?

(7) The amount of occasional profits, if any, which are earned amount of profits in relation to amount of losses

incurred, and to the amount of t/p’s investment and value of assets are useful; opportunity to earn substantial profit in highly speculative venture is ok

(8) The financial status of the taxpayer t/p doesn’t have substantial income/capital from other

sources? (9) Elements of personal pleasure or recreation

Rationale Cases

o Keanini v. Comm’r (p.576) Dog Breeding + Grooming; Court finds that these are a single

business- so their profit possibilities should be considered on the basis of aggregating their grooming activities and their breeding activities.

Rule: a taxpayer must engage in an activity with the objective of making a profit in order to fully deduct expenses under either §§162 or 212; Do not need to establish that their expectation of profit was reasonable as long as they had an 'actual and honest objective of making a profit.'

Relation to §280Ao §280A imposes limits on deductions that apply to rental income from

buildings that are used as a residence by a t/p (generally meaning they are used by t/p and fam more than 14 days during year)

deductions for these rental activities cannot exceed the amount of income generated by them, less any deductions that might be available for interest, taxes, casualty losses, or other business deductions

o also applies to deductions for the use of part of a personal residence as a business facility, such as a studio/clinic/office that is located in the t/p’s home

§280A first disallows all deductions related to the use of dwelling unit in (a), then restores deductibility in (b) for expenses that would ordinarily be deductible regardless of business use (home mortgage interest and local prop taxes), and then restores deductibility in (c) for select business or profit-seeking uses of the property

§280A(c)(1) allows deductions relation to a portion of dwelling unit that is used exclusively and regularly for business, if one of three conditions are met:

(1) it is used as the principal place of business for any trade or business of the taxpayer

(2) it is a place of business routinely used by patients, clients, or customers

(3) It is located in a separate structure, such as a garage, which is not attached to the dwelling unit.

Further- if its an employees house, the use of the home office must be for the convenience of his employer.

STANDARD DEDUCTION

Standard Deduction Taxpayers can elect to deduct the standard deduction in lieu of itemized

deductions from AGI in calculating taxable income Standard deduction amount = $12,200 for married filing jointly

o =$6,100 for single or married filing separatelyo =$8,950 for head of household

PROPERTY TRANSACTIONS

Steps: Has there been a sale or other disposition of property?

o T/p has some property right and sold/exchanged/bartered it for something else (including foreclosure and use of property to satisfy debts)

o Not when pure gift or charitable contributions (unless part gift/part sale=bargain sale)

What is the amount of the realized and recognized gain or loss on the transaction?

What is the basis of the property received in the transaction? What is the character of the recognized gain or loss

Definitions Realized gain=

o the excess of the amount realized on a transaction over the adjusted basis in the property transferred. §1001(a)

Realized loss= o the excess of the t/p’s adjusted basis in the property transferred over the

amount realized on the transaction. §1001(a) Amount Realized=

o The total value that the t/p receives in the transaction in exchange for the property transferred; can receive cash, property, services, and the assumption of liabilities as part of the exchange. §1001(b); Reg. §§1.1001-1, -2.

Cash received: AR = amount of cash Property received: AR = FMV of the property received Services received: AR=FMV of services received Assumption of Liabilities: AR=includes amount of liability assumed

by buyero Amount realized = total value received (= FMV of the property

transferred) Adjusted Basis

o Initial Basis For property acquired by purchase = cost of the property §1012 For property received from decedent= FMV on date of death §1014 For property received by gift= donor’s basis in property §1015(a)

If at the time of gift the donor’s adjusted basis > FMV then for purposes of determining loss on sale by the donee, the donee’s basis is the FMV at the time of the gift

This prevents property holders from transferring built-in loss to another via gift

Ex. A owns property with basis of $50k and FMV of $20k when A gives it to B. B’s basis under general rule would be $50k (equal to A’s)- this is the basis used for determining gain. But, if B sells the property later for $10k , her basis would be $20k instead of $50k, and she would have a $10k loss.

Ex. If B sells it for any amount between $20k (its FMV when gifted) and $50k (A’s basis), she will realize neither gain nor loss on the sale, because the basis for determining gain would produce a loss and the basis for determining loss will produce a gain. §1.1015-1(a)(2)

Exchanged basis property: sometimes when t/p gives up property in exchange for other property, the basis of the prop received depends on the basis of the property transferred; this is exchanged basis property §7701(a)(44).

o Adjustments to Basis Must adjust initial basis in property during ownership to reflect

additional investment in it and capital recovery with respect to the property. §1016.

Improvements: Result in an increase in the basis of the property. §1016(a)

Capitalized Interest and taxes: t/p may elect to capitalize rather than deduct otherwise

deductible interest and taxes on property used in business or held for investment. §266. If so, the interest and taxes attributable to the property are added to the basis.

Capital Recovery Deductions: When a t/p claims a deduction for capital recovery (MACRS or

amortization), they must adjust the basis downward by the amount of the deduction claimed.

Recognitiono Recognition of gain or loss means that t/p includes the gain in gross

income or may claim the loss as a deduction. §1001(c) requires that all realized gains and losses are recognized unless another provision says otherwise.

Tax-deferred transactions Gain exclusion (§121 exclude gain from sale of principal residence) Loss restriction (§1223 may deduct capital loss only to the extent of

capital gain, plus $3,000 of ordinary income) also (§165(c) may deduct only certain types of losses, like losses on the sale of assets held for investment but not on the sale of ones home)

Bargain Sale: if part gift/part sale transaction, the transferor will realize a gain in amount by which his amount realized exceeds the adjusted basis of the property transferred; but may not recognize a loss on the transaction even if the amount realized is less than adjusted basis.

§1001 §1001(a) states that a taxpayer realizes gain or loss on the ‘sale or

other disposition of property.’ §1001(a) is the most fundamental realization provision

o This rule invites taxpayer manipulation If a taxpayer wants to dispose of appreciated property but doesn’t

want to realize any gains (which would require them to pay tax on the gain), the game is to find a way to accomplish the economic equivalent of a sale without triggering § 1001(a)

If a taxpayer wants to retain depreciated property that he wants to deduct losses on, but wants to keep the property, the game is to find a way to sell the property (technically), while retaining the economic equivalent of ownership

o Realized gain- equal to the excess of the amount realized on the transaction over the t/p’s adjusted basis in the property transferred. Realized loss- equal to the t/p’s adjusted basis in the property minus the amount realized on the transaction.

o Recognized gain or loss means the amount ends up on a t/p’s tax return as income or a deduction

Recall: t/p must include in gross income gain from dispositions of property [exception for ex. §121 exclude gain from sale of a principal residence]; t/p’s who receive less in a sale than their investment in the property may be entitled to claim a deduction for the loss.

Material Difference Standardo Reg. §1.1001-1(a): An exchange of your asset for another asset will

qualify as a realization event so long as the exchanged assets differ materially either in kind or in extent

This is how you can accomplish a sale or other disposition for tax purposes, while retaining the substance of ownership

o § 1001(c) – withholds recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if the property exchanged is of like kind

o Cottage Saving Assoc. (p.266) Ct said that banks’ exchange of mortgage portfolios was a

realization event because it resulted in each having different legal interests

RULE: realization principle incorporates a material difference requirement: specifically, the exchange must result in t/p having different legal interests than they had before the transaction

§1091 – Wash Sale Rule under §1091, if a t/p realizes a loss on the sale of stock, no loss deduction is

allowed if the t/p purchases “substantially identical” stock “within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date.”

The disallowed loss is preserved in the new stock, under the special basis rules of §1091(d)

NOTE ALSO: §267(a)(1) disallows any loss deduction on a sale or exchange of property between certain related parties, including a parent and child.

§1211 Limitation on Capital Losses Stocks are capital assets (under §1221), and under §1211(b) you may deduct

capital losses only against capital gains, and $3,000 of non-capital gain income; the capital losses may be carried forward under §1212(b) to offset capital gains +$3k in later years

Policy

o Addresses concern that t/p may engage in ‘cherry picking’ – selectively realizing losses in their investment portfolios while deliberately not realizing gains

NONRECOGNITION TRANSACTIONS Nonrecognition transactions are those where gain or loss is realized by the

t/p but will not be recognized for tax purposes. (p.275) o §1031 generally, allows you to defer taxation of gains on property that is

exchanged for other property that is of ‘like kind’ with the transferred property

o §1033 allows you to defer taxation of gains on property that has been ‘involuntarily converted’ as by condemnation or physical destruction, if the proceeds of the involuntary conversion have been reinvested in other similar property

o §121 allows you to avoid taxation under certain conditions, of up to $250k of gain on the sale of personal residence ($500k if married)

Rationaleo Reason for allowing deferral of reckoning of gains and losses is that t/p

has maintained a substantially continuous investment only slightly altered in form

Electivityo Generally, it is beneficial to defer income but to accelerate losses- thus t/p

typically want to defer recognition of gain but not of losses The Role of Basis

o Nonrecognition is not intended to forgive taxation of gain forever... preservation of gain or loss for future taxability is a function of the basis account maintained for each asset (idea is to maintain a historical basis in one or more of the new assets, so that any differences between that basis and the FMV of that asset will preserve the opportunity to recognize gain/loss when the asset is sold or disposed of.

§1031 Like-Kind Exchanges Policy

o No change in investmento Liquidityo Fighting ‘lock in’ effect (t/p avoiding sale of property to avoid paying tax)

General Ruleo A t/p in a like-kind exchange transaction recognizes neither gain nor loss

on the transfer of property in the exchange, and takes the property received with an exchanged basis.

Requirementso Exchange

Must exchange property for propertyo Not prohibited property

Cant be inventory, stocks, bonds, notes, securities or other evidences of indebtedness, partnership interests, interests in a trust, or chooses in action. §1031(a)(2).

o Use of Property Transferred

The t/p must have held the relinquished property for use in a trade or business or for investment. §1031(a)(1).

o Like-Kind Properties: The replacement property must be like-kind to the property

exchangedo Use of Property Received

The taxpayer must intend to hold the replacement property for use in a trade or business or for investment

Tax Consequenceso Mandatory rule: if a transaction qualifies as a like-kind exchange, the t/p

recognizes neither gain nor losso Wont recognize gain or loss on the transfer unless he receives BOOT

which is any nonlike-kind property If boot received, realized gain on the relinquished property is

recognize to the extent of the FMV of the boot received. §1031(b) [realized gain is recognized in an amount equal to the lesser of the realized gain or the FMV of the boot received]

Receiving boot triggers recognition because it represents a partial sale of the property (treated as having sold part of original property for purposes of gain recognition)

o Loss is never recognized in a §1031 exchange, even when boot is received §1031(c)

Basis Calculation

oo Like-kind Property:

Basis in the like-kind replacement property is = to the basis of relinquished property, plus the gain recognized, minus the FMV of the boot received, minus any loss recognized on the transaction, plus any additional amount invested in the property acquired.

o Boot: The basis in any boot received is its FMV

o Loss taken into account in basis calculation If the t/p transfers property to the other party that has an adjusted

basis greater than its FMV, and the t/p recognizes a loss on the transfer

Ex. K has property 1 with FMV 90k, AB 50k and wants to transfer in like-kind exchange for S’s property 2 with FMV 100k. Therefore, K

adds a painting with FMV 10k (to =100k) and AB=15k, which means that she will recognize a 5k loss on transfer.

In computing her basis in Property #2, Kay will begin with her basis in Property #1 ($50,000) and the boot she paid ($15,000), add the gain recognized (0), subtract the fair market value of boot received (0), subtract the loss recognized ($5,000), and add the boot paid (0) since she has already taken into account the painting in step 1). Thus, her basis in Property #2 will be $60,000. Another way to think about this problem is to imagine that Kay sold the painting to someone else for

Like- Kind Requiremento refers to the 'nature and character' of the property and not to its 'grade or

quality' may qualify for ex. exchange of city real estate for a ranch/farm;

improved real estate for unimproved; fee interests for long-term leaseholds at least 30yrs

o tangible personal property may qualify if they are in the same 'asset class' ex. cars for cars, light trucks for light trucks, heavy trucks for heavy

trucks; but not truck for buso Intangible and nondepreciable personal property, and personal property

held for investment, must satisfy more general like-kind test; stricter than for real property

Ex. gold bullion coin exchanged for silver bullion coin was no like kind because intrinsically different metals used in different ways. Rev. Rul. 79-143

o Real Property Regs say that exchange of real property for real property qualifies

as like kind, regardless of the property’s status as improved or unimproved- as like-kind relates only to the quality of the real property, not its nature or character

Deferred and Three-Party Starker Exchangeso See Class Notes (yellow)

§1033 Involuntary Conversions See Class Notes (green)

IDENTIFYING THE TAXPAYER

Assignment of Income Progressive Tax Rates

o The progressive rate structure creates incentive in tax savings to taxpayers in shifting income from higher-bracket to lower-bracket taxpayers

o Especially with family members, who consider themselves in the same economic unit, they will be indifferent as to who actually receives the income and instead will minimize taxes paid overall.

o The joint return effectively taxes a husband and wife on their ‘group’ income, so that income-shifting between them is pointless.

Rule: Income is Taxed to the Taxpayer who controls the earning of the income

o Lucas v. Earl (p.767) Whether the taxpayer assigns his right to income for services

before performing the services or after performing the services (Helvering v. Eubank) the taxpayer, and not the assignee, is taxed on the income when it is paid.

Rule 2: Income from property is taxed to the one who owns the property and thus controls the income generated by the property.

o Helvering v. Horst Dad gave the interest coupons (detached from a bond he owned) to

his son shortly before the interest was due; son later collected the interest payments.

SCOTUS held that the taxpayer father, not the son was taxable on the interest.

Community Propertyo Under community property laws, earnings during marriage are deemed

the property of the husband-wife community and not the property of the spouse performing the services generating the earnings

o Poe v. Seaborn SCOTUS eld that the under the states comm prop laws, each spouse

was taxable on half of his own earnings and half of spouses earnings

Congress responded to Poe v. Seaborn by authorizing joint returns in 1948

Personal Exemption and Dependent Exemption 2013 Exemption amount (deduction) = $3,900 Personal Exemptions Dependent Exemptions Phaseout of Exemptions

o You must reduce the dollar amount of your exemptions by 2% for each $2,500 or part of $2,500 that your AGI exceeds the set amount (up to $122,500 at which point the amount of your deduction for exemptions is reduced to 0)

Married file separately - $150,000 Single - $250,000 Head of Household - $275,000 Married Filing Jointly - $300,000

CAPITAL VS. ORDINARY INCOME AND LOSS

Preferential Tax Rates for Capital GainLimitations on Deduction of Capital Loss

§1211 imposes significant restrictions n the deduction of capital losses for individuals-

o may deduct capital losses only to the extent of the capital gains for that year, plus the lower of $3,000 OR the excess of capital losses over capital gains. §1211(b)

o losses that cannot be claimed because of this limitation are called net capital losses and carry forward (not back) indefinitely.

in each succeeding year, the taxpayer is deemed to have a capital gain equal to the lesser of (1) $3,000 or the excess of losses over gains, whichever is lower, or (2) the taxpayers Adjusted Taxable Income. §1212(b)(2)(A)

Adjusted Taxable Income = taxable income increased by the lower of $3,000 or the excess of cap loss over cap gain plus personal exemption

Definitionso Ordinary income: any gain from the sale or exchange of property that is

neither a capital asset nor §1231 property. §64o Ordinary loss: loss from the sale or exchange of property that is not a

capital asset. §65o Capital Asset: any property held by the taxpayer (whether or not

connected with trade or business) except for eight categories of property. §1221

o Capital Gain net income: the excess of gains from sales or exchanges of capital assets over losses from such assets

o Net capital gain: the excess of net long-term capital gain for the taxable year over net short-term capital loss for that year

o Net capital loss: the excess of losses from the sale or exchange of capital assets over the amount allowable as a deduction under §1211

o Section 1231 gain or loss: net gain or loss from certain kinds of property used in the taxpayer’s trade or business (§1231 assets)

Capital Asset —definition:o Excludes

Inventory/stock in trade Real and depreciable property (aka §1231 property) Creative works Accounts/notes receivable Supplies used in a business

o “related to” the trade or business Corn Products Arkansas Best