Federal Income Tax - Brown

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Federal Income Tax Outline

Professor Brown

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I. OVERVIEW & BASIC PRINCIPLES

1. Overview
a. Study & Practice of Law
i. Three Sections of Federal Income Tax:
1. Income;
2. Deductions; and
3. The merging of the two.
b. Brief History
i. Federal Income Tax is outlined in USC, Title 26.
1. The most recent edition is 1986.
2. The Tax Code is a revenue maker and a means used to curb or
encourage certain behaviors.
ii. Amendment Sixteen set the groundwork for Congress to impose a federal income
tax.
1. The Amendment trumped the Apportionment Clause in Article 1, 8 & 9
because it would be impossible to impose.
2. Article 1, 8 gives Congress the power to levy taxes.
3. Courts consistently reject DPC and EPC taxpayer arguments
iii. Reagan is responsible for dropping the tax rates. Clinton raised the tax rates.
Currently, Bush is attempting to lower the tax rates again.
c. Tax Policy
i. This countrys federal income tax system is based upon Schanz-Haig-Simons. It
takes into account both wealth and personal consumption.
1. Individuals Income for a Year = Net increase in wealth plus the market
value of consumption for personal purposes during the year, measured at
year-end.
a. Arrived at indirectly by measuring: Current-year receipts minus
business and investment deductions plus the increase in wealth
or less the decrease in wealth.
ii. The Federal Income Tax is progressive, not proportionate (flat tax).
1. Taxpayers in higher marginal brackets benefit less from additional income
than taxpayers in lower marginal brackets, while taxpayers in higher
marginal tax brackets benefit more from deductions than taxpayers in
lower brackets.
2. FICA is a flat tax.
iii. This country generally has a time-based system of reporting, not a transactionbased system of reporting. An exception is gains and losses derived from
dealings in property.
iv. Higher Tax Rates versus Lower Tax Rates:
1. Lower Rates (Conservatives)
a. Lower rates result in more efficiency.
i. Eg. Purchasing machinery and investing.
b. Favor a Consumption Tax.
i. An individual is only taxed on personal consumption;
thus, the burden of a consumption tax falls hardest upon

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wage earners in part because they are not entitled to


certain business-related deductions.
1. Eg. If an individual has income that is invested in
machinery, it will not be taxed. However, if that
individual is a worker, with no business
expenditures, he will be taxed because he is
consuming his wages.
2. Higher Rates (Liberals)
a. Higher rates result in more equity.
i. Standard of Living Principle and Ability to Pay Principle.
ii. Utilitarianism is the philosophical tradition that postulates
that policy should be directed toward increasing
aggregate well-being (toward achieving the greatest
happiness for the greatest number of people).
iii. Eg. Poor people should pay less because of utility and
marginal utility.
b. Favor an Income Tax.
i. An income tax is based on income.
ii. This is our countrys system; however, this country is
moving towards a consumption tax.
v. Bush Policy:
1. Rates are being lowered in all respects that help the wealthy, including
business, investors, and high-income individuals. However, Bush portrays
the package as assisting low-income individuals.
2. At the same time that wage earners are more heavily taxed, the wealthiest
1% of individual taxpayers are seeing significant gains.
d. Methods of Accounting: Cash versus Accrual
i. Cash. Actual receipt or payment of cash, and that is when reported.
ii. Accrual. Legal right to receive or legal obligation to pay, and that is when reported.
2. Basic Principles
a. Gross Income
i. Three major terms that are determinative of tax base:
1. GI;
2. AGI; and
3. TI.
a. Follow these three steps along each problem.
b. SHS revisited: This is conceptually determinative of what is
included in the tax base.
i. Individuals Income for a Year = Net increase in wealth
plus the market value of consumption for personal
purposes during the year, measured at year-end.
1. The pressure is determining what is considered
consumption for personal purposes, because
business is excluded from the base.
ii. 61(a). Gross income defined (all income from whatever source derived, included
but not limited to).

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iii. 62(a). Adjusted gross income defined (GI minus the following deductions).
1. The deductions listed under 62 are above-the-line deductions. Thus, an
individual takes these deductions to get to AGI, and may take their
personal exemption and either the standardized deduction or itemized
deductions in addition to these above-the-line deductions.
iv. 151. Personal exemption defined.
1. (d). Personal exemption amount. (c). Dependents defined.
2. Allowance for living to meet the most basic needs.
v. 63(c). Standard deduction defined.
1. Allowance for living to meet the most basic needs.
vi. 63(a). Taxable income defined (GI minus the deductions allowed by this chapter
(other than the standard deduction)).
1. 63. Determines what is deducted from GI to get to taxable income.
2. TI is the tax base and the tax base is what is subject to taxation.
3. Tax Liability is what each individuals owes after their tax is determined.
vii. Problem 1.1.
1. Jorge (S)(No dependents)
a. Salary = 50,000
b. Dividend Income = 500
c. GI = 50,500
d. AGI = 50,500
e. TI = 50,500 - 500 (dividends) - 4,750 (standard) - 3,050 (personal)
= 42,200
f. TL = 500*15% + 3,910 + (25%*(42,200 - 28,400) = 7,345
b. Earned Income Credit
i. 32. Money is transferred back to taxpayers whose income is below a certain level
(transfer payment). Refundable credit, so a taxpayer does not have to pay this
amount back to the IRS.
1. 32(c). In order to qualify for this section, the taxpayer must be at least 25
and not over 65. This section also defines qualifying children.
ii. Problem 1.2(a).
1. Natasha (HH)(3 dependents)
a. Salary = 15,000
b. Standard = 7,000
c. Personal (x4) = 12,200
d. TI = Negative
2. Analysis.
a. (b)(1)(A): Get credit percentage by # of children.
i. 40%
b. (b)(2)(A): Get earned income amount by # of children.
i. 10,510
c. Credit percentage * earned income amount = maximum earned
income credit.
i. 40%*10,510 = 4,204
d. Limitation under (a)(2) (but see handout): Depending on amount
of children, once earned income (earned income defined in (c))

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hits a certain threshold amount, a phaseout begins, and if earned


income hits complete amount, an earned income credit is not
permitted.
i. Threshold Phaseout Amount = 13,730
ii. Complete Phaseout Amount = 33,692
1. 15,000 13,730 = 1,270
2. Pursuant (b)(1)(A), that amount time phaseout
percentage.
a. 1,270*21.06% = 267.
e. 4,204 267 = 3,937 amount of earned income credit refund.
iii. Problem 1.2(b).
1. Henry (HH)(3 dependents)
a. Salary = 16,000
b. Standard = 7,000
c. Personal (x4) = 12,200
d. TI = Negative.
2. Analysis.
a. Earned income credit starts at 4,204.
b. Phaseout:
i. 16,000 13,730 = 2,270
ii. 2,270*21.06% = 478
c. 4,204 478 = 3,276 amount of earned income credit refund.
iv. Problem 1.2(c).
1. Natasha and Henry marry.
a. Salary = 31,000
b. Standard = 9,500
c. Personal (x8) = 24,400
d. TI = Negative.
2. Example of another marriage penalty. If Congress made the earned
income credit more favorable for married people, they would have to tax
something else more heavily to make up for the loss of revenue.
a. Note: Under 32(d), if Natasha and Henry were married, they
cannot file separately just to get a more beneficial earned income
credit.
b. Congress is trying to mitigate this penalty under 24.
i. There is a 1,000/child tax credit. But unlike 32, the 24
credit is not refundable pursuant to There is a 1,000/child
tax credit. But unlike 32, the 24 credit is not refundable
pursuant to 24(d).
3. Analysis.
a. Earned income credit begins at 4,204.
b. Phaseout:
i. 31,000 14,730 = 16,270
ii. 16,720 * 21.06% = 3,426
c. 4,204 3,426 = 778 amount of earned income credit refund.
c. Rates & the Taxpaying Unit, Family-Related Allowances & Progressive Rates

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i. 1(a). Marital status is important because of the marriage penalty.


1. Once an individual gets over the 15% marginal rate, the tables have a
built-in penalty.
a. If single, head of household, or married and filing separately, an
individual can get more income in at a lower tax rate.
b. Exception: If one part of the couple is working and the other is not
working, there is an incentive built into the table.
i. Problem 1.3.
1. Condolezza (M)(No dependents)
2. Receipts = 200,000
3. Dividends = 10,000
4. Salaries Paid = 100,000
5. Office Rent = 20,000
6. Depreciation = 40,000
7. Keogh Plan = 10,000
a. Deferred compensation plans are
deducted to get to GI when they are
distributed.
8. Standard = 9,500
9. Personal (x2) = 6,100
10. GI = 200,000 + 10,000 = 210,000
11. AGI = 210,000 all business expenditures above
= 40,000
12. TI = 40,000 9,500 6,100 = 24,400
13. Remove 10,000 dividends, for 14,400 to plug into
tax table.
14. TL = 10,000*15% + tax rate answer = 2,960.
a. If Condolezza was single, her TL would
have been 4,465.
ii. 1(h). Net capital gains are pulled out from ordinary income before ordinary
income is plugged into a table, and then the net capital gains are taxed at a more
beneficial rate.
iii. 2(b). Head of household defined.
iv. 7703. State law dominates marriage law. If taxpayers are married on the last day
of the financial year, they are married for tax purposes.
v. Effective Rate versus Marginal Rate.
1. Marginal Rate is the rate an individual pays for each additional dollar of
income (the rate that an individual falls under in the tables).
2. Effective Rate is tax paid divided by taxable income.
II. OUTER LIMITS OF GROSS INCOME
1. Introduction
a. 61. States all income from whatever source derived should be included in GI.

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i. Thus, start with everything being included in GI (and tax base) and then determine
if may be excluded or deducted, etc. pursuant to 61s except as otherwise
provided
b. Glenshaw Glass (US 1955)
i. Rule. To be included in GI under 61, there must be three things:
1. Accession to wealth;
2. Clearly realized; and
3. Complete dominion.
ii. Importance. If not enumerated under 61, it must pass this three prong test to be
included in GI.
2. Windfalls & Property in Kind
a. Problem 2.1(a).
i. Winning new home on game show, or gambling winnings.
ii. Analysis.
1. Included in GI because passes Glenshaw Glass, and falls under 74, and
not 102 (thus falling under 61), because this is not a flat out gift,
because as a contestant some work had to be put in to get the house.
2. 74. Prizes and awards part of GI.
3. 102. Gifts are excluded from GI.
4. 1001. The amount of the winnings is the AB so the taxpayer is not taxed
twice.
5. Policy. Horizontal equity (similarly situated people should be treated the
same).
b. Problem 2.1(b).
i. Tanyas employer transfers to her title to land in exchange for services rendered.
ii. Analysis.
1. 61(a). Treated as compensation for services and FMV included in GI.
2. Policy. Horizontal equity.
c. Problem 2.1(c).
i. Finds a new handbag worth $500.
ii. Analysis.
1. Included in GI because Glenshaw Glass.
2. 1.61-14. Treasure trove constitutes GI when undisputed possession.
3. Note. If a taxpayer does not step forward and report, this is practically
impossible for the IRS to track.
3. Realization of Income
a. Problem 2.1(f).
i. Martha leases land. Tenant improves by adding a building in 2003 with AB of
500,000. In 2028, transfers back to Martha, and the FMV of the building is
550,000. Marthas AB in the land is 100,000. She sells later for 700,000 (100,000
allocated to land).
ii. Analysis.
1. 109. Overruled Bruun. The value of the improvement not included in GI
upon reversion. Thus, exclusionary section.

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a. Policy for 109. If Martha taxpayers had to include improvements


in GI upon reversion, they would have to sell the property to pay
the tax and do not want to impede these transactions.
i. Thus, 109 is a great benefit to property owners because
it almost acts as a tax shelter.
b. 1.61(8)(c). If the improvement was in lieu of rent, it would have
been included in Marthas GI.
2. 1019. No adjustment to AB either due to improvements.
3. 1011 & 1012. Thus, when Martha sells, she will recognize a 600,000
gain.
4. Blatt (US 1938)
a. Rule. Landlords do not include improvements in GI because
appreciation is not realized yet.
b. Problem 2.1(g).
i. Chamique receives stock dividend (worth 1,000) in lieu of cash dividend at the
companys choice. Her AB in the original stock was 200. She sells after the stock
dividend for 2,250 when the FMV was 2000.
ii. Analysis.
1. 305(a). This section puts Eiser into the code. No GI recognized when
receive the stock dividend.
a. (b) Exception. If the shareholder had an election to take cash
dividend or stock dividend, must include in GI.
2. In this case, Chamique does not recognize any GI when she receives the
stock dividend. When she sells, she recognized a gain of 2,250 200 =
2,050.
a. Thus, the gain is pretty much deferred until she sells.
3. Note. 1223(5). May be able to treat entirely as long term capital gain if
can tack on new stock dividend onto the original stock purchased.
4. Commercial Bargain Purchases
a. Problem 2.1(d).
i. Purchase car worth 5,000 from a stranger for 4,500, or rebate.
ii. Analysis.
1. Arms length transaction (parties are not affiliated with each other in any
regard), so the 500 is not included in GI.
2. 1001. AB is 4,500, so the 500 pretty much deferred.
3. Policy. The 500 does not have the same utility as cash, and difficult for
IRS to administer.
b. Problem 2.1(e).
i. Purchase car from employer worth 5,000 for 4,500. Employer purchased for
3,500.
ii. Analysis.
1. No longer an arms length transaction, so the 500 is included in GI
because treated like compensation for services.
a. Examples of non-arms length:
i. Employer/employee; and
ii. Corporation/shareholder.

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2. 1.61-2(d)(2)(i). Confirms this holding.
3. 102(c). Employer gifts must be included in GI.
a. Exception. Birthday gift.
4. AB = 5000

5. Barter Exchanges
a. Problem 2.1(h).
i. Brothers: Wedding cake (600) for will-drafting (600).
ii. Analysis.
1. 102. When relatives or friends in barter exchange, assumed to be
excludable. However, the parties must attempt to prove that there was
no reciprocity. They did it for each other just out of love.
2. Rev Rule 79-24 & 1.61(2)(d)(1). When strangers, treated as
compensation paid other than cash, so included in GI.
6. Imputed Income
a. The term imputed income refers to the gross annual fair rental value of consumer assets,
such as residences, automobiles, and the like, or the value of self-provided services.
i. Not included in GI because impossible to administer and people should not be
forced into the labor market. Also, can be seen as barter exchange and reciprocity
from the family standpoint.
1. Economists think that imputed income should be taxed because for
efficiency reasons.
b. Problem 2.1(i).
i. Thomas stays home and cares for the house and children when the wife works.
ii. Analysis.
1. Not included in GI.
2. Again, this is actually beneficial for tax purposes to Thomas and his wife
because of the Condoleeza problem.
a. Because this may provide incentive for taxpayers to stay at home,
there are two sections that mitigate this incentive:
i. 21. Allows a credit.
ii. 129. Allows a 5,000 credit when child-care is provided
by employer.
c. Problem 2.1(j).
i. Benefits of owning a home.
ii. Analysis.
1. Not included in GI, thus, an incentive is created for home ownership.
a. Again, economists hate this because they argue for market
efficiency, some should invest in the stock market and not in
homes.
III. IN-KIND CONSUMPTION BENEFITS
1. Introduction: Why Tax In-Kind Benefits (Fringe Benefits)?
a. 132(a). Lists fringe benefits that are excluded from GI. Why do we have this section?
i. Industry practices and employee expectations;

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ii. Convenience of employer;


iii. Administrative convenience; and
iv. Fairness/equity.
b. 132(j) Exception. Only for no additional cost service and employee discount, exclusion
only applies to highly compensated employees if there is no discrimination (meaning, lower
paid employees get the same benefits).
2. Employee Fringe Benefits
a. Problem 3.1.
i. Free parking for associates (FMV 220), but no free parking for secretaries.
ii. Analysis.
1. There is no non-discrimination requirement for parking.
2. 132(f)(2)(B). May exclude up to 190/month for parking. So, must include
30/month in GI.
3. 132(f)(2)(A). Transit pass up to 100/month.
4. Note. (f) only applies to commuting expenses, not business travel.
5. Policy. Industry practice and employer convenience.
b. Problem 3.2.
i. Regular price of 750. Marked down to 600 for customers. Maida with employee
discount purchased for 420. The gross profit percentage in the line of business is
25%.
ii. Analysis.
1. 132(c)(4). Must be qualified property or service to get an employee
discount. For that to occur, must be property (other than real or personal
property held for investment) or services which are offered in the ordinary
course of the line of business of the employer in which the employee is
performing services.
2. (c)(2). Gross profit percentage is (A)(i)/(A)(ii).
3. (c)(1)(B). This problem has a product, not a service. If a service is
involved, the discount cannot exceed 20% of the price at which the
services are being offered by the employer to customers.
4. (c)(3).
a. 600 (price offered to customers)*25% = 150.
b. 600 420 = 180.
c. 180 150 = 30 included in GI.
5. Policy. Industry practice and employer convenience.
c. Problem 3.3.
i. Free coffee and donuts every Wednesday morning, or photocopying or phone
calls or late night dinners or cab rides when working late.
ii. Analysis.
1. 132(a). Not included in GI, because de minimus. To be de minimus,
must meet to criteria:
a. Minor value; and
b. Too much trouble to keep track of.
2. Policy. Administrative convenience.
3. 119. Does not fall under here because to fall under this section, the
employees must need the food to perform their job.

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d. Problem 3.4.
i. Fred accumulates frequent flyer miles when on business trips that are deductible
under 162. He uses these miles for other client related trips.
ii. Analysis.
1. 132(d) or Gotcher. Working condition fringe, meaning, if employee paid
for it, and was able to exclude it under 162, or 167, it is excluded under
132 if the employer pays for it.
a. If primarily benefiting employer, than it is excluded from GI. Thus,
excludable by Fred.
2. Note. Even if Fred used these miles for personal use, they would not be
included in GI because it is impossible for IRS to administer. Actually, the
IRS put out a Notice, stating that personal use of frequent flyer miles
should be included in GI, but that they are delaying enforcement because
they dont know how to enforce.
e. Problem 3.5.
i. Freds wife accompanies on trip for personal purposes and the company
reimburses for that.
ii. Analysis.
1. 132(d). Must include her portion of the trip in Freds GI because Fred
cannot deduct her trip under 162 or 167. See also Gotcher (wifes trip
value included in GI).
a. Gotcher. The amount is included in Freds GI, not the wifes GI
because it is treated as a gift to the wife.
2. 274(m)(3). No deduction for spouse travel.
3. Meals & Lodging
a. Problem 3.6.
i. Firefighters work three day on, and three day off. On their days on, they are
provided free room and board.
ii. Analysis.
1. 119(a). Not included in GI because requirements for meals and lodging
are met.
a. For meals to be excluded, two requirements must be met:
i. For convenience of the employer; and
ii. Furnished on business premises.
b. 1.119-1(b). For lodging to be excluded, three requirements must
be met:
i. Furnished on business premises of employer;
ii. Furnished for convenience of the employer; and
iii. The employee is required to accept such lodging as a
condition of his employment.
1. Example of who would qualify:
a. Superintendent of building.
2. Example of who would not qualify:
a. Professor given housing because
requirement three missing.

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b. 119(d) Exception. If school owns
building and subsidizes, the professor
does not need to include the difference in
market rate and her rate in GI.

4. Other Compensatory Transfers


a. Problem 3.7.
i. Employer offers Bill stock in another company with retaining clause. When
granted, FMV of stock was 15,000. When vested, FMV of stock was 18,000.
Assume non-qualified stock option.
ii. Analysis.
1. 83(a)(1) & (2). The difference between FMV and the amount the
employee paid is included in GI when there could be no substantial risk of
forfeiture or the property is transferable. Whatever comes first.
a. 83(c)(1). Defines substantial risk of forfeiture.
i. If must work for another year before vesting, there is still
a substantial risk of forfeiture.
2. 83(b) Election. An employee can make an election to include the FMV in
GI when immediately granted, thus, typically having a lower GI. Must
make this election with 30 days of when granted.
a. Should only take the election if two things:
i. Confident there will be no forfeiture; and
ii. Confident the value will continue to increase.
1. Reason: No deduction permitted if loss in value.
3. Bills Situation:
a. If he took the (b) election, he would include 15,000 in GI, and that
would be is AB. This is also a good move because if he wants to
sell when vested, although he would have GI earlier, he would
have an additional 3000 gain later, but it would be capital and not
ordinary.
i. If he does not take the election, he includes the 18,000
when risk of forfeiture over or the stock is transferable.
4. Note. This section does not apply to stock options.
a. Stock options are good for employees because GI is only
recognized when sold and treated as capital gain. But they suck
for employers, because there is no deduction for stock options.
i. However, under 83(h), employers get a deduction for
non-qualified stock options.
b. Problem 3.8.
i. In 2003, employer grants option to purchase 20 shares of its stock for 10/share.
At the time of the grant, the stock was worth 20/share and the option itself had a
readily ascertainable FMV of 100. Exercised in 2004 for 10/share when the stock
had a value of 20/share. Sold in 2005 for 420. Assume non-qualified stock
option.
ii. Analysis to determine if ascertainable value.
1. 1.83-7(b). Two ways to determine:
a. If traded on an established market; or

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b. Four requirements under (b)(2) which are difficult to meet.


iii. Analysis if ascertainable value.
1. 1.83-7(a). If ascertainable, and no risk of forfeiture, must include in GI
immediately. Thus,
a. In 2003, 100 included in GI.
b. 83(e)(4). As a result, in 2004, when option exercised with
ascertainable value, no tax implications. However, increase in AB
of 200 because that is how much purchased for in 2004.
c. In 2005, when sold for 420, with AB of 100 (already included in
GI) + 200 (purchased for), he has a capital gain of 120.
iv. Analysis if no ascertainable value.
1. 1.83-7(a).
a. 83(e)(3). In 2003, no GI.
b. In 2004, when exercised, amount of what it is purchased for and
FMV is included in GI.
i. So, in this case, purchased for 200, and FMV is 400, so
GI is 200.
c. In 2005, when sold for 420, with AB of 200 (already included in
GI) + 200 (purchased for), he has a capital gain of 20.
th
c. Haverly (7 1978) (Unsolicited sample textbooks sent by publishers to a principal of a
school, which he subsequently donated to the schools library, constitutes GI)
i. Rule. When the intent to exercise complete dominion over unsolicited samples is
demonstrated by donating those samples to a charitable institution and taking a
tax deduction therefore, the value of the samples received constitutes gross
income.
IV. BORROWING & LENDING
1. Neither a Borrower nor a Lender Be
a. Loans Generally
i. General Rule. When there is a loan, neither the borrower or the lender recognized
any GI because offset by the obligation to repay.
ii. Problem 1.4.1.
1. Chuck embezzles 10,000 in 2003. Caught in 2004. Pays back in 2006.
2. Analysis.
a. James (US 1961)
i. Rule. When a taxpayer acquires earnings, lawfully or
unlawfully, without the consensual recognition, express
or implied, of an obligation to repay and without restriction
as to their disposition, he has received income.
1. An embezzler must include funds in GI because
the three requirements of Glenshaw are met. If
the embezzler pays the funds back, he may take
a deduction.

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b. So, in this case, in 2003, 10,000 included in GI. In 2006, may


take a 10,000 deduction.
iii. Problem 1.4.2(a).
1. Residential one-year lease with deposit (security) of one-month rent.
2. Analysis.
a. Indianapolis (US 1990) (IPL requires deposits to assure payments
of future services no GI because no guarantee IPL can keep the
money)
i. Rule. IPL hardly enjoyed complete dominion over the
customer deposits. Rather, these deposits were acquired
subject to an express obligation to repay either at the
time service was terminated or at the time a customer
established good credit.
1. Court focused on dominion. It did not matter
that IPL co-mingled the funds.
2. However, it comes down to timing; meaning, if
the deposit is applied to the bill, and it is known it
will not be reimbursed, it must be included in GI.
b. Thus, in this problem, not included in GI.
iv. Problem 1.4.2(b).
1. Commercial ten-year lease with last years rent paid up front.
2. Analysis.
a. Indianapolis (see above)
b. In this problem, must include in GI because advance payment of
rent is immediately included in GI.
i. In this problem, the tenant does not have control over
whether he receives the funds back, whereas in the last
problem he does. The landlord has the dominion in this
case.
c. Point. It comes down to dominion and obligation to repay. For
example, in Indianapolis, the company used the accrual method,
so they had an obligation to repay.
b. Worthless Debts
i. Problem 2.4.1(a).
1. In 2003, Jessica loaned her friend Monique 5,000 with obligation to repay
5,150 in 2004.
2. Analysis.
a. No tax consequences, but interest included in income pursuant to
61(a).
ii. Problem 2.4.1(b).
1. Now, Monique cannot repay because she lost her job and has no
prospects.
2. Analysis.
a. 1.166-2(b). A debt only becomes worthless when a "legal action
would not result in satisfaction because there is not a possibility of
repayment."

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i. If a person just does not want to repay, but has the ability
to that does not meet this standard.
b. 166(a). This is a wholly worthless debt.
c. 166(d)(2). Considered a non-business debt because they are
friends, and interest alone is not enough to turn into business.
d. 166(d)(1)(B). Because non-business debt, must be treated as
STCL, thus, may only take deduction up to the amount to offset
against STCG.
i. If no STCG, may still deduct up to 3,000.
ii. This is why business loans are favored. There does not
have to be CG to offset the worthless debt.
iii. Problem 2.4.1(c).
1. Now, Monique can only repay 2,500.
2. Analysis.
a. 166(a). For business debts, partially worthless debts are
deductible. But for non-business debts, no such deduction exists.
i. Thus, Jessica may not take a deduction.
b. Policy. The IRS does not want disguised gifts.
iv. Problem 2.4.2.
1. Anne recovers judgment for wrongful death of relative. She cannot
collect.
2. Analysis.
a. Rev Rule 93-27. A taxpayer is not entitled to a bad debt deduction
under 166 for the amount of the taxpayers own payment in
support of the taxpayers children caused by an arrearage in
court-ordered child support payments owed by a former spouse.
b. Thus, in this problem, Anne does hot have a basis in the money;
thus, she is not able to take a deduction. In fact, in all cases, if an
individual has a piece of paper stating that money is due them,
and they do not receive it, no deduction is permitted.
c. Debt Discharge Income
i. Problem 3.4.1.
1. Joshua loaned Mona 60,000 and discharged it because she filed
bankruptcy or her liabilities outweighed her assets by 85,000.
2. Analysis.
a. 61(a)(12) & Kirby. Generally, have to include debt discharge in
GI as ordinary income when the taxpayer knows that they are not
responsible for paying back any longer.
b. 108(a) Exceptions.
i. Four exceptions when taxpayer does not have to include
debt discharge in GI, including:
1. Filed for bankruptcy; or
2. The taxpayer is insolvent pursuant to 108(d)(3).
ii. 108(b). Although the taxpayer does not have to include
in GI, they have to take the amount they are not including

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in GI, and deduct that amount from any losses listed


under (b) in that order listed under (b).
c. Thus, in this problem, Mona does not have to include her debt
discharge in GI because she falls under two exceptions under
108(a).
i. Insolvency Limitation. May only exclude debt discharge
from GI only up to the amount of your insolvency. For
example, if Mona was only 55,000 insolvent, she would
have to include 5,000 in GI.
ii. Problem 3.4.2.
1. Corp sells a machine to Isiah for 90,000. Isiah gave a 90,000 nonrecourse loan. Because of proficiency problems, Corp reduced Isiahs
debt by 8,000.
2. Analysis.
a. 108(e)(5). In order to be considered a purchase price
adjustment,
i. Must be a seller financed acquisition; and
ii. Cannot be filing bankruptcy or insolvent.
b. If qualify as purchase price adjustment, then no recognition of
GI. Instead, AB is lowered by the amount.
c. So, in this problem, Isiah reduces his AB to 82,000, with nothing
included in GI.
iii. Problem 3.4.3.
1. Casino discharged Matts 1,000,000 gambling debt when there was no
reasonable prospect of collecting, although enforceable.
2. Analysis.
a. Zarin (3rd 1990) (Gambling debt discharged)
i. Holding. In NJ, this type of debt was unenforceable and
there is no property subject to debt under 108, thus, the
debt discharge is not included in income.
1. Criticism. The court came out with the wrong
result. It still holds true today, but it is a bad
result.
b. In this problem, Matt must include the 1,000,000 in GI because
the debt is enforceable. The casino may take a 1,000,000 bad
debt deduction.
iv. Problem 3.4.4.
1. Owe GW 20,000 loan but forgiven if work in public interest.
2. Analysis.
a. 108(f). Public interest qualifies as one of the certain professions
under (2)(D)(ii); thus, not included in GI.
i. Same situation with private loans if the private loan group
has an agreement with the school.
2. Transfers or Property & Debt
a. Introduction

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i. A nonrecourse debt is, in general, a secured obligation for which the debtor is not
personally liable. The nonrecourse lenders only remedy on default of a
nonrecourse debt is foreclosure on the property security.
ii. A recourse debt is, in general, one for which the debtor is personally liable;
whether or not the debt is secured by property, the lender can hold the debtor
personally liable if the recourse debt is not repaid.
iii. Point. Both types of loans included in AB.
b. Effects of Debt on Basis
i. Problem 4.4.1 & 4.4.2.
1. Crystal purchases building with 20,000 cash and 280,000 in recourse debt
or non-recourse debt.
2. Analysis.
a. 1012. Basis of property includes cost both cash and recourse
or non-recourse loan.
b. Thus, Crystals AB is 300,000.
ii. Hypo of Debt Relief Less than Property Value.
1. Crystal sells the building for 325,000. The buyer takes subject to the
debt, and pays 45,000 cash.
2. Analysis.
a. 1001(a) &(b) and Cranes Economic Benefit Theory. Debt relief
is included in AR.
b. Thus, 325,000 300,000 = 25,000 recognized capital gain.
iii. Problem 4.4.3.
1. Same as 4.4.1, but the value of the building rises to 340,000, and Crystal
borrows 40,000 to buy a car for personal use, using the building as
security.
2. Analysis.
a. Not indebtedness related to the building, so her AB in the building
does not change.
b. Also, it is a loan, so her AB in the car becomes 40,000, with no
recognition of GI because obligation to repay.
c. 1016(a)(1). If the loan was taken to improve the building, it would
be a capital expenditure, and it would have raised the AB of the
building 40,000.
c. Effect of Debt on Amount Realized when Debt Relief is Greater than Property Value
i. Problem 4.4.4.
1. Debt Relief Greater than Property Value: Crystals AB is 272,000
(because of depreciation). Debt is 280,000. FMV of building is 275,000.
Bank accepts conveyance in full satisfaction of the debt.
2. Recourse Analysis.
a. Rev Rule 90-16 (OConnors Tufts Concurrence). Must take a
bifuricated approach.
i. Discharge of indebtedness ordinary income: Recourse
debt FMV = 280,000 275,000 = 5,000
ii. Disposition of property capital gain: FMV AB = 275,000
272,000 = 3,000

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3. Non-Recourse Analysis (Tufts Majority).


a. Tufts (Concerned with tax symmetry)
i. Capital gain = Non-recourse debt AB = 280,000
272,000 = 8,000
ii. Problem 4.4.5.
1. Debt Relief Greater than Property Value: Crystal has non-recourse debt of
280,000. FMV of 270,000. Crystals AB is 300,000. Third party
purchases subject to the debt.
2. Tax Shelter. Why would the third party want to accept this property subject
to a larger debt than FMV?
a. To create a tax shelter (regardless if non-recourse or recourse).
Can take depreciation deductions and can offset them against
ordinary income. So no cash outlay, and get this deduction.
Great for wealthy people. Tax liability is being way pushed down
the line.
b. Two Limitations.
i. 465. May only take depreciation deductions as long as
no loss is created.
ii. 469. Aimed at investments, and partnerships. Have to
be actively involved in the business in order to take the
depreciation deduction, and those deductions can only
offset income.
3. Analysis for Crystal.
a. Non-recourse, so debt AB = 280,000 300,000 = 20,000 loss
treated as capital loss.
4. Analysis for purchaser.
a. What is the purchasers AB? Under Lebowitz, one of three
options:
i. FMV (Summit);
1. This is the default. This is used if the loan and
FMV are fairly different.
2. In this problem, this would be the purchasers AB.
Thus, 270,000.
ii. $0 (1.1001-2(a)(3) and Franklin); or
1. If a sham situation and the court does not believe
that there is genuine indebtedness. Typically
evidenced by a huge difference between FMV
and amount of loan.
iii. Amount of debt taken on (no authority).
1. If FMV is close to indebtedness, the taxpayer
may take on the debt as the AB for tax symmetry
purposes.
iii. Problem 4.4.6.
1. In 2000, Jose borrowed 250,000 non-recourse loan from Bank for
purchase of building. So his AB is also 250,000. FMV of building dropped

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to 100,000. In 2003, the Bank agreed to lower loan to 100,000 from
250,000. Jose is not bankrupt or insolvent.
a. Note. Because two year time has passed, he has taken 12,000 in
depreciation deductions, and his AB becomes 238,000.
2. Analysis.
a. Note. This falls under 108(c) and not 108(e) because this is not
seller financed. Better to fall under (e) because just reduces your
basis and defers gain.
b. Old Rev Rule 91-31 (Bad Law). Would include 150,000 of
discharge of indebtedness income, and that would side-step
Tufts. So Congress enacted 108(c).
c. 108(c)(1). There is an election to make:
i. Option One: Include the discharge of indebtedness in GI
and no change in AB; or
ii. Option Two: Exclude from GI, and reduce his AB.
1. Option Two Limitation (c)(2). Can only reduce AB
in the amount of the principal amount of the loan
minus new FMV of property.
d. In this case:
i. Option One: Jose would include 150,000 in GI.
ii. Option Two: Jose would reduce AB to 88,000, which is
238,000 (Current AB) 150,000 (amount discharged).
1. Limitation: 250,000 100,000 = 150,000. So
Jose may only reduce AB by 150,000, which he
is able to do here.

V. INTACT & SEPARATED FAMILY INCOME ATTRIBUTION


1. Support Obligations & Families
a. Intact Married Couples
i. Problem 5.1.
1. Married Couple (Table 1(a)):
a. Salary = 250,000
b. Standard = 9,500
c. Personal = 6,100
d. TI = 234,400
e. TL = 58,797
2. One Individual (Table 1(c)):
a. Salary = 250,000
b. Standard = 4,750
c. Personal = 3,050
d. TI = 242,200
e. TL = 67,497
3. Two Unmarried Individuals (Table 1(c)):
a. Salary = 125,000 each

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b. Standard = 4,750
c. Personal = 3,050
d. TI = 117,200
e. TL = 27,562 * 2 = 55,124
4. Note. Table 1(d) is married couples filing separately.
5. Married Couple versus Single.
a. Illustrates marriage bonus and single penalty built into tax tables.
b. Tax tables assume that the standard of living for one individual is
lower than married individuals.
c. 33% rate kicks in later for married taxpayers.
6. Married Couple versus Unmarried Couple.
a. Illustrates marriage penalty.
b. Unmarried Intact Couples
i. Problem 5.2
1. Gay Couple with Only One Earner (Table 1(c))
a. Salary = 250,000
b. Standard = 4,750
c. Personal = 3,050
d. TI = 242,200
e. TL = 67,497
2. Married Couple in Same Situation
a. TL = 58,797
3. Importance.
a. Gays cannot take advantage of marriage bonus because they
cant get married (Mueller in 7th Circuit).
b. Gays cannot even take advantage of head of household:
i. Would have to try under 2(b)(1)(A)(ii).
ii. But when flip to 151(c)(1)(A), can claim an exemption for
a dependent as long as GI is less than the exemption
amount. So that fits here, but now need to flip to 152 to
see if he is a dependent.
iii. 152(a)(9) may provide an in here to filing as head of
household. However, must look at 152(b)(5).
iv. 152(b)(5) was a hurdle, but it may not be anymore
because of Lawrence. However, now must look at 2(b)
(3)(B)(i).
v. 2(b)(3)(B)(i) means that head of household status would
not work for gays because can't take it if fall under
152(a)(9).
c. Couples Who Break Up
i. 71.
1. (a). Overrules Gould in defining alimony and separate maintenance
payments and states that alimony payments received are included in GI,
and are an above-the-line deduction (215) by the payor.
a. Note. If the parties still want Gould to rule, they just must explicitly
state it and no GI for payee, and no deduction for payor.

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b. (c). Child support still follows Gould.


2. (b). The requirements to be fall under 71:
a. Must be made under a divorce or separation agreement;
b. It must be cash or check;
c. Cannot be members of the same household; and
d. Cannot have any obligation to pay the payee after the death of
the payee.
3. (f). This section applies when all the requirements of (b) are met (thus,
alimony) and there is a front loading of payments (payments in the first
three years are more than 15,000 apart).
a. It addresses disguised property settlements and the effects are
only witnessed in the third year.
ii. Problem 5.3(a).
1. Husband and ex-wife agree that the Husband will pay ex-wife
10,000/month for minor children and 15,000/month for eight years.
2. Analysis.
a. Child Support: If the husband wanted the child support deductible
he should not have separated it out. He should have made it
seem part of the alimony and made sure to meet the
requirements of 71(b).
i. Thus, in this problem, no tax consequences.
b. Alimony: Husband may deduct 15,000/month above-the-line, and
the ex-wife must include 15,000 in GI.
iii. Problem 5.3(b).
1. First year H pays W 300,000. Second year 200,000. Third year 100,000.
2. 71(f) Analysis.
a. Must figure out if excess alimony payments. Note the 15,000
cushion provided in the first two years. The only way to do that is
to do first two years, second year first.
i. Second Year: 200,000 (second year alimony) - (100,000
(third year alimony) + 15,000) = 85,000 excess.
ii. First Year: 300,000 (first year alimony) - (1/2 ([200,000
(second year alimony) - 85,000 (second year excess)] +
100,000 (third year alimony)) + 15,000) = 177,500
excess.
iii. Third Year: 85,000 (second year excess) + 177,500 (first
year excess) = 262,500.
b. Tax Implications:
i. First Year: H deducts 300,000. W includes 300,000 in GI.
ii. Second Year: H deducts 200,000. W includes 200,000 in
GI.
iii. Third Year: H deducts 100,000 and includes 262,500 in
GI. W includes 100,000 in GI and deducts 262,500.
2. Property Settlements
a. 1041. Addresses transfers of property between spouses and former spouses. Thus,
applied to those married or divorced. This section overturns Davis (Spouse took the

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property with an AB of the transferors FMV and the transferor would suffer the tax
consequences).
i. 1041 does two things:
1. (a). There is no loss or gain realized on the transfer if married, or if it is
incident to the divorce. Thus, property transfers are not taxable to
anyone.
2. (b). The property transfer is treated as a gift. Thus, no GI, and the
transferee takes the AB of the transferor.
a. Effect: The gain or loss is built in and the tax consequences are
borne by the transferee.
ii. Regulations define (c)(2) as meaning within six years of the divorce. Thus,
incidence of the divorce lasts for six years, and the parties have that long to do
these property settlements.
b. Problem 5.4.
i. As incidence to the divorce, Max transferred to Sandra residence with AB of
275,000 and with FMV of 500,000. Sandra transferred to Max land with AB of
295,000 and FMV of 265,000 and 10,000 cash.
ii. Analysis.
1. Sandra: No GI, and takes an AB of 275,000. Sandra gets no deduction.
2. Max: No GI, and takes an AB of 295,000. Max gets no deduction.
3. Thus, the losses and gains are built into the land. Even the 10,000 cash
has no tax consequences, not even treated as GI.
a. Again, Max and Sandra could have agreed and made it fall under
71(b), it then there would have been tax consequences.
c. Problem 5.5.
i. Roberta owns land in which she has an AB of 40,000. The land has a FMV or
320,000 and is subject to 250,000 non-recourse mortgage. As part of a court
order, had to transfer to ex-husband as part of divorce settlement.
ii. Analysis.
1. Ex-husband: No GI, and takes an AB of 40,000.
2. Roberta: No tax consequences. (1041 trumps Crane).
3. If ex-husband sells for FMV, without paying off any of the debt:
a. AR = 320,000
b. AB = 40,000
c. Thus, gain recognized of 280,000.
i. Remember, if the ex-husband paid off any of the debt,
that would boost his AB.
VI. GRATUITOUS TRANSFERS
1. Introduction
a. 102(a). As a general rule, the value of property is not included in GI when it is a gift,
bequest, devise, or inheritance.
b. 102(b). States that exclusion of gifts from income does not extend to the income earned
on the property given as a gift.

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c. 102(c) & 1.102-1(f)(2). There cannot be a gift between employer and employee unless it
can be proven the gift was not given in recognition of the employees employment
(meaning, relatives or birthday).
d. Duberstein (US 1960)
i. Rule. In determining if a transfer is a gift, it depends on the transferors intent.
1. This is an extremely fact-based analysis and provides no bright lines.
2. A gift in the statutory sense proceeds from a detached and diminished
generosity, out of affection, respect, admiration, charity, or like impulses.
3. Olk and Harris agree. It is a factual analysis and it cannot be quid pro
quo.
a. Olk (Treated as GI because the gift was for services previously
rendered)
b. Harris (A person is entitled to treat cash and property received
from a lover as gifts, as long as the relationship consists of
something more than specific payments for specific sessions of
sex; but remember, donors intent controlling)
i. When personal relationship, it may not be quid pro quo,
and may be treated as a gift.
e. 1014(a). Addresses property received by death, provides that the basis of the property of
the transferee is the FMV at the date of the death. (Thus, loss eliminated if there is one).
i. 1022. Effective only for the year 2010. After 2010, 1014 is the relevant rule
again. In 2010, the AB of the beneficiary is the lower of:
1. The AB of the decedent; or
2. The FMV of the property as the date of the decedents death.
f. 1015(a). Addresses inter vivos gifts, states that the donors AB carries over to the donee if
the FMV exceeds the AB at the time of the gift, and if the AB exceeds the FMV at the time
of the gift, there are three possible outcomes (to discourage transfer of loss property):
i. If the AR on a sale by the donee is less than the gift-time value, the gift-time value
fixes the donees basis;
ii. If the AR by the donee is greater than the donors date of gift basis, the donee
takes the donors basis; or
iii. If the AR realized by the donee is greater than the gift time value but less than the
donors basis, the donees basis is effectively deemed to equal the amount
realized, resulting in no gain or loss to the donee.
g. There are always two types of taxes in the air when discussing gifts or inheritances:
i. Gift Transfer Tax; and
1. Remains intact.
2. The transferor must pay, and it is applicable when addressing inter vivos
gifts.
ii. Estate Tax
1. Slowly being repealed, and by 2010 there will be none.
2. Applicable when addressing transfer upon death.
h. Gift Transfer Tax Analysis.
i. General. Gift tax, with top rate of 35% is imposed on the transferors FMV without
deducting the donors AB.
ii. Exclusions.

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1. Lifetime Exclusion:
a. 1,000,000
2. Yearly Exclusion:
a. 11,000
iii. Example: If parents give you an inter vivos gift of 16,000, they may exclude the full
16,000 from the transfer tax.
1. 11,000 yearly, and then there 1,000,000 lifetime exclusion is reduced by
the excess 5,000. Thus, leaving their life exclusion at 9,995,000.
2. Once, the lifetime exclusion is tapped out, may only exclude up to
11,000/year.
3. Thus, if the lifetime exclusion has not been used ever, a one-year
exclusion can reach as high as 1,011,000.
4. Husband and wife count as two different taxpayers; so in essence, a
lifetime exclusion of 2,000,000.
iv. When the gift transfer tax is paid, the donee may increase her basis. See
Problem 6.4.
i. Estate Tax Analysis.
i. General. In 2003, there is a top 50% estate tax rate. In 2009, there will be a top
45% estate tax rate. In 2010, there is no estate tax (however, IRS compensates
by lowering AB).
1. These are graduated schedules, the larger the estate, the higher the tax.
ii. Exclusions. In 2003, may exclude up to 1,000,000 of estate from the tax. In 2009,
may exclude up to 3,500,000. Again, in 2010, no estate tax.
iii. See Problem 6.3(c) for 2010 AB analysis.
2. Gift, Bequest & Inheritance (Inter Vivos)
a. Problem 6.2(a).
i. Sayuri transfers land in which she has an AB of 50,000 and FMV of 75,000 to
Keren as an inter vivos gift. (Assume no transfer taxes).
1. Analysis.
a. 1015(a). Keren: AB is 50,000.
b. 102(a). Keren: No GI.
c. 1001. Sayuri: Gifts are no dispositions, so there is no gain
recognition. The gain is built in and transferred to Keren.
d. Sayuri: No deduction permitted for gifts.
b. Problem 6.2(b).
i. Sayuri transfer land in which she has an AB of 50,000 and FMV or 42,000 to
Keren, and two years later, Keren sells for:
1. 70,000
a. Keren: AB 50,000. AR 70,000. GR 20,000.
2. 40,000
a. Keren: AB 42,000. AR 40,000. Loss 2,000 (and may take under
165(c)(2)(1).
3. 80,000
a. Keren: AB 50,000. AR 80,000. GR 30,000.
4. 45,000

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a. Keren: AB is sales price, so no gain or loss. If Keren sells
anywhere in between FMV transferred to her and AB transferred
to here, her AB becomes the sales price.

c. Problem 6.4.
i. Winston owns land with AB of 100,000. Worth 400,000 when transfer inter vivos
gift to daughter Mitzi. Winston paid 80,000 gift transfer tax (note: may exclude if
lifetime exclusion not tapped out).
1. Analysis.
a. 1015(d)(1)(A). If the donor pays the gift transfer tax, the donee
may increase her AB.
b. 1015(d)(6)(A). Determines how much the AB may be raised:
i. First, determine percentage:
1. Numerator is donors appreciation; and
a. 400,000 100,000 = 300,000
2. Denominator is FMV of the gift.
a. 400,000
3. 75%.
ii. Second, take percentage and multiply it by the gift tax
paid:
1. 75% * 80,000 = 60,000.
iii. Thus, Mitzi may increase her AB by 60,000. So,
1. 100,000 + 60,000 = 160,000 AB
2. Important Note.
a. In order for there to be a gift transfer tax, there must be
appreciation in the property. Because the numerator/denominator
analysis, in determining the numerator, it must be a positive
number.
3. When gift tax rates and federal income tax rates are equal (30%), is
1015(d) successful in tax parity? Yes, the total tax burden is the same;
however, the tax is borne by different parties.
a. Gift Tax:
i. 400,000 (FMV) * 30% = 120,000
ii. 120,000 * 75% (calculation from above) = 90,000
iii. Mitzis AB is now 190,000
iv. If Mitzi sold for 400,000, RG of 210,000.
v. 210,000 * 30% (tax rate) = 63,000
vi. Total taxes paid by both parties = 183,000
b. If Winston sold the property and gave proceeds to Mitzi:
i. If Winston sold for 400,000, RG of 300,000.
ii. 300,000 * 30% = 90,000.
iii. Mitzi would receive 310,000 cash, and Winston would
have to pay gift tax of 30% on the 310,000.
iv. 310,000 * 30% = 93,000
v. Total taxes paid by Winston = 183,000
3. Gift, Bequest & Inheritance (Death)
a. Problem 6.3(a).

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i. A dies. AB in residence was 250,000 and on date of death, the FMV was 320,000.
Residence left to M in will.
1. Analysis.
a. 1014(a). Ms AB is 320,000.
i. Stepped up basis good for taxpayers because gain not
transferred over.
ii. Can act as a huge tax shelter if keep in family through
wills.
b. Problem 6.3(b).
i. A dies. AB in residence was 250,000 and on date of death, the FMV was 200,000.
Residence left to M in will.
1. Analysis.
a. 1014(a). Ms AB is 200,000.
i. Takes on FMV again, and cannot receive built in loss.
c. Problem 6.3(c).
i. In 2010, A dies. AB in residence was 250,000 and on date of death, the FMV was
320,000. Residence left to M in will.
1. 1022 Analysis.
a. Must take lower of decedents AB or FMV, so in this case,
250,000.
b. (b). Possibility of AB increase.
i. (b)(2)(B). Executor only allowed to distribute an
aggregate increase of 1,300,000 across the entire estate.
However, AB cannot be raised over FMV.
1. So, in this problem, Ms AB may be raised to
320,000.
c. (c). If the beneficiary is the spouse, only the spouse may get an
additional 3,000,000 AB adjustment. Again, cannot exceed FMV.
4. Part-Sale/Part-Gift
a. Problem 6.5(a).
i. Susan and Ulrike are sisters. S has AB in land of 15,000 with FMV of 40,000. S
sells to U for 25,000. (Note: Gain for transferor in part-sale/part-gift).
1. 1.1015-4 Analysis.
a. This is a part-sale/part-gift transaction because it is a sale for less
than FMV that is not an arms length transaction.
b. Susan:
i. Capital Gain Realized = AR AB
1. 25,000 15,000 = 10,000
ii. Gift Transfer Tax = FMV sale price
1. 40,000 25,000 = 15,000 gift
2. So, Susan, if cannot exclude because of yearly
or lifetime, would have to pay gift transfer tax on
that amount.
c. Ulrike:
i. AB = Greater of:
1. Transferors AB; or

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2. Amount paid.
ii. So, in this case, Ulrikes AB will be 25,000.
1. If Susan does pay gift tax, Ulrike can raise her
AB.
ii. Hypo. Instead of paying cash, Ulrike just assumes the 25,000 non-recourse debt
Susan had on the land.
1. Same result pursuant to Crane and the disposition of the loan.
b. Problem 6.5(b).
i. Susan and Ulrike are sisters. S has AB in land of 60,000 with FMV of 50,000. S
sells to U for 40,000. (Note: Loss for transferor in part-sale/part-gift).
1. Analysis.
a. 1.1001-1(e)(1) & 267(a)(1).
i. In a part-sale/part-gift transaction, losses may not be
recognized. Thus, Susan may not take her 20,000 loss.
b. 1.1015-4. The transferee must take the transferors FMV as her
AB unless the transferee ends up selling the property for more
than transferors AB they she must take the transferors AB.
i. In this problem, Ulrike would take on an AB of 50,000
unless she sells the property from more than 60,000.
5. Interest-Free or Below Market Loans
a. 7872(c). 7872 applies to the loans listed under (c). The most common ones are gift
loans (including below the market loans).
i. Gift Loan defined in (f)(3).
ii. Below Market Loan defined in (e)(1).
iii. Demand Loan defined in (f)(5).
iv. Compensation Related Loan defined in (c)(1)(B).
1. Loan between employer and employee or corporation and shareholder.
b. 7872(a). Gift Loans and Demand Loans (both below the market loans) fall under (a)
analysis for interest calculation.
i. Analysis. See Problem 6.6.
c. 7872(b). Term Loans (still a below the market loan) falls under (b) analysis for interest
calculation.
i. Analysis. Complicated, thus, not responsible for.
d. Problem 6.6.
i. Michael loans 100,000 to sister with 0% interest on January 1, 2003. It is a
demand loan because his sister only has to pay it back when requested by
Michael and falls under gift loan under (c)(1)(A). She pays back on January 1,
2008. For 2003, federal interest rate is 4% compounded semi-annually.
ii. Compounding.
1. First Half of Year: 100,000 * 2% = 2,000.
2. Second Half of Year: 102,000 * 2% = 2,040.
3. Thus, 2003 interest = 4,040.
iii. 7872(a) Analysis for 2003.
1. In essence, a fictional transfer because the interest is transferred and
retransferred on the last calendar day of the year.
2. Andrea:

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a. Under 102, may exclude the interest from GI because it is
treated as a gift.
b. 163(h). She may deduct the 4,040 if she uses the loan for a
business even though she does not have to recognize the interest
as income because of 102.
i. Point. These gift loans are great for the borrower, and
suck for the lender.
3. Michael:
a. Under 61(a), must include 4,040 interest in GI as interest
income.
b. Because a gift, Michael must also pay gift transfer tax on the
4,040 if he cannot exclude it under yearly exclusion or lifetime
exclusion.
4. Exceptions.
a. (c)(2). De minimus. If loan is under 10,000, then it is excluded
from 7872 rules. However, gift tax still applies.
5. Limitations for Gift Loans.
a. (d)(1)(A). When a loan does not exceed 100,000, no interest will
be retransferred back to the lender to recognize in GI, and if the
loan is over 100,000 and the borrower used the loan proceeds to
run a business or to derive net investment income, the interest
does get retransferred back to the lender to include in GI;
however,
i. The interest that gets retransferred back may not exceed
the borrowers net investment income.
1. So, in this problem, 4,040 would be the cap.
ii. And, according to (d)(1)(E), if there is net investment
income but it does not exceed 1,000, then it will be
treated as 0, and no interest will be retransferred back to
the lender to include in GI.
b. This limitation only applies to GI, the gift tax is still applicable.

e. Hypo.
i. If a compensation related loan, what are the consequences?
ii. Employee/Employer Analysis.
1. Borrower (employee):
a. 61: 4,040 included in GI because free interest treated as
compensation.
b. 163(h): If the employee can fall under one of these exceptions,
may deduct the interest.
2. Lender (employer):
a. 61: 4,040 included in GI because interest income.
b. 162: Lender may deduct 4,040 because may treat as salary or
compensation.
3. Note. No 100,000 exception/limitation in this type of below market loan.
4. Note. Again, this is only addressing GI, there are still the gift tax
consequences.

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5. Point. It could be a wash, and there would be no 7872 implications.


iii. Shareholder/Corporation Analysis.
1. Borrower (Shareholder)
a. 61: Includes in GI because treated as dividend.
b. 163(h): If the shareholder can fall under one of these exceptions,
may deduct the interest.
2. Lender (Corporation)
a. 61: Includes in GI.
b. But not-deductible at all.
3. Note. No 100,000 exception/limitation in this type of below market loan.
4. Note. Again, this is only addressing GI, there are still the gift tax
consequences.
VII. PERSONAL DEDUCTIONS
1. Introduction
a. Shift in course from what is included in GI to deductions and exemptions and what is not
included in the tax base. If it is not part of the base, then they are known as tax
expenditures because they act as subsidies to provide incentives for taxpayers to
undertake certain behavior.
b. SHS Model. All should be included in the tax base except for business and investment
items. Thus, all deductions and exemptions, other than those business and investment
items, could technically be criticized.
c. Above-the-Line Deductions. The deductions listed in 62(a). These deductions are
included in arriving at AGI, and may be taken in addition to the standard deduction.
i. Some highlights of above-the-line deductions:
1. (a)(1). Ordinary and necessary business expenditures (included selfemployed and entrepreneur).
2. (a)(2). If employee reimbursed by employer if expenses deductible under
161.
3. (a)(3). Capital losses.
4. (a)(10). Alimony payments.
5. (a)(17). Higher education interest payments.
6. (a)(18). Higher education expenses.
d. Below-the-Line Deductions. Those deductions not listed in 62(a). May take these
deductions pursuant to 63, (subject to limitations in 67 and 68) or standardized
deduction in arriving at TI.
e. Problem 7
i. Kai, a dentist, with a salary of 175,000, has two children (dependents) who live
with him. Lives with his committed partner Oscar, who is not a spouse or
dependent. Kais health insurance covers Oscar. Thus, must file as single status.
All analysis under VII. Personal Deductions pertain to them.
2. Individual & Household Allowances
a. Addressed at end of problem.
3. Medical Expenses

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a. 213. Relevant when patient pays and not reimbursed by employer.


i. (d). Defines medical care.
1. (d)(1)(D). Insurance premiums are deductible.
2. (d)(2)(9). Cosmetic surgery is not medical care unless it corrects a
deformity.
ii. (a). General Rule. If pay for expenses and they exceed 7.5% of AGI, then the
taxpayer may take the deduction.
b. 106. Relevant when employer directly covers and the employee never receives any
funds.
i. Rule. Employer provided coverage under a health plan is excluded from GI, but
the health plan must cover the taxpayer, spouse, or dependent.
c. 105. Relevant when employer covers amount but employee had to pay and he gets
reimbursed.
i. (a). General Rule. Amount employee receives from employer is included in GI.
ii. (b). Huge Exception. Excluded from GI if the money reimbursed went to cover
employee, spouse, or dependent.
d. 101(a). States that proceeds from life insurance are not included in GI.
e. Oscar in accident and seriously injured. The tortfeasor paid 100,000 for hospital bills
relating to physical injury and gave Oscar 500,000 FMV property for emotional distress.
i. 104(a)(2). Any amount of damages received from suit or agreement on account
of personal injuries is excluded from GI. However, punitive damages must be
included in GI.
1. Thus, all 100,000 excluded from Oscars GI.
ii. 104. Emotional distress is does not fall under (a)(2). However, Conference
Report (1996), states that is the emotional distress is derived from the physical
injury, then it may be excluded.
1. This illustrates this part of the law is left open. However, because Oscars
emotional distress is from witnessing anothers death, we will include the
500,000 in GI. Oscars AB becomes 500,000.
f. Kais insurance reimbursed Oscar 35,000 because of the accident injuries. The
employers cost to provide coverage relating to Oscar is 3,600/year.
i. 105(b). The 35,000 is excluded if Oscar is Kais dependent. But again, from
analysis under V(b) of Outline, Oscar most likely would not be considered a
dependent.
1. 105(a). If Oscar is dependent, no GI for him or Kai. If Oscar is not a
dependent, must look at:
a. 104(a)(3). Will exclude the 35,000 medical insurance payments
as long as the cost of medical insurance, the 3,600, is included in
GI.
2. Further Analysis.
a. Rev Rule 77-282. Defines support, and it argues that if Oscar
receives over half of his support from Kai, he is dependent.
i. Because 500,000 already included in Oscars GI, most
likely, half of his support does not come from Kai.

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b. 1.152-1(ii). Unlike the Rev Rule, suggests it does not depend on


whether Oscar has GI, it matters how much Kai contributes. Also
see Situation 4 on page 264.
ii. 106. Employers cost of 3,600 is included in Kais GI because Oscar is not a
dependent, and as a result, the 35,000 may be excluded.
g. Cafeteria Plan: in lieu of salary in the sum of 500, Kai opted for reimbursement of medical
car expenses of 500. This was for check ups.
i. 125. Advantage of cafeteria plan is it is excluded from GI, and does not have the
7.5% floor requirement of AGI like 213. The downside of cafeteria plans is the
money must be put in at the beginning of the year, and the taxpayer loses what is
not used.
1. Thus, Kais salary is reduced from 175,000 to 174,500.
6. Life Insurance, Prizes & Scholarships
a. Kai received a Dentist of the Year prize for 10,000 cash.
i. 74(a). Prizes are included in GI.
ii. 74(b). Exception. Among with two other requirements listed, if prize money is
immediately transferred to a charity.
1. Thus, Kai must include 10,000 in GI.
b. 117. Addresses scholarships.
7. Other GI
a. Kai, as part of divorce settlement, had to sell XYZ stock to wife for FMV of 100,000 when
his AB was 100,000.
i. 1041. Transfers of property incident to divorce means that no gain or loss is
recognized; thus, no affect on GI.
b. Kai received stock dividend due to stock split.
i. 305(a). As previously discussed earlier in outline, does not have to include in GI.
c. Kais employer sold him land that had a FMV of 20,000 for only 5,000. Thus, part-gift/partsale.
i. 1.61-2(d)(2). 15,000 included in Kais GI. Kais AB when he sells with be 20,000.
d. Kai had 10,000 of his dental school loans forgiven by providing services to low income
children.
i. 108(f). Exception to discharge of indebtedness, and does not have to include in
GI.
8. Above-the-Line Deductions
a. Alimony Payments
i. Kai paid ex-wife alimony payments of 24,000 pursuant to 71.
1. 62(a)(10). Because not frontloaded, 24,000 deductible.
b. School Loan Interest
i. Kai paid 5,000 on school interest loans.
1. 221.
a. (d). Defines higher education and covers tuition, room and board.
b. (b). Limitation & Phaseout:
i. Limitation. If AGI (as defined in this context under (c)),
exceeds 65,000, then no deduction is permitted.
ii. Phaseout.

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1. Fraction = (AGI (as defined in (c)) 50,000


(100,000 if joint return) / 15,000
2. Take result, and multiple by 2,500 (if 2003) and
that is the deduction permitted.
iii. In this case, Kais AGI is 175,500, so he does not get past
the limitation and may deduct nothing.
9. Below-the-Line (Itemized) Deductions
a. Charitable Contributions
i. Kai donated 7,000 to his church. In return, the church provided Kai with a meal
worth 1,000.
1. 170.
a. (c). Define what organizations qualify as a charitable group.
Churches fall under (c)(2)(B).
b. Limitations.
i. Hernandez. (Taxpayers argue their contributions to the
Scientologists should be deductible even though they
receive auditing and training in return court disagrees)
1. Rule. To be a charitable contribution (gift), it
cannot be quid pro quo.
2. Thus, Kai received 1,000 in return, and may not
deduct that.
ii. (b). Deduction cannot exceed 50% of taxpayers
contribution base (or 30% of contribution base if to private
foundation (a non-publicly funded charity but ran by
family defined in (b)(1)(D))).
1. (b)(1)(F). Contribution base is AGI.
2. (b)(1)(C). If are permitted to deduct FMV, then
can only deduct 30% of AGI.
3. However, taxpayer may carryover the amount
they cannot deduct for five years.
c. Thus, Kai may deduct 6,000.
b. Personal Interest
i. Kai paid 12,000 interest on his recourse mortgage home loan.
1. 163(a) & (h). General Rule. Personal interest only deductible if
corporation, not if individual taxpayer.
a. (h)(2) Exceptions. List six things that are not treated as personal
interest, and as such, deductible.
i. (h)(2)(D). Qualified residence as defined in (h)(5).
1. Under (h)(5), qualified residence means principal
residence as defined in 121, as well as another
residence (such as a vacation house). So may
actually deduct mortgage interest on both in the
same year.
b. (h)(2)(ii) Limitation. If the mortgage outstanding exceeds
1,000,000, then no interest deduction is permitted.
2. Kai may deduct all 12,000.

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ii. Kai borrowed 25,000 from bank to purchase an SUV for personal purposes.
1. In this case, not told if Kai borrowed money against the house, so no
interest is deductible.
2. However, if told he borrowed against his house, the interest on the loan for
the SUV would be deductible under (h)(3)(A)(ii).
a. (h)(3)(A)(ii). Home equity indebtedness interest is deductible.
i. Hypo: Kais FMV of home is 360,000 and his debt
outstanding is 285,000 and borrowed against that.
1. Limitation. As said, if secure a loan with house as
security, can deduct the interest on that loan too.
But there is a limit: whatever is lessor 100,000
or difference in FMV and acquisition debt of the
house. In this problem, Kai would only be able to
borrow 75,000 (360,000 285,000), so he does
not hit the 100,000 limitation.
a. But if Kai borrowed 100,000 from the
bank and used the house as security, he
would only be able to deduct the interest
on 75,000.
c. Two Limitations on Below-the-Line Deductions
i. 67. 2% Floor Limitation.
1. Analysis.
a. First, take AGI * 2%.
b. Second, aggregate all itemized deductions that are not excluded
from this limitation under 67(b).
c. Third, may only take the itemized deductions that exceed the 2%
of AGI.
2. In this problem, both charitable deductions, and personal interest are
exempt from this 67 because listed under (b).
ii. 68. Overall limitation.
1. Remember: Must do 67 before 68, and that 67 amount is what is
relevant under 68.
2. Analysis.
a. First, under (b)(1), the applicable amount for single people is
139,500. So AGI must be over that amount for 68 limitation to
apply.
b. Second, pursuant to (a), must reduce itemized deductions by
whatever is lessor:
i. (AGI applicable amount) * 3%; or
1. 175,500 139,900 = 35,600 * 3% = 1,080
ii. 80% * itemized deductions.
1. 80% * 18,000 = 14,400
3. So, in this problem, Kai must reduce his itemized deductions by 1,080.
a. So, total itemized deductions = 18,000 1,080 = 16,920.
d. Standard Deduction versus Itemized Deduction
i. A taxpayer should take whatever is larger.

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ii. In this problem, because Kai is Head of Household, his standard deduction would
only be 4,400 pursuant to 63(c)(2). So, he should take his itemized deductions.
e. Personal Exemptions
i. 151(d). Amount is 3,050.
1. (a). Taxpayer gets one.
2. (b). Spouse gets one.
3. (c). Other qualifying dependents get one.
a. 152(e)(1). The parent who has the children more than half of the
year get the personal exemption.
b. (a)(9). If another lives in household and has under 3,050 in GI,
they may also be counted as an exemption.
i. For our purposes, we will treat Oscar as not receiving the
500,000 and not an illegal relationship under 152(b)(5).
ii. Limitation under 151(d)(3).
1. For every 2,500 increment AGI is over head of household applicable
amount of 174,400, the personal exemption amount must be reduced by
2%.
a. Note. Different numbers for different status.
2. So, in this problem, Kais AGI is 175,500, which is only over 174,400 once,
so his personal exemption of 12,200 must be reduced by 2% = 11,956
personal exemption permitted.
10. Computing Federal Income Tax of Individuals
a. Kai Computation.
i. GI:
1. Salary (125 exclusion)
174,500
2. Prize (74)
10,000
3. Property Part-Gift
15,000
4. GI =
199,500
ii. AGI:
1. Alimonry
24,000
2. AGI =
175,500
iii. TI:
1. Personal Exemption (x4)
11,956
2. Itemized Deductions
16,920
3. TI =
146,624
iv. TL = 33,802.22
b. Oscar Computation.
i. GI and AGI = 500,000
ii. Standard Deduction = 4,750
iii. Personal Exemption = 0 (phaseout completely reduced)
iv. TI = 495,250
v. TL = 154,669.50
VIII. BUSINESS, PERSONAL OR INVESTMENT

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1. What is a Deductible Business or Investment Expense?


a. 162(a). General Rule.
i. An immediate deduction is allowed for ordinary and necessary paid or incurred in
carrying on any trade or business. Taxpayers try to fall under this so they dont
have to depreciate or amortize and can deduct immediately.
1. 62(a)(1). These deductions are above-the-line if employer either by selfemployment or entrepreneur.
2. 62(a)(2). If employee, and reimbursed by employer, then above-the-line.
If not reimbursed, below-the-line.
a. However, if employer reimburses, it is a wash because the
employee must included the reimbursed amount in GI. Also,
having the same effect is if the employee tried to exclude it under
132(d) as a working condition fringe.
ii. To fall under (a), must be:
1. Necessary; and
a. Appropriate and helpful.
2. Ordinary; and
a. Two definitions must be met in order to be considered ordinary:
i. Not extraordinary; and
1. The court mostly looks at the common accepted
practices in the business community because an
expenditure may not be regular, but it may be
ordinary.
ii. Must not be appropriate for capitalization.
1. Does the expenditure last beyond the year in
question? Does is significantly affect the
business in the future? Is the expense incurred
in day-to-day operations?
b. Welch (Paid debts to re-establish relationship with former
customers. Court said not ordinary and necessary because it is a
capital outlay due to the fact that he is building up his business
which will affect future years)
3. In trade or business.
a. The Code or Regulations do not define.
b. Groetzinger (As a full time gambler, the court held he was
engaged in a full time trade or business)
i. Standard. How regular, continuous, and substantial the
activity is.
c. 212. Reversed Higgins and states that a deduction is okay for
expenses incurred in the production or collection of income, and it
is an above-the-line deduction if it is a rental and royalty income
producing activities and below-the-line deduction if cost is for
investment activity.
i. This covers businesses that are not regular, continuous,
and substantial.

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1. Examples: Tracking stock investments,
dividends, owned rental property, and other side
businesses.
d. Primuth (Employee already in trade or business, but spends
money looking for another job in trade through employment
agency the court held that was deductible)

b. Problem 8.1.1.
i. Joan is self-employed and puts ad in paper for 290,000 correcting the fact that
she was part of a Nobel Prize scientist team.
1. Rev Rule 92-80. All advertising is deductible under 162(a) although there
are future benefits.
c. Problem 8.1.2.
i. Sylvester is employed as an auto mechanic with a GI of 35,000. Pays 600 to clean
uniform. Pays 400 in union dues. Pays 500 for WSJ subscription to track his side
investments.
1. Analysis.
a. May deduct the cleaning of the uniform and union dues under
162(a). May deduct the WSJ under 212.
i. All below-the-line because not employer reimbursed, so
would have to do 67 and 68 limitation analysis:
1. 67.
a. None of his itemized deductions are
excluded under (b), so he has total of
itemized deductions for 67 purposes of
1,500.
b. 35,000 * 2% = 700
c. So, may only take 1,500 700 = 800 in
itemized deductions.
i. Thus, he should take his
standard deduction.
b. Hypo. If Sylvester also had and interest deduction under 163(h)
(3), that would not be subject to 67 because listed under (b), and
68 is not relevant because only relevant if AGI is over certain
amount.
2. Loss Deductions
a. 165(a). General Rule. Losses in a trade or business entered into for profit are deductible.
i. 165(c). Limitations (only for individuals). May only deduct loss if:
1. (c)(1). Incurred in a trade or business; or
2. (c)(2). Incurred in any transaction entered into for profit, thought not
connected with a trade or business.
b. 183. Address hobby (activities that are not for profit, like puppy breeding for fun) losses.
i. General Rule. Deductions related to that activity may only be allowed up to the
income generated from that activity.
c. Problem 8.1.3.

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i. Paolo is self-employed. Receipts of 200,000 and 162 expenses (salaries,


advertising) of 223,000. Married to Jennifer with a salary of 100,000 and they file
jointly. What is the AGI?
1. Analysis.
a. GI = 200,000 + 100,000 = 300,000
b. Above-the-Line Deductions = 223,000
c. AGI = 77,000
2. 1.165. Even if Paolo did not have his wifes GI to offset the loss, he may
still may take the 23,000 loss as a 172 NOL. He may carry that NOL
back two years or forward twenty years.
a. 108. May not take loss if there is no income to offset it.
d. Problem 8.1.4.
i. Paolo is self-employed. Receipts of 200,000 and 162 expenses (salaries,
advertising) of 223,000. Married to Jennifer with a salary of 100,000 and they file
jointly. Jennifer also sold stock for a 3,000 loss in 20003. What is the AGI?
1. Analysis.
a. Although the stock is not affiliated with Jennifers trade or
business, she does fall under 165(c)(2), so she may take the
loss as an above-the-line deduction.
b. GI = 200,000 + 100,000 = 300,000
c. Above-the-Line Deductions = 226,000
d. AGI = 74,000
3. Business or Personal
a. Introduction
i. 162(a). Meals, lodging, travel, entertainment affiliated with trade or business may
be immediately deductible if meet many requirements.
1. Note. Records must always be adequately substantiated.
ii. 274(e)(3). All limitations affect the employer, not the employee.
iii. 274(a)(1)(B). Rental payments for a facility are not deductible.
b. Meals
i. In general, meals are deductible because the business nature predominates the
personal nature.
1. Moss (Employees eating lunch everyday with each and deducting the
court said they were not deductible)
a. Holding. The business nature was not predominating the personal
nature.
ii. Process.
1. First, 162(a).
a. Must be ordinary and necessary.
2. Second, 162(a)(2).
a. Must not be lavish or extravagant.
3. Third, 1.162-1.
a. Must be directly connected with or pertaining to the taxpayers
trade or business.
4. Fourth, 274(a).

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a. Must be directly related to, or in the case of an item directly


preceding or following a substantial and bona fide business
discussion, that such item was associated with, the active conduct
of the taxpayers trade or business.
i. Directly related to defined in 1.274-2(c)(3)(i-iv). There
are four requirements.
ii. Associated with defined in 1.274-2(d)(1)(i-ii). As long
as business discussion occurred directly before or directly
after.
iii. Note. 1.274-2(d)(4). Spouses qualify for deduction if
they attend the business dinner.
5. Fifth, 274(k).
a. Must not be lavish or extravagant and the employer or an
employee must be present at the furnishing of such food or
beverages.
6. Sixth, 274(n).
a. Only 50% of the meal is deductible by the employer. Applies all
the time. Even if the employee is traveling away from home.
i. Note. If the employee pays, the employer reimburses the
employee the full amount, and then they (the employer)
may only deduct 50%.
1. Again, a wash for the employee because
reimbursement included in GI, but an above-theline deduction as well.
iii. Problem 8.2.1.
1. Employee takes client to lunch to discuss pending matter. Meal cost 120,
with only 50 incurred by employee, but employee paid it all. Employer
reimburses all to employee.
a. Meets all hurdles, so employer may deduct 50%.
iv. Hypo.
1. Employee takes client out to dinner to discuss business. At the time he
did this, the employee knew he would not be reimbursed.
a. Technically, the employee may deduct. However, she may only
deduct 50% pursuant to 274(n). Also, it is below-the-line
because the employer did not reimburse, thus, subject to 67 and
68.
v. Problem 8.2.2.
1. Employee and other employee go to lunch and discuss office politics.
a. Non-deductible because does not even pass 162(a) hurdle.
c. Travel & Entertainment
i. Lodging
1. Process.
a. First, 162(a).
i. Must be ordinary and necessary.
b. Second, 162(a)(2).
i. Must not be lavish or extravagant.

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c. Third, 1.162-1.
i. Must be directly connected with or pertaining to the
taxpayers trade or business.
d. Fourth, 274(a).
i. Must be directly related to, or in the case of an item
directly preceding or following a substantial and bona fide
business discussion, that such item was associated with,
the active conduct of the taxpayers trade or business.
1. Directly related to defined in 1.274-2(c)(3)(i-iv).
There are four requirements.
2. Associated with defined in 1.274-2(d)(1)(i-ii).
As long as business discussion occurred directly
before or directly after.
e. Fifth, 274(k). Must not be lavish or extravagant and the
employer or an employee must be present at the furnishing of
such food or beverages.
i. If primarily business trip, does not apply, and entire cost
is deductible.
ii. If primarily personal, applies.
f. Sixth, 274(n).
i. If primarily business trip, does not apply, and entire cost
is deductible.
ii. If primarily personal, applies.
ii. Transportation (Actual Travel from Place to Place)
1. Process.
a. First, 162(a).
i. Must be ordinary and necessary.
b. Second, 162(a)(2).
i. Must not be lavish or extravagant.
c. Third, 1.162-1.
i. Must be directly connected with or pertaining to the
taxpayers trade or business. Two categories:
1. Business to business; and
a. Gets no commuting deduction.
2. Away from home (meaning, taxpayer lives in MA,
but works in CA).
a. Deductible if three Flower requirements
met:
i. Reasonable and necessary
travel expense;
ii. Incurred while away from
home; and
iii. Incurred in the pursuit of
business.
d. Fourth, 1.162-2.

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i. If trip primarily business, but there is some personal, the


travel fairs are completely deductible. If the trip is
primarily personal, even if some business, the travel fares
are not deductible.
1. This depends on facts.
2. If spend long weekend after the business trip is
completed, that weekend may not be deducted.
If spend five weeks, will be treated as primarily
personal.
e. Fifth, 274(a).
i. Must be directly related to, or in the case of an item
directly preceding or following a substantial and bona fide
business discussion, that such item was associated with,
the active conduct of the taxpayers trade or business.
1. Directly related to defined in 1.274-2(c)(3)(i-iv).
There are four requirements.
2. Associated with defined in 1.274-2(d)(1)(i-ii).
As long as business discussion occurred directly
before or directly after.
f. Sixth, 274(k). Must not be lavish or extravagant and the
employer or an employee must be present at the furnishing of
such food or beverages.
i. If primarily business trip, does not apply, and entire cost
is deductible.
ii. If primarily personal, applies.
g. Seventh, 274(n).
i. If primarily business trip, does not apply, and entire cost
is deductible.
ii. If primarily personal, applies.
iii. Entertainment
1. Process.
a. First, 162(a).
i. Must be ordinary and necessary.
b. Second, 1.162-1.
i. Must be directly connected with or pertaining to the
taxpayers trade or business.
c. Third, 274(a).
i. Must be directly related to, or in the case of an item
directly preceding or following a substantial and bona fide
business discussion, that such item was associated with,
the active conduct of the taxpayers trade or business.
1. Directly related to defined in 1.274-2(c)(3)(i-iv).
There are four requirements.
2. Associated with defined in 1.274-2(d)(1)(i-ii).
As long as business discussion occurred directly
before or directly after.

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d. Fourth, 274(n).
i. Only 50% of the meal is deductible by the employer.
1. Note. If the employee pays, the employer
reimburses the employee the full amount, and
then they (the employer) may only deduct 50%.

iv. Problems
1. Problem 8.2.3.
a. Associate sent to LV for deposition and treated like a king. Hotel:
2,100. Meals: 1,500. Celine Dion show with client: 400. Airfare:
1,000. Firm reimburses.
i. Hotel.
1. If worked all save days, even if some gambling
involved, then all deductible. If worked for first
four days, and personal last three days, pro-rate
the deduction.
ii. Meals.
1. If reasonable, may deduct 50%. If traveling, it is
irrelevant if client is at the meal, the employer
may still deduct 50%. Also, if traveling, the
employer may not deduct more than 50%.
iii. Celine Dion.
1. May deduct 50% if passes 274(a) test of being
associated with.
iv. Airfare.
1. All deductible.
2. Problem 8.2.4.
a. Same as 8.2.3, but wife accompanies him so she may vacation.
The firm also reimburses the cost of her trip.
i. 274(m)(3). Non-deductible by employer.
1. Also, he would have to include the reimbursed
amount in his GI, and it is treated as a gift to his
wife.
3. Problem 8.2.5.
a. Associate lives in DC. Sent to SF for three months on project.
Cost totals 20,000, some of which includes trips home on the
weekends to take care of personal matters. Also, did not stay in
hotel, but rented an apartment.
i. Analysis.
1. Henderson
a. Rule. If an employee is on temporary
stay away from principal place of
employment, the employer may deduct
expenses from temporary location back
to home as long as three requirements
met:

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i. The business connection to the
locale of the claimed home;
ii. The duplicative nature of the
taxpayers living expenses while
traveling and at the claimed
home; and
iii. Personal attachment to the
claimed home.
ii. Note.
1. Correll
a. Overnight Sleep and Rest Rule.
Traveling salesman could not deduct
meals because he was home every
night; thus, he never had to sleep away
from home. He just left in morning, and
returned at night.
iii. In this problem, employer may deduct all. Of course, only
50% for meals.
IX. CAPITALIZATION & DEPRECIATION

1. Capitalization
a. Basic Concepts & Consumption Tax Issues
i. Many taxpayers would favor a consumption tax model for capitalization because it
supports investment due to a larger net return. However, this country uses an
income tax model for capitalization. See calculations:
1. Consumption Tax.
a. Gross Wages Available for Investment
100,000
b. Tax on Wages (Assume 30%)
0
c. Net Investment after Tax
100,000
d. Gross Return (Assume 10%)
110,000
e. Tax
33,000
f. Net Return
77,000
2. Income Tax.
a. Gross Wages Available for Investment
100,000
b. Tax on Wages (Assume 30%)
30,000
c. Net Investment after Tax
70,000
d. Gross Return (Assume 10%)
77,000
e. Tax on Income
2,100
f. Net Return
74,900
b. Doctrine When is Capitalization Required?
i. 263(a) & 1.263(a)-1 & (a)-2. Any amount paid out for new buildings or property
or for permanent improvements or betterments made to increase the value of any
property or estate when related to business or trade must be capitalized.

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ii.

iii.

iv.

v.

vi.

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1. Essentially, if the useful life extends substantially beyond the year in


question, it may not be immediately deductible under 162(a). It must be
capitalized.
2. See examples in regulations.
When capitalize, what is done?
1. First, add the cost to AB of asset.
2. Second (optional), if depreciable or amortizable (intangible asset), recover
cost over period of time.
a. Indopco.
i. Holding. Although a rare circumstance, if a taxpayer
cannot deduct because they go out of business, they may
not recover the cost.
Problem 9.1.
1. Prepayment of commercial insurance premiums covering ten-year period.
a. Analysis.
i. Boylston
1. Rule. A taxpayer should deduct insurance
premiums for each tax year the pro-rata portion
of the prepaid insurance applicable to that year
because insurance creates an asset that
extends beyond the taxable year in question.
a. Basically, straight-line amortization.
Problem 9.2.
1. Commission of 500 paid to stock broker in connection with the purchase
of stock.
a. 1.263(a)-2(e). Capitalized, so typically added to AB in stock, but
when it comes to stock, it is actually deducted from AR when sell.
Also, this is not amortizable.
i. Note. This section also says that in the case of securities
dealers, they may immediately deduct commission paid
under 162.
Problem 9.3.
1. Attorneys fees of 50,000 paid in connection with litigation by majority
shareholders to establish fair price for shares to be purchased from
minority shareholders.
a. Analysis.
i. Woodward
1. Rule. Not immediately deductible, it is added to
the AB of the shares they purchased from the
minority shareholders.
Problem 9.4.
1. Appraisal fee of 1,000 paid in connection with purchase of commercial
building.
a. 1.263(a)-2(a). Expenditure is intimately connected with the
acquisition of the asset, so it must be capitalized. The 1,000 is
added to the AB of building, and depreciated with it.

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vii. Problem 9.5


1. 5,000 spent to paint interior of office building (necessitated by wear and
tear).
a. 1.162-4. It comes down to if this is considered a repair
(immediately deductible) or an improvement.
i. Repair: Keeps property in an ordinarily efficient operating
condition.
ii. Improvement: Materially add to the value of the property
or appreciably prolong its life.
b. In this case, most likely a repair, and immediately deductible.
c. Note 1.162-6. Professional expenses, such as books, furniture,
and professional instruments and equipment, the useful life of
which is short, is immediately deductible.
viii. Problem 9.6.
1. 5,000 to patch leaky roof of commercial building or 50,000 to replace
deteriorating roof either at time of purchase or five years after purchase.
a. 1.162-4 argument again (repair versus improvement).
b. American Bember (Floor caved in and had to fix)
i. Holding. Repair, so immediately deductible.
ii. Rule. In deciding whether the expenditures may be
classed as expenses of the business or whether they
were capital expenditures, we think it is appropriate to
consider the purpose, the physical nature, and the effect
of the work for which the expenditures were made.
1. Basically, if the property is purchased, and it is in
poor shape, it most likely will be treated as an
improvement. If the property is purchased in
good shape, and then deteriorates, and have to
fix it up, it is most likely a repair.
2. Note. This case is sometimes criticized because
older and falls under a more consumption model.
c. In this problem, the 5,000 would be a repair (just have to patch a
few shingles) and immediately deductible, and the 50,000 would
be a improvement (prolonging life of asset, major duty work), and
depreciated over its own 39 year life.
ix. Problem 9.7.
1. Investment banker fees of 1,000,000 paid to facilitate a friendly takeover
by a competitor corporation.
a. Analysis.
i. Indopco
1. Rule. Expenses such as these incurred for the
purpose of changing the corporate structure for
the benefit of future operations are not ordinary
and necessary business expenses; thus, must be
capitalized.
2. Hypo. What if a hostile takeover?

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a. Analysis.
i. Staley and Proposed Regulation 1.263(a)-4(iii).
1. Costs of fighting a hostile takeover are
immediately deductible.
3. Note. Regardless if friendly or hostile, for the acquiring company, the costs
are added to the AB of the cost of acquiring the company.
x. Notes.
1. Although it seems that some costs should be capitalized instead of
immediately deductible under the preceding analyses, the IRS has issued
many Rev Rules stating that certain expenses are immediately deductible:
a. Advertising expenses,
b. Hazardous waste clean up,
c. Employee training, and
d. Severance benefits.
c. Development of Business Opportunities (Start Up Costs)
i. 195. Overrules Frank, and states that start-up costs may be amortized over a 60month period ((b)(1) beginning when the business is up and running) if two
requirements are met:
1. (c)(1)(A). The costs were paid or incurred in connection with (three types
of costs); and
a. Investigating the creation or acquisition of an active trade or
business;
b. Creating an active trade or business; or
c. Any activity before the day on which the active trade or business
begins.
2. (c)(1)(B).The costs would have been deductible under 162, if the
business or trade was already up and running.
ii. Problem 9.8.
1. Herman is about to begin a publishing company. Travels to investigate
possible acquisitions. Pays attorney for drafting purchase agreement.
Pays appraisal fee for new building. Pays salaries to train office manager
before the business begins.
a. Analysis.
i. Travel: Passes 195, so may be amortized over 60
months.
ii. Attorneys Fees: Does not meet (c)(1)(B) requirement;
thus, must be capitalized with the building.
iii. Appraisal Fee: Same as attorneys fees; thus, added to
AB of building and depreciated with the building.
iv. Training: Rev Rule 96-62. May be amortized over 60
months.
1. If business was already up and running,
remember that training costs are immediately
deductible.
iii. Problem 9.9.

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1. Herman paid attorneys fees for purchasing agreement, but then


abandoned the purchase because of material misrepresentations by the
seller.
a. Rev Rule 77-254 & 99-23. If the attempted creation of a business
or acquisition fails or is abandoned, and immediate deduction is
permitted under 165(c)(2). However, to be deductible, there
must be a focus on a specific business or investment. It cannot
be a general expense.
d. Education (Human Capital)
i. 1.162-5. General Rule. Education expenses are not deductible.
1. Two Exceptions.
a. 1.162-5(a)(1) & (c)(1). Education to maintain or improve skills
required by the individual in his existing employment or other
trade or business; or
b. 1.162-5(a)(2) & (c)(2). Education meets the express
requirements of the individuals employer imposed as a condition
to retention by the individual of existing employment, status, or
compensation.
i. Two Exceptions to Exceptions. Even if meet one of those
two exceptions, non-deductible if:
1. 1.162-5(b)(2). Pays for education that is
required in order to meet the minimum
educations requirements for qualification in the
taxpayers employment or other trade or
business; or
2. 1.162-5(b)(3). Leads to qualifying the taxpayer
for a new trade or business.
2. Example. LLM would be able to take a 162 deduction. Below-the-line if
not reimbursed. Above-the-line if reimbursed. A JD would not fall under
162, but may take under 222 or Lifetime Learning Credit.
ii. Four Code Provisions. Two give a credit from tax liability and one deducts
education expenses.
1. 25A(b). Hope Credit.
a. Only allowed to take the first two years of post-secondary
education.
b. 1,500 limitation.
i. However, can claim Hope Credit for more than one
student in the same year.
c. Again, this is a credit, so deduct from tax liability.
2. 25A(c). Lifetime Learning Credit.
a. May take for any tuition, college or just a course.
b. May take 20% of any qualified tuition (up to 10,000). Thus, 2,000
limitation.
c. Again, this is a credit, so deduct from tax liability.
3. 222. Qualified Tuition Deduction.
a. May take for any education whatsoever.

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b. (b). In 2003, 3,000 limitation if modified AGI (pursuant to (c)) does


not exceed 65,000 (130,000 if joint return). If exceeds that AGI,
then 0.
i. In 2004 and 2005, limitation goes up. This section is no
longer available come 2006.
c. This deduction is above-the-line.
4. 221. School loan interest deduction.
iii. Problem 9.10.
1. Margaret, single, with AGI and modified AGI of 40,000. Daughter,
dependent, had tuition of 10,000 for college which Margaret paid.
Margaret, a nurse, took 1,000 course in emergency room medicine.
a. Important Note. Cannot use 222 deduction and 25A if same
person, but can take 222 deduction and 25A for different
individuals. Cannot use 25A(b) and 25A(c) together for same
individual, but can take 25A(b) and 25A(c) for different
individuals.
i. Thus, must do calculations and see what saves the most
money.
b. Option One: Takes 222 for her daughter. Thus, TI, with abovethe-line deduction, standard deduction and personal exemptions
becomes 23,900. TL is 3,085.
i. From here, Margaret can take 25A(c) or 162(a) for
herself.
1. 25A(c) is the best choice, and 20% of 10,000 =
200. Again, with this being a credit, the TL is now
only 2,885.
2. If she takes 162 (which she can because
passes exception to general rule, and does not
fall under exception to the exception), but it
would be a below-the-line deduction.
c. Option Two: Take Hope Credit for daughter and Lifetime Learning
Credit for herself.
i. Hope Credit for daughter is 1,500, and Lifetime Credit for
her is 200.
d. Option Three (Best Option): Take Lifetime Learning Credit for
daughter and 222 for her.
i. That way, 2,000 credit, and 1,000 above-the-line
deduction.
e. Point. Daughter can take either 222 or Hope or Lifetime.
Margaret can take either 222 or Lifetime or 162 depending on
what takes for her daughter. Remember Important Note above.
iv. Problem 9.11.
1. Tyler had law school tuition in 2003 of 15,000. Salary in 2003 of 30,000.
a. Analysis.

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i. Can take either Lifetime Learning Credit or 222. Would
take Lifetime here, because 10,000*20% = 2,000 credit.
Which is valuable.

2. Depreciation
a. Introduction
i. Once a taxpayer has a capital expenditure under 263, he is going to want to
depreciate. However, to depreciate (recovery cost), there are four requirements:
1. Property must be used in a trade or business (167);
2. Property held for the production of income (167);
3. Asset has a finite life; and
4. Exhaustible (subject to wear and tear).
a. Examples of non-depreciable: Art, corporate stock, unimproved
land.
ii. Once the taxpayer has a depreciable asset, three things must be determined
under 168:
1. What depreciation method is used?
2. What recovery period is used?
3. What convention is used?
iii. 167 gives authorization to depreciate. All depreciation is an above-the-line
deduction.
iv. 1011 determines the AB for the cost that may be recovered.
v. 1016(a)(2) states when deduct the depreciation, reduce the AB by that amount.
vi. This country has a favorable depreciation for four reasons. See page 537. It is
more similar to a consumption tax regime than an income tax regime to encourage
purchases.
vii. Three Provisions for Depreciation. Analysis should be done in this order:
1. 179. (Bonus Section).
a. (d). Only personal property and computer software in trade or
business fall under this section. Also, from (b) limitation, assumed
just for small businesses.
b. (b). For property put into effect between 2002 and 2005, there
may be a 100,000 immediate deduction. After 2005, 25,000
immediate deduction.
i. Two limitations.
1. (b)(2). If equipment purchased is over 400,000,
then each dollar over 400,000 must be deducted
from the 100,000 immediate deduction permitted.
a. Example: Purchase 410,000 machine,
may only be able to deduct 90,000.
2. (b)(3).The depreciation deduction under this
section may only be used to offset GI, it cannot
create a loss.
2. 168(k). (Bonus Section).
a. (k)(2)(A). Only personal property with a recovery period of 20
years of less and computer software qualify.

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b. (k)(4). If new property and placed in use between May 5, 2003


and before January 1, 2005, then 50% deduction may be taken
immediately.
i. If new property and not between those years, then 30%
immediate deduction.
ii. If used, does not qualify at all.
3. 168.
a. (c). Residential rental property (80% or more dwelling units):
i. Must use recovery period of 27.5 years, must use straight
line, and must use mid-month convention.
1. Chart on xvi.
b. (c). Nonresidential real property:
i. Must use recovery period of 39 years, must use straight
line, and must use mid-month convention.
1. Chart on xvii.
c. Personal property used in trade or business for production of
income subject to finite life and wear and tear.
i. (e). Defines recovery period.
ii. Must use half-year convention.
iii. Can use double-declining balance.
1. Chart on page xv.
d. Says treat residual value as 0.
b. Depreciation of Tangible Assets
i. Problem 9.12.
1. In September 2003, Sally bought new personal property (class life of 9
years) for business for 165,000. Her TI exceeded 200,000. She wants to
use DDB.
a. 179 (bonus). She qualifies.
i. May deduct 100,000 immediately.
ii. Thus, left with AB of 65,000.
b. 168(k) (bonus). She qualifies.
i. May deduct 50% of 65,000 = 32,500.
ii. Thus, left with AB of 32,500.
c. 168. DDB.
i. Under (e), property will be treated as 5-year property.
ii. Under chart xv, in 2003, may deduct 32,500 * 20% =
6,500.
d. Thus, in 2003, Sally may deduct 100,000 + 32,500 + 6,500 =
139,000.
ii. Problem 9.13.
1. On August 1, 2003, Ted bought commercial building which he used solely
for his business operations. He paid 350,000 for the building. What could
he deduct in 2003 and 2004?
a. Analysis.
i. Because real property, is not eligible for two bonus
provisions.

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ii. Use Chart xvii because non-residential real property.
1. In 2003, 350,000 * .96% = 3,360.
2. In 2004, 350,000 * 2.564% = 8,974.

c. Depreciation of Intangibles
i. 197(a). Intangibles that qualify must be amortized ratably over 15 years using
straight line.
1. Ratably means must actually, for the first year and last year, count down
to the days.
2. This is an above-the-line deduction like depreciation.
3. (c) & (d). To qualify as an intangible must be used in trade or business and
purchased after August 10, 1993 and cannot be self-created. Thus, this
includes:
a. Goodwill;
b. Going concern value;
c. Licenses; and
d. Covenant not to compete.
i. (f)(1)(B). Even if covenant not to compete is for three
years, must be amortized over 15 years.
ii. Note. Computer software is eligible for the 179 and 168(k) bonuses, and then it
falls under 197.
iii. Problem 9.14.
1. Leslie, on July 1, 2003, purchased goodwill for 50,000 and covenant not
to compete for 25,000.
a. Analysis.
i. Not computer software, so does not qualify under
bonuses.
ii. 197.
1. In 2003, 75,000 * 6/12 * 1/15 = 2,500.
2. In 2004, 75,000 * 1/15 = 5,000.
X. ADVANTAGES OF PROPERTY OWNERSHIP
1. Introduction
a. We have see property gains all semester, this topic is just variations on that.
b. 1001. Addresses recognition of gain or loss on the sale or disposition of property. Again,
AR AB.
i. (b). Addresses calculating AR.
ii. (c). States 1001 is subject to all others in the Code and determines recognized
gain.
c. 1011 & 1012.
i. Address calculating AB.
ii. 1016. Improvements increase AB and depreciation deductions decrease AB.
2. Realization & Recognition
a. Realization. An exchange gives rise to a realization even so long as the exchanged
properties embody legally distinct entitlements.

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b. Recognition. With respect to gains, the term recognition refers to the issue of whether a
realized gain is included in GI.
c. Problem 10.1.
i. Margaret owns vacant land (which means, unimproved) which she bought for
125,000. Sold to Jide for 138,000.
1. Analysis.
a. Margaret: Recognized gain is 13,000 and must include in GI
under 61.
b. Jide: AB is 138,000.
3. Non-Recognition Disposition of Principal Residence
a. Problem 10.2.
i. Mark and Millie married. Purchased principal residence on January 1, 2001 for
500,000. Sold in February 2003 for 795,000. In the summer months (June, July
and August) they spend most of their time in their beach house.
1. 121(a). One of the sections that trumps 1001(c), and states, that if a
taxpayer sells their principle residence, the gain is not recognized if they
have lived in the residence at least two years out of the five years
preceding the sale.
a. Two Limitations.
i. (b)(1) & (2). May only exclude up to 250,000 if single.
And may exclude 500,000 if joint if meet three
requirements:
1. At least one of the spouses owns;
2. Both spouses meet the use requirement; and
3. Neither of the spouses has used this section in
the past two years.
ii. (b)(3). May only take every two years.
2. 1.121-1(c)(2). Addresses determining if principal residence. States that it
is primarily a time based test and asking what residence was used most.
a. Further states use of vacation house still goes towards the time of
using the principle residence.
3. So, in this problem, Mark and Millie may exclude the 295,000 gain.
b. Problem 10.3.
i. Sandra, single, bought her house in January 2003 for 250,000. In June 2004, she
sold it for 475,000 and used the proceeds to buy a condo with one level because
she was old.
1. 121(c)(2)(B). Exception to two-year requirement:
a. May exclude gain from GI if sell principal residence for health
reasons, or new employment (can be different employer or same
employer in a different location).
i. 1.121-3T(d)(2). Safe harbor provision that says taxpayer
will qualify if gets recommendation from physician.
b. Limitation. Must pro-rate the dollar limitation if have not lived
there for two years. In this case, Sandra has lived there for 1.5
years.

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i. Thus, the 250,000 limitation must be multiplied by 1.5/2 =


187,500.
ii. So, Sandra may exclude up to that amount from GI.
ii. Hypo. Sandra sold her home to accept a new job in another state.
1. 121(c)(2)(B). Exception to two-year requirement:
a. May exclude gain from GI if sell principal residence for health
reasons, or new employment (can be different employer or same
employer in a different location).
i. 1.121-3T(c)(2)(ii). Safe harbor provision that says
taxpayer will qualify if new employment is at least fifty
miles away from old employment.
b. Limitation. Again, must pro-rate limitation.
4. Like-Kind Exchanges
a. 1031. This is another section that trumps 1001(c); thus, if a taxpayer can fall under it
with a like-kind exchange, they will not have to recognize any gain in their property
exchange.
i. Policy. Provides incentive for reinvestment in property that is held for productive
use. Thus, like a consumption tax. This section is not elective, it automatically
applies.
ii. (a). General Rule. No gain or loss recognized on the exchange or property held for
productive use in a trade or business or for investment if such property is
exchanged solely for property of like kind which is to be held for productive use in
a trade or business or for investment.
iii. (a)(2). Exceptions.
1. Must be for productive use in business or investment.
2. Cannot be inventory.
3. Stock for stock.
iv. (b). Address gains from not solely in kind. The recognized will be the amount of
the non-like kind boot.
1. Gain Analysis.
a. Realized gain = FMV received + debt relief + boot received (or
boot paid) old AB debt assumed.
b. Recognized gain = debt relief + boot received debt assumed.
v. (c). Addresses losses from not solely in kind.
vi. (d). Addresses AB. States the taxpayer keeps their old AB and adjusts it with any
recognized gain or loss. Thus, gain or loss deferred.
1. AB Analysis.
a. If received boot:
i. AB = Old AB - lessor of boot received or realized gain +
recognized gain (or - recognized loss) + debt assumed
debt relief.
1. AB will actually only change if the lessor amount
is the realized gain and not the boot.
b. If gave boot:
i. AB = Old AB + boot paid + recognized gain (or recognized loss) + debt assumed debt relief.

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b.

c.

d.

e.

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c. (d) also states that if property transferred subject to debt, the


transferor will treat it as boot received and an AB adjustment will
occur.
d. 1.1031(d)-2. Helps with all calculations.
vii. 1.1031(a)-2. Discusses how to qualify for a like kind exchange.
1. Real Property: Extremely easy to qualify. Even if taxpayer exchanges a
vacant land for land with building, it is like kind.
2. Personal Property: More difficult to qualify. See regulation for General
Asset Classes.
Problem 10.4.
i. Tyler exchanges vacant land (unimproved) with an AB of 100,000 and FMV of
130,000. In exchange, Mercedes gives a sailboat with an AB of 85,000 and FMV
of 130,000.
1. Analysis. Non-like kind, so 1031 does not apply.
a. Tyler: AR is 130,000. AB is 100,000. Recognized gain of 30,000.
b. Mercedes: AR is 130,000. AB is 85,000. Recognized gain of
45,000.
Problem 10.5.
i. Bugs Whiteacre: AB 100,000 and FMV 200,000.
ii. Daffy Blackacre: AB 90,000 and FMV of 170,000 and Cash of 30,000.
1. Analysis. Like kind because real property, but not solely kind.
a. Bugs:
i. Realized gain of 100,000.
1. Must recognize 30,000 gain and include in GI
because that in non-like kind amount.
ii. AB: 100,000 (old AB) 30,000 (lessor of realized gain or
boot received) + 30,000 (recognized gain) = 100,000
b. Daffy:
i. Realized gain of 80,000.
1. Nothing recognized because from his end, all
like-kind.
ii. AB: 90,000 (old AB) + 30,000 (boot received) = 120,000.
Problem 10.6.
i. Bugs Whiteacre: AB 100,000 and FMV 200,000.
ii. Daffy Blackacre: AB 90,000 and FMV of 170,000 and Cash of 30,000.
1. Daffy wants to sell Blackacre for cash, but Bugs wants a like kind
exchange. Can both be accommodated?
a. Klein Analysis.
i. Must use a third party. Daffy sells property to third party.
Third party would then exchange the land to Bugs. This
is okay as long as the cash that will eventually go to Daffy
is in escrow and Bugs or Daffy does not have discretion
over it, then it is okay.
ii. Bugs recognizes 30,000 gain and Daffy would recognize
full gain.
Problem 10.7.

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i. Bugs Whiteacre: AB 100,000; FMV 200,000; Mortgage 70,000


ii. Daffy Blackacre: AB 90,000; FMV 170,000; Cash 20,000; Mortgage 60,000
1. Analysis. Like kind because real property, but not solely like kind.
a. Bugs:
i. Realized gain = 170,000 (FMV received) + 70,000 (debt
relief) + 20,000 (boot received) 100,000 (old AB)
60,000 (debt assumed) = 100,000
ii. Recognized gain = 70,000 (debt relief) + 20,000 (boot
received) 60,000 (debt assumed) = 30,000.
iii. AB = 100,000 (old AB) - 20,000 (lessor of boot received
or realized gain) + 30,000 (recognized gain) + 60,000
(debt assumed) 70,000 (debt relief) = 100,000.
b. Daffy:
i. Realized gain = 200,000 (FMV received) 90,000 (old
AB) 20,000 (boot paid) + 60,000 (debt relief) - 70,000
(debt assumed) = 80,000.
ii. Recognized gain = 0. Because from his perspective it is
all like kind because he is receiving more debt than he
had. If Bugs did not have a mortgage, Daffy mortgage
relief would be considered boot.
iii. AB = 90,000 (old AB) + 20,000 (boot paid) + 70,000 (debt
assumed) 60,000 (debt relief) + 0 (recognized gain) =
120,000.
Problem 10.8.
i. Bugs Whiteacre: AB $100,000; FMV $200,000; Mortgage $70,000
ii. Daffy Blackacre: AB $90,000; FMV $170,000; Stock $20,000 (AB $8,000);
Mortgage $60,000
1. Analysis. Like kind because real property, but not solely like kind. Stock
treated like boot received for Bugs, but must separate out that AB. And for
Daffy, he must recognize all of the gain on the stock because does not
qualify under 1031.
a. Bugs:
i. Realized gain = 170,000 (FMV received) + 20,000 (boot
received) + 70,000 (debt relief) 100,000 (old AB)
60,000 (debt assumed) = 100,000.
ii. Recognized gain = 20,000 (boot received) + 70,000
(mortgage relief) 60,000 (debt assumed) = 30,000.
iii. Land AB = 100,000 (old AB) 70,000 (debt relief) +
60,000 (debt assumed) + 30,000 (recognized gain)
20,000 (boot received) = 100,000.
iv. Stock AB = 20,000.
b. Daffy:
i. Stock: 12,000 recognized gain.
ii. Land:
1. Realized gain = 200,000 (FMV received) +
60,000 (debt relief) - 20,000 (stock (boot) given)

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70,000 (debt assumed) 90,000 (old AB) =
80,000.
2. AB = 90,000 (old AB) + 70,000 (debt assumed)
60,000 (debt relief) + 8,000 (old AB in stock) +
12,000 (stock recognized gain) = 120,000.
XI. CAPITAL GAINS & LOSSES

1. Introduction
a. 1(h). Congress injected it preference for net capital gains.
i. A net capital gain is pulled out from ordinary TI before it is plugged into the tax
table. And then, that net capital gain will be tax preferential. Note. These
preferential rates are only permitted for individuals, not corporations.
ii. Under 1(h), net capital gain is taxed at:
1. 5% if ordinary income is taxed at marginal rate below 25%;
2. 15% otherwise;
3. 25% if sale of depreciable property under 1250; or
4. 28% if collectibles.
b. 1221 & 1222. To qualify for a capital gain or loss, must have:
i. A capital asset;
1. Everything (whether or not trade or business) except:
a. Inventory;
b. Personal property used in trade or business subject to
depreciation;
i. Note. See 1231 & 1245.
c. Real property used in trade or business;
i. Note. See 1231 & 1250.
d. Copyright; or
e. Notes (accounts) receivable.
ii. That is sold or exchange.
1. Short Term: Property held under a year.
2. Long Term: Property held more than a year.
c. Policy. This country has a preferential rate for four reasons:
i. Revenue raiser because encourages sales and exchanges of assets;
ii. Efficiency (property moves where it is needed most);
iii. Prevent bunching (because allows people to sell accumulated gain); and
iv. Encourage investment in capital (expands economy).
1. Huge Doubts to this Policy: Empirical evidence to the contrary.
d. Process.
i. First, 61. All capital gains (short term and long term) are added to arrive at GI.
ii. Second, 165(c)(2). All capital losses (short term and long term) are deducted to
arrive at AGI (thus, above-the-line deductions).
1. Limitations.
a. 1211.
i. Corporations: May only offset gains.

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ii. Individuals: May offset gains plus an additional 3,000.


(So, if no gain, but losses, may take up to 3,000 in
losses).
b. 1212.
i. Corporations: May carry back three years as long as
does not create or increase NOL, or may carry forward
five years.
ii. Individuals: May carry forward LTCL indefinitely. STCL
must be carried forward only one year.
1. Remember, must offset, but receive that 3,000
cushion.
iii. Third, take below-the-line itemized deductions or standard deduction, and
personal exemptions to arrive at TI.
iv. Fourth, 1222(11). Take out net capital gains from TI to tax at preferential rate, and
put remaining TI in tax table.
1. Net capital gain = Net LTCG Net STCL (if there is one); or
a. (LTCG LTCL) (STCL STCG) (if there is one).
i. 1(h)(11). Qualified dividends are added to LTCG once
calculated and treated at preferential rate.
b. Apply applicable rate.
2. When Gains Exceed Losses and Losses Exceed Gains
a. Problem 11.5(a).
i. XYZ Stock: Bought 3.1.03 for $25,000; Sold 12.20.03 for $40,000.
ii. T Stock: Bought 6.4.01 for $8000; Sold 8.20.03 for $20,000.
iii. ZT Stock: Bought 2.1.03 for $53,000; Sold. 11.1.03 for $42,000.
iv. Y Stock: Bought 8.1.02 for $30,000; Sold 9.1.03 for $20,000.
1. XYZ: Realized Gain of $15,000. STCG.
2. T: Realized Gain of $12,000. LTCG.
3. ZT: Realized Loss of $11,000. STCL.
4. Y: Realized Loss of $10,000. LTCL.
a. Total Gains = 27,000. Total Losses = 21,000.
v. Analysis.
1. GI = 125,000 (salary) + 15,000 (STCG) + 12,000 (LTCG) = 152,000.
2. AGI = 152,000 (GI) 11,000 (STCL) 10,000 (LTCL) = 131,000.
3. TI = 131,000 (AGI) 4,750 3,050 = 123,200.
a. Net Capital Gain = (12,000 10,000) 0 (because no Net STCL)
= 2,000
b. Thus, ordinary TI becomes 121,200.
c. And, net capital gain becomes 2,000 (taxed at preferential rate of
15% because ordinary TI is not taxed at a marginal rate below
25%).
b. Problem 11.5(b).
i. STCG: $15,000
ii. LTCG: $12,000
iii. STCL: $11,000
iv. LTCL: $20,000

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1. Total Gains = 27,000. Total Losses = 31,000.


2. Analysis.
a. GI = 125,000 + 27,000 = 152,000.
b. AGI = 152,000 30,000 = 122,000.
i. Limitation. Losses can only offset gains with 3,000
cushion. So, she may deduct 27,000 because that would
offset gains + 3,000 cushion; permitting a 30,000
deduction.
1. The 1,000 loss she cannot take may be carried
over indefinitely as a LTCL because she has a
LTCL.
c. TI = 122,000 4,750 3,000 = 114,250.
i. All ordinary because no net capital gain.
c. Problem 11.5(c).
i. MNB: LTCL of $13,000.
ii. DBB: LTCG of $5,000.
iii. ZZZ: LTCL of $12,000.
iv. RST: LTCG of $7,000.
1. Total Gains = 12,000. Total Losses = 25,000.
2. Analysis.
a. Because of limitation, may only deduct 15,000 in losses. And
10,000 carried over as LTCL. Again, because of loss, no net
capital gain.
d. Problem 11.5(d).
i. STCL of $12,000.
1. Analysis.
a. Because of limitation, may only deduct 3,000 in losses. The
9,000 is carried over as a STCL because she does not have any
LTCL. Thus, it may only be carried over for one year.
e. Problem 11.5(e).
i. STCL of $12,000.
ii. STCG of $3,000.
iii. LTCG of $4,000.
1. Total Gain = 7,000. Total Loss = 12,000.
2. Analysis.
a. Must include 7,000 in GI. May only deduct 10,000 to arrive at
AGI. 2,000 loss she could not take is carried over as a STCL
because she did not have any LTCL. Thus, it may only be carried
over for one year.
f. Problem 11.6.
i. Marsha has AB in painting of 50,000. Two years later, the FMV is 75,000 and she
donates it to a charitable organization. Her AGI is 100,000.
1. Analysis.
a. 1.170A-1(c). States the amount of the deduction will be FMV or
the property donated subject to 170(e), which states:
i. FMV must be reduced if:

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1. STCG, may only deduct AB, not FMV; or


2. LTCG on tangible personal property, and the
donees use is unrelated to the purpose or
function constituting the basis, then may only
deduct AB and not FMV.
a. Thus, real property does not apply.
b. Note. Remember other charitable limitations discussed under Kai
problem.
c. (d). May carry over deductions that could not take for five years.
2. In this case, if assumed the painting is hung up in the charitable
organization, then it is related use, and Marsha may deduct 75,000.
However, remember other limitations, if able to deduct FMV, then it cannot
exceed 30% of AGI. So, in this case, Marsha may only deduct 30,000,
and the 45,000 may be carried over.
3. Depreciation Recapture
a. 1231. Created to provide relief from 1221(a)(2) because things under that are not
subject to capital gains and thus, preferential rate. To fall under 1231, must have:
i. Personal property used in a trade or business subject to depreciation and held for
at least one year; or
1. If this is true, apply 1245. (Deprecation Recapture Rule)
a. Note. Whenever depreciate, make sure to invoke this rule.
ii. Real property used in a trade or business subject to depreciation and held for at
least a year.
1. If this is true, apply 1250.
b. Problem 11.7.
i. On September 1, 2003, Morris purchase personal property for 200,000 (with a
class life of 7 years) and placed in business. He sold that property on March 1,
2010 for 30,000.
1. 1245 Analysis.
a. AB was 200,000, but because 5 year depreciable life, Morris
deducted all 200,000.
b. (a)(1). States that the lower of (1) recomputed basis or (2) AR is
deducted from AB to get to ordinary income. The rest of gain
realized is treated as capital.
i. Recomputed Basis = Current Basis + All Depreciation
Deductions
c. Thus, in this problem, Morris recomputed basis is 200,000 and
his AR is 30,000. Thus, he takes the lower, 30,000.
d. Gain Recognized = Lower of the two actual AB.
i. 30,000 0 = 30,000 (treated as ordinary income).
ii. Hypo. Morris sells for 210,000.
1. Recomputed Basis = 0 + 200,000 = 200,000.
2. AR is 210,000.
a. Thus, uses 200,000.
b. Gain Recognized = 200,000 0 = 200,000 ordinary income. But
the other 10,000 of AR may be treated as capital gains.

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c. Problem 11.8.
i. On May 6, 2003, Tamara purchased a commercial building for 350,000 which she
used solely for her advertising business. She sold it on July 1, 2006 for 340,000.
1. 1250 Analysis.
a. Take lower of additional depreciation (which will always be 0 in
our cases because real property may only use straight line) or
actual AB after depreciation.
b. Deprecation Taken:
i. By putting in chart xvii, the total deprecation Tamara took
before she sold was 28,417. Leaving her with an AB of
350,000 28,417 = 321,583.
c. Realized Gain:
i. = 340,000 321, 583 = 18,417 and this is always
recognized as LTCG because we always take 0 from
above.
1. So what is the point of 1250?
a. Because although will always be treated
as LTCG, under 1(h), 1250 property
gets its own preferential rate of 25%.

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